Did Your Car Cause the Crisis?

If you ask an average American to explain just how we managed to get ourselves into this economic mess, he will most likely tell a fairly simple story. People borrowed too much, housing prices got out of hand, Wall Street went nuts, and eventually it all came down with a crash, leaving us in the worst downturn since the Great Depression. What will almost certainly be left out of the account is what was the biggest economic story of 2008, right up until Lehman Brothers went under -- a doubling in the price of a barrel of oil, and the resulting pain at the gas pump. Hard to imagine that the most significant oil shock since the 1970s has been relegated to historical sideshow, but these are the times in which we find ourselves.

But in fact, the oil spike of 2008 (following on almost a decade of steady increases in the price of crude) was an integral part of the economic storm that assailed the nation last fall. And the threat posed by expensive oil hasn't disappeared. Quite the contrary; it stands ready to derail a fledgling economic recovery this year and handcuff growth until Americans break their decades-long petroleum habit.

To understand why, one has to go back to the mid-1980s, as the American economy was finally emerging from the era of stagflation into a world where crude oil was once again cheap and plentiful. Cheap crude enabled two key trends that would dominate the next two decades, a period coincident with the settling down of the Baby Boomer cohort. Automobiles became ever larger, as the minivan surged to popularity before giving way to the Suburban and a kingdom of SUVs. And the second great wave of suburbanization took place, giving rise to the endless geography of the exurbs. These trends were an understandable reaction to the times; millions of households sought safety and security in their automobiles and in large, affordable homes miles away from cities imploding amid the crime spike of the crack age.

But the America that emerged at the turn of the millennium was one heavily dependent on cheap oil. This was an unappreciated vulnerability. Or rather, it was appreciated for all the wrong reasons. Even as national leaders fretted about the security implications of our dependence on oil, rapid economic growth in emerging markets like China and India began placing heavy pressure on resource stocks. The years of cheap oil had reduced the incentive to invest in exploration and production of new energy sources, and so supply had grown slowly even as demand had soared. Prices rose steadily, from around $12 per barrel in 1998 to just over $60 per barrel in 2007.

And then, for a variety of reasons, prices spiked. A key factor was the acuteness of the supply-demand mismatch, but loose monetary policy -- a reaction to the deteriorating economic picture -- made investment in commodities more attractive. Oil moved relentlessly upward in price, peaking in July of 2008 near $150 per barrel.

The effect on households was devastating. Households had leveraged themselves to the hilt during the housing boom, but things had begun to fall apart. As home prices peaked and fell, home equity credit rapidly dried up. The movement of the economy into a shallow recession in December of 2007 pushed jobless rates up, further crimping many household budgets. Most families had little, no, or even negative savings on which to draw in times of trouble.

In such an environment, rising gas prices directly impacted consumer spending; every additional dollar spent at the pump was one that could not be used for other purchases. The effect on households was most intense where commutes were longest, in the exurbs, a factor that exacerbated budget problems there and fueled housing defaults and foreclosures. American families spent years moving themselves steadily toward the brink. Expensive gas shoved them beyond it.

Economist James Hamilton has done the analytical work on the rise in oil prices, in an attempt to gauge its role in the dramatic economic crisis that took hold in the autumn of 2008. In a recent paper, he took several different models used to predict the impact of oil prices on macroeconomic outcomes and applied them to oil shock of 2007-8. His results were stunning -- in the absence of a sharp rise in the price of oil, the American economy would not have been in recession through the first three quarters of 2008. More remarkable still, the models predicted changes in output in late 2008 eerily similar to the actual path of GDP, based solely on the impact of expensive oil -- data on the housing and market crashes and financial crisis were not included. An observer looking at the models but entirely ignorant of the events of September and beyond would have nonetheless predicted a recession very much like the current one.

Hamilton acknowledges that oil should not be credited with the whole of the recession; the pain of the financial crisis and the decline in wealth due to housing and market crashes was significant. And yet it seems clear that the sudden and sharp increase in the price of a commodity so integral to all aspects of American life was very much responsible for putting us all in the uncomfortable situation in which we now find ourselves.

But here is the really worrying part. With the relentless demand destruction of the global recession, oil prices tumbled, falling from over $100 per barrel in October to around $70 per barrel in November, to roughly $40 per barrel by March. But March marked the beginning of the appearance of the so-called "green shoots." With every piece of positive economic news, oil prices have ticked upward. Just this week, prices once again crested $60 per barrel, and since the beginning of May the average price of a gallon of gas has edged from just a shade over $2 to $2.30 -- and rising.

This is very disconcerting. As gas prices rose last year, American families responded by adjusting habits -- driving less, taking transit more often, and trading in gas guzzlers for more efficient automobiles. But even at the height of oil price spike, behavioral changes were limited; there's only so much most Americans can do to use less gas in the short term. Since then, many of those gas-saving habits have persisted -- transit use remains at a high level, and miles driven have not bounced back entirely with the decline in oil prices -- but households remain extremely vulnerable. Most are still in debt, and even as the pace of economic decline has lessened consumption has stayed weak, a product of America's renewed appreciation for saving. A return to global growth will mean a continued rise in oil prices. That will mean cuts to consumer spending and problems for indebted households. And that represents a serious constraint on recovery.

Unfortunately, this is not a problem that can be resolved quickly. America's geography and automotive fleet took decades to assemble, during which time transit and walkable environments were neglected and woefully underfunded. It is simply impossible to move any significant percentage of American households to within reach of transit or into a highly efficient new automobile in a matter of months or a few years. This is the work of decades.

But that's no excuse for policy apathy. And indeed, concern over the effect of oil-dependence (along with awareness of the threat of climate change) has motivated the Obama administration to act. New fuel efficiency standards, announced this week, will pave the way for far more efficient cars and trucks. Congress isn't sitting still, either. A "cash for clunkers" plan -- offering incentives to individuals who purchase new and more efficient automobiles -- has been making its way through the legislature. The required increase in efficiency is small (in some cases no more than one or two miles per gallon to qualify for thousands of dollars in new car vouchers) but it is a step toward reduced oil dependence.

More is necessary, however. Policy should provide a steady nudge away from oil consumption, an incentive to economize on the black stuff even when its price is low. This approach won't inoculate the economy immediately, but it will ensure that as time goes on, households become ever less vulnerable to the threat of rising oil prices. To achieve this, policy should involve both a push and a pull.

On the pull side, transit service should be supported and expanded. The current recession has seriously impaired government budgets, including those for transit systems. The timing couldn't have been worse; fares have risen sharply and services have been curtailed, even as ridership figures have hit their highest mark in a half-century. Immediate steps should be taken to shore up transit operating budgets. Meanwhile, the groundwork should be laid, via the new transportation funding bill scheduled for congressional consideration this year, for a comprehensive and ambitious effort to reconstitute the nation's transit and rail networks. Automobile ownership should not be a requirement for participation in this society, particularly when it entails such high economic costs.

A push is also necessary, and that requires the handling of some serious political hot potatoes. An increase in the federal gasoline tax has been all but unthinkable for years now, but political stars may be aligning for a change in policy course. There is still a powerful national security message that resonates with voters, which can now be buttressed with economic and environmental arguments. Just as important, new revenue sources will be an absolute necessity in the near future, as Washington begins to grapple with record deficits.

Passing a series of substantial gas tax increases now, to take effect in 2011, would have multiple salutary effects. The expectation of a higher future price at the pump would continue to push households to economize on gas by buying more efficient vehicles, downsizing commutes, and switching to transit. It would provide an immediate incentive to firms throughout supply chains to address efficiency -- now, not in 2016, when the new CAFE rules are set to take effect. And it would allow the administration to continue working to invest in new infrastructure -- like a high-speed rail system, better freight rail and port facilities, and quality public transit -- in the knowledge that revenue will be available to handle the bills.

These steps would still leave households exposed to a near-term run-up in oil prices, which will almost certainly occur given recovery here and in emerging markets. But they would limit the pain and increase the speed and efficiency with which the American economy could adjust to and move beyond the economic and environmental shackles of our oil dependence.

These problems aren't going away. The sooner they are addressed, the better. As Hamilton put it in congressional testimony this week:

Notwithstanding, the recent rise in oil prices again underscores the present reality of the long-run challenges. Even if we see significant short-run gains in global oil production capabilities, if demand from China and elsewhere returns to its previous rate of growth, it will not be too long before the same calculus that produced the oil price spike of 2007-08 will be back to haunt us again.

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