Why the U.S.' Oil Dependence is Bad for the U.S. Economy

Energy policy -- or more specifically U.S. oil dependence -- comes and goes in media focus. Its prominence usually increases in direct proportion to the current price of oil or gas. In addition, there has been a growing movement called the "peak oil" movement, which argues world supplies are actually at or near their highest and will continually decline from here on out. While I can't comment on the veracity of peak oil's claims, I can state without a doubt that the U.S.' national energy policy -- and specifically our oil dependence -- is economically disadvantageous.

1. The U.S.' dependence on oil has had a negative impact on the U.S. trade deficit. In September 2006, the San Francisco Federal Reserve issued a paper titled Oil Prices and the U.S. Trade Deficit. It concluded:

Oil prices have almost quadrupled since the beginning of 2002. For an oil-importing country like the U.S., this has substantially increased the cost of petroleum imports. International trade data suggest that this increase has exacerbated the deterioration of the U.S. trade deficit, especially since the second half of 2004. One factor can explain this evolution: The real volume of U.S. petroleum imports has remained essentially constant. One explanation for why the demand for petroleum imports has not declined in response to higher prices comes from a model in which firms are fairly limited in their ability to adjust their use of energy sources, such as oil, in the short term.

The report's conclusion was not widely reported, although it should have been. Simply put, the U.S.' dependence on oil has increased the trade deficit.

2. Higher energy prices have an increasingly negative impact on incomes. As energy prices increase, the amount of disposable income available for discretionary purchases decreases. Currently, family energy prices are at their highest level since 1987. The Christian Science Monitor recently reported:

"Kilowatts, gallons -- they all add up. Energy is now sucking money out of Americans' bank accounts at a record level -- hitting $612 billion at an annual rate in the month of April, the last month of data. Over the past two years, energy bills as a share of income have risen and are now at their highest point since 1987, but still below the levels of the 1970s and early 1980s. For low-income households, some economists estimate energy consumption as a percentage of income is closing in on 10 percent."

Ten percent of income going to a necessary expense is a big chunk of change. In addition, higher energy prices usually decrease consumer sentiment, which can lead to decreasing consumer spending. This is not a good development for an economy that gets 70 percent of its growth from people buying stuff.

3. Oil prices increase overall inflation. Here is a graph from the St. Louis Federal Reserve's FRED system. The blue line is total inflation and the red line is energy inflation. Note the direct relationship between rising energy prices and overall inflation. Simply put, as energy prices increase, so does inflation. High inflation means the Federal Reserve is more likely to increase interest rates, which slows economic growth. In addition, higher inflation decreases incomes, especially those at the lower end of the pay scale.

4. The U.S.' dependence on oil makes the U.S. economy subject to geopolitical problems. I don't want to get too far into foreign policy here, but the U.S. and the Middle East have a very complex and difficult relationship, especially now. Exposing the U.S. economy to the political complexities of a region where the U.S. is, shall we say, not exactly popular is basically an economic suicide pact.

So what do we do about this? The answer is simple. The U.S. must develop alternate energy. This is a national security issue -- both politically and economically. The national security issue is explained in reason number four above. Out dependence on a region that really doesn't like us exposes the U.S. to a huge security problem.

Additionally, let's assume the peak oil argument is right (and again, I'm no expert on this argument). If the overall supply of oil is at or nearing its peak for all time, then the world must develop different alternate means of energy. This translates into the "jobs of tomorrow" in a big way. Being the market leader in alternate energy would lead to a big boost for the domestic economy. And that benefits everyone.

For economic commentary and analysis, please go to the Bonddad Blog.