If you have been following the news about oil prices, you are probably totally confused or seriously misinformed. The situation is both much better and far worse than you have been led to believe.
Start with the better. When prices hit $40 per barrel, motorists were upset. Or so we are told. But Americans keep buying gas-guzzling SUVs, and filling their tanks with gasoline that costs over $2 per gallon. So talk of high prices causing consumers to sulk on their couches rather than drive away to visit granny this summer, or take a spin down to the mall seem overblown, especially as the economy gathers steam, the jobs market improves, and incomes rise.
There is good reason for this lack of reaction. Petrol prices may seem high compared with a few months ago, but look back several years, and compare like with like. The Dallas Fed estimates that if we adjust for inflation, crude prices would have to rise to $75-$80 to get where we were in 1981, and gasoline prices to $3.50 per gallon. So oil and gasoline prices are not devastatingly high by historical standards.
Two other facts have to be entered on the better side of the ledger. The first is that the drain of high oil prices on the U.S. economy is not as great as press reports suggest. Almost half of Americas oil comes from domestic fields, meaning that a significant part of the higher price is paid by American motorists to American oil companies and their American shareholders and employees. And part of the rest is recycled to the U.S. when the Saudis drop by to denude Fifth and Madison Avenues, and Rodeo Drive of their luxury goods, Arab students pay tuition in universities here, and Arab dictators and royals purchase 747s for their personal use and fighter planes to keep their militaries non-mutinous.
The final bit of good news relates to the impact of higher oil prices. Various government and private forecasters say that $40 oil will cut about 0.5 percent off U.S. and world GDP growth. Which brings to mind the old joke: Economists use decimal places to prove they have a sense of humor. GDP estimates are enormously crude, and often subject to major revision. Forecasts of GDP are even chancier. For forecasters to believe that they can translate a given increase in oil prices into a one-half-of-one-percent change in GDP growth is hubris of a sort not seen since Nikita Khrushchev predicted that the growing Soviet economy would bury Americas in a few short years.
Besides, even if these analysts have crystal balls of unusual quality, the American economy might grow this year at a rate of, say, 4.5 percent rather than 5 percent, hardly something that would keep the crew working on the presidents reelection campaign awake at night. And, as Larry Lindsey, formerly head of the White House economic team reminded me, the 0.5 percent hit from higher oil prices would be a one-time affair, after which growth would resume, although from a slightly lower base.
Unfortunately, there is more to the oil story than the good news. The bad news is that this is probably not a price spikea temporary surge, with a specific and transient cause such as an impending war in Iraq. Demand for oil is surging, with China providing over half of the new demand, and America about 20 percent. Meanwhile, supplies are tight, in good part because Saudi Arabia persuaded the OPEC cartel to cut output and, although it has excess capacity, has talked about opening its valves, while not actually doing so. Never mind that American and British troops stood between Saddam and the palaces of the multiple Saudi princes when the Iraqi army rolled through Kuwait: gratitude is not one of the features of Saudi foreign policy. The Saudis will expand output and lower prices only if they become convinced that higher prices will make alternative technologies or new supply areas competitive, or induce a demand-shrinking recession in the West. So high prices may be with us for a whilea plateau rather than a spike.
That, however, may be the least of our problems. The greater problem, and a potential catastrophe for the world economy, would be an American defeat and withdrawal from Iraq that signals bin Laden and crew that they are free to pursue their goals without fear of an America that is sulking in its tent, as it did after Vietnam.
Which brings us to Saudi Arabia. The recent killings in the Kingdoms Yanbu oil hub demonstrate that the royal familys tight control is slipping. With millions of Saudi young people unemployed, disenfranchised, and trained in their mosques to hate America, there is mounting danger that the royals will be overthrown, whether they introduce modest reforms or choose to crack down on dissent. Worse still, a new regime may prefer caves to palaces, as bin Laden clearly does. If the nations new, radical leaders believe they can bring down Western economies, even at the cost of their own prosperity, they would willingly cut back oil production to drive prices to levels that would, indeed, induce a worldwide recession. The West would then have to borrow Spains white flag, or beg a weakened America to return to the fray after licking its Iraq-incurred wounds.
Thats whats at stake in Iraq. If America retreats, the enemies of the West will believe that nothing stands between them and their ultimate goal of world domination and an end to modernity. All they need is control of what they call the oil weapon, which can be used as a weapon of mass economic destruction. Next time you cant persuade a Bush or Blair critic of the moral correctness of the U.S.-U.K. Iraq policy, try this economic argument. It might just work.
This article appeared in Londons Sunday Times on May 16, 2004.