Will the S&P Downgrade Affect Interest Rates?

Daily Real Estate News | Monday, August 08, 2011


Standard & Poor downgraded the U.S.’s credit rating on Friday, despite Congress reaching a deal in the final hours on the debt ceiling crisis last week. And now many of your customers may be asking: What does this mean for interest rates?“The impact on your wallet of the Standard & Poor’s downgrade of the nation’s credit rating is similar to what would happen if your own credit score declined: The cost of borrowing money is likely to go up,” the Washington Post explained in the aftermath of S&P’s decision.

S&P downgraded the U.S.’s top-notch AAA credit rating for the first time in history, moving it down one notch to AA+; the rating reflects a downgrade in S&P’s confidence in the U.S. government’s ability to repay its debts over time. It’s not clear, however, whether S&P’s downgrade will instantly effect rates, analysts say.

The 10-year Treasury note is considered the basis for all other interest rates. And “the downgrade could increase the yields on those bonds, forcing the government to spend more to borrow the same amount of money,” the Washington Post article notes. “Many consumer loans, such as mortgages, are linked to the yield on Treasurys and therefore would also rise.”

Watch this video with NAR Chief Economist Lawrence Yun for more information.

While consumers who have fixed interest rate mortgages will be immune to any changes in borrowing costs, home buyers shopping for a loan or those with mortgages that fluctuate may see a rise in rates later on, some analysts say.

Mark Vitner, senior economist at Wells Fargo Securities, told the Associated Press that he doesn’t expect the downgrade to drive up interest rates instantly since the economy is still weak and borrowers aren’t competing for money and driving rates higher. However, he expects in three to five years, loan demand will be much higher and then the downgraded credit rating might cause rates to rise.

Analysts are still waiting to see if the other rating agencies, Moody’s and Fitch, follows S&P’s lead in its downgrade of the U.S. credit rating. If so, the aftermath could be much worse, analysts say.

The debt deal reached by Congress last week was expected to save the U.S. from any credit rating downgrade. However, S&P said lawmakers fell short in its deal. Congress’ deal called for $2 trillion in U.S. deficit reduction over the next 10 years; S&P had called for $4 trillion.

Source: “5 Ways the Downgrade in the U.S. Credit Rating Affects You,” The Washington Post (Aug. 8, 2011); Questions and Answers on Standard & Poor’s Downgrading of U.S. Federal Debt,” Associated Press (Aug. 6, 2011); and S&P Downgrade Will Shake Consumer and Business Confidence at a Fragile Time, Economists Say,” Associated Press (Aug. 6, 2011)

Read More

Real Estate OK in Debt Deal But Risks Remain

Commodity prices

Good news bears

Aug 8th 2011, 13:39 by The Economist online

A fall in commodity prices offers some cheer among the market gloom

THE equity markets may be suffering again as investors worry about sovereign debts and a slowing global economy. But the sell-off has also extended into the commodity market, particularly in oil: West Texas intermediate is trading at around $84 a barrel. This is a bearish story that is good news for western consumers. High raw-materials prices acted as a tax rise in the first half of the year; now they are falling the effect will be akin to a tax cut. There is just one caveat. The working assumption is that the recent sharp fall in the oil prices is caused by concerns about a slowing US economy; if it is really due to a sharp slowdown in emerging markets as well, equity markets will really have cause to worry.

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Welcome back to Earth !

BRL, you better find a parachute for you…

Deflation, your time has finally come, after 2.5 years of delay

We called it:…

We’re outperforming today as we did all of last week.

I remember in 2008 petroleum peaked in May for their highest price in history. The cause was never explained.

This price exceeded 2004 levels when the Gulf refineries were smashed by a series of Hurricanes notable Katrina and Rita. The prices exceeded the outbreaks of Gulf War 1 and 2 with Iraq and even the 9/11 attacks. The price of oil exceeded Supertankers being attacked by terrorist teams, Iran mining the critical choke point of the Strait of Hormuz where 40% of World travels, Putin’s energy cut offs, or raging piracy off the Somalian coasts.

I want to propose an actor and a plot. Follow the Money. Who has the Wealth and Power and the Means and Motive? The world’s largest exporter of oil is Saudi Arabia.

And in 2008 they saw an opportunity to influence the election of the most powerful office in the world. The Saudis grew tired of Bush and the Republicans. And the Republican Presidential Candidate McCain seem to want to open up a third war front on Iran. The other candidate was named Hussein and may prove to be a tribal brother.

And when your only tool is a hammer, every thing looks like a nail. By reducing oil imports by 5%, the Saudis can affect oil prices world wide instantly and to astonishing effect. The Saudis used their control over oil supply to jigger a shortage, which lead to price spikes 6 months before the election and precipitated the American Great Recession of 2008. John McCain argued their was no recession under Republican leadership and was soundly trounced in the election.

But this Recession snowballed into the Nov 2008 banking crisis, Lehman Bros downfall, the mortgage crisis, AIG insurance crisis, Automaker bankruptcy and the unemployment morass. All because of oil spikes.

An incumbent President’s greatest opponent is the state of the economy in an election year. And the Saudis are again using their hammer this time to LOWER the price of oil to brighten the American economy and re-elect President Obama. We are puppets on a string.

Unfortunately, the law of unintended consequence, the Recession they brought on in 2008 is still around and may be into a double dip. The Saudis are at it again doing their best to suppress the price of oil to promote a recovery.

Surprise, Money is Power! And Economic issues can influence Politics. Strange things happen in election years. Yes, even foreign actors can also pull some stringshmTzic3YT/

Your assertion that the Saudis influenced oil price to rout the Republicans in American presidential election is clever, but simply UNTRUE. The Saudis, or more accurately King Abdullah and the House of Saud, most likely WANTED warmongering hawks in the White House again, so that the US could wipe Iran and its nuclear programmes off the map. Wikileaks showed that King Abdullah, while posturing as an Islamic patriot who wanted the US to moderate its Mideast policies, privately encouraged GWB to attack Iran. This explains the confusion and the disorderliness with which the Saudi diplomatic corps to Washington D.C. have been conducting themselves vis-a-vis the Iranian issue.

And in this day and age, it is unwise to assume that the power to set the price of oil is centralized in Riyadh, Caracas or whatever. Thousands of traders tinker with the price of crude, and other governments can simply flood the market with their strategic oil reserves to drive the price down.

On this blog we publish a new chart or map every working day, highlight our interactive-data features and provide links to interesting sources of data around the we



There never was a surplus

Jul 27th 2011

YESTERDAY the White House published a chart that explains how we got from the Clinton administration projection that the government would pay off its entire debt and then build up $2.3 trillion in savings by 2011, to the $10.4 trillion in debt we actually wound up with. Of that $12.7 trillion shift, the Bush tax cuts account for $3 trillion. James Fallows explains: “As the figures demonstrated, the Bush-era tax cuts, extended last year under Obama, were the biggest single policy source of deficit increase over the past ten years. Therefore you can be for reducing deficits, or you can be for preserving the tax cuts, but you cannot rationally be for both.”

I think there’s something else we need to look at in this chart. It’s the very first item at the top of the chart’s right-hand column: the shift in the debt profile that resulted from no policy change at all, but from “Economic and technical changes (eg, lower tax revenues due to recession)”. It’s $3.6 trillion.

In other words, that massive surplus pile of government savings, or sovereign wealth, or whatever you want to call it, simply never existed.* The Clinton administration’s calculations in 2000 that the government would pay off its debt and accumulate savings of $2.3 trillion over the following ten years were wrong. And they were wrong not because of any stupid error or dramatically incorrect theory about the economic world, but simply because they failed to predict that the American economy would experience a financial crisis in 2008, followed by the worst recession since the Great Depression and a historically anaemic recovery. (I assume they failed to predict the 2001 tech-crash recession as well.) The Clinton administration delivered a couple of years of real verifiable budget surpluses in the late 1990s, and if Clintonian levels of taxation and spending had continued, they likely would have generated annual surpluses that would have shrunk the debt by over $2 billion over the decade thereafter. But the forecast that they would have eliminated the debt entirely and replaced it with trillions of dollars in sovereign wealth was a mirage.

This isn’t particularly surprising; we simply don’t know how to make long-term projections about the economy or government revenues that don’t have trillions of dollars worth of error margin on either side. Which is why we need to be careful about budgeting and get our tax rates and our spending more or less in balance over the long term, running surpluses in good years and deficits in bad ones. The Bush tax cuts did the opposite: $3 trillion worth of tax cuts were predicated on the premise that we were returning the people “their” money. As it turned out, the money wasn’t there to return. Even without the tax cuts, the wars, or anything else, the government would have entered 2011 with $1.3 trillion in debt, not $2.3 trillion in savings. Basically, in the grip of careless enthusiasm about the economic future, we borrowed $3 trillion from bond markets and handed it out to citizens in rough proportion to how rich they already were. In the middle of a recovery. This is not a useful thing for the government to do.

* I’ve changed the wording in this paragraph to avoid any potential reader confusion between annual budget surpluses, which Clinton-style budgets would have generated, versus an overall buildup of sovereign wealth rather than debt, which they wouldn’t have. (Incidentally, the fact that we don’t even have a readily available word for a buildup of sovereign wealth in the vocabulary we normally use to talk about the American government seems kind of worth noting.) Additionally, I realise that if we hadn’t had the Bush tax cuts, the entire economic story of the past decade could be different; perhaps we wouldn’t have had the financial crisis. Or maybe we would have anyway. I don’t know, and I think that takes things too far. What I’m trying to say in this post is that when you get a budget forecast that says, hey, over the next ten years we’re going to pay off our entire debt and then some, you shouldn’t go rushing out to spend the money on massive decade-long multi-trillion-dollar tax cuts. Ten-year economic forecasts are not very accurate. Not to mention the fact that your decade-long tax cut will be very hard to repeal at the end of the decade.

Dow Plunges Nearly 200 Points as Lawmakers Remain at Odds Over Debt Deal


Wednesday, 27 Jul 2011 04:13 PM


Anxiety about a deadline to raise the nation’s debt ceiling swept across Wall Street on Wednesday and drove the Dow Jones Industrial Average down almost 200 points. With Washington showing no sign it will find a solution, financial planners around the country said their clients were increasingly worried.

The Dow took a sharp drop during the last two hours of trading and closed down for the fourth session in a row. The declines have grown each day. The market turmoil was a sign that consequences of the debt fight were beginning to materialize in earnest.

With six days to go until the Treasury Department’s Tuesday deadline — raise the national borrowing limit or face an unprecedented federal default and unpredictable fallout in the economy — analysts suggested the market would only grow more volatile.

“The longer we go without any type of hope or concrete plans for resolution, the more concerned investors are going to become,” said Channing Smith, a managing director at the financial firm Capital Advisors Inc.

‘A Compelling Argument for a Chilling Conclusion’ — S&P
Over one million Americans have heard the evidence for 50% unemployment, 90% stock market crash, and 100% inflation. Be prepared. See the Evidence Now.

While no one was panicking, financial professionals who handle the investment accounts of everyday Americans — college funds, retirement accounts and other nest-eggs — said their customers were growing more worried by the day. One said he had not seen this level of anxiety since the 2008 financial crisis.

“We’re getting a ton of calls,” said Bob Glovsky, president of Mintz Levin Financial Advisors in Boston. “It’s all `What happens if the U.S. defaults? What’s going to happen to me?'”

The Dow finished the day down 198.75 points, at 12,302.55. About half of the decline came between 2 and 4 p.m., when the market closes for the day. It was the worst fall for the Dow since June 1, with 28 of the 30 component stocks losing value.

While the decline was not close to the stomach-churning days of the fall of 2008, when the Dow lurched lower and higher by 700 points some days, there were signs that fear on Wall Street was growing. The Dow fell 43 points Friday, 88 points Monday and 91 points Tuesday, then more than twice that on Wednesday.

“Right now the clouds are gathering,” said Chris Long, a financial planner in Chicago.

Without a deal by Tuesday, the Obama administration has said the government will be unable to pay all its bills, and could miss checks to Social Security recipients, veterans and others who depend on public help. In addition, credit rating agencies could downgrade their assessment of the government’s finances, further unnerving financial markets and perhaps causing interest rates to rise for everyone.

Already, some investors are taking precautions. Richard Shortt, 66, of Somerville, Mass., worries that a default, or even just a downgrade of U.S. debt, could cause bond and stock markets to tumble. Last week he sold about 10 percent of his stock holdings and put the proceeds into a money-market mutual fund.

“It might just be a short-term decline in the markets, but it could last a week or two while this gets resolved,” said Shortt, a semi-retired small business consultant. “If we do get any sort of debt downgrade, even if we avoid a default, that will change the game a bit.”

Financial advisers typically tell their clients not to tinker with their portfolios or try to play a short-term move in the market to their advantage. Of course, leaving investments alone could be a test of patience for the rest of this week.

On Friday afternoon, for example, it’s plausible that Congress could reach a deal in mid-afternoon and send the Dow soaring 300 points in the final hour of trading. It’s also plausible that there’s still no deal and traders decide staying in the market over the weekend is too risky, and send the Dow plunging.

Investors who rode out the financial turbulence in 2008 without rejiggering their portfolios have made up most of their losses. The stock market has almost doubled since its post-meltdown low in March 2009. Many people who withdrew their money from the stock market during the worst haven’t come close to breaking even.

“Trying to adjust to something on a day-to-day basis is how you get hurt,” Glovsky said. “You’ve got to take a long-term approach.”

The memory of the fall of 2008 remains vivid. The Dow plunged 778 points in a single day when Congress surprised investors by rejecting an early version of $700 billion legislation to bail out the nation’s biggest banks.

“We’ve been through this, or something like it,” said Leisa Aiken, a financial planner in Chicago. “I think what we went through in 2008 has toughened clients up a little. They realize that they will get through it if they don’t give in to a knee-jerk reaction.”

This time around, analysts say, the chances of similar turmoil are small but growing. Standard & Poor’s, one of the rating services, has said that “the reverberations of the showdown may be deep and wide — particularly if Washington does not come to a timely agreement on the debt ceiling.”

Bond traders were still betting on a last-minute deal on the debt. The yield on the 10-year Treasury note, which should rise when investors believe there is a greater risk they won’t get their money back, has stayed near 3 percent all month.

Even if Washington sails past the deadline without raising the debt limit, bond traders believe the Obama administration will keep up its interest payments and cut spending on everything else. The resulting shock to the economy and other financial markets would make Treasury bonds a safe place for investors to hide, which could result in lower yields.

For individual investors, experts are cautioning against overreaction.

Financial planner Jim Pearman, a principal in Partners in Financial Planning in Roanoke, Va., said he was telling clients his firm isn’t changing its investments based on a “game of chicken” in Congress.

“You have to make two decisions right when you try to time this thing. One is when you get out, and the other is when you get back in,” he said. “It’s hard to make that. We don’t try.”

One measure of investor concern, the Vix, or volatility index, shot up 14 percent on Wednesday. The tone of the market changed this week, as nervous investors began moving money out of stocks, said Howard Ward, a chief investment officer at asset manager GAMCO.

He said the stock market will likely become more volatile as the weekend nears, and while he said he was not repositioning his portfolio, he admitted: “Right now I’m pretty worried.”

Read more: Dow Plunges Nearly 200 Points as Lawmakers Remain at Odds Over Debt Deal
Important: Can you afford to Retire? Shocking Poll Results

Housing markets

Will housing save America’s economy?

Jun 20th 2011, 14:35 by R.A. | WASHINGTON

BACK in February of 2009, Paul Krugman was worrying about an insufficient policy response to the recession and he pondered the question: if America is to muddle through with too little stimulus, then how will growth return?

[R]ecovery comes because low investment eventually produces a backlog of desired capital stock, through use, delay, and obsolescence. And eventually this leads to an investment recovery, which is self-reinforcing.

And what do we mean by use, delay, etc.? Calculated Risk had a nice piece on auto sales, which I find helps me to think about this concretely. As CR pointed out, at current rates of sale it would take 23.9 years to replace the existing vehicle stock. Obviously, that won’t happen. Even if the desired number of vehicles doesn’t rise, people will start replacing vehicles that wear out (use), rust away (decay), or just are so much worse than newer models that they’re worth replacing to get the spiffy new features (obsolescence).

He mentions automobiles, but there is another, somewhat surprising possibility—that housing will lead the way to a durable recovery. This may seem strange to suggest. An epic housing collapse following a massive housing boom helped to trigger the downturn. Residential investment has been a drag on growth for five consecutive years. And yet some writers, like Karl Smith and Calculated Risk, are hinting that a housing recovery may be on the way. Matt Yglesias hints at one reason why with this chart:

As Mr Yglesias notes, housing starts have been at an unprecedentedly low level for a strikingly long period of time. And during that period, America’s population has continued to grow. Eventually, whatever the economy is doing, Americans require new houses, new houses mean new construction, and new construction means new employment. Rising rents were one of the factors pushing core inflation higher last month, and increasing rents will soon translate into construction.

Meanwhile, there is a larger demand backlog than most people may imagine:

America doesn’t simply face a situation in which housing has failed to keep pace with the growth in population. Since the onset of recession, household growth has fallen short of population growth as families doubled- and tripled-up on housing to economise. There are now nearly 2m fewer households than one would expect given growth in population. As economic conditions improve, many individuals and families now living with others in order to save money will seek their own homes. That should spark a period of catch-up household growth, which should in turn spark a large rise in rents and new construction. A recovering construction industry would help soak up unemployed workers, continuing a virtuous cycle of recovery. After five long years, housing may finally start pulling its economic weight again, or so many Americans must hope.


Oil markets and Arab unrest

The price of fear

A complex chain of cause and effect links the Arab world’s turmoil to the health of the world economy

Mar 3rd 2011 | BREGA, LONDON AND WASHINGTON, DC | From The Economist print edition

TWO factors determine the price of a barrel of oil: the fundamental laws of supply and demand, and naked fear. Both are being tested by the violence that is tearing through Libya, the world’s 13th-largest oil exporter. The price of a barrel of Brent crude now hovers around $115. On February 24th, however, it rose to almost $120, as traders realised that they might have to do for a while without some or all of Libya’s exports: some 1.4m barrels a day (b/d), or about 2% of the world’s needs.

The situation in Libya is grim, as the rebels and the forces of Muammar Qaddafi battle for control of the country’s only resource. Brega, the seat of the Sirte Oil Company in the east of the country, has changed hands three times in recent days. Most of the oil workers have fled, and production has fallen by two-thirds. The ports of As Sidra, Brega, Ras Lanuf, Tobruk and Zuetina, which together handle almost 80% of Libya’s oil exports, were all seized by the rebels; two have now been retaken by Colonel Qaddafi’s forces. The rebels remain in control of Africa’s largest oilfield, Sarir, pumping some 400,000 barrels on a normal day. But for how long?

The history of oil is marked by Middle Eastern strife, supply shocks and global recession, with the Arab oil embargo in 1972, the Iranian revolution in 1978 and Saddam Hussein’s invasion of Kuwait in 1990. To gauge the risks today you need to answer three questions. How vulnerable is the oil market to an interruption in supply? How sensitive is the world economy to oil-price spikes? And how well can policymakers cope with a shock if the worst happens? Take each in turn.

The troubles in Libya are only the most serious example of the impact of Arab unrest on global oil markets. Prices jumped as Egypt’s citizens took to the streets to oust President Hosni Mubarak. Egypt is an oil importer, but acts as a vital conduit between the huge oilfields in the Persian Gulf and markets in Europe, via the Suez Canal and through the SUMED pipeline. Although it seemed unlikely that protesters would or could disrupt oil shipments, events in Cairo were enough to add more than $5 to a barrel.

The spread of unrest to Bahrain, Oman and the Gulf has created a whole new dimension of anxiety. North Africa produces 5% of the world’s oil, but the Middle East produces 30%. Moreover, Bahrain’s problems are on Saudi Arabia’s doorstep. These bear on the situation in the eastern Saudi provinces, from which a huge quantity of oil is pumped into global markets.

Saudi Arabia is therefore the traders’ chief worry. But it is also, in oil terms, the world’s chief hope. It is the only producer with significant spare capacity that could quickly be released if the oil price rose too high. Although OPEC, in which Saudi Arabia is the biggest force, exists to keep oil prices buoyant, it does not want to see them reach a point where the world economy is damaged and demand for oil falls. When prices spiked in 2008, the Saudis said they had capacity to spare. Terrified oil markets doubted its existence, and prices rose anyway, to reach $145. Yet the subsequent collapse in the oil price in the second half of 2008 was only partly caused by the credit crisis and the rich-world recession that resulted. Saudi Arabia also pumped extra oil: nearly 2.5m b/d on top of the 8.5m it was already providing.

OPEC’s spare capacity now is put at anything between 6m b/d (by OPEC) and 4m-5m b/d (by industry analysts); Saudi Arabia’s share of that excess is perhaps 3m-3.5m b/d. The oil price has retreated from its peak in the past ten days largely because Saudi Arabia says it is pumping up to 600,000 b/d to replace the shortfall in Libyan exports. It has invested heavily in expanding capacity, with plans to spend perhaps $100 billion on wells and infrastructure by 2015. It has also been far more open about letting the world see what it has done. OPEC’s stated aim of stabilising oil prices relies on traders believing that the Saudis really do have the capacity to pump more when prices rise.

Why, then, are traders still so nervous? The answer is that the long-term trends of supply and demand were already unfavourable when the Arab shoe-throwers intervened. Before the uprisings, a barrel of Brent crude was commanding close to $100 a barrel. World demand grew by an extraordinary 2.7m b/d in 2010, according to the International Energy Agency. It will probably keep growing by another 1.5m b/d this year and the same again next, as the rich world recovers and demand surges in China and the rest of Asia. Net expansion of non-OPEC supplies is likely to be negligible in the coming years. Though the rich world’s inventories are high, with cover of around 50 days, it is not clear that Saudi Arabia can pump much more than it did in 2008; and the speed of oil released from government reserves, such as America’s Strategic Petroleum Reserve, also has upper limits.

If disturbances hit Algeria and threaten its oil industry too, the buffer of spare capacity would fall below where it stood in 2008. But demand now is much higher, so spare capacity as a proportion of that demand is much lower (see chart 1).

When oil markets tighten, another set of problems emerges. Saudi oil is generally more dense and sulphurous than the Libyan crude it will replace. Europe’s creaky old refineries will not be able to process the heavier Saudi crude, and fuel regulations there are less tolerant of sulphur content than elsewhere in the world. So the Gulf oil will have to be shipped to Asia’s newer refineries, which are designed to deal with a wide variety of grades of oil. West African oil, a close substitute for Libya’s output which usually goes to Asia, will be sent to Europe instead.

If the supply situation worsens, opportunities for this type of substitution will be fewer, creating supply bottlenecks, shortages of petrol and spikes within price spikes for different crudes and products, even when spare capacity remains. The price differential of about $15 a barrel that has built up between Brent crude, which more closely reflects global trade, and West Texas Intermediate, the benchmark for oil prices in America, is a good example of how oil markets can become distorted by local patterns of supply and demand. If supply gets even more stretched, oil could fetch a far higher price in some parts of the world than others. If supply problems become really grave, oil companies may even declare force majeure, raising the prospect that, as in 1978, oil markets fail altogether.

That is still a remote prospect, and the upward march of the oil price seems to have paused for now. The crucial question is how much oil will be lost, and for how long. When oil markets operate at the limits of supply, even the smallest extra disruption has a disproportionate effect. On February 26th, for example, Iraq’s biggest refinery shut down after a terrorist attack. This and other assaults could knock out another 500,000 b/d from the world’s fuel supplies. And if the raids on oil installations in previous elections in Nigeria are anything to go by, the next one, in April, may threaten another 1m b/d of supplies from west Africa. Meanwhile, Saudi Arabia remains far from secure (see article). On March 1st the country’s stockmarket, jittery about the neighbours, plunged by 7%, a worrying sign that confidence is fading.

Hobbling the world

All this is a dark cloud on an otherwise bright horizon for the global economy. Few things can short-circuit growth like an oil shock, both because of the fuel’s ubiquity and because of the relative insensitivity of demand. When the oil price jumps, consumers have little choice but to accept it, spending less on something else.

So how sensitive is the world economy to oil prices? Thus far the rise, and the likely damage, both look modest, in part because many forecasters had expected an increase this year anyway. Since the end of last year the price of Brent has risen by $23 a barrel, or about 25%, and West Texas Intermediate by $10, or 10%. The IMF reckons that a 10% increase in the price of crude shaves 0.2%-0.3% off global GDP in one year. As it happens, crude oil (using a blend of several grades), is now about 10% more costly than the IMF assumed in late January, when it projected global growth of 4.4% this year. That implies that the Fund would now foresee growth of about 4.2%.

Economists do not expect a repeat of the 1970s, when oil-price rises led to “stagflation” in the rich world. Olivier Blanchard, chief economist of the IMF, and Jordi Galí, of the Centre de Recerca en Economia Internacional in Barcelona, point out that two recent oil-price rises—one beginning in 1999 and another in 2002—were of the same order of magnitude as during those turbulent years. But the effect on both inflation and unemployment in the rich world was much smaller: in America, for example, a rise in inflation of only 0.7 percentage points on average, whereas the 1970s shocks had caused a rise of 4.5 points in the two years after the shocks.

The rich world is less vulnerable now because it has substantially reduced the amount of oil used per unit of output. America’s economy in 2009 was more than twice as large in real terms as in 1980. Yet over that period America’s oil consumption rose only slightly, from 17.4m b/d to 17.8m. Europe actually used less oil in 2009 than in 1980, even though its economy had grown.

Other factors may also have helped. Supply shocks generate larger increases in inflation and bigger falls in output when wages are rigid. So oil shocks have smaller effects today, because labour markets in rich countries have become considerably more flexible since the 1970s.

Emerging economies may be hit harder by a spike, since they use more oil per unit of output than rich countries do (see chart 2). America’s economy, though about three times the size of China’s, uses just over twice the amount of oil that China’s does. But oil intensity in emerging countries has also been falling in recent years, as manufacturing has become more efficient and less energy-intensive service industries have increased their share of the economy. So even these countries are less vulnerable to an oil shock than they used to be.

Among rich economies America tends to suffer the biggest immediate impact, because its economy is relatively energy-intensive and because its low petrol taxes interpose only a small wedge between crude oil and petrol prices. Goldman Sachs estimates that a 10% price increase trims GDP by 0.2% after one year, and 0.4% after two.

In Europe the effect is muted by lower energy intensity and high levels of tax. Excise and value-added tax represents roughly 60% of petrol prices and 52% of diesel prices in the euro area, according to the European Central Bank (ECB).

Emerging Asia is more complicated. Although its economies are more oil-intensive, several also export oil, and many subsidise fuel, limiting the impact on consumers. Thailand has resolved to hold the price of diesel below 30 baht (about $1) a litre until April; without the subsidy, which was raised on February 24th, it would be 34 baht. Citigroup estimates that each $10 increase in the price of oil costs India’s state-owned oil-marketing companies the equivalent of 0.5% of GDP, of which half is absorbed by the budget. An IMF staff study has estimated that emerging and developing countries subsidised fuel by about $250 billion in 2010.

Loosening, or tightening?

What can central banks do to protect the economy? Higher oil prices act as a tax on countries that import the stuff, which would normally call for easier monetary policy. But they also raise inflation, which calls for tightening. A one-off rise in prices would not produce a sustained increase in inflation, unless it boosts firms’ and workers’ expectations of future inflation, which can become self-fulfilling. The oil-price shocks of the 1970s rapidly found their way into broader inflation. Central banks had to clamp down drastically to suppress their inflationary effects.

In recent years, with inflation expectations more stable, central banks have responded more moderately to higher oil prices. But in July 2008 the ECB raised short-term interest rates because it feared that a rise in headline inflation would feed a wage-price spiral. In retrospect, that was a mistake. The global economy was already slowing, and over the next year both headline and core inflation (which excludes energy) fell sharply in the euro zone. Although America’s Federal Reserve did not tighten, it hinted at the possibility, which prompted markets (wrongly) to anticipate a rate increase. These hawkish signals may have compounded the slide in economic activity already under way.

This year their response is likely to be more subdued. Unemployment is higher in America and Europe than in 2008, and underlying inflation, except in Britain, is lower. At a forum on February 25th at the University of Chicago, officials from both the European and American central banks signalled willingness to hold fire unless inflation expectations grow. On March 1st Ben Bernanke, chairman of the Federal Reserve, said the recent rise in commodity prices would probably “lead to, at most, a temporary and relatively modest increase” in inflation.

In many emerging markets the risks are greater. Those economies are already operating at capacity, and both overall inflation and core inflation have risen: China’s January inflation rate was 4.9%, well above its official 4% target, and India’s was more than 9%. An increase in the price of energy can cause a steeper jump in inflation in emerging markets, because in many it has a larger weighting in their consumers’ baskets: 15.2% in Indonesia, 14.2% in India and 13.8% in Malaysia, compared with about 9% in America’s. Moreover, energy is a large input in food production, which has an even bigger weight.

Monetary policy has also been relatively loose in these countries, with real short-term interest rates negative in many of them, including, by some measures, China. Johanna Chua of Citigroup reckons that monetary conditions, including both interest rates and the exchange rate and, in China’s case, credit growth, have tightened already in Asia, but need to tighten further in both China and India.

The reason for a rise in the oil price is as important as how large it is. An increase forced by higher demand is less dangerous than one driven by constricted supply, because it is evidence of a healthy global economy. If rapid growth means that China and India are importing more oil, they are probably importing larger amounts of other things as well, lessening the pain for slower-growing consumers of oil.

Nonetheless, whether driven by demand or supply, a large enough spike in the price of oil can do great damage. Economists call such abrupt responses “non-linearities” and they suggest that when the price rises fast enough, consumers and businesses trim their spending and investment plans. This is often because prices are driven by other factors that hurt confidence, such as wide unrest in the Middle East. If another Arab government were toppled, pushing the oil price over $150, the economic impact would almost certainly be larger than the 0.5% to 1% of GDP that simple extrapolation suggests.

James Hamilton, of the University of California, San Diego, has identified numerous periods since the late 19th century in America when an abrupt rise in the price of oil or petrol coincided with recession. Many of these were caused not by an interrupted supply, but by demand growth colliding with unresponsive supply. That seems to explain the price spike above $140 in mid-2008. Although the financial crisis was the main cause of the recent recession, Mr Hamilton argues that oil explains why the economy had already begun contracting before the worst of the crisis hit that autumn. Robert McNally, of Rapidan Group, a consultancy, concurs, arguing that American consumer confidence fell sharply once petrol went past $3 a gallon (see chart 3). It is now at $3.38, after the biggest one-week increase since Hurricane Katrina in 2005.

Even if the unrest leaves supply unaffected, significantly higher prices may be only a matter of time. The same dynamic that drove the oil price skyward in 2008 is steadily reasserting itself. Supply is not growing substantially, and global demand, which regained its pre-recession peak last year, is expanding briskly again.

Given enough time, the rich countries should be able to adjust to higher prices. Jim Burkhard of IHS Cera, a consultancy, notes that OECD oil demand peaked in 2005 and has been slipping since in response to the upward march of prices. In America a shift in consumer purchases towards more fuel-efficient vehicles, ethanol mandates and higher fuel-economy standards have all capped growth in petrol demand. Meanwhile, the higher world price has unlocked new supply within the United States, and elsewhere, which was previously too expensive to exploit.

Yet it may take years for such trends to dent demand and boost supply by much; and the world may not have a lot of time. “Historians will look back on 2008 as the first time in modern memory that spare capacity ran out without a war in the Persian Gulf, and OPEC failed to cap prices,” says Mr McNally. “Eventually we’ll replay that scenario. If OPEC can’t control the market any more, that means prices will have to swing much more.”


The great debt drag

America looks likely to avoid a second recession. But with households still overburdened by debt, years of slow growth lie ahead

Sep 16th 2010 | WASHINGTON, DC | From The Economist print edition

IN THREE decades of selling cars in southern California, David Wilson has been through countless ups and downs. So when sales at his 16 dealerships, mostly around Los Angeles and Orange Counties, fell by a third in 2008, he naturally expected them to go up again. They still haven’t.

Mr Wilson now realises that his boom-year sales were a by-product of the state’s housing bubble. Dealers reckon that before the crisis a third of new cars in California were bought with home-equity loans. “Now there’s no home equity,” says Mr Wilson, “there’s no down-payment for cars.” He foresees no sales growth for another two to three years. “The country is not optimistic. If you’re not optimistic you don’t buy a new house or new car.”

He’s right: Americans are not optimistic. Official statistics say that the economy has been growing for nearly 15 months, but so sluggishly that most people seem to think it is still in recession. For a few months it looked as if the economy might even shrink again, as growth slowed to a mere 1.6% (at an annualised rate) in the second quarter, job creation almost stopped and home sales plunged.

Admittedly, the second quarter may have been unlucky, as Europe’s debt crisis and the BP oil spill sapped business confidence and an anomalous surge in imports ate into growth. More recent indicators on jobs and trade have all but put to rest fears of an imminent return to recession. A burst of corporate mergers, including several bidding wars, suggests business’s animal spirits are returning. Nevertheless, in the third quarter the economy has probably been growing at a rate of only 1.5-2%. A pace of 2-2.5% is likely in the fourth.

Since the recovery began, the economy has grown at a rate of less than 3%. That is faster than its long-term potential, of about 2.5%, but America has woken from past deep recessions at rates of 6-8%. Job creation has thus been too feeble to bring down the unemployment rate, which at 9.6% is much as it was at the start of the recovery. “Progress has been painfully slow,” acknowledged Barack Obama on September 8th—not what a president likes saying less than two months before an election.

What makes this recovery different is that it follows a recession brought on by a financial crisis. A growing body of research has found that such recoveries tend to be slower than those after “normal” recessions. Prakash Kannan, an economist at the IMF, examined 83 recessions in 21 rich countries since 1970. In the first two years after normal recessions growth averaged 3.7%. After the 13 caused by crises, growth averaged 2.4%. America has been doing slightly better than this (see chart 1).

The Federal Reserve brought on most post-war recessions by raising interest rates to squeeze out inflation. When the Fed cut rates, demand revived. Financial crises interfere with the transmission of lower rates to private borrowers. People can’t or won’t borrow because the value of their collateral—in particular, houses—has fallen. Banks are less able to lend because their capital has been depleted by bad loans, or less willing because customers can’t meet tighter underwriting standards.

“Where we are in the economy shouldn’t be surprising,” says Vikram Pandit, chief executive of Citigroup. Mr Pandit sees only two sure things ahead: that American consumers will continue to cut their debt (deleverage, in financial argot) and that emerging markets will grow quickly. At Citi, transaction-service revenues, such as foreign-exchange and cash management for multinationals, are growing healthily while revenue from American consumer loans is shrinking.

This reflects the economy as a whole. Exports have kept growing this year—but so have imports, so net trade has not contributed much to growth. Indeed, the IMF, which thought a year ago that trade would add to growth over the next four years, now sees it subtracting, in part because of trading partners’ slower growth. Business investment in equipment, brisk early in the recovery, has slackened. Firms may be reluctant to invest and hire partly because of uncertainty over Mr Obama’s regulatory and tax initiatives, but concern about consumer spending seems more important. Government spending has helped fill the hole, with direct federal injections of cash and cuts in taxes. But much of the federal effort has been neutralised by state and local cuts. And the stimulus is winding down. The end of a tax credit has caused the housing market new pain.

So if the economy is to grow much faster than its 2.5% trend, consumers must start borrowing and spending again. What is holding them back: are they reluctant to borrow, or are banks unwilling to lend?

Atif Mian of the University of California at Berkeley and Amir Sufi of the University of Chicago have found a close correlation at county level between car sales and household debt. The heavier the debt in a county at the start of the recession, the weaker sales have been since (see chart 2). Mr Sufi says large national banks have customers everywhere. So the sales gap suggests that debt-laden households are unable or loth to borrow.

This tallies with Mr Wilson’s experience. Leasing, which requires little or no down-payment, has grown from 25% of his business before the crisis to 40%. A customer who has defaulted on his mortgage but not his car payments can still get a car loan. But his interest rate and down-payment will be much higher—and may be unaffordable. And the heavily indebted need time to repair their finances. Melinda Opperman of Springboard, a credit-counselling agency with offices in five south-western states, says a typical debt-management plan takes three to five years to complete.

Tight-fisted, or frightened?

On the other side of the table, banks seem to have plenty to lend. Their capital equals almost 12% of assets, up from less than 9% in 2006. Recently analysts asked Mr Pandit why he was letting capital “build to ridiculously high levels” and why cash and other sources of liquidity “seem to keep going up all the time”. Moody’s, a ratings agency, has estimated banks’ total loan charge-offs between 2008 and 2011 at $744 billion, of which $476 billion has already been recognised in their accounts. They have enough loan-loss reserves to cover 80% of the remaining $268 billion.

But no one is really sure whether banks have adequately disclosed, or even know, their ultimate exposure. The IMF estimates that 11m properties are worth less than the mortgages secured on them, and that 7.6m of these are heading for foreclosure or are at risk of it. Banks have probably not recognised the likely losses on many of these loans, but there is no way of knowing. Christopher Whalen of Institutional Risk Analytics, a research firm, thinks charge-offs are understated by a third.

How long will deleveraging take? In a recent paper Carmen Reinhart of the University of Maryland and her husband Vincent Reinhart of the American Enterprise Institute looked at 15 crises since 1977. They estimate that on average deleveraging lasted seven years, during which growth was a percentage point lower than in the decade before a crisis. If America follows this pattern, its GDP will grow by 2.4% for the next four to seven years. Because that roughly equals potential, job creation should only just match population growth: the unemployment rate won’t fall.

Few economists are that gloomy. Most think a prolonged period of easy monetary policy and a slow release of pent-up demand for durable goods and homes can yield growth of at least 3%. Some also think that deleveraging is ahead of schedule. Richard Berner of Morgan Stanley predicts that, thanks in part to falling interest rates, debt service will be back to a “sustainable” 11-12% of disposable income later this year. Peter Hooper and Torsten Slok of Deutsche Bank reckon that if saving stays at about 6% of income, write-offs remain near today’s elevated level and household income rises by 4.5% a year, household debt will fall from 126% of disposable income now to around 85%, where it was in the early 1990s, by 2013 (see chart 3).

These calculations will be wrong if incomes stumble or consumers seek to save more than expected. The IMF notes that saving rates in Finland, Norway and Sweden ultimately rose by five to ten percentage points after housing busts in the late 1980s. America’s saving rate has gone up by four points so far.

More cheerfully, the Reinharts find that once economies start to grow after a crisis they tend not to slide back into recession without suffering some new shock. Spain, whose banking crisis began in 1977, was dragged back by global monetary tightening in the early 1980s. Countries recovering from the East Asian crisis of 1997-98 were hit by avian flu, the bursting of the American tech bubble and the economic effects of the terrorist attacks of September 11th 2001. Japan is a special case. It was shoved back into recession partly by its own policies: an ill-timed tax increase in 1997 and the (temporary) ending of the Bank of Japan’s zero-interest-rate policy in 2000.

American policymakers seem determined to avoid Japan’s mistakes. Unless the outlook improves dramatically the Fed is likely to resume quantitative easing (buying bonds with newly printed money in an attempt to drive long-term interest rates even lower). The subject will be on the table at its meeting next week. Fiscal policy is more of a problem: more stimulus is unlikely and it is unclear whether George Bush’s tax cuts, due to expire in December, will be extended. Senate Republicans want to keep them all; Mr Obama wants rid of those for the rich.

Without more action, though, deleveraging could drag on for a long time. South Korea and Sweden owed their relatively robust recoveries to policies to remove bad loans from banks’ balance-sheets. That was the original purpose of the Troubled Asset Relief Programme (TARP), before it was used to recapitalise banks, bail out carmakers and subsidise loan modifications.

America could hasten deleveraging and improve workers’ ability to move to new jobs by being more eager to cut the principal on mortgages to sums closer to homes’ actual values. That would often both be cheaper for lenders than foreclosure and let owners keep their homes. But cuts in principal have been rare—applied to a mere 120 of the 120,000 mortgages permanently modified through the federal government’s programme between October 2009 and March 2010. Banks don’t want to let borrowers who can really pay off the hook, to give others an incentive to default, or to recognise more losses.

Bankruptcy laws could be changed to allow courts to reduce principal, much as they can for the debt of a company in Chapter 11. John Geanakoplos of Yale University has argued for special federal trustees, empowered to insist on modifying or foreclosing impaired loans. They would choose the course giving the lender the highest return.

However, forcing banks to recognise losses would erode their capital. Some could raise more if they needed it, but others might fold. Since the TARP was wound down, the federal government has no money for buying the loans or recapitalising banks—and there is no political appetite for doing so. Indeed, arguably the opposite is happening as Fannie Mae and Freddie Mac, the two nationalised mortgage agencies, seek to compel banks to buy back loans of doubtful quality they had sold to the agencies.

There are, in theory, many ways to hasten recovery after a crisis. But Mr Reinhart says that policymakers are usually too “timid” to pursue them. In that respect, America is following the script.

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