"By Justin Lahart
Reeling from the housing bust and the banking crisis, it’s hard to think that the energy shock — the one that carried the average price of gasoline to a peak of $4.11 a gallon last July — was much more than a minor player in the economic downturn. But there’s the uncomfortable fact previous oil shocks, like the ones that came with the 1973 oil embargo, the 1979 Iranian revolution and the 1990 invasion of Kuwait, were also associated with recessions. And the 2001 recession, too, came on the heels of a run-up in oil prices.
In a paper presented at the Brookings Panel on Economic Activity Thursday, University of Calif.-San Diego economist James Hamilton crunched some numbers on how consumer spending responds to rising energy prices and came to a surprising result: Nearly all of last year’s economic downturn could be attributed to the oil price shock.
As he writes on his blog, that’s a conclusion that he doesn’t quite believe in himself. We’d like to think that, say, the seizing up of the credit markets this fall had something to with the economy falling off the table in the fourth quarter.
But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.
A more controversial argument on energy’s role in the credit crunch could go like this. Housing prices kept on climbing, but the Federal Reserve – laboring on the idea that it couldn’t identify bubbles and that even if it could, it shouldn’t pop them — didn’t do anything about them. But then rising oil prices started adding to inflationary pressures, so the Fed kept pushing rates higher, left them high even as housing prices collapsed, and was to slow to lower them when the credit crisis got rolling."
And, from Econbrowser:"Consequences of the Oil Shock of 2007-08
In a follow-up on my earlier post, I'd now like to discuss the second part of my paper, Causes and Consequences of the Oil Shock of 2007-08, which I presented today at a conference at the Brookings Institution. Here I'll review the role that the oil price shock may have played in causing the economic recession that began in 2007:Q4.
My paper uses a number of different models that had been fit to earlier historical episodes to see what they imply about the contribution that the oil shock of 2007-08 might have made to real GDP growth over the last year. The approaches surveyed include Edelstein and Kilian (2007), who examined the detailed response of various components of consumer spending, Blanchard and Gali (2007), who studied the extent to which the contribution of oil shocks has significantly decreased over time, my 2003 paper, which emphasized the role of nonlinearities, and a model-free data summary of the observed behavior of different economic magnitudes following this and previous oil shocks. Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.
One of the most interesting calculations for me was to look at the implications of my 2003 model. I used those historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?
The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.
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The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don't fully believe myself. Unquestionably there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.
It is interesting also that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters. The mortgage delinquencies and financial turmoil in the current episode are of course not the specific stresses that operated in earlier downturns, but the broad features of that multiplier process are surprisingly similar to the historical pattern.
My paper concludes:
Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.
Technorati Tags: oil, oil prices, oil shocks
Posted by James Hamilton at April 2, 2009 07:27 PM"
"A more conventional policy tool would be monetary policy. A number of observerssuggested that the very rapid declines of short-term interest rates in 2008:Q1 fanned the
flames of commodity speculation, with negative real interest rates encouraging investments
in physical commodities (e.g., Frankel, 2008). In January 2009, Federal Reserve Chair Ben
Bernanke offered the following retrospective on that debate:
The [Federal Open Market] Committee’s aggressive monetary easing was not
without risks. During the early phase of rate reductions, some observers expressed
concern that these policy actions would stoke inflation. These concerns
intensified as inflation reached high levels in mid-2008, mostly reflecting a surge
in the prices of oil and other commodities. The Committee takes its responsibility
to ensure price stability extremely seriously, and throughout this period
it remained closely attuned to developments in inflation and inflation expectations.
However, the Committee also maintained the view that the rapid rise in
commodity prices in 2008 primarily reflected sharply increased demand for raw
materials in emerging market economies, in combination with constraints on the
supply of these materials, rather than general inflationary pressures. Committee
members expected that, at some point, global economic growth would moderate,
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resulting in slower increases in the demand for commodities and a leveling out in
their prices—as reflected, for example, in the pattern of futures market prices. As
you know, commodity prices peaked during the summer and, rather than leveling
out, have actually fallen dramatically with the weakening in global economic
activity. As a consequence, overall inflation has already declined significantly
and appears likely to moderate further.
Bernanke seemed here to be taking the position that since the Fed got the long run
correct (ultimately there would be a significant downturn in both the economy and commodity
prices, with strong disinflationary pressure), the short-run consequences (booming
commodity prices in 2008:H1) were less relevant. On the other hand, if it is indeed the
case that the spike in oil prices was one causal factor contributing to the downturn itself,
there are concerns to be raised about ignoring those short-run implications. The evidence
examined here is consistent with the claim that if a slower easing of interest rates in 2008:H1
had succeeded in mitigating the magnitude of the oil price run-up, the result could well
have been a better outcome in terms of the 2008:H1 real GDP growth rate. Although the
Fed is not accustomed to think in such terms— that a rapid lowering of rates could actually
exacerbate the magnitude of an economic downturn— I think there is some reason to take
such a possibility seriously in this case.
But while the question of the possible contribution of speculators and the Fed is a very
interesting one, it should not distract us from the broader fact: some degree of significant
oil price appreciation during 2007-08 was an inevitable consequence of booming demand and
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stagnant production. It is worth emphasizing that this is fundamentally a long-run problem,
which has been resolved rather spectacularly for the time being by a collapse in the world
economy. However, the economic collapse will hopefully prove to be a short-run cure for the
problem of excess energy demand. If growth in the newly industrialized countries resumes at
its former pace, it would not be too many more years before we find ourself back in the kind
of calculus that was the driving factor behind the problem in the first place. Policy-makers
would be wise to focus on real options for addressing those long-run challenges, rather than
blame what happened last year entirely on a market aberration."
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