Think Plummeting Oil Prices a Good Thing? Think Again

This article first appeared on the American Enterprise Institute site.

It is far from clear whether the recent plunge in international commodity prices in general, and in oil prices in particular, will provide a boost to the U.S. economic recovery.

While those price declines would certainly provide the equivalent of a sizable tax cut for U.S. consumers, they will deliver a major blow to the increasingly important U.S. oil industry, as well as to commodity-producing emerging market economies.

In so doing, they could cause serious strains in the U.S. and global financial system.

Over the past year, the earlier super-international commodity boom has turned into a spectacular bust. International oil prices—which a little over a year ago had exceeded $100 a barrel—have declined by 70 percent to their present level of around $30 a barrel.

Similar outsized price declines have been recorded in a wide range of other industrial commodity prices like iron ore and copper. It is not expected that these price declines will be reversed anytime soon, especially given the marked slowing under way in Chinese economic growth.

Lower international oil prices soon translate into significantly lower gasoline prices at the pump, the equivalent of a tax cut for U.S. consumers. That in turn may boost the U.S. economic recovery. Indeed, various macro-economic estimates would suggest that the consumption boost to U.S. GDP growth from a 70 percent decline in oil prices could be anywhere between 0.75 percent and 1.5 percent.

Sadly, there are two major offsets of this benefit for the U.S. economic recovery. The first is that the U.S. economy itself now again has a large oil sector. Over the past five years, as a result of the shale oil revolution, U.S. oil production has increased by 50 percent from around 6 million barrels a day to its present level of 9 million barrels a day.

However, at $30 a barrel, the shale oil industry is no longer profitable. This is already causing major investment and employment cutbacks in the oil and gas industry, which is estimated to employ around 2 percent of the U.S. workforce. It is also raising the risk of major defaults on the $200 billion in loans that have been extended to the domestic shale oil industry.

The second major downside to the bust in international commodity prices is that it plunges into recession major emerging market economies like Brazil, Russia and South Africa. This could have important consequences for the U.S. and global economic recoveries.

According to World Bank estimates, a 1 percentage point decline in the growth of the BRICS economies (Brazil, Russia, India, China and South Africa) could shave off as much as 0.4 percent from global economic growth.

More serious still, the sharp reversal of the emerging market economies' fortunes could put into question their corporate sector's ability to service its $5 trillion in U.S. dollar denominated debt. That in turn could add to the stresses already appearing in the global financial system.

Hopefully, the Fed is paying close attention to the negative fallout from the international commodity prices on the emerging market economies. For then it might not be in quite as much of a hurry to raise U.S. interest rates three to four times in 2016, as it presently seems to be contemplating.

Desmond Lachman is resident fellow at the American Enterprise Institute.