EC Why Energy-Economy Models Produce Overly Optimistic Indications

I was asked to give a talk to a committee of actuaries who are concerned about modeling the financial future of programs, such as pension plans, given the energy problems that are often discussed. They (and the consultants that they hire) have been using an approach that puts problems far off into the future. I was trying to explain why the approach that they were using didn’t really make sense.

Below are the slides I used, and a little explanation. A PDF of my presentation can be downloaded at this link: The Mirror Image Problem.

FCAS stands for “Fellow of the Casualty Actuarial Society”; MAAA stands for “Member of the American Academy of Actuaries.” Actuaries tend not to be interested in academic degrees.

I try to explain how a more complex situation can be hidden in plain sight.

It is not obvious that both the needs of energy producers and energy consumers should be considered.

If we look back at what the discussions of the time were, we can see when remarks were that prices were too high for consumers, and when they were too low for producers. See for example my article, Oil Supply Limits and the Continuing Financial Crisis and my post, Beginning of the End? Oil Companies Cut Back on Spending. This latter article shows that companies were already cutting back on spending in 2013, when prices appeared to be high, because even at a $100+ per barrel level, they still were not high enough for producers.

Oil companies tend to extract the cheapest and easiest to extract oil first. Eventually, they find that they need to move on to more expensive to extract fields–even with technology enhancements, costs are rising. There seems to have been a step up in costs starting about the year 2000. The above chart is by Steve Kopits. This EIA data (in its Figure 10) also shows a pattern of sharply rising costs about the same time.

The problem, of course, is that wages have not been spiking in the same pattern. As a result, we encounter the problem of prices being either too high for consumers, or too low for producers, as we saw on Slide 4.

The economy is “built up” from many different parts. It includes governments, businesses, and consumers. It also includes people with jobs in the economy, and individuals and businesses making investments in the economy. It gradually changes over time, as new businesses and new laws are added, and as other changes are made. The wages that workers earn influence how much they can spend. The economy keeps re-optimizing, based on the goods and services available at a given time. Thus, slide rules are no longer commonly sold; it is not easy to buy horse-drawn carriages. This is why I show the economy as hollow.

Let’s talk a little about how economic growth occurs in a networked economy.

Clearly, tools and technology can be very helpful to creating economic growth. I am using the term “tools” very broadly, to include any kind of structure or device we build to aid the economy. This would even include roads.

Making tools clearly requires energy. Operating these tools very often requires energy as well, such as energy provided by diesel or electricity. With the use of tools, humans can more efficiently make goods and services. For example, if small parts need to be transported to a business, it is nearly always more efficient to transport them by truck than to deliver the parts by walking and carrying these parts in our hands. Clearly, tools such as trucks also allow us to do things that we could never do otherwise, such as deliver large and heavy parts to users.

Economists often talk about “rising worker productivity,” as if this rising productivity came about because of actions undertaken by the worker–perhaps attempting to work faster. Another possibility would seem to be taking a course on how to work more efficiently. We would expect that most of the time this rising productivity would come about as a result of the use of additional tools, or better tools. Thus, it is really the tools, and the energy that they use, that are acting to leverage worker productivity.

It is not intuitive that adding tools requires debt, unless a person stops to realize that it generally takes quite a bit of resources to make a tool (human labor, plus metal ores and energy products). Using these tools will provide a benefit over quite a long period in the future. A business making these tools has a problem: it must buy the resources to make the tools and pay the workers, before the benefit of the tools actually comes into existence. It is necessary to have debt (or a debt-like financial instrument, such as shares of stock), to bridge this gap.

This same kind of mismatch occurs, even if goods being purchased with debt are not really tools. For example, a home purchased with debt and paid for with a mortgage is not really a tool. The buyer needs to pay interest to a bank or some other intermediary, in order to finance the home over a period of years. Thus, part of the worker’s wages is going to the financial system, rather than to obtain the goods and services he really wants. Financing the home with debt is generally more convenient than paying cash, however. Because of the convenience factor, debt is generally essential for most home purchases. If a new home is being purchased, the builder who builds the home will need to buy lumber and pay workers when the house is built, rather than over the lifetime of the house. Because of this, debt is necessary so that the builder will have the funds to buy lumber and pay the workers.

Analysts coming from engineering and other “hard sciences” often miss this need for debt. Since a person can’t see or touch it, it is easy to think it isn’t needed. Interest payments are important, because they transfer goods and services made by the economy away from workers to other sectors of the economy (such as the financial system, retirees, and pension programs). Thus, they represent a different use for energy products, other than making goods for the use of workers.

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Gary Anderson 1 year ago Contributor's comment

Fascinating article to say the least. Interesting for me, the point about the impossibility of jubilee. Clearly though, a mechanism has to be established to give taxpayers a reasonable profit on the debt that is created by government. After all, that debt is used as gold by insurance companies, pensions, banks etc. But that debt being used as gold does require that the economy work. It does require that interest is paid. It does show us that debt as gold in usage as collateral should be paid for by those using it as collateral. Debt is so valuable as collateral that taxpayers should be compensated and they are not adequately compensated. I don't mean that interest rates should be higher, just that some value should be placed on bonds that reflects their value to Wall Street and to the financial system. That is not happening now.

Also, author's point about labor is important. Trump says he wants better paying jobs, but he is undermining labor in almost every decision he is making. He undermines their social security, medicare, health insurance, public schools. Labor is not treated with the respect it deserves. Capitalists need labor to buy their stuff. And pretty soon, if that demand goes away, if effective demand limit is reached per Edward Lambert, there won't be capital formation. Then the author of this article could be proven right. There was always the outlet of war, but now that road leads to mass nuclear destruction.

Wall Street needs to think more about this stuff. Hiding money is just one more tearing at the fabric of society. And certainly hiding money gets you elected president of the USA now. That is a sign of ultimate destruction of prosperity, not the enhancement of it.