#237. Asking for the moon


What the media calls the ‘cost of living crisis’ is fast turning into an affordability crisis. The former is where discretionary consumption slumps. The latter means that increasing numbers of people can’t keep up the payment streams on which the financial system depends.  

As the situation worsens, politicians and commentators are bombarding us with calls for action, proposing often-contradictory fixes for what can’t be fixed, but can only, at best, be managed.

If there’s a common theme, it is that we need to borrow even more than we already have.

If there’s a common fallacy, it’s that we just need to find the right financial answers to our woes.

None of this can work, because what we are witnessing now is absolute proof that the economy is an energy system, not a financial one.

Western Europe is one of the richest places on the planet, but its financial wealth will be meaningless – and will, in fact, evaporate – unless energy can be sourced in the requisite quantities, and at affordable prices.

Few regions are immune to this same problem. North America has substantial energy resources, but their costs are high, and rising. China has a sizeable energy deficit, as do other economies in the Far East. Even Russia, with her energy wealth, can’t emerge unscathed from a global economic slump caused by generalised energy deficiencies.

The war in Ukraine has reduced the supply of natural gas, but an end to that war, and the restoration of trade with Russia, wouldn’t solve our energy supply problem. This situation – including surges in the price of gas – was developing well before the first Russian tank rolled over the Ukrainian border. The costs of fossil fuels are continuing to rise relentlessly, and this is now pointing towards a decline in the volumes of oil, natural gas and coal available to the economy.

Some believe that renewables offer a complete replacement for the energy value hitherto obtained from low-cost fossil fuels. Some of us think that’s implausible.

But even the optimists have to concede that this can’t happen now, because a transition won’t be effective until the mid-2030s, at the very earliest, even if it can happen at all.

Renewables aren’t going to keep vehicles running, machines humming and households warm in the coming winter.   

As a direct result of problems with energy supply – interacting with a system founded on the hubristic assumption of infinite growth – the World is heading for a financial crash which is likely to dwarf the global financial crisis (GFC) of 2008-09.

Reality has arrived

These events should – and, in time, perhaps will – put paid to the notion that the economy is wholly a financial system, unconstrained by resource and environmental limits, and capable of delivering the logical impossibility of ‘infinite growth on a finite planet’.

It should also, if we’re lucky, put paid to political notions based on this same infinity fallacy. Everything that politicians promise or propose assumes that the right financial policies can deliver growth.

This simply isn’t true.

This is a fallacy shared by both ‘Right’ and ‘Left’. Collectivism can’t deliver energy abundance. ‘Leaving everything to the markets’ can’t deliver prosperity – even in theory, let alone in practice – if markets are deprived of the material goods and services for which, ultimately, markets act as financial proxies.

We can’t ‘stimulate’ our way to perpetual growth – and, by the way, Keynes never said that we could, confining the role of stimulus to the management of trade cycles.   

This is a time in which we need to shed all delusions based on monetary ‘fixes’. Changes to tax allocation can shift the burden of hardship between groups of people within a country, but borrowing to fund “tax cuts” can’t create “growth” in a contracting economy. Rate changes, and exercises in QE or QT, might act on the margins of inflation, but only within a recessionary-inflation trade-off.

Where monetary and fiscal policy is concerned, there’s something we need to be absolutely clear about – even if we were gifted with utterly brilliant decision-makers in governments and the central banks, there’s nothing they could do to boost the supply of affordable energy.

Lacking that ability, what they’re engaged in is a balancing-act – they can adjust the distribution of hardship between income groups, and they can try to defend exchange rates, but they can’t prevent the deterioration in material prosperity. That also means that there are limits to what they can do to tame inflation.

Inflation is not – thus far – being driven by excessive domestic demand, so raising the cost of existing debt won’t fix anything. Going forward, it’s the scale of lending that central bankers need to keep under control, not least because someone who borrows out of necessity is a far greater default risk than someone who borrows out of choice. Interest rates are a blunt instrument when it comes to restraining runaway borrowing and rising risk.

Principles and consequence

Under these extreme conditions, it’s necessary to remind ourselves of the ‘three principles, one consequence’ of economic reality.

The first principle is that the economy is an energy system, because nothing that has any economic value 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. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE.

Third, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the material economy.

These three principles lead inexorably to a logical consequence, which is that we need to think conceptually in terms of two economies – an energy-determined ‘real’ economy of goods and services, and a proxy ‘financial economy’, consisting of money and credit, which incorporates claims on material economic prosperity.

The economy can’t be understood effectively unless this conceptual distinction is recognized.

These principles are well-known to regular visitors to this site but, under current conditions, no apology seems necessary for their brief reiteration.

Conventional economic models can’t possibly act as reliable guides to our predicament. Their foundation assumptions are fallacious. The economy isn’t entirely a monetary system; resources are not some kind of substitutable adjunct to the economy; there are material and environmental limits to economic activity; and the promise of infinite growth on a finite planet is a delusion arrived at by reasoning from false premises.  

Energy-based economic analysis – like the SEEDS model used here – is the only way in which we can arrive at rational interpretations and forecasts.

The critical issue is the relentless rise in the ECoEs of oil, natural gas and coal. These account for more than four-fifths of global energy use, so this process has driven overall ECoEs to ever-higher levels. This process has killed off the scope for expansion in material prosperity, and has now put prior growth into reverse.

Rising ECoEs affect us, first, by making energy less prosperity-productive, because increasing costs reduce the surplus (ex-ECoE) value of each unit supplied. They are also starting to undermine quantitative supply itself, by making it ever harder to establish prices which both cover producer costs and are affordable for consumers.  

Not the turn of a card

This understanding should deal with claims that what we’re going through now is some kind of ‘run of bad luck’. In energy terms, pandemic-related shutdowns bought us a little time, simply because they amounted to a cutback in the consumption of energy, and of energy-dependent products and services.

The restoration of energy trade with Russia might, were it to happen, provide some temporary relief, but wouldn’t halt the rise in global ECoEs. Russia doesn’t have infinite supplies of hydrocarbons, and neither are its oil and gas operations particularly cheap.

Tempting though it is to blame the coronavirus, or Mr Putin, for current economic problems, then, this really won’t wash. The real culprits in the current situation are anyone who has promoted or believed the idea that material consumption can increase indefinitely on a planet with finite energy resources and finite environmental tolerance. This means pretty much all of us so, in that sense at least, the ‘blame-game’ is pointless.

Where blame can be placed is on the way in which prosperity – and, now, hardship – are allocated between different groups of people. Even here, though, arrogance and greed are compounded by ignorance.   

Where economic assertions are concerned, our collective hubris knows few bounds. We’ve been congratulating ourselves about “growth” over a long period in which prosperity has been contracting.

We’ve been piling up commitments that we can’t honour in pursuit of growth that can’t happen.

SEEDS analysis indicates that the average American has been getting poorer since 2000, and that the same thing had happened in almost all Western economies before 2008. Latterly, the inflexion-point in prosperity has been reached in an increasing number of EM countries, and global prosperity per capita has now turned down.

These inflexion-points in prosperity can be related directly to ECoEs, as the charts in fig. 1 illustrate.

Fig. 1

The West, in particular, has never accepted the idea that material economic expansion has ended, and has gone into reverse. Instead – and perhaps unknowingly – we have exploited the disconnect between the real and the financial economies to create a delusional simulacrum of “growth”.

Creating incremental monetary ‘claims’ on the economy doesn’t increase material wherewithal, any more than printing a lot more hat-checks can create more hats when checks are presented at the end of a function.

Because all money exists as a ‘claim’, the creation of monetary claims in the present adds to the aggregate of liabilities redeemable in the future.

Stated in dollars converted from other currencies at market rates, global debt at the end of 2021 stood at $236 trillion, or 245% of GDP ($96tn).

But formal debt hugely understates broader financial commitments, which can be estimated at $550tn, or 575% of GDP, and which include about $280tn in the ‘shadow banking system’. The ratios in some countries are far worse, including Britain (1263% as of the end of 2020), the Netherlands (1454%) and Ireland (1809%).

Even these ratios understate the true seriousness of our financial predicament, because the GDP denominator has been inflated artificially.

The basic principle involved here is simplicity itself. We create money which, by definition, is a ‘claim’ on the real economy and, because money itself is a claim, it’s also a forward liability. The spending of this money creates financial transactions, and the adding up of these transactions by statisticians creates the metric that we know as GDP. We then assume – quite mistakenly – that this ‘sum of financial transactions’ is economic ‘output’.

This means that we can inflate transactional activity by pushing ever more credit into the economy. This doesn’t add to material prosperity, but it does increase the overhang of forward claims that we won’t be able to honour.

Loaded dice

Beyond a tendency to ‘count the activity and ignore the liabilities’, the snag with this is that, over the past two decades, it has taken more than $3 of extra debt – and an increase of about $7.30 in broader financial liabilities – to produce $1 of additional transactional activity.

We can’t possibly win at these odds. A better option, were it feasible, might be to withdraw from the game, tying the rate of liability expansion to changes in the size of the economy – and, at the same time, desist from making implicit pension promises that a contracting real economy can’t possibly honour.

Instead, we carry on the self-delusion, even though the dynamics of the process are loaded against us. Every now and then, some bright spark tells us that, by borrowing now, we can create “growth” (which is true, but only in a statistical sense), and that this growth will then “pay off the debt” that we’ve taken on to create it (which simply isn’t possible, least of all in economies that rely on continuous credit expansion).

SEEDS modelling identifies the two critical equations that interpret our recent economic past realistically, and give us reasonable visibility on what happens next. With these understood, what we need to address is the matter of process.

Each equation requires two charts, and these are shown in fig. 2.

The first chart in fig. 2 shows how both debt and broader financial liabilities – known as ‘financial assets’ from the lender side of the equation – have dramatically out-grown GDP. Meanwhile, reported GDP has been inflated, not just by the ‘credit effect’ described above, but also because no allowance is made for ECoE.

Accordingly, we can plot, in the second chart, a widening divergence between the ‘financial’ metric of GDP and underlying prosperity, as calculated by SEEDS.

This divergence is a comparatively recent phenomenon – in past times, ECoEs were low, and we hadn’t embarked on the massive credit-creation binge that has become a seldom-noticed characteristic of the ‘delusional growth era’.

Back in, say, the 1950s, people weren’t using QE, ZIRP or NIRP, because they didn’t have to. ECoEs were low enough for the economy to deliver ‘growth without gimmickry’. The very adoption of these expedients is testimony to adverse underlying trends that we’ve failed to acknowledge.

The downside between the two economies is currently estimated at 40%, which gives us some idea of the scale at which financial ‘claims’ are likely to be eliminated once the inevitable restoration of equilibrium takes place.

Fig. 2

Most forecasters start with GDP and so, to produce projections on a comparable basis, SEEDS segmental analysis accepts the 2021 number (globally, $146tn PPP) as its start-point.

This does not, however, require us to accept the inaccurate statistical narrative of how we arrived at this number. Whilst reported real GDP doubled (+101%) between 2001 and 2021, prosperity increased by only 31% over that same period.

This enables us – as shown in the third chart in fig. 2 – to produce a reconciled trend in economic output, and to see how far this differs from reported numbers, which have been inflated by credit (claims) expansion, and which make no allowance for rising ECoEs.

This in turn enables us to interpret and project – as shown in the right-hand chart – the economy on the basis of the key segments, which are essentials, capital investment (in new and replacement productive capacity) and discretionary (non-essential) consumption.

What happens next

The technicalities of these interpretations and forecasts have been discussed here before, and might be revisited in the future. For now, though, what matters is the outlook itself, and what, if anything, might be done about it.

Starting with the economy, global aggregate output, referenced to prosperity, is heading for a downturn, and per capita prosperity is already declining. Meanwhile, the real costs of energy-intensive essentials are rising.

Accordingly, capital investment is poised to turn down, whilst we should anticipate relentless contraction in the affordability of discretionaries.

This will, probably sooner rather than later, undermine the confidence which investors and lenders place in businesses supplying non-essential products and services. Accordingly, these discretionary sectors will lead the decline in the valuation of assets. This will be accompanied by falls in the real prices of property, as these prices are linked to the metric of affordability, which is declining very markedly.

Though rate rises don’t help, the size of a mortgage that anyone can afford to service depends upon how much he or she has left after paying for necessities.

Assets, though, are less important in this context than liabilities. Asset prices are a function of the availability and cost of money – and money, as we know, is an aggregation of claims on the real economy. What happens now is that the vast burden of excess claims, created during a period of hubristic and futile denial of underlying reality, will be eliminated, either through inflation, through default, or a combination of both.

From the perspective of ‘two economies’, it’s clear than inflation is a function of the relationship between the material and the financial. Prices are the point of intersection in this relationship, because a price is the financial number ascribed to a material product or service.  

In real terms, we can’t prop up inflated asset prices, and it would be insane to try to carry on doing so. Neither can we ‘make good’ liability excesses, and any attempt to do so would involve the creation of money at a scale which would invite hyperinflation – which, ultimately, is an alternative, informal version of default.

Asset prices will tumble, then, and commitments won’t be honoured. What we’re left with is an economy in which, just as prosperity is declining, the cost of essentials will carry on rising.

Inequalities are inevitable in any economy, but these inequalities can be expected to combine with deteriorating prosperity to drive ever larger numbers of people into absolute poverty. This makes redistribution inevitable, even though the more privileged will fight this every step of the way.

The only way in which governments can seek moderate the rising cost of essentials is by spending less on public services (which count as essentials for our purposes, as the citizen has no ‘discretion’ about paying for them).

Time to call time on delusion

It would be a good idea if, whenever anyone suggests a financial ‘fix’ – rate rises, rate cuts, QT, QE, debt-funded tax cuts, more debt – we were to ask them to explain how these measures are going to deliver cheaper energy.   

This situation doesn’t leave us entirely powerless. We should, for instance, have long since embarked on energy efficiency measures, including the provision of public transport as a counter to the diminishing affordability of cars. Nuclear power offers some scope for supply relief, though it isn’t going to rescue us from energy deficiencies.  

But no workable amelioration measures can be crafted whilst our appreciation of the situation remains faulty.

The reality is that we need to concentrate on how to allocate and manage deteriorating prosperity. This has become a less-than-zero-sum game. We should not delude ourselves into believing that we can help some without taking from others.

This becomes a political choice and, many might say, a moral one. Social cohesion depends on facing this reality, and there’s no mileage in denying it, or trying to wish it away by proposing financial gimmicks that can’t work.

#236. The monetary conundrum


Following the Fed and the Bank of England, the ECB has become the latest central bank to adopt QT (quantitative tightening) and to raise interest rates, though the ECB’s 0.5% hike still leaves its deposit rate at zero. The ECB has also unveiled a mechanism – the Transmission Protection Instrument, or TPI – designed to ward off sovereign debt crises in some of the bloc’s weaker economies.

The details of these developments are set out very well in this Wolf Street article. The aim here is to discuss what policy actions – if any – make sense for the central banks.

Raising rates – and, by extension, putting prior QE into reverse – are straight out of the standard play-book for combatting inflation. It’s noticeable that central bankers are moving pretty slowly along this orthodox path, with each much-delayed rate rise far more than negated by the next surge in inflation.

But should they be tightening monetary policy at all?

The wrong response?

Some observers contend that raising rates isn’t the appropriate response under current conditions.

The argument runs that inflation isn’t being driven by internal demand excess, but by external factors over which the monetary authorities have no control. Rate rises in America won’t increase the supply of food to world markets, this argument runs, and QT in the Euro Area won’t ease shortages of oil and natural gas.

The argument against tightening monetary policy can be made either optimistically or pessimistically.

The optimistic line is that action isn’t needed, because the inflationary spike isn’t fundamental, but the product of happenstance. Given sufficient patience – and sufficiently accommodative monetary and fiscal policies – supply-lines ruptured by the pandemic will return to normality, as will the flow of energy, once the war in Ukraine reaches some kind of conclusion.

To the pessimist, the whole situation is hopeless anyway, so there’s no point in pulling forward the unavoidable crisis, or piling on the economic pain, when orthodox tightening policies cannot work.

Getting it half-right?

The view taken here is that central banks are right to pursue monetary tightening, though they might also be right in doing this fairly slowly.

Three lines of argument support this view.

First, inflation may have started with external factors, but could all too easily turn into an internal wage-and-price spiral. This kind of spiral is exactly what happened in the 1970s, even though the initial inflationary impetus came from events – the oil crises – outside the control of domestic monetary authorities.

To be sure, organised labour doesn’t have the clout that it had back then, and labour shortages aren’t likely to prove lasting. But the upwards pressure on wages remains, propelled by the need to ensure that employees can at least ‘make ends meet’.  

Second, this is a matter of degree.

Ever since ZIRP, NIRP and QE were adopted – as avowedly “temporary” and “emergency” expedients – in response to the GFC, nominal rates have been, almost always, below the rate of inflation.

But real rates, though negative, haven’t been deeply so. There’s a world of difference between rates that are negative to the tune of -2% or -3% and allowing them to fall to -8% or -10%, which could all too easily happen if central bankers don’t respond.

Negative real rates are anomalous, and harmful, and the damage is proportionate to the extent of negativity. Setting the cost of money below the rate of inflation invites debt escalation, which in turn leads to instability, such that deeply negative rates can be expected to lead to a full-blown crisis.

The market economy requires that investors earn positive returns on their capital, so an absence of these returns translates an ostensibly capitalist system into a dysfunctional hybrid. Letting real rates fall to extreme lows can only make this worse.

No good choices

Underpinning the view set out here, of course, is the understanding that prior growth in prosperity has gone into reverse because the energy equation that determines prosperity has turned against us.

This equation involves the supply of energy, its value and its cost, the latter measured, not financially, but as the proportionate Energy Cost of Energy.

Mainly because of the depletion of low-cost resources, the ECoEs of oil, gas and coal have risen relentlessly, pushing the overall ECoE of the system to levels far beyond those at which stability, let alone further economic expansion, remain possible.

You might believe that the ‘fix’ for the ECoE problem lies in transition to renewable energy sources. Even if you do believe that this is possible, though, it’s clear that it can’t happen now. The contrary point of view is that renewables can’t provide a like-for-like replacement for the energy value hitherto provided by fossil fuels.

Either way, inflation is one symptom of a divergence between the ‘real’ or material economy of goods, services and energy and the ‘financial’ or proxy economy of monetary claims on the real economy.

The further these two economies diverge, the greater the pressures become for the restoration of equilibrium between them.

The following charts summarize this dynamic. As ECoEs have risen, surplus (ex-cost) energy has contracted, and this effect is now carrying over into a decreasing total supply of energy as well.

The mistaken idea that we can boost material prosperity by stimulating financial demand has driven an ever more dangerous wedge between the financial or claims economy of money and credit and the underlying real economy of energy value.  

Fig. 1

The Fed – a shift in priorities

The third factor which helps justify conventional monetary responses to inflation is that each monetary area has its own idiosyncrasies and, where the Fed, the Bank of England and the ECB are concerned, these idiosyncrasies support the case for orthodoxy.

The Fed has, in some ways, the easier task of the three. Hitherto, rates have been kept ultra-low in the US in order to prop up and boost capital markets. Former president Donald Trump was wont to say that a high stock market was, ipso facto, indicative of a strong America. Mr Biden hasn’t repeated this nonsense – he can’t, whilst markets are correcting – but what’s really changed isn’t politics, but the context of intentions.

At times of low inflation, what monied elites fear most is a slump in asset prices. Once inflation takes off, however, this ‘elite priority’ shifts. A billionaire has a billion reasons for not wanting the purchasing power of the currency to be trashed.

This is why rate rises and QT aren’t taking America back to the “taper tantrums” of the past. The Fed might also hope that a commitment – albeit a much-delayed one – to the inflationary part of its mandate might help restore some public trust in the institution.

Britain – staving off the day

BoE priorities are different. For a start, the British fixation is with property prices rather than the stock market. Whilst the stock market “wealth effect” is an adjunct to the American economy, inflated property prices play a central role in supporting the illusion of prosperity in the United Kingdom.

The harsh reality is that the British economy is a basket-case. America might want stock market appreciation, but can get by without it. Britain needs property price inflation to keep the ship afloat.

The British economy depends on continuous credit expansion to produce the transactional activity, measured as GDP, which supports a simulacrum of ‘business as usual’. Inflated property prices play a critical role, providing both the collateral support and the consumer confidence required if credit expansion is to continue.

Fundamentally, Britain lives beyond its means, resulting in an intractable trade deficit. For a long time, this was bridged, at least in part, by income from exports of North Sea oil and gas. Once Britain became a net energy importer again, the emphasis switched with renewed force to asset sales.

Ultimately, though, this makes a bad situation worse, because each asset sale sets up a new outward flow of returns on overseas’ investors capital. These outflows are part of the broader current account deficit, which is dangerously high, and has become structural.

Former Bank chief Mark Carney warned about dependency on “the kindness of strangers”, but no realistic alternatives exist. Asset divestment – muddling through by “selling off the family silver” – is, by definition, a time-limited process.

The nightmare that must haunt the slumbers of British officials is a “Sterling crisis”. If the value of GBP were to slump, inflation would soar, vital imports could become unaffordable, and the local cost, not just of foreign currency debt but of servicing that debt as well, could soon become unsustainable.

Put simply, the BoE needs to show FX markets some resolve, even if that comes at the cost of some domestic economic pain. The Bank undoubtedly knows about – as some politicians seemingly do not – the price that could become payable for fiscal and monetary recklessness, if that recklessness were to trigger a currency crisis.

It’s a point seldom mentioned that, if a future leadership were to enact irresponsible tax cuts, the Bank might, as a compensatory measure, have no choice but to raise rates more briskly than would otherwise have been the case.

Some in Britain have dreamed, unrealistically, of turning the country into ‘Singapore on Thames’. The real and present danger is of turning into ‘Sri Lanka on Thames’, where a weak currency makes vital imports prohibitively expensive.

The prevention of a currency crisis has to be the overriding priority of responsible decision-makers. The balance of risk – no less than the balance of pain – has to be tied to the demonstration of sufficient resolve to stave off any such crisis.

The ECB’s camel

A camel was once described as “a horse designed by a committee”. A similar phrase could aptly describe the Euro system, created as a political ideal, and built on the most dubious of economic presumptions.

To work effectively, monetary policy needs to be aligned with fiscal policy. The Euro system doesn’t do this, but tries instead to combine a single monetary policy with 19 sovereign budget processes.

One of the consequences of fiscal balkanization is an absence of the ‘automatic stabilizers’ which operate in currency zones where the monetary and the fiscal are aligned.

If, for instance, Northern England was suffering a recession, whilst Southern England was prospering, less tax would be collected in the North, and more benefits would be paid there by central government, with the opposite happening in the South. Money would therefore flow, automatically, from South to North.

Critically, such regional transfers within the same currency zone are automatic, do not need to be enacted by government, and certainly do not depend on agreements between the differently-circumstanced regions.

By contrast, transferring money from, say, Germany to Greece isn’t automatic in this way, but depends on political negotiation, which is likely to be fractious, even at the best of times – which these times, of course, are not.

To be sure, Scotland and Wales have independent budgetary powers, as do American States. But there are, in both cases, over-arching sovereign budgets, set in London and Washington, which set the overall parameters. No such overarching budget exists in the Euro Area.

There are parallel problems in the Target2 clearing system. If a customer in Madrid buys a car made in Wolfsburg, Euros have to flow between countries, being debited in Spain and credited in Germany. But there are severe imbalances within the Euro clearing system.

As of May, Germany was a creditor of Target2 to the tune of €1.16 trillion, whilst Italy owed the system €597bn, and Spain €526bn. The official line is that this doesn’t really matter very much, but it’s hard to see how Germany can ever collect the sums owed to the country, via the system, by Italy and Spain.

One might argue that Target2 gives poorer EA nations rolling credit to fund imports from Germany.

The danger with a ‘one size fits all’ monetary policy, when applied in the context of a multiplicity of sovereign budgets, is that national bond yields can diverge, because each country, being responsible for its own budget, borrows individually on the markets.

Italy is a case in point. Prior to the formation of the Euro, Italy had a history of gradual devaluation of the Lira. Whilst this made Italians poorer in relative terms, it protected both employment and the competitiveness of Italian industry.

Once Italy joined the Euro at the end of 1998, this ceased to be possible.

This, in large part, is why Italian debt has increased, as the authorities have endeavoured to find other ways to deliver the support that would previously have been provided by gradual devaluation. This could, and does, make markets worry about Italian debt, putting upwards pressure on Italian bond yields.

If these yields were to blow out, Italy would encounter grave difficulties, not just in financing its fiscal deficits, but in maintaining the continuity of credit to the economy itself.

The ECB, in a rather belated effort to counter inflation, is committed to raising rates, and to letting its asset holdings unwind. This, though, could cause problems which culminate in drastically dangerous rises in bond yields in member countries such as Greece, Italy and Spain.

TPI – which the ECB must devoutly hope will never have to be put into effect – is designed to counter this process by varying the composition of QT. If rates spike in, say, Italy, the ECB could buy Italian bonds, simultaneously increasing its sales of German or Dutch bonds within the overall composition of QT.

This, though, presupposes that the Euro Area has “strong” as well as “weak” economies, a point that is now debateable.

The ultimate ‘strong economy’ in the EA has always been Germany, but the energy squeeze is putting that strength to the test. Moreover, much of Germany’s economic prowess is the trade advantage that the single currency confers on it. France has a moribund economy and elevated levels of debt, whilst Dutch financial exposure is uncomfortably high, with financial assets standing at 14.5X GDP as of the end of 2020, the most recent reporting date.  

In the final analysis

Ultimately, the challenge facing the ECB – and other central banks too – is to prevent two things from happening.

The first and most obvious is to guard against inflation taking on its own momentum, which could easily happen in a climate of apparent official indifference or resignation.

But the second is to ensure that the damage – and the crisis-risk – caused by a negative real cost of capital does not escalate, as it could if central banks allow real rates to slump into lethally deep negative territory  .

#235. The affordability crisis


What might be called the ‘consensus narrative of the moment’ is that our near-term economic prospects depend on the ability of central banks to tame inflation without tipping the economy into a severe recession. There are numerous complications, of course, but this is the gist of the story.

What these officials need to find, we’re told, are Goldilocks interest rates (‘not too hot, not too cold’), and all will be well if they succeed. If they err too far in one direction, inflation will run higher, and for longer, than is comfortable. If they lean too far the other way, a serious (though, by definition, a time-limited) recession will ensue.

Inflation itself, the narrative runs, has been the product of bad luck. First came the pandemic crisis, which impaired production capacity and severed supply-chains. Before we’d finished dealing with this, along came the war in Ukraine, disrupting supplies of energy, food and other commodities. There are some who add, sotto voce, that we might have overdone pandemic-era stimulus somewhat.

Our hardships, then, can be put down to a run of bad luck. Those in charge know what they’re doing.

It’s conceded, in some quarters, that we might face some sort of crisis if these challenges aren’t managed adroitly. This, though, shouldn’t be as bad as the GFC of 2008-09, and certainly won’t be existential.

We’re navigating choppy waters, then – not going over Niagara in a barrel.

The affordability reality

There is some truth in each of these propositions, but explanation in none.

What we’re really encountering now is an affordability crisis. The aim here is to explain this, without going into too much detail, and with data confined to two sets of SEEDS-derived charts at the end of this discussion.

The economy, as regular readers know, is an energy system. Nothing that has any economic value at all can be produced without the use of energy. Take away the energy and everything stops. Decrease the supply of energy, or put up its cost, and systems start to fail.

Energy isn’t free. Whenever energy is accessed for our use, some of that energy is always consumed in the access process.

This ‘consumed in access’ component – known here as the Energy Cost of Energy, or ECoE – has been rising relentlessly, mainly because depletion is forcing up the costs of oil, natural gas and coal.

This rise in ECoEs reduces the surplus (ex-cost) energy that is coterminous with prosperity. This equation reflects the fact that surplus energy determines the availability of all products and services other than energy itself.

Because ECoEs are rising, prosperity is decreasing.

At the same time that surplus energy prosperity is deteriorating, the costs of essentials are rising. This is happening because most necessities – including food, the supply of water, housing, infrastructure, the transport of people and products, and, of course, energy used in the home – are energy-intensive.

The material components of this equation – energy itself, supply costs, prosperity and the essentials – are translated, using the SEEDS economic model, into the financial language that, by convention, is used in economic debate.

We need to be absolutely clear, though, that money has no intrinsic worth, but commands value only as a ‘claim’ on the material products and services made available by the energy economy.

Money is an artefact validated by exchange. A million dollars would be of no use at all to a person adrift in a lifeboat, or stranded in a desert. A million euros would be worthless to someone who travelled to a distant planet where the euro is unknown.  

We are at liberty to create monetary ‘claims’ to an almost unlimited extent, but we can’t similarly create the material goods and services that are required if those claims are to be honoured ‘for value’.

Central banks can ‘print’ money (digitally), but they can’t similarly print low-cost energy. The banking system can lend money into existence, but we can’t lend resources into existence.

We can’t, for that matter, fix our environmental problems by writing a cheque to the atmosphere.

The meaning of compression

Whether we think in energy or in financial terms, what’s happening now is that the economic resources of households, and of the economy itself, have ceased to expand, and have started to contract, whilst the costs of essentials are rising.

This is what is meant by an affordability crisis.

An affordability crisis does what it says on the tin, and has two main effects.

First, consumers who have to spend more on necessities have to cut back on purchases of discretionary (non-essential) goods and services.

Second, households suffering from affordability compression struggle to “keep up the payments”.

Traditionally, these payments were largely confined to mortgages or rents, plus, perhaps, insurance premia collected door-to-door.

Now, though, these outgoings include credit servicing, car loans, student loans, subscriptions, purchase instalments and the plethora of other income streams created by an increasingly financialized economy.

Though they can’t be expected to like doing so, it’s possible for households to cope with affordability compression. Discretionary purchases are, after all, things that people want, but don’t actually need. People can cancel subscriptions, cut back on instalment purchasing, and cease using – and, in extremis, default on – various forms of credit.

To say this isn’t to minimize, in any way, the very real hardships being experienced by millions of households. The ‘cost of living crisis’ is the biggest challenge that has confronted households, and governments, in decades. As these problems worsen, the public are likely to get increasingly angry, and to demand redress, part of it through various forms of redistribution.

But an affordability crisis is much more serious for the system than it is for the individual.

Customers can decide to holiday at home rather than abroad, but the outlook for airlines, cruise operators and travel companies is grim if they do. Households can get by without entertainment subscriptions, but the providers of these services cannot survive if this happens. Motorists can hang on to their current vehicles for longer, and put off buying a new car, but the automotive industry is at grave risk if this happens.

These are what we might call the ‘industrial’ effects of affordability compression. Serious though these are, the financial effects are much worse.

The financial system depends on people “keeping up the payments” and, to a significant extent, increasing those payments over time.

The ability of the system to cope with defaults – or even with payment contraction – is severely circumscribed.

Perhaps the biggest single risk of the lot would be a wave of ‘can’t pay, won’t pay’ reaction by the public.

Getting to grips

When trying to navigate our way through the coming crisis we need, first, to understand what it is. Inflation, whether in prices or in wage demands, is a symptom, not the disease itself, and the root of the problem is an affordability crisis.

Second, we can’t borrow or print our way through an affordability crunch. Any attempt to do so just makes the problem worse.

Third, none of this is going away. An outbreak of peace and conciliation between Russia and its opponents, welcome though this would be, wouldn’t alter the fundamentals, which are that the ECoEs of energy supply are rising, reducing the affordability, not just of energy itself, but of all energy-intensive resources and products.

Fourthly, there’s no “tech fix” for structural affordability compression. As we’ve discussed in previous articles, renewables are vital, but they aren’t going to stem, still less reverse, rises in overall ECoEs. The ability of technology to somehow over-rule the laws of physics is one of the foundation myths of the age.

There’s no merit in finding new ways to use energy when the supply and the affordability of energy itself are getting worse. Electricity doesn’t come out of a socket in the wall, in unlimited quantities and at an ever-decreasing price. The expansion of renewables is imperative, but they are even less likely than nuclear to produce power “too cheap to meter”.   

It’s worth remembering, in this context, that energy sources must precede applications. The Wright Brothers didn’t invent the aeroplane first, and then sit around waiting for someone to discover petroleum. Cars weren’t invented until after gasoline had become available. Our ancestors didn’t build carts until they’d tamed their first horses.

Technologies are optimised to the energy sources available, not the other way around.

The big question now isn’t whether an affordability crisis is going to happen – because it already is – but when this reality is going to gain recognition as a feature of the system, not a glitch.

Hype springs eternal, and nobody is yet prepared to recognize that economic growth, previously powered by fossil fuels, has gone into reverse, because fossil fuels are becoming costlier to supply, and no alternative of equal economic value is available.

There are limits, though, to the capability for self-delusion. Risk will reach its apogee when investors, lenders and the public tumble to the reality that discretionary consumption has entered an irreversible decline, and that the economy, just like millions of households, is struggling to ‘keep up the payments’ required by an increasingly financialized system.

#234. Britain on the brink


Whether the country’s leaders know it or not, the United Kingdom is now at serious risk of economic collapse.

We must hope that this doesn’t happen. If it does, it will take the form of a sharp fall in the value of Sterling which, in these circumstances, is the indicator to watch.

A currency crash would cause sharp increases, not just in the prices of essential imports such as energy and food, but also in the cost of servicing debt. In defence of its currency, Britain could be forced into rate rises which would bring down its dangerously over-inflated property market.

This risk itself isn’t new. Rather, it results from a long period of folly, and can’t be blamed entirely on the current administration, inept though the Johnson government undoubtedly is. What we’re witnessing now seems to be a government on the edge of panic. The official opposition doesn’t offer a workable alternative programme, and mightn’t be electable if it did.

We need to be clear that the root cause of Britain’s problems is long-term adherence to an increasingly extreme ideology sometimes labelled ‘liberal’.

It’s one thing to recognize the merits of the market economy, but quite another to turn this into a fanaticism which judges everything on its capability of generating short-term private profit.

Extremism is divisive, and creates winners and losers to an extent that moderation does not. If solutions still exist for Britain’s worsening problems – and that’s a very big “if” – there are two reasons why such solutions mightn’t be adopted.

The first is that these solutions would anger a very vocal group of winners under the existing system.

The second is that those in charge would have to make a public admission of the failures of extremism.     

The practical problem

There are two main structural problems in the British economy, both of which are simply stated.

First, the economy operates on the basis of continuous credit expansion.

Even before the onset of the pandemic in 2020, Britain had spent twenty years adding £4 of new debt for each £1 of reported “growth” in GDP. The mathematics get even worse if we add broader financial liabilities, and unfunded pension commitments, to the equation. Where Britain is concerned, these broader liabilities are enormous.

Even this 4:1 ratio understates the grim reality, because the injection of liquidity creates transactional activity – measured as GDP – rather than adding value. SEEDS calculations indicate that, within recorded “growth” of £715bn (at constant 2021 values) between 1999 and 2019, only 30% (£215bn) was organic expansion, with the remaining 70% (£500bn) the cosmetic effect of borrowing at an annual average of 7.2% of GDP through this period.

This process is underpinned by the over-inflation of the values of assets, and principally of property. High and rising property values provide both the collateral and the confidence for perpetual credit expansion.

This is why successive governments have sought to promote, rather than try to tame, house price escalation.

Every initiative branded as “help” for young buyers has, in reality, been a device for propping up or further inflating the real estate market. At the first sign of a wobble in house prices, transaction taxes (stamp duties) are suspended. A property price crash is one of the nightmares that haunts the slumbers of British decision-makers.

It might even be contended, not without justification, that what passes for an “economy” has become, in reality, just an adjunct to an over-inflated property sector.

The second structural weakness is the permanent and worsening current account deficit. The United Kingdom consumes more than it produces. The system incentivizes people to make money – preferably through asset price escalation – rather than to produce goods and services.

A concept which has been described here before is the distinction between globally-marketable output (GMO) and internally-consumed services (ICS). In Britain, GMO has become dangerously small, such that excessive reliance is placed on ICS.

Hitherto, the structural current account gap has been bridged by the sale of assets to overseas investors, a process which has seen major companies, utilities and even football teams sold into foreign ownership.

This trend has become particularly acute since Britain ceased to be a net exporter of oil and gas.

Current account deficits, once embodied in the system and funded by asset sales, have become an autonomously worsening problem, because each asset sold to an overseas buyer sets up a new outflow of returns on capital to the new owners.

Self-created risk

The dangers implicit in this structure are clear.

First, a heavily indebted and credit-dependent economy is extremely vulnerable to rises in interest rates. This vulnerability has become acute now that the global rate cycle has turned upwards.  

As well as increasing the cost of servicing debts, rate rises threaten to crash asset markets, thereby taking away the collateral and confidence props required for the continuous credit expansion upon which the British economy relies.  

Second, overseas investors might start to wonder about Britain’s ability to cope with a steadily worsening structural current account shortfall, reasoning that there are limits to how long any economy can survive by “selling off the family silver” or relying on “the kindness of strangers”.

Additionally, of course, FX markets might fear a descent into chaos. The UK authorities’ approach to inflation looks – to put it charitably – like a product of blind panic.

Problems cannot be fixed by appointing a “tsar” and starting an ad-and-slogan campaign. There’s not much point in urging companies to hold down or even cut their prices when those companies’ own costs are soaring. Workers are unlikely to pay much heed when highly-remunerated officials urge the virtues of wage restraint.

It’s rumoured that, at the same time as increasing state pensions by 10%, the government plans to limit public sector pay increases to as little as 3% or even 2%. If this does indeed turn out to be the plan, chaos can be expected to ensue.

Britain could, of course, adopt what might be called a ‘5-5’ programme, setting 5% as a pay and pensions norm for the current year, with the rider that a further 5% increment will follow in the next year.

Funding this, though, would require major fiscal reforms which, whilst benefiting the young, would anger the (generally older) beneficiaries of the current system.

The clear and present danger now is that markets might decide that the dubious attractions of Sterling are far outweighed by the risks. A “Sterling crisis” would force the Bank of England into raising rates, crashing the property market to which the economy is, increasingly, an adjunct.

A crash in the value of GBP would trigger runaway inflation by increasing the cost of essential imports, including energy and food. Debts denominated in overseas currencies would soar, to a point where Britain could no longer afford to service these debts, let alone repay them.  

The ideology trap

Some, indeed many, of these problems and vulnerabilities are replicated elsewhere.

But what sets Britain apart is its long-standing adherence to an increasingly extreme ‘liberal’ ideology.

We’ve seen this over decades, with a succession of initiatives designed to translate taxpayer funds into private profits.  

Even those of us who favour the market over the state-run economy surely realize that there’s a balance to be struck between private incentive and the role of the public sector, and that any form of economic extremism tends to be both harmful and divisive.   

Taken to extremes, this version of ‘liberalism’ becomes the same system that sent small children up Victorian chimneys. That probably wouldn’t pay in the 2020s, but its modern equivalents – the “gig” economy, “zero-hours contracts” and the relentless undermining of security of employment – have all been warmly welcomed in Westminster and Whitehall.

Extreme liberalism has made the British economy, and British society itself, increasingly dysfunctional. The system is biased in favour of those generally older people who already own assets, and loaded against the generally younger people who aspire to accumulate them. It favours speculation over the creation of value.   

Perhaps the biggest problem of all is the extent to which the public has swallowed the propaganda of liberal extremism, an extremism which states that anything motivated by private profit must be superior to anything managed on the basis of the general good.

The problems of the 1970s are painted, not, as they in fact were, as the consequences of two global oil crises, but as the failures of Left-leaning governments and the malign behaviour of organized labour.

This is the same kind of myopia which remembers the Defeat of the Spanish Armada in 1588, but forgets the Defeat of the English Armada in the following year.

This becomes more pertinent when it is recalled that the debacle of 1589 resulted from efforts to turn a military expedition into a profitable enterprise. Floating a naval campaign as a quoted joint-stock company must have seemed as bizarre at the time as it does now.

If you’re interested in military history, you’ll know that the best of Britain’s trio of wartime heavy bombers were the Avro Lancaster and the Handley Page Halifax.

The danger now is that the name of the third one – the Short Stirling – might sound like an increasingly good idea to international investors.     

#233. Understanding inflation


Inflation isn’t like other economic problems.

It impacts the general public, immediately, and painfully. It feeds on itself, once wages start chasing surging prices.

It can’t be denied and, once it takes off, there are limits to how far it can be under-reported. It can’t be fixed – or, rather, it can’t be ‘kicked down the road’ – using any form of ‘magic money’ gimmickry.

Inflation is the brutal exposer of failure. It is already exposing, for example, the weaknesses of a British economic model built on perpetual credit expansion, and the contradictions in a European monetary system which tries to combine a single monetary policy with nineteen sovereign budgetary processes.

Small wonder, then, that soaring inflation induces panic, desperation and sometimes outright idiocy in the corridors of power.

On the basis of principle

Those of us who understand the economy as an energy system, rather than a wholly financial one, have a unique insight into inflation.

Because we recognize that the ‘real’ economy of goods and services is shaped by energy rather than by money, we also recognize the existence of the ‘financial’ economy as a monetary proxy to the energy dynamic which determines prosperity.

Prices are where the material and the monetary intersect. Prices are the financial values that are attached to physical goods or services. Inflation is a product of changes in the relationship between the ‘real’ economy of energy and the ‘financial’ economy of money and credit.  

To paraphrase Milton Friedman, inflation is always and everywhere a two economies phenomenon.

Because of the immediacy of soaring inflation, and because of the panic it induces in decision-makers, current events might seem to add credence to the “collapse” prophecies of modern-day Cassandras.

In fact, inflation can be interpreted rationally, and that’s the single aim of this discussion.

In search of reason

The basic principles of the energy interpretation are quickly stated.

The economy is an energy system, because nothing that has any economic value at all can be supplied without the use of energy.

Energy is never ‘free’, but comes at cost measurable as the proportion of energy that is consumed in the access process whenever energy is accessed for our use. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy).

Money has no intrinsic worth but commands value only as a ‘claim’ on the material goods and services supplied by the energy economy.

These principles lead inescapably to the concept of the ‘two economies’ of energy and money. Inflation – and, for that matter, currency crises, market falls and severe defaults – are products of imbalances between the ‘real’ and the ‘financial’ economies.

Until some point in the 1990s, the real and the financial economies expanded more or less in tandem.

The most notable previous disequilibrium between the two economies of energy and money happened in the 1970s, and was characterized by runaway inflation. Though energy remained cheap and abundant in those years, political divisions between the biggest producers and the main consumers of oil triggered a sharp rise in the cost of energy to Western consumers.

The situation righted itself, because there remained substantial reserves of relatively low-cost oil in places – most notably the North Sea and Alaska – that were outside the control of OPEC.

The robust growth of the 1980s owed everything to a ‘catch-up’ from the politically-induced energy shortfalls of the 1970s, and almost nothing to the ‘liberal’ economic ideologies which happened to supplant the Keynesian orthodoxy at that same time.

The road to here

By the 1990s, the fundamentals had started to deteriorate. ECoEs were rising at rates which were taking away the potential for further growth in the material economy. This was happening because of depletion, a process whereby lowest-cost energy resources are used first, leaving costlier alternatives for a ‘later’ which had now arrived.

What we have experienced since then has been a worsening process of self-delusion, based on the false proposition that we can increase material supply by stimulating financial demand.

The facts of the matter, of course, are that no amount of financial stimulus, and no increase in prices, can produce anything – in this instance, low-cost energy – which does not exist in nature.

What we can do is to create a simulacrum of “growth” by creating monetary ‘claims’ on the future which increase transactional activity in the present.

We’re at liberty to count these increases in transactional activity as ‘growth’, and to ignore the inability of the real economy to honour these forward commitments when they fall due.

This is what’s been happening through an era of collective self-delusion that began in the second half of the 1990s.

Between 1999 and pre-pandemic 2019, reported global GDP increased by $74 trillion in real terms, but debt escalated by $204tn between those years, and we can estimate that broader ‘financial assets’ – which are the liabilities of the household, government and corporate sectors of the economy – soared by about $480tn. Even this number excludes the creation of enormous pension promises which a faltering ‘real’ economy will be unable to honour.

The reported “growth” in the economy measured financially as GDP through this period was starkly at odds with what was happening in the real economy of energy. Whilst reported GDP slightly more than doubled (+110%) between 1999 and 2019, the total supply of energy increased by only 54%, a number that falls to 47% at the critically-important level of ex-ECoE surplus energy.

Reflecting this, aggregate prosperity, measured financially by the SEEDS economic model, expanded by only 34% worldwide over a period in which economic activity, recorded as the transactional use of money, rose by 110%. The 34% increase in money-equivalent prosperity was lower than the 47% rise in surplus energy, a differential reflecting deterioration in the efficiency rate at which surplus energy is converted into economic value.

The dynamics of disequilibrium

We need to be absolutely clear about what this means. Stimulation of transactional activity to levels far above underlying prosperity as determined by energy has created an enormous disequilibrium between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

Globally, the downside between the ‘two economies’ can be calculated, as of the end of last year, at 40% (see fig. 1). The equivalent numbers for the United States and China, respectively, are 32% and 54%.

Fig. 1

The inevitable restoration of equilibrium between the ‘two economies’ is readily explained, because it happens when the owners of financial ‘claims’ realize that the aggregate of these claims cannot be honoured ‘for value’ by the real economy of goods and services.

This enforced restoration of equilibrium is mediated through prices, which are best understood as the rate of exchange between the monetary and the material economies.

The result is experienced as accelerating inflation, a process which everyone understands can only be worsened by stimulus, and which we further understand must continue until something much closer to equilibrium has been restored.

It also follows, from this, that inflation will be most acute in those energy-intensive product categories which are ‘essential’, which means that consumers cannot choose not to buy them because their prices have increased.

Conversely, inflationary pressures will be less pronounced in those discretionary (non-essential) goods and services of which consumers will reduce their purchases as their ex-essentials prosperity (known in SEEDS as PXE) deteriorates.

Taking stock

This explanation, though, refers primarily to the flows of money and material prosperity. There are also ‘stock’ issues around the forward commitments created through the same process of stimulus which has driven the observable wedge between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

This is summarised in the flow-and-stock analysis produced by the SEEDS economic model.

In fig. 2, the flow distortion, seen earlier, is compared with two measures of ‘stock’ exposure. One of these is debt, which now stands at 4.1X underlying prosperity. The other relates to estimated broader financial assets, now at a multiple of 9.3X prosperity.

Neither of these ratios is sustainable, and a best estimate has to be that forward excess claims will be eliminated at a percentage rate broadly equivalent to the equilibrium downside measured as the flow relationship between the monetary and the material economies.    

Fig. 2

Inflation does, of course, reduce forward claims by impairing their real value.

Even so, the balance of segmental alignments – between essentials, discretionaries and capital investment – suggests that the elimination of excess claims cannot occur through inflation alone. Suppliers of essentials probably will be able to honour most of their forward commitments, whilst many discretionary sectors will not.

Since our focus here is on inflation rather than on economic activity and prosperity, we need, for now, only glance – as in fig. 3 – at the future prospects for an economy in which prosperity has stopped expanding and started to contract, whilst the real costs of essentials carry on rising.

Discretionary activities will shrink, whilst capital investment can be expected to diminish in a process that demands ever greater returns on capital.

On inflation, our conclusion needs to be that pressures will continue for as long as it takes for the restoration of equilibrium between the ‘real economy’ of energy, goods and services and the ‘financial economy’ of asset values, money and credit.

Within this overall trend, the prices of essentials will continue to out-pace those of discretionaries as the segmental mix of consumption and investment realigns.

For the authorities, this poses a difficult challenge, because many emerging trends will be unpalatable to a public which has been sold the myth of ‘growth in perpetuity’.

Whilst we can – perhaps – assume that no government or central bank would be so unwise as to try to use stimulus to counter inflation, there are two ways in which the authorities could make this worse.

One way would be to carry on trying to ignore, or unintentionally misunderstand, the forces that are manifesting as inflation.

The other would be to try to favour some interest groups over others.

Fig. 3

#232. All crises great and small


As explanations fail – ‘temporary’ post-coronavirus disruption, “transitory” inflation, ‘unexpected’ hardships caused by the war in Ukraine, and all the rest of it – hard facts are emerging, and few of them are palatable.

One of these unpalatable realities is escalating risk. We can’t, for instance, be sure that a relatively gradual retreat in capital markets won’t turn into an autumnal rout. Neither can we assume that some of the worst-managed Western economies will succeed, this time, in ‘muddling through’.

Part of this predicament can be quantified here, and framed, using the SEEDS economic model.

But it’s equally important that we understand the inner nature of a rapidly-unfolding crisis situation.

Prosperity is heading downwards, hardship is being worsened by the rising costs of necessities, and these material trends are invalidating two assumptions on which decision-makers have hitherto relied.

One of these failing assumptions, of course, is that we can deliver ‘happy outcomes’ using fiscal, credit and monetary gimmickry.

The other is the assumption that an economic consensus, generally labelled ‘liberal’, can prevail, by some kind of triumph of hope over reality.

We – or rather, millions of people in the former Soviet bloc, in pre-Deng China and elsewhere – have tried extreme collectivism, and it didn’t work.

But this gives us only a negative answer, in the sense of what not to do, when liberalism fails.

A rule of three

There’s a cardinal rule which states that, if you’re giving any kind of speech or presentation, you should limit yourself to making no more than three headline points.

These points may be as simple or as elaborate as you like, and as circumstances might require.

But their number should not exceed three.

On the basis of this useful discipline, our first point needs to be that prior growth in material prosperity has gone into reverse.

Our second is that systems – including the financial and the political – have been built on the contrary assumption of ‘growth in perpetuity’.

Our third is that this inherent contradiction is not understood.

This isn’t because it’s hard to grasp – indeed, its fundamentals are stark and obvious – but because we have a tendency to believe, not the factual and the obvious, but whatever it is that we want to believe.

Together, these points explain why we face crises of adjustment.

We have to adjust our financial system to a post-growth reality, and adjust our political systems to a situation in which it’s no longer enough to offer the public “jam tomorrow”, telling people that they’ll all be better off in the future if they just ‘keep the faith’ in the present orthodoxy.

Hard realities

Let’s start with the reality about prosperity. The large and complex modern economy has been built on an abundance of low-cost energy sourced from coal, oil and natural gas. This fossil fuel energy has already ceased to be cheap, and is now ceasing to be abundant.

Back in the 1950s and 1960s, we thought we had a replacement in nuclear power, which was going to be “too cheap to meter”. Today’s alternative narrative is that ever-cheaper and more abundant energy will be obtained from renewable energy sources (REs), such as wind and solar power.

This new narrative actually has even less plausibility than the old one about nuclear, but it fills the aspirational gap created by TINAR (“There Is No Acceptable Reality”).

We know that money has no intrinsic worth, but commands value only as a ‘claim’ on the ‘real’ or material economy of energy.

But money differs from the material by giving us time arbitrage – we can create monetary claims now, on the basis that they will be honoured (by exchange) in the future.

Investment is interwoven with the time arbitrage of money.

Investment began in agrarian societies, where a person could invest by surrendering present consumption for future improvement. Instead of consuming all of today’s harvest now (or its equivalents purchased through exchange), a farmer could trade some present consumption for an asset (perhaps a barn, or a plough) that would increase his prosperity in the future.

The principle of investment is, and always has been, that of making sacrifices now in return for greater prosperity at a later date.

Most of us today are not farmers, or millers, or bakers, able to surrender current consumption of bread or beer for a better future founded on efficiency-enhancing capital assets like barns and ploughs.

Our version of investment is a financialized one, and involves exchanging consumption now for returns on accumulated capital at some later date. But “later” has to mean “bigger” for this process to function.

The saver lends money on the basis that the return from the borrower will exceed what has been lent today. The investor in a business is motivated by the assumption that the value of the business, and hence of his or her investment in it, will rise over time.

A whole science has been built around this process of time arbitrage, and includes ‘rates of return’, the ‘time value of money’, and the relationship between ‘risk and return’.

Unfortunately, all of this is ultimately dependent on growth. If a person lending $1000 now is to receive $1,100 at a later date, the borrower has to improve his own circumstances by ‘putting money to work’. For the investor to get back more than he or she put into a business, that business has to grow.    

There are exceptions to this rule under any set of conditions. A borrower or an entrepreneur may fail even under favourable conditions of growth. Some lenders and investors may profit even if the economy has, as now, started to contract.

Indeed, the trick now is to work out which sectors will expand even as the economy as a whole gets smaller.

But a generality of growth is required if the generality of lenders and investors are to profit.

Of need and discretion

After the energy reasons for growth reversal, and the dependency of investment on growth, the next step in a logical progression is the hierarchy of needs.

Whatever the resources of the individual or household may be, the first call on those resources is made by necessities.

A person or family spends first on those things that are indispensable, some of which are food, water, accommodation, necessary travel and domestic energy. Only after these essential needs have been met can remaining resources be allocated to discretionary (non-essential) forms of consumption, which might be holiday, a trip to a restaurant or some new gadget.

This makes discretionary consumption a residual, meaning a number arrived at through the relationship between two primary factors, which in this case are prosperity and necessity.

Residuals, by their nature, are leveraged, because they are affected by changes in more than one primary factors.

An era of abundant, low-cost energy has applied positive leverage to the discretionary piece of the equation. Cheap energy has driven prosperity higher at the same time as holding down the cost of necessities.

Now, though, rising energy costs have turned this into negative leverage, with prosperity declining whilst the costs of essentials are rising.

By way of example, SEEDS indicates that, whilst British prosperity per capita declined by a comparatively manageable 10% in real terms between 2004 and 2021, the cost of essentials rose by an estimated 18%, again in real terms, over the same period. The leverage effect was to reduce the affordability of discretionary consumption by 15%.

This raises two particular problems.

First, discretionary contraction isn’t pleasant, particularly for anyone who’s been told that discretionary prosperity is supposed to carry on increasing over time.

Trying, both individually and collectively, to buck this trend – to increase discretionary consumption, even though discretionary prosperity is decreasing – worsens indebtedness, simultaneously exacerbating insecurity, and breeding discontent wherever it appears that a favoured minority is enjoying increased discretionary prosperity.

Promises can turn pretty quickly into expectations, and expectations into feelings of entitlement. The failure of promises, the disappointment of expectations and the denial of supposed entitlements can lead directly to resentment.   

The second problem is that these adverse trends are accelerating, worsening the effects of negative leverage. Having decreased by 15% over a period of seventeen years, British discretionary prosperity per capita is now set to contract by a further 35% over the coming decade.    

Of money and politics

When we apply these straightforward (though unwelcome) trends to the financial and the political systems, we unmask pressures for which very few people seem prepared.

The first of these is financial, where we can draw two conclusions from the foregoing.

One of these is time arbitrage, which for present purposes means that a futurity – a set of shared expectations for the future – is incorporated into the financial system. Another is the adverse leverage effect of discretionary contraction.   

Depending on how you define “essential” – which varies both geographically and over time – roughly 60% of economic activity in the modern Western economy is discretionary.

This means that about 60% (and probably more) of equity valuation, and of loans outstanding, is dependent on positive futurity as it affects discretionary prospects.

In other words, if the consensus expectation of discretionary expansion were to turn instead into a realization of discretionary contraction, the financial system would face pressures which have no precedent in the industrial era.

In government, the equivalent of futurity is expectation, which means that people expect – and have been led to expect – a continuous improvement in their material circumstances over time.

Economic ‘liberalism’ is particularly at risk because it is based on a claim, which might otherwise be called a promise, that the prosperity being enjoyed by the more fortunate in the present will, in the course of time, come to be enjoyed by everyone else as well.

Historically, there’s been some vindication of this promise. Back in the 1950s, only the wealthiest could afford to own a car, or to take holidays abroad. Growth in subsequent years has extended car ownership and foreign travel from the thousands to the millions.

Market liberals have always been able to assert, with considerable justification, that this progress wouldn’t have happened under a Marxist-Leninist system – as somebody once said about America, “if we’re so awful, we’re so bad, go and try the nightlife in Leningrad”. As a young citizen of communist Czechoslovakia once put it, “I don’t want to be a capitalist – I just want to live like one”.  

Unfortunately, this ties the fortunes of economic liberalism to a continuity of growth. If the majority ever has to told that, far from aspiring in the future to the standards of living enjoyed today by the fortunate, their own conditions of life are going to deteriorate, a new system will be required.

#231. Short and sharp


Might we very soon face a major financial crisis, at a scale exceeding that of 2008-09?

Are we heading for a global economic slump, or can current problems be explained away in terms of ‘non-recurring events’, such as the war in Ukraine?

Do the authorities have the tools and the understanding required to navigate the current economic storm? And what is the outlook for inflation?

These are valid questions, and I’m well aware that, whilst many visitors to this site are interested in economic principles, theory and detail, others prefer succinct statements of situations and prospects.

That’s understandable – these are deeply worrying times.

The aim with what follows is to (a) set out a brief summary of the economic and financial outlook, as seen through the prism of the SEEDS economic model, followed by (b) a succinct commentary on how these conclusions are reached.

Accordingly, what we might infer from these conditions is left for another day. Like me, you will have your own views on the political and other implications of what’s going on and what is to be expected, but the plan with this discussion is to stick to a strictly objective analysis of economic and financial conditions and prospects.

Data used here by way of illustration is a ‘top-line’ summary at the global level. We might, at a later date, look at some of this material in greater detail, and examine the circumstances of some of the 29 national economies modelled by SEEDS.

Where both the theoretical and the ‘succinctly-practical’ are concerned, urgency is being increased by what we can only call the ‘uncertainties and fears’ generated by current conditions.

In economic and financial terms, it’s becoming ever more obvious, not just that ‘things aren’t going according to plan’, but that decision-makers don’t have replacements for the tools and assumptions that have failed.

What’s clear now is that the shortcomings of money-based economic orthodoxy are becoming ever more apparent, evidenced principally by the failure of policies based on this orthodoxy.

The authorities have tried pretty much everything in the conventional play-book – plus quite a few ventures into the dangerously unconventional – and none of it has worked.

To use the contemporary term, this is a “narrative” of failure that starts with “secular stagnation” in the 1990s, and arrives – as of today – at the very real prospect of “stagflation”.

Where failure is concerned, the combination of high inflation and deteriorating prosperity is about as comprehensive – and as damning – as it gets.

Not too many years ago, the concept of the economy as an energy system might have been deemed a pretty radical ‘challenger theory’ to an established orthodoxy which insists that the study of economics is coterminous with the study of money.

Now, though, the case for the energy interpretation is gaining strength as the credibility of the prior orthodoxy is being eroded away by failure, albeit in a World that still refuses to acknowledge the inadequacies of conventional nostrums.

There are, of course, many different versions of the energy-economy interpretation, with differences of method and emphasis leading to differences of conclusions.

The main focus of effort here at Surplus Energy Economics has been on modelling the economy on an energy rather than a financial basis.

Modelling imposes a certain degree of caution, in that our conclusions should not be allowed to out-run what our models can tell us.

Inferences, of course, are a very different matter.

The outlook in brief

What, then, – and on the basis of what we know – should we now expect?

First and foremost, we can anticipate continuing declines in prosperity, with much the same deterioration already evident in the West now extending to those EM (emerging market) countries in which growth has, until quite recently, remained feasible.

This rate of deterioration can be expected to accelerate. The World’s average person is projected to be 6% poorer in 2030, but fully 21% less prosperous by 2040, than he or she was in 2021.

Meanwhile, the real costs of essentials will continue to rise, pointing towards a rapid contraction in the affordability of those discretionary (non-essential) goods and services which consumers ‘may want, but do not need’.

In real terms, discretionary consumption worldwide is likely to be 14% lower in 2030, and 52% lower in 2040, than it was last year.

Inflation has been driven higher by the rising costs of essentials but, looking ahead, is likely to be contained, to some extent, by deflationary trends in discretionary sectors.

The measure preferred here – which is RRCI, or the Realised Rate of Comprehensive Inflation – forecasts systemic inflation rising from 8.1% in 2021 to 8.6% this year, moderating to 5.3% by 2027.

These forecasts are summarised in fig. 1.

Fig. 1

Finally, in this brief list of projections, we can anticipate major financial dislocation, probably far more severe than the global financial crisis (GFC) of 2008-09. No attempt is made here to put a timescale on this, but it seems very unlikely that it can be long delayed.

The fundamental driver of this dislocation will be a dawning realization that the promises and assumptions incorporated both in asset prices and in forward commitments cannot be met by an economy that is not conforming to the consensus and official narrative of ‘growth in perpetuity’.

Along with this will go an invalidation of excuses and a discrediting of promises.

The public will cease to accept assertions that ‘everything would have been fine if it hadn’t been for’ the latest explanation du jour, which might be “the after-effects of the coronavirus crisis”, or “the war in Ukraine”, or “the dog ate my homework”, or whatever the next excuse might turn out to be.

At the same time, the public might come to realize that we cannot, for example, look forward, as promised, to ever-growing prosperity powered by ‘cheap’ renewables and the magic of technology.

The basis of projection

The foregoing has been intended for those who want a succinct statement of the outlook. You might wish to know how we arrive at forecasts which run directly contrary, both to the ‘official’ and the ‘consensus’ picture of the future.

If you’ve been visiting this site for any length of time, you’ll know the core principles on which the Surplus Energy Economics interpretation is based.

First, and in brief, we know that the economy is an energy system, because nothing that has any economic value whatsoever can be supplied without the use of energy.

We further know that energy is never ‘free’, and that, whenever energy is accessed for our use, a proportion of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy (ECoE).

The third core principle is that money, having no intrinsic worth, commands value only as a ‘claim’ on the material prosperity created by the use of energy.

It follows that we need to think conceptually in terms of ‘two economies’ – a ‘real’ or material economy of goods and services, and a ‘financial’, ‘proxy’ or claims economy of money and credit.

By measuring prosperity, the SEEDS model enables us to do two main things.

The first is to compare the real and the financial economies, calibrating the relationship between monetary claims and material substance.

Since, by definition, claims that cannot be honoured by the real economy must be eliminated, this indicates the extent of downside that must come into effect through a dynamic of returning equilibrium.

Second, we can use calibrations of changes in prosperity over time to restate prior trends as the basis for forward projection. Even if – for forecasting purposes – we accept nominal GDP (of $146 trillion) in 2021, as a baseline for projections, we don’t remotely need to accept a narrative that purports to explain, in glowing terms, how this number got to where it is.

It’s clear that a large proportion of prior “growth” has been a cosmetic property of stimulus, remembering that stimulus does increase the transactional (‘claims’) activity recorded as GDP, but doesn’t correspondingly increase the underlying value measured here as prosperity.

By restating past trends on realistic, prosperity-referenced lines – and by applying our knowledge of forward trends in prosperity – we are able to interpret past, present and future in a way that tells us a great deal about the prospects for the three critical segments of the economy.

These are the supply of essentials, the capability for investment in new and replacement productive capacity, and the affordability of discretionary goods and services.  

Three main conclusions emerge from this analytical approach.

First, and as shown in the left-hand chart in fig. 2, there has been a marked divergence between the real and the financial economies, a divergence that can be calculated, globally, at 40%. This gives us, in outline terms, a proportionate measure of the downside in the financial system.

Second, the aggregates of financial claims have increased enormously during a long period in which we’ve been trying – and failing – to use financial stimulus to boost material prosperity.

The application of the proportionate imbalance shown in the left-hand chart to the quantitative exposure shown in the middle chart reveals the truly enormous downside risk embodied in the financial system.

This is risk which we might be able to manage – but not if we continue to think of financial stimulus as a means to unattainable material objectives.  

Third, we can calibrate the relationship between prosperity – expressed in per capita terms in the right-hand chart – and trend ECoE.

Given the extreme improbability of ECoEs reversing their established upwards trend – and the virtual inevitability of continuing increases – further deterioration in prosperity becomes pretty much a certainty.

The rate of economic deterioration can be expected to worsen in accordance with systemic trends, including loss of critical mass (where essential inputs either cease to be available, or become prohibitively expensive), and adverse utilization effects (where unit costs rise as volumes contract).  

Again, deteriorating prosperity is a trend that we might be able to manage. But this will not be possible if, though a combination of wishful-thinking and adherence to orthodox nostrums, we remain in deep denial about its reality.    

Fig. 2

#230. The rule of three


In the autumn of 2008, as the full seriousness of the global financial crisis (GFC) became apparent to investors, markets fell with dizzying speed.

Something very similar happened in the first quarter of 2020, when it became clear that the coronavirus pandemic had severe implications for the economy.

Perhaps the single most striking aspect of the current situation is that markets haven’t – yet, anyway – gone into a tail-spin.

This might seem surprising, given the take-off in inflation, pressures on the supply of energy and other commodities, and a pretty general recognition that the interest rate cycle has turned.

There are, to be sure, what we might call ‘pockets of concern’, of which the obvious examples are the “tech” sector in America, and the value of GBP. These exceptions aside, though, market responses to the current crisis have been restrained, whilst property price bubbles haven’t burst.

As you may know, this site does not provide investment advice, and must not be used for this purpose.

But we’re entitled to look at the general behaviour of markets as a barometer of sentiment ‘at the sharp-end’ of opinion. Thus far, it’s fair to say that markets have behaved like the dog that didn’t bark “in the night-time” in the famous Sherlock Holmes story about stolen racehorse Silver Blaze.

As you may also know, the view here is that surging inflation signifies a fundamental tipping-point, a moment at which the reversal of prior growth in material prosperity moves from unconventional theory to inescapable fact.

If that is indeed the case, the outlook for the financial system is grim, because the entirety of the system is predicated on the presumption of ‘perpetual growth’.

“Won’t get fooled again”?

Why, then, are markets exhibiting comparative insouciance in the face of seemingly-grave economic trends?

There are, in essence, two main explanations for this relative calm. One of these can be labelled “won’t get fooled again”. The other is a belief that all of the bad news is already priced in to the markets.

The “won’t get fooled again” explanation is that investors lost huge amounts of money in the third quarter of 2008, and again in the first quarter of 2020, only to find out that the World hadn’t, after all, come to an end.

Investors seem determined not to fall for this ‘end of the World’ stuff for a third time.

Given that we should never underestimate the role of psychology in the markets, this is a persuasive argument.

The “already priced-in” explanation is slightly more complicated. For starters, falls in the NASDAQ and in GBP can be portrayed as isolated cases.

The prices of American “tech” stocks had, the argument runs, been inflated to absurd extremes, so what we’re seeing now is nothing more than a long overdue correction towards reality. There’s a precedent here, of course, making a ‘dotcom2’ bust a plausible thesis.  

An equally persuasive case can be made that Sterling, like “tech”, is a special case. It’s hard to deny that the British economy has very glaring weaknesses, and the market judgement seems to be that these weaknesses are not replicated, to anything like the same extent, in other Western countries.

This isn’t the place for an assessment of the British economy, but the broad view taken here is that, whilst the UK situation, as measured by SEEDS, is indeed pretty dire, other economies have broadly equivalent problems of their own.

The real question-mark is whether the UK has what it takes to navigate the coming storm.

More generally, the market view seems to be that inflation, whilst clearly not the “transitory” phenomenon claimed until recently by the Fed, can nevertheless be prevented from running wild.

With the coronavirus crisis behind us, it is argued, ruptured supply-chains can now return to normality, and the monetary largesse poured into the economy to counteract “lock-downs” is draining from the system.

Where the war in Ukraine is concerned, there are two ways in which a calm market response can be explained. The first is that, after a period of adjustment, energy and other commodities previously sourced from Russia and Ukraine can be obtained from elsewhere.

A second, more cynical view is that we can already see the outline shape of a conclusion to the conflict. As war cools towards stalemate and settlement – and as the approach of winter demand peaks starts to concentrate minds – the trade freeze might begin to thaw, with Western policy turning out to be no more resolute over Russia than it was in Afghanistan.

Arguing along these lines, whilst rates might indeed rise to perhaps 3% or even 4%, we’re not heading into a re-run of the double-digit rates experienced in the late 1970s and the early 1980s.               

A darker perspective

If you’ve been visiting this site for any length of time, you’ll know that the interpretation of the economy set out here differs starkly from the orthodox view which continues to inform decision-making in government, business and finance. The surplus energy interpretation is summarised briefly here, and in greater detail here.

Once we understand that the economy is an energy system, and not a financial one, it readily becomes apparent that material prosperity is a function of the supply, value and cost of energy.

Within this matrix, the most important determinant is cost, referenced here as the Energy Cost of Energy.

ECoE refers to that proportion of accessed energy which is consumed in the access process, and is not, therefore, available for any other economic purpose.

Largely because of depletion, the ECoEs of oil, natural gas and coal have been rising relentlessly, pushing overall trend ECoE to ever higher levels.

This has pushed prior growth in prosperity into reverse, because prosperity is a function of the surplus (ex-ECoE) energy available to the economy.

As ECoEs rise, surplus energy shrinks, and prosperity contracts.

Important though they undoubtedly are, renewable energy sources (REs), such as wind and solar power, can’t push overall ECoEs back down to levels at which growth is possible. The average person in the West has been getting less prosperous over an extended period and, latterly, the same thing has started to happen in EM economies which, by virtue of their lesser complexity, have higher thresholds of ECoE-tolerance.

Energy transition, though undoubtedly imperative on economic as well as on environmental grounds, cannot stem – still less reverse – this prosperity-sapping trend.

The connections between ECoE and prosperity per capita in America, Britain and China are illustrated in fig. 1. Prosperity per capita turned down in the United States from 2000 and in Britain from 2004, and China is now decelerating rapidly towards its own inflexion-point.

Fig. 1

Meanwhile, the real costs of essentials are rising, primarily because the supply of so many necessities is highly energy-intensive. Examples include food, water, housing, infrastructure, the transport of people and products and, of course, energy used in businesses and in the home.

Accordingly, the scope for the consumption of discretionary (non-essential) goods and services is being squeezed. The SEEDS metric PXE – prosperity excluding essentials – is in decline even in countries (such as China) where top-line prosperity has yet to inflect (fig. 2).

Fig. 2

Depending on how we define “essential”, upwards of 50% of Western economies ranks as discretionary, a proportion reflected in activity, employment and profitability.

One implication of falling PXE is a decline in the value of those discretionary sectors which account for more than half of all the businesses whose shares are traded on the markets.

Another implication is that, as the gap between prosperity and essentials narrows, the affordability of mortgages (and of rents) declines, with adverse implications for property.

These negative tendencies in stocks and property can only be exacerbated by rises in nominal interest rates, even if real rates remain negative because inflation is rising more rapidly than nominal rates.

Denial nears denouement    

None of this is accepted by an orthodox school of thought which depicts the economy entirely in monetary terms, thereby dismissing the possibility of material constraints, and assuring us of the possibility of ‘infinite growth on a finite planet’.

Accordingly, policymakers have tried to counter energy downside with financial stimulus.

As you can see in fig. 3, this has seen liabilities – such as debts and other financial commitments – rise much more rapidly than prosperity. (It should be noted that the financial “assets” shown in fig. 3 are the systemic counterparts of the liabilities of the government, household and corporate sectors).

Fig. 3

Meanwhile, this process has created cosmetic “growth” in metrics such as GDP, because these metrics measure monetary activity rather than material prosperity.

With this understood, it becomes apparent that there has been a relentless widening in the gap between the ‘financial’ or proxy economy of money and credit and the ‘real’ or material economy of goods and services.

This creates an ultimately irresistible force tending towards the restoration of equilibrium between the two economies of money and energy.

Inflation is a logical concomitant of this process, because prices are the point of intersection between the monetary (financial demand) and the material (physical supply). This relationship is illustrated in fig. 4.

Fig. 4

The necessary conclusion of this dynamic is that a large proportion of the monetary claims embedded in the financial system cannot possibly be honoured ‘for value’ by a faltering underlying economy of material prosperity.

The process of excess claims destruction can take place either (a) through an inflationary degradation in the purchasing power of money, or (b) through a process of failure and default driven by a determination to use rate rises to prevent ever-worsening rates of inflation.

In practical terms, what this means is that we face a choice between untamed inflation or a ‘hard default’ slump, both in forward commitments and in asset prices, which are the corollary of the liabilities side of the value equation.

Perhaps the single most disturbing aspect of the present situation is rigid adherence to the fallacy that fiscal and monetary policy can deliver ‘growth in perpetuity’ despite worsening resource (and environmental) limits to expansion.

When governments (and others) assure us that we can “grow out of” current pressures on living standards, and that we can promote policies of “sustainable growth”, they are – perhaps in all good faith – making promises that the material economy simply cannot honour.

#229. In the Eye of the Perfect Storm – 2

The previous article set out what was intended to be a short but comprehensive guide to the economy understood as a surplus energy system. It’s been pointed out that, however comprehensive that report may be, it’s far from being “short”.

Here, then, is “the short version”. The intention is to make both versions available as downloads.


With economies stumbling, the cost of living rising at rates not seen in forty years, and world markets gripped by nervousness, there are two ways in which we can try to make sense of current economic turbulence.

We can, if we wish, see all of this as temporary – caused by the lasting effects of the pandemic, latterly compounded by the war in Ukraine – and assure ourselves that the ‘normality’ of continuous economic “growth” will return once these crises are behind us.

The alternative is to face facts.

Ultimately, the economy is an energy system, not a financial one, because literally nothing that has any economic value whatsoever can be supplied without the use of energy.

The vast and complex economy as we know it today was built on energy from coal, oil and natural gas, in a process whose origins can be traced to 1776, when James Watt completed the first really efficient engine for the conversion of heat into work.

Whenever energy is accessed for our use, some of that energy is always consumed in the access process. For much of the time since 1776, this Energy Cost of Energy (ECoE) declined, driven downwards by economies of scale, technological progress and a worldwide search for lowest-cost energy resources.

Latterly, though, the positive impetus of scale and geographic reach has faded out, leaving depletion – the process of using lowest-cost resources first, and leaving costlier alternatives for later – to push fossil fuel ECoEs back upwards.

Technical innovation continues, but it should never be forgotten, even in an age obsessed with technology, that the scope for technological progress is limited by the laws of physics.

This is particularly pertinent to the assumed “transition” to renewable energy sources (REs). Instead of unthinking extrapolation from past reductions in their costs, we need to note that renewables, too, have their technical limitations.

One of these is the Shockley-Queisser limit which determines the maximum potential efficiency of solar panels. Another is Betz’s Law, which does the same for wind turbines. Best practice is already close to these theoretical limits.

Moreover, dramatic expansion in RE capacity will make huge demands on material resources, including steel, concrete, copper, cobalt and lithium. For the foreseeable future, these resources, even if they exist at all in the quantities required, can only be made available through the use of legacy energy from oil, gas and coal.

To be clear about this, we most emphatically should make every effort to transition to renewables, not just on environmental grounds, but for economic reasons as well.

But we cannot assume that the ECoEs of REs will ever fall to levels low enough to replicate the economic value of fossil fuels.

Environmental “sustainability” is a practical, no-brainer objective. But “sustainable growth” is no more than wishful thinking, and the probabilities are heavily stacked against it.

I drew attention to the implications of the energy economy when I was head of research at Tullett Prebon, publishing the Perfect Storm report back in 2013. Since then, I’ve carried on exploring this concept at Surplus Energy Economics, as well as building SEEDS, an economic model which runs on energy rather than financial principles.

What has emerged is that, as trend ECoEs have risen relentlessly, prior economic growth has petered out before going into reverse.

Throughout a quarter-century precursor zone that has preceded the onset of economic contraction, we’ve become adept at deluding ourselves that we can continue to rely on ‘infinite growth on a finite planet’.

Because GDP measures financial activity rather than material prosperity, we’ve been able to create an artificial simulacrum of “growth” by pouring vast quantities of cheap credit – and, latterly, cheap money as well – into the system.

Ultimately, of course, money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services produced by the energy economy. Prolonged financial gimmickry – sorry, “innovation” – has had the effect of driving a wedge between the ‘real’ or material economy of energy and the ‘financial’, ‘claim’ or proxy economy of money and credit.

Because prices are the point at which these two economies intersect, inflation is a logical outcome of this divergence between the material and the monetary.

Whether we carry on letting inflation run hot, or raise interest rates in an effort to tame it, the end result is that we get poorer, either through an economic slump, or through the inflationary destruction of the purchasing power of money.

And there’s a sting in this tail (or tale), too. Most of those products and services that we deem “essential” – including water, food, housing, infrastructure and the transport of people and products – are energy-intensive, meaning that the real costs of necessities will continue to rise, even as overall prosperity erodes.

This means that the affordability of discretionary (non-essential) goods and services – those things that consumers might want, but do not need – will contract, with obvious implications for large swathes of the economy.

Orthodox economics continues to deny all of this, asking us to believe that there is no material shortage that cannot be overcome by using financial “demand” to push prices upwards.

The reality, though, is that no amount of demand, and no increase in price, can produce anything that does not exist in nature. Neither can any amount of technological genius overcome the laws of physics in general, or the laws of thermodynamics in particular.

Recent trends, albeit overshadowed by concerns over covid and Ukraine, are confirming that the “precursor zone” has ended; that economic contraction has begun; and that even the myth of perpetual “growth” can no longer be sustained.

Beyond high inflation, deteriorating prosperity and the erosion of discretionary consumption, this also means that the financial system faces a process of drastic downsizing, a process that can be expected to be disorderly.  

The debate – between orthodox ‘perpetual growth’ and material (and environmental) physical constraint – may run for some time yet, but the outcome is now beyond dispute.

The question now devolves into one of preparation and adaptation, which can only start once the reality of economic limits is grasped.      

#228. In the eye of the Perfect Storm



The title of this report makes intentional reference to the Perfect Storm paper published by Tullett Prebon back in 2013, when I was head of research at that organization.

Since then, my efforts have been concentrated on (a) promoting discussion (at Surplus Energy Economics) about the energy basis of the economy, and on (b) building an economic model (SEEDS) founded on these principles.

Whilst theoretical debate will continue, and models can always be further refined, time has run out for the purely intellectual contest between conventional and energy-based interpretations of the economy.

Accordingly – and with due apology to those to whom much of this is already familiar – what follows is a comprehensive summary of what we know about the economy as an energy system, and what we can reasonably infer about the future based on this understanding.


Faced with rising inflation, worsening pressure on living standards and significant nervousness in the markets, we’re at liberty – if we so choose – to ascribe all of these problems to the combined effects of the coronavirus crisis and the war in Eastern Europe, and to assure ourselves that the ‘normality’ of never-ending economic growth will return once these temporary vicissitudes are behind us.

The alternative is to face facts.

These are that prior growth in material prosperity has gone into reverse, and that a financial system erected on the mistaken presumption of ‘infinite growth on a finite planet’ faces challenges of a magnitude which eclipse all past experience.  

Understood as a system supplying the goods and services which constitute material prosperity, the economy is a dynamic propelled by the supply, value and cost of energy.

The critical element in this equation is the Energy Cost of Energy, which determines how much surplus (ex-cost) energy is available to the system. The ECoEs of oil, natural gas and coal have been rising relentlessly, undermining the fossil fuel foundations of the modern economy.

Protracted efforts to overcome energy deterioration with financial innovation have failed, simultaneously driving a wedge of instability between the ‘real’ or material economy of resources, goods and services and the ‘financial’ or proxy economy of money and credit.

Since prices are the point of intersection between these two economies, surging inflation is a logical signifier of the moment at which divergence becomes unsustainable, and the system becomes subject to forces tending towards a restoration of equilibrium between the energy economy and its financial counterpart.

Financially, and as fig. 1 illustrates, the extent of the imbalance between the material and the monetary economies reveals the downside risk in a system of forward commitments which has grown exponentially as monetary expansionism has fought a losing battle against material deterioration.

Meanwhile, whilst top-line prosperity erodes, the scope for discretionary (non-essential) consumption is being compressed by relentless rises in the real costs of essentials, many of which are highly energy-intensive.

Fig. 1

The inability of financial stimulus to reinvigorate the energy economy is the first of at least three popular myths which are poised to fail in the face of reality.

A second is the supposed ability of renewable energy sources (REs) to replace fossil fuel energy without undermining economic prosperity – whilst a “sustainable economy” may indeed be feasible, “sustainable growth” is a pipe-dream.

Neither can we expect the alchemy of technology to triumph over the laws of physics.

From here, and as the financial system draws ever nearer to the trauma of disorderly downsizing, the economy enters an era in which, whilst “collapse” might be avoided, involuntary contraction has become inescapable.


One of the most profound shortcomings in orthodox economics is the mistaken assumption that “prosperity” is coterminous with “money”.

If this were true, it would enable us, through our control of money, to promote perpetual economic expansion, unfettered by any material constraints imposed by the finite nature of the planet in its physical and environmental characteristics.  

We have spent twenty-five years discovering, at enormous cost, that such assumptions are fallacious. Conventional economics, once dubbed “the dismal science”, might or might not be “dismal”, but cannot in any way be considered a science.

Those conclusions which orthodox economists are pleased to call “laws” are, in fact, no more than behavioural observations about the human artefact of money, and are not remotely analogous to the laws of science.

If there is ever to be a science of economics, it will be founded, not in finance, but in thermodynamics.  

Critically, we should dismiss the orthodox insistence that financial demand always creates material supply, in part by promoting substitution. No amount of financial stimulus, and no rise in price, can produce resources which do not exist in nature. We can lend and print money into existence, but we cannot similarly create the low-cost energy without which the economy cannot function.    

The reality is that prosperity is a material concept, understandable only in terms of resources in general, and of the “master resource” of energy in particular.

As a recent reappraisal by Gaya Herrington confirms, the authors of The Limits to Growth (LtG) were right when, back in 1972, they modelled the Earth as an inter-connected system, and found definite material limitations to expansion.

In the narrower fields of economics and finance, it’s becoming ever clearer that we have been living through a quarter-century precursor zone during which the potential for further growth has been exhausted.

What we are experiencing now is the disruption which attends the ending of this transitional phase, and the onset of involuntary economic contraction.

The aim in Part One is to uncover the operative principles of the economy understood in material terms, and to look at how these define the nature and progression of prosperity.

In Part Two, we look at what the application of these principles tells us about the future of the economy and the financial system.


The Surplus Energy Economics interpretation is based on three principles, each of which is fully in accordance both with logic and with observation.

First, the economy is an energy system, because nothing which has any economic utility at all can be produced without the use of energy. This applies, not just to services and manufactured products, but to other natural resources as well, because the supply of these materials is a function of the energy required to make them available.

The second principle is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, giving us the principle of ECoE.

Because no unit of energy can be used twice, rises in ECoEs reduce the economic value of any given quantity of energy available to the system. Rising ECoEs also undermine the economics of energy supply, and thus act as a constraint on the quantity, as well as the economic value, of energy available to the economy.

This means that material prosperity is a function of the surplus (ex-ECoE) energy available to the system. Prosperity can be – and, through the SEEDS system, is – quantified and modelled on this basis.  

The third principle is that, lacking any intrinsic worth, money commands value only as a ‘claim’ on the products of the material economy of energy.

Money is thus ‘a human artefact, validated by exchange’. It is not a ‘store of value’, but at best ‘a store of claims to value’. Since money is a claim on energy, debt, as a ‘claim on future money’, is in reality ‘a claim on future energy’.  

We are at liberty to create as many monetary claims as we see fit, but we cannot create the material prosperity required to honour these claims ‘for value’.

Money and money-equivalents created in excess of the deliverability capabilities of the ‘real’ economy of energy are known in SEE as excess claims. Since, by definition, these excess claims cannot be honoured, they must be eliminated, either through repudiation (‘hard’ default) or through an inflationary degradation of the purchasing power of money (‘soft’ default).

To the extent that these claims are regarded by their owners as ‘value’, divergence between aggregate claims and the material economy must result in ‘value destruction’.

What emerges from these principles is the critically important concept of two economies.

One of these is the ‘financial economy’ of monetary claims, and the other is the ‘real economy’ of energy. This conceptual understanding is vital to a meaningful interpretation of economic and financial conditions, trends and prospects.   

For so long as we persist with the time-honoured but fallacious notion of a material economy governed entirely by the immaterial artefact of money, we will continue to make costly mistakes, to cherish expectations which the economy cannot deliver, and to build dangerous risk into a financial system which is wholly predicated on the false assumption of ‘growth in perpetuity’.

ECoE and prosperity

As we have seen, ECoEs are the decisive arbiter of the material prosperity made available by the economy understood as an energy system.

For most of the time from its inception in the symbolic year of 1776, the industrial economy benefited from steady falls in ECoEs. These falls reflected the operation of three positive factors.

The first of these was an expansion in geographic reach, as pioneers scoured the world in search of lower-cost energy resources. The second was economies of scale, a product of the rapid expansion of the energy industries. The third was a steady improvement in the technology of energy extraction, processing and delivery.

The sparsity of data for earlier periods is such that we cannot know what ECoEs were in 1776, when James Watt completed the first truly efficient steam engine, starting the industrial era by enabling us to convert heat into work.

But we do know that ECoEs at that time were very high indeed. Energy operations were small in scale and limited in geographical range, whilst energy accessing technologies were in their infancy.

A long downwards trend then reduced ECoEs to a nadir at or below 1% during a post-1945 quarter-century remarkable for its rate of expansion in economic prosperity.

Latterly, though, ECoEs have turned upwards, largely because, with the benefits of reach and scale maximised, depletion has taken over as the primary driver of the ECoEs of fossil fuels. Depletion describes the way in which lowest-cost resources are used first, leaving costlier alternatives for a ‘later’ which has now arrived.

The overall development of trend ECoEs can be pictured as a stylised parabola, as illustrated in fig. 10 at the end of this report.

The contemporary situation, as shown in fig. 2, is that relentless rises in trend ECoEs are undermining prosperity through a dynamic that cannot be managed in any way by financial policies. Unlike money, low-cost energy can’t be loaned or printed into existence.

SEEDS analysis reveals that the prosperity of the average American has been declining since 2000, and has since (as of 2021) deteriorated by 8%. The ECoE of the United States at the prosperity inflexion-point in 2000 was 5.1% and, as a general observation, this is the approximate level of ECoEs at which prior growth in the prosperity of the Advanced Economies (AEs) of the West goes into reverse.

Emerging Market (EM) economies – by virtue of their lesser complexity, and their consequently lower maintenance demands – enjoy greater ECoE resilience, and prosperity per capita in China might not turn downwards until about 2027, by which time China’s trend ECoE is projected to have reached 13%.

This said, the rate of improvement in Chinese prosperity per capita has decelerated dramatically, and the anticipated increase between 2021 and 2027 is very small indeed (1.6%). The inflexion point calculated for China by SEEDS has moved successively nearer with each iteration of the model.

In some EM countries – including Mexico, South Africa, Argentina, Brazil, Chile and Indonesia – prosperity per person has already started to decrease.

Fig. 2

Globally, and over an extended period, deterioration in Western prosperity has largely been offset by continuing (though decelerating) progress in EM countries. Now, though, this ‘long plateau’ has ended, such that the prosperity of the world’s average person is heading downwards.   

This is an accelerating trend, and the ‘average’ person worldwide is likely to be 7% poorer by 2030, and fully 21% less prosperous in 2040, than he or she was in 2019.

With the economy understood as an energy system, we can recognise that the growth momentum injected into the system by the harnessing of energy from fossil fuels has now faded to a point at which prior growth in material prosperity has gone into reverse.

An almost universal failure (and refusal) to recognise this process poses the greatest single threat to global prosperity, material security and stability, a threat comparable with – and directly linked to – energy-induced deterioration in the environmental and ecological well-being of the planet.

This can NOT be “fixed”

Thus far, very limited (and generally mistaken) acknowledgement of the economy’s energy challenge has met responses founded in wishful thinking and, to be frank about it, outright ignorance.

Current problems have been compared with the energy crises of the 1970s, when sharp rises in the price of oil triggered severe disruption, soaring inflation and a sharp slump in the economy.

In fact, any such comparisons are completely inappropriate. There was no material shortage of petroleum in the 1970s, and price rises were caused entirely by political developments – the Oil Embargo of 1973-74, and the Iranian Revolution of 1978-79 – which fractured the relationship between the major consumers and the major exporters of oil.  

The reality is that, back in the 1970s, global all-sources ECoEs were between 1.3% and 1.8%, at which further growth remained eminently feasible, even in the highly complex Advanced Economies of the West.     

Now, though, trend ECoEs are close to 10%, a level at which prior growth in prosperity must go into reverse, even in less complex, more ECoE-resilient EM countries.  

Of the proposed solutions to energy and associated environmental issues, by far the most absurd is the idea that we can somehow “de-couple” economic prosperity from the use of energy. The case that has been made for “de-coupling” has rightly, and authoritatively, been described as “a haystack without a needle”.

Alternative energy sources offer a more realistic set of solutions, with most hope vested in the development of renewable energy sources (REs) such as wind and solar power. As the ECoEs of fossil fuels continue to rise, there is a compelling economic as well as environmental case for maximising the use of REs.

There is something close to an orthodox “narrative” which depicts REs as the assured driver of a new age of growth. This orthodoxy contends that indefinite continuation of past reductions in the costs of REs will provide a smooth transition to a new era in which ever-cheaper electricity will unite with new technologies to combine environmental sustainability with unlimited economic expansion.

Unfortunately, such expectations are informed by a fundamental fallacy, which is the mistaken assumption that REs can provide a complete quantitative and qualitative replacement for the economic value provided historically by fossil fuels.

This isn’t the case, not least because the material resources required for the expansion and maintenance of REs can only be supplied using the legacy energy from oil, gas and coal.

We do not have, and are most unlikely ever to have, a truly renewable system which obtains its necessary inputs (including steel, concrete, copper, cobalt and lithium) without recourse to fossil fuel energy.

It’s not even clear if these raw materials actually exist in the quantities needed for complete transition. Even if they do exist, the energy required to deploy them does not.

This resource connection necessarily ties the ECoEs of REs to those of fossil fuels. The ECoEs of renewables have fallen, from a high base, but we cannot use the ‘fool’s guideline’ of infinite extrapolation to conclude that energy from REs will become cheaper indefinitely.

Moreover, the technical efficiencies of these energy sources are already close to their theoretical maxima, as set for solar power by the Shockley-Queisser limit, and for wind turbines by Betz’s Law. Even the “green” credentials of renewables are subject to severe qualification.

Over-optimistic expectations for renewables are informed by a contemporary fascination with technology, an attitude which forgets that the potential of technology is bounded by the laws of physics.

In short, the only way in which involuntary contraction in material prosperity could be reversed would be by the discovery (and the rapid deployment) of sources of primary energy whose ECoEs are at or below 5%.

Those of renewables are unlikely ever to be lower than about 12%, and are likely to trend back upwards over time. Conventional nuclear power has an important role to play, as do hydroelectricity and, perhaps, geothermal energy. But none of these is remotely scalable to a point sufficient to replace the low-cost energy hitherto sourced from coal, oil and natural gas.

Even new discoveries (such as practicable nuclear fusion) may not be sufficiently scalable within the necessary time period to prevent a continuing deterioration in prosperity.

To be clear about this, it IS imperative that we maximise the development of renewables – to continue to tie the fortunes of the economy to the deteriorating dynamic of fossil fuels would be to invite, not just irreversible environmental deterioration, but economic ruin.

The mistake all too often made is the fallacious assumption that an RE-based economy somehow “must” be as big as, or bigger than, the fossil-based economy of today.

An understanding of the fallacy of this assumption reveals the distinction between a “sustainable economy”, which may and should be feasible, and the mantra of “sustainable growth”, which is impossible.

The mechanics of self-deception

As we have seen, the mistaken interpretation of the economy as entirely a financial system has fostered the delusion that economic growth can continue in perpetuity, and that “growth” is, in some mystical way, not just an inevitability, but an entitlement.

In reality, rising ECoEs started to undercut the scope for further growth during the 1990s, with trend ECoEs rising from 2.9% in 1990 to 4.2% in 2000. Though economic deceleration was noted – and labelled “secular stagnation” – it was not traced to its cause.

Rather, it was assumed that it must be possible to restore the supposed ‘normality’ of brisk growth by the use of financial policies.

The first of these innovations, known in SEE terminology as “credit adventurism”, was invoked from the mid-1990s, when credit was made easier to access than it had ever been before.

Between 1995 and 2007, whilst reported GDP expanded by 63%, global debt doubled, with each incremental dollar of GDP accompanied by $2.30 of net new debt.

Worse still, almost half of all the recorded “growth” of that period was the purely cosmetic effect of pouring additional liquidity into the system, and then counting the transactional use of that added liquidity as ‘activity’ for the purposes of measuring GDP.

It must be stressed that GDP is a measure, not of material prosperity, but of activity – a very important distinction that is seldom, if ever, made in conventional economic presentation. The ability to create activity without adding value has injected unproductive complexity at every level of the economy.

Divergence between debt and economic output, exacerbated both by asset price inflation and by failures of regulatory oversight, led directly to the crisis of 2008-09.

With grim predictability, the authorities then decided to compound prior mistakes with “monetary adventurism”, undertaken using supposedly “temporary” expedients such as QE and ZIRP.

These had the effect of boosting the expansion of financial claims which included, not just debt, but broader financial system “assets” (which are the liabilities of the government, business and household sectors), and the underfunding of pension commitments.

These responses to the GFC bought some time for the perpetuation of the status quo, but did so at enormous cost. The dangers of ‘moral hazard’ were disregarded, and the necessary linkage between risk and return was broken, whilst the essential process of creative destruction was stymied.

Perhaps worst of all, avowedly “emergency” innovations – which have since become permanent – invited us to operate a ‘capitalist’ economy without the essential pre-requisite of positive real (above inflation) returns on capital.

Quantifying self-delusion

The SEEDS model enables us to put these various processes into a value-referenced framework. Let’s start by analysing what happened between 1999 and 2019, the latter year chosen because it excludes the subsequent distortions created by the coronavirus crisis.

Unless otherwise noted, all global data produced by SEEDS and used here is expressed in international dollars, converted from other currencies using the more meaningful PPP (purchasing power parity) convention, and stated at constant 2021 values.

Between 1999 and 2019, recorded global GDP slightly more than doubled (+110%), increasing by $74 trillion. But debt increased by 180%, rising by $204tn, or $2.75 for each dollar of reported “growth”.

Moreover, we can estimate that this $204tn increase in debt was accompanied by a $275tn rise in other financial liabilities, and a worsening, probably of the order of $150tn, in the shortfall or “gap” in the adequacy of provision for future pensions.

Concentrating on debt alone, SEEDS calculates that “growth” in GDP, mathematically averaging 3.7% between 1999 and 2019, was made possible by borrowing that averaged 10.2% of GDP during that period (see fig. 3).

SEEDS calculates that, stripped of this ‘credit effect’, underlying or ‘clean’ economic output (C-GDP) increased by only $28tn, or 41%, over a period in which reported GDP increased by $74tn, or 110%.

This in turn means that fully 63% of all “growth” recorded between 1999 and 2019 was the cosmetic effect of pushing gargantuan quantities of credit into the system, thereby creating enormous forward excess claims whose elimination, through a process of ‘value destruction’, has now become inescapable.

If we were to include 2020 and 2021 in the calculation – and, as well as debt, to incorporate increases in other financial liabilities (such as those of the shadow banking system), plus worsening shortfalls in pension provision – we would find that each $1 of “growth” since 1999 has been fabricated using close to $10 of incremental forward commitments.

Fig. 3

Measuring prosperity

Underlying economic output, calibrated here as C-GDP, is not the same thing as prosperity, the difference between the two being the first call made on output by the Energy Cost of Energy.

Between 1999 and 2019, trend ECoEs rose from 4.1% to 8.7%. This means that a 41% rise in global aggregate output (C-GDP) translates into an increase of only 34% in aggregate prosperity.

Since world population numbers rose by more than 25% between those years, average prosperity per capita increased by only 6.6%, a far cry from the claimed improvement of 67% in GDP per capita. As of 2021, prosperity per capita was only 5.2% higher than it was back in 1999.

These global numbers disguise extremely divergent geographical experiences. In 2021, prosperity per capita in China was more than double (+276%) what it had been in 1999. But per capita prosperity has declined by 8% in the United States since 2000, and by 10% in Britain since 2004.

The typical pattern revealed by SEEDS modelling of 29 national economies shows that, after prosperity per capita has reached its inflexion-point, initial declines are gradual, but rates of deterioration accelerate thereafter. This worsening in the rate of deterioration reflects compounding processes that will be discussed later.

Prosperity inflexion-points occur later in EM countries than in Advanced Economies, but subsequent declines are more rapid in EM economies.

Essentials and the loss of discretion

To concentrate on top-line prosperity – whether per capita or in aggregate – would be to miss much of the point, because what really matters, where the economy and the circumstances of the individual are concerned, is the relationship between total prosperity and the cost of essentials. Many of these essentials are energy-intensive, meaning that their costs will carry on rising, even as prosperity itself erodes.

The difference between prosperity and the cost of essentials is known in SEE terminology as PXE (prosperity excluding essentials), and this is one of the most important calculations produced by the SEEDS economic model.

PXE is now in decline almost everywhere, even in countries where top-line prosperity has yet to reach its point of inflexion.   

The SEEDS model defines “essentials” as the sum of two components. One of these is household necessities, and the other is public services provided by the government.

These services count as “essential” because the citizen has no day-to-day discretion (choice) about paying for them.

It should be noted that government spending falls into two broad categories. One of these is transfers, involving redistributive payments such as welfare benefits and pensions. These are not included in the SEEDS definition of essentials, because they net out to zero at the aggregate and at the average per capita levels.

The other category of government spending, which is incorporated in the “essentials” definition, is the direct provision of services, such as education, health care and defence.

The definition of a “necessity” varies both geographically and over time. Something which was regarded as a luxury in 1962 or 1992 may be regarded as a necessity in 2022. A product or service considered optional in a poor country may be seen as essential in a wealthier one.

The SEEDS calculation of essentials is thus, necessarily, an estimate, and it’s unlikely that a universal definition of “essential”, applicable irrespective of place and time, could ever be agreed (though the importance of the topic merits intensive examination).

What really matters, though, isn’t the precise definition of a necessity, but the trend in the real cost of the broad category of “essentials”. Many necessities – including water, food, shelter and the transport of people and products – are highly energy-intensive. Accordingly, the costs of essentials have carried on rising even as prosperity itself has gone into decline.

With prosperity eroding and the real costs of essentials rising, SEEDS analysis shows a process of rapid convergence, shown in per capita terms in fig. 4.

Fig. 4

As fig. 4 makes clear, SEEDS projections show an impending point of crossover at which the prosperity of the ‘average’ person falls below his or her cost of essentials.

Two important points should be noted about these projected intersections.

First, we can anticipate re-definition of the term “essential”, with some products and services, now deemed necessities, coming to be seen as discretionary.

This will apply, not just to household necessities, but to public services as well. An example of the former might (and probably will) be a decline in car ownership, and an increased reliance on public transport, within a general reduction in travel. Governments will face the unenviable task of deciding which public services can no longer be afforded.

Second, the projections shown in fig. 4 relate to the ‘average’ person. In practice, some people will retain the scope for discretionary consumption whilst an increasing number of the less fortunate will become unable to afford essentials, at least as these are currently defined.


In Part One of this report, we have looked at how the economy functions as an energy system, at the meaning and quantification of material prosperity, and at the shortcomings of an economic orthodoxy predicated on the false premise that the economy can be explained, managed – and propelled to infinite expansion – on the basis of money alone.

Turning to projections, there are two issues on which energy-based modelling can provide forward visibility in a way consistent with these fundamentals.

One of these is calibration of the relationship between the financial economy of money and credit and the real economy of goods, services, labour and energy.

This reveals a process trending towards a restoration of equilibrium between the two economies of money and energy. This points towards an inevitable, and very probably a disorderly, contraction, of the order of 40%, in the financial system understood, as it must be, as an aggregation of monetary claims on the material prosperity of today and tomorrow.

First, though, we look at trends in overall economic prosperity and its components.

In preference to a conventional approach which defines the economy as the government, business and household sectors, the SEE interpretation concentrates on three functional segments, which are the provision of necessities, capital investment in new and replacement productive capacity, and the consumption of discretionary (non-essential) goods and services.

As we shall see, general expectations of continuing expansion are based, not just on the false assumption of infinite growth, but also on extrapolation of a recent past mispresented by distorted presentation of historic trends.

In other words, consensus projections are based on the indefinite continuity of a past that simply didn’t happen in the way that convention says that it did.

We conclude that, just as material prosperity is trending downwards, the cost of essentials will continue to rise. This is creating compression effects to which businesses will respond along lines described in SEE as the taxonomy of de-growth.

A primary challenge for governments, meanwhile, will be management of the deteriorating affordability of public services, many of which form part of the essentials which the economy provides to its citizens.  

Clarifying underlying trends

If you want to work out where you’re going, it’s rather important to have reliable information about where you’re starting from, and of how you got there.

In economic terms, this is information that orthodox methods cannot provide.

In search of underlying reality, we’ll look at developments between 1999 and 2021, a period which loosely coincides with the prolonged precursor zone preceding the onset of involuntary economic contraction.

Official data says that global real (constant value) economic output, measured as GDP, increased by 116% between 1999 ($68 trillion PPP) and 2021 ($146tn). If these numbers were accurate, they would mean that the world’s average person was 69% better off in 2021 than he or she had been back in 1999.

On this basis, we’re asked to accept that, since the economy expanded at a compound annual rate of around 3.5% (real) between 1999 and 2021, something similar can be relied upon in the future, once the pandemic, and the crisis in Ukraine, are behind us.

It should come as no surprise at all, then, that the long-range consensus is based on rates of growth of between 3.3% and 3.5%, which confirms the prevalence of extrapolation from misunderstood recent history.

As we’ve seen, this interpretation of past trends ignores the fact that GDP, as a measure of activity rather than value, has been inflated, artificially and dramatically, by rapid expansions in debt and other financial commitments. The average person’s share of GDP may have increased by 69% between 1999 and 2021, but his or her share of total debt far more than doubled – rising by 148% – over that period.

The conventional calculation also takes no account of a dramatic rise in trend ECoEs, from 4.1% in 1999 to a growth-crushing 9.4% in 2021.

On an underlying basis which incorporates these critical issues, the SEEDS model shows that global aggregate prosperity increased by only 35% (rather than 116%) between 1999 and 2021. This means that the world’s average person became better off by just 5.2% (rather than the claimed 69%) between those years.

SEEDS analysis informs us that annual growth in prosperity averaged only 1.3% (rather than 3.5%) during that period.

From a forecasting perspective, this enables us to produce two sets of calculations.

One of these, as mentioned earlier, is a calibration of the relationship between the real economy and the financial system.

The other is the ability to revise past trends onto a basis which provides a realistic rather than an optimistically-distorted historic foundation for forward projection.

RRCI – re-basing to prosperity

It should be understood that revising historic numbers is a routine process in economics.

For instance, global GDP rose from a reported $47tn (PPP) in 1999 to $146tn in 2021.

Everyone knows that this nominal increase (of 210%) is misleading, because it ignores inflation. Accordingly, the GDP deflator is applied, revising the 1999 number to $68tn, enabling ‘real’ growth since then to be calculated at 116%.  

Since GDP and its component parts are the generally-accepted basis for forecasts, projections produced by SEEDS need to start with the most recent GDP number, however misleading we know it to be.

This does not, though, mean that we need swallow the mythical growth figures – such as the supposed more-than-doubling of the real size of the world economy between 1999 and 2021 – when we know that the increase in underlying prosperity was only 35%.

Accordingly, we need to restate past nominal numbers on the basis of a more realistic assessment of systemic inflation, replacing the GDP deflator with a more meaningful measure of price changes over time.

This alternative measure is known in SEEDS terminology as the Realised Rate of Comprehensive Inflation (RRCI).  

Global systemic inflation between 1999 and 2021, measured as the annual GDP deflator, is reported at 1.7%. Applied to an annual rate of increase of 5.3% in nominal GDP, this produces a reported rate of real “growth” of just under 3.6%, compounding to 116% over the period as a whole.

As we’ve seen, though, we know that the expansion in prosperity between those years was only 35%, an annual compound rate of increase of less than 1.4%.   

If we accept – for forecasting purposes – the reported rate of growth in nominal (“money of the day”) activity of 5.3%, recognition that prosperity increased at a compound rate of only 1.36% (rather than 3.6%) reveals that the required compound deflator isn’t 1.7%, but 3.87%.

Globally, these RRCI calculations reveal that the purchasing power of money declined, not by the reported 30%, but by 57%, between 1999 and 2021.     

This restatement is consistent, not just with what we might call ‘everyday experience’, but also with the known shortcomings of orthodox inflation calculations.

For a start, we know that the preferred measure of headline inflation – the Consumer Prices Index – has, since the 1990s, been affected (and reduced) by innovations such as substitution, hedonic adjustment and geometric weighting. Studies based on the application of earlier techniques consistently reveal sizeable understatements in the contemporary presentation of consumer inflation.

Moreover, and as its name indicates, CPI measures only inflation as it is experienced by the consumer, thus excluding many other important metrics, one of which is the inflation in the prices of assets, including stocks, bonds and property.

Asset price inflation most emphatically IS relevant to the overall situation, and not just because of its importance to the relationship between a (generally older) demographic which already owns assets, and a (generally younger) group which aspires to acquire them.

A gamut of transactions in the financial system is linked directly to the prices of assets.

The GDP deflator is supposed to overcome some of these shortcomings through the use of chain-linked measures of volume.

But a large part of the economy – most obviously, financial activities such as banking and insurance – simply cannot be measured volumetrically. We can’t, for practical purposes, meaningfully measure activity in financial services in volume terms, simply by counting the numbers of bank statements provided and insurance certificates issued.

Trend reality

The application of RRCI re-basing to economic data is illustrated in fig. 5.

As mentioned earlier, instead of the usual practice of dividing the economy into sectors (government, businesses and households), these charts depict the world economy in the form of segments, which are essentials, discretionary (non-essential) consumption, and investment in new and replacement productive capacity.

In fig. 5, world economic output for 2021 is stated in all three charts at $146tn (PPP), the reported number for that year. In nominal terms, this reflected an increase of 210% since 1999, when current (“money of the day”) GDP was $47tn.

Application of the GDP deflator raises the 1999 number to $68tn at 2021 values, implying subsequent real “growth” of 116%.

On an RRCI, prosperity-referenced basis, however, the 1999 figure rises, not to $68tn, but to $109tn, reducing subsequent expansion to 35%.

The left-hand and central charts project the situation out to 2027 when, according to the consensus, real GDP is expected to have increased by about 22%. This – as we have noted, and as the middle chart reveals – amounts to extrapolation along the lines of the supposed “trend” rate of growth in recent times.

In the right-hand chart, SEEDS data is used to extend the forecasting period out to 2040, by which time economic output is projected to be lower (by 9%) than it was in 2021.

These, of course, are aggregate numbers, which take no account of increases in population numbers. These rose from 6.0 billion in 1999 to 7.7bn in 2021, and may reach a figure just short of 8.9bn by 2040. On this basis, prosperity per capita is projected by SEEDS to be 21% lower in 2040 than it was in 2021.

Fig. 5

Scoping the future

In fig. 6, SEEDS analysis is used to compare two versions of economic output for the global, American and British economies. In each case, reported 2021 GDP is accepted as a common start-point, even though we know that this is a ‘financial economy’ data-point which is at variance with the underlying ‘real economy’.

In each case¸ the RRCI-based SEEDS trend-line, shown in blue, starts from higher historical levels than those shown in the official ‘real’ equivalent shown in black. It readily becomes apparent that the consensus¸ framed as a continuation of the supposed past, extrapolates from a history that didn’t actually happen.     

If you believe, for example, that the American economy had, prior to 2020, been expanding at an annual trend real rate of 2.1%, there’s a superficial basis for believing that it will carry on growing at much the same supposed rate, such that GDP will be 13% higher in 2027 than it was in 2021.

The underlying situation, though, is that American prosperity actually expanded at only 0.5% annually between 1999 and 2019, and that even this slow rate of increase has been decelerating.   

The British situation is even less robust, with reported trend growth (of 1.8%) between 1999 and 2021 falling to just 0.3% on an underlying basis.

In both countries, underlying rates of growth in prosperity have, over a lengthy period, been lower than the trend increase in population, which expanded by 0.8% annually in the United States, and by 0.7% annually in the United Kingdom, between 1999 and 2021.

This leads us to an observational conclusion, which is that, if the average or ‘ordinary’ person in most Western countries thinks that he or she has been getting poorer (as well as more indebted) in recent times – rather than more prosperous, as asserted by the official view – the strong probability is that his or her perception is correct.

Fig. 6

It would be hard to over-state the significance of this interpretation, but it becomes of even greater importance when we recognise two other underlying realities.

The first is that divergence between the ‘real’ and the ‘financial’ economies has now reached a point at which even the myth of continuing growth has become untenable.

Mistaken presentation of past trends contributes to an unjustified confidence in the ability of the economy to carry – and, in due course, to honour – its gargantuan financial commitments.

The taxonomy of contraction

The second is that, whilst trends in prosperity per capita have adopted (or, in some economies, are soon to adopt) a trajectory of decline, the real cost of essentials is continuing to rise.

Using methodologies described earlier, fig. 7 sets out economic projections for America, Britain and South Korea, subdivided into essentials, investment in new and replacement productive capacity, and the affordability of discretionary consumption.

It should be stressed that each chart presents aggregates, and that adverse trends are more pronounced at the per capita level. It should also be emphasised that the projections for other countries follow broadly similar patterns.

In each instance¸ prosperity is trending downwards. Even aggregate prosperity is now at the point of inflexion in the United States, whilst the rate of decline in Britain has become relentless.

Likewise, the real costs of essentials are trending upwards.

Together, these processes are compressing both investment capability and discretionary affordability, which are the residuals in the equation.     

Stated at constant 2021 values, PXE – the residual difference between prosperity and essentials – is, by 2030, projected to be 14% lower in South Korea, 22% lower in America and 28% lower in Britain than it was in 2021.

Fig. 7

PXE is an indicator of the scope that exists for discretionary consumption and capital investment over time, and it should be said at once that neither of these segments can continue to be propped artificially by credit and monetary subsidy, as has been the case in the past.

This in turn means that, although the entire economy is exposed to the consequences of involuntary contraction, sectors supplying non-essential goods and services will be in the eye of the storm.

It would not be appropriate to specify activities or sectors here. The operative principle, though, can be likened to a household in which decreasing resources, and the rising costs of essentials, compel a reduction in discretionary purchasing.

Of course, no enterprise – whether it supplies discretionaries or essentials – can be expected simply to sit back and let this happen. Beyond general considerations of rising costs and decreasing revenues, there are two particular issues with which businesses will have to grapple.

One of these is a decline in utilization rates – as sales volumes decrease, fixed costs need to be spread across a diminishing number of customers. Passing on these rises in unit costs is likely to result in price increases which exacerbate the rate at which customers and revenues are lost.

The second is a loss of critical mass. As suppliers fail, or reduce the range of goods and services which they offer, a widening range of necessary inputs will either rise in price, or cease to be available at all.

Together, these two processes can be expected to worsen the rate at which economic prosperity declines. These compounding factors help explain why deterioration in prosperity is an accelerating process.

For businesses, the obvious response is simplification, both of product ranges and of supply processes. This will lead to de-layering, as some stages in the production process are eliminated altogether, or are reduced in scale to the point at which they are rendered uneconomic.

What we’re describing here is a process of de-complexification. As the industrial economy expanded, it also became progressively more complex, introducing wholly new activities, many of them very large, which did not exist in the earlier, smaller and less complex economy.

Together, decreasing utilization rates, loss of critical mass, simplification, de-layering and de-complexification form what is known in SEE terminology as the taxonomy of de-growth, though ‘contraction’ might be a more appropriate term than ‘de-growth’ for the description of trends which are part of an involuntary reduction in the scale and complexity of economic activity.

Financial contraction

With two vital concepts understood – the two economies, and the role of money as claim – it becomes apparent that rapid (and very probably disorderly) contraction is to be anticipated in the financial system.

There are many sectors in which the confidence of investors and lenders could very rapidly ebb away.

Calibration of these trends relies on two calculations. One of these is percentage exposure, meaning the gap that divides the ‘financial economy’ of money from the ‘real’ economy of energy, goods and services.

The widening of this gap has already progressed far enough to trigger a sharp and systemic upturn in inflation, a process which largely precludes any continuation of that reliance on “stimulus” which has characterised economic crisis-management over a remarkably prolonged period.

Whilst raising rates might not tame inflation – and perhaps nothing can – central bank inaction, allowing real rates to go ever deeper into negative territory, might not be tenable either.

It is not the purpose of this report to draw detailed comparisons between economies, but fig. 8 illustrates that percentage exposure is frighteningly larger in China (-54%), and markedly smaller in Italy (-10%), than in the United States (-32%), or in the world economy as a whole (-40%).    

Fig. 8

In any case, percentage downside is really meaningful only when applied to the proportionate size of the financial system which – within the principle of ‘money as claim’ – needs to be understood in terms of liabilities.

Globally, and stated at constant 2021 values, debt has soared from $113tn (PPP) in 1999 to a provisional $360tn at the end of 2021. Though the ratio of debt-to-GDP has risen to ‘only’ 240% now (from 166% in 1999), the way in which increases in debt inflate activity reported as GDP means that a linkage between numerator and denominator results in a progressive understatement of this oft-cited ratio.

Referenced to prosperity rather than GDP, the debt ratio today rises to over 400%, compared with a similarly-calibrated 175% back in 1999.

Much the same applies to financial assets, which are the counterpart of liabilities in the government, corporate and household sectors of the economy. On the basis of data available for countries accounting for about three-quarters of the world economy, we can estimate that these liabilities, which include those of the shadow banking system, may now equate to at least 930% of prosperity (and about 550% of GDP), compared with 440% of prosperity in 2002.

Inadequacies (“gaps”) in pension provision are harder to calculate, but available data suggests that these might now have risen to about 3x global prosperity, a sharp increase powered, at least in part, by policy-induced crushing of returns on invested capital.

Within the charts shown in fig. 9, it must be understood that we have only limited data on financial assets globally, and still less on the inadequacy of pension provision. The latter, in any case, tends to be referenced, not to firm commitments, but to general expectations, with global pension provision tending to be financed from government revenues rather than from funded provision.

Even so, we can conclude that, following a prolonged period in which forward claims have been increased exponentially in order to sustain a cosmetic simulacrum of “growth”, systemic risk has become enormous within an economy increasingly dependent on, and addicted to, a continuity of breakneck expansion of financial commitments, commitments which might have become impossible to honour ‘for value’ even if the material prosperity of the global economy hadn’t ceased growing, and started to contract.     

Fig. 9


It’s been well said that people have a strong inclination towards believing what they want to believe.

Even so, the extent of contemporary misunderstanding about our true economic and financial predicament can only be described as staggering.

The consensus view remains that current problems combine the lasting effects of the coronavirus crisis with the more recent stresses created by the war in Ukraine. The assumption, seemingly shared at all levels of opinion, is that, as and when these disruptions recede into history, “growth” will return, inflation will fall back to pre-crisis levels, and there need be no re-run of the financial crisis of 2008-09.

This consensus “narrative” is based on at least three critical misconceptions.

The first of these misconceptions is that “growth” can be maintained indefinitely in the future, as it supposedly has been in the past, through the operation of financial policies.

This view not only exemplifies the fallacious orthodoxy that the economy is entirely a financial system, but further ignores the reality of a recent past in which the simulacrum of “growth” has been manufactured by the relentless creation of forward commitments which cannot possibly be honoured ‘for value’.

The second misconception is that we can make a seamless transition from fossil fuels to renewable sources of energy without impairing the performance of the economy. Whilst imperative in environmental terms, this transition cannot replace the economic value hitherto provided by oil, gas and coal. The material resources to accomplish this transition, where they exist at all, can only be provided courtesy of legacy energy from fossil fuels.

Informing both of these is a third misconception which rests on remarkably over-sanguine expectations for technology. Ultimately, the scope of technology is bounded by the limits of physics in general, and thermodynamics in particular.

When we see past these misconceptions, what emerges is an economy poised for severe contraction because of (a) the depletion of the low-cost fossil fuel energy which has powered the industrial sage, (b) the absence of any plausible replacement for this low-ECoE energy, and (c) the sheer idiocy of the idea that we can somehow “de-couple” economic prosperity from the supply, value and cost of energy.

This gap between reality and misconception poses enormous risks for a financial system which has created gargantuan ‘forward claims’ that cannot possibly be delivered. These excess claims will have to be repudiated, through default, through runaway inflation, or a combination of both. This inevitable process of disorderly downside on the claims side of the equation has obvious implications for asset prices which have been inflated, often to the point of absurdity, through a period of ultimately-futile policy gimmickry.

Based on the same misconceptions which distort collective understanding of the economy and the financial system, it is widely assumed that existing political and social arrangements, and the intellectual dogmas that support them, will evolve only very gradually from where they are today.

We have reasonable grounds for concluding that this consensus view is shared by leadership cadres in government, business and finance. Whilst it is fashionable to question the candour of politicians, we can state with confidence that, if business bosses and investors really did have serious doubts about the validity of the consensus “narrative”, these doubts would already have become apparent, not least in corporate strategies and, most obviously, in the markets.

What we cannot calculate is the moment at which reality displaces all of these fondly-cherished delusions, economic, financial and political. A purely personal view – and an admittedly somewhat subjective one – is that we are now very close indeed to the moment at which the myth of perpetual growth succumbs to the hard facts of an economy heading into contraction; a financial system, built on false predicates, trips into a crisis of disorderly downsizing; and the public demands pragmatic responses to challenges which its leaders, perhaps in all good faith, have hitherto refused even to acknowledge.    

Fig. 10