Alex Tabarrok and Tyler Cowen do a series of podcasts on the economy of the 1970s. A few weeks ago, I commented on one of their previous podcasts, discussing the tricky problem of establishing causality for changes in inflation. Theirs the latest podcast discusses the oil shock and the business cycle, an area where causality is more difficult to establish:
TABARROK: Now, let’s talk about confusing economics because the price of oil is going up. The war begins in October of 1973. The US entered a recession in November 1973. Unemployment doubled from 4.5 percent to 9 percent. Now, I think most of our listeners will say, “Well, what’s so confusing about that? The price of oil goes up and you enter a recession. That seems normal.”
However, for economists, this is still a puzzle because although oil is obviously very important, it is not that big of an economic factor, and in fact there are complex theories, which say that if you have—this Hulten theory—if you have a sector shock of say 10 percent, something goes up, production goes down by 10 percent, the price goes up by ten percent or something like that, and that sector is a large share of the economy, say five percent, then the result in GDP should just be those two things multiplied together. 10 percent multiplied by 5 percent, which is just 0.5 percent of GDP.
COWEN: Those theories are wrong, right?
TABARROK: Yes.
The link between oil shocks and recessions appears to be very strong. And yet, I’m not entirely convinced that those theories are wrong. So how can we explain why recessions often follow oil shocks? Here are two possibilities:
1. Fiscal stabilization caused by (abnormal shocks.)
2. Reallocation of resources (real shock.)
Oil shocks often occur at a time when the global economy is booming. In many cases, this was preceded by an overly expansionary monetary policy. In the short term, the oil shock exacerbated the pre-existing inflationary problem. Monetary policymakers responded aggressively with a tighter currency, slowing NGDP growth. With a smaller GDP and sticky average wages, unemployment rises sharply. I call this the musical chairs model of recession.
In this case, the real cause of the recession is hard currency, but the oil shock partly explains why policymakers made this mistake. In the hypothetical scenario where NGDP continues to grow at trend, there is no recession after the oil shock.
In fact, oil price shocks can have an impact beyond its indirect effect on monetary policy and NGDP growth. As Arnold Kling emphasized, society will respond to large increases in oil prices by reallocating consumption and production to less energy-intensive parts of the economy. During the transition, the unemployment rate may rise. This is a real shock to the economy, which may affect employment even if fiscal policy maintains stable growth in NGDP.
How important is the real channel of oil price shocks? Later in the podcast, Alex and Tyler provide some suggestive evidence given to the War in Ukraine:
TABARROK: Yes. Many people, including German politicians, predicted that Germany would have to limit gas, people would freeze to death, and that the economy would enter a deep recession. Eventually, the German economy adapted to the extremely low supply of natural gas by using less and finding alternatives. The price of gas increased by a factor of more than eight, but instead of controlling prices and rates, the German government allowed the price to rise, but protected German consumers with a transfer sum based on past environmental use. gas.
That meant everyone had an incentive to heed the signal of higher natural gas prices. In the end, the German economy took out this big drop in the price of natural gas. To me, this is a sign that maybe economists have at least learned some lessons.
COWEN: I was shocked that it went as well as it did. You may remember, I think it was Deutsche Bank’s prediction of a major recession in Germany. I’m not sure if they had a recession at all, but if they did, it was a moderate recession, and they nailed it.
Tyler’s memory is correct; Germany had the smallest increase in unemployment, from 5% to 6%:
Why were pessimistic predictions wrong? Why did Germany experience such a small increase in unemployment? Monetary policy in the Eurozone remained accommodative, allowing for strong increases in NGDP:
Conversely, large increases in unemployment such as in 1980-82 are associated with tight monetary policies that significantly reduce the rate of NGDP growth.
Non-economists often underestimate the extent to which free markets can substitute when one commodity becomes scarce. (Even economists may briefly forget the importance of substitution, before waking up later in the podcast.)
One final point. In a previous post, I have argued that the number of people who have the talent to become a great artist or scientist far exceeds the number who achieve greatness, mainly because you also have to be in the right place at the right time. This discussion caught my attention:
TABARROK: Many of these studies, which we were talking about in the 1970s, you could say the 1970s led to Milton Friedman. Milton Friedman became the most important spokesman, representative of It’s Free to Chooseand so on, but Milton Friedman is long dead. People forget. People forget Milton Friedman, they forget what made Milton Friedman exist, which is all the mistakes we made in the 1970s.
COWEN: One of my takeaways is that the 1970s were a good time to study economics. The lessons were very visible.
TABARROK: Yes. I will put it in the following way. I think Milton Friedman was not the smartest economist. Maybe that’s Ken Arrow, but Milton Friedman was right about a lot of things. The reason why he is right about so many things is that he was lucky enough to be fulfilled at a time when we were doing everything wrong.
COWEN: That’s right.
A very clever observation. Overall, a very insightful podcast.
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