Why energy has remained stable during the Second Great Contraction

In a series of posts leading up to the World Economic Forum’s Energy for Economic Growth report launched on Wednesday 7th March 2012, Kenneth Rogoff talks about the impact of the Second Great Contraction on commodity prices.

One of the stunning features of the post-financial crisis global slowdown has been the relative strength of commodity prices in general and oil prices in particular. Oil prices dipped to US$ 40 per barrel at the depths of the financial crisis, but this was still far above the US$ 20 per barrel level of early 2001. Since 2008, prices have more than doubled despite continuing sluggishness and fragility in the global economy. The main reason for the relative robustness of oil prices is well known. Despite very slow recovery in the advanced economies, emerging markets have enjoyed more of a V-shaped recovery. Demand from these rapidly growing economies, especially China but also from the Middle East and other oil producing economies, has  significantly substituted for the lost growth from the rich countries. Nevertheless, it is worth stepping back to see how striking the transformation of the oil market has been.

Advanced economies, which still account for almost two-thirds of global exports of goods and services, have been mired in the deepest global slowdown since the Great Depression. Indeed, few countries have regained the per capita GDPs they had at the outset of the financial crisis. Their extremely sluggish recovery may seem surprising in light of the rapid post-recession recoveries that have been the norm since World War II. But in fact, as Carmen M. Reinhart and I show in our research (including our 2009 book This Time Is Different), slow and halting recoveries are the norm in the aftermath of deep financial crises, with countries typically taking more than four years to regain their initial per capita GDPs and with unemployment rising for a similar period.

Even the post-financial crisis wave of sovereign defaults that appears to be unfolding today is quite typical. As we argued, the ongoing slowdown is more accurately described as, The Second Great Contraction, with the 1930s representing the first one. The contraction applies not only to output and employment but other variables such as credit. The term Second Great Contraction far more accurately characterizes the downturn and slow recovery than the moniker that was given to the downturn early on, The Great Recession. The latter term seems to indicate that although the downturn was deep, the recovery will be proportionately stronger, provided of course that appropriate policies are followed. Yet the recovery in advanced economies has been anything but normal, and today growth remains both subpar and volatile.

By contrast, most emerging markets have enjoyed a V-shaped recovery. Even though an epic shrinkage of global trade hit Asian economies at the end of 2008 (rivalling the initial downturn in trade during the Great Depression), emerging markets enjoyed the robust recovery that so many pundits and policy-makers predicted for the advanced economies. Their recovery is at the root of the strong resurgence in global commodity prices, which also generally experienced a V-shaped recovery.

Still, with economies representing two-thirds of global exports mired in a Great Contraction, and only one-third having a V-shaped recovery, it is far from obvious that commodity prices would have remained so robust. What are the reasons? Again, some are familiar. Marginal growth in emerging markets is considerably more energy intensive than in rich countries, partly due to the composition of production (with an ever growing share of global manufacturing migrating to the developing world), and partly due to policies in some emerging markets that keep energy prices well below world market prices. But financial markets have also played a role, and not necessarily a malign one. First, the extremely low level of global real interest rates almost certainly has a significant effect on metals and energy in particular. Low interest rates drive up the price of long-lived assets. The empirical relationship between interest rates and commodity prices long predates the recent expansion of speculative markets in commodities.

The profound deepening of speculative commodity markets has also played a role. Although technical trading by speculators has surely magnified volatility at times, one can also make the case that the deepening of markets has helped prices better connect to the long-term growth story in emerging markets. If China, India and other emerging markets continue to expand, of course the demand for energy will continue to explode, putting enormous upwards pressure on prices into the foreseeable future.

This will only partly be tempered by new technologies, notably new methods for extracting natural gas. Well-functioning financial markets should translate this expected future demand for long-lived commodities into a much higher price today. And, by and large, that is exactly what they have done. So a combination of deeper financial markets and much higher emerging market growth lies behind the relatively strong performance of commodities.

The next stage of financial development has to be finding mechanisms for energy exporters to diversity their future income in a way that is fair to current and future generations, robust and credible. Energy prices, representing a long-lived asset, are always going to be volatile. But there are ways to potentially make the volatility less economically damaging.

Author: Kenneth Rogoff is Thomas D. Cabot Professor of Public Policy and Professor of Economics, Harvard University, USA.

Pictured: An oil tanker pulls into the port of a Repsol oil refinery in Cartagena, eastern Spain February 15, 2012. Oil hit a six-month high near $120 a barrel on Wednesday as concern about supply from Iran, other Middle East producers and Africa outweighed those about the health of the global economy. Prices jumped after Iran’s Press TV reported Iran had banned exports to six EU countries in retaliation for European Union sanctions against the Islamic state, only to pare gains after Iran’s Oil Ministry denied the report. REUTERS/Francisco Bonilla