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.


  1. That's all based on peak oil happening now and the market having full information right?

    The market has forever been guessing at oil supply. It was volatile when there was no OPEC-type-body because of the nature of sudden increase in supply i.e. discovery. It's volatile now because nobody actually knows how much supply is out there.

    We know the USA peaked in the 70's and Aus in the 80's but they are two relatively transparent countries. The market guesses more on what can be delivered i.e. production capacity (refineries etc) than supply because OPEC isn't transparent.

    Even if we can accurately predict peak oil, who will be able to predict the angle of slope on that long slow(?)supply line?

    This is where economic theory clashes with reality. How can economics account for an uninformed/misinformed market?

  2. Actually, the way I describe what is happening is based on imperfect information. All the market players can see is output (of oil and global gross product), and the price level. If they had perfect information, there would be no sudden change in demand- from optimistic (expectations of high growth) to pessimistic (expectations of low growth).

    I guess this is why I tried to say in the beginning that the macro-economic principles had to be interpreted correctly. If you assume perfect information, about oil output and global economic growth, then the price spikes of resources recent times, as well as the housing bubble, would not have occurred.

    For those in the blame game try this on. Assuming that OPEC countries are intentionally misleading the world about their oil reserves and their potential future rate of output, you can point the finger at these countries. For the alternative scenario, where they transparently revealed their oil reserves and expected future output, this could have been factored in to expectation of future global growth, and this whole crash would have been avoided. Don't forget that the boom of recent times would also have been avoided.

    Anyway. Some food for thought.