Oil Shocks & the Economy
James Hamilton recently had a number of posts regarding the recent Fourth Oil Shock (i.e., the ’07-08 oil price spike):
Causes, Bubble v. Fundamentals: http://www.econbrowser.com/archives/2009/04/causes_of_the_o.html
Future Prospects: http://www.econbrowser.com/archives/2009/05/Hamilton_JEC_2009_05_20.html
So, in Hamilton’s view:
1. Much of the recent oil shock can be attributed to fundamentals of supply & demand in the oil market; and
2. The oil shock was apparently a sine qua non for the recession.
Taking that into account, one can synthesize the following account of the recession’s origins:
1. Overindebtedness & the housing bubble set the stage for the financial crisis, then the oil price spike helped render bubble-priced houses unaffordable (*), both directly, via increased commuting costs – for bubblicious exurbs & elsewhere – rendered consumers less able to service their mortgages; and indirectly, by contributing to a decrease in car purchases & overall consumer spending (which in turn increased unemployment, which in turn increased mortgage delinquencies). Additionally, rising oil prices damaged other industries (e.g., automobiles), leading to rising unemployment therein.
2. Besides rising oil prices, the other factor contributing to bubble-priced houses’ unaffordability was simply the continued rise in housing prices, which, in turn, was both driven by, and a contributor to, the origination of junk loans. (These, in turn, were financed by securitization, demand for which came from decreased long-term interest rates & the scarcity of low-risk assets resulting from massive purchases of Treasuries & Agencies by foreign investors & CB’s. Lax credit rating was also factor.) When housing stopped appreciating, the availability of junk financing – previously premised on perpetual real housing appreciation – began to disappear, as did the proportion of housing demand previously funded by said financing. Couple the disappearance of such demand w/ the increased supply of housing “produced” by increasing FC’s (e.g., among subprimes who’d bought on the premise that they could refinance, or who were never able to afford their house in the long term), and you have the popping of the housing bubble.
3. Independent of the oil shock’s effects, the housing crash dragged down GDP, both directly via reduced residential investment & indirectly via reduced – and eventually negative – MEW. Decreased MEW in turn decreased consumption; so also did increased savings rates prompted by household attempts to rebuild their balance sheets following the evaporation of (bubble-induced) housing wealth.
4. Damaged fundamentals (see #1) & housing’s collapse (#3) transformed many poorly-underwritten loans/securities/etc. into junk, the losses from which eventually pushed our overleveraged, debt-heavy financial system to cause the financial crisis. The global run following Lehman’s collapse, and the “real economy” impacts therefrom (i.e., the massive post-Sept. decline in all economic indicators), had their proximate cause in Lehman’s BK – but that, in turn, had its roots in the aforementioned interaction between the oil shock & other factors. So, while it may be correct to say that the most recent (post 2008Q4) leg of the recession had its roots in the financial crisis, as a matter of economic history, the ultimate cause of the latter was the oil shock. This suggests that analyses (e.g., Reinhart-Rogoff) that consider the financial crisis the cause of the recession are still applicable, since the most recent leg of the recession was indeed caused by the financial crisis.
In this view, it wouldn’t be sufficient to say that the oil shock alone was responsible for the severity of this recession. While recession may have been inevitable following said shock, I suspect it would’ve been less painful had our financial system not been a disaster waiting to happen. If we hadn’t had overleveraged financial institutions holding lots of junk loans; and if housing hadn’t been allowed to bubble, or to collateralize (*) lots of junk loans (whether due to poor underwriting, or simply due to the fact that even solid loans backed by inflated collateral are doomed to become junk eventually); then I suspect the recession would be far less painful.
Aside re. Speculation & Monetary Policy: During ’08, it was commonly asserted that fundamentals were insufficient to explain the oil price spike; and that, as such, speculation must necessarily be the cause. Such speculation, in turn, was supposedly prompted by the Fed’s loosening of monetary policy (via interest rate cuts). If Hamilton is correct, however, the ’07-08 oil price spike is largely/fully explicable via fundamentals of supply & demand (i.e., the former stagnating while the latter wants to keep rising, such that balancing the two requires prices to keep increasing), then one needn’t necessarily invoke speculation as the predominant cause of said spike. This has important implications for monetary policy. If speculation was supposed to have been prompted by the Fed’s loosening of monetary policy (via interest rate cuts), then arguably loose monetary policy in the name of monetary stimulus could prove counterproductive by provoking speculation-induced commodity price bubbles (which would, in turn, damage the larger economy via higher costs for energy, raw materials, etc.). But this would not be so if high oil prices were explicable via fundamentals (such that speculation needn’t be invoked IOT explain the ’07-08 oil shock).
(*) To some extent, this is an inevitable byproduct of a system that relies upon mortgages to finance homebuying. If you have a housing bubble in such a system, even solid underwriting will produce lots of bad loans when housing deflation puts those loans underwater. Unless, that is, “solid underwriting” means requiring drastically higher DP’s in bubble-priced areas (which would not only limit loan losses, but also tend to kill housing bubbles in their infancy).