An Old Nemesis Returns

by futurist Richard Worzel, C.F.A.

What follows is another excerpt from the manuscript of a book I’m currently working on. I expect it to come out in late Spring or early Summer.

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“But with Benedict … he’ll kill you, and then he’ll go to work on you!”

– Character Reuben Tishkoff in the movie, Oceans’ Eleven

The section below is a vignette – a story about the future – that is intended to illustrate how I think we will experience the future:

Maria breathed a deep sigh, then turned the newspaper page. She’s spent a good 5 minutes reading the full-page ad for the Disney Cruise Line, mostly out of a sense of nostalgia and longing. At least, she told herself, if we can’t go on a cruise, I can dream about one. At least that’s free. She and her husband and two kids had gone on a four day cruise back in 2012, when the Disney Dream was still relatively new, and they’d loved it. They’d vowed to go back, and had even put down a deposit for another cruise in 18 months’ time.

Times had gotten tougher after that, though, and they’d had to ask for their deposit back when their full payment for the cruise was due. The Disney people were very nice, and had even offered to change the reservation for a later sail date and increase their On Board Credit from $100 to $200 – but Maria and Sean had needed the money, so just asked for the deposit back.

Sean still had his job, and Maria’s occasional graphic freelancing was still going reasonably well, but the cost of living was getting well out of hand. Sean had to commute 45 minutes each way to work in the city – and the cost of gas was horrendous. Last week, when they’d gone grocery shopping, Maria had noticed it was $4.57 a gallon! Sean had gone quiet when she commented, which was a bad sign. It meant he didn’t want to talk about it. Finally he’d told her that the price of gas had actually come down in the last couple of weeks, and he’d even seen it posted at $4.99 a gallon at one station in the neighborhood.

Meanwhile, their weekly grocery bill kept skyrocketing, too. They’d cut out almost all of their luxury foods, and were down to buying basics and staples, but it still went up. They were eating vegetarian twice a week to save money, and were using powdered milk, though their son, Sebastian, complained about it. And the steadily rising costs of the things they had to have kept going up, which meant that the fun things kept getting whittled away. She kept asking Sean to go in and demand a raise – and he kept telling her that they were laying people off. He was lucky to still have a job; there was no way he could ask for more money and keep his. And she kept telling him that if things went on as they were, she didn’t know how they were going to cope.

Then this week they’d received their property taxes for the new municipal year – and they’d gone up almost 60%! Maria had almost fainted when she saw it. Sean looked at it in disgust, and said it was the state government’s fault; the legislature was coping with their deficit by raising taxes, cutting spending, and downloading as much of the burden on the cities as possible. And the cities were responding by raising property taxes, which was killing the housing market. Sean and Maria had congratulated themselves by dodging the bullet of falling housing prices when they bought their house in 2010, but now it had fallen in price and was worth less than their mortgage – and the market wasn’t moving, anyway. They were trapped, and it hurt.

It meant that their world was getting smaller – and they were getting poorer. What Maria didn’t understand, and Sean couldn’t explain, which meant he probably didn’t understand either, was why this was happening. Maria felt poorer than at any time in her life – including when she was girl. Her family had been middle class more by courtesy than by money, but her mama hadn’t scrimped the way she was now, and her dad had never looked as worried as Sean did.

Something was badly wrong, and she didn’t know what to do about it.

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Why Inflation Is Coming Back

The RDCs [Rapidly Developing Countries] are making up a steadily increasing share of global GDP, so that their needs are having a progressively greater effect on global demand. According to the Organization for Economic Co-operation and Development (the “OECD”, sometimes known as the “rich countries club”), RDCs accounted for 40% of the global economy in 2000, growing to 49% in 2010, and will grow to 57% by 2030 (I actually think these estimates are conservative; I believe the RDC’s will account for 57% of global GDP well before 2030). So whereas what the developed countries did and bought had the largest effect on commodity prices through the 20^th century and into the beginning of the 21^st, today more than half of global demand is coming from countries whose economies are growing faster than ours.

And, as I described earlier about China’s rising demand for food, with the development of a rapidly expanding middle class, RDC demand for more expensive things that soak up more resources will rise much faster than their rate of population growth. Hence, while China’s population doubled from 1960 to 2000, it’s demand for food more than tripled, and an increasing share of those calories came from meat and dairy products. As a result, the resources required to feed China increased by roughly a factor of four. There’s a multiplier effect: it’s not just more people; it’s more people each consuming more resources. And as the economies of the developed world emerge from recession and begin to grow more robustly, our recovering demand will be added to the rapidly growing demands of the RDCs. Over time, this is going to create a perfect storm first for oil and food, but then other essential commodities as well, including metals, non-food agricultural products, and more.

Moreover, while demand in the Western economies slipped during the Great Recession, taking pressure off essential materials, China’s consumption continued to grow:

“… commodity prices are rising at an early stage in the economic cycle. Jeffrey Currie of Goldman Sachs worries that, as American oil demand recovers, it will “bump up against” China, which is consuming 23% more oil than it did in 2007—as well as 63% more copper, 18% more cotton and soybeans … With the global recovery fragile and unbalanced, higher commodity prices are the last thing the world needs right now.”[1]

The same is true of India, Brazil, and the other RDCs: their economies recovered before ours, resumed their expansion – and their consumption of oil, food, metals, and so on ballooned as well. This puts a much higher floor under commodity prices from which tomorrow’s demand will grow. That is why commodity prices are already rising at what would otherwise be an astonishingly early stage of the (Western) economic recovery.

The only (temporary) good news on that front is that commodity price increases so far are more moderate in this cycle than they were in 2008, when there was a virtual panic in developing markets over increases in the price of food in particular, and a near-panic everywhere over $147 a barrel oil. In January of 2011, for instance, the rate of global food price inflation was up “only” 37% over the year before, whereas in 2008, the rate of increase peaked at over 75%.[2] But as the American economy continues to improve, along with Canada and Europe, the demand for raw materials will grow far more rapidly in the short run than production can increase. As that happens, bottlenecks will begin to appear in supply chains, and prices won’t just rise, they’ll skyrocket, as happened with oil prices in 2007.

So we are guaranteed a rapid rise in inflation – unless demand winds up being substantially weaker than expected because of a renewed recession. Either way, we wind up losing out; another “heads I win, tails you lose” situation.

Now when central banks track inflation, they often use a yardstick called “core inflation”, which is typically the Consumer Price Index without food and energy prices. The reason why they leave these two important factors out of their calculations is that these two commodities tend to be very volatile, bouncing up and down from period to period. They look at other, slightly less volatile measures because they want to get a better reading on what’s happening overall.

Yet, this approach also attracts quite a lot of criticism: people don’t live in a world where they can choose to ignore food and energy prices, we have to suffer through them. Accordingly, I want to look at both of these for a moment, precisely because of their importance. I’m not going to go into detail on either subject. You can write books, or devote entire careers to these issues. Instead, I’m going to frost the highlights. The fundamental issue is the one discussed above: that the swiftly growing demand from the RDCs, when added to the demand from the recovering developed countries, is going to unbalance supply and demand and send prices through the roof.

Oil

First let me say that the world is not about to run out of oil. The statistic that I cite to underline that has nothing to do with oil: almost three-quarters of the Earth’s surface is covered with water. So far, the vast majority of the oil discovered and exploited has either been on, or very close to land. This means that there is an enormous amount of oil yet to be discovered, perhaps three times as much as has been exploited throughout history to date. To see this, witness the enormous oil find off the coast of Brazil. The Tupi field is estimated to contain five to eight billion barrels of light crude oil, which will make Brazil one of the world’s biggest producers of gasoline.

And oil from the ocean floor is not the only future source: both Canada and Venezuela produce less conventional heavy oils that require a great deal of processing to extract and use. And beyond these existing sources, there are other, even less conventional sources with enormous potential, such as shale oil, like the reserves locked up in the Green River deposits in the Western United States. A 2005 estimate set the world reserves of oil from shale oil deposits, for example, at over 400 gigatons, enough to yield around 3 trillion barrels of oil.

So there’s lots of oil left in the world; it’s just expensive, and will be slow to bring to market. Meanwhile, the demand for oil continues to expand. Here’s how the U.S. Energy Information Administration, an agency of the U.S. government, assessed the growing demand for oil:

World crude oil and liquid fuels consumption grew by an estimated 2.4 million bbl/d in 2010 to 86.7 million bbl/d, the second largest annual increase in at least 30 years.  This growth more than offset the reductions in demand during the prior two years and surpassed the 2007 consumption level of 86.3 million bbl/d. … Non-OECD countries will make up almost all of the growth in consumption over the next 2 years, with the largest demand increases coming from China, Brazil, and the Middle East.[3]

So, unless the global economy nose-dives into a renewed recession, the demand for oil will continue to grow faster than supply, forcing the price up. This will continue until consumers and organizations radically change their consumption patterns, which will happen when prices become painful enough. (Recall that in 2007, when oil prices spiked at $147 a barrel, some people were trying to give away their SUV’s because it was so expensive to fuel them.) And that pain will translate into reduced economic growth, as I’ll describe in a moment.

For those interested in pursuing this subject further, there are entire books on this topic, such as Jeff Rubin’s Why Your World Is About to Get a Whole Lot Smaller: Oil and the End of Globalization. Rubin, formerly the chief economist for CIBC World Markets, foresees a world with $200 a barrel oil, and projects the consequences of that. He may or may not be right, but to my view, there’s much more to the story than just oil. With that in mind, let’s move on to food.

Food

As I described earlier, the demand for food is multiplied by the numbers of people in the RDCs moving into the middle class. Yet, the food equation is, in many ways, much more complicated than that for oil, for all of its complications. In response to higher prices and demand for food, farmers can start planting more marginal land, as some Brazilian farmers have done by cutting swaths of the Amazon rainforest. Scientists and seed companies can come up with new kinds of plants, either through traditional hybridization, or through the more controversial – but more effective – genetic modification. And advances in genomics generally lead me to believe that we are rapidly approaching a new Green Revolution that may blow the lid off previous yields.

And yet, there will also be major difficulties in producing enough food to feed a global population that is expected to grow from today’s 6.8 billion to the projected peak of about 9 billion by the middle of this century before it starts to decline, particularly as the burgeoning global middle class will want to eat more meat and dairy products. Moreover, we are reaching limits on agricultural productivity. As The Economist wrote in a recent special report on food (February 26^th, 2011, page 8): “…at some point it may no longer be possible to persuade plants to put ever more energy into seeds [which are the parts we eat]. In animals biological limits are already clear: turkeys are so bloated that they can no longer walk; chickens grow so quickly that they suffer stress fractures.”

As well, agriculture naturally and universally attracts politics, which fouls up decision-making. For instance, it is virtually impossible to defend making ethanol from corn in America as an economic proposition. Yet, the politics of energy, environmentalism, and agriculture, plus the importance of the Iowa caucuses in American presidential elections, have combined to cause the American governments to mandate the blending of up to 10% ethanol in all gasoline sold to American motorists. Moreover, there is talk that America should aim for a 30% blend of ethanol in gasoline by 2030 for environmental reasons. Yet, while ethanol currently makes up only about 8% of America’s fuel, it takes almost 40% of its corn production to produce even that amount.[4] Quadrupling the amount of ethanol produced over the next 20 years, at least from corn, is not even possible, and makes no economic or environmental sense – except for a strange sort of political sense that takes little account of reality. But such efforts vastly complicate the prospects of significantly increasing the production of food – and in keeping food prices from shooting skywards.

And one of the biggest limitations on food production will be water – but I’ll deal with that in a separate chapter later on.

When you look at the factors at work – growing global population, the increase in food consumption in RDCs, and the difficulties in increasing food production fast enough in the short-run, it’s hard to escape the conclusion that food prices are going to rise dramatically over the next several years.

So unless we experience a renewed recession, our old nemesis, inflation, is going to return to savage us once again.

Harm’s way

Those who lived through the inflation of the 1970s know how corrosive it is. Your pay, pension, and investment income aren’t safe because their value is constantly being nibbled away. It’s harder to manage your investments because stock prices fall even when corporate profits rise. Even though interest rates are high, fixed income investors find that the combination of inflation and taxes leaves them worse off than before. And doing nothing isn’t safe, either, for inflation finds you anywhere. It’s very difficult to prosper during periods of high inflation. Indeed, about the only things in which to invest are commodities – which creates an ever-expanding speculative bubble in commodities, which then feeds back into even higher inflation.

This coming bout of inflation will be particularly hard on working people in developed countries. In the 1970s and into the 1980s, increases in the cost of living were at least partly offset by wage and salary increases. Indeed, some economists seem to be relieved that the prospects of price inflation are not translating into increased wage demands. This leads me to wonder whether such commentators actually live in the real world: one of the primary issues in most developing countries is high unemployment. As a result, while a few workers may be in a position to seek higher pay, most workers who have jobs will be keeping their heads down, and watching helplessly as the value of their pay-packets erode, just grateful to be employed. There is very little room for wage increases in today’s labor markets, for all the reasons I described in Chapter 7. Workers will mostly just helplessly soak up the damage.

Meanwhile, governments are hard-pressed to deal with inflation, much of which is international in scope, and they have their own problems coping with rising expenditures. And inflation plays favorites: savers are penalized, and debtors are rewarded as savings are eaten away and debts dwindle in value. So inflation is corrosive, and, left untreated, eventually degenerates into hyperinflation, which destroys faith in government, the value of currency, and the very pillars of the economy.

And inflation will limit growth

Beyond this, I expect that rising inflation will eventually put a damper on economic growth everywhere, because increases in commodity prices, especially for essentials like food and fuel, act as tax on consumption. Higher prices for essentials here will reduce the amount available for luxury or discretionary purchases. This will hurt consumers in our world, and will slow the movement of people in developing countries from poverty to economic middle class status; they’ll be spending much more on food and fuel, and won’t be able to buy televisions and cars.

So, in effect, there is a built-in restraint on global growth: higher demand produces higher prices, which reduces discretionary purchases. This might happen gradually, or it might happen because of a recession. But regardless of how it happens, the emergence of the RDCs as a major economic force puts upper limits on how fast the global economy can grow by causing significant price increases in essentials that eat into people’s ability to make discretionary purchases, effectively making them poorer than they would otherwise be.

Moreover, rising inflation causes national governments and central banks to seek to restrain it. Hence, as of early 2011, China was raising interest rates and reserve requirements for banks – policy steps that the Federal Reserve in the United States is talking about in only the most general possible terms. Meanwhile, inflation is already above the target ranges set by both the Bank of England and the European Central Bank (the central bank of the EU). So far, at time of writing, they have resisted raising interest rates because economic growth is still weak, but when they finally do raise rates, that will act as a further brake on demand and growth.

© Copyright, IF Research, April 2011.

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[1] “Back with a vengeance”, economist.com website, Jan. 20, 2011; http://www.economist.com/node/17969925.

[2] ibid.

[3] “Short-Term Energy Outlook”, U.S. Energy Information Adminsitration website, http://www.eia.doe.gov/steo/.

[4] “Plagued by politics”, from “The 9 billion-person question: A special report on feeding the world”, Economist, Feb. 26, 2011, p.6.