When it comes to oil prices today, the discussion is primarily about falling prices: Will they keep dropping, and what's the likely impact if they remain at today's relatively depressed levels or fall further?
But given the seemingly ever-rising geopolitical turmoil emanating from the oil-rich Mideast, it's dangerous to ignore the other possibility. What would happen if oil prices were to reverse abruptly and start leaping? It's a worrisome thought, given that nine of the 10 recessions the U.S. has suffered since World War II were sparked by a spike in oil prices.
The example still fresh in many minds is what happened after the 1973 OPEC oil embargo against the U.S. and other countries in response their support of Israel in the Yom Kippur war. The effects of the significant spike in oil prices were numerous and dramatic, and the timing could hardly have been worse.
As oil prices quadrupled, unemployment increased from 4.6 percent in October 1973 to 9 percent in April 1975. Inflation, which President Richard Nixon had unsuccessfully attempted to halt with wage and price controls in 1971, continued its upward path, peaking at 9 percent at the end of 1973. A recession began immediately and didn't end until the economy reached its lowest point in March of 1975.
Things got better after that, for awhile anyway. But the subsequent oil price shock in 1979 resulted in even worse economic conditions.
Is the U.S. as vulnerable today? Would a sudden halt to our ability to import oil from a large group of nations result in similar economic disruption?
Recent work by economist James Hamilton at the University of San Diego, who is known for this type of research, along with Christiane Baumeister of Notre Dame, looked at the impact that supply and demand shocks have on today's economy. They found that "oil price increases that result from supply shocks lead to a reduction in economic activity after a significant lag, whereas price increases that result from increases in oil consumption demand do not have a significant effect on economic activity."
Thus, oil supply shocks are potentially dangerous.
How large is the effect of a reduction in supply? According to Hamilton's earlier work, the 1973 oil price shock caused a 10 percent decline in world production and a 3.2 percent decline in U.S. GDP, the but 8 percent decline resulting from the 1990 Persian Gulf War caused a much smaller loss of GDP, just -0.1 percent.
Stated a different way, a "10 percent oil price spike would reduce U.S. output by almost 3 percent below the baseline over four quarters in 1949-80 but less than 1 percent in a sample that extends to 2005," according to a World Bank report issued earlier this year.
The impact today would likely be even smaller. That's thanks to dramatically increased capacity in the U.S., much less reliance on imported oil as the sole source of energy and an overall reduction in the energy intensity of GDP (the amount of energy needed to produce a given amount of output).
As for inflation, the World Bank report noted, "oil prices contributed substantially to U.S. inflation before 1981, but since that time the pass-through has been much smaller."
Thus, as with GDP, the sensitivity of the economy to oil price shocks is smaller than it was in the past. One big reason for this is the change in monetary policy in the early 1980s that put controlling inflation at the forefront of monetary policy decisions.
That doesn't mean that the U.S. is worry-free. A sustained change in oil prices in either direction can still have important consequences for the economy. Witness today how the sudden collapse in prices has quickly led to secondary impacts such as diminished incentives to develop traditional and alternative sources of energy.
But the ability of a temporary disruption in the supply of foreign oil to cause severe problems for the economy appears to have come to an end.