CONTINUITY, CONTRACTION OR COLLAPSE
THE REALITY OF SCARCITY, THE SCARCITY OF REALITY
In nineteenth-century England, pictures of great events and famous personages could be purchased “penny-plain or tuppence-coloured”.
Where the world economy is concerned, the price of flattering colouration has soared into the trillions, but the value of a “penny-plain” view has never been higher.
The penny-plain picture now, of course, is that a vast gap has opened up between the consensus expectation of continuity and the hard reality of a post-growth economy. This gap is the counterpart of the chasm that exists between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.
Our understanding of these dissonances sets an outline programme for ongoing analysis. The best routes to effective interpretation are those which (a) compare reality with perception, and (b) calibrate the relationships between the ‘two economies’ of money and energy. In the coming months, the aim here will be to add interpretive and statistical detail to the picture that is emerging as the aquatint wash of delusion fades away.
The divergence between expectation and reality isn’t – in itself – a new development. Many of us have long known that, over a very extended period, most economic “growth” has been a cosmetic product of breakneck and hazardous monetary expansion, that the underlying economy has been faltering, and that the confidence placed in ‘continuity’ lacks a basis in fact.
We can go further, recognizing that even the simulacrum of “growth” can’t last much longer, that the real prices of assets are destined to fall sharply in a context of broader financial distress, and that the balance of political power might be poised to shift, perhaps in a direction that, once upon a time, used to be called “left”.
What IS different now is that a process of fundamental change is already underway. The consensus case for continuity is crumbling, and is being exposed as a product of self-deception, wishful-thinking and economic incomprehension, spiced with absurd amounts of techno-utopianism.
The outcome mightn’t – and needn’t – be the wholesale “collapse” predicted by doomsayers.
But the game is up for what we might call the ‘continuity consensus’.
Of price and value
The single most obvious symptom of change is inflation. The Fed might – belatedly – have stopped calling this “transitory”, but the consensus view remains that this isn’t the start of a “stagflationary” trauma of the kind last experienced in the 1970s.
It’s widely argued that the take-off in inflation is a short-term product of the shortages and supply-chain fractures created by the coronavirus pandemic and, perhaps, of the gargantuan amounts of money injected to cope with the crisis. It’s further contended that labour lacks the pricing power to create a price and wage inflationary spiral.
Before buying this comforting narrative, it makes sense to look at the fundamentals. Prices are the point at which monetary demand meets material supply. Put another way, prices are where the ‘financial’ economy of money and credit intersects with the ‘real’ economy of goods and services.
Conventional theory states that the price mechanism enables strong financial demand to prompt corresponding rises in physical supply, because rising prices give producers an incentive to increase supply to the market.
This logic, though, holds true only under conditions of infinite capability. No rise in prices, or increase in financial demand, can prompt the delivery of products which do not exist in nature. If physical constraints exist, the theory that ‘demand creates supply under all circumstances’ is exposed as a fallacy.
This is particularly pertinent to the supply of energy. Surging European natural gas prices are a case in point. Conventional theory dictates that spectacular rises in prices ought to have brought new supply gushing into the market for gas. The reality is that no such new supply exists. To be sure, price differentials can divert supplies between competing markets, but they cannot increase the aggregate availability of gas. The same applies to other forms of traded energy, including oil and coal.
This brings us to the fundamental point about scarcity. Conventional economics, with its insistence that ‘demand creates supply’, dismisses the very concept of material constraint. Hard fact, on the other hand, decrees that the supply of fossil fuel energy at an affordable cost is constrained by the limits of resources.
Two observations are necessary here. The first is that the process of depletion has created sharp rises in the ECoEs – the Energy Costs of Energy – of oil, gas and coal. The second is that nothing that has any economic utility at all can be supplied without the use of energy.
Accordingly, rises in the ECoE-costs of energy must force up the cost of everything else, imposing changes in allocations, priorities and distribution. This is particularly applicable to resources such as food, water, minerals, metals and plastics, all of which are supplied through energy-intensive processes.
We can’t conjure them out of the ether by pouring money into the system.
Supply constraint and the implications for demand
Of course, conventional economic theory doesn’t limit its concept of the price mechanism to the assertion that rising prices must increase supply.
It states, also, that rising prices depress demand.
If we superimpose resource constraint onto this ‘equilibrium-through-price’ equation, what we’re left with is a process whereby supply isn’t increased – but demand IS depressed – by rising prices.
Put another way, the introduction of material scarcity into the pricing equation tells us that supply constraints will, through the mechanism of rising prices, reduce demand.
This is the point at which two realities have to be factored in. The first is that consumer purchases are divided, in order of priority, between essentials (things that the consumer must have) and discretionaries (things that he or she may want, but doesn’t need).
The second is that there is extraordinary sectoral and popular resistance to the idea that discretionary consumption might be trending downwards.
We can see these factors in operation right now. Because of resource scarcity in general – and energy scarcity in particular – the cost of essentials is rising markedly. We can see this, most obviously, in the rising costs of food, fuel and domestic energy, but we can be sure that this process is going to extend into other necessities.
It’s noteworthy that the Resolution Foundation, a British think-tank, is forecasting that 2022 will be a “year of the squeeze”. This description can be applied globally, differing only in pace and magnitude between countries and regions. The cost of everything from gas and electricity to fuel, travel fares, food, clothing and even water is going to rise.
The brunt of this pressure is felt initially by the poorest households, who spend the largest proportion of their incomes on necessities. But there need be no doubt that the rising tide of costs will move steadily up the gradient of household incomes.
For suppliers of discretionary goods and services, this is a double-edged sword. On the one hand, consumers whose living costs are rising have less to spend on non-essential purchases. On the other, the costs of supplying discretionaries are rising. Credit-funded discretionary spending, long the prop of non-essential sectors, is in the process of being undermined by inflation or, more specifically, by the monetary implications of the rising cost of necessities.
Behind the brittle optimism presented by every sector from travel and hospitality to ‘tech’ and the supply of consumer goods lies a reality shaped by rising costs, decreasing consumer resources, and an eroding capability to bridge the gap using cheap and abundant credit.
Prices as interface
In order to interpret the role of inflation correctly, we need to understand the conceptual distinction between the ‘two economies’ – the ‘financial’ or proxy economy of money and credit, and the ‘real’ or material economy of energy and resources.
What this distinction tells us is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services supplied by the real economy. If we wanted to be high-falutin’ about it, we could say that money is an artefact ‘validated only by exchange’.
What this really means is that inflation is a process governed by changes in the relationship between the availability of money and the supply of goods and services.
Over an extended period, we’ve been pouring enormous quantities of financial demand into the system, at the same time that material supply has become ever more constrained.
In this sense, inflation isn’t even a new phenomenon. Rather, price escalation has, hitherto, been channelled into asset prices, whose movements are – conventionally, but mistakenly – excluded from the measurement of inflation.
If we had, all along, been using a comprehensive, RRCI-type measure of inflation, we would have been far better prepared for, and much less surprised by, what is happening now.
Since there are no ‘fixes’ for material constraints, the only way in which inflation can be tamed is by pushing monetary demand back downwards into alignment with material capability.
This understanding re-frames what we know about monetary policy. As things stand, the real (ex-inflation) cost of money has fallen to unprecedentedly negative levels. Since we can’t create physical resources out of nothing, the only policy fix for the gap between the real and the financial economies is the elimination of the subsidy of deeply negative real rates. The scale of past recklessness has ensured that any such process would be extraordinarily disruptive.
This means that raising rates by enough to tame inflation would have two effects, not one. The first would be to temper the rate at which the supply of credit expands. The second would be to start unwinding past expansion in the quantity of credit.
It would be futile to suppose that we can have one of these effects without the other. We cannot restrain inflation simply by raising rates by just enough to deter new borrowing, without affecting either the servicing cost or the collateral backing of existing credit.
In any case, the current system depends on a continuity of increasing credit.
To be effective, then, rate rises would have to be big enough to trigger credit defaults, asset price slumps and a re-pricing of the financial system back into equilibrium with the constrained character of the underlying economy.
The paralysis of predicament
In practical terms, this means that positive real rates won’t be reinstated voluntarily, and this leaves us looking for pressures that might force us to act realistically.
The most obvious such pressure will come from households, which might accept the impairment of the scope for discretionary consumption, but won’t – and can’t – tolerate relentless increases in the cost of essentials.
This is where forecasting processes need to be reinvented, meaning rebased away from the fallacious assumption of ‘growth in perpetuity’.
By calibrating both prosperity and the trend in the real cost of essentials, we can make sense of a dynamic whose consequences will include widespread defaults, sharp falls in real asset prices and a fundamental shift in the political climate.
At the same time, our recognition of the relationship between the ‘real’ and the ‘financial’ economies should give us steadily-improving visibility on the economic, financial and broader outlook.
None of this necessarily spells “collapse”, but it does establish a relationship between systemic risk and the prevalence of self-deception.
In this sense, our best hopes for a manageable future rest on an orderly assertion of reality, and the retreat of delusion.
A FUNCTIONAL SYNOPSIS
As this might be the last article to appear here before the festive season, I’d like to take this opportunity to wish everyone a very merry Christmas and a happy and prosperous New Year, and to thank you for your interest in, and your contributions to, our conversations about energy, the economy and directly-related subjects.
I’m particularly appreciative of the way in which our debates have remained firmly concentrated on the economy. We could all too easily have dissipated our energies on subjects which, whilst topical and important, are not those on which we can add value through specialist knowledge.
It seems to me that the economy – with its profound implications for business, finance, government, society and the environment – is of such importance that clarity of focus is invaluable.
This clarity is singularly lacking in what we might call ‘the public discourse’. The economic debate, such as it is, has become reminiscent of that old Western movie hero who “jumped on his horse and rode off in all directions at once”.
Behind all the partisan argument, the mystification and the theorizing about nefarious plots, the plain fact is that the economy faces challenges and risks without precedent in modern times.
This simple fact is all too often lost in a miasma of misconception, false nostrums and self-interest.
One economy, two systems
We can add value in this situation because we understand two central realities that are neither known to, nor accepted by, the orthodox approach to economics.
First, we are aware of the critical distinction between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.
Second, we recognize that the real or material economy is an energy system, in which prosperity is a function of the availability, value and cost of energy.
This understanding enables us to define the current economic predicament. The financial economy has grown rapidly, driven by unprecedentedly expansive credit and monetary policies.
The real economy, meanwhile, has decelerated towards de-growth, because the energy equation has become progressively more unfavourable.
This has opened up a gap between the ‘two economies’ of energy and money. The wider this gap becomes, the greater are the forces trending towards a restoration of equilibrium. The take-off in inflation is a logical sign of the return of equilibrium, because prices are the point of intersection between the real economy and its financial proxy.
In terms of anticipating the future, the forced restoration of equilibrium between the financial and the material economies is critical.
The energy economy, shaped by physical realities, cannot be made to align itself with its financial counterpart.
Therefore, the return of equilibrium must involve shrinking the financial system back into proportion with the underlying economy.
The restoration of the rational
If we’re to achieve any kind of orderly exit from our current predicament, it’s essential that reasoned interpretation prevails over notions rooted in misunderstanding, denial, wishful-thinking and, to be blunt about it, sectoral self-interest.
Regular readers will, I hope, permit me a very brief restatement of the three critical principles involved.
First, the economy is an energy system, because nothing that has any economic value at all can be produced without the use of energy.
Second, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ’consumed in access’ component is known here as the Energy Cost of Energy (ECoE), and is not available for any other economic purpose. Material prosperity is, therefore, a function of the surplus energy that remains after ECoE has been deducted.
Third, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the material economy of energy.
It follows that, if the aggregate of monetary ‘claims’ is allowed to expand much more rapidly than the underlying economy of energy, the result is the creation of ‘excess claims’ which the material economy cannot honour.
To the extent that these excess claims are regarded as having ‘value’, the restoration of a viable relationship between the real and the financial economies must involve the process known as ‘value destruction’.
Measuring the gap
A very short set of statistics will suffice to illustrate quite how far the ‘two economies’ of energy and money have diverged.
Between 2002 and 2020, global prosperity increased by 29%, or $19 trillion at constant values. This calculation is sourced from SEEDS, a proprietary economic model which measures prosperity on energy principles.
Over the same period, reported GDP rose by 84%, or $60tn, but most of this “growth” was cosmetic. It was a product of allowing debt to rise by $203tn (+160%), and broader financial liabilities to grow by an estimated – and astonishing – $435tn (+201%).
The latter equates to the addition of $7.20 of new forward financial commitments for each dollar of reported “growth”. This number would rise to almost $10 if we included the emergence of enormous “gaps” in the adequacy of pension provision.
The following charts put these relationships into context. The first compares GDP both with debt and with broader financial assets. These assets – essentially the liabilities of the household, government and non-financial business sectors of the economy – are estimated on the basis of data that is available for countries which, together, account for three-quarters of the world economy.
As you can see, an enormous ‘wedge’ has been inserted between GDP and aggregate forward financial commitments.
The second chart, which uses the SEEDS calibration of prosperity, shows a corresponding divergence between reported GDP and the underlying performance of the real economy.
This second wedge might look enormous which, indeed, it is.
But, as the third chart shows, the difference (shown in solid red) between prosperity (last year, $85 trillion) and GDP ($132tn) pales into insignificance – indeed, you might need to enlarge the chart to see it at all – when set against the chasm (outlined in red) that has arisen between economic output and the enormously inflated scale of forward financial commitments (estimated at $650tn at the end of 2020).
A situation summarized
Three conclusions can be drawn from these figures.
First, most – nearly 70% – of all “growth” reported between 2002 and 2020 was the purely statistical effect of breakneck credit escalation.
Second, a long period of financial distortion has created an enormous gap between financial activity, reported as GDP, and the real level of prosperity, as measured in material terms.
Third, asset price inflation has been a corollary – intentional or not – of the ultra-loose monetary policies involved in the manufacturing of a simulacrum of “growth”.
If we put this together, what emerges, as remarked earlier, is a severe disequilibrium between the monetary and the material economies.
The fundamental issue now is the inevitable restoration of equilibrium between the economy as it is and the economy as it’s been made to appear by financial expansion.
To understand how this is likely to unfold, let’s start by noting the difference between prosperity and GDP. Prosperity is a measure, calculated by SEEDS, of trends in the material output of the economy over time. GDP, on the other hand, isn’t a measure of output, but of economic activity.
Simply stated, goods and services are produced using energy, but are exchanged using money.
These are quite different things.
One way of reconciling the divergence between GDP and prosperity would be to conclude that inflation has been understated over time. The SEEDS model assesses this using RRCI, the Realised Rate of Comprehensive Inflation.
RRCI remains a development project, but it indicates that official inflation (of 1.5% annually between 2000 and 2020) was understated against a comprehensive rate of 3.5%.
This difference mightn’t seem huge but, compounded over time, its effects are enormous.
There is, moreover, abundant evidence for the proposition that inflation has been significantly under-reported over many years.
Consumer inflation has been distorted by hedonic adjustment, substitution and geometric weighting.
Even more seriously, conventional measurement – including the problematic GDP deflator – excludes asset price inflation, which has been rampant since the GFC and the introduction of policies which have priced capital at negative real rates.
Probabilities of process
Reconciling reported activity with material prosperity is a worthwhile exercise, and it seems likely that RRCI will prove a useful addition to the suite of capabilities provided by the SEEDS economic model.
What matters most, though, is the process through which the restoration of equilibrium is likely to occur. Science-minded readers might usefully liken the impetus towards equilibrium to some of the forces that operate in physics.
In practice, what this means is that the financial economy, and the financial system itself, are going to be compressed back into alignment with the underlying material economy of goods, services, labour and energy.
There are, in functional terms, two ways in which this can happen. The first is rampant inflation, whose macroeconomic effect would be soft default on forward financial commitments that cannot be honoured by a deteriorating underlying economy. ‘Soft default’ is what happens when obligations are met, but in money that has lost a large proportion of its real value.
The second is that the authorities might intervene to curb inflation, primarily by raising real interest rates back into positive territory. This would trigger hard defaults, where debtors fail to meet their obligations.
To a certain extent, how this unfolds is a question of process, on which two observations are pertinent.
First, the trend in the real cost of essentials is critical, because sharp rises in the cost of living are guaranteed to trigger public engagement in a policy debate to which, in normal times, they pay scant attention.
SEEDS analysis – which notes the connection between ECoE trends and the cost of energy-intensive necessities such as food, water, housing and necessary travel – indicates that the real cost of essentials is set to carry on rising markedly over time.
Second, it seems likely that policy actions will, for the foreseeable future, be a case of ‘too little, too late’. For reasons best known to themselves, policy-makers attach disproportionate importance to the prices of assets such as stocks and property, and miss-state the role of a “wealth effect” whose real significance lies in the promotion of credit expansion.
The heart of the matter
What’s really important, though, is that the process by which equilibrium returns to the relationship between the monetary and the material economies is going to have profound financial, economic, political and social consequences.
Both the ‘soft default’ of inflation and the ‘hard default’ of failures are likely to intensify.
Levels both of capital investment (in new and replacement productive assets) and of discretionary consumption (of non-essential goods and services) are set to contract markedly.
Economic issues can be expected to rise ever higher in the priorities of voters, implicitly displacing matters of non-economic concern. Any politician who fails to recognize the rising popular concern about the cost of living can expect to be marginalized.
What we have here is a dynamic whose logic seems inescapable, and whose quantification is imperative.
You will not misunderstand me, I’m sure, if I say that our understanding of these issues gives us a competitive edge over interpretations founded on outmoded, ‘money-only’ nostrums which fail to recognize the essential materiality of the economy.
In short, our interpretation works, where orthodox alternatives do not.
The question for the year ahead is how we sharpen that edge, and put it to use.
MODELLING THE RETURN OF EQUILIBRIUM
“The proper study of mankind is man”, wrote the poet Alexander Pope in An Essay on Man.
We can usefully paraphrase this to the effect that ‘the proper study of economic man is prosperity’.
Correctly understood, material prosperity is a function of the use of energy.
We know, after all, that nothing that has any economic utility at all can be supplied without the use of energy. We also know that, whenever energy is accessed for our use, some of that energy is always consumed in the access process, so is not available for any other economic purpose.
From this understanding follows an equation, straightforward in principle, that calibrates material prosperity.
The ‘consumed in access’ proportion of energy supply is known here as the Energy Cost of Energy, or ECoE.
If we deduct ECoE from total energy available, we’re left with surplus energy, which is the direct material correlate of prosperity.
If we further divide this aggregate surplus energy prosperity by population numbers, the result is prosperity per capita.
The SEEDS economic model – the Surplus Energy Economics Data System – has been designed to interpret the economy in this way. Expressed (for convenience) in financial terms, global aggregate prosperity grew by slightly less than 1.4% annually between 2000 and 2020, meaning that it increased by a total of 31% between those years.
Over that same period, world population numbers increased by 25%. This means that the average person was slightly less than 5% better off in 2020 than he or she had been back in 2000.
These, of course, are global averages, combining performances that vary regionally and nationally. The average Western citizen has been getting poorer since well before the global financial crisis (GFC) of 2008-09. Prosperity per person has continued to improve, albeit it at decelerating rates, in the EM (emerging market) economies.
Looking ahead, we know that the ECoEs of economies which remain reliant on energy from oil, gas and coal are continuing to rise. There are compelling environmental and economic reasons for endeavouring to transition from fossil fuels to alternatives, principally renewable energy sources (REs) such as wind and solar power.
The question here isn’t the feasibility of quantitative conversion to REs. Rather, what we need to know is whether this transition will drive ECoEs back downwards. The hierarchy of challenges involved in transition make this improbable. Even if REs can usher in an era of lower ECoEs, they certainly can’t do so now.
This interpretation points unequivocally towards further deterioration in prosperity. The average Westerner will carry on getting poorer, whilst prior growth in prosperity per capita in EM countries will go into reverse.
Within this broad projection of eroding prosperity, we also know that the real cost of essentials will carry on rising, not least because most necessities are energy-intensive.
What results is a leveraged equation in which prosperity net of essentials falls more rapidly than top-line prosperity itself. This means that essentials will account for a steadily rising proportion of total prosperity.
It follows from this that both capital investment and the scope for the consumption of discretionary (non-essential) goods and services will be reduced.
None of this constitutes a prophecy of ‘collapse’.
Rather, it poses the challenge of adaption to lower prosperity after more than two centuries in which, thanks to the supply of ultimately finite low-cost fossil fuel energy, world prosperity has expanded very rapidly.
A process of denial
Conventional interpretations of economics do not recognize the analysis sketched out here. The economy is presented, not as an energy dynamic, but as a system that is wholly financial.
Energy and other resource constraints are dismissed with the nostrum that [financial] demand produces [material] supply.
This nostrum can be described as the systemic fallacy of conventional economics. The reality, of course, is that no amount of monetary demand can create resources (such as low-cost energy) that do not exist in nature.
By the same token, we cannot “stimulate” our way to greater material prosperity, “grow out of” debt and other financial commitments to the future, borrow our way to financial solvency, or “invest” (meaning monetise) our way to economic and environmental sustainability.
To paraphrase Pope again, though, ‘hype springs eternal in the human breast’. The latest version of cornucopian hype is that growth in perpetuity can be delivered through the alchemy of “technology”. This ignores the inconvenient reality that the potential of technology is limited by the laws of physics.
Things being as they are, conventional economic interpretation continues to insist that infinite economic growth remains a plausible outcome on a planet that, ultimately, is finite. Nowhere in classical economics will you find any recognition of the concept of ECoE. The word ‘prosperity’ is sometimes employed, but not in the precise and material sense in which it is used here.
This ‘money-only’ fallacy applies, not just to projections for the future, but to interpretation of the recent past. For the period between 2000 and 2020, for example, we’re told that the economy enjoyed “growth” averaging 3.4% annually, and expanded by 94% over that period as a whole.
In pursuit of reconciliation
Here, then, are two contradictory statements. The first is that the economy ‘grew by 3.4% annually’ between 2000 and 2020.
The second is that prosperity ‘expanded by less than 1.4% per year’ over that same period.
We could reconcile these two statements by asserting that the rate of inflation used in the measurement of ‘real’ (ex-inflation) GDP has been understated.
The SEEDS model makes this calculation by calibrating RRCI (the Realized Rate of Comprehensive Inflation). If you took out official inflation (of 1.5%) between 2000 and 2020, and used instead an RRCI rate of 3.5%, reported growth in real GDP would align with growth in real prosperity, as calculated on an energy basis.
There seems little doubt that inflation has been understated – routinely and significantly – in official numbers. This suggests that energy-based analysis can improve our understanding of the economy through the measurement of RRCI.
For present purposes, though, our best route is to accept that GDP and prosperity are measures of two different things.
Prosperity measures material economic output as it relates to the supply of goods and services.
GDP, on the other hand, is a measure of economic activity, referencing the financial transactions by which these goods and services change hands.
This presents us with a different requirement for reconciliation. The implication is that the financial value ascribed to activity has expanded much more rapidly than the far more pedestrian rate of increase in the output of material goods and services.
There is abundant evidence, both quantitative and qualitative, for this proposition.
Quantitatively, debt expanded by $216 trillion (190%) between 2000 and 2020, a period in which GDP increased by only $64tn (94%). Broader financial liabilities, which include the unregulated shadow banking system, have grown even more rapidly. The same is true of unfunded pension commitments, where we have seen the emergence of enormous “gaps” in the adequacy of provision.
Colloquially, we know that millions of Americans have been described, persuasively, as “debt slaves”, and that millions of people in Britain now use various forms of ‘BNPL’ (meaning “buy now, pay later”), even as more traditional forms of credit-funded consumption have continued to expand.
A growing proportion of the corporate sector has transitioned towards a model based on streams of income, in which the ‘signing up of’ customers is regarded as more significant than actual levels of current sales.
Evidence of the financialization of the economy is, of course, to be found in the prevalence of negative real interest rates, a product of policies which, when first introduced more than a dozen years ago, were presented as “temporary” expedients.
The negative real cost of capital has inflated the prices of assets to levels far beyond anything that can be justified using traditional measures of value.
From here, where?
As objective observers, our focus needs to be on predictable outcomes.
We have persuasive evidence that economic activity has been inflated to levels far in excess of underlying material prosperity. We can conclude that this process has created unsustainable rates of increase in financial commitments, which include formal debt, informal indebtedness, pension promises and expectations of futurity.
We also know that these processes have driven asset prices to unsustainably elevated levels.
Now that growth in prosperity has deteriorated into negative territory, it seems hard to avoid the conclusion that what lies ahead is an enforced restoration of equilibrium between the ‘financial’ economy of money and credit and the ‘real’ economy of goods and services (and, ultimately, of surplus energy).
Our attention now needs to be devoted to the mechanisms by which equilibrium is restored.
A recent SEEDS project has involved the calibration of a potential ‘soft landing’, by which we manage the restoration of financial and economic equilibrium.
You will not be surprised that the engineering of a ‘soft landing’ is both (a) mathematically feasible, and (b) politically almost impossible.
Essentially, economies would have to accept now adjustments that will, in any case, be enforced upon them at a later point by economic, material, political and environmental trends.
The key word here is “later”. Where unpleasant realities are concerned, ‘never accept today what you can put off until tomorrow’ is an axiom, not just of politics, but of society more generally.
Moreover, there are structural factors – most obviously in America, Britain and the Euro Area – which make the adoption of ‘soft landing’ policies virtually unthinkable.
In the absence of a soft landing, what lies ahead is a scenario in which we are forced to adjust to ‘prosperity reality’. The likeliest mechanism is inflation and, specifically, escalation in the cost of essentials.
As what is called colloquially ‘the cost of living’ accelerates beyond the affordability of millions, the authorities are likely to be dragged, with the utmost reluctance, into a situation where inflation has to be tamed.
That’s the point – and it’s likely to be very soon – at which equilibrium is restored between an inflated financial system and an eroding underlying economy.
There is analytical value in the modelling of what a soft-landing would look like, even though we know that this course of action isn’t going to be adopted.
Essentially, a conceptual soft-landing gives us a template against which to measure what actually happens, much as the measurement of prosperity provides a benchmark which can be used to quantify the difference between the economy as it appears and the economy as it is.
TIMING THE MOMENT OF FRACTURE
When and how can we know that a change of direction is fundamental and lasting, rather than a temporary departure from established trends?
That, in essence, is the call we need to make now. Far from being “transitory”, current conditions – including rising inflation, surging energy prices and the over-stressing of supply-chains – are indicators of a structural change.
Ultimately, what we’re witnessing is a forced restoration of equilibrium between a faltering real economy of goods and services and a drastically over-extended financial economy of money and credit.
This is where confidence in continuity crumbles, where the delusions of ‘growth in perpetuity’ succumb to the hard reality of resource constraint, and where ‘shocks that are no surprises’ shake the financial system.
If you want just two indicators to watch, one of these is the volumetric (rather than the financial) direction of the economy, and the other is the behaviour of the prices of essentials within the broader inflationary situation.
The economics of stress
In the science of materials, it’s observable that fractures happen quickly, even if the stresses that cause them have accumulated over a protracted period. We can spend hours, days, weeks or even years gradually increasing the tension applied to an iron bar, but the ensuing snap in that bar will happen almost instantaneously.
Economics isn’t a science, but there’s a direct analogy here. Anyone who understands the economy as an energy system will be well aware of a relentless, long-standing build-up of stresses.
They’ll be equally aware that this cannot continue indefinitely.
Two things matter now.
First, when will these cumulative pressures bring about the moment of fracture?
Second, what should we expect to see when this snapping-point is reached?
The answers to the second question are pretty clear.
Once the break-point has arrived, we should anticipate deterioration in the material economy of goods and services. Rather than being misled by financial proxies for economic activity, we need to focus on physical metrics, which range from energy and resource consumption, and the supply of goods and components, to the movement of products and people.
Looking behind distorted comparisons with coronavirus-depressed 2020, this is exactly what we’re seeing now.
All sorts of explanations might be advanced for lower physical supply, and many of these explanations are, within their limits, valid. Many interruptions can be identified, across the gamut from the manufacture of cars, chips and components to the availability of containers, transport capacity and skilled labour. Many businesses are in big trouble, not least from sharp rises in the costs both of direct inputs and of the utilities that every business requires.
But what matters here is the overall effect, and that effect is a weakening in the material or physical supply of products to the economy.
Overall downturns in these ‘non-financial metrics’ are of enormous significance, and can be expected to carry on trending downwards once the economic inflexion-point has been passed.
At the same time, we should anticipate major financial dislocation, including surging inflation, market slumps and a cascade of defaults. We can usefully refine the focus on inflation by stating that it won’t be broad inflation, but the rising prices of essentials, that will be the critical lead-indicator of systemic disruption.
Meanwhile, we should also expect to see the combination of financial stress and deteriorating material activity extend more broadly, most obviously into politics, and into wider manifestations of popular discontent and anxiety.
If we compare what we would expect to see with what we can observe, we have an answer to our first question.
The moment of fracture has arrived NOW.
Cumulative tensions between the economy and the financial system are clear to see, provided we know what we’re looking for.
Three metrics provide examples of what this means.
Between 2000 and 2020, global economic activity, expressed as GDP, increased by 94%, meaning that the economy is supposed to have “grown” by $64 trillion (at constant 2020 values).
This “growth”, though, has been paralleled by a far larger – 190%, or $216tn – real-terms surge in aggregate debt. The relentless stretching of the balance sheet becomes even more pronounced if we look beyond formal debt, and take into account rapid increases in broader financial liabilities, and the emergence of huge ‘gaps’ in the adequacy of pension provision.
The aggregate of commitments, then, is rising far more rapidly than reported “activity”, and it’s clear that much of this “growth” in activity is a statistical function of soaring commitments.
Our third metric, provided by the SEEDS economic model, is that global aggregate prosperity increased by only 31% ($19.9tn) over a period in which “growth” is claimed to have been $64tn, or 94%.
If we overlay a 25% rise in population numbers between those same years, what emerges is that a reported 55% increase in GDP per capita masks a rise of less than 5% in the prosperity of the World’s average person.
Add just a soupçon of widening inequality and we have a situation in which the median person gets poorer.
This has happened over two decades in which his or her share of aggregate debt has risen by 130% in real terms.
Just to be clear about this, these are long-term patterns, not fundamentally affected by pandemic-induced effects which, in 2020, reduced GDP by a reported 3.1%.
The Great Divergence
If you’ve been visiting this site for any length of time, you’ll know the importance of drawing a conceptual distinction between the real economy of goods and services and the representational or financial economy of money and credit.
In a process whose origins can be traced right back to the 1990s, these ‘two economies’ have diverged, creating a dangerous disequilibrium.
Contrary to conventional orthodoxy, the economy is an energy system, not wholly or even mainly a financial one. Nothing that has any economic utility at all can be supplied without the use of energy, and the delivery of material prosperity can be – though generally isn’t – expressed as an equation comprising the supply, value and cost of energy.
The most critical of these variables is cost, meaning the Energy Cost of Energy. ECoE references the fact that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. Material prosperity is a function of the surplus energy that remains after ECoE has been deducted from aggregate energy supply.
In short, rising ECoEs mean falling prosperity.
The problem, in an economy that still relies on fossil fuels for more than four-fifths of its energy supply, is that the ECoEs of oil, gas and coal have been rising relentlessly. SEEDS data indicates that the trend ECoE of fossil fuels has risen from 2.8% in 1990 to 6.3% in 2010, and 9.8% now.
Since most ex-ECoE (surplus) energy isn’t used for growth, but for system maintenance and renewal, a rise of 710 basis points in ECoEs, in an economy previously capable of growing at about 3% annually, is much more than enough, not just to eliminate the scope for further expansion, but to put prior growth into reverse.
The imperative, in economic as well in environmental terms, is to replace fossil fuels with lower ECoE sources of energy supply. If we can’t do this, then surplus energy – and, with it, material prosperity – must decline, initially in per capita terms and, latterly, in aggregate.
There is, as yet, no evidence that renewable energy sources (REs), such as wind and solar power, can supply this lower ECoE alternative to oil, gas and coal.
The probabilities, rather, are against this being possible.
Even if this can eventually be accomplished, it certainly can’t happen now. This is why the ‘real’ economy of goods and services has been decelerating, to the point at which involuntary “de-growth” has become a reality.
Whilst prosperity is, of necessity, a material concept, money is a human artefact, validated by its use as a medium of exchange. It has value only in terms of the things for which it can be traded. This means that money has no intrinsic worth, but commands value only as a ‘claim’ on those material goods and services for which it can be exchanged.
Conventional economics tries to circumvent this hard reality with the notion that [financial] demand creates [physical] supply. The fallacious logic here is that, so long as there’s enough financial demand for something, the availability of material supply will somehow follow automatically.
Where finite resources – such as low-cost energy – are concerned, this simply doesn’t work.
We can’t create something that doesn’t exist in nature, simply by putting up its price.
This is why we can’t spend (“stimulate”) our way to material prosperity, any more than we can borrow our way to solvency, or “invest” (meaning monetize) our way to environmental sustainability.
What we’re seeing here is a widening gap between the economy as it is and the economy as we choose to see and present it.
In essence, we’ve been creating apparent increases in economic activity (using expansions in credit and other liabilities) without creating much material economic value.
In the process, we’ve been driving a widening wedge, not just between ‘activity’ and commitments, but between the energy economy of goods and services and the proxy, financial economy of money and credit.
Inflation – the importance of the essential
Logically – because prices are the interface between financial demand and physical supply – inflation should be a prime mechanism in the restoration of equilibrium between the real and the financial economies. Using the material and the financial as the components of an equation, we can identify rates of inflation that substantially exceed reported numbers. Known as RRCI, this is an ongoing development project within the SEEDS economic model.
These broad trends, though, can’t really be seen in readily-available data. For a start, and as you may know, official inflation has been distorted by the use of concepts such as hedonic adjustment, substitution and geometric weighting.
Just as significantly, conventional measures of inflation confine themselves to movements in consumer (or ‘retail’) costs, thereby excluding those changes in asset prices which are a material component of the overall relationship between the quantitative and the financial dimensions of the economy.
The tendency with the use of official numbers is to compare inflationary rises in consumer costs with nominal changes in wages. Theoretically, at least, if consumer inflation is broadly matched by increases in incomes, then the ‘ordinary’ person’s situation doesn’t change all that much, except that his or her debts are inflated away, whilst savings are eroded.
There are many snags with this notion, of which the most obvious is that inflation can take on a momentum of its own, with wages chasing prices, and wage costs pushing up consumer inflation. This tendency threatens a destruction of the purchasing power, and hence of the critical credibility, of money. This is why, whilst low inflation is generally deemed to be acceptable – and is often regarded as beneficial – anything above about 2% is recognized as a problem.
Though true as far as it goes, this approach conflates two very different forms of inflation as the consumer experiences them.
The consumer spends his or her income in two ways. The first is the purchase of essentials, including food, housing, domestic energy, utilities and necessary travel. The second is the purchase of discretionary (non-essential) goods and services. These ‘discretionaries’ are residuals, meaning things that the consumer buys after he or she has met the cost of necessities.
It’s quite possible to envisage circumstances where the cost of essentials is rising much more rapidly than the prices of discretionaries. We might, for instance, have a situation in which, whilst broad inflation is running at 5%, the cost of essentials is rising by 10%. Incomes, if they too are rising at 5%, thus offset general inflation, but fail to keep up with the cost of necessities.
This inflationary divergence makes the consumer poorer because, whilst discretionary purchases such as cars, smartphones and holidays can be deferred – and are not, in any case, made continuously – essentials such as food, electricity, gas and other utilities have to be purchased, generally on a regular weekly or monthly basis.
The vital point about this ‘asymmetric inflation’ is that we need to put the emphasis, not on broad or theoretical inflation, but on trends in the real cost of essentials.
If the cost of, say, a smartphone or a foreign holiday increases, the consumer might not be much concerned about it, because he or she doesn’t need to buy it at all, and can certainly put it off for later.
If, on the other hand, there’s a sharp rise in the cost of food, or the utility charge for electricity or gas, or the price of fuel at the pumps, he or she notices it very quickly indeed – and is right to do so.
Critically, essentials are highly energy-intensive. This is as true of, say, food and water, and of the building and maintenance of homes, as it is, more obviously, of fuel and domestic energy.
The point of impact
What this asymmetric inflation means is that, as energy-based prosperity deteriorates, an obvious financial corollary is a rise in the cost of essentials. As well as causing public discontent, this also leaves the consumer with a reduced ability to purchase non-essential goods and services.
At the critical moment of impact, then, we should expect to see two important trends.
One of these is a rise in the cost of essentials, and the other is volumetric weakness in the economy, most obviously in the use and delivery of physical goods, and in deteriorating metrics in discretionary sectors.
This is exactly what we’re witnessing now. Whilst the prices of essentials are rising, volumetric consumption of discretionaries is trending down, even if this can be hard to see behind an anaemic “recovery” from the artificially-depressed conditions of 2020. When, as is frequently the case, we’re told that discretionary sectors are ‘growing’, it often transpires that this is true only in comparison with last year.
Given that stock markets are heavily skewed towards discretionary sectors, this trend alone is likely to become a worry for investors.
Moreover, rises in the cost of essentials have a direct bearing on decisions made around monetary policy. Consumers, who are also voters, might not make much of a fuss if the prices of discretionary purchases rise, but will react very strongly indeed if the cost of their utility bills, of filling up their car and of the weekly purchase of groceries moves markedly upwards.
It doesn’t take all that much inflation in the cost of necessities to create popular demands for action, demands which, in policy terms, can be met only by raising interest rates, and by easing back on, or reversing, asset purchase programmes.
Because prices, especially of necessities, are the point at which the financial economy of money intersects with the material economy of energy, current trends are unmistakable signs of the moment at which monetary delusion succumbs to energy reality.
It is, perhaps, fitting that this is happening as the pantomime season approaches. Borrowing our way to prosperity played to packed houses in the decade or so before 2008, and much of the glitter carried over into more-than-a-decade in which the speed of monetary expansion has deceived the eye of reality.
There comes, though – and, now, has come – a point at which the curtain descends, the glitter fades and the magic of beans and bean-stalks recedes into memory.
FUTURITY, REALITY AND THE COMING FINANCIAL CORRECTION
The simplest way to define the current economic and broader situation is that consensus expectations and realistically probable outcomes have become polar opposites.
One of the most predictable consequences of this disparity is a sharp fall, both in asset pricing and in the viability of forward financial commitments.
Shared by governments, businesses, the mainstream media and a large proportion of the general public, the consensus line is cornucopian, picturing a future of abundance characterised by continuing economic growth, exponential technological progress and a seamless transition from climate-harming fossil fuels to renewable energy sources (REs) such as wind and solar power.
This essentially optimistic narrative is based on a series of compounding fallacies, which we might summarise as misconceptions of capability.
Three critical realities are ignored. One of these is that the economy is an energy system, which cannot be propelled to infinite expansion by means of the human artefact of money.
A second is that the scope for technology is bounded by the laws of physics.
The third – and arguably the most important – reality ignored by the consensus narrative is that REs are unlikely to replicate the characteristics and economic value historically provided by energy from oil, natural gas and coal.
Those of us who understand the economy in energy terms have to weigh two possible courses of action. These are not mutually exclusive, but a balance does need to be found. One of these is the advocacy of reality. The other is analysis, which involves working out the probable series of events, and providing information which will be of value once the failure of the consensus narrative ushers in a new pragmatism.
The recent emphasis here has been on the fallacies which inform the current narrative. We’ve looked at why the credibility of conventional, money-based economics is waning rapidly, and at the hierarchy of challenges which make seamless, ‘growth-intact’ transition from fossil fuels to REs improbable.
The aim now is to formulate a realistic projection of what a less-than-cornucopian future might look like. In doing this, we need to refer to critical principles, and look at what these critical principles can tell us when translated into interpretation and projection.
Regular readers, to whom the central principles of the surplus energy economy are familiar, might welcome the fact that these principles, of which there are three, can be expressed with brevity.
The first is that the economy is an energy system, because nothing that has any economic utility at all can be supplied without the use of energy.
The second is that, whenever energy is accessed for our use, some of this energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, abbreviated ‘ECoE’.
The third critical principle is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services made available by the use of energy.
These principles immediately set up a distinction between a ‘real’ economy of energy, labour and resources and a ‘financial’ economy of money and credit.
The central fallacy of orthodox economics is that it places the ‘real’ economy of energy and resources in a subsidiary relationship to the ‘financial’ economy of money.
It asserts, for example, that demand (expressed as money) creates supply (of the goods and services produced using resources). The reality is the other way around – that the financial system is a proxy and an operating mechanism for the all-important economy of energy.
These principles should inform our understanding of the industrial era which can be dated to 1776, when James Watt completed the first efficient heat-engine, giving us access to the vast amounts of energy contained in coal, oil and natural gas.
Through much of the subsequent two centuries, the ECoEs of fossil fuels declined, reflecting widening geographic reach, rising economies of scale and improvements in the technology of energy access and application. This meant that surplus (ex-ECoE) energy expanded more rapidly than aggregate energy supply, such that prosperity out-grew increases in the amount of energy available to the economy.
Latterly, when the scope of reach and scale had been maximised, ECoEs started to rise through the mechanism of depletion. By the 1990s, fossil fuel ECoEs were rising exponentially, more than offsetting volumetric expansion, and creating the phenomenon described at the time as “secular stagnation”.
Our subsequent economic history has been characterised by failed efforts to use financial tools to cancel out this adverse ECoE effect. We began this process of denial and misconception in the 1990s, by making debt ever more readily available. This process of credit adventurism was compounded, after the 2008-09 GFC (global financial crisis), by the adoption of monetary adventurism, characterised by supposedly “temporary” expedients such as QE and ZIRP.
The result has been a widening gap between the ‘real’ and the ‘financial’ economies. Barring some kind of ‘energy miracle’ (which isn’t going to happen), this gap has to be narrowed, and equilibrium restored, by a sharp contraction in the financial system which, as we’ve seen, is a proxy for the real economy of energy.
This contraction in the financial system is our first clear projection for the future.
As we’ve seen, the real value of money resides in its function as a ‘claim’ on the output of the economy determined by energy. This means that it’s perfectly possible – indeed, under certain circumstances almost inevitable – for us to create claims on the real economy that exceed anything that that real economy can deliver. In Surplus Energy Economics, these are known as excess claims.
One of the mechanisms instrumental to the creation of excess claims is the operation of ‘futurity’. As distinct from the everyday meaning of ‘future’, the term futurity references the forward expectations that inform decisions taken in the present.
Whether it’s borrowing and lending, investing or fiscal planning, financial decisions are based on individual assumptions of what the future is likely to hold. Together, these expectations form a futurity consensus, and one of our biggest problems now is the sheer improbability of a futurity consensus based on a mistaken narrative of infinite growth and extrapolated technological advancement.
The most obvious example of futurity is debt. As a ‘claim on future money’, debt really functions as a ‘claim on future energy’. Expressed in international dollars – converted from other currencies using the PPP (purchasing power parity) convention – and stated at constant (2020) values, aggregate global debt has expanded from $127 trillion in 2002 to $330tn at the end of last year.
Debt, of course, is by no means the entirety of financial ‘claims on the future’. The shadow banking system, which has expanded particularly rapidly since the GFC, forms part of a broader category of financial assets which, for the most part, are the liabilities of the three non-financial sectors of the economy, which are households, governments and private non-financial corporations (PNFCs).
Data exists for countries equating to 75% of the global economy. On this basis, world financial assets can be estimated at $650tn – up from less than $220tn in real terms back in 2002 – which includes the previously-mentioned debt aggregates.
Meanwhile, there has been a super-rapid expansion in unfunded pension commitments. These commitments are often implicit rather than contractual, but rank as commitments because they cannot easily be repudiated by the governments which are the principle debtors in the situation (and neither, unlike debts, can they be ‘inflated away’).
We have data for pension ‘gaps’ for countries accounting for about half of the world economy. On this basis, it’s reasonable to infer that the global aggregate of unfunded pension promises stands at about $235tn, up from about $115tn (in real terms) back in 2002.
On this basis, we can estimate that the world owes – to its own future – financial claims totalling $890tn, and comprising debt (of $330tn), other financial liabilities ($320tn) and unfunded pension commitments ($240tn).
This total compares with a real-terms equivalent of $330tn back in 2002. Each of these numbers would be smaller if we used market rather than PPP conversion to dollars but, by the same token, so would any calibration of affordability used as a benchmark.
The conventionally-used benchmark is GDP which, since 2002, has increased by $60tn (84%) over a period in which financial claims have grown by an estimated $560tn (+170%). As a rule-of-thumb, we can infer that claims on the future have increased by $9.30 for each incremental dollar of reported GDP.
This calculation, though, assumes that GDP is a reliable indicator of the ability to meet forward claims. In fact, though, GDP is a measure of activity, not of value, which means that it is inflated artificially by the creation of debt and other forward commitments.
Though we can go into this issue in more detail on a later occasion, the energy-based SEEDS economic model indicates that prosperity has expanded by only $18.7tn (29%) over a period in which reported GDP has increased by $60tn.
Part of the difference lies in the inflationary effect of credit expansion. By excluding this, we can calculate growth in underlying or ‘clean’ output (in SEEDS terminology, C-GDP) at $23.9tn (+35%) rather than the reported $60tn. Also excluded from conventional measurement is the financial equivalent of the rise in ECoEs between 2002 and 2020, a number which SEEDS puts at $5.2tn.
As measured by SEEDS, then, global prosperity increased by only $18.7tn over an eighteen-year period in which we can estimate that the broad commitments of futurity have escalated by almost $560tn.
What this in turn means is that we have been engaged, on a massive scale, in the creation of excess claims, meaning financial commitments which far exceed anything that the real economy of goods, services and energy can ever hope to honour in the future.
The flip-side of this escalation in commitments has been massive inflation in the supposed ‘value’ of assets such as stocks, bonds and property.
There are all sorts of technical debates that can be had around these calibrations, but there are abundant sources of corroboration for the case that the system has created forward commitments far in excess of any realistic ability to meet those commitments out of future prosperity.
For a start, negative real interest rates are an anomaly, and a direct contradiction of the tenet that a capitalist economy is founded on the ability to earn real returns on capital. Asset prices stand at absurd ratios to any realistic benchmark, and have been inflated massively by the negative real pricing of capital.
From this situation of massively-inflated asset prices – and a correspondingly unsustainable increase in liabilities – only two routes back to equilibrium exist. One of these is the ‘hard default’ route of repudiation, and the other is the ‘soft default’ process of inflationary devaluation.
It can be no surprise whatsoever that inflation has started to rise, a phenomenon that would be even more apparent if we included rises in asset prices within a broad definition of inflationary processes.
This kind of broad inflationary definition is being developed within the SEEDS model, where it is known as RRCI (the Realised Rate of Comprehensive Inflation).
We can further use SEEDS to identify which sectors (governments, businesses and households), and which segments (investment, discretionary consumption and the provision of essentials) are most exposed to the twinned phenomena of deteriorating prosperity and the restoration of claims equilibrium.
For now, though, we can conclude that the divergence between the consensus and the realistic views of the future has created the scope for an enormous (and by no means pro rata) destruction of value within the financial system.
THE LIMITS OF TRANSITION
Logically considered, 2021 ought to have been the place where old assumptions go to die.
In many ways, it is.
Specifically, orthodox, money-based economic interpretation is being debunked. Current events are demonstrating that the economy isn’t, after all, entirely or even primarily a financial system. The proposition that demand produces supply is being discredited, because no amount of stimulus can deliver low-ECoE energy where that energy does not exist. In short, we’re discovering that the economy is an energy system.
Since the start of the Industrial Age, that has meant, overwhelmingly, a fossil fuel energy system. We’re in the process of encountering two constraints to the continuity of an economy built on oil, gas and coal.
The well-known constraint is that we have reached (or passed) the limits to environmental tolerance of our use of fossil fuels.
The second, barely-recognized-at-all constraint is that fossil fuels’ ECoEs – their Energy Costs of Energy – are rising exponentially, in a process that would destroy the fossil-dependent economy even if we were so unwise as to ignore the environmental issue.
The consensus answer to this situation is that we must endeavour to transition from reliance on fossil fuels to an economy based on alternative sources of energy.
This, undoubtedly, is a realistic conclusion.
The snag, though, is that the consensus view combines the logical conclusion of transition with the unfounded assumption of an economy which, far from contracting, continues to expand.
A balanced assessment of the issues indicates, rather, that a sustainable economy will also be a smaller one.
An appraisal of outcomes
At the level of theory, there’s nothing much wrong with the idea of outdated notions undergoing a mass extinction event.
Our understanding, and our ability to plan ahead, can only benefit from the discovery that the economy isn’t, after all, ‘a wholly monetary system, capable of infinite growth’, but is in fact an energy system, limited by the laws of physics as they apply to the Earth’s energy resources.
It is, after all, hard to plan effectively when your base predicates are false.
In practical terms, though, we’re faced with something that moves beyond an inconvenient truth into what is for most people an almost inconceivable one. This is the proposition that there may be no wholly sufficient replacement for the fossil fuel energy on which the economy of today is based.
Put another way, the desirable – indeed, imperative – de-carbonization of the economy is likely to involve shrinking it as well.
If you held any leadership position, you’d have to think long and hard before going public on any of this. Your wiser course of action might be to talk up the positives in the current situation whilst preparing, with the greatest urgency, for the new one.
Essentially, this comes down to a probability assessment of two possible outcomes.
The first is that alternative energy sources – primarily wind and solar power, but perhaps with a role for nuclear as well – can provide a complete and timely replacement for fossil fuels.
The second is that no such complete replacement exists, and that we have to plan for a smaller economy.
The latter needn’t be a disaster, so long as we prepare for it, and travel to this destination gradually.
But we have far too many growth-predicated systems and assumptions for any kind of sudden recognition to be manageable.
Needed – a new tin-opener
A story is told about three experts shipwrecked on a desert island. Their situation seems far from desperate. The island is well-found in fire-wood and fresh water. Washed ashore with them are thousands of tins of baked beans, offering nourishing if monotonous fare. They even have saucepans, plates and cutlery.
The one thing lacking is a tin-opener.
The chemist proposes putting the tins in water which, in due course, will corrode them. Unfortunately, they would starve long before this could happen.
The physicist suggests heating the tins to a temperature at which pressure causes them to explode. This, though, would splatter beans across the island, as well as subjecting the castaways to lethal shrapnel.
Appealed to, the economist has a simple solution – assume a tin-opener.
This encapsulates the consensus line as the long era of rising prosperity created by fossil fuels draws to a close. If we assume a replacement for fossil fuels, and further assume perpetual economic growth, our problems are solved.
A hierarchy of challenges
Though an expansion of nuclear energy might help at the margins, the assumed replacement for fossil fuels is electricity from renewable energy sources (REs), principally from wind and solar power.
There are two little snags with this assumption.
The first is that replacing FF with RE energy might not be possible for at least 10-20 years. A great deal – little of it good – can happen over that length of time.
The second is that it might very well not be possible at all.
There’s a hierarchy of challenges to RE transition.
Used as inputs when the wind is blowing and when the sun is shining, wind and solar power can provide electricity at costs which are more or less competitive with traditional methods of generation. The main potential snag is the cost of replacing wind turbines and solar panels when they reach the end of their productive lives, which are somewhere between fifteen and twenty-five years.
In other words, is this transition sustainable, to the point where RE capacity can be maintained and replaced without assistance from fossil fuels?
The second stage in the hierarchy of challenges is scale. In 2020, and despite the effects of covid-induced reductions in activity, fossil fuels supplied energy totalling 11.2 billion tonnes of oil equivalent (toe), or 82% of the total. Between them, wind and solar power provided only 0.57 bn toe (4.2%). The scaling challenge is largely a matter of accessing vast amounts of raw materials whose supply is – for the foreseeable future – dependent on the use of energy from fossil fuels.
The third challenge in the hierarchy is intermittency. If REs are to move from minor energy contributors to baseload suppliers, vast electricity storage is required. This would make enormous further demands on materials, some of which may not even exist, and would, again, make huge calls on the use of fossil fuels for their supply. Accessing many of these resources would have extremely adverse environmental and ecological consequences.
Even if all of this could be overcome, the cost of storing electricity is roughly 200x that of storing oil, gas or coal. This is why, taking America as an example, whilst fossil fuel inventories are measured in weeks and months, electrical backup is measured in minutes.
This cost differential may narrow, but the physics of storage processes limit quite how far the cost of electricity storage may fall. What this also means is that, to fill storage during periods when the wind is blowing and the sun is shining, generating capacity would need to be far larger – perhaps 60% greater – than the continuity-based equivalent. Costly redundancy, no less than storage capacity, would need to be built in to a system based on intermittent energy.
Next in the hierarchy comes the challenge of density. Oil, in particular, offers a very high ratio of power to weight. This density, which provides easy portability, is what makes today’s cars, commercial vehicles and aeroplanes practical. It’s at least arguable that an insistence on replacing these with battery-powered alternatives raises the power storage problem to ludicrous heights.
The fifth and – for now – final challenge in the hierarchy is adaptability. We might, for instance, find that, whilst grid-scale storage is feasible, self-contained storage is not, making trains and trams viable, but turning mass EV use into a pipe-dream.
Likewise, we might have enough continuous power to run necessary systems, but not to support much of what we now think of as “technology”. It might turn out that essential goods and services can be supported, but that many non-essentials (discretionaries) can’t.
The permutations are endless – but the potential supply of non-fossil energy, most emphatically, is not.
As well as assuming the tin-openers of sustainability, scale, continuity and density, then, the idea of seamless and complete transition assumes some resources that cannot be provided, and others that, though they can, would make enormous demands on legacy energy from fossil fuels. All and more of this legacy energy is already accounted for by the continuity requirements of consumption and capital asset replacement.
A new tin-opener is needed – but technology can’t supply it
Let’s be quite clear about the necessity for transition. As mentioned earlier, continued reliance on fossil fuel energy is a non-starter, for two reasons, both of which are so important that they merit reiteration.
First, there is the undoubted constraint of environmental tolerance.
Second, there’s the equally real issue of the rising ECoEs of oil, gas and coal. As well as wrecking the environment, continued dependency on fossil fuels would – assuredly, and rapidly – wreck the economy. The latter process has already started to happen, albeit thinly disguised, so far, behind increasingly desperate and harmful exercises in financial gimmickry.
Prophets of seamless transition take refuge in the supposed alchemy of technology – much of it simply extrapolated – whilst ignoring the obvious (though inconvenient) fact that the scope for technological progress is bounded by the limits of physics.
Where wind turbines are concerned, Betz’ law states that wind turbines cannot capture more than 59.3% of the kinetic energy of wind. Current best practice has already reached about 45%, leaving no scope for a quantum (rather than a modest and gradual) increase in efficiency.
Similarly, the Shockley-Queisser limit determines the maximum theoretical efficiency of photovoltaic panels. This limit is 33.7%, not very far ahead of current best practice of about 26%. Again, progress can be made, but no quantum leap in efficiency is possible. Both of these issues are discussed in an instructive article published by the Manhattan Institute, which also explains limitations to the potential capability of batteries.
Not content with assuming resources (and their energy input requirements) which do not exist, then, cornucopian transition theory also requires us to assume that technology facilitates the abolition of the laws of physics.
It was a famous dictum of Sherlock Holmes that “[w]hen you have eliminated the impossible, whatever remains, however improbable, must be the truth”.
Objective assessment of the situation suggests that both (a) fossil fuels continuity, and (b) a cornucopian complete replacement of fossil fuels are impossible. What remains is the seemingly-improbable – and in many quarters the almost unthinkable – reality of a smaller economy.
To recap, we’ve noted the imperative of transition – an imperative imposed by environmental considerations and by ECoE trends – but we’ve also noted that there are limits to what transition is capable of delivering.
What this means is that we have to bend every effort to the achievement of transition, but that we must also accept that transition cannot maintain the economy at its current levels of size and complexity.
The energy-based SEEDS economic model produces case-studies which scope the issues involved.
The central-case assumptions used by the SEEDS economic model project total energy supply 6% higher in 2040 than it was in 2020. Within this total, fossil fuel supply is projected to be lower by 3%, the combined contributions of nuclear and hydro-electric power are expected to increase by 21%, and a 2.4-fold surge in supply from wind and solar generation is anticipated. On this basis, energy supply per person would fall by 10%.
Over the same period, though, ECoEs are expected to rise from 9.0% to 18.1%, meaning that surplus (ex-ECoE) energy availability per capita would slump by 19%. This is reflected in a corresponding decrease in prosperity per person.
Putting practicalities on one side for the purposes of theoretical analysis, the complete replacement of fossil fuels with wind and solar power might deliver an overall 2040 ECoE of, at best, 15%. On this basis, surplus energy supply per person would still decline, but prosperity would fall by only 16%, rather than by the 19% projected under the central case.
Two important conclusions emerge from this assessment.
The first is that accelerated investment in RE capacity can blunt the rate at which prosperity declines.
This underscores the case for transitioning to REs at the fastest practicable rate.
The second is that, however we tackle the energy crisis, prosperity will be lower in 2040 than it is now.
This means that we need to temper commitment to transition with a realistic appraisal of what transition can be expected to accomplish.
This changes the central question from ‘must we live with less?’ – about which there is no choice – to ‘how can we live with less?’
Re-design – not re-set
The much-vaunted concept of an economic ‘re-set’ is predicated on the idea that an economy which continues to grow can be made both more equitable and more efficient, as well as being made sustainable.
Unfortunately, the essential predicate of growth is fallacious, in that we cannot reasonably expect – still less assume – continuity of growth in a post-fossil economy.
This implies that what we need isn’t re-set, but re-design.
At a later stage we may revisit the taxonomy of de-growth but, for now, we can note that a contracting economy implies a process of de-complexification. The range of products and services available will narrow, and methods of supply will be simplified as producers try to work around the adverse effects of falling utilization rates and the loss of critical mass. The simplification process will involve substantial de-layering.
The brunt of contraction in the private sector will be borne by sectors providing discretionary (non-essential) goods and services. Over time, we should assume that capital will be diverted towards sectors which supply necessities.
There are likely, also, to be sectors which expand, even as others are contracting. There may be a significant role to be played by venture capital and sovereign wealth funds in identifying and promoting activities whose potential has yet to be recognized by markets which remain fixated on “growth”.
Government activity, too, can be expected to contract, though less rapidly than the private sector. A trend already set in motion by the imperative of transition points towards reduced resources available to government, and a corresponding need to refocus questions of priority.
The critical question for policymakers now might be that of how we ensure that the essentials are available and affordable for everyone.
As so often, though, individuals will be called upon to accomplish much of the change if we’re to move to a system that, whilst being cleaner and more sustainable, is also likely to be smaller than that of today.
At all levels – households, government, business and finance – the challenge will be that of transitioning to an economy that, whilst smaller, need not necessarily be worse than the one built on oil, gas and coal.
THE ARRIVAL OF ECONOMIC CONSTRAINT
Some of us have long understood that the economy is an energy system, and is not – as orthodox economics insists – wholly a financial one.
We’ve identified credit and monetary adventurism as futile efforts to deny this reality, efforts which, whilst not ‘fixing’ low and reversing “growth”, have exacerbated financial risk by driving a wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit.
We’ve highlighted relentless rises in ECoEs (the Energy Costs of Energy) as the process by which expansion in economic output peters out, and prior growth in prosperity goes into reverse.
Recent sharp rises in the price of energy might look like just one aspect of the current worsening economic predicament, a predicament which is ‘a crisis in all but name’. Other adverse factors can be cited, but all of them, ultimately, are traceable to a fading energy dynamic.
We’ve built a large, complex and increasingly inter-dependent economy on the predicate that money can drive ‘growth in perpetuity’.
We’re now in the process of discovering that this predicate is false.
From here on, prosperity will continue to deteriorate, whilst rises in the real cost of essentials will leverage this decline into a more rapid erosion of discretionary prosperity.
The good news is that these processes can be understood and modelled, projected and managed.
The bad is that, so far at least, this reality is not being grasped.
It has to be said that no ideology is more rooted than ‘neoliberalism’ in the doctrine that the economy is a financial system, with limitless capability for growth.
This is why those economies most wedded to the ultra-liberal ‘super-fallacy’ are being hardest hit by the harsh reality that neither ‘demand’ nor ‘incentive’ can create low-cost resources.
A new model crisis
Despite the most lacklustre of recoveries from the pandemic-induced downturn, the global economy has collided with the reality of energy constraint.
Natural gas, in particular, is in short supply, but the effects of supply shortages are rippling, too, across the markets in electricity, oil and coal. Almost unthinkably, China – widely regarded as the powerhouse of the world economy – is having to ration supplies of energy to its industrial sectors, whilst grappling with the fall-out from exuberant financial expansion.
Consumer energy and fuel prices are surging, a process as adverse for industry as it’s uncomfortable for households. Though the rise in domestic energy costs is the most conspicuous aspect of energy price escalation, deeper consequences will be felt through sharp increases in the costs of supply to businesses.
All inputs, from minerals and chemicals to food and water, are functions of the energy used to extract and process them. If the supply of energy tightens, and its costs rise, the same happens across the entirety of economic activity.
This, in short, looks like the moment when the reality of energy and broader resource constraint makes itself felt, and the conceit of perpetual growth on a finite planet is revealed as fallacy.
We need to be clear that, insofar as this is an “energy crisis”, it has nothing in common with previous such crises. Neither can it be blamed on after-effects of the pandemic crisis, on gamesmanship (by Russia, or anyone else), on ‘little local difficulties’ (like “Brexit”), or even on the distorting effects of gargantuan financial stimulus, harmful though that has been. Least of all can it be ascribed to ‘brisk economic growth’, since the global economy is unlikely to be any larger in 2021 than it was in 2019.
Rather, what we are experiencing is a predictable – though, in general, not a predicted – collision between resource limitations and a desire for never-ending “growth”.
The economy has hitherto experienced two energy crises (or three, if we include the oil price spike experienced in the American Civil War), but what’s happening now is profoundly different.
During the 1973-74 embargo crisis, and the 1978-79 Iranian revolution, there was no physical shortage of oil, or of energy more generally. These were crises of management, and of trade imbalances and international relations, not of supply fundamentals. Fossil fuel ECoEs remained below 2% in the 1970s, but are nearly 10% now. Even if renewable energy sources (REs) can take over fully from fossil fuels in the future (and this is unlikely), they certainly can’t do so now.
A moment of truth
From an economic perspective, this is a watershed. What we are witnessing is decisive proof that the economy is indeed an energy system, and is not – as orthodox opinion has so long insisted – wholly a matter of money. Pouring yet more money – in econo-speak, demand – into the system isn’t going to create huge new supplies of oil, gas, coal or any other form of primary energy.
All of the world’s decision-making processes – most obviously in government, business and finance – are predicated on an assumption which is turning out to have been fallacious. The economy isn’t, after all, a ‘perpetual growth machine, powered and shaped by money’.
Rather, it’s an energy system, in which material prosperity is a function of the availability, value and ECoE-cost of energy.
With its emphasis on incentive, and its disdain both for government planning and for non-financial motivation, the ideology sometimes called ‘neoliberalism’ is most exposed to the discovery that the economy cannot, after all, be managed in purely financial terms.
This helps explain why those countries most wedded to the idea of ‘leave it to the market’ – and, with it, of accepting inequality as ‘the price of efficiency’ – face the toughest futures. Britain, most conspicuously, is experiencing the consequences of the liberal ‘super-fallacy’ now, but the United States, in particular, won’t be far behind.
Of course, hype – no less than hope – “springs eternal”. But surges in the direct household costs of energy and fuel are now impacting economies, and indirect, second-order effects (traceable to the rising cost of energy to industry) are already making themselves felt in supply shortages and inflation.
For those countries worst affected by energy supply strains, pious promises to “build back better” and to “level up” won’t remove the need to make tough, unpopular decisions. “Green growth” is going to have to transition into “green resilience”. Decades of denial – enacted through monetary gimmickry, and backed up by excessive faith in the alchemy of technology – threaten severe financial and broader consequences.
A rocky road
As the energy interpretation of the economy moves from left-field theory to demonstrable reality, theories and models based on the contrary assumption are breaking down. The economy is moving in directions not anticipated by orthodox theory, invalidating much, and arguably most, of the projections, methodologies, models and policies hitherto accepted as valid.
Those of us who understand the economy as an energy system can predict some, at least, of the consequences of present trends.
First, material prosperity will deteriorate. Properly understood, this has long been an established trajectory in the West, glossed over – but not changed – by increasingly desperate, illogical and hazardous exercises in credit and monetary adventurism. SEEDS analysis makes it clear that the average person in almost all Western economies has been getting poorer since well before the 2008-09 GFC (global financial crisis), and that an increasing number of EM (emerging market) economies, too, are reaching the climacteric at which rises in ECoEs put prior growth in prosperity into reverse.
The rates of decline in top-line prosperity itself look manageable. But rising ECoEs are set to drive up the real costs of essentials (including household necessities and public services). Together, the combined effects of falling prosperity, and the rising cost of essentials, are exerting a tightening squeeze on the scope for discretionary (non-essential) consumption.
This downwards pressure on discretionary prosperity is going to be unpopular, with consumers and with discretionary suppliers alike, and this may prompt efforts to prop up discretionary consumption with yet more reliance on credit expansion.
Denial, for the moment, remains unchallenged. In Britain, for example, households are likely to face further and even larger rises in the cost of gas and electricity, and the price of anything (which means everything) made using energy is going to rise as well. Discretionary consumption cannot continue unchecked through this process.
To be sure, wages might rise to accommodate these cost increases but this, if it happens, will simply fuel an inflationary cycle. The task of repairing the public finances will become harder with each worsening twist in the cost cycle.
Despite this, few yet anticipate contraction in the scope for everything from travel and leisure to the payment of subscriptions and the purchase of the latest gadget. Fewer still have grasped the read-across from deteriorating prosperity to the pricing of property and other assets.
Around the world, these processes in turn imply, not just that inflation will rise, but that the financial system will come under increasing stress. Together, discretionary sectors, and businesses that rely on the ‘stream of income’ model, are going to be in the eye of the storm.
The ‘basics’ of the situation – deteriorating top-line and discretionary prosperity, rising inflation and worsening financial stress – are simply the first-order effects of the deteriorating energy-prosperity equation. More complex processes can be anticipated, some of them identifiable in a taxonomy which sees businesses simplifying their products and processes, de-layering their supply chains, and trying to work around the challenges of falling utilization rates and the loss of critical mass. Popular priorities can be expected to change, intersecting with a deterioration in the affordable resources of governments.
These are issues on which we can reflect and which, to some extent, we can model and predict.
For now though, the imperative is that the realities of resource (and environmental) constraint are recognized, and that plans and assumptions are re-thought accordingly.
ASSET MARKETS AND THE LOOMING ‘SNAP-POINT’
Throughout the period since the global financial crisis (GFC) of 2008-09, capital markets have marched upwards, even as the economy itself has, at best, stagnated. After a sharp correction at the start of the coronavirus crisis, the prices of stocks and property, in particular, have kept hitting new highs, even as the much-vaunted “recovery” has petered out.
The casual observer might wonder, first, about why this great divergence between the economy and the markets has happened at all, and, second about, whether, or when, it will come to an end.
The aim here is to explain the former, and anticipate the latter.
Questions around the divergence between the economy and the markets have been accompanied by the suspicion that decision-makers may have wanted this to happen (in order further to enrich the wealthiest), and that they have ordered events accordingly.
We can start by stating that the fault of the policymakers has, very largely, been one of complicity rather than of design. Ultra-low interest rates weren’t adopted to boost asset prices, but to prop up a faltering economy. This said, the ‘great divergence’ could, and should, have been anticipated, and fiscal measures adopted to restrain it.
To be clear about this, there’s an equation which links economic adversity to rising markets. The weaker an economy becomes, the greater the likelihood that interest rates will be lower, for longer, than if the economy were performing well. Cheap money is favourable for markets, so there’s a mathematical linkage between economic weakness and market strength.
This, though a linear equation, isn’t an infinite one. A weak economy is good for asset prices, but there comes a point at which economic stagnation turns into deterioration, and at this point the equation snaps, and markets correct downwards, quite possibly very rapidly indeed.
Economic weakness that pushes people into taking on ever more debt is favourable for asset prices, until it reaches the moment at which borrowers can no longer support the debt that they already have, let alone take on yet more. We can call this the “snapping-point” at which the equation inverts, and market exuberance turns into fear.
The trick is to work out how, and when, this snapping-point is going to occur.
At this moment, there are some very evident economic problems, which include uptrends in inflation, a squeeze on the availability of energy supplies (and of natural gas in particular), the fracturing of supply-lines across a gamut of goods and services, and the perception – at least in Beijing – that financial risk is becoming excessive.
Mention of Beijing should remind us that what we need to identify are broad trends rather than national events, even when these are taking place in a country as important as China. The Chinese authorities have their own reasons for cracking down on speculative investment, banning crypto-currencies, taming ‘big tech’ and tackling the problem of moral hazard.
Likewise, we shouldn’t generalize from events in the United Kingdom, since many of Britain’s problems are self-inflicted, and are specific to a weak, vulnerable and badly-managed economy. There’s more reason – because America is much bigger and a great deal more important – for concern about the seeming irrationality of US economic and financial policy, with its one-trick-pony addiction to stimulus.
At present, the tendency is blame everything – including inflationary pressures, supply-chain disruption and financial stresses – on the after-effects of the coronavirus crisis. As an explanation, this ranks for credibility somewhere between “the dog ate my homework” and “I can’t buy a round of drinks because a spaceman from Mars stole all my money”.
After all, official figures indicate that global GDP fell by a less-than-catastrophic 3.3% last year. To believe that all of these economic problems only began in 2020 requires extreme myopia, and a very short memory.
Rather, and as regular readers know, the economy has been deteriorating over a very long period, which we can trace back to the identification of “secular stagnation” back in the 1990s.
In the final analysis, the size and complexity of the modern economy are products of the use of energy from oil, gas and coal. Now, though, the ECoEs (the Energy Costs of Energy) of fossil fuels are rising relentlessly, and the window of environmental tolerance of their use is closing.
This mightn’t have mattered if we had a fully adequate replacement source of energy available, and were willing to adapt the economy onto a new basis consistent with radically different sources of energy.
Neither is the case. Wind and solar power cannot provide a complete replacement for fossil fuel energy, and our unwillingness to adapt to very different energy conditions is exemplified by the insistence that battery-reliant EVs, rather than mains-powered trains and trams, must be the primary transport mode of the future.
Readers will be familiar with the reasons why like-for-like transition isn’t feasible. First, the expansion and maintenance of renewable energy sources (REs) is dependent on vast quantities of materials whose supply, in turn, depends on legacy energy from fossil fuels.
Second, the intermittency of wind and solar power requires batteries, a requirement which loads the material balance still further against seamless transition. Relatively low-cost additional energy sources become much more expensive when they transition to the role of base-load.
Third, REs are never going to yield the energy density to which we’ve become accustomed over two centuries of reliance on coal, oil and gas. The magic elixir of ‘technology’ isn’t going to fix this, not least because best practice in REs is already close to maxima dictated by the applicable laws of physics.
The bottom line is that the ECoEs of REs are unlikely ever to fall much below 10-12%, and even that might be an optimistic target. The modern economy was built on ECoEs of less than 2%, can’t really grow once ECoEs rise much above 6-7%, and is in deep trouble now that trend ECoE has risen above 9%. As ECoEs rise, the supply quantity (as well the economic value) of energy starts to deteriorate, a tendency already playing out in the availability of natural gas.
This much will be familiar to readers, who will also know that there can be no lasting financial ‘fix’ for an economy that, ultimately, isn’t financial at all, but is shaped by the supply and ECoE-cost of energy.
If we insist on throwing the financial system under the wheels of the ECoE juggernaut, we shouldn’t be surprised if it gets broken.
A critical issue now is the process by which this deterioration in economic fundamentals feeds through into the financial system in general, and into markets in particular.
To understand this, we need to recognize the role of essentials, defined here as the estimated total of household necessities and public services.
In absolute terms, the cost of these essentials is rising, because so many of them are energy-intensive, and thus exposed to the rising trajectory of ECoEs. Their proportionate burden will rise even more rapidly because, just as essentials are becoming more expensive, top-line prosperity is trending downwards.
Essentials are the leveraging factor that can turn comparatively gradual deterioration in prosperity and into something which is much more unpleasant.
This is particularly relevant to the markets. In equities, a large proportion of quoted companies are engaged in the supply of discretionary (non-essential) goods and services. Many of these stocks are priced by the markets on the basis of continuing growth, but energy-based analysis, as carried out here using the SEEDS economic model, makes it clear that discretionary prosperity is contracting, and that discretionary consumption has – thus far – been propped up by credit expansion alone.
More prosaically, a point is likely to be reached at which markets realize that pressures on household budgets – pressures reflected in energy and utility costs, in broader inflation and in the sheer scale of debt burdens – aren’t temporary or, in today’s buzz-word, “transitory”.
It will then become apparent that the rising cost of household expenses leaves consumers with less to spend on things like leisure and travel, cars and gadgets. It might also be recognized that decreasing discretionary prosperity leaves less resources available for the “streams of income” business model built on the continuity of subscriptions, stage payments and various forms of credit.
In practice, recognition of pressure on consumer discretionary resources may coincide with a realization that there are limits to the viability of perpetual stimulus. What SEEDS is telling us is that the affordability of everything from a foreign holiday and a day at the races to a new smartphone, a replacement car or an entertainment subscription is coming under worsening pressure. What orthodox data tells us is that consumers are still making these purchases, but are becoming ever more reliant on credit to finance them.
Here, then, is the “triple whammy” that is likely, sooner rather than later, to trouble the markets.
First, as discretionary purchasing power deteriorates, so does the outlook for any company supplying non-essential goods and services.
Second, these same pressures are putting the ‘stream of income’ business model at worsening risk.
Third, inflationary pressures – exacerbated by a non-“transitory” fracturing of supply lines – are taking us to the point where stimulus stops working and becomes dangerous, a point that might arise well before the authorities detect a need to raise rates.
These pressures are not, of course, unique to equity markets, but can be expected to extend to other asset classes, including property. Ultimately, what we’re witnessing is the compression of affordability in general, and discretionary affordability in particular, combined with arrival at the limits to the feasibility of stimulus.
Orthodox economics – with its insistence on a purely monetary ‘perpetual growth’ dynamic, unconstrained by resources – isn’t going to recognize any of this any time soon. Neither, for that matter, will governments, for whom predictions of anything but growth in perpetuity are anathema.
Don’t be too surprised, though, if markets tumble to what’s happening, long before reality penetrates the portals of economic orthodoxy or the corridors of power.
LONG-ODDS BET OR A PORTFOLIO OF SCENARIOS?