Wednesday, June 30, 2010

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.