#169. At the zenith of complexity

THE ONSET OF “DE-GROWTH” AND “THE GREAT SECTOR EXTINCTION”

In the previous article, we examined the scope for tangible value destruction in the global financial system. In some future discussion, we might look at the very substantial empowerment that is being handed to environmental causes by some of the direct and indirect consequences of the Wuhan coronavirus crisis.

Here, though, the issue is the economy itself, and readers will understand that this interpretation is framed by the understanding that the economy is an energy dynamic, and not a financial one.

For those who like their conclusions up front, the single most important takeaway from what follows is that the crisis caused by the coronavirus pandemic has triggered two fundamental changes that were, in reality, due to happen anyway.

One of these is a systemic financial crisis, and the other is the realisation that an era of increasingly-cosmetic economic “growth” has come to a decisive end.

The term which best describes what happens from here on is “de-growth”. This is a concept that some have advocated as a positive choice, but it is, in fact, being forced upon us by a relentless deterioration in the energy-driven equation which determines prosperity.

At its simplest, this means that the near-universal expectation of a future “economy of more” has been invalidated. We’re not, for example – and as so much planning has hitherto assumed – going to be driving more cars on yet more roads, and taking more flights between yet more airports. A seemingly-assured future of more consumption, more leisure, more travel, more wealth, more gadgets and more automation has, almost at a stroke, ceased to exist.  Economic considerations aside, the energy supply outlook alone has long since ceased to support any such assumptions.

More fundamentally, an economy which is shrinking is also one that will become progressively less complex. Whole sectors of activity will disappear through processes of simplification and de-layering. The pace of economic deterioration, and the rate at which the system de-complexifies, will be determined by identifiable factors which include falling utilization rates and the loss of critical mass in economic activities.

The inevitable arrives

Seen from the perspective of the energy-driven economy, the crisis is unveiling much that we already understood. Essentially, relentless increases in the Energy Cost of Energy (ECoE) are the constant in an economic (and financial) narrative that has been unfolding ever since the 1990s, and which has long pointed, unequivocally, towards both falling prosperity and a “GFC II” sequel to the 2008 global financial crisis (GFC).

Between 1990 and 2000, global trend ECoE rose from 2.6% to 4.1%, entering a level (between 3.5% and 5%) at which prior growth in the prosperity of the western Advanced Economies started to go into reverse. By 2008, when the world banking system was taken to the brink by the GFC, ECoE had already reached 5.6%.

The next critical point occurred during 2018-19, when trend ECoEs entered a higher band (between 8% and 10%) at which less complex, less ECoE-sensitive emerging market (EM) nations, too, start to experience a reversal of prior growth in prosperity. This latter event has confirmed that, after a remarkably long plateau, the prosperity of the world’s average person has turned down.

The financial and economic ‘high command’ has never understood this energy-based interpretation, and this incomprehension has created a parallel narrative of futile (and increasingly dangerous) financial adventurism.

This is why we can expect a GFC II-type event to coincide with a decisive downturn in the economy. Though the coronavirus crisis is acting as a trigger for these events, we should be in no doubt that both of them were due to happen anyway.

Welcome to de-growth

The term which best describes a downwards trajectory in prosperity is “de-growth”. Many have advocated de-growth as something that society ought voluntarily to adopt in its own best environmental and broader interests.

The surplus energy interpretation, though is that de-growth isn’t a choice that we might or might not make, but an economic inevitability.

Critically, de-growth doesn’t simply mean that the economy will become quantitatively smaller. It also means that much of the complexity which has developed in parallel with past economic expansion will go into reverse.

This de-complexifying process will have profound consequences. As well as determining the pace at which the economy shrinks, the retreat from complexity will impose changes on the shape, as well as the size, of the economy of the future.

Where the rate of prosperity deterioration is concerned, the interplay of two factors is going to prove critical.

One of these is the utilization effect, which describes changes in the relationship between the fixed and variable costs of the supply of goods and services. As utilization rates fall, the per-user share of fixed costs rises, and any attempt to pass such increases on to consumers is likely to accelerate the pace at which utilization rates fall.

The second operative trend is the critical mass effect. This describes the way in which supply processes are undermined by the lack of access to critical inputs. To a certain extent, suppliers of goods and services can work around this effect, by altering (and, in general, simplifying) both their products and their processes. Even so, there are limits to the ability to circumvent critical mass effects, and the likelihood is that capacity will decline, resulting in a corresponding reduction in the range of goods and services on offer to consumers.

Both the utilization and the critical mass factors introduce considerable uncertainty into the rate at which prosperity will deteriorate, but an even bigger imponderable is the combined impact of utilization and critical mass effects. It is easy to picture how these are likely to interact, with, for example, falling utilization rates removing inputs in a way that accelerates the loss of critical mass.

The end of “more”

One of the practical implications of this interpretation is that the current consensus about our economic future – a consensus which we might call ‘the economy of more’ – is becoming ever less plausible.

Until now, virtually all planning assumptions have been framed by this expectation of continuous expansion. We’re assured, for example, that by 2040, there will have been be a billion-unit (75%) rise in the world’s vehicle fleet (requiring more roads), whilst aviation passenger miles will have increased by about 90% (so we’ll need a lot more airport capacity).

These and similar projections are based on assumptions that we can consume about 28% more energy in 2040 than we do now, with petroleum and natural gas supply rising by, respectively, 10-12% and 30-32%. All of these consensus projections seem extremely unlikely to be realised, not least because of the crumbling economics of energy supply itself.

The miss-match between, on the one hand, the assumption of extrapolatory expansion in virtually all economic activities and, on the other, the improbability of the requisite growth in energy supply, seems never to have occurred to those whose plans inform the economic consensus.

What all of this means in practice is that projected rates of prosperity deterioration are conjectural, with probabilities favouring an acceleration in the pace of decline.

With this caveat understood, the base-case generated by SEEDS (the Surplus Energy Economics Data System) provides a useful reference-point for discussion. The model indicates that the average person worldwide will be poorer by 9.5% in 2030, and by fully 20% by 2040, than he or she is today. It follows from this, of course, that his or her ability to carry debt and other financial burdens – and to pay taxes – will be correspondingly impaired.

Fig. 1:

Simplification and de-layering

Two further trends, both of which are of fundamental importance, can be anticipated as consequences of the de-complexifying process.

One of these is simplification, which describes a rolling contraction in the breadth of choice on offer to consumers, and a corresponding contraction in systems of supply.

The second is de-layering, meaning the removal of intermediate economic processes.

The de-layering effect can be illustrated using food supply as a comparatively simple example (though the issues involved extend right across the gamut of products and services).

The pre-industrial system for supplying food had few stages between farmer and ultimate consumer. There were, to be sure, millers, carters, coopers, green-grocers, butchers and a number of other trades operative between producer and customer, but there was nothing on the scale of today’s plethora of intervening layers, which run from fertilizer suppliers and agricultural consultants at one end of the spectrum through to packaging and marketing consultants at the other.

Looking ahead, the application of simplification and delayering to the chain of food supply suggests that, whilst product choices will narrow (ten sorts of breakfast cereal, perhaps, rather than fifty), some of the intervening layers will contract, whilst others will disappear altogether. Simpler products and simpler product ranges require fewer intermediate stages.

Extended across the economy as a whole, the implication is that we face what might be called a “great extinction” of trades, specialisations and, indeed, of whole sectors. As and when this forward trend gains recognition, it’s likely that businesses and individuals will endeavour to withdraw from activities which are at high risk of being de-layered out of existence.

Surveying new horizons

The economic processes described here are going to have far-reaching implications, most of which will be matters for subsequent discussion. First, though, it makes sense to recap the critical points of the foregoing.

The fundamental change now in prospect is that economic de-growth will set in, and will eliminate most of the expectations hitherto covered by the term “the economy of more”. The rate at which the economy shrinks (and the average person becomes less prosperous) will be influenced by a number of variables, of which critical mass and utilization effects are amongst the most important.

A reasonable working assumption, generated by SEEDS, is that people are going to get poorer at annual rates of about 1%, though there will, needless to say, be major regional and national variations around this trend.

This rate may not sound all that dramatic – though we need to bear in mind that it might worsen – but the shock effects of the onset of de-growth are likely to be profound, not just in the economic and financial spheres, but socially and politically as well.

As the economy gets smaller, it will also become less complex. Central strands here are likely to include both simplification (of products and of processes) and de-layering. The latter will involve contraction in some areas of activity, and the elimination of others.

The coronavirus crisis itself is providing us with a foretaste of some of these anticipated trends. In economic terms, the most important effect of the crisis is the hiatus in the cash flows of businesses and households. The consequent need to conserve cash (and to avoid going further into debt under circumstances of extreme uncertainty) is inducing conservatism into economic behaviour.

Companies and families alike are imposing new and tougher criteria on their expenditures, meaning that households are cutting back on “discretionary” (non-essential) spending, whilst businesses are minimising outgoings wherever they can. Companies are likely to make severe cuts in their marketing spend (because there’s not much point in advertising things that customers can’t or won’t buy), and will seek to renegotiate (meaning reduce) rents, outsourcing costs and other overhead expenses.

If – as seems very likely – this event marks (though it will not have caused) the onset of de-growth, it’s probable that newly conservative attitudes will continue. Consumers are unlikely to go back to “splashing the cash”, even when (or if) something nearer to “normality” is restored. Businesses which have, for example, downsized promotional expenditures and simplified their operations, are unlikely to revert to former spending patterns.

In short, this crisis may well have kick-started the processes of simplification and de-layering described above. Both of these processes can be expected to shrink some areas of economic activity and, in some cases, to eliminate them altogether.

Finally, these effects are highly likely to be reflected in other spheres, causing major attitudinal changes. Voters can, for example, be expected to be more supportive of essential public services, and less tolerant of perceived excesses in the private sector.

Governments themselves are likely, in due course, to recognise the risk of contraction in their tax bases and will, in any case, have gone much further into debt as a direct consequence of the crisis. Pressure for redistribution, and a generally heightened emphasis on economic issues, were pre-existing political consequences of deteriorating discretionary (“in your pocket”) prosperity.

At the same time, it is surely self-evident that governments cannot risk repeating policies which, rightly or wrongly, have been encapsulated into a popular post-GFC narrative of “rescue for the wealthiest, austerity for everyone else”.

CORONAVIRUS – THE ECONOMICS OF DE-GROWTH