In recent discussions here, it’s been suggested that we need a brief explanation of Surplus Energy Economics (SEE). This is an interpretation which states that the economy is an energy system, not a financial one. This is the understanding which informs the SEEDS economic model.
The timing is certainly appropriate, as established economic conventions are being confounded by adverse trends which financial tools are proving wholly unable to counter. In this context, it’s not at all surprising that interest in SEE and SEEDS continues to increase.
Energy-based analysis reveals that, where the West is concerned, the scope for further economic expansion disappeared between 1997 and 2007, and that the same thing is now happening in the EM (emerging market) economies.
The principle SEEDS metric for economic well-being is prosperity, which the model calibrates both in aggregate and in per capita form. On the latter basis, the average American was (as of 2019) 6.6% poorer than he or she had been back in 2000, British prosperity had declined by 10.6% since 2004, and Canadians had become 8.6% poorer since 2007.
These findings are, of course, quite different from the conventional line, mainly because governments and central banks have resorted, perhaps in all good faith, to credit and monetary policies which have sustained a simulacrum of “growth” even though prosperity is now deteriorating.
The economic narrative of modern times is that, ever since “secular stagnation” was first noted (but not traced to its energy causation) back in the 1990s, the authorities have tried successive financial ‘fixes’ which have succeeded only in confirming that the economy, being an energy system, cannot be revitalized by monetary ‘innovation’.
‘Credit adventurism’, which led directly to the 2008-09 global financial crisis (GFC), has since been compounded by ‘monetary adventurism’, which has put the monetary system itself at great and increasing risk. We can be certain that the search is on for ‘gimmick 3.0’ – and equally certain that this, too, will fail.
The greatest single error made by conventional economics is the assumption that, if we understand money, we also understand the economy. This fallacy has driven an ever-widening gap between a financial system that has been growing exponentially, and an economy that has ceased expanding, and has started to contract.
In the interests of brevity, some of the implications of SEEDS analysis can only be noted here in outline. First, as prosperity per capita declines, so will the scope for funding public spending without recourse to ever-increasing government debt.
Second, just as prosperity has deteriorated, the cost of essentials has continued to increase, leveraging relatively gradual declines in top-line prosperity into far steeper falls in discretionary prosperity. This in turn means that a large and growing proportion of discretionary consumption has become dependent on continuing increases in debt.
Third, the calibration of prosperity reveals that levels of financial risk are far more severe than they appear on conventional metrics which use credit-inflated, ECoE-ignoring GDP as the denominator.
Each of these factors makes it seem unlikely that the energy basis of the economy will gain official recognition any time soon. Properly understood, the last real opportunity for a “reset” came – and went – back in 2008-09, when we opted to side-step the market implications of dangerously excessive credit.
The only practical alternative now is to try to buy a bit more time before ultra-loose monetary policies trigger a hyperinflationary slump in the value of money, and/or attempts to head off surging inflation trigger asset price collapses and a cascade of defaults.
Fundamentally, the aim now must be to minimize the economic consequences of a seemingly inescapable failure of the financial system.
Two interpretations, one reality
Essentially, there are two ways in which the working of the economy can be explained. One of these is the conventional or orthodox explanation, which states that the economy can be understood wholly in terms of money. The alternative, summarised here, is that the economy is an energy system.
If it were true, the monetary explanation would mean that there need be no end to economic growth, because money is a human artefact which is wholly under our control. Some proponents of traditional, money-based economics have been explicit about the absence of physical or resource limits to economic expansion.
It might be contended that the economy has indeed expanded enormously since the publication, in 1776, of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, the founding treatise of Classical Economics.
The alternative explanation is that it wasn’t Smith’s magnum opus, but the completion of James Watt’s radically more efficient steam engine – also in 1776, and also in Scotland – that really triggered two centuries of rapid economic growth, because it gave us access to the vast quantities of energy contained in coal, oil and natural gas.
The contest between these two schools of thought is reaching a climax now, because two factors are undermining the fossil fuels dynamic. One of these is the recognition that continued reliance on oil, gas and coal threatens to inflict irretrievable damage to the environment.
The other is that depletion – the practice of using highest-value energy resources first, and leaving costlier alternatives for a ‘later’ which has now arrived – is eliminating the ability of fossil fuels, not just to drive further growth, but even to maintain the economy at its current scale and complexity.
The view set out here is that this contest is already all but over, and that increasingly desperate reliance on financial gimmickry – plus the increasingly blind faith placed in technology – demonstrate the failure of an interpretation which insists that money, rather than energy, determines the size and shape of the economy.
The energy-based interpretation of the economy is founded on three principles, each of which is validated both by logic and observation.
The first is that the economy is an energy system, because nothing that has any economic utility (value) at all can be supplied without the use of energy.
The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy).
The third principle is that money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the energy economy.
Each of these principles seems incapable of refutation. We know, for example, that an economy deprived of energy would grind to a halt within days, and would collapse within months. We know that we can’t drill an oil well, manufacture a wind turbine or a solar panel, or build an electricity grid without using the products of energy. We know that no amount of money will help someone adrift in a lifeboat, lost in a desert, or in any other way cut off fromthe process of exchange.
The first set of charts puts these issues into context. The left-hand chart shows how dramatic increases in population numbers (from less than 0.7 billion in 1776 to 7.8 billion now) – and in the economic means of their support – have been driven by an even more dramatic increase in energy use. For most of that period, energy supply has grown morerapidly than population numbers, enabling prosperity to improve.
The situation now, though, is that trend ECoEs are rising rapidly, which has two adverse consequences for prosperity. The first is that rising ECoEs reduce the economic value obtained from each unit of energy consumed.
The second is that growth in energy supply is likely to cease, because producer costs are rising just as the prosperity of consumers is being undermined. This suggests that increased output of renewables and other non-fossil forms of energy will, at best, do no more than offset a decline in supplies of fossil fuels, leaving total energy availability broadly flat.
This means that, for the first time since the start of the Industrial Age, energy use per person will trend downwards. The deterioration is set to be even more marked at the level of surplus (ex-ECoE) energy per capita, which is the real driver of prosperity.
Financial consequences – the high price of denial
Perhaps the strongest evidence for the deterioration of the energy-based economy is the sheer extent – indeed, the outright desperation – of the financial gimmickry that has been necessary in order to sustain a simulacrum of “growth” as rising ECoEs have undermined economic prosperity.
As we shall see, prior growth in the prosperity of the advanced Western economies goes into reverse at ECoEs between 3.5% and 5.0%. Globally, these effects started to undermine growth between 1990 (an ECoE of 2.6%) and 2000 (4.1%). This was the period in which observers first identified a deceleration which they labelled “secular stagnation”.
This phenomenon has not, of course, been understood in energy terms. Rather, decision-makers have resorted to increasingly desperate, dangerous and futile financial innovations in an effort to counter it.
The first recourse was to ‘credit adventurism’, making debt easier to access than it had ever been before. Since 1995, reported “growth” (of 116%, or $71 trillion) in GDP has been far exceeded by a 247% ($235tn) escalation in debt. This means that each dollar of “growth” has been accompanied by $3.30 of net new debt.
Another way of looking at this is that, whilst annual “growth” averaged 3.3% between 2000 and 2020, annual borrowing averaged 10.8% of GDP. What was happening was that output and growth were being inflated artificially by the pouring of increasing amounts of credit into the system.
SEEDS analysis reveals that underlying or ‘clean’ output – known here as C-GDP – increased at an annual rate of only 1.6%, rather than 3.3%, through this period. Even this average number masks a steady deterioration in clean growth.
These compounding effects mean that reported economic output has now been inflated far above its underlying equivalent. Essentially, the insertion of a ‘wedge’ between debt and GDP has driven a corresponding wedge between reported (GDP) and underlying (C-GDP) economic output.
Needless to say, ‘credit adventurism’ has exacerbated financial risk. The artificial inflation of reported output has resulted in the understatement of risk calibrations, such as the ratio of debt to GDP, meaning that risk has become more opaque just as it has become more extreme. At the same time, the deregulatory processes involved in credit expansion have combined with ultra-loose monetary policy to weaken the link between risk and return.
This exercise in ‘credit adventurism’ necessarily culminated in the global financial crisis (GFC) of 2008-09. Rather than accept the market consequences of this process, the authorities opted to compound credit with ‘monetary adventurism’, through the adoption of supposedly “temporary” expedients including QE and ZIRP.
It does not require hindsight to recognize that, during the GFC, the last chance of a meaningful “reset” came and went. The adoption of ‘monetary adventurism’ has created a wholly unsustainable situation, in which real (ex-inflation) interest rates have been pushed permanently into negative territory – which means that people and businesses are paid to borrow – whilst saving is deterred. Other consequences of this process have included a dramatic, artificial inflation of asset markets, and the creation of a severe disequilibrium between asset prices and all forms of income.
Fundamentally, this has suspended the operation of a ‘capitalist’ system which, of course, requires positive real returns on capital. The necessary process of ‘creative destruction’ has been halted by a dynamic which keeps non-viable (‘zombie’) businesses afloat.
The effects of these processes extend far beyond debt itself. Since 2002, the broader category of financial assets – essentially, the liabilities of the government, household and corporate sectors – has expanded at a rate of $7.20 for each dollar of “growth” in GDP. Meanwhile, the crushing of returns on invested capital has contributed to the emergence of huge shortfalls (“gaps”) in the adequacy of pension provision.
In overall terms – and well before the onset of the coronavirus crisis – we had reached a point at which each “growth” dollar is being bought with $3.30 of new debt, $3.90 of other incremental financial liabilities and $2.50 of additional shortfalls in pension provision.
It would not be too much of an over-simplification to assert that we are taking on close to $10 of new liabilities in order to manufacture each $1 of “growth”.
The irony is that, of the supposed $71tn “growth” recorded since 2000, fully 60% ($40tn) has been purely cosmetic, with real economic expansion totalling only $26tn over that period.
The decisive factor– ECoE
From the foregoing, it will be obvious that the critically important dynamic has been the relentless rise in ECoEs, a trend that has put an end to economic expansion, and has already started putting prior growth in prosperity into reverse.
The history of the economy in recent times can best be understood as an attempt to use financial policy in a failed effort to ‘fix’ an economy hamstrung by a factor – rising ECoEs – that conventional economic interpretation wholly fails even to recognize.
For most of the Industrial Age, ECoEs have trended downwards. We don’t know what ECoEs were back in the 1770s, but we do know that they were high. They declined steadily over time, reflecting three operative processes.
The first of these was geographic reach, exemplified by the way in which the petroleum industry, from its origins in the Pennsylvania of the 1850s, expanded in pursuit of lower-cost supplies around the World.
The second was economies of scale, a facet of the rapid expansion of the coal, oil and natural gas industries.
The third driver was technology, which progressed from the simple extraction, processing and transport methods of the early Industrial Revolution to the far greater sophistication of the modern energy industries.
The ECoEs of the fossil fuel industries probably reached their nadir in the two decades after the Second World War, when ECoEs seem to have been at or below 1%. This drove the particularly rapid economic expansion of that period.
Latterly, however, the benefits of reach and scale have been exhausted, and depletion has started to drive ECoEs back upwards. Fossil fuel ECoEs reached 2% in 1984, 3% in 1993 and 5% in 2003, and are now close to 12%.
Since fossil fuels still dominate energy supply, overall ECoEs have risen relentlessly, from 2.6% in 1990, and 4.1% in 2000, to just above 9% now. As we shall see, complex advanced economies need ECoEs that are below 5%, and EM (emerging market) countries require ECoEs that are no higher than 10%.
It’s abundantly clear that there can be no financial ‘fix’ for rising ECoEs. Equally, we cannot overcome higher ECoEs by using ever larger gross (pre-ECoE) quantities of energy, because rising ECoEs undermine the economics of energy supply itself. Unless the rise in ECoEs can somehow be halted and reversed, economic prosperity must follow a path of continuing decline.
Supposed solutions to the ECoE problem fall into three categories, none of which is persuasive.
The least feasible of all is that we can somehow “de-couple” economic activity from the use of energy. This is impossible, of course, because the economy is an energy system. The evidence for “de-coupling” has been described by the European Environmental Bureau as “a haystack without a needle”. Only in the kind of alternative universe described by conventional, ‘money-only’ economics can we live on money, detached from physical (meaning energy-based) goods and services for which money can be exchanged.
The second delusion is that ‘there’s a technological solution to everything’. This is an era in which extravagant (and generally extrapolatory) claims are made for technology. The hard reality, of course, is that the scope of technology is limited by the envelope of physics. This is why, for instance, efforts to use shale resources to turn the United States into “Saudi America” have been such a costly failure.
Third, it’s asserted – and often simply assumed – that transition to renewable sources of energy (REs) can push overall ECoEs back downwards. Whilst there are compelling environmental and economic reasons for promoting RE expansion, the ECoEs of REs are unlikely to fall much below 10%, which is nowhere near low enough to prevent deterioration in an economic system built on ECoEs at or below 2%. Apart from anything ese, transition to REs will require enormous resource inputs, most of which can only be made available through the use of legacy energy from fossil fuels.
The prosperity connection
The SEEDS economic model enables us to identify the levels of ECoE at which Western prosperity turned down, and to measure and predict the equivalent inflexion-points for EM economies.
In the Advanced Economies, prior growth in prosperity per capita went into reverse at ECoEs between 3.5% and 5.0%. This happened in Japan in 1997 (at an ECoE of 4.4%), in the United States in 2000 (4.5%), in Italy in 2001 (4.8%%), in Britain in 2004 (4.5%) and in Canada in 2007 (4.0%).
Latterly, the same thing has started happening in EM countries, too, including Mexico in 2007 (at an ECoE of 5.1%), South Africa in 2008 (6.1%) and Turkey in 2018 (8.7%). SEEDS analysis shows that, in general, EM prosperity turns down at ECoEs of between 8% and 10%.
Latest data indicates that Chinese prosperity may not now turn down until 2025-26 – by which time ECoE is likely to be between 9.6% and 9.9% – though intervening increases in prosperity are likely to be very modest. The greater ECoE-resilience of the EM economies reflects a lesser degree of complexity, which means that upkeep of existing systems can be accomplished at lower levels of surplus energy.
There are, of course, local nuances around the connection between different countries’ ECoEs and their prosperity inflexion-points, but the ranges cited here – 3.5% to 5.0% for Western countries, and 8-10% for EM economies – are validated by comprehensive analysis.
For the World as a whole – and as the following charts illustrate – prosperity per person has been on a long plateau, during which continued growth in the EM economies has cancelled out Western deterioration. This helps explain the widespread perception that EM countries have been ‘carrying’ global growth since the GFC.
It would be a mistake, though, to assume that this EM resilience can be a continuing facet of the global economy. Rather, lesser complexity explains why countries like China and India have been able to carry on improving their prosperity pending their arrival at higher (and hence later) inflexion points.
Critically – and with most economies now past their economic climacterics – global prosperity per capita seems now to have turned down decisively from a plateau that has lasted since the early 2000s.
As the third of the following charts shows, the essence of the situation is that the World’s average person is now getting poorer, a problem compounded by an unfounded, blind faith insistence that no such thing can possibly be happening.