Oil and the Economy

Gas is the highest it has ever been at this time of year. It is forecast to set new record prices this Summer. This is bad news because gas and oil prices can have major and unexpected influences on the economy. I never see anyone mention it but the last round of gas price hikes triggered the Great Recession.

Here's what happened.

People were constantly refinancing their homes based on inflated prices. They were taking out variable rate mortgages which were running at record lows. This was because the Fed had been keeping interest rates down in order to stimulate the economy (through low mortgage rates). This is also how a single mother could afford a half-million dollar house.

This demand for housing caused by low-interest mortgages was the driving force behind the real estate bubble. Because there was such a demand for houses and because the value of houses kept going up (and because of Federal action to increase minority home ownership), the standards for getting a loan had been relaxed almost to non-existence. After all, if someone got in financial trouble they could always sell the house for a profit. Because of this, the default rate on mortgages, even sub-prime ones, was low which gave rise to the infamous financial instruments.

Then oil prices started going up. This not only affects the cost of driving. It affects the cost of shipping. It also affects the price of goods created from petroleum including plastic and fertilizers. Directly or indirectly the cost of everything was affected and we started seeing inflation. In order to head this off, the Fed made a minor adjustment in the prime rate.

That minor change showed up in variable interest rates. Suddenly a lot of people could not afford their houses. People began to default. Banks put their foreclosed houses on the market at bargain rates so they could recover their money. That was enough to burst the housing bubble. Housing prices started dropping and people suddenly found themselves underwater. This was amplified because the old requirement of a large down-payment had been dropped. In previous decades, a house could lose 10% of its value and still be worth more than the mortgage but this was no longer the case in the days of no-money-down mortgages.

Big financial institutions started failing. Some, like County Savings, were direct casualties of falling real estate prices. Others were taken down by the sub-prime-backed financial instruments.

The fall was inevitable. Too much debt was loose in the system and it was going to collapse eventually. The point is that it was the jump in oil that did it. It stressed the system enough to break it.

Could that happen again? There are not any obvious major bubbles but the economy is not in any shape to take new stresses. When gas prices go up, people start cutting back. Even if it does not cause a new recession, it could slow the recovery to a crawl (or a slower crawl).

There is a bright side to higher oil prices. The US has vast reserves of oil that are only recoverable at a high price. This includes deep-water wells and shale oil recovered through fracking. That can potentially create thousands of jobs. Will this be enough to offset job losses caused by high oil costs? And will an administration that is sold on clean energy support jobs from oil?