In the previous post, I reproduced some tweets from economist Alan Reynolds, in which he made the case that it was oil prices (and a tight-fisted Fed) that caused the Great Recession and 2008 financial crisis, rather than the bubble in home prices. In the present post, I will argue that Reynolds is simply mistaken, and that the conventional narrative (that it was housing) is actually correct in this case.
Alan Reynolds Argues Housing Wasn’t the Culprit
To refresh our memory, here are the three tweets from Reynolds:
Now I’ll present two charts to show why I don’t think the high price of oil in any way caused the economic chaos of 2008.
Oil Prices and the Unemployment Rate
In the previous post, I showed the close connection between home prices and construction employment on the one hand, and the national unemployment rate on the other. But in light of Reynolds’ commentary, could we do the same for oil?
Reynolds’ thesis is superficially plausible. In the chart above, we see the price of oil begin to skyrocket from $55 at the start of 2007 to a peak of $134 in June 2008. (These are monthly averages; daily prices would tell a slightly different story.) On its own, that portion of the chart could conceivably indicate that it was rising oil prices that caused the onset of the Great Recession (shaded region) and the financial crisis in September 2008.
However, further study reveals some problems with Reynolds’ story. For example, look at the period from mid-2003 to mid-2006. In this stretch, oil prices steadily rose from $31/barrel to $74/bbl, while the national unemployment rate steadily fell from 6.3 to 4.7 percent. This seems to indicate that the economy can “handle” oil at $74/bbl, as it went hand-in-hand with a steadily falling unemployment rate.
But that presents a problem for Reynolds. Because of the sharp $20 drop in oil from mid-2006 to early 2007, it meant that on the rapid ascent, it’s not until September 2007 that oil breaks its earlier high to reach $80/bbl. By December, oil sits at $92.
Reynolds’ thesis requires that in just three months (i.e. September 2007 to December 2007), oil went from a perfectly manageable level to one that would tip the economy into the worst downturn since the Great Depression.
On the other side of the ledger: If we agree with Reynolds that the high price of oil (and high Fed target rate to curb inflation) caused the onset of the recession, then why wouldn’t the utter collapse in oil in the later summer of 2008 (and the complete reversal of Fed policy soon thereafter) lead to a quick bounce back?
In other words, if this were really just a story about oil, wouldn’t it flow through the gears of the global economy smoothly, once the price snapped?
In housing, my Austrian story makes sense because there is a “memory” of past price bubbles, because too many resources flowed into too many extravagant homes. If builders engage in a construction spree chasing bubble prices, there is an overhang that could take years to clear out—and this includes reallocating workers out of construction and into other sectors that are sustainable.
In contrast, the soaring price of oil into the summer of 2008 didn’t suck workers and resources into oil drilling. No, Reynolds is appealing to the intuitive fact that the global economy runs on oil. If its price shoots up, it chokes off real economic activity. But to repeat myself, this could explain a slowdown in the flow of goods and services from the economic engine. But there’s no reason for this temporary scarcity to cause a lasting scar. When the price collapsed, that should have made every business once again profitable, if indeed it was expensive oil that was the fundamental problem.
The Tell-Tale Sign of a Speculative Bubble
Besides appealing to our collective memory (which is enshrined in movies like The Big Short) that it was the collapse of mortgage-related assets that triggered the financial crisis, we can also look at objective measures. For example, in the following chart we see the tell-tale sign of a speculative bubble in residential real estate:
Notice that the vacancy rate during the peak bubble years of 2005 and 2006 rises to unprecedented levels. This is the mark of a speculative bubble, where the price wasn’t driven by “the fundamentals” but rather by investors buying solely because they thought the price would keep rising. Now maybe they’re right, maybe they’re wrong, but the point is, people in 2005 and 2006 were buying residential homes not to live in, or even to rent out, but to hold for price appreciation. As the chart shows, this was unprecedented, with nothing like it before or since.
In contrast, I would argue that the oil price really was driven by “fundamentals.” Specifically, the Chinese economy was booming from the mid-2000s, and the global oil price began spiking in 2007 because the world’s spare capacity was razor thin. Now if the surge in oil prices were due to speculation, we would see rising above-ground oil inventories in the private sector (i.e. not including the government’s Strategic Petroleum Reserve). This would be the oil market analog of speculators pulling available supply off the market, and carrying it forward to the future (in the hope of selling for a capital gain). But unlike housing vacancy rates, we don’t see this pattern with oil:
To me, the above chart shows that it was the fundamentals, not speculation, that drove the surge in oil. Specifically, from June 2007 through January 2008, West Texas Intermediate rose from $70 to $98 per barrel. At the same time, above-ground (ex. SPR) crude oil stocks went from 337 million barrels down to 265 million. In other words, rather than bulking up on inventory in anticipation of further price rises, instead the oil industry was throwing its “savings” at the demand, trying to quench it.
Now it’s true, after drawing their inventory to a three-year low, in early 2008 the oil sector began rebuilding. For a grand total of four months, i.e. from January through May 2008, oil inventories were sharply growing again. For this four-month stretch, one could argue that the speculative demand (which pulled available oil away from current refining and stored it in inventory) fueled oil prices.
However, in the grand scheme we see that the sector was clearly just replenishing its normal carrying stock; in the relative peak in May 2008, oil inventories were lower than they had been through most of 2006 and 2007.
But then the decisive point: After May 2008, inventories once again fell off a cliff, while the price of oil continued to surge. These data are not at all consistent with a speculative thesis. Instead, it looks like the global economy ran hot and pushed up the price of oil—where the price was “doing its job” by signaling a scarcity in the fundamentals—and then when the “real” economy crashed, so too did the oil price.
Conclusion
In fairness, there could have been private inventories not captured in the EIA data shown above. Perhaps when looking at these stockpiles, the telltale signs of a bubble would emerge. Yet prima facie, based on the industry data that are readily available, I believe the more plausible interpretation is that the real economy caused the movements in oil prices, rather than the other way around, as Reynolds would have it.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together the dependability of Whole Life insurance policies with the benefits of blockchain-based finance.
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