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The ‘High Oil Prices = Recession’ Fallacy
Every time we see oil prices go up we hear that it will cause inflation and/or the economy will go into the tank.
... 7 out of the 8 postwar U.S. recessions had been preceded by a sharp increase in the price of crude petroleum. Iraq’s invasion of Kuwait in August 1990 led to a doubling in the price of oil in the fall of 1990 and was followed by the ninth postwar recession in 1990-91. The price of oil more than doubled again in 1999-2000, with the tenth postwar recession coming in 2001. Yet another doubling in the price of oil in 2007-2008 accompanied the beginning of recession number 11, the most recent and frightening of the postwar economic downturns. So the count today stands at 10 out of 11, the sole exception being the mild recession of 1960-61 for which there was no preceding rise in oil prices. [Hamilton, 2009. Rv. 2010]
The premise is wrong. What causes price inflation is an expansion of money supply (and a desire of people to spend it, often quickly). What causes recessions is malinvestment of capital caused, again, by money supply expansion.
The classic argument is that because 70% of the economy is driven by consumer spending, an increase in gasoline prices will cause a decrease in consumer spending, which will cause an economic decline. Sounds logical on its face. There are empirical studies that show either increases in gasoline prices will not impact discretionary spending (McCarthy, 20110) or that large increases in petroleum prices will cause recessions (Hamilton). Take your pick.
The above chart1 shows the peak of real YoY GDP percentage change (light blue lines) and the relative price of gasoline (red), the product that most directly affects consumers. If gasoline prices have been increasing prior to the peak, then there is statistical data showing that those prices may have had an impact on GDP. From that one might conclude that because oil prices were rising prior to the peak in GDP, and because GDP subsequently declined, then high oil prices may have caused a decline in GDP. (Because A happened and then B happened, thus A caused B?) Or, is it just a coincidence?
What we see in the data is coincidence rather than confirmation.
Take price increases of oil and gasoline. It doesn't cause price inflation (i.e., all prices rise). Instead it's a supply and demand thing. When OPEC jacks up oil prices, people spend more on gas and less on other things. The consumer goods they don't buy decline in price. Money is redirected by market forces to petroleum producers who are incentivized to discover and produce more oil. Ultimately, under normal circumstances, prices come down. This process is a bit distorted because we have a cartel-controlled market. But, if OPEC keeps prices too high, people reduce consumption, cartel revenues go down, and OPEC reduces prices to stimulate consumption. This is what happened in the current business cycle.
It is the same with recessions and oil prices. Each of the recessions we've had in the last 40 years can be adequately explained by causes other than oil/gas prices. For example, while oil/gas prices shot up prior to the 2008 Crash, no one suggests that was a cause of it. Rather we know that oil prices went up as a result of a fiat money fueled boom that drove up all commodity prices.
Looking at our chart, we can start with the 1973 - 1975 recession. That was the time of the Arab Oil Embargo (Oct. 1973 to March 1974). If the theory that high oil prices equals recession holds true then why did the economy recover when gas prices continued to rise post-recovery? What really happened was that the Fed cut interest rates by half in 1970-1971, and then started raising them in 1973 to combat rising prices. By the time the recession started in November 1973, the Fed Funds rate peaked at just over 10%. It isn't as if the oil embargo didn't cause disruption in the economy; it did, but most of the economic disruption was caused by the government's price controls and rationing. But it didn't cause the recession.
Next, GDP peaked in April 1978 (gasoline-PPG $0.631) and declined until October 1980 ($1.223). Recall that price inflation almost hit 15% in 1980. The recession started in January 1980 ($1.11) and ended in July 1980 ($1.247). Gasoline prices continued to increase during the subsequent recovery. There is no correlation between oil prices and recession or price inflation.
GDP peaked again in Q2 1981 ($1.353) and bottomed out in November 1982 ($1.268). We went into recession in July 1981 ($1.353) until November 1982 ($1.268). You can see an oil price correlation here, but other things were going on: high inflation. By June 1981, the CPI was still over 10%. Carter had appointed Paul Volcker as Fed Chairman in August 1979 and he started raising the Fed Funds rate from around 10% until it reached 19% in January 1981, and kept it high (8% to 10%) for much his term (ended in 1987). This broke price inflation (it settled in the 3.5 to 4.5 range). Thus monetary policy rather than oil prices was the cause of the recession.
From then on, gasoline prices declined and remained relatively stable until 1999 ($0.90 to $1.30) when it started climbing again. The July 1990 ($1.139) to March 1991 ($1.138) recession shows that GDP peaked in late 1987 (about $0.95) and gasoline prices peaked in January 1991 ($1.304) and the recession ended in March 1991. But again, other things were driving the economy: a real estate boom-bust cycle, and that was largely driven by cheaper money and accelerated depreciation rules (those rules ended in 1986).
Prices fluctuated but remained in the $1.20s for most of the next eight years.
By 1999, the rise in gasoline prices coincided with peak GDP in late 1999 (Dec., $1.353) and gas prices rose, almost steadily since then. The 2001 recession came and went (March-$1,503) — November-$1.324). But, what else was going on? This was a time of incredible production and technological innovation that again benefited from the Fed's cheap money (spurred by Greenspan to revive the economy from the 1990 - 1991 recession). It worked. But Dot Com boom turned into Dot Bomb bust as the Fed raised interest rates and cooled the economy off from its "irrational exuberance".
The Fed decided it needed to stimulate the economy from the bust and from November 2000 to June 2004, the Fed lowered interest rates from 6.5% to 1.00%. From then on oil prices followed commodities prices and gasoline prices continued to climb.
By late 2003 ($1.578) the rate of growth of GDP peaked and thereafter was slowing, although it continued to grow until January 2006 ($2.359). At this point, the Fed again sought to cool down the economy and the Fed Funds rate went from 1.00% up to 5.26% by July 2007. Again, it worked and the real estate markets began to come apart. By H2 2008 ($4.142), GDP began to decline, thus beginning the bust phase of our current boom-bust cycle. Current price is $3.591.
Thus, while you can argue that rising oil and gas prices may have had some negative effects on the economy because of some economic disruption, in every case, the cause of our recession was anything but rising prices.
Regardless you are still going to hear that rising oil and gas prices are going to ruin the economy and cause us to go back into recession. While I believe the economy will decline starting in H2 2012, the reasons have nothing to do with oil prices. Don't let the pundits scare you with this economic fallacy. There is enough to worry about.
1. Note that gasoline prices (red line) are not scaled to prices, but are scaled to an index (100). The GDP scale (blue line) shows YoY percent change.
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Here is how the oil markets operate in the short to mid term today. The price of physical oil is dictated by futures market prices which is dictated by exchange traded option prices (standardized derivatives) which is dictated by Over The Counter Derivative prices (non-standardized or custom derivatives). The last one is a paper market which is almost completely dominated by a handful of major financial institutions (I bet you can guess which ones by now); and practically speaking opaque to consumers and retail investors. Call it the tail wagging the dog, an upside down pyramid, whatever. The important thing to recognize is this: those age old forces of supply and demand for physical oil, which the Mainstream Media keeps telling us are determining its price every day, are now three steps removed from the truth of what really drives the markets. The price of oil is much more determined today by the supply and demand for money, credit, liquidity, and risk within the financial system itself.
Down to Long - Stellar comment. I'll try and expand on it a little. Do any of us remember the Primary Dealers lining up at the Fed discount window of Februrary 2008? I was thinking at the time how those PD's would dump it into oil and the other exchanges would follow. I believe it was $225 B 'lent out' at discount window.
Since Federal and State's both tax gasoline, I viewed the pump scheme as a form of inflation tax. I hate to say it, but if I am Bernanke in 2008 I would have strongly considered the same approach.
However, I would not have done it without other specific revenue programs to mitigate unemployment. Preventing leakage overseas would have been addressed too prior to such an operation. My view on all this is the U.S. bankers that run this government are invested in China, for it to be handed reserve peg baton. It is said a man can't serve to masters, he will love one and despise the other.
How that works out we will know very soon but that reasoning helps me understand why leakage of funds overseas or domestic revenue programs ignored (except for backroom deals that won't help us in the short or intermediate term).
"What causes price inflation is an expansion of money supply"
While often true, it is not the only cause. It is well documented that EROEI for oil has been falling since the discovery of oil; the reality is that oil is more expensive to produce today, in terms of input and regulatory costs, than in the past. As a result, the producer simply will not sell its oil at a price that does not produce adequate return, and certainly not at a loss. It may still only cost the Saudis very little to produce a barrel of oil, but even their daily capacity is limited and contracts close where the highest cost producer, not the lowest cost producer, makes money.
http://inflationdata.com/inflation/inflation_rate/historical_oil_prices_chart.asp clearly shows that even in inflation adjusted dollars the price of oil has been rising since 1999. The fact is that the easy oil has been found and produced or is in production. We don't drill deepwater wells in the Arctic because it is easy or cheap; we do it because there is no place else to get it.
"As a result, the producer simply will not sell its oil at a price that does not produce adequate return, and certainly not at a loss."
And here we have another person who has no clue about oil pricing. The futures markets set the oil price not the seller. Except for fixed contracts, prices are set in London and NYC not Riyadah.
Many nations like Libya, Iraq, Iran, and Venezuela are 90% dependent on oil revenues to purchase things like... food. So if the cost of a barrel goes down to $20 a barrel and they have fixed costs of $25 to produce it, they won't sell it? How are they going to get money to eat then?
You don't get how oil prices are set, and you don't get that most of the cost of oil production is spent up front. This notion that oil producers, unlike any other producer of goods in the world, are guaranteed profits is absurd.
"...they have fixed costs of $25 to produce it."
It can cost a lot to produce NEW wells especially deep sea wells (about $70 per bbl US Gulf of Mexico) , but established fields in the ME like Ghawar in Saudi Arabia have production costs between $1 and $13 (average is about $10). Of course you can do a lot of tricky shit with accounting when it comes to booking what is really a production cost and what isn't, but if they had to get that oil up for the minimum it would cost way less than $25 and some of it would be nearly free because it is under pressure and does not even need to be pumped. For some of it the only cost is the pipe maintenance crew and when you divide their salaries by the millions and millions of bbls per day it is vanishingly small overhead.
But, even taking your number and adding a really great 100% markup oil would still be well below half what it is on the markets today. Even tripling it would still be $31.67 below today's close.
So fine, big food export producing nations mostly are also the big oil importers with the obvious exceptions of Canada, and Russia, and the food production nations need oil about as bad as energy producing nations need food, and cruel as it might sound we have put up with their economic blackmail for 40 years now, so what we need to do is create OFEC, Organization of Food Exporting Countries. Embargo grains and other food till they meet our demands for our productive efforts. I assure you that food is in every bit as tight supply around the world as energy and even more so because with energy should we run out or it become uneconomical we can still eat, without food they die and the oil belongs to whomever is left alive.
Of course that is totally uncivilized, but then so is the economic strangulation they are engaging in, as well as their Medieval domestic practices and internal justice systems that make the Spanish Inquisition look like a senate hearing.
You misread what I said. Yes, price inflation, what is normally referred to as "inflation" is when all prices go up. When oil goes up, say far more than other commodities, then that is due to supply-demand factors. Thanks for reading and thanks for the comment.
we didn't misread what you said, we all just think that you're really fucking stupid, that's all
how could the price of water possibly effect the price of food? How could the price of fertilizer effect the price of food? How could the price of oil effect the price of pumping water, of making fertilizer, of trucking food, of making electricity to keep the food refrigerated?
How could the price of oil cause a recession? Oil is obviously independent of everything. Oil exists in a separate universe.
A universe in which econophile resides in a lofty white tower where he contemplates events in isolation and knows everything and understands nothing.
But I think you miss the point being made in the comments. It matters little the cause in the rise of oil prices for all practicle purposes, as high petroleum prices seep into virtually every aspect of dailey life, thus increasing general inflationary pressures.
Further to the supply/demand factors, we could do a lot toward reducing the cost simply by eliminating the options speculation.....but we don't want to do that now, do we? It might hurt JPM or GS. If we weren't getting totally screwed by the financial parasites speculating in all these instruments of financial destrution, we would have a much different economy - one much better for the average citizen. Simply eliminating options purchases by ANYONE unable to take final delivery would change everything and only harm the ones responsible for so much of the tragedy we are experiencing today....scum, vermin, and traitors.
Fine, then let's call it a "Decline in Disposable Income due to Increasing Gasoline Prices" has preceded most recessions...the calculation is pretty simple in this country where 70% of GDP is related to consumer purchases
LESS DISPOSABLE INCOME = LESS RETAIL PURCHASES ex Gasoline = LESS GDP GROWTH
There likely is a pretty good correlation about the size of the increase in gas vs. the size of the decline of the disposable income and this is all before inflation kicks in as airlines tack on fuel surcharges, etc...
Neosurf is absolutely correct.
Meanwhile...
The author (econophile), however, is {illogically} trying to say that the murder victim (consumer) did not die because of blood loss (loss of disposable income). Rather, the murder victim died because he was stabbed 27 times.
Of course the waters are muddied by the fact that part of the increase in the POO is due to inflationary money printing and part of the increase is due to a general decline in production in easy-to-get-to oil.
Either way, income is lagging pricing which will kill the consumption economy - which will, in turn kill credit growth, which will help kill the entire financial Ponzi system.
ECONOTARD: It is never a good idea to abruptly stop taking medications.
From the author: There are empirical studies that show either increases in gasoline prices will not impact discretionary spending
How so? The more money that the ordinary citizen spends on fuel (and food and everything else that requires oil for production/transport) surely must mean less money available to spend on other things?
...unless credit fills the gap.
How can fuel costs rise without affecting other spending? Nothing else seems to be getting any cheaper to compensate... so surely for the majority of ordinary people, high oil prices can't be anything other than bad.
The oil companies will be delighted with the price increase, of course, but there don't seem to be many bright sides to high oil prices.
The Arab oil embargo of the 70s drove up the price of gasoline which contributed to staflation. Says so in my economics text book.
Really....
If that is all it says, I would get another text book...
This is too simplistic. We all know that correlation is not causality. Perhaps including wage inflation/deflation would yield a logical analysis. With decreasing or even flat wages the high oil prices absolutely lead to recession, look at Europe.
i see by the votes that many do not like your analysis, but you are absolutely correct with your thesis....i am glad to see a breath of fresh air on this subject....
Looks like a left side article on why high gas prices are a good thing.
GDP as a measure for discretionary spending? Seriously?
I have connections to the real world - you know, blue collar Americans, and they are all saying the same thing:
My spine is nearly broken, gas prices will be the end. Paraphrased ofcourse, but that's the REAL consumer sentiment out there. Margins for LIVING right now are miniscule; this article is mind numbing.
We'll find out this time.
This time rates are not going back up for a long time, but oil is already off to the races.
This link explains everything, read top left statement on the Bill.
http://www.jeffpolachek.com/images/Lawful-Money/Twenty%20Dollar%20FRN%20Redeemable%20in%20Lawful%20Money.jpg
OPEC cutting prices in 2008 causing oil to drop from $147 a barrel to the mid $30s in a couple months is news to me. Im also sure it was OPEC cutting production that caused the resultant climb all the way back up even though demand actually continued to fall.
Recessions are caused by misallocation of capital which causes assets and products to increase in value over the true price determined by demand. Credit allows the misallocation of capital to continue much longer than the demand model would dictate, as people absorb the higher cost in the form of debt. Eventually the expansion of credit can not continue and the bubble pops.
THe quickest way to pop the bubble is to make it impossible for people to service the minimum payments on their debt. Average discretionary income ranges in the low hundreds of dollars per month. Minimum payments on debt must be met. If an increase in the cost of transporation uses up a consumers discretionary income and causes them to no longer have enough cash to service debt payments, they are forced to default. As the majority of consumers are al in the same boat, massive default waves begin, resulting in recession.
Oil prices may not have caused the recession directly but caused the consumer to no longer be able to service their debts.
"What causes price inflation is an expansion of money supply (and a desire of people to spend it, often quickly)."
What utter nonsense!! This is Milton Friedman always laying inflation at the feet of government. Higher demand for a consumer good doesn't influence inflation for that product? I guess the reason people who paid more to scalpers for tickets when Michael Jordan was playing in a game was because the Fed cranked up money supply on those days? It couldn't have been due to consumers wanting to see the greatest player of all time according to your and Friedman's dumb theory.
And inflation has nothing to do with a limited supply? So a war with Iran in the Persian Gulf that shuts off oil supply is no reason for oil prices to go up?
By the way, why is oil up at $110 from $33? Did the money supply triple since 2008?
Money supply is one aspect of price. Price factors also includes demand for a good, supply of a good, and demand for money/credit. I can't believe how many idiots think money supply is ALL that matters.
You should actually read the piece. I'm not a Monetarist and that's not what I'm saying at all.
Right, you aren't anything but wrong. You cite inflation as monetary expansion and don't back it up with monetary data.
If you actually purse through EIA and IEA data, you would see OPEC produced more oil last month that at any time since October 2008, so how is it that "OPEC jacks up oil prices"? Hmmmm.
Oil prices are dictated by the futures market not OPEC, and European money managers upped their long positions of WTI by 66% last month. That is what caused the price of oil to rise.
When the consumer has to pay more for oil products, he has less money to pay for his mortgage and other goods and services. Of course that has the capacity to trigger a recession. That was a partial cause of why the housing bust happened when it did. The housing bust took a lot longer than many of us thought, and high gas prices were the straw that broke the camel's back.
IMO then higher oil prices are due to European QE and the ECB printing like crazy. We have no idea what is coming for the U.S. now that there is a Euro with this amount of European QE. If Europe blows up, is that good or bad for the U.S.? That is the question you aren't answering. We are in uncharted waters and have plenty to worry about.
Your previous correlations to U.S. recessions has NOTHING to do with what is happening now. The reason we have higher oil prices today is light years removed from what happened in 1974 or 1979.
Econophile you're either a fucking idiot or you're a fucking idiot
Did the money supply triple since 2008?
http://research.stlouisfed.org/fred2/graph/?id=AMBNS
inflation is not the same thing as supply and demand.
That is not the money supply, you goof. That is the Fed balance sheet.
Your graph indicates there was no money from 1920 to 1950.
Try this one:
http://www.shadowstats.com/alternate_data/money-supply-charts
Estimates of M3, the best marker of money, were actually down when oil was rising from 2009 to 2010.
I agree with the premise of demand destruction, but using GDP as a measure is questionable considering it does not reflect real economic growth (or contraction). Head-out-the-window economics here suggests that since everything relies on oil in one way or another, there is an economic trend that is negative against a system that requires perpetual growth. EROEI is a drag. Just that the relationship is a tad more elusive than 1:1.
Reasons the economy might slow. Price is only one factor.
http://www.zerohedge.com/news/observations-engineer
I suspect there is a structural linkage where demand destruction is a trade off to higher oil prices. Government and banking interests may be favoring austerity as that may be preferrable in ways to oil inflation and higher prices. I think that if austerity wasn't policy then there would be higher prices that would be causing similar economic weakness in similar places because resources may be nearing a zero sum game where they are mostly spoken for and not much surplus available.
"When OPEC jacks up oil prices"
if only they "controlled" it
"SNIFF SNIFF"....
Is that bullshit I smell? It most certainly is. Look doofus. I don't care if 100 out of 101 of the past recessions prove your case...things are different now. Oil has NEVER been woven more into the fabric of everything we do, we drive, we wear, we are.
Yes, the clear spike up in the price of oil preceding every recession on the above chart (with the exception of the 1982 recession which was just an extension of the '79) wasn't the deciding factor in the recession that followed. Larger forces were at play. HOWEVER, the higher oil prices did not help either. AND at each time, the economy rebounded and/or was already stronger than now not only because of normal ponzi scheme shenanigans but from the economy actually being healthier at the time due in large part to the fact that we were still a manufacturing nation and had only started hollowing out our base in earnest.
Now....you really expect us to believe that oil will not be a straw...if not the straw...to break the rotten ol' back of this shambling camel of an economoy we have.
"SNIFF...SNIFF"....
You know....on second thought....I think that's CAMEL SHIT I smell.
The reality spinners are coming out in droves..
This author has lost all credibility. This is nonsense.
Boy howdy!
I agree completely. In the first sentence he lost me. He says that people say oil going up will cause inflation. This isn't even one degree of being accurate. It's at least two degrees off. Can't get basic definitions right and uses concatenations of conjunctions to fill in for lack of understanding.
It could be said rising gas prices are a SYMPTOM of inflation and that an increase in gas prices might cause increases in prices of other things.
It then could also be said that inflation is caused (or is directly defined as) by the increase in the supply of monetary units without a proportionate increase of supply of consumable goods.
"Oil causes inflation." Hahaha.
Lies damn lies and statistics.
Statistics are a proxy for economists. anybody rememer how many economist successfully predicted our current economic plight before the housing collapse in the golden age of 2007?
Economists, if they had a real pipeline to god they'd be front running everybody, instead of trying to pimp their prognostications to the press and sundry corporations.
High priestess to the black arts, they remain more prestidigitators than scientist.
Mark Twain nailed it. lies,damn lies and statistics, indeed!
War premium on oil will will sap whatever whatever economic benefits came from the warm winter.
Are you shivering in the 'warm winter'?
Hmm
When OPEC jacks up oil prices, people spend more on gas and less on other things. The consumer goods they don't buy decline in price.
Yes because clearly, rising gas prices don't affect the cost of producing/delivering anything except our asses to Walmart for a new 50" LED.
"When OPEC jacks up oil prices, people spend more on gas and less on other things. The consumer goods they don't buy decline in price."
Therefore, a decline in consumer spending is a boom to the economy? Hmmm...makes sense.
Rising gas is crushing the economy or what is left of it near me.
Absolutely correct, surf076. I have lived through this too many times. I deal in consumer goods with a diverse assortment of retailers - from Dollar Stores to Department Stores, to Gourmet & high-end specialty. This is bullshit, plain & simple....and if my gut is correct, this time it will be worse. People have less discretionary income now than any period I can recall.
Where is that extra $20/week per vehicle coming from? And, declining prices? Well not yet. I have been dealing with price increases all day. One of my competitors jacked up their quotes 35% to a key account....Boom. My quotes will likely get me the biz, but they are at least 25% higher than 6 months ago (turkish glassware factory). Prices in virtually every category of home furnishings are creeping up, and we have been scrambling to re-configure (reduce quality/quantity) in order to maintain retial price points for some time now. Inflation is very much alive and well today. I can't blame it all on oil. All those extra Benie Bucks have to go somewhere, and they are driving up prices in every direction., but oil is the nail in the coffin. There are simply no alternatives to driving your car or heating your home for most of us.
No one (in the 99%) has money. I've been dealing in criminal law for twenty one years at every level. The joke in criminal law is that parents will always find some money when their kid or love one is in jail or in trouble. They can't find it now. It's only getting worse. The percentage of cases being taken on by the public defender is larger than the system has ever seen and the defenders have always been overwhelmed. Add to that the bankrupt counties who are shortening their court clerk staff who are ten times more important than the judge to keep the system going. Add to that, the biggest county in our state just had to fire nearly twenty prosecutors. We are starting to see more and more mistakes with cases falling through the cracks. Am also seeing never before "criminals" often older middle class folks committing theft and an increase in domestic violence as the stress is hitting the families. One stole a large amount of coffee from Starbucks to help pay for his wife's medical bills as she lost her job and benefits and Starbucks was not supplying him any either.
Every product in the supermarket is getting smaller and smaller. Every product in vending machines is getting smaller and smaller. Everyone know it. Some , the ones who are optimistic leaders, refuse to admit the wall of crap that is rolling right at us. My company was told our clients can no longer pass along any additional costs. Therefore we cannot pass any additional costs to them. That means a merger. Which has already taken place. That means I am part of the U-6 by the end of the year. Software engineer, 10 years experience, 2 degrees. But I do not see one leader with any amount of commonsense or backbone to speak the truth.
There was an article on here about the negative feedback loop last week. Bennie Bucks are most of the increase.
I have to agree with most of the posts here. The rise in prices and inflation can be complex, just don't say that the price of gas and oil have NO effect on the economy or "prices". Everyone I know (which is more blue collar america) is absolutely crushed by rapidly rising gas prices. Sometimes the price doesn't immediately filter into CPI for a few months because the big industry users can hedge pretty well, but it will drag down the economy, maybe not drag down stocks because they are not as tethered to the real economy anymore, being more tied to central bank manipulation than anything else.