Delusions of Finance: Why most models are wrong

I wrote this post almost a year ago, and originally posted it at The Oil Drum. It is a write-up of a talk I gave in October 2009 at the Biophysical Economics conference in Syracuse, NY.

In October 2009, I participated in the 2nd International Biophysical Economics Conference at SUNY-ESF in Syracuse, New York. Charlie Hall had written to me, inviting me to come and give a talk. Specifically, he wanted me to go back to my post from January 2008 called Peak Oil and the Financial Markets: A Forecast for 2008 and explain why my forecasts had turned out pretty close to correct, while many others widely missed the mark. The title he suggested for the talk was Delusions of Finance.

My financial forecast really has implications for beyond 2008, so I added some more forecasting thoughts as well. In this post, I would like to share this presentation with you.

I am a casualty actuary by training and spent many years doing forecasting and modeling as an insurance company employee and later as a consultant to insurance companies. Many of these companies were small medical malpractice insurance companies that provided insurance for a group of hospitals or physicians. Medical malpractice claims are notoriously slow to be reported and to be paid, so we had to forecast many years of reporting and payments, (and corresponding investment income). These models were used both for determining appropriate insurance rates and for determining balance sheet reserves for these companies. Quite often I was involved in putting together models for proposed new companies in order to estimate likely capital requirements. I was also prepared a lot of estimates of the likely impacts of medical malpractice reforms.

All of this didn’t really give me any special training for making financial forecasts relating to peak oil, but it did give me a lot of practice with making forecasts and trying to think outside the box. I needed to figure out what was unique to each situation, and figure out a way to model it. I hadn’t gone through the standard MBA training, but I had bumped up against a fair amount of it along the way.

My background goes back far enough that I had a chance to see how badly insurance companies fared back in the 1974 period, when oil shocks affected insurance companies. One of my former employers went bankrupt, and another one nearly did. I could see that if a similar situation happened now, other financial companies would likely be affected as well.

Quite a bit of the rest of this presentation is fairly self-explanatory, especially if you have seen some of my other presentations, so I won’t provide too much in the way of comments.

Slide 3

This is a link to the full post. You may want to read it, if you haven’t previously.

Slide 4

My later slides explain these points more fully.

Slide 5

Slide 6

Slide 7

If you stop to think about it, there a quite a few differences in the way the economy functions in a period of economic growth and in a period of economic decline. The assumption of continued economic growth by traditional economists (who don’t consider resources and their limits) has been so strong that most have not even considered what the economy would look like in a period of long-term decline.

Slide 8

Many have observed that there would have been defaults, even without peak oil, because of the reckless lending that had been done. I would contend that at least part of the reason the lending had been done was to give the illusion of growth, when there really wasn’t much apart from that generated from very loose lending standards. Furthermore, even if loose lending standards were part of the problem, the problems related to peak oil made it worse (and can be expected to cause more problems in the future).

Slide 9

When there isn’t a problem like peak oil (or limits to growth in general), debt defaults are in fact pretty much independent. That is why the system for determining insurance charges to be included in the interest rates charged for loans worked pretty well until peak oil came along. In the absence of peak oil, a homeowner or businessman defaults because of some particular problems he or she has. Past history is likely to be predictive of the future, because while there are different individuals defaulting, the average number of defaults will tend to be pretty stable from year to year.

Slide 10

It is possible that there will be some loans in a declining economy, but their use will be much less widespread than we see today. Their cost will also tend to be higher.

Slide 11

When lending is increasing, businesses have more money to invest in new plants and equipment and homeowners find it easy to get loans of new homes or for home improvements.

Slide 12

Slide 13

As countries cut back their stimulus funds, the decline in credit available may be especially severe. I noticed this article this morning:

Lenders warn of mortgage shortages

Britain’s banks and building societies have warned that they will have to slash mortgage lending and raise rates on home loans if the government insists on prompt and full repayment of the £300bn they have received in state support since 2008.

Slide 14

Slide 14

In the US, homeowners used their homes as a piggy-banks when home values were rising. They could refinance their homes, remove the built-up equity, and buy new cars, furniture, and other things. When there are fewer home buyers (because of less loan availability), and continually declining values, the effect is reversed. [Note: The decline in consumer credit outstanding has continued in 2010.]

Slide 15

Credit problems are really what are likely to spread the lack of oil to a much broader reduction in fuel use, essentially through growing recession. This recession may affect OECD to a greater extent than non-OECD, but there are such great links between the two that I expect eventually all will be affected. This reduction in fuel use is likely to be described in the press as “reduced demand”–which it is, but because of recession induced by credit contraction (ultimately going back to lack of growth in oil supply).

Slide 16

Slide 17

Slide 18

I am sure that some trade will continue, even if countries have financial problems. But it seems to me that a very large amount of trade is needed to keep up our system at the current level. High tech equipment would seem to be hardest to create with local materials alone. We can make simple things, like wheelbarrows and shovels with recycled steel, but it is not clear that precision parts for things like computers and other high-tech equipment can be made without exactly the right imports from around the world, and factories set up with the right controls.

Slide 19

These changes could start very soon. It is hard to know precisely how things will play out.

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to inadequate supply.
This entry was posted in Financial Implications and tagged . Bookmark the permalink.

20 Responses to Delusions of Finance: Why most models are wrong

  1. Paul says:

    Your concern that globalization is necessary in order to support the manufacture of high tech products is, I think, too simple a reading of the real situation. The reason local supplies are not developed for many high tech input commodities is the sure knowledge that somewhere else in the world there is a place that it can be done more cheaply. Without import controls *that can be relied on*, or some other equally bold break with current economic theory, local investment is irrational.

    • George Mobus says:

      Paul,

      Gail can better defend her statements than I, but I would like to add my own perspective. Globalization is a chase after the cheapest developable (not a real word) resources, material and labor, substituting cheap transportation for the cost savings obtained. The reason that costs are higher in the OECD and particularly in the US is that labor is still a substantial part of the cost structure of work accomplished here. The reason labor costs are high is that the American (and OECD workers) have high energy consumption requirements. That is, their desires for products and services that allow them to maintain the kinds of lifestyles they have grown accustomed to (during the period of cheap fossil fuel energy) means they require more in wages than does, say, a Chinese worker.

      As fuel prices rise, however, and transportation takes a larger portion of the cost pie, the advantages of lower labor costs will diminish. At the same time the total costs for all products and services should rise with both direct and indirect energy costs rising. Thus, while you may be right to say that there are opportunities for more local development of high tech products (indeed all products) those opportunities will bear considerably more costs than we have been used to.

      As fuel prices rise even local development of resources will become excessive and will likely drive labor to accept lower wages to compensate. In short we will all be much poorer. Ironically, we will all be less able to afford the latest high tech gadgets as a result. And as Gail points out, less able to service our debts. I venture to suggest that no kind of rational import controls will be able to counter this effect.

    • I read today that China is reducing the amount of rare earth minerals it is exporting. All we need is to be missing a few necessary raw materials, and it will be very difficult to make high tech goods any more. We can start working on local supply, but everything takes time, and there is a lot of NIMBY-ism.

      I expect financial problems will play a bigger role than most expect in this unwinding. No one will want to sell products (or ores) to buyers that don’t appear to be capable of paying.

      • Paul says:

        My initial comment was about the general argument concerning foreign trade. But on the specifics of rare earth metals: Before China became dominant, the dominant producer was a rare earth deposit in California. Production at that deposit was shut down by the operators because they decided that they could not afford to comply with environmental regulations. The Chinese who took up the business were actually mafia types who were/are ignoring China’s environmental (and other) regulations. China is attempting to bring this rogue industry under the control of the government. Admittedly, it is not at all clear that they will be docile price takers once they gain control. But there *are* other deposits that could be developed to compete with the Chinese.

        Then in that world where Chinese are the dominant producer in the world market, who would develop some other source of supply in the context where the Chinese could easily bankrupt their fledgling business by lowering the price for however long it takes? Yes, there is NIMBY-ism. And there is colonialism. And other bad stuff. Only none of it is sufficient to *require* that we persist in the current style of globalization, IMHO.

        • Arthur Robey says:

          Sorry guy, but I cannot leave

          And there is colonialism. And other bad stuff.

          unchallenged.

          Under our (Rhodesian) watch the indigenous population exploded. When we were expelled the country, (Zimbabwe) collapsed. It went from being a haven for to the icon of a failed state.
          We fought to prevent it’s inevitable collapse, losing many lives in the process.
          However the will of the world prevailed when we were denied oil.
          I would personally like to congratulate all who supported Bob Mugabe.
          Congratulations, you won.
          Now go and fix up your mess.

          The idea that colonialism is bad needs so many caveats as to become a meaningless cliché.
          Perhaps your form of colonialism is malignant, but that is between you and your God.

          All life is colonizing. Even yeast.
          It is our duty to colonise whatever niches we can find.

  2. Kenneth says:

    http://www.theoildrum.com/node/7285
    http://www.theoildrum.com/node/7102

    Debt , economic growth and energy are logically interdependent, but according to our governmental agencies, this is a non issue for the next 25 years.
    How do we reconcile rosy energy supply predictions from EIA or IEA with articles such as yours or the Oil Drum? Is the IEA and EIA being purposely misleading or do they really believe that we will not have an energy shortage?

    • The IEA came as close as they could to saying that peak oil is here now. I expect they know, even if they are not saying, how unrealistic the scenarios they are presenting are.

      I am doing my best to see that the EIA is aware of what is really going on. I send high level EIA officials links I think would be helpful. I sent some links today.

      It seems like there would be a lot of political considerations for the EIA and IEA, in making oil forecasts. No elected official want to tell voters that things will not be as good in the future as they are today, or that we have problems, for which there is no good solution. The forecasts by EIA and IEA are a big part of the message elected officials bring to voters.

    • Don Millman says:

      IMHO, EIA, IEA, USGS, and CERA are all victims of groupthink. Nobody in establishment organizations dares to challenge the groupthink consensus. To a large extent, these establishment organizations are all in denial, and there is no way to challenge effectively the rosy scenarios that they paint.

      I trust the best of TOD analysts and forecasters far more than I do those of the four organizations listed above. Why? Because I have an ironclad crap detector, and IMHO, the establishment organizations’ analyses all have a distintive odor to them. When major changes are about to occur, the conventional wisdom is almost always wrong; I think Gail is fundamentally correct. Where I disagree with her is in my expectation of increasing rates of inflation being used to wipe out debt rather than allowing much greater rates of defaults than the current rates. In other words, I expect far far higher government deficits financed by the Fed buying Treasury securities of all maturities. I think political forces will drive increasing inflation as an alternative to increasing rates of defaults.

      I’m bearish on stocks, bonds, and even precious metals, which I think are now nearly ending a speculative boom. I expect in the U.S. little or no real economic growth in 2011–which is in sharp contrast to the consensus forecast among economists that 2011 U.S. real GDP growth will be about 4%.

  3. Usman A. says:

    Nice to see this presentation once again. I think many still underestimate the effects of oil on the economy. I am in the same camp as you and Steve over at Economic Undertow ( http://economic-undertow.blogspot.com ).

    There seem to be sound arguments against oil being the sole cause of the financial crisis. For example:
    http://theautomaticearth.blogspot.com/2010/02/february-17-2010-did-peak-oil-cause.html

    I think your contention that peak oil (high prices) were a driver for loose monetary policy and lending habits to maintain the illusion of growth is something that must be accounted for. If that’s certainly the case, then peak oil still remains the ultimate cause of the financial crisis and ongoing troubles.

  4. DavidB says:

    O.K. I accept this is not quite on topic, but who cares?

    I’ve followed the Peak Oil situation for some three years now, and it’s been a personal roller coaster for a variety of reasons.

    I’ve encountered several people online (that unfortunately I will never meet), who have been an absolute rock in my journey to an understanding of the need to change and adapt.

    Gail is one such person. Whether here on her own site ‘Our Finite World’ or the work she has accomplished on ‘The Oil Drum’, I simply wish to say Thank you.

    We’re a couple of days from the New Year 2011, which I think will be a very pivotal year in the changes that we all know is coming.

    Gail’s writing, and grounded perception, has been vital to my sanity, and my studies of the consequences of Peak Oil. I don’t know what 2011 holds for us but I hope that Gail will be there to make some sense of it.

    29th Dec 2010
    Best wishes to all
    David

    • Thanks for your vote of confidence! I am afraid you are right about 2011 being a pivotal year. A lot of peak oil problems have been hidden by government spending and relatively low oil prices. Now some governments are starting to realize that they can’t just keep high spending without raising taxes. Governments that haven’t figured this out may have the truth brought home to them in not too long, through higher interest rates. If oil prices rise too, we may have a lot of problems simultaneously.

    • YES! – what David said!!

  5. Arthur Robey says:

    The hallmark of genius is the ability to reduce a complex problem to the obvious.
    Isaac Asimov had it.
    Thanks for making simple what others only succeed in confounding, Gail.

  6. Matt says:

    I totally agree with Arthur, without people like Gail and the rest at the Oil Drum and a few other sites. We too would be completely clueless.
    Keep up the good work Gail.

  7. Owen says:

    You folks underestimate the length of the road down which the can is kicked.

    Goldman Sachs’ Hatzius released his call today and it leans pretty heavily on a presumed uptick in state/local tax revenue. GDP is up; so must be tax revenue, says his models.

    One would suspect that off the shelf models are not tinkered with lightly so the one that correlates state tax revenue with national GDP would be left unadjusted for 10% unemployment. I suspect therefore he will underestimate the drag that state spending reduction will have on GDP.

    But note the word used. “Reduction”. Not “avalanche”. Not “collapse”. It will decline, and tax revenues will be lower than expectations, and so spending will reduce the next year, too.

    You don’t get to avalanche or collapse territory until the police are laid off. That’s when the bricks start getting thrown into store windows and things stop altogether.

    In other words, not yet. The worsening will be more steep than “gradual” and less steep than “falls off a cliff”.

    None of which looks good for an Obama re-election.

  8. Pingback: Solutions to peak oil – part II: Consequences and myths | How to save the world?

  9. JVP says:

    Hooray for Gail.

    The fact that many leaders (in all levels of govt and media) won’t make the connection between our high debt loads hitting the lowering ceiling of inexpensive energy production is a shame, but also unacceptable to the American narrative the last 5o years.

    Its a tough story to tell and harder to understand.

    Thanks Gail for doing both.

    JVP

  10. WGR says:

    I am amazed at how most young people seem totally unaware of the coming breakdown in the easy life they grew up in. The suburbs , enclosed malls, ease of travel, multiple car familys and a wealth of consumer goods made life easy. I don’t believe there is any adjustment capability on the part of our youth. Even the brightest shuffle through college programs expecting that miracle job that continues the easy life. Meanwhile the peak energy wall already casts a shadow over their future and they don’t have a clue it exists or how they could possibly adjust to it. I was born in 1937 so maybe I am overly prejudiced. However, I grew up on a farm then and experienced the challenges of that era and it sure was not easy.

    • I always wonder how much video games and television contribute to the lack of interest in the real situation. If your mind is being filled with trivia, it is hard to think about anything else. And you get the impression that the current situation cannot change.

      Also, we are not being challenged with the real issues of producing our own food, water, clothing, and household goods. We are so far removed from what is really happening, and the whole process is broken into so many steps, that we do not comprehend the whole. We certainly not spending our time learning how to protect our crops from one or another type of pest, or figuring out better ways to store food for winter. So our brain is not working on the questions that ultimately will be important again.

Comments are closed.