Gavyn Davies
Dec 14 14:46
The financial markets saw only bad news in the oil shock last week. Despite extremely strong US consumer data, there is a reluctance to recognise the shock for what it is - a long-lasting structural change, with mostly beneficial consequences for aggregate demand in the developed economies.
As John Authers explains, weak Chinese data are causing concern, but there is little evidence that China has been the main cause of falling oil prices. Global oil demand has been fairly stable as supply has surged, and it is surely revealing that the latest oil price drop followed the Saudi decision to maintain oil output after the November OPEC meeting.
Like investors, economists have been thrown into confusion. Almost no-one in the profession (including myself) predicted the oil price collapse in advance. After the shock, it took months for oil price forecasts to be brought into line with the new reality. Futures prices in the oil market have performed no better: predicting oil prices can be a mug´s game.
More surprisingly, there has also been a disinclination to accept the potential benefits in the oil shock. Some economists have said it largely reflects an adverse demand shock in the global economy, so it is axiomatically bad news. Others have said that, even if it is a supply shock in the oil market, which would normally be beneficial, this time will be different, because it will be deflationary, and will therefore raise real interest rates.
There are some honourable exceptions, like Martin Wolf and David Wessel who have viewed it mainly as a supply shock with net beneficial consequences. But the pessimists have thrown up a lot of noise, reminding me of Professor Deirdre McCloskey´s maxim:
Pessimism sells. For reasons I have never understood, people like to hear that the world is going to hell, and become huffy and scornful when some idiotic optimist intrudes on their pleasure.
If the pessimists have a case, it is in oil producers in the emerging world, especially Russia. But, among oil importers in the developed world, it is hard to see too much of a dark side.
Let´s start with what Basil Fawlty would call "the bleeding obvious". A fall in oil prices redistributes income away from oil producers, of whom there are relatively few, towards oil consumers, of whom there are very many. To a first approximation, the long run effect of this income transfer on the global economy should be small, but beneficial. The beneficial part comes from permanently lower production costs, which allow central banks to target lower unemployment rates while still hitting their inflation targets. This is a long run supply-side gain that is the direct opposite of the stagflation that occurred in the 1970s.
However, there are also some important time lags at work. Some of the gainers, mainly "credit constrained" households, may adjust their spending upwards almost immediately in line with their higher incomes. The losers may be less constrained by their short term income, so they can take longer to adjust their spending. For example, even Russia can draw on its $419 billion foreign exchange reserves, which it has been doing. The net effect of these time lags is to provide a further boost to global demand and GDP growth.
These results have been established fairly conclusively over many previous oil shocks in both directions, so why should it be any different this time?
A new factor is the growing importance of oil producers within the developed world, notably in the US. It is unavoidable that there will be a large hit to oil producing regions, like Texas, which have accounted for much of the GDP growth in the US in recent years. But the hit to these regions should be more than compensated for by the gains to household spending elsewhere in the economy, as Bill Dudley of the New York Fed said recently.
What about the dangers of a financial shock? In June, about 10.3 per cent of the US equity market, and 15.9 per cent of the high yield corporate bond market, was in the energy sector.
There could certainly be further market disruption from highly leveraged oil producers in that sector, but it is hard to imagine these effects being large enough to affect the market as a whole.
So far, the financial market effects have remained localised in the energy sector. The combination of extreme leverage, opaque financial instruments and interconnectedness between institutions that turned subprime debt into a major global crisis does not seem to exist this time.
What about the euro area, which has virtually no indigenous oil production? Even there, pessimists (like the ECB) have found a reason to worry: the unhinging of inflation expectations.
If this did occur in a sustained manner, it would be no trivial matter. As we have seen in Japan, permanently lower inflation expectations translate into lower nominal wage and price increases, and at the zero lower bound for interest rates, that makes high levels of public and private debt less sustainable.
This chain of events is, however, far from inevitable. It is more likely that a decline in headline inflation will take short term inflation expectations down for a while, but core inflation will fall much less, and inflation expectations will subsequently rebound, especially if the ECB eases monetary policy markedly.
Furthermore, wage increases seem largely independent of either expected price inflation or the tightness of the labour market at present. Assuming that wage increases are unaffected by lower oil prices, this will amount to a much needed increase in real disposable income, which will make it easier, not harder, to service existing debt. A temporary spike in short term real interest rates will not be enough to offset these real income gains.
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If there is a really dark side to this oil shock, it is likely to stem not from the developed economies, but from its destabilising effects on Russia (as Paul Krugman has argued) and some other oil producers in the emerging world. That is what transpired, eventually, in the oil shock of 1997/98.
A collapse of the Russian economy, with its dangerous political consequences, is the most important reason to worry that the "idiotic optimists" will be wrong about the beneficial market impact of the 2014 oil shock.
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