Your Money guest blogger James D. Hamilton is a Professor of Economics at the University of California, San Diego\r\n\r\nFalling gasoline prices will provide some stimulus to the economy. But how much?\r\n\r\nAmericans consumed 142 billion gallons of gasoline last year. That means that when gasoline prices rose $1/gallon last spring, if consumers and fuel-using businesses had not reduced the quantity of gas they purchased, they would have had to reduce other expenditures by $142 billion. That's a bigger negative shock to spending power than the $90 billion that the federal government was trying to put back into consumers' hands through last spring's fiscal stimulus.\r\n\r\nThe run-up in gasoline prices hurt the economy not just by reducing consumers' spending power. The abrupt drops in spending on key sectors of the economy exerted significant effects of their own. As higher gas prices caused consumers to shun Detroit's gas guzzlers, U.S. production of motor vehicles and parts fell by 15% between 2007:Q4 and 2008:Q3 (BEA Table 1.5.6), subtracting an average of 0.6% from the annual GDP growth rate over the first three quarters of this year (BEA Table 1.5.2). The BLS reports that 135,000 fewer Americans were employed in motor vehicles and parts manufacturing in October 2008 compared with a year ago. And rocketing gasoline prices surely also contributed to plunging consumer confidence over the spring and summer.\r\n\r\nGood news, though. The "cavalry has already arrived", according to the WSJ. U.S. national retail gasoline prices are now down $2 a gallon from their height this summer, erasing the -$140 billion drain of last spring and adding net +$140 billion in disposable income for consumers and firms relative to where we stood one year ago.\r\n\r\nBut it's hard for me to believe that this is going to replace the negative developments of last spring and summer with a positive stimulus of the opposite sign. Those unemployed auto workers can't expect to report back to work any time soon. And although falling gasoline prices brought a temporary revival to consumer sentiment in September, Americans are now weighed down by other concerns as the economic deterioration sets in. The Michigan/Reuters index of consumer sentiment was back down to 57.6 in October and barely improved to 57.9 in November.\r\n\r\nNow that we're in our current mess, the whole affair looks to many as if it had an air of inevitability from the beginning. That, however, is not my view. How severe the financial bankruptcies and mortgage defaults ultimately prove to be will depend directly on how far real estate prices decline. The magnitude of the price decline will be bigger the more severe a recession we experience. The economy was continuing to putter along with positive growth despite a dismal housing sector for two years. That by itself wasn't enough to cause a recession. But when you put the depression in housing together with the negative effects of the oil price shock, it proved to be a potent combination.\r\n\r\nMy view is that we were teetering on the edge of a cliff last summer, and the oil price shock may have been just enough to tip us over the edge. As we did so, the financial disaster that had always been a potential became a reality.\r\n\r\nThe trouble is, now that the economy is in free fall, it's going to take more than $2 gasoline to pull us back up.\r\n\r\n
Read the rest of the blog here>>