Dawn of a New Era: More Expensive Energy and Wages?

Analysis

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Psychologists say that the human brain suffers from dozens of different biases, perhaps one of the most important being “recency bias.” We tend to project the past into the future. Assuming the hypothesis in the title of this article is correct, we likely face a very different future, says corporate finance columnist Les Nemethy.

I see, this period of high cost of energy and wages as being a phase; maybe five years, maybe ten. As the saying goes, the cure for high prices is… high prices. High prices will encourage energy innovation and substitution, robotics, etc., that will, over time, shift the supply of these production factors. But brace yourselves for a few tough years before we get there.

So, let’s look at the evidence behind higher costs for energy and wages, and then we will revert back to some implications for the future.

Over the past year or two, we have already seen a huge increase in energy prices. There has been a tendency to pin this on the Russo-Ukrainian war, but the trend was under way even before that, and in my opinion, would continue even if peace were to break out in Ukraine tomorrow. The Ukraine war did, however, accentuate the trend.

Let me summarize three non-war related reasons for increasing energy prices.

Spending: There has been a dramatic diminution in capital expenditure (e.g. drilling) for oil and gas companies, caused by societal expectations that we need to progress in a “greener” direction. Politicians and philanthropic organizations, for better or worse, have put huge pressure on industry, resulting in the cancellation or rollback of pipelines, drilling, etc. Oil and gas companies also risk being left with “stranded” assets if the switch to alternative energies were to be successful, which increases the risk of new capital expenditures.

Decision-making: Mistaken government policies (such as the shuttering of nuclear reactors in a number of countries) and poor planning (assuming alternative energy could supply adequate base load) have been a part of the problem. The U.S. Government has been haranguing European leaders for many years about the risk of dependency on Russian hydrocarbons. The Europeans turned a deaf ear.

Time Lags: The transition to alternative energies is taking longer, and is much more expensive, than most policymakers assumed. We do not have enough minerals (copper, nickel, cadmium, etc.) to switch the auto industry to all electric vehicles in the coming decade or two. 

Grossly oversimplifying, we have fallen between two stools. Don’t let the temporary and minor fall in oil prices fool you. While I am sympathetic to environmental considerations, we have neglected tried and proven fossil fuel supplies while under-estimating the cost and time needed to transition to alternative fuels. Once again, the good news is that this may only be a temporary (five-10) year phenomenon, provided that the policy errors are reversed, and proper planning is undertaken.

There is a vast demographic trend afoot in virtually all the world except part of Africa: the number of (highly productive) baby boomers leaving the labor market exceeds the number of (relatively inexperienced and less productive) young workers coming into the market by a very wide margin. At a time when the objective is “re-shoring” (bringing the production of at least strategic products home) we are likely to see demand for labor increase while supply decreases, causing wages to rise. (This theme is explored further in my last two columns on the subject of demographic trends.)

High energy and labor factor costs feed into all areas of the economy. Take, for example, agriculture, which requires large amounts of both factors. High energy costs have also caused radical rises in fertilizer prices, giving farmers the choice of eliminating or reducing fertilizers (and likely reducing yields), or charging higher fertilizer costs through to the consumer. Both are highly inflationary. To a greater or lesser degree, energy and labor costs have a similar ripple effect in just about every sector of the economy.

Today central banks are raising interest rates with a view to preventing the type of prolonged high inflation that existed in the 1970s. The difference today, depending on the country, is that there are many multiples of the level of debt compared to the 1970s. For example, U.S. sovereign debt is more than 10 times what it was in the late 1970s (about USD 30 trillion today, compared to USD 2 trillion back then), meaning that even a fraction of the interest rate levels achieved by 1980 would be enough to trigger a wave of defaults for sovereigns, corporates and individuals.

Recession or depression is likely to occur much sooner than inflation can be tamed. Something will break, and then we may well have both high inflation and recession, at which time the Fed will have little choice but to bring on the most expansionary monetary regime since World War II.

Inflation is never an accident. It is always the result of monetary and fiscal policies; unfortunately many of them were poor decisions, taken in the past. Central banks are increasingly caught between a rock and hard place.

Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.

This article was first published in the Budapest Business Journal print issue of September 23, 2022.

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