Fragile world economy as oil price rises

Written by Chris Huhne MEP and published in the Evening Standard on Thu 20th Sep 2001

The world economy was not looking solid even before the horrific attacks last week in Washington and New York. The US economy, in particular, appeared to be softening rapidly. The fall in equity prices - effectively a rise in the cost of capital - and over-investment in the new economy sectors had undermined investment spending. As demand weakened, businesses were cutting back sharply on costs, including their pay bills. Faced with job losses, there was real doubt about whether consumer confidence could be sustained. But Europe too was weakening. Consensus forecasts projected 2 per cent Euro-area growth compared with 3 per cent less than a year ago.

The Manhattan and Washington tragedies add to all these pressures. In microcosm, many companies are now experiencing the travails of the airline sector where redundancies are announced by the day, and Continental is the first of the big US airlines to announce that it cannot meet its debt repayments. Revenues are dropping, while costs are continuing to rise because of the spike in oil prices and rising security costs. Even borrowing costs are not coming down quickly for the companies that need relief, because risk premia (the spreads over risk-free borrowing rates) are rising sharply for both bank and bond market lending. Confidence about the future is bound to weaken further.

In this context, the half point cut in interest rates in both the United States (to 3 per cent) and in the Euro-area (to 3.75 per cent) is welcome. Judge central bankers not by what they say - there are always reassuring words at this point of the cycle - but by what they do. This is a strong response to perceived danger. The European Central Bank usually prefers more sedate quarter point moves and it has never before changed rates between fortnightly governing council meetings.

Rate cuts will nevertheless have a limited short-term impact. The famous 'animal spirits' of entrepreneurs - the great imponderable of Keynes - have probably turned decisively for the worse. Failing the prospect of rising demand and profitability, there is little incentive to undertake major new investment projects in the present climate even if borrowing costs are falling. In this context, low interest rates are a necessary but not a sufficient condition of rapid recovery. The upturn will take time to come when businesses no longer meet demand from stocks, and need more output.

The joker in the pack, though, is the oil price. Most forecasters have been surprised this year by the simultaneous slowdown in all the world's major economies. Most had expected that any US slowdown would have only limited knock-on effects on Europe and Japan given the limited trade linkages. As Andrew Oswald argues, the culprit was probably the rise in oil prices from $13 a barrel in 1998 to $28.9 last year. Oil largely determines other energy prices, and it squeezes costs and profits directly through the transport sectors of all economies.

If Professor Oswald's two year lags between activity and the real oil price hold, then next year will also be bleak. He foresees 7 per cent US unemployment (against a standardised 4.5 per cent now). As if that is not enough gloom, the danger for the global outlook - Europe included - is that there may still be shocks from the oil market. All three previous oil price spikes - 1973-4, 1979, 1990 - were associated with war or civil disruption in the middle east. By contrast, the rise in oil prices in the last three years occurred without any political surprises, which means that there is no much safety margin in the market.

At present, oil prices are sagging because the market thinks that reduced demand (from recession) will outweigh the risk of reduced supply (from political disruption). Iraq is pumping perhaps 2 million barrels a day, and may yet be implicated in the Manhattan attack. If the Saudis can keep their promise to pump enough to maintain the OPEC price target, the oil price can be capped, and global recovery can get underway. But if they can't or don't - perhaps under pressure from neighbours determined to limit western retaliation - the oil market could still be a source of unpleasant surprises, as it was in the seventies. For the world economic outlook, watch the politics.