#233. Understanding inflation

TWO ECONOMIES, ONE PROBLEM

Inflation isn’t like other economic problems.

It impacts the general public, immediately, and painfully. It feeds on itself, once wages start chasing surging prices.

It can’t be denied and, once it takes off, there are limits to how far it can be under-reported. It can’t be fixed – or, rather, it can’t be ‘kicked down the road’ – using any form of ‘magic money’ gimmickry.

Inflation is the brutal exposer of failure. It is already exposing, for example, the weaknesses of a British economic model built on perpetual credit expansion, and the contradictions in a European monetary system which tries to combine a single monetary policy with nineteen sovereign budgetary processes.

Small wonder, then, that soaring inflation induces panic, desperation and sometimes outright idiocy in the corridors of power.

On the basis of principle

Those of us who understand the economy as an energy system, rather than a wholly financial one, have a unique insight into inflation.

Because we recognize that the ‘real’ economy of goods and services is shaped by energy rather than by money, we also recognize the existence of the ‘financial’ economy as a monetary proxy to the energy dynamic which determines prosperity.

Prices are where the material and the monetary intersect. Prices are the financial values that are attached to physical goods or services. Inflation is a product of changes in the relationship between the ‘real’ economy of energy and the ‘financial’ economy of money and credit.  

To paraphrase Milton Friedman, inflation is always and everywhere a two economies phenomenon.

Because of the immediacy of soaring inflation, and because of the panic it induces in decision-makers, current events might seem to add credence to the “collapse” prophecies of modern-day Cassandras.

In fact, inflation can be interpreted rationally, and that’s the single aim of this discussion.

In search of reason

The basic principles of the energy interpretation are quickly stated.

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

Energy is never ‘free’, but comes at cost measurable as the proportion of energy that is consumed in the access process whenever energy is accessed for our use. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy).

Money has no intrinsic worth but commands value only as a ‘claim’ on the material goods and services supplied by the energy economy.

These principles lead inescapably to the concept of the ‘two economies’ of energy and money. Inflation – and, for that matter, currency crises, market falls and severe defaults – are products of imbalances between the ‘real’ and the ‘financial’ economies.

Until some point in the 1990s, the real and the financial economies expanded more or less in tandem.

The most notable previous disequilibrium between the two economies of energy and money happened in the 1970s, and was characterized by runaway inflation. Though energy remained cheap and abundant in those years, political divisions between the biggest producers and the main consumers of oil triggered a sharp rise in the cost of energy to Western consumers.

The situation righted itself, because there remained substantial reserves of relatively low-cost oil in places – most notably the North Sea and Alaska – that were outside the control of OPEC.

The robust growth of the 1980s owed everything to a ‘catch-up’ from the politically-induced energy shortfalls of the 1970s, and almost nothing to the ‘liberal’ economic ideologies which happened to supplant the Keynesian orthodoxy at that same time.

The road to here

By the 1990s, the fundamentals had started to deteriorate. ECoEs were rising at rates which were taking away the potential for further growth in the material economy. This was happening because of depletion, a process whereby lowest-cost energy resources are used first, leaving costlier alternatives for a ‘later’ which had now arrived.

What we have experienced since then has been a worsening process of self-delusion, based on the false proposition that we can increase material supply by stimulating financial demand.

The facts of the matter, of course, are that no amount of financial stimulus, and no increase in prices, can produce anything – in this instance, low-cost energy – which does not exist in nature.

What we can do is to create a simulacrum of “growth” by creating monetary ‘claims’ on the future which increase transactional activity in the present.

We’re at liberty to count these increases in transactional activity as ‘growth’, and to ignore the inability of the real economy to honour these forward commitments when they fall due.

This is what’s been happening through an era of collective self-delusion that began in the second half of the 1990s.

Between 1999 and pre-pandemic 2019, reported global GDP increased by $74 trillion in real terms, but debt escalated by $204tn between those years, and we can estimate that broader ‘financial assets’ – which are the liabilities of the household, government and corporate sectors of the economy – soared by about $480tn. Even this number excludes the creation of enormous pension promises which a faltering ‘real’ economy will be unable to honour.

The reported “growth” in the economy measured financially as GDP through this period was starkly at odds with what was happening in the real economy of energy. Whilst reported GDP slightly more than doubled (+110%) between 1999 and 2019, the total supply of energy increased by only 54%, a number that falls to 47% at the critically-important level of ex-ECoE surplus energy.

Reflecting this, aggregate prosperity, measured financially by the SEEDS economic model, expanded by only 34% worldwide over a period in which economic activity, recorded as the transactional use of money, rose by 110%. The 34% increase in money-equivalent prosperity was lower than the 47% rise in surplus energy, a differential reflecting deterioration in the efficiency rate at which surplus energy is converted into economic value.

The dynamics of disequilibrium

We need to be absolutely clear about what this means. Stimulation of transactional activity to levels far above underlying prosperity as determined by energy has created an enormous disequilibrium between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

Globally, the downside between the ‘two economies’ can be calculated, as of the end of last year, at 40% (see fig. 1). The equivalent numbers for the United States and China, respectively, are 32% and 54%.

Fig. 1

The inevitable restoration of equilibrium between the ‘two economies’ is readily explained, because it happens when the owners of financial ‘claims’ realize that the aggregate of these claims cannot be honoured ‘for value’ by the real economy of goods and services.

This enforced restoration of equilibrium is mediated through prices, which are best understood as the rate of exchange between the monetary and the material economies.

The result is experienced as accelerating inflation, a process which everyone understands can only be worsened by stimulus, and which we further understand must continue until something much closer to equilibrium has been restored.

It also follows, from this, that inflation will be most acute in those energy-intensive product categories which are ‘essential’, which means that consumers cannot choose not to buy them because their prices have increased.

Conversely, inflationary pressures will be less pronounced in those discretionary (non-essential) goods and services of which consumers will reduce their purchases as their ex-essentials prosperity (known in SEEDS as PXE) deteriorates.

Taking stock

This explanation, though, refers primarily to the flows of money and material prosperity. There are also ‘stock’ issues around the forward commitments created through the same process of stimulus which has driven the observable wedge between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

This is summarised in the flow-and-stock analysis produced by the SEEDS economic model.

In fig. 2, the flow distortion, seen earlier, is compared with two measures of ‘stock’ exposure. One of these is debt, which now stands at 4.1X underlying prosperity. The other relates to estimated broader financial assets, now at a multiple of 9.3X prosperity.

Neither of these ratios is sustainable, and a best estimate has to be that forward excess claims will be eliminated at a percentage rate broadly equivalent to the equilibrium downside measured as the flow relationship between the monetary and the material economies.    

Fig. 2

Inflation does, of course, reduce forward claims by impairing their real value.

Even so, the balance of segmental alignments – between essentials, discretionaries and capital investment – suggests that the elimination of excess claims cannot occur through inflation alone. Suppliers of essentials probably will be able to honour most of their forward commitments, whilst many discretionary sectors will not.

Since our focus here is on inflation rather than on economic activity and prosperity, we need, for now, only glance – as in fig. 3 – at the future prospects for an economy in which prosperity has stopped expanding and started to contract, whilst the real costs of essentials carry on rising.

Discretionary activities will shrink, whilst capital investment can be expected to diminish in a process that demands ever greater returns on capital.

On inflation, our conclusion needs to be that pressures will continue for as long as it takes for the restoration of equilibrium between the ‘real economy’ of energy, goods and services and the ‘financial economy’ of asset values, money and credit.

Within this overall trend, the prices of essentials will continue to out-pace those of discretionaries as the segmental mix of consumption and investment realigns.

For the authorities, this poses a difficult challenge, because many emerging trends will be unpalatable to a public which has been sold the myth of ‘growth in perpetuity’.

Whilst we can – perhaps – assume that no government or central bank would be so unwise as to try to use stimulus to counter inflation, there are two ways in which the authorities could make this worse.

One way would be to carry on trying to ignore, or unintentionally misunderstand, the forces that are manifesting as inflation.

The other would be to try to favour some interest groups over others.

Fig. 3

#232. All crises great and small

NUMBERS AND INNER NATURE

As explanations fail – ‘temporary’ post-coronavirus disruption, “transitory” inflation, ‘unexpected’ hardships caused by the war in Ukraine, and all the rest of it – hard facts are emerging, and few of them are palatable.

One of these unpalatable realities is escalating risk. We can’t, for instance, be sure that a relatively gradual retreat in capital markets won’t turn into an autumnal rout. Neither can we assume that some of the worst-managed Western economies will succeed, this time, in ‘muddling through’.

Part of this predicament can be quantified here, and framed, using the SEEDS economic model.

But it’s equally important that we understand the inner nature of a rapidly-unfolding crisis situation.

Prosperity is heading downwards, hardship is being worsened by the rising costs of necessities, and these material trends are invalidating two assumptions on which decision-makers have hitherto relied.

One of these failing assumptions, of course, is that we can deliver ‘happy outcomes’ using fiscal, credit and monetary gimmickry.

The other is the assumption that an economic consensus, generally labelled ‘liberal’, can prevail, by some kind of triumph of hope over reality.

We – or rather, millions of people in the former Soviet bloc, in pre-Deng China and elsewhere – have tried extreme collectivism, and it didn’t work.

But this gives us only a negative answer, in the sense of what not to do, when liberalism fails.

A rule of three

There’s a cardinal rule which states that, if you’re giving any kind of speech or presentation, you should limit yourself to making no more than three headline points.

These points may be as simple or as elaborate as you like, and as circumstances might require.

But their number should not exceed three.

On the basis of this useful discipline, our first point needs to be that prior growth in material prosperity has gone into reverse.

Our second is that systems – including the financial and the political – have been built on the contrary assumption of ‘growth in perpetuity’.

Our third is that this inherent contradiction is not understood.

This isn’t because it’s hard to grasp – indeed, its fundamentals are stark and obvious – but because we have a tendency to believe, not the factual and the obvious, but whatever it is that we want to believe.

Together, these points explain why we face crises of adjustment.

We have to adjust our financial system to a post-growth reality, and adjust our political systems to a situation in which it’s no longer enough to offer the public “jam tomorrow”, telling people that they’ll all be better off in the future if they just ‘keep the faith’ in the present orthodoxy.

Hard realities

Let’s start with the reality about prosperity. The large and complex modern economy has been built on an abundance of low-cost energy sourced from coal, oil and natural gas. This fossil fuel energy has already ceased to be cheap, and is now ceasing to be abundant.

Back in the 1950s and 1960s, we thought we had a replacement in nuclear power, which was going to be “too cheap to meter”. Today’s alternative narrative is that ever-cheaper and more abundant energy will be obtained from renewable energy sources (REs), such as wind and solar power.

This new narrative actually has even less plausibility than the old one about nuclear, but it fills the aspirational gap created by TINAR (“There Is No Acceptable Reality”).

We know that money has no intrinsic worth, but commands value only as a ‘claim’ on the ‘real’ or material economy of energy.

But money differs from the material by giving us time arbitrage – we can create monetary claims now, on the basis that they will be honoured (by exchange) in the future.

Investment is interwoven with the time arbitrage of money.

Investment began in agrarian societies, where a person could invest by surrendering present consumption for future improvement. Instead of consuming all of today’s harvest now (or its equivalents purchased through exchange), a farmer could trade some present consumption for an asset (perhaps a barn, or a plough) that would increase his prosperity in the future.

The principle of investment is, and always has been, that of making sacrifices now in return for greater prosperity at a later date.

Most of us today are not farmers, or millers, or bakers, able to surrender current consumption of bread or beer for a better future founded on efficiency-enhancing capital assets like barns and ploughs.

Our version of investment is a financialized one, and involves exchanging consumption now for returns on accumulated capital at some later date. But “later” has to mean “bigger” for this process to function.

The saver lends money on the basis that the return from the borrower will exceed what has been lent today. The investor in a business is motivated by the assumption that the value of the business, and hence of his or her investment in it, will rise over time.

A whole science has been built around this process of time arbitrage, and includes ‘rates of return’, the ‘time value of money’, and the relationship between ‘risk and return’.

Unfortunately, all of this is ultimately dependent on growth. If a person lending $1000 now is to receive $1,100 at a later date, the borrower has to improve his own circumstances by ‘putting money to work’. For the investor to get back more than he or she put into a business, that business has to grow.    

There are exceptions to this rule under any set of conditions. A borrower or an entrepreneur may fail even under favourable conditions of growth. Some lenders and investors may profit even if the economy has, as now, started to contract.

Indeed, the trick now is to work out which sectors will expand even as the economy as a whole gets smaller.

But a generality of growth is required if the generality of lenders and investors are to profit.

Of need and discretion

After the energy reasons for growth reversal, and the dependency of investment on growth, the next step in a logical progression is the hierarchy of needs.

Whatever the resources of the individual or household may be, the first call on those resources is made by necessities.

A person or family spends first on those things that are indispensable, some of which are food, water, accommodation, necessary travel and domestic energy. Only after these essential needs have been met can remaining resources be allocated to discretionary (non-essential) forms of consumption, which might be holiday, a trip to a restaurant or some new gadget.

This makes discretionary consumption a residual, meaning a number arrived at through the relationship between two primary factors, which in this case are prosperity and necessity.

Residuals, by their nature, are leveraged, because they are affected by changes in more than one primary factors.

An era of abundant, low-cost energy has applied positive leverage to the discretionary piece of the equation. Cheap energy has driven prosperity higher at the same time as holding down the cost of necessities.

Now, though, rising energy costs have turned this into negative leverage, with prosperity declining whilst the costs of essentials are rising.

By way of example, SEEDS indicates that, whilst British prosperity per capita declined by a comparatively manageable 10% in real terms between 2004 and 2021, the cost of essentials rose by an estimated 18%, again in real terms, over the same period. The leverage effect was to reduce the affordability of discretionary consumption by 15%.

This raises two particular problems.

First, discretionary contraction isn’t pleasant, particularly for anyone who’s been told that discretionary prosperity is supposed to carry on increasing over time.

Trying, both individually and collectively, to buck this trend – to increase discretionary consumption, even though discretionary prosperity is decreasing – worsens indebtedness, simultaneously exacerbating insecurity, and breeding discontent wherever it appears that a favoured minority is enjoying increased discretionary prosperity.

Promises can turn pretty quickly into expectations, and expectations into feelings of entitlement. The failure of promises, the disappointment of expectations and the denial of supposed entitlements can lead directly to resentment.   

The second problem is that these adverse trends are accelerating, worsening the effects of negative leverage. Having decreased by 15% over a period of seventeen years, British discretionary prosperity per capita is now set to contract by a further 35% over the coming decade.    

Of money and politics

When we apply these straightforward (though unwelcome) trends to the financial and the political systems, we unmask pressures for which very few people seem prepared.

The first of these is financial, where we can draw two conclusions from the foregoing.

One of these is time arbitrage, which for present purposes means that a futurity – a set of shared expectations for the future – is incorporated into the financial system. Another is the adverse leverage effect of discretionary contraction.   

Depending on how you define “essential” – which varies both geographically and over time – roughly 60% of economic activity in the modern Western economy is discretionary.

This means that about 60% (and probably more) of equity valuation, and of loans outstanding, is dependent on positive futurity as it affects discretionary prospects.

In other words, if the consensus expectation of discretionary expansion were to turn instead into a realization of discretionary contraction, the financial system would face pressures which have no precedent in the industrial era.

In government, the equivalent of futurity is expectation, which means that people expect – and have been led to expect – a continuous improvement in their material circumstances over time.

Economic ‘liberalism’ is particularly at risk because it is based on a claim, which might otherwise be called a promise, that the prosperity being enjoyed by the more fortunate in the present will, in the course of time, come to be enjoyed by everyone else as well.

Historically, there’s been some vindication of this promise. Back in the 1950s, only the wealthiest could afford to own a car, or to take holidays abroad. Growth in subsequent years has extended car ownership and foreign travel from the thousands to the millions.

Market liberals have always been able to assert, with considerable justification, that this progress wouldn’t have happened under a Marxist-Leninist system – as somebody once said about America, “if we’re so awful, we’re so bad, go and try the nightlife in Leningrad”. As a young citizen of communist Czechoslovakia once put it, “I don’t want to be a capitalist – I just want to live like one”.  

Unfortunately, this ties the fortunes of economic liberalism to a continuity of growth. If the majority ever has to told that, far from aspiring in the future to the standards of living enjoyed today by the fortunate, their own conditions of life are going to deteriorate, a new system will be required.

#231. Short and sharp

A SYNOPSIS OF DETERIORATION AND RISK

Might we very soon face a major financial crisis, at a scale exceeding that of 2008-09?

Are we heading for a global economic slump, or can current problems be explained away in terms of ‘non-recurring events’, such as the war in Ukraine?

Do the authorities have the tools and the understanding required to navigate the current economic storm? And what is the outlook for inflation?

These are valid questions, and I’m well aware that, whilst many visitors to this site are interested in economic principles, theory and detail, others prefer succinct statements of situations and prospects.

That’s understandable – these are deeply worrying times.

The aim with what follows is to (a) set out a brief summary of the economic and financial outlook, as seen through the prism of the SEEDS economic model, followed by (b) a succinct commentary on how these conclusions are reached.

Accordingly, what we might infer from these conditions is left for another day. Like me, you will have your own views on the political and other implications of what’s going on and what is to be expected, but the plan with this discussion is to stick to a strictly objective analysis of economic and financial conditions and prospects.

Data used here by way of illustration is a ‘top-line’ summary at the global level. We might, at a later date, look at some of this material in greater detail, and examine the circumstances of some of the 29 national economies modelled by SEEDS.

Where both the theoretical and the ‘succinctly-practical’ are concerned, urgency is being increased by what we can only call the ‘uncertainties and fears’ generated by current conditions.

In economic and financial terms, it’s becoming ever more obvious, not just that ‘things aren’t going according to plan’, but that decision-makers don’t have replacements for the tools and assumptions that have failed.

What’s clear now is that the shortcomings of money-based economic orthodoxy are becoming ever more apparent, evidenced principally by the failure of policies based on this orthodoxy.

The authorities have tried pretty much everything in the conventional play-book – plus quite a few ventures into the dangerously unconventional – and none of it has worked.

To use the contemporary term, this is a “narrative” of failure that starts with “secular stagnation” in the 1990s, and arrives – as of today – at the very real prospect of “stagflation”.

Where failure is concerned, the combination of high inflation and deteriorating prosperity is about as comprehensive – and as damning – as it gets.

Not too many years ago, the concept of the economy as an energy system might have been deemed a pretty radical ‘challenger theory’ to an established orthodoxy which insists that the study of economics is coterminous with the study of money.

Now, though, the case for the energy interpretation is gaining strength as the credibility of the prior orthodoxy is being eroded away by failure, albeit in a World that still refuses to acknowledge the inadequacies of conventional nostrums.

There are, of course, many different versions of the energy-economy interpretation, with differences of method and emphasis leading to differences of conclusions.

The main focus of effort here at Surplus Energy Economics has been on modelling the economy on an energy rather than a financial basis.

Modelling imposes a certain degree of caution, in that our conclusions should not be allowed to out-run what our models can tell us.

Inferences, of course, are a very different matter.

The outlook in brief

What, then, – and on the basis of what we know – should we now expect?

First and foremost, we can anticipate continuing declines in prosperity, with much the same deterioration already evident in the West now extending to those EM (emerging market) countries in which growth has, until quite recently, remained feasible.

This rate of deterioration can be expected to accelerate. The World’s average person is projected to be 6% poorer in 2030, but fully 21% less prosperous by 2040, than he or she was in 2021.

Meanwhile, the real costs of essentials will continue to rise, pointing towards a rapid contraction in the affordability of those discretionary (non-essential) goods and services which consumers ‘may want, but do not need’.

In real terms, discretionary consumption worldwide is likely to be 14% lower in 2030, and 52% lower in 2040, than it was last year.

Inflation has been driven higher by the rising costs of essentials but, looking ahead, is likely to be contained, to some extent, by deflationary trends in discretionary sectors.

The measure preferred here – which is RRCI, or the Realised Rate of Comprehensive Inflation – forecasts systemic inflation rising from 8.1% in 2021 to 8.6% this year, moderating to 5.3% by 2027.

These forecasts are summarised in fig. 1.

Fig. 1

Finally, in this brief list of projections, we can anticipate major financial dislocation, probably far more severe than the global financial crisis (GFC) of 2008-09. No attempt is made here to put a timescale on this, but it seems very unlikely that it can be long delayed.

The fundamental driver of this dislocation will be a dawning realization that the promises and assumptions incorporated both in asset prices and in forward commitments cannot be met by an economy that is not conforming to the consensus and official narrative of ‘growth in perpetuity’.

Along with this will go an invalidation of excuses and a discrediting of promises.

The public will cease to accept assertions that ‘everything would have been fine if it hadn’t been for’ the latest explanation du jour, which might be “the after-effects of the coronavirus crisis”, or “the war in Ukraine”, or “the dog ate my homework”, or whatever the next excuse might turn out to be.

At the same time, the public might come to realize that we cannot, for example, look forward, as promised, to ever-growing prosperity powered by ‘cheap’ renewables and the magic of technology.

The basis of projection

The foregoing has been intended for those who want a succinct statement of the outlook. You might wish to know how we arrive at forecasts which run directly contrary, both to the ‘official’ and the ‘consensus’ picture of the future.

If you’ve been visiting this site for any length of time, you’ll know the core principles on which the Surplus Energy Economics interpretation is based.

First, and in brief, we know that the economy is an energy system, because nothing that has any economic value whatsoever can be supplied without the use of energy.

We further know that energy is never ‘free’, and that, whenever energy is accessed for our use, a proportion 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).

The third core principle is that money, having no intrinsic worth, commands value only as a ‘claim’ on the material prosperity created by the use of energy.

It follows that we need to think conceptually in terms of ‘two economies’ – a ‘real’ or material economy of goods and services, and a ‘financial’, ‘proxy’ or claims economy of money and credit.

By measuring prosperity, the SEEDS model enables us to do two main things.

The first is to compare the real and the financial economies, calibrating the relationship between monetary claims and material substance.

Since, by definition, claims that cannot be honoured by the real economy must be eliminated, this indicates the extent of downside that must come into effect through a dynamic of returning equilibrium.

Second, we can use calibrations of changes in prosperity over time to restate prior trends as the basis for forward projection. Even if – for forecasting purposes – we accept nominal GDP (of $146 trillion) in 2021, as a baseline for projections, we don’t remotely need to accept a narrative that purports to explain, in glowing terms, how this number got to where it is.

It’s clear that a large proportion of prior “growth” has been a cosmetic property of stimulus, remembering that stimulus does increase the transactional (‘claims’) activity recorded as GDP, but doesn’t correspondingly increase the underlying value measured here as prosperity.

By restating past trends on realistic, prosperity-referenced lines – and by applying our knowledge of forward trends in prosperity – we are able to interpret past, present and future in a way that tells us a great deal about the prospects for the three critical segments of the economy.

These are the supply of essentials, the capability for investment in new and replacement productive capacity, and the affordability of discretionary goods and services.  

Three main conclusions emerge from this analytical approach.

First, and as shown in the left-hand chart in fig. 2, there has been a marked divergence between the real and the financial economies, a divergence that can be calculated, globally, at 40%. This gives us, in outline terms, a proportionate measure of the downside in the financial system.

Second, the aggregates of financial claims have increased enormously during a long period in which we’ve been trying – and failing – to use financial stimulus to boost material prosperity.

The application of the proportionate imbalance shown in the left-hand chart to the quantitative exposure shown in the middle chart reveals the truly enormous downside risk embodied in the financial system.

This is risk which we might be able to manage – but not if we continue to think of financial stimulus as a means to unattainable material objectives.  

Third, we can calibrate the relationship between prosperity – expressed in per capita terms in the right-hand chart – and trend ECoE.

Given the extreme improbability of ECoEs reversing their established upwards trend – and the virtual inevitability of continuing increases – further deterioration in prosperity becomes pretty much a certainty.

The rate of economic deterioration can be expected to worsen in accordance with systemic trends, including loss of critical mass (where essential inputs either cease to be available, or become prohibitively expensive), and adverse utilization effects (where unit costs rise as volumes contract).  

Again, deteriorating prosperity is a trend that we might be able to manage. But this will not be possible if, though a combination of wishful-thinking and adherence to orthodox nostrums, we remain in deep denial about its reality.    

Fig. 2