The Archdruid Report - Archive

It’s been a long road, but we’ve finally reached the point in these essays at which it’s possible to start talking about some of the consequences of the primary economic fact of our time, the arrival of geological limits to increasing fossil fuel production. That’s as challenging a topic to discuss as it will be to live through, because it cannot be understood effectively from within the presuppositions that structure most of today’s economic thinking.

It’s common, for example, to hear well-intentioned people insist that the market, as a matter of course, will respond to restricted fossil fuel production by channeling investment funds either in more effective means of producing fossil fuels, on the one hand, or new energy sources on the other. The logic seems impeccable at first glance: as the price of oil, for example, goes up, the profit to be made by bringing more oil or oil substitutes onto the market goes up as well; investors eager to maximize their profits will therefore pour money into ventures producing oil and oil substitutes, and production will rise accordingly until the price comes back down.

That’s the logic of the invisible hand, first made famous by Adam Smith in The Wealth of Nations more than two centuries ago, and still central to most mainstream ideas of market economics. That logic owes much of its influence to the fact that in many cases, markets do in fact behave this way. Like any rule governing complex systems, though, it is far from foolproof, and it needs to be balanced by an awareness of the places where it fails to work.

Energy is one of those places: in some ways, the most important of all. Energy is not simply one commodity among others; it is the ur-commodity, the foundation for all economic activity. It follows laws of its own – the laws of thermodynamics, notably – which are not the same as the laws of economics, and when the two sets of laws come into conflict, the laws of thermodynamics win every time.

Consider an agrarian civilization that runs on sunlight, as every human society did until the rise of industrialism some three centuries ago. In energetic terms, part of the annual influx of solar energy is collected via agriculture, stored in the form of grain, and transformed into mechanical energy by feeding the grain to human laborers and draft animals. It's an efficient and resilient system, and under suitable conditions it can deploy astonishing amounts of energy; the Great Pyramid is one of the more obvious pieces of evidence for this fact.

Such civilizations normally develop thriving market economies in which a wide range of goods and services are exchanged. They also normally develop intricate social abstractions that manage the distribution of these goods and services, as well as the primary wealth that comes through agriculture from the sun, among their citizens. Both these, however, depend on the continued energy flow from sun to fields to granaries to human and animal labor forces. If something interrupts this flow -- say, a failure of the harvest -- the only option that allows for collective survival is to have enough solar energy stored in the granaries to take up the slack.

This is necessary because energy doesn't follow the ordinary rules of economic exchange. Most other commodities still exist after they've been exchanged for something else, and this makes exchanges reversible; for example, if you sell gold to buy marble, you can normally turn around and sell marble to buy gold. The invisible hand works here; if marble is in short supply, those who have gold and want marble may have to offer more gold for their choice of building materials, but the marble quarries will be working overtime to balance things out.

Energy is different. Once you turn the energy content of a few million bushels of grain into a pyramid, say, by using the grain to feed workers who cut and haul the stones, that energy is gone, and you cannot turn the pyramid back into grain; all you can do is wait until the next harvest. If that harvest fails, and the stored energy in the granaries has already been turned into pyramids, neither the market economy of goods and services or the abstract system of distributing goods and services can make up for it. Nor, of course, can you send an extra ten thousand workers into the fields if you don't have the grain to keep them alive.

The peoples of agrarian civilizations generally understood this. It's part of the tragedy of the modern world that most people nowadays do not, even though our situation is not all that different from theirs. We're just as dependent on energy inputs from nature, though ours include vast quantities of prehistoric sunlight, in the form of fossil fuels, as well as current solar energy in various forms; we've built atop that foundation our own kind of markets to exchange goods and services; and our abstract system for managing the distribution of goods and services -- money -- is as heavily wrapped in mythology as anything in the archaic civilizations of the past.

The particular form taken by money in the modern world has certain effects, however, not found in ancient systems. In the old agrarian civilizations, wealth consisted primarily of farmland and its products. The amount of farmland in a kingdom might increase slightly through warfare or investment in canal systems, though it might equally decrease if a war went badly or canals got wrecked by sandstorms; everybody hoped when the seed grain went into the fields that the result would be a bumper crop, but no one imagined that the grain stockpiled in the granaries would somehow multiply itself over time. Nowadays, by contrast, it's assumed as a matter of course that money ought automatically to produce more money.

That habit of thought has its roots in the three centuries of explosive economic growth that followed the birth of the industrial age. In an expanding economy, the amount of money in circulation needs to expand fast enough to roughly match the expansion in the range of goods and services for sale; when this fails to occur, the shortfall drives up interest rates (the cost of using money) and can cause economic contractions. This was a serious and recurring problem in the late 19th century, and led the reformers of the Progressive era to reshape industrial economies in ways that permitted the money supply to expand over time to match the expectation of growth. Once again, the invisible hand was at work, with some help from legislators: a demand for more money eventually give rise to a system that produced more money.

It's been pointed out by a number of commentators in the peak oil blogosphere that the most popular method for expanding the money supply -- the transformation of borrowing at interest from an occasional bad habit of the imprudent to the foundation of modern economic life -- has outlived its usefulness once an expanding economy driven by increasing fossil fuel production gives way to a contracting economy limited by decreasing fossil fuel production. This is quite true in an abstract sense, but there's a trap in the way of putting that sensible realization into practice.

The arrival of geological limits to increasing fossil fuel production places a burden on the economy, because the cost in energy, labor, and materials (rather than money) to extract fossil fuels does not depend on market forces. On average, it goes up over time, as easily accessible reserves are depleted and have to be replaced by those more difficult and costly to extract. Improved efficiencies and new technologies can counter that to a limited extent, but both these face the familiar problem of diminishing returns as the laws of thermodynamics, and other physical laws, come into play.

As a society nears the geological limits to production, in other words, a steadily growing fraction of its total supply of energy, resources, and labor have to be devoted to the task of bringing in the energy that keeps the entire economy moving. This percentage may be small at first, but it's effectively a tax in kind on every productive economic activity, and as it grows it makes productive economic activity less profitable. The process by which money produces more money consumes next to no energy, by contrast, and so financial investments don't lose ground due to rising energy costs.

This makes financial investments, on average, relatively more profitable than investing in the kinds of economic activity that use energy to produce nonfinancial goods and services. The higher the burden imposed by energy costs, the more sweeping the disparity becomes; the result, of course, is that individuals trying to maximize their own economic gains move their money out of investments in the productive economy of goods and services, and into the paper economy of finance.

Ironically, this happens just as a perpetually expanding money supply driven by mass borrowing at interest has become an anachronism unsuited to the new economic reality of energy contraction. It also guarantees that any attempt to limit the financial sphere of the economy will face mass opposition, not only from financiers, but from millions of ordinary citizens whose dream of a comfortable retirement depends on the hope that financial investments will outperform the faltering economy of goods and services. Meanwhile, just as the economy most needs massive reinvestment in productive capacity to retool itself for the very different world defined by contracting energy supplies, investment money seeking higher returns flees the productive economy for the realm of abstract paper wealth.

Nor will this effect be countered, as suggested by the well-intentioned people mentioned toward the beginning of this essay, by a flood of investment money going into energy production and bringing the cost of energy back down. Producing energy takes energy, and thus is just as subject to rising energy costs as any other productive activity; even as the price of oil goes up, the costs of extracting it or making some substitute for it rise in tandem and make investments in oil production or replacement no more lucrative than any other part of the productive economy. Oil that has already been extracted from the ground may be a good investment, and financial paper speculating on the future price of oil will likely be an excellent one, but neither of these help increase the supply of oil, or any oil substitute, flowing into the economy.

One intriguing detail of this scenario is that it has already affected the first major oil producer to reach peak oil -- yes, that would be the United States. It's unlikely to be accidental that in the wake of its own 1972 production peak, the American economy has followed exactly this trajectory of massive disinvestment in the productive economy and massive expansion of the paper economy of finance. Plenty of other factors played a role in that process, no doubt, but I suspect that the unsteady but inexorable rise in energy costs over the last forty years or so may have had much more to do with the gutting of the American economy than most people suspect.

If this is correct, now that petroleum production has encountered the same limits globally that put it into a decline here in the United States, the same pattern of disinvestment in the production of goods and services coupled with metastatic expansion of the financial sector may show up on a much broader scale. There are limits to how far it can go, of course, not least because financiers and retirees alike are fond of consumer goods now and then, but those limits have not been reached yet, not by a long shot. It's all too easy to foresee a future in which industry, agriculture, and every other sector of the economy that produces goods and services suffer from chronic underinvestment, energy costs continue rising, and collapsing infrastructure becomes a dominant factor in daily life, while the Wall Street Journal (printed in Shanghai by then) announces the emergence of the first half dozen quadrillionaires in the derivatives-of-derivatives-of-derivatives market.

Perhaps the most important limit in the way of such a rush toward economic absurdity is the simple fact that not every economy uses the individual decisions of investors pursuing private gain to allocate investment capital. It may not be accidental that quite a few of the world's most successful economies just now, with China well in the lead, make their investment decisions based at least in part on political, military, and strategic grounds, while the nation that preens itself most proudly on its market economy -- yes, that would be the United States again -- is lurching from one economic debacle to another.

It is unfortunately also the case that many of the nations that have extracted their investment decisions from the hands of a self-terminating market system are not exactly noted for their delicate care for human rights. If that proves to be the wave of the future -- and it may be worth noting that Oswald Spengler, among others, predicted that outcome -- then the invisible hand may end up giving us all the finger.