Why are the 2000s so different from the 1970s? A structural interpretation of changes in the macroeconomic effects of oil prices …

In the 1970s, large increases in the price of oil were associated with sharp decreases in output and large increases in inflation.  In the 2000s, and at least until the end of 2007, even larger increases in the price of oil were associated with much milder movements in output and inflation.  Using a structural VAR approach Blanchard and Gali (2007a) argued that this has reflected in large part a change in the causal relation from the price of oil to output and inflation. In order to shed light on the possible factors behind the decrease in the macroeconomic effects of oil price shocks, we develop a new-Keynesian model, with imported oil used both in production and consumption, and we use a minimum distance estimator that minimizes, over the set of structural parameters and for each of the two samples (pre and post 1984), the distance between the empirical SVAR-based impulse response functions and those implied by the model.  Our results point to two relevant changes in the structure of the economy, which have modified the transmission mechanism of the oil shock:  vanishing wage indexation and an improvement in the
credibility of monetary policy.  The relative importance of these two structural changes depends however on how we formalize the process of expectations formation by economic agents.

So, why was the oil price shock in the 1970s different than that in the 2000s? Can you get it from reading a summary of a technical paper like this? Nope. I’m not sure I can tell you – but do you really think it had something to do with vanishing wage indexation and credibility of monetary policy? Maybe. But how about this:

The oil price “shock” in the 1970s was a result of a decrease in world oil supply. There was less stuff to go around. The oil price “shock” in the 2000s was largely a result on an increase in demand. There was more stuff to go around. So while in the 1970s, when we paid a lot more for oil and the things oil was used to produce, we had far less “stuff” to trade for the newly scarce oil. In the 2000s when we pay more for oil, we are richer, we have a lot more “stuff” to trade for oil. Or to put it another way, when oil prices rise due to a limited supply of it, we have to do more with less. When oil prices rise because more people wish to use oil relative to the past, we get to do more with more. Chinese and Indian demanders do not wake up one day and demand oil. They must first produce something of value in order to get that oil. If they increase their demand for oil by first producing goods and services others value, then the world is undeniably richer. If oil prices had risen because we blew up some wells in the Middle East, we still must make high tradeoffs at the margin to secure oil, but we don’t have all of that other good stuff produced by those would-be demanders.

Even simpler: expensive oil with less stuff < expensive oil with lots of stuff. What is so difficult to understand?

“if the House of Representatives has now declared it “illegal” for the Government of Saudi Arabia to restrict oil production, why is it still legal for the Government of the United States to restrict oil production”

Check out Mark Steyn’s OpEd here.