WHAT’S REALLY HAPPENING
What might be called the ‘consensus narrative of the moment’ is that our near-term economic prospects depend on the ability of central banks to tame inflation without tipping the economy into a severe recession. There are numerous complications, of course, but this is the gist of the story.
What these officials need to find, we’re told, are Goldilocks interest rates (‘not too hot, not too cold’), and all will be well if they succeed. If they err too far in one direction, inflation will run higher, and for longer, than is comfortable. If they lean too far the other way, a serious (though, by definition, a time-limited) recession will ensue.
Inflation itself, the narrative runs, has been the product of bad luck. First came the pandemic crisis, which impaired production capacity and severed supply-chains. Before we’d finished dealing with this, along came the war in Ukraine, disrupting supplies of energy, food and other commodities. There are some who add, sotto voce, that we might have overdone pandemic-era stimulus somewhat.
Our hardships, then, can be put down to a run of bad luck. Those in charge know what they’re doing.
It’s conceded, in some quarters, that we might face some sort of crisis if these challenges aren’t managed adroitly. This, though, shouldn’t be as bad as the GFC of 2008-09, and certainly won’t be existential.
We’re navigating choppy waters, then – not going over Niagara in a barrel.
The affordability reality
There is some truth in each of these propositions, but explanation in none.
What we’re really encountering now is an affordability crisis. The aim here is to explain this, without going into too much detail, and with data confined to two sets of SEEDS-derived charts at the end of this discussion.
The economy, as regular readers know, is an energy system. Nothing that has any economic value at all can be produced without the use of energy. Take away the energy and everything stops. Decrease the supply of energy, or put up its cost, and systems start to fail.
Energy isn’t free. Whenever energy is accessed for our use, some of that energy is always consumed in the access process.
This ‘consumed in access’ component – known here as the Energy Cost of Energy, or ECoE – has been rising relentlessly, mainly because depletion is forcing up the costs of oil, natural gas and coal.
This rise in ECoEs reduces the surplus (ex-cost) energy that is coterminous with prosperity. This equation reflects the fact that surplus energy determines the availability of all products and services other than energy itself.
Because ECoEs are rising, prosperity is decreasing.
At the same time that surplus energy prosperity is deteriorating, the costs of essentials are rising. This is happening because most necessities – including food, the supply of water, housing, infrastructure, the transport of people and products, and, of course, energy used in the home – are energy-intensive.
The material components of this equation – energy itself, supply costs, prosperity and the essentials – are translated, using the SEEDS economic model, into the financial language that, by convention, is used in economic debate.
We need to be absolutely clear, though, that money has no intrinsic worth, but commands value only as a ‘claim’ on the material products and services made available by the energy economy.
Money is an artefact validated by exchange. A million dollars would be of no use at all to a person adrift in a lifeboat, or stranded in a desert. A million euros would be worthless to someone who travelled to a distant planet where the euro is unknown.
We are at liberty to create monetary ‘claims’ to an almost unlimited extent, but we can’t similarly create the material goods and services that are required if those claims are to be honoured ‘for value’.
Central banks can ‘print’ money (digitally), but they can’t similarly print low-cost energy. The banking system can lend money into existence, but we can’t lend resources into existence.
We can’t, for that matter, fix our environmental problems by writing a cheque to the atmosphere.
The meaning of compression
Whether we think in energy or in financial terms, what’s happening now is that the economic resources of households, and of the economy itself, have ceased to expand, and have started to contract, whilst the costs of essentials are rising.
This is what is meant by an affordability crisis.
An affordability crisis does what it says on the tin, and has two main effects.
First, consumers who have to spend more on necessities have to cut back on purchases of discretionary (non-essential) goods and services.
Second, households suffering from affordability compression struggle to “keep up the payments”.
Traditionally, these payments were largely confined to mortgages or rents, plus, perhaps, insurance premia collected door-to-door.
Now, though, these outgoings include credit servicing, car loans, student loans, subscriptions, purchase instalments and the plethora of other income streams created by an increasingly financialized economy.
Though they can’t be expected to like doing so, it’s possible for households to cope with affordability compression. Discretionary purchases are, after all, things that people want, but don’t actually need. People can cancel subscriptions, cut back on instalment purchasing, and cease using – and, in extremis, default on – various forms of credit.
To say this isn’t to minimize, in any way, the very real hardships being experienced by millions of households. The ‘cost of living crisis’ is the biggest challenge that has confronted households, and governments, in decades. As these problems worsen, the public are likely to get increasingly angry, and to demand redress, part of it through various forms of redistribution.
But an affordability crisis is much more serious for the system than it is for the individual.
Customers can decide to holiday at home rather than abroad, but the outlook for airlines, cruise operators and travel companies is grim if they do. Households can get by without entertainment subscriptions, but the providers of these services cannot survive if this happens. Motorists can hang on to their current vehicles for longer, and put off buying a new car, but the automotive industry is at grave risk if this happens.
These are what we might call the ‘industrial’ effects of affordability compression. Serious though these are, the financial effects are much worse.
The financial system depends on people “keeping up the payments” and, to a significant extent, increasing those payments over time.
The ability of the system to cope with defaults – or even with payment contraction – is severely circumscribed.
Perhaps the biggest single risk of the lot would be a wave of ‘can’t pay, won’t pay’ reaction by the public.
Getting to grips
When trying to navigate our way through the coming crisis we need, first, to understand what it is. Inflation, whether in prices or in wage demands, is a symptom, not the disease itself, and the root of the problem is an affordability crisis.
Second, we can’t borrow or print our way through an affordability crunch. Any attempt to do so just makes the problem worse.
Third, none of this is going away. An outbreak of peace and conciliation between Russia and its opponents, welcome though this would be, wouldn’t alter the fundamentals, which are that the ECoEs of energy supply are rising, reducing the affordability, not just of energy itself, but of all energy-intensive resources and products.
Fourthly, there’s no “tech fix” for structural affordability compression. As we’ve discussed in previous articles, renewables are vital, but they aren’t going to stem, still less reverse, rises in overall ECoEs. The ability of technology to somehow over-rule the laws of physics is one of the foundation myths of the age.
There’s no merit in finding new ways to use energy when the supply and the affordability of energy itself are getting worse. Electricity doesn’t come out of a socket in the wall, in unlimited quantities and at an ever-decreasing price. The expansion of renewables is imperative, but they are even less likely than nuclear to produce power “too cheap to meter”.
It’s worth remembering, in this context, that energy sources must precede applications. The Wright Brothers didn’t invent the aeroplane first, and then sit around waiting for someone to discover petroleum. Cars weren’t invented until after gasoline had become available. Our ancestors didn’t build carts until they’d tamed their first horses.
Technologies are optimised to the energy sources available, not the other way around.
The big question now isn’t whether an affordability crisis is going to happen – because it already is – but when this reality is going to gain recognition as a feature of the system, not a glitch.
Hype springs eternal, and nobody is yet prepared to recognize that economic growth, previously powered by fossil fuels, has gone into reverse, because fossil fuels are becoming costlier to supply, and no alternative of equal economic value is available.
There are limits, though, to the capability for self-delusion. Risk will reach its apogee when investors, lenders and the public tumble to the reality that discretionary consumption has entered an irreversible decline, and that the economy, just like millions of households, is struggling to ‘keep up the payments’ required by an increasingly financialized system.