The following is a guest post by my good friend Dr. Saif K. Lalani of Vanderbilt University

MONETARY POLICY IN THE ERA OF PEAK OIL
by Saif Lalani
December 28, 2007



It is now clear now to anyone with at least a double digit I.Q. that the world oil production is at or near its maximum potential. Peak Oil will bring with it a host of new problems for the world's central banks. Rest assured that they do not have a Plan B to deal with ever rising prices of food and energy. With the way they are currently handling the housing crisis it does not seem that they even have a Plan A.

At some point in the near future the world's central banks will have to learn the difference between Geology and Economics. To my knowledge there are no central bankers with a major in one and a minor in the other. Absurd? Not really. Since oil is the lifeblood that keeps the world rolling one would hope that someone currently in power would have been enchanted with these two fields of study. (BTW the protagonists in the timeless classic “Atlas Shrugged” majored in 2 such apparently conflicting fields, Physics and Philosophy simultaneously). One teaches that the well once dry is dry. The other teaches that if we stand in front of the dry well with a large enough check, things can change. Hence their inability to understand the intractability of the problem.

There are currently 2 major schools of thought on how Peak oil will affect prices of things in general, the major concern for central banks. The first is that since oil is so essential for production and transportation of almost all things, the prices of everything will head to the stratosphere. The second and not so popular version is that once businesses acknowledge peak oil, spending and hiring will “collapse” resulting in deflationary forces that will match and even exceed the downward march in oil availability. I personally believe that we will have massive inflation in prices of everything essential and massive deflation in everything discretionary.

So what should the central bankers endeavor to do during the coming turbulent times?

Lets start as all physicians do. First, do no harm. Sounds quite simple but it isn't. Central bankers have egos as large as football fields. They think they can save the housing market, stock market, solve the energy crisis, cure cancer, make it rain and part the seas by slightly tweaking interest rates. Central banks need to understand what they can and what they cannot control. Trying to save sprawling suburbs with 0% interest rate policy is probably going to be less effective than trying to arrange good public transportation preferably in the form of electrified rail.

Second, publicly acknowledge peak oil. Do not put some technocrap spin on it. Tell it for what it is. Can you imagine the progress we would have made if one prominent central banker would have said this even 2-3 years back? Prepare the world for hardship. It is going to come regardless what they may say.

Third, ensure that loans are available for energy projects with a positive EROEI (energy returned on energy invested). Peak oil is likely to stress the banking sector to levels unseen since the great depression. Remember extremes can occur in both directions. Whereas once banks thought it made sense to extend no documentation loans to people to buy insanely expensive properties, they may not even fund good sound energy projects in the future. The fed and other central banks could in this case lend directly to fund such projects. Since energy prices would be the main reason for unemployment and inflation this would fall within their mandate. It is important to stress that positive EROEI is very important otherwise every action will just lead us into a deeper hole. They would likely need help with assessing EROEI but should have no problem in obtaining such help.

Fourth, do not attempt to rescue the dying industries. Detroit automakers, airlines and travel and tourism in general will come under increasing stress. The first 2 could not make money when oil was under $20 a barrel and will certainly not be able to survive for long without help in the future. There will be increasing pressure to “do something” about it. The Fed must resist the urge to help out. No rescue package for airline bonds or GM's junk paper will make an iota of a difference in the long run. Might as well fund an extra geothermal project with the money.

Finally it is paramount that we have honesty in statistics. The fed and other central banks need to report correct unadjusted inflation and GDP statistics. This will allow us to assess the actual impact of the problem and effects of the solutions we may try to implement.

I would like to end by thanking the central banks for making it a truly wonderful and entertaining

12 days of Christmas

On the 12th day of Christmas look what my true dove brought for me
Mortgage lenders with just no brains
Angry Crammer who never informs but always entertains
Never ending one time write-downs
Bank CEOS moonlighting as clowns
Surging food grain prices
Unsolvable housing crisis
Falling US dollar
Restaurant portions that keep getting smaller
3 rate cuts that messed up things
Gold prices that got wings
Double prices for milk and cream
And a C.P.I. report that said this was all just a bad dream.

Happy New Year to All


This post has been used by permission. © Saif K. Lalani