The ‘High Oil Prices = Recession’ Fallacy

Every time we see oil prices go up we hear that it will cause inflation and/or the economy will go into the tank.

… 7 out of the 8 postwar U.S. recessions had been preceded by a sharp increase in the price of crude petroleum. Iraq’s invasion of Kuwait in August 1990 led to a doubling in the price of oil in the fall of 1990 and was followed by the ninth postwar recession in 1990-91. The price of oil more than doubled again in 1999-2000, with the tenth postwar recession coming in 2001. Yet another doubling in the price of oil in 2007-2008 accompanied the beginning of recession number 11, the most recent and frightening of the postwar economic downturns. So the count today stands at 10 out of 11, the sole exception being the mild recession of 1960-61 for which there was no preceding rise in oil prices. [Hamilton, 2009. Rv. 2010]

The premise is wrong. What causes price inflation is an expansion of money supply (and a desire of people to spend it, often quickly). What causes recessions is malinvestment of capital caused, again, by money supply expansion.

The classic argument is that because 70% of the economy is driven by consumer spending, an increase in gasoline prices will cause a decrease in consumer spending, which will cause an economic decline. Sounds logical on its face. There are empirical studies that show either increases in gasoline prices will not impact discretionary spending (McCarthy, 20110) or that large increases in petroleum prices will cause recessions (Hamilton). Take your pick.

The above chart1 shows the peak of real YoY GDP percentage change (light blue lines) and the relative price of gasoline (red), the product that most directly affects consumers. If gasoline prices have been increasing prior to the peak, then there is statistical data showing that those prices may have had an impact on GDP. From that one might conclude that because oil prices were rising prior to the peak in GDP, and because GDP subsequently declined, then high oil prices may have caused a decline in GDP.  (Because A happened and then B happened, thus A caused B?) Or, is it just a coincidence?

 What we see in the data is coincidence rather than confirmation.

Take price increases of oil and gasoline. It doesn’t cause price inflation (i.e., all prices rise). Instead it’s a supply and demand thing. When OPEC jacks up oil prices, people spend more on gas and less on other things. The consumer goods they don’t buy decline in price. Money is redirected by market forces to petroleum producers who are incentivized to discover and produce more oil. Ultimately, under normal circumstances, prices come down. This process is a bit distorted because we have a cartel-controlled market. But, if OPEC keeps prices too high, people reduce consumption, cartel revenues go down, and OPEC reduces prices to stimulate consumption. This is what happened in the current business cycle. 

It is the same with recessions and oil prices. Each of the recessions we’ve had in the last 40 years can be adequately explained by causes other than oil/gas prices. For example, while oil/gas prices shot up prior to the 2008 Crash, no one suggests that was a cause of it. Rather we know that oil prices went up as a result of a fiat money fueled boom that drove up all commodity prices.

Looking at our chart, we can start with the 1973 – 1975 recession. That was the time of the Arab Oil Embargo (Oct. 1973 to March 1974). If the theory that high oil prices equals recession holds true then why did the economy recover when gas prices continued to rise post-recovery? What really happened was that the Fed cut interest rates by half in 1970-1971, and then started raising them in 1973 to combat rising prices. By the time the recession started in November 1973, the Fed Funds rate peaked at just over 10%. It isn’t as if the oil embargo didn’t cause disruption in the economy; it did, but most of the economic disruption was caused by the government’s price controls and rationing. But it didn’t cause the recession.

Next, GDP peaked in April 1978  (gasoline-PPG $0.631) and declined until October 1980 ($1.223). Recall that price inflation almost hit 15% in 1980.  The recession started in January 1980 ($1.11) and ended in July 1980 ($1.247). Gasoline prices continued to increase during the subsequent recovery. There is no correlation between oil prices and recession or price inflation.

GDP peaked again in Q2 1981 ($1.353) and bottomed out in November 1982 ($1.268). We went into recession in July 1981 ($1.353) until November 1982 ($1.268). You can see an oil price correlation here, but other things were going on: high inflation. By June 1981, the CPI was still over 10%. Carter had appointed Paul Volcker as Fed Chairman in August 1979 and he started raising the Fed Funds rate from around 10% until it reached 19% in January 1981, and kept it high (8% to 10%) for much his term (ended in 1987). This broke price inflation (it settled in the 3.5 to 4.5 range). Thus monetary policy rather than oil prices was the cause of the recession. 

From then on, gasoline prices declined and remained relatively stable until 1999 ($0.90 to $1.30) when it started climbing again. The July 1990 ($1.139) to March 1991 ($1.138) recession shows that GDP peaked in late 1987 (about $0.95) and gasoline prices peaked in January 1991 ($1.304) and the recession ended in March 1991. But again, other things were driving the economy: a real estate boom-bust cycle, and that was largely driven by cheaper money and accelerated depreciation rules (those rules ended in 1986). 

Prices fluctuated but remained in the $1.20s for most of the next eight years.

By 1999, the rise in gasoline prices coincided with peak GDP in late 1999 (Dec., $1.353) and gas prices rose, almost steadily since then. The 2001 recession came and went (March-$1,503) — November-$1.324). But, what else was going on? This was a time of incredible production and technological innovation that again benefited from the Fed’s cheap money (spurred by Greenspan to revive the economy from the 1990 – 1991 recession). It worked. But Dot Com boom turned into Dot Bomb bust as the Fed raised interest rates and cooled the economy off from its “irrational exuberance”.

The Fed decided it needed to stimulate the economy from the bust and from November 2000 to June 2004, the Fed lowered interest rates from 6.5% to 1.00%. From then on oil prices followed commodities prices and gasoline prices continued to climb.

By late 2003 ($1.578) the rate of growth of GDP peaked and thereafter was slowing, although it continued to grow until January 2006 ($2.359). At this point, the Fed again sought to cool down the economy and the Fed Funds rate went from 1.00% up to 5.26% by July 2007. Again, it worked and the real estate markets began to come apart. By H2 2008 ($4.142), GDP began to decline, thus beginning the bust phase of our current boom-bust cycle. Current price is $3.591.

Thus, while you can argue that rising oil and gas prices may have had some negative effects on the economy because of some economic disruption, in every case, the cause of our recession was anything but rising prices.

Regardless you are still going to hear that rising oil and gas prices are going to ruin the economy and cause us to go back into recession. While I believe the economy will decline starting in H2 2012, the reasons have nothing to do with oil prices. Don’t let the pundits scare you with this economic fallacy. There is enough to worry about.


1. Note that gasoline prices (red line) are not scaled to prices, but are scaled to an index (100). The GDP scale (blue line) shows YoY percent change.


17 comments to The ‘High Oil Prices = Recession’ Fallacy

  • I’ve been thinking about several issues while I have been a bit under the weather. This is one of them. I get tired of hearing the same old stuff from the TV pundits so I penned this piece to give me something to do. I will be interested in your comments. Jeff

    • TOM

      ALL IS POLITICS. Gone are the days when news was news. Nearly everything we hear on TV or Radio is pablum for the masses that don’t have a “BS” filter….or their filter is so clogged that everything new gets through. Journalism has long since been taken over by those who want to tell other people their opinion and the hiring process in those businesses has been biased (like teachers and unions) to include only those who agree with the existing staffs.
      Do we ever wonder why any call for cutting government spending is answered with threats of no police in streets or teachers in the schools or military protecting us from terrorist attacks?

  • My comment is that you have an peevish fixation on inflation, and an unhealthy obsession with the money supply. Andyou conflate trade, oil and th money supply is way that is dunderheaded.

    Actually, since oil is largely imported, printing up money and getting oil is not a bad deal. Indeed, there is about $800 billion in US currency, and several trillions in US bonds floating around offshore. We have been excellent traders—we trade paper for real products and services. People holding our bonds and cash offshore have a choice. They can keep it, or spend it here and get something back. Either way is a win for us.

    Inflation is dead in the USA. From 2008 to present marks a period of historically low inflation–if you trust government stats. Some hard-core right-wing economists, such as Don Boudreaux of George Mason, contend the CPI overstates inflation. In fact, the CPI is federal nominal index of prices, subjective and arbitrary. Due to businesses and consumers constantly migrating to a rapidly evolving and improving mix of goods and services, the CPI is probably high as a rule.

    The price of commodities is set globally, and US monetary authorities can do little in this regard.

    The purpose of US monetary policy should be expansion of the US economy, with a reasonable amount of inflation. This is best accomplished by Market Monetarism—transparent and public targeting of nominal increases in the GDP by central banks.

    I like prosperity and growth. Price stability is too high a price o pay for perma-recessions ala Japan.

    The Theo-Monetarists advise genuflection to gold and the worship of money. I prefer to worship economic growth.

    Read up on Scott Sumner.

    • dd

      i’m not even going to bother.

    • Benjamin, thank you for your comments.

      First, a point on style: you will not win points with clever lines like “peevish” “dunderhead”, “unhealthy” or “Theo-Monetarists.” The best way to convince someone is to state your point clearly and politely, back it up with theory and fact, and invite criticism. If you wish to rant, you may, but I urge you to be polite.

      This site is not “right wing” which I assume you use in a pejorative sense. We are Austrian economic theory adherents (ditto with Boudreaux) which seems to be quite different from what you are used to hearing. We are definitely not Monetarists. If you wish to learn more about this, see my reading list (see link at top of page). At least that will enable you to discuss things more intelligently and make criticisms relevant.

      I do not conflate oil prices and money supply, I say that the Fed is responsible for boom-bust business cycles as a result of their inflation and deflation of money supply. In fact I say the opposite, that all commodities prices are affected by an inflated money supply, but that when oil moves independently of other commodities, that is a supply-demand factor.

      You also confuse money and money supply with wealth. If the Fed could target economic growth, we’d all have been filthy rich decades ago. It can’t be done because the Fed creates pieces of paper, not wealth.

      Benjamin, I have taken the time to reply to you because you seem determined to criticize the writers here based on, well, to be blunt, an ignorance of basic economics. But, you aren’t alone and that’s one of the reasons our economy is in so much trouble. So, I will continue to let you comment if at least you are polite. If not you will be banned. I don’t mind harsh criticism as long as it is sincere, well thought out, and polite. This is strike one. Two strikes and you’re out.

      Thanks for reading, Jeff

    • TOM

      This reads like the kind of biased ramblings of too many university teachers (and many high school teachers also). State a few facts and then – without any evidence that those facts are tied together or lead to any rational conclusions – jump mightily to a conclusion. Yes, commodity prices are set globally and therein lies a problem (only one of them). Inasmuch as the price of oil or corn or any PM or commodity is priced in USD and that (exchange rate) price rises faster than earnings, the nation is impoverished with higher costs of basics and less paper money left for savings, vacations, college educations, better lifestyle. The money supply cannot create true wealth out of thin air by applying ink to paper….and yet that reality appears to escape some people.

  • Norman

    Interesting article, as well as the above comment by Mr. Cole. Of course, to the vast majority who don’t have a pocket full of dollars, well, no one seems to offer their side of the story, nor do they seem to care. Considering that we are all in this game together, it’s telling how ugliness has reared its head, that those who do have a pocket full of dollars can and do look down on those without or less then. What lessons are being learned?

  • Hans

    Thank you for raising this issue, Mr Harding! I must admit, I have been a believer in the theory, that if goo prices double, we go into a recession…

    According to this link, crude oil cost $3.oo pb from 1957 until 1972, when it exploded…

    I will continue to read the remainder of your works, whether or not you have dispelled this theory..

  • See latest post of Mark Perry at Carpe Diem (a right-winger btw). Energy, as a fraction of consumer outlays, has been steadily falling in the USA for a long time. As one would expect.

    The private-sector adapts, innovates, responds. Only the US military consumes oil as if there has been no price changes. Duh, guess why.

    The worst course of action is to suffocate the US economy with tight money in response to globally set commodities prices. That is sheer stupidity and pain with no gain.

    The genuflection to gold and worship of tight money usually satisfies some sort of moral or religious ethic in people’s DNA. Better to worship economic growth and material success.

    I love the boom times baby, bring them on.

  • iftheshoefits

    Is this the same Benjamin Cole who told us 2-3 years ago on Robert Rapier’s R-squared energy blog, that oil was headed to $10-15/barrel because of the effect of plug-in EVs and biofuels from jatropha trees in India?

    Worship has nothing to do with it. It’s called math, dude.

  • Hans

    It seems that you provided ample proof and statistical correlations to demonstrate that there is no cause and effect…

    Gasoline and recessions do appear to operate independently of one other…Hamilton does support the front end of this equation but not the back end…How does an economy exit a recession under a same or greater burden of energy costs? My only reply would be efficiency, but I would suspect it would take much longer than the length of an average recession…I may add, that the consumer, in general, does use these events to pay down debt and add to household savings and thus prepare the next economic springboard.

    I would argue, however, that the 1973 recession should not be used as an example, since not only was there pricing inflation but also energy shortages(gasoline & natural gas)as well.

    You have advanced an interesting and convincing theory, Mr Harding..Kudos to you!

  • 1. Energy prices oil prices. Energy includes electricity and transportation fuels. This article is about transportation fuel not about energy.
    2. Transportation fuel is a regressive tax on the economy. Increase regressive tax => increases low income failure => increase food stamps and other government social program => increase the deficit. This is already happening.
    3. Transportation expense competes with discretionary expense. Once discretionary expense is exhausted, transportation expense starts competing with mortgage payment. This is why we are seeing mortgage default rate at long commute counties continue to rise.

    So even if none of this causes recessions it for sure does not cause growth.

    But why spend ink on theory. We can test it now with a real world experiment. According to Hamilton chart, a recession is coming in July-August 2012.

  • Hans

    FFO, rising prices indicate both a demand as well as a need for additional capitalization…

    You are correct in stating that higher gasoline prices will lower discretionary spending, but extended drives are the sole responsibility of the commutee…

  • Hans

    I would like to add, that both recessions in the last decade finished with lower retail gasoline prices at the conclusion of both recessions…

  • [...] “The High Oil Prices= Recession Fallacy“, by Jeff Harding (DailyCapitalist). Ma il petrolio si sta veramente apprezzando? A rigor di logica, in un momento di crisi economica e frenata di consumi e produzione il prezzo di materie prime come rame, petrolio ecc non dovrebbe diminuire? In effetti è così spiego dove sta il trucco qui.  [...]