Days of Cheap Energy-Fueled Innovation Coming to an End

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by: Max Fraad Wolff

Months into a long overdue exploration of energy prices, few seem to mention issues related to the long history of affordable oil and capital, labor substitution. The age of oil has been a period of rapid and rapidly rising production of goods, services and wealth. The ability to harness technology-driven productivity and output enhancement has transformed the world in wave after wave. The vast quantities of wealth produced and the enormous increases in human population, food output, longevity, literacy and health all attest to this. Abundant and price competitive energy was substituted for human physical labor in industry after industry, nation after nation.

The very success and extent of this process has created the demand increase partially driving oil, coal and natural gas prices today. There are implications for the relations between capital and labor, wages and profits. Abundant, reliable and cost competitive new technologies must be run on abundant, reliable and cost competitive energy inputs. The length and scale of present energy price increases threatens to begin to alter the profitability and desirability of marginal production processes already. Most commentators don't focus on substitution between capital and labor in the face of energy price increases. The longer prices stay high, and the higher they go, the more important this area is to explore.

Skill biased technical change and globalization have influenced the split between wages and profits. Rising productivity has created the possibility of rising wages and profits. Sometimes this possibility becomes reality, sometimes it does not. Lately, in the US and abroad, the gains to productivity have gone more toward profits than wages. This makes clear that abundant, reliable and affordable energy has allowed greater wealth to be produced and a greater share of that greater wealth has been captured by profits. Rising energy prices could pressure this in two ways.

Energy prices are, directly or indirectly, input costs into most goods and services production. Sustained and significant energy cost increases eventually become higher food and living costs. We are already at least nine months into a significant acceleration in expected energy and food price increases. If wages don't rise, an increasing portion of incomes will be redistributed to food, energy and costs related to food and energy. This will act like a wage reduction to the extent that it is difficult for consumers to find suitable and stable priced substitutes for food and energy. Systematic wage increase demands can not be held off indefinitely. Rising unemployment may reduce demands but, costs of living apply persistent and acute pressure.

Meanwhile, firm costs of inputs are pressured up by rising prices and increasingly strained basic operational planning and design born of assumption about cheap, reliable energy and labor. Past imbalances between profit and wage gains from productivity are likely to increase demands for wage hikes. Further massive substitution of technology for labor will be more difficult as consumers struggle under high food and energy costs as firm costs rise.

Production processes with significant energy and labor cost components should be expected to be hit hardest and first. Here we might take airlines as the canary in the coal mine. We might also look hard at a Chinese economic model that relies on abundant, inexpensive labor and energy with a voracious appetite for distance shipped raw materials and final products.

The long term massive substitution of technology-driven innovation, fueled with cheap wages and energy, may be at increasing risk. Rising energy costs are hard to substitute around. Labor is an obvious substitute in relatively few cases. That may change on the margin. More broadly, high and rising energy prices may begin to pressure the divisions between wages and profits through direct business costs and wage demands.

The last three decades in America have been defined by rapid technological change, profit biased output growth and generally cheap and abundant energy. Clearly, the world will not change overnight and energy prices have not attained - nor will they likely in the near future attain levels - sufficient to decimate major structural pillars of modern economies. It may be getting toward a point where we entertain discussion of the implications of energy prices for inflation, wage rates and profits on a macroeconomic level.

Disclosure: None