Raedwald ponders the impact of $200pb oil prices. My question is: if this were to happen, wouldn’t it be a case for loosening fiscal policy?
The case for doing so is simple. Higher oil prices are, in effect, a tax upon oil users - which, directly or indirectly, is everyone. So, shouldn’t this be offset by a loosening in orthodox fiscal policy?
I am NOT talking here about a fuel price stabilizer. The incidence of higher oil prices falls not just upon motorists, but upon workers who lose their jobs because of the lower demand caused by higher oil prices. The case, then, is for a general fiscal loosening - lower taxes or higher spending - so that aggregate economic activity is unaffected by the oil shock, whilst we encourage people to consume less of the devils' excrement.
Let’s do some numbers. Last year, the UK consumed just over 1.6 million barrels of oil a day. This means that every $10pb rise in the oil price, if sustained for 12 months, is equivalent to a £3.7bn tax rise. That’s 0.25% of GDP. The $200pb oil discussed by Raedwald would, then, be equivalent to a tax rise of 2.5% of GDP - enough to cause a recession even in normal times.
Of course, only an arrogant charlatan can claim to be certain where oil’s going. But there’s a risk here. Oil prices are so volatile that a 37% rise in the oil price - equivalent to a 0.9% of GDP tightening - is a one-in-six chance.
In principle, the recessionary effect of this could be offset by looser monetary policy. But there are two arguments against using this. One is that there is a (slim?) chance that the temporary inflationary effect of higher oil prices will become a permanent one if it raises inflation expectations. Looser monetary policy would add to this danger. The other is that looser policy would have to take the form of quantitative easing, and the effectiveness of this in boosting real economic activity is doubtful.
Fiscal policy, then, is the more obvious way of offsetting an oil shock. A cut in VAT of one percentage point would put £4.1bn (pdf) into the economy, just offsetting the effect of a sustained $11pb rise in oil prices.
So, why shouldn’t fiscal policy loosen in the event of oil prices rising? Two obvious counter-arguments seem weak to me.
1. “It would add to the deficit.” True, but not obviously relevant. For one thing, the revenues of oil producers are likely to be recycled into western government bond markets; in the last five years, oil exporters' holdings of US Treasuries have almost trebled, to $218bn. This would hold borrowing costs down. Also, if oil does take off, there’ll probably be clamour for safe assets - equity prices at $200pb would not look pretty - and this high demand for index-linked gilts will make the deficit easily financeable.
2. “Loosening policy now would reduce credibility.” This matters only to the extent that it would raise gilt yields - and I suspect (though we can’t be sure) any adverse effect here would be offset by point 1. It could also be mitigated by ensuring that the fiscal loosening were temporary - for example, by a one-off cut in VAT.
A more valid counter-argument would be the Ricardian equivalence one; a temporary tax cut would have no stimulatory effect as people would merely anticipate higher future taxes. This argument, however, implies that a loosening would do no damage either.
There is, therefore, surely a case for considering using fiscal policy to offset an oil shock.