Anna Schwartz on the Financial Crisis

In 1963 Milton Friedman and Anna Schwartz published A Monetary History of the United States. It's a history of how bad monetary policy in the 1930's turned a stock market crash and recession into the Great Depression. Anna Schwartz is still working at NBER, and she has a few thoughts on what's happening this time around. She doesn't see the current crisis as one caused by a lack of liquidity.

To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Why does the price of oil change so much?

I got an interesting question in class on Friday. We were talking about the recent economic news, and one of the items was that oil had traded below $70. It was over twice that a few months ago so the quite obvious question was, "Why does the price of oil change so much?"

The simple, but unsatisfying answer is that it's all speculation. And truth be told, it is all speculation, but as an economist, we like to call it something else. What we like to call it is the Marginal User Cost.

Oil is a mineral. It is a non-renewable natural resource. There appears to be a fixed amount of it in the earth's crust which means that if we produce some today, we won't have it to produce tomorrow. Because of that, we break the cost of a non-renewable natural resource into two parts - the Marginal Extraction Cost and the Marginal User Cost.

The Marginal Extraction Cost is fairly straightforward. It is the incremental cost of extracting (producing) the next unit of the resource. For oil today, my guess is that it's around $40 a barrel. Said another way, it's the incremental cost of producing the most expensive barrel of oil we currently provide to the marketplace. Oil from some fields in the middle east come in at about $2 a barrel. The expensive stuff is deep offshore and from rather nasty places like the North Sea. Tar sands are in this range, and oil from shale is a bit out of this range.

As the Marginal Extraction Cost increases, so does the cost (price) of the resource. (Remember that prices are set at the margin.)

The Marginal User Cost is different. Since using the resource today means that we don't have it to use tomorrow, we pay a cost for that. The marginal user cost is the incremental cost of not having that unit of the resource to use in the future. That also means that the Marginal User Cost is dependent upon how people view the future.

If people believe that we will have substantially less of the resource available in the future, then the Marginal User Cost goes up. If they think we will have somewhat more, the Marginal User Cost decreases.

In addition, how much people discount future values changes the Marginal User Cost. If you heavily discount future values (a higher interest rate) the Marginal User Cost decreases. A lower discount rate (you value the future more highly) results in a higher Marginal User Cost. (BTW if you don't discount future values then I want to talk to you. You're going to be willing to lend me a lot of money at a really low interest rate, perhaps zero.)

So now we can talk about changes in the price of oil (or copper or any other non-renewable natural resource.) The question splits into two - what's happening to the Marginal Extraction Cost and what's happening to the Marginal User Cost.

In the short run, the Marginal Extraction Cost doesn't change much. Over long periods of time (decades or more) in real terms, this tends to go down. It seems that it ought to be increasing since we're always producing from more difficult circumstances (deeper, lower grade, further out...) However, we are an inventive lot, and we keep getting smarter about how to find and produce non-renewable natural resources and this more than offsets the other effect. (Hence I like to tell my students that as long as they keep getting smarter than we ever were, we're going to be OK.) But again, in the short run, the Marginal Extraction Cost doesn't change much.

That leaves the Marginal User Cost. When demand is increasing faster than supply it appears that there will be less of the resource available in the future so the Marginal User Cost increases. Up through the first half of 2008 this was happening with oil, copper and other commodities as demand had increased in China and India. The price was increasing faster than the Marginal Extraction Cost so it must have been Marginal User Cost. Similarly, when demand decreases, as it is today with a slowdown in the world economy, it appears that there will be ample supplies in the future and Marginal User Cost decreases. (That also implies that the Marginal User Cost is the incremental price consumers are willing to pay over the Marginal Extraction Cost so that they can consume it today and not have to wait until tomorrow. Using it in the present is more valuable than having it in the future. Some consumers will compete for the available resource today since their use is so valuable.)

Another thing that affects Marginal User Cost is the expectation of future production. If production will be restricted, as it is with oil offshore in the US, then Marginal User Cost will increase. If it appears that production will be opened up, then Marginal User Cost decreases. OPEC production quotas will affect Marginal User Cost in a similar manner if people believe that they will be enforced in the long run. (Note that if ample supplies appear to be available for the foreseeable future, the Marginal User Cost may go to zero. I think that is what happened to copper in the late 1990's. The Marginal Extraction Cost and the price in the market were essentially the same.)

So back to the original question,"Why does the price of oil change so much?" As best I can tell, the Marginal User Cost has decreased sustantially. In part I think this is due to reduced demand and in part I think this is due to the US actually talking about producing offshore resources.

Having answered that question, the obvious followup was, "Isn't that all really just speculation?" To which I reply yes, in truth it is. But as economists, we like to act like we're very precise about our guesses about the future so we call it changes in Marginal User Cost. Now you can too.

Getting Ready to Ride It Out

Small businesses are getting ready to hunker down.

Nearly 20 percent of small-business owners say they are at risk of going out of business, according to a new survey from American Express Open.

The survey is based on a nationally representative sample of 768 small-business owners and managers of firms with fewer than 100 employees.

Also

The number who expect their companies to grow during the next six months fell to 23 percent in October from 33 percent in August.

To shore up finances, more owners reported cutting back staff hours, salaries, capital expenditures and other costs.

(I don't know for sure, but a substantial number of small businesses are always ready to go out of business. So I don't know if 20% is a lot more than usual or not.)

Paint Equity Reduces Home Price

We can be awfully creative when it comes to selling something. Trend Homes in Chandler is now using "paint equity" to effectively reduce the price of its houses.

One local home builder is trying to paint itself out of a corner by handing out smocks, rollers and brushes to prospective buyers.

When builders found out in late July that the government was going to ban seller-funded down-payment assistance on Federal Housing Administration loans, they began a mad scramble to come up with another way to offer no-down-payment or low-down-payment mortgages.

After poring over FHA guidelines in search of a loophole, this is what Chandler-based Trend Homes came up with: paint equity.

FHA rules allow a home's seller to contribute up to 2 percent of the buyer's required 3.5 percent down payment as compensation for work performed by the buyer on the home.

Thus was born the Trend Homes Work Equity Program.

Previously they were simply giving the purchasers the money for the down payment.

From Shrimp to Diesel

An example of shifting capital resources (both physical and intellectual) from the production of one product to another.

When Gary Wood's family began experimenting with shrimp farming near Gila Bend in the mid-1990s, he said they kept things low-key because people would think they were "crazy."

But the tasty crustaceans eventually produced by Desert Sweet Shrimp turned into a sort of culinary sensation, garnering lots of attention and selling across the region despite their premium price.

But the farm has drastically cut shrimp production in the past few years. Sales have been hurt by imports from Asia, Wood said.

So the farm is making another bold move.

On Saturday, the farm turned on the water for several ponds where they will begin growing algae, with hopes of eventually raising enough green goo to refine their own biodiesel on site.

As they say, read the whole thing.