Economics: Ireland's economy could yet be driven towards recession if US-fuelled demand for our exports decreases

Most people associate rising oil prices with economic bad times. Nothing surprising about that. Eight of the nine international recessions since the second World War occurred in the wake of sharp increases in oil prices, including each of the four most recent: the recessions of 1973-75, 1980-82, 1990-91 and 2001.

But do oil price increases cause recession? Perhaps surprisingly, researchers are not unanimous in their answer to this question. Some studies, including one co-authored in 1997 by Ben Bernanke, the economist tipped by many observers as Alan Greenspan's likely successor as Fed chairman, argue that oil shocks do not of themselves cause recessions.

Still, by far the greater body of research on the subject maintains that large oil price increases do reduce economic activity, and the distilled wisdom that has entered public discussion is that every 10 per cent rise in the oil price reduces (US) GDP by 0.4 per cent.

Most studies are agreed too that the extent to which economies weaken in the aftermath of an oil price shock depends not only on the size and persistence of the shock, but also on how policymakers respond. In this regard, it is worth noting that responding to an oil price shock is an especially tricky business because a rise in oil prices tends to push up inflation and dampen economic activity at the same time.

To which of these tendencies do policymakers attach the greater concern? If it's the activity-dampening tendency, then the response will be to relax fiscal and monetary policy. If it's the inflationary tendency, policy settings will be tightened, for example by raising interest rates.

On the face of it, all of this seems irrelevant right now. Over the past two years, oil prices have more than doubled, from $30 a barrel in mid-2003 to more than $65 this week. At the same time, some of the world's leading central banks (notably the Fed, though not the ECB) have been raising interest rates. Yet, there has been no apparent slowdown in international economic activity.

On the contrary, US GDP growth accelerated from 2.7 per cent in 2003 to 4.2 per cent in 2004, and is expected to average a very respectable 3.6 per cent this year. European growth rates display a similar, if decidedly paler pattern:

1 per cent growth in 2003, accelerating to 2 per cent last year and forecast to settle in the 1.5-2 per cent range in 2005 and 2006.

So does this mean that the international economy has become immune to sharply rising oil prices? I don't believe so. First of all, it is possible (likely, even) that US and European growth rates would have been significantly higher in 2004 and 2005 if oil prices had not risen.

The fact that these economies have continued to expand does not mean that the oil price shock has not already had some dampening effect. Second, much of the oil price increase that has occurred since mid-2003 has been concentrated in the period since the start of this year (in early January crude oil was trading at under $45 per barrel), and so it is too early to expect its full impact to have been felt.

Third, there is the matter of expectations. Oil prices have been extraordinarily volatile over the past year or so, with wild swings of as much as $15-20 per barrel taking place within intervals of three months or less.

In these circumstances, economic agents may have been tempted to believe that the spikes upward were the result of transitory factors and that the higher levels would not persist. At the turn of the year, for example, it would not have been unreasonable to expect that prices, having tumbled from $55 to $42 per barrel over the previous two months, might settle in the $30-35 range. As recently as May, following the price action of the previous month or two, it would not have been unreasonable to expect prices to settle at $40 a barrel or less within a few months.

At this stage such expectations look hopelessly optimistic. Increasingly, the dominant feature of the oil price graph is the pronounced upward trend and not the big fluctuations, and increasingly, analysts are drawn to the conclusion that oil prices of more than (perhaps much more than) $50 a barrel are here to stay.

The risk in all of this is that consumers and businesses will adapt to these revised expectations by cutting back sharply on spending. The evidence that this process is under way is not compelling at the moment, although it's worth noting that consumer spending here has weakened appreciably of late. In three of the last four months for which data is available, the volume of retail sales has fallen by 1 per cent or more.

In its Spring Quarterly Bulletin, the Central Bank published its thoughts on oil prices and the Irish economy.

Having noted the big fall in the economy's reliance on oil since the early 1970s (a feature that Ireland shares with the rest of the OECD, indicating that the impact of any given oil price shock today will, other things equal, be considerably less than 20 years ago), the bank estimates that a 50 per cent rise in oil prices sustained over three years would reduce GDP by 1.1 per cent and raise consumer prices by 1.4 per cent by the third year. That's far from a doomsday scenario.

However, the bank points out that the estimate understates the likely effect because it omits the impact of reduced import demand by our trading partners. Therein lies the rub.

As I read it, one of the biggest risks to the global economy and, by extension, to Ireland, posed by the recent oil price hike is that it is the straw that breaks the back of the highly-indebted credit-hungry US consumer, who has acted almost single-handedly as the locomotive of world economic growth in recent years.

An early warning in this regard may have been provided by the latest US consumer confidence figures, published last week, which showed a steep four-point drop in August. Watch this space.

Jim O'Leary lectures in economics at NUI-Maynooth. He can be contacted at jim.oleary@nuim.ie