The Sound of an Invisible Hand Clapping
by Dmitry Orlov
It is a marvel to behold the inability of mainstream American economists to explain the present, never mind predict the future! After several years of steady ramp-up in energy prices, their pronouncements on the effects these prices should be having on the economy are turning out to be so far off the mark as to be laughable. But this is no laughing matter: high prices are one thing, actual energy shortages (which are coming) are another. If the economists are unable to explain what is happening now, how can we expect them to be of any use in helping us prepare for what will happen next?
I am an engineer, not an economist. But I have listened carefully to economists, and have tried to find some merit in what they are saying. And it made me want to exclaim something along the lines of "What are you people good at, anyway?" (By the way, these sorts of questions are what makes us engineers so charming in mixed company.) I eventually found an answer to this question, which I will get to.
One exceptional economist is Andrew McKillop. He is regarded as something of an apostate by people in his profession, to their certain detriment, because he was the first to recognize that high energy prices do not stifle economic growth, but instead accelerate it, and that higher energy prices do not reduce demand for energy, but instead increase it. These are key insights, and Andrew should be given credit for pointing them out.
There is one more discrepancy between economic theory and reality. According to the theory, higher energy prices should cause energy production to increase. The opposite appears to be the case. Here is a handy chart that summarizes these findings:
Theory A: High energy prices reduce economic growth
Reality A: High energy prices increase economic growth
Theory B: High energy prices reduce energy demand
Reality B: High energy prices increase energy demand
Theory C:High energy prices increase energy supply
Reality C: High energy prices reduce energy supply
We have had dire warnings from the G7 and the IMF that high energy prices with hurt economic growth. But energy prices have been going up roughly linearly for a few years now, some other commodity prices (gold, for instance) have more recently started going up roughly exponentially, and yet the economies that were booming before (China, India) are still booming, and even some economies that weren't growing so well before (US) are posting unexpectedly impressive numbers. There have also been numerous warnings that high energy prices would cause inflation, but it has failed to materialize.
Many economists say that higher energy prices will decrease demand and increase supply. Instead, demand is going up and the supply is dropping. It turns out that higher energy prices act as an economic stimulus, both directly, because profits from the energy sector are reinvested, and not necessarily within the energy sector, and indirectly, because, to pay for more expensive energy, people are forced to somehow come up with more money, through increased economic activity of all kinds. Because economic activity requires energy, all of this additional activity causes energy demand to increase, not decrease.
On the supply side of the equation, two distinct forces are at work, both of them acting to depress supply. One is the higher cost of inputs that go into energy production, such as steel, the manufacturing of which requires a great deal of energy, and so it increases in price as energy increases in price, but does so even faster, reducing the return on investment from energy exploration and development. The energy industry is used to seeing boom times followed by overproduction and price collapses, and is keen to avoid making investments in production capacity during a boom, which could potentially result in a negative return on investment.
The second force at work is the reluctance of energy producers to sell their oil just before the price is ready to go up again, which it is more or less all the time. It is entirely rational for them to hold on to their oil, if they feel that they can get more for it in the future. Realizing that excess supply is gone, some of the larger producers may even decide to withhold a portion of their production from the market, and realize the same profits, but from a smaller volume of sales, thanks to the higher prices that would immediately result. Some of the big oil producing countries use profits from oil sales to cover their expenditures, which may increase over time, but not as fast as the price of oil. Thus, as oil prices go up, the amount of oil they need to sell to fund their expenditures goes down. Also, all of the major oil exporting countries have limited reserves of oil underground, are past their all-time peak in production, and have no wish to accelerate their inevitable decline.
Such real-world complexities do not agree with the mental model favored by the economists, who like to think of supply and demand as two lines on a graph, and to imagine a magical invisible hand, which makes sure that they always cross. Thus, if energy becomes more expensive, people will buy less of it, until they can produce more of it. This is dogma, useless to argue about. Just as the 17th century physicians, so powerfully ridiculed by Molière, were primarily concerned with the smell of the patient's feces, and favored bloodletting as a cure-all, modern-day economists are primarily concerned with prices, and favor interest rate hikes to treat the economic maladies they misdiagnose.
The fact that reality does not agree with economic dogma is beside the point, because, you see, eventually it will! Just as the patient dies because "there was still some blood left in him," vindicating the physicians, in a few years, energy supply will fall due to resource depletion, while prices remain stratospheric, and the economists will exclaim: "You see, a demand response!" And if later on, due to some heroic efforts and a bit of luck, supply surges back up for a while, they will exclaim "You see, a supply response!" And they would of course be right. But then, who wouldn't be? If their theory is "What goes up must come down," then they just have to wait for whatever it is that's currently up to come back down. In the long run, they are either right, or dead.
While waiting us out, economists have some advice to offer to us. They like to tell oil producers how important it is for them to satisfy the market. They warn that failing to do so would destroy demand for their product by causing consumers to "substitute" other sources of energy, such as solar, biomass, wind, tar sands, oil shale, nuclear, clean coal, and, of course, everyone's favorite non-energy source, hydrogen. Apparently, they didn't get the memo: all these new sources of energy, added together, will never amount to more than just a small percentage of current, fossil fuel-based energy consumption. One also hears economists recommend that we invest in efficiency, by accelerating the turn-over of the huge fleet of cars and trucks, and replacing them prematurely with smaller, more efficient ones. The nice thing about smaller cars is that they fit more compactly into a traffic jam, allowing a greater number of people to spend more hours breathing each other's exhaust fumes. But if cars are already a problem, then making more of them hardly qualifies as a solution. Moreover, making cars is an energy-intensive activity, and so it is hard to see how scrambling to replace the entire fleet will decrease energy demand. Eventually, when most of us are walking or riding bicycles, and just a few of us can afford mopeds that run on ethanol, the economists will exclaim: "You see! Efficiency and substitution did the trick!" And they would of course be right.
But all of this waiting around for the economists to turn out to be right, or dead, in the long run, seems inadvisable. The physics of resource depletion doesn't care a whit about economic theories, and indicates that oil production has either passed its global peak, or is about to. After that, energy availability will dwindle with each passing year. It is one thing to have supply balanced on a knife's edge: minus a couple of hurricanes, plus an unusually warm winter, steady as she goes. It is quite another to have to live with chronic, ever-worsening shortages. A lot of well-laid plans will have to be abandoned, a lot of investments will become worthless, and business as usual will have to be replaced with the "new normal" – emergency management. And this brings us back around to the question I asked about the economists at the beginning: "What is it that you people are good at?" The answer, I think, is that they are good at making us continue to believe in the markets, in the status quo, and the continuation of business as usual, for as long as possible. They have to be good at this, as a matter of survival, because once we stop trusting their theories, their profession will no longer be economics – it will be history
