A Tale of Two Oil Shocks | Part 1: 1973-76
by ANDREW SCOTT COOPER
15 Jun 2012 15:05
When the Shah persuaded OPEC to double the price of oil, with global consequences.
Then, as now, a worldwide recession caused widespread political instability and social unrest. Then, as now, fears were expressed that bankruptcies in southern Europe would trigger shockwaves in the form of debt defaults, financial contagion, and the failure of major Wall Street banks. Then, as now, fraught relations between the United States and Iran complicated an already tense international situation. As political leaders grapple with today's fast-moving crises, they could do worse than heed the lessons of the Great Oil Shock of 1973-76, while considering anew the role high oil prices played four years ago in unleashing the Great Recession.
In the early 1970s, as in the early 2000s, a powerful convergence of economic and geopolitical developments ushered in an era of energy crisis and insecurity that the United States was remarkably ill equipped to meet. After U.S. oil production peaked in 1970, at a time of rising consumer demand, the Nixon administration discarded import quotas that until then had prevented the economy from becoming too dependent on any one foreign oil supplier. Foreign crude imports consequently rocketed and within a remarkably short period the United States became vulnerable to the vagaries of the world oil market.
The entry of the American leviathan into the global energy marketplace brought with it a slew of other complications. America's thirst for cheap oil quickly soaked up any excess capacity, tightening the market to the point where prices began spiraling upward for consuming nations everywhere. The United States was now competing against its own allies in Europe and Japan for the same shrinking pool of energy supplies. What had historically been a buyer's market had not turned in favor of sellers.
In 1973, the Middle East oil market was vulnerable to an interruption in supply caused by any number of potential "events" such as war, embargo, acts of terrorism, severe weather conditions, or direct political manipulation. In fact, several "events" led to the Great Oil Shock. As consumer demand for oil increased in the West and the market tightened, Arab oil producers took advantage of their newfound petro-power to nationalize the operations of foreign oil companies and force through higher prices.
The last three months of 1973 were memorably chaotic. In October, the Arab-Israeli War led to panic buying of oil supplies. In November, Arab oil producers imposed a blanket ban on the sale of oil to the United States and other Western countries to punish them for their support of Israel. The final blow came in December when the Shah of Iran, ostensibly a U.S. ally, took advantage of American impotence and persuaded the rest of the Organization of Petroleum Exporting Countries (OPEC) to more than double the price of a barrel of oil from $5.11 to $11.65.
Although these figures may sound modest when compared to today's oil prices of $100 per barrel, they take on new meaning when we consider that the price of oil increased by 470 percent in the span of a single year. No consumer economy, no matter how well prepared, can adjust to disruption on that scale without enduring massive structural change and dislocation. Historians describe the events of 1973-76 as a "shock" and for good reason: nothing like it had ever been seen before.
In the United States, where the price of foreign oil imports soared from $3.9 billion to $24 billion and the inflation rate climbed into the double digits, the economy shed jobs faster than at any time since the 1930s. The Dow Jones Industrial Average slumped by a third and housing starts fell by 38 percent. Pan American Airways, battered by high fuel costs, appealed to the federal government for a tax-payer funded bailout. The federal government estimated that in only 18 months the number of Americans living below the poverty line rose by 5.6 percent -- among children, 8 percent -- and real income declined 4 percent over a 12-month period. The American middle class was under real pressure. Here was the true cost of the Shah's oil shock.
In a White House transcript dated July 9, 1974, President Richard Nixon received an ominous briefing from his treasury secretary on the worsening state of the U.S. economy. "Oil prices have caused great instability in the international financial markets," Wiliam Simon warned the president. "The financial markets are close to panic. There are major corporations which are unable to borrow." Today's policymakers would recognize the sense of urgency on the part of senior U.S. officials as they prepared for the collapse of financial networks and the failure of big banks on Wall Street.
Three weeks later, on the eve of Nixon's resignation, Federal Reserve Board Chairman Arthur Burns confided to Secretary of State Henry Kissinger and other top officials that their efforts to stabilize financial networks had reached the end of the road. "We are headed towards disaster in the industrial world," he warned. Catastrophe beckoned unless oil prices were brought under control. Nixon's successor, Gerald Ford, had been in office a few hours when he was advised that he had three months to bring inflation under control "or face possible social unrest" amid mounting job losses and soaring inflation.
The picture abroad was just as dire. Rampant inflation and unemployment caused by high oil prices inflicted widespread misery and provoked political and social turmoil. High fuel costs were blamed for famine in sub-Saharan Africa, food shortages in India, higher rates of child mortality in Tanzania, and factory closures throughout Southeast Asia. The cash-strapped British government was forced to go cap in hand to the International Monetary Fund for four bailouts in the space of a year.
Southern Europe was a particular focus of concern for Ford and Kissinger. The Ford administration was engaged in the delicate task of helping reformist leaders in Greece, Portugal, and Spain transition to democracy after years of right-wing dictatorship. Economic misery inflicted by oil prices made their task far more difficult. It strengthened the hand of local communist parties and led to fears of a Red takeover of Europe's southern periphery. Neighboring Italy was also in trouble. The state of its finances was so parlous that the German chancellor, Helmut Schmidt, agreed to a bailout on condition Rome put up its gold bullion as collateral.
Then there were the banks. The massive transfers of petrodollars that followed the hike in oil prices in 1973 had mostly been handled by banks on Wall Street. The flexibility they showed to international lenders and debtors helped prevent an immediate meltdown of international financial networks. But their risk-taking created another, potentially bigger threat to the global economy. "So great was the activity that American banks have been thrust into the role of major suppliers of money to the world," reported the New York Times.
American banks were particularly eager to establish a presence in countries in southern Europe whose banking sectors had until then been closed to foreign competition. They extended generous loans to Greece, Portugal, and Spain without considering what might happen in the event of political unrest or worsening economic conditions. It was Wall Street's bad luck that by the summer of 1976 Rome, Athens, Lisbon, and Madrid teetered on the verge of bankruptcy. Their risky lending practices had left them dangerously exposed to events in Europe, threatened by debt defaults, and at risk from financial contagion. The most vulnerable banks are familiar names today: Bank of America, Citibank, Chase Manhattan, and the Morgan Guaranty Trust Company.
"How can presumably sophisticated bankers, who weigh every nickel of a $20,000 home mortgage loan, get so tangled up in bad or weak-quality loans running into the billions?" asked a columnist in the Washington Post in 1976. "To be sure, they are private institutions, but their solvency and stability have public ramifications." The warning signs "should be taken seriously by those bankers who still regard news media discussion of banking problems as an assault on the free enterprise system."
No global crisis ever follows the same script. But a historian would be derelict if he did not point out some of the disturbing parallels between today's Great Recession and yesterday's Great Oil Shock. The linkage between high oil prices, instability in southern Europe, and the threat of debt defaults, financial contagion, and bank failures deserves closer scrutiny. If legitimate connections can be made, these should be discussed and analyzed to help prevent or at least mitigate a future crisis.
You're hardly alone if you feel that you are living through a real-life version of the 1993 movie Groundhog Day. In my next column I will look at the role high oil prices played in triggering the 2008 financial collapse, the implications for Iran's economy, and how policymakers ignore the lessons of history at their peril -- and ours.
End of Part 1 | Part 2: 2007-12
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