Oil prices have been flirting with the $100 mark but the world economy chugs along despite this. What’s going on?
This is out of step with history. Previous oil shocks, in 1973, 1979 and 1990, sent large parts of the global economy reeling into recession. Oil prices have tripled in the past five years, yet the world has seen strong economic growth through this episode. Even now, the biggest threats to future growth emanate from the credit crisis in the West, China’s asset bubble, the collapse of the dollar—rather than from oil prices.
There are two main reasons why this oil shock has been benign. First, oil prices have been driven up in recent years by strong demand from countries such as India and China, rather than from sudden disruptions in supply. Lawrence Goldstein, an economist with the Energy Policy Research Foundation in the US, says this is the world’s first demand-led energy shock.
Previous episodes have been kicked off by supply shocks—when the oil exporters’ cartel squeezed output in 1973 and 1979, or when Saddam Hussein’s invasion of Kuwait in 1990 disrupted oil production in West Asia.
Why should it matter?
Supply shocks tend to be sudden, giving oil-importing economies little time to respond to the spike in energy prices. Prices rise at a gentler pace when they are pushed up by demand, giving the world time to respond. In more technical language, there is more time for relative prices to adjust. Economic disruptions are less likely.
The second big reason is that most economies today use less energy than before to produce one unit of their GDP. Since the mid-1970s, when the world first realized that the black gold lying under the hot sands of Arabia would not last forever, the energy intensity of economies has dropped.
There are many reasons for this decline. Public policy has frowned on lavish use of energy, from discouraging energy-wastage in production to better building rules. The shift away from manufacturing to services has helped, too. And higher oil prices, or even the threat of higher oil prices, have been an incentive for more fuel-efficient cars.
Each of these trends has lowered the amount of energy needed to produce one unit of GDP. Naturally, the risk to an economy from higher oil prices is far less than before.
India has not been an exception. Energy intensity has dropped from 0.30kgoe (kilogrammes of oil equivalent) per dollar of GDP in terms of purchasing power parity in 1972 to 0.19kgoe in 2003.
More needs to be done. Better rules on energy usage, including in office and residential buildings, are needed. Domestic oil prices should rise in tandem with global prices, since higher prices will be an incentive to use less energy. The current accounting fudge, where the government issues bonds to cover the losses of oil companies, will help nobody in the long run.
And to this can be added two requirements that are more relevant to India than to the West or China—better roads and investment in public transport. Traffic gridlocks in the major cities and along arterial highways mean higher energy consumption.
But does all this mean that economic growth has been totally delinked from energy usage? The ominous climb in global oil prices cannot be ignored—at some point, they will begin to pinch. But that point when we say ouch is further away than ever before. The ability of the economy to deal with oil shocks has improved dramatically.
India has slipped on previous oil slicks. There was a sharp drop in output and a steep rise in inflation after 1973, leading to political disruptions. The government had to go to the International Monetary Fund after 1979 and 1990.
This time, it’s different for a reason.
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