The Missing Linkages Needed to Describe the Role of Energy in the Economy

What if you realized that the fundamental economic framework of macroeconomics is insufficient to inform our most pressing concerns? The world is dynamic, in constant change, yet most economic models (even the most widely used “dynamic” model) lack fundamental feedbacks that govern long-term trends (e.g., regarding role of energy) and make assumptions that prevent the ability to describe important real-world phenomena (e.g., financial-induced recessions).

Monetary models of finance and debt often assume that natural resources (energy, food, materials) and technology are not constraints on the economy.  Energy scenario models often assume that economic growth, finance and debt will not be constraints on energy investment.  These assumptions must be eliminated, and the modeling concepts must be integrated if we are to properly interpret the post-2008 macroeconomic situation: unprecedented low interest rates, high consumer and private debt, high asset valuations, and energy and food costs that are no longer declining.

What is the solution?

As we attempt to understand newer and more numerous options (e.g., electric cars, renewables, information) regarding energy system evolution, it is paramount to have internally consistent macro-scale models that take a systems approach that tracks flows and interdependencies among debt, employment, profits, wages, and biophysical quantities (e.g., natural resources and population).

There is a tremendous research need to develop a framework to describe our contemporary and future macroeconomic situation that is consistent with both biophysical and economic principles.  Unfortunately, this fundamental integration does not underpin our current thinking.  This improved framework can contribute to more robust policy-making and investment under both current and future changing circumstances.

Background

Role of Resources in Preindustrial to Industrial Transition

Over the last 200 years human civilization has transformed from one dependent upon renewable energy flows (e.g., sunlight) to one dependent upon fossil energy stocks (e.g., oil, gas, and coal).  Climate change and resource depletion are driving society to understand how to again live off of low-carbon renewable flows of primary energy. Except this time we’re much smarter, and we have increased technological know-how.

“… all models are approximations. Essentially, all models are wrong, but some are useful.” G.E.P. Box (1987), p. 424

Narratives and models exist for describing past agrarian civilizations and their relation to resource access (Tainter, 1988, Tainter, 2011, Tainter et al., 2003) as well dynamics of population and social structure (Turchin et al., 2013, Turchin and Nefedov, 2009).  These narratives often describe how the quality and quantity of natural resources relate to the cyclical growth, structure, inequality, and/or complexity of society and/or the economy overall.  Because agrarian societies were limited by solar-driven energy, natural resources (e.g., land) were seen as a primary economic factor in classical economic thinking.

Narratives and models exist for describing the post-World War II economy characterized by unprecedented growth in economic activity, population, and energy consumption. But these (neoclassical) economic models largely do not even account for the role of natural resources, including energy. The neoclassical economic framework has proved useful for many purposes. But today’s challenges are those of new constraints pushing the boundaries of economic thinking.  Most current macroeconomic modeling approaches, often calibrated only to relatively recent fossil-fueled history, might be insufficient for understanding current and future economic growth with regard to constraints within food, water, and energy sectors; climate change; and debt (Pindyck, 2013, Stern, 2013, Keen, 2013).  For example, a body of research suggests that “productivity” (e.g., total factor productivity) is largely described by quality-adjusted energy (e.g., efficiency to services and useful work), and is a plausible explanation for lackluster labor productivity in recent years (Ayres and Voudouris, 2014, Ayres, 2008, Cleveland et al., 2000).  However, models used to inform the Intergovernmental Panel on Climate Change do not include “negative feedbacks on factor productivity” associated with increasing rates of an energy transition (as noted by (King, 2015a) in IPCC assumptions, e.g., Figure A.II.1 of (Krey et al., 2014)).  Thus, lack of energy feedbacks in macroeconomic models is a very important limitation that needs improvement.

What is different about today (21st Century)?

Central banking interest rates are lower (now negative in some cases) than any time in the history of central banking, and debt levels (public and private) are at all-time highs.  Since around the year 2000, globally food and energy are no longer getting cheaper (King, 2015b) after continuous decreases since the industrial revolution. Developed economy populations are aging due to below replacement level fertility rates that are fundamentally driven by increasing cost of living (relative to wages).  Economists are debating if we are just in another debt cycle or if there is a fundamental “secular stagnation” upon us, but they still neglect the role of resource availability as a possible underlying explanation (Teulings and Baldwin, 2014).  However, the size of the natural resources base, (e.g., energy) the sizes and ages of population, and financial factors such as debt, wages, and inequality are inherently interdependent.  We cannot coherently explain our current situation without accounting for these interdependencies.

How are debt, growth and energy consumption linked? The Earth is finite, so what are the relations and timing between resource size, population, and economic characteristics we should expect when growth stagnates?

New research is needed to answer these and other important questions.   We must create a consistent biophysical and economic framework to describe the industrial transition to our contemporary macroeconomic situation.

There exist models of macro-scale system dynamics of money, debt, and employment (e.g., the Goodwin and Minsky models of Steve Keen (Keen, 1995, Keen, 2013)). There exist macro-scale system dynamics models of biophysical quantities (specifically population and natural resources such as in (Meadows et al., 1972, Meadows et al., 1974, Motesharrei et al., 2014)).  In other words, there are models of each separately, but they have not been combined to fundamentally link the biophysical world to monetary frameworks.

If we were to perform this type of modeling, we could be more capable in answering important questions for a low-carbon transition. Here are two example questions.

  1. How does the rate of transition feedback to growth of population, economic output, and debt?

The faster we transition, the more capital, labor, and natural resources will be mobilized to become part of the “energy” sectors. The larger this mobilization, the higher the cost of energy will become as there is an increasing number of “energy” sector workers dependent upon selling energy to a decreasing set of “non-energy” sector consumers. Increasing labor and capital shares for energy is the exact opposite trend of industrialization as we know it, and there is a critical need to understand the associated feedbacks.  For example, the most recent oil and gas boom and bust cycle (2007-2015) could possibly be explained by too many resources being allocated into the energy sector over too short of a time for the rest of the economy to adjust. It is important we understand this growth feedback between the size (labor, capital, energy) of energy and food sectors and economic growth.

  1. How does the capital structure (e.g., fixed costs versus variable costs) of fossil and renewable energy systems relate to and affect economic outcomes?

Renewable and low-carbon energy systems (e.g., PV, wind, nuclear, electrochemical storage) are characterized by a much higher fraction of fixed (capital) costs as compared to fossil energy systems (e.g., coal, natural gas, and oil). Higher fixed costs systems are more favorable in certain (e.g., predictable) and lower growth (with low discount rate) environments whereas lower fixed cost systems are more favorable in uncertain and high growth situations (Chen, 2016).  The reason is that in high growth situations you do not want to be “stuck” with old capital in which you are still waiting for returns to reinvest.  Low economic growth, associated with low discount rates, also make high fixed cost and longer-life assets, like renewable systems, more favorable. Thus, we should expect low growth (“secular stagnation”) to be associated with low interest rates and high renewable energy installations, just as has happened over the last several years.

Figure 1. We need research to make the critical link between biophysical modeling concepts and those of economic models that specifically include the link of debt-based finance to employment and economic growth.

Energy and food costs have declined since industrialization, but no longer

Figure 2.  The amount spending on energy, relative to GDP of economies, has dramatically declined since the beginning of the Industrial Revolution and the fossil fuel era.

Takeaways from Figure 2:

  1. In the United Kingdom, the first country to transition through the Industrial Revolution, went from having energy expenditures equal more than 30% of its GDP to less than 6% be the turn of the 21st
  2. The defining characteristic of modern industrial economies is the replacement of physical labor (“power” in the fields of farms driving by human and animal muscles) by machines and fuels.

For the First time in the Fossil Fuel Era, Food and Energy Costs are No Longer Getting Cheaper

 

 

 

 

 

 

 

Figure 3.  (a) U.S. spending on the basic needs of food and energy declined for almost 70 years after World War II, but that trend has come to an end in 2002. (b) The cost of world food and energy (2 estimates for world energy spending, not including biomass and non-marketed energy) also seems to have passed its lowest point around the year 2000.

Takeaways from Figure 3:

  1. Food = energy.
  2. Food and energy became cheaper in the U.S. ever since the years following the Great Depression, but only until 2002. The driving factor for over 70 years has been decreasing food costs, but that is no longer the case.
  3. Thus, because of the cessation of the long-term trends in Figures 2 and 3, the post-2000 world will be governed by fundamentally different factors economically, socially, and technologically than the pre-2000 world.
  4. Because of these energy (and food) constraints, issues of equality are becoming more to the fore, but there is not yet a viable mathematical framework that makes this very important connection that the reason we need new approaches is because of resource constraints relative to the 7+ billion people now on the planet.

U.S. consumer costs of fundamental needs (energy, food, housing, transport) are no longer declining

Figure 4.  U.S. Personal Consumption Expenditures (PCE) as a percentage of spending category.  The year 2002 marks the low point in the percentage of PCE spent on “food and energy” [Bureau of Economic Analysis, Table 2.3.5].  The average U.S. personal income has not kept up with total spending (e.g., spending is outpacing income as represented by the declining line trend) and has been supplemented increasingly with debt [“compensation of employees” is from FRED time series “COE” then divided by PCE from BEA Table 2.3.5].

Takeaways from Figure 4:

  1. Increased GDP and declining costs of “fundamental needs” made room for increasing health care and finance costs. a. For 70 years, approximately 60% of personal spending has gone to “energy, food, and transportation” plus “health care”.
  2. Real spending power has been declining (spending is higher than income) for the last four decades, as indicated by the decline in compensation over spending (personal consumption expenditures, PCE).
  3. The lack of a decline in the cost share of “fundamental needs” helps explain why increased gross power consumption no longer occurred in the U.S. after 2005.

Money is Debt, and Personal “Debt / Income” increased as long as Relative Food (and Energy) Costs Declined

   
(a) (b)

Figure 5.  As (a) food costs and (b) “energy + food” costs declined for ~60 years after World War II (the inverse of spending/GDP is plotted on left axis), so have American consumers increased debt relative to income (right axis), until the Great Recession.  The minimum in food costs occurred in 2006, and the minimum in “food + energy” costs occurred in 2002 (very close to level in 1999).

When the level of debt relative to income, wages, or GDP is lower, this is an indication of the increased ability to pay back what is owed, and vice versa.  Thus, higher values of the “Household Credit (Debt) / Income” ratio means that people have less money relative to their liabilities (e.g., mortgage, car payments, student loans, etc.).  Both in the 1970s (high oil prices) and after 2008 (e.g., financial crisis and the beginning of the Great Recession), food costs stopped declining (e.g., black line stopped increasing in Figure 5(a)), and subsequently so did accumulation of debt.

Takeaways from Figure 5:

  1. Debt is money.
  2. Money is created when commercial banks lend money to businesses, not when the U.S. Treasury prints money or when Federal Reserve Bank lowers interest rates. Those government and Fed actions are reactions to the creation or destruction of money (e.g., paying back loans) within the real economy.
  3. Businesses seek new loans when economic opportunities are present. Thus, a growing economy can support more debt.
  4. Economic opportunities are present when consumers have disposable income to spend (and when innovative technologies supplant old technologies, thus lowering prices, and enabling growth).
  5. Consumers have more money to spend when core needs (e.g., food, energy, housing) are getting cheaper relative to incomes. Thus, if these core needs are no longer getting cheaper, this is an indication of the lack of income growth to support business investment. In turn banks stop lending because there are fewer viable business opportunities.
  6. The conclusion is that without decreasing food and energy costs to consumers, real incomes do not rise.
  7. This is a viable explanation of the post-2008 economy, but one ignored by practically all policy makers, economists, and advisors!
  8. Note: In 1999 the Gramm–Leach–Bliley Act repealed the Glass-Stegall Legislation of the 1933 Banking Act, just before household debt exploded out of historical proportion to food costs (Figure 5(a)).
  9. Note: In late 2001, China joined the World Trade Org., ~coincident with lowest “energy + food” costs.
  10. Note: Before the 1970s, household debt/income rose before energy and food costs declined; after the 1970s, this order is reversed, as energy and food costs first declined, then debt/income increased.
  11. Note: The intersection of the lines in 2015 (Figure 5(b)) imply that debt levels were more “normal”, yet now subject to fluctuations in both energy and food spending since food spending stopped declining.

Concluding Takeaways:

The evidence supports the view that the world economy has reached a fundamental turning point around the turn of the 21st Century.  This turning point is expected based upon the consideration of biophysical inputs, and thus limits to economic growth, that has been predicted using systems approaches to modeling world dynamics.

The trend of decreasing costs of the basic needs of food and energy is no longer occurring as it has since the start of the industrial era.  We need macroeconomic thinking and models that can integrate the major important factors governing world and U.S. dynamics. Many of these are already considered (e.g., population aging and demographics), but practically no one is considering the fundamental role of “food and energy resources” as a pivotal factor for the economy’s post-2008 lackluster performance and as an explanation for financial (wages and debt) difficulties.

Research that blends wages and debt into the resource-minded systems viewpoint is crucial, and in need of support for the research and dissemination of findings.

Research Funding

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