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 economyhas 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.