Remember all those #3 guys in al-Qaeda that we used to kill with such frequency? Well, with Osama bin Laden's death they've moved up to #2, and apparently we're still killing them.

Here's a little bit of a follow-up to my post yesterday about oil production and how it may now be a binding constraint on economic growth. The basic argument is fairly simple: Global production of oil has hit a ceiling — or, at best, will grow very slowly for the next few years on its way to a ceiling in 2015 or 2020 or so — and this is going to cause severe volatility in the global economy. As world GDP grows, demand for oil increases and bumps up against the supply ceiling, prices spike upward, and the world goes into recession. Demand for oil then decreases a bit, the economy recovers, rinse and repeat.

This is a plausible story, but as far as I know there's very little in the way of rigorous modeling of this entire scenario. At a minimum, any solid econometric model would need to account for the following:

  1. As the global economy grows, how does demand for oil increase?
  2. As demand for oil increases near the supply ceiling, how do prices spike?
  3. As prices spike, how does the economy react?

#1 is probably fairly straightforward. Doing the math rigorously is a challenge, but basically this is just a regression of oil consumption on world GDP. The evidence suggests that the relationship here is pretty strong: rich countries may have weaned themselves off oil a bit over the past couple of decades, but poor countries haven't. As incomes rise in developing countries, demand for oil goes up strongly regardless of how expensive it gets. This means that pretty much any period of global economic growth will very quickly push oil demand up to its supply ceiling.

#2 is a challenge because we've only been near the oil supply ceiling since about 2007 or so. There just aren't very many data points to work with here. However, we do know that earlier this year oil prices rose about $30 when we lost a mere 2% of global production thanks to the war in Libya. This certainly suggests that we're now in an era where very small changes in demand can have very large effects on price.

#3 would basically be a global version of the work James Hamilton and others have done on the effect of oil price spikes on the U.S. economy. You can see a bit of groping in this direction here, but I don't think anyone has done any kind of full-scale modeling.

All of this, of course, is contingent on the question of whether oil production really has hit a ceiling. That's still an open question, but we can say a few things for certain. First, oil production has certainly peaked in most of the world. The continental United States peaked in 1971 and has been in decline ever since. Prudhoe Bay peaked in 1989. The North Sea peaked in 1999. Norway peaked in 2001. China's massive Daqing field probably peaked around 2005. They're all still producing oil, but they produce less and less every year.

Second, the discovery rate of giant and supergiant oil fields, which produce most of the world's oil, peaked in the 1960s and has been in steep decline ever since.

However, there are still some big question marks in this picture. OPEC is one: no one knows for sure if OPEC, and Saudi Arabia in particular, has peaked or not. The Saudis claim they can continue to increase production, but there are some pretty good reasons to think they're at or near their peak. (They either couldn't or wouldn't pump more oil to make up for Libya's lost production earlier this year, for example.) On the other hand, Iraq's fields definitely have more production capacity. They just need to rebuild their pumping infrastructure. Still, taken as a whole, the balance of the evidence suggests that OPEC is either at or very near its peak and will be at a production plateau for the next decade or so before it starts to decline.

That leaves so-called "frontier oil" — polar and deepwater fields — and unconventional oil like the Canadian tar sands and Venezuelan heavy crude. This is truly uncharted territory, but it's wise to take the more optimistic forecasts with a grain of salt. If history is any guide, there will be some spectacular finds in these areas, but also the usual number of disappointments. And even if these sources pan out, the real question is whether they'll produce enough to offset the declines everywhere else. This is doubly uncharted territory because we don't know for sure how much oil we'll get from these new sources and we don't know for sure what the decline rate will be for the world's existing fields (improved drilling technology makes a big difference in the rate of decline). These are both hotly contested subjects, all the more so because in the past the official forecasts from places like the International Energy Agency have been so wildly — and frankly unbelievably — optimistic (see here and here).

The chart at the bottom shows an oil forecast from ASPO, the Association for the Study of Peak Oil. When you put everything together, they estimate that world production peaked in 2008 and is now in irreversible decline. My own personal guess (worth exactly what you've paid for it) is that this is too pessimistic. I suspect that production will continue to grow slowly for another five or ten years, peaking around 95-100 million barrels per day (compared to current production of 88 mbd). But the ASPO estimate and mine aren't really as far apart as they sound. Either way, demand for oil will increase faster than supply whenever the global economy is growing, and as long as that's the case, and we're bumping along near the peak, oil prices are going to be extremely volatile — and the global economy is going to be volatile right along with it.

This is not something that can be tamed with gasoline taxes in the United States or anything similar. It's a global phenomenon. But it's all the more reason we should be making Manhattan Project kinds of commitments to developing alternative energy sources and reducing our economy's dependence on oil. There's plenty of low-hanging fruit in the areas of conservation and increased efficiency, and no reason to waste any more time arguing about it. At the very least, we should be doing the easy stuff.

There are plenty of places to learn more about this. If you're interested in my lengthy takes on this from back in 2005, try reading "Crude Awakening," a piece I wrote for the Washington Monthly, and this five-part blog series I wrote around the same time in order to provide more detail (and charts!) than I could fit into the magazine.

No theme today, just some nice pictures of the cats taken as the sun goes down and provides some lovely lighting. Enjoy. And for all of you on the East Coast, human and otherwise, stay safe from Irene this weekend.

Jon Chait points out that the results of the latest Pew poll are pretty remarkable:

People always want leaders to compromise. It's amazing that a plurality wants Obama to confront the GOP more strongly. Want to see something even more amazing? You're seeing non-trivial numbers of Republicans say that Obama should stand up to the Republicans.

He's right. It's no surprise that liberal Democrats increasingly want Obama to fight back against Republicans, but that's not the real story here. The biggest shifts in attitude have come from the center. Take a look at the circled parts of the table: the entire middle of the political spectrum — liberal Republicans, independents, and conservative Democrats — is speaking pretty loudly here. They want Obama to fight back harder against the shouters in the tea party wing of the GOP.

As Chait points out, Obama is walking a tightrope: if he does get more confrontational, he risks losing ground in the areas where he's still viewed positively (trustworthy, well-informed, cares about people, etc.). But he better figure out how to walk it. His entire electoral strategy is based on winning the middle, and the middle is getting fed up.

You can see the full Pew poll here. It's interesting reading.

Herbert Grubel says that Warren Buffett's plan to raise taxes on the wealthy wouldn't do much good:

Recently, he used his formidable reputation to suggest in the New York Times, Financial Post and an interview with Charlie Rose on PBS that the U.S. government should raise taxes on the 400 super-rich, who in 2008 together earned $90.9 billion and paid only on average 21.5 percent of it in taxes. That is lower than the average percentage paid by most middle-income Americans.

....[If taxes on the super-rich went up to 50%] revenues from the top 400 earners would go up by $26 billion....Since this year alone, the U.S. federal deficit will be around $1.4 trillion, or $3.8 billion a day, the new revenue would cover less than seven days of deficits. The numbers are even worse for total federal spending. In 2010, that amounted to $3.6 trillion or $9.7 billion a day. Buffett’s new taxes up against that would be gone in just 2.7 days.

But these numbers are excessively optimistic because the amount raised by higher taxes is likely to be much smaller than $26 billion discussed above. That is because, as he notes, a large proportion of the total income of the super-rich comes from capital gains and financial trading, which is at the discretion of taxpayers.

Grubel is right. Raising taxes on 400 people won't do much good. But he seems unaware that this argument points directly to a simple solution: instead of raising taxes on 400 rich people, raise them on 4 million rich people. That would cover a lot more than seven days of the deficit. And that top 4 million has done mighty well for itself over the past three decades.1

The rest of Grubel's piece is a tired repetition of the usual talking points about how returning taxes to their Clinton-era levels would devastate the morale of entrepreneurs everywhere, all of whom are hoping to become the next Warren Buffett. These entrepreneurs, of course, did just fine in the 60s, when tax rates were considerably higher than they are today, and they did just fine in the 90s, when top rates were a crushing 4.6 percentage points higher than they are now. Buffett is right and Grubel is wrong: entrepreneurs can get discouraged, but not by the difference of a few points in their tax rates 20 years in the future. For most of these guys, a difference of five points in their tax rate is simply dwarfed by the key factor in their success: whether their company does well. That's it. If your company does well you'll be rich regardless of whether capital gains rates are 15% or 30%. If it doesn't, you won't. End of story.

It's a different story for corporate CEOs, Wall Street traders, and the idle rich. For them, this stuff really matters. But entrepreneurs? They just want you to buy their stuff. Don't believe the snake-oil salesmen who tell you otherwise.

1A reader reminds me that Buffett is well aware of his. His recent NYT op-ed, after calling for spending cuts, specifically endorsed higher taxes on a wide range of the wealthy:

But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate.

That's not 4 million, but it's a lot more than 400.

Is the Tea Party dead? Dave Weigel points out that, unlike 2010, Tea Party challenges to Republican incumbents have gone nowhere this year. Once vulnerable Senate candidates like Orrin Hatch, Richard Lugar, and Olympia Snowe now look pretty safe. But that's only because, for all practical purposes, they've abased themselves so utterly to the Tea Party's demands:

The Tea Party, the Club for Growth—the whole movement has succeeded in driving Republicans further to the right. Nuking a few moderates in primaries was only part of that—a great story for the horse-race media, but not something that would keep up as the GOP was purified....Republicans seem to have figured this out. It's increasingly likely that no incumbent Republican will lose a primary to a Tea Partier in 2012. The movement can consolidate its gains. Safe districts and the fear of primaries do more to keep Republicans straight than the occasional wins.

I think this was always the endgame for the Tea Party. Just like every other fluorescence of right-wing activism over the past 50 years, its destiny was to flare up, get incorporated into the Republican Party, and then die out. The big difference this time has been just how complete its incorporation has been. Ultra-conservative flare-ups in the past have been increasingly potent — the John Birch Society was more successful than the Liberty League, the Gingrich-inflected Clinton conspiracy theorists were more successful than the Birchers, and the Tea Party in turn has been more successful than the Gringrichites — which has brought us to the point where there's really no meaningful distance between the ultras and the Republican Party establishment. The Tea Party really is dying away, I think, but only because their victory has been so total. For the time being, anyway, they control the Republican Party from top to bottom.

But for how long? Good question. Look me up in another decade or so and I'll let you know.

It's now crystal clear that (a) there will be no further monetary stimulus, (b) there will be no further fiscal stimulus, (c) Europe is in real trouble that it's very unlikely to address aggressively, and (d) China's growth is slowing. We should be investing enormous amounts of money into green research and green adaptation (higher efficiency, conservation, etc.) but we're not, and there's little prospect of this happening in the near future.

It's very hard for me to be optimistic about the economy in any way these days. Karl Smith keeps trying to tell me that pent-up demand for housing will drive recovery, and I'm sort of clinging to that. Maybe he's right. But it remains the case that it takes money to buy a new house, no matter how pent-up your own personal demand is, and I don't know where that's going to come from. Last week a friend of mine finally gave up on keeping the mobile home she bought a few years ago. She just flatly can't find a job, so she's selling it (she hopes) and moving in with her sister. That has to stop happening before housing can recover, and so far I'm not sure it's stopping.

I guess 9% unemployment is the new normal. Given our current unwillingness to do anything about it, I wouldn't be surprised to see us stay at this level for two or three more years. Maybe longer. Maybe a lot longer.

I've talked a few times (first here, most recently here) about the possibility that world growth is now constrained by oil production. The basic story is simple: As long as there's spare oil-production capacity, increasing demand caused by economic growth produces only a steady, manageable increase in oil prices. But oil production is now close to its maximum and can't be easily or quickly expanded. When the global economy grows enough that demand starts to bump up against this ceiling, oil prices don't rise slowly and steadily; rather, they spike suddenly, causing a recession, which in turn reduces oil demand and drives down prices. When the economy recovers, the cycle starts all over. Because of this dynamic, the production ceiling for oil produces a corresponding ceiling for world economic growth.

Stuart Staniford puts some numbers to this for our most recent recession. What would it have taken for growth to continue at its 2000-08 rate over the past few years?

In the counterfactual world, 2009 gross world product would have been 6.4 percent larger than in the actual world. We can estimate the implications for oil supply because we know that the global income elasticity of oil demand is about 2/3. Thus the counterfactual world would have required an additional 4.5 percent more oil than the real world.

…2009 oil production was around 85 [million barrels per day] (depending on what source you like) so in the counterfactual world we would have needed it to be around 88-89mbd. Now, in 2008, oil production got up to around 86mbd (on an average basis) but doing so triggered (or required) an oil shock in which prices briefly reached $135/barrel on a monthly basis and almost $150 on a daily basis. What would the likely price path have been had the world then needed an additional 2-3mbd the following year?

To give an indication of the scale of 2-3mbd, note that the loss of 1.6mbd of oil this year (Libya) triggered something like a $30 increase in the price of oil (before it became clear that the global economy was slowing again causing prices to fall). That, along with other commodity price increases, was enough to cause a little bump in inflation that significantly reduced the Federal Reserve's latitude for action.

OPEC countries routinely claim that they can increase pumping capacity to meet world demand. "Our customers aren't asking for more supplies," is the usual phrasing. But that's not true. The world plainly wants more oil that OPEC can't provide. After all, if OPEC had plentiful supplies, we wouldn't see huge price spikes whenever demand gets near the neighborhood of 90 mbd. But we do.

Now, there are some caveats here. For one thing, no one can say for sure precisely what OPEC's pumping capacity is (Middle East regimes are very secretive on this score), and Iraq, in particular, can certainly increase its production capacity if it ever gets its infrastructure rebuilt. But in a way, that's small beer. Global production capacity right now seems to be a little under 90 mbd, and even if this increases to 95 mbd or 100 mbd a few years down the road, we're going to be continually bumping up against this ceiling along the way as the global economy grows. That's going to cause sporadic but frequent price spikes.

The effect this has on the economy is probably greater than even most pessimists realize. James Hamilton, a University of California-San Diego economics professor who's studied the economics of oil demand deeply, points out that 10 of the 11 recessions in the United States since World War II have been preceded by an increase in oil prices—and even small increases in oil prices can have a surprisingly big impact on economic growth. In a recent update of a model he originally published in 2003, he estimates that an oil price spike of 10 percent over its previous high produces a GDP decline of 1.4 percentage points one year later. To put this into real-world terms, his model suggests that the huge run-up in oil prices between 2007 and 2008, when prices nearly doubled, explains most of the Great Recession that followed. And he forecasts that the Libyan price spike early this year, which came on top of a 9 percent increase the previous quarter, will reduce GDP by an estimated 2.4 percentage points by the end of 2011. And the Libyan price spike was pretty modest.

The precise effect of oil prices on the economy depends on which model you prefer, and Hamilton says that a different model that uses a three-year window might be more accurate. That would be good news for the economy in 2011 (and 2012), but it doesn't matter much for the long run. Basically, we're stuck with two stubborn observations. First, world demand for oil is very near its production ceiling, which means that even small increases in demand (or small disruptions in supply) now result in large oil price spikes. And increases in demand are inevitable every time the economy starts growing even modestly. Second, even small increases in the price of oil cause large GDP losses. Price spikes of 20 to 30 percent are likely to be common in the future as we periodically bump up against production ceilings, and if Hamilton's model is correct, this will produce subsequent declines in GDP of 3 to 5 percentage points. That's huge. The effect on world GDP may be less pronounced, but it will still be significant.

If this model is accurate—and if the ceiling on global oil production really is around 90 mbd and can be expanded only slowly—it means that every time the global economy starts to reach even moderate growth rates, demand for oil will quickly bump up against supply constraints, prices will spike, and we'll be thrown back into recession. Rinse and repeat.

If you don't believe in global warming, that's one thing. But the evidence that the world is starting to reach growth constraints based on oil production is, if not a slam dunk case, still pretty compelling. So even if, as Rick Perry says, the world's climate scientists are just inventing global warming as a devious scheme to increase their funding, we still ought to be going balls to the wall to expand existing forms of alternative energy and fund research into new ones. Unless, of course, you really like the prospect of a future full of relentless and painful oil-induced recessions. It doesn't seem very agreeable to me.

Why is Ben Bernanke unlikely to announce any major action to help the economy in his Jackson Hole speech on Friday? Because of inflation hawks on the Fed board? Because of concerns that further monetary policy isn't effective when interest rates are already near zero? Because of a generalized fear of being on unfamiliar ground? Mark Thoma says it's all of the above:

But that is not quite enough. I think a majority on the FOMC would still push forward if it weren’t for the change in the political environment. When Bernanke wrote earlier in his career and criticized the Japanese central bank for not doing more, I don’t think he thought the consequences of being wrong about inflation were as severe as they are now. The Ron Pauls in Congress looking for a reason to attack and take away the Fed’s powers, the criticism from many on the left for all sorts of things, etc., etc., puts the Fed in a more precarious political position than they ever expected to be in, and the fear of making a mistake and losing independence is tying its hands. The Fed values independence first and foremost, and it is unwilling to put that in danger. Thus, the Fed is trading more unemployment now for less in the future, and it’s mainly the political environment rather than economics that is driving this decision.

Paul Krugman says much the same thing today. The political environment is so toxic right now that the Fed is afraid that helping the economy — and thereby "interfering" with next year's election — might produce a serious backlash in Congress.

But there's more to this. The Fed is secure from Republican backlash as long as (a) Obama remains president and (b) he refuses to go along with Republican mischief. So if fear of losing its independence is really what's holding back Bernanke and his allies at the Fed, it means they think there's a significant chance that either (a) or (b) or both won't be true over the long term. Fasten your seat belts.

The last refrigerator we had lasted about 20 years. Sometime around year 15 it finally blew out a condenser or a coil or whatever it is that makes refrigerators produce coldness and we paid $400 to have it fixed. A few years later it broke again and we bought a new one.

This one broke after eight years. But not because of a condenser or a coil or something comprehensibly structural. The repair guy took about five seconds to diagnose the problem: it stopped working because the "main board" blew out. That's it on the right. Now, maybe I'm off base on this because it's been so long, but this looks like a butt simple design to me. One small custom chip, some relays, a transformer, a couple of heat sinks, and a bunch of passive parts. Maybe a build cost of $20-30 or so? But GE's price to me was $250, plus $150 for the 20 minutes it took to pull out the old one and swap in the new one.

Paying $400 for a big piece of physical gear plus a couple hours of labor didn't bother me. Paying $400 for a primitive circuit board and a few minutes to plug it in does. The repair guy laughed good-naturedly when I mentioned this. "All the computer guys say the same thing," he told me. He even knew what I was going to say about the board before I said it. Our neighborhood is lousy with electrical engineers and other high tech weenies.

Bottom line: $400 because a $2.02 Song Chuan 832 Series 30 A SPDT 12 VDC Through Hole General Purpose Heavy Duty Power Relay burned out. So here's your economics question for the day: Did I stimulate the economy today? Or this an example of the broken refrigerator fallacy? Or did most of my consumption spending leak out to China? Please phrase your answers in the form of a koan.