#216. It’s now

TIMING THE MOMENT OF FRACTURE

When and how can we know that a change of direction is fundamental and lasting, rather than a temporary departure from established trends?

That, in essence, is the call we need to make now. Far from being “transitory”, current conditions – including rising inflation, surging energy prices and the over-stressing of supply-chains – are indicators of a structural change.

Ultimately, what we’re witnessing is a forced restoration of equilibrium between a faltering real economy of goods and services and a drastically over-extended financial economy of money and credit.

This is where confidence in continuity crumbles, where the delusions of ‘growth in perpetuity’ succumb to the hard reality of resource constraint, and where ‘shocks that are no surprises’ shake the financial system.

If you want just two indicators to watch, one of these is the volumetric (rather than the financial) direction of the economy, and the other is the behaviour of the prices of essentials within the broader inflationary situation.        

The economics of stress

In the science of materials, it’s observable that fractures happen quickly, even if the stresses that cause them have accumulated over a protracted period. We can spend hours, days, weeks or even years gradually increasing the tension applied to an iron bar, but the ensuing snap in that bar will happen almost instantaneously.

Economics isn’t a science, but there’s a direct analogy here. Anyone who understands the economy as an energy system will be well aware of a relentless, long-standing build-up of stresses.

They’ll be equally aware that this cannot continue indefinitely.

Two things matter now.

First, when will these cumulative pressures bring about the moment of fracture?

Second, what should we expect to see when this snapping-point is reached?

The answers to the second question are pretty clear.

Once the break-point has arrived, we should anticipate deterioration in the material economy of goods and services. Rather than being misled by financial proxies for economic activity, we need to focus on physical metrics, which range from energy and resource consumption, and the supply of goods and components, to the movement of products and people.

Looking behind distorted comparisons with coronavirus-depressed 2020, this is exactly what we’re seeing now.

All sorts of explanations might be advanced for lower physical supply, and many of these explanations are, within their limits, valid. Many interruptions can be identified, across the gamut from the manufacture of cars, chips and components to the availability of containers, transport capacity and skilled labour. Many businesses are in big trouble, not least from sharp rises in the costs both of direct inputs and of the utilities that every business requires.

But what matters here is the overall effect, and that effect is a weakening in the material or physical supply of products to the economy.  

Overall downturns in these ‘non-financial metrics’ are of enormous significance, and can be expected to carry on trending downwards once the economic inflexion-point has been passed.

At the same time, we should anticipate major financial dislocation, including surging inflation, market slumps and a cascade of defaults. We can usefully refine the focus on inflation by stating that it won’t be broad inflation, but the rising prices of essentials, that will be the critical lead-indicator of systemic disruption.

Meanwhile, we should also expect to see the combination of financial stress and deteriorating material activity extend more broadly, most obviously into politics, and into wider manifestations of popular discontent and anxiety.

If we compare what we would expect to see with what we can observe, we have an answer to our first question.

The moment of fracture has arrived NOW.        

Revealing trends

Cumulative tensions between the economy and the financial system are clear to see, provided we know what we’re looking for.

Three metrics provide examples of what this means.

Between 2000 and 2020, global economic activity, expressed as GDP, increased by 94%, meaning that the economy is supposed to have “grown” by $64 trillion (at constant 2020 values).

This “growth”, though, has been paralleled by a far larger – 190%, or $216tn – real-terms surge in aggregate debt. The relentless stretching of the balance sheet becomes even more pronounced if we look beyond formal debt, and take into account rapid increases in broader financial liabilities, and the emergence of huge ‘gaps’ in the adequacy of pension provision.

The aggregate of commitments, then, is rising far more rapidly than reported “activity”, and it’s clear that much of this “growth” in activity is a statistical function of soaring commitments.  

Our third metric, provided by the SEEDS economic model, is that global aggregate prosperity increased by only 31% ($19.9tn) over a period in which “growth” is claimed to have been $64tn, or 94%.

If we overlay a 25% rise in population numbers between those same years, what emerges is that a reported 55% increase in GDP per capita masks a rise of less than 5% in the prosperity of the World’s average person.

Add just a soupçon of widening inequality and we have a situation in which the median person gets poorer.

This has happened over two decades in which his or her share of aggregate debt has risen by 130% in real terms.

Just to be clear about this, these are long-term patterns, not fundamentally affected by pandemic-induced effects which, in 2020, reduced GDP by a reported 3.1%.

The Great Divergence

If you’ve been visiting this site for any length of time, you’ll know the importance of drawing a conceptual distinction between the real economy of goods and services and the representational or financial economy of money and credit.

In a process whose origins can be traced right back to the 1990s, these ‘two economies’ have diverged, creating a dangerous disequilibrium.

Contrary to conventional orthodoxy, the economy is an energy system, not wholly or even mainly a financial one. Nothing that has any economic utility at all can be supplied without the use of energy, and the delivery of material prosperity can be – though generally isn’t – expressed as an equation comprising the supply, value and cost of energy.

The most critical of these variables is cost, meaning the Energy Cost of Energy. ECoE references the fact that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. Material prosperity is a function of the surplus energy that remains after ECoE has been deducted from aggregate energy supply.

In short, rising ECoEs mean falling prosperity.

The problem, in an economy that still relies on fossil fuels for more than four-fifths of its energy supply, is that the ECoEs of oil, gas and coal have been rising relentlessly. SEEDS data indicates that the trend ECoE of fossil fuels has risen from 2.8% in 1990 to 6.3% in 2010, and 9.8% now.

Since most ex-ECoE (surplus) energy isn’t used for growth, but for system maintenance and renewal, a rise of 710 basis points in ECoEs, in an economy previously capable of growing at about 3% annually, is much more than enough, not just to eliminate the scope for further expansion, but to put prior growth into reverse.

The imperative, in economic as well in environmental terms, is to replace fossil fuels with lower ECoE sources of energy supply. If we can’t do this, then surplus energy – and, with it, material prosperity – must decline, initially in per capita terms and, latterly, in aggregate.

There is, as yet, no evidence that renewable energy sources (REs), such as wind and solar power, can supply this lower ECoE alternative to oil, gas and coal.

The probabilities, rather, are against this being possible.

Even if this can eventually be accomplished, it certainly can’t happen now. This is why the ‘real’ economy of goods and services has been decelerating, to the point at which involuntary “de-growth” has become a reality.

Whilst prosperity is, of necessity, a material concept, money is a human artefact, validated by its use as a medium of exchange. It has value only in terms of the things for which it can be traded. This means that money has no intrinsic worth, but commands value only as a ‘claim’ on those material goods and services for which it can be exchanged.

Conventional economics tries to circumvent this hard reality with the notion that [financial] demand creates [physical] supply. The fallacious logic here is that, so long as there’s enough financial demand for something, the availability of material supply will somehow follow automatically.

Where finite resources – such as low-cost energy – are concerned, this simply doesn’t work.

We can’t create something that doesn’t exist in nature, simply by putting up its price.

This is why we can’t spend (“stimulate”) our way to material prosperity, any more than we can borrow our way to solvency, or “invest” (meaning monetize) our way to environmental sustainability.

What we’re seeing here is a widening gap between the economy as it is and the economy as we choose to see and present it.      

In essence, we’ve been creating apparent increases in economic activity (using expansions in credit and other liabilities) without creating much material economic value.

In the process, we’ve been driving a widening wedge, not just between ‘activity’ and commitments, but between the energy economy of goods and services and the proxy, financial economy of money and credit.   

Inflation – the importance of the essential

Logically – because prices are the interface between financial demand and physical supply – inflation should be a prime mechanism in the restoration of equilibrium between the real and the financial economies. Using the material and the financial as the components of an equation, we can identify rates of inflation that substantially exceed reported numbers. Known as RRCI, this is an ongoing development project within the SEEDS economic model.

These broad trends, though, can’t really be seen in readily-available data. For a start, and as you may know, official inflation has been distorted by the use of concepts such as hedonic adjustment, substitution and geometric weighting.

Just as significantly, conventional measures of inflation confine themselves to movements in consumer (or ‘retail’) costs, thereby excluding those changes in asset prices which are a material component of the overall relationship between the quantitative and the financial dimensions of the economy.

The tendency with the use of official numbers is to compare inflationary rises in consumer costs with nominal changes in wages. Theoretically, at least, if consumer inflation is broadly matched by increases in incomes, then the ‘ordinary’ person’s situation doesn’t change all that much, except that his or her debts are inflated away, whilst savings are eroded.

There are many snags with this notion, of which the most obvious is that inflation can take on a momentum of its own, with wages chasing prices, and wage costs pushing up consumer inflation. This tendency threatens a destruction of the purchasing power, and hence of the critical credibility, of money. This is why, whilst low inflation is generally deemed to be acceptable – and is often regarded as beneficial – anything above about 2% is recognized as a problem.

Though true as far as it goes, this approach conflates two very different forms of inflation as the consumer experiences them.

The consumer spends his or her income in two ways. The first is the purchase of essentials, including food, housing, domestic energy, utilities and necessary travel. The second is the purchase of discretionary (non-essential) goods and services. These ‘discretionaries’ are residuals, meaning things that the consumer buys after he or she has met the cost of necessities.

It’s quite possible to envisage circumstances where the cost of essentials is rising much more rapidly than the prices of discretionaries. We might, for instance, have a situation in which, whilst broad inflation is running at 5%, the cost of essentials is rising by 10%. Incomes, if they too are rising at 5%, thus offset general inflation, but fail to keep up with the cost of necessities.

This inflationary divergence makes the consumer poorer because, whilst discretionary purchases such as cars, smartphones and holidays can be deferred – and are not, in any case, made continuously – essentials such as food, electricity, gas and other utilities have to be purchased, generally on a regular weekly or monthly basis.

The vital point about this ‘asymmetric inflation’ is that we need to put the emphasis, not on broad or theoretical inflation, but on trends in the real cost of essentials.

If the cost of, say, a smartphone or a foreign holiday increases, the consumer might not be much concerned about it, because he or she doesn’t need to buy it at all, and can certainly put it off for later.

If, on the other hand, there’s a sharp rise in the cost of food, or the utility charge for electricity or gas, or the price of fuel at the pumps, he or she notices it very quickly indeed – and is right to do so.

Critically, essentials are highly energy-intensive. This is as true of, say, food and water, and of the building and maintenance of homes, as it is, more obviously, of fuel and domestic energy.

The point of impact

What this asymmetric inflation means is that, as energy-based prosperity deteriorates, an obvious financial corollary is a rise in the cost of essentials. As well as causing public discontent, this also leaves the consumer with a reduced ability to purchase non-essential goods and services.

At the critical moment of impact, then, we should expect to see two important trends.

One of these is a rise in the cost of essentials, and the other is volumetric weakness in the economy, most obviously in the use and delivery of physical goods, and in deteriorating metrics in discretionary sectors.

This is exactly what we’re witnessing now. Whilst the prices of essentials are rising, volumetric consumption of discretionaries is trending down, even if this can be hard to see behind an anaemic “recovery” from the artificially-depressed conditions of 2020. When, as is frequently the case, we’re told that discretionary sectors are ‘growing’, it often transpires that this is true only in comparison with last year.     

Given that stock markets are heavily skewed towards discretionary sectors, this trend alone is likely to become a worry for investors.

Moreover, rises in the cost of essentials have a direct bearing on decisions made around monetary policy. Consumers, who are also voters, might not make much of a fuss if the prices of discretionary purchases rise, but will react very strongly indeed if the cost of their utility bills, of filling up their car and of the weekly purchase of groceries moves markedly upwards.

It doesn’t take all that much inflation in the cost of necessities to create popular demands for action, demands which, in policy terms, can be met only by raising interest rates, and by easing back on, or reversing, asset purchase programmes.

Because prices, especially of necessities, are the point at which the financial economy of money intersects with the material economy of energy, current trends are unmistakable signs of the moment at which monetary delusion succumbs to energy reality.    

It is, perhaps, fitting that this is happening as the pantomime season approaches. Borrowing our way to prosperity played to packed houses in the decade or so before 2008, and much of the glitter carried over into more-than-a-decade in which the speed of monetary expansion has deceived the eye of reality.

There comes, though – and, now, has come – a point at which the curtain descends, the glitter fades and the magic of beans and bean-stalks recedes into memory.