Prof. James Hamilton of University of California recently wrote a post called Thresholds in the economic effects of oil prices. In it, he concludes
As U.S. retail gasoline prices once again near $4.00 a gallon, does this pose a threat to the economy and President Obama’s prospects for re-election? My answer is no.
EDIT – I originally wrote this post thinking that Prof. Hamilton was looking at a broader question: Can an economy learn to live with increasingly high oil prices? After looking again at his article again, I realize that he is talking about a narrow question: Using the figures he was looking at (average gasoline prices across all grades), prices were for the week of September 17 near $4 a gallon, as they had been several times in the past, as they bounced up and down.
In that context, what he says is far closer to right than what my analysis of the broader question of whether an economy can learn to live with increasingly high oil prices, below, would suggest. There is a difference, because gasoline prices are not too closely tied to oil prices in short term fluctuations, and because the issue is likely to be as much one of consumer sentiment as anything else, as long as the issue is simply one of gasoline prices in a not-too-wide range. But I think there are some longer-term, more general issues we should be concerned about.
My Analysis of the More General Question: Can an Economy Learn to Live with Increasingly High Oil Prices?
As I see it, increasingly high oil prices weaken an economy because they reduce discretionary spending and indirectly cause people to be laid-off from work. They have many other adverse effects as well–they tend to raise food prices, with similar effect. The laid-off workers require unemployment compensation payments, and the same time they are contributing less tax revenue. All of this creates a huge imbalance between revenue collected by governments and expenditures paid out. If oil prices rise again, it will tend to make the imbalance worse.
An economy such as the United States can cover up the problems caused by high oil prices with variety of financial techniques. In my view, high consumer confidence measures the success of those cover-ups, more than it measures the actual underlying situation. One way the US government has managed to cover up how badly the economy is being hurt by high oil prices is by spending far more than the government takes in as revenue. This has happened continuously since late 2008, with outgo exceeding income by more than 50% each year, even though the country is supposedly not in recession.
Figure 1. US Government Income and Outlay, based on historical tables from the White House Office of Management and Budget (Table 1.1). Amounts include off-budget spending, such as Social Security and Medicare, in addition to on-budget spending. *2012 is estimated. http://www.whitehouse.gov/omb/budget/Historicals
The amount consumers have available to spend on cars and gasoline is very much affected by deficit spending. With deficit spending, government employment can remain high and transfer payments can continue, without anyone really “paying” for these costs, putting more money into the economy to spend on oil and cars.
There are other government programs as well. Interest rates on homes and new cars are being kept at record lows, leaving consumers with more money to spend on cars and gasoline. Low interest rates and low taxes also stimulate employers to hire more employees. Quantitative easing helps contribute to higher stock market prices, and makes it easier for the federal government to keep adding large amount of debt.
To me, the fact that the economy is not currently completely “in the tank” speaks more to the success of stimulus programs than having anything to do with adaptation to higher price levels. Countries such as Greece, Spain and Italy do not have the luxury of being able to hide the impacts of their high cost of oil. They are doing less well financially, but were not included in Hamilton’s analysis. Continue reading