Oil Prices

A former student writes in:

Oil prices were high in the 1970s, and we had a recession. Oil prices are now a third of what they were this summer... and the economy seems to be suffering. I remember learning in my undergrad that energy prices play a significant part in the economy overall. But, I thought the cheaper the energy...the better off the economy. So, what's going on now? Would we somewhat better off if gas prices increased?

Changes in oil prices can either cause, or be caused by, broader changes in the economy. That is, the causality can go both ways.

In the 1970s, oil prices rose in the US because of the Arab Oil Embargo. This caused a recession in the United States. The reason for this is that oil was an input into many firms' production processes. When input prices rise, firms produce less. This makes GDP (gross domestic product --- the sum value of all goods and services produced) go down. It also makes employment go down. Think of a trucking firm that hauls fewer loads because diesel is more expensive; this means fewer truck drivers will be employed.

In today's US economy, oil prices are much less important. We have fewer manufacturing jobs and more service jobs. Manufacturing jobs tend to be ones where "energy" is combined with "labor" to make "output". These are the jobs that go away when oil prices rise. In service industries (like mine), the price of oil has only a very minor impact on costs. So these jobs don't go away when oil prices go up.

This is why the changes in oil prices we saw from Jan 2007 to Aug 2008 didn't cause a severe recession.

Our current troubles are driven largely by the problems in the financial sector. We were already in a recession by Sept 2008, but the collapse of Lehman Brothers and subsequent problems in the credit markets have led to a serious economic slowdown.

Consumers in the US are spending a lot less money as a result. And this means less demand for "stuff." Because there's less demand for stuff, firms that manufacture things are cutting back. They're cutting back on output, which means using less labor and less energy. Unemployment in China has risen, due to reduced demand for workers by Chinese firms. Because these firms don't want as much energy, the demand for oil has fallen, and this is what has caused the recent drop in the price of oil. Think about all the TVs that aren't getting bought because US consumers feel poor. Those TVs would have been shipped from China on boats, and boats run on oil. This is a drop in the demand for oil, and this is why prices have fallen.

So, in the 1970s high oil prices caused the economy to struggle. Now, a struggling economy has caused oil prices to fall.

Here's a link to a recent NPR story that hits on the interconnectedness of the global economy that draws out some of these themes.