#256: A path of logic

IN SEARCH OF THE REAL ECONOMY

As outlined in the previous article, we’re starting to see the emergence of a modified consensus about the outlook for the global economy. In place of a previous, near-universal assumption that economic output could expand indefinitely at a continuing trend annual rate of about 3.5%, the World Bank has now steered growth expectations for the remainder of the 2020s down to 2.2%, simultaneously cautioning that the outcome could be even worse than this if we experience financial crises or a global recession – both of which are likely.

A similar narrative of cautious assurance prevails in the financial arena. The central banks, we are told, can use rate rises, and the reversal of QE into QT, to tame inflation without triggering either a credit crisis or an economic slump.

The facts of the matter, though, are that rates remain below any realistic measure of inflation, and a very small proportion of the liquidity created out of the ether since 2008 has yet been unwound. It isn’t possible for the Federal Reserve, let alone any other central bank, to go ‘full Volcker’, pushing returns on capital to levels above inflation. The economy has become so debt-burdened, and so credit-addicted, that any such drive towards financial normality would have catastrophic results.

Neither is it entirely clear what the real level of inflation actually is, since orthodox measurement excludes movements in asset prices, thereby implying that there is no necessary contradiction between moderate inflation, on the one hand and, on the other, the ludicrously over-inflated ‘everything bubble’ in asset prices.

Surveying the landscape

An overview of the situation is set out in the first set of charts. Since 2002, and stated at constant 2022 values, world GDP has expanded by $83 trillion, but debt has escalated by $265tn, meaning that $3.20 of net new debt was added for each $1 of reported “growth”. Put another way, average growth of 3.5% was achieved by borrowing at an annual average rate of 11.1% of GDP through this period.

It will be self-evident that, since the aggregate stock of debt at any given time can only be repaid out of the flow of income in the future, the divergent trends illustrated in Fig. 1A are not sustainable. In short, the equilibrium between liabilities and income must at some point be restored, with excess debt eliminated, either by formal (‘hard’) default or through the ‘soft’ default which occurs when inflation destroys much of the real value owed to creditors.

As we can also see, total financial assets – which are the liabilities of the household, government and non-financial corporate sectors of the economy – have been growing even more rapidly than debt itself. Ever since the global financial crisis (GFC) of 2008, central banks have been back-stopping the grotesquely-expanded credit mountain by creating liquidity out of thin air. The most that can be said of QT so far is that it has started to remove some of the most recent excesses, added during lockdowns.

Fig. 1

In fairness to the authorities, the modified consensus, and the moderated taming of monetary excess, are about as far as they can go towards reality without “frightening the horses”.

We can readily imagine what would happen if anyone in authority spelled out for us the sheer unsustainability of the situation as illustrated in the foregoing charts. Investors would pull out of unsustainably-leveraged assets and worst-exposed sectors, depositors and other creditors would try to get their money out of the system, and market chaos would be the first step towards a full-blown economic and financial crisis.

The application of reason

We know, then, that the authorities must speak reassuringly about the economy and the financial system, because it would be the height of irresponsibility for them to do otherwise.

But we don’t have to take their word for it, when the alternative exists for us to work things out for ourselves. We have a choice here between two hoary old sayings – many might opt for “ignorance is bliss”, but some of us prefer the adage of “forewarned is forearmed”.

The best place to start is with economic output. We know that this output, properly considered, comprises the quantity of material products and services supplied to the economy. We also know that this material output isn’t measured by GDP which, far from being a material measure is, rather, a summation of the financial transactions taking place in the economy. It is perfectly feasible, indeed commonplace, for transactions to occur without material economic value being added.

The next set of charts intentionally repeats two of the ones shown above. It further illustrates that we can take out the transaction-inflating effect of credit expansion – the ‘credit effect’, as it’s known here – to calculate the organic rate of change in economic output over time. This gives us the alternative data series calculated by the SEEDS model as underlying or ‘clean’ output, which SEEDS calls C-GDP.

This calculation reveals that annual growth has averaged 1.5%, rather than the reported 3.5%, over the past twenty years (Fig. 2C). This further implies that material output (C-GDP) is now 37% lower than the transactional equivalent reported as GDP (Fig. 2D).

Fig. 2

The data required for the calculation of C-GDP becomes patchy as we scroll back through the 1990s and beyond. For this reason, SEEDS commences the calculation of national and global C-GDP in 2000. This provides a historical series of more than twenty years, which is long enough for most analytical purposes. We are, then, using ‘C-GDP base-2000’ as the central output measure in the SEEDS system.

In a recent exercise, though – and one which applies only to the world economy, and not to its national components – the clock on C-GDP was started in 1980 rather than in 2000. The two base-cases are illustrated in the first of the following charts, showing the earlier (and hence lower) commencement of the ‘base-1980’ version of C-GDP (Fig. 3A).

What’s interesting about this is what happens when we compare base-1980 C-GDP with the consumption of primary energy over that same period, measured in billions of tonnes of oil-equivalent (bn toe) (Fig. 3B). The remarkably consistent relationship between output and energy use is illustrated in the third chart (Fig. 3C). Across that entire 43-year period, and despite the numerous vicissitudes experienced in energy supply and the economy, the maximum variance in the annual conversion ratio between energy and output was +/-4.1% from the 43-year average. Put another way, there has been a striking synchronicity between rises and falls in underlying output and increases or decreases in energy use (Fig. 3D).

This, of course, is exactly what we would expect, since literally nothing that has any economic value can be supplied without the use of energy.

We might wonder why there has been no improvement in the conversion ratio between energy and output over time, but this is capable of ready explanation – the process of resource depletion has worsened the economics of non-energy raw materials, and has done so at a rate which has cancelled out improvements in the efficiency with which energy is used to convert these raw materials into products.

Fig. 3

Of cost and prosperity

Just as we know that nothing of any economic value can be supplied without the use of energy, we also know that energy is never ‘free’ – in order for us to put energy to use, everything from oil wells and refineries to wind turbines and power grids have to be created, and this cannot be done without the use of energy.

In short, whenever we access energy for our use, some of this energy is always consumed in the access process, and this ‘consumed in access’ proportion is known here as the Energy Cost of Energy, or ECoE.

This enables us to make a simple statement about the nature of material prosperity. We use energy to supply material products and services to the economy, but a proportion of this output is absorbed by energy costs, and is therefore not available for any other economic purpose. Accordingly, prosperity is a function of surplus (ex-ECoE) energy. Within any given quantity of energy converted into economic output, a rise in ECoE creates a fall in prosperity.

We have already established a direct – and remarkably consistent – quantitative relationship between energy use and material economic output. To complete the calculation of prosperity, then, we need to put the ECoE cost component into the equation.

For much of the industrial era, the ECoEs of fossil fuels trended downwards, driven lower by economies of scale, widening geographic reach and improvements in technology. Latterly, though, with the potential benefits of reach and scale exhausted, depletion has become the primary driver of ECoEs, pushing them upwards because, in the past, we have quite naturally accessed lowest-cost resources first, leaving costlier alternatives for later. In an age often obsessed with technology, there is a tendency to overlook the fact that the potential of technology is limited by the laws of physics.

The same constraints limit what technology can achieve in the delivery of renewable sources of energy. Renewables such as wind and solar power are less dense than oil, natural gas and coal. Conversion ratios from wind and solar energy into electricity are subject to limits defined in physics. Rapid expansion in renewables requires vast material inputs, and the provision of these inputs creates correspondingly enormous demands for energy, which can only be sourced from ‘legacy’ fossil fuels.

Accordingly, we need to have realistic rather than over-sanguine expectations for the potential ECoEs of renewables. This is illustrated in the first of the following charts, which indicates that wind and solar are most unlikely to do more than moderate the relentless upwards trend in the overall Energy Cost of Energy.

Furthermore, we have seen that prosperity decreases as ECoEs rise. This means that, just as supplier costs are rising, consumer affordability is declining. The logical consequence is a decline in energy availability, with increases in the supply of renewables, plus nuclear and hydroelectric power, unable to offset in full the rate of decline in fossil fuel supply (Fig. 4B).

Over time, rising ECoEs will create a widening gap between total and surplus energy supply (Fig. 4C), whilst material prosperity will decline more rapidly than economic output, measured as C-GDP (Fig. 4D).

Fig. 4

At this point, it’s worth pausing briefly to summarise what we know about the nature of prosperity. Economic output, in the form of products and services, is a function of the use of primary energy. We can’t do much to improve conversion efficiency between energy and output, not least because technological advances in energy conversion efficiency are cancelled out by the effects of non-energy resource depletion. ECoE, by making a first call on the value obtained by energy, acts as a deduction from output in an equation in which prosperity is the residual.

The lesser density of renewables – reflected both in input intensity and in intermittency and the consequent problem of storage – makes it most unlikely that wind and solar power can provide prosperity at the same level as that hitherto sourced from fossil fuels. The combined effects of rising supplier costs and falling consumer prosperity point towards a decrease in energy availability, and hence in economic output, a trend which will be leveraged into a more rapid fall in prosperity by the consequences of rising ECoEs.

Finally, for now, we know that the supply of necessities – everything from food, water and housing to travel, transport and infrastructure – is energy-intensive. This means that the real cost of essentials will rise at the same time as top-line prosperity decreases.

The monetary corollary

All of the above could be expressed, and perhaps expressed best, in energy units, such as BTUs. Money acts as a parallel system, conferring on us both positive management capabilities and extraneous risks. Ultimately, the function of money is as a medium by which material products and services are exchanged and distributed. Money has no intrinsic worth – we can’t eat it, or power our cars with it – but commands value only as a ‘claim’ on the material prosperity made available by the use of energy.

Our need now, then, is to reference the behaviour of money to what we know and can predict about trends in material prosperity. This is why we need to think conceptually in terms of ‘two economies’ – the ‘real economy’ of goods and services, and the parallel ‘financial economy’ of money and credit. It’s worth reminding ourselves that, since money is ‘a claim on energy’, whilst debt is ‘a claim on future money’, then debt is ‘a claim on future energy’.

What most of us want to know is the forward trajectory of the economy experienced as money, in the form both of transactions (flow) and of stored assets and liabilities (stock). GDP in the latest period is an acceptable starting-point for such an assessment – GDP is a reasonable summation of transactional activity in the present but, as we have seen, prior trends have been distorted by the conventional, and perhaps therefore the unintended, exaggeration of growth.

This puts a number of important analytical tools at our disposal, of which three are of greatest interpretive value.

The first of these is harmonised analysis. This process accepts current GDP as a measure of experienced transactional activity, but rejects the misleading narrative about its past real trajectory, replacing it with a sequence based on the evolution of prosperity.

By making forward projections, not just of the trajectory of material prosperity but also of the probable trend in the cost of essentials, we can create a portrayal and projection of the economy divided into the functional segments of essentials, capital investment (in new and replacement productive capacity) and the provision of discretionary (non-essential) products and services to consumers.

This harmonised analysis is shown in Fig. 5A. Going forward, output is set to trend downwards, as energy availability decreases and the ECoE deduction rises. Within this declining total, the absolute and proportional share of essentials will rise. It’s likely that capital investment will decrease, but this won’t prevent a relentless fall in the affordability of discretionary products and services.

Fig. 5

Our second critical analytical tool is systemic inflation. This can be calculated by comparing current (money-of-the-day) financial transactions with the real (meaning the material) supply of products and services. The result is RRCI – the Realised Rate of Comprehensive Inflation.

Over an extended period, RRCI has been markedly higher than the official GDP Deflator number used in calculating “real” growth in the economy (Fig. 5B). In other words, the under-statement of systemic inflation has been an integral part of the over-statement of past economic growth.

The third tool is equilibrium analysis, applied by comparing the relative behaviour of the real and the financial economies. This, as a numerical measure, is influenced by the date of commencement of the C-GDP calculation, meaning that what we’re looking for is a relative trend. This, as of 2022, shows that the real economy is 43% smaller than its financial economy proxy (Fig. 5C).

But there is nothing relative about the rate of change in disequilibrium, or of its implications for the financial system. When we recall that the stock of financial claims can only be validated by the future flow of material prosperity, it becomes apparent that there is enormous downside in the realisable value of current obligations.

We can obtain a proportionate measure of this downside by applying calculated disequilibrium to the scale both of debt and of broader financial commitments (Fig. 5D). Since the owners of claims naturally regard these claims as ‘value’, the elimination of excess claims will be experienced as ‘value destruction’. This makes it relevant to recall that the bursting of a bubble does not, of itself, destroy value – rather, it reveals value already destroyed by the malinvestment that created the bubble.

We have solid reasons, then, for supposing that the authorities are doing two things – managing economic expectations downwards, whilst reassuring the public about the viability of a financial system hopelessly mired in debt. That these are the only courses now open to them doesn’t exonerate them from prior blame for allowing the financial system to be stretched to breaking-point in the hubristic pursuit of the chimera of infinite growth.

Pursuing our own investigation along logical lines isn’t going to change this. Whether we like it or not, the ‘everything bubble’ is going to burst, as all such bubbles do, and we cannot taper the Ponzi scheme into which the financial system has been turned by the reckless application of ‘extend and pretend’. The relentless tightening of affordability compression can’t be prevented, and its implications – both for discretionary consumption and for the streams of income upon which so much of the financial and corporate system depends – cannot be side-stepped.

What logical interpretation can do, though, is to give us advanced visibility on much that the authorities and the consensus couldn’t dare to tell us, even if – a moot question – they actually know about it.

#255: The emerging ‘modified consensus’

INCHING TOWARDS ACCEPTANCE?

As you may know, the interpretation long set out here is that the underlying ‘real’ or physical economy of products and services has deteriorated, via stagnation, into contraction. Partly because of a mistaken belief that monetary gimmickry can promote material expansion, a huge gulf now yawns between the ‘real economy’ and its ‘financial economy’ proxy. The financial system itself, understood as an aggregate stock of monetary ‘claims’ on the real economy of the future, is poised to fall into this chasm.

To understand this situation, we need to recognize the parallel existence of the ‘real’ and the ‘financial’ two economies, a concept which was examined at length in Life After Growth, first published in 2013.

A perennial question about this situation concerns how much ‘they’ – meaning decision-makers, or ‘the powers that be’ – know about these trends, as they are understood here.

A much better question, though, is ‘what would they do if they did understand it?’ The one thing of which we can be sure is that, if the situation was indeed understood, nobody in a position of authority could possibly come out and say so. To do this would be to precipitate a market crash, itself a prelude for the onset of generalised chaos.

In this situation, the only realistic course of action for the authorities would be a gradual retreat from over-sanguine assumptions around economic growth. They would need to manage expectations downwards, and this would require the crafting of a modified consensus. The authorities would not, and could not, say that economic growth has ceased, let alone that it has gone into reverse, and neither would any practical purpose be served by doing so. Instead, they would seek to steer expectations towards successively, but gradually, lower levels.

The view set out here is that this modified consensus has started to emerge. We need presuppose no conspiracy in this, or much in the way of co-ordination, because there’s no reason why different people and different institutions shouldn’t follow the same evidence to the same conclusions. For anyone in a position of authority or influence, the managed retreat labelled here ‘the modified consensus’ is the only practical form of response to economic deceleration.

Economic projections issued last month by the World Bank provide the first concrete evidence that just such a modified consensus is emerging. We might slot President Macron’s warning about “the end of abundance”, and Huw Pill’s highly controversial remarks about reduced prosperity, into this same trend.

Be that as it may, the astute observer needs to take early cognisance of this switch in perceptions, work out what it’s going to mean for expectations, and respond accordingly.

Anyone aspiring to a career in politics needs to start thinking about what happens when the existing reality of the rising cost of necessities collides with the soon-to-be-admitted fact of economic deceleration. For business leaders and investors, this would be a very bad time indeed to put capital into anything that presupposes resilience – let alone future growth – in households’ discretionary consumption.

Of logic and evidence

Those of us who understand the economy as an energy system rather than a financial one can advance two types of argument in support of the interpretation that prior growth in prosperity has been trending towards reversal as the fossil fuel dynamic winds down.

The first of these is the logic which connects the supply, value and cost of energy with prosperity in the form of material products and services. But logic can be a surprisingly hard sell, particularly where its conclusions are unwelcome. The generality of opinion is not about to be swayed by mere logic away from its insistence that control of money will enable us to enjoy ‘infinite growth on a finite planet’.

But the second category of argument – evidential observation – is a very different matter, and much harder to disregard. The Surplus Energy Economics view, evidenced in abundant statistics, is that we have been going to ever-greater extremes to fake ‘growth as usual’ over a very long period. Ever since the 1990s, we’ve been buying each dollar of reported economic “growth” with $3 of net new debt, supplemented, in recent years, by a rapid expansion in the aggregate of non-bank credit. Since the global financial crisis (GFC) of 2008-09, we’ve also been using extraordinary forms of monetary gimmickry to sustain a simulacrum of continuing expansion.

All gimmickry has its limits, and this legerdemain has now collided with reality in the form of two wholly predictable outcomes. The first of these is the resurgence of inflation, and the second is the emergence of extreme and worsening risk in the banking and broader financial system.

From evidence to modification

In short, the observational evidence in support of economic deceleration has become unanswerable. If the authorities sustain their commitment to monetary tightening, the consequences can be expected to include both a banking crisis and a severe recession. If, conversely, they revert to the easy money conditions of the recent past, runaway inflation beckons. If they are more fearful of the latter than of the former, their conclusion would be hard to fault, though their determination might be hard to sustain.

As we have noted, the authorities couldn’t possibly state publicly that the previous orthodoxy of robust growth in perpetuity has turned out to be fallacious. Their only recourse would be to managing expectations through gradual reductions in their forward guidance about economic prospects. In short, they would set to work on crafting a modified consensus.

It’s not too much of a stretch to perceive the first signs of just such a modified consensus emerging in the reassessment of economic prospects issued by the World Bank during its recent biannual conference with the IMF. This document repays study, and can be found here.

Essentially, the World Bank states that global growth capability, having fallen from 3.5% between 2000 and 2010 to 2.6% between 2011 and 2021, may now decline further, to 2.2%, during the remainder of the 2020s.

Moreover, the wording here is instructive – 2.2% references “potential” growth, and, says the Bank, the out-turn could be even worse “if financial crises erupt in major economies and, especially, if they trigger a global recession”. Many observers, perhaps even a majority of them by now, presumably recognise that both a financial crisis and a recession are likelier to happen than not.

The not unreasonable inference, then, is that global economic growth will be less than 2.2% between now and 2030.

Neither the World Bank nor any other institution in a position of authority is likely to make (or acknowledge) the connection between economic deceleration and energy deterioration, as those connections are routinely described here. Moreover, they do not need to do so, and the decline in growth can instead be explained by reference to conventional factors such as ageing demographics, weaker-than-expected international trade and investment, and the worsening consequences of environmental change.

All they need to do – for now, anyway – is to steer growth expectations downwards. There’s plenty of time between now and 2030 to introduce further caution into their guidance.

The emergence of a less sanguine ‘modified consensus’ has far-reaching implications. It counsels that governments’ resources in the future are likely to be lower than has hitherto been supposed. It has stark implications, too, for the affordability of discretionary (non-essential) consumption by households. It also, incidentally, feeds through into lower expectations of the energy likely to be needed by the economy in the future.

Scenario analysis

The emergence of a modified consensus takes us into territory familiar to planners in the spheres of government and business. Typically, scenario planning sets out three forward cases, combining the expected or ‘central’ case with higher and lower alternatives. This technique allows planners to apply sensitivity analysis to deviations from their central set of projections. I propose to do some of this here, using three distinct scenarios.

The ‘high case’ in this exercise is the former consensus, which assumes trend annual world economic growth of 3.5%.

The ‘central case’ is the modified consensus, where I’ve taken the liberty of assuming that ‘2.2%, if nothing goes wrong’ equates to ‘1.8%, if quite a lot does’.

The low third case is, of course, the prosperity trajectory projected by the SEEDS economic model.

The assumptions used in each of the three case-studies are summarised in Fig.1. The tables show annual percentage rates of growth, plus GDP aggregates stated in constant dollars at 2022 values.

As you can see, the cumulative differences between the ‘consensus’ and ‘modified consensus’ case-studies are sizeable – by 2030, overall growth from the 2022 baseline falls from almost 32% on the former basis to less than 15% on the latter. At a projected $191 trillion (at constant 2022 values), global GDP in 2030 is 11% lower on the modified consensus case than on the consensus basis ($215tn).

Fig. 1

Additionally, it remains the consensus assumption that global population numbers will continue to rise, albeit at decelerating rates. With this taken into account, economic output per capita is projected to be 23% higher in 2030 than in 2022 on the consensus case, but this projected improvement falls to only 9.4% on the modified consensus analysis. Per capita equivalents of the aggregates are set out in Fig. 2, in which you will also see that SEEDS analysis puts per capita prosperity 8.5% lower in 2030 than it was in 2022.

Fig. 2

Broad implications

It will readily be apparent that a reduction in forward growth expectations has profound consequences, of which three are of primary significance.

First, we – and the authorities – know that the real costs of household essentials have been rising rapidly. An optimistic view might be that the rate of increase in the costs of necessities might slow, though monetary tightening exerts comparatively little pressure on products and services which consumers have to purchase.

But it would be extremely fanciful to suppose that any of the recent inflation in the cost of essentials might be reversed. Housing might, perhaps, become cheaper than it is now, but this isn’t going to happen to the costs of food, water, energy, transport or any other household necessity.

Our concept of the ‘real’ and ‘financial’ economies informs a specific interpretation of varying household experiences. Those whose fortunes are tied to the financial economy have fared pretty well during the ‘easy money’ era, whilst those whose incomes and costs are tied to the material economy have suffered worsening conditions. This goes a long way towards explaining the apparent dichotomy which is reflected in islands of affluence within a widening ocean of hardship.

Economic deceleration, taken in conjunction with continuing rises in the cost of living, suggest that popular demands for help will only increase. At the same time, though, government resources are going to be undermined by lower-than-expected economic growth. A global growth trend of between 1.8% and 2.2%, sharply lower than the previously-assumed 3.5%, means that some economies can anticipate no growth at all, whilst others might start to experience contraction.

What, then, can resource-constrained governments do about expenditure commitments? Public spending falls into two categories – the provision of services, and the enactment of transfers (such as pensions and benefits) in support of the less well-off members of society. It’s axiomatic that, as economic hardship worsens, the need for transfers increases, and so do the demands placed on public services.

This implies that two political pressures will arise – growing demands for redistribution, and an increasing need both to boost efficiency and to tighten priorities in the delivery of public services. States may feel compelled, not just to ask for larger contributions from the affluent, but also to take some necessary services into public ownership. The political battleground of the future might take on some of the characteristics of the past debate between ‘collectivist’ redistribution and ‘liberal’ preferences for lower taxation and a minimised state.

Second, the combination of lower-than-expected growth and rises in the cost of essentials implies significant contraction in sectors supplying non-essential products and services to consumers. This is an issue that needs to be watched, and might soon start to be reflected in expectations for, the activities of, and the market valuations applied to businesses operating in consumer discretionary sectors.

Thirdly, of course, even a deceleration in growth, by conflicting with prior expectations, can be expected to increase stresses in the financial system. This is a topic that we’ve addressed before, and that we might revisit, just as we might look further into the political and business consequences of affordability compression.

Extended scenarios

The charts set out in Fig. 3 carry global scenario analysis forward to 2040, and set out the equivalents for the United States, the United Kingdom and China. If the early forecast period for the British economy looks a little odd, it’s because nobody expects much in the way of growth in the near term.

In carrying the modified consensus forward, the assumption is made that the projected rate of global growth is revised downwards again by 2030, this time falling from 1.8% to 1.4%. By the 2030s, of course, the SEEDS trajectory has become decisively negative.

Even on the ‘modified consensus’ scenario, though, the world economy is likely to be almost 30% smaller by 2040 than it would have been on the prior-consensus basis.

As remarked earlier, the outlook for government and businesses are issues to which we can, and perhaps should, return.

For now, though, we can conclude that expectations are critical to behaviour, not least in government and in the capital markets. If we are indeed witnessing the emergence of a ‘modified consensus’, there is a compelling need to anticipate the way in which expectations are likely to be steered in the near future.

Fig. 3