Oil Surge Is Holding the Economy Back
By Tony Crescenzi
Special to RealMoney.com
03/12/2003 02:48 PM EST
The recent surge in energy costs poses one of the greatest threats to the U.S. economy. Rising prices could prevent the economy from reaching its potential and thus delay gains in employment and capital spending.
Many factors are behind the rise in energy prices, and many of them relate to simple supply and demand. The rest of the increase can be attributed to worries about the possibility of a disruption in supply that might result from a war with Iraq. The simplest way to gain an understanding of the potential impact of energy costs on the U.S. economy is to multiply the total amount of oil consumed in the U.S. by the dollar change in the price of crude.
Here's the formula: (Daily consumption x change in price per barrel) x 365 days = impact on consumers The U.S. goes through about 19.5 million barrels a day, according to the Energy Information Agency of the Department of Energy. Using the above formula, this means that for every $1 change in the price of a barrel of crude oil, U.S. consumers will pay an additional $7 billion for energy (assuming the price change is sustained over a one-year period).
With the price of crude oil having increased $13 a barrel from its five-year average of $24, consumers could pay an extra $91 billion for oil this year. That equates to almost a full percentage point of annual gross domestic product. The 1% drag is significant because it could prevent the economy from reaching its growth potential.
When the economy grows below its potential, businesses have very little incentive to both add workers and increase their capital spending. An economy that expands at 2.5% can be materially different than an economy that grows at 3.5%, and the effects of such subpar growth can be similar to those seen in a recession.
Suppose that a company employs 100 people and that it produces 100 units of a product in a given year. In a subsequent year, the company has the ability to produce 103.5 units owing to a 2.5% increase in productivity and a 1% increase in the size of the labor force (a result of population growth). If the demand for the company's products were to increase by 2% to 102 units, the company will have excess capacity of 1.5 units.
To adjust for this costly situation, the company will either cut its employment or cut its capital spending. While the company will have experienced growth during the year (of 2%), it would be below its ability to produce, leaving it with the excess capacity.
This is an example of what happens in the overall economy when growth doesn't reach its full potential. For companies that already have excess capacity, subpar growth delays the removal of that excess capacity and therefore increases in hiring and spending.
Higher energy costs are a major threat to the growth in disposable income, or income minus inflation and taxes. Disposable income has grown strongly over the past year thanks to low inflation and tax cuts. Indeed, the growth in disposable income in the year following the end of the recession (presumed to have occurred in the fourth quarter of 2001) was one of the strongest for any year that followed any recession over the past 50 years.
This extraordinary growth, which was largely due to the 2001 tax cuts, helped buoy consumer spending and provides a solid explanation for the resilience seen in consumer spending since the financial bubble burst in 2000. Now, however, disposable income is being reduced by the surge in energy costs. This increases the need for further tax cuts, which would help maintain the growth in disposable income. Of course, the affordability and composition of tax cuts are another story.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of The Strategic Bond Investor. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. |
