A few weeks ago I wrote:

Our economy is built on cheap natural resources.  While oil gets most of the publicity to day it’s not just oil.  We are also approaching cheap copper, cheap iron, cheap rare earth minerals, cheap phosphorus and yes cheap water.  Our credit based economy requires economic growth to pay the interest and that economic growth is dependent on cheap and abundant natural resources.

Peak oil is here or very near:

The use of petroleum in the world is now up to about 30 billion barrels per year. The rate at which we have found new supplies of petroleum over the last 10 years has fallen to an average, of only about 10 billion barrels per year.

We’re obviously in an unsustainable situation. We are now using up a greater number of barrels that we have found in the recent past and that we have reserved in the ground. We are now beginning to use it up relatively quickly–with scary consequences for the future.

The peak of production usually comes sometime between 30 and 50 years after the peak of finding oil. “The peak of discovery,” as they call it. For instance, in the North Sea, the peak of discovery was in the late 1960s, and the peak of production was in the late 1990s. So it was around 30 years between the peak of finding oil and the peak production of that oil.

The world’s financial system is based on growth and that growth is dependent on cheap and plentiful liquid  fuels.  Gail Tverberg (Gail the Actuary) explains that the risk of peak oil represents a systemic risk to the world financial system.

While crude oil supply has not yet begun declining, it had been essentially flat since 2005, and this lack of growth is putting tremendous pressure on the world’s financial system, since we now must do more and more with essentially the same oil supply. Oil prices have risen, and this is one source of financial problems, because higher oil prices have a disruptive impact on balance of payments, and can also cause a reduction in profits of companies.

But higher oil prices can also lead to recession and debt defaults. High oil prices don’t give ordinary citizens more salary to spend, so they have to cut back on something else. One possibility is a cutback in discretionary spending, which will tend to lead to recession. If the cutback is in buying new homes, the price of new homes can be expected to drop. James Hamilton wrote a paper called, “Causes and Consequences of the Oil Shock of 2007-2008” showing that the run up in oil prices in the years prior to 2008 was sufficient to cause the major recession we have recently experienced.

If oil prices rise, they may also cause debt defaults. This occurs because people’s salaries don’t rise correspondingly, so they need to cut back somewhere, and some will default on debts. Businesses may also be more at risk of debt defaults, if their cash flow is declining. The lower values of homes may also play a role in increasing defaults.

While one cannot prove that the aforementioned problems were the only causes of the financial crisis of 2008, there is certainly a strong similarity between the expected problems and the types of problems we have recently seen.

It should be noted, too, that a seeming over-supply of oil should not be surprising. As higher prices give rise to recession, this causes a cutback in demand. Reduction in credit availability also tends to reduce demand. So the oil available may be more expensive than what individuals and businesses can afford. If the oil available were cheaper, the oversupply would disappear.

The Greenspan housing bubble was nearly enough to bring down the financial system it will seem insignificant when compared to the impact of diminishing oil supplies.

Our current economic system includes a huge amount of debt. Money is loaned into existence. Debt is used to finance many business expansions.  Governments rely heavily on debt.

The US economy has been growing for many years, with only brief interruptions, so nearly all of our experience with borrowing money, and paying it back with interest, has been during periods of economic growth.

Borrowing from the future is relatively easy when the economy is growing, because when the time comes to pay back the debt, the debtor’s economic condition is likely to be as good as it was when the loan was taken out, and may even be better. So defaults are relatively uncommon, and the growth in the economy between the time the loan was taken out and the time it is repaid provides some contribution toward the interest payments.

But what if we start encountering a very different kind of world, one with a decline in oil supplies? If oil resources constrain economic growth, debt defaults can be expected to rise, and the whole debt system underlying our financial system is at risk. Insurance companies are very much at risk too, because many of their assets are bonds. In the past, these bonds would have been repaid with interest, but in a world with little economic growth, and perhaps economic decline, the risk of default becomes much higher.

Unfortunately those who say there is no alternative to oil are right.  Without oil we can maintain the economic growth required to sustain the world financial system.  It is not a matter of if but when the collapse will occur.

Cross posted at Newshoggers