David Prosser: Another reason to fear a prolongedspike in oil prices

Outlook It is a given that the sort of supply shock we areseeing in the oil market courtesy of tensions in the Middle East is potentially dangerous for the global economy: higher fuel and energy prices represent a threat to the fragile recovery in themselves. But there is another reason to worry about a prolonged oil price rise, according to research published yesterday by the International Monetary Fund – it could cause the sort of financial instability that was responsible for triggering the financial crisis.

The IMF says that over the medium to long-term at least, the effect of lower oil supply (or higher prices), assuming it is moderate, on economic growth might be quite small – maybe slowing world growth by less than a quarter of a percentage point each year.

In the short term, however, it points out that an immediate result of an oil price spike would be to exaggerate the current account imbalances and huge flows ofcapital with which the world is already struggling.

It's not difficult to see why. In a period of rising prices, oil exporting nations are obviously going to enjoy larger current account surpluses, while importers will see their deficits rise higher. And if, as most people do, you accept the argument that these imbalances – and the capital flows they generate – are the primary source of instability in the global economy, that is a new headache to worry about.

In which case, what should be the policy response? Well, the first thing to do is to think harder about weaning the world off its oil dependency, which is why the IMF is now calling for governments to make more effort to promotealternative sources of energy, particularly renewables. But the cost of doing so is difficult at the best of times, let alone during the ongoing era of austerity in so many nations.

So we should also be working harder to confront the issue of imbalances. And here the oil issue might just be a help. China,understandably enough, has been resistant to move too quickly on international reforms that might see these instabilities reduced – its exporters have much to lose from a sudden increase in the value of the currency – though it did make some modest concessions at the most recent G20 summit, mostly on how to monitor key indicators of where capital flows are heading. Still, China has much to lose from rising oil prices, because it is an importer of crude. This is one trend that will not augment itscurrent account surplus – in fact, it actually went into deficit in February, partly because of higher energy costs – and that might just help the Chinese to move more quickly on reform.