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Some crystal ball gazing

If my last blog, about the peak of global oil production and a sustained fall in global production, contained an ounce of truth, some interesting trends should occur in the next year or two. First, we should see the price of oil rise again from its current price of around $60 a barrel. Second, we should see an increase in the inflation rate on a relatively global scale. (Note that in the UK, inflation is currently at 4.4%. With the base interest rate at 4.5%, the real interest rate is now effectively zero). Third, we will see a sustained decline in global output. Taken together, a recipe for stagflation. (I also predict continued volatility on financial markets as demand and supply expectations feed back on each other).

Interestingly, simple macro-economic principles can explain how this will occur if interpreted correctly. One simply has to remember that supply and demand are not independent from each other. Each drives the other in a dynamic feedback cycle. Let me try to explain.

If we use the simple aggregate supply (AS) and aggregate demand (AD) curves, we can describe what I believe has been occurring in the past two years, and will occur for the next few. Looking at the figure below, we see the intersection of AD and AS at price level P1. Taking my peak oil explanation of the current financial turmoil, we should first see slight shift to the right of the AD. This growth in demand expectations is what was been driving up the share market and commodity prices in 2005-2007. This was not accompanied by a large increase in supply as physical limits (peak oil) were being met (hence the steep AS curve). Therefore we see a rise in the price level (inflation), and we see why the Australian reserve bank lifted interest rates in that period.


In time, the realisation that these demand expectations would go unfulfilled, due to supply (output) failing to increase, demand expectations dropped, shifting the demand curve dramatically to the left. This had a huge impact on commodity prices, with large drops seen in metals prices, and the oil price, and shares prices in general.


But this is not the end of the story. If I am correct, and supply will begin a slow decline, demand expectations will begin to factor in this decline. Both AS and AD will creep leftwards. To arrest this de-growth or un-growth, monetary policy will be loosened, with the intention of stimulating investment and a growth in supply. But alas, this will not occur due to the physical limits of oil production having been reached.


Importantly, using the AD and AS graph, when this leftward creep happens, the price level remains the same. How does inflation occur in this circumstance? It occurs because the money supply does not contract as easily as output does. Additionally, the likely reaction of governments and central banks will be to stimulate demand with fiscal policy, (think of Kevin Rudd’s one-off payments in Dec), and stimulate investment in supply with loose monetary policy (lowering interest rates – remember the real interest rate is close to zero in the UK, and I would suggest that this may be the case globally very soon).

The ‘solutions’ to stagflation are simple. ‘Solution’ however is used very broadly here. If your problem is inflation and you want to stabilise the currency, you need to decrease the money supply. If your problem is de-growth, then you want to heavily invest in resource exploration and efficient production technologies. Supply constraints are physical and need physical technological solutions. In time of course, these technology changes will occur through native human ingenuity, and production will be able to increase once again. If you problem is the environment, stick with the stabilising the currency and let de-growth take its natural path.

Peak oil and the financial crisis.

We have reached the lowest oil price for about a year – down around $70 a barrel from a peak of over $140 a barrel not so long ago. Is this a sign that the theory of peak oil, that at some point the rate of global oil extraction will peak, is false, or at least is not here yet? I suggest the recent pattern of oil prices, and the financial upheaval around the world, are signs that we are very close to the global peak of oil production. I will attempt to explain why this is the case.

First we need to catch up on some economic principles. The price of a good is a relative measure, and reflects how many other resources are required to produce it. Consider a $100 pair of shoes. The price basically represents that the shoe required $100 of other resources to produce it. Such things as labour costs, materials, rents, distribution, design, advertising, and so on. A $50 pair of shoes requires around half of the amount of inputs. When the price of shoes is on the rise, it reflects increasing requirement of inputs. Thus a rising price is a sign of increased inputs necessary for production. And this also means that these inputs to production cannot be used to produce other things.

Now consider what happened to the price of oil recently. Regardless of what you believe about hedge funds, short selling, or any other financial trickery, the trend was a steep price increase for that past two years or so. This is a sign that more resources have been needed to produce oil, and were subsequently not being utilised for other production. Thus, the total production of goods in the economy must eventually drop. This is exactly as peak oil theorists would predict.

But what of the recent price drop. Again, we have to wait and see what the trend might be in the longer term, but this is also consistent with peak oil theories. The point here is that over the long term, the relative price of oil and other commodities (apart form labour) will be relatively constant. When oil becomes more expensive, so do other goods that need energy from oil in their production. Only the overall output of the economy will fall. The price spike we have just witnessed may simply have been a speculative signal based on expectations of future growth that were never going to come true.

On another note, I keep wondering that if oil is a non-issue, why the US has made such a huge sacrifice in waging war in Iraq?

If I am right, and the rate of oil production has peaked this year, or will peak in the near future, this is not necessarily a bad thing. As long as this ‘crisis’ does not provide excuses to wage wars, we can continue living a rather luxurious lifestyle with a downward trend in production just as easily as we did on the upward slope of the past half-century. In time, technology will evolve and allow us to produce more once again. For an environmental economist, peak oil is blessing for the environment. If I am wrong a global recession is a nice rest of our environment anyway.

Flow

Contemporary economists know that money doesn’t buy happiness. I take that back. Economists have trouble even defining money or happiness. But they can use stone-age tools (aka the art of regression) to ‘prove’ to us what most societies have known for millennia.

This, however, is a problem. Traditional economic thought has at its core the concept of utility - the thing that individuals try to maximise, and that we as a society should also strive to maximise. In effect, it is their best attempt at defining happiness. Economists are now struggling to get past this fundamental happiness contradiction. I would like to add some thoughts from psychology that may help our understanding, and reveal the underlying evolutionary explanation of how happiness is achieved.

I will preface this blog by saying that the majority of the views I am sharing actually come from a book called Flow: The psychology of optimal experience, by Mihaly Csikszentmihalyi. He breaks down happiness into to components – pleasure and enjoyment. Pleasure by itself will not provide us with happiness. It is the type of experience we have when we do not invest psychic energy in an activity. It is passive. Pleasure may come from watching a movie, walking in the park, admiring a work of art, listening to music. Enjoyment on the other hand requires the investment of psychic energy. The flow experience is how one gains enjoyment, and it comprises eight components:
1. Confronting tasks that we have a chance of completing
2. Concentration
3. Clear goals
4. Immediate feedback
5. Removes awareness of worries and frustrations
6. Provides a sense of control over one’s actions
7. Concern for the self disappears
8. The sense of time is altered

Clearly, a life without confronting tasks and clear goals is inherently unrewarding. But this is exactly the goal of much of societies development in the past century. The goal has been to make life easy, with no confronting tasks, and give us more choice, and as I have suggested earlier, this ‘choice-overload’ leads to less clear goals.

Surprisingly, Csikszentmihalyi found that people experience flow more often at work than during leisure time. It is easy to imagine many working environments where the first 4 components of flow are readily available. Other places people experience flow is when playing computer games. In fact, the game design field is probably the greatest user of the principles of flow. You know how you start with easy levels. You acquire greater skills, and are then confronted with more challenging tasks. All the way, there is plenty of feedback, and two hours have gone by in a flash. Edward Castranova has written about how people are shifting from their real lives, into online gaming worlds in search of flow.

One of the most interesting parts of flow is that to continue to have flow experiences, you need increasing complexity of challenges, and of skills to meet them. As a society , we have basically taken away much of the challenge of living, and also taken away many of the skills necessary to learn in order to live. Many people cannot cook themselves a meal from fresh ingredients. They cannot mend their own clothes, repair their houses, cut their own hair, clean their own house – what skills do we have?

I would to propose an evolutionary explanation for this desire for flow. In essence, those who sought more challenges, and reached them, were rewarded. You can imagine a tribe of early humans seeking out new lands in the face of increasing numbers of predators. The reward for this desire to rise above challenges, and persevere until new lands are found, would be greater reproduction and survival rates. Those early humans who did not have this desire to confront challenges, would ultimately perish before they could reproduce.

The ironic part of all this, is that flow often occurs in the times of most hardship. Csikszentmihalyi found that many prisoners of war, and people who have were faced with major physical disabilities, actually experienced flow more often than those of us living cushy urban lives in the 21st century. While we may find much pleasure in our comforts, this will not bring us happiness.

So what can we do to increase flow? We need to acknowledge that the most vital part to this story is that flow actually is self-determined. You can actually learn to be happy. External factors play no role. It is how you interpret your external environment that determines your happiness.

With all this great detail about human motivation and happiness, I still wonder why economists seek explanations use outdated concepts like utility to explain our actions. By sticking with this underlying theory they are stuck with trying to see whether factors such as wealth, number of children, marital status, age or any number of external circumstance or events can provide happiness. They pursue this even though they know can never prove a casual link. I guess reality and economics don’t mix sometimes.