Oil-price spikes don't shock any more
First-hand experience with oil crises, and attempts to model them since, have shown the OIES' Chris Allsopp that high oil prices hold little danger for the world economy today. He explains to Simon Crompton
CHRIS ALLSOPP, director of the Oxford Institute of Energy Studies (OIES), never had any particular desire to get into energy. But it was thrust upon him. Having become an economics lecturer at Oxford University in 1967, he took a year out beginning in September 1973 to head the Economics Prospects Division of the OECD in Paris. For a while, things seemed to be running pretty smoothly.
Then, on 19 October, the Arab members of Opec established an oil embargo in reaction to the US supplying arms to Israel. By December, the oil price had quadrupled. In response, the US announced rationing of gasoline. Allsopp took over full control of the Division on 1 January 1974 and was given five days to work out what the OECD's macroeconomic response to the crisis should be.
His new job made him responsible for high-level briefings – particularly to the Economic Policy Committee – and more visibly was editor of the OECD's Economic Outlook. He co-ordinated forecasting across the entire OECD. But no one knew what to forecast.
"There was a suggestion at one point, I remember, that you couldn't possibly have an outsider doing this role given the absolutely extraordinary circumstances," says Allsopp. "But it turned out to be a very good thing, because none of the old rules applied and you needed to come up with entirely new models."
The Division failed to predict the economic collapse after the summer of 1974. That was understandable, given the unprecedented nature of the events and the "phoney period of calm" that existed for the first six months of the year. Indeed, Allsopp says that for him the only useful precedent for the collapse of the world's economy after Lehman Brothers went bankrupt in September 2008 was the oil crisis of 1974. The sense of shock was very similar.
He could have made a bit of money on it, too. "Back then, the share market halved in value and then, when it stopped falling, regained half of that fall in the space of a fortnight. When the market crashed after Lehman, I gladly told all my friends that it would jump by 50% again as soon as the fall stopped. It did, but a few things prevented me taking advantage. Liquidity constraints, I think they're called."
But back to the oil price. Three or four days into his crisis forecast for the OECD, Allsopp developed a model that presented the oil shock as a large, indirect tax. It was effectively a levy by the producing nations on the consuming ones. That should lead to an immediate deflationary effect, as prices rocketed and people bought less gasoline, then an inflationary one as prices fed through to wage demands and manufacturers put up prices elsewhere.
That standard economic model for a rise in taxation worked pretty well in the early 1970s, with the reaction to inflation exacerbating the resulting economic downturn. And after the 1979 oil-price crisis, caused by the Iranian revolution and subsequent Iran-Iraq war, the reaction was even greater.
Inflation had dogged the US since the 1973 oil-price spike, dropping only to 7.6% in 1978 from a high of 11.2%. So in 1980, Paul Volcker, chairman of the Federal Reserve, increased interest rates significantly – up to 14% at one point in 1981 and up again to 10% in 1982 as inflation refused to come down. It fell to 3.2% in 1983, but the policy caused the biggest US recession since the 1930s Great Depression, as well as a debt crisis in Latin America, and resulted in a decade of lost growth.
"Contrary to popular belief, Volcker wasn't a monetarist. The view at the time was just that you needed to cause a recession to disinflate America," says Allsopp. "I could give you chapter and verse on that folly, but I'll resist the urge."
In 2008, as the oil price hit $147 a barrel, economists expected a similar inflationary effect. Indeed, the reaction to inflation was more predictable than ever before, as many countries now had a specific inflation-targeting policy – such as that at the newly independent Bank of England. Allsopp had served on the Bank's Monetary Policy Committee from 2003 to 2006; by then established at the OIES, he was building a model for how energy prices and the economy interacted.
"The first thing we noticed this time around was that the inflation effect wasn't happening. The oil price was not feeding through to either other prices or wages," Allsopp remembers. The deflationary effect on consumption from higher prices also wasn't as pronounced because the producing countries – particularly in the Middle East – were more bound in to the global economy than they were in the 1970s. The extra revenue was more likely to be spent on western goods, compensating for lower domestic demand in the West.
One reason the spike didn't send inflation spiralling higher was the change in the labour market, where the diminished power of unions has reduced the role of wage bargaining. But the growth of low-cost manufacturers such as China and India is also important: with the pressure they put on prices, other producers are less able to pass through higher prices to consumers.
"The big lesson of this recession was that the world coped extraordinarily well with high oil prices," says Allsopp.
As a percentage of world GDP, the rise in oil prices to their 2008 peak was higher than any other. "People used to ask me, how big is an oil crisis? Well, there used to be a convenient answer: in both the previous crises the price change relative to GDP was about 3%, as was the counter-shock in 1986. But this one was more like 4.5%," says Allsopp.
But this crisis had little effect on the economy, beyond the extra revenue for oil companies and producing nations. This recession had far more to do with banking practices than with oil. "And the factors behind the de-linking from inflation aren't going away, so the impact of future oil price rises is likely to be smaller," says Allsopp. "The world can cope with oil shocks."