Oil shocks and personal saving

Mark Thoma notes some interesting thoughts by Harvard professor Martin Feldstein on why the oil shock of 2005 was not more disruptive.

Feldstein wrote:

The price of imported oil in the US doubled between summer 2003 and summer 2005, reducing consumers’ purchasing power by more than 1 per cent of gross domestic product. Nevertheless, the economic slowdown that was widely expected never occurred. Consumers kept spending and businesses kept investing. … The continued strong growth contrasts sharply with the economic weakness that occurred after almost every previous significant rise in the oil price. How do we explain this remarkable difference?

Data source: BEA Table 2.1, line 34

The key to the economy’s strength in 2004 and 2005 was that household saving declined dramatically while the price of oil rose….The primary cause of this dramatic shift was the fall in interest rates and the resulting rise in mortgage refinancing. Homeowners who refinanced their mortgages took out cash and reduced their monthly payments at the same time. Much of the cash obtained by refinancing was spent on consumer durables, home improvements and the like.

The graph at the right displays the drop in personal saving to which Feldstein was referring, which was certainly dramatic. However, I would like to make a couple of observations about Feldstein’s conclusions.

The first point worth emphasizing is that shaving 1/2% per year off income growth would not really have been that noticeable. The relatively modest size of this number even for a doubling of oil prices has to do with a fact that I’ve long emphasized: given the relatively small dollar share of oil in total GDP, even a doubling in oil prices is not enough to produce a recession if the only effects were the dollar flow consequences to which Feldstein refers. Instead, in the earlier historical episodes which Feldstein mentions, GDP dropped by considerably more than this direct effect. In my opinion, this resulted from abrupt changes in the composition of spending and overall uncertainty about the future. Consumers could have maintained higher spending in these earlier episodes, too, had they been confident about the future, but chose not to.

We certainly saw the first stages of such an effect in the fourth quarter of 2005, when real GDP grew at an anemic 1.1% annual rate. In terms of accounting, one can attribute this entirely to difficulties in the auto sector– had motor vehicle sales and parts held steady, real GDP would have grown at a 3.2% rather than 1.1% rate. However, the recognizably temporary nature of the hurricane-related disruptions may have succeeded in arresting the usual oil shock macroeconomic dynamics. The typical consumer is now perhaps reasonably confident that all those problems are behind us.


A second observation I would like to make about the relation between saving and the 2005 oil shock is that, as Feldstein has of course been emphasizing throughout much of his career, the drop in saving is not something unique to 2005 but is instead the continuation of a longer term trend. The graph at the left projects the trend that I’d earlier fit to data through 2004. The decline in saving that actually appeared in 2005 is exactly what we would have predicted from extrapolating that trend. Although the mortgage refinancing and oil shock are unquestionably part of the mechanics of what produced this additional drop in saving in 2005, one also has to think that the long run trend played a very important role as well.

But none of this is to dispute the validity of the overall conclusion that Feldstein draws from all this:

The powerful effect of mortgage refinancing on consumer spending was a very happy coincidence for the American economy at a time when oil prices were depressing consumers’ real incomes. If oil prices were to rise again in 2006 or 2007, the adverse effect on consumers’ real incomes would not be offset by increased mortgage refinancing. Mortgage refinancing has now peaked and is declining. The Federal Reserve is raising interest rates again to counter the inflationary pressures that remain from the rise in energy costs. And individuals no longer have the large amounts of household equity against which to borrow.

I agree with that conclusion, in part because I would also add that the 2005:Q4 experience has already left consumers and the economy a bit unsteady. I would be quite concerned, for example, if current tensions led to a significant disruption of oil shipments from Iran… or Nigeria… or Iraq….

Markets this week seem to be shrugging off these concerns in the light of prospects of additional supplies. Let’s hope the market has this right.

18 thoughts on “Oil shocks and personal saving

  1. odograph

    However, the recognizably temporary nature of the hurricane-related disruptions may have succeeded in arresting the usual oil shock macroeconomic dynamics. The typical consumer is now perhaps reasonably confident that all those problems are behind us.
    I’m not sure I get this. Is $2.50/gal the new “normal?”
    (You might be amused by what I’m reading)

  2. outsider

    Thanks, Calmo, for vindicating my simple approach.
    Now, a scenario based on personalities and agendas for anyone’s consideration, the purpose of which is to plan for the proper allocation of assets. Prize winning economists (http://www.american-reporter.com/3831w/2.html) call the Iraq war at a cost of 2 trillion dollars accounting for the rebuilding of the military, care of wounded,etc.
    Cost of tax cuts, about 1.5 trillion over 10 or so years (re. Paul Krugman)
    The promotion of Ben Bernanke (the only contender who never crossed this administration’s agenda, and was thus a shoo-in crony), who the president visited on his confirmation (the 5th time, I believe, in U.S. history) and who is famous for his “Helicopter” comments about fighting deflation, and his fascination with the “29 crash and ensuing depresson, and the historical tendency (for the past 44 years) of stock market bottoms occurring 9 times in midterm years, and only once in the post presidential year) to ready the stage for the incumbents party to continue in power, it appears that the only resolution of these forces is inflation of the U.S. dollar…pay for profligacy with a printing press. (“deficits don’t matter, Reagan proved that” sorry, source lost to memory).
    Am I missing something?

  3. Rick

    “Personal Savings Rate” It sounds like such a great statistic. So encompassing. So easy for all to comprehend. I think it’s flawed and misleading. Major purchases usually paid over time are subtracted from income as a whole. Capital gains on 401k’s and IRA’s(arguably in an era of reduced pension plans from employers the most significant savings tool an individual has) are excluded from income, as are gains from the sale on a home. I think as a measurement for household financial asset status, the Personal Savings Rate calculation needs to be changed. (or change the name of the measurement)

  4. Jack

    (“deficits don’t matter, Reagan proved that” sorry, source lost to memory).
    Here’s a clue: He shot a member of his own hunting party recently.

  5. Stefan

    I recently got interested in geopolitics and I stumbled across this great blog. I find the balanced discussion in the comments very very informative.
    My question is not directly concerened with the topic of the article, but is more about the Cheney quote : “deficits don’t matter”
    If they really don’t matter, this would mean that the government could spend as much as they want. Which even could mean that they would be able to abolish taxes completely and finance the entire budget from borrowed money… Let me guess.. there is a flaw in the above statement?
    And do I see it right? The US consumer has arrived at zero savings?
    Sorry if this all sounds too naive, but I’m new to economics.

  6. caveatBettor

    Deficits do matter. Trade deficits are not so worriesome (nice article at http://www.tcsdaily.com/article.aspx?id=021006G, about trade deficits not really being a deficit, but a less-than-clarifying number due to accounting morays of “import” vs “export”).
    I’m not as sanguine about budget deficits. But we are not as irresponsible about them as most europeant countries nor Japan. See a ranking of debt-to-GDP ratios of such countries here http://www.optimist123.com/optimist/2006/01/jan_2006_nation.html
    Debt-to-GDP is a little like MortgageDebt-to-HouseholdIncome, as far as my simple mind can draw an equivalency. Debt is a bad thing, but if wealth grows faster than debt, its not really such a bad thing.

  7. Anonymous

    Thank you very much for your comment. Regarding your debt-to-GDP ratios I certainly agree that the US is not doing so bad compared to other developed countries. However as far as I understand, economics is a very dynamic system where dynamic variables such as the deficit-to-GDP plays a much bigger role than debt-GDP. And that’s where the US is doing very badly right now. Their debt is increasing much faster than most other developed counries. At least that’s my understanding.

  8. Steve Bodner

    It appears that problems with both Personal Savings and the Current Account began in the early 1980s, and these problems grew almost monotonically since then, independent of federal deficits/surpluses, independent of short-term interest rates, and independent of which party was in power. These two phenomenon are however correlated with a rather steady decline in long-term interest rates. My questions are:
    (1) Is one of the two above quantities more fundamental, and does it drive the other? Or is their simultaneous decline a coincidence? They are after all related in a basic economics equation.
    (2) Is total Personal Savings a meaningful quantity, or is it just an arbitrary function invented and defined by economists?
    (2) Is there some major phenomenon that is behind these long-term changes, such as the growing economic competitiveness of other nations relative to the US?

  9. caveatBettor

    Steve B: My simple answer to long-term interest rates is just an increased demand for US treasuries, which in part due to the economic competitiveness of the US relative to other nations. Bernanke addresses this in his “global savings glut” theory. And I can intuit China’s desire to import into the US and pegging the yuan FX rate, such that China will buy US treasuries with yuan, which will allow the US to buy imports without a decline in relative buying power. As long as parties are gobbling treasuries up, interest rates go/stay down.

  10. odograph

    Steve B – being an oil fixated dummy, I’ll immediately glom onto the fact that your turning point “in the early 1980s” was when we had our oil prices shocks, changed our “oil intensity” (relation of oil use to GDP) and started exporting energy-intensive energy as part of overall globalization. The “energy intensity” graphs I’ve seen show an inflection point at exactly the same point.
    I’ll leave it to smarter economists to remind me that this was not the only big happening in that timeframe.

  11. Ken Houghton

    odograph – The other “big thing” is that the Fed Chairmen (Volcker and then Greenspan) concentrated policy on inflation targetting.
    There’s an implication there that if it’s not measured in the inflation index–or if it’s effect is disporportionate to its weighting in the inflation index (e.g., health care spending for persons on fixed incomes, housing prices when the rent/buy ratio shifts)–it will be over/underattended in shaping economic policy.

  12. db

    And if true (ie increased oil prices help support dollar value via increased dollar demand) wouldn’t that just continue the same cycle that allows the US to continue taking on more debt?
    It seems that what would break this cycle would be if and when oil and other commodities are traded en mass in currencies other than the dollar. Would you agree?
    Perhaps our large growing debts over time will be the cause of such a shift.

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