A PLAIN TALE OF THE SHRINKING ECONOMY
The aim with what follows is to set out the Surplus Energy Economics interpretation of the economy with maximum clarity, laying out, in the most straightforward way, the interconnectedness of the economy, finance and the environment.
Here’s why.
In our discussions around the previous article, a reader mentioned a marked reluctance on the part of those unfamiliar with the energy basis of the economy to give open-minded consideration to this explanation.
This reluctance is understandable. Some of the conclusions reached here are unpalatable to many, and we might ourselves sometimes wish that the evidence pointed in different directions.
The official or consensus line is certainly more comforting, with its promise of a return to never-ending economic growth, and its assurances that our various leaderships ‘know what they’re doing’, at least where the economy is concerned. These notions are attractive, even if they don’t stand up to objective scrutiny.
To be sure, none of us wants to be perceived as a “doom and gloom merchant”, but it does seem difficult to deny the gravity of our economic, financial and environmental predicaments. Ignoring these issues, and simply hoping for the best, is hardly a practical strategy.
Much as we might regret the lack of open-mindedness in some, the task is surely obvious. It is to strive to make our thesis as clear as it can possibly be, at the same time remaining open to constructive criticism.
There’s no explanation that can’t be improved upon with greater clarity, greater emphasis on logical sequences, and an enhanced availability of data.
One thing seems certain, which is that we cannot hope to understand economic, financial and environmental issues by seeing them in isolation. Rather, the emphasis needs to be on examining and explaining material, environmental and financial interconnectedness.
If a mixed metaphor can be permitted, what we need is a logical pathway through the thickets of inter-related systems.
The proper study
According to Alexander Pope, “the proper study of mankind is man”. Likewise, the proper study of the economist is – or should be – prosperity. We need to know what prosperity actually IS, how it’s created, and how it can be measured.
As we shall see, prosperity certainly isn’t money. Rather, prosperity consists of the material products and services that the economy supplies to society. Money is simply the medium by which we acquire these components of prosperity, and exchange them with others.
This material prosperity provides two things to individuals, households and economies. First, it supplies the necessities, those things that make life possible, and which can help hold poverty at bay.
Second, it provides an ability to enjoy discretionary (non-essential) products and services.
The study of prosperity leads inexorably to the intersection of three systems. One of these is the material economy. A second is the financial system, which distributes material prosperity through exchange. The third is the environment, considered, not just as climatic conditions, but also as the source of the energy and other raw materials without which the economy cannot function.
It seems futile to deny that we face serious problems on all three fronts. Growth in the material economy has long been decelerating towards contraction. The financial system, which is the monetary counterpart of the material economy, has been overloaded towards the point of inevitable fracture. We face grave environmental and ecological dangers, in large part related to our economic activities.
It would be equally futile to isolate one of these systems from the other two. Indeed, this kind of ‘silo thinking’ makes it harder than it needs to be to understand intersecting issues, and to find practical solutions to our difficulties.
The mythology and reality of money
One of our ‘silo thinking’ problems is rooted in those tenets of orthodox economics that many of us learned about at school, college and university. This orthodoxy is shot through with fallacies, but has one defining error which leads to one disastrously inaccurate conclusion.
The central fallacy is that the economy can be understood in terms of money alone. The absurd conclusion is that money can enable us to enjoy ‘infinite economic growth on a finite planet’.
What orthodox economics claims is that there are no material obstacles that cannot be circumvented by financial means. Demand, prices and incentives confer upon us an ability to break free from the bounds of the physical.
Far from being ‘true’, the promise of ‘infinite growth on a finite planet’ isn’t even logical. It’s a fallacy which fundamentally misunderstands the role and character of money.
If we think that ‘money’ and ‘the economy’ are the same thing, we have zero chance of understanding either.
It’s surely clear beyond debate that we can’t use financial tools to overturn physical limits. We know that the banking system can’t lend low-cost energy (or any other natural resource) into existence. Central banks can’t conjure resources out of the ether. We can’t ‘fix’ climatic and ecological degradation by sending money to the environment.
Neither, for that matter, would any amount of money be of the slightest use to a person stranded on a desert island.
And this takes us to the heart of what money actually is.
Irrespective of its format – fiat currency, precious metals, cryptocurrencies, data entries in a digital ledger, or humble cowrie shells – money has no intrinsic worth. We can’t eat gold, or power our cars with bank-notes. Money commands value only in terms of those material things for which it can be exchanged.
Money is “a human artefact, validated only by exchange”. You might like to think of money as an ‘exchangeable token’. The terminology preferred here is that of money as ‘claim’.
There are two ways in which money is used. The first, known as flow, is the exercise of claims in the present. The other is stock, meaning claim entitlements that are set aside for exercise in the future.
Comparisons are often made between stock and flow – this is what we do when we express debt as a percentage of GDP. But there is a fundamental commonality here between stock and flow – they are different facets of the same thing. A person who has saved money for the future might change his or her mind, choosing instead to spend these savings now.
What, then, provides the value that enables monetary ‘claims’ to be honoured?
The answer is energy. Ultimately, the economy is an energy system, because nothing that has any economic value at all can be supplied without the use of energy.
This, at least, should not be a ‘hard sell’. We know that cutting off the supply of energy even for an hour would bring the modern economy to a halt. A week without energy would plunge the economy into chaos. A longer interruption would destroy it.
Accordingly, if money is a claim on products and services, it’s a claim on the energy needed to supply them. Debt, as ‘a claim on future money’ is, therefore, a claim on future energy. Money set aside for the future is another form of claim on future energy.
If, when the future arrives, there’s enough energy for all of these claims to be honoured in their entirety, everything is well. If, on the other hand, the future availability of energy is smaller than the claims previously established upon it, the claim value of money cannot be honoured in full, meaning that the value of money is impaired, and might even, in extremis, be destroyed.
The inflationary devaluation of money is what happens when we create financial claims which exceed what the material economy of energy can honour, either now or in the future.
With this understood, we can move on from the textbook fallacies of the orthodoxy to describe how the economy really works. This, in turn, will lead us into environmental as well as financial considerations.
Duality of the economy, duality of process
Once we understand the relationship between the material and the monetary, the existence of two economies becomes a conceptual necessity, meaning that there’s no other way of explaining the economy satisfactorily.
One of these is the “real economy” of material products and services. The other is the parallel “financial economy” of money and credit. The “financial” economy is a body of claims on the “real” economy of material substance.
How, then, is this material substance supplied?
The “real” economy operates by using energy to convert raw materials into products. This process connects directly to the environmental effects of human activity. The supply of services works in a parallel way, but let’s concentrate, in the interests of clarity, on physical products.
The critical point here is the dual material equation. As energy is used to convert raw materials into products, so a parallel – and inseparable – thermal process converts energy from dense into diffuse forms.
The positive outputs of this dual process are the products and services which meet our needs and wishes.
There are two negative outputs. One is material waste, which occurs when products wear out, or we choose to dispense with them, and when raw materials are wasted in the production process.
The other is waste heat, which is the consequence of the energy dissipative process.
Environmentalists are right to state that, when oil, natural gas and coal are used as the dense energy inputs to the dual process of production and dissipation, the resulting waste heat contains climate-harming gases.
This observation, though, doesn’t go far enough, because it can lead to the conclusion that we can overcome this environmental negative simply by replacing fossil fuels with a matching amount of alternative energy inputs, most obviously renewables, giving us the same (or more) economic output at lesser levels of environmental harm.
This view seems to be based on purely quantitative measurement of energy, whereas the reality is a lot more complicated than this.
To understand these questions effectively, we need to include the related issues of energy density and cost in the equation.
The productive process is driven by its dissipative thermal parallel. If we shift to energy inputs of lesser density, we shorten the dissipative process, simultaneously resulting in less material output, and a smaller economy.
The unfortunate reality is that wind and solar energy are less dense than fossil fuels. These renewables can power an economy, but not this economy. An economy powered by renewables might – though equally might not – be more sustainable than the economy that we have now, but lesser energy density decrees that it will also be a smaller economy.
We should not be blinded by the allure of technology to the fact that human ingenuity cannot overcome the problems posed by lesser density. Technology can’t over-rule the laws of physics – rather, the potential scope of technology is bounded by the limits of physical possibility.
Clearly, therefore, the energy source must come before the applications to be powered by it. This is why Orville and Wilbur didn’t invent the aeroplane first, and then sit around waiting for somebody to discover petroleum.
Of cost and value
Consideration of energy density leads straight to the question of the costs of energy. Fundamentally, these costs are material, not financial.
We need, first, to be quite clear that energy is never ‘free’.
Oil, gas and coal aren’t ‘free’ because they exist beneath our territory – they can only be put to use by constructing an infrastructure including mines, wells, refineries, pipelines and filling stations.
Renewables aren’t ‘free’ because the sun shines and the wind blows – rather, we can’t harness this energy without wind turbines, solar panels, distribution grids and storage systems.
Putting any kind of energy to use therefore requires an energy supply infrastructure. This infrastructure consists of physical things, meaning that making this infrastructure available requires that we access raw materials, and process them into the equipment that the energy industries need.
We can’t access or process raw materials without using energy. In short, the supply of energy is, by definition, a circular ‘in-out’ process in which we use energy to get energy.
It follows that, whenever we access energy for our use, some of that energy is always consumed in the energy access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE.
Because the same unit of energy cannot be used twice, ECoE is a deduction from the amount of energy available for all other economic purposes.
Two things happen when ECoEs rise, which is what we’ve been experiencing in modern times.
First, the economic value obtained from each unit of energy supplied to the system decreases.
Second, it becomes harder to strike prices which, whilst covering the (rising) costs of suppliers, also remain affordable within the (decreasing) resources of consumers.
The latter leads, in due course, to a reduction in total energy supply. This happens when energy suppliers can no longer earn satisfactory returns on their investment, and/or when purchasers become unable to afford energy at the higher prices dictated by material cost trends.
In short, ECoEs are a critical component of prosperity. Economic output is a function of the use of energy. Prosperity is what remains after the ECoE cost of energy has been deducted from energy supply.
Prosperity, in short, is a product of ex-cost surplus energy.
What, then, has happened to ECoEs through the industrial era?
The arc of the industrial age
The short answer is that ECoEs fell for a very long time, but have since turned upwards.
Far from coming as a surprise, this trend of ECoE decline, followed by a reversal into increase, has always been an implicit characteristic of fossil fuel energy. From a theoretical standpoint, the evolution of ECoEs follows a logical path, and observation confirms that this is what has happened.
Over a long period, the ECoEs of oil, gas and coal decreased. These costs were lowered by three positive processes. One of these is global exploration. As the search for oil, for example, spread out from Pennsylvania to embrace the world, this expansion of geographical reach led us to find successively lower-cost resources, most obviously in the Middle East.
Second, the growth of the fossil fuel industries harvested economies of scale.
Third, the technology used to access fossil fuels has improved over time, albeit incrementally rather than dramatically.
This process, though, has always had a built-in point of reversal. This occurred when the benefits of reach and scale had reached their limits, and depletion – first use of lowest-cost resources – took over as the primary driver of ECoEs.
Accordingly, it has always been predictable that the fossil-based economy would, after a slow start, grow dramatically, before plateauing ahead of contraction as the trend in ECoEs turned from decrease to increase. Though data gets patchier as we go back in time, there are reasons to suppose that fossil fuel ECoEs were at their lowest in the quarter-century after 1945.
At this juncture, it’s instructive to compare what we might have anticipated with what we have actually experienced, as set out in the following charts. (Please note that charts used here can be opened in a new tab for enhanced visibility).
The first and third charts are stylized representations illustrating what we would have expected to happen to ECoEs and economic prosperity, based on what our analysis tells us.
The second and fourth charts show what has been happening (and can be anticipated for the future) based on the more recent data, and the projections, that are available to us.
First, and as illustrated by the left-hand chart, our understanding of the processes of scale and reach would lead us to expect trend ECoEs to have fallen for a long time, but then to turn upwards as these drivers are exhausted, and the effects of depletion take over. Available information, shown in the second chart, confirms the latter part of this expectation.
Likewise, and as the third chart shows, our knowledge of the energy and cost basis of the economy would lead us to anticipate that accelerating growth would eventually give way to deceleration, stagnation and contraction. This, again, conforms with experience, as illustrated in the right-hand chart.
Fig. 1
Uncomfortable realities
The foregoing considerations lead us to some unpalatable conclusions.
One of these is that the prosperity of the industrial age is traceable to the moment at which we learned how to harness the enormous energy contained in coal, oil and natural gas. These fossil fuels have provided energy at a density that no alternative source of energy has matched.
The subsequent process has been that of ‘cherry-picking’ these energy resources. Quite naturally, we have used the lowest-cost (meaning lowest-ECoE) resources first, leaving costlier alternatives for later.
This sequence of ‘using the best first’ is known as depletion. As this trend progresses, each new source of fossil fuel energy is costlier than the one it replaces. New discoveries become successively smaller, more remote and more technically challenging than the ones that went before.
Without wishing to labour this critical point, what history, data and logic tell us is that the harnessing of fossil fuels was the start of a predictable arc or parabola. From the moment of fossil fuel discovery onwards, the economy would enter an accelerating growth phase, as the quantities of fossil fuels consumed increased, and as reach and scale pushed their ECoE costs downwards.
In due course, however, the onset of depletion would start to push ECoEs back upwards. The result would be that the pace of economic expansion would first decelerate, then fall to zero, and then turn negative.
We are, then, living through the moment when the impetus initially imparted to the economy by the harnessing of fossil fuels is fading out.
This parabola is dictated by the characteristics of oil, gas and coal. The only event that could prevent the eventual downwards trajectory – known here as the inflexion from growth to contraction – would be the discovery of a new source of low-cost primary energy.
We cannot know whether some low-cost energy successor to fossil fuels may be found at some point in the future. We do know, however, that renewables such as wind and solar power cannot provide this successor.
Since this runs contrary to consensus assurances, we need to know why this is.
The limits of renewables
First, renewables cannot match the energy density of fossil fuels. No electricity storage system can ever replicate the ratio of power-to-weight of the humble fuel tank. This ratio of power to weight is a critical limitation. It’s why we cannot use batteries to propel large aircraft, or build electricity-powered ships with the same cargo-carrying capabilities as vessels fuelled by oil.
Second, this lesser density creates a dependency relationship between renewables and fossil fuels.
The lesser density of wind and solar power, in comparison with fossil fuels, means that these energy systems require a correspondingly larger material infrastructure.
This in turn results in a disproportionately large requirement for material resources. Energy transition will demand vast quantities of everything from concrete and steel to copper, lithium, cobalt and the numerous other metals that renewables systems require.
Accessing these raw materials and using them to make equipment in turn requires huge quantities of energy. The most efficient sources of this energy are oil, gas and coal.
Moreover, we are trying to do this at a time when the prior economy of fossil fuels has already depleted the non-energy resource base. For example, the ore density of copper has fallen successively, and is far lower now than it was one or two hundred years ago. This means that the long era of fossil fuels has, in some important ways, made the development of renewables even more difficult than it might have been at some earlier time.
We should at this point dismiss the idea that technology can allow us to circumvent these material obstacles. The potential conversion efficiencies of wind and solar power are determined by physics, with Betz’ Law setting the limit for wind turbine efficiency, and the Shockley-Quiesser Limit doing the same thing for solar. Starting from low levels of efficiency, best practice has advanced rapidly, and is already close to both of these physical maxima.
None of this means that we should not pursue the development of these renewable sources of energy. Environmental sustainability is a worthy objective, and renewables are the only option on the table.
But the concept of “sustainable growth” is highly implausible.
Neither should we allow the supposedly “green” credentials of renewables to pass unquestioned. The ripping out of yet more raw materials from our lands and seas can have extremely adverse environmental, social and human consequences.
Confirmation, perception, projection
It would be natural for anyone confronted for the first time with the energy-economy thesis to require confirmatory evidence. This can be provided using data, because the economy is capable of statistical analysis along the lines set out here. This, indeed, is why the SEEDS economic model has been developed.
But there is a simpler, less theoretical way of confirming an analysis which points towards economic deceleration into contraction. This lies in observed behaviour. Essentially, no other construction can be placed on policy choices over the past twenty-five years.
From no later than the mid-1990s, decision-makers embarked on a sequence of policies which, considered in isolation, make absolutely no sense at all.
They began by making credit easier to obtain than it had ever been before. This led directly to the global financial crisis (GFC) of 2008-09. During and after this crisis, they then drove the real (ex-inflation) cost of capital into negative territory, a process in which the slashing of policy rates was reinforced by the creation of new money (QE) on a gargantuan scale.
Only now, confronted by a surge in headline inflation, have central banks started raising rates, and putting monetary expansion into reverse (as QT).
Policy preferences over the past quarter-century have been full-blown gimmickry, and three things should be noted about this.
First, it has run entirely contrary to all prior policy orthodoxy. Indeed, the principles of the market capitalist system itself have been directly contradicted by these policies. A system cannot be ‘capitalist’ if investors are unable to earn real returns on their capital. The levels of distortion introduced in twenty-first century monetary policy have had the effect of sidelining market processes.
Second, these policies have had disastrous effects.
Financially, they have resulted in debts rising at 3X the claimed rate of “growth” in the world economy. Latterly, growth in conventional debt has been compounded by super-rapid expansion in unconventional credit, most obviously in the NBFI or “shadow banking” sector, for which – and this should sound warning-bells – we don’t even have complete or timely data. Based on what we do know, we can infer that around $7 has been borrowed for each dollar of reported “growth” over the past twenty years.
We have, in short, saddled ourselves with debts (and broader liabilities) that we cannot possibly honour. Meanwhile, and as the World Economic Forum has pointed out, we have witnessed the emergence of enormous “gaps” in the adequacy of provision for future pensions.
Side-by-side with reckless liability expansion we have created an unprecedented “everything bubble” in the prices of assets. Markets have been turned into speculative casinos as participants chase the latest actual (or rumoured) tranche of monetary largesse from the authorities. Like all bubbles before it, this one will burst and it is, if anything, surprising that investors in stocks and property haven’t already stampeded for the exits.
Some of these trends are illustrated in the first two of the following charts, with the underlying reality pictured in the third and fourth.
But much more interesting is the ‘why?’ of these compounding exercises in apparent lunacy.
We might conclude that those in charge have submitted to some form of collective hallucination. Alternatively, this might have been a cynical exercise in the further enrichment of the already wealthy. The snag with this, though, is that these have been paper gains only, and cannot survive the inevitable bursting of the “everything bubble”.
We are left with a simpler, if chilling, explanation, which is that decision-makers have been acting as they have for reasons which, to themselves at least, have seemed rational.
This explanation divides into two possible motivations.
First, decision-makers have noted material economic deceleration without understanding its cause. If this has been so – and if they still believe in the orthodox tarradiddle that the material economy can be re-energised towards infinite growth using financial tools – then these might have been successively more extreme and desperate exercises in the impossible.
Conversely, they may be well aware that the economy has been decelerating towards contraction, for the reasons set out in this article. If that’s the case, then decision-makers have been buying time, in the hope that ‘something will turn up’.
In either case, we need to start looking at the economy in new ways, placing economics and finance in their material and environmental context
The idea that the authorities don’t know what’s really happening is every bit as disturbing as the notion that they understand this perfectly well, and are simply playing for time.
Fig. 2
Surplus Energy Economics 