A Painful Adjustment

A quick read through the morning paper reminded me just how much the future path of energy prices and energy sector investment depend on the economy, and on the measures intended to speed its recovery. It doesn't seem like so long ago that the situation was exactly reversed, with the economy faltering in part due to a massive oil price shock. Now, the very things that energy strategists and planners most took for granted--the steady pace of demand growth driven by an expanding global economy and unimpeded access to financing for projects large and small--have become the biggest uncertainties affecting the industry. A random selection of articles and op-eds in today's Wall Street Journal seems to confirm that these uncertainties won't be resolved quickly. Indeed, they cannot be, until the recession has done its unpleasant work of re-directing employment and investment away from sectors that grew unsustainably large during the parallel housing and consumer debt bubbles, and towards new and better uses.

In the Money & Investing section we read, "Oil Rallies on Stimulus Hopes." With the volatile expiration of the February crude oil contract behind us, March West Texas Intermediate settled at $43.67 yesterday. But the rally in question, of four days duration, doesn't change the fact that this same March contract has declined by about 70% since its high last July, and by 10% since last December 31. No one expects a return to last year's peaks, but the hopes for a quick agreement on an economic stimulus package ought to be tempered by the enormity of the task that package is intended to accomplish, and by our questionable ability to sustain the requisite deficits long enough to see its programs through.

The challenge is illustrated by an article that provides the kind of good news/bad news mix typical of a deep recession: "Home Construction at Record Slow Pace." At December's seasonally-adjusted annual rate of 550,000 units, new home construction is apparently at the lowest level since at least 1959, and half its rate of a year earlier. This is clearly bad news for anyone working in home construction and all the businesses that supply it. However, it's good news for current homeowners, since less supply will eventually lead to higher prices. It also reflects the reality that the home construction sector cannot be maintained at the scale it reached during the housing bubble. Too many of the country's resources were devoted to building new and bigger homes, fueled by unrealistically high levels of debt. Finding more productive and sustainable employment for the people and businesses affected is just one task of the stimulus, and of the recession itself. The same is true for a consumer-goods sector, including retail, that also grew unsustainably large, driven by massive home-equity and credit card debt.

For all the hopes pinned on the stimulus, its Achilles heel is the scale of the deficits involved, on top of a preexisting budget deficit and the enormous loans made to the banking sector. While the projected US deficits in 2009 and 2010 might look manageable as a share of GDP, their absolute magnitude raises serious, unanswered questions about funding. "The World Won't Buy Unlimited U.S. Debt," points out one op-ed in the Opinion section. I understand the risks of doing too little and the worries about a liquidity trap, in which monetary policy loses its effectiveness, or entering a deflationary spiral; however, the stimulus carries risks of its own. Nor can we forget that ours is not the only government taking on more debt to fund an urgent stimulus. "Expect the World Economy to Suffer Through 2009," conclude Ian Bremmer and Nouriel Roubini, of the Eurasia Group and NYU, respectively.

We need to keep all of this in mind, as we assess the stimulus package that the Congress and new administration are designing. Every assertion that it should be as big as possible should be balanced by a reminder that, because we will go deep into debt to fund it--with unpredictable consequences--it should not be one dollar larger than truly necessary. In particular, that means that provisions that can't be shown to have a high likelihood of putting people and businesses to work productively in the next 18 months should be deferred until we have a clearer sense of the receptiveness of global lenders for the mountain of Treasury bonds and T-bills the government must issue to pay for them. I'm glad I don't have to make those choices, and I wish our elected leaders the greatest success in this endeavor. Much more than just energy markets hinges on it.