#204. How it happens

DISCRETIONARY DISTRESS AND THE DYNAMIC OF REALIGNMENT

Even those who continue to think of the economy as a financial system must be feeling, at the least, bafflement and concern over a situation characterised by massive stimulus, worsening monetization of debts, negative real returns on capital, and clear signs of surging inflation, certainly in asset markets, and very probably in consumer prices as well.

For those of us who understand the economy as an energy system, none of these symptoms is at all surprising. We know that the energy dynamic that has driven growth and complexity since the start of the Industrial Age is deteriorating, because of relentless rises in the ECoEs (the Energy Costs of Energy) of fossil fuels.

We also know that there’s no ‘fix’ for this situation.

From this perspective, it’s easy to see that the financial economy of money and credit is becoming ever further detached from the underlying, material or ‘real’ economy of goods and services. This divergence is intrinsically unstable, and is – as the old saying puts it – ‘unlikely to end happily’.

Two immediate questions naturally follow. First, when will this instability culminate in some kind of crisis? Second, how will this come about, and what are the processes that are likely to shape it?

Nobody can be sure about timing, but we can, at least, be reasonably clear about process. With or without a surge in inflation – and/or tumbling markets and a cascade of defaults – what’s likely to happen is that the cost of essentials will carry on rising, whilst top-line prosperity continues to erode.

Being slightly more technical about this, we can call this a squeeze on the discretionary (non-essential) sectors of the economy.       

The issue around discretionary prosperity – defined as the difference between top-line prosperity and the cost of essentials – is scoped, using the SEEDS economic model, in fig.1.     

Fig. 1

Introduction

Less than a century ago, even in the World’s most prosperous countries, most of the incomes of ‘average’ people were spent on necessities. Car ownership was a luxury, and the typical holiday was likely to be spent in a boarding-house at a seaside resort, reached by train. Indeed, domestic appliances now taken for granted only started to reach the status of normality from the 1930s.

Historians of the future might well describe the post-1945 era as ‘the Age of Discretion’, with economic growth channelled into a rapid expansion of discretionary (non-essential) consumption. One of the clearest implications of the onset of deteriorating prosperity is that the scope for discretionary consumption will now contract, a trend as yet almost wholly unanticipated by governments, businesses and households.

As we shall see, it’s difficult to draw a hard-and-fast line between the essential and the discretionary, but non-essential – ‘want, but not need’ – goods and services probably account for at least two-thirds of the economic activities of Western countries. The idea that this part of the economy might contract will come as a great surprise, and an extremely unwelcome one.

In fact, though, the continuity of discretionary consumption has already, and over an extended period, become a function of credit expansion. Borrowing, whether by households, businesses or governments, has become the ever more important prop supporting everything from travel and leisure to the purchase of non-essential goods.

The ability of the average Western person to afford discretionary consumption without recourse to borrowing ceased growing, and started to shrink, between fifteen and twenty years ago. 

Anyone trying to understand how involuntary “de-growth” is likely to unfold can best focus on two issues – the contraction of discretionary activity, and the failure of a financial system manipulated to sustain growth in discretionary consumption long after organic growth in prosperity went into reverse.

Context – the onset of “de-growth”

If you’ve been visiting this site for any length of time, you’ll know that there are two, diametrically-opposite ways in which we can endeavour to make sense of the economy.

One of these is the ‘conventional’, ‘orthodox’ or ‘classical’ school of economics, which states that the economy is wholly a monetary system, not constrained by resource limitations, and assured of ‘growth in perpetuity’ through our control of the human artefact of money.

Quite aside from its lack of logic, this interpretation is discredited by the truly extraordinary financial and intellectual gymnastics that have been required in order to try to square this comforting thesis with what we see happening around us. The “temporary” (since 2008) expedient of negative real interest rates is just the most extreme (and arguably the most harmful) of the many exercises in gimmickry that have been necessary to sustain the myth of an ever-expanding economy, shaped entirely by money.

The alternative – advocated here, and modelled using SEEDS – is to interpret the economy as an energy system. From this perspective, growth in economic output since the 1770s has been the product of huge increases in the use of low-cost fossil fuels. Now, though – and quite apart from harming the environment – these fuels are losing the ability to support the complex modern economy as they cease to be ‘low-cost’.

In this context – in which energy is the economy, with money a medium of exchange – the only meaningful definition of ‘cost’ is the proportion of accessed energy that is consumed in the access process, and hence is not available for any of the other economic uses that constitute prosperity. Known here as ECoE – the Energy Cost of Energy – this equation is the primary determinant of economic prosperity.

Driven by depletion – since the earlier benefits of geographic reach and economies of scale have reached their limits – the ECoEs of fossil fuels are rising relentlessly. Assertions that this trend can be reversed using renewable energy sources (REs) such as wind and solar power – let alone that we can somehow “de-couple” the energy economy from the use of energy – are exercises in wishful thinking.

REs are indeed vitally important for the future, but we need to recognize that they are highly unlikely to provide like-for-like – scale and economic value – replacements for oil, gas and coal.

SEEDS modelling indicates that prior growth in the prosperity of complex, high-maintenance advanced economies goes into reverse at ECoEs of between 3.5% and 5.0%, territory that was traversed by global ECoEs between 1997 (3.6%) and 2005 (5.0%). Trend ECoEs have now entered the equivalent range (between 8% and 10%) at which prosperity turns down in less-complex, lower-maintenance EM countries. The lower bound of this range was reached in 2017, and the average person in some EM economies is already getting poorer.    

The following charts, familiar to regular readers, show the correlation between trend ECoEs (in black) and prosperity per person (blue) in America, Britain and Australia. In these versions, though, discretionary prosperity has been superimposed (in purple), revealing the extent to which changes in this critical indicator are leveraged by the relatively invariable (and, in general, rising) cost of essentials.

It should be emphasised that discretionary prosperity, as calculated for these charts, makes two assumptions about essentials. The first is that we do not, going forward, tame the rate at which the cost of essentials is rising, perhaps by redefining what we think of as ‘essential’. The second is that there is no acceleration in the rate of increase in this cost.

Fig. 2

The role of discretion

In order to anticipate the probable chain of events, we need to start by looking at how we use prosperity. A critical distinction needs to be drawn between essentials and discretionaries, the latter perhaps best described as “things that people want, but don’t need”. Even this distinction involves judgement calls, in that everyone needs food, but nobody necessarily needs caviar.  

The first call on economic resources is made by essentials. These are defined here in two parts. One of these is household necessities, and the other is public services provided by the government.

The latter qualify as ’essential’, at least in the sense that the citizen has no choice (‘discretion’) about paying for them. The public service and household categories of essentials overlap, particularly where services like health care and education are provided by the government in some countries, but are purchased privately in others.               

The definition of essentials changes over time, and varies by location. Televisions, for example, were still luxuries in most Western countries in 1950, but were regarded as necessities by the 1970s. Cars made a similar transition from luxury to necessity over a not-dissimilar period.

Something regarded as essential in contemporary America might be regarded as a discretionary purchase in less affluent countries. Another example of geographical variation is state-funded health-care, which is seen as vital in most of Europe, but is still no more than an aspiration (and a matter of debate) in the United States, where Obamacare was and remains controversial, and where implementation of a worthy ambition seems to have been surprisingly ill-judged.     

Variability, both over time and between locations, makes the calculation of ‘essentials’ a complicated issue, and it might not even be possible to arrive at a universally-applicable calibration meeting both sets of requirements.

Calibrating the essential

Where SEEDS modelling is concerned, “essentials” are a development project, and the model applies formulae whose results are to be regarded as indicative, not precise. The aims are (a) to calibrate an approximate and consistent measurement, and (b) to assess changes in the cost of essentials over time.

Public services are the more straightforward of the two components of ‘essentials’. Governments spend money in two main ways. One of these is the transfer of resources between people, in the form of benefits such as welfare and pensions payments. These transfers net out to zero at the aggregate and at the average per capita levels, so are not part of essentials for our purposes.

The other part of government spending, sometimes known as ‘government consumption’ or ‘own account’ spending, is used to provide public services. Whatever the individual’s opinion about the merits of various forms of service provision, these outlays rank as ‘essentials’ for our purposes, because the citizen has no choice about paying for them. This means that they are ‘non-discretionary’ outlays.

Household ‘necessities’ are the second – and the harder-to-define – component of ‘essentials’. It’s obvious that everyone needs food, water, accommodation, health care, education, some forms of transport and, of course, energy for direct consumption. Beyond this, what we regard as ‘necessary’ varies geographically and over time.

Amongst ‘obvious’ necessities like food, water and shelter, most are very energy-intensive, such that household energy use far exceeds amounts purchased directly for heating, cooking and fuel.

Critically, the deterioration of the energy equation caused by rising ECoEs makes it probable that the real (ex-inflation) cost of household necessities will continue to rise over time.

Tracking the discretionary squeeze

The group of charts shown earlier (fig. 1) sets estimates of essentials against SEEDS calibrations of prosperity per capita for America, Britain and Australia. The common tendency is for the real cost of essentials to rise, whilst prosperity per person has been declining in America since 2000, and in both Britain and Australia since 2004.

In most cases, these declines in top-line prosperity have, thus far, been fairly modest. In America, the average person was (as of 2019) 6.6% worse off than he or she had been back in 2000. Comparing 2019 with 2004, both British and Australian citizens were poorer by about 10.5%. Spread over lengthy periods – nineteen years in America, fifteen in Australia and Britain – these rates of deterioration have been relatively gradual.

At the same time, though, the estimated cost of essentials has been on an upwards trend in all three countries. This means that, since its highest point in each country, discretionary prosperity has fallen by far more than the top-line equivalents.

In America, discretionary (ex-essentials) prosperity fell by 31% (rather than 6.6%) between 2000 and 2019. Decreases in discretionary prosperity since 2004 have been 30% (rather than 10.6%) in Australia, and 27.5% (rather than 10.5%) in the United Kingdom.  

You’ll notice that, in each of these charts, there comes a point – typically in the late 2030s – when prosperity per capita is projected to fall below the cost of essentials. This is the moment at which, at least in theory, discretionary prosperity ceases to exist at the average level. This makes it imperative that we find ways of managing the cost of essentials if we’re to ensure the well-being of the ‘average’ person.

In practice, the likelihood is that deteriorating economic conditions will change our definitions of what is “essential”, at the levels both of household necessities and of public services. It might be, for instance, that car ownership ceases to be regarded as “essential” well before 2040, and that governments will be pressured into imposing tighter priority criteria on the services that they provide.

There are two particularly disturbing aspects of the trends modelled by SEEDS and set out here.

First, per capita averages are not the same as median numbers, and even the latter might not fully reveal widespread and worsening hardship – better-off citizens may continue to enjoy discretionary prosperity long after even the essentials have ceased to be affordable (other than through ever-deepening indebtedness) for many others.

Second, there is little or no sign that these trends are gaining the necessary recognition – and may not do so until governments and others have been compelled to realize that ‘perpetual growth on a finite planet’ is a fallacy (though, if they were to look at trends now – in debt, monetization and the cost of necessities – they could be disabused of this false perception).                

‘Indications and warnings’

As we have seen, discretionary prosperity is being squeezed between deteriorating top-line prosperity and the rising real cost of essentials. At the same time, discretionary consumption has continued to increase.

This situation reflects two important linkages. The first is rising ECoEs, which are pushing up the cost of essentials at the same time as driving prosperity downwards.

The second is that the divergence between discretionary prosperity and actual consumption of non-essential goods and services links directly to the economy’s worsening dependency on credit and monetary stimulus. If this stimulus were to contract for any reason, discretionary consumption would fall very sharply indeed.      

Where stimulus is concerned, the authorities presumably realize that a balance has to be struck between full-bore, ad infinitum monetization, with its inescapable inflationary risks, and counter-inflationary monetary tightening, which would be likely to drive markets sharply lower, and trigger cascading defaults.

The point is that, whichever way this goes, discretionary consumption has to fall back towards affordable (discretionary prosperity) levels. If inflation takes off, the cost of necessities will rise more rapidly than the price of discretionaries. If, alternatively, monetary policies are tightened, this would have a leveraged, adverse effect on discretionary purchasing.

This is going to have far-reaching effects. Commercially, entire sub-sectors and large fortunes have been built on discretionary consumption supported by credit.  Financially, both the capital values and the balance sheet viabilities of large swathes of the economy would be undermined by any check to credit-funded discretionary spending by consumers.

Business planning and investment perceptions remain firmly rooted in the false paradigm of ever-growing discretionary consumption, yet SEEDS analysis reveals that this paradigm is founded on the fallacious premise of perpetual growth, a premise whose fallacy has thus far been masked by credit and monetary activism. Politically, the rising real cost of necessities can be expected to cause a switch of focus towards alleviating the hardship caused by the rising prices of essentials.

This, then, is where the denouement occurs – and, if we want to understand how events are going to unfold, we need to keep a keen eye on the nominal and the real cost of essentials, whether purchased by households or funded through taxation.