The world today is in the middle of another grave energy crisis percolating in the OPEC nations and spilling over to rest of the world in respect to oil—the 21st Century’s most significant tradable natural resource. Bent crude oil prices have now dropped below $50, the sharpest fall seen in over a decade. While the benefit of lower oil prices seems to be passing to the consumer base of emerging markets, the economies of petro-states seem to be in shackles.

Without getting too much into the reasons for this particular crisis, it would be quite relevant to analyze the impact of oil price shocks on a dependent nation’s economy while reviewing the historical link between them. But what can history offer in better understanding the link between sharp fluctuations in oil prices and the economies dependent on it? Historical evidence, according to James Hamilton, indicates that “Nine out of ten of the US recessions since World War II were preceded by a spike up in oil prices”. While few scholars contest that this is more than mere coincidence, there is a little consensus among economic historians as to its meaning.

What does the history say?

Two 1970s episodes empirically showed how sharp fluctuations in oil prices could cause major economies like the US itself to crash or witness long term downturns. The 1970s were an interesting period in economic history for a number of reasons. It was a period that saw a high rate of inflation, economic downturn & increasing unemployment all at the same time period, leading to the coining of this period as the ‘Great Stagnation’.

The two significant periods of inflation in the 1970s and early 1980s were preceded by oil supply shocks in 1973/4 (OPEC Embargo I) and 1978/9 (Iranian Oil Crisis), lending credence to the view that oil price shocks were responsible for the bout of stagflation. Also, with the breakdown of the Bretton Woods System, the 1970s saw the implementation of a new monetary policy regime where the convertibility of US dollars to gold was suspended (the Nixon Shock). This created a new paradigm between the use of monetary policy and achieving economic objectives, adding to the complexity of disentangling whether oil price shocks or monetary policy were responsible for the downturn.

More recently, the role played by monetary policy during periods of oil price shocks has offered an alternative explanation. Some commentators argue that oil shocks precipitated the mechanism by which monetary policy led to an economic contraction. Other economic historians take this view even further, suggesting that monetary policy can actually account for all of the downturn as well as the oil shock itself. This view, while causing quite a stir amongst economic historians, has done little to prove that periods like the 1970s, 80s, 90s, and the current decade provide no or lesser evidence in offering a tangible link between sharp oil price fluctuations and consequent economic downturns seen across the regions.

The ‘Oil Price Effect’    –>  Economic Shock

There are several mechanisms through which an oil price shock (defined as an unanticipated change in the level of oil prices) could affect the economy. The first is through its effects on aggregate supply,where the explanation commonly begins with the production function relating the output (Y), produced by a particular firm, to its inputs of labor (L), capital (K), and energy (E).

Y=f (L,K,E)

Holding L and K equal when energy prices rise, firms cut back on their energy use, implying that less output is produced at any particular level of capital and labor. An increase in energy prices is therefore an adverse supply shock. A further area of investigation requires one to study the effect of oil price shocks on productivity. The idea here is that a reduction in the use of energy could reduce the productivity of labor and/or capital. The table below shows how productivity grew much slower after 1973. In fact, between 1973 and 1982, productivity growth was negative.

Table 1: Sources of Economic Growth in the United States (Denilson) (% per year)

Table1 DM

Source: Blanchard (2000)

 

Similarly, a related effect of oil in addition to productivity levels can be seen with respect to the level of employment. The NAIRU (non-accelerating inflation rate of unemployment) is the unemployment rate compatible with stable inflation. On the supply side, it is argued that real wage claims of labor unions increase after an oil shock. Richard Layard & Stephen John Nikell (1991) in their book that due to wedge effects, the wage setting curve is affected by oil price shocks.

For example, labour unions push to increase real wages by raising nominal wages, since the real price of oil and foreign consumption goods have increased. Layard et al (1991) then argued that this mechanism might be able to explain the asymmetric effects of oil prices as “Real wage resistance does not work so strongly in reverse,” although they do concede that they lack much in the way of evidence or theory to support the claim.

Another critical area of focus in studying an oil price shock effect is seeing its effect on the demand side, i.e. how oil shocks can lead to a reduction in demand for goods and services prompted by energy price shocks. Hamilton (2008) argues that the key mechanism through which energy price shocks affect the economy is through disruptions in consumer and business spending on goods and services. One such mechanism can be explained by the ‘sectoral shocks hypotheses’. As a model this hypothesis incorporates two direct effects, the uncertainty effect and the operating cost effect (Kilian, 2008b).

The uncertainty effect occurs when changing energy prices creates uncertainty about the future path of prices, leading consumers to delay or forego purchases of consumer durables. The operating cost effect similarly is the result of uncertainty created by changing energy prices; for example, households delaying the purchase of energy-using durables, such as motor vehicles. As the dollar value of such purchases may be large relative to the value of the energy they use, even relatively small changes in energy process can have large effects on output. It is argued that the absence of domestically produced fuel efficient automobiles in the US during the 1970s meant that consumers, conscious of increasing fuel prices, turned to the smaller fuel efficient foreign produced vehicles leading to a fall in US automobile sales (given below).

Figure 1: Oil Price Uncertainty and real consumption of durables (1971-2003)

Figure 1DM

Source: Barksy and Killian (2004)

 

Additionally, industries related to the automobile sector are likely to be most affected with rapid fluctuations in oil price levels. There is evidence that steel and transport equipment, two industries closely tied to the production of automobiles, declined sharply in the UK and the US, both of which produced less fuel efficient vehicles (read Bohli (1989) for more). On the other side, Japan and Germany, two countries that domestically produced fuel efficient automobiles, showed less of a decline or even growth in steel and transport equipment.

From all this, recently, the main effect felt from rapidly fluctuating oil price levels seems to be on the riskiest and most vulnerable bits of the oil industry, including, as the Economist explains:

“American frackers who borrow heavily on the expectation of continuing high prices. They also include Western oil companies with high-cost projects involving drilling in deep water or in the Arctic, or dealing with maturing and increasingly expensive fields such as the North Sea. But the greatest pain is in countries where the regimes are dependent on a high oil price to pay for costly foreign adventures and expensive social programmes. These include petro-states like Russia (which is already hit by Western sanctions following its meddling in Ukraine) Venezuela, Iran. Optimists think economic pain may make these countries more amenable to international pressure. Pessimists fear that when cornered, they may lash out in desperation.”

The core academic debate, however, as to what extent oil price shocks play a role on an economy’s performance is likely to continue for some time especially observing the impact factor of sharply falling crude oil prices on petro-states today. It is exceedingly difficult to isolate the individual effect of oil price shocks given the economic backdrop and the associated monetary policy response. Yet the emerging view that monetary policy plays a much bigger role than oil price level changes may provide some important lessons for the future.

 

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This article is a summarized piece from a detailed working paper entitled, “Macroeconomics of Oil Prices and Economic Shocks” that will be presented at the International Conference for Humanities and Education,2015 at Cornell University (20th, 21st Jan).  

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Image: National Institute for Occupational Safety and Health, Flickr

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