#138: Inflexion point

NOW WE KNOW – WORLD PROSPERITY IS FALLING

Whilst much of the world seems to be fixated with the tragi-comedy of “Brexit”, here, at least, we can discuss something of greater, indeed of profound importance. According to SEEDS, world prosperity per person has now turned down.

From here on, we get poorer.

Whilst prosperity has been deteriorating for a long time in almost all of the advanced economies of the West, this has been offset by continuing progress in a string of important emerging market (EM) economies such as China and India. This balance has kept the global average remarkably stable during a very extended ‘prosperity plateau’.

Now, though, latest updates to SEEDS – the Surplus Energy Economics Data System – indicate that the pattern has broken downwards. The EM economies can no longer carry global prosperity in the face of deterioration in their Western trading partners.

The inflexion-point in world prosperity has profound implications, of which three seem most important.

First, the downturn is a complete game-changer for politics and government.

Second, the divergence between dwindling prosperity and a still-expanding burden of financial claims and commitments makes some form of extreme correction inescapable.

Third, we need fundamental changes in how we interpret and manage economic affairs.

For this to happen, those who decide policy and mould opinion need to understand what prosperity actually is.

What is prosperity?

For the individual or household, prosperity is simply defined. A person’s prosperity isn’t his or her income, but what remains of that income after essential or ‘non-discretionary’ expenses have been deducted. An individual’s prosperity, then, is ‘discretionary’ spending power, meaning the resources over which he or she exercises choice.

For the economy as a whole, the rationale is the same, but the definition is different. At the macro level, the over-riding essential is the supply of energy. This is the number one priority outlay, for the simple reason that the economy itself is an energy system.

Conventional interpretation continues in the mistaken belief that the economy is a financial system, within which energy is ‘just another input’. But a moment’s thought is sufficient to debunk this illusion.

Money is a human artefact, which we can create at will. But money has no intrinsic worth, and commands value only to the extent that it can be exchanged for goods and services. The real function of money, therefore, is to act as a claim on the output of the real economy. Creating more of these monetary claims adds nothing whatsoever to the quantity of goods and services for which they can be exchanged.

Everything – literally everything – for which money can be exchanged is a product of energy. In pre-industrial times, the energy basis of the economy was confined to human and animal labour, and the nutritional energy inputs which these outputs required, The harnessing of exogenous forms of energy, starting with fossil fuels, leveraged this equation without changing its fundamental dynamic.

Whenever energy is accessed, some of that energy is always consumed in the access process. The driver of prosperity, then, isn’t the gross amount of energy to which we have access, but the net or surplus quantity which remains. This is why the Energy Cost of Energy, abbreviated here as ECoE, is a critical determinant of economic performance.

For fossil fuels, which continue to account for four-fifths of energy consumption, ECoE has followed a parabolic curve, trending downwards over a very long period before turning upwards in the immediate post-1945 decades.

The factors which drove fossil fuel ECoE downwards were geographic reach and economies of scale. Once these factors had been maximised, what took over was depletion, the simple effect of having accessed the easiest (lowest-cost) resources first, leaving costlier alternatives for later.

Technology has played, and continues to play, an important role, first accelerating the downwards trend in ECoE and latterly mitigating its rise. What technology cannot do, however, is over-rule the physical characteristics of the resource set.

Compared with the upwards trend in the ECoEs of mature fossil fuel resources, renewable forms of energy continue to enjoy the benefits of expanding reach and scale. But, and vital though renewables are, we must not exaggerate their capability to mitigate, let alone to reverse, the upwards trend in overall ECoE – critically, the inputs required for the development of renewables remain derivatives of the fossil fuel legacy, which ultimately links their potential ECoEs to those of oil, gas and coal.

The prosperity narrative

The exponential rise in ECoEs is the key factor explaining the evolution of economic affairs in recent years. According to SEEDS, global trend ECoE rose from a barely-noticeable 1.7% in 1980, and 2.6% in 1990, to 4.0% at the millennium (and it has doubled since then).

This increase, though at first pretty gradual, had, by the late 1990s, reached a point at which the capability for further increases in prosperity began to peter out.

This trend, perceived (if at all) as a seemingly-inexplicable slowing in secular growth, was not acceptable either to a system of governance based on continuously rising prosperity, or to a financial system wholly predicated on perpetual growth. The response was to try to evade this reality using monetary expedients. These are described here as financial adventurism.

Initially, this took the form of credit adventurism, which involved making debt ever easier to acquire. Between 2000 and 2007, debt expanded by much more (+43%) than the underlying aggregate prosperity available to carry it (+13%). This ensured, first, that a financial crash would occur and, second, that this crash, being debt-caused, would have its greatest impact on the banking system.

Latterly, the emphasis was switched from credit to monetary adventurism, characterised by the creation of vast quantities of new money, and the slashing of interest rates to all-but-zero, meaning that real, ex-inflation rates have been zero, or negative, since the 2008 global financial crisis (GFC I). Like its credit predecessor, monetary adventurism makes a financial crash inevitable, but with the difference that this event (GFC II) will not be confined to the banking system, but will threaten fiat currencies as well.

The underlying story

To understand what is really going on, it’s imperative that we look behind the “growth” supposedly created by financial adventurism.

Comparing 2017 with 2000 – and expressing all values in 2017-equivalent PPP dollars – reported GDP expanded by $55 trillion (+76%) whilst debt escalated by $152tn (+125%).

This means that, globally, each $1 of reported “growth” since 2000 has been accompanied by $2.76 of net new debt. During the earlier, credit adventurism phase, which was confined largely to the West, the world ratio of growth-to-borrowing was 2.1:1. Latterly, in the monetary adventurism phase, and with ZIRP in place and EM countries joining in, the ratio has been 3.3:1.

The fundamental point, though, is that most of the recorded “growth” in the years since 2000 has been nothing more than the simple spending of borrowed money. In order to identify what has really been going on, SEEDS strips out this ‘credit effect’ to identify clean GDP, and the rate at which this number has been growing.

Comparing 2017 with 2007, supposed “growth” of $29.7tn equates to an increase of only $7.7tn in clean GDP. The remaining $22tn – accounting for 74% of claimed “growth” over the period – was the effect of pouring almost $100tn of additional debt into the system.

This interpretation necessarily has a transformative effect on the measurement of risk. Put simply, the debt ratio implications of a borrowing binge are damped down by the apparent (though unsustainable) boost given to GDP by the spending of borrowed money. Thus, though world debt stood at a reported 215% of GDP at the start of this year, it equated to 301% of the smaller, credit-adjusted measure of clean GDP. Likewise, the true scale of the world banking system, as measured using aggregate financial assets, is far larger than the ratio calculated using credit-inflated headline GDP.

Prosperity – where now?

Once we’ve arrived at clean GDP, the calculation of prosperity further requires the deduction of trend ECoE from this number. World prosperity, thus calibrated, was $83.5tn last year, an increase of 24% since 2000.

Unfortunately, two other things have happened over that period – debt has more than doubled (+125%), and population numbers have expanded by 22%. The former number means that, worldwide, people have 85% more debt now than they had in 2000. The population increase means that they have become only marginally (+2.4%) more prosperous over the same period.

The plateau in overall world prosperity per person since 2000 has, of course, masked starkly divergent regional trends. Whilst people have become 120% more prosperous in China, and 87% better off in India, the citizens of most Western economies have been getting poorer, typically since the early 2000s.

Prosperity in the United Kingdom, for example, was 10.2% lower last year than it was in 2003, whereas Americans have become 7.3% less prosperous since 2005. The average Italian is 13% poorer now than he or she was back in 2001.

From here on, the big change is that prosperity growth in the EM economies is likely to slow to rates which can no longer cancel out continuing impoverishment in the West. Essentially, what’s happening in the EMs is that, with ECoE continuing to rise, and with their Western trading partners getting poorer, trend growth in countries like China and India will slow. It might, of course, be possible to maintain the semblance of “growth as usual” for a while, but only at the cost of piling on ever larger amounts of debt. That is exactly what’s been happening in China.

And this, of course, leads us to one of the most important consequences of deteriorating prosperity – the inevitability of the world financial crisis known here as GFC II.

Implications

Comparing 2017 with 2007 – the year before GFC I – debt has increased by 57%, whilst recorded GDP has expanded by 30%. Where debt ratios are concerned, this apparent “growth” has moderated the effect, such that the 57% rise in the quantity of debt has lifted the debt-to-GDP ratio by only 20%, from 179% in 2007 to 215% now. Conventional interpretation states that, in a climate of ultra-low interest rates, this increase in the debt ratio is manageable.

But this, of course, is misleading, for a series of reasons. First, most of the GDP “growth” recorded since 2007 has been cosmetic, amounting to nothing more than a credit effect which would disappear if the supply of cheap and easy credit dried up.

Second, the debt figure itself disguises other adverse balance sheet effects, most obviously the emergence, courtesy of ultra-low returns, of huge holes in pension provision.

Third, the explosion in the quantum of debt since GFC I has created gigantic bubbles in asset classes such as bonds, stocks and property.

To be sure, there’s a theoretical argument which states that these bubbles needn’t burst so long as money remains ultra-cheap. The drawback with this is that, because we’ve piled monetary adventurism on top of the credit variety, debt and the banking system are no longer the major locus of financial stress – we need now to be aware of the threat posed to the viability of fiat currencies by a decade of monetary extremism.

Beyond the inevitability of GFC II – an event likely to be at least four times the magnitude of its 2008 predecessor – the broader implications of the downturn in global prosperity must be left for further consideration.

We can, though, conclude that, from here on, prosperity becomes at best a zero-sum game, stripping away the logic of ‘mutual benefit’ founded on the Ricardian calculus of comparative advantage.

This “transition to zero-sum” logically marks the start of three new trends -the retreat of ‘globalism’, the rise of more nationalistic politics, and a new and growing emphasis on redistribution. Beyond redistribution, the political emphasis now is likely to swing towards opposition to immigration, based on perceptions that this process dilutes prosperity.

None of these trends is either wholly new or entirely a matter of prediction rather than observation – after all, declining prosperity has been a feature of most Western nations for at least a decade, so we’re already witnessing many of its political symptoms.

Predicting that the era of the ‘liberal globalist’ elites is over is the easy part – the hard part is to work out what replaces it, and how the transition takes place.

Another issue which must be deferred for later consideration is that of how we can best manage the downwards trajectory of prosperity. We have many useful tools, not least the interpretations bequeathed to us by thinkers like Adam Smith and John Maynard Keynes. Forging a practical approach is likely to require, first and foremost, a recognition that, whilst our intellectual inheritance is invaluable, doctrinal extremism is a luxury that we can no longer afford.

#137: Malice in Wonderland

A SHARP LESSON IN ENERGY ECONOMICS

“Show me a man who can join in a laugh at his own expense,” says a character in Nicolas Blake’s 1940 novel Malice in Wonderland “and [you] show me one of nature’s gentlemen”. Blake’s writing often hits the spot – not surprisingly, perhaps, since ‘Nicholas Blake’ was the pseudonym of poet laureate Cecil Day-Lewis – and I hope that my experiences over the last week or so pass this particular test. Laughing, as the saying goes, was the only alternative to tears.

Though few articles here are composed in the first person, what follows necessarily runs from the personal to the general. Whilst the “wonderland” of the title refers to the island where I live, the “malice” has no human agency, referring instead to the workings of the weather, and of inanimate objects.

This story begins with an inanimate object – recognition that my computer, which gets extremely heavy use, was in the process of falling to bits. Its replacement having arrived, I set aside last Saturday for installation, only to discover that the new machine was faulty, and required return and replacement.

So far, so bad, but much worse was to come. On Sunday, the temperature here dropped from a balmy 25°C to an unseasonal 11°, accompanied both by torrential rain and by winds which, over the coming week, were seldom to fall below gale force. Midway through that morning, a tornado took out a key part of the electricity distribution system, leaving most of the island without power. By Tuesday, the authorities had installed generators in some of the main conurbations, though even this was hardly trouble-free, with several of the generators reportedly bursting into flames, apparently under stress of excessive demand.

Obviously enough, this event denied me, not just light and power, but music, hot water, computing and hobbies. Things didn’t end there, though. Water supplies failed through lack of pumping, and even the front gates remained shut until I could figure out how to open them manually. First task after that was to find out which, if any, shops (one) and restaurants (none) had backup power supplies. The presence of mind of one bar-owner enabled locals to revel in Barcelona’s 5-1 annihilation of Real Madrid, though this generator didn’t extend to hot drinks, let alone meals. Fuel in cars had to be used sparingly, because lack of power shut down the filling stations.

Put simply, normal life ground to an almost complete halt. Almost all business and official premises remained shut, depriving the public of postal, banking and most other services. Loss of internet connection deprived me of contact with the outside world. I didn’t miss television (since I never watch it), but I did miss my music, my DVDs, my books, and working on my latest project (a 1/72^nd exact scale model of a Type 12 frigate). All that one could really do was to eat snacks, fight an impending cold with soluble vitamin C, sit around in the cold darkness – and think.

Since I’ve contended for very many years that the economy is an energy system with an artificial financial adjunct, I should have been less surprised than most at the near cessation of all normal activity by the simple interruption to the supply of electricity. Even so, the lesson taught by this event was the sheer totality, and the rapidity, too, with which the absence of energy brings normal life to a halt.

Let’s, then, summarise the predicament of the population of the island during the power hiatus. The immediate effects were loss of domestic electricity supply (and, with it, light, power, cooking facilities, refrigeration, water supply and communications). In the business sector, activities in almost all categories ceased, most obviously including financial services, retailing, distribution and the supply of energy. Most aspects of government, including administration, revenue raising, defence, policing, health care and social services, seem to have kept going, but only by courtesy of generators.

The nearest generator to me had to be refuelled at intervals of between five and six hours. This particular generator was kept supplied with fuel by tankers small enough to negotiate some very narrow streets, and generators sited in broader thoroughfares might have been serviced by larger vehicles, extending the resupply interval somewhat. Presumably, the generating capacity itself was supplied, by sea, either from the mainland or from a much larger neighbouring island, neither of which was affected by the outage.

Ultimately, three factors made the situation survivable. First, the community here has particularly strong social cohesion. Second, the loss of power was always known to be temporary, and unlikely to extend for as much as a week. Third, and critically, outside help was available, because the power loss was strictly localised to most of one small island.

It doesn’t take much imagination, though, to picture what might have ensued if none of these favourable conditions had prevailed. Even with outside support, the duration over which anything approximating to normality would prove sustainable is strictly limited – and this brief and incomplete sustenance of normality could not have happened had the rest of the country been affected simultaneously. It takes little imagination, either, to envisage the erosion of social cohesion had neither limited duration nor nearby support characterised the outage.

Let’s be quite clear about this. If energy supply is cut off, and is cut off in way that is of unknowable duration, and for which there is no outside help, economic and other normal life ceases to be possible.

Could money solve this problem? Well, if you will, imagine that, whilst unable to offer physical succour, Madrid or Barcelona had been able to supply the island with money – you might even picture airdrops of bank notes by the air force, or the delivery of millions of euros by naval auxiliaries. You will appreciate that this purely financial support would have had absolutely no positive effect on the situation. All that it might, conceivably, have achieved would have been to trigger massive inflation, with more money chasing an extremely small supply of goods and services.

Let’s be clear that weather-related outages like the one experienced here are not going to deprive even a sizeable national economy of energy, and neither are we, in any meaningful sense, going to “run out of” energy. There are, though, two very real threats which we should consider.

The first of these is a simple inability to purchase energy, even if global supplies remain generally accessible. This is what happens to an economy if the value of its currency collapses. Picture, if you will, a country relying on imported energy (or, for that matter, imported food, itself an energy product), and imagine that the country’s currency experiences a sudden 75% fall in its international value. What this means is that the local cost of energy has quadrupled. A variation on this theme is a situation in which the country’s currency ceases to be acceptable to foreign suppliers, who perhaps see reason to question its viability. Both scenarios are distinctly possible, given the sheer scale of credit and monetary risk adopted, as a sequential matter of policy, over the period since the late 1990s.

The second (and likelier) scenario involves an erosion of surplus energy, a situation which arises when, within any given quantity of accessible energy, the amount available for all purposes other than energy supply itself becomes squeezed by a rise in ECoE (the energy cost of energy). We don’t have to imagine this scenario, because it’s already happening – according to SEEDS, world ECoE has now risen to the point where global average prosperity per person is in decline.

Thus far, we’ve done a pretty good job of collective and official denial over this reality. We have poured huge amounts of debt – and, latterly, of cheap money as well – into the system in order to retain a misleading semblance of economic normality. We’ve told ourselves, along the lines of a bedtime story for frightened children, that renewables will rescue us from the economic and environmental follies of burning up fossil fuels at the maximum rate possible, heedless of the future.

In short, what happened here this week may, in itself, have been a freak occurrence – but it is no less unreal than the stories we tell ourselves about infinite growth on a finite planet.