Where is the Economy Going?

SUBHEAD: In the physical world, magic is precluded. So the amount of economic activity has nowhere to go but down. Image above: US Airways plane piloted by Sully Sullenberger makes a graceful landing on 1/15/09 in the the Hudson River near NYC. A best case scenario descent given the physical constraints at hand and available energy. From (http://www.groundedpilot.com/2009/01/15/amazing-photo-of-plane-crash-rescue). By George Mobus on 5 July 2010 in Question Everything - (http://questioneverything.typepad.com/question_everything/2010/07/where-is-the-economy-going.html)

Between a Rock and a Hard Place

The so-called 'recovery' is sputtering badly. The stimulus has only served to prolong the agony. Politicians' talk of 'green shoots' and 'moving in the right direction' has only served to keep hope afloat, but it is a leaky lifeboat.

I think Obama is right about the claim that moves toward austerity (in order to head off inflation and reduce the deficits countries are carrying) at this time will have exactly the opposite effect from a stimulus and help tip the global economy into another dip. When that happens, regardless of the 'cause' he will, no doubt, pull the old 'I told you so' ploy. But he is right only in the sense that austerity on the part of government spending, right now, will just hasten the inevitable. He is wrong to think that the economy will ever return to what everyone had grown used to thinking of as 'normal', even if there was more stimulus now.

There are really two kinds of painful outcomes depending on whether governments spend to create jobs or not. If they do, they will push their debt load still higher and their incapacity to ever pay it back will eventually become obvious to the creditors. Bonds will default and the entire global financial system will crash. If they do not spend, more and more people will drop out of the monetary economy. And because the OECD economies are based on consumer spending to produce a growing economy, the fact that those 'consumers' who are jobless cannot buy stuff means more companies and countries that make stuff will have to lay off more workers. It will be a devastating downward spiral far worse than the Great Depression.

In other words, the world leaders are actually between a rock and a hard place. No matter what they do in terms of normal economic policies, they will still witness collapsing economies.

The Keynesians' Call

Several Keynesian economists, most notably Paul Krugman and Robert Reich have called for more and massive spending on jobs creation and putting money in the pockets of people so that they will go out and buy stuff. Think about it. The so-called health of our economy is now viewed by just about everyone to be based on growth of consumption. If we don't consume there won't be work for other people to do to make the stuff (or services). Then there will be more people out of work and less spending, etc. What kind of corner have we painted ourselves into. Do these economists really believe that a growth scenario can go on forever?

The problem, of course, lies in the way we define work/jobs and income. The capitalist system that exists today is driven by the need to grow profits to satisfy investors who are looking for the maximum return on investment. The average investor no longer buys stocks for the long haul. If a share price doesn't tend upward then they move their investments somewhere else. And, of course, Wall Street benefits from the churn. The quest for profits, the basis for value assessments of firms judged worthy for investment, drives companies to continually squeeze costs (and occasionally get creative in their accounting practices). They get cutthroat in marketing to out compete anyone else who tries to horn in.

Way back when, we used to think competition in the modern capitalistic economy was a good thing. It drove innovation in product development. It gave us choices. And it helped drive prices down. All apparently true. Back then. Of late it is getting harder and harder to come up with true innovations in products that are actually filling needs. It is still operating in product areas where it is only filling wants (e.g. electronic gadgets like iPhones). But even that realm of innovation may have topped out of late. The truth is that now the only real innovation in the marketplace is in terms of creating bogus investment vehicles that promise extraordinary gains. There is still innovation in advertising where the trick is to get people to think they need some glitzy gizmo so the producer can go on growing sales and profits. The majority of so-called innovation today is rubbish. Worse still, it is rubbish that we have absolutely no idea what the true costs are.

We are in deep doo-doo when our whole belief system tells us that we have to consume mindlessly in order to keep our economy afloat. Remember president G.W. Bush's imploring the nation that the best thing people could do in the wake of 9/11 was to go shopping? At that point I wrote him off as insane. But now I have to write off all of these venerable economists as insane as well.

The anti-Keynesians, such as Jeffery Sachs want fiscal austerity on the theory that reducing budget deficits will work toward reducing the debt burden we all face as a result of profligate spending based on borrowing (from whom?) Even so, Mr. Sachs and others in this camp still believe in the basic notion of a growth-based economy. He is the author of a best-selling book on growing wealth for the developing nations. Unfortunately the kind of wealth that those nations want is the same junk that Americans and other OECD nations seem to think is worth buying. As we speak the Chinese workers are starting to make lots of noises about wages (and working conditions) because they want stuff too! We spoiled ourselves, why shouldn't they?

Peak Net Energy and the Capacity To Do Work

But, of course, this is all a fairy tale told to innocent children who know no better. Worse yet, it is a fairy tale told by people who apparently believe it themselves. And the children are less innocent and more duplicitous than one might suppose. Its a nice tale. We all get lots of stuff and happiness. Who wouldn't want to believe in that?

Unfortunately, just like the laws of nature seem to preclude fairy magic, they will also bring an end to the fairy tale we call growing the economy (through capitalism and free markets). The central problem for all of us is that our economy isn't based on innovation per se (though it certainly played a role). It is mostly based on energy flow and in particular from the high power sources of fossil fuels. The latter is actually what enabled technology innovation.

If it weren't for once abundant and easy to obtain oil there would have been no gasoline or diesel and thus no internal combustion engines, certainly not any widely available to just about anyone. Without an abundance of coal and hydroelectricity there would be no electronics inventions like computers and telecommunications.

The inventions didn't cause energy to be produced. Energy enabled motivated inventors to innovate. Energy provided the background state that gave rise to the foreground of inventions. Humans were the catalysts. We always want to go faster, get things done quicker, do bigger projects, eat more food, have bigger dwellings. We always want more. That is our nature in being a little less sapient than we should be for the good of our species. So when given the opportunity by the availability of high powered energy sources we went to town on invention and consumption.

And here is the best evidence regarding our general lack of adequate sapience — logically realizing that fossil fuels were a finite resource, we still let ourselves go wild and extract everything we could as fast as we could. We weren't dumb. We were just very foolish.

What happens to you when you stop eating? You starve. You don't die instantly. You wither away and die when your organs can no longer function. In other words, when you cut off the energy supply, you stop functioning properly and succumb. And the exact same thing will happen to the economy when the supplies of fossil fuels get so hard to extract and process that we will effectively be cutting off over 80% of our energy supply (probably more since alternative sources currently rely on fossil fuels for production of capital equipment and maintenance). Even if 20% of our economic activity might be classified as wasteful (not energy efficient or not necessary) that still means 80% of economic work would be curtailed by having at most 20% of the original energy flow available.

And in the physical world, magic is precluded. So the amount of economic activity has nowhere to go but down.

The figure below shows several scenarios for economic activity based on different assumptions about energy flows (where they will come from, how much, etc.) This isn't a graph of anything, just some plots of hypothetical futures. The vertical axes is an abstract concept of economic activity. It could be GDP, as is normally used, or it could be a truer measure of income, or it could even be population. The plots start from very recent history and show today we are at a peak in activity about to decline into what a growing number of economists are worried about — a so-called double dip recession.

Image above: Figure 1.

As measured in GDP or stock prices or some other hypothetical measure of activity, the economy seems to be trying to 'recover'. But the broader indicators, such as jobs and employment show very poor signs in that direction. The longer term picture will more likely look like this with dips and occasional seeming recoveries, only to dip further again. The long term trend is definitely downward.

Here I assume that there will be yet another seeming recovery after the next dip. Once again we will hear stories of how things are improving and we are going to get back to normal, yada, yada, yada. But all the while something is working against all other concerns for reestablishing a growing economy.

Net energy has peaked and is accelerating its downward slide. Indeed, the new cost structures that will be needed to allow deep water drilling now that we've seen what horrible things can happen (costly technology, increased regulation inspection and enforcement, slower operations for safety, etc.) will reflect a tremendous increase in energy costs for such drilling and extraction.

It could well be that deep water wells will have EROIs near unity (you also have to factor in oil spill cleanup costs, and increased insurance for both the extraction companies and the residents and businesses on the Gulf coast). Ergo, the net energy return from these ventures is going to be even less than we realize.

The plots show five scenarios, one absolutely ludicrous, the one economists and just about everyone favors — business as usual, exponential growth, and four others that might seem possible. The one that would be ideal, but also impossible given our situation, is to achieve an essentially steady-state economy. Most of the "Greens" believe that this is feasible if we would just get cracking on ramping up alternative, green, energy sources like solar and wind. This too, I'm afraid, is a fairy tale. True believers should check out this post by Euan Mearns of the Oil Drum: "Renewables to the rescue?".

Then we get to the most likely scenarios. I present three, a best-case decline, a most-likely case decline, and a worst-case decline. All are declines based on the declines in net energy that we are already experiencing.

The best-case decline is based on the notion that if all other things are held equal then our economic decline will simply reflect the decline in energy. It presumes that we can manage a descent in such a way that we minimize harm. This plot doesn't show it, but it also assumes that at some point the decline will level out at a sustainable steady-state level (above zero). This kind of decline is along the lines promoted by James Kunstler ("The Long Emergency") and John Michael Greer ("The Long Descent"). Both authors have based their thoughts on the symmetrical shape of the Hobbert curve that is favored by most peak oilists. But their models do not derive from net energy considerations and accelerating declines in EROI which would tend to cause the net curve to fall off more rapidly.

They may also not take into account the degree of coupling between subsystems in our complex economic world. The degree of coupling strength between components tends to make system more brittle when they are too tight. Nor do their analysis take into account, sufficiently, the dynamics of metastability in wildly oscillating systems (e.g. the volatility in stock prices). Such systems can fail catastrophically with the slightest nudge at the right time. We saw that with the stock market in Oct. 1987! Tight coupling (use of computerized trading programs) and volatility were the key factors in the stock market crash.

The lower plot (in red) is the worst-case scenario in which everything goes wrong in very short order and energy supplies, even at low EROIs are disrupted and fail. Then everything comes to a halt. We have actually seen a preview of this possibility in the form of demand destruction in oil and subsequent decline in investments in new projects. Under the current rules of return on investment (ROI) and the current expectations of what those returns need to be, given the perceived risks, throwing money at new oil ventures will become perceived as throwing money away. Ironically, once the impacts of cutting off gross energy supplies hits, there won't actually be any other profitable investment opportunities because no one will be able to get any work done!

The Most-Likely Scenario

Actually Greer and I agree on the likely shape of the decline. We both foresee periods of stasis and even possible up-ticks for short periods. But the overall trend is definitely downward. Where we disagree is on the timing and likely rate of decline. Were I to write a book on the subject I would probably title it "The Short Decline". I base this on the idea that we are looking at something like a phase transition, taken more broadly defined, in a natural system. The metastability factor mentioned above can lead to systems entering a critical point in which anything can happen. This is especially true for chaotic systems that may jump to a new attractor basins. This is what we are expecting from our climate under the heat forcings supplied by excess CO2. I suspect our economic systems embedded as they are in the whole Earth system, are just as chaotic if not much more so.

A key question will be what happens toward the end of this slide? Will it end at zero economic activity like I show the worst-case scenario? Or will it achieve a steady-state, albeit lower level of some economic activity when the flow from alternative energies actually are sufficient to supply demand?

Another, equally important, key question is: How much pain and suffering is represented in these decline scenarios? In the green version, steady-state, there would be no pain at all. We would simply transition to our new sources of energy, adapt to a no-growth philosophy, and yet everyone would somehow prosper (I should note that some versions of green thought actually see the growth scenario as a reasonable outcome due to their imagining alternatives are going to expand indefinitely and green jobs will pay so much more — I have no idea what rationale was used to come up with that particular fairy tale!) It will depend on the rate and what kinds of things break down if we suffer collapse in key subsystems.

For example if electricity breaks down so will water (pumping, filtering, purifying, etc), so will fuel delivery at gas stations (until someone installs hand pumps maybe). Refrigeration will break down and food delivery/maintenance at grocery stores and wholesale warehouses will disintegrate. One can devise any number of domino effect micro-scenarios that might obtain. But whatever goes first or last, you can bet that your life will depend on something in that chain. This is especially the case if you live in a metropolitan area (cities or suburbs).

I don't think there are too many economists who are modeling these scenarios. It is simply too beyond their grasp of reality to even consider. In my last blog I asked what was wrong with Krugman's pronouncement:

"Much of what Serious People believe rests on prejudices, not analysis. And these prejudices are subject to fads and fashions."

He was directing this at the anti-Kenesians who are calling for fiscal austerity at a time when Krugman's own non-biased, non-prejudiced analysis clearly indicates the government should spend, spend, spend, so that consumers can spend, spend, spend and get the economy growing again! Go figure. I wonder what he has to say about Jeffery Sachs' claims. Sachs must be prejudiced or holding onto a fad or fancy. It is an odd situation given that both men have Ph.D.s in economics!

Net energy is all that counts. Our economic systems depend crucially on a tremendous flow of very high power that can only come from fossil fuels in the near term (next 20 to 30 years is my guess). But that net energy flow is already in decline. The panic we are feeling about oil supplies and our justifications for drilling in deep water where we don't know what the hell we are doing is just an indication that the truth is starting to sink in. But it is fighting those prejudices and fancies that fill all economists' heads. Growth is the norm. Consumption is the norm. That is what we need to be happy.

Children sometimes grow up and no longer believe in fairy tales. Sometimes that is because they learn how the world really works, they gain knowledge about science, for example. Or they learn through bitter experience. If one is wise, regardless of how the knowledge is won, one will use that knowledge to moderate the future. How wise are our leaders and their economic advisers do you think?

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