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A Libyan Oil Shock?

A new risk to the recovery.

Mar 7, 2011, Vol. 16, No. 24 • By IRWIN M. STELZER
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Many economists argue that past oil shocks have had such a jolting effect on the economy because policy-makers reacted irrationally​—​they rationed supplies instead of letting prices rise, they tightened monetary policy to avoid inflation when they should have loosened it to offset the growth-dampening effect of higher oil prices. Unfortunately, this hard-won wisdom might not be applicable in current circumstances. Higher oil prices are hitting the economy at a time when monetary policy is already loose and, combined with eye-watering fiscal deficits, threatening to unleash an inflationary wave. With the printing presses already running at top speed, and a flood of red ink pouring over the national ledgers, policy-makers, even those wise enough to avoid past errors, have little room for maneuver should oil prices stay at anything like current levels.

The best attempt at a back-of-the-envelope calculation of the effect of higher oil prices on the current recovery comes from Marc Sumerlin of the Lindsey Group consultancy. Every $10 per barrel increase in the price of oil costs the American economy $46 billion in real income per year. That would offset about 38 percent of the stimulus effect of the $120 billion payroll tax cut agreed to by President Obama and the outgoing Congress at the end of last year, and knock about 0.3-0.4 percent off the growth rate. Since most forecasters are guessing that the economy will grow this year at somewhere between 3.5 percent and 4 percent, the recovery would continue, but at a somewhat reduced rate. A serious and sustained oil price shock (think unrest in Saudi Arabia should King Abdullah die) would roil financial markets and markedly increase the negative drag on the recovery.

The threat from oil markets is magnified by the fact that inflationary pressures are mounting. Even cut-price retailer Walmart is estimating that the price of its mix of goods will increase by 4 percent this year. If you don’t eat, drive, wear clothes, or take any medications, you will believe the Fed’s assertion that inflation is currently tame. Otherwise, you won’t. Andrew Clare of London’s Cass Business School reckons that the move from $90 to $100 per barrel could drive the headline inflation rate up by about half a percentage point, “creating a particular problem for the Fed.”

If inflation forces the Fed to stop buying Treasury IOUs; if Republicans and Democrats frighten investors by failing to agree on a deficit-reduction package, which in the absence of leadership from the president is likely; if rising commodity costs cut into profits and cause share prices to drop; if inflationary expectations increase in response to what consumers are experiencing at the supermarket; and if oil prices do stay high and the prices of other commodities continue their upward trend, interest rates will rise. That would have a calamitous effect on the federal budget, driving interest costs on the national debt to recession-inducing levels. And it would add to the pressures consumers feel from higher gasoline prices, which because of the repetitive nature of tank-filling expeditions to the gas station, have a disproportionately large effect on inflationary expectations. Recovery, R.I.P.

But these “ifs” must be weighed against a contrary set. If Libyan production is quickly restored; if the Saudis ramp up production; if refineries adjust to the kingdom’s heavy crude; if the Fed’s economists are right to believe that inflation is minimal, or that they will be wise enough to see it coming and immediately turn off the printing presses; if the International Energy Agency is right that “both consumers and producers have tools at hand to deliver adequate oil to the market,” then, a semblance of calm will be restored.

The important question will remain: Has the uproar in oil markets persuaded the Obama administration to lift its several obstructions to the development of domestic sources of oil? My guess is that the ideology that supports uneconomic subsidies for wind and solar, which have nothing to do with the transportation needs of America, will trump the reality of the nation’s continuing need for oil.

Irwin M. Stelzer is a contributing editor to The Weekly Standard, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).

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