What's wrong with this picture?

Or, why isn't the economy doing what Ben Bernanke wants it to?

The melt-down of the economy (US) has everyone wondering what is going on. It wasn't that long ago that economists and pundits were claiming that they didn't expect a recession, or if we got into one it would be shallow and short lived. Just this morning, in the New York Times, Paul Krugman admits that there is now common talk of a long and deep recession.

Twenty years ago when I wrote about the idea that we had it all wrong in our thinking about what money is and what it really means, naturally economists were not just dismissive, they told me I was crazy. Now, it is common knowledge that the cost of energy is contributing to inflation. But the pundits still try to explain what has happened (they can't really predict what is going to happen) using the arcane and just-plain-wrong theories from classical economics. They still think the dollar-measured value of oil (yesterday it went over $110 a barrel) is the relevant measure.

One way to approach this issue is to ask: What is a monetary unit, in reality?

Here is the kind of analysis (greatly simplified) that might help us understand this better and lead us to an answer. Consider the production of an electronic gadget — a widget in economeese. Let's just see where the cost elements come from. This hypothetical is highly simplified, but it isn't too far off the mark. I reconstructed the numbers (and proportions) from my days running an electronics design and manufacturing company in Southern California. So the numbers are roughly in the ballpark. [Also forgive any math errors - I did this at 4:00am! - it's the concept that counts.]

Cost of production (consumer electronic widget):

Cost of production (consumer electronic widget):
Materials                   $  500.00
Labor                       $5,000.00
Overhead (allocated)        $  100.00
Energy                      $   50.00
Transportation              $   10.00
-------------------------------------
Total Costs                 $5,660.00

Energy as percent of total:      .88%

If energy is such a small percentage of total costs, why worry about a mere 200% increase in the cost of oil over the last decade? Hell, energy is still cheap, right? Some economists say so.

But there is a problem. Let's start with Materials costs. We might think that we are paying for just physical material, right? Matter. But the reality is quite a bit more complicated.

Mining/Smelting/Forming Operations (proportioned):

Labor                       $  200.00
Equipment depreciation     $    1.00
Overhead                    $    2.00
Energy (to run equipment)   $   50.00
-------------------------------------
Total cost of mining        $  253.00
Profit                      $   30.00
-------------------------------------
Price                       $  283.00

Energy as percent of cost:        20%

And suppose we add up the average costs of parts manufacturing.

Materials                   $  283.00
Labor                       $  100.00
Overhead                    $   10.00
Energy                      $   55.00
Machinery depreciation      $    5.00
-------------------------------------
Total costs                 $  453.00
Profit                      $   47.00
-------------------------------------
Price                       $  500.00

Energy as percent of cost         12%

Total energy costs rolled up  $155.00

This is still only 2.4% of the total costs. Right? Well, what about labor? This one requires a much greater depth of analysis than I can fit in here, but just think about some basics. Consider the food eaten (energy) by the average worker. Consider the transportation costs to get the average worker to work (energy). Consider the cost of keeping the house warm in winter, cool in summer (energy). Now, it goes even deeper. For example, consider the work that was done in making the house (amortized over the life of the house, but nevertheless an energy input). Consider the work done to make the car. Consider the farm work needed to grow the food. And then consider that every one of the workers in this lower level have exactly the same energy needs as the workers at each of the above activities.

In other words, if you look carefully enough at all of the factors that go into making it possible for a worker (farm, blue collar, white collar, or no-collar) to work you will soon see that the above product is sitting atop a massive energy pyramid. We could perform the same analysis for equipment used in manufacturing, mining, and transportation of the goods. We get the same picture. Fundamentally, all of the work that goes into producing that one product is based on energy in one form or another. In the end, one can argue that nearly 100% of the cost of making the widget is energy.

Now, what is the effect of doubling the basic cost of energy? In the end everything is affected. It takes time for the cost increases to ripple through the economy. They are felt differently by different industries at different times. It isn't a single smooth curve. But it is inexorable. Over time, the costs will percolate upward driving everything from bottom to top up in dollar measures.

What causes the cost of energy to go up? And why does this impact the purchasing power of a monetary unit, say the dollar? The first one is ultimately very simple to answer. You have to use energy to get energy. The same analysis as above applied to, say, an off-shore oil drilling rig, or to the cost of exploration, or the cost of mining coal, will produce the same picture. The more machinery and labor that it takes to get the raw fuel, the more it takes to refine or process the fuel, the more equipment and anti-pollution measures you take to clean up the emissions and the environment (due to the release of toxic stuff in the fuel when burned), the more energy it takes to get the stuff in the first place. As the sources of oil are depleted and it takes more effort to get the same volume of fuels the energy it takes to get energy goes up as well.

In the end we have less net energy available for consumption as we labor on to make our widgets. The very same argument, by the way, holds for service industry work. And it is net energy that counts.

In an era in which the finding and extracting of easy to reach fuels was the norm, the net energy actually increased from year to year. As it did it could support a growing amount of work. The economy could expand and more people could enjoy more stuff, like widgets. Energy was cheap. For a while, it even grew cheaper in terms of the amount of energy it took to return a given unit of new energy. In monetary terms, and this helps to answer the second question above, we watched as dollars could buy more goods and services over the long-run. The period after WWII saw the most incredible expansion of the extraction of easy to get oil and natural gas (and coal too). Right up until sometime in the nineties we enjoyed the creation of unheard of wealth (well if you call SUV's wealth — I call them pseudo-wealth). And then things started to change. Overall energy production started to decelerate. That is, while still growing, its marginal rate of growth declined. This was an ominous sign. It portended something really different from what we had gotten used to.

In fact, I would argue that the debt crises we are experiencing is really due to a mismatch between expected growth in wealth production and actual growth due to energy limits. By attempting to pump more oil from very expensive (in energy terms) wells and expecting there will be even more in the future, we have borrowed, literally, against that future just at a time when everything is changing.

Eventually, if not already, the peak of energy production will arrive (see a summary of oil production here. That is, the gain in net energy will go to zero and, sometime thereafter, decline. We will be living in a world in which the value of our monetary units will go down. Inflation will increase at increasing rates until widgets' dollar price will be unreachable. This is inescapable save for some miraculous technology that can create energy out of... I'll save that question for another posting. Meanwhile we have bought a lot of stuff (expended energy in the past) with the expectation that there would be more energy in the future, not less. The energy deficit that we are realizing and the monetary deficit that we now face are linked.

Here is a not-so-simple-to-implement solution to our lack of understanding economics. Let a dollar equal a fixed number of energy units, say British Thermal Units (BTUs). Instead of a gold standard — remember you can't eat gold — we adopt an energy standard. More technically correct, we adopt a free energy standard. Free energy is what physicists call the energy available to do useful work. Not all energy qualifies. Think of the heat radiating from your home; it isn't able to do any work, but it is a lot of energy. A free energy standard says that there can be no more monetary units in circulation than there are units of stored and readily available units of free energy. This standard would already take into account the energy needed to obtain the stored energy. One of the beauties of this proposal is that the measure of amount of energy is fairly unambiguous. There is a standard unit of measure that is well defined. I remember that I started to think about this after reading something in Paul Samuelson's classic Introductory Economics (back in the 70's!) in which he noted that money is a lousy measuring tool, much like trying to measure a physical distance using a rubber yardstick. I guess this is one reason some folks prefer the gold standard. What Samuelson meant was that while it might be lousy in a physical sense, it was good enough for government work, literally. But what Samuelson and most other economists didn't know or understand is that there was a force pulling at both ends of that rubber yardstick that kept building a measurement error into every measurement act. Now we are going to see what happens when that force is removed — the yardstick will return to its earlier length.

A free energy standard would have unbelievable consequences for the way an economy works and how we understand that working. It would literally turn it into a system akin to the natural ecosystem where energy is the obvious currency. Spending would take on a whole new meaning. Borrowing would too. Most of all the price of everything we buy/sell would reflect the true value of things. Moreover, we could know the future value of owning things by virtue of knowing how much energy they could consume in the future. It would be an easier decision to make regarding the purchase of that widget if we knew that it's operation consumed so many BTUs per time unit. We see a basic start on this trend in looking at automobile mileage figures or refrigerator efficiency ratings. In that same vein we would have a good idea of how much it would cost to replace the item. In an age of diminishing energy we would be able to put a truer time value (discount rate) on things, knowing that they will cost more in monetary terms.

Right now everything is distorted in the economy. Economists can't really tell you what to expect because we are now operating in a different energy regime than when they developed their so-called economic laws. Things just don't work as they're supposed to under those laws. There is no small amount of head scratching going on in Washington and academia right now.

It is possible that the current crisis is just a temporary phenomenon. This kind of situation has happened before and has had similar effects in terms of the economy not working as advertised (remember stagflation during Jimmy Carter's administration). Historically we've survived and things seemed to return to normal. Maybe that will happen again. But the only way it can happen is if someone, some genius, somewhere invents the most stupendous energy production source ever imagined. Because that is what it is going to take to get us out of hot (forgive the pun) water now and return us to what we have thought of as normalcy in the future. Don't hold your breath, but if you are a believer, maybe pray.

Comments

[Trinifar]

"What causes the cost of energy to go up? And why does this impact the purchasing power of a monetary unit, say the dollar? The first one is ultimately very simple to answer. You have to use energy to get energy."

Your emphasis on net energy is spot on, to use the Brit phrase. And the comparison between a gold-standard and a free-energy standard is exactly what mainstream economists should be responding to.

[George Mobus]

Thanks Trinifar.

I am working a bit more on the idea of pegging monetary units to energy units. I'd like to do some work on how a 'shadow' accounting system might work to identify costs in energy units. Several ecological economists, Daly, Costanza, et al, have done some work along these lines. I will have to investigate where they stand on it.

George