A SURPLUS ENERGY ECONOMICS APPRAISAL
Since my previous article, German bunds have flirted with joining a group of negative-yielding bonds which already exceeded $10 trillion in value.
This means that investors are prepared to pay “safe-haven” borrowers (including the German and Swiss governments) simply to hold their money for them, in some instances for as long as thirty years. This “safe-haven” ploy simply means getting back the nominal amount, of course – and it has to be highly probable that some at least of that value will erode through the devaluing effects of inflation, particularly where long-dated bonds are concerned.
Such, today, is the sky-high price of a “safety” that is only relative anyway.
If you think about it in a detached way, any kind of negative interest rate situation is insane. Thinking through the concept of negative interest rates as they might apply to, say, mortgages, or saving, will quickly convince you that the very idea is something straight out of Lewis Carroll, Edward Lear or Monty Python.
More broadly, investing now means, at best, acceptance of a tiny income in return for a very high level of risk, whilst the likelihood of capital gain seems to rest entirely on the “greater fool” theory of central banks making money even cheaper than it already is. The normal relationships between investment and income, and between risk and return, have been destroyed.
If we take our thinking one stage further, we arrive at two unavoidable conclusions. The first is that we are trying to reinvent the financial system as we go along, in order to cope with gigantic debts that can never be repaid.
This can be likened to a blindfolded person on a bicycle trying to carry out brain surgery with a spanner.
Second, we wouldn’t be in this mess if the economy was growing. Clearly, therefore, it isn’t. The acceptance by the powers-that-be of the reality of “secular stagnation” reflects a dawning recognition that the economy is ex-growth.
We’ve examined the financial system at length here, but now it’s time we looked at the real economy – the economy, not of money, but of goods and services, of resources and labour.
The real economy
As most readers will know, my measurement of economic output and performance is based on the principles of Surplus Energy Economics (SEE). For those new to this approach, SEE adjusts output for the trend Energy Cost of Energy (ECoE), recognising that all economic activity is in the last analysis a function of energy, and that accessing energy has a cost in terms of the energy consumed in the access process.
This cost has been rising relentlessly for decades, reflecting the interplay of two factors. The first is the depletion of existing sources of fossil fuels, where declining output from old sources is replaced by supply from more recent sources which tend to be ever costlier because of smaller resources and higher costs of access.
The second factor, which offsets the upwards pressure of resource depletion, is the steady improvement of technology, but the effect of this is limited by the laws of thermodynamics. For example, technology has enabled us to access resources, such as shale oil, which we were not able to exploit twenty years ago. But what technology cannot do is to make shales and other newly-accessible resources as cheap to access as the giant, conventional oil fields of the past.
Much the same applies to renewables. Improved technology has brought the cost of – for example – solar power down dramatically. It may already have made solar, in particular, cost-competitive with the new oil and gas fields being developed today. But what solar can not do is replicate the economics of giant fields like Saudi Arabia’s Al Ghawar.
Renewables, in short, may stabilise ECoEs in a “post-giants” world, but they are not going to bring back an era of ultra-cheap energy produced from huge, technically very straightforward and readily-accessible sources of fossil fuels.
Of course, in the economy as we measure it in money, the costs of accessing energy are included, not least because, for example, an oil company’s costs are a contractor’s revenue. But the cost of accessing energy isn’t remotely a zero-sum game, for two main reasons. First, of course, money spent on developing energy sources is money that cannot be spent on anything else (roads, say, or hospitals). Second, our calculation of economic output does not account for the “economic rent” levied by the resource set, much as it also fails to account for the rising economic rent imposed by environmental constraints.
Taking stock: a surplus energy assessment of the economy
The impact of rising ECoEs on the global economy is shown in the first chart. This displays, as the financial economy, a measure known here as Standard Constant GDP (SCGDP), which is calibrated in market-rate dollars whilst measuring component growth in terms of purchasing power parity (PPP). (SCGDP has been a tricky concept to develop, and the detailed methodology is not something that I disclose).
The second line on the chart shows the real economy, after adjustment for trend ECoE. As you will see, the previously-small impact of ECoE has now become a major drag on economic output, to the point where the global real economy has hit a plateau and is facing impending decline.
The financial and real economies – global aggregates
Critically, the gap between the financial and real economies, which is measured as ECoE, is also the extent to which measured GDP overstates the underlying reality.
By basing our assessment of GDP on numbers which exclude ECoE, we have allowed the financial economy to become larger than the real one. And, since the financial economy of money and credit does not exist independently – it consists entirely of monetary “claims” on the real economy – we have been creating claims that cannot be met. These “excess claims” are the reason why the financial economy has become successively more abnormal, and has accumulated “excess claims” that are now big enough to bring down the financial system. This is a topic to which this discussion will return
The second chart applies the same approach to the United States. In common with many other mature developed economies, the US faces a steeper decline curve than the global aggregate.
The financial and real economies – the United States
The outlook for China, shown in the next chart, is for only very gradual deterioration, though this will be felt as a shock when contrasted with the spectacular growth previously enjoyed by China.
The financial and real economies – China
The striking feature of the Japan chart is the gap that already exists between the financial and real economies. The very large accumulation of “excess claims” provides corroboration that Japan’s very high debts are by no means some kind of statistical error, or are in any way irrelevant. The Japanese financial economy has created huge claims in excess of the capabilities of the real economy.
The financial and real economies – Japan
The United Kingdom chart, shown next, is grim, indicating that the real economy has commenced a serious and seemingly relentless decline. The reasons for this are not obscure, and are a combination of bad luck and bad management.
Though Britain’s ECoE (on a consumption basis) is not out of line with global trends, the sharp decline in domestic energy production is already having a very deleterious effect on the overall ECoE. The gap between the financial and real economies is fairly modest thus far, but a policy of denial over what has been happening to the real economy could easily result in a ballooning of excess claims.
Though the decline curve in North Sea oil and gas output has long been known, successive governments have failed to respond effectively. Plans for the replacement of Britain’s ageing nuclear fleet should have been decided by the second half of the 1990s at the latest, but nothing was done. Now, the UK has committed to costly and problematic technology as an adjunct of wanting others to pay for it. Investment in renewables has concentrated excessively on offshore wind, which increasingly looks like the wrong choice.
The on-going deterioration in net energy trade suggests that the already-severe current account deficit (around 6% of GDP) could worsen significantly, and could exhaust the expedient of covering this shortfall with asset sales and overseas borrowing.
The financial and real economies – the United Kingdom
The ‘black hole’ in the financial system
Finally, we need to consider the accumulation of “excess claims” which are created whenever the financial economy is larger than the underlying real economy.
Until relatively recently, excess claims were only being created at a relatively modest rate, and the accumulated pile of cumulative excess claims was not particularly dangerous. In 2000, for example, but expressed at 2015 values, excess claim creation stood at $2.4 trillion, and the outstanding total was $23 billion. By 2015, however, the accumulated pile of excess claims had reached $70 trillion, and is growing at over $4trneach year.
At $70trn, the outstanding total remains smaller than global debt ($150 trn), but has grown to the point where almost half of all global debt is incapable of repayment. In short, Surplus Energy Economics identifies a $70trn black hole where claims created by the financial economy cannot be satisfied by the real one.
With real economic output now static, and seemingly due to commence a relentless deterioration, this black hole is going to grow even more dangerous unless action is taken to remedy the habitual mortgaging of a future that is much less prosperous than the global authorities have yet realised.
Surplus Energy Economics, then, makes sense of an artificially-inflated financial system, and explains why maintaining the semblance of normality is already requiring remarkable monetary gymnastics.