Tuesday, December 4, 2007

High Oil Prices Will Save the World Economy?

Daniel Gros makes an interesting argument in the Financial Times today. Current high oil prices, he says, may just save the world economy from the intensifying credit squeeze. How so?

"The core of the issue is simple: oil producers tend to save about half of their windfall gains from higher oil prices. If the oil price stays around $90 a barrel, oil producers will increase their current account surpluses by $200bn-$300bn a year. The question will then be: who is willing and able to run corresponding deficits?"

In other words, the oil producing nations generate far more income than they spend and thus have excess savings. The excess savings will be lent out to (or used to buy assets from) countries willing to live beyond their means (i.e. run current account deficit). Since the world economy is being weighed down once again by tightening credit conditions that have emerged from the subprime mess, this injection of excess savings will provide the needed infusion of funding to keep the world economy going. Daniel Gros goes on to say,

"This prognosis implies, provided oil prices stay high, an ex ante savings surplus (in which surplus countries offer more savings than needed by deficit countries). That should lead to lower global real interest rates and/or higher asset prices – depending on the way petrodollars are recycled."

So excess savings from the oil exporters will keep real interest rates low and push asset prices back up. While I find this to be an interesting argument, I also find it confusing. Are we not in this current credit quagmire, in part, because of similar past excess savings from these same countries (and Asia) finding its way into the U.S. economy? (I say "in part" because I believe past U.S. monetary policy also played an important role) And why will there be more ex ante savings surplus this time around? If it is that oil prices are higher now, then why has there not been any impact already? I hope Daniel Gros is right and we soon see a lowering of spreads and easing of credit markets.

If, in fact, there will be more loanable funds coming to credit markets how will the underlying real economic distortions be worked out? Brad Sester provides one possibility in his posting "Should China buy Countrywide?": sell off U.S. assets, particularly troubled financial institutions invested in U.S. housing. He quotes Stephen Jen who says,

“We all know that SWFs [sovereign wealth funds] will have a very difficult time in the future, because of their vilified reputation. Buying cheap, strategic assets and appearing to be rescuing the US will carry immense long-term reputational benefits. More SWFs should jump in now, in my view. Countrywide would not be a bad choice. How much does it cost? Three weeks’ of reserve growth for China? Also, this may be the best time to buy US banks and financial institutions, as there would be the least political impediment to such inflows."

One implication, then, is that the excess savings will save the day as
foreigners indirectly (or directly in some cases) buy up the excess U.S. housing inventory. This brings a whole new meaning to home ownership in America.

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