Don't stop worrying about the economy

Just in case you’re being lulled into good feelings about the current economy, I wanted to share some poking around I’ve been doing re the impact of oil price spikes.  This goes back the second figure in this post, showing strains potentially building in global oil capacity.  (Read James Hamilton for authoritative analysis of the oil/macroeconomy nexus—he’s worried about this too.)

Rules of thumb here are as follows, though in a moment I’ll give you some reasons why they could be wrong. 

–A $10 increase in the cost of oil leads to about 25 cents more per gallon at the pump. 

–Every extra penny at the pump takes around a billion dollars from disposable income for other consumption.   

–That same $10 increase, if sustained for a year, shaves about 0.25 basis points (one-quarter of a percentage point) off of real GDP growth.

–Adding rules of thumb, for each percentage point that real GDP grows below trend, with trend around 2.5%, the unemployment rate goes up a half a percentage point.

[Pit stop: the price of benchmark crude went up something like $20 bucks over the past year, shaving one-half of a point off of real GDP growth, which was 1.5%, 2010q3-2011q3.  So stacking rules of thumb, and remembering that the invisible hand itself can be all thumbs, that increase may have shaved half-a-point of off GDP growth, and added 25 basis points on the unemployment rate, which amount to 375,000 more unemployed people!]

Now, forecasts for real GDP growth next year have us at or a bit below trend.  Adding the fact that we’re creeping up on global capacity, well…if a whale sneezes, or worse, in the Strait of Hormoz, you get the picture.

As promised, some caveats.  First, China has been a large and growing energy demander in recent years and there’s some evidence that their economy is slowing.  That could lead to other problems, of course, but in this context, it could be an escape valve for the capacity issue.

Second, the rules of thumb above assume historical relationships.  As I’ve written elsewhere, perhaps another rule of thumb—Americans respond inelastically to gas price increases—needs a rethink.  Or at least an adjustment for real income losses.

Miles driven, as shown in this fascinating chart from the Federal Highway Administration, declined quite significantly in historical terms in the Great Recession and haven’t recovered much.  So, at least in this period of high unemployment, real wage, and real wealth losses, people appear to be adjusting to higher prices at the pump by driving less and that may insulate us somewhat from the potential problems elaborated above.

Stay tuned—movements in the price of oil and our behavioral responses to them are always important, and in an election year, they can become..um…particularly germane.