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.
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.