Will Higher Gasoline Prices Sink the Economy?

I’m choking on the high gas prices–not because I can’t afford them, because it seems so, so, . . ., expensive!  The rational side of me says that it’s still a great bargain to be able to drive from home to a great sailing club for less than three bucks.  The less rational side fumes, because I’m used to less expensive gas.  I’ve already pointed to an explanation of "why gasoline prices are so high in 2007," but now let’s talk about their effect on the economy.

A new paper by University of Michigan economists Paul Edelstein and Lutz Kilian (hat tip to Jim Hamilton at Econbrowser)  looks at high gas prices and consumer spending.  They examine how consumer spending changes when gas prices rise.  They find the non-gas spending drops by MORE than the increase in gasoline costs.  The effect occurs across many sectors, but is largest for gas-guzzling vehicle sales.  However, they find that the impact on the overall economy is relatively mild, because 1) Detroit isn’t as important as it used to be, and 2) there’s a shift to buying smaller cars.  They also find that the economic impact is milder than it was a couple of decades ago.

I’m actually surprised that the impact is as strong as Edelstein and Kilian find it to be.  Back in 2004, one-third of the Wall Street Journal’s economic forecasting panel predicted that a recession would follow if oil prices remained above $50 a barrel.  Surprise!  Oil went well above $50, stayed up over $50, and so far no recession.  I was on the optimistic side (yes I’m bragging, but I deserve some credit here), expecting that there would be a bit of conservation, a bit less spending on other things, and lower savings, consistent with the permanent income hypothesis.

Business planning implications: the high gas prices will squeeze some consumers, limit the growth rate of sales of gasoline-using things (SUVs, stinky motorboats, etc.), but NOT drive the economy into recession.