April 6, 2009

Oil Price Spikes and the Recession

In the last two years we had two major economic shocks: The bursting of the American housing bubble and the resulting breakdown of the global financial system, and a historic spike in commodity prices, particularly for oil. For some reason, though, I've seen no one make the argument that the two may have been in some way connected. That's why I was so interested in a recent paper by James Hamilton (summarized here and here) that attributes almost all of the economic downturn in the last year or so to the run-up in oil prices. That seems rather odd, as even Hamilton acknowledges, but it leads naturally to a discussion of the link between the oil price boom and the credit crunch, as Justin Lahart does in a commentary on the Hamilton paper:
But then again, maybe what happened to oil prices had something to do with credit markets seizing up. The housing bubble saw people of lesser means traveling further afield to buy homes. That gave them long commutes that they were able to afford when gas was $2 a gallon, but maybe they couldn’t at $3. Housing in the exurbs got hit hardest, and one reason why is that high gasoline prices made it hard for people to lived in them [sic] to keep up with their mortgage payments, and hard for them to sell their homes without taking a steep loss. In some meaningful way, that has to have contributed to mortgage problems.
That's a very interesting theory, one that cries out for regression analysis. My sense, though, is that it wouldn't hold up to examination. Certainly higher gasoline prices make exurban housing less viable, but it's hard to see how the two spikes in 2005 and 2006 would have been enough to drive a critical number of homeowners into foreclosure, thus turning countless numbers of mortgage-backed securities and related assets into garbage. The sustained high prices in 2007 and 2008 no doubt hit particularly hard those having trouble making their mortgage payments, as well as those in exurban areas; but as a causal factor in the financial crisis broadly understood, I suspect high gas prices played, at best, a minor role. Remember, for one thing, that the housing bubble wasn't confined to exurban areas; even dense environments like Chicago and Baltimore got caught up in it as well. Besides, the nature of a bubble is that it is unsustainable: Gas going from $2 to $3 may have been enough to push a significant number of homeowners into foreclosure, but what really got this crisis going were the banks and hedge funds who made 20-to-1 or 30-to-1 leveraged bets on those mortgages and lost their shirts. In such an environment, any shock to the system, no matter how small, could bring everything crashing down. So if it had not been the oil price boom, it would have been something else.

Having said that, it's entirely fair to say that both the housing bubble collapse and the oil price boom have, rightly, called into question the bias in US housing policy toward sprawling, automobile-centric development. The days of cheap gasoline are no longer as assured as they once were, and we have seen that homeownership can be as much a curse as a blessing. We need to carry both insights with us going forward; but I am not sure of their applicability to resolving the current crisis.

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