Middle East Economic Survey
Economists Challenge Causal Link Between Oil Shocks And Recessions
The widely-held belief in a causal link between oil price shocks and economic recessions has been challenged by economists Robert Barsky and Lutz Kilian in a paper entitled Oil and the Macroeconomy Since the 1970s published by the Centre for Economic Policy Research. (The full paper is available at www.cepr.org/pubs/dps/DP4496.asp). The perception that oil price spikes have a serious negative effect on the world economy is based largely on the close correlation in the timing of oil price spikes and economic downturns, and is backed by academic research such as that of James Hamilton of the University of California (MEES, 29 September 2003). The same reasoning was behind the creation of the Strategic Petroleum Reserve (SPR) in the US following the 1974 Arab oil embargo, which was designed to provide a cushion against such shocks.
However, Barsky and Kilian highlight what they describe as the “conceptual difficulties in assigning a central role to oil price shocks in explaining macroeconomic fluctuations.” The timing of oil price increases and recessions is consistent with the notion that oil price shocks may contribute to recessions without necessarily being pivotal, they say. The authors challenge the idea that oil price shocks are exogenous with respect to the US economy. Instead they provide arguments in favor of ‘reverse causality’ from macroeconomic variables to oil prices. They also challenge the view that political events in the Middle East are the primary driver of oil prices. “Exogenous political events in the Middle East are but one of several factors driving oil prices,” they argue, and ”the effect of seemingly similar political events may differ greatly from one episode to the next, in accordance with variations in demand conditions in the oil market and global macroeconomic conditions.”
Variable Delays Between Oil-Related Events And Recessions
The authors point out that the period between an oil-related event and the associated macroeconomic ‘response’ is often long and variable. They note that there was a long delay between the Iranian revolution and the January 1980 recession, and between the outbreak of the Iran-Iraq war and the July 1981 recession. However, the November 1973 recession immediately followed the October war and the start of the oil embargo, while the onset of the July 1990 recession even preceded the August 1990 invasion of Kuwait by Iraq. “This irregular pattern argues against a mono-causal role for oil, but is still consistent with the view that oil events at least contribute to recessions. Thus, it is easy to see why many observers continue to assign an important role to political events in the Middle East in explaining US recessions,” say Barsky and Kilian.
Oil Shocks And Productivity
Oil shocks have also been blamed for falls in productivity and the phenomenon known as “stagflation,” where high inflation is accompanied by high unemployment, in a departure from the Phillips curve trade-off between the two variables. With regard to the former, the late 1970s and early 80s saw a period when total factor productivity fell to just 0.31% for 1974-85 – a period which experienced several severe oil price spikes. The 1974-85 level of productivity compares to 1.99% for 1950-59, 1.18% for 1960-73, and 1.34% for 1986-2001. This “phenomenon has prompted interest in establishing a theoretical link between oil prices and productivity which continues to this day,” say Barsky and Kilian.
However, they argue against a relationship between the high oil prices of the 1970s and early 80s, and the low productivity in that period. They cite Mancur Olsen who wrote in a paper – The Productivity Slowdown, the Oil Shock and the Real Cycle – in 1988, that “the fundamental problem is that the cost of energy is too small a part of GDP to explain the productivity slowdown.” Olsen quantified the US productivity losses that may be attributable to substitution away from oil and concluded that they were much too small to explain the productivity slowdown. He also noted that the opportunities for substitution were sharply limited during the initial years following the oil price shock. “This view is now widely accepted,” write Barsky and Kilian.
As for inflation, Barsky and Kilian say that the relationship between oil price shocks and consumer price index (CPI) inflation is not as apparent as one might have expected. “Some oil dates, such as the outbreak of the Iran-Iraq war in 1980, seem to have had little impact on CPI inflation, and others such as the war in Afghanistan in 2001 and the Iraq war of 2003 both were followed by a decline in oil prices,” say the authors. “The strongest case for a relationship emerges from focusing on medium-term trends in inflation. In particular, the period of sustained high inflation in the 1970s included two major oil events, which has given credence to the notion that both the economic stagnation and the high inflation rates of the 1970s were related to oil price shocks.”
The Greenspan View
The Chairman of the US Federal Reserve, Alan Greenspan, recently gave a similarly measured assessment of the relationship between oil prices and the macroeconomy (MEES, 14 June). Mr Greenspan told a gathering of banking delegates in London on 8 June that “the impact by oil prices in modern market-based economies is difficult to infer in a way in which policy is automatically obvious.” The Federal Reserve’s macroeconomic models estimate the impact of oil prices on the US and elsewhere, and the findings are that despite the fact that most of the recent recessions have been preceded by oil price spikes, the actual pattern of price change that has occurred over the last 30 years does not create recessions in the models. “Which tells us either that those relationships… are spurious or that there is a nonlinearity in the way oil prices impact market economies,” he concluded.