I think it’s considered a bit stodgy to discuss the macroeconomic impact of oil.

If rationality ruled, we would move away from oil quickly as a source of energy.  There’s plenty of room for optimism in this regard.  The world managed to produce the Prius in the decade of the Hummer and George Bush.  If we can get 80 mpg without even trying, how far can we be from the post-oil era?

I’m not well-versed in the technology of alternative energy, so I will focus here on the macroeconomic implications of oil dependency.  Much is made of the facts that the US is the world’s reserve currency and that almost all US debt is dollar-denominated.  Macroeconomists believe that real troubles are reserved for countries with high levels of foreign-currency denominated debt.  The best leading indicators for sovereign debt risk are high levels of external debt coupled with weak performance in external trade.

I believe that oil can increasingly be thought of as a large foreign-currency denominated liability of the US.  This hasn’t always been so — for many years the US ensured that dollar trade was priced exclusively in dollars.  Kevin Phillips explores this dynamic in Bad Money; the pricing of oil in dollars was a major foreign policy objective of the postwar era.  The US wanted all trade done in dollars (countries wishing to buy oil had to first convert their currency to dollars), then, crucially, the US wished that oil-producing countries kept this wealth in dollars.  The growth of the huge Eurodollar market in London was an indication that this policy objective was mostly successful.

The department store Harrod’s may still be thriving, but for the most part we can say that the dollar-driven oil regime is buckling.  Perhaps it has already cracked, maybe it is merely cracking — but the writing is on the wall: in the future, oil will not be dollar-driven, and a 1% decrease in the dollar will cause something like a 1% increase in the price of oil.

What we are left with is a $300 billion ANNUAL liability for oil consumption that is essentially foreign-currency denominated.  $300 billion is not much compared to a GDP of $14trillion, but it is quite significant compared to exports of approx $1.8 trillion.  In 2008, our trade deficit was around $800 billion.

Depending on your perspective, the US is either really good at trade (in that it gets a lot for a little every year) or really bad (in that it has no hope of bringing exports in line with imports).  The elasticities don’t work in our favor either; a halving of the dollar would cause something like a doubling in the dollar price of oil and something not too far from $600billion in oil imports.

The US susceptibility to an oil price shock — short-term or long-term (a near inevitability) — is truly scary, as are the political implications of an oil-driven world.  In his recent letter “The Financial Geopolitics of Peak Oil”, Kevin Harrington argues that political jousting among oil consumers will heat up over the next twenty years, and that the oil producers, especially those like Iran who’s oil production is faltering, have an incentive to foment instability to maximize their expected oil revenues.

Much is made of whether we have hit Peak Oil, but the true case against optimism in the oil sphere comes from the demand side.  In the US, 70% of the oil we consume is used for the transport sector. In the past, we’ve responded to gains in energy efficiency by driving more, flying more, and sending more FedEx packages, such that overall energy usage has trended continuously upwards.  All of the likely energy innovations — nuclear, solar, wind — are tough to use for planes and automobiles.  Electric cars might well be the future, but the transition will be slow.  The sale of 1 million electric cars would be a heroic feat, not likely to be seen for many, many years, and yet there are something like 65 million working cars in the US.

Oil is heavily subsidized in all oil-producing countries and in countries like Venezuela and Iran gasoline goes for about 35 cents a gallon.  Dubai famously has a 35-story ski slope in the middle of the desert — reported it gets about 3500 visitors a day and burns through 3500 barrels a day.   That is grotesque, to be sure, but how much better is Vegas when one factors in the flights to and from?  Las Vegas might not be a viable city in 2025 (though I’ll never go bearish on vice).

The juggernauts on the demand side are China and India, with 2 billion people between them.  People in these counties have not yet reached the threshold wealth level where they are driving and flying often. Many people in Latin America are just crossing that threshold now.  In 2008 in Peru, year-on-year new car sales were up 80%.

I think the case for extensive government-led investments in alternative energy (particularly towards improvements in the transport sector) is very, very strong.  Maybe the private sector can make substantial leaps here without the government providing incentives, but I don’t think so.  I know that if we have to little to no improvement in our energy regime in the next twenty years, we are drawing dead as an economy.  The US economic model is not viable at an oil price of $75, so it will surely be far from viable at prices well above $100.



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