Oil Prices, Tech Market and the Economy, Part I

IS-LM Model

Dow Jonesy enough for you?
The New Yorker

One of my colleagues and I were recently discussing the dizzying number of stimuli trying to play tug-of-war with the US economy in general and the financial markets (public and private) specifically. There's so much going on! Collapsing oil prices, prodding at the "tech bubble", the presidential elections, burgeoning threat of terrorist activities, Kim Jong-un inching towards insanity... What does all of this mean for our economy and our financial markets. 

As an economist, I like to (over)simplify the world by thinking in terms of frameworks, and the one framework that spoke to me in my macro courses was the IS-LM model, which illustrates the Investment/Savings - Liquidity Preference/Money Supply equilibrium. Behind this almost nonsensical jargon is a simple concept that interest rates and GDP are a function of how much money is sloshing around and whether people would rather invest or save that money.  

For those of you who want the details, the IS and LM curved are derived from the aggregate demand equilibrium where output (Y) = C (consumption) + I (investment) + G (government spending) + X(net exports)

The LM curve is a little harder to understand, but an easy way to think about it is that i(interest rates) is the price of holding on to money. That is, we all would rather have money in our checking accounts, readily accessible (holding money), but if i (price of money) is high enough, we'll let someone else (mutual funds, banks, etc) hold our money and pay us for it. 

The IS curve is pretty relevant today given the collapsing oil prices. Exogenous variables (not just the price) have resulted in a glut of oil supply. Conventional wisdom would tell us that lower oil prices would boost production of items where oil is an ingredient since input prices would go down. As The Economist mentions, however, that doesn't seem to be the case at the moment. 

"Cheaper fuel should stimulate global economic growth. Industries that use oil as an input are more profitable. The benefits to consuming nations typically outweigh the costs to producing ones. But so far in 2016 a 28% lurch downwards in oil prices has coincided with turmoil in global stock markets. It is as if the markets are challenging long-held assumptions about the economic benefits of low energy prices, or asserting that global economic growth is so anemic that an oil glut will do little to help."

Let's go back to our IS-LM framework: oil prices are low, so investment in oil should decline, shifting the IS part of the curve to the left (from IS to ISd). If investment in oil is lower, producers will be reluctant to produce oil (and many may not be able to produce given their much lower income). 

As The Economist says above, it could have been possible that although the I part of Y=C+I+G+X would decline, increase in production of goods could have boosted the C and X portions of the equation, hence leaving the IS curve unchanged or even higher (to the right, to ISi). That doesn't seem to be the case this time, however. It appears that C and X, for whatever reasons, need more to boost them than lower input prices. As an example, you'd like to buy a Lucite table that costs $500 last year and now costs $400 (Consumption), but you still don't think it's a good enough deal to purchase (perhaps wages haven't risen enough, prices of other goods have risen more than you had expected, your taxes have increased, etc). 

The impact of a lower IS curve is that GDP on the X axis (output, income, yield, or whichever other measure you'd like to use) is lower and the economy is producing less. What can be done to counteract that? 

Well, usually, the Fed could just shift the LM curve to the right by spurring money supply. That is, the Fed could increase the money supply by buying bonds (less bonds, more money in the market), which is the mechanism used to achieve what everyone refers to as "reducing interest rates". With lower i (interest rates, the price of money), instead of letting someone else hold your money (put it in a savings account, a mutual fund, etc), you hold it yourself as just a store of value. 

As we know, however, interest rates are pretty close to the lowest they can be. Although rates can be reduced a little more and into negative territory with quantitative easing, there's likely a limit to how low they can go before the economy becomes topsy turvey.

Paul Krugman at the New York Times says that at the rate of 0, the LM curve should be flat, like this:

When rates are at 0, people have no incentive to buy bonds or put money in a savings account; they'd rather hold cash. Changes in the money supply have no impact, which is known as a liquidity trap.

"And IS-LM makes some predictions about what happens in the liquidity trap. Budget deficits shift IS to the right; in the liquidity trap that has no effect on the interest rate. Increases in the money supply do nothing at all," Paul Krugman.

So if the LM curve can't be changed to counteract the lower IS curve and if lower oil prices aren't doing much to spur consumer demand, then we're left with the lower IS curve, meaning lower output and rates.

What does that mean for the rest of the economy? A lower IS curve is further away from full-employment, so we'll likely see higher unemployment, primarily from the energy sector. But rates will also remain low.

Low interest rates lead many investors to continue searching for higher yields elsewhere. That is, investors will take on riskier endeavors because risk-free investments (treasuries) or low risk investments (investment grade bonds) won't yield much. This impacts the technology market and silicon valley enterprises too. The lower the yields, the more money investors will be willing to put into startups and other technology ventures that have the possibility of an out-sized return. And we've seen this phenomenon for a while now since rates have been close to zero.

The demand side of the equation for technology and venture startups may be impacted negatively if products were meant to be sold to firms related to oil production. At this point, however, it doesn't seem likely that we'll see a major revenue slowdown for tech companies just because of lower oil prices. It also doesn't seem like lower oil prices are having a recessionary impact on the rest of the economy because it hasn't hit industrial production, the real GDP, real income or wholesale retail sales.

What about the "tech bubble" then? And do the weakness in the public markets portend an impending disaster? Should we expect a deleterious impact from a repeat of the 2000's tech crash? Or is this time different? I will address these issues in the context of a technological revolution in Part II of this post.