How high oil prices could squelch the recovery

As my colleague Steven Mufson reports today, tensions with Iran are putting upward pressure on crude prices — and oil was already at a record high in 2011. Analysts are now fretting that oil could kneecap the fragile recovery. So is there a good way of estimating the effects of pricier oil?

The Strait of Hormuz, where all the excitement is taking place. (MARWAN NAAMANI/AFP) Yes. According to a U.S. Energy Information Administration analysis, a $20 increase in the cost of a barrel of oil — roughly what we saw last year — is estimated to shave about 0.4 points off GDP growth in the first year alone and boost unemployment by 0.1 percentage points. So if Iran threatens to close the Strait of Hormuz (through which about 20 percent of the world’s oil flows) and prices start screaming upward from $107 per barrel to $120 or beyond, that would put a very noticeable dent in growth.

What’s more, oil shocks tend to have long-lingering effects. The EIA estimates that a $20 price increase would continue biting into the economy for at last another year thereafter. James Hamilton, an economist at the University of California, San Diego, has suggested that the consequences of a price spike can persist for several quarters, as the resulting slowdown in consumer spending takes some time to ripple through the economy. That’s true even if the spike is only temporary and recedes quickly.

Here’s another way of looking at it: In 2011, the United States paid about $125 billion more for oil imports than it did in 2010 (thanks, in part, to the disruptions caused by civil war in Libya). That “oil tax” was essentially enough to wipe out the entire stimulative effects of Barack Obama’s middle-class tax cut. A similar oil spike this year would cancel out a hefty chunk of the benefits of extending the $200 billion payroll tax cut bill that Congress is fighting over.

As with everything, there are caveats and uncertainties. As Jared Bernstein observes, China’s frenetic growth seems to be slowing of late, which could ease some of the pressure on oil prices. Meanwhile, Saudi Arabia claims that it has enough spare capacity to make up any shortages due to disruptions in Iran, but analysts tend to be skeptical of how much extra oil the Saudis can actually pump out.