Sunday, July 24, 2011

Energy and economics

Since 1970 when my most profound discovery from my first trip to Europe concerned the enormous impact fuel prices had on economic development, I have been dismayed at the trivialization of energy issues in economic discussions.  In USA, energy costs are not even counted in the major inflation indicators like CPI and anyone who brings up energy imports when the subject is the trade balance is treated like someone who cuts a loud smelly one at a fancy party.

Once ones eyes are opened to the energy questions, so much else becomes abundantly clear.  And economic forecasting becomes orders of magnitude easier to to do accurately.  I follow a lot of economic indicators but none is more accurate than the price of gasoline at the local filling station.

When I found this article the other day, I first dismissed it as a low-grade joke.  Did it REALLY require an economics history professor from Cambridge to tell us that the Industrial Revolution was really about lighting more fires in more clever ways?  Well Duh!  But then I remembered there was a time when I just thought of coal as a dirty rock and gasoline as a smelly liquid you didn't want to get on your clothes.  It turns out that if you don't have your arms around energy issues, essays like the following are required reading.

Opening Pandora’s box: A new look at the industrial revolution

Tony Wrigley  22 July 2011

Before the industrial revolution, economists considered output to be fundamentally constrained by the limited supply of land. This column explores how the industrial revolution managed to break free from these shackles. It describes the important innovations that made the industrial revolution an energy revolution.

The most fundamental defining feature of the industrial revolution was that it made possible exponential economic growth – growth at a speed that implied the doubling of output every half-century or less. This in turn radically transformed living standards. Each generation came to have a confident expectation that they would be substantially better off than their parents or grandparents. Yet, remarkably, the best informed and most perspicacious of contemporaries were not merely unconscious of the implications of the changes which were taking place about them but firmly dismissed the possibility of such a transformation. The classical economists Adam Smith, Thomas Malthus, and David Ricardo advanced an excellent reason for dismissing the possibility of prolonged growth. 
Smith and Ricardo as growth pessimists 
They thought in terms of three basic factors of production, i.e. land, labour, and capital. The latter two were capable of indefinite expansion in principle but the first was not. The area of land which could be used for production was limited, yet its output was basic – not just to the supply of food but of almost all the raw materials which entered into material production. This was self-evidently true of animal and vegetable raw materials – wool, cotton, leather, timber, etc. But it was also true of all mineral production since the smelting of ores required much heat and this was obtained from wood and charcoal. Expanding material production meant obtaining a greater volume of produce from the land but that in turn meant either taking into cultivation land of inferior quality, or using existing land more intensively, or both. This necessarily meant at some point that returns both to capital and labour would fall. In short, the very process of growth ensured that it could not be continued indefinitely. This was a basic characteristic of all “organic” economies, those which were universal before the industrial revolution. 
Adam Smith summarised the problem as follows: In a country which had acquired that full complement of riches which the nature of its soil and climate, and its situation with respect to other countries, allowed it to acquire; which could, therefore, advance no further, and which was not going backwards, both the wages of labour and the profit of stock would probably be very low. (Smith 1789) 
He went on to spell out in greater detail what his statement implied for the living standards of the bulk of the population and for the return on capital. When Ricardo tackled the same issue he came to the same conclusion and was explicit in insisting that the resulting situation “will necessarily be rendered permanent by the laws of nature, which have limited the productive powers of the land” (Ricardo 1817). 
The constraint stressed by the classical economists can be expressed differently in a way that highlights the change that transformed the possibilities of expanding output and enabled an industrial revolution to take place. 
Every form of material production involves the expenditure of energy and this is equally true of all forms of transport. In organic economies the dominant source of the energy employed in production was the process of photosynthesis in plants. The quantity of energy which reaches the surface of the earth each year from the sun is vast but photosynthesis captures less than 0.5% of the energy in incident sunlight. 
Photosynthesis was the source of mechanical energy which came predominantly from human and animal muscle power derived from food and fodder. Wind and water power were of comparatively minor importance. Photosynthesis was also the source of all heat energy used in production processes since the heat came from burning wood. 
The implications of this situation in limiting productive potential are clear and dire. The land constraint was a severe impediment to growth. It is epitomised in a phrase of Sir Thomas More. He remarked that sheep were eating up men. An expansion of wool production meant less land available to grow food crops. Or again, it is easy to show that, if iron smelting had continued to depend upon charcoal, a rise in the production of iron to the scale which became normal in the mid-nineteenth century would have involved covering the entire land surface of Britain with woodland. 
Breaking free from photosynthesis 
Access to energy that did not spring from the annual product of plant photosynthesis was a sine qua non for breaking free from the constraints afflicting all organic economies. By an intriguing paradox, this came about by gaining access to the products of photosynthesis stockpiled over a geological time span. It was the steadily increasing use of coal as an energy source which provided the escape route.
It was simple to substitute coal for wood as a solution to the problem of increasing the supply of heat energy, at least where the heat generated by burning coal and the object to be heated were separated by a barrier that allowed the transfer of heat but prevented chemical exchange. 
Coal could, for example, readily be substituted for wood to heat salt pans or dye vats. It could also readily be used as a source of domestic heat in an open fire though it was some time before trial and error gave rise to a chimney which could both improve combustion and evacuate smoke. The early expansion of coal production was largely for domestic use, dominated by the supply of coal from coal pits near the Tyne to London. The east coast coal trade expanded so greatly from Tudor times onwards that by the end of the seventeenth century roughly half the tonnage of the merchant navy was devoted to this trade. But it took many decades of trial and error to enable coal or coke to be substituted for charcoal in smelting iron because the transfer of chemical impurities prevented a good quality result. 
Until the early eighteenth century, coal, although used increasingly by the English, offered a solution only to the problem of supplyingheat energy. Mechanical energy remained a matter of muscle power and was therefore limited by the photosynthesis constraint. Hence the central importance of the slow development of an effective steam engine that made it possible to convert heat energy into mechanical energy. Once this was possible the problem of limited energy supply was solved for the whole spectrum of material production and transport. more
Now back to the energy problems of 2011.
Countdown to $100 oil - a date with history? 
Posted by Euan Mearns on July 11, 2011  
On two past occasions, the average annual oil price has hit $100 per barrel and this has been followed by recession. At time of writing (7th July) the annual average for Brent was $95.4, on course to breach $100 some time in September. Will history repeat itself? Or has the global economy grown immune to high energy prices? 
US regular gasoline prices mirror moves in the crude oil market. The overwhelming desire is to bring gasoline and other energy prices down. But politicians and policy makers must understand that if we see $2 gas in the near future it will most likely be due to peak oil recession #2 and that is not what they want. They must start pointing the finger at themselves. Borrowing and printing money creates demand that drives energy prices up. 
A simple peak oil model 
A simple model that has become popular among bearish peak oil commentators is that high oil prices, caused by growing scarcity of cheap oil, may lead to recession. As consumers spend more on gasoline and other energy services such as electricity and natural gas the amount left over to spend on iPads, wine and vacations becomes less, causing recession throughout non-energy parts of the economy. High energy prices also lead to inflation that in a monetarist world should be squashed by higher interest rates though central bankers seem all too aware now that higher interest rates and high energy prices would kill economic growth in many OECD countries and in so doing drive many major, over indebted, economies toward insolvency. 

Over the course of world history the average annual oil price has peaked to values close to $100 (adjusted to $2009) on only two occasions in 1979 and 2008 (data from BP 2010). On each occasion, deep recessions followed. Is this chance? Or is it the case that the global financial system actually runs on cheap energy and not cheap money? Just three years after the last peak we are once again testing the $100 threshold and it will be intriguing to see if history is repeated. The source of real worry for national governments should be the observation that the cost of producing new oil reserves is fast approaching this notional $100 threshold. Should the cost of adding marginal oil supply ever exceed the price that the global economy can afford to pay, then global oil production will fall as natural declines exceed new supplies. more

1 comment:

  1. Coal Industry would suggest the commodity isn't going anywhere. Coal reports show if we have to live with it, we may as well reduce the impact of coal and CCS seems to be the best solution found to date. Cherry www.coalportal.com While for some an ideal world would see no reliance on coal statistics to produce electricity,

    ReplyDelete