Alex Tabarrok and Tyler Cowen produce a series of podcasts about the economy of the 1970s. A few weeks ago, I commented on one of their earlier podcasts, which discussed the difficult 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 more difficult to establish:
TABARROK: Now let’s talk about some puzzling economic factors as oil prices rise. The war begins in October 1973. The US enters a recession in November 1973. Unemployment doubles from 4.5 percent to 9 percent. I think most of our listeners will say, “What’s confusing about that? The oil price rises and you enter a recession. That seems very normal.”
But for economists this is still quite confusing, because even though oil is clearly of relative importance, it is not that big of a feature of the economy, and in fact there are quite sophisticated theorems that say that if you have, this Hulten’s statement– if you give a sector a shock of, for example, 10 percent, something goes up, productivity goes down by 10 percent, the price goes up by 10 percent or something like that, and that sector is a relatively large part of the economy, for example 5 percent, then the effect on GDP should be just these two things multiplied together. Ten percent times 5 percent, which is only 0.5 percent of GDP.
COWEN: Those statements are wrong, right?
TABARROK: Yes.
The link between oil shocks and recessions seems quite strong. And yet I am not entirely sure that these statements are wrong. How then can we explain why recessions often follow oil shocks? Here are two possibilities:
1. Induced monetary tightening (a nominal shock).
2. Redistribution 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 term, the oil shock exacerbates the already existing inflation problem. Monetary policymakers are responding strongly with cash constraints, slowing NGDP growth. With lower nominal GDP and stable 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 finance, but the oil shock partly explains why policymakers make this mistake. In a counterfactual scenario where NGDP continues to grow on trend, there will be no significant recession after an oil shock.
In reality, oil price shocks can have an impact beyond their indirect effect on monetary policy and the growth of the natural gas transmission network. As Arnold Kling has emphasized, the public will respond to sharply rising oil prices by redistributing consumption and production to less energy-intensive parts of the economy. During the transition period, the unemployment rate may increase. This is a real shock to the economy, which could have consequences for employment even if monetary policy maintains steady NGDP growth.
How important is the real channel for oil price shocks? Later in the podcast, Alex and Tyler provide suggestive evidence from the war in Ukraine:
TABARROK: Yes. Many people, including German politicians, predicted that Germany would have to ration gas, that people would freeze to death, that the economy would enter a deep recession. Ultimately, the German economy adapted to a much lower supply of natural gas by using less and finding alternatives. The spot price of gas rose by a factor of more than eight at its peak, but instead of price controls and rationing, the German government allowed the price to rise but protected German consumers with a lump-sum transfer based on the past use of natural gas. gas.
That meant that everyone had an incentive to listen to the signal of the higher natural gas price. Ultimately, the German economy survived this huge drop in the amount of natural gas. To me, this is a sign that economists may have at least learned some lessons.
COWEN: I was shocked that it went so well. You may recall that I think it was Deutsche Bank that predicted a major recession for Germany. I’m not sure if they had a recession at all, but if they did it was only a marginal recession, and they weathered it well.
Tyler’s memory is correct; Germany experienced only a very modest increase in unemployment, from 5% to 6%:
Why were the pessimistic predictions wrong? Why did Germany experience such a small increase in unemployment? Monetary policy in the Eurozone remained expansionary, allowing a strong increase in the NGDP:
In contrast, large increases in unemployment, such as in 1980-1982, are associated with tight monetary policy that sharply reduces the growth rate of the NGDP.
Non-economists often underestimate the extent to which free markets can find substitutes when a particular product becomes scarcer. (Even economists may momentarily forget the importance of substitutes before coming to their senses in a podcast later.)
One last point. In previous posts I have argued that the number of people with the talent to become a great artist or scientist far exceeds the number who actually achieve greatness, mainly because you also have to be in the right place at the right time. This conversation caught my attention:
TABARROK: A lot of these lessons that we talked about in the 1970s, you could say the 1970s led to Milton Friedman. Milton Friedman became a much more important spokesperson, representative of Free to chooseand so on, but Milton Friedman has been dead for a while. People forget. People forget Milton Friedman, and they forget what created Milton Friedman: all the mistakes we made in the 1970s.
COWEN: One of my findings is that the 1970s were a great time to learn economics. The lessons were very visible.
TABARROK: Yes. I would formulate it as follows. I don’t think Milton Friedman was the smartest economist ever. Maybe that’s Ken Arrow, but Milton Friedman was right on most points. The reason he was right about most things was that he was fortunate enough to flourish at a time when we were doing everything wrong.
COWEN: That’s right.
A very astute observation. In short: a very enlightening podcast.