Energy Scarcity Could Lead to a Hyperinflationary Depression

Tight oil production, whether at a peak or not, will (has) cause(d) oil prices to rise. We saw this from 2004-2008. During late 2008, we also saw what happens to the economy when oil prices hit $145/bbl.

Despite what many believe, peak oil won’t create a Mad Max scenario with outlaw biker vigilantes roaming the roads. (At least not in the intermediate future.) Black leather and bad haircuts aside, peak oil will simply stealthily chip away at the edges of our financial system and living standards. Occasionally there will be flareups – we’ll give these names like ‘subprime crisis’ and ‘sovereign debt crisis’. But what’s really happening is that high oil prices are eroding the weakest links in the global economic system.

As oil prices rise, discretionary incomes get squeezed. Individuals and businesses (e.g. commuters) most reliant on transportation fuels will cut back the most. Although the initial impact to economic activity may be small, it will be enough to topple highly leveraged entities, whether they are hedge funds, businesses or Joe Smith.

Defaults then creep through the financial system putting many financial intermediaries at risk. Participants become paralyzed by fear and distrust pushing the entire economy to the brink of collapse.

Enter the central banks

The central banks – either directly or using the treasury as an intermediary – pump liquidity into the financial system and buy bad debts from the private sector. This effectively transfers the bad debt from the private sector to the public sector. In addition, fiscal stimulus (which tends to be directed monetary stimulus) adds additional public sector debt in the name of stimulating growth. In whole, debt burdens rise. Of course, all this is done under the assumption that the economy will somehow be able to repay these new debts through future growth.

Return to growth

Let’s assume that some sort of growth returns after the economy is stimulated. If growth returns, tax receipts will rise and governments can start to repay debts. However, growth will also increase demand for oil, sending prices up towards another threshold that once again breaks the weakest links of the economy. That threshold could be the same, higher or lower than the previous threshold. Also, the level of economic activity required to push oil prices beyond the next threshold may not be the same as before – this is especially true of exogenous demand (e.g. emerging markets) is driving up oil prices even as endogenous economic activity remains weak.

Bottom line is that at some point, there will be another oil-induced decline in economic activity. The default, bailout, growth scenario repeats.

As high oil prices become pervasive throughout the economy (remember that cheap oil has provided the world an energy subsidy by its role in transportation, plastics, agriculture, chemicals) the robustness of aggregate wealth creation will suffer. This will increase the number of weak links throughout the economy. It will also increase the sensitivity of the weak links.

Consequently, the cycle of private sector deleveraging and public sector leveraging becomes more desperate. Defaults become more difficult to manage, bailouts to support financial infrastructure and the growing mass of unemployed cause monetary growth to spiral out of control and economic ‘recoveries’ atrophy to periodic episodes of stabilization.

Over the long-run this scenario would look like a hyperinflationary depression, as central banks print while the economy shrinks. That is, unless we a) wean ourselves off oil dependency or b) find some more cheap energy.