Why your investment adviser can't advise the world

As stock markets around the world continue to plummet, most investment advisers are telling their long-time clients to stay put and wait for a rebound. With the world overflowing with newly printed (actually, electronically created) money waiting to be invested, a rebound might come despite sentiment that is now so extremely negative.

But the problem with investing (as opposed to saving) is that it is primarily a social phenomenon (rather than an individual one) and therefore has some of the characteristics of both a Ponzi scheme and a zero-sum game. Our savings usually go these days into bank accounts that are insured. The value doesn't fluctuate or rather fluctuates very gradually upward with each interest payment. No matter how many people choose to open savings accounts or CDs at a bank, your principal can neither go up nor down. (The interest payment you receive, however, might go down if too many people flood the bank with money that it cannot deploy profitably in the form of loans.) And, even if some choose to save in part through the purchase of, say, jewelry, gold coins or land, we insure these against loss and liability. Their market price can't be controlled, but loss from theft, damage or lawsuit can be. And, only a fool would think to put all of his or her savings into any one of these alternatives to bank accounts.

The same things can't be said for what most people call investments. Here people were advised to pile into the stock and bond markets with all of their savings. And, in these markets it is essential that there be people who continuously bid for what we have chosen to invest in in order for its value to increase or at least be maintained. Hence, investing is a social phenomenon. A sharp investment adviser will put his or her clients into the next profitable thing early and then have them sell to the latecomers before the trend reverses. And who are the latecomers? Some of them are undoubtedly people put into the same investment by other investment advisers who see the next profitable thing only somewhat later than our aforementioned sharp investment adviser. As each new cohort of investors piles into an investment, the early ones have an opportunity to bail out. This is what I mean when I say investing has some resemblence to a Ponzi scheme. The new investors pay off the original investors by buying their assets at a higher price.

Now, some will complain that if there is overall continuous growth in the economy, the latecomers will make money as the economy continues to expand. There is some truth to this, and yet the fabulous expansion of the world economy in the 20th and early 21st centuries hasn't prevented wide swings in markets that have made paupers of the latecomers. Whether that growth can continue is an open question since we are facing mulitple resource limits and the headwind of climate change.

But setting aside the growth question, we can still see that the social aspects of investing make it far more hazardous than what we call saving. For if a lot of people decide all at once to sell assets similar to what we ourselves own, they can create a panic that leads to much lower prices. And, that, of course, is what we've seen in the past several months.

But not everyone is poorer for this happening. There are short-sellers who have been making gobs of money. Those are the people that remind us of the zero-sum aspect of investing. They only make money if we who are in the market lose it.

The current market meltdown makes clear that the risks faced by amateur investors were much higher than they were told. Professional investors understand the risks better (but not much better, it seems!). Investing is really a form of gambling. If you go into a casino and lose your money, you will, of course, be disappointed. But you shouldn't be surprised. Unprepared, many amateur investors were surprised by recent events.

The upshot is that the vast majority of people are not fit to participate in the casino of investing. Their talents lie elsewhere. We are about to return to a world where a much smaller group of people risk capital in the stock, bond and commodity markets, people who can afford to or at least think they can afford to do so. For everyone else it will be back to the staples of savings: bank accounts, savings bonds, perhaps some gold coins, silverware, jewelry or a little land.

And, what of all those people who are currently being told that they should hang on for a rebound in the market? Well, it might very well come. And, if it does, will they be counseled to sell after a 20 or 30 percent rise? And, if they take such advice, it will turn out like every other socially-driven market move. Some will act first--perhaps from a special premonitory insight--and reap the rewards. Others will follow in successive waves. It is logistically impossible for everyone can sell at once because, as in every Ponzi scheme and zero-sum game, there has to be someone to sell to.

Unfortunately, there is a bell curve that describes the success of financial advisers just as there is in every other profession. This has less to do with talent than with the structure of the investment game. If your doctor tells you to eat right, exercise and get plenty of rest, it's advice that every one of his or her patients can profit from. But if everybody acted at once on the basis of one adviser's counsel, the investment game wouldn't work. And, that's why your investment adviser will never be able to advise the world.

Please state the nature of your emergency

When a 911 operator answers a call, the operator often begins as follows: "Please state the nature of your emergency." As anyone who has called 911 knows, how you describe your emergency has everything to do with how the police respond.

I was speaking to a friend by phone recently who is very active in sustainability efforts where he lives. He's noticed that many of those who were showing interest in cooperating with his efforts last year have now withdrawn into concerns about their own immediate future. The growing economic crisis is concentrating their minds on such questions as: Will I keep my job? Will I be able to afford my house or apartment? What should I do with my savings, especially if they have declined significantly? For those running organizations the most basic question is one of survival. Can my business survive lower sales? Can my nonprofit survive declining donations and grants?

The emergency has been defined primarily as a financial emergency, and so all these people are reacting quite rationally under that definition, my friend conceded.

When faced with what we perceive is a crisis, we focus on the crisis first and worry about what we perceive are long-term problems later. Another contact, Nate Hagens of The Oil Drum, told me that he worries that as the economic crisis deepens, people will become even more focused on the immediate. That, of course, has serious implications for those concerned about long-term sustainability. He has written about why humans discount the future so steeply as follows:

If we didn't have mortgage payments and college funds for our kids, our discount rates might even be steeper. It's quite logical - animals that deferred opportunities to eat, might come back and their food was stolen, or they might have been eaten themselves in the interim - the long arm of selection would have favored organisms that valued immediacy over those who preferred to wait.

But the human penchant for focusing on the immediate is easily hijacked by modern forms of stimuli, Hagens adds:

Our culture presents a smorgasbord of options that allow us to 'feel' like our ancestors did when they were successful. Neuroscientist Robert Sapolsky likens the physiology of two grand master chess players to a marathon runner - the body is experiencing the same neurotransmitters (presumably, they did not have chess back on the Pleistoscene). Many of the options available to us that engage our neurotransmitters are maladaptive. Pornography, fast food, arcade games, lottery tickets, etc. all give us feelings identical to those our ancestors were good at pursuing. But now they often trick our brains into thinking they too will lead to evolutionary success.

For those who don't engage in the pursuits listed above, Hagens offers another illustration of a highly abstract human task which activates ancient neural circuits:

Take stock trading for example. Neuroscience scans show that stock trading lights up the same brain areas as picking nuts and berries do in other primates, suggestive of what our ancestors must have 'felt' as they tried to increase resources.

This last example suggests why so many people are focused on the financial aspects of our crisis. The very top leadership around the world is positively convinced that the crisis we face is primarily a financial crisis with financial solutions. Hence, the huge bailout and spending packages being simultaneously proposed by governments around the world. These policymakers may simply believe (unconsciously, of course) that getting out of this economic slump is merely a question of picking nuts and berries at a much faster rate.

Here we have the problem of how the nature of the emergency is defined. Because the economic crisis has been labelled primarily a financial crisis and because that type of crisis appears to activate well-worn pathways in the human brain, this interpretation has gained wide acceptance.

But if we were to state the nature of the emergency as a sustainability crisis, could such an interpretation gain wide acceptance? Given the presumed short-term focus of most human behavior, such an outcome seems unlikely.

Certainly, people will agree that our current financial system is not sustainable. That much has become obvious. Or has it? Even here we find that most of the solutions to the financial crisis currently being offered merely prop up or try to re-energize existing financial institutions and practices. So, even now--in the throes of a tremendous crisis in which basic institutions ought to be questioned--most leaders and most people in general are not currently examining how the "nuts and berries" are produced. We simply want more of them and hope that doing more of what we've done in the past (for example, expanding debt) will work.

If the current efforts to revive the economy do not work, perhaps then we as a society will look more seriously at setting up alternative financial structures. But, that leaves us a long way from considering urgent areas of sustainability: energy depletion, food production, water depletion, population and climate change.

Each area has the potential to produce more than just local or regional crises. But until they are understood as urgent, I fear that little will be done on a national or international level. This, of course, does not preclude local efforts where people perceive these threats as immediate and ongoing. But I am reminded of Benjamin Franklin's saying, "We must all hang together, or assuredly we shall all hang separately." If some communities successfully address sustainability and other don't, it seems only a matter of time before those that don't become the predators of those that do.

So, my question remains. How can the sustainability crisis (of which the current financial crisis is most certainly a symptom) be framed as something that deserves our immediate and ongoing attention? What well-worn, evolutionarily successful pathways of thinking and feeling are available to motivate broader action?

The issue can't be merely that the problems we face in sustainability are too abstract. After all, stock trading is pretty abstract; but, it seems to map nicely to an already available pathway of thinking and acting. Can we find more of these and use them to communicate the sustainability imperative?

Clearly, simply stating the nature of the emergency as we have in the past is not enough.

The information society and its limits

The breathtaking expansion of the Internet and the sources of information now available on it have served to conjure a cybernetic vision of unlimited growth--growth that can never be slowed for long by lack of physical resources because it is mostly virtual. The Internet has undoubtedly allowed people to find information readily that would previously have taken hours of meticulous searching in a library or might not be found at all.

The vast quantities of information now available require some kind of filtering, and so various filtering services including news aggregators, weblogs, and specialty sites of all kinds have arisen. All of that is to the good. True, much of the information on the Internet is of questionable veracity. And, much of what passes for information not only on the Internet, but also in the broader media is nothing more than polemic dressed up as analysis. And, of course, the sheer volume of it all would be overwhelming were it not mitigated by the available filters or by simply turning away from the computer, the television and the radio.

But so many people cannot or will not turn away for any extended period of time. Instead, they believe they need to be "updated" on a regular basis. I put "updated" in quotes since to me the news seems more or less the same every day with a few widely spaced and prominent exceptions. It is these exceptions that I pay attention to. But most stories fit into rather predictable categories which I label as follows:

1. Prices are going up (or, more rarely, down).
2. There's corruption in government. (Who knew?)
3. The corporations are out to get us.
4. It's dangerous out there. (Crime stories)
5. Isn't that weird? (Human interest stories)
6. GI Joe. (War coverage)
7. How to lose 10 pounds without dieting. (Service stories)

Perhaps you can think of other categories. And, while stories in some of these categories are indeed important, those stories rarely provide the context or the intelligent analysis required to make them useful. On the other hand, crime stories are usually just sensationalism designed to attract subscribers and viewers.

Putting into the proper context what information we actually do need for something other than aiding and abetting our consumption--for, say, understanding public policy--requires conceptual training that can only come from reading well-written books and articles and engaging with other rigorous minds who challenge our own point of view. That is a much slower training process, and it will never occur at Internet speeds.

Environmental education giant David Orr likes to say that what we lack is "slow" knowledge. It is easy to learn how to take down a whole forest with a chainsaw. That's fast knowledge. But as I wrote in a previous post:

Teaching people the importance of trees in creating and protecting the soil, encouraging biodiversity, preventing runoff, storing carbon and influencing climate is a task that requires time, concentration and reflection. It assumes a body of knowledge about the natural world that most people simply don't have and therefore must acquire. And, it assumes an eye trained to look for subtleties in the natural landscape. Moreover, such learning does not yield the immediate and visible economic benefits of the chainsaw.

But even if we take the time to acquire the slow knowledge we need, we cannot solve the knowledge problem with more information. The world is too complex to comprehend by merely apprehending its parts. And, no human being can see all of the universe or even his or her part of it well enough to give anything but a very fragmentary account. We will always have huge areas of ignorance, particularly about the long-term consequences of the actions we take to reshape the ecosphere to our purposes.

And, even where we believe we have a lot of information--for example, the confident predictions about world oil and natural gas reserves or about the amount of uranium that can be extracted from the Earth's crust--we ought to look not to what we know for confirmation, but to what we don't know for guidance regarding the risks we face. Orr suggests that those lacunae in our knowledge should entreat us to employ wide margins of safety both in our daily actions and even more so in our collective policies.

It is possible, for example, that the optimistic estimates of the world's energy supplies are correct. The consequences of that would be that business as usual could proceed for a few more decades during which we could take a very leisurely attitude toward making the transition to a new energy economy. (I am, of course, setting aside the very serious risks related to climate change in this illustration.) The consequences of being wrong, however, could include catastrophic collapse. Hence, Orr's suggestion that we employ wide margins of safety when acting on what we think we know.

The hubris of the information society is that it imagines that data matter more than understanding and that we are moving closer and closer every day to completing the book of knowledge. The truth is we are creating vast new areas of ignorance. Two examples, one domestic and one industrial, illustrate the problem. Our highly productive modern farming and food production system has allowed the vast majority of people to forego learning anything about plants in their immediate area which are edible. And, since public policy in the United States (but no longer in Europe) puts the onus on the public to prove that a new chemical is harmful before it is banned (rather than putting the onus on industry to prove it is safe), industry releases thousands of new chemicals each year into the environment ignorant of their possible negative effects on humans and on ecosystems.

The most important first step in countering this trend is to recognize it and to act with the heightened sense of attentiveness, care and prudence which that recognition demands.

Lightering our way to abundance

Lightering is the process of transferring oil cargo between vessels of largely different sizes and is undertaken as many port facilities cannot accept ocean-faring tankers of the size of oil transports.
                                                                                                                            --Wikipedia

An old Wall Street shibboleth says that nobody rings a bell at the top. To prove the point, even as oil and other commodities were making blistering new highs on a daily basis last year, few people saw the carnage that was to come in those markets as the year progressed.

But the same cannot always be said at the bottom of a market. Quite often, there are many bells ringing. It's just that by the time a bottom arrives investors are usually too exhausted, too nervous or too broke even to care. And, it's true that the price of any commodity or stock can trace out a bottom for a very long time, longer than most people have patience, especially if they've already been burned in a crash. And so, the bells can go on ringing for years until they just seem like background noise.

Still, I am willing to take a stab at what may turn out to be a fool's errand and suggest that crude oil prices have bottomed out. My signal? The image of oil supertankers cruising aimlessly for weeks near many of the world's ports waiting for someone to purchase their cargoes. And, when someone finally does, the supertanker is obliged to lighter oil onto another smaller ship because the buyer only wants a portion of what's in the hold. When all the supertankers are full, the next step will simply be to spill oil on the ground at the point of extraction. But since this is an unlikely outcome, I suspect that oil producers will scale back production because they have to. The transit system and the storage system are now overflowing.

Of course, demand for oil could drop even further if the world economy continues to shrink. But at some point there will be a bedrock level below which oil consumption cannot fall or the lights will go out on civilization itself.

There is, in fact, one other promising sign of a bottom, and that's the move by oil companies and Wall Street firms to secure tankers in which to store oil in order to play the contango in the oil market. By leasing a tanker and filling it with oil purchased at the current low price while simultaneously selling it on the futures market for delivery later this year at a significantly higher price, they can generate considerable profit--enough to pay for the costs of storage on the high seas and take home handsome paychecks to boot.

The smart money is saying that oil won't remain this cheap much longer or that the prices on long-dated futures contracts will collapse. Either way the oil companies and investment bankers make money. But, even though the bottom may be in, it could take a long time for oil prices to move considerably higher.

What is disturbing about the entire tableau is the false impression it leaves that oil is an abundant resource. People are led to believe that if we can hardly find storage for all of the oil, it must be available to us in such quantities that we have few worries for the foreseeable future. But nothing could be further from the truth.

Oil is a commodity that unlike coal or copper is difficult and expensive to store. It's a flammable liquid capable of exceptional environment damage that must be carefully sequestered in special tanks with berms around them to prevent the spread of a leak or of a fire; or, it must be put in hugely expensive double-hulled tankers. Although it can be transported by truck as can coal and copper, it is most often transported by pipeline since this is quite a bit cheaper. The upshot is that you can't store oil just anywhere, and the storage space that is available is quite limited compared to its production. U. S. inventories last week stood at just 23.6 days of supply. And, this is at a time when storage facilities are chock full of the stuff.

Our existing oil infrastructure is pulling petroleum out of the ground at a rate that is currently faster than we can use it. This makes for a temporary glut and in no way mitigates the long-term problems we face with declining petroleum supplies. But we are now treating oil, not as the world's key commodity, a commodity upon which our very way of life depends, but as a plaything for investors to game for temporary profits. It's all part of the mentality that resources are interchangeable, that all of them can be replaced with enough ingenuity and investment whenever we need to without disruption to our lives, and that we have no cause to worry about the colossal waste of finite oil resources that is being fostered by low oil prices.

In the face of the worst economic downturn since the 1930s, the current focus of policymakers is understandably to restart world economic growth. And, many experts have pointed out that low oil prices and low energy prices in general are a plus for this purpose. They give energy consumers the equivalent of a huge tax cut.

But as those in the oil industry already know, low prices will lead to a reduction of new supply in the future, a reduction that could cripple any attempts to restart economic growth. And, failure to provide adequate supplies of the world's most essential fuel will not only stifle growth, but also impede attempts to create the renewable energy economy that we will need as oil supplies decline due to geologic constraints. We need the energy from fossil fuels and especially from oil to help make the next energy transition. That calls for a massive change of direction for energy investment that simply cannot take place in an environment of low energy prices.

The implication is that we now need to put a floor under fossil fuel prices so as not to discourage the development of alternatives. That means new taxes, but ones that could be offset with reductions elsewhere. We need to discourage what we don't want, namely, wasteful use of fossil fuels, and thereby encourage what we do want, namely, carbon-free energy technology.

And, although you couldn't tell it by this week's reports from the high seas, there is no way we are going to lighter our way to abundance.

Over the cliff for natural gas in North America?

My latest column on Scitizen entitled "Over the cliff for natural gas in North America?" has now been posted. Here is the teaser:

Is natural gas production in North America headed for a cliff? No one can know for sure; but all signs point down......Read more

Peak oil investment verities

Like many other verities in the investment world, peak oil investment verities have turned out to be anything but. Investment newsletter writer and author Jim Grant likes to say that knowledge in the sciences is cumulative, but knowledge in finance is cyclical.

And, so it has been with the general run of so-called peak oil investment strategies. Their heavy reliance on energy-linked investments made them a boon to all who followed them at first. But in the last six months such investments have suffered catastrophic reversals. The underlying cause, of course, was a devastating and unprecedented swoon in prices for oil, natural gas, and coal. Even uranium prices came down sharply, but this occurred somewhat earlier. Not surprisingly, the share prices of alternative energy companies, which rely on high prices for conventional fuels in order to remain competitive, followed the price of these fuels down sharply as well.

Even a stalwart of some peak oil portfolios, gold, managed to decline in the face of an obvious crackup in the world financial system. Everything seemed to be going down at once. The cause, in part, was that those who borrowed huge sums to gamble in the markets (mostly hedge funds and investment banks) had to sell at any price to pay back their loans before their investment portfolios completely vaporized. Selling begat more selling begat more selling. And with the selling, confidence in the financial system ebbed. The fundamental cause, however, was a swiftly declining economy, finally toppling under the burden of massive debt that individuals, companies and governments are increasingly unable to pay back.

This is not to say that some individuals who take peak oil seriously have not done well with their investments. But their strategies had to have been different from simply holding energy-related investments for the long run. The expectation for many peak oil investors had been that energy prices would rise more or less continuously due to increasing demand and constrained supply. That has not worked out as planned. Lately, economic contraction has led to declining demand which has had more influence on energy prices than any perceived constraint on production. But, of course, this doesn't mean that energy-laden investment portfolios might not prosper from this point on; no one can know for sure.

While the basic thesis of peak oil (and peak natural gas, coal and uranium for that matter) remains intact, its timing and exact effects continue to be elusive. Peak oil can still rightly qualify as a so-called "black swan event." The term, introduced to the public by former hedge fund manager and author Nassim Nicholas Taleb in his book "The Black Swan," denotes an unexpected and rare event of high impact which few people anticipate. It is precisely because few people anticipate it that is has high impact, and peak oil, though it is a better known concept today, remains poorly understood or unknown to the great majority of people on the planet.

The myriad factors that are leading us toward peak oil are not visible to any one observer. We can calculate, we can hypothesize, and we can prognosticate; but we cannot know for certain the date of its arrival or its ultimate effects on society and the markets. There will always be a gap between what we think we know and what we actually know.

The action in the investment markets ought to be a lesson for all those trying to envision what will happen in any complex system, especially one as complex as human society. Our powers of prediction are weak. We need to keep an open mind and observe carefully.

This doesn't mean we shouldn't try to plan or prepare or even invest. Humans are planning animals. But what they are really good at is improvisation. That's why careful attention to what is right before us rather than what we imagine for the future is of critical importance. The kick in the pants that all those who followed the peak oil investment paradigm received last year (including me to a minor degree) is a reminder that we ought not to allow our fantasies of the future to dominate our every action in the here and now.

The price illusion

The Institute for Energy Research (IER) emailed me last week to warn me about the Obama administration's "green jobs" plan. The press release said that the plan would increase energy prices and actually cause total employment to decline. Furthermore, the release stated, renewable energy production has "stagnated" for the past 15 years, contradicting claims of vigorous growth.

The organization's assertions rely on a series of omissions. The first one the IER admits. It leaves out wind generation to claim that renewable energy growth has stagnated. Second, whether a massive government-led green energy program would lead to employment declines depends entirely on the assertion that money will be siphoned away from the nonrenewable energy sector of the economy. That now seems unlikely given the huge slack in the world economy and given that the plan is expected to be largely financed through deficit spending. But perhaps the most egregious omission is the failure to understand what market prices don't include in their signals to the economy and society.

For the IER, which dedicates itself to "free-market energy and environmental policy" and "private property rights," the struggling fossil fuel industry has succeeded entirely through ingenuity and pluck. The "scholars" (as they are called) at the IER seem to know nothing of the free work nature has conducted over the past few hundred million years in creating those fuels. Thus, the fossil fuel industry produces exactly nothing, but rather extracts the bounty of nature's work and delivers it to society. This is not an inconsiderable labor. But it amounts to privatizing the profits derived from the work of nature, while socializing the costs of using fossil fuels through such effects as global warming and toxic spills. (Here I should say that I do not think that this is a problem peculiar to the fossil fuel industry, but rather endemic in modern capitalism. However, the excuse that "everyone is doing it" should not shield the industry from reprobation.)

The price of fossil fuels (and especially recent prices) reflect virtually none of this reality; so perhaps the reason the people at the IER call themselves scholars is that their obsession with price renders them devoid of any practical understanding of the facts and frees them to focus on entirely theoretical matters just like the scholastic philosophers of old.

However, to focus entirely on the price of various fuels without contemplating their long-term sustainability, their environmental side effects, and their effects on the political and economic structure of world society is the equivalent of killing all but your favorite child so you can direct all your attention to him or her.

Still, even if we focus just on price, one would barely know by reading the IER's report on the green jobs proposal that oil had recently swung from under $50 a barrel at the beginning of 2007 to almost $150 last July to under $40 today. Similar price swings have taken place in the natural gas and coal markets. Such volatility is usually a sign of a system in distress. And, such instability makes it difficult for governments, businesses and consumers to create long-term plans.

Moreover, the ultra-low fossil fuel prices of today are a product not of exploration success, but rather economic implosion which is killing energy demand at a colossal pace. These prices are not a sign of plenty, but the result in part of the huge stress of high energy prices on the world economy in the last few years--stress that ultimately helped to tip a fragile economy into the first debt deflation since The Great Depression.

And so, the prices we are seeing for fossil fuels are creating an illusion of plenty that masks the central issue of our time: How do we move from our nonrenewable energy economy to a renewable one and do it quickly enough to avoid a catastrophic and rapid decline in the total energy available to human society?

Why is a rapid decline possible? Because prices for finite resources almost always reflect the here and now rather than long-term supply prospects. Even though fossil fuels are finite, and we are much closer to the end of the fossil fuel age than we are to the beginning of it, fossil fuel prices reflect not their growing scarcity but their temporary oversupply. This an illusion of the first order, and one filled with perils of the most extreme kind.

Will energy show us that inflation and deflation can occur at the same time?

At the beginning of this decade investment advisor Marc Faber told incredulous investors that rising economic prosperity in Asia signalled the beginning of a new bull market in commodities, but would also have deflationary consequences for consumer prices. How could these inflationary and deflationary effects coincide? The answer has important implications for what is currently unfolding in the financial and commodity markets, and, in particular, the energy markets.

Before explaining why Faber believed such seemingly contradictory ideas, let's dispense with the technical monetary definitions of inflation and deflation. In their narrowest sense, inflation means an expanding money supply, and deflation means a contracting money supply. But whether the money supply is expanding or contracting, these definitions say nothing about where exactly that money goes. It is this question that concerned Faber, and it is in this context that he uses the words "inflation" and "deflation."

Most broadly, Faber wants to know whether money is chasing consumer goods and raw materials and thus pushing up what we normally call inflation as measured by the Consumer Price Index or whether it is chasing assets such as homes, equities, bonds, and even art. Policymakers and the general public normally favor the latter kind of inflation over the former. People feel richer as the value of their homes and stock portfolios rise and the cost of consumer goods remains stable or declines. More specifically, Faber wants to know which sectors of the economy are inflating, that is, receiving abnormal flows of money, and which are deflating, that is, experiencing a decline in money flows; to put it more simply, where are relative prices rising and where are they falling?

We should also mention the case in which the public and especially the investor class are clamoring for short-term government debt, bank deposits and money market accounts in an effort to shield their savings from losses. This occurs when we are either experiencing a transient panic or a generalized deflation in which money becomes more valuable as its supply contracts. That, of course, is what many believe is occurring now. There are many fans of asset inflation and even a few fans of raw material inflation--mining companies and farmers come to mind--but there are almost no fans of the generalized deflation we see today where the price of practically everything falls.

The fact that there is almost no political or economic constituency for generalized deflation is reflected in government and monetary policy around the world. Both types of policy have become highly expansive, and both are meant to get lending and economic activity growing again. Whether such policies will succeed at their aims or whether they are wise in their current form is a topic for another time. But it will be useful in the coming months to notice to which sectors of the economy money flows as the deflationary forces of the credit collapse and the inflationary forces of government fiscal and monetary policy collide.

To help us understand how Faber thinks, let's return to his observation at the beginning of this decade about the future course of the world economy, an observation that turned out to be roughly correct. At the time Faber reasoned that as manufacturing vastly expanded in Asia and global trade ferried the cheap goods produced there throughout the world, consumer prices would remain stable or decline. Simultaneously, a bull market in raw materials would emerge as the supply of materials to feed those factories would lag behind demand after two decades of underinvestment in mining, energy, and agriculture. Thus, there would come to be a disconnect between the prices of consumer goods and the prices of the raw materials used to make them. In Faber's terminology, one sector would be deflating and the other inflating.

The simple lesson from this is that money chases scarcity. That's why some sectors of the economy can inflate while others deflate at the same time. The economy never uniformly inflates or deflates. Even the current economic contraction will be no exception. First, what is scarce and in demand by definition becomes more valuable as people bid against one another to have what little there is of a scarce but necessary resource. Second, people tend to hoard what is difficult to get, especially if it is essential to their livelihoods or their peace of mind, and this further increases its scarcity in the marketplace. Third, speculators noticing the trend plow money into the sector of the economy where prices are rising through such investments as stocks, bonds, commodities, real estate and derivative securities linked to these. This further pushes up the price. As Faber would say, the chosen sector is "inflating."

Now, what can be scarce or perceived as such is virtually anything: food, metals, equities (believe it or not), and even financial peace of mind. To obtain financial peace of mind investors most recently sold stocks, commodities and corporate bonds and bought government bonds. Faber would say that the government bond market is "inflating" though clearly we are moving through a period marked by generalized deflation.

What this means for the coming year is that all of the money currently being willed into existence by the central banks of the world in an effort to stimulate the world economy will be going somewhere.* Since scarcity is the key to determining where those who have access to that money might put it, it is worth considering what might be perceived as scarce. (Disclaimer: The following shouldn't be construed as investment advice. Use it as such at your own risk. My task lies elsewhere.)

Certainly, paper promises in the form of stocks and corporate and mortgaged-backed bonds don't seem scarce. The thrill of paper gains that made them seem so has vanished. And, the crooked dealings of so many corporate executives has made owning individual stocks look far more risky than it seemed in the past. With monumental issuance of government debt throughout the world on the horizon, it is hard to see how government bonds will continue to be regarded as scarce much longer even though they may offer peace of mind to their owners for now. And, the various paper derivatives of all these investments could probably supply the world with wallpaper for a thousand years if turned into actual certificates. Hardly scarce!

What may turn out to be truly scarce is energy. There is no Wall Street paper mill that can turn it out as it does various securities. It can only be obtained through skilled, energy-intensive and highly complex processes. Right now the precipitous drop in world demand for energy has pummelled energy prices. What is not so obvious is that low prices and contracting credit are leading to low investment in the oil and gas fields, in the coal fields and in alternative energy technologies and deployment.

Even while many factories may now stand idle, the oil pumps, the natural gas pipelines, and the coal trains are still working relentlessly around the clock to bring us the energy resources we need and are therefore depleting the existing reserves in the ground. Without enormous and continuous investment, the energy industry cannot hope to keep up with this scale of depletion. Already for the past three years, record high prices for oil failed to conjure any additional daily production capacity into existence. Oil production was just about flat for the entire period.

With the ultralow prices we are experiencing now, the necessary capital will simply not flow to the energy industry to replace the reserves we are depleting or invest in alternatives to replace finite fossil fuels which will all reach a peak some day (perhaps soon) and then decline. (Many say that world oil production peaked in July 2008 and may never rise to that level again because of a combination of geologic constraints and the drop in investment in new productive capacity.)

So, my candidate for a surprise comeback this year or next is energy, even if the economy as a whole deflates more or just limps along at this level. If it happens, policymakers and the public need to see it for what it is: a certain sign that we are close to the end of the fossil fuel era. Even with the very high energy prices of this decade, we have not been able to build up the large inventory of new fossil fuel discoveries that might have been expected. It is getting harder and harder to find, extract and refine the nonrenewable energy sources that the world economy relies on for 86 percent of its energy. When the ongoing decline in energy supply capacity unexpectedly crosses with energy demand, that fact will be made plain for all to see if they want to see it.

What is likely to happen, unfortunately, is that once demand rises to meet available capacity or capacity shrinks to meet demand, catapulting energy prices will choke off any economic recovery which will in turn cause energy prices to plummet all over again. The high volatility in the energy markets, cycling from deflation to inflation and back to deflation again will make it exceedingly difficult for the energy industry to invest aggressively in finding new supplies. That is a problem that cannot be solved by central bank money printing or government spending, but which requires serious changes in policy and society, something that now seems sadly delayed though it is arguably more important in the long run than the economic emergency which we currently face.

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*For those who say that it is possible that more money will disappear from the world economy through debt defaults than will be created by central banks, this will still not prevent some sectors of the economy from inflating though they may be fewer and inflate less as a group.

No second chance

It is the mission of nearly every mainstream economist to overcome the pessimism of those who study the natural world and who don't see how the human endeavor can continue on its current course of endless exponential economic growth. "Now, now," these economists will say to the natural scientists, "you are being alarmist just like many before you. Let the marketplace work its wonders and let economic prosperity come to all parts of the world and this will enable us with our newfound wealth to address the many environmental problems we need to face."

Such arguments seem like mere nonsense to any scientist who believes that endless economic growth is the cause of those problems. But the difference between these two camps may be less than it appears. Enlightened economists do acknowledge the need to treat the environment which sustains us with more care. The main issue appears to be timetables.

Most economists believe that we are not in any imminent danger of societal collapse. We have plenty of resources and the big problem of global warming can be solved by taxing or otherwise restricting the use of carbon-based fuels. New technologies will give us what we need, in time and affordably. It has always been thus. (Except when it hasn't. But one would have to know the history of civilizations that did succumb to resource degradation and scarcity, and most economists are very much concerned with the utterly now.)

To the scientist who worries about sustainability and perhaps more urgently about the availability of enough energy, particularly oil, to run our society, this leisurely attitude seems quite dangerous. Partly, this is because the cheap fossil fuel energy we now enjoy will be needed to build the next energy economy. If we as a global society wait until the last minute to begin building that new energy economy, we may not have enough fossil fuels to do it. Those fuels may decline faster than we can replace the energy we currently get from them. This is often referred to as the rate-of-conversion problem.

Let us see how these different timetables might affect world society.

For the economist failure to grow would condemn billions to poverty, disease and ignorance. (Never mind that billions are condemned to that under the current system; but this is only because, as the economist will tell us, we haven't gone far enough with the spread of global capitalism.) If enough of the poor become middle class, their societies will undergo what is called the demographic transition. Birth rates will fall and so will death rates, and the population will level out or at least grow much more slowly. (Never mind that the true impact on the biosphere comes from per capita consumption and pollution times population, not population alone. Greatly increasing per capita consumption while slowing or ending population growth will not necessarily solve any environmental problems.)

But the path offered by my hypothetical economist is one without recourse. Once we commit to it, there is no going back. If the economist turns out to be wrong about the availability of resources or about the severity and pace of climate change, then global society could very likely face a fatal blow from which it cannot recover. There may be no second chance.

Let's look at an alternate path. If instead global society works very hard in the short term to curtail resource use and economize on energy use in an effort to reduce the throughput of physical resources radically, we may be able to build a highly efficient global economy that gives us many of the same services we have now. (Remember, it is not goods per se that we want, but the services they provide. We may want a car, but we want it because it is a convenient form of transportation. We seek the service of transportation.)

If we as a global society choose this path, and then it turns out that the pessimists in the scientific community are wrong about the severity of climate change and the availability of resources--that is, climate change turns out to be a minor problem and resource availability is much greater than anticipated by the pessimists--if this is the case, then we could choose to resume economic growth and use more resources to support it. In short, we would have a second chance to achieve the growth which the enlightened economist deems as necessary for the salvation of the poor. But we would do it within the context of a highly efficient, low-polluting system that tries to achieve all desired goals with minimal resource usage.

It is the asymmetry of risk in these trajectories that ought to give growth-oriented economists pause. Perhaps the economists will say that the risks simply aren't there. But then the record of most economists in predicting anything, even the direction of markets and market economies about which they presume to have specialist knowledge, has been nothing sort of dismal. Furthermore, the economists can give us no warranty for our society if it collapses under the weight of resource depletion and climate change. Wouldn't the more prudent path be to ensure that we don't have to face that possibility? Is the imperative for growth so great that we should risk the annihilation of our society in order to achieve it?

Energy and money

My latest column on Scitizen entitled "Energy and money" has now been posted. Here is the teaser:

Is energy merely another commodity among many in the modern industrial economy? Or is it the very basis of our financial and material life?
.....Read more