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

Let’s first look at a slide from Part 1, explaining the way in which the economy works like a giant factory.

Slide 20

As long as energy products are very inexpensive, it is possible for the economy to expand very rapidly. When this happens, the Goods and Services produced in Box 4 are able to grow so rapidly that all of the Resource Providers in Box 1 can be well compensated, simply by using a quasi-barter arrangement, facilitated by the use of money. With this approach, Resource Providers can get adequately paid using the Goods and Services produced in close to the same time period. Something of this nature occurred prior to 1970, when inflation-adjusted oil prices were less than $20 per barrel (Part 1, Slide 26).

Slide 35

If the growth of the economy slows, so that not enough Goods and Services are being created by the economy to use this approach, it is possible to work around the problem by adding debt. Adding debt makes it possible to substitute promised future Goods and Services for already produced Goods and Services.

Slide 36

Added debt makes it seem like more goods and services are available to pay resource providers.

Selling shares of stock acts very much like debt, because the funds provided by these shares also provide access to goods and services that others have already produced. In the case of the sale of shares of stock, the promises are for future dividends, capital appreciation, and partial ownership of the company.

Slide 37

Growing debt looks like it can solve all problems! No wonder that Keynesian economists found it so useful. But the return must remain high enough to repay debt with interest.

Slide 38

Borrowing money generally comes with the requirement that the amount borrowed be repaid with interest. If the energy purchased using debt allows the economy to grow fast enough, there is no difficulty in repaying debt with interest. If energy is very inexpensive (equivalent to oil cost less than $20 per barrel in inflation-adjusted price), this payback system generally works because a large amount of energy can be purchased for a small quantity of debt.

If the price of the energy rises, much more debt is required for the same amount of energy produced. For example, if oil is $80 per barrel, the affordability is much lower. It takes four times as much debt to pay for a barrel of oil. Repayment of debt with interest becomes more difficult.

Slide 39

In Part 1, we observed that US long-term interest rates have been falling almost continuously since 1981. This situation of falling interest rates led to falling mortgage payments for a given amount borrowed. Because of the lower monthly payments, homes became more affordable; in other words, there tended to be more potential buyers for homes at a given price level. Indirectly, the increased affordability of home ownership tended to raise the resale value of homes. It also encouraged the building of additional homes.

Building homes indirectly requires the use of many different types of commodities. Metals are used in pipes and in wiring. Wood is used for framing. Concrete is often used for the basement. Oil is needed to haul these goods to the site where the home is to be built. Thus, indirectly, falling interest rates tend to raise commodity prices.

Slide 40

Many assets are purchased with debt. If interest rates are very low, purchasing these assets becomes more affordable. The sale of shares of stock provides another way of raising capital for a company. In the case of oil-producing companies, the purchasers of shares of stock often think, “If extraction costs are rising, surely oil prices and other energy prices will rise as well.” This belief allows the price of shares of stock to be bid up to a high level.

Slide 41

When asset prices rise, economists sometimes refer to the wealth effect. Homeowners feel richer if their homes are worth more, and they can borrow more against them. Owners of shares of stock feel richer if their shares of stock have higher values. Owners of pension plans are happy when stock prices are high, because it looks as if these shares can be sold, allowing the plans to meet their pension obligations.

If the debt bubble stops growing, then the commodity price bubble cannot continue to grow. In fact, it may abruptly pop. This is what happened in the second half of 2008, when oil prices dropped precipitously, from $147 per barrel to the low $30s.

Slide 42

Government pension plans such as Social Security are not treated as debt because they are not guaranteed, but they act in much the same way as debt.

Slide 43

The gray bars on Slide 43 indicate recessions. These recessions often seem to be intentionally caused. If a person looks closely, it is possible to see that in most cases, increases in US short-term interest rates preceded recessions. In fact, if a person looks at the minutes of the Federal Reserve Open Market Committee, it is sometimes clear that the Open Market Committee raised interest rates to intentionally pop asset bubbles in order to “reduce volatile food and energy prices.”

Slide 44

The huge interest rate spike to 18% in 1981 on Slide 43 corresponds with the big drop in oil prices on Slide 44. Interest rates were so high that buyers could no longer afford new homes or factories. Prices seem to have been brought down by falling demand.

Slide 45

If we look at recent oil prices, we can also see that they also depend very much on interest rates. In my paper, Oil Supply Limits and the Continuing Financial Crisis, I show that the US debt bubble popped precisely when oil prices hit a peak in July 2008. That is when US consumer credit and mortgage debt started falling.

On Slide 45, QE stands for Quantitative Easing. This was a program that allowed lower long-term interest rates in addition to lower short-term interest rates. Thus, it gave the Federal Reserve (and other central banks) the power to reduce interest rates to an even greater extent than was possible by reducing short-term interest rates alone.

Slide 46

The Federal Reserve seems to have been instrumental in causing the Great Recession, as well. Slide 46 shows a larger scale of the same information about oil prices and short-term interest rates shown on Slide 43. There can be several years between the time interest rates are raised and the resulting recession occurs, so most people miss the role that intentionally raising short-term interest rates plays.

Also, high oil prices also tend to have an adverse impact on the economy because energy prices rise, but wages do not rise at the same time (Part 1, Slide 28). Consumers are forced to cut back on discretionary goods when the cost of necessities (such as the cost of commuting and the cost of food) rise.

In fact, it seems to be the combination of rising energy prices and increased interest rates that leads to recessions.

Slide 47

On this chart, I show some of the comments heard about oil prices. In mid-2008, it was clear that high oil prices were becoming a problem, especially for those with subprime mortgages who were living in homes that were distant from their work. By early 2014, we started hearing that oil prices had been too low for oil producers in 2013. Because of the unprofitability of oil production, some oil producers were cutting back on investment in new production. See my post, Beginning of the End? Oil Companies Cut Back on Spending.

Now, it is fairly clear that no oil price will work for both producers and consumers. Today’s Brent oil price of about $80 per barrel is both too low for producers and too high for some consumers. Consumers who are particularly affected are those whose currencies are falling relative to the dollar, such as consumers in Turkey and Argentina. Even countries with more modest decreases, such as China and India, are cutting back on automobile purchases. This change will affect future oil demand.

If, by some chance, oil prices should spike to a high level such as $100 per barrel, the affordability problem pretty much guarantees that oil prices will fall back fairly quickly. This issue, by itself, makes it impossible to believe that oil prices will increase endlessly.

I should mention, too, that we are also at a point where no interest rate works for everyone. Those buying new homes and new cars need low interest rates, in order for these goods to be affordable. Pension plans, on the other hand, need high interest rates, in order to meet their pension promises. There is no one interest rate that works for every purpose.

Thus, we have a combination problem: no interest rate works for everyone, and no set of energy prices works for everyone.

Slide 48

The Federal Reserve is now in the process of raising short-term interest rates (see Slide 43). It is also selling the QE securities that it previously acquired to reduce long-term interest rates. If buying these QE securities lowered long-term interest rates, selling them should raise long-term interest rates. Raising both short- and long-term interest rates sounds like a formula for creating a huge number of debt defaults and lowering prices of shares of stock. It is likely that these actions will also start a major recession.

Slide 49

Slide 50

On Slide 50, “earlier” refers to Slide 16 in Part 1 of this presentation. From Part 1, we remember that the first small peak refers to the California gold rush; the second larger peak about 1910 refers to “Electrification and Early Farm Mechanization.” The third peak about 1970 refers to the “Postwar Boom.” The last small peak refers to the expansion made possible by China’s growth, and the growth of other Asian countries.

Slide 50 shows that the troughs refer to periods that were bubble collapses, or the collapse of the central government of the Soviet Union. Slide 51 (next) gives details with respect to these low periods. These were bad times for economies: depression, debt collapses, and periods with significant wage disparity. They were not periods with high energy prices.

Slide 51

Clearly, none of these low periods was a good period for the economy. While we can see that there was low energy consumption during the periods, the primary reason for this low energy consumption was the collapse of a debt bubble or of a government.

Slide 52

Peak coal occurred in the United Kingdom in 1913, and World War I began shortly thereafter, in 1914. When peak coal occurred, wages for workers were very low, because diminishing returns had made the operation of coal mines increasingly expensive, but those purchasing coal could not afford higher coal prices. Thus, mining companies could not afford to pay workers adequate wages. World War I gave an alternative employment opportunity for coal miners and others with low wages.

Entering World War I was a very successful strategy for the UK. The fact that the UK was on the winning side allowed the UK to retain its role as the holder of the reserve currency. In this position, it was fairly easy for the UK to borrow the funds needed to obtain coal and other energy imports.

Germany seems to have encountered peak coal about the time World War II began. Was this an attempt to cover up Peak Coal? We don’t know for certain, but the timing certainly looks suspicious.

In both of these cases, low energy supply seems to have led to fighting, rather than high prices.

Slide 53

The collapse of the central government of the Soviet Union seems to have been an indirect impact of the long term low oil prices in the 1981-1991 period. The high oil prices of the 1970s had encouraged the Soviet Union to ramp up oil production. Once the US raised interest rates and oil prices fell, there were no longer funds for investing in new oil production. The Soviet Union was dependent on oil exports. It was able to continue for quite a few years with low prices, but eventually its central government collapsed. Over the long term, consumption has continued to be much lower, reflecting the permanent loss of industry.

Slide 55

Slide 55 is a graph of the “peaks” on Slide 50. If we listen to mainstream economists (including Paul Romer and William Nordhaus, who recently received the Nobel Prize in economics), improved technology can allow the world economy to become increasingly efficient, and thus overcome the problem of diminishing returns. Slide 55 shows that over a period of nearly 200 years, this has never happened in the past. The troughs represent collapses of one kind or another. These low periods did not represent sustainable situations.

The problem is that diminishing returns leads to the need for very different techniques to work around new problems. For example, if there are diminishing returns with respect to extracting fresh water from wells, the first alternative is to dig deeper wells. Efficiency gains can somewhat help offset the cost of deeper wells. But once the problem advances to the point where desalination is needed, plus remineralizing the water with the correct minerals after desalination, the cost of fresh water becomes much higher. It becomes impossible for improved technology to work around the very large increase in costs that diminishing returns seems to cause.

We haven’t been able to work around diminishing returns with increased efficiency before; we are likely kidding ourselves if we think we can do so now.

Slide 56

Slide 57

Slide 58

The point that should be emphasized is that the reason why the United States economy now looks fairly good is because we are at the top of a debt bubble. This bubble is partly the result of world’s long running low interest rates, and partly because of the United States’ recent tax cuts. Thus, the situation today is a lot like 1929 before the debt bubble collapsed, or a lot like 2007 before the economy derailed. Things look good, but they won’t necessarily stay favorable for very long.

Slide 59 Conclusions Continued v2

Slide 59

Separate Additional Conclusions for Various Audiences 

At this writing, I have actually given variations on this talk three different times, to different audiences. The first audience (which is the one I mentioned at the beginning of Part 1) was a meeting of about 100 property-casualty actuaries. These actuaries help determine rates and financial statement amounts for lines of insurance such as automobile, homeowners, and medical malpractice. The specialized conclusions I added for that audience were the following:

Slide 61

Slide 62

The second version of my talk was given at the 2018 Bermuda International Life and Annuity Conference, to a group of 300+ insurance executives of various kinds. This talk was called Energy Economics: Is a Discontinuity Ahead? This audience was especially interested in my talk because interest rates are central to the operation of pension plans. If interest rates do not rise, this is a major concern for this group.

The conclusion slides to that presentation were the following:

Conclusions -Slide 1 of 2 – Life/Pension version

Conclusions for Life and Annuity Providers – Slide 2 of 2

The third version of the presentation I gave was to a group of followers of Peak Oil theory. This presentation was somewhat shorter and slightly rearranged. The title of this presentation was How the Energy System Really Works and What Seems to Be Going Wrong.

Its short conclusions’ sheet mentions the following dangers:

Conclusions of Shorter Version

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 financial problems for oil producers and for oil exporting countries. We are really dealing with a physics problem that affects many parts of the economy at once, including wages and the financial system. I try to look at the overall problem.
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2,106 Responses to The World’s Fragile Economic Condition – Part 2

  1. Chrome Mags says:

    https://www.reuters.com/article/us-usa-economy-tradefigures/u-s-trade-gap-widens-deficit-with-china-rises-to-record-high-idUSKCN1N71DL

    ‘U.S. trade gap widens; deficit with China rises to record high’

    “The Commerce Department said on Friday the trade gap increased 1.3 percent to $54.0 billion, widening for a fourth straight month. The trade deficit continues to deteriorate despite the Trump administration’s protectionist trade policy, which has left the United States locked in a bitter trade war with China.”

  2. raul says:

    I remember to have read here in recent times that Gail Tverberg expected a collapse in 2 years at maximum. Can somebody here point to that prediction, please? Becasue I am curios about the date.

    • Jason says:

      Hard to predict future. Will be in 2020’s, maybe sooner. Got to go with probabilities, but no matter how low probability, some lucky gut wins lottery, so almost anything is possible.
      Can we keep it going another 10 years? Probably not, but there is a chance.

      • Kurt says:

        Monday, it’s on a Monday. Even Gail agrees with that.

        • Davidin100millionbilliontrillionzillionyears says:

          there aren’t too many Mondays in the 2020s…

          only about 520…

          perhaps that helps to narrow it down…

          pay no heed to the 52 Mondays in 2019…

      • DJ says:

        Adonis bets on every day, except mondays, so he will probably win.

        Except the collapse won’t happen on a single day, so no one talking about dates will be correct.

    • doomphd says:

      her date was 2015, prediction was made in 2012. Error bars are +/- 3 years, based upon rounding errors in the data used, IIRC. so technically, she has 2 more months to “win”, whatever that means. you may have to mail in your congratulations, as the internet might be down.

      • The mail might be down as well as the internet. Hopefully, major disruptions will wait until well after the end of 2018, but perhaps I will still be right. It is too soon to tell at this point.

      • raul says:

        Thankyou, but I sure the prediction I did read was stated in past two years approximately.

        • Yorchichan says:

          Maybe you are thinking about this post of Gail’s from 3 years ago:

          https://ourfiniteworld.com/2015/08/26/deflationary-collapse-ahead/

        • This is the last chart I have put together with a forecast. It only shows energy quantities at five year intervals. The first low point shown relates to the year 2020.

          A major point I make is that consumption of all types of energy fall at the same time, even so-called renewables. Another point is that reserves or resources in the ground and our level of technology have very little to do with the future amounts we can extract. Our problem is that we cannot get prices to rise high enough. It takes a big debt bubble to keep prices up. Once this debt bubble collapses, prices of all kinds drop. This is why consumption drops off so dramatically.

          Peak Oilers have been preaching the wrong story about what is ahead.

        • raul says:

          It predicts a twilight time, indeed. Maybe also she has posted a comment around that time, with estimation of two years until collapse.

  3. Jason says:

    Err, hale, that is.

  4. WSJ: US to Issue Waivers to Eight Countries Under Iran Sanctions
    Waivers allow countries that cut Iran oil imports to avoid U.S. sanctions

    The Trump administration said Friday it is granting waivers to eight unnamed countries to allow them temporarily to continue importing Iranian oil without punitive U.S. sanctions, buying time for them to switch to other suppliers.

    The announcement by Secretary of State Mike Pompeo and Treasury Secretary Steven Mnuchin came days before new sanctions take hold Monday against Iran, with the addition of more than 700 Iranian banks, companies and individuals to the U.S. sanctions blacklist. The administration didn’t identify the eight countries.

    Analysts have said that China, India and Turkey were among the countries most likely to be given more time to find alternative supplies.

    So Trump decided to back off. WTI seems to be at $62.86 now.

    • Jason says:

      Oil trumps everything.

    • Davidin100millionbilliontrillionzillionyears says:

      shall we look at the Brent price today?

      72.83

      wow… on October 3, it was above 86.00

      wow… it has “soared” about 15% in the past month…

      at that rate, it would be zero in another 6 months…

      NOT a prediction!

      trends almost always change course…

      but, you never know…

      • adonis says:

        To Plan B Or Not To Plan B That is the Question? http://www.mission2020.global/climate-turning-point/

        • This report is absolutely and completely nonsense. There is no way that the proposed things could be done. Basically, they depend on repealing the laws of physics.

          If the climate is changing, we need to accept the situation, and move on. We don’t have a way of fixing it–certainly not in the directions they propose. Economic collapse would do essentially the same thing, but remove most or all humans as well. That seems to be the direction we are headed. So we are already headed for a different Plan B: Collapse.

          • raul says:

            “If the … is changing, we need to accept the situation, and move on.”

            We see that now Gail Tverberg does accept the forbidden story. Me, I don’t.

  5. Duncan Idaho says:

    “The essential American soul is hard, isolate, stoic, and a killer. It has never yet melted.”

    ― D.H. Lawrence, Studies in Classic American Literature

    Get out and travel– with a one way ticket

  6. Davidin100millionbilliontrillionzillionyears says:

    so…

    does that mean The End is 12/3?

    December 3 is a Monday!

    or perhaps 1/23 next year?

    no?

    • adonis says:

      the planned collapse date is either 11th of November 2018 or 20th of November 2018 or 18th of December 2018

      • Davidin100millionbilliontrillionzillionyears says:

        no way…

        no Mondays there…

        12/3 is a Monday…

        parties should be planned for 12/1 and 12/2…

  7. Chrome Mags says:

    https://electrek.co/2018/11/02/tesla-multi-billion-investments-gigafactories/

    ‘Tesla is planning massive multi-billion investments in its gigafactories over the next 2 years’

    “In 2019, we expect to continue to increase the Model 3 production rate in our Fremont factory while needing only limited additional capital expenditures. As we continue to expand our existing manufacturing capacity, introduce new products, expand our retail stores, service centers, mobile repair services and Supercharging network, we will continue to utilize our increasing experience and learnings from past and current product ramps to do so at a level of capital efficiency per dollar of spend that we expect to be significantly greater than historical levels.”

    • Fast Eddy says:

      Excellent – more EVs mean more coal burned to produce the electricity to charge them.

    • “For now, the company claims to be able to get to 7,000 units per week “with only limited additional capital expenditures.””

      Perhaps use more tents for building cars.

  8. Chrome Mags says:

    https://oilprice.com/Energy/Energy-General/Soaring-US-Oil-Production-Forces-Prices-Down.html

    “U.S. to grant waivers to eight countries importing Iranian oil. The U.S. has granted exemptions to eight importers of Iranian oil just days before sanctions on Iran take effect. The countries will be allowed to continue to import oil without fear of retribution from the U.S. as long as they continue to make reductions in those purchases, according to Bloomberg. Four of the countries include Iran’s top buyers – China, India, South Korea and Japan. The other four were not identified in the Bloomberg report, but the decision is expected to be announced on Monday.”

    Never thought I’d see Trump blink, but he did on the Iranian oil sanctions. He’s granted exemptions to EIGHT countries, including CHINA, INDIA, SOUTH KOREA & JAPAN. The other FOUR countries will be announced Monday. Its rather obvious he blinked because OPEC did not have the spare capacity to make up for lost Iranian oil, so without somewhere for Iranian oil to go oil price would have shot so high up it would have dinged the US economy something fierce as it heads towards winter.

    Rather anti-climatic I’d say. The balloon has been popped. The tension building up on what would happen to Iran if they couldn’t sell their oil or what would happen to oil price, or the US economy if oil price went sky high, is over. The tension is gone. Relax, take it easy and watch oil price barely move now. But I guess that’s a good thing, right. More BAU at leas for now.

    • Hubbs says:

      But the good thing is the DIJA can get a new lease on life when GE is dropped from the index. in fact it is the last of the original DOW stocks. Nothing like managed survivorship bias to keep the index looking good.

    • Interesting! GE is one who bet on (1) long term care insurance, (2) the electric power industry, (3) oil and gas, (4) nuclear, and (5) financing big deals to make these things work.

      The Long Term Care insurance was a disaster from the beginning. Actuaries didn’t stop to think that entering an assisted living facility was largely an affordability issue. Once insurance was available, a lot more people would use these facilities. They would move in when they were younger and in better health, and live longer. Also, the high interest rates involved in pricing these policies (assuming the early premiums could be invested at high interest rates to pay for later claims) turned out to be wrong. Also, people new more about the state of their own health than indicated on the applications. Premiums often could not be raised by nearly enough to fix the problems.

      The other areas mentioned did not do well either. Too much energy business went to China and other parts of the world. Falling interest rates were a disaster. So was the Fukushima accident, driving up nuclear costs. Electricity rates went from a cost plus basis to a basis where rates were often too low. Companies stopped replacing electricity transmission until it was clearly failing.

      All of these areas looked good, from a point of view of a BAU economy. But if that was not what we were headed for, the strategy didn’t work.

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