#257: Of theory and practice


Even with the best intent, it can be hard for anyone to pause and take an objective look at his own work. For this reason, I’m very grateful to blogger The Naked Emperor (NE) for an article, entitled The Everything Bubble, The End Of Growth & Managing Expectations – A theory to explain everything, which sets out an admirably concise, balanced, accurate and readable summary of my economic thesis.

The bottom line of this thesis is that growth in the material economy of products and services has drawn to a close, and involuntary economic de-growth has begun. The financial system, entirely predicated on the contrary assumption of growth in perpetuity, has become disconnected from economic reality.

I don’t contend that the reversal of prior economic expansion has been any kind of sudden event – on the contrary, we’re witnessing the culmination of a decades-long process in which the economy has moved from deceleration, via stagnation, into contraction. If we haven’t seen this coming, it’s largely because we have had no wish to do so.

If I read the article correctly – and NE is welcome to put me right if I don’t – the inference is that the authorities’ own assessment of the situation runs along similar lines, and that this kind of analysis “convinces politicians to pursue policies which don’t seem to be in the public’s interest”.

This, NE says, could explain why we see “governments pushing for ever greater control”, which they will need “to control citizens as their prosperity declines”. NE cites my recent identification of an emerging “modified consensus” as evidence that “they are managing expectations downwards”. Pandemic lockdowns, “a self-destructive Net Zero agenda” and soaring immigration are placed in this same sequence of interpretation and response.

I can’t know if the authorities do see things in this way. What I can say, though, is that there’s no reason why they couldn’t have reached the same conclusions and, if they have, then many of the actions cited by NE would fit into a logical pattern.


What’s should we expect?

NE traces my writings as far back as ‘Perfect storm – energy, finance and the end of growth’, published in 2013, when I was Head of Research at Tullett Prebon, a leading intermediary in international financial and energy markets. NE summarises my conclusions as “a financial shock that will dwarf 2008”, “government breaking down in the face of failing prosperity”, and “the acceleration of economic deterioration”.

As things stand, a financial shock of unprecedented severity has become inescapable, because the financial system, understood as a vast interconnected mass of forward promises, now incorporates commitments far in excess of anything that the economy itself will be able to honour. High inflation would be one way of destroying excess forward commitments, but this could only work to defuse existing financial obligations if we didn’t simultaneously carry on creating new ones.

Part of the problem is that the authorities have only limited oversight over what’s happening to the creation of financial liabilities. They can’t control the supply of “shadow credit”, for which we don’t even have complete data. Some forms of non-bank credit, being already costly, have limited sensitivity to rate rises. ‘Buy now, pay later’, the label attached to some types of consumer credit, could be used as a description for what has happened to the financial system as a whole.

We might describe this as the provision, to households, of debt that they can’t repay to buy things that they don’t need.

Economic deterioration has long been under way in the West, and most EM (emerging market) economies, too, have now reached the point at which prior growth in material prosperity goes into reverse. The emergence of a “modified consensus” suggests to me that we’re nearing a point at which prior assurances of infinite economic expansion lose their credibility.

Whether government breaks down will depend very largely upon the ability of leaders to grasp what’s happening, and commit to tackling it in a way consistent with the best interests of the general public. To be sure, there’s scant evidence of any such commitment at present, but political trends do tend to be shaped by economic developments. It’s not impossible that major financial and economic crises will bring to the fore a new cadre of leaders who are more aware of economic reality, and more committed to the public good.

The incumbent strategy – if indeed there is one, beyond ‘buying time and hoping that something will turn up’ – seems to be to promise that current hardships, though they may prove protracted (the “modified consensus”), will be followed by a golden age of prosperity and environmental stability (“sustainable growth”), delivered by the march of technology and an abundance of low-cost energy sourced from renewables.

As I see it, this vision is extremely implausible, and so, therefore, is the maintenance and increase of the wealth and power of incumbent elites. The Naked Emperor may well be right about fear of the consequences of economic contraction being the motivation behind “governments pushing for ever greater control”.


The thesis

The central idea of my interpretation is the need to recognise the concept of two economies. These are the ‘real economy’ of material products and services, and the parallel ‘financial economy’ of money and credit. Making this distinction enables us to examine, as separate entities, the nature of each economy, and make comparisons between the two.

The ‘real’ or physical economy is an energy system, reflecting the obvious fact that nothing that has any economic utility at all can be made available without the use of energy. It’s equally obvious that money has no intrinsic worth – it would be of no use to us if we were stranded on a desert island – but commands value solely in terms of the things for which we can exchange it.

In other words, money functions only as a ‘claim’ on material products and services.

Accordingly, the ‘financial’ economy is a ‘claims proxy’ of the real economy.

Time to move on

The ‘two economies’ concept provides us with two interpretative opportunities. The first is that we can reject – or rather, we can move on from – an orthodoxy which states that the economy can be explained in terms of money alone. If we were to accept that money is the only driver of the economy, then the fact that money is a human artefact entirely under our control could easily lead us to conclude, quite mistakenly, that there need never be any limit to the scope for economic expansion.

By dismissing the constraints of the material in this way, conventional economics makes the illogical promise of ‘infinite growth on a finite planet’. It implies – dangerously, in my view – that we can use money to work around all physical limitations. If this were true, we could resolve our climatic and ecological problems by sending a cheque to the environment. The banking system could lend resources (including low-cost energy) into existence, and central banks could conjure them ex nihilo out of the ether.

In short, this is a tarradiddle, and has long been challenged by rational thinkers. The authors of the remarkably prescient The Limits to Growth (LtG) emphasised the primacy of the material back in 1972. In the following year, Kenneth Boulding, co-founder of general systems theory, said that “[a]nyone who believes exponential growth can go on forever in a finite world is either a madman or an economist”.

Reasoned analysis, then, has been knocking on the door for at least half a century.

Re-interpreting economics makes far more sense than trying to co-exist with the consequences of nonsense. There are plenty of reasons to think that we may now have the chance to move on with our economic thinking. This opportunity exists because material problems are forcing themselves upon our attention.

Environmental hazards, for example, which are amongst today’s most important issues, are emphatically material, and cannot be resolved financially.

Just as importantly, there is increasing evidence that prior growth in the physical economy of products and services has been faltering towards reversal. We’re seeing this at first-hand in widening hardship. Efforts to restore “growth” with credit and monetary gimmickry have been tried ever since the 1990s, and have failed spectacularly.

In short, the large and complex modern economy has been a product, not of money, but of energy, and the heirs to Adam Smith can no longer claim credit for the progression of prosperity delivered by the heirs to James Watt.


The scope for knowing

The second opportunity offered by the ‘two economies’ concept is the ability which it provides for us to interpret and model the real and financial economies independently of each other.

Comparing, say, dollars with dollars can’t really tell us all that much. Comparing dollars with joules, or BTUs, or tonnes of oil-equivalent, on the other hand, opens up broad new avenues for interpretation, innovation and, be it added, quantitative measurement. It would be ironic, but in no way surprising, if the ending of two centuries of assured growth coincided with a fundamental rethink about how the economy actually functions.

It’s for each individual to decide whether he or she accepts the concept of two parallel economies. My view is that it’s a truism about how the economy works. This concept makes it possible to calibrate and compare the material and the monetary.

Simply stated, we can use what we know about the material economy to reference what we think or are told about the financial one.

We can reasonably conclude that these two economies were closely linked for most of the industrial era, with monetary claims advancing at pretty much the same pace as material wherewithal. We weren’t driving a wedge between the financial and the material because, for as long as material growth continued, we had no need to fake it. The dangers of monetary recklessness had been understood at the level of general consciousness long before they were exemplified for subsequent generations by the Weimar hyperinflation crisis.

We can also, incidentally, view the experiences of the interwar years as something of a precursor for what’s happening now, with financial over-expansion in the 1920s resulting in the Great Depression of the 1930s. The world’s productive potential in 1930 was no smaller than it had been in 1920, and may well have been greater. What had gone wrong was that the financial had been allowed to get out of sync with the material.

The big difference – and it’s massive – between then and now is that, whilst the material economy remained capable of much further expansion as of 1930, this is not the case today. Back in the 1920s and 1930s, we made a mess of ‘the financial economy’, but were bailed out by continuing growth in ‘the real economy’. This cannot happen now.

Throughout the industrial era, we – or our leaders on our behalf – have made some colossal mistakes. Whenever this has happened, we’ve been rescued by growth. We’ve even seen countries laid waste by war turned into modern economic success-stories. In short, we’ve been able to ‘grow out of’ the consequences of our blunders, much as youngsters ‘grow out of’ childhood ailments.

My analysis indicates that this recovery capability no longer exists, because the underlying economic dynamic has turned against expansion. If we, or those taking decisions for us, carry on getting things wrong, we’ll have to live with the consequences.


Of ‘in and out’

Analytically, drawing a distinction between the two economies enables us to see the material economy for what it is – a system which uses energy to convert raw materials into physical products and services. We can define the output of this system as value, because we wouldn’t produce these various goods and services unless we valued them.

We can further observe that much of the material value thus created ends up in landfill. We can also say that ‘consumerism’ has been a product of an expanding material economy. We know that all of this is determined by the supply, value and cost of energy.

Just as money has value only as ‘claim’, and energy is the prerequisite for the supply of products and services, it’s an equally obvious fact – our third – that energy, as well as providing value, comes at a cost.

We can’t produce and consume oil or gas without wells, refineries, processing plants and a physical distribution system. We can’t put coal to use without investing in mining equipment. We can’t access wind or solar power without manufacturing turbines, solar panels, batteries and supply grids. We can also state, factually, that none of the infrastructure required to put energy to use can be made available without the use of energy.

The result is an ‘in-out’ energy equation, describing a process where we ‘use energy to get energy’. We benefit from this activity only when ‘energy out’ exceeds ‘energy in’. This comes pretty close to being a law of nature – an animal or a bird survives if, and only if, the energy obtained from consuming food exceeds the energy expended in obtaining it.


The role of money

We could, if we so decided, study and calibrate the ‘real economy’ entirely in energy units, without bringing money into the equation at all. But we need to express the real economy in financial notation if we’re to use it as a benchmark for referencing the parallel ‘financial economy’ proxy. The main purpose of the SEEDS model is to measure the ‘real economy’ and express it in financial terms, thereby making ‘two economies’ analysis possible.

We need to be quite clear about the temporal (over time) nature of money. If a certain amount of money arrives in somebody’s pocket today, he or she makes a choice between spending it now, or putting it aside for later.

Therefore, the financial economy exists in two forms – the flow of money used in day-to-day transactional exchanges of products and services, and the stock of money which, we assume, gives us valid claims on material products and services in the future.

This ‘now-or-later?’ choice is central to the entire financial process. The system can be managed in ways which influence this choice. If interest rates – more broadly, returns on invested capital – are high, people have an incentive to save. Saving is important, not just in allowing individuals to provide for the future, but also because it supplies capital for investment. If, on the other hand, returns on capital are low – and especially if inflation seems set to destroy the future purchasing power of money – people are incentivised to spend rather than to save.

We need to be quite clear that the distinction between stock and flow, which is so critical for the ‘financial economy’, has no counterpart in the ‘real’ economy. We can create monetary claims whose point of exercise lies decades in the future. But we measure the storage of fossil fuel energy in months, and electrical power in minutes.

The Naked Emperor quotes Czech economist Tomas Sedlacek to the effect that the interest-bearing credit system enables us to “energy-strip the future to the benefit of the present”. Another way of putting this is that, since debt is ‘a claim on future money’, whilst money itself is ‘a claim on energy’, it follows that ‘debt is a claim on future energy’.

Logically, this requires that anyone issuing or taking on a debt in the present ought to know whether this debt can be honoured by the amount of energy that will be available when the debt falls due for repayment.

This, of course, isn’t how the credit system actually operates. Lenders and borrowers simply assume that the economy, seen entirely in monetary terms, will expand enough over time to enable debt and interest to be paid.


The state of play

Here, then, is what we know about the ‘two economies’.

The ‘real economy’ is an energy system, and is defined as the use, in the present, of energy to supply products and services of value. The factors that determine the size of the real economy at any given time are the supply, value and cost of energy. Activity made possible by energy includes the construction of productive capacity, infrastructure, and facilities such as homes, hospitals and schools.

The ‘financial economy’ consists of monetary claims, of which some are exercised in the present, whilst others are set aside for the future. The financial system comprises an aggregation of forward claims, whose viability depends on the delivery capacity of the real (energy) economy of the future.

As remarked earlier, when creating these claims, we don’t assess their viability by enquiring into the probable size of the real economy of the future. We simply assume that the economy, defined financially, must carry on expanding.

On this basis, we have constructed a financial system that prioritises innovation over sustainability. Now that the ‘real’ economy has stopped growing, we’re about to discover that we have innovated our way to a systemic crisis.

The SEEDS model uses many techniques and metrics to interpret and describe the ‘two economies’ of energy and money, and some of the most important are summarised in the following charts.

The ‘financial economy’, represented by reported GDP, has carried on growing, largely because the transactional activity recorded as GDP has been inflated artificially by the breakneck creation of ever greater future claims (Fig. 1A). In other words, we’ve been flattering perceived flow by adding to the stock of liabilities, and then turning a blind eye to the linkage between the two.

Largely out of sight, the ‘real economy’ has been decelerating towards contraction (1B). This has happened because, through the process of depletion, the ECoEs – the Energy Costs of Energy – of fossil fuels have been rising relentlessly, reducing the amount of prosperity obtained from each unit of energy consumed.

Accordingly, a severe disequilibrium has emerged between the real and the financial economies (1C).

It’s only when we recognize that the eventually tendency must be towards equilibrium between the two economies – and apply the measured magnitude of disequilibrium to the current scale of forward liabilities (1D) – that we become aware of the inevitable destabilization of the financial system.


Fig. 1

What happens next?

By applying the logic of ‘the two economies’ to prior trends and current conditions, we can develop considerable visibility about the future course of economic and financial events.

Barring the discovery of a full value replacement for fossil fuels – which hasn’t happened yet, and is highly unlikely to happen within the limited time available – material prosperity will carry on contracting. The energy-intensive nature of so many necessities implies that, as the real costs of essentials rise, there will be a leveraged decline in the affordability of discretionary (non-essential) products and services.

Inevitably, we’re going to try to stave off these realities using financial gimmickry. This could be characterised by the suppliers of non-essential products and services trying to bolster their sales by providing credit to their customers. There are limits to how far the authorities can (or might be prepared) to contain this conversion of the economy into a BNPL (‘buy now, pay later’) system.

We need simply note that, every time we try to prop up parts of the real economy by borrowing from the future, we bring the financial system itself nearer to the edge of the cliff.

The only meaningful way in which we can assess the outlook for the financial system is by viewing it as an aggregated stock of financial claims on the real economy of the future. The sheer scale of disequilibrium and exposure in the system makes a crisis inevitable.

Asset prices can be expected to slump, but what really matters is the scale and viability of liabilities. We don’t even have a full calibration of the scale of these liabilities. The authorities could, of course, try to inflate away the real value of these commitments, but they cannot prevent a countervailing increase in outstanding liabilities, most obviously in the “shadow banking” sector.

One does not need to be an advocate of unlimited government power to regret that the regulatory remit of the authorities doesn’t extend further into the supply of credit. There’s a case for saying that, whilst the protection of the individual as depositor is important, there is a macroprudential case for far greater protection of the citizen as borrower.

How these issues – falling prosperity, rapidly decreasing discretionary affordability and systemic financial crises – are likely to unfold is in part a matter of speculation, but it does seem to me that certain preparatory measures might usefully be put in place.

It should already be apparent that we need a blueprint for a post-crisis financial system. Likewise, we need to think about how to cope with widening and worsening hardship as the economic means of many falls below the costs of necessities. If we can reach a point at which leaders cease to promise that a ‘temporary’ period of hardship will be followed by the ‘sunlit uplands’ of “sustainable growth”, some progress, at least, will have been made.


#256: A path of logic


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

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

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

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

Surveying the landscape

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

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

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

Fig. 1

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

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

The application of reason

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

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

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

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

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

Fig. 2

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

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

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

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

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

Fig. 3

Of cost and prosperity

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

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

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

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

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

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

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

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

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

Fig. 4

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

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

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

The monetary corollary

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

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

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

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

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

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

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

Fig. 5

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

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

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

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

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

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

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

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

#255: The emerging ‘modified consensus’


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

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

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

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

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

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

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

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

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

Of logic and evidence

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

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

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

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

From evidence to modification

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

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

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

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

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

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

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

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

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

Scenario analysis

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

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

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

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

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

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

Fig. 1

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

Fig. 2

Broad implications

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

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

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

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

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

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

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

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

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

Extended scenarios

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

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

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

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

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

Fig. 3

#254: A tale of two economies


After more than two centuries of expansion, the global economy has inflected into contraction, meaning that prior growth in material prosperity has gone into reverse. By 2040, aggregate prosperity is projected to be 13% lower than it was in 2019, implying that the prosperity of the world’s average person will have fallen by about 26% over that period.

Meanwhile, his or her real cost of energy-intensive essentials is likely to have risen by around 40% in real terms, except that the definition of ‘essential’ will have to have been changed in order to keep that number within the upper limit set by prosperity. Discretionary (non-essential) consumption will have collapsed.

The financial system, as it is currently understood, will have disappeared, the presumption being that a slimmed-down, more strictly-functional alternative will have taken its place. The process of financial implosion may involve runaway inflation, a cascade of defaults or, more probably, a combination of both.

What this means in social and political terms lies outside the scope of Surplus Energy Economics, but it seems unlikely that current arrangements, which combine pockets of affluence with widespread and worsening hardship, will still be in place.

It is, of course, sometimes easier to predict longer-term outcomes than more immediate events. In mid-1942, for instance, the objective observer might not have known that the Wehrmacht was going to lose the Battle of Stalingrad, but the ultimate defeat of the Axis powers was already highly probable.

As it applies to economics, this means that what will happen is a great deal clearer than when it will happen. If someone was about to take a very long holiday, not returning until 2040, he or she could work out which investments to ditch, which forms of value to accumulate, which national economies to avoid and, quite possibly, where to place a proxy vote in order to be on the winning side of elections taking place in 2040.

Since taking a seventeen-year vacation is outside the bounds of possibility for most of us, what we have to do is muddle through, but how effectively we can do this depends on how much visibility we have over the unfolding trends of the future. What we really need is a single key to unlock the mystery of forward events as their precursor trends exist in the present.

This key already exists. I first referenced it in Life After Growth, published almost ten years ago. It’s the concept of two economies.

Comes the day

If the day ever dawns when economics is taught rationally, the first item on the school or college curriculum will be the concept of ‘two economies’. One of these is the real (or ‘physical’) economy of material products and services. The other is the financial economy of money and credit.

There is an incontrovertible logic which informs this distinction. Money has no intrinsic worth, but commands value only in terms of the material things for which it can be exchanged. First-year students of the future might be taught this by being asked to picture themselves adrift in a lifeboat, or stranded in a desert. In such situations, no amount of money would be of the slightest value to them, and it wouldn’t matter if this money was fiat currency, bullion, gemstones, cryptos or even, for that matter, cowrie shells.

In other words, the financial economy is a proxy for the real economy, just as money and credit are proxies for the products and services for which they can be exchanged.

Anyone who understands the conceptual distinction between the material and the monetary is in a fair way towards knowing how the economy has evolved in the recent past, how it functions in the present, and what’s likely to happen to it in the future. Anyone who does not grasp this distinction, on the other hand, has embarked on the intellectual equivalent of G.K. Chesterton’s journey “to Birmingham by way of Beachy Head”.

The what and where of inflation

The reality of the two economies is playing out with particular force right now, and nowhere more obviously than with inflation. A ‘price’, logically considered, is ‘a financial value attached to a material product or service’. Prices, in other words, are the interface between the material and the financial economies. Accordingly, inflation or deflation – defined as rises or falls in prices – are functions of changes in the relationship between the material and the monetary economies.

This tells us something of great importance. We can understand the mechanisms of prices and inflation if we study the two economies, calibrate them separately, and examine the relationship between them. Conversely, we will never reach a full understanding of inflation unless and until we look at things in this way. It is, of course, pretty difficult to measure something, let alone manage it, if you don’t really know how it works.

Some aspects of this relationship are illustrated in the first set of charts, all of which present global numbers calculated by converting other currencies into constant dollars using the PPP (purchasing power parity) convention.

Between 2001 and 2022, reported world real GDP – a proxy for the financial economy – expanded by 109%, a compound annual rate of growth of just short of 3.6%. Material prosperity, by contrast, grew at an annual rate of just 1.2% between those years, increasing by only 30% between 2001 and 2022.

This means that underlying inflation – which the SEEDS model measures as RRCI, meaning the Realised Rate of Comprehensive Inflation – averaged 4.2% between those years, far higher than the 1.9% reported as the GDP deflator. To be clear, what SEEDS calculates as RRCI is the underlying or real rate of conversion between nominal economic transactional activity and the generation of material economic value over time.

Fig. 1

It’s probably a reasonable assumption that you wouldn’t be reading this article unless you knew, or at least suspected, that there’s something seriously amiss with the way in which issues are presented to us using the methodologies of orthodox economics. It seems an equally fair assumption that you’re interested in discovering how events are likely to develop on the basis of the system properly understood on the basis of the ‘two economies’ of the material and the monetary.

It will, no doubt, have occurred to you that, if we can calibrate the material and monetary economies as distinct entities, we can measure, not just the pricing relationship between them at any given time, but the degree of tension or stress between the two of them as well.

Likewise, the existence of ‘two economies’ makes it perfectly feasible for different people to have different experiences, depending upon which of the two economies – the monetary or the material – determines their circumstances.

This is why the same national economy can contain pockets of affluence within a broader landscape of hardship and decay.

The material economy – heading into contraction

Let’s start our analysis by looking at how the ‘two economies’ function. The ‘real’ economy is simply described – it uses energy to convert raw materials into products, and also uses energy to provide physical services to consumers. Historic analysis reveals a remarkably consistent and linear relationship between the amount of energy used in the economy and the quantity or ‘output’ of goods and services produced.

Actually, there are two dimensions to the generation of economic value using energy. One of these is output, meaning the quantitative supply of products and services into which energy is converted. The other is prosperity, and the difference between the two is the deduction of the cost of energy supply. This cost is defined here as the Energy Cost of Energy (ECoE), meaning ‘that proportion of accessed energy which, being consumed in the energy access process, is not available for any other economic purpose’.

This definition identifies a three-part equation determining the evolution of prosperity over time. To measure prosperity, we need to know (a) how much energy will be available at any given moment, (b) the rate at which this energy is converted into material economic value, and (c) the cost deduction which is the difference between output and prosperity.

Three observations assist us in this calculation. First, the conversion ratio between energy use and the value of economic output has been strikingly consistent for a very long time. Second, ECoEs evolve comparatively gradually, for reasons which are well understood. Third, the qualitative (cost) profile of energy exerts a significant influence of the quantitative availability of primary energy.

Let’s briefly review these parameters, referring to the charts shown in Fig. 2. Over a long period stretching back to 1980, the relationship between energy consumption and underlying or ‘clean’ economic output (C-GDP) has been remarkably consistent (see Figs. 2A and 2B).

Overall ECoEs have been rising relentlessly, a trend that is unlikely to change, given the lesser density of (and the associated complications with) wind and solar energy in comparison with fossil fuels (Fig. 2C).

This upwards trend in ECoEs makes it increasingly difficult to strike energy prices that meet the needs of both suppliers (whose costs are rising) and consumers (whose prosperity is decreasing). Accordingly, the likelihood is that the aggregate supply of energy to the economy will decrease, with the availability of fossil fuels falling more rapidly than the supply of renewables can be expanded to replace them.

Prior evidence suggests that there’s unlikely to be any major change in the ratio by which energy consumption is converted into economic value. Therefore, we can anticipate a relatively gradual, quantity-related decline in top-line economic output, but a more rapid contraction in the generation of prosperity, with rising ECoEs widening the gap between the two (Fig. 2D).

Fig. 2

The financial economy – scope for self-deception

As we turn from the ‘real’ economy of products and services to the ‘financial’ economy of money and credit, there are two points that we need to note. First, orthodox economics doesn’t recognize the distinction between the monetary and the material, regarding the latter as nothing more than a function of the former. Anyone finding this oversight hard to believe need only reflect on the absurdity of the promise of ‘infinite growth on a finite planet’ proclaimed by a conventional school of economic thought which dismisses the very concept of material limits.

Second, two centuries of economic expansion have been more than enough to create a culture of hubris and entitlement. We are, then, as unable to contemplate the concept of economic limits as we are, perhaps, to grasp the concept of an infinite universe.

The primary metric used in orthodox macroeconomics is gross domestic product. GDP, we are told, measures national or global economic output, and, by inference, also measures material prosperity. In fact, GDP doesn’t measure output, let alone prosperity. Rather, it measures the quantity of transactions that take place in the financial economy, which is a very different thing.

Because money can be created at will, there’s no theoretical limit to the number of transactions that can take place. This doesn’t, of course, mean that there are no limits to the supply of material products and services.

Conflating financial transactions with material output is one of the most bizarre examples of myopia in the modern world. Many people have argued, no doubt correctly, that ‘there’s more to life than money’. But few recognize the equally accurate statement that ‘there’s more to economics than money’.

Clearing up the money-output misconception is actually pretty straightforward. As we have seen, money is a human artefact, validated by exchange – money doesn’t contain value, but functions as a body of aggregated claims on the value made available by the material economy.

Whenever money changes hands – that is to say, whenever financial claims are exercised – the result is a transaction. Accordingly, it will be apparent that the value of a transaction lies, not in the transaction itself, but in the product or service that is the subject of the transaction.

GDP, being a purely financial metric, is in reality nothing more than a summation of transactions. It’s perfectly possible, indeed commonplace, for transactions to take place through which no material value is added to the economy. This is particularly true where quantities of money are interchanged without reference to material products or services, or where existing assets are the subject of transactions.

For example, person A has bought a house for $500,000. He or she now sells it to person B for $750,000. The item sold hasn’t changed – it’s the same house – but an incremental transaction has taken place, generating income for intermediaries. This income is a function of the transaction price of the asset (a stock), but is included in the aggregate flow of transactions measured and reported as GDP.

The process of divergence

In practical terms, and in part because asset prices are a function of the cost and availability of credit, this means that we can inflate transactional activity artificially by expanding the aggregate of credit. Exactly this effect is observable in the way in which, over the past two decades, each additional transactional dollar (counted as real GDP) has been accompanied by more than $3 of net new debt.

The consequence is that, if we disregard this ‘credit effect’ – and simultaneously disregard ECoE as well – we can grow reported GDP without reference to any positive or negative change in the value of the material economy. This is exactly what we’ve been doing since the 1990s, thereby driving a statistical wedge between the financial economy (of GDP) and the material economy (measured by SEEDS as prosperity). This process is illustrated in Fig. 3.

Together, the credit effect and the disregard of ECoE have created a relentless divergence between prosperity and GDP (Fig. 3A). A simultaneous consequence has been a widening gap between the flow of output (whether measured as transactional GDP or as material prosperity) and the stock of forward financial claims (Fig. 3B).

Fig. 3

When we compare the financial and the real levels of output, as in Fig. 3C, we are able to measure the relationship between the two.

Remembering that the financial economy of claims exists only as a proxy for the real economy of products and services, it becomes apparent that the eventual tendency must be towards equilibrium, where the quantity of claims matches the quantity of products and services against which these claims are, either now or in the future, capable of being validated by exchange.

Where the body of claims becomes excessive in relation to the value available for honouring them, this ‘excess claims value’ must, by definition, be destroyed, because it cannot be ‘honoured for value’.

This may seem very theoretical, but its implications are practical and its basic precepts are surely indisputable. We can create ‘claims’, primarily as credit, and we can count the transactional exchange of these claims, but we delude ourselves if we assert that the totality of claims exchanges corresponds to economic output and prosperity, which, in reality, it does not.

We can cut to the chase here by asking ourselves two questions. First, can the commercial banking system lend products, services – or their underlying energy basis – into existence? Second, can central banks create products, services or energy out of the ether? Since the answer to both questions is no, it becomes self-evident that the creation of claims does not simultaneously create the material wherewithal required to honour those claims.

Time arbitrage

There is one, and only one, area of ‘wriggle room’ in this equation, and that resides in the temporal (time-related) character of money. Monetary claims don’t have to be exercised entirely in the present – we can, instead, store (save) them for exercise in the future. This, though, buys time without changing the fundamentals, which are that monetary claims are valid to the extent (and only to the extent) that they can be honoured for value, either now or in the future.

This enables us to persuade ourselves that claims which are excessive in the present might become valid in the future, so long as the underlying wherewithal – the material economy – expands over time. We can thus convince ourselves that excessive debt and other commitments are, like childhood ailments, something we can ‘grow out of’. This, though, ceases to have any kind of validity once the material economy has ceased growing, and has started to contract, as is now the case.

The SEEDS model generates a ‘rule of thumb’ calculation for the extent of excess claims destruction embodied in the system, and this is illustrated in Fig. 3. As of 2022, the calculated flow gap (or ‘disequilibrium’) between the monetary and the material economies is put at -43% (Fig. 3C). If we apply this to outstanding debt and broader commitments (Fig. 3D), we can calculate a ready-reckoner for the extent of claims stock loss that can be anticipated as a product of the restoration of monetary-material equilibrium.

No way out?

The concepts we’ve been contemplating here – the “two economies”, material constraints, inflation as the two economies interface, and so on – have two shared characteristics. The first is that they are supported by logic and observation in ways that seem incontrovertible. The second is that they are disregarded, or indeed dismissed, both by orthodox economics and by those whose decisions and pronouncements are based on this orthodoxy.

One of the problems with orthodox economic interpretation is a refusal to contemplate even the possibility of fundamental misconception. Likewise, it seems incumbent on us to test our analysis by asking if there are any events which could change future outcomes from those projected and quantified here using the SEEDS economic model.

There are, surely, no contradictions to two of our basic precepts. We don’t need to set ourselves adrift in a lifeboat to prove to ourselves that money has no intrinsic worth. Neither do we need to shut down all supplies of energy to demonstrate that the economy is an energy system. In short, the concept of the ‘two economies’ of the material and the monetary seems to be incontrovertible.

What, then, could result in outcomes better than those with which we began this discussion? There’s a simple answer to this, which is the discovery of a fully-equivalent replacement for the energy hitherto supplied by oil, natural gas and coal. We cannot say that no such discovery will ever be made in the future. But we can conclude that any such full-value energy replacement won’t be found in a combination of solar panels, wind turbines and batteries.

The impossibility of a complete transition to a wind-and-solar version of the current economy can be explained in many ways. Building and maintaining such systems would require the use of raw materials on a vast scale, which really means that we would need correspondingly enormous amounts of energy to access these materials, convert them into products and equipment, and transport them to where they are needed. We cannot circumvent this problem by improving the conversion efficiency of wind turbines or solar panels beyond certain maxima clearly established in physics (Betz’ Law for wind power and the Shockley-Quiesser limit for solar).

Ultimately, though, the problem with renewables as currently understood is that their density is less than that of fossil fuels. Two conjoined processes define the material economy. One of these is the use of energy to convert raw materials into products. The other is the accompanying dissipative process which converts energy from a concentrated to a diffuse form. If we reduce the density of the energy input, we simultaneously truncate (shorten) the material conversion process, resulting in less output and a smaller economy.

In 1801, with Britain fearful of an invasion by Napoleon’s seemingly invincible armies, Admiral John Jervis, 1st Earl St Vincent, reassured the Admiralty in this way – “I do not say, my Lords, that the French will not come. I say only they will not come by sea”.

Likewise, it would be a step too far to assert that no complete replacement for the energy value hitherto sourced from fossil fuels will ever be found. We can only conclude that wind and solar power cannot provide this complete replacement.

This does not in any way undermine the case for maximising the potential of renewables. As the ECoEs of oil, gas and coal continue to rise, continued reliance on fossil fuels would be every bit as harmful for the economy as it is already proving to be for the environment.

We may – the jury is still out on this – be able to develop a sustainable economy on the basis of wind and solar power. What we cannot expect is that any such economy would be as large and as complex as the one we have now.

#253: How has it come to this?


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

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

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

Where’s the risk?

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

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

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

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

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

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

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

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

No way out?

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

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

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

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

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

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

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

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

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

Daring to look

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

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

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

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

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

#252: Hardest months, strangest years


Try as I might, I’ve never quite understood why T.S. Eliot picked on April as “the cruellest month”. In the northern hemisphere, winter is receding into memory by the time that April arrives, whilst spring sees nature getting back into its stride, with May and June, perhaps my favourite months, just around the corner.

April might not, then, be the cruellest month but, for me, it’s almost always the busiest. April is when we get a raft of new economic data, including final outcomes for a lot of prior year metrics, and all of this has to be incorporated into the SEEDS system.

From next month, 2022 replaces 2021 as the base year, meaning that constant financial data is expressed at 2022 values. This conversion of past numbers into their current equivalents requires application of the global GDP deflator, a series which, to the best of my knowledge, isn’t actually published anywhere. It should be noted, in passing, that there are two versions of the global deflator, depending on whether we’re converting other currencies into dollars at market or PPP (purchasing power parity) rates of exchange.

With apologies to those who already know this, SEEDS – the Surplus Energy Economics Data System – is a proprietary economic model built on the understanding that the economy is an energy system, and is not, as we are so routinely informed, entirely a matter of money.

With each year’s iteration, I try to improve the model, and the next version – ‘SEEDS 24A’, as it will be known – will incorporate more detail in two areas, which are broad financial liabilities, and the SEEDS-based RRCI (Realised Rate of Comprehensive Inflation) measure of systemic inflation.

Both are of obvious importance right now. The authorities are trying to tackle inflation without, in my opinion, having a system-wide measure of what it actually is, whilst the stability of the financial system going forward depends, not so much on ‘banks’ as such, but on the broader interconnected network of commitments. Expressed in market dollars, the aggregate of debts owed to banks by private (household and business) borrowers is just over US$90 trillion, but SEEDS estimates put global non-government liabilities at close to US$500tn.

For context, even in the wildly implausible event of all of the world’s central bankers getting together and agreeing to double their assets, the new funds thus created would cover less than 10% of broad private sector exposure.

Development of the SEEDS model began almost ten years ago, following the creation of the Surplus Energy Economics site and the publication of Life After Growth. Work on the latter persuaded me that, if the economy is indeed an energy system, there’s not much point in modelling it as though the only thing that matters in economics is money. The aim was to find out whether it was possible to model the economy on the basis of energy principles.

The strangest years

These, as you will know, have been strange years in economic and financial terms, though the period of strangeness stretches back a lot further than 2013. I hope that some reflections on this might assist our discussion of where things are likely to go next.

I like to begin the ‘narrative of the strangest years’ back in the 1990s. This, as many readers will remember, was the time when the USSR had collapsed, and satellite countries were in the process of leaving the Soviet system, variously known as COMECON and the Warsaw Pact.

For Western leaders, and indeed for their citizens, this seemed an era full of promise. The failure of Soviet collectivism appeared, by default, to have vindicated the superior merits of the market capitalist system. Western governments could anticipate a “peace dividend” from the ending of the Cold War. In the early 1990s, economies seemed set to benefit from ‘the great moderation’, a favourable combination of solid growth and low inflation. People were beginning to debate climate issues, but the threat of what was then known as “global warming” was a cloud that seemed, at that time, ‘little bigger than a man’s hand’.

If you recall this era, and concur with the foregoing description of it, you might be minded to wonder ‘where did it all go wrong?’ It’s fair to characterise our current time as one of extreme financial instability and, for millions, of worsening economic hardship. In stark contrast with the quarter-century after the Second World War, we have been witnessing a relentless widening in the gap between the wealth and incomes of the majority and those of an affluent elite.

There are all sorts of explanations for why so little of the promise of 1993 seems to have been realised in 2023, but only one interpretation really fits the facts. This interpretation is that the era of dramatic economic growth created by accessing coal, oil and natural gas has been drawing to a close.

This has happened in a gradual but relentless way, spanning a quarter-century precursor zone that has seen economic deceleration give way to stagnation, and stagnation succeeded by contraction. The SEEDS model indicates that average global prosperity per person turned down after 2019, and that world aggregate prosperity may have peaked in 2022.

Comparatively few people doubt that reliance on carbon energy has, at the very least, contributed to our environmental and ecological predicament, but it seems to me that fewer still are aware of the effect that the deteriorating economics of fossil fuels have been having on the economy and the financial system.

The effect of energy deterioration can best be expressed using a metric that is known here as the Energy Cost of Energy. Whenever energy is accessed for our use, some of this energy is always consumed in the access process. Within any given quantity of available energy, a rise in ECoEs reduces the remaining ‘surplus’ energy that’s available for any other economic purpose.

Throughout the fossil fuel era, we have always used lowest-cost resources first, saving costlier alternatives for later. The resulting process of depletion has been pushing up ECoEs, and this trend started to affect economic performance during the 1990s, with global trend ECoE from all sources of energy rising from 2.9% in 1990 to 4.2% in 2000.

What this meant was that growth in the material economy decelerated because of a factor, ECoE, which was and is neither recognized nor accepted by conventional economic theory. Fallacious (monetary) diagnosis has led to a succession of mistaken policy responses, starting in the 1990s with ‘credit adventurism’, when it became easier to access new debt than at any time in modern history. This led to the GFC (global financial crisis) of 2008-09, to which we responded with the ‘monetary adventurism’ of QE, ZIRP and NIRP.

Parallel sequences

This much regular readers will know, but what matters here is the equation of two parallel sequences. On the one hand, growth in material prosperity has decelerated, and then stagnated, before going into reverse. On the other, our ever more fallacious attempts to fix a material problem with monetary innovation has driven a widening wedge between the ‘real’ economy of products and services and the ‘financial’ or proxy economy of money and credit.

Once this is understood, past trends start to take on the character of a logical progression, and the future becomes both clearer and more daunting. The material economy will continue to deteriorate, and the ever-widening gap between the material and the financial will fracture the latter.

To be clear, the material economy cannot be compelled to accord with the monetary one – low-cost energy can’t be loaned into existence by the banking system, or created out of the ether by central bankers. Management of the financial system involves a choice between flexing with the real economy, or holding out rigidly against it to the point of fracture.

The course of events since the GFC illustrates our collective pursuit of the wrong choice. Ultra-cheap money was adopted in extremis, and its effects were, of necessity, inflationary. Advocates of QE have long denied that money creation causes inflation, but this stance is only tenable if we disregard sharp rises in the prices of assets, and we’ve been asked to believe that low inflation is consistent with the creation of an “everything bubble” in asset markets.

Inflation made the transition from assets to consumer purchases when, during the pandemic lockdowns, QE ceased to be channelled to investors alone, but was directed to households as well. The concept of systemic inflation, measured by SEEDS as RRCI, shows that inflation has been far higher than the reported headline numbers throughout the ‘free money’ era – and, of course, if we recalibrate inflation to levels which turn out to have been higher, the extent of negativity in real interest rates becomes still more pronounced.

Central banks have received a lot of criticism for raising rates, and reversing QE into QT, in  an effort to tame inflation. In fact, such criticism would be far better directed at the long period during which rates were kept below inflation. Anyone who favours market capitalism knows that this system cannot co-exist healthily with negative real rates, because capitalism absolutely requires that the investor earns positive returns on his or her capital.

The central bankers now find themselves in a situation which even they must recognise as being contradictory. On the one hand, they are reversing past money creation (QT) in an effort to bring inflation under control. On the other, they face the probability of having to create a great deal of new liquidity (QE) to backstop troubled parts of the banking and broader credit system. As we’ve seen, the assets of the entire global central banking system equate to less than 10% of world non-government financial liabilities.

Laying it on the line

The best way to try to make sense of all this is to ‘cut to the chase’, and here is how I suggest that we do so. Ultimately, the system of interconnected liabilities that we call ‘the financial system’ is viable if, and only if, household and business borrowers can honour their commitments. The banking and broader financial system wouldn’t be in trouble if, around the world, households were enjoying robust and improving prosperity, and businesses were enjoying high and rising profitability. This, of course, is the opposite of what households and businesses are experiencing now.

This means that effective interpretation requires an assessment of discretionary prosperity, meaning the resources left to consumers after the costs of necessities have been deducted from top-line prosperity. The situation on this metric is that, whilst prosperity is deteriorating, the real costs of energy-intensive necessities are rising.

This tells us two things. The first is that the affordability of discretionary products and services is declining, and the second is that the household sector will find it ever harder to ‘keep up the payments’ on everything from secured and unsecured credit to subscriptions and staged-payment purchases.

This analysis tells us that a large and growing swathe of discretionary sector businesses are under worsening pressure, and that the decline in the value of these sectors will be exacerbated by falling prices in other asset classes, most obviously commercial and residential property.

Perhaps the ultimate ‘statement of the blindingly obvious’ is that the financial system can remain viable only if (a) borrowers are able to meet their commitments, and if (b) the values of assets used as collateral for these obligations do not suffer significant impairment. Where this is not the case, the alternative outcomes are default, on the one hand, and, on the other, hyperinflationary destruction of liabilities.

Inflation has been called a “hard drug”, because it’s an easy habit for an economy to get into, and a hard habit to break. Whatever the sincerity of their current commitment to tackling the inflation caused by their earlier recklessness, central bankers are going to find it very hard indeed to say ‘no’ when pressed to create yet more new money to head off yet more crises.

These are issues to which I’m certain we’ll return. You will, I hope, allow me to say that none of these issues can be assessed effectively, let alone tackled successfully, unless we have a logical and quantified system of interpretation and projection.

#251: The Everything Crisis



Even the most cursory glance at economic and financial history will reveal a litany of bubbles and booms, crashes and crises. We’ve seen numerous instances of speculative manias, real estate bubbles, market collapses and banking crises. Even the dot-com bubble of 1995-2000 wasn’t really ‘a first’, since there’s at least one previous instance – the Railway Mania of the 1840s – of the public being blinded to reality by the glittering allure of the latest vogue in technology.

You’d be wrong, though, if you concluded that “there’s nothing new under the Sun” about what we’re experiencing now. The coming crunch – for which the best shorthand term might be ‘the everything crisis’ – sets new precedents in at least two ways.

First, it’s unusual for all of the various forms of financial crises to happen at the same time. Even the global financial crisis (GFC) of 2008-09 wasn’t an ‘everything crisis’. Now, though, it’s quite possible that we’re experiencing the start of a combined stock, property, banking, financial, economic and technological crisis, with ‘everything happening at once’.

Second, all previous crises have occurred at times when secular (non-cyclical) economic growth remained feasible. This enabled us to ‘grow out of’ these crises, much as youngsters ‘grow out of’ childhood ailments.

No such possibility now exists.

The true story of modern economic and financial history involves, on the one hand, the ending and reversal of centuries of economic expansion and, on the other, an absolute refusal to come to terms with this reality.

What follows is an attempt to tell that story as briefly as possible.

We’ve recently concluded our five-part synopsis of The Surplus Energy Economy, a series which begins here. This means that we don’t need to re-visit now a lot of detailed material that readers can access elsewhere at this site.

It starts here

One of the two core realities of our predicament is that the huge and complex modern economy was built on the abundant, low-cost energy made available by oil, natural gas and coal. Quite naturally, we have accessed lowest-cost energy sources first, leaving costlier alternatives for a ‘later’ which has now arrived. ‘Depletion’ is the term which describes this process, and you would not be far wrong if you concluded that, just as fossil fuel resources have depleted, so has the economy.

Depletion doesn’t mean that we ‘run out of’ the resource in question, but that its supply becomes progressively more expensive. The relevant metric here isn’t financial cost – because we can always create new money – but cost understood as the proportion of energy value which, being consumed in the process of accessing energy, is unavailable for any other economic purpose. This metric is known here as the Energy Cost of Energy, or ECoE.

Global trend ECoE (from all sources of primary energy) has risen from 2.0% in 1980 to almost 10% now, and is likely to reach 13% by 2030, and 17% by 2040. What this means is that, from every 100 units of accessed energy, the ‘available for use’ or surplus component has decreased from 98 units in 1980 to 90 units now, and is likely to have fallen to 83 units by 2040.

It’s important to remember that surplus energy isn’t used just to supply products and services to consumers, but to maintain and replace productive and social infrastructure as well. This means that sensitivity to rising ECoEs is an inverse function of complexity – the more complex an economy is, the greater is the surplus energy required just to sustain the system.

Complexity is highest in the Advanced Economies of the West which has meant, in practice, that prior economic growth in these countries went into reverse first, happening once their ECoEs reached about 5%, a climacteric which was traversed in the early 2000s. EM (emerging market) economies, by virtue of their lesser complexity, have been able to carry on expanding at ECoEs above 5%, but most of these countries have now hit their own inflexion-points, which occur at ECoEs of around 10%.

Accordingly, global prosperity per capita peaked in 2019, and preliminary data indicates that world aggregate prosperity may have peaked in 2022.

‘Affordability compression’ and the leverage of necessities

Any person or family whose economic resources start to decrease faces two main challenges. First, he or she has to devote an ever larger proportion of diminishing income to necessities, spending progressively less on discretionary (non-essential) purchases. Second, it becomes increasingly difficult to keep up the payments on debts and other financial commitments taken on in earlier, more affluent times.

The equivalents of both processes are occurring at the macroeconomic level, but each has a twist. First, a family experiencing a fall in income doesn’t tend to encounter a simultaneous rise in the cost of essentials, but this is happening now in the economy, because so many necessities are energy-intensive. The second twist is that, whilst individuals and households can’t conjure new money out of the ether, those managing the economy itself can do this (though they can’t, of course, create economic value by creating money).

The portmanteau term used here to describe this process is affordability compression. At its most basic, this is very simple to unpack:

  • Prosperity is deteriorating because ECoEs are rising.
  • The costs of necessities are rising because so many of them are energy-intensive.
  • The economy is experiencing relentless downwards pressure on its ability to afford discretionary products and services.
  • Prior financial commitments are proving ever harder to honour.

The great folly

    None of this is entirely new. Between 1990 and 2000, global trend ECoEs rose from 2.9% to 4.2%, the latter pretty close to the inflexion-point of 5% as it applies to the complex economies of the West. The practical consequence of this trend was growing awareness, during the 1990s, of “secular stagnation”, meaning a non-cyclical decline in the rate of growth.

    Intelligent people would have reacted to this phenomenon by enquiring into it, and responding accordingly. The concept of the economy as an energy rather than a financial system had been established well before then, and the remarkably prescient The Limits to Growth (LtG), published back in 1972, had warned us about what to expect.

    Needless to say, intelligent investigation and reasoned response wasn’t what happened back in the 1990s, which is when the story of our current problems arguably begins. The proponents of orthodox economics denied that there was anything to worry about because, according to their most cherished precepts, there was no reason why economic growth should ever come to an end. The broader perception was that LtG was wrong, not because its precepts and techniques were mistaken, but because its conclusions were unpalatable.

    The fundamental error within conventional economics is the presumption that the economy is entirely a financial system, which is not constrained by material limits and is, therefore, capable of delivering ‘infinite growth on a finite planet’. A sub-set of this folly is the belief that the ‘liberal’ process of de-regulation can boost ‘growth’, a fallacy that was particularly fashionable in the decade or so after the collapse of collectivism as represented by the USSR.

    Accordingly, the favoured response to “secular stagnation” was to make it easier to borrow than at any previous time in modern history. This was also required if globalization was to succeed in exporting the process of production to lower-cost countries whilst bolstering consumption in the West, a circle which could only be squared by making it ever easier for Westerners to borrow.

    These processes lead directly to the GFC, which was ultimately the result of reckless credit creation and shortcomings in macroprudential oversight.

    A new model idiocy

    The response to the GFC was a resort to ultra-cheap money. You could have seen this coming if in, say, 2008, you had added up the world’s debts, and then applied a normal interest rate to calculate the aggregate cost of debt service, arriving at a number that was completely unaffordable. This was why the “temporary” expedients of QE, ZIRP and NIRP became permanent fixtures of the system.

    It’s a permissible simplification to state that the general level of asset prices is the inverse of the cost of money. The more cheaply and abundantly capital is made available, the further the prices of stocks, bonds, property and other assets will rise.

    The snag, of course, is that aggregate asset prices are meaningless, because these aggregate valuations can never be turned into money. Just as asset prices soared, so debt and quasi-debt escalated. Obviously enough, we cannot sell the whole stock market – to whom? – to pay off the debts that have been taken on to inflate it. The application of marginal transaction prices to “value” aggregate units is a fallacy that convinces only those willing to be persuaded.

    All of this has left us hoping against hope that ‘something will turn up’ whilst, at the same time, dreading what that ‘something’ might turn out to be. Where sources of hope are concerned, we are really scraping the bottom of the barrel, pinning our faith on replacing dense (fossil) energy with less dense (renewable) alternatives, or backing technology to over-rule the laws of physics. We’re only now starting to discover that creating new money out of the ether is inflationary, a reality that we’ve ignored by persuading ourselves that asset price escalation ‘doesn’t count as inflation’.

    The likeliest course of events now is that the bursting of the “everything bubble” brings on an “everything crisis”. Even unsecured debt is, ultimately, backed by the ‘psychological collateral’ of the assumption that the economy will grow by enough to let us honour our collective obligations.

    To understand why we can’t ‘grow out of’ the unfolding crisis, we need to appreciate that prior economic expansion has gone into reverse. Understanding this issue isn’t difficult, but coming to terms with its implications most certainly is.

    #250: The Surplus Energy Economy, part 5



    Right from the outset, it was likely that the multi-article synopsis of The Surplus Energy Economy would extend to a fifth instalment on the subject of ‘what happens next?’

    What most of us probably want to know is whether the economy is destined for gradual decline or sudden collapse. The indications on this issue are contradictory. On the one hand, the economy itself is subject to trends which, whilst adverse, are essentially gradual. On the other, the financial system has been managed (meaning mis-managed) in ways which seem to eliminate any possibility of managed decline.

    The plan here is to start by examining, in brief, these two, seemingly-contradictory conditions, and then turn to what some of the implications of this asymmetry might be.

    1. The material economy

    As we know, the economy is a system for the supply of material products and services to the public. The resulting aggregate is calculated by the SEEDS economic model and is known here as prosperity. The deduction of necessities supplies a second SEEDS metric known as PXE (prosperity excluding essentials).

    The economy thus described is a product of the use of energy. The vast and complex economy of today can be traced directly to that point in history at which we discovered a means of converting heat into work. The date usually attached to this discovery is 1776, when James Watt completed the first truly efficient steam engine. This discovery enabled us to harness the vast reserves of energy contained in coal, oil and natural gas.

    Quite naturally, we have always accessed lowest-cost resources first, leaving costlier alternatives for later. This ‘later’ has now arrived. Over a lengthy period, the fossil fuel energy supplied to the economy has been getting steadily more expensive. The cost referenced here isn’t financial, but energetic – it’s the percentage of accessed energy which, being consumed in the access process, is not available for any other economic purpose.

    This ‘consumed in access’ component is known here as the Energy Cost of Energy. All-sources ECoEs are on a long-established and relentless uptrend, having risen from 2% in 1980 to 10% now. You might like to think of this as a five-fold increase in the material cost of energy to the economy. This process is continuing, and ECoEs are likely to reach 13% by 2030, and 17% by 2040.

    No economy, as currently conceived, can cope with these levels of ECoE. Complex Western economies have been experiencing (though not admitting to) deteriorating prosperity since the early 2000s, when ECoEs were between 4.2% (in 2000) and 5.7% (in 2008). Less complex EM (emerging market) economies, by virtue of their lower systemic maintenance costs, are better equipped to cope with rising ECoEs, but their prosperity, too, has started to contract now that ECoEs have reached double digits.

    It is widely supposed that we can overcome the effects of deteriorating fossil fuel economics – and simultaneously minimise environmental and ecological harm – by switching to renewable energy sources (REs), principally wind and solar power. These, we are told, can not only support current lifestyles, but deliver “sustainable growth” as well.

    This favourable outcome is, in fact, extremely implausible, for two main reasons. First, scale expansion of the magnitude required would demand vast quantities of concrete, steel, copper, lithium, cobalt and many other inputs which, even where they do exist in the requisite quantities, could only be accessed and put to use using correspondingly vast amounts of energy. Since this could only come from fossil fuels, there is an ‘umbilical link’ between the ECoEs of renewables and those of fossil fuels.

    The second obstacle is even more fundamental. It is that renewable energy is less dense than fossil fuels. The economy operates by using energy to convert raw materials into products, a process whose thermal counterpart is the conversion of energy from dense into diffuse forms, the latter being waste heat. The lesser density of renewables lies at the heart of the practical obstacles to transition – these obstacles include conversion efficiency limitations, intermittency, and the problem of storage.

    These considerations mean that, whilst a sustainable economy might be possible, it would be smaller than the economy that we have now. Simply stated, “sustainability” is feasible, but “sustainable growth” is a pipe-dream.

    Our problems with adjusting to the practical and psychological challenges of economic contraction are compounded by the problem of material leverage. Essentially, the economic resources made available by the use of energy are deployed in three ways. The first of these is the provision of essentials. The second and third, which are the residuals in this equation, are investment in new and replacement productive capacity, and the provision of discretionary (non-essential) products and services to consumers.

    The leverage issue involves the energy-intensive character of essentials. What this means is that, just as prosperity is being driven downwards by rising ECoEs, energy deterioration is driving the real costs of essentials upwards.

    These issues are summarised in the charts in Fig. 16, which are harmonised and, like all charts shown here, can be opened in another tab for improved visibility.

    The first chart (Fig. 16A) shows how energy deterioration is being experienced, not just in output (shown in grey), but also in the ECoE effect on prosperity (blue). The second chart shows segmental allocations between estimated essentials, capital investment and discretionary consumption.

    The third and fourth charts illustrate the compression effect created by the simultaneous decline in prosperity and rise in the cost of essentials. The purpose of the fourth chart, Fig. 16D, is to compare the SEEDS trajectory for PXE (in blue) with what you might anticipate if you relied on orthodox economics and its promise of infinite growth (black).

    Fig. 16

    2. The financial impasse

    As we have seen, then, the economy has already entered a contractionary process, and it’s important to emphasise that visible trends in the material economy, whilst adverse, and even daunting, are essentially gradual.

    ECoEs haven’t jumped from 2% to 10% overnight, but over four decades. Energy supply itself is likely to be driven downwards by deteriorating economics, but – except in certain instances, such as American shales – rates of decline in fossil supply are likely, once again, to be comparatively gradual, and the overall decrease in energy availability can be mitigated, though not reversed, by increases in supply from other sources, including wind, solar, nuclear and hydroelectric power.

    There are two problems, though, with any possibility of gradual or managed economic decline. One of these is the financial system, and the other is a collective and absolute refusal to accept and plan for any possibility other than the mythical (and utterly illogical) prospect of ‘infinite growth on a finite planet’. These, of course, are flip-sides of the same coin.

    We have discussed, in previous articles here, the illogicality of conventional economics, which, by insisting on an entirely monetary interpretation of the economy, dismisses any possibility that there might be material limits to economic activity. What the orthodoxy is pleased to call the “laws” of economics are, in reality, no more than behavioural observations about the human artefact of money, and are in no way analogous to the laws of science.

    Despite abundant evidence of economic deceleration, stagnation and contraction, decision-makers still put their faith in an orthodoxy that is being disproved by events. There has, indeed, been a Thirty Years’ War between orthodoxy and experience, and we are entitled to wonder about the sheer tenacity of mistaken theories about the economy. Why, for example, do decision-makers still pay heed to this outdated orthodoxy?

    There are two answers to this question. First, any orthodox convention that has established itself in systemic thinking can be extremely difficult to dislodge. Second, decision-makers like the orthodoxy because they like the results that it produces.

    In fairness to political leaders, it has to be said that any authoritative acknowledgement of economic contraction would, at the very least, crash the markets. They have good reasons, then, for not talking about economic decline. But they have no excuses whatsoever for failing to plan for it, or for making the situation worse. The latter is what they have been doing, and it’s important that we trace this process through its grim and depressing history.

    This story begins in the 1990s, when the phenomenon of “secular stagnation” – a non-cyclical fall in growth – started to attract attention. We, of course, know that was happening back then was caused by a relentless rise in ECoEs, but no such explanation was countenanced by an orthodoxy which insisted that all economic developments have monetary causes, and can be tackled using monetary tools. By putting together various things that Adam Smith and John Maynard Keynes hadn’t actually said, the chosen ‘fix’ was credit expansion.

    This, of course, didn’t work, because it can’t. Whilst GDP increased by 50% between 1997 and 2007, debt expanded by 77% over this same period. Essentially, each dollar of incremental GDP was being bought with $2.40 of net new debt, whilst 54% of reported “growth” was the cosmetic effect of credit expansion. This led directly to the global financial crisis (GFC) of 2008-09, an event caused by a combination of breakneck liability expansion and the proliferation of dangerous financial practices.

    A case can be made that, under the shot and shell of the GFC, the authorities were justified in using QE, ZIRP and NIRP to steady the ship. These, though, did not turn out to be the “temporary” expedients claimed at the time of their introduction. Even conventional economics would have counselled that negative real rates, reckless credit expansion and the creation of a gigantic “everything bubble” in asset prices could only end badly.

    We may never know why ‘the powers that be’ persisted with these utterly irresponsible practices – perhaps they were enjoying the ride as the financial system careered towards the cliff-edge, and perhaps they believed that people (well, the richest ones) really were getting wealthier as purely paper asset values implied.

    The latter, of course, isn’t even true, in any lasting sense, because inflated asset values will crash when the “everything bubble” bursts. It has been reported that the world’s wealthiest 218,000 people lost 10% of their wealth, or $10 trillion, over the past year, and this may be just a foretaste of what will happen when discretionary sectors start to implode, and defaults start to cascade through the world’s ludicrously over-stretched ecosphere of interconnected liabilities.

    This time around, the leverage effects have been even worse, with each dollar of “growth” between 2007 and 2021 bought with $3.60 of borrowed money, and reported “growth” has been even more cosmetic, with fully 64% of it ascribable to credit expansion. More worryingly still, broad liability expansion averaged an estimated $7 for each dollar of “growth” between 2007 and 2021. Much of this can be ascribed to the non-bank financial intermediary (NBFI) or “shadow banking” sector, which is very largely unregulated.

    The final chart in this five-part series, Fig. 17, endeavours to put this into context by comparing output, debt and estimated broad liability data stated at constant dollar values. Estimated broad liabilities now stand at almost 10X prosperity, and even this doesn’t include enormous “gaps” that have emerged in the adequacy of pension provision.

    Fig. 17

    3. So what next?

    On the basis of what we know, we have strong reasons to fear that the realities of economic contraction will continue to be ignored and that, in consequence, any lingering possibility of managed retreat will be rejected.

    At present, central banks are showing a commitment to taming the inflation that their own policies have created. They have, thus far, shown no inclination towards the “pivot” that many are urging upon them. The best near-term expectation is that current monetary and fiscal policies will continue until the reality of fracture becomes undeniable.

    We can, in the meantime, attach high levels of probability to two processes. One of these is contraction in discretionary sectors, and the other is cascading defaults, commencing at the outer perimeters of the financial system and then travelling inwards towards the regulated banking sector.

    A personal view is that the authorities will find themselves forced into trying to counter these trends by a reversion to expansionary monetary policies. Despite the very real downwards pressures created by economic contraction, it’s likelier that we face an inflationary rather than – or rather, as well as – a hard default resolution to over-inflated capital markets and ludicrously unsupportable levels of liabilities.

    These, of course, are purely economic and financial trends, and I’m sure that readers will have their own views on the broader implications between economic decline and financial chaos.

    Before handing this over to readers for comment, it’s worth asking ourselves what is the worst thing that can happen, in economic terms, in this kind of nightmare scenario. The answer would seem to be the destruction of the purchasing power of money. We may, then, find ourselves needing to find a new medium of exchange. That could be one of the most difficult tasks that we have ever been compelled to undertake – and we’re likely to find ourselves tackling it under very chaotic conditions.

    #249: The Surplus Energy Economy, part 4



    In this fourth instalment of The Surplus Energy Economy, we turn to perhaps the most complex part of the equation, which is the financial system. The connections between energy and material prosperity, though largely disregarded and dismissed by orthodox economics, are nevertheless comparatively straightforward, at least in principle.

    The nearest approach to the straightforward in finance is the concept of money as claim. Once we recognize that money has no intrinsic worth – but commands value only as a ‘claim’ on the output of the material economy – two things become apparent.

    The first is that the financial system consists of an aggregate ‘body of claims’ on the material economy of products and services. The second is that the viability and sustainability of the system depends on the extent to which these claims can be honoured ‘for value’ by the real economy. To be a little more specific, the system is viable as long as participants believe that these claims can be honoured.

    The situation now is that financial viability depending upon accuracy of proxy has been strained to breaking-point. As we have seen, prior growth in economic prosperity has gone into reverse. At the same time, though, the financial system, as a ‘body of claims’, has carried on expanding, in part because of the fallacious assumption that the material can be driven by the monetary.

    As we shall see, there are reasons to suppose that the ‘real’ economy of goods and services is now at least 40% smaller than the ‘financial’ economy of money and credit.

    A simple analogy might be useful here. When people arrive at a function, they hand over their hats and coats in return for paper checks, which act as claims. During the function, the managers of the venue print a large number of additional checks. The checks alone will not, of course, keep the attendees warm and dry on their journeys home, for which only physical hats and coats will suffice.

    Only at the end of the function does it become apparent that there aren’t enough hats and coats to honour every check. Neither is it clear which checks are or are not valid. The only way to stave off this denouement is to keep the function – or the party – going for as long as possible. 

    This is loosely analogous to the current situation, where financial ‘claims’ far exceed the capabilities of the underlying material economy to honour them. Modest disequilibria of this kind can be mediated by inflation which, in our analogy, varies the rate of exchange between checks and coats. But the current extent of disequilibrium could only be mediated by runaway inflation.

    Moreover, each person believes that every single check equates to an entitlement to a complete coat or hat. They are not going to be happy when they discover that this is not the case. The term for what ensues is value destruction, which is destined to happen in a way that is likely to be chaotic.

    The unfolding squeeze

    As well as noting that prior growth in material economic prosperity has gone into reverse, we have also observed that the real costs of energy-intensive necessities are on a strongly rising trajectory.

    The resulting process is known here as affordability compression. It has two effects. One of these is a relentless decline in the ability to afford discretionary (non-essential) products and services. The other is that it makes it increasingly difficult for households to ‘keep up the payments’ on everything from secured and unsecured credit to subscriptions and staged-payment purchases.

    This process helps us to gauge where the effects of the aforementioned process of ‘value (claims) destruction’ are likeliest to be experienced. As well as undermining sectors which depend on discretionary consumption, affordability compression poses a direct threat to the flows which inform the viability of the financial system. The world is awash with debt and quasi-debt obligations, much of which exist outside the regulated banking system, and some of which cannot even be quantified in their entirety. Many enterprises have been built on a business model which financializes, into capital value, forward income streams whose future reliability has, hitherto, been taken for granted.

    Within a material economy, the effects of affordability compression cannot long be ignored. As its reality gains recognition, asset values will fall sharply, albeit more severely in some sectors and asset classes than in others. This process is likely to occur along lines that are already quite predictable. But the real danger lies less in market slumps than in a degradation of the network of inter-connected liabilities that constitute the financial system.

    These problems are unlikely to be manageable, meaning that we should anticipate disorderly – and, quite possibly, chaotic – contraction in the financial system. Decision-makers seem to be woefully under-informed about these risks, even though various events, such as the recent LDI problem in the British pensions sector, should have provided clear warning.

    For the most part, policy-makers, and perhaps market participants too, continue to believe in an economic orthodoxy which states that the economy can never cease to grow and is not, therefore, subject to material constraints. They also seem to believe, again fallaciously, that the authorities can overcome any and every problem using monetary tools. There is, as yet, little or no appreciation that the banking system cannot lend material resources into existence, and that central bankers cannot conjure low-cost energy out of the ether.

    A few simple statistics serve to illustrate this point. Between 2002 and 2021, each dollar of reported growth in GDP was accompanied by $3.10 in incremental debt and an estimated increase of $4.75 in broader obligations. Over that same period, SEEDS calculates that fully 70% of reported “growth” was the cosmetic effect of pouring ever more liquidity into the economy, and counting the transactional use of that money as economic “activity”.

    In short, the financial system has parted company with the underlying economy, and the notion that the latter can “grow” sufficiently to re-validate the former belongs in the realm of myth and fable. As will be explained here, we can reasonably conclude that each dollar-equivalent of supposed value in the global financial system is now backed by less than $0.60 in material worth.

    Financialization of the economy has been an integral part of the confection created on the basis of absurdly ill-informed expectations for the economic future. Whilst the process of de-globalization is starting to gain some recognition, there is almost no appreciation of the likelihood and consequences of de-financialization.

    To explain why these things are happening, we need first to revisit some basics.

    Of money and matter

    There are, essentially, two ways in which we can seek to understand the working of the economy. One of these is the orthodox approach, which states that the economy can be explained entirely in terms of money. If this were true, it would mean that there need never be any end to economic expansion, because the behaviour of the economy is determined, not by material resources, but by money, a human artefact wholly under our control. This would make feasible the paradox of ‘infinite economic growth on a finite planet’.

    The alternative explanation, preferred here, is that the economy is a physical system for the supply of material products and services. Since none of these products and services can be made available without the use of energy, we can conclude that prosperity is a function of the supply, value and cost of energy. Instead of the limitless, immaterial potential of the economy defined as money, the surplus energy approach recognizes the existence of physical constraints to expansion. Though energy is ‘the master resource’, these limits also apply to non-energy resources, and to the finite tolerance of the environment.

    Energy-based analysis draws a clear distinction between the material and the financial. The critical concept here is that of ‘two economies’. Effective interpretation of the economy requires an understanding of the difference between a ‘real’ or material economy of products and services and a ‘financial’, representational or proxy economy of money and credit. This conforms to the principle of money as claim, which recognises that “money, having no intrinsic worth, commands value only as a ‘claim’ on the output of the material or ‘real’ economy determined by energy”.

    This in turn makes it perfectly possible for us to create ‘excess claims’, meaning a body of monetary claims which exceeds the delivery capability of the underlying economy. That is precisely where we are now. The financial system will be forced to renege on excess claims that the underlying economy cannot honour.

    This situation arises from the operation of a fallacious precept, which is that financial expansion can drive growth in the physical economy.

    This fallacy can best be explained in terms of what has actually been happening over an extended period. By the 1990s, adverse changes in the energy dynamic had created a phenomenon known as “secular stagnation”, meaning a non-cyclical decrease in economic growth. It was assumed, quite wrongly, that this material deceleration could be overcome using monetary tools.

    These efforts began with rapid credit expansion, which led directly to the global financial crisis (GFC) of 2008-09. Thereafter, “credit adventurism” was compounded with “monetary adventurism”, in the form of supposedly “temporary” gimmicks including QE, ZIRP and NIRP.

    These initiatives haven’t stemmed the deterioration in material economic expansion, of course, but they have had two extremely negative consequences. First, they have burdened the financial system with vast claims which cannot possibly be honoured in full.

    Second, they have abrogated the principles of market capitalism, a system which requires (a) that investors must earn a positive real return on their capital, and (b) that markets should be allowed to price value and risk without undue interference.

    It might be thought that repudiation of the principles of market capitalism has a broader significance. In previous generations, the public had a choice between collectivism, on the one hand, and market capitalism, on the other. The public appeal of the collectivist ideal has never recovered from the collapse of the Soviet Union, and capitalism has now been undermined by the abandonment of its central principles. There is no simple answer to the question “what economic system do we have now?”

    Be that as it may, our immediate concern, in this instalment of The Surplus Energy Economy, is with the financial situation. The conclusion set out here is that, whilst the material economy might be capable of gradual and managed decline, the financial system cannot escape severe and disorderly contraction.

    Questions of equilibrium

    The concept of ‘two economies’ sets the context for our interpretation of financial conditions. If the financial system exists as “a body of claims on the material economy”, then its viability depends on the claim-honouring capability of the real economy. Likewise, since prices are financial notations attached to material products and services, then systemic inflation or deflation are functions of changes in the relationship between the material economy and its financial corollary.

    The best ‘point of entry’ to this complex situation is the matter of economic equilibrium. Effective functioning of the ‘two economies’ dynamic requires a close relationship between the financial and the material. Put another way, the material economy must be capable of honouring the claims placed upon it by the financial economy.

    Small divergences between the two are manageable, and are arbitraged by changes in the level of pricing, because prices are the point of intersection between the material and the monetary. But the emergence of severe disequilibrium means that the financial system has created a large body of claims that cannot be honoured ‘for value’.

    Claims that cannot be honoured must, by definition, be repudiated. This can happen in one, or both, of two ways. The first of these is inflationary, whereby a person who is owed $1,000 is repaid in money which has lost a sizeable proportion of its purchasing power or claim value – he or she receives $1,000, but this has the purchasing power of only, say, $500 at the time that the commitment was created. This is known as ‘soft default’. The alternative is ‘hard default’, where the borrower repudiates the obligation on the basis of ‘can’t pay, won’t pay’.

    The current situation is illustrated in Fig. 12, in which the ‘financial economy’ is represented by reported GDP, and the ‘real economy’ by prosperity as calculated by the SEEDS economic model. These, to be clear, are measures of flow rather than stock – but the viability of the stock of assets and liabilities depends upon the validity of forward expectations for flow.

    As is shown in Fig. 12A, global debt has grown far more rapidly than GDP over an extended period, during which more than $3 of net new debt has been taken on for each $1 of reported “growth”.

    As we have seen, much of the supposed “growth” of the past quarter-century has been the cosmetic effect of credit expansion. SEEDS calculates prosperity by (a) stripping out this ‘credit effect’, and (b) deducting trend ECoE – the Energy Cost of Energy – from the resulting underlying or ‘clean’ economic output.

    The result, shown in Fig. 12B, is severe disequilibrium between the financial economy (represented by GDP) and the real economy (represented by prosperity). As of the end of 2021, the real economy was 40% smaller than its financial proxy. This gap will continue to widen, unless and until we cease the process of artificially inflating GDP using liability expansion.

    Fig. 12

    The remaining charts in Fig. 12 calibrate obligation downside by applying this 40% flow indicator to the stock aggregates of debt (Fig. 12C) and broader ‘financial assets’ (Fig. 12D). The latter, as assets of the financial sector, are the liabilities of the government, household and non-financial corporate sectors of the economy. 

    The process of equilibrium analysis isn’t designed to anticipate downside in the financial system in any detailed way, and we can deem it probable that the outcome will be worse than this portrayal, not least because of liability inter-connection, and sheer panic. Rather, what is illustrated here is a broad measure of exposure to the destruction or repudiation of commitments. If it transpires that ‘the future isn’t what it used to be’, then expectations, incorporated into values, will be recalibrated accordingly.

    As mentioned earlier, if the disequilibrium between ‘claim’ and ‘substance’ was small, it could be reconciled by comparatively modest inflation. But downside of 40% means that, absent hyperinflation, a cascade of hard defaults has become inescapable.

    Of pricing and inflation

    Before we move on to an assessment of exposure, it’s worth pausing to consider the concept of inflation. A broad definition of inflation is that it measures changes in the general level of prices – but what is meant by ‘price’?

    Orthodox economics ascribes pricing to the inter-action of ‘supply and demand’, but both of these are stated entirely financially, meaning that no allowance is made for the material. The role of the material is clearly of huge importance, something which is demonstrated, for example, every time a drought or other untoward event reduces the production of grain. In this situation, the price of grain rises, not because of choices made by suppliers or consumers, but because the material parameters of supply have changed.

    From the ‘two economies’ perspective, which does acknowledge the material, a very different definition of price emerges – essentially, prices are the financial notations attached to physical products and services. Two parameters are thus involved in the price equation – one of these is transactional activity, and the other is material availability.

    A lack of clarity on the issues of pricing and inflation is implicit in any system of notation which concentrates entirely on the financial, and disregards the material. Thus, the headline definition of inflation as changes in retail or consumer prices disregards changes in asset prices. This has enabled advocates of QE to ignore the “everything bubble” in asset prices and assert that QE ‘isn’t inflationary’.

    The reality, of course, is that QE is inflationary, but this inflation occurs at the point at which newly-created money is injected into the system. If, back in 2008-09, QE money had been handed to anglers, the prices of fishing paraphernalia would have soared. In the event, the money wasn’t given to fishermen, but to investors, so it was the prices of assets, rather than of rods, reels and lures, which took off.

    By convention, asset price changes are ignored in the computation of inflation. Accordingly, QE could be regarded as non-inflationary so long as its effects were confined to the prices of assets. This changed in 2021, when pandemic responses involved directing QE to households. This, needless to say, resulted in the spread of inflation from assets, where it is disregarded, into consumer products and services, where it makes headlines.

    Statisticians do not apply consumer price inflation when calculating ‘real’ economic growth, but use the broad-basis GDP deflator instead. This measure, though, has serious shortcomings of its own. In short, we cannot measure inflation effectively if we confine ourselves to measuring the financial against the financial, whilst disregarding the material.

    The SEEDS concept of RRCI – the Realised Rate of Comprehensive Inflation – is designed to overcome these shortcomings, and is compared with the conventional measure of systemic inflation in Fig. 13. As you can see, historic inflation has been understated in relation to the RRCI measure, of which a corollary has been that capital has been priced even more negatively than headline data implies.

    Fig. 13

    Looking ahead, it seems likely that global systemic inflation will retreat from a 2022 provisional estimate of 9.3%, but is likely to remain between 5% and 6%. This projection suggests that the matrix of factors governing pricing will include (a) continuing rises in the costs of necessities, (b) falls in the prices of discretionaries, (c) asset price corrections, and (d) interest rates that remain negative in relation to RRCI.

    How much exposure?

    Global financial liabilities need to be understood at several different levels. One of these is conventional debt, and another comprises those broad commitments which are known as ‘financial assets’ but which, as mentioned earlier, are the liabilities of the government, household and PNFC (private non-financial corporate) sectors of the economy. Both debt and broader liabilities can be subdivided into public- and private-sector commitments.

    Let’s start putting some numbers on the magnitude of global financial exposure. This is complicated, and Fig. 14 is intended to set out the broad structure of financial liabilities – at constant values – by comparing the end-of-2021 situation with the equivalent position on the eve of the global financial crisis (GFC) in 2007.

    Please note that, because international obligations need to be met through market transactions, the data set out in Fig. 14 is stated in dollars converted from other currencies at market rates, rather than on the PPP (purchasing power parity) convention generally preferred in Surplus Energy Economics.

    Both charts are calibrated at constant 2021 values, enabling direct comparisons to be made between the scale of liabilities at both dates. The biggest change by far has been the sharp increase in broad financial liabilities, which are estimated to have increased by 90% in real terms between 2007 and 2021, rising from $294tn to $555tn between those years.

    With GDP shown for reference, Fig. 14 divides liabilities into government debt, private debt and the aggregate of estimated financial assets. Private debt is further subdivided into sums owed to banks and other lenders.

    Fig. 14

    Conventional debt data is available from the Bank for International Settlements. BIS data shows that, at the end of 2021, governments owed $84tn (93% of GDP) whilst, within private sector debt totalling $153tn (166% of GDP), $95tn (98% of GDP) was owed to commercial banks.

    The real issue, though, isn’t debt, but broader financial exposure. These “financial assets” are reported by the Financial Stability Board.

    Financial assets fall into four broad categories. Three of these – central banks, public financial institutions and commercial banks – are self-explanatory, though it’s noteworthy that the total exposure of commercial banks (estimated here at $208tn) far exceeds the conventional debt owed to them by households and PNFCs ($95tn). The fourth is NBFIs, meaning ‘non-bank financial intermediaries’.

    We need to be clear that these broad liabilities are very largely unregulated. The FSB is not a regulatory authority, but works to improve transparency and encourage best practice. Individual jurisdictions are under no obligation to supply data to the FSB. As a result, available data is neither complete nor particularly timely, with information relating to the end of 2021 only published on the 22nd December 2022.

    In general, commercial banks are regulated where they act as ‘deposit-taking institutions’, meaning that the aim is to protect the public as customers of the banks. This is not the same thing as macro-prudential regulation, whose effectiveness is circumscribed by the exclusion of institutions which do not accept deposits from customers. The effect of tightening regulation on retail banks can be to drive more business towards unregulated players. There is, then, a huge gap in the ability of the authorities to maintain, or even to monitor, macroeconomic stability.

    This lack of regulation is particularly important when we look at NBFIs. This sector is commonly referred to as the “shadow banking system”. NBFI exposure is enormous, and can be estimated at about $275tn as of the end of 2021. This exceeds the combined total of global government and private debt ($237tn).

    The NBFI sector has various components, which include pension funds, insurance corporations, financial auxiliaries and OFIs (other financial intermediaries). This latter category includes money market funds, hedge funds and REITs.

    In an article published in 2021, Ann Pettifor provided a succinct description of the shadow banking system. She traces the rise of the sector to the privatisation of pension funds, which happened in 30 countries between 1981 and 2014, and which, she says, “generated vast cash pools for institutional investors”.

    Shadow banking participants “exchange the savings they hold for collateral”, generally in the form of bonds, usually government bonds. Instead of charging interest, they enter into repurchase (repo) agreements whereby the borrower undertakes to buy back the bonds at a higher price.

    She points out that securities “are swapped for cash over alarmingly short periods”, and that “operators in the system have the legal right to re-use a security to leverage additional borrowing. This is akin to raising money by re-mortgaging the same property several times over. Like the banks, they are effectively creating money (or shadow money, if you like), but they are doing so without any obligation to comply with the old rules and regulations that commercial banks have to follow”.


    This is a good point at which to pull together some of our observations about the relationship between the economy and the financial system.

    First, we have observed how the process of liability expansion has created cosmetic “growth” in GDP, which is mistakenly assumed to be a meaningful measure of economic output. Second, a large proportion of the stock of credit exists outside the envelope of banking regulation and macroprudential oversight. We can note that credit expansion, promoted by keeping the cost of capital at levels below the rate of inflation, has created a hugely over-inflated “everything bubble” in asset prices – and that all bubbles eventually burst. It’s worth remembering that the bursting of a bubble doesn’t, of itself, destroy value – rather, it reveals the value that has been destroyed during the preceding period of malinvestment.

    As we have seen, the underlying dynamic of the material economy is imposing affordability compression, which is the combined effect of the erosion of prosperity and rises in the real costs of necessities.

    We can trace two logical consequences of affordability compression. One of these is a decline in sectors supplying non-essential products and services to consumers. It’s reasonable inference that, as well as driving down stock prices in discretionary sectors, this will result in business failures and defaults on debt, compounded by the effects of job losses.

    The second consequence will be a degradation in the flow of income streams from households to the corporate and financial sectors. This sets the scene for a second set of stock price slumps, bankruptcies, defaults and redundancies.

    What these indicators suggest is rapid, largely uncontrolled and disorderly contraction in the financial system, understood as an inter-connected and overlapping network of liabilities. The system holds together only if participants have confidence in the honouring of commitments ‘for value’.

    The erosion of this confidence is likely to create a domino effect, which starts at the outer perimeter of unregulated lending and then moves inwards towards the regulated banking sector, with defaults compounded by the undermining of collateral values.

    It is likely to be assumed that, as in 2008-09, governments and central banks will be able to intervene to shore up the system, but it is in fact unlikely that this will be possible. Aggregate non-government financial liabilities are nearly twice as large now, in real terms, as they were back in 2007 on the eve of the GFC.

    With global GDP (in market-converted dollars) standing at $97tn, it is hard to see how the authorities can bail out any sizeable proportion of an estimated $480tn in non-government liabilities without engaging in the creation of liquidity on a scale that would be certain to trigger runaway inflation. The problem is compounded by the observation that the GDP denominator, at $97tn, is itself a dramatic overstatement of underlying material prosperity, a number which SEEDS puts at only $58tn.

    Surplus Energy Economics has never predicted that the economy somehow ‘must’ collapse, noting that the rate of decline in prosperity is comparatively modest, and could be manageable. Recognition of the energy dynamic of prosperity erosion does not compel anyone to join the ranks of the collapse-niks.

    But the financial complex, rather than the economy itself, is where real and extreme systemic risk does exist. We might be able, to put it colloquially, to ‘get by with less’, but we cannot ‘meet our commitments with less’. Much of this is a result of ignorance (about the real workings of the economy), intentional denial and limitations in oversight.

    With the idea of economic contraction deemed to be (quite literally) unthinkable, it has suited us to assume, quite wrongly, that we can energise the material economy with monetary innovations. As well as failing, this has burdened us with financial commitments that we cannot even fully quantify, let alone honour or manage. An admittedly speculative possibility is that decision-makers might, in desperation, opt for the ‘soft default’ of runaway inflation rather than the ‘hard default’ of reneging on interconnected commitments that cannot be honoured.

    As we have seen, the convention of disregarding asset prices within the calibration of inflation has enabled us to operate the system on the basis that ‘QE doesn’t cause inflation’. The situation changed when, during the pandemic crisis, QE was no longer confined to investors, but was extended to consumers as well.

    At this point, inflation extended from asset prices to CPI, prompting action – rate rises and QT – from central bankers. The patterns of central bank action are illustrated in Fig. 15, in which policy rates are compared with CPI inflation to calculate illustrative real (ex-inflation) interest rates, and trends in central bank assets are summarised in Fig. 15D. The surge in inflation caused real rates to plunge to extraordinarily negative levels before a combination of rate rises and retreating inflation caused a correction back towards zero.

    Thus far, the central banks, led by the Federal Reserve, have shown considerable resolve in their determination to use rate increases, and QT, to tame inflation. It is likely now, though, that CPI and similar calculations of inflation will fall, less because of monetary tightening than in response to economic deterioration.

    If, as is to be expected on the basis of energy-based prosperity analysis, this economic deterioration causes asset prices to fall, and drives headline inflation downwards, the ensuing hardship might create calls for monetary easing at an intensity that central bankers may be unable to resist.

    Knowing that the excess claims embedded in the financial economy must, by definition, be eliminated in one of only two ways, we cannot rule out a process of inflationary ‘soft default’.

    Fig. 15

    #248: The Surplus Energy Economy, part 3



    Now that we have addressed first principles, economic output and the role of energy, we can turn our attention to prosperity. The conclusions set out here are that, whilst aggregate prosperity has gone into decline, the real costs of energy-intensive necessities will continue to increase. This creates leveraged downside in the scope for both capital investment and the affordability of discretionary (non-essential) products and services. The dynamics of prosperity are explored here by reference to the SEEDS economic model.

    These conclusions do not, of course, accord with the essentially cornucopian assertions of orthodox economics, but we are in a position to observe that economics and the economy have parted company. It is suggested here that the energy-based interpretation of deteriorating prosperity is consistent with much that we can see around us.

    Ultimately, the purpose of economics is – or should be – to identify, explain, calibrate and anticipate the delivery of prosperity. To do this, we need to know what prosperity actually is. Properly considered, prosperity is a material concept, consisting of the products and services that are available to society.

    Prosperity isn’t ‘money’ but, rather, the things for which money can be exchanged, which is a significantly different concept. This is why orthodox economics, which concentrates on the financial and pays scant attention to the physical, struggles to interpret the meaning, quantum and processes of prosperity.

    By way of analogy, we can usefully equate prosperity with households’ ‘disposable income’, which is what remains after necessary expenses have been deducted from total income. At the macroeconomic level, output is the equivalent of total income, whilst the essential expense of system operation is the Energy Cost of Energy. Therefore, we can define prosperity as output minus ECoE.

    In part one of this series, we identified a direct (and remarkably invariable) relationship between underlying or ‘clean’ economic output (C-GDP) and the use of energy. Essentially, economic output rises or falls as the availability of energy increases or decreases, and this connection cannot be circumvented.

    In part two, we saw how relentless rises in ECoEs can be expected to continue, whilst increasing supplier costs are likely to combine with decreasing consumer affordability to reduce the quantitative availability of energy. In short, prosperity has started to decline because of rising ECoEs, and this process may be exacerbated by a decreasing supply of primary energy.

    The material and the monetary

    Though the economy needs to be understood in the material terms of energy, the economic debate is customarily conducted in the language of money. The calculation of prosperity in monetary terms is possible, because we can multiply energy use (calibrated in thermal units) by the relatively invariable unit conversion ratio (stated in money) to measure and project the financial equivalent of material economic output. From this, the deduction of ECoE, as a percentage, identifies prosperity as a financial number.

    This calibration of prosperity yields a wealth of useful statistics and benchmarks. We can, for instance, compare the scale of monetary transactions with prosperity to measure the degree of equilibrium (or disequilibrium) in the relationship between the ‘financial’ economy of money and credit and the ‘real’ economy of products, services and energy.

    We can likewise use the relationship between the monetary and the material to measure systemic inflation, noting that prices are the financial values attached to physical products and services. These issues will be addressed later in this series.

    Now, though, our interest is in the evolution of prosperity and its constituent parts. These are (a) the supply of necessities, (b) capital investment in new and replacement productive capacity, and (c) the scope for discretionary (non-essential) consumption. Critically, whilst aggregate and per capita prosperity are now contracting, the real costs of energy-intensive necessities are rising.

    The bottom line is that prosperity excluding essentials – a metric abbreviated in SEEDS terminology as PXE – is in leveraged decline. This means that the affordability both of capital investment and of discretionary consumption is coming under worsening pressure. This process of affordability compression also has implications for the streams of income which flow from households to the corporate and financial sectors.

    One conclusion which follows from this is that discretionary consumption will decline. Another, to be examined in the next part of this series, is that the global financial system is in very big trouble.

    Past, present and future

    From our energy-prosperity perspective, modern economic history fits into a logical framework. The accessing of energy from coal, petroleum and natural gas had a completely transformative effect on the economy. Advances in geographic reach, economies of scale and technology delivered falling ECoEs for most of the period in which energy use was expanding rapidly. Accordingly, for much of the industrial era, surplus – post-ECoE – energy supply increased even more rapidly than the total availability of energy itself.

    Latterly, though, the depletion of fossil fuels has started pushing ECoEs back upwards, threatening to bring down the curtain on two centuries of exponential economic expansion powered by oil, gas and coal.

    As the fossil fuel dynamic fades out, we can postulate three versions of the economic future. One of these, propounded by conventional economics, says that economic prosperity, being a wholly monetary phenomenon, isn’t subject to material constraints, such as those which apply to energy resources, or the limits of environmental tolerance.

    This idea – that innovation in the immaterial field of monetary policy can restore expansion to the delivery of material prosperity – has been tried, and has failed spectacularly, over a quarter of a century of futile financial gimmickry.

    Another claim is that technology can provide us with abundant, low-cost energy from renewables. As we saw in part two, this argument isn’t credible, because it overlooks the reality that the potential of technology is bounded by the laws of physics. Renewables cannot replicate the characteristics – including the density, portability and flexibility – of fossil fuels.

    This leaves us with the third, least palatable conclusion, which is that prosperity is deteriorating because we have no complete replacement for the fading dynamic of fossil fuels. This downturn in prosperity is by no means a sudden event, but one which can be traced through a long precursor zone of deceleration, stagnation and contraction

    Our understanding of prosperity as the post-ECoE value of energy enables us to calculate prosperity at any point in time, and to identify the trends which will determine prosperity in the future. For forward projection, we need to anticipate (a) the amount of energy available to the economy, (b) the financial equivalent of the output provided by this energy, and (c) the proportionate ECoE deduction that differentiates prosperity from output.

    Conventional economics cannot calibrate prosperity, because it does not recognize either the energy-output linkage or the ‘first call’ on resources made by ECoE. The best that orthodox economics can do is to count – as GDP – financial transactional activity, a measure which cannot inform us about value created within the economy.

    Energy-based modelling, such as the proprietary SEEDS system used here, can calculate prosperity, which can then be used, not just as an analytical and predictive tool, but as a benchmark for referencing numerous other calculations and ratios.

    The big picture

    Naturally, our first concern here is with the quantum of prosperity itself, stated either as an aggregate or in per capita terms. But we also need to explore a number of other issues which we can access with prosperity itself established.

    How, over time, is prosperity allocated between the provision of essentials, the financing of capital investment and the provision of discretionary (non-essential) products and services? Looking ahead to the next instalment of The Surplus Energy Economy, what is the relationship between the ‘real’ economy of prosperity and the ‘financial’ economy of monetary claims on that economy? And what can this relationship between the material and the monetary tell us about inflation?

    The outlook for prosperity itself is stark. Until recently, the global economy has carried on expanding, but at a decelerating rate. Now, prior growth in prosperity has gone into reverse. At the same time, the costs of energy-intensive necessities are increasing, not just as absolutes, but as a proportion of available resources. The resulting affordability compression undermines the scope both for discretionary consumption and for capital investment.

    As we shall see in part four, there is a severe disequilibrium between the material and the monetary economies, meaning that enormous ‘value destruction’ has become unavoidable. This points towards disorderly degradation within the interconnected liabilities which are the ‘money as claim’ basis of the financial system. 

    The basics, at the aggregate level and in per capita terms, are summarised in Fig. 8. Between 2021 and 2040, both energy consumption and underlying output (C-GDP) are projected to decline by -8%. With ECoE likely to rise from 9.4% in 2021 to over 17% by 2040, the fall in aggregate prosperity is leveraged from -8% to -16%. Further (though decelerating) increases in global population numbers indicate that prosperity per capita is likely to be 27% lower in 2040 than it was in 2021.

    Fig. 8

    It will be obvious that these projections differ starkly from orthodox forecasts, which are rooted in the proposition that financial management can enable economic output to increase in perpetuity, without encountering any material constraints imposed by the finite characteristics of energy, other resources or the environment.

    Within our energy-based interpretation we can conclude, not just that output and prosperity have turned downwards, but also that much prior “growth” in reported economic output has been the cosmetic product, not just of disregarding ECoEs, but also of creating transactional activity by the injection of ever-growing quantities of cheap credit and cheaper money into the system.

    With these parameters established, our interest now turns to the meaning of prosperity decline. First, though, we need to note that nothing that is happening now has occurred without prior warning.

    Indications and warnings

    Prior notice of impending economic contraction has taken two forms. One of these is modelled prediction, and the other is the action that has been taken by the authorities.

    Where prediction is concerned, pride of place must be given to The Limits to Growth (LtG), published back in 1972. Using the World3 system dynamics model, LtG examined the relationships between critical metrics including population numbers, industrial output, food production, the supply of raw materials and what was then called “pollution”. It concluded that economic growth must come to an end, with indicators pointing towards the early twenty-first century as the period in which this was likely to happen.

    The LtG projections have proved remarkably prescient, as has been demonstrated by subsequent re-examinations of the calculations. These warnings were disregarded, not because they were wrong, but because they were inconvenient.

    Policy actions and outcomes over the past quarter-century provide equally compelling proof of the gradual onset of economic contraction. We have been applying financial gimmickry in a series of futile efforts to restore economic growth, something which we would not have done had the economy itself been continuing to deliver expansion.

    To be clear about this, nobody introduced credit expansion, QE, ZIRP, NIRP or any other expedient for the fun of it, or ‘to see what might happen’. These and other innovations were adopted only because the economy and the financial system were in trouble. Where economic deterioration is concerned, this is ‘the evidence of behaviour’.

    In the 1990s, observers identified a phenomenon which they labelled “secular stagnation”, meaning a non-cyclical deterioration in the rate of economic expansion. Because of the convention which insists that all economic issues can be explained in terms of money alone, they did not trace this to its source, which was the relentless rise in trend ECoEs.

    Proceeding instead from the mistaken premise that money explains everything in economics, they sought to ‘fix’ this problem with monetary tools. Their solution, amenable to the deregulatory preferences of the day, was to ‘liberalise’ the supply of credit, making debt easier to access than it had ever been before.

    This initial policy approach is known here as “credit adventurism”, and there was a period in which it appeared to be working, with global real GDP increasing by 50% between 1997 and 2007. This, though, was accompanied by a 77% real-terms increase in debt, with each $1 of reported “growth” accompanied by $2.40 of net new debt. Stripping out this ‘credit effect’ reveals that, within the total “growth” recorded in this period, more than half (54%) was the purely cosmetic, transactional effect of pouring abundant new credit into the system.

    These strains, combined with hazardous lending practices and inadequate regulation, led directly to the global financial crisis (GFC) of 2008-09. Rather than accepting the failure of “credit adventurism”, though, we opted to compound it with “monetary adventurism”. ZIRP, NIRP and QE were used, supposedly on a “temporary” and “emergency” basis, to reduce the cost of capital to negative real levels, where it has remained ever since.

    In the process, we abrogated the basic principles of market capitalism, which are that (a) value and risk must be priced by markets free from undue interference, and that (b) investors must earn positive real returns on their capital.

    The results of this second-phase gimmickry have been completely predictable although, this time around, the numbers have been even worse. Between 2007 and pre-pandemic 2019, real GDP expanded by 48%, but debt increased by 81%. Each dollar of reported growth now required the creation of more than $3 of net new debt. Fully 64% of all the “growth” recorded between 2007 and 2019 was cosmetic.

    The way in which historians of the future are likely to describe this period seems clear – they will recognize that prosperity was trending downwards, and conclude that we were prepared to try anything and everything, however illogical and however dangerous, rather than come to terms with this unpalatable reality. We can best describe the period since the second half of the 1990s as a quarter-century “precursor zone” to the involuntary economic de-growth that has now arrived.

    During this long period, economic output and prosperity have followed a process of deceleration, stagnation and contraction. In denying this, and trying to fix a material problem with financial tools, we have created an asset bubble that is destined to burst, and a vast interconnected network of liabilities that cannot possibly be honoured ‘for value’ by a contracting material economy.

    Observing prosperity contraction

    As we have seen, a deteriorating energy dynamic has put prior growth in economic prosperity into reverse. This process will have to go a great deal further, and continue for a lot longer, before there will be any chance of this reality gaining widespread acceptance. We cannot expect recognition to arrive through persuasion, however logical and evidential such persuasion may be. For those of us who understand the dynamic that has put prior growth in prosperity into reverse, our best recourse is to knowledge, concentrating on the ‘why?’ and ‘what?’ of prosperity contraction.

    As we have also seen, the primary factor driving prosperity downwards is the relentless rise in ECoEs. As ECoEs rise, energy availability becomes increasingly problematic, and the post-cost value of remaining energy supply decreases.

    The way in which this works shows stark regional differences, and these are illustrated in Fig. 9, where trends in real prosperity per capita are compared with ECoEs.

    In the United States, prosperity per person turned down after 2000, with the same thing happening in Britain in 2004. But Chinese prosperity per capita has carried on improving, and is only now drawing close to its point of reversal.

    These inflexion-points have occurred at very different levels of ECoE. When prosperity turned down in America in 2000, national trend ECoE was 5.1%, and the British equivalent in 2004 was 4.7%. Almost all Western economies experienced prosperity reversal in the years before 2008, when global ECoEs were still below 6%. Yet if, as is now projected by SEEDS, prosperity per person in China turns down in 2023, it is likely to have happened at an ECoE above 11%.

    The cause of these differences can be traced to comparative complexity. The high levels of complexity in the Advanced Economies result in upkeep expenses which increase these economies’ sensitivities to rising ECoEs. In almost all Western countries, prosperity per capita had turned down even before the 2008-09 GFC.

    Less complex EM (emerging market) economies, which have lower systemic maintenance costs, are better equipped to cope with rising ECoEs. Only in recent years, at higher levels of ECoE, have EM countries started to encounter the process of prosperity reversal long ago experienced in the West. Whilst Mexican prosperity per capita inflected in 2007, and the same thing happened in South Africa in 2008, prosperity did not turn down in Brazil until 2013, followed by India and Indonesia in 2019, Turkey in 2021 and South Korea in 2022. One of the last countries to encounter this turning-point might be Russia where, all other things being equal, prosperity per person could carry on increasing until 2025.

    The global result has been a long plateau in prosperity per capita, as shown in Fig. 9D. This plateau has been caused by continuing progress in EM countries offsetting deterioration in the West.

    We do not need to conclude, as many have, that some form of greater national ‘vibrancy’ explains the superior economic performance of countries such as China, India, Russia and Brazil in comparison with supposedly ‘staid’ Western economies. Rather, the explanation lies in the varying impact of rising ECoEs in countries with differing levels of complexity.

    As a rule-of-thumb, we can state that Advanced Economies need ECoEs of less than 5% if they are to grow their prosperity, whereas EM countries can carry on doing so until ECoEs are between about 8% and 10%.

    Fig. 9

    Essentials – the leveraged equation

    Based on SEEDS analysis, aggregate global prosperity is likely to have peaked last year, at $88tn and will, by 2030, have fallen by a seemingly-modest 3%, though even this will equate to a 10% decrease in per capita terms. By 2040, aggregate prosperity is expected to have fallen by 16%, and its per capita equivalent by 27%, from their 2022 levels.

    These references, though, are to top-line prosperity, whether expressed per capita or in aggregate. Our need now is to calculate what deteriorating prosperity is likely to mean in terms both of economic activities and of lived experience.

    What we are watching is a two-stage process in which, just as top-line prosperity is falling, the real costs of energy-intensive necessities are rising. This creates a process of affordability compression which has far-reaching implications.

    Conventional economic presentation divides the economy into sectors, which are households, government and business, with the latter sometimes further subdivided into financials (such as banks and insurers) and private non-financial corporations (PNFCs).

    The SEEDS preference, on the other hand, is for functional segments, which are the supply of essentials, capital investment in new and replacement productive capacity, and discretionary (non-essential) consumption.

    There is no hard-and-fast definition of ‘essential’ which, in any case, varies between countries and over time. Many products and services now deemed essential were regarded as ‘luxuries’ (discretionaries) in earlier times. This process of definitional change can be expected to continue, though this time in the opposite direction, with some things now seen as essential once again becoming discretionaries as prosperity contracts.

    SEEDS analysis of ‘essentials’ fall into two categories. The first of these is public services provided by the state. This is not to assert that every service made available by government is indispensable, but these services rank as ‘essential’ because the individual has no discretion – choice – about paying for them. This definition does not embrace all public spending, because it excludes those transfers (such as pensions and welfare benefits) made between groups. The other category of essentials is household necessities.

    It will be apparent that, in definitional as well as quantitative terms, the ‘essentials’ numbers used by SEEDS are estimates. The composition of ‘essentials’ varies between countries, not least because services provided by the government in some states are paid for privately in others.

    Going forward, the general picture seems to be that public service costs are growing by about 1.5% annually on a per capita basis, with the costs of household necessities increasing by about 2.0%. Both are ‘real’ measurements, meaning that they are increases in excess of broad inflation. Rises in the real costs of necessities clearly over-shot this trend in 2022, because of sharp increases in the costs of energy and food. Inflation itself is an issue that will be examined later in this project.  

    Harmonised analysis

    As we have seen, reported GDP is a misleading metric, capable of being inflated artificially by precisely the kind of credit expansion that we have been experiencing over a very long period. Even so, latest-year GDP is a number in common use, and it’s helpful, for purposes of comparison, to base some SEEDS projections on this number. In SEEDS terminology, this is known as harmonised analysis.

    This process is illustrated in Fig. 10, which presents global GDP on three different formats. The first of these is nominal, otherwise called ‘current money’, in which GDP is shown without adjustment for inflation. On this basis, global GDP rose from $53tn in 2001 to $147tn in 2021, an increase of 177% (see Fig. 10A).

    It is essential, of course, that adjustment is applied for changes in the general level of prices. In conventional economics, this is undertaken by applying the broad-basis GDP deflator to convert historic numbers into their current-value equivalents. With 2021 set as 100, the global GDP deflator for 2001 is 72.6 and, on this basis, GDP for that year is revised upwards, by 100/72.6, from $53tn at current prices to $73tn at 2021 values. On this basis, ‘real’ growth in GDP was 101% between these years (Fig. 10B).

    As we have seen, though, this trend in recorded real GDP does not reflect the progression of prosperity over time – GDP has been inflated artificially through credit expansion, and no allowance has been made for ECoE.

    Using 2021 GDP as a basis for comparative forecasting does not remotely mean that we should accept the misleading past trends presented by conventional data. SEEDS analysis informs us that prosperity increased by only 32%, rather than the reported 101%, between 2001 and 2021. The application of this pattern to prior years gives us a ‘harmonised’ trajectory, whereby 2021-equivalent output in 2001 wasn’t $73tn, but $111tn. This is shown in Fig. 10C.

    As Fig. 10D illustrates, underlying growth (shown in red) has been far lower than the reported equivalent over an extended period, and has now turned negative.

    Fig. 10

    Segmental interpretation

    Restating past trends in economic prosperity has two purposes, both of which are extremely important. First, it provides a historical context for forward projections. Second, it gives us an ability to interpret segmental trends as they affect essentials, capital investment and discretionary consumption. This is illustrated in Fig. 11, where the first three charts correspond to their ‘nominal’, ‘real’ and ‘harmonised’ equivalents in Fig. 10.

    Nominal progressions (Fig. 11A) are of no great significance, as it’s generally recognised that allowance has to be made for inflation. But the inadequacy of past restatement on the basis of ‘real’ GDP is of huge importance. Seen in this conventional way, the rate of increase in the real costs of essentials has been more than matched by growth in top-line output, enabling both capital investment and the affordability of discretionaries to expand. Continuation of these positive trends – particularly in discretionary sectors – is the default assumption for anyone, in business or government, who makes plans on the basis of economic orthodoxy.

    Quite how mistaken such assumptions are is apparent in Fig. 11C, which sets out segmental progressions and projections on the basis of output harmonised to trends in prosperity. As prosperity deteriorates in a way that orthodox interpretation cannot project – and as the real costs of essentials continue to rise – the affordability both of capital investment and of discretionary consumption are set to decline markedly.

    It’s worthwhile pausing to contemplate what this means. Anyone involved in capital investment, or in the supply of discretionary products and services to consumers, is likely to be planning in the mistaken belief that these activities can be relied upon to expand. He or she is being misled by fallacious interpretations of the past into unrealistic expectations for the future.

    This issue of mistaken expectation is captured in the metric PXE. Meaning prosperity excluding essentials, PXE is a measure of the past and projected combined affordability of capital investment and non-essential consumption.

    In Fig. 11D, PXE is shown in two formats. The harmonised, SEEDS-interpreted history and outlook for PXE is shown in blue, and the equivalent based on orthodox economics is shown in black.

    Anyone planning on the conventional basis is using past growth (most of which didn’t actually happen) to project forward expansion (which is an unrealistic expectation). By comparing these lines, we can see the extent of mistaken expectation informing decisions in capital investment and in discretionary sectors.

    We don’t, in fact, need to rely on projection, in that ‘affordability compression’ has already become a reality. But the fundamental significance of this process lies in its implications for the financial system, something which will be examined in the next part of this series.

    In essence, affordability compression doesn’t only mean that consumers are going to have to adjust to a decreasing ability to make non-essential purchases. It also means that households will find it an ever-greater struggle to ‘keep up the payments’ on everything from secured and unsecured credit to staged-payment purchases and subscriptions.

    Readers can reach their own conclusions on what this means for individual sectors and for the broad shape of the economy. Our interest turns next to what declining prosperity and worsening affordability compression are likely to mean for the financial system.

    Fig. 11