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Friday, May 5, 2000

May 2000 Forecast

Published in May, 2000, on the Web Site Popular Economics

Are Oil Prices Leading to a New Recession?
British Economist Predicts Summer Downturn

    Whether we like it or not, it is too late to avoid a worldwide economic slowdown, according to British economist Andrew Oswald. Based on the dramatic increases in the price of oil since the first quarter of 1999, he points to a recession beginning later this year, probably in the summer. Oswald, Professor of economics at Warwick University, and two collaborators have tracked the price of the energy input from 1954, and found a startling correlation to the rate of unemployment. A rise in oil prices is followed 18 months later by a rise in the unemployment rate.

    "Historically, sharp rises in the price of energy are our best predictor of a slump to come. This happened in the mid 70s, late 70s, and early 90s. No doubt it will happen again," Oswald wrote in a paper released last month. Describing the implications of his work with countryman Alan Carruth and American Mark Hooker, he continued, "Energy is a key input. When inputs become more expensive, cost curves rise. Firms begin to go out of business. Petroleum is also the lifeblood of transport and delivery. It governs electricity prices too. This process cumulates."

    Oil prices tripled between the first quarter of 1999 and February of 2000. They have since fallen back somewhat, but the damage has already been done. "Even a sharp reversal of petroleum prices over the next few weeks would probably leave some kind of recession making its way through the western economies. Unemployment will probably begin to turn around this summer," Oswald said in a March interview. "Once the first gentle turn comes, history suggests that rises in joblessness will continue for a couple of years. In other words, it is likely that we are close to the bottom of the familiar U-shape in unemployment over the business cycle."

    The close connection between unemployment and economic downturns should not be surprising. "Everything in the world is made using energy and people. When energy becomes dearer, something has to give. Caveats aside, it has to be the price of people. More unemployment brings that about."

    The oil price model developed by the three economists has held up well when tested. When applied to the early 1990s, it outperformed by a wide margin the forecasts of a leading private forecasting firm and a consensus prediction of professional forecasters.

    In an article for the Financial Times in September of 1999, after oil had doubled in price from its low, the British economist advised central bankers to take notice. "Like other forces, the price of energy takes time to have its effect. But these lags are an enormous help to central bankers, and can be exploited by them," he wrote. "The worry now is that interest rates cycles in the US and Britain may be out of step with energy prices."

    At the end of April he was asked directly whether the Fed's raising interest rates in the face of rising energy prices would exaggerate a possible recession. "It seems a definite possibility that the Fed's timing is going to be wrong," he said. "They will hit the brake just as the vehicle begins to run out of gas. But stagflation is always the hardest thing for a central banker to deal with. The car is overheating but it's also slowing down. So what do you do? It depends whether you care more about the radiator or getting to your meeting on time. Not easy."

    The results of any Fed misplay may not be fatal, however. "By and large in economics, government policies probably do not affect the economy very much," he said in the March interview. "The idea that restrictive monetary policy caused the early 90s recession, for example, is probably wrong. The notion that somehow shrewd government actions by nations around the world created the late 1990s boom is equally incorrect -- another illusion of power. In these cases, energy prices did most of the job -- first in leading to a slump and then, after they collapsed, in stimulating boom."

    Likewise, he has little patience with claims that energy efficiency has made the new millennium different from preceding years, less reliant on oil, and thus less subject to the drag of high oil prices. "First of all, we should be looking at energy itself rather than oil narrowly. The price of oil has a major impact on the prices of other energy sources. We know these prices tend to move together through the years," he said.

    "Another point to be aware of is that the improvement in energy efficiency is not terribly large over even a couple of decades. It is fractionally more than one percent a year. So the UK economy, for instance, uses about 20 to 25 percent less energy per unit of GDP now than it did in 1980."

    "Also, the argument, so common among journalists at the moment, that we use less oil relative to GDP, omits something - - that this is true of all inputs. We use less labor per unit of GDP. We also use fewer machines. Probably less nickel and palladium and copper and so on too, though I'd have to check the numbers.

    "This is just the definition of economic growth. In other words, more productivity through the years: higher output coming out of a given stock of inputs. It does not make sense to see this process, which has been going on for hundreds of years, as magically reducing the intrinsic volatility of an economy to all shocks."

    When pressed with the fact that the industrial structure has changed, and industries which consume high levels of energy have been replaced by industries using lower levels of energy, Oswald protests that while the narrow point is true, it misses an essential fact: the transportation sector has grown enormously. "In a country like Britain, it is the transport sector that uses more energy than any other (most of it oil, by the way). Transport accounts for virtually as much energy consumption as services and industry combined."

    Neither does Oswald believe in a new economic paradigm. "When you hear young men and women saying that this is a new era in the economy and the stock market, and that old-timers do not know what they are talking about, it is best to put on your crash helmet," he said.

    "As I keep reminding any journalist willing to listen, forget software versus steel ingots. The new economy runs on petrol and aviation fuel."