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 pricesof 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.
Central bankers seem to think that adjusting interest rates is a nice little tool that they can easily handle. The problem is that higher interest rates affect the economy in many ways simultaneously. The lessons that seem to have been learned from past rate hikes may not be applicable today.
Furthermore, there can be quite a long time lag involved. Thus, by the time a central banker starts seeing an effect, it may be clear that the amount of the interest rate change is far too large.
A recent Zerohedge article seems to suggest that problems can arise with 10-year Treasury interest rates of less than 3%. We may be facing a period of declining acceptable interest rates.
What really causes falling productivity growth? The answer seems to be very much energy-related. Human labor by itself does not cause productivity growth. It is human labor, leveraged by various tools, that leads to productivity growth. These tools are made using energy, and they often use energy to operate. A decrease in energy consumption by the business sector can be expected to lead to falling productivity growth. In this post, I will explain why such a pattern can be expected, and show that, in fact, such a pattern is happening in the United States.
Preview of Figure 4. Total quantity of per capita energy used by the US Commercial and Industrial Sectors (excluding transportation). Computed by dividing EIA Energy Consumption by Sector by Total Non-Farm Employment from the Bureau of Labor Statistics.
We live in a world with limits, yet our economy needs growth. How can we expect this scenario to play out? My view is that this problem will play out as a fairly near-term financial problem, with low oil prices leading to a fall in oil production. But not everyone comes to this conclusion. What were the views of early researchers? How do my views differ?
We live in a world with limits. These limits are not just energy limits; they come in many different forms:
All these limits work together. We can work around these limits, but the workarounds are higher cost–for example, substituting less polluting energy resources for more polluting energy resources, or extracting lower grade ores instead of high-grade ores. When lower grade ores are used, we need to process more waste material, raising costs because of greater energy use. When population rises, we must change our agricultural approaches to increase food production per acre cultivated.
The problem we reach with any of these workarounds is diminishing returns. We can keep increasing output, but doing so requires disproportionately more inputs of many kinds (including human labor, mineral resources, fresh water, and energy products) to produce the same quantity of output. This creates higher costs, and can lead to financial problems. This phenomenon is one of the major things that a model of a finite world should reflect.
What is the real story of energy and the economy? We hear two predominant energy stories. One is the story economists tell: The economy can grow forever; energy shortages will have no impact on the economy. We can simply substitute other forms of energy, or do without.
Another version of the energy and the economy story is the view of many who believe in the “Peak Oil” theory. According to this view, oil supply can decrease with only a minor impact on the economy. The economy will continue along as before, except with higher prices. These higher prices encourage the production of alternatives, such wind and solar. At this point, it is not just peak oilers who endorse this view, but many others as well.
In my view, the real story of energy and the economy is much less favorable than either of these views. It is a story of oil limits that will make themselves known as financial limits, quite possibly in the near term—perhaps in as little time as a few months or years. Our underlying problem is diminishing returns—it takes more and more effort (hours of workers’ time and quantities of resources), to produce essentially the same goods and services.