Thought Experiment about Oil

10/27/2012 05:15:00 PM
In a previous post I pondered the meaning of "peak oil production." Today Brad Plummer has an excellent post on the possible future implications for the economy if oil becomes harder to find.

But I do have one critique on the IMF study, which largely takes the conventional view that oil is important for the economy, and if it starts to run out economic growth will be hampered. So here's the thought experiment I would like to propose: suppose we hear news that we will run out of oil in, say, ten years, and that this news is credible. What will the impact on the economy be?

The point that I think the IMF misses is that running out of oil would cause rapid depreciation of a large part of our capital stock; for example, internal combustion engines would suddenly be mostly worthless. However, this says little about the long run implications on growth, since it is unclear how alternative technologies--like electric cars--that don't require oil compare to the current ones we use. Suppose that the alternative technologies are close substitutes--then the rapid depreciation of capital as oil-based technologies become obsolete will have almost no impact on the long-run trend, but will have a large impact on output in the short run, as the economy works overtime to rebuild its capital stock.

In short, it is quite plausible--even likely--that the shock that accompanies depletion of the oil supply would actually increase economic growth in the short run, even if it means lower output trends in the long run.

As an aside, I will note that if microeconomic theory is right, we should never run out of oil, even if there only exists a finite non-renewable supply on earth, and even if oil is necessary for production. I have rigorously explained this theory here.