Energy and the economy 30 years later

Also at the meeting of the International Association for Energy Economics last week I was honored to receive an award from the association for outstanding contributions to the profession. Here are the remarks I made at the awards banquet.

In 1980 this organization was three years old and I was in my third year in the economics Ph.D. program at Berkeley. There was a lot of interest in what was going on in energy markets at that time. The oil embargo by the Organization of Arab Petroleum Exporting Countries in 1973-74 and the Iranian revolution in 1978-79 were both associated with significant disruptions in world oil production and big spikes in energy prices. Many of us were persuaded that these events made a contribution to the two economic recessions that followed the two oil supply disruptions.

I was supposed to write a third-year empirical paper at Berkeley. As I was looking into these events I was surprised to find that this wasn’t the first time something like this had happened. The Suez Crisis of 1956-57 resulted in a significant disruption in the flow of oil, and that had also been followed by an economic recession. There were quite dramatic increases in oil prices in 1947-48, and these were followed by the first of the postwar U.S. recessions. In fact, as of 1980, we’d seen seven recessions in the United States since World War II, and six of those had been preceded by a spike in oil prices. I thought, ok, maybe I should use this for my third-year paper.


As I was working on this topic, Iraq invaded Iran, knocking out even more global oil production, and sending oil prices to all-time highs. The National Bureau of Economic Research declared that the U.S. entered an eighth recession just 12 months after we got out of recession number seven. I thought, ok, maybe I should use this for my dissertation.


And so I did. I was resolved that once I finished the dissertation I was going to move on to other areas of research. But world events kept dragging me back. In 1990, after eight years of falling oil prices, and eight years without an economic recession, Iraq invaded Kuwait, knocking out two of the world’s biggest oil producers. Oil prices rocketed back up, and it was déjà vu all over again as the U.S. fell into postwar recession number nine. There was another dramatic move up in oil prices prior to the 2001 recession. And you’re all very familiar with the spectacular oil price spike of 2007-2008, which was as big in magnitude as any of these other episodes, and which was followed by what we have now come to refer to as the Great Recession. So the count is now up to 10 out of 11 postwar recessions were preceded by a spike in oil prices. I think there’s something to this.


But what could account for this apparent relation? It’s easy to write down a model in which energy shouldn’t be all that important for the economy. In a frictionless neoclassical model, the key parameter is the dollar share of energy out of total spending, and this is a relatively small number. According to neoclassical theory, equilibrium prices persuade firms and consumers to reduce their energy consumption in response to an exogenous disruption in supply, and any economic costs associated with voluntary reductions in energy use should be smaller than had the users decided just to pay the higher price and go on using energy the way they had been. The total economic loss should be less than the dollar cost of the lost energy.


But a frictionless neoclassical model won’t get you very far in understanding economic recessions no matter what kind of shocks you’re looking at. Most of us are persuaded that there are important inefficiencies associated with recessions, as labor and capital become underutilized relative to the efficient frontier. Once you start thinking along these lines, it’s easy to see how an energy shock could make a contribution. For example, we often see consumers suddenly stop buying the larger, less fuel-efficient vehicles that have historically been key to U.S. auto industry profits. Loss of income and layoffs in the auto sector then become a separate factor contributing to the overall decline in economic activity.


Certainly many of the economic developments in 2007 and early 2008 were consistent with the patterns in earlier oil shocks. Sales of larger vehicles plunged, and consumer sentiment and overall consumer spending responded to higher gasoline prices in much the same way we had seen them do in previous episodes.


But there was one important difference. Many of the historical oil shocks that I mentioned were associated with dramatic geopolitical events such as wars in the Middle East. But there were none of these in 2007-8. Instead what happened was global oil production stagnated even as demand from the emerging economies continued to surge, and this produced the dramatic spike in oil prices.


I think it’s clear today that this episode marked the beginning of a new era in which it has been hard for oil production to keep up with growing demand without big increases in oil prices. Since 2005, field production of crude oil has increased very little worldwide, with U.S. shale oil production accounting for more than 100% of the increase—in the absence of these new sources of supply, global production today would be lower than it was in 2005. Add to this the challenges of dealing with the consequences for the world’s climate of our fossil fuel consumption, and also add this week’s news coming out of Iraq, and it seems pretty clear that it is extremely important to study what is going on in energy markets right now, just as it was in 1980. So I think all of you are in the right place at the right time. The right place being the International Association for Energy Economics, the right time being June 2014. The world is in real need of the insights that each of you can bring to these challenges.


Thank you very much for this great honor.

iaee_award

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35 thoughts on “Energy and the economy 30 years later

  1. 2slugbaits

    Congratulations. I must say, reading your speech I’m not quite sure whether you came to praise King Oil or bury him. It could be read both ways. Nice touch.

    1. BC

      slugs, then you don’t fully understand Peak Oil and its implicit permanent structural effects on our non-negotiable “American Way of Life”, into which the long knives our waiting to thrust.

        1. BC

          Why was the US growth rate faster using coal, than it has been using oil?

          Faster population growth from a low base coinciding with the transition from low-energy-density agrianism to high-energy-density industrialization and an explosion in labor productivity and falling prices.

          1. Nick G

            Why do you feel that oil is essential to our economy, if coal was adequate to support high-energy-density industrialization and an explosion in labor productivity and falling prices?

  2. PeakTrader

    Yes, there’s been a strong correlation between the supply of output and the supply of oil.

    The higher price of oil only compensates for the lower supply of oil.

    Unfortunately, generating a mass hysteria in climate change has come at the wrong time, reducing supply and demand of fossil fuels, and worsening the deep depression, which began after the Bush recession ended in June 2009.

    1. Nick G

      mass hysteria in climate change

      There’s an international consensus that human-caused Climate Change is a very serious risk – that includes places like Saudi Arabia, Russia and China. There’s a scientific consensus as well. It’s only in the US that a minority of politicians (sadly, it’s Republicans) have been purchased by the oil and coal industries, and they disseminate enormous amounts of misinformation about Climate Change.

      reducing supply and demand of fossil fuels

      If only that were so. Actually, efforts to prevent Climate Change in the US really haven’t made a lot of difference for oil, though we are seeing encouraging signs that coal burning is actually going down.

      Sadly, the Republican effort to protect the oil industry is a significant part of our current recession: the oil industry knows that pollution can only be stopped by government, so it’s working to cripple government. Our economy is collateral damage.

      1. PeakTrader

        In the 1970s, we were worried about global cooling, and in the 2000s, we worried about global warming.

        Over a hundred years, the net change may be zero, and in the context of millions of years, it may amount to nothing.

        Real progress has been made with fossil fuels. They’re up to 99% cleaner than in the 1970s, and progress continues.

        Wind and solar cannot keep up with demand, because they’re not worth the costs.

        The goal is to raise living standards, not reduce them.

        Obviously, you’re playing politics.

        1. Nick G

          In the 1970s, we were worried about global cooling

          Not really. That’s a myth, disseminated by people who wish to mislead you.

          Real progress has been made with fossil fuels. They’re up to 99% cleaner than in the 1970s

          On a few measures, that’s true. Overall, not at all.

          wind and solar cannot keep up with demand, because they’re not worth the costs.

          What makes you say that? Have you looked at the costs? The US Energy Information Agency says that wind is cheaper than coal. Solar is growing with dramatic speed: it’s cheaper than grid power for a very large number of consumers (look at Australia, for instance), and they’re choosing solar very, very fast.

          Wind and solar would raise living standards. Consider, for a moment the 250,000 US veterans coming back from oil wars with serious, lifelong disabilities. Brain injuries, PTSD, etc. If we can prevent more oil wars, we’ll raise the living standard for a lot of people.

          Consider the costs of 10 recessions since WWII. Ten recessions! Millions of people thrown out of work, trillions in investments destroyed. That’s very costly.

          Only in the US is Climate Change a partisan question. In the rest of the world, and in the scientific community, it’s a unemotional, straightforward looking at the facts. Only in the US has the oil industry managed to make a large number of people think that the transition away from oil and Fossil Fuels is a commie plot.

          1. PeakTrader

            You’re in denial. The reality is output and population growth grew at a faster exponential rate, because of fossil fuels (for example, the difference between 1% annual per capita growth and 2% annual per capita growth over time is huge – even a small difference makes a big difference over 100 years). Without fossil fuels, living standards and life expectancy would be much lower.

            You can’t have a economic contraction without an economic expansion, and the contractions are much smaller than the expansions.

            Wind and solar haven’t been able to take up the slack, even with subsidies.

            At one time, the “experts” were sure the sun rotated around the earth. It’s arrogance and politics to assume we understand the interrelationships and interactions of natural forces, and can build a much more complex model than a general equilibrium model of a large economy, which we can’t do, in part, because of the many dimensions.

          2. Nick G

            You’re in denial.

            Well, let me ask: do you disagree that there is an international consensus on climate change? That pretty much all of the countries of the world signed off on the IPCC reports? Including China, Russia, Saudi Arabia?

            Do you disagree that the physics professional association has said strongly that we need to deal with Climate Change?

            The reality is output and population growth grew at a faster exponential rate, because of fossil fuels (for example, the difference between 1% annual per capita growth and 2% annual per capita growth over time is huge – even a small difference makes a big difference over 100 years). Without fossil fuels, living standards and life expectancy would be much lower.

            Sure. Even 20 years ago it was vaguely plausible to argue that wind and solar couldn’t do the job. But now? And what about nuclear? Do you disagree that nuclear would work?

            Wind and solar haven’t been able to take up the slack, even with subsidies.

            It takes a little while for things to grow. The same thing could have been said about cell phones, 20 years ago.

            At one time, the “experts” were sure the sun rotated around the earth.

            So, we should throw out all scientific knowledge, because scientists have been wrong in the past?

            It’s arrogance and politics to assume we understand the interrelationships and interactions of natural forces….

            That’s what science and engineering are supposed to do. Heck, even studies funded by the Koch brothers come to the same conclusion about Climate Change: it’s an enormous risk that we need to deal with.

            Again, do you disagree that the physics professional association has said strongly that we need to deal with Climate Change? Do you have a better source?

  3. westslope

    Congratulations JDH. Well deserved!

    From negative supply shocks to a negative demand shock. Or so it would appear.

    Though if I recall, the oil price shock of the mid-1970s was precipitated by a negative supply shock but the shock was short-lived. The OPEC oil embargo lasted less than two months. Then policy-driven demand growth took over and drove oil prices higher. At that point the US economy was no longer in recession but rather stagnated.

    Then there was the late stages of the Vietnam War during which time Americans mutually despised each other. I believe that sub-violent conflict played a role in the poor economic outcomes but it is a hunch that is tough to demonstrate or argue convincingly with data.

    Perhaps I need to simply review oil production during and following the 1973 Arab oil embargo. Anybody like to suggest references?

  4. Nick G

    Congratulations.

    I think there are some obvious takeaways:

    1) oil Is unreliable.

    2) oil’s unreliability is very costly: I remember hearing that the Great Recession vaporized $6T in capital. If we assume the oil shock caused 50% of the damage, that’s $3T divided by about 30B barrels of oil per year: that’s about $100 per barrel of oil pumped that year. If we have a continuing output gap of say $1T worldwide, $500B divided by 30B bbls/year gives about $15 per barrel. And that’s just economic costs – it doesn’t include trillion dollar oil wars or pollution.

    You might want to consider a paper which quantifies all of these indirect costs of oil. Maybe start with a paper that just deals with the costs of those 10 recessions.

  5. Joseph

    Unfortunately we can only mourn 30 years of missed opportunity to address the issue of economic fragility due to oil in particular and energy dependence in general. The symbolic turning point was when Ronald Reagan ripped the solar panels off the roof of the White House in fit of juvenile spite. It was clear that instead of a lesson learned due to the oil crisis, it was business as usual — “drill, baby, drill.”

    1. Rick Stryker

      Joseph,

      Reagan did not rip the solar panels off the roof of the Whitehouse in a fit of juvenile spite. Not sure where you got that myth from.

      It’s true that when Reagan got into the Whitehouse he wanted the solar panels removed–and for good reason. The solar panels were yet another example of the Carter’s administration’s love for feckless publicity stunts. The solar panels cost 28K to install and the Carter Administration estimated that they would save 1K per year. The panels did not provide electricity but instead provided most of the hot water in the Presidential offices. Since the company that manufactured them went out of business about 10 years after the 1979 installation date, the panels were likely to break and be unrepairable before their cost would ever be recovered.

      Still, the Reagan Administration did not remove the panels until 1986, when they had to be removed for a Whitehouse roof repair. The Reagan Whitehouse simply declined to have them re-installed, since the cost would be more than the remaining savings, which were trivial anyway.

      The panels lay fallow in a warehouse until a little college in Maine drove a school bus down to pick them up. They installed the lifeless panels on the top of their cafeteria, where they do nothing now other than to remind us all of the empty symbolism of the Carter Administration.

      Ironically enough, In 2006, a couple of students, driving a vegetable oil powered car, delivered one dead solar panel to the Carter Library in Atlanta, where it serves as a shattered monument to a shattered Presidency.

      1. Nick G

        symbolism of the Carter Administration

        The research and development of wind and solar that the Carter administration kick-started was enormously valuable. Despite the efforts of pro-oil Republican administrations since to dismantle them, the NREL and other programs helped lay lay the groundwork for a transition away from dirty, dangerous and expensive fossil fuels.

        Fossil fuels have put humanity at great risk. Without those programs, we would be much further behind in the race to move to better, safer and cheaper alternatives.

  6. Tom

    Well written speech. I see a credit-driven cycle with oil often prices often playing the role of trigger for the turn, and some of those oil price hikes partly driven by the credit cycle.

  7. David R. Henderson

    James,
    Congrats.
    You wrote, “Iraq invaded Kuwait, knocking out two of the world’s biggest oil producers.” Actually, it was the UN, at the behest mainly of the U.S. and U.K. governments, that knocked out 2 of the world’s biggest oil producers. Saddam Hussein had no desire, and no incentive, to cut his and Kuwait’s exports to zero.

  8. spencer

    interesting observation. Like with the weapons of mass destruction, westerners assuming they knew both Saddam’s capabilities and intentions.

  9. Steven Kopits

    I think Jim has an extraordinary gift as a clear communicator. In writing, as in person, Jim can convey the essence of a problem, imparting information without burdening the listener. I think that is virtue.

    In the economics profession, ‘hard’ is so often conflated with ‘useful’. If something is hard to understand or convey, then it must be useful. If you’re obscure, then you must be intelligent. There’s a lot of that in econ PhD programs.

    The older I get, the more I believe in simplicity and utility. There is so much out there to learn and master. Having a clear, comprehensible approach is essential to be understood and have an impact, at least on a broader educated public and the more curious segments of the policy machine. I think Jim, in the field of oil markets and the economy, can frame and explain issues better than anyone else I know.

    The award was well deserved.

  10. Tom

    Another point to which I think your speech speaks: that energy carries a special importance for economic activity beyond its direct cash value added.

    The other big problem with the model you’re referring to, besides lack of friction, is that it assumes that products and services are perfectly interchangeable. But having to substitute for oil is actually very expensive and disruptive, and substituting for energy is just plain impossible.

    1. Nick G

      having to substitute for oil is actually very expensive and disruptive

      Not at all. An Extended Range EV, like the Chevy Volt, is cheaper than the average ICE to buy or run, and is more convenient: 15 seconds a day to plug in, and very few trips to the gas station. Hybrids are much cheaper than ICEs over their life.

      substituting for energy is just plain impossible.

      Eliminating the need for energy is often the very cheapest solution. A higher MPG car; home insulation; LED bulbs, etc., etc. Net zero homes work extremely well.

      It’s very important not to allow the Koch brothers (and their allies: Fox, etc) to succeed in spreading their misinformation about oil vs alternatives: oil is dirty, expensive and risky. The alternatives are cheaper and better.

      1. Michael Cain

        I think Tom’s point is that substituting more rapidly than would happen otherwise can be expensive and disruptive. The auto fleet turns over about once every 20 years; replacing it in 10 to run on natural gas and electricity means a lot of capital purchases have to occur much sooner than otherwise. I agree that on a discounted cash flow basis eliminating energy use may be the best solution; that doesn’t solve the problem that, for example, converting an existing house to a net-zero house requires very substantial investment. My own fear — and I think it’s also implicit in many of the things that Steven Kopits writes — is that we can’t buy efficiency fast enough or cheap enough to keep the whole thing from spiraling down.

        1. Nick G

          Tom’s point is that substituting more rapidly than would happen otherwise can be expensive and disruptive.

          Yes, and one can’t really disagree with that, in principle. But, there is a lot of misinformation out there about the difficulty of transitioning away from oil. It’s not that hard.

          The auto fleet turns over about once every 20 years

          That’s a good example of misinformation. In fact, vehicles less than 6 years old account for 50% of vehicle miles travelled. So, in 6 years we could impact 50% of fuel consumption.

          Further, the average vehicle turns over every 3-4 years. Remember Pareto’s rule: a minority of vehicles accounts for a majority of consumption (think taxis). The 240M vehicles in the US fleet include a lot of under-used vehicles. With the proper incentives, a lot of older SUVs could be relegated to people who travel relatively few miles.

          converting an existing house to a net-zero house requires very substantial investment.

          Sure, but insulating your attic, fixing air leaks, and replacing light bulbs and old windows has a very, very fast payback. There’s a wide variety of optimal solutions, and many of them are very cheap and fast.

          My own fear … is that we can’t buy efficiency fast enough or cheap enough to keep the whole thing from spiraling down.

          I understand. Let me reassure you: it’s far easier than many people suggest. For instance, the US fleet average is 22MPG, and 50MPG vehicles are cheaper to buy and much cheaper to run. Passenger vehicles use more than 50% of US oil consumption: this is really not a hard problem.

          Keep in mind: many of the pundits who are writing are part of the oil industry – people who make their living consulting to the oil industry can’t offend their customers. Similarly, many Peak Oil enthusiasts used to work for the industry, and their perceptions are captured by their work. They just can’t imagine a world without oil. But, life without oil would be cleaner, safer and more prosperous.

  11. 2slugbaits

    Tom having to substitute for oil is actually very expensive and disruptive, and substituting for energy is just plain impossible.

    Let’s suppose that’s true. Unless you’re a climate change denier, then substituting against coal & oil is something that we’re going to have to do sooner or later. If you think it’s too expensive and disruptive to do it now, how much more expensive and disruptive will it be 10 years from now? Or 20 years from now? Kicking the can down the road doesn’t make it any less difficult. At the end of the day we’re going to have to transition away from coal & oil. We can do it stupid or we can do it smart. Historically our preferred choice is to do things stupid. That means lots of second best, third best, tenth best strategies. In a sense “Peak Oil” is kind of irrelevant because ultimately we’re going to have to leave 80% of the carbon in the ground.

    Steven Kopits I think Jim has an extraordinary gift as a clear communicator.

    I agree, but in this case I would give JDH credit for his ability to make a profoundly ambiguous speech sound like a clear and positive statement. That’s some kind of literary talent. I saw his speech as a kind of Rorschach test. You could read it either as a vote of confidence for the energy industry or as a backhanded slam in the same way that your boss might tell you that we wouldn’t be here today were it not for your efforts. Read it how you will. As a government worker I have a certain appreciation for double-speak and left-handed compliments.

    Peak Trader In the 1970s, we were worried about global cooling, and in the 2000s, we worried about global warming.

    Ummm….not exactly. This is an urban myth…or since it seems to be coming from the red states and the old Confederacy, perhaps I should say it’s a rural myth. Try looking at some actual climate science textbooks from the 1970s. There was a concern over sulfur dioxide cooling, but we’ve known for 100+ years that CO2 warms the atmosphere.

    Over a hundred years, the net change may be zero, and in the context of millions of years, it may amount to nothing.

    And you actually believe this nonsense??? You’re kidding, right?

    1. James_Hamilton Post author

      2slugbaits: Actually, I was intending to make a statement that was both clear and true, namely, that oil supply disruptions and price spikes have made contributions to a number of historical recessions. Different people might draw different policy conclusions from that observed historical relation, and I did not offer my own specific policy recommendations. I nevertheless believe that there is room (and a need) for economists to offer factual assessments like these without intermingling them with the researcher’s personal political agendas.

  12. Nick G

    Jim (if I may be so familiar),

    I appreciate greatly your getting involved with energy analysis – it’s a thankless job, in a world where any analysis at all scares people into attacking the messenger. Of course, if no one attacked your arguments, you wouldn’t be making a difference.

    I strongly encourage you to continue. I think it’s the “calling” of good economists to analyze the costs of various public policy options. Such work contributes to the relevance of the economics profession, and to the health of the country.

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