Subir Gokarn: The new global macroeconomy

This month, crude prices have been hovering around $64 a barrel. This is, of course, the highest ever level when measured in current prices.

More significantly, when corrected for inflation (using 1995 dollars as the base), this equals the highest ever levels reached. The real price of around $51 per barrel was last attained in January 1981. In that period, the real price of crude remained above $40/barrel from November 1979 until December 1982.

In the current situation, this level was first crossed in October 2004, but did not persist beyond the next month. It was again reached in March 2005 and the price has continued to climb since then.

By way of comparison, in between these two periods, the real price of crude reached a maximum level of $37/barrel during the Gulf crisis of 1990-91 in October 1990. It remained above the $30 mark for only three months, September to November 1990.

In the early 1980s, high oil prices precipitated a global recession. People will remember India's dependence on a large IMF loan to deal with the balance of payments crisis that we found ourselves in.

Latin America went into a deep external debt crisis as well. The developed countries were severely hit; the US saw an unprecedented combination of high unemployment and high inflation through 1980. Although inflation was brought under control relatively quickly, the recession persisted until 1983.

This time around, while the oil price trigger has been of comparable magnitude and duration, the global macroeconomic outcome is completely different. India is in a very comfortable growth-inflation configuration (even after allowing for the government's reluctance to raise administered prices of petroleum products), with forex reserves that will protect us against any conceivable external shock.

The US economy is also in a pretty comfortable growth-inflation zone, while China, which is the biggest incremental consumer of petroleum products today, has its policymakers more concerned about slowing down the economy than speeding it up. What a difference 25 years have made to the global economy's vulnerability to oil prices!

What has caused this? Both structural changes in the global economy, in terms of what kinds of goods and services are produced, and the efficiency (including energy efficiency) with which they are produced, have played their part.

But, to appreciate the true magnitude and significance of these changes, they have to be viewed within a framework of "vertical" and "horizontal" forces in the global economy. It is convenient to use the interrelationships between the US, India and China to develop the argument.

Vertical forces are those that have driven efficiency gains within each country. In the US, the dominant factor has been the breadth and depth of IT applications. The evidence of their contribution to US productivity growth over the last decade is persuasive.

In India, it has been the competitive pressure exerted by de-licensing of industry and trade reforms. Every sector in which these have been significant has seen continuing improvement in the price-quality combination offered to the consumer. In addition, human resources and a favourable macroeconomic environment have cemented a highly competitive position in services.

In China, enormous investments have generated huge benefits through economies of scale. High-quality and low-cost infrastructure and labour have reinforced these, enabling the economy to attain an unassailable competitive advantage in manufacturing.

Horizontal forces are those that have led to the transmission of productivity gains across countries. Here, it is the US that has benefited the most. It is the largest importer of manufactured goods from China and the largest importer of services from India.

It has, consequently, been able to appropriate for its own consumers the considerable gains in efficiency generated by vertical forces in those two countries. Indo-Chinese exchanges are still relatively small, denying both the potential benefits from each other's competitiveness. As volumes of exchange between these two countries increase, mutual productivity gains will significantly increase the capacity and stability of the global economy. But, that is a story for the future.

Vertical and horizontal forces have combined to favourably impact sustainable growth-inflation combinations in all these countries; the US, of course, is the best-off. Since a given rate of growth can be sustained at lower rates of inflation than before, central banks have been able to keep liquidity levels high without much fear.

This has reinforced domestic demand for goods and services without stoking inflationary pressures. It has also increased demand for assets, whose prices have been going up over the years.

From the US perspective, greater domestic liquidity has driven dollars out in search of returns, globalising the increase in asset prices and, in the process, depreciating the dollar vis-à-vis most currencies. It would be a mistake to interpret this trend as a sign of a weakening US economy.

Someday, of course, the power of today's vertical and horizontal forces will weaken. But, today, the opportunity and potential to exploit them are strong and will persist for a while. The US can easily expand its engagement with India and China, and between these two, as was argued above, the story is just beginning.

With respect to the potential threat from high oil prices, this reasoning would suggest that it can be mitigated by speeding up the processes that generate productivity gains at the macroeconomic level, in both the vertical and horizontal categories.

Inflation rates may increase marginally, but not to levels that will force central banks to clamp down on liquidity. The risks of a sharp, policy-induced recession are, therefore, low.

What if the oil price increases substantially beyond today's level? There is a possibility that, beyond a point, it will offset the positive impacts of the vertical and horizontal forces and precipitate the kind of global response that we saw in the early 1980s. What that point is, though, is anybody's guess.

But, while we speculate on what the new danger level might be, let's not lose sight of the central message. Domestic reforms, widespread access to new technologies and increasing global exchange have made both individual economies and the global collective more productive, more stable and more resilient. There is much to be gained from continuing down this path.

The author is chief economist, Crisil. The views here are personal