#185. The objective economy, part two

ARE DISCRETIONARY PURCHASES NO LONGER AFFORDABLE?

When somebody makes a discretionary (non-essential) purchase – pays for a leisure activity, for instance, or a consumer gadget, or a holiday – the assumption is that he or she ‘can afford it’. But the World economy runs on continuous infusions of credit, which makes the world “afford” subject to increasingly severe qualification.

This discussion presents an analysis of prosperity (as opposed to credit-financed ‘consumption’), in conjunction with assessments of taxation, and of the cost of household essentials. It indicates that the average person can not now afford discretionary purchases. Moreover, his or her ability to afford liens on income – the household counterparts of the streams of income now so critically embedded in an increasingly financialized economy – has to be open to very serious question.

As we near the point where we exhaust our ability to inflate economic ‘activity’ with perpetual credit injection, we are poised to make two very disturbing discoveries. The first is that swathes of discretionary activity are no longer affordable on a sustainable basis, to the point where sectors supplying these purchases are to a large extent living on the life-support of financial manipulation.

The second is that a large proportion of asset valuations – where they involve discretionary suppliers, capitalized streams of income, and property – are hanging by a thread.  

Introduction

In the previous article, we went in some depth into the workings of the economy as an energy system, concluding that prior growth in prosperity has gone into reverse as the energy equation has deteriorated. The aim here is to explore some selected implications of the onset of “de-growth”.

This can best be done, not by looking only in a ‘top-down’ way at institutions, systems and enterprises, but by following a ‘bottom-up’ rationale which starts with the circumstances of the ‘average’ or ‘ordinary’ person.

The central realities are (a) that this ordinary person’s prosperity is shrinking, and (b) that conventional definitions of economic output and individual income greatly overstate the economic resources to which he or she has access.    

There is a sequence of hierarchy in how the ‘average’ person spends his or her income. The first calls are taxation, and the cost of household essentials. Next come various liens on income owed to the financial and corporate system – these are the household counterparts of the streams of income on which so much corporate activity and capital asset value now depend. ‘Discretionary’ (non-essential) spending – everything from leisure and travel to the purchase of durable and non-durable consumer goods – is funded out of what remains, after these various prior calls have been met. 

Putting these two facts together leads to some striking conclusions. Because discretionary consumption comes last in the pecking-order of spending – and because a large and growing slice of apparent ‘income’ is no more than a cosmetic product of financial manipulation – then it follows that the underlying and sustainable level of discretionary expenditures is far lower than is generally assumed.

In essence, discretionary sectors of the economy are now on life-support, kept in being only by the drip-feed of credit and monetary stimulus. Additionally, the ability of households to sustain the stream-of-income payments to the financial and corporate sectors is hanging by a thread.

This means, first, that, as and when credit and monetary adventurism reach their practical limits, whole sectors of the economy will contract very severely.

Second, it means that we have reasonable visibility on the processes by which asset prices will slump into a new equilibrium with much-reduced economic prosperity.

Critical path

These findings have profound implications, so much so that it’s important to understand the analytical route by which they have been reached. This discussion follows a path which starts with a top-down examination of how the ‘real’ economy of goods and services actually functions, translates this into what it means for the ‘average’ or ‘ordinary’ person, and proceeds from there to various findings relevant to business, finance and government. This analysis is informed by the proprietary SEEDS economic model, which presents energy-based analysis in the financial ‘language’ in which, by convention, debates over these issues are conducted.      

If you’re new to energy-based interpretation of the economy, the ‘big picture’ is simply stated.

Essentially, the dramatic growth in economic output (and in the numbers of people supported by that output) since the 1760s has been a function of cheap energy from coal, oil and natural gas.

More recently, three trends have undermined this dynamic. First, fossil fuel energy has ceased to be ‘cheap’, in meaningful, energy-margin terms.

Second, this cost increase is taking away our ability to maintain (let alone to further increase) the supply of fossil fuels.

Third, we have reached – or passed – the limits of environmental tolerance of an economy powered by fossil fuel energy.

This means, either that we find an economic replacement for oil, gas and coal, or that we adapt ourselves to the ending of the fossil fuel prosperity dynamic. The authorities, who are aware of the environmental but not the economic implications of this situation, are pinning their hopes on transition to renewable energy sources (REs).

The environmental case for transition to REs is undoubtedly compelling. But the belief that REs can replicate the economic impetus of fossil fuels, far from being ‘proven’, is simply an assumption, based primarily on wishful thinking, and, far from success being assured, the probability of it happening is actually very low.

Considered in ECoE terms, whilst the costs of RE supplies are falling, they are unlikely ever to be low enough to replace the fossil fuel growth dynamic. The building out of RE capacity continues to rely on inputs which only the use of fossil fuels can provide. We cannot – yet, anyway – build solar panels using only solar energy, or construct wind-turbines using wind power alone.

Moreover, we should not assume that REs can ever be a like-for-like replacement for oil, gas and coal. An economy powered by REs will not replicate the one built on fossil fuels. The push to replace internal combustion engine (ICE) transport with electric vehicles (EVs) is a case in point. Whereas the properties of petroleum favoured the development of cars, RE-provided electricity is likely to work far more effectively as a power source for public transport.

Even if (and it’s a big ‘if’) RE electricity can replace the quantity of energy used by ICE vehicles, batteries cannot replicate the characteristics of the fuel-tank.  If we try to ‘buck the physics’ on this – if we insist on clinging on to cars, rather than switching to trains and trams – then we risk, not only a costly failure, but also an environmental disaster caused by mining the materials necessary for the requisite supply of batteries.

In parenthesis, it’s only fair to note that the authorities very probably don’t anticipate like-for-like replacement of ICE cars with EVs, but they can hardly tell voters that car ownership is set to fall markedly.

Economic conditions – the personal factor

Where this top-down situation leaves our ‘average’ person is with deteriorating prosperity. It might not look that way to him or her, but this is because both macro and micro perceptions have been obscured by the use of financial ‘innovation’, which has included sub-zero real interest rates (by which people are paid to borrow), and monetary expansion (which back-stops this escalation in debt and other obligations).

Wages and other forms of income have continued to increase, but only because we have been taking on between $3 and $5 of new commitments in exchange for each dollar of apparent “growth” in GDP and, therefore, in incomes. A point will, inevitably, soon be reached at which we have to renege on some of these promises, either by walking away from them (‘hard default’) or by devaluing them through inflation (‘soft default’). The idea that this somehow ‘doesn’t matter’ is a fiction, because one person’s debt is another person’s asset, and because broader promises (such as pensions) form the real basis on which people plan their lives.       

The deterioration in prosperity has been experienced first in the Advanced Economies, and prosperity per capita has been falling in almost all Western countries since the early 2000s. The high levels of complexity in these economies carry extensive maintenance costs, meaning that prior growth in prosperity goes into reverse at comparatively low levels of ECoE (between 3.5% and 5.0%). Less complex EM (emerging market) economies enjoy greater ECoE tolerance, but they, too, have now reached the ECoE inflexion-points (between 8% and 10%) at which prior growth in their prosperity, too, goes into reverse.

This, of course, means that the average person – first in the West, latterly in the EM countries – gets poorer. So far, at least, the rate of deterioration in top-line prosperity has been pretty gradual, but its effects on the average person are leveraged by taxation; by the priority that must be given to household essentials; and by the liens on income created by the increasing financialization of the economy.

Here’s a simple illustration of this leverage effect. A person has an income of $100. Of this, $35 goes in tax, $40 must be spent on essentials, and a further $15 goes out in interest, rent and various subscriptions and stage-payments. This leaves $10 of discretionary income for the person to spend as he or she wishes.

If this representative person’s income falls by $5, from $100 to $95, it’s mathematically true to say that he or she is worse off by ‘only’ 5%. But, because of the leverage in the equation, his or her discretionary spending capability has slumped by 50%, from $10 to $5.

This person may – and, in the real world, increasingly does – counteract this ‘discretionary squeeze’ by taking on extra debt, or by stringing out (staging) payments for purchases that hitherto would have been paid for up-front.

But all that this does is to increase the future cost of debt service and other liens on income.      

Taxing times

Where fiscal issues are concerned, the prosperity problem for households is leveraged by governments’ failure to set policy based on the realities of prosperity.

In the group of sixteen Advanced Economies (AE-16) modelled by SEEDS, aggregate taxation increased by an estimated 40% in real terms between 1999 and 2019. Since recorded GDP rose by a very similar 41% over this period, the apparent incidence of taxation – measured conventionally against GDP – has been remarkably static, seldom varying much above or below 36% over the past two decades.

When we look past credit-inflated GDP to prosperity, however, the burden of tax has risen from 39% in 1999 to 49% last year.

As this pincer effect has rolled on – with taxes rising whilst prosperity erodes – relatively modest decreases in prosperity per capita have been leveraged into much more extreme falls at the level of disposable (“left in your pocket”) prosperity.

The most striking illustration of this effect is France, where prosperity per capita peaked in 2004, at €30,910. Since then, this number has declined by a comparatively modest 6.2% (€1,910) in real terms, to €29,000. But tax per capita has increased (by €3,000 per person) over that same period. Accordingly, the disposable prosperity of the average French citizen has fallen by a dramatic 34% (€4,920), from €14,700 in 2004 to just €9,570 last year. Popular anger at this state of affairs is palpable.  

In few other countries has this leverage effect been quite so extreme, but declines in disposable prosperity per person have, nevertheless, been pretty striking, falling by 28.2% in Spain since 2001, by 28.0% in Britain since 2004, and by 17.4% in the United States since 2000 (see table 1).

Table 1.

Essential pressures

The adverse leveraging effect of taxation has fiscal and political implications, of course, though what interests us here is its impact on consumers.

This impact is, moreover, compounded by the growing slice of prosperity accounted for by the cost of household essentials.

SEEDS doesn’t monitor essentials spending on a country-by-country basis, but does carry out this exercise in the single instance of the United Kingdom. Over a twenty-year period ending in December 2019, average wages in Britain increased by a nominal 77%, outstripping CPI inflation (of 49%) such that, in theory, the wage-earner was better off by nearly 10% over that period.

However, the essentials index (TMUKEPI) rose by 96%, such that wages measured against household essentials decreased by almost 10% between 1999 and 2019. It’s also noteworthy that, whilst the average cost of domestic rent rose by 8% in real terms, the real cost of mortgages fell by almost 20%.

Since a sizeable part of the cost of household essentials is linked to commodities traded globally – most obviously, to foodstuffs, materials and, above all, energy – it’s a reasonable inference that these broad patterns have been replicated elsewhere in the Advanced Economies. From this, we can deduce that non-discretionary purchases, whilst they account for perhaps 37% to 40% of household expenditures, already absorb somewhere between 50% and 55% of prosperity.

If this calculation is correct, it would mean that the combined burdens of tax and household essentials are already close to, and may in a number of instances exceed, per capita prosperity. If these costs seem to remain affordable within incomes – but not within prosperity – the explanation lies in the credit effect of inflating incomes (and aggregate GDP) by purchasing “growth” using incremental debt in a ratio of 3:1.     

In short, indicative numbers suggest that, over the past five or so years, the combined burdens of taxation and essentials have come to absorb all of the prosperity of the average person in a growing number of Western economies.  

What this in turn means is that the average household increasingly relies on credit expansion to fund all discretionary (non-essential) purchases. In this context, ‘debt’ includes the individual’s share of all government and corporate (as well as household) borrowing. Albeit at one remove, government borrowing pays for services that would otherwise have to be funded by taxation, whilst corporate borrowing helps fund the incomes of employees, and may also serve to reduce the end-user cost of purchases.   

As set out in table 2, perhaps the most extreme example of this credit effect is Ireland. Since 2004, the annual pre-tax prosperity of the average Irish citizen has decreased by €3,000 which, at 7.4% and spread over fifteen years, may seem a comparatively modest decline. Over the same period, though, his or her share of the country’s debt has soared from €82,000 to €198,000. This means that, on average, the average person’s share of debt has increased by nearly €7,700 in each of the past fifteen years.     

Table 2.

Conclusions

It’s a reasonable guess that the central conclusions of this analysis will not contradict many readers’ intuitive perceptions of what has been happening.

We know that increases in income have been more than matched by increases in debt. We know that, increasingly, households are taking on financial commitments in addition to traditional obligations such as mortgages and rent. We know that taxes on the ‘typical’ household haven’t fallen to mitigate these pressures. We know that the real cost of household essentials has risen, and it will come as no great surprise that there is a corollary between rising household credit and continuing expenditures on non-essential purchases such as leisure, travel and gadgets. We also know that many other indicators of hardship chime with these observations.

In this context, it’s necessary to be clear about what we know, and what we infer. Observation over time confirms that financial ‘innovation’, and outright increases in debt and other obligations, are being used to sustain increasingly illusory ‘growth’. Our understanding of the energy basis of all economic activity should reinforce our confidence that rising ECoEs lie at the root of what began as “secular stagnation”, but has since turned into something a great deal more serious. SEEDS monitors real-terms taxation in countries accounting for about 80% of the World economy and, if we cannot calculate the costs of household essentials on a country-by-country basis, we have data sufficient for reasonable inference on this component.

We need to be somewhat nuanced in the conclusions that we draw from a diminishing, and perhaps vanishing, aggregate capability to fund discretionary purchases without resort to spiraling credit.

For one thing, inequalities between households affect the overall situation. Whilst the ‘average’ person might not be able to make discretionary purchases without using credit, there will be some below this average who already rely on credit to pay for the essentials, whilst others are in a better position, and can still make discretionary purchases without going into debt to do so. To take just one example, the interpretation presented here doesn’t imply that air travel will ‘collapse’, but does indicate that it will contract, suggesting that providers will need to carry fewer passengers, and charge them higher fares.

This said, there can be no disguising the underlying trends, which point towards overall contraction in discretionary sectors, and also highlight the vulnerability of any activity or asset which depends on income streams derived from increasingly squeezed household prosperity. Logically, the industrial landscape can be expected to rebalance away from discretionary activities, whilst a sharp correction in asset prices is likely to be led both by decay in discretionary components and by a degradation in the scale and reliability of ‘income streams’.        

#184. The objective economy, part one

IN PURSUIT OF THE EVIDENCE

The title of this article has two meanings. First, it signifies that the economy is a physical entity – indeed, is an energy system – rather than an immaterial construct based on the human artefact of money.

Second, it underlines an imperative need to examine evidence objectively. This is particularly important at a time when both of the contentions that vie for our acceptance – ‘continuity’ and ‘collapse’ – are so very far from persuasive. The aim here is to apply the principles of the energy economy, and the SEEDS economic model, to examine the real economic situation, free from assumption, denial and wishful-thinking.

Enormous changes do indeed lie ahead, and were underway well before the coronavirus pandemic struck a body-blow at the economy. The narrative of continuity – of indefinite economic growth, and of the perpetual preservation of current assumptions, systems and power structures – has been holed below the waterline.

But it does not follow, from this, that economic and social collapse has become inevitable. Big changes can happen without amounting to ‘collapse’. After all, history is peppered with dramatic, supposedly ‘World-ending’ events – including financial crashes, revolutions and the ousting of entire established elites – which did not, in reality, amount to ‘collapse’.

Our imperatives now fall into two categories. First, we need to understand how the economy really works, abandoning notions that purely financial expedients can overcome physical realities, and basing our interpretations on the evidence.

Second, we need to anticipate, and to be prepared for, the challenges posed by the invalidation of the established (though unfounded) notion of ‘economic growth in perpetuity’.

Additionally, we need to accept that the changes which lie ahead dwarf party politics into comparative irrelevance. To this end, the aim here is to leave discussion of politics and politicians to others, concentrating instead on economic and related fundamentals. Much as war-gamers enjoy re-fighting Waterloo or Jutland, there are places for debating the minutiae and meaning of elections – but these are not our priorities here. 

Introduction

In part one of Gulliver’s Travels, Jonathan Swift uses the neighbouring islands of Lilliput and Blefuscu to satirize the Europe of the early eighteenth century. The English political rivalry between Whigs and Tories is represented by people who favour shoes with low or high heels, whilst arguments about the right way to crack an egg (at the large end or the small?) correspond to the distinction between Catholicism and Protestantism. Matters of supposedly huge contemporary political and religious importance are thus reduced to trivialities at which readers are invited to laugh.

They have been doing so ever since 1726.

If a latter-day Swift was writing now, he could do worse than satirize the debate over ‘continuity’ or ‘collapse’ in much the same way. Continuity, of course, is the line taken by governments, business and much of the mainstream media. Collapse, though a fringe persuasion, is a remarkably widespread one. Even commentators who do not avowedly endorse the thesis of collapse often produce interpretations which point emphatically in that direction.

In a time of such polarized expectation, it’s as well to remember that continuity and collapse are not the only possibilities on the table. Whilst the continuity thesis owes a great deal to wishful thinking and denial, prophecies of collapse overlook the fact that, historically, such events have been extremely rare. Stock market crashes, national defaults, changes of governments and even the ousting of incumbent elites in their entirety have occurred pretty frequently, and haven’t resulted in economic or social collapse.

In short, the evidence either for continuity or for collapse is scant. Something new is happening, but we can only anticipate what that is likely to be by weighing the evidence. Doing so produces conclusions which, though they might be startling, are a long way short of collapse.

Taking ‘perpetual growth’ off the table will itself create profound changes. We can anticipate sharp downwards adjustments in asset prices, the fall from grace of many activities now regarded as gold-plated, and the overturning of many political arrangements and assumptions. But none of this, necessarily, amounts to collapse.

The economy – an energy system

To get anywhere at all with our investigation, we need to start by recognizing that the economy is an energy system, and not a financial one. Money is a human artefact used to exchange the goods and services that constitute economic output, but all of these are products of energy. Our economic history is a narrative of how we have applied energy to improve our material conditions.

This is illustrated by the way in which energy consumption, on the one hand, and, on the other, population numbers and their economic means of support, have related to each other over the centuries (fig. 1). It is no coincidence at all that population numbers took off exponentially when, from the 1760s, the discovery of the first efficient heat-engine enabled us to harness vast amounts of fossil fuel energy, starting with coal before moving on to oil and natural gas.

Just as importantly, the use of energy has grown even faster than population numbers throughout the Industrial Age. Expressed as tonnes of energy consumed per person, this ratio has moved steadily upwards, rising particularly quickly in the half-century before 1914, and in the years after 1945. This ratio flat-lined (but did not decrease) during the oil crises of the 1970s, and resumed its upwards trajectory in a period that correlates with the rise of China and other EM (emerging market) economies.

Fig. 1

Today, and pending further evidence to be considered here, we can postulate a decline in the quantity of energy consumed per person. Whilst prior trends of the growth in the use of oil, gas and coal are ceasing to look sustainable, it is by no means clear that renewable energy (RE) sources can grow rapidly enough to take up the baton from fossil fuels (FFs).

There’s a compelling case for believing that the aggregate supply of primary energy may not grow as rapidly in the future as it has in the past. Population numbers, meanwhile, are continuing to increase, albeit at decelerating rates.

The peaking of energy supply per capita is not recognized by believers in perpetual growth. Consensus supply expectations – as of late 2019, but probably not too different now – see us using about 20% more primary energy in 2040 than we did in 2018. Of course, RE supplies are projected to increase particularly rapidly, expanding by about 80%. But, because RE supply starts from a low base, this big percentage increment would still account for only about 16% of the assumed net increase in total energy supply.

If we are indeed to increase annual supply by about 2.8 bn tonnes of oil equivalent (toe) between 2018 (13.9 bn toe) and 2040 (16.6 bn toe), we are still going to need a projected 16% more fossil fuels, including an increase of between 10% and 12% in the supply of oil.

There are various reasons for supposing that this consensus view might be mistaken, but the main one is that the costs of fossil fuel supply are rising, an issue to which we shall return. The widely-canvassed view that REs can supplant FFs – such that the need for oil, gas and coal decreases rapidly – is very largely a product of wishful thinking. Independent estimates have put the cost of energy transition at between $95 trillion and $110tn, and even if such sums were affordable, numerous technical issues remain, amongst them the material resources required for such a programme.

This is put into context in fig. 2, from which you can see quite how much more RE (shown in green) would be required if we were to replace all or even most of our continued reliance on FFs (blue).

Fig. 2

As fig. 2 also shows, the SEEDS model has ceased using consensus projections for forward energy supply, employing instead a more cautious analysis in which declines in the availability of fossil fuels are, at best, matched by increases in supply from REs, nuclear power and hydroelectricity.

The resulting projection is that primary energy supply changes very little between now and 2040. SEEDS does not postulate a material decline in aggregate supplies of primary energy, but does suggest that energy use per capita may now be on a downwards trajectory.        

ECoE – of cost and quantity

The calculation of economic value at any particular time isn’t, unfortunately, a simple matter of dividing the quantity of energy supply by the number of people using it.

For one thing, the various sources of primary energy are unequal, in terms of the economic utility that they provide. A ton of feathers might, by definition, weigh the same as a ton of lead, but their characteristics are otherwise very different. Likewise, an oil-equivalent tonne of petroleum and an oe tonne of solar or wind power have quite different economic characteristics.    

For another, the supply of energy for economic use is never ‘free’ of cost. Rather, whenever energy is accessed for our use, some of that energy is always consumed in the access process. We need wells and refineries to put petroleum to use, pipelines and processing plants to access natural gas, mines and power-stations to make use of coal, and solar panels and wind turbines to channel the energy provided by the sun and the winds. Creating these facilities – and, just as important, maintaining them, and replacing them as they wear out – uses energy.

This equation divides any given stream of energy supply into two components. One of these, the ‘consumed in access’ part, is known here as the Energy Cost of Energy, or ECoE. What remains, and is available for all other economic purposes, is surplus energy.

Clearly, and within any given quantity of energy, the higher the ECoE, the lower the surplus. An ECoE of 1% leaves 99% of accessed energy available for us to use. If ECoE rises to 10%, however, the surplus shrinks to 90%.

Properly considered, the cost of energy supply isn’t measured by the number of dollars needed to bring energy to the consumer. What matters is the energetic equation between the ECoE cost, and the residual (surplus) utility, of energy that we access.

This has a direct bearing on the quantity of energy that can be supplied, which is why the rise in trend ECoEs is reflected in SEEDS projections that the aggregate supply of energy to the economy is unlikely to rise as rapidly in our higher-ECoE future than it did in our lower-ECoE past.

This is illustrated in fig. 3, which compares ECoE trends with projected supplies of primary energy in aggregate, and fossil fuels in particular. As overall ECoEs rise, growth in aggregate energy supply can be expected to taper off – and, as the ECoEs of fossil fuels rise particularly rapidly, available quantities are likely to decrease

Fig. 3

What emerges here is an equation in which the level of ECoE influences economic output in two ways, not one. First, ECoEs affect the economics of energy supply itself, influencing how much energy is available. Second, ECoEs determine, within that available quantity of energy, how much is absorbed in access cost, and how much remains for those economic purposes which constitute prosperity.

It should not concern us unduly that established interpretations of economics, and the methods used to forecast future energy availability, take no notice of ECoE. After all, spherical trigonometry, vital to navigators over the centuries, could not be understood or applied until Flat Earth interpretations had been confined to the history-books.

Where energy supply forecasting is concerned, the approach appears to be to take assumed levels of economic activity in the future and only then to calculate the energy required by an economy of that assumed future size. This, of course, is to put things in the wrong order – energy supply determines economic output, not the other way around.

ECoE trends – the relentless squeeze

These considerations make it imperative that we understand the ways in which ECoEs evolve.

In essence, four factors determine the evolution of ECoEs. Two of these act to reduce ECoEs; one pushes them upwards; and the fourth operates in ways which are, in general, misunderstood.

ECoEs are driven downwards by geographic reach and economies of scale. Until comparatively recently, the fossil fuel industries pursued the search for new, low-cost resources in locations which had not previously been explored, and which, in some cases, had been politically inaccessible. Economies of scale operate where increasing the size of operations enables the numerator of fixed costs to be spread over a larger denominator of units of output.

With both ‘reach’ and ‘scale’ exhausted, the driving factor now is depletion, which describes the way in which, quite naturally, lowest-cost energy sources are exploited first, leaving costlier alternatives for a ‘later’ which has now arrived.    

The potentialities of the fourth determinant, technology, are often overstated, because technological progress cannot change the physical characteristics of the resource.

Fracking, for instance, has reduced the cost of accessing shale hydrocarbons in comparison with the cost of accessing that same resource at an earlier time. What technology has not done is to put the economics of shales onto the same footing as giant, technically-straightforward fields in the sands of Arabia. This is rendered impossible by the starkly differing physical qualities of the two resources.

These principles can be presented diagrammatically as in fig. 4. The evolution of ECoEs follows a parabolic course, turning upwards as the downwards pressures of reach and scale are exhausted, and depletion takes over. Technology operates to accelerate the downwards trend in the early progress of ECoEs, and then to mitigate the upwards tendencies of depletion.

The right-hand, up-trending side of the parabola conforms to the observable exponential rate of increase in ECoEs since they reached their nadir in the immediate decades after 1945.     

Fig. 4

Measured in money

Thus far we have followed an interpretation of the economy which, though it lacks many of the complications of ‘conventional’ schools of thought, is surely far more persuasive. Describing the economy in solid, material terms – rather than in abstract, financial ones – accords with what we know about the importance of physical goods and services. Tying the economy to the demonstrable laws of thermodynamics makes far more sense than trying to link it to the behavioural observations of the artefact of money which conventional economics is pleased to call ‘laws’.

Thus presented, the economic history of the Industrial Age starts with the invention of the first heat-engine and the unlocking of the energy contained in fossil fuels. We have seen how – over time, and aided by technology – geographic reach and economies of scale have pushed ECoEs downwards, driving up material (meaning energy) economic output, and thereby enabling exponential increases in population numbers.

Latterly, as depletion has taken over from reach and scale, fossil fuel ECoEs have risen relentlessly, pushing us ever further into financial gimmickry in a futile effort to portray a continuation of ‘business [meaning growth] as usual’.   

When dealing with the World as it is, though, any case presented in thermodynamic terms must remain at the margins, excluded from debates which are conducted almost entirely in the idiom and nomenclature of money. To play any part in this debate, our conclusions need to be translated into financial language, and this is what the SEEDS model is designed to accomplish. 

We need to be clear from the outset that money has no intrinsic worth, commanding value only as a ‘claim’ on the physical output of the energy economy. Obviously, parachuting food or water to a person adrift in a lifeboat or lost in a desert would help them, but an air-drop of money would not alleviate their plight in the slightest degree. Money, as a medium of exchange, has no utility unless there are things for which it can be exchanged.

What is ‘output’?

The conventional measure of economic activity is GDP (gross domestic product), but one of the many problems with this metric is that it measures flow (the equivalent of a company’s income statement) in a way that is largely de-linked from stock (which corresponds to the balance sheet). You could not, in practice, manage a business by concentrating entirely on income, and treating the balance sheet as of little or no account.

This distorted interpretation means that, within certain prescribed (but very wide) limits, GDP can be pretty much ‘whatever you want it to be’, at least to the extent that you can push net new credit into the system.

The injection of credit has the effect, of course, of inflating asset prices, but such movements are excluded from definitions of inflation, which concentrate entirely on consumer (retail) prices. If the prices of food, cars, computers and other consumer purchases soar, we say that inflation has surged, but the same is not said of escalation in the prices of equities and property.

We can see some of these distorting effects in action if we compare, as examples, the United States and China over the past twenty years (fig. 5).

Between 1999 and 2019, Chinese GDP increased at an average annual rate of 8.3%, far higher than the 2.1% averaged in America. What is left out of this equation, though, is that annual borrowing averaged 23.7% of GDP in China, compared with 7.8% in America. The point here isn’t the absolute scale (or wisdom) of the borrowing undertaken in either country, but the direct relationship between borrowing and reported growth.

Fig. 5

The same analysis applied to the World economy – and calibrated in constant international dollars – is set out in fig. 6. Between 1999 and 2019, reported growth of $64.5 trillion (or 95%) in GDP was far exceeded by a $193tn (177%) increase in debt.

One way to look at this is that, during two decades in which reported GDP “growth” averaged 3.3%, annual borrowing averaged 9.9% of GDP. This, very obviously, is not a sustainable relationship. Another way to look at it is that each reported “growth” dollar was accompanied by $3 of net new debt, to which, for a fully rounded interpretation, might be added truly enormous increases in pension and other unfunded commitments.

We might choose to believe that debt – since we can default on it, or inflate it out of existence – ‘doesn’t matter all that much’. We might even extend such a rationale to pension promises, though that would be a hard sell to people whose pensions don’t turn up, or have been devalued enormously by inflation.

This dismissal of debt certainly seems to have been the policy logic during the decade before 2008, though the outcome of that state of mind can hardly be regarded as a positive one. The view taken here is that debt and pension commitments do matter, very much indeed, not least because one person’s liability is another person’s asset.

This debate over the meaningfulness of debt as a capital liability, though, misses the immediate point, which is that reported “growth” – and recorded GDP itself – are inflated artificially by the injection of credit.

If, for instance, annual net borrowing was to fall to zero, growth, too, would slump, to barely 1%. Likewise, if we actually paid down debt to its level at an earlier date, much of the intervening “growth” since that date would go into reverse, and recorded GDP would shrink.   

For our purposes, this ‘credit effect’ needs to be stripped out if we’re to arrive at a financial calibration that can be used in a meaningful appraisal of economic performance. The SEEDS model calculates that underlying or ‘clean’ output, known here as ‘C-GDP’, grew by an annual average rate of only 1.6% (rather than 3.3%) between 1999 and 2019. Furthermore, it reveals that even this lower rate of underlying growth has been fading, at the same time as ever more credit injection has been used to buttress reported “growth”.    

Fig. 6

There are three points to be noted from fig. 6. First, reported GDP has long been far exceeded by increments to debt. Second, exclusion of this credit effect reveals far lower levels of trend growth.

Third, these divergences have had compounding effects. The insertion of a wedge (shown in pink) between aggregate debt and recorded GDP has introduced a corresponding divergence between the reported (GDP) and the underlying (C-GDP) levels of economic output.

ECoE and prosperity

What emerges, then – from behind the smoke-and-mirrors of credit and monetary adventurism – is a deceleration in economic growth which accords with a deterioration in the energy equation that has driven the economy since the start of the Industrial Age, and was at its most dynamic in the decades immediately after the Second World War.

Deceleration has been particularly marked since the second half of the 1990s, when confidence in the “great moderation” turned pretty rapidly to concern about the onset of (seemingly inexplicable) “secular stagnation”.

This is where we need to bring in ECoE to complete the prosperity picture. By stripping out the ‘credit effect’ to identify underlying C-GDP, we have calibrated what might be thought of as ‘gross’ economic output, but, as we’ve seen, not all of the value obtained from the use of energy is ‘free and clear’ – some of it (ECoE) is consumed in the process of accessing energy, reducing what remains for all other economic purposes.

To express prosperity in financial terms, then, the required equation can be defined as C-GDP minus ECoE. This gives us an aggregate prosperity number that can then be divided by the population total to tell us the prosperity per capita of the average individual at any particular time.

When this calculation is undertaken on a consistent basis across the 30 national economies covered by the SEEDS model, a striking trend emerges.

In almost all Western advanced economies, prosperity per capita peaked and then turned down between 1997 (Japan) and 2007 (Canada and Greece). But, until quite recently, prosperity per person has continued to improve in the emerging market (EM) countries covered by the system.

This is not, of course, remotely coincidental.

In fig. 7, we compare prosperity per capita with national trend ECoE for America, China and the World as a whole. Where prosperity per person reaches its zenith (as referenced on the left-hand axis of each chart), a vertical line is taken down to ECoE at that time, and is read across to the scale on the right.

Thus, American prosperity reached its high-point back in 2000, when ECoE was 4.5%, whilst Chinese prosperity was still rising in 2019, at an ECoE of 8.2%. In the latter case, prosperity might, in the absence of the pandemic, have continued to improve, but not for much longer. Prior to the coronavirus crisis, SEEDS was indicating that Chinese prosperity was going to turn downwards during the period 2020-22.  

What emerges from SEEDS analysis is that Western and EM economies have different ECoE climacterics at which prosperity per capita ceases to grow and turns downwards. In the Advanced Economies, this climacteric occurs at ECoEs of between 3.5% and 5.0%. By virtue of their lesser complexity, which in turn means that energy maintenance costs are lower, EM countries can continue to expand prosperity per capita until ECoEs are between 8% and 10%.

This, incidentally, explains why EM economies have so often been described as being more ‘dynamic’ than Western countries. Many theories have been advanced in an effort to ‘explain’ the supposedly greater dynamism of, say, China or India in comparison with America and Europe.

The reality, though, is much simpler. It is that EM nations had yet to reach an ECoE threshold which, for them, was structurally higher than the one which had already put prosperity expansion in the West into reverse.

For many years now, global prosperity has reflected deterioration in the West, offset by continuing progress in the EM countries. As a result, World prosperity per capita has been on a long plateau – expressed in constant dollars converted on the PPP (purchasing power parity) convention, the average has seldom varied much from $11,000 per person since the early 2000s. This is why, in the right-hand chart in fig. 7, the climacteric in global prosperity, and the associated levels of ECoE, are shown as ranges rather than as a specific point.    

Now, though, it has become apparent that the long plateau has ended, such that the prosperity of the World’s average person has gone into decline. Even before the coronavirus crisis, it had looked likely that 2018-19 was going to be the turning-point in global prosperity. 

Fig. 7

The view from where we are

The aim in this analysis has been to move step by step along a logical path to reach conclusions which, whilst they invalidate the promise of ‘continuity of perpetual growth’, fall well short of endorsing prophecies of inevitable economic and social collapse.

We have seen how, as an energy system, the economy has grown rapidly on the basis of rising quantities of energy supply and – until relatively recently – falling ECoEs. Latterly, the rise in ECoEs has undermined the capability for further expansion, turning complex Western economies ex-growth before moving on to impose the same effects on lower-maintenance, less ECoE-sensitive EM countries.

Two expedients have been used, if not to halt this process, then at least to disguise it. First, we’ve been using ever-larger quantities of energy at the gross level to counteract a deterioration in the prosperity yielded by each unit of energy consumed.

Second, we’ve resorted to increasingly extreme exercises in financial gimmickry on the false premise that making money both cheaper and more abundant can somehow ‘fix’ trends that conventional, money-based interpretation cannot explain. Along the way, we’ve managed to persuade ourselves that policies such as ZIRP, NIRP and QE are somehow ‘normal’ and ‘sustainable’, when the obvious reality is that they are neither.

Looking ahead, we can anticipate that both of these expedients will fail.

It seems increasingly unlikely that we can carry on growing supplies of primary energy at rates that have been accomplished in the past, and are assumed to be possible in the future. The switch to renewable energy sources, imperative though it is on environmental and economic grounds, might not enable us to replace lost quantities of fossil fuels, and cannot be expected to push ECoEs back downwards to levels at which prior levels prosperity can be sustained.

At the same time, financial adventurism has rendered the financial economy very largely dysfunctional, introducing ever greater risk into the system.

Financial dislocation, which might well include slumps in asset prices, and/or the deliberate introduction of high inflation, has now moved from the ‘probable’ to the ‘virtually inescapable’. As hardship worsens, popular priorities can be expected to change, whilst political, commercial and financial models based on the false predicate of perpetual growth will come under increasing strains.

To be sure, the economy is an extensively interconnected system, and compounding effects – to be discussed in a subsequent instalment – are capable of accelerating the pace at which prosperity erodes. Indeed, the latest version of the SEEDS model now incorporates a facility for including these compounding effects into analysis and projection.

From where we are, though, we cannot assume that the outcome must be collapse. For those caught on the wrong side of fundamental changes in the past, it must have seemed that, for them, the World had ‘come to an end’. Examples from history are abundant, and include craft workers overtaken by the “dark satanic mills”, French and Russian aristocrats and functionaries swept aside by revolution, and investors destroyed by the Wall Street Crash.

Objectively, none of these events amounted to collapse. Each, moreover, included winners as well as losers, and gains, as well as losses, for the quality of life.

In the next instalment, we’ll start an analysis of how these ‘profound-but-short-of-collapse’ changes are likely to play out.

#183. A new stark clarity

WHAT HAPPENS NEXT?

Introduction

Sometimes, articles can be hard to put together because one has too little information. At other times, the challenge is the opposite one, the problem being to condense an abundance of information into something shorter than War and Peace. What follows falls into the latter category.

At an earlier stage in the crisis caused by the coronavirus pandemic, variables and possible permutations far outnumbered clear points of reference. This is no longer the case, and much of the time since the previous article has been spent refining the SEEDS economic model, and casting the multiplicity of its conclusions into a brief and logical sequence.

The first take-away here is that no amount of financial gimmickry can much extend our long-standing denial over the ending of growth in prosperity. The energy dynamic which drives the economy has passed a climacteric. The pandemic crisis may have anticipated this inflexion-point, and to some extent disguised it, but the coronavirus hasn’t changed the fundamentals of energy and the economy.

The second is that the downtrend is going to squeeze the prosperity of the average person in ways that are likely to be exacerbated by governments’ inability to understand the situation, and to adjust taxation and spending accordingly.

Third, this squeeze on household disposable prosperity is going to (a) have severely adverse effects on discretionary (non-essential) consumer spending, and (b) put at risk many of the forward income streams (mortgages, rents, credit, stage payments, subscriptions) that form the basis of far too many corporate plans, and have been capitalized into far too many traded assets.

Barring short-lived exercises in outright monetary recklessness, most discretionary sectors are set to shrink, and asset prices (including equities and properties) are poised for a sharp correction.

It is, after all, hard to sustain a high valuation on the shares of a company whose business has slumped, to buttress the market in homes whose prices far exceed impaired affordability, or to shore up the price of capitalized forward income streams that are in the process of failure.

Finally, economic concerns are set to dominate voters’ priorities, displacing non-economic issues from the top of the agenda. Calls for economic redress – including redistribution, and, in some areas, nationalization – are set to return to the foreground in ways to which a whole generation of political leaders may be unable to adapt.   

“Faith in the middle” – all bets lost

Spectator sport has been one of the more prominent victims of the coronavirus crisis, but let’s imagine that we’re listening in to a conversation between rival fans ahead of a hotly-contested fixture. Supporters of the home team are sure their heroes will inflict a massive defeat on their opponents. Followers of the visiting club are equally certain of a stunning victory.

The outcome, as often as not, is a low-scoring draw.

This is a useful analogy for our current economic and broader predicament. One side of an intensively-polarized debate pins its faith in the restoration of normality, or even of a sort of ‘super-normality’. The other is equally certain of catastrophic collapse.

What actually happens is likely to be ‘neither of the above’.  

That, certainly, is the view here, and it’s reinforced by economic modelling based on the understanding that the economy is an energy system, and is not – as established conventions so mistakenly insist – a financial one.

The conclusions of the SEEDS model form the subject of this discussion.

Where economic output is concerned, SEEDS warns that there can be no return to the rates of growth reported before the coronavirus crisis, with the proviso that a very large proportion of that pre-2020 “growth” was, in any case, illusory. After a period of ‘normalization’ that will fall a long way short of the mythical “V-shaped recovery”, rates of increase in output will fade (see fig. 1), falling below those at which population numbers are expected to carry on increasing.

Continuing rises in ECoE (the Energy Cost of Energy) will amplify these trends where prosperity itself is concerned.  

As remarked earlier, the predicament of the ‘average’ person in this deteriorating economy is likely to be made worse by governments’ failure to understand what’s happening, and to scale back their tax and spending plans accordingly. Meanwhile, we seem likely to be at or near that point of credit exhaustion after which we cannot continue to manipulate reported “growth” – or to shore up consumer discretionary expenditure – by injecting ever more debt into the system.

These trends point unequivocally towards declining discretionary (non-essential) expenditures by consumers, with businesses similarly focused on cost-control. It also implies a decay, and in some cases a failure, of many of the income streams on which so many corporate business plans, and so much capital valuation, now depend.  

Reverting to our sporting analogy, an outcome which favours neither of the extremes results in the loss of any bets placed by either side. This applies to the economy, too, where a wide range of financial and non-financial wagers – placed by governments and politicians, investors, businesses and campaigners for various causes – will be lost.

Fig. 1     

Dwindling output………..

Over the period between 1999 and 2019, World economic output – reported as GDP, and stated here at constant values on the PPP (purchasing power parity) convention – averaged 3.2%, for a total increase of 95%, or $64.5 trillion. During this same period, however, annual borrowing, expressed as a percentage of GDP, averaged 9.6%, with total debt expanding by $193tn, or 177%, between 1999 ($109tn) and 2019 ($302tn).

Another way of putting this is that each dollar of reported “growth” was accompanied by $3 of net new debt. Even this comparison understates the gravity of the situation, in that it does not include huge increases in pension and other commitments over two decades, with the overall situation worsening markedly after the 2008 global financial crisis (GFC).

You wouldn’t be too far off the mark if you concluded that, at the time that the crisis struck, each growth dollar was being ‘bought’ with at least $5 of new ‘hostages to futurity’.

What this in turn means is that most – according to SEEDS, 64% – of all “growth” in the World economy reported over that twenty-year period has been illusory. This is “growth” that would reverse if we ever tried to unwind prior expansions in debt and other financial commitments. More realistically, were we to stop all net new borrowing, growth would fall to no more than 1.5%, and to a lower level still were we also to cease adding to pension and other unfunded promises.      

Anyone surprised by this might usefully consider two questions. First, what would happen to rates of reported growth if annual net borrowing (last year, just over $13tn, or 10.3% of GDP) fell to zero?    

Second, what would happen to GDP itself, if we tried to pay down the $111tn of net debt taken on over the past decade?

The SEEDS model strips out this ‘credit effect’ to identify rates of change in underlying or ‘clean’ output, known here as C-GDP. This metric grew at annual rates averaging only 1.5% (rather than 3.2%) between 1999 and 2019 (see fig. 2). 

Moreover, as you’ll see if you refer back to fig. 1, this rate of growth has been fading, and stood at just 1.2% last year. Current SEEDS projections are that growth in C-GDP will taper off, ceasing by the early 2030s, after which it can be expected to go into reverse.

Needless to say, the immediate crisis is going to create negative growth in economic output, to be followed, according to most projections, by some kind of a recovery when (although some pessimists might say ‘if’) the pandemic is brought under control.

The consensus view, which anticipates a fall of -4.6% in GDP in 2020, and rebound of +5.1% next year, already looks far too optimistic. The SEEDS projection is that clean output (C-GDP) will decline by -7.2% this year, and grow by about +3% in 2021. Again, both of these projections may turn out to have been unduly bullish.

Here’s the big difference, though.

Where the consensus sees World GDP higher by 16% in 2025 than it was in 2019, SEEDS projections show no overall growth at all in C-GDP during that period.   

Fig. 2    

…… and rising ECoEs squeeze prosperity…..

If you’re familiar with the energy basis of the economy, you’ll know that the generation of economic value from the use of energy is only one half of the equation which determines prosperity. The other side is the Energy Cost of Energy (ECoE). This is the proportion, within any quantity of energy accessed for our use, that is consumed in the access process, and therefore is not available for any other economic purpose.

Though it’s ignored by conventional interpretation, the relentless rise in trend ECoEs is the factor that has undermined, and has increasingly eliminated, the scope for growth in global prosperity. 

As ECoEs rise, economies reach an inflexion-point after which prior growth in prosperity goes into reverse. The stage at which this happens varies between countries, affecting highly-complex, high-maintenance economies first. In the United States, for example, prosperity growth went into reverse at a trend ECoE of 4.5%, with the same happening to almost all of the Western advanced economies at ECoEs of between 3.5% and 5.0%.

Less complex emerging market (EM) economies enjoy greater ECoE-resilience, and can continue to grow prosperity per capita up to ECoEs of between 8.0% and 10.0%. The coronavirus crisis is likely to have brought forward the inflexion-point in China, at an ECoE of 8.2%, but this climacteric was due to be reached in the next year or two anyway. This is why reported “growth” in China has become ever more dependent on extraordinarily high levels of net borrowing.

This is illustrated in fig. 3, which compares ECoE trends with prosperity inflexion-points for China and the United States. As you can see, the relentless rise in the ECoEs of fossil fuels have pushed the overall curve sharply upwards, and the development of renewable energy (RE) sources, though essential, is most unlikely to do more than moderate the upwards trend.

Additionally, the economy has now reached the point at which rising ECoEs affect the availability of energy itself, trapping producers between the Scylla of rising costs and the Charybdis of diminishing consumer affordability.    

Fig. 3    

…..and taxation tightens the screw

As we’ve seen, prosperity per capita has turned down because of a combination of decelerating economic output, rising ECoEs and a continuing increase in the numbers of people between whom surplus energy value is shared. A weakening in energy supply volumes can be expected to add another twist to this deteriorating equation.

Where consumers are concerned, the adverse effects of this process are likely to be exacerbated by a rise in the proportion of prosperity taken in tax. Governments’ failure to understand the energy basis of economic activity lead them to measure the affordability of taxation against GDP.

On this conventional basis, the incidence of taxation worldwide has hardly varied at all over the past twenty years, remaining at or very close to 31% between 1999 and 2019. Unfortunately, and as we ‘ve seen, GDP has become an ever less meaningful measure of the value of economic output over time.

What this in turn means is that the incidence of taxation, when measured against prosperity, has risen relentlessly, from a global average of 32% in 1999 to 49% in 2019. On current projections, this is set to rise to 56% by 2025.

This is illustrated in fig. 4, which compares the per capita averages of prosperity and tax for the United States (where taxation is comparatively low), and of more highly-taxed France, with the global equivalents.

SEEDS analysis indicates that taxation absorbed 67% of French prosperity last year, compared with 53% back in 2004. For the average French citizen, this means that a comparatively modest decline of 6.2% (€1,910) in his or her overall prosperity has been exacerbated by a €3,010 increase in taxation, leaving disposable (“left in your pocket”) prosperity 34% (€4,920) lower in 2019 than it was in 2004.  

Fig. 4   

Discretionary spending falls, income streams fail

France, of course, is something of an extreme case, but the general tendency has been for rising taxation to magnify prosperity deterioration into a markedly more severe squeeze at the level of disposable prosperity.

For planners in government and business – and, of course, for individuals – this leveraged equation is central to much that is likely to happen in the coming years.

This can best be understood if we look at things from the perspective of the average or ‘ordinary’ person or household. He or she will experience falling prosperity, an observation for which, long before the coronavirus crisis, there has been steadily accumulating corroborative evidence. People in a growing number of countries know that their material circumstances are deteriorating, and are increasingly (and rightly) ignoring official statements and statistics which try to assert the contrary point of view.

As prosperity erodes, and as the proportion taken in tax increases, our ‘ordinary’ person is likely to turn both economically cautious and politically discontented. He or she will become increasingly unwilling to take on yet more credit, almost irrespective of the cost of debt. Essential purchases must carry on, of course, but scope for discretionary (non-essential) expenditure will deteriorate sharply.

Over time, increasing numbers of households are likely to struggle to keep up with the numerous financial demands that the system now makes on them, demands which have long since gone beyond mortgages, rent and utility bills to include subscriptions, staged purchases, the leasing of things which would hitherto have been bought outright, and credit taken on for a multiplicity of purposes including vehicle purchase and education costs.

This enables us to summarise three of the more direct and immediate implications of de-growth.

First, there will be adverse consequences for any business supplying discretionary purchases. We’ve been seeing a foretaste of this since 2018, with downturns in the sales of everything from cars to smartphones. The discretionary category doesn’t just apply to goods, of course, and service sectors particularly exposed include travel, leisure and hospitality. Just as households scale back non-essential spending, businesses are likely to trim discretionary outgoings such as advertising and outsourcing.

Second, the increasing strain on household budgets is going to put income streams at risk. This is extremely important, for two main reasons. One of these is the expanded prevalence of sales techniques which cultivate streams of income in preference to outright purchases, whether by consumers or by business customers. The other is the capitalization of income streams, a process pioneered by the securitization of future mortgage payments. A significant part of the capital markets now consists of capitalized streams of income linked to everything from car purchase and higher education to the supply of gadgets and domestic appliances.

Third, the public is likely to become increasingly focused on economic issues, demanding, not just lower taxation but pro-active measures to bolster household circumstances. We should anticipate growing pressure for nationalization (notably of utilities), combined with calls for greater redistribution from ‘the rich’ to the ‘ordinary’ voter.

For government, business and investors, this poses challenges that have, in many instances, yet to appear on the ‘radar’ of forward planning.      

Governments, whilst unwilling to scale back their activities to affordable levels, will nevertheless find that their scope for expenditure falls a long way short of previous expectations.

At the same time, the priorities of the public can be expected to undergo a sea-change, swinging resolutely towards the economic. As a result, many of the cherished ambitions of policymakers will become of diminished importance to the voters, just as they become ever less affordable. 

Fig. 5  

#182. The castaway’s dilemma, part two

WE CAN’T RESCUE FINANCE UNLESS WE RESCUE THE ECONOMY

As we enter an Autumn which many of us have all along expected to be ‘fraught with interest’, one question, above all others, dominates the economic and financial debate.

Are the authorities going to try to monetize their (meaning our) way out of the extreme difficulties exacerbated and catalyzed by the Wuhan coronavirus pandemic?

Or are they going to adhere to a form of monetary rectitude that was so conspicuously abandoned during the 2008 global financial crisis (GFC)?

The central conclusion reached here is that we have exhausted the scope for short-term, ‘band-aid’ fixes for a fundamental imbalance between (1) a growth-predicated financial system and (2) an underlying economy that is tipping over into “de-growth”. We simply cannot reconcile a ‘financial’ economy of money and credit that keeps getting bigger with a ‘real’ economy of goods and services that has reached the end of growth.

This has both near-term and longer-term implications. Longer-term, we need to find ways of rebalancing the economy towards quality rather than quantity, and shrinking the financial system back to a sustainable scale.

Why ‘2008 revisited’ won’t work

More immediately, we need to recognize that the stop-gap ‘fixes’ used during the GFC won’t work this time. 

Back in 2008, it was just about possible for the authorities to bail out the financial system whilst leaving the economy to its fate, an approach lambasted by critics at the time as ‘rescuing Wall Street at the expense of Main Street’.

This time around, no such possibility exists. On the one hand, the process of financialization has advanced to the point where credit has been inserted into virtually all economic transactions. On the other, forward income streams have been incorporated into financial instruments to such an extent that the financial system could not withstand any significant and prolonged interruption to underlying economic activity. Large swathes of the financial system have become hostages to the continuity of interest, rent and earnings streams from households and from private non-financial corporations (PNFCs).

What this means is that, if it were ever really perceived that economic deterioration is going to undermine the ability of households and businesses to maintain such payment streams, the financial system would fall apart.

We cannot know, of course, whether the authorities actually understand that they can’t repeat the tactic of rescuing the financial system whilst leaving the ‘real’ economy to its fate. Some policymakers, at least, might labour under the delusion that the prices of securities, and the validity of collateral, can be shored up even if the underlying entities (businesses, borrowers, tenants) go to the wall. Delusions undoubtedly still exist at the policy level, as evidenced by the wholly fallacious faith that some still seem to place in the ability of negative interest rates to ‘stimulate’ the economy, and to ‘support’ financial valuations.

The view taken here, though, is that most policy-makers, if they don’t already understand this point, will very soon have its reality imposed upon them. This means that, even where propping up the financial system remains their first priority, they will come to recognize that the only way to do this is to support the underlying economy.

This in turn means that even those governments currently proclaiming fiscal rectitude are likely to be pushed into larger (and longer) support programmes, running ultra-large deficits whose additions to public debt will, in due course and to a very large extent, be monetized by central banks. This points to a scenario in which initial deflation (imposed by sagging economies) is likely to be followed by soaring inflation (as the authorities try to force a quart of monetary stimulus into a pint-pot of economic capability).  

Under starter’s orders   

On the question of “monetize or not?”, participants in capital markets have already placed their bets – if they thought for one moment that governments and central banks were not going to intervene, the prices of equities (and, very probably, the prices of property and of a very high proportion of bonds, too) would already have crashed.

The clear message from the markets is that, faced with a worsening economic and financial crisis, governments are going to turn to full-bore fiscal support, with the highly probable corollary that central banks will create (in an earlier idiom, ‘print’) enough new money to monetize the gargantuan debts thus created. If it’s objected that huge monetization might trigger high inflation, markets would doubtless retort that, if this were indeed to happen, investors would be better off holding almost any form of asset in preference to cash.

If the markets are right, a large proportion of everything – from wages, debt service costs and rents to the purchasing of goods and services – will be propped up by government largesse. Taking equities as an example, high prices indicate, not only that capital isn’t expected to flow out of markets, but also that most of the businesses in which capital is invested will be kept viable – after all, no amount of market liquidity can attach much value to the stock of a company which has gone bust. So market thinking is certainly consistent – governments and central banks will prop up both the financial system and the economy itself.

The contrary argument begins with the observation that some governments seem already to have committed themselves to fiscal rectitude. More fundamentally, it’s argued that monetization could not, this time around, be ‘neutralized’ within the boundaries of capital markets, but would have to happen at such a scale, and in such a way, that faith in fiat currencies would be placed at grave risk.

There’s a strong body of opinion, then, to the effect that the authorities won’t take what could be existential risks with the monetary system. There’s a seldom-made argument, too, that no amount of monetary tinkering can save businesses, or indeed whole sectors, whose viability is gone, and which could continue to exist only, if at all, on the basis of perpetual financial life-support.   

The view taken here – which is that the authorities are likely to succumb to calls for expanded fiscal support, much of which will then be monetized by central banks – is based on a reading of the fundamentals which is informed by the understanding that the economy is an energy system, and is not wholly (or even largely) a financial one.

From this perspective, how did we get ourselves into a situation in which a single crisis (admittedly a severe one, compounded by inept responses) could put the whole system at risk?

The Great Divergence

The background to the current crisis is that the ‘financial’ economy of money and credit has far out-grown the ‘real’ economy of goods and services.

The ‘claim for the defence’ in this situation is that the real economy, whilst it may lag the process of financial expansion, remains capable of pretty decent rates of “growth”.

This statement, though, is only true if you ignore the way in which we’ve been using the financial system to ‘buy’ growth, using $3 of new net debt (plus a lot of other deferred commitments) to create $1 of “growth”. Also, of course, conventional presentation ignores an escalating energy cost of energy (ECoE), and makes no effort to internalise the costs of environmental degradation.

For the purposes of this discussion, it’s going to be assumed that readers are familiar with the principles of Surplus Energy Economics (SEE), and know how this interpretation is put into practice using the SEEDS economic model.

Simply put, there are two ways in which the economy can be understood. One of these, favoured here but very much a minority view, is that the economy is an energy system, and that prosperity is a product of the economic value that we obtain from the use of energy.

The other – the established or ‘conventional’ orthodoxy – is that the economy is a financial system, a persuasion that has sometimes portrayed natural resources in general (and energy in particular) as little more than incidental contributors to economic activity.

The energy view of economics accepts – as conventional interpretation does not – that resources (which for this purpose include the environment) set limits to the scope for expansion in prosperity.

Though all of this sounds theoretical, it is in fact central to an appreciation of our current circumstances. Over time, the physical or ‘real’ economy of goods and services, and the immaterial or ‘financial’ economy of money and credit, have diverged relentlessly.

Between 1999 and 2019, the official (financial) calibration of World economic output (GDP) grew at an annual average rate of 3.6%, whereas SEEDS measurement indicates that underlying or ‘clean’ output (in SEEDS terminology, C-GDP) has grown at an annual average rate of only 1.8%. Because, of course, these are compounding rates, a huge gulf now divides GDP from C-GDP.

For practical purposes, what this means is that conventional statements, both of output (a measure of flow) and of wealth (a related measure of stock, but in reality linked to flow), are dramatically exaggerated in relation to the underlying reality of economic value.

One illustration of this is provided by the ‘values’ conventionally imputed to assets. Asset prices have come to represent not, as logic says they should, discounted forward streams of underlying income, but current and anticipated monetary conditions.

If, for instance, we multiply the average price of a house by a country’s total number of houses, we can arrive at a pretty impressive ‘valuation’ of the national housing stock. A moment’s reflection, however, tells us that this valuation could never be realised (monetized), because the only people to whom all of these houses could be sold are the same people to whom they already belong.

This process – which uses marginal transaction prices to value the aggregate of an asset category – applies just as much to stocks and bonds as to property. When we read, for instance, that billions have been “wiped off” (or added to) the value of the stock market, it’s easy to forget that all of this is purely notional, because the market as a whole couldn’t have been turned into cash at any point in this process.

What this in turn means is that we’ve become accustomed to believing in aggregate valuations which are, in fact, purely notional. Just as we couldn’t turn the whole of the national housing stock, or the entirety of the equity market, into cash, the same applies individually to large corporations, and to the housing stock of, say, a town or a city.

The distorting effects of ‘notional value’

This concept of notional valuation extends in very important ways into everyday economic activity. Here’s an example.

If interest rates are 5%, a person who can afford $10,000 a year in mortgage payments can buy a house for $200,000 but, if rates now fall to 2%, his or her affordability rises to $500,000. Because the same applies to every other potential buyer, properties in general are re-priced accordingly. Because they can be pushed out almost indefinitely into the future, capital repayment considerations play an almost negligible role in such calculations.

A real estate agent, charging an unchanged rate of commission of 2%, earns $4,000 on the first transaction, but $10,000 on the second, even though the work done, or the real value added by that work, haven’t changed.

Meanwhile, the homeowner who bought at the earlier price-point has seen a big (though a paper) increase in his or her equity, making him relaxed about borrowing to finance a holiday, or the purchase of a new car. Unless he or she intends to cash out (monetize) the supporting equity – which is possible for some by trading down, but isn’t possible for everyone – then these debts, ultimately, remain tied to the future incomes of the borrowers.

This monetary inflation of asset prices – a process excluded, by the way, from conventional statements of inflation – needs to be considered in tandem with the broader financialization of the economy, a topic on which Charles Hugh Smith is particularly perceptive.

Historically, a car would have been made by a vehicle manufacturer and its employees, and bought by a motorist using his or her savings, which are in turn the product of his or her labour. Now, though, financial institutions have routinely been inserted into this transaction in a way which, from a purist point of view, might be regarded as unnecessary. The car is bought on the basis, not on saved income from the past, but of assumed income in the future

The packaging and sale of forward payment streams (as exemplified by mortgage-backed securities, but in reality a very widespread, almost universal practice) dominates the financialized system. This has had the adverse effect of driving a wedge between risk (offloaded onto the purchaser of the security) and return (of which a significant part is retained by the initiator of the transaction). This is an example of quite how distorted the relationship between the financial and the real economies has been allowed to become.

Critically, this entire financialized process is wholly dependent on continuity, which in this sense is coterminous with growth. If the earnings of a mortgage-payer or a car-purchaser fall, he or she may not be able to keep up with committed payments, just as a business whose income deteriorates may no longer be able to afford scheduled debt payments. The same applies to rent (whether household or commercial), because the assumed forward stream of these payments is likely to have been packaged and sold on, often to somebody who, in turn, relies upon this income to service the debt that he used to finance the purchase.

Before turning to practicalities, let’s state what this means in the starkest possible terms. The real economy, and the people who comprise it, can tolerate stagnation, or a modest decline in output – but the financial economy relies absolutely on continuity and growth.

Most ordinary people, if they were unencumbered by debt, could certainly cope if their real (inflation-adjusted) incomes stopped growing, and could probably manage reasonably well if that income dropped by a relatively modest amount. By extension, if we imagined a debt-free economy, it, too, could probably adjust to, say, a 5% or a 10% fall in income, which in this context means a decrease in the quantity of goods and services that are produced. Its citizens wouldn’t like this, of course – but they could survive it.    

All of this changes when you introduce the futurity of leverage into the equation. Whether it’s a household, a business or an economy, a significant part of future income is now earmarked for debt service. In this way, financialization of the economy takes away resilience.  A person or a business with debt to service loses the ability to cope with static or declining income, primarily because the financial system discounts a future wholly predicated on the assumption of perpetual expansion.

A dangerous asymmetry

What this interpretation also tells us is that, whilst the ‘real’ and the ‘financial’ economies are interdependent, this dependency is asymmetric. The economy of goods and services, though it would be greatly disrupted, might well survive a slump in the financial economy, but the reverse proposition is not the case. For the financial system to survive at all, the real economy must carry on growing, and the absolute, irreducible minimum is that it must not contract, other than by a very small extent, and for a very limited period.

The more financialized an economy (or a household, or a business) becomes, the more its resilience is undermined.

From where we are now, the critical point is that the financial economy, though it might just about weather another modest recession, would be destroyed by “de-growth”. Moreover, the advance of financialization suggests that even something well short of de-growth – for instance, a severe and prolonged recession, well short of what was experienced in the 1930s – would bring down the financial system.

For policymakers, this means, as mentioned earlier, that a “Wall Street versus Main Street?” choice no longer exists. If they were to intervene to rescue the financial system, whilst leaving the ‘real’ economy to its own devices, the financial system would collapse anyway.

We need to be absolutely clear that the Wuhan coronavirus pandemic, though it has appeared to many to be a ‘bolt from the blue’, has in reality catalysed and accelerated trends that were going to happen anyway. Since 2008 – and, arguably, for a lot longer than that – a reversal of growth has been inevitable. It has already started in the advanced economies of the West, and was always going to pose an existential threat to a financialized money and credit system wholly predicated on perpetual growth.

Let’s look at what this means at the present juncture. Long before the pandemic, people in the West were already getting poorer, and a similar climacteric was imminent for the EM (emerging market) countries. Worldwide, growth in aggregate prosperity has now fallen to levels which are lower than rates of increase in population numbers. Thus far, we’ve blinded ourselves to this by using credit to sustain consumption in excess of real value output. As well as encouraging consumers to do this, the corporate sector has added top-spin to this process by using debt to buy back stock, essentially replacing shock-absorbing equity with inflexible debt (which is another example of how financialization takes away resilience). Critically, buy-backs add debt without adding to productive capacity.

Whether we borrow as individuals to increase our consumption, or as corporations to boost stock prices through repurchases, the common result is that we mortgage the future in order to inflate apparent prosperity and value in the present. Because we’ve used debt to try to mask the trend towards deteriorating prosperity (a trend that we can neither stop nor reverse), the imbalances between the real and the financial economies have grown steadily more extreme.

Our situation has become one in which monetary manipulation has created value which only really ‘exists’ if we can carry on sustaining illusory levels of output. The only comfort that can be offered to those who’ve mishandled the coronavirus crisis is that this crunch point, if it hadn’t been precipitated now, would in due course have happened anyway – indeed, SEEDS has long identified 2020-22 as the period in which equilibrium would bite back.

At the end of gimmickry and denial

The immediate conclusion has to be that the authorities can no longer sustain a semblance of sustainability through monetary manipulation (though they are highly likely to try).

If they decide to prop up the financial system whilst leaving the economy itself to its own devices, the financial system could not escape the consequences of slumps in ‘real-world’ income streams (which would show up in bankruptcies and defaults).

If, recognizing this, they decided to prop up the real economy as well, using fiscal and monetary intervention, this, too would fail, both because the ability to ‘stimulate’ the real economy is circumscribed, and because action on the required scale would undermine monetary credibility.

This leaves us with the question of whether fundamental reform is possible. In purely practical terms, it probably is, but the likelihood of it actually happening – let alone of it happening in time – seems remote.

In the economy itself, we could adapt to the implications of worsening imbalances between energy ECoEs, labour availability and the environment, opting for what might best be termed “craft” solutions for our profligacy with energy and broader resources.

Financially, shrinking the system back into a sustainable relationship with the real economy is by no means an impossibility.

But the processes of decision-making, the myriad self-interests in play, and sheer ignorance about financial, economic and environmental realities, makes the voluntary adoption of such courses of action look depressingly unlikely.   

#181. The castaway’s dilemma, part one

MAPPING THE REAL ECONOMY

Of what value are facts?

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

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

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

A bad time for reality?

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

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

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

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

The energy economy

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

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

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

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

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

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

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

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

Mapping the real economy

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

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

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

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

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

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

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

The equations

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

Equation #1: measuring output

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

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

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

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

Fig. 1: economic output

Equation #2: calibrating economic efficiency

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

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

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

Fig. 2: economic efficiency

Equations #3 & 4: ECoE and volume

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

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

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

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

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

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

Fig. 3: ECoE and energy supply

Equation #5: measuring prosperity

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

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

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

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

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

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

Fig. 4: ECoE and prosperity

Equation #6: economics and the environment

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

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

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

 Fig. 5: The environmental dimension

Equation #7: deviation from the real

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

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

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

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

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

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

Fig. 6: reality and presentation

#180. In search of competitive edge

LOGIC, ‘CONTINUITY BIAS’ AND THE BALANCE OF IMPROBABILITIES

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

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

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

Government – right by default?

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

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

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

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

Inferences of process

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

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

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

Dynamic interpretation

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

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

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

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

Competitive edge

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

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

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

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

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

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

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

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

On the road – theory in practice

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

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

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

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

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

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

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

Flying blind – of aviation and technology

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

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

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

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

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

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

The ‘improbable’ versus the ‘impossible’

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

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

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

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

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

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

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

#179. Penny plain, tuppence coloured

“THE FUTURE’S NOT WHAT IT USED TO BE”

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

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

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

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

The material, immaterially considered

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

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

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

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

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

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

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

The cartographer’s dilemma

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

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

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

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

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

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

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

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

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

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

The inner life of figments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lost futures, contrarian opportunities?

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

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

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

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

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

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

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

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

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

#178. The Ides of Autumn

SEEDS, STAGFLATION AND CRASH RISK

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

#177. Poorer, angrier, riskier

MODELLING THE CRUNCH

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

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

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

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

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

These projections are summarised in the first set of charts.

Fig. 1

#177 Fig 1 personal

Consequences

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

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

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

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

Methodology – the three challenges

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

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

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

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

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

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

Top-line aggregates

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

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

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

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

Fig.2

#177 Fig. 2 aggregates

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

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

Fig. 3

#177 Fig. 3 chart aggregates

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

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

Personal prosperity – a worsening trend

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

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

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

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

Fig. 4

#177 Fig. 4 per capita table

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

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

Fig. 5

#177 Fig. 5 per capita chart

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

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

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

Governments – the hidden problem

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

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

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

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

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

Fig. 6

#177 Fig. 6 world tax

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

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

#176. Protect and Survive

THE AUTHORITIES’ ‘RACE AGAINST TIME’

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

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

The ‘standard model’ response

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

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

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

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

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

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

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

A time-constrained expedient

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

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

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

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

A race against time

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

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

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

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

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