Gamal, chair of Islamic economics, finance, and management at Rice University, and Jaffe, an energy expert at the university’s James A. Baker III Institute for Public Policy, tie together three features of the contemporary world: a global financial system subject to periodic unsustainable bubbles, a Middle East rife with conflicts, and a world economy heavily reliant on hydrocarbons, i.e., oil and natural gas. They argue that all three must be studied as an interacting whole, which goes somewhat further than what can be supported by their analysis.
A more cautious statement would be that the three factors reinforce a tendency towards wasteful booms and busts. Their description of the first two factors is less interesting than their account about hydrocarbons, which is the book’s real strength. Buried towards its end is an excellent summary of why oil prices gyrate so wildly, namely, the divergence between short-term and long-term incentives. During an oil price boom, the world invests heavily in oil extraction and refining capacity at just the moment when it is most expensive to do so because so many other investments are underway. But the additional capacity becomes available only during the recession caused by the high oil prices, leading to the crash of oil prices under the dual impact of stagnant demand and rising capacity. In turn, investors shy away from adding to capacity when prices are low. Meanwhile, the general economy takes off, raising oil demand at just the time when supply is stagnant. This process is exacerbated by a financial system which magnifies the trend of the moment—puffing up bubbles and then feeding panics rather than smoothing out cycles’ peaks and troughs.
Regrettably, Gamal and Jaffe bring up several issues with little obvious connection to their larger theme of global economic instability. For example, after a lengthy discussion of the role of the dollar in oil trade and the global financial system, they conclude that transition to a multi-currency system would make little difference regarding economic instability—in which case, it is not clear why the authors spend so much space on an issue whose importance is so often exaggerated.
More troubling is the authors’ assertion that the global reliance on hydrocarbons is at the heart of the investment boom-bust cycle they describe. It is by no means obvious why the same cycle would not prevail if the world were dependent on nuclear energy or wind power. Indeed, after their lengthy and useful account of how the boom-bust cycle has played out in the oil business for the last forty years, Gamal and Jaffe note that the same trends seem to be increasingly at work in the natural gas industry. It is clear that the divergence between short-term and long-term incentives would be no different with any energy source. Since all such sources require multi-year investments in large-scale facilities, such facilities simply cannot respond quickly to changes in price or quantity demanded.
In short, a strongly opinionated book, in which some of the views are well argued and some not so well.
