Be Not Afraid

September 28, 2007 • Commentary
This article appeared on National Review (Online) on September 28, 2007.

During the last week of September, 2003, oil was selling in U.S. spot markets for $23.86 a barrel. If one asked economists back then what would happen to the economy if oil prices were to hit $80 four years hence, they would have almost certainly predicted economic ruin. But the inflation, unemployment, and recession that supposedly follow oil price shocks are nowhere on the macroeconomic radar screen. If the economy goes into a tailspin, it will be in response to bad news in the housing market, not the oil market.

The lesson to be derived from this is pretty clear: While oil‐​price spirals are certainly nothing for consumers to celebrate, the widespread belief that the health of the American economy is held hostage to oil markets is, for the most part, incorrect.

The orthodox view that governed our understanding of oil‐​price shocks until recently was that the economic damage associated with those shocks was not the result of oil‐​price increases per se. Higher oil prices, after all, simply make oil producers richer, and everyone else poorer. Over the long run, more money spent on oil equals less money spent on everything else. This reduces the demand for, and thus the price of, everything (including labor!) save for oil. As long as oil producers are spending and/​or investing their increased profits, the net effect of all this — from a macroeconomic perspective — is zero.

All of this will eventually happen, but the length of time required to get oil consumers to adjust their behavior in response to a price shock is what was thought to trigger the economic downside associated with an oil crisis. If wages and consumption rates outside the oil sector fail to go down, either unemployment will follow (the demand for labor outside the oil sector will go down, but not the price) or inflation will result because there’s only so much money to go around unless the Federal Reserve accommodates everyone’s demand for money.

The main dissenting view was most strongly forwarded by then Princeton University economist and now Federal Reserve Board chairman Ben Bernanke and his colleagues. They argued that different (“better”) monetary policy — more specifically, one that maintains the federal funds rate at a constant level rather than raising it in the face of an oil shock — could reduce or even eliminate the recessionary effect of oil shocks. Economists James Hamilton and Anna Herrera, however, were skeptical of that proposition.

They argued that the “better” monetary policy advocated by Bernanke et al, effectively calls for massive declines in the federal funds rate over the entire course of an oil shock, something that is probably not possible in the real world. Moreover, the Federal Reserve would have to keep the funds rate below levels anticipated by market actors for 36 months in a row, which is, of course, an unlikely proposition. Interestingly enough, the Federal Reserve, now chaired by Ben Bernanke, is not pursuing the policies advocated by its chairman when the chairman was in the academy.

That was the state of the debate until the most recent price shock. The economy’s failure to respond to one of the steepest oil price increases in history with a recession, however, sent economists back to the theoretical drawing board.

Several important papers appeared in 2006, which reexamine the role of oil shocks in the macroeconomy. A common theme of those papers is that policy‐​imposed rigidities in the economy were responsible for the bad economic outcomes associated with past oil price shocks. An analysis by economists at the Federal Reserve Bank of Atlanta demonstrated that oil shocks had significant effects on the macroeconomy before 1985 but not after. The authors argued that the federal price control regime of the 1970s was the true cause of the recessions that decade. Economist David Walton at the Bank of England likewise argued that wage rigidities in the 1970s were the culprit responsible for that dismal decade. And economists at the Federal Reserve Bank of Cleveland offered evidence that oil price increases never have and never will cause inflation. They calculated that a doubling of oil prices would lead to a one‐​time increase in commodity prices of about 3‐​percent.

All the new analyses agree that the more flexible economy that we have now, allows us to cope more easily with oil price shocks. This development is of more than academic interest. First of all, it underscores the danger of return to the price control regimes of the 1970s, something that politicians are increasingly flirting with as energy prices continue to climb. Second, it puts into question a panoply of government programs (such as the Strategic Petroleum Reserve), the panicky rush to break our so‐​called “addiction” to oil (which is leading to all kinds of economic mischief), and a foreign policy excessively worried about oil supply disruptions around the world.

Of course, a sanguine macroeconomic view of oil price shocks would be severely tested by a truly unprecedented earthquake in oil markets, like, say, the permanent loss of Saudi Arabian, Kuwaiti, Iraqi, and Iranian crude oil (20‐​percent of the world market). Since World War II, there have been quite a few oil supply disruptions (12 in fact), but those disruptions, on average, reduced the world’s crude oil production by only 5.4-percent. The largest disruption was associated with the Suez Crisis of 1956 (11.9-percent of global production), which was triggered, like all of the disruptions, by exogenous events that came and went. A “20‐​percent event” would be unprecedented, but the lesson from past events is that flexible markets are our best response to shocks rather than any of our oil‐​market policy interventions.

Despite the revisionist macroeconomic views toward oil shocks, one feature of them is not in dispute. The minimal supply and demand response to oil price movements in the short run leads to large transfers of wealth from consumers to firms in times of high prices (1979–85, 2004-07), and firms to consumers in times of low prices (1991–99). While energy policy discussions often invoke macroeconomic rationales for government action, the real motivation for intervention is the distributional concerns of firms and consumers. Both attempt to enlist the assistance of government to prevent those wealth transfers.

Those calls for assistance should be resisted. Energy market interventions have failed to help consumers and done much damage to the economy. The oil price‐​control system in the 1970s induced shortages and increased reliance upon imports at a time when America’s stated policy was to reduce import dependency. Consumers were made materially worse off as a consequence. Likewise, federal policy to prop‐​up domestic oil prices in the 1960s with oil import quotas harmed consumers and made the economy far less efficient (energy and otherwise) than it could have been.

It is time for America to get over its inordinate fear of oil shocks. Soaring prices aren’t pretty, but they are scarcely the existential threat to our economy posited by many. Nevertheless, if we want to do something about those shocks, then we should keep government far, far way from the wage and price controls that are the true source of the macroeconomic mischief wrongly blamed on crude oil markets.

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