Uncharted Territory

December 8, 2009

Hansen vs. Krugman: Second (Third and Fourth Order Effect)s Out!

Yesterday’s NYT includes a right royal spat. Well, online it does, at least. In a piece titled Cap and Fade, James Hansen argues that carbon taxes would be more effective than cap and trade. Paul Krugman responds under the heading Unhelpful Hansen, by first telling Hansen to stay off his turf. Climate scientists shouldn’t dabble in economics, apparently. Tosh. Ideas have to stand on their own merits.

Having highlighted the intellectual ring-fencing which is at the root of many of the world’s problems, Krugman proceeds to un-blot his copy-book. He points out very convincingly that, from an individual consumer’s point of view, it matters not a jot whether gasoline is more expensive because of a tax or because of a cap and trade mechanism.

Krugman is right as far as it goes. But both Hansen and Krugman fail to mention the second, third and fourth order effects of pricing carbon emissions. And it is the second, third and fourth order effects that will determine the effectiveness of policy.

Let’s start at the end, because it’s more fun. The fourth order effect of pricing carbon will simply be a redistribution of spending power in the economy. I’m sure I’ve said it before, but I’ll say it again: money is just a means of distributing resources. The economic system will adjust so that the available resources are used.

Perhaps I should try to explain a little further. Money circulates. There is not a fixed quantity. Let’s imagine we put an astronomical tax on carbon. The money raised by that tax must be spent. Let’s say we decide to spend it on more doctors. Suddenly there will be more doctors to fly off to junkets round the world. Or maybe they’ll spend their money on art (or more expensive houses, or televised sport…). In which case the previous owners of the art (or houses, or sportsmen, their agents and other freeloaders) will be able to afford to fly more…

But before we even get to this unhappy state, we should consider, first, a second order effect of pricing carbon. Pricing carbon will tend to reduce the price of fossil-fuels. All that might happen is that the price of petrol at the pump remains the same, but less of the motorist’s money ends up going to the oil-producer and more goes to the government. Maybe a good thing in itself, but we’re trying to stop global warming here, not change the shares of unearned spoils divided with the Saudis. Sure, depressing the global oil price might have the desirable third order effect of reducing investment in the most expensive fossil-fuels for a while (until the lack of supply pushes prices up again), but we need to reduce consumption of fossil-fuels that cost virtually nothing: coal, in particular.

And unfortunately the second order effect of carbon pricing on the oil price is dwarfed by the third order effects of another second order effect. The second order effect (I’m trying to be rigorous, here!) is that taxes raise money. So does carbon trading. We need to consider the effects of how that money is spent.

Hansen argues that the money should be distributed to the population. This will, at least in the short-term, increase equality. And, unfortunately, when you’re trying to reduce consumption of mass-market products, equality is not your friend. Money will be taken from those whose consumption is not constrained by their financial situation and given to those who would like to spend more. Likely on heating, driving, flying and so on. Oh dear!

But there are problems with carbon trading, too. The precise outcome will depend on how carbon permits are distributed. If they’re given away to power companies, then any excess permits will accrue to these companies’ shareholders in the first instance. (Over time, these profits will encourage new market entrants, although this may not happen if only incumbents are able to access the permits). If permits are auctioned, though, then we reach a situation similar to the carbon tax. The outcome depends on what the government does with the revenue. Simply distributing it to the population would fall foul of the same equality problem as for the tax. Direct or indirect subsidies for renewable energy production would clearly be by far the best policy choice, in the hope that, once renewable energy has a huge cost advantage over fossil-fuels, everyone will switch to clean energy. Maybe.

In perverse support for Krugman’s argument that taxes and cap and trade are equivalent, government could spend tax revenues in the same way as those from auctioning permits. Very similar to Hansen’s position is the idea of tradeable personal carbon allowances. These would have the effect of transferring wealth from the rich to the poor. And remember, equality is not our friend…

Let’s make some tentative conclusions and observations:
1. The indirect ramifications of carbon pricing policies are more important than their immediate effects.
2. Carbon trading is philosophically preferable to carbon taxes, because it at least imposes a limit on total consumption. The problems arise from leakage (the concept is explained in a previous post). Unfortunately, these are very big problems – probably deserving a post of their own.
3. If there is a limit on the carbon price in a carbon trading system, then it becomes almost equivalent to a tax. However carbon is priced, governments must be prepared to push the price up indefinitely. Otherwise, I suggest, the economy will simply adjust to the price.
4. Carbon trading is a superior policy if you’re really serious about reducing fossil-fuel emissions, because government doesn’t have to set a tax at an eye-watering level. It can simply say: “this is all the fossil-fuel we can afford to burn, it’s supply and demand in the market-place which has pushed the price up.”

Unfortunately, I don’t see too many governments around the world that are about to bite the bullet and set an effective carbon price.

November 19, 2009

The Nature of Money and the Consequent Likely Ineffectiveness of Carbon Taxes: Revisiting the Man in the Wardrobe Fallacy

Filed under: Carbon taxes, Concepts, Economics, Global warming, Markets, Oil price — Tim Joslin @ 12:56 pm

I’m very disappointed to see policy-makers trying to solve the problem of global warming by ineffective – and possibly even counter-productive – measures such as raising efficiency standards and imposing carbon taxes.

What, for example, will California’s TV owners do with the money they save on their electricity bills? Maybe they’ll upgrade their set more often which will likely lead to more emissions per dollar than would have been incurred had they spent the money on California’s partially decarbonised electricity!

I touched on the problem with efficiency – the rebound effect – when I summarised the various problems with policies which put a price on carbon with the aim of reducing CO2 emissions.

All these problems arise because we are so reliant on fossil fuels. Virtually everything we do – and in particular everything we spend money on – is likely to result in CO2 (and often other GHG) emissions to the atmosphere.

Today I just want to look at the problems with taxes on carbon. After all, now that the middle word has been dropped from “Copenhagen or bust”, it seems national policies, rather than a global emissions trading regime, are to be the focus, at least for the time being.

I worry whether my previous attempts to explain the Man in the Wardrobe Fallacy, here and then here, were too theoretical. So I’m going to try to work through the argument, step by step, with examples.

The Nature of Money

Too many people are failing to consider what money really is. One way of looking at money as a means of allocating resources. The price of a good is not, as many suppose, a fundamental quality, but reflects its supply and the demand for it.

Consider Geoge Monbiot’s recent piece on peak oil. Maybe its the late noughties zeitgeist, but again I feel obliged to express my disappointment, this time that George seems to think an “end is nigh” attitude to oil helps in the fight against global warming. Indeed, the first comment on his article, by NeverMindTheBollocks, has been deleted, but the second, by Daveinireland points out the problem:

“Isn’t the oil running out a simple so[lu]tion to global warming then? No oil means billions starve and the number of those pesky carbon footprints drops d[r]amatically.

Isn’t that what you want?”

In actual fact, if we want to stop catastrophic global warming, we can’t afford to use up oil the all, given that we’re also using all the gas we can find and most of the coal.

George’s predictions of chaos as oil output declines are also wide of the mark. For the activities that use oil – driving and so on – to decline globally, it would be necessary for oil output to decline faster than the rate of increase in efficiency in use of oil plus the rate of substitution of the use of oil, e.g. by the use of electric cars and (though it doesn’t help us on the GW front) the use of liquid fuels from coal (and indeed biofuels). Oil output would only decline by a few percent a year, max, which – given the EU thinks we can generate 20% of our energy supplies from renewable sources by 2020 – is of the same order as the rate at which we can replace it. And this doesn’t even take account of forced energy efficiencies.

Why do I say “forced energy efficiencies”? Because at some point, an individual’s spending on fuel is limited by the price. If they still want to get to work they’ll simply have to trade in the SUV for a hybrid. Money determines how the available fuel is allocated.

Of course, in a world of massive financial inequality, some will carry on driving their SUVs, whilst others are forced to use even cheaper means of transport, such as buses, trams or trains. But this is the fault of the economic system, not the oil supply. Since we’re using oil so inefficiently – maybe on average we get 50% fewer mpg than is possible with current technology – the supply could decline by at least 50% before it was necessary in energy rather than financial terms for anyone to reduce the distance they drive at all.

Monbiot oversimplifies by attributing economic problems to resource constraints. He suggests, for instance, that:

“a permanent oil shock would price food out of the mouths of many of the world’s people.”

If we assume the food supply does indeed decline, or at least fail to keep up with population growth, then it is indeed the case that food prices could rise if nothing else is done. But food, like gasoline, is being used unevenly and inefficiently. Many of the world’s people already have too little to eat, for economic reasons rather than because of limits on global resources. Further, many of those with least to eat are not part of the global market economy. Rather they are subsisting (or not) on small patches of land, relying very little on oil-based fertilisers and oil-powered machinery.

It’s the urban poor who are most likely to be affected. But in many countries, the prices of basic foodstuffs are regulated by the state, so problems will arise only when countries are no longer able to afford imports. Meanwhile the price mechanism will reduce consumption in developed countries, specifically those which are net importers of food. Here, though, minimum wages (and state pensions and benefits) are generally negotiable and index-linked, negating the effect of price rises.

Who would have to reduce their consumption, then? It’s a mixed, even slightly rosy picture, but it seems the burden will fall on two groups:
– those whose governments are no longer able to import sufficient food;
– those urban poor presently existing on slightly more than subsistence-level food supplies, who will become relatively poorer compared to those reliant on social or government safety-nets.

In other words, more people will be food-poor, but famines, as now, will be associated with collapsed governments and environmental or social crises.

The point I am trying to make is that money is simply a way of allocating resources. And there are other ways.

Food is so fundamental that you can’t naively apply simple supply and demand economics. In the UK, for example, food was rationed for a decade just over 50 years ago, well within living memory. In the event of a complete food-supply catastrophe (and actually I think a bigger threat than a slowly declining oil-supply is a major volcanic eruption which could reduce harvests for several years), I have no doubt we’d see rationing again.

The effect of a decline in global food supply is complex, but one tentative conclusion might be that it would be governments rather than the individuals themselves who ensure their populations have an adequate food supply. Or not.

The Likely Ineffectiveness of Carbon Taxes

Let’s now consider the policy of taxing carbon, as is being implemented in France, for example. The idea is to tax gasoline, heating oil and so on. Fine, but the critical question is what happens to the money:

“But things get tricky. The €4.3 billion ($6.39 billion) raised annually by the tax would actually be returned to taxpayers in the form of tax reductions or ‘green checks.’ A family living in an urban area, for instance, would get a break of €112 ($166.53) on their income taxes. A family living in the country, which presumably would mean higher carbon taxes because of the lack of public transportation, would get an even bigger reduction of €142 ($211.14).”

What amuses me most is that the French have decided that carbon consumption because of a rural lifestyle is somehow legitimate! Apparently we should subsidise those who have profligate lifestyles in rural areas – a ludicrous position that is also taken for granted on this side of La Manche. An intelligent policy would instead pass on the various extra costs arising from their inefficient lifestyle to those in rural areas to encourage more to adopt a less costly urban lifestyle.

But the real problem is that the money raised by the carbon tax is simply redistributed. Only two things have happened:
– the spending power of the poor has been increased at the expense of that of the wealthy;
– the price of highly carbon-intensive activities has been increased relative to less carbon-intensive activities.

The first effect could actually make the situation worse, as some of those who could not afford to (say) use their car often or heat their homes as much as they’d like, can no afford to do so. This could (in fact very likely will) outweigh the effect on the wealthy, who may simply save less of their money!

The whole policy therefore rests on the magnitude of the second effect. Will people switch to less carbon-intensive technology? There are at least two reasons why they might not and even if they did, this would not necessarily reduce global or even French carbon emissions:
– first, it’s often difficult to tell which option is least carbon intensive;
– second, there may be insufficient supply of renewable energy;
– third, consuming less fossil fuel will simply allow its price to fall, allowing others to consume more.

Let’s explore the third problem a little more. Take the example of the oil price which is set globally in dollars. If the French purchase less oil, its price will drop slightly and someone else – China, say – will be able to purchase a little more of it. France acting on its own cannot reduce global oil production.

But it’s worse than this. France can afford a certain level of imports, over a long period of time equivalent in value to their exports. So, if France earns on average $100bn a year in exports (let’s assume imports and exports are all priced in dollars), then, on average, it will import an annual $100bn worth of goods. Money can store value but ultimately must be spent – in itself it has no intrinsic utility.

The carbon tax has no effect on France’s trade position – if anything it will help them increase their exports, by promoting more efficient use of fossil-fuel imports – so they still have (at least) the same hypothetical figure of $100bn to spend each year.

Likely a similar proportion of the $100bn will be spent on fossil-fuel such as oil. But let’s suppose France succeeds in reducing oil consumption. What else might they buy? If they buy manufactures, the “embedded carbon” in each $1bn worth will very likely be higher than in $1bn worth of oil! Why? Because manufactures require energy which will likely come from cheap indigenous (or Australian) coal, in China, say. Oil has a scarcity value because it is so useful. $1bn worth of oil might therefore contain less carbon than $1bn worth of manufactures!

And it gets worse. Whatever France buys, even if it’s software, they’ll give their dollars to the producers, let’s say in India. And the producers will then be able to import oil. Or manufactures.

The Man in the Wardrobe Fallacy

The Man in the Wardrobe Fallacy is simply that an internal change in an economy – a redistributive tax on carbon, say – has no direct effect on the external effects of that economy, its ability to import fossil-fuels, for instance.

At the present time, supply-side constraints – the rate at which low-carbon energy is being rolled out – are limiting our ability to reduce fossil-fuel consumption and hence carbon emissions. When gigawatts of wind energy capacity are held up in the planning system, all carbon taxes will do is act as a redistributive tax, increasing economic equality (all else being equal).

And, mirroring the case of the likely effect of production capacity constraints on food consumption, economic equality is, sadly, not your friend when you are trying to reduce consumption of a resource. Think about it. Consumption of any resource is surely minimised when the poor majority are constrained by their finances (or access to the resource), and the wealthy minority by their appetites!

In the example of food, the response to a drop in supply would be to increase the numbers of the poor majority, that is, those constrained by their finances. The number able to eat as much as they want, whenever they want, would tend to decline.

In the example of fossil-fuels, redistributive effects – such as from taxes – tend to increase consumption, the reverse effect. Indeed, we can see on a global scale how the spurt of development over the last couple of decades, and especially since the start of the millennium – a massive equalising of global spending power – has led to an increase in, for example, demand for oil.

Successful strategies to reduce global carbon emissions must involve a limitation on overall emissions. Kyoto – with crucial terms dictated by the hyperpower of the time, the USA – was intended to lead to such limits. Copenhagen, forged in the new multi-polar world, will consist of no more than a series of unenforceable, and, in many cases, vague, national undertakings, and will be entirely ineffective.

October 31, 2009

“Carbonomics” Critique, Part 1

I began reading “Carbonomics” by Steven Stoft late yesterday. I’m only just starting Chapter 3 (of 31) but I can already reach a conclusion.

My very first impression was that “Carbonomics” brings some logical thinking to the debate. I see no reason to change my view: there is no doubt a lot of good material in the book.

But within minutes I could see that Stoft’s overall prescription, sadly, is in dreamland.

I’m posting my initial thoughts immediately whilst I am still in a state of shock.

The history of thought is littered with discarded, but complex and sophisticated, bodies of knowledge, from scientific theories – the Ptolemaic universe perhaps, to political programmes – communism, for example; indeed more than bodies of knowledge, entire institutions, even civilisations, all built on foundations that later proved to be constructed of no more than intellectual straw.

Some of the foundations of “Carbonomics” consist of no more than straw.

I am indeed stunned. I started reading and first came across some encouraging comments in the Preface (a chapter which should never be skipped). The author notes the inefficiency of current policies to improve energy security and global warming and promises to “fix energy policy”. He will be guided by the story of physics, and produce Mr Tompkins in Wonderland for economics. “The hardest part of learning new ideas is giving up misconceptions”, he writes.

I must admit that by this point I was already starting to feel a little uneasy. I don’t, for example, believe that “physicists have a tradition of explaining advanced ideas to the public just because they find the concepts fascinating.” No, they do it to try to prove how clever they are (except for a small number who simply have Asperger’s syndrome). And, given that their belief system doesn’t hang together (relativity and quantum physics are as yet unreconciled) they hope that the more positive feedback – or pats on the back – they can extract from their audience, the truer what they have told them will become. Stoft notes that Einstein “found the uncertainty of quantum mechanics… so disconcerting that he never accepted it”. Quite right. Einstein was a holistic thinker. That was his genius. All the facts had to be taken into account, however alien a theory eventually resulted. He understood that all may not be as it seems, but he could not accept contradictions into his world view, even if others could live with them. So in asserting that “God does not play dice”, Einstein was not being a stick in the mud, but demonstrating he was on the side of the good guys. Even if he didn’t have the whole answer, at least he knew there was a question.

I labour the point because it soon became apparent that Stoft’s thinking is not sufficiently rigorous. He is not prepared to accept inconvenient truths.

It’s a shame, because Stoft starts so well with an excellent account of the effects of the 1970s oil price spike. When the Great Depression is so often mentioned as the worst of economic times, I often feel that the discourse is US-centric – cultural domination perhaps. For the 1970s was as decisive for modern Britain as the 1930s was across the Pond. Inflation and unemployment, a pervasive sense of decline tinged with incipient anarchy. The Punk Era, swept away by the Thatcher Revolution.

Never mind, my point is that Stoft’s prescription will fail. Reading his first chapter I assumed Stoft would urge measures to keep the oil price high. But it suddenly dawned on me that his prescription is the precise opposite!

There’s a why Stoft is wrong, which owes something, I feel, to a US-centric world view.

And then there’s the how Stoft is wrong. I’m afraid to say he has not followed his own prescription in the last line of his Preface, to “pay close attention to the way governments and markets really work”.

Stoft, it seems, still bears grudges against OPEC. On page 4 he explains how he wants to avoid “paying OPEC another trillion dollars in tribute”. He writes of how, by 1986 “OPEC had been crippled”. On p.5 he notes how he will explain “how to crush OPEC again”. On page 6 he reminds us that “conservation… crushed OPEC in the early 1980s”. There’s a bit of a lull while he advocates a “consumers’ cartel” to counter OPEC and worries about how to deal with “free rides”…

Powerful stuff. Where have I heard this sort of thing before? Oh, yes, I remember now – it’s eerily reminiscent of Russia railing against NATO. Yes, that’s right, Russia’s demon is a mutual-defence pact. To many in Russia (unfortunately many of those in positions of power), the idea of Ukraine or Georgia joining NATO – to ensure, as sovereign nations, their own defence – is little short of an invasion of the Motherland itself. I wonder, I just wonder, if OPEC members feel the same way. Let’s just step into Wonderland for a moment. Maybe they feel they have a right to the riches under the desert (or wherever). I know, I know, I’m of the view that oil wealth is a fortunate (or often not so fortunate) windfall. But the actual state of affairs is what we have to deal with – and de facto those countries endowed with generous fossil-fuel reserves are determined to maximise the value of those reserves.

In solving the problem of global warming (and energy security) we have to deal with the world as it is, not how we would like it to be.

Maybe I can lay down something of a more specific principle here. Short of war, there will only be progress in international negotiations if win-win situations are created. Sorry about the cliche. Maybe I can get rid of it. Because, actually, we’re in a multilateral situation and we need win-win-win… in fact a win superscript n, win raised to the power of the number of interest groups.

Stoft is writing from the US. Let’s put to one side that he hasn’t even convinced his own country’s body politic to take the problem seriously yet, let alone of his particular approach. Let’s pretend he manages to do that. Even if that were to happen, I’ve got news for him. The world out there is not full of buddies who will be happy to participate in a “consumers’ cartel”. In fact, it may be unfair only to Canada & Australia to say that the US has only one reliable sidekick with any clout at all on the world stage. Yeap. Be nice to the UK. OK, I’m being facetious – there is some alignment of national interests, at least with the EU and Japan. But the problem is that several populous developing countries show no clear sign of wanting to play ball.

I feel I’ve written moreorless enough for a first reaction, so it’s fortunate that how Stoft is wrong has already been touched on in previous episodes of Uncharted Territory.

The general problem is the Displacement Fallacy, though I appreciate that Stoft intends to avoid this through international agreements, starting with China. Good luck, mate, but I don’t think you’ll manage it.

Reflections on Oil supplemented by Reflections on Reflections on Oil considers how the oil market will react to attempts to choke off demand. The important point is that the oil producers themselves will act as buyers of last resort.

Before I sign off I should mention that Stoft’s discussion of a tax on fossil-fuel and an “untax” (general distribution of the tax revenues) will not work as he seems to expect for imported products. Stoft is clearly unaware of the Man in the Wardrobe fallacy. Oil at $80 + $20 tax (Stoft’s example in ch.2, on p.21) will not have the same outcome as oil at $100. In the first case, the importing country still has $20 to spend, perhaps on more oil imports or perhaps on other goods, the sellers of which can themselves then afford to import more oil.

I haven’t read enough yet to determine whether Stoft is aware of the rebound effect or Jevons’ Paradox, whereby using a resource more efficiently can actually increase consumption in the long term. The signs aren’t good, though.

Although I’m disappointed with Stoft’s overall vision, I will read on, because large parts of Stoft’s analysis are sound. The first part of chapter 2 shows, for example, how cheap it would be to move away from reliance on fossil fuels.

Watch this space.

—–
As an unreferenced endnote, I admit hypersensitivity to inaccuracies or ambiguities and two have been particularly irritating:
– in Ch.2, footnote 1, p.19 Stoft writes of a policy “that would ‘cap the long-term concentration of greenhouse gases [GHGs]… at 450 [ppm]’. We are now just over 380 ppm.” CO2 alone is at “just over 380 ppm”. I can only guess whether the policy proposal referred to is to keep all GHGs at a CO2 equivalent level of 450ppm or to keep CO2 below 450ppm – which, it’s now becoming clear, would be too high.
– at the start of Ch.3, on p.21 Stoft remarks that: “Back in the 1800s… Jevons predicted peak coal in England”. Maybe it’s a cultural thing, but to me “the 1800s” refers to the decade 1800-9, inclusive. Stoft means “the 19th century”, here. Jevons in fact wrote “The Coal Question” in 1865 (Wikipedia). And, btw, he was probably talking about Britain, not “England” (Wikipedia thinks so). No offence taken.

October 19, 2009

Paper Dragons: The Nature of Currencies, with Particular Reference to China’s $2trn Problem

My previous post, 50 Days to Save the World! made a simple point. If we’re planning an economic solution to the climate change problem, it’s critical that, first, we fully understand the phenomenon we’re trying to modify – the global economy, in this case.

We also need to have at least an outline understanding of the shape of the global economy of the future. My thinking has been stimulated by today’s column in the Guardian by Larry Elliott, Eastern promise holds little hope for west. But Larry doesn’t consider what will happen to China’s currency peg to the dollar. We need to listen to Bernanke, among others.

What is a currency? I expect if we surf a bit we’d find a definition that lists the characteristics of a currency. A currency, I’m sure we’d find, must be fungible (exchangeable) and act as a store of value. But these attributes are only a matter of degree. All currencies are only exchangeable under specific circumstances, some more specific than others. And some store value better than others. In fact, these attributes are shared by many physical and promissory items that are not generally regarded as currencies: gold, oil, works of art, debts (certificated or not), company shares and so on all share many of the properties of currencies.

Now, my point is that we all agree that the value of gold, oil, works of art, debts and company shares all depend on supply and demand. Currencies, such as the dollar and the yuan are no different. To attempt to peg their value is akin to defying a law of nature. Just as the tide reached Canute, so currencies will resist an attempt to confine them. Eventually the dragon will breathe flame.

China has amassed a surplus in excess of $2trn and they’re not the only culprit. The future depends to a large extent on what happens to that surplus.

Let’s first consider the problem in terms of supply and demand for dollars. China’s $2trn will lose value to the extent that the supply of dollars increases and/or there is a decline in supply of what those dollars could buy.

On the supply side, QE, for example, will tend to inflate the dollar. But so, too, will releveraging as the global economy starts to grow and any increase in trade imbalances and attempted hoarding of dollars by surplus countries.

On the demand side, though, the dollars will become worth less or more, the less or more there is to buy with them. If, for example, oil becomes priced in euros, then the store of dollars will be worth less.

Let’s make some observations:

1. The value of China’s supply of dollars depends on the dollar-yuan exchange rate only to the extent that holders of dollars wish to purchase Chinese goods (requiring a foreign exchange transaction). Externally to the Chinese economy, the dollars will still be worth $2trn, should China revalue the yuan.

2. Foreign currency reserves are being held in dollars because there are things that can be bought with dollars. Holding reserves in gold or Swiss francs, say, would introduce a currency risk. More than that, in fact, the supply of gold or Swiss francs would exceed what can be bought with them. And, to repeat a critical point, if oil should become denominated in currencies other than the dollar, then China’s dollar reserves would immediately become worth less.

3. China relies on US demand for dollars, not just for Chinese goods. If the US reduces demand for dollars by fiscal tightening (i.e. by reducing the supply of government bonds) and by controls on lending (reducing money-market rates), then China’s dollars will be worth less.

4. If China’s dollars become worth less then the value of something – probably many things – they could buy will inflate.

Now let’s try to identify some scenarios depending on US and Chinese behaviour and then consider what other players might do.

0. Asset bubbles in US: China keeps peg, US borrows

I’ve added this case later for completeness. We might, I suppose, simply repeat the Credit Crunch. It’s possible, but unlikely, that we will simply go round the same loop again. But US consumers are no longer credit-worthy and the US is obliged to try to improve its fiscal position.

1. Asset bubble: China keeps peg, US is prudent

In the most likely outcome, China tries to be cautious, maintains its export-led growth and amasses ever larger dollar reserves, whilst the US also repairs its public and private finances. It will be impossible, though, for the US to repair its trade deficit, at least with China (and other dollar peg currencies). The surplus dollars create asset and commodity price bubbles before the inevitable crash.

Even worse, there is another aspect to the problem: dollars will be exchanged for other currencies where growth prospects provide better returns. Increasingly investors will bet (like Soros on the pound) on a gain when the dollar peg finally snaps.

There must, surely, come a point when China cannot further relax currency exchange controls without immediately being forced to reflate. Surely, as soon as China starts to allow trade in yuan, no-one will want to trade at the official dollar rate. People will assume that in the future they’ll be able to buy more with yuan (i.e. demand for yuan will increase) and seek to accumulate them. The yuan will inevitably rise against the dollar much as the dollar rose against the pound post-WWII. Eventually China’s trade position will reverse. Plus ca change…

2. Inflation saves us: China keeps peg but experiences inflation

I spent an hour or two last week reading about the Bretton Woods system. My scepticism as to the worth of currency pegs was reinforced. All currency pegs do (unless they prove to be a step towards successful currency unification, of course) is slow down currency movements and force them to happen with unnecessary drama and disruption, rather than by (at least sometimes) smooth market movements.

The problem is that the currency of the trade surplus country has to inflate to restore the balance. But there is no mechanism for this to happen in an orderly fashion. Rather, the trade surplus country benefits from improving economies of scale – and it’s no accident that manufacturing leads to increasing trade surpluses, for it is in manufacturing that productivity improvements are easiest to achieve – and the only way inflation can occur is through asset-price bubbles. The Great Depression is an example of what can happen.

The risk for China, of course, is that it finds itself in the eye of the storm of a second Great Depression (or at best a Lost Decade, like Japan) when asset bubbles burst. China would no doubt wish to avoid this by evening out across the economy any inflation that took place, but this is difficult. Allowing workers’ wages to rise would actually lead to productivity increases and an even greater surplus! If commodity prices are the focus then, again, industry will use these more wisely…

3. China keeps peg, but has to spend dollars on commodities

If the price of oil (and commodities such as iron, uranium and so on) goes stratospheric and China cannot wean itself off, then more of the dollar surplus will transfer to the resource exporting countries.

This scenario could lead to something resembling stability, at least for a time. The global economy would become characterised by a kind of triangular trade. China exports to US, which exports technology and knowledge products to resource countries, which export commodities to China.

The problem, of course, is that China will tend to find substitute products for scarce commodities and, because of the currency peg, restore its surplus.

Ultimately, too, the resource exporting countries will rely on US demand for dollars.

There is great danger, too, that this scenario would lead to 1970s style global inflation.

4. China relaxes peg

The only rational course for China is to relax its currency peg to restore a rough trade balance with the US. Why risk asset bubbles (1) or try to manage internal inflation (2) or global, commodity-led inflation (3)?

What about the UK?

Well, our policy aims should be:

1. Reduce our trade deficit so that we are less prone to asset bubbles arising from lending of foreign sterling reserves to consumers in the UK.

2. Reduce our fiscal deficit to ensure we can withstand future economic crises and to reduce demand for sterling. Forcing banks to purchase government debt reinforces this policy.

3. Further reduce demand for sterling by controls on lending.

The result will be that sterling used to purchase imports to the UK (or invested overseas) must be spent on exports. Other places it can go will be minimal.

Sterling, which, fortunately, is a truly floating currency will decline until its value ensures approximate trade balance.

One thing the global economy certainly does not need right now, though, is a transfer of a further $100bn a year from trade deficit to trade surplus countries.

July 29, 2008

Biofuels: an Energy Security (and Price) Own Goal?

Filed under: Biofuels, Economics, Global warming, Oil price, Politics — Tim Joslin @ 12:13 pm

Here‘s the written form of the BBC story about the Obama campaign team’s second thoughts about biofuels, which I heard on the radio and wrote about yesterday. I wasn’t dreaming!

The written piece includes a couple of points I don’t recollect hearing in the radio version. Apparently, “[Obama] has also said in the past that the subsidies help with energy security and climate change” and he “has also backed President Bush’s controversial coal-to-liquid fuel programme which benefits coal miners in the south of his home state.”

Obama’s advisor, Professor “Kammen’s paper says that a car will emit more greenhouse gases [GHGs] driving on corn ethanol processed with coal than it will using normal petrol.”

What the BBC report (or Professor Kammen) doesn’t mention is the energy balance (or the energy returned on energy invested, EROEI) for corn ethanol. We established yesterday that biofuel subsidies do not help with climate change, so perhaps Obama should stop saying they do. If they don’t help with energy security either, then that would remove Obama’s entire rationale for supporting them. Not that, given the wonders of the political process, he couldn’t get away with simply falling back on the apparent European (and probably US) historic position that farmers (“ours”, not those in poorer countries, of course) are different to the rest of us and their lifestyle should be subsidised, period. At least we’d then all know where we stand.

What we also have to bear in mind is that, although some forms of energy are more useful for some applications than others, different forms are interchangeable, at the margin. Here in the UK, natural gas and electricity prices are rising steeply in step with the oil price. In fact, you more often here about the “energy crisis” than the “oil crisis”, since whereas the overwhelming priority in the US seems to be to carry on driving, here it’s simply to keep our poorly-insulated homes warm. There is a lot of concern about “fuel poverty” in the coming winter. Indeed, as Bush and Obama realise, over the longer term, coal can be converted to oil (if you don’t care about the GHG emissions).

Oil is the most valuable fuel, and, all else being equal (i.e. if the price at the pump doesn’t change enough to compensate), we may well be able to reduce national consumption by displacing some with biofuels, though, globally, we will likely simply use the oil elsewhere – the Displacement Fallacy (pdf). If every country produces biofuels, though, then the oil price will drop and consumption will rise. The oil price will in turn tend to rise again because of the increased consumption and we’ll simply be back where we started from. Oil will still be expensive, but we’ll simply be consuming biofuel as well, that is, more fuel in total (there’s nothing “closed” about the global warming problem). Clearly, there is a complete lack of clarity as to what we’re collectively trying to achieve even in terms of the oil market. More on this another time.

What I want to stress here is that, because some uses of oil are interchangeable with other forms of energy, there is a basic energy price even though oil is at a premium. So, if producing biofuel does require more energy than the oil it “displaces”, then, sure, we might reduce the premium commanded by oil, at least temporarily, but we’d be likely to increase the basic price of energy by a greater amount. Biofuel may be an energy security, and price, own goal.

Now, we can’t simply say that the EROEI is negative for corn ethanol, just because Professor Kammen has shown that the use of corn ethanol results in more GHG emissions than “normal petrol”. The corn ethanol inputs include coal which produces more emissions per unit energy than oil. But not much more – we’re not talking about the difference between oil and natural gas (i.e. methane) here. The link to their original source is broken, but the Energy Information Administration (EIA) notes that: “According to the United Nations Environment Program, coal emits around 1.7 times as much carbon per unit of energy when burned as does natural gas and 1.25 times as much as oil.”

But, when answering the question as to whether the American taxpayer gets any energy security in return for their corn ethanol subsidies, we need to include all the energy consumed in producing corn ethanol. We need to include the (amortised) energy cost of all the facilities required, from ethanol refineries to improved roads and vehicles. We need to include the energy consumed directly and indirectly by the people receiving the subsidies, compared to what they may have done otherwise. We would have to base “what would have happened otherwise” on the energy consumption of the average American. That is, we need to add in, as an energy cost of biofuel subsidies, all the energy, above that used by the average American, consumed by the owners, employees and contractors of the farms, refineries and distribution infrastructure required for corn ethanol production. We would also need to make an allowance for the extra energy consumption – made possible by the subsidy bonanza – by the communities in corn ethanol production regions. And, as I noticed one wit observe on a blog recently, we might need to allow for all the flights to Washington by corn ethanol lobbyists. I could add that we should also account for all the hot air expended on the campaign trail.

And water is important. We may find that we are reducing river flows by taking water to produce biofuels. Further downstream we may be having to put in energy to get water – either by building salination plants or using energy to import water.

Fully determining the EROEI for corn ethanol is a tricky exercise. I don’t believe it has been or can be done to a high level of accuracy. That’s why subsidies and quotas are evil. If the energy value of all the inputs and outputs was represented by their cash value we would know whether it was “worth” producing ethanol from corn, at least in energy terms. (Don’t forget I’m just talking about energy value here – I’ve already established that biofuels make the global warming problem worse. Once we put a cash value on carbon storage and other ecosystem services – which I advocate – then growing biofuel crops is for Tin Men: you’d only do it if you had straw for brains).

As it is, it is quite likely that we are putting more useful energy into corn ethanol than we are getting out. As the price of oil increases, many countries – not just the US – are instituting quotas and subsidies for biofuels without knowing whether they actually save energy. If they don’t, this will end up pushing up the market cost for all forms of energy. Or reducing energy security, for those who prefer to frame the issue that way. Panicking governments into even more generous incentives for biofuels…

July 28, 2008

The Biofuel Blues, or, it’s the Opportunity Cost, Stupid!

Filed under: Biofuels, Economics, Global warming, Media, Oil price, Politics — Tim Joslin @ 12:32 pm

As I woke up this morning BBC Radio 4 was telling me the very encouraging news that an adviser to Barack Obama has questioned his policy on biofuels. I can find no reference to this story on the Web, but Obama’s website still leads its entire discussion of energy with a speech made in Des Moines, Iowa, capital of the corn belt. For some reason the BBC suggested the policy was to win votes in Illinois. I wonder whether they’ve muddled the two states: won’t Obama win Illinois anyway, being already senator for that state, and isn’t it Iowa that is famous for being corn-country? Though corn does grow in Illinois, too.

Anyway, apparently the adviser is a university professor and has pointed out that ethanol from corn does not reduce greenhouse gas (“GHG”) emissions because of all the inputs to produce the crop. He also noted that it displaces soya-growing from USA which leads to more GHG emissions if it is then grown in areas of virgin forest.

At this point I realised that my arguments about biofuels may be going over people’s heads. Not because it’s such a high-falutin’ line of reasoning. But because, owing to short-comings of the education system (more on this astonishing story in due course), not to mention the political process and processes of public discourse, the average decision-maker or influencer is no better than a drunk lying in the gutter, in terms of the analytical tools they are able to deploy.

Much as I want to get on and discuss the other aspects of my agenda to save the planet, I realised, while waking on a rapidly warming day of a sticky British summer (which, fortunately, inductive reasoning suggests is likely to last only a few days more), that I would have to spell out even more carefully how the issue is not just one of biofuels displacing crops into virgin forests. Such displacement is fairly inevitable, but even if it didn’t happen – let’s say the total global area of land being used for agriculture declines even as we produce more biofuels – then there is still the question of what you could do with the land instead of growing biofuels. A point people seem to find extraordinarily difficult to grasp. Sigh! I have a case of the Biofuel Blues. It’s Too Damn Hot, as someone once sang.

A small amount of progress has been made in thinking about how to deal with global warming (henceforth “GW”). A book discussing “Kyoto2” is due out this week. George Monbiot (and I believe Mark Lynas) is enthusiastic so I looked at the web summary of the idea (if the book is out a few days early, as often happens, I’ll buy it today so I can sit under a tree out of the heat and read it!). The idea represents considerable progress. It advocates a supply-side solution, that is, restrictions on the production of fossil fuels rather than just their consumption. Correct. Targeting emissions alone will not in itself keep any oil, coal and gas in the ground. Much better to limit the amounts that are dug up, or pumped out. And, in conjunction with a supply-side solution, Kyoto2 advocates the use of existing market mechanisms – i.e. the price of oil etc. – to try to influence the whole global economy. Good work.

I too have been thinking along these lines. I too would like to treat the world as one global economy. I’ll comment when I’ve read the Kyoto2 book, but one problem is that we can’t do this. Unfortunately, as I’ve outlined, and even revisited once already, states and trading blocks distort the global economy. Massively. This has to be taken into account. I look forward to reading Oliver Tickell’s book to see if he’s done this.

But here’s what really baffles me. Why, oh why, does everyone advocate short-term – often annual targets for emissions? GW is a long-term problem. Any solution must be resilient through booms and busts, even wars. That’s why I’m Abebooks best customer right now for books on financial crises! If we’re going to try to solve GW through the price of commodities, such as oil, then we have to take account of the fact that demand and supply and hence commodity prices naturally fluctuate considerably.

GW is a long-term problem. Hold that thought.

Back to biofuels. Almost everyone analyses the problem in terms of the annual emissions of growing biofuels. So they consider the displacement of food crops onto other land as a short-term problem. This is fundamentally the wrong way of looking at the problem.

The last time I penned this argument I had Winnie the Pooh talking to Piglet about “100 Hectare Wood”. Very witty it was too, and highly topical just now, since the EU has banned the “acre”. (Sad, but maybe one less unit conversion to worry about). But then I got worried about whether or not Disney Corporation would be happy about a lengthy spoof on their “intellectual property” and wimped out of posting it. (I’ll leave it to another time to discuss whether we actually want a world where our rights to reference our cultural heritage actually are or should be allowed to be restricted in such a way).

The point is that if we have an area of land – say 100 hectares – we could use it to grow trees or we could perhaps use it to grow biofuel crops. The one is the opportunity cost of the other. If you do an MBA (and I recommend you do, since they are clearly not actually teaching how our society works in schools), one of the things you will learn is that for any investment project you have to tally up the costs and benefits of doing it and the costs and benefits of not doing it and compare the two. You may want to compare a number of alternatives.

For example, a project to manufacture widgets may make use of a factory already owned by the company you work for. You might mistakenly base your business case for manufacturing widgets on the cost of the factory being zero. If you did that, though, you would be sadly disabused of your opinion by your company accountant. It would be such a howler that he might even verbally abuse you as well.

Even if you weren’t charged for the factory space through internal company cost control processes you would still have to include in your business case a benefit in the alternative project of not manufacturing widgets. For the sake of argument this benefit would be the rental value of the factory through the period over which it is proposed to manufacture widgets. It is quite plausible that once the opportunity cost of renting the space to someone else is taken into account, it would make little business sense to use the factory to manufacture widgets. It might be much better to simply rent it out. This is the way you have to “run the numbers”. It is elementary.

In an MBA of course, costs and benefits are considered in cash terms. But we can do the same thing with carbon.

We could either grow biofuel crops on our land or we could simply leave it alone and trees would grow. Carbon would build up in the soil because it is not being ploughed. There would be other benefits, aesthetic and practical. All these benefits are positive to the project of not growing biofuel crops. Remember, to work out if the project makes carbon business sense we’re going to compare the two projects – growing biofuels and not growing biofuels – in fact, just as in the example of manufacturing widgets, we will have to subtract any benefits of not growing biofuels from the case for the project to grow biofuels.

When we correctly evaluate the case for growing biofuel crops it is a no-brainer. We could either grow crops for 100 years or grow a forest over that time. Even allowing for the possibility of fire, we can, on average, expect a hectare of forest to store at least 100 tonnes of carbon after 100 years. Once we allow for the energy costs of production, fertiliser and so on, it turns out that, in temperate regions, you will not be able to grow enough biofuel crops on a hectare of land to displace a tonne of carbon emissions a year. Nowhere near.

In tropical regions the case for growing biofuel crops also needs to be assessed in this way. I suspect, though, that, once realistic figures are used for the benefits of allowing forest to regrow (my 100 tonnes/hectare is a deliberately low figure, since the argument against growing biofuel crops in temperate regions is so strong there’s no need to make any potentially contentious assumptions), and for the carbon stored in forest soils, compared to the likely depletion of soils used to support annual biofuel crops, and for the value of water retention and maintained biodiversity, once all these figures are put together, the argument for growing biofuel crops will be seen to be remarkably weak.

This argument is developed further in my Biofuel papers.

I’m hoping that Obama doesn’t have straw for brains and won’t follow the yellow brick road being built by the corn ethanol lobby. Like that of the Wizard of Oz, their vision is an illusion. (Oh, sorry about the plot spoiler!).

Damn, I was hoping to end there, but now I remember I wanted to highlight two policies from Obama’s website:

Expand Locally-Owned Biofuel Refineries: Less than 10 percent of new ethanol production today is from farmer-owned refineries. New ethanol refineries help jumpstart rural economies. Obama will create a number of incentives for local communities to invest in their biofuels refineries.” [I won’t digress now – I’ll explain why “rural economy” is a contradiction in terms some other time].

“Confront Deforestation and Promote Carbon Sequestration: Obama will develop domestic incentives that reward forest owners, farmers, and ranchers when they plant trees, restore grasslands, or undertake farming practices that capture carbon dioxide from the atmosphere.”

Here’s a way out, Mr President-in-waiting (careful with the triumphalism, mate, we had a guy called Kinnock over here once, you may have heard of him). I’m not entirely unfamiliar with the political imperative to find ways to allow your constituency to have their cake and eat it. Here’s my advice: make it a no-brainer for land-owners to choose the second set of incentives over the first. That way you may still be able to tell everyone just what they want to hear! Isn’t politics great?

It’s hot – this flat wasn’t built for today’s climate so woe betide the poor wretch who has to live here in 50 years time. I’m going for a swim. Right now.

July 25, 2008

Reflections on Reflections on Oil

Filed under: Economics, Energy policy, Global warming, Markets, Oil price — Tim Joslin @ 6:49 pm

My piece yesterday was never intended to be the finished article.  My goal is to outline a solution to global warming that might prevent the human race destroying the natural world and many members of our own species.  A solution based on how the world is, will, I suggest, be superior to one based on how we would like the world to be.

But I now realise that, lengthy though it was, Reflections on Oil omitted a few points that might be vital to understanding the jigsaw.

Cycles within Cycles

As I write, oil is down 10% from its peak a week or two ago, much to the relief of stock markets around the world.  Is this the turning point marking the end of what I yesterday termed the First Oil Demand Shock?

Who knows?

The trouble is, that, like fleas (which, famously, have little fleas upon their backs to bite them…), markets have long cycles, short cycles, and everything in between.  Each cycle has its own cause, possibly in the “real” world, and may be reinforced or damped by positive and negative feedbacks.  The time element is crucial.  In the UK we see today that, though oil is down, the price to the domestic energy consumer is still going up.  If we’ve seen the oil peak, the price rises yet to be passed on represent more inflation, which could cause higher interest rates, which will reduce economic activity, which could cause the price of oil to overshoot on the way down…

On the other hand, oil might shoot up again.  I wrote a few days ago that the issue of Iran has not gone away.  As I recollect, the talks last weekend gave Iran a couple of weeks to show some movement in its negotiating position.  As many commentators have observed, there’s also a dangerous window between the US presidential election and inauguration.  Particularly if Obama wins.

Then again, I suspect China to have put off any steps to slow its economy until after the Olympics and maybe even to have over-bought oil to avoid any possibility of losing face during the event.

The puzzle deepens because we know that markets know about these factors.  Risks may or may not be fully discounted.

The whole point (as this New Scientist article bleedin’ obviously notes – subscribers only I’m afraid, but it’s worth reading to see that the authors and presumably sub-editors don’t actually know what moral hazard is!) is that any asset is only worth what someone is prepared to pay for it, regardless of its “theoretical” value, so prices are largely determined by the untamed animal that we call the market.

But I don’t believe anything – even the market – is as random as Taleb seems to insist.  Turning points in markets are difficult to predict, but nevertheless we know they will happen.  Prices must, by definition, peak or trough eventually.  Many smart commentators knew the UK housing market was overbought going into 2007, even if the average punter couldn’t detect the signal in all the (often self-interested) noise.

Lumpy oil supply and consumption

The patterns, albeit grossly simplified, that I suggest will (in the event of a lack of or the ineffectiveness of steps to avert global warming) appear in the data of future oil consumption and and hence price, are a result of the effect of nation states on the market.

I never cease to be amazed by the capacity of people’s sense of entitlement.  One might argue that windfall profits (beyond those necessary to incentivise the companies involved) from the extraction of natural resources should accrue not to individual states but be used for the benefit of the whole of humanity.  One would not get very far.  It is the small number of oil-producing countries which allows oil to be rationed to everyone else.  Now that these countries are wealthy, they have little need to compete amongst themselves for the oil market.

I mentioned demand-destruction yesterday, but we should also reflect on how the high profits from oil have led to a global search for new supplies.  But a large proportion of these new suppliers are already oil-producing countries.  Sure, there are pockets of oil and gas being found from Israel/Palestine to Australia, but the new frontier of the Arctic is controlled by Russia, Norway, Denmark and Canada.

Only a few oil-deficit countries, including the US and Brazil, can boost oil-production.  I’m an environmentalist.  I think it should all be left in the ground.  The rest of the world must be wondering, though, why it is only now that the US is prepared to remove restrictions on offshore drilling.  People must be thinking they can’t want it that much if it’s worth less than a few polluted beaches.  Which tends to imply oil could ultimately get a lot more expensive yet.  The US certainly, and likely Brazil too eventually, will soon be able to consume any additional oil they pump.  So, in terms of reducing the long-term oil price increase, it won’t be enough to delay the Second Oil Demand Shock for very long.

As I explained yesterday, this will eventually push up the oil price to extreme levels.

The argument is not changed by the fact that, over time, the population of oil-producing countries will rise, partly because their wealth will permit larger families than otherwise and partly through migration both of the wealthy and of cheap labour, as we see from Dubai to Alberta.  The population increase will simply cause an ever-increasing proportion of oil to be consumed near where it is produced.  George Monbiot laments the fact that:

“The UK’s entire climate change programme is based on a statistical artefact. The only reason our pollution appears to have declined is that we have outsourced our emissions. A fair account of our carbon emissions would include those we import minus those we export: a balance that can only worsen in a post-industrial economy.”

But if some of our highest emitters (F1 racing drivers, say) move to Dubai while we are still able to watch them on TV and British companies continue to profit from their work, then surely that migration also represents an outsourcing of our emissions.

The whole plan is daft.  The idea of rigid emission targets for specific geographical areas (aka countries) is deeply flawed, especially when the rate of reduction of emissions that is proposed is conceivably less than (highly variable) annual rates of migration and changes in trade.  And totally especially when much of the world is outside the trading system!  Doh!

Effect of New Technologies

Today’s Guardian reports on wind power in China.  This is encouraging, but however much wind and solar power is produced it will not in itself keep the fossil-fuel in the ground. We’ll simply use more energy.

And what’s more the price of oil could continue to rise.  There are (at least) two reasons for this:

– cost and price are separate concepts.  The excellent blog post (but where’s the sequel?) I referred to yesterday asked:

“Is there a limit to how high the prices can go? Yes, the price of alternatives. If say solar energy is available for $200 a barrel equivalent of oil, then the price of oil will stabilize at $200 a barrel.”

Just because the cost of production of, say, the production of solar power drops, this will not drive down the price of oil.  If there is not enough energy available in total, then the lucky owners of both the solar power and the oil (as well as those of other sources of energy), will continue to make large profits. (Which will encourage more entrants into the energy market until it once again becomes a buyer’s market – but this could take an indefinite amount of time, impossible to determine in advance).

– oil is a complex product.  Some uses of oil, e.g. to power aircraft cannot easily be replaced with the use of electricity (although this may be possible in the long-run).

There is no real limit to how high the price of oil could rise relative to other goods.  Even if the cost of a plane flight exceeded the median annual salary by many times, some could still afford to fly.  And money is just a way of allocating resources.  We could simply end up with more super-rich people who can afford to fly while the rest of us are stuck on the ground.

Governments distort the economy

Not only do we have a lumpy global economy, we also have huge distortions caused by the bizarre willingness of governments to manipulate prices and engage in all manner of subsidies.  I quoted an FT article yesterday which included the quite staggering statistic that “officials recently estimated [India’s] subsidy bill… at $60bn.”   That’s likely of the same order as they spend on health or defence.  Unbelievable.

Lest anyone think I’m singling out India, I recently came across this FT article which gives some impression of the full horror of China’s currency misalignment.  What this means is that vast resources are being mis-allocated.  That is, millions of jobs have been created which may not be viable in the long-term.  I suspect this will not end prettily.

And in the UK the government now – yes, I’m afraid it’s true – encourages the creation of jobs for which (to maintain a reasonable standard of living) it is necessary to have people pay negative taxation (“tax credits”).  More on that another time.

Against this background we have to deal with the problem of global warming.  Tricky.

July 24, 2008

Reflections on Oil

Filed under: Economics, Energy policy, Global warming, Markets, Oil price — Tim Joslin @ 4:52 pm

I once visited an art installation which consisted of a pool of oil maybe 10m long by 5m wide at about 1.25m high. It was indoors and still, so, at the angle you looked at it, the reflection was near-perfect. Apart from a few dust motes on the surface it was like a supernatural (using the word in the sense made popular by the late Lyall Watson) mirror onto the world.

Let’s see what light reflecting on oil can shed on the current economic turbulence.

My thoughts on the price of oil were prompted by a piece “Welcome to a world with $500 oil” by Willem Buiter at the FT (non-subscribers may not be able to view Buiter’s blog) a week ago. I was away from a computer, made some notes, lost them, and now I’ve found them again. So here goes…

If you’re not living on a desert island you will be aware that we are witnessing “demand-destruction” at current oil prices around $130 a barrel. How, you may wonder, could reputable economists predict a price of $500/barrel?

To answer this question we’ll have to explore the pathologies of the global economy. In short, when it comes to oil, the global economy is being severely distorted. The price you pay at the pump is not simply a result of supply and demand for oil around the world. Yes, we’re all connected in one global economy. But the global economy is as imperfect as the image seen in a fairground distorting mirror. The actual price of oil to consumers in (say) the developed countries is a result of political decisions, exchange rate manipulation and subsidies, in short government interference conducted on a colossal scale.

Now, in trying to prevent global warming, effective solutions will have to rely on market-forces. Perhaps, before proceeding, we need to consider how well our market is actually operating.

We live in a complex world, but let’s consider three classes of nation state:

– the “developed” (I hate this term) countries, in particular the EU and US – those who either are or can be expected (from 2012) to attempt to meet Kyoto-style consumption targets;

– the industrialising countries, such as China and India;

– the oil-producing countries, especially OPEC and Russia.

Developed Countries

With oil at $130 we are seeing demand destruction in the developed countries. Probably enough demand destruction to cause a cyclical downturn in the price of oil. As such cycles always overshoot, my bet is that we will see $50 oil again at some point in the next few years. Of course, once we have made efficiency improvements (in particular more mpg), consumption will increase again, since driving will be good value once more.

But this demand-destruction is only happening because governments are (by and large) making sure consumers pay the true supply and demand price of oil. In fact, they are even prepared to make consumers pick up the cost of some of the externalities of oil use by imposing fuel duty. Carbon-trading, where it is applied, represents an attempt to ensure consumers pay for the global warming externality.

Oil well and good.

Industrialising Countries

These countries do not, in general, pass on the full cost of oil to consumers. In India, for example, heating oil is subsidised. The price of oil doesn’t increase only far enough for consumers to change their habits. The government has to feel the pain and then impose a price rise on an unhappy population.

Not only that, but the currency of many countries is artificially pegged to the dollar.

Digression: Trade Imbalances Cause Credit Crisis AND Oil Spike

Here’s some food for thought. For years the Jeremiahs* have been warning us about trade imbalances. Now I just wonder if this isn’t an underlying cause of both the credit crisis – since the real problem was the cheap loans, partly made possible by the need to invest trade surpluses, which drove house prices up in the first place – and the oil price rise (and commodity inflation). What is happening in the world today, I suggest, is that – looking for gold at the end of the development rainbow – many people are doing work for much less than its true economic value. Many are being exploited and living in appalling conditions on low wages. But for other occupations in the same economy – say IT work in India, white-collar jobs carried out by the burgeoning Chinese middle class – consumption patterns are approaching those in developed countries. Such workers cost much less in dollar terms not because they are more efficient than the developed country competition (likely they are less efficient) but because they are in a “developing” country. In short, they benefit from the vast army of cheap labour.

Cheap Labour and the Cause of Trade Imbalances

Here’s my proposition:

1. Exploitation lowers costs indirectly for developing country exporters. It’s not that the IT worker in Bangalore is directly exploited. It’s the exploitation of the guy living on a few dollars a day who brings the lunch to the IT worker’s desk which allows the IT worker in Bangalore to undercut the IT worker in Basingstoke.

2. The inefficiency in labour terms of making the IT worker redundant in Basingstoke in order to employ two in Bangalore to do the same job allows the developing country to build up a trade surplus.

3. The problem would be much reduced if the IT worker in Bangalore had to pay the UK price for petrol. If it’s subsidised (or even if there is less duty and/or carbon tax included in the retail price) he will be able to consume more relative to the value of what he produces. The trade surplus allows more oil to be consumed than would otherwise be possible. [Actually India wisely allows the rupee to float, so doesn’t have an overall trade surplus. The argument applies insofar as India has a massive trade surplus in IT services].

How Developing Countries Will Cause the Next Oil Price Spike

I mentioned that many developing country currencies are pinned to the dollar allowing trade surpluses to be maintained, albeit at the cost of some inflation. Surely if the currencies were allowed to appreciate then developing countries could afford even more oil? Well, yes, they could as long as they were able to maintain their trade surpluses.

Here’s the problem for developed country consumers. If developing countries (China, you know who you are!) break the dollar peg (i.e. allow their currencies to appreciate) they will be able to push up the price of oil (at the expense of some loss of exports).

If they maintain their trade surplus (by keeping their currency low) they will be able to push up the price of oil, until the trade imbalances becomes unsustainable. Without currency movement this will happen in the worst case when developed countries are unable or unwilling to service their debts, but before then when they are unable to borrow or borrowing becomes too expensive. Recognise anything yet?

One problem is that the developed countries such as the UK and US seem to be happy to nationalise private debt either directly (Northern Rock, Fannie and Freddie) or indirectly by tax-giveaways and budget deficits. The wrong policy in my opinion, but let’s not digress too much.

The conclusion is that because of their trade surpluses and unwillingness to pass the true supply and demand cost of oil onto consumers, the developing countries will be able to push the price of oil up well beyond today’s levels. Many scenarios are possible, but here’s a likely one. Once demand-destruction in the US in particular pushes the cost of oil down to around $50, it will bounce because of demand from China and India, in particular, which will continue to increase even as the developed countries move away from oil. Until…

All this is a colossal mistake of course, because, in a short-termist rush to develop, economies are being created that are not only highly inefficient (in labour terms) but also reliant on limited supplies of energy. If we continue on this path, then somewhere along the line this inefficiency will be exposed, and there will be economic meltdown on the scale of the fall of the Soviet Union or the Great Depression.

Maybe the developing countries could push oil to $500/barrel, but there are other players in the market.

It gets even worse.

The Oil Producers

Now, here we have a real problem.

Oil producers get free money.

It’s only in the last half-century or so that countries have not had to work for resources. The security guarantees of the present world order, coupled with the voracious global appetite to consume, provide unparalleled riches without the burden of corresponding military expense.

Oil producers get free money.

They give oil (and money) away to keep their population happy. This raises the price of oil by reducing the amount available for export, that is, the supply to consumers in importing countries.

They have built up huge sovereign wealth funds (SWFs). They practically have more money than they know what to do with. More to the point, the larger the SWF, the more the oil-producing country can afford to consume each year. The process is cumulative.

Venezuela is giving away oil for political influence.

The Gulf states are building colossal cities. Building these consumes oil. The cities are unlikely to promote efficient use of oil, because it’s cheap in these countries. And worst, these projects, even if they could not be justified without the surplus capital from oil revenues, create industries and put money in the hands of their populations, leading to still more oil consumption.

Now, the oil producers only judge they need so much money from exports.

Here’s the screamer: the higher the oil price, the lower proportion of their oil the oil-producing countries will tend to export.

I see I should have written this blog post a week ago, since a comment on Willem Buiter’s blog makes a similar point, referring to a blog from India (hi over there!).

So over a period of decades there is a massive positive feedback in the system.

I suggest we’re witnessing only the First Oil Demand Shock, as consumers in “developed” economies are forced to cut back on their use. I suggest the most destructive in human terms will be the Second Oil Demand Shock when those countries who are currently building economies reliant on affordable oil are forced to cut back their consumption. If I had to guess I’d expect this Shock in about 2020. The Third Oil Demand Shock will be a long drawn-out affair when one by one the oil-producers are unable to maintain the profligate lifestyles of their populations and are afflicted by the Curse of Oil.

Unless of course we think in the meantime of some way of keeping the stuff in the ground.

* I wonder whether the language police have ruled this usage (“doleful prophet or denouncer of the present age”, Concise Oxford Dictionary 7th edition, 1982) ideologically unsound for some reason, since it doesn’t appear in Wikipedia, the Wiktionary or dictionary.com. Sorry if anyone’s offended.

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