This time round, it's an oil shock with a difference

Now the dynamics are different. The oil price rise is an inflationary shock hitting a deflationary world
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The Independent Online

Things creep up on you. Two or three weeks ago hardly anyone thought that this oil shock would prove as serious as the two previous versions, in 1973-74 and 1879-80. The world economy is now in better shape than it was then, Opec is less significant, the trend of inflation is down, not up and so on.

Things creep up on you. Two or three weeks ago hardly anyone thought that this oil shock would prove as serious as the two previous versions, in 1973-74 and 1879-80. The world economy is now in better shape than it was then, Opec is less significant, the trend of inflation is down, not up and so on.

There are a string of arguments you can advance to maintain that the likelihood of the oil price rise leading to another global recession is quite small. Those arguments still apply. Nevertheless, whereas even a couple of weeks ago the possibility of oil-induced global recession was largely ignored by the markets, now it is one of the main factors contributing to their current unease.

So how big is the danger? The best study of the impact of the oil price rise that I have seen comes in the current issue of the International Bank Credit Analyst. This is one of a stable of newsletters and research papers produced by an investment research group based in Montreal. The seven main conclusions of its paper are as follows.

One: the current oil shock is about two-thirds the size of the 1973-74 one, but were the oil price to rise to about $45 a barrel the shock would be similar.

Two: global growth will slow but recession will only become likely if oil stays in the mid-$40s range.

Three: the biggest loser is South -East Asia, where risks of a mild recession are already high.

Four: the biggest impact will beon profits, not inflation.

Five: the euro's weakness is consistent with the rise in oil prices, but the yen's strength is not.

Six: the oil shock is negative for world equity markets because of the impact on growth and profits.

And finally: since much of the oil price rise is already allowed for by the markets, once the price stop rising markets could do very well.

The graph shows some of the thinking behind these conclusions. The oil price is now back to the level of the 1980-85 period in absolute terms. Incidentally, next time you hear a government minister blaming the rise in the price of petrol on the oil price, you might like to note that the price of crude is still no higher than it was nearly 20 years ago, when the price of petrol was half its present level.

But the oil price has not been up in the $30 plus region for very long and world GDP is much higher now than it was in the early 1980s. The other line on the graph shows what the world spends on crude oil as a percentage of GDP. Last year it was tiny: about 1 per cent, much as it was in the early 1970s and nothing like the 6 per cent it was in 1982-83.

Now look at those three projections on the right hand side. If oil goes back to $28 the rise is line C; if it stays where it is now, the rise is line B; and if it goes to $45, it becomes line A. The jump in line A is similar to the jump in 1973-74 right over on the other side of the chart.

Other calculations have been made about the impact of the oil price rise so far both by commercial forecasters and by official ones like the IMF. The general judgement seems to have been that what has happened so far is likely to knock around half a percentage point off global growth next year. But that is not too much of a worry if the underlying growth rate is 4 per cent or more.

What that sort of calculation cannot do, though, is to capture the dynamics of a shock. There are two important differences now from the situation in the early 1970s. One is the inflationary/deflationary balance; the other the present state of currency blocs.

In the 1970s the oil price rise fed into the general inflationary situation, giving a further twist to the upward inflationary spiral. It did not cause the great global inflation, but it increased the cost of fighting that inflation. Now the dynamics are different. The oil price rise is an inflationary shock hitting a deflationary world. So it is much harder for companies to pass on the higher costs of energy by upping their prices - look at consumer resistance to higher petrol prices. In addition companies have a new technology available as a result of the communications revolution that enables them to make massive increases in efficiency. So while the rise in the oil price puts pressure on firms to crunch down all their costs, rather in the same way that any such squeeze (say from a strong exchange rate) would do, it comes at a time when they ought to be able to claw a lot of the costs back.

But not all companies and not all countries are equally affected. The region most affected is East Asia because it is relatively short of oil itself and because it has been experiencing high growth rates. Nevertheless some countries in the region, such as Malaysia, are significant producers and will gain growth; others, like Taiwan and Thailand, seem particularly exposed. The region as a whole is only just recovering from regional weakness of three years ago. The balance sheets of many companies and some banks are still weak. The danger is that there could be some sort of re-run of the domino effect of recent memory.

The other dynamic that is quite different is the state of currencies. At the time of the 1973-74 oil shock the world was adjusting to floating exchange rates. following the final collapse of the Bretton Woods fixed exchange rate system in 1972. Floating rates enabled the world to accommodate the shock, albeit at the cost of inflation. It could, so to speak, roll with the punches.

Now we have reinstated a fixed exchange rate system in the shape of the eurozone. True the big European oil producers, Norway and the UK, are outside the zone, but there are still differential effects. Some countries are more affected than others. Meanwhile, Europe as a whole may be more disadvantaged than North America. We simply don't know how large the oil shock is in relation to the other difficulties of Europe, but it does, so to speak, knock the currency when it is already down. High oil prices may be particularly bad for the euro.

It is these dynamics that raise the stakes. The basic calculation that the world economy ought to be OK with the oil price at $35 a barrel is still valid. But there are big risks and those risks increase every day. Keep fingers crossed.

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