Stone Age lesson on taming the oil price

Just as the credit crunch seems to be ending, the world faces a much more serious economic threat: the explosion of oil prices and the possibility of a return to 1970s-style inflation. Inflation is a more dangerous economic ill than deflation because it is so much harder to cure. Falling prices can be cured easily enough. All governments and central banks have to do is cut interest rates, cut taxes and boost public spending. These are popular steps that readily win political and business support.

The policies required to deal with inflation are, by contrast, always painful and unpopular – raising interest and taxes; cutting government spending and curbing public employees’ pay. It is hardly surprising, therefore, that only one country in the world – Japan – has faced a serious deflation problem since the 1930s, while inflation crises have afflicted every market economy in the postwar era and have triggered almost every big recession since 1945. The question, now that the focus of attention is moving beyond the credit crunch, is whether this sad history is likely to repeat itself in the year or two ahead.


The answer depends largely on how governments and central banks worldwide respond to the oil shock. The challenge most discussed in recent weeks is the one facing central banks. If the surge in oil prices causes accelerating pay growth and then a second round of price rises in goods and services not directly exposed to oil, central banks will face stark alternatives: either deliberately to create recessions and mass unemployment by raising interest rates even amid the present property slump, or to accept 1970s-style wage-price spirals, which will have to be cured eventually with even deeper recessions, higher unemployment and greater financial grief.

The other, even bigger, challenge of the oil shock is the one presented to governments. This is the question of what can be done to reverse the rise in oil prices. This question is even more important than the central banks’ inflation-deflation dilemma and yet is hardly discussed. Most politicians, economists and financiers simply assume that the trebling of oil prices in the past few years has been a natural phenomenon that must be accepted as an act of God – or at least an inexorable judgment by the markets. However, are there really no policy changes that could restore the more benign conditions in which oil prices of $40 or $50 were seen as normal?

The standard answer is