Stephen King: Oil prices are rising fast and it's come at the worst possible time for the West

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The Independent Online

Outlook In 2008, oil prices approached $150 per barrel. Shortly afterwards, the global economy collapsed. There were, of course, other problems at the time – an imploding US housing market, the beginnings of a securitisation crisis, the collapse of Lehman Brothers – but events three years ago nevertheless offer plenty of evidence that substantial changes in oil prices are big news for the global economy.

Indeed, for those who believe the global economy is ultimately fuelled by oil and gas (as opposed to, for example, excessive credit), events in 2008 simply confirmed a pattern seemingly in place since the 1970s. Regular as clockwork, increases in oil prices of more than 100 per cent (adjusted for inflation) lead to declining US GDP.

Fortunately, we're not quite there this time around: oil prices would have to rise to $150 per barrel – a return to their 2008 peak – to have doubled in real terms. But there are warning signs around for investors to feel a touch edgy.

There are some (modest) exceptions to the 100 per cent rule of thumb: the 2008/09 recession (which merely supports the idea that oil was not the only, nor indeed the main, influence on events at the time), the 1991 recession (which was probably more affected by the credit crunch than by the temporary spike in oil prices following Iraq's invasion of Kuwait), and the 1987 experience, when real oil prices did indeed double but there was no recession. That doubling came from a very low level (oil prices had collapsed in 1986) and, although recession was avoided, a stock market crash wasn't. For those around at the time, memories of October 1987 are enough to make the blood run cold.

But what of today's situation? An obvious problem lies in working out why oil prices are so high.

Late last year, oil prices seemed to be rising for two main reasons. First, the Federal Reserve and other central banks in the developed world were pursuing unconventional policies – widely seen as an abuse of the printing press – in an attempt to kick-start economic activity. As a hedge against all this "monetary madness", dollars were converted into "real" stores of value, leading to significantly higher commodity prices. Second, because the effects of quantitative easing were felt more acutely in the debt-lite emerging world than in the debt-heavy developed world, global growth became more oil-intensive: oil consumption as a share of GDP is much higher in the emerging world than in the developed world.

Now, however, the story has switched from demand to supply. While Tunisia and Egypt hold little relevance for the global oil market, Libya is a different kettle of fish. It is by no means the biggest oil producer in the world – that accolade belongs to the Russian Federation and to Saudi Arabia – but it still accounts for around 2 per cent of total output. If the Libyan oil taps were turned off, either oil output would need to come from somewhere else or, instead, oil prices would have to rise.

Saudi production should be flexible enough to make up for any Libyan loss (indeed, there has already been an increase in production over the last two months and there are plenty of estimates suggesting that Saudi oil capacity has risen further over the last couple of years). Yet even Saudi Arabia might struggle to make up for any shortfall should political upheavals spread to other major oil producing nations in the Middle East. Oil prices are high not just because of current supply disruption but also because of the fear that things could get a whole lot worse.

Wherever oil prices eventually end up, it's possible to tease out some of the more important economic effects. For any given shift in oil prices, there are immediate winners and losers. Net oil producers and exporters (Russia and the Middle East) gain while net oil consumers and importers (Europe and the US) lose out. There is a straight-forward redistribution of income.

If the story ended there, we could all go back to sleep. But it doesn't. For global demand, what matters more than anything else is the marginal propensity to spend of oil producing nations relative to oil consuming nations. Typically, that's a lot higher for oil consuming nations (compare, for example, the balance of payments position of the US with Saudi Arabia). A big increase in oil prices is, thus, likely to dampen global demand.

Then there's the issue of so-called second round effects. Higher oil prices can easily damage business and consumer confidence. As a result, activity weakens even further.

In theory, a lower level of demand should be sufficient to stop any initial pick-up in inflation in its tracks. But there are two additional worries.

First, there's uncertainty about an economy's supply potential. If a country's capital stock was installed on the basis that oil prices would average, say, $50 per barrel in future years but oil prices then doubled, at least some of that capital stock would now be loss-making and, thus, be scrapped.

Second, might higher prices lead to higher wages? At the moment, this seems like a bigger risk for the emerging world than for the developed world but there are plenty of Western policymakers now becoming increasingly nervous. Most obviously, three members of the Bank of England's Monetary Policy Committee (MPC) are now in favour of rate hikes, reflecting worries over wage growth and rising inflationary expectations.

Of course, an easy way to smooth over the effects of higher oil prices is either to offer an offsetting tax cut or, alternatively, to subsidise the price of oil and other energy products (in reality, subsidies are simply negative taxes). By doing so, inflationary pressures can be masked and real incomes can, for a while at least, be preserved.

The ability of countries to offer fiscal solace, however, depends critically on the fiscal starting point. Whereas most countries in the developed world have very little room to manoeuvre – a legacy of the financial crisis – the position for many emerging nations is a whole lot better.

Another "buffer" could potentially come from credit markets. A world of well-functioning credit markets should allow households to smooth their expenditures in the light of temporary disruptions to income. The same might be said of companies too. If, then, a rise in oil prices is regarded as temporary, households and companies may carry on spending.

But what happens in a world where households think they've borrowed too much and are keen to repay debt? What happens if banks have become risk averse for other reasons, are constrained by regulatory uncertainty or are facing a funding constraint? What happens, in other words, if the financial system is convalescing after the biggest financial crisis in living memory? In these circumstances, credit markets will not easily be able to do their traditional job and, as a result, a temporary dip in income may lead to a much bigger drop in spending.

The big worry for the developed world today ultimately relates to the combination of inflexible fiscal policy and poorly functioning credit. Add to this a growing desire on behalf of central bankers to regain credibility via higher interest rates and we may not be far off a perfect storm. On all measures of the real and financial economy – money supply, output gaps, labour market – there is no obvious case for raising interest rates. If they do eventually go up – reflecting a dose of the jitters within the central banking community – the flexibility of developed economies in the light of a global shock would be reduced still further. Put this way, higher oil prices have occurred at the worst possible time.

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