Responding to the Oil Shock: The U.S. Economy Since 1973
FEBRUARY 01, 1989 by RODOLFO GONZALES, ROGER NILS FOLSOM
Although solely responsible for the views expressed here, as well as for any errors, the authors greatly appreciate comments by J. Paul Leigh, Tim Sass, and David Saurman.
In 1981 the price of crude oil peaked at $36 per barrel; today it is less than half as high. Meanwhile, prices in general have risen almost 30 percent. The price-setting power of the Organization of Petroleum Exporting Countries (OPEC) cartel clearly has waned as oil consumers reduced their oil use, as the end of oil price controls encouraged oil production in the U.S. (the second largest producer in 1987, producing less than the Soviet Union but more than Saudi Arabia), as non-OPEC countries such as Britain, Norway, and Mexico greatly expanded their oil output, and as OPEC’s members surreptitiously produced above their OPEC quotas and discounted below OPEC prices. Occasional intermittent truces in this economic warfare still twitch the oil markets from time to time, as will the end of the Iran-Iraq war, but OPEC’s power is much diminished if not totally gone.
In the face of these developments, neither Keynesians nor monetarists have been able to supply a consistent explanation for the macroeconomic behavior of the U.S. economy since the first oil shock in 1973. Nevertheless, the main economic events of this period can be explained by assuming that private decision makers responded rationally to the energy “crisis” while policy makers, particularly the monetary authorities, did not.
In terms of aggregate economic output, energy is a complementary resource to both labor and real capital (including other natural resources). The shocks that decreased the availability of oil to the U.S. in the 1970s must have greatly decreased the (marginal) productivity of labor and also capital at that time. In contrast, if labor and the owners of real capital both believed that the energy crisis was temporary, and that energy would once again be plentiful, the oil shocks may not have significantly depressed the expected future opportunities for labor and capital in the 1980s.
Workers and capitalists may have been unimpressed by the argument advanced by many energy “experts” in the 1970s—that the rise in oil prices was a sign of dwindling worldwide energy sources. Instead, they may have realized that high oil prices almost certainly would induce energy conservation and the discovery and development of new oil supplies not controlled by the cartel, and might stimulate the development of alternatives such as solar power. If they correctly perceived the energy situation as a temporary disruption caused by the OPEC cartel, they should have assigned a high probability to a recovery of energy supplies in a not-too-distant future.
Cartels rarely prevail for long against competitive market forces that move investment to the activities expected to be most profitable. Moreover, even if a profit-maximizing oil cartel had a perfect and unassailable monopoly, it would not reduce oil production permanently, but would merely shift production to the future.
If we suppose that the suppliers of labor and capital anticipated the return of more plentiful energy supplies, and responded rationally to the difference between existing and expected future opportunities created by the oil crisis—and by government policies that were at least partly reactions to the oil crisis—by reallocating labor effort, leisure, and capital use over time, then the economic history of the U.S. in the 1970s and first half of the 1980s could read as follows:
The demand for labor decreased with the fall in its productivity, but real wages did not fall significantly because workers did not expect the oil crisis to last, and therefore they were reluctant to accept real wages lower than those they expected in the future. Instead they accepted unemployment and greater leisure, expecting to increase their labor supply to above-normal levels in the future, when energy supplies and labor productivity had returned to normal.
Decreased productivity also reduced the demand for capital, and owners of capital responded in the same general way that workers did. Capital depreciation increases with use, so rather than accept lower returns, capital owners opted for a lower rate of depreciation and greater excess capacity, expecting to use the saved capacity in the future, when capital again would earn high returns.
Thus the oil supply contractions of the 1970s and the resulting decline in productivity had a negative effect on real national output and income, which was magnified by rational decisions to shift the sale of labor and the use of plant capacity to an expected more productive future.
Given the expectation that after the temporary oil shortage was over, supplies of labor and capital would be higher than during the shortage, households must have believed that their current income was substantially below what it would be in later years. Therefore, consumption spending was relatively buoyant, leading to a steep decline in the savings rate measured against current national output and income.
Inflation and Recession
The supply of money—which government policy has largely insulated from market forces—did not adjust quickly enough to the slowdown in real economic activity. In fact, the Federal Reserve encouraged the banking system to provide more money than the public was willing to hold, in an apparent attempt to induce more economic growth than was compatible with the reduced supplies of oil, labor, and capital. The result was a rise in the inflation rate, as the public tried to exchange excess money for goods and services. With stagnant output and high spending levels, the worsening inflation decreased the public’s willingness to hold money even more.
By the end of the 1970s, accelerating inflation had so impaired public confidence in the government’s willingness to exercise monetary discipline that there was talk of a flight from money and possible hyperinflation. This process continued until the Federal Reserve abruptly decreased the money supply growth rate and induced the 1981-82 recession, which lasted until sharply lower inflation rates finally changed the expectation that inflation would get worse and worse. Unfortunately, the Federal Reserve reduced the money supply growth rate so erratically that it took unnecessarily long for people to realize that monetary policy had in fact changed.
Meanwhile, Ronald Reagan’s 1980 Presidential campaign suggested tax cuts that promised long-run benefits but that inevitably generated short-run uncertainty: whether a tax cut would be adopted at all, what its detailed provisions would be if adopted, and how long it would last before the next major tax change. As occurs with any tax cut proposal, the uncertain promise of lower tax rates encouraged people to shift economic activity to the future, when marginal tax rates might be lower (and almost certainly not higher), and when the best way to structure business decisions from a tax standpoint would be less obscure.
Unfortunately, these unavoidable incentives to postpone productive economic activity were compounded by the fact that the Economic Recovery Tax Act adopted in August 1981 phased its tax rate reductions so that they did not become fully effective until January 1984. Also, there were continual serious Congressional proposals to repeal or modify much or all of the 1981 tax cut, particularly its investment incentives, as occurred in the Tax Equity and Fiscal Responsibility Act adopted in late 1982. People were encouraged to postpone economic activity not only until 1981, but also until the lower marginal tax rates became fully effective and the details of the 1982 tax act (and the associated internal Revenue Service regulations) became clear. Thus, fiscal policy contributed to the economy’s below-capacity output between the 1979 and 1981-82 recessions, and worsened the length and severity of the 1981-82 recession.
During this period of low productivity and relatively high desired spending, many households were credit- constrained and unable to borrow as much as they wished. These households pressed for the Federal tax cuts discussed above, for state and local tax cuts (for example, Proposition 13 in California and Proposition “2.5" in Massachusetts), and for continued expansion of transfer payments and other government spending, and were unwilling to let government pay for increased defense spending by significant reductions in nondefense spending. In short, these households—unable because of their credit constraints to dissave as much as they wished for themselves—pressed for government dissaving. The U.S. government deficit exploded.
After 1982 the demand for real investment increased substantially, to prepare for the expected higher productivity of capital after the return of normal oil supplies and prices. But because of the decreased saving by households and dissaving by government, this increase in real investment had to be financed by a large change in the international flow of financial capital, so that the U.S. would have a large net inflow instead of its usual net outflow. Real interest rates in the U.S. rose very high in order to attract this net inflow of financial capital, which showed up statistically as a very large U.S. international trade deficit. The capital inflow increased the foreign demand for investment assets in the U.S., raising the international demand for dollars and consequently lifting the donar’s international exchange rate value to unprecedented heights.
An Inflow of Capital
The net flow of capital was from the rest of the world into the U.S., rather than the reverse, because the rise in the demand for investment relative to domestic savings was more pronounced in the U.S. than elsewhere. Although the oil shocks affected the whole Western world, oil was a more important productive input in the U.S. (Oil input per dollar of Gross Domestic Product was, and is, much higher in the U.S. than in Europe and Japan.) Consequently, the oil shocks decreased productivity—and contracted national income and saving—more in the U.S. than in other important centers of economic activity, while the need and willingness to invest in preparation for a greater abundance of oil was also higher in the more oil-reliant U.S.
Other things equal, high real interest rates raise the time value of money and encourage oil production out of existing fields, but simultaneously discourage oil exploration investments (along with other real investments). Thus the high real interest rates of the early and middle 1980s hit the major oil producing states such as Texas, Louisiana, and Oklahoma particularly hard, by driving oil prices even lower than they would have dropped otherwise and by decreasing oil exploration below even the levels that would be expected as a result of very low oil prices.
Once the expectation of lower oil prices had dramatically—albeit unsteadily—come true, the results were quite straightforward: con-fumed expectations of much lower oil prices expanded economic output and greatly reduced unemployment, excess capacity, real interest rates, the government budget deficit, and the size of the trade deficit relative to Gross Domestic Product, and dropped the international value of the dollar. The most recent data suggest that our trade deficit has begun to decline not only relative to Gross National Product, but also absolutely.
Here ends our history. Note that our initial assumption, that actors in the U.S. economy expected the oil shortages and resulting declines in productivity to be temporary, plays a key role in explaining most of the significant features (also known as “problems”) of the U.S. economy in the 1970s and early 1980s: slow real economic growth, severe inflation, high unemployment, excess capacity, low savings rates, huge government budget deficits, extraordinarily high real interest rates, large trade deficits, and a very high exchange-rate value of the dollar.
Given the steady improvement in the U.S. economy since 1982, there is no need to raise taxes in order to deal with the government budget deficit, which after peaking in fiscal 1986 then dropped by 30 percent. Nor is there any need to impose inefficient protectionist measures in order to reduce the trade deficit. Higher taxes (whether on personal or corporate income, oil, or energy), or higher trade barriers, would in fact be counterproductive.
The impatient may argue that because the improvement in the U.S. economy since 1985 has been not only steady but also slow, our optimism is too reminiscent of Pollyanna’s. But the sluggishness of the economy since 1985, as in 1980-82, can be explained easily within the framework of this paper. In May 1985, after digesting angry criticisms of U.S. Treasury tax reform proposals issued in late November 1984, the Reagan administration seriously proposed massive tax law revision and lower rates. The promise of lower future marginal tax rates, together with the enormous uncertainties generated by very different alternative proposals for massive revision of the tax code, encouraged people to postpone productive economic activity. Tax uncertainty lasted at least until the new tax law was enacted in late 1986 (numerous important regulations still remain to be written), and lower tax rates did not become fully effective until January 1988. And now we face new uncertainties about the tax and other economic policies to be adopted by President Bush and the Congress elected in 1988. In addition, adjusting to lower oil prices involves some costs: as resources are reallocated, some activities contract before others expand.
The economy is in transition. We need only to enjoy the supply-side benefits that will continue to come as the economy adjusts to lower oil prices and lower effective marginal tax rates. This prediction, of course, assumes that our legislators and monetary authorities will refrain from actions that would derail the current economic expansion.
1. As measured by the Gross National Product Implicit Price Deflator, which rose from 94.0 in 1981 to 121-8 at the end of the second quarter of 1988. In contrast, the “crude petroleum” component of the Producer Price Index fell 58 percent, from 109.6 in 1981 to 46.0 at the end of the second quarter of 1988.
2. The U.S. government could have taken steps, such as price decontrol of natural gas, to moderate the decrease in energy availability. Instead. the government decreased the supply of U.S. oil by continuing existing price controls (introduced by the Nixon administration as a general anti-inflationary measure in 1971) on oil and petroleum products, and in 1980, by imposing windfall profit taxes on domestic oil producers.
3. Our history reads as if there were a single oil shock to the U.S. economy in the early 1970s when in fact there was an initial shock with the Arab-Israeli war of 1973. followed by a partial recovery of oil supplies, and a second shock following the Iranian revolution in 1979. But to (treat each shock separately would add substantially to our history’s length without altering its substance.
4. Our analysis of household behavior builds on two ideas: first, that consumption depends primarily not on transitory income fluctuations but on expected permanent or “life-cycle” income; second. that credit constraints can significantly alter households’ abilities to spend as much as would be appropriate given their expected permanent or “life-cycle” income. The first of these ideas was introduced by Milton Friedman (A Theory of the Consumption Function, Princeton, 1957). and then in a series of papers by Franco Modigliani, Richard Bramberg, and Albert Ando (see. for example, Medisliani’s “The Life Cycle Hypothesis of Saving, the Demand for Wealth, and the Supply of Capital,” Social Research 33, 1966). The modifications necessary to incorporate credit constraints into these expected permanent “life cycle” income models am being developed by Thayer Watkins, in papers that have not yet been published.
5. Some real capital investments undoubtedly were delayed as investors waited to see whether Congress would respond to the government budget deficit by repealing the lower tax rates enacted in 1981 and raising taxes even more than they were raised in 1982.
6. See Charles E. McClure, Jr. and George R. Zodrow, “Treasury I and the Tax Reform Act of 1986: The Economics and Politics of Tax Reform,” Journal of Economic Perspectives, I (Summer 1987). pp. 37-58. The same issue contains a number of related papers.