Both in nominal and real terms, the scenario at first sight resembles the oil crises of the 1970s, provoking similar fears about the health of the world economy. The impression is misleading.
The 1970s were a time of high inflationary pressures in the US, and falling real gross domestic product (GDP) growth; 2000-06 has seen exactly the opposite in the American economy: positive GDP growth and low inflation.
Too little attention is paid to such vital underlying factors, as if the change in the oil price was the only relevant consideration. The reasons for oil price changes vary widely, and deliver quite different dynamics.
The price increases of the 1970s were mainly the result of OPEC deliberately reducing its oil supplies and war in the Middle East. The consequent increase in US production costs in turn drove up price and wage inflation, and reduced real wages and GDP.
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The situation today is less straight-forward. World oil consumption in the first half of this decade increased by more than 8%, despite even the inflation-adjusted price of oil more than doubling. The clear implication is that demand, not supply, was the driving force behind the sharp increase in prices.
These days non-members of the Organisation of Economic Co-operation and Development (OECD) account for more than 40% of world oil consumption, with China alone absorbing 8%. The production boom in these countries drove most of the 2000-06 increase in consumption. China’s consumption rose 40% in that period.
At the same time, the proportion of US imports from China doubled, from 8% to 16%. So in contrast to the 1970s, US consumers have been able to buy more and cheaper goods, which has held down prices and moderated the inflationary pressures of rising oil prices.
Indeed, depending on the proportion of goods being imported, consumer price index (CPI) inflation may actually fall and real wages rise. Moreover, as non-OECD countries become wealthier, their demand for imports will increase as well, which in turn has a positive effect on GDP growth.
In other words, not all oil shocks are the same, and their overall effect will depend on our relative openness to these other economies. In theory, powerful increases in oil prices can co-exist with low inflation, and with positive and sustained GDP growth.
The US experience in 2000-05 suggests that this is not just a theoretical possibility but the reality. To understand whether we are on the brink of a 1970s-style recession we need to disentangle the real reasons for oil prices at $100 a barrel and rising. Only then will it be clear how the US Federal Reserve Bank, or the European Union, should react – if at all.