Peak Oil

Does the long term real price of oil look like it is falling? Sure it may have fallen after the peak in the 70s and again recently, but overall it is up. Oil at $20 is likely gone forever. Oil at $30 is largely gone and unlikely to be seen other than briefly. Oil at $40 or $50 we should see until the next shortage drives another spike in oil prices. We have been able to extract more, but not more cheaply. We will use less, because it is more expensive. We will develop alternatives, because oil will eventually be more expensive than those alternatives. The only way it will fall in price over the long run is if it is displaced and no longer wanted.

Dividing the Division of Labor

The division of labor can produce higher quality output and do so more efficiently but only by a limited amount. Labor has specialized since the beginning of civilization but produced only infinitesimal growth. Only the application of scientific knowledge and the advent of powered machinery produced modern levels of growth. This has led to greater specialization but there is little reason to attribute growth to this beyond its embodiment in knowledge and technology. The real usefulness of the division of labor is not in labor at all but in gaining specialized knowledge and replacing labor with technology, automating production.

Two Centuries of Growth

The Growth of Real Income (real gdp per capita) in the US demonstrates the transition from an agrarian to industrial to post industrial power. Growth was slow initially but rose over the 19th century in fits and starts. It would rise sharply during booms only to stagnate or fall slightly through busts lasting a decade or more. A dramatic fall occurred over 1929 to 1933 followed by as dramatic a rise climaxing during World War II before settling back to extended consistent growth at the best rates ever. Variability has diminished somewhat over time. Most deviations are small from this upward drift over history. Growth appears to have reached an asymptote of about a factor of 10 per century or about 2.3% a year. So much for past golden ages.

Deflation is Depressing

Is deflation always bad? Some industries exhibit falling prices which are beneficial to consumers, so if deflation leads to most falling that should be good as well, right? No. Deflation leads to a riskless real return on money. This is bad for the economy as any investment that returns less than that, or even more than that but carries some risk is not made, and growth slows to reduce that return to zero. Falling prices lead to delayed sales and raises real debt burdens slowing the economy further and leading to more deflation. The economy has difficulty adjusting to deflation due to the lack of expectations and sticky prices, creating a vicious cycle. In a perfect world with known expectations and all planning, contracts, and prices adjusted seamlessly, deflation would not present a problem, but in such a world neither would it be necessary, and as prices must respond to supply and demand rather than uniformly, resistance and stickiness would remain. In the end, deflation is depressing.

Unbelievable

A really nice paper on the unsustainability of the bubble is this 2006 paper by Robert Parenteau, US Household Deficit Spending. We were well into Minsky's ponzi finance regime where debt is acquired to pay off previous debt leading to a debt trap. Even if income increased with productivity, it could not sustain debt rising with asset values. Finance wasn't growing with the economy, it was the growth of the economy, it was growing at the expense of the economy. This is why it is so unbelievable so many failed to see it coming. They had to close their eyes really tightly.

Investment, Speculation, and Bubbles

Investors invest on a value basis for the long term. They try to determine what an investment is worth and value investments according to the income they expect. Speculators invest on a momentum basis for the short term. They try to determine what others think an investment will be worth and value investments according to the gain they expect. These are caricatures somewhat as many will consider themselves investors only to turn into or be turned into speculators after the market moves against them.

During a bubble there is a transition from assessing value to assessing other peoples assessment of value recursively providing convergence in expectations and a positive feedback loop for the explosion of prices. Eventually it runs short of new money or participants. Price increases start falling short of expectations. Speculators are forced out or start selling out. Prices start to fall. Expectations change. Feedback turns negative resulting in an implosion of prices.

In no place was the difference clearer than the housing bubble. Incomes never grew through it. The Fed has largely come to define income growth as inflationary and stemmed any real increase in it so no one should expect rapidly rising incomes. There was no investment case for housing in general. Lower interest rates meant property prices would increase, but also meant if they rose, prices would decrease. They could only always be worth more if one expected interest rates to keep falling. That is quite hard to swallow. The reason prices rose was because speculators were investing on a momentum basis and the reason they fell is because they were disinvesting whether due to being unable to carry them or on the same basis.

Under efficient markets, price is value, bubbles don't exist, and none of this makes sense, but to make sense of efficient markets one has to theorize investors had expectations prices would continue to rise, but how could prices rise without incomes to support them? Did they really believe the Fed would inflate to keep prices heading up after 20 years of disinflation? Could they really believe interest rates had only one way to go, even after the Fed began raising rates? Efficient markets strain credulity the same way lending standards strained credulity during the bubble. The only way to make sense of it is to assume limited rationality that makes momentum speculation reasonable. The only problem with that is it undermines and makes a mockery of efficient markets.

The Housing Mirage

In a notable piece of research reported in the WSJ, mortgage equity withdrawal, 25% to 30% of equity increases, may have contributed as much as 2.3% to gdp over 2002 to 2006. This is consistent with the reports of CalculatedRisk. If one also adds to this the amounts due to increases in the construction and finance and real estate industries over this period, perhaps 1.0% to 1.5% of gdp, there likely was no real growth over this period, none at all. Economic growth was a complete mirage due to the housing bubble. The question now will be whether there will be any going forward. I have my doubts, but at least we are no longer under any illusions.