We see endless fighting between the Democrats and Republicans about the budget, but no real explanation as to what the issues are. My view is that there is a structural imbalance between government revenues and expense that is likely to get much worse in the years ahead. This structural imbalance is related to too few people with jobs, growing limits on oil supply, and the inability of the economy to continue growing as rapidly as required to maintain our current financial system. Let me explain the issues as I see them.
Too Few People with Jobs
Between 1970 and 2000, the percentage of the US population with jobs rose, at least partly because more women entered the work force. Since 2000, the percentage of people with jobs has been declining as jobs are increasingly sent to offshore locations, and economic growth stagnates.
Clearly, it is easier to keep a balanced budget when the percentage of the population employed is rising than when it is falling. When it is rising, there are more people to pay taxes, and fewer needing support benefits of various types. The reverse happens when the percentage of people employed is falling.
The Connection Between Jobs and Oil Demand
If we look at historical numbers (Figure 2), there seems to be a close tie between the number of US jobs and the amount of oil consumed in the US. One connection is that jobs often use oil in some way–operating machinery, or transporting goods. Anther connection is that people with good paying jobs can afford to buy goods and services (like vacations) that use oil, so the demand for oil stays high, even with high oil prices.
Unfortunately, even with rising prices, the amount of oil extracted in the world has been been approximately flat since 2005. The share of the oil that has been going to the US and other OECD countries has been falling.
Figure 3 shows that the countries that have been able to obtain an increasing share of oil are the “Other” category–(that is, excluding Former Soviet Union and OECD countries). These countries include OPEC oil exporting countries, plus China, India, and many other countries who use little oil on a per capita basis. Major oil importers like the US have tended to see recession as oil prices rise, cutting back demand for high-priced oil, and the jobs that go with this demand. Economist James Hamilton has determined that in the US, 11 out of 12 post-World War II recessions were preceded by oil price shocks.
When we look at US per capita oil consumption, we see it has been dropping since 2005, and especially since 2007 (Figure 4). This is as expected, based on Figure 3.
Demand for cheap oil is quite different for demand for expensive oil. Many potential buyers want and can use cheap oil. US infrastructure was built on cheap oil. Expensive oil tends to be a problem, causing recession for countries that import very much of it. The risk is that rising oil prices will again cause major recession among the major oil importers, and with it a further drop in demand for oil, and more loss of jobs.
Unfortunately, there is good reason to believe that there will not be a major uptick in oil supply that will ease the high price problem. The International Energy Agency says, “The Age of Cheap Oil is Over”. The Wall Street Journal published an article called IMF: ‘Increased Scarcity’ Ahead for Oil Markets which says:
Governments should brace for “increased scarcity” in global oil markets and the risk of additional sharp price increases in the coming years, the International Monetary Fund warned Thursday.
Private Industry Wages and Salaries Have Fallen
If we look at private industry wages and salaries (Figure 5), we find that as of the latest available data (February 2011), total wages and salaries were still below peak levels in the first part of 2008. These numbers have not been adjusted for inflation. If they were, the fall would be even more pronounced.
If there are not enough private industry jobs to go around, various approaches can be used to try to remedy the situation. One possibility is transfer payments, like unemployment insurance, Medicaid, and Social Security. Another is by hiring more government employees, including state and local employees. In this graph, the red line is private industry wages and the blue line is transfer payments plus government payrolls. While there are other sources of tax funds than private industry payroll (taxes on businesses, for example, and taxes on government employees’ wages) the narrowing of the gap between these two lines since 2008 is a major reason for the current budget problems.
Social Security Funding Issues
Social Security benefit payments have been escalating rapidly, at the same time that contributions have declined, since so few people have jobs (Figure 7). Interest credited by the Federal Government has been flat recently, because of declining interest rates. Despite all of the assurances the government makes, Social Security is on close to a pay-as-you-go funding basis. Each year, the government takes whatever excess revenue has been collected from recipients, and uses it for whatever purposes it deems fit (having nothing to do with Social Security). It replaces the funds it takes with non-tradable IOUs, which don’t show up in most compilations of US debt. It is the presence of these IOUs that allows the government to say that the program is funded until some distant year. See my Oil Drum post from a year ago, called Social Security and Medicare Funding Issues: Even Worse when One Considers Resource Constraints.
In calendar year 2011, Social Security contributions were reduced from 12.4% of taxable wages to 10.4%, a reduction of about 16%. This drop pretty much guarantees a funding shortfall for Social Security (even with investment income on the IOUs). This shortfall won’t show up in budget calculations, however, because it is an off-balance sheet item.
Growing Mismatch between Tax Revenues and Expenses
While government receipts have been rising, spending has been rising much faster.
Government receipts and expenditures shown in Figure 8 are broadly defined–they include state and local programs as well as federal programs, and programs like Social Security as well as ones that are budgeted yearly. I have used data on this basis, because all the programs are interrelated. If the federal government cuts back on its funding, state and local taxes will need to be higher.
Figure 9 shows that compared to private industry wages, government receipts have remained relatively level since 2000. What has grown is government expenditures (broadly defined, including state and local government expenditures, and including Social Security), relative to private industry wages.
Slight of Hand Approaches
There are various slight of hand approaches that governments can use to improve reported economic growth.
GDP is a measure of how an economy is faring. It can be temporarily increased in many ways: by debt-based government stimulus spending, or by artificially low interest rates, or by excessively loose lending standards, allowing people who cannot really afford to buy homes to do so. It is difficult (or impossible) to tell exactly how much benefit actions such as these have.
Theoretically, there ought to be a multiplier effect, beyond the direct additional spending. For example, if additional federal government spending allows a teacher who would not otherwise be employed to have a job, she will probably by more goods and services than she would have without a job, and the people who obtain money for those goods and services she buys will again spend the money she gives them.
In Figure 10, I made a rough estimate of what the effect of additional debt might be on US GDP, assuming a multiple of 1.0 to 2.0 is appropriate with respect to additional federal debt. With either multiple, the effect is quite large. Other indirect stimulus attempts, such as Alan Greenspan’s artificially low interest rates after the Dot-com bubble, and the later the encouragement of loose lending standards by banks, could also be expected to help reported GDP.
I would consider Quantitative Easing (between November 2008 and June 2010 and again between August 2010 and June 2011) to be another slight-of-hand approach. According to Bill Gross of PIMCO, the effect of QE recently has been to reduce interest rates on bonds by as much as 150 basis points. Because of the low interest rates available on bonds, interest in buying other asset classes, such as buying stocks and commodity futures is enhanced. The same article quotes Ben Bernanke as talking about how equity prices have risen significantly and volatility in the equity market has fallen in response to QE.
While approaches such as these have helped keep reported growth rosy, it is hard to see how creative approaches such as these are long-term solutions, especially if things continue to get worse.
There are two trends that are easy to spot:
1. Baby boomers are reaching retirement age, and the number of people drawing Social Security and Medicare benefits can be expected to grow significantly, without adding correspondingly to the number of people paying taxes (or Social Security premiums). Furthermore, many of these people will want to sell their large homes, adding to the oversupply of homes for sale.
2. Oil supplies are likely to get increasingly tight, causing prices to rise further, until recession brings prices down. More recession can be expected to bring further job loss.
The combination of these two trends suggests strongly that the imbalance between government receipts and expenditures (shown in Figures 8 and Figure 9) is likely to get much worse in the future than it is currently. Even more exotic ”slight of hand” approaches are likely to be needed, to maintain the appearance of reasonable economic growth.
Exponential Growth in a Finite World
One reason for concern is the fact that our financial system needs economic growth to function properly. Our economy is debt-based, meaning that money is created by lending it into existence. This money needs to be paid back with interest, but the interest component is not created at the same time. When the economy is growing, there is little difficulty, since by the time the loans come due, on average, there is enough growth to pay back the debt with interest. In a flat or declining economy, there tend to be huge numbers of debt defaults. Artificially low interest rates can partially fix the problem, the system really needs economic growth to function as planned.
The long term basis for economic growth tends to be fossil fuel use. Fossil fuel use has been growing for 200 years–about as long as the US has been in existence, so economists have tended to assume this growth is the natural state, and can be counted on indefinitely. Unfortunately, this assumption is not true.
If we look at a graph of world population (Figure 11) and compare it with a graph of fuel use overlaid on the same graph (Figure 12), it is pretty clear that the huge spike in population occurred at the same time as growth in fuel use (first coal, then oil, natural gas).
The reason for the connection is clear, if a person thinks about what fossil fuels, and in particular oil, are used for. Oil is used to power farm machinery; to power irrigation equipment; to make herbicides, pesticides, and fertilizer; to refrigerate food after production; and to transport food to market. If a farmer has to do all the work himself or herself, or with only the aid of animal power, his productivity is much less, and he is able to support many fewer people who are not farming. Additionally, oil is used to make many other things, such as medicines, which have allowed life expectancies to be much longer than in the past.
My blog is called Our Finite World. The world has a finite number of atoms; the amount of oil, natural gas, and coal that is economically extractable is also finite. The problem now is that we are reaching limits in their extraction, especially for oil. This causes oil production to stop rising, and prices to spike.
There is a parallel in the biological world. When organisms find an exhaustible food supply (for example, yeast eating sugars in a bottle of grape juice), their population tends to grow exponentially, then collapse, as the limited food source is exhausted. Oil and other fossil fuels enable the current very large food supply we have on earth. If we exhaust the fossil fuels that we can reach (even if this exhaustion comes because prices are too high for the economy to support), collapse in the world population can also be expected.
There are three views as to how the current human predicament can be expected to work out:
1. Continued Exponential Growth. This is what most economist assume, and what the scientist putting together climate change models assume. Fossil fuel use is expected to grow for the lifetime of the models, despite rising oil prices and investment cost. The big long-term issue is viewed as climate change.
2. Standard Peak Oil Theory. The belief here is that the supply of oil and other fuels is limited by geological factors, with economics making little difference. The expectation is that oil, gas, and coal supply will decline slowly over, say, the next 100 years or so. When Hubbert made projections of this type, he did it in the context of other fuels keeping the economy going on a “business as usual” basis, so that economics did not play a major role.
3. End to Growth and Collapse. This is my view of the major risk, in the years ahead. High oil prices are likely to bring on recession and a reduction in oil demand. The financial system cannot withstand the lack of economic growth that is likely to occur in such a situation, and many debt defaults and layoffs are likely to occur. The underlying cause is that it is becoming non-economic to extract oil–we are using more and more energy to extract oil, so that net energy from what is being extracted is dropping below the level needed to keep society operating. The result is likely to be collapse, as there are more and more debt defaults, and it becomes more difficult to keep financial institutions afloat.
If I am correct, we could see a major collapse in the next few years, relating to a significant extent to our ability to keep funding all of the programs we currently have, with a declining tax base.
We really don’t know what is ahead. Three scenarios come to mind as possibilities:
1. Somehow, political powers will figure out a way to reign in spending, by substantial cuts to military expenditures, Social Security, Medicare, Medicaid, government employment, road paving, education, medical research, and many other programs we have considered essential to date. Ben Bernanke (or his successor) will figure out a way to create major inflation, so we don’t formally default on our debt. Somehow, we will transition to a much lower energy economy through our normal political process, without actual collapse.
2. Huge infighting will continue between the Democrats and Republicans, until some outside force causes the current system to stop working. For example, it may become necessary to pay much higher interest rates because other countries raise their interest rates, and interest payments balloon. Or perhaps defaults by other countries will make it clear that the United States is in not a whole lot better shape than many of the others. If enough counties are unable to pay their debt, international trade might be cut back greatly, because countries will not trust one another to pay for goods shipped, unless potential buyers actually have other goods they are able to trade in return. Each country will attempt to go it alone, producing goods primarily based on its own resources. There may be a formal restructuring of debt, perhaps stretching out payment terms. As in (1), a huge number of programs will need to be cut back, like Social Security, unemployment insurance, and Medicaid, because of low taxes to support these programs.
3. Things fall apart. If collapse starts, the government could find itself with huge obligations in many areas, such as FDIC bank guarantees, pension guarantees, and Fannie Mae and Freddie Mac loan guarantees. At the same time, the tax base could erode further, due to more layoffs, falling property values, and falling stock market values. I can imagine a scenario similar to the dissolution of the Soviet Union situation taking place. The Federal Government might just disappear, and the individual states would be left on their own, either to go it alone, or band together with other states, and form new governments.
Responding to Our Predicament
I recently wrote a post called, What President Obama should have said regarding energy policy, in which I rough out a plan for the United States to get off fossil fuels. I also explain why I believe that what are now called “renewables” should be referred to “fossil fuel extenders” because they temporarily add a bit to supply, but do nothing to solve our long term problem. To the extent that fossil fuel extenders are high priced and require a lot of investment, I consider them to be part of the problem, not part of the solution.
I would like to see both Democrats and Republicans sit down, and figure out what the problem really is, instead of being so adamant that their own views are correct. Both sides seem to be to be significantly wrong in their views.
The Democrats should be aware that their views on attempting to help the climate are likely to make collapse sooner and more severe, and the models upon which they are basing their climate decisions assume unrealistically high fossil fuel use (see Appendix below). If collapse does occur, it likely will lead to a drop off in all fossil fuel use as well as a drop in world population. As a result, there will be less pressure on ecosystems of all kinds.
The Republicans seem to be overoptimistic as to what can be done with additional drilling, and with a partial switch to natural gas. I do not object to trying this approach, but believe optimism as to what it can reasonably accomplish should be tempered. Costs and energy used in oil and gas extraction are rising rapidly, and we too, are reaching the point where it will cease to be economic to drill, because the energy used in the process will be excessive compared to the energy of the oil and gas extracted.
Hopefully, we can find ways to mitigate the predicament we are in. I tried to lay out a rough transition plan for the US in my Obama post, mentioned above. Working on an international financial system would that is not debt based could be very helpful, if it allows more international trade to continue. The employment problem can be “fixed” if we can get workers transferred over non-fossil fuel approaches requiring more manual labor, if the economics can be worked out. I am not sure there is any “good solution,” but if all sides could sit down and understand where we are, it seems as though we would have a better chance at figuring out mitigations.
Appendix – Climate Change Estimates Using Lower Estimates of Fossil Fuels
Luis de Sousa and Euan Mearns put together an estimate of expected carbon dioxide equivalent emissions, using the estimates of fossil fuel use shown in Figure 14, as shown in this Oil Drum post. In this estimate, fossil fuel use peaks in 2018.
Luis de Sousa and Euan Mearns used the fossil fuel estimates in Figure 14 together with the MAGICC program used by IPCC modelers to estimate future CO2 equivalent emissions shown in Figure 15. If the actual situation is collapse, rather than the “Peak oil” type decline curve shown in Figure 14, the drop off in CO2 equivalent concentrations would seem to be greater and come more quickly.
Of course, climate change already seems to be a problem, and there are other reasons (such as ocean acidification) for eliminating excess CO2, so actions may still be needed. But decisions should be made in the context of understanding the full situation, including the downside if collapse is exacerbated and there is inadequate fuel for mitigation.