Sunday, March 05, 2006
Myths and legends about high oil prices
Posted by David Smith at 10:00 AM
Category: David Smith's other articles

One of the most enduring stories of the past three decades is that when oil prices go up, economies go down in flames. Oil price shocks, it has seemed, are just that - they shock the economy into higher inflation, sharply rising unemployment and general misery.

We know, so far at least, this has not been the case this time. Oil peaked at $70 a barrel last year and continues to hover around $60 - three times its level three years ago. Every time it attempts to break significantly lower being thwarted by some new scare, the latest being Al-Qaeda’s attempt to blow up Saudi oil installations.

The global economy, however, sails on regardless. Credit Suisse First Boston’s latest global economics snapshot puts world growth at 4.8% this year, even higher than 2005’s strong 4.5% rate and almost on a par with the 5.1% achieved in 2004. It has pencilled in 4.5% for 2007. For comparison, global growth over the 2001-3 period - before the big oil price rise - averaged 3%.

This, indeed, is part of the explanation for oil’s limited effect. Despite the efforts of Al—Qaeda, Nigerian militants, the Iranian government, and continued supply disruptions in Iraq, this oil price hike is essentially a demand shock.

Higher prices, in other words, are mainly a product of strongly rising demand and, as such, can be distinguished from the supply shocks of the past. If economies have enough momentum, which they appear to have, they will shrug off high oil prices. China is expected to contribute about a third of global economic growth this year, twice as much as America and more than three times as much as Europe.

Not only that but, as is well known, advanced economies are less sensitive than they were to expensive oil. The oil intensity of economic output has more than halved in Britain and elsewhere compared with the 1970s, mainly because of the rise of service industries. Even with recent rises, household energy outlays are about half what they were 20 years ago as a proportion of total spending.

We may also have got better in responding to high oil prices. In the past policymakers gave passable impersonations of headless chickens when faced with an oil shock. David Walton of the Bank of England’s monetary policy committee, in a speech a few days ago, said it was no coincidence that the current era of improved monetary policy arrangements, including inflation targeting in Britain, had seen oil’s impact muted.

The recycling of oil wealth from the Middle East producers also appears to have been less disruptive this time, not least because global financial markets are much more liquid.

How far could we go before oil did do some serious damage? Many economists, who thought $60-70 a barrel would tilt the world economy over the edge, now say it could require $90-100. It could be even at that price the damage would be relatively contained. Though I think the fundamentals point eventually to $40 oil, the net effect of a $100 price could be beneficial if the side-effect was to make a reality of George Bush’s dream of weaning America and the west off their addiction to Middle East oil (and rising energy use in general).

So this oil shock is different. Or is it? The fascinating possibility raised by Walton’s speech, ‘Has Oil Lost the Capacity to Shock?’, and by new research from the Centre for Economic Policy Research (CEPR), is that oil never quite had the destructive power we thought. In the many economic dislocations of the past 30 or so years, oil may have made only a minor contribution.

There is an obvious reason why it was natural to blame oil. Politicians will always seek a scapegoat that diverts attention from their own errors. Gordon Brown tried a bit of that in blaming oil for Britain’s slowdown last year. It was always an easy consensus when politicians from the oil-consuming countries gathered to pin the blame on greedy producers.

Walton, in his speech, noted that the episode that gave us the term “oil shock”, the Yom Kippur war of October 1973 and the Arab oil embargo that followed it, coincided with the introduction of an incomes policy by the Heath government in which workers were fully compensated for any rise in prices, guaranteeing what we now call second-round effects from higher oil prices. More importantly, the hike in prices came after the inflationary Barber boom.

The oil price rise that occurred around the time of Margaret Thatcher’s election in 1979 - caused by the Iranian revolution and sustained by the Iran-Iraq war - similarly appears to have been more an irritant than the cause of recession and high inflation. The Tory triple whammy; agreeing to implement a crazy pay deal for public sector workers; imposing high interest rates on the economy; and liberalising the banking system at the same time as trying to stick to strict money supply targets, guaranteed turbulence and pain for a time.

A decade later the UK recession of the early 1990s was already starting before Saddam Hussein invaded Kuwait and the first Gulf war gave us yet another oil shock. Interest rates, after all, doubled from 7.5% to 15% between May 1988 and October 1989, enough to knock any economy off track. At the very least, as Walton puts it: “The UK economy has been better placed to absorb the current oil price shock.”

Lutz Kilian of the University of Michigan, in his CEPR discussion paper, ‘The Effects of Exogenous Oil Supply Shocks on Output and Inflation: Evidence from the G7 Countries’, goes further.

Kilian writes that “the public’s collective memory” is that oil was to blame for past economic malaises, so it is no surprise that we have all come to fear high prices. But his study suggests the oil shocks of the past made remarkably little difference. Analysing five supply “shocks” - in 1973-4, 1978-9, 1980, 1990-1 and 2002-3 (Iraq) - he concludes that “the evolution of consumer price inflation in the G7 countries would have been remarkably similar overall to its actual path”.

When it comes to other effects, he finds neither 1973-4 nor 2002-3 had any discernible impact on G7 growth. The other three supply shocks did have a negative effect but this was “not as much as one might have conjectured”.
If this is correct, and it seems plausible, oil has been a relatively minor player in causing economic disruptions. Policy errors have been much more important.
While not wanting to minimise the consequences of high energy prices for firms and households, I find this heartening. If nothing else, it is a welcome antidote to the idea the world economy could be held hostage by Al-Qaeda or Iran.

PS I’m not used to being “out-doved” on interest rates but it’s
happened. The “shadow” MPC (monetary policy committee) has voted this month to cut interest rates at a time when I would not be doing so. Its 5-4 vote to cut will provoke a great deal of interest in the markets, at a time when rate-cut prospects were widely seen to be diminishing.

A word of context about the shadow MPC may be useful. It came into being, under the auspices of the Institute of Economic Affairs, shortly after the actual MPC was created in 1997. Originally it met quarterly, and still does, but thanks to modern technology and the urgings of this newspaper, it now has a monthly “meeting” by e-mail. Nine members vote each month, though because they are all busy people the nine voters are drawn from a cast list of 13 economists.

That said, the five cutters this month are all regulars; Roger Bootle, Andrew Lilico, Patrick Minford, Peter Spencer and Peter Warburton. Are they leading where the the Bank of England follows? Though I wouldn’t do it now, I still have a rate-cut pencilled in for later.

From The Sunday Times, March 5 2006

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