War, Oil and the World Economy

Do you remember the 1979 energy crisis? I hope not — or at least I hope many of you don’t. Because I’d like to believe that my readers aren’t all old codgers like me.

I, however, remember the gas lines and the panic they instilled. I remember the Iranian hostage crisis and the sense that we were all at risk from political instability on the other side of the world. I remember how soaring energy prices were followed by soaring inflation across the board.

Now Donald Trump has taken us to war with the nation that was at the epicenter of that crisis. Obligatory disclaimer: The Iranian regime is evil, and it would be a good thing if this war leads to its demise. But my topic today is the side consequences of the US attack.

Almost everyone assumes that the economic fallout from Operation Masculine Insecurity Epic Fury will be much less severe than the fallout from the rise of the mullahs nearly fifty years ago. And they’re probably — probably — right.

But it’s worth asking why the world economy looks less vulnerable to instability in Iran now than it did in 1979. The main explanation isn’t what you may think. And it’s also worth asking what new vulnerabilities have emerged over the last 47 years.

The following table shows some indicators that help explain how the world economy’s vulnerability to Middle East turmoil has changed since the eve of the Iranian Revolution:

Source: Our World in Data, FRED

As the first line of the table shows, Iran, while a significant oil producer, accounts for only a modest share of total world oil production. On that basis alone one would not expect a shutdown of Iranian exports, which is presumably happening as you read this, to cause a huge spike in world oil prices.

However, in 1978 Iran didn’t account for a large share of world oil production either. So why did world oil prices rise 165 percent after the Iranian Revolution? Fears of disruption in other Middle Eastern nations led to speculative hoarding, followed by Saudi production cuts that kept prices high. The lesson for today is that when assessing the impact of events in Iran on world oil markets, we need to consider the impact on exports from Iran’s neighbors.

And that’s somewhat worrying. In 1979 radical forces in Iran, whatever they did to oil production and exports from their own nation, couldn’t disrupt exports from Saudi Arabia, Kuwait and so on. Today the Iranian regime possesses large numbers of missiles and drones, which it has already used to strike Dubai, Bahrain, and other states in the region. Shipments of oil through the Strait of Hormuz, which is how most Middle Eastern oil reaches world markets, appear to have come to a more or less complete halt.

And the world still relies heavily on Middle Eastern oil. As the second line in the table shows, the Middle Eastern share of world production is only slightly lower now than it was in 1978. This share has remained high despite the fracking-based rise in U.S. production, shown in the third line of the table, which has made America self-sufficient in oil but hasn’t changed the fact that Middle Eastern oil remains crucial for the world economy as a whole.

As of this morning, oil prices were about $10 a barrel higher than they were in mid-February. That will add approximately 25 cents to the price of a gallon of gasoline. So far markets are in effect betting on a short, not-too-disruptive war, although that could change.

Yet the economic effect of an oil price shock should be less than it was in the 1970s, for two reasons.

First, major economies are much less dependent on oil than they were in the 1970s. The “oil intensity of GDP” is the ratio of oil consumption (measured in terawatt-hours of energy) to real GDP, measured in 2017 dollars. This indicator has declined more than 70 percent since the 1970s, which basically tells us that today’s economy uses much less oil to produce a given amount of output than the economy of the 1970s. One way to see this is to compare growth in US real GDP to the change in US oil consumption since 1978:

Source: Our World in Data, FRED

The U.S. economy has tripled in size, but oil consumption now is about the same as it was in the late 1970s.

How did we manage that? Among other things, the gas mileage of the average car has roughly doubled. Also, cheap natural gas has replaced oil in many uses, for example in home heating, and renewable energy is also starting to make a dent.

The reduced oil intensity of U.S. GDP means that even if the current war causes a large, sustained increase in oil prices, there will be less economic damage inflicted as a comparable increase would have done a few decades ago.

The next line of the table shows another reason to be less worried about an oil shock than in the past: Reduced risk of stagflation. The 1979 oil shock hit an economy that was already suffering from persistently high inflation. Furthermore, it was an economy in which, to use Federal Reserve jargon, expectations of future inflation had become “unanchored”: Companies reacted to sudden price increases by raising their own prices in the belief that there would be more to come, workers demanded wage hikes to offset the rising cost of living, and so on. As a result, the 1979 oil price shock set off a wage-price spiral.

Today, inflation — while still running above the Fed’s target of 2 percent — is much lower. Moreover, surveys show that most people expect inflation to return to normal levels in the future. So any effect of the new war on inflation will probably be transitory.

So far, so reassuring. Yet there are, as I see it, at least two reasons — in addition to the threat to shipping — to be moreworried about a war in the Middle East than we would have been decades ago.

First is financial fragility. In 1979 the U.S. financial system was still highly regulated, so that there was little room for serious bank runs and other disruptions. Today many observers have been warning about potential risks to financial stability, most urgently from private credit. Could the Iran war trigger a broader financial crisis? I don’t know, but it doesn’t seem alarmist to be worried.

Also, might the war burst a market bubble? The next to last line in the table shows the price-earnings ratio for the S&P 500, which was low in 1978 but is very high now. Will those high valuations be sustainable if the fallout from the war causes significant economic damage?

Finally, one point I haven’t seen many observers emphasize is that the modern Middle East now plays an important role in the world economy that goes beyond its status as a major source of oil. Dubai in particular is an important node in the global financial system, as well as playing host to many extremely rich people who thought they had found a safe haven. One indicator of that changing status is the transformation of Dubai International Airport into one of the world’s most important travel hubs.

To the extent that the war disrupts this new role for the region, that will be another risk to the world economy.

I don’t want to engage in doomsaying. But I do worry that people are too complacent about the economic risks this war creates.

MUSICAL CODA