Intepreting Yield Curves

A good article explaining yield curves, with a great animation of historic yield curves from March 1977 to January 2007.

http://fixedincome.fidelity.com/fi/FIHistoricalYield?refpr=obrfi14

The greatest shortcoming of the human race is our inability to understand the exponential function

Arithmetic, Population, and Energy

Dr Bartlett is a retired Professor of Physics from the University of Colorado. In his speech of 2004 quoted below he examines the arithmetic of steady growth, continued over modest periods of time, in a finite environment.

It's simply a great and eloquent example on why simple math matters, and of the disconnect between reality and popular perception in the modern world.

The Speech

"It's a great pleasure to be here, and to have a chance just to share with you some very simple ideas about the problems we're facing. Some of these problems are local, some are national and some are global.

They are all tied together, they're tied together by arithmetic and the arithmetic isn't very difficult. What I hope to do is I hope to be able to convince you that the greatest shortcoming of the human race is our inability to understand the exponential function.

Well, you say, what's the exponential function?

This is a mathematical function that you'd write down if you're going to describe the size of anything that was growing steadily. If you had something that was growing at 5% per year, you'd write the exponential function to show how large that growing quantity was year after year. And so we are talking about a situation where the requirements required for the growing quantity to increase by a fixed fraction is a constant 5% per year. The 5% is a fixed fraction, the three years a fixed length of time. So that's what we want to talk about. Its just ordinary steady growth.

Well if it takes a fixed length of time to grow 5%, it follows it takes a longer fixed length of time to grow 100%. That longer time's called the doubling time and we need to know how you calculate that doubling time. It's easy.

You just take the number 70, divide it by the percent growth per unit time and that gives you the doubling time. So our example of 5% per year, you divide that into 70, you find that growing quantity will double in size every 14 years.

Well, you might ask, where did that seventy come from, well, the answer is that it's approximately one hundred multiplied by the natural logarhythm of two. If you wanted the time to triple you would use the natural log rhythm of three. So it's all very logical. But you don't have to remember where it came from, just remember 70.

I wish we could get every person to make this mental calculation every time we see a percent growth rate of anything in a news story. For example, if you saw a story that said things had been growing at 7% per year for several recent years, you wouldn't bat an eyelash. But when you see a headline that says crime has doubled in a decade you say, my heavens what's happening.

Ok what is happening? Seven percent growth per year, divide the seven into seventy, the doubling time is ten years. But notice if you want to write a headline to get people's attention, you'd never write, crime is growing at seven percent per year, no body would know what it means. Now, do you know what seven percent means?

Let's take an example, another example from Colorado, the cost of an all day lift ticket to ski at Vale. It's been growing about seven percent per year ever since Vale first opened in 1963. At that time you paid $5 for an all day lift ticket. What's the doubling time for seven percent growth? Ten years. So what was the cost ten years later in 1973, ten years later in 1983 and ten years later in 1993, what was it in 2003, and what do we have to look forward to? (Audience laughter)

This is what 7% means. Most people don't have a clue. And how is Vale doing? They are pretty much on skip.

Let's look at a generic graph of something that is growing steadily. After one doubling time the growing quantity is up to twice its initial size, two doubling times, it's up to four times its initial size, then it goes to 8-16-32-64-128-256-512, in ten doubling times it's a thousand times larger than when it started. You can see if you try to make a graph of that on ordinary graph paper the graph is going to go right through the ceiling.

Now let me give you an example to show the enormous numbers you can get with just a modest number of doublings.

Legend has it that the game of chess was invented by a mathematician who worked for a king. The king was very pleased, he said, "I want to reward you". The mathematician said " My needs are modest, please take my new chess board and on the first square place one grain of wheat, on the next square double the one and make two, on the next square double the two and make four, just keep doubling until you've doubled for every square, that would be an adequate payment". We can guess the king thought this a foolish man. "I was ready to give him a real reward; all he asked for was just a few grains of wheat".

But let's see what is involved in this; we know there are 8 grains on the forth square. I can get this number 'eight' by multiplying three twos together. Its 2x2x2, its one two less than the number of the square, now that continues in each case. So on the last square, I find the number of grains by multiplying 63 two's together.

Now let's look at the way the totals build up. When we add one grain on the first square, the total on the board is one. We add two grains that makes a total three. We put on four grains, now the total is seven. Seven is a grain less that eight, it's a grain less than three two's multiplied together. Fifteen is a grain less than four two's multiplied together. That continues in each case, so when were done, the total number of grains will be one grain less than the number I get multiplying 64 two's together. My question is how much wheat is that?

You know, would that be a nice pile here in the room? Would it fill the building?Would it cover the county to a depth of 2 meters? How much wheat are we talking about?

The answer is that it's roughly four hundred times the 1990 world wide harvest of wheat. That could be more wheat than humans have harvested in the entire history of the earth. You say, how did you get such a big number and the answer is, it was simple. We just started with one grain, but we let the numbers grow steadily till it had doubled a mere 63 times.

Now there's something else that is very important, the growth in any doubling time is greater than the total of all the preceding growth. For example, when I put eight grains on the 4th square the eight is larger than the total of seven that were already there. I put thirty two grains on the 6th square; the thirty two is larger than the total of thirty one that were already there. Every time the growing quantity doubles, it takes more than all you'd used in all the proceeding growth.

Well, let's translate that into the energy crisis. Here is an add from the year 1975, it asks the question could America run out of electricity? America depends on electricity; our need for electricity actually doubles every 10 or 12 years. That's an accurate reflection of a very long history of steady growth of the electrical industry in this country. Growth of a rate around 7% per year which gives you doubling every 10 years.

Now with all that history of growth, they just expect that growth will go on forever. Fortunately it stopped, not because anyone understood arithmetic, it stopped for other reasons. Well, let's ask what if. Suppose the growth had continued then we would see here the thing we just saw with the chess board. In the ten years following the appearance of this ad, in that decade, the amount of electrical energy we would have consumed in this country would have been greater than the total of all the electrical energy we had ever consumed in the entire proceeding history of the steady growth of that industry in this country.

Now did you realise that anything as completely acceptable as 7% growth per year could give such an incredible consequence, that in just ten years you'd use more than the total of all that had been used in all the proceeding growth?

Well that's exactly what President Carter was referring to in his speech on energy. One of his statements was this. He said, in each of those decades more oil was consumed than in all of humankind's pervious history. By itself it's a stunning statement.

Now you can understand that the president was telling us the simple consequences of the arithmetic of 7% growth each year in world oil consumption, and that was the historic figure up until the 1970's.

There's another beautiful consequence of this arithmetic. If you take seventy years as a period of time and note that that's roughly one human lifetime, then any percent growth continued steadily for seventy years gives you an overall increase by a factor that's very easy to calculate. For example 4% per year for 70 years, you find the factor by multiplying four two's together it's a factor of 16.

A few years ago, one of the newspapers of my hometown of Bolder Colorado, quizzed the nine members of the Bolder City Council and asked them what rate of growth was Boulders population. You'd think it would be good to have in the coming years. Well the nine members of the Boulder City council gave answers ranging from a low of 1% per year, now that happens to match the preset rate of growth of the population of the United States. We are not at zero population growth, right now, the number of Americans increases every year by over three million people. No member of the council said Boulder should grow less rapidly than the United States is growing.

Now the highest answer any council member gave was 5% per year. You know I felt compelled, I had to write them a letter and say did you know that 5% per year for just 70 years - I can remember when just 70 years seemed like an awful long time, it just doesn't seem so long now. (audience laughter). Well that means Boulders population would increase by a factor of 32, and that is for today. We have one over loaded sewer treatment plant, in seventy years we will need 32 overloaded sewer treatment plants.

Now did you realise anything as completely all American as 5% growth per year could give such an incredible consequence in such a modest period of time? Our city council people have zero understanding of this very simple arithmetic.

Well, a few years ago, I had a class of non science students, who were interested in problems of science and society; we spent a lot of time learning to use semi logarithmic graph paper. It's printed in such a way that these equilaterals( 09:53)*** on the vertical scale each represent an increase by a factor of 10. So you go from one thousand to 10 thousand to a hundred thousand, and the reason you use this special paper is that on this paper a straight line represents steady growth.

Now we worked on a lot of examples, I said to the students lets talk about inflation, let's talk about 7% per year. It wasn't this high when we did this, it's been higher since then, fortunately it's lower now. And I said to the students, as I say to you, you have roughly sixty years life expectancy ahead of you, lets see what some common things will cost if we had sixty years of 7% annual inflation.

The students found that a 55cents gallon of gasoline would cost $35.20 - $2.50 for a movie would be $160. The $15 sack of groceries my mother used to buy for doallar and a quarter, that will be $960. A thousand dollar suit of clothes $6,400 a $400 automobile will cost a quarter of a million dollars and a $45,000 home will cost nearly three million dollars.

Well I gave the students this data, (shows overhead) these cam from a blue cross, blue shield ad, the add appeared in Newsweek magazine and gave these figures to show the cost escalation of gall bladder surgery in the year since 1950, when that surges cost $361. I said make a semi logarithmic plot, let's see what's happening. The students found the first four points lined up on a straight line whose slope indicated inflation of about 6% per year, but the fourth, fifth and sixth where on a steeper line almost 10% inflation per year. Well, then I said to the students, run that steeper line on out to the year 2000, lets get an idea of what a gall bladder operation might cost, 2000 was four years ago, the answer is $25,000. The lesson there was awfully clear. If you're thinking about gall bladder surgery do it now. (audience laughter)

In the summer of 1986 the news reports indicated that the world population had reached the number of five billion people growing at the rate of 1.7% per year. Well your reaction to 1.7% might be to say that that's so small nothing bad could ever happen at 1.7% per year. So you calculate the doubling time you find its only 41 years, now that was back in 1986, more recently in 1999 we read that the world population had grown from five billion to six billion . The good news is that the growth rate had dropped from 1.7% to 1.3% per cent per year. The bad news is that in spite of the drop in the growth rate, the world population today is increasing by about 75 million additional people every year.

Now, if this current modest 1.3% per year could continue, the world population would grow to a density of one person per square meter on the dry land surface of the earth in just seven hundred and eighty years and then the mass of people would equal the mass of the earth in just twenty four hundred years. Well we can smile at those, we know they couldn't happen. This one make for a cute cartoon, the caption says, "Excuse me sir, but I am prepared to make you a rather attractive offer for your square".

There's a very profound lesson in that cartoon. The lesson is that zero population growth is gonna happen. Now we can debate whether we like zero population growth or don't like it, its going to happen whether we debate it or not, whether we like it or not. It's absolutely certain people could never live at that density on the dry land surface of the earth. Therefore today's high birth rates will drop; today's low death rate will rise till they have exactly the same numerical value. That will certainly be in a time shorter than several hundred years. So maybe you're wondering then, what options are available if we wanted to address the problem.

In the left hand column I've listed some of those things we should encourage if we want to raise the rate of growth of population and in so doing make the problem worse. Just look at the list. Every thing in the list is as sacred as mother hood, there's immigration, medicine, public health, sanitation. These are all devoted to the humane goals of lowering the death rate and that's very important to me, if it's my death they are lowering. Then I've got to realise that anything that just lowers the death rate makes the population problem worse.

There's peace, law and order, scientific agriculture has lowered the death rate due to famine that just makes the population problem worse. It's widely reported that the 55 mph speed limit saved thousands of lives that just makes the population problem worse. Clean air makes it worse.

Now in this column are some of the things we should encourage if we want to lower the rate of growth of the population and in so doing help solve the population problem. Well, there's abstention, contraception, abortion, small families, stop immigration, disease, war, murder, famine, accidents. Now smoking clearly raises the death rate, will that help solve the problem?

Remember our conclusion from the cartoon of one person per square meter; we concluded that zero population growth is gonna happen. Lets state that conclusion in other terms and say its obvious nature is going to choose from the right hand list and we don't have to do anything except be prepared to live with whatever nature chooses from that right hand list. Or we can exercise the one option that's open to us, and that option is to choose first from the right hand list. We gotta find something here we can go out and campaign for. Anyone here for promoting disease? (Audience laughter)

We now have the capabilities of incredible war, would you like more murder, more famine, more accidents? Well, here we can see the human dilemma, every thing we regard as good makes the population problem worse, everything we regard as bad, helps solve the problem. There is a dilemma if ever there was one.

The one remaining question is education, does it go on the left hand column or the right hand column. I'd have to say thus far in this country it's been in the left had column and it's done very little to reduce the ignorance of the problem. So where do we start. Well, let's start in Bolder Colorado, here in my home town. Here is the 1950's census figure, the1960, -1970 in that period of twenty years the average growth rate of Boulders population was 6% per year. With big efforts, we've been able to slow the growth somewhat. There's the year 2000 census figure. I'd like to ask people, let's start with that 2000 figure go another 70 years, one human life time, and ask, what rate of growth would we need in Boulders population in the next seventy years so that the end of seventy years the population of Boulder would equal today's population of your choice of major American cities?

Boulder in seventy years could be as big as Boston is today if we just grew 2.58% per year. Now if we thought Detroit was a better model we would have to shoot for 3.1/4% per year. Remember the historic figure on the preceding slide 6% per year. If that could continue for one life time, the population of Boulder would be larger than the population of Los Angeles. Well, I'll just tell you, you couldn't put the population of Los Angles in the boulder valley, therefore its obvious. Boulders population growth is going to stop and the only question is will we be able to stop it while there is still some open space or will we wait until its wall to wall people and we're all chocking to death?

Now, every once in a while someone says to me, you know a bigger city just might be a better city and I have to say, wait a minute, we've done that experiment already. We don't need to wonder what will be the affect of growth on Boulder because Boulder tomorrow can be seen in the Los Angles of today, and for the price of an airplane ticket we can step seventy years into the future and see exactly what its like. What is it like? Here's an interesting headline from Los Angeles. (Shows slide) Maybe that has something to do with this headline from Los Angles. (Shows slide)

So how are we doing in Colorado? Well, we're the growth capital of the USA today and proud of it. The Rocky Mountain News tells us to expect another million people in the front range in the next 20 years, and what are the consequences of all this? They are totally predictable and no surprises, we know exactly what happens when you crowd more people into an area.

Well as you can imagine growth control is very controversial and I treasure the letter from which these quotations are taken. Now this letter was written to me by a leading citizen of our community. He's a leading proponent of controlled growth, controlled growth just means growth. This man writes "I take no exception to your arguments regarding exponential growth; I don't believe the exponential argument is valid at the local level."

So you see, arithmetic doesn't hold in Boulder. (Audience laughs) I have to admit that man has a degree form the University of Colorado; it's not a degree in mathematics in science or in engineering. Alright, let's look now at what happens when we have this kind of steady growth in a finite environment.

Bacteria grow by doubling. One bacterium divides to become two, the two divide to become 4, become 8, 16 and so on. Suppose we had bacteria that doubled in number this way every minute. Suppose we put one of these bacterium into an empty bottle at eleven in the morning, and then observe that the bottle is full at twelve noon. There's our case of just ordinary steady growth, it has a doubling time of one minuet, and it's in the finite environment of one bottle. I want to ask you three questions.

Number one; at which time was the bottle half full? Well, would you believe 11:59,one minuet before 12, because they double in number every minute.

Second Question; if you were an average bacterium in that bottle at what time would you first realise that you were running of space? Well let's just look at the last minute in the bottle. At 12 noon its full, one minute before its half full, 2 minutes before its ¼ full than 1/8th than a 1/16th . Let me ask you, at 5 minutes before 12 when the bottle is only 3% full and is 97% open space just yearning for development, how many of you would realise there's a problem?
Now in the ongoing controversy over growth in Bolder, someone wrote to the newspaper some years ago and said look, there's no problem with population growth in Boulder, because the writer said, we have fifteen times as much open space as we've already used. So let me ask you what time was it in Boulder when the open space was fifteen times the amount of space we had already used? And the answer is, it was four minutes before 12 in Boulder valley. Well suppose that at 2 minutes before 12, some of the bacterium realised they were running out of space, so they launch a great search for new bottles. They searched offshore and on the outer continental shelf and the overthrust belt and the Artic, and they find three new bottles. Now that's an incredible discovery, that's three times the total amount of resource they ever new about before, they now have four bottles, before their discovery they had one. Now surely this will give them a sustainable society, wont' it?

You know what the third question is? How long can the growth continue as a result of this magnificent discovery? Well look at the score, at 12 noon, one bottles filled, there are three to go, 12:01 two bottles are filled, there's two to go and at 12:02 all four are filled and that's the end of the line. Now you don't need any more arithmetic than this to evaluate the absolutely contradictory statements that we've all heard and read from experts who tell us in one breath we can go on increasing our rates of consumption of fossil fuels and then in the next breath don't worry, we will always be able to make the discoveries of new resources that we need to meet the requirement of that growth.

Well a few years ago in Washington our energy secretary observed that in the energy crisis we have a classic case of exponential growth against a finite source. So let's look now at some of these finite sources. We turn to the work of the late Dr M. King Hubbert, he's plotted here a semi logarithmic graph of world oil production. You can see the lines been approximately straight for about 100 years, clear up here to 1970, average growth rate very close to 7% per year. It's logical to ask how much longer can that 7% growth continue. That's answered by the numbers in this table (shows slide). The numbers in the top line tell us that in the year 1973, world oil production was twenty billion barrels, the total production in all of history, three hundred billion, the remaining reserves, seventeen hundred billion.

Now those are data, the rest of this table is just calculated out assuming the historic 7% growth continued in the years following 1973 exactly as it had been for the proceeding one hundred years. Now in fact the growth stopped, it stopped because OPEC raised their oil prices so we're asking here, what if? Suppose we just decided to stay on that 7% growth curve, let's go back to 1981, by 1981 on the 7% curve, the total usage in all of history would add up to five hundred billion barrels, the remaining reserves, fifteen hundred billion. At that point the remaining reserves are three times the total of every thing we have used in all history. That's an enormous reserve, but what time is it when the remaining reserve is three times the total of all you've used in all of history? The answer is its two minutes before twelve.

We know with 7% growth, the doubling time is 10 years. We go from 1981 to 1991, by 1991 on the 7% curve, the total usage in all of history would add up to a thousand billion barrels, there would be a thousand billion left. At that point the remaining oil would be equal in quantity to the total of everything we've used in the entire history of the oil industry on this earth. One hundred and thirty years of oil consumption. You'd say, That's an enormous reserve, but what time is it when the remaining reserves is equal to all you've used in all of history? The answer is its one minute before twelve. So we go one more decade to the turn of the century, that's like right now, that's when 7% would finish using up the oil reserves of the earth.

So let's look at this in a very nice graphical way. Suppose the area of this tiny rectangle represents all the oil we used on this earth before 1940, then in the decade to the 40's we used this much, that's equal to all that had been used in all of history. In the decade of the 50's we used this much, and that's equal to all that had been used in all of history. In the decade of the 60's we used this much, again that's equal to the total of all the proceeding usage. Here we see graphically what president Carter told us. Now if that 7% growth had continued through the 70's. 80's and 90's there's what we mean. That's all the oil there is.

Now there's a widely held belief that if you throw enough money at holes in the ground oil is sure to come up. Well there will be discoveries in new oil and maybe major discoveries, but look, we would have to discover this much new oil if we would have that 7% growth continue ten more years. Ask yourself, what do you think is the chance that oil discovered after the close of our meeting today will be in an amount equal to the total of all we've known about in all history. Then realise if all that new oil could be found that would be sufficient to let the historic 7% growth continue ten more years. Well it's interestingly to see what the experts say.

Here's from an interview in Time magazine, an interview with one of the most widely quoted oil experts in all of Texas, they asked him, "but haven't many of our bigger fields been drilled nearly dry"? He responded saying "there's still as much oil to be found in the US as has ever been produced" Now lets assume he's right. What time is it? And the answer is, one minute before twelve. I've read several things this guy's written; I don't think he has any understanding of this very simple arithmetic.

Well in the energy crisis about thirty years ago we saw ads such as this (shows slide) This is from the American Electric Power Company, it's a bit reassuring, sort of saying, now don't worry to much because we're sitting on half of the worlds known supply of coal enough for over 500 years. Where did that 500 year figure come from? It may have had its origin in this report to the committee on Interior and Insular Affairs of the United States Senate, because in that report we find this sentence "at current levels of output***** (27.23) these American coal reserves can be expected to last more than 500 years"

This is one of the most dangerous statements in the literature. It's dangerous because its true, it isn't the truth that makes it dangerous, the danger lies in the fact that people take the sentence apart, they just say coal will last 500 years. They forget the caveat with which the sentence started. Now what were those opening words, "at current levels", what does that mean? That means if, and only if we maintain zero growth of coal production.

So let's look at a few numbers. We go to the annual energy review, published by the dept of energy (DOE). They give this as a coal demonstrated reserve base in the United States, it has a footnote that says about half the demonstrated reserve base is estimated to be recoverable. You can not recover and get out of the ground and use 100% of the coal that's there. So this number then, is ½ of this number. We will come back again to those in just a moment. The report also tells us that in 1971 we were mining coal at this rate, twenty years later its at this rate, put those numbers together and the average growth rate of coal production in that twenty years is 2.86% per year. And so we have to ask, well, how long would a reserve last if you have steady growth in the rate of consumption until the last bit of it is used.

I'll show you the equation here for the expiration time. I'll tell you it takes first year college calculus to derive that equation, so it can't be very difficult. You know I have a feeling there must be dozens of people in this country who've had first year college calculus, but let me suggest, I think that equation is probably the best kept scientific secret of the century!

Now let me show you why, if you used that equation to calculate the life expectancy of the reserve base, or the one half they think is recoverable for different steady rates of growth, you'll find if the growth rate is zero, the small estimate would go about 240 years and the large one would go close to 500 years. So that report to the congress was correct. But look what we get if we plug in steady growth. Back in the 1960's it was our national goal to achieve growth of coal production up around 8% per year. If you could achieve that and continue it, coal would last between 37 - 46 years. President Carter cut that goal roughly in half, hoping to reach 4% per year if that could continue coal would last between 59-75 years. Here's that 2.86%, the average for the recent period of twenty years, if that could continue coal would last between 72-94 years. That's within the life expectancy of children born today. The only way you are going to get any where near this wild quote, this 500 year figure, is to be able to simultaneously do two highly improbable things.

Number one, you got to figure out how to use 100% of the coal that is in the ground. Number two, you got to figure out how to have 500 years of zero growth of coal production. Look at those figures, those are facts.

Back in the 1970's there was great national concern about energy. But these concerns disappeared in the 80's, now the concerns about energy in the 70's prompted experts, journalists, and scientist to assure the American people that there was no reason to be concerned. So let's go back now and look at some of those assurances from the 70's so we can see what to expect now that the energy crisis is returning.

Here is the director of the energy division of the Oakridge National laboratory telling us how expensive it is to import oil, telling us we must have big increases and rapid growth in our use of coal. Under these conditions, he estimates America's coal reserves were so huge they can last a minimum of three years, probably a maximum of a thousand years. You've just seen the facts, now you see what an expert tells us and what can you conclude? There was a three hour television special on CBS on energy, the reporter said; by the lowest estimate we have enough coal for 200 years, by the highest, enough for more than a thousand years. You've just seen the facts now you can see what a journalist tells us after careful study, and what can you conclude?

In the journal of Chemical education, on the page for high school chemistry teachers in an article by the scientific staff of the journal, they tell us our proven coal reserves are enormous and they give a figure. These can satisfy present US energy needs for nearly a thousand years. Well, let's do long division. You take the coal they say is there and divide by what was then the current rate of consumption, you get 180 years. Now they didn't say, current rate of consumption, they said present US energy needs. Coal today supplies about one fifth, about 20% of the energy we use in this country, so if you'd like to calculate how long this quantity of coal can satisfy present US energy needs, you have to multiply this denomination by five. When you do that you get thirty six years. They said nearly a thousand years. Newsweek magazine, in a cover story on energy, said, at present rates of consumption we have enough coal for 666.5 years, the point 5 means they think it will run out in July instead of January. (audience laughter)

If you round that off, and say roughly 600 years, that's close enough to 500 to lie within the uncertainty of our knowledge of the size of the reserves. So with that observation that's a reasonable statement, but what this lead into was a story about how we have to have major rapid growth in coal consumption. Well its obvious isn't? If you have the growth that they re writing about, it won't last as long as they said it would last with zero growth. They never mention this. I wrote them a long letter, told them I thought it was a serious misrepresentation to give readers the feeling we could have all this growth that they were writing about and still have coal around for 600 years. I got back a nice form letter; it had nothing to do with what I'd tried to explain to them.

I gave this talk at a high school in Omaha, and after the talk the high school physics teacher came to me, and he had a booklet, and he said have you seen this, and I hadn't seen it, and he said look at this, we've got coal coming out of our ears, as reported by Forbes magazine, that's a prominent business magazine, the United States has 437 billion tons of coal reserves. That is a good number; this is equivalent to a lot of BTU's or its enough energy to keep 100 million large generating plants going for the next 800 years or so. And the teacher said to me, how can that be true, that's one large electric generating plant for every two people in the United States. I said of course it can't be true, its absolute nonsense. Let's do long division to see how crazy it is. So you take the coal they say is there, divide by what was then the current rate of consumption, you find you couldn't keep that up for 800 years and we hardly at that time had 500 large electric plants, they said it would be good for a hundred million such plants.

Time magazine tells us that beneath the pit heads of Appalachia in the Ohio valley and under the sprawling strip mines of the west lie coal seams rich enough to meet the countries power needs for centuries, no matter how much energy consumption may grow. So I give you a very fundamental observation, don't believe any perditions of the life expectancy of a non renewable resource until you have confirmed the prediction by repeating the calculation. As a colliery we have to note that the more optimistic the prediction the greater is the probability that it is based on faulty arithmetic or on no arithmetic at all.

Again from Time Magazine, energy industries agree that to achieve some form of energy self sufficiency the US must mine all the coal that it can. Now think about that for just a moment. Let me paraphrase it. The more rapidly we consume our resources the more self sufficient we will be. Isn't that what it says?

David Bower calls this the policy of strength to exhaustion. Here's an example of strength to exhaustion. Here is William Simon, energy advisor to the president of the United States, Simon says we should be trying to get as many holes drilled as possible, to get the proven oil reserves. The more rapidly we can get the last of that oil up out of the ground and finish using it, the better off we'll be.

So let's look at Dr Hubberts graph for the lower 48 states in oil production, again its semi logarithmic. Here we have a straight line section of steady growth, but for quite a while now production has fallen below the growth curve while our demand continued on up this graph curve until the 1970's. It's obvious the difference between the two curves has to be made up with imports. It was in early 1995 that we read that the year 1994 was the first year in our nation's history in which we had to import more oil than we were able to get of our own ground.

Well, maybe you're wondering, does it make any sense to imagine that we can have steady growth with a rate of consumption of a resource till the last bit of it was used, then the rate of consumption would plunge abruptly to zero. I say no, that doesn't make sense. Okay, you say, why bother us with the calculation of this expiration time, my answer is this. Every segment of our society, our business, leaders government leaders, political leaders, at the local level, state level, national level, everyone aspires to maintain a society in which all measures of material consumption continue to grow steadily year after year after year; a world without end.

Since that's so central to every thing we do, we ought to know where it would lead. On the other hand we should recognise there's a better model and again we turn to the work of the late Dr Hubbert. He's plotted the rate of consumption of resources that have already expired, he finds yes, there's is an early period of steady growth, and a rate of consumption. But then the rate goes through a maximum and comes back down in a nice cemetric bell shape curve. Now when he did this some years ago and fitted it to the oil production in the US, he found at that time we were right there. We were at the peak; we were halfway through the resource, that's exactly what that Texas expert said that I quoted a minute ago.

Now let's see what it means. It means that from now on domestic oil production can only go down hill and its down hill all the rest of the way and it doesn't' matter what they say inside the beltway in Washington DC.

Now it means we can work hard and put some bumps on the down hill side of the curve, you'll see there's bumps on the uphill side. The debate is heating up over drilling in the Artic wildlife refuge. I've seen the estimate that they might find 3.2 billion barrels of oil up there. 3.2 billion is the area of that little tiny square; that's less than one years consumption in the United States. So let's look at the curve in this way, the area under the total curve that represents a total resource in the United States. It's been divided into three parts, here is the oil we've taken from the ground, we've used it, its gone. This vertical shaded band, that's the oil we've drilled into; we've found it, were pumping on it today. Shaded in green on the right is the undiscovered oil. We have very good ways now of estimating how much oil remains undiscovered. This is the oil we gotta find if were going to make it down the curve on schedule. Now every once in a while somebody says to me, but you know, a hundred years ago somebody did a calculation and predicated the US would be out of oil in 25 years, the calculation must've been wrong, therefore, of course, all calculations are wrong. Let's understand what they did. One hundred years ago this band of discovered oil was over in here some where (points to slide), all they did was to take the discovered oil divide it by how rapidly it was being used and came up with 25 years. They had no idea then how much oil was undiscovered. Well it's obvious; you got to make a new calculation every time you make a new discovery. We're not asking today how long will the discovered oil last, we're asking about the discovered and the undiscovered, we're now talking about the rest of the oil. What does the US geological survey tell us?

Back in 1984 they said the estimated US supply from undiscovered resources and demonstrated reserves were thirty six years at present rates of production or nineteen years in the absence of imports. Five years latter in 1989, that thirty six years is down to thirty two years, the nineteen years down to sixteen years. So the numbers are holding together as we march down the right hand side of Hubbert's curve.

Well every once in awhile we run into somebody who says we shouldn't worry about the problem, we can solve it. In this case we can solve it by growing corn, distilling it in ethanol, and run all the vehicles in the United States on ethanol. Lets just look what he says, he says today ethanol production displaces over 43 ½ million barrels of imported oil annually. That sounds pretty good doesn't it, until you think. First question you have to ask. Forty three and a half million barrels, what fraction is that of US vehicle consumption in a year. The answer is its 1%.

You would have to multiply corn production devoted to ethanol by a factor of 100 just to make the numbers look right. There isn't that much total agricultural land in the United States. There's a bigger problem. It takes diesel fuel to plough the ground to plant the corn to make the fertiliser to make the corn grow, to tend the corn, to harvest the corn. It takes more energy to distillate it, you finally get a gallon of ethanol, you will be lucky if there's as much energy in the gallon as it took to produce it. In general it's a looser. But this guy says not to worry; we can solve it that way.

Back in 1956, Dr Hubbert addressed a convention of petroleum geologists and engineers. He told them that his calculations led him to believe that the peak of US oil and gas production could be expected to occur between 1966 - 1971, no one took him seriously. So let's see whats happened. The data here is from the Department of Energy, DOE. Here is steady growth; here is 1956, when Dr Hubbert did his analysis. He said at that time that peak would occur between 1966-1971. There's the peak, 1970. It was followed by a very rapid decline. Then the Alaskan pipeline started delivering oil, and it was a partial recovery. That production has now peaked and every things going down hill in unison in the right hand side of the curve. And when I go to my home computer to figure out the parameters of the curve, that's the best fit to the data, from that fit it looks to me that we have consumed ¾ of the recoverable oil that was ever in our ground in the United States and we are now coasting down hill on the last 25% of that once enormous resource. So we have to ask about world oil.

Dr Hubbert in 1974, predicted that the peak of would oil would occur around 1995, so lets see what's happened. Here we have the data from the Department of energy (DOE). A long period of steady growth, there's quite a big drop there, and then there was a speedy recovery, then an enormous drop and a very slow recovery. Those drops are each due to a price hike from OPEC. Well it's clear we're not yet over the peak, so when I now go to fit the curve, I need one more bit of information before I can do the fit. I have to got to the geology literature and ask the literature what do you think is the total amount of oil we will ever find on this earth. The consensus figure in the literature is two thousand billion barrels. Now that's quite uncertain, plus or minus, maybe 40 -50%. If I plug that in and do the fit, the peak is this year. (2004) If I assume there is 50% more than the consensus figure the peak moves back to 2019. If I assume there's twice as much as the consensus figure, the peak moves back to 2030.

So no matter how you cut it, in your life expectancy, you are going to see the peak of world oil production. You've got to ask yourself, what is life going to be like when we have declining world production of petroleum and we have a growing world population and we have a growing world per capita demand for oil. Think about it.

In the March 1998 issue of the Scientific American, there was a major article by two real petroleum geologists, they said this peak would occur before 2010, so we are all in the same ball park. Now that article in Scientific American triggered a lot of discussion. Here is an article in Fortune magazine, Nov, 1999, talking about oil forever, and in that article we see a criticism of the geologist's analysis, and this is from an Emirates Professor of economics at MIT. And he said this analysis by the geologists is a piece of foolishness, the world will never run out of oil, not in 10,000 years. So let's look at what's been happening.

Here we have two graphs, on one scale, we have here in the bar graph graphs that's the annual discovery of oil each year, here is the annual production of oil each year. Notice since the 1980's we've been producing about twice as much as we've been finding. Yet you've seen and read and heard statements from PhD's and non scientists saying that we have greater resources of petroleum now than ever before in history. What in the world are they smoking?
Now here is another look at world oil production, but this is per capita. This is litres per person each day. There is two litres, a litre is about a quart, and so two litres is about ½ gallon. The upper curve assumes there was no growth in the world population since 1920, that it stayed fluid at 1.8 billion. This then is just a copy of that earlier curve. The lower curve uses the actual population of the world and what you find is that with a growing world population this curve is pulled down more and more as you go farther to the right. And notice that peak is at about 2.2 litres per person a day in the 1970's. It is now down to about 1.7 litres a person a day, so we can say that on any day any one of us uses more than 1.7 litres of petroleum directly or indirectly, we're using more than our share. Just think about what that means.

Well, we do have to ask about new discoveries. Here is a discussion from about eleven years ago about the largest discovery of oil in the Gulf of Mexico, in the past twenty years an estimated seven hundred million barrels of oil. That's a lot of oil, but a lot compared to what? At that time we were consuming 16.6 million barrels every day in the United States. Divide the 16.6 into seven hundred and you'd find that discovery would meet US needs for forty two days.

On the front page of the Wall Street Journal, we read about the new Hibernia oil field off the south coast of Newfoundland. Please read this one line in the headline " Now it will last fifty years" That gives you some kind of a feeling for what amount of oil may be out there, so lets follow up and read from that story in the Wall Street Journal. "The Hibernia field, one of the largest oil discoveries in North America in decades, should deliver its first oil by the end of the year. At least 20 more fields may follow offering well over one billion barrels of high quality crude providing a steady flow of oil, just a quick tanker away from the energy thirsty east coast".

So let's do some arithmetic. We take the amount of oil that we think is up there, a billion barrels. At that time the US consumption has grown to about 18 million barrels a day, divide the 18 million into the one billion and you would find that would meet US needs for fifty six days.

Now what was the impression you had from that line in the headline in the Wall Street Journal? And as you think about this, think about the definition of modern agriculture (*****48.13) use of land to convert petroleum into food and we can see the end of the petroleum.

Dr Hubbert testified before a committee of the congress, he told them that the exponential phase of the industrial growth which has dominated human activities during the last couple of centuries is now drawing to a close. Yet during the last two centuries of unbroken industrial growth we have evolved to what amounts to an exponential growth culture. I would say it's more than a culture it's our national religion, because we worship growth. Pick up any newspaper; you'll see headlines such as this, "State forecasts robust growth."

Have you ever heard of a physician diagnosing a cancer in a patient and telling the patient you had a robust cancer. It isn't just in the United States that we have this terrible addiction, the Japanese are so accustomed to growth that economists in Tokyo usually speak of a recession any time the growth rate dips below 3% per year.

So, what do we do?

In the words of Winston Churchill, "sometimes we have to do what is required." First of all as a nation we have to get serious about renewable energy. For a start we ought to have a big increase in the funding for research in the development and dispersion of renewable energy. We have to educate all of our people to understand the arithmetic and the consequences of growth, especially in terms of populations and in terms of the earth's finite resources. We must educate people to recognise the fact that growth in rates of population and growth in rates of consumption of resources can not be sustained. What's the first law of sustainability? You've heard thousands of people talking endlessly about sustainability; did they ever tell you the first law? Here it is, population growth and/or growth in the rates of consumption of resources cannot be sustained. That's simple arithmetic Yet nobody that I'm encountering will tell you about that when talking about sustainability. So I think it's intellectually dishonest to talk about saving the environment, which is sustainability, without stressing the obvious facts that stopping population growth is a necessary condition for saving the environment and for sustainability.

We must educate people to see the need to examine carefully the allegations of the technological optimist who assure us that science and technology will always be able to solve all of our problems of population growth, food, energy and resources.

Chief amongst these optimists was the late Dr Julian Simon, formerly professor of economics and business administration at the University of Illinois, and later the university in Maryland. With regard to copper, Simon has written that we will never run out of copper because copper can be made from other metals. The letters to the editor jumped all over and told him about chemistry, but he just brushed it off, "don't worry he said if its ever important we can make copper out of other metals.

Now Simon had a book that was published by the Princeton University press. In that book he's writing about oil form many sources including bio mass and he says clearly there are not many ***51:33? for this source except for the sun energy. He goes on to note but even if our sun was not so vast as it is, there well may be other suns elsewhere. Well Simons right, there are other suns elsewhere, but the question is, would you base public policy on the belief that if we need another sun we will figure out how to go get it and haul it back into our solar system.

Now you cannot laugh, for decades before his death, this man was a trusted policy advisor at the very highest levels in Washington DC. Bill Moyes interviewed Ivan Kasanof, he asked Kasanof what happens to the idea of the dignity of the human species if this population growth continues and Kasanof Says, it'll be completely destroyed.

I'd like to use what I call my bathroom metaphor. If two people live in an apartment, and they had two bathrooms then they both have freedom of the bathroom. You can go to the bathroom anytime you want, stay as long as you want, for whatever you need, and everyone believes in the freedom of the bathroom. It should be right there in the constitution. But if you have twenty people in the apartment and two bathrooms, then no matter how much every person believes in the freedom of the bathroom, there is no such thing. You have to set up times for each person; you have to bang on the door, aren't you through yet and so on. Kasanof concluded with one of the most profound observations I've seen in years, he says, in the same way, democracy can not survive over population. Human dignity can not survive over population. Convenience and decency cannot survive over population. As you put more and more people into the world, the value of life not only decline it disappears. It doesn't matter if some one dies, the more people, there are the less one individual matters. And so, central to the things that we must do is to recognise that population growth is the immediate cause of all our resource and environmental crisis.

And in the last one hour the world population has increased by about ten thousand people and the population of the United States has increased by about two hundred and eighty people. And so to be successful with this experiment of human life on earth, we have to understand the laws of nature, as we encounter them in the study of science and mathematics. We should remember the words of Aldous Huxley that "facts do not cease to exist because they're ignored". We should remember the words of Eric Severson; he observed that the chief source of problems is solutions. This is what we encounter everyday, solutions to problems just make the problems worse. We should remember the message of this cartoon "thinking is very upsetting, it tells us things we'd rather not know" We should remember the words of Galileo; he said "I do not feel obliged to believe that the same god who has endowed us with sense, reason and intellect has intended us to forgo their use". If there is one message it is this. We can not let other people do our thinking for us.

Now, except for those petroleum graphs the things I've told you are not predictions of the future, I'm only reporting facts, and the results of some very simple arithmetic. I do with confidence that these facts, this arithmetic and more important our level of understanding of them, will play a major role in shaping our future. Now, don't take what I've said blindly or uncritically, because of the rhetoric, or for any other reason. Please, you check the facts; please check my arithmetic, if you find errors please let me know. If you don't find errors, then I hope you'll take this very very seriously.

Now you are important people because you can think. If there's anything that is in short supply in the world today its people who are willing to think. So here's a challenge. Can you think of any problem, on any scale, from microscopic to global, whose long term solutions is in any demonstratable way, aided, assisted or advanced by having larger populations in our local levels, state levels, national level, or global level? Can you think of anything that can get better if we crowd more people into our cities, our towns, into our state our nation or on this earth?

Now I'll close with these words from the Late reverend Martin Luther King Jnr who said, unlike the plagues of the dark ages, our contemporary diseases, which we do not yet understand, the modern plague of over population is solvable with means we have discovered and with resource we posses. What is lacking is not sufficient knowledge of the solution, but universal consciousness of the gravity of the problem and the education of the billions who are its victims.

So I hope I've made a reasonable case for my opening statement, that I think the greatest shortcoming of the human race is our inability to understand this very simple arithmetic.

Thank you very, very much."

The video and audio of this speech can be found here:

http://globalpublicmedia.com/node/461

1) Housing: Up, up, and away...

Housing is a hot topic these days, with commentators and pundits flooding the internet and the printed press with opinions from both sides of the bull-bear argument. It’s a confusing spectacle, much of it full of spin and bias from both sides. So what can we see through the fog? What do we know, what’s conjecture, what can we say about the future, and is anything being overlooked?

1) What do we know?
By many measures, but not all, the cost of buying a house in the UK is more expensive than ever before. House prices are also similarly high across many international markets.

Real (Inflation Adjusted) House Prices
Adjusting for inflation, “real” UK house prices are at an all time historic high. They are simply more expensive than ever before.

Source - Nationwide

Price vs. Earnings ratio
The high real price of housing is reflected in the house price - earnings ratio. Traditionally this is one of the key housing measures, indicating how much earnings have kept pace with house prices. In the UK this metric once averaged within the 3-4x range, with notable spikes associated with housing boom-busts of the 1970s and late 1980s. Today this ratio is at an all time high, some 20% above the peak rates seen before. This has prompted some commentators to predict another bust.

Source - Nationwide

Price vs. Rent ratio
An alternative way to measure the relative price of housing is to look at the price vs. rents ratio. This simply measures if rents are keeping track with house prices. It’s also broadly comparable to the p/e (price/earnings) ratio commonly used to measure the value of shares. Again, by this measure property in the UK this is at an historic high, with the ratio currently 50% above the long-term average, and even higher than spikes associated with the bubble markets of the 1970s and 1980s.

Source: The Economist

“Affordability”
However, both of the above measures use the actual price of the property as a yard stick to measure against. Many commentators today argue that this is misleading because property is often purchased using debt and thus it is the cost of servicing the debt that is the key measure, not the headline cost of the property nor the amount of the debt itself.

Source: The Economist

By this “affordability”, or more properly “first year monthly affordability”, measure UK house prices are not at their peak at all. The historic peak of new mortgage affordability was in the late 1980s when nearly 60% of take home pay was needed to pay the mortgage. As of the end of 2005 just over 40% was required. Although it’s worth noting that this measure is on a steady upwards trend and, all things being equal, it will breach the late 1980s high some time around 2009/2010.

This lower “affordability” measure is driven by the low interest rate/low inflation environment that has characterised the globalised economy of the early 21st century. Low interest rates mean that for a given debt early payments are more affordable.

Source: Andrew Farlow

Unfortunately, the “affordability” description is also somewhat misleading as it does not take account of the low inflation environment that enables the low interest rates. “Affordability” as often discussed in the press is only really a measure of first year cash flow affordability and takes no account of payments in later years, nor the total cost of servicing the home loan.

Inflation has many faces. Whilst commonly viewed as public-enemy-number-one, it can actually be a friend to those in debt. If inflation is running high, interest rates and thus the cost of borrowing is generally higher too, so paying the mortgage hurts in the early years, but inflation driven wages rise rapidly and the mortgage payments quickly become much easier.

Source: Andrew Farlow

This was most typical experienced by those that bought houses during the oil shocks and stagflation of the 1970s. High inflation, and thus high interest rates, meant that many home buyers of that period will remember that they had to make significant sacrifices and experienced very tight finances for the first few years of their mortgage. However, this burden eased rapidly and they were quickly able to trade up or enjoy more spare money. It is here that the concept of a housing ladder was born.

In contrast, in a low inflation environment this “free” erosion of mortgage debt does not take place so rapidly. Low inflation lets debts linger longer. While initial payments might be cheaper than before they also stay higher for longer, and in later years the mortgage payer will pay a greater percentage of their salary than they would have done in a high inflation environment.

This has implications for the longer term.

The peak of the late 1980s boom was in 1989 and 1990. At that time UK interest rates were between 13% and 14%. It was within this context that the all-time record first year mortgage payments were eating up 60% of take home salary. However, at the same time inflation was running at over 10%. This meant that even if everything had stayed the same throughout the early 1990s it would have been approximately 10% easier to make the payments for each subsequent year of the mortgage, as earnings approximately track inflation. Thus it would have taken just over three years of a mortgage for the payments to drop from their record 60% to the 2005 rate of just over 40%, even without a change in interest rates. This is much more rapid than today, where we have inflation at circa 4% (RPI is more comparable to the inflation quoted in the 1990s than the modern CPI). As it was there was a housing bust and a recession anyway and interest rates dropped rapidly to ~6% by 1993. With this double combination of dropping interest rates and high inflation the difficulty in making mortgage payments decreased rapidly, becoming easier than the 2005 rate by 1992.

Thus, whilst the first year affordability of UK property is not yet at an historic high, the lack of inflation means the debt lingers longer. If interest rates and inflation remain broadly at current levels then the “crossover” point at which payments will become higher for today’s borrowers than even those that bought at the top of the late 1980s boom is somewhere in the 3rd year of the mortgage. In years subsequent to this mortgage payments will be greater and the owners will have less spare money to spend in the wider economy, and less ability to trade up the property ladder.

Is this storing up trouble for the future?

Source: Office of National Statistics, The Economist

The thing to remember is that even though early monthly payments are lower in a low interest rate/low inflation environment, the debt is still there and must be paid back. If house prices are also higher then the rungs of the property ladder have effectively moved further apart.

Simply put, in the absence of any shocks to the economy, those buying today are dedicating more their future earnings to servicing their debt than any other previous generation.

Lifetime affordability still counts.

Not many commentators, pundits, or pub experts really argue that housing is cheap. Many bears point to the real price of housing, or the price-earnings ratio and worry about a crash, whilst the more bullish point to the “affordability” and claim that we are not yet at an historic high.

However, it’s not often noted that the affordability description only focuses on the first year of payments and misses the point of higher payments in later years. Measuring the lifetime affordability of a mortgage might be more contentious, and may not affect purchase decisions, but it remains important, if not for its impact on house prices today then for the social and/or economic impacts tomorrow.

Whichever way you look at it there’s just no way around the fact that house prices are very, very expensive. High house prices alone do not mean that there will be a crash, but if there isn’t to be one there will have to be social consequences.

Part 2 -What’s less certain?
What’s less certain is why this has occurred, or what happens next. It’s clearly here that the bull vs. bear discussion really begins. There are quite a few arguments for either side, with the bears asserting that house prices will eventually (always next quarter) revert to some mean, whilst the bulls assert that house prices can continue to grow rapidly year on year forever with no consequences or risks… A quick summary of these arguments will form part 2 of this blog...

2) Housing - Why So Expensive?

The Modern UK Housing Market - Arguments?
Very few people argue that property is cheap today. By every measure, with the exception of first year “affordability”, housing costs more than ever before.

However, it is far from certain why this has occurred. Many press articles and “expert” reports concentrate on one explanation or another. But it’s a complex and thorny issue and there are quite a few arguments for either side. It is here that the bear-bull discussion gets more heated, with the “bears” generally using various arguments to assert that house prices are too high and will eventually (always next quarter) revert to some historical mean, whilst the bulls gather arguments that assert that it’s different this time and house prices are fair, and can continue to grow rapidly year on year forever with no risks and no consequences…

So why are houses so expensive? There are many theories, but generally they can be broken down into a few themes:

- Low interest rates
- Supply vs. demand
- Expanding money supply and the Global system
- Financial innovation
- Speculation and a psychology led market

Low Interest Rates

In the late 1990s it was very popular to ascribe the increase in house prices to a natural and sensible adjustment to low interest rates. Interest rates had dropped significantly since the early 1990s and the “common sense” position was that this justified the rise in house prices.

Unfortunately it is not that clear cut. The first confusion comes from a lack of general understanding regarding nominal vs. real interest rates. There is a fundamental difference. Nominal interest rates are those that are quoted by the press and generally known, whilst real interest rates account for inflation and are of real significance.

Looking at the graph of nominal interest rates below it can be seen that the house price booms of the 1970s and late 1980s actually occurred during times of high nominal interest rates. Futhermore there has never been a study that has found a link between nominal interest rates and any long-run determination in house prices.

Source: Andrew Farlow

Real interest rates take into account the inflation rate, and thus measure how the loan actually feels to repay. A 20% nominal rate with 50% inflation would feel very easy to pay after a few years, as your income would be freely growing by more than the debt costs you, but a 10% nominal rate at 0% inflation remains hard to pay, as your wages wouldn’t be increasing in the same way. In the first case the real interest rate is -30%, whilst in the second it is +10%.

If you look at the graph of real rates below you can see that real interest rates during the house price inflation of the late 1990s and early 2000s do not differ significantly from the preceding period, and are significantly higher the 1970s (a time of negative real interest rates - and when the concept of the housing ladder was born).

Source: Farlow

So throughout the 1990s real interest rates were similar and thus debt was no more affordable… But of course this is discussing the rational, real, cost of a mortgage over its entire lifetime. What lower nominal rates can do is increase the initial monthly affordability of the payments, and thus give the appearance of a cheaper mortgage. However, as outlined in part one, this is an illusion. All that really happens is that the payments for the mortgage are pushed further back into the lifetime of the loan, flattening the payment “pain” curve. Thus, whilst lower interest rates can be described as a facilitator for higher house prices, they are not a rational nor sensible driver, and we may be storing up problems for the future.

It also seems very unlikely that interest rates were the sole driver, as even nominal rates dropped long before the upturn in house prices, and prices continued to rise even though nominal interest rates rose by 35% in 2004, and again in 2006.

Source: BBC News

Supply vs. Demand

In recent years, as nominal rates have risen, it has become increasingly popular to ascribe the recent rocketing house prices to simple supply vs. demand.

Supply
The supply scenario was highlighted by the UK government’s 2004 Barker report, which detailed a chronic failure of UK housing supply. In the late 1960s over 400,000 houses were built each year in the UK. Whilst in 2002 only 183,000 houses were built, of which 138,000 were built in England. Yet household formation in England is expected to increase by between 155,000 and 179,000 per year, and ran at an estimated 196,000 households per year from 1990 – 2000. This is clearly a problem.

Source: Barker Report

The Barker report went on to stress that to achieve a real annual house price trend increase of 1.8% an additional 70,000 private sector houses are required each year. Alternatively, to reach the EU average of a 1.1% real price increase per year then an extra 120,000 houses are needed each year - nearly double current output…

Demand
The Barker report also notes that the average size of UK households has been falling for some time, and that this results in some of the demand pressure.

It's worth noting that much of the figures that the Barker report was based upon were from government statistics and the 2001 national census. Thus they miss what has recently been quoted as being another major potential drive in house price demand: immigration.

Migration Watch UK predict that 2 million people will arrive in the UK every 10 years for the foreseeable future, and that the average immigration rate between 1998 and 2004 was around 166,000 per year. Some higher estimates put eastern European migration at over 500,000 per year since a number of states, most notably Poland, joined the EU in 2004. This could obviously lead to increased demand, and due to the nature of immigration this demand is likely to be heavily regionalised, with many migrants settling in the south east of England.

Source: BBC News

However, whilst supply vs. demand is often quoted as a key an issue in the UK, and at face value the figures seem stark, the control that supply vs. demand has over the full magnitude of recent house price inflation remains contentious.

This is particularly true within economic academia. Whilst a limited supply is noted, many economic modellers are unable to match the predicted consequences of this under-supply with the rapid and significant price increases experienced in the late 1990s and early 2000s. Furthermore, the undersupply has been relatively constant, yet price increases vary in rate significantly. The economic modelling of Muellbaur and Murphy, a pair of academics from Oxford University, suggest that the supply shortage of today (~0.25% of total dwellings) should push up real house prices by just 0.5% per year. That’s clearly a big disconnect from what has really happened, although the model does make many assumptions, not least requiring perfectly rational and fully informed consumers. But if the model is in anyway close to correct then there must be other variables that matter too.

Many argue that changes in family size and the trend to smaller household formation is an additional factor for housing demand. But the key point is that it is just that - a trend. It has been happening since the 1960s and as such is a gradual feature that has long existed in the market. Gradual societal changes are not clear explanations for the recent significant and rapid gain in house prices. The only recent step-change event that has occurred recently is the expansion of the EU in 2004, and the significant immigration experienced by the UK in subsequent years. Yet prices have been rising rapidly since the mid 1990s, with the rate of increase actually lowering from 2004.

There is one final point that casts doubt on the simple supply-demand driver: house prices have been rising globally. From the US, to Australia, Belgium, France, New Zealand, South Africa, Ireland, to Spain and others. Nearly every major economy (and many developing ones) have experienced a huge inflation in the price of property.

Supply / demand is clearly an issue in the UK. However, the international nature of property inflation is demonstrably not just a local phenomenon that can be explained by the peculiar characteristics of a single country.

Expanding Money Supply and the Global System

Another more technical reason that has been proposed as a driver behind high house inflation is the expansion of money supply.

Money supply is simply a measure of all the money (hard cash, loan debt, and saving accounts for example) in an economy. The total money supply can be expanded or contracted by central banks, such as the Federal Reserve or the Bank of England. This control over money is in practice a combination of setting interest rates, banking reserve ratios, and the purchase or sale of government securities, which are basically just an interest charging IOU from the government.

In an expanding monetary system the purchase of government securities releases funds to private banks that can then be loaned on to customers through fractional reserve banking (where the banks only have to keep a small percentage of their liabilities in reserve). Thus money from the central bank effectively multiplies as it moves through the banking system. Similarly a decrease in the central bank interest rate can make it more attractive to borrow (and loan on) monies. Effectively, the central banks “print” money.

In classic economic theory, if the supply of money is expanded too quickly then it will cause inflation, as there is more money chasing the same amount of goods.

One theory is that the rapid house price increases of the late 1990s and 2000s are the consequence of a more rapidly expanding money supply, as central banks effectively printed money in an effort to prevent worldwide recession and deflation, and an increasingly globalised economy kept interest rates at historic lows.

In the late 1990s many policy makers and economic commentators were worried about the dramatic entrance of two billion Chinese and Indian workers into a rapidly globalising worldwide economy. As these combined with falling commodity prices, falling bond yields, and falling producer prices economists began to fear that this would cause serious deflation, a terrible outcome for western economies that were heavily dependent on debt, and that had witnessed the decline and fall of Japan’s once triumphant economy.

Source: The Economist

Source: The Economist

At the time of these worries the dot-com boom was in full growth and western economies were still growing. Indeed, the US Federal Reserve was actually raising rates. However on March the 10th 2000 the NASDAQ hit a high of 5,048 and the tech bubble burst, with the rapid fall continuing until 2003. As a result the major central banks worried about a major recession that would deliver the spectre of major deflation, so they rapidly eased monetary policy to encourage growth (and thus encourage inflation rather than deflation). This process was compounded by the 2001 terrorist attacks, when both the ECB and Fed dropped rates by ½ a percent. All in all, in an effort to prevent the imminent recession becoming a global collapse the Fed dropped interest rates eleven times by the end of the year, from 6.5% to just below 2%. The Federal Reserve, as central bank to the world’s reserve currency, led the way and other banks followed.

It is arguable that this process worked. The western economies did not experience a major recession. Inflation dropped to an historic low in the early years of this century and may have gone negative if it were not for these accomodative low rates and general continued growth.

However, the cure may have had significant implications for the housing market and the general balance of the economy.

The increased money supply was further facilitated by the rise of China and other developing economies on the international foreign markets. Globalisation meant that US and western consumers could buy cheaply manufactured goods from China, driving the feared of deflationary pressures. Determined to keep its economy growing China pegged its exchange rate at a low level against the dollar, stabilising its access to its most important export market. Increasing foreign trade and rapid growth then provided the Chinese government with a huge trade surplus and a flood of foreign exchange. China has consistently re-invested this primarily in US bonds, enabling the US Federal Reserve to keep interest rates lower than they would have otherwise done. The strong demand for government bonds means that China has basically been increasing their price and lowering their yield. The effects of this are two fold. One is that the purchase of the bonds at higher prices effectively adds to the money supply, and the second is that their decreased yield means that other investors are forced to chase higher returns elsewhere. Whilst this effect is American-centric, where the Federal Reserve and the dollar lead, the world follows.

The theory is that a rapidly increasing money supply flooded the market with cheap credit, enabling exuberant house purchasers and investors to “afford” ever higher prices. Additionally, those stung by the stock market busts at the turn of the century distrusted the markets, preferring to invest in bricks and mortar than pensions and funds. Furthermore, institutional investors chasing ever decreasing yields in traditional markets looked at other potential avenues of investment and revenue creation.

Thus a very loose monetary policy injected a huge amount of cash into the financial system. Traditionally this would have been associated with rising inflation, and yet consumer inflation has stayed low for years, even whilst oil trades at $60 a barrel!

Some of this low-inflation effect is due to fundamental changes in the global workplace. Today, western workers competing with international labour are less able to increase their wages. Additionally, the huge production capability of the developing world has kept the supply of consumables high, and modern measures of consumer inflation low. As a result, whilst western economies have grown, western workers have received gradually less and less of their countries GDP in wages (the difference going to the owners of capital) and their real wages have increased only slowly. As staff costs are a major driver in inflation this has helped keep inflation lower, for longer, than it might have done in the past.

But all that money still had to flow somewhere. As the money supply has not found its way into workers wage packets it has been primarily distributed by financial institutions. Their business is lending to home-buyers, and investing. Thus the flood of money has flowed in those directions, directly into the things that have inflated in price: housing, commodities, bonds...

All in all, this rebalanced the nature of the western economies such that they became dependent on consumer spending for growth. Borrowers were able to access cheap housing loans, house prices rose, and earlier owners felt richer and spent their paper wealth instead of saving, or even accessed the paper capital through mortgage equity withdrawal. As Eddie George, ex head of the Bank of England, put it – the UK spent its way out of a recession, driving growth with debt led consumerism, which is in turn ever dependent on house price increases.

However, the difficulty with assuming expanding money supply was the sole driver for house prices is that whilst the rate of house price increase did accelerate at this time, house prices had been rising in the UK since 1995. This rapid monetary easing cannot thus be held account for the entire boom, although it is likely to have been a major factor to its continuation, along with a closely related theme…


… Financial Innovation

Another suggested potential factor in driving the house price rises of recent years is financial innovation. The last 25 years of the 20th century saw a huge revolution in finance, as the intense competition in the world’s financial capitals led to a range of innovative products and the creation of complex financial instruments.

The earliest of these can probably be credited to Lewis Ranieri, a college dropout. His key creations were Mortgage Backed Securities and Collateralised Mortgage Obligations. Simply put, these are a financial process that, for instance, converts the future revenues owed to a mortgage company by a suite of home loans into interest earning bonds that can be sold on to investors anywhere in the world.

Banks in the late 1970s were struggling with sky high interest rates and finding it difficult to make money out of home loans just as demand from the baby boomer generation was surging. Their risk aversion meant that it could take months to get a mortgage approved. The newly packaged Mortgage Backed Securities spread risk and attracted investment, cutting the interest rate differential on mortgage loans (the difference between the lending bank and central rate) and making Salomon Brothers billions of dollars as MBS trading accelerated through the 1980s. The market grew grown rapidly. By 2000 the MBS market in the US over took the federal treasury market and by the first quarter of 2006 it was worth approximately $6.1 trillion.

This culture of rapid financial innovation continued throughout the 1990s, by which time J. P. Morgan and Merrill Lynch were marketing credit derivatives. The most common credit derivative is the credit default swap (CDS). A CDS is basically a financial vehicle that enables a bank or company to package up a stream of future revenues and further transfer the risk of the future revenues failing. For instance, a mortgage issuing company can package up a suite of mortgages into a Mortgage Backed Security and sell this to a second company. The second company can then manage its risk by issuing a further “interest” bearing credit derivative. This would earn the purchaser, a third company, an income, but at the risk of being forced to pay out to the issuer if the mortgage payers could no longer meet their obligations and the revenue stream of the Mortgage Backed Security failed.

This suite of complex financial products enables much wider trading and hedging of credit risk, facilitating companies to spread their risk according to their appetite – the mortgage issuers or MBS buyers can minimise their risks, whilst companies with an appetite for more risk can access a revenue stream. Additionally it allows the debts and derivatives to be recorded as assets on many companies books, and thus effectively removes institutional barriers to lending, as banks can draw on essentially unlimited funds to loan.

It is difficult to put a precise figure on how much this has affected the housing market. It is clear that this spread of risk had the effect of reducing the wariness of the mortgage issuing companies. The interest rate premium above the central bank rate lowered and application/vetting procedures eased. In general, whilst the market is very opaque and poorly understood, it can be safely said that the derivatives market markedly reduced the perception of risk across the entire industry. When combined with a loosening monetary policy and a pre-existing growth market it ensured that a flood of money entered the property industry chasing a piece of the action in the search for yield.

At the same time that financial innovation was removing barriers to money entering the housing market, regulatory change was providing a direction for the money to flow in the UK. In 1988 the UK’s Housing Act abolished security of tenure for tenants. In the late 1990s Buy to Let mortgages caught up with the legislation and became available to conventional borrowers (because of advanced risk management). Additionally, Mortgage Equity Withdrawal loans enabled those sitting on large paper wealth to access it. This enriched those already in property, and the money was either spent in the debt-led consumer boom, or it was invested, which leads to …

Source: Housepricecrash.com

Source: Housepricecrash.co.uk

… Speculation and Psychology
A final explanation for house price inflation is pure and simple speculation. Every expanding market has always attracted speculators and the housing market is no different. It has been suggested that the current market is strongly led by money pouring into it simply because it has grown so well over recent years. Participants don’t necessarily look at fundamentals, just that as the market continues to grow, or even accelerate, investors will pile in and prices will rise further and further. Some are investing in heavily geared Buy-to-Let properties, where the rental yield doesn’t cover the debt payments. Others simply leave the house empty, planning on selling at a later date. In the UK it is certainly clear that property market has become about more than just providing a roof over one’s head, and the percentage of Buy to Let investors has rocketed since the late 1990s. Commentators suggest that they have taken the role at the bottom of the market that used to be occupied by First Time Buyers, who now make up a much smaller percentage of the market than the historical norm.

The house price feeding frenzy has been further exacerbated by past rewards (an entire generation of owners have seen their wealth increase massively), and the resulting shift in press and television media attention. This has driven house prices to be regular front page news, and increases heralded as a boon for the economy. Furthermore, there is now an entire generation that has never experienced a major recession. Common sentiment is that house prices should be as high as they are, and that they are a good thing. Speculation and Psychology combine.

However, as with all of the suggested drivers behind the market, it is unlikely that speculation alone has driven the entire magnitude of house price inflation. It is likely simply a contributing factor.

Conclusion
All in all it can only be a fabrication to ascribe the significant house price rises of recent years to a single driving variable. Press reports, for the sake of readability, drastically over-simplify reality. There are likely to be many factors that are critical, and the relative influence of each is likely to have varied through time.

- House prices are at an all time REAL high, and the low inflation environment means that the real lifetime cost of the mortgage debt is also at a REAL high. Low interest rates do not have a fundamental affect on this, but low nominal rates do give the appearance of more affordable mortgages, encouraging consumers who have learnt only to measure cost only on an initial monthly basis.
- Supply and demand is clearly an issue in the UK, but doesn’t explain the global reach of house price inflation, nor its recent rapid and significant rise (immigration is a possible factor, but doesn’t tie well with the history)
- A loose monetary policy likely increased the money flowing into an already growing market, kicking off greater rises and triggering increased speculation.
- At the same time financial innovation reduced the financial industry’s traditional aversion to risk and enabled mortgage banks to meet the ever growing demand…

In a sense it's the perfect storm. But is it sustainable? What can we say about the future? And if nothing changes, what are the implications?