Storm, The (10 page)

There is one further dimension to moral hazard and the risks of banking, which concerns the borrower. Few would dispute the
general proposition that, if people borrow money, they have a responsibility to repay; and if they offer security, then that
security is forfeit in the event of default. There are a lot of questions about lending practices, particularly in respect
of sub-prime loans, and on mis-selling and the aggressive promotion of debt. But this is essentially an issue of the regulation
of lending practices. Few would advocate large-scale debt waivers, since the moral hazard in encouraging future excessive
borrowing is obvious. Recent changes in bankruptcy laws in the UK may, indeed, have encouraged such behaviour. There is, however,
at the heart of current policy a big issue of moral hazard in relation to borrowers. By slashing interest rates, governments
and central banks are rewarding borrowers and penalizing thrifty depositors. If current policy leads to inflation, then the
effect will be compounded. The economic expediency of expansionary policy has to be weighed against the danger of perverse
rewards.

There is a particular problem with mortgage debt, since calling in collateral means home repossession. This is not merely
distressing for the families concerned, but can involve – in the UK, though less so in the US – an obligation on the public
authorities to rehouse them. Repossession (‘foreclosure’ in America) is also a very costly process, and imposes costs on the
home owners if the process of auctioning or distress-selling drives down prices. Public policy has to address the issue of
borrowers who are willing and eager but temporarily unable to pay. In the UK,
it is possible, with conditions and qualifications, to obtain help with mortgage payments through social security. There is
also a reasonable concern that the taxpayer should not shoulder all the obligations of the borrower and the risks of the lender.
Payment protection insurance is another option, but, unless compulsory, will only be taken up by small numbers since policies
are costly and / or their cover heavily qualified.

What is needed, to avoid large-scale and unnecessary repossession, is for negotiated compromises in the event that payments
are missed, rather than the automatic triggering of legal action. In the UK the Council of Mortgage Lenders has a code of
conduct which requires lenders to offer a range of alternatives to try to keep families in their homes. Making such a voluntary
code binding on all lenders, including the ‘free-riders’, would be a useful step, and the government has now moved in that
direction, issuing fresh guidance to the courts in repossession cases. In the USA, there are proposals before Congress to
modify bankruptcy law and to reapportion losses more equitably between creditor and debtor. If the repossession crisis grows
in the USA and the UK, there will be growing pressure for the state to move further either to assume some of the risks and
costs or to intervene to protect the borrower.

Banking is an Alice in Wonderland world, in which financiers earn high salaries for taking and covering risks, and see themselves
as pillars of a competitive but responsible private-enterprise system. Yet, when crises and panics occur, governments are
expected to provide lender of last resort liquidity facilities, organize and pay for bail-outs of institutions deemed ‘too
big to fail’, and ensure depositors are fully protected. Yet, over and over again, throughout history, there have been episodes
of over-eager lending, reckless investing and poor risk management, leading to financial failure and calls for help. This
current crisis is supposedly different because the securitization of debt gave
the appearance of liquidity and sophisticated risk management. But it also had the same common themes of greed and stupidity.
A system that allows banks and other institutions to make profits and fat salaries from questionable and foolish practices,
while the public picks up the bill, should simply be unacceptable. The question is: what is the alternative? I return in a
later chapter to the issue of how the financial system might be reformed so as to avoid, or reduce, these risks. But I turn
now to a different aspect of the storm, the turbulence generated by oil prices.

In June 2004 a Sunday newspaper ran a fantasy horror story: ‘What If Bin Laden Conquers Saudi Arabia?’ In this scenario, crude
oil prices ‘are nudging $100’. In the real world, bin Laden is still in his cave and the accommodating Saudi royals were until
recently pumping as much oil as they could. Yet oil nonetheless touched $140 per barrel in mid-2008. Fact proved to be more
dramatic than fiction. What happened? And why did it happen during a financial crisis already causing difficulties enough
for the world economy? Prices have since more than halved from their peak and have fallen as low as $40 per barrel. Should
we be more concerned about the boom, or the bust? The links between the recent oil shock and the financial crisis and global
recession are indirect but very important, and in this chapter I try to trace them. The issue is not merely of historic interest,
since there is a serious risk that a strong global economic recovery will trigger another surge in oil prices. Even the tentative
global recovery in the summer and autumn of 2009 led to a doubling of prices from their low point.

Oil has been part of the boom and bust cycle of economies before. Rapid economic expansion and contraction, and financial
manias, have long had repercussions for commodities in general and oil in particular. In the Great Crash of the early 1930s,
following an earlier boom, oil prices fell through the floor and one of the tasks of the Roosevelt’s New Deal was to support
them. Harold L. Ickes, Roosevelt’s energy secretary, noted that oil companies ‘were
crawling to Washington on their hands and knees these days to beg the government to run their businesses for them’. Rather
like banks today. He judged, as governments judge today, that ‘there is no doubt about our absolute and complete dependence
upon oil… we have passed from the stone age to bronze to iron, to the industrial age and now to an age of oil’. (At the time
US production was 66 per cent of the world total.) Ickes resolved to rescue the industry from the dire prospect of depressed
prices. History may have come full circle since, barely three months after a panic about oil prices going through the roof,
there was a growing panic about them falling through the floor, imperilling new investment. President Obama, like his predecessor,
is being urged to understand the needs of the oil producers, albeit Arab as much as American.

Indeed, for most of its 150-year history, certainly since large supplies started to hit international markets from the US
and the Caucasus in the 1880s, the preoccupation of the oil industry has been one of oversupply. Such concerns eventually
led to the creation of OPEC. The two oil shocks of the 1970s and early 1980s radically changed the perception concerning ‘oversupply’
problems, but another decade and a half of weak prices reversed it again (with a brief interruption during the first Gulf
War). The steady climb in oil prices this century to the heady heights of $140 per barrel in mid-2008 – with predictions of
$200 (Goldman Sachs) and $250 (Gazprom) – reopened once again the issue of whether we are in fundamentally new, uncharted
waters or merely passing through another cyclical phase. A good case can be made for either position.

How did the recent oil shock occur? It crept up on us slowly in a way that the earlier shocks did not: the previous shocks
(in 1973–4, 1979–80 and, arguably, 1990) were seen as being caused by specific, identifiable restrictions in supply. In fact,
that is not true. Those crises, like the present one, came at the end of a steady period of supply trying unsuccessfully to
catch up with rising demand in the industrial and then the developing world. Supply disruptions merely
highlighted how tight the margins of spare capacity were becoming. In the period after 1960–72, demand in the non-communist
world more than doubled, from 19 million barrels / day to 44 million barrels / day (having more than doubled from 7 million
barrels / day in 1945). The US accounted for just under 40 per cent of world demand, western Europe about one third, and Japan
one tenth. The ‘swinging sixties’, in particular, were the era of unrestrained growth and booming oil consumption in the Western
world and Japan: more, faster, heavier cars; rapid growth of oil consumption in power generation, plastics and petrochemicals.
The USA, the world’s largest oil producer, reached its highest-ever oil production peak of 11.3 million barrels / day in 1971
and became a major importer by 1973 (at 6 million barrels / day). The Middle East became the ‘supplier of last resort’.

But, quietly, the new sources of expanding supply in the Middle East – which met two thirds of the increased demand – were
slipping under the control of producer country governments, with an assertive Iran under the Shah, the Ba’ath-led revolution
in Iraq, Gaddafi’s seizure of power in Libya, and the rise of nationalist politicians in Venezuela. The OPEC grouping had
been established in 1960, quite innocuously, and its potential only gradually began to be appreciated by producers. By the
early 1970s growth in demand was outstripping supply. A long period of low prices had blunted investment in the industry.
Spare capacity was 3 million barrels /day in 1970, but it had slipped to 1.5 million barrels /day in 1973, roughly 3 per cent
of demand. By the autumn it had fallen to 1 per cent, 500,000 barrels / day, as Kuwait and Libya cut production. This extraordinarily
tight margin created a very similar situation to that in 2008. There was already great alarm in some countries, with animated
discussion of an ‘energy crisis’ in the USA and panic-buying in the summer of 1973 by US and Japanese importers. Our collective
memories of a problem caused by this long, slow build-up of demand relative to supply have subsequently been largely obliterated
by the more visually striking pictures of the Yom Kippur War, launched on 6 October
1973. The Arab OPEC countries sought to use the ‘oil weapon’ – in practice, an embargo against the USA and the Netherlands,
and all-round production cuts – and withdrew 5 million barrels /day at the most severe point of the embargo (albeit with some
quirky, non-conforming behaviour, notably from Saddam Hussein who tried to help consuming countries and attacked the cutbacks
of Arab ‘reactionaries’ for driving Europe and Japan into the arms of the USA). The ensuing scramble for supplies drove up
the crude price from $5.40 to over $17 per barrel within two months. But in reality the ‘supply shock’ of the embargo simply
amplified the ‘demand shock’ of demand having outstripped supply.

The embargo was short-lived, but the impact was profound and its political and economic legacies are still with us. Great
prestige accrued to those who had anticipated the problem, albeit for different reasons: E. F. Schumacher, who published the
‘anti-growth’
Small Is Beautiful
in 1973 (he was a strong advocate of coal); and the Club of Rome, which had published
The Limits to Growth
in 1972, warning of resource depletion (and also of global warming). The practical consequences of the shock for the Western
world were a big push for nuclear power, a revival of coal, which had been losing ground to oil, a new preoccupation with
energy conservation and efficiency, and, where possible, new oil exploration and production, as in Alaska, Mexico and the
North Sea. The oil shock provided the impetus to a powerful market adjustment, both for demand and supply, which was reinforced
by the second oil shock which commenced with the cessation of Iranian production in December 1978 in the upheaval of the Iranian
revolution, which drove up prices from $13 to $34 per barrel. A panic scramble for oil, including ‘gas lines’ in the USA,
fed demand, creating a speculative ‘spike’. The Iranian crisis dragged on through 1980 and the oil market was beginning to
stabilize when Saddam Hussein attacked Iran in September, further disrupting supplies from the Gulf, removing 4 million barrels
/ day of production and briefly driving up prices to $42 per barrel.

The major consequence of these two closely consecutive oil shocks was a very powerful economic response which, within a few
years, had turned the oil famine into feast, scarcity into glut. That process of market adjustment is crucial to understanding
the big divide in opinion, now, as to the way the future will evolve. The oil pessimists, the ‘peak oil’ theorists, are heirs
to the tradition of the Club of Rome, which predicted that demand growth is inexorably and unsustainably outstripping supply.
That world view appeared to be vindicated by the experience of the 1960s and the first two oil shocks, and again in mid-2008.
Oil optimists point to the remarkably rapid market adjustment that took place in the 1980s as being indicative of how flexible
are both supply and demand when given powerful price signals.

What is undoubtedly true is that world energy demand was, for a while, very firmly knocked on the head. Oil consumption in
the non-communist world was cut from 52 million barrels / day in 1979 to 46 million barrels / day in 1983. This fall was partly
a consequence of recession, the deepest since the Great Depression of the 1930s. But there was also a combination of energy
conservation and fuel switching. Conservation came from measures such as efficiency standards in vehicles. By 1985, the USA
was 25 per cent more fuel efficient than in 1973 (measured by energy consumption per unit of GDP), and Japan over 30 per cent
more efficient. Further savings came from the comeback of coal, nuclear power and (starting in Japan) natural gas. One crucial
change was the disappearance of oil from power generation, leaving transport as its last bastion.