Saturday, January 15, 2011

The Great Debate, continued....?

The great debate lately, at least since the worlds recent financial debacle, is whether we are in for a period of inflation or deflation. There was certainly a short period of outright deflation as the prices of housing, stocks and commodities collapsed in 2009. Most of these prices have rebounded despite many questions about the vibrancy of western economys. There is a debate in some circles about the effect of energy availability on the outcome of this inflation/deflation debate. I believe, as many are coming to believe, that the days of plentiful and cheap oil are coming to an end. The "peak oil" phenomena as forcast by Hubbert 40 some years ago is probably upon us.In the nearer term it will not be about running out of oil so much as it will be the cost of oil. Think of the cost of oil not in dollars, but in how many barrels of oil it takes to get the oil out of the earth. In the early days of oil, the oil gushed up and was there for the taking. That easy oil is gone, and now the new discoveries are in deep water, or in polar regions where the cost of bringing energy to the market are much greater, ie., it takes alot more energy to produce the energy.
 Oil has been, in my view, the single greatest factor in the great rise of industrial production over the last 100 years. And the capital markets are the mechanism that allows society to distribute this energy and to use it. I think that early in the 20th century it became necessary to increase the supply of money to facilitate the distribution and use of this energy. (If you think of a static supply of money/credit then you can see that if someone has a highly useful commodity that can be widely marketed, if money is not created through credit, then soon the suppliers of the valuable product soon have all the money, and no money is left to buy further product.) Credit and lending is how money is created. Periodically the supply of credit gets ahead of the supply of oil/energy and inflation begins to be felt in an economy. This causes interest rates to rise, since moneylenders don't like to lend for less than the cost of inflation. So the economy contracts until the energy supply versus demand is balanced. A look back at the economic recessions and depressions of the last 100 years will lead to this conclusion, that they were the result of a demand/supply imbalance in the energy equation. Certainly in recent memory is the effect of the Arab oil embargo in the 1970's, and the rapid rise in oil prices in the early 2000's. Both of these events resulted in drastic economic slowdowns.
But what happens if/when the supply of cheap oil is constrained. The immediate effect is inflation. Energy costs more and since cheap energy is the basis for all industrial production, costs generally rise. However, this inflation is soon counterbalanced by higher interest rates. This is deflation.

Look at the graph at . "Debt in the United States".
Notice the largest slice of that graph is the light green portion entitled "financial instruments".
This is how money has been created lately. By the expansion of derivitives of other credit products. This is the housing bubble and the securitization of credit. This is how the money was created over the last couple decades. And these derivitives were the result of a long period of low and declining interest rates and low inflation that resulted from low energy prices.
If oil is getting harder to bring to market then the credit markets will have to rein in demand, interest rates will have to rise, and these credit derivitives that were predicated on ever LOWER interest rates will have to disappear. Have you noticed the price of gas lately? If the basic input to an economy costs more, wealth must be diverted to pay for these increased costs. If money is any store of wealth more must be diverted to energy production. This is a slowdown. This is deflation. It may be temporarily disguised as inflation if the money is diluted, and the economy is artificially stimulated to consume even more energy, but ultimately an energy shortage is deflationary. Crash and burn. That is my cheery thought for today. Remember, timing is everthing.

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