There’s an interesting dynamic swirling around the impact of Oil and the likelihood (or not) of a possible recession. Some economists are saying that, well, its different this time, and Oil won’t precipitate a recession, that "Expenditures on energy are a sufficiently small share of GDP" that it won’t matter much.
I disagree — not because of the relative size of Oil to GDP, but rather, due to Psychology of consumers in light of inflation, very high Gas prices, weak job creation, Real Wages, and an ongoing messy War.
click for larger graphic:
graphic courtesy of NYT
Over the past decade, we’ve seen several developments that makes the average consumer more sensitive to fuel prices. Most of the country now drives larger vehicles: SUVs, trucks, large sedans. Fuel economy for the average suburban family is down significantly. Combine that with leasing rates that allow people to obtain much more expensive vehicles than they could otherwise afford to buy outright. That put alot of trucks on the road; Drive to any suburban mall or shopping area, and every other car is an SUV.
But it also allowed people to spend and indebt themselves into a position where they don’t have a significant margin of budget safety. Now add to that the two recent wealth effects — stocks in the 1990s, and homes in the 2000s — that led people to feel flush, and further encouraged many of them to live relatively beyond their means.
Which brings us to 2005. While Oil may be a much smaller percentage of GDP today than it was in the 1970s, the relative financial conditions of indebted consumers may also be that much less able to absorb an extended shock than it was then.
There are two stats that always seem to get mustered to counter this: Some point to consumer debt, not as a percentage of GDP, but relative to net asset wealth. The other rationale is median personal income (not just wages) as showing how flush consumers are.
I find neither of these arguments convincing.
As we learned in 2,000, relying on net wealth which is subject to asset price fluctuation can lead to a rapid rise in asset to debt ratios when the values of those assets declines precipitously. When stocks crashed in 2000, suddenly people were sitting on a lot more debt percentage wise than before. Then the negative wealth effect led to a modest curtailment of spending, exasperating a mild recession.
Secondly, median personal income gains paint a misleading picture of the economy. A more accurate measure would be Real Hourly Wages. Thats the data point which impacts the vast majority of consumers, and therefore has the largest impact on spending. After inflation, we see little in the way of income gains. Median income, on the other hand, disproportionately reflects the benefits of tax cuts, dividends, and capital gains. These improvements are real, but not widely disbursed. Thats also why we see a bifurcated spending pattern developing: Wal-Mart’s losses are Tiffany’s gains.
Just because Bill Gates walks into a bar, everyone else in the bar isn’t better off. Sure, the mean income just went up dramatically, but the median is hardly changed. That’s an exaggeration of whats been occuring to personal income in the U.S. — some are doing very well, while others are slipping backwards.
Back to the recession issue: Longtime readers know I am a fan of Chaos theory, periodicy and cycles (or at least the cyclical nature of business ). A possible recession in the 2006-07 time frame is hardly a stretch. Consider the past few contractions, and then fill in the blank: 1990, 1994, 2000, ______.
Its even easier to presume a potential contraction when one looks at how stimulus driven this post-recession period has been, and the net results of what happens as that stimulus attenuates.
Which brings us back to Psychology. How much additional pressure can the consumer absorb before pulling in his/her spending? Despite good economic headlines, consumer confidence is mixed, and the President’s approval ratings have reached the nadir of his term (both Reagan and Clinton scored higher at the same time).
Consider all of the following: Record high gasoline prices, that fall back a little but stay inflated; Add a housing boom that doesn’t crash, but merely fizzles. The ongoing refinacing machine which drove so much consumer spending decellerates rapidly. Add to it a War which the majority of the country now believes turns out to be "Not worth it" and a significant percent (though not quite a majority) beleives we were led into under "false premises." Lastly, the myriad stimulus from the government — tax cuts, ultra low interest rates, deficit spending, increased money supply, military expenditures — all begin to fade.
What might all this a recipe for?
Economy Shows Signs of Strain From Oil Prices
By JAD MOUAWAD and DAVID LEONHARDT
Published: August 17, 2005
Do Higher Oil Prices Lead to Recessions? (Yes)
Sunday, June 06, 2004
U.S. Gasoline and Diesel Fuel Prices, 08/15/05
AAA Fuel Gauge Retail Gasoline Prices
Oil Spike Won’t Cause Oil Shocks of Past
By THE ASSOCIATED PRESS
Published: August 17, 2005
“Just because Bill Gates walks into a bar, everyone else in the bar isn’t better off. Sure, the median income just went up dramatically, but the mean is hardly changed.”
“Just because Bill Gates walks into a bar, everyone else in the bar isn’t better off. Sure, the mean income just went up dramatically, but the median is hardly changed.”
Good catch! (Duh — dyslexia) . . . I switched the two (italicized) to the way it should have been.
Should you add “flattening yield curve” as yet another harbinger of recession?
It has been said frequently of late that companies are repairing and strengthening balance sheets — accumulating cash and not borrowing much from banks.
If consumers, too, shift into balance sheet repair mode, who will do the borrowing needed to support money supply expansion via the fractional reserve mechanism? And if that mechanism stops working, how can the Fed expand the money supply?
Richard Koo’s “Balance Sheet Recession” describes how a situation of this sort was responsible for Japan’s Lost Decade.
I’ve noticed myself and more of my friends cutting massive amounts of recurring expenses out of their budgets. Who really needs 114 movie channels when the 14 HBOs produce the same number of shows to watch (3 [6ft, entourage, carnival]). Who needs a home phone anymore… especially when you’ve got a cellphone (or two). Single friend of mine just dumped two cars (taking $1800/mo from his wallet) in order to buy one newer car ($300/mo).
A great majority of my friends and family have increased their monthly cashflows by many multiples. Dollar menus at fast-food joints are more popular, feeding a family of 5 for $12… or a very hungry man for $5…
Most Americans should have a fairly easy time generated a hundred dollars in free cash every month by focusing on this type of stuff… and Target/Wal-Mart appear to be suffering for it.
I suppose it’s a better time to work for a growing small business than a large corp.
Whats even scarier is your scenario simply envisions a lessening in growth for a variety of variables; housing price appreciation slows, wage growth slows even more, refinancing growth slows, gas prices remain relatively high, and stimulus slows.
What if the situation gets worse than what you envision: housing growth reverses and gas prices keep going higher, with higher interest rates and wage growth that continues to be anemic.
entire industriescompanies (airlines) may go “poof”, and the following transition may cause blips (or more) in graphs and trends.
The airline industry will not go “poof.” The government has proved willing in the past to bail out industries considered integral to the national economy. A more interesting question is whether the peril of recession will prompt re-regulation. With companies like United Airlines leading the race to the bottom — using bankruptcy as a competitive advantage — I believe that a handful of airline industry players will continue to exist but industry contraction will prove painful for workers and consumers, alike.
Didn’t you just disprove your original point? If all those other things that could – and may well – lead to a recession are at work, then the high price of oil isn’t necessary to cause a recession.
In fact, the high price of oil is just one more consequence of burning money in non-productive
ways. Blowing up expensive munitions, thousands of air sorties and tens of thousands of potentially productive young menand women producing negative output in Iraq (blowing stuff up is negative output), leads to lower productivity and inflation.
I agree that the entire industry will not go poof. you make a good point.
However, it is possible that an entire company or two may go “poof.” hence the “companies” in my post.
What plans does the U.S. have to maintain stability for workers who are affected by this? Extending unemployment is arguably not the most optimal.
>Should you add “flattening yield curve” as yet
>another harbinger of recession?
Absolutely. The Fed was predicted to stop raising rates back in March, but instead they’ve keep going on like no tomorrow. At their current rate we will have an inverse yield curve, with short term rates yielding HIGHER than long term rates –always a strong flag for an upcoming recession.
If the Fed were really concerned about ballooning housing prices, they’d kick some sense into GNMA, Freddie Mac and the rest of the credit bubble perpetuators. In a time of low interest rates, these agencies should be SHORTENING the terms of mortages they’ll buy back.
If GNMA announced they will only purchase mortages of 15 years or less in duration, and a future schedule to move that limit to 12, then 10 years, that would be far more effective in reducing the credit bubble than jacking up interest rates.
The current solution seems to be to jack up interest rates until they’re upside down and we’re put into a recession. What an unimaginative solution.
Control of credit would have solved a lot of problems, not just housing. Think about the end of the stock market bubble and how governmental control of margin (by increasing the margin maintenance requirements) might have diverted that disaster somewhat. Or how lack of control and oversight over consumer credit has created an unprecedented magnitude of consumer debt.
The Fed seems intent on dealing with problems after they happen rather than being preventive and cautious in their approach. Such a shame, because there is always the chance that they will be unable to fix a problem of their own making after it surfaces.
“What plans does the U.S. have to maintain stability for workers who are affected by this?” – nate
If the last fifty years or so of U.S. economic policy are continued, then the workers will be told to build their skills and hope for the next employment opportunity. Bush’s response during the second presidential debate inarticulately made the same point. This is the drawback of capitalism; what does a government or society do with those who fall afoul of the system of free enterprise?
The current generator of American workers has a problem: their skills are not developing quickly enough to keep up with changes in the marketplace. Assuming a recession were to hit the service sector, how quickly could workers reorient to enter the education or healthcare service fields? I would argue that most would need a solid 12-18 months of training, if not more, but unemployment benefits will not cover that entire period and the savings rate is zero.
See the problem?
using words like “crisis” to describe social security may not help in regards to recessions-
even ExxonMobil traded down in today’s stock market.
Just wanted to give kudos to this blog. Great blog.
Barry Ritholtz uses the R word
There’s an interesting dynamic swirling around the impact of Oil and the likelihood (or not) of a possible recession. Some economists are saying that, well, its different this time, and Oil won’t precipitate a recession, that “Expend…
Basic econ question:
Would the two lines in the graph have a higher rate of convergence if interest rates didn’t fall as much during the post-1980 period?
Recession or depression?
Is the global economy at the brink of a breakdown much greater than its predecessor in 1929? How do the current imbalances compare to those late Roaring Twenties’ similar circumstances of consumer-level forward consumption, debt, overvaluation of assets, and industrial overcapacity? Will the devaluation and asset decay process at the end of the second 70 year sub-fractal – contained within the 140 year Second Grand Fractal cycle beginning in 1858 – be greater than at the end of its first 70 year sub-fractal?
A chicken in every pot and two cars in every garage has been replaced with eating out three of seven nights at the plethora of fast food and dining opportunities that ‘froth’ the highways and typify the service type of economy the States have become. Three SUV’s and a Hummer distributed between a primary residence and an investment residence have superseded the two cars in a garage. Buy a radio or washer on credit has been bested with buy and buy with abandon everything imaginable with ubiquitously facilitated debt from refinanced or second mortgages based on the surety of ever appreciating house prices -the latter caused in part by fed fund rates 1/4 of the rates in 1928.
The evenly balanced declining and increasing annual GDP growth rates prior to 1929 have been replaced with continuous positive annual GDP’s growth rates during the past 45 years. The great creditor nation status of 1929 has been substituted with a beggar man debtor bravado country wearing only the emperor’s new clothes. Its treasury is writing bad checks against future income that can only be guaranteed if the remaining 57 percent of the US private (nongovernmental) work force becomes governmentalized allowing a Weimar type of hyperinflation. In short the consumer saturation point of 1929 looks very appealing against the very poor economic hand that America now holds. Consider America’s current financial balance sheet and thereafter consider how badly the unbalanced excesses of 1929 unfolded.
In the next nine weeks, data – which has always been there – will be re-recognized. GM’s and Ford’s junk bond status and their probability of default on a collective 450 billion dollars of debt will reappear. The thousand mirrors that reflect a single dollar in the derivatives markets will have key reflecting glasses broken erasing the image in 925. The housing bubble, that is so historically remarkable in its uniqueness in that virtually all know it to be a bubble, will crack. The microcosm of forward consumption in the last two months of the American auto business will witness the expected necessary microcosm of historically poor follow-on monthly sales. Major airlines will throw in the towel declaring bankruptcy and pension amnesty. Declining monthly GDP will receive attention. The real position of the individual debtor and the debtor country in the face of declining asset valuations and projected tax revenues will get its due. Fiscally impossible city and state governmental pension funds whose futures are tied to the equity markets and escalating real estate property values will have a viability reality check. For the first time in many years the concept of consumer retrenchment will be seriously and widely explored as a probable scenario.
The comparative initiating decay fractals at the secondary summit, with respect to March 2000, of US equity indices suggest a very remarkable primary revaluation. Watch the general trend and descent of the long term US note and bond debt markets as exiting money from equities and commodities flows into these long term debt instruments driving their interest rates lower. Gold has potentially only one more week before completing its maximal 12/30/30 weekly growth cycle with an abrupt devaluation. Opposite to gold, the dollar will transiently trend well. Expect the unexpected. Within this quantum fractal decay process, expect nonlinearity. Gary Lammert http://www.economicfractalist.com/ ”
I think there’s a large, large distance between predicting a 15-30% slow fall in housing prices that have just recently risen 50%… and some sort of global economic collapse. That there’s a large, large gap between predicting a recession vs predicting the same old, same old tired Marxist fantasy of “The last gasp of capitalism” where the whole world economy collapses and then suddenly somehow the dictators that rise up, unlike every other dictators in history that first murder their internal political opponents and then start wars with their adjacent enemies… instead somehow build a “Worker’s Paradise”.
Gary, my man, to some I may be the pot calling the kettle black, but while I some re-adjustments in the near future, I just don’t see a basis for anything along the lines of what you’re predicting.
To put in in a sports analogy, I’m saying the home team has gotten sloppy, their training sucks, they need to trade a few players out to the bench, and am predicting a losing streak in the next series or two with the other teams winning.
You are predicting the end of baseball itself.
But hey, according to you, we’ll all know in 9 weeks. Whether we’re all still using worthless government backed paper currency instead of *gold coins* to buy loaves of bread on October 21st 2005 …will be exceedingly easy to verify.
Come on Blackwood, how could a non-linear quantum fractal decay process be wrong?
I don’t know if we’re heading towards recession or not. If you think there’s going to be a recession in the next few years, you’re probably going to be right. If you’d made this prediction at almost any time in the last 50 years, chances are you would have been correct too.
I don’t see our current situation as dismal. Too many bad things would have to happen at the same time to fall into depression. The only thing that could cause a depression are a sudden drop in oil supply, a major outbreak of war or terrorism, or a major pandemic like avian flu spreading worldwide. Everything that is strictly related to financial markets, like foreign central banks stop buying US dollars causing a major spike in interests rates and a major drop in US purchases or overseas goods, won’t likely occur because everyone would suffer.
I always thought the new paradigm mumbo jumbo of the internet boom was a bunch of baloney, but I do think the world economy is much different today than during past energy crises. China and India have recently added a couple of billion potential consumers to the world market place. China and India have enormous production capacity that will likely keep prices and interest rates low for a long time. At least until consumption in their own countries eats up a much larger percentage of what they produce. At that point, the dollar will depriciate faster and interest rates and inflation will rise faster, but I don’t think this will happen for a decade or more.
Oil prices will eventually drop below $50/barrel because at current costs there’s a lot of oil that can be extracted profitably that couldn’t be extracted profitably at $40/barrel. It’s going to take a few years for new production capacity to come on line, but once it does, oil will remain below $50/barrel. Maybe even below $40/barrel.
The US will gradually reduce their current account deficit over the coming years due to decreased gov’t deficits, baby boomers buying less and gov’t regulations that force countries like China to trade fairly. The dollar will also likely depreciate as China becomes less dependent on pegging the yuan. Social Security and medicare will be taken care of by lowering benefits and pushing back retirment ages.
I just don’t see any huge problems that won’t be solved.
Years ago, when I’d ask a friend of mine who was a very successful, dairy farmer, cattleman and John Deere dealer (from whom I bought a number of heifers and tractors) about the economy, he had two answers:
When times were good he would say: “Seems like there is plenty of money around.”
When times were bad he would say: “Doesn’t seem to be much money around.”
I think if he were around today he would say: “Seems like there is plenty of money around.”
When you can buy a brand new wide flat hdtv, no money down and no payments for two years; is the average consumer going to say “no”?. The same for furniture; appliances, etc. When you can purchase everything else on a credit card; will the consumer say, “no”? When you can borrow 125% of the value of your overvalued home at 4% interest only; fixed payment; negative amortization; will the consumer say “no”? Not the consumers I know.
So, when “There’s not much money around”; then we can talk about the bad times; not until.
Excellent and thought provoking article. It might be nip and tuck for a quarter or two if prices remain at current levels, but I think we should be able to skirt recession in 2006.
When I look at the economic cycle, I see a major 10 year cycle (1980-82, 1991, 2001, …) with mid-term interest rate driven inventory correction (1986, 1995). The fuel price spike may be triggering that correction in lieu of more aggressive Fed tightening at this point in the cycle.
Note that inventories contracted in Q2 following the rapid rise in energy costs in Q1. Detroit has almost assuredly caused a contraction in Q2. Lean inventories should allow the economy to nicely, especially if petroleum prices can sabilize for a quarter or two.
Given about 140b gallons of gas and diesel are consumed in the U.S. per year, every 10 cent rise in gas/diesel removes around $1.4 billion from potential discertionary spending to spending on energy. With gas and diesel prices up a blended 74 cents per gallon y/y, that suggests that about $100b fewer goods will be purchased in 2005. In an $11t economy, that is roughly 1pp of GDP growth.
Of course, the energy related jump in inflation may cause the Fed to push harder on the brake: At that point, we will be sure that higher energy costs triggered the recession
Barry Ritholz writes, “A possible recession in the 2006-07 time frame is hardly a stretch. Consider the past few contractions, and then fill in the blank: 1990, 1994, 2000, ______. ”
We had a recession in 1994?
I guess I didn’t get the memo, and neither did the NYT whose graphic you display.
My guess is that currency issues and interest levels will have more to do with the next recession than gas prices. Naturally oil prices affect the current account and therefore, indirectly, currency and interest rates, but the economy is more complex than psychology. People get pessimistic or optimistic based on real events. The media may be able to spook people or cheerlead for a while, but reality gets the last bite.
Mea Culpa — Charles is right —
My frame of reference is the market, and I was thinking of poor equity performance — I do not believe 1994 can technically be considered a recession, but it was a pretty spotty economy, and markets were on the ugly side — Nasdaq spent much of the year down 10%, the SPX was choppy, and only the Dow managed to close the year up slightly.
It maynot have been technically a recession, but it was hardly any fun . . .
It’s hard to be negative on future growth when we look at more than 70 years of history in economic growth but go read Babbitt by Sinclair Lewis and you might start seeing parallels between the 20s and today. You would not be able to say this of the 50s, the 60s, 70s, 80s or 90s but you can today.
Come on people, there are serious issues out there and if you think a depression can’t happen you’re deluded. Germans didn’t think Hitler was such a bad guy in the beginning. How do think he got away with murder for so long? A lot of people were naive. If you think there is no chance for a depression, it’s because you haven’t had serious negative blows in your life. For things to turn out just fine, we need to fix up a lot of stuff out there. First of all, we need to invest in the right industries. Are we doing this today? I don’t think so. We need to look at what North Americans are going to need in 5, 10, 15 yrs? I don’t think we need larger homes, farther away for the core with big SUVs. How many freaking furniture stores do we need? Our definition of status revolves around stuff. But the reality is that as people age, they need less stuff. Hell, my grandparents practically live on air. They have money and I don’t think they spend more than 20K a year!
Go look at the US population pyramid. Go to the census bureau and you’ll find it. Currently, the largest group in the US is around 45 yrs old. Incidently, this is the most productive group of the economy: peak earning power, peak spending. At 45, material based-status is at its peak. Now, take a look at the population pyramid in 5 yrs. The largest group will be 50. 50% of people over 50 suffer from arthritis and that is only one ailment. Do you think that the 50% with ailments will want 3,000 square feet of house and 2 or 3 of them! I’m willing to bet that in 5yrs there’s a large group of them that will want to buy smaller homes or own less of them. Interestingly the group that will be there to buy them, Gen-X and Gen-Y, will be smaller than the group doing the buying today.
Everyone talks about immigration but a quick look at the population pyramid shows you that there was a baby bust after the Boomers and immigration didn’t fully take care of this.
This brings me to another point… At the end of the 20s, the population pyramid looked at lot like it does today. The largest group in the population was in its most productive years and the group to take over was smaller, most probably a by-product of the war. How can an economy grow when the group taking over is smaller and supportting a group that did not save and spent like maniacs?
Look at the pyramid today, the group that will take over the Boomers is smaller once again. We haven’t seen this since the 20s! The median boomer has something like 175K saved up for retirement. I think the government is going to have to spend a lot of money to support the economy for quite a while.
Congratulations. A lot of incredibly good information.
Daniellle, please send me the graphica, Demographics is key.
Charlie yes! the world is a single boat and only the viruses and terrorists d’ont know that. And you’re right again, there’s always a recession to come in a few years.
I just feel that when we see
plu$ a comodity hungry Asia
plu$ a strenuous unending war
plu$ kind of end of party in the construction
plu$ neck indebted consumers
almost anything may triger dread and the next wave of adjustments.
All you have to do is Google IDB population pyramid. It will send you to the census bureau and once there you can pick any country, any year. It’s great and a real eye opener!
I know about problems in the future. India is the only major country that’s in good shape as far as their population pyramid goes. Japan and western Europe are in the same position we’re in, probably a little worse. China took birth control to an extreme and will be in a similar situation that we’re currently in. It won’t happen until a decade ot two after us, but it will happen. Taking care of the elderly is going to be an issue that’s difficult to solve. Difficult to solve doesn’t equate to economic collapse.
We’re going to reduce benefits to the elderly to help reduce gov’t expenses. Regardless of what politicians say, this is going to happen no matter what. We’re going to let young workers from India and south and central america into the country to help offset worker shortages. American will consume and produce less as a pct of world GDP and our standard of living compared to the rest of the world will be lower. I’m 90% sure this will happen. It’s not the end of the world for america though. I think most americans will cope just fine with not getting a new car every 3 years and not owning a beach house.
Recession in 2006-07?
If you just extrapolate the dynamics of past economic expansions, you’d say that a recession within the next few years is quite possible but by no means certain. The question is how much weight you want to attach to some of the other factors.