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Breaking the Vicious Circle of Oil

Kevin Drum has a very important piece that shows us the predicament of the oil-fueled society we’ve constructed over the past several years. The story is basically this. Oil production is static, if not falling, and emerging markets are increasing and broadening their wealth, leading more and more Chinese and Indians and Indonesians and Brazilians to desire a higher standard of living. Invariably this means oil demand goes up. Therefore, when global GDP growth increases, demand for oil and then the price of oil increases. And around the world, but especially in a country like ours that’s extremely dependent on oil, this creates a price shock and a reduction in growth. The political cartoon of this would be a man named “economic growth” jumping to the ceiling and consistently hitting his head on “the oil supply.” So we’re in a constant cycle of low growth and stable oil prices, followed by higher growth and oil shocks, which knocks the economy back to lower growth.

The effect this has on the economy is probably greater than even most pessimists realize. James Hamilton, a University of California-San Diego economics professor who’s studied the economics of oil demand deeply, points out that 10 of the 11 recessions in the United States since World War II have been preceded by an increase in oil prices—and even small increases in oil prices can have a surprisingly big impact on economic growth. In a recent update of a model he originally published in 2003, he estimates that an oil price spike of 10 percent over its previous high produces a GDP decline of 1.4 percentage points one year later. To put this into real-world terms, his model suggests that the huge run-up in oil prices between 2007 and 2008, when prices nearly doubled, explains most of the Great Recession that followed. And he forecasts that the Libyan price spike early this year, which came on top of a 9 percent increase the previous quarter, will reduce GDP by an estimated 2.4 percentage points by the end of 2011. And the Libyan price spike was pretty modest.

It’s a serious policy dilemma, and the answer is manifestly not to drill for more oil, or to facilitate the strip mining of tar sands in Canada with a giant pipeline. Two reasons: one, you run into another bound there, namely the increasing global temperatures, which cause more frequent and more destructive natural disasters. And if you think they have no impact on growth, look at what the Japanese tsunami did to the global supply chain. I am not saying that the Japanese earthquake was caused by global warming, only that natural disasters carry an enormous amount of economic destructive capability. The fact that Hurricane Irene will take oil refineries offline temporarily and probably in itself cause a price spike should be more than enough evidence of that. (And yes, you can make a case for climate change in the growth and destructive power of a hurricane like Irene).

Number two, there simply isn’t enough oil available outside of what’s already being produced to meaningfully change this dynamic. World oil production is simply near its ceiling, and growth-causing demand that outstrips this production causes price shocks. The production options left are either horribly dirty like the tar sands, facilitating more climate change, or horribly dangerous like deepwater drilling, and prone to ongoing environmental disasters that have their own economic impact.

The only option, then, though a gradual and at times a painful one, is to end the oil economy. That means curtailing suburban sprawl that spews all kinds of toxicity into the atmosphere. It means embracing mass transit and bike lanes and intercity rail and other eco-friendly means of transporting ourselves. It means supporting the new high fuel-efficiency standards for a newly resurgent auto industry, including the rapid deployment of electric cars with innovative battery technology. It means innovating our way out of fossil fuel dependence through renewable energy, and funding as much research as possible to get us there. Billions of dollars spent on how to make a blade of grass an energy source instead of a drop of oil is probably the best money you can possibly spend right now. The stimulus actually funded some of this, but not nearly enough. Because there’s no other way around the vicious circle of oil, where economic growth is met by price spikes and a reduction of that growth.

Without such a transformation, we are consigned to no meaningful growth in perpetuity, and oil recession after oil recession.

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David Dayen

David Dayen