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The Vicious Circle of Oil Price Induced Recessions

The Vicious Circle of Oil Price Induced Recessions

Former Secretary of Labor Robert Reich recently warned that the U.S. is likely headed back into recession:

The Economic Truth That Nobody Will Admit: We’re Heading Back Toward a Double-Dip

Why aren’t Americans being told the truth about the economy? We’re heading in the
direction of a double dip — but you’d never know it if you listened to the upbeat messages coming out of Wall Street and Washington.

Consumers are 70 percent of the American economy, and consumer confidence is plummeting. It’s weaker today on average than at the lowest point of the Great Recession.

The Reuters/University of Michigan survey shows a 10 point decline in March — the tenth largest drop on record. Part of that drop is attributable to rising fuel and food prices. A separate Conference Board’s index of consumer confidence, just released, shows consumer confidence at a five-month low — and a large part is due to expectations of fewer jobs and lower wages in the months ahead.

So is Reich correct? Are we headed back toward recession? We should be so lucky.

What is a Recession?

Recession is generally defined according to changes in Gross Domestic Product (GDP). The rule of thumb is that two down quarters of GDP mark a recession, but there are many other indicators such as unemployment rate, inflation, and household incomes that all change predictably during a recession. (There is no standard definition of depression, but some suggested definitions are a recession lasting at least two years, or a real decline in GDP of at least 10%).

According to the Bureau of Economic Analysis, (BEA) real (inflation-adjusted) GDP grew 2.9% in 2010 after a 2.6% decline in 2009. Measured in 2010 dollars, the change in GDP from 2009 to 2010 amounts to $541 billion. However, you may recall that the U.S. government embarked upon a massive stimulus plan in order to spur economic activity, borrowing money to fund growth. According to the U.S. Treasury Department, the federal government increased spending by $543 billion in 2009 by implementing a number of new spending initiatives (e.g., the Cash for Clunkers program).

Essentially, this is like borrowing money from the bank to give yourself a pay raise. The caveat of course is that if you are already living beyond your means when you give yourself this debt-based pay raise, you are simply digging a deeper hole that must ultimately be paid back. So you cross your fingers and hope that you eventually get a real pay raise while maintaining enough financial discipline to use that money to pay off your debts. In the case of federal spending, we are essentially mortgaging the futures of our children in order to keep the economy growing today.

But stimulus programs aren’t a sustainable way to fuel economic growth. Ultimately that stimulus money has to be paid back — with interest. If consumer confidence is high, we spend more money which drives economic growth. But as Robert Reich showed, consumer confidence is falling, based partly on the rise of fuel prices and food prices (in itself partially driven by fuel prices).

The Long Recession

This leads me back to my “Long Recession” thesis. In a nutshell, there is a strong correlation between rising oil prices and recession. The reason for that is simple; as oil prices rise consumers are forced to spend more of their budgets on energy, leaving less to spend on other things. Because the U.S. is heavily dependent upon imported oil, much of the increased spending leaves the country to fuel growth in other countries. (Professor James Hamilton recently surveyed the relationship between spiking oil prices and economic downturns in Oil Shocks and Economic Recessions).

When there is an adequate excess of energy production capacity in the marketplace, price increases will bring more product onto the market and price increases can be moderated. This was the case a decade ago when several producers outside of OPEC could bring spare capacity onto the market as needed. But in 2011, it appears increasingly likely that global oil production outside of OPEC has peaked, or is at least very close to peaking (Merrill Lynch, IEA). In this case, OPEC would remain the sole entity that could significantly impact the price of oil (at least until their production peaks), and it is in their best financial interest to keep oil prices high, as long as demand remains high.

This situation is evident when one considers that despite the recession, oil prices remained at very high levels. There was some demand destruction in the U.S., but countries like India and China increased their demand, which kept prices high. As the U.S. moves out of recession, economic activity increases, and this increases demand for oil. That did in fact happen in 2010; after demand for oil in the U.S. declined in both 2008 and 2009, it grew in 2010 as we came out of recession. But with little spare capacity in the system, increased demand pushes prices back up, transferring money from consumers to oil exporters and slowing economic activity.

Consider that in 2000, the U.S. imported 9.1 million barrels of oil per day. By 2005, that had increased to 10.1 million barrels per day, but the average global oil price had also increased from $27.07 in 2000 t0 $49.87 in 2005 (data from EIA). In 2010, oil imports had fallen to 9.2 million barrels per day due to a combination of several factors, but the price had increased significantly to $77.68. So the money that flowed out of the U.S. to pay for oil increased by $75.7 billion per year between 2000 and 2005, and another $92 billion per year between 2005 and 2010.

While it is true that the value of U.S. exports also increased from 2000 to 2005 to 2010, the cost of oil now represents over 50% of the U.S. trade deficit. In 2000, that fraction was 24%, but by 2010 it had grown to 52%. This situation is not sustainable, and it is a grave long-term threat to the U.S. economy.

Conclusions

Recurring oil-price induced recessions will likely be a vicious circle, and won’t be easy to break. It is a new phenomenon that is largely unrecognized by our political leaders. In the past, expanding oil production kept oil prices in check and could in turn spur economic growth. Once oil production stops growing — or worse, starts declining — history is no longer a good guide for predicting sustained economic growth following recession. With little spare production capacity, growth puts pressure on oil prices, which puts the breaks on growth.

How can we break this cycle? It won’t be easy, and politics as usual will make it even more difficult. Ultimately we will have to have some real political leadership to address this situation instead of the typical predictable goals and pandering that we have had for decades.

Otherwise, Robert Reich’s projection will have turned out to be optimistic.

By. Robert Rapier

Source: R Squared Energy Blog




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  • Anonymous on April 13 2011 said:
    I was touched - genuinely touched - by the moronic foreign secretary of the UK, opening a meeting in Qatar by talking about protecting civilians. If he and Sarkozy want to protect civilians, what about protecting those in London and Paris.These ignoramuses opened this business in Libya with the intention of getting a larger outflow of oil from Libya, and getting it soon. They failed, and now we are talking about a new recession.Oh yes. This is an interesting article. I just wish that our political leadership would take a look at it.

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