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.
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.