Themes > Current Issues
22.09.2000
C.P.
Chandrasekhar
The world economy is booming, with the US in the lead.
Yet uncertainty generated by the high level of oil prices is spoiling
the party. Officials and Ministers who gathered at Prague late September
for the biannual meetings of the World Bank and the IMF had much to
celebrate. According to IMF's World Economic Outlook prepared in time
for the occasion, the world economy is expected to grow by 4.7 per cent
in 2000, led by the US economy growing at 5.2 per cent. With consumer
prices in the advanced economies slated to rise only 2.3 per cent over
2000, the current period emerges as one of high growth and low inflation.
But delegates at the Prague meetings had to mix this evidence of high,
non-inflationary growth with assessments of the likely consequences
of persistent increases in oil prices and the growing public resentment
against the effects of those increases, manifested in the sometimes
violent blockades all over Europe this September. In the event, images
of those blockades by protesters demanding a roll-back in oil taxes
rather than the sloganeering of protesters against globalisation spoilt
the party for the assembled delegates.
The rise in oil prices mattered because, what has hitherto been missed in explanations of the historically unusual combination of high 'global' growth and low inflation, which routinely refer to "facts" such as the rapid increases in productivity in the "new economy", is the role played by depressed commodity prices in general and low oil prices in particular in holding down the price level in the buoyant developed economies. Oil prices, we should recall touched a low of $10 a barrel in late 1998; and even though they have more than tripled since then they still are in real terms a fraction of their levels at different points in the past. Through much of this period non-oil, commodity prices too were falling. The importance of these depressed commodity prices for the health of the developed economies and therefore of the 'global system' is now becoming increasingly clear, as oil prices remain at levels they have reached in the recent past.
It was for this reason that despite positive global growth indicators, the mood at Prague was glum. Oil prices have tripled since late 1998, rising from a debilitating low of $10 a barrel to close to $35 a barrel more recently. Initially the upturn in oil prices was seen to be the result of production cutbacks of a more disciplined OPEC, which managed to enforce three cuts in production over the year starting March 1998. But subsequently as oil prices touched new peaks, rising well above the preferred OPEC price range of $22-28 to the barrel, Saudi Arabia chose to "leak" additional supplies to the world system and more recently on September 10, OPEC itself decided to increase production by 800,000 barrels a day or the equivalent of around 1 per cent of world supply. Yet prices have remained firm and are threatening to cross the $35 to a barrel psychological barrier.
The reason for this stubborn rise in oil prices is the persisting boom in a world economy, which is still lubricated by the thick black liquid delivered largely by OPEC, all talk of successful oil conservation notwithstanding. It is now clear that the much-touted responses to previous oil price increases, in the form of increased exploration and changes in technology that substituted other fuels for oil and resulted in overall energy conservation have not reduced dependence on oil consumption to an extent where oil demand and oil prices are not very directly related to growth in the developed countries.
A slow down in world growth in 1998 in the wake of the financial crises in South East Asia and elsewhere combined with dissension within OPEC had indeed brought the nominal price of oil down to historic lows of close to $10 a barrel. It is also true that though the initial reversal of that sharp decline was due to the greater cohesion among OPEC producers induced by the debilitating consequences of that decline, the persistence of the increase in oil prices is related to higher growth in the world economy. The boom in the US and the hesitant recovery in East Asia have stimulated oil demand and run down oil stocks, resulting in an oil price spiral which has not been capped as yet by Saudi Arabian and OPEC efforts to increase supplies. According to reports, oil stocks in the US, the economy with the most robust growth record are at a 24-year low and refining capacity is under strain to meet the current level of demand. It is this state of affairs that has created a situation where the possibility that oil prices could touch close to $40 a barrel if the coming winter proves severe has become a real threat.
What is noteworthy in this situation is that the conventional strategy of pinning the blame for high oil prices and its adverse consequences on the OPEC has fewer takers. There are three obvious reasons for scepticism regarding that argument. First the current phase of rising oil prices comes in the wake of a collapse in oil prices during 1997-98, which took oil prices to an unprecedented low. The rise is partly seen as an inevitable correction. Second, even at their recent ten-year high at close to $35 a barrel, oil prices were in real terms, or when adjusted for the average increase in prices of all commodities, only half of their 1974 levels and a third below the level reached after the second oil shock in 1981. That is, when placed in the context of inflation in non-oil prices, the current oil price increase does not compare with the the oil shocks of the 1970s. Finally, the fact that it was an unprecedented low in oil prices that forced the OPEC to cut back production and that in response to the currently prevailing high prices the organisation has been willing to increase supply, even if with little effect on prices, has shifted the burden of blame for the high prices away from the organisation itself.
These factors are important in explaining the nature of the oil protests in Europe. Taking the cue from the fact that duties on fuel in Europe are astronomical when compared with the United States and encouraged by the experience in France where protests in the form of blockades by truckers and others had forced the government to relent on fuel taxes, various groups across Europe launched on a wave of protests in the first half of September. The basic thrust of the protests was that the best way to deal with adverse impact of high oil prices, resulting from the demand-supply imbalances generated by buoyancy in the world economy, was to partially neutralise the increase in base prices through cuts in fuel taxes.
These protests have blunted the effort of US and other developed-country governments to respond to rising oil prices with a strategy of dividing OPEC and forcing it to increase supplies to an extent where prices decline and risk setting themselves on a downward trend that could take them once again to historic lows. Advocates of that strategy were clearly against the alternatives to a return to a situation where oil prices registered a free fall. Why should the US Federal Reserve push up interest rates to hold back growth in an overheated economy and in the process risk a sudden slowdown in US growth? Why should European government lose revenues through cuts in fuel taxes and reduce expenditures to meet deficit targets specified as part of the effort at monetary union? These questions emanate from those who believe that the appropriate response to the current situation consists not of demand-side adjustments that slow growth in the developed countries, but supply-side adjustments by OPEC members that risk a return to the $10 a barrel era and slow growth in the OPEC-bloc. Needless to say, these arguments emanate from precisely those countries which are at the winning end of the current combination high growth and low inflation.
The explanation for this aggressive and divisive stance is not difficult to find. It lies in the fear of a repeat of the scenario of the 1970s and early 1980s, where oil price increases triggered a recession. Those fears stem from the realisation that price stability does not imply that high growth in the US in recent times had no inflationary consequences. It was just that those consequences rather than being reflected in higher prices had been visible in large and widening trade deficits. The monthly trade deficit, or the difference between what the US buys from and sells to the world, touched a record $31.9 billion in July, up from $29.8 billion in June. This situation where every day the US imports goods worth about a billion dollars has been the result of a continuous widening of the size of the US trade deficit. Those imports included a range of primary commodities whose prices were collapsing, which contributed in no small way to low inflation in the US.
The rising trade deficit had not bothered either the Fed or the US government because the US still serves as a safe haven for capital from across the world. Investments in financial assets in the US by investors abroad brought in enough money to finance the deficit, allowing the US to continue to enjoy the benefit of high growth and low inflation. But for those capital flows the dollar would have weakened and forced the Federal reserve to raise interest rates and slow demand growth. Those capital inflows also directly contributed to US growth. By sustaining high stock values in the capital markets, they substantially increased the wealth of US citizens, encouraging them to reduce their savings and spend more from current incomes.
These are the factors which are being ignored when analysts argue that technological change and efforts at conservation are responsible for the fact that, unlike in 1974, 1980 and 1990, when oil price increases led to recessions in the world economy, there are no such signs at present. There are at least two ways in which oil prices are threatening to adversely affect growth in the developed countries. First, as mentioned earlier, higher oil prices, are worsening the already large trade deficits on the US balance of payments, raising the possibility of reduced confidence in the dollar, that could reduce capital flows, set off a stockmarket decline and wipe out wealth with damaging consequences for consumer confidence and spending. The principal stimulus to US and thereby world economic growth in recent times can be foiled. Second, higher oil prices can soon start influencing the rate of inflation in the developed industrial economies, forcing their central banks to raise interest rates and slow growth. This is already happening in Europe where the European Central Bank has raised interest rates in response to the rising headline inflation rate. In the US the Fed has been less responsive, possibly partly because of the danger that an effort to apply the brakes and ensure a "soft landing" onto a slower growth path may spur a collapse in financial markets and of demand. But at some point it would be forced to intervene.
With no immediate signs of a reversal of the upward climb of oil prices, despite OPEC efforts to raise supplies and promises by oil companies and governments to release part of their stocks, these possibilities are threatening to realise themselves. If they do, the story of oil price increases leading to recessions could be repeated once again, with much greater severity given the fragile foundations on which the US boom rests. It was this prospect which was defining the mood at the Fund-Bank meetings at Prague, where even news of a persisting boom could not clear the gloom.
The rise in oil prices mattered because, what has hitherto been missed in explanations of the historically unusual combination of high 'global' growth and low inflation, which routinely refer to "facts" such as the rapid increases in productivity in the "new economy", is the role played by depressed commodity prices in general and low oil prices in particular in holding down the price level in the buoyant developed economies. Oil prices, we should recall touched a low of $10 a barrel in late 1998; and even though they have more than tripled since then they still are in real terms a fraction of their levels at different points in the past. Through much of this period non-oil, commodity prices too were falling. The importance of these depressed commodity prices for the health of the developed economies and therefore of the 'global system' is now becoming increasingly clear, as oil prices remain at levels they have reached in the recent past.
It was for this reason that despite positive global growth indicators, the mood at Prague was glum. Oil prices have tripled since late 1998, rising from a debilitating low of $10 a barrel to close to $35 a barrel more recently. Initially the upturn in oil prices was seen to be the result of production cutbacks of a more disciplined OPEC, which managed to enforce three cuts in production over the year starting March 1998. But subsequently as oil prices touched new peaks, rising well above the preferred OPEC price range of $22-28 to the barrel, Saudi Arabia chose to "leak" additional supplies to the world system and more recently on September 10, OPEC itself decided to increase production by 800,000 barrels a day or the equivalent of around 1 per cent of world supply. Yet prices have remained firm and are threatening to cross the $35 to a barrel psychological barrier.
The reason for this stubborn rise in oil prices is the persisting boom in a world economy, which is still lubricated by the thick black liquid delivered largely by OPEC, all talk of successful oil conservation notwithstanding. It is now clear that the much-touted responses to previous oil price increases, in the form of increased exploration and changes in technology that substituted other fuels for oil and resulted in overall energy conservation have not reduced dependence on oil consumption to an extent where oil demand and oil prices are not very directly related to growth in the developed countries.
A slow down in world growth in 1998 in the wake of the financial crises in South East Asia and elsewhere combined with dissension within OPEC had indeed brought the nominal price of oil down to historic lows of close to $10 a barrel. It is also true that though the initial reversal of that sharp decline was due to the greater cohesion among OPEC producers induced by the debilitating consequences of that decline, the persistence of the increase in oil prices is related to higher growth in the world economy. The boom in the US and the hesitant recovery in East Asia have stimulated oil demand and run down oil stocks, resulting in an oil price spiral which has not been capped as yet by Saudi Arabian and OPEC efforts to increase supplies. According to reports, oil stocks in the US, the economy with the most robust growth record are at a 24-year low and refining capacity is under strain to meet the current level of demand. It is this state of affairs that has created a situation where the possibility that oil prices could touch close to $40 a barrel if the coming winter proves severe has become a real threat.
What is noteworthy in this situation is that the conventional strategy of pinning the blame for high oil prices and its adverse consequences on the OPEC has fewer takers. There are three obvious reasons for scepticism regarding that argument. First the current phase of rising oil prices comes in the wake of a collapse in oil prices during 1997-98, which took oil prices to an unprecedented low. The rise is partly seen as an inevitable correction. Second, even at their recent ten-year high at close to $35 a barrel, oil prices were in real terms, or when adjusted for the average increase in prices of all commodities, only half of their 1974 levels and a third below the level reached after the second oil shock in 1981. That is, when placed in the context of inflation in non-oil prices, the current oil price increase does not compare with the the oil shocks of the 1970s. Finally, the fact that it was an unprecedented low in oil prices that forced the OPEC to cut back production and that in response to the currently prevailing high prices the organisation has been willing to increase supply, even if with little effect on prices, has shifted the burden of blame for the high prices away from the organisation itself.
These factors are important in explaining the nature of the oil protests in Europe. Taking the cue from the fact that duties on fuel in Europe are astronomical when compared with the United States and encouraged by the experience in France where protests in the form of blockades by truckers and others had forced the government to relent on fuel taxes, various groups across Europe launched on a wave of protests in the first half of September. The basic thrust of the protests was that the best way to deal with adverse impact of high oil prices, resulting from the demand-supply imbalances generated by buoyancy in the world economy, was to partially neutralise the increase in base prices through cuts in fuel taxes.
These protests have blunted the effort of US and other developed-country governments to respond to rising oil prices with a strategy of dividing OPEC and forcing it to increase supplies to an extent where prices decline and risk setting themselves on a downward trend that could take them once again to historic lows. Advocates of that strategy were clearly against the alternatives to a return to a situation where oil prices registered a free fall. Why should the US Federal Reserve push up interest rates to hold back growth in an overheated economy and in the process risk a sudden slowdown in US growth? Why should European government lose revenues through cuts in fuel taxes and reduce expenditures to meet deficit targets specified as part of the effort at monetary union? These questions emanate from those who believe that the appropriate response to the current situation consists not of demand-side adjustments that slow growth in the developed countries, but supply-side adjustments by OPEC members that risk a return to the $10 a barrel era and slow growth in the OPEC-bloc. Needless to say, these arguments emanate from precisely those countries which are at the winning end of the current combination high growth and low inflation.
The explanation for this aggressive and divisive stance is not difficult to find. It lies in the fear of a repeat of the scenario of the 1970s and early 1980s, where oil price increases triggered a recession. Those fears stem from the realisation that price stability does not imply that high growth in the US in recent times had no inflationary consequences. It was just that those consequences rather than being reflected in higher prices had been visible in large and widening trade deficits. The monthly trade deficit, or the difference between what the US buys from and sells to the world, touched a record $31.9 billion in July, up from $29.8 billion in June. This situation where every day the US imports goods worth about a billion dollars has been the result of a continuous widening of the size of the US trade deficit. Those imports included a range of primary commodities whose prices were collapsing, which contributed in no small way to low inflation in the US.
The rising trade deficit had not bothered either the Fed or the US government because the US still serves as a safe haven for capital from across the world. Investments in financial assets in the US by investors abroad brought in enough money to finance the deficit, allowing the US to continue to enjoy the benefit of high growth and low inflation. But for those capital flows the dollar would have weakened and forced the Federal reserve to raise interest rates and slow demand growth. Those capital inflows also directly contributed to US growth. By sustaining high stock values in the capital markets, they substantially increased the wealth of US citizens, encouraging them to reduce their savings and spend more from current incomes.
These are the factors which are being ignored when analysts argue that technological change and efforts at conservation are responsible for the fact that, unlike in 1974, 1980 and 1990, when oil price increases led to recessions in the world economy, there are no such signs at present. There are at least two ways in which oil prices are threatening to adversely affect growth in the developed countries. First, as mentioned earlier, higher oil prices, are worsening the already large trade deficits on the US balance of payments, raising the possibility of reduced confidence in the dollar, that could reduce capital flows, set off a stockmarket decline and wipe out wealth with damaging consequences for consumer confidence and spending. The principal stimulus to US and thereby world economic growth in recent times can be foiled. Second, higher oil prices can soon start influencing the rate of inflation in the developed industrial economies, forcing their central banks to raise interest rates and slow growth. This is already happening in Europe where the European Central Bank has raised interest rates in response to the rising headline inflation rate. In the US the Fed has been less responsive, possibly partly because of the danger that an effort to apply the brakes and ensure a "soft landing" onto a slower growth path may spur a collapse in financial markets and of demand. But at some point it would be forced to intervene.
With no immediate signs of a reversal of the upward climb of oil prices, despite OPEC efforts to raise supplies and promises by oil companies and governments to release part of their stocks, these possibilities are threatening to realise themselves. If they do, the story of oil price increases leading to recessions could be repeated once again, with much greater severity given the fragile foundations on which the US boom rests. It was this prospect which was defining the mood at the Fund-Bank meetings at Prague, where even news of a persisting boom could not clear the gloom.
© MACROSCAN 2000