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October 17, 2003

Economists put the skids under theory linking oil and inflation

By Alan Beattie
Financial Times
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The 1973 oil shock occupies a prominent place in the demonology of modern macroeconomics.

As the popular view goes, the quadrupling of oil prices and its aftermath plunged industrialised nations into an era of soaring inflation and low and volatile growth, introducing a new concept - stagflation - to common economic discourse.

It destroyed the deceptively stable postwar pattern where governments tried to buy a little more growth with a little more inflation, instead entrenching price stability as their primary concern. Within a decade it had contributed to a profound conservative shift in the political and economic centre of gravity, most notable in the US and UK.

Since then, rises in oil prices have aroused trepidation among economists. But it is doubtful that conditions now could replicate the years of turmoil that followed the 1973 decision.

Indeed, some economists argue that the popular view has the direction of causation wrong: that it was the inflationary environment at the time, not the political machinations within Opec, that made the oil shock so damaging.

Robert Barsky and Lutz Kilian, both academics at the University of Michigan, have argued that the oil shock was a consequence, not a cause, of rising inflationary pressure. In a famous academic paper which attempted to overturn accepted wisdom, they noted that money supply and the prices of many non-oil commodities were already rising sharply in the early 1970s.

According to this argument it was an overheating global economy and the failure of governments and central banks to control inflation - rather than the politics of the Arab world - that created excess demand for oil and allowed Opec to make its 1973 price rises stick.

"The apparent success of Opec oil producers in raising prices in the 1970s, and their failure to raise prices for sustained periods at other times, is no historical accident," the authors concluded. It was, they say, "driven in substantial part by global macroeconomic conditions".

Optimists say that even if a quadrupling of oil prices could be engineered today, the global economy could absorb the increase by prices falling elsewhere, without necessarily setting off an inflationary spiral. "One key difference between now and the 1970s is the level of background inflation and the credibility of central banks," says George Magnus, chief economist at UBS Warburg.

A study by three IMF economists concluded that the fact that oil price rises did not translate into big increases in core inflation during the 1980s and 1990s - the era when policymakers had apparently learned the lessons of the 1970s - merely reflected that those price rises were generally very short-lived. But this, too, could simply reflect the fact that, in a lower-inflation environment, oil producers find it harder to make price increases stick for long.

"Despite the mechanical impact of oil prices on higher consumer price inflation, the immediate reaction of most central banks to another oil shock now would be to worry about the demand-restraining deflationary impact, not the inflation-boosting impact," Mr Magnus says.

Even if the inflationary impact was muted, the real economy would still suffer, because an increase in the price of a basic input with imperfect substitutes would eat into real profits and wages for oil-importing countries.

The US Federal Reserve took the unusual step of publicly signalling its alarm about the effect of oil prices on growth earlier this year.

But even this is likely to cause less disruption than previously. The US Department of Energy estimates that energy use per real dollar of US gross domestic product has halved since 1970, as advanced economies have shifted from energy- intensive heavy manufac- turing to lighter service industries.

Some economists, such as Andrew Oswald at Warwick University, say this is misleading, and that the important factor is that oil use per head has risen. But most economists think that lower energy intensity makes the global economy less susceptible to shocks to oil supply.

The ability of the global economy to ride out an oil shock equivalent to that of 1973 has yet to be tested. If the optimists are right, it may never have to.

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