Comment to Professor Nouriel Roubini on: Effects of the Recent Oil Shock on the Global Economy in : How Much of a Global Slowdown? CICLO DE CONFERÊNCIAS MEI Perspectivas da Economia Mundial Miguel Lebre de Freitas GEE- Gabinete de Estudos e Estratégia

Real effects of the current oil shock not so significant so far: -Real oil prices did not rise that much -Sounder monetary policies –Lower dependency –Financial innovation –Until now consumers have reacted to the oil shock as if it was a temporary shock ( when a shock to real income is temporary and there are no liquidity constraints, it is optimal to maintain the consumption level and reduce savings).

Risks to global stability However, the global situation is fragile - Investment in most of Asia (taking out China) is too low, and high consumption in the U.S. is financed by rapidly increasing debt, coupled with high housing prices, while growth of domestic demand in Europe and Japan is too weak. -The persistency of high oil prices could trigger a global crises Oil prices interact with the global business cycle: –In the short run, oil demand and supply are inelastic, causing significant price swings, namely in response to the global business cycle. –OPEC countries are aware of this and usually try to adjust production plans so as to not cause recessions in the West. –The current situation, however, is of low spare capacity in oil producing countries and low refinery capacity in oil consuming countries (Hog Cycle). Moreover, the demand for oil is expected to keep rising

Three Scenarios 1. BW2 (with Asia playing the role of Europe in BW1): US economy financed by Asian banks, preventing the dollar depreciation and the interest rates from rising. In this scenario, exchange rate stability will fuel global growth. Oil prices will remain high. For how long? 2. Moderate slowdown in the US As the inflation rate surges, the Fed rises the interest rates, leading to a flattening of the housing bubble. Consumers’ confidence and expenditures will fall and the US current account will improve. Oil prices fall back. 3. US and global hard landing The (persistent) oil price shock triggers a consumption retrenchment, a bursting of the housing bubble, a deterioration of the US fiscal position and a massive flow of capital out of US. To avoid the hard landing: –Coordination of macroeconomic policies would be desirable –But there are political difficulties. –Thus, the likelihood of an orderly global rebalance is low.

On the global prospects With no question, there are some important and increasing risks: –The widening of global imbalances: –Higher and volatile oil prices, in a context of geo-political uncertainty But: –Global growth has been robust despite the oil prices –Inflation has picked up slightly, but it remains at moderate levels. –The global financial system is now much more resilient, with markets relatively stable. –The recent move towards flex in Asia (namely China) is good news for the global imbalance. Still: The risk of a global recession is not ruled out (IFM Managing Director, Mr. Rodrigo De Rato, 22 Sept: “oil prices have become certainly a threat for the world economy”).

My question: -If oil prices were indeed to stay high (optimistic scenario) -The shock was of a permanent nature -In the absence of significant investments aiming the expansion of the existing energy producing capacity -In the absence of effective efforts attain a greater efficiency in energy use -What would be the implications for a small, energy- dependent and energy-inefficient country like Portugal?

Real price of Oil in Portugal (as of August 2005) Source: GEE

Aggregate demand effects: In the current circumstances, in which households are somehow leveraged and interest rates are at historically low levels, a dump in consumption expenditures following a permanent rise in oil prices (and following the corresponding ECB reaction) would be difficult to avoid.

Asymmetric Incidence

Supply side effects: -In general, since oil is an input to many goods, producers would bear losses. -The impact on output and unemployment will depend on real wages: the shock will be smoother, the greater the ability of the firms to pass the burden to consumers and the more flexible nominal wages are, wherever the “pass through” is limited. –In sectors in which final goods are price-elastic (tradables), producers will take the hit. –As profit margins and returns on capital fall, capital will move away from energy-inefficient units to energy-efficient units (Disciplinary device?). –Adjustment costs: since factors do not move instantaneously from one sector to the other, unemployment rates may bust, propagating the business cycle.

Asymmetric Incidence

Current Account Adjustment : In a energy-dependent economy, an oil price shock acts as a transfer to oil producing countries abroad. –In the short run, a current account deficit will emerge. –If the shock is permanent, as external liabilities accumulate, capital inflows will become more difficult to sustain, calling for a real exchange rate depreciation –In the past, this was achieved by nominal exchange rate depreciation ( ). The fall in oil prices in 1986, in turn, was followed by a real appreciation. –In the present circumstances, no such mechanism exist. –Moreover, low efficiency in energy use is constraining the competitiveness of exporting firms and hence, the ability of the domestic supply to switch from nontradables to tradables. In sum, in a theoretical scenario of a permanent oil shock, with no new investments in alternative energy sources and without an effective move towards energy-saving technologies, the optimistic scenario could be quite painful to Portugal.