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Variations on a familiar theme Samuel Brittan: Financial Times 12/09/02 Any disruption of oil supplies would hit an already weak world economy and make policy even more difficult to formulate. Does anyone still remember the "Misery Index" - the sum of the unemployment and inflation rates? It was invented just after the first oil price crisis when the Yom Kippur war of 1973 put an end to the golden age of postwar prosperity. Hitherto it had been assumed inflation and unemployment were alternative dangers: the more you had of one, the less you had of the other. If mainstream economists had not been too proud to look at Latin America, or read Milton Friedman, they would have found the two evils could often coexist: that is, countries could have both high inflation and high unemployment. The first oil price explosion sent the Misery Index to unprecedented peaks. After falling in the later 1970s - but to nowhere near earlier levels - it exploded again with the second oil price spike triggered by the fall of the Shah of Persia. The Misery Index is, of course, crude. It gives too much weight to inflation compared with unemployment. In the past two decades the index has been historically low, with a tendency to fall. This is mainly because the world has entered an era of low single-digit inflation. But the index still has its uses. For instance it bumped up again at the time of the 1990 Gulf war. Indeed, it is a good generalisation that every significant setback to the world economy in the past three decades has been triggered by an oil price explosion, which in its turn was triggered by a Middle Eastern crisis. Could there be a further eruption associated with another war against Iraq? Karl Marx famously said that history repeats itself, initially as tragedy and then as farce. He did not say what would happen the fourth time round. The first oil price explosion introduced the western economies to that combination of inflation and recession known by the ugly word "stagflation". It has taken nearly 30 years for unemployment in the US and Britain to fall back to tolerably low levels; and in continental Europe it is still at dangerous highs. Although real growth took a hammering during all three oil price crises, the inflation performance was different. The average inflation rate in the Group of Seven highly industrialised countries rose from 4½ per cent in 1972 to 13 per cent in 1974. It then never went much below double-digit rates before exploding to 12c per cent in 1980. The inflation escalation associated with the the Gulf war was, however, very much less. But the cutback in world purchasing power was still sufficient to trigger a modest international recession. The Clinton campaign slogan of 1992, "It's the Economy, Stupid", could better have read: "It's the Oil Price, Stupid". What will happen this time round? One of the most systematic attempts to model the effects of a new disruption in oil supplies has been made by Goldman Sachs in its Global Economics Weekly of April 10, 2002. Its results are surprisingly reassuring. The authors analysed what they called a "supply disruption", in which the oil price rose temporarily to $45 a barrel in the last quarter of 2002 before falling back to $30 at the beginning of 2003 and falling still further as the year went on. Yet even in this simulation gross domestic product was reduced by only ¼ per cent in the main industrial countries and inflation rose by less than 1 per cent. For those who feared oil supplies might not resume that quickly in the event of a conflict, Goldman Sachs used an alternative method. This was to examine the effect of a sustained $10 rise. Multiply this by four to look at the scare scenario of a $70 oil price. Even then, GDP growth in industrial countries falls by only 1 per cent compared with what it would otherwise be and inflation rises by 2 percentage points. It is assumed in most simulations that whatever happens to other Middle Eastern oil producers, Saudi Arabia would prevent the oil price going through the roof. You may think so; but I would not bet on it. Even if the Saudi rulers wished to behave in this way, internal pressures might not allow them to do so. Of course, every oil crisis is different; and I would expect the next one to be more noteworthy for its recessionary than its inflationary tendencies. DeAnne Julius, a former member of the Bank of England's monetary policy committee, gave an eloquent warning of the dangers of world deflation last week. Her case was based on the existence of worldwide excess capacity in so many industries and also on the dismal growth prospect in the G7. Her argument was clinched by the low level of inflation from which we are starting - about 1 per cent for the G7 and about the same for the UK if the rate is measured by the harmonised inflation index. She explicitly warned that she was not taking into account factors such as "terrorist attacks or a Middle East invasion". Such events could reinforce her warning of stagnation or recession but, for a time at least, postpone the risks of deflation. This scenario would be even worse. Some financial institutions might be better off if recession were combined with inflation. But for the wider western economy there would be a further loss of purchasing power combined with a policy dilemma. It is important to prepare for contingencies - excluding appeasing Saddam Hussein. Should there be a second double-dip phase to the world recession, which threatens to become persistent, but without renewed inflation, the monetary authorities would need to pump spending power to try to get growth going at a sustainable rate. But should recession be combined with oil-price-induced inflation, the policy problem would be more subtle. The experience of previous oil shocks led to the conclusion that governments and central banks should "accommodate" a primary, oil-induced effect on the price level but sit firmly on attempts by unions or other economic agents to achieve catch-up pay and price increases. The difficulty this time would be that there are official inflation targets that could be breached. In that case they would have to be temporarily suspended to avoid a futile attempt to deflate other prices to offset what is happening to energy. In the early days of the MPC, Mervyn King, Bank of England deputy governor, believed (or hoped) that the "long-lost art of letter-writing" might be revived as a result of the Bank of England's obligation to write to the chancellor to explain deviations of inflation from the target range. One way or another, it looks as if his hopes may soon be realised.
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