Never has the world been less prepared for the oil shock delivered by the decision by the US and Israel to attack Iran. That’s especially true of the US, which precipitated a war with limited financial flexibility.
While this week’s ceasefire, if firing does indeed cease, offers some hope of an end the conflict and the re-opening of the Strait of Hormuz, the war’s legacy will be more debt and bigger deficits in a world already over-burdened with debt and deficits.
Governments around the world have, like the Albanese government and state governments here, responded to soaring oil and gas prices by cutting fuel excises, capping or subsidising energy prices, lowering the cost of using public transport and making compensation payments to households.
Those might be temporary measures, assuming that a ceasefire (in which none of the parties to it appear able to agree what they agreed) holds and enables a more lasting end to the hostilities, but they come at a heavy cost.
The Albanese government’s temporary halving of the fuel excise for three months will, for instance, cost an estimated $US2.55 billion ($3.62 billion). A mere month of free public transport in Victoria will cost the heavily indebted state government more than $70 million.
In Europe, some members of the European Union are calling for a relaxation of the union’s limit on budget deficits, capped at 3 per cent of gross domestic product, to enable them to offset the impact of the oil shock on companies and households while others are arguing for an EU-wide windfall profits tax on energy companies to fund their increased spending.
Europe doesn’t have a lot of fiscal room to move. It is still coping with the economic impacts of the war in Ukraine and the dramatic change to its energy supplies and their costs it caused. The government debt-to-GDP in the euro area is now close to 90 per cent.
That lack of fiscal flexibility is echoed around the world. According to the Institute of International Finance, global debt topped $US348 trillion early this year, or about 308 per cent of global GDP. Within that total, government debt of about $US108 trillion is around 95 per cent of global GDP.
That was before the war. In previous oil shocks, government debt levels were a fraction of what they are today. Ratios of debt to GDP were in the very low single-digits, providing scope for increased spending without generating fiscal stress.
In the US, the Trump initiated the war with government debt of more than $US39 trillion, of which more than $US32 trillion is held by the public. It has a budget deficit of 5.8 per cent of GDP that, according to the Congressional Budget Office (CBO), will grow (on the pre-war settings) to 6.7 per cent of GDP over the next decade.
Waging war is costly. In the 40 or so days since the first attacks on Iran, the US is estimated to have spent about $US45 billion. To replace the munitions expended, the Trump administration has asked Congress for a special $US200 billion allocation of defence funding.
In his latest budget, released last week, Donald Trump is asking for a $US500 billion or so increase in the defence budget, to $US1.5 trillion, after increasing its funding by $US150 billion last year.
Despite putting forward only limited cuts to spending, the administration seems to believe that its budget will cut deficits by $US6.7 trillion over the next decade by growing real GDP at an annual average of 3 per cent and raking in vast amounts of tariff revenue – against the CBO’s projection of 1.8 per cent average annual real GDP growth and the Federal Reserve Board’s 2 per cent.
Rather than the administration’s highly optimistic scenarios, the likelihood is that the debt levels that have exploded by about $US3.5 trillion already in Trump’s second term will continue to rise. He was adding about $US250 billion of debt each month in the less than 15 months that he’s been back in the White House. That was before the outbreak of the war.
For the US, and the rest of the world, the war – even if it does end in a fortnight – will increase deficits and debt relative to what they would have been had it never been launched.
Energy costs higher than they were before the war will weigh on the global economy and lower the growth rates that might help mute the impact of those increased deficits and debt.
Oil prices shot up from below $US70 a barrel before the war to more than $US110 a barrel immediately ahead of the ceasefire announcement. They’ve since fallen back into the mid-$US90 a barrel range.
A complete and permanent re-opening of the Strait of Hormuz –without the tolls Iran is demanding (and which it has been imposing, at $US2 million per vessel, paid in yuan) – might see the prices fall further, but they are unlikely to regain their pre-war levels any time soon.
The world has been awoken to how vulnerable the 20 per cent of global oil supply that used to flow through the strait is. Significant energy infrastructure the region has been damaged. Shipping and insurance costs have soared. A toll on shipping would just add another layer to the increased cost of accessing that oil in future.
Countries will look to alternate, more stable and less risky sources of supply and be prepared to pay premiums for that security of supply. That’s why US oil has recently traded at prices above the global Brent crude price, with flow-on effects for US gasoline and diesel prices.
They rose again yesterday, albeit only marginally, despite the announcement of the ceasefire. It will take time, and a secure peace, for the supply and pricing of transport fuels to find their post-war levels, which are likely to be higher than they were before the war.
Despite the continuing growth in renewables, economies remain highly sensitive to energy costs.
The rule of thumb for the US, for instance, is that a sustained $US10 a barrel increase in oil prices will add 0.2 percentage points to the inflation rate and subtract 0.1 per cent from GDP growth.
The Federal Reserve Board minutes from its official meeting last month that were released on Wednesday show they were very conscious of the impact of the war and the oil shock on inflation. But there were mixed views about whether that would lead to higher interest rates or, because of reduced consumer spending and economic growth, lower rates to mute the impact on the jobs market.
It is, of course conceivable – as it was even before the war – that the Fed and its peers elsewhere, who have been battling inflation rates above their target rates for years without convincing success, could face both spiking inflation rates and rising unemployment rates and an invidious choice of which to prioritise.
The oil shock could amplify those effects, making that choice even more difficult and its consequences more significant. Stagflation, or rising inflation and reducing growth, or a recession that drives both down, are possibilities.
The world and particularly the US, as the developed economy with the biggest budget deficit and with unsustainable government debt levels, wasn’t prepared for another economic threat. The war and the shock to energy supply and costs that it has induced has produced one, regardless of whether the war ends in two weeks or not.
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Stephen Bartholomeusz is one of Australia’s most respected business journalists. He was most recently co-founder and associate editor of the Business Spectator website and an associate editor and senior columnist at The Australian.Connect via email.
