#241. Behind the crisis

UNCOVERING THE HIDDEN DYNAMIC

As you would expect, both the mainstream and the specialist media have been giving us minute-by-minute, blow-by-blow coverage of the financial crisis which began with the British government’s 23^rd September “fiscal event”.

Unfortunately, this coverage and analysis is founded on a conventional school of economic thought which insists – rather, simply assumes – that all economic events can be explained in terms of money alone.

This assumption is fallacious. The fact of the matter is that we can immerse ourselves entirely in monetary theories and financial analyses until the proverbial “cows come home” without understanding more than the surface manifestations of the underlying situation.

As a corrective, let’s remind ourselves of something that ought to be self-evident. This is that the economy is a system which delivers those material products and services which together constitute prosperity. Money is simply a proxy for these products and services, a means of exchange and distribution which does not, of itself, determine the availability of this material prosperity.

This ‘money-only’ fallacy delivers false comfort, in at least two ways.

First, it enables us to explain away the current crisis in terms of idiosyncrasies – there’s a surface narrative which assures us that, if we can avoid the kind of bungling in which the new British leadership has become enmeshed, we can similarly avoid the kind of crisis now unfolding in the United Kingdom.

We might, indeed, be persuaded that even Britain can find a way out of this crisis through ‘rationalization’, which, in this case, might mean ‘finding rational people to manage its economic affairs’.

Now that growth has reversed

The second source of false comfort is the mistaken assumption that finding the right blend of fiscal and monetary policies can deliver the nirvana of perpetual growth.

Put another way, the implication is that premier Liz Truss and chancellor (finance minister) Kwasi Kwarteng were right to seek a “growth” elixir, even if they have been wrong about the mechanism for doing so.

This is simply not the case. The economy is an energy system, not a financial one. The entire narrative of the past quarter-century has been one of economic deceleration and deterioration caused by adverse changes in the energy dynamic which determines material prosperity.

Critically, the trend Energy Cost of Energy (ECoE) has been rising relentlessly, a process which, having started by creating “secular stagnation”, has now pushed us into involuntary economic contraction.

Fundamentally, we’re at the end of a long period of rising prosperity built on low-cost energy from coal, petroleum and natural gas. There is, as of now, no like-for-like replacement for the energy value hitherto sourced from fossil fuels.

Whilst we might hope to find a successor to waning (and climate-harming) fossil fuel energy value, three reasonable caveats need be recognized about this hope.

First, it is by no means assured. Second, the resulting economy is likely to be smaller, meaning poorer, than the one we have today. Third, no such transition can happen now, or spare us from the consequences of the fallacious assumption that we can rely on ‘infinite economic growth on a finite planet’.

The fact of the matter is that there are no financial ‘fixes’ for material economic deterioration. Looking for such fiscal and monetary fixes simply piles additional risk onto a global financial system already inflated beyond the point of sustainability.

When the financial dust settles, we will be left with a contracting economy, one in which deterioration in material prosperity is compounded by continuing increases in the real costs of energy-intensive necessities.

Accordingly, what we are witnessing is a process of affordability compression. This has many consequences, of which two are most important. First, the ability of consumers to afford discretionary (non-essential) products and services has entered secular contraction.

Second, the compression of affordability is undermining the ability of the household sector to ‘keep up the payments’ on a gamut of financial commitments ranging from mortgages and consumer credit to staged-purchase schemes and subscriptions.

In short, we can now project a future in which discretionary sectors contract relentlessly – with all that that means for employment, profitability and asset values – whilst the world’s gigantic system of interconnected financial liabilities unravels, with the latter process far likelier to be rapid and chaotic than gradual and managed.

A not-so-simple story

The superficial narrative of the current crisis pins the blame squarely on the new leadership of a single (though sizeable) Western economy.

The conventional story is that Ms Truss and Mr Kwarteng sought to find a way in which Britain could break out of a long period of economic underperformance. They decided to do this by cutting taxes, with the benefits skewed towards the better-off, perhaps in the belief that the much-derided theory of “trickle-down economics” might be valid after all.

These tax cuts, added to the decision to cap energy prices for households and businesses, threatened to create an enormous need to raise money by selling gilts (government bonds) to investors. This problem was compounded, first by the known intention of the Bank of England to unload gilts as part of a QT programme and, second, by the absence of the modelled and reasoned data and projections customarily provided by the Office for Budget Responsibility.

This ill-thought-out package occurred at a time of high inflation, to which it was known that the Bank intended to respond with rate rises and QT.

Markets responded to this ill-considered intervention in two ways, both of which should have been anticipated. First, FX markets sold off sterling, with GBP falling to slightly over $1.03, from levels above $1.22 just a few weeks previously. Second, the gilts market crashed, with yields on the 10Y bond spiking to over 4.5%, from 2% as recently as August.

This produced a toxic combination of expectations. A falling exchange rate would increase the prices of imports, driving inflation higher and, perhaps, forcing the Bank into a programme of accelerated monetary tightening involving rate hikes and QT.

Meanwhile, higher rates would increase borrowing costs, pushing property prices sharply downwards and, in all probability, triggering a wave of defaults on secured, unsecured and business debts.

In the event, nemesis came from a different quarter, with the viability of pension funds put at risk by falls in the value of gilts. It was this consideration which pushed the Bank into panic mode, intervening with a reversion to QE.

Behind the folly

So far, this is – to paraphrase a British radio soap – just “an everyday story of idiot folk”. Britain’s fiscal credibility has been shot to pieces, with one observer referring to the UK as a “submerging economy”. Policy folly has been compounded by a paralyzing sense of utter incompetence, with criticism extended from the executive leadership to the Bank.

Opposition politicians must have struggled to hide their partisan delight behind a façade of grave concern. Conservative MPs seem shell-shocked, worried as much about the prospect of plunging property prices as about marginal constituencies.

As objective observers, we need to look at this in different ways, of which one is specific to Britain, and the other more general. The common factor linking both is the belief in economic “growth”.

The British economy has long been living on borrowed time. The United Kingdom’s economic model is fundamentally flawed. Britain lives beyond its means, covering – but simultaneously exacerbating – its chronic current account deficit through the sale of assets. This is not sustainable, not least because a point is reached at which no saleable assets remain.

An economy thus structured relies on the continuous expansion of private credit. Credit expansion, in turn, requires both lender collateral and borrower confidence, and both have been provided by the inflated prices of assets, principally property.

There is, of course, an inherent contradiction here. On the one hand, the inflation of property (and broader asset) prices requires low and falling borrowing costs. On the other, debt expansion should, all things being equal, drive the cost of borrowing upwards.

Britain had already reached this point, as flagged by inflation, and as recognized by the Bank in its plans to raise rates and undertake QT. Even before 23^rd September, the best that Britain could reasonably hope for was a “soft landing”.

QE, of course, is no more than a temporary ‘fix’. QE might not, at least pre-covid, have created retail price inflation – which is the only part of the pricing process that most observers bother to look at – but it has undoubtedly created reckless asset price inflation.

Both in Britain and elsewhere, systemic inflation – modelled by SEEDS as RRCI – has long been a great deal higher than the broad calculation expressed as the GDP deflator.  

The wider issues

There is, though, a second and broader way in which we need to understand what’s really happening. The central mistake made by Liz Truss and Kwasi Kwarteng was the assumption that there must be some combination of fiscal and monetary policies which could deliver the Holy Grail of “growth”.

Methods and policies may differ, but this belief in the possibility of infinite growth is shared by decision-makers – and corporate leaders, investors and the general public – right across the globe. The whole of the financial system worldwide is entirely predicated on the assumption of growth in perpetuity.

Conventional economics, with its fallacious assertion that the economy is entirely a financial system, fosters and endorses this mistaken assumption.

But the harsh reality is that the economy really functions, not financially, but as a system for delivering material prosperity in the form of goods, services, built assets and infrastructure. Self-evidently, all of this depends on the value obtained from the use of energy.

This isn’t simply a matter of the absolute quantity of energy that can be supplied. Rather, 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.

Driven primarily by depletion, the ECoEs of fossil fuel energy have been rising exponentially. Since oil, gas and coal still account for more than four-fifths of total energy consumption, much the same has happened to overall trend ECoE. This has meant that aggregate prosperity has stopped growing, and prosperity per capita has already turned down.

What this means is spelled out in the following charts. Just as top-line prosperity is falling, the real costs of energy-intensive essentials have been rising (first chart).

The inevitable result is that the affordability of discretionary purchases is falling, a trend that cannot be reversed, and can no longer be disguised by using cheap debt to prop up discretionary spending (second chart).

Financially, our wholly futile efforts to ‘fix’ material economic problems with financial expansion have created gigantic commitments which the economy of the future will be wholly unable to honour (third chart).

Lastly, the ‘financial’ economy of money and credit and the ‘real’ economy of energy-determined products and services have diverged, creating downside that the SEEDS economic model calculates at 40% (fourth chart).

This disequilibrium – rather than the ‘mistakes of incomprehension’ made at the national level – is the real explanation for the crisis into which, with utter inevitability, the world has now been pitched.

Fig. 1

#240: Trussed for the block?

BRITAIN’S DESPERATE ECONOMIC GAMBLE

New British premier Liz Truss, and her chancellor (finance minister) Kwasi Kwarteng, have embarked on a gigantic economic gamble. If it succeeds, it will surprise, not just “trickle-down”-averse Joe Biden, but everyone who understands the realities of post-abundance economics.

If it fails, it’s likely to induce a “Sterling crisis”, with disastrous consequences for the costs of imports, and of servicing debts denominated in foreign currencies.

The verdict on this gamble will be passed, not by the voters, but by the currency and gilts (government bonds) markets. So far, a few hours after the chancellor’s statement, it’s not looking good, with Sterling down to just above $1.10. Investors are understandably reluctant to buy a pig in a poke, particularly when a detailed price-tag hasn’t been attached to it.

Many things are extraordinary about this gambit. It’s not new, of course, for governments to prioritize the greedy over the needy, but they are seldom quite so brazen about it. The Truss administration seems to be at war with permanent officials, and has already sacked the senior civil servant at the Treasury. For the first time since the Office for Budget responsibility was created back in 2010, the advice of the OBR has not been sought, and its economic and fiscal forecasts have not been published.

This site doesn’t ‘do’ party politics, still less the politics of personality, and our focus is on the economy understood – as it should be – as an energy system. But we’re entitled to comment when the government of a major Western economy takes extraordinary risks in pursuit of objectives that aren’t feasible, using policies that aren’t credible.

The Truss government has nailed its colours to the mast of economic “growth”. There are two main planks to this platform. One is the contention that, by borrowing now, an economy can generate enough growth to pay off, in the future, the additional debt incurred in the present. The second is that hand-outs to the better off will percolate through to benefit the less fortunate.

On the latter, Mr Biden has remarked within the last few days that he is “sick and tired of trickle-down economics. It has never worked”. It’s noteworthy that the term “trickle-down economics” is never used by those who advocate it, for the sufficient reason that it’s utter gobbledygook.

Mention of America, though, should remind us that Ms Truss, like her predecessor Mr Johnson, has no misgivings about antagonising Britain’s allies and trading partners. Mr Biden has already made it clear that a trade deal between Britain and the United States – the trophy promised and sought by so many supporters of “Brexit” – isn’t going to happen. The UK seems quite prepared to antagonize the EU – and, again, the White House – by reneging on a treaty determining trade arrangements affecting Northern Ireland.

Political analysts might observe, in this situation, a transference of weakness from party politics to national economics. Liz Truss’s own political fragility is being parlayed into worsening the economic and financial fragility of the British economy.

Ms Truss was not the preferred candidate of Conservative MPs, whose own choice was Rishi Sunak. Her ministerial changes have sent a large cadre of the disaffected to the back-benches. She owes her elevation to party members, a tiny and unrepresentative sliver (0.2%) of the British public. Many, even of those, might have preferred to reinstate Mr Johnson if his name had been on the ballot.

If there’s a Tory precedent here, it’s Benjamin Disraeli (1804-81). His great triumph, the Reform Act of 1867, was achieved by outflanking Mr Gladstone’s Liberals from the left. This seemingly left voters baffled by the difference, if any, between “Dizzystone and Gladraeli”. He may or may not – but it was in character – have said to a dissenting MP “damn your principles! Stick to your party!”. On his elevation to prime minister in 1868, he was wont to say that he had “reached the top of the greasy pole”, the big challenge now being to stay there.  

From an economic perspective, the problem with the new economic gambit is that it’s impossible – in Britain, or anywhere else – to buy growth with debt to a point at which the expanded economy then pays down the incremental borrowing.

Between 1999 and pre-covid 2019, the UK economy expanded by £0.72 trillion whilst increasing aggregate debt by £2.9tn. An equation in which each £1 of borrowing yields less than £0.25 of growth makes it impossible to a pull a rabbit of solvency out of the top hat of debt.

Analysis undertaken using the SEEDS economic model shows that, between 2001 and 2021, British real GDP increased by £560bn (at constant 2021 values) whilst debt soared by £2.93tn, a borrowing-to-growth ratio of 5.22:1. Within the “growth” reported over that period, fully 69% was the purely cosmetic effect of pouring so much extra credit into the system. Reported growth may have averaged 1.8% annually over that period, but annual borrowing averaged 7.2% of GDP.

Organic growth – calculated here as underlying or ‘clean’ economic output (C-GDP) – averaged only 0.6%, rather than 1.8%, through that period. This rate of underlying growth in economic output was less than the trend increase in population numbers (0.77%) through those same years.

Fig. 1

When we further factor-in rises in the Energy Cost of Energy (ECoE), it emerges that British prosperity per capita topped out in 2004, at £27,900 per person, and had, by 2021, fallen by 10%, to £25,090.

At the same time, the estimated real cost of essentials has been rising, even before the recent surge in energy prices. As you can see in the left-hand chart in fig. 2, the average British person is subject to relentless affordability compression. This is reflected in the second chart, which plots relentless contraction in the affordability of discretionary (non-essential) purchases.

This ‘affordability compression’ can be expected to undermine the ability of households to ‘keep up the payments’ on everything from mortgages and credit to staged payments and subscriptions. This is particularly important in an economy extensively leveraged to the global financial system. Despite some contraction in the aftermath of the global financial crisis, British financial exposure remains enormous. When last reported at the end of 2020, financial assets – the counterparts of the liabilities of the household, business and government sectors – stood at 1262% of GDP, far higher than the United States (588%), the Euro Area (795%) or Japan (871%).

Fig. 2.

We need to be clear that SEEDS analyses of other Western economies display, for the most part, patterns that are not dissimilar to those of the United Kingdom. As a direct result of relentless rises in ECoEs, Western prosperity turned down well before the 2008-09 global financial crisis (GFC). The idea that a deterioration in material prosperity can be countered with financial innovation has been a delusion shared by governments around the world.

Where Britain is different is in the government’s preparedness to gamble, and to insist that political will can triumph over economic reality. Though subjected to much criticism, the Bank of England has been doing its best to persuade the international markets that Sterling remains an investment-grade currency, despite the reckless behaviour of its bosses in Westminster. The Bank knows, as the government seemingly does not, that the economic viability of the United Kingdom rests on the credibility of its currency.

The probability has to be that the Truss administration’s gamble will fail. As well as not putting a price-tag on the full-year cost of its energy support programme and its generally regressive tax cuts, nothing has been said about public spending, particularly on health and defence.

What Mr Kwarteng offered the markets today was an un-costed exercise in bluster. The probable consequences are, at the least, weaker Sterling, costlier imports, rising rates and – irony of ironies, where Conservative supporters’ priorities are concerned – falling property prices.

The full consequences won’t be known until it’s clear how much the government needs to borrow, whether investors are willing to lend to it and, if so, at what price.

#239: Life after liberalism?

THE CESSATION OF GROWTH CHANGES EVERYTHING

There can be no doubt at all that the global economy is in very bad shape. For some, this portends a general “collapse”. This, however, presupposes that we don’t adapt to new conditions, and that we don’t learn from past mistakes. We have a pretty solid history of doing exactly that, even if we only arrive at the right conclusions after trying all of the wrong ones first.

Of course, to adapt to new conditions, and to learn from mistakes, we need to know what these conditions and these mistakes actually are. Conventional interpretations of economics are failing us through an inability to provide the information required for this understanding.

The view set out here is that we do have a greatly enhanced understanding of how the economy works. Orthodox economics may continue to cling to precepts first laid down in the eighteenth century – essentially, that the economy can be understood in terms of money alone – but broader thought has moved on, spurred by energy shortages, by environmental concerns, and by recognition that the ‘perpetual growth’ promised by the orthodoxy simply isn’t happening.

The big challenges now are two-fold. The first is to adapt society to an economy that, having ceased to grow, has now started to contract. The second is to redesign a financial system that is exposed to failure because it has been wholly predicated on the fallacious notion that the economy can expand in perpetuity.

Politics isn’t entirely a matter of economics, but it’s very nearly so. Socialist, social democratic, conservative, ultra-‘liberal’ and all other strands of political thought are all founded on particular conceptions of the economy. As Robert Lowe (1811-92) put it, politics is a contest “between those who have – to keep what they have got; and those who have not – to get it”.

Political parties might be described as ‘combinations of economic thought and self-interest’. In practical terms, what this means is that the invalidation of a party’s economic proposition reduces its platform to one of pure self-interest.

For example, politicians in the USSR might have been sincere believers in Marxist-Leninist economic dogma, but they would also have been cognisant of the privileges of Soviet leaders and officials. Likewise, even purist believers in extreme ‘liberal’ economics are not uninfluenced by the rewards that this ideology can provide, not just to its leaders but to its supporters as well.

Contemporary economic liberalism is founded on the proposition that unfettered markets best serve the public interest. As a principle, this is soundly rooted in Adam Smith. Economic liberalism is not threatened by an invalidation of the principle of competition.

But it is challenged on two other fronts.

One of these is the presumption that the economy can be understood in entirely financial terms, and is, on this basis, capable of delivering growth in perpetuity. The unravelling of classical, ‘money only, growth forever’ economics will thus be detrimental to the “liberal” economic proposition.

The other is the claim that, if “liberalism” isn’t very good at delivering equality, at least it compensates for this deficiency by delivering “growth”. As prior growth ceases and goes into reverse, this plank of the liberal economic platform will fail. The public will be left with ‘the inequality without the growth’.

We don’t yet know what political ideas and systems will emerge as we endeavour to address a contracting economy and a failing financial system. But we can be pretty sure that the future ascendancy won’t endorse economic ‘liberalism’.

In other words, a ‘post-growth’ economy will produce ‘post-liberal’ politics.

The duality of prosperity and money

A critical point about economic interpretation, as it’s understood here, is the conceptual distinction that needs to be drawn between two economies. One of these is the ‘real’ economy of goods and services. The other is the ‘financial’ economy of money and credit.

The principles underpinning this interpretation are simplicity itself. The first is that the economy which provides products and services is a material system, determined by the use of energy.

The second is that money, having no intrinsic worth, commands value only as a ‘claim’ on the output of the material economy.  

With this distinction drawn, a realistic appraisal is that, whilst the material economy of energy has ceased growing, the proxy economy of money has carried on expanding. This implies that, whilst economic deterioration may be manageable, the financial system is no longer fit for purpose, and will need to be re-designed.

Much the same applies to economic and political thinking. Extreme collectivism has been tried, and has failed. Extreme liberalism has now reached its equivalent point of failure.

Both of these failed extremes have been rooted in a particular view of the role of the market. For collectivists, the market doesn’t matter, and the economy can be operated on the basis of central diktat. This set of ideas failed in the Soviet Union and, prior to the Deng reforms, was failing in China.

The other extreme is the assertion that the market is all-important. Theoretical liberalism worships the market in much the same way that theocracies worship a deity – that is to say, extreme liberalism isn’t open to doubt about the principle that the market is all-important.

On the shoulders of giants

The irony here is that economic ideologies are variously rooted in things that great thinkers – such as Smith, Marx and Keynes – didn’t actually say. Marx, at least, knew as much, famously stating that “I am not a Marxist”.

The fallacies based on a misreading of Marx are not our priority here, because the unfolding event now is the failure of a ‘liberal’ economic ideology which claims to be based on the precepts of Adam Smith.

In this narrative, Smith is portrayed as a worshipper of the market, an advocate of uncontrolled market operation and an opponent of ‘the public sector’.

The snag is that this caricature misrepresents what Smith actually said.

Smith’s great understanding is that the market operates as a ‘hidden hand’, advancing the general good through the pursuit of individual aims. The public is provided with bread, for instance, not through the altruism of bakers, but through their striving to make a profit.

That is, the operative process driving economic betterment is competition. This remains a wholly valid conclusion.

From this, though, it follows that competition must be allowed to operate unfettered, a principle that we might summarize as markets that are ‘free and fair’.

For Smith, state intervention wasn’t at the top of the list of potential fetters to the beneficial working of the market. This is hardly surprising, because Smith wrote at a time when the state was very small indeed, and when the term ‘the public sector’ was not yet in use.  

Rather, the potential threats to free and fair competition existed, for Smith, in the realm of manipulation. The same competitive incentive that could promote the effective operation of the economy could also lead to self-serving distortion. Smith’s strongest invective is saved, not for the state, but for those market participants who strive to impose distortions, such as monopolies and oligopolies.

In short, Smith did not believe that markets could be free and fair if they were left to their own devices.

In modern terminology, we can state that Smith was an opponent of excessive market concentration and an advocate of effective regulation. Along the lines of “I am not a Marxist”, Smith might, had he lived long enough, have said that ‘I am not a deregulator’.

Effective markets are orderly, not a caveat emptor free-for-all, and they won’t stay free, fair or effective without supervision. The state is the only plausible provider of this supervision.

The realm of the material

The other thing to note about Adam Smith is that he was writing in a pre-industrial society. His master-work, The Wealth of Nations, was published in the same year (1776) as James Watt’s completion of the first truly efficient steam engine.

At the dawn of the industrial age, it would have been impossible for Smith – or Watt – to conceive the concept of resource limits as these are understood today. Where scarcity was recognized, it was scarcity of land, and of labour. The concept of energy or environmental limits could not be understood until we started to experience both.

Explaining the critical importance of the market under conditions in which the concepts of resource and environmental scarcity did not exist, Smith can be said to have laid the foundations for an economic orthodoxy which portrays the economy as a wholly financial system.

A big part of our problem today is that conventional economics hasn’t moved on from a perception which, after all, was laid down 250 years ago.

In numerous other fields of thought, ideas have moved on from precepts which have been challenged by subsequent events. Life scientists and technologists don’t insist on the observance of statements made in 1776.

But economics hasn’t moved with the times. The presumption remains that the economy can be understood in financial terms alone.

Unlike Adam Smith, we live in an energy-intensive economy. Aside from a few mills driven by water or wind, the dominant source of energy in his times was human and animal labour. This had been the case for millennia, so Smith can hardly be blamed for not knowing that this was about to change.

Today, we know that the supply of products and services is a function of the use of energy. If we didn’t know this before, recognition has been forced upon us by events, not just by the current energy crisis but by the events of the 1970s as well.

Even before the oil embargoes of the seventies, the centrality of energy to economic processes should have been obvious. For example, energy deficiencies drove Imperial Japan to fight a war with the United States, and American resource supremacy ensured the outcome. The aircraft, ships and tanks that helped win the war could not have been supplied without the then resource wealth of the American petroleum industry.

Conclusions about the critical importance of energy were expounded as long ago as 1957, by Admiral Hyman G. Rickover, USN, the “father of the nuclear submarine”. One of his observations should resonate particularly with anyone who understands the economy as a surplus energy system:

“Possession of surplus energy is, of course, a requisite for any kind of civilization, for if man possesses merely the energy of his own muscles, he must expend all his strength – mental and physical – to obtain the bare necessities of life” (my emphasis).

The emergence of constraints

We now know, then – as Smith could not – that the economy is a surplus energy system. We also know about the environmental issues associated with the use of energy. This knowledge should enable us to understand that all other materials – including food, minerals, plastics and even water – are products of the energy used to supply them.

Rather than adopt these realities – and to accept, as Admiral Rickover said, that “the Earth is finite” – orthodox economics has jumped through hoops in its insistence that infinite growth is made possible by the wholly financial character of the economy.

The principal plank of this platform is the assertion that demand creates supply – if sufficient financial incentives are provided, there is nothing that the market cannot deliver. If this is taken as a universal proposition, though, the implication is that financial demand stimulus can supply physical resources, of which the most important – the ‘master resource’ – is energy.

The hard facts of the matter are contrary to this proposition. The reality is that no amount of demand stimulus, and no increase in price, can produce anything that does not exist in nature.

It may be true that consumer demand can promote the supply of artefacts. If consumers want a new generation of smartphones, industry will supply them.

So far, so good. But, in a material economy, consumer demand is rooted in prosperity, whilst the ability of industry to respond to demand is dependent on the availability of resources.

The second line of defence for the ‘demand produces supply’ orthodoxy is substitution, meaning that, if a particular raw material is in short supply, market forces will combine with ingenuity to deliver an alternative.

This proposition is now being subjected to the stiffest possible test. An economy built on coal, oil and natural gas is being undermined by scarcity- and depletion-driven rises in fossil fuel costs, and by the worsening environmental consequences of fossil fuel reliance.

To pass this ‘test of substitution’, we would need to be able to transition from fossil fuels to renewables without economic contraction. We have discussed the implausibility of “sustainable growth” on previous occasions, so all that needs to be said here is that full value transition seems extremely unlikely.

In short, we probably can create a sustainable economy built on renewables, but this sustainable economy is going to be smaller – meaning less prosperous – than the economy that has built on fossil fuels.

Past falls in the costs of renewable energy cannot be extrapolated indefinitely, because physics dictates efficiency limits at the level of the individual wind turbine or solar array. Contrary to widespread supposition, technology operates within the parameters of physics, and cannot overcome those restrictions.

If we can’t overcome these limits to efficiency, what remains is a scale issue. If we can’t make wind turbines, solar panels or batteries that have infinite efficiency potential, then we need to build vast numbers of them to enable transition.

And this is where circularity comes into the equation. To build huge numbers of turbines, panels and batteries, we need correspondingly vast quantities of raw material inputs, including steel, concrete, copper, cobalt and lithium. Where these materials exist at all in the requisite amounts, their delivery is a function of the energy required to supply them.

For the foreseeable future, the availability of these resources depends on the legacy energy of fossil fuels. It’s not inconceivable that, at some future point, we may be able – for example – to extract, process and deliver copper, or steel, using renewable energy alone.

The problem with this isn’t feasibility, but efficiency. Renewables may replace fossil fuels in purely quantitative terms, but they can’t replicate the characteristics of oil, natural gas and coal. Oil, in particular, is energy-dense, storable and portable to an extent that electricity cannot match.

A troubled outlook

In past discussions, the SEEDS economic model has been used to provide projections for the scale and composition of the economy of the future. Rather than revisit these forecasting processes, let’s summarise what the key points are.

First, material prosperity will decline, because of the implausibility of replicating the energy value (and, for that matter, the energy flexibility) hitherto provided by fossil fuels.

Second, the real costs of energy-intensive necessities will continue to increase, as a consequence of this same energy dynamic.

Accordingly, the affordability of discretionary (non-essential) consumption will be subjected to relentless compression, as will the affordability of investment in new and replacement productive capacity and infrastructure.

These are the material or ‘real economy’ consequences of a deteriorating energy dynamic.

But there are financial, social and intellectual implications as well. The financial system is wholly predicated on perpetual economic growth. As this precept turns out to be fallacious, the financial system will need to be redesigned on very different assumptions. It’s hard to see how the existing financial system can give way to a new one without extreme trauma.

Intellectually, we should be prepared for the failure of an economic orthodoxy that has been created over more than two centuries of virtually continuous economic growth. Ideas are, to a considerable extent, products of their times and conditions. It’s no surprise that conventional economics has endeavoured to explain the growth that was visible to all participants in the process.

Hitherto, growth hasn’t stopped because of our inability to explain it effectively. Just as economists have developed financial theories about growth, the energy dynamic has carried on delivering growth itself.

In other words, the intellectual challenge has shifted, from explaining the presence of growth to explaining its absence.

Politically, the need to reinterpret the economy will undercut the political platforms of parties whose precepts are based on the old consensus of perpetual expansion driven by financial management.

Economically ‘liberal’ political movements are particularly exposed to this unfolding process. Their central assertion is that we need to accept the deficiencies of the market system – with inequality the most obvious such deficiency – because liberal market economics can be relied upon to deliver growth.

If this claim is invalidated – along with every other thesis founded on perpetual growth – any party which relies upon it faces the invalidation of its central principle.

Absolute monarchy, for instance, failed when the public ceased to believe in the divine right of kings, and when monarchs failed to deliver prosperity. This intellectual-material axis was at the heart of the French Revolution, a product both of new ideas and of hardship.

If economic liberalism is going to be seen as delivering inequality without the compensating benefit of material improvement, then its day has passed.

The task now – of finding an intellectual and political replacement for liberalism – is as challenging as the designing of a post-growth financial system.