#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”.

 

 

#171. Inflexion point

AT THE DEATH OF THE ‘V’

Though most people have better things to do than watch market indices, it hasn’t escaped public notice that stocks have risen at record rates just as economies have decelerated ever nearer to stall-speeds. Market logic, such as it is, seems to be that previous falls ‘priced in’ the consequences of the Wuhan coronavirus crisis, and that, latterly, investors have started to ‘buy the recovery’.

To put any trust at all in the thesis that has powered the market rebound, you’d need to place unquestioning faith in the concept of a ‘V-shaped’ economic recovery.

The hugely influential International Monetary Fund certainly endorses this view. In its latest, slimmed-down set of WEO projections, the IMF predicts that world economic output will fall by -3.0% in 2020, and then grow by +5.8% next year. This would mean that GDP was higher (by +2.6%) in 2021 than it was in 2019. It’s implicit, though it’s not stated, that growth will then revert to something not dissimilar to previously-anticipated annual rates of between 3.0% and 3.5%.

This is a classic ‘V assumption’.

The view that has been taken here throughout this crisis has been that this kind of rebound is extraordinarily implausible. If, as seems increasingly likely, the market now ditches the fiction of a ‘V-shaped recovery’, markets could be poised for catastrophic falls. If this is how things pan out, hindsight might decide that the ‘Lehmann moment’ in this second-wave crash was the news that investment guru Warren Buffett’s Berkshire Hathaway fund has liquidated its entire holdings of airline stocks.

Unless you’re an investor, none of this may seem to matter very much. After all, prolonged support from the Federal Reserve and other central banks has created a ‘positivity bias’ in the minds of investors, so it wouldn’t be a huge surprise to everyone else if the recent sharp rally in stocks turned out to be a colossal exercise in complacency and wishful thinking.

There are, though, far broader economic implications to the probability that, like investors, the government and business ‘high command’ has reached the point at which trust in a ‘V-shaped’ recovery starts to evaporate. Indeed, ‘ditching the V’ would have profound consequences, both for policy and for the practicalities of “exit” from lockdowns.

Airlines have become very much the bellwether for how the prospects for business and the economy are perceived.

Let’s remind ourselves that, prior to the crisis, the general expectation was that the aviation industry would continue to grow at annual rates of about 3%, implying aggregate expansion of around 90% by 2040.

Though it’s long been recognised that a sharp fall in passenger numbers during 2020 is inescapable, the ‘V-shaped’ assumption, hitherto, has dictated that this would be followed by a rapid rebound, with volumes pretty quickly recovering to (or very near) trend levels. This, it has been assumed, would leave the longer-term outlook largely intact, a scenario illustrated in the left-hand chart in fig. 1.

Fig. 1 

Air traffic

To believe this, you’d have had to assume that passengers would put away all of their fears about close proximity, dismiss from their minds any idea of a second wave of infections, and ignore their battered financial circumstances. If you did believe this, the only meaningful issues would be the duration of the crisis, and the ability of airlines to out-last it.

Where the longer-term outlook is concerned – and well before the advent of the coronavirus – the view here has been that continuing exponential growth in passenger aviation is implausible. This is a stance which forms part of a broader “peak travel” thesis.

This view isn’t confined to aviation, or to travel more generally. Rather, the Surplus Energy Economics interpretation is that the global economy has already reached the cusp of “de-growth”.

Simply stated, rapid rises in ECoE (the energy cost of energy) have put prior growth in prosperity into reverse, and are starting to exhaust the ability of financial gimmickry to hide this underlying reality.

This means that it would be counter-intuitive to expect exponential growth in any part of the economy, and particularly in any sector driven by discretionary consumer spending. The logic of de-growth is that we should now start to concentrate on those issues – including de-complexification, simplification, de-layering, loss of critical mass and falling utilization rates – which will determine the rate of de-growth, and the shape of the shrinking economy.

Returning to aviation, the outlook is likelier to be the “accelerated de-growth” scenario illustrated in the right-hand chart in fig. 1. The black line shows the “peak travel”, de-growth interpretation as it was understood before the pandemic, and the red one shows how the coronavirus crisis is likely to have modified this outlook. The gist of it is that any recovery in aviation from the 2020 slump will be very pedestrian indeed.

Of course, neither the consensus nor the ‘high command’ is going to accept the broader economic de-growth thesis any time soon – established ways of thinking are far too entrenched for that.

But what they are likely to do is to abandon trust in a ‘deep V’ recovery, not just in aviation, but more broadly too.

De-growth itself may remain a long way from acceptance, but two economic aspects of the coronavirus crisis are gradually gaining recognition.

One of these is that we face a very protracted period of “co-existence” between the virus itself and resumed economic activity.

The second is that some industries might not be able to survive for the duration of this extended co-existence. Together, these two considerations, extended across the economy as a whole, are likely to be more than enough to kill off the recovery in the markets. More importantly, we can expect ‘abandonment of V’ to have far-reaching implications for policy.

It’s important to note that, in the absence of an effective vaccine or treatment, lockdown has been the only policy response available to the authorities. Thus far, it has met with very high levels of public co-operation, flaunted only by small minorities of the obstinate and the anti-social. It seems to be succeeding in its stated aim of “flattening the curve” of virus transmission. Of course, there are alternative viewpoints, ranging from ‘coronavirus is just another flu’ to ‘this is the end of life as we know it’. Neither view has been accepted by governments as a reasonable basis for planning.

But the authorities have always known that lockdowns have two big problems.

The first is that, for as long as they continue, they inflict compounding damage to the economy.

The second is that, once restrictions are lifted, it would be very hard indeed to reimpose a “lockdown 2.0”. This latter consideration has inclined governments towards caution, despite the siren, often self-interested voices calling for an accelerated “exit”.

Recognition of “co-existence” seems to be moving the authorities away from an ‘everything stops, everything resumes’ stance towards a much more nuanced position, in which some economic activities can be restarted relatively quickly, whilst the resumption of other activities will take very much longer.

Aviation falls very much into the second category. If physical (wrongly labelled “social”) distancing needs to remain in situ, it’s almost impossible to see how airports and airlines can return to operation. Even if they could, it’s very hard to envisage passengers returning in their droves. Quite apart from the fact that most people are going to be a lot poorer after the crisis, there will remain an extreme and prolonged unwillingness to enter crowded spaces. Aviation has the additional handicap – which it shares with the cruise industry – that people will be reluctant to risk finding themselves put into extended isolation, either at their destination or on their return home.

Both the practical and the psychological implications of the crisis for consumers are likely to be profound, and to extend far beyond the international transport and tourism sectors. As and when the virus recedes, most households are likely to have experienced a draining of their savings, an increase in their debts and a meaningful reduction in their incomes. To health-related fears will have been added a new financial conservatism, reflected in a reduced propensity to engage in discretionary (non-essential) purchases.

Changes in consumer circumstances are likely to have their corollary in the commercial sector, too. Businesses which survive this crisis will, in a majority of instances, emerge with very stretched balance sheets and seriously impaired revenues and earnings. They can be expected to turn borrowing-averse, and to take an ultra-cautious line both on operating costs and on investment.

Just as consumers will be reluctant to spend on non-essential purchases, businesses are likely to keep discretionary outgoings to a minimum. This means that acceptance that a V-shaped recovery isn’t going to happen can be expected to have the same effect on sectors like advertising that it has on consumer areas such as travel.

Financially, both investor and government attitudes are likely to undergo significant alteration as the improbability of a V-shaped recovery becomes apparent.

Governments which might have been willing to support companies and sectors through a relatively short hiatus will take a markedly less accommodating line when faced with the prospect of providing such support for a very much longer time. They might also reflect that bankruptcy, whilst it wipes out shareholders, does not in fact ‘destroy’ businesses and their assets, but simply transfers ownership to creditors.

Framing these considerations will be recognition that the resources of governments face deep and permanent impairment, and that public priorities are very likely to have changed.

What is emerging now – and is likely to reach even into the rarefied levels of investor calculation – is that neither the assurance nor the comparative simplicity of a V-shaped recovery is persuasive.

The wise course from here would be an acceptance, if not (yet) of de-growth, then of a wholly altered economic, financial, political and social landscape. Denial will of course continue in many quarters, but the centre of gravity will move fundamentally as a single observation gains traction.

That observation is that a ‘V-shaped’ recovery is not going to happen.

 

#170. At the end of “new abnormality”

REFLECTIONS ON A CRISIS

As soon as it became clear that the Wuhan coronavirus pandemic was going to have profound economic consequences, the aim here was to scope (since it is impossible for anyone to forecast) the implications for the financial system, and for the economy itself. Both have subsequently been converted into downloadable reports which can be accessed at the resources page of this site.

There’s no denying that both reports, stats-rich and based on the SEEDS model, are complex, even though every effort was made to combine clarity with a minimum of jargon. Indeed, ‘complicated’ might well define the whole situation with the coronavirus crisis.

Where once we might have said that ‘whole rainforests are being pulped’ to feed the appetite for comment and expression about the crisis, the 2020 equivalent is that the internet is becoming saturated with information-and-opinion overload.

The aim here is to take the issues ‘on the volley’, in hopes that this might tease out the nuggets of the important from the overburden of sprawl.

First, then, the pandemic itself. There seems no reason to doubt the severity of the health crisis, since neither governments nor businesses are prone to this kind of over-reaction – far from going out of their way to create panic, shake public confidence and cripple the economy, the political and economic ‘high command’ is likelier to promote false reassurance than to whip up unnecessary panic.

Neither do conspiracy theories seem particularly convincing. It seems pretty clear that the virus originated in China, but the idea of spill-over from dangerous experimentation seems far less plausible than the simpler explanation, which is that the virus jumped the species barrier in one of China’s dangerous, insanitary and, frankly, bizarre ‘wet markets’. Equally, it seems logical that an authoritarian, one-party state would react to an unknown threat with a habitual (rather than a pre-planned) denial, and with a bureaucratic, almost instinctive silencing of dissenting opinions.

Likewise, Mr Trump’s apparent belief that the World Health Organisation kowtowed to China by labelling the crisis ‘covid-19’ (rather than, say, ‘Wuhan flu’) seems less likely than the simpler explanation, which is that the WHO conformed to that same contemporary preference for euphemism which has presented the erosion of working conditions as the “gig economy”.

This isn’t to say, of course, that China isn’t looking for ‘the main chance’ where the pandemic is concerned. But it’s only fair to say that such opportunism is by no means a uniquely Chinese preserve. People from all shades of opinion, from every political persuasion and from all points of self-interest are trying to find their own silver linings in the coronavirus cloud. From calls for a world government to demands that “Brexit” be put on ice, we’re seeing hobbyhorses, even of the most irrelevant kind, being ridden to exhaustion.

By the same token, the use of lock-downs seems, on the whole, to have been a sensible response, because a distinguishing feature of the Wuhan virus is its rapidity of spread. The only real mystery about this is why, in an age of digital communication, a policy of physical separation is being mislabelled ‘social distancing’.

Of course, lock-downs come at a huge economic and broader cost, automatically prompting the public to wonder how much longer this situation will prevail. It’s a fair bet that governments around the world are contemplating ‘exit strategies’, but only the rash would insist on governments going public on what those strategies might be.

The priority now has to be to ensure that the public adheres to the principles of lock-down, and that resolve could only be weakened by premature speculation about how this might end.

For their part, economists and others are trying to gauge the possible or probable extent of the damage that the coronavirus and the consequent reductions in activity are going to inflict on the economy. Though Britain’s OBR has presciently warned of the risk of longer-term “scarring” of the economy, the general supposition seems to be that, whatever the severity and the duration of the crisis turn out to be, it will be followed by a “recovery”, involving both the eventual restoration of pre-crisis levels of activity, and a reinstatement of the belief in “growth”.

The view expressed here is that trust in a full economic “recovery” – irrespective of the time that is allowed for this to happen – owes more to obstinacy and wishful-thinking than it does to logic. The very word “recovery” presupposes that the economy pre-virus was robust, was continuing to deliver meaningful “growth”, and constituted some form of “normality”.

It’s worth remembering that, long before the crisis, world trade in goods, and sales of everything from cars and smartphones to chips and electronic components, had already turned down. Financially, extreme strains were already emerging right across the system. Investors had already started turning their backs on shale, and the “unicorn” absurdity – the bizarre delusion that any company combining an “app” with a cash incinerator must come good in the end – was already going the same way as the Emperor’s New Clothes.

There is, after all, precious little “normality” to be found in a system which pays people to borrow, and which places an almost mystical faith in the ability of central banks to ensure that asset prices only ever move upwards.

No apology need be made for saying that a lot of us had already realised that the “new normal” – of ever-rising asset prices, and of an unending tide of cheap credit and cheaper money – had become absurd to the point of the surreal. The best reason, in addition to simple observation, for questioning the validity of this “new normal” mindset was a recognition that the economy is an energy system, and that the energy equation driving prosperity had already turned against us.

Rather than going into the technicalities of the energy-based interpretation, we can simply state that the relentless rise in the Energy Cost of Energy (ECoE) was applying a tightening squeeze to the surplus energy which determines prosperity.

The very extent of the financial adventurism happening in plain sight attests to the scale of bafflement and denial being required of the adherents of the dogma of perpetual growth. It doesn’t help, of course, that our entire financial system is wholly predicated on the implausible proposition that there need be no limits to economic expansion on a finite planet.

The reality, then, is that an ending of growth – and a consequent destabilising of the financial system – were lying in wait for us, needing only a catalyst, which the coronavirus has now supplied.

What this means is that “de-growth” has now arrived. This is not something that we have chosen, however compelling may have been the environmental or the human case for kicking our growth addiction. There’s nothing noble, voluntary or selected about the onset of de-growth which, rather, is a straightforward consequence of the unwinding of an energy dynamic which, courtesy of fossil fuels, has powered dramatic expansion ever since the first efficient heat-engine was unveiled back in 1760.

The necessity now is to understand de-growth, and to make the best of it. Those who have considered this likelihood have started to understand processes such as loss of critical mass, the threat posed by falling utilization rates, the inevitability both of simplification and of de-layering, and the equal inevitability that, just as economies became more complex as they expanded, they will be subject to a process of de-complexification now that prior growth in prosperity has gone into reverse. As shown below, these components of de-growth give us an outline taxonomy of the very different economic world of the future.

It doesn’t require a Pollyanna approach to understand that, just as “growth” has been a mixed blessing, de-growth offers opportunities as well as threats.

If you really valued ‘business as usual’, were looking forward to a world of widening inequalities and worsening insecurity of employment, enjoyed the glitz of promotion-drenched consumerism, and were unconcerned about what a never-ending pursuit of “growth” might do to the environment, you might find the onset of de-growth a cause for lament.

If, on the other hand, you understand that our world is not defined by material values alone, you might see opportunities where others see only regrets.

Degrowth diagram

= = = = = = = = = = = = = = =

Shapes V Z ADG

Scatter transport

#169. At the zenith of complexity

THE ONSET OF “DE-GROWTH” AND “THE GREAT SECTOR EXTINCTION”

In the previous article, we examined the scope for tangible value destruction in the global financial system. In some future discussion, we might look at the very substantial empowerment that is being handed to environmental causes by some of the direct and indirect consequences of the Wuhan coronavirus crisis.

Here, though, the issue is the economy itself, and readers will understand that this interpretation is framed by the understanding that the economy is an energy dynamic, and not a financial one.

For those who like their conclusions up front, the single most important takeaway from what follows is that the crisis caused by the coronavirus pandemic has triggered two fundamental changes that were, in reality, due to happen anyway.

One of these is a systemic financial crisis, and the other is the realisation that an era of increasingly-cosmetic economic “growth” has come to a decisive end.

The term which best describes what happens from here on is “de-growth”. This is a concept that some have advocated as a positive choice, but it is, in fact, being forced upon us by a relentless deterioration in the energy-driven equation which determines prosperity.

At its simplest, this means that the near-universal expectation of a future “economy of more” has been invalidated. We’re not, for example – and as so much planning has hitherto assumed – going to be driving more cars on yet more roads, and taking more flights between yet more airports. A seemingly-assured future of more consumption, more leisure, more travel, more wealth, more gadgets and more automation has, almost at a stroke, ceased to exist.  Economic considerations aside, the energy supply outlook alone has long since ceased to support any such assumptions.

More fundamentally, an economy which is shrinking is also one that will become progressively less complex. Whole sectors of activity will disappear through processes of simplification and de-layering. The pace of economic deterioration, and the rate at which the system de-complexifies, will be determined by identifiable factors which include falling utilization rates and the loss of critical mass in economic activities.

The inevitable arrives

Seen from the perspective of the energy-driven economy, the crisis is unveiling much that we already understood. Essentially, relentless increases in the Energy Cost of Energy (ECoE) are the constant in an economic (and financial) narrative that has been unfolding ever since the 1990s, and which has long pointed, unequivocally, towards both falling prosperity and a “GFC II” sequel to the 2008 global financial crisis (GFC).

Between 1990 and 2000, global trend ECoE rose from 2.6% to 4.1%, entering a level (between 3.5% and 5%) at which prior growth in the prosperity of the western Advanced Economies started to go into reverse. By 2008, when the world banking system was taken to the brink by the GFC, ECoE had already reached 5.6%.

The next critical point occurred during 2018-19, when trend ECoEs entered a higher band (between 8% and 10%) at which less complex, less ECoE-sensitive emerging market (EM) nations, too, start to experience a reversal of prior growth in prosperity. This latter event has confirmed that, after a remarkably long plateau, the prosperity of the world’s average person has turned down.

The financial and economic ‘high command’ has never understood this energy-based interpretation, and this incomprehension has created a parallel narrative of futile (and increasingly dangerous) financial adventurism.

This is why we can expect a GFC II-type event to coincide with a decisive downturn in the economy. Though the coronavirus crisis is acting as a trigger for these events, we should be in no doubt that both of them were due to happen anyway.

Welcome to de-growth

The term which best describes a downwards trajectory in prosperity is “de-growth”. Many have advocated de-growth as something that society ought voluntarily to adopt in its own best environmental and broader interests.

The surplus energy interpretation, though is that de-growth isn’t a choice that we might or might not make, but an economic inevitability.

Critically, de-growth doesn’t simply mean that the economy will become quantitatively smaller. It also means that much of the complexity which has developed in parallel with past economic expansion will go into reverse.

This de-complexifying process will have profound consequences. As well as determining the pace at which the economy shrinks, the retreat from complexity will impose changes on the shape, as well as the size, of the economy of the future.

Where the rate of prosperity deterioration is concerned, the interplay of two factors is going to prove critical.

One of these is the utilization effect, which describes changes in the relationship between the fixed and variable costs of the supply of goods and services. As utilization rates fall, the per-user share of fixed costs rises, and any attempt to pass such increases on to consumers is likely to accelerate the pace at which utilization rates fall.

The second operative trend is the critical mass effect. This describes the way in which supply processes are undermined by the lack of access to critical inputs. To a certain extent, suppliers of goods and services can work around this effect, by altering (and, in general, simplifying) both their products and their processes. Even so, there are limits to the ability to circumvent critical mass effects, and the likelihood is that capacity will decline, resulting in a corresponding reduction in the range of goods and services on offer to consumers.

Both the utilization and the critical mass factors introduce considerable uncertainty into the rate at which prosperity will deteriorate, but an even bigger imponderable is the combined impact of utilization and critical mass effects. It is easy to picture how these are likely to interact, with, for example, falling utilization rates removing inputs in a way that accelerates the loss of critical mass.

The end of “more”

One of the practical implications of this interpretation is that the current consensus about our economic future – a consensus which we might call ‘the economy of more’ – is becoming ever less plausible.

Until now, virtually all planning assumptions have been framed by this expectation of continuous expansion. We’re assured, for example, that by 2040, there will have been be a billion-unit (75%) rise in the world’s vehicle fleet (requiring more roads), whilst aviation passenger miles will have increased by about 90% (so we’ll need a lot more airport capacity).

These and similar projections are based on assumptions that we can consume about 28% more energy in 2040 than we do now, with petroleum and natural gas supply rising by, respectively, 10-12% and 30-32%. All of these consensus projections seem extremely unlikely to be realised, not least because of the crumbling economics of energy supply itself.

The miss-match between, on the one hand, the assumption of extrapolatory expansion in virtually all economic activities and, on the other, the improbability of the requisite growth in energy supply, seems never to have occurred to those whose plans inform the economic consensus.

What all of this means in practice is that projected rates of prosperity deterioration are conjectural, with probabilities favouring an acceleration in the pace of decline.

With this caveat understood, the base-case generated by SEEDS (the Surplus Energy Economics Data System) provides a useful reference-point for discussion. The model indicates that the average person worldwide will be poorer by 9.5% in 2030, and by fully 20% by 2040, than he or she is today. It follows from this, of course, that his or her ability to carry debt and other financial burdens – and to pay taxes – will be correspondingly impaired.

Fig. 1:

#169 03 prosperity regional

Simplification and de-layering

Two further trends, both of which are of fundamental importance, can be anticipated as consequences of the de-complexifying process.

One of these is simplification, which describes a rolling contraction in the breadth of choice on offer to consumers, and a corresponding contraction in systems of supply.

The second is de-layering, meaning the removal of intermediate economic processes.

The de-layering effect can be illustrated using food supply as a comparatively simple example (though the issues involved extend right across the gamut of products and services).

The pre-industrial system for supplying food had few stages between farmer and ultimate consumer. There were, to be sure, millers, carters, coopers, green-grocers, butchers and a number of other trades operative between producer and customer, but there was nothing on the scale of today’s plethora of intervening layers, which run from fertilizer suppliers and agricultural consultants at one end of the spectrum through to packaging and marketing consultants at the other.

Looking ahead, the application of simplification and delayering to the chain of food supply suggests that, whilst product choices will narrow (ten sorts of breakfast cereal, perhaps, rather than fifty), some of the intervening layers will contract, whilst others will disappear altogether. Simpler products and simpler product ranges require fewer intermediate stages.

Extended across the economy as a whole, the implication is that we face what might be called a “great extinction” of trades, specialisations and, indeed, of whole sectors. As and when this forward trend gains recognition, it’s likely that businesses and individuals will endeavour to withdraw from activities which are at high risk of being de-layered out of existence.

Surveying new horizons

The economic processes described here are going to have far-reaching implications, most of which will be matters for subsequent discussion. First, though, it makes sense to recap the critical points of the foregoing.

The fundamental change now in prospect is that economic de-growth will set in, and will eliminate most of the expectations hitherto covered by the term “the economy of more”. The rate at which the economy shrinks (and the average person becomes less prosperous) will be influenced by a number of variables, of which critical mass and utilization effects are amongst the most important.

A reasonable working assumption, generated by SEEDS, is that people are going to get poorer at annual rates of about 1%, though there will, needless to say, be major regional and national variations around this trend.

This rate may not sound all that dramatic – though we need to bear in mind that it might worsen – but the shock effects of the onset of de-growth are likely to be profound, not just in the economic and financial spheres, but socially and politically as well.

As the economy gets smaller, it will also become less complex. Central strands here are likely to include both simplification (of products and of processes) and de-layering. The latter will involve contraction in some areas of activity, and the elimination of others.

The coronavirus crisis itself is providing us with a foretaste of some of these anticipated trends. In economic terms, the most important effect of the crisis is the hiatus in the cash flows of businesses and households. The consequent need to conserve cash (and to avoid going further into debt under circumstances of extreme uncertainty) is inducing conservatism into economic behaviour.

Companies and families alike are imposing new and tougher criteria on their expenditures, meaning that households are cutting back on “discretionary” (non-essential) spending, whilst businesses are minimising outgoings wherever they can. Companies are likely to make severe cuts in their marketing spend (because there’s not much point in advertising things that customers can’t or won’t buy), and will seek to renegotiate (meaning reduce) rents, outsourcing costs and other overhead expenses.

If – as seems very likely – this event marks (though it will not have caused) the onset of de-growth, it’s probable that newly conservative attitudes will continue. Consumers are unlikely to go back to “splashing the cash”, even when (or if) something nearer to “normality” is restored. Businesses which have, for example, downsized promotional expenditures and simplified their operations, are unlikely to revert to former spending patterns.

In short, this crisis may well have kick-started the processes of simplification and de-layering described above. Both of these processes can be expected to shrink some areas of economic activity and, in some cases, to eliminate them altogether.

Finally, these effects are highly likely to be reflected in other spheres, causing major attitudinal changes. Voters can, for example, be expected to be more supportive of essential public services, and less tolerant of perceived excesses in the private sector.

Governments themselves are likely, in due course, to recognise the risk of contraction in their tax bases and will, in any case, have gone much further into debt as a direct consequence of the crisis. Pressure for redistribution, and a generally heightened emphasis on economic issues, were pre-existing political consequences of deteriorating discretionary (“in your pocket”) prosperity.

At the same time, it is surely self-evident that governments cannot risk repeating policies which, rightly or wrongly, have been encapsulated into a popular post-GFC narrative of “rescue for the wealthiest, austerity for everyone else”.

CORONAVIRUS – THE ECONOMICS OF DE-GROWTH

#168. Polly and the sandwich-man

SCOPING FINANCIAL RISK

By their very nature, events like the Wuhan virus epidemic (or whatever the history-books end up calling it) polarise opinions, some of which become ever more extreme as the crisis unfolds.

At one end of the spectrum, those who claimed that the coronavirus was just some kind of minor variant on ‘normal’ seasonal ailments are being taught a harsh lesson in reality.

At the other extreme, though, many continue to insist that this is an ‘existential’ event, from which neither the economy nor the financial system (or anything else that we hitherto took for granted) is going to emerge, at least in any recognizable form.

If you believed either of these things, you probably wouldn’t bother trying to plan, or, as is the case here, to try to ‘scope’ the course that economic and financial trends might take.

Generally, though, extremes, whether of optimism or of pessimism, usually turn out to be wrong. Neither the Pollyanna nor the Sandwich-Board Man approach is going to help. Whistling a cheerful tune isn’t going to give us greater visibility on the post-crisis situation, but neither is walking around wearing a placard proclaiming that “The End is Nigh”.

The rational and practical response is to reason from what we do know to what we need to know. This is why, in economics and finance, we do need to try to scope this crisis.

To do this effectively, it makes sense to adopt two working principles.

One of these is that we bring new thinking to bear, so that we’re not just playing new tunes on the broken fiddle of ‘conventional’ economics.

The other is that we’re clear about the limitations imposed by the uncertainties implicit in the situation.

This is where ‘scoping’ differs from prediction. What follows doesn’t try to forecast what will happen, just to set some parameters on what might.

From troubled skies

Though the epidemic itself couldn’t have been anticipated, many of us have long recognised that trends and conditions pointing towards “GFC II” – a different and more extreme sequel to the 2008 global financial crisis (GFC) – were already in place.

A condensed version of this narrative is that the authorities responded to the “secular stagnation” of the late 1990s, first with ‘credit adventurism’, and latterly with ‘monetary adventurism’ as well. Where the former put the credit (banking) system at risk, the latter called into question the viability of the entire fiat monetary structure. Beyond buying some time (at a very hefty price), neither expedient has achieved anything worthwhile, but has inflicted an enormous amount of damage along the way.

It is, indeed, reasonable to conclude that we’ve spent more than two decades packing dynamite into the foundations of the financial structure.

Signs that economic reality might have started to break through had become apparent well before the current crisis erupted. Sales of everything from cars and smartphones to chips and components had already turned down, world trade in goods was already shrinking, and severe financial stresses were already emerging, particularly in China, and in some of the more irrational parts of the global ‘cheap money’ economy.

This is why, rather than having hit us out of blue skies, this crisis is really a bolt from the grey. Whether people had noticed these gathering dark clouds largely depended on whether they were looking at the situation from a point of view founded in reality, or were still persuaded by the ‘conventional’ tarradiddle that there was nothing too abnormal in the situation (or, at any rate, nothing so abnormal that it couldn’t be handled by our omnipotent, omniscient central bankers).

The energy perspective

These past exercises in ‘adventurism’ have had a shared assumption, which has resulted from a fundamental misconception about how the economy really works.

In order to believe that we can boost the performance of the economy by financial gimmickry – whether by pouring cheap credit into the system, or by flooding it with even cheaper liquidity – you’d have to start by assuming that the economy is a wholly financial system. If this assumption was correct, you could conclude that fiscal and monetary policy are the effective levers of control.

In reality, of course, these assumptions are mistaken. An economy that exists wholly in the realm of the human artefact of money – and is unrelated to the physical world in which we live – is a fiction.

As regular readers will know, my approach is based on the understanding that the economy is not a financial system, but an energy dynamic.

Briefly stated, the surplus energy interpretation of the economy has three central tenets.

The first is that nothing of any economic utility whatsoever can be produced without the use of energy.

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

The third part of this “trilogy of the blindingly obvious” is that money has no intrinsic worth, and commands value only as a ‘claim’ on the output of the ‘real’ (energy) economy.

The credit connection

From this understanding, we can start with the observation that financial ‘claims’ have grown far more rapidly than the ‘real’ economy on which such claims can be honoured. Comparing data for 2018 with the numbers from 2008 reveals that each $1 of reported “growth” in the global economy over that decade was accompanied by $3 of net new borrowing.

The crucial interconnectedness in this situation is that pouring money and credit into the system doesn’t just increase the aggregate of financial claims, but also inflates the apparent size of the economy itself.

The ways in which this happens can be re-visited at a later date, but what we need to know now is that it happens.

The chart below illustrates this relationship. The vertical axis shows percentage growth in GDP during the years since the 2008 global financial crisis (GFC), whilst the horizontal shows annual borrowing, as a percentage of GDP, over the same period.

The clear outlier here is China, whose annual growth has been around 7%, but whose annual rate of borrowing has been about 25% of GDP. This is why slightly more than doubling Chinese GDP (+115%) required a near-quadrupling of debt (+290%), and why borrowing has exceeded growth in the ratio 3.6:1.

The numbers for India look a lot better (though they’ve been worsening for some time), because the country has achieved strong growth without a dramatic recourse to borrowing. Both France and Japan are on the negative side of the trend-line, borrowing a lot, but getting precious little growth in return.

Fig. 1

#167 Value Destruction 01B

Individual economies aside, though, the critical observation which emerges from this is that ‘the more you borrow, the more apparent growth you can report’.

Most of the countries shown on the chart – and the world and regional aggregates, too – are at, or close to, a trend-line which connects the extent of borrowing with the quantity of GDP growth that has been reported.

What this means, as it applies to current circumstances, is that the numerator of debt (and, for that matter, of broader commitments), and the denominator of GDP, are not discrete, but are linked together.

Upwards tendencies in debt have had an inflationary effect on apparent GDP. This means that a straightforward ratio which compares debt with GDP is extremely misleading because, when you increase the one, you simultaneously increase the other.

This in turn means that debt/GDP ratios operate in ways which tend towards complacency.

The prosperity benchmark

Energy-based calibration of prosperity, as undertaken by the SEEDS model, is designed to provide a measure of economic output which, as well as taking ECoE into account, is distinct from this ‘credit pull’.

The result is to revise the interpretation of economic trends, indicating that, rather than ‘an economy of $87tn, growing at 3% annually’, we entered this crisis with ‘an economy of $53tn, that is hardly growing at all’.

Taking non-government debt as an example, let’s examine the implications of this approach.

During 2009, nominal world GDP was $60tn, whilst private debt was $85tn, for a debt/GDP ratio of 141%. Since then, both debt and GDP are supposed to have grown by just over 20% in real terms, which means that the ratio between them (shown in blue in fig. 2) seems hardly to have changed at all.

When we shift the basis of calibration from GDP to prosperity, though, the resulting calculus is both very different, and a great deal more cautionary.

Compared with a real increase of 23% in private debt, aggregate world prosperity hasn’t actually grown at all since the GFC. One reason why this is so different from the narrative of “growth” is that most of the headline increases in GDP have been the simple consequence of spending borrowed money.

The other is that ECoEs have risen relentlessly, long since passing levels at which prior growth in Western prosperity goes into reverse, and, more recently, entering a band where the same thing starts to happen to the EM (emerging market) economies as well.

This means that the ratio which expresses GDP as a percentage of prosperity (shown in red) has expanded markedly, from 183% in 2009 (and 125% back in 2000) to a current level of just over 230%.

A reasonable inference from this is that the debt-to-prosperity ratio has moved a long way out of equilibrium, leaving it poised to fall back to a prior, much lower level.

Departure from debt equilibrium is, of course, exactly what you would expect to have happened after more than a decade in which people have been paid to borrow. But quirks in the calculations which use GDP as a measure of debt exposure have served to disguise this critical trend.

Indeed, when you take this enormous process of subsidised borrowing into account, any suggestion that proportionate indebtedness hasn’t increased becomes wholly counter-intuitive.

An understanding of this principle enables us to scroll back across the years of financial excess in search of ratios which might represent a sustainable equilibrium.

This same calculation, when expressed as debt aggregates in constant dollars (as in the right-hand chart), suggests that a sharp decrease in outstanding non-government debt might have become inescapable.

Unless we’re prepared to assume that dramatic inflationary effects will destroy the real value of debt (a ‘soft default’), the implication is that we may be facing a process of extensive default, for which the term used here is a default cascade.

Fig. 2

#167 Value Destruction 05

The bigger picture

Before we move on (in future discussions) to consider what a default cascade might look like in practice, it’s important to note that formal debt doesn’t, by any means, capture the full extent of financial exposure. A better way to look at this is to reference financial assets or, more specifically, the aggregate of such assets excluding those of the central banks.

Financial asset exposure, always important, has taken on renewed significance during the uncertainties of the epidemic, and a causal link can be identified between, for example, the extremity of British financial exposure and recent sharp falls in the value of Sterling. Private financial assets stand at 1100% of British GDP, whereas the ratio for the United States is only 460%, so a fall in the value of the pound against the dollar is a wholly logical response to extreme financial uncertainty.

At the global level, financial assets data for countries accounting for about 80% of the world economy is available, and this data puts private financial assets at 450% of GDP. This a number which, like the debt/GDP ratio, hasn’t worsened since 2009.

Expressed against prosperity, however, this metric has expanded, because real financial assets have grown (by about 15%) over a decade in which prosperity hasn’t increased at all.

If, as we did with debt, we track back across the years of excess in search of the equilibrium ratios towards which a return might seem likely, the inference is that, like debt, the broader class of financial assets may face a severe retrenchment and this, again, points to various forms of default.

Clear and present danger

In what is intended as a scoping exercise, attaching numbers to these interpretations requires the caveat that our conclusions must recognise the extremity of uncertainty implicit in current conditions.

Indications from SEEDS-based analysis suggest that we should not be too surprised if debt of $60tn, and broader financial assets of an additional $100tn, are at risk.

These, as stated earlier, are scoping numbers, not forecasts.

Even so – and given the sheer scale of what we know is happening to the economy – these numbers need not seem all that surprising. The Pollyannas out there might say that little or none of this is actually going to happen, whilst the words “Told you so!” might be added to the doomsters’ sandwich-boards. The strong likelihood is that, in finance at least, the sandwich-boarders are a lot nearer the reality than the ditty-whistlers.

On the basis of this scoping exercise, we can anticipate that the global financial system could be facing a hit of $160tn, which is 185% of GDP.

That might be something from which the economy itself could recover, albeit in a battered and bruised form.

But you’d have to be a long way towards the Pollyanna end of the axis of optimism to think that the financial system could survive without either severe inflationary effects or a systemically-dangerous process of default.

CORONAVIRUS – THE SCOPE OF FINANCIAL RISK

 

#167. Tests and correctives

VALUE AT RISK, OIL PRICES CRUSHED – A SYSTEM ON TRIAL

In any moment of crisis, it’s easy to be pulled two ways, between the immediate and the fundamental. But it helps when, as now, we can recognise that both themes meet at the same point.

In this sense, “the 2020 Wuhan crisis” (or whatever it ends up being called) has acted as a catalyst for severe risks built into the system over a protracted period of mismanagement, incomprehension, self-interest, hubris and sheer folly.

Just so that you know what’s coming, this discussion is going to concentrate on two issues.

The first of these is the scope for value destruction in the current situation. Here I believe that the use of an independent benchmarking system – based on energy economics – provides an advantage over the monocular, ‘the economy is money’, way of looking at these things.

The main theme here, though, is energy in general, and oil in particular.

On the one hand, the consensus assumption is that we’ll be doing more of every sort of activity (including driving and flying) that depends on having more energy (and more petroleum) in the future than we have now.

On the other, however – and even before the recent slump in oil markets – crude prices simply can’t support even the maintenance of oil supply, let alone the 10-12% increase seemingly required by consensus expectations.

What I aim to do here is to explore this contradiction.

Before we start, though, I’d like to apologise to anyone who, over the past two weeks or so, has wondered why their comments seem to have vanished into the ether, or why there seems to have been much less debate here than usual. What appears to have happened – for no apparent reason, and wholly outside my control – has been that most notifications of comments awaiting approval have ceased to reach me. For the time being, and as frequently as possible, I’m going to review the list of outstanding comments manually.

Short shock, long folly, value exposed

Right now, as markets and sentiment gyrate wildly, we’re watching a fascinating intersection between the immediate and the fundamental playing out before our eyes.

The system that’s being shocked by the coronavirus crisis was a system that was already in very bad shape, and we can be pretty certain that, if the catalyst hadn’t (or maybe hasn’t yet) come from Wuhan, it would have (or assuredly will) come from somewhere else.

As somebody might have said, ‘if you build a monster, don’t be surprised if it bites you’ – and as somebody once did say, “some days you eat the bear, some days the bear eats you, and other days you both go hungry”. I’ll leave it to you to decide what roles greed, incomprehension and sheer folly have played in the building of the financial monster.

One of the critical issues now has to be the potential for ‘value destruction’ in the current crisis. Amongst the advantages of having an alternative, non-financial (energy) approach to economics is that it provides a second basis of measurement (in this case, the SEEDS prosperity benchmark) for just this kind of contingency.

‘Value’ really falls into two categories. The first is largely ‘notional’, and covers assets such as equities and property. Since nobody could ever monetise the entirety of either asset class, these ‘values’ are functions of the changing narratives that we tell ourselves about what things are ‘worth’. No money actually leaves somebody’s bank account because of a slump in the market price of his or her property or share portfolio.

‘Real’ value, on the other hand, consists of defined commitments which may become incapable of being honoured. The obvious example now is debt, on which businesses or households may be forced to default because their sources of income have dried up.

My approach here has been to use the Surplus Energy Economics Data System (SEEDS) to scroll back through the long years of financial excess in search of reference point ratios more sustainable than those of today.

Without burdening you with too much detail on this, SEEDS-based calculations suggest that up to 60% of the world’s private debt could be at risk, with the exposure of the broader structure of other financial assets at about 70%. My calculations are that up to $70 trillion of debts, and as much as $190tn of broader financial commitments, may be exposed.

Huge though they are, it must be emphasised that these are estimates of the scope for ‘value destruction’ – and how much of this scope turns into real losses depends upon many variables, chief amongst them being the duration and severity of the virus crisis, and the policies adopted by the monetary and fiscal authorities.

Assuming that these authorities act with more wisdom than they’ve exhibited so far – and stop firing off their scant remaining rate policy ammunition before the target comes over the hill – then the outcome isn’t likely to be anywhere nearly this bad, and a full-blown cascade of defaults can be avoided. Meanwhile, it’s possible to see stock markets settling perhaps 40% below their pre-crisis levels, with property prices down by 30%.

This, of course, presupposes that decision-makers don’t resort to putting so much gas back into the balloon that it really does detonate, leaving us scattered with the fragments of exploded hubris. In essence, do we use this event to re-group, or do we insist on ‘irrationality as usual’, regardless of cost?

After all, with the levers of the system in the hands of people who actually think that over-inflated stock markets, and over-priced property markets, are both ‘good’ things, there’s almost no degree of folly that can wholly be ruled out.

Energy – cutting away the foundations

Properly considered, there are two separate market crises happening now, both of them linked to the Wuhan coronavirus event.

One of these is the wave of falls in global stock markets, which the Fed and other central banks are trying, Canute-style, to stem. It would be far better if markets were left to get on with it, with the official effort concentrated on getting businesses and households through the hiatus in their cash flows.

The other crisis – linked to the epidemic by the anticipated sharp fall in petroleum demand, though triggered by a spat between major producers – is the sharp fall in the price of crude oil.

Some observers have suggested that the fall in oil prices will offer some relief for consuming economies, whilst others point out that the oil sector itself is going to be hit by a wave of financial failures, just as much the same thing might be poised to happen across vast swathes of the rest of the economy. The real issue, though, is how much damage this is going to inflict on the oil and gas industry, and where it leaves the industry’s ability to invest.

For those of us who understand that the economy is an energy system, the link between these events takes on a fundamental significance. Oil may be “only” 34% of global primary energy consumption, but it continues to account for a lot more than 90% of all energy used in transport applications. Fossil fuels (FFs), meanwhile, still provide more than four-fifths of world energy supply, a number that has changed only fractionally over decades.

Enthusiasts and idealists might talk about a post-fossil economy, just as the airline industry tells us that it can continue to grow whilst moving towards zero net carbon emissions. But, in both of these instances, as in others, there’s a very big gap between aspiration and actuality.

In search of neutral ground, we can do worse than look at long-range energy demand projections from the International Energy Agency (IEA), the U.S. Energy Information Administration (EIA) and OPEC.

All three publish central case forecasts, essentially mixing consensus-based economic assumptions with the mix of policies in place around the world. In broad terms, all three are agreed that, unless there are changes to these central parameters, we’re going to be using 10-12% more oil in 2040 than we use today.

‘Please sir, can I have some more?’

If you look at these projections in greater detail, it further emerges that we’re going to be doing a lot more of the things for which oil, and energy more broadly, are pre-requisites.

We are, for example, going to be driving more, even though electrification should keep the rise in oil demand for road use pegged at single-digit percentages. By 2040, there are expected to be more than a billion (74%) more vehicles on the world’s roads than there are today. It seems to be assumed that, by then, about 40% of the global fleet will have been converted to EVs, but that will still see us using more oil on our roads – not less.

We’re also, it seems, going to be flying a lot more than we already do, requiring a lot more petroleum, despite an assumed pace of energy efficiency gains seemingly running at about 1.5% annually. My interpretation suggests that passenger-miles flown are expected to rise by about 90% over that same period, though, thanks to compounding efficiency gains, petroleum use in aviation is expected to rise by “only” about 38%.

Within the overall energy position, the expectation is that our consumption of primary energy will be about 28% greater in 2040 than it was in 2018. Within this increment (of 3,900 million tonnes of oil equivalent), about 12% (450 mmtoe) is expected to come from hydro, and 44% (1,720 mmtoe) from wind, solar and other forms of renewable energy (RE). Nuclear might chip in another 5% of the extra energy that we’re going to need.

But the remaining 39% or so of the required increase is going to have to come from expanded use of fossil fuels, some of it from oil though most of it from gas (though it’s also noteworthy that no reduction in our consumption of coal seems to be anticipated). From the above, it will hardly be a surprise (though it is certainly disturbing) that annual rates of CO2 emissions from the use of energy are expected to carry on rising.

If any of this is remotely likely, though, why are oil prices languishing around $30/b?

To be sure, we know that demand is going to be impacted by Wuhan, and that producers including Saudi and Russia are scrapping over who should absorb this downside. But oil prices were hardly robust, typically around $65/b, even before the epidemic became a significant factor.

The fact of the matter is that we simply cannot square oil prices of $30, or $60, or even $100, for that matter, with any scenario calling for increases in supply.

We all know that global oil supply has been supported by American shale production, which has in turn relied on subsidies from investors and lenders. Now, though, it’s becoming ever more apparent (as was set out in a recent official report from Finland) that even ‘conventional’ oil supply is in big economic trouble.

It’s a sobering thought that, were capital flows to dry up to the point where there was a complete cessation of new drilling, US shale liquids output would fall by about 50% within twelve months. But it’s an even more disturbing thought that, unless capital investment can be ramped up dramatically, conventional oil supply is going to erode, less spectacularly, perhaps, but relentlessly.

So here’s the question – how, under this scenario, are we supposed to find sources for an increase in oil supply going forward? More broadly, and with oil and gas generally produced by the same companies, can we really increase the supply of natural gas by more than 30% over the coming twenty years? And can we – and, for that matter, should we – be using just as much coal in 2040 as we do now?

No ‘get out of gaol free’ cards

Two suggestions tend to be offered in answer to such questions, so let’s get both of them out of the way now.

One of these is that the use of renewables – whose output is currently projected to rise from 560 mmtoe in 2018 to more than 2,280 mmtoe by 2040 – can grow even more rapidly than is currently assumed.

But the reality seems to be that meeting current assumptions – boosting hydro-electricity supply by 50%, and quadrupling power from other renewable sources – is already a tough ask. The unlikelihood of these ambitious targets being beaten is underscored in the figures.

Energy transition has been costed by IRENA at between $95 trillion and $110tn, the latter equivalent to 720x today’s equivalent of what it cost America to put a man on the Moon. This time, of course, it isn’t just rich countries that have somehow to find this level of investment, but poorer and middle-income nations, too.

Annual capital investment in REs was, in real terms, lower in 2018 than it had been back in 2011, mainly because prior subsidy regimes have tended not to be scalable in line with expansion. Yearly capacity additions, too, stalled in 2018.

The really critical snag with “big bang” transition is simple, but fundamental. RE technology has yet to prove itself truly “renewable”, because capacity creation, and the building of the related infrastructure, cannot yet be undertaken without the extensive use of fossil fuel energy in the supply of materials and components.

The second notion – which is that we can somehow “de-couple” the economy from the use of energy – is risible, even in an era in which we often seem to have “de-coupled” economic policy from reality. The EEB was surely right to liken the search for “de-coupling” to “a haystack without a needle”.

Until somebody can demonstrate how we can drive more, fly more, manufacture more goods and ship them around the world, build more capital equipment, and supply more of basics such as food and water, without using more energy, “de-coupling” will continue to look like a punch-line in search of a gag.

This is really a matter of physical limitations – and there’s no “app” for that.

Stand back………….

On the principle that “what can’t happen won’t happen”, we need to stand back and consider the strong possibility that the consensus of expectations for future energy supply is simply wrong.

Let’s assume, for working purposes, that RE supply does, as expected, expand by 2,170 mmtoe by 2040, and that hydro and nuclear, too, perform in line with consensus projections. In this scenario, supply of non-fossil fuel energy would, as specified, be higher by about 2,370 mmtoe in 2040 than it was in 2018.

At the same time, though, let’s make some rather more cautious assumptions, well supported by probabilities, about fossil fuels.

For starters, let’s assume that shale oil production doesn’t slump, and that other forms of oil production remain robust enough to keep total supplies roughly where they are now. This would mean that oil supply won’t have fallen by 2040, but neither will it have delivered the widely-assumed increase of 10-12%. Let’s further assume that gas availability rises by 15%, rather than by 30%, and that the use of coal falls by 10%.

In this illustrative scenario, fossil fuels supply remains higher in 2040 than it was in 2018, but by only about 300 mmtoe (+3%), instead of the generally-expected increase of 1,540 mmtoe (+13%). This in turn would mean that, comparing 2040 with 2018, total energy supply would be higher, not by the projected 28%, but by only about 19%.

…..and do less?

My belief is that this is a more realistic set of parameters than the ‘more of everything’ consensus about our energy future. If energy supply does grow by less than is currently assumed, growth in many of the things that we do with energy is going to fall short of expectations, too.

Let’s unpack this somewhat, to see where it might lead. First, if expectations for RE are achieved, we can carry on using more electricity, though not at past annual rates of expansion.

But less-than-expected access to oil would have some very specific consequences. With population numbers still growing, we’ll need to keep on increasing the supply of petroleum products to essential activities, such as the production, processing and distribution of food. You’ll know that my expectations for “de-growth” anticipate a lot of simplification and ‘de-layering’ of industrial processes, and there’s no reason why this shouldn’t apply to food supply. But it remains hard to see how we can supply more food from less oil.

In short, there are reasons to suppose that oil supply constraint is going to have a disproportionate and leveraged impact on the discretionary (non-essential) applications in which petroleum is used. At the same time, faltering energy supply – and a worsening trend in surplus energy, reflecting the rise in ECoEs – is likely to leave us a lot less prosperous than conventional, ‘economics is money’ projections seem to assume.

From here, it’s a logical progression to question, in particular, whether the assumption of continued rapid expansion in travel might, in reality, not happen. We could take – but, so far, haven’t taken – ameliorative actions, including limiting car engine sizes, and promoting a transition to public transport. My conclusion – which is tentative, but firming – is that we might be a lot nearer to ‘peak travel’ than anyone yet supposes.

The assumption right now seems to be that, as and when the virus crisis is behind us, we’ll go back to buying more cars and using them more often, flying more each year than we did the year before and, perhaps, rediscovering a taste for taking cruise-ship holidays.

Let’s just say that such an assumption might well prove to be a long way wide of the mark.