Yellow Pages Publishers, like all industries, rely on both a vibrant business community and a confident consumer base. Over the last few years, confidence in both sectors has taken a dramatic hit. For a while there was discussion of the decline being a “second great depression.” Luckily, we only suffered a “great recession” rather than a depression. Cynics point out that it is a recession when someone else loses a job and a depression when you lose your own.
As Jeff Rubin, formerly chief economist of the CIBC pointed out, four of the last five recessions were preceded by a shock to the price of oil. The most recent recession was not unexpected. A number of experts, including the renowned Nouriel Roubini, were warning anyone who would listen, back as early as 2006, that a spike in oil prices would have serious negative effects on both the US and global economies. James Hamilton of UC San Diego has detailed the causes and consequences of the Oil shock of 2007. As he says in his abstract:
"Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007-08 was caused by strong demand confronting stagnating world production."
Hamilton goes on to show that while the previous oil shocks of the last century were primarily caused by geopolitical events, from the Yom Kippur war to the invasion of Kuwait. He explains how the shock of 2007 was different. The inability of oil producers to keep up with demand caused the prices to rise, potential profits from buying long term contracts and selling again before delivery, drew speculators who pushed the cost to $ 145 a barrel in July 2008.
None of the above is news to those who follow Peak Oil news on a regular basis. However, Hamilton’s analysis of what was happening with physical production and delivery during the most recent shock was a source of new information for me. I was not surprised that stocks of oil declined. It makes good business sense to draw down reserves, purchased at previously lower prices and take advantage of the developing bubble only to replenish later when prices fall. The paper clearly demonstrates that speculation alone would not have accounted for the spike in prices. A shift in the fundamentals created the opportunity for speculation, rather than money looking for a good return. Peak Oil, specifically the inability or unwillingness to increase production, was at the heart of the problem.
The impact on behavior of consumers was on a scale higher than expected. Oil at $ 135 a barrel represents 15% of all US take home pay – around $ 1 Trillion. Hamilton states that although the increase in gas prices should only have caused a 1.7% decrease in non-energy expenditure, the reduction was 2.2%, the bulk of that decline took six months or more.
Car purchases took an immediate and unsurprising hit. While energy prices increased around 20%, it still only accounted for 5% of household expenditure. However sales of vehicles dropped 10%, a big enough shock to the automotive industry to warrant government intervention.
A bigger factor, one identified by Edelstein and Killian is the impact on consumer sentiment. Rising gas prices in early 2008 hit the confidence of consumers and sales of truck and SUV sales by as much as 25% and car sales by 7%, as consumers shifted to more fuel efficient vehicles. They recovered in the summer only to take a second hit in the fall. That second hit impacted all vehicle markets, cars more than SUV’s, which indicates the drop was not so much from the gas prices, but rather from a drop in income.
Fear is an important metric in the marketplace. It can drive consumption as well as hinder it. Safety features of vehicles leverage the fear of an accident. Fear of terrorism allows governments to channel billions of dollars to favored security industries and curtail civil liberties. Fear of losing one’s job or of not being able to afford necessities can impact spending patterns.
One point, which I do not believe has received as much attention as it should, was the key determinant of demand in Hamilton’s paper:
"The most important principle for understanding short-run changes in the price of oil is the fact that income rather than price is the key determinant of the quantity demanded."
If income and not price determines demand, and there is a requirement to reduce demand (or the wheels come off the economy) then an increase in unemployment is what we would expect.
What does that mean for jobs? Tackling unemployment in any efficient manner would create increasing demand as the working people can now drive happily around and consume. Extra energy to deliver the goods they are now able to buy. We bounce our collective heads off the ceiling of stagnant production again.
It should come as no surprise, then, that all efforts to reduce unemployment have not worked as well as the politicians told us they expected. It may be pure coincidence that the stimulus package led to a level of unemployment the economists predicted, despite the assurances it would create or save jobs. Is it now possible that unemployment is now a factor of energy availability and the plans and machinations of politicians are impotent in the face of that reality?
The spike in oil prices caused ripples throughout society. Gas companies were very quick to raise gas prices with every upward move of oil but people felt they took their time lowering the prices as oil fell. Gas prices have direct and indirect effects on the behavior of consumers. It hit the pockets of families directly as they saw the cost to fill up the family SUV rise week after week. As a result they drove less, shopping less. At the same time, the cost of delivery also went up; the further materials or goods had to travel, the greater the impact. As prices rose, demand fell until equilibrium was reached. In many areas, the rise in costs was hidden by keep prices constant but reducing quantity.
Oil prices dropped significantly as the speculative bubble popped, but the damage was already done. Confidence and credit has yet to recover. We hear every day that there is money sitting on the sidelines waiting for investment. Pundits and commentators tell us that the problem is the banks are not lending, that credit is too tight but not to worry. The economy us recovering well and green shoots can be seen everywhere and soon credit and money will flow and we will be back on track.
The state of retail tells us otherwise. Many malls have empty shops. Closed and shuttered businesses abound. Even those shops that are still open have less products. The aisles in the big box stores are noticeably wider and there are less display stands at the end of those aisles. Talking to a relative who works for a distributor delivering to both Wal-Mart and Target, I learned that the better performing stores are moving 10% less product than a year ago, while the worst are down more than 25%.
If the money that is ‘sitting on the sidelines’ were to start moving though the economy, what would it be spent on? With less goods on the shelves, less stores open, that increase in credit moving though main street would have an inflationary effect on prices, which still remains the biggest threat to fiscal stability.
How serious of an issue is the threat of inflation? Enough to cause politicians to do an end run around themselves to avoid increasing the money supply on main street.
We narrowly averted such a disaster earlier this year when the financial reform bill passed through Congress. I’m referring to the Lincoln Rule being stripped out of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The press gave a lot of coverage to the stripping of the Volckner Rule but far less about the Lincoln Rule. That is, until Matt Taibbi of Rolling Stone Magazine published a very detailed description of the political machinations surrounding the so-called reform.
In his usual style, Taibbi attributes the defeat of the major reforms to corruption of the political system. What he seems to fail to take into account is the impact the Lincoln Rule would have had on the wider economy. In essence, the Lincoln Rule, had it been implemented, would have forced banks to consider carefully if they wanted to play in the derivatives market. As Matt pointed out,
“Thanks to Clinton-era deregulation, the market for derivatives is now 100 times larger than the federal budget, and five of the country's biggest banks control more than 90 percent of the business.”
Put simply, this rule would have required the big banks to give up cheap loans from the Fed if they wanted to continue to play in the derivates market. So where would that money have gone if the derivatives market had been declared off limits? What would have been the impact on inflation if just one percent of that money had been redirected into the physical economy? That would have been the equivalent of the entire Federal Budget trying to find something to buy, creating its own shock in the marketplace. That could have created an earthquake in the economy that I, for one, feel thankful we have not yet had to face.
We are between a rock and a hard place. Businesses need easier credit if they are to get the economy moving, but too much credit in the system may precipitate a huge adjustment that many businesses are not ready to survive. As we struggle to navigate this bumpy plateau, our models need to assume less energy and less wealth.