July 10, 2005
Sunday

With oil prices parked above $55 per barrel, why hasn't the economy tanked?

Spikes in the cost of crude used to cause recessions, unemployment, gas lines, misery. This one hasn't. Drivers grouse, but the economy seems to hum along.

The reason oil hasn't dragged the economy down, as many forecasters expected, is that the economy doesn't depend as much on oil as it once did. Manufacturing jobs have moved overseas, coal and natural gas have replaced oil for fueling electrical plants, and cars go farther than before on a gallon of unleaded.

That doesn't mean soaring oil prices won't do damage at some point, particularly if battered consumers slow their purchases of other goods and services. But economists aren't sure how high prices have to climb before the economy stalls. A year ago, some would have suggested $60 per barrel.

"There's a breaking point that will come," said Steve Yetiv, professor of international affairs at Old Dominion University and author of "Crude Awakenings: Global Oil Security and American Foreign Policy."

"Is it $60? Is it in motion, and we just don't recognize it yet?" he said. "Is it $65, or $70?"

Don't look to history for an answer. America has never before experienced a price rise quite like this one.

The great oil shocks of the 1970s and 1980s started with sudden disruptions in the flow of crude triggered by the Arab oil embargo and the Iran-Iraq war. The current price increase comes from steadily rising demand, not an unexpected cut in supply. The economic effects are quite different when prices move up slowly rather than in a sudden jerk, because businesses and individuals alike have a better idea what's in store and can plan their finances accordingly.

That said, there remains widespread disagreement among economists about the basic relationship between oil's price and the economy.

Some experts argue that America can easily handle higher prices, while others say steep prices inevitably take a toll. A few even consider oil shocks a kind of mirage. Past recessions blamed on oil prices, they say, were largely caused by federal monetary policy instead.

"Clearly, oil price increases have some effect," said Jerry Taylor, director of natural resource studies at the Cato Institute. "The question is whether they're significant or trivial. There is no consensus about that."

They don't seem trivial to anyone with a car. Oil's escalating cost has shoved gas prices up 47 percent since the start of 2004. A few years ago, $2 per gallon was an outrage. Now, drivers place bets on when they'll see pump prices hit $3.

But gasoline is available, even if it is expensive. That's a significant change from October 1973, when Arab nations slapped an oil embargo on the United States for supporting Israel. The sight of cars lined up at tapped-out gas stations jolted Americans used to a life of plenty.

"People actually had to make do with less," said James Hamilton, professor of economics at the University of California-San Diego.

The embargo didn't last long, ending in five months. But it knocked 2.6 million barrels of oil per day off the world market and roughly quadrupled the price, from about $3 per barrel to $12.

The American economy, wobbly from years of anemic growth, reeled. The unemployment rate jumped from 4.6 percent at the start of the embargo to 6 percent a year later and would soon hit 9 percent. Consumer spending, which grew every other year during the 1970s, shrank 0.8 percent in 1974.

The economy, however, has changed since then.

America in the early 1970s was a manufacturing powerhouse, using cheap oil to power its industries. Detroit still dominated the domestic market for cars. Since then, American automakers and manufacturing in general have shrunk. The economy relies more on services and retail sales, both of which require less oil than factories. The amount of energy needed to generate a dollar of the nation's gross domestic product has dropped 46 percent since 1973.

"Now oil is a much smaller fraction of our economy than it used to be," said James Sweeney, a Stanford University economist. "It's a sharp change."

Since oil prices began to rise last year, the economy has softened at times but never faltered. It grew a respectable 3.8 percent in the first three months of 2005, according to federal figures released last week.

Many economists say high oil prices still can do damage. The modern economy leans heavily on spending by ordinary consumers, who have seen a steadily increasing share of their money disappear into the gas tank.

So far, consumers haven't changed their ways, at least not much. As angry as higher gasoline prices make them, they still drive.

"We don't see much reaction, in terms of consumption of gasoline, to these rising prices," said Walter Schubert, a finance professor at La Salle University. "We'd expect people not to travel, to stay home, and we don't see any of that."

People also haven't stopped spending on clothes, personal electronics and other items. Personal consumption grew 3.6 percent in this year's first quarter.

But there are signs of a shopping slowdown, at least among lower-income consumers. Wal-Mart's sales, for example, didn't grow as quickly in the first quarter as had been expected. The company blamed oil prices.

Higher oil and gasoline prices typically hurt lower-income Americans most because they live on tight budgets. People in other income levels, however, can absorb the blow. Compared with many necessities - such as food, medicine, insurance and housing - gasoline remains relatively cheap.

"It's significant, but for most budgets, it's not so overwhelming that you change your overall spending pattern," Sweeney said. "I think of it as maybe eight Starbucks coffees in a month."

Other economists say rising oil and gas prices eventually will stifle consumer spending across the board if they continue to outpace personal income growth.

"If I have to keep spending more on petroleum products, I can't spend my money on something else," Schubert said.

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