Published on Let's Talk Development

Save first, then spend: history’s lessons on the influence of low oil prices on global growth

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The impact of falling oil prices is becoming increasingly visible, but the global economy is yet to hit a nice stride - oil exporters face severe headwinds, oil-importing China continues to slow, other large oil-importing countries have seen mixed developments since the start of 2015, and financial market volatility has increased.

Are such mixed outcomes consistent with the evidence from past episodes of sharply declining oil prices? The latest Global Economic Prospects report addressed this question and found that past slumps in oil prices were in fact followed by slow but quite diverse global recoveries.

The drop in oil prices since June 2014 was the third largest among six episodes of significant declines over the past three decades, with particularly striking similarities with the 1985–86 episode.  Both episodes followed periods of high oil prices and a rapid expansion of non-OPEC oil supplies—Alaska, North Sea, and Mexico in the former, and U.S. shale oil, Canadian oil sands, and biofuels in the latter. In both cases OPEC changed its policy objective, from price targeting to market share.

Like the 1985-86 episode, the dominant role of supply factors behind the 2014–15 drop bodes well for its eventual impact on global activity. Estimates suggest that a purely supply-driven decline of 45 percent in oil prices could boost global GDP by 0.7-0.8 percent over the medium term (Baffes et al. 2015).

However, a look back at past episodes of sharply declining oil prices shows that these were generally followed by modest global recoveries, as benefits for oil importers took time to materialize and were in some cases offset by prevailing economic and financial headwinds.

Even after the 1985–86 oil price drop, which was most closely associated with changing oil supply conditions, global growth only recovered gradually in subsequent years. This modest performance was tightly connected to a period of debt turmoil in some large developing countries, slow growth in Japan and many European countries, and, at the end of 1987, a stock market crash.

Today, once again, a confluence of cyclical factors (a sluggish recovery from the 2008 crisis), structural forces (legacies from the crisis) and risks (policy normalization in advanced economies) are at work in the global economy. These could delay or mask the benefits of lower oil prices for some time. Current mitigating factors include regional spillovers from economic stress in oil exporters; an economic slowdown across major oil-importing developing economies; and high indebtedness, low labor utilization, and low productivity growth in a number of major advanced economies. These factors may encourage households and corporations to build up savings rather than spend income gains generated by lower energy prices.

A more benign view could be that the initial increase in savings will be reversed when consumers realize that energy prices will stay low over the medium term, or as confidence in economic prospects improves. This could release pent-up demand, further supporting the global recovery, as models would predict. Interestingly, such delayed reaction to lower oil prices was observed in the United States following the 1985-86 episode: consumption initially slowed and savings increased as consumers were unsure whether lower prices were there to stay. As prices stabilized at a lower level, savings dropped and spending accelerated, supporting a recovery in the United States and globally. Such delayed impact could materialize this time again. In fact, most underlying factors point to a prolonged period of lower oil prices in coming years while labor market conditions improve across major advanced economies, supporting consumer confidence. The latest Global Economic Prospects takes a relatively cautious view on the ultimate impact of the oil price slump on global activity, pointing to upside risks to current forecasts if benefits to domestic demand across major oil importers become more visible over time.

In summary, evidence from past episodes shows that sharply declining oil prices were generally followed by quite diverse global growth outcomes, pointing to other important forces either mitigating or reinforcing the impact of declining oil prices on activity. Supply factors played a dominant role in the recent plunge in oil prices, which bodes well for its eventual impact on the global economy. However, uncertainty remains, justifying cautious growth forecasts, but a full materializing of the benefits for oil importers represent an upside risks to our current projections. 


Marc Stocker

World Bank’s Country Economist for Madagascar

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