The Petro Panic

By GEORGE J. CHURCH

Leftist radicals who think capitalism thrives on war must have wondered what on earth to make of last week. The prospect of combat in the Persian Gulf touched off something resembling panic throughout the financial world. Stock prices sank rapidly in New York City, Tokyo, London, Paris, Frankfurt. At the lows on Thursday, shares of all U.S. stocks had lost more than $600 billion in paper value in slightly over a month, more than in the Black Monday crash of October 1987; on the Tokyo exchange, cumulative losses since the start of the year came to well over $1 trillion. Bond prices dropped in sympathy, sending interest rates spiraling; the yield on bellwether U.S. Treasury 30-year bonds Thursday hit an extraordinary 9.13%, the highest since April 1989. The dollar, which is losing its reputation as a safe haven, fell hard against nearly all other major currencies, touching a lowest ever rate of 1.54 against the deutsche mark.

On Friday markets generally steadied as traders and investors began to suspect that the earlier nose dive had been an overreaction: nothing so absolutely awful had happened yet. In Manhattan the Dow Jones industrial average climbed 49 points to a close of 2532.92 -- still down 112 points, or 4.2%, for the week and more than 460 points, or 16%, below its July 16 high of just under 3000. But no one could be sure that the worst was over. Some markets, notably bonds, kept right on going down. More important, the threat of war has not begun to fade, and the markets are operating on a frightening equation: war equals oil shortages equals skyrocketing petroleum prices equals an upsurge in general inflation plus sagging profits, lower production and more unemployment -- all at the same time. J. Richard Fredericks, a banking analyst at Montgomery Securities, a San Francisco brokerage, summarizes the thinking: "The gulf crisis has fueled the fears of rising inflation, deficits, recession and stagflation. That's a wicked combination."

Some of these worries might come true even without a war. The price of crude oil for October delivery leaped to $32.35 per bbl. at one point last Thursday, the highest since futures trading began in 1983, and closed Friday at $30.91, drastically above the $18 spot price that prevailed only a month ago. The worldwide embargo of Iraqi and Kuwaiti oil has removed about 4 million bbl. a day from international trade, and doubts are growing that other producers can make up the shortfall. Some experts are skeptical that Saudi Arabia can increase its production of crude quite as much as the 2 million bbl. daily it has promised. The Saudis notified customers last week that there would be no increase at all in their deliveries of refined products to the world market, - since the gasoline and jet fuel would be needed at home to supply Saudi and American planes and tanks defending the oil wells against Iraqi forces.

The results are likely to be especially severe in the U.S., which is uncomfortably vulnerable to any shock. Economists are debating whether the economy is merely on the brink of a recession or already in one. Output of goods and services grew only 1.2% in the second quarter, the fifth straight quarter of growth below 2%. That is likely to spark a continuing increase in unemployment, which rose last month to 5.5%, the highest since August 1988. Corporate profits have declined 12% in the first half, and are likely to sink further, in part because higher interest rates are making it more difficult for many corporations to pay off their swollen debts. Consumers also are too heavily in debt to increase their spending much.

The public has turned increasingly pessimistic. In a TIME/CNN poll taken last week by Yankelovich Clancy Shulman, 59% of the adults surveyed said they expect a recession, up from 55% two weeks ago. The vast majority expect conditions to deteriorate: 66% anticipate rising unemployment, 75% foresee higher interest rates, and 86% believe inflation will increase. They have good reason for gloom, beyond the tendency for such fears to become self-fulfilling prophecies. Big oil-price increases act like a stiff tax increase, pulling money out of consumers' pockets and reducing their ability to buy other products. A rule of thumb is that an annual increase of $8 per bbl. in oil prices reduces economic growth 1 percentage point a year. But petroleum has already risen more than that, and subtracting a point from growth leaves almost nothing. So if prices stay put, says a Bush Administration official, "growth is going to be a giant goose egg for the year. A big fat zero."

And that is an optimistic scenario. Continuing large price boosts, especially if produced by a protracted war on the Arabian Peninsula, could bring what a government official calls a "deep, deep recession." Worse yet, it would be an inflationary recession. Oil-price increases push up the cost of not only gasoline and heating fuel but also everything else made from petrochemicals: detergents, paint, ink, plastics and anything packaged in them, to name only a few. Anthony Vignola, chief economist of the Kidder Peabody brokerage firm, figures that if the recent rise of crude oil to almost $32 per bbl. is not rolled back, consumer prices this quarter will jump at an annual rate of 8.6%, nearly double their recent pace.

Worst of all, there seems to be little that government can do to head off such trouble. The conventional remedy for recession is deficit spending -- but the budget deficit is so swollen there is little room to pump it up further. The Federal Reserve Board is in an especially impossible position. To ward off or soften recession, the Fed would normally lower interest rates; to combat inflation, it would raise them. To fight both together, it should do -- what? The conventional wisdom is stumped for an answer. The time to move was much earlier: wise policy could have reduced U.S. dependence on imported oil and lowered the deficit during the prosperous years. By doing neither, the nation made itself vulnerable to an outside shock; it is all too likely to pay a stiff price now.

Other industrialized countries are, on the whole, in better shape than the U.S. to withstand an oil shock. Although their dependence on imported oil generally, and Persian Gulf oil specifically, is even greater, their economies for the most part have been growing faster than that of the U.S., and thus have more room to absorb some slackening.

Nonetheless, they have their own difficulties. Though the Japanese economy is still growing robustly, Japan shares U.S. worries about rising inflation and interest rates. In addition, real estate and stock prices by the end of last year had been bid up to what the country's economists concede were ludicrous and unsustainable heights. The stock market tailspin was largely inevitable, whatever happened to oil, but it may now have reached a scary point. Western analysts are worried, for example, that Japanese banks invested heavily in real estate loans that are going sour and industrial stocks that have fallen sharply in price; consequently the banks may have to reduce their lending to more productive enterprises. In Frankfurt the stock market has been battered by heavy selling of stocks (Daimler-Benz, Hoechst) that had previously been heavily propped up by Kuwaiti investment.

In Britain inflation had been expected to rise above 10% this fall, and the economy seemed to be headed for recession as well. No wonder, then, that the threat of war and further big oil-price increases pulled the London stock market down along with all others. Gerard Holtham, London-based chief international economist for Shearson Lehman Hutton, figures that the oil-price increases that have already occurred have "clinched" a downturn for the U.S., Britain, Canada and Australia. Says he: "If you speak English, you're in recession." More generally, no nation is likely to be able to resist the impact of an oil shortage and further price boosts.

In the Third World such nations as Brazil and Chile may have to default on debt repayments to their Western creditors. The new democracies of Eastern Europe have had enough trouble switching from Soviet oil at a subsidized $7 per bbl. to oil bought on world markets at $18; a further leap to $32 or more could severely disrupt their efforts to shift from command to free-market economies. And the Western industrial world is so thoroughly integrated that an inflationary recession in the U.S. is certain to have a global impact.

It is possible to foresee a different outcome. A prolonged standoff in the gulf might be accompanied by a rise in crude production by countries other than Iraq and Kuwait sufficient to reverse some of the recent price run-ups. Even war could end in a coup overthrowing Saddam Hussein, a quick American victory and a vast easing of economic strains. But it would be risky to bet on any such outcome. Last week's upheaval in the financial markets might have been an overreaction to what has happened so far, but unhappily it cannot be dismissed as mindless panic. In a few months it could even look like a sober reappraisal of darkening prospects for the world economy.

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CREDIT: TIME Charts by Steve Hart

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CREDIT: TIME Charts by Steve Hart

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With reporting by Anne Constable/London, Michael Duffy/Washington and Thomas McCarroll/New York