Did Rising Oil Prices Cause the Recession?

There is a clever blogger out their, Enoch Smith, (http://enochsmith23.blogspot.com/) who recently wrote a great post on the largely unrecognised contributing impact of rising petrol (gas in American terms) prices on the US recession.  Although I can’t disagree with much of what he says about the subject, (prior to the Lehman crash, I remember a lot of people commenting about the impact of $140 bbl oil on the world economy and Goldman Sachs were forecast $200 bbl in a relatively short term, but then it rapidly became old news as prices fell back).  My main comment however is that I see the rise in gas prices as being a a symptom rather than the cause of the recession, in just the way that defaulting mortgages (which Enoch commented and I agree as being the more widely reported cause) were a symptom in my view.  Let me explain.

In my view the cause can be traced back much further and what happened in 2008 with both mortgage defaults and gas prices were effectively just straws that broke the camel’s back.  By the 1980s, the economic consensus that had existed in the western economies since the end of WW2 was starting to fall apart.  The economic theories of Keynes, which had held the high ground for almost 40 years were now seen as outdated, as was the social compact between unions, the government and employers, and globalization was starting to take hold as a concept.  As many industries started to “modernise”, typically involving big reductions in labour forces and plant closures, one of the most traditional and old fashioned industries embarked on a different approach; that industry was banking and finance, more correctly defined as “financial intermediation”.  For perspective I have worked in the sector since 1987, the first 12 years in stockbroking and investment management and the more recent years in corporate finance.

New York and London, the two major centres for global finance were run more like gentlemen’s clubs to that point; legislation/regulation kept different firms from competing too closely.  The Glass-Steagall Act in the US prevented commercial banks being investment banks and vice versa and inter state banking was severely restricted, while in the UK, brokers, jobbers (I believe the term specialist is used on the NYSE for wholesale stock dealers that trade on their own book) and merchant banks were kept separate, not only from each other but also from commercial banks.  Stockbroking commissions were fixed, commodity markets were restricted to participants from the relevant industries and institutional investors were conventional pension, insurance and mutual funds.  Mutual and/or local institutions dominated the savings and housing finance markets, again operating on highly regulated, quasi-utility model.  Then over a 20 year period, nearly all the old rules and regulations were removed and replaced by regulations focussed almost entirely on “investor protection” and “disclosure”, i.e. you can pretty much anything you want as long as you tell everybody what you are doing and you don’t sell the products directly to Joe Public.

Financial intermediation does not add value in itself, but it helps everything else work better.  It is like oil in a car engine; the fuel and air push the pistons and drive the crankshaft but if there was no oil it would soon seize up.  The problem over the last 30 years has been that financial intermediation has become viewed as a method of value creation, but in reality it can only do this by charging more and taking value from those who actually do add value (the businesses being invested in) or the providers of the capital (the savers and investors).  And this has what they have done very successfully during that period.  The risk management models of the banks have been widely criticised, but I would suggest they were very successful; they managed to keep an inherently unstable system stabilised for much longer than it really should have done.  Using the car analogy again, they were a bit like holding an exhaust pipe together with duck tape; not recommended but can work for quite some time.

So they fed the furnaces of the money making machine, creating more and more leverage in order to generate greater numbers of transactions, slicing and dicing the economic pie (but not actually increasing it) in new and ever more ingenious ways that was meant to better allocate risk to those who can cope (which eventually meant socialising it but having the taxpayer underwrite the banks) and along the way take higher fees more often.  As an example, a typical old style mutual fund will charge a 5% upfront fee and a 1% management fee, while a typical hedge fund or private equity fund will take 2% annual management fee, a 20% performance fee once a hurdle rate has been achieved and a 10% carried interest for the management.

So how does this relate to gas prices?  The increasing involvement of financial investors in the oil market will certainly have contributed to increased volatility and have probably exacerbated prices rises, particularly recently when investors have been scrabbling to to find investments in the commodities sector, but I believe it is deeper than that.   Oil is a limited resource and by all reasonable measures I have seen, we have reached the “peak oil” point, i.e. production levels are falling, not collapsing, but gradually reducing.  This is at a time that demand is growing in economies such as China and India.  I believe that many financial investors identified this same issue and have seen the attraction of holding oil assets at a time of reducing supply are just another example of what I said 2 paragraphs back, i.e. taking an increasing slice of the economic pie.  In economic terms it is another example of “rent taking”, in just the same way as charging interest on a loan, a management fee on fund or rent on a property.

So what does this mean; in simple terms a larger slice of the economic pie is finding itself to fewer people and the rise in gas prices is just another aspect of it.  For most of the last thousand years, the general population has been in some form of “service” to the elite of the day, whether it is medieval fedalism, Tsarist serfdom, colonial slavery or the “dark satanic mills” of Britain’s industrial revolution.  The first half of the 20th century seemed to changed this; two apocalyptic world wars, the great depression and the rise of both fascism and communism appeared to result in the “masses” in western democracies getting a larger slice of the pie, almost as a reward for their earlier great sacrifices.  I ask the question as to whether that period of increased equality was a historical aberration and are we now moving to a 21st century version of feudalism, with CEOs and hedge fund managers the barons of their age? 

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