Nov 8, 2010. ASPO-USA
Much of the article has been snipped below:
It is easy to see how sub-prime mortgages blew up Wall Street; it is a little more challenging to see it as the author of the global recession.
- Why were there economies that had no sub-prime mortgages that experienced even deeper recessions than the United States?
- Why did those economies go into recession even before the US economy went into recession?
- Maybe, just maybe, there was something more important going on–more important to the global economy than Wall Street or sub-prime mortgages, like $147 barrel oil, for example.
- If we know anything about watching the global economy in the last 40 years, we know this: feed it cheap oil, and it runs very smoothly. All of a sudden, give it expensive oil, and it stops in its tracks.
Every major recession in the post-war period has oil’s fingerprints all over it.
- The 1973 first oil shock led to what was then the deepest post-war recession, at the time. The second OPEC oil shock led to no less than two recessions: 1979 and 1982.
- And then when Saddam Hussein invaded Kuwait, and left half of its oil fields on fire, and oil spiked to the then unheard-of price of $40 barrel, lo and behold, the industrialized world again fell into recession.
Oil prices went from about $30 barrel, at the beginning of 2004, to almost $150 barrel by 2008. Even inflation-adjusted, that price increase was over double the price increase of either the first or the second OPEC oil shock. If they had led to devastating recessions, why would not the biggest oil shock of them all, be the obvious culprit for what has been the deepest recession to date?
There are many ways in which oil shocks create global recessions.
- First, the transfer of income. When oil went from $30 barrel, to about $147 barrel, over $1 trillion of income was transferred from the industrialized oil consuming world to OPEC. Now, that was not neutral for the economy, because the savings rates from which money was coming from, like the United States, was virtually 0%, meaning that consumers spent everything they made. And where the money was going to, places like Saudi Arabia, or Kuwait, or the United Arab Emirates, had savings rates of almost as high as 50%, so it certainly was not demand neutral.
- High price also create recessions by crowding out non-energy expenditures. Two years ago, when gasoline cost us $4 gallon, low-income Americans were paying more to fill their tanks than they were to fill their stomachs.
- But by far, the most important mechanism, the most important path, by which oil prices cause recession is through their impact on inflation, and their impact on interest rates.
There is no shortage of people to blame for the subprime mortgage crisis. The real culprit behind subprime mortgages was the very low cost of capital and 0% interest rates. All the greed in the world could not do what the Fed’s easy money made possible. The subprime mortgage rates were created by interest rates and the subprime mortgage market was pricked by interest rates. Everybody would agree with that. What people don’t seem to ask is, “Why did interest rates go from 1% to 5.5% from 2004 to 2006?”
Any central banker will acknowledge that your borrowing cost is a mirror image of your inflation rate. We had 1% federal funds’ rate in 2004, because we had a 1% inflation rate. All of a sudden, in 2006, inflation was over 5.5%, the highest it had been in America, since, coincidentally, 1991, when we just happened to have the last oil shock. All of a sudden, money wasn’t free any more. All of a sudden, you weren’t getting credit cards in the mail any more that you never applied for. And all of the sudden, people who held negative amortization sub-prime mortgage rates had to start paying 7% or 8%.
If interest rates hadn’t risen, that wouldn’t have occurred. Why did inflation move up? Virtually all of the increase in inflation came from one component of the US consumer price index basket–the energy component. By the end of 2006, energy inflation was running at 35%, because of one price: the price of oil. The price of oil went from $30 barrel, which incidentally, every oil analyst at the time said it was going to stay at that level, to over $70 barrel. If oil had stayed at $30 barrel, inflation would never have spiked; neither would have interest rates. All of those good folk in Cleveland would probably still be there, in their homes financed by 0% interest rate sub-prime mortgages. Lehman Brothers and Bear Stearns would probably still exist, and I’d probably still be the chief economist at CIBC.
But that is not what happened. Why did oil prices go up to $147 barrel? Somewhere where virtually every economist said it could not go. Well, there were two reasons that economists said that oil prices could not get into triple digit range, and that was the cherished principles of supply and demand. First, the theory of the upward sloping supply curve–higher oil prices would bring new supply, just like it did after the OPEC oil shocks, where oil gushed from Prudhoe Bay and the North Sea. And not only did that break OPEC’s strangle-hold on the market, but sent oil prices tumbling down.
But there are no more Prudhoe Bays or North Seas to tap. Tar sands and deep water oil did bring new sources of supply, but only at prices we couldn’t afford to burn.
What about the cherished principle of demand? Would not triple digit oil prices quash demand? Well, it did, in certain places. It did in the United States, Canada, Japan, and Western Europe. Fifteen years ago, if those economies suddenly cut back their appetite for oil, oil prices would have fallen, because 15 years ago, those countries would have accounted for almost 75% of world oil consumption. Today, they account for 50%. Tomorrow, they will account for less than half.
Where do you think oil demand has been growing the strongest? Many of you will probably be saying China, and indeed it has. It’s grown from around 2 million barrels a day, to about 9 million barrels a day. But I know a place where the demand for oil is growing even faster than in China. And it is the same place your politicians have told you your supply is coming from in the future. Last year, OPEC and two non-cartel producers, Mexico and Russia, consumed 14 million barrels a day. That is almost two Chinas.
What makes OPEC so thirsty for its own fuel? In Venezuela oil is 20 cents a gallon, 40 cents in Saudia Arabia. And it’s 40 cents a gallon, whether oil costs $20 barrel, or whether oil costs $150 barrel. What’s the coolest thing to do in Dubai? Ski, of course. Skiing in an area where it’s hot enough to fry an egg on the pavement uses up a whole lot of energy. So the question isn’t really how much productive capacity that OPEC has. How much export capacity is the real question, and every year it’s less and less, because every year, more and more is consumed at home. So chances are, your future oil supply ain’t coming from OPEC, and chances are, it ain’t going to be cheap.
Now sure, oil prices fell to $40 barrel during the recession. And for many folk, that was evidence enough that it never had any business being in triple digit range in the first place. But what a lot of those folk forget is that in the last recession, world oil demand actually fell. It fell for the first time since 1983. Such was the severity that the recession was.
Peak oil is not a problem if the economy that it is powering is shrinking. Peak oil is only a problem if the economy we are in is starting to grow. The first thing you know about an economic recovery is that economies start burning more oil. The next thing you know about an economic recovery is that oil prices start rising. Where is oil trading today? It is trading at over $80 barrel. With the exception of Germany and Canada, every other economy in the G7 is still miles below the level of GDP that they were at before the recession began.
And yet, where oil is trading today, turn the clock back to three years ago, and that would have been a world all-time record high. Now, it is where oil trades in the shadow of the deepest global post-war recession. Where do you think oil prices are going?
I will tell you where I think oil prices are going. Even in this most anemic of economic recoveries, we are going to see triple digit oil prices.
Our rendezvous with triple digit oil prices is not in 10 or 15 years; it is in 10 or 15 months. So instead of trying to turn cow-shit into high octane fuel, we are going to have to learn to get off the road, and that is just what happened. In 2009, there were 4 million fewer cars on the road than there were the year before. In the next ten years, 40 million North Americans will be taking the exit lanes. The question is, “Will there be a bus to get on?” Instead of giving $40 billon to General Motors, what we should have done is spend $40 billion on public transit, so there would be a bus to get on.
In a world of triple digit oil prices, all of the sudden the economy’s speed limit changes. And that is one of the problems that we have here in America, is that we don’t recognize that our economy’s speed limit has changed. What the economy could grow at when oil was $20 to $30 barrel is a whole different speed limit than what the US economy can grow at when oil is $80 to $150 barrel.
And that is something that I don’t think the Administration recognizes. President Obama cannot get cheap oil. He can get expensive oil. We can build a pipeline from the Canadian tar sands down to the Gulf refineries, and we can get oil. But in order to get the kind of oil that will be required, that will require the triple digit oil prices that we can’t afford to pay. Trying to prime the economy with fiscal stimulus is not a substitute for cheap oil. It won’t make the economy grow any faster. It will just make the deficit that much bigger.
Worse than that, triple digit oil prices will not only take millions off the road, it will send our economy right back into recession. We can’t do a whole lot about triple digit oil prices.