Tuesday, December 29, 2015

Economy: An Overlooked Reason For The 2008 Crisis

(Drivebycuriosity) - The financial crisis from 2008 still rules the headlines. I am aware that the financial meltdown was partly caused by the bursting housing bubble that lead to a chain reaction of bank crashes.

                                              The Super Storm Effect

But I think there is another reason for the severe recession: The oil price spike from 2007/08 (chart below). I think both causes, the crashing housing market and the oil shock, worked together and merged into a perfect storm. This is the term used by meteorologists: 2 bad weather systems come together and amplify each other. Take for instance Super Storm Sandy that devastated parts of New York City in 2012. Then a hurricane, coming from the south, merged with a weather system coming from north: "A storm like Sandy would normally be losing steam as it moved into colder, less energetic waters..however, a trough of low pressure dipping down from the Arctic is feeding the hurricane, actually strengthening its intensity as it moves northward" commented one meteorologists  (livescience).

From summer 2007 through July 2008 the oil price spiraled from about $50 to $147! A study by Prof. James Hamilton (University of California, San Diego) shows this oil price shock turned the economic slowdown into a severe recession (econbrowser).: "The oil price increase over 2007:H2-2008:H1 should be regarded as a key development that turned the slowdown in growth into a recession" (archives).

Other researchers came to the same results: "Oil prices played a role in eventually bursting the US subprime bubble....In 2003, the average suburban household spent $1,422 a year on gasoline, which rose to $3,196 in 2008 (oilprice). "Rising household energy prices constrained household budgets and increased mortgage delinquency rates" (oilprice). Low income suburban homeowners suffered most from the rising gas prices.  Poor homeowners are called "subprime" and their delinquencies are known as "subprime crisis."

The 2007/08 oil shock wasn´t an exception. The chart below shows that oil price spikes were regularly followed by more or less severe recessions. For instance Opec`s oil embargo in the 1970s caused severe recessions and in 190/91 an oil price spike caused by the first Iraq war was followed by another recession. Rising oil and high prices from 2009/14 slowed the global economy down but a recession could be avoided thanks to zero interest policy and the massive QE programs of the Fed.

                                                           Herding Behavior

The question is - why did oil prices spike in 2008 when the US economy already was slowing down?

There were several reasons:

1. The begin of the Iran sanctions in 2006 and the sharpening of the conflict in the following years  - especially the curbing of Iranian oil exports - lead to a sharp rise of oil prices in the years 2007 and 2008  (   youtube).  Speculation on a possible war against Iran - which could disturb oil supply significantly - fanned the oil price spiral further.

2. Some Opec members reduced oil production because of homemade problems. Venezuela cut off oil sales to ExxonMobil during a legal battle over nationalization of the company’s properties there and oil production in Nigeria was shut down thanks to oil worker strikes and terror attacks (rff.org).

3. Investing in oil was fashionable. Hundreds of hedge funds, specialized commodity funds and others invested into oil in the hope of further rising prices. They bought directly - or indirectly via ETFs & bank certificates - financial contracts (futures) which are backed by oil (financialization). So oil became an asset which is traded on financial markets like stocks, currencies and bonds. The financialization process pumped billions of dollars into oil futures and created an additional demand for oil which drove prices upwards. Rising prices allured more speculators who followed just the trend (momentum players) leading to a snow ball effect. And Goldman Sachs called an oil price of $200!.

In 2008 I worked  for a German online service covering financial & commodity news. There was a huge demand for "oil news" because many readers (users) had invested in oil. Many believed in the peak oil theory, which claimed that the world will soon run out of oil and its price can only go up. They also set bets on geopolitical risks, the above mentioned Iran an other conflicts, that should make oil even more scarce and expensive. And in the first half  of 2008 banks recommend to invest in oil as an insurance against falling stock prices! Many speculators followed the advice and their purchases drove the oil price higher - the herding behavior worked as a self-fulfilling prophecy for a while. So  losses on the stock market fueled the oil price spiral - till the oil price bubble finally burst.

Conclusion: I think that the 2008 crisis was an odd accident caused by an oil shock (Iran conflict, commodity speculation, peak oil theory, herding behavior) in combination with severe bank problems created by the bursting housing bubble. Something like that could happen again,  but I believe that the probability is low.

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