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Tuesday, August 16, 2011

Reconsidering the Crash of 2008 - Gasoline Prices & Unemployment

Introduction

A frequent explanation for the economic crash of 2008 is that it was caused by lenders making it too easy for people to obtain mortgages. Bernanke (2009) presents this explanation, while noting "the question is complex, and experts disagree on how much weight to give to various explanations."

I will give some reasons to think that rapidly rising gasoline prices were one cause of rising unemployment, which in turn helped cause delinquent mortgages and bank failures leading to the financial crisis of 2008, and to subsequent escalating job losses. There may have been other factors that helped cause unemployment, such as job exportation, business taxation, etc., but my focus here is on the effect of oil prices.

Hamilton (2005) surveys research on the relation of oil prices to the economy. Including the current recession, ten out of eleven of the US recessions since World War II were preceded by a spike in oil prices, yet there is still theoretical disagreement about whether and how oil shocks cause recessions. Pearl (2009) gives a discussion of theoretical disagreements about evaluating causality in economics.

I will give some general remarks about previous research and the difficulty of reaching agreement about causality from a systems theory perspective. Then I'll give my two cents about implications regarding strategies for economic recovery.

Historical Data for the Crash of 2008 

To begin, consider the pictures in Figure 1. In January 2008, the United States had gained 766,000 jobs, over the previous 12 months.[Notes 1, 2] Over the next six months, the year-to-year gain in jobs decreased. In July 2008, it first went negative:  the US had lost 44,800 jobs, relative to the previous year. Two months later in September 2008, the US had lost 730,000 jobs compared to the previous year. By October 2009, the US had lost over 6 million jobs, compared to the previous year.

Next, consider Figure 2 below. During the period from January 2007 through July 2008, while US jobs were eroding, gasoline prices were steadily increasing. Gasoline prices reached a peak $4.16 per gallon[3] in July 2008. This was also the first month since at least January 2007 that US job growth was negative on a year-to-year basis.

Figure 3  below shows that as gasoline prices increased and jobs were lost nationwide, seriously delinquent mortgages increased during the first half of 2008.[4] This perhaps caused bank failures even though foreclosures had not yet escalated.[5] The financial crisis began in earnest in September 2008.

Although gasoline prices began to drop in August 2008, it appears at that point the damage to the US economy had already been done. Certainly, job losses continued, and rapidly escalated.

For the period from January 2007 through October 2008 there was a -0.79 correlation between gasoline prices and job growth, i.e. a strong correlation between increasing gasoline prices and job losses. This correlation for 22 monthly samples from January 2007 through October 2008 is statistically significant, with probability over 99% that it is not due to random chance.

However, a statistical correlation does not prove cause and effect. To understand causality, we need to consider economic processes by which one variable may influence another.

Causality, Previous Research, Theoretical Difficulty

Hamilton (2005) discusses several different ways in which oil shocks could cause economic problems, noting that the data supports different mechanisms to different degrees. He discusses previous research by a variety of authors, many of whom have presented evidence to support a causal relation between oil shocks and economic recessions.

It is plausible that rising gasoline prices may cause unemployment. since gasoline is a resource needed by many sectors of the economy, including transportation, farming, etc. Oil is also used for other fuels, and has many non-fuel uses, e.g. plastics. If oil and gasoline prices rise quickly then reduced profit margins may cause business failures and job losses for companies that cannot respond quickly by raising prices.

There does not seem to be a plausible argument that unemployment could directly cause gasoline prices to increase. However, some may argue that third factors could cause both unemployment and gasoline prices to increase. Thus, Barsky and Kilian (2005) provide arguments that macroeconomic variables may influence oil prices, and argue that oil prices may not be the only explanation for US stagflation during the 1970's.[6]

Pearl (2009) documents that statisticians and economists have generally avoided the study of causality in relation to economics. At this point there are theoretical disagreements about how causality in economic systems can be analyzed using statistical information. This does not change the fact that causal relationships exist (economic events are not just happening completely at random, independently of each other). Nor does it change the fact that understanding economic causality is important to the prosperity of nations.

My view is that from a systems theory perspective there are factors that make it inherently difficult for people to reach agreement about economic causality:  An economy is a multivariable system, with potentially circular relationships between variables, which may imply nonlinear, chaotic behavior. These relationships involve large-scale interactions between agents (individuals, corporations and nations) dynamically making choices at multiple levels affecting multiple variables, including not just the prices of resources and labor, but the price of money itself. Though these agents are often rational, their choices are effectively probabilistic events, in which agents act with imperfect information and imperfect logic seeking to optimize multiple variables. Economies are not closed, statically structured systems: they are open to innovations, changes in availability and usage of resources, influence by climate and ecology, national and global politics, warfare, etc.

Given these factors, although causal relationships exist in the economy in general we should not expect strong, long-term statistical correlations between any two economic variables. Since any economic variable X may be causally affected by several other variables, its correlation with any one variable Y over long periods of time is likely to be affected by fluctuations in other variables.

So it is to be expected that the correlation of gasoline prices with unemployment will be weaker over a much longer period of time. And indeed, there is only a 33.6% correlation between gasoline prices and unemployment in the US over the four decades from 1970 to 2010, illustrated by Figure 4 below. (This forty year correlation is statistically significant with a probability of 98.5%.)


As Figure 4 indicates, there was also a major increase in the US unemployment rate from 1974 to 1975, after the OPEC oil embargo caused an increase in gasoline prices from 1973 to 1974. Another major increase in unemployment occurred from 1980 to 1982, following a major increase in gasoline prices from 1979 to 1981.[7]

The 40-year statistical correlation of 33.6% would generally be considered at the low end of moderate, or the high end of weak, but again this does not imply gasoline prices have no effect on the unemployment rate, or the economy in general. Gasoline prices are just one variable in an economy, and unemployment may have other causes as well, such as job exportation, business taxation, etc. Likewise there may be economic processes that can cause job growth even if gasoline prices increase.

So, the fact that a statistically significant 33% correlation is observed over 40 years, combined with the plausibility of economic processes by which increases in oil prices could cause unemployment, indicates that rising gasoline prices are one of multiple factors that can cause unemployment. And considering a period of many months before the crash of 2008, when both gasoline prices and unemployment rose rapidly, a statistically significant 79% correlation indicates that rapidly rising gasoline prices can cause increases in unemployment, if other factors do not countervail.


Implications for Economic Recovery

While there are theoretical disagreements, the relationship of gasoline prices to unemployment is not a purely academic, theoretical question.

Returning to the current period, and the aftermath of the crash of 2008:  In late November 2008, gasoline prices dropped below $2 per gallon, perhaps in response to increased OPEC production, and perhaps also in response to diminished demand – fewer people were driving because by November 2008 over two million people were unemployed, compared to the previous year.

Since April 2009, gasoline prices have gone from $2 per gallon up to present levels over $3.50 per gallon --  another period of increasing prices, reaching $4.00 per gallon earlier this year. The US unemployment rate has remained over 9% since May 2009, despite a $787 billion US stimulus program. This may be seen as further indication that rising gasoline prices act as a hindrance to economic growth and recovery.

Unfortunately, the US stimulus program of 2009 and 2010 was not directed toward achieving a major, rapid gain in US oil, gas, coal, and nuclear energy production. It seems clear that if there had been a Manhattan Project to rebuild our energy infrastructure for oil, nuclear energy, clean coal and natural gas, it could have produced hundreds of thousands, and perhaps indirectly millions of long-term, self-sustaining jobs, at all income levels in many professions (engineers, construction, etc.). Like the funding of the Hoover Dam in the 1930's, such a program would have provided returns to the US economy for decades to come, though on a much larger, nationwide scale compared to the Hoover Dam.

Economic recovery and job growth should still result if the federal government encourages US companies to rapidly increase domestic energy production in oil, natural gas, clean coal and nuclear energy, and addresses regulatory issues as rapidly as possible. In principle, free enterprise could be more efficient and effective at restoring economic growth and employment, than a federal stimulus Manhattan Project for conventional energy development. [8]

Unfortunately, the Obama administration seems to act as though the only good energy sources are solar and wind. These are far from being able to support the economy in the near term, and not without  environmental impacts. The administration also seems convinced the US should bear the burden for relying on "clean" energy, while China, Russia and many other countries expand their use of coal and oil. And the administration is convinced the danger of global warming has been proved scientifically, though key questions remain open to scientific debate. (Lindzen, 2007; Orlowski, 2011)  In the 2011 State of the Union address, President Obama voiced a recognition that we need development of nuclear, clean coal and natural gas, yet it appears the executive branch is focused on regulation rather than encouragement of conventional domestic energy sources. 

The negative impact of oil prices on the economy seems to be generally recognized by the American public, and by commentators and economists in general. Earlier this year, Charles Krauthammer noted that we are now in a "slow oil shock" affecting our economic recovery, and Fatih Birol, the chief economist for the International Energy Agency warned that oil prices were “entering a dangerous zone for the global economy” and “becoming a threat to economic recovery.” (Pfeifer, 2011)

Perhaps the single most important thing we can do to create jobs and improve national security is to achieve some degree of energy independence. Domestic energy production is the foundation we need for a growing economy and job creation.

References

Barsky, Robert B. and Lutz Kilian (2004) Oil and the Macroeconomy Since the 1970s. Journal of Economic Perspectives, Volume 18, Number 4, Fall 2004, Pages 115–134. Available at:

Bernanke, Ben S. (2009) Four Questions about the Financial Crisis. Speech at the Morehouse College, Atlanta, Georgia, April 14, 2009. Available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm

Hamilton, James D. (2005) Oil and the Macroeconomy. Available at:
http://dss.ucsd.edu/~jhamilto/JDH_palgrave_oil.pdf

Lindzen, Richard S. (2007) Taking Greenhouse Warming Seriously. Energy & Environment, Vol. 18, No.7+8, pp. 937-950.

Lindzen, Richard S. (2008) An Exchange on Climate Science and Alarm. In Global Warming: Looking Beyond Kyoto (Ernesto Zedillo, editor), Brookings Institution Press, Washington, DC

Pearl, Judea. (2009) Causality: Models, Reasoning and Inference. Second Edition, Cambridge University Press.

Pfeifer, Sylvia. (2011) Rising oil price threatens fragile recovery. Financial Times, January 4 2011. http://www.ft.com/cms/s/0/056db69c-1836-11e0-88c9-00144feab49a.html?ftcamp=rss#axzz1Al4lsjO2

Wilson, Chris. (2009) When Did Your County's Jobs Disappear? Slate, December 30, 2009. Available at: http://www.slate.com/id/2216238/

Yergin, Daniel. (1990) The Prize: The Epic Quest for Oil, Money & Power.  Free Press.

Zubrin, Robert. (2007) Energy Victory: Winning the War on Terror by Breaking Free of Oil. Prometheus Books.

Notes

[1] These pictures are taken from Wilson (2009), who gives month by month pictures of US job growth and job losses from January 2007 to October 2009.

[2] Use of year-to-year comparisons tends to "abstract out" seasonal fluctuations, since it considers changes versus the same time a year ago, not versus a few months ago in a different season. The same results are obtained if we consider the government's data for seasonally adjusted unemployment rates.

[3]  Weekly U.S. All Grades, Areas and Formulations Retail Gasoline Prices.  http://www.data.gov/raw/1133

[4] Based on bank failure data from http://s.wsj.net/public/resources/documents/st_BANKFAIL_20090522.html, and foreclosure data from OCC and OTC Mortgage Metrics Reports. Data on foreclosures were only available on a quarterly basis. Since it happened at the end of the quarter, the graph shows the failure of Washington Mutual (the largest bank failure in US history) as occurring in 4Q08, though to be precise it happened 9/25/08.

[5] Bank failures may have also been directly caused by unemployment, independent of delinquent mortgages, due to withdrawals of deposits by people newly unemployed . This is logically possible, and may have been significant, though I do not have data regarding it.

[6] They discuss stagflation as a combination of high unemployment and increased inflation. My focus in this paper is just on the relationship of oil and gasoline prices to unemployment, independent of inflation, since inflation may be affected by monetary policy.

[7] Gasoline prices in Figure 4 are shown in inflated, present-day values, to support comparison of prices with unemployment rates at different times. 

[8]  Also, Congress should enact the Open Fuel Standards Act to ensure that US automobiles can run on methanol, which can be made cleanly without subsidies from coal, natural gas, or any kind of biomass (waste, inedible plants, etc.) This will enable methanol to compete with oil without subsidies. The US has enough coal to make methanol to power all our autos for 150 years. (Zubrin, Energy Victory, p.25)