Oil Limits Reduce GDP Growth; Unwinding QE A Problem

We know the world economic pattern we have been used to in years past–world population grows, resource usage grows (including energy resources), and debt increases. The economy grows fast enough that paying an interest rate a little higher than the inflation rate “works” for both lenders and borrowers. Borrowers are able to handle the required interest rate, because their wages are rising fast enough to buy homes and cars at prevailing interest rates. Unemployment is not too much of a problem because jobs grow with population and resource usage. Governments do fairly well, too, because they can tax the growing wages of the population sufficiently to get enough taxes to pay the benefits they have promised to constituents.

This model “works” fairly well, as long as the economy is growing fast enough–population continues to grow and resource extraction continues to grow as planned. In a finite world, we know that this model cannot work forever. At some point, we can expect to start reaching limits.

What do these limits look like? I would argue that in the case of resource extraction, these limits look like increasingly high cost of extraction. We need to extract resources from increasingly deep locations, in increasingly out-of-the way places, using increasingly more energy intensive techniques. For a while, improved technology is sufficient to keep costs down, but eventually the cost of extraction begins to rise. Some of the rising cost may even be taxes, because the country where the extraction is located needs higher taxes to keep a growing population properly fed and housed, so they do not rebel and disrupt production.

When the cost of extraction begins to rise, it is as if we are pouring more manpower and more resources of many types (steel, fracking fluid, jet fuel, electricity, diesel fuel) into a deep pit, never to be used again. When we put more resources in, we get the same amount of resource out, or even less than in the past. If we want to continue to increase the amount we extract, we have to further increase the quantity of resources used in extraction. I have referred to this issue as the Investment Sinkhole problem. Obviously, if we put more manpower and other resources into this pit, we have less for other purposes.

A recent example of resources hitting limits is oil. World oil prices started increasing about 2004 (Figure 1). Analysts say that James Hamilton found that 10 out of 11 United States recessions since World War II were associated with oil price spikes of 25% or more.

What Goes Wrong in the Expected Model, When Oil Prices Remain High?
In the first paragraph of this post, I outlined an expected model of how the world might operate, if economic growth remains high. Slower economic growth would be expected, if resource limits start having an impact on economic growth.

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What happens if oil prices remain high? I think the answers is fairly different for businesses, compared to consumers. Businesses can mostly shake off the impact of higher oil prices, by cutting back on the amount produced (and thus cutting the number employed), or by shipping production to a lower cost part of the world (again cutting back the number of US workers employed), but workers don’t have the benefit of making changes of these types. They can drop out of the workforce and apply for government benefits, but this does not really fix their lack of jobs, and the low growth in wages for those who do have jobs.

Because wages of workers are still adversely affected, even years after an oil price rise, and because the cost of goods now reflects the higher price of oil, consumers continue to find that their budgets are stretched. Some can afford to purchase a higher-mileage automobile, but most cannot–their budgets are still stretched, and some have dropped out of the work-force completely. The government can try to cover up this situation with artificially low interest rates for homes and cars, and with higher transfer payments using deficit spending. Unfortunately, the government programs don’t really fix the underlying problem, namely a lower percentage of the population with jobs, and wages of those with jobs not rebounding by much. Because there is no real fix for the underlying problem, the economy doesn’t really bounce back.

Quantitative Easing, and the Unwinding of Quantitative Easing
One way the government hides our current financial problems is with quantitative easing (QE). QE lowers longer-term interest rates, such as those that affect the price of mortgages. QE also lowers the interest rate the government pays on its own debt, helping to government to have closer to a balanced budget. The lower interest rates tend to increase stock market prices, and to raise prices of homes2 and farms, because investors seek investments that provide better yields than the absurdly low rates available on bonds. This doesn’t really fix the underlying problem, either.

The government can also try to induce banks to lend more money out, but if buyers don’t have high-paying jobs, it becomes increasingly difficult to actually get the money available for lending into the hands of potential buyers. Waiting for several years doesn’t really fix the situation either–the accumulated deficit just gets worse, and the bubbles blown by QE become larger. None of this fixes the underlying problem of high oil prices.

If the government tries to back off from QE, we will see longer term interest rates rise. This will make mortgage rates rise, and cut back on the number of buyers of homes. Rising interest rates are likely to bring back the problem of falling home prices, and reduce the number of new homes built. Car sales may also fall, as interest rates on loans for new cars rise.

The suddenly higher interest rates are likely to make the stock market fall, because with higher yields, bonds will become more attractive investments in comparison to stocks. As interest rates rise, the value of bonds can be expected to drop as well, because this is the way bonds are priced–the higher the available interest rate, the lower the resale price of the bond.

The declining values of stocks and bonds, and for that matter, houses, is likely to be a problem for citizens, because they will realize that their savings are worth less. The “wealth effect” will work backwards. People will realize that they are poorer than they were before, and spend less.

The decline in the value of stocks and bonds is likely to be a problem for banks, pension plans, and insurers–and for that matter, any kind of institution holding large amounts of stocks and bonds. The exact impact will depend on the accounting rules for the particular institution. If market value is used for stocks and bonds, institutions holding them will show large capital losses, perhaps putting them below regulatory limits.

Part of the capital losses may be covered up by special accounting rules, such as allowing bonds to be valued at amortized cost rather than market value. But there may still be an adverse impact on capital, possibly putting some institutions below regulatory limits. Also, if an institution needs to sell a bond or stock that is valued on its balance sheet for more than it is really worth, it will incur a loss.

The removal of QE will also mean that the interest rates the government pays on its own debt will rise. This is will push up needed tax rates, putting further pressure on the consumer.

With lower asset values and higher tax rates, debt defaults are likely to become more of a problem again. Banks may cut back in lending as well, especially if their capital ratios fall too low.

The Effect on Oil Prices
With values of most investments dropping lower and tax rates rising, my concern is that the sales price of oil will drop lower, causing a severe cutback in world oil production. This issue is really one of affordability of oil. Economists would call this inadequate “demand” for oil. Of course, people will still need to eat food and need oil for commuting, but this doesn’t come into economists’ definition of demand–demand is only how much people can afford, not what they need.

So we really are in a quandary. If oil prices stay high, recessionary effects can expect to continue for oil importers. In addition, China, India, and other developing countries are increasingly becoming oil importers, so they themselves can increasingly expect to be affected by high oil prices. Furthermore, these same countries find demand for their manufactured goods is reduced because of economic problems of the Eurozone, Japan, and possibly the US.

If oil prices drop, they will be too low for oil companies to make new high-cost investments. A drop in oil production will take place gradually, as existing wells continue to produce, but new ones are not added. The impact of this lower oil production may be quite severe. The collapse of the Former Soviet Union in 1991 seems to have been caused by too low oil prices. All countries are likely to be affected by this drop in production–importers because the lack of availability of oil for import, and exporters because of the lack of revenue from oil exports.

Even if we sail through our current set of problems, we can count on meeting them again in a few years, because the cost of oil extraction can be expected to keep increasing. If oil prices rise again, oil importers are likely to see a large increase in unemployment, and a squeeze on profit margins of businesses. Banks may again fail. Government will face a new round of problems, similar to those in 2008, or even worse, without having fixed their previous set of problems.

Notes:
[1] Acronym for Portugal, Italy, Ireland, Greece, and Spain, the countries in Europe with the most financial problems in the past few years.

[2] Many of the buyers for houses are institutional investors, planning to rent the houses out.

Written By: Gail Tverberg