Oil and the Wobbly Economy: A Long-Term Problem?

The economy, contemplating its possibly decisive influence in the election, is wobbling. Growth, so strong earlier in the year, has slowed abruptly—though not enough yet to divert the Federal Reserve Board from gradually pushing up interest rates. Sluggish growth plus dearer credit: not exactly a vote-winning combination.

What lies behind the wobbly economy, and might things change in time to help the Bush campaign? As it raised interest rates another quarter-point last week, the Fed in its economic commentary underlined the recent rise in oil prices. If the oil-price hike is the main cause of the broader slowdown, and if, as the Fed appears to believe, oil prices will fall again before long, then the economy will soon bounce back. In that event, the Fed's policy of continuing to raise interest rates from their present extraordinarily low levels would also make sense. Sadly, the Fed may be wrong on both points: The slowdown may reflect other factors as much as, or even more than, the price of oil, and costlier oil may, in any case, be a more persistent problem than the Fed expects.

High-priced oil reduces consumer spending, just as the Fed says, mainly by reducing people's real incomes. But this direct effect of oil prices is known to be far smaller this year than the unwinding of the Bush administration's mighty fiscal stimulus, together with the diminishing opportunity for mortgage refinancing, now that interest rates are going back up. And neither of these other negative influences is just a blip: The budget deficit rules out additional fiscal expansion until further notice, and the Fed, still with a lot of catching up to do, is committed for the time being to moving interest rates higher.

There are signs also that the international economy is putting a drag on domestic producers. The most recent monthly numbers surprised most analysts, showing the sharpest drop in export values in months, together with a big rise in imports (partly, but only partly, because of oil). Europe's recovery is still faltering. Japan's economy is doing better than before, but hardly breaking records. China's growth, and its voracious demand for American goods, may be cooling. All this is bad news for American producers.

So there is more to the current pause than the direct effects of more-expensive oil. To be sure, oil might matter more for its indirect effects on business and consumer confidence than for its immediate impact on disposable incomes—but that would only undermine the Fed's analysis in another way.

America's economic recovery has looked fragile, even if at times it has been energetic, because businesses and consumers are so heavily in debt. A bad surprise that causes borrowers to look hard at their finances and decide all of a sudden to start repairing them—leading to deep cuts in planned business investment and consumer spending, a decline in asset prices, and a severe recession—has long seemed a possible fate, all too plausible, for the United States economy. But if this is the concern, it would be wrong to think of a temporary oil-price shock as posing no more than a short-term risk to output. Bad news of this kind, blip or not, could easily stimulate a longer-term unraveling of America's overstretched balance sheets.

The recent high oil prices have not gotten businesses and consumers as alarmed as all that—so far, anyway. If prices fell soon, that would give some relief to domestic demand, even if less than the Fed hopes. But a fall in the price of oil is not certain to happen. Prices could stay above $40 a barrel between now and the election. And there might be, say, a 50-50 chance that they will go even higher.

The global oil market is behaving oddly. The reason, according to those who watch the industry closely, is that producers are running flat out: Production is as high as capacity currently allows. At today's rate of output, supply about matches demand (allowing for a bit of stock building). So the market has no margin of spare capacity, and that margin is what the oil producers' cartel—Saudi Arabia, especially—needs if it is to moderate or even just stabilize prices. As a result, the global market price is fluctuating under the influence of speculation (unusually active right now) and news (mostly bad, of late) about the short-term prospects for supply.

The Organization of Petroleum Exporting Countries is a puzzling outfit, to put it mildly. Of course, OPEC's members have a shared interest in holding oil prices higher than they would be in a free market, but not so high that they spur rapid development of alternative energy technologies or topple the world economy into a slump. However, the different members face different costs of production and have widely varying reserves. Saudi Arabia can produce very cheaply and has vast reserves, so it wants a lower long-term price than other members of the cartel, whose costs are higher and whose reserves will not last long enough for distant-future energy alternatives to be a great concern. In other words, OPEC members are busy gaming each other, as well as the world at large.

This makes it hard to know what is really going on when OPEC says, as it did last week, that it will increase output to lower prices, and nothing much then happens. Ali Al-Naimi, Saudi Arabia's oil minister, said that his country could increase its current oil production from 9.3 million barrels a day to 10.6 million barrels a day if needed. The oil market said, in effect, that it did not believe him—either because he was not being honest about the available spare capacity, or because, even if the capacity existed, the markets doubted that it would be brought on stream. (After all, so long as it avoids getting blamed, and so long as global demand does not shrivel, Saudi Arabia likes $45 a barrel just fine.)

What the market does know, however, is that global oil-supply capacity faces many other threats. Insecurity in Saudi Arabia is one. The continuing violence in Iraq, delaying the full-scale resumption of supply, is another; and market-watchers are increasingly worried that Iraqi production might be shut down altogether. Supplies from Russia are cast into doubt by Vladimir Putin's continuing legal assault on Yukos, the country's biggest producer. Venezuela, another big supplier, faces uncertainties of its own, by no means resolved by Hugo Chavez's victory in the recall referendum.

Cambridge Energy Research Associates said recently that a new supply disruption costing the market between 500,000 and 750,000 barrels a day for a period of several weeks would push the price above $50 a barrel. That is a level that starts to look alarming (even if, in real terms, it is still way below the prices seen during the oil crises of the 1970s). Oil at $50 or more might be enough to upset confidence, in the United States and elsewhere, in the way just described. Right now, Russia, Venezuela, and Iraq are all individually capable of delivering a shock of that comparatively modest size—and the ability (never mind the willingness) of the rest of OPEC to make up the shortfall is in doubt.

Between now and the election, there is little that the government can do, and nothing that either campaign can say, that would make any difference. The White House must be regretting its earlier, premature claiming of credit for the robust recovery, since that claim makes it difficult to deny responsibility for the current pause. But the Kerry campaign can no more plausibly blame the slowdown on the administration -- unless it describes a remedy of its own, which at the moment it appears to lack.

"Energy independence" for the United States, proclaimed from time to time by most politicians as a goal, is a mirage. An economy that consumes so much energy and produces so little cannot hope to achieve anything approaching "independence" without new and as-yet-unimagined technologies. Significantly reducing the demand for oil, a less dramatic goal, is both feasible and desirable, however. Its main benefit would be to tilt the self-interested calculations of OPEC in general, and Saudi Arabia in particular, toward cheaper oil. If demand were curbed, periods of little or no spare capacity would also be rarer, and that would help not just to suppress the price but also to reduce its volatility, a desirable result in its own right.

How then to reduce the demand for oil? Easy. Introduce a gas tax, levied at a low but gradually increasing rate, and use the proceeds, according to taste, to cut other (and more harmful) taxes, curb the fiscal deficit, or spend more on public programs. This tax would curb consumption of oil and powerfully stimulate research on alternatives at the same time. There is no intelligent economic argument against such a plan. It tells you something about American politics, doesn't it, that the idea is "unthinkable"?