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.

New wikipedia entry

Just a short note this time.

I have written a new wikipedia entry for the Rebound Effect - which many of you would know is the topic of my thesis. If you are interested in a brief summary of what I have been spending my time on this past year, take a look.

http://en.wikipedia.org/wiki/Rebound_effect_(conservation)

The Tyranny of Choice

No, the title is not original and there is a good reason for this – choices have long been a source of concern for many people. And in recent years, choices have grown at a rapid rate. The question posed by Barry Schwartz, author of the book The Paradox of Choice, is whether all this choice has improved the welfare of society. Or, as he suggests, has the dazzling array of choices put as all at a disadvantage. How does this paradox occur?

First imagine choosing an ice-cream flavour. First you go to a store with only chocolate and vanilla. You weigh up the benefits of each flavour against the other, and make a choice. If you choose chocolate, vanilla is what economists term the opportunity cost. It is the forgone alternative for making a decision. Every time we make a choice, not only are we choosing one alternative, we are choosing to forgo another.

No let’s consider an ice-cream store with 30 flavours. To make a decision here, you need to weigh up the benefits of each of the 30 flavours to decide which is preferred. This is no mean feat, considering the likely limitations in knowledge of each of the flavours. When we decide, the opportunity cost of the decision is any one of the 29 other flavours we have forgone. And quite simply, the more alternatives we forgo, the less likely we are to be assured that the decision we made was the best alternative. In fact, people are much less happy with the decision they made when there are more alternatives, even if it is definitely the best one for them. This is because there is only a slight benefit over the second best alternative, and people only judge outcomes on this marginal benefit.

Also, if we compare ice-cream flavours in a pairwise manner, which means comparing two at a time, to determine our preferred flavour, we end up with 2¬30 small decisions to make, equal to the one we made at the previous store when we only had to decide between chocolate and vanilla. This can often lead to decision paralysis, where we simply avoid the choice because the process of making a choice itself is such a burden that the ice-cream will not make up for it.

Decision paralysis can bee seen widely in everyday life. At the moment, a friend of mine is visiting from abroad, and is trying to make a choice about his direction in life. Because there are so many options to choose he cannot pick one over the other, and when he does choose, there will be a second best alternative very close to as good as the one he takes, which he will always compare himself to.

In behavioural economics experiments it has been clearly shown that too much choice is a hindrance. For example, consider those free taste tests you sometimes get at the supermarket. It has been shown that it is best not to give too many options. The taste tests that give less than five varieties get more people to buy any one of them than taste tests with ten or more varieties. Also, companies that offer only three or fewer alternative health insurance plans to their employees in the US, get a much higher uptake in insurance than those who offer between ten and thirty different plans.

This leaves us in a tricky situation. If we only derive satisfaction from the benefit we get from a choice compared with the next best alternative, than too much choice is bring down human welfare. It is making us unhappy. But is there an optimal amount of choice?

Valuing the apples and bananas

It has come up for discussion in blogs, at bbqs, and international conventions, but we are still no closer to a workable solution for valuing the environment. When I say environment, what I mean specifically are natural ecological systems. And when I say valuing, I mean determining the contribution of these systems to the welfare of humanity. The difficulty for environmental economists is determining the value of these ecological systems in a common measure with the value we derived from conventional consumption – that is, in dollar terms. If we can establish a value for the environment it becomes a simple procedure to evaluate the human welfare implications of any land development.

So how do we go about comparing apples (the welfare we gain from the environment) and bananas (the welfare we gain from consumption)? One approach often used is to estimate the contribution of one particular ecological service, for example pollination by insects, to the economic production (http://news.mongabay.com/2008/0916-pollination.html). But this conventional approach estimates the contribution of ecological services to the production of real goods – in the pollination example, the contribution to agricultural production. By this only tells half the story. It tells the banana story, as it only looks at the value to production. The apple story is the welfare we gain from pollination in terms of its role in ecological systems that provide us with clean air, water, and any other non-economic way it which it improves the human experience. We cannot maximise human welfare without an estimate of apples and bananas.

The only reason we have certainty that conventional consumption (the stuff money can buy) provides us with increased welfare is because we are willing to pay for it. If we are voluntarily willing to give up other consumption for consumption of that good we must be benefiting. But if we take this willingness to pay principle to the environment, we face some hurdles. First, imaging your willingness to pay for a day’s breathable air. For me, it is almost infinite (if there is no alternative way of getting breathable air). Then we can look at water. A man dying of thirst in the desert would pay his life’s fortune for a little clean water. So in a way, we could say that these environmental services we get each day for free are infinitely valuable.

But most of us still receive these free environmental services each day even though we have severely disrupted the ecological systems that support it. So how do we know whether development that destroys ecological systems leads to a reduction in the welfare?

These are just some of the hurdles we face when trying incorporate the value to humanity from the environment into consideration. If you know of other concerns, please let me know. This is a big topic that will be the focus of much future research.

Too fat to fail

I remember a quirky line from Richard Branson’s autobiography. It went something like this – if you borrow $40,000 from the bank and can’t repay, it’s your problem, but if you borrow $40million and can’t repay, it’s the bank’s problem. He was talking about borrowing to buy planes for Virgin airlines, but a similar principle applies in so many places – the larger your business, the more people who have an interest in keeping it going. This includes the lenders but also the employees, other firms that do business with you, and the customers.

The reason I raise this point is because of the US Federal government bailout of Freddie Mac and Fannie Mae - both private firms dealing in the secondary market for mortgages. While Fannie Mae is a former government agency, and was privatised in 1968, Freddie Mac is a wholly private company, chartered by the US congress in 1970 to provide competition in the secondary mortgage market. All assets of these companies are solely owned by the shareholders, who also reap the profits from their investment.

So we see an interesting dilemma. For an economist, competition between producers provides great benefits to society by responding to demands and pushing down prices. However, inherent in this competitive environment is that businesses will occasionally fail. Problems arise when firms become very large. You can imagine that if the Queensland bank Suncorp went broke – that’s 9000 people out of a job, not to mention the problems with people who are insured by them, and flow on effects to other businesses.

I think economists often forget that their model of perfect markets is far removed from reality. In this model there are a large number of buyers and sellers, and no barriers to entry. Any market with few players and high capital costs is not perfectly competitive. If a firm fails in these oligopolistic markets there can be quite a degree of social disruption. Governments see these social costs as motivation for bailing out large firms. The US, an icon of capitalism, has probably the worst track record for corporate bailouts, with the airline industry post 9-11 another example.

What is most interesting about the bailout of the two secondary mortgage market players is that the intention is to prop up the whole economy. But you don’t see the government propping up the family fish and chip shop, or the local grocer, even though that is their intention in the end. One must wonder what criteria is used to determine whether a corporate bailout will or will not occur.

It is a surprising that any government would go ahead and privatise an industry if they are going to guarantee the newly created private firm against bankruptcy anyway. One criteria for privatisation much surely be that the firm be allowed to go bust. In any case, the issue over excessive scale of corporate enterprise, to the point where failure of the firm creates massive social disruption, should be an issue for governments worldwide.

Any thoughts on this type of government involvement in private enterprise?

Change required for change - a common conundrum

I have witnessed an interesting trend from experts lately. And probably have for a long time, but only recently noticed. They all simply state the obvious - change can happen when change happens.

Maybe an example would help me explain. I watched an interesting movie lately called Where in the world is Osama bin Laden. The guy from Supersize Me goes in search of bin Laden, and along the way interviews an expert on the Middle East. He says, that peace will come, but whenever the process gets started, someone goes and blows something up. Only when people stop fighting for long enough can we begin the peace process. To translate – when peace comes, peace comes. The ‘process of peace’ is peace itself – so where on Earth do you start?

Another example. On the news a few nights ago, an expert on eating disorders said (and I’ll just paraphrase) “that people need to accept their eating disorder and overcome their emotional attachment before therapy can take place”. So, therapy only works if you’ve already cured yourself!

This got me thinking about the origins of change. If the experts can at best say that change comes because change comes, where did it really come from?

I think I’ve found an answer in agent-based computational modelling (ACM). What is that you might ask? Well it’s basically a computer tool that can show how the individual actions of agents (people) in an environment can generate order on a macro level. You simply give each agent a set of rules to live by, and then run the program. As the agents interact with each other and their environment, they simply follow the rules, and you often get amazing patterns occurring.

ACM has been used to show how cooperation can emerge from a population of selfish individuals. As they interact they learn how cooperation can bring beneficial outcomes. But occasionally one of the agents stops cooperating, and depending on the strategy of the others, they can all act selfishly again. But then, cooperation can build up once more.

There are parallels between this and the dilemma of peace in the Middle East. When peace appears to be on its way, one agent stops cooperating, then all the previous cooperation collapses. Then the whole thing starts again.

ACM also has found that long periods of cooperation actually reinforces cooperation by making individuals tolerant of small discrepancies from other agents. But at some point agents will begins to abuse this tolerance. They will free ride, until there are so many free-riders that the others stop benefiting from cooperation, and we start the process once more. The optimistic finding of one of these models is that after a few long periods of peace, a final period of peace emerged that was sustained until the limits of computational power. My only concern is that in this model agents lived forever, and my suspicion is that if agents reproduce, due to lack of experience of the population, the chances of getting to this point are much lower.

Anyway, the expert was right the peace is needed for peace.

The big feature of ACM is that radical changes can appear to happen spontaneously in an environmental where every agent is simple following the same set of rules. Individual actions change even though the rules they are applying stay the same. So the eating disorder person may simply one day ‘snap out of it’ simply because the unconscious, instinctual rules tell us to – just like the got us into it in the first place.

I would like some more examples of change requiring change if you have any.

Population - the forbidden debate

A newspaper article this morning got me thinking about the untouchable issue of population growth. It is available here. Basically, the article publicised the not so surprising fact that SE Queensland’s rate of population growth is slowing. But what it did mention was the causal relationship between the supply of housing and population growth.

If we are to believe this article then increasing the supply of housing causes population growth – it must be true if the opposite is true. We have probably heard the phrase ‘build it and they will come’. Such a saying did not gain popularity because it is irrelevant. It gained popularity because is very close to the truth. If you would like an rather academic discussion of Say’s law – the theoretical argument that supply constitutes demand, have a read here.

The main point I want to raise today is that population growth is not something we respond to, as the state government so often puts it. It is something that comes about in response to economic conditions. When there is a boom – high growth. When there is a bust – low growth. Just today I sat in a seminar on the impact of war on reproductive rates of women. And yes, the supply of men also has an impact on reproductive rates and population. Imagine how well we could plan cities, towns, and infrastructure, as well as putting away areas for conservation, if we knew which factors highly influenced peoples reproductive decisions. We could plan, knowing in advance, the flow on effects from our policies. I wonder how much discussion was had before the introduction of the baby bonus? Or even discussion of the need for such direct stimulation, if indirect means can be equally effective.

So why would I raise population growth as an issue. Because for an economist environmentalist, labour supply is an important component in determining the net environmental impact of society. The more people we have, the more man/woman hours can be put to work producing goods and consuming natural resources.

The question we need to ask ourselves is what population we would like? It seems pretty radical to think about this. It brings images of China, oppression, and a violation of peoples right to reproduce. But this need not be so. While the Chinese have targeted population growth directly, if we believe that external factors influence population growth, then all we need to do is manipulate these factors to give people incentive not to reproduce. If we want more growth – just build more houses.

Thinking about the little things

I want to take up a topic that probably not many other bloggers have dealt with – dog poo. Why is this an issue for an economist environmentalist you might ask? Because today I was chastised for letting the dog poo in the park, and it got me thinking about the inconsistency in many of our actions.

Now, I try and clean up after the dog when we walk – it seems ridiculous to leave dog poo on the footpath where it is likely to be stood on. But he doesn’t like doing his business out in the open, and generally finds a spot in a garden to do it (not a private garden, but I am trying to describe the type of area he likes). If this is the case, I leave it. And, this was the case today.

But it got me thinking about the whole dog poo in a plastic bag philosophy. I know that this type of regulation is trying to avoid poo all over the streets, but I sometimes see how ironic the situation can get. We go to get groceries and are told to refuse a bag, and then told in the next breath to get a bag for the dogs poo, which will then be trucked to some far away landfill, to wait thousands of years for the plastic bag to breakdown and be back on it’s way back through the ecosystem. And at the same time all of this is happening, we truck in poo from other animals of choice to put on the garden to help the plants grow. So after all of this, I get the feeling that no bag is a more logical choice.

Those who are very familiar with this blog would know that neither the use of poo bags, or not, will have an effect on the consumption of oil (of which the plastic is made). But is seems like an odd thing to keep people employed in the poo shipping business when a simpler alternative is available.

One further little thing I got thinking about is whether animal excrement is even a form of pollution. In some cases, we see ibis poo all over the ground and it bothers some people – the ibis are polluting our cities. But what about the poo of every other animal alive! What about koala poo? Surely koalas can’t be the perpetrators of pollution! Or would they be of they we nearby to our homes? We want nature close by, as long as it keeps to itself and we interact with it on our terms only.

Well, that’s just a small issue I’ve been thinking about today. Does anyone else think that animals can pollute? Thoughts on the poo bag conundrum?