#181. The castaway’s dilemma, part one

MAPPING THE REAL ECONOMY

Of what value are facts?

If this question arises with unparalleled force now, it’s because of the enormous, perhaps unprecedented divergence between the economy (and many other issues) as they are perceived and presented to us, and these same things as they actually are.

Starting with perception, the generally accepted narrative is that the Wuhan coronavirus pandemic is something which struck ‘out of a blue sky’, and could not have been anticipated. In due course, we’re assured, the economy will stage a ‘full recovery’, returning to pretty much its previous size, shape and direction, with monetary policy assisting this ‘return to normal’. Even the lasting damage inflicted on the economy can be made good over time. Life must go on, especially in politics, whilst most of the West’s incumbent regimes are making a pretty good fist of handling the pandemic-induced crisis.

This ‘consensus’ line on our current predicament is wrong, in almost every particular. Far from being unpredictable, the pandemic was anticipated by leading scientists whose prescient advice is, for the most part, still being ignored. Any economic ‘recovery’ from here will be largely cosmetic, the shape of the economy is going to be very different indeed, and monetary gimmickry can no more rehabilitate economic prosperity than central banks can ‘print antibodies’. Conventional, ‘business as usual’ party politics matter very little in this situation, and incumbent governments are, in general, making an unholy mess of the coronavirus crisis. When you look at what’s unfolding in, for example, Britain and America, you very literally ‘couldn’t make it up’.

A bad time for reality?

This situation – in which perception and presentation are at a premium, and factual analysis at a hefty discount – is not propitious for the subject-matter of this discussion, which outlines new developments which enable the SEEDS model to map the economy and some of its broader ramifications, the latter including the environmental harm caused by economic activity.

Part of the problem, of course, is an established insistence on the fallacy that the economy is a wholly monetary system, from which it follows that energy is ‘just another input’, and that “[t]he world can, in effect, get by without natural resources”.

Had Daniel Defoe’s Robinson Crusoe, shipwrecked on his desert island, only known about classical economics, he wouldn’t have wasted his efforts finding water, food, firewood and shelter, but would instead have spent his time accumulating bits of coloured paper. Indeed, had computers existed in 1719, he wouldn’t even have needed the paper.

In challenging this absurdity, those of us who understand that the economy is an energy system, and not a financial one, can sometimes feel as isolated as Robinson Crusoe himself. Some comfort can be drawn, though, from the reflection that reality usually wins out in the end, and that pre-knowledge of the outcome has considerable value.  

The energy economy

The energy interpretation of the economy is simply stated, and need only be reiterated in brief here for the information of anyone new to the logic of Surplus Energy Economics.

First, all of the goods and services which constitute the economy are products of the application of energy. Nothing of any economic value (utility) whatsoever can be supplied without it. An economy cut off from the supply of energy would collapse within days. (If they were denied energy, conventional economists would lose the ability to publish learned papers telling us how unimportant energy really is).

Second, whenever energy is accessed for our use, some of that energy is always consumed in the access process, meaning that it’s unavailable for any other economic purpose. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE, and its roles include defining the difference between output and prosperity.

Third, money has no intrinsic worth, and commands value only as a ‘claim’ on the output of the energy economy. Creating monetary claims that exceed the delivery capability of the economy itself must, therefore, result in the destruction of the supposed ‘value’ represented by those excess claims.

To be clear about this, money is a valid subject of study, so long as we never allow ourselves to be persuaded that to understand the human artefact of money is to understand the economy. Likewise, studying the lore and laws of cricket may be rewarding, but it won’t help you to understand a game of baseball.   

The importance of this very different way of understanding the economy is that it points to conclusions drastically at variance from the comforting narrative generally presented to us.

Well before the coronavirus pandemic, it was evident that prior growth in global average prosperity per person had gone into reverse, and that we were encountering limits to the ability to use financial manipulation to disguise economic deterioration in the advanced economies of the West. The narrative of an ‘economy of more’ – more “growth”, more vehicles on the world’s roads, more flights, more consumption, more profitability and more use of energy – was already well on the way to being discredited. The pandemic crisis merely accelerates trends that had been evident for quite some time.

Critically, this process invalidates a raft of assumptions and of expectations founded entirely on the false presumption of ‘growth in perpetuity’.    

Mapping the real economy

From the outset, the aims of the SEEDS model were (a) to interpret the economy from an energy perspective, and (b) to present this interpretation in the financial language in which debate is customarily conducted.

Development of SEEDS has reached the point where the reality of the energy-driven economy can be mapped. This can best be understood if it is stated as an ability to answer a string of critically-important questions, of which the following are examples.

First, how much economic value do we extract from each unit of primary energy that we consume, and where is this conversion efficiency relationship heading?

Second, from the value thus generated from the use of energy, how much ECoE must be deducted, now and in the future, to define the amount available for all other economic purposes?

Third, what can trends in ECoE tell us about the quantity and mix of energy likely to be available to us in the future? 

Fourth, how, using this knowledge, can we best maximise prosperity whilst minimizing the environmental harm caused by our use of energy?   

This list helps identify a short series of questions of which most can now be addressed as equations. These equations, together with a number of supplementary measurements, can be used mathematically to map the ‘real’ economy of energy and the environment in a way that can be pictured representationally as follows.

The equations

The following summary, though it doesn’t go too far into dry theory, is intended to provide an overview of the SEEDS mapping process.

Equation #1: measuring output

To calibrate the efficiency with which we turn energy use into economic value, we need to start by identifying a meaningful measure of economic output.

GDP cannot serve this purpose because it is subject to extreme monetary distortion. Essentially, reported “growth” is exaggerated by the use of credit and monetary activities which inflate apparent activity. The funding of anticipatory activity, and the inflation of the supposed value of asset-related transactions, are two of the ways in which this happens.

Reflecting this, reported average GDP “growth” of 3.6% between 1999 and 2019 was a direct function of net borrowing which averaged 9.8% of GDP over the same period.

Examination of the processes involved enables the calibration of this distortion, thereby identifying rates of growth in underlying or ‘clean’ output (C-GDP), which are far lower than their reported equivalents. The right-hand chart in fig. 1 illustrates how the insertion of a ‘wedge’ between debt and GDP has inserted a corresponding distortion between reported and underlying economic output.   

Fig. 1: economic output

Equation #2: calibrating economic efficiency

Measured on the basis of C-GDP, economic output per tonne of oil equivalent (toe) of energy consumed has declined steadily, from $7,400 in 1999 to $6,730 last year, reflecting the observation that C-GDP has increased by only 40% over a period in which primary energy consumption expanded by 54%.

This deterioration in conversion efficiency may seem counter-intuitive, but has several important inferences, in addition to the obvious statement that we are using energy less, rather than more, effectively over time.

Specifically, changes in the ‘mix’ of the energy slate seem to be trending towards lesser conversion efficiency, whilst technology has concentrated much more on finding additional applications for energy than on the more efficient use of energy itself.  

Fig. 2: economic efficiency

Equations #3 & 4: ECoE and volume

Trend ECoEs have been rising since a nadir that was enjoyed in the two decades or so after 1945, a period that also – although this was no coincidence at all – witnessed remarkably robust growth in world prosperity.

Latterly, though, a relentless rise in the ECoEs of fossil fuels has driven the overall trend sharply upwards. Optimists believe that the steady fall in the ECoEs of renewable sources of energy (REs) will solve this problem, but this expectation owes far more to hope and extrapolation than it does to realistic interpretation.

Though ECoEs play a critical role in the conversion of economic output into prosperity, they are relevant, too, for the quantities of energy likely to be available to the economy in the future. Hitherto, the consensus expectation has been that energy supply – including the amounts provided by fossil fuels – will continue the steady growth experienced in the past. In comparison with recent levels, this consensus sees us using 10-12% more oil, 30-32% more gas and about the same amount of coal in 2040, with total primary energy supply rising by about 20%.

The reality, though, is that a combination of two factors, both of them related to rising ECoEs, is starting to exert adverse effects on the volume outlook. First, rising costs are increasing the prices required by producers. Second, the upwards trend in ECoEs is, by undermining prosperity, reducing the amounts that consumers can afford to pay for energy.

Accordingly, SEEDS has now adopted a much more cautious scenario which projects little or no growth in aggregate energy supply, combined with a steady decrease in the availability of fossil fuels.      

You’ll appreciate at this point that, if energy volumes cease growing, and if conversion efficiency fails to recover, then real annual economic value output can only trend downwards.

Fig. 3: ECoE and energy supply

Equation #5: measuring prosperity

Properly understood, the economic output value that we derive from energy is not the same thing as prosperity, because the first call on this output is the cost component – ECoE – required for the provision of energy itself.

ECoE defines a proportion of output which, being required for energy supply, is not available for any other economic purpose. Accordingly, the deduction of ECoE from output determines prosperity, whether this is expressed as an aggregate or as a per capita amount.

At the aggregate level, rising ECoEs have inserted a widening wedge between underlying output (C-GDP) and prosperity. Since the rate of annual progression in aggregate prosperity has now fallen below the rate at which population numbers continue to increase, world prosperity per capita has now turned downwards from a lengthy plateau, with the coronavirus crisis seemingly accelerating the pace of deterioration.

Regionally, prosperity per capita in almost all Western advanced economies has already been trending downwards over an extended period, which helps explain why so many of these economies have long seemed moribund despite the increasing use of financial manipulation to present a semblance of continuing “growth”.

This might even make us feel some sympathy for politicians who feel obliged to offer voters “growth” when, on the only criterion that really matters – prosperity – growth has ceased to be feasible.

In the EM (emerging market) countries, prosperity growth was already, pre-pandemic, decelerating markedly towards an inflection point anticipated by SEEDS to occur between 2020 and 2022. This climacteric may have been brought forward by the coronavirus crisis.  

Fig. 4: ECoE and prosperity

Equation #6: economics and the environment

Though global temperature changes (and their causation) remain to a certain extent controversial, broader consideration, taking into account issues such as ecological loss and air quality, make it clear that human activity is harming the environment. By ‘activity’, of course, is meant the use of energy, and it’s surely obvious that we can only co-relate economic and environmental considerations if we place energy use in its proper place as the factor common to both.

Artificially-inflated measurement, such as recorded GDP, not only exaggerates apparent prosperity, but also supplies false comfort over environmental trends. As shown by a comparison of the period between 1999 and 2019 on a global basis, the false metric of GDP can be, and often is, used to assert that we are increasing the quantities of economic value achieved for each tonne of climate-harming CO² emitted into the atmosphere. Rebased to a C-GDP basis, however, it becomes apparent that CO² emissions have expanded by 48% whilst underlying economic output has increased by only 40%.

Moreover, rising ECoEs are worsening the relationship between prosperity and environmental harm. Critically, CO² emissions are related to gross amounts of energy used (including ECoE), whereas net amounts (excluding ECoE) determine prosperity.         

 Fig. 5: The environmental dimension

Equation #7: deviation from the real

The final mapping equation – in fact, a set of equations – cross-references the economy as it is to the version of the situation as it is presented to us.

Essentially, two components intervene between underlying prosperity and the version presented to the public as GDP. The first of these is ECoE, which conventional econometrics ignores. The second is the credit effect which arises where monetary policies are used to promote anticipatory activity, and to inflate the apparent value of asset-related transactions (as well as inflating asset values themselves).

SEEDS analysis enables us to quantify these distortions, and this, amongst other things, helps us to identify the adverse leverage in the mechanisms by which faltering prosperity is represented as expanding output.

From a purist perspective, this is something that we might ignore, concentrating our efforts on the identification of the ‘fact’ of prosperity.

In practical terms, however, this disparity is of the greatest importance, because it identifies the widening gap between semblance and substance.  

For anyone engaged in economic planning – whether in government, in business or in finance and investment – it can be argued that this is the most important equation of them all.

Fig. 6: reality and presentation

#180. In search of competitive edge

LOGIC, ‘CONTINUITY BIAS’ AND THE BALANCE OF IMPROBABILITIES

Those of us who understand the economy as an energy system know that fundamental change, long overdue, is being crystallised by the coronavirus crisis. Can that knowledge be the basis for establishing ‘competitive edge’?

The conclusion here is that it can, but realising this requires more than just knowing the difference between the logical (energy-driven) and the accepted-but-illogical (wholly financial) ways of interpreting the economy. We also need to recognise the ways in which continuity bias and extrapolation inhibit the application of logic and knowledge.  

This understanding reveals scenarios which, whilst they may appear improbable, are far more plausible than consensus lines of thinking which have become impossible.

Government – right by default?

It’s been well said that governments will “always do the right thing, after exhausting all other possibilities first”.

The Wuhan coronavirus crisis illustrates this axiom to good effect. For many years, scientists have warned (a) that the world is likely to experience some kind of viral pandemic, and (b) that no country would be able to counter such an outbreak unless it closed its borders to international travel until such time as the virus had been eliminated globally. In other words, no amount of lockdown or physical [“social”] distancing is going to work, if the virus can simply return on the next inbound flight.

Governments are under all sorts of conflicting pressures, so their reluctance to follow this logic is, perhaps, understandable. But this interpretation seems vindicated – certainly in Europe, and probably elsewhere – by a sequence in which the re-opening of passenger flights has been followed by “second waves” of infection.

Unless we’re prepared to assume the early development of a vaccine which is effective, safe and trusted by the public, then, it seems prudent to anticipate that the coronavirus is going to turn out to be a process rather than an event. Governments are likely to act when the gravity of the situation compels them to do so, but are equally likely, as soon as the situation eases, to roll back, prematurely, on unpopular policies.

Inferences of process

If we understand the pandemic as ‘a process rather than an event’, certain economic and financial inferences can be drawn from this conclusion. Equally important, though, is the evidence of what we might call a ‘continuity bias’ at work. There is, in a strictly non-political sense, a conservatism which impels organisations and individuals to lean towards continuity, not just in their expectations, but in their decisions, too.

This ‘continuity bias’ opens up a disconnect between perception and reality, and anyone seeking to progress – in the realms of ideas, of politics or of business – can benefit from a recognition of the way in which ‘continuity bias’ creates ‘perception deficiency’.

One aspect of this process is a susceptibility to extrapolation, the assumption that the future must be a continuation of the recent past. If, for example, the price of, or demand for, something has risen by X% over, say, the past ten years, the tendency is to assume that it must rise by a further X% over the next ten years. This extrapolatory assumption can be called ‘the fools’ guideline’, in that it blinds us to the possibility (and, under certain conditions, the probability) of a fundamental change of direction, even when logical examination ought to persuade us that fundamental change is likely.

Dynamic interpretation

As regular readers will know, the general thesis followed here is that infinite growth is implausible in an economy governed by a physical energy dynamic. We can, indeed, go further than this. We can (and without being guilty of unjustified extrapolation) compare (a) the trend in the rate at which energy is converted into economic value, with (b) the trend rate at which the ECoE (energy cost of energy) deduction from this value is increasing.

And, since the supply of energy is itself determined by a relationship between value and cost, we can also develop pretty good visibility on future trends in the quantum of energy supply.

What this means is that a per-unit progression of energy value (V minus ECoE) can be applied to a linked projection of quantity (Q) to produce an equation which interprets and predicts trends in the aggregate supply of economic value.

If the present position is termed ‘point zero’, we can then look either forwards (to points +1, +2, +3 and so on) or backwards (points -1, -2, -3). The value of forward visibility will be obvious, but backwards visibility can be of at least equal importance, because it can tell us the extent to which current interpretations of direction and value are mistaken.

Competitive edge

If our aim is to identify competitive edge, the best way to do this is likely to involve triangulating (a) accurate fundamental analysis, (b) prevalent false perceptions of current value, and (c) the effects of ‘continuity bias’.

Here’s an example of how, in the near future, such an equation might function.

We know that the Wuhan coronavirus pandemic has involved the provision of support for household and business incomes, together with the deferral of various household and business expenses (such as interest and rent payments). We can put these together mathematically to calculate a progression of fiscal shortfalls, and we can further postulate a point at which this progression becomes critical, requiring, perhaps, state ‘rescues’ of embattled lenders and landlords, and/or central bank money creation to support these initiatives.

This much, though, can be done by anyone, provided he or she has access to the numbers and the methodology required to calculate this progression. Accordingly, it does not, of itself, constitute ‘competitive edge’, other than in relation to those who are unable to carry out these same calculations.

This is where the equation of energy value, false perceptions of value and ‘continuity bias’ comes into play. The person who can calculate a fiscal progression with reasonable accuracy can be led astray by referencing this to a false perception of where the economy really is now, and where it can be expected to go in the future. Competitive edge arises when the background to this progression can be calibrated correctly.

More broadly, the ‘generality’ – governments, businesses, investors and the general public – has perceptions of how the economy has got to where it is and of where it will progress from here, and accepts current valuations imputed by these trends, all of which are mistaken.

These ‘mistaken perceptions of the generality’ define a situation of risk and opportunity. If, for example, you were in business, the ability to draw on accurate interpretation, plus your understanding of others’ extrapolation and ‘continuity bias’, would tell you to invest in certain areas, to divest from others, to buy certain undervalued assets and to sell some overvalued ones, to alter your slate of products and services, and to change your methods and practises in ways recommended by economic and financial knowledge not available to your competitors.

Without, of course, straying into investment specifics, it will be obvious that assets are priced in relation to current appreciations and forward expectations, both of which are founded in these same ‘mistaken perceptions of the generality’. 

On the road – theory in practice

From what we might term a ‘top-down’ standpoint, we can observe that a prior belief in ‘a future of more’ has, under pressure of circumstances, segued into ‘a certainty of recovery’. Some examples of this mindset are instructive, not because they are ‘right’, or even because they were ‘wrong before’, but because they ‘remain wrong now’.

Future sales of vehicles are an interesting example. As of 2018, there were 1,130 million cars on the world’s roads, and 236 million commercial vehicles. The consensus view, as of 2019, was that these numbers would, by 2040, have risen to about 1,970 million cars (+74%) and 460 million commercial vehicles (+94%). This view has been maintained despite evidence that sales of both classes of vehicles had started to deteriorate during 2018. The overall perception was (and probably still is) that the numbers of vehicles of all types was set to increase by 1.06 billion units (+77%) by 2040.

Under current, extreme circumstances, of course, sales of cars and commercial vehicles have slumped. Rationally, you might ask (a) whether pre-existing adverse probabilities have been crystallised by the crisis, and (b) whether consensus longer-term expectations are being invalidated.

What seems actually to be happening, though, is that the question has become, not ‘was our prior expectation wrong?’, but ‘how long will it take to get back on track?’. We should be clear that this latter question is based on assumption, not on logic.

Finding the ‘right’ answer to such questions is very far from being purely theoretical. It would have a critical bearing on your current actions and your future plans, if you manufacture vehicles or components, if you supply materials for these processes, or if you’re a government trying to plan forward infrastructure investments. If you’re an environmental campaigner, or an advocate of conversion from internal combustion (ICE) to electric vehicles (EVs), these issues are fundamental to how you frame and conduct your current activities.

Understanding of energy-economic principles would, in this instance, already have told you that ‘77% more vehicles’ was an implausible outcome. That in turn would provide a valid point of reference for the effects of the current crisis.  

It would, in other words, give you a competitive edge.

Flying blind – of aviation and technology

A second and a third instance are provided by aviation and technology.

In the former instance, the pre-crisis consensus – welcomed by the industry, disliked by environmentalists, but seemingly accepted by almost everyone, and used as a planning assumption by governments – was that passenger flights would increase by roughly 90% between 2018 and 2040. The coronavirus crisis has inflicted huge damage to the sector, but the ‘continuity bias’ assumption seems now to be that the prior trajectory will be restored, and that a worst-case scenario is the likelihood of a lengthy delay in returning to that prior trajectory.

It seems to be accepted that the duration of a recovery may be protracted, given the unknowns around travel restrictions and customer caution, but it also seems that no consideration is being given to the possibility that the prior (upwards) trajectory might not be restored at all.   

A third and final example is provided by the assumption that the future will comprise ever more technology, ranging from more ‘big data’, more AI and more gadgets to self-driving cars and ever-increasing industrial automation. Downturns in sales of smartphones, chips and electronic components, again dating from 2018, seem to have been dismissed as aberrational ‘noise’ around a robustly, indeed an unquestionably upwards trend.

Once again, energy-based interpretation of the economy suggests that this is a combination of ‘continuity bias’ and unquestioned extrapolation, seemingly at very considerable variance from economic probability.

Stated at its simplest, if consumers become poorer, and rebalance their priorities accordingly, whilst businesses emphasise cost control and concentrate on simplification, the balance of probability swings against the assumed future of unending automation.

The ‘improbable’ versus the ‘impossible’

Many more examples could be cited, but let’s finish by applying an acid test to these questions.

If you believe in ‘a future of more’ (more cars, more flights, more automation and so on) – or are persuaded by the theory that we will witness a ‘recovery’ (of whatever duration) back to the prior growth trajectory – then it follows that the economy of the future is going to need more energy than the economy of the present.

On this basis, expert forecasters have projected global primary energy supply rising by 18% between 2019 and 2040, adding roughly 2,500 mmtoe to our annual requirement. The experts think they can find just over 70% of this required increase from a combination of nuclear, hydro and the various forms of renewable energy (RE). This leaves them (and us) needing an extra 720 mmtoe or so from fossil fuel (FF) sources. It’s assumed, not only that this can be found, but that doing so will increase annual emissions of climate-harming CO² from 34.2 million tonnes in 2019 to about 38.4 mmt by 2040.   

Meeting the required increment to fossil fuel supply means that, comparing 2040 with 2019, we’ll be using roughly 11% more oil, at least 30% more gas and roughly the same amount of coal. If you look realistically at the state of the FF industries, though, you can see that any such expectations are pretty implausible, not least because the delivery of such gains would require price increases that would move far beyond the affordable.

Here, then, is the conundrum. Meeting assumed economic needs in the future requires quantities of oil, gas and coal whose provision seems implausible. Faced with this, do we conclude (a) that we’ll somehow ‘find a way’ to supply this much additional energy, or (b) that the foundation growth assumption might itself be wrong?

That the experts are wrong about the size of the future economy may seem improbable, but logic suggests that supplying the required amount of additional fossil fuel energy looks very nearly impossible.

In this situation, we could do worse than reflect on the axiom of Sherlock Holmes – “[w]hen you have eliminated the impossible, whatever remains, however improbable, must be the truth”. 

#179. Penny plain, tuppence coloured

“THE FUTURE’S NOT WHAT IT USED TO BE”

In a wonderfully entertaining and informative book about ‘sea lore’ published in 1935, Cyril Benstead referenced the observation that “[t]he weaknesses of mankind are generally accentuated under strange and unaccustomed conditions”.

The conditions brought about by the Wuhan coronavirus pandemic certainly qualify as “strange and unaccustomed”, and many of the “weaknesses of mankind” have indeed been accentuated by it. Whilst some countries have, of course, responded to the crisis in a pretty rational way, many more seem to have thrown reason to the winds. “Muddle through” is never much of a strategy, and a best guess at this point is that, whilst some countries will ‘get away with it’, others will not.

As you may know, there are many reasons why the coming autumn is likely to be a particularly testing time and, if there’s something that we need more than anything else at this point, that something is clarity. The thinking here is that, if a storm does indeed break in the coming months, we need to have a solid framework of understanding in place before it does. That’s why so much urgent effort has been put into completing incorporation of ‘the Wuhan effect’ into the SEEDS model.

What follows, then, is emphatically a “penny plain”, rather than a “tuppence coloured”, review of the economic and broader situation, set out during what may well turn out to have been “the lull before the storm”.

The material, immaterially considered

Clarity begins with the observation – familiar to regular readers, but so fundamental as to merit restatement – that the conventional or ‘consensus’ interpretation of economic processes is profoundly mistaken. This interpretation can be encapsulated in the statement that the economy is ‘a monetary system, capable of infinite growth’.

This, of course, is nonsense, in both particulars. Money is simply a human artefact, lacking intrinsic worth, and commanding value only as a ‘claim’ on the goods and services which constitute the economy. Literally all of these goods and services are products of the use of energy.

The process by which energy is applied to the creation of material prosperity is governed by an equation based on the interrelationship between (a) the aggregate value provided by energy, and (b) the proportion of that value which is consumed in the access process (and is, therefore, not available for any other economic purpose). Just as there are finite resources, not of energy itself but of energy value, so there are limits to the ability of the environment to tolerate some forms of energy use.

If, as is surely obvious, the economy is a material system, based on energy, we can only indulge in self-delusion if we carry on insisting that it’s an immaterial system, based on the human artefact of money. Money itself is worthy of study, whether mathematically or behaviourally, so long as we never confuse the study of money with the study of the economy. The laws and lore of cricket, likewise, may be a rewarding study, but they won’t enable you to understand a game of baseball.

If the economy isn’t, after all, the ‘monetary system, capable of infinite growth’ that it is so widely assumed to be, then two further observations necessarily follow.

The first is that policies based on this false assumption cannot be effective.

The second is that models reflecting this same false assumption cannot work.

The cartographer’s dilemma

These considerations mean that leadership, whether in government or in business, has spent a long time following a wholly false cartography, and continues to do so at a time when a soundly-based understanding of circumstances has become absolutely imperative.

If you were using a mistaken map to traverse an unfamiliar terrain, you would soon start to notice a progressive divergence between the map in your hand and the geographical features in front of your eyes. If you were sufficiently determined to insist that your map was accurate, in the face of accumulating evidence to the contrary, you would have to start inventing some increasingly surreal explanations, along the lines that ‘the river that I’ve just encountered must be a figment of the imagination, or a trick of the light, because it’s not shown on the map!’ 

The divergence between the ‘map’ of conventional economics and the ‘terrain’ of an energy-determined economy has indeed been progressive, because of the way in which the critical energy cost of energy (ECoE) has increased. Back in, say, 1990, when trend ECoE was 2.7%, a failure to incorporate it into interpretation might not be noticed if the accepted margin of error was, for instance, 3%. By 2000, though, with ECoE now at 4.1%, compounding errors had reached a point at which explanations such as ‘normal margin of error’ could no longer suffice.

This example has been chosen advisedly, because the decade between 1990 and 2000 spans the period in which followers of conventional interpretation began to notice – though they could not, of course, explain – a seemingly-baffling phenomenon which they labelled “secular stagnation”. Simply put, the economy of the 1990s started to diverge from expectations because ECoE, the critical factor omitted from those expectations, had now become large enough to matter.   

By the point in the 1990s when the false cartography of conventional interpretation began to take its users seriously off course, economic conditions in the advanced economies of the West were already nearing a critical point.

SEEDS analysis indicates that prior growth in the prosperity of Western economies goes into reverse at ECoEs of between 3.5% and 5.0%. The sixteen-country advanced economies group (AE-16) modelled by SEEDS entered this critical zone in 1995, when their weighted ECoE reached 3.5%, and reached the upward extremity of this range in 2003, at an ECoE of 5%. By then, the prosperity of almost all Western economies was past, at, or very near its downwards inflexion point. Between 1997 and 2007, per capita prosperity in all but one of these sixteen countries turned downwards.

This makes it no coincidence at all that ‘credit adventurism’ – adopted as a ‘false fix’ for the misunderstood onset of “secular stagnation” – was in full swing by 2000. This in turn meant that the global financial crisis (GFC), which hit the economy in 2008-09, had already been hard-wired into the system for at least a decade.

In fact, economic and financial developments had already taken on an internal momentum which has led us to where we are now.

Once the GFC struck, of course, a resort to ‘monetary adventurism’ became a foregone conclusion. This wasn’t so much a case of ‘when things get serious, you have to lie’ as of ‘when things get this bad, you have to crank up the self-delusion’.

As compounding monetary gimmickry has progressed, the economy has taken on increasingly surreal characteristics. These include paying people to borrow (which is what negative real interest rates mean), zombification of much of the corporate sector, and forlorn efforts to operate a ‘capitalist’ system without positive returns on capital. We could, of course, add numerous examples of the economically, the financially and the politically bizarre to this ‘list of the surreal’.

The inner life of figments

Returning to our cartographic analogy, these surreal characteristics are the economic equivalents of the ‘figment of the imagination’ and ‘trick of the light’ excuses adopted by the person determined to explain away the widening divergence between the real terrain in front of him and the false map in whose veracity he is committed to believe.

If you’ve been visiting this site for any length of time, some of the statistical characteristics of this divergence from rationality and reality will be familiar, so a brief recap will suffice.

Between 1999 and 2019, “growth” of 3.5% in world GDP was achieved only by annual borrowing averaging 9.4% of GDP. Each $1 of recorded “growth” was accompanied by $2.70 in net new debt. Stripping out this effect to identify underlying or ‘clean’ output – in SEEDS terminology, C-GDP – reveals that trend growth since 1999 has been only 1.7%, not 3.5%, and that fully 62% ($44tn) of the $72tn of global “growth” recorded since then has been purely cosmetic.

These trends – including the ‘wedge’ driven between GDP and underlying output by the divergence between GDP and debt – are illustrated in the following charts.

Some observers have used the term ‘Ponzi’ to describe these economic trends, though ‘compounding distortion’ might be a more polite way of expressing it. Either way, this sort of progression is entirely dependent on the continuity that alone enables the sleight of hand to deceive the eye.

The real meaning of the coronavirus crisis is that it has severed this all-important continuity.

If we carry on uninterruptedly pouring credit into the economy, and if this activity carries on creating an illusion of “growth”, then we may easily be lulled into an acceptance that what we’re experiencing is “normal”.

We only learn otherwise when, in the old phrase, “the music stops”, which is exactly what has now happened.     

Provided that we’re using energy-based interpretation of the economy – and have freed ourselves from the shackles of mistaken consensus paradigms – then the immediate outlook should be subject to a reasonably high level of visibility.

Critically, a genuine ‘v-shaped recovery’ can’t happen, because you cannot ‘recover’ a situation that didn’t really exist in the first place. The authorities can – and probably will – create a simulacrum of ‘recovery’, by pouring yet more newly-created liquidity into the system. They’re already doing this, of course, by monetising a large proportion of the deficit financing that has been used to support incomes during the first six months or so of the pandemic.

As well as providing support in the form of income replacement, though, governments have also operated policies of deferral, giving interest and rent ‘holidays’ to households and businesses. Though lenders in the United States have been allowed to book non-payments as ‘revenue’ – whilst various jurisdictions have adopted some pretty odd definitions of unemployment, and of rent and debt arrears – nothing can take away the real and extreme strains that these deferral programmes are inflicting on lenders and landlords.

This makes it likely that, probably by early autumn, the need for rescues will force governments into massive interventions, of which the almost inescapable corollary will be the indulgence in monetisation (through money creation) on a gargantuan scale.

Let’s put it like this. If governments were to take away rent and debt ‘holidays’, and to cease supporting the incomes of people idled by the crisis, they would not only inflict grave hardship on huge numbers of people, and destroy very large numbers of businesses, but would also deal a huge blow to demand in the economy.

On the other hand, though, if governments carry on providing this ‘support and deferral’, they will rapidly exhaust the resources of lenders and landlords, forcing the authorities into rescues that would certainly involve enormous levels of government borrowing, and very probably lead to correspondingly enormous exercises in monetisation.

This means that we can be pretty sure that the real test of monetary efficacy – and the corresponding challenge to monetary credibility – is likely to occur in the coming months.  

At the same time, government interventions are supporting demand whilst supply cannot be similarly supported. This implies that the prices of consumer essentials can be expected to rise, with the reverse happening to the prices of non-essential or discretionary purchases. The balance of probability strongly favours inflation over deflation, and the authorities might even be tempted to make a virtue of a necessity, recognising that the ‘soft default’ of inflation is the only way out of existentially dangerous levels of debt accumulated by years of ‘trying to get a quart of economic “growth” out of a pint pot of surplus energy value’.                 

Lost futures, contrarian opportunities?

Returning to the false cartography of mistaken economic interpretation, we find ourselves at a point where governments and businesses alike are planning for a future that isn’t going to happen.

In the words of the song, “the future’s not what it used to be”.

Until now, it’s been widely assumed that we could place unquestioning faith in a never-ending ‘future of more’ – more prosperity, more sales of every kind of service and every sort of gadget, more technology, more profits, more leisure, more flights, more use of energy and, on the downside, more environmental degradation. This delusion probably still governs the thoughts of decision-makers.  

Governments, for instance, are probably continuing to assume that the restoration of some kind of ‘normality’ will rehabilitate revenue streams to prior rates of increase, whereas the reality is that revenue-raising was already starting to exceed the prosperity resources of taxpayers. This is illustrated in the following charts which, in the central diagram, reference taxation in the advanced economies (AE-16) to prosperity, rather than simply to the misleading benchmark of GDP. In 2019, taxation may have accounted for ‘only’ 37% of the GDP of these sixteen countries, but it was already absorbing 50% of their citizens’ aggregate prosperity.

The right-hand chart illustrates how over-estimates of the affordability of taxation are likely to apply a tightening (and a very unpopular) squeeze to disposable, ‘left in your pocket’ prosperity, with adverse implications for anyone providing goods or services which the customer might want, but which he or she doesn’t actually need.

Some of the most cherished policies of many governments and parties, meanwhile, are likely to be pushed aside by a new popular concentration on economic issues, including voters’ concerns about their incomes, the cost of living and their economic security. Neither can we discount the possibility that profound hardship in various parts of the world will set up very large migration flows, something which, if it does happen, is going to have a significant impact on the political dialogue in many Western countries.

What this means is that the strains, not just on governments’ material resources, but upon their resources of judgement and wisdom as well, are going to intensify. Some governments’ escalating fiscal deficits seem already to be well on the way to being matched by competence deficits. It’s no coincidence at all that international tensions and suspicion seem to be increasing, or that some parts of some governments are already proving woefully inept. Political leaders surely need to rise above their preconceptions, and above partisan points-scoring – and doing this is even harder when your economic maps are turning out to be wrong.   

Even in extremis, it’s highly unlikely that governments will undergo a Damascene conversion to an energy-based interpretation of economic reality. To be quite blunt about this, any attempt to persuade them otherwise would probably be a waste of effort, conforming to the proverb which says that “he who washes his ass’s ears wastes both his time and his soap”.

For those of us who understand the energy basis of economics and finance, the wise course of action now seems to involve intellectual and interpretative preparedness; a willingness to put our interpretation at the disposal of those committed to limiting environmental degradation; and keeping a weather eye for the opportunities which fundamental, widely-misunderstood change almost invariably provides.     

#178. The Ides of Autumn

SEEDS, STAGFLATION AND CRASH RISK

For anyone involved in economic interpretation, these are hectic times. They’re frustrating times, too, for those of us who understand that the economy is an energy system, but have to watch from the sidelines as huge mistakes are made on the false premise that economics is ‘the study of money’, and that energy is ‘just another input’.

Latest developments with the SEEDS model add to this frustration, because it’s becoming clear that energy-based interpretation can identify definite trends in the relationships between energy use, economic output, ECoE (the energy cost of energy), prosperity and climate-harming emissions. Cutting to the chase on this, the efficiency with which we convert energy into economic value is improving, but only very slowly, whilst the countervailing, adverse trend in ECoEs (which determine the relationship between output and prosperity) is developing more rapidly.

Where observing our decision-makers and their advisers is concerned, we’re in much the same position as the soldiers who “would follow their commanding officer anywhere, but only out of a sense of morbid curiosity”. Essentially, policy-makers who’ve long been following the false cartography of ‘conventional’ economics have now encountered a huge hazard that simply isn’t depicted on their maps.

Having used SEEDS to scope out the general shape of the economy during and (hopefully) after the Wuhan coronavirus pandemic, there seem to be two questions of highest immediate priority. The first is whether the crisis will usher in an era of recessionary deflation or monetarily-triggered inflation, and the second concerns the likelihood of a near-term ‘GFC II’ sequel to the global financial crisis (GFC) of 2008.

On the latter, it’s becoming ever harder to see any way in which a crash (which has been long in the making anyway) can be averted. Indeed, it could be upon us within months. The ‘inflation or deflation?’ question is more complicated, because it needs to be seen within drastic structural changes now taking place in the economy.

Let’s start with how governments have responded to the economic effects of the pandemic. The ‘standard model’ has involved a two-pronged response, because the crisis has posed two classes of threat to the system. The first is an interruption to the incomes of people and businesses idled by lockdowns, and the second is that households could be rendered homeless, and otherwise-viable enterprises put out of business, by a temporary inability to keep up with payment of interest and rent.

Accordingly, governments have responded with policies which are termed here support and deferral. ‘Support’ has meant replacing incomes, albeit in part, by running enormous fiscal deficits, which, in the jargon, means injecting fiscal stimulus on an unprecedented scale. ‘Deferral’ has been carried out by providing payment ‘holidays’ for borrowers and tenants.

Neither of these responses is remotely sustainable for more than a few months, but there’s a difference between them in terms of timescales. Whereas support has to be (and has been) provided now, deferral pushes problems forward to that point in the near future at which lenders and landlords can no longer survive the effects of the payment ‘holidays’ granted to household and business borrowers and tenants.

The most pressing risk now is that the need to exit ‘deferral’ will arrive before the provision of ‘support’ has ceased to be necessary. We can think of this as a vector pointing towards the near future.

In the United States, for example, unemployment payments are being reduced, and payment ‘holidays’ are being terminated, precisely because of the vector which these converging policy responses create. Simply put, government cannot afford to continue income support indefinitely, whilst payment ‘holidays’ are already posing grave risks to the survival of counterparties (lenders and landlords) – and this triangulation is just as much of a problem in other countries as it is in America.

Unfortunately, the gobbledegook of ‘conventional’ economics acts to disguise how serious our economic plight really is. For example, British GDP was reported to have deteriorated by ‘only’ (in the circumstances) 20% in April, because an underlying deterioration (of close to 50%) was offset by the injection of £48bn borrowed by the government. Whilst a further £55bn borrowed in May took the total increase in government debt to £103bn, the Bank of England, in parallel, created a very similar (and by no means coincidentally so) £100bn of new money with which to purchase pre-existing government debt.

In other words – and across much of the world, not just in Britain – central banks are monetising the stimulus being injected into the economy by governments. All other things being equal, too much of this would pose a threat to the credibility and the purchasing power of fiat currencies. It’s not quite that simple, of course – and all other things aren’t equal – but it would be folly to dismiss this very real potential hazard.

The effects of these processes on the ‘real’ economy of goods and services are instructive. Where household essentials are concerned, demand has been sustained (by income support), but supply has been reduced by lockdowns. What this has meant is that the prices of household essentials have started moving up, at rates that would appear to have annualised equivalents of roughly 8%. This, incidentally, has been happening even though energy prices have slumped. What’s driving inflation in the ‘essentials’ category is the divergence between supply (impacted by lockdowns) and demand (supported by governments).

Where discretionary (non-essential) purchases are concerned, an opposite trend has set in. Consumers’ incomes, though supported by governments, are nevertheless lower than they were before the crisis, meaning that demand for discretionaries has fallen. This has been compounded by consumer caution, caused in part by fear and uncertainty, but also by impaired incomes, rising debts and diminished savings. Similar trends are visible amongst businesses which, much like consumers, are continuing to spend on things that they must have, but are slashing their expenditures (including their investment) on anything discretionary or, to put it colloquially, ‘optional’.

These trends are going to have profound consequences, not just for the economy, but for businesses in the favoured and unfavoured sectors, a theme to which we might return at a later time, because it also feeds into the broader issue of what “de-growth” is going to mean for business.

With the cost of essentials rising whilst the prices of discretionaries are falling, broad inflation has remained at or close to zero, but these are early days in a fast-changing situation. Whilst the statisticians are still-playing catch-up, the ordinary person probably already knows that the cost of essentials is rising, whilst his or her reduced spending on discretionaries might serve to disguise the countervailing falls in their prices.

Where the slightly longer-term is concerned, one school of thought contends that prolonged recession will induce deflation, whilst another states that monetary intervention is likely, on the contrary, to trigger rising inflation.

Those who are dovish on the issue point out that the extensive use of newly-created QE money back in 2008-09 did not promote inflation, though that argument is weakened if we include asset prices, and not just consumer purchases, in our definition of inflation.

The essence of the dovish case is that money injected into asset markets can be ‘sanitised’, such that it doesn’t ‘leak’ into the broader economy.  There is some justification for this view, because asset aggregates are purely notional values – whilst the investor can sell his stock portfolio, or the homeowner his house, the entirety of these asset classes can never be monetised, because the only potential buyers of, say, a nation’s housing stock are the same people to whom that stock already belongs. When ‘valuations’ are placed on the entirety of an asset class, what’s really happening is that marginal transaction prices are being applied to produce an aggregate valuation, even though the asset class could never be sold in its entirety.

In practical terms, this limits the ability of investors to ‘pull their money out’, because they can only do this by finding other investors willing to buy. It also leverages intervention, such that, for instance, the value of an asset class may be increased by a large amount (or a fall of that magnitude prevented) by a comparatively small intervention at the margin, especially where the psychology of intervention has deterred potential sellers.

Where inflationary consequences are concerned, though, these are matters of degree. Back in the GFC, the four main Western central banks (the Fed, the ECB, the BoJ and the BoE) increased their assets by $3.2tn between July 2007 ($3.55tn) and December 2008 ($6.73tn). In the space of just four months between February and June this year, these central banks spent $5.6tn, a larger sum even when allowance is made for the changing values of money.

To be clear, asset purchases thus far have not been enough to shake confidence in currencies. Neither $230bn of purchases by the Bank of England, $590bn spent by the Bank of Japan, or even the $1.85 tn injected by the European Central Bank, is a large enough sum to put currency credibility at risk. The Fed, meanwhile, having spent $2.94tn between February and May, pulled its horns in slightly during June, reducing net purchases thus far to $2.89tn.

To draw comfort from these numbers, though, would be to reckon without a number of other significant factors. One of these is that economic activity is falling much more rapidly now than it did back in the GFC, even though the extent of this fall is being disguised by the effects of fiscal stimulus. Whilst reported global GDP might decrease by about 11% this year, SEEDS calculations suggest that the slump in underlying or ‘clean’ economic output (C-GDP) is likely to be around 17%, and could be worse than that.

Secondly, and more significantly, there is a clear danger that the monetisation of borrowing may come to be seen as a ‘new normal’ (though, of course, a new abnormal would describe it better). If the running of fiscal deficits, which are then monetised, ceases to be regarded as a temporary and emergency measure, and comes instead to be seen as standard practice, a very hefty knock will have been dealt to faith in currencies.

The third (and still worse) risk is something that we might term ‘the Ides of Autumn’. If governments have to keep on running deficits, and are still doing this at a point where deferral ‘holidays’ force them to bail out lenders and landlords, then we could enter wholly uncharted territory. Additionally, the Fed has taken upon itself the task of propping up asset markets, in theory just in the US but, in practice, around the world.

To put this in context, we need to think ahead to some future point, quite possibly in September or October, when things could well start to go horribly wrong. Governments and central banks, still supporting incomes through stimulus programmes, now have a choice to make. Do they stand back and watch lenders and landlords fail, accept a wave of massive defaults on household and business debt, and allow a crash in the prices of (for example) stocks and property?

The strong probability has to be that they would not sit back and just let these things happen. If to this is added the likelihood of permanent (or, at least, very long-lasting) falls in productive capacity, we have the ingredients for monetary intervention on a scale quite without precedent. To be sure, the Fed has pulled back from intervention in recent weeks, but we can by no means assume a continuation of such insouciance in a situation where banks are on the brink of failure, Wall Street is tumbling, property prices are slumping and borrowers are on the edge of mass default.

There are, then, very good reasons for drawing at least two inferences from the current situation. The first is that, in a reversal of what happened in 2008-09, a financial crash might very well follow (rather than precede) an economic slump. The second is that, faced with the frightening alternatives, central banks might decide that massive monetisation is ‘the lesser of two [very nasty] evils’.

To return to where we started, energy-driven interpretation reveals that the financial system, and policy more broadly, has been building a monster for at least twenty years. It is indeed ludicrous that people and businesses have been paid to borrow, by negative real rates, and by the narrative that the Fed and others will never let anyone pay the price of recklessness.  As ECoEs have risen, and prosperity growth has ceased and then started to go into reverse, policymakers have persuaded themselves that ‘growth in perpetuity’ can be sustained by ever-greater credit and monetary activism, and by an implicit declaration that the whole system is ‘too big to fail’. That trying to fix the ‘real’ economy with monetary gimmickry is akin to ‘trying to cure an ailing house-plant with a spanner’ seems never to have occurred to them. We may be very close to learning the price of ignorance and hubris.

 

 

#177. Poorer, angrier, riskier

MODELLING THE CRUNCH

It became clear from a pretty early stage that the Wuhan coronavirus pandemic was going to have profoundly adverse consequences for the world economy. This discussion uses SEEDS to evaluate the immediate and lasting implications of the crisis, some of which may be explored in more detail – and perhaps at a regional or national level – in later articles.

Whilst it reinforces the view that a “V-shaped” rebound is improbable, this evaluation warns that we should beware of any purely cosmetic “recovery”, particularly where (a) unemployment remains highly elevated (there is no such thing as a “jobless recovery”), and (b) where extraordinary (and high-risk) financial manipulation is used to create purely statistical increases in headline GDP.

The bottom line is that the prosperity of the world’s average person, having turned down in 2018, is now set to deteriorate more rapidly than had previously been anticipated.

Governments, which for the most part have yet to understand this dynamic, are likely inadvertently to worsen this situation by setting unrealistic revenue expectations based on the increasingly misleading metric of GDP, resulting in a tightening squeeze on the discretionary (“left in your pocket”) prosperity of the average person.

Exacerbated by crisis effects, the average person’s share of aggregate government, household and business debt is poised to rise even more rapidly than had hitherto been the case.

These projections are summarised in the first set of charts.

Fig. 1

#177 Fig 1 personal

Consequences

The implication of this scenario for governments is that revenue and expenditure projections need to be scaled back, and priorities re-calibrated, amidst increasing popular dissatisfaction.

Businesses will need to be aware of deteriorating scope for consumer discretionary spending, and could benefit from front-running some of the tendencies (such as simplification and de-layering) which are likely to characterise “de-growth”.

The environmental focus will need to shift from ‘big ticket’ initiatives to incremental gains.

Amidst unsustainably high fiscal deficits, and the extreme use of newly-created QE money to monetise existing government debt, we need also to be aware of the risk that, in a reversal of the 2008 global financial crisis (GFC) sequence, a financial crash might follow, rather than precede, a severe economic downturn.

Methodology – the three challenges

Regular readers will be familiar with the principles of the surplus energy interpretation of the economy, but anyone needing an introduction to Surplus Energy Economics and the SEEDS system can find a briefing paper at the resources page of this site. What follows reflects detailed application of the model to the conditions and trends to be expected after the coronavirus crisis.

Simply put, SEE understands the economy as an energy system, in which money, lacking intrinsic value, plays a subsidiary (though important) role as a medium of exchange. A critical factor in the calibration of prosperity is ECoE (the Energy Cost of Energy), which determines, from any given quantity of accessed energy, how much is consumed (‘lost’) in the access process, and how much (‘surplus’) energy remains to power all economic activities other than the supply of energy itself.

Critically, the depletion process has long been exerting upwards pressure on the ECoEs of fossil fuel (FF) energy, which continues to account for more than four-fifths of the energy used in the economy. The ECoEs of renewable energy (RE) alternatives have been falling, but are unlikely ever to become low enough to restore prosperity growth made possible in the past by low-cost supplies of oil, gas and coal.

Accordingly, global prosperity per capita has turned downwards, a trend which can be disguised (but cannot be countered) by various forms of financial manipulation.

This means that, long before the coronavirus pandemic, the onset of “de-growth” was one of three main problems threatening the economy and the financial system. The others are (b) the threat of environmental degradation – which will never be tackled effectively until the economy is understood as an energy system – and (c) the over-extension of the financial system which has resulted from prolonged, futile and increasingly desperate efforts to overcome the physical, material deterioration in the economy by immaterial and artificial (monetary) means.

On these latter issues, the slump in economic activity has had some beneficial impact on climate change metrics, whilst we can expect a crisis to occur in the financial system because its essential predicate – perpetual growth – has been invalidated. The global financial system has long since taken on Ponzi characteristics and, like all such schemes, is wholly dependent on a continuity that has now been lost.

Top-line aggregates

With these parameters understood, the critical economic issue can be defined as the rate of deterioration in prosperity, for which the main aggregate projections from SEEDS are set out in fig. 2. Throughout this report, unless otherwise noted, all amounts are stated in constant international dollars, converted from other currencies using the PPP (purchasing power parity) convention.

During the current year, world GDP is projected to fall by 13%, recovering thereafter at rates of between 3% and 3.5%. This rebound trajectory, though, assumes extraordinary levels of credit and monetary support, reflected, in part, in an accelerated rate of increase in global debt.

Within debt projections, the greatest uncertainties are (a) the possible extent of defaults in the household and corporate sectors, and (b) the degree to which central banks will monetise new government issuance by the backdoor route of using newly-created QE money to buy up existing debt obligations.

This is a point of extreme risk in the financial system, where a cascade of defaults – and/or a slump in the credibility and purchasing power of fiat currencies – are very real possibilities, particularly if the ‘standard model’ of crisis response starts to assume permanent characteristics.

Fig.2

#177 Fig. 2 aggregates

Looking behind the distorting effects of monetary intervention, it’s likely that underlying or ‘clean’ output (C-GDP) will fall by about 17% this year and, after some measure of rebound during 2021 and 2022, will revert to a rate of growth which, at barely 0.2%, is appreciably lower than the rate (of just over 1.0%) at which world population numbers continue to increase. Additionally, ECoEs can be expected to continue their upwards path, driving a widening wedge between C-GDP and prosperity.

These effects are illustrated in fig. 3, which highlights, as a pink triangular wedge, the way in which ever-looser monetary policies have inflated apparent GDP to levels far above the underlying trajectory. This is the element of claimed “growth” that would cease if credit expansion stalled, and would go into reverse in the event of deleveraging. The gap between C-GDP and prosperity, meanwhile, reflects the relentless rise of trend ECoEs. This interpretation, as set out in the left-hand chart, is contextualised by the inclusion of debt in the centre chart.

Fig. 3

#177 Fig. 3 chart aggregates

Fig. 3 also highlights, in the right-hand chart, a major problem that cannot be identified using ‘conventional’ methods of economic interpretation. Essentially, rapid increases in debt serve artificially to inflate recorded GDP, such that ratios which compare debt with GDP have an intrinsic bias to the downside during periods of rapid expansion in debt.

Rebasing the debt metric to prosperity – which is not distorted by credit expansion – indicates that the debt ratio already stands at just over 350% of economic output, compared with slightly under 220% on a conventional GDP denominator. As the authorities ramp up deficit support – and, quite conceivably, make private borrowing even easier and cheaper than it already is – the true scale of indebtedness will become progressively higher, thus measured, than it appears on conventional metrics.

Personal prosperity – a worsening trend

The per capita equivalents of these projections are set out in fig. 4, which expresses global averages in thousands of constant PPP dollars per person. After a sharp (-18%) fall anticipated during the current year, prosperity per capita is expected to recover only partially before resuming the decline pattern that has been in evidence since the ‘long plateau’ ended in 2018, and the world’s average person started getting poorer.

Meanwhile, each person’s share of the aggregate of government, household and business debt is set to rise markedly, not just in 2020 but in subsequent years. By 2025, whilst prosperity per capita is set to be 17% ($1,930) lower than it was last year, the average person’s debt is projected to have risen by nearly $17,900 (45%).

These, in short, are prosperity and debt metrics which are set to worsen very rapidly indeed. The world’s average person, currently carrying a debt share of $40,000 on annual prosperity of $11,400, is likely, within five years, to be trying to carry debt of $58,000 on prosperity of only $9,450.

This may simply be too much of a burden for the system to withstand. We face a conundrum, posed by deteriorating prosperity, in which either debt becomes excessive in relation to the carrying capability of global prosperity, and/or a resort to larger-scale monetisation undermines the credibility and purchasing power of fiat currencies.

Fig. 4

#177 Fig. 4 per capita table

In fig. 5 – which sets out some per capita metrics in chart form – another adverse trend becomes apparent. This is the fact that taxation per capita has continued to rise even whilst the average person’s prosperity has flattened off and, latterly, has turned down.

What this means is that the discretionary (“left in your pocket”) prosperity of the average person has become subject to a squeeze, with top-line prosperity falling whilst the burden of tax continues to increase.

Fig. 5

#177 Fig. 5 per capita chart

This also means that, in addition to deteriorating prosperity itself, there are two leveraging processes which are accelerating the erosion of consumers’ ability to make non-essential purchases.

The first of these is the way in which taxation is absorbing an increasing proportion of household prosperity, and the second is the rising share of remaining (discretionary) prosperity that has to be allocated to essential categories of expenditure.

These are not wholly new trends – and they help explain the pre-crisis slumps in the sales of non-essentials such as cars and smartphones – but one of the clearest effects of the crisis is to increase the downwards pressure on consumers’ non-essential expenditures.

Governments – the hidden problem

This has implications for any business selling goods and services to the consumer, particularly where their product is non-essential. It also sets governments a fiscal problem of which most are, as yet, seemingly wholly unaware.

As can be seen in fig. 6, governments have, over an extended period, managed to slightly more than double tax revenues whilst maintaining the overall incidence of taxation at a remarkably consistent level of about 31% of GDP.

This has led them to conclude that the burden of taxation has not increased materially, even though their ability to fund public services has expanded at trend annual real rates of slightly over 3%. When – as has happened in France – the public expresses anger over taxation, governments seem genuinely surprised by popular discontent.

The problem, of course, is that, over time, GDP has become an ever less meaningful quantification of prosperity. When reassessed on the denominator of prosperity, the tax incidence worldwide has risen from 32% in 1999, and 39% in 2009, to 51% last year (and is higher still in some countries). On current trajectories, the tax ‘take’ from global prosperity per capita would reach almost 70% by 2030, a level which the public are unlikely to find acceptable, especially in those high-tax economies where the incidence would be even higher.

Conversely, if (as in the right-hand chart in fig. 6) taxation was to be pegged at the 51% of prosperity averaged in 2019, the resulting ‘sustainable’ path would see taxation fall from an estimated $43tn last year to $38tn (at constant values) by 2030. At -12%, this may not seem a huge fall in fiscal resources, but it is fully 27% ($14tn) lower than where, on the current trajectory, tax revenues otherwise would have been.

Fig. 6

#177 Fig. 6 world tax

Politically, there seems little doubt that the widespread popular discontent witnessed in many parts of the world during the coronavirus crisis has links to deteriorating prosperity. Historically, clear connections can be drawn between social unrest and the related factors of (a) material hardship and (b) perceived inequity.

At the same time, the sharp deterioration in prosperity seems certain to exacerbate international tensions, where countries competing for dwindling prosperity may also seek confrontation as a distraction technique. These are amongst the reasons why a world that is becoming poorer is also becoming both angrier and more dangerous.

#176. Protect and Survive

THE AUTHORITIES’ ‘RACE AGAINST TIME’

Before we can assess the outlook for the economy after the Wuhan coronavirus pandemic, we need to be familiar with the measures adopted by the authorities to tackle the crisis itself. Whilst these measures themselves are reasonably well-known, it seems that some of the associated risks are by no means so clearly understood.

Critically, governments and central banks face an imprecise (but undoubtedly critical) time-deadline which, if missed, could create an extraordinarily hazardous combination of circumstances.

The ‘standard model’ response

The coronavirus crisis, and the use of lockdowns in an effort to curb the spread of the virus, have posed two different challenges to the economy, and these have been met by two different types of response.

The more obvious and immediate impact has been the sharp fall in economic activity itself.

The second is the risk that households may lose their homes, and that otherwise-viable enterprises might be put out of business, by an inability to keep up with rent payments and debt servicing due to the temporary impairment of their incomes.

Official responses to these problems have involved, respectively, support and deferral.

Support has been provided by governments running extraordinary (and, in anything but the very short term, unsustainable) fiscal deficits in order to replace incomes, with these deficits essentially monetised by central banks’ use of newly-created QE money to acquire pre-existing government debt. The alternative, of course, would be for central banks to sit this out, and let government debts soar, but monetisation seems to have been judged, perhaps correctly, as the lesser of two evils.

Deferral, meanwhile, has taken the form of rent, debt and interest ‘holidays’, whose effect is to push such costs out into the future.

Fiscal support programmes are exemplified by the British situation, in which a deficit of £48bn limited, to ‘only’ 20.4%, a decline in April GDP which would otherwise have been a slump of close to 50%. A further deficit of £55bn during May pushed the two-months’ total to £103bn, a number remarkably (and surely by no means coincidentally) similar to the £100bn of QE thus far undertaken by the Bank of England.

A time-constrained expedient

Though there have been variations around this theme – most notably in the United States, where the Fed seems to have attached inordinate importance to the prevention of slumps in asset prices – there has been an identifiable ‘standard model’ of responses which combines deficit-funded support for the economy with central bank monetisation of equivalent amounts of existing public debt. Over the course of three months, the three main Western central banks – the Fed, the ECB and the Bank of Japan – have increased their assets by $4.5 trillion, or 31%, a sum equivalent to 10.5% of their aggregate annual GDPs.

Essentially, and despite some variations in the types of assets purchased, this amounts to the back-door monetisation of the new debts incurred to support economic activity. Although Japan has been getting away with wholesale debt monetisation for many years, this process nevertheless carries very real risks. If markets, and indeed the general public, ever came to think that the monetisation of deficits had become the ‘new abnormal’, the credibility and purchasing power of fiat currencies would be put at very serious risk.

This risk most certainly should not be underestimated – after all, the $2.9tn of asset purchasing undertaken by the Fed between February and May equates, on an annualised basis, to 55% of American GDP, with the equivalent ratios for other areas being 39% in Japan, 32% in the Euro Area and 23% in Britain.

If any of these central banks actually did monetise debt at these ratios to GDP over a whole year, currency credibility would suffer grievous impairment.

A race against time

This ‘standard model’ of support response, then, is a time-constrained process, viable for a single quarter, and perhaps for as much as six months, but not for longer.

Meanwhile, there are obvious time constraints, too, on a deferral process which imposes income delays on counterparties such as lenders and landlords.

If all goes well, a reasonably rapid economic recovery will enable governments and central banks to scale back deficits and monetisation before this process risks impairing credibility. An optimistic scenario would postulate that, by the time that this normalization has been concluded, the authorities will also have worked out how to wind up the deferrals process in ways that protect households and businesses without imperilling landlords and lenders.

There is, though, an all-too-plausible alternative in which deficit support is still being provided at a point when deferral is no longer feasible. This is a ‘nightmare scenario’ in which, as well as continuing to monetise high levels of fiscal deficits, central banks also have to step in to rescue lenders and landlords.

Thus understood, governments and central bankers are engaged in a race against time. They cannot carry on monetising deficit support for more than a few months, and neither can they prolong rent and interest deferrals to the point where landlords and lenders are put at risk. This makes it all the more surprising (and disturbing) that some countries are acting in ways that seem almost to invite a crisis-prolonging “second wave” of coronavirus infections.

 

 

#175. The Surplus Energy Economy

AN INTRODUCTION

In response to the previous article, it was suggested that it would be helpful if we had a comprehensive statement, a sort of Surplus Energy Economics 101, for new readers. This makes a great deal of sense, particularly given how many people have joined the SEE readership since the last time the thesis was set out in this way. The plan is that the article which follows will be made available as a downloadable PDF in the near future.

The aim here is to encompass two themes in a single article. The first is the basic logic informing the Surplus Energy Economics approach. This builds on the long-established principle that the economy should be understood as an energy system, not a financial one.

The second is an evaluation of where we are today on the evolution of the economy as energy interpretation explains it. This makes extensive use of the Surplus Energy Economics Data System (SEEDS), which models the economy as an energy system.

PART ONE: PRINCIPLE

The best way to start is with the “trilogy of the blindingly obvious”. No-one new to the subject can go far wrong if they bear in mind these three principles.

1.1. The economy is energy

The first principle is that all forms of economic output – literally all of the goods and services which comprise the ‘real’ economy – are products of energy.

Nothing of any economic value or utility can be supplied without using energy. Energy can be defined as ‘a capacity for work’ and, historically, everything that we wanted or needed was produced using the labour (work) of humans and animals, plus some early application of the power of wind and water. That changed from the late 1700s, when we learned how to deploy the vast reserves of energy contained in fossil fuel (FF) deposits of coal, oil and natural gas.

There is an abundantly clear correlation between escalating use of energy and the massive increases in population numbers, and their economic means of support, since the late eighteenth century (see fig. 1).

It should be noted that other natural resources (such as foods and minerals) are energy products, too, since we can’t grow wheat, for example, or extract and process copper, without using energy to do so.

Fig. 1

175-1 Population & energy

1.2. Of cost and surplus

Second, whenever we access energy for our use, some of that energy is always consumed in the access process. We can’t drill an oil well, construct a refinery, build a gas pipeline, manufacture a wind turbine or a solar panel, or install a power distribution grid, without using energy, and neither can we operate or maintain them without it. The energy that is consumed in the supply of energy therefore comprises both a capital (investment) and an operating component.

This principle is central to the established concept of the Energy Return on Energy Invested (EROI or EROEI), in which the consumed, cost or invested component is stated as a ratio. In Surplus Energy Economics (SEE), the cost element is known as the Energy Cost of Energy or ECoE, and is stated as a percentage.

Understood in this way, any given quantity of energy divides into parts. One of these is the cost element, known here as ECoE. The other – whatever remains – is surplus energy. This surplus drives all economic activity other than the supply of energy itself. This makes surplus energy coterminous with prosperity.

We can, of course, use this surplus wisely or foolishly, and we can share it out fairly or inequitably. But what we can not do is to “de-couple” economic output from energy or, to be more specific about it, from surplus energy.

1.3. Money – only a claim

The third part of the “blindingly obvious” trilogy is that money acts only as a ‘claim’ on the output of the real (energy) economy. Money has no intrinsic worth, and has value only in terms of the things for which it can be exchanged. No amount of money – be it currency, gold or any other token – would be of any use whatsoever to somebody stranded in the desert, or cast adrift in a lifeboat.

PART TWO – APPLICATION

This, then, is how the economy works – we access energy (’losing’ some of it as a ‘cost’ in the process); we use what remains (the surplus) to produce goods and services; and we exchange these with each other using money.

Where, though, are we now, on the evolution of ‘surplus energy, prosperity and money’?

2.1. The short version

If you want a succinct answer to this question, it is that ECoE (the Energy Cost of Energy) is rising, relentlessly and exponentially. The exponential rate of increase in ECoE means that this cannot be cancelled out by linear increases in the aggregate amount of total or gross (pre-ECoE) energy that we can access. The resultant squeeze on surplus energy has been compounded by increasing numbers of people seeking to share the prosperity that this surplus provides.

As a result, prior growth in prosperity per person has gone into reverse. People have been getting poorer in most Western advanced economies (AEs) since the early 2000s. With the same fate now starting to overtake emerging market (EM) countries too, global prosperity has turned down. One way of describing this process is “de-growth”.

In recent times, we’ve tried to use financial gimmickry – credit and monetary adventurism – to counter this adverse trend. Since money acts simply as a claim on economic output generated by energy, this is wholly futile, and can be likened to “trying to fix an ailing house-plant with a spanner”. We’ve been piling up financial excess claims on prosperity at a rate that guarantees a crisis in the financial system. This crisis must take the form of value destruction, which may happen through ‘hard’ defaults, ‘soft’ inflationary destruction of the value of money, or some combination of both.

2.2. The ECoE process

The Energy Cost of Energy (ECoE) at any given time is a product of four factors or ‘drivers’. Each of these evolves gradually, so ECoEs need to be understood and applied as trends.

The first of these is geographic reach, and the second is economies of scale. Both of them push ECoEs downwards, and both can best be illustrated by reference to the petroleum industry.

Starting from its origins in the Pennsylvania of the 1850s, the oil industry spread across the globe in search of new, larger, lower-cost sources of production. At the same time, growth in the size of operations reduced unit costs by spreading the fixed costs of operations across a larger amount of oil produced, processed and delivered. Accordingly, the ECoE of petroleum supply fell steadily through the contributions of reach and scale.

The third ‘driver’, which pushes ECoEs upwards rather than downwards, is depletion. Quite logically, the most profitable (lowest cost) sources of any resource are accessed first, leaving less profitable (costlier) alternatives for later. As this process unfolds, ‘later’ arrives, with low-cost resources exhausted, and replaced by successively higher-cost alternatives. This is why depletion drives ECoEs upwards.

The four ECoE-determining factors – reach, scale, depletion and technology – can be put together in an illustrative parabola (fig. 2). In the early part of the sequence, ECoEs fall through the combined effects of reach and scale. As these drivers are exhausted, depletion takes over, forcing ECoEs back up again.

Fig. 2

175-2 Parabola 2

Technology helps to accelerate downwards trends in ECoEs in the early part of the parabola, and then acts to mitigate increases on the upswing. It’s extremely important that we don’t get the role and potential of technology out of context. Technological potential is always limited by the ‘envelope’ of the physical characteristics of the resource.

For example, advances in fracking techniques have reduced the costs of extracting shale oil to levels lower than the cost of producing that same resource at an earlier time. What this has not done is to turn shales into the economic equivalent of large, conventional oil fields in the sands of Arabia – technology, then, cannot overcome the differences in physical characteristics between these resources.

2.3. The irresistible rise in ECoEs        

As we’ve seen, the ECoEs of FFs have progressed along a historic parabola, and are now rising relentlessly. This trajectory is illustrated in fig. 3.

It must be stressed that the earlier part of the chart, shown as a dotted line, is simply illustrative – we don’t have enough data to know what ECoEs were in 1800, for example, or in 1900. We do, though, know enough about historical events, and about the processes involved, to have a pretty good general idea about where ECoEs were in earlier times. Evidence strongly suggests that a low-point – an ‘ECoE nadir’ – was reached in the two decades or so after 1945. This makes it wholly unsurprising – and not remotely coincidental – that this was a ‘golden age’ of growing prosperity.

Fig. 3

175-3 Long run ECoE NEW

Looking at this historically, it’s noteworthy how two factors, not one, favoured the development of the Industrial Economy through a very extended period. Just as ECoEs were falling (thanks to reach, scale and technology), so the total supply of FF energy was increasing as well. This meant that we enjoyed a ‘virtuous circle’ in which the supply of surplus (ex-ECoE) energy was rising more rapidly than the total (‘gross’) availability of energy.

The situation today, though, is that the reverse applies, with a ‘vicious circle’ rather than a virtuous one. Just as trend ECoEs are rising relentlessly, so our ability to carry on increasing the gross supply of energy is being undermined, not just by the depletion of resources but also by the way in which rising ECoEs are undercutting the economics of the energy industries themselves.

To remain viable, these industries need to sell energy at prices which are both (a) above costs of supply, and (b) affordable to the consumer. The situation now is that, whilst costs are rising, increases in ECoE are also undermining affordability, by impairing the prosperity of the consumer.

In the period immediately preceding the coronavirus crisis, the consensus assumption was that total supply of energy was going to carry on rising at rates not dissimilar to those of the recent past.

Three authoritative suppliers of forecasts agreed that, by 2040, consumption of oil would be 10-12% greater than it was in 2018, that the use of gas would have grown by 30-32%, and that even the use of coal would not have decreased. Along with this would go an increase of about 75% in global vehicle numbers, and of about 90% in passenger aviation.

To those of us who understand the energy economy and the trends in ECoEs, these were never realistic projections.

2.4. Renewables – imperative, but not an economic ‘fix’

As the ECoEs of FFs continue to rise, and as concern increases over the threat to the environment posed by emissions, many believe that a “transition” to renewable energy (RE) sources will transform the situation.

We should be in no doubt that, on economic as well as environmental grounds, transition to REs is imperative. Continued reliance on FF energy might or might not wreck the environment, but would definitely wreck the economy, as the ECoEs of oil, gas and coal continue their relentless increases.

There are, though, two reasons for doubting the ability of REs to underpin economic prosperity by driving overall ECoEs back down the parabola.

The first of these is that RE remains essentially derivative of FF energy. We cannot (yet, anyway), build a wind turbine using only wind power, or a solar panel using solar energy alone. For the foreseeable future, the development of RE capacity will remain reliant on inputs whose availability depends on the use of energy sourced from FFs.

This limits the potential for further reductions in the ECoEs of energy sources such as wind and solar power, tying these ECoEs to the (rising) energy costs of fossil fuels. This is why, as shown in fig. 4, it’s unrealistic to assume that the ECoEs of REs will fall indefinitely, the likelihood being that the linkage will limit further declines in RE ECoEs, and could start to push them back upwards.

This linkage is reflected in the truly gigantic costs (which have been put at between $95 and $110 trillion) of transitioning from an FF to an RE economy. It doesn’t help, of course, that we’re reluctant to accept that the structure of an economy powered by RE electricity must differ from one powered by FFs. In the transport sector, for example, the portability of oil has favoured cars, but trams would make far more sense in an economy powered by electricity.

Fig. 4

175-4 Segment ECoE

The second limiting factor for a transition of the industrial economy to REs is that their ECoEs may never be low enough.

SEEDS modelling indicates that prosperity turns down at ECoEs of between 3.5% and 5.0% in the advanced economies, and between 8% and 10% in the less-complex EM countries (see fig. 8 at the end of this report). The likelihood is that the ECoEs of renewables may fall no further than 8% (at best, with 10% more probable). This would certainly make REs competitive with FFs (on a straight ‘ECoE to ECoE’ comparison), but it wouldn’t be low enough to stem, still less to reverse, the decline in prosperity that is already taking place.

This leads us naturally to the subject of prosperity, but it’s necessary, first, to look at how financial manipulation (‘adventurism’) has simultaneously (a) failed to shore up “growth”, (b) obscured what’s really happening to the economy, and (c) created enormous systemic risk.

2.5. GDP – a victim of distortion

As we’ve seen, money acts simply as a claim on the goods and services produced by the energy economy. Unfortunately, though, the energy basis of all economic activity has never gained recognition at the level of official decision-making, which instead continues to adhere to, and act upon, the belief that economics is ‘the study of money’, and that energy is ‘just another input’.

Accordingly – and heavily influenced by the contemporary fashion for deregulation – the authorities responded to the onset of deceleration in the 1990s by labelling it “secular stagnation”, and trying to ‘fix’ it using monetary policies.

In the period preceding the 2008 global financial crisis (GFC), the emphasis was on ‘credit adventurism’, which involved making debt ever cheaper, and ever easier to obtain. The result was that, though the economy appeared robust, what was really happening was that apparent activity was being inflated by increases in credit. At the same time, world debt grew far more rapidly than reported GDP (see fig. 5), whilst risk not only increased, but became ever more diffuse and opaque.

When these trends triggered the GFC, the authorities set their faces against any kind of “reset”, opting instead to enact various forms of ‘monetary adventurism’. This hasn’t worked either, which is why the world entered the coronavirus crisis with (a) the financial system dangerously over-extended, and (b) no available policies, than those which have already failed so spectacularly.

From a surplus energy perspective, the critical point here is that borrowing has far exceeded “growth” through a twenty-year period in which average annual “growth” (of 3.5%) has been made possible by rates of borrowing which have averaged 9.5% of GDP (see the right-hand chart).

Fig. 5

175-5 World Fig. 2

This in turn means that a large proportion (more than half) of this “growth” has been cosmetic. This goes far beyond the simple ‘spending of borrowed money’, important though that has been. Monetary manipulation drives asset prices upwards, boosting the incomes of all of the many activities which are tied to assets. It also enables governments to provide services that, on an ex-borrowing basis, they could not afford to fund.

Even those people who haven’t piled on extra personal debt almost invariably have customers, or an employer, who has, whilst governments, by definition, borrow on behalf of all citizens.

The situation now is that, if debt was held at current levels (that is, it ceased to increase), global “growth” would slump, from a pre-crisis 3.5% to barely 1.0%.

If we tried to reduce debt to prior levels, much of the intervening “growth” would be reversed.

This leaves us with the third option of continuing to increase our debts, enabling incremental credit to keep flowing into the economy.

Unfortunately, this process creates a tension between liabilities and incomes which must result in one of two things happening. Either borrowers default on debts which they can no longer afford to service (let alone repay), or the authorities have to push so much new liquidity into the system that the value of currencies collapses in an inflationary spiral which constitutes ‘soft’ default.

Along the way, the collapse in returns on invested capital has played a major role in creating enormous gaps in pension provision, a situation that has rightly been dubbed a Global Pension Timebomb.

2.6. The economy – coming clean

What matters here is that financial manipulation, whilst it cannot (by definition) change the trajectory of energy-determined prosperity, can disguise the situation by manufacturing “growth” and “activity” through the creation of debt and other financial ‘claims’ that forward economic output will not be able to honour. (These are known as “excess claims” in SEEDS terminology, and are useful in the measurement of financial sustainability).

This gives us the choice of either (a) waiting for an enforced reset through a financial collapse, or (b) endeavouring to work out what is really happening to the economy behind the illusionary data presented, generally in good faith, to decision-makers, analysts and the public.

The latter course involves the calculation of underlying or ‘clean’ output by adjusting for the GDP distortion induced by credit and monetary adventurism. On this basis, we can identify clean growth, which averaged only 1.7% (rather than the reported 3.5%) between 1999 and 2019 (see fig. 6).

This provides a measure of underlying output (C-GDP) which, essentially, is what GDP would fall back to if we tried to deleverage the balance sheet back to prior levels of debt and other liabilities. Because debt is included in the right-hand chart in fig. 6,  both sides of the distortionary linkage are readily apparent.

Fig. 6

175-6 World Fig. 3

2.7. The prosperity dimension

With C-GDP established, the deduction of trend ECoE enables us to measure prosperity, whether nationally, regional and globally, either as an aggregate or in per capita terms. Prosperity data is illustrated in fig. 7, in which all charts are calibrated in constant value international dollars, converted from other currencies using the PPP (purchasing power parity) convention.

The left-hand and centre charts show a situation that will, by now, be familiar, with reported GDP deviating ever further from the underlying situation (C-GDP), whilst debt escalates, and rising ECoEs drive a widening wedge between C-GDP and prosperity. When, as in the centre chart, we calibrate debt, not against (increasingly meaningless) GDP, but against prosperity, we see how financial exposure, with its growing component of excess claims, has become totally out of control. This situation would look even more acute, of course, if either aggregate financial assets (a measure of exposure), and/or gaps in pension provision, were also depicted.

Rising asset prices provide no useful offset at all, because these are purely notional valuations – they cannot be monetised, because the only people to whom these assets in their entirety could ever be sold are the same people to whom they already belong.

The right-hand chart shows one aspect of the challenge facing governments, as the ability to raise taxes is squeezed by deteriorating prosperity. This presents governments with the choice between curbing their expenditures, or creating hardship (and provoking anger) by worsening the squeeze on discretionary (“left in your pocket”) prosperity.

Fig. 7

175-7 world prosperity debt tax

We can and do, of course, take this analysis a great deal further. SEEDS data and interpretation is used to spell out the implications of de-growth; the extraordinary stresses facing every sector from the corporate and the financial to the realms of politics and government; and the insights that can be gained by applying the SEE understanding to our environmental challenge.

It is hoped, though, that this resumé summarises the logic, methods and conclusions of the Surplus Energy Economics approach in a comprehensive but convenient form. As a final reminder of how energy economics (and ECoE in particular) connect with prosperity, fig. 8 shows the relationships between the two, identifying the levels of ECoE at which prosperity per capita has turned down in the United States and worldwide and was, pre-coronavirus, poised to turn down in China.

Essentially, once trend ECoEs rise above a certain point, the average person starts getting poorer – a trend which no amount of financial tinkering can alter.

Fig. 8

175-8 ECoE prosperity 2

SEE INTRODUCTION 175

#174. American disequilibrium

THE IMBALANCE MENACING THE US ECONOMY

At a time when tens of millions of Americans are unemployed, with millions more struggling to make ends meet, it‘s been well noted that the response of the Federal Reserve has been to throw $2.9 trillion in financial subsidies, not at the economy itself, but at a tiny elite of the country’s wealthiest. Another astute observer has set out reasons why Fed intervention couldn’t – even if so intended – pull the US economy out of its severe malaise.

The discussion which follows assesses the American situation from a perspective which recognises that the economy is an energy system. It concludes that the US has responded particularly badly to the onset of de-growth, something which has been induced, not by choice, but by a deteriorating energy equation.

An insistence on using financial manipulation as a form of denial of de-growth has increased systemic risk whilst exacerbating differences between the “haves” and the “have-nots”.

De-growth has, of course, been a pan-Western trend, one which has now started to extend to the emerging market (EM) economies as well. But few if any other countries have travelled as far as the US down the road of futile and dangerous denial.

Whatever view might be taken of Fed market support policy on grounds of equity, the huge practical snag is that this approach has created a dangerously unsustainable imbalance between the prices of assets and all forms of income.

If the Fed withdraws incremental monetary support to the markets, the prices of stocks, bonds and property will crash back into equilibrium with wages, dividends and returns on savings. If, on the other hand, the Fed persists with monetary distortion of asset prices, the resulting inflation will push nominal wages and other forms of income upwards towards the re-establishment of equilibrium.

Either way, the apparent determination to sustain asset prices at inflated levels can only harm the US economy through an eventual corrective process that cannot escape being hugely disruptive.

The irony is that, whether the outcome is a market crash or an inflationary spiral, the biggest losers will include the same wealthy minority whose interests the Fed seems so determined to defend and promote.

At a crossroads

Critics have spent the best part of two centuries writing premature obituaries for the United States, and that certainly isn’t the intention here. Along the way, various candidates have been nominated as potential inheritors of America’s world economic, financial and political ascendancy, but the latest nominee, China, looks no more credible a successor than any of the others, having severe problems of her own. These lie outside the scope of this analysis, but can be considered every bit as acute as those facing the United States.

This said, it would be foolish to deny that America faces challenges arguably unprecedented in her peacetime history. The Wuhan coronavirus pandemic has struck a severe blow at an economy which was already seriously dysfunctional. Anger on the streets is a grim reminder that, 155 years on from the abolition of slavery, and half a century after the civil rights movement of the 1960s, American society continues to be blighted by racial antagonism. In the political sphere, party points-scoring continues to be prioritised over constructive action, whilst even the most inveterate opponent of Donald Trump would be hard-pressed to name any question to which “Joe Biden” is an answer.

The focus here is firmly on the economy, and addresses issues which, whilst by no means unique to the United States, are perhaps more acute there than in any other major economy. By way of illustration, the last two decades have seen each additional dollar of manufacturing output dwarfed by $11.60 of increased activity in the FIRE (finance, insurance and real estate) sectors. Moreover, each dollar of reported growth has come at a cost, not just of $3.80 in new debt, but of a worsening of perhaps $3.40 in pensions provision shortfalls.

Most strikingly of all, America’s economic processes no longer conform to any reasonable definition of a market economy. Nowhere is this more apparent than in capital markets, which have been stripped of their price-discovery and risk-calibration functions by systematic manipulation by the Fed.

Another way of putting this is that America has been financialised, with the making of money now almost wholly divorced from the production of goods and services. There are historical precedents for this financialization process – and none of them has ended well.

The economy – in search of reality

What, then, is the reality of an economy which, in adding incremental GDP of $7 trillion (+51%) since 1999, has plunged itself deeper in debt to the tune of $27tn (+105%), and is likely to have blown a hole of about $25tn in its aggregate provision for retirement?

To answer this, we need to recognise that economies are energy systems. They are not – contrary to widespread assumption – monetary constructs, which can be understood and managed in financial terms.

For those not familiar with this interpretation, just three observations should suffice to make things clear.

The first is that all of the goods and services which constitute economic output are the products of energy. Nothing of any utility whatsoever can be produced without it.

The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process (a component known here as the Energy Cost of Energy, or ECoE).

Surplus energy (the total, less the ECoE component) drives all economic activity other than the supply of energy itself. This surplus energy is, therefore, coterminous with prosperity.

The third is that, lacking intrinsic worth, money commands value only as a ‘claim’ on the output of the ‘real’ (energy) economy. Creating ‘new’ money does nothing to increase the pool of goods and services against which such claims can be exercised. If, as has been the case in the US, newly-created money is injected into capital markets, the result is the creation of unsustainable escalation in the prices of assets.

Once these processes are appreciated, the mechanics of economic prosperity become apparent, as does the futility of trying to tackle them with financial gimmickry. This understanding provides insights denied to ‘conventional’ economic thinking by its obsession with money, and its treatment of energy as ‘just another input’.

The faltering dynamic

Ever since their low-point in the two decades after 1945, worldwide trend ECoEs have been rising exponentially, a process reflecting rates of depletion of low-cost energy from oil, gas and coal. SEEDS analysis indicates that, in highly complex advanced economies, prosperity ceases to grow, and then turns downwards, at ECoEs between 3.5% and 5.0%. By virtue of their lesser complexity, emerging market (EM) countries are more ECoE-tolerant, hitting the same prosperity climacteric at ECoEs of between 8% and 10%.

These trends are illustrated in the following charts, each of which compares economies’ trend ECoEs with prosperity per capita, calibrated in thousands of dollars, pounds or renminbi at constant (2018) values.

A1 Fig 6

In the United States, prosperity has been deteriorating ever since ECoE hit 4.5% back in 2000. A similar fate overtook the United Kingdom in 2003 (when ECoE was 4.2%), and – pre-crisis – was expected to impact China during 2021-22, when ECoE was projected to reach 8.8%.

Critically, there is nothing that can be done to circumvent this physical equation. Prosperity can, of course, be managed more effectively, and distributed more equitably, but it cannot be increased once the energy equation turns against us. Though their development is highly desirable, renewable energy (RE) sources are not going to restore overall ECoEs to the ultra-low levels at which then-cheap fossil fuels powered prior increases in prosperity.

Technology, such as the fracking techniques used to extract oil and gas from US shale formations, cannot overturn cost parameters set by the physical characteristics of the resource. The idea that we can somehow “de-couple” economic activity from the use of energy is a definitional absurdity, and efforts to prove otherwise have rightly been described as “a haystack without a needle”.

For these reasons, the onset of “secular stagnation” in the Western economies from the mid-1990s had a perfectly straightforward explanation, albeit one wholly lost on those who, having coined this term, were unable to understand the processes involved.

The narrative over the subsequent twenty-five years – in the United States as elsewhere – has been one of trying to manufacture “growth” where the capability for continued increases in prosperity has ceased to exist.

Struggling in a trap

The situation from the mid-1990s, then, was that theory and reality were pulling apart. Conventional thinking stated that growth could continue in perpetuity, but this thinking had never taken into account the energy basis of economic activity. Hitherto, ECoE had been small enough to pass unnoticed within normal margins of error, and only now was it starting to act as an insuperable block to expansion. In their contention that the world would never ‘run out of’ oil, opponents of the ‘peak oil’ thesis had supplied the right answer to the wrong question.

This, moreover, was a period of remarkable hubris. The collapse of Soviet communism seemed to demonstrate the final victory of the ‘liberal’ economic model over its collectivist rival, so much so that some even opined that history was now ‘over’. “De-regulation”, it was argued, could be equated with economic vibrancy and, together with enlightened monetary policy, could prolong, in perpetuity, the “great moderation” which, in a brief sweet-spot in the early 1990s, had seemingly combined robust growth with low inflation.

Those who remained critical had, in any case, another target for their invective – globalisation. This was indeed a faulted model, and was always bound to use cheap credit to fill the gap between Western production (which had been outsourced), and consumption (which had not). But globalisation remained a symptom, whilst the malaise itself, which was a deteriorating energy dynamic, went almost wholly unnoticed.

Accordingly, ‘solutions’ to the problem of “secular stagnation” were sought in monetary and regulatory policy. From the late 1990s, the Fed embarked on a process of credit adventurism, keeping rates low, and making credit easier to obtain than it had ever been in living memory.

Between 1999 and 2007, American GDP grew at rates of close to 3%, which seemed pretty satisfactory. Unfortunately, borrowing was growing a lot more quickly than recorded output. Through the period between 1999 and 2019 as a whole, when US growth averaged 2.1%, annual borrowing averaged 7.8% of GDP, whilst aggregate debt increased by $27tn to support economic growth of just $7.1tn.

Along the way, de-regulation weakened and, in many cases, severed altogether the necessary linkages between risk and return. Risk became both mis-priced and increasingly opaque, leading directly, of course, to the global financial crisis (GFC) of 2008.

This presented the authorities with two alternative courses of action. One of these, which was rejected, was to accept a ‘reset’ to the conditions which preceded the debt-fuelled boom of the pre-GFC years. The other, adopted enthusiastically by the Fed and other central banks, was to compound credit adventurism with its monetary counterpart.  As well as slashing policy rates to all but zero, QE was used to bid bond prices up, and thus force yields downwards. The result was ZIRP (zero interest rate policy), effectively negative (NIRP) in ex-inflation terms.

Remarkably, nobody in a position of authority seems to have thought it in any way odd that people and businesses should be paid to borrow.

A2 Fig 8

The result, inevitably, has been increasing financial and economic absurdity. The necessary process of creative destruction has been stymied by the supply of credit cheap enough to keep technically defunct ‘zombie’ companies in being, whilst investors and lenders have seen merit in using ultra-cheap capital to finance ‘cash-burners’, confident that any losses will be handed back to them by a beneficent Fed.

Another, barely noticed consequence has been the emergence of huge gaps in the adequacy of pension provision. In a report appropriately dubbed the Global Pension Timebomb, the World Economic Forum calculated that the shortfall in US retirement provision stood at $28tn as of 2015, and was set to reach a mind-boggling $137tn by 2050.

Though other factors have been involved, a critical role has been played by a collapse in returns on invested capital. The WEF stated that forward real returns on American equities had slumped to 3.45% from a historic 8.6%, whilst bond returns had crashed from 3.6% to just 0.15%. On this basis, we can calculate that a person who hitherto had invested 10% of his or her income in a pension would now need to save about 27% to attain the same result at retirement, a savings ratio which, for the vast majority, is wholly impossible.

Faking it

Analytically, though, by far the most important aspect of US economic mismanagement has been the manufacturing of “growth” by the injection of cheap credit and cheaper money. The direct corollary of this process has been the driving of a wedge between asset prices and all forms of income.

This process goes far beyond the simple “spending of borrowed money”, which creates activity that could not have been afforded had consumers’ expenditures been limited to their own resources. Since asset prices are, to a very large extent, an inverse function of the cost of money, revenues in all asset-related activities, most obviously in financial services such as banking, insurance and real estate, have been inflated, directly and artificially, by ultra-loose monetary policies. Even the few who have not been sucked into this borrowing binge are almost certain to have benefited from employers or customers who have.

Using the SEEDS model, the following charts illustrate how monetary manipulation has driven a wedge between reported GDP and underlying or “clean” levels of output. In the absence of this manipulation, growth between 1999 and 2019 wouldn’t have averaged 2.1%, but just 0.8%.

At the household level, this means that increases in the average American’s income have been far exceeded by an escalation in his or her liabilities. These liabilities embrace not just personal credit but the individual’s share of corporate and government indebtedness, and include the pensions gap as well.

A3 Fig 7

This process helps explain why mortgage, consumer, auto and student loans have soared, and why cheap (but inflexible) debt has been used to destroy costlier (but shock-absorbing) equity in the corporate sector.

The popular notion that these increases in liabilities have been offset by rises in the values of homes and equities is wholly mistaken, because it ignores the fact that these are aggregate values calculated on the basis of marginal transactions.

An individual can sell his or her home, or unload a stock portfolio, but the entirety of the housing stock, or the whole of the equity market, cannot be monetised, because the only possible buyers are the same people to whom these assets already belong.

By applying the ECoE deduction to the ‘clean’ level of output (C-GDP), we can identify what has really happened to the prosperity of the average American over the past two decades. In 2019, prior to the current pandemic crisis, his or her annual prosperity stood at an estimated $44,385, which was $3,660 (8%) lower than it had been back in 2000. Over the same period, taxation per capita increased by $3,485, so that the average person’s discretionary (‘left in your pocket’) prosperity is lower now by more than $7,100 (22%) than it was in 2000.

Meanwhile, each person’s share of America’s household, business and government debt has risen from $94,000 to more than $160,000 (at constant values), and nobody has yet proposed a workable solution to a rapidly rising pension gap which probably stands at more than $35tn, or $107,000 per person.

This predicament, which is summarised in the final set of charts, is beyond uncomfortable – and even this, of course, preceded the economic hurricane of the coronavirus pandemic.

A4 Fig 9

The lethal disequilibrium

As well as understanding what these circumstances mean in practical terms, we need to note another consequence of using financial adventurism in the face of deteriorating prosperity. This is the way in which the relationship between incomes and assets has been bent wholly out of shape.

It’s an essential prerequisite of a properly functioning economy that there is a stable and workable balance between, on the one hand, all forms of income and, on the other, the valuation of assets, including equities, bonds and property. The problem facing anyone trying to calculate this relationship is that financial adventurism has falsified some forms of income in much the same way that it has distorted GDP. This is where prosperity, calibrated using an energy-based model such as SEEDS, is particularly important.

Essentially, equity prices need to be low enough to give stockholders a satisfactory real return on their investment, with much the same applying to bonds. Meanwhile, if typical property prices become too high in relation to median earnings, the market becomes dysfunctional, because it prices out new buyers, leaving owners vulnerable to any weakening in monetary support.

When – as has happened in the United States and elsewhere – monetary manipulation distorts these relationships, one of three things must happen. First, the authorities need to carry on, indefinitely, making incremental additions to their monetary largesse. Second, and if ever they cease to do this, then asset prices must correct downwards into equilibrium with all forms of income. Third, nominal incomes must be increased to restore equilibrium, something which, with prosperity no longer increasing, can only happen through rising inflation.

For as long as a disequilibrium between asset prices and incomes continues, the effect is to benefit asset owners to the detriment of those depending on incomes (which may be wages, dividends, profits, pensions or returns on savings). Accordingly, a wealthy elite becomes the beneficiary of processes whose outcomes are negative for those with little or no ownership of assets.

Put another way, inequalities will continue to widen – even if the authorities don’t adopt policies aimed deliberately at such an outcome – until a financial pendulum effect restores equilibrium.

What now?

From the foregoing, it will be apparent that America’s current predicament is by no means wholly a function of the coronavirus pandemic, or of the latest upsurge in racial tensions. Rather, the US is at the culminating point of a series of adverse trends:

First, the energy dynamic which determines prosperity has turned down, and a failure to recognise this climacteric has driven the authorities, in the US as elsewhere, into a chain-reaction of mistaken policies.

Second, the financialization of the economy has hidden underlying fundamentals from view, whilst simultaneously creating enormous systemic risk.

Third, failed monetary policies have driven a wedge between those who own assets, and those who depend either on wages or on other forms of income.

Fourth, and most dangerously of all, policy has created a dangerous disequilibrium between asset prices and incomes. It is no exaggeration to say that this disequilibrium is poised over the US economy like the Sword of Damocles.

Along the way, America has allowed market principles to be over-ruled by financial engineering, something typified by the way in which markets have become extensions of monetary policy.

The danger implicit in the latter point, in particular, is that monetary manipulation will be relied upon to resolve issues that lie outside its competence. There are strong reasons to believe that the US has reached a point of ‘credit exhaustion’, after which households refuse to take on any more debt, however cheap and accessible it may become. That is the point at which monetary policy becomes akin to “pushing on a string”.

This futility implies that either (a) the authorities give up on monetary stimulus, at which point asset markets crash, or, and more probably, (b) they ramp up injections of liquidity to a point at which dollar credibility implodes.

This creates a very realistic possibility that deflationary pressures push the Fed into the creation of new money on such a scale that inflation accelerates.

It is particularly worrying that a combination of self-interest and the polarisation of opinions prevents the adoption of pragmatic policies which, even at this very late stage, might manage the economy back into equilibrium.

 

 

#173. The affordability crisis

THE SCALE AND IMPLICATIONS OF TUMBLING PROSPERITY

In the previous article, we looked at what our handling of the Wuhan coronavirus crisis might tell us about our ability to tackle the looming, even greater challenges of de-growth and environmental risk.

The focus now shifts to the nearer-term, and to the nuts and bolts of economies trying to emerge from crisis. Though faith in a rapid ‘V-shaped recovery’ may have faded, it seems that governments, and many businesses and investors, are still pinning their hopes on over-optimistic expectations. If there’s a consensus now, it might be ‘flatter and longer than it used to be, but it’s still a V’ – and which still places unswerving belief in an eventual return to pre-crisis levels of output and “growth”.

In particular, it seems still to be an article of faith that monetary stimulus can boost economic activity, through and after the pandemic. Though monetary largesse can, of course, be used to inflate capital markets, its effectiveness at the level of the ‘real’ economy is falling ever further into question. Specifically, any realistic appraisal of the probable circumstances of households and businesses in the aftermath of the crisis ought to highlight the nearing of ‘credit exhaustion’, after which point further monetary stimulus becomes tantamount to ‘pushing on a string’.

As you’d expect, the investigation summarised here is conducted from the radically different interpretation that the economy is an energy system, not a financial one. This provides a much more realistic basis of appraisal, not least because it looks beyond the cosmetic “growth” manufactured by compounding monetary gimmickry.

Set out here are the interim conclusions of an analysis undertaken using SEEDS (the Surplus Energy Economics Data System). After addressing the critical issue of prosperity, we look at some regional variations, macroeconomic trends, and some of the implications for households, businesses and governments.

Conclusions

Here are the chief conclusions reached in this analysis:

  1. Average prosperity per person is poised to fall very sharply, and to remain at depressed and worsening levels.
  2. Despite a sharp fall in governments’ current-year tax ‘take’, the medium-term outlook is that discretionary (‘left in your pocket’) prosperity will fall even more rapidly than top-line prosperity.
  3. Households’ financial circumstances will be worsened further by increases in debt, erosion of savings, and falls in asset values.
  4. Consumer ‘discretionary’ (non-essential) purchases can be expected to decrease very sharply, and are unlikely to stage any meaningful recovery.
  5. Popular demands for lower overall taxation are likely to be accompanied by intensifying calls for much more redistribution.
  6. Governments will struggle to match diminished revenues with popular demands for greater spending on essential public services.
  7. Further challenges for governments will include pensions affordability and the need to address worsening impoverishment.
  8. Leadership in government and business may have no real idea of what the post-crisis world is going to look like.

It should be added that what follows assumes that there’s no serious “second wave” of coronavirus infections, not least because any such outcome could have devastating economic and broader consequences. In those countries which have handled the initial wave particularly badly, this may turn out to have been an over-optimistic assumption.

Prosperity

As the first set of charts illustrates, the most important conclusion of the lot is that people are going to have experienced a sharp fall in their prosperity this year, and it’s not really going to get any better after that. Despite relentless voter pressure for reductions in taxation, global average discretionary prosperity is set to fall even more rapidly in the medium-term.

In short, what we’re facing is a full-blown affordability crisis, for households and governments alike.

Additionally, though this is not shown in these charts, people are going to emerge from the crisis with their savings reduced and the value of their assets seriously impaired, and with average levels of indebtedness a great deal higher than they were before the pandemic.

Summary global prosperity numbers, stated in thousands of PPP dollars per person at constant values, are set out in the table accompanying the charts.

Fig. 1

1. Prosperity metrics

Fig. 1A

1A prosperity metrics

Regional prosperity

The next set of charts sets out some regional comparisons, at both the total and the discretionary levels of prosperity per capita.

During 2020, top-line prosperity is projected to fall by between -10% (China) and -18% (United Kingdom). By 2024, the average person is expected to remain poorer than in 2019 by 11% in China, 16% in Germany, 17% in America and 18% in Britain.

At the discretionary level, rapid falls in tax collection are expected to cushion this year’s slump in prosperity. By 2024, though, and, in comparison with 2019, the ‘left in your pocket’ prosperity of the average person is projected to be lower by 19% in the United States, 20% in Germany, 22% in Britain and – perhaps surprisingly – by 23% in China. Again, supplementary data is summarised in the accompanying tables.

Fig. 2

2. Regional prosp

Fig. 2A

2A Stats regional prosp

Fig. 2B

2B Stats regional disc

Broad economic trends

From a macroeconomic perspective, the current SEEDS working scenario equates to a fall of 18% in world GDP this year, followed by recoveries of about 4% in subsequent years, leaving the number for 2024 still some 5% lower than it was in 2019.

Even this, though, would mean that GDP had become a still less meaningful metric than it already is, because the only way in which even this kind of modest rebound could be engineered would be via enormous exercises in monetary stimulus. In other words, it’s possible to massage reported GDP using monetary adventurism, but this simply piles up forward commitments, and inflates nominal wealth, without boosting underlying conditions.

At the much more meaningful level of prosperity – a measure which excludes monetary manipulation, and is stated net of the trend energy cost of energy (ECoE) – global aggregate real economic output is projected to fall by 14% this year, and to remain 13% below the 2019 level in 2024 (by which time the world’s population is likely to have grown by a further 5%).

Although levels of private sector borrowing (and defaults) are almost impossible to quantify at present, surges in government borrowing (and in state underwriting of private debts) imply that debt aggregates are set to go on escalating at least as rapidly as they have in the recent past.

By 2024, world debt stated as a percentage of GDP is projected to have risen to 300%, compared with a provisional 217% at the end of 2019. Critically, though, global debt as a multiple of prosperity is projected to soar from 350% now to a frightening 540% over the same short period.

Since prosperity is the most appropriate measure of the economy’s ability to carry its debt burden, this projection implies financial stresses far exceeding anything in our previous experience.

The aggregate of governments’ estimated tax revenues is projected to fall by 21% ($9tn) this year, and to remain 6% lower in 2024 than it was in 2019. Historic and projected debt, GDP and prosperity aggregates are summarised in fig. 3, with supplementary data again provided.

Fig. 3

3 Metrics macro

Fig. 3A

3A Stats macro

Households

The single most important macroeconomic conclusion to emerge from this analysis is that households are going to be much poorer than they used to be, both in 2020 and in subsequent years. Falls in prosperity are likely to have been accompanied by a severe erosion of savings and, in the absence of quite extraordinary levels of monetary intervention, it should be assumed that most countries will experience a sharp correction in property prices, where affordability issues are likely to outweigh efforts at monetary support.

Additionally, of course, the behaviour of consumers is going to be affected by fears and uncertainties. At the basic level, and even if the coronavirus recedes without a “second wave” of infections, people have now encountered a crisis of which most, in the West at least, had no prior experience. The severe deterioration in their financial circumstances will be exacerbated by broader feelings of insecurity. We should therefore assume that the numerical deterioration in prosperity will be fully reflected in new levels of consumer caution.

Moreover, it’s likely that we have reached the point of ‘credit exhaustion, after which households are unwilling to go even further into debt, almost irrespective of how cheap (and how accessible) credit has become.

This would mean that further efforts at monetary stimulus would equate to ‘pushing on a string’.

These trends indicate sharp falls in households’ discretionary (non-essential) expenditures. It also suggests that affordability issues will start to exert downwards pressures on variable expenses such as rents.

Businesses

To the extent that they continue to anticipate some kind of ‘flattened V’ recovery, businesses could be in for some very unpleasant surprises in the aftermath of the coronavirus hiatus. This said, some sectors are implementing capacity cuts which seem consistent with assumptions of long-lasting impairment in their markets.

A major new reality for businesses is likely to be a sharp downturn in consumer discretionary spending. Sectors which supply consumers with things that are ‘wants, but not needs’ may find themselves waiting for demand improvements which fail to materialise.

Like households, many businesses will emerge from this crisis forced into more conservative behaviour by impaired cash flows, increased debts and changed perceptions of risk. Many are likely, in any case, to try to prolong cost savings implemented during lockdowns.

This suggests that B2B (business to business) expenditures may remain much lower than they were before the crisis, and that companies will be reluctant to return capital investment programmes to pre-crisis levels.

Government

As remarked earlier, governments’ estimated tax revenues are projected to have fallen by $9bn (21%) this year, whilst expenditures will have soared. In many instances, fiscal deficits could be in excess of 20% of countries’ (reduced) GDPs, dwarfing the deficits incurred during the 2008-09 global financial crisis (GFC).

Unfortunately, the protracted divergence between GDP and prosperity has led governments to underestimate the true burden of taxation as it is experienced by the average person.

As the following charts show, global taxation has remained at around 31% of GDP over a very lengthy period, leading governments to assume that the fiscal burden on the public has not increased. But tax has increased relentlessly as a proportion of prosperity, reaching an estimated 50% worldwide by this measure in 2019, compared with 41% in 2010, and 33% in 2000. In countries (such as France), where the incidence of taxation as a fraction of prosperity is far above global averages, this has already given rise to significant popular discontent.

During 2020, most governments will experience a sharp fall in tax revenues, but are likely to endeavour to push their incomes back upwards in subsequent years. This is likely to encounter popular opposition to an extent which governments may fail to understand, for so long as they persist in the mistaken belief that GDP is an accurate reflection of public prosperity, and hence of the real burden of taxation on individuals.

Fig. 4

4 Tax charts

Fig. 4A

4A Tax table

Voters are, of course, at liberty to act inconsistently – demanding higher expenditure on health care and other public services at the same time as they call for a lower burden of taxation – and this divergence might well characterise public opinion in the coming years.

It will, moreover, be assumed by many taxpayers that their tax burden would be lower if “the rich” and “big business” paid a larger proportion of the total. It will not have helped public perceptions that governments have appeared able to conjure huge sums out of thin air, particularly where investors and large corporates have required (or requested) taxpayer or central bank support.

As we’ve seen, the public are likely to have been shocked, not just by the coronavirus itself but by what has happened to their financial circumstances, and to their sense of economic security. This is likely to mean that the public’s order of priorities undergoes major change, lifting issues of economic concern to, or near, the top of voters’ agendas. Rightly or wrongly, the popular narrative of 2008-09 has become one of ‘bail-outs for the few, and austerity for everyone else’, making the public preternaturally sensitive to any apparent signs of a repetition of this narrative.

Problems don’t, unfortunately, end there for governments. The current crisis will have exacerbated longer-term issues (such as pensions affordability), and shone a new spotlight on topics such as employment insecurity and the plight of the poorest.

Governments might well, of course, be tempted to ask central banks to monetise their debt, a policy which could have catastrophic financial consequences.

In theory, these conditions could be fertile territory for politicians of the traditional ‘Left’, so long as they re-order their policy agendas onto economic affairs, promising greater redistribution and, quite possibly, the taking of important sectors into public ownership. This, though, would mean reversing the main thrust of centre-left policy over an extended period in which they have, to a large extent, accepted the ‘liberal’ ideology of economics.

This makes it quite conceivable that new insurgent (“populist”) parties will make inroads, this time promising left-leaning policy agendas which include redistribution and nationalisation.

 

#172. Orchestra, lights, beginners!

THE CORONAVIRUS AS DRESS REHEARSAL

As recently as January, the word coronavirus would have conveyed no meaning to the vast majority of the general public, whilst outside China very few, other than geographers, would ever have heard of Wuhan. All this has changed, of course, since the pandemic spread around the world in the early months of 2020.

Those of us who understand the economy as an energy system, and those people who are most concerned about environmental risk, had no reason to be any more prescient about this than anybody else.

Almost nobody saw this coming.

But energy and environmental understanding does serve to cast the current crisis into a very different light.

In short, and unless you believe in perpetual growth, the economic impact of the coronavirus pandemic can be seen as a dress rehearsal for the main event. That ‘main event’ is the onset of “de-growth”. One of the most interesting aspects of the pandemic is the light that it sheds on our ability – or, in a disturbing number of cases, our inability – to cope with fundamental change.

The energy economics perspective puts our situation into long-term context. Simply stated, the modern world was created when, in the late 1700s, the invention of the first efficient heat-engines enabled us to access the vast energy resources contained in coal, oil and natural gas. Population numbers, and the economic means of their support, have expanded exponentially since we ceased to depend entirely on the energy of food and the labour of humans and animals. This relationship, illustrated below, surely demonstrates, beyond dispute, the relationship between energy use and the quantum of population and economic activity.

Population & energy

Whether or not this relationship is understood defines the differences between two schools of thought.

For the majority of those who comment on these things, and who influence commercial and policy decisions, the economy is an entirely monetary system. Since we can create money at will, this means that there need be no limit to the scale of our economic activity (and the numbers of people which that activity sustains).

For a minority of us, though, the finite nature of the Earth and its resources implies an eventual cessation of economic and population growth. Some think that environmental considerations put limits to the scope for ‘carrying on as we are’. Others, recognising that low-cost energy is a finite resource, observe that the energy cost of energy (ECoE) is now rising in a way that is putting an end to “growth”, however much we might try to fake continuity by pouring cheap credit and cheaper money into the system.

In recent weeks, the main effort here has been to quantify, so far as is possible, the potential impact of the coronavirus crisis on economic activity and the financial system.

The detailed conclusions of these studies would probably give you far more information than you need or want to know, though the outlook for sixteen advanced economies, fourteen EM countries and the global average is illustrated here:

Prosperity trends

The bottom line is that economic activity – and the prosperity of the average person around the world – are going to be savaged by the coronavirus crisis, and that any subsequent recovery is going to be painfully slow, and incomplete. It’s by no means clear that a financial system wholly predicated on perpetual growth can survive this severe check to continuity.

This much is probably common ground with the ‘conventional’ interpretation. The difference is that, from an energy or an environmental perspective, the pandemic crisis isn’t a stand-alone incident.

It’s the first instalment of “de-growth”.

Rational responses to risk?

Members of the medical profession provide an excellent service in diagnosing our ailments and, when appropriate, prescribing treatment, but few of us would expect or want them to give economic advice. Simple courtesy suggests that we should reciprocate, confining ourselves here to economic and related issues, and leaving health matters to the experts.

It’s interesting, though, that there seems to have emerged an open rift between the British authorities and some, at least, of the experts advising them on coronavirus policy. Simply put, and with new infections continuing at a daily rate of about 8,000, some scientists think that the government is exercising insufficient caution as it lifts lockdown restrictions. It’s probable that similar debates are taking place elsewhere, though few countries seem to be as deeply enmeshed in the pandemic, or to be handling it quite as ineptly, as Britain and the United States.

Scientific interpretation is best left to the experts, and governments have other (including economic) considerations to weigh in the balance. From a lay-person’s point of view, the issue seems to be whether or not relaxation of restrictions risks triggering a serious “second wave” of infections, which could in turn force a return to lockdowns.

The operative term here is “risk”. We cannot accurately calibrate the probability of a second wave, but we can reach a pretty effective estimation of the consequences should it happen.

The subsidiary question is whether there are “right” and “wrong” – “prudent” or “irresponsible” – ways of emerging from lockdown.

It’s almost impossible to overstate the economic implications of a second wave. China aside, the coronavirus struck most countries’ economies in late March, so first quarter output was only reduced by about 3-5%. In a second quarter wholly overshadowed by the pandemic, activity is likely to have fallen by between 40% and 50%.

A cautious, incremental approach might see this year-on-year gap narrowed to perhaps -30% by the fourth quarter, with something close to normality being restored by the end of 2021. This might only be “close to” normal, because there are some sectors which it would be imprudent to reopen until the virus risk is very largely behind us.

Unduly rapid exit, on the other hand, risks triggering a second wave of infections, at which point economies would be forced back into lockdown.

Any ‘lockdown 2.0’ would be far worse than the original one. It would probably have to last a lot longer than the first version. As well as forcing economic activity sharply back downwards, this would strip people of much of the hope that has sustained them through the period of restriction. It would throw government and commercial planning into disarray, and would risk both severing supply lines and triggering a full-blown financial crash.

Any recovery thereafter would be very gradual indeed, and might take too long to avoid permanent, perhaps even existential, economic and financial damage.

Issues of responsibility

It cannot be emphasised too strongly that no encroachment on the preserves of the medics is intended here. The world already has more than enough ‘instant experts’ on the coronavirus, and certainly doesn’t need any more.

The aim is simply to examine the possible economic consequences of allowing the system to risk being hit by a second wave of infections. The implication, though, is that purely economic probabilities favour caution.

Of course, it can be objected – and quite correctly – that official consideration needs to be given to matters that are neither medical nor economic. Lockdowns restrict freedoms, are stressful, and have extremely painful human consequences, including physical (though not, strictly speaking, social) isolation from relatives and friends. Nobody wants to stay in lockdown any longer than is necessary.

This doesn’t mean, though, that exit strategies can’t be prudent, and nuanced to remove the worst human and economic consequences whilst also minimising the risk of a second wave. It seems logical that the authorities could decide what should, and what should not, be reopened, on the combined basis of importance, and of comparative safety. If people can work, or meet, at safe distances, there seems no reason for stopping them from doing so. Cramming people onto beaches or into aircraft seems far less advisable.

This discussion has probably reached – or passed – the point at which some readers riposte that the coronavirus ‘is no worse than flu’, ‘only affects the elderly’ and ‘leaves no lasting health impairments’ (though each of these points seems unproven). Others might reference ‘herd immunity’ (although, even in badly-hit England, official survey data indicates that only 6.78% of the public have antibodies).

These are opinions, to which anyone is entitled. But the problem with such arguments is that none of us makes decisions for himself or herself alone. We might, as individuals, think that risk is low, so we’re relaxed about crowded spaces, and pay little attention to precautionary guidelines. It can be argued that we have a right to make that choice, always presupposing that we accept the risk that we might be wrong.

But the risks of such decisions are not confined to those who take them. During the Second World War, night-time blackouts were imposed, to make it harder for enemy bombers to find their targets. This would have been pointless if even a small minority, disagreeing with the blackout policy, had kept their homes lit up like Christmas trees.

At issue here is collective responsibility, and the question of adhering to rules with which we, as individuals, might disagree.

The intelligence factor

The merits or demerits of rapid or cautious “exit strategies” from lockdown are not intended to be the main focus of discussion here.

Rather, the issue of greatest significance is the way in which, collectively, we have responded to this ‘dress rehearsal’ for de-growth.

The view expressed here is that de-growth has become very probable indeed. For purposes of explanation – and with a new downloadable summary of surplus energy economics in preparation – it might suffice to note that all economic activity is a function of energy, and that the energy cost of energy (ECoE) determines how much of any accessed energy is consumed in the access process, and how much remains for all economic purposes other than the supply of energy itself. Needless to say, no tinkering with the financial system of ‘claims’ on economic output can change the fundamental energy (not financial) dynamic which determines our prosperity.

Analysis of these trends indicates that de-growth had already started, well before the economy was hit by the pandemic. During 2018-19, sales of everything from cars and smartphones to chips and components had turned down. Unmistakable signs of stress were already starting to appear right across the financial system.

The arrival of de-growth finds us with a financial system that has been rendered unnecessarily fragile by futile efforts to counter “secular stagnation” – and, latterly, de-growth – with monetary gimmickry. Not content with allowing escalating debt to create cosmetic activity and “growth”, the authorities had already resorted to monetary policies which, as well as paying people and businesses to borrow, had destroyed returns on invested capital, with particularly adverse consequences for pensions.  The following charts illustrate the extent of financial exposure.

GDP & obligations

You can take your pick between escalating ECoEs and worsening environmental risk as the primary drivers, but the onset of de-growth looks inescapable.

This, simply put, poses a challenge unprecedented since the start of the Industrial Age. There have always been recessions, of course, and depressions have occurred at longer intervals. But these events, however severe, have never amounted to a permanent cessation and reversal of economic growth.

Another way to state the case is that de-growth has put an end to ‘business as usual’. Have we the intelligence, individually and collectively, to adapt to this drastic change? Moreover, do our societies and our institutions have the systemic intelligence to respond rationally?

This isn’t the place to revisit what de-growth is likely to mean, but we can expect fundamental change in economic, political and other areas. Economically, products and services are likely to be simplified, with the same happening to supply processes (as part of a wider trend towards unwinding the complexity created during more than two centuries of growth). Whole sub-sectors are likely to be de-layered out of existence. Any culture in which people derive their sense of self-worth from material affluence is likely to be undermined. Current distributions of income and wealth might not be tenable in a shrinking economy.

It remains to be discovered whether we have the intelligence (which is not the same thing as cleverness) to adapt ourselves to such fundamental changes.

Seen as a dress rehearsal for de-growth, the coronavirus crisis gives us scant reason to trust that “it’ll be alright on the night”.