#243. The Great Inflexion

A SYSTEM UNRAVELS

INTRODUCTION

As everyone surely knows by now, the global economy has entered a recession which is likely to be both severe and protracted. For the most part, governments and central bankers are concentrating on the task of trying to tame inflation.

Their critics tend to argue for more expansionary fiscal and monetary policies, contending that stimulus could soften or shorten the recession. They claim, in defiance both of experience and of logic, that expansionary monetary policies needn’t contradict the effort to bring inflation under control.

Where almost everybody is in agreement is that, however long it takes, the recession will end. But there’s a striking absence of explanations for how or why growth is supposed to resume. The fall-back position is no more than an assumption – a recovery will arrive for no better reason than that all previous economic downturns have been followed by rebounds.

The underlying presumption here is cyclicality, a process accepted as routine, not just by policy-makers and central bankers, but by investors, business leaders and the general public alike. It is well understood that the Big Numbers – like economic output, and the aggregate value of the markets – oscillate in sine-wave patterns around central trends.

It’s further assumed that these secular trends are always positive – each recovery exceeds the preceding recession, and each market rebound more than cancels out the latest dip.

This latter assumption has reached the point of invalidation. What economies and markets are now experiencing is trend-inflexion. Cyclicality may indeed continue but, from here on, it will do so around downwards-inflected trends. This process of reversal can only be managed if it is recognized.

The consequences of trend inflexion are readily summarised. On an ex-inflation basis, economic output will deteriorate, whilst the real costs of necessities will carry on rising, even if there are some retreats from the severe spikes experienced in recent times.

The resulting process of affordability compression will drive contraction in discretionary (non-essential) activities. It will also undermine financial flows from households to the corporate and financial sectors. We can anticipate a rolling process of investment contraction, business failures, defaults and rising unemployment.

Asset prices can be expected to fall, though the real risk to the financial system is on the liabilities side of the ledger. None of this is necessarily unmanageable, but its disruptive potential is enormous.

Beyond having to explain why the anticipated recovery has failed to arrive, governments will be under pressure to help out with the cost of living, and can anticipate increasing demands for redistribution. There will be a strident chorus of advocacy of looser monetary policy, risking a breakdown in the resolve to tackle inflation.

Before we get into the processes driving trend inflexion, it’s worth remarking that if, to many people, this recession starts to feel more severe and more unpleasant than any downturn in their previous experience, that’s because it is.

A SYSTEM IN FLUX

Understanding trend inflexion requires appreciation of how the economy really works, and this, needless to say, cannot be gleaned from orthodox economics, for which infinite growth is an article of faith. This is based on a seemingly unshakeable conviction that the economy can be explained in terms of money alone, a line of argument which dismisses any possibility that there are material limits to economic expansion.

This, of course, isn’t how the economy actually works. There are very real limits, not just to material prosperity but to environmental and ecological tolerance as well.

In a descriptive rather than a pejorative sense, the modern economy is a dissipative landfill system. Energy is used to convert raw materials into products, of which the vast majority are quickly relinquished, generally into landfill. This is a dissipative process because it operates by converting dense or concentrated energy into diffuse forms, essentially waste heat which, in a carbon-based economy, includes climate-harming gases.

The commercial economy has evolved in tandem with this dissipative landfill model. This is why there’s little mileage in supplying consumers with products that will last for decades, and plenty of profit to be made by accelerating the cycle of creation-disposal-replacement.

The dissipative process at the heart of the system is unravelling because access to concentrated energy is in retreat, and has been over a lengthy period. The economic value of concentrated energy is determined by an equation in which the conversion of energy into total worth is offset by the cost of doing so. This cost is known here as the Energy Cost of Energy. ECoE recognizes the fact that, whenever energy is accessed for use, some of this energy is always consumed in the access process.

As the ECoEs of oil, natural gas and coal have risen as a consequence of depletion, underlying growth has deteriorated along a trajectory that leads to contraction in the dissipative landfill system. Though nuclear and hydroelectric power may play an important role in providing alternatives to fossil fuels, the general assumption is that most of the energy of the future will be sourced from renewables, primarily wind and solar power.

Transition to renewables is not just possible, but imperative. The economy, no less than the environment, is at grave and worsening risk unless this happens. Sustainability is a worthy goal, and there’s no reason why it shouldn’t be an attainable one.

Where this logic breaks down is at the point at which transition is spun, not as sustainability, but as “sustainable growth”.

This latter claim isn’t feasible, for a very simple reason – renewables cannot match the energy density of oil, gas and coal. As a result, a transition to renewables will truncate the process of diffusion which is central to the dissipative landfill economic system.

The characteristic of lesser density shows up right across the application of renewables. Despite widespread assurances to the contrary, the processes of renewables generation cannot be transformed by technological advances, because the potential of technology is bounded by the laws of physics.

The potential efficiency of solar energy is determined by the Shockley-Queisser Limit, with Betz’ Law doing the same for wind power, and best practice is already close to these physical maxima. Intermittency is part of the low-density character of renewables, and no advance in technology is going to enable batteries to match the power-to-weight ratio of the humble fuel tank.

In the absence of transformative technologies, the heavy lifting of transition is going to have to be done by volumetric expansion. This requires enormous quantities of concrete, steel, copper and other raw materials, and these can only be extracted, processed and delivered – where they exist at all in the requisite quantities – using legacy energy from fossil fuels.

Since the same unit of energy cannot be used twice, the question becomes one of what other energy uses are going to be relinquished to make this energy available for transition. We could, in theory, drive less, fly less, consume less and consign less to landfill, but there, is as yet, no acceptance of a need to do any of this.

None of the foregoing should be read as scepticism about the transition to renewables. There are compelling environmental and economic imperatives for committing maximum effort to transition, and there is no reason in principle why sustainability should not be accomplished.

An essential first step might be to drop, or at least water down, claims that transition can provide affordable growth, because this isn’t possible where the concentration of energy inputs is decreasing.  

CONSEQUENCES

The unfolding process of contraction is going to have a series of identifiable adverse effects, and it’s far better that we model them than resort to either guess-work or denial. Aggregate economic output, which has been decelerating over an extended period, is now very close to its point of inflexion. Prior growth in material prosperity, which is defined here as output minus ECoE, has already gone into reverse. In per capita terms, both output and prosperity have already turned down.

At the same time, the real costs of energy-intensive necessities are rising. The net effect is affordability compression. This, as remarked earlier, has two principal consequences. First, the ability of consumers to afford discretionary products and services is in retreat, and cannot be expected to return to growth.

Second, we should be prepared for contraction in the streams of income which flow from households to the corporate and financial sectors. Put colloquially, people will find it ever harder to ‘keep up the payments’ on everything from mortgages and credit to subscriptions and staged-payment purchases.

Readers who are so minded can decide for themselves what constitutes a discretionary or a stream-of-income sector. A question often asked here – the issue of timing – can now be answered, because trend inflexion has already started. Asset prices must correct as the underlying economy contracts, but we need to be in no doubt at all that the real threat to the financial system exists on the liabilities rather than the assets side of the equation.

Properly understood, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the ‘real’ or material economy. Monetary expansion can increase these claims, but governments, central bankers and the commercial banking system cannot create low-cost energy – or any other component of the material economy – out of the ether.

Prices, as financial values ascribed to material products and services, are at the interface between the ‘real’ economy of goods and services and the ‘financial’ or proxy economy of money and credit. We cannot expect to understand inflation, let alone manage it, until the reality of this relationship is appreciated.

Money, as a claim on products and services, is in reality, a claim on the energy required to make them available. Likewise, debt, as a ‘claim on future money’, is really a claim on future energy. Accordingly, as the dissipative energy system contracts, an increasing number of forward financial claims will be invalidated. It might be contended that, if we decided to allow inflation to run hot, we may be able to ‘inflate away’ part of our enormous mountain of debt and quasi-debt. But this wouldn’t work unless we could somehow curb the creation of new liabilities, and such curbs are irreconcilable with high inflation. In any case, debt elimination through inflation simply transfers losses from borrowers to lenders.

In the previous article, we looked at the mechanics of economic contraction, and these and other issues can be revisited in the future. For now, the following charts illustrate some of the most pertinent aspects of SEEDS interpretation.

Critically, mistaken interpretation of past trends has fostered unrealistic expectations for the future, illustrated here for overall economic output and for discretionary affordability. This leads to policy-makers, businesses and investors planning for a future that isn’t going to happen.

Systemic inflation has long been understated in orthodox data, leading to assertions that inflation ‘has been low’ despite the creation of the enormous “everything bubble” in asset prices. Although systemic inflation – measured here as RRCI – now exceeds 9%, this can be expected to trend downwards, with continuing increases in the real costs of necessities being offset by deflationary pressures in discretionary sectors and in asset markets. This, of course, assumes that the authorities continue to turn a deaf ear to siren calls for them to relax their concentration on defending the purchasing power of money.  

Fig. 1