#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.