In recent months, we have seen a dramatic drop in oil prices. For many consumers and business this fall in the price of oil will be welcome reduction in the cost of living and a reduction in the cost of business. However, is such a steep fall in oil prices good for the economy?
Benefits of falling oil prices
In normal economic circumstances, a fall in the oil price can help the economy.
- Lower oil prices reduce cost of transport and lead to lower costs for business, which can increase profitability.
- Consumers see a reduction in cost of transport and heating, leading to higher discretionary incomes
- This fall in oil prices helps to reduce inflation.
- The combined effect of lower prices, more spending power and lower costs of business can help boost economic growth.
Falling oil prices, shift SRAS to the right, creating a double benefit of lower prices and higher real output.
Impact on monetary policy
With lower oil prices, Central Banks have a better trade off between inflation and unemployment. With falling prices helping to reduce inflation, Central Banks are able to keep interest rates lower without the risk of headline inflation.
Oil prices as tax cut
Sometimes it is said that a fall in oil prices is like giving consumers a tax cut, and this has the same effect as expansionary fiscal policy. If petrol prices fall 10%, then consumers will spend less on petrol / getting to work, and have the ability to spend this extra discretionary income on other goods. Therefore, the fall in oil prices can lead to higher consumer spending in other areas of the economy.
But, are falling oil prices really good for the world economy?
Usually, a moderate fall in oil prices could be a fillip to both developed and developing economies who consume oil. However, there are fears that this particular fall in oil prices could start to actually become damaging – even for oil importers.
The problem is that this particular fall in oil prices is causing economic hardship. Prices have fallen so much that oil companies are going out of business. Areas, such as North Sea Oil, oil extraction from the Arctic and other high cost areas are now no longer economic. Firms have no option but to cut back on production and lay off workers.
With oil firms going bankrupt and investment being curtailed, there will be a negative impact on the global finance system. Banks which had lent money for oil investment are at risk of losing money, leading to a possible tightening of global credit. (with parallels to previous credit crunch)
Even OPEC countries, such as Saudi Arabia are feeling the crunch. If countries like Saudi Arabia are forced to pursue austerity, it will reduce flow of global capital (both short-term capital and long-term investment). The danger is that with many oil producing economies facing recession, it could be a tipping point which leads to a slow down in global economic growth.
Directly, Western consumers benefit from lower oil prices (although the reduction in petrol prices is less than fall in oil prices). However, indirectly, there is a danger that the global economy could be derailed by bankrupt firms, bank losses and a decline in global confidence.
A small fall in oil prices wouldn’t hit oil countries too much. But, this time, the fall in oil prices is so severe, that oil producers will be hit much more than previous oil price falls.
Inflation is already low.
If we had high inflation, a fall in oil prices can help inflation become closer to the government’s target of 2%, but with inflation already close to zero, falling oil prices are not helping reduce excess inflation – they are in danger of causing outright deflation. If we get deflation, then it can cause many problems in the economy, such as debt deflation, rising real interest rates and rising real wages. Falling oil prices could help embed deflationary pressures in the economy.
The point is that falling oil prices can be beneficial in normal economic circumstances. However, because the global economy is already weak, falling oil prices threaten deflation, and this can outweigh the benefits of ‘the tax cut effect’
Micro-effect of falling oil prices
One final point, many consumers are happy at lower prices. But, evidence suggests that consumers are responding to a fall in petrol prices by driving more. A 10% increase in traffic levels on UK’s crowded roads could cause very significant problems of congestion. It may be cheaper to drive, but it may well take much longer to travel anyway.
Falling oil prices would be a perfect time for the government to raise revenue from increasing petrol tax and cut tax on North Sea Oil producers.
Falling oil prices could have benefits of encouraging firms to stop oil extraction from new areas. But, on the other hand, lower oil prices are encouraging consumption. Also, falling oil prices could harm the growing markets for renewable energy and reduce the attractiveness of cars which use alternative fuel sources.
Problems of falling oil prices for oil producers
The problem of falling oil prices will be felt most significantly by oil producing countries and oil companies. The fall in oil prices will lead to lower revenues and a deterioration in their current account.
Countries such as Russia, which relied on oil for significant parts of GDP and tax revenues have been hard hit by falling oil prices. They have seen a rapid devaluation in the Rouble, (causing inflation and a decline in living standards) For oil exporters, a fall in oil prices leads to a worsening current account deficit. Other countries, such as Venezuela also relied on oil revenues to fund many social programs, with falling oil prices, there isn’t sufficient funds to meet the requirements of social services, such as health care and education.
Evaluation for oil producers
In the short term. oil producers like Venezuela and Russia face an unwelcome combination of falling tax revenues, devaluation, inflation and a decline in living standards. However, the fall in oil prices is forcing the economies to diversify and invest in industries, such as manufacturing and agriculture. In the long term, this could lead to benefits as it is always dangerous to have an economy reliant on one commodity, such as oil. Countries which rely on oil exports, can suffer from a phenomena known as the “Dutch Disease” So the painful re-adjustment may be worth it in the long-run.
Usually falling oil prices have been beneficial for the global economy. However, this time is different because the oil price is falling to a level which is making most oil production uneconomic. Many oil producers are likely to lose significant amounts of money. This unprecedented losses could have serious effects for global finance and the state of the global economy. This will outweigh any benefits consumers and firms may notice from cheaper petrol prices.