The Independent Market Observer

Unsustainable Trends: A Closer Look at Limits

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 28, 2014 9:48:00 AM

and tagged Economics Lessons

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unsustainable trendsWe talked the other day about the power of compounding and how it can be used to help determine whether trends are sustainable. The idea is that the compounded returns will at some point run into a limit that can’t be surpassed.

It sounds simple, but the idea of limits actually isn’t so clear. In many cases, the real issue isn’t a physical limit, but an economic and technological one.

Economic limits vs. physical limits

Consider Thomas Malthus and his population and food limit predictions, which were based on the technology of his day. Those predictions were correct, until the technology changed and food production skyrocketed. Similarly, the idea of “peak oil,” which was popular several years ago before the fracking boom really got going, has turned out to be wrong, at least for the moment, as U.S. production continues to increase.

These are not isolated instances. In a famous wager made in 1980, two scientists bet on whether commodity prices would increase over a decade. They didn’t, although prices did increase over most other 10-year periods in the past century.

The point is, in many cases, scarcity is determined more by economic factors than by real physical limitations. “The cure for high prices is high prices” is the underlying logic here, with higher prices—for oil, say—driving more research and development, which leads to something like the fracking boom. We see this pattern again and again throughout history.

Of course, there are instances where real physical limits do come into play. I'm reminded of Jared Diamond’s discussion of Easter Island, when he describes the felling of the island's last tree. The islanders depended on the trees to build boats, and when that last tree was cut down, they lost access to the ocean, including fishing and trade. A more recent example here in the U.S. is the collapse of the cod fishery off the New England coast, when fishermen took more cod than nature could replace. 

So, what kind of limit is it?

When we look at limits, then, we first need to determine whether it’s a hard physical limit (e.g., fish stocks) or an economic one, such as oil, where a supply exists but is not economic to develop.

If it’s the latter, and if technology is allowed to develop and—critically—generate a profit, there’s a good chance the problem will be solved. High prices are the cure for high prices.

Again, a good example is the U.S. fracking boom. Small entrepreneurs could develop, exploit, and profit from the technology. Landowners controlled mineral rights and could profit from the drilling on their land, which made them more willing to participate. 

In almost any other country in the world, it's hard to imagine this happening. We have the technology, as well as the supporting economic and legal systems. One is not enough; you need all three. 

As we examine trends over the next month or so, we’ll look at several different components: 

  • The underlying assumptions, to predict what the current trend implies in the next 20 years or so
  • Whether or not there’s a hard physical limit (and if not, what is the underlying economic limit?)
  • The factors in place (technological, social, and legal) that would allow the trend to transcend economic limits

I’m excited to think this through. I haven’t seen other analyses that deal with trends in this way, and I’m not sure what we will find. Just one more thing to look forward to and be grateful for this week.

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