#227. Pictures of imperfection

CHARTING THE COMING CRISIS

Jane Austen once wrote in a letter of how much she disliked “pictures of perfection” which, she said, “make me sick and wicked”.

Perfect pictures are, of course, the preserve of the artist, but the latest version of the energy-based SEEDS system does an improved job of picturing the imperfections that are driving us towards both a rapid deterioration in the economy and a severe financial crisis.

Under normal conditions, we might spend at least a little time discussing the improvements and refinements incorporated into the SEEDS 23 iteration of the model.

The harsh reality is that current conditions are very far from normal, so the priority now has to be to concentrate on what the model is telling us rather than at the way in which this is told.

Anyone new to Surplus Energy Economics and the SEEDS project can find a summary of energy economy principles here, whilst this article discusses the way in which the model generates forecasts.

Before looking at the annotated picture gallery which follows, it must first be warned that that a certain stoicism is required. If you’d prefer a happy ending, where prosperity doesn’t fall, asset prices don’t slump, liabilities aren’t repudiated through force majeure and the ‘liberal consensus’ that has ruled the roost for forty years remains intact, this isn’t the place for you.

The reality is that 2022 is the year where old illusions go to die.

Neither the long-established notion of TINA (There Is No Alternative) nor the newly-minted concept of TINAR (There Is No Acceptable Reality) can serve under conditions of rapid and adverse change.

To be clear about this, the energy dynamic which determines material prosperity is deteriorating, as indeed it has been over an extended period. Relentless rises in the ECoEs – the Energy Costs of Energy – of fossil fuels have put Western prosperity onto a declining trajectory since the early 2000s.

The average American, for instance, is now 11% poorer than he or she was back in 2000. Prosperity per capita has fallen by 13% in Britain since 2004, and by 7% in Japan since 1997.

These trends are now being replicated in less complex, more-ECoE resilient EM (emerging market) economies such as China and India. This means that global prosperity has now turned down after a long plateau in which continued (though decelerating) progress in the EM countries offset continuing deterioration in the West.

Fig. A

There can be no ‘fix’ – financial or technological – for these problems. Monetary manipulation has done no more than buy some time (at huge expense) for a failing system.

The capabilities of technology – whisper it who dares – are bounded by the laws of physics. Transition to renewable energy sources (REs), though imperative, cannot replicate the economic characteristics of fossil fuels.   

That worsening economic trends have not been evident in conventional data reflects the way in which various forms of adventurism have been used to create a simulacrum of “growth”. Pouring cheap credit and cheaper money into the system has had the effect of creating activity (as measured by GDP) even though the value of economic output has been deteriorating.

Between 1999 and pre-covid 2019, each $1 of reported “growth” was accompanied by increases of $2.70 in new debt plus an estimated $3.75 in broader financial liabilities. Were unfunded pension promises included in this calculation, it would emerge that close to $10 of forward commitments have been adopted for each “growth” dollar.

All of these numbers precede coronavirus crisis interventions, which have made all of these ratios far worse. Historians of the future are likely to characterise these gargantuan interventions as the ‘last hurrah’ of the money-for-nothing form of denial.

In practical terms, what this long era of self-delusion has accomplished is the driving of an ever-widening wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.

The operative process now is one that will forcibly restore equilibrium between the two economies of money and energy. Globally, the gap between them can be calculated at 40%, giving an approximate measure of the extent to which the financial system will be forced to contract.

Fig. B

Since money functions as an aggregate of claims on the real economy, this indicative calculation references the liabilities side of the financial equation. Asset markets will fall by more than this, reflecting the extent of leverage in the dynamic which links the pricing of assets to the underlying structure of liabilities.

This is where the need for stoicism comes in. The stark reality of the situation is that the prices of stocks, bonds and property are poised for extremely sharp falls.

The bond market situation is that the permanence of the inescapable rise in interest rates will, once recognized, drive yields sharply higher. Corporate bonds will be undermined further by a relentless deterioration in the financial conditions of the business sector.  

Just as prosperity is eroding, the real costs of essentials – many of which are energy-intensive – are rising rapidly. The SEEDS indicator termed PXE – prosperity excluding essentials – is on a sharp downwards trajectory.

Fig. C

As well as impairing the scope for investment in new and replacement productive capacity, this PXE compression will exert relentless downwards pressure on the affordability of discretionary (non-essential) goods and services.

Though there are ameliorating measures – known here collectively as the taxonomy of de-growth – which businesses can and will adopt to manage deterioration, it is clear that discretionary sectors will bear the brunt of a process by which equity markets start to price the future as it is, rather than as we would like it to be. A series of growth-predicated business models will fail, including the popular “streams of income” model which prioritises the signing up of customers over current revenues.

For property, meanwhile, the combination of deteriorating affordability and rising interest rates creates a dynamic which requires no amplification here.

Fig. D

As asset prices tumble and defaults cascade through the system, the last delusion will fail.

This delusion is that, if we engage in enough tantrums, the adults in the room – meaning central bankers – will step in to ‘kiss it better’.

The take-off in inflation – which has long been under-reported when compared with the SEEDS measure of RRCI (the Realised Rate of Comprehensive Inflation) – makes such intervention impossible.

The game-changer of systemic inflation means that the authorities can no longer, as they did in 2008-09, step in to rescue the reckless whilst penalising the prudent.

It would take a very special form of madness to invoke the supposedly “temporary” gimmicks (sorry, the “unconventional innovations”) of the GFC under conditions of rapidly accelerating inflation.

Barring surrender to a hyperinflationary destruction of the purchasing power of money, neither ZIRP nor QE can be re-invoked. The extinguishers used to fight (or at least to damp down) the fires of the global financial crisis now contain, not foam or water, but gasoline.  

“Nobody ever feels or acts, suffers or enjoys, as one expects”, wrote Jane Austen in another letter. Put another way, the era of self-delusion is over, and the stoicism involved in facing reality will now be the characteristic most required to adapt to a new era.                            

#226. The siblings of misunderstanding

TRUSTING TINA, FEARING TINAR

Though they would be the last to admit it, governments no longer have economic strategies worthy of the name.

On the single most serious economic challenge of the day – which is the escalation in “the cost of living” – the cupboard of answers is bare. What remains is a vague, fingers-crossed faith in continuity, reinforced by pious hopes that energy transition and technology will somehow reverse the palpable decline in public prosperity.

Ultimately, the only thing that now props up the orthodoxy – and similarly both supports artificially-inflated markets and stands in for the lack of a persuasive sense of direction – is TINA, the acronym for There Is No Alternative.

TINA may not seem particularly rational – until, that is, you meet TINAR.

Passing the buck

In economic terms, there’s nothing altogether new in this situation, since governments largely abdicated from economic policy back in 2008-09 when, during the GFC (global financial crisis), responsibility for the parlous state of economic affairs was dropped into the laps of central bankers.

Given what faces them now, these worthies might well wish that they could hand this burden back to the politicians. If central bankers don’t raise interest rates sufficiently, the inflationary spiral could very well get out of control. If, on the other hand, rates are hiked significantly, impairing the affordability of debt and stemming the flow of new credit, the consequences will include a major recession and a slump in asset markets.

Either way, the implications are so stark that not even the most Pollyanna-accredited optimist could spin them as ‘just a temporary problem’. 

Monetarily, by far the likeliest outcome is an unsatisfactory compromise. Western central banks’ policy rates might rise to, say, 3% or a bit more by the end of this year, by which time inflation could easily be into double digits.

Nominal interest rates (which determine how much borrowers actually have to pay) are thus set to rise, whilst real (ex-inflation) rates may simultaneously plumb new depths of negativity, worsening the economic distortion that this long-established anomalous condition has already created.  

The predicament of the ‘average person’ should be front and centre of any assessment of the economic situation. His or her discretionary prosperity is being compressed by the way in which the cost of essentials is rising much more rapidly than incomes. He or she is already heavily in debt – particularly so when per capita shares of government and corporate indebtedness are added to direct household debts – and faces the consequences of sharp increases in the nominal cost of credit.

One should not pick out any single government in this generalized crisis, but British policy does typify the bafflement of the authorities. The partial solution to painfully dramatic rises in energy bills is seen as a system of loans. The longer-term fix is presented as an expansion of renewable energy sources (REs), such as wind and solar power, with the possible inclusion of ‘fracking’, and of a renewed commitment to nuclear.

Neither solution can be expected to work.

Reliance on loans must reflect an implausible assumption that the cost of domestic gas and electricity will, somehow, and of its own accord, fall back to some kind of “normal”. Not even its most optimistic advocates, in Britain or anywhere else, claim that energy transition can reduce the burden on households in other than the long term.  

In these circumstances, it’s not unreasonable to assume that public dissatisfaction is likely to worsen, fostering increasing suspicion that the system is somehow loaded against the “ordinary” person.

This suspicion might or might not be well-founded, but it should not induce us to believe that governments have answers which only malign intent prevents them from enacting.

The fact of the matter is that governments have no solutions, palatable or otherwise, to a generalised deterioration in prosperity.  Still less have they solutions to the broader implications of prior economic growth going into reverse.

Explanations are not solutions

Since its inception, this site has had two objectives. The first has been to explore and refine the principles of the economy understood as an energy dynamic rather than a financial system.

The second has been to find out whether these principles could be incorporated into an economic model providing an improved interpretation of the present and the recent past, and an enhanced ability to forecast the future.

The basis of principle has been set out in one recent article, whilst projections produced by the SEEDS economic model have been outlined in another. April is a month particularly replete with new data, but it’s highly unlikely that the next iteration of the model (SEEDS 23) will reveal any significant shift in future trends that can now be predicted with a pretty high degree of confidence.   

At no point has it been anticipated here that the energy basis of the economy would prompt a serious re-think of the money-based economic orthodoxy, still less that decision-makers, in government or beyond, would accept a reality based on the emerging evidence that the economy is an eroding energy system, subject to material constraints, rather than an entirely financial one, capable of delivering ‘infinite growth on a finite planet’.

Even the acceptance of environmental constraint has been gradual and reluctant, leading largely to policy prescriptions chosen far more for their acceptability than for their practicality. Acceptance of economic limits would be a bridge too far, not just for decision-makers but for the general public as well.

The best that can be hoped for – at least until conditions become far worse – is shadow appraisal of the implications of the orthodoxy turning out to be mistaken. Scenario planning is helpful, in that it can build preparedness for the worst without requiring the adoption of that worst as a declared basis of policy.

Trust TINA

With the logical and empirical foundations of the continuity presumption falling apart, the best things that the orthodoxy has going for it now are two versions of TINA.         

In its economic dimension, TINA applies to a long-established penchant for buying time in the hope that ‘something will turn up’. Faced with the demonstrable failure that was the real lesson of the GFC, the decision was taken to compound credit with monetary “adventurism”.

Nobody seemed unduly troubled, either by the moral hazard thus unleashed or by the contradiction involved in trying to run a capitalist system without the essential pre-requisite of positive real returns on capital.

Hopes now are pinned on the proposition that rates can be raised by enough to tame inflation without either crashing asset prices or triggering a severe recession.

This situation confronts investors with a TINA of their own – the prices of equities, bonds and property may look extremely over-inflated, but, with rates deeply negative and likely to become more so, the only alternative, which is to be cash-long, is the sole sure way of losing money,

Put another way, deeply negative real returns on cash are now the only prop standing in the way of a market slump.

A cupboard empty of answers

The political version of TINA is the absence of a persuasive alternative to the ‘liberal consensus’ that has been in place since the start of the 1980s.

Even where they are in opposition rather than in government, centre-Left parties propose no systemic alternative to the precepts of economic policy that have been accepted since the interventionist, mixed-economy model seemed to fail in the 1970s, and the Soviet version of collectivism actually did fail at the end of the 1980s. 

Cassandra-style prophecies of collapse have zero appeal to the public, whilst conspiracy theories deter far more voters than they can ever persuade.  

This situation is, of course, inherently unstable.

Where markets are concerned, there are limits to how long the downside in discretionary sectors can be ignored by equity investors, and to how long the bond markets can dismiss rate pressures as nothing more than a short-term irritant. The relentless compression of affordability, and the inevitability of a rise at least in nominal rates, have unmistakable implications for property.

Politically, too, there are limits to quite how much hardship voters will accept without putting some tough questions to TINA. The tax base is being squeezed, because the only part of the economy that can really be taxed in a net-positive way is the margin that exists between top-line prosperity and the cost of necessities. There really is no practical mileage in taxing people to the point where hardship requires the hand-back of taxes through welfare.

Given the absence of alternatives, governments cannot really be criticised for a Micawberism which promises, and simultaneously hopes, that “something will turn up”, even if that “something” gets ever less realistic as time goes by.

The magic of monetary manipulation, and the alchemy of technology founded in denial of the laws of physics, may look implausible even to those most minded to put faith in them, but – yet again – the ‘rule of TINA’ applies.

It’s all very well to understand that the accessibility and affordability of essentials are the political battlegrounds of the future, but there are serious obstacles to an early recognition of this reality.   

As the soldier is supposed to have said in the First World War, “if you know a better fox-hole, go to it!”

The evil twin

In this situation, prognosis can become more than just unpopular, if prognosis lacks an effective prescription.

As just one example, the lack of practical alternatives means that, whilst the political Left might advocate imposing ever greater taxation on ‘the rich’, such proposals ignore the fact that much of the supposed wealth of the wealthiest is a notional product of market distortion, and cannot be monetized into taxable cash. 

We can reasonably infer that there can be no soft landing from a choice between market collapse and soaring inflation, and that the public cannot be expected to go on buying implausible long-term answers to worsening short-term economic hardship.

We are, likewise, at liberty to produce reality-based assessments of the present, and to set out probable trends in the future. We can demonstrate, for instance, that most of the “growth” of the past twenty years has been cosmetic, that prosperity is already in relentless decline, and that rises in the real costs of energy-intensive necessities are strangling the scope for discretionary consumption. We can point out that monetary policy has been driven into a cul-de-sac, and that there is no policy ‘fix’ that avoids both the Scylla of inflation and the Charybdis of recession.

How, though, does any of this help those burdened with responsibility for decisions?

We can go on to draw reasonable inferences, which include the probability that asset price delusions will fade away, and that popular patience may not much longer survive the solvent of worsening hardship.

None of this, though, offers a palatable alternative to TINA.

It might seem almost heartening that, in the absence of logic and evidence, TINA has become the sole prop retained by the consensus “narrative”.

We need to beware, though, that TINA may have a far less forgiving sibling, with the confusingly-similar acronym TINAR – There Is No Acceptable Reality.               

In other words, popular expectations may become ever more entrenched, and public demands ever more strident, even as the wherewithal for satisfying them ebbs away.