The Iran War Doesn’t Have to Be a Rerun of ‘That ’70s Show’

Are we headed for stagflation and recession? The parallels with the 1970s are ominous: Inflation surges and then retreats but gets stuck a bit too high. Trouble brews in Iran, and oil prices spike. In 1979 inflation surged, followed by a severe recession. Most postwar recessions were preceded by oil price spikes.

In fact, energy prices turn into recessions only if bad policies compound their effects. Price controls, credit controls, windfall profits taxes, export controls, the 55-mph speed limit, corn ethanol, cardigan sweaters, malaise, and a slow-to-react Federal Reserve all fed the misery of the 1970s. They need not do so again.

The fundamentals are also better. The U.S. imported a lot of oil in the 1970s. Now, on net, we export, thanks to fracking and the reversal of many energy restrictions. Gasoline is more expensive, but the country earns money that can be spent on other goods. The U.S. uses a lot less oil to generate each dollar of income. We are more of a service economy and less an energy-dependent manufacturing economy. There are many more suppliers to the international market than in the 1970s. While they can’t ramp up production instantly, at persistently higher prices a lot more oil can come out of the ground.

An oil price rise is like a tariff. As we have seen, tariffs, while damaging to overall growth, need not cause a recession.

The most important questions are when the Strait of Hormuz opens and how the war ends. It is hard to believe that after their lopsided military victory, the U.S. and Israel will leave Iran with a veto over oil. The end depends only on whether we have the will to accomplish what is surely in our means. But defeat has been clutched from the jaws of victory before.

Oil futures markets offer a glimpse of where things might be headed. West Texas intermediate futures are trading at $97 a barrel for late May but decline to $80 by late October and $74 next April. Futures markets expect a costly summer and resolution by fall.

Governments will be tempted by ham-handed policy responses. The European Union is already considering subsidies, price caps, oil profits taxes, and other controls. Ah, Europe—tax energy, send carbon-emitting industry off to China, ban domestic drilling and fracking, destroy nuclear, all in the name of climate. When prices rise, add subsidies and controls. Fortunately, many Europeans now understand how costly their energy policies have been.

With “affordability” and gasoline prices in the news, the U.S. will feel similar temptations. The administration already ramped up corn ethanol, that great counterexample of our country’s ability to run sane energy or industrial policy. China has enacted an export ban, which the U.S. tried in the 1970s. It did great damage.

Higher gasoline prices need not mean inflation. But governments will produce inflation if they hand out money so people can pay higher prices. Price controls mean gas lines, which increase economic damage. The most productive users who can’t substitute away then can’t get the energy they need, and suppliers see no incentive to help. Windfall profits taxes in bad times dampen the incentive to invest in spare capacity in good times. The first principle of economics is: Don’t transfer income by distorting prices. The first principle of politics is the opposite.

High energy prices do slow the economy. But a slowdown turns into a recession only when something financial goes wrong. The aftermath of an energy price spike depends a lot on how central banks respond. If the Fed reacts slowly, along with harmful economic policies, stagflation could again break out quickly, and then recession could follow when the Fed reacts to inflation.

The central bank will be tempted to react to supply-induced softening with demand stimulus. It will be tempted to “look through,” i.e., ignore, the transitory inflation of an oil-price shock as it looked through Covid-era inflation, until inflation reached 8%. Fed officials planned to look through tariffs as well.

But, as in 1979, people who saw substantial inflation may be quick to expect more inflation, and then the Fed will have to react strongly, as it did in 1980. I also fear that the Fed may be paralyzed during its change of leadership or may try to avoid moving interest rates by relying on quantitative tightening or credit restrictions. All that will cause needless financial turmoil.

What should government do about rising energy prices? Nothing. Or, more concretely, get out of the way, ease restrictions, and let the market work its magic of sending energy to the most economically important uses while encouraging others to save, substitute or provide new energy. Keep inflation under control, and don’t induce financial problems.