Iran's Real Weapon Of Mass Destruction Is Oil Prices

     Oil prices jumped 8% last week after Iranian Vice-President Mohamad Reza Rahimi threatened to close the Strait of Hormuz if the rest of the world slapped an embargo on his country’s oil exports. Today, Reuters reports the European Union will do just that, with its diplomats agreeing in principle to halt Iranian imports.
There are lots of practical reasons to suspect Iran is bluffing. Not only would attacking shipping in the Strait be military suicide, but the regime needs the hard currency it gets from exporting 2.1 million barrels a day. Still, Iran is playing a powerful hand when it threatens to disrupt shipping through the narrow Strait and choke off what the Energy Information Administration estimates is 20% of the world’s traded crude.

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2012 Outlook: Crude Oil Prices Could Rise This Year, But Prices Could Be Very Volatile Kitco News Contributor

As my friend and economist Ed Hirs pointed out in a paper in 2010, the loss of 10 million barrels a day of Middle East production could drive short-run oil prices to $413 a barrel, given the inability of consumers to rapidly shift to other fuels. And that kind of shock is enough to blast the U.S. economy back into recession. Economist Kevin Kliesen with the Federal Reserve Bank of St. Louis said that sudden and sustained increases in oil prices increase the odds of recession by 50% in the first year, and 90% after three years.
“If you look at the historical data, nine of the past 10 recessions in the U.S. were preceded by sharp increases in oil prices,” Kliesen said. “If it’s large enough, it can cause people to adjust their future path of spending.”
A 50-cent increase in gasoline prices sucks $70 billion a year out of the pockets of U.S. consumers. And none less than Federal Reserve Chairman Ben Bernanke, earlier in his career, wrote that unexpected new information like jumping oil prices can cause businesses to delay capital spending, since the “option value” of waiting to see what happens next exceeds the expected return on investment.
Economists re-examining the 2008 financial meltdown are increasingly identifying the sudden, 55% jump in oil prices that preceded it as a big contributor to the subsequent decline in economic activity. Economist James D. Hamilton of the University of California at San Diego, for example, found that a model of the impact of oil prices on gross domestic product he created in 2003 predicted, with an error of less than 0.2%, the actual decline in GDP in the third quarter of 2008.
The surprising thing, Hamilton told Congress in 2009, is that oil caused so much economic damage given other problems at the time. Plunging residential investment only accounted for about half the shrinkage in GDP in the first three quarters of 2008, for example, and some of that might have been due to consumers resisting buying homes in far-flung suburbs because they were worried about the rising cost of commuting.
“Something else, in addition to the pre-existing problems in the housing sector, contributed to tipping the scales from an economic slowdown into a self-feeding dynamic of falling output and employment,” Hamilton told Congress. “I see little basis for doubting that a key aspect of that new drag on the economy resulted from the effects of the oil price shock.”
Kliesen of the St. Louis Fed also believes high oil prices had a lot more to do with the recent recession than many people think.
“It was a key event that really helped slow things down,” Kliesen told me. “Clearly we had some different shocks in that period that really hammered the economy but oil was one of those shocks that was lost in all the reporting about the financial crisis and housing downturn.”
Sudden changes in oil prices hit the capital-goods market particularly hard, Kliesen has found, since businesses simply stop investing until they get a better sense of where prices are going (that was Bernanke’s thesis, in a more general way).  Higher oil prices also drive investors to shift money toward sectors of the economy that are less affected “and such reallocation is costly,” Kliesen has written.
     
A 2000 study by the International Monetary Fund found that a $5 permanent increase in oil prices cuts world GDP growth by 0.25% over the first four years. But the impact on the U.S. was a larger 0.3%, reflecting this country’s high per-capita energy use.
According to the EIA, 14 crude tankers a day pass through the Strait of Hormuz, a 21-mile-wide passage the EIA calls “the world’s most important oil transit chokepoint.”
  

Iran's Real Weapon of Mass Destruction is Oil Prices