[Editors] MIT economist sees U.S. weathering oil prices

[Elizabeth Thomson]

MIT News Office
Massachusetts Institute of Technology
Room 11-400
77 Massachusetts Avenue
Cambridge, MA  02139-4307
Phone: 617-253-2700
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MIT economist sees U.S. weathering high oil prices
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For Immediate Release
THURSDAY, JAN. 17, 2008
Contact: Elizabeth A. Thomson, MIT News Office -- Phone: 617-258-5402  
-- Email: thomson at mit.edu

CAMBRIDGE, Mass.--As the price of oil doubled over the last year, it  
may have looked like 1973 all over again to some observers. But  
research by MIT macroeconomist Olivier Blanchard shows that a return  
to 1970s-style gas lines and stagflation-the grim mix of inflation  
and stagnant growth-isn't in the cards.

In a paper titled "The Macroeconomic Effects of Oil Price Shocks: Why  
are the 2000s so different from the 1970s?" Blanchard and a colleague  
show how changes in U.S. and global economic policies have reduced  
the impact of oil price shocks.

Co-written with Jordi Gali of the Center for International Economic  
Research in Barcelona, the work was published as an MIT Economics  
Working Paper and is available online at http://papers.ssrn.com/sol3/ 
papers.cfm?abstract_id=1008395.

Blanchard, the Class of 1941 Professor of Economics, is a former MIT  
economics department head and widely published author whose articles  
on economics appear regularly in U.S. and French media. He discussed  
his research on oil shocks during a recent interview with the MIT  
News Office.

Q: Four price-doubling oil shocks have occurred in 35 years-1973,  
1979, 1999 and now. How have economic reactions differed?

A: In the 1970s, there were two sharp recessions and sharply higher  
inflation. This time around, the economy has remained strong, and  
inflation has barely bulged.

Q: What's behind the differences? Why was 1973 so different from 2007?

A: In the 1970s, the adverse effects of oil price increases were  
compounded by other adverse shocks-a sharp slowdown in productivity  
growth and large increases in the price of raw materials.

In the 2000s, the effects of oil price increases have been partly  
offset by other shocks, this time favorable-sustained productivity  
growth and strong Asian growth, for example.

Q: Higher oil prices make dramatic news, yet your research indicates  
oil actually affects the U.S. economy less than it did 35 years ago.  
Why is that?

A: Those previous large increases in the price of oil did their job:  
they led to decreased demand. The share of oil and gas in U.S.  
production and consumption today is roughly two thirds of what it was  
in the 1970s. Thus, any given increase in the price of oil has only  
two-thirds of the impact it had then.

Q: Do oil prices still affect wages, as they did in the 1970s?

A: Oil doesn't have the impact it did because workers don't have the  
bargaining power they did. In the 1970s, oil price increases led  
workers to try to maintain their purchasing power by seeking higher  
wages, which they often won through union contracts. This increase in  
wages led in turn to an increase in the price of all goods, which led  
to a further increase in wages and so on.

In the 1970s, wage increases were also made easier by the fact that,  
in many countries, wages were indexed to inflation, so they  
automatically went up. To fight inflation, central banks tightened  
monetary policy, leading in turn to declines in output.
Things are very different now: Indexation clauses are largely gone.  
And workers' bargaining position is much weaker than in the 1970s.  
Thus, for the most part, wages have not gone up with the price of  
oil, and inflation has remained low. There has been no need-so far- 
for tighter monetary policy.

Q: What role has monetary policy played in differentiating the 1970s  
from the 2000s?

A: For the last 25 years, monetary policy has aimed at stabilizing  
inflation, and people have come to rely on it as a credible policy.  
Now, when the price of oil increases, workers do not anticipate  
impending inflation and thus, do not feel they have to ask for large  
wage increases.

Q: Are there any macroeconomic benefits to higher oil prices?

A: Higher oil prices have many complex implications for the world  
economy. Let me just take one, which may seem paradoxical: The  
increase in the price of oil helps finance the U.S. current account  
deficit. The reason is that oil producers know that oil revenues will  
not last forever, so they save a good part of those revenues. Not  
having great investment opportunities at home, they are eager to lend  
outside their country, and, in particular, to lend to the U.S.

Such willing creditors allow the U.S. to continue to borrow abroad  
and to run a large current account deficit. Were it not for oil- 
producing countries, the demand for U.S. assets would be smaller, and  
the dollar would be even weaker than it is today.

Q: What if oil-producing countries suddenly took their money out?

A: The dollar would plunge. But so would the value of their dollar  
investment, so they are very unlikely to use this tool/threat.

Q: Will the price of oil keep going up?

A: I truly have no clue-despite talking to many of the people whose  
job it is to forecast oil prices. Most believe that based on what we  
know about the elasticity of supply and the elasticity of demand, the  
current price is surprisingly high. At 90 or 100 dollars a barrel,  
there is a lot of oil worth extracting, and a lot of alternative  
energy sources worth exploiting. Futures markets do not predict much  
change from current levels; this seems a reasonable assumption.

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Written by Sarah Wright, MIT News Office