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Oil Price Shocks and Global Recovery

Interviewee: A. Michael Spence, Distinguished Visiting Fellow, Council on Foreign Relations
Interviewer: Roya Wolverson, Staff Writer, CFR.org
March 4, 2011

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Rising oil prices and rocky financial markets resulting from uprisings in the Middle East have renewed concerns about the strength of the global economic recovery. Nobel Prize-winning economist Michael Spence says that for the United States, higher oil and commodity prices "won't dominate. Any impact would be small to medium in size." However, Spence warns that the United States will not enjoy a quick rebound. Shifting dynamics in the global economy suggest that the days of access to cheap capital are numbered for the United States, he argues. Considering these costs, U.S. energy efficiency and security should be a higher priority. Spence says unemployment will be a persistent problem for the United States even after economic growth returns. With middle to lower-class incomes in decline, he warns that a more globalized labor market will make income disparity a more pressing issue.

Federal Reserve chairman Ben Bernanke told Congress this week that fuel prices were not yet a serious threat to the recovery or inflation. Do you agree?

For the U.S. economy in the short run there's a negative effect, because people don't have time to respond to the higher fuel prices. So they spend more money on fuel and less on other things, and the rest of the economy is hurt by the reduced spending on other things. And then after time goes by, people start taking action that economizes on fuel. And the reactions get bigger as time goes on, because they have more options. So we insulate the house, or buy a different car.

Once those reactions take effect, it has a significant dampening effect on the initial negative response of the economy. People are also hoping this particular rise in fuel prices is more because of a surprise shock or nervousness about Libya and other countries, as opposed to demand outstripping the supply. There's a reasonable chance that will go away. So the U.S. economy will probably weather it OK. Developing countries, especially the poorer ones, will be a different story.

Given all the uncertainty, couldn't oil producers miscalculate what prices the global economy is willing to tolerate?

Yes, there are two effects. The price doesn't just fluctuate in response to demand. It responds to speculation and betting on future prices. There's no question that as long as the emerging economies, especially the big ones, keep growing, the demand for oil will keep growing. So, the kind of situation we saw before the crisis, in 2006 through 2008 when there was a big spike in commodity prices, could return.

The argument that we're just going to go back to so-called "normal" is incorrect. And the notion that we have a temporary shock and then rebound back to where we were is wrong. We're not going back to where we were before the crisis. Emerging markets are going to continue to grow, although nobody knows how fast. There's a cyclical mentality that tends to dominate macroeconomic thinking, but the world is steadily changing its structure and characteristics.

What role should the Fed play in all this, especially considering the heat it's getting for rising commodity prices?

There's a cyclical mentality that tends to dominate macroeconomic thinking, but the world is steadily changing its structure and characteristics.

The Fed is trying to do whatever it can with the arsenal of instruments it has available. Low short-term interest rates and quantitative easing have been controversial, but these are not very powerful weapons. The main actor in the game is our balance sheet recession, with huge amounts of balance sheet damage, especially in the household sector. And sometimes you just have to let the patient heal. And that's what we're doing. It is taking longer than people initially expected when we thought the recession would be an ordinary one, and we discounted the balance sheet side of it. The Fed is doing the best it can balancing the fledgling recovery with the potential threat of inflation. The outside world has a less kindly view: Money is pouring into emerging markets, causing inflation and potential asset bubbles. If they had their choice, these countries would adopt a different monetary policy [for the United States]. But this is not a world yet where we have policy coordination.

So is the benefit of quantitative easing worth the risks to the global economy?

The external view has two forms. One, the Americans are discounting the external problems, distortions, and potential damage. Second, and more conspiratorial, the United States is trying to export inflation by devaluing the dollar. These are not balanced views of the situation. Everybody has a considerable stake in the restoration of growth in the U.S. market. And so it is not derailing growth in major emerging markets.

Will rising oil prices give U.S. energy policy more prominence?

Energy efficiency and security should be a higher priority. We're going to experience a higher cost of capital than we've been used to in the last decade and a half, so we ought to get our house in order fiscally as fast as we can [by improving energy efficiency and security]. The McKinsey Global Institute recently wrote a report (PDF) suggesting that emerging-market growth is going to reverse the global pattern of declining investments as a fraction of GDP over the past several decades [when more of the world was saving than investing, which drove down interest rates on borrowing for advanced countries]. Advanced markets have had declining investment levels and emerging countries have been rising. With high investment levels in the advanced economies, we're close to a recovery. But the emerging markets are getting bigger, which will over time reverse the pattern of excess savings [in emerging markets] and low interest rates [in advanced markets].

Timeline: Oil Dependence and U.S. Foreign Policy

Will rising oil prices compromise Obama's export strategy?

Oil prices will have a negative effect on the current account balance, because in the short run, we'll just import more because the prices went up, and the supply response isn't that large. That doesn't help our situation, but it's possibly temporary if we do the right things and allow the economy to respond.

What about the effects on the debates surrounding the deficit, the debt limit, and taxes?

This is not the right environment to have man-made shocks that are superimposed. Standoffs on these fronts can be potential risky, especially if we can avoid them. We're working toward a compromise on the fiscal deficit, and we have several deficits to deal with. We also have the trade deficit. We don't want to keep a large trade deficit, which is a lot more complicated than tackling the fiscal deficit.

Could the rise in commodity prices, combined with the oil price spike, derail the U.S. economic recovery?

These factors won't dominate. Any impact would be small to medium in size. The U.S. economy spends about 5 percent of GDP on energy. For developing countries, it's much more. At a more fundamental level, the global economy is moving outside of the United States, and we're moving up the value-added chain, which alters the structure of our economy. There's a reasonable possibility that growth and unemployment are diverging for the first time in post-war history.

What does that mean?

Economic growth is probably going to come back, but the employment problem will stay. And that competitive problem in the tradable sector shows up as a stubbornly high deficit.

The economy has two parts. A very large part is non-tradable, services that have to be reduced and supplied domestically, such as government, education, hotels, restaurants, construction. It's hard to build a building in downtown Manhattan in another country. The other important sector is the tradable sector. It's expanding but is still less than about one-third of the economy. In some parts of the tradable sector there are highly educated people, having a lot of fun, and experiencing rising incomes. But a fair amount of that sector is migrating to other countries, more so as [those countries] expand and move up the value-added chain. In our economy the upper end is doing very well, but employment opportunities and income of lower middle range are declining. This is very worrying because people don't think their kids are going to have the same opportunities they did, which we've never had before. So there's a major long-term structural issue regarding the scope of the tradable sector, and the menu of options with respect to employment. We will probably have a real employment problem in the next year. Economic growth is probably going to come back, but the employment problem will stay. And that competitive problem in the tradable sector shows up as a stubbornly high deficit.

So what's the solution?

The president tasked a commission to think about exports. That wasn't quite on target. The recent commission with the CEO of General Electric Jeffrey Immelt focuses on employment and the structure and the competitiveness of the economy, and that is more on target. So there are signs that we're starting to take this seriously. The answers are quite complex. Education is part of it. There are defects in our education system and a certain amount of falling behind. But certainly that's not the whole problem. The tax system, incentives for investment, how we focus our public-sector resources on investment and technology--those are important pieces of the puzzle. And there are more complicated factors. If the global economy really does have all of its price effects, including [lowering or raising] the costs of labor in various skills and education categories, how do we think about our income distribution?

It is striking how different the income distributions are across developed countries, which are subject to the same global market trends and forces.  After restoring competitiveness and employment, there are ways to ameliorate the income distribution effects. That will be complicated, and no one knows the answer yet.  A good starting point is figuring out the benefits and costs associated with countries that have much more even income distributions.

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