If I bake a batch of cookies and the recipe calls for two cups of flour but I have only one, it is pretty clear that I can’t bake a full batch of cookies. All I can make is half a batch. I will end up with half of the sugar, and half of the eggs, and half of the shortening that I originally planned to use left over.
Liebig’s Law of the Minimum applies in situations like this. In agriculture, it says that growth is controlled not by total resources available, but by the one in scarcest supply. If a baker does not have enough of one necessary ingredient, he will have to make a smaller batch. I wonder if it isn’t a little like this with oil and the economy.
Oil seems to me to be a necessary “ingredient” in our economy. If for some reason oil is not available (perhaps because the buyer cannot afford it), then to some extent other “ingredients” in the economy, like human labor and new houses and stores in shopping malls, are less needed as well. That is why as oil consumption decreases, there are so many layoffs, and the effect multiplies and affects all areas of the economy, even housing prices and demand for business property.
If worldwide oil price is on the high side (like it is now), customers are faced with a choice: should they buy the full amount of high-priced oil, or should they cut back in some way? For example, a state transportation department might find that asphalt (an oil product) is high priced. They might decide to buy less and fix fewer roads. If they do this, they won’t need as many workers to spread the asphalt, so they may lay off some workers. With less demand, refineries that make the asphalt won’t need to process as much oil, so some of the older refineries can be closed, and their workers laid off.
The laid-off workers will have less money to spend, so they will cut back: go out to restaurants less, take fewer trips, and wait longer between haircuts. And of course, there will be little need to build new refineries, or to buy new trucks for spreading asphalt, so these changes will impact workers in the construction business and in the manufacturing of trucks. A laid-off worker may miss mortgage payments, and this will trickle through the economy in other ways. Housing prices may drop from lack of demand because some workers have lost their jobs and because foreclosed houses are on the market at low prices.
Sometimes there may be the possibility of substitution: in this example, switching to concrete or gravel roads instead. But even in this case there may be layoffs: less need for refineries, for example. Also, spreading gravel may take fewer workers. Concrete roads may last longer and therefore affect employment in years to come.
Let’s take another example. If oil prices rise, airlines will need to raise their prices to cover the cost of fuel. Because of higher prices, businesses can be expected to cut back on travel, and less-wealthy vacation travelers may stay home. The reduction in travel can be expected to lead to layoffs in the airline industry. There will be less demand for new airplanes (unless an inventor can truly figure out a way to make a more fuel efficient airplane!), and less demand for workers who build the airplanes. Fewer travelers will pass through the airport, so airport restaurants and shops are likely to lay off workers.
As a third example, if oil prices rise, grocery stores will raise the price of the food they sell because oil is used in food production and transport, and stores will need to pass the higher costs through to the customer. While customers are likely to “trade down” to the less-expensive items offered, in total, they are still likely to spend more on groceries than in the past. To compensate, customers can be expected to cut back on their discretionary expenditures elsewhere. A few may even miss mortgage payments.
How can this problem of layoffs, debt defaults, and falling housing prices be avoided when oil prices rise? I am not sure that it can be.
If a government has a huge amount of money for oil subsidies, perhaps it can subsidize oil prices so the effect isn’t felt throughout the economy. Usually it is only the oil exporters who can afford such subsidies.
Or a government can make a rule that companies can’t lay off workers, no matter how much demand drops. Unfortunately, such a rule is likely to result in many bankrupt companies. If they continue making goods few can afford, they will end up with a lot of excess inventory as well.
Or governments can try to cap oil prices. But now we are running short of oil that can be extracted from the ground at low cost, so capping prices has the perverse effect of reducing supply. Governments can also raise taxes on oil companies, but to some extent this also has the effect of reducing supply. The fields that had marginal profitability before the tax hike are likely to be closed.
If the government wants to keep employment up, somehow it needs to find less expensive alternatives to oil, so as to stop this vicious cycle of higher oil prices sending the economy into a tailspin. Higher priced substitutes are not helpful — they just make the situation worse! That is why most of the alternatives now under consideration are dead ends, unless the costs can be brought way down, say to $50 or $60 a barrel. Even electric cars need to be inexpensive to really help the economy.
Too many people don’t really understand where the economy is running into trouble and are proposing solutions that can’t fix the problem. Our real problem is that the economy cannot afford high priced oil; it is not that there is too little (high priced) oil in the ground.
We have always assumed that we can have cheap and available ingredients for our societal “recipe” for how our current economy functions. Now this assumption is coming into question.
Gail Tverberg, actuary and writer, is an editor of The Oil Drum.
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