THE CAUSAL LINE – FROM ENERGY TO THE GLOBAL PONZI
What we are witnessing now is the unravelling of a global economic system that has been turned into a giant Ponzi scheme. Collapse is the only way in which such schemes can ever end.
Current turmoil in the financial markets might presage this event. To be sure, more time might yet be bought, albeit at huge and futile expense.
This, however, is simply a matter of when. The if of collapse is not in doubt.
Technically, this is a financial system disaster rather than an economic one, though this distinction will do nothing to shield the real economy from the consequences.
This unfolding disaster can be traced to many causes. Economies have been undermined by structural weaknesses, some of them traceable to globalisation, others to capitalism debased into corporatism. The financial tail has been allowed to wag the economic dog. Political leadership has been clueless and cowardly – the same political ideologues who trumpeted the virtues of “deregulation” have abdicated responsibility, dropping a problem of their own making into the laps of hapless central bankers, with the result that a failure to fix a debt problem has simply compounded it with a monetary one.
Surreal ideas like negative interest rates, permanent QE and the banning of cash serve only to confirm that the policy cupboard is devoid of anything practical. Passing off the spending of borrowed money as “growth” has ceased to persuade. The idea that “debt doesn’t matter” has been exposed as one of the Big Lies of our era, ranking alongside “globalisation benefits everyone” and “inequality isn’t harmful”.
The intellectual and political leadership cadre is scrabbling around for solutions to a problem that it cannot understand, let alone fix.
But what is the real heart of this problem? There are two answers to this.
The first answer lies in a system which has no reverse gear, dodgy steering, and very little in the way of brakes. Our system is so predicated on growth that it is being overwhelmed by a stagnation that could yet turn into something even worse.
But why, then, is the economy failing to deliver growth? The answer to this second question is simplicity itself. Money is the token of the economy, not its substance. The substance itself is energy, and our (and our leaders’) ignorance of this simple fact denies us the only sane transition to a post-Ponzi world.
Fixing a pot-plant with a spanner
As most readers will know, my approach to economic and financial issues is rooted in a very clear (and unashamedly radical) way of looking at the economy. I call this Surplus Energy Economics, or ‘SEE’.
This states that the economy is, always has been, and always will be an energy system.
For anyone unfamiliar with this, I’ll start with a brief introduction to SEE. But my main aim in this discussion is to relate SEE to the issues that (a) are bewildering policymakers and economists, and (b) are prodding them down to the road towards policy disaster.
Unless you grasp the energy basis of the real economy, you cannot understand why a lethal gap has opened up between the “financial economy” and the real one.
If I’m right about the energy basis of the economy, then it follows that those who make the big decisions from a completely different perspective are grappling to cope with something that they simply do not understand.
Imagine that you were trying to fix some piece of machinery, believing – quite wrongly – that you understood how it worked.
That false understanding would frame how you went about trying to fix it. Your solutions would not work, because they could not work.
It would like trying to fix an ailing pot-plant with a spanner, or to repair a stuttering engine with fertiliser.
Each failure would prompt you into trying more and more radical solutions, all of them still based in the same misunderstanding. You would draw false lessons from each successive failure. Ultimately, your piece of machinery, only slightly malfunctioning when you started, would turn into a pile of junk.
With no apology for repetition, let me make my conclusion quite clear.
What I call “the global economic Ponzi” is moving ever nearer to the precipice because the powers that be are trying, with increasing desperation, to fix something that they simply do not understand.
The energy dimension
My thesis was encapsulated in Life After Growth, a book whose title tells you where I think we are. Economic growth has resulted from a supply of energy which has been readily-accessible, abundant and (in a rather special sense) “cheap”. For some years now, though, that essential precondition for growth has been ceasing to apply.
The word “energy” does not just mean fuels like oil, gas and renewables. Human labour is energy, as is the nutrition that makes labour possible. For all but two hundred years of our history, nutrition and labour accounted for the overwhelming majority of the energy in the economy.
The Industrial Revolution changed this fundamentally, giving us access to vast reserves of accumulated energy, but this pool has been depleted, not quantitatively but qualitatively.
No-one should rule out the possibility that new technologies will give the energy economy a new lease of life, but the limiting factor here may lie not in a failure of ingenuity, but rather in limits imposed by the laws of physics.
Energy has never been “free”. In the agrarian age, there was no “free lunch” – you had to you to hunt or farm to get nutritional energy. Today, you have to drill wells, build refineries and pipelines, or manufacture solar panels. All of this has a cost, but it is fundamentally an energy cost rather than a financial cost.
This really means that, however we access energy, we consume some of that energy in the process. From this come the concepts of “net energy” and “energy returns on energy invested” (EROEI). My preferred measure is ECoE (the Energy Cost of Energy).
So what matters isn’t the total amount of energy that you have, but the free-to-use surplus energy that you can unlock. 100 units of energy have no value if you have to use up all 100 to get at it. Here, ECoE is 100%, and surplus energy is nil. On the other hand, if you can get 100 units of energy by consuming only 5 units in the process, your ECoE is 5%. The sheer abundance of fossil fuels has given us more than two centuries of energy that has had an even cheaper ECoE than that.
As we all know, it would be absurdly cumbersome to run any economy on barter alone, so we created the concept of money to make things more practical. In doing this, we created a parallel or proxy system and, until recently, this has served us pretty well.
But this must prompt two observations of which our decision-makers are dangerously ignorant. First, there are “two economies”, which I call the “real” economy and the “financial” one. The real economy is the substance, and the financial economy is the proxy.
Second, money has no intrinsic worth. Its only value lies in what it can be exchanged for.
Therefore, the “financial economy” is an accumulation of “claims” on the real economy. If we misjudge the relationship between the two economies, the result is that we create “excess claims”.
The real hole at the heart of the Ponzi – excess claims
“Excess claims” are not the same as “debt”. Someone may take on a debt that he is perfectly capable of repaying in due course. There is nothing wrong with that. An “excess claim” arises when debts are created that cannot be repaid by the real (energy) economy.
An excess claim, since by definition it cannot be met, must be destroyed, in one form or another. Reneging on it, or “going bust”, is one way of doing this, but “debasing” the debt (perhaps through inflation) can accomplish the same thing.
Though debt is a handy indicator, the overhang that is really going to take down the system is “excess claims”. Over fifteen years or so, the accumulated stock of “excess claims” has grown from a minor and manageable drawback into a mountain. Worse still, our system has become addicted to adding to this mountain, at ever-increasing rates.
The creation of a money and credit in a “financial” economy proxying the real one introduced a new factor which “hand-to-mouth” and barter could not supply. This is the “anticipatory” element which can enable us to plan ahead. This has been extremely useful, but its viability depends upon using forecasts for the future which are realistic.
That essential realism has broken down in a system which assumes perpetual growth without ever really understanding where growth actually comes from.
The energy explanation – a harder sell?
Paradoxically – since we live in an energy-based economy – few topics are more misunderstood and misrepresented than energy. At the moment, energy prices are very low, with the price of oil in particular having fallen by more than 75% over less than eighteen months. The oil market is characterised by excess supply and burgeoning inventories.
Even those who really ought to know better assure us that the threat of scarcity has gone away for good, even supposing that it ever existed in the first place.
This is idiocy of the highest order. Propelled by a combination of brisk demand growth and the time-lag necessarily involved in responding to it, energy prices soared between 2000 and 2007, then remained high for a further seven years despite the economic hiatus that followed the banking crisis. Sustained high prices funded huge investment in capacity, much of which was of dubious economic viability in anything other than boom conditions.
Now that demand growth has slackened, capacity substantially exceeds the requirements of the consumer. This situation could continue for another year, or maybe two, possibly even three,
But to proclaim it as the start of a new era of abundance is fatuous in the extreme.
The biggest component of the supply increase over a decade has been the arrival of shale oil and gas in the United States. But, and even before the slump in prices, the US authorities themselves expected shale oil output to peak and then start to decline within a decade. The output from shale wells deteriorates very rapidly indeed – decline rates of 70% in the first year of production are not untypical. This means that output in the aggregate can only grow, or even be maintained, by continuous activity which has been dubbed “the drilling treadmill”.
The industry can fall off this treadmill if it runs out of capital investment or exhausts its highest-potential locations. The first has already happened, and the second is inevitable, the only question being “when?”
In the rest of the non-OPEC world, output from existing oil fields declines, such that output would deteriorate by about 8% annually in the absence of new investment. The collapse in prices – from an artificial high to an equally unsustainable low – has killed off at least $400bn of new investment, making the prospect of falling output very real indeed. Whole mature provinces – such as the UK North Sea – have been dealt a blow from which they may never recover.
The lifting of sanctions on Iran should enable OPEC to deliver more supplies, but not even Saudi Arabia has limitless supplies of low-cost oil. There is abundant evidence to show that the ECoE (surplus-to-cost) ratio of new developments has been deteriorating relentlessly for decades. Huge reserves of oil do indeed remain in the ground, but their value – on a net-of-ECoE basis – has been declining rapidly. The big growth areas of recent years have been capital-intensive US shales and even costlier bitumen sources.
Much progress has been made by renewables, and their share of the global energy market is likely to go on increasing despite the body-blow to their economics dealt by the collapse in hydrocarbon prices. But they may not be a transformative technology and, even if they are, it would be a transformation to be measured in decades. If, as BP has suggested, supplies of renewables grow at a compound rate of 6.6% annually, they will still account for just 9% of all energy consumed in 2035.
Technology has made huge strides in renewables, but to extrapolate this indefinitely is to ignore the envelope imposed by the laws of physics. The idea of a 747-sized aircraft being powered by electricity is a pipedream.
Renewables may give us a safe and sustainable supply of energy. They may well do so at a lower ECoE cost than today’s replacement sources of fossil fuels.
But they are not going to take us back to the high-surplus, ultra-cheap energy on which today’s economy was built.
From here to the Ponzi
Before we turn to the financial, let me pause here to ensure that the fundamental economic issues are clear.
1. The economy is an energy system, propelled by the surplus energy which exists after the access cost of energy has been deducted.
2. That cost element – EcoE – has been on a rising trend for decades, and is indeed rising exponentially.
3. We do not have a shortage of energy in the absolute, but we do have a shortage of high-margin, input-cheap energy.
To deny this, on the basis of a temporary glut, would be like saying that “because it’s raining this morning, I don’t believe in climate change”.
Not measured, not managed
Our methods of measuring the economy do not incorporate ECoE. They embrace the saleable value of gross energy, and they also incorporate the costs that we incur, but they exclude the “economic rent” component imposed by the resource set.
Until relatively recently, this didn’t seem to matter. My estimates are that, in the halcyon days of the 1950s and 1960s, ECoE was well below 2% anyway, which is easily within the general margin of error implicit in any GDP computation. If I’m right about the ECoE trend, it had still only reached just over 4% in 2000. By ignoring it, then, we were inflating our estimate of global economic output to $46.7trn (at 2015 values) from an underlying $44.7trn.
As the exponential rise in underlying ECoE continued, however, two nasty things started happening, neither of them captured in figures which ignore economic rent.
First, the gap between the financial and the real economies widened, from less than $2trn in 2000 (at 2015 values), to $3.8trn in 2007 and $5.9trn in 2014.
That’s pretty bad, but what is far worse is that the accumulated stock of excess claims had soared from $24trn (51% of GDP) in 2000 to $78trn (99% of GDP) by the end of 2014.
An updated “excess claims” figure for end-2015, by the way, is likely about 115% of GDP. From this rate of accumulation, you will appreciate why I do not believe that the global economic Ponzi can last much longer.
“Excess claims” are not the same as debt. Global debt, excluding the inter-bank sector, currently stands at about $160trn, but much of this could, at least under normal circumstances, be repaid when it falls due. “Excess claims”, on the other hand, cannot be repaid, because they are based on the accumulated fiction that our economy, now and in the future, is and will be far bigger than it really is.
Beyond the global debt mountain there are quasi-debt welfare promises made by governments. Many governments – the US and the UK most obviously – have entered into enormous such commitments, and it is already becoming clear that these cannot be delivered. Quasi-debts do not count as debt in the strictest sense, because a state could, for instance, reduce future payment levels on public sector pensions, or raise the age at which entitlements begin.
The bottom line
Many factors have come together to turn the global economy into a giant Ponzi scheme. But my concern here is that we may be missing the biggest one of the lot, simply because we are failing to notice, let alone to account for, the “economic rent” implicit in any finite resource set.
Contrary to purely temporary tales of glut and abundance – and irrespective of purely quantitative estimates of remaining “reserves” – the qualitative value of the resource set, on a net-of-ECoE basis, is continuing to erode.
It is doing so in ways that are completely unrelated either to investment patterns or to assumptions that technology can repeal the laws of physics.
My hope is that, when we sift through what remains after the global Ponzi has detonated, the very searching nature of the post-mortem will enable us to find the real cause of the disaster.
If we can do that, we can rebuild in ways that are sustainable.