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Can the world economy continue to shrug off high oil prices?

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PostPosted: Fri Aug 26, 2005 8:21 am    Post subject: Can the world economy continue to shrug off high oil prices? Reply with quote

Can the world economy continue to shrug off high oil prices? from the August 25th Economist magazine

HAD you been told in late 2001?not long after that September's terrorist attacks, and when stockmarkets had been tumbling for 18 months or so?that the price of crude oil would more than triple within four years, you might well have predicted global economic meltdown. The price of a barrel of West Texas Intermediate has risen from $18 in November 2001 to record levels: it hit yet another new high, above $67, this week. This is similar in scale to the price jumps of 1973-74, 1978-80 and 1989-90, all of which were followed by worldwide recession and rising inflation. Today, though, global GDP growth is well above trend, while inflation remains low. Why has the world economy fared so comfortably this time?

There are several popular explanations. The simplest is that, although the latest price increase is about as big as those in previous episodes, it has been more gradual. In 1979 the price of oil doubled in six months; this time it took 18 months, giving households and firms more time to adjust and so doing less damage to their confidence and finances and hence to economic activity. This is plausible, but unlikely to be the whole story: no matter what the pace of the increase, it pains Americans to pay $3-plus for a gallon of petrol.

Another common line is that in real terms oil is not terribly expensive. True, adjusted for American consumer-price inflation, the price of a barrel of crude would have to be about $90 to beat the mark it set in 1980. But this is small comfort: thus measured, the real price is already above its peaks of 1974 and 1990, which were high enough to bring on recession.

Moreover, a calculation of real prices depends on the deflator used. Relative to American producer output prices, the appropriate measure for businesses, real oil prices are already close to their 1980 peak. For an oil-importing economy as a whole, however, the relevant deflator is arguably export prices, since the main way that dearer oil causes pain is through the terms of trade. Relative to global export prices, oil prices are at an all-time high (see chart).

A third argument used by the sanguine is that the modern economy now runs on brain power and microchips rather than on oil. Developed countries use half as much oil per real dollar of GDP as in the mid-1970s, thanks to improved energy efficiency, a switch to other sources of energy and the shift from manufacturing to services. This means that a given rise in oil prices makes a smaller dent in output. However, while rich countries have greatly reduced the oil content of their GDP, many emerging economies are still big energy guzzlers. Some Asian economies, such as India and South Korea, use more oil per dollar of GDP today than they did in the 1970s.

Furthermore, even if America consumes less oil relative to GDP than it did 30 years ago, it also produces less, so its net oil imports are roughly the same as a percentage of GDP (just under 2%). And the impact of oil prices on GDP depends on net imports not on consumption, because oil producers gain when prices rise.

Crude analysis
According to the IMF's model, an increase of $10 a barrel in oil prices should knock three-fifths of a percentage point off the world's output in the following year. Thus the increase of $30 over the past year or so should have reduced global growth by almost two percentage points. However, all such ready-reckoners are based on previous oil shocks, when the main cause of higher prices was a disruption to oil supplies: the OPEC oil embargo in 1973-74; the Iranian revolution in 1979; and Iraq's invasion of Kuwait in 1990.

The current episode, however, has its origin in increasing demand, notably in China, the rest of Asia and the United States. Last year's increase in global oil consumption was the biggest for almost 30 years. The old rules of thumb based on supply shocks do not work for price increases driven by rising demand. If oil prices rise because of a shortfall in supply, they will unambiguously cause GDP growth to fall. However, if higher oil prices instead reflect strong demand, then they are the product of healthy global growth. They will therefore be less damaging.

The downside is that, if prices are high because of strong demand rather than a supply shock, they are likely to stay high for longer. In past oil shocks, a rise in price as a result of a temporary supply disruption caused oil consumption to decline, so that when supply returned to normal prices promptly fell. But if oil prices are being pushed higher largely by rising demand in China and other emerging economies, a sudden collapse is less likely.

This is not to deny the role of speculators, whose bets that prices have further to climb have given the market an extra momentum?perhaps leaving it vulnerable to a future drop. Even so, with demand growing strongly and supply unusually tight as a result of years of inadequate spending on exploration, development and refining capacity, any serious supply disruption would push prices yet higher. The basic fact is that the equilibrium price of oil has risen: analysts at Goldman Sachs expect oil to fetch an average of $68 a barrel next year and $60 for the next five years. In the long run, such high prices will encourage exploration and bring forth increased supply that will eventually dampen prices, but this will take time.

The inflation novelty
The relatively gradual rise in prices, the lower oil-intensity of many economies and the role of strong demand rather than a fall in supply all go some way to explaining why this time the effects of higher oil prices on world GDP have so far been muted. However, perhaps the biggest difference between today's high oil prices and earlier bouts lies in the response of inflation and interest rates. In the past, rising oil prices pushed inflation up sharply; sooner or later, central banks raised interest rates. And this time? Figures out last week showed that the headline rate of inflation in America leapt to 3.2% in July from 2.5% in June, largely because of higher oil prices, yet the core rate of inflation only edged up from 2% to 2.1%. Indeed, inflation worldwide is unusually low, thanks partly to global competitive pressures from China and elsewhere. Subdued inflation, and the expectation that it will stay that way, have allowed central banks to hold interest rates lower than in the past.

As a result of low interest rates, America and some other economies have enjoyed a boom in house prices, accompanied by a surge in household borrowing and a falling saving rate. Higher oil prices have acted like a tax on consumers, leaving them less money to spend on other goods. But in America this has been fully offset by borrowing against soaring home prices. This explains why higher oil prices appear to have depressed domestic demand by more in Europe than in America: in most euro-area economies there has been little or no cushion from increased borrowing against property.

The fact that America's economy has been able to shrug off higher oil prices mainly as a result of a housing and mortgage bubble is hardly a comforting thought. What happens when house prices flatten, or even fall? Consumers will then feel the full force of dearer oil. Come to think of it, a further spike in oil prices could even be what pops the housing bubble, if it unsettles consumers enough. So far, the rising oil price has done little harm; but worse may well be on the way.


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PostPosted: Fri Aug 26, 2005 8:34 am    Post subject: Reply with quote

Maybe we should be honest and say we don?t know?

The economy is a highly dynamic, non-liner chaotic system. Trying to predict or understand the behavior of such a system is really impossible. It emerges out of the interaction of a number of agents and small differences can cause large variations in out come. You will never know exactly what is going on at every level to get a good understanding of what the system is doing they best you can do is talk about general trends and say the econ goes in cycles.

The only future we have is the one we make!



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PostPosted: Fri Aug 26, 2005 12:21 pm    Post subject: Reply with quote

A good article from the Economist I thought.

Obviously devoid of many of the "dirty words" that are forbidden in econ-land but FAR closer to the true picture then we might have expected.
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PostPosted: Fri Aug 26, 2005 1:12 pm    Post subject: Reply with quote

Was it not the case that there were shortages in the 1970s? It's one thing to have high prices without shortages, something else having high prices with shortages.

Has anyone plotted supply vs demand in the 1970s? The price spikes may be an indicator but not necessarily the root cause of economic slowdown.
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