#150: The management of hardship

GOVERNMENT AND POLITICS IN AN AGE OF DETERIORATING PROSPERITY

Though just over a month has passed since the previous article (for which apologies), work here hasn’t slackened. Rather, I’ve been concentrating on three issues, all of them important, and all of them topics where a recognition of the energy basis of the economy can supply unique insights.

The first of these is the insanity which says that no amount of financial recklessness is ever going to drive us over a cliff, because creating new money out of thin air is our “get out of gaol free card” in all circumstances.

This isn’t the place for the lengthy explanation of why this won’t work, but the short version is that we’re now trying to do for money what we so nearly did to the banks in 2008.

The second subject is the very real threat posed by environmental degradation, where politicians are busy assuring the public that the problem can be fixed without subjecting voters to any meaningful inconvenience – and, after all, anyone who can persuade the public that electric vehicles are “zero emissions” could probably sell sand to the Saudis.

And this takes us to the third issue, the tragicomedy that it is contemporary politics – indeed, it might reasonably be said that, between them, the Élysée and Westminster, in particular, offer combinations of tragedy, comedy and farce that even the most daring of theatre directors would blush to present.

From a surplus energy perspective, the political situation is simply stated.

SEEDS analysis of prosperity reveals that the average person in almost every Western country has been getting poorer for at least a decade.

Governments, which continue to adhere to outdated paradigms based on a purely financial interpretation of the economy, remain blind to the voters’ plight – and, all too often, this blindness looks a lot like indifference. Much of the tragedy of politics, and much of its comedy, too, can be traced to this fundamental contradiction between what policymakers think is happening, and what the public knows actually is.

Nowhere is the gap in comprehension, and the consequent gulf between governing and governed, more extreme than in France – so that’s as good a place as any to begin our analysis.

The French dis-connection

Let’s start with the numbers, all of which are stated in euros at constant 2018 values, with the most important figures set out in the table below.

Between 2008 and 2018, French GDP increased by 9.4%, equivalent to an improvement of 5.0% at the per capita level, after adjustment for a 4.2% rise in population numbers. This probably leads the authorities to believe that the average person has been getting at least gradually better off so, on material grounds at least, he or she hasn’t got too much to grumble about.

Here’s how different these numbers look when examined using SEEDS. For starters, growth of 9.4% since 2008 has increased recorded GDP by €201bn, but this has been accompanied by a huge €2 trillion (40%) rise in debt over the same decade. Put another way, each €1 of “growth” has come at a cost of €9.90 in net new debt, which is a ruinously unsustainable ratio. SEEDS analysis indicates that most of that “growth” – in fact, more than 90% of it – has been nothing more substantial than the simple spending of borrowed money.

#150 France SEEDS summary

This is important, for at least three main reasons.

First, and most obviously, a reported increase of €1,720 in GDP per capita has been accompanied by a rise of almost €27,500 in each person’s share of aggregate household, business and government debt.

Second, if France ever stopped adding to its stock of debt, underlying growth would fall, SEEDS calculates, to barely 0.2%, a rate which is lower than the pace at which population numbers are growing (about 0.5% annually).

Third, much of the “growth” recorded in recent years would unwind if France ever tried to deleverage its balance sheet.

Then there’s the trend energy cost of energy (ECoE), a critical component of economic performance, and which, in France, has risen from 5.9% in 2008 to 8.0% last year. Adjustment for ECoE reduces prosperity per person in 2018 to €27,200, a far cry from reported per capita GDP of €36,290. Moreover, personal prosperity is lower now than it was back in 2008 (€28,710 per capita).

Thus far, these numbers are not markedly out of line with the rate at which prosperity has been falling in comparable economies over the same period. The particular twist, where France is concerned, is that taxation per person has increased, by €2,140 (12%) since 2008. This has had the effect of leveraging a 5.3% (€1,510) decline in overall personal prosperity into a slump of 32% (€3,650) at the level of discretionary, ‘left in your pocket’ prosperity.

At this level of measurement, the average French person’s discretionary prosperity is now only €7,760, compared with €11,410 ten years ago.

And that hurts.

Justified anger

Knowing this, one can hardly be surprised that French voters rejected all established parties at the last presidential election, flirting with the nationalist right and the far left before opting for Mr Macron. Neither can it be any surprise at all that between 72% and 80% of French citizens support he aims of the gilets jaunes (yellow waistcoat) protestors. “Robust” law enforcement, whilst it might just temper the manifestation of this discontent, will have the almost inevitable side-effect of exacerbating the mistrust of the incumbent government.

Because energy-based analysis gives us insights not available to the authorities, we’re in a position to understand the sheer folly of some French government policies, both before and since the start of the protests.

From the outset, there were reasons to suspect that the gloss of Mr Macron’s campaign hid a deep commitment to failed economic nostrums. These nostrums include the bizarre belief that an economy can be energized by undermining the rights and rewards of working people – the snag being, of course, that the circumstances of these same workers determine demand in the economy.

After all, if low wages were a recipe for prosperity, Ghana would be richer than Germany, and Swaziland more prosperous than Switzerland.

Handing out huge tax cuts to a tiny minority of the already very wealthiest, though always likely to be at the forefront of Mr Macron’s agenda, looks idiotically provocative when seen in the context of deteriorating average prosperity. Creating a national dialogue over the protestors’ grievances might have made sense, but choosing a political insider to preside over it, at a reported monthly salary of €14,666, reinforced a widespread suspicion that the Grand Debat is no more than an exercise in distraction undertaken by an administration wholly out of touch with voters’ circumstances.

Whilst Mr Macron has appeared flexible over some fiscal demands, he has ruled out increasing the tax levied on the wealthiest. This intransigence is likely to prove the single biggest blunder of his presidency.

Even the tragic fire at Notre Dame has been mishandled by the government, in ways seemingly calculated to intensify suspicion. Rather than insisting that the restoration of the state-owned Cathedral would be funded by the government, the authorities made the gaffe of welcoming offers of financial support from some of the most conspicuously wealthy people in France.

This prompted some to wonder when corporate logos would start to appear on the famous towers, and others to ask why, if the wealthiest wanted to make a contribution, they couldn’t have been asked to do so by paying more tax. It didn’t help that the authorities rushed to declare the fire an accident, long before the experts could possibly have had evidence sufficient to rule out more malign explanations. After all, in an atmosphere of mistrust, conspiracy theories thrive.

The broader picture

The reason for looking at the French predicament in some detail is that the problems facing the authorities in Paris are different only in degree, and not in direction or nature, from those confronting other Western governments.

The British political impasse over “Brexit”, for instance, can be traced to the same lack of awareness of what is really happening to the prosperity of the voters – whilst “Brexit” itself divides the electorate, there is something far closer to unanimity over a narrative that politicians are as ineffectual as they are self-serving, and are out of touch with real public concerns. Similar factors inform popular discontent in many other European countries, even when this discontent is articulated over issues other than the deterioration in prosperity.

At the most fundamental level, the problem has two components.

The first is that the average person is getting poorer, and is also getting less secure, and deeper into debt.

The second is that governments don’t understand this issue, an incomprehension which, to increasing numbers of voters, looks like indifference.

It has to be said that governments have no excuses for this lack of understanding. The prosperity of the average person in most Western countries began to fall more than a decade ago, and any politician even reasonably conversant with the circumstances and opinions of the typical voter ought to be aware of it, even if he or she lacks the interpretation or the information required to explain it.

Governments whose economic advisers and macroeconomic models are still failing to identify the slump in prosperity need new advisers, and new models.

A disastrous consensus

Though incomprehension (and adherence to failed economic interpretations) is the kernel of the problem, it has been compounded by the mix of philosophies adopted since the 1990s. Following the collapse of the Soviet Union, an informal consensus was created in which the Left accepted the market economics paradigm, and the centre-Right tried to be ‘progressive’ on social issues.

Both moves robbed voters of choices.

Though the social policy dimension lies outside our focus on the economy, the creation of a pro-market ‘centre-Left’ has turned out to have been nothing less than a disaster. Specifically, it has had two, woefully adverse consequences.

The first was that the Left’s adoption of its opponents’ economic orthodoxy destroyed the balance of opposing philosophies which, hitherto, had kept in place the ‘mixed economy’, a model which aims to combine the best of the private and the public sector provision. The emergence of Britain’s “New Labour”, and its overseas equivalents, eliminated the checks and balances which, historically, had acted to rein in extremes.

Put another way, the traditional ‘Left versus Right’ debate created constructive tensions which forced both sides to hone their messages, as well as preventing a lurch into extremism which, whilst it might sometimes be good politics, is invariably very bad economics.

The second, of course, was that the new centre-ground – variously dubbed the “Washington consensus”, the “Anglo-American model” and “neoliberalism” – has proved to be an utterly disastrous exercise in economic extremism. One after another, its tenets have failed, creating massive indebtedness, huge financial risk and widening inequality before finally presiding over the wholesale replacement of market principles with the “caveat emptor” free-for-all of what I’ve labelled “junglenomics”.

As well as undermining economic efficiency, these developments have created extremely harmful divisions in society. Whilst Thomas Piketty’s thesis about the divergence of returns on capital and labour is not persuasive, the reality since 2008 has been that asset prices have soared, whilst incomes have stagnated. This process, which has been the direct result of monetary policy, has rewarded those who already owned assets in 2008, and has done nothing for the less fortunate majority.

There is a valid argument, of course, which states that the authorities’ adoption of ultra-cheap money during and after the 2008 global financial crisis (GFC I) was the only course of action available.

But the role of policymakers is to pursue the overall good within whatever the economic and financial context happens to be. So, when central bankers launched programmes clearly destined to create massive inflation in asset prices, governments should have responded with fiscal measures tailored to capture at least some of these gains for the unfavoured majority.

Simply put, the unleashing of ZIRP and QE made a compelling case for the simultaneous introduction of higher taxes on capital gains, complemented by wealth taxes in those countries where these did not already exist.

Failure to do this has hardened incompatible positions. Those whose property values have soared insist, often with absolute sincerity, that their paper enrichment is the product entirely of their own diligence and effort, owes nothing to the luck of being in the right place at the right time, has had nothing whatever to do with the price inflation injected into property markets (in particular) by ultra-cheap monetary policies, and hasn’t happened at the expense of others.

For any younger person, often unable to afford or even find somewhere to live, it is necessarily infuriating to be lectured by fortunate elders on the virtues of saving and hard work.

It’s a bit like a lottery winner criticizing you for buying the wrong ticket.

A workable future

The silver lining to these various clouds is that future policy directions have been simplified, with the paramount objectives being (a) the healing of divisions, and (b) managing the deterioration in prosperity in ways that maximise efficiency and minimise division.

Any government which understands what prosperity is and where it is going will also reach some obvious but important conclusions.

The first is that prosperity issues have risen higher on the political agenda, and will go on doing so, pushing other issues down the scale of importance.

The second conclusion, which carries with it what is probably the single most obvious policy implication, is that redistribution is becoming an ever more important issue. There are two very good reasons for this hardening in sentiment.

For starters, popular tolerance of inequality is linked to trends in prosperity – resentment at “the rich” is muted when most people are themselves getting better off, but this tolerance very soon evaporates when subjected to the solvent of generalised hardship.

Additionally, the popular narrative of the years since 2008 portrays “austerity” as the price paid by the many for the rescue of the few. The main reason why this narrative is so compelling is that, fundamentally, it is true.

The need for redistribution is reinforced by realistic appraisal of the fiscal outlook. Anyone who is aware of deteriorating prosperity has to be aware that this has adverse implications for forward revenues. By definition, only prosperity can be taxed, because taxing incomes below the level of prosperity simply drives people into hardships whose alleviation increases public expenditures.

In France, for example, aggregate national prosperity is no higher now (at €1.76tn) than it was in 2008, but taxation has increased by 17% over that decade. Looking ahead, the continuing erosion of prosperity implies that rates of taxation on the average person will need to fall, unless the authorities wish further to tighten the pressure on the typical taxpayer.

Even the inescapable increase in the taxation of the very wealthiest isn’t going to change a scenario that dictates lower taxes, and correspondingly lower public expenditures, as prosperity erodes.

A new centre of gravity?

The adverse outlook for government revenues is one reason why the political Left cannot expect power to fall into its hands simply as a natural consequence of the crumbling of failed centre-Right incumbencies. Those on the Left keen to refresh their appeal by cleansing their parties of the residues of past compromises have logic on their side, but will depart from logic if they offer agendas based on ever higher levels of public expenditures.

With prosperity – and, with it, the tax base – shrinking, promising anything that looks like “tax and spend” has become a recipe for policy failure and voter disillusionment. This said, so profound has been the failure of the centre-Right ascendancy that opportunities necessarily exist for anyone on the Left who is able to recast his or her agenda on the basis of economic reality.

Tactically, the best way forward for the Left is to shift the debate on equality back to the material, restoring the primacy of the Left’s traditional concentration on the differences and inequities between rich and poor.

On economic as well as fiscal and social issues, we ought to see the start of a “research arms race”, as parties compete to be the first to absorb, and profit from, the recognition of economic realities that are no longer (if they ever truly were) identified by outdated methods of economic interpretation.

Historically, the promotion of ideological extremes has always been a costly luxury, so is likely to fall victim to processes that are making luxuries progressively less affordable. Voters can be expected to turn away from the extremes of pro- public- or private-sector promotion, seeing neither as a solution to their problems.

This, it is to be hoped, can lead to a renaissance in the idea of the mixed economy, which seeks to get the best out of private and public provision, without pandering to the excesses of either. Restoration of this balance, from the position where we are now, means rolling back much of the privatization and outsourcing undertaken, often recklessly, over the last three decades.

Both the private and the public sectors will need to undergo extensive reforms if governments are to craft effective agendas for using the mixed economy to mitigate the worst effects of deteriorating prosperity.

In the private sector, governments could do a lot worse than study Adam Smith, paying particular attention to the explicit priority placed by him on promoting competition and tackling excessive market concentration, and recognizing, too, the importance both of ethics and of effective regulation, both of which are implicit in his recognition that markets will not stay free or fair if left to their own devices.

For the public sector, both generally and at the level of detail, there will need to be a renewed emphasis on the setting of priorities. With resource limitations set not just to continue but to intensify, health systems, for example, will need to become a lot clearer on which services they can, and cannot, afford to fund.

Starting from here

Though this discussion can be no more than a primer for discussion, there are two points on which we can usefully conclude.

First, a useful opening step in the crafting of new politics would be the introduction of “clean hands” principles, designed to prove that government isn’t, as it can so often appear, something conducted “by the rich, for the rich”.

Second, it would be helpful if governments rolled back their inclinations towards macho posturing and intimidation.

A “clean hands” initiative wouldn’t mean that elected representatives would be paid less than currently they are. There is an essential public interest in attracting able and ambitious people into government service, so there’s nothing to be said for hair-shirt commitments to penury. In most European countries, politicians are not overpaid, and it’s arguable that their salaries ought, in some cases at least, to be higher.

There is, though, a real problem, albeit one that is easily remedied. This problem lies in the perception that politics has become a “road to riches”, with policymakers retiring into the wealth bestowed on them by the corporate sponsors of ‘consultancies’ and “the lecture circuit”. This necessarily creates suspicion that rewards are being conferred for services rendered, a suspicion that is corrosive of public trust, even where it isn’t actually true.

The easy fix for this is to cap the earnings of former ministers and administrators at levels which are generous, but are well short of riches. The formula suggested here in a previous discussion would impose an annual income limit at 10x GDP per capita, which is about £315,000 in Britain, with not-dissimilar figures applying in other countries. It seems reasonable to conclude that anyone who thinks that £300,000, or its equivalent, “isn’t enough” is likely to have gone into politics for the wrong reasons.

Where treatment of the “ordinary” person is concerned, there ought, in the future, be no room for the intimidatory practices which have become ever more popular with governments whose real authority has been weakened by failure.

One illustrative example is the system by which council tax (local taxation) arrears are collected in Britain. At present, the typical homeowner pays £1,671 annually, in ten monthly instalments. If someone misses a payment, however, he or she is then required to pay the entire annual amount almost immediately, compounded by court costs of £84 and bailiff fees of £310. Quite apart from the inappropriateness of involving the courts or employing bailiffs, it’s hard to see how somebody struggling to pay £167 is supposed to find £2,067.

This same kind of intimidation occurs when people are penalized for staying a few minutes over a parking permit, or for exceeding a speed limit by a fractional extent. Here, part of the problem arises from providing financial incentives to those enforcing regulations, a practice that should be abandoned by any government aware of the need to start narrowing the chasm between governing and governed.

We cannot escape the conclusion that the task of government, always a thankless one even when confined to sharing out the benefits of growth, is going to become very difficult indeed as prosperity continues to deteriorate.

There might, though, be positives to be found in a process which ditches ideological extremes, uses the mixed economy as the basis for the equitable mitigation of decline, and seeks to rebuild relationships between discredited governments and frustrated citizens.

#148: Where now for energy?

WHY SUBSIDY HAS BECOME INESCAPABLE

What happens when energy prices are at once too high for consumers to afford, but too low for suppliers to earn a return on capital?

That’s the situation now with petroleum, but it’s likely to apply across the gamut of energy supply as economic trends unfold. On the one hand, prosperity has turned down, undermining what consumers can afford to spend on energy. On the other, the real cost of energy – the trend energy cost of energy (ECoE) – continues to rise.

In any other industry, these conditions would point to contraction – the amount sold would fall. But the supply of energy isn’t ‘any other industry’, any more than it’s ‘just another input’. Energy is the basis of all economic activity – if the supply of energy ceases, economic activity grinds to a halt. (If you take a moment to think through what would happen if all energy supply to an economy were cut off, you’ll see why this is).

Without continuity of energy, literally everything stops. But that’s exactly what would happen if the energy industries were left to the mercies of rising supply costs and dwindling customer resources.

This leads us to a finding which is as stark as it is (at first sight) surprising – we’re going to have to subsidise the supply of energy.

Critical pre-conditions

Apart from the complete inability of the economy to function without energy, two other, critical considerations point emphatically in this direction.

The first is the vast leverage contained in the energy equation. The value of a unit of energy is hugely greater than the price which consumers pay (or ever could pay) to buy it. There is an overriding collective interest in continuing the supply of energy, even if this cannot be done at levels of purchaser prices which make commercial sense for suppliers.

The second is that we already live in an age of subsidy. Ever since we decided, in 2008, to save reckless borrowers and reckless lenders from the devastating consequences of their folly, we’ve turned subsidy from anomaly into normality.

The subsidy in question isn’t a hand-out from taxpayers. Rather, supplying money at negative real cost subsidizes borrowers, subsidizes lenders and supports asset prices at levels which bear no resemblance to what ‘reality’ would be under normal, cost-positive monetary conditions.

In the future, the authorities are going to have to do for energy suppliers what they already do for borrowers and lenders – use ‘cheap money’ to sustain an activity which is vital, but which market forces alone cannot support.

How they’ll do this is something considered later in this discussion.

If, by the way, you think that the concept of subsidizing energy supply threatens the viability of fiat currencies, you’re right. The only defence for the idea of providing monetary policy support for the supply of energy is that the alternative of not doing so is even worse.

Starting from basics  

To understand what follows, you need to know that the economy is an energy system (and not a financial one), with money acting simply as a claim on output made possible only by the availability of energy. This observation isn’t exactly rocket-science, because it is surely obvious that money has no intrinsic worth, but commands value only in terms of the things for which it can exchanged.

To be slightly more specific, all economic output (other than the supply of energy itself) is the product of surplus energy – whenever energy is accessed, some energy is always consumed in the access process, and surplus energy is what remains after the energy cost of energy (ECoE) has been deducted from the total (or ‘gross’) amount that is accessed.

From this perspective, the distinguishing feature of the world economy over the last two decades has been the relentless rise in ECoE. This process necessarily undermines prosperity, because it erodes the available quantity of surplus energy. We’re already seeing this happen – Western prosperity growth has gone into reverse, and growth in emerging market (EM) economies is petering out. Global average prosperity has already turned down.

From this simple insight, much else follows – for instance, our recent, current and impending financial problems are caused by a collision between (a) a financial system wholly predicated on perpetual growth in prosperity, and (b) an energy dynamic that has already started putting prosperity growth into reverse. Likewise, political changes are likely to result from the failure of incumbent governments to understand the worsening circumstances of the governed.

Essential premises – leverage and subsidy

Before we start, there are two additional things that you need to appreciate.

The first is that the energy-economics equation is hugely leveraged. This means that the value of energy to the economy is vastly greater than the prices paid (or even conceivably paid) for it by immediate consumers. Having (say) fuel to put in his or her car is a tiny fraction of the value that a person derives from energy – it supplies literally all economic goods and services that he or she uses.

The second is that, ever since the 2008 global financial crisis (GFC I) we have been living in a post-market economy.

In practice, this means that subsidies have become a permanent feature of the economic landscape.

These issues are of fundamental importance, so much so that a brief explanation is necessary.

First, leverage. The energy content of a barrel of crude oil is 5,722,000 BTU, which converts to 1,677kwh, or 1,677,022 watt-hours. BTUs and watt-hours are ‘measures of work’ applicable to any source or use of energy. Human labour equates to about 75 watts per hour, so a barrel of crude equates to 22,360 hours of labour. At the (pretty low) rate of $10 per hour, this labour would cost an employer $223,603. Yet crude oil changes hands for just $65 which, undeniably, is a bargain. If the price of oil soared to $1,000/b, it would wreck the economy – but it would still be an extremely low price, when measured against an equivalent amount of human effort.

The economy, then, could be crippled by energy prices that would still be ultra-cheap in purely energy-content terms. More to the point, this could happen at prices that were still too low to ensure profitability in the business of energy supply.

The comparison between petroleum and its labour equivalent is meant to be solely illustrative – the relevant point is that the economy is gigantically leveraged to the ‘work value’ contained in all exogenous energy sources.

Second, the end of the market economy. The market economy works on a system of impersonal rewards and penalties. If you make shrewd investments, you’re likely to make a profit – but, if you act recklessly (or simply have a run of bad lack), you stand to lose everything. Failure, as penalised impersonally by market forces, is the flip-side of reward, itself (in theory) equally impersonal. Logically, market forces don’t allow you to have reward without the risk of failure. Using debt to leverage your position acts to increase both the scope for profit and the potential for loss.

The 2008 crisis was a culminating failure of reckless financial behaviour, by individuals, businesses, banks, regulators and policymakers. Left simply to the workings of the market, the penalties would have been on a scale commensurate with the preceding folly. Individuals and businesses which had taken on too much debt would have been bankrupted, as would those who had lent recklessly to them. If market forces had been allowed to work through to their logical conclusions, 2008 would have seen massive failures, bankruptcies and defaults – spreading out from those who ‘deserved’ to be wiped out to take in ‘bystanders’ with varying degrees of ‘innocence’ – whilst asset prices would have collapsed, and much of the banking system, as the primary supplier of credit, would have been destroyed.

Some economic purists have argued that this is exactly what should have happened, and that we will in due course pay a huge price for the ‘moral hazard’ of rescuing the reckless from the consequences of their actions.

They might well be right.

Be that as it may, though,  the point is that market forces were not allowed to work out to their logical conclusions. As well as simply rescuing the banks, the authorities set out on the wholesale rescue of anyone who had taken on too much debt. This was done primarily by slashing interest rates to levels that are negative in real terms (lower than inflation). Though described at the time as “temporary” and “emergency” in nature, these interventions are, for all practical purposes, permanent.

There’s irony in the observation that, though idealists of ‘the Left’ have dreamed since time immemorial of overthrowing the ‘capitalist’ system, the market economy has not been destroyed by its foes, but abandoned by its friends.

The Age of Subsidy

Critically for our purposes, what began in 2008 and continues to this day is wholesale subsidy. ZIRP has provided emergency and continuing sustenance for everyone who had borrowed recklessly in the years preceding the crash. It has also multiplied the incentive to borrow. Negative real interest rates are nothing more nor less than a hand-out to distressed borrowers, not only sparing them from debt service commitments that they could no longer afford, but inflating the market value of their investments, too.

Though less obvious than its beneficiaries, this subsidy has turned huge numbers into victims. Savers, including those putting resources aside for pensions, have been only the most visible of these victims. We cannot know who might have prospered had badly-run, over-extended businesses gone to the wall rather than continuing, in subsidised, “zombie” form, to occupy market space that might more productively have gone to new entrants. We do know that the young are victims of deliberate housing cost inflation.

There’s nothing new about subsidies, of course, and governments have often subsidised activities, either because these are seen to be of national importance, or because they have pandered to the influential interests on whom the subsidies have been bestowed.

Purists of the free market persuasion have long castigated subsidies as distortions of economic behaviour and they are, theoretically at least, quite right to think this.

The point, though, is that, since 2008, the entire economy has been made dependent on the subsidy of money priced at negative real levels.

Anyone who is ‘paid to borrow’ is, of necessity, in receipt of subsidy.

That we live in ‘the age of subsidy’ has a huge bearing on the outlook for energy. With this noted, let’s return to the role of energy in prosperity.

Prosperity in decline – turning-points and differentials

As we’ve noted, once the Energy Cost of (accessing) Energy – ECoE – passes a certain point, the remaining energy surplus becomes insufficient to grow prosperity, or even to sustain it. This point has now been reached or passed in almost all Western economies, so prosperity in those countries has turned down. Efforts to use financial adventurism to counter this effect have done no more than mask (since they cannot change) the processes that are undercutting prosperity, but have, in the process, created huge and compounding financial risks.

In the emerging market (EM) economies, prosperity continues to improve, but no longer at rates sufficient to offset Western decline. Global prosperity per person has now turned downwards from an extremely protracted plateau, meaning that the world has now started getting poorer. Amongst many other things, this means that a financial system predicated on the false assumption of infinite growth is heading for some form of invalidation. It also poses political and social challenges to which existing systems are incapable of adaption.

How, though, does the energy-prosperity equation work – and what can this tell us about the outlook for energy itself?

According to SEEDS (the Surplus Energy Economics Data System), global prosperity stopped growing when trend ECoE hit 5.4%. It might, at first sight, seem surprising that subsequent deterioration has been very gradual, even though ECoE has carried on rising relentlessly, now standing at 8.0%. This apparent contradiction is really all about the changing geographical mix involved – until recently, deterioration in Western prosperity had been offset by progress in EM countries, because the ECoE/growth thresholds differ between these two types of system.

Essentially, EM economies seem to be capable of continuing to grow their prosperity at levels of ECoE a lot higher than those which kill prosperity growth in Western countries.

The following charts illustrate the comparison, and show prosperity per capita (at constant 2018 values) on the vertical axis, and trend ECoE on the horizontal axis. For comparison with America, the China chart shows prosperity in dollars, converted at market exchange rates (in red) and on the more meaningful PPP basis of conversion (blue). For reference, ECoE at 6% is shown as a vertical line on both charts.

#148 energy comp US CH

As you can see, American prosperity had already turned down well before ECoE reached 6%. Chinese prosperity has carried on growing even though ECoE is now well above the 6% level.

How can China carry on getting more prosperous at levels of ECoE at which prosperity has already turned down, not just in America but in almost every other advanced economy?

There seem to be two main reasons for the different relationships between prosperity and ECoE in advanced and EM economies.

First, prosperity isn’t exactly the same thing in a Western or an EM economy – put colloquially, how prosperous you feel depends on where you live, and where you started from.

In America, SEEDS shows that prosperity per person peaked in 2005 at $48,660 per person (at 2018 values), and had fallen to $44,830 (-7.9%) by 2018. Over the same period, prosperity per person in China rose by an impressive 84% – but was still only $9,670 per person last year. Even that number is based on PPP conversion to dollars – converted into dollars at market exchange rates, prosperity per person in China last year was just $5,130.

Both numbers are drastically lower than the equivalent number for the United States. Not surprisingly, Chinese people feel (and are) more prosperous than they used to be, even at levels of prosperity that would amount to extreme impoverishment in America. Before anyone says that “America is a more expensive place to live”, conversion at PPP rates is supposed to take account of cost differentials – and, even in PPP terms, the average Chinese citizen is 78% poorer than his or her American equivalent.

The second critical differential lies in relationships between countries. Historically, trade relationships favoured Western over EM economies, though this has been changing, perhaps helping to explain the gradual narrowing in personal prosperity between developed and emerging countries.

Moreover, there are often quirks in the relationships between countries, even where they belong to the same broad ‘advanced’ or ‘emerging’ economic grouping. Germany is an example of this, having benefited enormously from a currency system which has been detrimental to other (indeed, almost every other) Euro Area country. For some time, Ireland, too, was a beneficiary of EA membership, though those benefits have eroded since the period of “Celtic Tiger” financial excess.

The conclusion, then, is that there’s no ‘one size fits all’ answer to the question of ‘where does ECoE kill growth?’, just as prosperity means different things in different types of economy.

It should also be noted that China’s ability to keep on growing prosperity at quite high levels of ECoE is not necessarily a good guide to the future. As things stand, China’s economy, driven as it by extraordinary levels of borrowing, is looking ever more like a Ponzi scheme facing a denouement.

The situation so far

Given how much ground we’ve covered, let’s take stock briefly of where we are.

We’ve observed, first, that the rise in trend ECoEs is in the process of undermining prosperity. Much of this has already happened – prosperity in most Western economies has now been deteriorating for at least a decade, whilst continued progress in EM economies is no longer enough to keep the global average stable. As ECoEs continue to rise, what happens next is that EM prosperity itself turns down, a process which will accelerate the rate at which global prosperity declines. SEEDS already identifies one major EM economy (other than China) where strong growth in prosperity will soon go into reverse.

Second, a world financial system predicated entirely on perpetual ‘growth’ in prosperity has become dangerously over-extended. Again, this observation isn’t something new. The inauguration, more than ten years ago, of mass subsidy for borrowers and lenders surely tells us that we’ve entered a new ‘era of abnormality’, in which subsidy is normal, and where historic principles (such as positive returns on capital) no longer apply.

If you stir energy leverage into this equation, an inescapable conclusion emerges. It is that we’re going to have to extend our current acceptance of ‘financial adventurism’ to the point where energy supply, just like borrowers and lenders, becomes supported by monetary subsidy.

The only way in which this might not happen would be if we could somehow escape from the implications of rising ECoE. Some believe that renewables will enable us to do this – after all, just as trend ECoEs for oil, gas and coal keep rising, those of wind and solar continue to move downwards.

This situation is summarised in the first of the following charts, which shows broad ECoE trends over the period (1980-2030) covered by SEEDS. As recently as 2000, the aggregate trend ECoE of renewables (shown in green) was above 13%, compared with only 4.1% for fossil fuels (shown in grey). Renewables are already helping to blunt the rise in ECoE, such that the overall number (in red) is lower than that of fossil fuels alone. We’re now pretty close to the point where the ECoE of renewables will be below that of fossil fuels.

On this basis, it’s become ‘consensus wisdom’ to assume that renewables will, like the 7th Cavalry, ‘ride to the rescue in the final reel’. Unfortunately, this comforting assumption rests on three fallacies.

The first is “the fallacy of extrapolation”, which is a natural human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. (One of my mentors in my early years in the City called this “the fallacy of the mathematical dachshund”). The reality is much likelier to be that technical progress in renewables (including batteries) will slow when it starts to collide with the limits imposed by physics.

The second fallacy is that projections for cost reduction ignore the derivative nature of renewables. Building, say, a solar panel, a wind turbine or an electrical distribution system requires inputs currently only available courtesy of the use of fossil fuels. In this specialised sense, solar and wind are not so much ‘primary renewables’ as ‘secondary applications of primary fossil input’.

We may reach the point where these technologies become ‘truly renewable’, in that their inputs (such as minerals and plastics) can be supplied without help from oil, gas or coal.

But we are certainly, at present, nowhere near such a breakthrough. Until and unless this point is reached, the danger exists that that the ECoE of renewables may start to rise, pushed back upwards by the rising ECoE of the fossil fuel sources on which so many of their inputs rely. This is illustrated in the second chart, which looks at what might happen beyond the current time parameters of SEEDS. In this projection, progress in reducing the ECoEs of renewables goes into reverse because of the continued rise in fossil-derived inputs.

#148 energy comp segments

The third problem is that, even if renewables were able to stabilise ECoE at, say, 8% or so, that would not be anywhere near low enough.

Global prosperity stopped growing before ECoE hit 6%. British prosperity has been in decline ever since ECoE reached 3.6%, and an ECoE of 5.5% has been enough to push Western prosperity growth into reverse.

As recently as the 1960s, in what we might call a “golden age” of prosperity growth – when economies were expanding rapidly, and world use of cheap petroleum was rising at rates of up to 8% annually – ECoE was well below 2%.

In other words, even if renewables can stabilise ECoE at 8% – and that’s a truly gigantic ‘if’ – it won’t be low enough to enable prosperity to stabilise, let alone start to grow again.

Energy and subsidy –  between Scylla and Charybdis

The idea that we might need to subsidise energy ‘for the greater economic good’ is a radical one, but is not without precedent. Though the development of renewables has been accelerated in various countries by subsidies provided either by taxpayers or by consumers, the important precedent here doesn’t come from the solar or wind sectors, but from the production of oil from shales.

There can be no doubt that shale liquids, primarily from the United States, have transformed petroleum markets – without this production, it’s certain that supplies would have been lower, and prices could well have been a lot higher. Yet the supply of shale has owed little or nothing to the untrammelled working of the market. Rather, shale has received enormous subsidy.

Repeated studies have shown that shale liquids production isn’t ‘profitable’, because cash flow generated from the sale of production has never been sufficient to cover the industry’s capital costs, let alone to provide a return on capital as well. The economics of shale are too big a subject to be examined here, but the critical point is the rapidity with which production declines once a well is put on stream. This means that any company wanting to expand (or even to maintain) its level of production needs to keep drilling new wells – this is the “drilling treadmill” which, critically, has always needed more investment than cash flow from operations can supply.

Yet shale investment has continued, despite its record of generating negative free cash flow. It’s easy to attribute this to the support provided by gullible investors, but the broader picture is that shale producers, like ‘cash burners’ in other sectors, have been kept afloat by a tide of ultra-cheap capital made available by the negative real cost of capital.

In all probability, this is the pattern likely to be followed by the energy industries more generally, as profitability is crushed between the Scylla of rising costs and the Charybdis of straitened consumer circumstances.

In short, we’re probably going to have to ‘create’ the money to keep energy supplies flowing. If the argument becomes one in which energy is described as ‘too important to be left to the market’, energy will join a growing cast of characters – including borrowers, lenders and ‘zombie’ companies – kept in existence by the subsidy of cheap money.

 

#143: Fire and ice, part one

TRAUMA FOR THE TAX-MAN

Is 2019 the year when everything starts falling apart?

It certainly feels that way.

The analogy I’m going to use in this and subsequent discussions is ‘fire and ice’.

Ice, in the potent form of glaciers, grinds slowly, but completely, crushing everything in its path. Whole landscapes have been shaped by these icy juggernauts.

Fire, on the other hand, can cause almost instantaneous devastation, most obviously when volcanoes erupt. Back in 1815, the explosion of Mount Tambora in the Dutch East Indies (now Indonesia) poured into the atmosphere quantities of volcanic ash on such a vast scale that, in much of the world, the sun literally ceased to shine. As a result, 1816 became known as “the year without a summer”. As low temperatures and heavy rain destroyed harvests and killed livestock, famine gripped much of Europe, Asia and North America, bringing with it soaring food prices, looting, riots, rebellions, disease and high mortality. Even art and literature seem to have been influenced by the lack of a summer.

The economic themes we’ll be exploring here have characteristics both of fire and of ice. The decline in prosperity is glacial, both in its gradual pace and its ability to grind assumptions, and systems, into the ground. Other events are likelier to behave like wild-fires or volcanoes, given to rapid and devastating outbursts, with little or no prior warning.

Fiscal issues, examined in this first instalment of ‘fire and ice’, have the characteristics of both. The scope for taxing the public is going to be subjected to gradual but crushing force, whilst the hard choices made inevitable by this process are highly likely to provoke extremely heated debate and resistance.

Let’s state the fiscal issue in the starkest terms:

– Massive credit and monetary adventurism have inflated GDP to the point where it bears little or no resemblance to the prosperity experienced by the public.

– But governments continue to set taxation as a percentage of GDP.

– As GDP and prosperity diverge, this results in taxation exacting a relentlessly rising share of prosperity.

– Governments then fail to understand the ensuing popular anger.

France illustrates this process to dramatic effect. Taxation is still at 54% of GDP, roughly where it’s been for many years. This no doubt persuades the authorities that they’ve not increased the burden of taxation. But tax now absorbs 70% of French prosperity, leading to the results that we’ve witnessed on the streets of Paris and other French towns and cities.

Few certainties

It’s been said that the two certainties in life are “death and taxes”, but ‘debt and taxes’ hold the key to fiscal challenges understood improperly – if at all – by most governments. The connection here is that debt (or rather, the process of borrowing) affects recorded GDP in ways which provide false comfort about the affordability of taxation – and therefore, of course, about the affordability of public services.

The subject of taxation, seen in terms of prosperity, leads straight to popular discontent, though that has other causes too. In order to have a clear-eyed understanding of public anger, by the way, we need to stick to what the facts tell us. I’ve never been keen on excuses like “the dog ate my homework” or “a space-man from Mars stole my wallet” – likewise, we should ignore any narrative which portrays voter dissatisfaction as wholly the product of “populism”, or of “fake news”, or even of machinations in Moscow or Beijing. All of these things might exist – but they don’t explain what’s happening to public attitudes.

The harsh reality is that, because prosperity has deteriorated right across the advanced economies of the West, we’re facing an upswell of popular resentment, at the same time as having to grapple with huge debt and monetary risk.

If you wanted to go anywhere encouraging, you wouldn’t start from here.

The public certainly has reasons enough for discontent. In the Western world, prosperity has been deteriorating for a long time, a process exacerbated by higher taxation. The economic system has been brought into disrepute, mutating from something at least resembling ‘the market economy’ into something seemingly serving only the richest. As debt has risen, working conditions, and other forms of security, have been eroded. We can count ourselves fortunate that the public doesn’t know – yet – that the pensions system has been sacrificed as a financial ‘human shield’ to prop up the debt edifice.

This at least sets an agenda, whether for 2019 or beyond. The current economic paradigm is on borrowed time, whilst public support can be expected to swing behind parties promoting redistribution, economic nationalism and curtailment of migration. Politicians who insist on clinging on to ‘globalised liberalism’ are likely to sink with it. The tax base is shrinking, requiring new priorities in public expenditure.

If you had to tackle this at all, you wouldn’t choose to do it with the “everything bubble” likely to burst, bringing in its wake both debt defaults and currency crises. But this process looks inescapable. With its modest incremental rate rises, so derided by Wall Street and the White House, the Fed may be trying to manage a gradual deflation of bubbles. If so, its intentions are worthy, but its chances of success are poor.

And, when America’s treasury chief asks banks to reassure the markets about liquidity and margin debt, you know (if you didn’t know already) that things are coming to the boil.

Tax – leveraging the pain

If it seems a little odd to start this series with fiscal affairs, please be assured that these are very far from mundane – indeed, they’re likely to shape much of the political and economic agenda going forward. The biggest single reason for upsets is simply stated – where prosperity and the ability to pay tax are concerned, policymakers haven’t a clue about what’s already happening.

Here’s an illustration of what that reality is. Expressed at constant values, personal prosperity in France decreased by €2,060, or 7.5%, between 2001 (€29,315) and 2017 (€27,250).

At first glance, you might be surprised that this has led to such extreme public anger, something not witnessed in countries where prosperity has fallen further. Over the same period, though, taxation per person in France has increased by €2,980. When we look at how much prosperity per person has been left with the individual, to spend as he or she chooses, we find that this “discretionary” prosperity has fallen from €13,210 in 2001 to just €8,230 in 2017.

That’s a huge fall, of €4,980, or 38%. Nobody else in Europe has suffered quite such a sharp slump in discretionary prosperity – and tax rises are responsible for more than half of it.

This chart shows how increases in taxation have leveraged the deterioration in personal prosperity in eight Western economies. The blue bars show the change in overall prosperity per capita between 2001 and 2017. Increases in taxation per person are shown in red.

#143 01

In the United Kingdom, for example, economic prosperity has deteriorated by 9.8% since 2001, but higher taxation has translated this into a 29.5% slump in discretionary prosperity. Interestingly, economic prosperity in Germany actually increased (by 8.2%) over the period, but higher taxes translated into a fall at the level of discretionary prosperity per person.

Prosperity and tax – Scylla and Charybdis

The next pair of charts, which use the United Kingdom to illustrate a pan-Western issue, show a problem which is already being experienced by the tax authorities, but is not understood by them.

The left-hand chart (expressed in sterling at constant 2017 values) shows a phenomenon familiar to any regular visitor to this site, but not understood within conventional economics. Essentially, GDP (in blue) and prosperity (in red) are diverging.

This is happening for two main reasons. One is the underlying uptrend in the energy cost of energy (ECoE). The second is the use of credit and monetary adventurism to create apparent “growth” in GDP in the face of secular stagnation. This, of course, helps explain why people are feeling poorer despite apparent increases in GDP per capita. Total taxation is shown in black, to illustrate the role of tax within the prosperity picture.

The right-hand chart shows taxation as percentages of GDP (in blue) and prosperity (in red). In Britain, taxation has remained at a relatively stable level in relation to GDP, staying within a 34-35% band ever since 1998, before rising to 36% in 2016 and 37% in 2017.

Measured as a percentage of prosperity, however, the tax burden has risen relentlessly, from 35% in 1998, and 44% in 2008, to 51% in 2017.

#143 02

Simply put, the authorities seem to be keeping taxation at an approximately constant level against GDP, not realising that this pushes the tax incidence upwards when measured against prosperity. The individual, however, understands this all too well, even if its causes remain obscure.

What this means, in aggregate and at the individual level, are illustrated in the next set of charts. These show the aggregate position in billions, and the per capita equivalent in thousands, of pounds sterling at 2017 values.

#143 03

As taxation rises roughly in line with GDP – but grows much more rapidly in terms of prosperity – discretionary prosperity, shown here in pink, becomes squeezed between the Scylla of falling prosperity and the Charybdis of rising taxation. The charts which follow are annotated to highlight how this ‘wedge effect’ is undermining discretionary prosperity.

#143 04

Finally, where the numbers are concerned, here’s the equivalent situation in France. As far back as 1998, tax was an appreciably larger proportion of GDP in France (51%) than in the United Kingdom (34%). By 2017, tax was absorbing 54% of GDP in France, compared with 37% in Britain.

This means that taxation in France already equates to 70% of prosperity, up from 53% in 1998. Even though the squeeze on overall prosperity (the pink triangle) has been comparatively modest so far (since 2001, a fall of 7.5%), the impact on discretionary prosperity (the blue triangle) has been extremely severe (39%). This is why so many French people are angry – and why their anger has crystallised around taxation.

#143 05

The political fall-out

When you understand taxation in relation to prosperity, you appreciate a challenge which the authorities in Western countries (and beyond) have yet to comprehend. Most of them probably think that, going forward, they can carry on pushing up taxation roughly in line with supposed “growth” in GDP. Presumably, they also assume that the public will accept this fiscal trajectory.

If they do make these assumptions, they’re in for a very rude awakening. The modest tax tinkering implemented in France, for instance, is most unlikely to quell the anger, even though it’s set to widen the deficit appreciably.

Politically, the leveraging effect of rising taxation feeds into a broader agenda which, so far, is either misinterpreted, or just not recognised at all, by the governing establishment.

Here, simply stated, are some of the issues with which governments are confronted:

Prosperity per person is continuing to deteriorate, typically at annual rates of between 0.5% and 1.1%, across the Western economies.

Rising taxation is worsening this trend, leading increasingly to popular resistance.

– The public believes (and not without reason) that immigration is exacerbating the decline in prosperity, both at the total and at the discretionary levels.

– Perceptions are that a small minority of “the rich” are getting wealthier whilst almost everyone else is getting poorer.

Politicians are seen as both heedless of the majority predicament and complicit in the enrichment of a minority.

The popular demands which follow from this are pretty clear.

Voters are going to be angered by the decline in their prosperity, and will become increasingly resistant to taxation. The greatest resentment will centre around “regressive” taxes, such as sales taxes and flat-rate levies, which hit poorest taxpayers hardest.

They’re going to demand more redistribution, meaning higher taxes on “the rich”, not just where income taxes are concerned, but also extending to taxes on wealth, capital gains and transactions.

Popular opposition to immigration is likely to intensify, as prosperity deteriorates and tax bites harder.

Finally, public anger about former ministers and administrators retiring into very lucrative employment is going to go on mounting.

A challenge – and an opportunity?

In terms of electoral politics, most established parties are singularly ill-equipped to confront these issues. Some on “the Left” do embrace the need for redistribution, but almost invariably think this is going to fund increases in public expenditures, which simply isn’t going to be possible.

Others oppose increasing taxes on the wealthiest, and fail to appreciate that fiscal mathematics, quite apart from public sentiment, are making this process inescapable.

On both sides of the conventional political divide there is, as yet, no awareness that economic trends are going to exert glacier-style downwards pressure on public spending. Nowhere within the political spectrum is there recognition of the consequent need to set new, more stringent priorities. In areas such as health and policing, declining real budgets mean that policymakers face hard choices between which activities can continue to be funded, and those which will have quietly to be dropped.

It seems almost inconceivable that established parties are going to recognise what faces them, and adapt accordingly. The “Left” is likely to cling to dreams of higher public expenditures, whilst the “Right” will try to fend off higher taxation of the wealthiest. Even insurgent (aka “populist”) parties probably have no idea about the tightening squeeze on what they can afford to offer to the voters. It’s likely that very few people in senior positions yet realise that an ultra-lucrative retirement into “consultancies” and “the lecture circuit” is set to become electorally toxic.

Politically, of course, problems for some can be opportunities for others. It wouldn’t be all that hard to craft an agenda which capitalises on these trends, promising, for example, much greater redistribution, ultra-tight limits on immigration, and capping the retirement earnings of the policy elite.

If you did promise these things, you’d probably be elected. Unfortunately, though, that’s the easy bit. The hard part is going to be grappling with the continuing decline in prosperity at the same time as fending off a financial crash.

How, having been voted into power, are you going to tell the voters that we’re all getting poorer, and that some public services are ceasing to be affordable within an ever more rigorous setting of priorities? And are they going to believe you when you tell them that the destruction of pensions is entirely the work of your predecessors? Finally, what are you going to do when one of the big endangered economies fails?

 

#142: Past, present and future

LOOKING BACK AND LOOKING FORWARD

As we near the end of a year that can certainly be called ‘interesting’, I’d like to reflect on what’s happened, what’s happening now, and what we might expect to happen going forward. I can’t be sure that this is the last article for 2018 but, in case it is, I’d like to thank everyone for their interest, their comments and their many invaluable contributions to the themes we discuss here – and, of course, to wish you a very merry Christmas and a happy and successful New Year.

Where Surplus Energy Economics, this site and SEEDS are concerned, this has been a memorable year. SEEDS – the Surplus Energy Economics Data System – was finally completed in early 2018, and, amongst other things, this has freed up time for more thematic analysis. It’s both humbling and gratifying to know that about 44,000 people have visited the site this year, another big increase over the preceding twelve months. Most importantly – though this is for you to judge – I like to think we’ve developed a pretty persuasive narrative of how the economy works, and how things are trending.

We can take less satisfaction in what we see around us. According to SEEDS, most of the Western economies have now been getting poorer for at least a decade – and, ominously, the ability of the emerging market economies to grow enough to offset this deterioration, and keep global prosperity static, seems to have ended. World prosperity per person has been on a remarkably long plateau at around $11,000 (constant values, PPP-converted), but has now started to erode.

Deteriorating prosperity might be ‘a new fact’ in the world as a whole, but it’s an established reality in the West – with the single exception of Germany (rather a special case), no developed economy covered by SEEDS has enjoyed any improvement in prosperity at all since 2007. In most cases, the decline in personal prosperity has been happening for longer than that. But our societies seem to have learned almost nothing about what’s going on – and, until the processes are understood, crafting effective responses is impossible.

Historians of the future are likely to be bemused by our futile efforts to escape from the energy dynamic in the economy. From the turn of the millennium, we started pouring ever larger amounts of debt into the system. This led, with utter inevitability, to the 2008 global financial crisis (GFC I).

Undeterred, we then compounded cheap and abundant debt with ever cheaper money, yet the inevitable consequences of this process will still, no doubt, be declared both ‘a surprise’ and ‘a shock’ when they happen. We surely should know by now that we have an “everything bubble” propped up by ultra-cheap money, and that bubbles always burst. If there’s any sense in which “this time is different”, it is that, since 2008, we’ve taken risks not just with the banking system, but with money itself.

The death of debt?

There’s one theme which, though we’ve touched on it before, really needs to be spelled out. Throughout the era of growth, we’ve come to accept the process of borrowing and lending as a natural component of our economic system. Indeed, this practice long pre-dates the industrial age, when borrowing and lending, which then was more commonly called “usury” (the lending of money for interest), began to be de-criminalised after Christian Europe had been shaken up by the Reformation.

Leaving theological and ethical issues aside, we need to be clear that the process of borrowing and lending is a product of growth, because debt can only ever be repaid (and, indeed, serviced) where the prosperity of the borrower grows over time.

For simplicity, we can divide debt into two categories. If someone borrows money to expand a successful business, it is the growth in the income of the business which alone enables interest to be paid and the capital amount, too, to be reimbursed in due course. This is termed “self-liquidating debt”.

“Non-self-liquidating debt”, on the other hand, is typified by the loans consumers take out to pay for a holiday, buy a car or replace a domestic appliance. Here, the borrower is buying something which he or she cannot afford out of current income, and the only way in which this can be repaid is if the borrower’s prosperity increases over time.

Take away the assumed growth in prosperity, however, and both forms of borrowing cease to be viable. “Self-liquidating” debt assumes that an expanded business can earn greater profits, but it’s hard to count on this when potential customers are getting poorer. As for “non-self-liquidating” debt, the all-important rise in the borrower’s means can no longer be relied upon when people generally are getting poorer.

In short, the very process of borrowing and lending is likely to be stripped of its viability as prosperity declines. This should be an extremely sobering thought in a world which is awash with debt, and where supplying cheap credit is seen as a panacea for economic stagnation.

You might well ponder at least two things about this. First, what happens to the large quantities of debt owed by those Western economies whose prosperity has already moved significantly along the downwards curve? Second, what happens to asset prices in a world where the credit impetus goes into reverse?

Reflecting on the essential linkage between debt and growth, you might also wonder why we’re not already seeing the debt edifice crumbling. There are two main answers to this. The first is that the debt structure has been buttressed by de-prioritising another form of futurity – simply put, we’ve already created huge (and burgeoning) gaps in pension provision as part of the price of preserving the edifice of debt.

The second answer is simpler still – we’ve not seen the debt edifice start to crumble yet……

Feeling the pain

People across the Western world certainly seem to know that their prosperity is eroding, and they’re far from happy about it. We can see the effects both in political choices and in rising popular discontent. If you understand deteriorating prosperity, then you understand political events in America, Britain, Italy, France and far beyond – events which, if you didn’t understand the economic process, must seem both baffling and malign.

Though understandable, anger isn’t a constructive emotion, and what we really need is coolly analytical interpretation, understanding and planning. If it’s true that we’re not getting this from government, then it’s equally true that government reflects the climate of opinion. We can hardly expect governments to understand the economic realities when opinion-formers stick resolutely to conventional interpretation. It’s more surprising that conventional methods still command adherence as outcomes continue to diverge ever further from expectations.

Making glib promises is part and parcel of politics and, in fairness, those who don’t do this can expect to lose out to those who do. What is more disturbing is the continued promotion of economic extremism. Nationalising everything in sight won’t work, and neither will dismantling the state and turning the economy into a deregulated, ‘law of the jungle’ free-for-all.

Over the years, we’ve tried both, and should know by now that the lot of the ‘ordinary person’ isn’t bettered by these extremes. At least, when prosperity was still growing, we could live with the price of ideological purity – now that prosperity (in the West, at least) has turned down, though, these consequences are something that we can no longer afford.

If you think about it, the extremes either of collectivism or of ‘laissez faire’ have always been absurdly simplistic. Have we ever really believed that benign apparatchiks can manage things better than people can do for themselves? Or that unfettered ‘capitalism’, which concentrates wealth and power just as surely as collectivism, can do things better? Perhaps most importantly, why do so many of us persist in the view that possessions, material wealth and nebulous ideas of relative ‘status’ are a definition of happiness?

Logically, deteriorating prosperity means that we concentrate on necessities and dispense with some luxuries. Amongst the luxuries that we can no longer afford are ideological extremes, and an outlook founded wholly or largely on ownership and consumerism.

The need for ideas

The good news is that we’re not going into this new era wholly lacking in knowledge. The trick is to understand what that knowledge really is. Keynes teaches us how to manage demand – or can teach us this, so long as we don’t turn him into a cheerleader for ever bigger public spending. Likewise – if we can refrain from caricaturing him as a rabid advocate of unregulated and unscrupulous greed – Adam Smith tells us that competition, freely, fairly and transparently conducted, is the great engine of innovation. More humbly, or perhaps less theoretically, but surely more pertinently, experience tells us that the “mixed economy” of optimised private and public provision works far better than any extreme.

Going forward, we should anticipate the collapse of the “everything bubble” in asset prices, and should hope that we don’t, this time, go so far into economic denial as to think we can cure this with a purely financial “fix”. I’m fond of saying that “trying to fix an energy-based economy with financial fixes is like trying to cure an ailing pot-plant with a spanner”. We should understand popular concerns, which seem to point unequivocally towards a mixed economy, extensive redistribution and an economic nationalism that needs to be channelled, not simply vilified.

Another, positive point on which to finish is that a deterioration in prosperity needn’t prevent us – indeed, should compel us – to make better use of the prosperity that we do have. There’s no situation which can’t be made worse by rash decisions, or made better by wise ones. The forces described here – economic trends, and their political and social corollaries – all contain the seeds (no pun intended…) of divisiveness. This being so, cohesion and common purpose have never been so important.

Togetherness, and concern for the welfare of others, are, and certainly should be, part of the fabric of Christmas. Seldom can these characteristics have been more important than they are now.

 

#140: Are yellow jackets the new fashion?

POPULAR UNREST IN AN AGE OF FALLING PROSPERITY

This weekend, the authorities plan to field 89,000 police officers across France in response to anticipated further mass protests by the ‘gilets jaunes’. In the capital, the Eiffel Tower will be closed and armoured cars deployed, whilst restaurateurs and shopkeepers are being urged to close their businesses at one of the most important times of their trading year.

Though the government has climbed down on the original cause célèbre – the rises in fuel taxes planned for next year – there seems to be no reduction in the worst protests experienced in the country since the 1960s. Reports suggest that as many as 70% of French citizens support the protestors, and that the movement may be spreading to Belgium and the Netherlands.

For the outside observer, the most striking features of the protests in France have been the anger clearly on display, and the rapid broadening of the campaign from fuel prices to a wider range of issues including wages, the cost of living and taxation.

The disturbances in France should be seen in a larger context. In France itself, Emmanuel Macron was elected president only after voters had repudiated all established political parties. Italians have entrusted their government to an insurgent coalition which is on a clear collision-course with the European Union over budgetary matters. The British have voted to leave the EU, and Americans have elected to the White House a man dismissed by ‘experts’ as a “joke candidate” throughout his campaign.

Obviously, something very important is going on – why?

Does economics explain popular anger?

There are, essentially, two different ways in which the events in France and beyond can be interpreted, and how you look at them depends a great deal on how you see the economic situation.

If you subscribe to the conventional and consensus interpretation, economic issues would seem to play only a supporting role in the wave of popular unrest sweeping much of the West. You would concede that the seemingly preferential treatment of a tiny minority of the very rich has angered the majority, and that some economic tendencies – amongst them, diminishing security of employment – have helped fuel popular unrest.

Beyond this, though, you would note that economies are continuing to grow, and this would force you to look for explanations outside the purely economic sphere. From this, you might conclude that ‘agitators’, from the right or left of the political spectrum, might be playing a part analogous to the role of “populist” politicians in fomenting public dissatisfaction with the status quo.

If, on the other hand, you subscribe to the surplus energy interpretation of the economy professed here, your view of the situation would concentrate firmly on economic issues.

Though GDP per capita may be continuing to improve, the same cannot be said of prosperity. According to SEEDS (the Surplus Energy Economics Data System), personal prosperity in France has deteriorated by 7% since 2000, a trend starkly at variance with the growth (of 12%) in reported GDP over the same period.

Not only is the average French person poorer now than he or she was back in 2000, but each person’s share of the aggregate of household, business and government debt has increased by almost 70% since 2000. These findings are summarised in the following table, sourced from SEEDS.

France prosperity snapshot

Two main factors explain the divergence between the conventional and the surplus energy interpretations of the economy. One of these is the pouring of enormous quantities of cheap debt and cheap money into the system, a process which boosts recorded GDP without improving prosperity (for the obvious reason that you can’t become more prosperous just by spending borrowed money). The other is the exponential rise in the energy cost of energy (ECoE), a process which impacts prosperity by reducing the share of output which can be used for all purposes other than the supply of energy itself.

In France, and with all sums expressed in euros at constant 2017 values, GDP grew by 23% between 2000 and 2017. But this growth, whilst adding €433bn to GDP, was accompanied by a €3.07tn increase in aggregate debt. This means that each €1 of reported growth in the French economy has come at a cost of more than €7 in net new debt. Put another way, whilst French GDP is growing at between 1.5% and 2.0%, annual borrowing is running at about 9.5% of GDP.

Cutting to the chase here, SEEDS concludes that very little (about €100bn) of the reported €433bn rise in GDP since 2000 has been sustainable and organic, with the rest being a simple function of the spending of borrowed money. Shorn of this credit effect, underlying or clean GDP per capita is lower now (at €29,550) than it was in 2000 (€30,777).

Meanwhile, trend ECoE in France is put at 7.8%. Though by no means the worst amongst comparable economies, this nevertheless represents a relentless increase, rising from 4.6% back in 2000. At the individual or household level, rising ECoE is experienced primarily in higher costs of household essentials. In the aggregate, ECoE acts as an economic rent deduction from clean GDP.

Between 2000 and 2017, clean GDP itself increased by only 5.7%, and the rise in ECoE left French aggregate prosperity only marginally (2.2%) higher in 2017 than it was back in 2000. Over that same period, population numbers increased by 10%, meaning that prosperity per person is 7.1% lower now than it was at the millennium.

In France, as elsewhere, the use of credit and monetary adventurism in an effort to deliver “growth” has added markedly to the aggregate debt burden, which is €3.1tn (86%) higher now than it was in 2000. The per capita equivalent has climbed by 69%, making the average person €41,800 (69%) more indebted than he or she was back in 2000.

The prosperity powder-keg

To summarise, then, we can state the economic circumstances of the average French citizen as follows.

First, and despite a rise in official GDP per capita, his or her personal prosperity is 7.1% (€2,095) lower now than it was as long ago as 2000.

Second, he or she has per capita debt of €102,200, up from €60,400 back in 2000.

Third, the deterioration in prosperity has been experienced most obviously in costs of household essentials, which have outpaced both wages and headline CPI inflation over an extended period.

This is the context in which we need to place changes in the workplace, and a perceived widening in inequality.

On this latter point, part of the explanation for the anger manifested in France can be grasped from this chart, published by the Institut des Politiques Publiques.

In the current budget, policy changes hurt the disposable incomes of the poorest 10% or so (on the left of the scale), but ought to be welcomed by most of the rest – and perhaps might be, were it not for the huge handouts seemingly being given to the very wealthiest. Moreover, these benefits aren’t being conferred on a large swathe of “the rich”, but accrue only to the wealthiest percentile.

French budget 2

This is part of a pattern visible throughout much of the West. Unfortunately, perceptions of hand-outs to a tiny minority of the super-rich have arisen in tandem with a deteriorating sense of security. Security is a multi-faceted concept, which extends beyond security of employment to embrace prosperity, wages, living costs and public services.

Even in the euphoric period immediately following his election, it seemed surprising that French voters would back as president a man committed to ‘reform’ of French labour laws, a process likely to reduce workers’ security of employment. Add in further deterioration in prosperity, and an apparent favouring of the super-rich, and the ingredients for disaffection become pretty obvious.

Where next?

The interpretation set out here strongly indicates that protests are unlikely to die down just because the government has made some concessions over fuel taxes – the ‘gilet jaunes’ movement might have found its catalyst in diesel prices, but now embraces much wider sources of discontent.

Given the context of deteriorating prosperity, it’s hard to see how the government can respond effectively. Even the imposition of swingeing new taxes on the super-rich – a wildly unlikely initiative in any case – might not suffice to assuage popular anger. It seems likelier that the authorities will ramp up law enforcement efforts in a bid to portray the demonstrators as extremists. The scale of apparent support for the movement – if not for some of its wilder excesses – suggests that such an approach is unlikely to succeed.

Of course, it cannot be stressed too strongly that the French predicament is by no means unique. Deteriorating prosperity, a sense of reduced security and resentment about the perceived favouring of the super-rich are pan-European trends.

In the longer term, trends both in prosperity and in politics suggest that the West’s incumbent elites are fighting a rear-guard action. The credibility of their market economics mantra suffered severe damage in 2008, when market forces were not allowed to run to their logical conclusions, the result being a widespread perception that the authorities responded to the global financial crisis with rescues for “the rich” and “austerity” for everyone else.

This problem is exacerbated by the quirks of the euro system. In times past, a country like Italy would have responded to hardship by devaluation, which would have protected employment at the cost of gradual increases in the cost of living. Denied this option, weaker Euro Area countries – meaning most of them – have been forced into a process of internal devaluation, which in practice means reducing costs (and, principally, wages) in a way popularly labelled “austerity”. The combination of a single monetary policy with a multiplicity of sovereign budget processes was always an exercise in economic illiteracy, and the lack of automatic stabilisers within the euro system is a further grave disadvantage.

Finally, the challenge posed by deteriorating prosperity is made much worse by governments’ lack of understanding of what is really happening to the economy. If you were to believe that rising GDP per capita equates to improving prosperity – and if you further believed that ultra-low rates mean that elevated debt is nothing to worry about – you might really fail to understand what millions of ordinary people are so upset about.

After all, as somebody might once have said, they can always eat brioche.

= = = = = = =Pop per capita #141 5

#139: The surplus energy economy

HOW THE SYSTEM REALLY WORKS

According to conventional interpretation, the world economy faces no problems more serious than sluggish growth and rising tensions over trade. Though debt is high and asset prices are inflated, these issues are manageable within a monetary context that remains “accommodative” (meaning cheap).

Surplus Energy Economics offers a radically different and far more disturbing interpretation. Fundamentally, it states that global prosperity per person is now declining. This is a game-changer in terms not just of economics and finance but of politics and government, too. Deteriorating prosperity means that current debt levels are wholly unsustainable, and makes an asset market crash inescapable, even if the authorities persist with policies of ultra-cheap money.

This take on the economy could hardly be more starkly at odds with the consensus position. With due apologies to those regular readers for whom much of this is familiar fare, what follows is a synopsis of how the economic system is understood here. In stark contrast to conventional interpretations which portray the economy as a financial system, this article explains how, in reality, all economic activity is a function of energy.

As you will see, this simple observation turns the key in the door to an understanding of  how the economy has evolved in recent times, and where it is likely to go next.

Ever since the millennium, we have been engaged in trying to apply futile financial fixes to a deteriorating secular trend in energy-based prosperity. That’s akin to trying to fix an ailing pot-plant with a spanner. These efforts have bought us some time, but have caused serious economic, political and social harm without in any way changing the economic fundamentals.

Where planning and policy are concerned, we are in a truly peculiar situation. Those of us who understand prosperity know that the ongoing downturn is going to have profound consequences – but, as societies, we cannot even start crafting responses whilst consensus interpretation remains in a state of profound denial.

The energy economy

Surplus Energy Economics is a radically different interpretation which recognises that the economy is driven by energy, not by money. Energy is required for the supply of literally all of the goods and services that constitute the economy. Money, on the other hand, acts simply as an exchangeable claim on the products of the energy-based system.

Unfortunately, long habituation to economic expansion has led us into the false assumption that growth is a perpetual phenomenon on which the physical limitations of our planet have no bearing. The harder reality is that the characteristics of the earth as a resource package are the envelope which imposes boundaries on the scope for growth.

Human activity has always been an energy system, starting with the simple balancing of the inputs of nutritional energy with the outputs of labour energy required to obtain this nutrition. This equation was leveraged in our favour by the greater efficiencies introduced by agriculture, though the vast majority of labour remained dedicated to the supply of food. Only when the heat-engine enabled us to harness the vast energy potential of fossil fuels did we create conditions in which the securing of nutrients and other essentials became a minority activity.

The equation governing the value obtained from exogenous (non-human) forms of energy has two components.

The first is the total or gross quantity of energy to which we have access.

The second is the proportion of that total energy which is consumed in the process of accessing it, and therefore is not available for other purposes. The quantity consumed in the access process is described in Surplus Energy Economics as the Energy Cost of Energy (ECoE).

The difference between the gross energy quantity and ECoE is surplus energy. Because this is the source of all goods and services other than the supply of energy itself, this surplus determines prosperity.

We can, of course, deploy this surplus with greater or lesser efficiency. But we cannot escape from the prosperity parameters imposed by the surplus energy dynamic.

The energy cost equation

The quantity of surplus energy-based prosperity available to us is determined by the relationship between energy resources and the technology we apply to them.

At the gross level, the limits to potential are determined, not by the resources available, but by the quantities which can be accessed in ways where ECoE is less than the total energy value obtained. This means that the concept of “running out of” oil, gas or coal is not meaningful. Rationally, reserves of oil, gas or coal whose ECoE exceeds their gross energy value are not worth accessing, so will remain in the ground.

Where fossil fuels are concerned (though the principle is universal), four factors determine ECoE. Over an extended period, ECoE was driven downwards by geographical reach and economies of scale. Once these processes had been maximised, however, the new governing factor became depletion, a consequence of having accessed lowest-cost resources first, and leaving costlier alternatives for later.

The fourth determinant, technology, operates within the physical envelope of resource characteristics. During the phase where reach and scale dominated, technology accelerated the downwards trend in ECoE. Now that depletion has become the primary factor, technology acts to mitigate the rate at which ECoE is rising.

It must clearly be understood, however, that technology cannot breach the resource envelope determined by physical characteristics. For example, new techniques have made shale oil cheaper to extract now than that same resource would have been at an earlier time. But what technology has not done is to imbue shale reservoirs with the same characteristics as a simple, giant oil field like Saudi Arabia’s Al Ghawar. Technology works within the laws of physics, but it cannot change those laws.

It is mathematically demonstrable that, like any type of linear progression, the ECoE curve is exponential. Population numbers illustrate the exponential function. If a population of 1,000,000 people increases by 5% in any given period, the addition in that period is 50,000. Once the base number rises to 10,000,000, however, the increment is 500,000, even though the rate of change remains 5%. When charted, exponential progressions appear as ‘j-curve’ or ‘hockey-stick’ patterns, their apparent shapes determined only by the scale of the quantity axis.

The ECoE trap

Energy sources such as oil, gas and coal have matured to the point where the maximum benefits of reach and scale have been attained, and depletion has become the dominating driver. Fossil fuel ECoEs reached the low point of their parabola in the two decades after 1945, and have since been rising exponentially.

According to the SEEDS model, the fossil fuel ECoE progression has been as follows:

  • 1980: 1.7%
  • 1990: 2.6%
  • 2000: 4.1%
  • 2010: 6.7%
  • 2020E: 10.5%
  • 2030E: 13.5%

Renewable energy sources remain at an immature stage at which ECoEs are falling. Taken together, the ECoE progression for renewables is stated by SEEDS at:

  • 1980: 16.7%
  • 1990: 14.2%
  • 2000: 13.3%
  • 2010: 12.1%
  • 2020E: 11.1%
  • 2030E: 10.2%

In pure calorific terms, the ECoEs of renewables are likely to become lower than those of fossil fuels at some point within the early 2020s.

This does not, however, mean that transitioning to renewables will enable us to escape from the fossil fuel “ECoE trap”. There are three main factors which make this unlikely.

First, renewables account for just 3.6% of all primary energy consumption, with fossil fuels continuing to contribute 85% (and the remaining 11% coming from nuclear and hydroelectric power).

Second, renewables remain to a large extent derivates of the fossil fuel economy, requiring inputs which can be supplied only with the use of energy from oil, gas or coal. This imposes a linkage between the ECoEs of renewables and those of fossil fuels.

Third, and relatedly, it is unlikely that the ECoEs of renewables can fall far enough to restore the efficiencies enjoyed in the early stages of fossil fuel abundance. The overall ECoE of renewables is projected by SEEDS to fall to 10.2% by 2030, but this remains drastically higher than the ECoE of fossil fuels as recently as 2000 (4.1%), let alone back in 1980 (1.7%).

The world ECoE trend for all form of primary energy is as follows:

  • 1980: 1.7%
  • 1990: 2.6%
  • 2000: 3.9%
  • 2010: 5.9%
  • 2020E: 8.3%
  • 2030E: 9.8%

 

Economic implications

With the economy understood as a surplus energy equation, the history of economic development fits a logical pattern.

Throughout the period from 1760 to 1965 – roughly speaking, from the start of the Industrial Revolution to the post-1945 low-point of the ECoE parabola – the world economy was characterised by rapid growth in aggregate prosperity. This translated into steady improvement in personal prosperity despite the huge growth in population numbers over that period.

This era was characterised by (i) expansion in the gross amounts of energy consumed, and (ii) reductions in ECoE caused by reach, scale and technology. Surplus energy per person was thus on a strongly rising trajectory, growing at rates faster than the expansion in aggregate energy supply. The world became accustomed to growth, which came to be regarded as a natural phenomenon, even though some economists have conceded that our understanding of what makes growth happen is imperfect.

After about 1965, though the bottom of the cost parabola had been passed, ECoEs remained very low, rising from about 1.0% in the mid-1960s to 1.7% in 1980. This rise was modest enough not to impair the trajectories of growth in energy use, economic output, aggregate prosperity and population numbers.

Latterly, however, as the upwards trend in ECoE has become exponential, the scope for further expansion in prosperity has been undermined. It is probable that the rise in trend ECoE between about 1990 (2.6%) and 2000 (3.9%) marked a significant turning-point after which growth became ever harder to attain.

Because the 1990s had been regarded as a propitious period in economic terms – with expansion robust and inflation low – the onset of deteriorating growth was improperly understood. Indeed, this misunderstanding was inevitable given the absence of the ECoE factor from mainstream economic interpretation.

Responses to secular deceleration were required, for two main reasons. First, the public has long regarded growing prosperity as both a norm and an entitlement. Second, the world financial system is entirely predicated on perpetual expansion in the economy. Debt can only ever be repaid if the prosperity of the borrower increases over time.

With the consensus firmly established that the economy was a financial system, it was inevitable that financial solutions would be sought to address secular deceleration. This process began with making credit ever easier to obtain, a process furthered both by deregulation and by reducing real interest rates.

For some years, this expedient appeared to have been successful, as reported economic output boomed between 2000 and 2007. It transpired, of course, that this was a credit-induced boom, a familiar phenomenon, though one in which, this time, inflation was concentrated in asset markets rather than in consumer prices.

When this process led, inevitably, to the 2008 global financial crisis (GFC), the response once again was a financial one. In fairness to decision-makers, this response was largely forced upon them by the rapid expansion of debt – the only way in which a debt default crash could be prevented was by making debt ultra-cheap, both to service and to roll over.

Accordingly, policy rates were slashed to sub-inflation levels, whilst huge amounts of newly-created QE money were used to force up the prices of bonds, thus driving yields to extremely low levels.

It was always predictable – and is now becoming evident – that the monetary expedients adopted after the GFC would be no more effective than the ones which caused that crisis. Debt has continued to expand, asset prices have continued to inflate, and a series of adverse economic consequences have emerged as side-effects of the process.

In short, just as the process of credit adventurism operative between 2000 and 2007 led directly to the GFC, the subsequent policy of monetary adventurism must lead inevitably to a second financial crisis (“GFC II”).

Because the mechanism leading to GFC II has been different from the mechanism operative before the 2008 crisis, GFC II is likely to differ in important respects from its predecessor, with money, rather than just the banking (credit) system, at the eye of the storm. GFC II is likely, also, to be much larger than GFC I, with SEEDS indicating that exposure now is roughly four times the size of exposure in 2007.

The financial dimension

One of the most important lessons of recent economic history is that it is impossible to alter the course of an energy-determined economy using purely financial tools.

The reason for this mismatch is quite straightforward. Having no intrinsic worth, money commands value only as a claim on the goods and services supplied by a physical economy driven by energy. Though financial claims can be created at will, the creation of additional claims does not expand the quantities of goods and services for which these claims can be exchanged.

Inflation has long been understood as a monetary phenomenon, in which prices are forced upwards where the supply of money (“claims”) expands at rates faster than the pace of growth in economic output. Two significant qualifications are required to this statement. The first is that the velocity of money (the speed at which it changes hands) is as important as the stock of money in circulation. The second is that inflation may occur in a variety of locations, including asset prices as well as consumer prices. With these caveats stated, inflation is indeed “always and everywhere a monetary phenomenon”.

The relationship between two quantities – (i) the output of the physical economy, and (ii) the quantum of claims exercisable against that output – plays a critical role in determining financial conditions.

The economic experience since 2000 has been one in which claims have been created at levels far in excess of the rate of expansion in output. This statement has profound economic and financial implications.

Initially, excess claims were created primarily in the form of debt. Latterly, this process has been compounded by the creation of excessive monetary amounts. Stated in PPP-converted US dollars at constant 2017 values (the convention used throughout this discussion), aggregate debt expanded by $53 trillion between 2000 and 2007, and by $99tn between 2007 and 2017.

The increase in debt since 2007 has been accompanied by a rise of similar magnitude in the deficiency of pension provision, a process driven by the collapse of returns on investment which has itself been a function of ultra-cheap money. According to a study published by the World Economic Forum, real returns on US bond holdings have slumped to just 0.15% from a historic norm of 3.6%, whilst returns on equities have fallen from a historic 8.6% to only 3.45%.

This has more than doubled the rate of savings required to achieve any given level of pension provision at retirement. For the vast majority, levels of saving required to deliver pension adequacy have become unaffordable. The pension gap “timebomb” is likely, in due course, to become a hugely important economic and political issue.

These developments, most obviously the escalation in debt levels, have created huge increases in the prices of assets such as bonds, stocks and property. Put simply, bond prices are the inverse of the market yield requirement established by the cost of money, whilst equity pricing is driven by considerations similarly linked to interest rates. Property prices, too, are largely determined by the equation of inverse interest rates applied as a multiple to the median payment capabilities of purchasers.

That bubble conditions prevail across asset markets seems beyond dispute. But the mere existence of a bubble does not on its own imply an imminent crisis. The scale of risk associated with a bubble depends primarily on two issues, not one.

The first of these is the monetary context going forward (a bubble may be sustainable, and may indeed continue to inflate, so long as credit remains both cheap and easy to access). The second is the prosperity of borrowers. The latter, ultimately, is a function of the energy-based economy.

Another way to look at this is that, if monetary conditions tighten, asset prices are likely to fall, perhaps rapidly. Meanwhile, if the prosperity of borrowers diminishes, so does their ability both to service existing debts and to take on additional indebtedness, even if credit remains cheap. Under these conditions, supportive monetary policy is not guaranteed to prevent asset price falls

What this means is that forecasting the future cost of money is not a sufficient way of anticipating crashes in asset prices. In addition, we have to understand trends in borrower prosperity – but this metric is not provided by conventional econometrics.

Calibrating the energy economy

During the period between 2000 and 2007, aggregate debt expanded by $53tn whilst world GDP rose by $25tn. Between 2007 and 2017, growth in GDP was $29.7tn whereas debt increased by $99tn. In the earlier period, therefore, $2.08 was borrowed for each $1 of recorded growth, whilst the ratio in the latter period was $3.33 of borrowing for each growth dollar.

Over the last decade, credit has expanded at the rate of 9% of GDP, roughly three times the pace at which GDP has increased.

Conventional interpretation of the relationship between debt and GDP omits a critical connection between the two. Within any given amount of money borrowed, a significant proportion necessarily finds its way into economic activity. An economy which takes on substantial additional debt will, therefore, experience apparent “growth” in GDP, created by the spending of that borrowed money.

This credit effect is artificial, in the sense that (i) the apparent rate of growth would not continue in the absence of continued increases in debt, and (ii) growth would be put into reverse if the incremental debt was paid down.

This interpretation is reinforced by observation of the type of “growth” supposedly enjoyed. The experience of the United States in the decade between 2007 and 2017 illustrates this point.

Over that period, reported GDP expanded by $2.5tn, to $19.4tn in 2017 from $16.9tn (at 2017 values) in 2007. The combined output of manufacturing, construction, agriculture and the extractive industries contributed just 1.9% of that growth ($48bn). A further 7% came from increased net exports of services. But the vast majority – 91% – of all growth came from services that Americans can sell only to each other.

We need to be clear about what this means. The products of manufacturing, farming and extraction are traded globally and are priced by world market competition, so these activities can be grouped together as GMO (globally marketable output). But internally consumed services (ICS) are priced locally, so are residuals of consumer spending capability.

In short, what was happening during this decade was that American GMO was stagnant, not even increasing in line with population numbers. But ICS activities – residuals which Americans sell only to each other – increased markedly. This is wholly consistent with the fact that, during this period in which GDP increased by $2.5tn, debt expanded by $10.2tn. Money pushed into the economy by cheap borrowing shows up almost entirely in residual ICS activities.

The credit effect is so important that, in order to measure prosperity, it is necessary to arrive at a ‘clean’ measure of output from which this effect has been excluded. The ultra-loose credit conditions of recent years have created a large and widening gap between ‘clean’ (or financially sustainable) output, and recorded GDP numbers inflated by the credit effect.

For instance, within global growth of $25.3tn between 2000 and 2007, the SEEDS algorithms identify clean growth of $10.3tn and a credit effect of $15tn. The $29.7tn of growth recorded between 2007 and 2017 comprised a credit effect of $19.4tn and clean growth of $10.3tn. Therefore, the credit effect accounted for 59% of all reported growth in the earlier period, and 65% in the latter.

Once clean GDP has been identified by the exclusion of the credit effect, what results is a measure of sustainable output, something which equates to the aggregate of financial resources available for deployment. But the first call on these resources is the cost of energy supply because, if this economic rent is not paid, energy supply dries up, and activity grinds to a halt.

Therefore, prosperity is identified by deducting trend ECoE from clean GDP. This calibration is the primary purpose of SEEDS, the Surplus Energy Economics Data System.

Principal findings

Aggregate prosperity furnishes us with personal prosperity data, and also provides a critical denominator against which all other financial metrics can be measured. Here are some of the most important conclusions emerging from this process.

First, prosperity is already in marked decline in almost all Western economies, typically having peaked between 2000 and 2007. The only significant exception to this pattern is Germany, largely because of the benefits conferred on the Germany economy by the euro system.

Deteriorating prosperity, in conjunction with monetary manipulation adopted in failed efforts to counter it, have built huge risk into the financial system. The Western economies where risk is most acute are Ireland, the United Kingdom and Italy.

Most emerging market (EM) economies are at an earlier stage in the prosperity curve, and continue to enjoy increasing personal prosperity. But progress is now slowing markedly, not least because of the impoverishment of Western trading partners. China has grown its debt at a particularly dramatic pace in order to sustain activity and employment, and must be regarded as extremely risky.

Prosperity deterioration is already having a palpable effect on political sentiment in most Western countries. Popular dissatisfaction is eroding support for the ‘globalist liberal’ elites which have been in government for most of the last thirty years, and insurgent (sometimes called “populist”) movements have been the main beneficiaries of this process. At the same time, the decline in prosperity has started to erode the tax base.

Future domestic policy directions are likely to focus on (i) redistribution and (ii) opposition to immigration. We should assume that voters will turn increasingly to parties committed to these policies. We should also anticipate growing opposition to globalisation.

These, of course, are just some of the more important consequences of the downturn in prosperity. Critically, an understanding of the energy basis of the economy explains issues which necessarily baffle conventional interpretation which remains predicated on purely financial assumptions.

 

#133: An American hypothesis

IS DONALD TRUMP THE FIRST ‘ECONOMIC REALIST’?

When the historians of the future get around to writing up our current era, one of the things likeliest to strike them will be the difference between what is actually happening and what most decision-makers think is happening. Historically, it is fascinating to speculate on how many of the worst decisions of governments have sprung from false interpretation and incorrect information.

From a contemporary perspective, what is evident now is an ever-widening chasm between conventional economic evaluation and the actual trend of events. Where conventional interpretation sees growing prosperity and contained financial risk, you don’t have to step very far outside the box to see a process of economic deterioration, elevated risk and, most seriously of all, a growing threat to the stability of currencies.

For regular readers, of course, this is familiar fare. We know that an economy hampered by a rising trend in the energy cost of energy (ECoE) is being subjected to an ultimately-futile process of denial based on credit and monetary adventurism.

Rather than revisiting this strategic theme, the aim here is to pose a theoretical question, and see where it leads.

Here is the question – what would a government do if it did recognise these realities, and came to understand that prosperity is already declining in the West, and may, before long, turn downwards in the emerging market (EM) economies, too?

It is beyond doubt that such a recognition would bring about drastic changes, both in assumptions and in policy. What follows is an examination of what those changes might be. It’s also safe to assume that these changes would be resented by those still wedded to the conventional, and that their mystification would lead rapidly to anger, suspicion and hostility.

It is suggested here that, if any government anywhere in the world is behaving in ways which are consistent with this pattern, it is the Trump administration. To what extent can Mr Trump be credited with – or, by some, accused of – acting on the basis of ‘new reality’?

What if understanding dawned somewhere?

If a government did discover the processes that are at work in the economy, the first conclusion that such a government would reach is that prosperity has become, at best, a zero-sum game. This would mean that, instead of the world becoming more prosperous in shared progression, the prosperity of one country can only be enhanced at the expense of others.

This, of course, is anathema to conventional economics, which pins its faith in David Ricardo’s “comparative advantage” theory. Essentially, Ricardo argues that we all get richer if we all concentrate on what we’re, so to speak’, ‘most best at’. From this, it follows that maximising trade between nations is to the benefit of all. This has long been an article of faith for economists.

What Ricardo did not have to consider, though, was the concept of a world with finite characteristics. It’s a reasonable hypothesis that constraints on the maximum availability of resources (such as land, water and, above all, energy) might render the law of comparative advantage inoperable. In short, once you postulate limits to potential prosperity, ‘all in it together’ quickly becomes ‘every man for himself’.

Trade, currencies and national advantage

If a government did arrive at the ‘zero-sum prosperity’ conclusion, it would concentrate on pursuing national advantage in trade. Governments already do this, of course, but they are in general influenced sufficiently by the Ricardian calculus to pursue national advantage in a mutual context. Whilst they want to skew trade agreements in their own favour, they do so from an assumption that there are mutual benefits to be accrued from such agreements.

The various trade deals pursued by the Obama administration illustrate this. Though these deals undoubtedly had a pro-American bias, they were nevertheless framed in an ‘internationalist’ way, based on assumptions of potential mutual benefit.

Our imaginary zero-sum prosperity government would differ radically, because its disbelief in mutual advantage would result in an instinctive preference, if not for outright protectionism, then at least for blatantly one-sided arrangements. The result would be a more aggressive stance on trade, characterised by an undisguised pursuit of national benefit, almost heedless of what the consequences for other countries might be.

This government would also want to leverage whatever benefits it might get from the relative strength of its currency. Under normal circumstances, a strong currency is bad for trade, making home-produced goods costlier than foreign alternatives. That matters a lot less, though, if you use tariffs to decide what you do and do not want to buy from overseas. For example, you might decide that a strong currency helps you purchase resources from abroad, but the strength of the currency needn’t suck in more manufactured goods because, if this starts to happen, you simply stick tariffs on them.

It need hardly be stated that the politics and the rhetoric accompanying this stance would be nationalist in tone. Moreover, this nationalist approach towards trade would be certain to show up, too, in other, non-trade aspects of foreign policy, including areas such as diplomacy and the management of alliances. Neither is it at all fanciful to assume that this nationalism would be replicated in domestic policies. Politicians often ‘wave the flag’ in pursuit of votes – the only difference about a government founded on a zero-sum prosperity assumption would be that the nationalism invoked would be the real thing.

The emphasis on nationalism described here need not, though, result in bellicosity. Indeed, it is likelier to take the form of isolationism or, at least, of a reluctance to expend “blood and treasure” in ways that do not benefit the country’s prosperity.

Thus far, we have envisaged a government determined to use trade to pursue national prosperity – and, implicitly, broader national advantage as well – on the basis of zero-sum world potential. As well as being implicitly inimical to free trade in goods and services, this argues for an equally restrictive attitude towards the movement of capital and labour.

For a start, the government we are envisaging would not want foreign investors acquiring domestic assets. At the same time, it would not want to see its businesses investing overseas rather than at home, something which they might well be inclined to do if costs elsewhere were lower, a differential that would be exaggerated by a strong currency.

Likewise, such a government would be inimical to the free movement of labour. If its preference was for businesses to invest at home – rather than moving their operations to lowest-cost locations – then it would be equally opposed to that cheap labour being imported through immigration. It would see large-scale immigration as the domestic face of a globalist calculus that it wished to disrupt.

Battle lines

What we are envisaging here is a government which – by interfering with the flow of trade, capital and labour – is challenging the most treasured objectives of the ‘globalists’.

In critical ways, some demarcations are being drawn here between our theoretical government and those who, either in principle or in pursuit of profit, work from diametrically opposite assumptions. A nationalist stance, reinforced by opposition to immigration, plays to a domestic audience often branded “populist” by its increasingly unpopulist opponents.

Essentially, then, any government operating on the premise of nationalism founded on a zero-sum prosperity calculus would face fervent opposition, both at home and abroad. Opponents would fall into two main categories – those who benefit from the globalist model, and those who are internationalist out of conviction. Those persuaded by internationalism out of conviction overlap extensively with those whose policies are self-defined as ‘liberal’.

What emerges from this is that the opponents of our theoretical government might be defined as ‘liberal globalists’. Since this essentially defines the long-established political and economic consensus of the Western world’s ruling elites, the government that we are envisaging would, of necessity, be ‘anti-establishment’, challenging both the vested interests and the conventional assumptions which favour globalism.

Donald Trump – theory into practice?

Just to recap, then, a government which became persuaded about zero-sum global prosperity could be expected to ditch huge swathes of what has been the economic consensus for more than three decades.

It would pursue policies of national advantage which would be hostile to free trade, and opposed to the free movement of capital and labour. It would abandon the substance (and, very probably, the rhetoric, too) of mutuality. It would face very stiff, often visceral opposition both from internationalist and from globalist persuasions.

So much for theory – what about practice?

The government which comes closest to our theoretical outline is the Trump administration. Mr Trump’s political platform can be described as ‘populist-nationalist’, and his opposition to globalisation is palpable. If Mr Trump has an identifiable enemy, that enemy resides, not in Beijing or in Moscow, but in Davos.

This interpretation has been influenced by a two-part essay by analyst Thierry Meyssan. His argument is that Mr Trump’s political stance, developed over the fifteen years before he entered the White House, is based on opposition to American ‘imperial’ behaviour and a renewed focus on domestic prosperity alone. As Mr Meyssan puts it, Mr Trump is “a politician who refuse[s] to engage his country in the service of transnational elites”.

It is certainly striking that, unlike his predecessors, Mr Trump shows no appetite for military interventions, in the Middle East or anywhere else. He certainly does not want America to be ‘the world’s policeman’, especially if what is being policed benefits globalist corporates a lot more than it benefits Americans

Ideologically, some of this puts Mr Trump in some positions which, at first sight, can look pretty bizarre. For example, it seems unlikely in the extreme that Lenin was ever one of the President’s favourite authors, but Thierry Meyssan is surely on to something when he cites this passage by the Soviet leader at the start of his second essay:

 

“Imperialism is capitalism which has arrived at a stage of its development where domination by monopolies and financial capital has been confirmed, where the export of capital has acquired major importance, where the sharing of the world between international trusts has begun, and where the sharing of all the territories of the globe between the greatest capitalist countries has been achieved”

 

Brought forward into the circumstances of today, references to monopolies, the dominant role of international capital and the free flow of capital between countries are indeed redolent of what Davos likes, and Mr Trump, instinctively and perhaps calculatedly, does not.

According to Mr Meyssan, the President’s election was based on a “promise to return to the earlier state of Capitalism, that of the ‘American dream’, by free market competition”. Thus interpreted, Mr Trump opposes the small number of “multinational companies [which] gave birth to a global ruling class which gathers every year to congratulate itself, as we watch, in Davos, Switzerland. These people do not serve the interests of the US population, and in fact are not necessarily United States citizens themselves, but use the means of the US Federal State to maximise their profits”.

Synthesis

Thus far, we have been examining two distinct issues.

The first is an interpretation of what a government might do, if it became persuaded that the scope for growth in global prosperity has been exhausted.

The second is Thierry Meyssan’s acute interpretation of Donald Trump as a nationalist opponent of globalisation and its attendant ideologies and policies.

What is surely very striking is how these two strands intersect. It’s doubtful if Mr Trump and his advisors are familiar with the energy-based interpretation of economics, certainly as discussed here, and modelled by SEEDS. But it’s by no means improbable that he has arrived at similar conclusions by different routes.

It certainly seems apparent that the consensus symbolised by Davos is vehemently opposed to Mr Trump’s apparent agenda. Moreover, if he has indeed picked a fight with “Davos man”, he could hardly have chosen a more formidable opponent. What we do know is that he has already thrown some big spokes into the wheel of a model which favours the global flow of goods, capital and labour on a basis geared towards the maximisation of the share of GDP which goes into corporate profits rather than labour.

If this interpretation is correct, we should anticipate efforts to break up some of the most powerful global corporations with large shares in their respective markets. Mr Trump might not have read Lenin, but he certainly seems to understand Adam Smith’s emphasis on the primary importance of competition, free, fair, and unfettered by excessive concentration. Once that is understood, trust-busting becomes logical.

Outcomes

Fascinating though the politics of all this undoubtedly are, the decisive issue is likely to be economic. Essentially, can nationalism deliver more for American voters than globalisation has achieved?

The reality is that, in pure economic terms, globalisation isn’t a hard act to follow. The essential premise of globalisation is that profits can be increased by locating production in the cheapest places, whilst continuing to sell goods and services in the (relatively) wealthy West.

There was always a huge contradiction at the heart of this philosophy – essentially, if well-paid jobs are shipped out of Western markets, how are Western wage-earners supposed to carry on with high levels of consumption? Thus far, the answer has been to make credit cheaper, and more readily accessible, than it has ever been before. This strategy has landed us with extraordinary levels of debt, unprecedentedly cheap money, and all of the risks associated with financial adventurism.

According to SEEDS, the United States has not bucked the trend towards lower prosperity in the West. Whilst not as badly affected as, say, Britain or Italy, SEEDS indicates that the average American is 7.7% ($3,380) poorer than he or she was back in 2005.

Though GDP data appears to contradict this calculation, two factors can be cited to support it. First, an overwhelming majority (93%) of all growth in American GDP in recent years has come from internally-consumed services (ICS) – such as finance, real estate and government – whilst the aggregate contribution to growth of hard-priced, globally marketable output (GMO), such as manufacturing, construction, agriculture and the extractive industries, has been zero. (The other 7% came from increased exports of services).

Second, growth in GDP has been far exceeded by an ongoing escalation in debt. Comparing 2017 with 2005, GDP has grown by $3.25tn, but debt has expanded by $14tn, a ratio of $4.30 of new debt for each $1 of reported growth. By definition – and, latterly, based on experience as well – pouring cheap credit into the system to sustain consumption in the face of deteriorating wages is not a sustainable way of running the economy.

In short, there is a compelling case to be made that Americans are significantly poorer now than they were twelve years ago – and, were this not the case, there has to be a strong possibility that Mr Trump would not have become President.

The first conclusion we can reach seems to be that, in linking prosperity with nationalism, Mr Trump has been pushing at an open door. We cannot know whether his policies can deliver more for Americans than globalisation, but it won’t be all that long before we find out. Obviously, nobody should underestimate the opposition that Mr Trump will go on encountering from those whose economic interests he threatens.