Energy spikes and economic growth

August 22, 2011 | By | Reply More

Troy Media – By Will Van’t Veld

Economists love to find relationships between different prices in the economy. And one of the prices they love deciphering the most is that for crude oil. It’s so important to the global economy that even modest movements in its price can have big impacts.

But oil price movements between 2000/2008 showed some unusual patterns – ones that have prompted some economists to re-examine the relationship between oil prices and general economic growth.

Oil prices and the economy

The price of crude oil quadrupled during the period of economic expansion that led up to the ‘Great Recession’. Typically, we’d expect that energy price increases of this magnitude would have a dampening effect on economic growth in oil importing nations like the United States, but U.S. growth powered ahead regardless before being halted by a cancerous mortgage sector. So was this period just an anomaly? With gasoline prices surging again, it’s a question worth asking.

A common analogy that is made to explain how high energy prices impact the economy is to equate it with a tax hike. Households often find it difficult to avoid driving, and higher gas prices lowers the amount of cash they have to spend elsewhere. But whereas tax revenues tend to be spent locally, dollars spent importing oil is an outflow of cash to foreign countries.

Automobile and energy intensive equipment sales are also negatively affected when crude prices jump, either because such investments are delayed due to uncertainty, or because some past investments become obsolete sooner and aren’t replaced. For instance, an older tractor-trailer might make economic sense when diesel is $.75 cent/litre. But at $1.25/litre, the farmer has to decide: re-invest in a more fuel-efficient vehicle, or exit the business.

Before making any major investment decision, some delay could be expected, which would stall economic activity. Once the decision is made there will also be some economic loss due to transition costs which occur when a company has to alter its product line (such as Detroit automakers moving away from big SUVs towards more fuel-efficient cars).

If energy prices become incorporated into higher retail prices, central banks become concerned about inflation. In a worse case scenario, the higher prices consumers see at the pump create expectations of higher future inflation, causing wage demands to increase (as workers want to maintain their material standard of living). A wage-price cycle and dreaded stagflation (i.e. high unemployment and rising prices) is then possible.

Different emphasis has been placed on these arguments over the past few decades to explain why energy price shocks have historically been followed by recessions or slow growth. Why this past decade may have been unique was the subject of a recent paper produced by economists at the International Monetary Fund (IMF).

In other eras, crude oil shocks were contrived by oil exporting nations or geo-political fear. In the most recent decade, by contrast, it was primarily driven by strong demand and tight supplies. According to the authors of the IMF paper, this might have resulted in a much higher level of demand for U.S. goods and services from emerging market economies than in the past.

Consumers more easily absorbing oil price increases

Professor James Hamilton of the University of California, who has been called before Congress to explain the relation between energy prices and the U.S. economy, has a simpler explanation as to the more muted effect over the past decade: the proportion of U.S. income spent on energy had dropped significantly, making it easier for consumers to absorb rising energy costs (a gap which has since closed). Other reasons put forward include better monetary policy and a more service-sector oriented economy.

Fast-forward to today: the year-over-year amount Americans spent on energy in the second quarter of 2011 jumped by about $100 billion dollars, accounting for 20 per cent of the increase in total consumer spending over the period. That tax analogy mentioned above now doesn’t sound far fetched, which means expecting strong U.S. growth despite high gas prices might be wishful thinking.

Will Van’t Veld is an economist with ATB Financial.

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Category: Alberta, Business

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