#216. It’s now


When and how can we know that a change of direction is fundamental and lasting, rather than a temporary departure from established trends?

That, in essence, is the call we need to make now. Far from being “transitory”, current conditions – including rising inflation, surging energy prices and the over-stressing of supply-chains – are indicators of a structural change.

Ultimately, what we’re witnessing is a forced restoration of equilibrium between a faltering real economy of goods and services and a drastically over-extended financial economy of money and credit.

This is where confidence in continuity crumbles, where the delusions of ‘growth in perpetuity’ succumb to the hard reality of resource constraint, and where ‘shocks that are no surprises’ shake the financial system.

If you want just two indicators to watch, one of these is the volumetric (rather than the financial) direction of the economy, and the other is the behaviour of the prices of essentials within the broader inflationary situation.        

The economics of stress

In the science of materials, it’s observable that fractures happen quickly, even if the stresses that cause them have accumulated over a protracted period. We can spend hours, days, weeks or even years gradually increasing the tension applied to an iron bar, but the ensuing snap in that bar will happen almost instantaneously.

Economics isn’t a science, but there’s a direct analogy here. Anyone who understands the economy as an energy system will be well aware of a relentless, long-standing build-up of stresses.

They’ll be equally aware that this cannot continue indefinitely.

Two things matter now.

First, when will these cumulative pressures bring about the moment of fracture?

Second, what should we expect to see when this snapping-point is reached?

The answers to the second question are pretty clear.

Once the break-point has arrived, we should anticipate deterioration in the material economy of goods and services. Rather than being misled by financial proxies for economic activity, we need to focus on physical metrics, which range from energy and resource consumption, and the supply of goods and components, to the movement of products and people.

Looking behind distorted comparisons with coronavirus-depressed 2020, this is exactly what we’re seeing now.

All sorts of explanations might be advanced for lower physical supply, and many of these explanations are, within their limits, valid. Many interruptions can be identified, across the gamut from the manufacture of cars, chips and components to the availability of containers, transport capacity and skilled labour. Many businesses are in big trouble, not least from sharp rises in the costs both of direct inputs and of the utilities that every business requires.

But what matters here is the overall effect, and that effect is a weakening in the material or physical supply of products to the economy.  

Overall downturns in these ‘non-financial metrics’ are of enormous significance, and can be expected to carry on trending downwards once the economic inflexion-point has been passed.

At the same time, we should anticipate major financial dislocation, including surging inflation, market slumps and a cascade of defaults. We can usefully refine the focus on inflation by stating that it won’t be broad inflation, but the rising prices of essentials, that will be the critical lead-indicator of systemic disruption.

Meanwhile, we should also expect to see the combination of financial stress and deteriorating material activity extend more broadly, most obviously into politics, and into wider manifestations of popular discontent and anxiety.

If we compare what we would expect to see with what we can observe, we have an answer to our first question.

The moment of fracture has arrived NOW.        

Revealing trends

Cumulative tensions between the economy and the financial system are clear to see, provided we know what we’re looking for.

Three metrics provide examples of what this means.

Between 2000 and 2020, global economic activity, expressed as GDP, increased by 94%, meaning that the economy is supposed to have “grown” by $64 trillion (at constant 2020 values).

This “growth”, though, has been paralleled by a far larger – 190%, or $216tn – real-terms surge in aggregate debt. The relentless stretching of the balance sheet becomes even more pronounced if we look beyond formal debt, and take into account rapid increases in broader financial liabilities, and the emergence of huge ‘gaps’ in the adequacy of pension provision.

The aggregate of commitments, then, is rising far more rapidly than reported “activity”, and it’s clear that much of this “growth” in activity is a statistical function of soaring commitments.  

Our third metric, provided by the SEEDS economic model, is that global aggregate prosperity increased by only 31% ($19.9tn) over a period in which “growth” is claimed to have been $64tn, or 94%.

If we overlay a 25% rise in population numbers between those same years, what emerges is that a reported 55% increase in GDP per capita masks a rise of less than 5% in the prosperity of the World’s average person.

Add just a soupçon of widening inequality and we have a situation in which the median person gets poorer.

This has happened over two decades in which his or her share of aggregate debt has risen by 130% in real terms.

Just to be clear about this, these are long-term patterns, not fundamentally affected by pandemic-induced effects which, in 2020, reduced GDP by a reported 3.1%.

The Great Divergence

If you’ve been visiting this site for any length of time, you’ll know the importance of drawing a conceptual distinction between the real economy of goods and services and the representational or financial economy of money and credit.

In a process whose origins can be traced right back to the 1990s, these ‘two economies’ have diverged, creating a dangerous disequilibrium.

Contrary to conventional orthodoxy, the economy is an energy system, not wholly or even mainly a financial one. Nothing that has any economic utility at all can be supplied without the use of energy, and the delivery of material prosperity can be – though generally isn’t – expressed as an equation comprising the supply, value and cost of energy.

The most critical of these variables is cost, meaning the Energy Cost of Energy. ECoE references the fact that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. Material prosperity is a function of the surplus energy that remains after ECoE has been deducted from aggregate energy supply.

In short, rising ECoEs mean falling prosperity.

The problem, in an economy that still relies on fossil fuels for more than four-fifths of its energy supply, is that the ECoEs of oil, gas and coal have been rising relentlessly. SEEDS data indicates that the trend ECoE of fossil fuels has risen from 2.8% in 1990 to 6.3% in 2010, and 9.8% now.

Since most ex-ECoE (surplus) energy isn’t used for growth, but for system maintenance and renewal, a rise of 710 basis points in ECoEs, in an economy previously capable of growing at about 3% annually, is much more than enough, not just to eliminate the scope for further expansion, but to put prior growth into reverse.

The imperative, in economic as well in environmental terms, is to replace fossil fuels with lower ECoE sources of energy supply. If we can’t do this, then surplus energy – and, with it, material prosperity – must decline, initially in per capita terms and, latterly, in aggregate.

There is, as yet, no evidence that renewable energy sources (REs), such as wind and solar power, can supply this lower ECoE alternative to oil, gas and coal.

The probabilities, rather, are against this being possible.

Even if this can eventually be accomplished, it certainly can’t happen now. This is why the ‘real’ economy of goods and services has been decelerating, to the point at which involuntary “de-growth” has become a reality.

Whilst prosperity is, of necessity, a material concept, money is a human artefact, validated by its use as a medium of exchange. It has value only in terms of the things for which it can be traded. This means that money has no intrinsic worth, but commands value only as a ‘claim’ on those material goods and services for which it can be exchanged.

Conventional economics tries to circumvent this hard reality with the notion that [financial] demand creates [physical] supply. The fallacious logic here is that, so long as there’s enough financial demand for something, the availability of material supply will somehow follow automatically.

Where finite resources – such as low-cost energy – are concerned, this simply doesn’t work.

We can’t create something that doesn’t exist in nature, simply by putting up its price.

This is why we can’t spend (“stimulate”) our way to material prosperity, any more than we can borrow our way to solvency, or “invest” (meaning monetize) our way to environmental sustainability.

What we’re seeing here is a widening gap between the economy as it is and the economy as we choose to see and present it.      

In essence, we’ve been creating apparent increases in economic activity (using expansions in credit and other liabilities) without creating much material economic value.

In the process, we’ve been driving a widening wedge, not just between ‘activity’ and commitments, but between the energy economy of goods and services and the proxy, financial economy of money and credit.   

Inflation – the importance of the essential

Logically – because prices are the interface between financial demand and physical supply – inflation should be a prime mechanism in the restoration of equilibrium between the real and the financial economies. Using the material and the financial as the components of an equation, we can identify rates of inflation that substantially exceed reported numbers. Known as RRCI, this is an ongoing development project within the SEEDS economic model.

These broad trends, though, can’t really be seen in readily-available data. For a start, and as you may know, official inflation has been distorted by the use of concepts such as hedonic adjustment, substitution and geometric weighting.

Just as significantly, conventional measures of inflation confine themselves to movements in consumer (or ‘retail’) costs, thereby excluding those changes in asset prices which are a material component of the overall relationship between the quantitative and the financial dimensions of the economy.

The tendency with the use of official numbers is to compare inflationary rises in consumer costs with nominal changes in wages. Theoretically, at least, if consumer inflation is broadly matched by increases in incomes, then the ‘ordinary’ person’s situation doesn’t change all that much, except that his or her debts are inflated away, whilst savings are eroded.

There are many snags with this notion, of which the most obvious is that inflation can take on a momentum of its own, with wages chasing prices, and wage costs pushing up consumer inflation. This tendency threatens a destruction of the purchasing power, and hence of the critical credibility, of money. This is why, whilst low inflation is generally deemed to be acceptable – and is often regarded as beneficial – anything above about 2% is recognized as a problem.

Though true as far as it goes, this approach conflates two very different forms of inflation as the consumer experiences them.

The consumer spends his or her income in two ways. The first is the purchase of essentials, including food, housing, domestic energy, utilities and necessary travel. The second is the purchase of discretionary (non-essential) goods and services. These ‘discretionaries’ are residuals, meaning things that the consumer buys after he or she has met the cost of necessities.

It’s quite possible to envisage circumstances where the cost of essentials is rising much more rapidly than the prices of discretionaries. We might, for instance, have a situation in which, whilst broad inflation is running at 5%, the cost of essentials is rising by 10%. Incomes, if they too are rising at 5%, thus offset general inflation, but fail to keep up with the cost of necessities.

This inflationary divergence makes the consumer poorer because, whilst discretionary purchases such as cars, smartphones and holidays can be deferred – and are not, in any case, made continuously – essentials such as food, electricity, gas and other utilities have to be purchased, generally on a regular weekly or monthly basis.

The vital point about this ‘asymmetric inflation’ is that we need to put the emphasis, not on broad or theoretical inflation, but on trends in the real cost of essentials.

If the cost of, say, a smartphone or a foreign holiday increases, the consumer might not be much concerned about it, because he or she doesn’t need to buy it at all, and can certainly put it off for later.

If, on the other hand, there’s a sharp rise in the cost of food, or the utility charge for electricity or gas, or the price of fuel at the pumps, he or she notices it very quickly indeed – and is right to do so.

Critically, essentials are highly energy-intensive. This is as true of, say, food and water, and of the building and maintenance of homes, as it is, more obviously, of fuel and domestic energy.

The point of impact

What this asymmetric inflation means is that, as energy-based prosperity deteriorates, an obvious financial corollary is a rise in the cost of essentials. As well as causing public discontent, this also leaves the consumer with a reduced ability to purchase non-essential goods and services.

At the critical moment of impact, then, we should expect to see two important trends.

One of these is a rise in the cost of essentials, and the other is volumetric weakness in the economy, most obviously in the use and delivery of physical goods, and in deteriorating metrics in discretionary sectors.

This is exactly what we’re witnessing now. Whilst the prices of essentials are rising, volumetric consumption of discretionaries is trending down, even if this can be hard to see behind an anaemic “recovery” from the artificially-depressed conditions of 2020. When, as is frequently the case, we’re told that discretionary sectors are ‘growing’, it often transpires that this is true only in comparison with last year.     

Given that stock markets are heavily skewed towards discretionary sectors, this trend alone is likely to become a worry for investors.

Moreover, rises in the cost of essentials have a direct bearing on decisions made around monetary policy. Consumers, who are also voters, might not make much of a fuss if the prices of discretionary purchases rise, but will react very strongly indeed if the cost of their utility bills, of filling up their car and of the weekly purchase of groceries moves markedly upwards.

It doesn’t take all that much inflation in the cost of necessities to create popular demands for action, demands which, in policy terms, can be met only by raising interest rates, and by easing back on, or reversing, asset purchase programmes.

Because prices, especially of necessities, are the point at which the financial economy of money intersects with the material economy of energy, current trends are unmistakable signs of the moment at which monetary delusion succumbs to energy reality.    

It is, perhaps, fitting that this is happening as the pantomime season approaches. Borrowing our way to prosperity played to packed houses in the decade or so before 2008, and much of the glitter carried over into more-than-a-decade in which the speed of monetary expansion has deceived the eye of reality.

There comes, though – and, now, has come – a point at which the curtain descends, the glitter fades and the magic of beans and bean-stalks recedes into memory.                

#215. The price of equilibrium


The simplest way to define the current economic and broader situation is that consensus expectations and realistically probable outcomes have become polar opposites.

One of the most predictable consequences of this disparity is a sharp fall, both in asset pricing and in the viability of forward financial commitments.

Shared by governments, businesses, the mainstream media and a large proportion of the general public, the consensus line is cornucopian, picturing a future of abundance characterised by continuing economic growth, exponential technological progress and a seamless transition from climate-harming fossil fuels to renewable energy sources (REs) such as wind and solar power.

This essentially optimistic narrative is based on a series of compounding fallacies, which we might summarise as misconceptions of capability.

Three critical realities are ignored. One of these is that the economy is an energy system, which cannot be propelled to infinite expansion by means of the human artefact of money.

A second is that the scope for technology is bounded by the laws of physics.

The third – and arguably the most important – reality ignored by the consensus narrative is that REs are unlikely to replicate the characteristics and economic value historically provided by energy from oil, natural gas and coal.  

Those of us who understand the economy in energy terms have to weigh two possible courses of action. These are not mutually exclusive, but a balance does need to be found. One of these is the advocacy of reality. The other is analysis, which involves working out the probable series of events, and providing information which will be of value once the failure of the consensus narrative ushers in a new pragmatism.

The recent emphasis here has been on the fallacies which inform the current narrative. We’ve looked at why the credibility of conventional, money-based economics is waning rapidly, and at the hierarchy of challenges which make seamless, ‘growth-intact’ transition from fossil fuels to REs improbable.

The aim now is to formulate a realistic projection of what a less-than-cornucopian future might look like. In doing this, we need to refer to critical principles, and look at what these critical principles can tell us when translated into interpretation and projection.

Regular readers, to whom the central principles of the surplus energy economy are familiar, might welcome the fact that these principles, of which there are three, can be expressed with brevity.

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

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

The third critical principle is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services made available by the use of energy.

These principles immediately set up a distinction between a ‘real’ economy of energy, labour and resources and a ‘financial’ economy of money and credit.

The central fallacy of orthodox economics is that it places the ‘real’ economy of energy and resources in a subsidiary relationship to the ‘financial’ economy of money.

It asserts, for example, that demand (expressed as money) creates supply (of the goods and services produced using resources). The reality is the other way around – that the financial system is a proxy and an operating mechanism for the all-important economy of energy.   

These principles should inform our understanding of the industrial era which can be dated to 1776, when James Watt completed the first efficient heat-engine, giving us access to the vast amounts of energy contained in coal, oil and natural gas.

Through much of the subsequent two centuries, the ECoEs of fossil fuels declined, reflecting widening geographic reach, rising economies of scale and improvements in the technology of energy access and application. This meant that surplus (ex-ECoE) energy expanded more rapidly than aggregate energy supply, such that prosperity out-grew increases in the amount of energy available to the economy.

Latterly, when the scope of reach and scale had been maximised, ECoEs started to rise through the mechanism of depletion. By the 1990s, fossil fuel ECoEs were rising exponentially, more than offsetting volumetric expansion, and creating the phenomenon described at the time as “secular stagnation”.

Our subsequent economic history has been characterised by failed efforts to use financial tools to cancel out this adverse ECoE effect. We began this process of denial and misconception in the 1990s, by making debt ever more readily available. This process of credit adventurism was compounded, after the 2008-09 GFC (global financial crisis), by the adoption of monetary adventurism, characterised by supposedly “temporary” expedients such as QE and ZIRP.

The result has been a widening gap between the ‘real’ and the ‘financial’ economies. Barring some kind of ‘energy miracle’ (which isn’t going to happen), this gap has to be narrowed, and equilibrium restored, by a sharp contraction in the financial system which, as we’ve seen, is a proxy for the real economy of energy.   

This contraction in the financial system is our first clear projection for the future.

As we’ve seen, the real value of money resides in its function as a ‘claim’ on the output of the economy determined by energy. This means that it’s perfectly possible – indeed, under certain circumstances almost inevitable – for us to create claims on the real economy that exceed anything that that real economy can deliver. In Surplus Energy Economics, these are known as excess claims.

One of the mechanisms instrumental to the creation of excess claims is the operation of ‘futurity’. As distinct from the everyday meaning of ‘future’, the term futurity references the forward expectations that inform decisions taken in the present.

Whether it’s borrowing and lending, investing or fiscal planning, financial decisions are based on individual assumptions of what the future is likely to hold. Together, these expectations form a futurity consensus, and one of our biggest problems now is the sheer improbability of a futurity consensus based on a mistaken narrative of infinite growth and extrapolated technological advancement.

The most obvious example of futurity is debt. As a ‘claim on future money’, debt really functions as a ‘claim on future energy’. Expressed in international dollars – converted from other currencies using the PPP (purchasing power parity) convention – and stated at constant (2020) values, aggregate global debt has expanded from $127 trillion in 2002 to $330tn at the end of last year.

Debt, of course, is by no means the entirety of financial ‘claims on the future’. The shadow banking system, which has expanded particularly rapidly since the GFC, forms part of a broader category of financial assets which, for the most part, are the liabilities of the three non-financial sectors of the economy, which are households, governments and private non-financial corporations (PNFCs).

Data exists for countries equating to 75% of the global economy. On this basis, world financial assets can be estimated at $650tn – up from less than $220tn in real terms back in 2002 – which includes the previously-mentioned debt aggregates.   

Meanwhile, there has been a super-rapid expansion in unfunded pension commitments. These commitments are often implicit rather than contractual, but rank as commitments because they cannot easily be repudiated by the governments which are the principle debtors in the situation (and neither, unlike debts, can they be ‘inflated away’).

We have data for pension ‘gaps’ for countries accounting for about half of the world economy. On this basis, it’s reasonable to infer that the global aggregate of unfunded pension promises stands at about $235tn, up from about $115tn (in real terms) back in 2002.

On this basis, we can estimate that the world owes – to its own future – financial claims totalling $890tn, and comprising debt (of $330tn), other financial liabilities ($320tn) and unfunded pension commitments ($240tn).

This total compares with a real-terms equivalent of $330tn back in 2002. Each of these numbers would be smaller if we used market rather than PPP conversion to dollars but, by the same token, so would any calibration of affordability used as a benchmark.

The conventionally-used benchmark is GDP which, since 2002, has increased by $60tn (84%) over a period in which financial claims have grown by an estimated $560tn (+170%). As a rule-of-thumb, we can infer that claims on the future have increased by $9.30 for each incremental dollar of reported GDP.

This calculation, though, assumes that GDP is a reliable indicator of the ability to meet forward claims. In fact, though, GDP is a measure of activity, not of value, which means that it is inflated artificially by the creation of debt and other forward commitments.

Though we can go into this issue in more detail on a later occasion, the energy-based SEEDS economic model indicates that prosperity has expanded by only $18.7tn (29%) over a period in which reported GDP has increased by $60tn.

Part of the difference lies in the inflationary effect of credit expansion. By excluding this, we can calculate growth in underlying or ‘clean’ output (in SEEDS terminology, C-GDP) at $23.9tn (+35%) rather than the reported $60tn. Also excluded from conventional measurement is the financial equivalent of the rise in ECoEs between 2002 and 2020, a number which SEEDS puts at $5.2tn.

As measured by SEEDS, then, global prosperity increased by only $18.7tn over an eighteen-year period in which we can estimate that the broad commitments of futurity have escalated by almost $560tn.     

What this in turn means is that we have been engaged, on a massive scale, in the creation of excess claims, meaning financial commitments which far exceed anything that the real economy of goods, services and energy can ever hope to honour in the future.

The flip-side of this escalation in commitments has been massive inflation in the supposed ‘value’ of assets such as stocks, bonds and property.   

There are all sorts of technical debates that can be had around these calibrations, but there are abundant sources of corroboration for the case that the system has created forward commitments far in excess of any realistic ability to meet those commitments out of future prosperity.

For a start, negative real interest rates are an anomaly, and a direct contradiction of the tenet that a capitalist economy is founded on the ability to earn real returns on capital. Asset prices stand at absurd ratios to any realistic benchmark, and have been inflated massively by the negative real pricing of capital.

From this situation of massively-inflated asset prices – and a correspondingly unsustainable increase in liabilities – only two routes back to equilibrium exist. One of these is the ‘hard default’ route of repudiation, and the other is the ‘soft default’ process of inflationary devaluation.

It can be no surprise whatsoever that inflation has started to rise, a phenomenon that would be even more apparent if we included rises in asset prices within a broad definition of inflationary processes.     

This kind of broad inflationary definition is being developed within the SEEDS model, where it is known as RRCI (the Realised Rate of Comprehensive Inflation).

We can further use SEEDS to identify which sectors (governments, businesses and households), and which segments (investment, discretionary consumption and the provision of essentials) are most exposed to the twinned phenomena of deteriorating prosperity and the restoration of claims equilibrium.

For now, though, we can conclude that the divergence between the consensus and the realistic views of the future has created the scope for an enormous (and by no means pro rata) destruction of value within the financial system.

#214. Needed – a new model tin-opener


Logically considered, 2021 ought to have been the place where old assumptions go to die.

In many ways, it is.

Specifically, orthodox, money-based economic interpretation is being debunked. Current events are demonstrating that the economy isn’t, after all, entirely or even primarily a financial system. The proposition that demand produces supply is being discredited, because no amount of stimulus can deliver low-ECoE energy where that energy does not exist. In short, we’re discovering that the economy is an energy system.

Since the start of the Industrial Age, that has meant, overwhelmingly, a fossil fuel energy system. We’re in the process of encountering two constraints to the continuity of an economy built on oil, gas and coal.

The well-known constraint is that we have reached (or passed) the limits to environmental tolerance of our use of fossil fuels.

The second, barely-recognized-at-all constraint is that fossil fuels’ ECoEs – their Energy Costs of Energy – are rising exponentially, in a process that would destroy the fossil-dependent economy even if we were so unwise as to ignore the environmental issue

The consensus answer to this situation is that we must endeavour to transition from reliance on fossil fuels to an economy based on alternative sources of energy.

This, undoubtedly, is a realistic conclusion.

The snag, though, is that the consensus view combines the logical conclusion of transition with the unfounded assumption of an economy which, far from contracting, continues to expand.

A balanced assessment of the issues indicates, rather, that a sustainable economy will also be a smaller one.  

An appraisal of outcomes

At the level of theory, there’s nothing much wrong with the idea of outdated notions undergoing a mass extinction event.

Our understanding, and our ability to plan ahead, can only benefit from the discovery that the economy isn’t, after all, ‘a wholly monetary system, capable of infinite growth’, but is in fact an energy system, limited by the laws of physics as they apply to the Earth’s energy resources.

It is, after all, hard to plan effectively when your base predicates are false.  

In practical terms, though, we’re faced with something that moves beyond an inconvenient truth into what is for most people an almost inconceivable one. This is the proposition that there may be no wholly sufficient replacement for the fossil fuel energy on which the economy of today is based.

Put another way, the desirable – indeed, imperative – de-carbonization of the economy is likely to involve shrinking it as well.  

If you held any leadership position, you’d have to think long and hard before going public on any of this. Your wiser course of action might be to talk up the positives in the current situation whilst preparing, with the greatest urgency, for the new one.

Essentially, this comes down to a probability assessment of two possible outcomes.

The first is that alternative energy sources – primarily wind and solar power, but perhaps with a role for nuclear as well – can provide a complete and timely replacement for fossil fuels.

The second is that no such complete replacement exists, and that we have to plan for a smaller economy.

The latter needn’t be a disaster, so long as we prepare for it, and travel to this destination gradually.

But we have far too many growth-predicated systems and assumptions for any kind of sudden recognition to be manageable.

Needed – a new tin-opener        

A story is told about three experts shipwrecked on a desert island. Their situation seems far from desperate. The island is well-found in fire-wood and fresh water. Washed ashore with them are thousands of tins of baked beans, offering nourishing if monotonous fare. They even have saucepans, plates and cutlery.

The one thing lacking is a tin-opener.

The chemist proposes putting the tins in water which, in due course, will corrode them. Unfortunately, they would starve long before this could happen.

The physicist suggests heating the tins to a temperature at which pressure causes them to explode. This, though, would splatter beans across the island, as well as subjecting the castaways to lethal shrapnel.

Appealed to, the economist has a simple solution – assume a tin-opener

This encapsulates the consensus line as the long era of rising prosperity created by fossil fuels draws to a close. If we assume a replacement for fossil fuels, and further assume perpetual economic growth, our problems are solved.

A hierarchy of challenges

Though an expansion of nuclear energy might help at the margins, the assumed replacement for fossil fuels is electricity from renewable energy sources (REs), principally from wind and solar power.

There are two little snags with this assumption.

The first is that replacing FF with RE energy might not be possible for at least 10-20 years. A great deal – little of it good – can happen over that length of time.

The second is that it might very well not be possible at all.

There’s a hierarchy of challenges to RE transition.

Used as inputs when the wind is blowing and when the sun is shining, wind and solar power can provide electricity at costs which are more or less competitive with traditional methods of generation. The main potential snag is the cost of replacing wind turbines and solar panels when they reach the end of their productive lives, which are somewhere between fifteen and twenty-five years.

In other words, is this transition sustainable, to the point where RE capacity can be maintained and replaced without assistance from fossil fuels?  

The second stage in the hierarchy of challenges is scale. In 2020, and despite the effects of covid-induced reductions in activity, fossil fuels supplied energy totalling 11.2 billion tonnes of oil equivalent (toe), or 82% of the total. Between them, wind and solar power provided only 0.57 bn toe (4.2%). The scaling challenge is largely a matter of accessing vast amounts of raw materials whose supply is – for the foreseeable future – dependent on the use of energy from fossil fuels.

The third challenge in the hierarchy is intermittency. If REs are to move from minor energy contributors to baseload suppliers, vast electricity storage is required. This would make enormous further demands on materials, some of which may not even exist, and would, again, make huge calls on the use of fossil fuels for their supply. Accessing many of these resources would have extremely adverse environmental and ecological consequences.

Even if all of this could be overcome, the cost of storing electricity is roughly 200x that of storing oil, gas or coal. This is why, taking America as an example, whilst fossil fuel inventories are measured in weeks and months, electrical backup is measured in minutes.

This cost differential may narrow, but the physics of storage processes limit quite how far the cost of electricity storage may fall. What this also means is that, to fill storage during periods when the wind is blowing and the sun is shining, generating capacity would need to be far larger – perhaps 60% greater – than the continuity-based equivalent. Costly redundancy, no less than storage capacity, would need to be built in to a system based on intermittent energy.

Next in the hierarchy comes the challenge of density. Oil, in particular, offers a very high ratio of power to weight. This density, which provides easy portability, is what makes today’s cars, commercial vehicles and aeroplanes practical. It’s at least arguable that an insistence on replacing these with battery-powered alternatives raises the power storage problem to ludicrous heights.

The fifth and – for now – final challenge in the hierarchy is adaptability. We might, for instance, find that, whilst grid-scale storage is feasible, self-contained storage is not, making trains and trams viable, but turning mass EV use into a pipe-dream.

Likewise, we might have enough continuous power to run necessary systems, but not to support much of what we now think of as “technology”. It might turn out that essential goods and services can be supported, but that many non-essentials (discretionaries) can’t.

The permutations are endless – but the potential supply of non-fossil energy, most emphatically, is not

As well as assuming the tin-openers of sustainability, scale, continuity and density, then, the idea of seamless and complete transition assumes some resources that cannot be provided, and others that, though they can, would make enormous demands on legacy energy from fossil fuels. All and more of this legacy energy is already accounted for by the continuity requirements of consumption and capital asset replacement. 

A new tin-opener is needed – but technology can’t supply it

Let’s be quite clear about the necessity for transition. As mentioned earlier, continued reliance on fossil fuel energy is a non-starter, for two reasons, both of which are so important that they merit reiteration.

First, there is the undoubted constraint of environmental tolerance.

Second, there’s the equally real issue of the rising ECoEs of oil, gas and coal. As well as wrecking the environment, continued dependency on fossil fuels would – assuredly, and rapidly – wreck the economy. The latter process has already started to happen, albeit thinly disguised, so far, behind increasingly desperate and harmful exercises in financial gimmickry.   

Prophets of seamless transition take refuge in the supposed alchemy of technology – much of it simply extrapolated – whilst ignoring the obvious (though inconvenient) fact that the scope for technological progress is bounded by the limits of physics.

Where wind turbines are concerned, Betz’ law states that wind turbines cannot capture more than 59.3% of the kinetic energy of wind. Current best practice has already reached about 45%, leaving no scope for a quantum (rather than a modest and gradual) increase in efficiency.

Similarly, the Shockley-Queisser limit determines the maximum theoretical efficiency of photovoltaic panels. This limit is 33.7%, not very far ahead of current best practice of about 26%. Again, progress can be made, but no quantum leap in efficiency is possible. Both of these issues are discussed in an instructive article published by the Manhattan Institute, which also explains limitations to the potential capability of batteries.

Not content with assuming resources (and their energy input requirements) which do not exist, then, cornucopian transition theory also requires us to assume that technology facilitates the abolition of the laws of physics.

Nil desperandum

It was a famous dictum of Sherlock Holmes that “[w]hen you have eliminated the impossible, whatever remains, however improbable, must be the truth”.

Objective assessment of the situation suggests that both (a) fossil fuels continuity, and (b) a cornucopian complete replacement of fossil fuels are impossible. What remains is the seemingly-improbable – and in many quarters the almost unthinkable – reality of a smaller economy.

To recap, we’ve noted the imperative of transition – an imperative imposed by environmental considerations and by ECoE trends – but we’ve also noted that there are limits to what transition is capable of delivering.

What this means is that we have to bend every effort to the achievement of transition, but that we must also accept that transition cannot maintain the economy at its current levels of size and complexity.

The energy-based SEEDS economic model produces case-studies which scope the issues involved. 

The central-case assumptions used by the SEEDS economic model project total energy supply 6% higher in 2040 than it was in 2020. Within this total, fossil fuel supply is projected to be lower by 3%, the combined contributions of nuclear and hydro-electric power are expected to increase by 21%, and a 2.4-fold surge in supply from wind and solar generation is anticipated. On this basis, energy supply per person would fall by 10%.

Over the same period, though, ECoEs are expected to rise from 9.0% to 18.1%, meaning that surplus (ex-ECoE) energy availability per capita would slump by 19%. This is reflected in a corresponding decrease in prosperity per person.

Putting practicalities on one side for the purposes of theoretical analysis, the complete replacement of fossil fuels with wind and solar power might deliver an overall 2040 ECoE of, at best, 15%. On this basis, surplus energy supply per person would still decline, but prosperity would fall by only 16%, rather than by the 19% projected under the central case.

Two important conclusions emerge from this assessment.

The first is that accelerated investment in RE capacity can blunt the rate at which prosperity declines.

This underscores the case for transitioning to REs at the fastest practicable rate.

The second is that, however we tackle the energy crisis, prosperity will be lower in 2040 than it is now.

This means that we need to temper commitment to transition with a realistic appraisal of what transition can be expected to accomplish.    

This changes the central question from ‘must we live with less?’ – about which there is no choice – to ‘how can we live with less?’

Re-design – not re-set

The much-vaunted concept of an economic ‘re-set’ is predicated on the idea that an economy which continues to grow can be made both more equitable and more efficient, as well as being made sustainable.

Unfortunately, the essential predicate of growth is fallacious, in that we cannot reasonably expect – still less assume – continuity of growth in a post-fossil economy.

This implies that what we need isn’t re-set, but re-design.

At a later stage we may revisit the taxonomy of de-growth but, for now, we can note that a contracting economy implies a process of de-complexification. The range of products and services available will narrow, and methods of supply will be simplified as producers try to work around the adverse effects of falling utilization rates and the loss of critical mass. The simplification process will involve substantial de-layering.   

The brunt of contraction in the private sector will be borne by sectors providing discretionary (non-essential) goods and services. Over time, we should assume that capital will be diverted towards sectors which supply necessities.

There are likely, also, to be sectors which expand, even as others are contracting. There may be a significant role to be played by venture capital and sovereign wealth funds in identifying and promoting activities whose potential has yet to be recognized by markets which remain fixated on “growth”.

Government activity, too, can be expected to contract, though less rapidly than the private sector. A trend already set in motion by the imperative of transition points towards reduced resources available to government, and a corresponding need to refocus questions of priority.

The critical question for policymakers now might be that of how we ensure that the essentials are available and affordable for everyone.

As so often, though, individuals will be called upon to accomplish much of the change if we’re to move to a system that, whilst being cleaner and more sustainable, is also likely to be smaller than that of today.

At all levels – households, government, business and finance – the challenge will be that of transitioning to an economy that, whilst smaller, need not necessarily be worse than the one built on oil, gas and coal.    


#213. A moment of truth


Some of us have long understood that the economy is an energy system, and is not – as orthodox economics insists – wholly a financial one.

We’ve identified credit and monetary adventurism as futile efforts to deny this reality, efforts which, whilst not ‘fixing’ low and reversing “growth”, have exacerbated financial risk by driving a wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

We’ve highlighted relentless rises in ECoEs (the Energy Costs of Energy) as the process by which expansion in economic output peters out, and prior growth in prosperity goes into reverse.

Recent sharp rises in the price of energy might look like just one aspect of the current worsening economic predicament, a predicament which is ‘a crisis in all but name’. Other adverse factors can be cited, but all of them, ultimately, are traceable to a fading energy dynamic.

We’ve built a large, complex and increasingly inter-dependent economy on the predicate that money can drive ‘growth in perpetuity’.

We’re now in the process of discovering that this predicate is false.

From here on, prosperity will continue to deteriorate, whilst rises in the real cost of essentials will leverage this decline into a more rapid erosion of discretionary prosperity.

The good news is that these processes can be understood and modelled, projected and managed.

The bad is that, so far at least, this reality is not being grasped.    

It has to be said that no ideology is more rooted than ‘neoliberalism’ in the doctrine that the economy is a financial system, with limitless capability for growth.

This is why those economies most wedded to the ultra-liberal ‘super-fallacy’ are being hardest hit by the harsh reality that neither ‘demand’ nor ‘incentive’ can create low-cost resources.       

A new model crisis

Despite the most lacklustre of recoveries from the pandemic-induced downturn, the global economy has collided with the reality of energy constraint.

Natural gas, in particular, is in short supply, but the effects of supply shortages are rippling, too, across the markets in electricity, oil and coal. Almost unthinkably, China – widely regarded as the powerhouse of the world economy – is having to ration supplies of energy to its industrial sectors, whilst grappling with the fall-out from exuberant financial expansion.

Consumer energy and fuel prices are surging, a process as adverse for industry as it’s uncomfortable for households. Though the rise in domestic energy costs is the most conspicuous aspect of energy price escalation, deeper consequences will be felt through sharp increases in the costs of supply to businesses.

All inputs, from minerals and chemicals to food and water, are functions of the energy used to extract and process them. If the supply of energy tightens, and its costs rise, the same happens across the entirety of economic activity.  

This, in short, looks like the moment when the reality of energy and broader resource constraint makes itself felt, and the conceit of perpetual growth on a finite planet is revealed as fallacy.

We need to be clear that, insofar as this is an “energy crisis”, it has nothing in common with previous such crises. Neither can it be blamed on after-effects of the pandemic crisis, on gamesmanship (by Russia, or anyone else), on ‘little local difficulties’ (like “Brexit”), or even on the distorting effects of gargantuan financial stimulus, harmful though that has been. Least of all can it be ascribed to ‘brisk economic growth’, since the global economy is unlikely to be any larger in 2021 than it was in 2019.

Rather, what we are experiencing is a predictable – though, in general, not a predictedcollision between resource limitations and a desire for never-ending “growth”.  

The economy has hitherto experienced two energy crises (or three, if we include the oil price spike experienced in the American Civil War), but what’s happening now is profoundly different.

During the 1973-74 embargo crisis, and the 1978-79 Iranian revolution, there was no physical shortage of oil, or of energy more generally. These were crises of management, and of trade imbalances and international relations, not of supply fundamentals. Fossil fuel ECoEs remained below 2% in the 1970s, but are nearly 10% now. Even if renewable energy sources (REs) can take over fully from fossil fuels in the future (and this is unlikely), they certainly can’t do so now.

A moment of truth

From an economic perspective, this is a watershed. What we are witnessing is decisive proof that the economy is indeed an energy system, and is not – as orthodox opinion has so long insisted – wholly a matter of money. Pouring yet more money – in econo-speak, demand – into the system isn’t going to create huge new supplies of oil, gas, coal or any other form of primary energy. 

All of the world’s decision-making processes – most obviously in government, business and finance – are predicated on an assumption which is turning out to have been fallacious. The economy isn’t, after all, a ‘perpetual growth machine, powered and shaped by money’.

Rather, it’s an energy system, in which material prosperity is a function of the availability, value and ECoE-cost of energy.

With its emphasis on incentive, and its disdain both for government planning and for non-financial motivation, the ideology sometimes called ‘neoliberalism’ is most exposed to the discovery that the economy cannot, after all, be managed in purely financial terms.

This helps explain why those countries most wedded to the idea of ‘leave it to the market’ – and, with it, of accepting inequality as ‘the price of efficiency’ – face the toughest futures. Britain, most conspicuously, is experiencing the consequences of the liberal ‘super-fallacy’ now, but the United States, in particular, won’t be far behind.

Of course, hype – no less than hope – “springs eternal”. But surges in the direct household costs of energy and fuel are now impacting economies, and indirect, second-order effects (traceable to the rising cost of energy to industry) are already making themselves felt in supply shortages and inflation.

For those countries worst affected by energy supply strains, pious promises to “build back better” and to “level up” won’t remove the need to make tough, unpopular decisions. “Green growth” is going to have to transition into “green resilience”. Decades of denial – enacted through monetary gimmickry, and backed up by excessive faith in the alchemy of technology – threaten severe financial and broader consequences.

A rocky road

As the energy interpretation of the economy moves from left-field theory to demonstrable reality, theories and models based on the contrary assumption are breaking down. The economy is moving in directions not anticipated by orthodox theory, invalidating much, and arguably most, of the projections, methodologies, models and policies hitherto accepted as valid.    

Those of us who understand the economy as an energy system can predict some, at least, of the consequences of present trends.

First, material prosperity will deteriorate. Properly understood, this has long been an established trajectory in the West, glossed over – but not changed – by increasingly desperate, illogical and hazardous exercises in credit and monetary adventurism. SEEDS analysis makes it clear that the average person in almost all Western economies has been getting poorer since well before the 2008-09 GFC (global financial crisis), and that an increasing number of EM (emerging market) economies, too, are reaching the climacteric at which rises in ECoEs put prior growth in prosperity into reverse. 

The rates of decline in top-line prosperity itself look manageable. But rising ECoEs are set to drive up the real costs of essentials (including household necessities and public services). Together, the combined effects of falling prosperity, and the rising cost of essentials, are exerting a tightening squeeze on the scope for discretionary (non-essential) consumption.

This downwards pressure on discretionary prosperity is going to be unpopular, with consumers and with discretionary suppliers alike, and this may prompt efforts to prop up discretionary consumption with yet more reliance on credit expansion.

Denial, for the moment, remains unchallenged. In Britain, for example, households are likely to face further and even larger rises in the cost of gas and electricity, and the price of anything (which means everything) made using energy is going to rise as well. Discretionary consumption cannot continue unchecked through this process.

To be sure, wages might rise to accommodate these cost increases but this, if it happens, will simply fuel an inflationary cycle. The task of repairing the public finances will become harder with each worsening twist in the cost cycle.

Despite this, few yet anticipate contraction in the scope for everything from travel and leisure to the payment of subscriptions and the purchase of the latest gadget. Fewer still have grasped the read-across from deteriorating prosperity to the pricing of property and other assets.  

Around the world, these processes in turn imply, not just that inflation will rise, but that the financial system will come under increasing stress. Together, discretionary sectors, and businesses that rely on the ‘stream of income’ model, are going to be in the eye of the storm.

The ‘basics’ of the situation – deteriorating top-line and discretionary prosperity, rising inflation and worsening financial stress – are simply the first-order effects of the deteriorating energy-prosperity equation. More complex processes can be anticipated, some of them identifiable in a taxonomy which sees businesses simplifying their products and processes, de-layering their supply chains, and trying to work around the challenges of falling utilization rates and the loss of critical mass. Popular priorities can be expected to change, intersecting with a deterioration in the affordable resources of governments.

These are issues on which we can reflect and which, to some extent, we can model and predict.

For now though, the imperative is that the realities of resource (and environmental) constraint are recognized, and that plans and assumptions are re-thought accordingly.       



#212. Are we nearly there yet?


Throughout the period since the global financial crisis (GFC) of 2008-09, capital markets have marched upwards, even as the economy itself has, at best, stagnated. After a sharp correction at the start of the coronavirus crisis, the prices of stocks and property, in particular, have kept hitting new highs, even as the much-vaunted “recovery” has petered out.

The casual observer might wonder, first, about why this great divergence between the economy and the markets has happened at all, and, second about, whether, or when, it will come to an end.

The aim here is to explain the former, and anticipate the latter.

Questions around the divergence between the economy and the markets have been accompanied by the suspicion that decision-makers may have wanted this to happen (in order further to enrich the wealthiest), and that they have ordered events accordingly.

We can start by stating that the fault of the policymakers has, very largely, been one of complicity rather than of design. Ultra-low interest rates weren’t adopted to boost asset prices, but to prop up a faltering economy. This said, the ‘great divergence’ could, and should, have been anticipated, and fiscal measures adopted to restrain it.

To be clear about this, there’s an equation which links economic adversity to rising markets. The weaker an economy becomes, the greater the likelihood that interest rates will be lower, for longer, than if the economy were performing well. Cheap money is favourable for markets, so there’s a mathematical linkage between economic weakness and market strength.

This, though a linear equation, isn’t an infinite one. A weak economy is good for asset prices, but there comes a point at which economic stagnation turns into deterioration, and at this point the equation snaps, and markets correct downwards, quite possibly very rapidly indeed.

Economic weakness that pushes people into taking on ever more debt is favourable for asset prices, until it reaches the moment at which borrowers can no longer support the debt that they already have, let alone take on yet more. We can call this the “snapping-point” at which the equation inverts, and market exuberance turns into fear.

The trick is to work out how, and when, this snapping-point is going to occur. 

At this moment, there are some very evident economic problems, which include uptrends in inflation, a squeeze on the availability of energy supplies (and of natural gas in particular), the fracturing of supply-lines across a gamut of goods and services, and the perception – at least in Beijing – that financial risk is becoming excessive.

Mention of Beijing should remind us that what we need to identify are broad trends rather than national events, even when these are taking place in a country as important as China. The Chinese authorities have their own reasons for cracking down on speculative investment, banning crypto-currencies, taming ‘big tech’ and tackling the problem of moral hazard.

Likewise, we shouldn’t generalize from events in the United Kingdom, since many of Britain’s problems are self-inflicted, and are specific to a weak, vulnerable and badly-managed economy. There’s more reason – because America is much bigger and a great deal more important – for concern about the seeming irrationality of US economic and financial policy, with its one-trick-pony addiction to stimulus.               

At present, the tendency is blame everything – including inflationary pressures, supply-chain disruption and financial stresses – on the after-effects of the coronavirus crisis. As an explanation, this ranks for credibility somewhere between “the dog ate my homework” and “I can’t buy a round of drinks because a spaceman from Mars stole all my money”.

After all, official figures indicate that global GDP fell by a less-than-catastrophic 3.3% last year. To believe that all of these economic problems only began in 2020 requires extreme myopia, and a very short memory.

Rather, and as regular readers know, the economy has been deteriorating over a very long period, which we can trace back to the identification of “secular stagnation” back in the 1990s.

In the final analysis, the size and complexity of the modern economy are products of the use of energy from oil, gas and coal. Now, though, the ECoEs (the Energy Costs of Energy) of fossil fuels are rising relentlessly, and the window of environmental tolerance of their use is closing.

This mightn’t have mattered if we had a fully adequate replacement source of energy available, and were willing to adapt the economy onto a new basis consistent with radically different sources of energy.

Neither is the case. Wind and solar power cannot provide a complete replacement for fossil fuel energy, and our unwillingness to adapt to very different energy conditions is exemplified by the insistence that battery-reliant EVs, rather than mains-powered trains and trams, must be the primary transport mode of the future.

Readers will be familiar with the reasons why like-for-like transition isn’t feasible. First, the expansion and maintenance of renewable energy sources (REs) is dependent on vast quantities of materials whose supply, in turn, depends on legacy energy from fossil fuels.

Second, the intermittency of wind and solar power requires batteries, a requirement which loads the material balance still further against seamless transition. Relatively low-cost additional energy sources become much more expensive when they transition to the role of base-load.

Third, REs are never going to yield the energy density to which we’ve become accustomed over two centuries of reliance on coal, oil and gas. The magic elixir of ‘technology’ isn’t going to fix this, not least because best practice in REs is already close to maxima dictated by the applicable laws of physics.

The bottom line is that the ECoEs of REs are unlikely ever to fall much below 10-12%, and even that might be an optimistic target. The modern economy was built on ECoEs of less than 2%, can’t really grow once ECoEs rise much above 6-7%, and is in deep trouble now that trend ECoE has risen above 9%. As ECoEs rise, the supply quantity (as well the economic value) of energy starts to deteriorate, a tendency already playing out in the availability of natural gas.

This much will be familiar to readers, who will also know that there can be no lasting financial ‘fix’ for an economy that, ultimately, isn’t financial at all, but is shaped by the supply and ECoE-cost of energy.

If we insist on throwing the financial system under the wheels of the ECoE juggernaut, we shouldn’t be surprised if it gets broken.

A critical issue now is the process by which this deterioration in economic fundamentals feeds through into the financial system in general, and into markets in particular.

To understand this, we need to recognize the role of essentials, defined here as the estimated total of household necessities and public services.

In absolute terms, the cost of these essentials is rising, because so many of them are energy-intensive, and thus exposed to the rising trajectory of ECoEs. Their proportionate burden will rise even more rapidly because, just as essentials are becoming more expensive, top-line prosperity is trending downwards.

Essentials are the leveraging factor that can turn comparatively gradual deterioration in prosperity and into something which is much more unpleasant.

This is particularly relevant to the markets. In equities, a large proportion of quoted companies are engaged in the supply of discretionary (non-essential) goods and services. Many of these stocks are priced by the markets on the basis of continuing growth, but energy-based analysis, as carried out here using the SEEDS economic model, makes it clear that discretionary prosperity is contracting, and that discretionary consumption has – thus far – been propped up by credit expansion alone.

More prosaically, a point is likely to be reached at which markets realize that pressures on household budgets – pressures reflected in energy and utility costs, in broader inflation and in the sheer scale of debt burdens – aren’t temporary or, in today’s buzz-word, “transitory”.

It will then become apparent that the rising cost of household expenses leaves consumers with less to spend on things like leisure and travel, cars and gadgets. It might also be recognized that decreasing discretionary prosperity leaves less resources available for the “streams of income” business model built on the continuity of subscriptions, stage payments and various forms of credit.

In practice, recognition of pressure on consumer discretionary resources may coincide with a realization that there are limits to the viability of perpetual stimulus. What SEEDS is telling us is that the affordability of everything from a foreign holiday and a day at the races to a new smartphone, a replacement car or an entertainment subscription is coming under worsening pressure. What orthodox data tells us is that consumers are still making these purchases, but are becoming ever more reliant on credit to finance them.

Here, then, is the “triple whammy” that is likely, sooner rather than later, to trouble the markets.

First, as discretionary purchasing power deteriorates, so does the outlook for any company supplying non-essential goods and services.

Second, these same pressures are putting the ‘stream of income’ business model at worsening risk.

Third, inflationary pressures – exacerbated by a non-“transitory” fracturing of supply lines – are taking us to the point where stimulus stops working and becomes dangerous, a point that might arise well before the authorities detect a need to raise rates.

These pressures are not, of course, unique to equity markets, but can be expected to extend to other asset classes, including property. Ultimately, what we’re witnessing is the compression of affordability in general, and discretionary affordability in particular, combined with arrival at the limits to the feasibility of stimulus.

Orthodox economics – with its insistence on a purely monetary ‘perpetual growth’ dynamic, unconstrained by resources – isn’t going to recognize any of this any time soon. Neither, for that matter, will governments, for whom predictions of anything but growth in perpetuity are anathema.

Don’t be too surprised, though, if markets tumble to what’s happening, long before reality penetrates the portals of economic orthodoxy or the corridors of power.                      

#211. The case for contingency planning


An intelligent investor – as distinct from a gambler – doesn’t put all his or her money on a single counter. He doesn’t stake everything on a single stock, a single sector, a single asset class, a single country or a single currency. The case for portfolio diversification rests on the existence of a multiplicity of possible outcomes, of plausible scenarios which differ from the investor’s ‘central-case’ assumption.

This isn’t a discussion of market theory, even though that’s a fascinating area, and hasn’t lost its relevance, even at a time when markets have become, to a large extent, adjuncts of monetary policy expectation. The concept of ‘value’ hasn’t been lost, merely temporarily mislaid.

Rather, it’s a reflection on the need to prepare for more than one possible outcome. Sayings to this effect run through history, attaining almost the stature of proverbs. “Hope for the best, prepare for the worst” is one example. Others include “strive for peace, but be prepared for war”, and “provide for a rainy day”. There’s a body of thought which has always favoured supplementing hope with preparation.

Dictionaries might not accept the term “mono-scenarial”, but it describes where we are, working to a single scenario, with scant preparedness for any alternative outcome. The orthodox line is that the economy will carry on growing in perpetuity. Obvious problems, such as the deteriorating economics of fossil fuels and the worsening threat to the environment, will be overcome using renewable energy and the alchemy of “technology”, with “stimulus” deployed to smooth out any economic pains of transition.

The alternative scenario is that “growth” cannot continue indefinitely on a finite planet, that there’s no fully adequate replacement for the fading dynamic of fossil fuel energy, that the capabilities of technology are confined by the limits of physics, and that stimulus is a form of tinkering which can, at best, only bolster the present at the expense of the future.

There’s a duality of possible outcomes here, where we can indeed “hope for the best” (meaning continuity of growth) but should also, to a certain extent at least, be “prepared for the worst” (the ending and, by inference, the reversal of growth).

Those of us who understand the accumulating evidence favouring de-growth have a choice. We can act as latter-day Cassandras, predicting collapse, or we can think positively, contributing to the case for a “plan B”. The latter is the constructive course.

The centrality of growth   

This won’t be easy. The ‘D-word’ – de-growth – is the great taboo. It’s the one contingency for which we have no preparedness, and of which we have no prior experience.        

There’s a reason why, in the story by Hans Christian Andersen, only one small child blurts out the reality that the Emperor’s new clothes don’t exist.

Nobody else wanted – or was prepared to risk – challenging the collective mind-set, however mistaken that mind-set might have been. If the child had possessed wisdom beyond his years, he might have presented a solution (perhaps a better tailor) at the same time that he laid bare – so to speak – the problem of the imaginary garments. 

The idea that growth might have ended is one of the most emphatic ‘no-go areas’ of our times.    

Everything else, you see, is manageable. Incumbent governments might be replaced, large parts of the financial system might swoon into crisis, and the fashionable industrial sectors of the day might become old-hat. All of this has happened many times before, and we’ve coped. So, for that matter, have we emerged from those temporary interruptions to growth that we know as ‘recessions’ and ‘depressions’.

What hasn’t happened before is the cessation and reversal of economic growth.   

Economic growth is the universal panacea. It pays off our debts, holds out hope for a more prosperous future, builds investment pots for retirement, bails us out of our own collective follies, keeps the public happy, allows new governments to promise success where old ones have failed, and creates new commercial titans to replace those whose day in the sun has passed.

Collectively, we pride ourselves on our ability to handle change. We can indeed cope pretty well with linear change, so long as the economy’s secular trajectory remains one of growth. Ideology is flexible, and has moved through feudalism, mercantilism, imperialism, socialism and Keynesianism in a sequence in which ‘neoliberalism’ is but the most recent fashionable “-ism”. In business, as on the catwalk, fashions change, and there’s no reason why the current ascendancy of “tech” should prove any more permanent than the earlier pre-eminence of textiles, rail, steel, oil, petrochemicals and plastics.

There’s nothing here that can’t be managed.

The ending of growth, on the other hand, is the one twist that invalidates assumptions, and wrecks systems.

It’s been said that ‘if God didn’t exist, we’d have to invent Him’. Theology is way off-topic here, but we can say, in a similar vein, that ‘if growth didn’t exist, we’d have to invent It’.

It’s arguable that, for more than twenty years, we’ve been doing exactly that.

The end of growth – breaking the taboo

If we look at situations objectively and dispassionately, the case that growth is ending is persuasive. It’s certainly a scenario against which it would be wise, if it’s possible, to ‘hedge our bets’.

The Limits to Growth (LtG), published back in 1972, made the lines of development clear, reaching the rational conclusion that there’s only so much energy use, so much resource extraction, so much pollution and so many people that a finite Earth can support.

Subsequent evaluation of intervening data underscores the prescience of this analysis, and suggests that the hundred-year window suggested in the original LtG may have narrowed to the point where barely a decade, if that, separates us from the ending of growth.

We might think of the time-scales like this. LtG gave us, as an approximation, a century-long window in which to adapt. Almost half of that – nearly fifty years – has passed since that projection was made. It was, and has remained, easier to dismiss or ignore this thesis than to respond to it.

There’s a strong case to be made that about half of that intervening fifty years has been spent in a precursor zone in which, though growth has continued, the economy has decelerated, a process that was always much more likely than a sudden, out-of-the-blue collision with finality.

In the narrower sphere of the economy, there really are no excuses for our failure to get to grips with the factual. The fact that the economy is an energy system is surely obvious, since nothing of any economic utility can be supplied without it.

So, too, is the operation of an equation which sets absolute energy access against the proportion of accessed energy – known here as the Energy Cost of Energy, or ECoE – that is consumed in the access process.

The idea that, far from being material and subject to physical limits, the economy might instead be immaterial – and governed by the monetary artefact created and controlled by us – has never been more than an illogical conceit, tenable only whilst another dynamic (that of energy) kept the growth process rolling.

History, and the laws of physics, combine to demonstrate that the dramatic growth in the size and complexity of the economy that has occurred since the 1770s was entirely a property of the use of fossil fuels. If we look, not at the finality of quantity but at the limitations of the value capability of that resource, it was only a matter of when, rather than if, we would reach the limits of that growth-driving dynamic.

The equation that determines the way in which we turn energy into economic prosperity has become constrained, both by the finite characteristics of fossil fuels and by the limits of environmental tolerance.

The solutions offered conventionally for this predicament are, to put it very mildly, far from wholly persuasive. Essentially, we’re told that REs can take over from fossil fuels, with any associated problems overcome by the relentless power of technology.

Far from being assured, this transition is very far from proven. The efficiencies of wind and solar power are governed by laws which set limits to their capabilities. Best practice is already pretty close to these physical limits to efficiency.

Renewables, though important, seem unlikely to repeat the fossil fuel experience by giving us quantum changes in available energy value. Their expansion makes vast demands on natural resources which, even if they exist, can only be accessed and put to use using legacy energy from fossil fuels. Most of this legacy energy is already spoken for in a society that insists on channelling the vast majority of it into consumption, rather than investment.

We’re unable, albeit for wholly understandable reasons, to redeploy much legacy energy from consumption into investment. We seem similarly unable to accommodate our practices to the intermittency of energy supply from renewables.

The resource demands of batteries are the additional weight that could break the back of the feasibility camel. Batteries are never going to give us the energy density – if you prefer, the power-to-weight ratios – of fossil fuels in general, or petroleum in particular. Storing petroleum energy in a fuel tank is cheap, reliable, and needs only steel. No amount of extrapolation from positive trends is going to assure the same result for batteries.

The difficulties with REs mean that we might need to ‘think the unthinkable’. It might transpire, for example, that cars and trucks are products of the fossil fuel economy, and that a society powered by electricity must develop alternative modes of transport.

An economy based on electricity is certain to be different from one powered by fossil fuels.

There’s a strong likelihood, too, that it may be smaller.

A case-study

We can hope, then, for growth in perpetuity, but this outcome isn’t guaranteed, or even particularly probable. There’s a compelling case for preparedness for the alternative outcome of de-growth.

What, then, could or should we be preparing for?

The best way of answering this question is to explore what de-growth would mean.  The following analysis looks, as an example, at a single economy. The methodology is the SEEDS economic model, which is based on the principles of (a) the economy as an energy system, (b) the critical role of ECoE, and (c) the subsidiary status of money as a ‘claim’ on the output of the ‘real’ (energy) economy.

At the level of the national economy, explaining this requires two sets of charts. The example used here is the United Kingdom, but it cannot be stressed too strongly that this interpretation is in no way unique to Britain. Similar patterns – differing in detail and timing, but not in broad thrust – show up in SEEDS analyses of other countries. 

Starting with conventional aggregates, we can see how a big wedge has been driven between GDP and aggregate debt (which includes government, businesses and households). Stated at constant 2020 values, British GDP increased by £400bn (24%) over two decades in which debt increased by £2.8tn (196%).

Because GDP, measured as activity, is inflated by credit creation, this process has driven a corresponding wedge between GDP as it’s recorded, and underlying (credit-adjusted) economic output (C-GDP). The gap between C-GDP and prosperity, meanwhile, has widened as ECoE – which makes a prior call on economic resources – has increased.

Switching from aggregates to their per capita equivalents, we can further see how prosperity per person, again expressed at constant 2020 values, has deteriorated since an inflexion-point which occurred in 2004, when British trend ECoE was 4.7%.

This deterioration in prosperity per capita has been comparatively gradual, such that the average British person was £4,300 less prosperous in 2020 (£23,900) than he or she had been in 2004 (at 2020 values, £28,200). That’s a 15% decline, spread over sixteen years, which might not sound too bad.

But the big leveraging factor in play is that, whilst top-line prosperity has been decreasing, the estimated real cost of essentials – combining household necessities with public services – has been rising. This increase can be expected to continue, not least because many essentials are energy-intensive, which ties their costs to the rising ECoEs of energy.

The result is that discretionary (ex-essentials) prosperity is falling a lot more rapidly than its top-line equivalent. On this basis, the average British person became poorer by £5,300 (32%) over a sixteen-year period in which prosperity itself declined by £4,300 (15%).

The middle chart below compares deteriorating discretionary prosperity per capita with an inferred measure of actual discretionary consumption. This shows a widening gap, indicating that a large and growing proportion of discretionary spending has become a function of credit expansion.

Finally, this trend can be tied back to the aggregates by comparing prosperity with total debt, and with the broader measure of financial assets, essentially the liabilities of the non-financial sectors of the economy (government, businesses and households).

Questions and scenarios

This interpretation raises some obvious questions.

First, will there come a point when it’s no longer feasible to use credit and broader liability expansion to support discretionary consumption in excess of prosperity?

Second, could prosperity per person fall, on average, to the point where it no longer covers the cost of essentials? And, given that these are per capita averages, are poorer people already experiencing this squeeze?

Third, are there steps that could be taken to prepare for these eventualities?

This, of course, is energy-based analysis, “should you choose to accept it”.

If you – or we – choose not to do so, however, we’re left in need of other explanations for the first chart (which shows each £1 of “growth” accompanied by £6.80 of new debt), and the sixth (which sets out ongoing – rather than simply projected – exponential rates of expansion in financial commitments). 

Here’s the scenario as SEEDS describes it. The fossil fuel dynamic fades out, and we can’t provide a complete replacement using REs. Wind and solar power hit the physical limits to their efficiencies, and we don’t have the resources to provide complete solutions to intermittency. We over-strain battery capability by trying to replace conventional cars and commercial vehicles with EVs as well as using batteries to manage grid intermittency.  

Fundamentally, ECoEs carry on rising, and prosperity continues to fall. This results in supply shortfalls which financial stimulus can’t fix. The expansion of aggregate financial claims hits limits which threaten the credibility of fiat money. The financial system is shocked by the discovery that its central predicate – growth in perpetuity – is turning out to be invalid.

Meanwhile, discretionary prosperity falls, discretionary consumption corrects back to this level in the absence of perpetual stimulus support, and an increasing number of people struggle to afford the combined essentials of household necessities and public services.

Not unthinkable, not impossible  

At this point, anyone interested in these issues – and this includes decision-makers – has a choice to make. We can believe that continuity of growth is a valid theory. The choice is whether we wholly rule out the de-growth alternative, at levels of confidence which make it unnecessary to plan for this contingency.   

Surprising as it may seem, adapting to the consequences of de-growth is by no means impossible. The public around the world have coped with considerable privations during the coronavirus crisis. Historically, people have been driven into revolt by food shortages, but deprivation of smart-phones and cheap holidays – and even, perhaps, of cars – is unlikely to provoke a similar response.

Preparedness for physical problems requires planning, and can have substantial lead-times, but there’s no reason why, for example, trains and trams shouldn’t replace most petroleum-powered vehicles. Pressing ahead with plans for EVs doesn’t prevent us from developing trains and trams as well.  

Our definition of “essential” is likely to change, but this has never been a static concept. Ensuring that essentials are available and affordable for all would be a worthy political objective. Job losses, most obviously in discretionary sectors, could be offset by the trend towards a greater requirement for human skills as supplies of high-value energy inputs decrease. If removal of the growth predicate reduces asset prices, the problem of inequality might have a self-correcting dynamic.

Above all, ideas and values are likely to change.

To be sure, few will welcome trends such as deteriorating discretionary prosperity, and very few might choose de-growth as a preferred outcome. Consumerism can be expected to fight a robust rear-guard action. What de-growth means, though, isn’t that we choose to retreat from consumerism, but that economic realities compel us to do so.

If, then, energy and environmental pressures impose de-growth, there’s no reason to believe that we can’t adapt to it. Preparation – involving consideration of scenarios other than ‘growth in perpetuity’– could make the process of adaption a great deal less difficult.

#210. As the window narrows


These are hard times for what British politicians ritually call “hard-working families”. Taxes have been raised to levels not seen since the post-War years. The ‘cap’ on the costs of electricity and gas has been increased by 23% so far this year.

Our focus here is on global economic issues, not local political ones, so this isn’t the place to debate whether the tax increases could have been implemented more equitably (which probably they could), or whether the additional revenues will be sufficient to fund the cost of social care for the elderly (which very probably they won’t).

The point is that paying more tax – and having to spend more on electricity and gas – leaves less money in the pockets of “hard-working families”.

Inflated asset prices may enable statisticians to claim that Britain has ‘never been wealthier’, and official figures continue to show “growth” in the economy.

But the inflated prices of property, equities and other assets are functions of the ultra-low cost of money, whilst “growth” in GDP is a conjuring-trick – comparing 2020 with 2000, aggregate British debt has increased by £2.8 trillion in real terms, whilst GDP has “grown” by just £400bn. Even this ratio – of £6.90 borrowed for each £1 of “growth” – understates the true extent to which “growth” has been bought with credit. Asset prices, meanwhile, cannot be monetized in aggregate, because the only people to whom an entire asset class can ever be sold are the same people to whom it already belongs.  

GDP measures economic activity, whether as money spent and invested, or received as incomes. It doesn’t concern itself with where this money comes from, or connect recorded “activity” to a balance sheet showing forward commitments.

GDP thus measured can always be inflated by pouring credit into the economy. Within the parameters of currency credibility, GDP can be ‘pretty much whatever you want it to be’, so long as you can pour enough liquidity (which conventional economics calls demand) into the system.

In 2020, the year of the coronavirus crisis, British GDP fell by 9.9%, or £230bn, but that’s after the authorities had pushed more than £280bn of additional liquidity – borrowed by the government, and monetized by the Bank of England – into the system.

What we’re describing here is a flagging economy, with GDP juiced using credit expansion, at an adverse rate of exchange where nearly £7 of borrowing gets you £1 of “growth”.  Meanwhile, the cost of essentials – whether purchased by households or provided by the state – is rising, whilst underlying prosperity is not. The overhang of liabilities – debt, other financial commitments and forward pension promises – keeps getting bigger.   

We need to be clear that these problems are by no means unique to the United Kingdom, and are worse in other countries, including the United States. The situation may look better in some of the EM (emerging market) economies, but all this really means is that the West has already encountered problems which, for some Asian countries, still lie in the future.

What we’re experiencing, at least in economic terms, is the approach of The Limits to Growth (LtG), as forecast back in 1972 by Donella Meadows, Dennis Meadows, Jørgen Randers and William Behrens. Recent analysis by Gaya Herrington has used intervening data to demonstrate, first, that the authors of LtG got it right, and, second, that we may be within “a decade or so” of the point at which growth comes to an end.

If this is indeed the case, it’s highly unlikely that the ending – and, in all probability, the reversal – of growth will be an event, narrowly identifiable in time. It’s always been likelier that this would be a process, characterised by (a) economic deceleration, and (b) increasing stress on all systems that are – like the global financial system – wholly predicated on growth.

This is exactly where we are now. To be more specific, the world economy entered what we can call a precursor zone back in the 1990s. That was when observers began to worry about “secular stagnation”, and the authorities embarked on ‘credit adventurism’ – and, latterly, on ‘monetary adventurism’ as well – in an effort to ‘fix’ a problem that they didn’t understand.

Once we’re clear about the real dynamics of the economy, we can see why growth has been tipping over into involuntary “de-growth”, and we can also understand the lead-indicator mechanics of the “precursor zone”. Growth has flagged for reasons which have little or nothing to do with money, and everything to do with the energy dynamic which really determines prosperity.

Unable to understand this process, and shackled to the imperative of delivering ‘growth in perpetuity’, decision-makers have poured ever more credit into the system, much of it monetized by central banks. Though efforts have been made to improve regulation of the banking system since the 2008-09 global financial crisis (GFC), much of the subsequent expansion in credit has occurred in the unregulated ‘shadow banking’ system.

For a group of twenty-three economies (G23) for which fully comprehensive data is available – and which, between them, account for 80% of the global economy – aggregate financial assets (which, for the most part, are the liabilities of the non-financial economy) now stand at an estimated 495% of GDP, up from 300% back in 2002.

Even this ratio increase is a severe understatement of the real extent of exposure, because credit and monetary expansion has inflated GDP to levels far ahead of underlying economic prosperity. If we measure the financial assets of the G23 countries against prosperity, the ratio already stands at about 700%.

Regular readers will be familiar with the concept of prosperity, and how it differs from the increasingly misleading conventional measure that is GDP. The first point to be understood is that economic output is a function of the use of energy, because nothing that has any economic utility at all can be supplied without the use of energy. The history of the Industrial Age has been one of using ever larger amounts of energy to deliver economic value at rates of growth which, until quite recently, exceeded the rates at which population numbers were increasing.

The second critical point is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy). The role played by ECoE is that it’s the difference between economic output (a function of the use of energy) and prosperity (which is what remains after the deduction of ECoE).  

This understanding provides us with an equation which, in principle at least, is comparatively straightforward. Prosperity is a function of the quantity of energy used, the value and cost of that energy, and the number of people between whom the resulting aggregate is shared. Money isn’t an intrinsic part of the prosperity equation, but acts as a proxy and a medium of exchange – money has no intrinsic worth, but commands value only as a ‘claim’ on the products of the energy economy.  

In recent times, the prosperity calculus has become a constrained equation, in which the constraints are (a) the rising ECoEs of energy supply, and (b) the limits to environmental tolerance of the use of fossil fuels.

The only way of breaking out of these constraints would be to find an alternative source of energy which delivers low and falling (rather than high and rising) ECoEs, and can be utilized without causing environmental harm. Desirable though their expansion undoubtedly is, renewable sources of energy (REs) such as wind and solar power cannot meet these requirements. Their expansion, maintenance and replacement are dependent on legacy energy from fossil fuels, and their ECoEs are highly unlikely ever to be low enough to support current levels of prosperity, let alone allow for a resumption of “growth”.

As the following charts show, even the rapid expansion of RE capacity cannot be expected to do more than blunt the rate at which overall ECoEs rise. The pace at which global aggregate prosperity has been growing has decelerated markedly since we entered the precursor zone in the 1990s, and we are now at or very near the point where aggregate prosperity starts to shrink. Because aggregate prosperity growth has fallen below the rates at which population numbers have continued to increase, prosperity per capita has already turned down.      

As this ‘top-line’ measure of prosperity per person has turned downwards, the cost of essentials has continued to rise, in part because many necessities are at the high end of the energy intensity spectrum. This means that the discretionary (ex-essentials) prosperity of the average person in each of the Western economies is already under increasing pressure, as typified in the charts for Japan, the United States and the United Kingdom.

‘Essentials’ are defined here as the estimated total of household necessities and public services provided by the government. The British situation exemplifies the rising trend in essentials – taxes have had to be increased to fund public services (in the current instance, health and social care), whilst rises in the costs of electricity and gas reflect trends which can be expected to extend to other energy-intensive necessities, not just in Britain but across the world.

As well as a deterioration in prosperity which is adversely leveraged at the discretionary level, this situation also leaves us trying to support an ever-growing burden of financial commitments on a static and, in due course, contracting basis of aggregate prosperity.

The final set of charts illustrates this process with reference to the G23 countries which represent four-fifths of the global economy.

Since we entered the precursor zone in the 1990s, both debt and broader financial assets have grown much more rapidly than GDP. Output reported as GDP has itself been inflated by credit expansion, and now far exceeds both underlying output (C-GDP) and prosperity.

Measured against prosperity, both debt and broader liabilities have become unsustainably large, pointing towards either the ‘hard’ default of repudiation or the ‘soft’ default of inflationary devaluation.

Asset prices, meanwhile, have been driven to highly over-inflated levels, primarily because the prices of assets move inversely with the cost of money. We might suppose that asset prices will remain at inflated levels until the liability side of the equation reaches the nemesis of hard or soft default.

Examination of the precursor zone and the dynamics of falling discretionary prosperity do, though, suggest that another process might trigger asset price slumps. Equity markets are dominated by the suppliers of discretionary goods and services, which is likely to worry investors once they realise that the scope for discretionary consumption, already propped up by the continuity of credit expansion, is shrinking. At the same time, the affordability of property is linked to incomes on a post-essentials, credit-adjusted basis.       

#209. A path of reason, part two


In the previous article, we sought out a logical and evidential alternative to the continuity assumption that the economy can shrug off resource and environmental limitations in order to grow in perpetuity.

We demonstrated that the economy is an energy system – not a financial one – and that the fossil fuel dynamic on which the vast and complex economy of modern times was built is fading away, with no fully sufficient alternative in sight. The equation which calibrates prosperity in terms of energy use, value and cost has become a constrained equation, the constraints being (a) the relentless rise in the ECoEs of fossil fuels, and (b) the limits of environmental tolerance.

This does not, of itself, vindicate collapse theories, but it does mean that the world is getting poorer. The downturn in prosperity per person was preceded by a long period of deceleration, first identified (though not explained) in the 1990s, when it was labelled “secular stagnation”. Much of our economic experience in the intervening quarter-century has been characterized by failed efforts to use financial policies to ‘fix’ an economic problem which is not financial in nature, and thus cannot be countered using credit or monetary adventurism.

The onset of involuntary “de-growth” has profound implications for the four components of the economy which we can categorize as the household, business, government and financial sectors. Of these, the most important – and the easiest to project into the future using the SEEDS model – is the household sector. Simply stated, the average person will get poorer, on a continuing rather than a temporary basis, and his or her discretionary prosperity will be eroded by relentless rises in the real cost of essentials. At the same time, he or she enters this era with uncomfortably elevated levels of debt and quasi-debt commitments.

Through its effects on households as consumers, producers, savers, borrowers and voters, this process will shape the future development of the financial system, business and government.

The faith mistakenly placed in the ‘perpetual growth’ assumption has been strong enough to ensure that there has, thus far, been little awareness of, and even less planning for, the downtrend in global prosperity. Decision-makers in government, business and finance still seem to think that we can muddle through using denial, wishful thinking and a cocktail of things that Smith and Keynes didn’t actually say.

Financial – the high price of failed fixes

The immediate battleground for the conflict between continuity and reality is the financial system. Efforts to use financial policies to ‘fix’ the process of economic deceleration and decline have driven an enormous wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit. Between 2000 and 2020, each dollar of reported “growth” was accompanied by more than $3 of net new debt creation and an increase of nearly $4 in broader financial commitments – and even these numbers exclude the emergence of enormous “gaps” in the adequacy of pension provision. Buying $1 of largely cosmetic “growth” with upwards of $7 of forward financial promises is not a sustainable way of managing an economy.

This has put the authorities between the Scylla of runaway inflation and the Charybdis of sharp rises in the cost of money. To be clear, finance ministries can run enormous fiscal deficits, and central banks can monetize the ensuing increases in debt, but neither can create the new sources of low-ECoE energy without which the economy must contract.

When we understand money as a claim on the output of the real economy, it becomes clear that the rampant creation of money and credit can only result in the accumulation of excess claims. These cannot, by definition, be met ‘at value’ by a contracting economy. This means that the value supposedly incorporated in these excess claims must be eliminated, either through the soft default of inflation or the hard default of repudiation.                      

The conundrum facing the authorities is simply stated. If they continue with negative real interest rates, which deter saving and encourage borrowing – and if they carry on believing that ever-larger injections of stimulus can somehow return the real economy to “growth” – they will drive the system into an inevitable process by which inflation destroys the purchasing power of money.

If, on the other hand, they decide to defend the value of money by raising rates into positive real territory, they will trigger slumps in the values of assets, and set a cascade of defaults running through the system.

The current policy is one of ‘hoping for the best’, assuring the public that the current spike in inflation is a “transitory” phenomenon caused by the coronavirus pandemic.

There are two main reasons for knowing that this explanation is false. First, ‘we’ve heard it all before’. The term “transitory” is the 2021 equivalent of the promise that the introduction of QE and ZIRP back in 2008-09 were “temporary” and “emergency” expedients. The more direct analogy is with the 1970s, when inflation was deemed a “temporary” problem, and governments even introduced the concept of “core” inflation, which excluded those very items (energy and food) whose prices were rising most dramatically at that time.

The second factor arguing against the “transitory” description of inflation is that soaring prices take on a momentum of their own. Rises in the cost of living prompt demands for higher wages, which in turn raise producer costs and push prices higher. To a significant extent, inflation is a product of expectation, a form of self-fulfilling prophecy that gives the authorities a rationale for understating what’s really happening in an effort to damp down public expectations. This, though, cannot work when consumers can see the prices of goods and services rising. This time around, the long-standing inflation in the prices of assets reinforces perceptions of inflation at the consumer level.

Where the inflationary issue is concerned, we need to be clear about causation. The chain of events began with a deterioration in the energy equation which determines prosperity. The authorities sought to counter this deterioration in ways which have led, with grim inevitability, to where we are now.

The policy of ‘credit adventurism’ – of making debt more readily available than at any time in the past – started a rise in asset prices, and created a surge in debt. When these trends crystalized in the 2008-09 GFC, the authorities responded with ‘monetary adventurism’, taking the real cost of money into negative territory.

This boosted asset prices still further, and created yet more debt, much of it channelled through the shadow banking system rather than through the more regulated channel of mainstream banking. Now we are in the grip of reckless stimulus, being carried out in the desperate hope that injecting ever more deficit finance, and persuading central banks to monetize most or all of it, will somehow reinvigorate the real economy (which it won’t), without triggering runaway inflation (which it will).        

The outcome of the inflationary conundrum is likely to follow the pattern set in the late 1970s and the early 1980s. First, the authorities dismiss inflation as a passing phase, and refuse to raise rates to counter it. Latterly, they take a reluctant and belated decision to act, raising rates in a macho demonstration of resolve.

That’s when asset prices collapse, and a wave of defaults rips through the system.

Back in the 1980s, this process triggered a sharp recession, but this proved temporary, because ECoEs remained low, and the economy remained capable of growth.

Neither condition prevails today. ECoEs have risen from 1.8% in 1980 to 9.2% now. Recovery in the 1980s involved the restoration of positive trends which had driven prosperity steadily upwards between 1945 and the disruptive and inflationary first oil crisis of 1973-74. Today, by contrast, inflation risk comes in the context of a long period of economic deceleration which, in the West, segued into deterioration between 1997 and 2007.

The first set of charts illustrates the magnitude of financial imbalances, comparing debt – and broader financial assets, which include the shadow banking system – with reported GDP and underlying prosperity. Full financial assets data isn’t available for the global economy as a whole, so the left-hand chart illustrates a group of 23 countries for which numbers are available and which, between them, represent four-fifths of the World economy.    

Fig. 1

Households – leveraged hardship

In any case, the financial system faces challenges which are far broader than the comparatively straightforward (though daunting) choice between inflation and rises in rates. This is where trends in the critically-important household sector shape the outlook. 

The average person in the West has been getting poorer over an extended period, though this reality has been masked by financial manipulation. Trends in prosperity, set against debt per capita, illustrate this situation as it has affected France, Britain and Canada (see fig. 2). Debt, it must be emphasised, has to be considered in the aggregate, including the government and business sectors, not just household indebtedness. Even these debt numbers exclude per capita shares both of broader financial assets and of off-balance-sheet commitments such as the underfunding of pensions.

In France, prosperity per person reached its zenith in 2000, since when the average person has become poorer by 8% (€2,540), whilst his or her share of debt has increased by 91% (€59,500). The inflexion-point in Britain occurred in 2004, since when prosperity has fallen by £4,600 (16%) whilst debt per person has increased by £23,800 (39%). The average Canadian has become 12% poorer, and 60% deeper in debt, since 2007.

Fig. 2

One of the myths of the contemporary economy is that sharp increases in indebtedness are cancelled out by rises in the prices of assets.

The reality, of course, is that increases in the supposed value of property and financial assets cannot be monetized, because the only people to whom a nation’s property or asset stock can be sold are the same people to whom they already belong.

The individual property owner can monetize the gain in property values, but even he or she then needs to obtain alternative accommodation. But homeowners in aggregate cannot do this, and reported aggregate ‘valuations’ are an error rooted in the use of marginal transaction prices to put a ‘value’ on housing stock in its entirety. Essentially, asset prices are functions of the cost of money, and of the quantum of credit in the system. As the economy moves further into de-growth, and as the inflationary spiral has to be countered by raising rates, inflated asset valuations can be expected to melt away like snow on the first warm morning of spring.

The decreases in prosperity cited here may seem pretty modest – the average French person has become 8% poorer over twenty years, the average British person’s prosperity has fallen by 16% over sixteen years, and Canadian prosperity has deteriorated by 12% over thirteen years. People in these countries have, then, been getting poorer at rates at or below about 1% per annum.

In terms of living standards, though, these rates of deterioration have been leveraged by relentless increases in the cost of essentials. In the SEEDS model, the calibration of essentials remains at the development stage, where ‘essentials’ are defined as the sum of household necessities and public services provided by the government. The definition of ‘essential’ varies over time and between countries, such that essentials may defy detailed calibration.

This said, the overall picture seems clear. As prosperity has fallen, the share of prosperity accounted for by essentials has risen. Moreover, the real cost of essentials is being driven upwards, because the energy-intensive character of many necessities creates a linkage between their real costs and rises in ECoEs.

What this leverage means is that, over a twenty-year period in which French top-line prosperity has fallen by 8%, discretionary prosperity – what remains after essentials have been paid for – has slumped by 23%. British discretionary prosperity has fallen by 34% (rather than 16%) since 2004, and the decline of 12% in Canadian prosperity since 2007 has seen discretionary prosperity fall by 24% (fig. 3).

Fig. 3        

These sharp falls in discretionary prosperity have not been reflected in actual discretionary consumption – but the gap between the two (which SEEDS can quantify) has been filled by continuous expansions in credit.

In some sectors this effect has been a direct one, and few people now buy a new car, for example, as a one-off purchase. Households may borrow on their own account to pay for, say, a holiday, but the broader effect is that household credit increases are supplemented by government and business borrowing – the former reduces the tax burden on households, whilst, in the absence of business borrowing, employment and wages would be lower, and consumer goods and services would be either more expensive and/or less readily available.

Full circle

There is, of course, a direct connection between an over-inflated financial system and deteriorating household prosperity. As and when a halt has to be called on perpetual credit and broader financial expansion, discretionary consumption will slump.

This of itself will impact the perceived values of discretionary sector businesses, and this trend will be compounded as businesses respond to de-growth tendencies including de-complexification, simplification (of product ranges and processes), adverse utilization effects and the loss of critical mass. At the same time, households will be forced to relinquish many of the outgoings which form streams of income for the corporate sector.

Ultimately, there are adverse feedback loops which connect deteriorating prosperity with a degradation of the financial economy. At the same time, the public is likely to be distressed, not just by the loss of cherished discretionary products and services, but by the widening hardship which occurs as falling prosperity draws ever nearer to the rising cost of necessities. The implications of this dynamic for government and the corporate sector are certain to be profound, but these implications must await another stage in our journey from ‘what we know’ about the present to ‘what we want to know’ about the future.     

In the meantime, here’s a reminder – if a reminder were needed – of how rising ECoEs drive prosperity downwards in a way that is frighteningly not understood by decision-makers in government, business and finance.  

Fig. 4

#208. A path of reason, part one


Most of us, for one reason or another, want to know “what comes next”. There are many wrong ways of going about this. We can, for instance, take our expectations for the future ‘on trust’ from others, or we can simply assume (meaning hope) that the future will be what we want it to be.

The only effective way of forming rational expectations, though, is to follow a ‘path of reason’ from “what we know” (about the present) to “what we want to know” (about the future).

The original plan here was to try to encompass this within a single discussion. Practicality, though, suggests that we tackle this in two or three stages.

This first instalment starts with “what we know”.

This turns out to be rather a lot.

We know, for example, that the economy is an energy system. This knowledge identifies an equation which expresses the conversion of energy into material prosperity.

We know, further, that this is a constrained equation. The constraints on our conversion of energy into prosperity are set (a) by the physical characteristics of energy resources, and (b) by the limits of environmental tolerance.

This knowledge enables us to clear the ground by dismissing the fallacy of the infinite. Infinite growth isn’t feasible on a finite planet and within a finite ecosphere.

Far too much of our thinking, and far too many of our economic and broader systems, are based on this ‘infinity fallacy’. We assume, for instance, that economic growth can continue in perpetuity, and that a sustainable financial system can be built on this false assumption. We assume that businesses can offer perpetual expansion to their shareholders, and that governments can promise never-ending “growth” to their electorates.

We’ve reached a point at which the reality of constraint is discrediting the fallacy of the infinite. Environmental constraint is demonstrating itself to us with shocking force. Resource constraint has pushed us into a self-deluding falsification of economic “growth”.

Effective planning for the future requires recognition of the realities of constraint.       

At the end of certainty

As well as casting a long shadow over society and the economy, the coronavirus pandemic has created a remarkably extreme ‘dialogue of the deaf’ between competing certainties.

On the one hand, the authorities present vaccines as a ‘magic bullet’, whose efficacy and safety are questioned only by the anti-social and the deranged.

On the other, critics insist, with equal certainty, that the whole ‘covid and vaccine show’ is some kind of nefarious plot by malign agents of ‘the elites’.

Those of us who don’t have specialist knowledge of life sciences cannot determine where reality resides within this shouting-match. Even the experts may not, as yet, have all the requisite information.

But the extremes of the debate about the coronavirus are echoed in similarly extreme views on the economy, finance and government. On the economy, opinions range all the way from ‘assured growth in perpetuity’ to ‘imminent collapse’.       

We are entitled to be sceptical, in an impartial way, about certainties.

Excessive certainty, after all, is close kin to extremism, which has seldom served us well. Entrusting everything to the state worked out very badly in the Soviet Union. Handing everything over to ‘the market’ – or, in reality, to unfettered “animal spirits” – is turning out to have been an even bigger mistake.

It’s a reasonable presupposition that ‘all isn’t well’ in the economy, in finance, in government and in the broader categories of trust and social cohesion. 

To enquire further than this, it’s necessary to proceed by logical steps from what we know (about the present) to what we want to know (about the immediate and longer-term future).

From what we know

For those who like their conclusions up front, “what we know” can be summarized as follows.

First, the economy is an energy system, whose historic dynamic – fossil fuels – is winding down.

Second, we face severe environmental and ecological threats. These are linked to a significant extent to energy use, which means that our economic and environmental “best interests” are not opposed to each other but, rather, are connected dimensions of a shared predicament rooted in energy.

Third, the world is becoming more confrontational. Wars and revolutions, of course, are recurrent features of history, but a notable feature of modern times is internal antagonism, based in (and further contributing to) suspicions of the motives of others.

Our fourth problem is a widespread lack of understanding of these issues. This might be simple ignorance of the realities around energy, the economy and the environment. It might, alternatively, be some form of denial, in which groups of any size (ranging from ‘elites’ or governments to the public generally) don’t wish to understand, or choose not to accept, the reality of our economic and environmental predicament.

The energy dynamic

In reasoning from “what we know” to “what we want to know”, the place to start is with the economy as an energy system.

As regular visitors to this site will appreciate, the evidence for this interpretation is overwhelming. Apart from anything else, nothing of any economic utility at all can be produced without the use of energy. Interruption to the continuity of energy supply would, and over a pretty short period, result in economic collapse. 

Historical evidence affirms both this linkage and its causal direction. The exponential take-off in population numbers (and in their economic means of support) from the late 1700s paralleled a similarly exponential increase in the use of energy, the vast bulk of which, hitherto, has been sourced from fossil fuels.

Fig. 1

These exponential take-offs occurred from the 1770s, when ‘what changed’ was the development of the first efficient heat-engines, which enabled us to put coal, oil and natural gas to economic use. So the causal linkage is clear enough – access to fossil fuel energy drove population and economic expansion, not the other way around.

A second, parallel and important observation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This is the principle of ECoE (the Energy Cost of Energy).

We know this to be a factual observation because, at the most basic level, we know that we cannot drill an oil well, lay a gas pipeline, manufacture a solar panel or a wind turbine, or install an electricity distribution grid without using energy. Just as energy has to be used to create energy-accessing assets, further energy has to be consumed in their maintenance, and in their eventual replacement. ECoE, then, comprises both initial investment and subsequent upkeep.

These observations form an equation which, in principle, is comparatively simple.

Economic output is a function of the use of energy. The economic value derived from energy use is a function of the surplus energy which remains after the ECoE proportion has been deducted. The resulting material prosperity is a function of the number of people between whom this surplus energy value is shared.

To understand economic prosperity, therefore, we need to know about trends in (a) total energy supply, (b) the ECoE deduction and the residual surplus energy, and (c) population numbers.

In passing, any economic interpretation or model which excludes any of these three components is founded on a fallacy which renders it worthless.             

The realization of constraint

Recent times have seen the emergence of two constraints to continued reliance on fossil fuel energy.

The first of these constraints is the environment. We know that emissions from the burning of fossil fuels threaten to raise atmospheric temperatures, and we also know that “global warming” and “climate change” are short-hand for a much broader set of challenges. Pollution alone would be harmful, even if it wasn’t associated with temperature change. Ecological degradation is a consequence, not just of the use of oil, gas and coal, but of the economic growth made possible by fossil fuels.

We can accept, then, that fossil fuel consumption and broader economic expansion have moved us to a point of environmental and ecological constraint.

The second, less-recognized constraint is that the ECoEs of fossil fuels are rising relentlessly. This alone would, in due course, degrade and then destroy an economy wholly reliant on oil, gas and coal.

This means that the environment isn’t the only constraint on the use of fossil fuels. Anyone minded to oppose transition away from fossil fuels needs to be aware that, even if we were so unwise as to ignore environmental issues, rising fossil fuel ECoEs would, in any case, ultimately destroy the economy.

Put another way, those campaigning for greater environmental responsibility and a reduction in fossil fuel use have a “second string to their bow” in the form of ECoE.

The factors which drive ECoEs are – with one exception – reasonably well understood, and can be depicted as an ECoE parabola (see fig. 2).

In the initial stages of energy resource use, ECoEs are driven downwards by economies of scale and geographic reach. Once these drivers are exhausted, ECoEs are pushed back upwards by depletion, a natural consequence of using low-cost resources first, and leaving costlier alternatives for later.

Fig. 2

The limits of technology and the reality of the finite

The exception to general understanding of ECoE is the role of technology. In the energy sphere, positive technological progress involves improvements in the efficiency with which energy is accessed and put to use. This progress accelerated the downwards trend in ECoEs and, latterly, has acted to mitigate the rise in energy costs.

But there are two other things that we need to know about technology.

First, its scope is constrained by the laws of physics. Technology has, for instance, lowered the cost of extracting tight oil and gas in the United States, but it hasn’t transformed American shale reserves into the equivalent of the conventional resources of Saudi Arabia.

That this has been impossible illustrates that technology operates within the confines of the characteristics of the resource itself. We cannot, by ignoring these physical constraints, extrapolate past technological trends indefinitely into the future.

Second, most technology doesn’t help us to use energy more efficiently but, rather, finds more ways to put energy to use. This isn’t ‘bad’ in itself, but it can contribute to a mindset which both (a) exaggerates the potential of technology as a ‘fix’, and (b) disguises the important dimension of energy efficiency within the loose category of ‘technology for the sake of technology’.          

This consideration of constraints reminds us of another point which is too often forgotten. Economic growth, properly understood, is a matter of using the Earth’s resources to deliver material economic prosperity. These resources are not infinite.

We can debate the extent of the natural resources that were in place originally, and which remain today. These resources include energy, minerals and environmental tolerance.

What we can’t do with any credibility, though, is to claim that these resources aren’t, ultimately, finite. Any philosophy which ignores this reality, and which claims that economic growth can continue in perpetuity on a finite planet, is based on a fallacy of infinity.

The constrained equation

As we’ve seen, then, there’s an equation which relates energy use to the delivery of material prosperity. We’ve also seen that this is a constrained equation, whose limits are set (a) by resource characteristics (availability and ECoE-cost), and (b) by environmental and ecological boundaries.

Unfortunately, we’ve managed to disguise from ourselves the meaning, and even the existence, of this “constrained equation”. We’ve developed an economic philosophy which presupposes that “growth” can continue in perpetuity. We’ve allowed this infinity fallacy to influence our thinking about the world around us, and we’ve embedded this same fallacy into systems.

It’s important to be aware of the extent to which our economy and society are shaped by the “infinity fallacy”. Our financial system is entirely predicated on growth in perpetuity. Businesses, too, are conducted on the basis of a never-ending pursuit of expansion. Governments are assumed – by themselves and by the public – to have a mandate to deliver, in perpetuity, the ‘benefits of growth’.

Politicians and the public may, and do, argue about how growth should be used, and how it should be distributed between people and groups.

But nowhere – in finance, business, government or amongst the general public – is there any kind of preparation for an alternative to an assumed context of perpetual growth. If you ask a financier, a business leader or a politician about his or her plans if “growth” ceases – let alone if it goes into reverse – you’ll be met by a blank stare of incomprehension.

Everything that government, business and finance endeavours to achieve is informed by the assumption of growth. In response to environmental risk, proposals are almost always expressed in terms such as ‘green growth’, ‘responsible growth’, ‘sustainable growth’ and ‘equitable growth’.   

To use a hackneyed term, there’s no “plan B” for an ex-growth economy, let alone for an economy whose prior growth has gone into reverse.

The fallacy of the infinite economy

Proceeding step by step, we’ve learned a great deal that conventional thinking fails (or refuses) to encompass.

To recap, the energy economy provides us with a prosperity equation that is constrained both by resource characteristics and by the limits of environmental tolerance. It is further constrained by the ultimately finite character of the Earth, both as a ‘resource set’ and as an ecosphere.

At no point, in reaching these conclusions, have we needed to consider money.

Money itself is a human artefact. As such, the creation of money isn’t bounded by the physical finality that limits material economic activity. But the only value of money is as a proxy for material goods and services whose supply is subject to these limits.

We can study the operation of money, and this study yields certain worthwhile insights. But the findings which orthodox economics is pleased to call “laws” are, in fact, simply behavioural observations about money. They are not remotely analogous to the laws of physics. Economics, as conventionally understood, may or may not be “gloomy”, but it certainly isn’t a “science”.

The central fallacy of orthodox economics is that it portrays the economy as a monetary system, when the reality, of course, is that it’s an energy dynamic.

The misconception here is huge. Observation and logic inform us that economic prosperity is the product of a physical dynamic that is subject to constraint. Conventional economics seeks to persuade us, instead, that the economy is an immaterial system shaped by the use of the unlimited human artefact of money.

As well as being a misconception, this is also a conceit. If it were true that economic activity was wholly a product of the use of money, then we, as the creators of money, would be in full control of what might grandiloquently be called our ‘economic destiny’.

Our actual position is a more modest one, in that our degree of control is strictly circumscribed by physical factors that we can’t control.      

The human artefact of money is claimed to have three qualities. However, it’s an extremely poor ‘store of value’, and how well it functions as a ‘unit of account’ really depends on what it is that we’re trying to quantify.

The fundamental role of money is as a ‘medium of exchange’. Exchange, of course, is a process that depends upon there being something that people are able and willing to exchange. This is why no amount of money, in any form, would be of the slightest use to somebody lost in a desert, or cast adrift in a lifeboat.

Money, then, is validated by exchange, and the “something” for which it can be exchanged is the material value provided by the energy economy.       

What this in turn means is that money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the energy economy.

To be clear about this, our control over the supply of money and credit enables us to create financial ‘claims’ that exceed the current or future delivery capability of the economy itself. When we do this, we create excess claims.

When we assign the concept of ‘value’ to the aggregate of claims, we create a situation in which the excess component of this supposed ‘value’ must be destroyed. This value destruction can take the form of repudiation (otherwise called hard default), or of the inflationary erosion of the value of money itself (soft default).

It has to be one, or both, of the above because, by definition, excess claims cannot be honoured, which means that supposed ‘value’ attached to these excess claims must be eliminated.      

Of two economies

Given the relationship that exists between the constrained equation of the energy economy and the seemingly unconstrained scope for creating monetary claims, it’s helpful to think in terms of ‘two economies’ – the ‘real’ economy of goods and services, and the proxy or ‘financial’ economy of money and credit.

An understanding of the interface between the energy and the financial economies is critical to effective interpretation of the economy that we see around us.

This interface isn’t addressed by orthodox economic interpretation, because conventional economics is based on the false assumption that money is the economy. The objective of the SEEDS economic model is to understand the economy as an energy system, but to present conclusions in the financial idiom in which, by convention, economic issues are debated.

SEEDS analysis indicates that, in the advanced economies of the West, growth in energy-based economic output slowed during the 1990s, and went into reverse in the first decade of the twenty-first century. Modelling of the constrained equation indicates that prosperity per capita turned down in Japan from 1997, in America from 2000, and in Britain from 2004.

These inflexion-points correlate with the rise of trend ECoEs into a range between 3.5% and 5.0%. By virtue of their lesser complexity and their correspondingly lower system maintenance requirements, the equivalent climacterics for EM (emerging market countries) occur at higher levels of ECoE, levels which SEEDS places between 8% and 10%.

The downturn in prosperity which impacted the West between 1997 and 2007, then, isn’t something from which EM countries are immune. Rather, their inflexion-points happen in the same way, but at a later stage on the ECoE curve. 

The relationship between ECoEs and prosperity per capita – in America, China and globally – is illustrated in fig. 3.

In the United States, prosperity per person turned down after 2000, when trend ECoE was 4.5%. The equivalent climacteric in China is projected to occur in 2026, when China’s ECoE is likely to be just below 10%.

For the world as a whole, prosperity has been on a long plateau, reflecting the interaction between Western countries (where people have been getting poorer over a lengthy period) and EM economies (where prosperity has continued to improve).

Perhaps the single most important economic event of our times is the ending of this plateau and the onset of de-growth on a global basis.   

Fig. 3

Exercises in denial

Recognition of this energy-constrained reality was, and remains, denied to those who believe in the infinity fallacy born of the mistaken assumption that the economy is a wholly monetary system. When deceleration – then labelled “secular stagnation” – started to be noted during the 1990s, the natural (though wholly mistaken) assumption was that there must exist a financial ‘fix’ for this unwelcome trend.

Briefly, the history of the intervening period is that the authorities tried, first, to restore growth by pouring abundant credit into the system, a process known here as credit adventurism. The fallacy here was the assumption that the creation of demand must, by some immaterial process, be met by increased supply, an assumption which is invalid in any situation governed by material constraints.

When, as was always inevitable, this gambit took the credit (banking) system to the brink of collapse, a resort was made to monetary adventurism. This process threatens to do to money what credit adventurism so nearly did to the banking system.

The policy of pricing money at sub-zero real levels has had a string of consequential effects. One of these has been an escalation in debt, and another has been rapid growth in the shadow banking system, known more formally as the ‘non-bank financial intermediation’ sector.

Over the past twenty years, we’ve been using credit and monetary policy to ‘buy’ economic “growth” at an adverse rate of exchange. Each dollar of “growth” reported since 2000 has been accompanied by more than $3 of net new debt, and by getting on for $4 of broader financial liabilities. Even these metrics exclude the emergence of huge “gaps” that have emerged in the adequacy of pension provision.

Using SEEDS, we can quantify the deterioration in prosperity, identify the correlation between rising ECoEs and the inflexion-points in underlying economic activity, and map the relationships between liabilities and the maintenance of a simulacrum of “growth”.

But the central issue here is the widening gap between (a) the real economy (of energy, value and prosperity), and (b) the proxy financial economy and its excess claims against non-existent future economic value.


Any article with the professed aim of preferring reasoned interpretation over received certainties must leave readers to determine how sure we can be about the conclusions that are reached here.

This said, there is very substantial evidence – logical and observational – for the proposition that the economy is a physical dynamic, driven by an energy equation that we can identify, and limited by the constraints both of resource characteristics and of environmental tolerance.

We can observe, too, that there is a general ignorance around this proposition, and an insistence, instead, on perpetual growth, driven by the immaterial processes of money within a context of assumed infinity.

If our interpretation is correct, then there exists a serious disconnect between the economy as it is and the economy as it is mistakenly assumed to be. A misunderstanding as fundamental as this goes quite far enough to explain the insistence on assumed certainties in the context of the emergence of a very different reality.    


#207. Could the dollar crack?


How big is the Chinese economy? On one level, that question is easily answered – last year, China’s GDP was RMB 91 trillion.

For comparative purposes, though, what’s that worth in dollars? Authoritative sources will tell you that China’s dollar GDP in 2020 was $14.7tn. Those same sources will also inform you that it was $24.1tn. That’s a huge difference. On the first basis, the Chinese economy remains 30% smaller than that of the United States ($20.9tn). On the second, it’s already 15% bigger.

The explanation for this very big difference lies, of course, in the two ways in which economic data from countries other than the United States can be converted into dollars. One of these is to apply average market exchange rates for the period in question. For convenience, we can call this market conversion.

The alternative is PPP, meaning “purchasing power parity”. To apply this conversion, statisticians compare the prices of the same products and services in different countries. (One such common product is a hamburger, which is why, in its early days, PPP was sometimes called “the hamburger standard”).

The differences between market and PPP calibrations of GDP are enormous. Last year, world GDP was $85tn on the market convention, but $132tn in PPP terms. At the same time, the use of PPP conversion diminishes America’s share of the global economy. Last year, the United States accounted for 25% of global GDP in market terms, but only 16% on the PPP basis.

Using PPP instead of market conversion doesn’t make the economy ‘bigger’, of course. It just means that a higher dollar value is ascribed to economic activity outside the United States.

There’s no ‘right’ or ‘wrong’ way of converting non-American economic numbers into dollars. To a certain extent, it’s case of selecting the convention best suited to the topic being examined. Market conversion is appropriate for transaction values, such as trade, and cross-border assets and liabilities. PPP provides a better measure of the comparative sizes of economies around the world. (The SEEDS economic model produces parallel output on both conventions, though with a preference for PPP).

For macroeconomic purposes, the PPP convention is arguably more meaningful than market conversion, because it better reflects the economic scale of countries like China and India. Additionally, it leaves both market sentiment and short-term vicissitudes out of the process. PPP conversion has been with us for decades, and is carried out by reputable authorities, such that we can accept it as a valid and consistent alternative basis of currency comparison.

Market rates are determined by many factors other than economic comparison. FX market players have multifarious reasons for liking or disliking various currencies. Their opinions do not constitute economic ‘facts’.

An obvious example here is the reaction to the “Brexit” vote. British citizens obviously didn’t wake up 20% poorer on the morning after the referendum, but that’s what market dollar valuation of the UK economy implied. By the same token, market-rate conversion asks us to believe that the economy of resource-rich Russia is a lot smaller (at $1.4tn) than that of Italy ($1.9tn).

People in Russia, China, India and elsewhere are not poorer because FX markets don’t, relatively speaking, like their currencies. Currency undervaluation against PPP equivalence does make these countries’ imports more expensive, but it also gives their exports a competitive advantage.

Benchmarking the market dollar premium

For present purposes, the importance of having two FX conversion conventions is that it enables us to benchmark the dollar itself. Using world economic data going back over four decades, we can examine the relationship between the PPP and the market valuations of the dollar.

In 2020, for example, the GDP of the world outside the United States (WOUSA) was $63tn on the market basis, but $111tn in PPP terms. From this we can infer, either that market conversion undervalues the WOUSA economy, or that the market dollar trades at a premium to its PPP equivalent.

For convenience, we can call this difference the market dollar premium, and calculate the ratio for 2020 at 1.74:1. Put another way, the market dollar commanded a 74% premium over the PPP dollar last year.

There’s nothing abnormal about the dollar enjoying a valuation premium over other currencies. The dollar’s pre-eminence can be traced back to 1945, when America accounted for half of the global economy, and was the world’s biggest creditor. The dollar, after all, is the world’s reserve currency, and the benchmark against which other currencies are measured. Most oil trade continues to take place in dollars, providing a ‘petro-prop’ for the USD, because anyone wanting to purchase oil must first buy dollars.

This being so, it’s no surprise that PPP comparison reveals a market dollar premium.

What’s interesting, though, is the upwards trend in this premium.

In 1980, it stood at 30%.  It reached 40% in 2001, and 50% during 2005-06. The market dollar premium reached 60% in 2009, and 70% in 2015. Based on consensus projections, the premium is expected to carry on rising, from 74% last year to 79% by 2026. Perhaps most strikingly, the dollar premium is twice as big now (74%) as it was in 1999 (37%).

Does the market’s attachment of a widening premium to the dollar make economic sense? It’s at least arguable that it doesn’t. Quite aside from the rise of economies such as China – and America’s falling share of world GDP – there are reasons to suppose that the economic pre-eminence of the United States is eroding, and that the market dollar premium, far from widening, should be contracting.

The most obvious negatives for the market dollar premium are to be found in the fiscal and monetary spheres. Starting in 2008, the Fed has operated monetization policies on a gargantuan scale, lifting the Fed’s assets from $0.8tn in June 2008 to $8.1tn today. Interest rates have been below any realistic estimate of inflation since the 2008-09 global financial crisis (GFC) and, with inflation now rising, are negative to the tune of at least 4.0%, and probably more. With the administration seemingly addicted to fiscal stimulus, and with the Fed apparently willing to go on monetizing deficits, these trends seem set to continue.

Scaling back or reversing QE – or, for that matter, raising rates to head off inflation – would prompt a greatly-amplified repeat of the 2013 “taper tantrum”, and tightening monetary policy could harm the US economy, would trigger sharp falls in asset prices, and would push up the cost of government borrowing. Neither monetization, large scale money creation or negative real rates can be considered positive for the value of a currency.

There’s a clear danger, then, that the US could push the dollar’s “exorbitant privilege” too far.

Meanwhile, the Fed also has to be mindful of the shadow banking system, sometimes called “non-bank financial intermediation”. This isn’t the place for a detailed consideration of shadow banking, but the system resembles an inverted pyramid, with very large assets (which have been put at $200tn) resting on a narrow base of collateral. Government bonds in general, and American bonds in particular, play a central role in this collateral.

Simply stated, a battle royal is likely to be waged between not-so-“transitory” inflation, on the one hand, and, on the other, pressing reasons for not raising the cost of money. 

This might not matter all that much if the market dollar premium hadn’t risen as far as it has. The use of PPP for benchmarking isn’t common practice, but the calculations required for calibrating the market dollar premium aren’t exactly rocket-science – and the implications of this calculation are stark.        

The conclusion seems to be that the dollar now trades at a more-than-exorbitant premium to other currencies – just as America is getting mired in a tug-of-war between stimulus and inflation.