#209. A path of reason, part two

PUTTING IT TOGETHER – HOUSEHOLDS AND THE FINANCIAL SYSTEM

In the previous article, we sought out a logical and evidential alternative to the continuity assumption that the economy can shrug off resource and environmental limitations in order to grow in perpetuity.

We demonstrated that the economy is an energy system – not a financial one – and that the fossil fuel dynamic on which the vast and complex economy of modern times was built is fading away, with no fully sufficient alternative in sight. The equation which calibrates prosperity in terms of energy use, value and cost has become a constrained equation, the constraints being (a) the relentless rise in the ECoEs of fossil fuels, and (b) the limits of environmental tolerance.

This does not, of itself, vindicate collapse theories, but it does mean that the world is getting poorer. The downturn in prosperity per person was preceded by a long period of deceleration, first identified (though not explained) in the 1990s, when it was labelled “secular stagnation”. Much of our economic experience in the intervening quarter-century has been characterized by failed efforts to use financial policies to ‘fix’ an economic problem which is not financial in nature, and thus cannot be countered using credit or monetary adventurism.

The onset of involuntary “de-growth” has profound implications for the four components of the economy which we can categorize as the household, business, government and financial sectors. Of these, the most important – and the easiest to project into the future using the SEEDS model – is the household sector. Simply stated, the average person will get poorer, on a continuing rather than a temporary basis, and his or her discretionary prosperity will be eroded by relentless rises in the real cost of essentials. At the same time, he or she enters this era with uncomfortably elevated levels of debt and quasi-debt commitments.

Through its effects on households as consumers, producers, savers, borrowers and voters, this process will shape the future development of the financial system, business and government.

The faith mistakenly placed in the ‘perpetual growth’ assumption has been strong enough to ensure that there has, thus far, been little awareness of, and even less planning for, the downtrend in global prosperity. Decision-makers in government, business and finance still seem to think that we can muddle through using denial, wishful thinking and a cocktail of things that Smith and Keynes didn’t actually say.

Financial – the high price of failed fixes

The immediate battleground for the conflict between continuity and reality is the financial system. Efforts to use financial policies to ‘fix’ the process of economic deceleration and decline have driven an enormous wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit. Between 2000 and 2020, each dollar of reported “growth” was accompanied by more than $3 of net new debt creation and an increase of nearly $4 in broader financial commitments – and even these numbers exclude the emergence of enormous “gaps” in the adequacy of pension provision. Buying $1 of largely cosmetic “growth” with upwards of $7 of forward financial promises is not a sustainable way of managing an economy.

This has put the authorities between the Scylla of runaway inflation and the Charybdis of sharp rises in the cost of money. To be clear, finance ministries can run enormous fiscal deficits, and central banks can monetize the ensuing increases in debt, but neither can create the new sources of low-ECoE energy without which the economy must contract.

When we understand money as a claim on the output of the real economy, it becomes clear that the rampant creation of money and credit can only result in the accumulation of excess claims. These cannot, by definition, be met ‘at value’ by a contracting economy. This means that the value supposedly incorporated in these excess claims must be eliminated, either through the soft default of inflation or the hard default of repudiation.                      

The conundrum facing the authorities is simply stated. If they continue with negative real interest rates, which deter saving and encourage borrowing – and if they carry on believing that ever-larger injections of stimulus can somehow return the real economy to “growth” – they will drive the system into an inevitable process by which inflation destroys the purchasing power of money.

If, on the other hand, they decide to defend the value of money by raising rates into positive real territory, they will trigger slumps in the values of assets, and set a cascade of defaults running through the system.

The current policy is one of ‘hoping for the best’, assuring the public that the current spike in inflation is a “transitory” phenomenon caused by the coronavirus pandemic.

There are two main reasons for knowing that this explanation is false. First, ‘we’ve heard it all before’. The term “transitory” is the 2021 equivalent of the promise that the introduction of QE and ZIRP back in 2008-09 were “temporary” and “emergency” expedients. The more direct analogy is with the 1970s, when inflation was deemed a “temporary” problem, and governments even introduced the concept of “core” inflation, which excluded those very items (energy and food) whose prices were rising most dramatically at that time.

The second factor arguing against the “transitory” description of inflation is that soaring prices take on a momentum of their own. Rises in the cost of living prompt demands for higher wages, which in turn raise producer costs and push prices higher. To a significant extent, inflation is a product of expectation, a form of self-fulfilling prophecy that gives the authorities a rationale for understating what’s really happening in an effort to damp down public expectations. This, though, cannot work when consumers can see the prices of goods and services rising. This time around, the long-standing inflation in the prices of assets reinforces perceptions of inflation at the consumer level.

Where the inflationary issue is concerned, we need to be clear about causation. The chain of events began with a deterioration in the energy equation which determines prosperity. The authorities sought to counter this deterioration in ways which have led, with grim inevitability, to where we are now.

The policy of ‘credit adventurism’ – of making debt more readily available than at any time in the past – started a rise in asset prices, and created a surge in debt. When these trends crystalized in the 2008-09 GFC, the authorities responded with ‘monetary adventurism’, taking the real cost of money into negative territory.

This boosted asset prices still further, and created yet more debt, much of it channelled through the shadow banking system rather than through the more regulated channel of mainstream banking. Now we are in the grip of reckless stimulus, being carried out in the desperate hope that injecting ever more deficit finance, and persuading central banks to monetize most or all of it, will somehow reinvigorate the real economy (which it won’t), without triggering runaway inflation (which it will).        

The outcome of the inflationary conundrum is likely to follow the pattern set in the late 1970s and the early 1980s. First, the authorities dismiss inflation as a passing phase, and refuse to raise rates to counter it. Latterly, they take a reluctant and belated decision to act, raising rates in a macho demonstration of resolve.

That’s when asset prices collapse, and a wave of defaults rips through the system.

Back in the 1980s, this process triggered a sharp recession, but this proved temporary, because ECoEs remained low, and the economy remained capable of growth.

Neither condition prevails today. ECoEs have risen from 1.8% in 1980 to 9.2% now. Recovery in the 1980s involved the restoration of positive trends which had driven prosperity steadily upwards between 1945 and the disruptive and inflationary first oil crisis of 1973-74. Today, by contrast, inflation risk comes in the context of a long period of economic deceleration which, in the West, segued into deterioration between 1997 and 2007.

The first set of charts illustrates the magnitude of financial imbalances, comparing debt – and broader financial assets, which include the shadow banking system – with reported GDP and underlying prosperity. Full financial assets data isn’t available for the global economy as a whole, so the left-hand chart illustrates a group of 23 countries for which numbers are available and which, between them, represent four-fifths of the World economy.    

Fig. 1

Households – leveraged hardship

In any case, the financial system faces challenges which are far broader than the comparatively straightforward (though daunting) choice between inflation and rises in rates. This is where trends in the critically-important household sector shape the outlook. 

The average person in the West has been getting poorer over an extended period, though this reality has been masked by financial manipulation. Trends in prosperity, set against debt per capita, illustrate this situation as it has affected France, Britain and Canada (see fig. 2). Debt, it must be emphasised, has to be considered in the aggregate, including the government and business sectors, not just household indebtedness. Even these debt numbers exclude per capita shares both of broader financial assets and of off-balance-sheet commitments such as the underfunding of pensions.

In France, prosperity per person reached its zenith in 2000, since when the average person has become poorer by 8% (€2,540), whilst his or her share of debt has increased by 91% (€59,500). The inflexion-point in Britain occurred in 2004, since when prosperity has fallen by £4,600 (16%) whilst debt per person has increased by £23,800 (39%). The average Canadian has become 12% poorer, and 60% deeper in debt, since 2007.

Fig. 2

One of the myths of the contemporary economy is that sharp increases in indebtedness are cancelled out by rises in the prices of assets.

The reality, of course, is that increases in the supposed value of property and financial assets cannot be monetized, because the only people to whom a nation’s property or asset stock can be sold are the same people to whom they already belong.

The individual property owner can monetize the gain in property values, but even he or she then needs to obtain alternative accommodation. But homeowners in aggregate cannot do this, and reported aggregate ‘valuations’ are an error rooted in the use of marginal transaction prices to put a ‘value’ on housing stock in its entirety. Essentially, asset prices are functions of the cost of money, and of the quantum of credit in the system. As the economy moves further into de-growth, and as the inflationary spiral has to be countered by raising rates, inflated asset valuations can be expected to melt away like snow on the first warm morning of spring.

The decreases in prosperity cited here may seem pretty modest – the average French person has become 8% poorer over twenty years, the average British person’s prosperity has fallen by 16% over sixteen years, and Canadian prosperity has deteriorated by 12% over thirteen years. People in these countries have, then, been getting poorer at rates at or below about 1% per annum.

In terms of living standards, though, these rates of deterioration have been leveraged by relentless increases in the cost of essentials. In the SEEDS model, the calibration of essentials remains at the development stage, where ‘essentials’ are defined as the sum of household necessities and public services provided by the government. The definition of ‘essential’ varies over time and between countries, such that essentials may defy detailed calibration.

This said, the overall picture seems clear. As prosperity has fallen, the share of prosperity accounted for by essentials has risen. Moreover, the real cost of essentials is being driven upwards, because the energy-intensive character of many necessities creates a linkage between their real costs and rises in ECoEs.

What this leverage means is that, over a twenty-year period in which French top-line prosperity has fallen by 8%, discretionary prosperity – what remains after essentials have been paid for – has slumped by 23%. British discretionary prosperity has fallen by 34% (rather than 16%) since 2004, and the decline of 12% in Canadian prosperity since 2007 has seen discretionary prosperity fall by 24% (fig. 3).

Fig. 3        

These sharp falls in discretionary prosperity have not been reflected in actual discretionary consumption – but the gap between the two (which SEEDS can quantify) has been filled by continuous expansions in credit.

In some sectors this effect has been a direct one, and few people now buy a new car, for example, as a one-off purchase. Households may borrow on their own account to pay for, say, a holiday, but the broader effect is that household credit increases are supplemented by government and business borrowing – the former reduces the tax burden on households, whilst, in the absence of business borrowing, employment and wages would be lower, and consumer goods and services would be either more expensive and/or less readily available.

Full circle

There is, of course, a direct connection between an over-inflated financial system and deteriorating household prosperity. As and when a halt has to be called on perpetual credit and broader financial expansion, discretionary consumption will slump.

This of itself will impact the perceived values of discretionary sector businesses, and this trend will be compounded as businesses respond to de-growth tendencies including de-complexification, simplification (of product ranges and processes), adverse utilization effects and the loss of critical mass. At the same time, households will be forced to relinquish many of the outgoings which form streams of income for the corporate sector.

Ultimately, there are adverse feedback loops which connect deteriorating prosperity with a degradation of the financial economy. At the same time, the public is likely to be distressed, not just by the loss of cherished discretionary products and services, but by the widening hardship which occurs as falling prosperity draws ever nearer to the rising cost of necessities. The implications of this dynamic for government and the corporate sector are certain to be profound, but these implications must await another stage in our journey from ‘what we know’ about the present to ‘what we want to know’ about the future.     

In the meantime, here’s a reminder – if a reminder were needed – of how rising ECoEs drive prosperity downwards in a way that is frighteningly not understood by decision-makers in government, business and finance.  

Fig. 4

#208. A path of reason, part one

THE CONSTRAINED EQUATION

Most of us, for one reason or another, want to know “what comes next”. There are many wrong ways of going about this. We can, for instance, take our expectations for the future ‘on trust’ from others, or we can simply assume (meaning hope) that the future will be what we want it to be.

The only effective way of forming rational expectations, though, is to follow a ‘path of reason’ from “what we know” (about the present) to “what we want to know” (about the future).

The original plan here was to try to encompass this within a single discussion. Practicality, though, suggests that we tackle this in two or three stages.

This first instalment starts with “what we know”.

This turns out to be rather a lot.

We know, for example, that the economy is an energy system. This knowledge identifies an equation which expresses the conversion of energy into material prosperity.

We know, further, that this is a constrained equation. The constraints on our conversion of energy into prosperity are set (a) by the physical characteristics of energy resources, and (b) by the limits of environmental tolerance.

This knowledge enables us to clear the ground by dismissing the fallacy of the infinite. Infinite growth isn’t feasible on a finite planet and within a finite ecosphere.

Far too much of our thinking, and far too many of our economic and broader systems, are based on this ‘infinity fallacy’. We assume, for instance, that economic growth can continue in perpetuity, and that a sustainable financial system can be built on this false assumption. We assume that businesses can offer perpetual expansion to their shareholders, and that governments can promise never-ending “growth” to their electorates.

We’ve reached a point at which the reality of constraint is discrediting the fallacy of the infinite. Environmental constraint is demonstrating itself to us with shocking force. Resource constraint has pushed us into a self-deluding falsification of economic “growth”.

Effective planning for the future requires recognition of the realities of constraint.       

At the end of certainty

As well as casting a long shadow over society and the economy, the coronavirus pandemic has created a remarkably extreme ‘dialogue of the deaf’ between competing certainties.

On the one hand, the authorities present vaccines as a ‘magic bullet’, whose efficacy and safety are questioned only by the anti-social and the deranged.

On the other, critics insist, with equal certainty, that the whole ‘covid and vaccine show’ is some kind of nefarious plot by malign agents of ‘the elites’.

Those of us who don’t have specialist knowledge of life sciences cannot determine where reality resides within this shouting-match. Even the experts may not, as yet, have all the requisite information.

But the extremes of the debate about the coronavirus are echoed in similarly extreme views on the economy, finance and government. On the economy, opinions range all the way from ‘assured growth in perpetuity’ to ‘imminent collapse’.       

We are entitled to be sceptical, in an impartial way, about certainties.

Excessive certainty, after all, is close kin to extremism, which has seldom served us well. Entrusting everything to the state worked out very badly in the Soviet Union. Handing everything over to ‘the market’ – or, in reality, to unfettered “animal spirits” – is turning out to have been an even bigger mistake.

It’s a reasonable presupposition that ‘all isn’t well’ in the economy, in finance, in government and in the broader categories of trust and social cohesion. 

To enquire further than this, it’s necessary to proceed by logical steps from what we know (about the present) to what we want to know (about the immediate and longer-term future).

From what we know

For those who like their conclusions up front, “what we know” can be summarized as follows.

First, the economy is an energy system, whose historic dynamic – fossil fuels – is winding down.

Second, we face severe environmental and ecological threats. These are linked to a significant extent to energy use, which means that our economic and environmental “best interests” are not opposed to each other but, rather, are connected dimensions of a shared predicament rooted in energy.

Third, the world is becoming more confrontational. Wars and revolutions, of course, are recurrent features of history, but a notable feature of modern times is internal antagonism, based in (and further contributing to) suspicions of the motives of others.

Our fourth problem is a widespread lack of understanding of these issues. This might be simple ignorance of the realities around energy, the economy and the environment. It might, alternatively, be some form of denial, in which groups of any size (ranging from ‘elites’ or governments to the public generally) don’t wish to understand, or choose not to accept, the reality of our economic and environmental predicament.

The energy dynamic

In reasoning from “what we know” to “what we want to know”, the place to start is with the economy as an energy system.

As regular visitors to this site will appreciate, the evidence for this interpretation is overwhelming. Apart from anything else, nothing of any economic utility at all can be produced without the use of energy. Interruption to the continuity of energy supply would, and over a pretty short period, result in economic collapse. 

Historical evidence affirms both this linkage and its causal direction. The exponential take-off in population numbers (and in their economic means of support) from the late 1700s paralleled a similarly exponential increase in the use of energy, the vast bulk of which, hitherto, has been sourced from fossil fuels.

Fig. 1

These exponential take-offs occurred from the 1770s, when ‘what changed’ was the development of the first efficient heat-engines, which enabled us to put coal, oil and natural gas to economic use. So the causal linkage is clear enough – access to fossil fuel energy drove population and economic expansion, not the other way around.

A second, parallel and important observation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This is the principle of ECoE (the Energy Cost of Energy).

We know this to be a factual observation because, at the most basic level, we know that we cannot drill an oil well, lay a gas pipeline, manufacture a solar panel or a wind turbine, or install an electricity distribution grid without using energy. Just as energy has to be used to create energy-accessing assets, further energy has to be consumed in their maintenance, and in their eventual replacement. ECoE, then, comprises both initial investment and subsequent upkeep.

These observations form an equation which, in principle, is comparatively simple.

Economic output is a function of the use of energy. The economic value derived from energy use is a function of the surplus energy which remains after the ECoE proportion has been deducted. The resulting material prosperity is a function of the number of people between whom this surplus energy value is shared.

To understand economic prosperity, therefore, we need to know about trends in (a) total energy supply, (b) the ECoE deduction and the residual surplus energy, and (c) population numbers.

In passing, any economic interpretation or model which excludes any of these three components is founded on a fallacy which renders it worthless.             

The realization of constraint

Recent times have seen the emergence of two constraints to continued reliance on fossil fuel energy.

The first of these constraints is the environment. We know that emissions from the burning of fossil fuels threaten to raise atmospheric temperatures, and we also know that “global warming” and “climate change” are short-hand for a much broader set of challenges. Pollution alone would be harmful, even if it wasn’t associated with temperature change. Ecological degradation is a consequence, not just of the use of oil, gas and coal, but of the economic growth made possible by fossil fuels.

We can accept, then, that fossil fuel consumption and broader economic expansion have moved us to a point of environmental and ecological constraint.

The second, less-recognized constraint is that the ECoEs of fossil fuels are rising relentlessly. This alone would, in due course, degrade and then destroy an economy wholly reliant on oil, gas and coal.

This means that the environment isn’t the only constraint on the use of fossil fuels. Anyone minded to oppose transition away from fossil fuels needs to be aware that, even if we were so unwise as to ignore environmental issues, rising fossil fuel ECoEs would, in any case, ultimately destroy the economy.

Put another way, those campaigning for greater environmental responsibility and a reduction in fossil fuel use have a “second string to their bow” in the form of ECoE.

The factors which drive ECoEs are – with one exception – reasonably well understood, and can be depicted as an ECoE parabola (see fig. 2).

In the initial stages of energy resource use, ECoEs are driven downwards by economies of scale and geographic reach. Once these drivers are exhausted, ECoEs are pushed back upwards by depletion, a natural consequence of using low-cost resources first, and leaving costlier alternatives for later.

Fig. 2

The limits of technology and the reality of the finite

The exception to general understanding of ECoE is the role of technology. In the energy sphere, positive technological progress involves improvements in the efficiency with which energy is accessed and put to use. This progress accelerated the downwards trend in ECoEs and, latterly, has acted to mitigate the rise in energy costs.

But there are two other things that we need to know about technology.

First, its scope is constrained by the laws of physics. Technology has, for instance, lowered the cost of extracting tight oil and gas in the United States, but it hasn’t transformed American shale reserves into the equivalent of the conventional resources of Saudi Arabia.

That this has been impossible illustrates that technology operates within the confines of the characteristics of the resource itself. We cannot, by ignoring these physical constraints, extrapolate past technological trends indefinitely into the future.

Second, most technology doesn’t help us to use energy more efficiently but, rather, finds more ways to put energy to use. This isn’t ‘bad’ in itself, but it can contribute to a mindset which both (a) exaggerates the potential of technology as a ‘fix’, and (b) disguises the important dimension of energy efficiency within the loose category of ‘technology for the sake of technology’.          

This consideration of constraints reminds us of another point which is too often forgotten. Economic growth, properly understood, is a matter of using the Earth’s resources to deliver material economic prosperity. These resources are not infinite.

We can debate the extent of the natural resources that were in place originally, and which remain today. These resources include energy, minerals and environmental tolerance.

What we can’t do with any credibility, though, is to claim that these resources aren’t, ultimately, finite. Any philosophy which ignores this reality, and which claims that economic growth can continue in perpetuity on a finite planet, is based on a fallacy of infinity.

The constrained equation

As we’ve seen, then, there’s an equation which relates energy use to the delivery of material prosperity. We’ve also seen that this is a constrained equation, whose limits are set (a) by resource characteristics (availability and ECoE-cost), and (b) by environmental and ecological boundaries.

Unfortunately, we’ve managed to disguise from ourselves the meaning, and even the existence, of this “constrained equation”. We’ve developed an economic philosophy which presupposes that “growth” can continue in perpetuity. We’ve allowed this infinity fallacy to influence our thinking about the world around us, and we’ve embedded this same fallacy into systems.

It’s important to be aware of the extent to which our economy and society are shaped by the “infinity fallacy”. Our financial system is entirely predicated on growth in perpetuity. Businesses, too, are conducted on the basis of a never-ending pursuit of expansion. Governments are assumed – by themselves and by the public – to have a mandate to deliver, in perpetuity, the ‘benefits of growth’.

Politicians and the public may, and do, argue about how growth should be used, and how it should be distributed between people and groups.

But nowhere – in finance, business, government or amongst the general public – is there any kind of preparation for an alternative to an assumed context of perpetual growth. If you ask a financier, a business leader or a politician about his or her plans if “growth” ceases – let alone if it goes into reverse – you’ll be met by a blank stare of incomprehension.

Everything that government, business and finance endeavours to achieve is informed by the assumption of growth. In response to environmental risk, proposals are almost always expressed in terms such as ‘green growth’, ‘responsible growth’, ‘sustainable growth’ and ‘equitable growth’.   

To use a hackneyed term, there’s no “plan B” for an ex-growth economy, let alone for an economy whose prior growth has gone into reverse.

The fallacy of the infinite economy

Proceeding step by step, we’ve learned a great deal that conventional thinking fails (or refuses) to encompass.

To recap, the energy economy provides us with a prosperity equation that is constrained both by resource characteristics and by the limits of environmental tolerance. It is further constrained by the ultimately finite character of the Earth, both as a ‘resource set’ and as an ecosphere.

At no point, in reaching these conclusions, have we needed to consider money.

Money itself is a human artefact. As such, the creation of money isn’t bounded by the physical finality that limits material economic activity. But the only value of money is as a proxy for material goods and services whose supply is subject to these limits.

We can study the operation of money, and this study yields certain worthwhile insights. But the findings which orthodox economics is pleased to call “laws” are, in fact, simply behavioural observations about money. They are not remotely analogous to the laws of physics. Economics, as conventionally understood, may or may not be “gloomy”, but it certainly isn’t a “science”.

The central fallacy of orthodox economics is that it portrays the economy as a monetary system, when the reality, of course, is that it’s an energy dynamic.

The misconception here is huge. Observation and logic inform us that economic prosperity is the product of a physical dynamic that is subject to constraint. Conventional economics seeks to persuade us, instead, that the economy is an immaterial system shaped by the use of the unlimited human artefact of money.

As well as being a misconception, this is also a conceit. If it were true that economic activity was wholly a product of the use of money, then we, as the creators of money, would be in full control of what might grandiloquently be called our ‘economic destiny’.

Our actual position is a more modest one, in that our degree of control is strictly circumscribed by physical factors that we can’t control.      

The human artefact of money is claimed to have three qualities. However, it’s an extremely poor ‘store of value’, and how well it functions as a ‘unit of account’ really depends on what it is that we’re trying to quantify.

The fundamental role of money is as a ‘medium of exchange’. Exchange, of course, is a process that depends upon there being something that people are able and willing to exchange. This is why no amount of money, in any form, would be of the slightest use to somebody lost in a desert, or cast adrift in a lifeboat.

Money, then, is validated by exchange, and the “something” for which it can be exchanged is the material value provided by the energy economy.       

What this in turn means is that money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the energy economy.

To be clear about this, our control over the supply of money and credit enables us to create financial ‘claims’ that exceed the current or future delivery capability of the economy itself. When we do this, we create excess claims.

When we assign the concept of ‘value’ to the aggregate of claims, we create a situation in which the excess component of this supposed ‘value’ must be destroyed. This value destruction can take the form of repudiation (otherwise called hard default), or of the inflationary erosion of the value of money itself (soft default).

It has to be one, or both, of the above because, by definition, excess claims cannot be honoured, which means that supposed ‘value’ attached to these excess claims must be eliminated.      

Of two economies

Given the relationship that exists between the constrained equation of the energy economy and the seemingly unconstrained scope for creating monetary claims, it’s helpful to think in terms of ‘two economies’ – the ‘real’ economy of goods and services, and the proxy or ‘financial’ economy of money and credit.

An understanding of the interface between the energy and the financial economies is critical to effective interpretation of the economy that we see around us.

This interface isn’t addressed by orthodox economic interpretation, because conventional economics is based on the false assumption that money is the economy. The objective of the SEEDS economic model is to understand the economy as an energy system, but to present conclusions in the financial idiom in which, by convention, economic issues are debated.

SEEDS analysis indicates that, in the advanced economies of the West, growth in energy-based economic output slowed during the 1990s, and went into reverse in the first decade of the twenty-first century. Modelling of the constrained equation indicates that prosperity per capita turned down in Japan from 1997, in America from 2000, and in Britain from 2004.

These inflexion-points correlate with the rise of trend ECoEs into a range between 3.5% and 5.0%. By virtue of their lesser complexity and their correspondingly lower system maintenance requirements, the equivalent climacterics for EM (emerging market countries) occur at higher levels of ECoE, levels which SEEDS places between 8% and 10%.

The downturn in prosperity which impacted the West between 1997 and 2007, then, isn’t something from which EM countries are immune. Rather, their inflexion-points happen in the same way, but at a later stage on the ECoE curve. 

The relationship between ECoEs and prosperity per capita – in America, China and globally – is illustrated in fig. 3.

In the United States, prosperity per person turned down after 2000, when trend ECoE was 4.5%. The equivalent climacteric in China is projected to occur in 2026, when China’s ECoE is likely to be just below 10%.

For the world as a whole, prosperity has been on a long plateau, reflecting the interaction between Western countries (where people have been getting poorer over a lengthy period) and EM economies (where prosperity has continued to improve).

Perhaps the single most important economic event of our times is the ending of this plateau and the onset of de-growth on a global basis.   

Fig. 3

Exercises in denial

Recognition of this energy-constrained reality was, and remains, denied to those who believe in the infinity fallacy born of the mistaken assumption that the economy is a wholly monetary system. When deceleration – then labelled “secular stagnation” – started to be noted during the 1990s, the natural (though wholly mistaken) assumption was that there must exist a financial ‘fix’ for this unwelcome trend.

Briefly, the history of the intervening period is that the authorities tried, first, to restore growth by pouring abundant credit into the system, a process known here as credit adventurism. The fallacy here was the assumption that the creation of demand must, by some immaterial process, be met by increased supply, an assumption which is invalid in any situation governed by material constraints.

When, as was always inevitable, this gambit took the credit (banking) system to the brink of collapse, a resort was made to monetary adventurism. This process threatens to do to money what credit adventurism so nearly did to the banking system.

The policy of pricing money at sub-zero real levels has had a string of consequential effects. One of these has been an escalation in debt, and another has been rapid growth in the shadow banking system, known more formally as the ‘non-bank financial intermediation’ sector.

Over the past twenty years, we’ve been using credit and monetary policy to ‘buy’ economic “growth” at an adverse rate of exchange. Each dollar of “growth” reported since 2000 has been accompanied by more than $3 of net new debt, and by getting on for $4 of broader financial liabilities. Even these metrics exclude the emergence of huge “gaps” that have emerged in the adequacy of pension provision.

Using SEEDS, we can quantify the deterioration in prosperity, identify the correlation between rising ECoEs and the inflexion-points in underlying economic activity, and map the relationships between liabilities and the maintenance of a simulacrum of “growth”.

But the central issue here is the widening gap between (a) the real economy (of energy, value and prosperity), and (b) the proxy financial economy and its excess claims against non-existent future economic value.

Conclusions

Any article with the professed aim of preferring reasoned interpretation over received certainties must leave readers to determine how sure we can be about the conclusions that are reached here.

This said, there is very substantial evidence – logical and observational – for the proposition that the economy is a physical dynamic, driven by an energy equation that we can identify, and limited by the constraints both of resource characteristics and of environmental tolerance.

We can observe, too, that there is a general ignorance around this proposition, and an insistence, instead, on perpetual growth, driven by the immaterial processes of money within a context of assumed infinity.

If our interpretation is correct, then there exists a serious disconnect between the economy as it is and the economy as it is mistakenly assumed to be. A misunderstanding as fundamental as this goes quite far enough to explain the insistence on assumed certainties in the context of the emergence of a very different reality.    

 

#207. Could the dollar crack?

MEASURING THE USD PREMIUM

How big is the Chinese economy? On one level, that question is easily answered – last year, China’s GDP was RMB 91 trillion.

For comparative purposes, though, what’s that worth in dollars? Authoritative sources will tell you that China’s dollar GDP in 2020 was $14.7tn. Those same sources will also inform you that it was $24.1tn. That’s a huge difference. On the first basis, the Chinese economy remains 30% smaller than that of the United States ($20.9tn). On the second, it’s already 15% bigger.

The explanation for this very big difference lies, of course, in the two ways in which economic data from countries other than the United States can be converted into dollars. One of these is to apply average market exchange rates for the period in question. For convenience, we can call this market conversion.

The alternative is PPP, meaning “purchasing power parity”. To apply this conversion, statisticians compare the prices of the same products and services in different countries. (One such common product is a hamburger, which is why, in its early days, PPP was sometimes called “the hamburger standard”).

The differences between market and PPP calibrations of GDP are enormous. Last year, world GDP was $85tn on the market convention, but $132tn in PPP terms. At the same time, the use of PPP conversion diminishes America’s share of the global economy. Last year, the United States accounted for 25% of global GDP in market terms, but only 16% on the PPP basis.

Using PPP instead of market conversion doesn’t make the economy ‘bigger’, of course. It just means that a higher dollar value is ascribed to economic activity outside the United States.

There’s no ‘right’ or ‘wrong’ way of converting non-American economic numbers into dollars. To a certain extent, it’s case of selecting the convention best suited to the topic being examined. Market conversion is appropriate for transaction values, such as trade, and cross-border assets and liabilities. PPP provides a better measure of the comparative sizes of economies around the world. (The SEEDS economic model produces parallel output on both conventions, though with a preference for PPP).

For macroeconomic purposes, the PPP convention is arguably more meaningful than market conversion, because it better reflects the economic scale of countries like China and India. Additionally, it leaves both market sentiment and short-term vicissitudes out of the process. PPP conversion has been with us for decades, and is carried out by reputable authorities, such that we can accept it as a valid and consistent alternative basis of currency comparison.

Market rates are determined by many factors other than economic comparison. FX market players have multifarious reasons for liking or disliking various currencies. Their opinions do not constitute economic ‘facts’.

An obvious example here is the reaction to the “Brexit” vote. British citizens obviously didn’t wake up 20% poorer on the morning after the referendum, but that’s what market dollar valuation of the UK economy implied. By the same token, market-rate conversion asks us to believe that the economy of resource-rich Russia is a lot smaller (at $1.4tn) than that of Italy ($1.9tn).

People in Russia, China, India and elsewhere are not poorer because FX markets don’t, relatively speaking, like their currencies. Currency undervaluation against PPP equivalence does make these countries’ imports more expensive, but it also gives their exports a competitive advantage.

Benchmarking the market dollar premium

For present purposes, the importance of having two FX conversion conventions is that it enables us to benchmark the dollar itself. Using world economic data going back over four decades, we can examine the relationship between the PPP and the market valuations of the dollar.

In 2020, for example, the GDP of the world outside the United States (WOUSA) was $63tn on the market basis, but $111tn in PPP terms. From this we can infer, either that market conversion undervalues the WOUSA economy, or that the market dollar trades at a premium to its PPP equivalent.

For convenience, we can call this difference the market dollar premium, and calculate the ratio for 2020 at 1.74:1. Put another way, the market dollar commanded a 74% premium over the PPP dollar last year.

There’s nothing abnormal about the dollar enjoying a valuation premium over other currencies. The dollar’s pre-eminence can be traced back to 1945, when America accounted for half of the global economy, and was the world’s biggest creditor. The dollar, after all, is the world’s reserve currency, and the benchmark against which other currencies are measured. Most oil trade continues to take place in dollars, providing a ‘petro-prop’ for the USD, because anyone wanting to purchase oil must first buy dollars.

This being so, it’s no surprise that PPP comparison reveals a market dollar premium.

What’s interesting, though, is the upwards trend in this premium.

In 1980, it stood at 30%.  It reached 40% in 2001, and 50% during 2005-06. The market dollar premium reached 60% in 2009, and 70% in 2015. Based on consensus projections, the premium is expected to carry on rising, from 74% last year to 79% by 2026. Perhaps most strikingly, the dollar premium is twice as big now (74%) as it was in 1999 (37%).

Does the market’s attachment of a widening premium to the dollar make economic sense? It’s at least arguable that it doesn’t. Quite aside from the rise of economies such as China – and America’s falling share of world GDP – there are reasons to suppose that the economic pre-eminence of the United States is eroding, and that the market dollar premium, far from widening, should be contracting.

The most obvious negatives for the market dollar premium are to be found in the fiscal and monetary spheres. Starting in 2008, the Fed has operated monetization policies on a gargantuan scale, lifting the Fed’s assets from $0.8tn in June 2008 to $8.1tn today. Interest rates have been below any realistic estimate of inflation since the 2008-09 global financial crisis (GFC) and, with inflation now rising, are negative to the tune of at least 4.0%, and probably more. With the administration seemingly addicted to fiscal stimulus, and with the Fed apparently willing to go on monetizing deficits, these trends seem set to continue.

Scaling back or reversing QE – or, for that matter, raising rates to head off inflation – would prompt a greatly-amplified repeat of the 2013 “taper tantrum”, and tightening monetary policy could harm the US economy, would trigger sharp falls in asset prices, and would push up the cost of government borrowing. Neither monetization, large scale money creation or negative real rates can be considered positive for the value of a currency.

There’s a clear danger, then, that the US could push the dollar’s “exorbitant privilege” too far.

Meanwhile, the Fed also has to be mindful of the shadow banking system, sometimes called “non-bank financial intermediation”. This isn’t the place for a detailed consideration of shadow banking, but the system resembles an inverted pyramid, with very large assets (which have been put at $200tn) resting on a narrow base of collateral. Government bonds in general, and American bonds in particular, play a central role in this collateral.

Simply stated, a battle royal is likely to be waged between not-so-“transitory” inflation, on the one hand, and, on the other, pressing reasons for not raising the cost of money. 

This might not matter all that much if the market dollar premium hadn’t risen as far as it has. The use of PPP for benchmarking isn’t common practice, but the calculations required for calibrating the market dollar premium aren’t exactly rocket-science – and the implications of this calculation are stark.        

The conclusion seems to be that the dollar now trades at a more-than-exorbitant premium to other currencies – just as America is getting mired in a tug-of-war between stimulus and inflation.