The ghost of crises past Published: October 13 2000 18:42GMT | Last Updated: October 13 2000 19:13GMT

Don't panic. As that message flashed across trading screens on Friday, the disturbing questions remained. Could this week's violence in the Middle East provoke another oil crisis like the one that shook the world in 1973? Question two: how should western governments then minimise the damage?

After a turbulent Thursday, markets were calmer on Friday with the oil price a little down from its peak. Still, there are some ominous similarities with the situation 27 years ago. The crisis then was triggered by the Yom Kippur war on October 6, just as the big oil companies were meeting the Organisation of Petroleum Exporting Countries to negotiate the latest round of oil price rises. The anti-US feeling caused by the war stiffened the resolve of Gulf oil producers to double prices.

As the US ignored European pleas to moderate its support for Israel, Gulf producers took the next decisive step: they cut production and declared an embargo on oil exports to the US, Portugal and the Netherlands. By 1974 oil prices were six times more than in 1970; and despite production increases elsewhere, supplies to the west were 9 per cent below their pre-crisis levels.

One lesson for today is that the initial rise in oil prices was not caused by cuts in Arab production, so much as by a rise in western demand following a period of rapid economic expansion. But a relatively small cut in the world's total supply could then produce devastating consequences. Such reflections pushed oil prices up above $34 per barrel this week and encouraged the sharp fall in equity prices.

But the west is now much better able to resist an oil shock. Friday's calmer mood in the markets may have reflected this as well as hopes that the violence could be contained.

Exagerrated fears

Perhaps the most important difference between then and now is psychological. The 1973 crisis inspired feelings of near panic: that the oil would soon run out and that an era of economic growth had ended. Despite the inflation, debt, recession and unemployment that followed, those fears proved to be exaggerated. The world's economic growth rate never again touched the dizzy peak of almost 7 per cent achieved in 1973, but a steady expansion has resumed, with a growth rate of more than 4 per cent still expected for this year and next.

One important reason for the recovery is that oil consumption relative to national output has halved in the US and Europe during the last 25 years. At the same time, exploration and technical advances have greatly increased potential supplies. So any oil crisis in the coming winter is not expected to last very long. Within a year or so, new supplies could be brought on stream, while technologies to help industrial countries to economise on oil are much more advanced. For that reason, a rise in the oil price to $40, (close to its inflation-adjusted price in the mid 1970s) is viewed with reasonable equanimity by market analysts.

Painful effects

Goldman Sachs, the investment bank, for example, thinks that $40 oil for a year might reduce the growth in company profits by about 5 percentage points, cut world economic growth by about 1 percentage point and add perhaps 1 to 2 percentage points to inflation. This would, however, be particularly painful in some regions.

For example, south east Asian countries other than Japan have failed to reduce their oil dependency much in recent decades. And their economic recovery depends on selling electronic goods to western markets. As the 1997-1998 crisis showed, western economies could be upset by renewed financial difficulties in that region.

Another familiar danger is that financial markets in the US could amplify a general loss of confidence and so precipitate a much sharper fall in equity prices than the "economic fundamentals" seemed to warrant. A deterioration in consumer confidence might have a more direct effect. If US citizens decided to save, say, 5 per cent of their income instead of about zero as at present, economic growth would be sharply squeezed.

These dangers to confidence make the dilemma for the authorities even more difficult. The obvious lesson of 1973 was that an over-accommodating monetary and fiscal policy led to steep rises in world inflation, peaking at 16.3 per cent in 1980. The economic cost of squeezing this inflation out of the system proved to have been much greater than it needed to be.

Yet if an oil price rise is generally thought to be temporary, it would be folly to tighten too much, just as economic activity was being squeezed. The alarm should sound only if a sustained oil shock were to feed through into wages and general inflation. Getting the timing right will be difficult, but this time, the job must not be shirked.

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-- Martin Thompson (mthom1927@aol.com), October 14, 2000