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« What is market regulation - really? | Main | What is wealth - really? »

March 28, 2008

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Constantine

George,

How do you reconcile your view that money=energy with the fact that oil prices have risen 6 fold in the past few years but the economy has continued to grow (until possibly recently)?

Certainly a given unit of money corresponds to an ever changing amount of energy.

But even our national income seems only loosely related to the cost of energy. If the cost of all energy inputs doubles, does the economy collapse? Actually, it may not even shrink.

Additionally, if the economy is not really that sensitive to the cost of energy (which is quite volatile) why introduce a massive instability into the system by pegging a currency to the historically very unstable cost of energy?

It's been a while since I dug into things economic but I remember reading stuff on the theory of money in my salad days. It's complex stuff. One thing that money attempts is to arbitrate across very different and often conflicting assessments of value. Truth is, nothing has a fixed value from an objective standpoint, certainly not energy, not water, not gold. Nothing. Yet we desire -- in our ceaselessly changing universe -- a stable store of value and means of exchange. Thus we create and rely on that problematic abstraction called money.

Robert

There is nothing wrong with borrowing as long as the total amount of debt does not exceed a certain percentage of GDP and the borrowers are economically viable entities. The present credit crisis is not so much the result of peak oil as the result of the fact that too much money was loaned out in total. The problem was further aggravated by the fact that money was loaned to people and companies (even governments) who should not be taking out any loans as their economic capacity to repay these loans did not exist in the beginning. These factors are independent of any slowing economic activity due to resource constraints (peak oil). The great JP Morgan, when asked, what is the essential characteristic of creditworthiness, emphasized the character of the person applying for the loan. There is some truth in that statement.

There will be borrowing in the post peak world. In fact, no economy can function without credit. Suppressing borrowing is equivalent to suppressing savings. Without borrowing, savings do not make sense. An economy without savings and borrowing that's even more primitive than what was practiced in the former Soviet Union.

George Mobus

I'm sorry if I left the impression that all borrowing is wrong. And I agree that borrowing against savings is legitimate.

However, the rest of your comment seems to come straight from the economics text books. Perhaps you missed the premise of the money = energy upon which this blog was based. If that premise is true, then there is no real decoupling between energy deficits (as when peak oil causes diminishing energy availability) and the consequences of borrowing against a future that doesn't come. Your statement, "The present credit crisis is not so much the result of peak oil as the result of the fact that too much money was loaned out in total." is actually what I am talking about. More money was loaned than there is energy backing those loans.

And, as far as GDP being used as a measure of anything real, I've already covered that issue. Anyone still using GDP as a measure of economic activity is currently scratching their heads wondering what is happening.

George

George Mobus

Constantine,

"How do you reconcile your view that money=energy with the fact that oil prices have risen 6 fold in the past few years but the economy has continued to grow (until possibly recently)?"

It depends on what you use to measure growth. Commonly economists talk about growth in terms of year over year increase in GDP. As I covered in my What is money post, monetized measures are currently so skewed and distorted that it is nearly impossible to really know what has been happening. The expansion of sales in consumer goods and services over the last five or six years appears now to have been funded from debt. There has been no real growth per se, so no reconciliation is needed.

"Certainly a given unit of money corresponds to an ever changing amount of energy."

It does under current conditions. But that is exactly the problem. Depending on efficiency factors in different kinds of work the amount of energy being consumed is always the same. When you drive your car it burns roughly the same amount of gasoline on average, with variations depending on driving speed, conditions, etc. But the amount of energy you use is a stable, relatively fixed number (ave. MPG). So if dollars were pegged on energy content then what you payed at the pump would alway be the same. Of course, with true energy costs completely made visible, that price might be quite a bit higher than it is now.

"But even our national income seems only loosely related to the cost of energy. If the cost of all energy inputs doubles, does the economy collapse? Actually, it may not even shrink."

There are so many distortions in the valuation of currencies right now that it is impossible to answer this question. You can't use the dollar value of oil, for example, to do much projection. It takes time for the increase in dollar costs of oil to propagate through the economy to start affecting the cost of other products. I just read though that a particular fitting (used on an oil rig) made of bronze that used to cost $20 (roughly) now costs $150 due to increased cost of energy needed to mine, smelt, and form the raw materials. If this cost amplification continues throughout the oil industry infrastructure then the overall costs of drilling and pumping oil will escalate making oil even more expensive in dollars. This is called the receding horizon I believe. It is definitely a negative spiral.

"Additionally, if the economy is not really that sensitive to the cost of energy (which is quite volatile) why introduce a massive instability into the system by pegging a currency to the historically very unstable cost of energy?"

Good question. But my proposal is exactly for stopping this phenomenon. The volatility of which you speak is due to the above distortion factors (and several others). The BTU content needed to do the useful work doesn't fluctuate. And the increase in energy costs to extract and pump oil is a relatively smooth function (though it could end up being exponential).

"Truth is, nothing has a fixed value from an objective standpoint, certainly not energy..."

I suspect you mean something different here, but if the above statement were interpreted literally it would disappoint many physicists. The whole point of my proposal is to use the stable nature of energy (a BTU is a BTU today and tomorrow) to stabilize the value of currencies. The gold standard had something of this effect, if only psychologically, but you are right that gold wasn't anything like an ideal standard.

"Thus we create and rely on that problematic abstraction called money."

For now. Actually, if you really dig deeply into the origins of money and accounting you should be able to see a much clearer picture of the evolution of our thinking about money. Its our thinking that is unstable in this system.

We are so used to thinking about measuring commodities like oil in dollars that it is hard to think the reverse way - measuring dollars in energy units.

George

Constantine

Let me rejoin on just a couple of key issues.

George wrote and here is the nub:

"The BTU content needed to do the useful work doesn't fluctuate."

This is false.

It depends crucially on many many factors. Expertise, technology and social organization, for instance, which effect output enormously even when energy inputs are similar. To make the point with an exotic example: the same amount of energy pulsing through Einstein's brain accomplishes something completely different in terms of useful work than than it would in my Saint Bernard's headspace.

But, in general, I can't see how the concept of work as it is used in physics can be usefully applied in general to our economy. The complexities are staggering beyond belief. It seems about as useful as saying it all comes down to atoms. Let's analyze everything in terms of atoms!!!

In addition, don't forget, George that it is now *twice* in the last century that energy prices have spiked by practically an order of magnitude without causing anything like a proportionate downturn in output. We have substantial evidence that economies can absorb energy shocks. And it's not all debt. Other economies are growing without dept levels rising despite stagnating oil production.

I'm not an economist but I would suggest that you run your ideas past your colleagues that are. Peak oilers seem to be constantly attempting an end run around economics but it can't be done!!! :-) How monetary value is assigned to goods and services in our society many be imperfect but it is a highly nuanced process sensitive to many factors that don't vary in concert with *commercial* *marketed* energy.

Commercial marketed energy is only a fraction of what it takes to make the economy tick. I accept peak oil, but as far as I can see, it's actually many of my fellow peak oilers that are scratching their heads about GDP because by their lights it should have collapsed!!! :-)

Constantine

One added note:

Back in the mid 80s when I took a few econ courses the profs attempted to drill into us some key concepts regarding money.

One is that money (in any form) is tricky. The public generally has little clue and is subject it all kinds of money illusions.

You seem to have a craving for the concrete. But economists have known for a while now that there is much that is not concrete about money in any form (despite what the gold miser thinks). And this is, in some ways, a *good* thing. It makes society more resilient. Because the strength of the currency is based not on a single feature like the oil in the SPR or all those tanks in Cushing, Oklahoma but on our society's aggregate capacity to produce, adapt and survive (and the gov's ability to tax it!).

Constantine

Here's a little more to put some meat on my critique.

Take your example (March 14) of the Consumer Electronic Widget. If energy costs double, what happens?

I could be wrong, but since you state that "nearly 100% of the cost of making the widget is energy", it seems that the conclusion is that eventually the total cost of the widget doubles.

But that doesn't happen. Instead, a number of adaptations occur and efficiencies are found. Labor for instance is likely unable to pass their increased costs along to you, the manufacturer. Their lifestyle changes by dropping some luxury consumption, and wasteful habits, and finding ways to adjust and, when all else fails, make do with less. It's unlikely that work performance is effected much.

Similarly your suppliers, if they think it will hurt business to pass on the increased costs, get to work on efficiency issues. They may transition to less energy intensive processes or swap one form of energy consumption for another.

End result is that the increased energy costs that percolate through the system get spread over many years and a very decent chunk doesn't get passed through at all!

It's quite possible that, in the end, doubling the energy cost results in a 20% increase in production costs spread over 5 or 6 years. During that period, there is also the possibility that improvements in the production process (not associated with energy usage) are enough to offset a decent part of that 20%. In fact, production costs could even fall!!

Constantine

George,

You wrote:

I just read though that a particular fitting (used on an oil rig) made of bronze that used to cost $20 (roughly) now costs $150 due to increased cost of energy needed to mine, smelt, and form the raw materials.

Could you pass on the source for this? Are we sure the increase cost for the part is all because of increased energy costs? There has been a massive increase in drilling. One would expect that parts suppliers are up against all kinds of constraints that have little to do with energy. i.e. competition for raw materials for which new supply has yet to come online. How about manufacturing capacity constraints? ie. If there is a surge in demand, it's normal for the costs to surge as marginal production is inefficient given current capacity. Certainly rising energy costs are an issue, but given that the world economy is pretty overheated, there is lots of other stuff that causes cost increases not directly associated with energy.

George Mobus

I seem to have hit a nerve!

Constantine, I must admit I have trouble following your reasoning, but it seems you are arguing from a neoclassical economist's perspective.

It remains for you to show how work can be accomplished without energy. My argument is from first principles. Yours seems to be from assumed principles in economics. You keep wanting to decouple energy from the actual work that is accomplished and then claim that the monetary value has no relationship. My question is why do you feel so strongly that this is the case? Why are you against a possible direct relationship between the value of a currency and the availability of energy to do useful work? Why does this proposal impel you so? Are you defending neoclassical economics?

George Mobus

Constantine,

As an example. You said: "Take your example (March 14) of the Consumer Electronic Widget. If energy costs double, what happens?

I could be wrong, but since you state that "nearly 100% of the cost of making the widget is energy", it seems that the conclusion is that eventually the total cost of the widget doubles."

Clearly the cost in energy does double. But that is measured in energy units not dollars. My whole argument for why using dollar units is no good is that exactly the kinds of shifts of which you speak distort the relationship. So in the end, the dollar measurements do not reflect the actual cost in the true currency - energy.

As long as you insist that dollar measurements are the standard, you will never be able to see that it is dollars that fluctuate, not BTUs.

It is true, that higher costs (in dollars paid for energy) may cause an eventual shift in efficiencies such that energy inputs go down. But that doesn't change the fact that it is the energy inputs that count in the first place.

In this issue you must either accept physics or economics. But as things currently stand you can't have it both ways. I prefer physics because the laws of thermodynamics will win in the end. Indeed, I claim that is exactly the result we are seeing in the confusions in the markets. People clinging desperately to their beliefs in economics principles are having a very hard time understanding why things aren't really working out the way the principles say they should. At the same time explanations based on thermodynamics (esp. 1st and 2nd laws) are holding up just fine.

Ask yourself about your own motives for holding your position. Why do you believe what you do? Is it because you believe in neoclassical economics or can you also argue from first principles in physics?

George Mobus

Constantine, and others,

I just went to the Oil Drum site where I read about the brass fitting (I think). I couldn't find the reference you asked for, but I did find this article. It is a slightly different slant on my main thesis, but based on the same fundamental idea - that it is energy that is the true currency of the economy.

"Why EROI matters"

By Charles Hall
State University of New York
College of Environmental Science and Forestry
Syracuse New York
http://www.theoildrum.com/node/3786#more

George Mobus

Constantine wrote:
'[GM:]"The BTU content needed to do the useful work doesn't fluctuate."

This is false.

It depends crucially on many many factors. Expertise, technology and social organization, for instance, which effect output enormously even when energy inputs are similar. To make the point with an exotic example: the same amount of energy pulsing through Einstein's brain accomplishes something completely different in terms of useful work than than it would in my Saint Bernard's headspace.'

The original claim stands. The relationship between work and energy is fixed (given the efficiency factors, etc.) That is just plain physics.

Now lets take your example, which it turns out proves my point. As it happens the wiring in Einstein's brain and your dog's is completely different. Einstein had many more synapses and cells firing in doing the thought work you allude to. It turns out that every synapse in a mammalian brain uses about the same amount of energy in its activities. So Einstein's brain required considerably more energy than does your dog's brain, even in the so-called resting state.

If Einstein's brain only had the amount of energy to work with that your dog's brain has then he would not have been able to think as he did. Brains are energy hogs and the human brain is the hogiest! It is the sheer complexity (numbers of synapses per cerebral neuron) that accounts for the difference in energy consumption and products produced. This, BTW, accounts for why elephant, whale, and large dolphin brains don't consume as much energy per unit mass as the human brain does.

Sorry, but you just can't argue physics away. Work is work.

Constantine

George wrote:
"In this issue you must either accept physics or economics."

No! False dichotomy!!

You are saying something different from Hall and that makes all the difference.

He is offering an alternative and supplemental analysis of the role of energy but is not advocating changing the currency.

To quote him:

"Can we supplement or improve upon our ability to do economics and financial analysis by using procedures that focus more on the energy available (or not) to undertake the activity in question? I next attempt to make that case."

From a article of his a couple of months ago:

"While we are used to thinking about the economy in monetary terms, those of us trained in the natural sciences consider it *equally* *valid* to think about the economy and economics from the perspective of the energy required to make it run."

http://www.theoildrum.com/node/3412

You do not have to choose between economics and physics. You can have both. In fact, you must have both.

My barrage of posts above was an attempt to show that there is no way to get rid of the economic side of things. The strict equation of money=energy would lead to enormous distortions of it's own because it can't capture the complexity of what money and markets are all about.

Essentially, I think your viewpoint suffers from "greedy reductionism".

http://en.wikipedia.org/wiki/Greedy_reductionism

To quote Hall:
"In other words, are finances beholden to the laws of physics?"

Absolutely.

Can we devise a workable finance and economics in solely in terms of low level physics concepts like its definition of work.

Not a chance in hell.

(But I know you are going to attempt it! :-)

Constantine

To add to the above....

Many peak oilers (including Hall actually) say that economics is divorced from the underlying physical reality.

I would agree that there is often a lag before reality is perceived by economic players but I disagree that it is divorced from it. Getting a mortgage is tied to thermodynamics via the price of energy which is often used to calculate eligibility.

For instance here:
http://money.canoe.ca/FinancialTools/mortgage_calc.html

Sure things get out of sync. Then they correct.

True, at times you can borrow against a future that does not exist. But then the lenders loose their money. That's the punishment.

I can't see any reason why Halls insights etc couldn't be assimilated into current economic thinking. Many energy traders are aware of EROI, and you even see equivalent expressions in the mainstream financial press in relation to ethanol.

My first year econ text from the mid '80's actually uses the expression "addiction to oil" and includes frank discussion of the possibilities of resource depletion.

Yesterday, I got a copy of Mankiw's famous econ text from the library. His position is that until prices give indication you don't worry about limits to growth. Since he wrote his text (2005) prices have spoken loudly and he has advocated a Pigovian tax.

Heck we had an article on Malthus on front page of the WSJ a few day back. You can't argue that system is blind to reality. It is however slow (but there have been many many false alarms in the past)

The reason I've been fairly aggressive on this issue here isn't out of desperate clinging to the past. It's out of concern that gross simplifications will be advanced as serious alternatives to what we have. Those 'solutions' are sure to compound our problems.

Constantine

Interesting info re dogs' brains. Didn't know that.

However, the point I had in mind was missed and could easily be made by comparing my brain with Einstein's! They both use approx the same amount of energy yet his was capable of vastly more important work.

My general point is that 'work' in the economic sense -- activity that results in goods or services that can marketed -- is only vaguely linked to work in physics. Much work in a modern economy involves figuring out a solution to something. Very little energy is expended, yet the result can be extraordinarily productive. If you set Einstein to solving a task, you are not going to be able to predict the value of his efforts based on his energy consumption. I'm sure, in some sense, the laws of thermodynamics limit what Einstein can do. But it's not obvious that knowing that is useful to us at all. Einstein, as a productive system, is too complex, too opaque.

Give him 3000 calories per day, or give him 4000. What is the relationship between the work he does and the energy inputs? Does it change? Would his work be reduced should he be fed only 1800?

A decent chunk of a modern economy aren't Einsteins but they are people figuring things out. Say, you take a software engineer and slash his salary in half and put him on a diet? Does thermodynamics tell you how much less code he will write or how fewer bugs he will fix? Of course, not.


Constantine

Another issue:

If the currency is pegged to BTUs then there is no way to change the price of energy vis a vis money that is already in the hands of economic players.

ie. Say a pipeline goes down for maintenance unexpectedly. Supply of gasoline falls. But there is no means to ration consumption based on price, because it is fixed. In addition, price can't provide an incentive for conservation. As soon as I get my hands on some dough, I have fixed my energy costs for all time. No matter what happens in the real world regarding energy supply, my costs are fixed for life.

That doesn't seem very smart. Instead it seems better to allow rising prices to confront consumers with the new reality of changed supply (as we do). An energy backed currency could introduce enormous rigidities into a system that must remain flexible given the vagaries of life on this planet.

George Mobus

Constantine,

Hall and I are actually very much on the same wavelength and saying pretty much the same thing. His specialty is EROI, mine is work flow. I think it is you who are creating a false dichotomy since I am not advocating getting rid of economics per se, only revising the rules and principles to come into alignment with reality.

In fact there is a whole field of economics that is exactly in accord with this called ecological economics. These people are revising the rules of neoclassical economics to reflect physical reality and we are, as far as I can tell, in complete alignment.

My proposal is to take the idea to its logical conclusion by using an energy-based standard for currencies. This isn't eliminating anything economic. It is providing a firmer basis for accounting for work flow. It gives us a better understanding of true costs. That's all.

I suspect this conversation would go better if you were to read some ecological economics work (Hall's work is related but not exactly the same).

"An energy backed currency could introduce enormous rigidities into a system that must remain flexible given the vagaries of life on this planet."

You make a very dramatic claim. Back it up with evidence and logic. And please do a good job of explaining those vagaries your refer to. Did it never occur to you that the flexibility you refer to is overdone and the source of the problems that we are suffering?

Constantine

There is one last point from your March 14 post that I would like to quibble with, if I may.

"[A free energy currency] would literally turn [the economy] into a system akin to the natural ecosystem where energy is the obvious currency."

Nope. Natural ecosystems have many currencies. Energy is just one (though very important). Much of the land portion of this planet is arid or semi-arid...in other words, ecosystems that are often thoroughly flooded with energy to an extent that life is threatened. But the flora and fauna are instead evolved to handle severe water scarcity. And much of their physiology and behavior indicates that water is very much the currency in these regions.

I'm not biologist but I'd bet dollars to donuts that there are plenty of examples of competition for various nutrients (like fixed nitrogen) in settings where the individuals are not experiencing energy constraints to the same degree.

All of this points to the difficulty of trying to analyze high level complex phenomena solely in terms of a slim selection of low level scientific theories. (first principles)

This general methodology seems questionable to me. It reminds me of Roger Penrose's attempt to reduce neuroscience and neurology to quantum mechanics. The project came to nothing. Nobody uses his work in those fields.

I'll stop pestering you for now and drop in again in a few days. Wife has a list of chores for me! :-)

George Mobus

Constantine,

I too need to get onto other matters. So I will attempt to answer two more points that you have raised and then give it a rest.

Point one has to do with your claim of multiple currencies. As an example you mentioned water and nutrients as being equally valid as currencies for life. It is true these are certainly limiting factors in specific regions. However, these are material things, composed of atoms that can, in principle be imported from regions of greater abundance. We have turned more than one desert area into agricultural production by importing water and nutrients. But, and here is the crux of the argument, we do it using energy. We pump water from one region (or deep underground) to where we have abundant sunshine and space for crops. It takes energy to pump water. Thus what was a limitation is no longer so because we used energy to do useful work. So ultimately energy is the only real requirement. Matter, unlike energy, can be recycled as well. Atoms don't get used up except that the material can become so degraded that it has been cheaper to throw things away. But in principle this need not be the case. We could, given enough - guess what - energy, recover every atom from every scrap heap. Again, it is energy that makes it possible.

Energy, on the other hand, cannot be recycled. The Second Law of Thermodynamics describes the fact that as energy is used (converted from a high-grade form to other forms and eventually to low-grade heat) up in work processes. It is lost forever and needs to be replenished continually. Except for the occasional fortuitous situation like using waste heat from generating electricity for chemical process heat or space heating (co-generation plants) energy forever runs downhill in its quality and that is what makes it so fundamentally different that it stands alone as the basis for wealth creation and maintenance. It is the basis of all capital.

Your second point, from above, is that sunlight is energy but when it falls on, say a desert, it can have the opposite effect of creating wealth (given the absence of plants that need water). I think a problem you may have is in understanding what is meant by 'free' energy, or the energy available to do useful work. Not all energy is necessarily free energy. The term comes from physics where two specific forms, Gibbs free energy, and Helmholtz free energy, are defined quite precisely for electrochemical and heat engine systems specifically. The notion of free energy can be generalized to include systems far from equilibrium where the input of raw, high potential energy (such as sunlight) can be *captured* and stored, at least temporarily, and then routed into a work process where it can be used effectively. Thus raw energy that is wasted, say by simply reflecting back into space, does not count as free energy. We could turn it's availability into free energy by constructing solar energy collectors in the desert. It would take work and energy investment in building the collectors and infrastructure, hence we would need to route some of our existing free energy, say from oil or coal, to that end. It is exactly the same argument as above though. In the end it is energy usage that counts as the basic input.

My proposal is to standardize the value of money (currencies) on the availability of free energy. From an accounting perspective, say cost accounting for example, this actually isn't a particularly hard thing to do. In fact nothing would really change other than the valuation judgments for assets and liabilities (on the financial side) and costing work flows. Mechanically they would basically be doing what they have always done. Only now, the actual value of money would be fixed to the free energy standard and thus make the judgments much more meaningful.

In the end the only thing that moves through the economy or the natural ecosystem is energy. Materials may be displaced in space over time, but only energy makes the complete trek through every single aspect of everything that we or nature does. It may look daunting to you. But you haven't put thirty years of thought and modeling into the idea either. So I hope you will dig a little deeper in your thinking and studying to see what might be possible. My search started with a question. If everything the economists say is true about how things work then why... followed by an ever increasing list of discrepancies between text book economics and reality.

I will say I do appreciate the challenges since they have given me an opportunity to try and explain my position better. So thanks for that.

George

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