The Energy Futurist

Economic theory and the Real Great Contraction

Posting in Energy

SmartPlanet's resident energy futurist Chris Nelder explains why economist Adam Smith was a peakist, and how energy will force the economy to contract.

"At the Time of the Louisville Flood,” Kentucky 1937, by Margaret Bourke-White

The contemporary debate over the future of natural resources features two competing theories of economics.

The view that dominates all economic policy and theory today is rooted in the work of Adam Smith, published from 1759 to 1776. It holds that self-interest, if unimpeded by regulation, can be harnessed and trusted to produce socially desirable outcomes. His argument was that free trade maximizes the utility of producers to ration the demand of scarce resources and allocate them via an “invisible hand” to consumers with the highest marginal demand more efficiently than allocation by dictate could. History proved him right: the world’s supply of energy has continued to increase steadily ever since.

Smith wrote his seminal book, The Wealth of Nations, after becoming enamored of the Physiocracy theory emerging in France. It viewed the entire economy as being built upon agricultural output, which it mostly was. In Smith’s time, the world was primarily powered by our most ancient energy sources: plants, wind and water. The exploitation of coal had only just begun, and the steam engine had only just been invented. The age of oil wouldn’t even begin for another 140 years.

The competing view holds that the world is approaching “peak everything.” Peak oil, peak coal, peak gas, peak food, peak water, and ultimately, peak population. At some point the supply of these critical resources can no longer be increased; they will peak, and then decline, taking economic productivity down with them. Or in economic terms, the price at which new supply can be offered to the market will be a price that the market can’t support.

Being of a scientific mind, I prefer data over faith, which puts me in the latter camp.

When oil got to $120 per barrel in 2008 it cut into real productivity, and forced the world’s most developed economies to shrink. At $147, it wreaked serious damage. The subsequent economic crash took oil prices all the way down to $33 a barrel within six months. U.S. petroleum demand declined by nearly two million barrels per day (mbpd) from 2007 through 2009, of which 85 percent was lost in the commercial and industrial sector.

Every dollar of gross domestic product up until 2005 was generated on the back of cheap and easy oil. Without energy, there can be no economic activity. When global conventional crude oil production hit its peak-plateau in 2005, ending its 150-year-long trajectory of growth, it appears that global GDP per capita did too. Further, the last three major recessions in the U.S. all occurred after petroleum expenditures rose to more than 5.5 percent of GDP. (For additional studies on the relationship between energy expenditures as a fraction of GDP and recessions, see here and here.) At more than nine percent of GDP, we are well above that threshold again today.

But under modern laissez-faire economic theory, perpetual economic growth is axiomatic and mandatory. It is built into all our assumptions and our generally accepted accounting practices. It is presumed by the issuance of sovereign debt and the printing of money, both of which are essentially claims on future productivity. Growth must be maintained, at all costs. This presumption justified the creation of financial instruments like mortgage-backed securities based on no-money-down loans, to juice up a housing sector that would have gone flat if only truly creditworthy borrowers could buy a house. It justified trillions of dollars worth of Keynesian stimulus since 2007, and many economists argue that trillions more are needed still.

In short, when the gas tank on the engine of economic growth ran low, we turned to inflating monetary bubbles, and stuffed those in the tank. It created the temporary illusion of a bit more economic growth, but it came at the cost of several future generations’ worth of debt.

Despite these obvious facts, the entire world still assumes that growth will continue. Everyone thinks the world will get to nine billion people by 2050, when seven billion today are already encountering fierce competition for food and fuel. Every economic model offered by government agencies projects at least a 1.5 percent annual growth rate for another two decades.

Just as a fish has no concept of water, the faith that technology will somehow produce enough food and fuel to feed those nine billion is so embedded into our thoughts, so intrinsic to the economic theories we have been taught, that it isn’t even questioned. There is no need to worry about the declining energy content of our fuels, and the declining supply of basic agricultural nutrients like phosphorus. We needn’t bother with the fact that the net energy (the energy left over after subtracting the energy expended in production; also known as energy return on investment, or EROI) of all our major fuels is in long-term decline. The invisible hand will provide! Always!

I maintain that all of these beliefs are wrong. They are based on faith, not current realities, and they misconstrue what Adam Smith actually believed. They are as bankrupt intellectually as our economy is financially.

Not only are we finding it painfully expensive and difficult to produce new resources, the so-called free market no longer provides socially beneficial results. It now produces crashing global fish populations, depleted and vanishing topsoil, water in the Gulf of Mexico contaminated by blown-out oil wells and the runoff of agricultural fertilizers, hundreds of square miles of landscapes rendered lifeless in the pursuit of coal and tar sands, totally unsupportable and dysfunctional topographies of cars and roads and suburbs, and air so filthy that last week Milan banned all vehicles from its streets and Beijing’s air is rated as “hazardous” or worse nearly every day. It now produces social unrest via a chain of geopolitical causality so long, most people can’t even follow it. And it externalizes the true costs of energy in the form of environmental destruction.

Modern economic theory has no plan to address these very real problems. Indeed, it is utterly blind to them. It does not attempt to achieve fairness, only efficiency. It has no ambition to achieve a sustainable result. It does not capture the time value of use; it only serves to bring supply to market as quickly as demand warrants, which is particularly unfortunate when our most rational strategy now would be to make the last half of our oil endowment last as long as possible, not to use it as quickly as possible.

The reason we like laissez-faire capitalism is not because it’s intrinsically correct and comprehensive, but because it only asks us to do what we want to do, and confers a mantle of legitimacy upon self-interest. Or, in Milton Friedman’s more modern formulation of Smith’s theory, it offers “the possibility of cooperation without coercion.” But if you look closely at the data on fossil fuels, agricultural inputs, arable land, water, and all the rest of the resources necessary for human life and economic growth, it’s clear that the situation has changed. We have reached the end of growth, no matter how much faith we have to the contrary.

The Great Contraction

The question we now must ask is: What comes after the end of growth? The answer should be obvious.

While crude remains on its current production plateau, OECD economies may expect growthless stagnation. Oil has become a zero-sum market, where the OECD’s loss in demand owing to high prices, staggering debt, and anemic growth will be the gain of emerging economies as they work their way up the economic ladder. When crude begins its inevitable, terminal decline somewhere around 2014 or 2015, depriving the world of about two percent of its primary energy supply every year, it will slowly strangle economic output, under a scenario I call the Real Great Contraction. Milton Friedman used The Great Contraction as the title of his book on the Great Depression, and economist Kenneth Rogoff borrowed it to describe his view of the 2008 financial crisis, but even Rogoff has not incorporated the concept of peak oil, which will greatly exacerbate the effects of his scenario.

After oil begins its decline, gas and coal will too. By roughly 2030, 78 percent of our current global primary energy supply will be in decline. There is no way that renewables can make up that loss in time to prevent economic decline. When I run the calculations, I find that the world would need to build the equivalent of all existing renewable energy capacity every year just to make up for the decline of oil, let alone coal and gas. Since that is unlikely, the only remaining option is to reduce demand through efficiency gains. Given that the world is nowhere near on a trajectory to make enough efficiency gains to maintain even a flat economy, it must contract.

The modern interpretation of Smith’s invisible hand -- that the market can always call forth adequate resources at an acceptable price -- is self-evidently not true. It is merely a misreading of Smith’s theory, an artifact of developing economic theory in an age of energy surplus. Take that surplus away, and it doesn’t work anymore. High prices can still ration demand, but they cannot call forth adequate supply. But most economists fail to recognize this simple truth. No one remembers the last time humanity failed to find a substitute for a declining incumbent fuel, so we don’t think it can ever happen again. Two hundred and fifty years of recency bias is a bitch.

The connection between abundant, cheap energy and economic growth, and the phase transition from an age of surplus to an age of less, continues to confound and elude mainstream economists. They can’t see it, even as the farsighted wealthy convert their assets denominated in fiat money, like stocks and bonds, to hard assets, like gold and farmland. The 50X rise of gold from $35 to over $1,800 an ounce over the last 40 years is but an aberration within the narrow perspective their free market blinders affords, rather than a gradual deterioration of faith (credere, in Latin, the root of the word credit) in fiat. Even economist Nouriel Roubini, who famously staked out a contrarian position by anticipating the crash of the U.S. housing market and the financial system in 2008, still hates gold and derides it as a “barbarous relic.” Now the global financial regime teeters on the edge of failure, as European banks struggle to maintain their illusion of surplus wealth for just a few moments longer.

Rather than admitting that the fiction of wealth (money) is overextended far past its basis in real wealth (hard assets), we demand that our economic oracles perform rituals to appease the gods, dropping paper money from helicopters like some sort of cargo cult.

The Physiocrats of the late 18th century believed mankind would eventually overshoot its resources, since land is finite. (The emerging contemporary field of biophysical economics follows in that tradition.) That they could not have imagined the wealth of fossil fuels yet to be exploited does not disprove their thesis; it merely delayed it, and ensured that when human demands finally do overwhelm the capacity of a finite planet to satisfy them, the overshoot and crash will be spectacular.

Adam Smith believed that government would have to take action to prevent the tragedy of the commons as a necessity of civilized society. His notion of the invisible hand was simply a way of explaining how the appetites of the rich would unintentionally benefit the poor; it was not a proclamation that only self-interest should guide economic policy.

By modern standards, Adam Smith was a peakist. He would have been aghast to see the economic edifice built in his name, and would be demanding intervention to stop our headlong rush to overshoot.

Lacking energy alternatives that can be scaled and substituted for fossil fuels within two or three decades, true believers in free market theory must now hang their hopes on science fiction saviors like fusion reactors, colonization of space, fundamental breakthroughs in materials science, and aliens bestowing us with antigravity technology. In my view, none of these things are likely. If we do not muster the political will and the mechanisms needed to execute a rapid deployment of efficiency gains and a massive transition to renewables while we still have fossil fuels with which to do it, this century will see humanity slide back down the ladder of energy consumption and credit expansion in a long and volatile reversion to the mean of human history, to a much lower equilibrium of complexity and consumption. The Real Great Contraction is here.

The remaining question is: What sort of economic theory can maximize social cohesion and non-coerced trade during the Age of Less? And if we had such a theory, would we have the will to employ it?

Photo: “At the Time of the Louisville Flood,” Kentucky 1937, by Margaret Bourke-White (Cea/Flickr)

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Chris Nelder

Columnist (Energy)

Chris Nelder is an energy analyst and consultant who has written about energy and investing for more than a decade. He is the author of two books on energy and investing, Profit from the Peak and Investing in Renewable Energy, and has appeared on BBC TV, Fox Business, CNN national radio, Australian Broadcasting Corp., CBS radio and France 24. He is based in California. Follow him on Twitter. Disclosure