Sunday, September 12, 2010

The Invisible Hand, The Bastille and the Overthrow of the Ruling Elite

September 13, 2010

The key mechanism of Adam Smith's capitalism is a self-interest which manifests itself systemically as The Invisible Hand. It's a concept that offers a wealth of self-satisfaction: by pursuing our most selfish interests, the whole of society benefits.

The essential corrollary of The Invisible Hand is the notion that the free market will always supply a substitute for any product or service which becomes scarce (and thus costly) for whatever reason.

The French Revolution offers up an example of the limits of The Invisible Hand. Due to various State (central government) policies and other conditions, the cost of the essential staple grain of France, wheat (and thus bread) rose steadily in the 1780s. Not coincidentally, the price of wheat reached an apex in the week that the populace rose up to tear down the hated symbol of Royal/Nobility/State oppression, the Bastille prison.

The key metric is the percentage of income which must be devoted to the FEW essentials (food, energy and water) by each class of citizenry. As the cost of wheat rose to the point that 50% or more of the urban working poor's income was spent on bread, life became financially impossible.

Meanwhile, this same rapid rise in the cost of bread made little difference to the incomes of wealthy merchants and the rentier nobility. To those with substantial incomes, the tripling in the cost of bread meant that the percentage of income devoted to supplying the household with bread rose from 1% to 3%--an entirely marginal impact.

The key points are:

1. There was no instantly-available, scalable substitute for wheat/bread.

2. A price increase that offered minor inconvenience to the upper classes compelled the lower classes the overthrow the ruling Elites.

This history of price increases, stagnant wages and the resulting political consequences (overthrow the ruling Elites) can be found in the excellent book The Great Wave: Price Revolutions and the Rhythm of History.

For a modern-day example, let's consider the potential for gasoline to triple in cost.

The proximate reason could be political--the Gulf Oil states might experience a change in leadership to regimes which prefer to keep their remaining oil in the ground, for example--or depletion of major oil fields in Mexico, Alaska, the North Sea, etc. that can no longer be replaced with new fields in West Africa.

Since oil is priced on the margin, a 3% shortfall can drive a 30% increase overnight. A 10% gap between supply and demand could easily power a 300% increase, at which point the cost of gasoline would rise from $3/gallon to $10/gallon.

To those who say "that can't happen," let's wait until 2016 before making that judgment.

The key characteristic of oil is that it cannot be replaced quickly or cheaply. Scaling up natural gas, solar/hydrogen/fuel cells, algae-based fuels, etc. will take decades and trillions of dollars in capital investments.

As for the Strategic Oil Reserve, that 600 million barrels represents one whole month of U.S. consumption (30 days X 20 million barrels a day), so anyone counting on the Reserve for more than a short-term "fix" to a serious disruption in oil imports is destined to be disappointed.

So let's say that gasoline is suddenly scarce, and price responds by tripling to $10/gallon. To those households who enjoy annual incomes of $300,000 or more, a tripling in the cost of fuel would be marginal when measured as a percentage of their income.

If the household fuel costs rise from $3,000 a year to $9,000, the consequences would be modest. Toss in a few thousand dollars to cover higher airfare, and the total cost would crimp discretionary income but would not threaten the household's lifestyle.

Meanwhile, the rise in fuel costs would severely impact those with household incomes in the $30-$40,000 range. From roughly 10% of total household income, fuel would suddenly eat up a third of household income.

With no substitutes available on an economy-wide scale, those of modest incomes could compensate to some degree with conservation, but to reckon that The Invisible Hand of self-interest will magically supply billions of gallons of substitute fuels in a timeframe which will alleviate crisis for the bottom 80% of the citizenry is akin to the French nobility of the 1780s suggesting that the working poor in Paris replace bread with cake.

I will be tending to family matters during September and will be unable to read or respond to email--please accept my apologies in advance. Please post comments to the Daily Java forum.

Posts may be sporadic until 9/15/10.

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