Consequences of the Oil Shock of 2007-08

In a follow-up on my
earlier post
,
I’d now like to discuss the second part of my paper, Causes and Consequences of the Oil Shock of 2007-08, which I presented today at a conference at the Brookings Institution. Here I’ll review the role that the oil price shock may have played in causing the economic recession that began in 2007:Q4.

My paper uses a number of different models that had been fit to earlier historical episodes to see what they imply about the contribution that the oil shock of 2007-08 might have made to real GDP growth over the last year. The approaches surveyed include Edelstein and Kilian (2007), who examined the detailed response of various components of consumer spending,
Blanchard and Gali (2007), who studied the extent to which the contribution of oil shocks has significantly decreased over time, my 2003 paper, which emphasized the role of nonlinearities, and a model-free data summary of the observed behavior of different economic magnitudes following this and previous oil shocks. Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

One of the most interesting calculations for me was to look at the implications of my 2003 model. I used those historically estimated parameters to find the answer to the following conditional forecasting equation. Suppose you knew in 2007:Q3 what GDP had been doing up through that date and could know in advance what was about to happen to the price of oil. What path would you have then predicted the economy to follow for 2007:Q4 through 2008:Q4?

The answer is given in the diagram below. The green dotted line is the forecast if we ignored the information about oil prices, while the red dashed line is the forecast conditional on the huge run-up in oil prices that subsequently occurred. The black line is the actual observed path for real GDP. Somewhat astonishingly, that model would have predicted the course of GDP over 2008 pretty accurately and would attribute a substantial fraction of the significant drop in 2008:Q4 real GDP to the oil price increases.



Solid line: 100 times the natural log of real GDP. Dotted line: dynamic forecast (1- to 5-quarters ahead) based on coefficients of univariate AR(4) estimated 1949:Q2 to 2001:Q3 and applied to GDP data through 2007:Q3. Dashed line: dynamic conditional forecast (1- to 5-quarters ahead) based on coefficients reported in equation (3.8) in Hamilton (2003)
(which was estimated over 1949:Q2 to 2001:Q3) applied to GDP data through 2007:Q3 and conditioning on the ex-post realizations of the net oil price increase measure.
bpea3.gif



The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper, and is a conclusion that I don’t fully believe myself. Unquestionably there were other very important shocks hitting the economy in 2007-08, first among which would be the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

It is interesting also that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters. The mortgage delinquencies and financial turmoil in the current episode are of course not the specific stresses that operated in earlier downturns, but the broad features of that multiplier process are surprisingly similar to the historical pattern.

My paper concludes:

Eventually, the declines in income and house prices set mortgage delinquency rates beyond a threshold at which the overall solvency of the financial system itself came to be questioned, and the modest recession of 2007:Q4-2008:Q3 turned into a ferocious downturn in 2008:Q4. Whether we would have avoided those events had the economy not gone into recession, or instead would have merely postponed them, is a matter of conjecture. Regardless of how we answer that question, the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.



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81 thoughts on “Consequences of the Oil Shock of 2007-08

  1. slather

    thanks for this article. intuitively this makes sense. at a micro level, it makes sense that an overly indebted subprime mortgagee (living in a house he couldn’t afford, and living a fair distance from work) would tend to also be driving a car he couldn’t afford. an additional unexpected expense for gasoline would be the trigger for not being able to make debt payments.

  2. GK

    If the downturn was largely due to high oil prices, should not have things rebounded once oil became cheap?
    But it did not. At least not in the first 4 months of cheap oil.
    So this thesis is invalid.

  3. Steve

    If the downturn was largely due to high oil prices, should not have things rebounded once oil became cheap?
    But it did not. At least not in the first 4 months of cheap oil.
    So this thesis is invalid.”


    Do you know what a vicious cycle is?

  4. JDH

    GK: Please consult my 2003 paper and New Palgrave entry for discussion of whether oil price decreases have a parallel positive effect to the contractionary influence of an oil price increase. In particular, note that the equation from which the above figure is generated does not have the implication that you assert.

  5. Robert Bell

    GK: there is likely path dependence, as there probably is with credit conditions.
    JDH: really great post!

  6. Steve Kopits

    James Rubin, then Chief Economist of CIBC, highlighted the importance of oil in the current recession back in late 2008. His analysis can be found on the Oil Drum.
    In any event, if we believe this analysis, then the #1 goal of US (and global) energy policy must be to prevent a return to the oil pricing environment of mid-2008. That, in turn, implies a managed price regime.

  7. Mark

    Is there similar analysis of the early 80′s recession and the 79 oil shock?
    (I learned, I think, that there was consensus that the 80′s recession was purposely created by the Fed to bring inflation under control.)
    Thanks.

  8. Steve

    The Professor is right, the oil bubble blew up the economy, which was fueled with money borrowed from our homes. Be thankful, it was better to burst early then to have gone another lap. The reason the economy will not be back in gear, even with the lower fuel costs, is due in large part to the American middle class getting the message! We are currently paying down consumer debt, which is driving the savings rate up and the consumer debt bubble down. With, the coincidental tightening of credit by the banks making it hard to borrow, as well, additional money into these institutions via the “new” savings will build and eventually the credit will have to loosen up. The nice part of the almost forced debt repayment/savings bubble being created is that we (U.S.) may not need to borrow so much capital from the world for all the reckless spending going on. While Washington and the Fed are flooding the market place with cash, people are using it to pay down “personal debt” as fast they can. For those that do not like Obama, as I do not, it is going to be hard because we (U.S) will roar back in late spring, 2010. Unemployment will be high into 2012, but coming down enough to re-elect Obama. Whether we like it or not, we are being forced to accept a new, socialized world economy.
    As an aside, go UNC! LOL

  9. Terry

    I agree that the gas price bubble was the wake-up call for the American consumer. He/she finally realized that he/she was in way over his/her head, and cut back substantially on spending, starting with travel. The rest, as they say, is history.

  10. Hitchhiker

    I love reading evidence that supports my own previously held conclusions. Without a recession, I think the mortgage problem would have gone unnoticed a little bit longer, of course. The underlying credit risk would still be there but, it took a recession and consequent slide in home values to expose the amount of risk in the system.
    Thanks Chris and Barney. I also think the current amount of money being thrown at the affirmative action problem is absolute craziness. Thanks to mark to market the current values of those assets are now vastly understated where before they were overstated by not accounting for the level of risk. Didn’t I just hear that the rule was suspended? I would like to see how that plays out before throwing another trillion or two to the banking system. But then, imo, most of the crap being done to solve the problem has little to no basis in economic facts and very much to do with political agendas.

  11. steve blitz

    enjoyed your piece, even through a quick read, but i think the tie of gdp to oil may be a bit spurious. the cause of the recession begins with global capital flows. when the fed eased beginning late 07 it was a monetary boost to china and all the other dollar-pegged nations that were already growing quite rapidly. no surprise oil prices accelerated higher. well i think you can fill in the rest.

  12. Anonymous

    JDH wrote:
    “…the evidence to me is persuasive that, had there been no oil shock, we would have described the U.S. economy in 2007:Q4-2008:Q3 as growing slowly, but not in a recession.”
    This actually begs the question. Why was there an oil shock?
    It would be perfectly reasonable for a politician to take this statement to support his solution of price controls on oil.

  13. Steve

    This actually begs the question. Why was there an oil shock?
    It would be perfectly reasonable for a politician to take this statement to support his solution of price controls on oil.
    Perhaps with the huge losses Wall Street took on speculating with long term securities in short term funds, they had to create a buble to try and recoup losses! Of course, I’m only speculating!

  14. massi

    I am not familiar with these models. Is it a real shock we are talking about? That is, do the models control for the fact that a depreciation of the dollar due to an increase in the money supply would result in an increase in oil prices? Just trying to figure out whether this rules out the fact that part of this shock could be due to monetary policy shocks.

  15. Sebastian

    Steve said: “…The reason the economy will not be back in gear, even with the lower fuel costs, is due in large part to the American middle class getting the message!…”
    I think Steve has it right. A rational actor (in the economic sense) would respond “symmetrically”, i.e., cutting back on spending with higher oil prices and increasing spending with lower oil prices. However, the oil/gasoline price spikes last year put the fear of God into everyone.:)
    Sebastian
    p.s. Go UNC.:)

  16. oops

    couldn’t a monetarist substitute “the price of money” for oil? eventually the MR gained with oil at some level is no longer larger than the MC.
    seems like this happens in every economic bubble and that the price of oil was a result of too much leverage everywhere

  17. MikeR

    GK, the price of oil rose from $30 in 2003 to $50 by late 2004 and $60 by 2005, but the economy did not start slowing until late 2007. So yes, the price of oil is now down, but it will take time for the positive effects to impact the economy.

  18. Roger Chittum

    I found the paper on causes quite implausible (as I said in a comment there), but the 2003 black box generated consequences that seem very plausible to me. Energy is a big chunk of family budgets and when it doubles from 2.5 to 5 % of GDP something has to give–and pretty quickly.

  19. wogie

    Using the Nov endpoint of the graph the percent decline from trend in real GDP is about 0.63%. In 4th Q 2008 GDP was falling at about 3.8% annual rate. So, what was elasticity of GDP with respect to oli price change and oil share GDP?

  20. GK

    “Do you know what a vicious cycle is?”
    Do you know what a virtuous cycle is?
    “So yes, the price of oil is now down, but it will take time for the positive effects to impact the economy.”
    The impact to consumer spending is almost immediate (given that tanks have to be filled once a week, and shipments to retail stores are weekly, daily in the case of perishable produce).
    “Energy is a big chunk of family budgets and when it doubles from 2.5 to 5 % of GDP something has to give–and pretty quickly. ”
    And when it shrinks back to the lower size relative to GDP, the reverse happens quickly.
    JDH,
    I scanned over your paper. I would argue that oil was above $100 for only a few months, and it has been below $60 for a longer period than that already. Certain things are not linearly corelated as the demand curve is not linear, but general inflation/deflation effect is equal in both directions.
    If one examines the pyschological impact, it is even more in favor of a drop being stimulative. Until 2004, $52/barrel was considered very high. But today, no one considers that to be troublesome, simply because $147 was briefly hit before.

  21. Nick G

    James, I calculate a projected GDP of 12,210B, and a counter-factual GDP of 11,533. This gives an oil price impact of -5.9%.
    First – is this correct?
    2nd – what does the model project for 1 year from now, say?

  22. Roger Chittum

    GK: I agree consumer spending on non-energy goods should pick up quickly in response to retail price declines. A large majority of people have been spending every dime of income. Two possible reasons for a slow consumer response to declining oil prices: high oil prices were not the only important contributor to the recession (I would certainly agree with that) and/or non-linear effects–one of which I will suggest.
    If I want my stores fully stocked for the holiday selling season, the goods need to ship from China no later than October 15, and I must have ordered them weeks earlier, usually no later than August. That means the latest numbers I will have on which to project demand will be for July. If the goods aren’t in the stores, they won’t be sold and that’s reflected in lower GDP.

  23. ReformerRay

    The U.S. economy is operating in a world in which we are competing with Germany and Japan and a few other nations for a way to participate in world trade with a high pay labor force. We must sell some goods on the international market.
    Our major competitor – Germany – has already adjusted its economy to high priced gasoline.
    WE must figure out someway to move toward equal trade AND move toward an economy that can operate with high priced gasoline.
    That is the problem that Obama will be forced to solve – unless his dream of some alternative to gasoline can be found.
    I realize Germany GDP is down more than U.S. because their exports are down. Nevertheless, Germany is better positioned to compete in the global economy.

  24. tj

    If the relationship you find between oil and gdp is correct, then should we expect a series of severe boom and busts until we solve the energy problem?
    It seems with all the production cutbacks in oil producing states that it will be even easier for quantity demanded to quickly exceed quantity supplied as the global economy recovers.
    Expectations of higher oil prices are already beginning to cause the price of oil to bubble higher in the futures market even though we are ‘swimming in oil’ right now in the spot market.
    Expectations of higher oil prices shift the demand curve to the right and the supply curve to the left, no? I think it will take a prolonged L shaped recession to purge the expectation of a quick rebound in oil prices from the minds of producers and consumers.

  25. Mike Laird

    JDH, congratulations on teasing apart the impact of oil prices and mortgage stress inside a complex feedback system that we call the economy. Very nice. I particularly like your Chart 3 in the paper which shows how consumer oil expenses as a percent of GDP “came apart” from the trend channel in 2005 and beyond. Maybe we should call this the SUV/Hummer recession.

  26. Hitchhiker

    GK: One possible explanation for low oil prices not being reflected yet in demand or GDP in my view would be the statements of our dear leader that he wants to bankrupt coal using electricity generators and see electricity rates triple and his view on the need for cap and trade to curb those noxious gases polluting our planet. What will be the impact of that? Inquiring minds want to know and we will not spend until we do.

  27. Hitchhiker

    GK: I think politics is what is preventing a quick recovery. If one attempts to simplify (a very difficult proposition) the voters into the producers and the dependents, I would say the producers are scared to death and the dependents that mostly contributed to our current political regime (and in a state of euphoria) don’t have any money to spend.

  28. Mattyoung

    Housing and transportation have a moderate correlation in the consumer’s mind. The home being an inventory center and the car the chief freight handler. The demand for housing, at the time being mainly tract housing, would have accelerated the use of the car for freight. Oil, being the least elastic, shot up the fastest, faster than housing. In the suburbia model, tract housing and automobile go together.
    What was bubbling housing? Mainly technology, and secondarily some further constraint. Internet technology, in the house, removes 1/3 of the need for automobile freight handling in terms of locating cheap goods. About 10-15% of the housing bubble was justified by the broadband internet, probably another 10% was justified in waiting for technology to solve the next constraint in the household.
    So, JDH would normally say oil shocks result in a period of innovation in transportation. But this time the consumer killed the car and kept the house, like a divorce. The consumer did that because his house had just enough technology to displace about 1/3 of his monthly fixed car expenses.

  29. davidw

    Hamilton is actually a genius. “It’s the oil stupid”. He has been saying this for decades, and people keep forgetting.
    I even lost my faith a bit when oil prices were high and there wasn’t a ‘recession’. It turns out there was.

  30. Radley77

    I was at a lecture in Calgary titled “Oil Price Uncertainty” by Dr. Apostolos Serletis. In it, he examined the effects of an oil price shock. Both a positive and negative shock. I believe his conclusion about a negative oil price shock was that GDP fell as well.

  31. GK

    ” would say the producers are scared to death and the dependents that mostly contributed to our current political regime (and in a state of euphoria) don’t have any money to spend.”
    That is certainly true.
    US GDP per capita is currently $45,000. But it has not risen in real terms in almost a decade.
    I think that once a society reaches a certain level of prosperity, leftists become a large enough percentage of the population that they enact policies that prevent further economic growth. The ratio of leftists to productive people becomes high enough to paralyze any prospects of economic growth.
    The 60-year-old women at Code Pink, in yesteryears, would have had to work in the fields, factories, or as housekeepers. They would have no luxury of causing trouble while on the taxpayer dole.
    It might not be possible for any large country (more than 10m people) to ever cross $60,000 a year in per-capita GDP in 2009 dollars. That might be a self-inflicted ceiling that human societies impose on themselves.

  32. ReformerRay

    GK – Could be that consumers do not need/want all the stuff that would be available at a higher income/GDP level.
    More stuff is not the only value available. Personally, I would give up some of my current stuff for an economy operating smoothly, without stress -(reliant on oil, large trade deficit, high debt, reliant upon extensive credit).

  33. bakho

    The market price of oil does not impact the consumer as much as the price at the pump.
    If one looks at US oil consumption, it dropped by over 20% after the implementation of the Carter energy policies. Reagan stalled efficiency efforts and consumption returned to 1978 levels by 2000. In 2000, pump prices first went over $2 in the Midwest. Fuel efficiency needs to get back on track.
    Families have a “Transportation” budget, not a “fuel” budget. Increases in fuel costs translates into fewer car purchases. We have seen US car sales go from over 17 million to under 10 million. Some of that is people finding out how to live with fewer cars and liking the savings they realize. A typical car costs about $7,000 per year. A wage worker at $8 per hour earns only $16,000 per year. GO figure.
    http://www.eia.doe.gov/emeu/aer/pdf/pages/sec5_20.pdf

  34. JDH

    Mark: The paper has an extensive analysis of four recessions that followed four earlier oil shocks prior to the most recent experience. To that list could also be added the Suez Crisis of 1956-57, and in fact there is some upward move in oil prices prior to every postwar recession with the single exception of 1960. I’ve been writing about this for many, many years.

    wogie: Note that the graph is already in units of 100 times the log, so the actual change (not the percentage change) is already in units of approximate 100 basis points. That is, the correct calculation is 940.98 – 935.91 = 5.07, meaning that the oil shock is estimated to have reduced the 2008:Q4 level of real GDP by about 5.07% relative to what it would have been without the oil shock. Note also that the green dotted line is not a “trend line”, but instead is the forecast from a univariate fourth-order autoregression estimated over 1949:Q2 to 2001:Q3. The last two quarters of GDP before this forecast begins (2007:Q2 and 2007:Q3) were both above-average growth rates (4.8% at an annual rate), and the nature of an autoregression is that, in the absence of other disturbances, you would have expected the next few quarters (2007:Q4 through 2008:Q2) to have also come in a bit above average. For this reason, the green line predicts that real GDP would have increased by a total of 4.88% between 2007:Q3 and 2008:Q4 in the absence of an oil shock, whereas the red line predicts that real GDP would have decreased by a total of -0.19% with the oil shock, for a net difference of 5.07%. Actual real GDP fell by -0.87% between 2007:Q3 and 2008:Q4. All percentage changes reported here represent 100 times the log difference.

    Nick G: See details given to wogie above. For what they’re worth, the forecasts from here out from equation (3.8) call for GDP growth rates (annual rate) as follows: 2009:Q1 -2.5%; 2009:Q2 -0.8%; 2009:Q3 +3.9%.

    tj: You could argue that’s part of what did happen in the 1970s.

  35. JM

    A telling thing on that graph is how the “actual” line starts diving below the “expected” trend around alte August. This is around the time all the crap started hitting the fan on how screwed up the financial world really was, and a minor recession became something muchn worse.
    While the oil shock led to a change in behavior that slowed and eventually retracted the economy (more than real GDP figures showed at the time, since real people had inflation well above the 4% that was being used as a deflator at the time), it was the realization of the financial meltdown and the collapse in asset prices that forced the real changes and cutbacks that we’re still suffering from.
    Regardless, it’s good info, Dr. Hamilton.

  36. Vangel

    While the high energy prices may have helped trigger the economic contraction a readjustment of economic activity was inevitable. No matter how we look at it, we had a phony economy that was based on borrowing and spending. That had to come to a bad end no matter what happened with oil prices.
    Looking forward we should be able to note some vulnerabilities that seem to be ignored by most analysts and commentators. The bottom line is that the price declines that come with inventory liquidations are bound to end sooner than most people expect because the supply side response has been swift as factories have closed down operations and commodity producers have acted just as rapidly to shut down marginal operations. In the case of oil that means that supply is in rapid decline and that without new capital investment even a depression will be unable to keep prices from rising eventually.
    At the same time the risk to savers is very large as central banks have threatened the purchasing power of savings by creating money out of thin air. This increases the risks of an inflationary depression in the United States and Western Europe that is similar to national depressions seen in many Latin American countries during the past few decades.

  37. Dave Cohen

    Finally, I have the opportunity to provide a reminder to the world that oil (and its price) can not be taken for granted.

    I haven’t read the paper yet, but the price shock seems to have been the result of 3 factors.

    • Fundamentals, where world crude oil supply fell in 2006 and 2007 as demand skyrocketed

    • Declines in the value of the dollar over much the period 2005-2008:Q2

    • A speculative premium after 2007:Q4

    If oil prices had followed the trend since 2003, I figured the price at about $110-115/barrel. So, I chalk up prices higher than that to #2 and #3.

    To the extent that the financial crisis itself caused some (but not nearly all) of the price shock, it is hard to separate causes and effects.

  38. Daniel

    There will be no rebound of the economy stemming from low oil prices. Oil production is now declining worldwide, the recession just covers that up because currently the consumption declines even faster.

    But look at what happened after the G-20 meeting. Stock markets went up about 5% in a bit of optimism but that immediately triggered a 10% rise in oil prices.

    If the economy recovers enough to actually try some growth again, demand will outrun supply again very fast and the oil price, inelastic as it is as soon as you get a sellers market, will shoot through the roof once more, triggering the next recession cycle.

  39. ReformerRay

    Past experience is the only guide we have to the future. At the same time, I am with the “look-at-what-is-different-today” school.
    “the price declines that come with inventory liquidations are bound to end sooner than most people expect because the supply side response has been swift as factories have closed down operations and commodity producers have acted just as rapidly to shut down marginal operations. In the case of oil that means that supply is in rapid decline and that without new capital investment even a depression will be unable to keep prices from rising eventually”.
    The rapid foward looking response of many corporations (to reduce production and employment) suggests to me that we will see an upward growth in corporate profits soon and an uptick in the stock market before corporate profits begin to increase.
    This change will be short lived because the low employment will not sustain economic growth.
    To compete in the global economy, the U.S. economy must be restructured to be able to produce profits when gasoline prices are high – which all parties refuse to acknowledge.

  40. Dave Cohen

    I have now had a chance to look at this paper.

    Which is the correct elasticity, 0.06 or 0.10?

    The big news of 2008:H1 was the surprising observation that even $100 oil was not going to be sufficient to prevent global quantity demanded from increasing above 85.5 mb/d…

    I have raised the possibility that miscalculation of the long-run price elasticity of oil demand
    by market participants was one factor behind the oil shock of 2007-08, and that speculative
    investing in oil futures contracts may have contributed to that miscalculation.

    It needs pointing out at this juncture that I can find nothing in Obama’s energy policies–I have looked–that shows any level of concern about the low long-run price elasticity of demand for oil. Magical efficiency improvements from revised CAFE standards seem to be all that is required. JDH has been tracking the terrible car sales data, and we might expect that to continue for some years. Obviously this will weaken the effectiveness of CAFE improvements.

    I have written two articles on all this.

    1. Steven Chu’s Energy Miscalculations

    2. The Secretary of Synthetic Biology

    “Miscalculation of the long-run price elasticity of oil demand by market participants” continues.

  41. aaron

    GK, the decline in certainty makes it more difficult to make investments decisions. So a negative price spike should lead to increased consumption, but it doesn’t lead to increased capital investment. I think that means we see a very small increase in the overall economy and pretty much no increase in productivity.

    Also, a rough analysis of fuel consumption and vehicle miles traveled suggests that we saw declining productivity in response to high gasoline prices. When I look at gasoline and diesel consumption and vehicle miles traveled, it looks to me that price pressure lead to modest improvements in commercial vehicle traffic, but this was offset by declines in efficiency (in the logistical/egronomic sense, not economic) in passenger vehicle travel.

    So now we have two problems, we aren’t investing in increasing supply, and productivity has declined. So if demand magically returned to previous levels, we’d see even higher prices and smaller profits. Lot’s of risk and uncertainty which makes capital investment decisions hard to make.

  42. steve from virginia

    Extremely interesting paper, I am also reading a parallel paper:
    http://www.econ.yale.edu/seminars/macro/mac08/Swagel-090409.pdf

    What a difference perspective makes?

    The issue of oil price consequences in the overall economy is disputed hotly on Oil Drum and elsewhere. Gail Tverborg wrote a long article about this not too long ago and the argument is persuastive to the point where one asks:

    ‘In a house of cards, does it matter which particular card is ‘critically important’?’

    I think your regressions could also be applied to hard capital in general – particularly aggregated savings both in the US and overseas – and come up with similar curves. The issue of hard capital has been obscured by the geometric increase in bank- financial system credit. Viewing credit as a promise to deliver a good in the future (or some future production as Jean Baptiste Say would describe it) the promises were wearing thin even before the Bernanke Fed was raising interest rates in 2004.

    The question then becomes was it shortage of capital (leading to overleveraging to compensate) or rising petroleum prices and the answer would be both but more a capital shortage since the effects on tightening credit were apparent much faster.

    The other side of capital insufficiency is found here:

    http://research.stlouisfed.org/publications/review/06/01/ChomPennCross.pdf

    The date given as the beginning of the subprime strategy is 1995 more or less, that being at the tail end of the 1989- 91 recession brought on by the Savings and Loan collapse. The point is not the details of the strategy but the existence of the strategy itself; that in America beginnning in 1995 every person with the means and desire to own a house already owned one … and some owned two! The only way to put customers into the millions of new houses being built every year was to enlist a new class of borrowers, those who could not ordinarily qualify for a mortgage loan.

    The subprime (or Alt-A or floating rate) loan origination served the homebuilding industry not the borrowers; and that ten years of production of houses for a market with fictional or imaginary earning power has left the country with a surplus or market overhang of twenty million unsellable (at a profit) houses.

    The resulting deflation in real estate and related industries is the simple expression of supply (being forced by foreclosure and demographics) and (diminishing) demand. Supply and demand renders credit availabilty irrelevent; (over) supply is real and credit is more and more ‘virtual’. A consequence is for house prices to continue to decline.

    Capital insufficiency began in 1982 when Reagan broke PATCO and business declared war on unions. Wages have never caught up to price inflation since; household expenses by category are tilted toward housing costs, then medical, higher education and conumer borrowing (interest) costs. (Here it would seen that relative lower petroleum prices would subsidize the other categories like consumer borrowing) Mom would tell you never borrow to pay operating costs but the credit card bills (a sigma of household operating expenses over time) paid for by refinancing the house and taking out equity did just that. The consequence was more erosion of capital.

    It was capital insufficiency that became apparent once Bear- Stearns’ hedge funds failed along with the failure of another mortgage security fund that precipitated the credit freeze- up, this was in June of 2007. From that point onward bank/finance credit sufficiency has been replaced by central bank credit, a condition that is unsustainable on its face; solvency cannot be cured by liquidity.

    Nevertheless, the situation going forward indicates a greater vulnerability to relative high petroleum prices with a self- moderating effect. There is both less credit available to end users in 2009 and less wage income due to expanding unemployment. There is less speculative wherewithall in the investment community to finance ‘spread chasing’ as was the case in commodity markets in 2008. The US is importing elasticity from overseas (which would explain why the Chinese are so eager to escape dollar ‘hegemony’) but the shrinking of capacity to consume versus the relative inelasticity of production capacity (the marginal return on production cuts is diminishing plus market share competition) causes a large production overhang relative to demand. This is the self- moderating effect that would tend to prevent prices from approaching $100/bbl even $75/bbl would be unaffordable.

    China demand cannot expand quickly enough to compensate for the loss of demand in the US. If Al Qaeda took over Saudi Arabia, they would still sell us oil; when GM is bankrupt, their production is gone forever and cannot be replaced by cars the Chinese or Indians can make that the Chinese or Indians can affort (or the Americans would want).

    The dollar cost (seigniorage) is also a price moderater. This benefits Amerian consumers at the expense of producers and non- dollar consumers who have to buy dollars first to buy petroleum.

    Before this comment runs on endlessly, the real issue is purchasing power more than demand elasticity since the latter can be imported while purchasing power is not being imported, now that Americans are not buying Chinese goods nor American goods, either. The effect of shrinking PP means a lower price rise in oil will have some shrinking effect on GDP here with $55 (my hunch) being the price where Americans drive less. But since driving less in a lower price environment has less effect on GDP here and more on the GDP in countries stuck with our in- elasticity. This would manifest in lower production in China or India (Brazil) and agriculture shortages in countries dependent on oil imports for irrigation, fertilizer, and transport; also more cheating – and increased production – by OPEC.

  43. wogie

    Monetary policy, the GDP share of oil demand, and
    the local level of oil production are found to be key determinants of the impact of oil shocks.
    The Effects of Oil Shocks on the Global Economy
    Luca Guerrieri
    June 2005
    GDP impacts heavily dependent on oil demand share of GDP. Share with 100% increase in oil price results in drop of about 1.4% in GDP over a number of years (see graph at back of study).
    http://economics.ca/2006/papers/0926.pdf

  44. marmico

    I have difficulty reconciling nominal personal consumption expenditures with the output contraction. Gasoline, oil consumption increased from $267 (billion) [BEA Table 2.4.5U, line 119] in calender year 2007 to $380 in 2008 which was 50% offset by a consumption decline of motor vehicles and parts (line 2) from $440 to $379.
    The worst balance sheet recession and (maybe in the fullness of time) the worst output contraction in 75+ years should not have happened based on that data set.

  45. JDH

    marmico: All calculations reported in the paper are based on real magitudes. If the price of oil goes up and you buy the same quantity of oil there is no increase in real consumption spending on oil.

  46. Vangel

    I agree that purchasing power is extremely important ans suspect that the increase in the supply of money and credit will mean much higher prices in a world where the supply of oil is falling. What I do not agree with is the argument that we are about to see a lot more cheating and increased production by OPEC because most OPEC nations have trouble with their ageing oil fields.
    To see the extent of the problem we need to look close to home at Mexico’s great Cantarell oil field, where production peaked at just over 2.1 million barrels per day in 2003. Since then the field’s production has declined by more than 60% and there is no amount of new investment that will reverse the decline. Other great fields such as China’s Daqing, Kuwit’s Burgan are also in decline and will require production levels well below their maximum capacity if total output value is to be optimized. Production in Russia is in decline and the North Sea production levels have fallen by more than 50% since the peak a decade agon.
    The bottom line is that previous demand increases were being met by excess capacity that was available as needed. As we debate this that capacity is virtually gone and we are looking at a need for massive investment just to keep production flat. Given the fact that the production of light sweet crude peaked in 2005 and that the additional barrels that were reported have come from NGLs and unconventional sources the picture looks quite bleak. That leads me to conclude that the way forward will mean a forced contraction of demand that will mainly come from the United States, which has little in the way of real products to trade to the rest of the world in order to pay for its energy use. It would not surprise me to see the purchasing power of the USD fall in half or more and to see American demand fall relative to the rest of the world.

  47. ReformerRay

    Pessimism is applealing to me. I want to believe that Vangel is right in his bleak assessment of the future world supply of oil. In addition to the problem of the total world supply, we have the reality of China lining up long term contracts to purchase oil from individual nations.
    However, Vangel is wrong when he says that the U.S. has little in the way of real products to trade to the rest of the world. The U.S. was the second leading goods export nation in the world (in 2007).
    The obvious and proper response of the U.S. to this situation is to establish a new trade policy, aimed at equal trade in manufacturing goods with all our trading partners. This will mean explicit change in import rules, since imports are the only part of trade controlled by the U.S.
    To do this, the U.S. must make a 180 degree turn in goals, substituting equal trade for free trade.
    Newspaper editorial writers will scream “Protectionism”. I ask them to tell me how else we are to avoid the decline in the purchasing power of the USD Vangel foresees.

  48. Dave Cohen

    Vangel said

    While the high energy prices may have helped trigger the economic contraction a readjustment of economic activity was inevitable. No matter how we look at it, we had a phony economy that was based on borrowing and spending. That had to come to a bad end no matter what happened with oil prices.

    Exactly right. I am having a lot of trouble swallowing JDH’s analysis. Oil consumption does follow real GDP (income), but look what happened to household net worth after 2006, look at household debt levels, etc. I wish some attempt had been made to look at these variables instead of just drawing a conclusion from energy prices alone. There’s something seriously wrong here.

  49. aaron

    Increases in debt are manageable so long as they are matched by relative increases in income. Problem wasn’t simply increases in debt, it was debt based on unreasonable expectations of income which were shattered by increasing costs.

  50. Vangel

    I agree that purchasing power is extremely important ans suspect that the increase in the supply of money and credit will mean much higher prices in a world where the supply of oil is falling. What I do not agree with is the argument that we are about to see a lot more cheating and increased production by OPEC because most OPEC nations have trouble with their ageing oil fields.
    To see the extent of the problem we need to look close to home at Mexico’s great Cantarell oil field, where production peaked at just over 2.1 million barrels per day in 2003. Since then the field’s production has declined by more than 60% and there is no amount of new investment that will reverse the decline. Other great fields such as China’s Daqing, Kuwit’s Burgan are also in decline and will require production levels well below their maximum capacity if total output value is to be optimized. Production in Russia is in decline and the North Sea production levels have fallen by more than 50% since the peak a decade agon.
    The bottom line is that previous demand increases were being met by excess capacity that was available as needed. As we debate this that capacity is virtually gone and we are looking at a need for massive investment just to keep production flat. Given the fact that the production of light sweet crude peaked in 2005 and that the additional barrels that were reported have come from NGLs and unconventional sources the picture looks quite bleak. That leads me to conclude that the way forward will mean a forced contraction of demand that will mainly come from the United States, which has little in the way of real products to trade to the rest of the world in order to pay for its energy use. It would not surprise me to see the purchasing power of the USD fall in half or more and to see American demand fall relative to the rest of the world.

  51. Vangel

    “Pessimism is applealing to me. I want to believe that Vangel is right in his bleak assessment of the future world supply of oil.”
    Actually, I want to be wrong but do not see data to show that there is an optimistic scenario in our future.
    “In addition to the problem of the total world supply, we have the reality of China lining up long term contracts to purchase oil from individual nations.”
    And as the Chinese drill more and arrange long term contracts the Obama administration is discouraging American production by changing the tax rules and cancelling leases.
    “However, Vangel is wrong when he says that the U.S. has little in the way of real products to trade to the rest of the world. The U.S. was the second leading goods export nation in the world (in 2007).”
    I believe that in 2008 American exports trailed those of Germany and China. But the data, as with most economic data, is skewed because American ‘exports’ to Canada and Mexico are parts and components that are reimported right back into the country. That said, the US is clearly a global leader in such things as heavy machinery, weapons systems and civilian aircraft and as such there will be some demand for American products. The problem is that there cannot be enough to offset the massive demand for imports in energy, electronics, clothing and even food.
    I also have trouble with the USD denominated measure of exports and prefer to look at the actual real flows of real goods and services instead. What I have noted is the vast imbalance between container ships that deliver goods to the US and the container ships that take goods abroad. In the past many containers that were coming in full of products for American consumer markets were sent back empty or loaded with such trivial low value items as scrap metal, recycled cardboard and other scrap.
    “The obvious and proper response of the U.S. to this situation is to establish a new trade policy, aimed at equal trade in manufacturing goods with all our trading partners. This will mean explicit change in import rules, since imports are the only part of trade controlled by the U.S.”
    Only if you want to harm American consumers more. Why would anyone want to force American citizens to pay more for sugar, oil, cars, steel, lumber, socks, underwear or other goods just because domestic suppliers of those items can’t produce them at competitive prices? And if they are made to pay more what happens to the current sellers of American goods and services that will see their sales collapse as American consumers have less money to spend?
    “To do this, the U.S. must make a 180 degree turn in goals, substituting equal trade for free trade.”
    I think that you are very confused here. As I said, if American producers can’t compete then American consumers will pay much more. Given the fact that the amount of money that consumers have is limited, domestic producers of other goods will lose market share.
    “Newspaper editorial writers will scream “Protectionism”. I ask them to tell me how else we are to avoid the decline in the purchasing power of the USD Vangel foresees.”
    If you do what you are suggesting the USD will collapse even faster and Americans will be much poorer because their income will buy so much less than it does now. To eliminate the crisis you have to let the market work properly. That means letting inefficient businesses fail and stop using the taxpayer to bail out bad decisions made by the banks. It also means having a limited government and low taxes once again.
    What made America great was its protection of individual liberty and insistence that individuals took responsibility for their own actions. If you want it to be great again you better hope that the voters have the courage to reject the meddling politicians and charlatans that run the mainstream parties. My guess is that the voters don’t understand economics and history and that even if they did, they do not have the courage to do what they must at the ballot box.

  52. ReformerRay

    Vangel assumes that the amount of income U.S. consumers have to purchase goods is the same, regardless of the size of the U.S. trade deficit. Not so. The size of GDP and therefore income available to be spent, is dependent upon the size of domestic production, which is chocked off by imports in excess of exports. Equal trade would force production in the U.S., therby increasing domestic income. Our current system creates leakage of the stimulus dollars overseas. The domestic producers that are forced out of business by excessive imports are still able to produce goods at reasonable prices.
    Yes, I am willing to see the price domestic consumers pay for goods increase, if that is the way to get U.S. production increased.
    Germany’s tax system rebates value added taxes to firms that export. This enables German firms to sell goods overseas at cheaper prices than at home. Germany’s export prowess is supported by the German public. If the U.S. public were smart, they would accept restrictions on imports so at to increase domestic production in the U.S.
    Reducing the U.S. trade deficit to zero is not likely to happen any time soon, but it should be the objective. Marginal change is all that can be accomplished. I want a system in place that will continue the downward trend in the U.S. trade deficit.
    Since the year 2005, the ratio of the goods trade deficit to goods imports in the U.S. has declined from 47% to 38% (in 2008). This situation coincides with increased personal savings. No indication that they U.S. consumer is harmed by this change. If imports were restricted by law, this trend would be certain to continue, with the result of increased production and employment in the U.S.
    In my view, U.S. politicans have not meddled enough in foreign trade. They have been outmaneuvered by their counterparts in Gemany, Japan and China. Our only hope is that we as a country will learn to protect our country just as the leaders of other nations are doing for their country.

  53. bakho

    The changes in gas prices change the resale value of used vehicles. Gas guzzlers have little market and prices dropped precipitously. Many folks are underwater on the cars anyway. If they cannot sell them, they cannot pay down on a new one. Trade in value won’t even pay off the old loan, let alone put money down on the new one. So new car sales tank. Money that might have gone into saving for a new car is sucked up by record oil profits. So people stick with the old car and drive it fewer places and spending less. It all adds to the downward spiral.
    The cost of gas price increase is not spread evenly. Lower middle class workers often have longer commutes and use more not less fuel than those above the median income. Velocity of money is higher in the lower classes than it is in the upper classes. If most of the couch change is being vacuumed out of the economy by record oil profits, then money with the highest velocity drops out. This triggers a downward spiral as decline demand has greater effects across the bottom rungs of the economy.

  54. ReformerRay

    Higher gas prices will come again. My preference is to face this reality head on. I would like to see a gradual increase in gasoline taxes to be created by the Congress at a rate that the economy can absorb rather than wait for supply and demand to determine the size of the change – and its timing. I hate being in the position of a scared rabbit.
    We did not benefit from our interlude of low gas prices when they existed because we developed a life style dependent upon cheap gasoline.

  55. ReformerRay

    Vangel says: “What made America great was its protection of individual liberty and insistence that individuals took responsibility for their own actions”.
    The U.S. created the most productive economy in the world in the period from the Civil War to 1929 because a lot of factors converged – abundant agricultural land available to be used, the stage of the industrial revolution, the invention genie created by successful farm work, the emerging economy advantage, immigration, a stable government that allowed free enterprise to have sway, committment to education and other public works, etc. Freedom and personal responsibility was a part of the mix.
    That era cannot be recreated. Today we live in a global economy in which some rich countries have learned how to continue production to serve other nations and the U.S. has not really faced the reality of produce or decline. A strong and capable government is the requirement that must be created, for the U.S. to continue to prosper.

  56. Vangel

    Vangel assumes that the amount of income U.S. consumers have to purchase goods is the same, regardless of the size of the U.S. trade deficit.
    No. I am arguing that in a world where resources are limited people are better off when they are made by those that are the most efficient. There is no need for New York State to put up tariffs against Florida oranges just because Florida has a natural advantage and does not have to grow its oranges in greenhouses. There is no need to put tariffs on Brazilian ethanol just because sugar cane based ethanol is cheaper than ethanol that comes from American grown corn.
    Equal trade would force production in the U.S., therby increasing domestic income.
    When goods are purchased from less efficient producers real income goes down. Many states run trade deficits with other states. If we were to stick to your logic you would argue that income would go up if the US started to put up trade barriers within its borders. But even you should be able to see that is a ridiculous argument and that free trade within American borders have made Americans richer.
    The domestic producers that are forced out of business by excessive imports are still able to produce goods at reasonable prices.
    First, it is the existence of more efficient competitors that force domestic producers out of business. Some goods should not be produced in wealthy countries because their value added content is too low to justify the investment. (Most Americans do not want low paying jobs in which they have to work 10 hours per day sewing cloth together.) Second, much of the inefficiency can be attributed to government meddling that makes it difficult for producers to establish operations inside the United States. In many cases the regulatory burden is so high that only the very large companies can afford to divert so much of their time and energy for compliance activities.
    Yes, I am willing to see the price domestic consumers pay for goods increase, if that is the way to get U.S. production increased.
    You and other individuals are already free to pay more for American goods if that is what you wish to do. But that does not seem good enough for you because you want the force of government to make others pay more than they would choose to.
    Germany’s tax system rebates value added taxes to firms that export. This enables German firms to sell goods overseas at cheaper prices than at home.
    So? The fact that the German government does not make foreign consumers pay taxes on consumer made goods seems to be a good deal for consumers.
    The US government can do exactly the same thing for consumers by simply cutting the taxes that corporations pay when they make competing goods. If you want higher real incomes and more jobs lower taxes would go a long way towards that goal. On the other hand, tariffs will destroy jobs and lower real incomes.
    Germany’s export prowess is supported by the German public. If the U.S. public were smart, they would accept restrictions on imports so at to increase domestic production in the U.S.
    Like I said, the consumer is free to voluntarily purchase higher priced American goods. The fact that most people choose not to do so suggests that they prefer lower prices. It is possible to use the force of government to
    Reducing the U.S. trade deficit to zero is not likely to happen any time soon, but it should be the objective. Marginal change is all that can be accomplished. I want a system in place that will continue the downward trend in the U.S. trade deficit.
    As many have pointed out a number of times, there have been trade imbalances within Americas borders for centuries and nobody would argue that what we need are tariffs between states, counties, cities, neighbourhoods, etc.
    Since the year 2005, the ratio of the goods trade deficit to goods imports in the U.S. has declined from 47% to 38% (in 2008). This situation coincides with increased personal savings. No indication that they U.S. consumer is harmed by this change. If imports were restricted by law, this trend would be certain to continue, with the result of increased production and employment in the U.S.
    The decline coincides with changes in foreign exchange and the price trends for commodities.
    In my view, U.S. politicans have not meddled enough in foreign trade. They have been outmaneuvered by their counterparts in Gemany, Japan and China. Our only hope is that we as a country will learn to protect our country just as the leaders of other nations are doing for their country.
    Well that seems to be a very popular view among the left and progressives but that view cannot be supported by logic. As I said, the benefits of voluntary economic transactions is fairly obvious to anyone with an open mind and the ability to think. The argument that using governments to force people to make other choices will make them better off is not logical or supported by facts.

  57. Vangel

    “Higher gas prices will come again. My preference is to face this reality head on.”
    It is my preference as well. If you believe that higher prices are inevitable you can prepare by investing in energy producers in politically secure areas and by reducing your own consumption.
    “I would like to see a gradual increase in gasoline taxes to be created by the Congress at a rate that the economy can absorb rather than wait for supply and demand to determine the size of the change – and its timing. I hate being in the position of a scared rabbit.”
    But you are already free to pay more for gasoline already. Every time you fill up your car you can set money that you send to the government or a charity. I suspect that you do not just want to pay more for gasoline but that you want others to do the same.
    “We did not benefit from our interlude of low gas prices when they existed because we developed a life style dependent upon cheap gasoline.”
    You did not benefit? From what I can see, lowre class Americans have a lifestyle that would have been the envy of the upper classes a century ago. A typical middle class earner was able to travel to other countries, eat exotic foods, purchase high quality goods and health care that were unavailable to all but the richest individuals of their grandfathers’ generation.
    You need a reality check. Cheap energy is good for us and helps us live a much higher standard of living than ever before. What we need is for governments to get out of the way and permit people to come up with a way to transition to other viable sources because governments have proven totally incapable of coming up with any solutions. (See the ethanol/biodiesel fiacso for perfect examples.)

  58. Yu'er

    Let’s see:
    First, excessively easy monetary policy caused increasing demand for consumption and housing investment, which raised house prices and mortgage equity withdraw and further increases in consumption, which translated to the boom in China and increasing oil demand, which translate to oil price shocks that eventually tipped US economy — oh yes, those mortgages originated between 2003 – 2007 helped to make a normal recession to a full blown crisis. Professor, you just gave a new meaning to the saying that every post WWII recession is caused by the Fed — I might add, caused by their arrogant attempts to prevent/lift the economy from a recession.
    Oh, what are they doing right now?

  59. ReformerRay

    The creation of a large internal market in the U.S. without trade barriers is one of the reasons this country became so productive and powerful. The Civil War estalished the principle that this is one country, united and governed by a central government.
    All U.S. citizens benefit from the profits earned by orange growers in Florida selling in New England because we all are in the same taxing and tax distribution unit.
    Profits earned by grape growers in Chile do not benefit U.S. citizens because the taxes they pay on their profits do not benefit us. The wages they pay to people who provide the product do not benefit citizens of the U.S.
    Inability to see a difference between internal trade within a nation, which benefits all citizens, and foreign trade, which has a different distribution of benefits, is deliberate blindness.
    Ignoring national boundaries is unrealistic. Citizens of the U.S. benefit from all our advantages that others do not share. We must learn that these benefits are being reduced because the U.S. has been unwilling to defend itself against foreign trade that produced a 30 year goods trade deficit, culminating in the U.S. consumer as the major prop for the world economy in the period 2002 – 2005.
    The U.S. trade deficit can no longer be supported by fictious profits supposedly earned by the finance sector. We must move toward equal trade.
    The means choosen to move toward equal trade is just as important as the change in objective. That is another issue, to be discussed elsewhere.

  60. ReformerRay

    I welcome the opportunity to debate the merits of free trade versus equal trade as a goal or objective. However, that debate should be transferred elsewhere because trade is a side issue in this forum.

  61. Dave

    An earlier commenter asked if a temporary increase in energy costs could tip us into this recession then what will be the effect of Cap and Trade? No doubt, the housing bubble and deficit issues set us up for this situation, providing the deep hole we fell into due to the oil price run up. But will Cap and Trade permanently cripple our economy due to highly increased input costs?

  62. KnotRP

    As anyone with an engineering degree knows, you can remove the input from a feedback system AFTER causing a response, and not necessarily return to the original state – it all “depends” on the system arrangement. In this case, gas prices were the final straw, on the monthly grunt’s budget — already stressed by mortgage resets, which drove house prices into a self-reinforcing downward spiral which no longer required any specific gas price to propagate the signal.
    The paper matches real world an anecdotal experience, Professor. Well done.

  63. Iconoclast421

    I’ve been writing about this a lot over the years. To me it is obvious exactly how and why this entire mess was created by lack of energy. Just apply 8th grade level reasoning for a minute. You have a housing bubble where everybody and their brother is owning a home. OK so that means you have a huge and growing national energy footprint. The home with its energy needs, the SUV in the driveway, the toys in the garage and shed. etc etc. But here in the real world we have peaking crude oil production since 2005. No amount of money is able to drive production any higher. Collapse was imminent. More info on my homepage link.
    I respect James Hamilton for attempting to model this stuff academically, but its really so simple and clear that one has to wonder what is the point in trying to devise a complicated model to explain it? The people disagreeing with our basic premise are going to continue to disagree, because that is what they are paid to do. That is how they make their living. The elite believe that the proles are simply not meant to know this stuff, even though it is so simple one can only wonder how friggin stupid they expect us to be before they consider us to be good little slaves?

  64. Vangel

    “The creation of a large internal market in the U.S. without trade barriers is one of the reasons this country became so productive and powerful. The Civil War estalished the principle that this is one country, united and governed by a central government.”
    Correct. Free trade allowed the goods to be produced by those that were the most productive and citizens benefited from an increase in purchasing power.
    “All U.S. citizens benefit from the profits earned by orange growers in Florida selling in New England because we all are in the same taxing and tax distribution unit.”
    That is not true. Most US citizens are harmed by the high level of taxation and the poor services forced upon them by the federal government. While some states and some citizens are net recipients most are net losers.
    “Profits earned by grape growers in Chile do not benefit U.S. citizens because the taxes they pay on their profits do not benefit us. The wages they pay to people who provide the product do not benefit citizens of the U.S.”
    I think that you are confused. You can’t buy grapes from American producers during the winter so you certainly benefit if you want to consume grapes by buying them from Chile.
    “Inability to see a difference between internal trade within a nation, which benefits all citizens, and foreign trade, which has a different distribution of benefits, is deliberate blindness.”
    I think that you are the person who is having trouble seeing the benefits of voluntary trade so you argue that the force of government should be used to limit consumer choice. You also try to conveniently dismiss the fact that you have to ignore the boundary argument because it illustrates the absurdity of your position. As I wrote before, if your contentions were valid then there is no reason why the textile workers in Connecticut could not complain about cheaper competition from out of state regardless of where the competition were located. But the reason why calls for such protectionist measures are not made is because without the veil of patriotism and xenophobia to hide behind, the advocates cannot convince voters that political boundaries have no legitimate economic meaning. That is why nobody worries about the balance of payments between states, counties or cities.
    It is very obvious to anyone that a call by companies in Michigan for tariffs on goods made by lower cost jurisdictions such as Kentucky would be seen as a simple attempt to rip off the consumers in Michigan in order to protect the state’s inefficient producers. Well, calls for similar protection from more efficient domestic producers are also attempts to rip off consumers for the benefit of inefficient domestic producers.
    “Ignoring national boundaries is unrealistic. Citizens of the U.S. benefit from all our advantages that others do not share. We must learn that these benefits are being reduced because the U.S. has been unwilling to defend itself against foreign trade that produced a 30 year goods trade deficit, culminating in the U.S. consumer as the major prop for the world economy in the period 2002 – 2005.”
    As I have argued before, citizens don’t benefit if they have to pay more for products because they are made by inefficient domestic producers. And if they are forced to pay more they can’t buy other things that would have been made by other domestic producers. There is a net loss of purchasing power and citizens are poorer.
    “The U.S. trade deficit can no longer be supported by fictious profits supposedly earned by the finance sector. We must move toward equal trade.”
    I agree that the profits by the finance sector are fictitious and have argued that the bailouts should not have happened. But just because your government is pro business instead of pro market it does not mean that the failed mercantilism that you support will make things any better.
    “The means choosen to move toward equal trade is just as important as the change in objective. That is another issue, to be discussed elsewhere.”
    I think that it is very clear that you have no clue about trade and economics in general. The mercantilism that you are supporting was discredited quite some time ago by men such as Smith, Hume and Locke and has never had much intellectual support among economists because no rational argument can be made in support of it.

  65. ReformerRay

    I cannot remain quiet. Adam Smith was able to show that it was not necessary to have a trade surplus to benefit from trade. With that I agree. The mercantilest were wrong when they insisted that a trade surplus was necessary to benefit from trade. Adam Smith’s legitimate argument was that equal trade will benefit all parties, a conclusion with which I heartily agree.
    However. he tried, unsuccessfully, to show that a trade deficit does not harm a country. Anyone who reads his argument on this point will see that he is unpersuasive. He says, first, that what is true for a household is true for a nation. That is the Fallacy of Composition. Firms that import goods into the U.S. benefit but the nation as a whole suffers a reduction in GDP (when the imports are not matched by exports).
    Then he argues that excessive imports can be resold to a third party. Good luck when China remains willing to continue to sell at the price you paid. Then he says that the currency that is used to pay for imports was created by domestic production, thus the difference between an equal exchange and payment with currency can be ignored. But when we have equal trade, that forces production in the present to pay for the imports. Use of currency means work done previously or in the future will pay for the import. Not the same thing.
    He says the ability of the “Colonies” (meaning the U.S.)to prosper in spite of a trade deficit proves that a trade deficit is not harmful. When excessive imports are machines for producing more goods, a trade deficit has value. But when the excess imports are consumption goods or things that can be efficiently produced domestically, one should compare the marginal difference between the imported goods and the domestic goods to get an estimate of the benefits of the excessive imports and subtract from that the total cost of the not produced domestic product, to see the impact of that excessive import on GDP. If that comparison were made on a systematic basis, one would learn that much of the excessive imports in the U.S. are doing more to reduce GDP than they are increasing consumer benefits.
    I realize increase in consumer benefits cannot be compared to loss of GDP without holding ones nose, but I insist that we must do so, if we want to evaluate the benefits of trade to the U.S.
    The benefits of trade as calculated by my favorite textbook are not persuasive because they calculate deviation from a perfect world – a world that does not exist.
    In my opinion, too many economists have been too willing to accept received opinion without reading what Adam Smith really said or looking at the assumptions made by international trade textbooks.
    I see that I cannot resist responding to argument that I think invalid. I apologize to the readers who are not interested in this topic. Tis true that I believe that ALL the intellectual arguments in support of free trade are weak, not just those that are presented by Vangel.
    I have much more to say on this topic but I fear the charge of being off the approved topic of this blog.

  66. ReformerRay

    In the JEP article in 2004, the model used by Sanuelson assumed both equal trade and full employment. Even with that limitation, he argued that trade is not necessarily a win-win situation for all parties all the time.
    How many of the Richardian models that justify trade assume equal trade? I am merely trying to bring reality into conformity with the models.
    How many models can be cited that show a benefit of trade when a 30 year trade deficit exists? How many of the models assume perfect competition?
    I realize that Bernanke was able to cite one article that he said justifies the assumption that the U.S. has benefited from trade in the last two decades, but that article was not based on any model accepted in the economics profession. The Final Report of the U.S.
    Trade Deficit Commission in 2000 argued that the U.S. trade deficit should be ignored (Republican version) but they did not depend upon any well established models to justify that conclusion.
    We are all in the same boat – ad hoc arguments are all we have to discuss current trade policy. And ad hoc arguments can be developed by anybody.

  67. Vangel

    “However. he tried, unsuccessfully, to show that a trade deficit does not harm a country. Anyone who reads his argument on this point will see that he is unpersuasive. He says, first, that what is true for a household is true for a nation. That is the Fallacy of Composition. Firms that import goods into the U.S. benefit but the nation as a whole suffers a reduction in GDP (when the imports are not matched by exports).”
    The argument still remains the same. Voluntary economic transactions are more beneficial to the two parties than ones in which governments use force to dictate terms. If you agree that the boundary argument is absurd at the state level then you have to justify why it isn’t absurd at the national level. You have to explain why a trade deficit between Windsor and Detroit is more harmful to an individual living in Dallas than a trade deficit between Detroit and Seattle would be. As I wrote above, if your contentions were valid then there is no reason why the textile workers in Connecticut could not complain about cheaper competition from out of state regardless of where the competition were located. They lose their jobs regardless of where their more productive competitors are located.
    The reason why calls for such protectionist measures are not credible because without the veil of patriotism and xenophobia to hide behind, the advocates cannot convince voters that political boundaries have no legitimate economic meaning. That is why the Bush and Obama administrations took another route and decided to hand out taxpayer funds to inefficient automobile factories in Michigan and Ohio so that they can compete against more efficient competitors in Kentucky, Alabama, South Carolina or Tennessee.
    The bottom line is that–in the absence of fraud–voluntary economic transactions are much more beneficial to the parties involved than transactions in which outside parties such as governments use force to change the terms.

  68. ReformerRay

    1. Vangel’s world consist of individuals who are somehow independent of the nation in which they live.
    2. A world in which governments do not try to influnce international trade exists only in someone’s imagination. The question of whether we would all be better off if such a world did exist is irrelevant. Powerful countries will always attempt to maintain and extend their power. Today international trade is one of the means to power.
    3. I was born in Arkansas, educated all over the U.S. and found employment in Chicago and other midwestern cities because of the wealth that had been created in those locations by decades of work by previous generations. The creation of wealth in the midwest proved to be very beneficial to a citizen of another state who had the opportuntity to seek both education and employment all over the nation. To pretend that economic growth in Canada or Mexico or Chile is just as beneficial to me as economic growth in Californina is to ignore the degree to which citizens of the U.S. have opportunities not available to those living outside our borders.
    4. AS repeated above, benefits to consumers, which exist when trade provides products locally superior to domestic production, are created by equal trade. With equal trade, our trading partners are required to open their door to goods created in the U.S. If they cannot find something produced in the U.S. that is worth purchasing, the U.S. must restrict imports from that nation (manufactured products only) so as to bring manufactured exports and imports into balance. This does reduce the options available to consumers. But, it does not reduce those options as much as it improves the total domestic goods produced by the nation.
    5. On a more theoretical level, I challenge any reader to provide a persuasive description of Adam Smith’s defense of his decision that a trade deficit is benign. He was blowing smoke here. Generations of economists have failed to call him out on it.

  69. ReformerRay

    Equal trade is not the topic of this blog. But I want to add two more points, if I may.
    1. Comparative advantage requires equal trade. At the end of the story about comparative advantage, the output of one nation is TRADED for the output of the other (implicitly). If the equal exchange does not take place, the gains listed for the two parties do not exist.
    2. Adam Smith’s objective was to create the intellectual conditions which would result in specialization of production and increased efficiencies all over the world via increase in trade. The main hinderance to implementation of this vision were those politically powerful industrialists and merchant who were able to persuade their respective governments to impose tariffs and other barriers to trade ON PRODUCTS THEY PRODUCED. These “enemies” existed in all nations, but his main target was industrialists in England. The argument used by these “protectionists” was that protection of their product was necessary to counter protection extended to producers of this product in another country. They were hiding behind the argument that equal trade requires barriers to trade.
    Smith argued that the trade data were not able to show that another country was engaged in unfair trade. He tried to innoculate the legislature from these requests by arguing that equal trade is not the proper goal – free trade is the only proper goal.
    In my opinion, Adam Smith led astray generations of U.S. economists because he was fixated on countering the influence of supporters of protection of their own production.
    He did not envision the kind of trade deficit that was created in the U.S. so he made no effort to set conditions that would avoid it.

  70. Vangel

    “1. Vangel’s world consist of individuals who are somehow independent of the nation in which they live.”

    No. I merely point out that borders are irrelevant for economic purposes. When consumers freely choose to exchange their earnings for goods they choose the most preferable option. That usually means purchasing goods from the individual or business that provides the best product at the best price whether that product is made Oslo, Omsk, Orillia or Omaha.

    The simple fact is that if they are made to purchase from less efficient producers society as a whole becomes much poorer because there is more waste and fewer goods to distribute among the individual members of society. This is why hampered economies tend to be much poorer than those in which there is more competition and free trade.

    “2. A world in which governments do not try to influence international trade exists only in someone’s imagination. The question of whether we would all be better off if such a world did exist is irrelevant. Powerful countries will always attempt to maintain and extend their power. Today international trade is one of the means to power.”

    I agree totally that governments interfere with trade. But my point is that societies in which goods are permitted to enter without barriers are better off.

    “3. I was born in Arkansas, educated all over the U.S. and found employment in Chicago and other midwestern cities because of the wealth that had been created in those locations by decades of work by previous generations. The creation of wealth in the midwest proved to be very beneficial to a citizen of another state who had the opportuntity to seek both education and employment all over the nation. To pretend that economic growth in Canada or Mexico or Chile is just as beneficial to me as economic growth in Californina is to ignore the degree to which citizens of the U.S. have opportunities not available to those living outside our borders.”

    I think that you are confused once again. Your high standard of living is due to the fact that American governments meddled less in the economy than most foreign governments. And I would say that you would be much better off by not buying Californian goods and services because the government of California has made its industries too inefficient to provide you with competitive products.

    And I don’t know about you but most people prefer to buy as much with their disposable income as possible. The fact that they do so does not prevent you from doing what you wish to do and support less efficient, high cost producers.

    “4. AS repeated above, benefits to consumers, which exist when trade provides products locally superior to domestic production, are created by equal trade. With equal trade, our trading partners are required to open their door to goods created in the U.S. If they cannot find something produced in the U.S. that is worth purchasing, the U.S. must restrict imports from that nation (manufactured products only) so as to bring manufactured exports and imports into balance. This does reduce the options available to consumers. But, it does not reduce those options as much as it improves the total domestic goods produced by the nation.”

    And as I said, there is nothing stopping consumers from purchasing from higher cost domestic producers. What pisses you off is that the consumers make choices that you do not agree with and as a good little statist you think that you know what is best for them. But your way has been tried many times and has failed over and over again. And because people will not make the decisions you want willingly you propose to force them by using the power of government to make them use up more of their income than they would willingly just so you can protect the large inefficient businesses that you support.

    “5. On a more theoretical level, I challenge any reader to provide a persuasive description of Adam Smith’s defense of his decision that a trade deficit is benign. He was blowing smoke here. Generations of economists have failed to call him out on it.”

    On a practical level try using a little logic when you try to convince others that using force to make people support politically favoured businesses is better for them than giving them a choice to dispose of their income freely.
    That said, a very smart economist did away with your ridiculous mercantilist position quite some time ago. Given that you are not familiar with the argument I have provided it below.

    A PETITION From the Manufacturers of Candles, Tapers, Lanterns, sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting.

    To the Honourable Members of the Chamber of Deputies.

    Gentlemen:

    You are on the right track. You reject abstract theories and little regard for abundance and low prices. You concern yourselves mainly with the fate of the producer. You wish to free him from foreign competition, that is, to reserve the domestic market for domestic industry.

    We come to offer you a wonderful opportunity for your — what shall we call it? Your theory? No, nothing is more deceptive than theory. Your doctrine? Your system? Your principle? But you dislike doctrines, you have a horror of systems, as for principles, you deny that there are any in political economy; therefore we shall call it your practice — your practice without theory and without principle.

    We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival, which is none other than the sun, is waging war on us so mercilessly we suspect he is being stirred up against us by perfidious Albion (excellent diplomacy nowadays!), particularly because he has for that haughty island a respect that he does not show for us [1].

    We ask you to be so good as to pass a law requiring the closing of all windows, dormers, skylights, inside and outside shutters, curtains, casements, bull’s-eyes, deadlights, and blinds — in short, all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses, to the detriment of the fair industries with which, we are proud to say, we have endowed the country, a country that cannot, without betraying ingratitude, abandon us today to so unequal a combat.

    Be good enough, honourable deputies, to take our request seriously, and do not reject it without at least hearing the reasons that we have to advance in its support.

    First, if you shut off as much as possible all access to natural light, and thereby create a need for artificial light, what industry in France will not ultimately be encouraged?

    If France consumes more tallow, there will have to be more cattle and sheep, and, consequently, we shall see an increase in cleared fields, meat, wool, leather, and especially manure, the basis of all agricultural wealth.

    If France consumes more oil, we shall see an expansion in the cultivation of the poppy, the olive, and rapeseed. These rich yet soil-exhausting plants will come at just the right time to enable us to put to profitable use the increased fertility that the breeding of cattle will impart to the land.

    Our moors will be covered with resinous trees. Numerous swarms of bees will gather from our mountains the perfumed treasures that today waste their fragrance, like the flowers from which they emanate. Thus, there is not one branch of agriculture that would not undergo a great expansion.

    The same holds true of shipping. Thousands of vessels will engage in whaling, and in a short time we shall have a fleet capable of upholding the honour of France and of gratifying the patriotic aspirations of the undersigned petitioners, chandlers, etc.

    But what shall we say of the specialities of Parisian manufacture? Henceforth you will behold gilding, bronze, and crystal in candlesticks, in lamps, in chandeliers, in candelabra sparkling in spacious emporia compared with which those of today are but stalls.

    There is no needy resin-collector on the heights of his sand dunes, no poor miner in the depths of his black pit, who will not receive higher wages and enjoy increased prosperity.

    It needs but a little reflection, gentlemen, to be convinced that there is perhaps not one Frenchman, from the wealthy stockholder of the Anzin Company to the humblest vendor of matches, whose condition would not be improved by the success of our petition.

    We anticipate your objections, gentlemen; but there is not a single one of them that you have not picked up from the musty old books of the advocates of free trade. We defy you to utter a word against us that will not instantly rebound against yourselves and the principle behind all your policy.

    Will you tell us that, though we may gain by this protection, France will not gain at all, because the consumer will bear the expense?

    We have our answer ready:

    You no longer have the right to invoke the interests of the consumer. You have sacrificed him whenever you have found his interests opposed to those of the producer. You have done so in order to encourage industry and to increase employment. For the same reason you ought to do so this time too.

    Indeed, you yourselves have anticipated this objection. When told that the consumer has a stake in the free entry of iron, coal, sesame, wheat, and textiles, “Yes,” you reply, “but the producer has a stake in their exclusion.” Very well, surely if consumers have a stake in the admission of natural light, producers have a stake in its interdiction.

    “But,” you may still say, “the producer and the consumer are one and the same person. If the manufacturer profits by protection, he will make the farmer prosperous. Contrariwise, if agriculture is prosperous, it will open markets for manufactured goods.” Very well, If you grant us a monopoly over the production of lighting during the day, first of all we shall buy large amounts of tallow, charcoal, oil, resin, wax, alcohol, silver, iron, bronze, and crystal, to supply our industry; and, moreover, we and our numerous suppliers, having become rich, will consume a great deal and spread prosperity into all areas of domestic industry.

    Will you say that the light of the sun is a gratuitous gift of Nature, and that to reject such gifts would be to reject wealth itself under the pretext of encouraging the means of acquiring it?

    But if you take this position, you strike a mortal blow at your own policy; remember that up to now you have always excluded foreign goods because and in proportion as they approximate gratuitous gifts. You have only half as good a reason for complying with the demands of other monopolists as you have for granting our petition, which is in complete accord with your established policy; and to reject our demands precisely because they are better founded than anyone else’s would be tantamount to accepting the equation: + x + = -; in other words, it would be to heap absurdity upon absurdity.

    Labour and Nature collaborate in varying proportions, depending upon the country and the climate, in the production of a commodity. The part that Nature contributes is always free of charge; it is the part contributed by human labour that constitutes value and is paid for.

    If an orange from Lisbon sells for half the price of an orange from Paris, it is because the natural heat of the sun, which is, of course, free of charge, does for the former what the latter owes to artificial heating, which necessarily has to be paid for in the market.

    Thus, when an orange reaches us from Portugal, one can say that it is given to us half free of charge, or, in other words, at half price as compared with those from Paris.

    Now, it is precisely on the basis of its being semigratuitous (pardon the word) that you maintain it should be barred. You ask: “How can French labour withstand the competition of foreign labour when the former has to do all the work, whereas the latter has to do only half, the sun taking care of the rest?” But if the fact that a product is half free of charge leads you to exclude it from competition, how can its being totally free of charge induce you to admit it into competition? Either you are not consistent, or you should, after excluding what is half free of charge as harmful to our domestic industry, exclude what is totally gratuitous with all the more reason and with twice the zeal.

    To take another example: When a product — coal, iron, wheat, or textiles — comes to us from abroad, and when we can acquire it for less labour than if we produced it ourselves, the difference is a gratuitous gift that is conferred up on us. The size of this gift is proportionate to the extent of this difference. It is a quarter, a half, or three-quarters of the value of the product if the foreigner asks of us only three-quarters, one-half, or one-quarter as high a price. It is as complete as it can be when the donor, like the sun in providing us with light, asks nothing from us. The question, and we pose it formally, is whether what you desire for France is the benefit of consumption free of charge or the alleged advantages of onerous production. Make your choice, but be logical; for as long as you ban, as you do, foreign coal, iron, wheat, and textiles, in proportion as their price approaches zero, how inconsistent it would be to admit the light of the sun, whose price is zero all day long!

    Frederic Bastiat (1801-1850), Sophismes Economiques, 1845

  71. ReformerRay

    Bastiat is argueing against industrialist who advocated protection of those products they have to sell.
    He is not arguing against me. I am opposed to barrier to trade by product. I do not propose to ban “foreign coal, iron, wheat, and textiles”. I do not aim to reserve the domestic market for domestic industry. I aim to expand domestic production in lock step with domestic consumption.
    I support equal trade. In my opinion, equal trade can best be worked toward by the U.S. by imposing a tariff on ALL PRODUCTS manufactured in China, Japan, Germany, Canada and Mexico. Why those 5 nations? The account for 60% of the U.S. trade deficit. The way to reduce the U.S. trade deficit is to impose tariffs on all products from those 5 nations and to allow imports to come into the U.S. from all other nations.
    I said above that the way equal trade is sought, the laws to be passed by the U.S., is equally as important as the shift from free trade to equal trade.
    All independent readers of these exchanges should be clear that you are fighting against a position that I do not advocate. I am just as much against protectionism by product as you are.
    My position retains competition. Protectionism by product does not retain competition.
    Incidently, I love the command of language exhibited by these ancient philosophers. I greatly enjoyed reading Adam Smith for the same reason. There is wisdom in these materials. I do not disagree with anything Bastiat has to say. Thanks for allowing me to read him.

  72. jpa

    Ray, why are you advocating so strongly for intervention to balance US trade? What is wrong with a trade in-balance?
    As I see it, US consumers get products for cheaper than they would if trade deficit was balanced.
    China sells us products, then buys US Debt with those profits (to keep their currency down in relation to the US dollar, to keep exports up). Then the US debt is devalued as we print more and devalue the dollar. So the US consumer is buying stuff on credit that isn’t going to be fully paid back in real terms, while China gets to build up their productive capacity.
    Basically, we are buying foreign products with TBills that lose value over time.
    Obviously, this can’t continue forever, and when China stops suppressing the Yuan, the US – China trade balance will decrease.
    Is my understanding correct?

  73. ReformerRay

    In my opinion, currency value markedly influences the trade balance in the short run but not in the long run. The real, broad trade weighted value of the dollar was about the same value in 2008 as it was in 1976, yet the U.S. trade deficit is quite different in the two periods.
    Ultimately, the level of a trade deficit depends upon the relative productivity of the manufacturing sector in each nation and the degree to which each nation arranges its economy to support exports and reduce imports.
    The U.S. trade deficit has been in decline since 2005 according to my preferred measure (goods trade deficit as a share of goods imports). But the decline in the value of the dollar and the sudden economic collapse will disappear some day. On that day, I expect the U.S. trade deficit to begin to increase and grow and grow unless stopped by a change in U.S. policy.
    The U.S. trade deficit sent 5 trillion dollars overseas in the last dozen years to pay for imports in excess of exports. I believe that equal trade should have existed at that time. If it had, the U.S. wealth today would be much more than 5 trillion dollars larger than it is today because of all the profits and earning created by production of 5 trillion dollars worth of goods.
    This all seems so simple and clear to me. Adam Smith led us astray when the advocated free trade as a means of stopping protectionism all over the world. I agree that his influence was helpful in moving the world away from protectionism but his influence carried over into the present where equal trade was needed – to prevent the richest nation in the world from rapidly loosing its wealth. Wealth will inevitably become more evenly distributed among the nations of the world over time. There is, however, no need for the richest nation in the world to continue with a trade policy that artfically increses the speed of the convergence. The more wealth that remains in the U.S., the greater the liklyhood that the convergence of all nations will be at a higher level rather than a lower one.
    It is true that the U.S. consumer benefits from free trade. It is also true that the U.S. worker is punished by free trade. I don’t like the trade-off. We get products that are 20% better than a domestically produced product in exchange for a reduction in GDP that is 100% of the value of the U.S. domestic product not sold.

  74. ReformerRay

    “So the US consumer is buying stuff on credit that isn’t going to be fully paid back in real terms, while China gets to build up their productive capacity.
    Basically, we are buying foreign products with TBills that lose value over time”.
    When those Tbills decrease in value the wealth that I possess, or can create by working, also looses its value to pay for imports. Sooner or later, the U.S. will be forced to begin to produce goods of equal value to the goods we consume. Why not create that reality now, by legislation, while the dollar still has some value? I think our generation has an obligation to our hard working ancestors to cease destroying the value they have created in the U.S. We can live without goods produced overseas for 20% less than we can produce them (cars being the prime example)(cheap goods can be produced overseas with a margin of 60% perhaps, but for many high valued goods, the U.S. production is competitive but not equally competitive).
    China will inevitably increase its productive capacity but it is not in the interests of the U.S. to support that activity my maintaining a trade deficit.

  75. Donal

    The only inputs to economic activity is energy; either surplus production from land, or the mining of energy such as oil. The ‘real’ economy is energy; the money economy is linked to it by the ‘price’ of oil. Turn it around; see the oil as the base and the money price of oil as the exchange rate, and it’ll become clear.
    If oil (or other energy) is the base, then the high price of oil last year becomes a financial squeeze. If money keeps on expanding despite the contraction in energy available, then money devalues and the oil price rises again. That’s what will happen next; e.g. oil prices will rise as money devalues.
    Oil is the real economy.

  76. Pete

    I sat in a seminar in the late 1990s at a gas industry event that covered similar information. What was presented was that since the 1970s, every significant spike in oil prices has been followed by an economic downturn. What was surprising was that oil prices were extremely high for a long time from around 2003/2004 through the crash in 2008. Prices did not spike but rose steadily to spike-like levels and then did the move to well over $100 ($149). My thought at the time was the steady rise allowed consumers to get used to the higher prices without shocking them and it was only until they jumped and became too painful that the impact began to be felt by the consumer in a way that they noticed it.
    Also, the government and analysts presented this as “the new cost of oil” even though it was clearly something else–that something else is not being addressed so we will see a repeat of those prices as soon as the economy recovers IMHO. With “the new cost of oil” mantra, consumers were encouraged to accept rather than reject and they didn’t change habits until much later than they might have. That includes transporters who added surcharges rather than renegotiated shipping rates, which likely muted the impact on end consumers in terms of the price rise in goods at the grocery store or Walmart.

  77. frosty

    If the thesis is expanded to all ‘commodities’ it is even more plausible. Oil is perhaps the most important commodity, however many others are nearly as so. There are many dependencies here as foods, ores, etc. have to be shipped (using oil). So increases in oil cause increases in other commodities. And commodities are used to make everything and feed all of us. As they rachet up, our costs rachet up, most noticeably for gas, electricity, energy in general, but for virtually everything we buy. This doesn’t even take into account all the intermediaries involved in turning a grain of wheat into cereal or pound of ore into a snow blower, each one taking a commission because of their extraordinary financial expertise. Absent equivalent increases in income, our credit driven economy doesn’t flinch at first, we just rachet up borrowing. Of course our financial intermediaries are there to accomodate by letting you borrow 105% of value of your home and then let you decide how much you want to pay back each month. And we’re all so credit-worthy! Think of this debt as building up behind a new dam. It looks fine for awhile but absent a spillway and controls, eventually it will spill over and in an extreme case, burst.

  78. Ross

    Thank you for doing the research to backup what I (and many others) believe to be true: the rise in oil prices caused the recession. Every recession since the 1960s has been preceded by a rise in oil prices. There have been a few increases that did not cause a recession, but there is a clear correspondence. The only good economic time (defined by a substantial increase in the standard of living for middle class wage earners) since the 1960s occurred during historically low oil prices. Unfortunately, despite efforts made during the 1970s, our economy is largely dependent on cheap oil (although, to be fair, it is not as dependent as it used to be).
    I might add that people much smarter (and successful than me) came to the same conclusion: http://tinyurl.com/cf2u8g

  79. Anonymous

    Fascinating work. I’ve been wondering for months about this very premise. your work put several pieces in place for me and answered very specific questions that have naggedc my mind. Thank you, job well done
    Steve Kirkland

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