Monday, February 8, 2016

Low Energy Prices and Recession? Analysts Ignore the Supply-Side Elephant in the Corner

Gloom and doom is wreaking havoc in financial and commodity markets as oil prices probe new lows. Headlines proclaim that domestic energy producers face bankruptcy, layoffs, and can’t pay back toxic loans. Meanwhile, energy-producing countries must contend with deteriorating public finances and recession. The old reliable China is no longer around to take up the slack in energy and commodity markets. It turns out, so the business-page pundits say, that low energy prices are a curse that could push the U.S. and the rest of the world into recession. An article on the Wall Street Journal op ed pages, no less, warns that “we face the first one (recession) ever caused falling oil prices.” Student of Economics 101 learn the opposite: low energy prices, resulting from exogenous forces, stimulate the economy.  Can it be that widespread belief in bad economics can send the world economy into a nose dive?

Our media business gurus have fallen for the “that which is seen and that which is unseen” illusion of which the French economist Frederic Bastiat warned in 1850. Bastiat applied this principle to international trade, where those who lose from trade are more visible and vocal than those who gain. Business journalists write about the “visible” loss of jobs in the oil patch. They do not write about the “invisible” gains of chemicals, heavy manufacturing, transportation, and even many services from lower energy costs. At best, they use Keynesian blinkers to focus on the extra pocket money of consumers from lower pump prices, but worry that spooked households are saving their windfall, not spending (despite no evidence of an increase in the saving rate). Yes. Keynes still dominates the financial press.

There is no doubt that the Petro States are being deeply harmed by the collapse of oil prices. Russia relies on oil for more than half of its state revenue and is completing two years of recession with more likely to come. Saudi Arabia and Kazakhstan join Russia in drawing down oil funds accumulated during good times. Petro States with access to capital markets may have to sell shares of their national oil companies to survive. There is even discussion of public offerings of Aramco and Rosneft. The Venezuela of the Chavistas can no longer afford payoffs to core voters or ship subsidized oil to Cuba. Iran is returning to world oil markets just in time for historically low prices.

The Petro States account for only around ten percent of world GDP. The oil and gas sector accounts for a half of one percent of employment in the United States. Their losses are the “what is seen.” Those who gain from lower energy prices account for the bulk of world output and employment.

Returning to basic economics: There seems to be agreement that the massive negative oil price, shock is the result of the fracking revolution; e.g., the consequence of technological change. Standard macroeconomic principles texts teach that exogenously-induced lower energy prices reduce the cost of doing business throughout the economy, thereby increasing aggregate supply. More aggregate supply means higher real GDP and a lower price level. We certainly learned the negative effects of positive energy price shocks in the mid-1970s and early 1980s. Should we not expect now to sit back and enjoy the reverse? That’s not the case. For some strange reason, economic journalists and pundits have concluded that low energy prices are harmful.
Pundits complain that politicians are interested in the short run and that CEOs worry only about quarterly earnings. Economic pundits are equally handicapped by short-run thinking. The aggregate supply curve may not shift to the right immediately, but it will.

Economists work on the principle of abstraction: Economic theory aims to isolate the most important factors causing economic phenomena, brushing aside the less significant ones with the ceteris paribus assumption. Abstraction tells us that the gains from lower energy prices are widespread throughout the U.S. and world economy, whereas the losses are limited geographically and sector-wise. Financial writers should begin their analysis with the economic basics and not get distracted by other details. In this case, by ignoring the supply side, they are missing the elephant sitting in the corner.


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