The quadrupling of oil import prices in one year, quite apart from Arab supply cutbacks, has greatly increased the urgency and gravity of the questions that were lurking in the shadows even in the earlier, balmier days of the energy crisis.1 No less an authority than the managing director of the International Monetary Fund (IMF) has warned that the combination of oil shortages and price increases in 1974 is likely to produce "a staggering disequilibrium in the global balance of payments . . . that will place strains on the monetary system far in excess of any that have been experienced since the war." And Treasury Secretary Shultz has stated that the recent oil price increases raised "literally unmanageable" problems for many nations.

These, then, are the questions that confront us:

- Can the international monetary system sustain a transfer of wealth of such unprecedented dimensions without extensive disruption or even collapse because of intolerable balance-of-payments strains?

- Will the consuming countries be able and willing to absorb the immense investments the oil-producing countries may wish to make?

- Will new financial mechanisms be necessary to assure reasonable stability?

- What will happen to currency values?

- Will the consuming countries be able to make the necessary internal adjustments without severe dislocation and with no lasting impairment of growth?

- Will the increase in oil prices further accelerate the inflationary spiral?

- How severe will be the impact of higher prices on living standards?

- How will the resource-poor Third World be able to cope with the oil crisis, and what will be the political consequences for the industrial countries?

II

The starting point for an analysis of the monetary impact of the energy crisis is the quantum jump in import bills implied by higher oil prices. For the United States, Europe and Japan, oil imports this year may be nearly $50 billion more than in 1973. What will happen beyond this year is highly conjectural, depending on the responses of supply and demand to sharply higher prices in the consuming countries, and on the pricing and production policies of the nations that make up the Organization of Petroleum Exporting Countries (OPEC). If demand does not fall off appreciably when prices rise and if supplies remain tight, import bills will keep rising. By 1985 they might well approach $200 billion, some $150 billion more than in 1973. The OPEC investable surpluses may total nearly $100 billion by the end of 1974, and could cumulate to almost $500 billion by 1980 and more than $600 billion by 1985. These magnitudes would seem to be enough to scuttle any monetary system.

There are plenty of unknowns as we set out to forecast the outcome. But there are also a number of knowns which, if we sort them out, can help to advance the analysis.

(1) Although all importing countries will be transferring wealth to OPEC, the payments problems that may result will primarily involve financial relations among the importers.

(2) An OPEC decision to export more oil than they need to pay for imports is a decision to invest abroad.

(3) There are no limits in any financial sense on the absorptive capacity of importing countries for OPEC funds, but there may well be psychological and political problems.

These somewhat surprising conclusions will become clear if we trace through the financial flows set into motion by higher oil import bills. To the extent that the consuming countries can increase their exports of goods and services to the producing nations, higher oil imports will entail neither balance-of-payments deficits for the former, nor surpluses for the latter. But we already know that even the most rapid increases of imports by the OPEC countries must necessarily lag far behind the explosive growth of their income. And the entire excess of OPEC income over expenditure must necessarily flow back to the importing countries so as to eliminate the payments gap between themselves and OPEC. In other words, the payments flows from the importing countries as a group to OPEC must be exactly offset by reverse flows of funds for imports and investment from OPEC.

Now, how can we be so sure that what flows out will flow back? Consider this: when a U.S. company makes a payment to, say, Saudi Arabia, what happens is that title to a dollar account in a U.S. bank is shifted from a U.S. resident to a foreign government. This money actually never leaves the United States, but convention would have it that the funds flow to Saudi Arabia and then return. By simply endorsing and depositing the U.S. importer's check, Saudi Arabia increases her investment in the United States. And this foreign investment will stick to her like a burr until the Saudis spend it on imports or, to raise an unlikely possibility, give it away as grant aid to developing countries. These are the only ways their foreign investments can be drawn down. To be sure, they can switch out of dollars into deposits in other currencies. Or they can switch out of bank balances into stocks, bonds, direct investments or real estate abroad. Or they can buy World Bank bonds or lend to the International Monetary Fund (IMF). But these are all different forms of foreign investment, and shifts from one into another do not alter the total.

In this perspective, note that OPEC purchases of gold, Rembrandts, and industrial equipment, for example, count as exports, not investment. They draw down bank balances abroad and leave no claims against the industrial countries once they have been shipped to the OPEC nations. They are, of course, forms of domestic investment for the OPEC countries. But here we are speaking only of investment forms that involve claims on foreigners.

In the long run, domestic investment by OPEC will feed back on the balance of payments, for example, by generating locally produced goods that can displace imports or gain a foothold in foreign markets. Indeed, given their small population base, industrialization of the Gulf states would necessarily make them dependent on the export markets of their oil customers for profitable operations. This, in turn, would provide the oil-importing countries with new, possibly important, bargaining power for future negotiations with the countries concerned.

The second and third startling propositions follow from this analysis. There are only three ways OPEC could avoid investing abroad: first, to spend their entire oil export earnings on imports; second, to trim back oil exports to the level needed to pay for the imports they want; and third, to give immense gifts of money (grant aid) to their oil-poor Arab neighbors and other countries. Given the enormity of their income, the first solution would be possible only if oil prices were slashed deeply. The second solution could be difficult to implement in view of the counter-pressures the importing countries might exert to safeguard their vital interests. Besides, some OPEC members at least might decide that, at present prices, oil in the ground will not long be better than money in the bank. The third solution is simply not going to occur. Even if OPEC were to provide foreign aid in amounts many times the $1 billion annual sum volunteered by the Shah of Iran on behalf of his nation, their coffers would scarcely be dented. Even more to the point, the Shah proposed to lend the money-in other words, to make foreign investments-not to make outright grants.

These conclusions carry a number of important implications. For one thing, they set to rest any concern that the OPEC nations might deny the importing countries the capital flows needed to redress imbalances. For another, they suggest that OPEC demands for investment vehicles that would safeguard them against inflation and devaluation-vehicles that do not now exist anywhere-do not have to be taken quite as seriously as they have been in some quarters. It is reasonable to suppose, however, that OPEC will take the attractiveness of investment opportunities in the industrial countries into account when deciding on how much to produce and export. In particular, special inducements might be necessary for OPEC to invest in ways conducive to international monetary stability. But the essence of the problem is OPEC's willingness to produce and export oil. There is simply no way of getting around it: above a certain level, an OPEC decision to export oil is a decision to invest abroad.

III

If foreign investment is inevitable, perhaps we should lean back and enjoy it. That there are no general absorptive problems follows from the fact that the investment initially involves no more than the transfer to foreign ownership of bank balances that already exist. Now, to be sure, there could be disturbances in the capital markets if OPEC's portfolio preferences differed greatly from preëxisting patterns. This could involve significant changes in interest-rate relationships or price-earnings ratios, for example. And shifts in the location of funds from the United States to small countries like Switzerland could give rise to troublesome inflationary pressures, if the governments concerned attempted to hold their exchange rates steady, or to severe deterioration in their trade balances, if they allowed their currencies to rise.

Indeed, this latter contingency may be a psychological barrier to the willingness of some countries to absorb foreign investment. A strong mercantilist tradition still pervades our world, equating trade surpluses with virtue and deficits with sin. Higher oil prices will, by themselves, push the trade balances of most, if not all, industrial countries into deficit. To prevent simultaneous downward pressure on their currencies, they might individually accept offsetting capital inflows. But to go beyond that, to allow inflows of foreign investments that would push their exchange rates up and accentuate their trade deficits could well be unacceptable.

In some instances the limits of absorptive capacity may be set by political rather than economic considerations. The industrial countries might not be prepared to accept massive ownership of home enterprises by foreign investors, especially if those investors are not a large and diverse number of foreign individuals or companies, but a handful of governments with political fish to fry. And OPEC attempts to focus their investment interest on a limited number of securities could raise antitrust problems as well as the possibilities of disturbances in the equity markets.

Actually, the likelihood that these problems will occur has faded with the recent price increases and embargoes. Even before they declared economic war on the industrial world, the OPEC nations had a passion for anonymity in their investments. Now, they may be even more leery of having visible hostage assets abroad. Far better, from this point of view, to put funds into the Eurocurrency market, where they can circulate throughout the world without anyone being the wiser as to their origin.

IV

Now, let us return to our initial question. We began by asking whether the international monetary system could sustain the prospective immense transfer of wealth to the OPEC countries, and have concluded, so far, that the payments problems, if any, will be among the consuming countries, not between them and the OPEC countries. But there is less comfort in this than meets the eye. The essential question then becomes whether imbalances among the consuming countries will be so great as to tear the system apart. After all, the consuming countries, as a group, could all be in equilibrium at the same time that each of them suffered horrendous, but offsetting, imbalances. On the other hand, there would be no balance-of-payments strains for any country if it should happen that the OPEC countries placed their investable funds abroad in relation to the payments needs of each. But this is more than can be reasonably expected. Some countries are obviously more attractive than others as places to invest or as producers of the things the OPEC countries want to buy. Thus, some consuming countries stand to get more offsets, others less. How, then, are things likely to sort themselves out? Will new financial mechanisms be necessary to assure reasonable stability?

Let us see what is needed and what we can expect of existing mechanisms. The essential problem among the consuming countries, once their equilibrium is disturbed by more expensive oil imports, is to move to a new structure of trade compatible with the altered flow of international investment funds. In this process, exchange-rate movements are likely to be the main equilibrating force. They will rise for countries receiving capital inflows in amounts that exceed the increase in their oil import bills. This will make those countries less competitive internationally. Their exchange rates will continue to rise until the deterioration of their trade balances becomes large enough to offset the extra capital inflows. Countries that fail to attract sufficient capital will experience the reverse process. Thus, if market forces are allowed to work, each country's trade and capital accounts would seesaw to a new equilibrium.

This is all right as far as it goes. But it raises as many questions as it answers. For example: Just how much adjustment in trade balances might be required for individual countries, and how much change in their exchange rates? Will free market forces be permitted to operate if some countries face a severe deterioration in their trade balances and marked changes in their currencies? Would the capital flows that induced these changes in trade be stable, or would they slosh around across currency boundaries preventing trade adjustment, indeed, disrupting trade and investment?

There is certainly a danger that free market forces will not be permitted to work themselves through and that the industrial world will retreat to protectionism. We have already spoken of the pervasive mercantilist ethic that holds trade surpluses to be the essential goal of foreign commerce. Now, the industrial countries as a group cannot help being in an overall trade deficit. This would go against the grain, even if the deficit were evenly distributed among all. But that some might have to bear a disproportionately large share of the total deficit might seem wholly unacceptable. To avoid this contingency, the nations so threatened might resort to competitive devaluations or trade restrictions. The new era of floating exchange rates has heightened the danger of predatory currency practices, both by breaking the IMF rule that any country's exchange rate adjustment requires multilateral approval and by facilitating currency manipulation. At the same time, the energy crisis has increased the motivation for competitive devaluation. Before the crisis, devaluation could only aggravate the problems of over-full employment and rampant inflation confronting most countries. But now, with recessionary tendencies in evidence, devaluation may appear more attractive as a way of maintaining output in the face of shrinking demand-at the expense, of course, of other countries. This conjures up disquieting images of the 1930s.

The maintenance of a multilateral, outward-looking trade and payments system may therefore be conditional on capital flows that go quite far toward offsetting the bulk of the payments strains resulting from the energy crisis. As was said earlier, it would be possible for OPEC to prevent each and every consuming country from experiencing any balance-of-payments strain whatsoever, by the simple expedient of channeling their investments to each in accordance with its need. In practice, how close to this result is the outcome likely to be?

So far, the OPEC countries have demonstrated a preference for investing in the Eurocurrency market, rather than in national money markets or directly in securities. There, they find both anonymity-a valuable feature to governments anxious to avoid creating "hostages" abroad-and high returns on short-term deposits. The Eurocurrency market is a highly efficient mechanism for financial intermediation. The funds deposited there are quickly re-lent to commercial borrowers and to governments. Britain and Italy, through borrowings by their public authorities, have already drawn on this large pool of international liquidity to finance their balance-of-payments deficits. And on January 31 France announced intentions to borrow around $1.5 billion in the Eurocurrency market specifically for the purpose of helping to pay for the higher cost of oil imports. (Finance Minister Giscard d'Estaing reportedly expressed hope that similar actions could be taken by the Common Market to recycle Arab funds to the European nations that will need them.)

But governments need not borrow directly to use the resources of the Eurocurrency market for this end. Tight money conditions, for example, might induce their residents to borrow abroad rather than at home, thereby giving rise to the desired capital inflows. In general, since no one can know better than the deficit country concerned what its financing needs are, any institution like the Eurocurrency market that can recycle OPEC surpluses in accordance with the initiatives of the borrower should go far toward reducing payments strains.

The U.S. money markets could also perform this function if, directly or indirectly, Arab funds flowed into the U.S. money or capital markets-something that has evidently not yet occurred on a significant scale. If the OPEC countries acquired U.S. bank balances, or bought stocks, bonds, industrial property, etc., the liquidity of American financial markets would be increased. Interest rates here would tend to fall. This would attract foreign borrowers at the same time that relatively higher foreign interest rates encouraged American investors to place their funds abroad. Similar recycling mechanisms would be activated if London, Zurich, Frankfurt or any other financial center were favored by the OPEC countries. The ability of market forces to induce such intermediation has been greatly enhanced by the termination, at the end of January, of U.S. and Canadian controls on capital outflows, and by an easing of restrictions on capital inflows by a number of European countries and by Japan.

Other institutions could also help in the recycling. The IMF, for example, with its resources augmented by OPEC funds, could play a significant role in easing payments strains-a role for which it was originally designed. The World Bank and the Bank for International Settlements in Basel could help. And loans among central banks could also make a contribution.

It is one thing to identify mechanisms, and another to say that they will suffice to do the job. As things stand, the Eurocurrency market has several defects for present purposes. In essence, there can be no assurance that the allocation of loans based on such commercial banking considerations as creditworthiness and relative interest rates will coincide with the requirements of balance-of-payments equilibrium. Thus, for example, the Eurocurrency market is not well suited to resource-poor or politically unstable developing countries with low credit standing. Here, a partial solution, at least, may lie in World Bank borrowing from the OPEC countries and re-lending to the Third World. Such recycling through the World Bank, for which there is already some precedent, will receive new impetus from the announced intention of the Shah of Iran to invest in World Bank bonds a portion of the $1 billion in aid funds that he pledged to make available this year. In addition, the Arab countries have already spoken of establishing a development lending bank of their own, and the Shah has proposed a new international development fund whose capital would come jointly from oil-exporting countries and the major industrial nations. But what about countries which, realistically speaking, have no prospects whatsoever of repaying a loan? Such countries-and there are quite a number-would be outside the circle of recycling funds. Their situation would be further aggravated by the likely reluctance of the industrial countries, now preoccupied with their own problems, to continue aid at existing levels, let alone contribute the added amounts the poor countries need to pay for oil.

Another problem with the Eurocurrency market is that funds placed there tend to be on short-term deposit, while the debts required to ease the payments strains of oil imports will need to be relatively long-term. This problem might be resolved through normal market processes bringing the terms desired by borrowers and lenders into closer alignment. But given the enormous speed of the Arab investment buildup, these processes might not work quickly enough.

And finally, what can be said about the danger of financial instability resulting from sudden and massive shifts of funds out of particular money markets and across currency lines? Note that this threat would not be confined to possible actions by OPEC countries. In the complicated system of intermediation sketched above, the financial boat could be rocked by any of the many borrowers, creditors, or speculators within the system, anywhere along its chain. It has often been said that OPEC's self-interest in seeing their investments prosper would deter any destructive moves on their part. The same would apply to the other actors on our stage. And yet one might wish for greater reassurance. Financial panics have occurred in the past, even though those who precipitated them lost what otherwise might have been saved.

This question of financial instability may turn out to be the biggest of the threats posed by the energy crisis. Recurring upheavals in the foreign exchange markets could trigger protectionism and bring about a severe contraction in world trade, conjuring up visions of another world depression. Accentuating the dangers here are the incredibly large OPEC surpluses that are in prospect and the extraordinary rapidity with which they will accumulate. Existing mechanisms and institutions are simply untested in handling international transfers on this order of magnitude. It is as if we asked whether, after having safely lived for nearly three months in the skylab, our astronauts could survive for another five years in outer space.

This question, moreover, puts into useful perspective any efforts at quantifying the balance-of-payments implications of various oil price and volume scenarios. In a nutshell: we could envision a cumulative OPEC surplus, including investment yields, of around $450 billion by 1980. Suppose this estimate is wrong and that it will turn out to be around $550 billion; or suppose that it is only $350 billion, or even less. Would the higher or the lower figure be materially different with respect to its implications for international financial stability? I submit that it would not, that we have taken a quantum jump into a new world that is qualitatively, not merely quantitatively, different from the old.

Recognition of the potential for instability in these extraordinary financial flows underlies the various suggestions that have been made for averting the dangers by tying up Arab funds in nonliquid form. In this connection, oil consultant Walter J. Levy has suggested buying oil now and paying part of the cost later. Also in this category is the suggestion that the IMF provide new, value-guaranteed instruments to OPEC to sop up their liquidity and then recycle it to the oil-importing countries. Secretary Shultz has suggested consideration of a new kind of multinational joint venture-a type of mutual fund, as it were-which would employ expert investment management to channel OPEC funds into a diversity of profitable investment outlets in the consuming countries. The investing nations, which would be encouraged to "commit sizable funds for extended periods," would "maintain control over some basic decisions concerning the volume and distribution of the funds." And Secretary Shultz's proposal of lower oil prices would, of course, reduce the size of the financial problem to begin with. Only time will tell whether reasonable stability can be maintained without the help of such special instruments.

But one essential point must be kept in view. The key to the viability of the international monetary system is not some stroke of inspiration in inventing a new investment vehicle with such irresistible features that it will swallow up most of OPEC's funds and neutralize them. No paper certificate or financial contract can go beyond the underlying willingness of the OPEC governments to coöperate now and in the future, changing circumstances notwithstanding. At best, such certificates provide a convenient channel for coöperation. It would no doubt be a costly channel as well, because OPEC may insist on features that no government has been willing to offer in the past-including maintenance-of-value guarantees for inflation and devaluation. Moreover, OPEC's willingness to accumulate such assets does not involve a once-and-for-all decision, but rather daily decisions because, as long as oil flows, funds flow to the producing countries. Considering also a natural desire for investment diversification, it seems likely that any special arrangements would absorb only a fraction of the funds at OPEC's disposal. Therefore, even though they can help, there is no guarantee that they would suffice to make the difference between monetary stability and instability.

Now, let us try to pull these threads together. On the positive side, the OPEC surpluses necessarily remain within the financial markets of the consuming countries, and the existing institutional framework would seem more or less capable of the intermediation necessary to channel funds to the point of need, at least within the industrial world. On the other hand, there are uncertainties as to the ability of existing institutions to cope with the immense magnitudes we envisage, the ability of the resource-poor developing countries to keep their heads above water, and the stability of a financial system so heavily dependent on international lending. No doubt, this list of problems could be expanded greatly.

The long and short of it is that no one can be sure that the financial side of the oil crisis is manageable. Perhaps the best that could be said is that, if the consuming and producing countries can coöperate in working out solutions, there is nothing about the institutional structure that would preclude a happy ending. Regrettably, the comfort inherent in this idea is somewhat marred by the history of international monetary coöperation.

V

Despite the uncertainties, what can be said about the outlook for individual currencies? Major imbalances would remain for the United States, Europe and Japan after the initial increase in oil import bills has been partially offset by oil industry profit remittances, shipping earnings and the like, and by higher exports to the OPEC countries. Unfortunately these calculations do not take us as far as we would like with respect to exchange rates because, as we already know, these will be driven by the engine that recycles capital. And there is really no way to predict the ultimate destinations of OPEC funds.

It must also be remembered that, in forecasting exchange rates as in forecasting stock prices, it is not enough to be right about the underlying forces at work. One must also predict correctly the psychology of the people who make the markets. And these people-foreign exchange traders, investors, businessmen and speculators-will probably be watching the trade and current account positions of the major countries rather than the capital accounts. This is both a matter of conventional analysis and of necessity-because while trade data are released monthly, information on capital flows is fragmentary and incomplete if it is available at all.

A "first-round" look at the magnitude of the deterioration that is likely to occur in trade and current account positions reveals that all of the consuming areas are hard hit. The rapidity of the escalation in oil prices, however, has struck particularly heavily at Europe. If OPEC incomes had reached their high levels gradually, Europe, as principal supplier of OPEC's imports, would have been able to offset a substantial part of its high oil import bills with a large volume of exports. But OPEC's import spending simply cannot keep up with the explosive growth of oil income. Consequently, over the next few years at least, money that would have been spent on imports, largely in Europe, will instead flow into the capital markets.

The initial response of exchange rates to the oil crisis that erupted with the Arab-Israeli war already provides us with a frame of reference for further analysis. To be sure, the market reaction so far has been based not only on the effects of more expensive oil, but also on the possible repercussions of the disturbances caused by embargoes and cutbacks. The latter, we hope, will be short-lived. In any event, the markets reasoned that the United States was most favorably situated, with relatively low dependence on imported energy, a strong initial trade position, and favorable prospects for attracting funds. And Japan was seen at the other end of the spectrum. On fundamentals, these judgments seem realistic.

To be sure, some tempering of optimism about the dollar became evident in the foreign-exchange markets when the United States and some other nations ended their controls on capital exports and imports, respectively, at the end of January and when the oil imports of other leading countries proved to be somewhat lower than had been expected. Thus, toward the end of January, the dollar came within less than one percentage point, on a trade-weighted basis, of recovering its decline relative to Smithsonian rates. However, by the end of February, it had receded to a range roughly midway between Smithsonian levels and the nadir it reached early in July 1973.

On the other side of the coin, the major European currencies and the yen first declined substantially relative to the dollar, since last October, and then recovered about half of their losses. The pound, having risen less earlier in 1973, also fell less. And the lira, having participated in the earlier decline of other European currencies, has failed to share appreciably in their recent strength. That the pressures were great is reflected not only in the magnitude of the changes, but in France's defection on January 19 from the attempt by seven European countries to maintain fixed exchange rates among themselves while floating jointly against other currencies. France was unwilling to commit any more of her dwindling reserves to the defense of her weakening currency.

For the time being, the foreign exchange markets will probably continue their erratic search for new sustainable relationships, a process that is likely to involve abnormally large day-to-day fluctuations. This instability does not yet reflect the actual impact of Arab funds, but rather the anticipatory adjustment of positions by dealers, traders and investors who traditionally dominate these markets. It should not be surprising if, after their vigorous comeback relative to the dollar, the European currencies and the yen receded somewhat in the near term, in step with the march of monthly trade data.

The longer-term outcome will be dominated by capital flows and therefore defies prediction. The fundamentals are ambiguous. Europe will probably be the main beneficiary of the rising trend of OPEC import spending. Indeed, on the somewhat unrealistic assumptions that this trend will continue its steep ascent and that Europe will keep its high export share, OPEC's trade surplus with Europe would be falling rapidly by the late seventies and actually turning into deficits by the mid-1980s. By 1980, Britain could well have joined Norway in being self-sufficient in energy. All of this suggests that the European exchange rates should strengthen toward the end of the decade. We should also be leery of underestimating the long-term potential of the yen. The ingenuity of the Japanese, their productivity, their export orientation, the likelihood that an easing of restrictions would greatly increase the inflow of foreign investment-all of these suggest that the yen, too, may recover its luster toward the end of the decade.

On the other hand, the United States may be favored by the rising tide of capital flows, either directly or as a result of the intermediation of the Eurocurrency market. Moreover, the dollar will be reinforced to the extent that "Project Independence" bears fruit and leads to an acceleration of energy production from indigenous sources.

But this leaves the long-term outcome very much in doubt. At this point, we simply cannot forecast how trade and investment flows might sort themselves out and what exchange-rate movements would be required to do the job. However, one thing is clear: the chances of an early return to fixed exchange rates, which were bleak even before the oil crisis, are now zero. Present and prospective international reserves will simply be no match for the rapidly rising volume of international liquidity resulting from the immense outpouring of funds to oil producing countries. These funds, once mobilized by fears of loss or expectations of gain, or by political considerations, could quickly sweep over even the strongest defenses like tidal waves. Faced with this possibility, no country is likely to risk the loss of its reserve assets in an attempt to hold back pressures that, in the end, probably cannot be contained.

VI

Let us turn to the question of domestic adjustments within the economies of the consuming countries. How much dislocation and how much impairment of growth might there be? Analytically, there are two problems. The first is the transitional problem of adjusting the structure of production to reflect the changing pattern of consumption. Examples would be to shift automobile output away from gas-guzzlers toward compacts, or even to decrease automobile production and improve mass transport systems. The second problem is to maintain a full employment economy in the face of a worldwide tendency for consumption to decline and savings to increase. This is conceptually the more difficult problem to understand, although it is not necessarily more difficult to resolve than the other. The problem is, in reality, simply our old question of ability to absorb OPEC funds in a different guise. We have already concluded that, in a financial sense, there is no problem of absorption, because the funds earned by OPEC do not represent new money that must somehow be shoe-horned into the world's money and capital markets, but money already there that simply changes title. In an economic sense, however, the question is this: will the industrial countries be able to translate into productive, job-creating activities at home the financial savings of the oil-producing countries available to them? Unless they succeed, they face a lasting increase in unemployment and retardation in growth.

Let us examine the dynamics of this problem. Because crude oil prices have risen fourfold in the Gulf over January 1973 levels, consumers in the importing countries will have to spend a larger percentage of their incomes on petroleum products. If they spend a larger percentage on oil, however, they will have less to spend on other things. And, since the increased expenditures for oil accrue primarily to OPEC governments-that is, to nonresidents-total spending by residents on domestically produced goods must fall. This drop implies, in turn, a tendency for domestic employment and output to fall.

Some of this pressure toward higher unemployment will be offset by increased exports to the OPEC countries. Some of it, too, will be offset by a tendency on the part of consumers to maintain their living standards in the face of the higher oil prices by reducing savings, and by a tendency for wages to rise somewhat in response to higher prices. On balance, however, not all of the initial drop in demand for domestically produced goods is likely to be offset. Thus, the entire world will probably experience a tendency for the share of consumption to drop and for that of savings to rise, with the savings increase occurring primarily in the OPEC countries. If income and output are to be sustained in the industrial world, OPEC's extra savings will either have to be translated into investments or into spending for consumption. The latter alternative would counteract the tendency for worldwide savings to rise by offsetting OPEC's higher savings with lower savings-possibly even some outright dissaving-in the industrial countries.

Is solving this problem difficult? No, at least not in concept, because it is essentially the Keynesian problem of overcoming demand inadequacies. This has been studied and understood so thoroughly by several generations of policy-makers that success in developing future solutions could normally be assumed. All that is required, in principle, is that the governments of the consuming countries follow expansionary policies to stimulate domestic demand and offset the drop caused by the diversion of spending from domestic goods to foreign oil.

In the present situation, however, there is a new, complicating factor. When the consuming countries look at their trade balances this year, virtually all of them should find that they are running deficits. Normally, the prescription for such deficits is contractionary monetary and fiscal policies. This would tend to reduce imports and increase exports, thereby eliminating the problem.

To counteract the effect of lower demand, however, expansionary policies are needed. Thus, the instinct to safeguard the trade balance will be in conflict with the instinct to maintain full employment. The logic of the situation is that the latter instinct will prevail, but that will not necessarily happen immediately and, indeed, cannot be taken for granted even in the long run.

VII

Now, let us turn to the inflationary consequences of higher oil prices. These are no easier to fathom than the retarding effects of higher oil prices on demand and output. To be sure, one would have to be blind not to perceive the direct inflationary impact of the jump in oil prices. And it is also apparent that higher oil prices will pull up the prices of coal and other forms of energy, and spark demands for higher wages by workers attempting to keep up with inflation. For the United States, these developments will probably add about two percentage points to the GNP deflator in 1974, and a little more than three to the cost-of-living index.

Beyond these more or less immediate effects, however, lurk others that are more difficult to trace. Structural changes will be necessary within the oil-importing countries that will surely involve shifts in consumption patterns, for example, to smaller cars and better insulated homes. There may also be shifts from the production of consumption goods to investment goods as a joint result of two forces in that direction: on the supply side, an increase in world savings associated with the transfer of wealth to OPEC nations with low absorptive capacities; and on the side of demand, an urgent need in the consuming countries to step up investments in their energy industries, in particular, and, more generally, a need of some years' standing to expand industrial capacity.

Changes in relative prices provide the necessary carrot-and-stick inducements that are the traditional means for bringing about desired shifts in employment, production and investment patterns. But prices have been increasingly "sticky" on the downside, for a variety of reasons. This means that price increases will have to play a proportionately larger role in the adjustment process, and this is clearly inflationary.

In addition to these possible developments, the balance-of-payments strains resulting from higher oil prices will undoubtedly generate pressures to increase international reserves, through stepped up creation of Special Drawing Rights (SDRs), revaluation of monetary gold stocks, or other means. This, too, would tend to be inflationary.

Moreover, there is a danger that the success of OPEC in raising oil prices will inspire attempts by nations producing other essential materials to form cartels of their own. This might conceivably occur in copper, aluminum, coffee, tin, natural rubber, timber, and even such items as tea, cocoa and pepper. Some, but not much, comfort can be gleaned from the conclusions of a recent study by Bension Varon and Kenji Takeuchi published in this issue of Foreign Affairs. In essence, these authors found less potential for increases in the price of non-fuel minerals than existed in the case of oil, because of both market factors limiting the ability to raise prices and greater difficulties in forming an effective cartel.

Finally, currency changes will be inflationary or deflationary for individual countries, depending on whether their exchange rates move down or up. For the world as a whole, however, the effects of currency changes on inflation should be essentially neutral because the experiences of individual countries will tend to be canceled out in the process of aggregation.

As against these inflationary tendencies, only a few counter-forces appear present. First, there is the deflationary impact, which we have already described, of the wealth transfer itself. In depressing consumption, it will tend to restrain price increases. Second, a shift toward more investment should, in the long run, moderate inflation. And third, after giving inflation a boost with their initial quantum jump, energy prices may subsequently slow the inflationary spiral by rising more slowly than other prices, possibly even by declining from present levels.

On balance, it would seem that the oil crisis has set in motion a number of forces that, in combination, will increase inflation not only in 1974, but also beyond.

VIII

Even if the monetary system should get through the energy crisis with its feathers unruffled, which seems unlikely, and even if there is no long-term damage to the growth and inflation prospects of the industrial world, which would take a bit of luck, I don't think that we can count on getting by with no skin off our collective backs. The transfer of wealth to oil-producing countries cannot fail to take its toll on the living standards of the industrial world, although even here some of the real burden could be shifted to future generations.

What impairment of living standards means in this context is having less of the nation's output available to its own people. And this is a different matter from employment or economic growth. An example will make this clear. Suppose that the OPEC countries were able to spend every cent of their higher incomes, and that what they wanted to buy in the United States was precisely those things which Americans could no longer afford because of higher oil prices. In that case, no one would lose his job or suffer a loss of money income, the existing structure of output would be maintained and, with it, the country's growth rate. But income in the United States would buy less, and output that would have been enjoyed by Americans would be shipped to the OPEC countries. We can estimate roughly what this would amount to in quantitative terms. If, indeed, the United States paid for the increased cost of oil imports with current output, the transfer would entail roughly the same burden as a ten percent increase in personal income taxes.

Now, consider the opposite extreme. Suppose that the OPEC countries did not wish to spend any of their money for imports, and that their entire income went into investments abroad. In this case, there need not be any change in jobs, incomes, growth or even consumption in the industrial countries. For illustrative purposes, suppose that the higher cost of imported oil were offset by tax cuts in the consuming countries. This would maintain their consumers' purchasing power. The resulting government deficits could then be financed by drawing on the capital accumulations of OPEC. The real burden of the wealth transfer would then occur in the future, not in the present.

In reality, the actual outcome will be somewhere between these two extremes. In the early years, while OPEC import spending remains low in relation to income, the current burden of the wealth transfer may be light for the industrial countries, and their future output will be mortgaged. Later, when OPEC expenditures rise to meet income, the current burden will intensify.

IX

Now, let us say a few words about the effects of the world oil crisis on the Third World. To oversimplify for this purpose, we can effectively split the globe in half, carefully cutting to include West Africa and Latin America in one semi-sphere, and East Africa and Asia in the other. In the western half, there is enough indigenous energy or exportable mineral wealth to leave many of the countries relatively unscathed by the rocketing energy import prices.

In the eastern half, where nearly one billion people already struggle on a per capita GNP of $100 to $200, the consequences will be acutely felt. In most cases, local energy supplies are minimal or not readily expandable. Energy imports are large relative to mineral exports or indeed total exports. There appear to be few opportunities for efficiencies or a reduction in luxury imports to counterbalance the substantial impending increase in the import bill. What oil these countries purchase will be paid for dearly in terms of imported capital equipment and therefore future growth forgone, and what oil they forgo importing will result in current GNP losses. Thus, the eastern half of the Dark Continent will become darker still and the nations of the subcontinent of Asia will no longer merit the adjective "emerging." These latter countries represent those very dominoes to which the United States has paid such profound attention during the cold war. It seems unlikely that the industrial nations or the oil-rich Arab states will be willing to provide financial support on the scale that could well be necessary to avoid political violence and anarchy in these countries.

X

This article has ranged broadly over the domestic and international implications of the recent extraordinary increases in oil import prices. Difficult internal adjustments will be necessary in the economies of oil-importing countries, but serious harm to employment, growth, inflation and living standards can probably be avoided at least in the industrial world. In many developing countries, however, the consequences will be severe, if not ruinous.

The resource-poor Third World is not the only area of particular vulnerability to the impact of the energy crisis. The Achilles' heel of the entire world economy may turn out to be the international payments system. The financial flows associated with more expensive oil are so immense as to threaten intolerable balance-of-payments strains and currency instability. While technical solutions to many, if not all, of the financial problems can be devised, it remains to be seen whether international coöperation will be up to the task of implementing them. The price of failure could be high. To fail would be to risk competitive devaluations and trade restrictions that would amplify recessionary tendencies already set in motion by the energy crisis.

Footnote

1 The views expressed in this article are solely my own and do not necessarily reflect those of Exxon Corporation or of the individuals whose assistance is acknowledged below. Important contributions were made by my colleagues Kerin D. Fenster, James W. Hanson and John F. Kyle. In addition, I have benefited from discussions with Sterie T. Beza, IMF; Samuel Pizer, Board of Governors, Federal Reserve System; and F. Lisle Widman, U.S. Treasury Department.

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