Saturday, September 3, 2011

Energy and the Economy Part 2.

I am going to engage in some speculation. Let us accept the following assumptions as a premise for this argument,

1. The economy is a chaotic system.
2. Both our markets and our economy are displaying classic chaotic bifurcating behaviour (they are bouncing up and down).

Question: Why the bifurcating behaviour? What is driving the instability?

I am going to argue that the answer is blindingly simple and very obvious when you think about it, but a full understanding requires some background knowledge.

1. Mathematically, what does the economy look like?

To understand the driver of the instability, we need to tackle another issue: Mathematically, what does the economy look like – what drives the economy?

As a first order approximation, the answer is simple and obvious. The economy grows exponentially. The expansion is a requirement of the Fractional Reserve System. To quote Wikipedia : “Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply.” The amount of money in circulation (the money supply) each year MUST increase, in order to make the Fractional Reserve system work. This has a tendency to create inflation if it is not balanced by an equal increase in GDP.

In simple, non-maths terms the economy MUST grow by a few percent every year.

The reason for this is simple. If the amount of money in circulation increases, but goods produced do not increase, then you have more money chasing the same quantity of goods, so each “unit” of goods will be “worth” a higher amount of money. Actually it is much more complex than that (look up “Velocity of money” as a starting point) but that is a good first-order explanation.

So. The mathematical description of the economy is very simple – money supply must expand exponentially (driven by the nature of the Fractional Reserve system), and the underlying productivity that the money “maps” to must expand with it.

Failure of expansion in either the money supply or GDP will result in problems.

If money becomes unavailable (as occurred during the depression) then the Fractional Reserve System fails – there is no money available to pay debt so debts are defaulted on. Since money (in our system) is based on debt, the default causes the money to “disappear” (the debt is “written off” by the bank), and this reduces the amount of money in circulation, exacerbating the problem (as occurred in the Great Depression).

John Maynard Keynes  had the insight that this problem can be fixed by central banks – they step in and inject money into the system to “re-inflate the economy”. Once the amount of money in circulation is once again in line with the required growth rate, the normal investments that businesses need to do (in order to grow) can be carried out, and growth returns. (Again, this is a grotesque simplification – but good enough for a first order understanding. For more detail read the Wiki article).

Since the 1980s our economy has been dogged by a series of recessions, which the Central banks have responded to by injecting cash (another simplification, but it will do).

The cash injections worked, but a pattern emerged: as a rough approximation, it is fair to say that each recession required more central banking intervention than the last – culminating in the 2007/2008 GFC, which required unprecedented intervention. The GFC was odd, in that the interventions don’t seem to have worked.

2. On Bubbles.
The injection of money into the economic system is meant to encourage investment in productive businesses and thus re-start growth. However recent decades have seen a different pattern. Injection of money has led to investment in a series of “bubbles” and in intangible “Financial Instruments” rather than investment in productive businesses (i.e. businesses that produce tangible things).

The most recent bubble was the housing bubble. A house has a limited “lifespan”, so the value of a house should depreciate as it ages. However, in recent years the value of a house has gone up, not down.

In common with other bubbles has been a faith in the “Greater Fool” theory: The theory that you can buy an object at an inflated price now and sell to a “Greater Fool” for an even more inflated price later – even though the value of the object should have depreciated.

Why would people invest in a depreciating asset - and thus implicitly trust to the “Greater Fool” theory? The answer is obvious. They do this if there is money to invest and no better investment available.

If you can’t invest in a sound business (a business that produces something new of tangible value) then you invest in a bubble (depend on a Greater Fool).

So a bubble requires two elements:

i)  A supply of cash, looking for investments.
ii) Limited sound business investments.

3. Putting it together.
So suddenly Keynes isn’t working. Why not? The answer is obvious. The Economy has two parts which must “map” to each other:

i)   Money supply
ii) GDP (a proxy for "stuff made" or productivity).

We have just said that it appears that productive investments don’t seem to be available – so any expansion of GDP is due to phantom bubble blowing, not real productivity.

Injecting money only works if it can engender “real” growth. If the production of tangible goods is not an option, the money leads to a bubble, which collapses. A fair description of the last 15 years.

The Dow Jones has collapsed to a level below where it was in 2000 (in real terms). US GDP should probably do the same and if the US dollar continues to decline the value of the US economy (in real terms) probably will drop to pre-2000 levels (it may have already, I haven’t done the maths).

So now we can answer the question: Why is the economy undergoing a chaotic bifurcation?

The Keynes strategy was designed to deal with a contraction in money supply. But money supply maps to underlying productivity. What if the problem is a contraction in the ability to grow? This won't be cured by adding money - the money needs to be invested in growth.

A few simple data points:

i) Growth of economies is correlated with growth of consumption of energy supplies. Recent studies that found a possible weakening in this correlation for developed nations failed to consider the fact that the energy consumption had simply been outsourced to the manufacturing nations. (See the Bundeswehr study referenced in Part 1 for more discussion and references).
ii) Oil production peaked and plateaued in around 2005. (See the Bundeswehr study referenced in Part 1 for more discussion and references).
iii) Energy and mineral resources required to extract energy and minerals is increasing exponentially as the quality of resources decreases (see here and here for discussion.).

Given these trends it is obvious that the quantity of resources available to do useful work for society is going to struggle to keep up with growth. This is reflected in an increase in prices for these resources – making investment in any resource-requiring production (i.e. any production of tangible goods) difficult. This clearly encourages investment in “phantom” productivity – bubbles and intangible “services” or products.

If the growth in money supply over recent years was invested in phantom bubbles, then of course it will collapse until it represents the value of the “real” economy.

This is seemingly well under way.

But there is an underlying issue: The Fractional Reserve System REQUIRES growth. If growth is not possible, then this system is fundamentally unsound.

So here is the issue in a nutshell: The Keynes policy approach addresses an issue with money supply. It would allow money to be invested in growth. But what we have is an issue with growth. The system is much more complex than I have indicated, but this fundamentasl mismatch is (I believe) at the core of the problem.

It is simple, and (when you think about it) obvious.

The bifurcation(s) must drive a decrease in complexity until a stable system evolves. If growth is less possible, a new system must evolve.

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