GROWING, GROWING, GONE
After more than two centuries of expansion, the global economy has inflected into contraction, meaning that prior growth in material prosperity has gone into reverse. By 2040, aggregate prosperity is projected to be 13% lower than it was in 2019, implying that the prosperity of the world’s average person will have fallen by about 26% over that period.
Meanwhile, his or her real cost of energy-intensive essentials is likely to have risen by around 40% in real terms, except that the definition of ‘essential’ will have to have been changed in order to keep that number within the upper limit set by prosperity. Discretionary (non-essential) consumption will have collapsed.
The financial system, as it is currently understood, will have disappeared, the presumption being that a slimmed-down, more strictly-functional alternative will have taken its place. The process of financial implosion may involve runaway inflation, a cascade of defaults or, more probably, a combination of both.
What this means in social and political terms lies outside the scope of Surplus Energy Economics, but it seems unlikely that current arrangements, which combine pockets of affluence with widespread and worsening hardship, will still be in place.
It is, of course, sometimes easier to predict longer-term outcomes than more immediate events. In mid-1942, for instance, the objective observer might not have known that the Wehrmacht was going to lose the Battle of Stalingrad, but the ultimate defeat of the Axis powers was already highly probable.
As it applies to economics, this means that what will happen is a great deal clearer than when it will happen. If someone was about to take a very long holiday, not returning until 2040, he or she could work out which investments to ditch, which forms of value to accumulate, which national economies to avoid and, quite possibly, where to place a proxy vote in order to be on the winning side of elections taking place in 2040.
Since taking a seventeen-year vacation is outside the bounds of possibility for most of us, what we have to do is muddle through, but how effectively we can do this depends on how much visibility we have over the unfolding trends of the future. What we really need is a single key to unlock the mystery of forward events as their precursor trends exist in the present.
This key already exists. I first referenced it in Life After Growth, published almost ten years ago. It’s the concept of two economies.
Comes the day
If the day ever dawns when economics is taught rationally, the first item on the school or college curriculum will be the concept of ‘two economies’. One of these is the real (or ‘physical’) economy of material products and services. The other is the financial economy of money and credit.
There is an incontrovertible logic which informs this distinction. Money has no intrinsic worth, but commands value only in terms of the material things for which it can be exchanged. First-year students of the future might be taught this by being asked to picture themselves adrift in a lifeboat, or stranded in a desert. In such situations, no amount of money would be of the slightest value to them, and it wouldn’t matter if this money was fiat currency, bullion, gemstones, cryptos or even, for that matter, cowrie shells.
In other words, the financial economy is a proxy for the real economy, just as money and credit are proxies for the products and services for which they can be exchanged.
Anyone who understands the conceptual distinction between the material and the monetary is in a fair way towards knowing how the economy has evolved in the recent past, how it functions in the present, and what’s likely to happen to it in the future. Anyone who does not grasp this distinction, on the other hand, has embarked on the intellectual equivalent of G.K. Chesterton’s journey “to Birmingham by way of Beachy Head”.
The what and where of inflation
The reality of the two economies is playing out with particular force right now, and nowhere more obviously than with inflation. A ‘price’, logically considered, is ‘a financial value attached to a material product or service’. Prices, in other words, are the interface between the material and the financial economies. Accordingly, inflation or deflation – defined as rises or falls in prices – are functions of changes in the relationship between the material and the monetary economies.
This tells us something of great importance. We can understand the mechanisms of prices and inflation if we study the two economies, calibrate them separately, and examine the relationship between them. Conversely, we will never reach a full understanding of inflation unless and until we look at things in this way. It is, of course, pretty difficult to measure something, let alone manage it, if you don’t really know how it works.
Some aspects of this relationship are illustrated in the first set of charts, all of which present global numbers calculated by converting other currencies into constant dollars using the PPP (purchasing power parity) convention.
Between 2001 and 2022, reported world real GDP – a proxy for the financial economy – expanded by 109%, a compound annual rate of growth of just short of 3.6%. Material prosperity, by contrast, grew at an annual rate of just 1.2% between those years, increasing by only 30% between 2001 and 2022.
This means that underlying inflation – which the SEEDS model measures as RRCI, meaning the Realised Rate of Comprehensive Inflation – averaged 4.2% between those years, far higher than the 1.9% reported as the GDP deflator. To be clear, what SEEDS calculates as RRCI is the underlying or real rate of conversion between nominal economic transactional activity and the generation of material economic value over time.
Fig. 1
It’s probably a reasonable assumption that you wouldn’t be reading this article unless you knew, or at least suspected, that there’s something seriously amiss with the way in which issues are presented to us using the methodologies of orthodox economics. It seems an equally fair assumption that you’re interested in discovering how events are likely to develop on the basis of the system properly understood on the basis of the ‘two economies’ of the material and the monetary.
It will, no doubt, have occurred to you that, if we can calibrate the material and monetary economies as distinct entities, we can measure, not just the pricing relationship between them at any given time, but the degree of tension or stress between the two of them as well.
Likewise, the existence of ‘two economies’ makes it perfectly feasible for different people to have different experiences, depending upon which of the two economies – the monetary or the material – determines their circumstances.
This is why the same national economy can contain pockets of affluence within a broader landscape of hardship and decay.
The material economy – heading into contraction
Let’s start our analysis by looking at how the ‘two economies’ function. The ‘real’ economy is simply described – it uses energy to convert raw materials into products, and also uses energy to provide physical services to consumers. Historic analysis reveals a remarkably consistent and linear relationship between the amount of energy used in the economy and the quantity or ‘output’ of goods and services produced.
Actually, there are two dimensions to the generation of economic value using energy. One of these is output, meaning the quantitative supply of products and services into which energy is converted. The other is prosperity, and the difference between the two is the deduction of the cost of energy supply. This cost is defined here as the Energy Cost of Energy (ECoE), meaning ‘that proportion of accessed energy which, being consumed in the energy access process, is not available for any other economic purpose’.
This definition identifies a three-part equation determining the evolution of prosperity over time. To measure prosperity, we need to know (a) how much energy will be available at any given moment, (b) the rate at which this energy is converted into material economic value, and (c) the cost deduction which is the difference between output and prosperity.
Three observations assist us in this calculation. First, the conversion ratio between energy use and the value of economic output has been strikingly consistent for a very long time. Second, ECoEs evolve comparatively gradually, for reasons which are well understood. Third, the qualitative (cost) profile of energy exerts a significant influence of the quantitative availability of primary energy.
Let’s briefly review these parameters, referring to the charts shown in Fig. 2. Over a long period stretching back to 1980, the relationship between energy consumption and underlying or ‘clean’ economic output (C-GDP) has been remarkably consistent (see Figs. 2A and 2B).
Overall ECoEs have been rising relentlessly, a trend that is unlikely to change, given the lesser density of (and the associated complications with) wind and solar energy in comparison with fossil fuels (Fig. 2C).
This upwards trend in ECoEs makes it increasingly difficult to strike energy prices that meet the needs of both suppliers (whose costs are rising) and consumers (whose prosperity is decreasing). Accordingly, the likelihood is that the aggregate supply of energy to the economy will decrease, with the availability of fossil fuels falling more rapidly than the supply of renewables can be expanded to replace them.
Prior evidence suggests that there’s unlikely to be any major change in the ratio by which energy consumption is converted into economic value. Therefore, we can anticipate a relatively gradual, quantity-related decline in top-line economic output, but a more rapid contraction in the generation of prosperity, with rising ECoEs widening the gap between the two (Fig. 2D).
Fig. 2
The financial economy – scope for self-deception
As we turn from the ‘real’ economy of products and services to the ‘financial’ economy of money and credit, there are two points that we need to note. First, orthodox economics doesn’t recognize the distinction between the monetary and the material, regarding the latter as nothing more than a function of the former. Anyone finding this oversight hard to believe need only reflect on the absurdity of the promise of ‘infinite growth on a finite planet’ proclaimed by a conventional school of economic thought which dismisses the very concept of material limits.
Second, two centuries of economic expansion have been more than enough to create a culture of hubris and entitlement. We are, then, as unable to contemplate the concept of economic limits as we are, perhaps, to grasp the concept of an infinite universe.
The primary metric used in orthodox macroeconomics is gross domestic product. GDP, we are told, measures national or global economic output, and, by inference, also measures material prosperity. In fact, GDP doesn’t measure output, let alone prosperity. Rather, it measures the quantity of transactions that take place in the financial economy, which is a very different thing.
Because money can be created at will, there’s no theoretical limit to the number of transactions that can take place. This doesn’t, of course, mean that there are no limits to the supply of material products and services.
Conflating financial transactions with material output is one of the most bizarre examples of myopia in the modern world. Many people have argued, no doubt correctly, that ‘there’s more to life than money’. But few recognize the equally accurate statement that ‘there’s more to economics than money’.
Clearing up the money-output misconception is actually pretty straightforward. As we have seen, money is a human artefact, validated by exchange – money doesn’t contain value, but functions as a body of aggregated claims on the value made available by the material economy.
Whenever money changes hands – that is to say, whenever financial claims are exercised – the result is a transaction. Accordingly, it will be apparent that the value of a transaction lies, not in the transaction itself, but in the product or service that is the subject of the transaction.
GDP, being a purely financial metric, is in reality nothing more than a summation of transactions. It’s perfectly possible, indeed commonplace, for transactions to take place through which no material value is added to the economy. This is particularly true where quantities of money are interchanged without reference to material products or services, or where existing assets are the subject of transactions.
For example, person A has bought a house for $500,000. He or she now sells it to person B for $750,000. The item sold hasn’t changed – it’s the same house – but an incremental transaction has taken place, generating income for intermediaries. This income is a function of the transaction price of the asset (a stock), but is included in the aggregate flow of transactions measured and reported as GDP.
The process of divergence
In practical terms, and in part because asset prices are a function of the cost and availability of credit, this means that we can inflate transactional activity artificially by expanding the aggregate of credit. Exactly this effect is observable in the way in which, over the past two decades, each additional transactional dollar (counted as real GDP) has been accompanied by more than $3 of net new debt.
The consequence is that, if we disregard this ‘credit effect’ – and simultaneously disregard ECoE as well – we can grow reported GDP without reference to any positive or negative change in the value of the material economy. This is exactly what we’ve been doing since the 1990s, thereby driving a statistical wedge between the financial economy (of GDP) and the material economy (measured by SEEDS as prosperity). This process is illustrated in Fig. 3.
Together, the credit effect and the disregard of ECoE have created a relentless divergence between prosperity and GDP (Fig. 3A). A simultaneous consequence has been a widening gap between the flow of output (whether measured as transactional GDP or as material prosperity) and the stock of forward financial claims (Fig. 3B).
Fig. 3
When we compare the financial and the real levels of output, as in Fig. 3C, we are able to measure the relationship between the two.
Remembering that the financial economy of claims exists only as a proxy for the real economy of products and services, it becomes apparent that the eventual tendency must be towards equilibrium, where the quantity of claims matches the quantity of products and services against which these claims are, either now or in the future, capable of being validated by exchange.
Where the body of claims becomes excessive in relation to the value available for honouring them, this ‘excess claims value’ must, by definition, be destroyed, because it cannot be ‘honoured for value’.
This may seem very theoretical, but its implications are practical and its basic precepts are surely indisputable. We can create ‘claims’, primarily as credit, and we can count the transactional exchange of these claims, but we delude ourselves if we assert that the totality of claims exchanges corresponds to economic output and prosperity, which, in reality, it does not.
We can cut to the chase here by asking ourselves two questions. First, can the commercial banking system lend products, services – or their underlying energy basis – into existence? Second, can central banks create products, services or energy out of the ether? Since the answer to both questions is no, it becomes self-evident that the creation of claims does not simultaneously create the material wherewithal required to honour those claims.
Time arbitrage
There is one, and only one, area of ‘wriggle room’ in this equation, and that resides in the temporal (time-related) character of money. Monetary claims don’t have to be exercised entirely in the present – we can, instead, store (save) them for exercise in the future. This, though, buys time without changing the fundamentals, which are that monetary claims are valid to the extent (and only to the extent) that they can be honoured for value, either now or in the future.
This enables us to persuade ourselves that claims which are excessive in the present might become valid in the future, so long as the underlying wherewithal – the material economy – expands over time. We can thus convince ourselves that excessive debt and other commitments are, like childhood ailments, something we can ‘grow out of’. This, though, ceases to have any kind of validity once the material economy has ceased growing, and has started to contract, as is now the case.
The SEEDS model generates a ‘rule of thumb’ calculation for the extent of excess claims destruction embodied in the system, and this is illustrated in Fig. 3. As of 2022, the calculated flow gap (or ‘disequilibrium’) between the monetary and the material economies is put at -43% (Fig. 3C). If we apply this to outstanding debt and broader commitments (Fig. 3D), we can calculate a ready-reckoner for the extent of claims stock loss that can be anticipated as a product of the restoration of monetary-material equilibrium.
No way out?
The concepts we’ve been contemplating here – the “two economies”, material constraints, inflation as the two economies interface, and so on – have two shared characteristics. The first is that they are supported by logic and observation in ways that seem incontrovertible. The second is that they are disregarded, or indeed dismissed, both by orthodox economics and by those whose decisions and pronouncements are based on this orthodoxy.
One of the problems with orthodox economic interpretation is a refusal to contemplate even the possibility of fundamental misconception. Likewise, it seems incumbent on us to test our analysis by asking if there are any events which could change future outcomes from those projected and quantified here using the SEEDS economic model.
There are, surely, no contradictions to two of our basic precepts. We don’t need to set ourselves adrift in a lifeboat to prove to ourselves that money has no intrinsic worth. Neither do we need to shut down all supplies of energy to demonstrate that the economy is an energy system. In short, the concept of the ‘two economies’ of the material and the monetary seems to be incontrovertible.
What, then, could result in outcomes better than those with which we began this discussion? There’s a simple answer to this, which is the discovery of a fully-equivalent replacement for the energy hitherto supplied by oil, natural gas and coal. We cannot say that no such discovery will ever be made in the future. But we can conclude that any such full-value energy replacement won’t be found in a combination of solar panels, wind turbines and batteries.
The impossibility of a complete transition to a wind-and-solar version of the current economy can be explained in many ways. Building and maintaining such systems would require the use of raw materials on a vast scale, which really means that we would need correspondingly enormous amounts of energy to access these materials, convert them into products and equipment, and transport them to where they are needed. We cannot circumvent this problem by improving the conversion efficiency of wind turbines or solar panels beyond certain maxima clearly established in physics (Betz’ Law for wind power and the Shockley-Quiesser limit for solar).
Ultimately, though, the problem with renewables as currently understood is that their density is less than that of fossil fuels. Two conjoined processes define the material economy. One of these is the use of energy to convert raw materials into products. The other is the accompanying dissipative process which converts energy from a concentrated to a diffuse form. If we reduce the density of the energy input, we simultaneously truncate (shorten) the material conversion process, resulting in less output and a smaller economy.
In 1801, with Britain fearful of an invasion by Napoleon’s seemingly invincible armies, Admiral John Jervis, 1st Earl St Vincent, reassured the Admiralty in this way – “I do not say, my Lords, that the French will not come. I say only they will not come by sea”.
Likewise, it would be a step too far to assert that no complete replacement for the energy value hitherto sourced from fossil fuels will ever be found. We can only conclude that wind and solar power cannot provide this complete replacement.
This does not in any way undermine the case for maximising the potential of renewables. As the ECoEs of oil, gas and coal continue to rise, continued reliance on fossil fuels would be every bit as harmful for the economy as it is already proving to be for the environment.
We may – the jury is still out on this – be able to develop a sustainable economy on the basis of wind and solar power. What we cannot expect is that any such economy would be as large and as complex as the one we have now.
Surplus Energy Economics 