First Katrina and then Rita, both abolished the foundations of the Gulf of Mexico and New Orleans with Katrina attributed to some 200,000 jobless claims and for gasoline prices briefly touching $5/US gallon ($1.30/L), which would be the highest real price for gasoline paid in the United States during the internal combustion era.
With such destruction Rita appeared as a further drag on a weakened US economy. However, that was solely concerned to weaken the US economy, what repercussions the Asian Economies, particularly Pakistan would have to endure, is a concern not yet clarified.
According to the report released by Nouriel Roubini and Brad Sester of NYU and Oxford on effects of the recent oil prices on the US and global economy, oil prices shocks have a stagflationary domino effect on oil importing macro economies, which ultimately results in a recession.
Stagflation that relates to less growth, high prices finally leads to high inflation. However, before computing oil shock effects, categorically on growth and price levels, some factors are required for analysis:
-- The size of the shock, both in terms of percentage increase in oil prices and the real price.
-- The shock's persistence
-- The dependency of the economy on oil and energy
-- The policy response of monetary and fiscal authorities
These factors are not trivial and were the underlying factors, which contributed in the US and global economies' recessions in the past. Specifically, if the 1970 period is taken into consideration, the tripling of the prices of oil following the Yom Kippur war and the following oil embargo triggered the 1974-1975 recession, which was more detrimental.
Unlike the 1970s recession, the latest catastrophe, explicitly the 2001 US and global recession was partly caused by the sharp increase in the prices of oil in 2000 following California's energy crisis and the tensions in the Middle East (the beginning of the second intifada). But other factors were more important: the bust of the Internet bubble, the collapse of real investment and, in smaller measure, the Fed tightening between 1999-2000.
1. There will be a transfer of income from oil consumers to oil producers. As the propensity to spend of those who lose income (energy consumers) is generally larger than the propensity to spend of those who gain income (energy producers), there will be some fall in demand.
On an international level, the transfer is from oil importing countries to oil exporters, and oil exporters tending to expand demand only gradually. In addition, a reduction in demand can also occur within producing countries that allow higher oil prices to feed through to consumers, as energy producers tend to have a lower propensity to consume than energy consumers.
2. There will be a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. As the oil intensity of production in advanced countries has fallen over the past three decades, the supply side impact for a given increase in oil prices can be expected to be less than in the past episodes.
In developing countries, however, where the oil intensity of production has declined less, the impact may be closer to that in the earlier period.
3. There will be an impact on the price level and on inflation. Its magnitude will depend on the degree of monetary tightening and the extent to which consumers seek to offset the decline in their real incomes through higher wage increases, and producers seek to restore profit margins.
These responses can create a wage/price spiral, as was the case, during the oil shocks in the 1970s.
4. There will be both direct and indirect impact on financial markets. Actual as well as anticipated changes in economic activity, corporate earnings, inflation, and monetary policy following the oil price increases will affect equity and bond valuations, and currency exchange rates.
5. Finally, depending on the expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production (to the extent that there is scope for doing so) and investment, and for oil consumers to economise.
However, the question that arises here is why the 1970's recession was more detrimental than the 2005 recession? There can be several reasons derived for that cause; however, a few highly significant could be with respect to 2005 catastrophe:
The shock's persistence: Early shocks were more persistent as compared to 2000 shocks. It took about four/five years until the real price of oil fell back significantly. The 1999 and 2000 shocks were temporary (lasting about 3 quarters). But the latest shock, starting in 2002 has been quite sharp and highly persistent so far (lasting about 13 quarters).
The 1973 and 1979 shocks hit an economy that was more dependent on oil than today in terms of consumption). Current oil dependence on oil imports (as measured by net imports as a share of GDP) is as high as in the 1970s. Net oil have increased from 0.9% of GDP in 1970 to 1.2% in 2003 as domestic production has fallen relative to domestic consumption, and the pace of improvements in energy efficiency has moderated.
Net oil imports are more relevant than the economy's overall energy efficiency in assessing the growth effects of an oil shock. If net imports were zero, an oil price increase would not affect real GDP and would only redistribute income from domestic consumers to domestic producers of oil. Thus, the real GDP effect of an oil shock depends on the size of net imports.
The magnitude of the negative effect on disposable income of the latest oil shock is similar to that of the 1990 and 2000 shocks, about 0.6% of disposable income (estimate from Goldman Sachs). This is about half the hit on disposable income of the 1973-74 and 1979-80 shocks.
In the early 2001 when the effects of the 2000 oil shocks were starting to kick in, inflation was low and falling (and there were concerns about deflation) and the dollar was strong.
The Fed could afford not to worry about inflation and worry instead only about growth and unemployment, reducing the Fed Funds rate from 6.5% to 1% inspite of oil prices going up.
Keeping in perspective the high prices of oil at this time of year, that have resulted from the fact that US had been piling up oil stock reserves in the prior years and now with excessive reserves, it has triggered oil prices in the entire world. Asian Economies - heavily dependent on imported oil - should maintain petroleum stockpiles at this imperative stage which would become conducive for us in the coming years.
Likewise, the adverse impacts on Asian economies that are somewhat inevitable could be minimised to some extent as well.
With Asian economies having petroleum stockpiles, the question of importing oil would no more exist. The excessive reserves would compensate for the excessive demand in the Asian region and income distribution in the world would stabilise to some extent.
With the fact that Asian region now holds sufficient oil stockpiles, the other dependent countries, particularly US, would have to import it for Asian countries to facilitate its unwarranted demand for oil.
This would create an inflow of foreign direct investment in the Asian region that would reduce the prices that are charged in the Asian region these days.
Even if countries in the Asian region, for instance, India and Pakistan would import oil from other Asian countries - with oil stockpiles - that would take place at lower prices as compared to the high prices prevailing at this time.