Did oil cause the downturn?
The implication that almost all of the downturn of 2008 could be attributed to the oil shock is a stronger conclusion than emerged from any of the other models surveyed in my Brookings paper. Unquestionably, there were other very important shocks hitting the economy in 2007-08, most notably the problems in the housing sector. But housing had already been subtracting 0.94% from the average annual GDP growth rate over 2006:Q4-2007:Q3, when the economy did not appear to be in a recession. And housing subtracted only 0.89% over 2007:Q4-2008:Q3, when we now say that the economy was in recession. Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.
There is also an interactive effect between the oil price shock and the problems in housing. Lost jobs and income were an important factor contributing to declines in home sales and prices, and the biggest initial declines in house prices and increases in delinquencies were in the areas farthest from the urban core, suggesting an interaction between housing demand and commuting costs. Once house price declines and concomitant delinquencies reached a sufficient level, the solvency of key financial institutions came into doubt. The resulting financial problems turned the mild recession we had been experiencing up until 2007:Q3 into a much more severe downturn in 2008:Q4 and 2009:Q1. Whether those financial problems were sufficiently insurmountable that we would have eventually arrived at the same crisis point even without the extra burden of the recession of 2007:Q4-2008:Q3 is a matter of conjecture. But it seems to me that oil prices indisputably made an important contribution to both the initial downturn and the magnitude of the problems we’re currently facing.
It is also interesting that the observed dynamics over 2007:Q4-2008:Q4 are similar to those associated with earlier oil shocks and recessions. The biggest drops in GDP come significantly after the oil price shock itself. What we saw in earlier episodes was that the drops in spending caused by the oil price increases resulted in lost incomes and jobs in affected sectors, with those losses then magnifying other stresses on the economy and producing a multiplier dynamic that gathered force over subsequent quarters. The mortgage delinquencies and financial turmoil in the current episode are, of course, not the specific stresses that operated in earlier downturns, but the broad features of that multiplier process are surprisingly similar to the historical pattern.
My paper concludes that the economic downturn of 2007-08 should be added to the list of recessions to which oil prices appear to have made a material contribution.
Acknowledgment: The above was adapted from testimony by the author before the Joint Economic Committee of the US Congress and summaries at the website Econbrowser.
