#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.