It has been flying chickens in the barnyard on Wall Street for two months now, as falling oil prices came out of the sky like a redtail hawk, scattering analysts and leaving investors concerned, confused and clucking. As with Great Financial Crisis, the unexpected has quickly been labeled “exogenous.”
On Monday Goldman Sachs moved markets with its note calling for “lower for longer,” cutting its six-month price target from $70 to $49. (Never mind Goldman’s history of bad calls on oil, nor its central role in commodity speculation and manipulation.) On Tuesday, the New York Times opined, “The oil industry, with its history of booms and busts, appears to be in the early stages of its latest downturn… What’s behind the Drop? It boils down to the simple economics of supply and demand.”
Instead, the oil price crash is best seen as what we are going to call an “endogenous shock” – a violent event not expected by the mainstream, nor explained by its model. Like the debt bubble that expired in 2008, the oil and commodities decline was wholly predictable in nature if not in timing.
IDEA’s 2015 Outlook was released this week. Authored by Steve Keen and subtitled “Global Debt Deflation and Manipulated Asset Markets,” the Outlook describes in detail the threat of excess private debt on economies around the world. Sagging demand from stagnating economies weighed down by historically unprecedented levels of private debt. Much of the growth in that debt in the last five years has gone into energy and into financial assets. Very little has gone into real investment by government or corporations in physical or human capital. The inevitable outcome has been buoyant prices in financial assets, ballooning incomes and paper wealth for the owners and traders of those assets, and a real economy that has been left to stagnate. The Outlook goes into detail for major economies.
Practicing economics while ignoring the weight of private debt and the manipulation of asset markets is like sailing without paying attention to the wind. Sudden changes in fortune, even capsizing, may be unexpected, but are hardly to be ascribed to outside forces.
Financial markets have ridden to new highs on the Fed’s QE, the Greenspan/Bernanke put. Nothing illustrates better than the price of oil.
Figure 1: Price of Oil v. the Fed’s QE
Figure 2: The Financialization of Oil
Figure 3, Oil Prices (Brent Crude) since 2000
As impressive of Ponzi finance as is the direct line of prices from north to south, also worth a note is the improbable and regular pattern between 2010 and 2014, when billions of dollars were made trading commodities and billions more in financing the American oil miracle, a period of central bank credit at zero and trading houses cited for commodity speculation..
The fall in oil and gasoline prices is welcomed by households and trumpeted by the sell side on Wall Street to the effect that this will be a great boon to disposable incomes and thus a positive for the economy. But consumers smooth their consumption when they can, and may choose to pay down debt with unexpected income. Indicators such as consumer confidence and small business optimism rose. Retail sales did not. More to the point, falling prices themselves indicate weak demand.
For oil producers, the price drop is a calamity. Venezuela, Nigeria, Russia and others depend on plus $60 oil to fund their budgets and keep domestic harmony. For frackers, the prospect is similar. Capital costs are now sunk costs, and there is debt to pay. Producers will continue to pump at almost any price, plus they have debt service to pay. This leads to a short-term problem for the New York Time’s “simple economics,” a downward sloping supply curve. As prices drop, producers are pumping more, not less.
Much as with the housing bubble, oil has been financialized by commodifying debt through derivatives. With the aid of a massive expansion of low-cost credit and leverage, global Wall Street has pyramided risk on what was believed to be the solid collateral of oil in the ground. That risk has been distributed to the usual suspects: investors stretching for yield, including pension funds.
Can the oil crash lead to another financial crisis?
The financial sector is heavily exposed to oil. Trillions of dollars in junk bonds, loans and derivatives – debt – are based on the collateral of oil. Earnings reports coming out on Thursday indicated losses in fixed income trading in the big houses which were likely attributable to the December drop in oil. But the full extent of exposure is hidden behind opaque derivatives.
It is not hard to imagine a scenario similar to that leading up to the 2008 financial crisis. In this scenario heavily indebted oil producers play the role of subprime borrowers, leveraged loans and other derivatives fill in for CDOs, and credit default swaps sit in their accustomed position of masking and even amplifying risk. In 2002-2007, investors desperate for yield pushed money into housing, with the aid of 1% interest rates. In 2009-2014, high yield energy was the plan, and rates were even lower. (Worth a look is this enthusiastic critique. Also a report on early losses in banking.)
One is reminded again of the US Senate report which determined that big players like Goldman Sachs, Morgan Stanley and JP Morgan were not satisfied with cheap chips from the Fed, and engaged in overt rigging of the wheels. Further pause is given by the last-minute insertion of language in a post-election budget bill extending taxpayer protection to commodity derivatives with a notional value of $7 trillion. This after the collapse in oil prices was well underway.
That banks have protected themselves (at taxpayer expense) prior to the fact of derivative and trading losses is not a comforting thought, but that protection may dull the edge of an event. Negotiations for write-downs and restructurings are likely to be less one-sided than in the mortgage meltdown. The appetite for another bailout is low among the broad public, but may be much higher in a Congress dependent on campaign contributions from Finance and Big Oil.
On the other hand, losses will be heavy, and interconnectedness and leverage can only complicate things. Players will face their Minsky Moments. The collapse of oil will lead to the collapse of currencies in nations such as Russia and Venezuela. While the trade balance will improve for the US, a strengthening of the dollar and fewer dollars available to pay back dollar-denominated debt will be a serious problem for the emerging market economies who owe that debt. The ramifications are unknowable.
Is this, as it is being portrayed, exogenous or endogenous to the economy? That is the question that is relevant to the reform of economics as it is practiced.
Energy itself can hardly be separated from an economy, where it is second only to labor in importance as an input. In magnitude, the commercial enterprise of oil extraction and distribution is arguably an eighth wonder of the world, over 70 million barrels a day extracted, transported, refined, sold. On the back end, even leaving aside the geopolitical engagements, the costs and impacts of energy use on the environment and thus the productive capacity of the planet, are phenomena that can be placed outside the economy only by economists’ myopia, technical term “externality.” Finance and debt likewise are exogenous only to an economics rigidly ignoring the real world.
But it is one thing to include energy and finance in an umbrella category of “economy” and another to explain the movements of oil prices as deriving from the internal dynamics of that economy.
After all, serious price disruptions occurred in the 1970s with the rise of OPEC and the Iranian oil embargo, and another price spike came with the Gulf War in 1990. To characterize these earlier episodes as endogenous would invite a longer and more difficult debate. But returning to Figure 3, in spite of the New York Times, we do not see supply and demand, but the rise of commodities as an asset class and subject to the dynamics of debt.
See also the long-run real price in Figure 4.
Figure 4: The Real Price of Oil, 1970-2015
Around 2004-2005, commodities arose as an “asset class.” Previously commodities were tradable products of investment. Although there were attempts to corner markets, or withhold product – often agricultural product – to drive up prices, such activity was not elevated to the level of “asset management.” Futures markets were used by principals – producers or consumers – primarily to hedge against price volatility. Speculators had a place in keeping those markets liquid, but did not dominate them as they do today.
This change began in earnest in the middle of 2007, when traders and investors left traditional asset markets and went into commodities, often on the theory that commodity values would rise with an inflation that was sure to follow from the Fed’s doing “whatever it takes” with monetary policy.
Oil prices peaked and then crashed in July 2008, just ahead of the headline events of the Great Financial Crisis. Subsequently prices began to rise again. Government and corporate investment stagnated in an austerity response to the recession, but investment in commodities and particularly energy, facilitated by the growth of exchange traded funds and encouraged by the big trading houses was robust. Prices found an irregular plateau in the $100-$120 range fairly quickly and remained there, with their suspicious sawtooth pattern, for four years. Now they have broken out.
Equilibrium models have to be embarrassed by such a violent change in price. It is simply not credible that supply and demand in forward-looking markets can produce such phenomena. Dynamics, on the other hand, expects them, by phase change or bifurcation (where one equilibrium gives way to another). A dynamics which includes debt and a financial sector is wholly up to the task.
The alternative – “exogenous shock” – explanation sometimes centers on the role of Saudi Arabia. (See here for a version of this explanation.) The premise is that the price collapse followed from Saudi Arabia’s refusal to cut production, and that the Saudis were targeting Russia, Iran and/or North American frackers. This and other “supply glut” explanations do not account for the sagging demand, and certainly cannot produce a chart where the price is halved in three months. Beyond this, since prices were already in freefall at the time of the Saudi’s announcement, it would have taken time travel to make such a cause precede the effect. This is eerily similar to the explanation for the Great Recession most favored by the Tea Party: that it followed from ballooning government deficits. Those deficits ballooned after the onset of the recession and were directly attributable to it. Nevertheless, Republicans were willing to go to the mat and shut down the government over the issue.]
What determines exogenous and endogenous?
Conventional economics – on Wall Street and in Academia – has treated the Great Financial Crisis as an exogenous event, coming from outside the system, the cause of events rather than an effect. As disorganized and unconvincing as it is, and in spite of some temporary self-doubt, the view quickly regained control of the narrative and never really lost its grip on policy. Prof. Keen was famously cited as the economist who best predicted the crisis and the stagnation of its aftermath, but neither his comprehensive explanation, nor that of others, nor six years of bad forecasts and a “recovery” isolated to financial markets have been sufficient to inspire review.
Sadly for the integrity of the profession, the accepted explanation for the collapse in oil will be derived in a similar manner. Economists and politicians will focus on the consequences of the great event with nine out of ten words. The causes and conditions (and dynamics) will be left to subordinate clauses reflecting the writer’s previous framework. Data and observation will be plentiful and granular in examining the crash, but the observations of those who saw it coming will not find an ear.
The weakness in oil prices derives from sagging demand. The precipitousness of the collapse is part and parcel of a speculative bubble. The level of debt is a tremendous burden on households. The change in debt, the credit accelerator, determines change in demand in an economy with stagnant incomes. Leveraging up in financial markets amounts to Ponzi debt, very susceptible to a Minsky Moment, and unless bailed out by central banks, liable to provoke crises in those markets.
Oil and commodity weakness, like the collapse of the debt bubble in 2008, is an “exogenous shock” to mainstream models. In fact, is hard to think of anything more endogenous to a capitalist economy than finance or energy. Yet we are convinced that just as in 2008, the real causes will be ignored and the narrative will be captured and eventually coalesce into an explanation that ignores debt, the familiar “simple economics.”