Tuesday, 6 October 2009

The Financial System will collapse because of Peak Oil Part I

The Financial System will Collapse because of Peak Oil.

It's often heard on peak oil doomer sites that Peak Oil will lead to the collapse of our financial system because our system depends on growth and peak oil will cause growth to stop and thus since our financial system owners know this, once peak oil is identified, all the money will be pulled out and things collapse.

Let's take a look at these one by one.

1. Our Financial System Depends on Growth
This is really a two part argument. The first is about interest and the second is about growth in the economy. In the first case the argument is that the financial system depend on interest and that it needs interest to continually be paid back otherwise the scheme will collapse.
OK Let's look at that.
What is interest?
It's a percentage of the principal of a loan which will be paid back in addition to the original principal.
OK with me so far? It's naively possible to say that if the lender doesn't get paid the interest the system will collapse, right? And further, that OIL is required to generate the income to pay it back. Well, interestingly (no pun intended) interest doesn't always get paid back, and also interest existed long before we had an oil based economy.
The money to pay back interest is generated from income which is not spent now and comes from labour OR capital. Note that I said labour OR capital, not capital only.
Is the financial system based on interest?
Certainly part of it is, but it's naïve to say that all of it is.
The system in fact is based on RISK. The higher the risk, the greater the reward. Sometimes this reward comes in the form of interest (as in money lending). Sometimes it comes in the form of asset appreciation due to speculation, yet other times it comes from "buy low, sell high".
The argument that interest will disappear with peak oil must be extended fully to mean that no profit can be made post peak oil. This is clearly false.
In fact, even the interest part of the financial system is based on risk. The riskier the debtor, the higher the interest the debtor must pay in exchange for the loan. In other words, the interest is a reward for taking the risk, not a guarantee of return. Currently as it stands, loans are not repaid all the time. Some of them are collected and some are not. The bankruptcy system is in place to make sure that an honest but insolvent debtor can escape his/her debts and the bad debt is written off via the taxation system.
The best the peak oilers can argue is that an oilshock induced recession would increase the number of bad debts (as recessions always do) and thus the amount of credit available to the system would reduce (called "tightening lending"). This is hardly a disaster and is the normal situation. Post recession, any banks would be better placed to predict who would be a good creditor and who wouldn't. So the interest part would conceivably contract but not disappear.
Is the entire system based on interest? No it is not.
Parts of it (the commodities market, the futures market and the stock market) are based on asset appreciation. Bidders for the various instruments bid on their perceived value of an instrument whether it is undervalued (if they're going long) or whether it is overvalued (if they're going short). This type of instrument (in the stock market for example) is based on the premise that a profitable company will be worth more in the long run and thus pay higher dividends (share of profit) in the future, or not as the case may be. Since stock markets existed in the seventeenth century (pre industrial revolution) and commodities markets for much longer than that, it's hard to argue that they depend on oil.

The second case is an interesting one because it using the word growth to mean many things. In the context of the peak oil doomer argument, growth is generally assumed to mean "growth in resource usage" because of the assertion that economic growth needs energy growth and that the only "real" kind of growth is growth that creates more "stuff". The doomer argument is that you cannot have unlimited growth in a finite world and our system (based on infinite growth) is therefore unstable and will ultimately collapse.
Well, if you look at the question of "growth", with regards to the financial system, what you're really talking about is the growth of savings. Is it possible that savings can grow without an oil based economy? Why yes it is. All someone has to do to grow their savings is to spend less than they earn. Unless the doomers are going to argue that peak oil means everybody suddenly has to spend every penny they ever earn from now on, then the argument that growth of savings will stop is nonsensical. Clearly we can grow savings.
Can we grow the economy? Yes we can. All we need to do is have people spend more and more money. How is this possible even today if people don't have infinite money? It isn't possible long term even today. Growth today is based on fractional reserve banking which multiplies the money in deposit accounts by the "money multiplier". This allows the economy to grow beyond it's natural rate limited by the growth of savings.
Now the more astute among you will have noticed an anomaly when we talk about growth.
It's this: growth cannot possibly continue forever unless either income rises forever or else the money multiplier is infinite.
So we have stumbled on a fundamental truth. Our current system isn't based on growth.
The horror!
So what IS it based on?
This is evident in the commodities markets where the cycles are visible based on growing seasons. EVERY other market is exactly the same, except the cycles are longer.
Clearly since summer always follows winter, a system based on cycles will always seed, grow, boom and bust only to do the same again next time. The key point is that one industry is replaced by another and "growth" is in the new industry which replaces the old.
What we are witnessing with peak oil is the end of the boom phase of the oil industry. Concurrently with this we are in the very early stages of the "seed" phase of the industries that will replace oil.
Our system is based around this fundamental fact.
Now the doomers could say "but our economy has been growing steadily concurrently along with oil".
I would argue that what they are seeing is correlation, not causation.
In an apples to apples comparison, a large populous country with similar laws and infrastructure to a smaller country in terms of population with similar laws will have a smaller economy.

There is thus a reasonable argument behind the proposition that just maybe, the world economy is so large because the population is so large and that the larger the population, the more energy is used. The causative factors are exactly backwards from what the doomer crowd would have us believe.

The second part will follow later.

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