Oil price spikes are not good for the economy, especially in the short term. But neither are they fatal.
The U.S. economy, like other market economies, is more resilient than many people give it credit for. It can adjust to higher energy prices, just as it repeatedly has in the past. And, if history and economic theory are guides, sharp increases in the price of any resource usually are followed by long periods in which prices rise by less than average inflation.
Start by considering how gas prices have evolved in the past century.
Ignoring inflation, a slow increase occurred from 1919 to 1973. Since then, an upward trend took hold that saw sharp spikes whenever there was trouble in the Middle East, usually followed by declines as tensions eased.
The first such spike came after the 1973 Arab-Israeli War when Arab-dominated OPEC first flexed its muscle and U.S. gas prices rose from 39 cents a gallon in 1973 to 57 cents a gallon in 1975. There were subsequent spikes as the regime of the Shah of Iran began to crumble in 1979, and from 2002 to 2008 with the Iraq War.
Prices fell from 2008 into 2009 but have since risen, particularly as the West’s confrontation with Iran over its nuclear program has become more acute.
Interestingly, the 1991 Gulf War was not accompanied by a dramatic increase in prices because Saudi Arabia and its Arab allies sharply increased oil output to counteract any shortfalls caused by the conflict.
If one adjusts for inflation, the picture looks much different, with a general trend down from 1919 to 1972 followed by great volatility thereafter. The 17-year period from 1986 through 2003 had lower prices than at any time prior, including the 1950s and 1960s, which many of my generation remember as the glory days of cheap gas and muscle cars.
Prices are high now and likely to get higher unless there is some miraculous easing of tension with Iran. But we are not in a markedly worse position than 30 years ago when mean household incomes were 29 percent lower than now, adjusted for inflation.
Higher crude oil and gasoline prices pose challenges for households and national economies in the short run because it takes time to adjust to changes. In the short run, if an individual has to pay more for gas, she may have substantially less to spend on other things. Higher diesel fuel means it costs more to till an acre of ground, construct a mile of road or deliver a ton of freight.
So prices of many goods rise, although the overall price level may be kept constant if the central bank clamps an iron hand on the money supply.
But in the longer run, both households and national economies adjust. In general, the growth of our gross domestic product since the mid-1970s has been somewhat slower than in the 30 years before, but we have seen good growth.
Plus, the amount of all energy and of petroleum products needed to produce a dollar’s worth of output has fallen sharply. The U.S. now uses only half as much energy relative to GDP as we did 40 years ago.
Moreover, we can continue to improve. Countries including the United Kingdom, Germany and Japan produce 20 percent to 30 percent more GDP per unit of energy used than we do, with comparable median household incomes.
The disparity is not necessarily due to gross wastefulness on our part. Many population centers in our country have substantially colder winters or hotter summers than the countries cited. We have lower population density and thus greater average travel distances for people and shipping distances for freight. But we have adjusted to higher energy costs in the past, and we can do so in the future.
In 1932, British economist J.R. Hicks explained why, when he wrote "a change in the relative prices of the factors of production is itself a spur to invention, and to invention of a particular kind-directed to economizing the use of a factor that has become relatively expensive."
A "factor of production" means some input like crude oil or gasoline. When the price of oil rises compared to other inputs, a market economy automatically devotes resources to finding new ways to continue to produce output while using less oil. This may mean developing new technology or applying existing technology to uses that did not make sense when oil prices were lower.
For example, diesel fuel is rising sharply compared to natural gas, which is more abundant due to new technology. We soon may see over-the-road trucks or delivery-service vans running on natural gas rather than diesel. Such "induced innovation" cannot be immediate, but it inexorably occurs.
Moreover, people "adjust their consumption patterns," which is how economists describe people buying fewer SUVs or taking the bus more often. It may be an inconvenience, especially at first, but we made adjustments like this in the 1970s and survived.
So, yes, rising gas prices are a real headache for many households. Higher fuel costs challenge many businesses.
But the economy will survive and eventually prosper, just as it has done in the past.