Alex Tabarrok and Tyler Cowen are doing a series of podcasts on the economy of the 1970s. A few weeks back, I commented on one of their previous podcasts, which discussed the tricky problem of establishing causality for changes in inflation. Their most recent podcast discusses oil shocks and the business cycle, an area where causality is even harder to establish:
TABARROK: Now, let’s talk about some puzzling economics because the price of oil goes up. War starts in October of 1973. The US goes into a recession in November of 1973. Unemployment doubles from 4.5 percent to 9 percent. Now, I think most of our listeners will say, “Well, what’s puzzling about that? Price of oil goes up and you go into a recession. That seems entirely normal.”
Yet for economists, this is still quite puzzling because even though oil is obviously of relative importance, it’s not that big a feature of the economy, and there in fact are pretty sophisticated theorems, which say that if you have—this is Hulten’s theorem—if you have a shock to a sector of say 10 percent, something goes up, productivity goes down 10 percent, price goes up 10 percent or something like that, and that sector is a relatively large share of the economy, say 5 percent, then the effect on GDP should just be those two things multiplied together. Ten percent times 5 percent, which is just 0.5 percent on GDP.
COWEN: Those theorems are wrong, right?
TABARROK: Yes.
The link between oil shocks and recessions seems pretty strong. And yet, I’m not entirely sure that those theorems are wrong. So how can we explain why recessions often follow oil shocks? Here are two possibilities:
1. Induced monetary tightening (a nominal shock.)
2. Reallocation of resources (a real shock.)
Oil shocks often occur at a time when the global economy is booming. In many cases, this is preceded by excessively expansionary monetary policy. In the short run, the oil shock makes the pre-existing inflation problem even worse. Monetary policymakers respond vigorously with tight money, slowing NGDP growth. With less nominal GDP and sticky nominal wages, unemployment rises sharply. I call this the musical chairs model of recessions.
In this scenario, the actual cause of the recession is tight money, but the oil shock partly explains why policymakers make this mistake. In a counterfactual scenario where NGDP keeps growing on trend, there is no significant recession after an oil shock.
In reality, oil price shocks can have an impact beyond their indirect effect on monetary policy and NGDP growth. As Arnold Kling has emphasized, the public will respond to sharply rising oil prices by re-allocating consumption and production toward less energy intensive parts of the economy. During the transition period, the unemployment rate may rise. This is a real shock to the economy, which can affect employment even if monetary policy maintains steady growth in NGDP.
How important is the real channel for oil price shocks? Later in the podcast, Alex and Tyler provide some suggestive evidence provided by the Ukraine War:
TABARROK: Yes. A lot of people, including German politicians, predicted that Germany would have to ration gas, that people would freeze to death, that the economy would go into a deep recession. In the end, the German economy adapted to a much lower supply of natural gas by using less and finding substitutes. The spot price of gas rose by a factor of more than eight at peak, but instead of price controls and rationing, the German government let the price rise, but they did protect German consumers with a lump sum transfer based upon the past use of natural gas.
That meant everybody had an incentive to listen to the signal of the higher price of natural gas. In the end, the German economy rode out this massive decline in the quantity of natural gas. To me, this is a sign that maybe economists at least have learned some lessons.
COWEN: I was shocked that went as well as it did. You may recall, I think it was Deutsche Bank forecast a major recession for Germany. I’m not sure they had a recession at all, but if they did, it was just a marginal recession, and they nailed it.
Tyler’s memory is correct; Germany had only a very modest rise in unemployment, from 5% to 6%:
Why were the pessimistic forecasts wrong? Why did Germany experience such a small rise in unemployment? Monetary policy in the Eurozone remained expansionary, allowing for a strong rise in NGDP:
In contrast, large increases in unemployment such as 1980-82 are associated with tight money policies that sharply contract the rate of growth in NGDP.
Non-economists tend to underestimate the extent to which free markets can find substitutes when one commodity becomes more scarce. (Even economists may briefly forget the importance of substitutes, before coming to their senses later in a podcast.)
One final point. In previous posts, I’ve argued that the number of people with the talent to become a great artist or scientist far exceeds the number that actually achieve greatness, mostly because you must also be in the right place at the right time. This conversation caught my eye:
TABARROK: Many of these lessons, which we’ve been talking about in the 1970s, you can say the 1970s led to Milton Friedman. Milton Friedman became a much more important spokesperson, representative of Free to Choose, and so forth, but Milton Friedman’s been dead for some time. People forget. People forget Milton Friedman, and they forget what caused Milton Friedman to come into being, which is all of the mistakes which we made in the 1970s.
COWEN: One of my takeaways is simply the 1970s was a great time to learn economics. The lessons were very visible.
TABARROK: Yes. I would put it the following way. I think Milton Friedman was not the smartest economist ever. Maybe that’s Ken Arrow, but Milton Friedman was right on the greatest number of things. The reason he was right on the greatest number of things was that he was lucky enough to come to fruition at a time where we were doing everything wrong.
COWEN: That’s right.
A very astute observation. Overall, a very insightful podcast.
Read More: Real shocks and recessions – Econlib