Since words like Trillion or Billion mean different things in different places, in this text money is quantified with the prefixes of the International System, where Tera (T) signifies a factor of 1012.
Growing
A simple way to look at this subject is to use the expressions Hubbert himself used when addressing the US Congress on the subject in 1974. Two exponential functions can describe the way money and resources' supply grows:
If M<sub>0</sub> be a national monetary stock at an initial time, and i the mean value of the interest rate[1], then at a later time t the sum of money M<sub>0</sub> will have grown exponentially to a larger sum M given by the equation
Next consider the rate of physical production. Let Q be the generalized output of the industrial system at the initial time, and a be the rate of industrial growth. The industrial production at time t will then be given by
At any given time the ratio of a sum of money to what the money will buy is a generalized price level, P. Hence
which, when substituted into equations 6 and 7, gives
| P=M/Q = M<sub>0</sub>eit / Q<sub>0</sub>eat = (M<sub>0</sub>/Q<sub>0</sub>) e (a-i)t |
However, M<sub>0</sub>/Q<sub>0</sub> = P<sub>0</sub>, the price level at the initial time. Therefore,
P = P<sub>0</sub>e (a-i)t
|
[1] Although Hubbert calls i the mean interest rate, this is actually the money supply growth rate, which is usually different.
To hold from these is that money and industrial output both grow exponentially at the rates of i and a respectively. And this simple model can help understand the way prices behave and the economy evolves with the relation between these constants:
- i = a - money and industrial output grow at the same pace, prices remain unchanged;
- i > a - money grows faster than industrial output, creating price Inflation;
- i < a - money grows slower than industrial output, creating price Deflation;
The traditional concept of healthy economy is one where both i and a are positive and close to each other. Currency supply is controlled by central banks in order to keep close to this equilibrium. Both Inflation and Deflation are usually symptoms of economic failure and have negative social impacts, as described below.
In the Capitalist economic model, that is now common to most of the world, money is created as debt. Individuals borrow a sum of money today that they will repay plus interests in the future; the initial amount of money comes to existence only when inserted in the individual's bank account. Such is possible for economic growth provides extra wealth in the ensuing years to pay the debt plus interest. In the Capitalist model, low Inflation can actually be beneficial for it helps debtors complying with their interest obligations in face of industrial slowdown.
Resource Limits
If resource limits are reached and the industrial output slows or retracts, economic growth slows down or stops and in turn money supply should be reduced accordingly. But many individuals are in debt, relying on future growth; if i is immediately reduced after the reduction in a, debt default will set in, along all its ominous consequences. Using Hubbert's expressions, Inflation should be expected as the primary economic outcome of resource scarcity in a capitalist debt based system.
Interestingly there is today a set of data that points towards that same conclusion. Figure 1 shows a graph were the price of a Brent crude oil barrel is plotted for several paper currencies as percentage of their January 2004 value. Adding to that is the same price evolution but in gold terms; gold is also a currency but theoretically not manipulated by central banks and a direct function of industrial output (less the energy available, less the gold mined).
Figure 1 - Paper currencies and gold against Brent crude oil as percentage of January 2004. Source: Bank of Portugal. Click to enlarge.
|
This time series starts before the, as of now still undeniable, OPEC production ceiling hit in the summer of 2004. In this first months all currencies observed evolved closely to each other. The price of crude continued growing and by the beginning of 2005 the currencies started to take different paths. In August 2005 something beside the Hurricanes in the Caribbean and Gulf of Mexico happened: gold started decoupling from paper currencies. From then on gold took a clear downward trend, presently standing at 150% of its value in oil in 2004; at the same time paper currencies kept their weakness against crude oil. Today paper currencies are spreading among themselves with the Yen devaluating clearly more than the others and during the last year with the US dollar and Swiss Franc decoupling from the Euro and the Sterling.
Clearly the paper currency supply has grown faster than the resources drawn to the economy. Also of note is the fact that paper currencies, although varying more freely among them, are still somewhat close to each other; apart from the Yen, no other currency devaluated significantly against the others.
This decoupling of currency supply from resource supply can also be perceived by observing the path taken by non-currency metals against Brent:
Figure 2 - Brent crude oil prices against several industrial use metals as percentage of January 2004. Source: KitcoMetals.com. Click to enlarge.
|
A different scenario, although varying between the summer of 2005 and the summer of 2006, the value of these metals against oil has been below that of January 2004. It is indeed the currency supply that is inflating prices, during 2005 and 2006 the spot prices of these commodities shot up to accommodate this imbalance. During 2006 the prices of food commodities also increased by extremely fast, although that can be also attributed to extreme weather conditions during the year.
From this set of data it can be concluded that during the past two years the rate of growth of resources drawn to the economy eased off, while the money supply kept growing, hence the doubling of energy and commodities prices.
Resource scarcity will inevitably translate into lowering living standards, and theoretically it is the way that central banks adjust money supply that will define how the Economy will accommodate that: through Inflation or Deflation. Theoretically.
Economic Disruptions
As Samuelson and Nordhaus wrote in their educational textbook Economics, that Employment is the most important concern of this science:
Of all the macroeconomic indicators, employment and unemployment are those more directly felt by individuals. Everyone wants to find well paid jobs without having to search much for it or wait for a long time, and want job security and good benefits when they are employed.
[...]
The unemployment rate usually reflects the state of the economic cycle: when the product diminishes, the demand for work reduces and the unemployment rate grows.
Inflation is probably the best form to absorb the effects of resource scarcity, both socially and economically. Individuals maintain their jobs and the social framework is kept mostly intact. Wages become less and less valuable, food and clothing grow their weight on the family budget to the expense of traveling and diversion. The most important factor of social pressure on an inflationary setting is the default on mortgages; slowly families will loose their ability to afford a house. If the rate of inflation is not too high families can plan to move to smaller homes or simply quit ownership and shift to renting - it's not a pleasant move, but with job security behind is not the worst of scenarios.
On the other hand the inflation rate can get out of hand and move to hyperinflation, where prices can double in a matter of months. Paper money loses any value in such case, long term planning becomes impossible and most individuals struggle. Such periods happened in the past, notably in Brasil during the 1980s. Some stories remained from that time, like bread prices going up 30 times from the bakery to the grocery store and bus tickets being paid with chewing gum and hair pins. During hyperinflation periods social welfare deteriorates rapidly and the middle class tends to disappear.
Deflation poses different challenges. Falling prices are synonym of retracting demand with business and enterprises failing, throwing its employees to unemployment. If with Inflation the monthly budget gets tighter and tighter, on a deflationary period it simply disappears for some individuals. Non-basic goods and services take the first hits, but this time companies collapse and some economic activity sectors can totally disappear; food, clothing, and repair/recycling services are usually the last to suffer, in some cases they can even benefit at the local level.
Unemployment grows fast during a price contraction period and can create a depression spiral. More people without work retract demand even further creating more unemployment in its turn. The social pressure is immense; individuals can go from a comfortable life to begging in a short period of time, loosing all they had in the process - what they had, was dependent on their debts. Apart from the social elites, the rest of the society is severely shaken up and the power hierarchy erodes. During these kind of periods some individuals recur to desperate measures.
The Petrodollar
Before deciding between Inflation ar Deflation there's an important piece of the puzzle left to address: the Petrodollar and foreign currency reserves.
The Petrodollar can be defined as US currency hold by foreign countries with the purpose of buying oil. After the collapse of the Bretton Woods system it became the de facto pan-currency, for oil exporting countries demanded this currency for trade. This created an extra demand for the dollar putting the US, as the printer of the pan-currency, in a very favourable position. The Wikipedia summarizes it in this way:
Take the following example: Japan needs to import oil for domestic use. To do so it must first acquire dollars, as the dollar is the main currency in which oil is traded. To acquire these dollars, Japan must sell goods and services to the U.S. economy. The Japanese build a Honda to sell to the U.S. The U.S. federal reserve prints a certain amount of dollars and gives these to the Japanese in exchange for the Honda. The Japanese buy oil from Saudi Arabia using these dollars. The Saudis take the dollars and reinvest them in the Federal Reserve Bank of the U.S., and from then on they will only be used as a reserve currency.
Either way the Petrodollar ended up as the preferred reserve currency kept by Central Banks, substituting, above all, gold. To face an emergency the Petrodollar was the perfect currency, everyone needs oil and has to pay with dollars for it, pilling up the greenback seemed an intelligent thing to do. The problem is that contrary to what happened during the Bretton Woods system, when the dollar (and other currencies) where tied up to a fixed amount of gold, today there's no link between paper currency and gold. Today a dollar corresponds to about 2.4 liters of crude oil, but tomorrow it can be worth more or less than that - there's no guarantee of the amount of oil a dollar can yield in the future.
This Petrodollar system, without a tie between paper value and physical value, brought another problem, if the internal currency of a country starts to get too valuable against the dollar, internal prices also become over-valued. Without check this situation can evolve internally to Deflation, something to avoid at all costs, as seen above. To keep internal currencies stable, central bankers make sure that the dollar doesn't devaluate, acquiring more petrodollars or growing their internal currencies supply.
The Petrodollar system worked quite well during twenty years of oil trade growth between the early 1980s and the early 2000s. But now this system seems to be faltering.
Foreign Currency Reserves
There are today three main sources of pressure pointed as weakening the Petrodollar:
- The lack of spare production capacity by the OPEC - this means that if someone has oil to sell and demands chewing gum or hair pins in exchange, they'll get it, whereas in the past the traditional oil for dollars exporters would join to get that someone out of business.
The US twin deficits - Since 2000 two deficits have been opening in the US: the Budget deficit created by the tax policy and the Trade deficit consequence of the country's growing dependence on energy imports.
The emergence of an alternative pan-currency, the Euro - although no more than just another paper currency, the euro doubled its value against the dollar in 10 years, making it more attractive to central bankers.
The first two issues are outside the control of foreign central bankers, whereas the third is something of an answer against the weakening Petrodollar. But above all what is disrupting the Petrodollar is the lack of a formal tie with a physical value: the amount of oil available to trade cannot grow like it did in the past, thus the Petrodollar weakens. This weakness compels foreign central bankers to acquire more Petrodollars to avoid over-valuation of their internal currencies:
Figure 3 - World foreign currency reserves in Tera US $. Source: COFER. Click to enlarge.
|
Up to 2002 the amount of foreign currency reserves kept growing mildly, going over 10% only in 1996. In 2002 it grew by 17%, in 2003 by 26%, in 2004 by 24%, in 2005 it slowed down to 11% just to go back to 20% in 2006. In less than 48 months the amount of foreign currency reserves doubled, from 2.5 T$ to 5 T$.
How much is 5 T$? Since its primary function is to buy oil in international trade the best way to assess the real amount of these reserves is to convert it to oil barrels: at 70 $/b 5 T$ convert close to 72 Gb. In round numbers 14.5 Gb of oil were traded internationally in 2006, meaning that current foreign currency reserves represent about 5 years of international oil trade.
At current growth rates the amount of foreign currency hold by central banks will reach 6 T$ still in 2007 and go over 10 T$ before the end of 2010. At the same time the amount of oil flowing to international markets will not grow as it did in the past and will likely start to decline.
Playing Games
The setting is clear: a growing currency supply faces a slowing (or declining) energy supply. A growing number of currency units will be needed to acquire the same number of energy units. The Petrodollar has to devaluate (the price of energy will have to inflate). Central bankers might not be aware of the oil/energy supply constraints the world faces but they have other evidence of the impending Petrodollar devaluation.
At the turn of the century the tax policy pursued in the US was slowing economic growth. To foster the economy, currency supply rates were brought to exceptionally low ciphers; as long as demand for Petrodollars kept strong that would work. By the mid of 2004 OPEC's pedal hit the metal, the US economy faced increasingly higher energy prices and a breathtaking Trade deficit. There were two options, keep the strong money supply and take the inflationary pressure or shorten the money supply and take the economic slowdown (the house bubble was a special concern). The latter option was taken.
After a succession of rate hikes up to 6% the economic slow down is here and the house bubble started to burst. But at the same time record energy prices are being registered, as so decade lows of the dollar against other currencies. These are very clear signs that economic hardship is on the horizon for the US, and that holding Petrodollars is not a good strategy anymore.
Even in the face of these evidences of a long term decline of the dollar's value, a sudden dump of petrodollars in the market is not to be expected. To understand why an interesting tool can be used: John Nash's Game Theory.
Before the current downward pressures set in, it was clear that holding dollars as reserve currency was beneficial; dumping those reserves could hurt internal economies. Taking for instance a game with two central bankers, both with the options of holding or selling dollar reserves, having as simple outcomes loosing or winning - getting better or worse:
Table 1 - A game with two bankers and a strong dollar. A Nash Equilibrium is achieved with both bankers holding reserves.
| Hold | Sell |
Hold | Win, Win | Loose, Win |
Sell | Win, Loose | Loose, Loose |
|
Today the returns have changed, with a week dollar, holding reserves of that currency means a long term negative impact. The same game for the current days:
Table 2 - A game with two bankers and a weak dollar. A Nash Equilibrium is achieved again with both bankers holding reserves.
| Hold | Sell |
Hold | Loose, Loose | LooseAll, Win |
Sell | Win, LooseAll | LooseMore, LooseMore |
|
A Nash Equilibrium is possible again, for as long as both bankers hold their reserves the dollar keeps some value and the losses are limited. If someone starts dumping reserves, the dollar looses its value quickly and both loose. Moreover, if a serious sell off occurs, the current wealth represented by those dollars can simply go up in smoke, something all will try to avoid.
But obviously there are more than two central bankers playing this game and its outcome is not as simple. Some countries may slowly dump small sums in exchange for imported goods, or they could just stop accepting dollars in exchange for their exports. Figure 4 shows the composition of current foreign currency reserves:
Figure 4 - Share of foreign currency used as reserves. Source: COFER. Click to enlarge.
|
Although the amount of dollars hold abroad the US continues to grow, it has been growing slower than other currencies. Despite a shy recovery in the end of 2005, there's a clear downward trend since 2001. The dollar position aggravated quite fast during 2006, from 66.5% on the first quarter to 64.7% in the last.
Stagflation
From the information gathered above it is clear that the first economic impact felt in face of resource constraints is Inflation - money supply continues to grow, fast decoupling from resource availability. As mentioned above, Inflation increases the weight of basic needs (food, clothing, health) on monthly wages, overall purchasing power goes down. This creates a downward pressure on demand for non essential goods, e.g. holidays in the Caribbean.
Eventually the erosion of purchasing power will bring deflationary pressures on the economy, with some sectors going into recession. But at the same time prices for goods directly tied with energy or natural resources will keep inflating. In the long term both inflationary and deflationary pressures will set in, perhaps in different sectors of the economy, perhaps in succeeding periods of time.
This awful economic setting got the interesting name of Stagflation in the 1960s. Awful because it means that there's no fiscal or monetary policy to manage a way out of it. Any strategy will imply a compromise, e.g. more jobs with less purchasing power or more purchasing power with unemployment. But that's exactly what should be expected of resource constraints, there's no easy strategy, the only way out to bring growth back is to draw more resources into the economy.
Historically Stagflation was felt in the West throughout the 1970s and early 1980s, as a consequence of the Peak in US oil production and the embargo imposed by OPEC in 1973. In the early 1980s the outburst of the Iran-Iraq war created an unprecedented energy supply collapse and many countries went into Deflation (Portugal was one - maybe a story for another time). The North Sea and Saudi Arabia would eventually put an end to the crisis (but ended up exporting it to the USSR).
It is interesting to note that on his educational textbook Understanding the Economy, from 1984, Andrew Dunnett wrote:
Summing up, the inflation of the 1970s is, partially, result of resources' scarcity. The frightening scenario of resources fight, at the international level, forecast by the models of catastrophe, may have started already. Such signals the end of an era of fast and continuous growth of living standards that seemed to be the natural way of things since the beginning of the Industrial Revolution.
Final notes
Today Stagflation seems the most likely long term outcome of the Hubbert Peak of World conventional oil production and of natural gas in Europe and North America. These resources have no replacement at hand and the Economy is already feeling their lack with commodity prices growing steadily during the past two years.
A sudden collapse of energy/resource supply imposed by the Hubbert Peak, immediately yielding a Deflationary crisis like that of the early 1980s, is not to be expected. Deflation is a likely outcome only in the wake of some extreme event (large scale natural disaster, war, etc). The crisis will evolve slowly with results more similar to those endured during the 1970s. But this time Stagflation could be much harder to solve or soften, given the amount of foreign currency reserves kept by central bankers, which could seriously reduce the effects of their monetary policies.
Luís de Sousa
July 2007
