#80. Grossly Distorted Prosperity

ECONOMIC DECELERATION – AND HOW TO MEASURE IT

One of the quirks of economics is that, within GDP (gross domestic product), all output is included, irrespective of what it really adds to prosperity. GDP, like Oscar Wilde’s cynic, knows “the price of everything, but the value of nothing”. If government paid 100,000 people to dig holes, and another 100,000 to fill them in, the cost of this activity would be included in GDP.

Is there a better way of measuring prosperity? Well, consider two people who both earn $30,000. Theoretically, their circumstances match. However, if the first has to spend $20,000 on household essentials, leaving him $10,000 to spend as he chooses – whilst the second spends only $5,000 on essentials, leaving him $25,000 for “discretionary” spending – then clearly the second is much more prosperous.

This is analogous to what has been happening to the economy. The long-run trend towards higher energy costs is feeding through into essentials such as food, water, chemicals, minerals, plastics, construction and virtually every other essential purchase. This is undermining the scope for discretionary spending, leaving the economy poorer even if the headline statistics do not seem to bear this out.

On the ground data bears this out. In the United Kingdom, for example, average wages increased by 25% between 2005 and 2015, but the cost of essentials rose by 48%. This process is happening around the world.

For the economy as a whole, it can be illustrated like this:

Fig. 1: “Growth”? – the impact of higher energy costs

GDP is higher in the second picture, but far more is spent on energy and essentials, leaving a smaller surplus available for everything else. This surplus – and not the recorded total of GDP – determines prosperity.

Where this leaves the economy is with two pictures that do not match – raw growth numbers imply a prosperity that people seem not to experience. As a result, we – whether as individuals or as governments – have been using borrowing to supplement a diminished capability for discretionary expenditures.

This in turn accounts for the escalation in debt. Between 2000 and 2007, world debt (1) escalated from $87 trillion to $142 trillion, triggering the global financial crisis. Slashing interest rates to all-but-zero has enabled us to co-exist with this debt, but the amount outstanding has continued to soar, now exceeding $200 trillion – whilst near-zero rates have been very far from cost-free.

How does the cost of essentials, and the resulting impact on prosperity measured as capability for discretionary spending, help us to explain this?

The energy economy

As most readers will know, the interpretation which guides all of my work is that the “real” economy of goods and services is an energy equation and not, as is so generally supposed, a monetary one.

Everything that we buy or sell, produce or consume is a product of energy. Far back in history, this energy came entirely from human or animal labour. This changed fundamentally with the Industrial Revolution, when we began supplementing this labour with inputs such as coal, oil and gas. This process triggered a dramatic escalation in economic output which has totally transformed our society over more than two centuries.

The modern economy is entirely a function of energy. As well as obvious uses such as transport fuels and plastics, energy is critical in access to minerals – without energy inputs, we could not possibly extract 1 tonne of copper from 500 tonnes of rock (and doing this using manual labour would make copper impossibly costly).

That the earth now supports 7 billion people, compared with just 0.8 billion back in 1800, is entirely due to the use of energy in agriculture, both as indirect inputs as well as directly in planting, harvesting, transport, processing and distribution. Water, too, could be not accessed without energy inputs.

If you doubt any of this, imagine how farming and the food chain would operate without energy inputs. Planting and harvesting would rely on large numbers of labourers and animals, all of whom would have to be fed. Inputs like phosphates would not be available without the energy needed to extract and transport them. Processing and transporting crops would be incredibly costly and difficult, as would storage without refrigeration. In short, without energy inputs, food supply as we know it today would collapse.

Taking this a stage further, it is obvious that the cost of food must reflect the cost of energy at each stage of the process.

Correlation between energy costs (here represented by crude oil) and other essentials is illustrated in the next chart, which shows how the prices of wheat, rice, vegetable oils and copper have all tracked oil prices in recent years. This is far from surprising, since energy is the key input in the supply of these resources. They have tracked not just the increase in oil prices but also the post-2014 decline – but remain about twice as costly as they were in 2000, which compares with broad inflation of about 38%, globally, over the same period (2).

Fig. 2: Commodity prices – the energy connection (3)

Ultimately, the physical economy can be defined like this – it is a process of applying power inputs (rather than human labour) to raw materials which are themselves accessed using energy.

Our homes, roads, schools, factories, railways, ships and hospitals could not possibly have been built by manual labour alone, or by relying on materials accessed without energy inputs.

A key point will have occurred to you from the foregoing, which is this – an increase in GDP can correspond to a decrease in prosperity, if the proportion of GDP which has to be spent on energy (and energy-linked essentials) grows.

We know that energy has a cost, which in fact is an opportunity cost – money spent on oil platforms, refineries, pipelines and solar panels is money that we cannot spend instead on hospitals and schools. The more expensive energy is, the less we have to spend on everything else.

The cost equation

Energy is never free. The human capacity for physical work derives from energy gained from food, and obtaining food requires the use of energy. Likewise, accessing the energy contained in oil, gas, coal or renewables requires the expenditure of energy. Oil platforms, refineries, pipelines, wind turbines and solar panels cannot be built without spending energy. Extracting iron from ore requires energy, as does converting it into steel – and, on top of this, there is the energy expended in building the steel works itself in the first place. This applies to all components used in the energy access process.

So the equation which determines prosperity is the relationship between, on the one hand, the amount of energy accessed and, on the other, the proportion of this energy consumed in the access process.

This equation can be expressed in two ways. EROEI – the Energy Return On Energy Invested – expresses the gross amount as a multiple of the cost. My preferred measure is ECoE – the Energy Cost of Energy – which expresses the cost as a fraction of the gross amount of energy accessed.

These equations change over time, through the interplay of two factors. The first of these, which pushes costs (ECoEs) up, is depletion. Naturally, we have exploited the lowest-cost energy sources first – just as you would always choose to develop a large oil field before a neighbouring small one, you would not extract costly oil from deep water fields, from shales or from bitumen if you could instead tap giant, simple reservoirs of high quality crude. As the most economical sources of energy deplete, we turn to successively costlier resources which push overall costs upwards.

The second determinant, offsetting the depletion effect, is technology, where the advance of knowledge enables us to access energy more efficiently, and thus at lower cost, than in the past.

The critical point about technology is that its limits are set by the physical characteristics of the resource. For example, the advance of technology has made shale oil far cheaper to produce than shale oil was ten years ago. What is has not done – and cannot do – is to transform shale resources into the equivalent of a giant conventional oil field like Al Ghawar in the sands of Saudi Arabia.

Likewise, renewables are cheaper to produce now than the same renewables were ten or even five years ago. This has, in many instances, made renewables cost-competitive with oil, gas and coal. But this is a two-part process – the competitiveness of renewables has benefitted both from cost-lowering technology and from rises in the cost of fossil fuels. Renewables can compete with oil or gas developed today – but they could not compete with giant oil fields like Al Ghawar.

Thus seen, the driver of costs is depletion (determining the physical envelope of energy access), with technology acting as a mitigating factor (improving efficiency within that envelope).

Cost trends

It will be obvious from the above that we are studying comparatively gradual processes. Depletion is something that happens over time. Technology can advance more quickly than this, but the pace at which technology is applied is dictated both by capital investment and by the depreciation of earlier plant.

Because the cost change process is gradual, it should be equally obvious that longer-term trends are critical. The immediate cost of energy to end-users can oscillate very rapidly through market forces, but these are oscillations around a longer term trend.

Fig. 3 illustrates my analyses of where the ECoE costs of various energy sources now are. Obviously, these are broad-brush estimates, but should suffice for at least a general interpretation.

The process of depletion has driven the ECoE of oil sharply higher. If we could go back to the 1950s and 1960s, we would see that oil production costs were extraordinarily low, which helps account for the very rapid annual consumption growth rates (as high as 8%) experienced at that time. But there has been a profound rise in oil costs in recent years. Coal costs, too, have been rising sharply, not least because the energy content per tonne has been falling markedly as the highest-quality resources are depleted. Gas costs, too, have been rising, though it remains markedly cheaper than oil or coal.

Fig. 3: Estimated ECoEs by fuel

The good news, of course, is that the ECoE of renewables has fallen sharply, making them cost-competitive with oil and coal, and no longer markedly more expensive than gas. The factors involved in reducing the ECoEs of renewables are technology and economies of scale. As little as ten years ago, renewables were a lot costlier to produce than oil, but this is no longer the case.

A cautionary note is needed here, however. In 2015, renewables accounted for just 2.9% of primary energy consumption. As a still-small industry, renewables can be assumed to have cherry-picked the best sites first, just as oilmen developed the cheapest oil fields first. Rates of growth which are easily achieved from a low base become progressively harder to sustain as the base enlarges. Renewables can be expected to go on increasing their penetration of electricity supply very markedly, though the nature of solar and renewables suggests that some fossil- or nuclear-powered capacity will still be required.

Other applications will be harder to crack, particularly where the sheer density of oil (measured as energy per unit of weight) remains critical. The gigantic petroleum-powered machines that hack minerals out of rock at concentrations of less than 0.5% might be hard to replace with electric alternatives, and an electric-powered aircraft of anything approaching the size of a 747 remains a pipe-dream.

The overall picture

What we have, then, is a changing mix in which the overall ECoE is rising because of the uptrend in costs in the still-dominant fossil fuels sector. The next chart, comparing the annual cost of energy with the long-term trend, reflects this.

Fig. 4: Trend and current energy costs

The current cost of energy to end-users oscillates dramatically over comparatively short periods and, historically, oil has been the pivotal component. In the 1970s, OPEC drove oil prices sharply higher, where they stayed for a decade until weak demand, and a surge in non-OPEC supply, broke the cartel’s grip. From 2000, oil prices began to move up sharply, largely due to demand growth in China and other emerging market economies (EMEs). High prices invited massive investment in new supply, which has now pushed prices sharply downwards. This is an essentially cyclical process, and the slump in investment since 2014 suggests that supply shortages will in due course push prices back upwards.

These price movements occur on timescales far shorter than the cost trends dictated by the interplay of depletion and technology. Depletion has for decades been driving the trend costs of fossil fuels upwards, in a way that can only be mitigated, not reversed, by technology. Technology is making renewables cheaper, but these account for just 2.9% of current global consumption. So the underlying trend cost of energy is rising relentlessly.

Counting the cost

Where, though, does this show up in our measurement of the economy? If energy costs more, we have less to spend on other things – but money spent on obtaining energy still forms part of GDP. After all, energy expenditures show up in activity measures, and money spent by an energy company provides business for suppliers and wages for those working in the energy and related industries.

So the bottom line is that rising energy costs do not necessarily impair GDP, but do undermine prosperity, by reducing how much we have to spend on everything else. Rising energy costs will eventually impact GDP as we record it, because they will reduce our capacity for investing in other things. This makes GDP a trailing indicator of the economic impact of higher trend energy costs.

If we want to anticipate this, and measure the current impact, there are two routes open to us. Both are based on the recognition that prosperity is a function, not of income in the absolute, but of discretionary spending capacity (the income that remains after the cost of essentials, really meaning the cost of energy, has been deducted).

The first way of measuring the current impact of trend energy costs is a bottom-up measure of prosperity which factors in the cost of essentials at the individual level. The second, far more practical approach is to deduct the trend (not the current) cost of energy from reported GDP. Since the cost of all essentials – such as food, water, minerals, plastics and transport – is dictated by energy costs, deduction of the trend energy cost essentially identifies discretionary GDP.

The global situation and outlook is set out in fig. 5. As trend ECoEs have risen, a widening gap has emerged between the financial and the real economies. This shows up within individual experience as an increase in the proportion of incomes absorbed by essentials. For the economy as a whole, the proportion of GDP that has to be spent on energy and its derivatives – including food, water and basic materials – has been rising, crowding out scope for discretionary expenditures even where total GDP is supposedly increasing.

To picture what this means in practice, imagine a government health system whose share of GDP is constant, so that cash resources increase in line with GDP. This ought to make it possible for health provision to be enhanced – but the opposite happens, because the cost of essentials absorbs a growing proportion of its budget.

In due course, this “crowding out” will impact investment in discretionary areas, meaning that headline GDP itself will start to fall. But prosperity – as it is experienced both individually and in the aggregate – will fall before the deterioration in the underlying situation is reflected in GDP.

Fig. 5: World financial and real economies

Finally – and whilst not wishing to intrude on private grief – fig. 6 shows what is happening to the real economy of the United Kingdom, and links it to trends in ECoE.

From 1980 to about 2005, the UK enjoyed a lower ECoE than the global average, mainly because Britain was a major net exporter of oil and gas. But energy production has fallen sharply, from 249 mmtoe (million tonnes of oil-equivalent) in 2002 to 108 mmtoe last year, and the UK now has to import almost half of its energy requirements, despite a decrease in demand.

This is a mathematical calculation delivered by SEEDS, and is reflected in a precipitate decline in real economic output. But what does this mean in practice – and can we see it in action?

What it ought to mean, first, is that the comparative (through-cycle) cost of energy in the UK is rising – which it is because, since 2005, the cost of energy to British consumers has risen by far more (90%) than general inflation (27%). It ought to mean that the cost of essentials is absorbing a growing proportion of incomes – which, again, is the case, the cost of essentials having grown by far more (48%) than average wages (25%). It ought to mean that government budgets buy less services, even where those budgets have at least kept pace with inflation – as is palpably the case with health care. It ought to undermine ability to provide for the future, something which is reflected in huge pension fund deficits.

That these trends are set to continue seems equally evident. Energy costs in Britain are rising, as reflected in the ultra-high contract price for electricity from the new Hinkley C nuclear plant. The cost of essentials will continue to rise (which the slump in the value of Sterling ensures). This will continue to make people feel poorer, as the cost of essentials continues to out-pace incomes. And it will further stretch public services (such as health), even where budgets rise at least in line with inflation.

I rather doubt whether planners and policymakers, in Britain or elsewhere, understand this dynamic. If they don’t, they must be baffled by the phenomenon of more money buying less.

Fig. 6: UK economy and comparative ECoE

The concluding point, generally applicable, is that the rising trend cost of energy – and hence of energy-derivatives such as food and minerals – is squeezing discretionary spending capability even before it exerts major downwards pressure on gross output. The latter is beginning to happen as well, though, through a squeeze on discretionary investment capacity.

What this all means is that we should take headline GDP figures with the proverbial pinch of salt. What really matters is prosperity, meaning scope for discretionary spending after the cost of essentials (really meaning energy) has been deducted from incomes.

By this critical measure, we are at the end of growth – and no amount of borrowing, or of mortgaging the future, can change this, or even long disguise it.

 

Notes:

1. Includes financial sector. Debt excluding the financial sector was $67 trillion in 2000 and $105 trillion in 2007, and is about $155 trillion now.
2. Source: SEEDS database
3. Source of data: IMF