Friday, June 20, 2008

Julian Simon’s Virtuous Cycle: the good news and the bad news

Why don’t we run out of resources? The late Julian Simon had several theoretical explanations for why finite natural resources are not, in the long run, a binding constraint on economic growth. One of the most important pieces of the explanation was his account of the "virtuous cycle." It works like this:

Suppose there is a fixed physical amount of some important material. Suppose also that per capita income grows, as does population. We would expect that this would begin to drive up the price of the material, which in turn would depress economic growth.

The result?

The higher price discourages consumption of the material, and thus slows the rate of depletion, but more importantly, the higher the price the more intense the search for substitutes, alternatives, and technical improvements that allow more services to be obtained from a given quantity of the material. As Simon pointed out, historically this search consistently generates knowledge and innovation that leaves us wealthier than if the problem had never been encountered. The end result is a virtuous cycle that drives economic growth. And furthermore, because there are increasing returns to knowledge, this process becomes stronger with higher levels of development.

This cycle makes theoretical sense, and empirically it’s a fundamental factor in historical economic growth. Now let’s apply it to oil.

Prices of crude oil have been sharply increasing throughout this decade. Economic growth, especially in Asia, is the fundamental factor. James Hamilton (Econobrowser) has some interesting figures suggesting that this has only begun. Most notably, oil demand in China grew 7.2% annually from 1990 to 2006, and in 2006, the Chinese consumed 2 barrels of oil per person. Contrast this with the average Mexican’s 6.6 barrels, or the average American’s 25, and it’s obvious that there’s enormous scope for growth in demand. We may debate peak oil and similar supply constraint theories (I’m doubtful), but the near certainty of sharply increasing world demand mean that prices will continue to rise. Even with optimistic projections for new oil sources, demand will grow faster than supply, and price will rise.

But while increasing scarcity isn’t good news, Simon’s cycle suggests it’s not a crisis, either. High prices are a central factor that will drive a rational switch to non-carbon energy sources. And over the longer haul, we ought to be better off for it.

That’s the good news.

So what was the downside? Consider that governments everywhere are working to interfere with prices, not by increasing supply or reducing demand, but by directly interfering with prices, as well as energy marketing decisions. For example, in the United States, members of Congress have suggested price ceilings, windfall profit taxes, excise tax cuts, drilling ANWR, increases in the Strategic Petroleum Reserve, decreases in the Strategic Petroleum Reserve, suing OPEC, nationalizing American oil companies, and who knows what else, all with the avowed intention of reducing prices. Some of the proposed actions might make sense in themselves, but many are utterly insane. But in all cases, the fixation on reducing prices is completely misplaced. Congress is not going to be able to restrict world demand. And let the French fishermen, British truckers, and their ilk strike all they want, neither will the French or U.K. governments, nor the E.U. for that matter. High prices for oil are a certainty. (One of the great ironies in all this is that at the same time the public and pols are clamoring for lower prices, many of the same are also calling for reduced oil consumption, for a variety of environmental, economic, and political reasons.)

The only choice we have is how we will respond to higher prices. We can either let them alone, and allow people to respond entrepreneurially, unleashing Simon’s virtuous cycle, or we can let governments take command, and attempt to eliminate scarcity by legislation and decree through political processes. This latter approach won't work, and will make the adjustment to economic realities much more difficult. Unfortunately, I can’t name a powerful politician today who doesn’t favor this latter approach.

And that’s the bad news.

(Oil barrel gif from Hisland Oil and Gas)

Comments: Post a Comment

<< Home

This page is powered by Blogger. Isn't yours?