Continuing in this theme of the economy, if money = energy, then what are some of the consequences in terms of economic phenomena? Here is an interesting consequence of this thesis in the realm of finance.
Why do we borrow money?
The typical answer today is that we (private citizens) borrow so we can spend and consume. We buy houses. We buy cars. Both are big ticket items that require years, or months in the case of cars, of labor to accumulate the cash needed, so we turn to financing. We borrow the cash from a lending institution (the term bank is so yesterday) to cover our payment, less some nominal down payment from our savings, and agree to pay the loan back over some amount of time. That is we expect to earn enough extra cash in the future to pay down this loan plus the interest the lender charges for the service. This has certainly sounded reasonable and has pretty much worked in the past.
But then we got into borrowing on smaller ticket items. Unlike houses and, to a lesser degree cars, these items might not have the longevity factor. That is, they might not have a useful life long past the term of the loan. Entertainment electronics and even computers fall in this category. These are have to have items. Worse, they are often seemingly obsolete in a time not much longer than the loan term! Indeed, in some people's minds some items need replacing before the term is up!
What about corporations and other institutions? Why do they borrow? According to the nice sounding myth of capitalism, when a firm sees an opportunity to expand its activities, but has not been able to garner enough investment capital, or finds itself short of cash, it turns to a lender. The presumption is that the borrowed money will be invested wisely, end up producing more revenue than would have otherwise been the case and thus more revenue in excess of costs. Thus the firm can repay the loan with interest and still make a profit. It can grow its equity as well as its capital assets. Makes a great story and looks good in text book print.
It actually works as far as this picture goes, when the parties are honest and frugal. I know because I took out loans from time to time to purchase equipment and modify production lines to allow my company to expand production and sales. It really does work if you manage it carefully.
But as the current debt crises, in all of its various forms, shows, something is amiss with the above picture. Both people and companies (many of both, anyway) are not borrowing for the good reasons stated above. They're borrowing to make quick, huge, profits or to support an image they don't deserve. They are speculating.
In various times past this scheme has actually worked for the first ones in. They speculate on houses or some other asset driving the prices up. Everyone sees the prices going up and there is a rush to get into whatever market handles that asset. The bubble expands and at some right time the smart money sells off, the bubble collapses and the late comers are left holding the devalued assets with egg on their faces. But, as I have pointed out in previous blogs, the only reason this hasn't resulted in complete economic chaos is that we have been pumping more energy into the economy each year. When energy influx is growing you can afford some number of really stupid mistakes. That is changing rapidly.
What are we doing when we borrow?
If my assertion that money = energy is right then we need to look at what is going on energetically when we borrow. Energy production is a process of converting fuels into useful forms of kinetic energy such as electrical or mechanical power. Production grows as more fuels per year are added to the economy. Under ordinary circumstances some of the fuel is stored (also water behind a dam is stored energy) meaning that it is not yet into transformation to kinetic form. Ultimately there is untapped fuel in the ground as a big reservoir or so-called reserve. The problem with this latter reservoir is that we don't have really good ways of telling how much is actually recoverable economically. We make our best guess based on geological data and past experience. It's too bad we can just dip a measuring stick down a hole and read off how full the reservoir is.
Our experience over time has been that, first, we continued to find new reservoirs in the past, and, second, we continued to increase the rate of extracting the fuels. Again, with the money = energy theory this means there was always an increase in the supply of money to reflect the increase in the supply of oil, with minor exceptions during oil embargoes and such. Wealth was always growing. We simply got into the habit of thinking that that was the natural order of things and that it would always grow. Incidentally, this argument doesn't just apply to the industrial age. Ever since humans started supplementing their energy inputs with agriculture, wood burning, etc. we have been increasing wealth. But it really took off in the early 19th century with the increased uses of coal, oil, and natural gas. Growth of wealth seemed a given, it was fun, it was exhilarating, and it had many truly good benefits for civilization.
Under those circumstances it isn't hard to see why people thought borrowing was OK. What you were doing, in effect was betting on the future availability of more energy. The above ground reserves could supply more energy on a short-term demand basis as long as new fuels were being extracted at a greater rate to replenish. The economic activities that resulted from the borrowing — building more houses, more cars, more of everything, and innovation, could be viewed as simply improving our ability to use energy in the future (remember by energy I also mean money). This would especially be the case for the creation of true wealth, what I call tools (see What is money, really?).
But two things happened to make this neat picture not so neat any more. First we got cocky. Innovation became a purpose unto itself. We started wanting non-essential stuff and advertising help us believe we need it. We started investing (and hence borrowing) more in frivolity, luxury, and oversized everything. Money might not have grown on trees but it sure was easy to pump more out of the ground. We spoiled ourselves and even though there have been a number of thoughtful people who warned us against these excesses we have largely ignored them or their claims, indeed we have ridiculed most of the most vocal proponents. So we have been borrowing against tomorrow to pay for nonsense today.
The second thing that happened is we didn't notice the turning point when the marginal rate of oil and natural gas exploitation started negative. Most of us didn't even want to believe it would ever come to that. And with the distortions that exist in the use of money to represent energy the economy as measured by things like GDP were very insensitive to the shift. Economic indicators gave no explicit signals that something fundamental had changed. But then economics was based on insufficient, and sometimes wrong, theory.
Now we have come to an interesting juncture. It appears rather certain that we have reach a plateau of production for oil world wide. This plateau is the short time scale view at the top of Hubbert's peak. Oil production is no longer able to keep up with demand and we have pumped all the easy stuff out of the ground. What is left takes increasingly more energy to extract meaning the net energy gain is in decline. The bottom line (sad pun intended) is that we have less energy available in the economy and hence less real currency (regardless of the printing press). This is the fundamental cause of inflation. Things cost more because there is less energy to support the work we want done.
What about all that borrowed money that we haven't paid back yet. Surprise! We are going to be making less money because there is less energy in storage so will have increasing problems paying it back. Paying back a loan always depended on there being more real wealth in the future. If there is going to be less in the future then how will we be able to pay back our debts? We can't. And note that neither can the government.
I think Shakespeare had it basically right in Hamlet: "...neither a borrower nor a lender be." Of course the application may be a little different than his intention, but it sums it up nicely. If there will be an increase in energy in the future then borrowing prudently can often be helpful. But if there is to be less energy available then just what are we borrowing against?