Slippery slope or economic lift?

Nov 20, 2001 01:00 AM

by Paul Krugman

The price of crude oil, which was around $ 30 per barrel earlier this year, plunged to as little as $ 17, with warnings that it could go still lower. Alas, it's all too likely that today's oil price plunge will set the stage for tomorrow's oil price surge, in a repeat of a cycle that has been a major source of world instability these past three decades. Intelligent policies could break this cycle, but actual US policies seem, if anything, likely to make the cycle worse.
The good news is that cheaper oil provides a significant boost to the US economy. The fall in oil prices transfers money at the rate of about $ 100 bn per year from Arab sheiks, Texas millionaires and other people who don't need the money to ordinary citizens. This will do far more for the economy than those giveaways to corporations and the wealthy that some politicians are trying to justify in the name of stimulus.

So what's not to like about cheap oil? For one thing, it may undermine some of the United States' shakier allies. Everyone now realizes that Saudi Arabia, with its growing debt and soaring population, is an Afghanistan waiting to happen; a falling oil price brings the day of reckoning that much closer. It's less widely realized that Russia also depends crucially on sales of oil and natural gas; the relative stability and prosperity since Vladimir Putin came to power have arguably been the product more of high oil prices than of his leadership skills.
Beyond this, an oil glut now can all too easily produce an oil crisis later. Economists used to talk about something called the "corn-hog cycle." Since 1970, the world has suffered from something similar, but involving oil and sports utility vehicles (SUVs) rather than maize and porkers. Call it the oil-hog cycle.

Start with a world awash in cheap oil, as in the early 1970s or early 1990s. This cheap oil encourages profligate consumption, including the purchase of gas-guzzling vehicles. As world demand for oil grows, the supply comes increasingly from the Persian Gulf, which has most of the world's oil reserves. At some point a handful of producing nations realize that they control the market's swing capacity and that if they cut their production, they can drive prices far higher. And they do.
High prices, though, eventually undermine the cartel's power. They are a drag on world growth, they lead to increased production in non-cartel countries, and sustained high oil prices lead to a lot of conservation. Oil consumption in the United States peaked in 1979, then, thanks to higher prices, declined more or less steadily until the dawn of the SUV era.
As demand shrinks and competing production rises, the cartel must follow its initial production cuts with further cuts, or watch the price of oil plunge again. Eventually, it can cut no more, and the world is once again awash in cheap oil, ready to begin another cycle.

And that's the stage we have now reached. The oil cartel, faced with declining demand, is no longer willing to reduceproduction as other producers, Russia in particular, expand their exports. So OPEC has made any further production cuts contingent on matching cuts elsewhere.
In effect, the cartel is demanding that Russia become a de facto member, much as Mexico did in 1998. If this game of chicken succeeds, prices will go back up again soon. If the game fails, prices will fall even further. Either way, the oil-hog cycle will eventually repeat itself.
If we were wise, we would try to break out of the loop. What would this involve? The most obvious thing is to prevent another dangerous surge in oil consumption. And it so happens that conservation policies would be politically easier to implement now than at any time in recent memory. We've just had a vivid reminder of the dangers of dependence on Middle East oil supplies.
All we need is some leadership. Will the Bush administration drop its fixation on drilling in the Arctic, which would produce too little oil, too late to make any difference, and realize that conservation isn't just a "sign of personal virtue" but a way to make the world more stable?

Paul Krugman is a columnist for The New York Times.

Source: New York Times
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