AN OIL shock as bad as that of the Seventies. This was how Gordon Brown depicted the troubles facing the global economy as he explained on Friday why he is about to stage an embarrassing climbdown over his rose-tinted economic forecasts.
In Washington for the annual meetings of the International Monetary Fund and World Bank, the Chancellor put a brave face on his retreat. But exploitation of the bad news from the black stuff must have had pretty uncomfortable resonances for the man who will soon become Labour’s new leader.
Grim Seventies-style images of oil shocks, soaring inflation, faltering growth, and that period’s failed chancellorships — all against a backdrop of the IMF — can hardly recall Labour’s glory days for the Prime Minister-in-waiting. This is not the mood music he would choose as he prepares to rally Labour’s activists to an impending Brown premiership at the party’s conference this week.
Soaring oil is, though, a handy excuse for Mr Brown’s failed forecasts and overoptimism. It resonates with the public, with its folk memories of Seventies traumas. The economic reality, however, is a little different. No one but the Chancellor ever saw his claims that the economy could grow by 3 per cent to 3.5 per cent this year as at all plausible.
It has been clear since last year that this was unachievable. Oil has certainly played a part. But the steepest of the gains in crude costs have come relatively recently, halfway through the year. Compared with Mr Brown’s March Budget forecasts (he expected oil prices to average $40 a barrel) the Treasury’s rules of thumb suggest that the rise to $65 or so now should mean perhaps 0.6 to 0.7 percentage points off growth. Yet the likely outcome for growth this year, as little as 2 per cent, is as much as 1.5 points less than the Chancellor projected.
Treasury officials admit that the housing downturn, and its impact on consumer spending and higher interest rates, have played a part, too. But it is on to oil and Opec’s sheikhs that the Chancellor hopes to deflect the biggest share of the blame.
It is worth recording here that Mr Brown says that the Treasury doesn’t see much net effect from record oil prices on the nation’s finances. So if the IMF is proved right and he ends up borrowing £15 billion more than he planned in 2006-07, claims that it is all down to oil will be, well, a pretty crude defence.
All of this, however, is history. The bigger question is what do oil prices do to the UK and world economy next? At the IMF last week, Raghuram Rajan, its impressive chief economist, sounded pretty worried. Oil, he said, poses a “clear and present danger” to prosperity worldwide.
As the Fund outlined, the impact of the long, steep run-up in oil prices over the past two years to present highs, where in real terms they are far above the levels of the 1973-74 oil shock, has so far been relatively benign. The global economy has been remarkably resilient.
But for Mr Rajan and many other economists, the growing anxiety is that this good fortune cannot last. The question many are asking is, if oil continues to climb, where is the “tipping point” — where energy costs start to take a bigger toll on activity, or truly stoke inflation, or both.
To think about this, we need to consider the roots of the surge in crude prices, and the reasons why the repercussions have so far been tame.
One reason why the fallout has been limited, is that this is not a simple re-run of the Seventies when oil prices spiked very rapidly as the Middle East’s taps were turned down. This is not a supply shock, but one driven by demand for oil — which is itself a symptom of the strength of global economic activity.
A second, commonly cited factor in dampening the impact is that developed economies now use much less oil for each unit of output they produce — Britain is about half as “energy intensive” as it was three decades ago.
Beyond this, though, what has been crucial is that the inflationary consequences have been dampened by a series of fundamental structural changes in the world economy. Across the West, inflation was low to begin with, compared with the Seventies. Intense global competition, heightened by the role of cheap production in China and India, has made it hard for companies to respond to rising energy costs by pushing prices higher. Companies are also now better run, and with higher productivity, and have been better able to absorb the increased costs. And workers are less compelled or able to demand higher wages as oil squeezes disposable incomes.
Many of these protections against the oil threat look set to persist. But, still, things are now starting to look much trickier.
If prices stick at $65 to $70 a barrel, policymakers, including the Bank of England’s, will increasingly be caught in a vice between the threat that energy costs spill over into rising prices and wages, risking an inflationary spiral, and a big squeeze on profits, investment, disposable incomes, and so growth across the economy.
The presumption has been that with little sign yet of so-called “second round effects”, where high oil prices stoke more general inflation, central banks will largely set aside the immediate boost to inflation and focus on the dangers to growth.
It it far from clear that all central bankers are really this relaxed, or completely buy into arguments that they should simply focus on “core” inflation — measures which strip out the inconvenient but real effects of soaring energy costs. We shall see. But if oil prices do hold at present levels it seems likely that, ultimately, the toll on output will come to dominate decisions — and lead to lower interest rates.
There are important reservations about simulations of the effects of oil prices, like those shown here, which are better at explaining history than projecting the future. Still, HSBC’s John Butler estimates that by the end of this year, higher fuel costs will knock a hefty 1.2 percentage points off growth in Britons’ disposable incomes — the worst such effect since 1991 in the depths of the last recession. Mr Butler notes, too, that the recovery in UK corporate profits over the past two years has now stalled. So unless wages take off, more rate cuts probably lie ahead — and the storm will be weathered.
If, though, oil were to shoot still higher, to $80 or $100, the quandary for the Bank and its US and eurozone counterparts will become very severe. Next year’s UK growth could fall to barely more than 1 per cent, even as consumer price inflation rose to 4 per cent or more. Cutting rates in such a context would be very hard indeed. The “tipping point” would loom — and both the Bank and Mr Brown would face their biggest test.
