Oil Prices and Economic Growth

Last week I solicited perspectives on the relationship of oil prices and economic growth.  Thanks to all who emailed and commented.  This post shares some further thoughts.

First, there does appear to be a sense of conventional wisdom on this subject.  For instance, from last Friday's New York Times:

A sustained $10 increase in oil prices would shave about two-tenths of a percentage point off economic growth, according to Dean Maki, chief United States economist at Barclays Capital. The Federal Reserve had forecast last week that the United States economy would grow by 3.4 to 3.9 percent in 2011, up from 2.9 percent last year.

Similarly, from Friday's Financial Times:

According to published information on the Federal Reserve’s economic model, a sustained $10 rise in the oil price cuts growth by 0.2 percentage points and raises unemployment by 0.1 percentage points for each of the next two years.

Jan Hatzius, chief US economist for Goldman Sachs in New York, comes up with similar numbers ...

Today's New York Times sames something very similar:

Nariman Behravesh, senior economist at IHS Global Insight, said that every $10 increase in the price of a barrel of oil reduces economic growth by two-tenths of a percentage point after one year and a full percentage point over two years.

And adds:

As a rule, every 1-cent increase takes more than $1 billion out of consumers’ pockets a year.

Reuters offers some different numbers:

In 2004, the International Energy Agency calculated that an increase of $10 per barrel would reduce GDP growth in developed countries by 0.4 percent a year over the following two years. It would also add 0.5 percent to annual inflation. The impact was more severe in the developing world: in Asia, growth would be 0.8 percent lower and inflation 1.4 percent higher.

But the IEA’s estimates were made when the oil price was just $25 per barrel. While a $10 price increase today is lower in percentage terms, the absolute level is much higher: at the current price, oil consumption accounts for more than 5 percent of global GDP.

That these numbers seem unsatisfying 9at least they do to me) should not be surprising, as economists have devoted precious little attention to understanding the role of energy in economic growth.  David Stern of the Australian National University has a nice review paper titled "The Role of Energy in Economic Growth" that asserts:

The principal mainstream economic models used to explain the growth process (Aghion and Howitt, 2009) do not include energy as a factor that could constrain or enable economic growth, though significant attention is paid to the impact of oil prices on economic activity in the short run (Hamilton, 2009).

James Hamilton, cited above by Stern and a professor of economics at UCSD who blogs at Econbrowser, explains the math as follows:

Americans consume about 140 billion gallons of gasoline each year. I use the rough rule of thumb that a $10/barrel increase in the price of crude oil translates into a 25 cents per gallon increase in the price consumers will eventually pay for gasoline at the pump. Thus $10 more per barrel for crude will leave consumers with about $35 billion less to spend each year on other items, consistent with a decline in consumption spending on the order of 0.2% of GDP in a $15 trillion economy.

So much for that fancy Federal Reserve model, but I digress.  Hamilton has a new paper out on oil shocks here in PDF.

From this cursory review, it seems that the details of the relationship of energy prices and economic outcomes remains fairly cloudy in the economic literature, with conclusions resting significantly on assumptions and the specification of relationships.  Even so, the big picture is clear enough to draw some general conclusions, such as this prescient assertion put forward by Professor Hamilton in 2009 testimony before the U.S. Senate:

Even if we see significant short-run gains in global oil production capabilities, if demand from China and elsewhere returns to its previous rate of growth, it will not be too long before the same calculus that produced the oil price spike of 2007-08 will be back to haunt us again.

The conclusion that is draw is that regardless of the best way to represent oil prices and GDP in economic models, we need to work harder to make energy supply more reliable, abundant, diverse and less expensive.

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