CRUDE oil prices hit their highest level this week and there was not even a war. Speculators picked up on warnings of terrorist attacks in Saudi Arabia, the world’s biggest oil exporter; and Iran, one of the other big suppliers, is playing games of dare over moves to develop nuclear capability. These sound alarming risks but such forebodings are sadly routine in the Middle East.

Adjusting for inflation, oil prices are not really at their peak. They were markedly higher from 1979 to 1981. Oil cost roughly the same after the first oil shock in 1973-74, during the spike at the end of the 1980s after Iraq invaded Kuwait, and cost nearly as much in 1999.

This perspective does not bring much solace. On all four of those previous occasions, America, Britain or both suffered some kind of recession and the world economy slowed down. In 2000-01 the US recession was modest and UK output, along with that of China and other countries, continued to grow. But it was a bad time in the industrial world.

Can we escape a recession this time? According to the Organisation for Economic Cooperation and Development, a $10 per barrel change in the price of crude oil should affect the output of the world economy by about 0.6 per cent, other things being equal. Money is used more effectively in consumer countries than in producer nations so a shift in wealth from consumers also reduces total wealth. In April the IMF predicted that world output would grow by 4.3 per cent this year, down from 5.1 per cent.

This week’s updated forecasts from the Bank of England project UK output slowing below its 2.5 per cent trend this year but recovering into 2006 and 2007. Oil, it is argued, is no longer so important to Western economies, painful as high prices may be to distribution costs and to consumers. In America, it is calculated, oil is only half as important per unit of output as it was a generation ago.

Consumers and bond investors are not so sure. We remember the new economic paradigm propounded in the late 1990s. It held that breakthroughs in communications and digital technology had created such a shift in our potential to raise productivity that Western economies could continue to grow indefinitely at a brisk pace without running into the inflationary sand. In reality, a key reason for that decade of uninterrupted growth was that commodity prices, including most importantly the price of oil, remained strangely subdued. For that, we could probably thank the drastic decline of industrial production in the former Soviet empire after the communist system collapsed.

Once Western demand filled this gap, oil prices rose sharply. That certainly contributed to the wider inflationary fears that persuaded the US Federal Reserve to raise interest rates, finally bursting the dot-com bubble in stock markets.

Throughout industrial history, the leading commodity has played a role in economic cycles. Until the 1850s UK industrial fluctuations were closely linked with wheat harvests. Good harvests left consumers more to spend after buying bread. Bad harvests reduced industrial growth.

Money itself used to be a commodity because money supply was linked to the supply of gold. Big new gold finds brought inflation. More damagingly, the lack of sufficient new gold supply to back growth, particularly in America, was blamed for recessions and became one of the most contentious subjects of debate in American politics.

The more hopeful question today is which came first: the Western inflationary chicken or the oil price egg? Oil was the world’s most important commodity in the 1950s and 1960s but was produced and marketed at steady prices by competing integrated oil companies. Only when Opec countries nationalised oil production did it become a commodity priced by cartel decree and later by financial markets.

In 1973-74, although prices were quadrupled as a political act, they were actually catching up with inflation in the West. In 1979, when there was again an excessive shock rise, it came at the end of an inflationary boom. Inflation inspired the jump in oil prices. The oil shock killed the boom. Lesser price spikes in 1989 and 1999 came at the end of Western booms too.

Today there is no inflationary boom in the West. Far from it. Oil prices are spiralling mainly because the rapid growth of China’s economy, which is highly energy-intensive, has pushed global demand close to capacity. In these tight market conditions, speculators can exploit short-term fears of disruption to drive prices up.

Western central banks can afford to react calmly to the oil price surge, treating it as a factor depressing growth rather than as the last inflationary straw. It is China, which is already grappling with inflationary pressures in an economy enjoying extended rapid growth, that has most to fear.

graham.searjeant@thetimes.co.uk

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