Stephen King: Oil price surge has avoided inflation but it's not all good news for Western workers

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Bob works for Jill. Both of them buy their food from Frank. Sharon arrives on the scene and also wants food. Frank reluctantly has to raise his prices. Bob and Jill are worse off. Frank is better off. He lends his money to Bob and Jill. They now have higher debts but they can carry on spending. Bob doesn't need to ask Jill for a pay rise. Facing higher food prices, Jill wants to rebuild her profits. She makes Bob redundant and, instead, employs Sharon who is willing to work for a lower wage than Bob. Bob now has too much debt and no income: he stops spending. Jill has to cut her prices. The central bank decides to lower interest rates.

Just in case you're wondering whether I'm turning into the economists' version of the Brothers Grimm, I have no intention of taking these nursery tales much further. They suggest, though, that the effect of a simple increase in food prices can vary depending on, first, what the food producer does with the extra income; second, how much competition there is for labour among the food consumers; and third, how the central bank reacts to the signals coming from the economy more broadly.

All of this is also relevant for oil. Bob is your average Western worker. In the early 1970s Bob might have been tapping his feet to the latest offering from T-Rex or, feeling a little more experimental, to Bowie during his androgynous phase. He probably worked for British Leyland. Today's Bob sells insurance from a call centre. Unlike his 1970s counterpart, he has no union membership. To his friends, he's a big U2 fan but, secretly, he quite likes Scissor Sisters.

Jill, meanwhile, could be one of a number of companies. Sharon is my collective term for China and India. Frank is Opec, or oil-producing nations more broadly, and Frank's mattress is long gone: oil-producing nations these days convert their extra profits into holdings of foreign assets - in other words, loans to others - typically in the form of Treasuries and other liquid US dollar paper.

My two stories help explain why, this time around, we haven't seen the sorts of effects stemming from an oil price shock that we saw in the 1970s. Among the more obvious differences is the lack of inflation. In 1973 and 1974, inflation surged as oil prices went up: in the UK, for example, inflation peaked at 26.9 per cent. This time around, inflation has hardly shifted. While it's true that headline inflation has gone up, there is little evidence to suggest either that "core" inflation (excluding food and energy and, in some cases, tobacco and alcohol) has gone up or that wages have accelerated.

The table shows headline and core inflation rates at the beginning of this year and in the latest available month for a group of major industrialised countries. Looking at the numbers, you would never know that there had been a surge in oil prices. Core inflation has been stable in the US, has risen only gently in the UK and, remarkably enough, has actually fallen in the eurozone. Meanwhile, wage increases have been subdued. In the UK, average earnings growth (including bonuses) is running at 4.2 per cent, below the rate the Bank of England regards as being consistent with its inflation objective. In Germany, many workers were forced to accept wage cuts last year despite higher oil prices: the alternative of outsourcing to Poland or China was a lot less attractive (Bob preferred to keep his job, much to Sharon's chagrin).

The 1973 oil price shock came at a time when Western workers were often members of labour monopolies. Unions were able to withdraw their labour whenever they felt like it. With governments supposedly guaranteeing full employment and with a broad absence of monetary policy credibility following the collapse of the Bretton Woods exchange rate system, the unions' strategy wasn't so daft: their members benefited at the expense of all those living on fixed incomes who would become worse off through higher inflation.

We will never see another oil price shock quite like 1973. Central banks have a lot of credibility so people no longer expect inflation-busting pay increases. Unions no longer enjoy the powers they once had. Regulations on what unions can do are a lot tougher. More importantly, capital is more mobile. It simply isn't possible for unions to create monopolies: even if they succeeded on a national scale, competition for jobs now comes from foreign climes (although, with mobile capital, not necessarily from foreign companies).

Remove the inflationary element from an oil price shock and what are you left with? The simple answer is a redistribution of income from oil consumers towards oil producers through changes in the terms of trade. Oil consumers, other things equal, are worse off and oil producers are better off. But, within oil-consuming nations, capital and labour may have differing experiences. So long as capital is potentially mobile, profits are likely to rise relative to wages. That's exactly what we've seen in recent years. Real wages have been squeezed in many countries - they've been flat or declining in the US and Germany - yet profits as a share of GDP have been rocketing skywards. There can be no doubt that the combination of new technologies and plenty of Sharons has made a significant difference.

How will workers react? Real wages may have been squeezed but, in the US at least, consumers have happily carried on spending. They've been helped by an environment of very low interest rates. Even though the Federal Reserve has been raising short-term interest rates, inflationary expectations still seem to be under control, leaving long-term interest rates very stable at a little more than 4 per cent. But low long-term interest rates aren't just a result of anti-inflation credibility. They're also a reflection of the recycling of oil producers' windfall gains: whether it's Russia's huge increase in foreign exchange reserves, or the rapid gains in current account surpluses in the Middle East (see chart) extra cash has been reinvested in Western assets, leaving prices higher and yields lower. No longer do oil producers stuff their gains under the mattress.

This recycling has kept US consumers spending. The household saving ratio has tumbled this year, helped along by persistently low long-term interest rates. But will consumer largesse continue? The Permanent Income Hypothesis provides some clues. Milton Friedman argued that consumers would happily spend so long as they believed, first, that the nasty shock to their incomes was transitory and, second, that they had decent access to capital markets. In the 1970s, the Opec mattress smothered the second of these conditions. The more likely danger today is that consumers eventually realise that the rise in oil prices is a permanent change in the economic landscape, a reflection of Sharon's economic success. When that happens, the incentive to borrow more will fade: and, with it, so will the prospects for Bob's living standards in the years ahead.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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