On peak oil, economic planning, and the story of a pencil

Peak oil has been in my mind for quite a while.  There's been a huge amount of work done in regards to the legitimacy of peak oil and about when the peak was reached.  Resources peak oil, (and here), one cannot help but think about what the possible impacts may be.  Unfortunately, I think most people who discuss peak oil get it completely wrong; not in that peak oil is real, but it's impacts and mitigating factors that should be put in place. 

Ryugyong Hotel poster from CafeHayek

To compound the peak oil issue, it creates a mixture of interacting problems:

1. We have this troubling correlation to peak oil and GNP which is illustrated beautifully over here at Crash Watcher. There is a fear that peak oil will be the end to economic growth.  I'll discuss these as primary impacts.

2. Mitigation controls - Probably the most troublesome and reactionary issue.  The idea that the government should enact policy to soften "the blow" of an increase in prices.  This has resulted in government incentives for biofuels, hybrid, and electric cars.  I'll discuss these as secondary impacts. 

For all the history of petroleum, the supply of oil had to be constrained to maintain a profitable level of price.  With the advent of peak oil, the previous model, price driving supply, will be inverted to supply driving price.  The primary concern with peak oil, at a macro level, is that by constraining supply it will thereby constrain economic growth.  Crash watcher made a great graph correlating GNP and petroleum consumption   He smartly brings up the fact that correlation is not the same as causation.  It is very likely that GNP growth has driven the consumption of petroleum. 

Much of the primary impact argument is academic.  It is likely that peak oil will have some significant impact on the economy and economic growth.  However, increasing of prices are necessary signals to the market in order for it to find a way forward. Things are made far worse through these "mitigation controls" which cause secondary impacts. 

We have extensive case studies through history for what happens when governments try to be helpful through price controls, subsidizing of commodities (food and fuel) and building things that were unnecessary.  It usually doesn't end well.  Even in the best cases where a government built out infrastructure, what good could have the market done with that capital that instead was wasted by the government?  Governments usually do their people a disservice when putting these mitigating controls in place. When a government implements price controls, shortages ensue, usually creating a gray and black market for the goods as well.  When a government subsidizes a given product, it changes the incentive structure for that product and others usually being counterproductive. 
 
So what will happen when peak oil becomes more clear and evident at the pump?  Prices will go up accordingly with demand of the supply.  Substitutions will occur when available, which will interact with other markets and products.  To think that a government or even the smartest engineers could predict the best way to deal with peak oil is arrogant at best.  Likely, most of the things a government would do would be wrong.  Certainly there will be changes to society, and how we live our lives, but that happens anyway every generation or so.  It's quite possible and very likely that there will be substantial impacts on all of us around the world by the constrained supplies of petroleum.  However,  it begs the question: Where has the increase of our standard of living come from, availability of cheap energy, or innovation, trade and comparative advantage?

Globalization and trade will certainly not end after oil supplies begin to decline, or even if we ran out of oil completely.  Individuals will always seek a way to eliminate labor, or make their labor easier, through tools, innovation and trade.  Leonard Read said it most eloquently in his wonderful story "I Pencil".  Quotes from the ending are below:

The above is what I meant when writing, "If you can become aware of the miraculousness which I symbolize, you can help save the freedom mankind is so unhappily losing." For, if one is aware that these know-hows will naturally, yes, automatically, arrange themselves into creative and productive patterns in response to human necessity and demand—that is, in the absence of governmental or any other coercive masterminding—then one will possess an absolutely essential ingredient for freedom: a faith in free people. Freedom is impossible without this faith...

 The lesson I have to teach is this: Leave all creative energies uninhibited. Merely organize society to act in harmony with this lesson. Let society's legal apparatus remove all obstacles the best it can. Permit these creative know-hows freely to flow. Have faith that free men and women will respond to the Invisible Hand. This faith will be confirmed. I, Pencil, seemingly simple though I am, offer the miracle of my creation as testimony that this is a practical faith, as practical as the sun, the rain, a cedar tree, the good earth.

Here's Milton Friedman discussing the same story: