We get the balance wrong. Sometimes relatively small events can be seen with hindsight to have massive consequences; sometimes the reverse.
Like everyone, I have been trying to think through the implications of the deepening crisis in North Africa and the Middle East, and now of the earthquake off the coast of Japan. The economic aspects of both are secondary to the human catastrophe and it is important to those of us who spend our lives writing about finance and economics to remember that people matter vastly more.
But the civil unrest in the oil producers have had economic consequences, as we know every time we fill up our cars, and the earthquake and tsunami will have consequences too. Some thoughts about the first and then some more truncated comments on the second.
On oil, the most sensible assumption now must be that we are likely to experience another shock of a similar magnitude to those in the late 1970s, the late 1990s and 2007-08. The big graph shows the year-on-year percentage change in the oil price in real terms, rather than the actual oil price, so it is concerned with the shock impact. Commenting on it, the HSBC team that wrote this report noted: "Regular as clockwork, increases in oil prices of more than 100 per cent lead to declining GDP."
We are not there yet, fortunately. The oil price won't have doubled until it hits $150 a barrel. But we cannot, I am afraid, completely rule that out. On Friday the oil price fell back a bit, partly in reaction to promises from Saudi Arabia that it would make up any shortfall in supply from the disruption in Libya, and partly because of some signs of a slowing of demand from China. But the fundamental supply/demand balance remains tight and the present incipient political unrest in Saudi Arabia could conceivably develop into something much more serious. Faced with these huge uncertainties, what should we reasonably expect to happen?
We have to include the possibility of oil at $150 a barrel. Were that to happen, some people – such as Dr Noriel Roubini, the economist who correctly predicted the global financial crisis – think that there would indeed be a serious risk of a double-dip recession. That can occur: as you can see from the big graph, it did in the early 1980s – though then the reason for the second leg was the high interest rates imposed by the Federal Reserve to control inflation because the oil price by then had settled down.
But a second leg to the recession would not be inevitable even were oil to go to $150 a barrel. For that to happen there would have to be something else, some other disruptive event. There are plenty of candidates for that, including a run on the dollar or a surge in long-term interest rates. But we know enough about what happens when oil goes to $150 a barrel to be reasonably confident that it would not stay there for too long. At that price, the world conserves like mad, as it did after the last peak in prices. You can see that in one simple indicator, the growing fuel efficiency of the vehicle fleet. More than 40 models of car on sale in the UK will, on official figures at least, do more than 70 mpg. We adapt. The "natural" price for oil, the one that it would seem to settle around, may be above $100 a barrel, but it is not $200 a barrel, that's for sure.
Still, expensive oil will be a constraint on growth everywhere and some calculations by Barclays are shown in the right-hand graph. If oil stays around $100 a barrel, the world loses less than a quarter of 1 per cent off this year's growth, but if it goes to $125 that rises to nearly half a percentage point, and if to $150 it goes to nearly three-quarters of a point. That would not of itself be enough to push the developed world back into recession but it would be a nasty shock.
And the Japanese catastrophe? We just don't know yet, and it seems almost indecent to start making financial calculations. What can perhaps be said is that this will be an additional financial burden on the world's most indebted country. The Kobe earthquake of January 1995 cost the equivalent of 2.5 per cent of the country's GDP and that would seem the best template to assess the impact of this disaster. The impact of the Kobe earthquake on output was quite limited as initial losses were more than offset by a large public-spending programme on reconstruction.
That will happen again. In addition, the Bank of Japan will pump liquidity into the banking system – measures are expected to be announced tomorrow. The difference between 1995 and now is that the overall indebtedness of the country was not really an issue then, whereas now it is. My instinct is that the additional debt burden will be acceptable: there is the overriding need for reconstruction and the costs will not be material in the totality of the Japanese debt problem. Nomura points out that the ratings agency, Moody's, has reported that the event is unlikely to affect the country's credit rating. But it will focus unwelcome attention on Japanese sovereign indebtedness more generally.
The blow also comes at a bad time. The Japanese economy had dipped back into recession during the final quarter of last year and the additional blow will hurt. It is possible that there will be two negative quarters, particularly adding in the impact from the higher oil prices noted above.
So while we know Japanese society will pull together following this disaster, as it always does, and while it should be said again that the human element of the catastrophe is much more important than any financial aspect, there is no disguising the fact that there are unfortunate economic consequences.
So an already uncertain period for us all has become yet more uncertain. We live in an interconnected world. While there are many positive elements to the global economy – we are still in the early stages of a cyclical upswing – there is no denying that this has been a difficult period in all sorts of ways and it will continue to be difficult in the weeks ahead.
In the land of make-believe, Mervyn King points a sensible way forward
Calls for fundamental reform of the world's financial system always have an element of make-believe about them. When officials and academics were debating the shortcomings of the Bretton Woods fixed exchange-rate system in the 1960s it never occurred to them that the system would reform itself. Fixed exchange rates were swept away in the 1970s by the financial markets and the world moved to floating rates. But the present system has led to huge imbalances, in particular between the US and the rest of the world, so it is by no means beyond criticism. Some of its failings were highlighted by Mervyn King in a speech at the Stanford Institute for Economic Policy Research on Friday. The thrust of his case is that the present system has led to these imbalances. As he put it, to "unsustainable paths for domestic demand, net debt and long-term real interest rates".
The authorities have managed to patch things (my expression, not his) but, as the Bank of England governor said: "Yet this extraordinary policy response has simply postponed much of the required adjustment in spending patterns around the world. And long-term real interest rates are unsustainably low." (Moral: Don't buy gilts.)
Fundamental reform will not happen, but we can make the present system work better. King called for "a grand bargain" between the countries of the G20:
*An agreed path for the reduction or increase of net exports;
*A framework for allowing real exchange rates to help unwind the imbalances;
*Rules under which countries would be able to limit short-term capital flows;
*Prudential policies to limit the build-up of imbalances; and
*Structural policies to raise savings in deficit countries and to cut them in surplus ones.
Is that too much to ask? Maybe. But this is a useful start to a hugely important conversation.Reuse content