Oil Prices and the Economy

Posted: April 11th, 2008 by: h2

The predictions about the results of oil price increases are hard to really get a sense of, though I found an interesting analysis of this matter, from I think about 2003, though it’s not dated:

Conventional economic reasoning, embodied in the notion of ‘price elasticity’ of demand, is that large oil price rises will necessarily cut oil demand and economic growth, perhaps resulting in zero economic growth, or recession. The higher the rise of oil prices, the faster it is assumed that ‘price elastic’ responses will play. Higher oil prices will “of course” reduce economic growth, may generate stock exchange panics and will produce inflation, leading to monetary and financial instability. Higher interest rates, and even a plunge into recession will then be needed to combat this through rapidly ‘decompressing’ the economy, thus cutting world oil demand, and reducing its price in a context where oil supply is always thought of as growing as fast, or faster than demand.

No received wisdom has any utility unless it can be demonstrated and proved, if it is have any more than the status of belief. The relation between oil prices and economic growth is in fact complex. The notion that price elastic responses describe inevitable, real and worldwide responses, and that any oil price rise necessarily and immediately reduces economic growth is in fact a travesty of the facts. From today’s price levels for oil (around $30/barrel in the USA for light crudes), ‘extreme’ price levels would be needed before world economic growth fell. Until very elevated oil prices are achieved – probably well above $70/barrel in 2003 dollars – world economic adjustment mechanisms will always result in higher oil demand through the economic expansion, with or without inflation, that higher oil prices bring about at the world, or ‘composite global’ economic level.

It’s interesting to see how the world is scrambling to try to figure out what is happening and fit it into some model or other when the sad fact is there is no model to fit it into, because nothing like this has every happened on a global scale before.

This article is kind of interesting, and is worth a read because it points out that the general theories that oil price increases of X dollars per barrel would result in Y% decline in the growth rates of economies is not nearly as clear-cut as it might seem. Although now we are going to really get a sense of this re China and its previous record growth. Will that continue now that oil is hovering at more than US $110 bbl?

And you aren’t reading much about the ‘old’, and by ‘old’, I mean about 1 year or less ago, idea that every rise in oil prices would yield a fixed percentage point decline in economic growth. That notion seems to have been very quietly dropped, and the economists are I assume now busy constructing models about how the economy can work in a world of rising oil prices, while they quietly begin to drop the absurd notion that you can transmute capital into oil, ignoring physics. It’s not as if we need even more examples that most economists actually have essentially no clue or science at all to back up anything they believe.

It is tempting of course to point to the essentially zero percent growth rate (which is what the word ‘recession’ means) of the US economy as verification that in fact, with at least first world economies, this original theory might be somewhat accurate, but we’ll soon enough know more than we ever wanted to know about re the results of very high oil/crude/coal/natural gas prices on a modern industrial economy.

But that would be simplifying matters far too much, since we also are faced with a global finance mess that has only partial connection to oil prices.

But even more interesting is to note that in almost no time, a few years, we are already WELL beyond the almost inconceivable situation they listed above, prices above US $70 a barrel.

These are strange times we live in, and how we react to them now is going to show a lot about what our future might look like.

Speaking from a much more macro viewpoint, I am tempted to say that the global energy we were wasting through the 80s and 90s had a direct material influence on our thinking, which has also grown incredibly wasteful as time has passed.

The vast network of always on computer data centers, routers, and cabling required to run the internet is just one example of this extravagance. Absurdly cheap air travel is another, but that is falling fast as marginal airlines fail and major ones consider mergers to deal with the latest fuel price problems.

And if you haven’t figured out the problem here, let me help:

“Some of our competitors talk about their new fuel-efficient fleets,” the Delta chief financial officer, Edward Bastian, told analysts last month. “We think one of the best ways to manage the fuel crisis is actually not to fly the aircraft.”
International Herald Tribune

And that’s what’s going to happen more and more, fewer flights, higher ticket prices. What does that achieve? A fundamental change in the post-deregulation way we deal with air travel as a global system.

Each piece of the economic puzzle is hopelessly interlinked with the fast fading dream of eternal cheap oil, and as each piece weakens, the overall economy has one less strength to hold it up.

And of course it won’t just be airplanes staying in their hangers, it will be first cars driven less or left parked, then cars not bought, except for those who can afford either the gas or the cost of a new Prius or one of the extremely expensive GM Volt cars, rumoured to be costing almost US$50k per car. I assume they will sell at a loss the first year, but you get the idea, the battery pack alone is supposed to cost US $10k, lithium ion.

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