Oil and the recession

on Apr 03 in Financial Market, Oil Market tagged by Trevor Hicks

James Hamilton at Econbrowser describes a paper he recently presented about the relationship between the price of oil and the recession we’ve experienced. It supports my intuition that the recession was started by the oil shock of 2007 to 2008:

Although the approaches are quite different, they all support a common conclusion: had there been no increase in oil prices between 2007:Q3 and 2008:Q2, the U.S. economy would not have been in a recession over the period 2007:Q4 through 2008:Q3.

This is a very serious claim.  Hamilton concedes that the slowdown in housing which had already begun was a factor, but: 

Something in addition to housing began to drag the economy down over the later period, and all the calculations in the paper support the conclusion that oil prices were an important factor in turning that slowdown into a recession.

Granted, my intuition is likely largely shaped by the fact that I’ve been a semi-regular reader of Hamilton’s blog for a couple of years.

I think the story playing out in most people’s heads is that the banks caused this terrible recession, despite the fact that the recession began many months before the first crack in the banking foundation at Bear Stearns. Here’s the story as it plays out in my head. The housing bubble was already showing signs of deflating by late 2007 causing a mild slowdown in the economy. The rise in oil prices then vacuumed up so much cash from consumers that the slowdown became a recession in late 2007. It also turned the deflation of the housing bubble into a collapse as the rising price of transportation devastated the housing prices in the exurban communities where many of the marginal buyers in bad loans were buying. As oil spiked in the summer, the banks with their brittle portfolios were pushed past their breaking point and starting failing, thus turning our garden variety recession into a long and deep one.

If you’re wondering, I’m using the term ‘brittle’ to describe the bank portfolios the way a software developer would describe a certain type of poorly written computer code. That is, it works fine under expected or normal conditions, but under stress or a slight change in the environment it breaks down. Brittle portfolios, like brittle code, are generally the result of inadequate effort put in to thinking about what the design assumptions are and how they might go wrong.