Oil Price Increases Are Irrelevant to the Recovery
With oil above $100 a barrel, and gas nearing $4 a gallon, doomsayers wrongly predict the end of the recovery. Zachary Karabell on how the economy no longer lives and dies with energy.
With gas prices approaching $4 at the pump and turmoil roiling Libya and other parts of the oil-rich Middle East, the past week has seen multiple warnings that rising oil prices imperil the American economy. David Rolley, a money manager who helps oversee $150 billion for the firm Loomis Sayles, is typical of the breed, declaring that higher prices at the pump "mean there is going to be less money to spend on anything else" and his firm promptly cut its forecasted growth for the U.S. economy this year to 3.1 percent from 3.5 percent.
Most Americans have a sense of the oil shocks of the mid-1970s, which contributed mightily to the economic malaise of those years. And between 2005 and 2008, spiking global demand for oil led to an ever-larger burden at the pump (though that did not deter many from loading up on gas-thirsty SUVs that an antediluvian Detroit rolled out by the millions, presaging the auto-industry collapse in the fall of 2008). These earlier oil shocks, followed by deep economic crises, have created a widespread belief that as oil goes up, the economy goes down.
It seems a neat explanation, but it's not true, not now and not really in the past. Yes, the extremely rapid rise in prices at the end of 1973 and into 1974 triggered by OPEC's embargo in protest of U.S. support of Israel in the 1973 Arab-Israeli War did shock the U.S. economy. But the United States had already entered a recession before the oil crisis and that simply accelerated it. The increases before 2008 aggravated people, but those grumblings did little to halt consumer spending. If anything, people just started to drive less and companies found a way to become more efficient. Higher energy prices didn't torpedo the economy; derivatives and leverage in the financial system did.
The common formula used by economists is that for every 10 percent increase in the price of a barrel of oil, the U.S. loses 0.2 percent of annual growth. Those figures, however, are derived from past patterns when oil increased, such as 1973-1974, 1979, and again a few years ago. The problem is that lots of other things were going on at the same time, so it is impossible to say that oil was the reason. There is a correlation, but is there causation? In addition, oil and energy has been steadily declining as a percentage of overall spending. It was as much as 9 percent of spending in the 1970s, and it has been between 4 and 6 percent in the past decade. That means that oil has to rise much more to have the same effect as it did in the past, and for a real oil shock comparable to earlier periods, the price would have to rocket up to nearly $200 a barrel in a matter of a few months.
Sentiment is a fuzzier issue. Another argument used to stoke concern of an oil crisis is that higher prices freak people out. They see $4 at the pump, and bang, their wallets snap shut and no more meals at Cheesecake Factory. First of all, the only evidence of that is anecdotal, and it is easy enough for a politician to pull out a constituent letter or a journalist to find a quote of someone saying that is what they are doing. But why people spend or don't is one of life's greater mysteries, and sentiment has been an extraordinarily unreliable guide to spending patterns. People are perfectly prepared to feel anxious and spend, and the only reliable indicators of spending patterns are income and employment. Both of those have been weak in America, and that is cause for real concern, but it has little to do with the price of oil.
The ones who will suffer the most from rising oil prices are the ones who have the least impact on the economy.
Americans today consume about 23 barrels of oil per person each year. That means that every $10 increase in the price of oil is a $230 hit to the "average" American. That burden hits different people differently. Let's say that oil goes up to $150 a barrel, which would be dramatic. That would cost us another $1,000 each. OK. But this year, with the Social Security tax rebate, most of us have about $1,000 more than last year, so it's a wash.
Even so, for tens of millions either unemployed or underemployed, that's a bit hit and will likely crowd out other spending—although a not-inconsiderable portion of those tens of millions don't own a car. Maybe they will suffer as companies like Proctor & Gamble raise the price of their products to pass on higher oil costs, but those companies have been eating most of the price spikes. And to be blunt, whatever growth there is in the unwieldy beast we call the American economy isn't coming from that struggling group. It is coming from corporate America and the more affluent. In short, the ones who will suffer the most from rising oil prices are the ones who have the least impact on the economy as it is and the ones doing badly already. That's a harsh truth, and cold comfort to be sure, but there it is.
As for the middle and upper end of the spectrum, some might put off travel as airlines raise fares or as pump prices make that Winnebago trip exorbitant. But they might spend more on that local restaurant, or buy a new videogame, and if they delay foreign travel, that will actually lead to more domestic spending. And for those who gobble up the new generation iPhone 5, or the next iPad or this season's new Coach bag, it's safe to say that they are price insensitive to oil shocks. That's why LVMH recently shelled out billions to buy Bulgari: They know that in the world today, the high-end consumer from San Fran to Shanghai is in a global sweet spot.
Finally, financial markets have been atypically sanguine and even levelheaded. Yes, stocks have been moderately weak in the past days, but are still up for the year and on a multi-month roll. There hasn't been a flight of epic proportion by traders in "safe" assets like gold and Treasuries, though these have done well of course. Markets often send the wrong messages, and traders aren't models of taking a deep breath, but in this case, the moderation of markets is a good sign that the system today can absorb these oil shocks.
The myth of rising oil prices is that we are in the same boat called "the economy." The fact is we aren't. Higher oil prices hurt those who are hurting and barely affect those who are not. The purported effect on our growth statistics is another attempt by economists and statisticians to quantify the unquantifiable, and when you look at past patterns, they offer fewer clear lessons for the present than many believe. The only thing we can say for certain is that the costs hitting wage earners aren't being offset, and that makes the contrast between those thriving and those not even starker. The "economy" will weather this surge just fine. Growth will putter along. Apple will sell millions of iPads, and Nissan its Leafs, and millions more will watch, as if looking through a window of a shop filled with goods they cannot afford and have ever less chance of obtaining.
Zachary Karabell is president of River Twice Research and River Twice Capital. A regular commentator on CNBC and columnist for Time, he is the co-author of Sustainable Excellence: The Future of Business in a Fast-Changing World and Superfusion: How China and America Became One Economy and Why the World's Prosperity Depends On It.