This note examines Prabhat Patnaik's argument that the contemporary international financial system crucially requires the stability of oil prices in terms of the dollar. By comparing the macroeconomic impact of recent oil shocks to those of the 1970s, it argues that sharp changes in the dollar price of oil need not necessarily lead to instability

Bhattacharya, Jyotirmoy

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MPRA
Munich Personal RePEc Archive
Oil Shocks: How Destabilizing are they?
Jyotirmoy Bhattacharya
Indian Institute of Management Kozhikode
2008
Online at http://mpra.ub.uni-muenchen.de/12116/
MPRA Paper No. 12116, posted 12. December 2008 19:54 UTC
OIL SHOCKS: HOW DESTABILISING ARE THEY?
JYOTIRMOY BHATTACHARYA
Abstract. This note examines Prabhat Patnaik’s argument that
the contemporary international financial system crucially requires
the stability of oil prices in terms of the dollar. By comparing the
macroeconomic impact of recent oil shocks to those of the 1970s,
it argues that sharp changes in the dollar price of oil need not
necessarily lead to instability.
One of the most striking conclusions reached in Prof. Prabhat Pat-
naik’s recent book The Value of Money is that the world monetary
system is still de facto a commodity money world, despite having bro-
ken all de jure links to the world of commodities after the collapse of
the Bretton Woods system (Patnaik, 2008, Chapter 19).
Prof. Patnaik’s argument proceeds in two steps. The necessity of
the value of money being stable in terms of commodities—established
earlier in the book for a single capitalist economy—takes the form of the
necessity of the ‘leading currency’ maintaining a stable value in terms
of commodities when the analysis moves to the setting of a world with
many capitalist economies.
A threat to this stability can come from two main sources— au-
tonomous increases in the price of labour power and increases in the
price of primary commodities. Prof. Patnaik considers the former to
be unlikely in the present deflationary regime imposed by finance capi-
tal. As for the latter, non-oil primary commodities do not pose a major
threat to stability, most importantly because of their low share in the
gross GDP of the advanced capitalist countries.
Thus, by elimination, the essential condition for the sustenance of the
present world monetary regime with the dollar as the leading currency
is the maintenance of a stable dollar price of oil—what Prof. Patnaik
terms the oil-dollar standard—and it is in this sense that this regime
is a de facto commodity money system.
This conclusion not only has far-reaching implications for the aca-
demic understanding of the international monetary system, it also pro-
vides a basis for an understanding of the recent tendencies of US im-
perialism.
I am extremely grateful to Prof. Jayati Ghosh, Rohit, Prasenjit Bose and the par-
ticipants at the 2008 IDEAS conference on ‘The Value of Money and Contemporary
Capitalism’ for very helpful comments on an earlier version of this note.
1
2 JYOTIRMOY BHATTACHARYA
The converse of Prof. Patnaik’s argument is that periods in which
the dollar price of oil rises would, ceteris paribus, be periods of in-
stability of the world capitalist system. This suggests the possibility
of empirically testing, as it were, Prof. Patnaik’s analysis of the con-
temporary international monetary system by looking precisely at such
periods when the dollar price of oil has been rising.
It is our purpose in the present note to set the grounds for such a
test by reviewing the existing evidence on the response of advanced
capitalist economies to oil price shocks.
We are aware that any attempt at empirical verification on these
lines is subject to a number of difficulties. First, there is no way to
directly control for the violation of the ceteris paribus clause. Given
that we only have a handful of episodes of large oil price increases
over a number of decades during which the economies under study
have changed drastically, there is no way to mechanically filter out the
effects of our failure to control for ‘other factors’. The best way forward
seems to be to try to identify the most significant such factors for each
episode and at least informally gauge the effect that they may have
had.
The second difficulty in our exercise, common to all empirical macroe-
conomics, is our inability to observe expectations. As Prof. Patnaik
points out, temporary fluctuations in oil prices do not pose any threat
to the oil-dollar standard. Only secular increases, or more importantly,
increases perceived to be secular increases do. However, we feel that
by not looking at all changes in oil prices but limiting ourselves to oil
price ‘shocks’, i.e. significant and sustained increases in oil prices, we
address this difficulty to some extent.
1. The Evidence
Following the stagflation of the 1970s, it had till recently been the
general opinion among macroeconomists that oil price shocks pose a
serious threat to the stability of the world economy, including the ad-
vanced capitalist countries. As Hamilton pointed out in his pioneering
study of the impact of oil price shocks on the US economy, Hamilton
(1983): “All but one of the U.S. recessions since World War II have
been preceded, typically with a lag of around three-fourths of a year,
by a dramatic increase in the price of crude petroleum”.
The twenty-first century has not been kind to this consensus. The
increase in petroleum prices that have followed the US invasion of
Iraq have cumulatively been as large as those of the 1970s. Yet, the
advanced capitalist countries have not faced either recession or infla-
tion comparable to those of the stagflation era, even though the lat-
est episode of price increase extended much beyond Hamilton’s lag of
“three-fourths of a year”. The fact that these economies are now in a
recession precipitated by an international financial crisis does not offer
OIL SHOCKS 3
Figure 1. US Oil Prices—West Texas Intermediate
[Source: FRED (Federal Reserve Economic Data)]
a resolution either. Even if a mechanism could be found whereby high
oil prices would be a cause of the US housing bubble bursting, the long
lag between the price increase and the slowdown would still cast doubts
on any simple mechanisms connecting oil price increases to economic
instability.
Such doubts had already started being voiced during the 1990s based
on research which showed an apparent break in the relationship be-
tween oil prices and macroeconomic variables in the 1980s, with the
relationship being much weaker in the later period. These observa-
tions led to three broad questions. Was there really a weakening in the
oil-macroeconomy relationship during the 1980s or was the apparent
weakening a statistical artifact? If the relationship was weak during
the 1980s, had it been strong even in the 1970s? If the relationship
was strong during the 1970s and weak in the 80s and 90s, what had
changed in between?
1.1. Oil shocks. Figure 1 plots the nominal US oil prices from 1970:1
to 2008:8.
Different methods have been suggested to identify and time ‘oil
shock’ events from price series. Any such criteria will to some ex-
tent be arbitrary. For the sake of illustration we follow Blanchard and
Gal´ı (2008) who define a ‘large oil shock’ as “an episode involving a cu-
mulative change in the (log) price of oil above 50 percent, sustained for
4 JYOTIRMOY BHATTACHARYA
run up period 50% rise date max log change ($) max log change (real)
O1 1973:3–1974:1 1974:1 104% 96%
O2 1979:1–1980:2 1979:3 98% 85%
O3 1999:1–2000:4 1999:3 91% 87%
O4 2002:1–2007:3 2003:1 125% 110%
Table 1. Postwar Oil Shock Episodes. [Source: Blan-
chard and Gal´ı (2008)]
O1 O2 O3 O4 AVG(1,2) AVG(3,4)
Canada 4.7 1.8 2.2 0.5 3.3 1.4
Germany 0.1 2.6 1.1 -0.2 1.4 0.4
France 5.4 3.1 1.3 0.5 4.2 0.9
U.K. 10.2 4.3 0.0 0.5 7.3 0.3
Italy 7.7 5.6 1.0 -0.1 6.6 0.4
Japan 7.9 1.0 -1.7 0.9 4.4 -0.4
U.S. 4.9 4.0 1.7 -0.2 4.5 0.7
G7 4.8 1.9 0.3 0.0 3.3 0.2
Euro12 4.3 2.7 1.3 -0.5 3.5 0.4
OECD 4.9 1.8 0.1 -0.5 3.4 -0.2
Table 2. Oil Shock Episodes: Change in Inflation.
[Source: Blanchard and Gal´ı (2008)]
O1 O2 O3 O4 AVG(1,2) AVG(3,4)
Canada -8.3 -1.0 -1.5 3.2 -4.6 0.8
Germany -9.6 -3.5 1.3 -2.5 -6.6 -0.6
France -7.6 -4.4 0.6 1.2 -6.0 0.9
U.K. -16.4 -9.2 0.4 2.5 -12.8 1.4
Italy -8.6 0.4 3.0 -2.0 -4.1 0.5
Japan -16.1 -4.4 7.6 3.3 -10.3 5.4
U.S. -13.3 -11.8 -3.7 7.1 -12.5 1.7
G7 -12.6 -7.7 -0.2 3.9 -10.2 1.8
Euro12 -9.1 -2.9 1.0 -0.4 -6.0 0.3
OECD -11.2 -6.5 0.1 4.1 -8.9 2.1
Table 3. Oil Shock Episodes: Cumulative Change in
GDP.[Source: Blanchard and Gal´ı (2008)]
more than four quarters”. Using this criteria they identify the episodes
shown in Table 1.12
1Blanchard and Gal´ı conclude their analysis at 2007:3. But it is evident from
figure 1 that O4 is still continuing.
2Blanchard and Gal´ı’s criteria does not identify the shock triggered by the first
Gulf War since the price increase was reversed quickly
OIL SHOCKS 5
For the four episodes that they identify, Blanchard and Gal´ı calculate
the change in inflation and GDP for the individual G7 countries as
well as a few aggregates of advanced countries. These are shown in
Tables 2 and 3. With a few exceptions both these tables show the
pattern referred to above. In the 1970s, oil price shocks clearly lead
to stagflation. In the 1990s and 2000s, the effect is much less, if not
non-existent.
Starting with Hamilton (1983), attempts have been made to look
at the same relationship using the entire time series of oil prices and
macroeconomic aggregates rather than individual shock episodes. Mork
(1989), Hooker (1996), Hamilton (1996) are important contributions to
this literature. Once we move away from looking only at oil price in-
creases clearly associated with political/military events in the Middle
East, two problems need solving. First, to what extent can we con-
sider oil price changes as being exogenous to macroeconomic fluctua-
tions. Second, we have to account for the possibility that the effect of
oil price increases and oil price decreases may not be symmetric. The
answer to these questions have an important bearing when evaluating
alternative theoretical explanations of the oil-price economy relation-
ship, but none of the adjustments needed to account for them overturn
the basic conclusions in the tables above—oil-price increases had a large
impact on output and inflation in the 1970s, the effect is much less in
the 1990s and 2000s. The challenge for theory is to account for both
these facts simultaneously.
2. Recessions
2.1. Large impact on output. Any attempt to develop a theoretical
understanding of the effect of oil price shocks on output and prices
immediately comes up against the obstacle that simple models of the
macroeconomy predict changes in output that are too small. While
we would expect an increase in the price of oil to reduce the demand
for oil and for directly or indirectly energy-intensive commodities like
automobiles, it is not immediately clear why an oil price shock should
create a downturn as sharp as those of the 1970s. This is a problem
for both demand-side and supply-side theories.
The simplest supply-side mode is competitive market-clearing neo-
classical model. In a model of that sort, output is most easily modelled
as being produced jointly by labour, capital and energy by a production
function:
Y = F (N,K,E) (1)
If the price of energy is exogenously given, and a rise in energy
prices causes other factors to be substituted for energy, this may cause
output to fall. But a simple consequence of profit maximisation with
production function (1) is that the elasticity of output with respect to
a change in energy use equals the share of energy costs in total output.
6 JYOTIRMOY BHATTACHARYA
For the U.S. economy a reasonable value for this share would be 4%,
which would imply an output reduction of 0.4% for every 10% decrease
in energy use, much smaller than what was observed during the 1970s.
A naive demand-side argument which sees an oil price increase as a
tax which reduces the disposable income of oil buyers and increases the
income of oil sellers would fare no better. Even if we assume that oil
sellers do not consume any domestic goods out of their extra income,
the relative income fall of oil buyers would at most be proportional to
the share of oil in consumption expenditures, and that number would
once again be too small to explain the recessions of the 1970s.
Given this, attempts have been made to explain the recessionary ef-
fects by bringing in secondary factors which may magnify the initial
impact of oil price increases. Rothemberg and Woodford (1996) bring
in imperfect competition and mark-up pricing, Finn (2000) introduces
complementarity between energy and capital and variable capital util-
isation and Hamilton (1988) introduces frictional employment arising
out of the need to move labour out of industries which are directly
or indirectly energy intensive (such as automobiles) to other indus-
tries. Apart from limited empirical support, a major problem for all
these models is their inability to explain the weakening of the oil-price
macroeconomic relationship in the last two decades.
2.2. Monetary policy and the bargaining power of workers.
Given these difficulties in explaining the stagflation of the 1970s on the
basis of purely private sector responses, one strand of literature starting
with Bernanke et al. (1997) attributes the recession to incorrect mone-
tary policy on the part of the Fed. Working in a vector auto-regression
framework, Bernanke et al. (1997) tried to simulate the effects of a
monetary policy that did not respond to oil price shocks and found
that the reduction of output was lesser in their hypothetical regime.
While the exact results of their analysis have been questioned on sta-
tistical grounds by Hamilton and Herrera (2004), it seems reasonable
to assume that at least a part of the downturn of the 1970s must be at-
tributed to recessionary monetary policies of that period. This would
fit into a picture of an attempt to defend the oil-dollar standard by
squeezing the real claims of the working class. But then, the question
that follows is why such recessionary policies were not needed during
later oil shocks?
A simple mechanism of explaining this discrepancy would be by in-
voking differences in expectation formation. The oil shocks of the 1970s
were an unprecedented event and neither citizens nor policy-makers
had any experience of dealing with such shocks and they had no way
of predicting of what the shocks would imply for the trajectory of the
economy. This brought greater uncertainty and a greater likelihood
of the shocks being considered permanent and hence triggering off a
OIL SHOCKS 7
wage-price spiral. The later oil shocks were different both due to prior
experience as well as due to the fact that in these later episodes there
was a gradual increases in oil prices rather than a more abrupt jump.
The last shock was also widely believed to have been caused by spec-
ulation. All of these might have led to a perception of the shocks as
being transitory and hence might not have triggered off a wage-price
spiral.
While there may be an element of truth in this argument based on ex-
pectations, it cannot negate the fact that the cumulative changes in oil
prices were roughly comparable in the earlier and later episode. There-
fore we would have expected a wage-price spiral to have been triggered
off ultimately. The fact that it was not must therefore be attributed, in
a conflicting-claims framework, to the flexibility of the claims of some
strata. Two possible explanations stand out. One, a squeeze in the
claims of domestic workers made easier by de-unionization and a re-
duction in the rights of workers in general. Two, a squeeze in the claim
of foreign workers mediated through cheaper imports. The fact that
one or both of these leads to a muting of the destabilizing effect of oil
shocks is certainly not a cause for celebration, since this muting comes
at the cost of growing inequality. However, such muting does increase
the resilience of the world monetary system based on the dollar. And
we expect that this muting would become easier as a declining energy
intensity of output makes the required squeeze in real wages smaller
over time.
3. Conclusion
The response of contemporary capitalist economies to oil price shocks
has changed. Why, can only guess, and maybe the next oil shock will
prove all predictions of fundamental change wrong. But what we do
see is that at least in certain conjunctures large oil price increase do
not automatically lead to a crisis for the system.
Does this demand a change in the analysis of the world monetary
system presented in Prof. Patnaik’s book? In essence, not at all. The
fundamental impossibility of explaining the value of money through
supply-and-demand and even the need for the leading currency of the
time to maintain a stable value vis-a-vis commodities are conclusions
that stand independently of the importance or otherwise of oil.
However, the idea of an ‘oil-dollar standard’ may indeed require re-
examination. The evidence of recent years points to the possibility of
oil joining other non-oil primary commodities in being quantitatively
insignificant in determining the trajectory of the advanced capitalist
countries.
8 JYOTIRMOY BHATTACHARYA
References
Bernanke, B., M. Gertler, and M. Watson (1997): “System-
atic Monetary Policy and the Effects of Oil Price Shocks,” Brooking
Papers on Economic Activity 1.
Blanchard, O. and J. Gal´ı (2008): “The Macroeconomic Effects
of Oil Price Shocks: Why are the 2000s so different from the 1970s,”
Unpublished working paper.
Finn, M. G. (2000): “Perfect Competition and the Effects of Energy
Price Increases on Economic Activity,” Journal of Money, Credit and
Banking, 32, 400–416.
Hamilton, J. D. (1983): “Oil and the Macroeconomy since World
War II,” Journal of Political Economy, 91, 228–248.
——— (1988): “A Neoclassical Model of Unemployment and the Busi-
ness Cycle,” Journal of Political Economy, 593–617.
——— (1996): “This is what happened to the oil price-macroeconomy
relationship,” Journal of Monetary Economics, 38, 215–220.
Hamilton, J. D. and A. Herrera (2004): “Oil Shocks and Ag-
gregate Macroeconomic Behavior: The Role of Monetary Policy.”
Journal of Money, Credit & Banking, 36, 265–287.
Hooker, M. A. (1996): “What happened to the oil price-
macroeconomy relationship?” Journal of Monetary Economics, 38,
195–213.
Mork, K. (1989): “Oil and the Macroeconomy When Prices Go Up
and Down: An Extension of Hamilton’s Results,” Journal of Political
Economy, 97, 740.
Patnaik, P. (2008): The Value of Money, Tulika Books.
Rothemberg, J. J. and M. Woodford (1996): “Imperfect Com-
petition and the Effects of Energy Price Increases on Economic Ac-
tivity,” Journal of Money, Credit & Banking, 28, 549–577.
Indian Institute of Management Kozhikode
E-mail address: jyotirmoy@jyotirmoy.net


Oil Shocks: How Destabilizing are they?

Munich RePEc Personal Archive

MPRAMunich Personal RePEc ArchiveOil Shocks: How Destabilizing are they?Jyotirmoy BhattacharyaIndian Institute of Management Kozhikode2008Online at http://mpra.ub.uni-muenchen.de/12116/MPRA Paper No. 12116, posted 12. December 2008 19:54 UTCOIL SHOCKS: HOW DESTABILISING ARE THEY?JYOTIRMOY BHATTACHARYAAbstract. This note examines Prabhat Patnaik’s argument thatthe contemporary international financial system crucially requiresthe stability of oil prices in terms of the dollar. By comparing themacroeconomic impact of recent oil shocks to those of the 1970s,it argues that sharp changes in the dollar price of oil need notnecessarily lead to instability.One of the most striking conclusions reached in Prof. Prabhat Pat-naik’s recent book The Value of Money is that the world monetarysystem is still de facto a commodity money world, despite having bro-ken all de jure links to the world of commodities after the collapse ofthe Bretton Woods system (Patnaik, 2008, Chapter 19).Prof. Patnaik’s argument proceeds in two steps. The necessity ofthe value of money being stable in terms of commodities—establishedearlier in the book for a single capitalist economy—takes the form of thenecessity of the ‘leading currency’ maintaining a stable value in termsof commodities when the analysis moves to the setting of a world withmany capitalist economies.A threat to this stability can come from two main sources— au-tonomous increases in the price of labour power and increases in theprice of primary commodities. Prof. Patnaik considers the former tobe unlikely in the present deflationary regime imposed by finance capi-tal. As for the latter, non-oil primary commodities do not pose a majorthreat to stability, most importantly because of their low share in thegross GDP of the advanced capitalist countries.Thus, by elimination, the essential condition for the sustenance of thepresent world monetary regime with the dollar as the leading currencyis the maintenance of a stable dollar price of oil—what Prof. Patnaikterms the oil-dollar standard—and it is in this sense that this regimeis a de facto commodity money system.This conclusion not only has far-reaching implications for the aca-demic understanding of the international monetary system, it also pro-vides a basis for an understanding of the recent tendencies of US im-perialism.I am extremely grateful to Prof. Jayati Ghosh, Rohit, Prasenjit Bose and the par-ticipants at the 2008 IDEAS conference on ‘The Value of Money and ContemporaryCapitalism’ for very helpful comments on an earlier version of this note.12 JYOTIRMOY BHATTACHARYAThe converse of Prof. Patnaik’s argument is that periods in whichthe dollar price of oil rises would, ceteris paribus, be periods of in-stability of the world capitalist system. This suggests the possibilityof empirically testing, as it were, Prof. Patnaik’s analysis of the con-temporary international monetary system by looking precisely at suchperiods when the dollar price of oil has been rising.It is our purpose in the present note to set the grounds for such atest by reviewing the existing evidence on the response of advancedcapitalist economies to oil price shocks.We are aware that any attempt at empirical verification on theselines is subject to a number of difficulties. First, there is no way todirectly control for the violation of the ceteris paribus clause. Giventhat we only have a handful of episodes of large oil price increasesover a number of decades during which the economies under studyhave changed drastically, there is no way to mechanically filter out theeffects of our failure to control for ‘other factors’. The best way forwardseems to be to try to identify the most significant such factors for eachepisode and at least informally gauge the effect that they may havehad.The second difficulty in our exercise, common to all empirical macroe-conomics, is our inability to observe expectations. As Prof. Patnaikpoints out, temporary fluctuations in oil prices do not pose any threatto the oil-dollar standard. Only secular increases, or more importantly,increases perceived to be secular increases do. However, we feel thatby not looking at all changes in oil prices but limiting ourselves to oilprice ‘shocks’, i.e. significant and sustained increases in oil prices, weaddress this difficulty to some extent.1. The EvidenceFollowing the stagflation of the 1970s, it had till recently been thegeneral opinion among macroeconomists that oil price shocks pose aserious threat to the stability of the world economy, including the ad-vanced capitalist countries. As Hamilton pointed out in his pioneeringstudy of the impact of oil price shocks on the US economy, Hamilton(1983): “All but one of the U.S. recessions since World War II havebeen preceded, typically with a lag of around three-fourths of a year,by a dramatic increase in the price of crude petroleum”.The twenty-first century has not been kind to this consensus. Theincrease in petroleum prices that have followed the US invasion ofIraq have cumulatively been as large as those of the 1970s. Yet, theadvanced capitalist countries have not faced either recession or infla-tion comparable to those of the stagflation era, even though the lat-est episode of price increase extended much beyond Hamilton’s lag of“three-fourths of a year”. The fact that these economies are now in arecession precipitated by an international financial crisis does not offerOIL SHOCKS 3Figure 1. US Oil Prices—West Texas Intermediate[Source: FRED (Federal Reserve Economic Data)]a resolution either. Even if a mechanism could be found whereby highoil prices would be a cause of the US housing bubble bursting, the longlag between the price increase and the slowdown would still cast doubtson any simple mechanisms connecting oil price increases to economicinstability.Such doubts had already started being voiced during the 1990s basedon research which showed an apparent break in the relationship be-tween oil prices and macroeconomic variables in the 1980s, with therelationship being much weaker in the later period. These observa-tions led to three broad questions. Was there really a weakening in theoil-macroeconomy relationship during the 1980s or was the apparentweakening a statistical artifact? If the relationship was weak duringthe 1980s, had it been strong even in the 1970s? If the relationshipwas strong during the 1970s and weak in the 80s and 90s, what hadchanged in between?1.1. Oil shocks. Figure 1 plots the nominal US oil prices from 1970:1to 2008:8.Different methods have been suggested to identify and time ‘oilshock’ events from price series. Any such criteria will to some ex-tent be arbitrary. For the sake of illustration we follow Blanchard andGal´ı (2008) who define a ‘large oil shock’ as “an episode involving a cu-mulative change in the (log) price of oil above 50 percent, sustained for4 JYOTIRMOY BHATTACHARYArun up period 50% rise date max log change ($) max log change (real)O1 1973:3–1974:1 1974:1 104% 96%O2 1979:1–1980:2 1979:3 98% 85%O3 1999:1–2000:4 1999:3 91% 87%O4 2002:1–2007:3 2003:1 125% 110%Table 1. Postwar Oil Shock Episodes. [Source: Blan-chard and Gal´ı (2008)]O1 O2 O3 O4 AVG(1,2) AVG(3,4)Canada 4.7 1.8 2.2 0.5 3.3 1.4Germany 0.1 2.6 1.1 -0.2 1.4 0.4France 5.4 3.1 1.3 0.5 4.2 0.9U.K. 10.2 4.3 0.0 0.5 7.3 0.3Italy 7.7 5.6 1.0 -0.1 6.6 0.4Japan 7.9 1.0 -1.7 0.9 4.4 -0.4U.S. 4.9 4.0 1.7 -0.2 4.5 0.7G7 4.8 1.9 0.3 0.0 3.3 0.2Euro12 4.3 2.7 1.3 -0.5 3.5 0.4OECD 4.9 1.8 0.1 -0.5 3.4 -0.2Table 2. Oil Shock Episodes: Change in Inflation.[Source: Blanchard and Gal´ı (2008)]O1 O2 O3 O4 AVG(1,2) AVG(3,4)Canada -8.3 -1.0 -1.5 3.2 -4.6 0.8Germany -9.6 -3.5 1.3 -2.5 -6.6 -0.6France -7.6 -4.4 0.6 1.2 -6.0 0.9U.K. -16.4 -9.2 0.4 2.5 -12.8 1.4Italy -8.6 0.4 3.0 -2.0 -4.1 0.5Japan -16.1 -4.4 7.6 3.3 -10.3 5.4U.S. -13.3 -11.8 -3.7 7.1 -12.5 1.7G7 -12.6 -7.7 -0.2 3.9 -10.2 1.8Euro12 -9.1 -2.9 1.0 -0.4 -6.0 0.3OECD -11.2 -6.5 0.1 4.1 -8.9 2.1Table 3. Oil Shock Episodes: Cumulative Change inGDP.[Source: Blanchard and Gal´ı (2008)]more than four quarters”. Using this criteria they identify the episodesshown in Table 1.121Blanchard and Gal´ı conclude their analysis at 2007:3. But it is evident fromfigure 1 that O4 is still continuing.2Blanchard and Gal´ı’s criteria does not identify the shock triggered by the firstGulf War since the price increase was reversed quicklyOIL SHOCKS 5For the four episodes that they identify, Blanchard and Gal´ı calculatethe change in inflation and GDP for the individual G7 countries aswell as a few aggregates of advanced countries. These are shown inTables 2 and 3. With a few exceptions both these tables show thepattern referred to above. In the 1970s, oil price shocks clearly leadto stagflation. In the 1990s and 2000s, the effect is much less, if notnon-existent.Starting with Hamilton (1983), attempts have been made to lookat the same relationship using the entire time series of oil prices andmacroeconomic aggregates rather than individual shock episodes. Mork(1989), Hooker (1996), Hamilton (1996) are important contributions tothis literature. Once we move away from looking only at oil price in-creases clearly associated with political/military events in the MiddleEast, two problems need solving. First, to what extent can we con-sider oil price changes as being exogenous to macroeconomic fluctua-tions. Second, we have to account for the possibility that the effect ofoil price increases and oil price decreases may not be symmetric. Theanswer to these questions have an important bearing when evaluatingalternative theoretical explanations of the oil-price economy relation-ship, but none of the adjustments needed to account for them overturnthe basic conclusions in the tables above—oil-price increases had a largeimpact on output and inflation in the 1970s, the effect is much less inthe 1990s and 2000s. The challenge for theory is to account for boththese facts simultaneously.2. Recessions2.1. Large impact on output. Any attempt to develop a theoreticalunderstanding of the effect of oil price shocks on output and pricesimmediately comes up against the obstacle that simple models of themacroeconomy predict changes in output that are too small. Whilewe would expect an increase in the price of oil to reduce the demandfor oil and for directly or indirectly energy-intensive commodities likeautomobiles, it is not immediately clear why an oil price shock shouldcreate a downturn as sharp as those of the 1970s. This is a problemfor both demand-side and supply-side theories.The simplest supply-side mode is competitive market-clearing neo-classical model. In a model of that sort, output is most easily modelledas being produced jointly by labour, capital and energy by a productionfunction:Y = F (N,K,E) (1)If the price of energy is exogenously given, and a rise in energyprices causes other factors to be substituted for energy, this may causeoutput to fall. But a simple consequence of profit maximisation withproduction function (1) is that the elasticity of output with respect toa change in energy use equals the share of energy costs in total output.6 JYOTIRMOY BHATTACHARYAFor the U.S. economy a reasonable value for this share would be 4%,which would imply an output reduction of 0.4% for every 10% decreasein energy use, much smaller than what was observed during the 1970s.A naive demand-side argument which sees an oil price increase as atax which reduces the disposable income of oil buyers and increases theincome of oil sellers would fare no better. Even if we assume that oilsellers do not consume any domestic goods out of their extra income,the relative income fall of oil buyers would at most be proportional tothe share of oil in consumption expenditures, and that number wouldonce again be too small to explain the recessions of the 1970s.Given this, attempts have been made to explain the recessionary ef-fects by bringing in secondary factors which may magnify the initialimpact of oil price increases. Rothemberg and Woodford (1996) bringin imperfect competition and mark-up pricing, Finn (2000) introducescomplementarity between energy and capital and variable capital util-isation and Hamilton (1988) introduces frictional employment arisingout of the need to move labour out of industries which are directlyor indirectly energy intensive (such as automobiles) to other indus-tries. Apart from limited empirical support, a major problem for allthese models is their inability to explain the weakening of the oil-pricemacroeconomic relationship in the last two decades.2.2. Monetary policy and the bargaining power of workers.Given these difficulties in explaining the stagflation of the 1970s on thebasis of purely private sector responses, one strand of literature startingwith Bernanke et al. (1997) attributes the recession to incorrect mone-tary policy on the part of the Fed. Working in a vector auto-regressionframework, Bernanke et al. (1997) tried to simulate the effects of amonetary policy that did not respond to oil price shocks and foundthat the reduction of output was lesser in their hypothetical regime.While the exact results of their analysis have been questioned on sta-tistical grounds by Hamilton and Herrera (2004), it seems reasonableto assume that at least a part of the downturn of the 1970s must be at-tributed to recessionary monetary policies of that period. This wouldfit into a picture of an attempt to defend the oil-dollar standard bysqueezing the real claims of the working class. But then, the questionthat follows is why such recessionary policies were not needed duringlater oil shocks?A simple mechanism of explaining this discrepancy would be by in-voking differences in expectation formation. The oil shocks of the 1970swere an unprecedented event and neither citizens nor policy-makershad any experience of dealing with such shocks and they had no wayof predicting of what the shocks would imply for the trajectory of theeconomy. This brought greater uncertainty and a greater likelihoodof the shocks being considered permanent and hence triggering off aOIL SHOCKS 7wage-price spiral. The later oil shocks were different both due to priorexperience as well as due to the fact that in these later episodes therewas a gradual increases in oil prices rather than a more abrupt jump.The last shock was also widely believed to have been caused by spec-ulation. All of these might have led to a perception of the shocks asbeing transitory and hence might not have triggered off a wage-pricespiral.While there may be an element of truth in this argument based on ex-pectations, it cannot negate the fact that the cumulative changes in oilprices were roughly comparable in the earlier and later episode. There-fore we would have expected a wage-price spiral to have been triggeredoff ultimately. The fact that it was not must therefore be attributed, ina conflicting-claims framework, to the flexibility of the claims of somestrata. Two possible explanations stand out. One, a squeeze in theclaims of domestic workers made easier by de-unionization and a re-duction in the rights of workers in general. Two, a squeeze in the claimof foreign workers mediated through cheaper imports. The fact thatone or both of these leads to a muting of the destabilizing effect of oilshocks is certainly not a cause for celebration, since this muting comesat the cost of growing inequality. However, such muting does increasethe resilience of the world monetary system based on the dollar. Andwe expect that this muting would become easier as a declining energyintensity of output makes the required squeeze in real wages smallerover time.3. ConclusionThe response of contemporary capitalist economies to oil price shockshas changed. Why, can only guess, and maybe the next oil shock willprove all predictions of fundamental change wrong. But what we dosee is that at least in certain conjunctures large oil price increase donot automatically lead to a crisis for the system.Does this demand a change in the analysis of the world monetarysystem presented in Prof. Patnaik’s book? In essence, not at all. Thefundamental impossibility of explaining the value of money throughsupply-and-demand and even the need for the leading currency of thetime to maintain a stable value vis-a-vis commodities are conclusionsthat stand independently of the importance or otherwise of oil.However, the idea of an ‘oil-dollar standard’ may indeed require re-examination. The evidence of recent years points to the possibility ofoil joining other non-oil primary commodities in being quantitativelyinsignificant in determining the trajectory of the advanced capitalistcountries.8 JYOTIRMOY BHATTACHARYAReferencesBernanke, B., M. Gertler, and M. Watson (1997): “System-atic Monetary Policy and the Effects of Oil Price Shocks,” BrookingPapers on Economic Activity 1.Blanchard, O. and J. Gal´ı (2008): “The Macroeconomic Effectsof Oil Price Shocks: Why are the 2000s so different from the 1970s,”Unpublished working paper.Finn, M. G. (2000): “Perfect Competition and the Effects of EnergyPrice Increases on Economic Activity,” Journal of Money, Credit andBanking, 32, 400–416.Hamilton, J. D. (1983): “Oil and the Macroeconomy since WorldWar II,” Journal of Political Economy, 91, 228–248.——— (1988): “A Neoclassical Model of Unemployment and the Busi-ness Cycle,” Journal of Political Economy, 593–617.——— (1996): “This is what happened to the oil price-macroeconomyrelationship,” Journal of Monetary Economics, 38, 215–220.Hamilton, J. D. and A. Herrera (2004): “Oil Shocks and Ag-gregate Macroeconomic Behavior: The Role of Monetary Policy.”Journal of Money, Credit & Banking, 36, 265–287.Hooker, M. A. (1996): “What happened to the oil price-macroeconomy relationship?” Journal of Monetary Economics, 38,195–213.Mork, K. (1989): “Oil and the Macroeconomy When Prices Go Upand Down: An Extension of Hamilton’s Results,” Journal of PoliticalEconomy, 97, 740.Patnaik, P. (2008): The Value of Money, Tulika Books.Rothemberg, J. J. and M. Woodford (1996): “Imperfect Com-petition and the Effects of Energy Price Increases on Economic Ac-tivity,” Journal of Money, Credit & Banking, 28, 549–577.Indian Institute of Management KozhikodeE-mail address: jyotirmoy@jyotirmoy.net

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Oil Shocks: How Destabilizing are they?

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