#270: Normalising money and value

EXPLORING THE TRANSACTIONAL CURVE

Why has the global economy become credit-addicted, and why has a post-capitalist kleptocracy replaced the market economy? Why is the much-vaunted transition to EVs decelerating, and why are the costs of renewable energy development rising? Can we really achieve nil-net-cost net zero, switching to more climate-friendly energy sources without becoming poorer in the process?

The answers to these and many other questions lie in economics, but not, as we shall see, in the way that economic issues are customarily presented to the public, and debated by decision-makers in business and government.

We can’t explain any of these trends by reference to money alone, but need to bring the material, and the laws of physics, into the equation.

 

Monetary experience, material substance

It’s understandable that the material gets lost in an economic system experienced in monetary form, Contracts of employment, for instance, don’t state that the employer will provide food, accommodation and transport in exchange for labour. Instead, the employee receives money with which to buy these necessities, hopefully with a margin left over for the purchase of discretionary (non-essential) products and services.

Whether we’re earning or spending, lending or borrowing, or investing for the future, we experience (and inter-act with) the economy in monetary form, but the prosperity of society, and the ways in which economic resources are allocated, are determined by the material.

In short, energy and materials are the substance of an economic system that is experienced financially.

What we’re going to discuss here is how the material has shaped the monetary over time, and how we can normalise the transactional curve to the underlying materiality of the economy.

For those who like some of their conclusions up front, the consensus narrative of a future in which everyone drives around in an EV powered by cheap and abundant clean energy isn’t going to happen, because it contravenes the limits of the material.

The rise of the post-capitalist kleptocracy can be traced to the sacrifice of market principles on the altar of a promised – but impossible – indefinite continuity of growth.

Whole sectors of the economy are heading into contraction and, in some cases, outright disappearance. We are witnessing massive malinvestment as capital is allocated to ‘growth’ sectors which have no real prospects of expansion. Some economies are far closer to the cliff-edge than has yet been realised.

Many of us would like to know how economic and broader trends are likely to unfold. Monetary trajectories alone cannot tell us this, but the harmonising of the monetary to the material can do so.

 

The basics – of materials and money

Effective interpretation of the economy requires the application of a concept wholly unknown in orthodox economics. This is the concept of two economies – a “real economy” of material products and services, and a parallel “financial economy” of money, transactions and credit. I introduced this concept in my 2013 book Life After Growth.

This concept is a necessity because, contrary to the insistence of the orthodoxy, the economy isn’t entirely, or even primarily, a financial system. Having no intrinsic worth, money has value only in terms of the material products and services for which it can be exchanged (the concept of money as claim).

By excluding the material, the economics orthodoxy manages to promise ‘infinite growth on a finite planet’, something which, in the words of Kenneth E. Boulding, co-founder of general systems theory, could only be believed by “a madman or an economist”.

The orthodoxy has various ingenious work-arounds for the finality of resources, but no amount of incentive, financial stimulus, substitution or innovation can supply something which does not exist in nature.

To be quite clear about this, we can lend money into existence, and central bankers can create it at a key-stroke, but we can’t similarly conjure energy or raw materials out of the ether. Natural resources are, by definition, finite in character.

When we think about natural resources, we tend to put fossil fuels, minerals, water and productive land into this category. But the environment, too, is a finite natural resource – it’s finite in its tolerance, meaning its ability to absorb the effects of human economic activity.

We know that the material exists. A long-ago writer said that we discover the reality of the material in infancy, when our first hesitant steps bring us into painful collision with the furniture. The human mind may struggle to grasp the concept of infinity, but we should have no trouble with comprehending the finite.

My efforts over the past decade have been concentrated on exploring, explaining and calibrating the “real” or material economy, and using it to benchmark the “financial” economy of monetary transactions.

We know how this “real economy” works, and it’s a matter of energy, raw materials and physics – not money.

 

Understanding the material

I don’t intend to go into technicalities here, but the biggest challenge of the SEEDS project has been to translate the substance of the material into the language of the monetary. The whole aim of the project has been to link the financial to the material.

Stated at its simplest, the physical economy functions by using energy to convert raw materials into products and services. The latter emphatically belong in this category, because no service can be provided without material assets, such as vehicles for delivering packages, and a network for the supply of on-line services.

We can no more render the economy ‘immaterial’ by displacing goods with services than we can somehow “de-couple” the economy from the use of energy. The latter is impossible because the economy IS an energy system.

As regular readers may know – but new visitors might not, and this simply can’t be reiterated too often – there are two distinct characteristics of the material economy which can guide us to effective interpretation.

The first is that energy is never “free”, and the second is that the critical characteristic of energy is its density, something which can be likened, for convenience, to the power-to-weight equation as it affects the performance of vehicles.

Energy is never “free”, because it cannot be put to use without a physical infrastructure. Oil and gas aren’t “free” because they exist beneath our territory, and renewables aren’t “free” just because the sun shines and the wind blows. We need wind turbines, solar panels, power storage systems and distribution grids for the harnessing of renewables, just as surely as we need wells, mines, pipelines and processing plants for the supply of oil, natural gas or coal.

This infrastructure is physical, meaning that its creation, operation, maintenance and replacement require raw materials. These raw materials cannot be accessed or processed without the use of energy.

Accordingly, putting energy to work is an ‘in-out’ process, in which, whenever energy is accessed for our use, some of this energy is always consumed in the access process. This ‘consumed in access’ component is known in Surplus Energy Economics as the Energy Cost of Energy, abbreviated ECoE.

 

The productive equation

The second material precept – the critical importance of energy density – can be explained by reference to the dual nature of the economic production process. When energy is used to convert raw materials into products, so energy itself is converted from a dense to a diffuse state.

These two processes are inseparably linked, so we can’t have the one without the other. In this productive-dissipative equation, if we shorten or truncate the dissipative process by reducing the density of energy inputs to the system, we correspondingly shorten the productive process, resulting in a smaller economy.

It’s regrettable, but undeniable, that renewables are less dense than fossil fuels. Transitioning to renewables may have environmental benefits – though even this claim needs to be treated with caution – but an economy powered by less energy-dense renewable energy must be smaller than an economy powered by more energy-dense oil, gas and coal.

The environmental (as well as the supposed economic) merits of renewables need to be heavily qualified, because a system based on less dense energy needs a correspondingly larger physical supply infrastructure. This in turn means an expanded need for raw materials, and this is likely to have many adverse environmental and ecological consequences.

Moreover, the accessing and processing of these raw materials increases the need for energy inputs. Indeed, the term “renewable” is questionable, because the only energy source capable of supplying everything from concrete and steel to copper, lithium and cobalt, in the quantities needed for transition, is legacy energy sourced from fossil fuels.

The energy-productive process thus described does not operate in a vacuum. Other critical factors include the quantity and quality of mineral resources and food-productive land. As mentioned above, a further critical resource is the natural environment, meaning the capability of the environment to absorb the effects of economic activity. Just like iron ore or arable land, environmental tolerance is a finite resource.

 

Not to infinity

The foregoing should frame our understanding of the sheer impossibility of ‘infinite economic growth on a finite planet’.

As well as being ultimately finite in character, natural resources interact with the economy in a specific way. Faced with choices, we always, and quite naturally, use the lowest-cost resource first, setting aside costlier alternatives for later. As this process progresses, it results in depletion, whereby each new resource becomes costlier than the one it replaces.

With energy, this results in a distinctive ECoE curve or parabola, illustrated in Fig. 1A.

Taking petroleum as an example, ECoEs declined as the industry explored the globe in search of larger, lower-cost reserves; as the expansion of the oil business yielded economies of scale; and as the technology used in the industry improved.

Eventually, though, the potential benefits of scale and geographic reach were exhausted, and depletion took over as the primary driver of ECoEs, which then turned upwards. There are strict limits to how far technological advance can offset this rising trend, because the potential of technology is limited by the physical characteristics of the resource.

Here’s an issue that we need to look fairly and squarely in the face. The dramatic growth in the size and complexity of the modern industrial economy is a direct consequence of harnessing the vast amounts of low-cost energy contained in the planet’s reserves of fossil fuels. Nothing like it had ever happened before.

Its continuity is entirely dependent on the discovery of alternatives, and these must be at least as energy-dense as oil, gas and coal.

We cannot rule out the discovery of a new energy source matching or exceeding the density of fossil fuels, but there are two observations that are extremely pertinent to our situation.

First, renewables aren’t going to provide energy of the necessary density. Second, we are rapidly running out of time for such a discovery, because the trend ECoEs of fossil fuels are rising very rapidly indeed.

Though we don’t have the data needed to track the ECoE curve back to the early years of the twentieth century and beyond, we can say two things, with considerable confidence, about the nadir of the fossil fuel ECoE curve.

The first is that it probably occurred in the quarter-century after 1945. The second is that the trend ECoE of fossil fuels was probably well below 1% at its lowest point. From 2% in 1980, and 4.2% in 2000, all-sources trend ECoE has already broken the 10% barrier, and is likely to reach 18% by 2040.

In the absence of some spectacular scientific discovery, trend ECoEs must carry on rising, and material prosperity must inflect from growth into contraction. This is shown in Fig. 1, in which stylized long-run ECoE and prosperity curves are paired with more recent trends for which data is available.

 

Fig. 1

We need to be in no doubt that, if this is what’s happening to the “real” economy of material products and services, the parallel “financial” economy cannot wander off in a different direction, because money is validated only by our ability to exchange it for the material.

As extreme disequilibrium emerges between the ‘two economies’, we cannot compel the material to conform to the financial, because the exchange value connection between them doesn’t operate in that direction.

 

From the material to the monetary

I said we wouldn’t go into technicalities in this discussion but, in outline, SEEDS analysis plots two distinct curves, globally, and for each of the 29 national economies covered by the model. The prosperity curve of the “real” economy, though material in character, is presented in monetary terms for the purposes of benchmarking and comparison with the “financial” curve.

As you may know, GDP is a measure of transactional activity, not material economic output. As such, it is capable of distortion, not least by the injection of large amounts of credit into the system. Between 2002 and 2022, and stated at constant values, GDP increased by $83tn, or 103%, whilst debt expanded by $266tn, or 209%.

These are not discrete series, because the sole purpose of taking on credit is to spend it, meaning that growth in debt necessarily drives increases, unrelated to value, in the transactional activities measured as GDP. We can calculate that each dollar of reported “growth” between 2002 and 2022 was accompanied – and made possible – by a $3.20 increase in debt. Put another way, we had to borrow at an annual average rate of 11% of GDP to deliver annual average “growth” of 3.5% between those years.

Additionally, of course, no allowance is made for ECoE in the measurement of GDP. Trying to measure the economy without including energy in general, and ECoE in particular, is like staging Hamlet without the Prince.

The artificial ‘credit effect’ is something that happens over time, and this makes the analytical value of reported GDP equivocal. We probably can accept that $164tn is a reasonably accurate snapshot of transactional activity in 2022, but we can’t accept that this was an increase of 103% (real) over the previous twenty years, because of the distorting effects of credit creation over time.

Accordingly, if we want to know the real rate of change in the economy in past years, we need to retrofit (“harmonise”) transactional activity to the curve of the material. This is illustrated, on a global basis, in Fig. 2.

Using this same technique, we can project the economy forwards along the curve of material prosperity, and allocate output to the three critical segments of essentials, discretionary (non-essential) consumption, and capital investment in new and replacement productive capacity.

 

Conclusions

If we don’t mind stretching the relationship between the financial and the material, we can carry on, perhaps for a while longer yet, creating additional transactional activity by pouring new credit into the system. This describes the simulacrum of “growth” that economies have been reporting in the age of subsidised money.

But this doesn’t mean that extra economic value has been delivered, and the consequence of this process is that liabilities will rise to a point at which the likelihood of their ever being honoured ‘for value’ ceases to be credible. Market vertigo is going to be one of the main factors that triggers the coming financial crash.

The general conclusions of SEE analysis of transactional trends are wholly consistent with what we know about the economy from the standpoint of material analysis. Just as rising ECoEs are driving down the supply and ex-cost economic value of energy, so the real costs of energy-intensive necessities are being pushed upwards.

This can be expected to undercut returns on invested capital, such that capital investment decreases. As this happens, and as asset markets slump, the effect will be to expose enormous malinvestment. Calibrating the scope of this malinvestment, and determining where it has occurred, is perfectly feasible, but not in the compass of this article.

The affordability of discretionary products and services will be subject to leveraged compression, a process already visible in economies worst exposed to the “cost of living crisis”.

Discretionary compression will, of course, have financial as well as economic effects, undermining the ability of the household sector to carry its massively-expanded burden of financial commitments.

Where the economy itself is concerned, though, the process of discretionary compression is the trend to watch as material conditions continue to deteriorate.

 

Tim Morgan

 

Fig. 2

#269: How will “exorbitant privilege” end?

THE WHY AND HOW OF DE-DOLLARIZATION

As America’s public debt spirals ever further out of control – and with the expanding BRICS+ group working on a common trading currency and a rival settlement system – the question of de-dollarizing the global financial system is becoming a hot topic.

We need to look at this issue, not in terms of reserve currencies, but of flows of trade and investment. The dollar isn’t going to be ‘overthrown’ or ‘replaced’ so much as circumvented.

The patterns that emerge from this circumvention are going to have profound – and adverse – implications, not just for the US, but for the broader Western world as well.

Introduction

Though de-dollarization is going to happen, it’s not likely to involve a switchover to a basket of currencies or IMF SDRs, still less the adoption of another currency, such as the euro or the renminbi, to take over from USD. The dollar now accounts for 59% of global currency reserves, and this, whilst down from 66% in 2015, and 72% in 2001, continues to dwarf nearest rival the EUR (20%), let alone the RMB (less than 3%).

But reserve currency status isn’t the point at issue. What really matters is the currency denomination of flows of trade and investment around the world. Trade flows are likely to exit the dollar system in a piecemeal manner, starting with oil and moving on to other important commodities, and investment can be expected to follow trends in international trade.

Hitherto, the conduct of these flows in USD has conferred an enormous exorbitant privilege on the United States, and critics allege that the US abuses this privilege, not just when it indulges in enormous public borrowing to prop up its otherwise-faltering economy, but also when it “weaponizes” the dollar through the use of USD-based settlement systems to enforce sanctions on countries such as Russia and Iran.

Geopolitics aside, the critical issue is the flip-side of “exorbitant privilege”. This is the cost imposed, through the market dollar under-valuation of their output, on other countries in general, and EM economies in particular.

As we shall see, it can be calculated that the rest of the world gets only $0.54 for each dollar-equivalent of economic value that their countries produce. Put the other way around, we can calculate that the market dollar is over-valued by about 85% in relation to underlying value in the world outside the United States.

What we should expect to see is a rolling shift towards bilateral and multilateral trade and investment in currencies other than the dollar. Beginning with oil, this can be expected to move on to natural gas, chemicals, minerals and agricultural commodities. A point is likely to be reached at which most of the ‘hard’ trade (and associated investment) in energy, raw materials and commodities shifts over to non-USD transactions outside the ‘dollar fence’. ‘Softer’ trades may follow, but at some remove from commodities.

The dynamic here is straightforward. In a global economy now inflecting from growth into contraction, national economies can get by without dollar-denominated Hollywood blockbusters and the latest gizmos from Silicon Valley, but they must have energy, chemicals, minerals and food.

Ironically, most of the raw materials needed for transition to renewable energy are likely to end up on ‘the other side’ of the de-dollarized ‘fence’, a trend which fits within some broader implications that we’ll consider later in this discussion.

The basis of the dollar system

Back in 1945, it made perfect sense to base new global trade and investment arrangements on the dollar. America accounted for 50% of global GDP, and was the world’s biggest creditor nation. There was no rival – not even the USSR – to America’s geopolitical and economic supremacy.

The Bretton Woods system, established in 1944, was the foundation-stone of the post-war economic and financial architecture. Other currencies moved around a dollar which itself was tied to gold. The major transnational institutions – which now include the BIS and the FSB as well as the IMF and the World Bank – are dollar-denominated agencies, meaning that their activities and reporting are undertaken in dollars.

But a great deal has changed since 1945. Depending on how we measure it, the US share of global GDP has fallen to either 25% or, more realistically, 15%, and America is now the world’s biggest debtor nation.

The Bretton Woods system was broken in 1971, when Richard Nixon suspended the gold convertibility of the dollar.

This meant that the dollar gained primacy in a wholly fiat system which, in theory, sets no limits on how much currency any individual jurisdiction can issue. In practice, America has direct access to a global credit system to which all other countries’ access is mediated by the markets.

America may or may not be gaming this system to political advantage through sanctions, but the US certainly abuses its primacy when it undertakes reckless public borrowing. The latest trillion-dollar increment to US government debt was added in the final fourteen weeks of 2023.

No other country – not even China – can get away with anything remotely like this. A case in point was the attempt of the British government, in September 2022, to borrow £220bn (about $330bn) to finance £60bn of household energy support plus £161bn of tax cuts to be spread over five years.

The markets stopped this plan, by selling GBP down to crisis levels, and driving the yields on gilts (British government bonds) sharply upwards. Some might argue that that particular fiscal gambit deserved to be stopped, but the point is that dollar-denominated markets pass verdicts on government policies.

America isn’t exempt from market pressure, but its public borrowing is direct-from-source, and the Fed has far more rate-determining influence than any other central bank.

Matters of cost

The way the dollar-denominated system works can be illustrated by reference to oil. Any country wishing to import oil must first earn or buy the dollars needed to settle this trade, and the oil exporting recipients must, for want of alternatives, put their receipts into a world financial system denominated in dollars. The US not only has privileged access to the global credit system but could even, in extremis, simply create (“print”) the dollars needed for imports, whether of oil or of anything else.

Is there a cost, to this dollar-denominated system, for countries in the WOUSA (the World outside the United States)? It’s arguable, not just that there is such a cost, but that this cost is exorbitant.

In considering the cost of dollar privilege, we need to draw a clear distinction between finance and economics. Whilst financial transactions between currencies necessarily take place at market rates, there’s an alternative (and more meaningful) convention when it comes to making international comparisons and calculating global economic aggregates.

This is PPP conversion into international dollars.

PPP means “purchasing power parity”. If, for instance, the same product or service sells for £10 in Britain and $15 in America, the PPP GBP exchange rate for that particular item is $1.50. The greater meaningfulness of PPP conversion is reflected in its use for the calculation and forecasting of global GDP. If it’s confirmed (by the IMF) that the world economy grew by 2.5% last year, that will be a PPP-based measurement.

In Western countries, PPP rates are seldom very far from market ones, but very different circumstances apply in much of the EM world. In 2022, Russian GDP (of 153tn roubles) translated to $4.8tn in PPP dollars, but only $2.2tn at market rates. Similarly, Chinese dollar GDP in 2022 was $29.9tn (bigger than the American economy) in PPP terms, but only $17.9tn in market dollars.

If, for purposes of comparison with the US, we converted the defence budgets of China and Russia into market dollars, we’d be understating how much those countries are really spending on pay and procurement undertaken in local currencies, because we’d be using a misleading basis of currency comparison.

For our purposes, the point about drawing a clear distinction between finance and economics when using these different FX conventions is that what the FX markets think about a currency isn’t economic ‘fact’.

PPP gives us a much more meaningful measure of the comparative size of economies, and therefore provides important information about different countries’ roles in the global economy.

This is illustrated in Fig.1.

Taking provisional data for 2023 in market dollars, global GDP was $103tn, or $77tn in the WOUSA economy. But WOUSA GDP in international (PPP) dollars was far higher than this, at $143tn PPP.

What’s important here is the international purchasing power of countries other than the US. They produce local-equivalent GDP of $143tn, but would get only $77tn for it in the theoretical event of selling it all on forex markets.

In other words, every PPP dollar-equivalent of WOUSA GDP is priced at only $0.54 in market dollars.

These countries aren’t, of course, going to “sell” their GDP on dollar-denominated markets, but conversion into dollars at market rates exerts a major influence on their economic standing, particularly when it comes to borrowing and investment. This also has a bearing on bilateral and multilateral trade and investment flows between countries.

The application of PPP enables us to calculate the rate of exchange between the market dollar and its international counterpart. The market dollar has been weakening on this basis (Fig. 1D), but the exorbitant privilege of the USD remains substantial.

Fig. 1

Starting with oil

There’s no reason, in principle, why countries shouldn’t agree to settle bilateral or multilateral trades in currencies other than the dollar. China, for instance, can buy oil from Saudi Arabia, and pay for it in renminbi, riyals or a combination of the two. Such trades could even be settled in gold.

The BRICS+ group is well on its way to doing exactly this. The accession, effective 1^st January, of Iran, Saudi and the UAE to a group which already includes Russia means that BRICS+ accounts for getting on for half of all global oil production and an even larger proportion of the international trade in petroleum.

Regular readers will need no reminder about the geopolitical importance of energy in general, and petroleum in particular. Those who want us to ‘just stop’ the use of oil have yet to tell us how we’d manage without tractors, combine harvesters, food delivery trucks or ambulances. It would be tricky to mine, process and transport steel, copper or lithium – or any other commodity needed for transition to renewable energy – if we had to rely entirely on shovels, mules and human labour.

There’s a strong environmental case to be made for reducing discretionary (non-essential) consumption of oil by, for example, driving less and flying less. But such choices are likely to be imposed upon us anyway, as the costs of energy-intensive necessities rise within a contracting economy.

In the world as it was and still is, oil remains a vital commodity.

America won the Pacific war because the US had oil, and Imperial Japan, despite seizing the Dutch East Indies, did not. Germany might have emerged victorious from the European war had she seized the oil fields of the Near and Middle East. This made Malta the “hinge of fate”, because forces based on the island seriously disrupted supplies to the Afrika Korps.

In more recent times, the imposition of the OAPEC oil export embargo in response to the 1973 Yom Kippur war caused crude prices to almost quadruple in a matter of months. This plunged much of the world into the chaos of severe inflation, sharp rate rises, fuel rationing, power blackouts and industrial unrest, the latter caused by workers demanding pay rises sufficient to keep up with the soaring cost of living.

It was (and remains) unfortunate that some politicians were able to persuade voters that the hardships of the seventies were caused, not – as was in fact the case – by two successive oil crises, but by ‘leftist’ (Keynesian) government policies and the malign influence of organised labour.

The events of 1973-74 may have faded into memory and political-economic folklore, but it’s worth remembering that much of the world is only ever two seaway closures away from a re-run.

Winners and losers in a divided world

More prosaically, there’s no reason why BRICS+ countries shouldn’t extend their non-dollar trade from oil into natural gas, chemicals, minerals and agricultural commodities, or why other countries, within or outside an expanding BRICS+ group, shouldn’t do the same.

Where trade and investment are concerned, the BRICS+ member nations don’t need to wait unless and until they have a fully-formed settlement system, or a common currency usable in the superstores of Shanghai or the coffee-shops of Riyadh.

They can get on with non-dollar trade right now, and have enormous incentives for doing exactly that.

Dollar hegemony, then, isn’t likely to be ended by a replacement currency or currencies, but by the successive splitting-off of important trade flows from the dollar-denominated system.

The danger in this, from an American and Western perspective, is the division of the global economy into two parts, where “we” (the West) have all the Hollywood blockbusters and Silicon Valley gizmos (and most of the debt), whilst “they” have all the oil, natural gas, chemicals, minerals and foodstuffs.

That would put “us” on the wrong side of new patterns in global trade.

This is a particularly disturbing prospect for a Europe which doesn’t have America’s resource wealth, and can no longer import energy from Russia.

But America should be, and perhaps is, concerned that its privileged access to debt capital, and to comparatively cheap dollar-priced commodity supplies, is becoming time-limited.

Tim Morgan

#268: At the end of the last delusion

TOWARDS A ‘NEW ECONOMICS’

One discovery really can change everything. What we are now discovering is that the economy – the system which supplies material products and services to society – has stopped growing, and has started to contract.

What this discovery means is that everything affected by economic conditions – including finance, politics, and the balance of forces within society – is going to change in ways that are only now starting to become apparent.

This is isn’t a difficult discovery or, even remotely, a new one. It has been known since at least as far back as 1972, when the authors of The Limits to Growth gave us a remarkably prescient picture of how events would pan out.

Far from being a hard concept to grasp, the reality is the simple impossibility of infinite economic expansion on a finite planet. That energy is at the core of everything material – which of necessity includes the economy – is day-one knowledge for every student of biology, chemistry or physics.

What falsified the gloomy predictions of Thomas Malthus was the omission of energy from his calculus. He didn’t, and arguably couldn’t, have foreseen how the harnessing of energy from coal, oil and natural gas was going to transform everything, including the production of food.

We cannot conclude, as an absolute certainty, that the fading out of the fossil fuel impetus is going to compress society back to a pre-industrial scale and simplicity.

But we are entitled to conclude that the economy will contract unless and until a successor form of energy is discovered. That successor energy must match or exceed the energy density of fossil fuels. Neither renewables nor – in our current state of knowledge – nuclear power can deliver on that requirement.

The idea that the economy is entirely under our control is nothing more than formalised hubris. The “dismal science” of economics may or may not be dismal, but it certainly isn’t a science. The “laws” of economics are nothing more than behavioural observations about the human artefact of money, and are in no way analogous to the laws of the physical sciences.

We are inching, painfully slowly, towards a new conception of economics. This will be built on a combination of disciplines. Thermodynamics will answer material questions, such as the creation, operation, maintenance and replacement of the productive system. Behavioural analysis will address questions of human interaction within the monetary parallel of the material economic system.

There’s a prior analogy for this duality, though in that instance the disciplines drew apart rather than converging. This dates from a time when the study of the material was known as “natural philosophy”, as distinct from the “moral philosophy” of studying behavioural issues in society. From this duality emerged the separate concepts of “natural sciences” and philosophy as the study of the human condition.

Economics, which has to try to balance the relationships between the “natural” (science) and the human (“philosophy”), has managed, in its orthodox or classical form, to get this duality hopelessly mixed up.

No apology need be made for reiterating that the banking system cannot lend energy or other resources into existence, and that central bankers can’t conjure them from the ether. When we pore over the latest puffs of smoke from the Federal Reserve, or mull over the promises and pronouncements made by politicians, what we’re considering is finance, which isn’t remotely the same thing as economics.

However painful and protracted the process may be, fact always wins out over fiction.

The facts of the economy are that we use energy to extract raw materials and convert them into products and services. This, like so much else, is a duality. Just as energy is used to convert materials into products, so energy itself is converted from a dense to a diffuse form. This diffuse form is waste heat, and, when fossil fuels are the dense energy input to the system, this waste heat contains climate-harming gases.

These productive and diffusive systems are inseparable, and of corresponding length. If we switch to energy inputs of lesser density, we truncate (shorten) the dissipative process. This means that the productive sequence, too, is shortened, resulting in a smaller economy.

This applies just as much to services as it does to products. We cannot deliver parcels without a vehicle, or provide technological services without hardware. In both cases, energy is required to operate the hardware, as well as to create it and, in due course, replace it.

Economic supply is thus a productive-dissipative equation. It becomes a dissipative-landfill system when we choose to accelerate the cycle of creation, disposal and replacement.

Hitherto, this dissipative-landfill model, which is the basis of consumerism, has been feasible because we’ve had the material abundance of the energy needed to make it work, and the assumed abundance of the ability of the environment to absorb the by-products of this behaviour.

Time is being called on the dissipative-landfill model, and this call is coming from two directions.

It is surely clear beyond dispute that we are testing, and probably over-taxing, the absorption tolerances of the natural environment.

Meanwhile, our past exploitation of the easiest, lowest-cost sources of fossil fuel energy has put us onto a decline path, where each new source of oil, gas or coal has a lesser ex-cost value than the one that it replaces.

My approach to the duality of economics has been to propose the concept of “two economies”. One of these is the “real economy” of material products and services, a system driven by energy. The other is the parallel “financial economy” of money, transactions and credit.

SEEDS – the Surplus Energy Economics Data System – interprets and projects the economy on the basis of this duality. It reveals that numerous economic problems are traceable to imbalances in the relationship between the “two economies” of the material and the monetary.

The linkage between the two is hierarchical. At least in theory, the “real” economy could exist without its financial counterpart. It is at least possible for us to operate the material economy on the basis of sharing, barter or centralised allocation.

But the “financial” economy cannot exist without its material corollary. Having no intrinsic worth, money commands value only as an exercisable “claim” on the material products and services for which it can be exchanged.

Beyond efficiency of exchange, what the financial economy brings to the party is temporal distinction. Money can be spent now (“flow”), or it can be set aside for the future (“stock”). We measure the stock of the material in days or weeks of forward demand (or, in the case of electricity, in minutes or seconds). With the stock component of money, we can enter into transactions extending decades into the future.

Critically, though, the choice between flow and stock does not change the fundamental monetary characteristic of exchange value as “claim”. We can make promises ranging far into the future, but we cannot honour them if, at the due date, there is an insufficiency of material products and services required for the process of exchange.

As a human artefact, money is vulnerable to fakery, even if there is no malign intent.

In the world of fine art, fakery is deliberate if it involves knocking up a picture at home and trying to pass it off on an unsuspecting buyer as a Rembrandt. Fakery can be unintentional if we’ve always believed – mistakenly – that the painting that’s been hanging in the drawing room for generations is a genuine Gainsborough.

The same applies to financial commitments. When we enter into transactions whose closure will not occur until decades have passed, the best we can do is to either calculate – or simply assume – that, when that day comes, the material wherewithal required will be available.

The financial economy, in its stock function of assets and liabilities, is based on a set of assumptions which are – in most cases inadvertently – false. The idea that the economy is an infinitely-expanding system powered by money is a fallacy. The economy is, in reality, an energy system, limited by the finality of resource value and the finality of environmental tolerance.

This, ultimately, is why we’ve been using fakery – perhaps innocent, perhaps intentional – to keep the financial system from toppling over. We tried to counter the deceleration (“secular stagnation”) of the 1990s by ramping up the supply of credit to the system. When this led, not to the nirvana of accelerating material growth, but to the crisis of 2008-09, we opted to turbocharge the credit flow with monetary gimmickry.

The result has been the simultaneous creation of an “everything bubble” in asset prices (which is destined to burst) and a liabilities mountain (which must collapse because it cannot possibly be honoured).

This has turned into a version of the old childhood game of “pass the parcel”. We don’t know when the music will stop, but we do know that it will. What we need to find, in the rubble of the detonated asset bubble and the debris of the exploded credit mountain, is a way of understanding the economy, not as we might like it to be, but as it really is.

 

Tim Morgan

 

#267: How to be happy, wealthy, and bankrupt

FINANCIALIZATION, ANOMALY AND RISK IN AN INFLECTING ECONOMY

It’s been said that, when events turn fast, furious and frightening, and civilians are panicking, the professionals get ever cooler and more calmly calculating.

If this is so, we’ll need to be very professional indeed in 2024.

One of our most serious challenges is that economic and financial forces are pulling in opposite directions. Transactional activity, and the aggregates of assets and liabilities, are continuing to expand, even as the underlying material economy is inflecting from growth into contraction.

Our interest, in this first article of 2024, is in the process of financialization which is driving this divergence. We need to know why parallel forces are driving us to a state of simultaneous affluence and destitution, and why trends increasingly obvious to investors in energy are still invisible to those investing in almost everything else.

Just one consequence of this disconnect is the ludicrous proposition that fossil fuel assets – without which we cannot possibly transition to renewables – are somehow “stranded” and valueless, when the reality is the polar opposite of this exercise in absurdity.

Where wealth is concerned, capital theory tells us that, as the authorities continue to prop up the flow side of the economy by wrecking the stock side of the equation, the resort to ever-looser monetary policies should result in continuing rises in asset prices.

At the same time, though, a point will soon be reached at which the sheer magnitude of our mountainous debt and quasi-debt liabilities induces confidence-snapping vertigo.

Soaring asset prices are, logically, going to make us rich, then, just as escalating liabilities are going to land us in the poor-house. Since logic baulks at the concept of affluent bankruptcy, it’s hard to avoid the conclusion that we’re going to end up owning vast amounts of worthless money.

We’re going to need every analytical skill at our disposal, and every piece of innovative thinking we can lay our hands on, to come out on the right side of this progression.

Meanwhile, in the markets, and indeed in industry, we’re seeing the emergence of a remarkable anomaly.

On the one hand, investors, and energy industry decision-makers too, are reluctantly coming to terms with a material reality, which is that renewables aren’t going to deliver the much-vaunted abundance of low-cost energy after all.

We’re not going to get rich, then, by investing in wind, solar or hydrogen companies, and the development of these energy sources is going to be much costlier, and far less profitable, than had hitherto been assumed. Indeed, it’s hard to escape the conclusion that transition to renewables, if it’s going to happen at all, is going to need subsidy, which can only come from consumers, taxpayers, or both.

On the other hand, though, nobody is yet making the connection from the suppliers to the users of energy. If renewable energy isn’t going to be cheap for those who produce it, neither can it power a tech-and-leisure utopia in which the broader market still believes.

Our need, as I see it, is to deepen our understanding of a series of complex dynamics – the material and the monetary in economics, flow-stock equations in finance, and the energy-prosperity relationship in the material economy.

So let’s get started.

 

What is financialization?

Technically speaking, the term “financialization” references growth in the absolute and proportionate size of the financial services sector of the economy, a process that carries with it increases in intermediation, and rises in debt-to-equity ratios in business. It’s a term used to describe the rise of ‘financial capitalism’, a variant of, or a successor to, the industrial capitalism of the past.

One can easily see why the term financialization is used pejoratively. Critics allege, for example, that the manufacture and sale of a car needs to be no more than a bilateral transaction between the manufacturer and the purchaser of the vehicle, and that both parties lose out through the unnecessary insertion, for profit, of financial intermediation into such transactions. A riposte to this might be that, without the availability of finance, the car could neither be made nor purchased at all.

The aim here, though, is to be analytical rather than judgemental.

Leaving the politics out of things, financialization has two primary effects. The first is the insertion of more transactional activity into the exchanging of any given quantity of material products and services. The second is that debts and quasi-debts (debt-equivalents) have to increase in order to fund this increased transactional activity or churn.

To emphasise – because this is critical to understanding – the analytical significance of financialization is that it increases transactional activity without adding material economic value. Why this matters will become apparent shortly.

Financialization has been moving on from the established definition of increasing the use of financial services, and hence of credit, within the economy. For example, when a person’s information is garnered for sale to advertisers, his or her data has been financialized. When our otherwise-unvalued time spent waiting to be served at a post office or a delicatessen is used as a marketing opportunity by putting a screen in front of us, that waiting time, too, has been financialized.

This extension of financialization feeds into a new business model. Historically, the aim of businesses has been to sell products or services to customers. Increasingly, this aim has shifted towards the development of streams of income, most commonly as ad-supported or subscription services. There has been a parallel rise in staged payment purchases – in shorthand, BNPL (buy-now, pay-later) – which is a process that comes nearer to the standard definition of financialization.

The streams-of-income model has carried over from the flow side of the financial equation to the stock side, which is what happens when such hypothecated revenue streams are capitalised.

This presents two specific challenges. First, this business model is likely to turn out to be far more fragile than has yet been recognised – ad spending and subscriptions are amongst the easiest savings possible for hard-pressed businesses and households.

Second, its failure could trigger interconnected detonations across the financial system.

Before we get into that, though, let’s remind ourselves about some little-known fundamentals of finance and, first, the economy itself.

 

Financialization in context

As you may know, there is an essential prerequisite for the effective understanding of finance and the economy.

This is the conceptual necessity of two economies.

One of these two economies is the “real economy” of material products and services, and the other is the parallel “financial economy” of money, transactions and credit.

We can, if we choose, stick to the old Flat Earth notion of a materially unconstrained economy, capable of perpetual expansion, and explicable in terms of money alone. But, in an age of increasingly apparent material and environmental boundaries, the classical immaterial straightjacket to economic thinking, with its assurances of infinite growth on a finite planet, is going the way of the dodo.

The material has arrived, in the sense that physical and environmental limitations are forcing themselves upon our unwilling attention. Environmental deterioration can’t be bought off with money. Central bankers can’t conjure low-cost energy, or high-density mineral resources, out of the ether.

It transpires that most processes – including inflation/deflation, asset price bubbles and liability-driven crises – are ultimately traceable to distortions within the relationship between these “two economies”.

As the fossil fuel impetus fades away, and with no real (as opposed to mistakenly suppositional) complete alternative in sight, the material “real” economy is inflecting from growth into contraction.

At the same time, the parallel financial economy has been expanding at an accelerating pace.

This divergence is dangerous, because it moves the system away from the fundamentally necessary equilibrium between the financial and the material.

This equilibrium is a necessity because, properly understood, money has no intrinsic worth, and its value resides entirely in its role as an exercisable claim on the material economy. If the aggregate of these claims outgrows the wherewithal to honour them, the resulting body of “excess claims” must be diluted or destroyed. We can try to push the restoration of equilibrium out into the future, but we can’t eliminate the dynamic.

Financialization, as we’re looking at it here, is driving this worsening disequilibrium because, as we’ve noted, it involves the attachment of additional financial transactional activity to any given quantity of material economic value in the form of goods or services.

The necessary accompaniments of this form of financialization are (a) the inflating and subsequent bursting of asset price bubbles, (b) the parallel accumulation and destruction of enormous financial liabilities, and (c) the monetary degradation that may attend efforts to prevent these reversions to equilibrium from playing out.

We cannot trace this process through conventional metrics, because, contrary to widespread misunderstanding, GDP is a measure, not of material economic output, but of transactional activity. Accordingly, financialization creates a comforting illusion of growth in ways that serve to disguise the real hazards of super-rapid liability and asset market expansion.

This is why we need to use our own tools and insights, based here on “two economies” and the SEEDS economic model.

 

A big anomaly

One of the skills we’re going to need going forward is an enhanced ability to spot internal contradictions.

One such anomaly is the divergence between the energy-supplying and the energy-consuming sides of the capital markets.

In energy supply, one myth remains intact, and one is now succumbing to reality.

The intact myth is that fossil fuel assets are somehow “stranded”, and of little or no value. As we shall see, this must be one of the daftest conclusions ever reached in investment analysis.

The myth that’s now succumbing to reality is the notion that renewable energy can only get less expensive over time.

This is where an anomaly of perceptions – a failure to link up the fortunes of energy suppliers with those of energy users – is coming to the fore.

Energy users don’t come any bigger, in simple financial terms, than the Big Seven tech stocks. These continue to storm ahead – their aggregate market value increased by about 75% in 2023, and now matches the combined market capitalisations of the Japanese, British, Chinese, French and Canadian exchanges.

But nobody seems to be asking the hard questions about what’s going to power tech activities (or anything else) in an energy-constrained future.

The almost universally-proffered answer is that Big Tech – and pretty much everything else – will be powered by cheap renewable energy. The only fly in this ointment is that renewables aren’t going to be cheap. Their lesser energy-densities, in comparison with fossil fuels, make this impossible.

Some people, though, are asking this question rather than simply assuming a comfortable answer to it. These are the people who manage, and invest in, the renewable energy supply sector of the market.

A little forensic analysis gives us a clue to this big anomaly that’s emerging in the financial markets, albeit as yet seemingly unnoticed by asset allocators.

As the always-insightful Goehring & Rozencwajg have pointed out, the prices of a host of renewable energy stocks – including Orsted, Nextera and Plug Power – have plunged from previously-exuberant highs, whilst the corporate appetite for investment in renewables projects has been decreasing markedly.

The stock price examples cited by G&R are not exceptions to an otherwise positive trend. On the contrary, as of mid-December, the S&P Global Clean Energy Index and the S&P Global Clean Energy Select Index had fallen by 21% and 28%, respectively, since the start of 2023. This contrasts very starkly indeed with a rise of about 25% in the S&P 500 itself over that same period.

To be clear about this, renewables development is still happening, but it’s turned into an uphill slog. Power prices have to rise to keep it viable, and subsidy may be the only way to stop the wheels from falling off.

Ultimately, business and domestic consumers will have to pay for that, either as customers or as taxpayers, because there’s nobody else who can. And, by definition, if people have to spend more on one thing, they have less to spend on something else.

 

The advance of non-cheap renewables

The underlying problem is that ‘cheap’ renewable energy is turning out not to be cheap after all. Some of us have never believed it would be.

For a start, cheap wind and solar power requires cheap fossil fuel energy to deliver all the steel, cement, copper, lithium, cobalt and other raw materials needed to build, operate, maintain and replace the system.

This linkage dictates that, if the material (ECoE) costs of fossil fuels are rising relentlessly, which they are, those of renewables cannot decrease. This linkage also makes the very idea of “stranded” or ‘valueless’ fossil fuel assets an absurdity.

To return to a point made earlier, the rationale informing the impossibility of cheap renewable energy is a straightforward matter of energy density. The densities of renewables are lower than those of fossil fuels, and technology can’t overturn the laws of physics in order to change this material relationship. The lower the density of an energy source is, the larger – the more material-intensive, and the more costly – the delivery infrastructure has to be.

The message clearly being taken on board by energy investors is that, contrary to what had previously been received wisdom, wind and solar power are not going to deliver enormous profits through the supply of ultra-cheap energy for sale at healthy margins to domestic and business customers.

Where investors in energy itself are concerned, then, this penny seems to have dropped. But, if renewables aren’t going to be highly-profitable or low-cost for those who supply them, what about those who use them?

Is it feasible that non-cheap energy can power us to an ultra-profitable tech and leisure nirvana?

Can consumers really become more prosperous when the material cost of the energy embedded in everything they buy carries on rising?

Somebody, somewhere, has got their wires crossed.

With that noted, let’s get back to financialization, and the disequilibrium between the “two economies”.

 

The credit engine

With financialization, of necessity, goes credit expansion. When seen through the prism of “two economies”, it’s readily apparent that there’s no other way of financing the churn.

Over the past twenty years – and stated in real (ex-inflation) terms in international PPP dollars – global debt has increased by $265 trillion, but this doesn’t include broader financial liabilities, such as those of “shadow banking” (the non-bank financial intermediary or NBFI sector).

Because of glaring gaps in the availability of data, we can only estimate growth in these broader liability aggregates, put here at about $320tn, which is almost certainly a pretty conservative calculation. Beyond this again lie rapid rises in the “gaps” in unfunded pension commitments, and the potential nightmare that is derivatives.

Global broad liabilities, then, have increased by about $585tn in real terms over twenty years. which is roughly 7X the expansion in reported real GDP (+$83tn).

That ratio, in itself, is wholly unsustainable. But the real sting in the tail here is that three-quarters of that supposed “growth” has been the cosmetic effect of financialization itself.

By backing out the growth-inflating “credit effect”, and deducting the first call on output made by the Energy Cost of Energy, SEEDS analysis reveals that world material economic prosperity increased by only $20.6tn (rather than $83tn) between 2002 and 2022. We should never forget that, as mentioned earlier, gross domestic product isn’t a measure of material economic output, but of financial transactions, which is a very different thing, and the creation of non-value-additive transactional activity is a necessary statistical product of financialization.

What the numbers tell us is that, in annual, inflation-adjusted terms, we have become, over twenty years, materially better off by less than $21tn, having ramped up our collective liabilities by getting on for $600tn.

We can see the sleight-of-hand of financialization in numerous instances. If IMF data published in October is confirmed by final outcomes, for example, the American economy, measured as real GDP, will have grown by about 2.1% in 2023. But the same data puts ‘general government net borrowing’ – the fiscal deficit – at 8.2% of GDP.

This means that about US$530bn of growth will have been bought with upwards of US$2.1tn of government borrowing, the latter confirmed by American public debt breaking the US$34tn barrier. This is even before we include increases in household and corporate debt (and, of course, in their NBFI and other quasi-debt exposures).

It’s an often-remarked fact that the American consumer has been extremely resilient in recent times, comfortably out-spending inflation – but it’s hard to see how he or she could have been anything less than resilient, when being handed this much additional liquidity, borrowed on his or her behalf by the government.

 

Another anomaly – the concept of wealthy bankruptcy

Part of the contradiction in the financialized morass in which we have become entangled is that the same factors that seem ‘good’ for asset prices are simultaneously ‘bad’ for economic stability.

Within capital theory, there’s a valid debate to be had about which – interest rates or liquidity? – is the primary driver of asset prices. A reasonable conclusion might be that asset prices are a function of the supply and the cost of capital, because these are linked – an increase in the quantity of money (a rise in liquidity) is consistent with a decrease in its price (interest rates).

On this basis, expansionary fiscal and monetary policies point towards continuing rises in the prices of stocks and property. To prop up GDP, and pretend to deliver “growth”, the authorities will have to carry on driving public (and, for that matter, private) debt upwards.

Some observers think that the central banks’ real motivation in pushing rates upwards was to create headroom for cutting them again when exigencies require. The logic of ever-rising public debt points towards both lower rates (to keep government debt servicing affordable) and a reversion from QT to QE, to create enough debt-rollover liquidity in the system and, perhaps, to fund public borrowing if other sources fail.

So far, so good. But the same dynamics that seem destined to make us wealthy (by driving asset prices upwards) also seem destined to put us in a Marshalsea debtors’ gaol (by pushing debt and quasi-debt to ever more stratospheric levels).

We are, then, going to be both (a) rich beyond the dreams of avarice, and simultaneously (b) bankrupt, defined as having liabilities that we can’t possibly honour. (We can’t, collectively, pay off the debts by selling the assets, because any amount of asset sales requires a matching quantity of purchases).

 

A twisting road to reality

Just as surely as nature abhors a vacuum, logic abhors the concept of wealthy bankruptcy.

There are two ways – though they are not mutually exclusive – in which this contradiction can be resolved. First, the mountain of liabilities could collapse, taking asset values down with it. The second is that runaway money-creation could destroy the purchasing power of currencies.

We might, then, find ourselves the possessors of vast amounts of worthless money. If this is how things turn out, financialization, in all of its various forms, will have been ‘a road to ruin, paved with bad incentives’.

Before it quite gets to this, though, some other processes can be expected to kick in. These are best considered pictorially, using charts sourced from SEEDS.

The first chart shows how rapidly debts and broader liabilities have been outstripping even GDP, let alone underlying prosperity.

At the same time, risk itself has been rising as the disequilibrium between the real and the financial economies has become progressively more extreme (Fig. 1B).

In short, the quantum of liabilities has been rising, just as their risk profile has been worsening.

If we retrofit transactional activities to the prosperity curve (Fig. 1C), we can see how much prior “growth” has been inflated artificially.

The further introduction of segmental analysis – dividing output into essentials, capital investment and discretionary consumption – enables us see an emerging dynamic in which consumers’ ability to afford non-essential products and services is coming under relentless pressure.

What Fig. 1D does is to reveal to us those economic processes which are being experienced as the ‘cost of living crisis’. We’re at the start of a steep downwards incline, not just in the affordability of discretionaries, but also in the ability of the household sector to service its ever-growing mountain of financial commitments.

Meanwhile, and just as financial investment is increasing, capital investment – that’s to say, investment in the creation and replacement of productive capacity – is on a declining path.

 

Fig. 1

Where now?

Looking at our predicament, whether as description or as charts, a number of critical points become apparent.

First, the same financialization process which is creating a simulacrum of “growth” is driving debt and broader liabilities to a point at which vertigo sets in. A clear implication is that the “everything bubble” in asset prices must explode, and that decision-makers must adopt ever looser fiscal and monetary policies in an effort to keep the show on the road.

Analysis of the material economy, meanwhile, reveals a background process in which certain sectors – led by discretionaries, and by those over-invested in the supposedly-perpetual miracle of financialization – either contract or disappear.

Your guess is as good as mine as to whether the economy contracts gradually, or a financial collapse burns out the wiring linking the components of the material economy.

All we can really do is work out the pattern of stresses in the system, thereby trying to push the odds in directions favourable for ourselves.

It’s an old adage that ‘the most dangerous part of a car is the nut holding the steering wheel’.

Where decision-making is concerned, we can only hope that the arrival of materiality brings wisdom where the progression of financialization has brought folly.

 

Tim Morgan