Brad Setser on the Current Three-Cornered Balance of Financial Terror: Asian Manufacturers, American Homeowning Consumers, and Middle-Eastern Oil Producers

Nouriel Roubini is scared of $70-a-barrel oil.

Brad setser writes:

RGE - Abridged Roubini on oil at $70 -- and not-so-abridged Setser on Petrodollars: A condensed version of Dr. Roubini's latest post: "I was wrong about the impact of $40 oil, but I'll be right about the impact of $70 oil." I know Dr. Roubini was wrong about the impact of $40 oil because my name also appears on the 2004 note. We both were wrong. We thought high oil prices would be a drag on the economy in 2004. They often are.

Yet, global growth was very, very strong in 2004. Judging from the evidence, the magic formula for global growth is an undervalued Chinese RMB, high oil prices and a growing US current account deficit financed by the central banks of really poor countries and a few really rich oil sheiks. The formula is just so counter-intuitive that it took a long time to discover... 2005 wasn't quite as good as 2004, but it wasn't bad by any means.... I think James Hamilton would say that a strong global growth has been a tonic for oil producers. Oil prices are high mostly because demand for oil is high....

Nouriel identifies a couple of reasons why high oil prices might be a bigger drag going forward: The current run-up in oil prices seems to be driven at least in part by concerns about supply. Iran. Nigeria's delta. And, more generally, the folks that have oil are far more interested in renegotiating the terms of their existing contracts with big oil companies than in reaching agreement with the big oil companies on a new round of investment.... In 2003, 2004 and 2005, consumers tapped into their rising home equity (or just saved less as their homes appreciated) and kept on spending even as oil prices rose. Nouriel thinks that this process won't continue. The Fed will get in the way, pushing up short-term rates until long-term rates have to go higher. Or US consumers will simply burn out, and lose their desire to take on more debt.... I certainly wouldn't rule it the scenario he describes. But at least so far, there isn't much evidence the US consumer is cutting back. And I have been very struck by one thing that Nouriel doesn't put a lot of emphasis on. Call it the oil savings glut.

There is no doubt that the spare savings of the world's oil exporters - savings in excess of their investment - is now enormous. And with oil at $70, it will only get bigger. And there is no doubt that the United States' need to borrow savings is enormous. And it too is getting bigger. I suspect one of the reasons why oil didn't exert more of a drag on the world economy is that the US had - by that time - entered into a cycle of expansion fueled by a surge in residential investment and rising consumption spurred by consumers' ability to borrow against rising home values. The oil exporters spare savings stepped into the breach left by the reduction in the pace of Asian central bank intervention. Non-Chinese Asian central bank intervention that is. China is a special case: its current account surplus grew even as its oil import bill grew.

By holding US real interest rates down, the oil exporters reinforced a process that got started with the Fed cut rates, and got further fuel from Asia's unwillingness to allow their currencies to appreciate against the dollar from 2002 on. There is a certain lovely symmetry: The countries with the highest propensity to save - China and the oil exporters - financed the country with the highest propensity to borrow in order to spend.