Why Energy-Economy Models Produce Overly Optimistic Indications

I was asked to give a talk to a committee of actuaries who are concerned about modeling the financial future of programs, such as pension plans, given the energy problems that are often discussed. They (and the consultants that they hire) have been using an approach that puts problems far off into the future. I was trying to explain why the approach that they were using didn’t really make sense.

Below are the slides I used, and a little explanation. A PDF of my presentation can be downloaded at this link: The Mirror Image Problem.

Slide 1

FCAS stands for “Fellow of the Casualty Actuarial Society”; MAAA stands for “Member of the American Academy of Actuaries.” Actuaries tend not to be interested in academic degrees.

Slide 2

I try to explain how a more complex situation can be hidden in plain sight.

Slide 3

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What has gone wrong with oil prices, debt, and GDP growth?

Our economy is a mystery to almost everyone, including economists. Let me explain the way I see the situation:

(1) The big thing that pulls the economy forward is the time-shifting nature of debt and debt-like instruments.

If we want any kind of specialization, we need some sort of long-term obligation that will make that specialization worthwhile. If one hunter-gatherer specializes in finding flints that will start fires, that hunter-gatherer needs some sort of guarantee that others, who are finding food, will share some of their food with him, so that the group, as a whole, can prosper. Others, who specialize in gathering firewood, or in childcare, also need some kind of guarantee that their efforts will be rewarded.

At first, these obligations were enforced by social norms such as, “If you don’t follow the rules of the group, we will throw you out.” Gradually, reciprocal obligations became more formalized, and included more time shifting, “If you will work for me, I will pay you at the end of the month.” Or, “If you will pay my transportation costs to a land of more opportunity, I will repay you with 10% of my wages for the first five years.” Or, “I will sell you this piece of land, if you will pay me x amount per month for y years.”

In some cases, the loan (or loan-like agreements) takes the form of stock ownership of an enterprise. In this case, the promise is for future dividends, and the possibility of growth in the value of the stock, in return for the use of funds. Even though we generally refer to one type of loan-like agreement as “equity ownership” and the other as “debt,” they have a great deal of similarity. Funds are being provided to the enterprise, with the expectation of greater return in the future.

As another example, governments make promises for future benefits, such as Social Security, healthcare, and payments to the unemployed. These payments are not guaranteed, so are not considered debt. Even without a guarantee, they act in many ways like debt. Citizens plan their lives around these payments, even though they may be reduced or eliminated.

Surprisingly, even “cash” is debt. It is similar to a bond that pays zero interest and has no redemption date; this type of bond can also be easily transferred from person to person. Since cash can be hidden under mattresses, it too can be used as a device for time-shifting.

(2) The big thing that goes wrong in this time-shifting approach to operating the economy is the loss of what I would call an “opportunity gradient.”

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Debt: The Key Factor Connecting Energy and the Economy

There are many who believe that the use of energy is critical to the growth of the economy. In fact, I am among these people. The thing that is not as apparent is that growth in energy consumption is dependent on the growth of debt. Both energy and debt have characteristics that are close to “magic” with respect to the growth of the economy. Economic growth can only take place when growing debt (or a very close substitute, such as company stock) is available to enable the use of energy products.

The reason why debt is important is because energy products enable the creation of many kinds of capital goods, and these goods are often bought with debt. Commercial examples would include metal tools, factories, refineries, pipelines, electricity generation plants, electricity transmission lines, schools, hospitals, roads, gold coins, and commercial vehicles. Consumers also benefit because energy products allow the production of houses and apartments, automobiles, busses, and passenger trains. In a sense, the creation of these capital goods is one form of “energy profit” that is obtained from the consumption of energy.

The reason debt is needed is because while energy products can indeed produce a large “energy profit,” this energy profit is spread over many years in the future. In order to actually be able to obtain the benefit of this energy profit in a timeframe where the economy can use it, the financial system needs to bring forward some or all of the energy profit to an earlier timeframe. It is only when businesses can do this, that they have money to pay workers. This time shifting also allows businesses to earn a financial profit themselves. Governments indirectly benefit as well, because they can then tax the higher wages of workers and businesses, so that governmental services can be provided, including paved roads and good schools.

Debt and Other Promises

Clearly, if the economy were producing only items for current consumption–for example, if hunters and gatherers were only finding food to eat and sticks to burn, so that they could cook this food, then there would be no need for the time shifting function of debt. But there would likely still be a need for promises, such as, “If you will hunt for food, I will gather plant food and care for the children.” With the use of promises, it is possible to have division of labor and economies of scale. Promises allow a business to pay workers at the end of the month, instead of every day.

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How our energy problem leads to a debt collapse problem

Usually, we don’t stop to think about how the whole economy works together. A major reason is that we have been lacking data to see long-term relationships. In this post, I show some longer-term time series relating to energy growth, GDP growth, and debt growth–going back to 1820 in some cases–that help us understand our situation better.

When examining these long-term time series, I come to the conclusion that what we are doing now is building debt to unsustainably high levels, thanks to today’s high cost of producing energy products. I doubt that this can be turned around. To do so would require immediate production of huge quantities of incredibly cheap energy products–that is oil at less than $20 per barrel in 2014$, and other energy products with comparably low cost structures.

Our goal would need to be to get back to the energy cost levels that we had prior to the run-up in costs in the 1970s. Growth in energy use would probably need to rise back to pre-1975 levels as well. Of course, such a low-price, high-growth scenario isn’t really sustainable in a finite world either. It would have adverse follow-on effects, too, including climate change.

In this post, I explain the reasoning that leads to this conclusion. Some back-up information is provided in the Appendix as well.

Insight 1. Economic growth tends to take place when a civilization can make goods and services more cheaply–that is, with less human labor, and often with smaller quantities of resources of other kinds as well.

When an economy learns how to make goods more cheaply, the group of people in that economy can make more goods and services in total because, on average, each worker can make more goods and services in his available work-time. We might say that members of that economy are becoming more productive. This additional productivity can be distributed among workers, supervisors, governments, and businesses, allowing what we think of as economic growth.

Insight 2. The way that increased productivity usually takes place is through leveraging of human labor with supplemental energy from other sources.

The reason why we would expect supplemental energy to be important is because the amount of energy an individual worker can provide is not very great without access to supplemental energy. Analysis shows that human mechanical power amounts to about 100 watts over a typical laboring day–about equal to the energy of a 100-watt light bulb.

Human energy can be leveraged with other energy in many other forms–the burning of wood (for example, for cooking); the use of animals such as dogs, oxen, and horses to supplement our human labor; the harnessing of water or wind energy; the burning of fossil fuels and the use of nuclear energy. The addition of increasingly large amounts of energy products tends to lead to greater productivity, and thus, greater economic growth.

As an example of one kind of leveraging, consider the use of oil for delivering goods in trucks. A business might still be able to deliver goods without this use of oil. In this case, the business might hire an employee to walk to the delivery location and carry the goods to be delivered in his hands.

A big change occurs when oil and other modern fuels become available. It is possible to manufacture trucks to deliver goods. (In fact, modern fuels are needed to make the metals used in building the truck.) Modern fuels also make it possible to build the roads on which the truck operates. Finally, oil products are used to operate the truck.

With the use of a truck, the worker can deliver goods more quickly, since he no longer has to walk to his delivery locations. Thus, the worker can deliver far more goods in a normal work-day. This is the way his productivity increases.

Insight 3. Growth in GDP has generally been less than 1.0% more than the growth in energy consumption. The only periods when this was not true were the periods 1975-1985 and 1985-1995. 

This is an exhibit I prepared using data from the sources listed.

Figure 2. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil's Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

Figure 1. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil’s Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

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What Greece, Cyprus, and Puerto Rico Have in Common

We all know one thing that Greece, Cyprus, and Puerto Rico have in common–severe financial problems. There is something else that they have in common–a high proportion of their energy use is from oil. Figure 1 shows the ratio of oil use to energy use for selected European countries in 2006.

Figure 1. Oil as a percentage of total energy consumption in 2006, based on June 2015 Energy Information data. (Inverted order from chart originally shown.)

Figure 1. Oil as a percentage of total energy consumption in 2006, based on June 2015 Energy Information data. (Inverted order from chart originally shown.)

Greece and Cyprus are at the top of this chart. The other “PIIGS” countries (Ireland, Spain, Italy, and Portugal) are immediately below Greece. Puerto Rico is not European so is not on Figure 1, but it if were shown on this chart, it would appear between Cyprus and Greece–its oil as a percentage of its energy consumption was 98.4% in 2006. The year 2006 was chosen because it was before the big crash of 2008. The percentages are bit lower now, but the relationship is very similar now. Continue reading