Paul Krugman has a post to Substack that is very much to my taste in some ways but raises a question in another. I net out a bit confused but convinced that the US will not bear the brunt of the adjustment if Hormuz stays closed.
The point I like about Krugman’s take is that he identifies causation correctly. Modeling the effect of this or that oil price assumption misses the point, if the analysis is of the global effect. If the supply of oil to the global economy is durably constrained, then demand will have to be destroyed to accommodate that constraint. And the most likely path to that result will be a decline of global GDP (growth). The price will go to whatever level is required to deliver that result. So, reasoning from the thing we can’t know and don’t even need to know is wrong. This is a point I have made myself.
Krugman has some very cool data showing that this very simple template is exactly how it worked with the first oil shock in 1973. He also points out that the lower oil intensity of GDP might not be a blessing here. After all, what matters is not the level of the oil intensity of GDP but how flexible it is. If the intensity of GDP is fixed in the short run, then the percentage decline in global GDP (relative to baseline) will have to mirror that of the decline of oil supply. In fact, Krugman suggests that the lower intensity might mean that the low hanging fruit has been picked and that the intensity might be even less flexible, precisely because it is already low.
And it is on this point where I think I might disagree. Krugman is right to insist on the inflexibility of the oil intensity, rather than its depressed level. But I suspect he gets backward implications of the low intensity itself. I suspect that a low intensity will mean that the flexibility is actually slightly higher, not lower, a minor relief.
If the oil intensity is low, then the price reaction required to deliver a given hit to oil demand will be proportionately higher. That sounds bad if you reason from price. But we have already agreed that we ought not do that. Instead, the greater price change implied by the lower oil intensity means that there is a stronger price signal to bring on alternative sources of energy or shift toward less energy intensive economic activity. And so a lower oil intensity should mean more, not less, flexibility of it.
To put it in layman’s terms, e.g., my own, Americans may be more inclined to dine out on locally sourced food and less inclined to fly. And they might even start burning coal. I will leave it to the experts to point out exactly how this adjustment works. But as a general point, the greater the required price response to get a given demand destruction in percentage terms, i.e., the lower the energy intensity, the more flexible should be that energy intensity in a market economy. I think.
Net net I side with Krugman that this is worrying. The main point is that we ought not expect oil intensity globally to change much in the short run. But my quibble over his final speculation reinforces my point that the US suffers relatively less, compared to other, poorer countries, from this supply shock, whatever it turns out to be. In fairness to Krugman that was not his main point. But it is one I choose to surface.
