Dear Julia (again)

The discussion of the GFC has 2 orthogonal threads. The main one we hear is between those favouring more stimulation (led by Paul Krugman) and those favouring deficit reduction and to hell with the consequences. The other thread is whether the problem is just about finance (how the money goes round in circles) or is there some real physical problem that is causing economic problems. If you don’t look at both these questions together correctly then there is no chance of getting the right answer.

There is a real physical problem. The world’s economy is heavily dependent on oil. High oil prices have been unable to raise production over the last 5 years. We have started looking for oil in insanely expensive places. You only have to watch the markets. Whenever there is growth then the price of oil goes up. Whenever the price of oil goes up then growth stalls.

So Julia, please wander down the corridor and ask the Treasurer to get you a report on what will happen if world oil production starts declining at 2% a year. Don’t ask whether that is possible: they’ll just tell you “If the price of eggs is high enough then roosters will lay”. You need to talk to non-economists to figure out if it is possible. However economists should be able to tell you the economic effect of such a decline. I hope so. Oil production has been closely coupled to growth for 60 years. The question we need to understand is how quickly we can decouple.

The other issue is that without more stimulation then we will drift, or more likely plunge, into the Third Depression (recently so named by Paul Krugman: the first 2 started in 1873 and 1930).
We cannot stimulate economies back to “Business as Usual”. Until we decouple from oil, BAU is over. Nor do we need to look for shovel-ready stimulation. Things are going to be bad for a long time and we need to do the right thing, not any thing.

And the right thing is clear. We need to put all possible effort into decoupling from oil. To a large extent that means changing the driving engine of the economy from oil to electricity. Prof David MacKay (Chief Scientific Advisor to Britain’s Ministry of Energy) has worked out that getting of oil and natural gas means we will need 3 times as much electricity production as we have now. We also have to electrify a huge amount of infrastructure, particularly transport.

I hope that soon after your election victory you tell the Australian people: “I have just received a report from the Treasurer on the expected impact of the end of the era of cheap oil. It makes sobering reading.” And then you tell us what the government is going to do about it. I advise you to be very skeptical if your advice suggests that renewables can do a large part of the job, and seek independent verification of that. Oil works because it is cheap (still). Electricity is not as convenient for many purposes and needs to be even cheaper to maintain our current level of prosperity.

Dear Julia

What a pleasure it is to have a secular leader who is never likely to be influenced by loyalty to a higher power than the Australian people.

Let me make a point on climate change. A warmer world will almost certainly be wetter rather than drier. Warmer oceans evaporate more. Models suggest that Australia might be drier south of a line from Sydney to Perth, but this is really irrelevant. Addressing climate change has to be done by all countries, not just those that lose out. The results of climate change remain "uncertain and possibly very serious", as Prof MacKay, the Chief Scientific Advisor to the British Ministry of Energy and Climate, always says. So we can't build the public consensus on the basis of the negative effect on Australia, because that just invites the countries that expect to gain (such as Russia and Canada) to refuse to cooperate. It also opens the way for those opposed to action to say "Global warming is the reason Lake Ayre has filled two years in a row and the outback is blooming" and then the whole thing can become a battle between Northern and Southern parts of Australia. It is important to focus on the effect on the world.

Unfortunately it is tough to adopt a consistent position on climate change. If you run the climate models under various scenarios you find that there is only one variable that makes much difference over 50 years, and that is: the amount of coal that gets left in the ground. However the coal industry is very important for Australia domestically and for exports. And the coal industry unions are very powerful. The sensible place for a tax on carbon is: as it comes out of the ground.

But let's be realistic. It will be politically nearly impossible to raise the price of electricity in Australia, despite our prosperity. Our energy importing friends in the Western world are going to have far worse political issues with this. Realistically the one way to stop coal consumption is to find a cheaper source of electricity. And indeed there is. The German government has imposed a super profits tax on the companies that can produce carbon-free electricity very cheaply: the Nuclear Power industry. I urge you to conduct a thorough impartial investigation into Australia's energy future. Even if it is politically impossible to introduce Nuclear Power now, can we please at least enhance our engineering education and our R&D capability in the area.

There is no more easy oil to find on the world, and soon there will only be hard oil. We will never run out of oil, but that hard to get oil will be expensive. That is going to keep depressing the world economy for many years until we move to alternatives. There are also significant energy security concerns with oil. The world needs to move to electricity for transport, heating and a whole lot more. Let me assure you that this will work very badly if the electricity isn't cheap and reliable. The world is being seriously misled about the effectiveness of renewable energy. If anybody talks about generating "capacity" then they are trying to mislead, because wind and solar only operate at a fraction of their capacity (apart from their impact on the countryside). The key number to determine and keep in mind is how much extra electricity we need if we are to use electricity for transport and everything else. The answer determined by Prof MacKay is that Britain will need 3 times as much electricity as it currently produces. Our figure will be lower but still very big.

So the world as a whole has to move to nuclear power, and it will, and it is doing so. Maybe Australia can survive on renewables. But would that be wise? Here is a point that all Australians can understand: Even if it is possible to build an economy on renewable energy, there are inherent limitations that will eventually put a cap on prosperity. Once that limit is reached the countries running on nuclear power will become ever stronger than us. But actually, we can see, this will happen long before we get anywhere near that limit.

Understanding Inflation

Paul Krugman keeps telling us that we need to keep stimulating the economy in America and Europe. What he rarely says too loudly is that there is a limit to how much this can be done by borrowing. The only possible source of money for that stimulation is to print it. [Of course it isn't literally printed: it is all just numbers in computers.]

When GFC/I hit, then banks did start printing money. They called it "Quantitative Easing". They used the printed money to buy bonds, and they promised that they would later unprint the money by selling the bonds. Printing money is criticized for causing inflation. Commentators seem to have no trouble saying this with a straight face when the reality in America and Europe is damaging deflation. We can certainly agree that unprinting money at this time will add to deflation.

So why is everyone so hysterical about inflation? We are usually pointed at Germany's bout of hyperinflation in the early 1920s as a lesson in the bad things that can happen. But hang on: After their burst of hyperinflation sorted out their economy, Germany got its act together, and only 15 years later they nearly conquered the whole of Europe. Meanwhile their victorious opponents who were also basket cases in the early 1920s didn't have inflation and they were still basket cases 15 years later. So we need to understand what inflation does that is helpful. But first a foray into politics.

Listen to the debate between the stimulators (led by Paul Krugman) and the deficit-reducers (led by right-wing parties everywhere, with the left too nervous to criticize). You would think that this was a purely technical debate about how best to run the economy in the national interest. Nothing could be further from the truth. When governments act they produce winners and losers. This has the unfailing effect of bringing out the engines of disinformation on both sides. And inflation makes losers of the most powerful people on the planet: lenders and people with cash in the bank.

Inflation makes it easy for borrowers to pay back their loans. This means that borrowers come to fully own the real physical assets that were the collatoral for the loan. They then lavish care and attention on those assets and make them as productive as they can be. Consider on the other hand what happens when the economy is weak and there is also deflation. The borrowers know that they can never repay that loan. They squeeze as much value as they can out of the assets without the ability or incentive to properly maintain them. The employees who know how to operate the equipment leave. Eventually the lenders get the assets but the value of those assets is substantially reduced.

So who wins from deflation and loses from a bit of inflation? Hardly anyone. Except that this misses some important human traits. One is that we hate seeing other people get something for nothing, and there is no doubt that debtors get that with inflation. Also humans see gains and losses in relative terms: we like to do better than others, particularly our neighbors. That's why increasing standards of living don't increase happiness. So the lenders rightly see inflation as transferring real wealth from them to debtors. And the lenders are the most powerful people on the planet.

So how much inflation do we need? Our main experience since WWII is that economies run well with about 3% growth and 2% inflation. This means about 5% growth in the nominal economy (the size of the economy in dollars, without taking into account the decline in the value of the dollar). It seems likely that this applies whatever the growth rate. If the real growth rate is 10% then a 5% deflation rate won't cause any problem. On the other side of the ledger, if the economy is declining at 2% for some reason, then you need 7% inflation to keep the wheels of commerce moving. [Note that we should be taking population change into account, so that the required growth in the nominal economy is probably 3% per head of population, assuming the added people are statistically similar to the existing population. But I'll ignore this subtlety.].

Why do we need this nominal growth? Without it then people who just sit on their money, and don't try to use it to generate wealth, do nearly as well as, or perhaps better than, the people who are trying to move the economy along.

Many people think the world would work better if money was a store of value as well as being a medium of exchange. That wouldn't work. Still there is merit in society storing valuable commodities to prepare for difficult times ahead. The government could sell certificates representing a basket of stored commodities. This would act as an additional sort of money that was a store of real world value. It would be similar to the gold standard back when you really could change your notes for gold, but it would not be based on a single commodity. Certificates would be cashable for money at any time for the current market value of the commodities. When the government has less certificates than stored commodities it would sell the commodities to restore balance.

The basket of commodities would be chosen (and adapted over time) to reflect the manufacturing and direct consumption needs of society. As such it would not be a distortion of production. Compare this with people that want to restore the gold standard. This would take monetary policy out of the hands of people trying to make the economy work, and place it back into the hands of miners, alchemists and conquistadors.