The Oil Crisis of 1973-1974: Causes and Effects on the American Economy

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The objective of this study is to explain the impact that the 1973-1974 oil crisis, stemming from the countries known as OPEC (Organization of Petroleum Exporting Countries), had on oil prices, the American economy and the world economy. This essay discusses the causes of the oil crisis as well as the extent of the impact on the American economy. Some of the macroeconomic concepts that will be explored are inflation, wage-price controls and monetary policy. It is evident from the findings that the US government made a response to the crisis through wage-price controls and the Federal Reserve’s stop-go monetary policy which in turn worsened the impacts of the embargo. To conclude, I will briefly outline how the oil price shock has changed the United States dependency on oil through rapid growth in renewable and energy efficiency sectors since 1973; this oil price shock shows how one event can affect the globe.

Introduction

The 1973-1974 OPEC oil embargo began during the Yom Kippur Arab-Israeli War in October 1973 in retaliation for the US decision to re-supply the Israeli military and to gain leverage in the post-war peace negotiations (www.history.state.gov, 2017). This meant that petroleum export to the targeted nations – the US, the UK, and the Netherlands – were temporarily banned and introduced cuts in oil production which disrupted a decades old oil pricing system, which worsened the embargo’s effects. In 1973, 36% of the world’s oil was supplied by the Middle East countries (Schumacher D., 1985, ‘The 1973 Oil Crisis and Its Aftermath’). Oil from that region was more abundant and cheaper to produce; therefore, this embargo put a huge strain on the US economy that had grown increasingly dependent on foreign oil; the United States consumed one third of the World’s oil at this time (www.khanacademy.org, 2015). This led to major oil shortages and a severe rise in oil prices which created an economic crisis in the US and other developed countries.

Discussion and Analysis

OPEC member countries produce about 42% of the world’s crude oil and control 60% of the total petroleum exports and 72% of proven oil reserves (www.thebalance.com, 2020). As a result of this large market share, OPEC creates a market similar to a monopoly market. Consequently, OPEC’s actions can, and do, influence international oil prices as highlighted through the 1973-1974 oil embargo.

Tensions between OPEC members and the US had built up in the years prior to the embargo as a result of actions taken by President Richard M. Nixon in an attempt to boost the sluggish American economy. Nixon ordered the release of the dollar from the gold standard, which had been in place since the end of World War II; the resulting devaluation of the currency led to financial losses to oil-producing countries, whose revenues comprised largely of US dollars (www.britannica.com, 2020). The world became adapted to cheap gasoline and relatively stable prices which led to Western oil consumption more than doubling in the preceding 25 years, contributing to the severity of the crisis. During the 1973 Yom Kippur Arab-Israeli War in efforts to pressure Western countries to force Israel to withdraw from seized lands, Arab members of OPEC announced harsh production cuts and then banned the sale of oil to the United States and the Netherlands.

Over the next 6 months oil prices quadrupled and remained at a higher level after the embargo ended in March 1974; inflation-adjusted oil prices went up from $25.97 per barrel (bbl) in 1973 to $46.35 per barrel (bbl) in 1974 (www.thebalance.com, 2020), an increase of 78.48 percentage points.

Oil prices rapidly increased and remained high after the embargo; the embargo had long lasting effects and changed oil prices forever. In 1981 the price of crude oil cost $36 per barrel; 40 years later it is less than half as high. Meanwhile, prices in general have risen almost 30% (www.fee.org, 2017). The rapid rise in prices imposed socioeconomic impacts such as gas stations introduced color-coded signs for when gas was available. In efforts to conserve gas, states introduced odd-even rationing which meant drivers with license plates ending in even numbers could only get gas on even-numbered days and the national speed limit was also reduced to 55 miles per hour (www.thebalance.com, 2020).

In response to the embargo Nixon enforced wage-price controls which forced companies to keep their wages high resulting in businesses laying off workers to reduce costs which alongside higher production costs of oil reduced aggregate supply in the economy. Aggregate demand had also fallen as unemployment rose resulting in lower disposable income due to higher gas prices. This resulted in a great decrease of marginal productivity of labor. The Federal Reserve had also consistently raised and lowered interest rates making businesses unable to plan for the future. Consequently, cost-push inflation occurred the high levels of inflation were the result of an oil supply shock resulting in increasing the price of gasoline, which drove the prices of everything else in the economy higher.

Monetary policy involves using interest rates and other monetary tools to influence the levels of consumer spending and aggregate demand; it aims to stabilize the economic cycle by keeping inflation low and in turn avoid recessions. The Central Bank can influence the extent to which supply shocks affect inflation, but they face a trade-off. Due to the widespread affect higher oil prices have on goods and services throughout the economy they will tend to generate both inflationary pressures and slower growth (www.federalreservehistory.org, 2013). The Federal Reserve’s subsequent tightening of monetary policy had a much more severe impact than the direct effects of the oil price shock themselves. This led to a period of stagflation which is defined as a period of slow economic growth occurring simultaneously with high rates of inflation. Inflation rates rapidly rose in from 3.21% in 1972 to 11.04% in 1974, an increase of 7.83 percentage points.

Arthur Okun, an economist in the 1960’s created the Misery Index which was equal to the sum of inflation and unemployment rate to provide a snapshot of the US economy. The higher the index, the more is the misery felt by US citizens. It is evident that unemployment and inflation were highest in the years following the OPEC oil embargo which further highlights the long term impacts the oil shock had on the US economy; the Misery Index rose from 9% in 1972 to 20% in 1975, an increase of 11 percentage points. The oil embargo is widely blamed for causing the 1973-1975 recession.

Although the embargo led to a recession in the US economy, there were also some positive effects. High oil prices encouraged a switch to smaller, more fuel-efficient vehicles resulting in Japanese firms such as Toyota and Honda becoming dominant in the UK and further afield (www.theguardian.com, March 2011). The crisis was a major factor in shifting Japan’s economy from oil-intensive industries towards a focus in electronics. If energy levels had continued at 1973 levels, today’s energy use would be over 40% greater than current levels (www.eesi.org, October 2013). Renewable energy e.g. biomass, wind, solar, biofuels have become the fastest growing energy source from supplying next to none of US energy in 1973 to in 2019 supplying 11% of total US energy consumption and about 17% of electricity generation (www.eia.gov, May 2020).

Conclusion

To conclude, the 1973 oil price shock is reported to have shrunk the US economy by approximately 2.5% and the increased unemployment and inflation spun the economy into a severe and extended recession from 1973-1975 (www.csis.org, 2013). It took the US economy several years for economic output and inflation rates to fall to their pre-crisis levels. Capitalist countries have been forced to embark on a process of economic restructuring in response to the 1973 embargo in order to reduce dependency on foreign oil. In 2013, the US were on target to achieve more than 90% energy self-sufficiency. Moreover, energy usage per unit of GDP is less than half the 1970s level (www.csis.org, 2013); thus, proving that the economic restructuring to reduce risk of further oil price shocks has been successful. Subsequently, the effects of the embargo are still being felt today.

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The Oil Crisis of 1973-1974: Causes and Effects on the American Economy

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