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Vysoká škola ekonomická v Praze Fakulta Mezinárodních vztahů

Obor: Mezinárodní ekonomické vztahy Diplomová práce

Macroeconomic Effects of Oil Price Fluctuations on Emerging and Developed Economies

Autor: Bc. Tomáš Kacerovský

Vedoucí práce: prof. Ing. Mansoor Maitah, Ph.D. et Ph.D.

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Prohlášení:

Prohlašuji, že jsem diplomovou práci vypracoval/a samostatně a vyznačil/a všechny citace z pramenů.

V Praze dne 20.11.2020 ………

Tomáš Kacerovský

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Poděkování

Tímto bych rád poděkoval vedoucímu této diplomové práce, panu profesoru Mansooru Maitahovi, za jeho trpělivost, laskavost a pomoc po celou dobu vytváření práce. Dále bych chtěl poděkovat Johnu a Kateřině Vanderpoolovým za jejich vstřícnost a neobyčejnou ochotu při korektuře textu.

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1 Abstract

This Diploma Thesis focuses on macroeconomic impacts of oil price fluctuation on the developed and developing economies. Primarily, it aims to challenge some widely accepted theoretical views regarding the impact of oil price fluctuations on economies.

The initial chapter is devoted to the theoretical findings of institutions such as the International Monetary Fund and also to the claims of various economists such as Milton Friedman and Hyman Minsky. Emphasis is going to be put on the different effects of the 1970’ oil shocks on several economies including the United States and West Germany.

The second chapter evaluates the most decisive events within the oil markets since the end of the World War 2 such as the establishment of OPEC.

The last two chapters are going to examine energy sectors of the Russian Federation and of the United States. Then a case study is to be driven outlining some different impacts of 2014 energy crisis.

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3 Introduction

The oil price and its fluctuation has been a popular topic, not only among financial professionals, economists and politicians. It has been widely regarded as one of the key indicators of economic stability throughout the world. Many countries, such as those in the Middle East, were fortunate enough, to be founded on a territory that provided them with significant oil resources. For many of them, this was a chance to escape from poverty that has been common for their region. The world has witnessed such merry stories both with envy and amazement. Being an oil rich country became a synonym for a thriving economy and stability.

Primarily in the 20^th century, given the bold technological expansion, oil became a key raw material. It was an elementary precondition for any further economic development, and oil exporters knew it well.

In the beginning of the 1960s, the major oil exporters established an organization that has aimed to secure stable relationships between its oil exporting members, who would no longer act as individuals when quoting their oil prices. The oil exporters called this alliance Organization of the Petroleum Exporting Countries, commonly known as OPEC.

Due to its establishment in the beginning of the 1960s, OPEC was given a chance to prove its firm unity during the Yom Kippur War in 1973 between Israel, a young Jewish state, and the alliance of Arab countries. The winner of this war, Israel, did not win solely due to its own resources. Western countries, such as the United States or the United Kingdom provided Israel with a large amount of military equipment and a diplomatic support. The defeated Arab countries were humiliated and urged OPEC, which consisted of mainly Arab countries, to intervene. OPEC imposed an oil embargo on the western countries who stood behind Israel in the Yom Kippur War.

This embargo caused a significant harm in the West. It was common to witness almost never- ending ques of drivers trying to buy at least some gasoline at their local petrol stations. The United States was one of the most affected countries. They were hit by severe inflation that was not confined only to the transportation goods and services. At its highest point, the United States faced a 16% inflation rate. The United Kingdom was hit even more severely. It reported inflation of 24%. On the other hand, countries such as West Germany did not face any inflation squeeze. At this point, the situation became rather confusing. In the 1970s, the United States had to import 50% of its oil consumption from abroad. The United Kingdom was even an oil

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exporter. West Germany had been importing 100% of its oil consumption and did not suffer from an inflation increase. In the 1970s, there were already voices that doubted the explanations that politicians addressed their peoples with, in which governmental officials, such as the U.S.

president Nixon blamed the overwhelming inflation on the oil shock. One of these sceptical voices belonged to a Nobel prize economist Milton Friedman, who pointed out that there has never been an inflation without an increased money supply. He claimed that it is the government and central banks who are to be blamed for the inflation of the 1970s. The fact that the United Kingdom, an oil exporting country, faced 24% inflation while West Germany who had to import all of its oil from abroad dealt at that time only with 4.5% inflation rate, giving Friedman and his fellow sceptics at least some portion of credibility.

If one declines the simple, some would say official explanation, that most of the economic issues of the 1970s were caused by oil shocks, he or she shall seek to find the true impacts of oil shocks and oil price fluctuation. This paper is going to ask the exact question. It aims to find out the true effects of oil price fluctuation on economic growth by observing the macroeconomic indicators such as export earnings, imports, exchange rates or inflation.

Given the complex aim of this thesis, it will provide the reader with three independent chapters.

In the first of these chapters, the reader is going to have a chance to acquire a theoretical background for the impact of oil prices fluctuations on the economic growth. It is an essential precondition for any further conclusion, shall the reader seek one.

This paper acknowledges that it cannot act foolish when giving ideas and conclusions. In order to provide its reader with a detailed overview, it is going to divide the first chapter into three subchapters.

The first subchapter aims to stress the differences between the net oil exporters and the net oil importers. The former face difficulties when dealing with an oil price decrease. The latter struggle when oil prices soar. The reader would be right assuming that such conclusion is not hard to make indeed. If the reader devotes his/her attention to this paper first chapter, he/she will not be provided with this elementary conclusion. This paper’s part is going to outline different effects of oil price fluctuation on the net exporters and importers within different economic time periods. It will focus both on the impact in the short run and in the long run.

After outlining the different effects in the long run and short run, the first chapter’s second subchapter will be devoted to the oil prices fluctuation’s impact on inflation.

Inflation is one of the key macroeconomic indicators. It is also crucial for this paper’s research since inflation has been widely regarded as one of the main features of higher oil prices. As the reader saw in the beginning of this paper’s introduction, there is a dispute whether inflation is,

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in reality, linked to higher oil prices or, as sceptics suggest, has nothing to do with it. It is going to be a crucial part of this thesis. In order to offer a reliable background for any further conclusions regarding the relationship between oil prices and inflation, this paper is going to employ a data analysis that was released by the International Monetary Fund. This data analysis is going to provide the reader with various findings that will be later compared with the actual development in this paper’s case study.

The third subchapter of this paper’s initial chapter is going to evaluate the relationship between oil prices and exchange rates, especially with the United States dollar. The U.S. dollar is the world’s reserve currency and according to many observations it has an inverse relationship with oil prices. The last part of the first chapter is going to explain to the reader the logic behind such unusual negative correlation and will provide him/her with a theoretical background for understanding the exchange rate movements that are linked to the oil price fluctuation.

At the beginning of the introduction, there was an oil embargo mentioned. The reader certainly recalls the Yom Kippur War and the shortage of oil in the Western countries, after the OPEC organization imposed its sanctions over Israel’s supporters. This sole event was an important episode in the oil market history. An important, but not a single most important one. In order to offer the reader a proper educational background of the oil market’s history, the second chapter of this paper is going to be devoted to the major events that had had a significant impact on the oil markets.

Between 2014 and 2015, the price of oil fell by more than 50%, from 112 USD per barrel in June 2014 to 48 USD per barrel in January 2015. In this period, the Russian Federation went through major economic difficulties. In 2010, the Russian government decided to establish two reserve oil funds. They both were built on the revenues from Russia’s oil exports. The first of these funds was established in order to support the governmental expenditures shall the government run out of its funds. In 2018, Russia’s government officials announced that this fund, created to secure country’s public spending, ran out of its financial capital. Having learned about the collapse of Russia’s reserve fund, it does not require one to have an advanced degree to understand that Russia faced some significant economic decline. But was it the oil shock of 2014 that caused Russia’s economic crisis?

To answer this question, one has to examine the importance of oil for the Russian Federation.

The first subchapter of the final chapter of this paper is going to focus on Russia’s energy sector.

It will analyse its core fundamentals and examine the impact of the oil shock of 2014 on Russia’s economy. The second subchapter of the final part of this thesis is going to perform the same analysis for the United States of America.

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Are the impacts going to differ? Could the theoretical base that was presented in the initial chapter provide us with a fairly accurate forecast which one could use while modelling any future scenario? The final part of the third chapter is going to provide reader with a comparison of the theoretical expectations and the real effects the oil shock of 2014 had on the Russian Federation and the United States of America.

This is also the main question that this paper poses. Are the widely accepted theoretical findings regarding the impact of oil price fluctuations on the economic growth accurate? Was Friedman or Minsky right when they claimed that oil shocks have nothing to do with inflation? Do exchange rates react to the oil shocks the way theory suggests? Are there any exceptions?

The author of this paper suggests that the widely accepted theoretical base presented here only applies for countries, whose reliance on oil is overly profound. On the other hand, diversified economies do not suffer from oil shocks much, shall their monetary policy makers act wisely.

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4 Oil Price Fluctuations and the Economic Growth: Theoretical Part

This chapter is going to analyse the effects of the oil price fluctuations on economic growth and vice versa. It aims to examine the relation between oil prices and GDP growth by analysing the oil price’s effects on inflation, exchange rates and monetary policy.

The initial parts of this chapter are going to evaluate the significance of oil price fluctuations for the economic growth.

The second part of this chapter is dedicated to the analysis of different effects of the oil price fluctuation on the net oil importers and importers.

4.1 Introduction

Since the late 19^th century, oil has become one of the key indicators of the economic activity due to its position as the key source of energy for the increasing global demand. Nowadays, the importance of oil decreased as various alternative sources of energy appeared (solar, hydro, wind power). In spite of the new energy forms, oil has kept its important role within the global economy. Such a role exceeds a purely economic field and has a direct impact on many aspects of social life. Therefore, a predominant number of economists and scholars argue that there is a strong relationship between the oil price changes and the economic growth. A prevailing portion of research claims that the oil price fluctuations have a significant impact on the economic activity. Arguably, such impact is different in oil exporting countries and in oil importing countries. The oil exporting countries are expected to welcome any oil price increase whereas the importers shall be well aware of the negative consequences they may face, shall the oil price surge. Naturally, should the opposite scenario take place, a reverse effect is to be expected.¹

The transmission mechanisms through which oil prices have an impact on real economic activity include both supply and demand channels.²

1 Ghalayini, Latifa, The Interaction between Oil Price and Economic Growth, Review of Middle East Economics and Finance, 1/2011, p 127

2 Ghalayini, p 128

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Both supply and demand side could be harmed once oil prices increase. Crude oil is an input to the production, therefore, a price increase leads to higher production costs and induces companies to lower output, which harms the supply channel.³

The demand side (consumption) could be harmed both directly and indirectly. Oil demand is inelastic.⁴ Therefore, consumers tend to demand approximately the same quantity of oil despite the unpleasant price increase. However, when their disposable income stays at the pre-oil shock level, consumers limit their demand for other goods and services in order to afford a suddenly more expensive gasoline. The same applies for businesses who have to ship goods from place to place.⁵ Thus, when an oil shock (unexpected price surge) is perceived as long lasting, businesses may limit their investments and other expenses to withstand higher oil prices and along with the general public.⁶

The indirect effects of oil price fluctuation on the demand channels are based on its impact on inflation and exchange rates (which are to be discussed in the latter parts of this chapter).⁷

3 Ghalayini, p 128

4 Economics Online, The Oil Market, economicsonline.co.uk/Competitive_markets/The_market_for_oil.html

5 Federal Reserve Bank of San Francisco, What are the possible causes and consequences of higher oil prices on the overall economy, 2007, frbsf.org/education/publications/doctor-econ/2007/november/oil-prices-impact- economy/

6 Federal Reserve Bank of San Francisco, What are the possible causes and consequences of higher oil prices on the overall economy, 2007, frbsf.org/education/publications/doctor-econ/2007/november/oil-prices-impact- economy/

7 Ghalayini, p 128

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4.2 Impact of Higher Oil Prices: A General Comparison of Exporters and Importers

This subchapter is going to examine the impact of higher oil prices on countries that are net oil exporters and will compare them with net oil importers. It will focus on different stages that follow an oil price increase. Therefore, both short-run and long-run consequences for both exporters and importers will be discussed.

4.2.1 Impact of Higher Oil Prices: Net Exporting Countries

For oil exporting countries, an increase of the oil price increases the real income via higher export earnings. Such increases are often partly offset by a lower demand from the trading partners who suffer from the economic difficulties caused by the oil price increase.⁸

Due to the fact that the short-term demand for oil is inelastic, consumers tend to maintain (or slightly decrease) their oil consumption as they did before the price surge.⁹ This factor may help the net oil exporters in case of a short-term price increase. Their trading partners would not decrease their demand and even pay more while sticking to their longer-term economic plans. Therefore, the consumers are going to pay more due to higher prices and the same level of consumption. At the same time, their economic activity stays unhindered, which leads to a further increase of demand for oil.

In the event of a longer-term oil price increase, consumers would be forced to decrease their economic activity. This leads to a decrease in demand for oil since countries and companies would halt many of their projects or would be trying to lower their oil dependency. Thus, such ramifications of the long-lasting price increases explain why the demand for oil tends to be more elastic in the long run.¹⁰

An additional effect is that higher oil prices attract more market participants and lead to increases in exploration. This factor could affect the oil market structure by increasing supply and by reshaping the market hierarchy.¹¹

8 Ghalayini, p 131

9 Economics Online, The Oil Market, economicsonline.co.uk/Competitive_markets/The_market_for_oil.html

10 Khan Academy, Elasticity in the long run and short run, khanacademy.org/economics-finance- domain/microeconomics/elasticity-tutorial/price-elasticity-tutorial/a/elasticity-in-the-long-run-and-short-run

11 Ghalayini, p 132

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Figure 1: Oil Price Elasticity in Short-Run and Long-Run (Prices of the 1970s)

Source: Khan Academy

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4.2.2 Impact of Higher Oil Prices: Net Importing Countries

The apparent effect of higher oil prices on oil importing countries are national income losses.

The severity of national income losses depends on a country’s oil demand elasticity. As mentioned in the former subchapter, demand for oil in the short term is inelastic. In the short run, consumers adjust their spending by reducing expenditures on other goods and services in order to be able to cover higher increased oil expenses. Consequently, the economic growth slows down.¹² However, after a longer period of high oil prices, consumers tend to change their habits to adjust to the higher oil price levels, i.e., demand for public transport rises. Car manufacturers also design automobiles that are less oil dependent, etc.¹³

US petroleum consumption was down even though the US economy was one-fourth larger in 1983 than in 1973. The reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars...and other fuel-conserving choices, the demand curve for energy had become more elastic.¹⁴

Such measures decrease the demand for oil and drive its price lower. A falling price of oil convinces part of the consumers to demand more gasoline. At the same time, businesses become aware of another possible oil price shock and increase their oil supply. In addition to this factor, high oil prices make the formerly too costly production profitable and attract new producers.

Therefore, supply increases and demand for oil becomes more elastic.¹⁵

12 Ghalayini, p 133

13 Pettinger, Tejvan, Adjusting, to oil price shocks, economicshelp.org/blog/164216/economics/adjusting-to-oil- price-shocks/

14 Khan Academy, Elasticity in the long run and short run, khanacademy.org/economics-finance- domain/microeconomics/elasticity-tutorial/price-elasticity-tutorial/a/elasticity-in-the-long-run-and-short-run

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Figure 2: Adjusting to Oil Shock in SR and LR

Source: Pettinger, Tejvan, Adjusting to Oil Price Shocks

1) SR: Supply falls from S1 to S2. Consequently, price rises to P2 while demand falls.

2) LR: Demand becomes more elastic and moves to D2.

3) LR: Firms are aware of another price shock and increase their supplies of oil. Such action makes the supply shift from S2 to SLR.

4) LR: Demand stays on lower level than before the initial price shock. New price equilibrium is found at P3.¹⁶

SLR

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4.2.2.1 Conclusion

Due to the inelasticity of demand, the net oil exporters benefit from the short-run consequences that follow an oil price increase. In the short run, their trading partners do not tend to limit their consumption. Therefore, the exporting countries increase their national income while enjoying further rise of demand from an unhalted economic activity of their trading partners.

On the other hand, the net oil importers are harmed in the short run. They suffer from a sudden increase in expenditures. They do not lower their oil consumption, but adjust their other expenses. In a long-run, they adapt to the situation by manufacturing products that are less oil- dependent, such as more fuel-efficient automobiles or by using other means of transport.

Companies in the oil-importing countries also increase their oil supply to soften impacts of another possible oil price shock. Consequently, their oil demand becomes more elastic.

Therefore, they are more resilient to any upcoming oil shock.

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4.3 Impact of Higher Oil Prices on Inflation

It has been a widely accepted view that oil prices and inflation are directly connected in a cause- effect relationship. As the price of oil augments, general prices (thus inflation) follow them in the same direction. On the other hand, plummeting oil prices ease the inflationary pressure.¹⁷ The following part of this paper is going to examine whether the popular view is valid.

Therefore, it will focus on the alleged relationship between price of oil and inflation and the causes of such relationship.

4.3.1 Introduction

It is only natural that after an oil price surge, the energy basket of the Consumer Price Index follows. A more interesting question is whether an oil price increase influences the overall inflation (CPI stripped of the Energy basket) and if it does, how lasting is such effect? What are the factors that determine the severity of the impact on inflation? Are these factors based on how developed a particular country is, and if so, does the oil price fluctuation harm predominantly the developed or developing economies?

In 2017, the International Monetary Fund came up with a study called Oil Prices and Inflation Dynamics: Evidence from Advanced and Developing Economies. In their research, the IMF scholars tried to answer question similar to those we ask in this paper.

4.3.2 Channels and Estimation Strategy

This subchapter is going to outline the data analysis by International Monetary Fund that is based on annual data from 72 developed and developing economies. There will be an estimation method employed in order to measure the impact of oil price fluctuations on examined economies.

17 Renou-Maissant, Patricia, Is Oil Still Driving Inflation, The Energy Journal, 2019, p 199

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The headline of CPI shall be denoted by 𝑃𝑡, which is expressed as:

𝑃𝑡=𝑃𝑡𝑁𝑤𝑡𝛿

,¹⁸

Where 𝑤𝑡=𝑃𝑡𝑂/𝑃𝑡𝑁 stands for the ratio of oil to non-oil part of CPI; 𝛿is the share of oil within CPI; N stands for non-oil and O for oil. Taking logarithms and first differences of the 𝑃𝑡=𝑃𝑡𝑁𝑤𝑡𝛿equation, we can write the headline inflation as:

𝜋𝑡=𝜋𝑡𝑁+𝛿∆𝑙𝑜𝑔𝑤𝑡

¹⁹

Our second equation shows how global oil prices influence headline inflation. The direct effect is based on changes in the log of the ratio of oil to non-oil CPI (∆𝑙𝑜𝑔𝑤). Such effect is a function of the share of oil in CPI (𝛿). The second effect is through changes in non-oil (core) inflation (𝜋𝑁).

In order to estimate the impact of the fluctuation of oil prices on domestic CPI, the IMF employed a method that consists of estimating impulse response functions from local projections.

For each period (in this case annum) k, one can use the following equation:

𝜋𝑖,𝑡+𝑘=𝛼𝑖𝑘+𝜗𝑡𝑘+∑𝛾𝑗𝑘𝑙𝑗=1𝜋𝑖,𝑡−𝑗+𝛽𝑘𝛿𝑖,𝑡−1𝜋𝑡𝑜𝑖𝑙+∑𝜃𝑗𝛿𝑖,𝑡+𝑗−1𝜋𝑡+𝑗𝑜𝑖𝑙+𝑘𝑗=1𝜀𝑖,𝑡𝑘²⁰

Where 𝜋 represents domestic inflation; 𝜋𝑡^𝑜𝑖𝑙 stands for the global oil inflation in time (annum) t; 𝛿𝑖𝑡−1 stands for the share of oil in the domestic basket, i stands for an examined country; 𝛼𝑖𝑘 are country-fixed effects, 𝜗𝑡^kstands for the time-fixed effect; 𝛽𝑘 is a measurement of the impact of oil prices on domestic inflation within the period k; 𝛾𝑗𝑘 stands for the persistence of domestic inflation.

18 Choi et al., Oil Prices and Inflation Dynamics: Evidence from Advanced and Developing Economies, International Monetary Fund Working Paper, 2019

19 Choi et al., p 11

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4.3.3 Results of the IMF Working Paper

Results that came up from the IMF data analysis suggest that the oil price shocks clearly affect domestic inflation. They claim that a 10% increase in oil prices increase domestic inflation by 0.4% in the short run but becomes insignificant two years after the shock. Given that many of the oil shocks exceeded a 50% increase, it is a significant impact.²¹

Figure 3: Results of IMF's Analysis’

Source: IMF

4.3.3.1 Impact of Oil Price Shocks (or Bad Monetary Policy) on Inflation Over Time

To reflect the fundamental changes of the global economy over time, the IMF researchers employed the above outlined formulas for two different time periods. The first-time period consisted of the data from 1970 to 1992 and the second one from 1993 to 2015.

Figure 4: The Impact of Oil Price Shocks on Domestic Inflation, 1970-1992; 1993-2015 (%)

Source: IMF

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The Figure 4 shows that the impact of oil price shocks declined. During the first examined time period (1970–1992), the effect of an oil price shock was more than three times stronger than in the latter period (1992–2015).²²

Similar findings were made by Paul Segal, a scholar of the Oxford Institute for Energy Studies in 2007.

The monetary policy component of the explanation for the decline in the impact of oil prices on output therefore seems to rest on the fact that oil prices have less of an impact on core inflation than in the past.²³

The key question is why the oil price shocks resulted in more severe inflationary pressure in the 1970s than nowadays. Paul Segal argued that one of the reasons may be based on a weakening bargaining position of the labour unions. He claims that the labour unions were more powerful in the 1970s than they are today. Formerly, in order to compensate for an oil price surge, the unions immediately demanded major wage increases. Segal argues that nowadays, due to a higher capital mobility, their negotiating position is not as strong as it used to be in the 1970s.²⁴²⁵

In his paper, Segal also claims that globalization has been a factor lowering the impact of oil shocks on inflation. He argues that businesses nowadays face a stronger competition. They prefer to maintain their market share at lower margins rather than give up their sales to the low-priced imports from Asia. Therefore, companies absorb losses rather than increase prices.²⁶

The third reason, according to Segal, is a more credible monetary policy. He suggests that economic agents fear that any wage-price spiral would be followed by a tough interest rate response. Therefore, despite facing an oil shock, they do not demand higher wages.²⁷

23 Segal, Paul, Why Do Oil Price Shocks No Longer Shock, Oxford Institute for Energy Studies, New College, Department of Economics, University of Oxford, 2007, p 17

24 Segal, p 18

25 One could claim that Segal’s point regarding the trade unions as the key accelerators of inflation seems rather vague. Inflation has occurred in countries with no effective labour and trade unions and price stability was achieved in economies with strong and effective unions.

26 Segal, p 18

27 Segal, p 18

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However, the IMF study came up with some other suggestions regarding the declining impact of oil price shocks on economy. After examining fundamentals of 72 economies in their working paper, they argue that there are some general explanatory factors.²⁸

• Transport share in Consumer Price Index: Countries with a higher share of transport in their CPI basket tend to suffer more from oil price shocks.²⁹

• Fuel share of merchandise import on the ratio of net energy imports to total energy use³⁰: IMF claims that changes in oil price could have opposite effects on the level of prices and the foreign exchange rate between net oil exporters and net oil importers. The impact of oil price increase on domestic inflation tend to be smaller for an economy with low oil imports or high oil exports.³¹

• Past Inflation and Inflation Expectations: Countries with a higher level of inflation ten to suffer a higher inflationary effect from oil shocks. It is due to higher inflation expectations. Businesses in a high inflationary environment expect oil shocks to be long lasting and adjust their production and wage policies to such expectations.

Consequently, their actions strengthen the inflationary impact of the incoming oil shock.³²

• Inflation targeting regime: When a central bank seeks to hold an inflation rate at a specified level, it lowers inflation expectations and (reversely to the point above) reduces the impact of oil shocks on domestic inflation. In their working paper, IMF recalls the study done by Furceri et al. (2016) who found that economies with inflation targeting suffer less from inflation shocks.³³

• Central Bank Autonomy: According to IMF, a greater central bank independence tends to be associated with a more credible monetary policy. Therefore, central bank autonomy reduces the impact of oil price shocks on domestic inflation.³⁴

• Energy Subsidies as a Share of GDP: Countries possessing a high level of energy subsidies tend to be affected less from oil price shocks. According to IMF, subsidies

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distort the price signals from oil shocks and hinder the pass-through of surging oil prices to overall inflation.³⁵

An important question is: which of the points above are superior to others? In his writings, Segal recalls findings of Blanchard and Galí (2007). They found that West Germany did not face any significant inflation increase between 1970 and 1983 whereas the rest of the western countries did.

Also using a VAR, Blanchard and Galí (2007) similarly find that oil price rises over 1970–83 had a strong effect on most rich countries, but very little effect on inflation in West Germany, or on inflation or output in Japan.³⁶

In the beginning of the 1970s, West Germany was a highly industrialized economy with a major automotive industry and a high transport share.³⁷ West Germany’s inflation reached 4.5% p.a. in 1970.³⁸ Therefore, going off the IMF research, one could claim that West Germany was to be smashed by inflation when facing two oil shocks of the 1970s.

Surprisingly, just as Segal reports, it was not. Unlike other western economies such as the United States, West Germany did not hold interest rates at low levels and reached price stability through a restrictive monetary policy. It increased interest rates and contracted its money supply. According to Bundesbank, this prevented the inflation rate from rising into double digits.³⁹

While the West German experience contradicts some of the IMF findings, it supports the claim that an independent central bank could prevent an inflation increase. Bundesbank was, in comparison with other central banks, a significantly more independent institution and later served as a model for the institutional reconstruction of other central banks.⁴⁰

Central banks have been transformed into independent institutions over the past few decades and are tasked with safeguarding the value of the currency to prevent

36 Segal, p 3

37Rahlf, Thomas, Deutschland in Daten: Zeitreihen zu Historischen Statistik, 2015, p 262, https://www.econstor.eu/bitstream/10419/124185/1/4938_zb_dtindaten_150714_online.pdf

38 Inflation.eu, https://www.inflation.eu/en/inflation-rates/germany/historic-inflation/cpi-inflation-germany.aspx

39 Bundesbank, Lessons Learnt from History, 2012, https://www.bundesbank.de/en/tasks/topics/inflation-lessons- learnt-from-history-666006

40 Bundesbank, Lessons Learnt from History, 2012

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government monopolisation of monetary policy. The Bundesbank served as the model for the institutional structure.⁴¹

Learning about the German experience of the 1970s, could one assume that the most important factor behind a successful oil shock management are central banks’ independence and not increasing the money supply? Are these two factors superior to others, such as to the transport industry share or to inflation expectations?

In his book called Free to Choose, Milton Friedman of the University of Chicago claims that there has never been a case of substantially rising inflation without being accompanied by a rapid increase in the money supply.⁴²

However, to our knowledge there is no example in history of a substantial inflation that lasted for more than a brief time that was not accompanied by a roughly correspondingly rapid increase in the quantity of money; and no example of a rapid increase in the quantity of money that was not accompanied by a roughly correspondingly substantial inflation.⁴³

Regarding our German case, Friedman takes a clear stance. He argues that in the five years after the first oil shock in 1973, inflation both in Germany and in Japan declined from 7% to 5%, and from over 30% to less than 5% respectively. In the United States, inflation peaked 12 months after the oil shock of 1973 as it reached 12% and then declined to 5% in 1976 – only to rise again to over 13% in 1979.⁴⁴

Could such different experiences be explained by the oil shock, which affected all western countries? Friedman points out that both West Germany and Japan were, in the 1970s, 100%

dependent on imported oil, whereas the United States was only 50% dependent, additionally the United Kingdom was even a major producer of oil.⁴⁵

One could suggest that both Germany and Japan – as countries 100% dependent on imported oil, should suffer an overwhelming inflation increase. On the other hand, the United States

41 Bundesbank, Lessons Learnt from History, 2012

42 Friedman, Milton, Free to Choose: A Personal Statement, 1980, p 256

43 Friedman, p 256

44 Friedman, p 263

45 Friedman, p 263

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should be at least partially spared, and the United Kingdom should not be harmed at all.

Figure 5 proves otherwise.⁴⁶

Figure 5: United Kingdom Consumer Prices

Source: Federal Reserve Bank of St. Louis

What did the United States do wrong that made them suffer from inflation much more than Japan and West Germany did? According to Friedman, the monetary policy and employment targeting are to blame. He claims that the United States accelerated growth of its money supply (thus printing money and consequently inflation) for three reasons: the rapid growth in the U.S.

government spending, the full employment policy and a mistaken policy pursued by the Federal Reserve System.⁴⁷

Assuming Friedman’s claims are correct, could we suggest that oil shocks were, in fact, not the key inflation driver in the 1970s? Both Segal’s and IMF’s studies found that after the 1970s, the impact of oil shocks decreased.⁴⁸ ⁴⁹ But was it the impact of oil shocks that caused the weakening or did the central bankers adopt better monetary policies? Did governments stop financing their increased spending with newly printed money? Or are Milton Friedman’s ideas led by his sceptical monetarist attitude towards government role in economy?

In his book Stabilizing an Unstable Economy, a Post-Keynesian economist Hyman P. Minsky expresses views that are similar to Friedman’s. He claims that it is indeed a governmental commitment to maintain a certain level of employment, which can cause inflation.⁵⁰

46 Federal Bank of St. Louis, fred.stlouisfed.org/series/FPCPITOTLZGGBR

47 Friedman, p 264

48 Segal, p 18

50 Minsky, Hyman P., Stabilizing an Unstable Economy, Yale University Press, 1986, p 314

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In a world in which the government is committed to building some targeted number of homes or achieving some unemployment rate, increases in money wages will trigger the increased financing of government spending. Only if monetary and fiscal policy is set to so as to maintain target unemployment levels or output can an autonomous rise in money wages lead to inflation.⁵¹

Minsky genuinely claims that when governments or central banks aim to maintain a specific level of employment, they will probably end up having to substitute private sector’s investments with government spending.⁵² As Friedman argues, government will more likely increase money supply rather than raise taxes to finance jobs they artificially keep alive in order to maintain the target employment rate.⁵³ If such jobs do not increase output at least as much as the money supply increases, inflation is going to surge.⁵⁴

4.3.3.2 Conclusion

Inflation was perhaps the most significant problem for many western countries throughout the 1970s. Given the fact that two biggest oil shocks came in the same time period, both economists and general public regard these two elements as strongly connected. But how do we explain that countries that were 100% dependent on imported oil, such as Japan and West Germany, did not suffer from an increased inflation following the two oil shocks while the United States with only 50% imported oil dependency, ended up with a double-digit inflation? How is it possible that the United Kingdom’s inflation reached 24% in 1975, given the fact that it was a net oil exporter?⁵⁵

51 Minsky, p 314

52 Minsky, p 314

53 In his book Free to Choose – A Personal Statements Friedman explains why governments prefer money printing over issuing bonds and taxes. If they issue bonds, interest rates will increase, making it more expensive for individuals and companies to borrow money or to get a mortgage. If they raise taxes, they could lose elections or they could fail to pass the taxation bill through parliament. On the other hand, printing new money does not require tough political disputes or facing an angry public. It is much easier for politicians to kindly ask their central bankers to provide additional funds by printing money. Other advantage of printing new money lies in the fact that its inflationary effect does not arrive immediately. In the beginning, people will feel as their real income increased.

Unfortunately, they realize later that their savings lost some of their value and that prices surged more than their wages. (Friedman, 1980)

54 Friedman, 264

55 Friedman, 263

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Every time the author of this thesis led a conversation with his fellow students and scholars regarding the factors that led to the 1970s inflation, oil shocks were the first and also the last thing that came up on everyone’s mind.

But how could one finish the discussion with such a conclusion when two of the most important economists of the late 20^th century both claim it was not oil shocks of 1973 and 1979 that caused inflation?

In his book Stabilizing the Unstable Economy, Minsky devoted two entire chapters to inflation.⁵⁶ This book came out in 1980; 7 years after the oil shock in 1973 and immediately after the second one in 1979. One could expect him to exhaustedly complain about the deadly oil shocks that caused such a high inflation. Surprisingly, oil was not mentioned once in Minsky’s two chapters about inflation. In these terms, Milton’s Friedman’s Free to Choose does not differ much. Friedman regards oil shocks as a mere short-term factor.

Both Minsky and Friedman find other reasons for inflation of the 1970s: employment rate targeting followed by accelerated money printing.⁵⁷

This view corresponds with findings of Paul Segal, who claimed that in the 1970s, the United States’ trade unions had a strong bargaining position.⁵⁸ Given that the governments targeted a certain level of employment, unions enjoyed a strong negotiation leverage. Their demands for wage increases led to a wage-inflation spiral that was to be financed by newly printed money.

Consequently, the full employment strategy was a total failure. Even though such policies caused high inflation and contributed to the 1970s stagflation, government officials were not eager to confess their incompetent actions to the general public. According to Milton Friedman, in order to escape from being held responsible, elected officials blamed inflation on oil shocks.⁵⁹

Oil shocks should not be regarded as the cause of inflation that took place in the 1970s.

56 Minsky, p 284

57 Friedman, p 265

58 Segal, p 18

59 Friedman, Milton, Money Mischief – Episodes in Monetary History, p 232,

https://books.google.cz/books?id=lDF_uNIWQ_oC&printsec=frontcover&dq=milton+friedman+%22money+mi schief%22&hl=en&newbks=1&newbks_redir=0&sa=X&redir_esc=y#v=onepage&q=monetary%20phenomeno n&f=false

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They might have had a severe short-term effect (as the IMF found out⁶⁰), but their significance for inflation is vastly overestimated. In terms of inflation, countries such as West Germany and Japan were not hurt at all by either of the 1970s oil shocks. It was due to their non-inflationary monetary policy. Neither of the countries targeted their employment or supported their government spending by printing new money. The United States spent the 1970s doing the exact opposite. They increased money supply while targeting a specific employment rate.⁶¹ Unfortunately, every artificially sustained job cost the United States more than it produced.

Consequently, the United States faced significant inflation throughout the hole decade - but in this case, oil shocks should not be held responsible.

4.4 Impact of Oil Price Fluctuation on Foreign Exchange Rates

This chapter aims to analyse the impact of oil price fluctuations and generally higher oil prices on exchange rates and Asset Prices. It will focus predominantly on the relationship between oil prices and the United States Dollar.

In one of its Working Paper Series published in 2014, called Oil Prices, Exchange Rates and Asset Prices, the European Central Bank (ECB) points out the negative correlation between USD and oil prices. The ECB argues that even though there was no such correlation (or in this case – a negative correlation) before the early 2000s, it reached almost -0.6 in 2009.⁶²

Figure 6: Oil/USD Correlation

Source: ECB

61 Friedman, p 265

62 European Central Bank Working Series, Oil Prices, Exchange Rates and Asset Prices, 2014, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1689.pdf, p 4

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The inverse relationship between the oil price and USD was also the main subject of Czech National Bank’s Inflation Report in November 2011. As well as theCB, the CNB also observed the strengthening negative correlation between the dollar exchange rate and oil price.

In its inflation report, the CNB claims that an inverse relationship has been evident since 2002 when rising oil prices had been accompanied by depreciation of USD.⁶³

According to the ECB report, there are multiple channels that allow oil price volatility to affect exchange rates. The first channel is through trade. Increase in oil prices leads to deterioration of trade balances of the oil importing countries, which leads to depreciation of their currencies.

The other channel is based on the so-called wealth effect. Higher oil prices tend to transfer wealth from net oil importers to net oil producers which causes changes in the exchange rate of the importers due to current account imbalances and portfolio reallocation.⁶⁴

On the other hand, this could happen vice versa - changes of exchange rates may affect oil prices. The ECB argues that exchange rates could influence oil prices on both oil supply and demand side and through financial markets. On the supply side, weakening of the dollar may convince oil producers to limit oil production, thus limiting oil supply in order to raise oil prices to stabilize the purchasing power value of their export revenues (which are denominated in USD).⁶⁵

Regarding the demand side, a weaker USD may increase the demand for oil since its price becomes more affordable. Net oil importers such as China (who even pegs its currency to USD) can therefore avail this opportunity to increase their oil purchasing.

Exchange rates may also influence oil prices via financial markets or through other financial assets, e.g. through portfolio rebalancing or hedging. Oil prices are denominated in USD. Since the inverse relationship between oil prices and USD is vastly accepted by a large number of financial professionals, many of them could regard oil futures as an effective hedge against a possible dollar depreciation. The ECB paper notes that the importance of financial markets has been growing in terms of their impact on oil prices as the volume of oil futures traded on NYMEX quintupled since the beginning of the 21^st century.⁶⁶

63 Czech National Bank Inflation Report, The Relationship between the Brent Crude Oil Price and the Dollar Exchange Rate, 2011, https://www.cnb.cz/en/monetary-policy/inflation-reports/boxes-and-annexes-contained-in- inflation-reports/The-relationship-between-the-Brent-crude-oil-price-and-the-dollar-exchange-rat

64 European Central Bank, p 7

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Figure 7: Inverse Relationship of Oil Prices and Exchange Rate

Source: Czech National Bank

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5 Events and Characteristics of the Oil Market 1945 – 2020

5.1 Introduction

This chapter aims to describe the oil market conditions and major events throughout the last 75 years. The objective of the chapter Events and Characteristics of the Oil Market 1945–2020 is to introduce the major disputes and shocks that had a significant macroeconomic impact on the global economy. It will serve as a background for our further research within the following chapters.

The first part of this chapter is going to focus on OPEC and the Seven Sisters. These two groups were the key subjects of the oil markets in the 1950s and 1960s. In the following subchapter, we are going to analyse the first oil shock that took place after the Arab Oil Embargo in 1973.

The third part of this chapter will be dedicated to the OPEC unity crisis and the second oil shock that followed the Iran–Iraq War and China’s economic liberalisation. We are going to describe some of its effects on the global economy before we analyse its economic impacts more sufficiently in the following chapters.

The last subchapter is going to examine the latest events in oil markets such as the negative oil futures price, the increasing role of the United States as the shale oil producer and the Russia–

Saudi Arabia Oil Price War.

5.2 Post War Period: Seven Sisters and Foundation of OPEC

In the 1950s, Crude Oil prices had been ranging between 2 and 3 USD per barrel. The key events that had a decisive effect on the price of oil in the 1950s were the Korean War (1951–

1953) and postcolonial issues in the Middle East.⁶⁷

At that time, oil markets were dominated by the Seven Sisters. The Seven Sisters was a group of seven most powerful oil companies: Anglo-Persian Company, Royal Dutch Shell, Standard Oil Company of California, Gulf Oil, Texaco, Standard Oil Company of New Jersey (nowadays a part of ExxonMobil), Standard Oil Company of New York (nowadays ExxonMobil).⁶⁸

67 WRTG Economics, wtrg.com/prices.html

68 Sampson, Anthony, The Seven Sisters: The Great Oil Companies and the World They Shaped, New York: Viking Press. ISBN 0-553-20449-1, 1975, p 11

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The group of these seven oil companies had aimed to negotiate as a cartel. The Seven Sisters later lost its dominant position after the establishment of the Organization of the Petroleum Exporting Countries (OPEC).⁶⁹

In 1960, the Organization of the Petroleum Exporting Countries (OPEC) was formed. The founding members of OPEC were Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. In the following year, those five countries were joined by Qatar (1961–2019), Indonesia (1962–2016), Libya (1962), United Arab Emirates (1967), Algeria (1969), Nigeria (1971), Ecuador (1973–

2020), Angola (2007), Gabon (1975), Congo (2018).⁷⁰

Foundation of OPEC crucially changed oil markets. In its core declaration called Declaratory Statement of Petroleum Policy in Member Countries (1968), OPEC member states called for a permanent sovereignty over their energy resources.⁷¹

OPEC’s formation by five oil-producing developing countries in Baghdad in September 1960 occurred at a time of transition in the international economic and political landscape, with extensive decolonisation and the birth of many new independent states in the developing world. The international oil market was dominated by the “Seven Sisters”

multinational companies and was largely separate from that of the former Soviet Union and other centrally planned economies. OPEC developed its collective vision, set up its objectives and established its Secretariat, first in Geneva and then, in 1965, in Vienna. It adopted a ‘Declaratory Statement of Petroleum Policy in Member Countries’ in 1968, which emphasised the inalienable right of all countries to exercise permanent sovereignty over their natural resources in the interest of their national development…⁷²

5.3

Arab Oil Embargo 1973

In 1972, the price of crude oil was 3 USD per barrel. By the end of 1974, the price reached 12 USD per barrel. This 400% price change was caused by the Arab Oil Embargo that was imposed

69 Sampson, p 13

70 OPEC.org, opec.org/opec_web/en/about_us/24.htm

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on Israel’s western allies as a vengeance for their support of Israel during the Yom Kippur War.⁷³

Arab countries decreased their oil production by 5 million barrels per day. This was a shock to the world. In a short period of time, oil prices climbed from 3 USD to 12 USD per barrel. OPEC member states proved that they were able not only to cause a major price swing, but also manage to keep the price at the new level for a long period of time. From 1974 to 1978, the price of oil moved only from 12 USD to 14 USD per barrel. If we adjust the price to inflation, it shows us that it did not move at all.⁷⁴

The impact of the Arab Oil Embargo was profound. In spite of the fact that the citizens of the United States and of the other targeted countries stockpiled the oil supplies, the embargo significantly increased consumer costs. The embargo also coincided with the depreciation of the dollar. There was an imminent danger of a global recession.⁷⁵

Figure 8: Oil prices after the Arab Oil Embargo

Source: Macrotrends

The surge of oil prices allegedly caused a high and energy-driven inflation (in the years 1970–

1973, the energy inflation lagged behind the overall inflation). From 1973 to 1974, the energy basket of the Consumer Price Index surged by 32% (gasoline by 41%) and the overall CPI climbed by 11%.⁷⁶

75 Office of the Historian, Oil Embargo 1973–1974, history.state.gov/milestones/1969-1976/oil-embargo

76 U.S. Bureau of Labor Statistics, One Hudred Years of Price Change, bls.gov/opub/mlr/2014/article/one- hundred-years-of-price-change-the-consumer-price-index-and-the-american-inflation-experience.htm

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The difficult inflation of the 1970s is often associated with the energy supply shocks of the era. Energy prices were indeed exceptionally volatile during the period. Surges in gasoline prices created two towering peaks in the CPI-U that explain much of the overall inflation of the era.⁷⁷

Figure 9: U.S. Energy CPI

Source: Bureau of Labor Statistics

Arab Oil Embargo is often seen as the main factor behind the 1973–1975 recession. In the latter parts of this thesis, we are going to examine whether it was in fact the oil price fluctuation which caused this or any other oil shock-linked crises.

Table 1: CPI 1968-1976

Source: U.S. Bureau of Labour Statistics

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5.4 1979 Oil Crisis

The Oil Crisis of 1979 was the second major event of the decade. The surging demand and the falling supply of oil brought the old fears from the times of the Arab Embargo back and had a significant impact on the global economy. It also put the OPEC member states under pressure and harmed their mutual relations.

The Oil Crisis of 1979 is usually regarded as a result of the Iranian revolution. In spite of the significance of the overthrown Iranian ruler Shah Pahlavi and the subsequent decrease in the Iranian oil production, the revolution was not the only factor behind the oil crisis. The other and perhaps the key factor behind such sharp surge of oil prices was the increasing oil demand.

The oil demand surge was based on two factors: a booming global economy and precautionary reasons.⁷⁸

In comparison with the embargo crisis in 1973, the price fluctuations in 1979 were not coordinated. Although the global economy was severely hit by the Arab Oil Embargo, the solution to the crisis was simple – OPEC countries had to be convinced to stop containing their production. In 1979 the situation was different – the OPEC member states were the ones who found themselves in chaos.⁷⁹

When the Iranian Revolution came, the spot price of oil surged to 40 USD per barrel. This surge caused a significant shake-up to the whole oil market. The OPEC countries failed to come up with a joint decision. Instead of a coordinated management, the OPEC countries failed to manage to post unified prices, and each of the member states followed their own policy.⁸⁰ The situation worsened in 1980 due the outbreak of the Iran–Iraq War. The price reached 41 USD per barrel again. In October 1981, the OPEC member states came to a joint quotation of 34 USD per barrel. After more than a year of chaos, the oil market was stabilized. Although the OPEC countries were, in the end, able to calm the market down, they did not act fast enough.

The reputation of OPEC was severely harmed.⁸¹

Witnessing the chaos, many western politicians encouraged their governments to lower the dependency on oil produced in the OPEC countries.⁸²

78 Federal Reserve History, federalreservehistory.org/essays/oil_shock_of_1978_79

79 The Middle East Institute, Washington DC, The 1979 Oil Shock: Legacy, Lessons and Lasting Reverberations, p 10

80 The Middle East Institute, Washington DC, The 1979 Oil Shock: Legacy, Lessons and Lasting Reverberations, p 11

81 Middle East Institute, Washington DC, The 1979 Oil Shock: Legacy, Lessons and Lasting Reverberations, p 11

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After reaching record levels early in the decade, prices began to weaken, before crashing in 1986, responding to a big oil glut and consumer shift away from this hydrocarbon.

OPEC’s share of the smaller oil market fell heavily and its total petroleum revenue dropped below a third of earlier peaks, causing severe economic hardship for many Member Countries.⁸³

Due to a falling demand for oil following the global recession in 1981–1982, OPEC lost its dominant position. Its output fell to 18.1 million barrels per day from 30.5 million per day (1979). The overall output fell by 40%. OPEC lost its control over oil prices. In 1982, the non- OPEC supply overtook the OPEC production by 1 million barrels per day.⁸⁴

Figure 10: OPEC Crude Oil Market Share

Source: IEA

Allegedly, the crisis of 1979 had a significant impact on inflation. The annual inflation in the United States reached an even higher level than during the Arab Embargo crisis in 1973. The energy basket of the Consumer Price Index reached 45% while the overall inflation surged to approximately 15% per annum.⁸⁵

In Europe, the impact was also severe but not as much as in 1973. The United Kingdom reported an overall inflation of 27% in 1973 but “only” 23% in 1979.⁸⁶

84 Middle East Institute, Washington DC, The 1979 Oil Shock: Legacy, Lessons and Lasting Reverberations, p 11

86 Economics Help, economicshelp.org/blog/2647/economics/history-of-inflation-in-uk/