Wednesday, March 02, 2011

Oil and the Economy

It has been less than three years since we saw $4/gallon gas prices but people have already forgotten how this caused the Great Recession. This happened in three different ways.

First, rising oil prices started fears of inflation. People fixated on the cost of filling the gas tank and cut back on other purchases. Air fare also went up making all travel more expensive. The vacation industry was hit especially hard.

But that was minor compared to what happened next. In reaction to rising prices, the Fed raised interest rates. This was their normal response but things had changed since the last time they did this. The housing balloon had happened. This had several sub-components of its own. There was the sub-prime market - people with bad credit ratings who got a mortgage anyway. Most of these people had variable rate mortgages with little equity. The interest rates on their loans had been so low that even a minor increase in interest caused their monthly payments to rise beyond what they could afford. But this was not limited to the sub-prime market. People were treating their homes as ATMs, taking out loans based on the increase in housing values. They were hit just as hard by the rise in interest rates. Unlike previous decades when people had to put down substantial down payments, modern homeowners had very little of their own money tied up in their homes. There was a great incentive to walk away from mortgages that they could not afford. This caused a spike in the number of houses on the market which, in turn, caused a huge drop in house values.

The housing bubble would have burst at some point regardless but it was the rise in interest rates meant to counter inflation (which, in turn was caused by oil prices) that triggered it.

Finally there was the effect on automakers. For years they made their money by selling SUVs. These had low mileage and high profit margins. Chrysler had a line-up of almost nothing but SUVs, most of them getting less than 15 MPG. GM was not much better. Because the economy was beginning to contract, people were reluctant to buy cars and when they did, they bought the wrong cars. The government mandates fleet fuel efficiency. In order to meet this target, the car makers have to sell smaller, more efficient cars. The market does not want these cars so the car makers have to cut their profit margin in order to stimulate sales. In some cases the cars are being sold at a loss. All of this worked as long as they sold enough SUVs but when the market for SUVs evaporated they could not make enough money on the smaller cars. In a way it was only fair that the government had to bail out GM and Chrysler since government mileage requirements contributed to their problems. Regardless, rising gas prices hurt car makers which had a ripple effect through the economy.

When the world economy collapsed the price of oil dropped with it. Now the world economy is recovering and there is political unrest in many oil-producing areas. Oil is expensive again which could act as a brake on the world economy.

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