At the start of last year, it would have been hard to find many economists willing to predict current circumstances in all their dire totality. Let us count the ways: a collapsing housing market; a credit-supply breakdown; a Federal Reserve making up new rules as it goes along; an ever-dwindling dollar; a commodity-price explosion; and oil at $130 a barrel. But it would have been impossible, I think, to find even one economist willing to predict all this and still conclude that the economy might yet scrape by without a full-blown recession.
President Bush was widely mocked a few weeks ago when he said he did not believe that the economy was in a recession. But when the provisional figures for
first-quarter national income were released, they showed a slight increase over those for the fourth quarter of 2007.
Rising unemployment and other indicators confirm that the economy has slowed. This downturn could very well become a recession--commonly defined as two consecutive quarters of negative growth. We might yet learn, as more data come in, that a recession did start during the first quarter. Nonetheless, it is not the weakness of the economy that is most remarkable but its resilience in the face of setbacks. Like a presidential candidate I could mention, the American economy has a hard time knowing when to quit.
Not long ago, a spike in oil prices as steep as this would have been expected to flatten the economy all by itself. In the summer of 2006, when the price of oil was at a measly $65 a barrel, the Congressional Budget Office puzzled over the mild response to the "large and persistent rise in energy prices"--the price of oil had doubled since 2003. Since 2006, it has doubled again--it set another record this week--and the economy's response, so far, is still pretty mild.
T. Boone Pickens, the billionaire hedge-fund manager and energy market guru, expects the price to rise even further, to $150 a barrel. Goldman Sachs, the investment bank, talks of a possible surge to $200--which would mean gas at $6 a gallon. Could even that be shrugged off?
Back in 2006, CBO's report highlighted several reasons why the impact of pricier oil was less now than in the 1970s. Some of the reasons have dated rather quickly and offer little comfort. CBO's economists noted that the oil price rise of 2003 to '06 barely dented consumer confidence. When their report was published, the main index of consumer sentiment stood at more than 80; during the 1970s, it fell to record lows of less than 60. Where does the index stand today? At 63, a 25-year low, and not much higher than in the troughs of the 1970s. This is a sign that the economy, for all its resilience, is going to get worse before it gets better.
In explaining the indefatigably optimistic consumer of 2006, CBO's economists also noted the greater willingness and ability of households, as compared with their counterparts in the 1970s, to borrow against their housing wealth. Previously, the report pointed out, financial regulations had caused mortgage finance to dry up as interest rates rose. Thanks to deregulation and innovation (mortgage securitization, credit derivatives, and interest-rate swaps all received honorable mentions from CBO), the economy was more flexible than before. As a result, mortgage borrowing was used to unlock home equity from 2003 to '06, helping to buoy the economy.
Well, that was then. The verdict on financial deregulation and innovation looks different now. In 2008, mortgage financing has dried up as banks and other borrowers strain, in the aftermath of the subprime debacle, to rebuild their depleted capital. Today, falling house prices are wiping out household wealth. There would be diminishing home equity to borrow against even if anybody were willing to lend. Borrowers want to reduce their debts, not add to them. (Taxpayers tell pollsters that they will save their tax rebates, just now starting to arrive, rather than spend them.)
Another factor cited in 2006 was the reduced scale of the oil price shock. Even after doubling between 2003 and 2006, the value of U.S. oil consumption was about 4 percent of gross domestic product--less than half as large, in relation to the economy, as at the end of the 1970s. That was true at a price of $65 a barrel. But at today's $130, oil consumption is nearly as high a percentage of GDP as it was in 1980. The claim that oil is less important in the economy than before is no longer true. At $200 a barrel, the value of oil consumption would be bigger in relation to national income than it was in the 1970s.
So what is the answer? Why has this extraordinary surge in oil prices not already sent the economy into a steep dive? One reason is monetary policy. In the 1970s, inflation was a persistent problem even before the price of oil moved up. Inflationary expectations were deeply ingrained, and the oil price rises served to ratchet them higher. The Federal Reserve was determined to restore price stability, and in those conditions it took high interest rates and a recession to do it. In 2008, inflation is lower to begin with, and nobody expects the oil price spike to drive a wage-price spiral that creates a permanently higher rate of inflation. Unlike before, monetary policy does not need to induce a recession; on the contrary, the Fed can concentrate on avoiding one.
Another big difference is that the rise in oil prices has been more gradual, and therefore much less alarming, than it was in the 1970s. Back then, the West was confronted in two abrupt bursts with what felt like an entirely new set of economic rules. It really was a "shock," a kind of revolution. From 2003 to 2008, the price of oil has moved higher than anybody thought likely, and rapidly as well--but not in giant steps, driven by sudden acts of policy in Saudi Arabia or elsewhere. If the dollar's decline of the past few years had happened all at once, it would have been regarded as an economic crisis; because it was gradual, it has been taken in stride. More than one might have expected, the same seems to be true of the rising price of oil.
Some oil market experts think that the current price is propped up by speculation, and that it will fall back soon. Others agree with Boone Pickens and Goldman Sachs. What seems certain, thanks to the rise of China and India and rapid growth in other developing countries, is that with current technologies, global demand for oil is on a faster-rising track than global supply--and that oil's equilibrium price (the price minus any speculative premium) is therefore bound to rise as well.
Over a long enough time span, the problem solves itself. Higher prices will encourage people to economize, and they will spur the new technologies that will break the world's addiction to oil. Higher prices, in short, are the solution.
This price signal does work--even, in case you were wondering, in the United States. "As Gas Costs Soar, Buyers Flock to Small Cars," a New York Times headline announced earlier this month. "Soaring gas prices have turned the steady migration by Americans to smaller cars into a stampede." As a European accustomed to seeing gas at $8 a gallon and up, I cannot say I am surprised. "In another first," The Times goes on, "fuel-sipping four-cylinder engines surpassed six-cylinder models in popularity in April." Can a four-cylinder engine that sips fuel really move a car to and fro, you ask? Yes, it can. I swear. As The Times cautiously sums it up: "How the downsizing of America's vehicle fleet will affect fuel consumption is still largely unknown. When gas prices rise, as they are now, many drivers simply drive less to save money. But there are some indications that the trend toward smaller vehicles will reduce the nation's fuel use." Er, exactly.
Aside from its other drawbacks, the gas-tax holiday proposed by John McCain and Hillary Rodham Clinton would not assist this process. A much better policy would take the opposite approach: use taxes to put a floor under the current gas price, and encourage people to regard dearer oil not as a brief anomaly but as something that is here to stay.
The hard part is to get to this long-term solution--reduced demand for oil, increased supply of alternatives--without oil-induced slumps in the meantime. If 2008 does see a recession, as it most likely will, you will be able to blame a financial-market breakdown and crashing house prices as well as oil at $130 a barrel. And if it does not, you will be able to say you witnessed two amazing feats of Clintonian tenacity in one year.
This article appears in the May 24, 2008, edition of National Journal Magazine Contents.