#163. Tales from Mount Incomprehension

THE FALSE DICHOTOMY CLINGS ON

There was more than a grain of logic in the observation by US treasury secretary Steven Mnuchin that climate activist Greta Thunberg should save her advice until “[a]fter she goes and studies economics in college”. If the authorities were to consent to her demand for the immediate cessation of the use of fossil fuels, the economy would crash and, quite apart from the misery that this would inflict on millions, we would have abandoned any capability to invest in a more sustainable way of life.

This said, taking a course in economics, as it is understood and taught conventionally, would not enhance, in the slightest, her understanding of the critical issues. Conventional economics teaches that economics is ‘the study of money’, and that energy is ‘just another input’. These claims cannot be called ‘contentious’. They are simply wrong.

Worse still, her audience at Davos – the Alpine pow-wow of the world’s political and economic high command – are almost wholly persuaded by a false interpretation which states that action on climate risks carries a “cost”, meaning that doing what she asks would be costlier than carrying on as we are, with an economy powered by oil, gas and coal.

This is a folly every bit as absolute as the argument that we must immediately cease all use of the energy sources on which the economic growth of the past two centuries has been based. Continued reliance on fossil fuels might or might not destroy the environment, but it would certainly condemn the economy to collapse.

A commonality of interests

Because I have an extensive ‘to-do’ list – and in the hope that readers might appreciate some brevity on this issue – let me be absolutely clear that neither side of the debate over the economy and the environment understands how these processes really work. Worse still, it seems that neither side wants to understand this reality.

There’s a hugely damaging false dichotomy around the assumption that there’s some kind of trade-off between our environmental and our economic best interests. If “Davos man” thinks that the economy can prosper so long as we cherry-pick the profitable bits of the environmental agenda (like carbon trading, and forcing everyone to buy a new car), and pour bucket-loads of greenwash over the rest of it, he (or she) could not be more wrong

Because literally none of the goods and services which comprise the economy could be produced without energy, it should hardly be necessary to point out that the economy is an energy system. Equally, it should be obvious that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This access component is known here as the Energy Cost of Energy (ECoE), and it forms a critical part of the equation which determines our prosperity.

The third part of this ‘trilogy of the blindingly obvious’ is that money has no intrinsic worth, and commands value only as a ‘claim’ on the products of energy. I make no apology for repeating that air-dropping cash (or any other form of money) to a person stranded in the desert, or cast adrift in a lifeboat, would bring him or her no assistance whatsoever.

Money is simply a medium of exchange, valid only when there is something for which it can be exchanged.

The complexity trap

The modern industrial economy is not only enormous by historic standards, but is extraordinarily complex as well. Scale and complexity make the modern economy high-maintenance in energy terms. Output grew rapidly in the period (roughly between 1945 and 1965) when trend ECoEs were at their historic nadir, but has struggled since then, as ECoEs have risen.

Analysis undertaken using SEEDS (the Surplus Energy Economics Data System) indicates that prosperity in the Advanced Economies (AEs) of the West ceased to grow when ECoEs hit a range between 3.5% and 5%. Less complex Emerging Market (EM) economies have greater ECoE tolerance, but they, too, start to become less prosperous once ECoEs reach levels between 8% and 10%. Both China and India have now entered this ‘growth killing ground’.

Back in the high-growth post-War decades, ECoEs were between 1% and 2%. By 2000, though, global trend ECoE had reached 4.1%, which is why the advanced West was already encountering something which bewildered economists labelled “secular stagnation”, though they were at a loss to explain why it was happening. By 2008 – when ECoE had reached 5.6% – efforts at denial based on credit adventurism had achieved nothing other than an escalation in risk which brought the credit (banking) system perilously close to the brink.

Since then, and whilst futile exercises in denial have segued into monetary adventurism, ECoE has continued its relentless rise. Last year, world trend ECoE broke through the 8% threshold at which prior growth in EM prosperity goes into reverse. This, ultimately, explains why global trade in goods is deteriorating, and why sales of everything from cars and smartphones to chips and components are sliding.

The average person in the West has been getting poorer for more than a decade, and, increasingly, he or she knows it, whatever claims to the contrary are made by decision-makers who, for the most part, still don’t understand how the economy really works.

Something very similar now looms for EM countries and their citizens – and, when evidence of EM economic deterioration becomes irrefutable, the myth of “perpetual growth” in the world economy will be exploded once and for all.

When that happens, all of the false assumptions on which a bloated financial system relies will crumble away.

Tenacious irrationality

The irony here is that, far from avoiding economy-damaging “costs”, continued reliance on fossil fuels would be a recipe for economic oblivion. The destructive upwards ratchet in ECoEs is driven by fossil fuels, which still provide four-fifths of our energy supply, and whose costs are rising exponentially now that depletion has taken over from scale and reach as the primary driver of cost. Far from imposing “costs” that will push us towards economic impoverishment, transitioning away from fossil fuels is the best way of minimising future hardship.

This means that economic considerations, when they are properly understood, support, rather than undermine, the arguments put forward by environmentalists.

But we should be equally wary of claims that renewable energy (RE) can usher in some kind of economic nirvana. The ECoEs of REs are highly unlikely ever to fall below 10%, a point far above prosperity maintenance thresholds (of 3.5-5% in the West, and 8-10% in the EMs), let alone give us a return to the ultra-low ECoEs of the post-1945 era of high growth.

Critically, transition to REs would require vast amounts of inputs whose supply relies almost entirely on the use of FFs. The idea that we can somehow “de-couple” economic activity from the use of energy, meanwhile, is utterly asinine.

The only logical conclusion is that we should indeed transition towards REs, but should not delude ourselves that doing this can spare us from deteriorating prosperity, or from other processes (such as de-complexification and de-layering) associated with it. The one-off gift of vast surplus energy from fossil sources is fading away, which, from an environmental point of view, might be just as well. What matters now is that we manage, in a pragmatic and equitable way, the transition to lower levels of energy use and gradually eroding prosperity.

It’s a disturbing thought that our economic and environmental futures are trapped in a slanging match between green fanaticism and Davos-typified cynicism. It’s a truism, of course, that people tend to believe what they want to believe – but this is a point at which the reality of energy as the critical link between prosperity and the planet needs to force its way to the fore.

If there’s cause for optimism here, it is that reality usually triumphs over wishful thinking. The only real imponderables about this are the duration of the transition to reality, and the scale of the damage that protracted delusion will inflict.

#162. The business of de-growth

ENTERPRISE IN A DE-GROWING, DE-LAYERING ECONOMY

We start the 2020s with the political, economic, commercial and financial ‘high command’ quite remarkably detached from the economic and financial reality that should inform a huge variety of policies and decisions.

This reality is that the relentless tightening of the energy equation has already started putting prior growth in prosperity into reverse. No amount of financial gimmickry can much longer disguise, still less overcome, this fundamental trend, but efforts at denial continue to add enormously to financial risk.

This transition into uncharted economic waters has huge implications for every category of activity and every type of player. Just one example is government, for which the reversal of prior growth in prosperity means affording less, doing less, and expecting less of taxpayers (with the obvious corollary that the public should expect less of government).

Governments, though, do at least have alternatives. ‘Doing less’ could also mean ‘doing less better’ – and, if the public cannot be offered ever-greater prosperity, there are other ways in which the lot of the ‘ordinary’ person can be improved.

At first sight, no such alternatives seem to exist for business. The whole point of being in business, it can be easy to assume, is the achievement of growth. Whether it’s bigger sales, bigger profits, a higher profile, a growing market value or higher dividends for stockholders, every business objective seems tied to the pursuit of expansion.

None of this, in the aggregate at least, seems compatible with an economy in which the prosperity of customers is shrinking.

In reality, though, both de-growth and de-layering offer opportunities as well as challenges. The trick is to know which is which.

For those of us not involved in business, the critical interest here is that, driven as they are by competition, businesses are likely to be quicker than other sectors to recognise and act upon the implications of the post-growth economy.

Getting to business

How, then, are businesses likely to position themselves for the onset of de-growth? The answer begins with the recognition of two realities.

The first of these is that prosperity is deteriorating, and that there is no ‘fix’ for this situation.

The second is that ‘price isn’t value’.

As regular readers will know, prosperity in most of the Western advanced economies (AEs) has been in decline for more than a decade, and a similar climacteric is nearing for the emerging market (EM) nations.

This fundamental trend is, as yet, unrecognised, whether by ‘conventional’ economic interpretations, governments, businesses or capital markets. It is already felt, though, if not necessarily yet comprehended, by millions of ordinary people.

‘Conventional’ economics, with its fixation on the financial, fails to recognise the deterioration of prosperity because it overlooks the critical fact that all economic activity is driven by energy. There is no product or service of any economic utility which can be supplied without it. Money and credit are functions of energy because, being an artefact wholly lacking in intrinsic worth, money commands value only as a ‘claim’ on goods and services – all of which, of course, are themselves products of the use of energy.

The complicating factor in the prosperity equation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This consumed proportion is known here as ECoE (the Energy Cost of Energy), a concept related to previously-defined concepts such as net energy and EROI.

Critically, what remains after the deduction of ECoE is surplus energy. The aggregate of available energy thus divides into two components. One of these is ECoE, and the other is surplus energy, which drives all economic activity other than the supply of energy itself.

This makes surplus energy coterminous with prosperity.

The relentless (and unstoppable) rise in ECoEs has now squeezed aggregate prosperity to the point where the average person is getting poorer. There is nothing that can be ‘done about’ this, so the necessity now is to adapt.

SEEDS – the Surplus Energy Economics Data System – has been built and refined to model the economy on this basis. Its identification of deteriorating prosperity accords with numerous ‘on the ground’ observations, whether in economics, finance, politics or society.

But general recognition of this interpretation has yet to occur, and, in its absence, the economic history of recent years has been shaped by efforts to use the financial system to deny (since we cannot reverse) this process. The main by-product of this exercise in denial has been excessively elevated risk.

Conclusions come later, but an important point to be noted from the outset is that, as the economy gets less prosperous, it will also get less complex, resulting in the phenomenon of ‘de-layering’. An understanding of this and related processes will be critical to success in an economic and business landscape entering unprecedented change.

The reality of deteriorating prosperity

A necessary precondition for the formulation of effective responses is the recognition of where we really are, and there are two observations with which this needs to start.

The first is the ending and reversal of meaningful “growth” in prosperity. Any businessman or -woman who believes that economic “growth” is continuing ‘as usual’, or can somehow be restored, needs to reframe his or her interpretation radically. Indeed, it’s been well over a decade (and, in many instances, nearer two decades) since the advanced economies of the West last achieved genuine growth in economic prosperity.

For illustration, the deterioration in average personal prosperity in four Western countries, both before and after tax, is set out in the following charts. Examination of the trend in post-tax (“discretionary”) prosperity in France, in particular, does much to explain widespread popular discontent.

Worse still, from a business perspective, a similar downturn is now starting in the hitherto fast-growing EM economies, including China, India and Brazil.

#162 business 01

To be sure, the authorities have done a superficially plausible job of hiding the reality of falling prosperity, first by pumping cheap credit into the system and, latterly, by doubling down on this and turning the real cost of money negative. The only substantive products of these exercises in credit and monetary adventurism, though, have been enormous increases in financial exposure.

The cracks are now beginning to show, and in ways that should be particularly noticeable to business leaders.

Sales of a broadening number of product categories, from cars and smartphones to chips and components, have turned down. Debt continues to soar (which is hardly surprising in a situation in which people are being paid to borrow), and questions are starting to be asked about credit ratings, debt servicing capability and the possible onset of ‘credit exhaustion’ (the point at which borrowers no longer take on any more credit, however cheap it may be).

Whole sectors (such as retailing and air travel) are already being traumatised. Returns on invested capital have collapsed, and this has had knock-on effects in many areas, but nowhere more so than in the adequacy of pension provision (where the World Economic Forum has warned of a “global pensions timebomb”). Even before this pensions reality strikes home to them, ordinary people are becoming increasingly discontented, whether this is shown on the streets of Paris and other cities, or in the elections whose outcomes have included Donald Trump, “Brexit” and a rising tide of “populism” (for which the preferred term here is insurgency) and nationalism.

There are, of course, those who contend that falling sales of cars and chips ‘don’t matter very much’, because we can continue to sell each other services which, even where they are of debateable value, can still be monetised, so will continue to generate revenues. These assurances tend to come from the same schools of thought which previously told us that debt, too, ‘doesn’t matter very much”.

This wishful thinking, arguably most acute in the ‘tech’ sector, ignores the fact that, as the average consumer gets poorer, he or she is going to be become more adept, or at least more selective and demanding, in the ranking of value. In a sense, the failure to recognise this trend repeats some of the misconceptions of the dot-com bubble – and the answer is that you can only be happy about ‘virtual’ and ‘intangible’ products and sales if you’re equally relaxed about earning only virtual and intangible profits. But business is, or should be, about cash generation – nobody ever bought lunch out of notional profits.

Let’s put this in stark terms. If someone is in the business of selling holidays, he or she makes money when people actually travel to the facility, and pay to use its services. They could, of course, sell them computer-generated virtual tours of the facility as a sort of proxy-residency – but does anyone really think that that’s a substitute for the revenue that is earned when they actually visit in person?

Another way to look at this is that businesses are likely to become increasingly wary of middle-men and ‘agencies’. This reflects de-layering, an issue to which we shall return later. But the general proposition is that, in de-growth, businesses will prosper best when they capture as much of the value-chain as possible, ensuring that ‘value’ predominates over ‘chain’.

Ancillary services, and ancillary layers, are set to be refined out, and businesses are likely to become increasingly wary of others trying to monetise parts of their chain.

Understanding value

The second reality requiring recognition is that the prices of capital assets, including stocks, bonds and property, have risen to levels that are both (a) wholly unrelated to fundamental value, and (b) incapable of being sustained, under present or conceivable economic conditions.

Statements like “the Fed has your back” are illustrative of quite how irrational this situation has become. The idea that inflated asset prices can be supported indefinitely by the perpetual injection of newly-created liquidity is puerile beyond any customary definition of that word.

We may not know how long asset prices can continue to defy economic gravity, or how the eventual reset will take place, but the definition of ‘unsustainable’ is ‘cannot be sustained’.

A general point needing to be made is that is called “value” by Wall Street and its overseas equivalents is of little relevance to what the word should mean in business. The interests of business and of the capital markets are by no means coterminous, since the objectives of each are quite different. The astute business leader might listen to the opinions of those in the financial markets, but acts only on his or her own informed conclusions.

From a business perspective, the value of an asset is the current equivalent of its future earning capability. No apology is made to those who already understand this universal truism, because, though fundamental, it is all too often overlooked. This principle can be best be illustrated by looking at a simple example such as a toll bridge.

To the owner (or potential acquirer) of a toll bridge, various future factors are known, though with varying degrees of confidence. He or she should know, at high levels of confidence, appropriate rates of depreciation and costs of maintenance. He has an informed opinion, albeit at a somewhat lesser level of confidence, about what the future toll charges and numbers of users are likely to be.

This information enables him to project into the future annual levels of revenue and cost. He can, moreover, divide the cost component into cash and non-cash components, the latter including depreciation and amortisation. From this, he can create a numerical forward stream of projected cash flows and earnings.

The question which then arises is that of what value today can be ascribed most appropriately to the income stream to be realised in the future.

This process requires risk-weighting. Costs and taxes may turn out to be higher or lower than the central case assumptions, and the same is true of revenue projections. Customer numbers and unit revenues may be influenced by factors outside either the control of the owner or of his ability to anticipate. Degrees of variability can and should be factored in to the calculation of appropriate risk.

What happens now is that a compounding discount factor is created by combining risk, inflation, cost of capital and the time-value of money. Application of this factor turns future projections into numbers for discounted cash flow (DCF) as a net present value (NPV).

There is nothing at all novel about DCF-NPV calculation, and it is used routinely by those valuing individual commercial assets. It is, incidentally, far more reliable than ROI (return on investment) or ROC (return on capital) methodologies, let alone IRR (internal rate of return).

Importantly, though, this valuation procedure is applicable to all business ventures. The process becomes increasingly complex as we move from the simple asset to the diversified, multi-sector business, and increasingly conjectural where rising levels of uncertainty (over, for instance, future rates of growth) are involved.

But the principle – that the worth of a business asset is coterminous with what it will earn in the future – remains central.

The nearest that capital markets tend to get to this is to price a company on the basis of its future earnings, which is where the P/E ratio (and its various derivatives) fit into the process. A more demanding (but more useful) approach substitutes cash flow for earnings, and generates the P/CF ratio. P/FCF (price/free cash flow) is a still better approach, though all cash flow-based calculations need to ensure that a tight definition and a robust methodology are involved.

Where P/E ratios are concerned, both growth potential and risk should be (though often aren’t) reflected in multiples. When one company is priced at, say, 10x earnings whilst another is priced at 20x, it’s likely that the latter is valued more aggressively than the former because growth expectations are higher (though it is also possible that the lower-rated company is considered to be riskier).

Much of the foregoing will be well-known to any competent business leader or analyst. It is referenced here for two reasons – first, because it produces valuations which typically bear little or no resemblance to today’s hugely inflated financial market pricing of assets and, second, because an understanding of fundamental value needs to be placed at the centre of any informed response to the onset of de-growth.

Markets are driven by many factors beyond the trinity of ‘fear, greed and [sometimes] value’. Supplementary, non-fundamental market factors, whether or not they are of meaningful relevance to investors and market professionals, should not exert undue influence on the decisions made by business leaders. “What will my share price be in a year from now?” may be an interesting subject for speculation, but should play little or no part in planning.

This point is stressed here because deteriorating prosperity will invalidate almost all market assumptions. This deterioration is an extraneous factor not yet known to the market. It destroys the credibility of the ‘aggregate growth’ assumption which informs the pricing both of individual companies and of sectors. It impacts customer behaviour, and customer priorities, in ways that markets could not anticipate, even if they were aware of the generalised concept of de-growth.

This is why business strategy needs to incorporate a concept which may be called ‘de-complexifying’ or, more succinctly, de-layering.

The critical understanding – the de-layering driver

It’s useful at this point to reflect on the way in which our economic history can be defined in surplus energy terms.

Our hunter-gatherer ancestors had no surplus energy, because all of the energy that they derived from nutrition was expended in the obtaining of food. Agriculture, because it enabled twenty individuals or families to be fed from the labour of nineteen, created the first recognizable economy and society because of the surplus energy which enabled the twentieth person to carry out non-subsistence tasks. This economy was rudimentary, reflecting the fact that the energy surplus was a slender one. Latterly, accessing the vast energy contained in fossil fuels leveraged the surplus enormously, which meant that only a very small proportion of the population needed now to be engaged in subsistence activities, with the vast majority now doing other things.

This process made the economy very much larger, of course, but it’s more important, especially from a business perspective, to note that it also made it very much more complex. Where once, for example, we had only farmers and grocers, with very few layers in between, food supply has since become vastly more diverse, involving an almost bewildering array of trades and specialisations. The linkage between expansion and complexity holds true of all sectors.

The most pertinent connection to be made here is that, just as prior growth in prosperity has driven growth in complexity, the deterioration in prosperity is going to have the opposite effect, initiating a trend towards a reduction in complexity. One term for this is ‘simplification of the supply chain’. Another, with applications far beyond commerce, is de-layering.

This has two stark and immediate implications for businesses.

First, a business which can front-run de-layering, simplifying its operations before others do so, can gain a significant competitive advantage.

Second, if a business is one that might get de-layered, it would be a good idea to get into a different business.

First awareness

In this discussion we have established three critical understandings:

– Prosperity is deteriorating, for reasons which mainstream interpretation has yet either to recognise or to understand.

– Attempts to ‘fix’ this physical reality by means of financial gimmickry have resulted only in increases in risk, many of them associated with the over-pricing of assets.

– As prosperity decreases, the economy will de-complexify.

These points describe a situation whose reality is as yet largely unknown, but one reason for selecting business (rather than, say, government, the public sector or finance) for this first examination of the sector implications of deteriorating prosperity is that businesses are likely to discover this new reality more quickly than other organisations.

Whilst by no means free from the assumptions, conventions, ‘received wisdoms’ and internal group interests that operate elsewhere, businesses are driven by competition – and this means that, should a small number of enterprises discover and act upon the implications of de-growth, de-layering and disproportionate risk, others are likely to follow.

We cannot, of course, discuss here the many practical steps which are likely to follow from recognition of the new realities and, in some cases, it might be inappropriate to do so.

It seems obvious, though, that a business which becomes familiar with the situation as it is described here will seek to take advantage of inappropriately elevated asset prices, and to test its value-chain and its operations in the light of future de-layering. Ultimately, the aim is likely to be to front-run both de-layering and revaluation. Moreover, awareness of those countries in which prosperity deterioration is at its most acute is likely to sharpen the focus of multi-regional companies.

 

#161. A welcome initiative

MR CUMMINGS’ BOLD ENDEAVOUR

As we’ve been discussing here, Dominic Cummings, senior policy advisor to British premier Boris Johnson, has issued a clarion call for “data scientists, project managers, policy experts, assorted weirdos” and others to join an effort to transform the workings of government.

Here is how Mr Cummings defines his objectives:

“We want to improve performance and make me much less important — and within a year largely redundant. At the moment I have to make decisions well outside what Charlie Munger calls my ‘circle of competence’ and we do not have the sort of expertise supporting the PM and ministers that is needed. This must change fast so we can properly serve the public”.

Let me start by making two points about this initiative. The first is to commend Mr Cummings for taking it. New thinking is needed as never before in government, not just in Britain but around the World.

The second is that I think Mr Cummings has a better-than-evens chance of success. He’s not the first person in government to try to think “the unthinkable” or “outside the box”, but conditions do look propitious.

The long-running political guerrilla war over “Brexit” has had a numbing effect in numerous important areas, not just on policy but on constructive debate, so there’s a lot of catching up to do. My hunch (and it’s not much more than that) is that Mr Johnson is more open than his predecessors to genuinely new thinking. Additionally, of course, his large Parliamentary majority will help very considerably.

So, too, will the fact that his Labour opponents are in such disarray that they might even replace Mr Corbyn with somebody who still thinks that trying to stymy the voters’ decision over leaving the EU was a good idea. Labour, it should be said, has a vital part to play in the political discourse, but cannot do this effectively until it reinstalls issues of economic inequality at the top of its agenda.

Lastly, and notwithstanding the kind (and beyond-my-merits) encouragement of some contributors here, I’m not going to be sending my CV to Downing Street. This, at least, frees me to muse on what I would be saying if I were submitting an application.

First and foremost, I’d urge Mr Cummings to recognize that the economy is an energy system. This will require no explanation to regular visitors here, but I would add that this interpretation can enable us to place our thinking about economics on a scientific footing. The ‘conventional’ form of economics which portrays the economy in purely financial terms may or may not be “gloomy”, but it certainly isn’t a “science”. We’ve spent the best part of two decades finding out that ‘tried and tested’ financial paradigms range from the incomplete to the outright mistaken, and that pulling financial levers doesn’t work.

Mr Cummings won’t need me to tell him that paying people to borrow (as we’ve been doing ever since 2008), whilst penalising savers, is a very bad idea. I’m sure he will appreciate, too, that trying to run a supposedly “capitalist” system without positive returns on capital is a contradiction in terms. Moreover, those of us who believe in the proper working of markets cannot applaud a situation in which asset prices are propped up by intervention. Any country which deliberately supports over-inflated property prices ought to face tough questioning from the younger members of the electorate.

Second, I’d suggest to Mr Cummings that recognition of the energy-determined character of the economy reframes the debate about the environment. I would steer him towards sources which debunk the illogical notion that we can “de-couple” the economy from the use of energy. Economic prosperity, and the broader well-being embodied in environmental and ecological issues, share the common axis of energy.

Getting into the nitty-gritty, and being wholly candid about the situation, I would go on to contend that the energy equation, which hitherto has driven our prosperity upwards, has turned against us. That, after all, is why we’ve been trying one financial gimmick after another in an effort to convince ourselves that “growth” in our prosperity is continuing, when a huge amount of evidence surely demonstrates that it is not.

In the United Kingdom, “growth” (of 26%) between 2003 and 2018 added £430 billion to GDP, but at the cost of £2.16 trillion in net borrowing. You don’t need a degree in advanced mathematics to recognize that borrowing £5 in order to purchase “growth” of £1 isn’t a sustainable plan.

In Britain, as in most other Western countries, a very large part of the “growth” recorded in recent years has been a simple function of spending borrowed money. If we stopped borrowing (leaving debt where it is now), rates of growth would gravitate to somewhere barely above zero. Trying to reduce debt to its level at some earlier time would eliminate a lot of the “growth” recorded in the past into reverse, leaving GDP a lot lower than it is today.

Adding rising ECoEs into the equation, I would seek to demonstrate that the prosperity of the average Western citizen has been deteriorating for more than a decade. Increasing taxation, meanwhile, has been making this worse. Over a fifteen-year period in which the average British person has become £2,570 (10%) less prosperous, his or her burden of tax has increased by £2,240.

Of course, one cannot expect statistical, model-based numbers to make a wholly persuasive case, especially when the techniques involved avowedly ditch conventional notations. But I would urge Mr Cummings to look at a range of other indicators in order to triangulate some conclusions. Such indicators would include homelessness, the relentless rise of consumer credit, the dependency of the economy on credit-funded consumption, the associated symptoms of debt distress, and the millions generally recognized to be “just about managing”. He could reflect, too, on correlations that can be drawn between adverse trends in prosperity and rising public discontent, whether on the streets of Paris or in the voting booths of the United States and much of Europe.

Finally, none of this would be presented as a cause for despair. Accepting that government cannot make people richer doesn’t involve concluding that it cannot make them more contented.

The smart move at this point is to recognize what’s really happening, steal a march on those still in ignorance and denial, and work out how to improve the quality, both of people’s lives and of the society in which they live.

#160. New Year’s Revolutions?

THE SURPLUS ENERGY ECONOMY – CONTEXT AND CHOICE

One of the things that used to puzzle me, as a very small boy, was why the day after Christmas was called “Boxing Day”.

Did people in the classic “Dickensian Christmas” – in the era evoked by traditional festive icons like snow, holly and robins – really set aside a day for pugilism? It seemed even less likely that a day of fist-fighting contests formed any part of the first Christmas.

All became clear, of course, when it was explained to the very young me that this was the day on which Christmas “boxes” (gifts) were exchanged. In those times, people drew a distinction between the Christian celebration, on 25th December, and the giving and receiving of presents, on the following day.

This distinction is even more pronounced here in Spain, where the exchange of gifts is deferred to the “Night of the Kings”, two weeks after Christmas itself. The festive season is thus more protracted here than in, say, Britain or America, but it’s also markedly less frenetic, and culminates, in most towns and cities, with a thoroughly enjoyable Night of the Kings carnival.

Depending on where you are and how you look at it, the Christmas holidays end, and something like “normality” resumes, at some point between the 2nd and the 7th of January. My view is that the word “normal”, whose definition has, in economic and broader terms, already been stretched a very long way indeed, might soon lose any realistic meaning. A situation in which the Fed is in the process of injecting at least $1 trillion of newly-created money into the system typifies the extent to which abnormality has already become the norm.

In these circumstances, my immediate aim is to produce a guide, comprehensive but succinct, to the surplus energy interpretation of the economy.

This will cover the energy basis of all economic activity, the critical role played by ECoE (the Energy Cost of Energy), and the true nature of money and credit as an aggregate claim on the output of the ‘real’ (energy) economy.

It will move on to discuss how SEEDS models, interprets and anticipates economic trends, and to set out an overview of where we are in energy-interpreted terms. It might also – if space permits – touch on what this tells us about the false dichotomy between environmental challenges and the customarily-misstated concept of “growth”.

What I aim to do here is to close out the year with some observations about where we are as we head into the 2020s.

The best place to start is with the deterioration in prosperity, and the simultaneous increase in debt, that have already destroyed the credibility of any ‘business as usual’ narrative in the Advanced Economies (AEs).

Starting with Japan back in 1997, and finally reaching Germany in 2018, the prosperity of the average Western person has hit a peak and turned downwards, not in a temporary way, but as part of a secular process which conventional economics cannot recognise, much less explain.

This process is now spreading to the emerging market (EM) economies, most of which can expect to see prior growth in prosperity per person go into reverse within the next three years. The signs of deceleration are already becoming apparent in big EM countries such as China and India.

Thus far, global average prosperity has been on a long plateau, with continuing progress in the EM economies largely offsetting deterioration in the West. Once decline starts in the EM group, though, the pace at which the average person Worldwide becomes poorer can be expected to accelerate.

If deteriorating prosperity is the first point worthy of emphasis, the second is that a relentlessly increasing Energy Cost of Energy (ECoE) is the fundamental cause of this impoverishment process. ECoE reflects that fact that, within any given quantity of energy accessed for use, a proportion is always consumed in the access process.

ECoE is a direct deduction from the aggregate quantity of energy available, which means that surplus (ex-ECoE) energy is the source of all economic activity other than the supply of energy itself.

In other words, prosperity is a function of surplus energy.

In the past, widening geographic reach, economies of scale and technological advance drove ECoEs downwards, to a low-point (of between 1% and 2%) in the immediate post-1945 decades. The subsequent rise in trend ECoEs has been driven by the fact that, with the benefits of reach and scale exhausted, depletion has now become the primary driver of ECoEs in the mature fossil fuels industries which continue to provide four-fifths of global energy supply. The role of technology has been re-cast as a process which can do no more than blunt the rate at which ECoEs are rising.

By 2000, when World trend ECoE had reached 4.5%, Advanced Economies were already starting to face an insurmountable obstacle to further growth. Prosperity turned down in Japan from 1997 (when ECoE there was 4.4%), and has been declining in America since 2000 (4.5%).

SEEDS studies demonstrate that prosperity in advanced Western countries turns down once ECoE enters a band between 3.5% and 5%. EM economies, by virtue of their lesser complexity, are less ECoE-sensitive, with prosperity going into reverse once ECoEs enter a range between 8% and 10%. Ominously, ECoE has now reached 8.2% in China, 10.0% in India and 8.1% in the EM countries as a group.

The key point about rising ECoEs is that there is nothing we can do about it. This in turn means that global prosperity has entered de-growth. The idea that we can somehow “decouple” economic activity from the use of energy is utter wishful thinking – not surprisingly, because the economy, after all, is an energy system.

This presents us with a clear choice between obfuscation and denial, on the one hand, and acceptance and accommodation, on the other. Our present position is one of ‘denial by default’, in that the decision-making process continues to be based on the false paradigm that ‘the economy is money’, and that energy is “just another input”.

This leads us to the third salient point, which is financial unsustainability.

Properly understood, money functions as a claim on the output of the ‘real’, energy-driven economy. Creating more monetary claims, without a corresponding increase in the goods and services against which these claims can be exercised, creates a gap which, in SEEDS terminology, is called “excess claims”.

Since these “excess” claims cannot, by definition, be honoured, then they must be destroyed. There are various ways in which this “claims destruction” can happen, but these mechanisms can loosely be divided into “hard” default (the repudiation of claims) or “soft” default (where claims are met, but in greatly devalued money).

These processes mean that “value destruction” has become an inevitability. This may involve waves of asset market crashes and defaults, or the creation (through reckless monetary behaviour) of hyperinflation.

The likelihood is that it’s going to involve a combination of both.

These issues take us to the fourth critical point, which is the threat to the environment. Let’s be clear that this threat extends far beyond the issue of climate change, into many other areas, which range from pollution and ecological damage to the dwindling availability of essentials such as water and food.

Conversion to renewable energy (RE) isn’t the solution to these problems, if by “solution” we mean “an alternative which can sustain our current level of prosperity”. RE, despite its many merits, isn’t going to replace the surplus energy that we’ve derived hitherto from fossil fuels. RE might well be part of the solution, but only if we take on board the inevitability of degrowth.

This brings me to my final point, which is choice. For well over two centuries we’ve been accustomed to an energy context which has been so favourable that it has given us the ability both to improve personal prosperity and to extend those benefits across a rapidly increasing population.

With this favourable context fading into the past, we have to find answers to questions that we’ve never had to ask ourselves until now.

The faculty of choice requires knowledge of the options, and this we cannot have whilst we persist in the delusion that “the economy is a financial system”. It isn’t, it never has been, and it never can be – but our ignorance about this fundamental point has been one of the many luxuries afforded to us by the largesse of fossil fuels.

This seems pretty depressing fare to put before readers at the start of the festive season. The compensating thought has to be that the connection between prosperity and happiness has always been a falsehood.

A lack of sufficiency can, and does, cause misery – but an excess of it has never been a guarantee of contentment.

In the coming days, Christians will recall with renewed force that Jesus was born in a humble stable. He went on to throw the money-changers out of the Temple, and to instruct people to lay up their treasure, not on Earth, but in Heaven. I hope it will be taken in the right spirit if I add that He never earned an MBA, or ran a hedge fund.

The single most important challenge that we face isn’t deteriorating prosperity, or the looming probability of a financial catastrophe. Rather, the great challenge is that of how to jettison the false notion that material wealth and happiness are coterminous.

‘Value’ may indeed be heading for mass destruction.

But values are indestructible.

#159. The perils of equilibria

‘INDICATIONS AND WARNINGS’

Putting together what might turn out to be the last article published here this year has been one of two main items on my agenda. (I’m hoping to slip a third, pre-Christmas article into the list but, should this not happen, please accept my premature good wishes for the season).

In back-to-front order, the second ‘agenda item’ is a much-updated guide to the principles of Surplus Energy Economics, and to the latest – SEEDS 20 Pro – version of the model. The Surplus Energy Economics Data System has now evolved into a very powerful analytical tool, and I plan to make even greater use of it to inform discussions here in the future.

You can download at the end of this discussion, or from the Resources, page a summarised statistical guide to selected EM economies, whose prospects are one of the issues discussed here.

Two disequilibria

The aim here is to set out two of the trends that I suspect are going to ‘go critical’ in the year ahead.

The first of the two narrative-shaping issues that I’m anticipating for 2020 is a marked slowdown in the emerging market (EM) economies.

We can say what we like about the advanced economies (AEs), where monetary adventurism seeks to disguise (since it cannot reverse) an economic stagnation that has morphed into a gradual (but perceptible) deterioration in prosperity.

But, all along, we’ve known that our trading partners in the EM countries have been “doing stuff” – churning out widgets, building infrastructure, ‘going for growth’, and doing a quite remarkable job of improving the economic lot of their citizens.

This positive trend is, in my analysis, starting to top-out and then go into reverse. Even ‘conventional’ numbers are now starting to reveal what SEEDS has been anticipating for quite some time. The cresting and impending reversal of the wave of prosperity growth in countries like China and India – and the consequent financial strains – are likely to inform much of the economic narrative going forward.

The implications of what I’ll “the EM crest” will be profound.

We will no longer be able to say that ‘the Western economies may be stagnating, but the emerging nations are driving the global economy forward’. Their less complex, less ECoE-sensitive economies now face the self-same issues that have plagued the West ever since the onset of ‘secular stagnation’ from the late 1990s.

The second critical issue is financial disequilibrium, and the ‘devil or the deep blue sea’ choice that it poses.

Here’s an example of what this ‘disequilibrium’ means. In nominal terms, the value of equities around the World increased by 139% in a decade (2008-18) in which nominal World GDP expanded by 33%. Applying inflation to both reduces the numbers, of course, but it leaves the relationship unchanged. What’s true of equities is also true, to a greater or lesser extent, of the prices of other assets, including bonds and property.

What matters here is the relationship between asset prices and incomes, with ‘incomes’ embracing everything from wages and pensions to dividends, corporate earnings and coupons from bonds.

This divergence is, of course, a direct result of monetary policy. But the effect has been to stretch the relationship to a point from which either surging inflation (by driving up nominal incomes), or a crash in asset prices, is a necessary element of a return to equilibrium.

We may have to choose between these, with inflation the price that might need to be paid to prevent a collapse in asset markets.

Our industrious friends

A critical issue in the near-term is likely to be the discrediting of the increasingly fallacious assumption that, whilst much of the “growth” (and, indeed, of the economic activity) reported in the West is cosmetic, emerging market (EM) economies really can go on, indefinitely,  producing more “stuff” each year, so a big part of the World remains genuinely more and more productive.

Westerners, the logic runs, might increasingly be making their living by using a ‘churn’ of newly-created money to sell each other ever-pricier assets and ever more low-value incremental services, but the citizens of Asia, in particular, remain diligent producers of everything from cars and smartphones to chips and components.

This, unfortunately, is a narrative whose validity is eroding rapidly. China’s pursuit of volume (driven by the imperative of providing employment to a growing urban workforce) has driven the country into a worsening financial morass, whilst a former Indian finance minister has warned of “the death of demand” in his country.

Figures amply demonstrate the development of these adverse trends, not just in China and India but in other members of the EM-14 group that is monitored by SEEDS.

On the principle that a picture is worth a thousand words, here are SEEDS charts showing that, whilst Western prosperity is already in established decline, something very similar is looming for the EM-14 economies. Of these, some – including Brazil, Mexico, South Africa and Turkey – have already started getting poorer, and many others are nearing the point of inflexion.

159 prosperity

And, as the next pair of charts shows, you don’t need SEEDS interpretation to tell you that the divergence between GDP and debt in the EM countries doesn’t augur well.

159 EM divregence

What’s starting to happen to the EM economies has profound, global implications. Perhaps most significantly, the dawning recognition that the World’s economic ‘engine’ is no longer firing on all cylinders is likely to puncture complacency about global economic “growth”.

When this happens, a chain reaction is likely to set in. With the concept of ‘perpetual growth’ discredited, what happens to the valuations of companies whose shares are supposedly priced on their own ‘growth potential’?

More important still, what does this mean for a structure of debt (and broader obligations) predicated on the assumption that “growth” will enable borrowers to meet their obligations?

In short, removing ‘perpetual assured growth’ from the financial calculus will equate to whipping out the ace of diamonds from the bottom tier of a house of cards.

Timing and equilibrium

This brings me to my second theme, which is the relationship between assets and income.

Just like ratios of debt to prosperity – and, indeed, mainly because of cheap debt – this relationship has moved dramatically out of kilter.

The market values of paper assets put this imbalance into context.

Globally, data from SIFMA shows that the combined nominal value of stocks and bonds increased by 68% between 2008 and 2018, whilst recorded GDP – itself a highly questionable benchmark, given the effects of spending borrowed money – expanded by a nominal 33%.

Equities, which were valued at 79% of American GDP in 2008 after that year’s slump, rose to 148% by the end of 2018, the equivalent global percentages being 69% and 124%.

For the United States, a ‘normal’ ratio of stock market capitalisation to GDP has, historically, been around 100% (1:1), so the current ratio (about 1.5:1) is undoubtedly extreme.

Prices of other assets, such as residential and commercial property, have similarly outstripped growth in recorded GDP.

Whilst this isn’t the place to examine the mechanisms that have been in play, it’s clear that monetary policy has pushed asset prices upwards, driving a wedge between asset values and earnings.

This equation holds true right across the system, typified by the following relationships:

– The prices of bonds have outstripped increases in the coupons paid to their owners.

– Share values have risen much more sharply either than corporate earnings or dividends paid to stockholders.

– The wages of individuals have grown very much more slowly than the values of the houses (or other assets) that they either own or aspire to own.

This in turn means that people (a) have benefited if they were fortunate enough (which often means old enough) to have owned assets before this process began, but (b) have lost out if they were either less fortunate (and, in general, were too young) when monetary adventurism came into play.

The critical point going forward is the inevitability of a return to equilibrium, meaning that the relationship between incomes and asset values must revert back towards past norms.

You see, if equilibrium isn’t restored – if incomes don’t rise, and prices don’t fall – markets cease to function. Property markets run out of ‘first-time buyers’; equity markets run out of private or institutional new participants; and bond markets run out of people wishing to park some of their surplus incomes in such instruments.

To be sure, markets might be kept elevated artifically, even in a state of stasis, without new money being put into them from the earnings of first-time buyers and new investors. But the only way to replace these new income streams would be to print enough new money to cover the gap – and doing that would destroy fiat currencies.

This means either that incomes – be they wages, bond coupons or equity dividends – must rise, or that asset prices must fall.

In a World in which growth – even as it’s reckoned officially – is both subdued and weakening, the only way in which nominal incomes can rise is if inflation takes off, doing for wages (and the cost of living) what it’s already done for asset prices.

With inflation expectations currently low, you might conclude, from this, that asset prices must succumb to a ‘correction’, which is the polite word for a crash.

But that ‘ain’t necessarily so, Joe’. It’s abundantly clear that the authorities are going to do their level best to prevent a crash from happening. It seems increasingly apparent that, as Saxo Bank has argued so persuasively, the Fed’s number one priority now is the prevention of a stock market collapse.

Additionally, of course, and for reasons which presumably make political sense (because they make no economic or social sense whatsoever), many governments around the World favour high property prices.

The linkage here is that the only way in which the authorities can prevent an asset price slump is ‘more of the same’ – the injection of ever greater amounts of new money at ever lower cost. This is highly likely to prove inflationary, for reasons which we can discuss on a later occasion.

My conclusions on this are in two parts.

First, the authorities will indeed do ‘whatever it takes’ to stop an asset price collapse (and they might reckon, too, that the ‘soft default’ implicit in very high inflation is the only route down from the pinnacle of the debt mountain).

My second conclusion is that it won’t work. Investors, uncomfortably aware that only the Fed and ‘unconventional’ monetary policy stand between them and huge losses, might run for the exits.

They know, of course, that when everyone rushes in a panic for the door labelled ‘out’, that door has a habit of getting smaller.

There’s an irony here, and a critical connection.

The irony concerns the Fed, the President and the stock market. Opinions about Mr Trump tend to be very polarised, but even his admirers have expressed a lot of scepticism about his assertion that a strong stock market somehow demonstrates the vibrancy of the American economy.

So it would indeed be ironic if the Fed – in throwing everything and the kitchen sink into stopping a market crash – found itself acting on the very same precept.

The connection, of course, is that equity markets, just like bonds and other forms of debt, are entirely predicated on a belief in perpetual growth. If, as I suspect, trends in the EM economies are set to destroy this ‘growth belief’, we may experience what happens when passengers in the bus of inflated markets find out that the engine has just expired.

EM 14 December 7th 2019

#158. An air of unreality

DE-GROWTH AND DENIAL IN THE UNITED KINGDOM

Now that a general election has become the latest twist in the saga of “Brexit” – Britain’s ‘on-off-maybe’ withdrawal from the European Union – it seems appropriate to review the situation and outlook for the United Kingdom from a Surplus Energy Economics perspective.

The aim here is to set out an appraisal of the British economy, concentrating on performance and prospects.

No attempt is made, though, to suggest future policy directions, since the likelihood of a wholesale awakening to the realities of de-growth seems remote.

Before we start, I hope I can take it that the ‘energy, not money’ interpretation of economics is familiar to readers (though, given the accelerating pace of change in the world economy, it might be desirable to publish an updated introduction to this in the near future).

The understanding that the economy is an energy system, and not a financial one, can provide insights denied to those wedded to the ‘conventional’ interpretation which states that the economy can be understood, and managed, in monetary terms alone. It is becoming clearer, almost by the day, that this simply is not true.

Long-standing visitors won’t need reminding, either, that, beyond believing that everyone should respect the democratic decision, I’m avowedly neutral on whether British voters made the ‘right’ or the ‘wrong’ choice in the 2016 “Brexit” referendum.

There can be no doubt, though, that “Brexit” has been a huge distraction – indeed, it’s “the excuse that keeps on giving” – and has induced something very close to complete paralysis of the decision-making process.

Policy paralysis is particularly unfortunate in the economic sphere, where “Brexit” has prevented debate over a deteriorating economy and a rising level of financial risk. Even on the basis of official data, Britain’s financial assets ratio – a measure of exposure to the financial system – stands at more than 1300% of GDP. This compares with 480% in the United States, and is a dangerous place to be as a GFC II sequel to the 2008 global financial crisis (GFC) becomes ever more probable.

The place to start is with the economic situation as interpreted by SEEDS (the Surplus Energy Economics Data System) which, for Britain as for any other economy, lays bare the realities behind the published statistics.

Growth, output and debt – coming clean

If you were to believe official figures, British economic output increased by 11% between 2008 and 2018, adding £212bn (at 2018 values) to recorded GDP. This in itself is far from impressive and, since population numbers increased by 7% over that decade, left GDP per capita just 3.6% ahead.

Even these uninspiring figures flatter to deceive. Over a decade in which GDP has increased by £212bn, debt has risen by £890bn, meaning that each £1 of recorded “growth” has been accompanied by £4.18 in net new borrowing.

This, to be sure, is an improvement over the 2000-08 period, which witnessed a reckless, credit-driven bubble in which debt increased by £5.63 for each £1 of “growth”. But the UK economy remains excessively dependent on continuing increases in debt.

The numbers are summarised in fig. 1, which shows how far annual growth has been exceeded by net borrowing, particularly in the period of policy insanity which preceded 2008.

Fig. 1

#158 UK 01

As a result of a continuing addiction to cheap and easy credit, most (83%) of the recorded growth in British GDP since 2008 has been a function of the simple spending of borrowed money.

SEEDS calculations show that, if net new borrowing ceased as of now, trend growth would fall to between 0.1% and 0.4%, well adrift of the 0.6% rate at which population numbers are increasing.

If the United Kingdom hadn’t joined in the pan-Western (and, latterly, pan-global) debt binge in the first place, output last year would have been £1.63 trillion, 22% below the recorded £2.08tn.

Where underlying realities are concerned, SEEDS indicates that, rather than ‘output of £2.08tn, growing at 1.4% annually’, Britain has underlying, ‘clean’ GDP (C-GDP) of £1.63tn, growing by between 0.1% and (at best) 0.4% – and this is even before we turn to the critically-important energy situation. Comparisons between recorded GDP and the credit-adjusted equivalent are set out in fig. 2.

Fig. 2

#158 UK 02

Like so many others, the British economy shows all the hallmarks of “activity” created artificially by the injection of credit – high value-adding activities (like manufacturing) have stagnated at best, displaced by “growth” coming mostly from minimally value-adding sectors which are characterised by low wages and worsening insecurity of employment.

Replacing, say, £1bn of hard-priced manufacturing output with £1bn of residually-priced manicures and fast food deliveries isn’t progressive, least of all if this change has been financed with rising debt, most obviously in the household sector.

The mistaken idea, held as tenaciously in London as it is in the Élysée, that lowering wages somehow makes an economy ‘more competitive’, ignores one rather obvious fact – if low labour costs were an economic positive, Ghana would be more prosperous than Germany, and Swaziland richer than Switzerland.

The energy dimension

Because all economic activity is a function of energy, the cost of energy supply is a vital determinant of prosperity. This cost is calibrated here as ECoE – the Energy Cost of Energy – which measures, within any given quantity of energy accessed and put to use, how much of that energy is consumed in the access process.

For reference, SEEDS indicates that, for complex developed economies, prior growth in prosperity goes into reverse at ECoEs between 3.5% and 5.5%. In Britain, prosperity has been shrinking since trend ECoE hit 4.2% back in 2003. The subsequent rise in trend ECoE – to 9.5% last year – has tightened the screw relentlessly.

This goes a long way towards explaining why the average British person is 10.8% (£2,673) worse off than he or she was back in 2003 (as well as being nearly £27,000, or 49%, deeper in debt).

These calculations also do a lot to explain both popular discontent and the “productivity puzzle” which so baffles the authorities.

At 9.5%, Britain’s trend ECoE is significantly worse than the global average (7.9%) (fig. 3). This competitive disadvantage is of comparatively recent origin since, back in 2003, Britain’s ECoE (of 4.2%) was rather lower than the global average (4.6%). Whereas world trend ECoE has risen by 3.3 percentage points (+71%) since then, the British equivalent has more than doubled (+127%), increasing by 5.3 percentage points.

Fig. 3

#158 UK 03

Part of this relative slippage is due to a shrinkage in domestic energy supply – output of primary energy has declined by 56%, to 119 million tonnes of oil-equivalent last year from 272 mmtoe in 1999. Most of this decrease results from declines in output from the mature oil and gas production operations in the North Sea, though output from coal and nuclear has fallen as well. Against a 162 mmtoe decrease in fossil fuels production, supply from renewables has grown by just 23 mmtoe.

Over the same period, energy consumption, too, has fallen, by 15% or 33 mmtoe. Though often claimed as a sign of improved energy efficiency, this decline is indicative, rather, both of deteriorating prosperity and of the offshoring of energy-intensive (but important) industrial activities.

Perhaps because of complacency induced by the past largesse of North Sea oil and gas, British energy policy has seldom seemed particularly astute. Right back in the 1980s, ‘quick-buck’ thinking permitted both the export of gas and its use in the generation of cheap electricity, both of which were short-term expedients which made excessive demands on a resource which was never huge. Latterly, the authorities dithered for more than a decade over the future of nuclear before making the wrong technology choice for the wrong reasons. The current commitment to renewables, though commendable in principle, does not seem to be well-thought-out, and is likely to impose excessive costs on industry and households alike.

Whatever the local causes, ECoE is projected to rise from 10.0% this year to 12.0% by 2025 and 13.8% by 2030. These numbers indicate irreversible de-growth in the economy, and are markedly worse than those faced by significant competitors – by 2025, when British ECoE is projected to hit 12%, that of the United States is likely to be 10.8%, with France at 8.9%, resource-deficient Japan at 12.5%, and the world average at 9.6%.

Prosperity

When adverse trends in ECoE are set against essentially stagnant output as measured by C-GDP, the aggregate prosperity of the United Kingdom is actually slightly lower now (at £1.47tn) than it was back in 2003 (£1.48tn).

Over that same period, though, the population has increased by 11.4%, from 59.6 million to 66.4 million. Taken together, these figures explain why the average person is 10.8% worse off now (£22,191) than he or she was fifteen years ago (at 2018 values, £24,832).

Rises in taxes have exacerbated this deterioration, with a £2,673 fall in prosperity compounded by a £2,240 (24%) increase in taxation per person. Accordingly, discretionary (‘left in your pocket’) prosperity is £4,913 (32%) lower now (£10,432) than it was in 2003 (£15,345). This isn’t as bad as what has happened in France (-40% over the same period), but the French experience is extreme, and Britain is not far behind in the league-table of impaired prosperity.

Where pre-tax prosperity is concerned, British citizens have suffered more than most over an extended period (see fig. 4). The outlook is for further erosion of prosperity, making the average person 15% worse off by 2024 than he or she was in 2003.

This continuing deterioration in prosperity poses a huge policy problem for decision-makers and opinion-influencers, few (if any) of whom even understand what is really happening to the economy.

Fig. 4

#158 UK 04

Risk and response

If you were to put the foregoing points either to decision-makers or to practitioners of ‘conventional’ economics, the probable reactions would be denial and disbelief.

Additionally, you’d probably be told that the national balance sheet shows net assets at an all-time high of £10.4tn, which sounds impressive – until you realise that 83% of this (£8.6tn) consists of land and buildings, whose nominal values have been inflated by ultra-low interest rates, and which cannot be monetised because the only people to whom they could ever be sold are the same people to whom they already belong.

In fact, corroboration of the cautionary conclusions of the SEEDS analysis of the United Kingdom is particularly easy to find. In recent years, the British economy has been characterised by real and worsening hardship, evident in homelessness, the millions ‘just about managing’, highly elevated levels of household debt, rising recourse to food banks and a dearth of well-paid job opportunities and affordable accommodation for the young. High-profile corporate failures in the retailing and leisure sectors attest to the severe downwards pressure on consumers’ discretionary prosperity.

When calibration is switched from credit-inflated GDP to underlying prosperity, the true extent of financial risk becomes apparent. The debt ratio rises from 263% of GDP to 370% of prosperity, and even this excludes off-balance-sheet “quasi-debts” such as unfunded public sector pension commitments. Worse still, financial exposure – measured as the ratio of financial assets to income – rises from an already-dangerous 1300% of GDP to a frightening 1870% on a prosperity basis.

The sharp fall in prosperity has created significant acquiescence risk, meaning that public support for economic and financial policy initiatives can no longer be taken for granted. The decrease in discretionary prosperity over the past ten years hasn’t been as severe in Britain as in France (-29.3%), but, at -20.9% the United Kingdom ranks third out of the 30 countries modelled by SEEDS, just behind second-ranked Denmark (-23.4%), just ahead of the Netherlands (-20.7%) and Australia (-20.6%), and a long way ahead of Canada (-16.6%), Japan (-14.1%), Italy (-13.6%) and the United States (-12.9%).

This does not mean that Britain faces the imminent arrival of an equivalent of the French gilets jaunes movement, but it does help to explain both the result of the “Brexit” vote and the steadily worsening public disenchantment with the elites. It also means that any attempt to repeat the 2008 banking rescues would be likely to meet with huge popular opposition.

These considerations are set to recast the political agenda entirely, with economic and welfare issues coming to the fore, and non-economic subjects falling ever further down the public’s order of priorities. In the coming years it’s likely that popular demands for redistribution will increase to the point where any party not adopting this agenda will find scant electoral support.

Meanwhile, and despite growing. political pressure for the imposition of much higher taxes on the wealthiest, it should be assumed that the tax base will start to shrink. Tax may account for ‘only’ 37.6% of British GDP, but it already takes a 53% bite out of the prosperity of the average person, up from 44% back in 2008. Any promises based on “tax and spend” are losing credibility, which might be one reason why both major parties are now promoting policies predicated, not on higher taxation, but on sizeable increases in government debt.

The reality, though, is likely to be a growing need for the prioritising of public services, emphasising those services deemed to be essential whilst withdrawing from activities of lesser importance.

The big question from here is whether the elites recognise deteriorating prosperity and act on its implications, or try to ‘tough it out’ and wait for an economic ‘recovery’ that isn’t going to happen.

There are ways of managing a society in economic de-growth, but the first imperatives – a recognition that this is what’s happening, and a preparedness for debate on the issue – still seem as far away as ever.

 

 

#157. Trending down

THE ANATOMY OF DEGROWTH – A SEEDS ANALYSIS

Unless you’ve been stranded on a desert island, cut off from all sources of information, you’ll know that the global economy is deteriorating markedly, whilst risk continues to increase. Even the most perennially optimistic observers now concede that the ultra-loose policies which I call ‘monetary adventurism’, introduced in response to the 2008 global financial crisis (GFC), haven’t worked. Popular unrest is increasing around the world, even in places hitherto generally regarded as stable, with worsening hardship a central cause.

As regular readers know, we’ve seen this coming, and have never been fobbed off by official numbers, or believed that financial gimmickry could ‘fix’ adverse fundamental trends in the economy. Ultimately, the economy isn’t, as the established interpretation would have us believe, a financial system at all. Rather, it’s an energy system, driven by the relationship between (a) the amount of energy to which we have access, and (b) the proportion of that energy, known here as ECoE (the Energy Cost of Energy), that is consumed in the access process.

Properly understood, money acts simply as a ‘claim’ on the output of the energy economy, and driving up the aggregate of monetary claims only increases the scope for their elimination in a process of value destruction.

We’ve been here before, most recently in 2008, and still haven’t learned the brutal consequences of creating financial claims far in excess of what a deteriorating economy can deliver.

The next wave of value destruction – likely to include collapses in the prices of stocks, bonds and property, and a cascade of defaults – cannot much longer be delayed.

What, though, is happening to the real, energy-driven economy? My energy-based economic model, the Surplus Energy Economics Data System (SEEDS), is showing a worsening deterioration, and now points to a huge and widening gap between where the economy really is and the narrative being told about it from the increasingly unreal perspective of conventional measurement.

The latest iteration, SEEDS 20, highlights the spread of falling prosperity, with the average person now getting poorer in 25 of the 30 countries covered by the system, and most of the others within a very few years of joining them..

To understand why this is happening, there are two fundamental points that need to be grasped.

First, the spending of borrowed money doesn’t boost underlying economic output, but simply massages reported GDP into apparent conformity with the narrative of “perpetual growth”.

Second, conventional economics ignores the all-important ECoE dimension of the energy dynamic that really drives the economy.

Overstated output – GDP and borrowing

Ireland is an interesting (if extreme) example of the way in which the spending of borrowed money, combined in this case with changes of methodology dubbed “leprechaun economics”, has driven recorded GDP to levels far above a realistic appraisal of economic output.

According to official statistics, the Irish economy has grown by an implausible 62% since 2008, adding €124bn to GDP, and, incidentally, giving the average Irish citizen a per capita GDP of €66,300, far higher than that of France (€36,360), Germany (€40,340) or the Netherlands (€45,050).

What these stats don’t tell you is that, over a period in which Irish GDP has increased by €124bn, debt has risen by €316bn. It’s an interesting reflection that, stated at constant 2018 values, Irish debt is 85% higher now (at €963bn) than it was on the eve of the GFC in 2007 (€521bn).

When confronted with this sort of mix of GDP and debt data, two questions need to be asked.

First, where would growth be if net increases in indebtedness were to cease?

Second, where would GDP have been now if the country hadn’t joined in the worldwide debt binge in the first place?

Where Ireland is concerned, the answers are that trend growth would fall to just 0.4%, and that underlying, ‘clean’ GDP (C-GDP) would be €212bn, far below the €324bn recorded last year.

In passing, it’s worth noting that this 53% overstatement of economic output has dramatic implications for risk, driving Ireland’s debt/GDP ratio up from 297% to 454%, and increasing an already-ludicrous ratio of financial assets to output up from 1900% to a mind-boggling 2890%.

These ratios are rendered even more dangerous by a sharp rise in ECoE, but we can conclude, for now, that the narrative of Irish economic rehabilitation from the traumas of 2008 is eyewash. Indeed, the risk module incorporated into SEEDS in the latest iteration rates the country as one of the riskiest on the planet.

Though few countries run Ireland close when it comes to the overstatement of economic output, China goes one further, with GDP (of RMB 88.4tn) overstating C-GDP (RMB 51.1tn) by a remarkable 73%. Comparing 2018 with 2008, Chinese growth (of RMB 47.2tn, or 115%) has happened on the back of a massive (RMB 170tn, or 290%) escalation in debt. SEEDS calculations put Chinese trend growth at 3.1% – and still falling – versus a recorded 6.6% last year, and put C-GDP at RMB 51tn, 42% below the official RMB 88.4tn. Essentially, 62% (RMB 29tn) of all Chinese “growth” (RMB 47tn) since 2008 has been the product of pouring huge sums of new liquidity into the system.

In each of the last ten years, remarkably, Chinese net borrowing has averaged almost 26% of GDP, a calculation which surely puts the country’s much-vaunted +6% rates of “growth” into a sobering context. After all, GDP can be pretty much whatever you want it to be, for as long as you can keep fuelling additional ‘activity’ with soaring credit. Even second-placed Ireland has added debt at an annual average rate of ‘only’ 13.5% of GDP over the same period, with Canada third on this risk measure at 11.5%, and just three other countries (France, Chile and South Korea) exceeding 9%. China and Ireland are the countries where cosmetic “growth” is at its most extreme.

Fig. 1 sets out a list of the ten countries in which GDP is most overstated in relation to underlying C-GDP. The table also lists, for reference, these countries’ annual average borrowing as percentages of GDP over the past decade, though it’s the relationship between this number and recorded growth which links to the cumulative disparity between GDP and C-GDP.

Fig. 1

#157 SEEDS C-GDP

Of course, C-GDP is a concept unknown to ‘conventional’ economics, to governments or to businesses, which is one reason why so much “shock” will doubtless be expressed when the tide of credit-created “growth” goes dramatically into reverse.

Those of us familiar with C-GDP are likely to be unimpressed when we hear about an “unexpected” deterioration in, and a potential reversal of, “growth” of which most was never really there in the first place.

The energy dimension – ECoE and prosperity

Whilst seeing through the use of credit to inflate apparent economic output is one part of understanding how economies really function, the other is a recognition of the role of ECoE. The Energy Cost of Energy acts as a levy on economic output, earmarking part of it for the sustenance of the supply of energy upon which all future economic activity depends.

As we have discussed elsewhere, depletion has taken over from geographic reach and  economies of scale as the main driver of the ECoEs of oil, gas and coal. Because fossil fuels continue to account for four-fifths of the total supply of energy to the economy, the relentless rise in their ECoEs dominates the overall balance of the energy equation.

Renewable sources of energy, such as wind and solar power, are at an earlier, downwards point on the ECoE parabola, and their ECoEs are continuing to fall in response to the beneficial effects of reach and scale. The big difference between fossil fuels and renewables, though, is that the latter are most unlikely ever to attain ECoEs anywhere near those of fossil fuels in their prime.

Whereas the aggregated ECoEs of oil, gas and coal were less than 2% before the relentless effects of depletion kicked in, it’s most unlikely that the ECoEs of renewables can ever fall below 10%. One of the reasons for this is that constructing and managing renewables capacity continues to depend on inputs from fossil fuels. This makes renewable energy a derivative of energy sourced from oil, gas and coal. To believe otherwise is to place trust in technology to an extent which exceeds the physical capabilities of the resource envelope.

This, it must be stressed, is not intended to belittle the importance of renewables, which are our only prospect, not just of minimizing the economic impact of rising fossil fuel ECoEs, but of preventing catastrophic damage to the environment.

Rather, the error – often borne of sheer wishful thinking – lies in believing that renewables can ever be a like-for-like replacement for the economic value that has been provided by fossil fuels since we learned to harness them in the 1760s. The vast quantities of high-intensity energy contained in fossil formations gave us a one-off, albeit dramatic, economic impetus. As that impetus fades away, it would be foolhardy in the extreme to assume that the economy can, or even must, continue to behave as though that impetus can exist independently of its source.

For context, SEEDS studies show that the highly complex economies of the West become incapable of further growth in prosperity once their ECoEs enter a range between 3.5% and 5.5%.

As fig. 2 shows, the first major Western economy to experience a reversal of prior growth in prosperity per capita was Japan, whose deterioration began in 1997. This was followed by downturns in France (from 2000), the United Kingdom (2003), the United States (2005) and, finally, Germany, with the deterioration in the latter deferred to 2018, largely reflecting the benefits that Germany has derived from her membership of the Euro Area.

Fig. 2

#157 SEEDS ECoE prosp advanced

Less complex emerging economies have greater ECoE tolerance, and are able to continue to deliver growth, albeit at diminishing rates, until ECoEs are between 8% and 10%. These latter levels are now being reached, which is why prosperity deterioration now looms for these economies as well.

As fig. 3 illustrates, two major emerging economies, Mexico and Brazil, have already experienced downturns, commencing in 2008 and 2013 respectively. Growth in prosperity per person is projected to go into reverse in China from 2021, with South Korean citizens continuing to become more prosperous until 2029. The latter projected date, however, may move forward if the Korean economy is impacted by worldwide deterioration to a greater extent than is currently anticipated by SEEDS.

Fig. 3

#157 SEEDS ECoE prosp emerging

Consequences – rocking and rolling

As we’ve seen, then – and for reasons simply not comprehended by ‘conventional’ interpretations of the economy – worldwide prosperity has turned down, a process that started with the more complex Western economies before spreading to more ECoE-tolerant emerging countries.

For reasons outlined above, no amount of financial tinkering can change this fundamental dynamic.

At least three major consequences can be expected to flow from this process. Though these lie outside the scope of this analysis, their broad outlines, at least, can be sketched here.

First, we should anticipate a major financial shock, far exceeding anything experienced in 2008 (or at any other time), as a direct result of the widening divergence between soaring financial ‘claims’ and the reality of an energy-driven economy tipping into decline. SEEDS 20 has a module which provides estimates of exposure to value destruction, though its indications cannot do more than suggest orders of magnitude. Current exposure is put at $320tn, far exceeding the figure of less than $70tn (at 2018 values) on the eve of the GFC at the end of 2007. This suggests that the values of equities, bonds and property are poised to fall very sharply indeed, something of a re-run of 2008, though with the critical caveat that, this time, no subsequent recovery is to be anticipated.

Second, we should anticipate a rolling process of contraction in the real economy of goods and services. This subject requires a dedicated analysis, but we are already witnessing two significant phenomena.

Demand for “stuff” – ranging across a gamut from cars and smartphones to chips and components – has started to fall, a trend likely to be followed by falling requirements for inputs.

Meanwhile, whole sectors of industry, including retailing and leisure, have experienced severe downturns in profitability. Utilization rates and interconnectedness are amongst the factors likely to drive a de-complexifying process that is a logical concomitant of deteriorating prosperity. This in turn suggests that a widening spectrum of sectors will be driven to and beyond the threshold of viability.

Finally, the political challenge of deteriorating prosperity is utterly different from anything of which we have prior experience, and it seems evident that this is already contributing to worsening unrest, and to a challenge to established leadership cadres. This process is likely to relegate non-economic agendas to the lower leagues of debate, and has particular implications for policy on redistribution, migration, taxation and the provision of public services.

My intention now is to use SEEDS to provide ongoing insights into some of the detail on issues discussed here. If we’re right about the economic direction of travel, what lies ahead lies quite outside the scope of past experience or current anticipation.