GDP and the cost of fuel

Year-over-year percent change in real GDP and percent GDP spent on fuel

NOTE:  I posted the article below on 12/19/14.  Since then, no new information I'm aware of has come along that argues that the relationship between cost of energy and economic health isn't as strong as Charles Hall and I argued in the article to which I refer in the article below.  What has changed since 2014 is that the new technology of hydraulic fracturing has made possible a huge increase in the production of both oil and gas in the U.S., which has led to significant price declines in these energy sources.  The U.S. economy, and to a lesser degree other economies in the world, have almost certainly benefited hugely.  How long relatively cheap fossil fuel will remain in good supply is an open question. 

And, as I've argued in other posts, emissions of carbon dioxide from the combustion of fossil fuels risk driving the Earth into a new regime that is likely to be inhospitable to human civilization and could have even worse impacts.  Putting a steadily-increasing price on carbon would do much to shift the world's economies  away from reliance on fossil fuels and toward low- and zero-carbon sources including solar, wind, and nuclear.  To the extent that a price on carbon is revenue-neutral - for example by being funneled back into the economy via a rebate to households - and to the extent that renewables and next-generation nuclear prove to be cost-competitive with fossil fuels, this price on carbon and the resultant increase in the cost of fossil fuels may not significantly harm the world's economies.  Given the increasingly clear evidence that emissions of carbon dioxide and other greenhouse gases pose an existential threat, there seems little choice but to do what's necessary to curtail the combustion of fossil fuels. 

I’m happy to report that an article I had the honor to co-write with Charles Hall has recently been published.  It’s titled “Does a Change in Price of Fuel Affect GDP Growth? An Examination of the U.S. Data from 1950–2013.”  It’s an open source document, available at http://www.mdpi.com/1996-1073/7/10/6558

We gathered U.S. data on fuel consumption and costs for 1950 through 2013.  We then compared the percent of U.S. gross domestic product (GDP) spent each year on fuels, including fossil fuels and nuclear ore, and the year-over-year change in GDP.  As shown in the chart above, we found that these variables are inversely correlated. (In the chart, "per." represents "period."  The periods are years; "5 per. Mov. Avg." is a 5-year moving average.)  Since 1970, the 5-year moving averages of the percent of GDP spent on fuel and the year-over-year change in GDP are close to mirror images of each other. 

This correlation argues that the availability and cost of energy is a significant determinant of economic performance. Further, we found that a threshold exists in the vicinity of 4%.  If the percent of GDP spent on fuels is greater than this, poorer economic performance appears likely; if the cost of fuels to the economy is less than 4% of GDP, the economy seems to do well.  

An implication of our study is that the cost of fuels has a major impact on the economy.  Others have made this point as well, but it is frequently argued by economists that because energy costs are small compared to other expenditures that make up GDP (e.g., consumer spending, which makes up about 70%), that energy costs are unlikely to be significant.  But energy appears to be different.  It exerts a multiplier effect.   If the price of energy goes up, almost everything costs more, and these costs propagate through the economy.  Nitrogen fertilizer may be a useful analogy.  Adding 50 kg of nitrogen per hectare can change the yield of corn by several tons per hectare, a multiplier effect of 50 or more. This is because nitrogen is typically a limiting nutrient.  It may be that energy is the limiting nutrient of the economy.

Recently, with the dramatic drop in the price of crude oil, the overall percent of GDP spent on fuels has declined significantly.  It is very likely now below the 4% threshold we identified.   And not surprisingly, the economy seems to be rebounding from the recession that began when oil prices spiked in 2008.

Will better economic conditions continue?  Our study argues that it depends in no small degree on whether energy prices remain relatively low.  And this in turn depends on whether the recent, surprising, boom in unconventional oil (and gas) production continues, on whether renewable sources (PV and wind) truly have what it takes to grow to be major energy suppliers, and on whether next-generation nuclear power gains acceptance.  

The view that energy costs are key leads to a prediction that I don't think many economists would make:  This prediction is that, as long as the price of crude oil stays in its current range (i.e., around $50 per barrel), the economies of the EU and of Japan will improve, no matter what fiscal policy (e.g., stimulus or austerity) they pursue.