How Well Can We Withstand This Current Oil Price Shock

Much has been said  about whether this current surge in world oil prices is different this time around from previous oil shocks in the past.  The longer oil tankers are held to ransom in the Straits of Hormuz, the longer energy prices will remain elevated. Can the world  withstand higher prices ? Do governments  have the fiscal capacity to help their nations absorb the negative  impacts of higher oil prices?. These are two separate perspectives that need to be examined, yet both come into play simulataneously in addressing the frequently asked question: is this time different?

Oil intensity has changed dramatically since the last great oil shock of 1980 when the price of oil shot up from  $10/ bbl in 1973 to $40/bbl in response to the Iranian Revolution of 1979. Today’s oil shock features a price increase  from $70/bbl to $110/bbl and  pales in comparison to the experience 45 years ago. The US and EU countries have dramatically reduced oil consumption per unit of GDP in the last 40  years, by 65%-70%.  EU oil consumption is now running 15% -20% below the peak years of 1979-80, all the while the continent’s economy is nearly double in size today.

While oil remains the premier energy source, we have become so much more efficient in its use, as well as expanding alternative energy sources as substuties. To a large extent, this current burst in oil prices would be much worse had the developed countries not  introduced energy-saving techniques into all facets of manufacturing and transportation activities.  Today it takes less than ⅓ of the amount of oil to generate a unit of economic output as it did in 1980. 

Source: Gemini AI

The spike in oil prices in 1980 was a major contributor to one of the deepest recessions in the post- WW2 era, when inflation reached double-digits, forcing central banks to increase borrowing costs to as high as 20%. The deflationary impact of today’s oil spike has yet to fully be evidenced, nonetheless it is reasonable to expect that income levels will not be as  negatively impacted as they were  in 1980.  The OECD downgrades global growth, expecting US growth to drop from 2% to 1.7% and the eurozone barely to expand by 0.8% The extent of the slow down in economic growth is still a matter of great uncertainty, and most likely to weaken further should the war drag on for several more months.  

Let's turn to the question of whether the governments today can offer fiscal support to ease the impact of higher prices on economic growth. Budget deficits as a percentage of GDP offer a good measure of the fiscal capacity of a country to respond to the  loss of income. Here we see a marked difference between the US and  individual EU countries. The US deficit in 1980 was 2.6% of GDP and today is estimated to be around 6%. Even that number is at risk to increase, as the President has requested a huge increase in military spending related to the Iranian war. So much of that additional spending continues to be vulnerable as the conduct  war  remains open-ended. The EU members deficits are relatively stable over the years,  in which Germany and Italy have smaller relative deficits today and France is experiencing a sizable increase in its spending. Globally, the OECD estimates that the industrialized nations are subject to deficits of 5.3% of GDP, a reflection of the heavy borrowing needs of the US and Japan, in particular.  Such high levels of deficit spending, and the accompanying accumulated debts impair the degree to which national governments can buffer their populations from further  financial strain.

Summing up, the advanced economies have done a lot to improve their efficient use of energy, allowing them to absorb the higher costs today. However, should the oil price continue to go higher, these countries will be constrained in their efforts to offset the loss in economic growth.