Introduction
For years to come the oil price increases in 1973â4, and again in 1979, will be looked upon as a turning point in recent international relations. They have even been labelled âthe Oil Revolutionâ, rather like âthe Industrial Revolutionâ. Later developments may, however, prove that it could be a premature judgement and the whole thing might turn out to be no more than another episode of history, magnified under the weight of the moment but fading away as its memory recedes.
This can by no means be true for the Gulf states. Whatever would be the final assessment, the âoil shockâ makes a milestone in the history of the Gulf states, thus promoting them from relative remoteness to the forefront of international finance and politics. Suddenly, peripheral countries are called upon to assume a world central role to maintain the world economic and financial health. The establishment of a ânew world economic orderâ, an old dream, came for a while very close to realisation. Such a gigantic enterprise cannot, however, be undertaken by small countries. Soon, the financial pre-eminence of the Gulf states was overshadowed by their economic, political and military shortcomings. Even the ânew oil orderâ, which was taken for granted, was now seriously undermined, and the all-powerful OPEC came to face enormous problems from within and without. The contrast between the core and the periphery did not fail to manifest itself in the oil showdown.
The oil shock coincided with, or perhaps resulted from, major changes in the world economic and financial setting. The breakdown of the international monetary system and the near failure of economic policies helped to magnify the impact of the oil price increases. Increasing world interdependence is accompanied by decreasing economic understanding. National political assertiveness is growing amid a more interdependent world while unregulated categories, such as the Euromarkets, are plaguing economic policies. Confusion and uncertainty are â and no wonder â the lot of our times.
The Oil Shock; Relative Prices or Income Redistribution
Early at the beginning of the century the oil barrel cost about $1.2 in the US. By 1970 it was only $1.69 (Ahmadi, Kuwait) â a remarkable stability with no parallel in recent history. In the last decade the official oil price went up to $34, reaching more than $45 in spot markets in overheated periods. This is the oil shock, or rather the two oil shocks of 1973â4 and 1979.
In fact, since late 1970, oil prices timidly started to move up with the Tehran Agreements. On 16 October 1973, while the crossing and the counter-crossing of the Suez Canal and the Golan Heights hypnotized the world politicians and public opinion, six Arab OPEC members (OAPEC) met in Kuwait and increased posted oil prices from $3.01 to $5.12 per barrel. The oil price increase was blended with a systematic monthly reduction of oil production and selective embargo measures. Stunned by surprise, the spot market reacted nervously, prices reaching more than $20 per barrel. On 23â24 December 1973, OPEC met in Tehran and increased the posted price to $11.65 while Arab embargo and production cuts continued â very cold news for Christmas and the New Year. The change was sudden, unexpected and grave. It was aptly called the first oil shock.
After a series of inconclusive annual increases in oil prices, the Iranian Revolution offered another opportunity for a second oil shock. From $13.34 in January 1979, oil prices reached $26.00 by January 1980 in successive OPEC meetings. It would, however, be a great mistake to think that oil price increases in the seventies were the result of the whims and eccentricities of some oil producing countries. The oil price rises reflected increasing scarcities in oil supply. In fact, the growth of oil consumption began to exceed the growth of additions to reserves. It is reported that by 1968 the State Department had sent word by foreign Governments that US oil production would soon reach the limits of its capacity. In 1970 US domestic oil production peaked and began to decline. The situation in most other countries was hardly any better. Moreover, economists have insisted, long ago, on the need to increase prices of exhaustible resources in an effort to rationalize their use in the economic system.1 Rather than increasing over time, nominal oil prices were kept constant and eventually declined (1959) in a world of general price increase. Relative oil prices in fact went down instead of going up. They were thus bound to increase. The âshockâ was related to the suddenness of the price rise rather than to its trend; possibly also because it did overshoot.
The oil shocks implied two major changes: a change in relative prices and a change in world income distribution. By and large the price effect, because more apparent and immediate, drew most of the attention to the neglect of the perhaps more important distribution of income effect. Though both are operating and mutually reinforcing, it is always analytically useful to distinguish the two effects. While it is usually the price effect that dominates the rest, in the OPEC case it is probably the redistribution of income and the subsequent impact on macro-categories that have had far-reaching ramifications.
Rising Energy Prices
The shift from cheap and abundant energy to higher prices and scarcity has been the dominant feature of the seventies. The oil price increases since 1973, the so-called energy crisis, spectacularly attest to this point.
It seems, however, that it was not merely an energy crisis, but actually a total economic crisis. Economic activity, after remarkable sustained growth, slid or plunged; unemployment scored peak records, unknown since the Great Depression; inflation soared to unprecedented levels, at least in living memory, thus giving rise to stag- or slumpflation; productivity gains slowed down with negative signs in some years; trade figures declined, while resuscitated protectionism is once again in vogue; international indebtedness looms largely in the fate of developing countries, undermining the financial system.
To what extent were oil price rises accountable for such a depressing picture? In the aftermath of the oil shock, it was the fashion to attribute all or most economic evils to oil price changes. Like most emotional generalization, the statement, though possibly partially justifiable, is overly distorted. The oil prices eventually triggered new economic forces which, combined with economic policies within the institutional set-ups, contributed to the final results.
Manifestly, OPEC oil imports and imports generally are vastly exaggerated overall. In the United States the domestic content of the inclusive gross national product (GNP) is over 90 cents per $1 of goods sold for home demand or exports. The percentage of imports from OPEC to GNP moved from 0.3 per cent in 1973 to 1.6 per cent in 19792 â a very negligible trickle indeed. Oil imports are more substantial in Western Europe and Japan, but still a very minor element in their gross national product (GNP). Total oil imports of OECD countries from OPEC and other sources are estimated at $180 billion in 1979 against a total gross domestic product of around $6,500 billion, a mere 2.7 per cent.3
Such a minimal price-level bite of oil imports from OPEC can hardly substantiate a simple cost-push inflation argument. A more subtle case focuses on the role of oil price because of its strategic nature on the one hand and its impact on expectations on the other.
Prices, we are told in general equilibrium models, are set in an interdependent manner where every price affects and is affected by other prices. Some prices however, are dominant thus influencing the rest of prices more than others. Prices tend to be determined, in the final analysis, by the cost of production. The fact that various inputs are variably used in the productive system accounts for the non-uniform effect of a particular commodityâs price on the rest of the economy. Energy prices in industrial countries and food prices in less developed countries are examples par excellence of such dominant prices.
With the exception of labour, no other input is as widely used in the productive system in industrial economies as energy. It follows that energy prices have a dominant effect cutting across the rest of the economy. Other fuel prices would sympathize with oil prices and, more importantly, other product prices, with varying lags, would follow suit. Of course, one might think that only a disarrangement in relative prices takes place with little or no change in the general price level. However, this is not so, since there always exist downward rigidities in some nominal prices. The realignment of relative prices will usually be accompanied by a substantial rise in the general price level. The case is stronger when the initial change affects a reference price like energy prices. Product price increases can hardly keep wage rates unaffected. The stage is set for a wage-price duet. The total impact of the oil price increase is, thus, far more important than the initial price rise. Sympathetic price rises in other fuels and throughout the productive system would lead to wage-price spiral and accordingly a general price increase.
The concern with energy prices in modern economies is only matched by the obsession of classical economists with food prices. The history of the Corn and Anti-Corn Laws in England attest to this point. English corn laws originated in the Middle Ages, limiting or prohibiting the export and import of corn. High prices during the Napoleonic Wars and later in the first half of the nineteenth century led to the establishment of the Anti-Corn Law League in Manchester in 1839. The raison dâĂȘtre behind this movement was clearly to prevent food prices from rising, thus providing a basis for low wages and improved competitiveness. The share of food (corn in particular) in labour consumption and accordingly in the wage bill can hardly be overestimated. The repeal of the Corn Laws thus became the touchstone of the British industrial economy of the time. With the Peel Act in 1846 in the aftermath of the Ireland potato-rot cheap corn became one of the principles of British economic policies.
The parallel between food prices in the early stages of industrialization and energy prices in present-day industrial societies is very suggestive indeed. In both cases we are not simply faced with a commodity price, but rather with a reference price on which the whole price system is virtually founded. Because of their pervasive use throughout the economic system, food prices in the first case and energy prices in the second determine respectively the price level.
Nineteenth-century agricultural economies are not historical curiosities. They are to a great extent variations of the present-day less developed countries (LDCs). Two different types of economies are juxtaposed; the industrial or developed countries (DCs) and the less developed. The first type is sensitive to energy prices and the second to food prices and also to energy prices.
It was the fate of the world economy in the early seventies to witness simultaneously both the food and the energy crises. Food prices soared in 1972 only to be followed by the oil shock in 1973. Both rich and poor countries were plunged into price orgies, and a new era of higher inflation was thus inaugurated due to the increase in reference prices: food and oil.
Changes in oil and food prices are supply shocks affecting the cost of production. This does not mean, of course, that the oil shocks did not produce various secondary reductions in aggregate demand; in fact they did. It remains true, however, that the oil price increases are supply-side changes which would have required a component of supply management.4 An expansionary fiscal and monetary policy would have been effective in cancelling out the decline in aggregate demand that resulted from the increase in the price of oil. There was a point, in these circumstances, to pursue an accommodative fiscal and monetary policy provided it was made clear that such a policy was not accommodating inflation but rather acting to cushion the economy against the reduction in demand resulting from the oil price increases.
It is significant to notice that, precisely at this juncture, most countries resorted to stringent monetary policies. In the US, real M2 fell by 3.4 per cent between the end of 1973 and that of 1975. Monetary policy was, for the first time, on M1target. It seems that the âFedâ decided to pursue an M1strategy at the wrong time in an effort to vindicate the Friedman dictum: âCentral bankers are not to be trustedâ. The situation in other industrial countries was hardly any different. Monetary policies thus exacerbated a deteriorating situation with no frontal attack on the supply-side inflationary pressures.
To add insult to injury, OPEC taste for theatrical decisions on price increases during their over-publicized semi-annual ministerial meetings created a fertile ground for permanent price rise expectations. It is the merit of the rational expectation doctrine to introduce information and reactions to its knowledge to the economic body theory. Economic agents attempt to anticipate future policies and accommodate their actions to it. It is true the theory originated in the context of the behaviour of economic agents with regard to domestic monetary and fiscal policies. Rational expectation is, however, a general postulate to account for economic behaviour vis-Ă -vis all economic policies â national or foreign. OPEC decisions to increase oil prices are already discounted in private agentsâ behaviour and fully reflected in their costing. OPEC, in turn, is confirmed in the belief that oil price increases are designed to offset the growing inflation. A new vicious circle has already trapped the economic system.
Important as it may be, the price effect falls short of absorbing the total impact of the oil shock. Oil price increase is not an act of God, the way a harvest failure or an earthquake is; there is no net loss but rather a transfer of income from oil consuming to oil producing countries. The way in which the oil proceeds are used affects the final outcome.
New Savers
More important than the change in energy relative prices is, perhaps, the transfer of wealth from oil consuming to oil producing countries and the subsequent change in the macro-aggregatesâ behaviour.
From its pre-oil-shock level of about one per cent of the gross domestic product (GDP), oil cost absorbed about five per cent of the GDP.5 The oil import bill rose from $28 billion in 1970 to $535 billion in 1980, an increase of almost twentyfold over the decade. In 1970 the oil trade represented seven per cent of the world trade and reached 21 per cent ten years later.6
Notwithstanding the latent economic need for price increases of exhaustible resources, a dramatic redistribution of world income took place at short notice. On the face of it nothing seems to have changed in the underlying economic forces to warrant such a major change. The world resource base, the technology available and tastes have not undergone any sudden change before and after the oil shock. By and large, the world economic system continues to enjoy the same resource base and to apply the same known technology in order to satisfy the same final demand; only the share of oil producing countries in world produce has risen spectacularly with the oil shock. The change in the balance of power between the oil consuming and the oil producing countries (OPEC) made it possible for the latter to appropriate a bigger share in the world income. A coup dâĂ©tat in the world economic order allowed a group of small countries, holding a vital commodity (oil), to levy an oil tax on the oil consuming countries.7
The principal oil exporting countries, mainly in the Arabian Peninsula and the Gulf, are very thinly populated and already enjoy a relatively high per capita income. It is axiomatic that a redistribution of income in favour o...
