James Hamilton has written another article regarding the correlation of energy costs and the current economic difficulties.
He says,
… the oil shock of 2007-08 was big enough to have made a material negative contribution to real GDP over the period 2007:Q4 to 2008:Q3, and the details of what happened over that period are quite consistent with the predictions. (Made in the paper below.)
The reason that I think this is an interesting finding is that this period– 2007:Q4 to 2008:Q3– was when the U.S. entered recession #11. The fourth quarter of 2008 saw a very dramatic deterioration in all the economic indicators, but if you focus just on the first 12 months of the recession– 2007:Q4 to 2008:Q3– things wouldn’t have had to be much better before most analysts would have said that the economy was not even in a recession prior to 2008:Q4. For example, real GDP actually grew by 0.7% between 2007:Q3 and 2008:Q3.
Dave Cohen argues that the GDP figures are too optimistic, and I agree. But whatever your preferred measure might be, it wouldn’t take much to nudge 2007:Q4-2008:Q3 into a range that’s not usually associated with recessions. For example, gross domestic income on average fell by -0.45% over 2007:Q4-2008:Q3. My paper calculated that using any of the models surveyed this would have been a positive number if there had not been the contractionary effects of the oil shock. Alternatively, a 12-month drop in total employment is sometimes used as another indicator of whether the economy is in a recession. We crossed that threshold in the summer of 2008. But if we had not shed 150,000 jobs in auto manufacturing– job losses that I think were pretty clearly tied directly to the oil price shock– employment growth would still have been positive going into the fall of 2008.
The basis for this series is an article commissioned by the Brookings Institution:
Causes and Consequences of the Oil Shock of 2007-08
Hamilton correlates oil price increases with energy prices as they intersect with demand inelasticity; as production falls in relation to consumption, the stability or inelasticity of that demand results in a radical steepening of the price curve. Interestingly, Mr. Hamilton focuses on Fed activity after 2007, when the crisis had manifested itself in mortgage lending and while oil prices – while high – were below $100/bbl:
I have raised the possibility that miscalculation of the long-run price elasticity of oil demand by market participants was one factor behind the oil shock of 2007-08, and that speculative investing in oil futures contracts may have contributed to that miscalculation. Were any policies available to mitigate this? One option to consider would have been for the U.S. government to sell some oil directly out of the Strategic Petroleum Reserve in the spring of 40 (Quarter) 2008, perhaps timing the sales to coincide with the NYMEX crude contract expiry dates.If there was speculative momentum buying, such steps might have succeeded in reversing it. If not, the worst would be that the government made a profit on its SPR investment by buying low and selling high.
A more conventional policy tool would be monetary policy. A number of observers suggested that the very rapid declines of short-term interest rates in 2008:Q1 fanned the flames of commodity speculation, with negative real interest rates encouraging investments in physical commodities (e.g., Frankel, 2008).
In January 2009, Federal Reserve Chair Ben Bernanke offered the following retrospective on that debate:
The [Federal Open Market] Committee’s aggressive monetary easing was not without risks. During the early phase of rate reductions, some observers expressedconcern that these policy actions would stoke nflation. These concerns intensified as inflation reached high levels in mid-2008, mostly reflecting a surge in the prices of oil and other commodities. The Committee takes its responsibility to ensure price stability extremely seriously, and throughout this period it remained closely attuned to developments in inflation and inflation xpectations.
However, the Committee also maintained the view that the rapid rise incommodity prices in 2008 primarily reflected sharply increased demand for rawmaterials in emerging market economies, in combination with constraints on the supply of these materials, rather than general inflationary pressures. Committee members expected that, at some point, global economic growth would moderate, resulting in slower increases in the demand for commodities and a leveling out in their prices—as reflected, for example, in the pattern of futures market prices.
As you know, commodity prices peaked during the summer and, rather than leveling out, have actually fallen dramatically with the weakening in global economic activity. As a consequence, overall inflation has already declined significantly and appears likely to moderate further.
Bernanke seemed here to be taking the position that since the Fed got the long run correct (ultimately there would be a significant downturn in both the economy and commodity prices, with strong disinflationary pressure), the short-run consequences (booming commodity prices in 2008:H1) were less relevant.
On the other hand, if it is indeed the case that the spike in oil prices was one causal factor contributing to the downturn itself, there are concerns to be raised about ignoring those short-run implications. The evidence examined here is consistent with the claim that if a slower easing of interest rates in 2008:H1 had succeeded in mitigating the magnitude of the oil price run-up, the result could well have been a better outcome in terms of the 2008:H1 real GDP growth rate. Although the Fed is not accustomed to think in such terms— that a rapid lowering of rates could actually exacerbate the magnitude of an economic downturn— I think there is some reason to take such a possibility seriously in this case.
I can understand the attention paid to the price spike leading to $147, a truly astounding sum for something that is simply burned up and wasted. Such a price over a year would mean $4.5 trillion sent to OPEC and other good global citizens like Angola and Kazakhstan. This is completely unsustainable as it would represent at the wellhead price 6% (more or less) of world GDP and would be magnified down the processing/consuming chain leading to a much greater – and even less sustainable hemorrhage of global GDP.
The question is rather not what was the effect of the $147 price but at what price does the economic system break down. Is it $100 nominal or is it $50? Consider that two conditions exist that did not during the 1970’s and 80’s. One is very easy credit for a very long time and second is the rise to dominance of structured finance as a means to amplify credit creation – and also remove constraints on production as surpluses could be hedged.
Consider that during the period from 1990 to 2002, the yearly average price for crude oil was $21 and change a barrel and from 2003 onward the average was over $42 a barrel. Current average for this year is likely to be over $42 and some prognosticators have put prices over $50 a the end of this year as posted previously.
NetZero poll of business conditions
Also:
Consider that our crisis is centered around the private sector credit creation; there is currently none; the breakdown of credit prior to 2007 was an outgrowth of Federal Reserve Funds rate increases as a response to oil price increases beginning in 2002. The entire article is here:
Further Evidence of the Influence of Energy on the U.S. Economy
Increased interest rates intercept the formation of fractional reserve lending at the source. So also does increases in crude oil prices, which impact at the level just below finance credit creation. Fuel prices are felt in all levels of the economy beginning with input transformation – from ores to metal, from seed to crops – basic manufacturing, oil costs translate into other primary input costs as all mining and extraction are oil- dependent. Oil sets the prices for base load electricity to power businesses, factories and transport and further downstream in the credit chain. Oil and credit are equally embedded in all goods and services, they don’t simply emerge at the consumer level.
Consider that structured finance appears to be very vulnerable to anything other than the lowest interest rate background with very small basis risk (see LTCM) and the economy as a whole was very dependent (and probably still is) on very cheap inputs.
So, the real question is, can $50 a barrel be sustainable? If $41 oil plus an historically moderate Funds rate hike to 5.25% can precipitate our current calamity what will $50 oil prices do?
High oil prices act as a direct tariff on the core of credit creation. Personal income or sales taxes act upon the periphery of credit creation – more credit can be supplied to overcome the effects of higher personal income taxes, Fed rates and energy prices both act to remove a fraction from fractional reserve and do so whether actual lending takes place or not. There is, in other words, a ‘negative multiplier’ that has to be overcome by a lender to create more credit to compensate for the increase in either base credit or base energy. In other words, $51 oil would have the same effect a 8% Funds rate.
In 2008, there was sufficient credit available in the system to allow an oil price of $147. We appeared to be richer, credit creation momentum allowed refiners to appear richer than they really were. Refiners did not have to reallocate finance resources to pay for $147 oil. Credit in the credit pipeline allowed refiners to pay the high price for oil in the oil pipeline. When the credit ran out the oil price collapsed.
Our current ‘Green Shoots’ rebound is a reaction to the market possibility that oil prices might fall back to a historically sustainable level of $21 barrel. Currently, there is little or no fractional credit being formed – despite trillions of dollars in bailout lending. All cash to purchase oil has to be reallocated from some other, presumably more lucrative, endeavor.
There are two narratives to watch, One is the what happened prior to the 2008 spike, when the good times were rolling but oil prices and interest rates were heading skyward. The other narrative is the one that is unfolding around us; prices are too low to support increases in production, too low so that depletion is encouraged because of increasing consumption, prices too high to allow credit formation and a return to effective structured finance. Not a good place for us to be in …