Sept 29, 2000 Global: Impact of an Oil Shock Stephen Roach (New York)

Its tempting to dismiss the global impacts of an oil shock. After all, in one respect, such a disruption is nothing more than a zero-sum game -- a transfer of income from oil consumers to producers. Yet the record of history argues very much to the contrary. Each of the previous three oil shocks -- 1973, 1979, and 1990 -- actually triggered global recessions. Why dont the pluses outweigh the minuses as the zero-sum logic suggests?

There are three channels through which an oil shock can adversely impact the global economy. The first hinges on the so-called recycling of the oil dividend. The negative impact on the oil-consuming portion of the world economy is straight-forward: The shift in relative prices that an oil shock triggers is the functional equivalent of a tax increase -- it siphons purchasing power away from non-energy discretionary items. Consumers and businesses alike are forced to cut back on aggregate demand, an outcome that crimps GDP growth. A standard rule of thumb developed by OECD researchers places the magnitude of such an impact at about -0.25 percentage point of GDP growth in the industrial world for each $10 hike in the oil price.

But what about the offset from the incremental proceeds accruing to oil producers? The issue, in this instance, is the ultimate disposition of those proceeds by oil producers -- whether they show up in the form of increased imports from the rest of the world, a paydown of debt, or new flows into financial assets. As I see it, the larger the oil shock, the smaller the share of the proceeds from such a windfall that oil producers are likely to direct toward real imports. In any case, it seems quite unlikely that any oil-led import gains in the relatively small energy-producing complex can outweigh the negative impacts hitting oil consumers. According to the IMF, fuel-based exporters account for just 3.3% of total world GDP -- a relatively small slice of the world that is lacking in the scale, or import capacity, that could absorb the full proceeds of an outsized oil shock.

However, to the extent that oil dividends are not recycled into imports, the balance would then show up in financial markets. The potential of this latter effect is huge. Stephen Li Jen, our currency economist, has estimated that under the admittedly extreme assumption that oil prices hold in the $40 to $50 range, OPEC could earn as much as $400 billion of petrodollars annually, almost twice Asias current account surplus. Under this same scenario, Saudi Arabias current account surplus would eventually exceed that of Japan. Of course, the impacts of a small oil price increase would be far less extreme. In that case, I believe that a larger portion of the impact would be skewed toward the real economy via the import channel, thereby minimizing the "leakage" into financial markets. The smaller these leakages, the closer the global outcome is to a zero-sum result.

But theres more to the impacts of an oil shock than the arithmetic of recycling. A second channel of transmission is the "uncertainty factor" -- the impacts that heightened volatility in the oil price have on expectations of future growth in consumer incomes and business profitability. If this volatility factor widens, the hurdle rate on long duration assets will be raised -- thereby crimping demand for consumer durables and business capital spending. That, in fact, is exactly what happened during the first two OPEC shocks on the 1970s. Moreover, such heightened uncertainty could also raise risk aversion in financial markets, pushing asset allocators into defensive equities and sovereign bonds.

A third avenue by which an oil price shock can impact the global economy is through the response of monetary and fiscal authorities. The risk of a policy blunder in response to an oil shock is hardly trivial. The actions of world central banks in the 1970s are particularly noteworthy in this regard -- with monetary policies that remained far too accommodative in the face of rising inflationary expectations. Could similar blunders occur today?

Unfortunately, I wouldnt altogether rule them out. For example, fixated on a battered euro, the ECB could well tighten monetary policy further at precisely the point when the Euroland economy is already slowing; such excessive tightening could reinforce the downside risks to Euroland growth, raising the possibility of recession. Moreover, the authorities efforts to overtly manage the oil price are disconcerting, to say the least; Americas release of oil from its Strategic Petroleum Reserves is especially worrisome, as is the French capitulation to the protest of its truckers. Similarly, whos to say that the US fiscal authorities wouldnt opt for a quick-fix tax cut to temper the adverse impacts of an energy shock? Yet the impacts of any such action would likely occur after the oil price has come down and the economy is reaccelerating. To the extent that such fiscal relief reinforces the renewed vigor of a fully-employed economy, inflation risks could well intensify -- underscoring the possibility of a boom-bust scenario like that in the 1970s.

History does not look kindly on the view that an oil shock is a non-event for the global economy. Such a disruption rarely happens in isolation from other factors that also put pressure on the macro climate. In that important respect, todays circumstances are strikingly reminiscent of past. The Fed and the ECB have both engineered significant monetary tightenings over the past 15 months. The lagged impacts of those moves are only just beginning to play out. My biggest worry for the world economy is that the oil shock could well act to reinforce those downside risks at precisely the wrong point in the global business cycle. My greatest concern for world financial markets is that an oil shock is inherently stagflationary -- it both cuts output and increases inflation. Many of todays investors were still in diapers during the great stagflation of the 1970s. Those who werent will never forget the darkest period in modern financial market history. It was as far from a zero-sum outcome as you could ever imagine.

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-- Martin Thompson (mthom1927@aol.com), September 29, 2000