Showing posts with label Forecasts. Show all posts
Showing posts with label Forecasts. Show all posts

Tuesday, August 9, 2011

Chart of the day: Shares v houses in the US

A fellow blogger has pointed out a comparable chart to yesterday's share price v house price chart for Australia since 2003 from the Federal Reserve Bank of St Louis.


Just because housing investors (in some Australian cities) have made relatively good returns over the past four years, that shouldn't be interpreted as an indication of future outcomes.  There are precedents for large sustained falls in home values which will be extremely financially painful for the leveraged investor.

Sunday, July 31, 2011

RBA pragmatism and global stagflation

Since the higher than expected CPI print last Wednesday, the economic blogosphere has flooded our screens with opinions on the likely RBA decision at its board meeting tomorrow. Some have argued that the CPI was filled with ‘once-off’ movements in price (eg, the deposit and loan facilities and some fruits) and should therefore be taken with a grain of salt. Others have argued that the CPI is clear evidence that the RBA should move on interest rates to get ahead of the inflation curve.

I have a different opinion.

Raising the cash rate while Australia could be in a technical recession is a situation the RBA needs to avoid more than anything else. Think about the criticisms – “How could our central bank be so out of touch?” “Give Glenn the boot!” The very institution itself would be at risk. Forget demonstrating independence. Self preservation is the name of the game (note also that the inflation target is not a mandate of the RBA, but its own interpretation of how to fulfil is statutory role).

Therefore, the only logical decision for the RBA board tomorrow is to leave the cash rate unchanged, even if it has strong concerns about inflation. It is the same action central banks are taking in the UK and other developed countries in similar situations.

But there is more to this story. The present bout of high inflation and low growth is global, and there is little our domestic policy can do to intervene. Further, I suspect that this has much to do with physical constraints to global oil supply (at least in the short term).

As I said two years ago during the financial crisis –

...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).

The following three graphs show the oil production, oil price and the correlation between oil price and inflation in Australian, Asia, and other developed markets (DM). (Thanks Ricardian Ambivalence for the third graph).


The simple explanation for oil price led inflation is that a century of capital equipment, particularly in transport, is reliant on oil, has very little ability to substitute to other energy sources.  Therefore, the cost of goods is at the mercy of the oil price due to our invested capital.

Typically, there is an expectation oil production will respond to higher prices. But if there are short term physical and technological limitations, this cannot occur. In 2007 the oil price was double the price in 2005, yet total global oil production was identical. If there was not a physical limit to oil production, oil producers should have responded to this price by greatly increasing supply.

Ricardian Ambivalence has weighed in with an opinion that global inflation is not about oil. Oil price leading inflation globally in the above graph is explained away because “Oil leads CPI, in part, because variations in demand lead variations in CPI”. There may be some element of demand and oil price as co-contributors to price volatility, but my suspicion is that physical production limits to oil are the key.

Indeed, the reason these limits are having such a dramatic effect is because they were not foreseen, and investment decisions were made on the expectation of higher volumes of oil available at similar prices.

As a final statement, I want to address the ‘lunacy’ of peak oil. Many economic thinkers rule out the possibility of such an occurrence, as high prices lead to more inaccessible reserves becoming viable, as well as substitute energy sources becoming economical. Yet the recent evidence is that global oil production is back where it was in the late 1990s even though the oil price is more than 5x higher. This doesn’t seem consistent with the economic rationalism, which ignores the major prolonged adjustments necessary for these investments and subsitutions to occur.

Some may still be arguing in their mind that the reason for lower oil production currently is because of a global demand slump. But again, this fails to explain why we are willing to pay 5x the price for oil, and producers are not willing to sell any more oil at that price.

In the end, Australia is at the mercy of global forces as much as anyone, and it would be foolish for the RBA to believe that our domestic interest rate will have any significant effect on inflation without crushing our economy.

Tuesday, July 12, 2011

Google economic indicators

I have mentioned Google’s real time price index before. Today I want to go ‘around the grounds’ to see how internet prices and search results are being used as economic indicators.

MIT is doing it with their Billion Prices Project. Their index appears to be very similar to Google’s and appears to track the official index in the US well, and a little advanced. That is promising.


The Bank of England is using search term frequency as a complement to survey data to provide a better picture of the labour market. The chart below shows that quite a few search terms provide an indication of conditions in the labour market.


The Economist uses search term frequency to reveal concerns about the fragility of the Chinese economy. For some reason ‘hard landing’ as a search term is rapidly becoming more popular. (Hopefully this is not because of a new rock band by that name, otherwise that would be embarrassing.)


Economist bloggers are also very keen on the possibilities that Google search statistics present. Justin Wolfers tests some search terms over at the Freakonomics blog, while a local economic blogger finds a strong correlation between the unemployment rate and the search term ‘piercing pictures’. Yes, correlation does not imply causation.


And of course yours truly has used Google search terms to investigate whether Australians believe they are in a housing bubble, with reference to the trends in housing prices and Google searches in the US.


Lastly, the academic community is finding that search term frequency a useful tool as a proxy measure for real life frequency of events.

We propose, based on the premise that the occurrence of a phenomenon increases the likelihood that people write about it, that the relative frequency of documents discussing a phenomenon can be used to proxy for the corresponding occurrence-frequency. 

I feel like this is just the tip of the iceberg in terms of the power of the data being collected by Google.  And I hope that this valuable data continues to be provided for free to the general public.

Tuesday, November 30, 2010

GDP only positive because of rain drenched agriculture

Today’s National Accounts figures were not a huge surprise - except, of course, to many of the mainstream economic commentators, some of whom continue to demonstrate their undying faith by stating that the decline is nothing to worry about.

Neither are the downward revisions to the June quarter figures worth a second look.  The June quarter growth trend down was revised down from 0.9% to 0.7%, and seasonally adjusted down from 1.2% to 1.1%.

And possibly my favourite lines from the ABS release
In seasonally adjusted terms, Agriculture (up 21.5%) contributed 0.4 percentage points to GDP growth driven largely by strong forecasts for grain crops... GDP increased 0.2% in the September quarter, while non-farm GDP fell 0.2%

If it wasn’t for the surge in agriculture driven by last season’s strong rains, GDP growth for the quarter would have been negative, and for the year, just 2.3%.

Perhaps it is time to revisit some forecasts by our favourite economists back in September.

Peter Jolly, NAB - Our year ended GDP forecast has lifted to 3¼% from a little under 3%
Christopher Joye, Rismark - The economy is about to embark on a period of above-trend growth
Warren Hogan, ANZ - Hogan believes we are about to see a period of serious inflationary pressures thanks to the commodities boom's income wave
Michael Blythe, CBA - reckons the income surge will add 3 or 4 per cent to GDP over the next couple of years.

Yet the serious inflationary pressures and above trend growth seem to be a little hard to come by at the moment.

At least I can give myself a plug.  Heck, isn’t that what economists do?  My prediction from early September - Inflation and GDP will surprise on the low side in the September quarter.

Steve Kates explains much better how the data early in the year was deceptive due to the dramatic impact of fiscal stimulus, and that the private sector recovery is yet to appear. 

Monday, September 6, 2010

Economist forecasts for the record

Just for fun here are some recent forecasts from some of Australia’s leading economists.

Bill Evans – Westpac Chief Economist - 3 September 2010
At present we are expecting rates to rise by 75 basis points during 2011. Markets will need to adjust a long way to accommodate that view

Peter Jolly – NAB  Head of Global Research - 4 September 2010
Our year ended GDP forecast has lifted to 3¼% from a little under 3% As a consequence, we debated whether the 100bps of tightening in our forecast starting February 2011 was enough. We think it is, but it did remind us that a 2010 hike remains possible should either a) Q3 inflation in late October be shockingly high or b) the economy grows above trend in the 2nd half and the unemployment rate (now 5.3%) plunges through 5% - quite possible

Christopher Joye – Rismark - 23 Aug 2010
The economy is about to embark on a period of above-trend growth (mean of the ABS trend measure since June 2000 is 0.7%/qtr or 0.4%/qtr/capita)

Warren Hogan – ANZ Chief Economist - 1 September 2010
The consensus seemed to be that the Reserve Bank will be happy to sit pat for six months and then raise rates by 100 basis points through next year. The ANZ's Warren Hogan was the hawkish outlier of the group, predicting 150 or 170 points over the next 18 months.

Hogan believes we are about to see a period of serious inflationary pressures thanks to the commodities boom's income wave – the CBA's Michael Blythe reckons the income surge will add 3 or 4 per cent to GDP over the next couple of years

Dr Frank Gelber – BIS Shrapnel Chief Economist - 7 September 2010
Interest rates are set to rise and commercial property values will skyrocket.
"I've never seen a lower risk, higher prospective return, in the commercial property market, ever," he said. "We're looking at rents and property values doubling in Sydney and Melbourne over the next five years." [commercial property]

Cameron Murray –Economist, blogger (you read it here first)
Inflation and GDP will surprise on the low side in the September quarter.  Remember, the June quarter had a booming terms of trade (which is now languishing), fiscal stimulus (which is now finished) and two interest rate moves by the RBA which could drain consumer confidence and spending, especially when combined with house price nerves and debt concerns.  Therefore I expect the RBA to keep rates on hold for the next 6 months (with some independent upward moves of mortgage rates by banks), with a possible stimulatory move by the RBA next year.

On a different note, for those who want a little more insight into Australia’s own residential mortgage backed securities market, this piece from Adam Dellaverde might pique your curiosity.

Tuesday, March 30, 2010

Glenn Stevens' predicament: He wants us to believe interest rates are heading up without actually putting them up

I imagine it is a tough job being the nation's central banker. But the recent television interview with Glenn Stevens, RBA Governor, has made it quite clear the predicament he currently faces.

Stevens warned that property speculation is not the path to riches (the Real Estate Institute of Australia was apparently surprised by this statement). Obviously he is very worried about the stability of Australia's massive residential property market.  But to achieve the desired outcome, he needs to fool us all.

Sunday, January 24, 2010

How randomness rules our lives and why statistics need discipline


I have been reading Leonard Mlodino’s terrific book The Drunkard’s Walk, which is essentially an historical narrative on the development of thought around randomness and probability intertwined with modern statistical anecdotes. I would highly recommend this book to you all (especially if the inner nerd in you enjoys a little mathematical philosophy like mine does).

I feel the need to share some of the most interesting insights, and highlight some of my remaining concerns about the nature of randomness and probability. My main reason for caution is because the normally practical and insightful discussion occasionally crosses the boundary between mathematical and statistical insight and plain old common sense. These instances reiterate my stance that statistics need discipline. For now I will put these to one side – topics for future posts.  Today I want to share one of the more interesting insights into differentiating luck from skill with some basic probability theory.

Sunday, November 29, 2009

Australia, meet Dubai

The property market is Dubai is crashing and burning as we speak.  It was inevitable of course, but never underestimate the perseverance of a property boom.

On that note I want to talk about the future here in Australia.  In 2010 and beyond I foresee the following sequence of events.

1. Rate hikes of another 0.5%
2. Property prices will flatten and fall in some areas
3. The government will run out of ways to keep housing demand propped up – we had more cash injections and foreign buyers (although as yet I can’t imagine what else may be dreamt up).
4.  Inflation will be a major concern again – the USD will recover and the fuel price here will head up.
5.  September 2010 will lead to another correction on the share market, taking the ASX200 down below 4000 again.
6.  But then a strong rebound in November up to 4400
7.  House price will stabilise at 10% below their peak (in nominal terms) but real growth in house prices will not occur until 2015.
8.  A Current Affair and Today Tonight will has specials about house prices crashing in certain areas and people being forced out of their homes by mortgagees.
9.  Even while this is happening, people will continue to shout and scream about a housing shortage and argue for reduced taxes on developers (even though we have the world's biggest houses)
10.  The 2011 census data will show that demolition rates were less than expected and that the total number of dwellings in Australia is higher than expected (the remarks by the RBA’s Ric Battellino seemed a bit pushy on the supply constraint issue).

It’s not a catastrophic forecast, but it seems reasonable to me. Anything I've missed?

Wednesday, November 4, 2009

Psychologists at the RBA?

People have instinctual short sightedness. It is a primal trait. Each passing day adds risks to the realisation of future events. Our probability of dying increases, and the waiting time captures multiple risks of the event not occurring at all. In economese, that’s why we discount the future.

However, it is not all that simple. Behavioural economists have shown that people don’t discount in the expected rational way. Instead of treating each year into the future as capturing the same risk, each consecutive year is treated as less risky than the previous year – a concept known as hyperbolic discounting.
For instance, when offered the choice between $50 now and $100 a year from now, many people will choose the immediate $50. However, given the choice between $50 in five years or $100 in six years almost everyone will choose $100 in six years, even though that is the same choice seen at five years' greater distance
Why does the RBA need to know this?

The strategy of a gradual withdrawal of monetary stimulus by incrementally raising interest rates is meant to allow people time to adjust to higher interest rate levels. However, if people discount the likelihood and impact of each further interest rate rise, they will not adjust until it is too late anyway. The instinct of the masses will be to all but ignore the highly probably increases in interest rates in the near future.

This may be one reason for the long lags between execution and outcome in monetary policy.

A quarter of a percent increase in rates every month (1% over four months) is going to hardly register in our animal minds – each change is too marginal, and probability and impact of each future change is heavily discounted. A 1% immediate increase followed by no change for 4 months would actually change behaviour in the way the incremental approach is intended.

Have you heard people who have just bought a new house talk about the inevitable interest rate hikes – “We’ll deal with that when the time comes”. They are simply acting on instinct.

Tuesday, November 3, 2009

Fractal Finance

Ever heard of the Elliot Wave Theory? Maybe you have, but I hadn't until last week. Put simply, this theory suggests that markets behave is a predictable way which is not driven by fundamentals (actual production of goods, actual jobs, etc) but simply by human behaviour in the marketplace – the collective investor psychology.

The image below show the fundamental Elliot wave – 3 peaks (1, 3, 5) and two troughs (2, 4) on the way up, and two troughs (A, C) and one peak (B) on the way down.


While quirky (as an economist I like to think in terms of the fundamental patterns of production) this theory has a lot going for it.

Tuesday, October 6, 2009

Whether the weather increases volatility of markets

I recently read, and thoroughly enjoyed, the book Rigged. In one scene a young trader is asked what factor contributes most to changes in the price of oil - to which he responds, the weather. For example, a cold winter in North America or Europe signals an increased demand for oil and sends the price up. 

So my question is this. Given how weather dependent our agricultural industry, our energy industry, and other essential primaries industries can be, how much less volatile would financial markets be if we had predictable or constant weather?

Monday, October 5, 2009

UPDATE - Turning points

Recently I posted about the spike in population growth experienced in Australia over 2008, and how we cannot simply extrapolate the trend, or we will miss important turning points. I predicted that the rate of population growth will fall from this level over the next few years as a result of

1) reduced migration, and
2) a decline in birth rates due to the ‘bringing forward’ of births encouraged by the baby bonus.

I didn’t have to wait long for some supporting evidence. The ABS today released overseas arrivals and departures data showing a significant increase in departures, and decline in arrivals, since April 2009.  It looks like migration is on its way back down.  When the June 2009 release of the population statistics is published on 3rd December we might just see the turning point in population growth I forecast back in September. 

Sunday, October 4, 2009

iTunes v Foxtel

I know; there is no battle between iTunes and Foxtel (yet) but it seems like a good attention grabbing headline. The relevant point here is that Foxtel is releasing a new service where subscribers can download movies and TV programs. Although the service has its drawbacks, it sounds like the next big thing to me.

Whenever I see innovation like this, I can’t help but see it as another example of economics in action. It also makes me wonder what industries will be next to leap into the downloadable marketplace. Given that music and books have taken the leap, probably in response to pirated downloads, movies were an obvious candidate to jump soon. But what next?

Tuesday, August 25, 2009

In good company on a W-shaped recovery

These blog entries are my ideas. I have them, then I write them down. And when I find my ideas are being taken up by others (most likely independently), or my predictions prove accurate, I like to take some credit by posting a little reminder.

It seems my prediction of a second share market crash is now shared by a number of prominent economists. I'm not certain whether their predictions are based on oil supply considerations, but that is the fundamental basis for my own.

If we could get economic forecasting like this, where a two week range was proposed for a Chinese stock market crash, and was off the mark by only a week, economics would gain some serious social status.

Tuesday, July 28, 2009

Random and poorly linked observations

Can Generation Y, those twenty-somethings often labelled by baby-boomers as bludgers who had everything dished out to them, actually take credit for the ‘soft-landing’ of the current recession (can we call it that yet)?

I say this after a weekend catching up with friends. Some had been involuntarily retired from their previous jobs, but being tech savvy, were on the books for temp work within hours, and within days had started new jobs. That friction economists love to talk about when discussing unemployment seems non-existent. So my friends continued to earn and spend just as they had before. I wonder if those older generations (whatever you want to call them) would adjust so quickly.

And what of the healthcare system? Are we stuck with a baby-boomer health system in a Gen Y world?

Recent debates have been streaming in from both Australia and the US about reforming the ‘health care system’. It makes me wonder two things that are rarely discussed:

1. What exactly is the boundary of the system?
2. Wouldn’t a system designed to prevent death always seem to be poorly performing?

There have been great comments from the blogosphere about US health reform. In particular, the fact that much health care actually resides outside ‘the system’ – panadol, vitamins (if you believe they actually have health benefits), bandages, etc – you know, stuff a pharmacy sells. If we had concerns about the widespread, affordable supply of these goods, what we we do about the 'allied health system'.

I think what is clear is that while regulation of quality, labelling, etc. is important, regulation of the distribution of services may be overstepping the mark and lead to poor services.

If you want my opinion, there is nothing wrong with healthcare in this country as far as I can see. We have the option of private health cover, and are penalised for not taking it up if our incomes are particularly high. If we don’t have private cover we should expect a baseline of care and nothing more. Even then, the poor are still looked after. Many of you wouldn’t know this, but you can get a doctor to visit you at home, 24 hours a day, and bulk bill. We’ve used this service a couple of times. To me this is medical utopia!

So, since we’ve now solved the ‘health crisis’ by revealing that, in fact, there is no crisis, we can move on other things. Like child care.

Why is it that government feels the need to subsidise the costs of child care? I took my young son for the first time to child care yesterday and for $50 you can have him looked after and fed for 10 hours. But with the child care subsidies, it works out more like $20! So, when weighing up the alternatives of my wife staying home to look after our son, my mother looking after him, and child care, it gives a huge advantage to the latter. Should I be king for a day, this is one of many subsidies I would scrap that appears to be encouraging fragmented families, and the culture of children being raised by ‘the system’.

Finally, I would like to announce that today 29th July 2009 is the official 1st January 2000 of climate change. That date represents the date that we all realised that the millennium bug, Y2K, was actually just symbol of repressed fears being expressed en masse. I feel that climate change is simply an outlet for our caring side in the apparently uncaring world we live in. While I have spent the past few years examining the mechanisms for action to reduce GHG emissions, I am coming to the conclusion that there are many other immediate problems that should be the focus of attention.

A departing thought (from here):

NYTM: Have you ever seen “American Idol”?

Arlo Guthrie: No, I have never watched it. But I’m thankful we’re living in a world where we can actually afford to waste your time. What a great thing that is.

Until next time.

Tuesday, February 24, 2009

Updates

Well, it appears I was ahead of the crowd on at least some of the issues I've been discussing in this blog.

For starters, a previous blog that was critical of the research paper proposing to fix the floor in the emissions trading scheme pre-empted the current debate, which threatens to postpone any emissions reductions measures. You can read about the political debacle it created here.

Another point getting more publicity is the proposal that governments make no new policies in response to the GFC (that's Global Financial Crisis for those out of the loop). My stimulating paradox blog came to the same conclusion as Dan Denning. But hey, who trusts what they read on the internet.

A final update regards the announced (finally) Queensland elections. Given the GFC, the basic lack of innovation over the past decade, the threat to the Great Barrier Reef from climate change, the massive social disruptions likely to be caused from mining operations closing down, I am surprised there is even an opposition wishing to get elected! My bet is that whoever has the catchiest slogan will win - yes, it is a fickle business. But really,there may be plenty of fodder for bloggers in the next month.

Sorry for the cop-out blog, but there will be some detailed analysis next time.

Tuesday, February 17, 2009

Homogenous Humanity

I want to take a bit of a break from the financial crisis to talk about humanity, and more specifically, racial identity. The growing number of interracial and relationships I have witnessed, including my own, has led me along a line of enquiry that has some interesting implications.

To summarise, the question bugging me is whether the increased interracial breeding, especially in Australia, and probably much more so around the world, will cause distinct racial identities fade away? More importantly, will we end up with a ‘standardised’ race of humans? Or, will other environmental factors contribute to changing the nature of humans? Could we develop new races?

Overall, what will this impact have on our society?

The issue has bugged me since I learnt that there are in fact different races. At primary school I was completely ignorant of race. I had friends back then who I only now realise are Aboriginal, Indian, and Chinese. Further confusion was raised when I discovered that there are many policies that specifically determine outcomes based on race – with various Aboriginal assistance programs. There is an obvious justification for singling out the Aboriginal people for assistance given Australia’s history, but what about the half Aboriginal guy? Should he get half the assistance? Should half of him assist the other half of him? Why does he identify as Aboriginal and not Irish anyway? What about the quarter Aboriginal Chinese Indian African guy? Or is he something else altogether?

This brings me to the important social implications of such racial change. With which groups will the mixed race generations identify. Am I Indian or Chinese? And what if India was at war with China (heaven forbid); with which powerhouse will I side? My point is that the destruction of racial identity might have a beneficial effect of decreasing animosity amongst nations. In Australia especially it would be difficult to conjure domestic support for wars with nations whose racial heritage runs through the blood of many of our citizens.

Will religiousness fade away as racial ties fade? What religion would the son of a Buddhist and a Catholic be?

Would we try and preserve ‘pure’ races? Will some become extinct through breeding alone?

Maybe I should have at least proposed some hypothetical answers to these questions before I started writing. Please, I am interested to know your thoughts. Having a half Anglo-Saxon (what am I anyway?), half Chinese son myself I expect that many more questions will be raised. Will this generation of interracial children have trouble fitting in at school, being neither in the Chinese nor Aussie crowd? Who knows.

Tuesday, December 23, 2008

The bright side - a simple solution.

Many of my blogs have been perceived as a little pessimistic. This final blog of the year is intended to provide some optimism.

The positive message is this - Humans are infinitely adaptable, and can change very quickly when required.

Often I see graphs of exponentially growing resource consumption and environmental destruction, accompanied by the saying – this can’t go on. And that is absolutely right. It can’t go on forever. No matter what happens, we will adjust. We can’t defy physical limits. In times of crisis it amazes me how people can quickly make tough decisions, and devote their energies to the greater good. It appears that for most people then, there is no environmental crisis just yet, but I am certain when reality bites, actions will follow.

Now to the more specific task of reducing carbon emissions. I have made the point many times that we need to take a supply side approach, which means focussing on the actual source of pollution. Therefore pollution/emission limits are the only way to go. More importantly, this limit must consider all parties involved. For carbon emissions, we require global cooperation. Otherwise, there will always be incentive for those exempt from the limit to take advantage of the situation.

To explain why this is the case, consider the classic common pool resource problem (aka the tragedy of the commons). A common pool resource is non-excludable (you can’t stop anyone using it) and rivalrous (when someone uses it, others cannot). A park bench exhibits these features. Anyone can use it, but when someone is, others cannot. The atmosphere has similar characteristics. If one party uses the atmosphere to dispose of carbon, others cannot use it for providing a steady climate. The incentive in this situation is for the polluter to use as much of the resource as possible, as they receive all the benefits, while everyone else shares the costs. Water resources have, until recently, been much the same.

This issue has been historically solved by rituals, traditions, religion, and other enforceable means the limit use. The classic example is the summer meadows in alpine areas. Anyone can graze their farm animals there, but when there are too many other animals, there will not be enough grass for yours. To solve this problems of competing demands, one must enforce grazing limits (or some kind of rationing system) on all people involved. It is not enough that one person decide to do their bit and limit their herd, as it allows others to increase the size of their herd. Even if all but one farmer exercises self-control and limits their herd, the last farmer will take advantage of this and graze all remaining fodder.

In climate change lingo, the slack taken up by other countries is known as the displacement hypothesis. Tight pollution controls in developed countries stimulate the relocation of polluting industries to countries without environmental controls. This is the reason some countries appear to have been successfully reducing their carbon emissions.

Clearly then, we need enforceable limits on pollution at the relevant scale. For carbon emissions, this means global cooperation (this appears to be getting closer each day). For water management, whole catchment areas must be involved. It is a simple recipe for halting environmental degradation. As we have seen recently with the Murray-Darling Basin Authority, when we reach the point of ‘crisis’ effective actions follow swiftly.

Finally, to keep you give you a taste of what is in store for next year, some topics that are swirling around in my mind right now include:
- the similarity between Bernard Madoff’s pyramid scheme and the banking system
- the welfare benefits of piracy
- and the parallels between cap and trade regulations and land conservation.
- problems and solutions to degrowth

Merry Christmas.

Tuesday, October 28, 2008

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.

Monday, October 20, 2008

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.