Will Gas Prices Trigger Another Recession? 5-05-2011 - WNEM TV 5

Will Gas Prices Trigger Another Recession? 5-05-2011

We have recently been witnessing political unrest and military conflict in North Africa and the Middle East and a surge in world oil prices. If you have the feeling you've seen this story before, you're right.
Recent concerns about Egypt, for example, might cause some old-timers to recall the Suez Crisis of 1956-57, in which a military conflict led to closing of the Suez Canal and sabotage of some key oil pipelines. Total oil production from the Middle East fell by 1.7 million barrels per day in November 1956, which amounted to 10% of global production at the time.
Many more will remember another Arab-Israeli conflict in 1973, in response to which the Arab members of OPEC refused to sell oil to countries deemed supportive of Israel. That time we saw global oil production fall by 7% in the space of a few months.
A few years later, in January 1979, the shah of Iran was overthrown. The tumult crippled oil production from the country, which had been contributing 7% to global oil supplies before the unrest. And just as oil production from Iran was beginning to recover, Iraq began a war with its neighbor in September 1980, taking 6% of world oil production off the market.
Iraq started another war when it invaded Kuwait in August 1990. The war completely knocked out oil exports from the two countries, which had accounted for almost 9% of world oil production before the conflict.
And each of the above five episodes was followed by an economic recession in the United States.

We've also experienced episodes of rapidly rising oil prices even when there was no significant disruption of supplies. Between 2005 and 2008, there was a big increase in consumption of oil from newly industrialized countries like China, yet there was no growth in world oil production.
That meant oil prices had to increase by enough to persuade consumers in the United States, Japan and Europe to decrease consumption, and a huge price increase turned out to be necessary before that happened. That oil price spike was accompanied by a recession that began in the United States in December 2007.
In fact, of the 11 recessions in the United States since World War II, 10 were preceded by a spike in oil prices.
So we have some good reasons to be watching current developments in North Africa and the Middle East with great concern.
So far, the lost production has been confined to Libya, which accounted for about 2% of world oil production before the recent unrest. While that is significant, it is less than a third the size of the disruption of any of the first five episodes mentioned above. It is more comparable to the loss of Iraqi production in 2003 after the U.S. invasion, in which we saw a noticeable bump up in the price of oil but no recession.
What does history suggest could be the economic consequences of the latest developments?
Since January, the average price Americans pay for gasoline is up 80 cents a gallon. With consumption of about 140 billion gallons per year, that's an extra strain on consumer budgets of $112 billion over the course of a year, which is about .75% of a $15 trillion U.S. economy.
If Americans try to buy the same number of gallons despite the price increase (and the historical experience suggests that's pretty close to the initial response of most people), that means we'd see cuts in spending on other items to the tune of a little less than 1% of GDP. That would definitely mean slower growth than we would have otherwise seen, but not enough to produce another recession.
The reason that historical oil shocks have often led to bigger economic effects than this simple calculation suggests is that the changes in consumer spending can hit some firms particularly hard. The resulting loss of incomes and jobs in those sectors can lead to a multiplier effect on GDP.
A key sector has been autos, with sales of the less fuel-efficient vehicles manufactured in the U.S. usually falling dramatically in these episodes. Here I see grounds for some optimism for 2011.
Before the latest gasoline price increase, sales of SUVs in the U.S. were significantly below the levels to which the industry had become accustomed in 2006. The U.S. auto sector should not be quite as vulnerable today as it was when gas prices approached $4 a gallon for the first time in 2007-2008.
Another critical factor is that although higher gasoline prices are squeezing household budgets, the gains we've been seeing in employment and income as the economy continues to recover from the last downturn have been an even bigger contributor on the plus side.
The historical oil shocks mentioned above often coincided with other negative shocks hitting the economy about the same time, such as tightening monetary policy. This time we may be a little luckier in that the underlying momentum of the economy before the oil price run-up was distinctly positive.
My conclusion is that if the oil production disruptions are confined to Libya and there's no further run-up in oil prices, it could reduce U.S. real GDP growth by 1% or so but should not be enough to produce a new recession.
However, the lesson I take from history is that Libya is not the only country whose oil production is likely to be disrupted as a result of political upheaval and military conflict over the next decade. Indeed, the lesson from current news accounts is that Libya may not be the only country whose oil production turns out to be disrupted in 2011.
If the conflict does spread, this episode and its economic consequences might look a lot more like the other big oil shocks of the past half century.
The opinions expressed in this commentary are solely those of James D. Hamilton.

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