#210. As the window narrows

EXPLORING THE ‘PRECURSOR ZONE’

These are hard times for what British politicians ritually call “hard-working families”. Taxes have been raised to levels not seen since the post-War years. The ‘cap’ on the costs of electricity and gas has been increased by 23% so far this year.

Our focus here is on global economic issues, not local political ones, so this isn’t the place to debate whether the tax increases could have been implemented more equitably (which probably they could), or whether the additional revenues will be sufficient to fund the cost of social care for the elderly (which very probably they won’t).

The point is that paying more tax – and having to spend more on electricity and gas – leaves less money in the pockets of “hard-working families”.

Inflated asset prices may enable statisticians to claim that Britain has ‘never been wealthier’, and official figures continue to show “growth” in the economy.

But the inflated prices of property, equities and other assets are functions of the ultra-low cost of money, whilst “growth” in GDP is a conjuring-trick – comparing 2020 with 2000, aggregate British debt has increased by £2.8 trillion in real terms, whilst GDP has “grown” by just £400bn. Even this ratio – of £6.90 borrowed for each £1 of “growth” – understates the true extent to which “growth” has been bought with credit. Asset prices, meanwhile, cannot be monetized in aggregate, because the only people to whom an entire asset class can ever be sold are the same people to whom it already belongs.  

GDP measures economic activity, whether as money spent and invested, or received as incomes. It doesn’t concern itself with where this money comes from, or connect recorded “activity” to a balance sheet showing forward commitments.

GDP thus measured can always be inflated by pouring credit into the economy. Within the parameters of currency credibility, GDP can be ‘pretty much whatever you want it to be’, so long as you can pour enough liquidity (which conventional economics calls demand) into the system.

In 2020, the year of the coronavirus crisis, British GDP fell by 9.9%, or £230bn, but that’s after the authorities had pushed more than £280bn of additional liquidity – borrowed by the government, and monetized by the Bank of England – into the system.

What we’re describing here is a flagging economy, with GDP juiced using credit expansion, at an adverse rate of exchange where nearly £7 of borrowing gets you £1 of “growth”.  Meanwhile, the cost of essentials – whether purchased by households or provided by the state – is rising, whilst underlying prosperity is not. The overhang of liabilities – debt, other financial commitments and forward pension promises – keeps getting bigger.   

We need to be clear that these problems are by no means unique to the United Kingdom, and are worse in other countries, including the United States. The situation may look better in some of the EM (emerging market) economies, but all this really means is that the West has already encountered problems which, for some Asian countries, still lie in the future.

What we’re experiencing, at least in economic terms, is the approach of The Limits to Growth (LtG), as forecast back in 1972 by Donella Meadows, Dennis Meadows, Jørgen Randers and William Behrens. Recent analysis by Gaya Herrington has used intervening data to demonstrate, first, that the authors of LtG got it right, and, second, that we may be within “a decade or so” of the point at which growth comes to an end.

If this is indeed the case, it’s highly unlikely that the ending – and, in all probability, the reversal – of growth will be an event, narrowly identifiable in time. It’s always been likelier that this would be a process, characterised by (a) economic deceleration, and (b) increasing stress on all systems that are – like the global financial system – wholly predicated on growth.

This is exactly where we are now. To be more specific, the world economy entered what we can call a precursor zone back in the 1990s. That was when observers began to worry about “secular stagnation”, and the authorities embarked on ‘credit adventurism’ – and, latterly, on ‘monetary adventurism’ as well – in an effort to ‘fix’ a problem that they didn’t understand.

Once we’re clear about the real dynamics of the economy, we can see why growth has been tipping over into involuntary “de-growth”, and we can also understand the lead-indicator mechanics of the “precursor zone”. Growth has flagged for reasons which have little or nothing to do with money, and everything to do with the energy dynamic which really determines prosperity.

Unable to understand this process, and shackled to the imperative of delivering ‘growth in perpetuity’, decision-makers have poured ever more credit into the system, much of it monetized by central banks. Though efforts have been made to improve regulation of the banking system since the 2008-09 global financial crisis (GFC), much of the subsequent expansion in credit has occurred in the unregulated ‘shadow banking’ system.

For a group of twenty-three economies (G23) for which fully comprehensive data is available – and which, between them, account for 80% of the global economy – aggregate financial assets (which, for the most part, are the liabilities of the non-financial economy) now stand at an estimated 495% of GDP, up from 300% back in 2002.

Even this ratio increase is a severe understatement of the real extent of exposure, because credit and monetary expansion has inflated GDP to levels far ahead of underlying economic prosperity. If we measure the financial assets of the G23 countries against prosperity, the ratio already stands at about 700%.

Regular readers will be familiar with the concept of prosperity, and how it differs from the increasingly misleading conventional measure that is GDP. The first point to be understood is that economic output is a function of the use of energy, because nothing that has any economic utility at all can be supplied without the use of energy. The history of the Industrial Age has been one of using ever larger amounts of energy to deliver economic value at rates of growth which, until quite recently, exceeded the rates at which population numbers were increasing.

The second critical point 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 role played by ECoE is that it’s the difference between economic output (a function of the use of energy) and prosperity (which is what remains after the deduction of ECoE).  

This understanding provides us with an equation which, in principle at least, is comparatively straightforward. Prosperity is a function of the quantity of energy used, the value and cost of that energy, and the number of people between whom the resulting aggregate is shared. Money isn’t an intrinsic part of the prosperity equation, but acts as a proxy and a medium of exchange – money has no intrinsic worth, but commands value only as a ‘claim’ on the products of the energy economy.  

In recent times, the prosperity calculus has become a constrained equation, in which the constraints are (a) the rising ECoEs of energy supply, and (b) the limits to environmental tolerance of the use of fossil fuels.

The only way of breaking out of these constraints would be to find an alternative source of energy which delivers low and falling (rather than high and rising) ECoEs, and can be utilized without causing environmental harm. Desirable though their expansion undoubtedly is, renewable sources of energy (REs) such as wind and solar power cannot meet these requirements. Their expansion, maintenance and replacement are dependent on legacy energy from fossil fuels, and their ECoEs are highly unlikely ever to be low enough to support current levels of prosperity, let alone allow for a resumption of “growth”.

As the following charts show, even the rapid expansion of RE capacity cannot be expected to do more than blunt the rate at which overall ECoEs rise. The pace at which global aggregate prosperity has been growing has decelerated markedly since we entered the precursor zone in the 1990s, and we are now at or very near the point where aggregate prosperity starts to shrink. Because aggregate prosperity growth has fallen below the rates at which population numbers have continued to increase, prosperity per capita has already turned down.      

As this ‘top-line’ measure of prosperity per person has turned downwards, the cost of essentials has continued to rise, in part because many necessities are at the high end of the energy intensity spectrum. This means that the discretionary (ex-essentials) prosperity of the average person in each of the Western economies is already under increasing pressure, as typified in the charts for Japan, the United States and the United Kingdom.

‘Essentials’ are defined here as the estimated total of household necessities and public services provided by the government. The British situation exemplifies the rising trend in essentials – taxes have had to be increased to fund public services (in the current instance, health and social care), whilst rises in the costs of electricity and gas reflect trends which can be expected to extend to other energy-intensive necessities, not just in Britain but across the world.

As well as a deterioration in prosperity which is adversely leveraged at the discretionary level, this situation also leaves us trying to support an ever-growing burden of financial commitments on a static and, in due course, contracting basis of aggregate prosperity.

The final set of charts illustrates this process with reference to the G23 countries which represent four-fifths of the global economy.

Since we entered the precursor zone in the 1990s, both debt and broader financial assets have grown much more rapidly than GDP. Output reported as GDP has itself been inflated by credit expansion, and now far exceeds both underlying output (C-GDP) and prosperity.

Measured against prosperity, both debt and broader liabilities have become unsustainably large, pointing towards either the ‘hard’ default of repudiation or the ‘soft’ default of inflationary devaluation.

Asset prices, meanwhile, have been driven to highly over-inflated levels, primarily because the prices of assets move inversely with the cost of money. We might suppose that asset prices will remain at inflated levels until the liability side of the equation reaches the nemesis of hard or soft default.

Examination of the precursor zone and the dynamics of falling discretionary prosperity do, though, suggest that another process might trigger asset price slumps. Equity markets are dominated by the suppliers of discretionary goods and services, which is likely to worry investors once they realise that the scope for discretionary consumption, already propped up by the continuity of credit expansion, is shrinking. At the same time, the affordability of property is linked to incomes on a post-essentials, credit-adjusted basis.