For the first time in more than a decade, oil price increases are front-page news. Crude oil has tripled and consumer gasoline has increased by 50 percent in about a year.
Will this largely unexpected oil price shock cause rampant inflation? Will it choke off the long economic expansion the U.S. has been enjoying?
The short answers to these questions are “probably not” and “not necessarily.”
Don’t get me wrong: These answers are not weasel words or obfuscation. The simple fact is that while an oil price spike is not inherently an economic disaster, its effects on the U.S. economy depend on whether we respond with prudent policies or stupid ones.
In a market economy, prices send signals. That’s the most important thing to remember in all of this. Rising prices indicate that a product is becoming scarcer and signal consumers to use less and producers to produce more. If we adopt policies that blunt such signals, we discard the advantages of a market economy.
That principle should rule out inane initiatives such as price controls. It should also rule out decreases in state and federal taxes, which in the face of limited short-term supplies, would largely transfer money from taxpayers to oil companies without benefiting consumers.
Second, we need to remember that inflation is a rise in the general price level, not just in one or two commodities. True, crude oil is more important than buggy whips in a modern economy. If the price of oil goes up, the cost of transporting goods and people does also.
In addition, crude oil derivatives are an important industrial feedstock, meaning increases in cost affect firms such as DuPont or H.B. Fuller. These firms will have to raise prices or cut costs or accept lower prices.
But increases in the price of one commodity—even one as important as oil—will only drive up the general price level if the spike is met by loose monetary policy, and Greenspan surely won’t let that happen.
As for companies raising prices, it’s very difficult today because of worldwide competition. We don’t have the quasi-monopolies in steel, autos and electronics that we did 25 years ago.
So, taken together, the inflationary effects of $30 oil are not nearly as great as many people fear.
In the 1960s and 1970s, there was great debate among economists on the causes and cures for inflation. Keynsians, who generally favored government management of the economy, were one group. They distinguished between “cost-push” and “demand-pull” inflation and argued about how effective wage and price controls or “tax-based incomes policies” might work as inflation controls. The opposing group were Monetarists. To use a famous phrase of their leader, Nobel Laureate Milton Friedman, they believed that inflation was “always and everywhere a monetary phenomenon.” In other words, inflation only happens when a central bank lets the money supply grow too fast.
Both ideological groups are now somewhat passe, but as far as inflation strategy goes, the monetarists won the argument. While U.S. and British economists had wrung their hands and dithered for nearly 20 years about how to control inflation, Paul Volcker at the U.S. Federal Reserve and Margaret Thatcher’s successive Chancellors of the Exchequer showed you could choke inflation in a few years with tighter money. That policy had its social costs, but it is pretty clear to me that cost was less that the social cost of letting inflation course unabated for a similar period.
Rising oil prices push up firms’ costs and cut households’ effective disposable income. Companies will want to raise prices to make up the difference and households will seek higher wages. In the 1970s, these reactions, abetted by a complacent Federal Reserve, helped fuel inflationary spirals. But firms face much more competition today. We don’t have the quasi-monopolies in steel, autos and electronics that we did 25 years ago. And labor markets are similarly more competitive. So unless the Fed opens the monetary taps, which is highly unlikely given the current makeup of the Federal Open Market Committee, the inflationary effects of $30 oil are not nearly as great as many people fear.
Whenever a product goes up in price, the effect on consumers is the same as if their income had been cut. Bu the cut is not necessarily equal to the price increase multiplied by the quantity of gas they usually bought.
When gasoline prices increase, consumers can react by taking the bus instead of driving to work, vacationing in Northern Minnesota rather than driving to the Grand Canyon, or by trading the Lincoln Navigator in for a Geo Metro. Economists call these reactions the “substitution effect.”
But a household’s expenditures on gasoline usually do rise somewhat, especially in the short run, and thus they have less money to spend on other things. This is called the “income effect.” If a family spends $15 more per week filling their gas tanks, even after cutting back on driving, that is $15 they cannot spend on other things. There is no getting around that fact.
That cut in spending on other things results in reduced demand for producers of other things. Taken by itself, that leads to a slowing in the economy. But the extra $15 spent on gasoline does not go into a black hole. It goes to an oil company, either here in the U.S. or in another country. U.S. oil companies have been cutting back on spending for nearly three years in response to low prices. Now they can loosen their belts.
Who will that help? Well, it might be closer to home than you think.
Four years ago the oil patch of western North Dakota was booming. As many as 25 drilling rigs were operating at one time, most round the clock. Motels in towns like Dickinson were jammed with drilling crews. You could not find a seat in breakfast diners, and local oil companies were busy ferrying diesel fuel to thirsty drilling rigs.
Moreover local inhabitants were in malls and Main Street stores spending the initial payments they had gotten for selling exploration rights. All that collapsed when oil fell to $10 per barrel, but you can bet things are brightening already.
The Saudis and Kuwaitis—two big oil producers—have been similarly pinched in recent years. They have a backlog of demand for machinery and consumer goods, much of which will be imported from the U.S. So higher oil prices will mean that some U.S. exporting firms will have fatter order books. This will help to offset declines in domestic household spending.
So while higher oil prices alter who has extra money to spend, they don’t necessarily alter total spending. If total spending does not drop, the economy need not slow.
In the real world, however, a price shock like the one we are experiencing usually does have some effects on the real economy.
The Organization for Economic Cooperation and Development—an international organization made up of the world’s wealthiest countries—has estimated that a $10 increase in the cost of a barrel of oil increases inflation in OECD countries by half a percentage point and cuts growth by one fourth of a point. We have seen a $20 increase, so that would mean a 1 percent increase in the price level and a 0.5 percent reduction of output.
Neither would be fatal for an economy that has the lowest unemployment in more than 30 years, and growth that is stronger than most economists think can be sustained over the long run.
The global economy, however, is full of complex interactions. The U.S. economy is strong, but that of Japan, which is much more dependent on imported oil, remains weak.
European economies have been strengthening but continue to have much more slack than the United States. Labor and product markets are more rigid there. It is impossible to predict how these countries’ reactions to higher oil prices will affect us.
Similarly, oil-exporting nations in the Third World will benefit. More money flowing into nearby Mexico and Venezuela is generally good for U.S. business. But oil-importing trade partners, such as Brazil, will experience additional stress on their already fragile economies. That will cut their imports from the U.S. and will reduce profitability for U.S. businesses with operations in those nations.
On balance, higher oil prices are not necessarily a disaster. But they certainly will make the next couple of years interesting ones, for consumers as well as economists.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.