April 6, 2009 3:00 am

Theory of oil-shock recession

Ed Crooks, energy editor, examined the controversial idea put forward by Professor James Hamilton of the University of California, San Diego, that the US recession was caused by the oil shock of 2007-08.

Prof Hamilton says it is "a conclusion that I don't fully believe myself".

But his work ( http://bit.ly/EG3pj) raises the important question of whether the role of oil in the US and global downturn has been underestimated.

It also deals a blow to the comforting idea, promulgated by the International Monetary Fund among others, that the demand-led oil price rise of the 2000s would be more economically benign than the supply-led shocks of 1973 and 1979.

Of course, there were many other problems in the US economy last year - not least the housing crash. But house prices started to fall in 2006 and the economy continued to grow. In Prof Hamilton's model, if the oil price was taken out of the equation, the economy would have grown throughout last year.

His paper argues: "The evidence to me is persuasive that, had there been no oil shock, we would have described the US economy in fourth-quarter 2007 to third-quarter 2008 as growing slowly, but not in a recession."

Other economic models do not come up with such a powerful role for oil. But, given the central importance of events such as the steep fall in vehicle sales, the general slowdown in consumer spending and the plunge in consumer sentiment in the first half of 2008 - all of which are strongly influenced by petrol prices - it does not seem implausible to think that the cost of oil was a critical factor in the downturn.

However, in case anyone was tempted to think of the oil price as yesterday's problem, Prof Hamilton has a warning for the future.

"Some degree of significant oil price appreciation during 2007-08 was an inevitable consequence of booming demand and stagnant production . . . If growth in the newly industrialised countries resumes at its former pace, it would not be too many more years before we find ourselves back in the kind of calculus that was the driving factor behind the problem in the first place."

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Tom Miller, managing editor of China Economic Quarterly, wrote in the Dragonbeat blog about China's demand for commodities and the world recession.

Last autumn's sudden collapse in commodity prices left a lot of China bulls with egg on their faces. Didn't China's insatiable demand for stuff, driven by a long-term process of urbanisation and rising incomes, guarantee the good times would roll for another two or three decades?

For the past seven years, commodity prices were essentially considered a simple function of Chinese demand. As the world's top consumer of commodities, China was thanked (and blamed) for heralding a new era of inflated raw material prices. After the commodities crash, this theory appears in tatters.

Indeed, over the next two or three years China is likely to play only a small role in setting global commodity prices: even if Chinese demand recovers, markets will be overwhelmed by shrivelling demand everywhere else.

But after the rest of the world stabilises and excess production capacity is absorbed - somewhere between 2010 and 2013 - China will again emerge as the key driver of global demand. Assuming that Beijing maintains economic and social stability, the pace and scale of industrial and urban development in China should drag up commodity prices.

The pace of urbanisation in China is unprecedented. In 1980 a paltry 20 per cent of Chinese citizens lived in urban areas, a figure associated with the poorest countries on earth. By 2030, when more than 1bn Chinese citizens will live in towns and cities, that figure will reach 70 per cent - higher than in Japan or Italy today.

As China's growth and urbanisation continues for another couple of decades, Chinese demand for commodities will rise substantially - especially hard commodities used for building houses and roads.

China has only just reached the most commodity-intensive stage of urbanisation, with metal intensity four times higher than in developed countries and twice as high as in other developing countries, according to the World Bank.

Global commodity markets have tanked and Chinese demand has stuttered. But the hungry dragon is not yet sated - he's just pausing between courses.

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