Levi: What The Nobel Prize Tells Us About Oil

Michael Giberson

Michael Levi, at his CFR blog, explains “What The Nobel Prize Tells Us About Oil“:

Do you think that it’s straightforward to figure out whether high oil prices cause recessions? Many people apparently do. The 2011 Nobel Prize in Economics, awarded today to Thomas Sargent and Christopher Sims for “empirical research on cause and effect in the macroeconomy”, should make them reconsider. The basic reason is simple: if it was easy to separate cause from effect and thus measure the relationship between stimulus and response, they wouldn’t be awarding Nobel Prizes for related progress.

Indeed the difficulty of distinguishing economic cause from effect is a big reason for economists’ longstanding interest in oil price shocks, particularly those of the 1970s. Those price hikes were clearly spurred by events outside the economic system, in 1973 by the Arab oil embargo, and in 1979 by the Iranian revolution (though even on these points there is some dissent). Identification should thus be simple: the oil shock is the cause, and any macroeconomic change is a consequence. This provides an unusually clean laboratory in which to study economics.

Alas, there is a problem. The oil price shocks of the 1970s prompted big interest rate hikes in consuming countries, as policymakers tried to stem inflation. One now must ask: were the economic slowdowns that followed the oil price shocks the result of the shocks themselves, or consequences of the monetary policy reaction? The difference matters, because one leads to an energy policy solution, while the other points to better monetary policy as the right response.

Levi then explores a paper by Bernanke, Gertler, and Watson (BGW) examining the connections between oil price shocks and monetary responses that draws upon methods developed by recent Nobel laureate Christopher Sims. As it happens, Sims contributed a critique that accompanied the publication of the BGW paper in Brookings Papers on Economic Activity (1997). Levi summarizes the Sims critique and concludes by examining whether BGW or Sims’ response has better stood the test of time.