Higher oil prices have raised concerns about the strength of the economic recovery. A $10 increase in oil prices could reduce real GDP growth by 0.2 percentage points, and a sustained rise in prices could shave 0.5 to 1.0 percentage points off growth. Meanwhile, state and local governments face budget strains and are cutting jobs, weakening the recovery. Congress has yet to pass any of the 13 appropriations bills to fund the government, risking a shutdown as the current resolution expires on March 4th.

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Weekly Commentary by Dr. Scott Brown
Oil And Vinegar
February 28 – March 4, 2011
Higher oil prices have raised new concerns about the strength of the economic recovery. If sustained, the
rise in gasoline prices will restrain the pace of economic growth noticeably, but does not appear to be
large enough (so far) to derail the expansion. Meanwhile, a federal government shutdown looms as
lawmakers bicker over the future path of expenditures. Austerity at all levels of government is well-
intentioned, but is not advisable at this point in the economic recovery.
Higher oil prices are often associated with recessions. In fact, $4 gasoline was a contributing factor to the
Great Recession. The economic impact of higher oil prices depends on the magnitude of the increase and
also the duration. Brief spikes generally do not have a big effect on growth.

2. As a rule of thumb, a $10 increase in the price of oil corresponds to about a 20 cent increase in the price of
gasoline or about a 0.2 percentage point reduction in real GDP growth. However, that estimate does not
account for multiplier effects. A large, sustained increase in gasoline prices, will reduce spending on other
thing, leading to broader jobs losses (or smaller job gains) than would have occurred otherwise. If
sustained, the recent rise in oil prices could shave about 0.5 to 1.0 percentage point from GDP growth –
not enough to cause a recession, but not helpful to the recovery. If GDP growth was expected to be 3.5% to
4.0% this year, we may see 2.5% to 3.5% instead. Note also that higher gasoline prices have a mixed effect
across income. The top 20% of income earners account for about half of income growth and about half of
consumer spending. Those households don’t care much about what it costs to fill their SUVs. For those at
the lower end of the income scale, higher gasoline prices matter a lot more.
The recession contributed to a sharp drop in tax revenues at all levels of government. Revenues have
rebounded as the economy expands, but are not back to where they were. Most states and local
governments have balanced budget requirements. Remember, a third of the federal fiscal stimulus was aid
to the states. About 70% of that went to education and healthcare, with no requirements that these
governments work to reduce future budget deficits. That federal support is winding down, but the budget
strains remain. As a result, many states are cutting government jobs. State and local government shed
about 20,000 jobs per month in 2010. Normally, they would be adding about 20,000 per month – more
or less in line with population growth. While we all would like to see leaner, more efficient governments,
in the short-term these job losses weaken the economic recovery. These workers have families and
mortgages and spend most of what they make.

3. We are now five months into FY11. Of the 13 appropriations bills that fund the government, lawmakers
have passed not a single one. The fifth Continuing Resolution will expire on Friday (March 4) and a
government shutdown looms if an agreement cannot be reached. Most likely, we’ll get a sixth Continuing
Resolution to cover government operations for a few more weeks. Many Republican lawmakers, those
who have been around for a while, remember the lesson of the last government shutdown (1995), which
elevated Bill Clinton’s standing with the public and damaged the Republicans. However, the newer breed
of Republicans, swept in on the Tea Party sentiment, do not remember, or choose to ignore, this particular
history. The 1995 showdown was the result of differences between a Democratic president and a
Republican Congress. This time, the split is entirely in Congress – and even within the Republican party.
The leadership would likely negotiate, but can’t get the troops to compromise. Within the next few
months, Congress will also have to approve an increase in the federal debt ceiling. The U.S. government is
not going to default on its debt, but the threat may unsettle the markets to some extent.