Recently the Annual Meeting of the World Economic Forum, in Davos, came to a conclusion. My attention was caught by the mildly positive statements of some of his most notorious participants. So, for example, while Christine Lagarde (head of the International Monetary Fund) declared that economic growth and job creation will remain fragile, Angela Merkel (together with other EU leaders) expressed more confidence in economic recovery. Cautious optimism on the return of economic growth is also expressed in the event formal report. Since, in my modest opinion, seldom has the public at large had the opportunity to understand what the real reasons of the current economic crisis are (except for the reference to the infamous American sub-prime bubble), I will do my best to point them out. The thesis I plan to expose and defend is the following: the current crisis is not primarily a financial one, but rather an energy one.
Brown et al. (2012), in a suggestive article titled “Energetic Limits to Economic Growth” estimate a significant positive relationship between per-capita GDP and per-capita energy use for 220 nations over 1980-2003. Their findings fit well within what the authors call a macro-ecological perspective. The perspective simply implies that society, like organisms, also have a metabolism and require energy to sustain themselves (as I pointed out in a previous post). Given the importance of fossil fuels, which currently account for about 85% of total energy consumed globally, it is not surprising that a close relationship between economic growth and oil production exists (oil accounts for about 37% of total energy consumption, followed by coal at 25% and gas at 23%). This relationship is clearly illustrated below (Source: Hirsh, 2008), where a lock-step pattern between oil production growth and GDP growth emerges.
The fact that global oil production has been essentially flat since 2005, has probably got something to do with the situation we are facing now. Global oil production has not expanded despite the surge in oil prices due to increasing demand. The relationship between oil scarcity and economic recessions can also be gauged by looking at the graph below (Source: Rubin & Buchanan, 2008)
Despite energy playing such a crucial role in economic growth, it is seldom accounted for in macroeconomic models, which tend to focus more on traditional factors of production like labor and capital. The reason for this is that energy expenditure traditionally represents a small fraction of GDP, while expenditure on capital and labor are certainly more significant. This should have led economists to think that energy is under-priced, rather than thinking that it is unimportant! Here is a funny thing. Normally estimates of GDP using only labor and capital as factors of production poorly fit the data. The difference between the real data and the fitted model, goes under the name of Solow-residual and it is assumed to be an indicator of technological progress!!! When energy is properly accounted for, not in monetary terms but rather in terms of its ability to perform physical work, the Solow residual almost disappears and most of what was thought to be magical technological development is now explained by the increased energy use! In fact technological development does not disappear, but becomes something much less magical/immaterial and much more mundane: the ability to mobilize and use larger quantities of exosomatic energy. This is clearly illustrated by the figure below (Source: Warr & Ayres, 2012). The dashed line is the estimated value of GDP using only capital and labor as factor of production (i.e., Solow production function). As it can be seen this model fits the real data (solid black line) very poorly. The difference between the Solow estimation and the real data is the Solow residual, which alledgedly indicates the effect of technological development. The 2 linex specifications (which account for the physical work embedded in the energy use) provide a much better fit. The Solow residual has now almost completely disappeared.
Moreover, despite the unquestionable advances in technology occurred over the past 60 years, the relationship between energy and GDP remains strong. An absolute decoupling between economic growth and energy use has not materialized, as illustrated below (Source: Sustainable Development Commission, 2009). An increase in energy efficiency could actually lead to an increase in energy use, generating the so-called Jevons paradox.
I believe that there is so far substantial evidence that it is the end of cheap and abundant energy, namely cheap oil, that strangles the economic recovery baby in the cradle. This situation is markedly different from anything we have experienced over the past 60 years, where expanding cheap energy supply was the norm (with the exception of a few shocks). The availability of abundant and cheap energy has been the main driver of economic expansion. This in turn has allowed also the expansion of debt. Economic growth is in fact a very important element in allowing debtors to service their debt and repaying the interest (as noted also by Tverberg, 2012). The debt crisis we are currently facing then reflects the fact that GDP growth has not been able to keep the pace with debt growth, thus leading to a progressive deterioration of the debt/GDP ratio, until the bubble burst.
The fact that policy makers fail to mention how the global energetic situation plays a central role in the current economic crisis (certainly alongside what happened in the largely deregulated financial sector) is appalling! Yet one has to wonder whether, behind this silent facade, the increasing number of conflicts in energy-resource-rich areas aimed at securing geopolitical control of these regions signals a complete awareness of the issues discussed here. Actions speak louder than words.