Why we get bad diagnoses for the world’s energy-economy problems

The world economy seems to be seriously ill. The problem is not overly high oil prices, but that does not rule out energy as being a major underlying problem.

Two of the symptoms of the economy’s malaise are slow wage growth and increasing wage disparity. Tariffs are being used as solutions to these issues. Radical leaders are increasingly being elected. The Bank for International Settlements and the International Monetary Fund have raised concerns about the world’s aggregate debt levels. The IMF has even suggested that a second Great Depression might be ahead if major banks should fail in the manner that Lehman Brothers did in 2008.

Figure 1. Ratio of Core Debt Growth (non-financial debt including governmental debt) to GDP, based on data of the Bank of International Settlements.

If the economy were a human being, we would send it to a physician for a diagnosis regarding what is wrong. What really is needed is a physician who has a wide overview, and thus can understand the many symptoms. Hopefully, the physician can also provide a reasonable prognosis of what lies ahead.

Individual specialists studying the world’s economic and energy problems tend to look at these problems from narrow points of view. Some examples include:

  •  Curve fitting and cycle analysis using economic data by country since World War II, as is often performed by economists
  • Analysis of oil supply based on technically recoverable reserves or resources
  • Analysis of fresh water supply problems
  • Analysis of population problems, including rising population relative to arable land, and rising retiree population relative to working population
  • Analysis of ocean problems, including rising acidity and depleting fish stocks
  • Analysis of the expected impact of CO2 production from fossil fuels on climate
  • Analysis of rising debt levels

In fact, we are facing a combined problem, but most analysts/economists are looking at only their own piece of the problem. They assume that the other aspects have little or no influence on their particular result. What we really need is an analysis of the overall economic malady from a broader perspective.

In some ways, the situation is analogous to having no physician with a sufficient overview of where the world economy is headed. Instead, we have a number of specialists (perhaps analogous to a psychiatrist, a urologist, a podiatrist, and a dermatologist), none of whom really understands the underlying problem the patient is facing.

One point of confusion regarding whether today’s oil prices should be of concern is the fact that the maximum affordable oil price seems to decline over time. This happens because workers around the world increasingly cannot afford to buy the goods and services that the world economy produces. Inadequate wage growth within countries, growing globalization and rising interest rates all contribute to this growing affordability problem. To make matters confusing, this growing affordability problem corresponds to “falling demand” in the way economists frame the issues we are facing.

If we believe the technical analysis shown in Figure 2, the maximum affordable West Texas Intermediate oil price has declined from $147 per barrel in July 2008 to $76 per barrel recently. The current price is about $62 per barrel. The chart suggests that downward price resistance might be reached at $55 per barrel, assuming no major event occurs to change the current trend line. Any upward price bounce would appear to leave the price still much lower than oil producers need in order to reinvest sufficiently to allow future oil production to be maintained at current levels.

Figure 2. Down sloping diagonal line at the top of chart gives an estimate of the trend in maximum affordable West Texas Intermediate (WTI) oil prices. The downward trend line starts in July 2008, when oil prices hit a maximum. This high point occurred when the US real estate debt bubble started unwinding. Later maximum points correspond to points when oil prices stopped rising and crude oil reservoirs started refilling. Chart prepared by Amit Noam Tal.

Thus, our concern about adequate future oil supplies should perhaps be focused on keeping oil prices high enough. It takes a growing debt bubble to keep oil demand high; perhaps our concern should be keeping this debt bubble high enough to allow extraction of commodities of all kinds, including oil. Figure 1 seems to show a recent downward trend in Debt to GDP ratios for the Eurozone, the United States and China. This may be part of today’s low price problem for commodities of all types.

Needless to say, climate analyses do not consider the severity of our energy problems, nor do they consider the extent to which there is a connection between energy supply and the ability of the economy to operate as usual. If the real issue is a near-term financial crash that will radically affect future fossil fuel consumption, the climate analysis will certainly miss this event.

The Real Nature of the Limits to Growth Problem

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The World’s Fragile Economic Condition – Part 2

The world economy can appear to be operating quite well but can be hiding a major problem that causes it to be fragile. My presentation The World’s Fragile Economic Condition (PDF) explains why we should expect financial problems if energy consumption stops growing sufficiently rapidly. In fact, a global sell off in the equity markets, such as we have started to see recently, is one of the kinds of energy-related impacts we would expect.

This is Part 2 of a two-part write up of the presentation. In Part 1 (The World’s Fragile Economic Condition – Part 1), I explained that a large portion of the story that we usually hear about how the world economy operates and the role energy plays is not really correct. I explained that the world economy is a self-organized system that depends upon energy growth to support its own growth. In fact, there seems to be a dose-response. The faster energy consumption grows, the faster the world economy seems to grow. The period with fastest growth occurred between 1940 and 1980. During this period, interest rates were rising and workers saw their wages increase as fast as, or faster than, inflation. After 1980, the rate of growth in energy consumption fell, and the world needed to tackle its growth problems with a different approach, namely growing debt.

In this post, I explain how debt (and its partner, the sale of shares of stock) help pull the economy forward. With these types of financing, investment in new production becomes almost effortless as long as the return on investment stays high enough to repay debt with interest and to repay shareholders adequately. At some point, however, diminishing returns sets in because the most productive investments are made first.

The way diminishing returns plays out in energy extraction is by raising the cost of producing energy products. In order for the sales prices of energy products to rise to match the rising cost of production, rising demand is needed to give an upward “tug” on sales prices. This rising demand is normally produced by adding increasing amounts of debt at ever-lower interest rates. At some point, the debt bubble created in this manner becomes overstretched. We seem to be reaching that point now, especially in vulnerable parts of the world economy.

Slide 34

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The World’s Fragile Economic Condition – Part 1

Where is the world economy heading? In my opinion, a large portion of the story that we usually hear about how the world economy operates and the role energy plays is not really correct. In this post (to be continued in Part 2 in the near future), I explain how some of the major elements of the world economy seem to function. I also point out some relationships that tend to make the world’s economic condition more fragile.

Trying to explain the situation a bit further, the economy is a networked system. It doesn’t behave the way nearly everyone expects it to behave. Many people believe that any energy problem will be signaled by high prices. A look at history shows that this is not really the case: fighting and conflict are also likely outcomes. In fact, rising tariffs are a sign of energy problems.

The underlying energy problem represents a conflict between supply and demand, but not in the way most people expect. The world needs rising demand to support the rising cost of energy products, but this rising demand is, in fact, very difficult to produce. The way that this rising demand is normally produced is by adding increasing amounts of debt, at ever-lower interest rates. At some point, the debt bubble created to provide the necessary demand becomes overstretched. Now, we seem to be reaching a situation where the debt bubble may pop, at least in some parts of the world. This is a very concerning situation.

Context. The presentation discussed in this post was given to the Casualty Actuaries of the Southeast. (I am a casualty actuary myself, living in the Southeast.) The attendees tended to be quite young, and they tended not to be very aware of energy issues. I was trying to “bring them up to speed.” This is a link to the presentation: The World’s Fragile Economic Condition.

Slide 1

Slide 2

This post covers only Items 1, 2, and 3 from the Outline in Slide 2. I will save Items 3 through 6 for a post called “The World’s Fragile Economic Condition-Part 2.”

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Introduction to the “World’s Fragile Economic Condition”

I will be giving a presentation to a group of casualty actuaries on September 17 called “The World’s Fragile Economic Condition.” I plan to write up the presentation in two posts, one covering the first three of the six sections of the presentation, and the second one covering the second three sections, so that it is easier to read online.

I am putting up a link now to the presentation, to allow those who want to look at the presentation now, a chance to do so.

The World’s Fragile Economic Condition

This presentation pulls together quite a few things I have been talking about. It also adds a new model of how our self-organizing economy works.

This is the outline of what I discuss in the presentation:

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How energy shortages really affect the economy

Many people expect energy shortages to lead to high prices. This is based on their view of what “running out” of oil might do to the economy.

In this post, I look at historical data surrounding inadequate energy supply. I also consider some of the physics associated with the situation. I see a strange coincidence between when coal production peaked (hit its maximum production before declining) in the United Kingdom and when World War I broke out. There was an equally strange coincidence between when the highest quality coal peaked in Germany and when World War II broke out. A good case can be made that inadequate energy supply is associated with conflict and fighting because leaders recognize how important an adequate energy supply is.

Some of my previous analysis has shown that if we view energy in terms of average energy supply per person, the world as a whole may be again entering into a period of inadequate energy supply. If my view is correct that inadequate energy supply leads to increased conflict, the recent discord that we have been seeing among world leaders may be related to today’s low supply of energy. (My energy analysis considers the combined energy supply available per person from fossil fuels, nuclear, and renewables. It is not simply an oil-based analysis.)

The physics of the low energy situation may be trying to “freeze out” the less efficient portions of the economy. If successful, the outcome might be analogous to the collapse of the central government of the Soviet Union in 1991, after oil prices had been low for several years. Total energy consumption of countries involved in the collapse dropped by close to 40%, on average. The rest of the world benefitted from lower oil prices (resulting from lower total demand). It also benefitted from the oil that remained in the ground and consequently was available for extraction in recent years, when we really needed it.

The idea that oil prices can rise very high seems to be based on the oil price increases of the 1970s and of the early 2000s. While oil prices can temporarily rise very high, it is hard to make a case that they can remain high for an extended period. For one thing, high oil prices tend to cause recessions and lower employment. In such an environment, affordability of energy products is lower, and oil prices tend to fall. For another, it is easy for the Federal Reserve to get oil prices back down by raising interest rates. In fact, the Federal Reserve is raising interest rates right now.

In my opinion, we should be more concerned about low oil prices than high because we live in a world economy with huge debt bubbles. Debt bubbles are part of what enable today’s high employment. Debt bubbles support employers that are close to the edge financially; they also support buyers who would not be able afford automobiles or college educations, if loans were to become more expensive because of higher interest rates. Employment in the affected industries would be cut back, leading to recession.

Because of these issues, pricking the debt bubble is likely to lead to a major recession and, indirectly, lower energy prices, as in late 2008 (Figure 12). These lower prices are not good news because energy providers of all kinds need fairly high energy prices to survive–probably equivalent to oil at $80 per barrel or higher. If energy prices stay persistently low, the world is likely to see much lower oil supply, in part because oil exporters need the tax revenue that they obtain from high-priced oil to fund their programs.  Continue reading

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