The U.S. Economy is as Vulnerable as Ever to an Oil-Shock
March 9th, 2005
With oil prices consolidating above $50 per barrel, forming a base upon which future price increases will likely be built, there is no shortage of Pollyannas willing to dismiss the toll higher oil prices will exact on the U.S. economy. The most recent of these is The Wall Street Journal columnist Thaddeus Herrick, who in his March 8th article entitled "Retooling Keeps Economy Growing despite Steep Increases in Oil Prices" postulates that even sustained oil prices of $70 per barrel would not push the U.S. economy into recession. His familiar, yet extremely naive conclusion rests on the argument that as oil now constitutes a significantly reduced percentage of U.S. GDP, oil prices have a minimal impact on the economy. Wall Street analysts are only too eager to accept this flawed logic, as it allows them to sweep yet another major economic problem under an already lumpy rug.
First of all, Herrick's claim that U.S. manufacturers have "retooled" and "streamlined" is somewhat misleading. The reality is they have "de-tooled" and shut down, as the U.S. economy itself has de-industrialized. The result, as he correctly points out, is that energy expenditures have declined from about 14% of GDP in 1980 to only 7% today. However, to argue that this makes the U.S. economy less dependent on oil is overly simplistic, and leads to a fallacious conclusion.
Just because America now imports many of the goods that it formerly produced domestically does not mean that it is now less dependent on the oil necessary to manufacture them. In fact, due to the increased energy now required to transport these goods to America, the U.S. economy is more vulnerable than ever to rising oil prices. Though foreign oil consumption does not directly factor into U.S. GDP, oil remains a necessary component in the manufacturing process, the cost of which is increasingly indirectly included in the price of imports.
For example, in 1980 a pair of shoes purchased in New Haven, Connecticut might have been manufactured in a factory in Hartford. The oil necessary to produce these shoes would have been consumed domestically, and therefore directly included in U.S. GDP. However, since today that pair of shoes is likely to have been produced in China, the oil consumed in the production process is now excluded from U.S. GDP. Instead, that cost is indirectly passed on to American consumers in the price of the shoes. Oil is just as significant to U.S. GDP; it's just that its costs are hidden in the prices of non-oil imports.
However, since shoes manufactured in China must also be shipped across the Pacific Ocean, the oil consumed in transportation is now far more significant today than it was in 1980. The cost of the oil needed to ship shoes to America, and the extra cost required for those ships to return to China empty, are also indirectly passed on to American consumers in the price of imported shoes. Once these shoes arrive at a port in California, they must then be trucked 3,000 miles to the East Coast. The cost of oil consumed in domestic transportation, which is included as part of U.S. GDP, is nevertheless significantly higher than it was in 1980, when those shoes needed to be transported fewer than 100 miles.
Further, Mr. Herrick's claim that the dominance of non energy-intensive sectors, especially financial services, protects the over-all economy from suffering adverse consequences from higher energy costs, is also false, as it ignores the impact rising energy costs will have on interest rates, upon which financial services are highly dependant.
One of the main ways that the Fed has been able to keep interest rates low is by ignoring over-all CPI data in favor of the "core" rate, which excludes energy. The theory has validity only if one assumes that recent price increases are temporary, and are likely to be reversed in the coming years. However, if as Mr. Herrick correctly points out, high oil prices are not only permanent, but headed significantly higher, the Fed will no longer be able to ignore the headline number. When the Fed is forced to admit that it had its eye on the wrong ball, it will have to be far more aggressive in raising short-term interest rates.
In addition, as higher energy costs exert additional upward pressure on consumer prices, particularly energy intensive imports, it will be harder for the Fed to maintain the illusion that inflationary pressures are contained. As inflation expectations become more in line with inflation reality, long-term interest rates will rise substantially as well. With the Fed well behind a rapidly accelerating inflation curve, it might be forced to get extremely aggressive with short-term interest rates, potentially inverting the yield curve with both long and short term rates substantially above current levels. The impact of double-digit interest rates on financial services, and other interest rate sensitive sectors, will be severe. When factoring in their impact on highly inflated asset prices, which collateralizes borrowing and finances a significant portion of consumer spending, the effects could be catastrophic.
In conclusion, considering the indirect cost of oil now embedded in import prices, the additional transportation costs, and the relative fuel inefficiency of its current fleet of vehicles, America's dependence on oil has never been greater. Further, given that the significant rise in interest rates that will untimely accompany higher oil prices comes at a time when a highly-leveraged American economy can least afford it, it is certainly not credible to be downplaying the significant risks associated with rising oil prices.
C.E.O. and Chief Global Strategist
Euro Pacific Capital, Inc.
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