Subpriming the Pump: Oil Wealth Used to Hurt Only Those Who Had It. Now, It's Hurting Everyone

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The resource curse has gone global.

For years, oil wealth was mostly a danger to those, paradoxically, who possessed it. Resource-rich Middle Eastern countries, and their labor-exporting neighbors, failed for decades to invest adequately in their people or to diversify their economies. A massive influx of oil receipts and worker remittances discouraged investment in sectors conducive to steady long-term growth, fostered corruption and patronage, inflated regional real estate and stock markets, and provided irresistible incentives for governments to spend with wasteful, shortsighted abandon.

But today, the Middle East's resource curse is spilling over into the international financial system. Unanticipated petrodollar flows are fueling financial bubbles, financing a Middle Eastern arms race, and damaging the global economy through speculative oil-price feedback loops. All the elements of previous boom-and-bust cycles in the 1970s and 1980s and again in the past decade remain in place.

What's happening is both comfortingly familiar and terrifyingly new. Sudden surges in oil-revenue flows to and from the Middle East--known as "petrodollar recycling"--have certainly been a problem before. But in the last few years, they have become critically destabilizing. Today's Great Recession has generally been understood as a story about real estate excesses and regulatory shortcomings. But it's also a cautionary tale about the increasingly pernicious role that oil is playing in the global economy.

Into the middle of this decade, economists' worries were focused on global imbalances between China and the United States. For Harvard University economist Lawrence Summers, now a top White House advisor, the world was caught in the grip of "a balance of financial terror." Deutsche Bank researchers argued that this temporary imbalance, wherein Chinese excess savings financed excess consumption in the United States, constituted nothing less than an informal sequel to the Bretton Woods international financial system, one they thought would be sustainable for a few more years.

But this optimistic analysis overlooked a major piece of the global economic puzzle: oil receipts. Leading into 2006, the capital exiting Saudi Arabia and Kuwait alone matched the funds leaving China (approximately $200 billion per year). For five years, from 2003 to 2008, the Middle East's massive petrodollar outflows, combined with excess liquidity due to low interest rates and a voracious appetite for credit risk, fueled bubbles in global financial markets, including real estate, credit derivatives, and ultimately commodity prices. The investment frenzy pushed markets into what the late economist Hyman Minsky called "Ponzi finance." Unsustainable serial financial bubbles distorted incentives toward the financial sector and away from investments more conducive to long-term economic growth, such as infrastructure and research and development, especially for alternative-energy fuels.

In this way, interconnected financial markets have globalized the resource curse, and all countries with relatively open economies and limited capital controls are now exposed to energy-market risks as a result-even ones as diverse as Britain, Russia, and the United States, which are blessed with their own plentiful supply of fuels. As we saw last year in spectacular fashion, financial contagion feeds back and amplifies demand-driven spikes in oil prices, exacerbating the eventual real-economy slowdown that economist James Hamilton and others have noted.

How did this happen? Capitalist economic systems, as Minsky, Charles Kindleberger, and other economists have argued, are intrinsically unstable. Prolonged periods of economic growth invite growing appetites for risk, as optimism about rising profits and lower rates of bankruptcy lull investors into a false sense of security. Optimism ultimately grows into euphoria, which former U. …