MANAGING WHAT WE CAN’T FIX
What the media calls the ‘cost of living crisis’ is fast turning into an affordability crisis. The former is where discretionary consumption slumps. The latter means that increasing numbers of people can’t keep up the payment streams on which the financial system depends.
As the situation worsens, politicians and commentators are bombarding us with calls for action, proposing often-contradictory fixes for what can’t be fixed, but can only, at best, be managed.
If there’s a common theme, it is that we need to borrow even more than we already have.
If there’s a common fallacy, it’s that we just need to find the right financial answers to our woes.
None of this can work, because what we are witnessing now is absolute proof that the economy is an energy system, not a financial one.
Western Europe is one of the richest places on the planet, but its financial wealth will be meaningless – and will, in fact, evaporate – unless energy can be sourced in the requisite quantities, and at affordable prices.
Few regions are immune to this same problem. North America has substantial energy resources, but their costs are high, and rising. China has a sizeable energy deficit, as do other economies in the Far East. Even Russia, with her energy wealth, can’t emerge unscathed from a global economic slump caused by generalised energy deficiencies.
The war in Ukraine has reduced the supply of natural gas, but an end to that war, and the restoration of trade with Russia, wouldn’t solve our energy supply problem. This situation – including surges in the price of gas – was developing well before the first Russian tank rolled over the Ukrainian border. The costs of fossil fuels are continuing to rise relentlessly, and this is now pointing towards a decline in the volumes of oil, natural gas and coal available to the economy.
Some believe that renewables offer a complete replacement for the energy value hitherto obtained from low-cost fossil fuels. Some of us think that’s implausible.
But even the optimists have to concede that this can’t happen now, because a transition won’t be effective until the mid-2030s, at the very earliest, even if it can happen at all.
Renewables aren’t going to keep vehicles running, machines humming and households warm in the coming winter.
As a direct result of problems with energy supply – interacting with a system founded on the hubristic assumption of infinite growth – the World is heading for a financial crash which is likely to dwarf the global financial crisis (GFC) of 2008-09.
Reality has arrived
These events should – and, in time, perhaps will – put paid to the notion that the economy is wholly a financial system, unconstrained by resource and environmental limits, and capable of delivering the logical impossibility of ‘infinite growth on a finite planet’.
It should also, if we’re lucky, put paid to political notions based on this same infinity fallacy. Everything that politicians promise or propose assumes that the right financial policies can deliver growth.
This simply isn’t true.
This is a fallacy shared by both ‘Right’ and ‘Left’. Collectivism can’t deliver energy abundance. ‘Leaving everything to the markets’ can’t deliver prosperity – even in theory, let alone in practice – if markets are deprived of the material goods and services for which, ultimately, markets act as financial proxies.
We can’t ‘stimulate’ our way to perpetual growth – and, by the way, Keynes never said that we could, confining the role of stimulus to the management of trade cycles.
This is a time in which we need to shed all delusions based on monetary ‘fixes’. Changes to tax allocation can shift the burden of hardship between groups of people within a country, but borrowing to fund “tax cuts” can’t create “growth” in a contracting economy. Rate changes, and exercises in QE or QT, might act on the margins of inflation, but only within a recessionary-inflation trade-off.
Where monetary and fiscal policy is concerned, there’s something we need to be absolutely clear about – even if we were gifted with utterly brilliant decision-makers in governments and the central banks, there’s nothing they could do to boost the supply of affordable energy.
Lacking that ability, what they’re engaged in is a balancing-act – they can adjust the distribution of hardship between income groups, and they can try to defend exchange rates, but they can’t prevent the deterioration in material prosperity. That also means that there are limits to what they can do to tame inflation.
Inflation is not – thus far – being driven by excessive domestic demand, so raising the cost of existing debt won’t fix anything. Going forward, it’s the scale of lending that central bankers need to keep under control, not least because someone who borrows out of necessity is a far greater default risk than someone who borrows out of choice. Interest rates are a blunt instrument when it comes to restraining runaway borrowing and rising risk.
Principles and consequence
Under these extreme conditions, it’s necessary to remind ourselves of the ‘three principles, one consequence’ of economic reality.
The first principle is that the economy is an energy system, because nothing that has any economic value whatsoever can be produced without it. The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE.
Third, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the material economy.
These three principles lead inexorably to a logical consequence, which is that we need to think conceptually in terms of two economies – an energy-determined ‘real’ economy of goods and services, and a proxy ‘financial economy’, consisting of money and credit, which incorporates claims on material economic prosperity.
The economy can’t be understood effectively unless this conceptual distinction is recognized.
These principles are well-known to regular visitors to this site but, under current conditions, no apology seems necessary for their brief reiteration.
Conventional economic models can’t possibly act as reliable guides to our predicament. Their foundation assumptions are fallacious. The economy isn’t entirely a monetary system; resources are not some kind of substitutable adjunct to the economy; there are material and environmental limits to economic activity; and the promise of infinite growth on a finite planet is a delusion arrived at by reasoning from false premises.
Energy-based economic analysis – like the SEEDS model used here – is the only way in which we can arrive at rational interpretations and forecasts.
The critical issue is the relentless rise in the ECoEs of oil, natural gas and coal. These account for more than four-fifths of global energy use, so this process has driven overall ECoEs to ever-higher levels. This process has killed off the scope for expansion in material prosperity, and has now put prior growth into reverse.
Rising ECoEs affect us, first, by making energy less prosperity-productive, because increasing costs reduce the surplus (ex-ECoE) value of each unit supplied. They are also starting to undermine quantitative supply itself, by making it ever harder to establish prices which both cover producer costs and are affordable for consumers.
Not the turn of a card
This understanding should deal with claims that what we’re going through now is some kind of ‘run of bad luck’. In energy terms, pandemic-related shutdowns bought us a little time, simply because they amounted to a cutback in the consumption of energy, and of energy-dependent products and services.
The restoration of energy trade with Russia might, were it to happen, provide some temporary relief, but wouldn’t halt the rise in global ECoEs. Russia doesn’t have infinite supplies of hydrocarbons, and neither are its oil and gas operations particularly cheap.
Tempting though it is to blame the coronavirus, or Mr Putin, for current economic problems, then, this really won’t wash. The real culprits in the current situation are anyone who has promoted or believed the idea that material consumption can increase indefinitely on a planet with finite energy resources and finite environmental tolerance. This means pretty much all of us so, in that sense at least, the ‘blame-game’ is pointless.
Where blame can be placed is on the way in which prosperity – and, now, hardship – are allocated between different groups of people. Even here, though, arrogance and greed are compounded by ignorance.
Where economic assertions are concerned, our collective hubris knows few bounds. We’ve been congratulating ourselves about “growth” over a long period in which prosperity has been contracting.
We’ve been piling up commitments that we can’t honour in pursuit of growth that can’t happen.
SEEDS analysis indicates that the average American has been getting poorer since 2000, and that the same thing had happened in almost all Western economies before 2008. Latterly, the inflexion-point in prosperity has been reached in an increasing number of EM countries, and global prosperity per capita has now turned down.
These inflexion-points in prosperity can be related directly to ECoEs, as the charts in fig. 1 illustrate.
The West, in particular, has never accepted the idea that material economic expansion has ended, and has gone into reverse. Instead – and perhaps unknowingly – we have exploited the disconnect between the real and the financial economies to create a delusional simulacrum of “growth”.
Creating incremental monetary ‘claims’ on the economy doesn’t increase material wherewithal, any more than printing a lot more hat-checks can create more hats when checks are presented at the end of a function.
Because all money exists as a ‘claim’, the creation of monetary claims in the present adds to the aggregate of liabilities redeemable in the future.
Stated in dollars converted from other currencies at market rates, global debt at the end of 2021 stood at $236 trillion, or 245% of GDP ($96tn).
But formal debt hugely understates broader financial commitments, which can be estimated at $550tn, or 575% of GDP, and which include about $280tn in the ‘shadow banking system’. The ratios in some countries are far worse, including Britain (1263% as of the end of 2020), the Netherlands (1454%) and Ireland (1809%).
Even these ratios understate the true seriousness of our financial predicament, because the GDP denominator has been inflated artificially.
The basic principle involved here is simplicity itself. We create money which, by definition, is a ‘claim’ on the real economy and, because money itself is a claim, it’s also a forward liability. The spending of this money creates financial transactions, and the adding up of these transactions by statisticians creates the metric that we know as GDP. We then assume – quite mistakenly – that this ‘sum of financial transactions’ is economic ‘output’.
This means that we can inflate transactional activity by pushing ever more credit into the economy. This doesn’t add to material prosperity, but it does increase the overhang of forward claims that we won’t be able to honour.
Beyond a tendency to ‘count the activity and ignore the liabilities’, the snag with this is that, over the past two decades, it has taken more than $3 of extra debt – and an increase of about $7.30 in broader financial liabilities – to produce $1 of additional transactional activity.
We can’t possibly win at these odds. A better option, were it feasible, might be to withdraw from the game, tying the rate of liability expansion to changes in the size of the economy – and, at the same time, desist from making implicit pension promises that a contracting real economy can’t possibly honour.
Instead, we carry on the self-delusion, even though the dynamics of the process are loaded against us. Every now and then, some bright spark tells us that, by borrowing now, we can create “growth” (which is true, but only in a statistical sense), and that this growth will then “pay off the debt” that we’ve taken on to create it (which simply isn’t possible, least of all in economies that rely on continuous credit expansion).
SEEDS modelling identifies the two critical equations that interpret our recent economic past realistically, and give us reasonable visibility on what happens next. With these understood, what we need to address is the matter of process.
Each equation requires two charts, and these are shown in fig. 2.
The first chart in fig. 2 shows how both debt and broader financial liabilities – known as ‘financial assets’ from the lender side of the equation – have dramatically out-grown GDP. Meanwhile, reported GDP has been inflated, not just by the ‘credit effect’ described above, but also because no allowance is made for ECoE.
Accordingly, we can plot, in the second chart, a widening divergence between the ‘financial’ metric of GDP and underlying prosperity, as calculated by SEEDS.
This divergence is a comparatively recent phenomenon – in past times, ECoEs were low, and we hadn’t embarked on the massive credit-creation binge that has become a seldom-noticed characteristic of the ‘delusional growth era’.
Back in, say, the 1950s, people weren’t using QE, ZIRP or NIRP, because they didn’t have to. ECoEs were low enough for the economy to deliver ‘growth without gimmickry’. The very adoption of these expedients is testimony to adverse underlying trends that we’ve failed to acknowledge.
The downside between the two economies is currently estimated at 40%, which gives us some idea of the scale at which financial ‘claims’ are likely to be eliminated once the inevitable restoration of equilibrium takes place.
Most forecasters start with GDP and so, to produce projections on a comparable basis, SEEDS segmental analysis accepts the 2021 number (globally, $146tn PPP) as its start-point.
This does not, however, require us to accept the inaccurate statistical narrative of how we arrived at this number. Whilst reported real GDP doubled (+101%) between 2001 and 2021, prosperity increased by only 31% over that same period.
This enables us – as shown in the third chart in fig. 2 – to produce a reconciled trend in economic output, and to see how far this differs from reported numbers, which have been inflated by credit (claims) expansion, and which make no allowance for rising ECoEs.
This in turn enables us to interpret and project – as shown in the right-hand chart – the economy on the basis of the key segments, which are essentials, capital investment (in new and replacement productive capacity) and discretionary (non-essential) consumption.
What happens next
The technicalities of these interpretations and forecasts have been discussed here before, and might be revisited in the future. For now, though, what matters is the outlook itself, and what, if anything, might be done about it.
Starting with the economy, global aggregate output, referenced to prosperity, is heading for a downturn, and per capita prosperity is already declining. Meanwhile, the real costs of energy-intensive essentials are rising.
Accordingly, capital investment is poised to turn down, whilst we should anticipate relentless contraction in the affordability of discretionaries.
This will, probably sooner rather than later, undermine the confidence which investors and lenders place in businesses supplying non-essential products and services. Accordingly, these discretionary sectors will lead the decline in the valuation of assets. This will be accompanied by falls in the real prices of property, as these prices are linked to the metric of affordability, which is declining very markedly.
Though rate rises don’t help, the size of a mortgage that anyone can afford to service depends upon how much he or she has left after paying for necessities.
Assets, though, are less important in this context than liabilities. Asset prices are a function of the availability and cost of money – and money, as we know, is an aggregation of claims on the real economy. What happens now is that the vast burden of excess claims, created during a period of hubristic and futile denial of underlying reality, will be eliminated, either through inflation, through default, or a combination of both.
From the perspective of ‘two economies’, it’s clear than inflation is a function of the relationship between the material and the financial. Prices are the point of intersection in this relationship, because a price is the financial number ascribed to a material product or service.
In real terms, we can’t prop up inflated asset prices, and it would be insane to try to carry on doing so. Neither can we ‘make good’ liability excesses, and any attempt to do so would involve the creation of money at a scale which would invite hyperinflation – which, ultimately, is an alternative, informal version of default.
Asset prices will tumble, then, and commitments won’t be honoured. What we’re left with is an economy in which, just as prosperity is declining, the cost of essentials will carry on rising.
Inequalities are inevitable in any economy, but these inequalities can be expected to combine with deteriorating prosperity to drive ever larger numbers of people into absolute poverty. This makes redistribution inevitable, even though the more privileged will fight this every step of the way.
The only way in which governments can seek moderate the rising cost of essentials is by spending less on public services (which count as essentials for our purposes, as the citizen has no ‘discretion’ about paying for them).
Time to call time on delusion
It would be a good idea if, whenever anyone suggests a financial ‘fix’ – rate rises, rate cuts, QT, QE, debt-funded tax cuts, more debt – we were to ask them to explain how these measures are going to deliver cheaper energy.
This situation doesn’t leave us entirely powerless. We should, for instance, have long since embarked on energy efficiency measures, including the provision of public transport as a counter to the diminishing affordability of cars. Nuclear power offers some scope for supply relief, though it isn’t going to rescue us from energy deficiencies.
But no workable amelioration measures can be crafted whilst our appreciation of the situation remains faulty.
The reality is that we need to concentrate on how to allocate and manage deteriorating prosperity. This has become a less-than-zero-sum game. We should not delude ourselves into believing that we can help some without taking from others.
This becomes a political choice and, many might say, a moral one. Social cohesion depends on facing this reality, and there’s no mileage in denying it, or trying to wish it away by proposing financial gimmicks that can’t work.