This paper examines the potential macroeconomic consequences of an oil supply shock stemming from the impending U.S.-Iraq conflict in the early 2000s. Drawing on Iraq's vast oil reserves and the risk of deliberate sabotage by Saddam Hussein, the paper estimates a possible shortfall of up to 6 million barrels per day and prices reaching $80 per barrel. It then analyzes two primary macroeconomic costs for the United States: upward pressure on inflation and interest rates through the consumer price index, and reduced output and consumption resulting from energy's role as a key production input. Historical oil shocks from 1973–1974, the late 1970s, and the early 1990s are cited as precedent for recession risk.
War with Iraq is imminent. While any degree of instability in the Middle East region is reason enough for concern, coupling this reality with the widely held view that Saddam Hussein is an unpredictable actor compounds the potential for disaster many times over. Unfortunately for the United States, this disaster will not be contained to the immediate region of the Persian Gulf. The oil supply disruption that is likely to follow the launch of an American military campaign will reverberate throughout the world and will hit the U.S. economy especially hard, given its high dependence on this fossil fuel.
To gain some perspective on this issue, consider the extent of Iraq's known oil reserves. According to reliable estimates, these reserves alone "could cover current U.S. imports for almost a century." Add to this the 220 billion barrels of oil that may still lie beneath Iraqi soil (Zagorin, 2003, p. 32). If forced into a corner, Saddam Hussein could sabotage these reserves as well as the oil fields of neighboring countries. In that scenario, "a major shortfall of up to 6 million bbl. a day — 8% of world consumption — is foreseeable" (Zagorin, 2003, p. 33). Such a cut in supply would send a shock through the oil market severe enough to drive prices to $80 per barrel before the situation could be brought under control (Zagorin, 2003, p. 33).
The relevance of this issue is clear. The central question is: how will an oil shock of this magnitude affect the United States economy? To begin with, the U.S. is highly dependent on imported oil. While imports represented 35% of total oil consumed in 1973, that share had risen to 50% by 2000, and some economists project it will reach 64% by 2020 (Energy, n.d., p. 1). Unless policymakers open Alaska to development or scientists develop a truly viable energy alternative, the United States will remain dependent on foreign oil for the foreseeable future. With this in mind, the discussion turns to two primary macroeconomic costs associated with high oil prices: higher inflation and interest rates, and decreased output and consumption.
At the most basic level, when oil prices rise, so do everyday prices for gasoline and heating oil. This increase eventually registers in the consumer price index (CPI), since "rising energy prices contribute directly to general inflation" (Pindyck, 1980). Because the CPI influences interest rates, consumers will feel the effects of higher energy costs across the various credit markets they participate in — most notably credit cards and mortgages. Making matters worse, monetary policy responses to an oil price shock can themselves aggravate the situation. For example, "expanding the money supply or targeting interest rates can soften the impact on aggregate output, but will place upward pressure on prices" (Huntington, 1998). If the macroeconomic response to higher prices involves expanding the money supply and injecting funds through fiscal measures, the result will be even higher inflation and a further reduction in GNP (Huntington, 1998).
"Higher energy costs shrink investment and output"
This means that the current weak recovery from the most recent U.S. recession could be placed in jeopardy. History has certainly demonstrated this risk. "The price shocks of 1973–74, the late 1970s/early 1980s, and early 1990s were all followed by recessions." To put it another way, high oil prices place pressure "on aggregate prices in the economy [which] created adjustment problems for the economy as a whole" (Energy, n.d., p. 1). Given the near certainty that military conflict will come to the region, the U.S. economy faces a difficult road ahead.
Energy Price Impacts on the U.S. Economy (n.d.). Retrieved February 12, 2003 from
Huntington, H. G. (1998). Crude oil prices and U.S. economic performance: Where does the asymmetry reside? The Energy Journal, Vol. 19, Issue 4. Retrieved February 12, 2003 from ).pdf.
Pindyck, R. S. (1980). Energy price increases and macroeconomic policy. The Energy Journal, Vol. 1, Issue 4. Retrieved February 12, 2003 from ).pdf.
Zagorin, A. (2003). All about the oil. Time, 32–34.
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