#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.   

 

#156. Actual fantasy

OUR URGENT NEED FOR RATIONAL ECONOMICS

Everyone knows the quotation, of course, which says that “when it gets serious, you have to lie”.

Actually, when it gets even more serious, we have to face the facts.

I’m indebted to Dutch rock music genius Arjen Lucassen for the observation that the counterpart to “virtual reality” is actual fantasy – and that’s where the world economy seems to be right now.

You may think it’s imminent, or you might believe that it still lies some distance in the future, but I’m pretty sure you know that we’re heading, inescapably, for “GFC II”, the much larger (and very different) sequel to the 2008 global financial crisis (GFC).

SEEDS 20 – the latest iteration of the Surplus Energy Economics Data System – has a new module which calculates the scale of exposure to “value destruction”. This exposure now stands at $320 trillion, compared with $67tn (at 2018 values) on the eve of GFC I at the end of 2007.

How this number is reached, and what it means, can be discussed later. Additionally, potential for value destruction needn’t mean that this is the quantity of value which actually will be destroyed when a crash happens. Rather, it gives us a starting order-of-magnitude.

For now, though, we can simply note that risk exposure seems now to be at least four times what it was back in 2008. Moreover, interest rates, now at or close to zero, cannot be slashed again, as they were in 2008-09. Neither can governments again put their now-stretched balance sheets behind their banking systems, even if global interconnectedness didn’t render such actions by individual countries largely ineffective.

Finally – in this litany of risk – two further points need to be borne in mind. First, global prosperity is weakening, and has been falling in most Western economies for at least a decade, so any new crash will test an already-weakened economic resilience.

Second, and relatedly, any attempt to repeat the rescues of 2008 would be unlikely to be accepted by a general public which now – and, in general, correctly – characterises those rescues as ‘bail-outs for the wealthy, and austerity for everyone else’.

The high price of ignorance

It’s tempting – looking at a world divided between struggling, often angry majorities, and tiny minorities rich beyond the dreams of avarice – to think the surreal state of the world’s financial system reflects some grand scheme, driven by greed. Alternatively, you might feel that far too many countries are run by people who simply aren’t up to the job.

Ultimately, though – and whilst greed, arrogance, incompetence and ambition have all been present in abundance – the factor driving most of what has gone wrong in recent years has been simple ignorance. For the most part, disastrous decisions have been made in good faith, because thinking has been conditioned by the false paradigm which states that ‘economics is the study of money’, and which adds, to compound folly still further, that energy is ‘just another input’.

I don’t want to labour a point familiar to most regular readers, so let’s wrap up recent history very briefly.

From the late 1990s, as “secular stagnation” kicked in (for reasons which very few actually understood, then or now), the siren voices of conventional economics argued that this could be ‘fixed’ by making it easier for people to borrow than it had ever been before. This created, not just debt escalation, but a lethal proliferation and dispersal of risk, which led directly to 2008.

In response, the same wise people, those whose insights caused the crisis in the first place, now counselled yet more bizarre gimmicks, the worst of which was that we should pay people to borrow, whilst simultaneously destroying the ability to earn returns on capital. Nobody seems to have wondered (still less explained) how we were supposed to operate a capitalist economy without returns on capital – and that, by the way, is why what we have now isn’t remotely a capitalist system based on properly-functioning markets.

When GFC II turns up, it’s as predictable as night following day that the zealots of the ‘economics is money’ fraternity will come up with yet more hare-brained follies. We already know what some of these are likely to be. There are certain to be strident calls for yet more money creation (but this time with a label saying that “it’s not QE – honest”). Some will advocate ‘helicopter money’, perhaps calling it ‘peoples’ QE’. There will be calls for negative nominal interest rates, with the necessary concomitant of the banning of cash. Ideas even more barking mad than these are likely to turn up, too.

Ultimately, what’s likely to happen is that the authorities will respond to GFC II by pouring into the system more additional money than the credibility of fiat currencies can withstand.

We know, of course, that any new gimmicks, just like the old ones, won’t ‘fix’ anything, and can be expected to make a bad situation even worse.

So the question facing everyone now – but especially decision-makers in government, business and finance, and those who influence their decisions – is whether we abandon conventional economics before, or after, the next mad turn of the roulette wheel.

Put another way, should the creators of “deregulation”, QE and ZIRP – and the facilitators of sub-prime and “cash-back” mortgages, collateralised debt obligations and the alphabet soup of “financial weapons of mass destruction” – be allowed to introduce yet more insanity into the system?

Before making this decision, there’s one further point that everyone needs to bear in mind. In 2008, financial gimmickry nearly, but not quite, destroyed the banking system. The only reason why this didn’t happen was that fiat money retained its credibility. But, whilst the follies which preceded the GFC imperilled only the credit (banking) system, those which have followed have put the credibility of money itself at risk.

This is perhaps the most powerful reason of all for not letting the practitioners of ‘conventional’ economics have another swing at the wrecking-ball.

I hope that, reflecting on this, you’ll agree with me that we can no longer afford the folly of financial economics.

Moreover, we need to say so, making fundamental points forcefully, and resisting any temptation to wander off into esoteric by-ways.

A scientific alternative?

If there can be no doubt at all that money-based interpretation of the economy has ended in abject failure, there can be very little doubt that a workable alternative is ready and waiting. That alternative is the recognition that the economy is an energy system.

This idea is by no means a new one and, though I’d prefer not to particularize, it’s been pioneered by some truly brilliant people. If those of us who base our interpretations on the energy-economics paradigm can see a long way into the future, it’s because we’re “standing on the shoulders of giants”.

Moreover, much of the work of the pioneers is rooted in solid science, meaning that, for the first time, there is the prospect of a genuine science of economics, firmly located within the laws of thermodynamics. This has to be a more rational option than continuing to rely on economic ‘laws’ which try to impute immutable patterns to the behaviour of money – something which is, after all, no more, than a human construct.

I like to think that my much more modest role in this direction of travel has been to recognize that, if energy economics is going to transition from the side-lines of the debate to its centre, it needs to tackle conventional economics on its own turf.  That means that, whilst as purists we might prefer to set out our findings in calories, BTUs and joules, we have to talk in dollars, euros and yen if we’re to secure a hearing. It also means that we need models of the economy based firmly on energy principles.

If you’re a regular visitor to this site then the basics of what I call surplus energy economics will be familiar. Even so, and with new visitors in mind, a brief summary of its main principles seems apposite.

Core principles

The first principle of surplus energy economics is that everything that constitutes the economy is a function of energy. Literally nothing – goods, services, infrastructure, travel, information – can be supplied without it. Even in the most basic aspects of our lives, everything that we need – including somewhere to live, food and water – is a product of the application of energy. The more complex a society becomes, the more energy it requires, even if this is sometimes masked when energy-intensive activities are outsourced to other countries. The idea that we can somehow “decouple” economic activity from the use of energy has been debunked comprehensively by the European Environmental Bureau as “a haystack without a needle”.

You need only picture a society even temporarily deprived of energy to see the reality of this. Without energy, food cannot be grown, processed or delivered, water fails when the pumps stop working, our homes and places of work become cold and dark, and schools and hospitals cease to function. Without continuity of energy, machinery falls silent, nothing can move from where it is to where it is needed, individuals lose the mobility that we take for granted, and, in a pretty short time, social order fails and chaos reigns.

Ironically, financial systems are amongst the first to collapse when the energy plug is pulled. People cannot even write learned papers telling us that energy is ‘just another input’ when their computer screens have just gone down.

The second principle of surplus energy economics is that, whenever energy is accessed, some of that energy is always consumed in the access process. Stated at its simplest, you cannot drill an oil or gas well, excavate a mine, or manufacture a wind turbine or a solar panel without using energy. Much of this energy goes into the provision of materials, of which just one example is copper. This is now extracted at ratios as low as one tonne of copper from five hundred tonnes of rock. Supplying copper, then, cannot be done with human or animal labour – and, of course, even if this were possible, the need for nutritional energy would keep the circular, ‘in-out’ energy linkage wholly in place.

Taken together, these principles dictate a division of available energy into two streams or components.

The first is the energy consumed in the access process, known here as the Energy Cost of Energy (ECoE).

The second – constituting all available energy other than ECoE – is known as surplus energy. This powers all economic activity, other than the supply of energy itself.

This makes ECoE an extremely important component, because, the higher ECoE is, the less surplus energy remains for those activities which constitute prosperity.

Four main factors drive trends in ECoEs. Taking oil, gas and coal as examples, these energy sources benefited in their early stages from economies of scale and expanding geographic reach. Latterly, though, with these drivers exhausted – and as a consequence of the natural process of using the most attractive sources first, and leaving costlier alternatives for later – ECoEs have been driven upwards relentlessly by depletion.

A fourth factor, technology, accelerates movement along the early, downwards ECoE trajectory, and then acts to mitigate subsequent increases. Mitigation, though, is all that technology can accomplish, because the scope for technological improvement is bounded by the envelope of the physical properties of the energy resource itself.

Lastly on this, because the four factors driving ECoEs – reach, scale, depletion and technology – all act gradually, ECoEs evolve, and need to be measured as trends.

Application – the money complication

With the basic principles established, and the role of ECoE understood, it might seem that, to arrive at a measure of prosperity, all we need do now is to subtract ECoE from economic activity. That would indeed be the case – if we had a reliable data series for output.

But this is something that we simply don’t possess, least of all in reported GDP. Essentially, GDP has been manipulated for the best part of two decades, and, arguably, for even longer than that.

By manipulation, I’m not referring to tinkering at the production boundary, or understating the deflator necessary for making comparisons over time.

The kind of manipulation I have in mind is the simple matter of pillaging the future to inflate perceptions of the present.

Expressed in PPP-converted dollars at constant 2018 values, reported world GDP increased by 36% between 2000 and 2008, and has grown by a further 34% since then. During those same periods, though, world debt increased by, respectively, 50% and 58%. Each $1 of incremental GDP between 2000 and 2008 was accompanied by $2.30 of net new borrowing, a number that has increased to more than $3 in the decade since then. Sustaining annual “growth” of about 3.5% in recent years has required annual borrowing of about 9% of GDP.

In short, GDP and growth have been faked by the simple spending of borrowed money. This exercise in cannibalising the future to sustain the present would look even more extreme were we to include in the equation the creation of huge holes in pension provision.

In this context, we need to answer two questions before we can calculate a useful output metric against which ECoE can be applied.

First, what would happen now, if we stopped piling on yet more debt?

Second, where would GDP be today if we hadn’t embarked on a massive borrowing spree?

You’ll understand, I’m sure – with government, business and finance still hamstrung by the failed economic methodologies of the past – why I won’t go into details here about the SEEDS algorithms which provide answers to these questions.

What I can say, though, is that, in the absence of further net borrowing, growth in world GDP would fall from a reported level of around 3.5%, to about 1.2% now, decreasing to just 0.6% by 2030.

On the second question, setting growth since 2000 of $61tn against borrowing of $167tn over the same period puts in context quite how far reported GDP has been inflated by the spending of borrowed money – and, if this borrowing binge hadn’t happened, GDP now would be 30% below the numbers actually recorded. Instead of “GDP of $135tn PPP, growing at 3.5% annually”, we’d have “GDP of $94tn, growing at barely 1%”.

Prosperity – the ECoE connection

When we set growth in real, “clean” GDP (C-GDP) of 31% since 2000 against a global trend ECoE that has risen from 4.1% to 7.9% over the same period – and stir a 23% increase in population numbers into the pot as well – you’ll readily understand why people have started to become poorer.

This is set out in fig. 1. In the left-hand chart, the gap between reported GDP (in blue) and C-GDP (black) represents the compound rate of divergence in a period when debt of $167tn has been injected into the system, together with large amounts of ultra-cheap liquidity.

If we were now to unwind these injections, GDP would fall to (or below) the black C-GDP line, over whatever period of time the debt reduction was spread. The gap between C-GDP (black) and prosperity (red) shows the impact of rising ECoEs, and illustrates how the worsening ECoE trend is set to turn low (and faltering) growth in C-GDP into a deteriorating prosperity trend.

The middle chart adds debt, to set these trends in context. In the right-hand chart, per capita equivalents illustrate how the average person has been getting poorer, albeit – so far – pretty gradually.

Fig. 1

#1567 Global

Comparing 2000 with 2018 (in constant PPP dollars), a rise of 31% in C-GDP has been offset by an ECoE deduction that has soared from $2.7tn to $7.4tn. Aggregate prosperity has thus increased from $69tn ($71.9tn minus ECoE of $2.7tn) in 2000 to $86tn ($93.5tn minus $7.4tn) last year.

This is a rise of 26%, only slightly greater than the increase (of 23%) in world population numbers between those years. In fact, SEEDS indicates that global prosperity per capita peaked in 2007, at $11,720, and had fallen to $11,570 by last year.

On the cusp of degrowth

This, to be sure, has been a very small decrease, essentially meaning that per capita prosperity has plateaued for slightly more than a decade. Before drawing any comfort at all from this observation, though, the following points need to be noted.

First, the post-2007 plateau contrasts starkly with historic improvements in prosperity. The robust growth of the first two decades after 1945, for instance, coincided with a continuing downwards trend in overall ECoE, as the ECoEs of oil, gas and coal moved towards the lowest points on their respective parabolas.

Second, the deterioration in prosperity, though gradual, has taken place at the same time that debt has escalated. Back in 2007, and expressed at 2018 values, the prosperity of the average person was $11,720, and his or her debt was $27,000. Now, though prosperity is only $140 lower now than it was then, debt has soared to $39,000.

Third, these are aggregated numbers, combining Western economies – where prosperity has been falling over an extended period – with emerging market (EM) countries, where prosperity continues to improve. Once EM economies, too, pass the climacteric into deteriorating prosperity – and that is about to start happening – the global average will fall far more rapidly than the gradual erosion of recent years.

Fourth, as these trends unfold we can expect the rate of deterioration to accelerate, not least because our economic system is predicated on perpetual expansion, and is ill-suited to managing degrowth. In a degrowth phase, in which utilization rates slump and trade volumes fall, increasing numbers of activity-types will cease to be viable (a process that has already commenced). Additionally, of course, we ought to expect the process of degrowth to damage the financial system and this, amongst other adverse effects, will put the “wealth effect” – such as it is – into reverse.

The differences between Western and EM economies is illustrated in fig. 2, which compares the United States with China. On both charts, prosperity per person is shown in blue, and ECoE in red.

In America, prosperity turned down from 2005, when ECoE was 5.6%. In China, on the other hand, SEEDS projects a peaking of prosperity in 2021, by which time ECoE is expected to have reached 8.8%. The reason for this difference is that complex Western economies have far less ECoE-tolerance than less sophisticated EM countries.

As a rule of thumb, prosperity turns downwards in advanced economies at ECoEs of between 3.5% and 5.5%, with the United States far more resilient than weaker Western countries, most notably in Europe. The equivalent band for EM countries seems to lie between 8% and 10%, a threshold that most of these countries are set to cross within the next five or so years.

Where China is concerned, it’s noteworthy that, with ECoE now hitting 8%, there are very evident signs of economic deterioration, including debt dependency, increasing liquidity injections, and falling demand for everything from cars and smartphones to chips and components.

Fig. 2

#1567 US vs China

The energy implications

In conjunction with the SEEDS 20 iteration, the system has adopted a new energy scenario which differs significantly from those set out by institutions such as the U.S. Energy Information Administration and the International Energy Agency.

Essentially, SEEDS broadly agrees with EIA and IEA projections showing increases, between now and 2040, of about 38% for nuclear and 58% for renewables, with the latter defined to include hydroelectricity.

Where SEEDS differs from these institutions is over the outlook for fossil fuels. Using the median expectations of the EIA and the IEA, oil consumption is set to be 11% higher in 2040 than it is now, gas consumption is projected to grow by 32%, and the use of coal is expected to be little changed.

Given the strongly upwards trajectories of the ECoEs of these energy sources, it’s becoming ever harder to see where such increases in supply are supposed to come from. With the US shale liquids sector an established cash-burner, and with most non-OPEC countries now at or beyond their production peaks, it may well be that far too much is being expected of Russia and the Middle East. The oil industry may, in the past, have ‘cried wolf’ over the kind of prices required to finance replacement capacity, but we cannot assume that this is still the case.

The implication for fossil fuels isn’t, necessarily, that worsening scarcity will cause prices to soar but, rather, that it will become increasingly difficult to set prices that are at once both high enough for producers (whose costs are rising) and low enough for consumers (whose prosperity is deteriorating). It’s becoming an increasingly plausible scenario that the supply of oil, gas and coal may cease to be activities suited to for-profit private operators, and that some form of direct subsidy may become inescapable.

Conclusions

It is to be hoped that this discussion has persuaded you of two things – the abject failure of ‘conventional’, money-based economics, and the imperative need to adopt interpretations based on a recognition of the (surely obvious) fact that the economy is an energy system.

Until and unless this happens, we’re going to carry on telling ourselves pretty lies about prosperity, and acting in ways characterised by an increasingly desperate impulse towards denial. Many governments are already taxing their citizens to an extent that, whilst it might seem reasonable in the context of overstated GDP, causes real hardship and discontent when set against the steady deterioration of prosperity.

Meanwhile, risk, as measured financially, keeps rising, and the cumulative gap between assumed GDP and underlying prosperity has reached epic proportions. Expressed in market (rather than PPP) dollars, scope for value destruction has now reached $320tn.

Only part of this is likely to take the form of debt defaults, though these could take on a compounding, domino-like progression. Just as seriously, asset valuations look set to tumble, when we are forced to realise that unleashing tides of cheap debt and cheaper money provides no genuine “fix” to an economy in degrowth, but serves only to compound the illusions on which economic assumptions and decisions are based.

 

#155. The art of dark sky thinking

ECONOMICS, THE ENVIRONMENT AND THE PROBABILITY OF ‘DE-GROWTH’

One of the clichés much loved by business leaders and others is “blue sky thinking”. An implication of this term, it seems to me, is that there’s an infinity of possibility. Although the mainstream press has, in the past, dubbed me “Dr Gloom” and “Terrifying Tim”, I don’t discount the concept of infinite possibility. I’m an incurable optimist – when I’m not looking at the economic outlook, anyway.

However positive you are, though, if you set out on a lengthy expedition, it’s as well to take some wet weather clothing with you, because blue skies can turn dark grey pretty quickly. ‘Hoping for the best but preparing for the worst’ seems a pretty prudent way to think.

Before we address some of the financial, economic and broader issues which might darken our skies, I’d like to draw your attention to an important distinction, which is that ‘situations’ and ‘outcomes’ are different things. ‘Situations’ are circumstances calling for decisions, but, in themselves, they generally contain a multiplicity of possible results. ‘Outcomes’ are determined by the responses made to any particular set of ‘situations’.

This is important, because a lot of what I’m going to discuss here concerns ‘situations’. Many of these look pretty daunting, but the point about a multiplicity of possible ‘outcomes’ remains critical. Bad decisions turn difficult situations into malign outcomes, but wise choices can, at the very least, preclude the worst, and can even produce good outcomes from unpromising situations.

The gloomy non-science

Economics has been called “the gloomy science”. In fact, economics – as currently practised – may or may not be “gloomy”, but it isn’t a “science”. The fundamental flaw with conventional economics is that it assumes that the economy is a financial system, to be measured in dollars, pounds, euros and yen.

This, in reality, is a huge misconception. Throughout history, systems of money have come and gone. A collector might well buy a Roman coin from you, but you couldn’t use it in a café or a shop.  Money is simply a human artefact, often of temporary duration, which we can create or destroy at will.

The purpose of money is the facilitation of exchange, something more convenient than barter. Its other often-claimed functions (as “a store of value” and a “unit of account”) are flawed at best. The “store of value” concept is particularly unconvincing. If somebody in a Western country dug up some banknotes buried in the garden by his or her great-grandmother, their purchasing power would be dramatically lower than when the biscuit-tin containing them was interred between the cabbages and the carrots. Measured using the broad-basis GDP deflator, the US dollar has lost 62% of its purchasing power since 1980 alone, and the pound has shed 71% of its value. Moreover, many countries change their notes and coins at frequent intervals, invalidating older versions.

Money does have important characteristics – which we’ll come to – but it’s not in any sense coterminous with a ‘real’ economy that consists of goods and services. All of these are products of the use of energy. Once you grasp this fundamental point, a ‘science’ of economics becomes a possibility, but as a branch of the laws of thermodynamics, and not, as now, as ‘the study of money’.

The energy fundamentals

As regular readers will know, whenever energy is accessed, some of that energy is always consumed in the access process. This divides the totality of energy supply into two streams – the consumed component is known here as ECoE (the Energy Cost of Energy), and the remainder is surplus energy. Because this surplus energy powers all forms of economic activity other than the supply of energy itself, it is the determinant of prosperity.

The SEEDS model calculates that, over the last twenty years, global trend ECoE has more than doubled, from 3.6% in 1998 to 7.9% last year. That’s already taken a huge bite out of our ability to grow our prosperity, and there’s no likelihood of ECoE levelling out in the foreseeable future, let alone turning back downwards.

The ECoEs of renewables are falling, just as those of fossil fuels are rising exponentially. This is a topic that we’ve discussed before, and will undoubtedly return to in the future, but it seems unlikely that a full transition to renewables, utterly vital though it is, is going to stabilise overall ECoE at much below about 10%. For context, back in the 1960s, when real economic growth was robust (and when petroleum consumption was growing by as much as 8% annually, whilst car ownership was expanding rapidly), world trend ECoE was less than 2%.

There are two reasons – one obvious, one perhaps less so – why an understanding of ECoE is critical to the environmental debate.

Obviously, if we continue to tie our economic fortunes to fossil fuels, the relentless rise in their ECoEs is going to carry on making us poorer, so there’s a compelling economic (as well as environmental) case for transition to renewables.

Less obviously, whilst prosperity is a function of surplus (aggregate less-ECoE) energy, climate-harming emissions are tied to total (surplus plus ECoE) energy. Essentially, we need to reduce our emissions from fossil fuels at a rate which at least matches the rate at which their ECoEs are rising if we’re to stand any chance at all of overcoming climate risk.

It’s a dispiriting thought that, whilst energy-based economics could make a powerful contribution to the case for environmental action, conventional, money-fixated economics can only interact negatively, by telling us how much it’s going to “cost”. Unfortunately, mainstream economics can’t really tell us the cost of not transitioning.

These “costs”, to be sure, are dauntingly large numbers. IRENA – the International Renewable Energy Agency – has costed transition at between $95 trillion and $110tn. These equate to between 619 and 721 Apollo programmes at the current-equivalent cost ($153bn) of putting a man on the Moon.

Moreover, the Americans of the 1960s had a choice about whether or not to fund a space programme. In economic as well as in environmental terms, there is no choice at all about our imperative need to transition.

The invalidation of futurity

The gigantic costs that energy transition involve bring us back to money, where we need to note something that couldn’t really be done with barter, but is well facilitated by money. That concept is futurity.

Time itself has always formed part of economic transactions, and this was the case even before the invention of the first efficient heat-engine enabled us to tap the energy wealth of fossil fuels. When someone bought, say, a table, he or she was paying for the labour (which, of course, is energy) that had gone into making it. Hiring someone to plough a field was a payment for labour in the present, and engaging someone to build a barn was payment for labour in the future.

But futurity is something different. When someone invests, he or she is looking to the future, hoping that income from the investment, or its future saleable value, will exceed the initial outlay. When an insurance policy is agreed, both parties have in mind the likelihood, and possible cost, of some future eventuality. Perhaps most importantly of all, loan transactions make a lot of assumptions about the future in which the loan, and interest, are to be repaid. Very much the same applies to saving for a pension.

All of these transactions can make a positive contribution to the effective functioning of the economy. Vitally, though, they require making assumptions about conditions at some future date. To a large extent, these assumptions – which, collectively, form a consensus – are based on prior experience. To this extent, decisions taken about futurity are only as good as the consensus on which they are based.

Imagine that you’re an insurer, issuing a policy on a car. Historically, this type of car, and this category of driver, is likely to be involved in an accident once in ten years, so the policy is priced accordingly, remembering that competitor insurance companies are likely to be working on a very similar basis of calculation. Then, though, these cars start crashing, not once every ten years, but once in every three. You’ll lose money, because your futurity assumption has been invalidated.

This is a simple example, with corollaries in any transaction involving futurity. The danger arises when prior experience ceases to be a valid guide to the future.

A good real-world example involves the provision of pensions. Prior to the 2008 global financial crisis (GFC), historic long-run returns on American bonds and equities averaged 3.6% and 8.6%, respectively. Now, though, forward calculations need to be based, according to the World Economic Forum, on returns of only 3.45% for equities, and just 0.15% for bonds. Critically, this doesn’t just apply to funds invested after the fall in rates – it also cripples forward returns on capital accumulated before rates of return collapsed.

This, says the WEF, has helped created shortfalls so large that they amount to a “global pension timebomb”. Since, according to my calculations, a person investing 10% of his or her income in a pension fund before the GFC now needs to raise that to about 27% to get the same outcome – a percentage not remotely affordable for most people – we can almost say that private pension provision worldwide has been rendered inoperable by post-2008 monetary policy.

If my energy-based interpretation of the outlook for prosperity is correct – and I’d contend, simply, that its logic keeps getting more and more corroboration from events – then the entire basis of ‘consensus futurity’ has been invalidated. SEEDS shows prosperity growth petering out, not in the future, but now, and over a period which began roughly twenty years ago.

This invalidated the futurity consensus used during the massive issuance of debt before 2008, and, equally, destroys the assumptions on which subsequent monetary adventurism has been based.

Slow or negative growth – something which invalidates any projection based on pre-2000 experience – means that “secular stagnation” (or whatever euphemism you care to use) isn’t something that the economy will “grow out of”, much as youngsters grow out of childhood ailments. It’s the ‘new normal’, though it’s not the kind of thing that anyone is going to recognize as ‘normal’.

This, sooner or later, can be expected to cause a financial crash on a scale much larger than 2008, and this event (‘GFC II’) is going to hit, not just the banks, as in GFC I, but the financial system, and the very validity of fiat currencies.

Put another way, the ‘real’ and the ‘financial’ economies have moved so far apart that the latter is destined to topple over into the gap.

And this, remember, is the same financial system that needs to find the equivalent of more than 700 Apollo space programmes to finance energy transition.

I hope I’m wrong about financial crash risk, but I can see only one possible way out of the gigantic commitments – debt, pensions and much more – that we have made to a future that isn’t going to be what we thought it was going to be. The theme tune for this could be a song by the late, great Mickey Newbury – “The future’s not what it used to be”.

That only possible way out is the deliberate triggering of inflation. This would allow borrowers to ‘soft default’ their way out of unaffordable debt, ‘repaying’ lenders but in greatly devalued money. But it’s a medicine whose economic side-effects are at least as bad as the disease. High inflation has killed more currencies than any other cause.

‘De-coupling’ fiction and ‘de-growth’ fact

Rather than going into the implications of a financial crisis dwarfing that of 2008, my aim here is to look at the broader economic and environmental issues both before and after GFC II. Optimistically, one consequence of that event could be a general reappraisal of our situation – and this, of course, is where the logic of choices determining the ‘outcomes’ of ‘situations’ becomes all-important.

One set of possible choices is to try to recreate the status quo ante, but a more positive interpretation is that we will finally be forced to face a reality that, hitherto, few have understood, and fewer still have been prepared to confront.

Already, though, here have been some encouraging exceptions. In Britain, for example, chief environmental scientist Professor Sir Ian Boyd, has said recently that environmental objectives can be achieved only if people can be persuaded to move away from consumption.

This followed a report from a committee of legislators which concluded that, “[I]n the long-term, widespread personal vehicle ownership does not appear to be compatible with significant decarbonisation”. The committee said that the government should “aim to reduce the number of vehicles required”, promoting public transport and making it cheaper than car ownership. (In passing, it’s regrettable that the committee also advocated the inclusion of hybrids in the future ban on the sale of petrol- and diesel-powered cars, when it could instead have called for a near-term all-hybrids policy, and a limit on engine sizes).

The situation to be faced can be summarised as follows. Our obsession with “growth” has led us into behaviours which are destructive, not just of our environment and ecology, but in ways that we might term ‘social’, ‘political’ and ‘behavioural’. Now, though, energy-based interpretation suggests that the scope for further growth has ceased to exist. This compels us to change our thinking about the economy.

Of course, I don’t doubt that, even in extremis, a consensus based on conventional financial interpretation of the economy will express outright denial over this, and will come up with yet more hare-brained schemes to follow on from failed credit and monetary adventurism. These may well be attempted but, of course, they won’t work.

The fundamentals are that the surplus energy from fossil fuels which, hitherto, has driven economic growth is being squeezed, from two directions. Whilst the trend ECoE of fossil fuels is rising, our ability to try to counter this by increasing aggregate (pre-ECoE) supply is nearing its limits. The petroleum industry may indeed be guilty of having “cried wolf” in the past over the sorts of prices it needs to overcome depletion, but the reality of ECoE – especially where oil is concerned – suggests that the economics of the industry in many parts of the world really are in trouble. We can anticipate higher production from at least two OPEC countries – Iraq and Iran – and might extend this hope to Russia, though the costs of Russian production are far from encouraging. But US shale production alone is barely economic (if that), and has required, from the outset, subsidy, from optimistic investors and very insouciant lenders.

Whether ‘peak oil’ is brought about by cost-based supply constraint, or by the diminishing ability of customers to purchase petroleum, is something of a secondary consideration. But we do need to note that about 97% of all transport is powered by oil, with electric railways the only sizeable exception.

At the same time, we should dismiss the idea that we can somehow “decouple” the economy from energy. Fortunately, a quite superb recent report from the European Environmental Bureau (EEB) has debunked the concept of “decoupling” so comprehensively that we can defer detailed consideration to a later discussion.

“Our finding is clear”, the EEB report concludes – “the decoupling literature is a haystack without a needle”.

There – political leaders please note – goes your cherished ambition to deliver “sustainable growth”. ‘Sustainable’ is something to which we can and must aspire. But “growth” is not.

Transition is vital – but at what scale?

This, of course, takes us back to transition. I’ve aimed to leave nobody in any doubt about my belief in the imperative need to make this transition. I share the experts’ concern about climate change, and am horrified by many broader issues, such as the loss of habitats and species.

All of these consequences are a price far too high to pay for an obsession, rooted in quite recent history, with ‘growth at all costs’.

But I do question, very seriously indeed, whether we can wholly replace today’s use of fossil fuels with renewables, let alone use them to increase the aggregate supply of primary energy to the economy.

Financially, a capital requirement of $95tn to $110tn, even spread over thirty years, suggests that we need to be investing an average of about $3,400bn annually, against which actual spending (last year, $304bn) simply doesn’t cut it. Unit costs will continue to decrease. But so too – in a world with diminishing prosperity, and with a near-manic prioritization of immediate consumption over long-term investment – will our capacity for investment.

Then there’s the sheer volumetric scale of what needs to be done. In 2018, the world consumed more than 11,740 million tonnes of oil equivalent (mmtoe) of oil, gas and coal. Replacing that, again over thirty years, requires annual additions of output from renewables averaging 390 mmtoe, from a current base of 561 mmtoe. Last year’s actual increase was only 71 mmtoe, and the rate of capacity expansion has stalled. Even the 390 mmtoe number assumes no further increases in energy supply.

The third consideration, in addition to capital requirements and volumetric scale, is resources. Transition to full like-for-like replacement of fossil fuels would require vast material inputs, most obviously steel, copper and plastics. Ironically, the supply of these inputs currently relies very heavily indeed on the use of fossil fuels.

Back in the 1960s, the television series Thunderbirds looked ahead to a near future in which nearly everything – from cars and trucks to aeroplanes, ships, space rockets and, perhaps, even the humble lawnmower – was going to be nuclear-powered. Some of today’s portrayals of the future as a bigger, cleaner, glossier version of today look like similar techno-dreaming.

The idea that we’ll be driving just as many (or more) cars as we do today (except that they’ll be electric), and that we’ll be taking just as many flights (but in aeroplanes powered by batteries) seems pretty implausible.

Both economic and environmental reality suggest a need to embrace the concept of de-growth. The trick will be so to manage it that an economy that is smaller in size is also more in tune with human needs.

#154. An autumn nexus

A CONVERGENCE OF STRESS-LINES

If you’ve been following our discussions here for any length of time, you’ll know that the main focus now is on the need for energy transition. This is a challenge made imperative, not just by environmental considerations but, just as compellingly, by the grim outlook for an economy which continues to rely on energy sources – oil, gas and coal – whose own economics are deteriorating rapidly.

These, of course, are long-term themes (though that’s no excuse for the gulf between official and corporate rhetoric and delivery). But the short term matters, too, and an increasing number of market participants and observers have started to notice that a series of significant stress-lines are converging on the months of September and October, much as railway lines converge on Charing Cross station.

The context, as it’s understood from an energy economics perspective, is that a fracture in the financial system is inevitable (though ‘inevitable’ isn’t the same thing as ‘imminent’). Properly understood, money has no intrinsic worth, but commands value only as a claim on the output of the ‘real’ economy of goods and services. Whilst the mountain of monetary claims keeps getting bigger, the real economy itself is being undermined by adverse energy economics.

Ultimately, financial crises happen as correctives, when the gap between the financial and the ‘real’ economies becomes excessive.

This is what happened with the 2008 global financial crisis (GFC), which followed a lengthy period of what I call “credit adventurism”. A sequel to 2008, known here as “GFC II”, is the seemingly inevitable consequence of the “monetary adventurism” adopted during and after 2008. This, incidentally, is where the parallels end because, whilst credit adventurism put the banking system in the eye of the storm in 2008, the subsequent adoption of monetary recklessness implies that GFC II will be a currency event.   .

An understanding of the inevitability of GFC II doesn’t tell us when it’s likely to happen. All that I’ve ventured on this so far is that a ‘window of risk’ has been open since the third quarter of 2018. Whether that window has yet opened wide enough to admit GFC II is a moot point. But the converging stresses are certainly worthy of consideration.

Chinese burns

Three of the most important lines of stress originate in China.

As we’ve seen – and with the country’s Energy Cost of Energy (ECoE) now in the climacteric range at which prosperity growth goes into reverse – there’s no doubt at all that the Chinese economy is in trouble. After all (and expressed at constant 2018 values), China has added debt of RMB 170 trillion (+288%) over a period in which reported GDP has expanded by RMB 47 tn (+114%), and no such pattern can be sustained in perpetuity.

This is complicated by Sino-American trade tensions, and, given the huge divergence between Chinese and American priorities, there seems little prospect that these can be resolved in any meaningful way.

The third and newest component of the Chinese risk cocktail is unrest in Hong Kong. Few think it likely that Beijing would be reckless enough to make a forceful intervention there, but it’s a risk whose relatively low probability is offset by the extremity of consequences if it were to happen.

In this context, it’s interesting to note that markets initially responded euphorically to Mr Trump’s delaying of new sanctions, seemingly interpreting it as some kind of ‘wobble’ on his part. It looks a lot more like a Hong Kong-related cautionary signal, seasoned with a twist of gamesmanship and soupçon of characteristic showmanship.

Whilst I’m not one of Mr Trump’s critics, it does seem undeniable that he makes too much of the (actually very tenuous) relationship between economic performance and the level of the stock market. This adds his voice to the chorus of those advocating ever cheaper money.

When the next crash does, come, of course, this chorus will rise to a crescendo, but central bankers will in any case have started pouring ever larger amounts of liquidity into the system in an effort to prop up tumbling asset prices. This, in turn, is likely to lead to a flight to perceived safe havens, one of which is likely to be the dollar, whilst other currencies come under the cosh.

But this is to look too far ahead.

“Brexit” blues

The focus in Europe, of course, is on “Brexit”. I’m neither an admirer nor a critic of Boris Johnson, any more than I’m a supporter or an opponent of “Brexit” itself (a subject on which I’ve been, and remain, studiously neutral).

This said, Mr Johnson is surely right to assert that you’ll never get anything out of negotiations if you start off by committing yourself to accept whatever the other side deigns to offer. This does indeed look like brinkmanship on his part, but it’s remarkable how often negotiations, be they political or commercial, do go “right down to the wire”, being settled only when time presses hard enough on the parties involved.

I’ve said before that the EU negotiators worry me more than their British counterparts in this process. The British side has, of course, mishandled the “Brexit” situation, but this can have come as no great surprise to anyone familiar with Britain’s idiosyncratic processes of government.

Unfortunately, British floundering has been compounded by remarkable intransigence on the EU side of the table. The attitude of the Brussels apparatchiks, all along, has been ‘take it or leave it’, and this seems to have been based on two false premises.

The first is that the British have to be ‘punished’ to deter other countries from following a similar road. This is a false position, because influencing how French, Spanish, Italian and other citizens cast their votes in domestic elections is wholly outside Brussels’ competence.

In any case, ‘punishment’ should not be part of the lexicon of any adult participant in statesmanship.

The second false premise is that Britain attends the negotiating table as a supplicant, because a chaotic “Brexit” will inflict far more economic harm on the United Kingdom than on the other EU member countries.

My model suggests that this is simply not true. The country at single greatest risk is Ireland, whose economy is far weaker than its “leprechaun economics” numbers suggest, and whose exposure, both to debt and to the financial system, is as worrying as it is extraordinary.

Ireland is followed, probably in this order, by France, the Netherlands, Italy and Germany. The French economy looks moribund, despite its relentlessly-increasing debt, and the prosperity of the average French person has been subjected to a gradual but prolonged deterioration, a process so aggravated by rising taxes that it has led to popular unrest.

Though its economy is stronger, the Netherlands is exposed, by the sheer scale of its financial sector, to anything which puts the global financial system at risk.

Germany, whose own economy is stuttering, must be wondering how quite much of the burden of cost in the wider Euro Area it might be asked to bear.

Moreover, the European Central Bank’s actions endorse the perception that the EA economy is performing poorly. The ECB has made it clear that there is no foreseeable prospect of the EA being weened off its diet of ultra-cheap liquidity.

This makes it all the more remarkable (in a macabre sort of way) that none of the governments of the most at-risk EA countries have sought to demand some pragmatism from Brussels. What we cannot know – though it remains a possibility – is whether the ever-nearer approach of ‘B-Day’ will energise at least, say, Dublin or Paris into action.

Madness, money and moods

Long before the markets took fright at the inversion of the US yield curve, the financial system (in its broadest sense) has looked bizarre.

In America, the corporate sector is engaged in the wholesale replacement of flexible equity with inflexible debt, whilst investors queue up to support “cash burners”, and buy into the IPOs of deeply loss-making debutants. The BoJ (the Japanese central bank) now owns more than half of all Japanese Government Bonds (JGBs) in issue, acquired with money newly created for the purpose.

Around the world, more than $15 trillion of bonds trade at negative yields, meaning that investors are paying borrowers for the privilege of lending them money. The only logic for holding instruments this over-priced is the “greater fool” theory. This states that you can profit from buying over-priced assets by selling them on to someone even more optimistic than yourself. There’s something deeply irrational about anything whose logic is founded in folly.

The same ultra-low interest rates that have prompted escalating borrowing have blown huge holes in pension provision – and have left us in a sort of Through the Looking Glass world in which we’re trying to operate a ‘capitalist’ system without returns on capital.

Until now, markets seem to have been insouciant about the bizarre characteristics of the system, for two main reasons.

First, they seem to assume that, whatever goes wrong, central banks will come to the rescue with a monetary lifeboat. To mix metaphors, this attitude portrays the system as some kind of kiddies-fiction casino, in which winners pocket their gains, but losers are reimbursed at the door.

If, as seems increasingly likely, we’ve started a ‘race to the bottom’ in currencies, this should act as a reminder that the value of any fiat currency depends, ultimately, entirely on confidence – and central bankers, at least, ought to understand that excessive issuance can be corrosive of trust.

The markets’ second mistake is a failure to recognize the concept of “credit exhaustion”. The assumption seems to be that, just so long as debt is cheap enough, people will load up on it ad infinitum. What’s likelier to happen – and may, indeed, have started happening now – is that borrowers become frightened about how much debt they already have, and refuse to take on any more, irrespective of how cheap it may have become.

A measured way of stating the case is that, as we look ahead to autumn, we can identify an undeniable convergence of stress-lines towards a period of greatly heightened risk.

This perception is compounded by a pervading mood of complacency founded on the excessive reliance placed on the seaworthiness of the monetary lifeboat.

I’m certainly not going to predict that a dramatic fracture is going to occur within the next two or three months at the nexus of these stress lines. We simply don’t know. But it does seem a good time for tempering optimism with caution.

 

#153. One for the sceptics

THE STRICTLY ECONOMIC CASE FOR ENERGY TRANSITION

We need to be rather careful about the term “opinion is divided”.

When English league champions Manchester City were drawn to play fourth-tier minnows Newport County in the F.A. Cup, the opinions of football-watchers over the expected outcome probably were “divided” – but only in the sense that, whilst 99% expected the giants to win, only 1% hoped (in vain, as it turned out) for a miracle.

The same caution should apply to any claim that informed opinion is “divided” over the threat to the environment. Even if you’re not convinced by the concept of climate change, or of human activity as one of its main causes, you’d struggle to dismiss species extinction, water supply exhaustion, land degradation, desertification, melting glaciers or simple pollution as figments of the imagination.

We don’t, after all, have to assume that absolutely everything ever stated by ‘the establishment’ or the mainstream media is a pack of porky-pies, even if quite a lot of it is.

There’s one point, though, which really does need to be addressed. This is the widespread assumption that environmental and economic objectives are opposed, and that tackling environmental imperatives will have an economic “cost”.

This is a wholly false dichotomy. Far from ensuring ‘business as usual’, continued reliance on fossil fuel energy would have devastating economic consequences. As is explained here, the world economy is already suffering from these effects, and these have prompted the adoption of successively riskier forms of financial manipulation in a failed effort to sustain economic ‘normality’.

If you take just one point from this discussion, it should be that a transition to sustainable forms of energy is every bit as important from an economic as from an environmental imperative.

“What if?” A contrarian hypothesis

To explain this, what follows begins from a hypothetical basis that ‘there’s no truth in the story of man-made climate damage’.

Just for the moment, I’d like you to suspend your disbelief – as, writing this, I’ve had to suspend mine – and adopt the starting position that human activity, and in particular our use of energy, isn’t threatening the planet.

If they were of this persuasion, what conclusions might be reached by decision-makers in government and business?

It’s probable that, stripped of the environmental imperative, the case for transitioning our supplies of energy, away from fossil fuels and towards renewable sources such as solar and wind power, would either be dismissed altogether, or watered down to the point of irrelevance.

Even as things stand, efforts to transition to sustainable sources of energy are faltering.

Once persuaded that we could do so safely, there would be considerable support – reinforced by the human traits of self-interest, conservatism and inertia – for taking a “business as usual” approach, in which oil, gas and coal remained, as they are now, the source of fourth-fifths of the energy that we consume.

From this start-point, a great deal of inconvenience could be prevented. We wouldn’t need to change our practices, or our way of life. We could carry on travelling in gasoline- or diesel-powered vehicles. Holidaying abroad would remain an activity with a future. We needn’t expend huge sums in plastering our countryside with wind turbines and solar panels. We’d be likely to abandon vastly-expensive, technically unproven plans to switch over almost entirely to EVs (electric vehicles), confining them instead to marginal urban use. By heading off the need for drastic increases in power supply, this in turn would make it easier for industry to keep on coming up with new products and processes (like drones and robotics) which call for increases in our use of electricity.

In short, in a purely hypothetical situation in which it could be proved that the environmental activists were wrong, there’d be a huge collective sigh of relief, from government, business and the general public alike. Few people, after all, really like change and disruption.

The energy reality of the economy

What has to be emphasized – indeed, it cannot be stressed too strongly – is that, even if it were environmentally safe to carry on relying on fossil fuels, doing so could be expected to cripple the economy within, at most, twenty-five years.

Indeed, the process of economic deterioration is already well under way.

That this is not generally understood results primarily from the mistaken view that the economy is ‘a financial system’.

It has long been traditional for us to think of the economy in this way. This, in part, is a legacy of the founders of economics, men like Adam Smith, David Ricardo and James Mill. They established what are called the “laws” of economics from a financial perspective. They demonstrated the way in which the pricing process determines supply and demand. Specifically, they contended that, if there’s a shortage of something, the solution is to raise its price, thereby encouraging increased supply. All of their work, then, was expressed in the notation of money.

We should be in no doubt that these founding fathers of economic interpretation have bequeathed us invaluable lessons, of which none is more important than the role of free, fair and uncluttered competition in promoting economic progress. The successors to the early pioneers have added new economic interpretations, of course, but almost all of these are money-based theories, which perpetuate the idea that the economy is a financial system.

But the founders of classical economics lived in a world totally different to that of today. Smith died in 1790, Ricardo in 1823, and Mill in 1836, and even Mill’s son, John Stuart passed away in 1873, which was 99 years before the publication of The Limits To Growth. In their era, there was little or no reason for anyone (other than the maverick Thomas Malthus) to think about physical limitations, still less of the environmental issues that have entered our consciousness over the last twenty-five years or so.

They were right to state that higher prices can stimulate the supply of shoes or beer – but no increase in price can conjure forth new, giant and low-cost oil fields where these do not exist.

There can be few, if any, other matters of twenty-first-century importance which are tackled on the basis of eighteenth-century precepts. Neither, logically considered, is there any reason for clinging on to monetary interpretations of the economy.

If, as in fig. 1, we look at the relationship between, on the one hand, global population numbers (and related economic activity), and, on the other, the use of energy, we can see an unanswerable case for linking the two. It’s no coincidence at all that the exponential upturn in the world’s population took off at the same time that, thanks to James Watt’s 1776  invention of the first effective heat-engine, we learned how to harness the vast energy potential contained in fossil fuels.

Not just the size of the world economy, but its prosperity and complexity, too, are products of the Prometheus unleashed by Watt and his fellow inventors.

Fig. 1.

Population and energy

Moreover, observation surely tells us that literally everything that constitutes the ‘real’ economy of goods and services relies entirely on energy. Without energy supplies, the economy would grind to a halt, and the society built on it would disintegrate.

After all, if you were adrift in a lifeboat in mid-Atlantic, and a passing aircraft dropped you a huge pile of banknotes, but no water or food, you’d soon realize that money has no intrinsic worth, but commands value only in terms of the things for which it can be exchanged.

Money, then, acts simply as a claim on the products of an economy which, itself, is an energy system.

The cost component

Anyone who understands the energy basis of the economy knows that the supply of energy is never cost-free, though the relevant measure of cost needs to be stated in energy rather than financial terms. Drilling a well, digging a mine, building a refinery or laying a pipeline requires the use of energy inputs, as, for that matter, does installing a wind-turbine or a solar panel, or constructing an electricity distribution grid.

This divides the aggregate of available energy into two streams – the energy which has to be consumed in providing a continuity of energy supply, and the remaining (“surplus”) energy which powers all other economic activity.

The cost component is known here as the Energy Cost of Energy (ECoE). This is the critical determinant of the ability of surplus energy to drive economic activity. Low ECoEs provide a large surplus on which to build prosperity, but rising ECoEs erode this surplus, making us poorer.

Further investigation reveals that, where fossil fuels are concerned, four factors determine the level of ECoE.

One of these is geographic reach – by extending its operations from its origins in Pennsylvania to places as far afield as the Middle East and Alaska, the oil industry lowered ECoE by finding new, low-cost sources of supply.

A second is economies of scale – a plant handling 300,000 b/d (barrels per day) of oil is a lot more cost-efficient than one handling only 30,000 b/d.

Now, though, the maturity of the oil, gas and coal industries is such that the benefits of scale and reach have arrived at their limits. This is where the third factor steps in to determine ECoE – and that factor is depletion.

What depletion means is that the lowest-cost sources of any energy resource are used first, leaving costlier alternatives for later.

The crux of our current predicament is that ‘later’ has now arrived. There are no new huge, low-cost sources of oil, gas or coal waiting to be developed.

From here on, ECoEs rise.

To be sure, advances in technology can mitigate the rise in ECoEs, but technology is limited by the physical properties of the resource. Advances in techniques have reduced the cost of shale liquids extraction to levels well below the past cost of extracting those same resources, but have not turned America’s tight sands into the economic equivalent of Saudi Arabia’s al Ghawar, or other giant discoveries of the past.

Physics does tend to have the last word.

Unravelling economic trends

Once we understand the processes involved, we can see recent economic history in a wholly new way. The narrative since the late 1990s can be summarised, very briefly, as follows.

According to SEEDS – the Surplus Energy Economics Data System – world trend ECoE rose from 2.9% in 1990 to 4.1% in 2000. This increase was more than enough to stop Western prosperity growth in its tracks.

Unfortunately, a policy establishment accustomed to seeing all economic developments in purely financial terms was at a loss to explain this phenomenon, though it did give it a name – “secular stagnation”.

Predictably, in the absence of an understanding of the energy basis of the economy, recourse was made to financial policies in order to ‘fix’ this slowdown in growth.

The first such initiative was credit adventurism. It involved making debt easier to obtain than ever before. This approach was congenial to a contemporary mind-set which saw ‘deregulation’ as a cure for all ills.

The results, of course, were predictable enough. Expressed in PPP-converted dollars at constant 2018 values, the world economy grew by 36% between 2000 and 2008, adding $26.8 trillion to recorded GDP. Unfortunately, though, debt escalated by $61.5tn over the same period, meaning that $2.30 had been borrowed for each $1 of “growth”. At the same time, risk proliferated, and became progressively more opaque. Excessive debt and diffuse risk led directly to the 2008 global financial crisis (GFC).

With depressing inevitability, the authorities once again responded financially, this time adding monetary adventurism to the credit variety that had created the GFC. In defiance of a minority who favoured letting market forces work through to their natural conclusions (and who probably were right), the authorities opted for ZIRP (zero interest rate policy). They implemented it by slashing policy rates to all-but-zero, simultaneously driving market rates down by using newly-created money to buy up the prices of bonds.

This policy bailed out reckless borrowers and rescued imprudent lenders, but did so at a horrendous price. Since 2008, we’ve been adding debt at the rate of $3.10 for each $1 of “growth”. The proper functioning of the market economy has been crippled by the distortions of monetary manipulation. The essential regenerative process of ‘creative destruction’ has been stopped in its tracks by policies which have allowed ‘zombie’ companies to stay afloat. Asset prices have soared to stratospheric levels, supported by a tide of debt which can never be repaid, and can be serviced only on the assumption of perpetual injections of negatively-priced credit. The collapse in returns on invested capital has blown a gigantic hole in pension provision. As the Federal Reserve is in the process of discovering, no route exists for a restoration of monetary normality. We are, in short, stuck with monetary adventurism until it reaches its point of termination.

The relentless rise of ECoE   

Back in the real economy, meanwhile, ECoEs keep rising. SEEDS calculates that global trend ECoE has risen from 4.1% in 2000, and 5.6% in 2008 (the year of the GFC), to 8.1% now. Critically, the upwards trajectory of ECoE has become exponential, with each incremental increase bigger than the one before.

As this trend has progressed, prosperity has turned downwards, initially in the advanced economies of the West.

To understand this process, we need first to look behind GDP figures which have been inflated by the simple spending of borrowed money. In the decade since 2008, an increase of $34tn in world GDP has been accompanied by a $106tn surge in debt. What this means is that most of the reported “growth” in GDP has been bogus. Rates of apparent “growth” would slump to, at best, 1.5% if we stopped pouring in new credit, and would go into reverse if we ever tried to deleverage the world’s balance sheet.

Once we’ve established the underlying rate of growth – as a “clean” measure of GDP which excludes the effects of credit injection – we can apply ECoE to see what’s really been happening to prosperity.

In the West, people have been getting poorer over an extended period. Prosperity per capita has fallen by 7.2% in the United States since 2005, and by 11.3% in Britain since 2003. Deterioration in most Euro Area economies has been happening for even longer. Not even resource-rich countries like Canada or Australia have been exempt. As an aside, this process of impoverishment, often exacerbated by taxation, can be linked directly to the rise of insurgent political movements sometimes labelled “populist”.

The process which links rising ECoE to falling prosperity is illustrated in figs. 2 and 3. In America, prosperity per person turned down when ECoE hit 5.5%, whereas the weaker British economy started to deteriorate at an ECoE of just 3.4%.

Fig. 2 & 3.

EcoE & prosp US UK

World average prosperity per capita has declined only marginally since 2007, essentially because deterioration in the West has been offset by continued progress in the emerging market (EM) economies. This, though, is nearing its point of inflexion, with clear evidence now showing that the Chinese economy, in particular, is in very big trouble.

As you’d expect, these trends in underlying prosperity have started showing up in ‘real world’ indicators, with trade in goods, and sales of everything from cars and smartphones to computer chips and industrial components, now turning down. As the economy of “stuff” weakens, a logical consequence is likely to be a deterioration in demand for the energy and other commodities used in the supply of “stuff”.

Simply stated, the economy has now started to shrink, and there are limits to how long we can hide this from ourselves by spending ever larger amounts of borrowed money.

Safe to continue?

Let’s revert now to our hypothetical situation in which, unconcerned about the environment, we remain resolutely committed to an economy powered by fossil fuels.

The critical question becomes that of what then happens to the economy moving forwards.

Unfortunately, the ECoEs of fossil fuels will keep rising. SEEDS puts the combined ECoE of fossil fuels today at 10.7%, a far cry from the level in 2008 (6.5%), let alone 1998 (4.2%). Projections show fossil fuel ECoEs hitting 12.5% by 2024, and 14.5% by 2030.

For context, SEEDS studies indicate that, in the advanced economies of the West, prosperity turns down once ECoEs reach a range between 3.5% and 5.5%. Because of their lesser complexity, EM countries enjoy greater ability to cope with rising ECoEs, but even they have their limits. SEEDS analysis identifies an ECoE band of between 8% and 10% within which EM prosperity turns down. Sure enough, China’s current travails coincide with an ECoE which hit 8.7% last year, and is projected to rise from 9.0% in 2019 to 10.0% by 2025. A similar climacteric looms for South Korea  (see figs. 4 & 5).

Figs. 4 & 5

EcoE & prosp CH KOR

In short, then, continued reliance on fossil fuels would condemn the world economy to levels of ECoE which would destroy prosperity.

Hidden behind increasingly desperate (and dangerous) financial manipulation, the world as a whole has been getting poorer since ECoE hit 5.5% in 2007. As more of the EM economies hit the “downturn zone” (ECoEs of 8-10%), the so-far-gradual impoverishment of the average person worldwide can be expected to accelerate.

After that, various adverse consequences start to impact the system. The financial structure cannot be expected to cope with much more of the strain induced by denial-driven manipulation. The political and geopolitical consequences of worsening prosperity, exacerbated perhaps by competition for resources, can be left to the imagination. Economic systems dependent on high rates of capacity utilization can be expected to fail.

This, then, is the grim outlook for a world continuing to rely on fossil fuels. Even if this continued reliance on oil, gas and coal won’t destroy the environment, it can be expected, with very high levels of probability, to wreck the economy.

Even as things stand today, the energy industries seem almost to have stopped trying to keep up. Capital investment in energy, stated at constant 2018 values, was 20% lower last year (at $1.59tn) than it was back in 2014 ($2tn), and is not remotely sufficient to provide continuity of supply. Even shale investment only keeps going courtesy of investors and lenders who are prepared to support “cash-burning” companies.

Critically, what this means is that the supposed conflict between environmental imperatives, on the one hand, and economic (“cost”) considerations, on the other, is a wholly false dichotomy.

For the economy, no less than for the environment, there is a compelling case for transition. But the implications of the future trend in ECoEs go a lot further than that.

As the ECoEs of fossil fuels have risen inexorably, those of renewable alternatives have fallen steadily. It is projected by SEEDS that these will intersect within the next two to three years, after which renewables will be “cheaper” (in ECoE terms) than their fossil alternatives.

At this point, it would be comforting to assume that, as the ECoEs of renewables keep falling, and the extent of their use increases, we can make a relatively painless transition.

Unfortunately, there are at least three factors which make any such assumption dangerously complacent.

First, we need to guard against the extrapolatory fallacy which says that, because the ECoE of renewables has declined by x% over y number of years, it will fall by a further x% over the next y. The problem with this is that it ignores the limits imposed by the laws of physics.

Second, renewable sources of energy remain substantially derivative of fossil fuels inputs. At present, we can only construct wind turbines, solar panels and their associated infrastructure by using energy sourced from fossil fuels.  Until and unless this can be overcome, sources termed ‘renewable’ might better be described as ‘secondary applications of primary energy from fossil fuels’.

Third, and perhaps most disturbing of all, there can be no assurance that the ECoE of a renewables-based energy system can ever be low enough to sustain prosperity. Back in the ‘golden age’ of prosperity growth (in the decades immediately following 1945), global ECoE was between 1% and 2%. With renewables, the best that we can hope for might be an ECoE stable at perhaps 8%, far above the levels at which prosperity deteriorates in the West, and ceases growing in the emerging economies.

Policy, reality and the false dichotomy

These cautions do not, it must be stressed, undermine the case for transitioning from fossil fuels to renewables. After all, once we understand the energy processes which drive the economy, we know where continued dependency on ever-costlier fossil fuels would lead.

There can, of course, be no guarantees around a successful transition to renewable forms of energy. The slogan “sustainable development” has been adopted by the policy establishment because it seems to promise the public that we can tackle environmental risk without inflicting economic hardship, or even significant inconvenience.

It is, therefore, far more a matter of assumption than of verifiable practicality.

Even within the limited scope of declared plans for “sustainable development”, efforts at transition are faltering. Here are some examples of this disturbing insufficiency of effort:

–   According to the International Energy Agency (IEA), additions of new renewable generating capacity have stalled, with 177 GW added last year, unchanged from 2017. Moreover, the IEA has stated that additions last year needed to be at least 300 GW to stay on track with objectives set out in the Paris Agreement on climate change.

–   The IEA has also said that capital investment in renewables, expressed at constant values, was lower last year (at $304bn) than it was back in 2011 ($314bn). Even allowing for reductions in unit cost, this reinforces the observation that renewables capacity simply isn’t growing rapidly enough.

–   In 2018, output of electricity generated from renewable sources increased by 314 TWH (terawatt hours), but total energy consumption grew by 938 TWH, with 457 TWH of that increase – a bigger increment than delivered by renewables – sourced from fossil fuels.

The latter observation is perhaps the most worrying of all. Far from replacing the use of fossil fuels in electricity supply, additional output from renewables is failing even to keep pace with growth in demand. Where power generation is concerned, this has worrying implications for our ability to transition road transport to EVs without having to burn a lot more oil, gas and coal in order to do so.

The deceleration in the rate at which renewables capacity and output are being added seems to be linked to decreases in subsidies. These, though affordable enough at very low rates of take-up, have been scaled back as the magnitude of the challenge has increased.

This calls for a thoroughgoing review of energy policy, and it seems bizarre that a system which can provide financial support for the banking system cannot do the same for the far more important matter of energy. Even within the fossil fuels arena, the continued growth of American shale production has relied on cheap capital, channelled into loss-making shale producers by optimistic investors and seemingly-complacent lenders.

We need to understand that, when an individual pays for electricity, or puts fuel in a car’s tank, this represents only a small fraction of what he or she spends on energy. The vast majority of energy expenditure isn’t undertaken as direct purchasing by the consumer, but is embedded in literally all of his or her outlays on goods and services. The scope for direct purchasing is determined by the scale of embedded use.

As prosperity deteriorates, then, the ability of the consumer to purchase energy is reduced. There is every likelihood that energy suppliers could find themselves trapped between the Scylla of rising costs and the Charybdis of impoverished customers.

We should, accordingly, be prepared for the failure of a system which relies almost entirely on commercial enterprise for the supply of energy. Far from prices soaring in response to tightening supplies, it’s likely that the impoverishment of consumers keeps prices below costs, resulting in a shrinkage of energy supply as part of a broader deterioration in economic activity.

As the situation develops, we may need to think outside the “comfort zone” of current policy parameters. For instance, the promise that the public can exchange their current vehicles for EVs may prove not to be capable of fulfilment, forcing us to evaluate alternatives, including electric trams and rail.

For now, though, one imperative predominates. It is that we must stop believing in the false dichotomy in which the environmental need for a transition to renewables is “moderated” by wholly false considerations of “cost”.

Simply put, we’re likely to pay a quite extraordinarily high price for a continuation of the assumption that the economy, demonstrably an energy system, is characterised by, and can be managed using, purely financial interpretation.

= = = = =

SEEDS environment report July 2019

 

 

#152: Stuffed

WHY THE MONETARY LIFEBOAT WON’T FLOAT

The global financial system has come to rest on a single complacent assumption, one which is seldom put explicitly into words, but is remarkably implicit in actions.

This assumption is that the authorities have, and are willing to deploy, a monetary ‘fix’ for all ills.

Accordingly, the system has come to be seen as a bizarre casino, in which winning punters keep their gains, but losers are sure that they’ll be reimbursed at the exit-door.

So ingrained has this assumption become that it’s almost heresy to denounce it for the falsity that it is.

The theme of this discussion is simply stated. It is that the complacent assumption of a monetary fix is misplaced. The authorities, faced with a crash, might very well try something along these lines, and might even adopt one or more of its most outlandish variants.

But it won’t work.

The reason why no monetary expedient can provide a “get out of gaol free” card is that the economy and the financial system are quite different things.

The complacent rush in  

You can see financial manifestations of mistaken complacency wherever you look.

It emboldens those who have lent most of the $2.9 trillion that, over the last five years, American companies have ploughed into the insane elimination of flexible equity in favour of inflexible debt.

It informs those who pile into the shares of cash-burners, or queue up to buy into overpriced IPOs.

It reassures those long of JPY, despite the monetization of more than half of all outstanding JGBs by the BoJ.

It tranquilizes those who, unable to see the contradiction between gigantic financial exposure and a stumbling economy, remain long of GBP.

It blinds those to whom the Chinese economic narrative remains a miracle, not a credit-fueled bubble.

The aim here is a simple one. It is to counter this complacency by explaining why economic problems cannot be solved with monetary tools, and to warn that efforts to do so risk, instead, the undermining of the credibility of currencies.

A casino which hands back losers’ money belongs in the realm of pure myth.

The secondary status of money

Money has no intrinsic worth. Someone adrift in a lifeboat in mid-Atlantic, or stranded in the Sahara, would benefit from an air-drop of food or water, but even a gigantic amount of money descending on a parachute would do nothing more than allowing him or her to die rich.

Conventionally, money has three roles, but only one of these is relevant. Fiat money has been an atrociously bad ‘store of value’, and money is a very flawed ‘unit of account’. Money’s only relevant role is as a ‘medium of exchange’.

For this to work, there has to be something for which money can be exchanged.

This means that money has no intrinsic worth, but commands value only as a claim on the products of the economy. If you build up a structure of claims that the economy cannot honour, then that structure must – eventually, and in one way or another – collapse.

Conceptually, it’s useful to think in terms of ‘two economies’. One of these is the ‘real’ economy of goods and services, its operation characterised by the use of labour and resources, but its performance ultimately driven by energy.

The other is the ‘financial’ economy of money and credit, a parallel or shadow of the ‘real’ economy, useful for managing the real economy, but wholly lacking in stand-alone substance.

To be sure, the early monetarists oversimplified things with the assertion that inflation could be explained in wholly quantitative monetary terms. The price interface between money and the real economy isn’t determined by the simple division of the quantity of economic goods into the quantity of money.

Rather, it’s the movement or use of money that matters. The quantitative recklessness of Weimar would not have triggered hyperinflation had the excess been locked up in a vault, or in some other way not put to use. It’s not hair-splitting, but an important distinction, that Weimar’s true downfall was not that excess money was created, but that it was created and spent.

The process of exchange, which really defines the role of money, makes the interface dynamic, and, as such, introduces behavioural considerations. The creation of very large amounts of new money needn’t destabilize the price equilibrium if people hoard it, but a lesser increment can be extremely destabilizing if is spent with exceptional rapidity. This is why the simple quantitative interpretation needs to be modified by the inclusion of velocity, making Q x V a much more useful monetary determinant.

Behaviourally, velocity falls when people turn cautious – they did this during and after the 2008 global financial crisis (GFC), a tendency which reduced the inflationary risk of the loose money responses deployed at that time.

Even so, claims that the monetary adventurism unleashed at that time did not trigger inflation are simply untrue, unless you accept a narrow definition of inflation. To be sure, retail prices haven’t surged since 2008, but asset prices most certainly have, the truism being that the inflationary effects of the injection of money turn up at the point at which the money is injected.

Additionally, inflation is influenced by expectations – which have been low in an era of ’austerity’ – and by the performance of the economy. An economy which is performing weakly puts downwards pressure on inflation.

What it does not do, though, is to eliminate latent inflation. Any erosion of faith in the reliability of money would cause velocity to spike, as people rush out to spend it whilst it still has value.

Fiat fallacy

One of the analytically adverse side-effects of monetary manipulation is that it inflates apparent activity. Globally, and expressed in constant 2018 PPP dollars, the $34tn increase in recorded GDP since 2008 cannot be unrelated to the $110tn escalation in debt over the same period. According to SEEDS, most (67%) of the “growth” recorded over that period was nothing more than the simple effect of spending borrowed money.

This matters, first because a cessation in credit injection would undermine supposed rates of “growth” and, second, because a reversal would put much prior “growth” into reverse.

By falsifying GDP, this ‘credit effect’ also falsifies any relationships based on it – so the ‘comfortable’ 218% global ratio of debt-to-GDP masks a real ratio which is nearer to 340%, and higher by more than 100% than it was ten years ago (236%). It also distorts the measurement of financial exposure, so lulling us into misplaced insouciance about those countries (such as Ireland and Britain) whose financial assets stand at huge multiples to the real value of their economies.

Behind the mask of ‘the credit effect’, global economic performance is at best lacklustre, growing at about 0-9-1.3% annually whilst population numbers are growing by 1.0%.

Moreover, these numbers disguise regional disparities – whilst the average Chinese or Indian citizen continues to become more prosperous (for now, anyway), the average Westerner has been getting poorer for at least a decade.

Of course, there’s a countervailing ‘wealth effect’, giving false comfort to those whose assets have soared in price – and few, if any, of them appear to wonder what would happen if there was a rush to monetize inflated values.

But the drastic distortion in the relationship between asset values and incomes has real downsides exceeding its (illusory anyway) upside. Policymakers and their advisers may remain ignorant of the deterioration in Western prosperity, but to voters it is all too real, something which has been a major contributor to those changes in voter responses which have informed “Brexit”, Mr Trump’s ascent to the White House, and the rolling repudiation of established political parties across much of Europe.

The decline of “stuff”

The weakness of the underlying picture has now started showing up unmistakeably in weakening in demand for everything from cars, domestic appliances and smartphones to chips and drive-motors. Logically, deterioration in the economy of “stuff” will extend next into commodities because, if you’re making less “stuff”, you need less minerals, less plastics and, critically, less energy with which to make it.

Whilst all of this is going on in plain view, markets and policymakers alike are failing to recognize the risks implicit in the widening gap between a stumbling economy and escalating financial exposure. As well as borrowing an additional $110tn since 2008, we’ve blown a not-dissimilar-sized hole in pension provision, because the same low cost of capital which has incentivized borrowing has also crippled the rates of return on which pension accrual depends.

Additionally, of course, the prices of equities and property have reached heights from which any descent into rationality would have devastating direct and collateral consequences.

When the next crisis (GFC II) shows up, the complacent expectation is that everything can be ‘fixed’ with even looser monetary policy. Some of the more bizarre suggestions aired in 2008 – including ‘helicopter money’, and NIRP (negative interest rate policy, with its implicit need to outlaw cash) – will doubtless come to the fore again, accompanied by a whole crop of new ‘innovations’. The authorities are likely, in the stark despair which follows protracted denial, to act on at least some of these follies.

The trouble is that it won’t work.

You might as well try to rescue an ailing pot-plant with a spanner as try to revive an ailing economy with monetary innovation.

The form that failure takes need not necessarily involve massive inflation, though this is the only non-default route down from the debt mountain. Authorities capable of believing that EVs are “zero emissions”, or that we can overcome the environmental challenge with some form of “sustainable growth” (rather than degrowth), are perfectly capable of also believing that we can fix economic problems with monetary recklessness.

If inflation doesn’t spoil the party, two other factors might. One is credit exhaustion, in which massively indebted borrowers refuse to take on yet more debt, irrespective of how cheap the offer may be.

The other factor might well be a loss of faith in money, which might also be accompanied by a ‘flight to quality’, perhaps favouring the dollar (as ‘the prettiest horse in the knackers’ yard’), whilst hanging weaker currencies out to dry.

However it pans out, though, we know that an economy whose prosperity is faltering cannot indefinitely sustain an ever-growing burden of financial promises. By definition, whatever is unsustainable eventually fails, and this is as true of monetary systems as of anything else.