TCS Daily

The IMF and Oil Prices

By Desmond Lachman - October 12, 2004 12:00 AM

On reading the IMF's most recent and sanguine World Economic Outlook report, one cannot help but be reminded of the apocryphal story regarding the inquiry into the sinking of the Titanic. When asked why he did not turn the ship away from the iceberg to avoid the collision, the surviving captain of the Titanic asked "What iceberg?" With international prices now trading at over $50 a barrel, one must wonder whether the IMF is not missing something equally visible and obvious that has the real potential to slow the global economic recovery.

Despite the approximately two thirds increase in oil prices since the start of this year, the IMF is projecting that the global economy will continue to grow at above trend in 2005. Thus, following a banner 2004 when the global economy is expected to have grown by 5 percent, the IMF is projecting that world economic growth will remain strong at around 4 ¼ percent in 2005 At the same time, it is projecting that US economic growth will slow only moderately from 4 ¼ percent in 2004 to 3 ½ percent in 2005.

On the basis of these projections, the IMF is appealing for a significant tightening in global macro-economic policies. Specifically, it is suggesting that central banks should raise global interest rates further to more normal levels as the recovery proceeds. At the same time, it is suggesting that governments should take advantage of the global economic upturn to address fundamental medium-term problems associated with higher than desirable budget deficits.

A critical assumption underlying the IMF's rosy economic forecast is that international oil prices will decline steadily from their present lofty levels of over $50 a barrel to an average of $37 a barrel in 2005. While one certainly cannot exclude that possibility, one must note that it flies in the face of the view held by a number of respected international energy analysts. These analysts believe that the recent run-up in oil prices is not a fleeting phenomenon. Indeed, far from foreseeing any sustained relief from presently high international oil prices, they are suggesting that the balance of risks points to even higher international oil prices over the next two years.

The more gloomy view of international oil price prospects rests on the belief that there has been a fundamental change in the global energy situation. Philip Verleger, a senior fellow at the Institute for International Economics in Washington DC, suggests that this is the case for the following four reasons. First, China and India have emerged on the global energy scene as major buyers of oil just as they have begun to make a mark on the global economic scene. Second, both OPEC and the large multinational oil companies did not anticipate the increased energy demand over the past few years. As a result, they failed to expand capacity at an adequate rate to meet that demand. Third, political circumstances in a number of key oil-exporting countries -- including Iraq, Iran, Nigeria, Russia, and Venezuela -- have become increasingly precarious to say the least. Fourth, investment in refinery processing and transportation capacity has been neglected in the United States and Europe.

Our past sad experience with international oil price shocks during the 1970s and early 1990s suggest that these shocks do have a major impact on the global economy. Indeed, the IMF itself estimates that, despite the considerable progress made over the past thirty years in reducing the industrialized economies' energy dependence, a sustained $5 a barrel increase in oil prices reduces global GDP growth by 0.3 percentage points. Moreover, it reduces US GDP growth by 0.4 percentage points. On that basis, one would expect that were oil prices to stay above $50 a barrel in 2005, we would be lucky to have global GDP growth much above 3 percent and US GDP growth much above an anemic 2 percent in 2005.

Economists like to think of an oil price hike as similar to an increase in indirect taxes, whose proceeds accrue to a foreign government. This has the effect of both raising the domestic price level and reducing domestic demand. In the context of a global recovery that has only recently gained traction and of a global inflation picture that remains benign, one must wonder about the wisdom of the IMF now proposing that policymakers compound the contractionary impact of the oil price shock with a tightening of monetary and fiscal policies. Might it not make more sense for policy makers to wait and see how permanent the oil price shock proves to be and to gauge how damaging is that shock to the global recovery before rushing to tighten economic policies?

The author is Resident Fellow, American Enterprise Institute and a TCS contributor.


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