09 October 2011

Cornucopians vs. Malthusians

Back in 1980, Paul Ehrlich and Julian Simon made their famous bet, recounted by John Tierney at its culmination 10 years later:
In 1980 an ecologist and an economist chose a refreshingly unacademic way to resolve their differences. They bet $1,000. Specifically, the bet was over the future price of five metals, but at stake was much more -- a view of the planet's ultimate limits, a vision of humanity's destiny. It was a bet between the Cassandra and the Dr. Pangloss of our era.

They lead two intellectual schools -- sometimes called the Malthusians and the Cornucopians, sometimes simply the doomsters and the boomsters -- that use the latest in computer-generated graphs and foundation-generated funds to debate whether the world is getting better or going to the dogs. The argument has generally been as fruitless as it is old, since the two sides never seem to be looking at the same part of the world at the same time. Dr. Pangloss sees farm silos brimming with record harvests; Cassandra sees topsoil eroding and pesticide seeping into ground water. Dr. Pangloss sees people living longer; Cassandra sees rain forests being decimated. But in 1980 these opponents managed to agree on one way to chart and test the global future. They promised to abide by the results exactly 10 years later -- in October 1990 -- and to pay up out of their own pockets.
What was the result?  Simon won handily.

But recent goings on with commodity prices have some people asking whether Simon's timing was just lucky and perhaps Ehrlich views will ultimately triumph. In August, The Economist reported that had the famous bet extended to 2011, Ehrich would have won, as shown in the graph below.
In its survey of the global economy from a few weeks ago The Economist presented its entire time series for global commodity prices.  On that graph I have superimposed a red line showing the dates of the Ehrlich-Simon bet.
Note that the original bet covered five commodities, and the graph from 1845 covers a much larger set.  Of course, the original bet was meant to be representative of such broader trends.

In its survey The Economist explains the recent spike in commodity prices as follows:
The Economist’s index of non-oil commodity prices has trebled in the past decade. The recent surge has reversed a downward trend that had lasted a century. Industrial raw-material prices fell by around 80% in real terms between 1845, when The Economist began collecting data, and their low point in 2002 (see chart 3). But much of the ground lost over 150 years has been recovered in the space of just a decade.

This has raised the incomes of commodity-rich countries such as Brazil and Australia as well as parts of Africa. It has also caused even sober analysts to speak of a “new paradigm” in commodity markets. . .

What accounts for this turnaround? The price spikes over the past century were linked to interruptions in supply, notably during the first world war. But recent price rises have been too broad-based and long-lasting to be adequately explained by frost or bad harvests. Nor is it obvious that producers are hoarding supplies. . .

The demand side has been boosted by industrial development unprecedented in its size, speed and breadth, led by China but not confined to it. Growth in emerging markets is both rapid and resource-intensive. The IMF estimates that in a middle-income country a 1% rise in GDP increases demand for energy by the same percentage. Rich economies are far less energy-hungry: the oil intensity of OECD countries has steadily fallen in recent years.

China’s appetite for raw materials is particularly voracious because of the country’s size and its high investment rate. Though it accounts for only about one-eighth of global output, China uses up between a third and half of the world’s annual production of iron ore, aluminium, lead and other non-precious metals (see chart 5). Most of the energy for Chinese industry comes from coal—a dirty fuel that contributes to China’s poor air quality. Its consumption of oil roughly tallies with the economy’s size but is likely to grow faster than GDP as China gets richer and buys more cars.
OK brave forecasters, here is your chance.  Where are commodity prices headed?  Will Simon's optimism continue to win out and demand create new supply, again pushing prices down, as they did through the last century?  Or will Ehrlich's pessimism finally have its day, and are we entering an new era of scarcity?

25 comments:

  1. Simon was and is right. Human ingenuity will win out. If a particular commodity becomes (too) expensive, then a substitute will be found. Dr. Pangloss for ever!

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  2. received by email from Tim:

    "I think using $US as a reference point is deceptive because it does not take into account the depreciation of the $US.

    If you measured that chart in JPY or Chinese Yuan the results would be quantatively different."

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  3. Human ingenuity will win out _BUT_ that doesn't mean that China's coming of age won't result in a significant multi-decade upward trend.

    The key point is that this is a temporary trend which is the exception to the long term rule. The rate of growth in middle class human beings is in the middle of a massive spike that will necessarily disrupt the long term trend.

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  4. Since Tim (emailing Roger) raised some methodological point, let me add my two cents (cents of constant dollars).

    1. Both the Ehrlich-Simon bet and the Economist index are based on a fixed basket of products, i.e. keeping quantities fixed over time and just letting prices vary. This ignores not only the relative importance of the various products at the base year, but specially the change in their relative importance over time. This may cause (as usual in this sort of index) a "substitution bias", usually tending to overstate rises and understate falls in the index. In the case of price indexes such as the CPI this tends to overstate inflation (slightly per year, but accumulating more bias over time).
    2. The best measuring rod is not a particular currency but a basket of other goods and services against which the price of these raw materials is measured. In this case, the market prices are deflated with the US CPI (in the case of Ehrlich-Simon) or the US GDP deflator (for The Economist index). Thus in fact it is not measured in dollars as a currency, but in units of purchasing power of the dollar (in terms of consumer goods and services, or the entire GDP). Using Yen or GBP, deflated by Japan or Britain price indexes, would probably lead to a slightly different numerical outcome, but not very different indeed. On the other hand, the international price of raw materials is actually denominated in US dollars, and therefore using the purchasing power of the US dollar in the US as a measuring rod is correct. Wish one had a global price index to deflate a worldwide weighted basket of currencies, but one hasn't.

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  5. It will continue to be a down-trending sawtooth waveform, with peaks and troughs looking steeper for the next few decades.

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  6. Commodity prices will flatten and eventually decline.

    Higher prices cause substitution. Increased market share of the substituted good causes prices to fall which creates a downward price pressure on original commodity.

    We used to generate electricity, heat our homes and power our vehicles with oil. For the most part we don't generate electricity or heat our homes with oil anymore and there is anecdotal evidence from India that natural gas may become the 'fuel of choice' for transportation.

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  7. In the near-term, say five years, it depends on demand, specifically China as per the article - 'China uses up between a third and half of the world’s annual production of iron ore, aluminium, lead and other non-precious metals'.

    China's rate of capital formation is unprecedented, fixed investment running at 50% of GDP from memory, which naturally uses quite a lot of copper and steel and so on.

    Many independent hedge funds (pace the IMF 'completedevaluations' blogged here recently by Roger) reckon that this has to collapse, which (ceteris paribus, a not unreasonable assumption given the 1/3 to 1/2 statistic) would have to lead to a substantial fall in prices.

    Their bet is not based on any view of human ingenuity, solely on the view that such a rate is unsustainable and will lead to a bubble.

    I should also mention that these funds also bet successfully on sub-prime and the eurozone. This doesn't mean they will be right, but perhaps means their view should be considered.

    I doubt they have any opinion on Ridley versus Erlich, or Jeremy Grantham (the latter's new paradigm opinion equally should not be ignored).

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  8. @Roddy

    You said: "I doubt they have any opinion on Ridley versus Erlich, or Jeremy Grantham (the latter's new paradigm opinion equally should not be ignored)."

    I'd caution you to consider Grantham in any way an objective source.

    Even ignoring his very public opinions, written as well as oral, which are clearly Ehrlichian (top soil depletion, worldwide starvation, etc etc), Grantham as well as many hedge fund managers devote large sums of money specifically gearing political processes to take advantage of specific beliefs.

    This is less an objective evaluation of what is occurring than it is a cynical exploitation of these belief systems.

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  9. "Will Simon's optimism continue to win out and demand create new supply, again pushing prices down, as they did through the last century?"

    My guess is that over time, we'll decide that comparing commodity prices over long time frames is essentially meaningless, as they are strongly affected by larger-scale variables, such as broad-scale shifts in the economy, manufacturing processes, etc (as alluded to in Harrywr2's comment).

    That doesn't diminish the importance of commodity prices over the short term. All we need to do is look at the impact of the Commodities Futures Modernization Act - and the resulting deregulation of derivatives - to see that.

    Nor does it diminish the amount you can decipher about someone's politics by how they spin the data related to this debate.

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  10. I concur with Joshua that in the long term these changes in the price of some commodities relative to other commodities may have lesser importance, as people's behavior, technology and other variables adjust to the new structure of relative prices. For instance, with the wage levels of 1900 in Western developed countries, food represented about 50% of a worker's household expenditure, even with a meager and insufficient diet mostly composed of staple foodstuffs (cereals, tubers). Now, also for a typical worker (even one with lower skills), food represents not more than 10-12% of expenditure in developed countries, with a much more abundant and varied diet (in fact, with an excess of food frequently leading to obesity). Even if food were more expensive now (but it is not), increased wage (and other income) levels would have made up for any such increase in cost, as they made up for the enormous increase in the amount and quality of the food consumed.

    The same is valid for other needs besides food, such as energy or housing. The mere rise in price, even corrected for inflation, is just one half of the story, concerning only the first order event (real prices go up or down). It ignores the second and higher order changes (in technology, in income, in the composition of demand) through which the economy responds to the primary event of a change in relative prices.

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  11. @Roddy:

    China does have to experience a collapse, probably within a year.

    But on a multidecadal time scale, that collapse will be nothing more than a blip. The hedge fund guys aren't suggesting otherwise.

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  12. Jason

    I agree the likely collapse of the Chinese investment bubble will be a "blip", but it seems clear that the current increase in commodity prices is also just a blip, caused by the unprecedented growth in Chinese investment.Neither the bubble, nor the eventual collapse, negate the robust long term downtrend in commodity prices, as predicted by Simon.

    This is because natural resources are not something we dig out of the ground, but are rather the result of human ingenuity - the one resource which really IS unlimited.

    If the internal combustion engine had never been invented, what would oil be worth now? And if oil cost $1000/barrel, how much longer would we drive petrol driven cars? We'd either develop a new fuel or a new engine (or both), and whatever that runs on will become the new "natural resource". A resources' value derives from what we can use it for, rather than any intrinsic value, and that is determined by our technology and wealth.

    So I'm with Julian Simon. In the medium term prices will react to events, but in the longer term mankind will make either better use of, or find a substitute for, anything which becomes too expensive. Nothing will rise in price forever, and most things will fall.

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  13. Ehrlich was wrong, even if prices do rise.

    He predicted a drop in supply would lead to increased prices. That stuff would run out basically.

    In fact supply has increased tremendously. It is just that demand is increasing more. What's more demand is increasing because people are better off, not worse.

    There is no competition for dwindling resources as in the Malthusian scenario.

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  14. I elect not to enter the prediction stakes but I've always wondered how the Simon-Ehrlich bet looked in a wider time context and now I know. By strange coincidence I bought the dead tree version of The Economist in London today for the first time for years - to read what it had to say on Steve Jobs and the future of mobile electronic devices. As if in response the blogosphere shows its worth again. Thanks Roger.

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  15. Jason - I think I agree with your point, I certainly don't disagree. Mine was a narrow point (Roger didn't specify a timescale, I did, a short one of five years). And no investment managers bet on a multi-decadal timescale.

    Khan - I don't know if you are more or less familiar with Grantham's views and potential biases and use of his wealth than I am, maybe more, maybe less. My comment on his views could be paraphrased as a) play the ball not the man, and b) he is not stupid, so listen, especially when he talks about his knowledge of markets, regardless of your view of his view on topsoil depletion (both views being irrelevant to commodity prices).

    I have no respect for authority or wealth per se, but a sneaking regard for people who've made money out of markets on a, ok I'll say it, multi-decadal timescale. Whether Buffett or Grantham.

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  16. From Tim by email, who apparently has offended the Blogger software:

    "Hector M,

    I did some back of the envelope calculations base on currency shifts and CPI for USD, CAD and JPY.

    The differences are NOT trivial.

    If I do the calcuation in JPY I get a 29% decrease in real JPY cost between 1980 and 2010.
    If I do the calculation in CAD I get a 16% decrease in real CAD cost between 1980 and 2010.

    This assumes the USD price increased at the USD CPI during the period."

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  17. Do any readers have the digitized time series from the 1845-present Economist graph? Tim? ... Thanks!

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  18. @Roddy

    You said: "Khan - I don't know if you are more or less familiar with Grantham's views and potential biases and use of his wealth than I am, maybe more, maybe less. My comment on his views could be paraphrased as a) play the ball not the man, and b) he is not stupid, so listen, especially when he talks about his knowledge of markets, regardless of your view of his view on topsoil depletion (both views being irrelevant to commodity prices).

    I have no respect for authority or wealth per se, but a sneaking regard for people who've made money out of markets on a, ok I'll say it, multi-decadal timescale. Whether Buffett or Grantham."

    I do have great familiarity with Grantham, both in terms of his sales techniques (his monthly/quarterly reports) as well as his NGO activities (the Grantham Institute for Climate Change).

    While indubitably Grantham is a smart man, I'd again caution you to conflate a financial advisor with someone who actually builds stuff.

    Buffett may be a sort of bank for companies, but ultimately his corporation seeks to produce value by aggregating companies which create actual products. Even his insurance and reinsurance operations have real impact on everyday lives.

    Grantham in contrast impacts lives only via helping rich people get richer.

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  19. Khan, you've offered me (and thank you) two pieces of advice:

    'I'd caution you to consider Grantham in any way an objective source.'

    'I'd again caution you to conflate a financial advisor with someone who actually builds stuff.'

    I wasn't aware I was at risk of the first, hence my 'play the ball not the man' comment, and I simply don't understand the second! Do people who build stuff understand the future of commodity prices?

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  20. Actually, missing from the above discussion is the impact of dramatic reduction in mining/processing production costs resulting from scale economies and the development of improved technology.

    I think that you would find that cash opex per unit of production for most commodities has declined very substantially in real terms. This means that previously uneconomic deposits can now be extracted.

    A further observation is that if you plot the log of price per unit (say per tonne) against log of annual output, you find that nearly all commodities are priced in proportion to the annual output. That is, low volume products (diamonds, rare earths, platinum, gold) are priced high, while high volume products such as dimension stone, aggregate, iron ore are priced low. And as output increases, prices tend to fall accordingly.

    So to the extent that technology continues to deliver lower production costs, and to the extent that production increases, past history says that in the long run, prices will continue to decline.

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  21. Does it matter to Cornucopians whether scarcity is imposed by the natural world or political fiat?

    I'd think that Malthusians would predict that high carbon emissions taxes would lead to economic ruin because it's difficult to substitute for fossil fuels, while Cornucopians would predict that high carbon taxes would lead to little change in the price of energy and a rapid shift to clean energy because markets innovate and substitute to get around scarcity.

    Is there a flaw in this description?

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  22. @Roddy

    You said: "I wasn't aware I was at risk of the first, hence my 'play the ball not the man' comment, and I simply don't understand the second! Do people who build stuff understand the future of commodity prices?"

    People who build stuff have a long term relationship with commodities, because their livelihoods depend on them. Furthermore, when you build stuff, you cannot easily drop what you are building and switch to something else.

    This doesn't make builders of stuff automatically perfect, but it does force them to be far more disciplined and rigorous in their business practices than a financial shell gamer.

    The financial shell gamer has the luxury of being able to switch in and out of any number of areas.

    The difference could be seen in a single man: Soros and the British pound.

    Soros did see that the pound was overvalued, attacked it, and was vindicated.

    But then he moved on.

    The Central Bank of England, however, had and still has the long term responsibility for the GBP.

    My other point was that anyone who stands to make millions via the promotion of a specific meme is very much a possibility of being a promoter, as opposed to an observer.

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  23. @21 Jonathan Gilligan

    Is there a flaw in this description?

    Yes. The flaw is the lower standard of living and poverty it will impose over the decades or centuries it will take for the cost of greed energy to come down to anything like parity with fossil fuels.

    A high tax on ox, horse, and donkey carts by Caesar would not get the transition to air transport going much sooner.

    In fact the more resources wasted on needlessly expensive energy, the less that is available to research alternatives. Further once a tax makes your form of greed energy the cheapest your best allocation of resources is to work on the political system to increase that tax.


    .

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  24. Jonathan Gilligan said... 21

    Does it matter to Cornucopians whether scarcity is imposed by the natural world or political fiat?

    Yes. Political fiats are frequently rescinded.
    Political uncertainty just adds to the list of uncertainties that favor inefficient short term investment decisions over more efficient long term investment decisions.








    I own a coal fired plant that is 10 years old.
    Solar panel prices are projected to decline 50% in 10 years.

    An 'artificially imposed' scarcity forces me to abandon my investment in coal fired energy at a 75% loss of capital and invest immediately in solar panels at a 100% cost premium as oppose to waiting 10 years to make the substitution.

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  25. @Harrywr2 (24): Very good point about fickle policies and the value of consistent and predictable conditions for long-term investments.

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