#180. In search of competitive edge

LOGIC, ‘CONTINUITY BIAS’ AND THE BALANCE OF IMPROBABILITIES

Those of us who understand the economy as an energy system know that fundamental change, long overdue, is being crystallised by the coronavirus crisis. Can that knowledge be the basis for establishing ‘competitive edge’?

The conclusion here is that it can, but realising this requires more than just knowing the difference between the logical (energy-driven) and the accepted-but-illogical (wholly financial) ways of interpreting the economy. We also need to recognise the ways in which continuity bias and extrapolation inhibit the application of logic and knowledge.  

This understanding reveals scenarios which, whilst they may appear improbable, are far more plausible than consensus lines of thinking which have become impossible.

Government – right by default?

It’s been well said that governments will “always do the right thing, after exhausting all other possibilities first”.

The Wuhan coronavirus crisis illustrates this axiom to good effect. For many years, scientists have warned (a) that the world is likely to experience some kind of viral pandemic, and (b) that no country would be able to counter such an outbreak unless it closed its borders to international travel until such time as the virus had been eliminated globally. In other words, no amount of lockdown or physical [“social”] distancing is going to work, if the virus can simply return on the next inbound flight.

Governments are under all sorts of conflicting pressures, so their reluctance to follow this logic is, perhaps, understandable. But this interpretation seems vindicated – certainly in Europe, and probably elsewhere – by a sequence in which the re-opening of passenger flights has been followed by “second waves” of infection.

Unless we’re prepared to assume the early development of a vaccine which is effective, safe and trusted by the public, then, it seems prudent to anticipate that the coronavirus is going to turn out to be a process rather than an event. Governments are likely to act when the gravity of the situation compels them to do so, but are equally likely, as soon as the situation eases, to roll back, prematurely, on unpopular policies.

Inferences of process

If we understand the pandemic as ‘a process rather than an event’, certain economic and financial inferences can be drawn from this conclusion. Equally important, though, is the evidence of what we might call a ‘continuity bias’ at work. There is, in a strictly non-political sense, a conservatism which impels organisations and individuals to lean towards continuity, not just in their expectations, but in their decisions, too.

This ‘continuity bias’ opens up a disconnect between perception and reality, and anyone seeking to progress – in the realms of ideas, of politics or of business – can benefit from a recognition of the way in which ‘continuity bias’ creates ‘perception deficiency’.

One aspect of this process is a susceptibility to extrapolation, the assumption that the future must be a continuation of the recent past. If, for example, the price of, or demand for, something has risen by X% over, say, the past ten years, the tendency is to assume that it must rise by a further X% over the next ten years. This extrapolatory assumption can be called ‘the fools’ guideline’, in that it blinds us to the possibility (and, under certain conditions, the probability) of a fundamental change of direction, even when logical examination ought to persuade us that fundamental change is likely.

Dynamic interpretation

As regular readers will know, the general thesis followed here is that infinite growth is implausible in an economy governed by a physical energy dynamic. We can, indeed, go further than this. We can (and without being guilty of unjustified extrapolation) compare (a) the trend in the rate at which energy is converted into economic value, with (b) the trend rate at which the ECoE (energy cost of energy) deduction from this value is increasing.

And, since the supply of energy is itself determined by a relationship between value and cost, we can also develop pretty good visibility on future trends in the quantum of energy supply.

What this means is that a per-unit progression of energy value (V minus ECoE) can be applied to a linked projection of quantity (Q) to produce an equation which interprets and predicts trends in the aggregate supply of economic value.

If the present position is termed ‘point zero’, we can then look either forwards (to points +1, +2, +3 and so on) or backwards (points -1, -2, -3). The value of forward visibility will be obvious, but backwards visibility can be of at least equal importance, because it can tell us the extent to which current interpretations of direction and value are mistaken.

Competitive edge

If our aim is to identify competitive edge, the best way to do this is likely to involve triangulating (a) accurate fundamental analysis, (b) prevalent false perceptions of current value, and (c) the effects of ‘continuity bias’.

Here’s an example of how, in the near future, such an equation might function.

We know that the Wuhan coronavirus pandemic has involved the provision of support for household and business incomes, together with the deferral of various household and business expenses (such as interest and rent payments). We can put these together mathematically to calculate a progression of fiscal shortfalls, and we can further postulate a point at which this progression becomes critical, requiring, perhaps, state ‘rescues’ of embattled lenders and landlords, and/or central bank money creation to support these initiatives.

This much, though, can be done by anyone, provided he or she has access to the numbers and the methodology required to calculate this progression. Accordingly, it does not, of itself, constitute ‘competitive edge’, other than in relation to those who are unable to carry out these same calculations.

This is where the equation of energy value, false perceptions of value and ‘continuity bias’ comes into play. The person who can calculate a fiscal progression with reasonable accuracy can be led astray by referencing this to a false perception of where the economy really is now, and where it can be expected to go in the future. Competitive edge arises when the background to this progression can be calibrated correctly.

More broadly, the ‘generality’ – governments, businesses, investors and the general public – has perceptions of how the economy has got to where it is and of where it will progress from here, and accepts current valuations imputed by these trends, all of which are mistaken.

These ‘mistaken perceptions of the generality’ define a situation of risk and opportunity. If, for example, you were in business, the ability to draw on accurate interpretation, plus your understanding of others’ extrapolation and ‘continuity bias’, would tell you to invest in certain areas, to divest from others, to buy certain undervalued assets and to sell some overvalued ones, to alter your slate of products and services, and to change your methods and practises in ways recommended by economic and financial knowledge not available to your competitors.

Without, of course, straying into investment specifics, it will be obvious that assets are priced in relation to current appreciations and forward expectations, both of which are founded in these same ‘mistaken perceptions of the generality’. 

On the road – theory in practice

From what we might term a ‘top-down’ standpoint, we can observe that a prior belief in ‘a future of more’ has, under pressure of circumstances, segued into ‘a certainty of recovery’. Some examples of this mindset are instructive, not because they are ‘right’, or even because they were ‘wrong before’, but because they ‘remain wrong now’.

Future sales of vehicles are an interesting example. As of 2018, there were 1,130 million cars on the world’s roads, and 236 million commercial vehicles. The consensus view, as of 2019, was that these numbers would, by 2040, have risen to about 1,970 million cars (+74%) and 460 million commercial vehicles (+94%). This view has been maintained despite evidence that sales of both classes of vehicles had started to deteriorate during 2018. The overall perception was (and probably still is) that the numbers of vehicles of all types was set to increase by 1.06 billion units (+77%) by 2040.

Under current, extreme circumstances, of course, sales of cars and commercial vehicles have slumped. Rationally, you might ask (a) whether pre-existing adverse probabilities have been crystallised by the crisis, and (b) whether consensus longer-term expectations are being invalidated.

What seems actually to be happening, though, is that the question has become, not ‘was our prior expectation wrong?’, but ‘how long will it take to get back on track?’. We should be clear that this latter question is based on assumption, not on logic.

Finding the ‘right’ answer to such questions is very far from being purely theoretical. It would have a critical bearing on your current actions and your future plans, if you manufacture vehicles or components, if you supply materials for these processes, or if you’re a government trying to plan forward infrastructure investments. If you’re an environmental campaigner, or an advocate of conversion from internal combustion (ICE) to electric vehicles (EVs), these issues are fundamental to how you frame and conduct your current activities.

Understanding of energy-economic principles would, in this instance, already have told you that ‘77% more vehicles’ was an implausible outcome. That in turn would provide a valid point of reference for the effects of the current crisis.  

It would, in other words, give you a competitive edge.

Flying blind – of aviation and technology

A second and a third instance are provided by aviation and technology.

In the former instance, the pre-crisis consensus – welcomed by the industry, disliked by environmentalists, but seemingly accepted by almost everyone, and used as a planning assumption by governments – was that passenger flights would increase by roughly 90% between 2018 and 2040. The coronavirus crisis has inflicted huge damage to the sector, but the ‘continuity bias’ assumption seems now to be that the prior trajectory will be restored, and that a worst-case scenario is the likelihood of a lengthy delay in returning to that prior trajectory.

It seems to be accepted that the duration of a recovery may be protracted, given the unknowns around travel restrictions and customer caution, but it also seems that no consideration is being given to the possibility that the prior (upwards) trajectory might not be restored at all.   

A third and final example is provided by the assumption that the future will comprise ever more technology, ranging from more ‘big data’, more AI and more gadgets to self-driving cars and ever-increasing industrial automation. Downturns in sales of smartphones, chips and electronic components, again dating from 2018, seem to have been dismissed as aberrational ‘noise’ around a robustly, indeed an unquestionably upwards trend.

Once again, energy-based interpretation of the economy suggests that this is a combination of ‘continuity bias’ and unquestioned extrapolation, seemingly at very considerable variance from economic probability.

Stated at its simplest, if consumers become poorer, and rebalance their priorities accordingly, whilst businesses emphasise cost control and concentrate on simplification, the balance of probability swings against the assumed future of unending automation.

The ‘improbable’ versus the ‘impossible’

Many more examples could be cited, but let’s finish by applying an acid test to these questions.

If you believe in ‘a future of more’ (more cars, more flights, more automation and so on) – or are persuaded by the theory that we will witness a ‘recovery’ (of whatever duration) back to the prior growth trajectory – then it follows that the economy of the future is going to need more energy than the economy of the present.

On this basis, expert forecasters have projected global primary energy supply rising by 18% between 2019 and 2040, adding roughly 2,500 mmtoe to our annual requirement. The experts think they can find just over 70% of this required increase from a combination of nuclear, hydro and the various forms of renewable energy (RE). This leaves them (and us) needing an extra 720 mmtoe or so from fossil fuel (FF) sources. It’s assumed, not only that this can be found, but that doing so will increase annual emissions of climate-harming CO² from 34.2 million tonnes in 2019 to about 38.4 mmt by 2040.   

Meeting the required increment to fossil fuel supply means that, comparing 2040 with 2019, we’ll be using roughly 11% more oil, at least 30% more gas and roughly the same amount of coal. If you look realistically at the state of the FF industries, though, you can see that any such expectations are pretty implausible, not least because the delivery of such gains would require price increases that would move far beyond the affordable.

Here, then, is the conundrum. Meeting assumed economic needs in the future requires quantities of oil, gas and coal whose provision seems implausible. Faced with this, do we conclude (a) that we’ll somehow ‘find a way’ to supply this much additional energy, or (b) that the foundation growth assumption might itself be wrong?

That the experts are wrong about the size of the future economy may seem improbable, but logic suggests that supplying the required amount of additional fossil fuel energy looks very nearly impossible.

In this situation, we could do worse than reflect on the axiom of Sherlock Holmes – “[w]hen you have eliminated the impossible, whatever remains, however improbable, must be the truth”. 

#179. Penny plain, tuppence coloured

“THE FUTURE’S NOT WHAT IT USED TO BE”

In a wonderfully entertaining and informative book about ‘sea lore’ published in 1935, Cyril Benstead referenced the observation that “[t]he weaknesses of mankind are generally accentuated under strange and unaccustomed conditions”.

The conditions brought about by the Wuhan coronavirus pandemic certainly qualify as “strange and unaccustomed”, and many of the “weaknesses of mankind” have indeed been accentuated by it. Whilst some countries have, of course, responded to the crisis in a pretty rational way, many more seem to have thrown reason to the winds. “Muddle through” is never much of a strategy, and a best guess at this point is that, whilst some countries will ‘get away with it’, others will not.

As you may know, there are many reasons why the coming autumn is likely to be a particularly testing time and, if there’s something that we need more than anything else at this point, that something is clarity. The thinking here is that, if a storm does indeed break in the coming months, we need to have a solid framework of understanding in place before it does. That’s why so much urgent effort has been put into completing incorporation of ‘the Wuhan effect’ into the SEEDS model.

What follows, then, is emphatically a “penny plain”, rather than a “tuppence coloured”, review of the economic and broader situation, set out during what may well turn out to have been “the lull before the storm”.

The material, immaterially considered

Clarity begins with the observation – familiar to regular readers, but so fundamental as to merit restatement – that the conventional or ‘consensus’ interpretation of economic processes is profoundly mistaken. This interpretation can be encapsulated in the statement that the economy is ‘a monetary system, capable of infinite growth’.

This, of course, is nonsense, in both particulars. Money is simply a human artefact, lacking intrinsic worth, and commanding value only as a ‘claim’ on the goods and services which constitute the economy. Literally all of these goods and services are products of the use of energy.

The process by which energy is applied to the creation of material prosperity is governed by an equation based on the interrelationship between (a) the aggregate value provided by energy, and (b) the proportion of that value which is consumed in the access process (and is, therefore, not available for any other economic purpose). Just as there are finite resources, not of energy itself but of energy value, so there are limits to the ability of the environment to tolerate some forms of energy use.

If, as is surely obvious, the economy is a material system, based on energy, we can only indulge in self-delusion if we carry on insisting that it’s an immaterial system, based on the human artefact of money. Money itself is worthy of study, whether mathematically or behaviourally, so long as we never confuse the study of money with the study of the economy. The laws and lore of cricket, likewise, may be a rewarding study, but they won’t enable you to understand a game of baseball.

If the economy isn’t, after all, the ‘monetary system, capable of infinite growth’ that it is so widely assumed to be, then two further observations necessarily follow.

The first is that policies based on this false assumption cannot be effective.

The second is that models reflecting this same false assumption cannot work.

The cartographer’s dilemma

These considerations mean that leadership, whether in government or in business, has spent a long time following a wholly false cartography, and continues to do so at a time when a soundly-based understanding of circumstances has become absolutely imperative.

If you were using a mistaken map to traverse an unfamiliar terrain, you would soon start to notice a progressive divergence between the map in your hand and the geographical features in front of your eyes. If you were sufficiently determined to insist that your map was accurate, in the face of accumulating evidence to the contrary, you would have to start inventing some increasingly surreal explanations, along the lines that ‘the river that I’ve just encountered must be a figment of the imagination, or a trick of the light, because it’s not shown on the map!’ 

The divergence between the ‘map’ of conventional economics and the ‘terrain’ of an energy-determined economy has indeed been progressive, because of the way in which the critical energy cost of energy (ECoE) has increased. Back in, say, 1990, when trend ECoE was 2.7%, a failure to incorporate it into interpretation might not be noticed if the accepted margin of error was, for instance, 3%. By 2000, though, with ECoE now at 4.1%, compounding errors had reached a point at which explanations such as ‘normal margin of error’ could no longer suffice.

This example has been chosen advisedly, because the decade between 1990 and 2000 spans the period in which followers of conventional interpretation began to notice – though they could not, of course, explain – a seemingly-baffling phenomenon which they labelled “secular stagnation”. Simply put, the economy of the 1990s started to diverge from expectations because ECoE, the critical factor omitted from those expectations, had now become large enough to matter.   

By the point in the 1990s when the false cartography of conventional interpretation began to take its users seriously off course, economic conditions in the advanced economies of the West were already nearing a critical point.

SEEDS analysis indicates that prior growth in the prosperity of Western economies goes into reverse at ECoEs of between 3.5% and 5.0%. The sixteen-country advanced economies group (AE-16) modelled by SEEDS entered this critical zone in 1995, when their weighted ECoE reached 3.5%, and reached the upward extremity of this range in 2003, at an ECoE of 5%. By then, the prosperity of almost all Western economies was past, at, or very near its downwards inflexion point. Between 1997 and 2007, per capita prosperity in all but one of these sixteen countries turned downwards.

This makes it no coincidence at all that ‘credit adventurism’ – adopted as a ‘false fix’ for the misunderstood onset of “secular stagnation” – was in full swing by 2000. This in turn meant that the global financial crisis (GFC), which hit the economy in 2008-09, had already been hard-wired into the system for at least a decade.

In fact, economic and financial developments had already taken on an internal momentum which has led us to where we are now.

Once the GFC struck, of course, a resort to ‘monetary adventurism’ became a foregone conclusion. This wasn’t so much a case of ‘when things get serious, you have to lie’ as of ‘when things get this bad, you have to crank up the self-delusion’.

As compounding monetary gimmickry has progressed, the economy has taken on increasingly surreal characteristics. These include paying people to borrow (which is what negative real interest rates mean), zombification of much of the corporate sector, and forlorn efforts to operate a ‘capitalist’ system without positive returns on capital. We could, of course, add numerous examples of the economically, the financially and the politically bizarre to this ‘list of the surreal’.

The inner life of figments

Returning to our cartographic analogy, these surreal characteristics are the economic equivalents of the ‘figment of the imagination’ and ‘trick of the light’ excuses adopted by the person determined to explain away the widening divergence between the real terrain in front of him and the false map in whose veracity he is committed to believe.

If you’ve been visiting this site for any length of time, some of the statistical characteristics of this divergence from rationality and reality will be familiar, so a brief recap will suffice.

Between 1999 and 2019, “growth” of 3.5% in world GDP was achieved only by annual borrowing averaging 9.4% of GDP. Each $1 of recorded “growth” was accompanied by $2.70 in net new debt. Stripping out this effect to identify underlying or ‘clean’ output – in SEEDS terminology, C-GDP – reveals that trend growth since 1999 has been only 1.7%, not 3.5%, and that fully 62% ($44tn) of the $72tn of global “growth” recorded since then has been purely cosmetic.

These trends – including the ‘wedge’ driven between GDP and underlying output by the divergence between GDP and debt – are illustrated in the following charts.

Some observers have used the term ‘Ponzi’ to describe these economic trends, though ‘compounding distortion’ might be a more polite way of expressing it. Either way, this sort of progression is entirely dependent on the continuity that alone enables the sleight of hand to deceive the eye.

The real meaning of the coronavirus crisis is that it has severed this all-important continuity.

If we carry on uninterruptedly pouring credit into the economy, and if this activity carries on creating an illusion of “growth”, then we may easily be lulled into an acceptance that what we’re experiencing is “normal”.

We only learn otherwise when, in the old phrase, “the music stops”, which is exactly what has now happened.     

Provided that we’re using energy-based interpretation of the economy – and have freed ourselves from the shackles of mistaken consensus paradigms – then the immediate outlook should be subject to a reasonably high level of visibility.

Critically, a genuine ‘v-shaped recovery’ can’t happen, because you cannot ‘recover’ a situation that didn’t really exist in the first place. The authorities can – and probably will – create a simulacrum of ‘recovery’, by pouring yet more newly-created liquidity into the system. They’re already doing this, of course, by monetising a large proportion of the deficit financing that has been used to support incomes during the first six months or so of the pandemic.

As well as providing support in the form of income replacement, though, governments have also operated policies of deferral, giving interest and rent ‘holidays’ to households and businesses. Though lenders in the United States have been allowed to book non-payments as ‘revenue’ – whilst various jurisdictions have adopted some pretty odd definitions of unemployment, and of rent and debt arrears – nothing can take away the real and extreme strains that these deferral programmes are inflicting on lenders and landlords.

This makes it likely that, probably by early autumn, the need for rescues will force governments into massive interventions, of which the almost inescapable corollary will be the indulgence in monetisation (through money creation) on a gargantuan scale.

Let’s put it like this. If governments were to take away rent and debt ‘holidays’, and to cease supporting the incomes of people idled by the crisis, they would not only inflict grave hardship on huge numbers of people, and destroy very large numbers of businesses, but would also deal a huge blow to demand in the economy.

On the other hand, though, if governments carry on providing this ‘support and deferral’, they will rapidly exhaust the resources of lenders and landlords, forcing the authorities into rescues that would certainly involve enormous levels of government borrowing, and very probably lead to correspondingly enormous exercises in monetisation.

This means that we can be pretty sure that the real test of monetary efficacy – and the corresponding challenge to monetary credibility – is likely to occur in the coming months.  

At the same time, government interventions are supporting demand whilst supply cannot be similarly supported. This implies that the prices of consumer essentials can be expected to rise, with the reverse happening to the prices of non-essential or discretionary purchases. The balance of probability strongly favours inflation over deflation, and the authorities might even be tempted to make a virtue of a necessity, recognising that the ‘soft default’ of inflation is the only way out of existentially dangerous levels of debt accumulated by years of ‘trying to get a quart of economic “growth” out of a pint pot of surplus energy value’.                 

Lost futures, contrarian opportunities?

Returning to the false cartography of mistaken economic interpretation, we find ourselves at a point where governments and businesses alike are planning for a future that isn’t going to happen.

In the words of the song, “the future’s not what it used to be”.

Until now, it’s been widely assumed that we could place unquestioning faith in a never-ending ‘future of more’ – more prosperity, more sales of every kind of service and every sort of gadget, more technology, more profits, more leisure, more flights, more use of energy and, on the downside, more environmental degradation. This delusion probably still governs the thoughts of decision-makers.  

Governments, for instance, are probably continuing to assume that the restoration of some kind of ‘normality’ will rehabilitate revenue streams to prior rates of increase, whereas the reality is that revenue-raising was already starting to exceed the prosperity resources of taxpayers. This is illustrated in the following charts which, in the central diagram, reference taxation in the advanced economies (AE-16) to prosperity, rather than simply to the misleading benchmark of GDP. In 2019, taxation may have accounted for ‘only’ 37% of the GDP of these sixteen countries, but it was already absorbing 50% of their citizens’ aggregate prosperity.

The right-hand chart illustrates how over-estimates of the affordability of taxation are likely to apply a tightening (and a very unpopular) squeeze to disposable, ‘left in your pocket’ prosperity, with adverse implications for anyone providing goods or services which the customer might want, but which he or she doesn’t actually need.

Some of the most cherished policies of many governments and parties, meanwhile, are likely to be pushed aside by a new popular concentration on economic issues, including voters’ concerns about their incomes, the cost of living and their economic security. Neither can we discount the possibility that profound hardship in various parts of the world will set up very large migration flows, something which, if it does happen, is going to have a significant impact on the political dialogue in many Western countries.

What this means is that the strains, not just on governments’ material resources, but upon their resources of judgement and wisdom as well, are going to intensify. Some governments’ escalating fiscal deficits seem already to be well on the way to being matched by competence deficits. It’s no coincidence at all that international tensions and suspicion seem to be increasing, or that some parts of some governments are already proving woefully inept. Political leaders surely need to rise above their preconceptions, and above partisan points-scoring – and doing this is even harder when your economic maps are turning out to be wrong.   

Even in extremis, it’s highly unlikely that governments will undergo a Damascene conversion to an energy-based interpretation of economic reality. To be quite blunt about this, any attempt to persuade them otherwise would probably be a waste of effort, conforming to the proverb which says that “he who washes his ass’s ears wastes both his time and his soap”.

For those of us who understand the energy basis of economics and finance, the wise course of action now seems to involve intellectual and interpretative preparedness; a willingness to put our interpretation at the disposal of those committed to limiting environmental degradation; and keeping a weather eye for the opportunities which fundamental, widely-misunderstood change almost invariably provides.