#186. The objective economy, part three

CRAFTING THE FUTURE

Behind most complex issues lies a stark simplicity which, once grasped, imposes logic on seemingly-baffling situations. That’s certainly true of our economic and broader predicament.

Ultimately, the economy is an energy system, and energy, though abundant, cannot be ‘had for free’. Whenever energy is accessed, some of that energy is always consumed in the access process. This input-output equation – known here as the Energy Cost of Energy (ECoE) – has now turned against us, undermining the dynamic which has driven economic growth ever since the late 1700s, when the invention of the efficient heat-engine first enabled us to harness the power of fossil fuels.

The fossil fuel dynamic worked in our favour for far longer than it takes to become complacent, and to assume – on the basis, not of analysis, but simply of past experience and extrapolation – that economic growth must continue in perpetuity. 

A second stark simplicity is that we cannot ‘fix’ an energy problem with monetary tools, any more than one could ‘fix’ an ailing house-plant with a spanner. If we switch our metaphors and picture rising ECoEs (and dwindling surplus energy) as an oncoming truck, our responses over the past quarter-century have amounted to throwing the financial system under the wheels.

Since the economy is a product of the energy dynamic, changes in that dynamic affect not just the size of the economy, but its shape and character as well. Having spent more than two centuries building an energy-profligate dissipative-landfill system, we now face reversion to a more energy-frugal economy in which the relationship between (a) exogenous energy inputs, and (b) the human component tilts back towards the latter. A useful shorthand term for this human component is ‘craft’, a word which captures skills as much as, or more than, it references physical labour.

This tilt in the equation does not portend a return to some romantically-imagined past, and neither does it imply that we can make ‘by hand’ products supplied today by energy-intensive mass production.

Rather, it means that the production and purchasing of these products will dwindle, a process which is already under way. As we’ve seen, demand for discretionary (non-essential) goods and services has already become dependent on a necessarily finite process of credit expansion.

Changes in consumer purchasing will be accompanied by changes of supply processes. These changes – which will include de-layering and simplification, and will be spurred by falling utilization rates and progressive losses of critical mass – can be summarised as “de-complexification”, which involves the reversal of the economic and broader complexity that has been created by abundant, ECoE-cheap energy.                  

Introduction

At the very start of his 1929 novel The Good Companions, J.B. Priestly puts the reader high above the Pennine hills in the northern English county of Yorkshire. From there, we descend gradually, concentrating first on a town, then on a street, then on a sea of cloth-capped men walking home from a football match, and finally on a single man, Jess Oakroyd, one of the central characters in the narrative.

Looking down from a similarly elevated position, the World economy has become a dissipative-landfill system, using energy-profligate processes to transform raw materials into products which, for the most part, are rapidly abandoned to landfill or other methods of disposal. This is in stark contrast to the craft model which prevailed before the Industrial Age, when the balance between energy-derived inputs and human skills was very different, and in which the quality of goods, and certainly their durability, was rated a lot more highly than it is today.

Three hundred years ago, people were far likelier to maintain, repair and reuse artefacts than they are now. These are skills that we’re going to need to re-learn.

Properly understood as an energy system, the economy has reached the end-point of a phase in which material prosperity has expanded massively because of the abundant availability of cheap energy from oil, gas and coal.

One of the factors which is bringing this long chapter to an end is the dawning recognition that the environment can no longer tolerate the further expansion, or even the continuity, of a system based on the profligate use of fossil fuels.

The other factor, as yet largely unrecognized, is that oil, gas and coal have ceased to be ‘cheap’ in the only meaningful sense, which is the Energy Cost of Energy (ECoE). After all, abundance of energy supply would be completely meaningless if we were ever to find ourselves using 101 units of energy to access 100 units.  

Where supply systems are concerned, the fundamental issue at stake is the changing relationship between exogenous energy inputs and the human contribution.

This human contribution has always had two components. In past times, human physical labour, sustained by farming and augmented by the use of wind, water and animals, supplied the bulk of the energy used by the economy.

But the second (and arguably the more important) human function has always been the direction and application of energy, however that energy is sourced. In pre-industrial times, skills known as crafts played a very important role in a context of resource and energy scarcity.

As the balance tilts away from energy profligacy, we should anticipate a greater reliance, not just on human labour itself, but even more on the application of craft, a term which needs to be understood as a combination of design and skill.

The importance of ‘craft’ is simply stated. Starting with the same materials, and expending the same amount of labour, one person might produce an artefact of quality and durability, whilst the efforts of another might result in failure. The difference between the two is the meaning of ‘craft’ as the word is used here.  

This tilting balance does not imply a return to some halcyon rustic age of craftsmanship, let alone to a bucolic existence which looks far better to nostalgic hindsight than ever it felt to the vast majority at the time. Rather, it suggests profound changes along lines which this article aims to explore.

Properly understood, we can anticipate some, at least, of the economic processes involved, and this should give us a reasonable level of visibility on what the post-dissipative economy is going to look like.               

Context – the end of energy profligacy

The necessary parameters here – which are familiar to regular visitors to this site, and can be stated briefly – start with recognition that the economy is an energy system, and not the financial one as which it is so often misrepresented.

All goods and services which have any economic utility at all are products of the use of energy. Properly understood, and although it is used for many other purposes, money operates primarily as a medium of exchange. This means that money has no intrinsic worth, and commands value only as a ‘claim’ on the goods and services produced by the energy economy. This interpretation was set out in more detail in part one of this series.

The critical factor in the energy economy is the observation that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This component is known here as the Energy Cost of Energy (ECoE), and the level of ECoE determines how much remaining (surplus) energy is available for all economic purposes other than the supply of energy itself.

Analysis undertaken using the SEEDS model indicates that sensitivities to ECoE are inverse functions of complexity. In the highly-complex Western advanced economies, prosperity per capita turns downwards at ECoEs of between 3.5% and 5.0%, thresholds which were passed between 1997 and 2005. Since then, the average person in these economies has been getting poorer, a trend which no amount of financial gimmickry can reverse.

The equivalent threshold for less complex emerging market (EM) economies lies at ECoEs between 8% and 10%, a band which the World entered in 2017. Accordingly, global prosperity per person has now turned down from a long plateau, and our efforts to use credit and monetary adventurism to disguise and deny (since we cannot change) this trajectory explain the increasingly surreal character of the global financial system.

Critically, and as we discussed in part two, the process of deteriorating prosperity takes place through a hierarchy of calls on incomes. First calls are made by taxation, and by the cost of household essentials. These prior calls leverage the way in which a deterioration in prosperity reduces the residual capability to make discretionary (non-essential) purchases. SEEDS analysis indicates that, in a growing number of countries, discretionary prosperity has already been squeezed almost out of existence within recent years.

Of course, this doesn’t mean that no discretionary purchases are made by the average person. But it does mean that such purchases are now, for the most part, financed using credit. Moreover, and reflecting deviations in income around the average, some households can still make discretionary purchases without resorting to debt, whereas others are already using credit to fund part of the cost of essentials. This is a variance which points strongly towards growing popular demands for redistribution.

Since debt is ‘a claim on future money’, whilst money is ‘a claim on energy’, debt can be defined as ‘a claim on future energy’. If, when credit falls due for payment, the presupposed level of applicable surplus (ex-ECoE) energy is found not to exist, neither conventional debt or other financial promises (such as pensions) can be met. At this point, the only choice which remains is between ‘hard’ default (where we renege on commitments) or ‘soft’ default (where commitments are met, but in money devalued by inflation). Historically, the preference has tended to be for the latter.

A further complicating factor is that the financial and corporate sectors have created liens on income which are the household counterparts of the streams of income on which so many business models now depend. Once confined largely to rent and mortgage payments, these liens have since extended into a gamut of payment streams which include credit, staged purchases and subscriptions. Additionally, many of these streams of income have been capitalized into traded assets, originally exemplified by the mortgage backed securities (MBSs) which became so prominent during the 2008-09 global financial crisis (GFC).

How it happens

These considerations form the essential context for how the transition from the dissipative-landfill model to a more craft-based economy can be expected to take place.

It is, of course, extremely implausible that we will start selling hand-assembled cars, and even less likely that we’ll switch over to man-made gadgetry, or craft-produced computers. But this isn’t the way that change is going to happen.

Rather, we will simply make and buy less of these energy-dissipative products over time. Since we know that the scope for discretionary consumption is subject to a relentless squeeze – a trend that currently is being staved off by credit expansion alone – we can further infer that transition will involve falling sales of consumer products manufactured along energy-intensive, dissipative-landfill lines. This can be expected to begin in discretionary product classes.

There are already several pointers towards such trends. First, hindsight seems likely to confirm that sales volumes in a string of product areas – including cars, smartphones, computer chips and electronic components – peaked during 2017-18.

Second, plans to replace internal combustion engine (ICE)-powered cars and lorries with electric vehicles (EVs) are likely to happen on a less than one-for-one basis, resulting in decreasing fleet sizes, with ICE vehicles disappearing more rapidly than EVs arrive to replace them.  

Third, various ideas are being canvassed that would see people renting items which, hitherto, they would have owned. These ideas raise important issues about ownership, about the distribution of income and wealth, and about income streams, but they do point towards reduced ownership, implying smaller quantities and falling sales in a gamut of product categories.

Because the economy is characterized by complex inter-connectedness, it’s not too difficult to describe how these processes will unfold. These have been discussed here before as part of the “taxonomy of de-growth”.

First, we should anticipate a reversal of the process by which, as the real economy of prosperity grew larger, it also became progressively more complex. Even an industry as seemingly basic as the supply of food has expanded from a relatively limited number of trades into a host of specializations, whilst whole sectors of the economy exist as service adjuncts of others.

As this process goes into reverse, we will witness both simplification and de-layering. Whilst the latter term is self-explanatory, describing the shrinkage and elimination of whole tiers of activity, ‘simplification’ refers both to products (with customer choice reducing towards more basic ranges) and to processes, where methods of production will become less complex, whilst supply chains are shortened.

Meanwhile, we should anticipate the compounding effects of two further processes. One of these is falling utilization rates. This can be considered using the example of a bridge, whose economic viability relies on spreading the fixed costs of operations over a large number of users. As user numbers decrease, the share of fixed costs needing to be allocated to each user increases, pushing prices upwards, and accelerating the rate at which user numbers fall. This effect applies to any activity whose viability relies on economies of scale, which means that exposure to this downwards pressure is going to be virtually ubiquitous across the economy.               

A second and related process is the loss of critical mass. This occurs where some of the many components or other inputs required by a production process cease to be available. Some such gaps can be worked around, and will indeed form part of the simplification process. But others either cannot be surmounted cost-effectively, or cannot be overcome at all. Accordingly, products cease to be made because some necessary inputs can no longer be sourced.

Importantly, loss of critical mass and falling utilization rates can be expected to interact in a compounding process (for which provision is now made in the SEEDS economic model). We can, for instance, picture a manufacturer ceasing to make a product because critical inputs cannot be obtained. This reduces the purchasing of other components, whose supply then ceases because suppliers’ own utilization rates have fallen below the threshold of viability.

Services – rapid shrinkage

It makes sense to pause here and recap what we’ve observed so far. Energy-based analysis indicates that, because of deterioration in the energy dynamic, past growth in prosperity has gone into reverse, which makes the average person poorer over time. We also know that, because of the hierarchy of calls on incomes, we’re witnessing a leveraged squeeze on the scope for discretionary purchasing, to the point where much, perhaps most, of the ‘discretionary economy’ has become hostage to the ultimately-finite process of credit expansion.

We can further note that, as consumer discretionary purchases contract, we will witness de-layering, product and process simplification, and the compounding effects of falling utilization rates and losses of critical mass. Together, these processes point towards a shift away from energy-profligate, dissipative-landfill production methods towards smaller, more local and more ‘crafted’ supply processes which rely less on exogenous energy inputs and more upon human skills.

Thus far, we’ve concentrated primarily upon physical goods, though it must be emphasized that the whole “de-complexification” process will affect services at least as much as (and probably more than) it affects the supply of goods. Service sectors are prime candidates for de-layering, are likely to be amongst the first casualties of simplification, and are particularly exposed to the adverse effects of falling utilization rates.

There is, though, an additional, quite fundamental point to be noted about the diminishing role of services in an economy transitioning away from the dissipative-landfill model to which we have long become accustomed.

Ultimately, service industries are adjuncts of the supply of goods, and are a product of the complexity and the efficiencies created by the energy-profligate system.

This is not a conclusion that a perusal of conventional economic data would reveal. Official statistics indicate that services account for 63% of World economic activity (as of 2017), and that the proportions are even higher in the United States (80%), Britain (79%), the European Union and Australia (both 71%).

Since ‘industry’ (of all kinds) accounts for 30% of World GDP, and for lower proportions still in the advanced economies, one could easily conclude that services are ‘at least twice as important’ to the economy as manufacturing, and all other production activities, put together.

This is a wholly misleading interpretation, in much the same way as similar statistics could be used to ‘prove’ that, since agriculture is ‘only’ 6% of World economic output, 94% of the economy could continue unscathed even in a situation in which the production of food had become impossible.

The reality is that, in the pre-industrial economy, services were few in number, and rudimentary in character, and a retreat from an energy-profligate system can be expected to drive their role back towards that situation. Historically, the availability of low-cost fossil fuel energy starkly and relentlessly reduced the numbers of people required for the supply both of food and of physical goods, which meant that the numbers no longer required for these activities soared. This was the dynamic which drove the expansion and proliferation of service activities, and the consequent reallocation of financial activity is reflected in statistics which seem to show that services are now ‘more important’ than production.

The obvious corollary is that service activities will shrink more rapidly than the supply of goods as the economy moves away from the dissipative-landfill model.

A final conclusion – for now – is that many of the giants of the commercial and financial landscape will fade from prominence as the economy rebalances away from the dissipative-landfill system.

This, at least, should not cause undue surprise to anyone who has a knowledge of commercial history – after all, global trade is no longer dominated by businesses like the Honourable East India Company and the Hudson’s Bay Company, any more than the Dow Jones Industrial Average is populated by former stalwarts such as the Distilling & Cattle Feeding Co., the United States Leather Co., the Remington Typewriter Co., or the Victor Talking Machine Co..  

265 thoughts on “#186. The objective economy, part three

  1. I’d like to add my gratitude in with the rest and hope you take a few days off for your on sanity at the very least.
    I share your site and insight with anyone who engages with me about ECoE. All the best in the future to all who frequent here, whatever that may indeed look like.

  2. Unfortunately, armed as we are with the insights to be derived from your intellectual achievement and its implications for the economy – above all the vastly important and obviously fast failing discretionary sector – we shall have the frustrating experience of watching our governments pursue policies which are based on the old and false axioms of economic orthodox (energy as just another input, to be solved by ‘Green energy’, viability of continued growth, etc.) and a belief that a strong recovery after the pandemic has passed will be almost automatic and can be fostered with monetary policy, and sponsorship of new technology in immature markets.

    In so far as this recovery will be based on selling us gadgets and services which we elect to buy, they may well be in for a severe shock! Of course, they will try to force them on us, so that an i-phone or the like is non-discretionary and mandatory (this has already happened in some professions!) or very difficult to live without.

    We shall be able to draw conclusions for our own likely prospects, and maybe adjust accordingly, but otherwise we will be like those who knew in the 1930’s just why rearmament was necessary observing the levers of power in the stubborn hands of the appeasers.

    But one supposes that it is still better to understand the fundamentals and be more or less impotent than to be bewildered and without a decent guide. As in life, so in economics!

    Meanwhile, the universities will continue to churn out business and economics graduates trained in principles and unexamined assumptions that no longer apply as they appeared to in the years of wild growth fuel by coal and oil.

    Once again, heartfelt thanks for what has clearly been a great effort in every way, and for your generosity in making it so readily available!

  3. Dr Morgan,
    Your blog is the first site I visit after I have checked my emails and the weather each day.
    I find the content totally absorbing. Your work is so valuable.
    I had always felt in my bones there was an economic model based on the laws of physics.
    Reading your book was a true revelation. I have never , since then , come across any statement made concerning energy or economics that could contradict the views expressed therein.
    Just wish the views were more widely understood. I have where possible drawn attention to your work . Hopefully in time the tide will turn.
    May you enjoy good health and happiness in 2021.
    As we say in my home country at the start of a new year – “ Lang may your lum reek “
    Realise that it is not a politically correct statement these days but the sentiment is genuine.

  4. I’d like to wish everyone here a very happy new year, despite the outlook! First, a special thanks to Dr. Tim, not only for his tireless and superb work, analysis and great writing, but also for hosting this amazing comment section and keeping it on track! Thanks to everyone who contributed to these discussions, it was a great, great year for comments and discussion. A lot if newcomers who have added a lot to our discussion! I am hoping for more in the new year!

    Best to all!

  5. Also my best wishes for the commenters and of course Dr. Tim. Your articles provoking the finest creativity in the commenting section is a pleasure. ‘See’ y all soon!

  6. Skip your Swiss hotel to evade mandated quarantine and then, once safely over the border, call the hotel to demand a refund!

    Chutzpah, or moronic?

    “More than 200 British skiers fled a coronavirus quarantine in the popular Swiss resort of Verbier on Saturday night, reports say.

    A spokesman in Valais canton said 420 British guests had booked into Verbier accommodation before Christmas and now only about a dozen were left.

    Switzerland imposed a 10-day quarantine backdated to 14 December because of the new virus strain spreading in the UK.

    The country also stopped flights from the UK and South Africa on 20 December.

    Some Swiss hoteliers only discovered the guests had vanished when room service trays were left untouched outside doors, Swiss media reported. Others were called by British tourists demanding their money back once they had safely crossed into France, the BBC’s Imogen Foulkes reports from Geneva.

    Verbier is especially popular among the British, who normally make up about one-fifth of the resort’s winter clientele”.

    https://www.bbc.co.uk/news/world-europe-55465079

    • Dr Morgan,
      In today’s Guardian there is an article by Jim Al-Khalili who is one of the greatest enlighteners in matters scientific.
      It is essentially about disinformation regarding COVID-19.
      Could we ask him to cover the disinformation perpetrated by the economists in regard to growth in the world economies? He is after all a physicist who one would imagine understands the laws of thermodynamics.

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