#218. The real state of the economy

A FUNCTIONAL SYNOPSIS

As this might be the last article to appear here before the festive season, I’d like to take this opportunity to wish everyone a very merry Christmas and a happy and prosperous New Year, and to thank you for your interest in, and your contributions to, our conversations about energy, the economy and directly-related subjects.

I’m particularly appreciative of the way in which our debates have remained firmly concentrated on the economy. We could all too easily have dissipated our energies on subjects which, whilst topical and important, are not those on which we can add value through specialist knowledge.

It seems to me that the economy – with its profound implications for business, finance, government, society and the environment – is of such importance that clarity of focus is invaluable.

This clarity is singularly lacking in what we might call ‘the public discourse’. The economic debate, such as it is, has become reminiscent of that old Western movie hero who “jumped on his horse and rode off in all directions at once”.

Behind all the partisan argument, the mystification and the theorizing about nefarious plots, the plain fact is that the economy faces challenges and risks without precedent in modern times.

This simple fact is all too often lost in a miasma of misconception, false nostrums and self-interest.   

One economy, two systems

We can add value in this situation because we understand two central realities that are neither known to, nor accepted by, the orthodox approach to economics.

First, we are aware of the critical distinction between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

Second, we recognize that the real or material economy is an energy system, in which prosperity is a function of the availability, value and cost of energy.

This understanding enables us to define the current economic predicament. The financial economy has grown rapidly, driven by unprecedentedly expansive credit and monetary policies.

The real economy, meanwhile, has decelerated towards de-growth, because the energy equation has become progressively more unfavourable.  

This has opened up a gap between the ‘two economies’ of energy and money. The wider this gap becomes, the greater are the forces trending towards a restoration of equilibrium. The take-off in inflation is a logical sign of the return of equilibrium, because prices are the point of intersection between the real economy and its financial proxy.  

In terms of anticipating the future, the forced restoration of equilibrium between the financial and the material economies is critical.

The energy economy, shaped by physical realities, cannot be made to align itself with its financial counterpart.

Therefore, the return of equilibrium must involve shrinking the financial system back into proportion with the underlying economy.

The restoration of the rational

If we’re to achieve any kind of orderly exit from our current predicament, it’s essential that reasoned interpretation prevails over notions rooted in misunderstanding, denial, wishful-thinking and, to be blunt about it, sectoral self-interest.

Regular readers will, I hope, permit me a very brief restatement of the three critical principles involved.

First, the economy is an energy system, because nothing that has any economic value at all can be produced without the use of energy.

Second, 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 the Energy Cost of Energy (ECoE), and is not available for any other economic purpose. Material prosperity is, therefore, a function of the surplus energy that remains after ECoE has been deducted. 

Third, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the material economy of energy.

It follows that, if the aggregate of monetary ‘claims’ is allowed to expand much more rapidly than the underlying economy of energy, the result is the creation of ‘excess claims’ which the material economy cannot honour.

To the extent that these excess claims are regarded as having ‘value’, the restoration of a viable relationship between the real and the financial economies must involve the process known as ‘value destruction’.

Measuring the gap

A very short set of statistics will suffice to illustrate quite how far the ‘two economies’ of energy and money have diverged.

Between 2002 and 2020, global prosperity increased by 29%, or $19 trillion at constant values. This calculation is sourced from SEEDS, a proprietary economic model which measures prosperity on energy principles.  

Over the same period, reported GDP rose by 84%, or $60tn, but most of this “growth” was cosmetic. It was a product of allowing debt to rise by $203tn (+160%), and broader financial liabilities to grow by an estimated – and astonishing – $435tn (+201%).

The latter equates to the addition of $7.20 of new forward financial commitments for each dollar of reported “growth”. This number would rise to almost $10 if we included the emergence of enormous “gaps” in the adequacy of pension provision.

The following charts put these relationships into context. The first compares GDP both with debt and with broader financial assets. These assets – essentially the liabilities of the household, government and non-financial business sectors of the economy – are estimated on the basis of data that is available for countries which, together, account for three-quarters of the world economy.

As you can see, an enormous ‘wedge’ has been inserted between GDP and aggregate forward financial commitments.

The second chart, which uses the SEEDS calibration of prosperity, shows a corresponding divergence between reported GDP and the underlying performance of the real economy.

This second wedge might look enormous which, indeed, it is.

But, as the third chart shows, the difference (shown in solid red) between prosperity (last year, $85 trillion) and GDP ($132tn) pales into insignificance – indeed, you might need to enlarge the chart to see it at all – when set against the chasm (outlined in red) that has arisen between economic output and the enormously inflated scale of forward financial commitments (estimated at $650tn at the end of 2020).    

 

A situation summarized

Three conclusions can be drawn from these figures.

First, most – nearly 70% – of all “growth” reported between 2002 and 2020 was the purely statistical effect of breakneck credit escalation.

Second, a long period of financial distortion has created an enormous gap between financial activity, reported as GDP, and the real level of prosperity, as measured in material terms.

Third, asset price inflation has been a corollary – intentional or not – of the ultra-loose monetary policies involved in the manufacturing of a simulacrum of “growth”.     

If we put this together, what emerges, as remarked earlier, is a severe disequilibrium between the monetary and the material economies.

The fundamental issue now is the inevitable restoration of equilibrium between the economy as it is and the economy as it’s been made to appear by financial expansion.

To understand how this is likely to unfold, let’s start by noting the difference between prosperity and GDP. Prosperity is a measure, calculated by SEEDS, of trends in the material output of the economy over time. GDP, on the other hand, isn’t a measure of output, but of economic activity.

Simply stated, goods and services are produced using energy, but are exchanged using money.

These are quite different things.  

One way of reconciling the divergence between GDP and prosperity would be to conclude that inflation has been understated over time. The SEEDS model assesses this using RRCI, the Realised Rate of Comprehensive Inflation.

RRCI remains a development project, but it indicates that official inflation (of 1.5% annually between 2000 and 2020) was understated against a comprehensive rate of 3.5%.

This difference mightn’t seem huge but, compounded over time, its effects are enormous.

There is, moreover, abundant evidence for the proposition that inflation has been significantly under-reported over many years.

Consumer inflation has been distorted by hedonic adjustment, substitution and geometric weighting.

Even more seriously, conventional measurement – including the problematic GDP deflator – excludes asset price inflation, which has been rampant since the GFC and the introduction of policies which have priced capital at negative real rates.

Probabilities of process

Reconciling reported activity with material prosperity is a worthwhile exercise, and it seems likely that RRCI will prove a useful addition to the suite of capabilities provided by the SEEDS economic model.

What matters most, though, is the process through which the restoration of equilibrium is likely to occur. Science-minded readers might usefully liken the impetus towards equilibrium to some of the forces that operate in physics.   

In practice, what this means is that the financial economy, and the financial system itself, are going to be compressed back into alignment with the underlying material economy of goods, services, labour and energy.

There are, in functional terms, two ways in which this can happen. The first is rampant inflation, whose macroeconomic effect would be soft default on forward financial commitments that cannot be honoured by a deteriorating underlying economy. ‘Soft default’ is what happens when obligations are met, but in money that has lost a large proportion of its real value.

The second is that the authorities might intervene to curb inflation, primarily by raising real interest rates back into positive territory. This would trigger hard defaults, where debtors fail to meet their obligations.

To a certain extent, how this unfolds is a question of process, on which two observations are pertinent.

First, the trend in the real cost of essentials is critical, because sharp rises in the cost of living are guaranteed to trigger public engagement in a policy debate to which, in normal times, they pay scant attention.

SEEDS analysis – which notes the connection between ECoE trends and the cost of energy-intensive necessities such as food, water, housing and necessary travel – indicates that the real cost of essentials is set to carry on rising markedly over time.

Second, it seems likely that policy actions will, for the foreseeable future, be a case of ‘too little, too late’. For reasons best known to themselves, policy-makers attach disproportionate importance to the prices of assets such as stocks and property, and miss-state the role of a “wealth effect” whose real significance lies in the promotion of credit expansion.

The heart of the matter

What’s really important, though, is that the process by which equilibrium returns to the relationship between the monetary and the material economies is going to have profound financial, economic, political and social consequences.

Both the ‘soft default’ of inflation and the ‘hard default’ of failures are likely to intensify.

Levels both of capital investment (in new and replacement productive assets) and of discretionary consumption (of non-essential goods and services) are set to contract markedly.

Economic issues can be expected to rise ever higher in the priorities of voters, implicitly displacing matters of non-economic concern. Any politician who fails to recognize the rising popular concern about the cost of living can expect to be marginalized.

What we have here is a dynamic whose logic seems inescapable, and whose quantification is imperative.   

You will not misunderstand me, I’m sure, if I say that our understanding of these issues gives us a competitive edge over interpretations founded on outmoded, ‘money-only’ nostrums which fail to recognize the essential materiality of the economy.

In short, our interpretation works, where orthodox alternatives do not.

The question for the year ahead is how we sharpen that edge, and put it to use.     

#217. No ‘soft landing’

MODELLING THE RETURN OF EQUILIBRIUM

“The proper study of mankind is man”, wrote the poet Alexander Pope in An Essay on Man.

We can usefully paraphrase this to the effect that ‘the proper study of economic man is prosperity’.

Correctly understood, material prosperity is a function of the use of energy.

We know, after all, that nothing that has any economic utility at all can be supplied without the use of energy. We also know that, whenever energy is accessed for our use, some of that energy is always consumed in the access process, so is not available for any other economic purpose. 

From this understanding follows an equation, straightforward in principle, that calibrates material prosperity.

The ‘consumed in access’ proportion of energy supply is known here as the Energy Cost of Energy, or ECoE.

If we deduct ECoE from total energy available, we’re left with surplus energy, which is the direct material correlate of prosperity.

If we further divide this aggregate surplus energy prosperity by population numbers, the result is prosperity per capita.

Measuring prosperity

The SEEDS economic model – the Surplus Energy Economics Data System – has been designed to interpret the economy in this way. Expressed (for convenience) in financial terms, global aggregate prosperity grew by slightly less than 1.4% annually between 2000 and 2020, meaning that it increased by a total of 31% between those years. 

Over that same period, world population numbers increased by 25%. This means that the average person was slightly less than 5% better off in 2020 than he or she had been back in 2000.

These, of course, are global averages, combining performances that vary regionally and nationally. The average Western citizen has been getting poorer since well before the global financial crisis (GFC) of 2008-09. Prosperity per person has continued to improve, albeit it at decelerating rates, in the EM (emerging market) economies.

Looking ahead, we know that the ECoEs of economies which remain reliant on energy from oil, gas and coal are continuing to rise. There are compelling environmental and economic reasons for endeavouring to transition from fossil fuels to alternatives, principally renewable energy sources (REs) such as wind and solar power.

The question here isn’t the feasibility of quantitative conversion to REs. Rather, what we need to know is whether this transition will drive ECoEs back downwards. The hierarchy of challenges involved in transition make this improbable. Even if REs can usher in an era of lower ECoEs, they certainly can’t do so now.    

This interpretation points unequivocally towards further deterioration in prosperity. The average Westerner will carry on getting poorer, whilst prior growth in prosperity per capita in EM countries will go into reverse.

Within this broad projection of eroding prosperity, we also know that the real cost of essentials will carry on rising, not least because most necessities are energy-intensive.

What results is a leveraged equation in which prosperity net of essentials falls more rapidly than top-line prosperity itself. This means that essentials will account for a steadily rising proportion of total prosperity.

It follows from this that both capital investment and the scope for the consumption of discretionary (non-essential) goods and services will be reduced.

None of this constitutes a prophecy of ‘collapse’.

Rather, it poses the challenge of adaption to lower prosperity after more than two centuries in which, thanks to the supply of ultimately finite low-cost fossil fuel energy, world prosperity has expanded very rapidly.  

A process of denial

Conventional interpretations of economics do not recognize the analysis sketched out here. The economy is presented, not as an energy dynamic, but as a system that is wholly financial.

Energy and other resource constraints are dismissed with the nostrum that [financial] demand produces [material] supply.

This nostrum can be described as the systemic fallacy of conventional economics. The reality, of course, is that no amount of monetary demand can create resources (such as low-cost energy) that do not exist in nature.

By the same token, we cannot “stimulate” our way to greater material prosperity, “grow out of” debt and other financial commitments to the future, borrow our way to financial solvency, or “invest” (meaning monetise) our way to economic and environmental sustainability.

To paraphrase Pope again, though, ‘hype springs eternal in the human breast’. The latest version of cornucopian hype is that growth in perpetuity can be delivered through the alchemy of “technology”. This ignores the inconvenient reality that the potential of technology is limited by the laws of physics.

Things being as they are, conventional economic interpretation continues to insist that infinite economic growth remains a plausible outcome on a planet that, ultimately, is finite. Nowhere in classical economics will you find any recognition of the concept of ECoE. The word ‘prosperity’ is sometimes employed, but not in the precise and material sense in which it is used here.

This ‘money-only’ fallacy applies, not just to projections for the future, but to interpretation of the recent past. For the period between 2000 and 2020, for example, we’re told that the economy enjoyed “growth” averaging 3.4% annually, and expanded by 94% over that period as a whole.

In pursuit of reconciliation

Here, then, are two contradictory statements. The first is that the economy ‘grew by 3.4% annually’ between 2000 and 2020.

The second is that prosperity ‘expanded by less than 1.4% per year’ over that same period.

We could reconcile these two statements by asserting that the rate of inflation used in the measurement of ‘real’ (ex-inflation) GDP has been understated.

The SEEDS model makes this calculation by calibrating RRCI (the Realized Rate of Comprehensive Inflation). If you took out official inflation (of 1.5%) between 2000 and 2020, and used instead an RRCI rate of 3.5%, reported growth in real GDP would align with growth in real prosperity, as calculated on an energy basis.

There seems little doubt that inflation has been understated – routinely and significantly – in official numbers. This suggests that energy-based analysis can improve our understanding of the economy through the measurement of RRCI.

Measuring difference

For present purposes, though, our best route is to accept that GDP and prosperity are measures of two different things.

Prosperity measures material economic output as it relates to the supply of goods and services.

GDP, on the other hand, is a measure of economic activity, referencing the financial transactions by which these goods and services change hands. 

This presents us with a different requirement for reconciliation. The implication is that the financial value ascribed to activity has expanded much more rapidly than the far more pedestrian rate of increase in the output of material goods and services.

There is abundant evidence, both quantitative and qualitative, for this proposition.

Quantitatively, debt expanded by $216 trillion (190%) between 2000 and 2020, a period in which GDP increased by only $64tn (94%). Broader financial liabilities, which include the unregulated shadow banking system, have grown even more rapidly. The same is true of unfunded pension commitments, where we have seen the emergence of enormous “gaps” in the adequacy of provision.

Colloquially, we know that millions of Americans have been described, persuasively, as “debt slaves”, and that millions of people in Britain now use various forms of ‘BNPL’ (meaning “buy now, pay later”), even as more traditional forms of credit-funded consumption have continued to expand.

A growing proportion of the corporate sector has transitioned towards a model based on streams of income, in which the ‘signing up of’ customers is regarded as more significant than actual levels of current sales.

Evidence of the financialization of the economy is, of course, to be found in the prevalence of negative real interest rates, a product of policies which, when first introduced more than a dozen years ago, were presented as “temporary” expedients.

The negative real cost of capital has inflated the prices of assets to levels far beyond anything that can be justified using traditional measures of value.            

From here, where?

As objective observers, our focus needs to be on predictable outcomes.

We have persuasive evidence that economic activity has been inflated to levels far in excess of underlying material prosperity. We can conclude that this process has created unsustainable rates of increase in financial commitments, which include formal debt, informal indebtedness, pension promises and expectations of futurity.

We also know that these processes have driven asset prices to unsustainably elevated levels.

Now that growth in prosperity has deteriorated into negative territory, it seems hard to avoid the conclusion that what lies ahead is an enforced restoration of equilibrium between the ‘financial’ economy of money and credit and the ‘real’ economy of goods and services (and, ultimately, of surplus energy).           

Our attention now needs to be devoted to the mechanisms by which equilibrium is restored.

A recent SEEDS project has involved the calibration of a potential ‘soft landing’, by which we manage the restoration of financial and economic equilibrium.

You will not be surprised that the engineering of a ‘soft landing’ is both (a) mathematically feasible, and (b) politically almost impossible.

Essentially, economies would have to accept now adjustments that will, in any case, be enforced upon them at a later point by economic, material, political and environmental trends.

The key word here is “later”. Where unpleasant realities are concerned, ‘never accept today what you can put off until tomorrow’ is an axiom, not just of politics, but of society more generally.

Moreover, there are structural factors – most obviously in America, Britain and the Euro Area – which make the adoption of ‘soft landing’ policies virtually unthinkable.   

In the absence of a soft landing, what lies ahead is a scenario in which we are forced to adjust to ‘prosperity reality’. The likeliest mechanism is inflation and, specifically, escalation in the cost of essentials.

As what is called colloquially ‘the cost of living’ accelerates beyond the affordability of millions, the authorities are likely to be dragged, with the utmost reluctance, into a situation where inflation has to be tamed.

That’s the point – and it’s likely to be very soon – at which equilibrium is restored between an inflated financial system and an eroding underlying economy.

There is analytical value in the modelling of what a soft-landing would look like, even though we know that this course of action isn’t going to be adopted. 

Essentially, a conceptual soft-landing gives us a template against which to measure what actually happens, much as the measurement of prosperity provides a benchmark which can be used to quantify the difference between the economy as it appears and the economy as it is.