#220. The human factor

CONTINUITY, CONTRACTION OR COLLAPSE

Over an extended period, but with growing intensity in recent times, there has been a discussion, here and elsewhere, about whether we can prevent economic contraction from turning into collapse.

This is part of a broader debate in which every point of view seems to begin with the letter C. The orthodox or consensus line is Continuity, meaning that the economy will continue to expand in the future as it has in the past, and is claimed still to be doing in the present. The main contrarian theme is the inevitability of Collapse. Those of us who believe even in the existence of a third possibility – Contraction – are in a tiny minority. 

Of these three points of view, the only one that we can dismiss is continuity. The economic “growth” that we’re told can be extended indefinitely into the future isn’t even happening in the present. 

Most – roughly two-thirds – of the reported “growth” of the past twenty years has been cosmetic. The preferred metric of gross domestic product (GDP) measures activity, not prosperity. If we inject liquidity into the system, and count the use of that liquidity as ‘activity’, we can persuade ourselves that the world economy has been growing at rates of between 3% and 3.5%.

The classic illustrative example is of a government paying one large group of workers to dig holes in the ground, and another group to fill them in again. This adds no value, of course, but it does increase activity, and therefore boosts GDP.

In this example, the obvious question is that of how the government pays for all this zero-value ‘activity’. The simple answer is to use borrowed money. Conveniently, GDP, as a measure of activity, calculates flow without reference to stock. This sleight-of-hand has persuaded many that their national economies have now recovered in full from the coronavirus downturn, a claim that is only valid if changes in the stock of government (and broader) liabilities are left out of the equation.

Statistically, world GDP increased by 94%, or $64 trillion, between 2000 and 2020. This “growth”, though, was accompanied by an increase of $216tn (190%) in total debt, meaning that more than $3.35 was borrowed to deliver each $1 of “growth”. On the basis of broader liabilities (including those of the shadow banking system), this ratio rises to an estimated $7.25 of new commitments for each dollar of “growth”.

If we further included the emergence of enormous deficiencies (“gaps”) in the adequacy of pension provision, this number would rise to somewhere close to $10.     

The artificial inflation of GDP does more than persuade us that the economy is growing at a satisfactory rate. It also affects the denominator used in numerous calculations and ratios. On this basis, it can be contended, for example, that debt and other liabilities are ‘not excessive’, and that government expenditures remain at a ‘modest and sustainable’ percentage of the economy.

This pattern of behaviour merits the term “Ponzi”, with the proviso that there may not have been any conscious and deliberate intent in the creation of this situation.

In objective terms, we can conclude that two factors have informed decision-making through a period that began with ‘credit adventurism’ before, in the aftermath of the GFC (global financial crisis), adding ‘monetary adventurism’ into the mix.

The first factor has been a determination to support the status quo, and the second has been the misplaced faith placed in an orthodox school of economics which dismisses resource constraints as part of a money-only interpretation of the economy which promises infinite growth on a finite planet.

Decision-makers may have drawn comfort from the relentless rise in the prices of assets such as equities and property. The snag here is that the aggregate valuations of these and other asset classes are purely notional, meaning that they cannot be monetized.

We can, for instance, multiply the average price of a house by the number of properties to arrive at an impressive-sounding ‘value’ for a nation’s housing stock. This ignores the inconvenient reality that the only potential buyers of this stock are the same people to whom it already belongs.  On this basis, we can calculate that aggregate assets are ‘worth’ a sum comfortably in excess of aggregate liabilities. Any such calculation may be reassuring, but the reality is that it is meaningless.

As regular readers will know, the alternative interpretation favoured here is that we need to draw a conceptual distinction between a ‘financial’ economy of money and credit and a ‘real’ economy of goods and services. The connection between these ‘two economies’ is that money, having no intrinsic worth, commands value only as a ‘claim’ on the goods and services produced by the real economy.

With this distinction established, we can further observe that the ‘real’ economy is an energy system, because nothing that has any economic utility at all can be supplied without the use of energy. Put another way, economic prosperity is determined by an equation involving the supply, value and cost of energy.

Over a long period of time, the conversion ratio of energy into economic value has been largely static. The quantitative supply of energy is a function of the value and cost of energy, as applied to the physical availability of the energy resource. 

These considerations identify cost as the critical part of the energy equation which determines prosperity. We know 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 the Energy Cost of Energy, or ECoE.

If ECoEs rise, the surplus (ex-ECoE) energy which determines prosperity contracts. Rising ECoEs also exert an adverse effect on the value-versus-cost equation which determines the quantity of energy supplied.   

Critically, trend ECoEs have been rising relentlessly, primarily reflecting the effects of depletion on an economy which still derives more than four-fifths of its primary energy from oil, natural gas and coal.

Decision-makers still fail to recognize the constraint imposed by a rise in the ECoE costs, and a deterioration in the surplus value, of fossil fuels. They have, though, reached a belated recognition of a second constraint, imposed by the limits of environmental tolerance.

The proposed solution is a “transition” to renewable energy sources (REs) such as wind and solar power. These REs may pass the test of being better for the environment than fossil fuels, but they are unlikely ever to pass the second, critical test of delivering ECoEs that are as low as, or lower than, those of oil, gas and coal.

The slogan used almost universally in this context is “sustainable growth”. Within this term, the word “sustainable” – meaning environmentally tolerable – might indeed be delivered. After all, we had this kind of “sustainable” economy before the first effective heat-engine was completed in 1776.

But the word “growth” is simply an assumption, based on that same ‘money-only’ theory of economics which, by dismissing resource constraints, also dismisses the entire concept of ECoE. 

Those of us who understand the energy basis of prosperity, and who also recognize the critical duality of the financial and the real economies, can arrive at the reality behind an economy in which prosperity per person has ceased growing, and has started to contract.

For us, involuntary “de-growth” is a situation, defined as ‘a set of circumstances allowing of more than one possible outcome’. On this basis, and for so long as the alternative of ‘contraction’ exists, we cannot state that ‘collapse’ is inevitable, though it is eminently possible.

Having ruled out continuity, the difference between orderly contraction and disorderly collapse devolves into a question of management, a question which necessarily involves government and politics.

Our understanding of the situation, applied here using the SEEDS economic model, enables us to project various trends into the future, trends which are either unknown to, or ignored by, decision-makers in government, business and finance.

We know, for instance, that a simulacrum of “growth” cannot be maintained for much longer in the face of a trend towards the restoration of equilibrium between the real economy of energy and the financial economy of money and credit.  We know that this process will involve rapid (and probably disorderly) contraction in the financial system, which will need to shrink by at least 35-40%, and perhaps more, to reach stable alignment with the material economy.  

We further know that the real cost of energy-intensive essentials – including food, water, domestic energy, necessary travel and the building and maintenance of housing and infrastructure – will continue to rise, even as top-line prosperity erodes.

We also know that the scope, both for discretionary consumption and for capital investment in new and replacement productive capacity, will be compressed by the narrowing of the margin between prosperity and the cost of essentials.

We can further set out the taxonomy of de-growth which describes how businesses will seek to adapt to falling consumer prosperity, rising costs, worsening supply vulnerability and deteriorating financial conditions.

But what we cannot know is how society will adapt to a future which involves reduced prosperity, worsening hardship and insecurity, severe financial disruption and a loss of faith in the continuity of growth.

We can anticipate, of course, that economic considerations will rise steadily up the agenda of popular priorities, and that a leadership cadre, unaware of the inevitability of deteriorating prosperity and financial dislocation, will make every effort to maintain the status quo.   

Until we have answers to these questions, we cannot know whether the future will be one of orderly contraction (which is theoretically feasible) or of disorderly collapse (which is frighteningly plausible).               

#219. The unravelling begins

THE REALITY OF SCARCITY, THE SCARCITY OF REALITY

In nineteenth-century England, pictures of great events and famous personages could be purchased “penny-plain or tuppence-coloured”.

Where the world economy is concerned, the price of flattering colouration has soared into the trillions, but the value of a “penny-plain” view has never been higher.

The penny-plain picture now, of course, is that a vast gap has opened up between the consensus expectation of continuity and the hard reality of a post-growth economy. This gap is the counterpart of the chasm that exists between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

Our understanding of these dissonances sets an outline programme for ongoing analysis. The best routes to effective interpretation are those which (a) compare reality with perception, and (b) calibrate the relationships between the ‘two economies’ of money and energy. In the coming months, the aim here will be to add interpretive and statistical detail to the picture that is emerging as the aquatint wash of delusion fades away.

The divergence between expectation and reality isn’t – in itself – a new development. Many of us have long known that, over a very extended period, most economic “growth” has been a cosmetic product of breakneck and hazardous monetary expansion, that the underlying economy has been faltering, and that the confidence placed in ‘continuity’ lacks a basis in fact.

We can go further, recognizing that even the simulacrum of “growth” can’t last much longer, that the real prices of assets are destined to fall sharply in a context of broader financial distress, and that the balance of political power might be poised to shift, perhaps in a direction that, once upon a time, used to be called “left”.

What IS different now is that a process of fundamental change is already underway. The consensus case for continuity is crumbling, and is being exposed as a product of self-deception, wishful-thinking and economic incomprehension, spiced with absurd amounts of techno-utopianism.

The outcome mightn’t – and needn’t – be the wholesale “collapse” predicted by doomsayers.

But the game is up for what we might call the ‘continuity consensus’.

Of price and value

The single most obvious symptom of change is inflation. The Fed might – belatedly – have stopped calling this “transitory”, but the consensus view remains that this isn’t the start of a “stagflationary” trauma of the kind last experienced in the 1970s.

It’s widely argued that the take-off in inflation is a short-term product of the shortages and supply-chain fractures created by the coronavirus pandemic and, perhaps, of the gargantuan amounts of money injected to cope with the crisis. It’s further contended that labour lacks the pricing power to create a price and wage inflationary spiral. 

Before buying this comforting narrative, it makes sense to look at the fundamentals. Prices are the point at which monetary demand meets material supply. Put another way, prices are where the ‘financial’ economy of money and credit intersects with the ‘real’ economy of goods and services.

Conventional theory states that the price mechanism enables strong financial demand to prompt corresponding rises in physical supply, because rising prices give producers an incentive to increase supply to the market.

This logic, though, holds true only under conditions of infinite capability. No rise in prices, or increase in financial demand, can prompt the delivery of products which do not exist in nature. If physical constraints exist, the theory that ‘demand creates supply under all circumstances’ is exposed as a fallacy.

This is particularly pertinent to the supply of energy. Surging European natural gas prices are a case in point. Conventional theory dictates that spectacular rises in prices ought to have brought new supply gushing into the market for gas. The reality is that no such new supply exists. To be sure, price differentials can divert supplies between competing markets, but they cannot increase the aggregate availability of gas. The same applies to other forms of traded energy, including oil and coal.

This brings us to the fundamental point about scarcity. Conventional economics, with its insistence that ‘demand creates supply’, dismisses the very concept of material constraint. Hard fact, on the other hand, decrees that the supply of fossil fuel energy at an affordable cost is constrained by the limits of resources.

Two observations are necessary here. The first is that the process of depletion has created sharp rises in the ECoEs – the Energy Costs of Energy – of oil, gas and coal. The second is that nothing that has any economic utility at all can be supplied without the use of energy.

Accordingly, rises in the ECoE-costs of energy must force up the cost of everything else, imposing changes in allocations, priorities and distribution. This is particularly applicable to resources such as food, water, minerals, metals and plastics, all of which are supplied through energy-intensive processes.

We can’t conjure them out of the ether by pouring money into the system.

Supply constraint and the implications for demand

Of course, conventional economic theory doesn’t limit its concept of the price mechanism to the assertion that rising prices must increase supply.

It states, also, that rising prices depress demand.

If we superimpose resource constraint onto this ‘equilibrium-through-price’ equation, what we’re left with is a process whereby supply isn’t increased – but demand IS depressed – by rising prices.

Put another way, the introduction of material scarcity into the pricing equation tells us that supply constraints will, through the mechanism of rising prices, reduce demand.

This is the point at which two realities have to be factored in. The first is that consumer purchases are divided, in order of priority, between essentials (things that the consumer must have) and discretionaries (things that he or she may want, but doesn’t need).

The second is that there is extraordinary sectoral and popular resistance to the idea that discretionary consumption might be trending downwards.

We can see these factors in operation right now. Because of resource scarcity in general – and energy scarcity in particular – the cost of essentials is rising markedly. We can see this, most obviously, in the rising costs of food, fuel and domestic energy, but we can be sure that this process is going to extend into other necessities.

It’s noteworthy that the Resolution Foundation, a British think-tank, is forecasting that 2022 will be a “year of the squeeze”. This description can be applied globally, differing only in pace and magnitude between countries and regions. The cost of everything from gas and electricity to fuel, travel fares, food, clothing and even water is going to rise.

The brunt of this pressure is felt initially by the poorest households, who spend the largest proportion of their incomes on necessities. But there need be no doubt that the rising tide of costs will move steadily up the gradient of household incomes.

For suppliers of discretionary goods and services, this is a double-edged sword. On the one hand, consumers whose living costs are rising have less to spend on non-essential purchases. On the other, the costs of supplying discretionaries are rising. Credit-funded discretionary spending, long the prop of non-essential sectors, is in the process of being undermined by inflation or, more specifically, by the monetary implications of the rising cost of necessities.

Behind the brittle optimism presented by every sector from travel and hospitality to ‘tech’ and the supply of consumer goods lies a reality shaped by rising costs, decreasing consumer resources, and an eroding capability to bridge the gap using cheap and abundant credit.      

Prices as interface           

In order to interpret the role of inflation correctly, we need to understand the conceptual distinction between the ‘two economies’ – the ‘financial’ or proxy economy of money and credit, and the ‘real’ or material economy of energy and resources.

What this distinction tells us is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services supplied by the real economy. If we wanted to be high-falutin’ about it, we could say that money is an artefact ‘validated only by exchange’.

What this really means is that inflation is a process governed by changes in the relationship between the availability of money and the supply of goods and services.

Over an extended period, we’ve been pouring enormous quantities of financial demand into the system, at the same time that material supply has become ever more constrained.

In this sense, inflation isn’t even a new phenomenon. Rather, price escalation has, hitherto, been channelled into asset prices, whose movements are – conventionally, but mistakenly – excluded from the measurement of inflation.

If we had, all along, been using a comprehensive, RRCI-type measure of inflation, we would have been far better prepared for, and much less surprised by, what is happening now.  

Since there are no ‘fixes’ for material constraints, the only way in which inflation can be tamed is by pushing monetary demand back downwards into alignment with material capability.

This understanding re-frames what we know about monetary policy. As things stand, the real (ex-inflation) cost of money has fallen to unprecedentedly negative levels. Since we can’t create physical resources out of nothing, the only policy fix for the gap between the real and the financial economies is the elimination of the subsidy of deeply negative real rates. The scale of past recklessness has ensured that any such process would be extraordinarily disruptive. 

This means that raising rates by enough to tame inflation would have two effects, not one. The first would be to temper the rate at which the supply of credit expands. The second would be to start unwinding past expansion in the quantity of credit.

It would be futile to suppose that we can have one of these effects without the other. We cannot restrain inflation simply by raising rates by just enough to deter new borrowing, without affecting either the servicing cost or the collateral backing of existing credit.

In any case, the current system depends on a continuity of increasing credit. 

To be effective, then, rate rises would have to be big enough to trigger credit defaults, asset price slumps and a re-pricing of the financial system back into equilibrium with the constrained character of the underlying economy.

The paralysis of predicament

In practical terms, this means that positive real rates won’t be reinstated voluntarily, and this leaves us looking for pressures that might force us to act realistically.

The most obvious such pressure will come from households, which might accept the impairment of the scope for discretionary consumption, but won’t – and can’t – tolerate relentless increases in the cost of essentials.

This is where forecasting processes need to be reinvented, meaning rebased away from the fallacious assumption of ‘growth in perpetuity’.

By calibrating both prosperity and the trend in the real cost of essentials, we can make sense of a dynamic whose consequences will include widespread defaults, sharp falls in real asset prices and a fundamental shift in the political climate.

At the same time, our recognition of the relationship between the ‘real’ and the ‘financial’ economies should give us steadily-improving visibility on the economic, financial and broader outlook.

None of this necessarily spells “collapse”, but it does establish a relationship between systemic risk and the prevalence of self-deception.

In this sense, our best hopes for a manageable future rest on an orderly assertion of reality, and the retreat of delusion.