Oil’s Cloud Over Global Economy

By Desmond Lachman –
WASHINGTON, DC (Business Day) — A dangerous myth is stalking international economic policy-making circles. It is the notion that rising oil prices will not be a drag on global economic growth because they are mainly a reflection of buoyant world demand rather than of any serious supply disruption. If policy makers act on that myth, they run the danger of worsening the global slowdown that will surely follow in the wake of increased oil prices.

Last September, in a prescient paper entitled “The Gathering Storm,” Philip Verleger correctly predicted the inevitable rise in international oil prices to between $50 and $70 a barrel this year. He based his diagnosis on the observation that, over the past 10 years, oil companies had underestimated the strength and durability of the economic emergence of China and India. In his view, they had done so in much the same way as they had earlier underestimated the strength and durability of the German and Japanese economic miracles in the 1960s. That miscalculation paved the way for the devastating 1973 oil price shock.
By not having invested sufficiently in new development, the oil companies have brought only two major oilfields on stream over the past 10 years. This has proved far from adequate to meet increasing global demand and to replace declining production at ageing wells. As a result, the world is confronting a situation where surplus oil productive capacity has not been lower over the past 30 years. Little relief is in sight, given the long time that it takes to bring new oil production on stream.
It is in this context that the continued rapid economic growth in China and India has resulted in pressure on oil prices. With global oil production capacity seemingly fixed in the immediate future at 83-million barrels a day, the increased demand that flows from continued economic growth can only drive oil prices in one direction. And up oil prices have gone in the spot market, breaching with seemingly greater ease successive market barriers of $40, $50, and $60 a barrel.
More disturbing has been the parallel increase in long-dated future oil prices. As far out as 2010, oil for future delivery is trading at more than $60 a barrel. These future prices indicate the market’s belief that the balance between oil demand and oil supply will remain tight for a long time. They also suggest that the recent rise in oil prices is unlikely to be a passing phenomenon.
From the consumers’ perspective, an oil price increase must be viewed as the equivalent of an indirect tax hike. As such, an oil price increase has the effect of curbing domestic expenditure on nonpetrol items and of raising the general price level. In an important study in 2000, the International Monetary Fund (IMF) estimated that a sustained $5-a-barrel increase in oil prices shaved off about 0,3 percentage points from global economic growth and added about 0,4 percentage points to the general price level.
Even if the IMF estimate of oil’s economic effects was overstated, the $25 rise in oil prices over the past year must be expected to have a very large effect on the global economy. Even if one were to assume that the effect of higher oil prices was only about half the IMF’s estimate, one would still be forced to the conclusion that higher oil prices would shave off close to a full percentage point from global gross domestic product growth.
John Makin of the American Enterprise Institute has suggested that the reason why we are yet to experience the full effect of high oil prices on the U.S. economy is that it is being masked by the supportive effect on consumption of rising home prices.
However, as the pace of home price increases probably slows in the second half of this year, the damaging effect of higher oil prices will come into view. All that need happen for U.S. consumption to slow is for home price increases to moderate, rather than actually decline. Makin cites the recent UK experience, with a levelling off in home prices and declining consumer demand.
It would be a mistake for policy makers in the Group of Seven (G-7) to take comfort from the fact that the recent rise in oil prices might be the result of a demand shock from China and India rather than of any supply shock. For even were that the case, consumption in the G-7 would surely slow as higher oil prices reached the petrol pump and as home price increases moderated. To be tightening monetary policy in those circumstances runs the risk of deepening any oil-induced global economic slowdown.

Lachman is resident fellow at the American Enterprise Institute.

Source: Resource Investor