The recent price increases are attributed to the combination of cutbacks in oil production by the Organization of Petroleum Exporting Countries (OPEC) and increased demand as the world economy continues its economic recovery from recession in the late 1990s.

When the prices of oil and gasoline go up, the world takes notice -- especially the world's big oil and gas consumers.  The United States alone accounts for 25.6% of annual world oil consumption.  Western Europe accounts for another 20.4%, and Japan consumes 7.5%.  In the newly industrializing countries (NICs) such as Korea and Taiwan and in many less developed countries (LDCs), oil consumption has been increasing as a per cent of their GDPs.  In the early 1970s emerging economies only accounted for 29% of total world oil consumption.  Now they account for 43%.  When the price of oil goes up, oil producers earn more petrodollars while oil and gas consumers pay more for less.

The graph above shows that oil prices fell to very low levels early in 1999 but have been increasing steadily since then.  As the two graphs below demonstrate, oil and gasoline prices naturally tend to move together because oil is the raw material that is distilled or "cracked" under pressure into gasoline.

Oil is the world's principal source of energy.  It permeates economic activity in forestry, farming, mining, manufacturing, construction, transportation, and travel.  Therefore, rising oil and gasoline prices have the potential to send an inflationary shock wave throughout the global economy.  Many of us recall the oil shocks of 1973-74, 1979-80, and 1990.  In each of those instances economies around the world went into recession following the dramatic increases in the prices of oil and gasoline.  More specifically, they experienced what is called stagflation -- the combination of recession and inflation.  The 1973-74 bout with global stagflation was particularly acute.  Some experts are now warning that the latest surge in oil and gas prices could cause another dose of stagflation in the global economy later this year.

Does history repeat itself?  Is it likely that the world will experience an acute case of stagflation in the months ahead?  Well, the answers are "yes and no."  Certain events like oil shocks do recur from time to time, but the prevailing economic conditions when they occur are never exactly the same.  Some experts are predicting that the current oil shock is likely to be rather benign in the context of recent trends and the current state of the global economy.

An article in the March 11 edition of The Economist magazine (page 77) warns of the possibility of another nasty encounter with global stagflation.  However, it also cites four "good reasons to think that the economic consequences of the jump in oil prices will be less severe than they were in the 1970s": (1) The recent surge in oil prices comes at a time when oil prices were at their lowest level in real terms (i.e., adjusted for inflation) since 1972.   Even after the latest round of price increases, real oil prices are barely half their 1981 level --[See Graph Below].  (2) Industrialized economies are much less dependent on oil than they used to be.  Their consumption of oil expressed as a percentage of of GDP is just over half what it was in 1972.  Shifts to other fuels, the decline in manufacturing, and changing consumer behavior over the past 25 years account for this decrease.  (3) Attributing this third point to J.P. Morgan economist Philip Suttle, The Economist notes that previous oil price hikes were associated with wars that added an element of uncertainty.  This time oil production is being cut back voluntarily by OPEC in the absence of a military encounter -- [See Graph Below].  (4) Previous oil shocks took place when the rich economies were already overheating.  In contrast, only the United States economy appears overheated at this time, while Europe and especially Japan currently have excess capacity.  All of these points lead to the conclusion that the recent surge in oil prices have the potential to slow the global economy down with a smaller effect on inflation than in the past.  It would appear that most countries are more likely to get a future dose of mild deceleration instead of acute stagflation in the next twelve months.

Stagflation -- a recession combined with higher prices -- originates at the micro level.  When the price of oil and gasoline goes up, each consumer is having to pay more which leaves less income to spend on other goods and services such as food, clothing, housing, furniture, electronics, insurance, personal care, entertainment, and medical services.  When the consumer cuts back spending on these other items, the economy begins to recede. If the inflationary effects of higher oil and gas prices are greater than the deflationary effects of declining demand for other goods and services, then the economy experiences stagflation.  The reason that the inflationary effects tend to outweigh the deflationary effects is that the demand for oil and gasoline is inelastic.  That means that the per cent increase in oil and gas prices is greater than the per cent decrease in the quantity demanded.  The consumer literally spends more money to purchase the same amount or less.  (Note: If the demand for oil and gasoline were relatively elastic, then the consumer would spend less of their disposable income on oil and gasoline when their prices increased because they would cut back their consumption of oil and gasoline to a greater degree than the increase in prices.  However, economic studies consistently indicate that the demand for oil and gasoline is highly inelastic).

Consider a typical consumer in the United States who spends about $2.50 on motor fuel out of every $100.00 of disposable income, leaving $97.50 to spend on everything else.  If we assume (for simplicity) that the demand for gasoline is perfectly inelastic, then an increase in the price of gasoline from $1.00 per gallon to $2.00 per gallon will force the consumer to spend $5.00 to buy the same amount of gasoline, leaving only $95.00 for everything else.  Each consumer will cut back spending on other goods and services by $2.50 for every $100.00 of disposable income.

The phenomenon of each consumer spending more money for the same amount or less gasoline while cutting back consumption of other goods and services, combined with the fact that higher oil and gas prices are raising the costs of energy and power to producers of everything from transporting goods by truck to lighting a baseball field at night, spreads throughout the economic system.  It soon begins to show up in the economy's macroeconomic performance measurements.  In the absence of any other offsetting effects, aggregate supply decreases and the macro economy drifts toward stagflation.  It is particularly disagreeable because real GDP declines, cyclical unemployment increases, and the general price level rises.

The picture below shows the playing field of The World Game of Economics.  Stagflation is depicted in the upper left corner.  When an economy is in the stagflation corner, real GDP is falling and both unemployment and inflation are rising.  The further into the corner an economy goes, the worse the stagflation and the lower the score.  (Red numbers are a negative score in the game).  When oil production is deliberately cut back to create a shortage as in the case of OPEC's recent action (or if other resources and raw materials are becoming increasingly scarce without offsetting technological advances), economies will drift toward the stagflation corner.

The extent to which an economy drifts toward the stagflation corner due to an oil supply cutback depends on a number of factors:  (1) The higher the price of oil and gasoline goes relative to other prices, the greater the adverse effects on an economy's GDP and inflation; (2) The longer the duration of the price increase without offsetting events, the greater the impact; (3) The greater an economy's consumption of oil and gasoline, especially as a per cent of its GDP,  the more severe the stagflation will be for that country;  (4) If an economy already has inflation or is in recession at the time of the oil shock, then the oil and gas prices will exacerbate an already undesirable situation.  It's likely that the effect on a country already in recession will be less on inflation and more on output and unemployment. (5) The higher the concentration of oil production, exports, refining, and distribution, the greater the potential for inflationary effects of an oil shock on the world's economies.

When we apply these generalizations to the current oil shock, we are led to the conclusion that its effect will be remarkably different on the economies around the world.  Were it not for the fact that oil consumption has declined to a relatively small per cent of its GDP, the United States economy would be the most vulnerable because of its sheer volume of oil consumption and imports and the fact that its economy is already operating at full employment.  It imports approximately 8.225 million barrels of oil per day and accounts for nearly one fourth of total world imports.  However, it is sitting on 570 million barrels of government reserves, which the Clinton administration is considering releasing into the market.  Japan, the world's second largest economy, is in a more precarious position.  It imports all of its oil at about 4.584 million barrels per day, and its economy recorded negative growth in GDP in the 4th quarter of 1999.  The current increase in oil prices is likely to have much less impact on Japan's inflation rate than it will on dashing its hopes for economic recovery.  Western Europe is likely to experience a little of both the "stag" and "flation" in the term stagflation.  Ironically, the most vulnerable economies and the ones that are likely to feel the dual adverse effects of an oil shock are the developing countries in Asia and South America that have just recently bounced back from recession.  Oil consumption as a per cent of their GDPs has risen significantly in the past 25 years, their economies are just beginning to boom again, and some of them are already experiencing accelerating levels of inflation.

The previous analysis assumes that oil and gas prices stay at their current levels.  They may actually decline in the next few months.  OPEC is not nearly as powerful as it was in the 1970s.  [The thirteen members of OPEC are Algeria, Ecuador, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela].  These countries currently account for 60 per cent of world exports, but only 40 per cent of world production.  Externally, non OPEC countries like Mexico might increase their production levels and undermine OPEC's attempt to curtail supply.  Internally, OPEC has its own problems.  If Venezuela, which controls about 11 per cent of OPEC's quotas, were to break ranks and increase production in an attempt to help its own economy recover from recession, then oil prices would go down.  If the United Nations were to relax the sanctions against Iraq's oil exports, there would be further downward pressure on oil prices.  Iraq currently commands about 8.4 per cent of OPEC's quota system.  The main county to watch in OPEC is Saudi Arabia, which accounts for nearly one third of OPEC's production.  Negotiations are currently underway with Saudi Arabia to, at the very least, maintain production and  prices at their current levels and, preferably, to increase production and bring prices back down a little.

However, a very good normative and ethical case can be made on behalf of the OPEC countries that they are merely recouping the deterioration in their terms of trade over the past twenty years and that it's reasonable for the rest of the world to accept the current oil production and price levels.  Most prices for other goods and services have increased much faster than oil and gasoline over that time period.  For that reason alone, one could understand OPEC's resistance to political pressures to bring oil prices back down.  And it's difficult to defend the complaints of a typical gas consumer in the relatively rich and industrialized countries when they are burning gasoline in their sport utility vehicles and big engine autos on gridlocked freeways as if it were rain water.

That said, the industrialized economies are currently in a better position to countervail OPEC than they have been in earlier years.   In the past, oil shock stagflation has eventually been tamed through discretionary policy actions and the long run effects of market forces. Even though stagflation poses a demand side policy dilemma (i.e. increases in government spending and lower interest rates cause more inflation while decreases in government spending and higher interest rates will create still more unemployment), it can be attacked on the supply side.  Deregulation and increased competitiveness in the oil exploration, production, and distribution sectors can bring prices down.  Recent developments in technology have made it possible for oil producers to react more quickly and more effectively to higher oil prices; and higher oil prices encourage more exploration, development, and the search for alternatives in the long run.

The recent surge in oil and gas prices has definitely caused the world to take notice.  There has already been a  re-distribution of real income and wealth from oil consumers to oil producers.  Some would reasonably argue that it merely evens things out over the last twenty years.  The degree to which this recent trend continues in the months ahead remains to be unveiled.  However, in light of the global economy's contemporary macroeconomic situation, it's likely that oil and gas prices will soon stabilize somewhere near their current levels and remain there until the next shock; and it's doubtful that the oil shock of 2000 will be considered one of the most eventful in world history.  [Note: An important OPEC meeting scheduled for Monday, March 27 in Vienna, Austria may provide new insights into which direction oil prices are likely to move in the months immediatley ahead].

Postscript:  April 1, 2000  The meeting of OPEC Ministries earlier this week in Vienna resulted in a tentative agreement to restore previous cutbacks in oil production and increase output by 1.7m barrels per day.  Iran refused to sign the agreement, but indicated that it would increase production.  The price of oil has dropped to below $30 per barrel in reaction to these developments.  OPEC oil ministers have indicated that they would like to see the international price of oil stabilize at somewhere between $23 to $26 per barrel.

Sources and recommended links:

The Economist Magazine (March 11th - 17th, 2000)

Berry Petroleum Company:  www.bry.com

Oil World:  www.oilworld.com

WTRG Economics:  www.wtrg.com

Organization of Petroleum Exporting Countries:  www.opec.org

U.S. Department of Energy. Energy Information Administration:  www.eia.doe.gov