Alex Tabarrok and Tyler Cowen have a series of podcasts about the economy of the 1970s. A few weeks ago I commented on one of my previous podcasts that discussed the difficult problem of establishing causality for changes in inflation. their recent podcasts We discuss oil shocks and business cycles, an area where causality is even more difficult to establish.
Tabarok: Now let’s talk about the puzzling economics of rising oil prices. In October 1973, war begins, and in November 1973, the United States falls into recession. The unemployment rate doubled from 4.5 percent to 9 percent. Now, I think most listeners would say this. Oil prices rise, leading to a recession. That seems perfectly normal. ”
But for economists, this is still very puzzling. Despite oil’s obvious relative importance, it is not a very large feature of the economy, and in fact there is a fairly sophisticated theorem. Furten’s theorem—If there is a shock to say 10 percent of a sector, something will rise, productivity will fall by 10 percent, prices will rise by 10 percent, etc., and that sector accounts for a relatively large share of the economy (say, 5 percent). Masu. In that case, the impact on GDP should be the product of these two factors. 10 percent x 5 percent, or just 0.5 percent of GDP.
Cowen: Those theorems are wrong, right?
Tabarok: yes.
The relationship between oil shocks and recession seems to be very strong. Still, I’m not at all convinced that these theorems are wrong. So how can we explain why recessions often occur after oil shocks?There are two possibilities.
1. Induction of monetary tightening (nominal shock)
2. Reallocation of resources (this is really shocking)
Oil shocks often occur during times when the global economy is booming. This is often preceded by overly expansionary monetary policy. In the short term, oil shocks will exacerbate existing inflation problems. Monetary policymakers have responded vigorously with tighter funding, slowing NGDP growth. When nominal GDP declines and nominal wages stagnate, the unemployment rate rises sharply. I call this the recession musical chairs model.
In this scenario, the actual cause of the recession is tight money, but oil shocks partly explain why policymakers make this mistake. In the counterfactual scenario in which NGDP continues to grow on trend, no significant recession occurs after the oil shock.
In reality, oil price shocks can have effects that go beyond their indirect effects on monetary policy and NGDP growth. As Arnold Kling has emphasized, citizens will respond to the sharp rise in oil prices by reallocating consumption and production to less energy-intensive parts of the economy. Unemployment rates may rise during the transition period. This could be a huge shock to the economy and affect employment. Even if monetary policy maintains stable growth in NGDP.
How important is the actual path of the oil price shock? Later in the podcast, Alex and Tyler provide some suggestive evidence brought about by the Ukraine war.
Tabarok: yes. Many, including German politicians, predicted that Germany would have to ration gas, people would freeze to death, and the economy would fall into a deep recession. Eventually, the German economy adapted to a much smaller supply of natural gas by using less gas and finding alternatives. The spot price of gas rose more than eight times at its peak, but instead of price controls and rationing, the German government allowed prices to rise, while lump-sum transfers based on past natural gas usage forced German consumers to Protected. gas.
That meant everyone had an incentive to heed the signal of rising natural gas prices. Ultimately, the German economy weathered this significant decline in natural gas volumes. To me, this is a sign that perhaps economists have learned at least some lessons.
Cowen: I was shocked that it worked. As you may remember, I think Deutsche Bank predicted a major recession in Germany. I don’t know if they ever had a recession at all, but if they did, it was only a small recession, and they nailed it.
Tyler’s memory is correct. In Germany, unemployment rose only very slightly, from 5% to 6%.
Why did the pessimistic prediction come true? Why did unemployment rise so slightly in Germany? Monetary policy in the euro area remained expansionary, allowing for strong growth in NGDP.
In contrast, large increases in unemployment, such as those from 1980 to 1982, are associated with tight monetary policies that sharply reduce NGDP growth.
Non-economists tend to underestimate the extent to which a free market can find substitutes when a good becomes scarce. (Even economists sometimes forget the importance of substitutes momentarily, then realize it later on a podcast.)
One last point. In previous posts, I have argued that the number of people who have the talent to become great artists and scientists far exceeds the number of people who actually achieve greatness; The main reason is that you need to be in the right place at the right time. This conversation caught my eye.
Tabarok: 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, Free to chooseetc. But Milton Friedman has been dead for a while. people forget. People forget Milton Friedman, and they forget what led to Milton Friedman. That’s all the mistakes we made in the 1970s.
Cowen: One of my takeaways is that the 1970s was a great time to study economics. The lessons were very clear and easy to understand.
Tabarok: yes. I would say: I don’t think Milton Friedman was the smartest economist ever. It may be Ken Arrow, but Milton Friedman was right about a lot of things. The reason he was right about the most things was because he was lucky enough to succeed when we were all wrong.
Cowen: That’s correct.
He has very keen powers of observation. All in all, a very insightful podcast.
