Friday, January 29, 2010

Oil prices and economic resilience

One of the differences between history and sociology has to do with the nature of explanation. Historians, originating in the humanities, tend to favor ideographic explanations -- the idea that every event is fundamentally unique and, while it is possible to talk about the 'causes' of an event, each event is the product of a unique set of factors. Sociology, classified as a social science, tends to favor nomothetic explanations -- the idea that there are general causal processes and, hence, it is possible to find regularities in the causes of particular types of events.

In this light, it is interesting to contrast conventional press coverage of recessions -- which much like history treat each recession as a unique event -- and recent work examining the relation between energy prices and the economy.

The graph below suggests a connection between energy prices (specifically the price of oil) and the onset of a recession. Four of the past five recessions were preceded by a significant increase in the price of oil.

While this is interesting, the data don't really shed much light on the mechanism that would account for the association. The more complicated look at these events, shown in the diagram below, provides more insight into the specifics of the potential causal process. Over the past 40 years the same sequence of events occurred before each recession: a spike in the price oil, followed by an increase in the percent of GDP used to purchase oil, followed by a recession. In other words, it isn't the price of oil per se but, rather, the impact of changing energy prices on the standard dynamics of production and consumption (represented by the shift in percent of GDP expended on oil) that flips the system into a different equilibrium state (the recession).

Further details on the economics of the process are available in James Hamilton's report Causes and Consequences of the Oil Shock of 2007-8.

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