Cautious optimism

The economy is regaining momentum, despite oil turbulence
Chief Economist, OECD

Since the 2001 slowdown, the world economy has moved in fits and starts. Economists as well as the general public are now longing for a smooth and sustained recovery, undisturbed by chronic geopolitical risks or abrupt gyrations in oil prices and financial markets.

Although there have been contrasting economic fortunes over the past few quarters, with the US forging ahead, east Asia slowing but from a rapid pace, and continental Europe plodding along, households seem to have been lacking confidence OECDwide. This pervasive sense of uncertainty has proved somewhat contagious, since after a year of record growth in world trade, business confidence has fallen back to just above the historical average in the US and Europe, dashing hopes that GDP would keep growing above trend over the next few months.

Compared to cautiously upbeat assessments that could be made even two months ago, this turnaround has been a source of disappointment. It has been prompted in large part by a surge in oil prices that has depressed real incomes as well as confidence in the OECD countries. There are nonetheless good reasons to believe that despite recent oil price turbulence, the world economy will regain momentum in a not-too-distant future.

Supported by strong balance sheets and high profits, the recovery of business investment should continue in North America and start in earnest in Europe, while consumer spending will benefit from the recent retreat of oil prices to less onerous levels, in a context where job creation is progressively strengthening and monetary conditions remain very accommodating. All in all, there are still some good grounds to expect OECD economies to grow above trend again in the course of 2005 and 2006.

From a geographical perspective, the momentum of this recovery will benefit from continued Asian dynamism, in China, where activity accelerated in the third quarter, following a desirable slowdown during the first half of the year, and Japan, which has staged a spectacular comeback, based on a renewed export drive, broadening into a recovery of investment, employment and finally consumption, before marking a pause over the past few months. The strength of this recovery will also be enhanced by positive developments in North America. But it remains to be seen whether continental Europe will play a strong supportive role through a marked upswing of final domestic demand.

On the latter issue, this Outlook takes a reasoned, but positive, bet on Europe. It tables a significant pick-up of final domestic demand in the euro area in 2005-06, while world trade and OECD output would not accelerate over the period. Continental Europe, and more specifically, Germany, would then have to find enough autonomous momentum to achieve a higher relative growth path. For this scenario to materialise, a modicum of stability in oil prices and exchange rates is required, which would allow a less resilient euro area to start catching up with the fast growing economies of the OECD.

A strong appreciation of the euro, in a context of worsening external imbalances, or further rises in oil prices, may thus bear disproportionately on continental Europe, where growth is still over-reliant on exports. However, Europe might not be at such a disadvantage, compared with the rest of the OECD, in coping with higher oil prices. Should an additional oil shock hit, the OECD countries would be less vulnerable than in the past. First, dependence on oil, expressed as a share of GDP, has been halved since the 1970s, leading to a much lower income burden for both households and businesses than in the past. Also, and more importantly, inflation expectations are now low and well anchored, so that rising oil prices have only impacted so far on headline inflation, while nominal wages and core inflation barely budged. It would thus be very surprising if OECD countries were to suffer again, as they did in the 1970s, from a nightmarish situation where wages and prices spiral out of control and central banks are forced to switch into severe “tightening mode”.

Nonetheless, when it comes to the impact of oil price shifts, the perceptions of economic agents and the received wisdom of economists do not seem to coincide. Estimates derived from econometric models signal a rather modest impact on output and inflation, yet oil price fluctuations take centre stage in the public debate and have a strong influence on confidence.

In this context, it was natural to devote a special chapter of this Outlook to the economics of oil. To better understand why oil matters, it is necessary to go beyond the short run. In a world where people are more “forward-looking”, uncertainty about future oil prospects may have more of an impact on the current economic situation than, say, month-to-month changes in market prices.

Here, OECD expertise suggests that recent oil prices were certainly well above longterm equilibrium levels, even allowing for strong market power on the part of the OPEC cartel. There are still important resources available on the supply side, especially among OPEC producers, to match increasing demand for oil, and the efficiency of existing facilities could be significantly improved. Furthermore, alternative sources of energy may already become profitable at current prices.

This does not mean, however, that oil prices will quickly fall back to the low levels which prevailed three or four years ago. First, the fall may not be rapid in a context where strong geopolitical uncertainty and high price volatility inhibit investment in new oil facilities. Second, looking past the current situation, oil prices will retreat somewhat but are likely to remain higher than during the 1990s.

In this world of durably more expensive oil, demand emanating from dynamic emerging economies will play a strong role in shaping future prices. The importance of emerging economies stems not only from their increasing contribution to world growth, but also (and more importantly) from the fact that, for a given increase in activity, their demand for oil is far larger than the OECD average. Indeed, future oil prices will crucially depend on further progress in energy conservation in emerging economies as well as the US.

Prudent management of non-renewable natural resources is not the only issue that matters for the long-run sustainability of OECD societies. Restoring order to public finances is also of vital importance for the well-being of future generations. In line with previous editorials, it bears repeating that, given existing budgetary plans, most of the largest OECD countries will see no substantial progress in bringing down structural deficits. This is regrettable in a context where pension and healthcare reforms are generating painful debate, and so, progressing with difficulty.

It might be hoped, of course, that prudent people would react to public profligacy by stepping up their own private saving efforts, and there certainly is evidence pointing in this direction. This is indeed the message delivered by the special chapter devoted in this OECD Economic Outlook to the long-term impact of fiscal policies. But, as a general rule, private saving does not fully offset public dissaving and this precautionary reaction may be contingent on national and historical circumstances. It is, for instance, hardly discernible in the case of the United States.

At the end of the day, the role of fiscal policy is not to add to the financial pressures arising from ageing populations. It is rather to relieve them, and enable us to take advantage of the ongoing recovery to finally implement gradual but far-reaching retrenchment.

References

OECD (2004), Economic Outlook, No. 76, November 2004 (preliminary edition), available at www.oecd.org/economics. 

Cotis, Jean-Philippe (20014), “Resilience and risks”, in OECD Observer No 244, September 2004.

©OECD Observer No 245, November 2004




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