Off the keyboard of Monsta666
Discuss this article at the Money Table inside the Diner
The terms below should prove useful in understanding the content of this article:
|Anchor/Reserve Currency – Is the currency that is most commonly held by foreign central banks as reserves and is most commonly used to settle accounts when trading for vital commodities such as food/oil etc.|
|Fixed Exchange Rate – Sometimes referred to as a pegged exchange rate. A fixed exchange rate means a currency is priced at fixed range to another currency most commonly the reserve currency. Fixed exchange rates offer price stability to exporters but this comes at the expense of the country being unable to alter its competitiveness, in terms of exports, on the world market. A fixed exchange rate also leaves the country open to speculative attack meaning the country’s central bank must defend its exchange rate using foreign reserves. Notable examples of a country failing to defend its exchange rate occurred in 1992 when the UK failed to defend its rate in what was to be later dubbed “Black Wednesday”.|
|Floating Exchange Rate – Is when a currency is openly allowed to be traded in the foreign exchange market. A floating exchange rate allows the currencies to become more or less competitive depending on market forces but comes at the expense of greater volatility in currency prices. This issue of volatility is problematic for less developed countries and it is this reason why they tend to favour fixed exchange rate policies.|
In part 2 and part 3 we established not only the basic mechanics of the monetary system but also that all major currencies are debt based. Moreover due to the component of interest the total level of debt will always exceed the money supply of an economy. It is this property that means that long-term stability can only be assured if there is continued growth in the money supply and for this growth to remain viable it requires that the growth in the overall economy i.e. wealth increases in lockstep. Since resources and ultimately wealth in the planet is finite it follows that the balance between money and wealth will eventually fall out of sync and we will be faced with a situation of too much money (hyperinflation) or too little money (deflation). This part of the money/wealth series will attempt to answer the question of what scenario is more likely.
It is perhaps logical to think that if the rate of wealth extraction (GDP) declines and money supply increases then the obvious conclusion would be that hyperinflation would be the inevitable end-point as the number of claims on wealth (money) would vastly exceed the amount of actual wealth available in the economy. While such a conclusion sounds plausible it is important to consider that hyperinflation is only a relative measurement. That is the value of the currency can only diminish relative to something else so when making such statements it should be made explicit what the currency is hyperinflating against. In light of this it is best to make a small detour by explaining the International Monetary System and the one remaining function of money that has been neglected up to this point which is:
Relative valuation mechanism: Money acts a means of putting a numeric value to every good or service in the economy.
While this function may seem patently obvious the act of adding numeric value to each good or service greatly facilitates trade. To understand why this is the case it is best to consider a situation where no money exists. In a less developed community with no money the main means of exchange would likely be barter. The issue with barter is exchange rates for each item must be made so if we had carrots, tuna and milk we would need to devise an exchange rate for each combination of item i.e. 5 carrots = 1 tuna, 1 tuna = 3 litres of milk, 1 litre of milk = 1 carrot. While this system of barter maybe possible with a low number of items once the number of goods or services on offer increases then it becomes exceedingly difficult to maintain valuations for all items as all the possible combinations for trade become staggering high even with a modest number of items to trade for.
This issue becomes especially problematic if the availability of some items is very volatile (say some items go in and out of season). Moreover if there is a large degree of trade taking place it will become necessary to keep a number of goods in reserve as some goods such as tuna would be more easily bartered for certain goods while in other circumstances carrots maybe needed to barter for other items.
As we can already see the system of barter is quite cumbersome and the costs of storing all those reserves and maintaining exchange rates for dozens maybe even hundreds of items for future trade create addition costs than can quickly become prohibitive. It is this reason why most communities – once reaching a sufficient size – develop a monetary system as money serves to add numerical value to all items in question eliminating the need for constant reserves and constant revaluation of exchange rates.
As it happens this system is not only useful on a national scale but is especially important when it comes to the matter of international trade where the reserve or anchor currency serves the same function of “money” as it does with a small community described above. For the same reasons mentioned above, it would be impractical for every exporting nation to trade their domestic currency in exchange for each nation it happened to import into. If this method of trade occurred then every nation would need large amounts of reserves of every currency it happened to trade with and this dynamic would suffer the same inefficiencies as highlighted earlier. To avoid this issue a reserve currency has been established and all nations settle the vast majority of international accounts using that reserve currency. As a result all major central banks hold this currency in their reserve (hence the name). If we look at the chart below we find that there has always been a reserve currency and this dynamic has occurred for hundreds of years:
Bretton Woods System
In 1944 when the US officially became the world’s reserve currency with the establishment of the Bretton Woods system as it was clearly the most creditworthy and powerful nation in the world as all its former rivals literally lay in ruin.
In this particular incarnation the reserve all other foreign nations had their currencies pegged to the dollar at a fixed exchange rate. The dollar could then be redeemed for gold and $35 was enough to acquire one troy ounce of gold. This dynamic would continue until August 1971 when Richard Nixon closed the gold window making the dollar a fiat currency.
So how do countries decide on which currency becomes the reserve currency of the world? Generally a currency gains reserve status if it is the currency that belongs to the largest and most creditworthy country in the planet.
While there are definite benefits to having a reserve currency there are clear weaknesses with this system. This weaknesses stems from the fact that if a reserve currency is decided upon then the demand for that currency rises significantly as not only is the currency used for domestic purposes but foreign nations will demand enormous quantities of this currency to settle international accounts. In fact in many cases these international settlements will not even directly involve the country that holds the reserve currency. This large demand creates a strong incentive for the nation holding the reserve currency to overspend and run large deficits so it can supply other nations with the necessary reserves (and liquidity) to allow them to trade. Indeed after only 15 years of the Bretton Woods system being established Robert Triffin made the following observation:
“If you choose a currency because it’s a strong credit, and then give the issuing nation a financial incentive to borrow and print money recklessly without penalty, eventually that currency won’t be the strongest credit anymore!” – Robert Triffin, 1959
This statement would later become known as Triffin’s dilemma. It was this overconsumption and the subsequent over-indebtedness caused by this consumption that ultimately led to the demise of the Bretton Woods system. Despite this demise however the dollar retained its status as the reserve currency of the world. So why did this happen? As stated earlier the chief reason for this system being implemented in the first place was it facilitated international trade by making it far more efficient so despite its obvious flaws, weaknesses and privileges it bestows to the nation holding the reserve currency the system was maintained for this reason. The other major reason for the dollar maintaining its reserve status was the simple fact that there were no viable alternatives that could supplant the dollar and this fact remains largely true even today.
As time went on another problem became apparent and it centred on large exporting nations such as Germany, Japan the OPEC nations and more recently China. The most obvious and perhaps logical action is to think that foreign nations who received dollars for their exported products would sell the dollars they received from their exports in exchange for local currency via their central banks. However if this actually happened then it would have terrible consequences for the export nations future competitiveness. This is because the act of selling dollars would not only cause the value of the dollar to decline; it would also cause their own local currency to appreciate in value relative to the dollar. If this continued then over the time the value of the exported goods would become more expensive and reduce the nation’s ability to export further products.
The solution to this problem was for the central banks of the exporting nations to hold onto the dollars it received from the exporting company and then issue those companies with newly printed money in their domestic currency. Over time however the amount of dollars these central banks held became substantial and so they invested those dollars back into the US economy with the most obvious target for this investment being US treasury bonds. By doing this the exporting nation avoided the problem of an appreciating currency. This dynamic however had the side-effect that an artificial demand for US bonds was created resulting in the rates the US pays for its debts being kept artificially low. This then encouraged the US to spend beyond its means even further as their lack of financial discipline was not punished with higher interest rates as would occur with other nations. This ability to go into debt without incurring any cost became known as exorbitant privilege and is an advantage that no other nation enjoys.
So why did the export nations such accept this dynamic for decades even though they knew the US was becoming increasingly over-indebted, less creditworthy and generally less financially stable? There are several reasons why this dynamic has persisted but one of the reasons could be the simple fact there was no real challenge to the US dollar. Other reasons would be the strength of the US military and influence in international diplomacy meant that many countries were frightened to not challenge the status quo.
Perhaps the most significant reason for the US retaining its reserve status however may lie in the fact the US insured that all oil is traded in dollars. The US clearly understood the benefits of this exorbitant privilege and wished to maintain it even after the demise of the Bretton Wood system. To achieve this they had to ensure that people had to use the dollars to obtain some vital resource and that resource was oil therefore by linking the dollar to oil the dollar gained petrodollar status. To insure petrodollar status however the US had to make an agreement with various Arab nations that if they kept trading their oil exports in dollars they would receive their “protection” from attack. The Arab states agreed to this agreement and have traded their exports in US dollars ever since. This agreement to trade in oil can offer a possible reason why the US waged a war against Iraq as it was said that Saddam Hussein wanted to trade Iraq’s oil exports in Euros and if successful this would have posed a clear threat to the US’s exorbitant privilege and general hegemony of the US dollar.
How is this related to the deflation/hyperinflation story?
So the question maybe asked why this detour was necessary in the first place. The reason it is important to understand the international monetary system is because by realising how the system operates we can begin to appreciate that the reserve or perhaps the more appropriate term: anchor currency is the currency which all other currencies base their value on.
Considering the anchor currency is the dollar then this means all other currencies gain most of their value by how they are valued relative to the dollar as the dollar acts as the lynch pin to the entire international monetary system. In other words, if the dollar were to hyperinflate then the international monetary system would have no benchmark for other currencies to base their value on and so it would be likely that other currencies would have to hyperinflate themselves to maintain relative valuations to the dollar or more likely global trade would collapse. To understand this phenomenon more easily it is best to offer a hypothetical example.
If we consider the dollar to hyperinflate then it must hyperinflate relative to something else. This would most likely be the Euro the Yen or a currency held by an OPEC member. It can be either one; it does not matter. If the dollar hyperinflated against the Euro then the competitiveness of the Eurozone exports would decline to roughly zero as anyone trading in dollars could not afford to buy them. This lack of competiveness may be obvious to see in terms of US customers being unable to afford Euros as the dollar would be worthless but why would it be bad news for trading with other countries? This is because a considerable amount of international trade is settled in dollars and if the dollars themselves are worthless why would the vast majority of exporters continue to accept payment? It is likely they would refuse payment and so trade would drop dramatically (it can be noted that such an event would be highly deflationary as a collapse of global trade would render many companies insolvent). Now the only way trade could continue to remain viable is if the Euro reduced the value of its own currency rapidly to maintain some parity to the hyperinflating dollar. By doing so its exports could remain competitive and exporters can gain some value from their dollar denominated exports although the rapidly changes are likely to bring about its own issues.
It is this property in the international monetary system that almost guarantees the dollar can only hyperinflate once all other major currencies have already done so. The only scenario that can prevent this from happening is if another currency replaces the dollar as the anchor currency. However this seems rather unlikely because most currencies have generally moved from a fixed exchange to a floating exchange rate. This movement is significant because in the past when more currencies had a fixed exchange rate they held more foreign currencies in case they needed to “defend” their currency to keep it within its fixed exchange rate. By not having a fixed rate then there is no such need to hold these reserves which results in the currency fluctuating over a wider range. This however makes it harder for currencies to move towards a new reserve currency as they need to build more reserves of the new future currency.
On this topic of reserves it is instructive to look at the distribution of currencies held in reserve to see what the most viable alternatives for a reserve currency are:
Foreign reserve figures obtained from the International Monetary Fund.
As we see the only other currency that could realistically supplant the US dollar is the Euro and as off 2011 just under 24% of all foreign reserves is held in Euros. It remains questionable however if the Euro will actually take over the dollar considering the on-going Euro crisis that is making foreign investors question the future stability of the Euro. Indeed many of the developing countries are shedding their reserves of Euro at a tune of $90 billion since 2011. If this trend continues, and it seems likely that it will, then it means the chances of the Euro gaining sufficient worldwide confidence to become the next reserve currencies are slim. If the Euro cannot displace the dollar and become the new reserve currency then it is unlikely any other currency will in the foreseeable future seeing as the next largest reserve currency is the Pound sterling which only makes up around 4% of the world’s reserve currency.
The other popular suggestion for a successor to the dollar is the Chinese Renminbi (RMB) however there are several issues China would need to address in making the RMB a viable contender to replacing the dollar. First it must allow the RMB to be fully convertible so investors can move money in and out of the country easily, second there needs to be greater access to its domestic stock/bond markets which foreigners are largely barred from taking part in. Once these barriers are removed then it can be viewed as a more serious contender but even then the Chinese would need to address the issue of a lack of RMB in the world market. To increase the amount of RMB outside of China it would need to run a trade and capital deficit (as the US did) which is a complete reverse of what policies China is currently undertaking. Due to these reasons it seems unlikely China could become the reserve currency in the foreseeable future. For more information on this matter it is recommended to read Patrick Chovanec’s article which summarises the issue quite nicely.
This all leads back to the situation that the most likely scenario is the dollar will maintain its hegemony over the world market and so because of this the chances of it hyperinflating will be low until the other major currencies collapse first. It is possible however that another major currency such as the Euro could hyperinflate and this collapse could cause the dollar to hyperinflate as the breakdown in the European banking system may trigger a collapse in the global trade rendering the dollar useless outside its domestic market.
Before drawing such conclusions however we must consider the inflationary and deflationary currently at work. On the one hand we have various central banks such as the Federal Reserve with their open ended $85 billion a month QE program and more recently the Bank of Japan following suit with their own $43 billion a month program. These programs have created some inflation but only in the assets market and have had a minimal impact on the general economy; this particular issue was addressed in part 2 of this series. The other possible inflationary forces would be in the case of underlying wealth in the economy declining while the overall money supply would increase thus creating a large inflationary force. This inflationary force has been the main driver of inflation in the general economy and as energy prices have risen so has the cost of producing goods/services.
Speaking of energy it is useful to note that in the build-up to the 2008 financial crisis the price of oil shot up to $147 a barrel and these high prices likely played a significant role in triggering the financial crisis that was highly deflationary. These deflationary forces occurred because a large number of bankruptcies meant that a large amount of the money supply was destroyed as debt had to be removed from the balance sheets of various banks. Mass layoffs reduced spending and these combination of factors caused not only the price of oil to collapse to $35 but it also caused large scale declines in various assets prices from real estate to stock and even bond valuations.
It seems likely that another run up in prices in food, energy and oil prices will likely trigger similar events in the future and unless the inflationary forces are stronger than this then the most likely scenario is for a deflationary end-point. This scenario does assume however that the various central banks will not resort to “naked printing” i.e. giving money directly to consumers to spend. Which is a big assumption to make and it is very possible that if a country’s sovereignty faces an existential crisis then it is very possible they may resort to measures such as naked printing or money printing directed towards large government projects that will prove highly inflationary. Moreover it is very possible for currencies other than the dollar to face imminent hyperinflation once the world markets lose confidence in the currencies viability.
In the story of hyperinflation/deflation it is important to note these terms are all relative. If a currency hyperinflates or deflates it always does so against some other currency. Moreover for an event such as hyperinflation to take place it requires that people can take their currency and transfer this money into something of perceived value; which will be some other stable currency. This explains why governments always add capital controls during periods of high to hyperinflation as it makes peoples’ job of moving their money that much harder thus reducing the rate of inflation.
To demonstrate this last point let us consider a recent case of a currency collapse. In the case of Zimbabwe in 2009 the people of Zimbabwe could transfer their wealth to an object of perceived value, in this case the dollar. In the event of a dollar collapse however it is difficult to envision such an option being available as the value of wealth held in dollars is not only much higher but the amount of currency (say Euros, gold etc) is unlikely to be available in sufficient quantities to hold all this perceived value. If people cannot transfer these dollars into any other asset then hyperinflation cannot take place. Seeing as a collapse of the dollar would also cause global trade to decline massively it becomes even harder to see how hyperinflation would take off as assets and currencies across the board would be affected. In other words there would be no place where wealth could be reliably stored and maintained (which was not the case in Zimbabwe). It should also be noted that if global trade were to collapse then there would be many bankruptcies and most significant bankruptcies of major international banks. As was hinted on in part 2 of this series many of these banking institutions hold derivatives that are worth hundreds of trillions of dollars. If these contracts were not honoured it will lead to a significant perhaps catastrophic deflationary event. In any case though even if the dollar hyperinflated then the value of the other currencies would quickly diminish as their profits from exports would quickly plunge to zero due to massive currency appreciation against the dollar.
The other possible “run” on the dollar could be into precious metals such as gold but even this is unlikely to create hyperinflation either as there is not enough gold to absorb all the lost value from the dollar. This issue becomes even more problematic if we consider that gold ownership is more concentrated than ownership over actual dollars. Moreover such runs are likely to be prevented either through high taxation of gold related transactions or outright confiscation of gold as happened during the Great Depression. In addition to all this if there is a collapse in global trade the amount of goods/services in circulation would greatly diminish so the amount of real wealth in the economy would drop while the amount of gold in circulation would remain the same. If the money supply (in this possible case gold) remains stable while real wealth drops then this will create inflation as the claims are not following the rates of shrinkage in the underlying economy.
With all that said a great deal of caution must be exercised. These matters are far from certain and it should be recognised that at best everything said is informed speculation. We also need to acknowledge there is a good probability that the government can bring in some monetary policy that is highly inflationary particularly if their very existence is under threat. Then there is always the possibility of a black swan event that can change the outcome of the world economy quite markedly.
A war between Iran and Israel or a war between North and South Korea are possible examples of black swan events. In the case of an Iran-Israel war oil pipelines could be destroyed creating such havoc in the oil markets that would likely cease to function making international trade very difficult. A lack of confidence in receiving goods/services could see large exporters dumping their dollar reserves in mass leading to the dollar hyperinflating.
Black Swan Event: A low probability high impact event. Such events often take people by surprise however it is actually quite rare for a true “black swan” event to occur as often the event can be accurately predicted years in advance if people scrutinise data thoroughly in an unbiased manner. The last commonly stated black swan event would be the 2008 financial crisis as claimed by various neoclassic economists.
Assuming such events do not transpire however it seems inconceivable that the dollar could hyperinflate unless the government decided to hand people open checks to consumers to spend as these please or started some major government project using printed money (as was the case in the American Civil War). Also while the fate of the dollar is not likely to result in immediate hyperinflation within the foreseeable future the same cannot be said of other currencies. This I suppose could be included as part of the exorbitant privilege that the US enjoys. However even here there is an important fact to take note and that is in recent years some other currencies have enjoyed this privilege albeit to lesser degree. The UK and Japan have enjoyed low interest payments (which are actually negative in real terms) in their bonds despite both economies experiencing high debt, high fiscal deficits, trade deficits AND low growth prospects. The reason this happens is because both these economies enjoy “safe haven” status due to the on-going Euro crisis. Once the crisis in the Euro is resolved then it remains to be seen how the pound or yen will fair. In the event of a major currency collapse (such as that of the Euro) then it is likely we see appreciation in the Yen, Sterling and most significantly the US dollar in the immediate after mass which is the opposite of a hyperinflation end-point.
 = Black Wednesday: The day that Britain went over the edge (The Telegraph)
 = Currency Composition of Official Foreign Exchange Reserves – COFER (IMF: PDF document)
 = Developing World: Euro Loses Attraction as Reserve Currency (SPIEGEL)
 = Zimbabwe abandons its currency (BBC)
 = Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument (Bank of International Settlements – pdf file)
 = Roosevelt’s gold confiscation: could it happen again? (The Telegraph)
 = QE4 Is Here: Bernanke Delivers $85B-A-Month Until Unemployment Falls Below 6.5% (Forbes)
 = Bank of Japan’s Haruhiko Kuroda in aggressive growth move (BBC)
Off the keyboard of Monsta666
Discuss this article at the Money Table inside the Diner
The terms below should help those unfamiliar with financial terms to understand how to read money supply graphs and what the various metrics are used when determining money supply:
|Transactional Deposit – Also known as a demand deposit account, checking account (US) or a current account (UK). These accounts are used to deposit and withdraw money easily as well as make payments to various other parties. The money in transaction accounts can be used as a medium of exchange.
|Savings Deposit – Are accounts that are used to accrue interest but cannot directly be used as a medium of exchange. To use the money held in a savings account it must first be transferred to a transactional account. Interest generated from savings accounts are subjected to taxes at source before it even enters the holders saving accounts. Tax deductions are income and not capital gain based.|
|Time Deposit – Also known as certificate of deposits (US) or bonds (UK). These operate in much the same manner as savings account except that the money is kept for a fixed term until it can be withdrawn. If money is withdrawn before the term has expired then a penalty will be charged. Time deposits are not subject to reserve requirements in the US.|
|M0 money supply (US) – Notes and coins in circulation.M0 money supply (UK) – Notes and coins in circulation plus the commercial bank deposits in the Bank of England. This metric is referred to as “narrow money”.
|M1 money supply (US) – M0 + money held in checking accounts.
|M2 money supply (US) – M1 + money held in savings accounts and small time deposits (under $100,000).|
|M3 money supply (US) – Broadest measure of money supply and is M2 + all time deposits and other large liquid assets. M3/M0 is the multiplier ratio.|
|M4 money supply (UK) – Equivalent to M3 money supply for US is referred to as “broad money”. M4/M0 is the multiplier ratio.|
In part two of this series the basic mechanics of how the monetary system works was explained. In part three of this money series we will go into the implications of having a debt-based currency speculating on how it was created as well as discussing the various advantages and disadvantages of using such a system.
To observant readers who read the second part you will notice that in all instances described money was created by some form of credit expansion. In other words all money that currently exists has been loaned into existence. As we know, all loans made carry an interest component and it is this interest that means that the money supply must always increase at an exponential rate to meet debt repayment obligations. It is this interest bearing component and the exponential rising money supply that acts as a large driver on why the economy must grow and grow at an exponential rate even if this economic growth comes at a detrimental cost such as environmental degradation, rising social inequality, loss of freedoms etc. as repayments must be made.
Another inherent property of the momentary system is that the amount of debt in the system is greater than the total money supply. If you notice with the example provided with the fractional reserve system all money was loaned to new customers what was not highlighted in that instance was the fact those loans carry interest. The same is also true for the quantitative easing; in those instances we can see that the total debt exceeds the money supply because if we include the interest on those loans then we need more money than currently exists. It is this property of the monetary system that means some existing debts (at least if we consider things on a total macro level) must be rolled over with new debts as it would be impossible to repay all the existing debts in their entirety with the current money supply. As a result the existing system can only be sustained if there is continued growth of the money supply and for the money supply to continue growing it requires that the underlying economy must also keep growing.
This need for constant economic growth comes because – as highlighted in the first part of this series – the claims on wealth (money) must roughly equal the amount wealth in the underlying economy. If the number of claims against actual wealth goes out of balance then the value of money diminishes as it no longer offers a reliable means of valuing wealth even on an exchange value basis. Indeed it is this lack of economic growth in the major advanced economies of the world that is the chief cause for the instability in the financial system. While there can be complex debates about the precise nature of why these events transpired and who is to blame it must be recognised that the inherent properties of the system means it can only maintain stable if there is continued growth in the economy. Unfortunately infinite growth is not possible as the amount of wealth (resources) in the planet is finite so at some point this basic reality must be confronted.
This leads us to the question of why such a system came into being in the first place. Why create a system that is so inherently unstable? Now what comes next – at least in terms of how the debt based currency was created – is informed speculation on my part so it must be taken with a pinch of salt. However we can be sure that this is the system that currently exists so we are only speculating about its creation and not its existence. With that in mind I will offer a number of explanations of why this system was established. One of the major reasons is probably as mundane as a basic ignorance of how the monetary system operates. This allows the money makers to create an insidious system with relatively little resistance. Second the desire to make a return on investment is so high that without proper regulation there is always an incentive over time to use any asset be it food, gold a house etc. as collateral for a loan and then gain an income through the interest accrued by those loans. If a person earns enough income through interest then there will be no need to labour (and generate actual wealth) for an income; you just live through the “rents” from the interest and you become part of the rentier class. If enough parties seek a return for their investments then over time money will often naturally evolve to become debt based to service those needs.
Perhaps the biggest driver for a debt based currency however is that debt provides the means to fight wars more effectively. As we know wars are expensive and as time has gone on wars have become increasingly expensive; so much so that merely taxing the populace was not enough to fund a war. As a result many countries eventually had to find other means of securing funds and this came through utilizing debt to increase military spending. After all it is often the side that spends the most becomes the winner. Furthermore it is the winner of the war that gets to dictate the terms of peace and this often involves passing on the debt and most important of all the interest to the losing state. This is what happened at the conclusion of World War I and explains why the loser, Germany, went bankrupt as it was forced into paying all the debts (from itself, Britain and France) accumulated during the war years.
Therefore in light of this it should not come as any surprise that the first ever government bond issued was made by the Bank of England in 1694 to raise funds for a war against France. If all the above is true then we can establish the motive of using this system and why it started but then even this explanation fails to answer the question why this system of bonds (and by extension debt servitude) persisted outside of the wars. Wouldn’t it make more sense if the government simply issued debt free money instead of having to pay interest on money it created? The reason why this system of debt likely persisted outside of war is because in many cases the people who fund wars are either rich domestic citizens or foreign investors both of which are likely to hold significant political clout. This relationship becomes even more telling if these investors are other national states especially if that national state is stronger than the debtor nation (examples of this abound between third world debtor states and first world creditor nations). It is because of those reasons that interest payments must be honoured or the country in question will be cut off from international markets.
Over the centuries these debt obligations have become even stronger. First as most countries moved away from monarchist rule to that of democratic governments this meant that debts accumulated through previous administrations never died. In the past when a king died his debt died with him but under a democratic arrangement all debts become that of the state and so debts never expire. This issue is highlighted in the case when a despotic regime is overthrown but the new government is still under obligation to payback old debts from the old regime; such debt is sometimes recognised as odious debt in international law.
This issue of debt repayments has become even more acute in today’s globalised economy as nations have become dependent on the global economy to provide its basic needs such as food, energy and basic goods. This dependence coupled with the strength of “foreign investors” who own the largest financial and corporate institutions means that states are beholden to their demands and can only function by staying in this globalised system as national states have, for the most part, lost their autonomy as they have lost their means of production for some vital resource and can only obtain them from other markets. This can lack of “production” even extends to money itself as states do not create money themselves as all money is essentially created by private institutions that governments must effectively pay a rent (interest) to use; this dependence in obtaining money (debt actually) means the relationship between state and private financial institutions has – over time – come to resemble more of a parent and child relationship than that where both counterparties wield equal power. This issue of dependence would explain why various EU nations have continued to accept the onerous bailout conditions despite the damage it does to the country’s economy, finances and political legitimacy. This control, through financial dependence, seems to be recognised by various financial elites most notably Mayer Amschel Rothschild who had this to say:
“Give me control of a nation’s money supply, and I care not who makes its laws” – Mayer Amschel Rothschild
In addition, as noted earlier; all money is created into existence through loans and since these loans are created out of “thin air” it does not cost the people who issue the loans anything. Because of this money can act as an instrument of wealth extraction due to the interest bearing component of all debts accumulated this system. This means so long as the person controls the money supply it is possible from them to extract wealth from people with no/limited money (or credit) who must not only labour to repay the principle on the loan but they must work that “bit extra” to pay off the interest on the debt. All that’s really required is that the loans issued are not invested too badly to allow someone to accumulate great wealth over time as effectively they will claim a small percentage of the entire countries production. If even this gain is 1% (it is likely higher than this) then through compound growth large numbers will be generated in a relatively modest timeframe. Thus another inherent property of this system is it acts as a form of wealth redistribution that sieves wealth from the bottom and takes it towards the top. It should come as no surprise then that during a period of large banking (and by extension credit expansion) that the level of inequality in society will rise appreciably. The video below describes the points raised quite well:
Note: While Damon explains the money side of the equation well he largely ignores the wealth side of the debate which concerns limited resources. Because of this oversight his theory of how the world banks will rule the world is likely to be false as the large institutions can only be maintained with abundant sources of energy.
Saying all that there are numerous advantages to this monetary system and these must be acknowledged. First of all as already established since the monetary system expands at an exponential rate this insures that the money supply can match the increase in the economy as both tend to expand at an exponential rate. It is important to recognise that the economy is expanding at an exponential rate and is not increasingly in a linear manner (which tends to be what we think intuitively). If we look at the production and consumption of various resources we can see this exponential growth more clearly:
For most of human history economic growth primarily came from expanding populations but in more recent years, economic expansion came about through increased worker productivity. It is commonly stated that this increase in productivity came through the use of machine but as explained in Energy part 1 this increase in productivity primarily comes from the arbitrage between expensive labour energy and cheap energy that derives from fossil fuels. In fact the difference in use and exchange value as described in part 1 of this series has been a huge source of wealth and is one of the instrumental factors in how the US has maintained hegemony over the global economy by not only being the reserve currency of the world but by directly tying their currency to that of oil thus forming the petro dollar. This issue will be described more fully in part 4 of this series.
In any case an exponentially increasing economy means more wealth enters the human economy (at the expense of the overall ecosystem) so for a money system to remain stable (in the sense of stable prices) then the claims on this wealth must increase in tandem. This balancing act between money supply and the real wealth of an economy is crucial because if this balance is not kept then we will either see inflation (too much money) or deflation (too little money). Therefore an exponentially rising money supply serves as a good platform in the sense it avoids deflation (a fall in prices) which is a perennial problem of capitalism as there is always the issue of overproduction or as it is sometimes described underconsumption or declining aggregate demand (which is the current issue facing economies since the financial crisis). To learn more about this particular matter it is advisable to read the Waste-Based series (here and here) as this is a topic in itself. It should be noted however that deflation also means that it becomes harder to pay debts which is another big reason why central banks strive to avoid deflation. In fact one of their chief objectives is to avoid deflation. Indeed Ben Bernanke, head of the Federal Reserve, has made a doctrine about avoiding deflation and had this to say about deflation:
“The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an on-going basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress.” – Ben Bernanke, 2002
Another advantage that comes from a debt based monetary system is it reduces the issue of hoarding which is quite problematic in gold based or less developed monetary systems (such as those in Sudan). The dilemma that comes with saving is that money leaves the economy and until this money is spent it is left out of the money supply. If enough people save or hoard money (under the mattress perhaps) then it will mean insufficient amounts of money can be invested which will adversely affect the economy as growth will be severely curtailed. By offering interest to these savers there is an incentive for savers to give their money to the banks who then loan this money out to other users who will invest or spend it in the greater economy. A percentage of the interest gained from those loans is then passed back onto the saver and this is how the saver can accrue interest from their savings account. This method of incentivising savers through interest also has the beneficial effect that less savings must be held by the saver privately to meet on-going expenses thus reducing the cost of providing security in protecting and transporting this hoarded cash.
It is due to these advantages why this monetary system has persisted and can even explain why a fiat based system has even superseded the gold standard as the money supply can increase faster if it is fiat based and does not follow a gold standard. By doing so, this allows the relationship between a growing economy and growing money supply to be maintained for longer. Saying that, this was not the only reason for the departure from the gold standard and a large cause for leaving gold was to prevent the US losing its entire gold reserves which would eventually lead to it defaulting on its debt obligations. On this note of debt repayments it is important to understand and appreciate the mathematics of compounding growth.
Mathematics of compounding growth
We often here that the economy is growing annually by 1% or if we are lucky 2.0% and consider this growth rate rather benign and harmless at least from a resource depletion perspective but if we consider the matter more deeply we will find the basic arithmetic that comes from compound growth means that very large numbers can be generated by a modest number of doublings. Albert Bartlett in the video below describes this phenomenon succinctly:
To understand the significance of compound growth it is best to consider the amount of time it takes for a given quantity to double. The simple method in calculating this would be to apply the rule of 70 which has the advantage of being relatively easy to calculate mentally. In fact if any annual percentage is given (say for the rate of interest) then it is highly recommended you apply this mental calculation in your head to see how quickly it will reach its doubling time. To make a more precise calculation however the following formula should be applied:
Doubling time = In 2/ In (1+R)
r= Interest for example 1%=0.01
For the mathematically inclined the following
formula came from this equation:
FV = PV*(1+r)t
2 = 1 * (1+r)t
In 2 = In (1+r)t
In 2 / In (1+r) = t
where FV =Future Value , PV = Present Value, r= interest t =time
When using the rule of 70 or the formula shown above we will find that the doubling time is 70 years for 1% compound growth and this will decline to approximately 35 years for 2% compounding growth. What is most significant in this process is that after every double the total number of the new doubling amount will be greater than the sum of all the preceding growth. This phenomenon can be easily seen in the table below:
|Growing quantity||Cumulative total|
The significance of this chart is that as demonstrated earlier we live in an exponential world where various resources are consumed at an exponential rate (or needs to meet exponential growth rates) in tandem with economic and money supply growth. However as there are limits to growth due to resources being finite this dynamic of compound growth insures that the end point will be reached surprisingly quickly. In fact as we will find out many of the resources exhibit a bell type curve for its depletion profile and this is most notably the case for oil (see the peak oil article for more information on this). It is likely that when the most critical resource reaches the decline phase of the bell curve we will see issues with the monetary system as well as, on a fundamental level; it will not reflect the amount of wealth that is being extracted. Once this happens it is likely the claims of wealth will go out of sync and we will either experience deflation or hyperinflation as the monetary system can longer reflect reality of the actual wealth in our country.
We have a debt based currency system where the vast majority of all money creation comes from commercial banks and not the central banks. As a result it is primarily the commercially banks that will dictate what happens with the money supply. While the central banks can add reserves to these commercial banks this does not create new money for the general economy unless these banks decide to actually loan this money out. If that can happen then there would be an expansion of the money supply. Therefore much of the growth or possible destruction of money will come from the side of commercial banks and it is their activities we must monitor if we wish to determine how the monetary system will unfold.
Since all money is created out of interest bearing debt then it means our money supply increases at an exponential rate and can only survive by continued growth. This continued growth while clearly unsustainable has worked well however as the growth in the money supply has matched economic growth that also increases exponentially. However due to maths of compound growth it will become increasingly untenable for this dynamic to continue particularly if energy resources pass their peak in global production. When looking at the depletion profile of critical resources such as oil we find it follows a bell shaped curve:
If we observe the graph carefully we will notice that the first half of the bell shaped curve resembles the profile of an exponential curve and it is this property why the money supply could match increasing rates of consumption quite well for most of the 20th century and the early part of the 21th century. It is after this point of peak however where we will see a mismatch between our money supply and our overall economy. Since money is a claim on wealth if the monetary continues expanding despite a reduction in our economy then we would get high inflation to possible hyperinflation. If on the other hand money is destroyed (via bank defaults or excessive hoarding) caused by a contracting economy then we may get deflation but only if money is destroyed at a faster rate than a reduction in the overall economy.
In part four of this series we will explore the possibilities of this hyperinflation/deflation debate.
 = My life and work (pg. 179)
 = ‘Money: Whence it came, where it went’ (pg. 5)
 = Economics 12th Edition by Lipsey, R. G. and Chrystal, K. A. (2011) (Oxford University Press. pg. 455)
 = Banking Regulation of Uk and Us Financial Markets (pg. 83)
 =The Financial Crisis Inquiry Report: Official US government edition (pdf document: enter page 76 on pdf file is page 48 on actual report.)
 = Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument (Bank of International Settlements – pdf file)
 = GDP ranking (World Bank – pdf file)
 = Remarks by Governor Ben S. Bernanke (Federal Reserve Board)
 = National Economic Accounts (Bureau of Economic Analysis)
 = Tax on bank and building society accounts (HM Revenue & Customs)
Off the keyboard of Monsta666
Discuss this article at the Money Table inside the Diner
Below are a small set of terms that may prove useful for those unfamiliar with financial terminology:
|Bonds – A form of loan (or more correctly debt security) where the party who issues the bond is the borrower (debtor) while the party that purchases and holds the bond is the lender (creditor). A bond will pay interest usually on a quarterly or annual basis and this interest is called a coupon or yield. Nearly all bonds mature after an agreed period of time at which point the principle on the loan is fully repaid. There are some rare instances where a bond never matures.The most commonly traded bonds are local/state government bonds and corporate bonds. There are some hybrid bonds where the bonds can be redeemed for stocks in a company. Bonds tend to offer less returns than stock but the returns are more reliable as they tend to be less influenced by market conditions.|
|Stocks – Are a form of equity where a party owns a share (a fraction of ownership) in a company. Shareholders are often entitled to quarterly or yearly earnings through dividends. While the level of returns in stocks is generally higher, stocks carry greater risks as they are more subject to market conditions. Unlike bonds, stocks do not mature and remain outstanding indefinitely unless the company goes bankrupt or its ownership model changes significantly.|
|Derivatives – Are contracts that derive their value from some other asset. For example a long-term future contract for a food item derives its value by what the value of food is perceived to be in the future. The most widely known derivative contracts are futures, forwards, option and swaps. Traditionally such contracts were used by farmers as means of insuring they received stable prices for the food they sold throughout the year to protect themselves from food prices which fluctuated quite dramatically during the year. A stable price would aid a farmer when it came to planning their future income and outgoings. In more recent years energy companies have heavily used these contracts for similar reasons.A few years prior to the financial crisis the derivatives market increased dramatically as banks began trading heavily in Repurchasing agreements (Repo) which are basically formal contracts to roll over existing debts. Collateralised Debt Obligations (CDO) which is a form of loan where 100s even 1000s of mortgage loans are bundled together and sold to other parties. Finally there are Credit Default Swaps (CDS) which is basically a form of insurance to protect the lender in case a party fails to meet its debt repayments. The issue with CDS is that the owner of a CDS is under no obligation to buy the product they are insuring against which leads to the moral dilemma where they have an incentive to make the counterparty default. To offer an analogy it would be like owning fire insurance for my neighbour’s house. Since I do not own the property I am insuring against I would suffer no loss (financial or material) from its burning and would only gain profit if a fire were started by “accident”.|
|Hypothecation –The process where a borrower offers collateral to secure a debt. Thus the lender “hypothetically” controls the asset should the borrower default. A common form of hypothecation would be mortgages.|
|Re-hypothecation – Is the process where the creditor resells the loan that was secured by collateral by the borrower. To take the example used above; the bank will resell the mortgage that you are paying off to another party and then take the proceeds from that sale. As a result the new party holds “hypothetical” ownership to the collateral, in this case the house. At least that is the theory; sometimes due to how contracts were written ownership of the loan/property can become a matter of dispute.
“The people must be helped to think naturally about money. They must be told what it is, and what makes it money, and what are the possible tricks of the present system which put nations and peoples under control of the few.” – Henry Ford, 1922
In the first part of this series we explored the fundamental differences between wealth and money which described that at best; money is only a claim on wealth and is not wealth itself. In this second part we delve more into the actual mechanics of how our monetary system operates how it shapes our world and interacts with the underlying wealth that ultimately comes from the ecosystem.
Fractional reserve banking
It is perhaps one of the largest misconceptions that most of the money created in an economy comes from the central bank but this belief, even though it is promoted somewhat by various central bankers, is a false one. In fact most money creation occurs through commercial banks via the fractional reserve banking system. The system itself is largely counterintuitive in the sense that because the process generates money so easily it is rejected for being morally objectionable. Indeed this is exactly what John Kenneth Galbraith a former Economics professor in Harvard had to say about our monetary system:
“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled.” – John Kenneth Galbraith, (1975)
So what is the fractional reserve system? In essence it is the process of how banks lend out money that is a multiple of the amount of deposits (or reserves) held in their vaults hence the term fractional reserve as the reserve amount is only a fraction of the total money supply. To make this clearer it is best to offer a real life example of a working process of this system in action. Suppose we had a fractional reserve system with a 10% reserve requirement. In this scenario the amount of money in circulation will be ten times greater than the amount of deposits held. In other words 90% of the money created will come from commercial banks through bank loans while the original $100 came from the central bank. The process occurs because when a person deposits $100 into a bank the bank will loan 90% of this deposit out and retain the remaining 10% as reserve. However in this process of loaning money out the money supply has increased to $190 and not $100 as one may initially suspect. This is because the extra credit issued does not come from the account of the depositor as commonly thought but is in fact money created out of thin air. This process of loaning new money while retaining the 10% reserve amount will be repeated numerous times until eventually the amount of money in circulation will be ten times greater than the reserve amount, in this case $1000. If this process sounds a little complicated then it may prove useful to watch this video:
Note: While this video does explain the process of fractional reserve banking well caution must be exercised against its conclusions made against the Fed. The primary influence on money supply comes from the commercial banks and the fractional reserve system and not the central bank. It should also be known that the free banking era was marked with less financial stability than the post Fed period (1913+) as there was no lender of last resort.
As a note while the example described above may sound dramatic in reality the reserve requirements for countries such as the UK is lower than this as the Bank of England does not actually set compulsory reserve requirements and reserves have been cited as being as low as 2.1% as of 2010 of the total money supply. The table below illustrates how the money supply grows after the first person is given $100.
|Transaction No:||Amount deposited||Amount lent out||Reserves|
Who owns the depositors money?
A simple question with a surprising answer and one that should definitely be noted in the case of bank runs. When someone deposits money into a commercial bank the deposited money is no longer the property of the depositor as the ownership of that money is transferred to the bank. What happens is the depositor becomes an uninsured creditor to the bank and owns some bank equity/shares or bank stock that the bank is obliged to pay back with cash.While this may sound complicated what it really means is that if the bank went into a state of bankruptcy then the depositor is a mere uninsured creditor and unless their money is insured by the government which it will be (at least on paper) if the deposit is less than $/£100,000. If however the deposit is greater than this this amount then the depositor will be at the mercy of more senior creditors that will be paid first. It should finally be noted that the most senior creditors are the customers that deal with derivative contracts which is mostly conducted by the too big to fail banks. Seeing as the notional value of those contracts is $639 trillion as of June 2012 it becomes questionable how much money any creditor below those senior creditors will receive considering this amount is a multiple of the global economy which is valued at around $70 trillion
It is this fact why the banking system is inherently unstable because if people ever decided to withdraw their money in mass then the bank could not meet this demand as they do not have sufficient funds in their vaults.
The reason this system can remain viable however is because the banks know that people generally do not withdraw all their money at once. In fact they have found that if their reserves are sufficient to meet the demands of net withdrawals (that is deposits minus withdrawals) then they can remain solvent at least on an on-going basis. This last point is crucial because banks make most of their profits by loaning money so if a system can allow them to loan money by a multiple of the underlying value of deposits then it follows that their profits would increase by a multiple amount also. The important issue here is to match their reserve amount to that of net withdrawals and not total amount lent out (as commonly perceived). Banks must also make an assessment of the risks taken when extending credit as the capability of its lenders to payback loans issued by the bank will vary and if a bank can attract more creditworthy lenders then that will mean the bank’s capital (which is mostly loans) will be of higher quality.
Despite this safeguard and careful assessments of risk banks have gone bankrupt on a continual basis and this is especially true in a country without a central bank. The two main safeguards that are made against a bank run are interbank lending (notable examples include Federal Funds Rate, LIBOR and Euribor) where numerous banks can exchange loans to one another. These loans would serve to cover any surge in withdrawals that took an individual bank by surprise and would allow them to meet this extra demand until the situation returned to normal. It is only if withdrawals remained high for a protracted period of time or the problem was more systemic in nature that greater action would be warranted. The second and final line of defence against bank runs comes in the form of the central bank who acts as a lender of last resort.
While the central bank has numerous tools to mitigate a bank run (they can lower the reserve requirements for example) the most powerful way of protecting bank is to engage in open market operations, more specifically the purchasing of bonds by issuing credit to the commercial banks themselves. If a central bank lends out money they are increasing the reserves of the commercial banks which allows them to meet their lending obligations (which is often an issue when many loans are no longer repaid). There are two notable points to remember in all this, unlike what is commonly depicted in the media, quantitative easing is not direct money printing. The central bank loans money to its clients (the commercial banks) in exchange for financial assets. In most cases the assets in question are government loans more commonly known as government bonds (or gilts in the UK) however these assets can take other forms with the most notable example being Mortgage Backed Securities (MBS).
This exchange of financial assets while often overlooked forms a crucial role in maintaining financial stability. If a central bank actively buys financial products such as sovereign bonds or MBS they are creating artificial demand for these products. As a result two things will happen. First the book value of those loans rises which strengthens the balance sheet (remember loans are assets to banks). As the value of these assets or collateral rises then the ability to repay existing debts will rise. More crucial however is the fact that interest paid on those loans decline allowing banks and governments to make interest payments more easily.
In fact it is these purchases and the orchestrated nature of quantitative easing (the central banks often give ample warning before undergoing such programs) that undermine one of the central tenets of central banking. That is many of the advanced economies have laws in place that prevent central banks from lending directly to the treasury or directly funding a government deficit. These measures have been put in place to prevent this form of intervention leading to runaway inflation as this money creation does not go into the wages of government employees which would act as a huge driver of inflation (this would be the case if it were paid to the treasury directly).
The central banks across the world however have in effect circumvented this rule as the commercial bank buys the government bonds from the treasury who then turns around and sells those bonds (which are likely worthless without this money printing) to the central bank. This dynamic of buying and selling bonds or other financial instruments that are almost worthless to central banks is not limited to bonds and occurs with other financial assets. In effect the central bank is acting like the big “bad bank” and is the party that buys all the bad or “loser loans” from the commercial banks that either no else will buy or will not buy in sufficient quantities to make the loans valuable or even viable. However what is significant in these transfers is that the liabilities of the debt repayments shift from the commercial banking sector onto the taxpayer.
It is likely that this dynamic has allowed governments and banks to remain solvent as this demand for loans created by quantitative easing has been chiefly responsible for keeping interest rates down. If these programs were stopped or worse the interest rates set by the central bank were raised then the rise in interest rates would likely render many economies and banks insolvent. The fact that countries such as the US, UK and Japan run high fiscal deficits means that every year the interest rate threshold to remain solvent will need to decline year after year unless these deficits can be closed.
The second important point – which IS highlighted by the media – is the actual transfer of credit. It is often said that quantitative easing will lead to mass inflation as this “printed money” will be added to the commercial banks reserves and the banks will then lend this new money out to businesses and people creating a huge rise in the money supply via the fractional reserve system mentioned earlier, the so called money-multiplier effect. While this theory sounds plausible the reality is this has not been the case. If we look at the total money supply we find that despite unprecedented amounts of quantitative easing (in the case of the US $85 billion a month) the total money supply has been increasing at slower rate than prior to the financial crisis:
So why the lack of money growth? The reason for this is the banks see few opportunities to make a profit in lending so instead they hang onto the money. This lack of lending is also reflected by the fact the velocity of money; that is the measurement of how quickly money is exchanging hands has declined markedly since the 2008 crisis and has plateaued since around 2011:
Nominal interest rates: Typical rate you will see in the brochure of a bank when it advertises its interest rates.
Real interest rates: Nominal interest rate – Inflation
If real interest rates become negative it creates the perverse situation where it effectively costs money to save while it pays to loan money. This occurs because the rate of inflation exceeds the returns made through interest. When borrowing the opposite will be true. Negative real interest rates benefit highly indebted parties at the expense of savers.
Saying all that it would be a mistake to think the money is simply laying in the banks vaults doing nothing. A lot of this newly issued credit is invested and goes towards the stock market and other forms of speculation. In fact it is these cash injections that have likely fuelled the large amount of asset inflation in the form of rising stock prices. If we look at various stock indices such as the Dow Jones, FTSE 100 and other stock indices as these stock markets have seen significant increases despite poor performances in the general economy (in fact these stock indices are performing more strongly than stock markets in more buoyant economies such as China).
GDP figures obtained from the Bureau of Economic Analysis.
This is not the only reason for the stock markets to rise. Another side-effect of quantitative easing is that the artificial demand created for bonds will cause bond yields to decline, so much so that bonds no longer offer good returns for investors. As a result investors will be forced to invest their money in more risky products such as stocks due to the fact that bonds, savings accounts and real estate do not offer good enough returns to beat the current rate of inflation. This issue of low returns is particularly problematic for low-risk pension plans but it is this forced investment into stocks that has also contributed to the recent large gains in major stock markets across the world.
It is my belief that the two factors described above have been the chief reasons why we have witnessed large gains in the stock market. Both these reasons have stemmed from the process of quantitative easing either directly through money entering these markets or indirectly by forcing investors to leave the bond market due to lower returns caused by interventions in the bond market. To me it seems unlikely that the gains in the stock markets are the result of strong fundamentals in the underlying economy as low or negative growth in the economy cannot justify the gains we have seen in the stock market. It is this combination of gains in the bond and stock market that have been a boon for the government, banks and pension funds.
Most money in the monetary system is created by commercial banks and not central banks therefore the supply of money is largely determined by the activities commercial banks engage in. This statement is supported by the fact that despite the central banks intervention at an unprecedented scale through various programs of quantitative easing the total money supply is not only increasing more slowly but the velocity of money is (number of exchanges made with the money) decreasing also. This is due to the commercial banks lack of lending having a greater influence than what the central banks are doing. This leads us to the issue of inflation and deflation. While it is commonly cited that further rounds of quantitative easing will inevitably lead us to a hyperinflation end-point we must recognise that the lack of lending and more significant, increasing amounts of bankruptcies and austerity measures implemented will lead to deflationary pressures as austerity, defaults all cut spending which reduces the money supply.
At this present moment of time the inflationary pressures applied by the central banks just about equal the deflationary forces that exist in the main economy. It is this combination of inflation/deflation forces that will make the final end-point more complicated and nuanced than what people will generally expect. Please read part four of this series to find out more about this issue. For observant readers you will notice that all forms of money creation involved the use of loans thus the statement: all money is loaned into existence becomes true. In part 3 we will examine the implications of having a debt based monetary system.
 = My life and work (pg. 179)
 = ‘Money: Whence it came, where it went’ (pg. 5)
 = Economics 12th Edition by Lipsey, R. G. and Chrystal, K. A. (2011) (Oxford University Press. pg. 455)
 = Banking Regulation of Uk and Us Financial Markets (pg. 83)
 =The Financial Crisis Inquiry Report: Official US government edition (pdf document: enter page 76 on pdf file is page 48 on actual report.)
 = Amounts outstanding of over-the-counter (OTC) derivatives by risk category and instrument (Bank of International Settlements – pdf file)
 = GDP ranking (World Bank – pdf file)
 = Remarks by Governor Ben S. Bernanke (Federal Reserve Board)
 = National Economic Accounts (Bureau of Economic Analysis)
Off the keyboard of Monsta666
Discuss this article at the Economics Table inside the Diner
When talking about collapse issues one of the most prominent yet most commonly misunderstood areas comes with our basic understanding of what wealth and money really is. Both are seemingly simple matters yet upon closer inspection we find that are many nuances and subtleties in this story that people often miss. This misconception can even be extended to economists or people in finance that are well versed in money matters.
Indeed it is the complexity of money and all the financial products that derive from it with things such as bonds, stocks or other investment vehicles that can make us easily forget what wealth is really about. In fact it is this distraction through complexity that makes us commonly believe that wealth and money are one of the same things. It is useful to really grasp what wealth is lest we fall into a trap that many people, including the iluminati, who base much of their wealth in abstract financial instruments.
To understand wealth first we must realise that money only acts as a medium of exchange and by itself is not wealth. In addition to being a medium of exchange, money also acts as a means of measuring the relative value between various goods and services. This means of relative valuation while somewhat abstract is essential in any economy as the means of measuring relative values between goods/services becomes too complex without the use of money (for more information on this topic please refer to the Energy-Money Equilibrium series). These issues of valuation only become more prominent in international trade. Despite these obvious advantages all forms of money from fiat to even gold based currencies do not hold any intrinsic value by themselves. In other words we only place value in money because we can exchange items of value for it. In essence the value of money comes largely from the trust and faith that we have placed in it. This is even truer for fiat based currencies that cannot be redeemed for gold. If money cannot be exchanged for goods or services then any notional value money they have will disappear. For example if one was placed with a $1,000,000 and 1000 gold bars in a desert those forms of money would be of little use. You could not eat, drink or keep cool with this money and so without trade money would be utterly worthless perhaps even a burden and liability due to its weight and the danger it would pose against thieves by simply possessing them. From this simple example we can see that money has no value by itself and therefore cannot be counted as actual wealth. While this example may seem a bit silly the mechanics of money becoming worthless through hyperinflation work in the same dynamics.
However as noted money derives its value by the fact it can be exchanged for items of value so what we can say about money is that it is a claim on wealth. If we extend this claim concept a little bit further we can say that since debt is a claim on future income (money) then what debt really is a claim to a claim to wealth. That maybe a bit of convoluted way of expressing debt but if we wish to distil this last expression we can simply say that debt and money are both claims on the underlying wealth of an economy.
This all sounds nice and rather straightforward but it begs the question of what wealth actually is? Wealth can simply be expressed as the actual assets that a person owns for example a house, SUV, iPhone or other tangible items are all forms of wealth. As a side-note wealth is a measure of stock while money or income is measure of flow. This point while seemingly innocuous now will be an important concept to grasp as we progress further in this topic. As you see these tangible items – the items that society values – is the true wealth of an economy and the only role that money plays (which intrinsically has no value by itself) is it allows and facilitates the transfer of wealth between various agents in an economic system.
The other role money does play is it acts as a store of wealth so if we wish to store money then the money should be able to be exchanged at a later date for the same amount of wealth as if traded that day. At least this is what “sound money” should do. As we know due to the effects of inflation this proves not to be the case. However it is this issue of money acting as a store of wealth which leads to the first source of confusion between money and wealth. The means of wealth storage via money results in wealth being measured in monetary terms. The issue of measuring wealth through monetary values then leads to the point of determining how things are valued in the first place.
In modern economics the value or utility of any given item comes from the exchange value it has in a market. In other words the wealth of any item is only determined or realised once it has a value in the market which it can be sold for. While this may not seem like an issue, at least on first glance, this issue of exchange value does pose a problem. This is because there is a difference between exchange value (the value an item gets in the market) and use value (the value an item has to an individual or society). To illustrate the difference and problems posed by these differences of worth it is best to consider the age old concept of the diamond and water paradox. While water is a requirement for life and therefore has a high use value to people its exchange value is very low while a diamond; which is not needed at all for life and therefore has no or little use value has a high exchange value.
This is a curious development that comes from how our economic system places value on items. So what accounts for the difference? The reasons are actually quite easy to explain: water while highly useful has generally been abundant and easy to extract so even though its use value is high its exchange value has been low due to its abundance and easy extraction. Since the opposite is true for diamonds (it is rare and harder to extract) its exchange value has been high even though its actual use value is considerably lower.
The large discrepancy between use and exchange values generally occurs for many vital commodities such as food, air and most significantly energy resources. These differences in values have become more pronounced in recent years due to the abundances of energy in the last 200 years of the industrial revolution that have made not only energy cheap (from an exchange value standpoint) but have also made other resources such as food and water cheap as energy acts as an enabler of all other resources. For this reason energy can be regarded as the master resource. As a result of this phenomena it is likely we have grossly underestimated the wealth we have accumulated or perhaps in other cases (such as in fossil fuel depletion) we have grossly underestimated the wealth we have liquidated by only focussing on the exchange value of items and not their use value.
While this point may still seem to be of only academic interest it should be noted these very issues do tend to crop up in times of deprivation and economic dislocation when items in high demand are not bought as people do not have the means to pay the exchange or “going” rates. As a result while the use value of items such as food are still high; perhaps even higher in desperate times (people are more malnourished during these times) since people do not have the means to pay for the goods the exchange value will tend to be lower than in normal times. This leads to the paradoxical situation where the farmer produces a “surplus” of food even though there are millions of people malnourished or even starving. As a result of this “surplus” less food is produced (to cut losses from “overproduction”) which only further exacerbates the situation as there is even less food to go around. These issues can be extended to modern day equivalents when many lands in Africa maybe very fertile yet the amount of wealth is not as high as one would first believe as the exchange value or income ultimately determines the value and wealth of the land. It does not matter how much the people want food, the only thing that matters economically is what people are able to pay for the said food. On the other hand due to the flaws of this exchange value mechanism it can observed that an overweight person from a developed country will gain more utility (in a pure economic sense) from this food than a starving person because they can pay the exchange value and so wealth will transfer to this person as it delivers the greatest amount of utility from an economic standpoint even though the use value is obviously less. This issue is clearly not the best outcome from a social or moral standpoint and this example is a chief reminder of the flaws of the value system used in modern economics.
On this topic of land, the other important point can be made about wealth. That is fundamentally all wealth that we see in the planet comes from either the ecosystem of the Earth or the energy from the sun. Normally from a purely economic perspective we consider wealth as items such as factories, cars, roads or other items that have economic value. While such statements are indeed valid and can be correctly deemed as forms of wealth it is important to note that all these sources of wealth ultimately come from the Earth as they all require resource inputs such as oil, metals etc. to be formed. Therefore from this we can say the economic system that we live in today is actually part of the larger ecosystem and all the wealth we accumulate in the economy derives from the underlying ecosystem we live in.
As a result of this we can easily deduce that for the overall wealth of the human economy to grow it must come at the expense of the natural ecosystems wealth. Since all wealth comes from the Earth or the products from the sun’s energy (which is applicable to many forms of agriculture) it is not technically correct to say man creates wealth rather he merely extracts it from existing resources in the ecosystem.
This relationship between resource extraction and wealth extraction is quite obvious to see in the primary economy when resources are extracted directly from the ecosystems to provide goods of economic value but it can seem even with this wealth extraction concept recognised one may still envision the possibility of wealth creation through the transformation of a resource. To offer an example of this possible wealth creation let us consider the information sector which at its base claims to create wealth by using cheap resource inputs from metals and transforms these input into high value products such as computers and smart phones. While this process does appear to create extra wealth – at least on first glance – it should be noted that the process of manufacturing these products is highly energy intensive. First to build a typical computer or smart phone requires the resources that are scattered across the globe and as result requires large energy inputs to make these long supply lines viable as the video below clearly suggests:
Furthermore the energy use in manufacturing the product in the factory is also very energy intensive and requires very precise conditions (such as dust free rooms) to be maintained. In fact on a weight to weight basis computer manufacturing is around 10 times more energy intensive than the manufacturing or a car.This high energy consumption all stems from the second law of thermodynamics (to read more information on this topic please refer to the Energy: Part II article). In addition to these facts another general pattern can be observed; that is the more complex any given technology becomes the larger the amount of supporting infrastructure is required to build and maintain the technology. This support infrastructure does not just come from physical items such as longer supplier chains or more sophisticated factories but also in the form of higher education and training required for the workers to operate in these environments. These embodied energy costs while not directly related to the construction of the item itself are considerable and will pose a larger energy cost to society in general. This will be an even bigger issue in a declining net energy environment which is likely to be the case in the coming decades.
As noted earlier the exchange value of vital resources such as energy do not capture the true use value of this resource. To understand why this is the case for energy we need to consider how much energy is embodied in the various forms of fossil fuel energy. For example the energy extracted from one barrel of oil is equivalent to around 7 years of labourwhile the burning of one short ton of coal delivers around three times the amount of energy as a barrel of oil all at a lower cost.While the exchange value in these cases is around $108.50 for the barrel and around $64.96 for coal (at the time of writing) the amount of use value in terms economic output far exceeds their exchange value It is this arbitrage between exchange and use value that has been main reason for the explosive amount of economic growth we have seen in the last two centuries during the industrial age.
If the true use value of these fossil fuels plus the associated external costs (due to pollution) were accounted for then it is likely the amount of wealth created through this process would be considerably less. Furthermore as noted earlier all this wealth creation comes at the expense of fossil fuel depletion which is really the destruction of stocks of wealth. If we subtract the true losses of wealth from fossil fuel depletion coupled with the smaller addition of wealth created by capturing the true costs then it is likely no wealth has actually been created in this process. It is also important to note that once these resources are burned they are gone so it really a onetime deal and these stocks act like an endowment from nature.
As a result of this it is actually not appropriate to count the burning of fossil fuels as a form of income because really the burning of fossil fuels is a liquidation of stocks of wealth which is a one time deal. To give an analogy it would be like selling your home and then counting the proceeds as part of your yearly income. Such a thought sounds silly but if we consider how many nations count the burning/selling of this resource as part of their GDP (which is a measure of income) it becomes apparent how flawed our accounting system for measuring income and wealth is.
In any case what we can say with a good degree of confidence is that any wealth generated from this endeavour will come at the expense of a reduction in wealth in the natural ecosystem. For wealth to be created in the economy either resources or energy inputs must be consumed from the ecosystem. Now this is not to say this wealth extraction process is always unsustainable because in many instances, at least theoretically, it can be sustainable. This sustainability can arise because our ecosystem is not a completely closed system as it receives energy from the sun. As a result of this solar energy land can regenerate and create new wealth in the ecosystem. Indeed for much of human history wealth primarily came from the solar energy of the sun and wealth was obtained into the economy on a “pay-as-you-go” basis from wealth created from photosynthesis. It is only in the last 250 years that significant sources of energy came from the drawdown of fossil fuels and it is this drawdown that was responsible for the large amount of economic growth in the industrial age.
While it is possible in some circumstances for the human economy to grow for a time it should be noted that growth is only really sustainable if the resources extracted from the ecosystem do not exceed the capacity of the Earth to regenerate new resources and empty various sinks of pollution. Unfortunately in the world we live in today our current rates of consumption of resources exceed the world’s regenerative capacity and as a result many vital resources such as topsoil, water tables, fish stocks and animals are all experiencing declines.In addition the amount of pollution emitted exceeds the capacity of the Earth’s sinks to absorb these waste products and as result the pH in oceans are altering which has an adverse effect on various ocean fauna.In addition oceans accumulate increasing concentrations of pollutants and the atmosphere grows warmer due to C02 emissions. And this is all occurring at current rates of consumption; if we wish to pursue more economic growth and increase the wealth of the human economy even further then it must come at the cost of further degradation of the environment. If continued then it is likely these set of actions will lead to resource collapse (ecosystem bankruptcy?) and uncontrolled climate change.
Another important aspect to consider in this wealth story is that of profit. The normal definition for profit is that the supplier of a good or service must sell at a higher price than they took to produce the good/service. If we consider this from a wealth prospective then this means the cost of procuring the resource must be less than what the transformed resource will sell at the market. In other words the costs of the good/service should be less than the exchange value that it will sell for. However since we are only dealing with the exchange value and do not account for the use value then it is likely the actual profit from wealth standpoint is less than what we would get from an exchange or monetary standpoint. What’s more if all external costs such as pollution and environmental degradation (environmental costs should include the costs for removal of fossil fuels) are fully accounted for then it is likely that there would be no profit at all in various economic transactions (in certain cases it could be even a negative profit). In fact to obtain a real profit it is likely that a combination of three things must happen. Either the external costs are omitted or resources and/or labour must be exploited. By exploitation the price paid to procure these resources or labour must be below their true use value for wealth to accumulate. It is my personal belief that it is a combination of exploitation and unaccounted costs that allows nearly all economic transactions to produce a profit on paper.
Wealth and money are two fundamentally different concepts and the confusion between the two terms mainly arises from the fact we use money as a store of wealth. As a result of this all wealth is measured in monetary terms. However as money has no actual intrinsic value by itself then its value only comes from the fact it can be exchanged for items of value. It is this fact that means all items of wealth is only measured by their exchange value and not their use value. As a result of this money cannot capture the true value of wealth as not all values are accounted for.
As a result we cannot accurately account for the loss of wealth due to depletion of various resources and this issue is only compounded by the fact all external costs are rarely accounted for. If all these factors were factored in then it is likely the amount of profit or actual real wealth accumulated through our economy is a lot less than we imagined and could even be negative considering the declining quality of resources that we are now extracting.
Finally it should be noted that since money is only a claim on wealth and is not a source of wealth by itself then it follows that if the money supply increases faster than the underlying wealth in the economy then the result will be inflation (if the opposite occurs then we get deflation). It is this dynamic of changing money supply relative to overall wealth that will be explored in the next part of this money and wealth primer.
 = The monster footprint of digital technology (Low-tech Magazine)
 = What is a Human Being Worth (in Terms of Energy)? (The Oil Drum: Europe)
 = What is the average heat (Btu) content of U.S. coal? (EIA)
 = BBC News Market Data: Commodities (BBC)
 = Coal News and Markets (EIA)
 = What If the World’s Soil Runs Out? (TIME Magazine)
 = Chapter 3: Emerging Water Shortages: Falling Water Tables (Earth Policy Institute)
 = World fish stocks declining faster than feared (Financial Times: google title name for link)
 = THE EXTINCTION CRISIS (Biological Diversity)
 = How will ocean acidification affect marine life? (Ocean Acidification)
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner
Much of the mainstream media in the US bills shale gas as the next revolution that will push the country towards energy independence but the facts do not support these claims. Furthermore due to the high costs of extracting shale gas it is not economical to produce at current market prices. The effect of these low prices are already being felt from producers as drilling activity has decreased significantly throughout 2012 which has resulted in production levels plateauing.
It is likely that the US will peak in total natural gas production in the coming two years as peak production of conventional gas has already been reached and the high decline rates of shale gas make it very difficult to sustain even existing levels of production for a prolonged period of time due to the high levels of investment required to maintain exponential growth of drilling.
While the European region may have more reserves than the US and ultimately the problems will not be as acute the region is heavily dependent on Russia for its gas and will become increasingly dependent due to increasing consumption and reduced production in the EU region. As a result Europe will need to make some difficult decisions on how it procures its gas either from Russia or the Middle East which is rich in natural gas. Gaining access to the Middle East gas may prove to be difficult however due to the need for large investments in pipelines or LNG terminals. In addition to these financial (and possibly political) barriers there is likely to be strong competition from Asia and most particularly China for these natural gas resources as those economies grow faster than European countries.
Natural gas can come in various forms and this list should offer you a glance of the grades of natural gas available in the market:
|Conventional Gas – Consists primarily of methane but also contains other gases such as ethane, propane, other hydrocarbons, hydrogen sulphide, carbon dioxide and nitrogen.Although natural gas emits less C02 than other fossil fuels when burned it should be noted that methane itself is 72 times more potent than C02 as a greenhouse gas so any natural gas leakages in pipelines/LNG terminals will mean its advertised environmental advantages will be significantly reduced.|
|Condensate – Gases often found in oil wells and some gas wells. The gas found in these “wet” wells contain heavier hydrocarbons (such as pentane) which are found as a gas upon extraction but then condense to form liquids when reaching room temperature hence the term condensate.|
|Coal-bed Methane – Natural gas extracted from coal beds. This form of natural gas lacks hydrogen sulphide and is often called “sweet gas” because of this property. Coal-bed methane also contains less ethane and propane and none of the heavier condensate hydrocarbons.|
|Shale Gas – Natural gas found in shale rock. This form of natural gas has a slightly different composition to standard natural gas which can result in higher processing costs.  |
The importance of a global peak production of natural gas is somewhat less relevant than its peak coal or peak oil counterparts. This is because unlike coal or oil natural gas is not exported in large quantities. This is particularly true for the North American market as the costs of exporting natural gas over the Atlanta and Pacific oceans are excessively high. This makes the market for gas far less open and the closed nature of these markets is reflected in the huge differences in spot prices:
Natural gas prices obtained from BP Statistical Review of World Energy June 2012.
As a result of these closed markets it becomes more relevant to examine the time when natural gas will peak in each region. If we divide the world’s natural gas production into its respective continents we find the top three largest markets are the Europe, America and Asia Pacific.
|North America||Europe + Russia||Asia Pacific||Middle East||South America|
|2011 Total Consumption||863.8 billion cubic metres||1101.1 billion cubic metres||590.6 billion cubic metres||403.1 billion cubic metres||154.5 billion cubic metres|
|2011 Total reserves||10.8 trillion cubic metres||78.7 trillion cubic metres||16.8 trillion cubic metres||80.0 trillion cubic metres||7.6 trillion cubic metres|
|2011 % of world reserves||5.2%||37.8%||8.0%||38.4%||3.6%|
|2011 Production||864.2 billion cubic metres||1036.4 billion cubic metres||479.1 billion cubic metres||526.1 billion cubic metres||167.7 billion cubic metres|
|Year reserves are depleted||2023||2086||2046||2163||2056|
Data obtained from BP Statistical Review of World Energy June 2012.
|PROVEN RESERVES (1P) = Reserves that have a 90% or greater probability of being present, the term is often shortened to 1P.
PROBABLE RESERVES (2P) = Reserves that have a 50% chance of being present. 2P represents proven + probable reserves.
POSSIBLE RESERVES (3P) = Reserves that have only a 10% chance of being present. 3P represents proven + probable + possible reserves.
This figure of an 8% depletion rate equating to a 12.5 year supply is certainly a contentious and alarming point to make. It should be noted that other reputable sources such as the EIA arrive at similar figures claiming the US has a 13.7 year supply if taken on a R/P basis (R/P = Reserves/Production rate). In the case of the EIA it does stress however that discoveries currently exceed production rates. Still, this is quite different to the picture painted out by the media and even Obama who claimed that the US has enough natural gas to meet current needs for 100 years. This discrepancy over how long these reserves will last mainly stem from the fact that Obama included proven, probable, possible, speculative AND coal-bed methane reserves when applying the R/P ratio. It should also be noted that even adding all those reserves the total still only accounts for 95 years (it would appear the papers simply rounded of for the final five years). In the case of BP and EIA the supply time was calculated only using proven reserves.
In any case it is best to breakdown natural gas into its different grades to gain a greater understanding of the overall situation of natural gas production:
Natural Gas Production data obtained from EIA.
Note: Since January 2012 the EIA has only published aggregate totals for natural gas production.
From this graph we see that while natural gas production has risen slowly but steadily peak production of conventional natural gas was reached in December 2006 when 1.56 trillion cubic feet of gas was extracted that month. Since then production of conventional natural gas has declined by 35.5% for the period of December 2006 to December 2011. These declines in conventional gas have been masked by steep increases in shale gas production; in fact these large gains in shale gas have been the main reason why total natural gas extraction has risen in recent years. This large increase in shale gas is reflected in that fact that until 2007 there was negligible amounts of shale gas being produced but as of December 2011 shale gas makes up 33% of total natural gas production.
With conventional gas already reaching a peak it would seem that the US’s future in gas production lies firmly in shale gas production. Unfortunately the cost of producing shale gas is higher than conventional gas as it requires the use of more expensive horizontal drilling not to mention hydraulic fracturing (informally known as fracking) which on average the fracturing operation alone cost $6-7 million per well. This $6-7 million cost may not even cover the entire expenses imposed on society as hydraulic fracturing is a very water intensive activity with each operation requiring the use of 1.2-3.5 million gallons of water. Each well (of which there are currently thousands in operation) requires hydraulic fracturing and in some cases multiple fracturing operations are performed on the same well. Furthermore there is on-going controversy over the fact that the chemicals used in fracturing can result in water contamination on a chemical and even possibly radioactive level. It is also speculated that these drilling activities can result in minor earthquakes.
(10 minute extended trailer it is recommend you watch the entire movie for more information)
Other issues with shale gas come from its composition as shale gas is slightly different to conventional natural gas as it contains higher concentrations of ethane, propane, hexane and even diluents such as C02 and nitrogen;  this view is also supported by Dmitry Orlov. This means that the processing costs as well as drilling costs will be higher than conventional natural gas. To cover such costs it often stated that shale oil has to be priced at least $4 per thousand cubic feet but the figure is more likely to be $6 or even higher. Considering current natural gas prices are $3.19 per thousand cubic feet at the time of writing it means the vast majority of shale gas is being produced at a loss. As a result it should be expected that the number of rigs that drill for gas will be declining and upon inspection of drilling rigs that does appear to be the case:
US Active rigs engaged in oil/gas drilling, according to Baker Hughes.
The period between December 29th 2011 and December 28th 2012 saw the rig count for natural gas decline from 809 to 431 rigs a 46.7% decline in just one year! It is this decline in drilling that has resulted in total production for most of 2012 to stagnate. To make matters even worse is the fact that shale gas plays have high decline rates of around 65%-85%. As a result of these two factors it seems only a matter of time before shale gas and by extension total natural gas production in the US to decline. Indeed many shale gas producing regions such as the Barnett Shale, Haynesville Shale and Fayetteville have seen production rates plateau while The Eagle Ford and Woodford Shale have already began to experience declines. The only shale gas region that still appears to exhibit exponential growth in rates of production is the Marcellus Shale. However even with strong growth in this region it seems highly likely that production will hit a peak within the next two years due to the fact that annual decline rates for the US now totals 32% or 22 billion cubic feet per day and these decline rates will continue to increase even further as a larger percentage of gas wells are devoted to shale gas production.
Europe + Eurasia
While on the surface the European situation may not seem as acute as that of the US it should be noted that European natural gas production is dominated by Russian production with the country producing 58.6% of the gas in the entire region. Furthermore the United Kingdom; which was the third largest producer in the region as recently as 2008, is now experiencing major declines with the latest decline figures for 2011 being 20.8%. This on-going decline means as time goes on the Western European nations can no longer depend on Britain for exports and will become increasingly dependent on exports from further regions, the most obvious being Russian exports but this will also include other former Soviet countries such as Turkmenistan or Azerbaijan.
Natural gas production data obtained from BP Statistical Review of World Energy June 2012.
These issues of dependence will be further compounded if Germany follows through with its plan to phase out nuclear energy as natural gas will be the favoured fossil fuel to replace nuclear energy due to its lower C02 emissions. Indeed this move towards natural gas is a pattern repeated by many European nations as many strive to meet the EU quotas of reducing 20% of their 1990 C02 emissions by 2020. If we look at the energy mix of Europe we find that the amount of energy obtained from natural gas has consistently been increasing in the last 20 years:
Natural gas production data obtained from BP Statistical Review of World Energy June 2012.
It is this increased demand that means Europe will have to look elsewhere for gas to meet internal demand. Another candidate apart from the former Soviet states is the Middle-East most notably Qatar but also possibly Algeria. Qatar has the third largest reserves in the world and has trebled its exporting capacity since 2006 through the installation of numerous Liquefied Natural Gas (LNG) terminals. However such terminals are expensive and to be economically viable require the use of long-term contracts. Moreover Europe will face strong competition from Asia countries who are not only long-term customers to this exported gas but their economies are expected to grow faster than Europe.
Another avenue being pursued is that of shale gas however it is still early days to make any educated judgement on what will transpire here as most EU nations have opted to take a cautious stance to shale gas and wish to seek a rigorous regulatory framework being formed before pursuing this issue further. However the United Kingdom and Poland have been more aggressive in their pursuit of shale gas with both nations giving the green light to drilling. 
Regardless of what happens with shale gas in Europe the situation will not massively change. The simple fact of the matter is if we exclude Russia and other former Soviet nations the main EU block has already peaked in 2004 with a production of 327.5 billion cubic metres and since then production has declined by 15%. Seeing as the current trend is for natural gas consumption to increase then it means Europe must build extra infrastructure to accommodate more natural gas imports from either Russia or the Middle East but each option has its own set of problems. If Europe relies heavily on Russia they will have a monopoly and will gain an increasingly strong foothold on the energy market and the chances of a large scale disruption such as the disputes in 2006 and 2009 in Ukraine is likely to become more common place. This is a particular issue because 80% of all European gas imports from Russia flow via Ukraine pipelines. The probability of such disruptions occurring will only increase if numerous European countries experience recessions and struggle to pay their debt obligations as this was the chief cause for Russia shutting its pipelines to Ukraine.
If on the other hand Europe decides trade with the Middle East then it must invest heavily in either pipelines or LNG terminals to gain access to Middle Eastern gas but even then Europe will likely face the prospect of stiff competition from Asia for this resource and likely higher prices which will harm economic growth.
As we go forward it seems quite likely that supplies of natural gas will become increasingly strained. This will be particularly true in the west as production in Europe has already passed its peak and the growth of Asian economies will mean most of the excess supply from the Middle East and former Soviet bloc will largely be diverted to them. Moreover it is likely that the Asian economies will be able to tolerate higher prices natural gas prices (as is the case with oil) which will stand them in good stead in the future when it is reasonable to assume natural gas prices will rise (this will happen because of demand rising faster than supply).
The reason the Asian economies will be able to tolerate higher gas prices better is because of a concept known as energy leveraging. That is, when an economy faces high prices it will leverage these high energy costs against cheaper energy sources. In the case of Asia they have cheaper sources such as coal and even cheaper labour (which is less the case in Europe). This means any expensive energy sources can be diverted into economic activities that are more productive for example an Asian country will use this natural gas to provide electricity for a corporation which is a more economically productive use of this energy than if it were used to heat a domestic home in a European country. To learn more about energy leveraging please refer to this article. This dynamic will become even more prominent should there be a shortage of coal as suggested in my previous article.
These issues of constrained natural gas supply will be further compounded if the US reaches its own peak in the near future. While we cannot be certain this will be the case I believe this will peak will occur soon because of the high decline rates of shale gas. These high decline rates mean a high level of investment (which must increase on an exponential basis) needs to be sustained for production to continue rising or even to maintain a plateau. However since current market prices are below production costs these investments cannot be supported and as a result drilling activity will decline (this has already happened).
This sudden reduction in investment by itself would not necessarily result in production peaking even with high decline rates. For example if prices were to rise quickly then investments would return to normal levels fairly quickly. However I do not believe this will be the case. This is because due to the on-going recession in the US and the milder winters demand for natural gas has not kept up with supply. As a result the amount of gas held in storage has increased over the last few years:
As we see from the diagram storage capacity is near five year highs, indeed storage capacity has been close to the point of overcapacity. As a result it will take a considerable length time of time before storage levels get low enough for the price of natural gas to rise sufficiently to induce large scale investments. What is more if prices of natural gas rise above $4 per thousand cubic feet then that will mean it will become more economical to mine coal reducing demand for gas even further.
If this period of low gas prices carries on for a considerable length of time then producers will lose even more money and this is likely to make investors more cautious in reinvesting in the future after the shale gas bubble bursts. In the after mass of such an event it is likely any investors still interested in investing will scrutinise the economics more deeply and according to analysis from Arthur E. Berman and Lynn F. Pittinger (warning their detailed analysis is not for the faint of heart!) the shale gas plays are only marginally profitable even under the best of circumstances. This view is further supported by Richard Heinberg who suggests that the EROEI of shale gas can be as low as 6:1. With a ratio this low it is likely that these plays can only be supported if subsidised with higher EROEI energy sources. Therefore as time goes on and there are less cheap energy resources available it is very possible that shale gas production will largely cease as it would no longer prove economical from a financial and energetic basis to drill.
 = BP Statistical Review of World Energy June 2012 (BP as .pdf file)
 = U.S. Crude Oil, Natural Gas, and NG Liquids Proved Reserves (EIA)
 = The Math Behind the 100-Year, Natural-Gas Supply Debate (CNBC)
 = What the Frack? (Slate)
 = Natural Gas Gross Withdrawals and Production (EIA)
 = Landscape with well (The Economist)
 = Unconventional Gas Shales: Development, Technology, and Policy Issues (Congressional Research Service as .pdf file see pg. 11)
 = Shale Gas Measurement And Associated Issues (Pipeline & Gas Journal)
 = Shale Gas: The View from Russia (ClubOrlov)
 = Economics of Shale Gas (energybiz)
 = The murky future of U.S. shale gas (smartplanet – Chris Nelder)
 = Rotary Rig Count (Baker Hughes)
 = U.S. marketed natural gas production levels off in the first half of 2012 (EIA)
 = Barnett Report (Pickering Energy Inc. as doc file see pg. 19)
 = Chesapeake Energy – Haynesville Shale Decline Curve (Haynesville Shale)
 = After The Gold Rush: A Perspective on Future U.S. Natural Gas Supply and Price (The Oil Drum)
 = What is the EU doing about climate change? (European Commission)
 = The Cold Facts About a Hot Commodity: LNG (The Oil Drum)
 = Fracking for shale gas gets green light in UK (the guardian)
 = Poland Moves Ahead With Shale Gas Production (Arkansas Business)
 = Fourth Assessment Report (IPCC as .pdf file see pg. 212)
 = Natural gas storage capacity up 3.3 pct: EIA (REUTERS)
 = Headwinds for Rally in Natural Gas (Wall Street Journal)
= Gas Bubble Leaking, About to Burst (Energy Bulletin)
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner
The prevailing wisdom is that the US supply of coal is so abundant that the reserves will be able to satisfy current consumption needs for 200 years or more. Similar optimistic predictions are also made on a global level. However this optimism is not supported by facts based upon valid research.
In fact the quality and reliability of the available data makes any predictions highly suspect as much of the data has not been updated in many years often decades and there has been a history of reserves being repeatedly revised downwards. Moreover the quality of remaining coal is not only poorer but often has a higher polluting content due to higher CO2 emissions per capita energy, SO2, mercury and other toxins. In addition to this the poorer grade of coal is often more difficult to extract. It is this combination of factors that mean peak coal is likely occur much sooner than anticipated and this event is likely to occur just as the world – particularly the Far East – is making a transition from oil to coal.
Peak coal unlike its peak oil counterpart is a little trickier to define as maximum coal production can pertain to one of two things: peal coal production can mean the maximum amount of coal mined or it can be defined on its energetic peak. The reason these differences exist is because the heat content of the four major grades of coal are significantly different as described below:
|Anthracite – Has the highest carbon content (86% to 97%) and releases around 33,000 BTUs per kilogram. Rare in the U.S., it comprises only 0.2% of total coal production. All the anthracite mines in the U.S. are located in north-east Pennsylvania.|
|Bituminous coal – Contains the widest range of carbon content (45% to 86%) and releases around 23,100-34,100 BTUs per kilogram. Bituminous coal makes up 45% of U.S. coal production by weight and 54% by energy. West Virginia leads production, followed by Kentucky and Pennsylvania.|
|Sub-bituminous coal – Contains (35% to 45%) carbon content and releases around 18,200-28,600 BTUs per kilogram. Sub-bituminous coal makes up 47% of U.S. coal production by weight and 41% by energy. Wyoming produces the vast majority of sub-bituminous coal in the U.S.|
|Lignite – Contains the lowest carbon content (25 to 35%) carbon content and releases the lowest energy content of the four types at 8,800-18,260 BTUs per kilogram. Lignite makes up 7% of U.S. coal production by weight and 5% by energy. Texas and North Dakota are the main producers of lignite.|
Calculating the time when the globe will reach its peak in coal production both in total tonnage mined or energetic levels is problematic because the data available is of poor quality. This poor data manifest itself in two ways: first countries have demonstrated a consistent tendency of overstating proven reserves only to downgrade these estimates in the following years. Between the periods of 1980 to 2005 for example global coal reserves have declined by 55% from 10 trillion tons hce (hard coal equivalent) in 1980 to 4.5 trillion tons hce in 2005.On this point it should be noted that the EIA which has stated that it’s Estimated Recoverable Reserves (ERR) of 268 billion short tons for the US cannot technically be deemed reserves because of the fact these “reserves” have not been analysed for profitability of extraction. It remains to be seen whether we will see further declines in total reserve figures but considering the past data amendments it seems likely there will be further reductions made in the future. Thus any projections made in this article must be taken with a degree of caution as it is likely the peak production will come earlier than projected due to subsequent future downgrades of total reserve amounts.
Another issue we see is that many countries – most notably China – have not updated their reserve data for many years despite the fact there has been significant extraction of reserves since the last update. In China’s case the last update was made in 1992 and this is despite the fact that it has extracted over 20% of its reserves since then. With those shortcomings in mind we can try and make a basic overview of the coal situation in the four largest producers who account for 75% of global coal reserves :
|2011 Total reserves||237 Billion tonnes||157 Billion tonnes||115 Billion tonnes||76 Billion tonnes||61 Billion tonnes|
|2011 % of world reserves||27.6%||18.2%||13.3%||8.9%||7.0%|
|2011 Production||992.8 Million tonnes||333.5 Million tonnes||3520 Million tonnes||415.5 Million tonnes||588.2 Million tonnes|
|Year reserves are depleted||2250||2488||2044||2193||2116|
Data obtained from BP Statistical Review of World Energy June 2012.
What becomes immediately apparent are the large production and rapid depletion rate of China’s coal reserves. If China could maintain this 2011 extraction rate then their entire coal reserves would be exhausted by 2044 assuming there are no additions or reductions made to the reserve figures. While this fact is startling enough we must assume that production rates will continue to rise in the coming years as China undergoes further economic growth. If we examine the coal production rates of China against GDP we find that the two factors are closely in line with one another as the graph clearly demonstrates so this assumption of rising extraction is not an unreasonable one to make:
For the mathematically inclined this expiration date
was calculated by applying the formula below:
Te = 1/k × In ((kR/ E)+1)
Te= Expiration time k= percentage as a fraction i.e. 7%= 0.07 E=Production rate
Thus using the known figures of:
k= 0.075, R=1.15×1011,E= 3.52×109
Te = 1/0.075 x In ((8.625/3.52)+1) = 16.51 years
To calculate the time taken to deplete 50% of reserve base
Te= 1/0.075 x In ((4.3125/3.52)+1) = 10.66 years
If current trends were to continue then coal production would grow at a rate of 7.5% per annum which has been the average rate of growth for the 2000-11 period. Taking our current knowledge of existing production rates, total reserve amounts and growth rates we can calculate the number of years until China depletes 50% of its reserve base (when peak coal would theoretically occur) and we find the time required to deplete 50% of the reserve would be 10.7 years while the entire reserve would be depleted in 16.5 years if current growth trends were to continue.Thus by applying some arithmetic we can predict that China will reach domestic peak coal output of 7.61 billion tonnes by around 2022 or 2023. This peak year is not much different to the analysis provided by Dr. Minqi Li who projected a peak coal for China in 2027.
As stated previously, these figures must be approached with some scepticism as we cannot say with any confidence how accurate the data is. Still, even if we were to assume the best that this data is indeed accurate then the figures still paint a rather troubling picture as it demonstrates that current growth rates of coal consumption cannot be sustained for a period much beyond a few years even under the best of circumstances.
On the other hand if we assume that China is similar to other nations and will make downward revisions to its reserve base in the future then the peak is likely to occur even earlier than projected and this will be especially true if we apply the principle of Liebig’s law of minimum. That is production will be constrained by a factor that is most scarce in the production process. In China’s case what is likely to constrain production will be insufficient rail/road infrastructure to transport the coal, water shortages required for power plants and other bottlenecks be it economic (future demand rises more slowly), political (other energies gain more political support) or social (people do not want more pollution) in nature. Indeed it is these combination of reasons why Zhang Guobao; head of the China’s Energy Administration does not wish coal production to exceed four billion tonnes per annum. If that does prove to be the case then peak coal production will be reached in China in the very near future. This lower peak should enable reserves to last a bit longer but it will come at a cost of future GDP growth as China is heavily dependent on coal to generate its electrical needs (in 2009 for example 78.7% of total electrical production and 67.1% of total energy production in China came from coal). As a result, a reduction in coal production growth will reduce electrical supply growth and likely increase utility costs for consumers and businesses in the country. Whatever happens the depletion rates of coal will exceed 3% per year in either scenario which is an unacceptably high rate of depletion and means there reserve will be depleted by 2050.
Often dubbed the “Saudi Arabia” of coal the US has the highest coal reserves in the world accounting for 27.6% of global coal reserves.  It is often quoted by the media that the US has enough coal to last over 200 years under current rates of consumption. While this statement sounds hopeful there are numerous grounds to doubt whether this figure is really accurate. First of all, the estimates made in the 1970s have not been updated.  Second as stated earlier, the EIA has admitted that its reserve figures of 268 billion short tons are not reserves in the true sense as not all reserves have been analysed for profitability. What is more if we plot a graph for US coal production breaking down production into the four grades of coal we find discover a number of trends that may cast doubt that coal reserves are as abundant as commonly thought:
* = Please note that anthracite can be found at the bottom of the graph over the x-axis.
From this graph we see that the best source of coal; anthracite has largely been depleted. In fact the US anthracite production peaked way back in 1914 while the second best source, bituminous coal peaked in 1990 at 693 million short tons. It should be noted that bituminous coal production could, at least in theory, increase from current levels of production as the 1990 Clean Air Act did curtail coal production in the East coast as bituminous coal from this region contained a higher sulphur content. Still, it remains doubtful whether the 1990 peak could ever be eclipsed even if this act was repealed on account production has declined by 28% since the 1990 peak.
More significant however is the fact that the US has peaked on an energetic basis in 1998 with an output of 603.2 million tonnes of oil equivalent. The chances of this energetic peak being surpassed are higher however as 2008 production was within 2% of this energetic peak and the recent declines in gross coal output can reasonably be attributed to the recent shale gas revolution that has – at least temporarily – made natural gas the cheapest fossil fuel in the US market. Once the shale gas revolution ends and natural gas prices rise to more typical levels then we can determine whether this peak will be surpassed with greater certainty.
In any case we can say the EROEI for the US coal will decrease from now on because of the fact that more coal will be needed to be mined to deliver the same energy output due to the quality of coal being mined declining. This declining EROEI is also reflected in the fact that since 2000 US worker productivity, which is measured by tons mined per worker, has declined suggesting that the remaining coal is harder to extract and most of the “easy coal” has already been mined. This decline in worker productivity is a complete reversal of the historic trend in the US coal mining as prior to the year 2000 worker productivity had always been increasing in the country. This declining EROEI is likely to mean that we may have peaked in the amount of net energy this coal can provide, and considering that net energy is the energy used by greater society then that is troubling news indeed. For those that are interested in learning more about US coal reserves I would recommend watching the video below:
While the US has seen a recent decline in coal production and consumption, the same cannot be said for the rest of the world where coal continues to be the cheapest fuel on a BTU basis with a million BTUs in coal costing around $2.5-$3.5. It is this fact that makes coal the favourite choice for many developing nations in the Far East that utilise coal as the chief energy source as coals low cost has been the fuel to drive rapid economic growth. Moreover due to stringent regulations regarding coal pollution in the EU and US much of the heavier industries have shifted to Asia to take advantage of these lower costs. All this means that the production and consumption rates of the Asian block has sky-rocketed in the last 10 years with production increasing by 128.6% in Asia and 63.5% on a global basis since 2000. Off course for people concerned about climate change, CO2 emissions and other pollutants released by coal this increase is terrible news; it is certainly not the future many envisioned and if current trends hold then coal will be set to become the primary energy source of the world as soon as 2013.
Data obtained from BP Statistical Review of World Energy June 2012.
Conventional wisdom – a wisdom that is also shared by many climate change proponents – is that there are abundant amounts of coal in the ground that is sufficient to meet our needs for decades if not centuries. However upon closer inspection of actual reserve estimates we find there is great uncertainty on not just the reliability of the data available but there are also serious questions marks about whether our reserves can cope with the level of growth of consumption in recent years particularly the growth we see in the Asian countries.
Another troubling fact is the large depletion rates in China are likely to result in peak coal occurring in China within the next 20 years. If that is the case then that would have large ramifications on the countries future growth, as despite assertions to the contrary, coal dominates the energy mix in China and will continue to do so for the foreseeable future. Indeed it is this combination of rapidly rising demand and frequent downgrading of reserves that has organisations such as the Energy Watch Group projecting a global peak production of coal in the year 2025.
Diagram from Energy Watch Group projects global energetic peak coal occurring in 2025.
Richard Heinberg and David Fridley also share similar sentiments to the Energy Watch Group stating that the world will soon see the end of cheap coal. These higher costs will come as combination of declining coal quality and the remaining coal deposits being buried deeper underground or away from population centres. This issue of deeper coal deposits will be a particular issue in China as much of its large coal reserves are deep underground and will therefore pose considering engineering challenges to extract. Meanwhile in Siberia and Alaska there are large coal deposits in those regions but it seems unlikely these sources will be utilised due to the fact it would require a considerable amount of capital investment to not only mine the isolated and inhospitable regions but also build the necessary infrastructure for the coal to be transported vast distances so it can be sold in areas where it is needed.
The issues mentioned above will be further exacerbated if the world experiences a terminal decline in world oil consumption as demand for coal will increase even further to make up for the shortfall in lost oil energy. However what people are likely to find is that not only will there not be enough coal to meet new demand but it is also quite likely that any coal that is still available will be of a poorer quality and harder to extract. This therefore means the net energy or EROEI these coal deposits yield is likely to not be sufficient to take the slack from the lost oil production to allow economic growth to occur as commonly believed by many people and pundits.
 = Today in Energy (EIA)
 = Types of Coal (American Coal Foundation)
 = Coal: Resources And Future Production (Energy Watch Group as .pdf file – pg.11)
 = Peak Coal – Coming Soon? (The Oil Drum)
 = Full cost accounting for the life cycle of coal (The New York Academy of Science Journal as .pdf file – pg. 4)
 = BP Statistical Review of World Energy June 2012 (BP as .pdf file)
 = China GDP: how it has changed since 1980 (the guardian)
 = Forgotten Fundamentals of the Energy Crisis (Al Bartlett.org)
 = Peak coal and China (Energy Bulletin)
 = China’s Coal Crisis (The Wall Street Journal)
 = Facing China’s Coal Future (OECD/IEA as .pdf file – pg. 7)
 = US Coal Reserves: 1997 Update (EIA as .pdf file – pg. eight)
 = Coal (EIA)
 = Nuclear And Fossil Fuels (Dr. M. King Hubbert as .pdf file – pg.36)
 = Clean Air Act Taking Toll on High-Sulfur Coal Mines (Los Angeles Times)
 = Coal: The Ignored Juggernaut (PeakProsperity)
 = Coal: Resources And Future Production (Energy Watch Group as .pdf file – pg.7)
 = The end of cheap coal (Energy Bulletin)
Off the keyboard of Monsta666
Discuss this article at the Diner Newz Channels Table inside the Diner.
So 2012 has ended and we can look forward to another year tentatively wondering if 2013 will finally be the year when TEOTWAWKI arrives. In a morbid kind of way we find ourselves in a most peculiar position; on the one hand we wish for extra time to get some extra preps in but on the other we almost wish for it to come and finally get rid of the doomer fatigue that seems to plaguing the old veteran doomers. I know it is next to impossible predicting what will come in 2013 with any degree of certainty. In fact predicting such stuff is largely a fool’s game which could explain why economists and politicians like to base their careers on such predictions. Still, despite this fact I am willing to lay my neck on the line and try and predict what may come about in the following year. I just hope my predictions are not so bad so I end up being a head shorter.
The beginning of the year promises to start with a bang as we get front row seats on how the fiscal cliff will be handled. Even now I wonder as I type this on December 30th whether I have started too early with the guessing game and should allow the year to end properly before dishing out the predictions to see if a deal is finally made on the eleventh hour. If the worst does indeed come to pass we can expect a series of ($370 billion) tax hikes and ($230 billion) spending cuts which will amount to about $600 billion. Seeing as that is half the entire deficit one has to wonder how that will affect the economy. I should add that the main thing that has kept the US afloat has been this wild deficit spending, without it we are likely to see a big plunge in growth rates if we can even believe the massaged GDP numbers. According to Filch Ratings they are saying that this fiscal cliff could cut world GDP growth in half. And toadd to all these fiscal cliff dramas is the fact that Timothy Geithner recently stated that the US will hit its debt ceiling of $16.394 trillion on December 31st 2012 and can only extend this limit by two months at which point the US would default so at this point congress will have to decide on what to do about the fiscal cliff AND debt ceiling.
What seems most likely to me is the debt ceiling will be raised while the payroll tax holiday will be allowed to expire; people will need to make more payments towards Medicare, long-term unemployed benefits will end and people will see a hike in personal taxes. To me I predict and this is only based on a hunch that the Bush-cuts, at least for the vast majority of Americans, will be extended for a little longer. However if we are to assume the worst then the combination of taxes rises will cost the average American $3,500 or $2,000 for middle-earners which consist of 60% of the population. Scary numbers and the results should be pretty predictable if this cliff really comes to pass. One need only look at the experiences of the UK and other European countries who engaged in cuts to see what will happen. Not only did those cuts cause a recession but they did not even reduce the budget as much as promised. In fact if the subsequent recession is bad enough then deficits could even rise on the count of lower tax revenues and higher expenses that need to be paid for the rising unemployment. On this end I predict the deficit will be cut but only to about $900-800 billion.
As for broader US energy situation, I foresee softening prices for oil with WTI oil prices likely to remain around the $90 mark and may even dip as low as $75 if the fiscal cliff induced recession really bites hard, a bold prediction perhaps especially coming from a peak oiler. The shale gas situation should see some more dramas developing here as the rig count for gas has consistently been dropping throughout this year.
US Active rigs engaged in oil/gas drilling, according to Baker Hughes.
Seeing as these shale gas wells have such steep decline rates it seems quite possible that a peak of natural gas production will come at some point in 2013. As a result I predict natural gas prices to exceed $5 per million BTUs. These higher natural gas costs are likely to raise energy bills for the average US consumer thus reducing discretionary incomes even further. Speaking of high costs the drought of 2012 is also likely to lead to an inflation in food prices although I do not expect it to hit the wallets of the American too badly, the ones that are likely to suffer the most from these food price hikes are the people who live in poorer nations that rely on US food exports.
So with all those points put into consideration, I predict a recession coming (official one that is) for the US how big it will be is an interesting question…
2013 promises to offer much of the same as 2012, despite an almost year long recession that only showed growth in the quarter following the Olympics Cameron seems hell bent on carrying out further austerity measures. It is all done under the misguided belief that spending cuts will reduce the colossal deficit. It doesn’t take a genius to see this strategy has clearly failed in mainland Europe but in typical Tory fashion which takes clear abandon of common sense they will consider the UK a special case that is different to the irresponsible pigs. Problem is the fundamentals of high debt:
UK Public Debt with growth projections until 2015.
And exploding deficit says there is not much difference between the two and despite assertions to the contrary these cuts have done nothing to bring the deficit down. England’s deficit for the financial year of 2012/13 is projected to be even higher than the financial year of 2011/12. For those unfamiliar the austerity measures only began in earnest in 2012.
In fairness to Cameron as big as the public debt problem is it is not the main issue. You see if you aggregate British private and public sector debt then the amount comes to 507% GDP! What’s more it maybe even as high as 900% if you want to include liabilities and obligations such as public sector pensions. That is no typo! It is all the product of an economy that is too heavily centred on banks not to mention having a debt based monetary system (again no word in the media or schools about how money is REALLY made) but that is another story that deserves its own tale… To put this into perspective the PIIGS states of Portugal, Ireland, Italy, Greece and Spain have total debt loads of 356%, 663%, 314%, 267% and 363% respectively. The only thing staving Britain from bankruptcy is the low interest rates it pays on bonds but those low rates can’t last forever especially if foreign investors finally catch on we are broke… It would seem the EU crisis can have some unintended benefits for Britain!
In any case with higher energy bills, petrol, housing and food prices coupled with anaemic growth in wages it is hard to see anything but another year of recession. Overall I predict the economy will contract over the full course of the year but “official” unemployment will hover around the same total which is 7.8% or 2.51 million people. I should add however that this unemployment is clearly massaged as many unemployed people will be shifted into training programs that go nowhere or the unemployed will be encouraged to become “self-employed” for one hour a week… In addition some of the people on job seekers will be booted out of their benefits. Nothing will really change as a result of these shenanigans but Cameron can at least look smug with the outstanding improving figures these games will produce.
I can see the papers trumpeting any news that suggest extra jobs are being created; the thing they will be loath to mention is the fact most of these jobs are part-time or worse zero contract hour jobs which pay hardly anything. It continues to amaze me how senior economists such as Stephanie Flanders can continue to be baffled that service jobs paying £6 an hour for 30 or less hours a week cannot create a recovery! It is times like this where I almost want to hide the fact I studied economics…
As for the energy situation in England well the island is mostly tapped out. The North Sea continues to post double digit decline rates (this year it is 18%) and could even dip below 1mb/d next year which is a far cry from its peak of 2.7 mb/d in 1999. Hardly any mention of this in the media but it will have a significant effect on the economy as we will need to import more expensive oil (assuming demand does not fall) and that will increase the trade AND fiscal deficit. The same story holds true for natural gas although as usual the government has the hair brained idea that UK fracking of shale gas can somehow solve that problem. In any case the overall energy strategy for the UK can at best be described as muddled and the name of the game seems to be denial. If we can deny the worsening energy situation hard enough then maybe, just maybe, it will go away and solve itself. Alas it is never so. My advice, look at the energy bills as an indicator of how much gas and oil this country has. The onward trend is up. Oil prices have only levelled off recently due to the poor economy and the continued postponing of the planned rises in fuel tax duty. We can expect those breaks in fuel duty to end going into January 2013 however. My prediction for UK gas prices is it will top £1.50 a litre for unleaded petrol at some point in 2013.
I am almost at a loss to say what will happen in the EU. Upon reflection of 2012 I am actually a little surprised by how well the people from the PIIGS nations are taking austerity considering the sky-high unemployment and worsening future outlook. It cannot last and it is only a matter of time before Europe experiences its own “Arab Springs”. Saying that I do not see an implosion of the Euro as an imminent event so I am predicting there will still be a Euro come the end of 2013. Super Mario has made his intentions very clear that he will buy bonds in unlimited quantities to keep European banks afloat. While I am not suggesting this can ever be the ultimate solution I do think if Mario keeps true to his words then the sinking ship should hold for another year. Italian and Spanish bonds which are arguably the most important factors to consider have declined in recent months in light of this news so it is having its intended effect.
What’s more the temporary rescue funds provided used to help Greece, Ireland and Portugal will become permanent with the establishment of the European Stability Mechanism (ESM). This coupled with the relaxation of meeting various fiscal targets and the likely restructuring (politically correct way of describing a default) of Greek debts should ensure some measure of stability so that this charade can go on a little longer. Sure these measures are never a REAL solution but they do buy time which is what can kicking is all about. I am sure if need be extraordinary measures will be taken to safe to the Euro as there is no way the Euro will collapse on the year Merkel runs for election this coming November.
As always though, it is the issue of growth that will continue to be an issue that can undermine all the plans mentioned above. I don’t think it really counts as a prediction to say Greece, Spain and Italy will experience further recessions as austerity measures continued to bite. What becomes harder to predict is how Germany and some of the northern states will fair. The Bundesbank currently projects that growth for the German economy will be around 0.4% in 2013. Considering how these predictions are invariably over optimistic I will stick my neck out on this one and predict an overall recession for Germany in 2013. Could get burnt as the call is a little dicey but let us see how things fair out, eh?
The Far East, which for the purpose of this article consists of the Asian tigers (Hong Kong, Singapore, South Korea and Taiwan) plus China and Japan. These economies are generally regarded by many pundits as the future of the world economy with the influence of west waning in favour of the east. Indeed some go so far to claim that the 21st century will be the Asian century in the same token the 20th century was the US and 19th UK. Yet when we look back on 2012 we find the growth rates of several of these economies have been slipping.
To take the poster child of Asia let us look at China which posted a robust growth rate of 7.2% for the last quarter (if you can even believe the numbers). While this may sound impressive it has been the seventh consecutive quarter of declining growth. However seeing as much of their governmental figures are manufactured to the extent that even Li Keqiang – the favourite to become the next head of state – suggests that the figures are manmade we might need to consider that maybe, just maybe these numbers are bogus. As usual most of the mainstream press seem to ignore this inconvenient fact preferring to side with the China bulls. Fact is the best way to gauge China’s economic performance is not through GDP numbers but by monitoring electricity production/consumption, rail cargo volume and bank lending (as recommended by Li Keqiang). On that front China’s performance has not been doing so well with some regions reporting a 10% year-on-year decline. It remains to be seen how accurate this form of measuring is but what we can say is that since 2008 China has depended less on exports and more on investments to drive its economy. What is more investment now makes up a whopping 48% of GDP. To put this into context Japan and South Korea; who are other export driven economies that are also heavily dependent on fixed capital investments reached a peak investment rate of just under 40% of GDP.
Such a high investment figure suggests there is likely to be numerous bubbles as there an oversupply AND misallocation of capital, witnesses the ghost cities, bridges to nowhere and empty malls as proof of this wasted industrial capacity. So what do I predict for 2013 for China you ask? Well the Chinese government will NEVER report negative growth numbers so I can only predict growth if I hope to be right. However I do think China will actually grow in real terms not by much but some however since we can say the numbers are so fudged we will never really know how right (or wrong) my prediction will be, well I suppose there is always the chance of another Chinese revolution and in that case I would definitely be wrong if I predicted growth. But I don’t think the time has come for that… Yet!
As for the other economies of Asia Japan continues to experience more woes with recessions and more surprising their balance of trade going negative for a number of quarters. For an export nation to have the value of their imports exceed exports for numerous months can only be described as a disaster. To stop the rot newly elected president Shinzō Abe has pledged to fully open the money printing press spigot to devalue the yen. In addition in an attempt to shore excess imports of fossil fuels and bring back the trade deficit to the positives he has foolishly pledged to restart Japan’s nuclear plants. I guess nuclear disasters don’t have the impact they once had or consensus based group think is unusually strong in Japan… In any case despite such measures I do not predict many good things for the land of the rising sun and see another recession in 2013 with Abe being the next prime minister to pass through the revolving doors of Kantei soon after 2013. Some people suggest that Japan will be the surprise package that implodes financially due to its burgeoning public debt levels of 235.8% GDP but I do not see that crisis happening in 2013 later certainly but not now. For the crisis to really take effect bond rates need to rise and since about 90% of bonds are held by Japanese investors  the risk of interest rates rising quickly are not high, for now. The number of foreigner holders of Japanese bonds is rising however due to the fact that Japanese pension pay-outs to pensioners now exceeds pension contributions from existing employed workers so in time interest payments on bonds will rise.
The Asian tigers should see more promising growth and I expect them to show more positive results for 2013 so I will make a fairly bullish prediction and say that growth for these economies will exceed about 3%. A fun fact to keep in mind is that South Korea’s economy is heavily based on big conglomerates which are known as chaebol in South Korea. In fact the five largest chaebol control 57% of the GDP of South Korea so if you want to monitor the countries fortunes just look out for how Samsung, Hyundai, LG, SK and Lotte are performing.
It is hard to make any firm bets on what the outlook for the global economy will be for 2013 especially since the whole fiscal cliff issue has yet to be resolved. What we can say with some degree of certainty is the economic conditions in Europe are likely to worsen as further austerity measures are applied. Greece has been in a solid recession for many years and there is little evidence to think why this should not continue. As for the other PIIGS nations, wage reductions will be made in order to make the southern European states more competitive but this will lower economic output and increase unemployment. Expect to see more protests and strained nerves as the economic troubles we have seen in Greece begin to spread in earnest to Spain and Italy and as always low economic growth will lead to more bank problems/bails outs. These lower wages will also harm Germany who is a major exporter to these regions and since those nations are poorer they will buy less BMWs.
Poor performances in Europe is also likely to negatively impact other exporting nations such as China and the Asian tigers so growth is likely to slow there as well. Japan on the other hand will continue losing ground to its competitors so at best they will see further stagnation but more likely there will be another recession. The low interest rates in Japan and its perception as a safe haven will insure the Yen remains strong much to the chagrin of its exporting industries.
As for overall growth of the world economy, it is likely that there will be some growth overall but it will be small and it will be less than what we have seen for 2012. I will not discount the possibility of an outright global recession especially if the fiscal cliff is handled poorly in the US. Other issues to be aware of is the effects of the 2012 drought which is likely to lead to food inflation across the globe. The poorer countries in Africa the Middle-East and India will suffer to a disproportionate degree to these higher food prices. This will lower growth in those regions as incomes become squeezed and we cannot discount the possibility of food riots erupting in localised regions if prices rise high enough.
On the energy front 2013 should mark a few interesting landmarks namely that global coal consumption is likely to exceed oil for the first time in 60 years. This has come about because oil production since 2005 has roughly plateaued at 74mb/d while coal production has ramped up due to high growth of Asian nations which primarily use coal for electricity generation.
However these Asian nations have not just increased their consumption of coal, they have also increased their thirst for oil and 2013 should also mark the time when total oil consumption of the developed OECD countries will fall below 50% which will be an unprecedented event.
Predicting oil prices for 2013 will be a challenge, on the one hand you have rising demand with a constrained supply which will serve to higher prices but at the same time the on-going demand destruction in the West will lower prices. As a result I predict that average Brent prices of oil will for the most part stagnant at around $110 for the year which has been the average price for 2012. I cannot say with any certainty when we will leave the plateau in global crude oil production but according to the grapevine the year I keep hearing is 2015 which finally enough is what a former expert in the IEA is suggesting. In any case, global oil net exports are likely to decrease over 2013 as has been the general trend since 2005.
 = US Senate leader Harry Reid voices fiscal cliff fear (BBC)
 = All-out U.S. ‘fiscal cliff’ could cut world growth in half: Fitch (REUTERS)
 = Geithner: Debt Limit of $16.39 Trillion Will Be Met New Year’s Eve (CNSNews)
 = Q&A: The US fiscal cliff (BBC)
 = Rotary Rig Count (Baker Hughes)
 = Total Planned* Public Spending (UK Public Spending)
 = Office for National Statistics (ONS) data
 = Osborne Says He Needs More Time to Rid U.K. of Budget Deficit (Bloomberg)
 = Total Debt in Selected Countries Around the World (Global Finance)
 = The End of Britain (MoneyWeek)
 = UK unemployment falls by 82,000, says ONS (BBC)
 = North Sea oil tax revenues fall offers glimpse into a diminishing future (the guardian)
 = Labour loses fuel rise delay vote (BBC)
 = All hope not lost (The Economist)
 = Spanish Bond Yields Drop to 8-Month Low (Bloomberg)
 = Bundesbank Slashes 2013 German Growth Forecast to 0.4% (Bloomberg)
 = China’s economy slows but data hints at rebound (BBC)
 = China’s GDP is “man-made,” unreliable: top leader (REUTERS)
 = Capital controversy (The Economist)
 = Yen Weakens to 20-Month Low on Abe BOJ Pledge; Euro Drops (Bloomberg)
 = IMF urges Japan to tackle debt problem (Financial Times: Google headline name to see full story)
 = OECD: Japan Public Debt in ‘Uncharted Territory’ (Wall Street Journal)
 = Japanese pension assets fall as payouts exceed contributions (Pensions & Investments)
 = Business as usual for South Korea’s chaebol under Park (Yahoo! News)
 = Oil will decline shortly after 2015, says former IEA oil expert (The Oil Drum)
 = Updated “Gap” Charts, using annual data through 2011 (The Oil Drum: westexas)
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner.
In the first part of this two part series we discussed how the sheer amount of energy coupled by its cheap cost enabled society to increase the amount of work that could be produced at a much reduced cost. It was this cheap energy subsidy that made the process of arbitrage between human labour and fossil powered capital very profitable as the price difference between hiring labour “energy” and capital “energy” was so vast.
This huge energy subsidy not only provided great wealth to the ruling classes who owned the factories and other capital infrastructure it also enabled the workers to become more materially wealthy as the cost of producing items was reduced drastically. This happened because all work requires energy to transform a basic resource into a commodity that is of economic value. If the energy cost is reduced and the supply of energy is greatly increased then the amount of work that can be achieved by a society will greatly expand and thus the items produced well sell at lower price due to the principles of supply of demand. What is important when discussing these matters of energy availability and will become increasingly important going forward is the concept of net energy. To understand this concept it would be wise to understand the laws of thermodynamics, more precisely the first law of thermodynamics. This law was originally described as:
“In all cases in which work is produced by the agency of heat, a quantity of heat is consumed which is proportional to the work done; and conversely, by the expenditure of an equal quantity of work an equal quantity of heat is produced.” – Rudolf Clausius, 1850
For the mathematically inclined the following
formula captures the law of conservation as
any heat input will equal the work done.
dU = dQ – dW
where U =Internal energy of system, Q = Heat input,
W = work done
To many this statement may seem a little unwieldy and rather abstract but it basically describes the concept that energy cannot be created or destroyed and all energy transactions are merely conversions of one form of energy source to another. This idea is an important one to grasp since we can never actually generate energy; we merely extract it from existing sources.
This statement may seem rather obvious but since terms such as energy production and energy generation are so widespread it is easy to forget this fact. If we were to take such statements as energy production on a literal level they would be a clear violation of the first law of thermodynamics. Perhaps it can be argued this is just an argument over semantics and most people will know you cannot actually create energy but let us not underestimate the power of language and how it can shape conversations and narratives; over time people will believe such statements at face value as true even if they are patently false. This is especially relevant today when we hear so much talk about the US becoming not only energy independence but also becoming the top energy producer in the world.
But I digress, the main thing to take home is no form of energy extraction, be it from coal, nuclear fission (fusion for the optimists) and wind or solar actually generates energy. It just utilises existing energy sources. In the above examples energy is extracted either through nuclear fission/fusion reactions, potential chemical energy in coal/oil/gas or wind and solar energy. Another concept that will come from this basic idea and one that perhaps even more relevant is that it takes energy to get energy. This concept while important is something that rarely (if ever) gets discussed in the mainstream media. Much of the talk about oil, coal or gas “production” only refers to the amount of total energy that can be obtained from burning or utilising a given resource. This amount is merely the gross energy obtained from the ground. If we wish to determine the amount of useful energy available for greater society however we need to subtract the amount of energy used to obtain the resource in the first place. This is because it is only this energy that gets to be used by society for other economy activities. Thus for us to work out net energy we subtract the gross energy by the energy needed to extract the resource as described in the formula.
Gross energy = Total amount of energy obtained from energy source.*
Net energy = Gross energy – Energy required to obtain energy source.
* = Energy maybe expressed in other ways such as barrels of oil or million short tons of coal.
As a note net energy should not be confused with the similar but different term EROEI (Energy Return On Energy Invested) which describes the potential energy return from an energy source. The terms maybe used interchangeably by other commentators in the blogosphere but it would be a mistake to think they are the same thing. The way to calculate EROEI is quite different as demonstrated below:
EROEI =Gross energy / Energy required to obtain energy source.
EROEI = (Net energy/ Energy required to obtain energy source.) + 1
NOTE: Net energy is the energy available to society and thus something greater society would be interested in whereas EROEI is more of a potential concern for the person who wishes to see a return on their investment.
Since it is only net energy that gets used by the greater economy it is this value that we should be interested in knowing about rather than the gross amount. For example it is quite possible for our total gross energy to increase while our total net energy is actually in decline. If this were to happen we could easily see a scenario where we are getting materially poorer even though our total energy output is increasing. This process of increasing gross energy but declining net energy comes about due to the principle of low hanging fruit. That is the easiest and most favourable economic sources of energy – which yield the highest net energy – are extracted first and as those resources are depleted we move onto progressively worse and worse sources. It is this fact that the decline in net energy will be much steeper than gross energy decline.
This trend of declining net energy has likely already past as the newest sources of energy, a lot of which is touted as the energy source that will give the US energy independence actually yield poor amounts of new net energy. This is despite the fact this new energy sources (shale oil/gas) increase the amount of gross energy expended by the economy quite substantially. As a result from an economic standpoint these new sources of energy will deliver less economic benefit to society than would otherwise be believed as the extra net energy available will be more limited. It this reason why we should exercise caution when listening to claims that these sources of energy can offer a panacea to our economic troubles. In fact when hearing such claims it is useful to know the energy returns on energy for various sources as while this is not net energy which is ultimately the most important metric to gauge the EROEI can still provide an insight on how useful these sources will be:
As the graph clearly demonstrates; early sources of energy yielded a very high return of energy on energy invested. These high returns came about because early sources of energy such as shallow coal mines did not need much capital investment to extract the resource furthermore once these resources were obtained they would yield high quality energy such as light sweet oil or in the case of coal high quality anthracite. It is this reason in fact why net energy or EROEI has largely been ignored as historically gross energy for all intents and purposes equalled net energy.
In recent years however this has not been the case and the difference between gross and net energy is sufficiently large to warrant greater attention. Moreover another troubling fact to take note is that once EROEI reaches about 10:1 or lower the graph goes into steep decline. This steep decline means the available net energy that can be used by society will begin dropping at an alarming rate if current trends of extracting lower quality energy sources continue. If we take a recent major discovery of shale oil we discover the EROEI for this resource is 5. In net energy terms this represents 20% of the total gross energy being used to extract the energy source. So from this information we can say that if all existing resources of energy were replaced by sources that were to yield returns equivalent to shale oil then our total net energy available to society would decline by 20%. This assumes there are no efficiency gains in how we utilised this energy and total gross energy remained constant. If that is the case then this would effectively mean we are 20% poorer as less energy would be available for economic transactions.
Off course what is more likely to happen is the EROEI and thus net energy will decline even faster than suggested in the previous paragraph as worse and worse sources of energy come online to replace existing high EROEI resources. As a result we are likely to see a steep decline in net energy available to society and we can say with some certainty that this decline in net energy will be faster than the rate of efficiency gains which has been around 1.7-3.0% per annum since the 1970s. 
What is more due to the rebound effect (see this article for more info) it is likely that any efficiency gains made will need to exceed declines in available net energy by a few percentage points each year if we want sustain economic growth (which is a requirement for the financial system to remain stable). This all seems unlikely particularly if we consider that energy efficiency and conservation strategies will see diminishing rates of return as it becomes harder to increase energy efficiency after each progressing year. After all no economic activity can ever achieve 100% efficiency. Speaking of 100% efficiency this leads on nicely to the second law of thermodynamics which states:
“That the entropy of an isolated system never decreases, because isolated systems spontaneously evolve towards thermodynamic equilibrium — the state of maximum entropy.”
Like the first law, this sentence describing the second law can seem a little unwieldy. In fact it is best to breakup this statement into two sentences as the quotation above addresses two very relevant points the first of which is displayed below:
In other words no energy transaction can ever be 100% efficient meaning some energy will always be lost when converting energy into some form of work. This point while blatantly obvious is often overlooked in the contexts of economics and broader society. It is this reason why there will always be a limit to amount of economic growth that can be realised as the planet has a finite number of resources and there are limits to the amount of efficiency that can be achieved. Another major consequence that does derive from the second law of thermodynamics comes from this statement:
While at first glance, the concept of heat transfers may seem a little out there this statement does pertain to one important idea. That is over time all bodies and structures go from a process of order to disorder. For those that are really curious about this process and wish to learn more about the exact mechanics of this process please look up entropy. If this idea still seems a bit out there consider the fact that all structures, be it capital or labour, degrade over time and require maintenance to allow proper functioning. This maintenance always requires energy and thus some resources will always be needed to maintain current capital or labour.
The entropy of a system can be calculated by applying the following formula:
dS = dQ / T
where S = entropy, Q = Heat input, T = Temperature of system.
If we use the formula from the first law of thermodynamics and
rearrange the formula
shown above this statement can be derived:
dU + dW = TdS
*4 basic thermodynamic relationships develop out of this math
Internal Energy dU=TdS-PdV+ΣμdN
Enthalpy (Heat) dH=TdS+Vdp+ΣμdN
Hemholtz Free Energy dF=-TdS-pdV+ΣμdN
Gibbs Free Energy dG=-TdS+Vdp+ΣμdN
If you do a little basic algebra, you get
This equation gives the Free Energy available in a system as a function of the
Heat Content, the Temperature and the Entropy in the system. Only reactions
with positive dG can go forward without Heat Input.
In the case of labour humans need food to stay alive and remain functioning while capital requires some energy inputs to prevent it from degrading and evening breaking down over time. What is more the greater the complexity of a structure the more energy will be required for maintenance. This is because a more complex structure has a greater degree of order and since things naturally go from a state of order to disorder then more energy will be needed to prevent overcome this natural process.
This is another weakness with applying the logic that technology will save the day as increasing the complexity of technology not only increases the existing maintenance cost due to the second laws of thermodynamics; the cost of producing such items increases as more energy per unit weight are needed in the manufacture of the product. To demonstrate this example a car requires something in the region of 12-25 barrels of oil to build a car depending on the weight of the car but a computer – on a weight by weight basis – requires 10 times the amount of energy to manufacture. A similar cost will be borne in maintaining these two pieces of capital. While in theory there can be energy savings on a production basis as less energy will be consumed despite the increased weight for weight costs (we do not need 1000kg+ worth of computers after all) what will increase significantly are maintenance costs of more complex infrastructure. To give a better idea of this concept at work consider healthcare. As the capital becomes increasingly complex capital then the maintenance costs will rise for the reasons described above.
To summarise this article and the one before it; when we wish to engage in a discussion on energy we need to be aware of range of things. First we need to understand the sheer amount of energy fossil fuels provide. It is truly immense and is a miracle resource and there needs to be a greater appreciation just how much energy they can deliver. From this we can truly grasp the scale of the task an energy transition (if it is even possible) will be. It is seems unlikely to me any combination of renewable or nuclear energy can fill the gap left by fossil fuels. That is not to say renewables cannot make life easier, they do have their uses but we would be setting our expectations too high if we expect them to maintain our current industrial lifestyles.
The other important points that need to be considered is the point we should be interested in not only the quantity of energy delivered but also the quality of energy. At the end of the day it is net energy or EROEI we are really interested in as it is this energy that gets used for greater society. Finally we need to be aware that due to the increasingly complexity of society our maintenance costs will rise due to the second law of thermodynamics so these costs need to be accounted for.
 = Clausius, R. (1850). Ueber die bewegende Kraft der Wärme und die Gesetze, welche sich daraus für die Wärmelehre selbst ableiten lassen, Annalen der Physik und Chemie (Poggendorff, Leipzig), 155 (3): 368-394, particularly on page 373, translation here taken from Truesdell, C.A. (1980), pp. 188-189.
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner
Energy despite its utmost importance is a topic that doesn’t receive much attention and is a subject that is poorly understood particularly in the mainstream media or even economics. It is curious to think that this is the case especially if we consider that without energy nothing would literally happen. Taken in this context it is easy to see why energy could be regarded as the most critical resource for without it there would be no life on planet Earth.
It seems that one of the major reasons we forget about the importance of energy and take it for granted is the fact energy is ubiquitous in modern day society. If one cares to look outside their window it is likely they will see numerous cars whizzing around at high speeds (they are high if we compared their speeds to humans and animals which was the historic norm before the industrial age). If one thinks about this last point it can be quite an enlightening process; how much energy does it take to cart an object that weighs in excess of 1000kg at around 30MPH? Then think all this energy can be found in a single gallon of gasoline/diesel. And as startling as this thought maybe we can say we consume even more energy in total in our homes and workplaces and that is despite the fact there are over one billion cars – which nearly all run on oil – running across our planet. Quite a thought isn’t it? 
So in short we can say we are addicted to using energy. However this should not come as any surprise because man has always needed SOME energy to ensure his survival. The amount needed for basic survival is relatively modest however since the only real energy source man needed at first was direct consumption through food to stay alive. However through time man found other external inputs of energy that made life easier for him. The heat from fire allowed man to keep warm not to mention allowed him to cook and provide a source of light in the dark. Domesticated animals also reduced the burden of labour in the fields and allowed great productivity not just in hunting but also in managing the fields when man shifted to agriculture.
These external inputs of energy not only allowed man to extend his natural range of environments he could live on but it also spurred growth in population and prosperity as external energy meant more of the burden of labour could be shifted away from man. As time went on the number the external sources of energy increased and so did the amount of energy used by man. It was not until man began harnessing fossil fuels in earnest however that his energy use suddenly exploded. The graph below can clearly attest to this fact.
While this final fact is widely known it is still quite difficult to fully grasp and appreciate how much of a boon these fossil fuels were to mankind. To illustrate just how much energy we can obtain from these fossil fuels I feel it is best to apply a little maths. To make comparisons between different energy sources it is necessary to know what a BTU is. For people unfamiliar with the term a BTU stands for British Thermal Unit and one BTU represents the energy required to heat one pound (454g) of water by one degree Fahrenheit which comes to approximately 1055 joules.  Now if we consider the most expensive fossil fuel, which is oil, then we will find that burning one barrel of oil (42 US gallons or 159 litres) releases 5.8 million BTUs or 6.1 gigajoules of energy.  These large numbers may seem rather abstract and arcane but if we covert this total energy content into man hours then the facts can be more easily absorbed. The energy delivered from 6.1 gigajoules would equate to a man spending 1.45 million kilocalories. If we assume a man consumes somewhere between 100-200 kilocalories an hour then that would mean a barrel of oil produces the equivalent amount of energy as 7,290-14,597 hours of labour depending on how hard the man works. Assuming there are 48 forty hour weeks a year that equates to 3.8-7.6 years of human labour. Armed with this information it makes you wonder how we can ever consider a barrel of oil is overpriced at $90 dollars a barrel when one barrel delivers the equivalent of 3.8-7.6 years labour!
To put this into an even greater context if we decided to pay the man a decent wage of $10 an hour then we would need to pay him anywhere between $73,000-$146,000 to deliver the same amount of work as a barrel of oil. With this perspective it becomes clear what a boon fossil fuels have been proven to be as effectively we have been using these fuels as “energy slaves” due to the fact they produce so much energy at such a low cost. With energy being so cheap it becomes obvious just how profitable the exercise of replacing man and animal labour with capital powered by cheap fossil fuels has been as the price differential between the two markets is simply enormous. And let us not forget in all this that oil is the most expensive fossil fuel in today’s market and its price is abnormally high when compared to historical prices so it was even more economical in the past than it is today.
Saying all that we do need to recognise the flaws in making such comparisons or more generally, using BTUs in general. That is not all work achieved with a certain resource can be easily substituted with another resource for example no amount of men dragging a car would make it travel at 30MPH as could be achieved if the car was powered by oil. Therefore the figures above can only deal with the total energy expenditure and allow comparisons on that end but they say nothing about the quality of the work achieved nor can they describe how easily the work can be substituted with another resource. This is an important concept to grasp as quite often it is stated that we can substitute oil consumption with renewable, nuclear or even coal and gas energy which while such statements are true to a certain extent, not all uses can be substituted for. Coal, renewables and nuclear energy cannot be easily made into a liquid fuel as these energy inputs are primarily used for electrical generation or home heating. It is this lack of fungiblity which results in people often making the distinction between a liquid fuel crisis and an energy crisis as these are two distinct phenomenon as each crisis poses a different set of problems and will therefore require a different set of solutions (assuming solutions even exist) to solve or manage if there are no viable solutions.
Despite these limitations or perhaps because of them we can reach certain conclusions. The increase in the availability and affordability of energy has done more than reduce the cost and amount of work that can be achieved. It has also played a big part in increasing productivity. This increase in productivity comes because, as described in the previous paragraph, there are certain forms of work that can only be utilised with fossil fuels and these activities cannot be done regardless of the amount of men employed in particular tasks. Jobs that are energy intensive such mining, steel production or heavy vehicle transport all require intense and constant inputs of energy. Since they require intense AND constant energy inputs these tasks cannot easily be substituted into labour nor is renewable energy a suitable candidate for substitution due to its intermittent nature. However it cannot be denied all these economic activities contribute to increased productivity as less labour will be needed to be deployed to accomplish these tasks (assuming these tasks could be completed at all without fossil fuels).
Many mining operations such as the tar sands mining operation in Canada would be much harder if not outright impossible without cheap
abundant energy inputs provided by fossil fuels.
A more troubling fact does emerge from this however and that is it becomes apparent that our modern industrial society is heavily dependent on not just abundant energy but cheap energy to remain viable. Even today with oil priced at $90 a barrel which is still an excellent deal when taken in the context described above this price is sufficiently high that many developed economies struggle to grow quickly due to the “high” energy costs as we are repeatedly reminded by the media. In fact these high energy costs have resulted in much demand destruction in the major OECD countries for oil that are most sensitive to price changes as demonstrated in graph below.
This demand destruction primarily manifests itself through higher unemployment and reduced oil consumption from remaining employed workers due to a decline in real wages. This high price of oil has not curbed demand in all countries as the developing economies, which are less sensitive to price increases, continue to demand more of the product. This demand increase of the non-OECD countries is roughly equal to the decreased demand in the OCED countries so overall global oil demand has remained constant at around 30 billion barrels per annum.
The more significant trend has not been with changing patterns in oil consumption but with the changing energy mix in which the global economy utilises. Since oil is priced at $90 it is the most expensive fossil fuel in the market. In the US the next most expensive fossil fuel is coal which is priced at $68.15 per short ton. Seeing as one short ton on average releases 19.6 million BTUs of energy which is roughly three times that of a barrel of oil we see that coal is just over 4 times cheaper than oil on BTU basis. In light of this fact it would be natural to think and expect coal consumption to rise rapidly during this period however coal consumption has actually declined in recent years (for the US at least) because the cheapest fuel in recent years has been natural gas which reached levels as low as $1.90 per million BTUs earlier this year. Seeing as coal has been priced generally been priced at around $3 per million BTUs for the last three years it is easy to see how natural gas consumption has surged.
It should be noted however that at this present moment natural gas is currently priced at $3.48 per million BTUs (accurate at time of writing) and seems to be rising in the past few months. If natural gas price rise much further then coal will become the cheapest fossil fuel in the US and demand for this fuel should increase provided the trend of rising natural gas prices continues. If we talk about fuels on a global basis the story is quite different as globally coal is by far the cheapest commodity and it is these cheap prices that have caused global coal demand to surge in recent years. The high price of oil and the fact that main users of coal (Eastern Asia) have seen rapid economic growth in recent years have been other contributing factors in the increase in the amount of coal demanded.
If this trend of growing coal consumption continues it will not be long before coal becomes the top source of energy in the world and this is a fact that is likely to catch many people by surprise. Saying that, one should throw some caution to this current trend of surging coal demand as it is quite likely that growth in the global economy will slow down and may even decline. If that is the case then the rate of increase in demand will decline or demand may even decline entirely should the world enter a global recession.
Another important consideration and one that is almost universally overlooked in the mainstream is the concept of Energy Return on Energy Invested (ERoEI). In the second part of this topic I will discuss this concept in more detail and also explore the laws of thermodynamics that is largely neglected in the media and economics in general. Do not worry; it will not be a boring physics session with lots of large scary numbers. In any case I wish all diners a merry Christmas and a happy new year.
 = World Vehicle Population Tops 1 Billion Units (WARDSAUTO)
 = British thermal unit (Btu) (Business Dictionary)
 = Barrel of oil equivalent (Wikipedia)
 = Coal News and Markets (EIA)
 = What is the average heat (Btu) content of U.S. coal? (EIA)
 = Coal News and Markets Archive (EIA)
 = Commodity Prices (CNN Money)
Off the keyboard of Monsta666
Discuss this article at the Environment Table inside the Diner
This article should form the final connection between the Water article written by RE
and the Peak Oil Primer written by myself earlier
this week. As I like to stress to many people the connection between the vital
commodities of food, water and oil are numerous. What is more these commodities
cannot be easily substituted and in the case of water and food there are no
alternatives if we wish for humans to survive on this planet. A man has got to
eat and drink!
The means of acquiring food have changed throughout the
ages with much of these changes coming as result of increased pressures from
population growth. As we know when man first climbed out of the trees his main
means of procuring food came from either gathering food or hunting wild game.
While this simple method is the most sustainable and leaves the smallest
footprint on the environment this method of food extraction also supports the
least people in any given area. As a result of this paradigms limitations it was
not long before man’s population had increased to such a degree that he soon
began hunting at an unsustainable rate. This excessive hunting resulted in the
extinction of numerous species particularly the larger fauna roaming the plains
at the time. In effect man had reached the natural carrying capacity of the land
following the hunter gather paradigm. As the population continued to rise
despite this fact it created social stresses and the number of conflicts between
humans increased as there were more disputes over the remaining food resources.
It was around this time that agriculture was developed. This change did
not come because agriculture was superior to the hunter-gatherer paradigm as
commonly depicted in literature but rather this change came about due to
necessity as agriculture could support denser human populations. In other words
this move was not a move of inspiration and a sign of man progressing and taking
a step towards civilisation rather this was a move of desperation on the part of
mankind to support increasing populations. Indeed archaeological evidence
supports this assertion for early farmers were not only six inches (15cm)
shorter than their hunter gatherer counterparts but they also suffered from a
greater range of diseases due to closer contact with more people and animals.
Other negative aspects came from the fact that the early farmer’s diet was less
varied as his diet consisted of a small range of crops as opposed to the varied
diets of his ancestors. This lack of variety in the diet would result in
increasing incidents of malnutrition.  To many people of the time these lower
standards of living would be seen as a step backwards.
In addition to these negative aspects
described above agriculture also placed greater stress on the natural
environment as more land was needed to be cleared to grow the said crops thus
displacing more animals and even deforestation if forests were cleared to
acquire crop land. Once the land is cleared for farming the land itself is put
under major stress as every year the farmland is ploughed and replanted
resulting in the loss of some topsoil. If enough topsoil is lost then it can
mean the land is no longer suitable for growing crops and it will make the area
more prone to desertification. The removal of topsoil is also largely
irreversible as it can take 500 years to regain one inch of topsoil
back. What is more by planting only a small range of crops the
habitat contained less diversity and therefore became less resilient to changes
in the environment. Moreover this lack of diversity also meant the soils that
were used to grow crops would degrade in quality if it was not carefully managed
through crop rotation and natural fertilizers such as manure.
biggest issue that resulted from agriculture however is that it places large
demands on water resources in the area as crops need large amounts of water to
grow. For example one kilogram of wheat corn requires 880-2200 litres of water
while a kilo of corn requires 880 litres. 
Seeing as these two crops are one of the most widely grown crops in the US it
easy to see how dependant agriculture is on rich water sources. If we consider
meats then water demand increases by an order of magnitude so if we wanted to
produce a kilo of beef we would need around 10-20,000 litres of water. . This large demand for water was one of the
main reasons why many early cities formed around rivers as these regions were
most suitable for growing crops.
As populations expanded and the demand for food increased the water
demanded also increased since food production is so dependent on water. This
continual increase in water demand lead to innovations such as the irrigation
which can allow more marginal lands to produce food or allow existing fields to
increase yields of crops. Such methods however are not without their
disadvantages however as over use of irrigation can lead to reduce water flows
to rivers, saline, reduced water tables (a particular concern for deep water
aquifers) and water pollution. Another side issue with over intensive farming
methods is it can lead to desertification of regions if the farm land is not
managed properly. It is said
that Mesopotamia (the region encompassing modern day Turkey, Syria and Iraq)
used to contain the most fertile lands on the planet but due to over irrigation
and exploitation of these lands the region gradually turned into a desert. This
loss of land played a significant part in the collapse of civilisations such as
Greece, Carthage and the Roman Empire. 
For the most part
despite the listed disadvantages the agriculture paradigm did deliver in feeding
its population provided the farms were properly managed and were not
overexploited. This allowed human population too slowly but steadily rise as
more and more land was devoted to growing crops. Innovations in farming
equipment, better crop varieties (for example the introduction of potato as a
stable crop in the 16th century) and improvements in irrigation allowed
incremental increases in yields during this time facilitating further population
The real turning point started around the advent of industrial
revolution particularly after 1900 when the rate of population growth began to
accelerate in earnest due to improvements in sanitation and medicine that
lowered the death rates in various countries. This issue became more acute and
noticeable during the world war periods particularly in World War II when not
only had the population exceeded two billion by that point but food production
was effected by the on-going wars. As a result of these factors rationing took
place in many countries and for the first time many nations were no longer
self-sufficient in meeting its local food demands. This food insecurity resulted
in various governments placing a greater priority in increasing food production
to ensure they were no longer dependant on food imports and had to endure the
accompanying swings in food price from the world food market.
main way this food security became assured was by deploying more farm machinery,
pesticides, synthetic nitrogen/potassium and phosphate fertilizers as well as
improved crop varieties. All these factors lead to huge increases in crop yields
and was later called the Green Revolution. Once this development, which began
in Mexico in 1943 by Norman Borlaug with the help of the Rockefeller Foundation
was discovered the practice was quickly adopted by other nations.  As the name implies the green revolution had a
large effect on many countries particularly the developing countries (not Africa
however) such as India which during the 1960s was in the brink of mass
starvation. Not only did the green revolution make India and other nations
self-sufficient and not dependent on food imports it also allowed lower food
prices which facilitated not only population growth but enabled greater economic
growth due to reduced living costs.
Like all new technologies these
innovations in farming came with their own disadvantages. The chief problem
about sustaining the green revolution is the fact that much of the inputs
necessary for this form of farming are non-renewable. For example synthetic
nitrogen fertilizers come from either natural gas or coal which is not only
non-renewable but the processes to make this fertilizer are energy intensive.
Meanwhile potassium and phosphorus based fertilizers come from potash and
phosphate rock respectively which have to be mined thus they are subject to peak production
rates which in the case of phosphate is likely to come around
2030. The pesticides used in farms are derivatives
The other big issue with the green revolution is the number of
environmental issues it imposes on the area. Modern farming practices reduce
biodiversity to an even greater degree than traditional farming methods. This is
because one of the main ways of achieving the higher yields is to use specially
selected breeds that only really thrive under the artificial conditions of
inorganic fertilizers and pesticides. As a result the number of viable species
used in farms has significantly declined making them less resilient to changes
in environment (which is a bigger concern if one considers the impacts of global
warming). It should be also noted that these new strains of crop do not perform
better than traditional crop varieties if no artificial fertilizers or
pesticides are applied. Another problematic aspect of these modern practices
comes from the fact that over time fields that use phosphate type fertilizers
will gradually sterilise the soil thus making farmers dependant on using only
artificial fertilizers to keep growing crops on their fields. Finally these new
farming practices have done little to reduce the increased demand for water. As
food yields have increased so has water consumption.
are also large economic implications; first of all such methods are less labour
intensive and more capital intensive meaning that not only is less labour needed
but the demand for credit will increase as more capital investments become
necessary to start a farming operation. Since richer farmers have easier access
to credit it means they can gain a bigger competitive advantage to poorer
farmers thus increasing existing inequalities which will eventually lead to
further consolidation of the farming industry which can further exacerbate the
issue of decreased diversity in crop inventories.
Another issue that can
extend from this last point is the fact that oil becomes more extensively used
as it is needed to fuel the farm machinery and due to the larger fields that can
be deployed using modern farming methods the amount of oil consumed is that much
greater. If were to include processing and distribution in food in this equation
the use of oil is increased further. It is this increased oil dependence that
has made food prices strongly correlate with oil prices as oil is used in all
stages of food production, processing and distribution.
factors have meant that while industrialised farming has resulted in increased
efficiently in terms of crop yields per acre it has become less efficient in
terms of energy consumption. 
What is more like most things the gains
made from the green revolution have suffered from diminishing returns for
example the period between 1950-1984 global food production increased by 250%
yet the increase between 1984 and the present is only 40%. More important
however is the fact that for the past 60 years increases in global food
production have consistently surpassed population however this trend is unlikely
to continue much longer as production increases are barely keeping up with
how it is expected that the population will reach 9.1 billion by 2050 with food and water demand increasing by 70% and 55% respectively it seems questionable whether
these targets can be achieved. These already ambitious targets seem even more
daunting if one considers the fact that we are already extracting water at
non-sustainable rates. This unsustainable water extraction comes about from the
fact that many water tables across the globe are falling and once these water
reservoirs are depleted then the source of water can only be extracted by its
natural recharge rate. More worrying is the fact that many deep water aquifers
are not rechargeable at all from rainfall. These aquifers, sometimes dubbed
“fossil water” for the fact they only charge at very slow rates spanning
hundreds of years is a serious issue in India, China and perhaps most notably
the US which is depleting the Ogallala aquifer; one of the biggest deep aquifers
in the world.
Another significant issue is that of peak oil. Seeing as
modern agriculture is so heavily dependent on oil a decline in total oil
production is very likely to lead in a reduction in total FOOD
production which will result first in higher food and eventually shortages.
However it is likely the globe will face problems even before peak oil arrives
due to fact that as oil production increases stops rising at the same rate as
population growth then prices of oil will raise which will eventually lead to
higher food prices. Once food prices get high enough the probability of a food
riot increases considerably. It should not be forgotten that during the big oil
spike in 2008 when oil reached $147 a barrel there was a large number of food
riots. When high food prices struck again in 2011 the world witnessed the Arab
Springs which was a revolution that started because of mass youth unemployment
and high food prices.
exacerbating issues in delivering these targets will come from global warming
which is likely to lead to more extreme weather patterns that can adversely
affect crop yields. The recent drought 2012 in the US is one of the worst
droughts in the US for 50 years and has decimated many crops and livestock in
the region. Considering that the US is the biggest food exporter in the world
(and indirectly water exporter) then it is likely that food prices will be
considerably higher in 2013. If these droughts are a sign of things to come then
it is very possible that we may actually see a peak in global food production in
the coming decade particularly if these changing weather patterns occur
simultaneously with declining global oil production AND water
= People Grew Shorter Growing Crops (Discover
 = The USGS Water
Science School (U.S Geological Survey)
 = Reducing the impact of humanity’s water footprint
 = Ecology of desert systems, p.277
 = The Nobel Peace Prize 1970 Norman Borlaug
 = Peak Phosphorus (Wikipedia)
 = Why Our Food is So Dependent on Oil (Energy
 = World
population to reach 9.1 billion in 2050 (UN)
 = Global agriculture towards 2050 (Food And Agricultural
Organization of the United Nations)
 = Global Water Forum
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner
Peak Oil is an old topic for long time Doomers, but many Rookies in the Collapse Blogosphere are not that well versed in the ramifications of energy depletion issues. Here, Monsta666 gives a cogent overview of the Peak Oil situation as it stands now-RE
Peak oil is not “running out of oil” as commonly depicted by critics in the mainstream press rather it is the time when total oil production reaches its maximum. After peak oil the total amount of oil production goes into terminal decline. It is really quite simple what peak oil is but people have a habit (not just with oil) of making the definition overly complicated.
A good example of peak oil can be seen in the graph below which shows that US oil production peaked at 9.6mbpd (million barrels per day) in 1970 and since then has gone into decline. There have been two recoveries with the first occurring in the late 1970s to late 1980s. This first recovery came about when the biggest oil field in the US (Prudhoe Bay) came online. There has also been a more recent recovery in production and this new recovery was mainly the result of the shale oil revolution in the late 2000s. None of these recoveries have exceeded the peak of 1970 however. This oil production profile is typical of most countries and perhaps the US is even slightly unusual in this aspect when compared to other countries as most countries do not experience a recovery periods.
Since peak oil is concerned with production rates it is about flow rates. That means it is not about reserve numbers as flow rates cannot be accurately determined by looking at reserve numbers in isolation. This point must be stressed particularly in light of recent years were a disproportionate amount of new oil comes from unconventional sources. As well as providing lower EROEI (Energy Return On Energy Invested) the flow rate from these sources tend to be lower relative to reserve size. This means that huge reserves number can be added but as they have low flow rates then these sources cannot offset the declines of conventional oil which incidentally are expected to decline by about 7% per annum according to the EIA (Energy Information Administration). Thus peak oil will be reached even though total reserves may increase substantially.
It should be noted that the dynamics of a global peak oil production will be quite different to the peak oil of an individual country. This is because unlike a single country, a change in the supply on a global scale will have a profound effect on the global price. An individual country on the other hand has a small influence on the world price (at least for the vast majority of countries). If the world supply of oil becomes constrained the price of oil will rise and this will either create a recession, bring more oil to the market or a combination of both. These factors will likely result in an extended plateau as more oil is brought online to offset declining fields while the high price will reduce demand keeping production from having to get too high. The graph below of world oil production demonstrates the trend described in this paragraph:
This plateau cannot be maintained indefinitely. As time progresses the amount of investment required to maintain production rates rises exponentially which means higher and higher price is required to maintain flow rates. At some point the global economy cannot support the costs required to maintain flow rates and as a result total oil production will decline. If the flow rates decline then the total supply in the market will decrease and if demand remains constant or worse rises, then oil prices must rise in tandem. Now the issue to bear in mind and this is a point that is often forgotten or overlooked even to people aware of peak oil, is the belief that oil prices will rise to infinity. I would say such a scenario is not going to happen, at least not within the foreseeable future..
It should be remembered that the price of oil has a profound effect on the world economy. If the price of a barrel of oil reaches a certain threshold it will send the economies that import oil into a recession. When a country enters a recession the demand for oil will decrease which will result in a price drop. We have seen two examples of this demand destruction in recent years; the first occurred in 2008 when oil reached $147 a barrel before the price fell dramatically due to the onset of the global financial crisis. The second more recent crash happened in March 2012 when oil reached $128 a barrel (Brent oil) and then subsequently fell to $90 a barrel. These high prices contributed to the ensuing recession in the major OECD countries particularly Europe and this demand destruction has been the chief contributor to the recent price decreases. We can therefore say there is a limit on how high oil prices can reach before it results in a recession and prices come down. The correlation between oil prices and recessions is strong with nearly all recessions in the last 50 years coincided with a recent rise in world prices as shown in the graph below:
Another important aspect to remember is when oil prices rise the economies of oil exporting nations grow leading to more internal consumption of its oil resource. In nearly all cases this internal consumption increase exceeds the rise in total production which results in less oil being exported. This rise in internal consumption is even more pronounced in Middle-Eastern countries were the price of oil is heavily subsidised and the culture for efficient use of petroleum is not widespread. Furthermore a significant amount of electrical energy, which is also heavily subsidised in the Middle-East, comes from oil which creates a strong downward pressure on the total amount of oil exported. As less oil is exported the price needed by these exporting countries to balance its books rises.
This issue of balancing the budget becomes even more acute if the exporting country needs to pay large fuel subsidies or/and social programs as these costs will be added on top of the increased investments required to maintain/increase oil production. These elevated costs are further exacerbated if the population is rising rapidly which is often the case in Middle-Eastern countries. If the price of oil were to fall below the break-even price for an extended period of time then the exporting country will reduce supply in an attempt to bolster prices. Thus there is a price floor for oil and since global net exports are decreasing this price floor will slowly rise over time. This decline in global net oil exports is clearly seen in the graph below:
Now with both those facts established we can see that there is a price ceiling which oil prices cannot exceed without creating a recession and there is also a price floor that oil will not stay below for long. Since the price floor will rise over time, there will come a time when the price floor meets the price ceiling and when that time arrives it is likely to create significant problems on the global economy.
This constraint supply and shifting price floors/price ceilings (which will come closer together over time) will also lead to another phenomenon. That is an increase volatility of oil prices. In fact a high volatility of price can be seen as indicator that the amount of spare capacity in the system is low. This increasing price volatility can easily be seen in this graph below:
As a result of this increasing price volatility it will become more difficult for consumers and suppliers of such oil to make long-term business plans which will raise costs indirectly as result as it becomes harder to maintain favourable long-term contracts. However what is more significant is since oil prices are so heavily connected to the state of the economy there is a good chance these bigger fluctuations will lead to greater volatility in growth rates (going from recession to growth and back again).
It should be noted that as stated earlier, there are limits to how high prices can rise and it is likely that coming oil crunch will not manifest itself initially as an oil crisis (with oil lines at the petrol station) but as a financial crisis with large numbers of bank insolvencies and other associated systemic risks that will stem from this initial crisis. It should also be noted that global economy is highly efficient and can produce goods and services at extremely low costs but this high efficiency comes at the price of low resilience. This is because many of the supply chains that supply our economies with goods/services are not only long spanning many countries but also operate on a JIT (Just-In-Time) basis. With the risk of various systemic failures what are the chances these low resilient supply lines can continue to operate in the midst of a financial AND liquid fuel crisis?
This distinction between and an energy crisis and a liquid fuel crisis is an important one because 90% of the energy for global transportation comes from oil. This transportation energy covers the most obvious examples such as cars, trucks, planes etc. but what should also not be forgotten is the machinery (and pesticides) necessary for agriculture and the mining of various metals that is needed for various goods including metals needed for the construction of renewable sources of energy. These sources, at this current time all depend on oil for these products are either transported or extracted using oil or oil itself is a basic input in the production of the said resource. In fact we can easily say that oil is an enabler of other vital resources so when we face an oil shortage it is likely we will also face a shortage in other resources. Again it is likely this scarcity will not initially manifest itself with the resource or good disappearing but merely that the price of the goods rises considerably.
While price rises and the accompanying demand destruction will serve to alleviate the constraint supply of oil for a time eventually higher prices can no longer manage a basic shortage. There will come a time when the price of oil rises creating a recession. However unlike previous cycles the next price rally will not generate a sufficient amount of income to overcome the existing decline rates from old fields. When this time comes not only will global oil production decline but more important, the rate of global oil exports will decline at an even greater rate. This decline will be higher than what developed countries can handle and adjust to so it is likely at that point that real oil shortages will occur.
Once the perception of an oil shortage begins to take hold then it is likely to induce not only higher prices but hoarding of the available resource. This behaviour occurs not only on a consumer level but also on an interstate level as exporting nations will begin hoarding their oil from the importing oil countries. The exporting nations will hoard oil as it will wish to save its remaining resources to itself as it will prioritise the needs of its citizens over the needs of foreign customers. This hoarding behaviour has been seen in the UK in two occasions when there was a perceived shortage of oil, first in 2000 and more recently in 2012 when an oil shortage induced consumers to panic buy and hoard the valued resource thus exacerbating an already difficult situation. It is likely that when a strong perception of shortage is felt then rationing will need to take place to avoid such irrational behaviour. In any case, when thinking about peak oil in its later stages, the physiological component cannot be forgotten as that will play a big part in how this situation unfolds. This last point cannot be understated as it is likely that once the problem of peak oil becomes apparent it is likely that other systems and conduits will be in a severely degraded state. What is more a shortage of oil is likely to compound any existing problems that are occurring.
Off the keyboard of Monsta666
Discuss this article at the Energy Table inside the Diner
A prevailing viewpoint we often encounter in the mainstream media is the view that our current society is very wasteful with its use of resources and if we were more efficient then we can live an equitable life with a tiny fraction of resources consumed. This view is so prominent that it is quite commonly supported even in the doom blogosphere. However this belief that we can transition to an efficient waste free society without large scale economic and social implications is a wrong one.
While the first statement is correct; we do indeed live in a wasteful society what follows next is not so achievable under our current economic system. What people need to understand when making such statements of cutting “waste” is that all people employed produce either goods or services. If we wish to cut on wasteful production then we must cut the total amount of goods/services produced and since labour is involved in this said production then in effect by cutting on waste we are also cutting on jobs. After all, one man’s waste is another man’s job. That extra hot dog the average overweight American consumes (and does not need) is providing a job to some J6P albeit a poor paying job. While this is just one example it can extend too many occupations in our society.
Now cutting on jobs may be a necessary evil to saving the planet/future generations but one should fully consider the implications such actions would entail on the global economy. We live in an economy that requires infinite growth and one of the big drivers of this growth comes from our monetary system that is all debt based. To service this ever expanding debt load we must increase production even if this production is not needed. Indeed this need to continually expand production has caused the long-standing issue of overproduction.
As the industrial revolution took hold in the western economies and many industrial factories were built (using debt) it soon became apparent that more goods were being produced than what J6P needed or could even afford. To overcome this problem of overproduction the industry of advertising grew in earnest to generate new demand for unneeded items. It is should be noted that it is important these unneeded goods were sold because many of these new factories were built using credit so they needed to be fully utilised to pay back the debt WITH interest.
This dynamic of increasing production has created further issues however even with the aid of a large advertisement industry as demand for products has struggled to keep up with supply. The reason for this struggling demand comes from the fact that real income of households needs to rise in tandem with the increasing amount of goods produced. This issue of slow growth in real incomes became quite acute during the 1970’s oil crisis as this period marked the time that the average incomes in the US no longer rose significantly in real terms and have made up a smaller percent of total US GDP.
To compensate for this development a range of actions were deployed the two most notable being globalisation and easier access to credit. Globalisation allowed goods to be produced at a lower price as the main manufacturing bases were moved to cheaper regions were the cost of capital and labour was lower so the prices of goods sold would be lower and this would serve to prop up demand. The process of globalisation also had the benefit of increasing the numbers of potential consumers so while there was no longer great returns in the western world more countries were sucked into the debt machine and the costs could be spread over a wider base.
Obtaining credit was also made easier so J6P could still keep buying his cars and maintain his American lifestyle even though his wage was not going up and the cost of items were rising faster than his wages. Other more insidious methods to maintaining demand included such things as planned obsolesce. By having items designed to break after a set period of time J6P could no longer buy durable goods such as washing machine that would last for 20 years as they were designed to breakdown within a planned timeframe usually shortly after the warranty period. All these measures while effective, at least for a time, do not solve this problem of overproduction. It merely postpones the day of reckoning and due to the nature of credit expanding over time the problem is actually compounded (literally) when it is delayed.
What I have stated thus far maybe already widely known to people but it is important to realise the dynamic of why all this overproduction is necessary because in essence since nearly all major capital investments are financed by credit there is always a need to expand production to cover the interest on the loans. By cutting the waste in society what happens is all the capital currently being deployed will be underutilised and the loans this capital were backed by will no longer be honoured. This is likely to lead to large scale defaults and large unemployment.
The most notable example of capital investment that serves as the basic platform that makes most of our economic activities viable is that of basic infrastructure. This form of capital investment is most susceptible to the issues described above as nearly all major public works cannot be supported on their own merits and must therefore require finance to be sustained. This issue has been discussed previously in the diner and if you are interested in learning more about this subject please refer to the Large Public Works Projects series here, here and here.
Like most capital investments, major public infrastructure projects are financed by debt. Not only is ever increasing expansion credit a needed condition but as an extension to this fact is that the number of service users using the said infrastructure needs to increase or if the number of users do not increase then the average usage per customer has to rise. This increase of the amount of service user’s makes the infrastructure more viable as economies of scale can be achieved meaning the cost per unit production declines but more important is the fact the cost per user decreases.
This need for greater infrastructure usage does generate much wasteful economic activities and much is said about reducing such wasteful activities. After all how many articles have you read about reducing the amount of wasted water or electricity per customer? The issue with reducing demand is that while it can be a positive thing on an individual level on a more macro level it will lead to a more negative outcome as it would mean a drop in aggregate demand.
Since the infrastructure is financed by debt a decrease in aggregate demand would mean the overheads can no longer be covered and the price per user will have to rise. This last point is important because when it comes to covering costs “wasteful” activities cannot be discounted as unneeded. For example much of the telecommunications infrastructure achieves its low price because certain users using it frivolously for unneeded economic activities such as the child playing on a XBOX 360 using gigabytes of bandwidth. This unneeded activity allows the small business round the corner to enjoy cheaper prices. If you removed the wasteful user in this case then the costs imposed on the needed users would rise and their economic activities are less likely to remain viable. This is the big issue, as prices rise the user base will decline leading to more users being unable to afford using the infrastructure. If this process were to continue then the infrastructure would suffer tremendously as the same expensive overheads would still need to be paid but with fewer users. Even if such structures could remain intact they would begin suffering from diseconomies of scale; that is the costs per unit production would rise as the number of users decline. In short if the number of users decline sufficiently it is likely the whole project will lead to some kind of death spiral.
While the issue is most acute in basic infrastructure works the dynamic remains largely the same for any good produced; the wasteful demand cannot be dismissed as disregarding that demand not only leads to direct unemployment (people responsible for that production are laid off), it also means the cost borne on the remaining users who demand the product rises as the total costs are spread over fewer users. This then results in even less people who can afford buying the goods/services at this new higher price leading to even higher prices as there are even less users to support the cost of overheads. Thus this process leads to a destructive feedback loop developing that is likely to result in dire outcomes.
If we want to reduce wasteful activities we need to recognise a reduction in waste will lead to mass unemployment and large scale defaults since many assets are backed by the debt which would no longer be met if the factories were only working at low utilisation rates. Another important point to consider is that since much of the upper class hold assets in these factories a large scale default is going to hurt them disproportionately hard so it seems unlikely such reductions would be tolerated even if the lower classes could recognise the issue which is unlikely since their jobs depend on these wasteful activities.
An argument often made to make such investments more viable is to increase the efficiency of such capital so the cost per unit output is less even if the number of users or usage per user remains the same. Therefore as a result of this the reduced costs will be passed onto the consumer. While there are definite merits to this approach, which should be pursued, it must be noted that none of these actions will provide an ultimate solution to the problems faced.
The issue with greater efficiency in resource consumption actually lies in its perceived strength that is the lower cost in using the said item. For example if we can provide an infrastructure that produces electrical energy 5% more efficiently the cost per user will decrease. This decrease in costs will result in demand rising negating some of the efficiency gains made. This effect is known as a rebound effect and any increase in efficiencies will cause some kind of rebound effect. As a result of this one must be wary of any claims that suggest that all efficiency gains will result in the same reduction in total usage. It may still bring total demand down but it will always be more marginal than hoped on account of the rebound effect.
Indeed in some cases increase in efficiencies can actually result in greater resource consumption and these occurrences are known as the Jevons paradox. This issue of rebound effect and possible Jevons paradox is not a new topic; it was first in early 1865 and was covered in Jevons book: The Coal Question. It should be noted however this effect only applies if demand is highly elastic where demand rises disproportionally to price decreases. Thus this paradox is more likely to occur in competitive markets were small price differences can lead to significant gains in market share or the amount of users consuming the said commodity. This final point of expanding user bases should be considered in an expanding world of globalisation.
Inelastic Demand resulting in only the rebound effect
Elastic Demand Resulting in Jevon’s Paradox
There are also further issues with increase efficiencies and this issue of increasing efficiencies, like many other things, suffers from diminishing returns. That is over time the returns per unit investment declines and there will come a point that further gains will become prohibitively expensive and even if such expensive gains were pursued the return would be smaller. In other words there will be a limit to how much efficiency can be gained before it reaches some hard limits either from an economic standpoint (which is likely to come first) or a thermodynamic limit. After all it is impossible for us to have 100% efficiency!
The final issue, and one that is perhaps most pressing, is that most cases made for pursuing wide scale adoption of efficiency gains requires extensive use of credit. It is likely going forward that credit will become increasingly constrained so the amount of available credit necessary to fund aggressive efficiency projects will not be available. Without widespread credit the chances of rapid increase in efficiencies being developed are considerably less. This issue of a lack credit is often avoided or implicitly assumed by strong advocates of making things more efficient but it is an assumption that is likely to prove false.
In short while increasing efficiencies can buy some time and keep capital investments particularly basic infrastructure projects viable for a longer period of time there are limits to this process and increased efficiency cannot provide the ultimate solution. At some point efficiency gains will cease occurring in any meaningful level and due to the required need for further credit expansion those issues will have to addressed at some point even if efficiencies could be maximised which is unlikely considering that further credit is likely to become more limited going forward.
The other solution of outright demand destruction as commonly suggested will lead to very negative outcomes as explained above to the investments in question and more generally the global economy. What needs to be recognised is our current economic and monetary systems are not suitable for dealing with declines in demand or credit. They only function well in world of expanding demand and credit as this is how the system was designed for. If we wish to cut all waste then we need to devise a system that can operate under the condition of perpetual demand destruction.
Off the keyboard of Monsta666
Discuss this article at the Economics Table inside the Diner
It is often said by people who support gold backed currencies that the chief weakness of fiat currencies is it encourages governments and central banks to issue excess amounts of money/credit. While this fact is true it would be a mistake to think this is the main reason why currency devaluation occurs. This is because the issues of overleveraging are primarily problems that stem from the private sector as most money generated in the economy comes from COMMERICAL banking and NOT central banking. In fact depending on sources or the countries in question the amount of money/loans generated as a result of fractional reserve system can be 97% or perhaps even higher if one includes other complex financial instruments such as derivatives in the total money supply.
This excessive money creation can lead to catastrophic results to the national currency if no measures are taken to limit this over expenditure. This over expenditure is present in all monetary systems both fiat and gold based currencies because each system operates with a fractional reserve system. The fiat currency maybe marginally worse because the central banks can encourage even more overleveraging as none of the new money issued by the central bank is bound by gold reserve requirements. This component of money creation only constitutes a small part of total money creation however despite assertions you may hear from Ben Bernanke.
Still, despite this relative small amount of money generated through QE or simple naked money printing this form of money creation can lead to some significant results. As this new money is issued it will enter the commercial banks and due to the process of fractional reserve banking this money can be multiplied creating further inflation in either the real economy or various asset classes such as houses or stocks. In fact this process is called the money multiplier effect in Monetary economics and this is one reason why this practice is promoted by Keynesian economists who wish the governments to issue some money as this printed money will be multiplied by banks by loaning this money out to its customers. Problem is, in this current recession many banks instead of lending have hoarded this money since there are no real returns on investments that can be made from these loans. Instead most of that money is gambled in the biggest casino in the world which is the stock/bond market and since there is quite a lot of excess money floating around this excess cash has the tendency of generating bubbles with overvaluations in stocks such as Facepalm.
But let us go back to the topic at hand which is the issue of currency devaluation. This process has occurred many times in the past even during the eras when countries followed the gold standard which we should note: is a point often forgotten by many people advocating a return to the gold standard. It should be remembered that the US suffered numerous financial crises in the 19th century when it did follow the gold standard, the most notable being the 1873-1879 Long Depression. Indeed this depression was known as the Great Depression until this event was supplanted by the Great Depression of the 1930s. All of which occurred during an era when all the major currencies of the world followed the gold standard.
The causes of this Long Depression are – like the great depression of the 1930s – are still debated among economists but the general problems would appear to share striking similarities. Like the 1930s depression the Long Depression came at a time shortly after a major war, increasing globalisation and most important of all excessive credit creation by the commercial banks. In the case of the Long Depression this was the American Civil War while the Great Depression had World War 1. Such wars meant that the central governments issued an excessive amount of credit to fund the war effort and this excessive spending came despite the fact the gold standard places heavy penalties on countries that do not practice fiscal restraint. This scenario of excessive credit creation coming through war would then spur further credit creation once the main commercial banks got hold off this money. In fact the money created by those banks would be a multiple of the amount of money the government printed. In any case, these wars times should be noted for the fact it is one of the few instances where governments are prepared to risk mortally damaging their currency by money creation. We need to remember they are creating money on two levels: one by direct money printing or QE and then the subsequent process of this money being multiplied by the commercial banks. This behaviour of excessive spending under this circumstance can apply to whatever monetary system is applied be it gold or fiat based currency system. This excess spending and subsequent credit expansion by commercial banks also result in the formation of various bubbles.
To say the Long Depression was caused by excessive war spending would not tell the whole story however. To not mention the next point would be to neglect raising another commonality between the two eras. That is, the immediate period after the civil war was a boom period for the US economy (which again is repeated in the roaring 1920s). This boom in both cases occurred because of an expansion in the money supply. In the case of the 1860s this money expansion came about due to the government and major private companies investing heavily in railroads. Much of those railroads were financed by loans, bonds and subsidies which in many cases were backed by the US government. These cheap loans created overinvestment in the industry and eventually lead to a bubble forming (or overcapacity). As it became clear many of these rail companies could never pay back their loans this caused many banks to fail which eventually culminated with the failure of the major banks of Jay Cooke and Henry Clews which brought the financial sector to its knees. The resulting recession would last six years and growth was below normal until after the 1890s.
Again this period of recession and sluggish growth shares a similar similarity to the Great Depression. So why bring up the point of the Long Depression and Great Depression? I think the point to take from all these events is that despite being on the gold standard (in the case of the 1870s the gold and silver standard) banks and corporations found ways of overleveraging the monetary system and the main method was by employing the system of fractional reserve banking. When those loans could not be paid back it resulted in large scale defaults which almost caused the destruction of the financial system. Now it can be argued that since a fiat currency encourages more spending (as currency is no longer bound by reserves of gold) then the magnitude of the problem will be that much greater so the level of defaults required to bring the system into balance would be greater but then the argument becomes one of a matter of degree.
The main issue I see with the gold standard – despite assertions to the contrary – is it is not immune to reckless spending. Reckless spending can come through poor lending practices and these practices have a particular tendency of loosening during WAR TIMES and BOOM TIMES. In the case of war the risk of financial collapse is acceptable to fight the war while in the case of boom times the perception of risk becomes distorted so market participants take out excessive loans thinking the risk of failure is lower than reality. This human behaviour must be accounted for when suggestions of moving to a gold standard system are ushered.
If one wants to assure there is no risk of financial mismanagement then one needs to get at the root of the problem and that is one of leverage. Every major currency in existence today follows a debt based fiat currency system with many of the commercial banks operating with a fractional reserve system. This system of fractional reserve banking is not well understood by most members of the public but most of the loans/money generated through the system comes about through here. This point is important as it is the leveraging that ultimately causes the instability in the monetary system NOT whether the currency is backed by gold or promises (as is the case in fiat).
To gain a good idea how a fractional reserve works it is best to find out how the system started in the first place. That way we can learn it simply and not be baffled and confused with all the mumbo jumbo that some smarty pants will put in front of us to confuse us. All these terms and convoluted descriptions are just smoke and mirrors to make the public feel intimidated and not ask further questions about the fraud being committed right in front of their eyes. Notice how no one actually teaches how monetary systems actually operate in school? Anyways, I digress and let us focus on the topic at hand.
The fractional reserve system originally came about when early bankers would help store pieces of gold bullion for various customers. To make transfers more convenient the early banks would issue notes which allowed the customer to redeem their gold. This meant people did not have to travel back and forth with gold bars which was a major drag (literally) not to mention quite dangerous. After sometime however the banks realised that customers would only trade these notes instead of exchanging gold directly. In fact those notes became a form of ad-hoc currency and it became apparent that the more notes that were issued the more money would be generated which meant more profit to the banks. So the banks began the path to the dark side by issuing more notes than they held in gold reserves. Thus it was the beginning of the fractional reserve banking and as the name implies, the banks only hold a fraction of the total deposits in reserves.
Once the banks had found that most people did not take out money or gold from their deposits creating excessive notes posed no real risk of them being found out or going bankrupt. However this practice did lead to the issuing of more money which while fraudulent benefited the upper class massively as it allowed them greater means to spend, invest – and most important – lend money to various major public projects. It should be remembered that most major public projects cannot pay for themselves and such projects can only be financed through debt. To see more information on this matter please refer to the three part Large Public Work series.
These extra loans also had the effect of extracting more wealth from its subjects via interest payments from the extra loans generated from this operation. As a result even though this form of fraud became known to the government it was not outlawed. Instead laws were made to limit the amount of risk such practices posed to the overall financial system. From this point onward the financial system developed extra complexity but on a fundamental level they all operate on the same premise. To many this is really a legalised system of fraud and one wonders how the general population would behave if it learnt the truth of the matter and how money really works. It is this fact why all banks are vulnerable to a bank runs because if people run to the banks in mass to collect their deposits the bank would soon become bankrupt due to lack of reserves.
In light of these facts if one wishes for stability then one needs to confront the fractional reserve system. If a person does wishes for total stability then the reserves must equal 100% of the currency available. Any leverage will create some instability and the more leveraged it becomes the greater the resulting instability. It should be noted however that the fractional reserve system – despite its obvious flaws and shortcomings – has one big advantage. This method of generating excess cash has a great effect in delivering growth for the general economy which was a great BOON to an ever expanding industrial economy. In fact if one looks at the term capitalism the main objective of this system is to acquire capital. This can be through actual assets or cash and since fractional reserve banking delivers on this objective one can see why it is so prevalent in modern economic systems. However as noted by many others this growth cannot go on indefinitely and in a contracting economy excessive credit creation can quickly become a bane to society. In fact one can easily say a fractional reserve system would not be fit for purpose for an economy that is continually contracting. In fact it would be catastrophic.
Still, one should not forget that this system must be removed if one wishes for future stability. What needs to be understood however is if one does wish for complete stability with full fractional reserve banking then one must confront several problems most of which are considerable; by moving from a fractional based reserve system to a fully backed reserved system it would mean a large percentage of the total money supply be removed or large amounts of new capital must be acquired. To take the former option of money/credit destruction would mean a massive almost total deflationary event. In other words, all current assets would lose nearly all their value. In addition since all existing loans will still remain the same in nominal terms then a massive deflationary event will mean the value of those outstanding loans would rise massively in real terms leading to large scale defaults which would create further havoc on an already overstrained system. These defaults, which are likely to be considerable, if not total, would reduce the money supply further still. In short this solution could not provide an acceptable method of returning to a fully backed reserve system.
The other option highlighted in the paragraph above is to increase the amount of capital or reserves in the system. The easiest way of achieving this feat would be through some means of issuing non-debt based money which would basically amount to a form of debt jubilee. This process of money generation would however, if left unrestrained, lead to massive inflation as a large amount of money would be spent on non-essential purchases. Even if laws were put in place to force consumers to pay back all existing debts before the money could be used for other activities it would result in a large scale deflation event as a lot of the existing debt based money is wiped from the system. This solution however would not result in larger scale defaults mentioned earlier as those debts would be expunged from the system. It should be noted that such a move would directly harm the banks as they would lose nearly all their assets and as such they could be forced into bankruptcy. Furthermore the other biggest losers would be the financial elite who hold most of the world assets. Since these people and organisations have the most influence in this current system it seems fanciful they would implement a plan that damages their interests the most. This solution has numerous proponents most notably economist Steve Keen (see 19:00 of the video).
For this solution to have a lasting effect however it would need to put a full reserve banking system in place after the debt jubilee is issued otherwise the system will fall into the same problems of excessive debt.
If such a system of full reserve banking were developed it would then lead to another problem which is a lack of growth of debt that is required for modern banking to operate. Without debt accumulation it is hard to see how banks could generate sufficient profits to remain viable. If banks do not possess the ability to create money through loans then the only income they could derive would be from service charges from holding deposits. The other possibility would be to use those existing deposits for lending to businesses and corporations who would then pay the banks with interest through means of expansion. However such a system could not operate unless there is an expansion of the money supply by a central bank or by the banking sectors growing at the expense of other industries. In any case such a system would sacrifice much growth and could still face some potential dangers in currency devaluation.
It would seem that while a transition to a more sound system is favourable it cannot realistically occur until there is a large-scale reduction in the existing money supply, loss of capital by some other means or large scale debt jubilees of which the outcome is unlikely to come and even if implemented will lead to large scale bankruptcies and possible supply-chain contagion as result of this.
One also needs to consider the possibility of a society that can be happy with a non-growth economy which would be basically be enforced by applying a full reserve banking system. This question needs to be considered under the light of growing populations and the three desires of greed, power and competitive nature of man. What are the chances some expansionary monetary system will be devised to cater to such basic desires and realities facing man in the future?
Off the keyboard of Monsta666
Discuss this article at the Geopolitics Table inside the Diner
|Introduction from RE:
The Diner is happy to add Monsta666 as one of our Native Diner Authors. His contributions inside the Diner are detailed and insightful, and he often brings a different perspective to many threads pursued at the Diner Tables.In my last two articles, The Burning of the Great Library at Alexandria and Panarchy & the One-to-the-Many: The Final Countdown, I viewed the Collapse of Industrial Civilization from the perspective of recurring cyclical events, which occur on differing timescales in a Fractal manner.This of course is not the only way to look at this collapse, it also can be viewed from the perspective Complex Systems Theory, pioneered by Joseph Tainter, and applied recently to the collapse by David Korowicz. Monsta takes a concise look here at how these concepts are affecting the progress of Cascade Failure of systems throughout our society.
The rest below from the keyboard of Monsta666.
I do find that one of the big differences between the doomer lites and normal doomers comes from whether one grasps the normal behaviour of complex systems and consider factors such as efficiency and resiliency. The people who do place a higher importance on such issues tend to hold a more pessimistic outlook while those who do not value or consider such factors in any great depth tend to hold a more optimistic outlook for our world economy. The most notable example I can recall where a system thinker projected a detailed doomer scenario is that of David Korowicz with his report on Financial System Supply-Chain Cross-Contagion. For those unfamiliar with his work I would advise reading the 78 page .pdf file here. If this file is too long I would recommend reading the blog entry of Watching the Global Economic System by George Mobus as a suitable short summary. In either case both sources provide a good backdrop to what I will discuss later on this article.
At the moment our economic system has undergone a process spanning several centuries from a point of high resiliency and low efficiency to one that is highly efficient but carries significantly less resilience. This process of increasing efficiency and interconnections has resulted in greater profits as the resource and energy stocks are allocated in an increasingly more efficient manner. These increased profit margins that can come from greater efficiency arise because the amount of output per unit input declines meaning the costs of the inputs are lowered relative to the proceeds of output. This process of increased efficiency often comes at a cost of resiliency; as the means of production become leaner and carry less redundancy. To offer an example of this many businesses today operate with significantly lower stocks of inventories and much of this remaining inventory arrives on a Just-In-Time basis. This process reduces storage costs but means any unplanned event can cause the business to grind to a halt more quickly as there is less of a buffer to absorb these shocks.
This increased efficiency and declining resiliency is also further exacerbated by the increased amount of interconnections. This increase in the number of interconnections has also resulted in the economic system undergoing a process of consolidation where more and more factors of production have been concentrated into fewer but larger organisations. This consolidation process while offering some increased resiliency from local shocks has meant that the nodes have become less autonomous and more dependent on the overall system to meet its needs. Since there are fewer but larger players it means the whole system has become more vulnerable to wider systemic shocks. While smaller shocks can be more easily absorbed larger shocks have a greater potential of causing cascading failures in the overall system. This occurs because although smaller shocks can be absorbed more readily by a larger network if there is a shock sufficiently large to overwhelm one node the amount of flows/stocks that will get disrupted is likely to be sufficient to cause failures of other nodes. Such examples can be seen in large electrical distribution networks where if there is a failure higher up the chain where more electrical power is transmitted then a failure of this module is likely to cause failure in other nodes as all the excess load is offloaded to other nodes which are then more likely to become overloaded and fail as well.
Another important element to consider is that of risk. In a larger system the risks are never entirely eliminated but merely dispersed. In other words the costs of a disruption are no longer borne by one party but are diffused to many members of society. To offer an example of this phenomenon, before the advent of widespread trade a local farmer could only depend on the food they produced as well as that of his nearby neighbours. If there happened to be drought the farmer would absorb all of the costs from this disruption. With the advent of more widespread trading this risk has afforded the farmer greater resiliency but has made him more dependent on the overall system to provide his income and wellbeing as he depends on the incomes of other trading partners to sell his produce. He is no longer entirely self-sufficient and depends on distant markets to meet his income. However even with this arrangement the risk of disruption has not been eliminated; it has merely been diffused across more party members. As a result, if there is a disruption then this will be borne with rising food prices.
This diffusion of risk while acceptable or even desirable can also create an insidious effect of making it appear that risk has been eliminated when it has merely been diffused and displaced. This perception of no risk can lead market participants to act out in an overly aggressive or optimistic manner heightening the chances of systemic failures. This behaviour of underestimating risk was most famously seen just prior to the 2008 financial market crisis where various mortgages were bundled into mortgage backed securities. This process diffused the risk of mortgage defaults across many more participants but it did not eliminate the risk; it merely displaced it. The general perception however was the risks had been eliminated and the resulting over exuberant behaviour that came from this incorrect assumption almost resulted in the total failure of the financial system.
While the economic system that has developed is highly effective at allocating and expanding resource extraction efficiently it is less resilience and becomes less resilient year on year. This overall behaviour comes because the objective of the system is to expand and increase efficiencies (or profits) and since resilience is not an objective of the system devised it is always the factor that is sacrificed to promote its primary objectives. However as the resilience lowers then the set of suitable conditions required to maintain current system behaviour narrows and the range of parameters for it to achieve a dynamic equilibrium becomes more difficult to maintain.
Like all complex system, once under stress there will be various feedback mechanisms that will be placed on the overall system. At this moment the system is under some stress however the various negative feedback loops (stabilising loops) serve to maintain system integrity. These negative feedback loops can be seen everywhere for example the price of oil places a strain on the economic system. To compensate for this stress factor the system undergoes a process of demand destruction and allocates this critical resource in a more efficient manner that primarily serves to keep the core functions running. This reallocation of resources serves to maintain the system while it is under stress. Another analogy can be made when the human body is suffering from hypothermia. In this state the body will cut circulation from the peripheral regions such as the arms and legs to maintain a normal temperature at the core. These two negative feedback processes come from two different set of complex systems but they both achieve the same purpose of maintaining or preventing the death of the overall system. I am sure with some thought you could offer some other negative (stabilising) feedback loops.
However this behaviour of the two complex systems highlighted will result in similar outcomes if the factor causing the distress is not relieved in short order. In the case of the human body if circulation is not restored to the arms and legs then eventually the cells in those regions will slowly die and if no further action is taken the regions will develop gangrene and these infected regions will spread to the other regions (a contagion effect) where the whole body dies. A similar process will occur in the economic system where the peripheral regions such as the PIIGS or MENA countries suffer first. When those regions economies finally collapse their bad debts will pass toxic amounts of risk to the core economies and then those will eventually cease to operate thus a contagion effect serves to cause a series of cascading that brings the overall system down.
Also in all this, we need to remember there are positive feedback (self-reinforcing) feedback loops. In the case of the economy a positive feedback loop can be found in economies suffering from deflation where lower demand for products will mean more job losses which then results in more demand destruction and further job losses. Such feedback loops are often known as vicious circle when describing a negative cycle or virtuous cycle when describing something positive. These positive feedback mechanisms – if left unconstrained by negative feedback loops – can cause the system to radically change in short order. However at this moment of time it seems the various negative feedback loops are roughly as powerful as the positive feedback loops so the overall system seems to be in some kind of dynamic equilibrium. However in time it is quite likely that the force of positive feedback loops will become more powerful than the negative feedback loops so the parameters in the system will change and the stresses and risks will escalate.
As this happens the system will leave the island of stability and it will soon reach a tipping point i.e. the point when the systems response to a stress event is disproportionate to the stress itself. It is impossible to say when this tipping point will be reached but this point will come provided the stress factors are not removed or contained. When that happens it is likely we will see dramatic changes in behaviour (or collapse) in the overall system. Most system thinkers are aware of such points and even a recent IMF report on oil prices does highlight the fact there would be a tipping point in oil prices that can cause significant changes in the behaviour of various economies. In either case I would say this tipping point is something that is often neglected by doomer lites as they feel the system can carry on getting more and more stressed without the overall system suddenly undergoing drastic changes in behaviour. This lack of tipping point does not generally happen in complex systems or in ecology so I do not see any reason why the economic, political or social systems will fair any differently, they are complex systems after all.
Saying all that, one should not draw the conclusion that all complex systems are inherently unstable. Some complex systems are highly adaptable, resilient and can withstand large disturbances in the level of stocks and flows before being pushed out from its equilibrium range. Such examples of stable complex systems occur in many natural ecosystems which exhibit great stability despite their extreme complexity. What needs to be stressed is the fact that the current economic system man has devised is a complex system that is highly unstable because one of the prime objectives of this particular complex system is to increase efficiency and promote growth. This increased efficiency and accompanying growth often come at the expense of resilience and this lack of resilience is what makes the system unstable.
What needs to be remembered when making an assessment of how a system behaves and will operate is to consider what the primary objectives of a complex system are. Every system has a primary objective and this objective will be maintained at any cost, even to the detriment of other important factors. With humans the primary goals is to avoid death and reproduce. These objectives will be maintained at any cost even if it means the cost of a limb, local habitat or any other large cost. The cost of life may even be an acceptable cost if the first objective is reproduction. The same concepts described here can also be applied to our economic system. Since the primary objectives of our current economic system are efficiency and growth then redundancy and resiliency will be an anathema to our system as not only does redundancy means less efficiency (which translate to less profits) it also means each subsystem can operate more autonomously which is not good for the illuminati who wish to control everything by making its subjects more dependent on the system to provide its needs.