Friday, March 26, 2010

The Step-Wise Descent Scenario

I am trying to put together a coherent account of my thoughts behind an ongoing cyclical downturn. Here it is in a nutshell:
1. Starting in around 2004 oil production reached a plateau, and a decline in energy availability (due to declining EROEI and declining energy availability per person) reduced per capita global economic production.
2. Hank Paulson and other officials in charge of monetary policy around the world failed to understand the root cause of the GDP decline and attempted to address it by increasing liquidity, in the expectation that increased liquidity would lead to increased production. Unfortunately, there was no way to provide an increased oil supply in order to support an increase in production of real, tangible goods. The liquidity had to go somewhere so this liquidity created a market for illusory production, and was absorbed by the phantom "production" of financial vehicles, such as CDOs, SIVs, CDSs, etc.
3. The economic decline really kicked in when the unreality of the financial "products" was unmasked. When the market started valuing these products at what they were worth hundreds of billions of dollars simply vanished, and the economy started to decline to the level of our real productivity.
4. Unfortunately, this economic decline reduced activity and thus reduced energy consumption, masking the problem - which is our reduction in per capita energy availability.
5. However the recent economic decline didn't just reduce energy consumption - it limited investment in energy exploration and production, thus undermining our ability to produce energy over the next few years. This, in conjunction with natural decline rates and a gradual economic rebound will soon lead to another round of energy insufficiency.
6. This next round of reduced energy availability per capita will further decrease per capita economic production and lead to another economic step down.

Where does it end? I have said before that markets are about perception. It ends when the magnitude of the problem is perceived by enough people. What happens then? In my view, people will act to protect their own interests. There will be winners and losers.