#215. The price of equilibrium

FUTURITY, REALITY AND THE COMING FINANCIAL CORRECTION

The simplest way to define the current economic and broader situation is that consensus expectations and realistically probable outcomes have become polar opposites.

One of the most predictable consequences of this disparity is a sharp fall, both in asset pricing and in the viability of forward financial commitments.

Shared by governments, businesses, the mainstream media and a large proportion of the general public, the consensus line is cornucopian, picturing a future of abundance characterised by continuing economic growth, exponential technological progress and a seamless transition from climate-harming fossil fuels to renewable energy sources (REs) such as wind and solar power.

This essentially optimistic narrative is based on a series of compounding fallacies, which we might summarise as misconceptions of capability.

Three critical realities are ignored. One of these is that the economy is an energy system, which cannot be propelled to infinite expansion by means of the human artefact of money.

A second is that the scope for technology is bounded by the laws of physics.

The third – and arguably the most important – reality ignored by the consensus narrative is that REs are unlikely to replicate the characteristics and economic value historically provided by energy from oil, natural gas and coal.  

Those of us who understand the economy in energy terms have to weigh two possible courses of action. These are not mutually exclusive, but a balance does need to be found. One of these is the advocacy of reality. The other is analysis, which involves working out the probable series of events, and providing information which will be of value once the failure of the consensus narrative ushers in a new pragmatism.

The recent emphasis here has been on the fallacies which inform the current narrative. We’ve looked at why the credibility of conventional, money-based economics is waning rapidly, and at the hierarchy of challenges which make seamless, ‘growth-intact’ transition from fossil fuels to REs improbable.

The aim now is to formulate a realistic projection of what a less-than-cornucopian future might look like. In doing this, we need to refer to critical principles, and look at what these critical principles can tell us when translated into interpretation and projection.

Regular readers, to whom the central principles of the surplus energy economy are familiar, might welcome the fact that these principles, of which there are three, can be expressed with brevity.

The first is that the economy is an energy system, because nothing that has any economic utility at all can be supplied without the use of energy.

The second is that, whenever energy is accessed for our use, some of this energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, abbreviated ‘ECoE’.  

The third critical principle is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services made available by the use of energy.

These principles immediately set up a distinction between a ‘real’ economy of energy, labour and resources and a ‘financial’ economy of money and credit.

The central fallacy of orthodox economics is that it places the ‘real’ economy of energy and resources in a subsidiary relationship to the ‘financial’ economy of money.

It asserts, for example, that demand (expressed as money) creates supply (of the goods and services produced using resources). The reality is the other way around – that the financial system is a proxy and an operating mechanism for the all-important economy of energy.   

These principles should inform our understanding of the industrial era which can be dated to 1776, when James Watt completed the first efficient heat-engine, giving us access to the vast amounts of energy contained in coal, oil and natural gas.

Through much of the subsequent two centuries, the ECoEs of fossil fuels declined, reflecting widening geographic reach, rising economies of scale and improvements in the technology of energy access and application. This meant that surplus (ex-ECoE) energy expanded more rapidly than aggregate energy supply, such that prosperity out-grew increases in the amount of energy available to the economy.

Latterly, when the scope of reach and scale had been maximised, ECoEs started to rise through the mechanism of depletion. By the 1990s, fossil fuel ECoEs were rising exponentially, more than offsetting volumetric expansion, and creating the phenomenon described at the time as “secular stagnation”.

Our subsequent economic history has been characterised by failed efforts to use financial tools to cancel out this adverse ECoE effect. We began this process of denial and misconception in the 1990s, by making debt ever more readily available. This process of credit adventurism was compounded, after the 2008-09 GFC (global financial crisis), by the adoption of monetary adventurism, characterised by supposedly “temporary” expedients such as QE and ZIRP.

The result has been a widening gap between the ‘real’ and the ‘financial’ economies. Barring some kind of ‘energy miracle’ (which isn’t going to happen), this gap has to be narrowed, and equilibrium restored, by a sharp contraction in the financial system which, as we’ve seen, is a proxy for the real economy of energy.   

This contraction in the financial system is our first clear projection for the future.

As we’ve seen, the real value of money resides in its function as a ‘claim’ on the output of the economy determined by energy. This means that it’s perfectly possible – indeed, under certain circumstances almost inevitable – for us to create claims on the real economy that exceed anything that that real economy can deliver. In Surplus Energy Economics, these are known as excess claims.

One of the mechanisms instrumental to the creation of excess claims is the operation of ‘futurity’. As distinct from the everyday meaning of ‘future’, the term futurity references the forward expectations that inform decisions taken in the present.

Whether it’s borrowing and lending, investing or fiscal planning, financial decisions are based on individual assumptions of what the future is likely to hold. Together, these expectations form a futurity consensus, and one of our biggest problems now is the sheer improbability of a futurity consensus based on a mistaken narrative of infinite growth and extrapolated technological advancement.

The most obvious example of futurity is debt. As a ‘claim on future money’, debt really functions as a ‘claim on future energy’. Expressed in international dollars – converted from other currencies using the PPP (purchasing power parity) convention – and stated at constant (2020) values, aggregate global debt has expanded from $127 trillion in 2002 to $330tn at the end of last year.

Debt, of course, is by no means the entirety of financial ‘claims on the future’. The shadow banking system, which has expanded particularly rapidly since the GFC, forms part of a broader category of financial assets which, for the most part, are the liabilities of the three non-financial sectors of the economy, which are households, governments and private non-financial corporations (PNFCs).

Data exists for countries equating to 75% of the global economy. On this basis, world financial assets can be estimated at $650tn – up from less than $220tn in real terms back in 2002 – which includes the previously-mentioned debt aggregates.   

Meanwhile, there has been a super-rapid expansion in unfunded pension commitments. These commitments are often implicit rather than contractual, but rank as commitments because they cannot easily be repudiated by the governments which are the principle debtors in the situation (and neither, unlike debts, can they be ‘inflated away’).

We have data for pension ‘gaps’ for countries accounting for about half of the world economy. On this basis, it’s reasonable to infer that the global aggregate of unfunded pension promises stands at about $235tn, up from about $115tn (in real terms) back in 2002.

On this basis, we can estimate that the world owes – to its own future – financial claims totalling $890tn, and comprising debt (of $330tn), other financial liabilities ($320tn) and unfunded pension commitments ($240tn).

This total compares with a real-terms equivalent of $330tn back in 2002. Each of these numbers would be smaller if we used market rather than PPP conversion to dollars but, by the same token, so would any calibration of affordability used as a benchmark.

The conventionally-used benchmark is GDP which, since 2002, has increased by $60tn (84%) over a period in which financial claims have grown by an estimated $560tn (+170%). As a rule-of-thumb, we can infer that claims on the future have increased by $9.30 for each incremental dollar of reported GDP.

This calculation, though, assumes that GDP is a reliable indicator of the ability to meet forward claims. In fact, though, GDP is a measure of activity, not of value, which means that it is inflated artificially by the creation of debt and other forward commitments.

Though we can go into this issue in more detail on a later occasion, the energy-based SEEDS economic model indicates that prosperity has expanded by only $18.7tn (29%) over a period in which reported GDP has increased by $60tn.

Part of the difference lies in the inflationary effect of credit expansion. By excluding this, we can calculate growth in underlying or ‘clean’ output (in SEEDS terminology, C-GDP) at $23.9tn (+35%) rather than the reported $60tn. Also excluded from conventional measurement is the financial equivalent of the rise in ECoEs between 2002 and 2020, a number which SEEDS puts at $5.2tn.

As measured by SEEDS, then, global prosperity increased by only $18.7tn over an eighteen-year period in which we can estimate that the broad commitments of futurity have escalated by almost $560tn.     

What this in turn means is that we have been engaged, on a massive scale, in the creation of excess claims, meaning financial commitments which far exceed anything that the real economy of goods, services and energy can ever hope to honour in the future.

The flip-side of this escalation in commitments has been massive inflation in the supposed ‘value’ of assets such as stocks, bonds and property.   

There are all sorts of technical debates that can be had around these calibrations, but there are abundant sources of corroboration for the case that the system has created forward commitments far in excess of any realistic ability to meet those commitments out of future prosperity.

For a start, negative real interest rates are an anomaly, and a direct contradiction of the tenet that a capitalist economy is founded on the ability to earn real returns on capital. Asset prices stand at absurd ratios to any realistic benchmark, and have been inflated massively by the negative real pricing of capital.

From this situation of massively-inflated asset prices – and a correspondingly unsustainable increase in liabilities – only two routes back to equilibrium exist. One of these is the ‘hard default’ route of repudiation, and the other is the ‘soft default’ process of inflationary devaluation.

It can be no surprise whatsoever that inflation has started to rise, a phenomenon that would be even more apparent if we included rises in asset prices within a broad definition of inflationary processes.     

This kind of broad inflationary definition is being developed within the SEEDS model, where it is known as RRCI (the Realised Rate of Comprehensive Inflation).

We can further use SEEDS to identify which sectors (governments, businesses and households), and which segments (investment, discretionary consumption and the provision of essentials) are most exposed to the twinned phenomena of deteriorating prosperity and the restoration of claims equilibrium.

For now, though, we can conclude that the divergence between the consensus and the realistic views of the future has created the scope for an enormous (and by no means pro rata) destruction of value within the financial system.