28 June 2008

Oil, Food and Economics - Sumita Kale

If the subprime crisis wasn’t bad enough, the oil price spike has unnerved the world this year. And with food and fuel prices soaring in all countries, the policy prescriptions are back to the standard myopic solutions of interest rate hikes, duty cuts, export curbs etc. But if we step back and try to see the larger picture to decipher what these prices are signalling, what do we find? One theory that has finally got the prominence it has deserved is the Peak Oil Theory. In fact, for Matt Simmons, energy investment banker and ‘Peak Oil’ theorist, the signs that crude was entering danger zones have been clear since 1989, but it was only post 2002 when China kick started its explosive growth that the situation became bleak. For most of the world though, peak oil has become a keyword only recently because of the rapid rise in the oil price this year. According to Simmons, it was the unplanned for growth from developing countries that has taken up 99 percent of spare capacity and which has continued despite a ten fold rise in prices. Of course, to a large extent consumers are insulated from international oil prices : Price increases from about the $60 level have not been passed on to consumers, especially in the developing countries. State revenues are being sacrificed and/or consumers are being insulated by subsidies. To begin with, the true extent of oil reserves in the world remains an unknown; the rising share of state-owned oil companies has led to secrecy on reserves data. Spare supply capacity is fuzzy and this explains the frenzied rise in prices currently as there is a paranoia that is gripping the market. In short, supply constraints are more than likely to stay, than disappear. There are also various industry issues such as aging oil wells, rising costs of extraction, chronic rig and skilled manpower shortages etc. – the list is long. 80% of oil infrastructure needs to be rebuilt; the fresh demand for steel will in turn impact inflation. Simmons who has been anticipating this for long now says that the world has to go on a ‘war footing’ now and force a change in consumption pattern – the current trend is just not sustainable. What about food prices? At a symposium convened in March by the Banque de France, Martin Redrado, Governor of the Central Bank of Argentina, was spot on when he said that the rising inflation is to a large extent due to the ‘convergence’ of consumption levels – the developing countries are catching up in consumption patterns (growth in auto demand etc.) and change in dietary habits at a time when there is a delicate balance between production and demand. Two unanticipated impacts on the already delicate balance between supply and demand have had an impact on prices. The first is climate change reducing global grain output (droughts in Australia and Ukraine etc.); and the second is the impact of high crude prices in diverting grain for bio-fuel production that has triggered off the rising prices in corn, soya, wheat etc. Since food contributes a significant portion of consumer budgets in emerging economies, this will show up in forthcoming wage revisions, putting more pressure on prices. Higher energy and food prices will impact growth via higher interest rates that are being forced upwards in an attempt to curb the price rises. Redrado’s paper has interesting policy implications as it throws a spotlight on the social and political tensions that will arise as countries are forced into a period of lower growth and higher inflation. Per capita consumption of food and crude oil is much lower in China and India, than in the US- to bet on a slowdown in these economies, therefore, has social ramifications as well. On the other side, high oil prices are causing prosperity in oil-rich countries, the recent debate over sovereign wealth funds is just one instance of the political implications of this growing wealth. Prices may settle this year or the next, already there is relief coming in on the wheat front with better output forecast in Australia this year. Relief on the oil front though at this point seems doubtful. But all these problems hitting the world today highlight one important signal : you ignore the environment and natural resources at your peril. Would this have been the case if economics didn’t try so hard to distance itself from geography, sociology and other ‘soft’ disciplines? Trying to go deeper into this, I came across this interesting piece on Ecological Economics by Robert Constanza from the University of Vermont. “Ecological economics is a transdisciplinary effort to link the natural and social sciences broadly, and especially ecology and economics (Costanza 1991). The goal is to develop a deeper scientific understanding of the complex linkages between human and natural systems, and to use that understanding to develop effective policies that will lead to a world which is ecologically sustainable, has a fair distribution of resources (both between groups and generations of humans and between humans and other species), and efficiently allocates scarce resources including “natural” and “social” capital. This requires new approaches that are comprehensive, adaptive, integrative, multiscale, pluralistic, evolutionary and which acknowledge the huge uncertainties involved. For example, if one's goals include ecological sustainability then one cannot rely on the principle of "consumer sovereignty" on which most conventional economic solutions are based, but must allow for co-evolving preferences, technology, and ecosystems (Norton et al. 1998). One of the basic organizing principles of ecological economics is thus a focus on this complex interrelationship between ecological sustainability (including system carrying capacity and resilience), social sustainability (including distribution of wealth and rights, social capital, and coevolving preferences) and economic sustainability (including allocative efficiency in the presence of highly incomplete and imperfect markets).” Sounds familiar to my previous post on Mukherjee’s ideas on what Economics should include. Clearly the need of the hour for us economists! Looking forward to a debate on this one! ********************** PS: This post includes valuable inputs from Suyodh Rao, (an economist based in Hyderabad, India)- thanks Suyodh, for all your mails about oil, food and water!


  1. very nice post and good blog Sumita, keep it up

  2. Thanks tatoiribarne! You could also send me some links that you feel are fitting to post on this blog. Best, Sumita