#63. Why the world economy has stagnated

As many readers will know, I am an enthusiastic advocate of a new way of looking at the economy, something which I call “surplus energy economics” (“SEE”). In support of this, I’ve developed something known as “SEEDS”, or Surplus Energy Economics Data System.

With the finishing touches being put to the 2016 version, what I aim to do here is to outline some of its principal conclusions. This will also serve as something of a primer for those not familiar with SEE.

SEEDS-16 confirms that, despite a price-war in oil markets and a weakening in demand resulting from economic slowdowns (most significantly in China), the underlying trend in the “energy cost of energy” remains strongly upwards. Energy market surpluses do not change the fundamental point, which is that depletion continues to make replacement sources of fossil fuels increasingly expensive.

Rapid expansion in shale output doesn’t change this, because the big weakness with shales is the very rapid rate at which production from individual wells declines. The future clearly lies with renewables (and principally with solar), but, as discussed later, these are unlikely to change the dynamics of an increasingly-costly energy supply mix.

What this means is that, after a hiatus, there will be a resumption of “energy sprawl”, meaning that the resource and financial requirements of energy supply will continue to absorb a rising proportion of economic output. This in turn means that the real measure of prosperity – that is, output net of the economic rent attributable to the imperative of energy access – will come under increasing pressure, despite the assumption that economic efficiency will improve.

As the first chart shows, the world’s real economy – that is, the economy of goods and services, rather than their “financial economy” proxy – can be expected, first, to stagnate, and then to enter gradual decline.

SEEDS 16 chart 03 - Real Economies

Some of the world’s most vibrant economies, such as India and China, may buck this trend for as much as a decade. With few exceptions, the outlook for the mature developed economies is bleak, with Britain and Japan set to suffer the worst declines, in both cases for quite specific reasons.

At the same time, continued expansion in the “financial” economy of money and credit – which have value only as “claims” on the real economy – has created a very dangerous situation. Essentially, the financial economy has created far more claims than the real one can ever satisfy, and SEEDS-16 quantifies these “excess claims” at $67 trillion.

The basics – the surplus energy economy

Essentially, SEE argues that we need to think in terms of two economies, not one. The first of these – the “real economy” – consists of goods and services, labour and resources.

This real economy is a function of energy, not money. After all, money has no intrinsic value, and can be (and has been) created at will, without adding anything to the real output of the goods and services that we need. Energy, as the basis of the real economy, needs to be defined broadly, to include labour and nutrition as well as the more familiar forms of energy such as fossil fuels and renewables.

Since it has no intrinsic worth, money possesses value only as a “claim” on the output of the underlying – real – economy. Money, then, has only “claim value”, whilst debt, as a “claim on future money”, is in reality a claim on the future output of the real economy.

Together, money and credit comprise the second or “financial” economy. This is the economy of monetary data (such as GDP, incomes, spending and debt) with which everyone is familiar, but in reality it is nothing more than a convenient proxy for the real economy of goods and services.

The financial economy, consisting entirely of created claims on real output, can in principle help us to manage the real one to best effect. But an obvious danger exists where we create claims that exceed what the real economy can deliver. Where this happens, the difference is known in SEE as “excess claims”, meaning “financial claims on economic output that the real economy cannot satisfy”.

And this is exactly what has happened over the last decade and more. The financial system has created credit (money and debt) at a much faster rate than growth in the real economy. “Excess claims” show up primarily as escalating debt which we know can never be repaid.

SEEDS-16 quantifies a global aggregate of “excess claims” of $67 trillion as of the end of 2014. Put simply, these “excess claims” are “value” within the financial system that, one way or another, has to be destroyed, because it cannot be satisfied.

This $67 trillion number is not analogous to global debt, which is very much larger (around $200 trillion). Rather, the excess claims figure is indicative of the scale of debt and other claims that cannot be met, and will therefore have to be written-off in one way or another.

On this basis, it is a permissible simplification to say that about one-third of all global debt can never be repaid.

This creation of “excess claims” has happened for two main reasons. The first is simple recklessness. The second is a miss-match between what the financial system expects the real economy to produce, on the one hand, and, on the other, what the real economy has actually delivered. This “anticipatory error” reflects a tendency to assume that the future will be an extrapolation of the recent past. The trouble with this is that it has been derailed by the disappearance of the rates of economic growth that had become familiar in the past.

So the debt colossus that hangs over the world financial system like the Sword of Damocles has resulted both from the excessive creation of debt and from the poor performance of the global economy.

The real economy

Why, then, has the real economy become so weak?

That it has indeed weakened is underlined by performance since the 2008 slump. Generally, a recession tends to be followed by catch-up growth, as businesses and households alike carry out spending deferred during the down-turn. This time, however, here has been no such catch-up rebound.

The explanation for the weak performance of the global economy lies in the rising trend cost of energy.

To understand this, it must be appreciated that energy cannot be accessed at zero cost. Capital and operating expenses, though usually considered as money amounts, need to be assessed in energy terms to make sense of this equation.

The critical equation here is EROEI, meaning the Energy Return On Energy Invested. An EROEI of 30:1 means that, within 31 units of energy accessed, 1 unit is the energy cost incurred, and the remaining 30 units are available for use.

The SEEDS system uses the inverse of EROEI, which is ECOE, or the Energy Cost Of Energy. If the EROEI of a given source is 30:1, the ECOE of that source is 3.2%, which is 1 divided by 31.

Like EROEI itself, the ECOE progression is non-linear. If EROEI falls from 60:1 to 30:1, ECOE rises from 1.6% (1/61) to 3.2% (1/31), a relatively small increase in cost for a halving of EROEI. Reduce the EROEI to 15:1, however, and ECOE rises to 6.25% (1/16), a very material increase in cost. At EROEIs of 10:1 and 5:1, ECOE is 9.1% and 16.7%.

What this in turn means is that the overall EROEI of the economy can move a long way before its effects become apparent. Critical territory is entered, however, once EROEIs fall below about 15:1.

Conceptually, the “energy cost of energy” can be thought of as the economic rent which the resource set imposes on the economy. Historically, unfortunately, it has not be accounted for in this way.

Rather, it has tended to be overlooked altogether.

Of course, the actual cost of energy in any given year is determined by factors only tangentially linked to underlying trends. Political factors, such as wars, revolutions and OPEC policies can drive prices sharply upwards, as they have on many occasions.

The price-war

Conversely, a slump in activity – and hence in demand – can undermine prices very significantly, particularly if they follow a period in which sustained high energy prices have led to a spike in investment.

The latter describes the current situation. Until 2014, growth in demand for energy was pretty robust, and was expected to remain so. High prices encouraged big investment in supply, most notably in the production of oil and gas from shale formations in the United States. At the same time, high prices stimulated investment in renewable energy sources such as wind and solar power.

Latterly, with the slowdown in Chinese expansion, the global economy has all but lost what previously had been almost its only engine of growth.

This has come as something of a shock to the system, mainly because of a widespread failure to recognise that China, like the West before it, had been delivering growth primarily on the back of enormous incremental borrowing. At the same time, hefty capital investment had resulted in big increases in supply, principally from US shales.

What we have now is, to all intents and purposes, a price-war, between US shale producers on the one hand, and, on the other, Saudi Arabia and its fellow Gulf exporters.

Both sides are suffering severe financial pain from this price-war. The Gulf countries have experienced drastic falls in their export revenues, which have in turned created enormous fiscal deficits. In the United States, companies specialising in shales have suffered carnage, reporting sharply lower cash flows and profitability, and rapidly increasing debts. Much of this debt is deeply into “junk” territory, and equity value has slumped, all but cutting off the shale sector from access to new capital.

This has extremely important implications for the future production outlook. Though the sheer scale of oversupply suggests that the price-war may prove protracted, the tactical weakness of shale lies in rapid depletion rates. It is by no means uncommon for production to decline by as much as 75% in the first year of a shale well’s operation. This means that, to maintain or increase output, operators need to carry out an on-going drilling programme, something that has been likened to a “drilling treadmill”. As a result, the drying up of investment funds is likely to result, relatively quickly, in declines in production. The Gulf producers appear likeliest to win the price-war, though that can be by no means a certainty.

The critical equation – the trend cost of energy

Whatever the outcome of the oil price-war, the salient point is that energy prices are extremely volatile, whereas what is needed for purposes of economic analysis is a trend rate of changes in ECOEs.

This is shown in the next chart. Between the first oil crisis in 1973 and around 1990, actual energy prices were well ahead of trend. They were again above-trend between 2004 and 2013, but have now fallen back to below-trend levels.

SEEDS 16 chart 02 - energy prices

We need to be very well aware that the current weakness in prices is caused in large part by the price-war, so we most certainly can not assume that we have moved back into an era of cheap energy.

Indeed, the overwhelming burden of evidence indicates that the upward trend in real prices (and ECOEs) remains very much in place. This doesn’t reflect any assumption that global economic growth will improve, since this actually looks unlikely. Rather, indications from the supply side of the equation strongly suggest a continuing uptrend in costs

Starting with oil, the cost of developing and producing new sources of oil has risen relentlessly for at least two decades, and arguably even longer. The world’s biggest, most cost-effective fields were developed first, and the fields which replace them are ever smaller, ever more remote and ever more costly to produce.

It has, indeed, been argued that the production of conventional oil peaked in 2005, and that subsequent net increases in supply have come from unconventional sources (which may be why influential publications now talk about “liquids” rather than “oil”). The most important unconventional source of liquids is shale, but this suffers from very rapid rates of depletion. High investment can cope with this, of course, but not if returns diminish because the best locations have – quite logically – been used first.

Though conventional natural gas has yet to peak, gas is otherwise in much the same situation as oil, with the most cost-effective fields already depleted, and costs rising as ever more marginal resources are developed.

Reserves of coal are relatively abundant, but the calorific value of the production slate is declining, because the best coal (such as anthracite) has been extracted first. Furthermore, environmental considerations strongly militate against expanded use of coal, something which might be difficult to do anyway, given the decline in calorific content. The role of nuclear will clearly increase, but nuclear fuel supplies are by no means abundant, and dealing with spent fuels remains extremely difficult.

What all of this means is that renewables will account for a rising share of the energy slate in the future. This said, renewables only accounted for about 2.5% of primary energy supply last year, and increasing this proportion will be expensive. Within the mix of renewables, the most promising (by a very wide margin) is solar power. The track-record of wind-power is somewhat mixed, and its economics seem to rely on heroic assumptions for the longevity of plant. Biofuels are of limited scope, not least because a lot of liquid energy is used up in planting, harvesting, processing and distribution. Moreover, a big increase in biofuels output would pose a clear threat to food production, a critical issue which may already be at serious risk due to water depletion, the declining nutrient content of land, the high (energy) cost of inputs, and the implications of climate change.

There are two other points to note about renewables. First, and before the outbreak of the oil price-war, the best renewables (principally solar) had showed that they can compete reasonably well with fossil fuels in price terms. But their pricing, and their cost-effectiveness, only looks solid when they are compared with the oil and gas production mix of today, and more specifically with the high-cost sources that are increasingly being accessed.

To put it another way, renewables may be able to compete with an oil and gas slate whose costs have already risen sharply, but they cannot replace the world’s rapidly-dwindling (but still significant) legacy of large, long-established and very low-cost fields.

Second, renewables cannot match the energy density – the quantity of calories-per-kilo – offered by fossil fuels, especially oil. Propelling a Boeing 747 with electricity is not remotely possible today and, despite rapid progress in battery technology, may be prevented by the laws of physics from ever becoming possible.

The energy/economy relationship

Though the day-to-day relationship is subject to huge volatility, the underlying trend in the ECOE – the energy cost of energy – is emphatically an upwards one. Even with a price war in full swing, the “economic rent” which energy imposes on the economy remains far higher today than it was ten years ago.

Though it may take several years to happen, the likelihood is that energy prices will in due course move back into higher territory, partly in response to big cuts in capital investment. This is to some extent a cyclical phenomenon, but the cycles behave in sine-wave formation around a secularly-rising trend. This is termed the “oscillating trend”, and is shown conceptually in the next chart.

SEEDS 16 chart 04 - oscillating

The secular rise in trend energy costs is already taking its toll on the real economy. The energy cost drain has resulted in escalating indebtedness, because the world has gone on acting as if the “economic rent” exacted by the energy resource set does not exist. The cost of household essentials has soared, undermining discretionary spending capacity in ways not measured by conventional calculations of inflation.

The weakening real economy has already forced us to cut returns on capital to levels which deter investment. What this really means is the pressure on the real economy is forcing us to prioritise consumption.

The next stage of the ECOE squeeze will involve economic deterioration that can no longer be disguised. In future articles, I will look in more detail and how and where this is likely to happen.


#62. The integrity deficit


Surprising though it may seem, there are people who really believe that they take nothing on trust, accept nothing without proof, and ascertain all the facts before doing anything. This belief is, of course, nonsense, and our everyday lives would be impossible without trust.

The same is true of our everyday economic lives, which also depend on trust. It simply isn’t possible to operate an economy effectively without a very great deal of trust.

Though what has happened at Volkswagen is extreme, it does provide a useful reminder of the importance of trust in how the economy functions. This issue needs to be considered because, unfortunately, policymaking has, for far too long, been dominated by economic thinking which fails to take account of the critical importance of trust.

The ideology which asserts that the market economy is a sort of free-for-all – in which caveat emptor (“buyer beware”) over-rides the need for integrity – has created a dangerous deficit in trust.

Ultimately, this deficit could be more critical than the familiar trade and fiscal shortfalls with which economies continue to grapple.

To this end, this article looks at why trust is so important to the economy, and at why the apparent undermining of trust may be a very serious economic negative. Of course, there is a limit to what we can cover here, but there can be no doubt that the issue of trust is critical. When the current “anything goes” economic orthodoxy is overthrown – which is surely only a matter of time – whatever replaces it must rediscover the critical role of trust.

Why trust matters

Trust in others is so integral to our everyday lives that few of us ever question it.
When someone hands you a cup of coffee, you don’t test it for toxins. When you get in a cab, or someone offers you a lift, you don’t demand to see the vehicle’s roadworthiness certificate. When you get on a bus or a train, you don’t insist on seeing the driver’s licence, or testing him for alcohol. When you see a doctor, you don’t demand proof of his credentials. And so on.

Trying to check such everyday things would make life quite impossible. The sheer bulk of the test equipment you’d have to carry around with you is just the first of the problems you’d encounter. How are you to be sure that the suppliers of this test equipment are themselves trustworthy? When the bus driver shows you his driving licence, how are you to check that it was obtained legitimately?

The reality is that we have no choice but to exercise trust on numerous occasions in our everyday lives. It cannot, realistically, ever be otherwise.

The same is true of our “economic lives”. When a utility sends you a bill based on your consumption of electricity, gas, water or phone-time, you really have no choice but to take their word for it. Homes are metered, of course, and checking the meter reading can be a good idea, but the meter is likely to have been provided by the same supplier from whom you purchase your gas or electricity.

The quickest of reflections will convince you of the sheer extent to which trust is required in economic transactions. Virtually any purchase of goods or services requires trust in the supplier, as does any venture into investment, or any use of financial services.

Trust and economics

Economic trust is so fundamental that it should be incorporated into any understanding of the economy. Unfortunately, conduct of the world economy has, for three decades or so, been dominated by a school of thinking which fails to make this vital connection.

This school of thought – variously labelled “the Anglo-American economic model”, “the Washington consensus” and “neoliberalism” – asserts, instead, that the free market economy operates along “law-of-the-jungle” lines. Customer self-interest is seen as self-sufficient, making trust less relevant.

This thinking is utter nonsense, but this has not prevented it from gaining massive influence over how economic affairs are conducted.

Where economics and trust are concerned, what are the fundamentals? Well, wherever you stand on the spectrum, you would struggle to deny that competition is the most important discovery that we have ever made about the economy.

It is, incidentally, for his emphasis on competition, and not for a supposedly-doctrinaire preference for the private sector over the state, that Adam Smith is rightly venerated.

The theory of competition is straightforward. Multiple suppliers seek the customer’s business. To get it, each strives to offer a better price than the others, or better quality, or a combination of the two. This process drives innovation, and best value for customers, and in these ways promotes the general betterment of the economy.

This theory is by no means confined to competing suppliers of brooms or vacuum cleaners, and the benefits of competition stretch far beyond the consumer. Workers benefit where potential employers compete for their skills. Savers benefit where businesses compete to offer the best returns on investment. Society, and the economy as a whole, benefit because competition stimulates striving and innovation.

Adam Smith was at his most emphatic when he condemned the threat posed to competition by cartels and monopolies, and there are many often-quoted Smith remarks about the evils of concentration, something which Smith condemns as being, everywhere and always, aimed at duping the customer by rigging the market.

Incidentally, Smith’s strictures against monopoly are often wilfully misrepresented as opposition to the state and a preference for private ownership. This is nonsense, both historically and logically.

Historically, it is nonsense because there were no nationalised industries in Smith’s day, when a minimalist state provided little more than basic government, a legal framework and national defence. There wasn’t even a state-funded police force in Smith’s era, let alone state provision of health care, or involvement in industry – so there wasn’t a “public sector” for Smith to be opposed to. Moreover, his condemnation of cartels and monopolies was specifically addressed at private-sector market abuse.

Essentially, the market theory associated with Smith demonstrates that monopolies and cartels are bad for the economy, irrespective of whether they are private- or state-owned.

What is equally clear is that markets cannot operate effectively if participants lie or cheat.

The whole theory of markets is that buyers choose from a range of alternatives, and this in turn absolutely requires that the purchaser knows what these alternatives are. If one or more potential suppliers lie about their products, the ability to exercise an effective choice is undermined, and potentially lost altogether.

The essential preconditions

From the competitive theory associated with Smith – and ignoring the endeavours of those who wish to co-opt him on one side or another of today’s debate – we can arrive at certain necessary foundations for the successful economy.

First, we can state that unfettered competition is imperative, and that any departure from it weakens the economy.

Second, we can assert that any monopoly or cartel, irrespective of who owns it, is bad for the economy.

Third, and arising from this, there must be a regulatory power that prevents excessive concentration. Left to themselves, stronger players would drive out weaker ones, either by acquiring them, or by using pricing power to drive them out of business.

So regulation, and by extension the state as guarantor of competition, is an implicit part of competitive economic theory. The role of the regulating power, through the prevention of concentration, is in fact that of “saving capitalism from itself”.

Fourth, we can assert that trust is an absolute requirement for an effective economy. Competition relies on freely-exercised choice, and this cannot happen where market participants lie or cheat.

Doctrines of distortion

All of this is a very far cry from the extreme neoliberal doctrines that endeavour to disguise themselves in Adam Smith’s clothing. These ideologies seek to persuade us that “all’s fair in love, war and the market-place”, and also assert that private ownership is the best solution to each and every issue.

In so doing, they necessarily understate the dangers of concentration, and of the abuse of market power. They paint the state as the antithesis of the free market, rather than as the essential guarantor of efficient markets. Such thinking also tends to understate the role of trust, and this may be its greatest single weakness.

The neoliberal extreme isn’t, even remotely, a truly market-capitalist analysis, of course. For a start, the free market isn’t anarchy, and doesn’t operate along “law-of-the-jungle” lines. If it did, smaller competitors would be destroyed, which would reduce or eliminate competition. Regulation, as we have seen, is an indispensible part of the effective market.

Equally, honest dealing is imperative, for which caveat emptor is no substitute. Given the practical impossibility of customers checking everything for themselves, it is absolutely essential that market participants are honest and truthful, enabling trust to be exercised. If it is imperative that suppliers tell the truth about the goods and services that they offer, it is equally imperative that information presented to investors is true and fair.

As well as guarding against concentration, the state has a critical role to play in underpinning market integrity. We should applaud the largely unsung heroes of the consumer protection profession, and welcome the recent tightening of UK consumer legislation. I have been delighted to see the EU throwing a spoke in the wheels of corporations that want to ship our data across the Atlantic, and admire all of those who help us to block internet ads and disable tracking cookies.

But there are limits to how much any government agency, however diligent and however well-resourced, can do to protect market integrity.

So we still have to take a very great deal on trust

Is trust under attack?

This, of course, is where the Volkswagen test-rigging scandal is so important. Hoodwinking government agencies is pretty bad in itself, but the worst feature of this whole sorry saga is the way in which a hitherto-respected company has lied to millions of customers.

The prospective purchaser of a vehicle needs to know about emissions, and has no real choice but to accept what competing manufacturers tell him about this. Equally, the customer has no choice but to believe what manufacturers tell him about performance, fuel economy, safety and many other issues central to his choice.

It may be unlikely that what has happened at VW has occurred elsewhere in motor manufacturing – for one thing, it seems doubtful that other companies would have done anything quite so stupid, since it would surely be impossible to get away with something like this indefinitely.

Financial services seem to be the greatest single area of weakness in the structure of trust that is imperative to the effective functioning of the market economy. The sector’s integrity has been brought low by the sheer scale of the scandals that have been unearthed, from the rigging of Libor to the sale of payment protection insurance (PPI).

One reason for this lies in the relative lack of sophistication of customers – people who have a good understanding of how a car or a refrigerator functions may have far less ability to judge the quality or value of a financial product, and this opens up scope for abuse. Another factor seems to lie in a debasement of the industry culture along the lines of “buyer beware” and “law-of-the-jungle”.

But the breakdown of trust has by no means been confined to financial services. To cite just one example, utilities have been found guilty of duping customers, something to which the authorities, regrettably, tend to apply the comparatively-innocuous label “miss-selling”, when what has really happened is surely a form of fraud.

Another huge regulatory mistake, particularly in the banking sector, has been the preference for punishing the company (meaning its hapless shareholders) rather than the individuals actually responsible for the various scandals that have been unearthed. Fining shareholders is not much of a deterrent to executive dishonesty, and a combination of fines, imprisonment and asset-stripping would surely be far more effective.

It is strange – to say the least – that the authorities have failed to see how individual accountability is the appropriate deterrent to misbehaviour by individuals.

We should not for a moment believe that the breakdown of trust is unique to banking and financial services. Many businesses in the broader economy seem to have moved away from integrity, not least when they can use one-sided “terms and conditions” to cloak bad practice in literal legality.

It is surely obvious that, just because something is legal, that does not necessarily make it honest. I was reminded of this when, on a recent holiday, I was offered a “rotational enjoyment facility” (meaning a time-share) in a “new” and “exciting” resort that is actually both long-established and drab.

The trust deficit

Of course, economists recognise that the only real foundation for a country’s currency is “the full faith and credit” of the issuer – if trust in this is ever lost, a currency can rapidly cease to have any value at all.

Beyond this, however, one must question quite how seriously economists and strategists take the broader issue of trust. Properly considered, trust – and its operative counterpart, integrity – is essential to the effective functioning of markets, and observation strongly suggests that integrity has weakened to an extent that is far more dangerous than is yet widely recognised.

This seems to be a particular problem in countries that pride themselves on the “open-ness” of their economies and the extent of their commitment to “markets”.

Anyone who wants to see the current economic system reformed – rather than overthrown altogether – needs to demand a far greater emphasis on integrity. Though vital, there are limits to quite how much can be accomplished by regulation, legislation and sanctions.

The broader problem is cultural, and its solution may require a challenge to the logic of materialistic self-gratification. We need to rediscover the fundamental principle that, far from being a form of anarchy, markets need to be “free” and “fair” in ways that make honesty and integrity imperative.

The attitudes that we bring to our economic interaction are, of course, a dimension of our broader attitudes to society, a linkage that operates in both directions. Any philosophy founded on self-interest alone becomes more fatuous the more closely you examine it, as, surely, does any view of life which concentrates only on the materialistic.

A preference for trust over dishonesty is a view that any sensible person may hold.
But is a salutary reflection – and, I hope, an informative one – that an economy simply cannot be effective in the absence of trust and integrity.

In other words, if your instinct is to prefer a society in which trust and integrity are central, you may be pleased to discover that you have sound economic logic on your side.

Ultimately, a shortfall in integrity could prove to be the most dangerous deficit of the lot.