Do high oil prices really damage the world economy?

Oct 15, 2004 02:00 AM

by Richard Dean

US President George W. Bush never tires of complaining about the damage that high oil prices cause to the global economy. Privately, he is in constant talks with Saudi Arabia, pressuring the world's biggest oil exporter to raise production in a bid to lower prices. And with crude hovering close to $ 50 per barrel throughout much of 2004 -- double its historic average -- his comments have never been more forceful.
But are his complaints really justified? Do high oil prices really stifle global economic growth? Or is the president simply worried that high gasoline prices at US pumps in an election year will hurt his chances of winning a second term in the White House?

First, the evidence supporting the argument that high oil prices hurt the global economy. Most economists agree that oil prices do indeed have an impact on the global economy. They may disagree about the extent -- and the nature -- of the impact, but there is broad consensus that high oil prices do leave their mark.
How does this happen? In a number of ways. First, high crude prices drive up domestic fuel prices and, by extension, depress consumer spending and business investment. If consumers are spending more money filling up their cars and paying their heating bills, they have less money left over for everything from washing machines to haircuts.

A recent study by the Maguire Energy Institute in the US forecast that US gasoline (petrol) prices will average up to $ 2 a gallon in 2004, up from a 2003 average price of $ 1.57 and a 2002 average of $ 1.40. For an average American family that drives two cars approximately 15,000 miles a year, that amounts to an extra $ 650 in gasoline costs this year. That means $ 650 less to spend on everything else. Add on an average, $ 100 or so more on heating and air-conditioning bills, and the figure becomes significant for the majority families with limited disposable income.
"The reality is the vast majority of Americans are middle or lower income, and they consume most of the stuff -- and they're really being creamed by higher gas prices," says Susan Fulton, a principal of US investment management firm WealthTrust.

Similarly, if companies are paying high fuel bills, they have less money left over for investment. Indeed, businesses are hit doubly hard, because many of the raw materials they use are oil-based. For example, plastic is made from petrochemicals, the price of which is directly linked to crude prices. And remember that these higher costs come at a time when consumers are spending less at cash tills because they've got less money left over after paying their fuel bills. Companies are hit on the revenue and expenditure sides.
A recent study by Royal Bank of Scotland (RBS) in the UK analysed this impact on the UK economy, the world's fourth largest. It found that some sectors will be hit harder than others.

"For some sectors, of course, the negative effects of high oil prices would be more concentrated. In the short run, our analysis suggests that, as household spending slows in response to the drag on incomes from higher energy prices, the hardest-hit sectors would be service and consumer-facing industries -- particularly where spending is discretionary," RBS highlights electronics, automotive and travel services as particularly vulnerable.
"In the longer term, sectors most adversely affected would be those that are most reliant on oil as an input to their production processes." Utilities, transport services and agriculture are among the most exposed to this effect.

Inflation is also hit by high oil prices. Directly, energy costs make up a significant portion of any basket of consumer prices, sending inflation higher. Indirectly, companies pass on higher energy and raw materials costs through higher prices for finished products ranging from cars to carrier bags. In the 1970s, the sharp spike in oil prices following the 1973 Arab oil embargo was one of the main causes of rampant inflation that saw the global economy stagnate for the best part of a decade.
A recent study by the Energy Information Administration (IEA) and the International Monetary Fund quantified this impact. It found that a sustained $ 10 per barrel increase in oil prices from $ 25 to $ 35 would result in the OECD (the world's advanced economies) as a whole losing 0.4 % of GDP in the first and second years of higher prices. Inflation would rise by half a percentage point and unemployment would also increase.

This twin impact -- weaker growth and higher inflation -- presents policymakers with a headache. To stimulate growth, they want to cut interest rates. But to head off inflation, they want to raise interest rates. This leads to a conflict for the likes of Alan Greenspan, head of the US Federal Reserve and the man charged with setting interest rates in the US.
As OER went to press in late September, Greenspan was poised to reveal the new US interest rate. Most economists felt he would raise rates from 1.5 to 1.75 % -- effectively, they feel the main worry is inflation rather than slow growth. Either way, Greenspan admits that high oil prices are one of the main threats to the US economy at the moment.
"If it weren't for the oil price spike, I would be very optimistic about where the economy is going," he said on September 8.

What about the evidence that supports the counter-argument -- that high oil prices do not harm the global economy? Certainly, high oil prices are not nearly as harmful as they were in the 1970s.
"The major industrialised economies are much less dependent on oil than they were in the early 1980s, reducing the impact of oil price shocks overall compared with the past," says the report by RBS. "Net oil imports now account for only 1 % of OECD GDP, compared with around 3 % in the 1970s. This reflects both improved energy efficiency and a shift away from energy-intensive industrial production towards service-sector activities."

However, this does not mean Bush's fears for the global economy are unfounded. Nor are they selfish domestic concernsthinly disguised as global concerns. Yes, the US is the world's biggest energy consumer. But a series of studies, including those by the IEA and RBS, show that the US is among the least vulnerable to high oil prices.
"Euro-zone countries, which are highly dependent on oil imports, would suffer most in the short term, their GDP dropping by 0.5 % and inflation rising by 0.5 % in 2004," says the IEA. "The US would suffer the least, with GDP falling by 0.3 %, largely because indigenous production meets a bigger share of its oil needs. Japan's GDP would fall 0.4 %, with its relatively low oil intensity compensating to some extent for its almost total dependence on imported oil."

Research by the IEA must be treated with some caution. It is funded by the OECD, the club of the world's major industrialised nations, including the US. As such, some questions may be raised about bias in its findings (although most within the industry do regard it as a credible organisation with a reasonable degree of independence).
RBS, by contrast, is a privately owned bank and, therefore, has no political allegiance. Significantly, RBS economists came to similar conclusions as those at the IEA -- that the countries suffering most from high oil prices are not heavyweights such as the US and UK, but developing countries.

"Oil-importing developing countries tend to be worst affected as they are more dependent on oil-intensive manufacturing activities, which partly explains the large negative impact on China's GDP growth, and are less energy efficient," says RBS. "Furthermore, their access to global capital markets (to smooth oil consumption by borrowing) is more restricted."
Clearly, George W. Bush does have his own personal agenda when it comes to oil price policy. Which politician does not? But on this occasion, it seems his complaints about the painful impact of high oil prices on the global economy are based on hard facts, not electoral necessity.

The author is director of Middle East Analysis, a Dubai-based economic consultancy.

Source: Oman Economic Review
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