#226. The siblings of misunderstanding

TRUSTING TINA, FEARING TINAR

Though they would be the last to admit it, governments no longer have economic strategies worthy of the name.

On the single most serious economic challenge of the day – which is the escalation in “the cost of living” – the cupboard of answers is bare. What remains is a vague, fingers-crossed faith in continuity, reinforced by pious hopes that energy transition and technology will somehow reverse the palpable decline in public prosperity.

Ultimately, the only thing that now props up the orthodoxy – and similarly both supports artificially-inflated markets and stands in for the lack of a persuasive sense of direction – is TINA, the acronym for There Is No Alternative.

TINA may not seem particularly rational – until, that is, you meet TINAR.

Passing the buck

In economic terms, there’s nothing altogether new in this situation, since governments largely abdicated from economic policy back in 2008-09 when, during the GFC (global financial crisis), responsibility for the parlous state of economic affairs was dropped into the laps of central bankers.

Given what faces them now, these worthies might well wish that they could hand this burden back to the politicians. If central bankers don’t raise interest rates sufficiently, the inflationary spiral could very well get out of control. If, on the other hand, rates are hiked significantly, impairing the affordability of debt and stemming the flow of new credit, the consequences will include a major recession and a slump in asset markets.

Either way, the implications are so stark that not even the most Pollyanna-accredited optimist could spin them as ‘just a temporary problem’. 

Monetarily, by far the likeliest outcome is an unsatisfactory compromise. Western central banks’ policy rates might rise to, say, 3% or a bit more by the end of this year, by which time inflation could easily be into double digits.

Nominal interest rates (which determine how much borrowers actually have to pay) are thus set to rise, whilst real (ex-inflation) rates may simultaneously plumb new depths of negativity, worsening the economic distortion that this long-established anomalous condition has already created.  

The predicament of the ‘average person’ should be front and centre of any assessment of the economic situation. His or her discretionary prosperity is being compressed by the way in which the cost of essentials is rising much more rapidly than incomes. He or she is already heavily in debt – particularly so when per capita shares of government and corporate indebtedness are added to direct household debts – and faces the consequences of sharp increases in the nominal cost of credit.

One should not pick out any single government in this generalized crisis, but British policy does typify the bafflement of the authorities. The partial solution to painfully dramatic rises in energy bills is seen as a system of loans. The longer-term fix is presented as an expansion of renewable energy sources (REs), such as wind and solar power, with the possible inclusion of ‘fracking’, and of a renewed commitment to nuclear.

Neither solution can be expected to work.

Reliance on loans must reflect an implausible assumption that the cost of domestic gas and electricity will, somehow, and of its own accord, fall back to some kind of “normal”. Not even its most optimistic advocates, in Britain or anywhere else, claim that energy transition can reduce the burden on households in other than the long term.  

In these circumstances, it’s not unreasonable to assume that public dissatisfaction is likely to worsen, fostering increasing suspicion that the system is somehow loaded against the “ordinary” person.

This suspicion might or might not be well-founded, but it should not induce us to believe that governments have answers which only malign intent prevents them from enacting.

The fact of the matter is that governments have no solutions, palatable or otherwise, to a generalised deterioration in prosperity.  Still less have they solutions to the broader implications of prior economic growth going into reverse.

Explanations are not solutions

Since its inception, this site has had two objectives. The first has been to explore and refine the principles of the economy understood as an energy dynamic rather than a financial system.

The second has been to find out whether these principles could be incorporated into an economic model providing an improved interpretation of the present and the recent past, and an enhanced ability to forecast the future.

The basis of principle has been set out in one recent article, whilst projections produced by the SEEDS economic model have been outlined in another. April is a month particularly replete with new data, but it’s highly unlikely that the next iteration of the model (SEEDS 23) will reveal any significant shift in future trends that can now be predicted with a pretty high degree of confidence.   

At no point has it been anticipated here that the energy basis of the economy would prompt a serious re-think of the money-based economic orthodoxy, still less that decision-makers, in government or beyond, would accept a reality based on the emerging evidence that the economy is an eroding energy system, subject to material constraints, rather than an entirely financial one, capable of delivering ‘infinite growth on a finite planet’.

Even the acceptance of environmental constraint has been gradual and reluctant, leading largely to policy prescriptions chosen far more for their acceptability than for their practicality. Acceptance of economic limits would be a bridge too far, not just for decision-makers but for the general public as well.

The best that can be hoped for – at least until conditions become far worse – is shadow appraisal of the implications of the orthodoxy turning out to be mistaken. Scenario planning is helpful, in that it can build preparedness for the worst without requiring the adoption of that worst as a declared basis of policy.

Trust TINA

With the logical and empirical foundations of the continuity presumption falling apart, the best things that the orthodoxy has going for it now are two versions of TINA.         

In its economic dimension, TINA applies to a long-established penchant for buying time in the hope that ‘something will turn up’. Faced with the demonstrable failure that was the real lesson of the GFC, the decision was taken to compound credit with monetary “adventurism”.

Nobody seemed unduly troubled, either by the moral hazard thus unleashed or by the contradiction involved in trying to run a capitalist system without the essential pre-requisite of positive real returns on capital.

Hopes now are pinned on the proposition that rates can be raised by enough to tame inflation without either crashing asset prices or triggering a severe recession.

This situation confronts investors with a TINA of their own – the prices of equities, bonds and property may look extremely over-inflated, but, with rates deeply negative and likely to become more so, the only alternative, which is to be cash-long, is the sole sure way of losing money,

Put another way, deeply negative real returns on cash are now the only prop standing in the way of a market slump.

A cupboard empty of answers

The political version of TINA is the absence of a persuasive alternative to the ‘liberal consensus’ that has been in place since the start of the 1980s.

Even where they are in opposition rather than in government, centre-Left parties propose no systemic alternative to the precepts of economic policy that have been accepted since the interventionist, mixed-economy model seemed to fail in the 1970s, and the Soviet version of collectivism actually did fail at the end of the 1980s. 

Cassandra-style prophecies of collapse have zero appeal to the public, whilst conspiracy theories deter far more voters than they can ever persuade.  

This situation is, of course, inherently unstable.

Where markets are concerned, there are limits to how long the downside in discretionary sectors can be ignored by equity investors, and to how long the bond markets can dismiss rate pressures as nothing more than a short-term irritant. The relentless compression of affordability, and the inevitability of a rise at least in nominal rates, have unmistakable implications for property.

Politically, too, there are limits to quite how much hardship voters will accept without putting some tough questions to TINA. The tax base is being squeezed, because the only part of the economy that can really be taxed in a net-positive way is the margin that exists between top-line prosperity and the cost of necessities. There really is no practical mileage in taxing people to the point where hardship requires the hand-back of taxes through welfare.

Given the absence of alternatives, governments cannot really be criticised for a Micawberism which promises, and simultaneously hopes, that “something will turn up”, even if that “something” gets ever less realistic as time goes by.

The magic of monetary manipulation, and the alchemy of technology founded in denial of the laws of physics, may look implausible even to those most minded to put faith in them, but – yet again – the ‘rule of TINA’ applies.

It’s all very well to understand that the accessibility and affordability of essentials are the political battlegrounds of the future, but there are serious obstacles to an early recognition of this reality.   

As the soldier is supposed to have said in the First World War, “if you know a better fox-hole, go to it!”

The evil twin

In this situation, prognosis can become more than just unpopular, if prognosis lacks an effective prescription.

As just one example, the lack of practical alternatives means that, whilst the political Left might advocate imposing ever greater taxation on ‘the rich’, such proposals ignore the fact that much of the supposed wealth of the wealthiest is a notional product of market distortion, and cannot be monetized into taxable cash. 

We can reasonably infer that there can be no soft landing from a choice between market collapse and soaring inflation, and that the public cannot be expected to go on buying implausible long-term answers to worsening short-term economic hardship.

We are, likewise, at liberty to produce reality-based assessments of the present, and to set out probable trends in the future. We can demonstrate, for instance, that most of the “growth” of the past twenty years has been cosmetic, that prosperity is already in relentless decline, and that rises in the real costs of energy-intensive necessities are strangling the scope for discretionary consumption. We can point out that monetary policy has been driven into a cul-de-sac, and that there is no policy ‘fix’ that avoids both the Scylla of inflation and the Charybdis of recession.

How, though, does any of this help those burdened with responsibility for decisions?

We can go on to draw reasonable inferences, which include the probability that asset price delusions will fade away, and that popular patience may not much longer survive the solvent of worsening hardship.

None of this, though, offers a palatable alternative to TINA.

It might seem almost heartening that, in the absence of logic and evidence, TINA has become the sole prop retained by the consensus “narrative”.

We need to beware, though, that TINA may have a far less forgiving sibling, with the confusingly-similar acronym TINAR – There Is No Acceptable Reality.               

In other words, popular expectations may become ever more entrenched, and public demands ever more strident, even as the wherewithal for satisfying them ebbs away.           

#225. Gravitational pull

MANAGING THE REALITY OF ‘LIFE AFTER ORTHODOXY’

A new ‘heavenly body’ has entered the cosmology of political and corporate decision. This new influence is the emerging reality that the economy is turning out, after all, to be an energy system, and that long-accepted ideas to the contrary are fallacious.

The concept of limits is replacing the paradigm of ‘infinite growth’.

Where decision-making is concerned, this emerging reality isn’t likely to have an immediately transformational effect. Established nostrums can have a tenacity that long out-lasts the demonstration of their falsity.

We’re not, then, about to see sudden, open and actioned acceptance of the fact that the economy is an energy rather than a monetary system.

Rather, we can expect to see energy reality exert an increasing gravitational pull on the tide of decisions and planning, most obviously in government and business. Policy statements may not change, but the thinking that informs planning and strategy undoubtedly will.

This gravitational effect is starting, as of now, to re-shape perceptions of the present, change ensuing “narratives” of the future, and trigger a process of realignment towards the implications of a world with meaningful constraints.        

The aim here is to examine the practical consequences of a contest of interpretations which, whilst it has already been decided at the theoretical level, leaves ‘everything to play for’ in political and commercial practice.

And then there was one

There are, essentially, two ways in which we can seek to explain the working of the economy.

One of these is the conventional or orthodox school of thought, which presents economics as a process determined by the behaviour of money, and acknowledges no limits to the potential for growth.

For the best part of nine years, this site has endeavoured to encourage, explore, model and quantify the alternative interpretation, which states that prosperity is a product of the use of energy, and that there are very real resource and environmental limits to economic expansion.

There are two ‘adjudicators’ of this debate. One of these is logic, and the other is experience.

Logic has always favoured the energy interpretation. The concept of material constraints is not remotely a new one. A notable milestone in the exploration of this thesis was The Limits To Growth, which was published back in 1972, and is now looking remarkably prescient. Hitherto, though, LtG and similar theses could be, and have been, dismissed as theoretical rather than practical challenges to the orthodoxy. 

What’s different now is that experience is in the process of confirming the verdict of logic.

In fact, the only thing that the orthodox explanation still has going for it is ‘custom and practice’.

Readers will not misunderstand me if I state that, at the purely intellectual level, this contest is ‘all over bar the shouting’ (though there will be plenty of that).

What lies ahead is a process of adjustment – we might call it realignment – to the new reality of an economy in which the scope for expansion is constrained by limits, both to energy value and to environmental tolerance.

Policy-makers and business leaders may have grasped the latter constraint, but have still to discover the reality of the energy limits to prosperity.

So here’s the question. If you were a decision-maker – in government, say, or in business – what would you do if you knew that the consensus “narrative” of our ever-expanding economic and broader future was heading into the blender?

Theory and narrative, #1 – money and myth

In essence, orthodox theory states that the economy can be explained entirely in terms of money.

The “laws” of economics are not, in fact, analogous to the laws of science. Rather, they are observations about the behaviour of money.

The central conclusion of this orthodoxy is that there need be no limits to economic growth, because the driver of expansion is under our control as the creators and managers of money.

Monetary causation enables us to use pricing, incentives and demand to circumvent all material limitations.

A more recent refinement of this theme combines technical innovation with monetary management to assure us that all material limits can be circumvented, through technology and monetary management, such that ‘growth in perpetuity’ is perfectly feasible, and can be used as a reliable forward presumption.

To use the contemporary idiom, what follows from this is a “narrative” of a perpetually-expanding economy.

Where planning and projections are concerned, this narrative is emphatically directional, flowing from assumed growth to everything else that we want to anticipate.  

Here’s what this means in forecasting terms.

Planners and forecasters start with – and tend seldom to question – assumptions about the future size of the economy. If, for instance, we accept a trend real annual rate of growth of 3.5%, simple mathematics tells us that the economy will be twice as big in, say, 2040, as it was in 2020. If we assume trend growth of only 3.0%, growth over that period is 80%. At 4.0%, it will be 120%. 

With this presupposition in place, only then do they calculate what this is going to mean in practical terms. If we know that the economy will be, say, X% larger in 2040 than it is now, it can be calculated that the need for energy, for instance, will have expanded by Y%.

If it is further assumed that we need to reduce our use of fossil fuels by Z% over that same period, what remains is a non-fossil market of predictable size, requiring to be filled, in varying possible proportions, by nuclear power, hydroelectricity and renewable energy sources (REs).

This ‘start with growth’ process of calculation delivers the narrative of seamless energy transformation, ever-expanding prosperity, and a billion vehicles powered by batteries or hydrogen.

Theory and narrative, #2 – resources and reality

The alternative thesis reasons from entirely different predicates. Instead of assuming that future energy requirements are a function of assumed economic expansion, our understanding is that prosperity is a function of the availability of energy value.

If we happen to agree that the availability of energy value might indeed conform to the Y% number calculated by growth-predicated forecasts, we might also agree that the economy will be X% bigger by the target date.

The sequence of reasoning, though, is entirely different. It operates in the opposite direction.  

In the simplest of terms, conventional forecasting assumes that Y (energy demand) is a function of X (economic growth). The alternative is to restate this as X (economic growth) is a function of Y (energy availability).

The energy approach to economics starts with recognition that the economy is an energy system, because nothing that has any economic utility at all can be provided without the use of energy.

Pausing only to dismiss the quaint notion (the “haystack without a needle”) that the economy can somehow be “de-coupled” from the use of energy, we move on to introduce a second predicate, which is ‘the principle of ECoE’.

This recognizes that, whenever energy is accessed for our use, some of this energy is always consumed in the access process. In Surplus Energy Economics (SEE), this ‘consumed in access’ component is known as the Energy Cost of Energy (ECoE), and is expressed as a percentage.

Importantly, energy cannot be used twice. This means that the proportion of total energy supply absorbed as ECoE cannot also be used for any other economic purpose.

This in turn means that material economic prosperity is a function of the availability of surplus (ex-ECoE) energy. 

This makes it vital that any process of interpretation and projection starts with an examination of the trend in ECoEs from the various sources which constitute energy supply.

We know that ECoEs are shaped by geographic reach, economies of scale and the process of depletion. With the potential of reach and scale now exhausted, depletion has become the factor driving the ECoEs of oil, gas and coal.

To be sure, technology acts favourably, accelerating falls in ECoEs when these are declining, and mitigating rises when trend ECoEs are increasing.

Critically, though, it is self-evident that the potential of technology is circumscribed by the limitations of physics, which in this case means the material characteristics of energy resources. 

This understanding is critical, because it takes the potential of REs out of the realm of wishful thinking, and requires us to accept two limitations to the potential economic value of renewables.

First, we know that the resources required for the creation and maintenance of RE capacity are products of the legacy energy provided by oil, gas and coal. This means that the trajectory of the ECoEs of renewables is linked to that of fossil fuels.

Second, we also know that REs have their own constraints, most obviously the Shockley-Queisser limit to the theoretical maximum efficiency of solar power generation, and the Betz’ law equivalent for wind power.        

We further recognize that ECoEs affect both the delivery costs and the affordability of energy. This means that ECoE trends determine, not just the qualitative nature of available energy, but the quantitative issue of supply.

The last of our three principles – otherwise known as “the trilogy of the blindingly obvious” – is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services made available by the material economy of energy.

Money can be defined as “a human artefact, validated by exchange”.

On this basis, we arrive at the transformative conception that there are two economies. One of these is the proxy or financial economy of money, credit and assets. The other is the material or real economy of goods, services, labour and energy.

With this understood, our ‘control’ over the creation and use of money ceases to endow us with the ability to drive infinite economic growth. It becomes, instead, nothing more than an ability to manage one side (the financial part) of a ‘two economies’ equation determining the relationship between money and material prosperity.

On this basis, the creation of money in its various forms can outgrow the underlying economy, but this process simply creates what are known in SEEDS terminology as “excess claims”.

Much of our recent economic and financial experience can be explained as the creation of ever more abundant excess claims which, by definition, cannot be honoured ‘for value’ by a smaller underlying or ‘real’ economy.

The contemporary financial system is at severe and worsening risk because of the gargantuan scale of the ‘excess claims overhang’ that has been created on the false assumption that the creation of money and credit in their various forms (known to conventional economics as “demand”) can somehow expand the real economy of goods and services.                            

A future redefined

Applied using the SEEDS economic model, these principles point to a very different future, and, for that matter, present a very different past and present, from those described by orthodox economics.

This, of necessity, results in a very different forward “narrative”.

The following charts provide a snapshot of the interpretation provided by SEEDS (the Surplus Energy Economics Data System).

The left-hand chart shows how, as trend ECoEs have risen relentlessly, average world prosperity per person has plateaued, and has now turned downwards.

At the regional level, prior growth in prosperity has long since inflected in the advanced economies of the West, whilst less complex, less ECoE-sensitive EM (emerging market) countries have continued to enjoy improving prosperity, albeit at a steadily decelerating pace.

Meanwhile, and as the middle chart shows, the real cost of essentials has continued to rise, in large part because so many necessities are energy-intensive.

This process has initiated severe compression of the SEEDS metric of prosperity excluding essentials. PXE is a measure of the affordability, in aggregate, of (a) discretionary (ex-essential) consumption, and (b) capital investment in new and replacement productive capacity.    

Finally, where these overview indicators are concerned, an enormous gap has emerged between the financial and the real economies, such that the economy of goods, services and energy is now about 40% smaller than its financial proxy of money, credit and assets.

You will appreciate that, because prices are the interface between the real and the financial economies, inflation is a natural consequence of this divergence or, rather, of the pressures that operate towards the restoration of equilibrium between the two economies.

You might, indeed, wonder why – more than thirteen years on from the adoption of supposedly “temporary” expedients such as QE and ZIRP – inflation hasn’t accelerated before now.

Part of the answer lies in the systemic understatement of inflation by conventions which, amongst other quirks, exclude asset price rises from a definition of inflation which concentrates on – and, even then, understates – changes in consumer prices.

The SEEDS calculation of the Realised Rate of Comprehensive Inflation (RRCI) indicates that, over the two decades between 2000 and 2020, systemic inflation averaged 3.5% annually, far higher than the official rate of 1.5% over that period.   

Fig. A

“The future’s not what it used to be”

What we have been describing is a process of divergence which has driven a wedge between a ‘real’ economy (shaped by the energy dynamic) and a ‘financial’ economy (whose size is determined by monetary policy).

This explains a great deal that, from an orthodox perspective, seems baffling. It warns us that a major correction looms between the ‘two economies’, a correction that must involve financial ‘value destruction’ as a consequence of the elimination of ‘excess claims’.  

As we have seen, the contemporary consensus narrative rests on the false premise that we can start with assumptions about future growth and then predict what can be expected to happen in numerous categories of forward outcomes.

Uncovering the false premise – and the ensuing fallacious direction of reasoning – of the consensus narrative acts in a way that might be likened to taking out the bottom brick of a speculative wall.

For example, once we know that future prosperity is a function of energy trends rather than the other way around, we know that we cannot assume that the supply of renewable energy somehow ‘must’ expand in conformity with what growth assumptions supposedly tell us about the scale of energy supply in the future.

Reasoning in this opposite direction has a liberating effect on thought processes. This realization enables us to place into the equation factors which conventional thinking has been forced to ignore, or to treat as anomalous and inconvenient.

We are now at liberty to recognise that each rise in the price of fossil fuels, whilst it increases the cost of using conventional cars and commercial vehicles, also raises the price of all of those materials (including steel, concrete, copper, lithium and cobalt) that are required for energy transition.

We can place the undoubted environmental downsides of this transition into a broader context. We can take cognisance of the fact that the ECoEs of renewables are linked to those of fossil fuels through renewables’ reliance on resources which can only be made available by the legacy energy provided by oil, gas and coal.

What had previously been nagging reservations – such as the resource and investment demands of renewables, the Shockley-Queisser limit, Betz’ law, doubts about how “green” renewables really are, and so on – can now find their appropriate places in a broader understanding of energy, the economy and the environment.

Accommodating gravitational effect

What we’ve been doing here is following a logical process to a point at which a raft of consensus assumptions about the future turn out to have been the products of mistaken assumptions.

Though the theoretical approach is essential, what matters in practical terms is that this interpretation is being borne out by the trend of events. Its consequence is an invalidation of all of the preconceptions which inform the “consensus narrative” of our economic, financial, political and broader future.

If you’re in government, it tells you that future resources are going to be far less than you might hitherto have assumed, and that the provision of essentials is set to become the critical battleground between competing priorities.

If you’re in business, it tells you that we cannot rely on growth, least of all in discretionary sectors, and that the scope for capital investment is poised to decrease rather than to expand.

It anticipates the wholesale failure of business models based on false predicates, and suggests that the taxonomy of de-growth – with its emphasis on product and process simplification, on delayering, and on managing utilization and critical mass risks – is the appropriate template for decisions.

This discussion is not, in any sense, intended as any kind of primer for the conduct of business or government in a future that’s not going to conform to a mistaken consensus.

But one issue is of immediate relevance to the theme that interests us here – are governments, businesses and other organizations going to start a process of fundamental re-appraisal?

The view taken here is that these institutions are not about to reveal a Damascene conversion to the realities of a material (and constrained) rather than a monetary (and unlimited) conception of the economy.

Nobody is likely to start telling shareholders, voters, workers, consumers, the markets or anybody else that the consensus narrative is mistaken, and that, in the words of Mickey Newbury, “the future’s not what it used to be”.

Rather, “gravitational effect” is the appropriate analogy here. Any large organization is entitled to operate research units looking into “what if?” scenarios, and is under no obligation to share the results of such evaluation with others.

This is likely to be the way in which new thinking about the economy crosses the boundary from theory into practice.

It seems most unlikely that institutions will ignore the various factors, some of them described here, which put ‘the currently-assumed’ into the category of ‘the speculative and the potentially mistaken’.

Research processes are likely to act on planning in much the same way that a piece of iron, placed on the rim of a binnacle, acts on a magnetic compass.

New economic thinking can be expected to work its way into decision-making processes in a way more akin to gradual absorption than to a flood.

For practical purposes, the revolution in economic thinking “will not be televised”, but neither can it continue to be dismissed as nothing more than ‘inconvenient theory’.   

#224. Unaffordable, stranded, at risk

DISCRETIONARY COMPRESSION AND THE VULNERABILITY OF ASSETS

One of the more striking trends in a shifting consensus appreciation of economic issues has been an increasing focus on what’s being called a “cost of living crisis”.

There’s no doubt that this is serious – but is it, as the public is assured, only temporary? And, if it’s not, what are its implications?  

Though the seriousness of this situation is gaining recognition, its implications – not least for asset markets – remain generally unappreciated.  

Properly understood, what we’re witnessing is part of a broader dynamic, long discussed and calibrated here as the erosion of discretionary prosperity. As prior growth in prosperity goes into reverse, and the cost of necessities rises, consumers are losing the ability to afford non-essential (discretionary) purchases.  

Governments, businesses and the markets are profoundly mistaken if they assume that this is some kind of passing phase, caused by nothing more than the temporary consequences of ‘unexpected events’, such as coronavirus disruption, and war in Eastern Europe.  

Will the consensus of opinion – only now, and belatedly, catching-on to the pressures on discretionary consumption – also recognize what’s happening to affordability? And will it then move on to re-define the concept of “stranded assets”, realizing that this term applies, not to hydrocarbon projects after all, but to a far broader range of investments?

Moreover, will asset markets start to recognize the broader implications of deteriorating affordability, particularly where property is concerned?

Hidden in plain sight 

As regular readers will know, downwards pressure on the affordability of discretionary goods and services is one of the two most critical issues identifiable through interpretation of the economy as an energy rather than a financial system.

The other is the unbridgeable gap that now divides the ‘financial economy’ of money, credit and asset values from the ‘real economy’ of material output, labour and energy.

Current events may be leading towards a moment at which issues of affordability collide with an over-inflated financial system to trigger far-reaching negative reactions. 

The much-discussed “cost of living crisis” means, not just that households are struggling to cope with the rising cost of necessities, but also that their disposable incomes are under severe, indeed unprecedented, downwards pressure.

In short, if people have to pay more for necessities – such as food, heat, power and essential travel – they are left with less to spend on all of those many things that they may want, but do not need.

This extends far beyond non-essential purchases, having equally serious implications for the affordability of credit.

If you’ve been visiting this site for any length of time, you’ll know that these trends have long been anticipated here. SEEDS-based analysis has been warning, over an extended period and with increasing urgency, of a worsening squeeze on discretionary (non-essential) prosperity.

This expectation has been based on recognition of two critical trends, neither of which is accepted by conventional economic interpretation, and both of which are related to the way in which prosperity is defined by the availability, value and cost of energy.

First, relentless increases in ECoEs – the Energy Costs of Energy – have been undermining the prosperity-determining availability of surplus (ex-ECoE) energy. 

Second, and just as top-line prosperity has been trending downwards, the real costs of energy-intensive essentials have been rising remorselessly.

What this means is that the indicator known in SEEDS terminology as “PXE” – prosperity excluding essentials – is on a pronounced downwards trajectory. This trend is illustrated in the following charts, which compare prosperity per capita with the estimated cost of essentials in America, Britain and China.

You’ll note that, as in Britain and China, it’s perfectly possible for PXE to turn down well before the zenith of top-line prosperity has been reached. 

This trend is, in fact, by no means new, but has hitherto been disguised, where consumption is concerned, by the availability of ultra-cheap credit.

This ability to use credit to provide artificial support for discretionary consumption is now being eliminated by an acceleration in inflation, driven by the rising cost of necessities and, again, long predictable through energy-based analysis of the economy.

“Stranded”, but not as we know it

Even as the energy basis of prosperity has been deteriorating, techno-utopians have taken to describing big investments in fossil fuel projects as “stranded assets”.

The argument has been that, as renewable energy sources (REs) displace fossil fuels, demand for oil, natural gas and coal will slump, causing energy companies to lose money on investments “stranded” – cut off from consumers – by this supposedly-inevitable revolution in energy markets.

In reality, this has always been unlikely, not least because we cannot expand and maintain RE capacity without recourse to legacy energy inputs from oil, gas and coal. This means that the ECoEs of REs are linked to those of fossil fuels.

As energy costs rise, so, too, does the cost of everything – including steel, copper, cobalt, lithium and plastics – required, not just to expand RE generating capacity itself, but also to advance the use of technologies powered by electricity rather than by oil and gas.

A simple example is that, just as rising fossil fuel prices make conventional vehicles more expensive to run, so battery and hydrogen alternatives become costlier to produce, as does the RE infrastructure by which they are supposed to be powered.   

A proper appreciation of actual rather than hypothecated trends reveals that we need to re-define “stranded assets”.

Instead of oil and gas projects, the investments cast adrift by decreasing demand are likely to be aircraft, hotels, leisure complexes, broadcasting rights contracts, and anything else predicated on the false assumption that consumer discretionary spending will increase indefinitely.

The circumstances of the ‘average’ household or individual illustrate this unfolding process. As increases in the costs of necessities outpace incomes, people have less to spend on everything from holidays or a new car to subscriptions for television and internet services.

At the same time – with rates rising, and levels of debt already highly elevated – they can no longer resort to cheap credit to finance non-essential purchases.

Just as customer affordability is falling, businesses providing discretionary goods and services are subject to relentless increases in their own costs of operations.

These trends are likely to have adverse implications for a string of business models, including the ‘high-volume, low-margin’ template used in some sectors, the ‘streams of income’ model popular in many others, and the widespread dependency on revenues from advertising.

Unfortunately for businesses supplying discretionary products and services, the conventional over-statement of past trends has provided misplaced comfort, often to the point of inducing complacency.

As we have seen in a recent assessment, the same fallacious methodologies which overstate real economic growth have created the misleading impression that nominal increases in activity in discretionary sectors translate into robust trend growth which can be relied upon to continue into the future. 

This is illustrated in the following charts, in which conventionally-calibrated trends, shown in black, are compared with SEEDS analyses shown in blue.

What SEEDS interpretation reveals is that discretionary affordability, having already decelerated, has now entered a pronounced down-trend, completely contrary to the expectations on which so much investment and planning in discretionary sectors is based.

It’s always possible, at least to some extent, to reallocate assets, and to modify or replace business models – but not if you don’t know what to expect.

Financial implications

As a rule-of-thumb, discretionary goods and services account for roughly 60% of Western consumer spending, a proportion that includes swathes of durables including, most obviously, domestic appliances and vehicles.

The ‘average’ consumer is now finding that his or her ‘disposable income’ – the mainstream term for what SEEDS calls discretionary prosperity – is subject to severe downwards pressures.

The essentials still have to be purchased, and are now costing more. This means, first, that unpalatable choices have to be made.

The consumer may need to spend less on leisure activities, take fewer holidays, and cut back on outgoings such as subscriptions. He or she may also need to put off making ‘big ticket’ (consumer durables) purchases, such as a new washing machine or a replacement car.

A second implication is that the affordability of all forms of credit (and continuing payment commitments) is being undermined. The more that people have to spend on essentials, the less remains for the servicing of debt and the upkeep of obligations.

The compounding factor here, of course, is the rise in the cost of borrowing.

False confidence might be drawn from the fact that, in overall terms, rates are rising less rapidly than inflation, reducing the ‘real’ (ex-inflation) cost of debt.

But nominal rates matter, too. If the rate of interest on a mortgage increases from, say, 3% to 6%, the resulting increase in outgoings is very ‘real’, albeit in a different sense, to the borrower.

It’s of little or no comfort to the borrower to be told that the rise in rates is less than the increase in inflation, particularly where the inflationary effect on incomes lags, or is less than, the rate at which the cost of necessities is increasing.

This raises two questions about the affordability of credit. First, can the borrower carry on servicing existing debts at higher nominal rates of interest?

Second, can he or she really be expected to carry on financing otherwise-unaffordable non-essential spending by going still further into debt?

The far greater likelihood is that we’ve reached that point of “credit exhaustion” after which consumer purchasing and debt servicing capabilities can no longer be inflated to ever-higher levels on a tide of cheap credit.

Although rates are clearly heading upwards, property prices have enjoyed a boost provided by borrowers rushing to lock-in rates in anticipation of rising mortgage costs. It may seem illogical to pay over-inflated prices in order to keep borrowing costs low, but this is exactly the behaviour that has helped drive house prices upwards.

In the aftermath of this ‘anticipatory blip’, questions of affordability may now put enormous downwards pressures on real estate markets, defying the extrapolatory assumption that ‘prices can only rise over time’.

If investors – and lenders too – start to recalibrate affordability calculations, and accordingly to view property markets with more caution, there’s every reason why they might look at a broad swathe of discretionary-dependent businesses in a very similar way.

What, after all, are the prospects for companies supplying non-essential goods and services to increasingly hard-pressed consumers?        

Systemic exposure 

This takes us to an observation, set out in #222: The Forecast Project, that the ‘financial’ economy now stands at an unsustainable premium to a faltering underlying ‘real’ economy. This excess varies between countries, with China particularly exposed to a process of forced restoration of equilibrium between the financial and the material economies.

What this analysis indicates is that apparent economic “growth” has been inflated artificially by the injection of credit which, whilst boosting recorded activity, actually adds very little incremental value. In the business sector, this has created a trend towards unproductive complexity.

The SEEDS taxonomy of de-growth identifies many steps – including de-layering, and product and process simplification – which companies are likely to take in order to bolster profitability, and protect themselves against utilization risk and loss of critical mass.

But we need to be clear that there are limits to how far any business can counter a relentless erosion of demand for its product or service.

The onset of deterioration in discretionary sectors creates a serious risk that investor and lender confidence might erode when forward expectations are revised from growth to contraction. The pivotal issue is likely to be the extent to which forward commitments cease to be regarded as viable.     

In short, the financial system could be driven into disorderly contraction by a dawning recognition that both affordability, and the viability of discretionary sectors, are being undermined by trends which cannot be explained away by short-term setbacks.

#223. Trading with the (common) enemy

THE SHARED CONSEQUENCES OF RESOURCE CONSTRAINT

The tragedy unfolding in Ukraine, as well as being horrific in itself, has brought us face-to-face with a brutal fact whose reality we’ve always, hitherto, managed to ignore.

This fact is that the world has become accustomed to a standard of living that its energy resources can no longer support.

This is as true of, for example, China as it is, more obviously, of Western Europe. Indeed, once forward trajectories – and the all-important matter of ECoE – are taken into account, the United States has the self-same problem.

Neither can we assume that countries favoured with extensive indigenous energy resources are insulated from this problem. It simply isn’t possible for Russia – or, for that matter, for the oil-rich states of the Middle East – to pull up the drawbridge and let the rest of the world ‘freeze in the dark’.

The people of Ukraine are the obvious victims of this crisis, but the hardship being inflicted by the underlying issue stretches, in varying degrees, into most corners of the world.

Westerners – hit by rising living costs, and fearing that their trinket-laden lifestyles and their penchant for foreign holidays may be receding into the past – might spare a thought for citizens of the world’s poor and poorest nations, where the harsh realities of energy constraint are already showing up in the worsening unaffordability of food and other necessities.   

The current crisis is bringing us ‘up close and personal’ with a string of fundamental issues.

First, the emergence of energy constraints is destroying the long-favoured illusion that we can enjoy ‘growth in perpetuity’.

To paraphrase Kenneth Boulding, idiots and orthodox economists might continue to believe in the tarradiddle of infinite growth on a finite planet, but the rest of us have to face facts.  

Second, our efforts to pretend otherwise have inflated the global financial system to a point of extreme vulnerability.

Third, we can’t use the magic of money, or the alchemy of technology, to resolve the twin challenges of resource scarcity and environmental degradation. 

This time IS different

Many might be tempted to think that ‘we’ve been here before’.

Back in the 1970s, the Oil Embargo and the Iranian Revolution starved much of the world of petroleum, setting off sympathetic rises in the prices of other fuels, and triggering a severe combination of economic stagnation and soaring inflation.

Some observers now seem to think that, just as the Western world survived the oil crises, we can similarly brush off the effects of this latest threat to the reliability of affordable energy supplies.

The fundamental difference is that global ECoEs – the Energy Costs of Energy – are drastically higher now than they were back in the 1970s.

Superficially, at least, the effects of the oil-induced stagflationary crisis of the 70s are reasonably well-understood.   

First, it put an end to the super-rapid rates of oil consumption growth that had characterised the post-1945 world. Remarkable though this may now seem, there were times in that post-war period in which consumption of petroleum grew at annual rates as high as 8%. 

Second, the crises created the incentives for the development of new sources of oil in non-OPEC regions, most importantly in Alaska and the North Sea.

By the early 1980s, a new generation of far more fuel-efficient cars had reached global markets. Oil had become recognised as a premium fuel, and was ceasing to be used for substitutable activities such as the generation of electricity.

The oil market was subject to transitional (though lasting) over-supply from new sources. Arguably, OPEC over-played its hand by propping up prices in the first half of the 1980s.

Oil markets crashed at the end of 1985.

This, coincidentally or not, was also a period of significant political change. The doctrines variously described as “Thatcherism” and “Reaganomics” claimed, and for the most part were given, credit for an economic revival which, in reality, was the product, not of market ‘liberalization’, but of the downwards leg of an artificially-distorted long-cycle in energy supply.

The critical point, though, was that the ECoEs, both of oil and of energy generally, remained at levels low enough to facilitate continued economic expansion. The resource backdrop to the oil crises of the 1970s was that ECoEs remained at or below 2%.

The new reality

Today, global all-sources ECoEs are over 9%, far beyond levels at which further growth in aggregate material prosperity remains possible.

In the West, rising ECoEs have already put prior growth into reverse, a trend temporarily disguised (though not, of course, overcome) by successive exercises in financial legerdemain.

As ECoEs have continued to rise, much the same combination of deteriorating prosperity, financial gimmickry and worsening self-delusion has started to emerge in less complex, more ECoE-tolerant EM (emerging market) economies.    

Faced with the stark reality of what the Ukraine crisis has crystalized in global energy markets, it’s natural for us to hope that we can side-step the implications of resource scarcity.

Some think that a switch to EVs can replicate the increased fuel efficiency of the 1970s, and that wind and solar power can act as latter-day successors to the supply-side solution provided back then by the North Sea and Alaska.  

All of these hopes miss the fundamental point, which is that ECoEs are very much higher now (above 9%) than they were in the 1970s (at or below 2%).

Between these data-points lies a climacteric which, once crossed, sees the assumed continuity of growth replaced by an inevitability of contraction.

Moreover, ECoEs are continuing to rise, and this trend cannot be countered, either by technology or by financial innovation.

In this situation, prosperity deterioration is inescapable, though the chaos of a disorderly economic ‘collapse’ remains avoidable, at least in theory, if the right choices are made.

Creative involvement

For those of us who understand the economy as an energy system, the most useful thing that any of us can do is to describe, model and project the situation as accurately as possible, and to delineate the choices that others, on our behalf, will have to make.   

Given our inability to influence tragic events in Ukraine, the most constructive action that we can take here is to intensify and develop our interpretation of the economy as an energy system,

This urgency – the need to ‘up our game’ – existed before Russian tanks moved into Ukraine. This is why the previous article broke new ground for this site by publishing specific forecasts informed by the SEEDS economic model.

Essentially, at least three dynamics are now in operation.

First, trend ECoEs are continuing to rise, pushing prior growth in economic prosperity into reverse. This trend cannot be stemmed (though it might to a limited extent be moderated) by an enhanced recourse to alternatives, including both REs (renewable energy sources) and nuclear.

Second, increases in the real costs of essentials are combining with deteriorating top-line prosperity to undercut the affordability of discretionary (non-essential) goods and services.

Much the same is happening to the scope for capital investment in new and replacement productive capacity.

To a certain extent, the definition of “essential” is imprecise, and certainly varies both geographically and over time. If we had a hard-and-fast definition of essentials – and therefore of discretionaries – planning, both for government policy and for investment, would be a great deal easier.

Efficiency could thereby be enhanced, because governments could set an agenda for debate around the prioritizing of services, whilst markets could start to redirect capital from discretionary into essential activities.

As it is, the fluid character of ‘necessities’ means that we need to use more nuanced appraisal, both of those services that governments must prioritize and of those sectors in which investment should be concentrated.

Third, so accustomed has the world become, both to growth itself and to its benefits, that there are major intellectual and psychological obstacles to reasoned acceptance and effective management of post-growth societies.

De-growth, in turn, creates the probability of increasing political and geopolitical instability, and this instability is likely to prompt, not just increasing conflict, but worsening hardship and consequent migration flows.  

It seems reasonable to assume that most of us lament the hardship being suffered within and beyond Ukraine, and are hoping against hope that wiser counsels will prevail.

Likewise, we must hope that decision-makers, and the public generally, can respond realistically and effectively to the challenges of a post-growth economy. 

To go beyond hoping for the best, we need to explore, discuss and quantify a world in which the assumption of ‘growth in perpetuity’ looks ever more likely to go the way of the Dodo.  

#222. The Forecast Project

PREDICTING THE ECONOMY OF THE FUTURE

In the Western world, at least, there’s an almost palpable sense of public uncertainty, anxiety and discontent which might be attributed to a variety of causes.

Some ascribe it to specific issues, some to the over-reach and incompetence (or worse) of governments, and others to widening inequality between “the elites” and everyone else.

The view taken here is that the deteriorating public mood has a more straightforward explanation, which is that prior growth in economic prosperity has gone into reverse.

The cessation of growth and the onset of involuntary economic contraction are, of course, denied by governments, but this makes popular dissatisfaction worse.

If the economy as a whole is supposed to be growing, but the individual finds that his or her economic circumstances are deteriorating, it’s easy to assume that there must be some kind of bias in the system.

In fact, we don’t need to posit conspiracy theories, or look to ‘the machinations of the mighty’, to explain worsening hardship.

The simpler reality, hidden in plain sight, is that the prosperity of the average person is eroding and so, at the same time, is his or her sense of economic security. Efforts to use financial innovation at the macroeconomic level to stave off this trend have failed, driving people ever deeper into the coils of debt and other financial commitments. 

In short, the average person is getting poorer, and feeling less secure. He or she doesn’t like it, and is baffled and suspicious over official assurances that it isn’t happening at all.

Projection – the land of hazard

Forecasting involves entering territory ‘where angels fear to tread’. But the publication of projections has now become imperative, made so (a) by the rapid worsening in the public mood, and (b) by the incomprehension that continues to inform policy decisions.

The projections that interest us come in two main forms. The first category, covering the economic and the financial, is addressed here. The plan is that broader forecasts, which necessarily include the political, will be tackled in a subsequent article.

To ‘cut to the chase’, analysis undertaken using the energy-based SEEDS economic model reaches two principle conclusions.

The first is that the ‘financial economy’ – the monetary counterpart of the ‘real economy’ of material goods and services – will contract by between 35% and 40%, in real terms, and on a global basis.

This is a process to which asset-prices are over-leveraged, so overall falls in the equity, bond and property markets are likely to be a great deal more severe. In parallel with tumbling asset prices, downsizing of financial commitments can be expected to involve both the ‘soft default’ of inflation and the ‘hard default’ of failure.

Second, economic prosperity will continue to deteriorate, whilst the real cost of essentials will carry on rising.

Reflecting this, the scope for the consumption of discretionary (non-essential) goods and services will shrink rapidly, as will the capability for investment in new and replacement productive capacity.  

Country-specific analysis suggests that, in comparison with pre-pandemic 2019, discretionary consumption in the United States will have declined by 14% by 2030, and by a further 41% by 2040. In Britain, discretionary consumption is projected to be 57% lower in 2040 than it was in 2019.  

Projected trends in discretionary consumption in America, Britain and France are illustrated in the first set of charts, which compare conventional measurement (in black) with SEEDS analyses of underlying trends (blue).

As we shall see, conventional interpretation of past trends has been extremely misleading, conveying the idea that discretionary consumption has continued to grow, from which the inference is that further expansion in discretionary consumption can be expected.

SEEDS modelling shows that the affordability of non-essential goods and services has (at best) plateaued in the United States, and has been trending downwards, over a lengthy period, in most other Western economies.    

Two observations are pertinent here.

First, and obviously, the scope for the discretionary consumption of goods and services that people might want, but don’t need, is poised to fall rapidly.

Less obviously, this deterioration is sharply at odds with what might be expected, based on the misleading prior trajectories shown in black.

A critical point to emerge from SEEDS-based analysis is that these prior trajectories have been distorted, such that false interpretations of the past and present have created gravely mistaken expectations for the future.   

Fig. A

Principles of analysis

The basis on which prior trends are analysed here, and forward projections are made, has conceptual complications.

In principle, the process of interpretation has to move forwards from the past to evaluate financial risk, but backwards from the present to create the preconditions for effective forecasting.

It’s hoped that this apparent contradiction will be clarified by the description that follows.

Let’s start with GDP. This measure, central to conventional economics, is generally assumed to quantify material prosperity but, in reality, it does no such thing.

Rather, GDP is a measure of activity, which is by no means coterminous with prosperity. If liquidity is injected into the system, the resulting use of that liquidity can create activity that has very little material value.

This is exactly what’s been happening over a period stretching back to the 1990s, when governments and their advisers first noticed the phenomenon of “secular stagnation”, wholly failed to understand its causes, and sought in vain to ‘fix’ it with various forms of financial gimmickry.

This started with ‘credit adventurism’ before, in response to the 2008-09 GFC (global financial crisis), ‘monetary adventurism’ was added to the mix.

As well as over-inflating asset prices, this process has created activity without adding value, and has injected unproductive complexity into the economy. It has also led to chronic and cumulative understatement of inflation, properly understood as the rate at which money loses purchasing power.

On this basis, GDP has become increasingly misleading, a confection inflated by the injection of low- or even nil-value activity into the system.

By analysing trends forwards from the past, we can plot the divergence between activity (measured as GDP) and prosperity (calculated using the energy-based SEEDS economic model).

Conversely, though, current GDP is where everyone thinks we’re starting from.

This sets contemporary GDP as the logical point from which forecasts need to begin. This is where analysis needs to reason backwards from the present to reveal the prior trends that will shape future developments.

In other words, we need to think of current GDP both as a polite fiction and as a baseline for forecasts.

Benchmarking the economy

Putting this into practice requires a benchmark, and the reference-point used here is prosperity.

This is calculated, using SEEDS, on the basis of principles familiar to regular readers. The first of these principles is that material prosperity is a function of the use of energy. This is an obvious truism, given that literally nothing that has any economic utility at all can be provided without the use of energy.

The second principle is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process, meaning that it is not available for any other economic purpose. With the ‘consumed in access’ component known here as the Energy Cost of Energy, this is ‘the principle of ECoE’.

In short, prosperity can be calibrated as a function of the supply, value and cost of energy.

On this basis, SEEDS calculates that global prosperity increased by 31% between 2000 and 2020. Allowing for a 25% rise in population numbers between those years, the world’s average person was just 4.8% more prosperous in 2020 than he or she had been back in 2000.

The third principle of surplus energy interpretation is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services provided by the energy economy.

Taken together, these principles point towards the need to draw a conceptual distinction between a ‘real’ economy of goods and services (though ultimately of energy) and a ‘financial’ economy of money and credit.

These ‘two economies’ are perfectly capable of diverging from each other, if we create financial ‘claims’ in excess of the material output of the ‘real’ economy.

This, since the 1990s, is exactly what’s been happening.

Since prices are the point of intersection between the financial and the real economies, inflation ought to reconcile any divergence between the real and the financial economies.

It can only do this, though, if inflation is measured accurately, which hasn’t been the case.       

Forward from the past

The official line, of course, is that material hardship cannot explain popular discontent because, with the exception of the coronavirus crisis of 2020, economic output (measured as GDP) has, with remarkable consistency, grown much more rapidly than population numbers, making people successively better off.

Stated at constant 2020 values, and calculated in international dollars converted from other currencies using the PPP (purchasing power parity) convention, world GDP grew by 94% between 2000 ($68 trillion) and 2020 ($132tn). The global population increased by 25% over that same period, so the world’s average person became 55% more prosperous between those years. 

Bearing in mind that GDP measures activity – and the use of money – rather than prosperity, this claim of rapid improvement in material well-being is easily demolished.

For a start, reported “growth” of +94% ($64tn) between 2000 and 2020 was accompanied by an increase of +190% ($216tn) in debt, meaning that each dollar of “growth” came at a cost of $3.40 in net new borrowing.

Using estimates for broader financial exposure (including the shadow banking system), this ratio rises to $7.20 of incremental commitments for each “growth” dollar. If we further include escalation in the shortfalls (“gaps”) in pension provision, we can arrive at incremental ‘hostages to the future’ of close to $10 for each dollar of reported economic expansion.

In short, since the 1990s, we’ve been inflating GDP artificially by injecting liquidity into the system, and counting the use of that liquidity as ‘activity’ for the purposes of measuring GDP.

The alternative calculation of prosperity is undertaken in two stages. First, the model normalises reported output for the effects of credit expansion.

Second, trend ECoE is deducted from the resulting underlying or ‘clean’ output number (C-GDP), because ECoE, as the first and inescapable call on resources, is the difference between output and prosperity.

The next charts show, for the United States and the global economy, the widening divergence between GDP and prosperity.

It’s worth reminding ourselves that, in a twenty-year period in which GDP reportedly rose by 94% worldwide, prosperity increased by only 31% whilst, for context, debt escalated by 190%, and estimated broader commitments (excluding pension provision shortfalls) rose by close to 250%. 

These broader global trends are illustrated in the right-hand chart. The gap between GDP as reported, and prosperity as calculated by SEEDS, is shown in solid red, and is far smaller than the enormous ‘wedge’ (shown in outline) that has been inserted between debt, broader liabilities, and either calibration of economic output.         

Fig. B

Backwards – and forwards – from the present

As we’ve seen, then, recorded GDP has been inflated artificially by massive credit and liquidity injection. By examining trends over a period going back to the 1990s, we can calculate that 2020 GDP of $132tn drastically overstates underlying prosperity of only $87tn.

The ratio between these numbers provides a measure of the extent to which the financial system, including asset prices and liabilities, will need to contract to restore equilibrium between the financial and the real economies.

Where forecasting forward trends is concerned, however, we are faced with a conundrum. Current GDP may be an extremely misleading number but, for most observers, it’s the point from which forward projections need to commence.

The solution is to use today’s GDP as the basis for forecasts, but to apply our knowledge of underlying dynamics to re-state the way in which that number arrived at where it is.

We can – and, for forecasting purposes, we must – use a base-year (2020) world GDP number of $132tn, but we don’t for one moment have to swallow the fiction that this figure has grown by 94%, in real terms, since, 2000.

In other words, we must use our knowledge to recalibrate the past – not just in total, but in component form as well.

In fact, conventional economics routinely re-states the past for purposes of comparison. When calculating “growth”, economists compare current year GDP, not with its nominal (‘money-of-the-day’) equivalent in previous years, but with those prior numbers restated to a constant, inflation-adjusted basis.

For example, a direct comparison between American GDP in 2020 ($20.9tn) and 2000 ($10.3tn) might suggest growth of 104%, but everyone knows that this number has been distorted by inflation between those years.

The application of the GDP deflator raises the 2000 number to $14.9tn at 2020 values, from which growth over that period is then calculated at a ‘real’ (ex-inflation) 40%.

This is where the SEEDS concept of the Realised Rate of Comprehensive Inflation comes into the equation. What RRCI says is that, whilst the nominal GDP figures for each year might be accepted as an accurate measurement of activity, calculation of ‘real’ change over time has been distorted by a severe underestimation of intervening inflation.

Put another way, the purchasing power of money has declined far more rapidly than official data suggests.

It should, of course, come as no surprise to anyone that inflation has, routinely and to a large extent, been under-reported over time. The conventional measurement of inflation uses a number of questionable assumptions, and very largely excludes changes in the prices of assets.  

Globally, and on the PPP currency convention, nominal GDP was $50.3tn in 2000, and $132tn in 2020. Official data converts the earlier number to $68tn at 2020 values, resulting in the assertion that the world economy has grown by 94%. The official rebasing calculation infers that broad inflation averaged 1.5% between 2000 and 2020.

RRCI analysis indicates that systemic inflation actually averaged 3.5% annually, not 1.5%, over that period. Accordingly, GDP in 2000 is restated to 2020 values, not at $68tn, but at $100tn. This in turn indicates that ‘real’ growth between 2000 and 2020 was 31%, not 94%.

This is very far from being a purely theoretical point, because working out how far GDP has really travelled over the past twenty years also reveals trends in its components.

It’s almost inevitable that past trends act as the basis of forward expectations.

Accordingly, misunderstanding of the past leads naturally to mistaken expectations for the future.   

These components can be stated as “sectors”, which are government, households, financial businesses (such as banks and insurers), and PNFCs (private non-financial corporations). 

For our purposes, though, a more useful analysis is one which divides the economy into three segments, which are capital investment (in new and replacement productive capacity), the provision of essentials, and the supply of discretionary (non-essential) goods and services to the consumer.

Interpretation and projection

Again using the United States as an example, the next charts show three alternative interpretations of the evolution of essentials, capital investment and discretionary consumption, within overall economic output, over time.

The first chart shows nominal GDP, not adjusted for inflation, whilst the second translates everything to 2020 values based on official inflation data.

As you can see in the second chart, economic output, and each of the three segments within it, is supposed to have carried on increasing, even in the recent period in which debt and other financial commitments have been accelerating unsustainably.

On this basis, it might seem reasonable to infer, not just that aggregate economic output will continue to expand, but also that the future expansion of capital investment and discretionary consumption is assured.

The right-hand chart, whilst accepting 2020 GDP as a point-of-arrival for analysis and a point-of-departure for forecasting, uses RRCI analysis to recast the way in which that point has been reached.

The clear message to be taken from this analysis is that both capital investment and discretionary consumption have flat-lined, with the latter already starting to turn downwards.      

Fig. C

The next charts use SEEDS economic projections to carry the RRCI-referenced interpretation of the American situation forwards, and to do the same for the British and the global economies.

For Britain and America, the implications are that, whilst further rises in ECoEs and deterioration in broader resource supply are going to drive economic output downwards, the real costs of energy-intensive essentials will continue to rise.

This means that, looking ahead, both capital investment and discretionary consumption are set to be compressed in ways that interpretations based on mistaken analysis of past trends are incapable of anticipating.

Where global projections are concerned, we’re still in the process of learning the severity of the effect that Western deterioration is going to have on economic performance in EM (emerging market) economies such as China and India. Current indications are that projections for EM prosperity may need to be revised downwards, showing earlier and more pronounced contraction.        

Fig. D 

This dynamic can be expressed using the SEEDS metric of prosperity excluding essentials (PXE).

The next charts illustrate this metric, showing top-line prosperity as a thin blue line, and PXE as a thicker one. The gap between these lines represents the real cost of essentials, but it should be remembered that PXE states the scope, not just for discretionary consumption, but for capital investment as well.

What is revealed here, where America and Britain are concerned, is pre-existing stagnation, followed by impending rapid deterioration, in PXE.

Global calibration seems to show that PXE might not – quite – have peaked yet, but this projection is subject to the previously-mentioned variable about Western effects on the performance of the EM economies.  

Fig. E

Finally, where charts are concerned, the experience and prospects of the average person can be set out by illustrating prosperity and the cost of essentials on a per capita basis. Because population numbers have continued to increase, the per-capita equivalents of the compression of PXE aggregates are more pronounced than the same metrics expressed as aggregates.

In America and Britain, whilst top-line prosperity per person has been trending downwards over an extended period, the real cost of essentials has been rising inexorably.

You’ll notice that, in each of these charts, projection of the per capita cost of essentials ceases in 2030, before the future point at which the lines cross over, and essentials cease to be affordable at all for the average person.

The reason for this is that, long before 2040 – and probably much sooner than that – we’re going to have to re-define what we mean by “essential”.     

Fig. F

Conclusions

Lengthy though this discussion has been, the focus has necessarily been confined to an overview of trends, with selected economies used as illustrative examples.

Our first conclusion, which ought to come as no real surprise at all, is that the ‘financial’ economy of assets and liabilities has become grotesquely over-inflated. This informs us that – because of the dynamic that links the financial and the material – it’s only a matter of time before an inescapable process trending towards equilibrium triggers a correction.

SEEDS analysis cannot, of course, tell us when this will happen, but it can indicate a magnitude, varying between economies but, in overall terms, implying a contraction of 35% to 40% in the financial system as a whole.

The leverage within the equation suggests that the repudiation of liabilities at this scale will translate into markedly more severe falls in asset prices.

It should be remembered that aggregate asset pricing is no more than notional, in the sense that totals thus calculated can never be monetised. If, say, asset values fall by $50 trillion, it doesn’t make the economy “poorer” by that amount. In reality, the aggregate ‘valuation’ of asset classes amounts to nothing more than what we – collectively, and through marginal pricing – choose to tell ourselves that our assets are “worth”.

The second and third conclusions are (a) that both discretionary consumption and capital investment are poised to fall very sharply, and (b) that these contractions aren’t “priced in” to collective expectations for the future, because these expectations are based on severely misleading interpretations of recent trends.       

 

 

#221. Strategies for a post-growth economy

PART ONE: BUSINESS IN A NEW ERA

Under current conditions, it’s increasingly hard to understand why the inevitability of economic contraction remains so very much a minority point of view.

Many of us have long understood why past growth in material prosperity has gone into reverse.

Here, with the SEEDS economic model, we can go still further, quantifying past trends, and charting a future in which economies get poorer, living standards are squeezed by rises in the real cost of energy-intensive essentials, and the financial system buckles under the weight of its own contradictions.

None of this has to be a disaster, but the management of involuntary economic ‘de-growth’ requires innovative strategies, most obviously in business and government.

The aim here is to concentrate on the PNFC (private non-financial corporate) sector, evaluating strategies that could mitigate the worst effects of economic contraction.

Other sectors – government, households and the financial system – may be the subject of future instalments, whilst the role of technology might merit separate discussion.

Don’t over-simplify

Readers are reminded that this site does not provide investment advice, and must not be used for this purpose.

In any case, it would be an over-simplification to assume that the decline in prosperity must crush discretionary sectors whilst leaving suppliers of essentials largely unscathed.

In fact, suppliers of intermediate (and intermediary) services are at even greater risk than businesses which supply products and services that the consumer might want, but doesn’t need.

Rather, future trends will be more nuanced than a simple decline in all forms of discretionary consumption.

What emerges from this analysis is that businesses will need – and will be pressured by market forces – to front-run the process of de-complexification that will parallel contraction in the size of the material economy.           

To be clear about this, we’ve reached a point at which there are no easy choices, and certainly no painless ‘fixes’.

Transition to renewable energy (RE) alternatives to fossil fuels, imperative though it is on environmental and economic grounds, isn’t going to restore the energy abundance of the past. It would be wholly irrational to expect financial stimulus to produce a supply of low-cost energy that does not exist in nature.

The idea that technology can solve all problems is one of the greatest delusions of the age.  

Strategically, the critical point is that the ever-increasing complexity which has accompanied two centuries of growth has now become a liability rather than an asset.

During the quarter-century precursor period which has preceded the onset of de-growth, this problem has been exacerbated by the expansion of unproductive complexity, a consequence of policies which have promoted activity (as measured by GDP) without adding value.

Just as businesses now need to front-run a process of de-complexification that will accompany de-growth, there’s a corresponding requirement for governments to reset priorities, and increase efficiency as resource availability declines.

The reality of involuntary de-growth

For the purposes of this discussion, it’s going to be assumed that readers understand the inevitability of de-growth.

The fundamental principle is that prosperity is a function of the supply, value and cost of energy. The relentless rise in the ECoEs – the Energy Costs of Energy – of fossil fuels has put prior economic expansion into reverse.

Efforts to counter this material problem with financial responses have failed, in the process creating enormous risk by driving a wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

At the same time that the prosperity of the average person is declining, the cost of essentials is rising, not least because the supply of so many necessities is energy-intensive.

Essentials make the first call on prosperity, which means that other uses of economic resources are being compressed by this process. One of these ‘other uses’ is capital investment, meaning the addition and replacement of productive capacity.

The other is the supply of discretionary (non-essential) goods and services to the consumer.

Meanwhile, and because prices are where the material and the financial intersect, rising inflation is a logical consequence of the imbalance between the ‘two economies’ of energy and money.

The authorities face unenviable choices, mainly because the costs of necessities (including energy and food) are rising within a broader inflationary context. What’s being called the “cost of living crisis” has far-reaching political implications.

Unchecked, it could open the door to ‘left-populist’ parties offering to provide subsidies (paid for by “the rich”), perhaps reinforced with promises to nationalize “fat-cat” utilities.

The lack of logic in such broad-brush proposals cannot be counted upon to reduce their popular appeal.

Letting events take their course risks undermining what consumers can afford to spend on discretionary (non-essential) goods and services, a process which can’t be guaranteed to tame inflation, but would be certain to drive unemployment higher, and induce a recession.

Much the same applies to raising interest rates from deeply negative real levels, which would have the added consequence of triggering sharp falls in the prices of stocks, bonds, property and other assets.

Nominal rates will need to be increased – though this might do little or nothing towards pushing the real cost of capital back into positive territory – and asset prices cannot be propped up indefinitely.

But monetary policy offers no “magic bullet” fix for financial instability.

In these circumstances, subsidizing the cost of living might, to decision-makers, seem the least-bad policy option. But this would send already-elevated public debt soaring, with the almost inevitable consequence of monetization by central banks.

Not for nothing has inflation been called “the hard drug of the capitalist system” – though market economies certainly have no monopoly on the debasement of the purchasing power of money.

The implications for business

Where strategies are concerned, we need to be clear about two things.

First, the rapid economic growth of an Industrial Age powered by fossil fuels was accompanied by ever-greater complexity, making it inevitable that involuntary quantitative ‘de-growth’ will be accompanied by a process of de-complexification.  

Second, policy trends during a growth climacteric which began in the 1990s have added unproductive complexity to the economy.

Efforts to use monetary expansion to stem the onset of economic deceleration and contraction have boosted activity (measured as GDP) without improving the delivery of value.

Where businesses and governments are concerned, this has had the effect of adding to complexity without improving profitability, efficiency or resilience.

From a business perspective, the issues have at least the merit of clarity. Consumer prosperity is deteriorating, whilst resource constraints are the primary factor driving business costs upwards. The appropriate responses are (a) cost control and (b) the pursuit of resilience. These need to be seen as distinct but connected challenges.

There are two stand-out risks to business resilience.

The first of these is adverse utilization effects. As sales volumes shrink, the unit equivalent of fixed costs increases, and passing on these unit cost rises to customers in higher prices is likely to exacerbate the decline in volumes.

The copybook example here is a road bridge, which has high fixed expenses and low user-variable costs. If, say, fixed costs are $10m, and 2 million customers use the facility, a cost of $5.00 has to be incorporated into tariffs. If user numbers fall to 1 million, the fixed cost per user rises to $10. The consequent increase in tariffs may cause further declines in user numbers.

This is a simplistic example, but no business is free from fixed overheads which, of course, include management and promotional expenses, and the servicing of capital.

Importantly, this trend has adverse effects, not just for the bridge operator in our example, but also for nearby businesses whose employees rely on the bridge to get to their place of work, and whose suppliers rely on the bridge for deliveries.

The second risk to resilience is loss of critical mass, where components, inputs or services either cease to be available, or their cost becomes prohibitive. When calculating fade rates for the economy of the future, these factors need to be considered in tandem.

The counter to both of these risks is simplification, which applies both to product offerings and to processes.

Reducing the variety of products offered to customers – from, say, twenty different types of widget to five – streamlines operations, simplifies delivery, and boosts efficiency.

Simplifying the way in which widgets are manufactured (or services are supplied) makes production less expensive, and simultaneously reduces dependency on the supply of inputs. If the number of inputs required in the manufacture of a widget is halved, so, logically, is the risk associated with the loss of access to their supply. 

Carried forward, simplification will reduce managerial and other overheads, and will lead to de-layering, where external service inputs are reduced, taken in-house, or eliminated altogether.

Conclusions

Globally, SEEDS analysis shows that prosperity increased by only 31% between 2000 and 2020, whilst the estimated cost of essentials rose by 80%.

At the aggregate level, prosperity excluding essentials (PXE) was essentially flat over that period, but PXE per capita turned downwards in 2007, since when it has declined – making people feel poorer – by 18%.

By 2030 – with top-line prosperity deteriorating, and the real cost of essentials continuing to rise – even the aggregate PXE number is likely to be 28% lower than it was in 2020.

Logically, this relentless squeeze on PXE implies that the greatest pressures will be imposed on sectors supplying discretionary goods and services to consumers.

But – and even if it were appropriate to do so here – we cannot simply list discretionary sectors ranked by their exposure to contraction or, for that matter, to the rising cost of energy and other inputs.  

Any such listing would be based on the mistaken assumption that neither businesses nor governments will react to declining prosperity and the rising cost of essentials – which, of course, they will.

As we’ve seen, the likelihood is that businesses will react along the lines of the taxonomy of de-growth, shown below. Though different, more positive-sounding phraseology will no doubt be employed, the operative trends can be listed as simplification of products and processes, de-layering and cost reduction within the general theme of de-complexification.  

This predictable trend nuances the outlook, such that the greatest pressures are likely to be exerted, not just on discretionary sectors, but at least equally on those intermediate and intermediary stages capable of de-layering, reduction and elimination. 

Without being sector-specific, this situation has particular implications for technology, of which, as a general proposition, far too much is expected.

Technologies which improve the efficiency (and, specifically, the energy-efficiency) of household and business users can make a premium contribution during de-complexification.

But the future is bleak for technologies which promote new ways of putting energy to discretionary use. 

#220. The human factor

CONTINUITY, CONTRACTION OR COLLAPSE

Over an extended period, but with growing intensity in recent times, there has been a discussion, here and elsewhere, about whether we can prevent economic contraction from turning into collapse.

This is part of a broader debate in which every point of view seems to begin with the letter C. The orthodox or consensus line is Continuity, meaning that the economy will continue to expand in the future as it has in the past, and is claimed still to be doing in the present. The main contrarian theme is the inevitability of Collapse. Those of us who believe even in the existence of a third possibility – Contraction – are in a tiny minority. 

Of these three points of view, the only one that we can dismiss is continuity. The economic “growth” that we’re told can be extended indefinitely into the future isn’t even happening in the present. 

Most – roughly two-thirds – of the reported “growth” of the past twenty years has been cosmetic. The preferred metric of gross domestic product (GDP) measures activity, not prosperity. If we inject liquidity into the system, and count the use of that liquidity as ‘activity’, we can persuade ourselves that the world economy has been growing at rates of between 3% and 3.5%.

The classic illustrative example is of a government paying one large group of workers to dig holes in the ground, and another group to fill them in again. This adds no value, of course, but it does increase activity, and therefore boosts GDP.

In this example, the obvious question is that of how the government pays for all this zero-value ‘activity’. The simple answer is to use borrowed money. Conveniently, GDP, as a measure of activity, calculates flow without reference to stock. This sleight-of-hand has persuaded many that their national economies have now recovered in full from the coronavirus downturn, a claim that is only valid if changes in the stock of government (and broader) liabilities are left out of the equation.

Statistically, world GDP increased by 94%, or $64 trillion, between 2000 and 2020. This “growth”, though, was accompanied by an increase of $216tn (190%) in total debt, meaning that more than $3.35 was borrowed to deliver each $1 of “growth”. On the basis of broader liabilities (including those of the shadow banking system), this ratio rises to an estimated $7.25 of new commitments for each dollar of “growth”.

If we further included the emergence of enormous deficiencies (“gaps”) in the adequacy of pension provision, this number would rise to somewhere close to $10.     

The artificial inflation of GDP does more than persuade us that the economy is growing at a satisfactory rate. It also affects the denominator used in numerous calculations and ratios. On this basis, it can be contended, for example, that debt and other liabilities are ‘not excessive’, and that government expenditures remain at a ‘modest and sustainable’ percentage of the economy.

This pattern of behaviour merits the term “Ponzi”, with the proviso that there may not have been any conscious and deliberate intent in the creation of this situation.

In objective terms, we can conclude that two factors have informed decision-making through a period that began with ‘credit adventurism’ before, in the aftermath of the GFC (global financial crisis), adding ‘monetary adventurism’ into the mix.

The first factor has been a determination to support the status quo, and the second has been the misplaced faith placed in an orthodox school of economics which dismisses resource constraints as part of a money-only interpretation of the economy which promises infinite growth on a finite planet.

Decision-makers may have drawn comfort from the relentless rise in the prices of assets such as equities and property. The snag here is that the aggregate valuations of these and other asset classes are purely notional, meaning that they cannot be monetized.

We can, for instance, multiply the average price of a house by the number of properties to arrive at an impressive-sounding ‘value’ for a nation’s housing stock. This ignores the inconvenient reality that the only potential buyers of this stock are the same people to whom it already belongs.  On this basis, we can calculate that aggregate assets are ‘worth’ a sum comfortably in excess of aggregate liabilities. Any such calculation may be reassuring, but the reality is that it is meaningless.

As regular readers will know, the alternative interpretation favoured here is that we need to draw a conceptual distinction between a ‘financial’ economy of money and credit and a ‘real’ economy of goods and services. The connection between these ‘two economies’ is that money, having no intrinsic worth, commands value only as a ‘claim’ on the goods and services produced by the real economy.

With this distinction established, we can further observe that the ‘real’ economy is an energy system, because nothing that has any economic utility at all can be supplied without the use of energy. Put another way, economic prosperity is determined by an equation involving the supply, value and cost of energy.

Over a long period of time, the conversion ratio of energy into economic value has been largely static. The quantitative supply of energy is a function of the value and cost of energy, as applied to the physical availability of the energy resource. 

These considerations identify cost as the critical part of the energy equation which determines prosperity. We know that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE.

If ECoEs rise, the surplus (ex-ECoE) energy which determines prosperity contracts. Rising ECoEs also exert an adverse effect on the value-versus-cost equation which determines the quantity of energy supplied.   

Critically, trend ECoEs have been rising relentlessly, primarily reflecting the effects of depletion on an economy which still derives more than four-fifths of its primary energy from oil, natural gas and coal.

Decision-makers still fail to recognize the constraint imposed by a rise in the ECoE costs, and a deterioration in the surplus value, of fossil fuels. They have, though, reached a belated recognition of a second constraint, imposed by the limits of environmental tolerance.

The proposed solution is a “transition” to renewable energy sources (REs) such as wind and solar power. These REs may pass the test of being better for the environment than fossil fuels, but they are unlikely ever to pass the second, critical test of delivering ECoEs that are as low as, or lower than, those of oil, gas and coal.

The slogan used almost universally in this context is “sustainable growth”. Within this term, the word “sustainable” – meaning environmentally tolerable – might indeed be delivered. After all, we had this kind of “sustainable” economy before the first effective heat-engine was completed in 1776.

But the word “growth” is simply an assumption, based on that same ‘money-only’ theory of economics which, by dismissing resource constraints, also dismisses the entire concept of ECoE. 

Those of us who understand the energy basis of prosperity, and who also recognize the critical duality of the financial and the real economies, can arrive at the reality behind an economy in which prosperity per person has ceased growing, and has started to contract.

For us, involuntary “de-growth” is a situation, defined as ‘a set of circumstances allowing of more than one possible outcome’. On this basis, and for so long as the alternative of ‘contraction’ exists, we cannot state that ‘collapse’ is inevitable, though it is eminently possible.

Having ruled out continuity, the difference between orderly contraction and disorderly collapse devolves into a question of management, a question which necessarily involves government and politics.

Our understanding of the situation, applied here using the SEEDS economic model, enables us to project various trends into the future, trends which are either unknown to, or ignored by, decision-makers in government, business and finance.

We know, for instance, that a simulacrum of “growth” cannot be maintained for much longer in the face of a trend towards the restoration of equilibrium between the real economy of energy and the financial economy of money and credit.  We know that this process will involve rapid (and probably disorderly) contraction in the financial system, which will need to shrink by at least 35-40%, and perhaps more, to reach stable alignment with the material economy.  

We further know that the real cost of energy-intensive essentials – including food, water, domestic energy, necessary travel and the building and maintenance of housing and infrastructure – will continue to rise, even as top-line prosperity erodes.

We also know that the scope, both for discretionary consumption and for capital investment in new and replacement productive capacity, will be compressed by the narrowing of the margin between prosperity and the cost of essentials.

We can further set out the taxonomy of de-growth which describes how businesses will seek to adapt to falling consumer prosperity, rising costs, worsening supply vulnerability and deteriorating financial conditions.

But what we cannot know is how society will adapt to a future which involves reduced prosperity, worsening hardship and insecurity, severe financial disruption and a loss of faith in the continuity of growth.

We can anticipate, of course, that economic considerations will rise steadily up the agenda of popular priorities, and that a leadership cadre, unaware of the inevitability of deteriorating prosperity and financial dislocation, will make every effort to maintain the status quo.   

Until we have answers to these questions, we cannot know whether the future will be one of orderly contraction (which is theoretically feasible) or of disorderly collapse (which is frighteningly plausible).               

#219. The unravelling begins

THE REALITY OF SCARCITY, THE SCARCITY OF REALITY

In nineteenth-century England, pictures of great events and famous personages could be purchased “penny-plain or tuppence-coloured”.

Where the world economy is concerned, the price of flattering colouration has soared into the trillions, but the value of a “penny-plain” view has never been higher.

The penny-plain picture now, of course, is that a vast gap has opened up between the consensus expectation of continuity and the hard reality of a post-growth economy. This gap is the counterpart of the chasm that exists between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

Our understanding of these dissonances sets an outline programme for ongoing analysis. The best routes to effective interpretation are those which (a) compare reality with perception, and (b) calibrate the relationships between the ‘two economies’ of money and energy. In the coming months, the aim here will be to add interpretive and statistical detail to the picture that is emerging as the aquatint wash of delusion fades away.

The divergence between expectation and reality isn’t – in itself – a new development. Many of us have long known that, over a very extended period, most economic “growth” has been a cosmetic product of breakneck and hazardous monetary expansion, that the underlying economy has been faltering, and that the confidence placed in ‘continuity’ lacks a basis in fact.

We can go further, recognizing that even the simulacrum of “growth” can’t last much longer, that the real prices of assets are destined to fall sharply in a context of broader financial distress, and that the balance of political power might be poised to shift, perhaps in a direction that, once upon a time, used to be called “left”.

What IS different now is that a process of fundamental change is already underway. The consensus case for continuity is crumbling, and is being exposed as a product of self-deception, wishful-thinking and economic incomprehension, spiced with absurd amounts of techno-utopianism.

The outcome mightn’t – and needn’t – be the wholesale “collapse” predicted by doomsayers.

But the game is up for what we might call the ‘continuity consensus’.

Of price and value

The single most obvious symptom of change is inflation. The Fed might – belatedly – have stopped calling this “transitory”, but the consensus view remains that this isn’t the start of a “stagflationary” trauma of the kind last experienced in the 1970s.

It’s widely argued that the take-off in inflation is a short-term product of the shortages and supply-chain fractures created by the coronavirus pandemic and, perhaps, of the gargantuan amounts of money injected to cope with the crisis. It’s further contended that labour lacks the pricing power to create a price and wage inflationary spiral. 

Before buying this comforting narrative, it makes sense to look at the fundamentals. Prices are the point at which monetary demand meets material supply. Put another way, prices are where the ‘financial’ economy of money and credit intersects with the ‘real’ economy of goods and services.

Conventional theory states that the price mechanism enables strong financial demand to prompt corresponding rises in physical supply, because rising prices give producers an incentive to increase supply to the market.

This logic, though, holds true only under conditions of infinite capability. No rise in prices, or increase in financial demand, can prompt the delivery of products which do not exist in nature. If physical constraints exist, the theory that ‘demand creates supply under all circumstances’ is exposed as a fallacy.

This is particularly pertinent to the supply of energy. Surging European natural gas prices are a case in point. Conventional theory dictates that spectacular rises in prices ought to have brought new supply gushing into the market for gas. The reality is that no such new supply exists. To be sure, price differentials can divert supplies between competing markets, but they cannot increase the aggregate availability of gas. The same applies to other forms of traded energy, including oil and coal.

This brings us to the fundamental point about scarcity. Conventional economics, with its insistence that ‘demand creates supply’, dismisses the very concept of material constraint. Hard fact, on the other hand, decrees that the supply of fossil fuel energy at an affordable cost is constrained by the limits of resources.

Two observations are necessary here. The first is that the process of depletion has created sharp rises in the ECoEs – the Energy Costs of Energy – of oil, gas and coal. The second is that nothing that has any economic utility at all can be supplied without the use of energy.

Accordingly, rises in the ECoE-costs of energy must force up the cost of everything else, imposing changes in allocations, priorities and distribution. This is particularly applicable to resources such as food, water, minerals, metals and plastics, all of which are supplied through energy-intensive processes.

We can’t conjure them out of the ether by pouring money into the system.

Supply constraint and the implications for demand

Of course, conventional economic theory doesn’t limit its concept of the price mechanism to the assertion that rising prices must increase supply.

It states, also, that rising prices depress demand.

If we superimpose resource constraint onto this ‘equilibrium-through-price’ equation, what we’re left with is a process whereby supply isn’t increased – but demand IS depressed – by rising prices.

Put another way, the introduction of material scarcity into the pricing equation tells us that supply constraints will, through the mechanism of rising prices, reduce demand.

This is the point at which two realities have to be factored in. The first is that consumer purchases are divided, in order of priority, between essentials (things that the consumer must have) and discretionaries (things that he or she may want, but doesn’t need).

The second is that there is extraordinary sectoral and popular resistance to the idea that discretionary consumption might be trending downwards.

We can see these factors in operation right now. Because of resource scarcity in general – and energy scarcity in particular – the cost of essentials is rising markedly. We can see this, most obviously, in the rising costs of food, fuel and domestic energy, but we can be sure that this process is going to extend into other necessities.

It’s noteworthy that the Resolution Foundation, a British think-tank, is forecasting that 2022 will be a “year of the squeeze”. This description can be applied globally, differing only in pace and magnitude between countries and regions. The cost of everything from gas and electricity to fuel, travel fares, food, clothing and even water is going to rise.

The brunt of this pressure is felt initially by the poorest households, who spend the largest proportion of their incomes on necessities. But there need be no doubt that the rising tide of costs will move steadily up the gradient of household incomes.

For suppliers of discretionary goods and services, this is a double-edged sword. On the one hand, consumers whose living costs are rising have less to spend on non-essential purchases. On the other, the costs of supplying discretionaries are rising. Credit-funded discretionary spending, long the prop of non-essential sectors, is in the process of being undermined by inflation or, more specifically, by the monetary implications of the rising cost of necessities.

Behind the brittle optimism presented by every sector from travel and hospitality to ‘tech’ and the supply of consumer goods lies a reality shaped by rising costs, decreasing consumer resources, and an eroding capability to bridge the gap using cheap and abundant credit.      

Prices as interface           

In order to interpret the role of inflation correctly, we need to understand the conceptual distinction between the ‘two economies’ – the ‘financial’ or proxy economy of money and credit, and the ‘real’ or material economy of energy and resources.

What this distinction tells us is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services supplied by the real economy. If we wanted to be high-falutin’ about it, we could say that money is an artefact ‘validated only by exchange’.

What this really means is that inflation is a process governed by changes in the relationship between the availability of money and the supply of goods and services.

Over an extended period, we’ve been pouring enormous quantities of financial demand into the system, at the same time that material supply has become ever more constrained.

In this sense, inflation isn’t even a new phenomenon. Rather, price escalation has, hitherto, been channelled into asset prices, whose movements are – conventionally, but mistakenly – excluded from the measurement of inflation.

If we had, all along, been using a comprehensive, RRCI-type measure of inflation, we would have been far better prepared for, and much less surprised by, what is happening now.  

Since there are no ‘fixes’ for material constraints, the only way in which inflation can be tamed is by pushing monetary demand back downwards into alignment with material capability.

This understanding re-frames what we know about monetary policy. As things stand, the real (ex-inflation) cost of money has fallen to unprecedentedly negative levels. Since we can’t create physical resources out of nothing, the only policy fix for the gap between the real and the financial economies is the elimination of the subsidy of deeply negative real rates. The scale of past recklessness has ensured that any such process would be extraordinarily disruptive. 

This means that raising rates by enough to tame inflation would have two effects, not one. The first would be to temper the rate at which the supply of credit expands. The second would be to start unwinding past expansion in the quantity of credit.

It would be futile to suppose that we can have one of these effects without the other. We cannot restrain inflation simply by raising rates by just enough to deter new borrowing, without affecting either the servicing cost or the collateral backing of existing credit.

In any case, the current system depends on a continuity of increasing credit. 

To be effective, then, rate rises would have to be big enough to trigger credit defaults, asset price slumps and a re-pricing of the financial system back into equilibrium with the constrained character of the underlying economy.

The paralysis of predicament

In practical terms, this means that positive real rates won’t be reinstated voluntarily, and this leaves us looking for pressures that might force us to act realistically.

The most obvious such pressure will come from households, which might accept the impairment of the scope for discretionary consumption, but won’t – and can’t – tolerate relentless increases in the cost of essentials.

This is where forecasting processes need to be reinvented, meaning rebased away from the fallacious assumption of ‘growth in perpetuity’.

By calibrating both prosperity and the trend in the real cost of essentials, we can make sense of a dynamic whose consequences will include widespread defaults, sharp falls in real asset prices and a fundamental shift in the political climate.

At the same time, our recognition of the relationship between the ‘real’ and the ‘financial’ economies should give us steadily-improving visibility on the economic, financial and broader outlook.

None of this necessarily spells “collapse”, but it does establish a relationship between systemic risk and the prevalence of self-deception.

In this sense, our best hopes for a manageable future rest on an orderly assertion of reality, and the retreat of delusion.

#218. The real state of the economy

A FUNCTIONAL SYNOPSIS

As this might be the last article to appear here before the festive season, I’d like to take this opportunity to wish everyone a very merry Christmas and a happy and prosperous New Year, and to thank you for your interest in, and your contributions to, our conversations about energy, the economy and directly-related subjects.

I’m particularly appreciative of the way in which our debates have remained firmly concentrated on the economy. We could all too easily have dissipated our energies on subjects which, whilst topical and important, are not those on which we can add value through specialist knowledge.

It seems to me that the economy – with its profound implications for business, finance, government, society and the environment – is of such importance that clarity of focus is invaluable.

This clarity is singularly lacking in what we might call ‘the public discourse’. The economic debate, such as it is, has become reminiscent of that old Western movie hero who “jumped on his horse and rode off in all directions at once”.

Behind all the partisan argument, the mystification and the theorizing about nefarious plots, the plain fact is that the economy faces challenges and risks without precedent in modern times.

This simple fact is all too often lost in a miasma of misconception, false nostrums and self-interest.   

One economy, two systems

We can add value in this situation because we understand two central realities that are neither known to, nor accepted by, the orthodox approach to economics.

First, we are aware of the critical distinction between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

Second, we recognize that the real or material economy is an energy system, in which prosperity is a function of the availability, value and cost of energy.

This understanding enables us to define the current economic predicament. The financial economy has grown rapidly, driven by unprecedentedly expansive credit and monetary policies.

The real economy, meanwhile, has decelerated towards de-growth, because the energy equation has become progressively more unfavourable.  

This has opened up a gap between the ‘two economies’ of energy and money. The wider this gap becomes, the greater are the forces trending towards a restoration of equilibrium. The take-off in inflation is a logical sign of the return of equilibrium, because prices are the point of intersection between the real economy and its financial proxy.  

In terms of anticipating the future, the forced restoration of equilibrium between the financial and the material economies is critical.

The energy economy, shaped by physical realities, cannot be made to align itself with its financial counterpart.

Therefore, the return of equilibrium must involve shrinking the financial system back into proportion with the underlying economy.

The restoration of the rational

If we’re to achieve any kind of orderly exit from our current predicament, it’s essential that reasoned interpretation prevails over notions rooted in misunderstanding, denial, wishful-thinking and, to be blunt about it, sectoral self-interest.

Regular readers will, I hope, permit me a very brief restatement of the three critical principles involved.

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

Second, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ’consumed in access’ component is known here as the Energy Cost of Energy (ECoE), and is not available for any other economic purpose. Material prosperity is, therefore, a function of the surplus energy that remains after ECoE has been deducted. 

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

It follows that, if the aggregate of monetary ‘claims’ is allowed to expand much more rapidly than the underlying economy of energy, the result is the creation of ‘excess claims’ which the material economy cannot honour.

To the extent that these excess claims are regarded as having ‘value’, the restoration of a viable relationship between the real and the financial economies must involve the process known as ‘value destruction’.

Measuring the gap

A very short set of statistics will suffice to illustrate quite how far the ‘two economies’ of energy and money have diverged.

Between 2002 and 2020, global prosperity increased by 29%, or $19 trillion at constant values. This calculation is sourced from SEEDS, a proprietary economic model which measures prosperity on energy principles.  

Over the same period, reported GDP rose by 84%, or $60tn, but most of this “growth” was cosmetic. It was a product of allowing debt to rise by $203tn (+160%), and broader financial liabilities to grow by an estimated – and astonishing – $435tn (+201%).

The latter equates to the addition of $7.20 of new forward financial commitments for each dollar of reported “growth”. This number would rise to almost $10 if we included the emergence of enormous “gaps” in the adequacy of pension provision.

The following charts put these relationships into context. The first compares GDP both with debt and with broader financial assets. These assets – essentially the liabilities of the household, government and non-financial business sectors of the economy – are estimated on the basis of data that is available for countries which, together, account for three-quarters of the world economy.

As you can see, an enormous ‘wedge’ has been inserted between GDP and aggregate forward financial commitments.

The second chart, which uses the SEEDS calibration of prosperity, shows a corresponding divergence between reported GDP and the underlying performance of the real economy.

This second wedge might look enormous which, indeed, it is.

But, as the third chart shows, the difference (shown in solid red) between prosperity (last year, $85 trillion) and GDP ($132tn) pales into insignificance – indeed, you might need to enlarge the chart to see it at all – when set against the chasm (outlined in red) that has arisen between economic output and the enormously inflated scale of forward financial commitments (estimated at $650tn at the end of 2020).    

 

A situation summarized

Three conclusions can be drawn from these figures.

First, most – nearly 70% – of all “growth” reported between 2002 and 2020 was the purely statistical effect of breakneck credit escalation.

Second, a long period of financial distortion has created an enormous gap between financial activity, reported as GDP, and the real level of prosperity, as measured in material terms.

Third, asset price inflation has been a corollary – intentional or not – of the ultra-loose monetary policies involved in the manufacturing of a simulacrum of “growth”.     

If we put this together, what emerges, as remarked earlier, is a severe disequilibrium between the monetary and the material economies.

The fundamental issue now is the inevitable restoration of equilibrium between the economy as it is and the economy as it’s been made to appear by financial expansion.

To understand how this is likely to unfold, let’s start by noting the difference between prosperity and GDP. Prosperity is a measure, calculated by SEEDS, of trends in the material output of the economy over time. GDP, on the other hand, isn’t a measure of output, but of economic activity.

Simply stated, goods and services are produced using energy, but are exchanged using money.

These are quite different things.  

One way of reconciling the divergence between GDP and prosperity would be to conclude that inflation has been understated over time. The SEEDS model assesses this using RRCI, the Realised Rate of Comprehensive Inflation.

RRCI remains a development project, but it indicates that official inflation (of 1.5% annually between 2000 and 2020) was understated against a comprehensive rate of 3.5%.

This difference mightn’t seem huge but, compounded over time, its effects are enormous.

There is, moreover, abundant evidence for the proposition that inflation has been significantly under-reported over many years.

Consumer inflation has been distorted by hedonic adjustment, substitution and geometric weighting.

Even more seriously, conventional measurement – including the problematic GDP deflator – excludes asset price inflation, which has been rampant since the GFC and the introduction of policies which have priced capital at negative real rates.

Probabilities of process

Reconciling reported activity with material prosperity is a worthwhile exercise, and it seems likely that RRCI will prove a useful addition to the suite of capabilities provided by the SEEDS economic model.

What matters most, though, is the process through which the restoration of equilibrium is likely to occur. Science-minded readers might usefully liken the impetus towards equilibrium to some of the forces that operate in physics.   

In practice, what this means is that the financial economy, and the financial system itself, are going to be compressed back into alignment with the underlying material economy of goods, services, labour and energy.

There are, in functional terms, two ways in which this can happen. The first is rampant inflation, whose macroeconomic effect would be soft default on forward financial commitments that cannot be honoured by a deteriorating underlying economy. ‘Soft default’ is what happens when obligations are met, but in money that has lost a large proportion of its real value.

The second is that the authorities might intervene to curb inflation, primarily by raising real interest rates back into positive territory. This would trigger hard defaults, where debtors fail to meet their obligations.

To a certain extent, how this unfolds is a question of process, on which two observations are pertinent.

First, the trend in the real cost of essentials is critical, because sharp rises in the cost of living are guaranteed to trigger public engagement in a policy debate to which, in normal times, they pay scant attention.

SEEDS analysis – which notes the connection between ECoE trends and the cost of energy-intensive necessities such as food, water, housing and necessary travel – indicates that the real cost of essentials is set to carry on rising markedly over time.

Second, it seems likely that policy actions will, for the foreseeable future, be a case of ‘too little, too late’. For reasons best known to themselves, policy-makers attach disproportionate importance to the prices of assets such as stocks and property, and miss-state the role of a “wealth effect” whose real significance lies in the promotion of credit expansion.

The heart of the matter

What’s really important, though, is that the process by which equilibrium returns to the relationship between the monetary and the material economies is going to have profound financial, economic, political and social consequences.

Both the ‘soft default’ of inflation and the ‘hard default’ of failures are likely to intensify.

Levels both of capital investment (in new and replacement productive assets) and of discretionary consumption (of non-essential goods and services) are set to contract markedly.

Economic issues can be expected to rise ever higher in the priorities of voters, implicitly displacing matters of non-economic concern. Any politician who fails to recognize the rising popular concern about the cost of living can expect to be marginalized.

What we have here is a dynamic whose logic seems inescapable, and whose quantification is imperative.   

You will not misunderstand me, I’m sure, if I say that our understanding of these issues gives us a competitive edge over interpretations founded on outmoded, ‘money-only’ nostrums which fail to recognize the essential materiality of the economy.

In short, our interpretation works, where orthodox alternatives do not.

The question for the year ahead is how we sharpen that edge, and put it to use.     

#217. No ‘soft landing’

MODELLING THE RETURN OF EQUILIBRIUM

“The proper study of mankind is man”, wrote the poet Alexander Pope in An Essay on Man.

We can usefully paraphrase this to the effect that ‘the proper study of economic man is prosperity’.

Correctly understood, material prosperity is a function of the use of energy.

We know, after all, that nothing that has any economic utility at all can be supplied without the use of energy. We also know that, whenever energy is accessed for our use, some of that energy is always consumed in the access process, so is not available for any other economic purpose. 

From this understanding follows an equation, straightforward in principle, that calibrates material prosperity.

The ‘consumed in access’ proportion of energy supply is known here as the Energy Cost of Energy, or ECoE.

If we deduct ECoE from total energy available, we’re left with surplus energy, which is the direct material correlate of prosperity.

If we further divide this aggregate surplus energy prosperity by population numbers, the result is prosperity per capita.

Measuring prosperity

The SEEDS economic model – the Surplus Energy Economics Data System – has been designed to interpret the economy in this way. Expressed (for convenience) in financial terms, global aggregate prosperity grew by slightly less than 1.4% annually between 2000 and 2020, meaning that it increased by a total of 31% between those years. 

Over that same period, world population numbers increased by 25%. This means that the average person was slightly less than 5% better off in 2020 than he or she had been back in 2000.

These, of course, are global averages, combining performances that vary regionally and nationally. The average Western citizen has been getting poorer since well before the global financial crisis (GFC) of 2008-09. Prosperity per person has continued to improve, albeit it at decelerating rates, in the EM (emerging market) economies.

Looking ahead, we know that the ECoEs of economies which remain reliant on energy from oil, gas and coal are continuing to rise. There are compelling environmental and economic reasons for endeavouring to transition from fossil fuels to alternatives, principally renewable energy sources (REs) such as wind and solar power.

The question here isn’t the feasibility of quantitative conversion to REs. Rather, what we need to know is whether this transition will drive ECoEs back downwards. The hierarchy of challenges involved in transition make this improbable. Even if REs can usher in an era of lower ECoEs, they certainly can’t do so now.    

This interpretation points unequivocally towards further deterioration in prosperity. The average Westerner will carry on getting poorer, whilst prior growth in prosperity per capita in EM countries will go into reverse.

Within this broad projection of eroding prosperity, we also know that the real cost of essentials will carry on rising, not least because most necessities are energy-intensive.

What results is a leveraged equation in which prosperity net of essentials falls more rapidly than top-line prosperity itself. This means that essentials will account for a steadily rising proportion of total prosperity.

It follows from this that both capital investment and the scope for the consumption of discretionary (non-essential) goods and services will be reduced.

None of this constitutes a prophecy of ‘collapse’.

Rather, it poses the challenge of adaption to lower prosperity after more than two centuries in which, thanks to the supply of ultimately finite low-cost fossil fuel energy, world prosperity has expanded very rapidly.  

A process of denial

Conventional interpretations of economics do not recognize the analysis sketched out here. The economy is presented, not as an energy dynamic, but as a system that is wholly financial.

Energy and other resource constraints are dismissed with the nostrum that [financial] demand produces [material] supply.

This nostrum can be described as the systemic fallacy of conventional economics. The reality, of course, is that no amount of monetary demand can create resources (such as low-cost energy) that do not exist in nature.

By the same token, we cannot “stimulate” our way to greater material prosperity, “grow out of” debt and other financial commitments to the future, borrow our way to financial solvency, or “invest” (meaning monetise) our way to economic and environmental sustainability.

To paraphrase Pope again, though, ‘hype springs eternal in the human breast’. The latest version of cornucopian hype is that growth in perpetuity can be delivered through the alchemy of “technology”. This ignores the inconvenient reality that the potential of technology is limited by the laws of physics.

Things being as they are, conventional economic interpretation continues to insist that infinite economic growth remains a plausible outcome on a planet that, ultimately, is finite. Nowhere in classical economics will you find any recognition of the concept of ECoE. The word ‘prosperity’ is sometimes employed, but not in the precise and material sense in which it is used here.

This ‘money-only’ fallacy applies, not just to projections for the future, but to interpretation of the recent past. For the period between 2000 and 2020, for example, we’re told that the economy enjoyed “growth” averaging 3.4% annually, and expanded by 94% over that period as a whole.

In pursuit of reconciliation

Here, then, are two contradictory statements. The first is that the economy ‘grew by 3.4% annually’ between 2000 and 2020.

The second is that prosperity ‘expanded by less than 1.4% per year’ over that same period.

We could reconcile these two statements by asserting that the rate of inflation used in the measurement of ‘real’ (ex-inflation) GDP has been understated.

The SEEDS model makes this calculation by calibrating RRCI (the Realized Rate of Comprehensive Inflation). If you took out official inflation (of 1.5%) between 2000 and 2020, and used instead an RRCI rate of 3.5%, reported growth in real GDP would align with growth in real prosperity, as calculated on an energy basis.

There seems little doubt that inflation has been understated – routinely and significantly – in official numbers. This suggests that energy-based analysis can improve our understanding of the economy through the measurement of RRCI.

Measuring difference

For present purposes, though, our best route is to accept that GDP and prosperity are measures of two different things.

Prosperity measures material economic output as it relates to the supply of goods and services.

GDP, on the other hand, is a measure of economic activity, referencing the financial transactions by which these goods and services change hands. 

This presents us with a different requirement for reconciliation. The implication is that the financial value ascribed to activity has expanded much more rapidly than the far more pedestrian rate of increase in the output of material goods and services.

There is abundant evidence, both quantitative and qualitative, for this proposition.

Quantitatively, debt expanded by $216 trillion (190%) between 2000 and 2020, a period in which GDP increased by only $64tn (94%). Broader financial liabilities, which include the unregulated shadow banking system, have grown even more rapidly. The same is true of unfunded pension commitments, where we have seen the emergence of enormous “gaps” in the adequacy of provision.

Colloquially, we know that millions of Americans have been described, persuasively, as “debt slaves”, and that millions of people in Britain now use various forms of ‘BNPL’ (meaning “buy now, pay later”), even as more traditional forms of credit-funded consumption have continued to expand.

A growing proportion of the corporate sector has transitioned towards a model based on streams of income, in which the ‘signing up of’ customers is regarded as more significant than actual levels of current sales.

Evidence of the financialization of the economy is, of course, to be found in the prevalence of negative real interest rates, a product of policies which, when first introduced more than a dozen years ago, were presented as “temporary” expedients.

The negative real cost of capital has inflated the prices of assets to levels far beyond anything that can be justified using traditional measures of value.            

From here, where?

As objective observers, our focus needs to be on predictable outcomes.

We have persuasive evidence that economic activity has been inflated to levels far in excess of underlying material prosperity. We can conclude that this process has created unsustainable rates of increase in financial commitments, which include formal debt, informal indebtedness, pension promises and expectations of futurity.

We also know that these processes have driven asset prices to unsustainably elevated levels.

Now that growth in prosperity has deteriorated into negative territory, it seems hard to avoid the conclusion that what lies ahead is an enforced restoration of equilibrium between the ‘financial’ economy of money and credit and the ‘real’ economy of goods and services (and, ultimately, of surplus energy).           

Our attention now needs to be devoted to the mechanisms by which equilibrium is restored.

A recent SEEDS project has involved the calibration of a potential ‘soft landing’, by which we manage the restoration of financial and economic equilibrium.

You will not be surprised that the engineering of a ‘soft landing’ is both (a) mathematically feasible, and (b) politically almost impossible.

Essentially, economies would have to accept now adjustments that will, in any case, be enforced upon them at a later point by economic, material, political and environmental trends.

The key word here is “later”. Where unpleasant realities are concerned, ‘never accept today what you can put off until tomorrow’ is an axiom, not just of politics, but of society more generally.

Moreover, there are structural factors – most obviously in America, Britain and the Euro Area – which make the adoption of ‘soft landing’ policies virtually unthinkable.   

In the absence of a soft landing, what lies ahead is a scenario in which we are forced to adjust to ‘prosperity reality’. The likeliest mechanism is inflation and, specifically, escalation in the cost of essentials.

As what is called colloquially ‘the cost of living’ accelerates beyond the affordability of millions, the authorities are likely to be dragged, with the utmost reluctance, into a situation where inflation has to be tamed.

That’s the point – and it’s likely to be very soon – at which equilibrium is restored between an inflated financial system and an eroding underlying economy.

There is analytical value in the modelling of what a soft-landing would look like, even though we know that this course of action isn’t going to be adopted. 

Essentially, a conceptual soft-landing gives us a template against which to measure what actually happens, much as the measurement of prosperity provides a benchmark which can be used to quantify the difference between the economy as it appears and the economy as it is.