#242. The dynamics of global re-pricing



There is a growing acknowledgement that the World economy has entered a new era. We know that the cost of capital is trending upwards, with adverse consequences for asset prices. But there’s been remarkably little inclination to examine the underlying processes that are causing this to happen. Neither is there much in the way of recognition that entire sectors could be crushed, or even eliminated altogether, as re-pricing becomes more selective.

We need to dismiss any idea that this is temporary. There are some linkages connecting the resurgence of inflation with pandemic-era QE, and with the war in Ukraine, but these are little more than symptoms.

The underlying dynamic is that the economic driver of the industrial era – the supply of low-cost energy from oil, natural gas and coal – is winding down, and there is no assured replacement at hand. Transition to renewables is imperative, but there’s no guarantee that an economy based on wind-turbines, solar panels and batteries can be as large as the fossil-based economy of today. The probabilities are that it will be smaller.

Had we been prepared to do so, we could have seen this coming. The chain of causation starts in the 1990s, when the authorities responded to “secular stagnation” with deregulation programmes that made credit easier to obtain. The subsequent financial crisis forced the adoption of QE, initially to prop up the banking system, and latterly as a self-standing form of stimulus. We were assured, quite wrongly, that QE would not be inflationary, but it has created a systemically-dangerous “everything bubble” in assets.

The fundamental issue is that the material costs of energy supply have been rising relentlessly. We cannot “de-couple” the economy from energy use, and this report describes a remarkable linearity between the quantity of energy that is used and the economic output that ensues. Meanwhile, and whilst economic output is poised to contract, material prosperity will be further impaired by rises in the Energy Cost of Energy (ECoE).

The true cause of inflation is the worsening disequilibrium between the ‘real’ economy of products and services and the ‘financial’ economy of money and credit. The only way to tame inflation is to eliminate the anomaly of negative real costs of capital. Combined with deterioration in material prosperity, this points towards a fundamental re-pricing of the economy.

With the real costs of energy-intensive necessities continuing to rise, two parts of the economy are at particularly elevated risk. One of these is the supply of discretionary products and services to consumers. The other is those parts of the corporate and financial system which rely on flows of income from the household sector.


The global economy is heading for re-pricing, which means a fundamental change in the relationship between economic flow (including output, incomes and expenditures) and financial stock (the valuations of assets, collateral and liabilities). This process has already commenced – and is going to be chaotic – but its real causation has yet to gain recognition.

As we shall see, there is no non-inflationary way in which economic flow can be increased. This means that, as dynamics of this relationship change, stock valuation must fall.

The reduction of the global balances of assets and liabilities will be an uneven process, both geographically and between sectors, but the generality of financial stock degradation is likely to be of the order of 40-50%, measured from the start of 2022. Sectors providing necessities to consumers will fare better than those supplying discretionaries, for whom the outlook is grim.

The ‘why?’ of re-pricing is simple to describe, but making sense of it requires a major change in how we think about the economy. We need to move away from the economic orthodoxy which continues to assert that the economy is entirely a financial system, not subject to material limitations.

As well as meaning that there need never be any end to growth, the classical conception also asks us to believe that the flow of economic output can be measured by counting financial transactional activity. But transactional activity can be inflated using monetary policies, and it’s perfectly possible for transactions to take place which add no economic value at all. This makes GDP a particularly poor metric for the measurement of prosperity in the economy.

The prerequisite for effective interpretation is recognition that the economy is a system which supplies material goods and services to consumers. The provision of these products and services is a function of the use of energy.

Once this is understood, we need to draw a distinction between economic output and prosperity. Output is analogous to the income of a household, whilst prosperity corresponds to how much of that income remains after the costs of necessities have been met.

The economic output side of the equation involves the conversion of primary energy into economic value. This energy conversion ratio is remarkably static, hardly varying at all over the past forty years. Globally, economic output rises or falls in accordance with increases or decreases in the availability of energy.

The prosperity dimension of the equation is determined by the Energy Cost of Energy. This has been rising relentlessly over a very long period, and there are no realistic grounds for expecting it not to carry on doing so.

The pricing of assets is a function of a process of the futurity which links current prices with forward value expectations. The consensus forward projection has been, and remains, one of continued economic expansion, albeit with minor setbacks along the way.

But material trends are invalidating the money-only notation of classical economics. As this reality sinks in, the consensus futurity will be degraded, introducing a wholly new dimension into equations linking current pricing and forward expectations.

This is going to induce the equivalent of vertigo, as market participants realise that we’ve been pricing a future that cannot happen. The degradation of futurity will trigger chain reactions right across the interconnected, collateralized World financial system.


How can we know that this is going to happen? The answers lie, not in the ebb and flow of market sentiment or, for that matter, of policy, but in the fundamentals.

The effective interpretation of economic processes requires some straightforward foundation principles.

The first of these is that the economy is an energy system, because nothing that has any economic utility whatsoever can be supplied without the use of energy. This applies, not just to products and services, but to the entirety of the economy. The creation and maintenance of infrastructure and capacity is entirely reliant on the availability of energy. Access to raw materials – ranging from minerals, chemicals and plastics to food, fertilizers and water – is a function of the energy required to supply them.

The second principle is that energy is never ‘free’. 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. This is the principle of ECoE.

Oil isn’t ‘free’ because it exists beneath your land – you still need wells, pipelines, refineries and the rest of the supply system. Solar and wind power aren’t ‘free’ just because the sun shines and the wind blows – we still need solar panels, wind turbines and distribution systems, with the added complication of storage capacity to offset intermittency. None of this infrastructure can be built or maintained without the use of energy.

The third foundation principle is that money has no intrinsic worth. Rather, it commands value only as a ‘claim’ on the output of the material economy. This is the principle of money as claim.

From these principles, two conclusions naturally follow.

First, material prosperity is a function of the surplus energy which remains after ECoE has been deducted from total supply.

Second, the economy, as presented financially, is a representation or proxy of the underlying material economy determined by the supply, value and cost of energy.

This wouldn’t be a problem if conventional financial notation was an accurate representation of the material economy.

Unfortunately, though, it is not. We have to take a brief journey into history to see why.


The widening gap between material fact and financial representation can be traced all the way back to 1776. The huge, complex and energy-intensive economy of today began when James Watt unveiled the first really efficient device for converting heat into work, giving us access to the vast energy resources contained in fossil fuels.

Adam Smith’s The Wealth of Nations, published in that same year, was the foundation treatise for a school of economics which seeks to explain everything in terms, not of energy, but of money alone.

Writing as he was in an agrarian, low-energy economy, Smith cannot be blamed for not anticipating the transformation that would result from work that his fellow Scot was at that moment completing just a few miles away. But his successors can, and should, be criticized for a blind adherence to precepts which, by insisting on the financial, rigorously exclude the material.

With material factors disregarded, it becomes perfectly possible to predict infinite economic growth on a finite planet, a proposition which no sensible person should accept. Perhaps Kenneth Boulding, co-founder of general systems theory, put it best, when he said that “[a]nyone who believes exponential growth can go on forever in a finite world is either a madman or an economist”.

On the flimsy foundation of immaterial, money-only interpretation, classical economics has erected what its adherents are pleased to call the “laws” of economics. These, of course, are simply behavioural observations about the human artefact of money, and are in no way analogous to the laws of science.

One example is the assertion that price is the outcome of the interaction of demand and supply, both of which are, of course, stated financially. The inference is that price movements create an automatic adjustment whereby supply increases in accordance with rises in demand.

If demand increases, this logic runs, prices rise such that producers have sufficient incentive to deliver a corresponding increase in supply. Higher prices also reduce demand, but the assumption remains that rising prices create additional supply. Supply is thus a function of demand, mediated by price.

But this could only work if the possibility of unlimited expansion of monetary demand was matched by a correspondingly infinite potential for material supply.

The reality, of course, is that no increase in demand, and no rise in price, can supply anything which does not exist in nature. The banking system cannot lend low-cost energy into existence, any more than central bankers can conjure it ex nihilo from the ether.

Instead of the outcome of some theoretical equation involving financial supply and financial demand, prices should be defined as the monetary values assigned to material products or services. If the balance between the financial and the material changes, prices change with it.

This should be obvious, even to those who insist that QE ‘doesn’t cause inflation’. To be clear about this, the use of QE during and after the GFC (global financial crisis) of 2008-09 may not have caused consumer price inflation, but it most certainly triggered harmful asset price escalation. When, during the pandemic, QE was aimed directly at households rather than, as hitherto, at asset markets, consumer price inflation necessarily ensued.

The mythology of economic infinity remains tenacious, and is evidenced whenever political leaders offer assurances of economic “growth” to the public. The problem at the heart of the ongoing fiscal fiasco in Britain has been the insistence that growth can be manufactured through a carrot-and-stick blend of incentive and need – if the financial framework is right, the argument runs, the better-off will have the incentive to invest, and everyone else will be compelled to work harder, thereby improving productivity. At no point has it been considered that, with global material conditions as they are, meaningful economic “growth” cannot be delivered at all.

Even the conventional calibration of productivity is misleading – dividing economic output by the quantity of human labour is of little real relevance, given that labour is a truly tiny component of the energy used in the modern economy.


Until comparatively recently, the divergence between the material and the classical-financial hasn’t been readily apparent. The heirs to Watt have carried on growing the economy, and the heirs to Smith have carried on representing this growth as the product of financial rather than thermodynamic processes.

Now, though, the energy dynamic is winding down. The supply costs of oil, natural gas and coal are rising through the effects of depletion. There is no assured, like-for-like replacement for the energy value sourced from fossil fuels. Prior growth in material prosperity has gone into reverse.

This is not reflected in financial calibration of economic flow. This calibration will become mistrusted before a new system of economic interpretation and quantification arrives to replace it.

Simply stated, market participants will suffer a loss of faith in what they’re being told about the economy. This will result in downwards revisions of ‘futurity’, a term describing those perceptions of the future that are priced in to the valuation of financial stock. Rising risk premia will be the first manifestation of a much more fundamental realignment between the financial and the material.

We have a choice between getting ahead of the curve on material recognition, or hewing to the tried-and-failing notions of wholly immaterial – financial – causation and explanation.

Based on the principles outlined earlier, there are three things that we need to know. First, how much energy supply can we expect in the future?

Second, how does the use of energy translate into economic value? Third, to what extent will cost trends cause prosperity to deviate from output thus calibrated?

These are complex issues, made more so by orthodox economic conventions which, as exemplified by GDP, conflate transactional activity with material economic output.

A relatively brief set of answers to these questions requires the use of no less than three sets of charts (Figs. 1, 2 and 3), sourced from SEEDS (the Surplus Energy Economics Data System).

The measurement unit used here for energy is the tonne of oil-equivalent (toe). Financial numbers are stated in international dollars, converted from other currencies, not at market rates, but on the more representative basis of purchasing power parity (PPP), which is the convention used for measuring and forecasting global growth. Unless otherwise stated, financial numbers are expressed at constant 2021 values, so the notation is $PPP 2021.


Historically, we can observe that, whilst global real GDP almost quadrupled (+292%) between 1980 and 2021, World consumption of energy slightly more than doubled (Fig. 1A). The implication is that the efficiency with which energy is converted into economic output improved by 85% between those years (Fig. 1B). This makes it easy to understand the popularity of the mistaken notion that we can somehow “de-couple” the economy from the use of energy.

Accepting this at face value, though, would involve disregarding the rapid build-up of debt. Whilst energy use rose by 112% between 1980 and 2021, and GDP expanded by 292%, debt exploded, increasing by about 925% (Fig. 1C). (Comprehensive data for global debt gets hard to find as we scroll backwards from the 1990s, but the estimates used in Fig. 1C are intended to be consistent with subsequent trends – and, in any case, of the additional debt incurred between 1980 and 2021 [estimated here at $323bn], almost three-quarters [$239bn] has been taken on since 2000).

We may have increased GDP per toe of energy consumption by 85% since 1980, then, but the quantity of debt carried per toe of energy use expanded by 380% over that same period (Fig. 1D).

Fig. 1

The fact of the matter is that GDP and debt are not discrete series, because increasing debt boosts the transactional activity measured as GDP. If we reined in credit growth, GDP would, at best, stop growing and, if we tried to reduce outstanding debt, it would slump.

What we have witnessed in modern times is that reported GDP has been inflated artificially by super-rapid debt expansion.

It’s worth reflecting that, if this were not the case, we could reach a point of complete absurdity – the economy would become both extraordinarily wealthy (in terms of GDP), but also bankrupt (through the sheer weight of liabilities which the system couldn’t possibly honour).

The ratio between borrowing and growth has averaged slightly less than 3:1 since 1980, meaning that almost $3 of debt has been added for each $1 of reported growth in GDP. There has been an upwards tendency in this global trend, and the ratios in many of the advanced economies of the West have been appreciably higher than World averages.

This relationship is pictured in Fig. 2A, which compares GDP growth with debt expansion, the latter expressed as a percentage of GDP. Between 1980 and 2021, real GDP expanded at a compound annual rate of slightly less than 3.4%, but the real rate at which debt increased exceeded 5.8%. Reported “growth” of 3.4% was achieved by borrowing at an average annual rate of 10% of GDP.

The SEEDS economic model strips out this ‘credit effect’ to calibrate underlying or ‘clean’ economic output, known here as C-GDP. The annual rate of growth on this basis was materially lower between 1980 and 2021, at slightly less than 1.9%, rather than 3.4% (Fig. 2B). Accordingly, underlying output increased by only 114% – rather than the reported 292% – over that period (Fig. 2C).

Critically, the calculated expansion in C-GDP (of 114%) tallies almost exactly with the increase in energy consumption (112%) over this forty-year period. Put another way, the relationship between underlying economic output and the use of energy is linear.

This was not an anticipated finding during the financial calibration of C-GDP back to 1980 from its previous start-date in 2000. But it reinforces the view, which has been demonstrated in various financial and non-financial ways, that “de-coupling” the economy from the use of energy cannot happen. The European Environmental Bureau reached this conclusion in 2019, describing the case for de-coupling as “a haystack without a needle”.

In short, if we consume less energy, the economy gets smaller. Likewise, if we use less energy per capita, the average person gets poorer.

This doesn’t necessarily describe individual national economies because, just as primary energy is traded between countries, so are energy-containing products. A country can, for example, consume less energy simply by importing cars and computers – or, for that matter, food – rather than producing these items at home.

Looking ahead, though, such trades are likely to be moderated by arbitrage, to the detriment of economies which rely heavily on the import of energy-intensive commodities and products.

The overall situation is what matters, and this is that reductions in global energy supply lead to a shrinking of the World economy.

Fig. 2


SEEDS projections for World energy use are illustrated in Fig. 3A. Essentially, supply is expected to be 10% lower in 2050 than it was in pre-pandemic 2019.

Within these totals, it’s estimated that fossil fuel production will decline by 26%, a decrease of rather more than 3.0 bn toe. Though rapid, growth in output from renewable energy sources (REs) is likely to make up less than 1.2 bn toe of this shortfall. The combined contributions of nuclear and hydroelectric power are projected to increase by 28%, but these are too small a share of the energy slate to offset the decline driven by the falling availability of energy from oil, gas and coal.

As can be seen in Fig. 3B, there may be a very slight, and probably temporary, improvement in the conversion ratio between energy and economic value expressed as C-GDP. The assumption involved here is that a significant proportion of energy-intensive, non-essential economic activities will contract rapidly through decreases in affordability. But it’s extremely unlikely that there will be material or lasting deviation from the linear relationship between energy use and economic output.

Accordingly, C-GDP is projected to be 8% lower in 2040 than it was in 2021 (the grey line in Fig. 3D), matching the expected decline in primary energy supply over that same period.

As we have seen, though, output isn’t the same thing as prosperity, the difference between the two being the prior claim on resources made by the Energy Cost of Energy.

Fig. 3C shows the projected continuing rate of increase in overall global trend ECoE. The rates of decrease in the ECoEs of renewables are expected to slow, and may then start to rise. There are physical limits to the potential efficiencies of both wind (the Betz Limit) and solar power (the Shockley-Queisser Limit), limits which are well explained here. It’s extraordinarily unlikely that the storage cost-efficiency and flexibility provided by a simple fuel tank are ever going to be replicated by batteries. Moreover, fossil fuels are not subject to the burdens of intermittency.

Critically, the vast material inputs required for RE expansion can only be provided through the use of legacy energy from fossil fuels. This creates a linkage between the ECoEs of fossil fuels and the ECoEs of renewables.

It should never be forgotten – though it almost routinely is – that the potential capabilities of technology are limited by the laws of physics.

These are important points, because it’s all too easy to assume that the economy can transition, seamlessly, from fossil fuels to renewables. This mistaken assumption – and it’s no more than that – informs vast swathes of corporate, financial and government planning.

The application of ECoE to the projected outlook for C-GDP reveals that economic prosperity – shown in blue in Fig. 3D – is set to fall a lot more rapidly than material output itself. By 2040, global prosperity is projected to be 16% lower than it was in 2021. If population numbers continue to rise, albeit at historically low rates, prosperity per capita could decrease by 27% between 2021 and 2040.

At no point since 1776 – not even during the Great Depression between the wars, which caused severe hardship, but was temporary – have we ever had to confront anything even remotely comparable.

None of this, of course, is yet incorporated into the futurity currently priced by the markets. But the unfolding deterioration in underlying economic conditions can be expected to compress the gap between financial expectation and material economic reality.

Fig. 3


The foregoing should have made it clear that two diverging trends have shaped the economy over an extended period. On the one hand, the material economy of products and services, determined by energy, has been decelerating towards involuntary de-growth.

On the other, extraordinary levels of financial commitments have been taken on in an ultimately-futile effort to counteract or deny this tendency. These trends, and some of their future implications, are illustrated in Fig. 4.

Since the late 1990s, the financial economy, measured as GDP, has diverged from the material or ‘real’ economy to the point where the downside between the two has widened to 40% (Fig. 4A). There can be no indefinite prevention of the restoration of equilibrium between the material and the financial, and this has direct read-across implications for the levels of liabilities depicted in Fig. 4B.

Though the global debt mountain is serious, real exposure needs to be referenced to those broader ‘financial assets’ which are the liabilities of the government, household and business sectors of the economy. These broader liabilities include the NBFI (non-bank financial intermediary) sector, sometimes called the “shadow banking system”.

As we saw in a recent article, available data is incomplete, accounting for 85% of the global economy, but quite possibly excluding major asset exposure in specialist financial centres not included in reported numbers. A best estimate is that total financial exposure stands at about 575% of World GDP, but 925% of global prosperity.

Perhaps the single most disturbing aspect of worsening imbalances is the extent of leverage embodied in the economy and the financial system.

As we have seen, a projected decrease of 8% in energy supply between now and 2040 produces a corresponding decrease in real global economic output. But rises in ECoEs leverage this into a 16% fall in aggregate prosperity.

This implies that prosperity per capita will be about 27% lower in 2040 than it was in 2021. But the cost of energy-intensive necessities will carry on rising markedly, in response to increases in ECoE. This is illustrated in Fig. 4C. This implies a near-50% fall in the affordability of discretionary (non-essential) products and services, even though top-line economic output is only projected to fall by 8%.

Fig. 4


This leverage is critical, because the affordability connection ties the sustainability of financial liabilities, not to top-line output, but to PXE, the SEEDS term for “prosperity excluding essentials”. When we consider, for example, the affordability of mortgage payments, it’s clear that this affordability must be related, not to total household incomes, but to household disposable incomes, and much the same applies at macroeconomic level.

This is why, where the business and broader economic outlook is concerned, we have entered an affordability crisis. This has two implications.

First, and most obviously, consumers whose disposable resources are being compressed between falling incomes and the rising costs of necessities experience a leveraged reduction in what they can afford to spend on discretionary purchases.

Second, it becomes ever harder for households to sustain payments on everything from secured and unsecured credit to subscriptions and staged-payment purchases.

In short, not only will sectors supplying discretionary products and services to consumers experience a relentless deterioration in volumes and profitability, but the same thing will happen to those parts of the corporate and financial ecosphere which rely on streams of income from the household sector.

Where segmental projections are concerned, it should be noted that the data in Figs. 4C and 4D is harmonized. This means that, whilst GDP in 2021 is accepted as the baseline – enabling comparison with other sources of forecasts – prior and future trends are restated in accordance with energy-based calculations of output and prosperity. The segmental balance illustrated in Fig. 4D shows that the affordability, not just of discretionary purchases but of capital investment as well faces severe compression.


The final set of charts – Fig. 5 – looks at the broad economic structure, inflation, and the critical divergence between expectations and probable outcomes.

Fig. 5A provides an at-a-glance view of the five core components of the economy. One of these is C-GDP output, which correlates closely with energy availability. The second is ECoE, a deduction which itemises the difference between output and prosperity. Next, in this leveraged equation, comes the estimated cost of essentials. The remaining components are discretionary consumption and capital investment, which are the residuals in this leveraged situation.

RRCI – the Realized Rate of Comprehensive Inflation – is the SEEDS tool for measuring systemic price change. Historically, this has been materially understated by the GDP deflator measure used to calculate ‘real’ economic output and growth (Fig. 5B).

Barring outbreaks of monetary policy derangement, the outlook is for RRCI to trend downwards, though remaining above officially-acknowledged rates of broad inflation. Though the costs of essentials will continue to rise, we should anticipate severe and worsening deflation across the discretionary and ‘stream-of-income’ sectors of the economy.

Comparing probable outcomes with expectations is a critical component of planning and strategy – essentially, good decisions can be made by those who understand why consensus expectations are mistaken.

As shown in Fig. 5C, past misstatement of the financial equivalent of material economic performance leads to over-optimistic expectations for the future of the economy. This applies even more strongly to the affordability of discretionary products and services (Fig. 5D), where past trends provide no effective guidance at all to the impending rapid decline of discretionary consumption.

Fig. 5

#241. Behind the crisis


As you would expect, both the mainstream and the specialist media have been giving us minute-by-minute, blow-by-blow coverage of the financial crisis which began with the British government’s 23rd September “fiscal event”.

Unfortunately, this coverage and analysis is founded on a conventional school of economic thought which insists – rather, simply assumes – that all economic events can be explained in terms of money alone.

This assumption is fallacious. The fact of the matter is that we can immerse ourselves entirely in monetary theories and financial analyses until the proverbial “cows come home” without understanding more than the surface manifestations of the underlying situation.

As a corrective, let’s remind ourselves of something that ought to be self-evident. This is that the economy is a system which delivers those material products and services which together constitute prosperity. Money is simply a proxy for these products and services, a means of exchange and distribution which does not, of itself, determine the availability of this material prosperity.

This ‘money-only’ fallacy delivers false comfort, in at least two ways.

First, it enables us to explain away the current crisis in terms of idiosyncrasies – there’s a surface narrative which assures us that, if we can avoid the kind of bungling in which the new British leadership has become enmeshed, we can similarly avoid the kind of crisis now unfolding in the United Kingdom.

We might, indeed, be persuaded that even Britain can find a way out of this crisis through ‘rationalization’, which, in this case, might mean ‘finding rational people to manage its economic affairs’.

Now that growth has reversed

The second source of false comfort is the mistaken assumption that finding the right blend of fiscal and monetary policies can deliver the nirvana of perpetual growth.

Put another way, the implication is that premier Liz Truss and chancellor (finance minister) Kwasi Kwarteng were right to seek a “growth” elixir, even if they have been wrong about the mechanism for doing so.

This is simply not the case. The economy is an energy system, not a financial one. The entire narrative of the past quarter-century has been one of economic deceleration and deterioration caused by adverse changes in the energy dynamic which determines material prosperity.

Critically, the trend Energy Cost of Energy (ECoE) has been rising relentlessly, a process which, having started by creating “secular stagnation”, has now pushed us into involuntary economic contraction.

Fundamentally, we’re at the end of a long period of rising prosperity built on low-cost energy from coal, petroleum and natural gas. There is, as of now, no like-for-like replacement for the energy value hitherto sourced from fossil fuels.

Whilst we might hope to find a successor to waning (and climate-harming) fossil fuel energy value, three reasonable caveats need be recognized about this hope.

First, it is by no means assured. Second, the resulting economy is likely to be smaller, meaning poorer, than the one we have today. Third, no such transition can happen now, or spare us from the consequences of the fallacious assumption that we can rely on ‘infinite economic growth on a finite planet’.

The fact of the matter is that there are no financial ‘fixes’ for material economic deterioration. Looking for such fiscal and monetary fixes simply piles additional risk onto a global financial system already inflated beyond the point of sustainability.

When the financial dust settles, we will be left with a contracting economy, one in which deterioration in material prosperity is compounded by continuing increases in the real costs of energy-intensive necessities.

Accordingly, what we are witnessing is a process of affordability compression. This has many consequences, of which two are most important. First, the ability of consumers to afford discretionary (non-essential) products and services has entered secular contraction.

Second, the compression of affordability is undermining the ability of the household sector to ‘keep up the payments’ on a gamut of financial commitments ranging from mortgages and consumer credit to staged-purchase schemes and subscriptions.

In short, we can now project a future in which discretionary sectors contract relentlessly – with all that that means for employment, profitability and asset values – whilst the world’s gigantic system of interconnected financial liabilities unravels, with the latter process far likelier to be rapid and chaotic than gradual and managed.

A not-so-simple story

The superficial narrative of the current crisis pins the blame squarely on the new leadership of a single (though sizeable) Western economy.

The conventional story is that Ms Truss and Mr Kwarteng sought to find a way in which Britain could break out of a long period of economic underperformance. They decided to do this by cutting taxes, with the benefits skewed towards the better-off, perhaps in the belief that the much-derided theory of “trickle-down economics” might be valid after all.

These tax cuts, added to the decision to cap energy prices for households and businesses, threatened to create an enormous need to raise money by selling gilts (government bonds) to investors. This problem was compounded, first by the known intention of the Bank of England to unload gilts as part of a QT programme and, second, by the absence of the modelled and reasoned data and projections customarily provided by the Office for Budget Responsibility.

This ill-thought-out package occurred at a time of high inflation, to which it was known that the Bank intended to respond with rate rises and QT.

Markets responded to this ill-considered intervention in two ways, both of which should have been anticipated. First, FX markets sold off sterling, with GBP falling to slightly over $1.03, from levels above $1.22 just a few weeks previously. Second, the gilts market crashed, with yields on the 10Y bond spiking to over 4.5%, from 2% as recently as August.

This produced a toxic combination of expectations. A falling exchange rate would increase the prices of imports, driving inflation higher and, perhaps, forcing the Bank into a programme of accelerated monetary tightening involving rate hikes and QT.

Meanwhile, higher rates would increase borrowing costs, pushing property prices sharply downwards and, in all probability, triggering a wave of defaults on secured, unsecured and business debts.

In the event, nemesis came from a different quarter, with the viability of pension funds put at risk by falls in the value of gilts. It was this consideration which pushed the Bank into panic mode, intervening with a reversion to QE.

Behind the folly

So far, this is – to paraphrase a British radio soap – just “an everyday story of idiot folk”. Britain’s fiscal credibility has been shot to pieces, with one observer referring to the UK as a “submerging economy”. Policy folly has been compounded by a paralyzing sense of utter incompetence, with criticism extended from the executive leadership to the Bank.

Opposition politicians must have struggled to hide their partisan delight behind a façade of grave concern. Conservative MPs seem shell-shocked, worried as much about the prospect of plunging property prices as about marginal constituencies.

As objective observers, we need to look at this in different ways, of which one is specific to Britain, and the other more general. The common factor linking both is the belief in economic “growth”.

The British economy has long been living on borrowed time. The United Kingdom’s economic model is fundamentally flawed. Britain lives beyond its means, covering – but simultaneously exacerbating – its chronic current account deficit through the sale of assets. This is not sustainable, not least because a point is reached at which no saleable assets remain.

An economy thus structured relies on the continuous expansion of private credit. Credit expansion, in turn, requires both lender collateral and borrower confidence, and both have been provided by the inflated prices of assets, principally property.

There is, of course, an inherent contradiction here. On the one hand, the inflation of property (and broader asset) prices requires low and falling borrowing costs. On the other, debt expansion should, all things being equal, drive the cost of borrowing upwards.

Britain had already reached this point, as flagged by inflation, and as recognized by the Bank in its plans to raise rates and undertake QT. Even before 23rd September, the best that Britain could reasonably hope for was a “soft landing”.

QE, of course, is no more than a temporary ‘fix’. QE might not, at least pre-covid, have created retail price inflation – which is the only part of the pricing process that most observers bother to look at – but it has undoubtedly created reckless asset price inflation.

Both in Britain and elsewhere, systemic inflation – modelled by SEEDS as RRCI – has long been a great deal higher than the broad calculation expressed as the GDP deflator.  

The wider issues

There is, though, a second and broader way in which we need to understand what’s really happening. The central mistake made by Liz Truss and Kwasi Kwarteng was the assumption that there must be some combination of fiscal and monetary policies which could deliver the Holy Grail of “growth”.

Methods and policies may differ, but this belief in the possibility of infinite growth is shared by decision-makers – and corporate leaders, investors and the general public – right across the globe. The whole of the financial system worldwide is entirely predicated on the assumption of growth in perpetuity.

Conventional economics, with its fallacious assertion that the economy is entirely a financial system, fosters and endorses this mistaken assumption.

But the harsh reality is that the economy really functions, not financially, but as a system for delivering material prosperity in the form of goods, services, built assets and infrastructure. Self-evidently, all of this depends on the value obtained from the use of energy.

This isn’t simply a matter of the absolute quantity of energy that can be supplied. Rather, 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, or ECoE.

Driven primarily by depletion, the ECoEs of fossil fuel energy have been rising exponentially. Since oil, gas and coal still account for more than four-fifths of total energy consumption, much the same has happened to overall trend ECoE. This has meant that aggregate prosperity has stopped growing, and prosperity per capita has already turned down.

What this means is spelled out in the following charts. Just as top-line prosperity is falling, the real costs of energy-intensive essentials have been rising (first chart).

The inevitable result is that the affordability of discretionary purchases is falling, a trend that cannot be reversed, and can no longer be disguised by using cheap debt to prop up discretionary spending (second chart).

Financially, our wholly futile efforts to ‘fix’ material economic problems with financial expansion have created gigantic commitments which the economy of the future will be wholly unable to honour (third chart).

Lastly, the ‘financial’ economy of money and credit and the ‘real’ economy of energy-determined products and services have diverged, creating downside that the SEEDS economic model calculates at 40% (fourth chart).

This disequilibrium – rather than the ‘mistakes of incomprehension’ made at the national level – is the real explanation for the crisis into which, with utter inevitability, the world has now been pitched.

Fig. 1

#240: Trussed for the block?


New British premier Liz Truss, and her chancellor (finance minister) Kwasi Kwarteng, have embarked on a gigantic economic gamble. If it succeeds, it will surprise, not just “trickle-down”-averse Joe Biden, but everyone who understands the realities of post-abundance economics.

If it fails, it’s likely to induce a “Sterling crisis”, with disastrous consequences for the costs of imports, and of servicing debts denominated in foreign currencies.

The verdict on this gamble will be passed, not by the voters, but by the currency and gilts (government bonds) markets. So far, a few hours after the chancellor’s statement, it’s not looking good, with Sterling down to just above $1.10. Investors are understandably reluctant to buy a pig in a poke, particularly when a detailed price-tag hasn’t been attached to it.

Many things are extraordinary about this gambit. It’s not new, of course, for governments to prioritize the greedy over the needy, but they are seldom quite so brazen about it. The Truss administration seems to be at war with permanent officials, and has already sacked the senior civil servant at the Treasury. For the first time since the Office for Budget responsibility was created back in 2010, the advice of the OBR has not been sought, and its economic and fiscal forecasts have not been published.

This site doesn’t ‘do’ party politics, still less the politics of personality, and our focus is on the economy understood – as it should be – as an energy system. But we’re entitled to comment when the government of a major Western economy takes extraordinary risks in pursuit of objectives that aren’t feasible, using policies that aren’t credible.

The Truss government has nailed its colours to the mast of economic “growth”. There are two main planks to this platform. One is the contention that, by borrowing now, an economy can generate enough growth to pay off, in the future, the additional debt incurred in the present. The second is that hand-outs to the better off will percolate through to benefit the less fortunate.

On the latter, Mr Biden has remarked within the last few days that he is “sick and tired of trickle-down economics. It has never worked”. It’s noteworthy that the term “trickle-down economics” is never used by those who advocate it, for the sufficient reason that it’s utter gobbledygook.

Mention of America, though, should remind us that Ms Truss, like her predecessor Mr Johnson, has no misgivings about antagonising Britain’s allies and trading partners. Mr Biden has already made it clear that a trade deal between Britain and the United States – the trophy promised and sought by so many supporters of “Brexit” – isn’t going to happen. The UK seems quite prepared to antagonize the EU – and, again, the White House – by reneging on a treaty determining trade arrangements affecting Northern Ireland.

Political analysts might observe, in this situation, a transference of weakness from party politics to national economics. Liz Truss’s own political fragility is being parlayed into worsening the economic and financial fragility of the British economy.

Ms Truss was not the preferred candidate of Conservative MPs, whose own choice was Rishi Sunak. Her ministerial changes have sent a large cadre of the disaffected to the back-benches. She owes her elevation to party members, a tiny and unrepresentative sliver (0.2%) of the British public. Many, even of those, might have preferred to reinstate Mr Johnson if his name had been on the ballot.

If there’s a Tory precedent here, it’s Benjamin Disraeli (1804-81). His great triumph, the Reform Act of 1867, was achieved by outflanking Mr Gladstone’s Liberals from the left. This seemingly left voters baffled by the difference, if any, between “Dizzystone and Gladraeli”. He may or may not – but it was in character – have said to a dissenting MP “damn your principles! Stick to your party!”. On his elevation to prime minister in 1868, he was wont to say that he had “reached the top of the greasy pole”, the big challenge now being to stay there.  

From an economic perspective, the problem with the new economic gambit is that it’s impossible – in Britain, or anywhere else – to buy growth with debt to a point at which the expanded economy then pays down the incremental borrowing.

Between 1999 and pre-covid 2019, the UK economy expanded by £0.72 trillion whilst increasing aggregate debt by £2.9tn. An equation in which each £1 of borrowing yields less than £0.25 of growth makes it impossible to a pull a rabbit of solvency out of the top hat of debt.

Analysis undertaken using the SEEDS economic model shows that, between 2001 and 2021, British real GDP increased by £560bn (at constant 2021 values) whilst debt soared by £2.93tn, a borrowing-to-growth ratio of 5.22:1. Within the “growth” reported over that period, fully 69% was the purely cosmetic effect of pouring so much extra credit into the system. Reported growth may have averaged 1.8% annually over that period, but annual borrowing averaged 7.2% of GDP.

Organic growth – calculated here as underlying or ‘clean’ economic output (C-GDP) – averaged only 0.6%, rather than 1.8%, through that period. This rate of underlying growth in economic output was less than the trend increase in population numbers (0.77%) through those same years.

Fig. 1

When we further factor-in rises in the Energy Cost of Energy (ECoE), it emerges that British prosperity per capita topped out in 2004, at £27,900 per person, and had, by 2021, fallen by 10%, to £25,090.

At the same time, the estimated real cost of essentials has been rising, even before the recent surge in energy prices. As you can see in the left-hand chart in fig. 2, the average British person is subject to relentless affordability compression. This is reflected in the second chart, which plots relentless contraction in the affordability of discretionary (non-essential) purchases.

This ‘affordability compression’ can be expected to undermine the ability of households to ‘keep up the payments’ on everything from mortgages and credit to staged payments and subscriptions. This is particularly important in an economy extensively leveraged to the global financial system. Despite some contraction in the aftermath of the global financial crisis, British financial exposure remains enormous. When last reported at the end of 2020, financial assets – the counterparts of the liabilities of the household, business and government sectors – stood at 1262% of GDP, far higher than the United States (588%), the Euro Area (795%) or Japan (871%).

Fig. 2.

We need to be clear that SEEDS analyses of other Western economies display, for the most part, patterns that are not dissimilar to those of the United Kingdom. As a direct result of relentless rises in ECoEs, Western prosperity turned down well before the 2008-09 global financial crisis (GFC). The idea that a deterioration in material prosperity can be countered with financial innovation has been a delusion shared by governments around the world.

Where Britain is different is in the government’s preparedness to gamble, and to insist that political will can triumph over economic reality. Though subjected to much criticism, the Bank of England has been doing its best to persuade the international markets that Sterling remains an investment-grade currency, despite the reckless behaviour of its bosses in Westminster. The Bank knows, as the government seemingly does not, that the economic viability of the United Kingdom rests on the credibility of its currency.

The probability has to be that the Truss administration’s gamble will fail. As well as not putting a price-tag on the full-year cost of its energy support programme and its generally regressive tax cuts, nothing has been said about public spending, particularly on health and defence.

What Mr Kwarteng offered the markets today was an un-costed exercise in bluster. The probable consequences are, at the least, weaker Sterling, costlier imports, rising rates and – irony of ironies, where Conservative supporters’ priorities are concerned – falling property prices.

The full consequences won’t be known until it’s clear how much the government needs to borrow, whether investors are willing to lend to it and, if so, at what price.

#239: Life after liberalism?


There can be no doubt at all that the global economy is in very bad shape. For some, this portends a general “collapse”. This, however, presupposes that we don’t adapt to new conditions, and that we don’t learn from past mistakes. We have a pretty solid history of doing exactly that, even if we only arrive at the right conclusions after trying all of the wrong ones first.

Of course, to adapt to new conditions, and to learn from mistakes, we need to know what these conditions and these mistakes actually are. Conventional interpretations of economics are failing us through an inability to provide the information required for this understanding.

The view set out here is that we do have a greatly enhanced understanding of how the economy works. Orthodox economics may continue to cling to precepts first laid down in the eighteenth century – essentially, that the economy can be understood in terms of money alone – but broader thought has moved on, spurred by energy shortages, by environmental concerns, and by recognition that the ‘perpetual growth’ promised by the orthodoxy simply isn’t happening.

The big challenges now are two-fold. The first is to adapt society to an economy that, having ceased to grow, has now started to contract. The second is to redesign a financial system that is exposed to failure because it has been wholly predicated on the fallacious notion that the economy can expand in perpetuity.

Politics isn’t entirely a matter of economics, but it’s very nearly so. Socialist, social democratic, conservative, ultra-‘liberal’ and all other strands of political thought are all founded on particular conceptions of the economy. As Robert Lowe (1811-92) put it, politics is a contest “between those who have – to keep what they have got; and those who have not – to get it”.

Political parties might be described as ‘combinations of economic thought and self-interest’. In practical terms, what this means is that the invalidation of a party’s economic proposition reduces its platform to one of pure self-interest.

For example, politicians in the USSR might have been sincere believers in Marxist-Leninist economic dogma, but they would also have been cognisant of the privileges of Soviet leaders and officials. Likewise, even purist believers in extreme ‘liberal’ economics are not uninfluenced by the rewards that this ideology can provide, not just to its leaders but to its supporters as well.

Contemporary economic liberalism is founded on the proposition that unfettered markets best serve the public interest. As a principle, this is soundly rooted in Adam Smith. Economic liberalism is not threatened by an invalidation of the principle of competition.

But it is challenged on two other fronts.

One of these is the presumption that the economy can be understood in entirely financial terms, and is, on this basis, capable of delivering growth in perpetuity. The unravelling of classical, ‘money only, growth forever’ economics will thus be detrimental to the “liberal” economic proposition.

The other is the claim that, if “liberalism” isn’t very good at delivering equality, at least it compensates for this deficiency by delivering “growth”. As prior growth ceases and goes into reverse, this plank of the liberal economic platform will fail. The public will be left with ‘the inequality without the growth’.

We don’t yet know what political ideas and systems will emerge as we endeavour to address a contracting economy and a failing financial system. But we can be pretty sure that the future ascendancy won’t endorse economic ‘liberalism’.

In other words, a ‘post-growth’ economy will produce ‘post-liberal’ politics.

The duality of prosperity and money

A critical point about economic interpretation, as it’s understood here, is the conceptual distinction that needs to be drawn between two economies. One of these is the ‘real’ economy of goods and services. The other is the ‘financial’ economy of money and credit.

The principles underpinning this interpretation are simplicity itself. The first is that the economy which provides products and services is a material system, determined by the use of energy.

The second is that money, having no intrinsic worth, commands value only as a ‘claim’ on the output of the material economy.  

With this distinction drawn, a realistic appraisal is that, whilst the material economy of energy has ceased growing, the proxy economy of money has carried on expanding. This implies that, whilst economic deterioration may be manageable, the financial system is no longer fit for purpose, and will need to be re-designed.

Much the same applies to economic and political thinking. Extreme collectivism has been tried, and has failed. Extreme liberalism has now reached its equivalent point of failure.

Both of these failed extremes have been rooted in a particular view of the role of the market. For collectivists, the market doesn’t matter, and the economy can be operated on the basis of central diktat. This set of ideas failed in the Soviet Union and, prior to the Deng reforms, was failing in China.

The other extreme is the assertion that the market is all-important. Theoretical liberalism worships the market in much the same way that theocracies worship a deity – that is to say, extreme liberalism isn’t open to doubt about the principle that the market is all-important.

On the shoulders of giants

The irony here is that economic ideologies are variously rooted in things that great thinkers – such as Smith, Marx and Keynes – didn’t actually say. Marx, at least, knew as much, famously stating that “I am not a Marxist”.

The fallacies based on a misreading of Marx are not our priority here, because the unfolding event now is the failure of a ‘liberal’ economic ideology which claims to be based on the precepts of Adam Smith.

In this narrative, Smith is portrayed as a worshipper of the market, an advocate of uncontrolled market operation and an opponent of ‘the public sector’.

The snag is that this caricature misrepresents what Smith actually said.

Smith’s great understanding is that the market operates as a ‘hidden hand’, advancing the general good through the pursuit of individual aims. The public is provided with bread, for instance, not through the altruism of bakers, but through their striving to make a profit.

That is, the operative process driving economic betterment is competition. This remains a wholly valid conclusion.

From this, though, it follows that competition must be allowed to operate unfettered, a principle that we might summarize as markets that are ‘free and fair’.

For Smith, state intervention wasn’t at the top of the list of potential fetters to the beneficial working of the market. This is hardly surprising, because Smith wrote at a time when the state was very small indeed, and when the term ‘the public sector’ was not yet in use.  

Rather, the potential threats to free and fair competition existed, for Smith, in the realm of manipulation. The same competitive incentive that could promote the effective operation of the economy could also lead to self-serving distortion. Smith’s strongest invective is saved, not for the state, but for those market participants who strive to impose distortions, such as monopolies and oligopolies.

In short, Smith did not believe that markets could be free and fair if they were left to their own devices.

In modern terminology, we can state that Smith was an opponent of excessive market concentration and an advocate of effective regulation. Along the lines of “I am not a Marxist”, Smith might, had he lived long enough, have said that ‘I am not a deregulator’.

Effective markets are orderly, not a caveat emptor free-for-all, and they won’t stay free, fair or effective without supervision. The state is the only plausible provider of this supervision.

The realm of the material

The other thing to note about Adam Smith is that he was writing in a pre-industrial society. His master-work, The Wealth of Nations, was published in the same year (1776) as James Watt’s completion of the first truly efficient steam engine.

At the dawn of the industrial age, it would have been impossible for Smith – or Watt – to conceive the concept of resource limits as these are understood today. Where scarcity was recognized, it was scarcity of land, and of labour. The concept of energy or environmental limits could not be understood until we started to experience both.

Explaining the critical importance of the market under conditions in which the concepts of resource and environmental scarcity did not exist, Smith can be said to have laid the foundations for an economic orthodoxy which portrays the economy as a wholly financial system.

A big part of our problem today is that conventional economics hasn’t moved on from a perception which, after all, was laid down 250 years ago.

In numerous other fields of thought, ideas have moved on from precepts which have been challenged by subsequent events. Life scientists and technologists don’t insist on the observance of statements made in 1776.

But economics hasn’t moved with the times. The presumption remains that the economy can be understood in financial terms alone.

Unlike Adam Smith, we live in an energy-intensive economy. Aside from a few mills driven by water or wind, the dominant source of energy in his times was human and animal labour. This had been the case for millennia, so Smith can hardly be blamed for not knowing that this was about to change.

Today, we know that the supply of products and services is a function of the use of energy. If we didn’t know this before, recognition has been forced upon us by events, not just by the current energy crisis but by the events of the 1970s as well.

Even before the oil embargoes of the seventies, the centrality of energy to economic processes should have been obvious. For example, energy deficiencies drove Imperial Japan to fight a war with the United States, and American resource supremacy ensured the outcome. The aircraft, ships and tanks that helped win the war could not have been supplied without the then resource wealth of the American petroleum industry.

Conclusions about the critical importance of energy were expounded as long ago as 1957, by Admiral Hyman G. Rickover, USN, the “father of the nuclear submarine”. One of his observations should resonate particularly with anyone who understands the economy as a surplus energy system:

“Possession of surplus energy is, of course, a requisite for any kind of civilization, for if man possesses merely the energy of his own muscles, he must expend all his strength – mental and physical – to obtain the bare necessities of life” (my emphasis).

The emergence of constraints

We now know, then – as Smith could not – that the economy is a surplus energy system. We also know about the environmental issues associated with the use of energy. This knowledge should enable us to understand that all other materials – including food, minerals, plastics and even water – are products of the energy used to supply them.

Rather than adopt these realities – and to accept, as Admiral Rickover said, that “the Earth is finite” – orthodox economics has jumped through hoops in its insistence that infinite growth is made possible by the wholly financial character of the economy.

The principal plank of this platform is the assertion that demand creates supply – if sufficient financial incentives are provided, there is nothing that the market cannot deliver. If this is taken as a universal proposition, though, the implication is that financial demand stimulus can supply physical resources, of which the most important – the ‘master resource’ – is energy.

The hard facts of the matter are contrary to this proposition. The reality is that no amount of demand stimulus, and no increase in price, can produce anything that does not exist in nature.

It may be true that consumer demand can promote the supply of artefacts. If consumers want a new generation of smartphones, industry will supply them.

So far, so good. But, in a material economy, consumer demand is rooted in prosperity, whilst the ability of industry to respond to demand is dependent on the availability of resources.

The second line of defence for the ‘demand produces supply’ orthodoxy is substitution, meaning that, if a particular raw material is in short supply, market forces will combine with ingenuity to deliver an alternative.

This proposition is now being subjected to the stiffest possible test. An economy built on coal, oil and natural gas is being undermined by scarcity- and depletion-driven rises in fossil fuel costs, and by the worsening environmental consequences of fossil fuel reliance.

To pass this ‘test of substitution’, we would need to be able to transition from fossil fuels to renewables without economic contraction. We have discussed the implausibility of “sustainable growth” on previous occasions, so all that needs to be said here is that full value transition seems extremely unlikely.

In short, we probably can create a sustainable economy built on renewables, but this sustainable economy is going to be smaller – meaning less prosperous – than the economy that has built on fossil fuels.

Past falls in the costs of renewable energy cannot be extrapolated indefinitely, because physics dictates efficiency limits at the level of the individual wind turbine or solar array. Contrary to widespread supposition, technology operates within the parameters of physics, and cannot overcome those restrictions.

If we can’t overcome these limits to efficiency, what remains is a scale issue. If we can’t make wind turbines, solar panels or batteries that have infinite efficiency potential, then we need to build vast numbers of them to enable transition.

And this is where circularity comes into the equation. To build huge numbers of turbines, panels and batteries, we need correspondingly vast quantities of raw material inputs, including steel, concrete, copper, cobalt and lithium. Where these materials exist at all in the requisite amounts, their delivery is a function of the energy required to supply them.

For the foreseeable future, the availability of these resources depends on the legacy energy of fossil fuels. It’s not inconceivable that, at some future point, we may be able – for example – to extract, process and deliver copper, or steel, using renewable energy alone.

The problem with this isn’t feasibility, but efficiency. Renewables may replace fossil fuels in purely quantitative terms, but they can’t replicate the characteristics of oil, natural gas and coal. Oil, in particular, is energy-dense, storable and portable to an extent that electricity cannot match.

A troubled outlook

In past discussions, the SEEDS economic model has been used to provide projections for the scale and composition of the economy of the future. Rather than revisit these forecasting processes, let’s summarise what the key points are.

First, material prosperity will decline, because of the implausibility of replicating the energy value (and, for that matter, the energy flexibility) hitherto provided by fossil fuels.

Second, the real costs of energy-intensive necessities will continue to increase, as a consequence of this same energy dynamic.

Accordingly, the affordability of discretionary (non-essential) consumption will be subjected to relentless compression, as will the affordability of investment in new and replacement productive capacity and infrastructure.

These are the material or ‘real economy’ consequences of a deteriorating energy dynamic.

But there are financial, social and intellectual implications as well. The financial system is wholly predicated on perpetual economic growth. As this precept turns out to be fallacious, the financial system will need to be redesigned on very different assumptions. It’s hard to see how the existing financial system can give way to a new one without extreme trauma.

Intellectually, we should be prepared for the failure of an economic orthodoxy that has been created over more than two centuries of virtually continuous economic growth. Ideas are, to a considerable extent, products of their times and conditions. It’s no surprise that conventional economics has endeavoured to explain the growth that was visible to all participants in the process.

Hitherto, growth hasn’t stopped because of our inability to explain it effectively. Just as economists have developed financial theories about growth, the energy dynamic has carried on delivering growth itself.

In other words, the intellectual challenge has shifted, from explaining the presence of growth to explaining its absence.

Politically, the need to reinterpret the economy will undercut the political platforms of parties whose precepts are based on the old consensus of perpetual expansion driven by financial management.

Economically ‘liberal’ political movements are particularly exposed to this unfolding process. Their central assertion is that we need to accept the deficiencies of the market system – with inequality the most obvious such deficiency – because liberal market economics can be relied upon to deliver growth.

If this claim is invalidated – along with every other thesis founded on perpetual growth – any party which relies upon it faces the invalidation of its central principle.

Absolute monarchy, for instance, failed when the public ceased to believe in the divine right of kings, and when monarchs failed to deliver prosperity. This intellectual-material axis was at the heart of the French Revolution, a product both of new ideas and of hardship.

If economic liberalism is going to be seen as delivering inequality without the compensating benefit of material improvement, then its day has passed.

The task now – of finding an intellectual and political replacement for liberalism – is as challenging as the designing of a post-growth financial system.

#238. Money and the end of abundance


Amongst the world’s decision-makers, French president Emmanuel Macron has come closer than anyone to spelling out the reality of the current economic situation, saying that “we are in the process of living through a tipping point or great upheaval”, and referencing “the end of abundance” (my emphasis).

If his words are taken seriously – as they should be – a major crisis looms. The global financial system is entirely predicated on perpetual economic growth.

As important as what Mr Macron has said is what he didn’t say. He didn’t say that abundance is over ‘for a year or two’, or that we’ll have to live through this ‘until better times return’. He didn’t make fatuous promises of ‘sunlit uplands’ or ‘a new golden age’.

Some of us have long known that an age of abundance made possible by low-cost energy was coming to an end. Until now, though, decision-makers have fought shy of this conclusion, taking refuge in the tarradiddle of ‘infinite growth on a finite planet’ proffered by a deeply flawed economic orthodoxy.

What should concern us now isn’t when, or whether, other leaders will arrive at this same conclusion. The trend of events is going to impose that emerging reality upon them.

Rather, we need to be prepared for what happens when market participants arrive at the same conclusion as Mr. Macron.  

The nature of the crisis

Preparedness requires clarity, and we need to be in no doubt that what we’re witnessing now is an unfolding affordability crisis. This means two things – and both of them point towards a major financial slump.

First, the ability of consumers to make discretionary (non-essential) purchases is in structural decline. This spells relentless contraction, not just in obvious discretionary sectors like leisure, travel and entertainment, but in ‘tech’ and consumer durables as well.

Second, households will find it increasingly difficult to ‘keep up the payments’ on everything from mortgages and credit to subscriptions and staged-payment purchases.

All of this has obvious negative implications for stock and property markets. But the real risk to the financial system resides, not in asset prices, but on the liabilities side of the equation.

The problems here are inter-connectedness, scale and opacity. Globally, private sector debt totalled $144 trillion at the start of the year, of which $85tn was owed to banks. But these numbers are dwarfed by broader private sector exposure. Analysis carried out for this report puts this number at $513tn, but this is no more than an informed estimate, because available data is neither complete nor timely. The probabilities are that $513tn understates the real scale of the problem.

Most disturbingly of all, the majority of this credit exposure isn’t subject to reporting and regulatory rules of the sort that apply to deposit-taking banks.

With hindsight, the causes of the global financial crisis (GFC) – sub-prime lending, securitization, imprudent lending and inadequate regulatory oversight – should have been apparent long before 2008.

Likewise, historians of the future can be expected to marvel at the subsequent further break-neck growth of an enormous network of interconnected commitments based on the false premise of infinite economic expansion.

Fig. 1 – whose constituent parts are discussed later – provides an overview of the scale of world financial exposure, comparing, at constant dollar values, the situation today with that of 2007, on the eve of the GFC.

Fig. 1

At the end of abundance

Regular visitors to this site will know why material abundance is ending, and will also know that this turning point hasn’t hit us like a thunderbolt from cloudless skies. In fact, we’re at (or very near) the end of an end-of-growth precursor zone which we can trace right back at least as far as the 1990s.

It is surely self-evident that the economy is an energy system, not a financial one. But material prosperity isn’t a simple function of the quantitative availability of primary energy. Rather, the flow of economic value generated by the use of energy divides into two streams.

One of these is cost, meaning the proportion of accessed energy that, being consumed in the access process, is not available for any other economic purpose. This ‘consumed in access’ component is known here as the Energy Cost of Energy. Material prosperity is a function of the surplus energy that remains after ECoE has been deducted from the aggregate (or ‘gross’) amount of energy available.

Rising ECoEs affect the energy-prosperity dynamic in two ways. First, they reduce prosperity by decreasing the quantity of surplus energy available. Second, they make it ever harder to strike prices which meet the needs of both producer and consumer. In this equation, prices are an interface between producers’ costs and consumers’ prosperity. As costs rise and consumer affordability diminishes, aggregate supply starts to contract.

ECoEs have been rising over a very extended period, driven primarily by the effects of depletion on fossil fuels. Quite naturally, we have used lowest-cost resources first, leaving costlier alternatives for a ‘later’ that has now arrived.

This trend is a global one, and not even energy-rich countries like Russia or Saudi Arabia are exempt from it. Those who blame the current energy crisis on “Putin’s war” are victims of self-deception. The conflict in Ukraine has, at most, brought the end of energy abundance forward by a small number of years. Neither Saudi nor anyone else can ‘rescue’ us from the effects of rising ECoEs.

After the hope that trade with Russia will resume, the second consolation offered to the public – offered, perhaps, in full sincerity – is that transition to renewable energy sources will recreate the economic abundance hitherto bestowed by oil, natural gas and coal.

The reality, though, is that this is most unlikely to happen. The expansion of renewables depends upon the use of enormous quantities of materials including steel, concrete, copper, cobalt and lithium. These material requirements can only be made available by the use of legacy energy from fossil fuels.

The case for ‘seamless’ transition to renewables is based on three sources of self-delusion. One of these is mistaken extrapolation from past decreases in cost. The second is a failure to recognize that the capabilities of technology are bounded by the laws of physics. The third is simple wishful-thinking.

Advocates of transition to renewables are right to emphasise the critical importance of wind and solar power. A “sustainable economy” may indeed be possible, though it’s being made harder to achieve by our insistence on modelling the future on an adaptation of the processes of today (which is why we’re promoting electric vehicles, when trams and trains make a lot more sense).

But “sustainable growth” is a myth – there’s no reason to suppose that an economy powered by renewables will be as large as the fossil fuel economy of today, and every reason to expect that it will be smaller.

Understanding affordability compression

Just as prosperity decreases, the real costs of energy-intensive essentials will continue to rise. This is part of a broader pattern best understood by dividing economic resources into three functional segments.

These are the provision of essentials, capital investment in new and replacement productive capacity, and discretionary (non-essential) consumption.

These patterns are illustrated in fig. 2. These charts are designed to facilitate comparisons with other forecasts, so they accept latest-year (2021) GDP as a start-point, but use SEEDS prosperity calculations to restate prior trends, and to project future outcomes. Each is stated in national currencies at constant 2021 values.

As you can see, whilst aggregate prosperity is deteriorating, the costs of essentials are rising. This means that both capital investment capability and discretionary affordability are falling.

Fig. 2 

What this means at the household level is illustrated in fig. 3, where prosperity per capita is compared with trends in the estimated costs of essentials. These charts show average per capita numbers, meaning that the situations of those on below-average incomes are worse than these graphs might suggest.

Fig. 3

Of course, decision-makers have never acted on any assumption other than ‘growth in perpetuity’. When rising ECoEs began to bear down on economic performance in the 1990s, the concept of energy causation was disregarded, and it was assumed that the material deceleration involved in “secular stagnation” could be fixed with financial tools.

Accordingly, access to credit was expanded, causing debt to rise rapidly. At least until 2008, this appeared to be working. In fact, though, what we had been doing was creating cosmetic “growth” with liability escalation.  

The GFC should have laid bare the fallacy that we can create material supply with financial demand. Instead, decision-makers doubled down on this fallacy by supplementing “credit adventurism” with “monetary adventurism”. Negative real interest rates are a dangerous anomaly, incentivising borrowing whilst discouraging investment. The capitalist economy, after all, relies upon positive returns being earned by the owners of capital. It also depends on allowing markets to price risk without undue interference.

This means that, in 2022, we’re discovering what many have known (or at least suspected) all along – that we’ve been sacrificing the stability of the financial system, and the effective working of a market economy, in pursuit of a chimera of “growth”.    

Go figure – the scale of exposure

Let’s start putting some numbers on the magnitude of global financial exposure. This is complicated, and fig. 1 (shown earlier) is intended to set out the broad structure of financial liabilities – at constant values – comparing the current situation with the equivalent position on the eve of the global financial crisis (GFC) in 2007.

Please note that the data set out in fig. 1 is stated in constant (2021) dollars converted from other currencies at market rates, not on the PPP (purchasing power parity) convention generally preferred here.

Conventional debt data is available from the Bank for International Settlements. BIS data shows that, at the end of last year, governments owed $81tn whilst, within private sector debt totalling $144tn, $85tn was owed to commercial banks.

The real issue, though, isn’t debt, but broader financial exposure. These “financial assets” – which are the liabilities of the government, household and private non-financial corporate (PNFC) sectors – are reported by the Financial Stability Board.

Financial assets fall into four broad categories. Three of these – central banks, public financial institutions and commercial banks – are self-explanatory, though it’s noteworthy that the total exposure of commercial banks (estimated here at $224tn) far exceeds the conventional debt owed to them by households and PNFCs ($85tn). The fourth is NBFIs, which means ‘non-bank financial intermediaries’.

We need to be clear that the FSB data is neither timely nor complete. The data covers 29 countries which, between them, account for about 85% of the world economy when measured as GDP. The most recently-available data, published on 16th December 2021, relates to the situation at the end of 2020.

To assess the current global position, then, we need to make informed estimates, brought forward to the present, based on the data that is available.

At this point, it’s vital to note that the FSB is not a regulatory authority. Generally speaking, deposit-taking institutions are regulated, but other credit providers are not. This is a huge gap in the ability of the authorities to maintain, or even to monitor, macroeconomic stability.

This lack of regulation is particularly important when we look at NBFIs. This sector is commonly referred to as the “shadow banking system”. NBFI exposure is enormous, and can be estimated at about $290tn as of the end of 2021. This exceeds the combined total of global government and private debt ($225tn).

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

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

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

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

Measuring the shadow

How much risk attaches to this depends, of course, on the scale at which it exists, and this is where we run into difficulties. As remarked earlier, FSB reporting covers only 29 economies, though these do account for about 85% of the global economy.

What we need are informed estimates of global financial exposure. The approach used here is to divide the financial assets universe into three parts.

One of these comprises the 23 (of 29) FSB reporting countries that are also covered by the SEEDS economic model.

The second group comprises specialist financial centres, of which two – Luxembourg and the Cayman Islands – are covered by FSB data.

As of 2020, Luxembourg had financial assets of $19.3tn, and a GDP of $79bn. The equivalent numbers for the Caymans were $8.9tn and $4.9bn. Accordingly, their respective ratios of financial assets to GDP were 23,678% (Luxembourg) and 253,485% (the Caymans).

The third group consists of all countries other than the 23 SEEDS-covered economies and the two specialist financial centres.

Together, these calculations suggest that aggregate financial assets totalled $520tn at the end of 2020, rising to an estimated $589tn last year. The deduction of the central bank and PFI (public financial institution) component puts private sector exposure at an estimated $513tn, most of which is unregulated.  

The composition of available data and estimates is illustrated in fig. 4. (Like the other charts used here, fig. 4 can be expanded by opening it in a new tab).

Fig. 4

Assets and liabilities – “the future is almost gone”

There’s no absolute “right” or “wrong” level of financial exposure. What matters is the relationship between monetary commitments and the underlying economy.

Those of us who understand the economy as an energy system are at a unique advantage when it comes to assessing the level and tendency of financial risk. The concept of “two economies” enables us to recognize the true nature of money – in short, we know that money isn’t ‘the economy’, but exists instead as an aggregate of ‘claims on the economy’, which is a wholly different proposition.

As you may know, money has no intrinsic worth, but commands value only as a ‘claim’ on the products and services supplied by the ‘real’ or material economy of products and services.

Three useful distinctions can be made here. First, current monetary activity is a financial representation of the underlying economy of goods and services. Second, liabilities are a claim on the material economy of the future. Third, asset pricing represents a collective perception of what the material economy of the future will be able to deliver.

As we’ve seen, the representation of the economy has become distorted by the use of monetary expansion to create cosmetic “growth”. Liabilities at their current size, meanwhile, could only be honoured “for value” if the underlying economy were to continue to expand indefinitely which, as we’re beginning to discover, cannot happen. Asset prices have been inflated, not just by ultra-low interest rates, but also on the basis of a collective misconception about the future size and shape of the economy.  

Let’s clarify this a little by recognizing that both asset prices and liabilities are embodiments of collective futurity. By “futurity”, we mean common expectations for the future.

If forward expectations are positive, investors assume growing corporate profitability, whilst lenders assume an ability to service and honour expanding debt and quasi-debt commitments. If the expectations embodied in collective futurity are downgraded, asset prices become vulnerable to sharp corrections and, more importantly, assumptions about borrower viability are called increasingly into question.

The current economic crisis is causing an increasing resort to credit by struggling households and businesses. These ‘borrowers from need’ are a far greater default risk than ‘borrowers from choice’, but this worsening risk profile hasn’t – yet, anyway – been reflected in the availability and cost of credit.

Lenders’ collective insouciance about providing credit to high-risk borrowers may reflect a general assumption that credit providers will be bailed out ‘if the worst comes to the worst’.

We need to be absolutely clear that systemic-scale rescues aren’t possible, which is surely obvious to anyone who compares over $500tn of non-government liabilities with a $96tn economy.

This isn’t 2008, when “toxic assets” were largely confined to securitized sub-prime mortgages and reckless real estate-related lending. What we face now is the culling of large swathes of the discretionary economy, combined with degradation of the income streams which flow from households to the corporate and financial sectors. If the authorities attempted to backstop all of this with newly-created money, the result would be hyperinflation.

So the real problem now is – in the words of Mickey Newbury – that “the future’s not what it used to be”. We might also reference a newly-released song by Monkey House – “the future is almost gone”.

The essentially-positive collective futurity that has shaped both asset prices and the cost and supply of capital is turning out to have been wrong. This has a direct read-across to the expectations and attitudes, not just of investors, but of lenders as well.

If we’re making a list of critical interpretational phrases to help us understand changing conditions, we can add “a futurity reset” to “affordability compression”. Both are compatible with Mr Macron’s “end of abundance”.

A process of implosion

As we’ve seen, the long-established positive collective futurity is being undermined by a dawning recognition of the reality that we cannot rely on perpetual economic growth. We can’t know what the sequence of events is likely to be as this reality sinks in, but we do know some of its critical components.

One of these is a slump in capital markets, led by an investor flight from discretionary sectors. This can be expected to occur as soon as investors realize that affordability compression isn’t temporary but is, rather, an intrinsic component of the ending of abundance.

Another is a sharp fall in property prices, reflecting impaired affordability, compounded both by rate rises and by the prospect of distressed sales. People who can no longer afford to service the mortgages they already have are in no position to take on ever larger commitments. We have no systems in place for coping with collapsing property prices, even though such systems would not be difficult to design.  

Governments can be expected to act, even before the financial system starts to implode, because of the need to address the hardship now being suffered by the public. But this is where the authorities are brought to a recognition of quite how limited their options really are. If they resort to full-on monetary intervention, the effects would be to drive inflation higher – particularly in the categories of necessities – which would make household hardship worse.

We need to be clear, meanwhile, that there is no single “right answer” to the rate policy conundrum. The Fed seems to think that rate rises, and the reversal of QE into QT, will defend the purchasing power of the dollar.

The Bank of England has been much criticized for raising rates, and is likely to face more flak over future rate hikes. In fact, it’s highly unlikely that the Bank is naïve enough to think that it can counter double-digit inflation with 0.5% increases in rates. Rather, the Bank can be presumed to be endeavouring to demonstrate to the markets that it’s not indifferent to defending the value of the pound. The very worst thing that could happen to the British economy would be a “Sterling crisis”, and the independence of the Bank is the single strongest defence against this happening.  

The biggest danger of the lot, though, is an implosion within the credit sector, affecting not just banks but NBFIs as well. Here, market participants may – for some time, at least – hold their nerve, placing their trust in the (actually impossible) assumption that, as in 2008-09, governments and central banks will intervene to backstop the system.

Eventually, though, the network of interconnected liabilities will start to unravel, in a similar (though vastly larger) re-run of the ‘credit crunch’ of 2007. At this point, credit flows dry up, because nobody knows which counter-parties are or are not viable.

“All roads”, it’s said, “lead to Rome”, but all of the discernible trends in the financial system point to financial implosion.

As abundance ends, so, too, must any system that is predicated entirely on its infinite continuance.

#237. Asking for the moon


What the media calls the ‘cost of living crisis’ is fast turning into an affordability crisis. The former is where discretionary consumption slumps. The latter means that increasing numbers of people can’t keep up the payment streams on which the financial system depends.  

As the situation worsens, politicians and commentators are bombarding us with calls for action, proposing often-contradictory fixes for what can’t be fixed, but can only, at best, be managed.

If there’s a common theme, it is that we need to borrow even more than we already have.

If there’s a common fallacy, it’s that we just need to find the right financial answers to our woes.

None of this can work, because what we are witnessing now is absolute proof that the economy is an energy system, not a financial one.

Western Europe is one of the richest places on the planet, but its financial wealth will be meaningless – and will, in fact, evaporate – unless energy can be sourced in the requisite quantities, and at affordable prices.

Few regions are immune to this same problem. North America has substantial energy resources, but their costs are high, and rising. China has a sizeable energy deficit, as do other economies in the Far East. Even Russia, with her energy wealth, can’t emerge unscathed from a global economic slump caused by generalised energy deficiencies.

The war in Ukraine has reduced the supply of natural gas, but an end to that war, and the restoration of trade with Russia, wouldn’t solve our energy supply problem. This situation – including surges in the price of gas – was developing well before the first Russian tank rolled over the Ukrainian border. The costs of fossil fuels are continuing to rise relentlessly, and this is now pointing towards a decline in the volumes of oil, natural gas and coal available to the economy.

Some believe that renewables offer a complete replacement for the energy value hitherto obtained from low-cost fossil fuels. Some of us think that’s implausible.

But even the optimists have to concede that this can’t happen now, because a transition won’t be effective until the mid-2030s, at the very earliest, even if it can happen at all.

Renewables aren’t going to keep vehicles running, machines humming and households warm in the coming winter.   

As a direct result of problems with energy supply – interacting with a system founded on the hubristic assumption of infinite growth – the World is heading for a financial crash which is likely to dwarf the global financial crisis (GFC) of 2008-09.

Reality has arrived

These events should – and, in time, perhaps will – put paid to the notion that the economy is wholly a financial system, unconstrained by resource and environmental limits, and capable of delivering the logical impossibility of ‘infinite growth on a finite planet’.

It should also, if we’re lucky, put paid to political notions based on this same infinity fallacy. Everything that politicians promise or propose assumes that the right financial policies can deliver growth.

This simply isn’t true.

This is a fallacy shared by both ‘Right’ and ‘Left’. Collectivism can’t deliver energy abundance. ‘Leaving everything to the markets’ can’t deliver prosperity – even in theory, let alone in practice – if markets are deprived of the material goods and services for which, ultimately, markets act as financial proxies.

We can’t ‘stimulate’ our way to perpetual growth – and, by the way, Keynes never said that we could, confining the role of stimulus to the management of trade cycles.   

This is a time in which we need to shed all delusions based on monetary ‘fixes’. Changes to tax allocation can shift the burden of hardship between groups of people within a country, but borrowing to fund “tax cuts” can’t create “growth” in a contracting economy. Rate changes, and exercises in QE or QT, might act on the margins of inflation, but only within a recessionary-inflation trade-off.

Where monetary and fiscal policy is concerned, there’s something we need to be absolutely clear about – even if we were gifted with utterly brilliant decision-makers in governments and the central banks, there’s nothing they could do to boost the supply of affordable energy.

Lacking that ability, what they’re engaged in is a balancing-act – they can adjust the distribution of hardship between income groups, and they can try to defend exchange rates, but they can’t prevent the deterioration in material prosperity. That also means that there are limits to what they can do to tame inflation.

Inflation is not – thus far – being driven by excessive domestic demand, so raising the cost of existing debt won’t fix anything. Going forward, it’s the scale of lending that central bankers need to keep under control, not least because someone who borrows out of necessity is a far greater default risk than someone who borrows out of choice. Interest rates are a blunt instrument when it comes to restraining runaway borrowing and rising risk.

Principles and consequence

Under these extreme conditions, it’s necessary to remind ourselves of the ‘three principles, one consequence’ of economic reality.

The first principle is that the economy is an energy system, because nothing that has any economic value whatsoever can be produced without it. The second is that, 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, or ECoE.

Third, money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the material economy.

These three principles lead inexorably to a logical consequence, which is that we need to think conceptually in terms of two economies – an energy-determined ‘real’ economy of goods and services, and a proxy ‘financial economy’, consisting of money and credit, which incorporates claims on material economic prosperity.

The economy can’t be understood effectively unless this conceptual distinction is recognized.

These principles are well-known to regular visitors to this site but, under current conditions, no apology seems necessary for their brief reiteration.

Conventional economic models can’t possibly act as reliable guides to our predicament. Their foundation assumptions are fallacious. The economy isn’t entirely a monetary system; resources are not some kind of substitutable adjunct to the economy; there are material and environmental limits to economic activity; and the promise of infinite growth on a finite planet is a delusion arrived at by reasoning from false premises.  

Energy-based economic analysis – like the SEEDS model used here – is the only way in which we can arrive at rational interpretations and forecasts.

The critical issue is the relentless rise in the ECoEs of oil, natural gas and coal. These account for more than four-fifths of global energy use, so this process has driven overall ECoEs to ever-higher levels. This process has killed off the scope for expansion in material prosperity, and has now put prior growth into reverse.

Rising ECoEs affect us, first, by making energy less prosperity-productive, because increasing costs reduce the surplus (ex-ECoE) value of each unit supplied. They are also starting to undermine quantitative supply itself, by making it ever harder to establish prices which both cover producer costs and are affordable for consumers.  

Not the turn of a card

This understanding should deal with claims that what we’re going through now is some kind of ‘run of bad luck’. In energy terms, pandemic-related shutdowns bought us a little time, simply because they amounted to a cutback in the consumption of energy, and of energy-dependent products and services.

The restoration of energy trade with Russia might, were it to happen, provide some temporary relief, but wouldn’t halt the rise in global ECoEs. Russia doesn’t have infinite supplies of hydrocarbons, and neither are its oil and gas operations particularly cheap.

Tempting though it is to blame the coronavirus, or Mr Putin, for current economic problems, then, this really won’t wash. The real culprits in the current situation are anyone who has promoted or believed the idea that material consumption can increase indefinitely on a planet with finite energy resources and finite environmental tolerance. This means pretty much all of us so, in that sense at least, the ‘blame-game’ is pointless.

Where blame can be placed is on the way in which prosperity – and, now, hardship – are allocated between different groups of people. Even here, though, arrogance and greed are compounded by ignorance.   

Where economic assertions are concerned, our collective hubris knows few bounds. We’ve been congratulating ourselves about “growth” over a long period in which prosperity has been contracting.

We’ve been piling up commitments that we can’t honour in pursuit of growth that can’t happen.

SEEDS analysis indicates that the average American has been getting poorer since 2000, and that the same thing had happened in almost all Western economies before 2008. Latterly, the inflexion-point in prosperity has been reached in an increasing number of EM countries, and global prosperity per capita has now turned down.

These inflexion-points in prosperity can be related directly to ECoEs, as the charts in fig. 1 illustrate.

Fig. 1

The West, in particular, has never accepted the idea that material economic expansion has ended, and has gone into reverse. Instead – and perhaps unknowingly – we have exploited the disconnect between the real and the financial economies to create a delusional simulacrum of “growth”.

Creating incremental monetary ‘claims’ on the economy doesn’t increase material wherewithal, any more than printing a lot more hat-checks can create more hats when checks are presented at the end of a function.

Because all money exists as a ‘claim’, the creation of monetary claims in the present adds to the aggregate of liabilities redeemable in the future.

Stated in dollars converted from other currencies at market rates, global debt at the end of 2021 stood at $236 trillion, or 245% of GDP ($96tn).

But formal debt hugely understates broader financial commitments, which can be estimated at $550tn, or 575% of GDP, and which include about $280tn in the ‘shadow banking system’. The ratios in some countries are far worse, including Britain (1263% as of the end of 2020), the Netherlands (1454%) and Ireland (1809%).

Even these ratios understate the true seriousness of our financial predicament, because the GDP denominator has been inflated artificially.

The basic principle involved here is simplicity itself. We create money which, by definition, is a ‘claim’ on the real economy and, because money itself is a claim, it’s also a forward liability. The spending of this money creates financial transactions, and the adding up of these transactions by statisticians creates the metric that we know as GDP. We then assume – quite mistakenly – that this ‘sum of financial transactions’ is economic ‘output’.

This means that we can inflate transactional activity by pushing ever more credit into the economy. This doesn’t add to material prosperity, but it does increase the overhang of forward claims that we won’t be able to honour.

Loaded dice

Beyond a tendency to ‘count the activity and ignore the liabilities’, the snag with this is that, over the past two decades, it has taken more than $3 of extra debt – and an increase of about $7.30 in broader financial liabilities – to produce $1 of additional transactional activity.

We can’t possibly win at these odds. A better option, were it feasible, might be to withdraw from the game, tying the rate of liability expansion to changes in the size of the economy – and, at the same time, desist from making implicit pension promises that a contracting real economy can’t possibly honour.

Instead, we carry on the self-delusion, even though the dynamics of the process are loaded against us. Every now and then, some bright spark tells us that, by borrowing now, we can create “growth” (which is true, but only in a statistical sense), and that this growth will then “pay off the debt” that we’ve taken on to create it (which simply isn’t possible, least of all in economies that rely on continuous credit expansion).

SEEDS modelling identifies the two critical equations that interpret our recent economic past realistically, and give us reasonable visibility on what happens next. With these understood, what we need to address is the matter of process.

Each equation requires two charts, and these are shown in fig. 2.

The first chart in fig. 2 shows how both debt and broader financial liabilities – known as ‘financial assets’ from the lender side of the equation – have dramatically out-grown GDP. Meanwhile, reported GDP has been inflated, not just by the ‘credit effect’ described above, but also because no allowance is made for ECoE.

Accordingly, we can plot, in the second chart, a widening divergence between the ‘financial’ metric of GDP and underlying prosperity, as calculated by SEEDS.

This divergence is a comparatively recent phenomenon – in past times, ECoEs were low, and we hadn’t embarked on the massive credit-creation binge that has become a seldom-noticed characteristic of the ‘delusional growth era’.

Back in, say, the 1950s, people weren’t using QE, ZIRP or NIRP, because they didn’t have to. ECoEs were low enough for the economy to deliver ‘growth without gimmickry’. The very adoption of these expedients is testimony to adverse underlying trends that we’ve failed to acknowledge.

The downside between the two economies is currently estimated at 40%, which gives us some idea of the scale at which financial ‘claims’ are likely to be eliminated once the inevitable restoration of equilibrium takes place.

Fig. 2

Most forecasters start with GDP and so, to produce projections on a comparable basis, SEEDS segmental analysis accepts the 2021 number (globally, $146tn PPP) as its start-point.

This does not, however, require us to accept the inaccurate statistical narrative of how we arrived at this number. Whilst reported real GDP doubled (+101%) between 2001 and 2021, prosperity increased by only 31% over that same period.

This enables us – as shown in the third chart in fig. 2 – to produce a reconciled trend in economic output, and to see how far this differs from reported numbers, which have been inflated by credit (claims) expansion, and which make no allowance for rising ECoEs.

This in turn enables us to interpret and project – as shown in the right-hand chart – the economy on the basis of the key segments, which are essentials, capital investment (in new and replacement productive capacity) and discretionary (non-essential) consumption.

What happens next

The technicalities of these interpretations and forecasts have been discussed here before, and might be revisited in the future. For now, though, what matters is the outlook itself, and what, if anything, might be done about it.

Starting with the economy, global aggregate output, referenced to prosperity, is heading for a downturn, and per capita prosperity is already declining. Meanwhile, the real costs of energy-intensive essentials are rising.

Accordingly, capital investment is poised to turn down, whilst we should anticipate relentless contraction in the affordability of discretionaries.

This will, probably sooner rather than later, undermine the confidence which investors and lenders place in businesses supplying non-essential products and services. Accordingly, these discretionary sectors will lead the decline in the valuation of assets. This will be accompanied by falls in the real prices of property, as these prices are linked to the metric of affordability, which is declining very markedly.

Though rate rises don’t help, the size of a mortgage that anyone can afford to service depends upon how much he or she has left after paying for necessities.

Assets, though, are less important in this context than liabilities. Asset prices are a function of the availability and cost of money – and money, as we know, is an aggregation of claims on the real economy. What happens now is that the vast burden of excess claims, created during a period of hubristic and futile denial of underlying reality, will be eliminated, either through inflation, through default, or a combination of both.

From the perspective of ‘two economies’, it’s clear than inflation is a function of the relationship between the material and the financial. Prices are the point of intersection in this relationship, because a price is the financial number ascribed to a material product or service.  

In real terms, we can’t prop up inflated asset prices, and it would be insane to try to carry on doing so. Neither can we ‘make good’ liability excesses, and any attempt to do so would involve the creation of money at a scale which would invite hyperinflation – which, ultimately, is an alternative, informal version of default.

Asset prices will tumble, then, and commitments won’t be honoured. What we’re left with is an economy in which, just as prosperity is declining, the cost of essentials will carry on rising.

Inequalities are inevitable in any economy, but these inequalities can be expected to combine with deteriorating prosperity to drive ever larger numbers of people into absolute poverty. This makes redistribution inevitable, even though the more privileged will fight this every step of the way.

The only way in which governments can seek moderate the rising cost of essentials is by spending less on public services (which count as essentials for our purposes, as the citizen has no ‘discretion’ about paying for them).

Time to call time on delusion

It would be a good idea if, whenever anyone suggests a financial ‘fix’ – rate rises, rate cuts, QT, QE, debt-funded tax cuts, more debt – we were to ask them to explain how these measures are going to deliver cheaper energy.   

This situation doesn’t leave us entirely powerless. We should, for instance, have long since embarked on energy efficiency measures, including the provision of public transport as a counter to the diminishing affordability of cars. Nuclear power offers some scope for supply relief, though it isn’t going to rescue us from energy deficiencies.  

But no workable amelioration measures can be crafted whilst our appreciation of the situation remains faulty.

The reality is that we need to concentrate on how to allocate and manage deteriorating prosperity. This has become a less-than-zero-sum game. We should not delude ourselves into believing that we can help some without taking from others.

This becomes a political choice and, many might say, a moral one. Social cohesion depends on facing this reality, and there’s no mileage in denying it, or trying to wish it away by proposing financial gimmicks that can’t work.

#236. The monetary conundrum


Following the Fed and the Bank of England, the ECB has become the latest central bank to adopt QT (quantitative tightening) and to raise interest rates, though the ECB’s 0.5% hike still leaves its deposit rate at zero. The ECB has also unveiled a mechanism – the Transmission Protection Instrument, or TPI – designed to ward off sovereign debt crises in some of the bloc’s weaker economies.

The details of these developments are set out very well in this Wolf Street article. The aim here is to discuss what policy actions – if any – make sense for the central banks.

Raising rates – and, by extension, putting prior QE into reverse – are straight out of the standard play-book for combatting inflation. It’s noticeable that central bankers are moving pretty slowly along this orthodox path, with each much-delayed rate rise far more than negated by the next surge in inflation.

But should they be tightening monetary policy at all?

The wrong response?

Some observers contend that raising rates isn’t the appropriate response under current conditions.

The argument runs that inflation isn’t being driven by internal demand excess, but by external factors over which the monetary authorities have no control. Rate rises in America won’t increase the supply of food to world markets, this argument runs, and QT in the Euro Area won’t ease shortages of oil and natural gas.

The argument against tightening monetary policy can be made either optimistically or pessimistically.

The optimistic line is that action isn’t needed, because the inflationary spike isn’t fundamental, but the product of happenstance. Given sufficient patience – and sufficiently accommodative monetary and fiscal policies – supply-lines ruptured by the pandemic will return to normality, as will the flow of energy, once the war in Ukraine reaches some kind of conclusion.

To the pessimist, the whole situation is hopeless anyway, so there’s no point in pulling forward the unavoidable crisis, or piling on the economic pain, when orthodox tightening policies cannot work.

Getting it half-right?

The view taken here is that central banks are right to pursue monetary tightening, though they might also be right in doing this fairly slowly.

Three lines of argument support this view.

First, inflation may have started with external factors, but could all too easily turn into an internal wage-and-price spiral. This kind of spiral is exactly what happened in the 1970s, even though the initial inflationary impetus came from events – the oil crises – outside the control of domestic monetary authorities.

To be sure, organised labour doesn’t have the clout that it had back then, and labour shortages aren’t likely to prove lasting. But the upwards pressure on wages remains, propelled by the need to ensure that employees can at least ‘make ends meet’.  

Second, this is a matter of degree.

Ever since ZIRP, NIRP and QE were adopted – as avowedly “temporary” and “emergency” expedients – in response to the GFC, nominal rates have been, almost always, below the rate of inflation.

But real rates, though negative, haven’t been deeply so. There’s a world of difference between rates that are negative to the tune of -2% or -3% and allowing them to fall to -8% or -10%, which could all too easily happen if central bankers don’t respond.

Negative real rates are anomalous, and harmful, and the damage is proportionate to the extent of negativity. Setting the cost of money below the rate of inflation invites debt escalation, which in turn leads to instability, such that deeply negative rates can be expected to lead to a full-blown crisis.

The market economy requires that investors earn positive returns on their capital, so an absence of these returns translates an ostensibly capitalist system into a dysfunctional hybrid. Letting real rates fall to extreme lows can only make this worse.

No good choices

Underpinning the view set out here, of course, is the understanding that prior growth in prosperity has gone into reverse because the energy equation that determines prosperity has turned against us.

This equation involves the supply of energy, its value and its cost, the latter measured, not financially, but as the proportionate Energy Cost of Energy.

Mainly because of the depletion of low-cost resources, the ECoEs of oil, gas and coal have risen relentlessly, pushing the overall ECoE of the system to levels far beyond those at which stability, let alone further economic expansion, remain possible.

You might believe that the ‘fix’ for the ECoE problem lies in transition to renewable energy sources. Even if you do believe that this is possible, though, it’s clear that it can’t happen now. The contrary point of view is that renewables can’t provide a like-for-like replacement for the energy value hitherto provided by fossil fuels.

Either way, inflation is one symptom of a divergence between the ‘real’ or material economy of goods, services and energy and the ‘financial’ or proxy economy of monetary claims on the real economy.

The further these two economies diverge, the greater the pressures become for the restoration of equilibrium between them.

The following charts summarize this dynamic. As ECoEs have risen, surplus (ex-cost) energy has contracted, and this effect is now carrying over into a decreasing total supply of energy as well.

The mistaken idea that we can boost material prosperity by stimulating financial demand has driven an ever more dangerous wedge between the financial or claims economy of money and credit and the underlying real economy of energy value.  

Fig. 1

The Fed – a shift in priorities

The third factor which helps justify conventional monetary responses to inflation is that each monetary area has its own idiosyncrasies and, where the Fed, the Bank of England and the ECB are concerned, these idiosyncrasies support the case for orthodoxy.

The Fed has, in some ways, the easier task of the three. Hitherto, rates have been kept ultra-low in the US in order to prop up and boost capital markets. Former president Donald Trump was wont to say that a high stock market was, ipso facto, indicative of a strong America. Mr Biden hasn’t repeated this nonsense – he can’t, whilst markets are correcting – but what’s really changed isn’t politics, but the context of intentions.

At times of low inflation, what monied elites fear most is a slump in asset prices. Once inflation takes off, however, this ‘elite priority’ shifts. A billionaire has a billion reasons for not wanting the purchasing power of the currency to be trashed.

This is why rate rises and QT aren’t taking America back to the “taper tantrums” of the past. The Fed might also hope that a commitment – albeit a much-delayed one – to the inflationary part of its mandate might help restore some public trust in the institution.

Britain – staving off the day

BoE priorities are different. For a start, the British fixation is with property prices rather than the stock market. Whilst the stock market “wealth effect” is an adjunct to the American economy, inflated property prices play a central role in supporting the illusion of prosperity in the United Kingdom.

The harsh reality is that the British economy is a basket-case. America might want stock market appreciation, but can get by without it. Britain needs property price inflation to keep the ship afloat.

The British economy depends on continuous credit expansion to produce the transactional activity, measured as GDP, which supports a simulacrum of ‘business as usual’. Inflated property prices play a critical role, providing both the collateral support and the consumer confidence required if credit expansion is to continue.

Fundamentally, Britain lives beyond its means, resulting in an intractable trade deficit. For a long time, this was bridged, at least in part, by income from exports of North Sea oil and gas. Once Britain became a net energy importer again, the emphasis switched with renewed force to asset sales.

Ultimately, though, this makes a bad situation worse, because each asset sale sets up a new outward flow of returns on overseas’ investors capital. These outflows are part of the broader current account deficit, which is dangerously high, and has become structural.

Former Bank chief Mark Carney warned about dependency on “the kindness of strangers”, but no realistic alternatives exist. Asset divestment – muddling through by “selling off the family silver” – is, by definition, a time-limited process.

The nightmare that must haunt the slumbers of British officials is a “Sterling crisis”. If the value of GBP were to slump, inflation would soar, vital imports could become unaffordable, and the local cost, not just of foreign currency debt but of servicing that debt as well, could soon become unsustainable.

Put simply, the BoE needs to show FX markets some resolve, even if that comes at the cost of some domestic economic pain. The Bank undoubtedly knows about – as some politicians seemingly do not – the price that could become payable for fiscal and monetary recklessness, if that recklessness were to trigger a currency crisis.

It’s a point seldom mentioned that, if a future leadership were to enact irresponsible tax cuts, the Bank might, as a compensatory measure, have no choice but to raise rates more briskly than would otherwise have been the case.

Some in Britain have dreamed, unrealistically, of turning the country into ‘Singapore on Thames’. The real and present danger is of turning into ‘Sri Lanka on Thames’, where a weak currency makes vital imports prohibitively expensive.

The prevention of a currency crisis has to be the overriding priority of responsible decision-makers. The balance of risk – no less than the balance of pain – has to be tied to the demonstration of sufficient resolve to stave off any such crisis.

The ECB’s camel

A camel was once described as “a horse designed by a committee”. A similar phrase could aptly describe the Euro system, created as a political ideal, and built on the most dubious of economic presumptions.

To work effectively, monetary policy needs to be aligned with fiscal policy. The Euro system doesn’t do this, but tries instead to combine a single monetary policy with 19 sovereign budget processes.

One of the consequences of fiscal balkanization is an absence of the ‘automatic stabilizers’ which operate in currency zones where the monetary and the fiscal are aligned.

If, for instance, Northern England was suffering a recession, whilst Southern England was prospering, less tax would be collected in the North, and more benefits would be paid there by central government, with the opposite happening in the South. Money would therefore flow, automatically, from South to North.

Critically, such regional transfers within the same currency zone are automatic, do not need to be enacted by government, and certainly do not depend on agreements between the differently-circumstanced regions.

By contrast, transferring money from, say, Germany to Greece isn’t automatic in this way, but depends on political negotiation, which is likely to be fractious, even at the best of times – which these times, of course, are not.

To be sure, Scotland and Wales have independent budgetary powers, as do American States. But there are, in both cases, over-arching sovereign budgets, set in London and Washington, which set the overall parameters. No such overarching budget exists in the Euro Area.

There are parallel problems in the Target2 clearing system. If a customer in Madrid buys a car made in Wolfsburg, Euros have to flow between countries, being debited in Spain and credited in Germany. But there are severe imbalances within the Euro clearing system.

As of May, Germany was a creditor of Target2 to the tune of €1.16 trillion, whilst Italy owed the system €597bn, and Spain €526bn. The official line is that this doesn’t really matter very much, but it’s hard to see how Germany can ever collect the sums owed to the country, via the system, by Italy and Spain.

One might argue that Target2 gives poorer EA nations rolling credit to fund imports from Germany.

The danger with a ‘one size fits all’ monetary policy, when applied in the context of a multiplicity of sovereign budgets, is that national bond yields can diverge, because each country, being responsible for its own budget, borrows individually on the markets.

Italy is a case in point. Prior to the formation of the Euro, Italy had a history of gradual devaluation of the Lira. Whilst this made Italians poorer in relative terms, it protected both employment and the competitiveness of Italian industry.

Once Italy joined the Euro at the end of 1998, this ceased to be possible.

This, in large part, is why Italian debt has increased, as the authorities have endeavoured to find other ways to deliver the support that would previously have been provided by gradual devaluation. This could, and does, make markets worry about Italian debt, putting upwards pressure on Italian bond yields.

If these yields were to blow out, Italy would encounter grave difficulties, not just in financing its fiscal deficits, but in maintaining the continuity of credit to the economy itself.

The ECB, in a rather belated effort to counter inflation, is committed to raising rates, and to letting its asset holdings unwind. This, though, could cause problems which culminate in drastically dangerous rises in bond yields in member countries such as Greece, Italy and Spain.

TPI – which the ECB must devoutly hope will never have to be put into effect – is designed to counter this process by varying the composition of QT. If rates spike in, say, Italy, the ECB could buy Italian bonds, simultaneously increasing its sales of German or Dutch bonds within the overall composition of QT.

This, though, presupposes that the Euro Area has “strong” as well as “weak” economies, a point that is now debateable.

The ultimate ‘strong economy’ in the EA has always been Germany, but the energy squeeze is putting that strength to the test. Moreover, much of Germany’s economic prowess is the trade advantage that the single currency confers on it. France has a moribund economy and elevated levels of debt, whilst Dutch financial exposure is uncomfortably high, with financial assets standing at 14.5X GDP as of the end of 2020, the most recent reporting date.  

In the final analysis

Ultimately, the challenge facing the ECB – and other central banks too – is to prevent two things from happening.

The first and most obvious is to guard against inflation taking on its own momentum, which could easily happen in a climate of apparent official indifference or resignation.

But the second is to ensure that the damage – and the crisis-risk – caused by a negative real cost of capital does not escalate, as it could if central banks allow real rates to slump into lethally deep negative territory  .

#235. The affordability crisis


What might be called the ‘consensus narrative of the moment’ is that our near-term economic prospects depend on the ability of central banks to tame inflation without tipping the economy into a severe recession. There are numerous complications, of course, but this is the gist of the story.

What these officials need to find, we’re told, are Goldilocks interest rates (‘not too hot, not too cold’), and all will be well if they succeed. If they err too far in one direction, inflation will run higher, and for longer, than is comfortable. If they lean too far the other way, a serious (though, by definition, a time-limited) recession will ensue.

Inflation itself, the narrative runs, has been the product of bad luck. First came the pandemic crisis, which impaired production capacity and severed supply-chains. Before we’d finished dealing with this, along came the war in Ukraine, disrupting supplies of energy, food and other commodities. There are some who add, sotto voce, that we might have overdone pandemic-era stimulus somewhat.

Our hardships, then, can be put down to a run of bad luck. Those in charge know what they’re doing.

It’s conceded, in some quarters, that we might face some sort of crisis if these challenges aren’t managed adroitly. This, though, shouldn’t be as bad as the GFC of 2008-09, and certainly won’t be existential.

We’re navigating choppy waters, then – not going over Niagara in a barrel.

The affordability reality

There is some truth in each of these propositions, but explanation in none.

What we’re really encountering now is an affordability crisis. The aim here is to explain this, without going into too much detail, and with data confined to two sets of SEEDS-derived charts at the end of this discussion.

The economy, as regular readers know, is an energy system. Nothing that has any economic value at all can be produced without the use of energy. Take away the energy and everything stops. Decrease the supply of energy, or put up its cost, and systems start to fail.

Energy isn’t free. Whenever energy is accessed for our use, some of that energy is always consumed in the access process.

This ‘consumed in access’ component – known here as the Energy Cost of Energy, or ECoE – has been rising relentlessly, mainly because depletion is forcing up the costs of oil, natural gas and coal.

This rise in ECoEs reduces the surplus (ex-cost) energy that is coterminous with prosperity. This equation reflects the fact that surplus energy determines the availability of all products and services other than energy itself.

Because ECoEs are rising, prosperity is decreasing.

At the same time that surplus energy prosperity is deteriorating, the costs of essentials are rising. This is happening because most necessities – including food, the supply of water, housing, infrastructure, the transport of people and products, and, of course, energy used in the home – are energy-intensive.

The material components of this equation – energy itself, supply costs, prosperity and the essentials – are translated, using the SEEDS economic model, into the financial language that, by convention, is used in economic debate.

We need to be absolutely clear, though, that money has no intrinsic worth, but commands value only as a ‘claim’ on the material products and services made available by the energy economy.

Money is an artefact validated by exchange. A million dollars would be of no use at all to a person adrift in a lifeboat, or stranded in a desert. A million euros would be worthless to someone who travelled to a distant planet where the euro is unknown.  

We are at liberty to create monetary ‘claims’ to an almost unlimited extent, but we can’t similarly create the material goods and services that are required if those claims are to be honoured ‘for value’.

Central banks can ‘print’ money (digitally), but they can’t similarly print low-cost energy. The banking system can lend money into existence, but we can’t lend resources into existence.

We can’t, for that matter, fix our environmental problems by writing a cheque to the atmosphere.

The meaning of compression

Whether we think in energy or in financial terms, what’s happening now is that the economic resources of households, and of the economy itself, have ceased to expand, and have started to contract, whilst the costs of essentials are rising.

This is what is meant by an affordability crisis.

An affordability crisis does what it says on the tin, and has two main effects.

First, consumers who have to spend more on necessities have to cut back on purchases of discretionary (non-essential) goods and services.

Second, households suffering from affordability compression struggle to “keep up the payments”.

Traditionally, these payments were largely confined to mortgages or rents, plus, perhaps, insurance premia collected door-to-door.

Now, though, these outgoings include credit servicing, car loans, student loans, subscriptions, purchase instalments and the plethora of other income streams created by an increasingly financialized economy.

Though they can’t be expected to like doing so, it’s possible for households to cope with affordability compression. Discretionary purchases are, after all, things that people want, but don’t actually need. People can cancel subscriptions, cut back on instalment purchasing, and cease using – and, in extremis, default on – various forms of credit.

To say this isn’t to minimize, in any way, the very real hardships being experienced by millions of households. The ‘cost of living crisis’ is the biggest challenge that has confronted households, and governments, in decades. As these problems worsen, the public are likely to get increasingly angry, and to demand redress, part of it through various forms of redistribution.

But an affordability crisis is much more serious for the system than it is for the individual.

Customers can decide to holiday at home rather than abroad, but the outlook for airlines, cruise operators and travel companies is grim if they do. Households can get by without entertainment subscriptions, but the providers of these services cannot survive if this happens. Motorists can hang on to their current vehicles for longer, and put off buying a new car, but the automotive industry is at grave risk if this happens.

These are what we might call the ‘industrial’ effects of affordability compression. Serious though these are, the financial effects are much worse.

The financial system depends on people “keeping up the payments” and, to a significant extent, increasing those payments over time.

The ability of the system to cope with defaults – or even with payment contraction – is severely circumscribed.

Perhaps the biggest single risk of the lot would be a wave of ‘can’t pay, won’t pay’ reaction by the public.

Getting to grips

When trying to navigate our way through the coming crisis we need, first, to understand what it is. Inflation, whether in prices or in wage demands, is a symptom, not the disease itself, and the root of the problem is an affordability crisis.

Second, we can’t borrow or print our way through an affordability crunch. Any attempt to do so just makes the problem worse.

Third, none of this is going away. An outbreak of peace and conciliation between Russia and its opponents, welcome though this would be, wouldn’t alter the fundamentals, which are that the ECoEs of energy supply are rising, reducing the affordability, not just of energy itself, but of all energy-intensive resources and products.

Fourthly, there’s no “tech fix” for structural affordability compression. As we’ve discussed in previous articles, renewables are vital, but they aren’t going to stem, still less reverse, rises in overall ECoEs. The ability of technology to somehow over-rule the laws of physics is one of the foundation myths of the age.

There’s no merit in finding new ways to use energy when the supply and the affordability of energy itself are getting worse. Electricity doesn’t come out of a socket in the wall, in unlimited quantities and at an ever-decreasing price. The expansion of renewables is imperative, but they are even less likely than nuclear to produce power “too cheap to meter”.   

It’s worth remembering, in this context, that energy sources must precede applications. The Wright Brothers didn’t invent the aeroplane first, and then sit around waiting for someone to discover petroleum. Cars weren’t invented until after gasoline had become available. Our ancestors didn’t build carts until they’d tamed their first horses.

Technologies are optimised to the energy sources available, not the other way around.

The big question now isn’t whether an affordability crisis is going to happen – because it already is – but when this reality is going to gain recognition as a feature of the system, not a glitch.

Hype springs eternal, and nobody is yet prepared to recognize that economic growth, previously powered by fossil fuels, has gone into reverse, because fossil fuels are becoming costlier to supply, and no alternative of equal economic value is available.

There are limits, though, to the capability for self-delusion. Risk will reach its apogee when investors, lenders and the public tumble to the reality that discretionary consumption has entered an irreversible decline, and that the economy, just like millions of households, is struggling to ‘keep up the payments’ required by an increasingly financialized system.

#234. Britain on the brink


Whether the country’s leaders know it or not, the United Kingdom is now at serious risk of economic collapse.

We must hope that this doesn’t happen. If it does, it will take the form of a sharp fall in the value of Sterling which, in these circumstances, is the indicator to watch.

A currency crash would cause sharp increases, not just in the prices of essential imports such as energy and food, but also in the cost of servicing debt. In defence of its currency, Britain could be forced into rate rises which would bring down its dangerously over-inflated property market.

This risk itself isn’t new. Rather, it results from a long period of folly, and can’t be blamed entirely on the current administration, inept though the Johnson government undoubtedly is. What we’re witnessing now seems to be a government on the edge of panic. The official opposition doesn’t offer a workable alternative programme, and mightn’t be electable if it did.

We need to be clear that the root cause of Britain’s problems is long-term adherence to an increasingly extreme ideology sometimes labelled ‘liberal’.

It’s one thing to recognize the merits of the market economy, but quite another to turn this into a fanaticism which judges everything on its capability of generating short-term private profit.

Extremism is divisive, and creates winners and losers to an extent that moderation does not. If solutions still exist for Britain’s worsening problems – and that’s a very big “if” – there are two reasons why such solutions mightn’t be adopted.

The first is that these solutions would anger a very vocal group of winners under the existing system.

The second is that those in charge would have to make a public admission of the failures of extremism.     

The practical problem

There are two main structural problems in the British economy, both of which are simply stated.

First, the economy operates on the basis of continuous credit expansion.

Even before the onset of the pandemic in 2020, Britain had spent twenty years adding £4 of new debt for each £1 of reported “growth” in GDP. The mathematics get even worse if we add broader financial liabilities, and unfunded pension commitments, to the equation. Where Britain is concerned, these broader liabilities are enormous.

Even this 4:1 ratio understates the grim reality, because the injection of liquidity creates transactional activity – measured as GDP – rather than adding value. SEEDS calculations indicate that, within recorded “growth” of £715bn (at constant 2021 values) between 1999 and 2019, only 30% (£215bn) was organic expansion, with the remaining 70% (£500bn) the cosmetic effect of borrowing at an annual average of 7.2% of GDP through this period.

This process is underpinned by the over-inflation of the values of assets, and principally of property. High and rising property values provide both the collateral and the confidence for perpetual credit expansion.

This is why successive governments have sought to promote, rather than try to tame, house price escalation.

Every initiative branded as “help” for young buyers has, in reality, been a device for propping up or further inflating the real estate market. At the first sign of a wobble in house prices, transaction taxes (stamp duties) are suspended. A property price crash is one of the nightmares that haunts the slumbers of British decision-makers.

It might even be contended, not without justification, that what passes for an “economy” has become, in reality, just an adjunct to an over-inflated property sector.

The second structural weakness is the permanent and worsening current account deficit. The United Kingdom consumes more than it produces. The system incentivizes people to make money – preferably through asset price escalation – rather than to produce goods and services.

A concept which has been described here before is the distinction between globally-marketable output (GMO) and internally-consumed services (ICS). In Britain, GMO has become dangerously small, such that excessive reliance is placed on ICS.

Hitherto, the structural current account gap has been bridged by the sale of assets to overseas investors, a process which has seen major companies, utilities and even football teams sold into foreign ownership.

This trend has become particularly acute since Britain ceased to be a net exporter of oil and gas.

Current account deficits, once embodied in the system and funded by asset sales, have become an autonomously worsening problem, because each asset sold to an overseas buyer sets up a new outflow of returns on capital to the new owners.

Self-created risk

The dangers implicit in this structure are clear.

First, a heavily indebted and credit-dependent economy is extremely vulnerable to rises in interest rates. This vulnerability has become acute now that the global rate cycle has turned upwards.  

As well as increasing the cost of servicing debts, rate rises threaten to crash asset markets, thereby taking away the collateral and confidence props required for the continuous credit expansion upon which the British economy relies.  

Second, overseas investors might start to wonder about Britain’s ability to cope with a steadily worsening structural current account shortfall, reasoning that there are limits to how long any economy can survive by “selling off the family silver” or relying on “the kindness of strangers”.

Additionally, of course, FX markets might fear a descent into chaos. The UK authorities’ approach to inflation looks – to put it charitably – like a product of blind panic.

Problems cannot be fixed by appointing a “tsar” and starting an ad-and-slogan campaign. There’s not much point in urging companies to hold down or even cut their prices when those companies’ own costs are soaring. Workers are unlikely to pay much heed when highly-remunerated officials urge the virtues of wage restraint.

It’s rumoured that, at the same time as increasing state pensions by 10%, the government plans to limit public sector pay increases to as little as 3% or even 2%. If this does indeed turn out to be the plan, chaos can be expected to ensue.

Britain could, of course, adopt what might be called a ‘5-5’ programme, setting 5% as a pay and pensions norm for the current year, with the rider that a further 5% increment will follow in the next year.

Funding this, though, would require major fiscal reforms which, whilst benefiting the young, would anger the (generally older) beneficiaries of the current system.

The clear and present danger now is that markets might decide that the dubious attractions of Sterling are far outweighed by the risks. A “Sterling crisis” would force the Bank of England into raising rates, crashing the property market to which the economy is, increasingly, an adjunct.

A crash in the value of GBP would trigger runaway inflation by increasing the cost of essential imports, including energy and food. Debts denominated in overseas currencies would soar, to a point where Britain could no longer afford to service these debts, let alone repay them.  

The ideology trap

Some, indeed many, of these problems and vulnerabilities are replicated elsewhere.

But what sets Britain apart is its long-standing adherence to an increasingly extreme ‘liberal’ ideology.

We’ve seen this over decades, with a succession of initiatives designed to translate taxpayer funds into private profits.  

Even those of us who favour the market over the state-run economy surely realize that there’s a balance to be struck between private incentive and the role of the public sector, and that any form of economic extremism tends to be both harmful and divisive.   

Taken to extremes, this version of ‘liberalism’ becomes the same system that sent small children up Victorian chimneys. That probably wouldn’t pay in the 2020s, but its modern equivalents – the “gig” economy, “zero-hours contracts” and the relentless undermining of security of employment – have all been warmly welcomed in Westminster and Whitehall.

Extreme liberalism has made the British economy, and British society itself, increasingly dysfunctional. The system is biased in favour of those generally older people who already own assets, and loaded against the generally younger people who aspire to accumulate them. It favours speculation over the creation of value.   

Perhaps the biggest problem of all is the extent to which the public has swallowed the propaganda of liberal extremism, an extremism which states that anything motivated by private profit must be superior to anything managed on the basis of the general good.

The problems of the 1970s are painted, not, as they in fact were, as the consequences of two global oil crises, but as the failures of Left-leaning governments and the malign behaviour of organized labour.

This is the same kind of myopia which remembers the Defeat of the Spanish Armada in 1588, but forgets the Defeat of the English Armada in the following year.

This becomes more pertinent when it is recalled that the debacle of 1589 resulted from efforts to turn a military expedition into a profitable enterprise. Floating a naval campaign as a quoted joint-stock company must have seemed as bizarre at the time as it does now.

If you’re interested in military history, you’ll know that the best of Britain’s trio of wartime heavy bombers were the Avro Lancaster and the Handley Page Halifax.

The danger now is that the name of the third one – the Short Stirling – might sound like an increasingly good idea to international investors.     

#233. Understanding inflation


Inflation isn’t like other economic problems.

It impacts the general public, immediately, and painfully. It feeds on itself, once wages start chasing surging prices.

It can’t be denied and, once it takes off, there are limits to how far it can be under-reported. It can’t be fixed – or, rather, it can’t be ‘kicked down the road’ – using any form of ‘magic money’ gimmickry.

Inflation is the brutal exposer of failure. It is already exposing, for example, the weaknesses of a British economic model built on perpetual credit expansion, and the contradictions in a European monetary system which tries to combine a single monetary policy with nineteen sovereign budgetary processes.

Small wonder, then, that soaring inflation induces panic, desperation and sometimes outright idiocy in the corridors of power.

On the basis of principle

Those of us who understand the economy as an energy system, rather than a wholly financial one, have a unique insight into inflation.

Because we recognize that the ‘real’ economy of goods and services is shaped by energy rather than by money, we also recognize the existence of the ‘financial’ economy as a monetary proxy to the energy dynamic which determines prosperity.

Prices are where the material and the monetary intersect. Prices are the financial values that are attached to physical goods or services. Inflation is a product of changes in the relationship between the ‘real’ economy of energy and the ‘financial’ economy of money and credit.  

To paraphrase Milton Friedman, inflation is always and everywhere a two economies phenomenon.

Because of the immediacy of soaring inflation, and because of the panic it induces in decision-makers, current events might seem to add credence to the “collapse” prophecies of modern-day Cassandras.

In fact, inflation can be interpreted rationally, and that’s the single aim of this discussion.

In search of reason

The basic principles of the energy interpretation are quickly stated.

The economy is an energy system, because nothing that has any economic value at all can be supplied without the use of energy.

Energy is never ‘free’, but comes at cost measurable as the proportion of energy that is consumed in the access process whenever energy is accessed for our use. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy).

Money has no intrinsic worth but commands value only as a ‘claim’ on the material goods and services supplied by the energy economy.

These principles lead inescapably to the concept of the ‘two economies’ of energy and money. Inflation – and, for that matter, currency crises, market falls and severe defaults – are products of imbalances between the ‘real’ and the ‘financial’ economies.

Until some point in the 1990s, the real and the financial economies expanded more or less in tandem.

The most notable previous disequilibrium between the two economies of energy and money happened in the 1970s, and was characterized by runaway inflation. Though energy remained cheap and abundant in those years, political divisions between the biggest producers and the main consumers of oil triggered a sharp rise in the cost of energy to Western consumers.

The situation righted itself, because there remained substantial reserves of relatively low-cost oil in places – most notably the North Sea and Alaska – that were outside the control of OPEC.

The robust growth of the 1980s owed everything to a ‘catch-up’ from the politically-induced energy shortfalls of the 1970s, and almost nothing to the ‘liberal’ economic ideologies which happened to supplant the Keynesian orthodoxy at that same time.

The road to here

By the 1990s, the fundamentals had started to deteriorate. ECoEs were rising at rates which were taking away the potential for further growth in the material economy. This was happening because of depletion, a process whereby lowest-cost energy resources are used first, leaving costlier alternatives for a ‘later’ which had now arrived.

What we have experienced since then has been a worsening process of self-delusion, based on the false proposition that we can increase material supply by stimulating financial demand.

The facts of the matter, of course, are that no amount of financial stimulus, and no increase in prices, can produce anything – in this instance, low-cost energy – which does not exist in nature.

What we can do is to create a simulacrum of “growth” by creating monetary ‘claims’ on the future which increase transactional activity in the present.

We’re at liberty to count these increases in transactional activity as ‘growth’, and to ignore the inability of the real economy to honour these forward commitments when they fall due.

This is what’s been happening through an era of collective self-delusion that began in the second half of the 1990s.

Between 1999 and pre-pandemic 2019, reported global GDP increased by $74 trillion in real terms, but debt escalated by $204tn between those years, and we can estimate that broader ‘financial assets’ – which are the liabilities of the household, government and corporate sectors of the economy – soared by about $480tn. Even this number excludes the creation of enormous pension promises which a faltering ‘real’ economy will be unable to honour.

The reported “growth” in the economy measured financially as GDP through this period was starkly at odds with what was happening in the real economy of energy. Whilst reported GDP slightly more than doubled (+110%) between 1999 and 2019, the total supply of energy increased by only 54%, a number that falls to 47% at the critically-important level of ex-ECoE surplus energy.

Reflecting this, aggregate prosperity, measured financially by the SEEDS economic model, expanded by only 34% worldwide over a period in which economic activity, recorded as the transactional use of money, rose by 110%. The 34% increase in money-equivalent prosperity was lower than the 47% rise in surplus energy, a differential reflecting deterioration in the efficiency rate at which surplus energy is converted into economic value.

The dynamics of disequilibrium

We need to be absolutely clear about what this means. Stimulation of transactional activity to levels far above underlying prosperity as determined by energy has created an enormous disequilibrium between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

Globally, the downside between the ‘two economies’ can be calculated, as of the end of last year, at 40% (see fig. 1). The equivalent numbers for the United States and China, respectively, are 32% and 54%.

Fig. 1

The inevitable restoration of equilibrium between the ‘two economies’ is readily explained, because it happens when the owners of financial ‘claims’ realize that the aggregate of these claims cannot be honoured ‘for value’ by the real economy of goods and services.

This enforced restoration of equilibrium is mediated through prices, which are best understood as the rate of exchange between the monetary and the material economies.

The result is experienced as accelerating inflation, a process which everyone understands can only be worsened by stimulus, and which we further understand must continue until something much closer to equilibrium has been restored.

It also follows, from this, that inflation will be most acute in those energy-intensive product categories which are ‘essential’, which means that consumers cannot choose not to buy them because their prices have increased.

Conversely, inflationary pressures will be less pronounced in those discretionary (non-essential) goods and services of which consumers will reduce their purchases as their ex-essentials prosperity (known in SEEDS as PXE) deteriorates.

Taking stock

This explanation, though, refers primarily to the flows of money and material prosperity. There are also ‘stock’ issues around the forward commitments created through the same process of stimulus which has driven the observable wedge between the ‘real economy’ of goods and services and the ‘financial economy’ of money and credit.

This is summarised in the flow-and-stock analysis produced by the SEEDS economic model.

In fig. 2, the flow distortion, seen earlier, is compared with two measures of ‘stock’ exposure. One of these is debt, which now stands at 4.1X underlying prosperity. The other relates to estimated broader financial assets, now at a multiple of 9.3X prosperity.

Neither of these ratios is sustainable, and a best estimate has to be that forward excess claims will be eliminated at a percentage rate broadly equivalent to the equilibrium downside measured as the flow relationship between the monetary and the material economies.    

Fig. 2

Inflation does, of course, reduce forward claims by impairing their real value.

Even so, the balance of segmental alignments – between essentials, discretionaries and capital investment – suggests that the elimination of excess claims cannot occur through inflation alone. Suppliers of essentials probably will be able to honour most of their forward commitments, whilst many discretionary sectors will not.

Since our focus here is on inflation rather than on economic activity and prosperity, we need, for now, only glance – as in fig. 3 – at the future prospects for an economy in which prosperity has stopped expanding and started to contract, whilst the real costs of essentials carry on rising.

Discretionary activities will shrink, whilst capital investment can be expected to diminish in a process that demands ever greater returns on capital.

On inflation, our conclusion needs to be that pressures will continue for as long as it takes for the restoration of equilibrium between the ‘real economy’ of energy, goods and services and the ‘financial economy’ of asset values, money and credit.

Within this overall trend, the prices of essentials will continue to out-pace those of discretionaries as the segmental mix of consumption and investment realigns.

For the authorities, this poses a difficult challenge, because many emerging trends will be unpalatable to a public which has been sold the myth of ‘growth in perpetuity’.

Whilst we can – perhaps – assume that no government or central bank would be so unwise as to try to use stimulus to counter inflation, there are two ways in which the authorities could make this worse.

One way would be to carry on trying to ignore, or unintentionally misunderstand, the forces that are manifesting as inflation.

The other would be to try to favour some interest groups over others.

Fig. 3