If Murphy’s Law ever met 2010, it could literally mean the end of an era that began in the industrial revolution, what will one day be called the industrial age. An age that will be marked by three phenomena: consumption, extreme violence (against humans and the environment), and innovation. The beginning of the 19th Century saw the perfect synthesis of an untapped, virtually virgin planet earth, a scientific culture on the brink of major breakthroughs and a human culture economically organized to create and fulfill unlimited human demand.
As we look back at the post-war era from a post industrial age perspective it will seem like a drunken paradise. Paradise in the sense of being able to quench, at least by the rich, almost any whim or desire, a limitless orgy. Drunken because only an intoxicated society could have been so blind to the destruction it was causing. Even while on the brink of disaster, the wealthy kept on living as if nothing was ever going to happen to them. The Titanic had already hit the iceberg but they refused to believe it. History will not be kind to this generation.
Another, much larger part of the world, looked on in envy and despair, left out of the party, stripped of their natural resources and left broke by corrupt governments and overwhelming foreign debt. They have little to lose and will only cry because of their compatriots who made it to the Promised Land only to suffer along with the rich. The year 2009 will be remembered as the false peace, the year when the rich decided to dive headfirst back into the cookie jar instead of wising up. Who doesn’t sense now that something is very wrong? Remember that feeling of real confidence in the future, like the 1990’s? Does anyone believe that we are really okay? Is there any confidence left in financial, political, or media elites?
There are two terms that will become the catchwords of 2010, and unfortunately they are neither sexting nor iPhone. We will look back nostalgically for the time when we could have the luxury to care about Tiger Wood’s sex life. The two key terms we will have to deal with are Peak Oil and Fractional Banking/Quantitative Easing. People will scream and howl about how our politicians and leaders were so blind, how they did nothing about this, and they will only be denying their own guilt. These concepts have been around for over a quarter of a century, and since the onset of the Internet, widely circulated. We can only blame ourselves. We let this happen, and we must find a solution.
Peak Oil is a concept developed by a Shell geologist M.K. Hubbert in 1956. He correctly predicted that America would hit Peak Oil around 1970. Peak Oil simply means that we have used half of all available oil. If there were, imagine, a total of 1,000 barrels of oil in the ground, when we extract barrel 500, we have reached peak. Below is a graph which describes peak oil. It is impossible to predict exactly when we reach peak because calculations of how much oil is in the ground, and fluctuations in demand either bring it closer, or push it farther out. The time when we reach peak can be debated, but the concept itself is just simple math, not much to argue about.
Why is Peak Oil a problem? Once we hit peak can’t we just switch to solar, wind or even nuclear power? Not so easy. Petroleum is the basis of our entire society: agriculture, transportation, electricity, in short, just about everything we do, eat, wear, consume, listen to or watch is based on cheap and available oil. The United States uses almost as much oil for food production as for driving, not to mention highways, plastics and airplanes.
Once we hit peak, or come very close to it, something dramatic happens. World demand for oil is relatively static. In a major world recession demand might fall two or three percent, but in most cases, especially considering the growth of China and India, world demand for oil will grow about two or three percent a year. Oil is not like caviar, if the price gets too high we can’t stop consuming it. We have to drive to work, heat our houses, eat food that is grown with tractors, shipped by truck, stored in a refrigerated supermarkets that are powered by an electrical grid based in part on oil. Once we hit peak, demand will remain constant, but supply will fall. This means two things. The price will sky rocket and someone will have to go without. Every day that passes there will be less oil available, meaning that prices will continue to rise and more shortages will occur. The geo-political implications are obvious. It’s possible that we have already hit peak oil at 85 million barrels a day, but only time will tell as demand grows again in an expanding world economy.
Not only will our economy unravel, so will our financial system. Human history from the beginning of the industrial revolution and the advent of cheap energy, coal and oil, has had one characteristic that has set it apart, constant growth. Have you ever wondered why the economy must grow? Things aren’t so bad now, so what if they stay the same for a few years? We must grow because our financial system is based on loaning money. Banks loan money to businesses and people at rates in the developed world on average from 5% – 15%. For those businesses, and in turn people, to pay the money back, they must make a return on the money that allows them to pay back the loan, and make a profit. If the economy doesn’t grow it means a lot of bad debt.
Cheap energy has allowed us to grow in away that is unprecedented in human history. It has also allowed us to create a banking system that creates money out of thin air. The fractional banking system permits banks to keep only a fraction of the money they have on deposit and loan the rest, usually they can loan out about 80% or 90%. When it is loaned out, someone spends the money, which is then deposited, and again, loaned out at 80%. Eventually, the original deposit is multiplied by 5 in a system where the bank must keep 20% on deposit. See diagram below.
By lowering the interest rates from which banks borrow money from the Federal Reserve, in the case of the United States, the Fed can encourage banks to loan more money thereby creating liquidity and creating extra money out of nothing. Now, if interest rates go to zero, the reserve banks are not completely out of options. There is something called quantitative easing. This is a term invented by the Japanese as they looked for ways to inject liquidity into an economy that stagnated even with interest rates at 0%. What the reserve banks then do is buy back their own debt from the banks with invented money, ex nihilo. In the case of the United States, the Federal Reserve purchases US government bonds from banks, but not with borrowed money or money raised from taxes, but with ex nihilo, hence the bank will hopefully lend the money and overall money supply will increase.
This sounds like something that should eventually lead to Zimbabwe type inflation. Not necessarily. If the economy grows at a reasonable rate, population grows, etc. the economy needs more liquidity, and so while there is some inflation it can be kept low, combined with growth and things can move on smoothly as they have been for the last 60 years. Cheap energy gave us growth, which let us borrow money, run up big debts, and continue to grow. A few times in the last 50 years it seemed like the end was near. In the late 70’s the US lost much of its inertia and the baton seemed ready to pass to Japan and Europe as the leaders of the world economy. But Ronald Reagan led a remarkable spending spree, running up incredible debt and creating a renewed economic expansion while Japan became mired in an unending stagnation. But even then, after a minor hiccup in the late 80’s and early 90’s, two things extended the debt party.
The cold war ended giving the world a new sense of hope, the first Gulf War a warning sign of what new challenges lay ahead. Peak oil was still 20 years down the road, and Ronald Reagan taught us to live for today, not like that stuffed shirt Carter. And the 1990’s brought with it the information age, a true economic revolution; the United States actually had a balanced budget. While peak oil was beginning to raise its ugly head most people, overwhelmed with technological advances, were convinced that technology could solve everything. In reality, the worldwide economic boom was bringing peak oil ever closer but who could really believe it amidst the splendor of the 1990’s? Then came 9/11 and the dark, violent years that followed. Oil prices began their slow march upward and the markets began to sense the realities of peak oil.
Then the summer of 2008 oil reaches an all time high of $146 a barrel that should bring the world economies to a screeching halt, or at least slow them. We would later find out that we were already in a recession, but it didn’t feel like it. Eight months into a recession with oil prices at $146 a barrel? Then the world financial crisis two months later. Few connected the dots, but they should have.
The connection between peak oil and debt (fractional banking/quantitative easing) is a simple one. Oil means easy economic growth. For banks to loan money with interest, there must be economic growth, if not, the whole pile of debt, close to $60 trillion of it combined public and private in the USA alone, on a GDP of $15 trillion, cannot be serviced. Any kind of minor hiccup and the $3 trillion dollars or so just in interest payments on that debt (assume around 5% average interest) and there is a problem. Tack on the insanity of Wall Street and their derivatives on mortgages with that hiccup, and it is easy to see what happened. We are on a roller coaster and we are reaching the top, the click, click, click is getting louder, the tension is growing. When you feel your stomach turn it will be too late to get off, if it isn’t already.
The panic could hit even before we reach peak. Once this idea reaches critical mass, which it hasn’t yet, it won’t make much difference if we hit peak in 2009, 2010 or 2011. When Peak Oil becomes completely mainstream the speculation will collapse the financial system. I am certainly not the first to connect the dots and begin to shoot off flares. As more and more see the iceberg through the fog, the panic will spread, and it will not be pretty.
What will happen? Shortages, unemployment, social unrest. We will wish guns had never been so ubiquitous in our society. The absurdity of oil shortages, SUV’s, and no viable public transportation in cities like Houston or LA will give them a surreal and apocalyptic air. Politics will actually become a serious business. We will stop paying attention to political/entertainment and turn to the government for food, heat and basic transportation. People will wonder how they didn’t see this coming. How could we spend so many years consuming like there was no end while we worked at meaningless and unproductive jobs pushing paper and selling consumption.
The enormous egos of our public figures and our own not so small ones will take a bashing. We will experience as a country a real economic and cultural decline. The future will be worse than the present for a long time to come. The hangover will be immense and special interest groups that have controlled the media and Wall Street will be in for a rude awakening as old taboos fall by the wayside.
How will this playout? First the US and world economy must begin to recover. Employment will improve; GDP will become positive, people will actually begin to believe we are finally out of the hole. Once there is hope, banks begin to lend all that cash they are sitting on. Real estate will look cheap; there will seem to be big opportunities. That is the moment to cash out. We will see rising inflation, but our Ivy League leaders will tell us it is a small price for renewed hope and employment. Ben Bernanke, in all his Greenspanesque brilliance and his Robert Rubin appointed Wall Street cronies in Washington have injected so much liquidity into the economy that once it begins to circulate and be loaned out again the inflationary monster will rise out of control before anything can be done to stop it.
The spending and greed orgy has been described in detail in many places, lets just look at one part. The Fed has bought close to 85% of all new mortgages issued in the United States in 2009. This is equal to about $1 trillion, or about 6% of GDP. Imagine when that $1 trillion becomes $5 trillion, what will happen to inflation? And no rest for the weary, all this at a time when 14% of mortgages are either in foreclosure or delinquent, with the numbers sure to be worse in 2010. Great investment Ben!
How did the Fed raise so much money? Taxes? I think not. They made it up, out of thin air and it will multiply in a heated economic environment. How many times? How quickly? Nobody really knows. If this were the only problem, we would survive. But this is not it. As world oil demand begins to increase again after the major world recession, we will find that it can’t be met. Peak oil will hit just as we reach runaway inflation. Could this happen in 2011, or the even more poetic 2012? Maybe, but grant me one moment of artistic license. When Time magazine made Ben Bernanke man of the year in 2009, I knew in my bones it had to be 2010.
Hopefully I will be writing a long piece before New Year’s Eve in 2010 on why none of this happened. But just in case it does, make sure you really enjoy this one. Happy New Year!
This essay is for my very good friend Jim Horky, a Doomsayer par excellence. May all your puts be in the money in 2010. Thanks for all your help and I will be in touch soon. Happy New Year!