Sunday, April 10, 2005
Why aren't we skidding on sky-high oil prices?
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

At first it was a curiosity. When oil prices rose above $30 a barrel before the invasion of Iraq two years ago, we knew they were following a familiar pattern. Sure enough, once the statues of Saddam Hussein began tumbling, so did the oil price, dropping below $25 a barrel.

But that did not last either. Rather than settling at a non-crisis level, and indeed within the Organisation of Petroleum Exporting Countries’ target range of $22 to $28, the oil price began a fresh climb and hit $40 a barrel a year ago.

That, you might have thought, was that. But it wasn’t. North Sea Brent hit the giddy heights of $50 a barrel last autumn, subsided a bit over the winter, but has been above $55, before dipping late last week. But prices could rise again.

In an eye-catching report, Goldman Sachs suggests that oil prices could “super-spike” to more than $100 a barrel, with US crudes reaching $105 or more. This, it should be said, contains many ifs and buts, and is not intended to be the firm’s main forecast. But even its base case has Brent crude averaging $50-$55 a barrel this year and next, before coming down in 2007.

These are big numbers and raise key questions. Why haven’t prices at this level caused more obvious economic distress? Oil has been associated with some of the great economic disasters of the past, so why not now?

Will there be a big impact on growth, or inflation, or both? Oil plays a central role in the economy: petrol is perhaps the most visible price. People who could not tell you the cost of a loaf of bread would have a fair stab at the price per litre of unleaded. Unless you drive with your eyes closed, never sensible, petrol prices are hard to avoid.

The same is true in America. Petrol is already above $3 a gallon.The threatened rise to $4 is a “nightmare scenario” the White House has been studying, not least because it looks as though it might come true.

Alan Greenspan joined the fray a few days ago, referring to the lack of global refining capacity as “worrisome” but predicting that the “price frenzy” would subside. The Federal Reserve Board chairman also offered the fascinating statistic that 11% of the world’s energy consumption was by vehicles on US roads.

Although Britain is also more car- dependent than ever, and the government admits it will miss its target for cutting carbon-dioxide emissions to 20% below 1990 levels by 2010, oil has less of an economic impact here than it had in the past.

The “oil intensity” of gross domestic product in Britain has declined by more than 60% since 1970. This does not mean that oil demand has dropped by that much. The economy is much bigger, and so is our demand for oil.

It does mean that the ratio of oil consumption to GDP has dropped. So, whereas in the past a 1% rise in GDP was associated with roughly a 1% rise in oil demand, now it means a 0.4% rise. Oil intensity has also dropped, though by slightly less, in other industrial countries.

The reasons are familiar. Industry in general, and heavy industry in particular, has been in retreat, replaced by a less energy-intensive service sector. Energy efficiency has improved; in the past quarter of a century average new-car fuel consumption has fallen by 25%.

It does not mean, emphatically, that high oil prices are an economic non-event. But it does mean we should think about them differently. Higher oil prices push up inflation, and the extent to which this becomes a problem depends on so-called second-round effects; the extent to which they are reflected in higher wages, for example.

Rises in oil prices also reduce growth, particularly in a world where most firms (except the oil companies) find it hard to pass on cost increases. This reduces profits, investment and employment.

Last year the International Energy Agency, together with economists from the Organisation for Economic Co-operation and Development and the International Monetary Fund, carried out simulations on the effect of a sustained $10 rise in the price of oil, from $25 to $35 a barrel.

It suggested that industrial countries’ GDP would be reduced by 0.4% in the first year and by a further 0.4% in the second. Consumer prices would be 0.5% higher in the first year and 0.6% in the second.

Applying this to the $30-a-barrel rise we have seen, assuming that it sticks, would hit economic growth by 1.2% a year for two years, and push prices up by 1.5% to 2%. In a low-inflation world that would be a big hit.

If oil rose to $100 a barrel and stayed there for any length of time, a global recession and much higher inflation — stagflation — would be what the models predict.

Why, with oil well established in the $50-plus range, are we not seeing many of these effects so far? The models could be wrong, although the IEA stressed that its approach was conservative. It may be too soon. We do not yet know whether $50 will stick, let alone that the super-spike to $100 feared by Goldman Sachs will come to pass.

Perhaps, too, policymakers have become more sensible. In the past, higher oil prices would have had central bankers quickly responding with interest-rate rises, thereby exacerbating the impact on growth.

Both the Bank of England and European Central Bank left interest rates unchanged last week. They recognise that dearer oil is a brake on growth. The last thing the economy needs is a heavy foot on that brake.

PS: With an election looming, I’m glad to say this column is maintaining a reputation for balance. The number of readers accusing me of being too soft on Labour is balanced by those suggesting I am a Tory stooge. Most, I should say, are too polite to infer either.

Let me continue in this balanced vein by coming to the aid of the Treasury, and by implication Gordon Brown. Lord Lamont, the former Tory chancellor, has challenged Labour’s claim that it has presided over the longest continous period of economic growth since 1701. His challenge was taken up last week by The Daily Telegraph.

Lamont says it is “a joke” for Brown to claim this. What next, will Labour be claiming the longest run of growth since the Normans or Saxons? I feel his pain.

This period of unbroken growth started in 1992, when Lamont was chancellor, and owes much to the framework he put in place after sterling’s exit from the European exchange-rate mechanism (ERM). But not even his own prime minister described him as the best chancellor for 100 years.

Lamont is, however, wrong on this one. Quarterly figures for gross domestic product go back to the mid-1950s and do show that the current run of 50 consecutive quarters of growth is a record. Even in the “golden age” of the 1950s and 1960s, stop-go policies produced regular dips in GDP. There were such dips, for example, in 1956, 1957, 1958 and 1960.

Looking back beyond the 1950s, Professor Nick Crafts of the London School of Economics says the present spell is indeed the longest run of GDP growth since 1830, when Charles Feinstein’s historical series began. Before that, only partial figures exist, for industrial production. But industry was volatile, and so was agricultural output, so the 1701 claim is also probably true.

Given the fluctuations of agricultural output in a rural economy before then, this may indeed be the longest period of growth since the Normans, or even the Saxons.

A better question, says Crafts, is whether the recent rise in prosperity has been better than before and here, he suggests, the golden age comes out well on top of the Gordon age.

From The Sunday Times, April 10 2005


I would like to present one probable explanation of the observed effect. There is a wrong understanding of the causality principle among economists. They consider "before" means "because of". Economy, however, is not about production, but about people ranking.
Economics is a natural process deals only with the distribution of effective capability to earn money (same as produce income). Whatever is physically produced is distributed according to some common rules. These rules result from the interaction between people (expressed as dynamic ranking of the people according to the personal income) and hold for a relatively long time. In the distribution process, people have varying effective capability to defend their rights to obtain (possess) a share of total product, which includes everything with a price denominated in money. In the end, individual shares are proportional to the effective capability to defend their right of possession.
Wealth is a sum of parts of production belonging to every member of that society expressed in some money form convenient for calculation. Since individual parts of the wealth are proportional to the corresponding effective capabilities to earn money, the total wealth can be expressed as a sum of the individual capabilities independent on the volume and specific features of the produced good and services. The effective capability to earn money, which is called below capability, has a numerical value evolving with time according a very simple law. Whatever is produced in kind and volume (for example, oil, computers, loans, financial advises, …), the total amount of "wealth" changes according to evolution of the distribution of the shares expressed in money rather than in physical units.
Physical production of “goods” and “services” is a realization of some random process dependent on human capability to invent. This creates some confusion about the relative importance of “constituent parts” of the total economy. A monetary description of that process, however, is a simple time function. This function is known to the extent that the population distribution over age and distribution of capabilities to earn money is known. One can find the total monetary “weight” or size of an economy (GDP) by summing the individual monetary incomes earned by the working age population. There is an infinite number of product realizations corresponding to one “money” or “wealth” state. Hence, one can study an economy independent of production (including oil), the latter being only a set of means for earning money (to chop personal part), with total volume of money predefined and fixed at a given time. Innovations are needed to obtain a larger part of the total (but predefined) income relative to any previous technological solution.

Posted by: I.Kitov at April 11, 2005 04:17 PM

On the extremely high oil prices, its outrageous, wrong, impolitical, and overall unconstitutional. We as the people of our government should be able to have a say in these oil prices and be heard. We as the people should not be told by the rich snob oil producers what our oil prices should be. Also if they are to be this high ,oil prices, we need to find "affordable" solutions for transportation. I have many more opinions but it would take all day so the basic will do.

Posted by: jarid at May 2, 2006 06:59 PM