#195. The unrelenting squeeze

MONEY, CREDIT AND THE DECLINE OF DISCRETIONARY PROSPERITY 

Henry Ford may have said that “history is bunk”, but a glance backwards can sometimes help us to focus on the future. Though they are not the subject of this discussion, fiat currencies are an example of this.

The world monetary system moved on to a fiat or “command” basis back in 1971. For the following quarter-century, this worked reasonably well, and it seems likely that historians of the future will date the decline of fiat from the second half of the 1990s.

That was when we embarked on the financial excesses which culminated in the global financial crisis (GFC) of 2008-09. The rest – as the saying goes, and with apologies to Mr Ford – “is history”, with the ultimate fate of fiat determined from the moment when the world’s ‘market’ economies decided to turn their backs on market forces, and to ‘make it up as we go along’.

The aim here isn’t to revisit the subjects discussed in the previous article, but it’s worth considering why a monetary system that previously had worked pretty well then turned on to a dangerous path.

What, fundamentally, changed in the 1990s?

The answer, of course, was that ECoEs – the Energy Costs of Energy – reached what was, for Western economies, the climacteric zone that lies between 3.5% and 5.0%. SEEDS dates this ECoE climacteric to the period between 1996 (a global ECoE of 3.4%) and 2005 (5.0%).

From 1997, the prosperity of the average Japanese citizen turned downwards. The same fate overtook Americans in 2000, and the British in 2004, and most other Westerners by 2008.

Well before then, baffled observers had started to wonder about the phenomenon of “secular stagnation”, something which they could identify, but could not explain.

The rest is indeed “history”, because money-based systems of economic interpretation could propose only futile financial solutions for a trend rooted, not in money, but in energy.

Why, then, did the ECoE inflexion-point in Western prosperity put “the writing on the wall” for fiat currencies? The answer seems to lie in the flexibility that is at once fiat money’s greatest virtue and its fundamental weakness.

So long as the underlying economy keeps growing, fiat money can expand at a roughly commensurate rate, and that’s its virtue.

Once the economy turns down, however, a divergence begins, because fiat systems are incapable of a corresponding contraction, and that’s the system’s inherent vice.

Unless you understand the economy as an energy system, though, you couldn’t – and still can’t – see what’s happening.

Monetary expansion in a contracting economy can only create excesses of those financial ‘claims’ that, customarily, are called “value”. From that point on, the only real question is whether the instrument of “value destruction” is going to be a series of market crashes and debt defaults, or a hyperinflationary debasement of the value of money.

Here, history again provides a pointer, suggesting that decision-makers will almost always avoid formal or ‘hard’ default if the ‘soft’ alternative of inflationary value destruction is available.

So much for history, and the rise and fall of fiat. Turning to the future, here are some charts that ought to (but, of course, won’t) act as a wake-up call for decision-makers.

Fig. 1

Though extended out to 2040, these charts will be familiar to regular readers. What they show is the SEEDS calibration of prosperity per capita, set against the cost of essentials. The latter, defined as the sum of public services and household necessities, remains a development project, but the bottom line is clear enough.

In essence, the prosperity of the average person in America, in Britain and – now – even in China is deteriorating. The cost of essentials is continuing to rise. Accordingly, the scope for discretionary (non-essential) expenditure, within the parameters of prosperity, is eroding fast.

People will still undertake discretionary spending in excess of this shrinking capability, of course, as indeed they are doing now. But they can only do this by resorting to borrowing for this purpose. Discretionary consumption within the affordability of prosperity is undergoing rapid contraction.

More worryingly still, there seems to be every likelihood that the cost of essentials will, in due course, rise above prosperity per capita. As you can see, this might not happen until some time in the 2030s, but that doesn’t mean that we can ignore it until then.

For one thing, these are average numbers, not medians. For every person whose discretionary prosperity remains comfortably positive, there’s another who’s already near, or at, the point of reliance on credit to pay for the essentials.

Here is where we’re entitled to ask some questions. Are governments aware of this situation, as they continue to plan on the basis of rising revenues, and carry on investing in sectors geared towards discretionary consumption?

Do they, and central bankers, really think we can somehow overcome these fundamental, energy-driven trends by pouring yet more cheap credit and cheaper money into the system? Do businesses selling discretionary goods and services realise that they’re becoming hostages to the fortunes of credit expansion? And do those companies and investors reliant on assumed increases in consumer income streams understand the dynamic that is squeezing consumer discretionary prosperity?

In most cases, the answer, very probably, is “no”.

Have political leaders looked ahead to the very different agendas that will concern voters once the gravy-train of cheap credit either hits the deflationary buffers or crashes off the inflationary rails?

Again, probably not.