Sunday, July 13, 2008

The Impact of Energy Prices on the Rest of the World

We're all justifiably concerned about increased energy prices. Yeah, it sucks to pay $75 to fill up your car just so you can drive to work every day. Yeah, it sucks to pay $500 for a flight to Vegas for the weekend when it used to be $199.

Yeah, more importantly it's running US businesses into the ground, causing stagflaton, job loss, and a steady leak in our national wealth. It may even lead us into new wars.

It may toss the US, Europe, and Japan into recession and your 401k may look anaemic for a while but there's no reason to worry that either will not come back. Just be thankful you're not in charge of a rapidly-industrializing country like India, China, Indonesia, or Malaysia.

The recent success of these countries relies entirely on the shift from subsistence agriculture to low skill and energy-intensive manufacture for export. As Thomas Friedman says till he's hoarse, the incredibly low cost of long-haul freight enables their success by allowing them to manufacture cheaply and then sell where prices are high (=in the US, Japan, and Europe).

Here in the US, we have used sophisticated financial leverage (=borrowing) to throw fuel on our economic fire. In industrializing countries, they use the more direct means of government subsidy. Via price controls, via controlled exchange rates, or via direct subsidies, all these countries attempt to deliver cheap inputs (especially energy) to their "national champion" businesses.

The most sensical among the subsidizers see it as a temporary way to vault their countries into the league of rich nations. The less admirable do it to retain their political power. For evidence of this look no further than the 12 cent gas in Venezuela.

Regardless of the motivation, these subsidies are quietly bankrupting national governments. India and Malaysia are but two examples of countries who have recently been forced to decrease their subsidy on oil. Malaysia recently raised gasoline prices by 40 percent and plans further increases in the future. The economic impact won't bee seen for a few quarters, even in countries which are not so astute at cooking their books (ahem - China). Eventually, these governments will have to admit that they cannot continue to be the buffer between the world economy and their own. Oil subsidies will not be the end, either. Governments will have to admit they can no longer afford the luxury of other economic accellerants such as tax credits on businesses.

Moreover, businesses which have become successful (but dependent) on the back of cheap energy and favorable fiscal treatment will face a tremendous test. Most of these businesses are only as old as the current boom. They've never felt the pain of an economic downturn, which explains why most never saw the need to put safety nets or buffers in place. These businesses will close. Their entrepreneurial chiefs will be fine, having squirrelled away for a rainy day. The labor force, on the other hand, have also grown up in the boom and will be caught out.

On a macro level, these countries will have to admit that their heady growth is going to dip. I see the current credit/mortgage and energy/inflation crises as a testament to the robust, large, open and free Western economies. We will absorb and we will rebound. Industrializing countries, including India are going to have a much rougher time of it.

Fiscal crises inevitably lead to political crises. People will riot when the price of their heating and cooking oils goes up. They will get violent when increased transport costs cause their food prices to increase. It will be an extreme challenge for leaders in much of Asia and South America to maintain their positions of power. Due to their past propensities, it's safe to assume socialism will present itself as a savior, and many people will take that bait.

The question for countries and businesses is: what can they do about it? Some suggestions:
  • De-industrialize in favor of Western-style virtualization and services
  • Raise prices (at the risk of losing competitiveness)
  • Finally invest in efficiency over volume
  • Liberalize to become more robust
  • Go green. We're seeing hints that China wants to become the greenest country on the planet ... sheesh they have a long way to go!
  • Find closer markets
  • Shift to cheaper, low-friction transport (boats and trains instead of trucks and planes)
  • Ally together in an attempt to gain the necessary economies of scale
  • Ally with nearby developed countries (think NAFTA and EU)

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