May 31, 2011
Peak Oil and Economic Contraction
What is Peak Oil?
- World Crude oil production has increased exponentially, climbing eightfold since 1950. However, from 2005 to the current day, production has effectively reached a plateau of 72-74 million barrels a day (1). This leveling or ‘peak in production’ has occurred despite record oil prices and demand (2).
- Instances of finite natural resource extraction tend to follow a curve similar to a bell curve, whereby the cheapest, easiest to obtain resource is used first on the upside of the curve (3). The expensive, hardest to reach resource is obtained on the downside of the production curve, post peak.
- Oil companies have moved decisively into high risk locations in order to maintain the current level of global oil supply (4),(5),(6).
- Peak US oil discovery was in the 1930s. US peak oil occurred 40 years later in the 1970s. Peak GLOBAL oil discovery occurred in 1965 (7). We are currently discovering one barrel of oil for every four that we burn.
Oil and The Economy
- The Economy (the Global Gross Domestic Product or GGDP) is always a function of available energy. Economic growth generally requires an increase in available energy.
- Capitalism, the world’s primary economic paradigm, is dependent on growth. Without growth there is not the incentive to invest or to lend. Therefore, capitalism requires ongoing increases of available energy, year after year.
- Oil is the master energy resource, for which there is no ready substitute, and currently has a hand in virtually every single dollar of GGDP.
- The global demand for oil and GGDP are therefore mutually dependent. The Economy and the global demand for oil are so intricately linked that for simplicity here I will refer to them as DEMAND.
- By definition, peak oil means that the SUPPLY of oil cannot be increased, and thereafter the supply is destined to decline. Again, this issue is seperate and distinct from the absolute number of barrels of oil that are still left in the ground.
- When SUPPLY is capped, the economic implication of any upward DEMAND pressure is a sharp rise in PRICE. High oil prices place strong downward pressure on economic growth. Extremely high prices cause economic contraction (11).
- The total of allUSdebt (government, business and consumer) is now somewhere in the neighborhood of 360 percent of GDP. Never before has theUnited Statesfaced a debt bubble of this magnitude.
- Sovereign debt is also now moving into uncharted waters with US Government Debt about to eclipse US GDP (12).
- Many economies around the globe are in a similar or worse debt position than the US – notably Japan, Greece, Iceland, Italy, Ireland, UKand Portugal (13). These ‘greater than GDP debt scenarios’ will become unsustainable when the long-term projected rate of economic growth falls beneath the cost of capital (the average interest rate on existing debt). The cost of new debt will rise until creditors refuse to underwrite the ongoing interest payments with more debt (14).
- Economic contraction causes unemployment and consumers to earn less. This results in an increase in debt default, causing further contraction and stressing bank balance sheets. Defaults and fear of default then curb lending further and reinforce the credit reduction cycle – economic contraction. As debtors scramble to sell any and all assets to service or reduce their existing debt exposure, a downward spiral of asset prices result.
- Cascading debt failure and asset price reduction then becomes ‘self-feeding’ and could easily result in a full blown deflationary crash until equilibrium is reached. Asset prices would only stabilize when the supply of credit falls to a level that is reasonably collateralized to the surviving creditors.
Thoughts on increasing resilience to Peak Oil and
- Risk reduction. An economic contraction will almost certainly punish high risk investments first and hardest. The flight from risk will then spread thoughout the entire stock market including ‘blue-chip’ stocks. Bonds with less than investment grade are likely to be hit hardest but even AAA ratings may not provide haven from the fear of default.
- Debt reduction. Debt will be more of a burden in a deflationary environment. The less debt you have the better.
- Precious Metals are widely considered a good hedge against debasement of currency and monetary inflation and will likely be less affected than other asset sectors during a deflationary crash.
The Truth about the US Economy
The U.S. economy continues to stagnate. It’s growing at the rate of 1.8 percent, which is barely growing at all. Consumer spending is down. Home prices are down. Jobs and wages are going nowhere.
It’s vital that we understand the truth about the American economy.
How did we go from the Great Depression to 30 years of Great Prosperity? And from there, to 30 years of stagnant incomes and widening inequality, culminating in the Great Recession? And from the Great Recession into such an anemic recovery?
The Great Prosperity
During three decades from 1947 to 1977, the nation implemented what might be called a basic bargain with American workers. Employers paid them enough to buy what they produced. Mass production and mass consumption proved perfect complements. Almost everyone who wanted a job could find one with good wages, or at least wages that were trending upward.
During these three decades everyone’s wages grew — not just those at or near the top.
Government enforced the basic bargain in several ways. It used Keynesian policy to achieve nearly full employment. It gave ordinary workers more bargaining power. It provided social insurance. And it expanded public investment. Consequently, the portion of total income that went to the middle class grew while the portion going to the top declined. But this was no zero-sum game. As the economy grew almost everyone came out ahead, including those at the top.
The pay of workers in the bottom fifth grew 116 percent over these years — faster than the pay of those in the top fifth (which rose 99 percent), and in the top 5 percent (86 percent).
Productivity also grew quickly. Labor productivity — average output per hour worked — doubled. So did median incomes. Expressed in 2007 dollars, the typical family’s income rose from about $25,000 to $55,000. The basic bargain was cinched.
The middle class had the means to buy, and their buying created new jobs. As the economy grew, the national debt shrank as a percentage of it.
The Great Prosperity also marked the culmination of a reorganization of work that had begun during the Depression. Employers were required by law to provide extra pay — time-and-a-half — for work stretching beyond 40 hours a week. This created an incentive for employers to hire additional workers when demand picked up. Employers also were required to pay a minimum wage, which improved the pay of workers near the bottom as demand picked up.
When workers were laid off, usually during an economic downturn, government provided them with unemployment benefits, usually lasting until the economy recovered and they were rehired. Not only did this tide families over but it kept them buying goods and services — an “automatic stabilizer” for the economy in downturns.
Perhaps most significantly, government increased the bargaining leverage of ordinary workers. They were guaranteed the right to join labor unions, with which employers had to bargain in good faith. By the mid-1950s more than a third of all America workers in the private sector were unionized. And the unions demanded and received a fair slice of the American pie. Non-unionized companies, fearing their workers would otherwise want a union, offered similar deals.
Americans also enjoyed economic security against the risks of economic life — not only unemployment benefits but also, through Social Security, insurance against disability, loss of a major breadwinner, workplace injury and inability to save enough for retirement. In 1965 came health insurance for the elderly and the poor (Medicare and Medicaid). Economic security proved the handmaiden of prosperity. In requiring Americans to share the costs of adversity it enabled them to share the benefits of peace of mind. And by offering peace of mind, it freed them to consume the fruits of their labors.
The government sponsored the dreams of American families to own their own home by providing low-cost mortgages and interest deductions on mortgage payments. In many sections of the country, government subsidized electricity and water to make such homes habitable. And it built the roads and freeways that connected the homes with major commercial centers.
Government also widened access to higher education. The GI Bill paid college costs for those who returned from war. The expansion of public universities made higher education affordable to the American middle class.
Government paid for all of this with tax revenues from an expanding middle class with rising incomes. Revenues were also boosted by those at the top of the income ladder whose marginal taxes were far higher. The top marginal income tax rate during World War II was over 68 percent. In the 1950s, under Dwight Eisenhower, whom few would call a radical, it rose to 91 percent. In the 1960s and 1970s the highest marginal rate was around 70 percent. Even after exploiting all possible deductions and credits, the typical high-income taxpayer paid a marginal federal tax of over 50 percent. But contrary to what conservative commentators had predicted, the high tax rates did not reduce economic growth. To the contrary, they enabled the nation to expand middle-class prosperity and fuel growth.
The Middle-Class Squeeze, 1977-2007
During the Great Prosperity of 1947-1977, the basic bargain had ensured that the pay of American workers coincided with their output. In effect, the vast middle class received an increasing share of the benefits of economic growth. But after that point, the two lines began to diverge: Output per hour — a measure of productivity — continued to rise. But real hourly compensation was left in the dust.
It’s easy to blame “globalization” for the stagnation of middle incomes, but technological advances have played as much if not a greater role. Factories remaining in the United States have shed workers as they automated. So has the service sector.
But contrary to popular mythology, trade and technology have not reduced the overall number of American jobs. Their more profound effect has been on pay. Rather than be out of work, most Americans have quietly settled for lower real wages, or wages that have risen more slowly than the overall growth of the economy per person. Although unemployment following the Great Recession remains high, jobs are slowly returning. But in order to get them, many workers have to accept lower pay than before.
Starting more than three decades ago, trade and technology began driving a wedge between the earnings of people at the top and everyone else. The pay of well-connected graduates of prestigious colleges and MBA programs has soared. But the pay and benefits of most other workers has either flattened or dropped. And the ensuing division has also made most middle-class American families less economically secure.
Government could have enforced the basic bargain. But it did the opposite. It slashed public goods and investments — whacking school budgets, increasing the cost of public higher education, reducing job training, cutting public transportation and allowing bridges, ports and highways to corrode.
It shredded safety nets — reducing aid to jobless families with children, tightening eligibility for food stamps, and cutting unemployment insurance so much that by 2007 only 40 percent of the unemployed were covered. It halved the top income tax rate from the range of 70 to 90 percent that prevailed during the Great Prosperity to 28 to 35 percent; allowed many of the nation’s rich to treat their income as capital gains subject to no more than 15 percent tax; and shrunk inheritance taxes that affected only the top-most 1.5 percent of earners. Yet at the same time, America boosted sales and payroll taxes, both of which took a bigger chunk out of the pay the middle class and the poor than of the well off.
How America Kept Buying: Three Coping Mechanisms
Coping mechanism No. 1: Women move into paid work.
Starting in the late 1970s, and escalating in the 1980s and 1990s, women went into paid work in greater and greater numbers. For the relatively small sliver of women with four-year college degrees, this was the natural consequence of wider educational opportunities and new laws against gender discrimination that opened professions to well-educated women. But the vast majority of women who migrated into paid work did so in order to prop up family incomes as households were hit by the stagnant or declining wages of male workers.
This transition of women into paid work has been one of the most important social and economic changes to occur over the last four decades. In 1966, 20 percent of mothers with young children worked outside the home. By the late 1990s, the proportion had risen to 60 percent. For married women with children under the age of 6, the transformation has been even more dramatic — from 12 percent in the 1960s to 55 percent by the late 1990s.
Coping mechanism No. 2: Everyone works longer hours.
By the mid 2000s it was not uncommon for men to work more than 60 hours a week and women to work more than 50. A growing number of people took on two or three jobs. All told, by the 2000s, the typical American worker worked more than 2,200 hours a year — 350 hours more than the average European worked, more hours even than the typically industrious Japanese put in. It was many more hours than the typical American middle-class family had worked in 1979 — 500 hours longer, a full 12 weeks more.
Coping mechanism No. 3: Draw down savings and borrow to the hilt.
After exhausting the first two coping mechanisms, the only way Americans could keep consuming as before was to save less and go deeper into debt. During the Great Prosperity the American middle class saved about 9 percent of their after-tax incomes each year. By the late 1980s and early 1990s, that portion had been whittled down to about 7 percent. The savings rate then dropped to 6 percent in 1994, and on down to 3 percent in 1999. By 2008, Americans saved nothing. Meanwhile, household debt exploded. By 2007, the typical American owed 138 percent of their after-tax income.
The Challenge for the Future
All three coping mechanisms have been exhausted. The fundamental economic challenge ahead is to restore the vast American middle class.
That requires resurrecting the basic bargain linking wages to overall gains, and providing the middle class a share of economic gains sufficient to allow them to purchase more of what the economy can produce. As we should have learned from the Great Prosperity — the 30 years after World War II when America grew because most Americans shared in the nation’s prosperity — we cannot have a growing and vibrant economy without a growing and vibrant middle class.
(This is excerpted from my testimony to the U.S. Senate Committee on Health, Education, Labor, and Pensions, on May 12. It is also drawn from my recent book, Aftershock: The Next Economy and America’s Future.)
Robert Reich is Professor of Public Policy at the University of California at Berkeley. He has served in three national administrations, most recently as secretary of labor under President Bill Clinton. He has written twelve books, including The Work of Nations, Locked in the Cabinet, and his most recent book, Supercapitalism. His “Marketplace” commentaries can be found on publicradio.com and iTunes.
A little real life parable
In 1975 I was an electrician in a foundry. I was working on a machine after the production shift was done and the foundry foreman walked up and asked if he could borrow a pencil. Sure. An hour later I went to the foreman’s office to get my pencil back.
He said “can you find another one. I need this one”. Ok. I got back to the maintenance office and asked for a pencil.
Don’t have any.
I go over to the office building and ask the secratary for a pencil.
“I only have 1. Sorry”
I go to the purchasing agent.
“Sorry” he says, “Dick (accountant) says you guys are spending too much on pencils”.
I go to see Dick.
He starts ranting about pencils and do I know how much we spend on office supplies?
I say, “how much do you suppose it costs for a foreman and an electrician to go looking for a pencil?”
“Get out of my office!”
Dick had a new computer and that allowed him to spend a lot of time thinking up ways to save money.
He had the president’s ear because now he could make himself look good by talking about all the ways he was saving money. In the meantime, the foundry was spending too many hours looking for pencils and it was no longer cost effective to have so many people on the payroll. So we had to farm out some castings to Japan, Taiwan, China…….
Get the picture?
Greed and shortsightedness. Lack of common sense in business. Accountants calling the shots in manufacturing.
Oh, by the way. At that time I had a family of 4 and it cost me $2.62 a week for 100% full medical coverage (excluding prescriptions). I owned a house. I took vacations. I was 25. I liked my job.