Regular readers will remember that I have long been saying (since 2012) that the current global financial/ credit crisis, which started in 2008, will find its end through deleveraging coming from a sharp and continuous drop in energy prices. This will come on the back of a new wave of technological innovation, which will put money in the hands of the world’s poor, and lead to a structural upturn in real economic activity.
Declaimer: This article written was originally in February 2015, and some of the data points may be outdated.
In some cases (like Europe), the people who took the old debt, will not be the ones who will get the new wealth/ oil savings. In others, like the US, new domestic production of shale oil will reduce imports, giving them energy independence and a sharp drop in their CAD. In Japan too, there will be big savings. Other importers like China and India will also benefit, even as their households have better Balance Sheets.
The first Wave of change in oil price
Yes, some (producer) economies will suffer, but they are not a big part of the world economy, and anyway, this re-ordering of the world pecking order will be good for consumers. I will only talk about the beneficiaries for now. First, this is only the first wave of change: while oil prices will now rebound, remember one very important and permanent change in the oil market now.
The earlier oil market (of 2005) was oligopolistic, dominated by a cartel, OPEC. In the new situation, OPEC only has a 44% share, and the new “swing producer” is not Saudi Arabia, but the cabal of shale oil producers in the US. As oil gets oversold and some shutdowns happen, it will recover, but this time, remember that these (swing) capacities will come back when it reaches, say, $80- 90. So this time, unlike in 2008, prices will be capped by a free-world player who is not cartelized.
Compare this to the “unkind monopoly” of OPEC, which raised prices in a measured fashion, based on the global economy’s “ability to bear”, rather like a parasite that feeds on the host, stopping short only to keep him barely alive. For a long time, we have heard it said that “a $10 increase in the price of oil drops world growth by 0.5%”. This time, the converse will not be true, because much of the savings will be used by the consuming world to deleverage the excess debt of the 2008 binge.
The new market structure
In the new market structure, OPEC has lost power, and the oil market is no longer run by a cartelized oligopoly, rather, it is now close to being perfectly competitive. When all this stabilizes, there will be normal investment returns in oil production, and prices will be capped. The next wave of discontinuous innovation is already around the corner in electricity production, where we could see another 70-85% drop in the costs of production of (maybe solar or other renewable) energy. This will trigger another wave of innovation in, say, oil from other sources (like bio-mass). The final implication of all this is that oil will no longer see ‘monopolistic’ pricing, but will become a chaotic, ‘efficient’ market that will overall reduce the price of energy.
This will trigger the next wave of human progress. India now has a Modi, who seems determined to harness this fortuitous event into a vehicle for pulling the lower half of India out of poverty. The deployment of solar energy in its various forms will replace oil, kerosene, and coal…..all of which will see steep drops in prices, until “the real cost of energy will drop to zero”. That will create surpluses up to 10% of the world economy, about $7 trn. Even though all this will not immediately stimulate new consumption, it will reduce debt in the developed countries and lead to some real growth in the developing world.
In money terms, the energy industry will halve in size. Corporate debt in the US is already low, and companies are sitting on large cash surpluses. As personal Balance Sheets improve, US consumers are coming back; as tax receipts improve, even the Govt deficits will improve. With real growth momentum, the US is already back as the engine of world growth.
For a long time, we are headed toward a supply-side (positive) shock, which will bring down inflation. While some parts of the world (Europe) will have to deal with deflation, this disinflationary process will be welcome. Higher domestic savings in India will replace any potential drop in overseas remittances, either (Middle East) NRI remittances or FDI. The CAD is not under pressure. India, which used to spend 1% of GDP in 2001 on commodity imports, ran up to 7% at the peak; this is now down to 3.5%. Unless these gains are frittered away again in gold imports, I see a huge positive as the Indian savings rate goes up, financing new investment demand.
Towards this end, thankfully, the Modi Govt/ RBI has used this disinflation to keep real interest rates positive, hoping this will draw money out of gold/ real estate into financial savings. If this happens materially, it will help finance India’s industrial expansion with domestic money. The fact that Bank deposits are already running ahead of Bank credit growth, shows that this new policy is having a salubrious effect on financial savings.
Since we are crystal-gazing the long-term direction of inflation
Since we are crystal-gazing the long-term direction of inflation, we would need to consider the possibility of a violent reversal (in inflation). The only country with any kind of demand momentum was India (and now the US), and they both have responsible governments that will not be printing money. The ones doing so (i.e. printing money) have weak demand (Europe and Japan) and deflationary tendencies. I cannot think of a scenario that shows the likelihood of high global inflation. The series of (Greenspan-led) rate-reducing initiatives is behind us, and all the conditions for a long-term decline in global inflation are in place. From here, any income growth will go to individual bottom lines. This will eventually bring back growth.
If you look back at the last Depression, the global economy revived on the back of a slew of technological innovations that dropped the real consumption cost. The next 6 years to 2020 will be better than the last 6. By 2020, the world economy will have significantly lower leverage ratios, except in pockets like Japan, where the Govt is bankrupt. Europe might be the other exception, but China will most likely revive, or at least, not decline anymore. Its Govt debt ratios are not bad (~25%), and it has large forex reserves, which can be drawn on to fund a recapitalization of its Banking system, should it be needed. There is no end-of-the-world scenario there. And its shift towards a more consumption-oriented economy augurs well for India, which has much to benefit from a rise in China’s imports. That would correct the largest part of India’s trade deficit, kicking off a virtuous cycle that would contribute some serious growth momentum to both sides of the Himalayas. I am particularly optimistic about Indian agricultural exports to China through overland routes.
So lastly, what am I saying? Assets that base their returns on inflation (i.e. gold and to a lesser extent, real estate) don’t have it good. Debt depends on real returns, which depends on policy….the outlook for that looks very positive. Keeping interest rates up above inflation will significantly increase the life of the coming growth momentum, and prevent serious mal-investment, which sows the seeds of the next bust. Focussing huge energy investments into the coming new technologies will keep India’s Investment Demand going…..the underlying consumption demand is already in place. Give it a little time, and new industrial demand will come in, as the cost of energy goes down. Agriculture will be a big beneficiary, as its most important cost goes down. Water management will improve, pushing up agricultural productivity and pushing down food inflation. Nothing will improve Indian living standards more than a sharp and permanent drop in food inflation. Remember: on average, most of India spends up to 40% of its household budget on food. If food and housing (another 40%) come down, the spare cash will go into discretionary expenditure and savings, kicking off quite a domestic boom. For an aging pensioner like me, that is something to look forward to.