When Royce Drake of Alexandria headed north yesterday for a week at a sculling camp in Vermont, the Iraqi invasion of Kuwait began to cost him money. Like millions of his vacationing counterparts across the United States, Drake paid more than he would have a few days ago each time he pulled into a service station for gasoline.
The added cost for the 1,500 miles Drake plans to drive while he's gone won't be much, probably only about $5 or $6, based on the increases in pump prices so far. That amount is only a tiny addition to the cost of his vacation, but it will be $5 Drake can't spend on something else.
Multiply Drake's $5 or $6 by the huge number of other motorists on the road during America's peak driving season and the impact of higher gasoline prices, and all the small purchases perhaps not made as a result, begins to take shape.
With the U.S. economy already virtually dead in the water, that shape may turn out to be one of recession.
Even if world crude oil prices stick close to $25 a barrel, about where they were on Friday, there appeared to be little likelihood, however, that any slump in the economy would approach the severity of the one that followed the first oil price shock in 1973, or the one that ultimately followed the second price shock in 1979.
Both of the earlier price shocks hit the United States at a time when the economy was gripped by inflationary booms. The impact of rising energy prices also was magnified on both those occasions by soaring food prices.
In contrast, this time the economy seems to have been slowly coasting to a stop rather than being in a boom, although the civilian unemployment rate, even after the July rise to 5.5 percent reported Friday, has been at levels most economists regard as full employment. Most important, there is no large overhang of unsold goods on businesses' shelves that is likely to mean big cuts in future factory production schedules. The buildup of unwanted inventories, and the production cutbacks to get rid of them, have usually been the key to the severity of U.S. recessions.
Nevertheless, each $1 per barrel increase in crude oil prices has the same depressing effect on consumer spending, at least in the short run, as a $1 per barrel excise tax imposed by the government. With current U.S. oil consumption running about 17 million barrels a day, a $1 tax or price increase costs oil users about $6 billion a year.
A $5 or $6 per barrel increase, which is what has occurred in spot markets, would be the equivalent of a $30 billion or $35 billion tax increase. What's more, as oil prices go up, so does the cost of other forms of energy such as natural gas and coal, although not necessarily by as much and usually only after a lag. Still, those increases magnify the impact of higher oil costs.
Altogether, the short-term depressing effect is probably on the order of $50 billion or more, or about 1 percent of the gross national product.
This prospect poses an acute problem both for the Bush administration, which has been trying to strike a deal with congressional leaders to reduce future federal budget deficits, and for the Federal Reserve, which will have to decide how to respond to the simultaneous threat of recession and worsening inflation.
Since any attempt to cut federal spending and raise taxes would also tend to depress the economy, the already difficult chore of striking a budget agreement could become even harder to achieve if oil prices stay high.
One congressional source close to the negotiations suggested that it might be appropriate to change the "configuration" of the planned deficit reduction by having less of it in fiscal 1991, when the impact of higher oil prices is being felt keenly, and more of it in later years.
It is far from clear, however, how already skeptical financial markets would respond to such a deal. Postponement of the anticipated $50 billion to $60 billion cut in the deficit for next year could lead investors to questionthe seriousness of a budget deal. If this happens, then long-term interest rates likely would not come down, regardless of the deal or of Fed attempts to lower them.
The administration is counting on the Fed to cut interest rates to offset any significant tightening of fiscal policy, and Fed Chairman Alan Greenspan has indicated the central bank will do so. But the Fed has far more influence over short-term rates than long-term rates, and if investors balk, there is little it can do.
With oil prices surging, the whole exercise is much more complicated from the Fed's point of view. If the Fed tries to lower short-term rates significantly to offset recessionary pressures just as inflation is getting worse, investors might decide that the central bank was giving up on its long-running fight to control inflation.
On the other hand, officials at the central bank have been carefully trying to avoid a recession, partly out of fear of what a downturn could do to debt-laden businesses and the sometimes shaky banks that have lent to them. The oil price hikes just make those concerns more acute.
The question is whether investors believe that the Fed's longer-term goal would still be to reduce inflation even if it eases rates to deal with a shorter-term problem.
"It comes back quickly to what we call the credibility of the central bank," said one Fed official. "We can do it better now than in the '70s" when financial market trust in the Fed as an inflation fighter was not high. "But we do not have an overabundance of credibility."
Not all the impact of higher energy prices is negative, however.
Part of the impact of higher crude oil prices should be offset down the road by more investment by the oil industry and by businesses and consumers seeking to use less energy. Even in the short run, some parts of the country and some sectors of the economy will be boosted rather than hurt by higher oil prices.
While all U.S. oil users will be paying more, U.S. oil producers will be getting more for their crude. In the first 200 days of this year, net oil imports averaged 7.8 million barrels daily, or just over half of what is consumed. That means that foreign and domestic oil producers each probably will end up with about $15 billion to$17 billion more income. The bulk of the income associated with higher prices for natural gas and coal would also flow to U.S. firms.
The fact that domestic energy producers get more than half of the added amounts oil users will pay softens the depressing impact on the economy. Higher oil prices likely will stimulate oil and gas drilling in states such as Texas and Louisiana, which have still not recovered from the devasting decline in oil prices in 1985 and 1986.
A healthier economy in the Southwest could even save the federal government some money by increasing the value of some of the real estate and other assets the government now owns as a result of having taken over hundreds of insolvent banks and thrift institutions there.
But the stimulus to the oil patch will build slowly because it takes time to make and execute new drilling plans, and having been badly burned once by falling prices, both independent oil drillers and major companies alike are apt to be cautious until they can be sure prices will stay up.
Meanwhile, energy-short Northeastern states, some of which are already clearly in a slump, will be hard hit right away because of their high dependence on oil.
But the impact in the Northeast, as in the nation as a whole, will not be as severe as in the 1970s, both because the oil price increase is far smaller -- in 1973-74 prices quadrupled rather than merely rising by one-third, if they stay around $25 -- and because the U.S. economy uses considerably less energy per dollar of GNP than it did then. Furthermore, in both previous episodes, energy prices were subject to price controls, which slowed the process of adjusting to the increase in energy prices.
"Energy is very important to the economy," said one government analyst, "but it is much less important than it used to be. There is more flexibility, and there is more business knowledge about how to handle a big increase in the relative price of oil.
"But having said that, it is important to understand just how important energy is," he continued. "It works its way through every nook and cranny of the economy. When you change the cost structure of something as large as that, it shakes the rafters."
That shaking would be much greater had the earlier price shocks not occurred. For instance, while the number of cars on U.S. highways has risen steadily, gasoline consumption has not because the average mileage each car gets per gallon has gone up, too.
For instance, after adjusting for inflation, consumers so far this year have been spending no more for gasoline and oil than they did five years ago, according to Commerce Department figures.
According to one government agency's assessment, a $5 rise in crude oil prices will cause consumer prices to be 1 percent higher 12 months later as the effects work their way through the economy. The usual rule of thumb is that GNP will be half a percentage point lower at the end of a year than it otherwise would have been if consumer prices go up 1 percent over the same period.
A half a percentage point decline in the output of goods and services in the United States would represent a very mild recession. If the economy otherwise were growing even modestly, GNP might not go down at all.
On the other hand, the invasion of Kuwait has added a new level of uncertainty about the economy, and uncertainty itself can depress spending.
On Friday, White House spokesman Marlin Fitzwater told reporters the administration still does not expect a recession despite the bad news on employment and oil prices. But Fitzwater also acknowledged that the administration's outlook is based on its assumption that the increase in oil prices will be moderate.
"The possibility of extreme change and damage is very great," Fitzwater noted. "It's a large concern and a growing concern."