#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.