Is Petroleum A Barrier to U.S. Economic Growth?

We hear much discussion of U.S. oil imports.  Some of it is informative, some just scare-mongering but little of it focuses on the cold, hard economic reality.  With only a limited knowledge of a few simple macroeconomic concepts, the outlines of the oil-price noose on economic growth become plainly visible.

The basic Keynesian model divides up the aggregate flows of spending into four basic categories: Consumption — the biggest category; Investment — purchases of long-lived, real assets; Net Government Spending — spending minus taxes or the annual deficit; and Net Exports (exports minus imports).  These concepts all refer to spending for real goods and services, so set aside the financial sector for the moment.

If any category gets bigger, then there is more spending for goods and services and the economy grows.  Conversely, when any of these four categories shrinks, then the economy shrinks (recession).  Especially important are sudden changes.

Because our traded sector has historically been small, American economists tend to focus on the other three.  However, a sudden change in the value of net exports amounting to several percentage points of GDP can still have a substantial impact on the direction of the overall economy.

Net exports are the main channel through which the price of crude oil impacts the overall economy.  Depending on how households alter their driving and spending patterns, prices at the pump may or may not affect consumption spending.  However, the effect of price changes on net exports is entirely mechanical.  Let’s take a look at recent history.

On the left-hand axis, we measure the value of petroleum imports (price times quantity) as the share of GDP (data from the indispensable Economic Report of the President 2010).  Because our petroleum exports are minimal, the increase in the oil import bill has a direct, negative effect on net exports (which may be offset by other changes in the composition of foreign trade but let’s keep it simple).  An increase in oil prices, as we had during the decade of the “aughts” results in a significant decrease in net exports — rising from one percent to nearly four percent (price data from EIA).

Let’s take a closer look at the period of the recession, which began in December 2007 and ended in June 2009.

By 2006, when the economy was starting to slow, the petroleum import share had already doubled from the one percent level of the 1990s.  By the end of 2007, the import share had rise by half to three percent and during 2008, it nearly hit four percent.

Clearly, the U.S. economy cannot tolerate such a large and sudden negative hit.  Was it the chief factor in the recession?  Maybe, maybe not but it certainly didn’t help!

Of course, it’s not news that high oil prices are bad for the economy.  The critical point is to understand the transmission mechanism of net exports.  This helps us to understand the policy choices that lie ahead.

Oil imports as a share of total U.S. consumption will not change any time soon, staying close to two-thirds.  Global oil production seems to have reached a plateau.  Hence, any return to strong global growth that includes the United States (the world’s biggest oil consumer) will see oil prices move up accordingly.  Through the mechanism of net exports, this will have a negative impact on aggregate demand, in turn, slowing the U.S. economy.

We use more than a fifth of the world’s annual output but have only two percent of the world’s oil reserves.  Ignoring the BP oil spill, policy makers will press forward with weakening environmental protections to expand offshore oil drilling along all of our coasts but it won’t move the needle much as our once-great on-shore oil fields continue their steady depletion.

Even if policy makers could find a way to put their foot on the accelerator, they would be hitting the brake at the same time.

The United States is no longer the only economy that matters.  Petroleum demand in Asia has grown significantly since the 1990s.  This explains why the price of crude oil doesn’t “go all the way back down” during recessions.  There appears to be a ratchet effect in operation: two steps forward but only one step back.  You can see the ratchet working in the second chart where, even in the depths of the Great Recession, oil imports as a share of GDP did not drop back to one percent (compare with the first chart) and is already heading back towards the two percent level.

In the short to medium term, there appear to be no ready substitutes for all the petroleum we import.  Electric vehicles will take a long time to have much impact.  U.S. military operations are extremely petroleum-intensive.  And then there’s the cultural factor: We Americans strongly identify petroleum with power and prosperity — it’s what we have experienced for the past century.

Escaping petroleum addiction will be painful and protracted for our country.

For any state like Maryland that imports 100 percent of its petroleum consumption, the economic choking effect of oil prices is even greater.  Maryland’s leaders should put themselves in the shoes of a small nation like Denmark that produces no oil and no cars.  Because oil and cars must all be imported, they constitute a burden to the Danish economy and are heavily taxed.

Automobile use should be strongly discouraged in Maryland in order to reduce the economic risks of oil price increases.  This can be done through taxes on fuel, parking and automobile ownership, an end to wasteful new highway construction and changes in land-use policy to promote denser, transit-oriented development.

“Impossible!” politicians and voters will say, but offer no alternative other than keeping our collective head in the oil-price noose.

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