#253: How has it come to this?

ECONOMIC REALITY, UP-CLOSE AND NASTY

It’s no exaggeration at all to say that the IMF is increasingly worried about the global economy and the financial system. In its latest World Economic Outlook, the IMF warns about instability in the financial sector, a problem which extends beyond banks into pension funds and insurers. Central banks’ efforts to combat inflation by tightening monetary policy pose an obvious risk to a financial sector which has long since become accustomed – one might equally say ‘addicted’ – to ultra-low rates. The effort to tame inflation is proving harder than expected, not because of a price-wage spiral, but because businesses are using inflation as an excuse for pushing up margins.

Where I take issue with the IMF is over the title of the latest WEO, A Rocky Recovery. For all of its undoubted expertise, the organisation sticks rigidly to an orthodoxy which insists that the economy can be explained and managed by reference to money alone. On this line of thinking, a “recovery” simply has to happen, the only matters at issue being how long it will take, and which fiscal and monetary policies are required to bring it about.

Needless to say, the Surplus Energy Economics view is that, far from being inevitable, a meaningful (as opposed to a purely cosmetic) “recovery” cannot happen, because the economy has reached the point at which it inflects from expansion into contraction.

Where’s the risk?

Let’s start by looking at financial risk. Global debt stands at about US$240 trillion, of which US$155tn is owed by private borrowers. This is within broader financial assets – the liabilities of the non-financial sectors – that we can estimate at about US$565tn, of which the non-government component is about US$490tn (we have to say “estimate” and “about” because complete global data on “shadow banking” – non-bank financial intermediaries, or NBFIs – does not exist).

Ultimately, banks get into trouble when borrowers become unable to meet their commitments. Accordingly, my preferred metric for front-line risk combines (a) debts owed to banks by household and business borrowers with (b) the estimated assets of those NBFIs which, whilst they aren’t regulated ‘banks’ (because they don’t take deposits), nevertheless provide credit to the system. This number stands just short of US$180tn.

What, though, is – or should be – the real cost of servicing these various levels of commitment? Inflation, and its relationship to the cost of capital, is the critical issue here.

In 2022, broad inflation, measured as the GDP deflator, was 6.9%. The SEEDS alternative – which is RRCI, or the Realised Rate of Comprehensive Inflation – was 9.2%. Even if we accept the former – and there are plenty of reasons why we might not – the cost of money has to be at or above 6.9% if the capitalist system is to function as the textbooks say it should.

In fact, rates need to exceed inflation if investors and lenders are to earn a real return on their capital. If, though, we were to raise rates such that the ’average’ borrower paid, say, 8.5% for credit, asset prices would collapse, defaults would cascade through the system and the economy would go into a tail-spin.

This has been the hard mathematical reality for a long time, perhaps pre-dating the GFC (global financial crisis) of 2008-09. The sums are easy to work out. Starting with inflation at whatever you think it is, add the ‘real return’ premium that you think appropriate, which gives you a target interest rate. Apply this rate to global debt and quasi-debt and you come up with a sum of interest that borrowers ought to be paying. Whatever that sum is, the system cannot afford to pay it to lenders and investors.

Of course, there are plenty of reasons for supposing that inflation will trend downwards, mainly because the economy is weakening. The projected course of the global GDP deflator sees it falling to below 2% by 2025. The RRCI measure has systemic inflation at 5.2%, down from 9.2%, by that year.

It might be argued that, if inflation is poised to fall back in this way, central banks don’t need to carry on raising rates, and might even be able to reduce them. The snag, though, is that rates need to be above inflation if the capitalist system is to function correctly.

No way out?

Basically, we’re on the horns of a dilemma. If we tighten monetary policy to tame inflation, we price capital at levels which household and business borrowers can’t afford. If, on the other hand, we keep rates below inflation, two things can happen – inflation might accelerate, and the “everything bubble” in asset prices might become even more dangerous than it already is.

With the SEEDS model now into its latest iteration, it’s tempting to go into technicalities, but this is something that the urgency of the current situation does not allow. What SEEDS is saying is that global aggregate material prosperity is going into decline, having already turned down at the per capita level back in 2019.

Here’s how this works – it is, of course, a function of the supply and cost of energy, because literally nothing that has any economic value at all can be made available without the use of energy.

Whilst global supplies of primary energy might not decline quite yet, they are most unlikely to increase, even at a rate equivalent to the continuing (though decelerating) rate of growth in population numbers. The probability is that the world’s average person is going to have to get by with less energy than the amounts to which he or she has become accustomed in the past. Economic output – the sum total of goods and services supplied to the economy – is a function of the conversion of energy into products.

The relationship between energy use and production has been remarkably consistent over time. If energy supply contracts, or even ceases to grow, so does material economic output.

The really big problem, though, isn’t the volumetric supply of energy, but its cost. The Energy Cost of Energy – that proportion of accessed energy which is consumed in the access process – has been rising relentlessly, climbing from 2% in 1980, and 6% in 2010, to over 10% now. This, of course, has largely reflected depletion effects in the supply of oil, natural gas and coal, but there are no solid reasons to believe that the less dense energy alternatives offered by renewables can do much to blunt the rise in ECoEs, let alone start pushing them back down again.

If economic output stagnates or declines, whilst ECoEs continue to rise, prosperity decreases. This isn’t necessarily going to happen rapidly, and might, in that limited sense, be manageable. But there are two huge complicating factors.

The first of these is that necessities, being energy-intensive, are set to carry on increasing in price, just as top-line prosperity declines. This is the process of affordability compression so often highlighted here.

The second complicating factor is that we’ve constructed a financial system absolutely predicated on the assumption that the underlying economy will never stop expanding.

Daring to look

This gives us pretty good forward visibility, always supposing that we choose to avail ourselves of it. Discretionary (non-essential) consumption will contract, squeezed between declining prosperity and the rising cost of necessities. Many discretionary sectors will shrink, or disappear altogether, causing losses of money to investors and lenders, and losses of jobs to the economy. The latter effect should be absorbed as the balance of costs between exogenous energy and human labour adjusts, but this will be, at the least, a socially and politically stressful process.

Meanwhile, the financial system can’t, for much longer, cope with the invalidation of its core predicate of infinite economic expansion. It is, in a way, surprising that it has survived for as long as it has. As of 2022, the underlying ‘real’ or material economy of products and services was already 43% smaller than the ‘financial’, representational or proxy economy of money and credit.

We can return to these subjects at a later date, but there are three issues with which it makes sense to conclude. The first, of course, is that it’s high time we abandoned the tarradiddle of ‘infinite growth on a finite planet’, at the same time ditching any money-only, non-material school of economic interpretation which supports it.

Second, as the economy gets poorer, increasing numbers of people will find it ever harder to afford the essentials, defined here as the sum total of household necessities and public services provided by the state. The real value of government resources will, of necessity, decrease as prosperity contracts. Societies are going to have to make a choice – an unpopular one, even at the best of times – between redistributing incomes, or tolerating ever-worsening economic hardship and social discontent.

Third, of course, we need to have plans in place for the moment when the penny drops – the moment, that is, at which it becomes clear, beyond the possibility of further self-deception, that the financial system of assets and commitments comprises a body of monetary claims that cannot be honoured ‘for value’ by a contracting material economy.