#171. Inflexion point

AT THE DEATH OF THE ‘V’

Though most people have better things to do than watch market indices, it hasn’t escaped public notice that stocks have risen at record rates just as economies have decelerated ever nearer to stall-speeds. Market logic, such as it is, seems to be that previous falls ‘priced in’ the consequences of the Wuhan coronavirus crisis, and that, latterly, investors have started to ‘buy the recovery’.

To put any trust at all in the thesis that has powered the market rebound, you’d need to place unquestioning faith in the concept of a ‘V-shaped’ economic recovery.

The hugely influential International Monetary Fund certainly endorses this view. In its latest, slimmed-down set of WEO projections, the IMF predicts that world economic output will fall by -3.0% in 2020, and then grow by +5.8% next year. This would mean that GDP was higher (by +2.6%) in 2021 than it was in 2019. It’s implicit, though it’s not stated, that growth will then revert to something not dissimilar to previously-anticipated annual rates of between 3.0% and 3.5%.

This is a classic ‘V assumption’.

The view that has been taken here throughout this crisis has been that this kind of rebound is extraordinarily implausible. If, as seems increasingly likely, the market now ditches the fiction of a ‘V-shaped recovery’, markets could be poised for catastrophic falls. If this is how things pan out, hindsight might decide that the ‘Lehmann moment’ in this second-wave crash was the news that investment guru Warren Buffett’s Berkshire Hathaway fund has liquidated its entire holdings of airline stocks.

Unless you’re an investor, none of this may seem to matter very much. After all, prolonged support from the Federal Reserve and other central banks has created a ‘positivity bias’ in the minds of investors, so it wouldn’t be a huge surprise to everyone else if the recent sharp rally in stocks turned out to be a colossal exercise in complacency and wishful thinking.

There are, though, far broader economic implications to the probability that, like investors, the government and business ‘high command’ has reached the point at which trust in a ‘V-shaped’ recovery starts to evaporate. Indeed, ‘ditching the V’ would have profound consequences, both for policy and for the practicalities of “exit” from lockdowns.

Airlines have become very much the bellwether for how the prospects for business and the economy are perceived.

Let’s remind ourselves that, prior to the crisis, the general expectation was that the aviation industry would continue to grow at annual rates of about 3%, implying aggregate expansion of around 90% by 2040.

Though it’s long been recognised that a sharp fall in passenger numbers during 2020 is inescapable, the ‘V-shaped’ assumption, hitherto, has dictated that this would be followed by a rapid rebound, with volumes pretty quickly recovering to (or very near) trend levels. This, it has been assumed, would leave the longer-term outlook largely intact, a scenario illustrated in the left-hand chart in fig. 1.

Fig. 1 

To believe this, you’d have had to assume that passengers would put away all of their fears about close proximity, dismiss from their minds any idea of a second wave of infections, and ignore their battered financial circumstances. If you did believe this, the only meaningful issues would be the duration of the crisis, and the ability of airlines to out-last it.

Where the longer-term outlook is concerned – and well before the advent of the coronavirus – the view here has been that continuing exponential growth in passenger aviation is implausible. This is a stance which forms part of a broader “peak travel” thesis.

This view isn’t confined to aviation, or to travel more generally. Rather, the Surplus Energy Economics interpretation is that the global economy has already reached the cusp of “de-growth”.

Simply stated, rapid rises in ECoE (the energy cost of energy) have put prior growth in prosperity into reverse, and are starting to exhaust the ability of financial gimmickry to hide this underlying reality.

This means that it would be counter-intuitive to expect exponential growth in any part of the economy, and particularly in any sector driven by discretionary consumer spending. The logic of de-growth is that we should now start to concentrate on those issues – including de-complexification, simplification, de-layering, loss of critical mass and falling utilization rates – which will determine the rate of de-growth, and the shape of the shrinking economy.

Returning to aviation, the outlook is likelier to be the “accelerated de-growth” scenario illustrated in the right-hand chart in fig. 1. The black line shows the “peak travel”, de-growth interpretation as it was understood before the pandemic, and the red one shows how the coronavirus crisis is likely to have modified this outlook. The gist of it is that any recovery in aviation from the 2020 slump will be very pedestrian indeed.

Of course, neither the consensus nor the ‘high command’ is going to accept the broader economic de-growth thesis any time soon – established ways of thinking are far too entrenched for that.

But what they are likely to do is to abandon trust in a ‘deep V’ recovery, not just in aviation, but more broadly too.

De-growth itself may remain a long way from acceptance, but two economic aspects of the coronavirus crisis are gradually gaining recognition.

One of these is that we face a very protracted period of “co-existence” between the virus itself and resumed economic activity.

The second is that some industries might not be able to survive for the duration of this extended co-existence. Together, these two considerations, extended across the economy as a whole, are likely to be more than enough to kill off the recovery in the markets. More importantly, we can expect ‘abandonment of V’ to have far-reaching implications for policy.

It’s important to note that, in the absence of an effective vaccine or treatment, lockdown has been the only policy response available to the authorities. Thus far, it has met with very high levels of public co-operation, flaunted only by small minorities of the obstinate and the anti-social. It seems to be succeeding in its stated aim of “flattening the curve” of virus transmission. Of course, there are alternative viewpoints, ranging from ‘coronavirus is just another flu’ to ‘this is the end of life as we know it’. Neither view has been accepted by governments as a reasonable basis for planning.

But the authorities have always known that lockdowns have two big problems.

The first is that, for as long as they continue, they inflict compounding damage to the economy.

The second is that, once restrictions are lifted, it would be very hard indeed to reimpose a “lockdown 2.0”. This latter consideration has inclined governments towards caution, despite the siren, often self-interested voices calling for an accelerated “exit”.

Recognition of “co-existence” seems to be moving the authorities away from an ‘everything stops, everything resumes’ stance towards a much more nuanced position, in which some economic activities can be restarted relatively quickly, whilst the resumption of other activities will take very much longer.

Aviation falls very much into the second category. If physical (wrongly labelled “social”) distancing needs to remain in situ, it’s almost impossible to see how airports and airlines can return to operation. Even if they could, it’s very hard to envisage passengers returning in their droves. Quite apart from the fact that most people are going to be a lot poorer after the crisis, there will remain an extreme and prolonged unwillingness to enter crowded spaces. Aviation has the additional handicap – which it shares with the cruise industry – that people will be reluctant to risk finding themselves put into extended isolation, either at their destination or on their return home.

Both the practical and the psychological implications of the crisis for consumers are likely to be profound, and to extend far beyond the international transport and tourism sectors. As and when the virus recedes, most households are likely to have experienced a draining of their savings, an increase in their debts and a meaningful reduction in their incomes. To health-related fears will have been added a new financial conservatism, reflected in a reduced propensity to engage in discretionary (non-essential) purchases.

Changes in consumer circumstances are likely to have their corollary in the commercial sector, too. Businesses which survive this crisis will, in a majority of instances, emerge with very stretched balance sheets and seriously impaired revenues and earnings. They can be expected to turn borrowing-averse, and to take an ultra-cautious line both on operating costs and on investment.

Just as consumers will be reluctant to spend on non-essential purchases, businesses are likely to keep discretionary outgoings to a minimum. This means that acceptance that a V-shaped recovery isn’t going to happen can be expected to have the same effect on sectors like advertising that it has on consumer areas such as travel.

Financially, both investor and government attitudes are likely to undergo significant alteration as the improbability of a V-shaped recovery becomes apparent.

Governments which might have been willing to support companies and sectors through a relatively short hiatus will take a markedly less accommodating line when faced with the prospect of providing such support for a very much longer time. They might also reflect that bankruptcy, whilst it wipes out shareholders, does not in fact ‘destroy’ businesses and their assets, but simply transfers ownership to creditors.

Framing these considerations will be recognition that the resources of governments face deep and permanent impairment, and that public priorities are very likely to have changed.

What is emerging now – and is likely to reach even into the rarefied levels of investor calculation – is that neither the assurance nor the comparative simplicity of a V-shaped recovery is persuasive.

The wise course from here would be an acceptance, if not (yet) of de-growth, then of a wholly altered economic, financial, political and social landscape. Denial will of course continue in many quarters, but the centre of gravity will move fundamentally as a single observation gains traction.

That observation is that a ‘V-shaped’ recovery is not going to happen.

 

#170. At the end of “new abnormality”

REFLECTIONS ON A CRISIS

As soon as it became clear that the Wuhan coronavirus pandemic was going to have profound economic consequences, the aim here was to scope (since it is impossible for anyone to forecast) the implications for the financial system, and for the economy itself. Both have subsequently been converted into downloadable reports which can be accessed at the resources page of this site.

There’s no denying that both reports, stats-rich and based on the SEEDS model, are complex, even though every effort was made to combine clarity with a minimum of jargon. Indeed, ‘complicated’ might well define the whole situation with the coronavirus crisis.

Where once we might have said that ‘whole rainforests are being pulped’ to feed the appetite for comment and expression about the crisis, the 2020 equivalent is that the internet is becoming saturated with information-and-opinion overload.

The aim here is to take the issues ‘on the volley’, in hopes that this might tease out the nuggets of the important from the overburden of sprawl.

First, then, the pandemic itself. There seems no reason to doubt the severity of the health crisis, since neither governments nor businesses are prone to this kind of over-reaction – far from going out of their way to create panic, shake public confidence and cripple the economy, the political and economic ‘high command’ is likelier to promote false reassurance than to whip up unnecessary panic.

Neither do conspiracy theories seem particularly convincing. It seems pretty clear that the virus originated in China, but the idea of spill-over from dangerous experimentation seems far less plausible than the simpler explanation, which is that the virus jumped the species barrier in one of China’s dangerous, insanitary and, frankly, bizarre ‘wet markets’. Equally, it seems logical that an authoritarian, one-party state would react to an unknown threat with a habitual (rather than a pre-planned) denial, and with a bureaucratic, almost instinctive silencing of dissenting opinions.

Likewise, Mr Trump’s apparent belief that the World Health Organisation kowtowed to China by labelling the crisis ‘covid-19’ (rather than, say, ‘Wuhan flu’) seems less likely than the simpler explanation, which is that the WHO conformed to that same contemporary preference for euphemism which has presented the erosion of working conditions as the “gig economy”.

This isn’t to say, of course, that China isn’t looking for ‘the main chance’ where the pandemic is concerned. But it’s only fair to say that such opportunism is by no means a uniquely Chinese preserve. People from all shades of opinion, from every political persuasion and from all points of self-interest are trying to find their own silver linings in the coronavirus cloud. From calls for a world government to demands that “Brexit” be put on ice, we’re seeing hobbyhorses, even of the most irrelevant kind, being ridden to exhaustion.

By the same token, the use of lock-downs seems, on the whole, to have been a sensible response, because a distinguishing feature of the Wuhan virus is its rapidity of spread. The only real mystery about this is why, in an age of digital communication, a policy of physical separation is being mislabelled ‘social distancing’.

Of course, lock-downs come at a huge economic and broader cost, automatically prompting the public to wonder how much longer this situation will prevail. It’s a fair bet that governments around the world are contemplating ‘exit strategies’, but only the rash would insist on governments going public on what those strategies might be.

The priority now has to be to ensure that the public adheres to the principles of lock-down, and that resolve could only be weakened by premature speculation about how this might end.

For their part, economists and others are trying to gauge the possible or probable extent of the damage that the coronavirus and the consequent reductions in activity are going to inflict on the economy. Though Britain’s OBR has presciently warned of the risk of longer-term “scarring” of the economy, the general supposition seems to be that, whatever the severity and the duration of the crisis turn out to be, it will be followed by a “recovery”, involving both the eventual restoration of pre-crisis levels of activity, and a reinstatement of the belief in “growth”.

The view expressed here is that trust in a full economic “recovery” – irrespective of the time that is allowed for this to happen – owes more to obstinacy and wishful-thinking than it does to logic. The very word “recovery” presupposes that the economy pre-virus was robust, was continuing to deliver meaningful “growth”, and constituted some form of “normality”.

It’s worth remembering that, long before the crisis, world trade in goods, and sales of everything from cars and smartphones to chips and electronic components, had already turned down. Financially, extreme strains were already emerging right across the system. Investors had already started turning their backs on shale, and the “unicorn” absurdity – the bizarre delusion that any company combining an “app” with a cash incinerator must come good in the end – was already going the same way as the Emperor’s New Clothes.

There is, after all, precious little “normality” to be found in a system which pays people to borrow, and which places an almost mystical faith in the ability of central banks to ensure that asset prices only ever move upwards.

No apology need be made for saying that a lot of us had already realised that the “new normal” – of ever-rising asset prices, and of an unending tide of cheap credit and cheaper money – had become absurd to the point of the surreal. The best reason, in addition to simple observation, for questioning the validity of this “new normal” mindset was a recognition that the economy is an energy system, and that the energy equation driving prosperity had already turned against us.

Rather than going into the technicalities of the energy-based interpretation, we can simply state that the relentless rise in the Energy Cost of Energy (ECoE) was applying a tightening squeeze to the surplus energy which determines prosperity.

The very extent of the financial adventurism happening in plain sight attests to the scale of bafflement and denial being required of the adherents of the dogma of perpetual growth. It doesn’t help, of course, that our entire financial system is wholly predicated on the implausible proposition that there need be no limits to economic expansion on a finite planet.

The reality, then, is that an ending of growth – and a consequent destabilising of the financial system – were lying in wait for us, needing only a catalyst, which the coronavirus has now supplied.

What this means is that “de-growth” has now arrived. This is not something that we have chosen, however compelling may have been the environmental or the human case for kicking our growth addiction. There’s nothing noble, voluntary or selected about the onset of de-growth which, rather, is a straightforward consequence of the unwinding of an energy dynamic which, courtesy of fossil fuels, has powered dramatic expansion ever since the first efficient heat-engine was unveiled back in 1760.

The necessity now is to understand de-growth, and to make the best of it. Those who have considered this likelihood have started to understand processes such as loss of critical mass, the threat posed by falling utilization rates, the inevitability both of simplification and of de-layering, and the equal inevitability that, just as economies became more complex as they expanded, they will be subject to a process of de-complexification now that prior growth in prosperity has gone into reverse. As shown below, these components of de-growth give us an outline taxonomy of the very different economic world of the future.

It doesn’t require a Pollyanna approach to understand that, just as “growth” has been a mixed blessing, de-growth offers opportunities as well as threats.

If you really valued ‘business as usual’, were looking forward to a world of widening inequalities and worsening insecurity of employment, enjoyed the glitz of promotion-drenched consumerism, and were unconcerned about what a never-ending pursuit of “growth” might do to the environment, you might find the onset of de-growth a cause for lament.

If, on the other hand, you understand that our world is not defined by material values alone, you might see opportunities where others see only regrets.

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#169. At the zenith of complexity

THE ONSET OF “DE-GROWTH” AND “THE GREAT SECTOR EXTINCTION”

In the previous article, we examined the scope for tangible value destruction in the global financial system. In some future discussion, we might look at the very substantial empowerment that is being handed to environmental causes by some of the direct and indirect consequences of the Wuhan coronavirus crisis.

Here, though, the issue is the economy itself, and readers will understand that this interpretation is framed by the understanding that the economy is an energy dynamic, and not a financial one.

For those who like their conclusions up front, the single most important takeaway from what follows is that the crisis caused by the coronavirus pandemic has triggered two fundamental changes that were, in reality, due to happen anyway.

One of these is a systemic financial crisis, and the other is the realisation that an era of increasingly-cosmetic economic “growth” has come to a decisive end.

The term which best describes what happens from here on is “de-growth”. This is a concept that some have advocated as a positive choice, but it is, in fact, being forced upon us by a relentless deterioration in the energy-driven equation which determines prosperity.

At its simplest, this means that the near-universal expectation of a future “economy of more” has been invalidated. We’re not, for example – and as so much planning has hitherto assumed – going to be driving more cars on yet more roads, and taking more flights between yet more airports. A seemingly-assured future of more consumption, more leisure, more travel, more wealth, more gadgets and more automation has, almost at a stroke, ceased to exist.  Economic considerations aside, the energy supply outlook alone has long since ceased to support any such assumptions.

More fundamentally, an economy which is shrinking is also one that will become progressively less complex. Whole sectors of activity will disappear through processes of simplification and de-layering. The pace of economic deterioration, and the rate at which the system de-complexifies, will be determined by identifiable factors which include falling utilization rates and the loss of critical mass in economic activities.

The inevitable arrives

Seen from the perspective of the energy-driven economy, the crisis is unveiling much that we already understood. Essentially, relentless increases in the Energy Cost of Energy (ECoE) are the constant in an economic (and financial) narrative that has been unfolding ever since the 1990s, and which has long pointed, unequivocally, towards both falling prosperity and a “GFC II” sequel to the 2008 global financial crisis (GFC).

Between 1990 and 2000, global trend ECoE rose from 2.6% to 4.1%, entering a level (between 3.5% and 5%) at which prior growth in the prosperity of the western Advanced Economies started to go into reverse. By 2008, when the world banking system was taken to the brink by the GFC, ECoE had already reached 5.6%.

The next critical point occurred during 2018-19, when trend ECoEs entered a higher band (between 8% and 10%) at which less complex, less ECoE-sensitive emerging market (EM) nations, too, start to experience a reversal of prior growth in prosperity. This latter event has confirmed that, after a remarkably long plateau, the prosperity of the world’s average person has turned down.

The financial and economic ‘high command’ has never understood this energy-based interpretation, and this incomprehension has created a parallel narrative of futile (and increasingly dangerous) financial adventurism.

This is why we can expect a GFC II-type event to coincide with a decisive downturn in the economy. Though the coronavirus crisis is acting as a trigger for these events, we should be in no doubt that both of them were due to happen anyway.

Welcome to de-growth

The term which best describes a downwards trajectory in prosperity is “de-growth”. Many have advocated de-growth as something that society ought voluntarily to adopt in its own best environmental and broader interests.

The surplus energy interpretation, though is that de-growth isn’t a choice that we might or might not make, but an economic inevitability.

Critically, de-growth doesn’t simply mean that the economy will become quantitatively smaller. It also means that much of the complexity which has developed in parallel with past economic expansion will go into reverse.

This de-complexifying process will have profound consequences. As well as determining the pace at which the economy shrinks, the retreat from complexity will impose changes on the shape, as well as the size, of the economy of the future.

Where the rate of prosperity deterioration is concerned, the interplay of two factors is going to prove critical.

One of these is the utilization effect, which describes changes in the relationship between the fixed and variable costs of the supply of goods and services. As utilization rates fall, the per-user share of fixed costs rises, and any attempt to pass such increases on to consumers is likely to accelerate the pace at which utilization rates fall.

The second operative trend is the critical mass effect. This describes the way in which supply processes are undermined by the lack of access to critical inputs. To a certain extent, suppliers of goods and services can work around this effect, by altering (and, in general, simplifying) both their products and their processes. Even so, there are limits to the ability to circumvent critical mass effects, and the likelihood is that capacity will decline, resulting in a corresponding reduction in the range of goods and services on offer to consumers.

Both the utilization and the critical mass factors introduce considerable uncertainty into the rate at which prosperity will deteriorate, but an even bigger imponderable is the combined impact of utilization and critical mass effects. It is easy to picture how these are likely to interact, with, for example, falling utilization rates removing inputs in a way that accelerates the loss of critical mass.

The end of “more”

One of the practical implications of this interpretation is that the current consensus about our economic future – a consensus which we might call ‘the economy of more’ – is becoming ever less plausible.

Until now, virtually all planning assumptions have been framed by this expectation of continuous expansion. We’re assured, for example, that by 2040, there will have been be a billion-unit (75%) rise in the world’s vehicle fleet (requiring more roads), whilst aviation passenger miles will have increased by about 90% (so we’ll need a lot more airport capacity).

These and similar projections are based on assumptions that we can consume about 28% more energy in 2040 than we do now, with petroleum and natural gas supply rising by, respectively, 10-12% and 30-32%. All of these consensus projections seem extremely unlikely to be realised, not least because of the crumbling economics of energy supply itself.

The miss-match between, on the one hand, the assumption of extrapolatory expansion in virtually all economic activities and, on the other, the improbability of the requisite growth in energy supply, seems never to have occurred to those whose plans inform the economic consensus.

What all of this means in practice is that projected rates of prosperity deterioration are conjectural, with probabilities favouring an acceleration in the pace of decline.

With this caveat understood, the base-case generated by SEEDS (the Surplus Energy Economics Data System) provides a useful reference-point for discussion. The model indicates that the average person worldwide will be poorer by 9.5% in 2030, and by fully 20% by 2040, than he or she is today. It follows from this, of course, that his or her ability to carry debt and other financial burdens – and to pay taxes – will be correspondingly impaired.

Fig. 1:

Simplification and de-layering

Two further trends, both of which are of fundamental importance, can be anticipated as consequences of the de-complexifying process.

One of these is simplification, which describes a rolling contraction in the breadth of choice on offer to consumers, and a corresponding contraction in systems of supply.

The second is de-layering, meaning the removal of intermediate economic processes.

The de-layering effect can be illustrated using food supply as a comparatively simple example (though the issues involved extend right across the gamut of products and services).

The pre-industrial system for supplying food had few stages between farmer and ultimate consumer. There were, to be sure, millers, carters, coopers, green-grocers, butchers and a number of other trades operative between producer and customer, but there was nothing on the scale of today’s plethora of intervening layers, which run from fertilizer suppliers and agricultural consultants at one end of the spectrum through to packaging and marketing consultants at the other.

Looking ahead, the application of simplification and delayering to the chain of food supply suggests that, whilst product choices will narrow (ten sorts of breakfast cereal, perhaps, rather than fifty), some of the intervening layers will contract, whilst others will disappear altogether. Simpler products and simpler product ranges require fewer intermediate stages.

Extended across the economy as a whole, the implication is that we face what might be called a “great extinction” of trades, specialisations and, indeed, of whole sectors. As and when this forward trend gains recognition, it’s likely that businesses and individuals will endeavour to withdraw from activities which are at high risk of being de-layered out of existence.

Surveying new horizons

The economic processes described here are going to have far-reaching implications, most of which will be matters for subsequent discussion. First, though, it makes sense to recap the critical points of the foregoing.

The fundamental change now in prospect is that economic de-growth will set in, and will eliminate most of the expectations hitherto covered by the term “the economy of more”. The rate at which the economy shrinks (and the average person becomes less prosperous) will be influenced by a number of variables, of which critical mass and utilization effects are amongst the most important.

A reasonable working assumption, generated by SEEDS, is that people are going to get poorer at annual rates of about 1%, though there will, needless to say, be major regional and national variations around this trend.

This rate may not sound all that dramatic – though we need to bear in mind that it might worsen – but the shock effects of the onset of de-growth are likely to be profound, not just in the economic and financial spheres, but socially and politically as well.

As the economy gets smaller, it will also become less complex. Central strands here are likely to include both simplification (of products and of processes) and de-layering. The latter will involve contraction in some areas of activity, and the elimination of others.

The coronavirus crisis itself is providing us with a foretaste of some of these anticipated trends. In economic terms, the most important effect of the crisis is the hiatus in the cash flows of businesses and households. The consequent need to conserve cash (and to avoid going further into debt under circumstances of extreme uncertainty) is inducing conservatism into economic behaviour.

Companies and families alike are imposing new and tougher criteria on their expenditures, meaning that households are cutting back on “discretionary” (non-essential) spending, whilst businesses are minimising outgoings wherever they can. Companies are likely to make severe cuts in their marketing spend (because there’s not much point in advertising things that customers can’t or won’t buy), and will seek to renegotiate (meaning reduce) rents, outsourcing costs and other overhead expenses.

If – as seems very likely – this event marks (though it will not have caused) the onset of de-growth, it’s probable that newly conservative attitudes will continue. Consumers are unlikely to go back to “splashing the cash”, even when (or if) something nearer to “normality” is restored. Businesses which have, for example, downsized promotional expenditures and simplified their operations, are unlikely to revert to former spending patterns.

In short, this crisis may well have kick-started the processes of simplification and de-layering described above. Both of these processes can be expected to shrink some areas of economic activity and, in some cases, to eliminate them altogether.

Finally, these effects are highly likely to be reflected in other spheres, causing major attitudinal changes. Voters can, for example, be expected to be more supportive of essential public services, and less tolerant of perceived excesses in the private sector.

Governments themselves are likely, in due course, to recognise the risk of contraction in their tax bases and will, in any case, have gone much further into debt as a direct consequence of the crisis. Pressure for redistribution, and a generally heightened emphasis on economic issues, were pre-existing political consequences of deteriorating discretionary (“in your pocket”) prosperity.

At the same time, it is surely self-evident that governments cannot risk repeating policies which, rightly or wrongly, have been encapsulated into a popular post-GFC narrative of “rescue for the wealthiest, austerity for everyone else”.

CORONAVIRUS – THE ECONOMICS OF DE-GROWTH

#163. Tales from Mount Incomprehension

THE FALSE DICHOTOMY CLINGS ON

There was more than a grain of logic in the observation by US treasury secretary Steven Mnuchin that climate activist Greta Thunberg should save her advice until “[a]fter she goes and studies economics in college”. If the authorities were to consent to her demand for the immediate cessation of the use of fossil fuels, the economy would crash and, quite apart from the misery that this would inflict on millions, we would have abandoned any capability to invest in a more sustainable way of life.

This said, taking a course in economics, as it is understood and taught conventionally, would not enhance, in the slightest, her understanding of the critical issues. Conventional economics teaches that economics is ‘the study of money’, and that energy is ‘just another input’. These claims cannot be called ‘contentious’. They are simply wrong.

Worse still, her audience at Davos – the Alpine pow-wow of the world’s political and economic high command – are almost wholly persuaded by a false interpretation which states that action on climate risks carries a “cost”, meaning that doing what she asks would be costlier than carrying on as we are, with an economy powered by oil, gas and coal.

This is a folly every bit as absolute as the argument that we must immediately cease all use of the energy sources on which the economic growth of the past two centuries has been based. Continued reliance on fossil fuels might or might not destroy the environment, but it would certainly condemn the economy to collapse.

A commonality of interests

Because I have an extensive ‘to-do’ list – and in the hope that readers might appreciate some brevity on this issue – let me be absolutely clear that neither side of the debate over the economy and the environment understands how these processes really work. Worse still, it seems that neither side wants to understand this reality.

There’s a hugely damaging false dichotomy around the assumption that there’s some kind of trade-off between our environmental and our economic best interests. If “Davos man” thinks that the economy can prosper so long as we cherry-pick the profitable bits of the environmental agenda (like carbon trading, and forcing everyone to buy a new car), and pour bucket-loads of greenwash over the rest of it, he (or she) could not be more wrong

Because literally none of the goods and services which comprise the economy could be produced without energy, it should hardly be necessary to point out that the economy is an energy system. Equally, it should be obvious that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This access component is known here as the Energy Cost of Energy (ECoE), and it forms a critical part of the equation which determines our prosperity.

The third part of this ‘trilogy of the blindingly obvious’ is that money has no intrinsic worth, and commands value only as a ‘claim’ on the products of energy. I make no apology for repeating that air-dropping cash (or any other form of money) to a person stranded in the desert, or cast adrift in a lifeboat, would bring him or her no assistance whatsoever.

Money is simply a medium of exchange, valid only when there is something for which it can be exchanged.

The complexity trap

The modern industrial economy is not only enormous by historic standards, but is extraordinarily complex as well. Scale and complexity make the modern economy high-maintenance in energy terms. Output grew rapidly in the period (roughly between 1945 and 1965) when trend ECoEs were at their historic nadir, but has struggled since then, as ECoEs have risen.

Analysis undertaken using SEEDS (the Surplus Energy Economics Data System) indicates that prosperity in the Advanced Economies (AEs) of the West ceased to grow when ECoEs hit a range between 3.5% and 5%. Less complex Emerging Market (EM) economies have greater ECoE tolerance, but they, too, start to become less prosperous once ECoEs reach levels between 8% and 10%. Both China and India have now entered this ‘growth killing ground’.

Back in the high-growth post-War decades, ECoEs were between 1% and 2%. By 2000, though, global trend ECoE had reached 4.1%, which is why the advanced West was already encountering something which bewildered economists labelled “secular stagnation”, though they were at a loss to explain why it was happening. By 2008 – when ECoE had reached 5.6% – efforts at denial based on credit adventurism had achieved nothing other than an escalation in risk which brought the credit (banking) system perilously close to the brink.

Since then, and whilst futile exercises in denial have segued into monetary adventurism, ECoE has continued its relentless rise. Last year, world trend ECoE broke through the 8% threshold at which prior growth in EM prosperity goes into reverse. This, ultimately, explains why global trade in goods is deteriorating, and why sales of everything from cars and smartphones to chips and components are sliding.

The average person in the West has been getting poorer for more than a decade, and, increasingly, he or she knows it, whatever claims to the contrary are made by decision-makers who, for the most part, still don’t understand how the economy really works.

Something very similar now looms for EM countries and their citizens – and, when evidence of EM economic deterioration becomes irrefutable, the myth of “perpetual growth” in the world economy will be exploded once and for all.

When that happens, all of the false assumptions on which a bloated financial system relies will crumble away.

Tenacious irrationality

The irony here is that, far from avoiding economy-damaging “costs”, continued reliance on fossil fuels would be a recipe for economic oblivion. The destructive upwards ratchet in ECoEs is driven by fossil fuels, which still provide four-fifths of our energy supply, and whose costs are rising exponentially now that depletion has taken over from scale and reach as the primary driver of cost. Far from imposing “costs” that will push us towards economic impoverishment, transitioning away from fossil fuels is the best way of minimising future hardship.

This means that economic considerations, when they are properly understood, support, rather than undermine, the arguments put forward by environmentalists.

But we should be equally wary of claims that renewable energy (RE) can usher in some kind of economic nirvana. The ECoEs of REs are highly unlikely ever to fall below 10%, a point far above prosperity maintenance thresholds (of 3.5-5% in the West, and 8-10% in the EMs), let alone give us a return to the ultra-low ECoEs of the post-1945 era of high growth.

Critically, transition to REs would require vast amounts of inputs whose supply relies almost entirely on the use of FFs. The idea that we can somehow “de-couple” economic activity from the use of energy, meanwhile, is utterly asinine.

The only logical conclusion is that we should indeed transition towards REs, but should not delude ourselves that doing this can spare us from deteriorating prosperity, or from other processes (such as de-complexification and de-layering) associated with it. The one-off gift of vast surplus energy from fossil sources is fading away, which, from an environmental point of view, might be just as well. What matters now is that we manage, in a pragmatic and equitable way, the transition to lower levels of energy use and gradually eroding prosperity.

It’s a disturbing thought that our economic and environmental futures are trapped in a slanging match between green fanaticism and Davos-typified cynicism. It’s a truism, of course, that people tend to believe what they want to believe – but this is a point at which the reality of energy as the critical link between prosperity and the planet needs to force its way to the fore.

If there’s cause for optimism here, it is that reality usually triumphs over wishful thinking. The only real imponderables about this are the duration of the transition to reality, and the scale of the damage that protracted delusion will inflict.

#162. The business of de-growth

ENTERPRISE IN A DE-GROWING, DE-LAYERING ECONOMY

We start the 2020s with the political, economic, commercial and financial ‘high command’ quite remarkably detached from the economic and financial reality that should inform a huge variety of policies and decisions.

This reality is that the relentless tightening of the energy equation has already started putting prior growth in prosperity into reverse. No amount of financial gimmickry can much longer disguise, still less overcome, this fundamental trend, but efforts at denial continue to add enormously to financial risk.

This transition into uncharted economic waters has huge implications for every category of activity and every type of player. Just one example is government, for which the reversal of prior growth in prosperity means affording less, doing less, and expecting less of taxpayers (with the obvious corollary that the public should expect less of government).

Governments, though, do at least have alternatives. ‘Doing less’ could also mean ‘doing less better’ – and, if the public cannot be offered ever-greater prosperity, there are other ways in which the lot of the ‘ordinary’ person can be improved.

At first sight, no such alternatives seem to exist for business. The whole point of being in business, it can be easy to assume, is the achievement of growth. Whether it’s bigger sales, bigger profits, a higher profile, a growing market value or higher dividends for stockholders, every business objective seems tied to the pursuit of expansion.

None of this, in the aggregate at least, seems compatible with an economy in which the prosperity of customers is shrinking.

In reality, though, both de-growth and de-layering offer opportunities as well as challenges. The trick is to know which is which.

For those of us not involved in business, the critical interest here is that, driven as they are by competition, businesses are likely to be quicker than other sectors to recognise and act upon the implications of the post-growth economy.

Getting to business

How, then, are businesses likely to position themselves for the onset of de-growth? The answer begins with the recognition of two realities.

The first of these is that prosperity is deteriorating, and that there is no ‘fix’ for this situation.

The second is that ‘price isn’t value’.

As regular readers will know, prosperity in most of the Western advanced economies (AEs) has been in decline for more than a decade, and a similar climacteric is nearing for the emerging market (EM) nations.

This fundamental trend is, as yet, unrecognised, whether by ‘conventional’ economic interpretations, governments, businesses or capital markets. It is already felt, though, if not necessarily yet comprehended, by millions of ordinary people.

‘Conventional’ economics, with its fixation on the financial, fails to recognise the deterioration of prosperity because it overlooks the critical fact that all economic activity is driven by energy. There is no product or service of any economic utility which can be supplied without it. Money and credit are functions of energy because, being an artefact wholly lacking in intrinsic worth, money commands value only as a ‘claim’ on goods and services – all of which, of course, are themselves products of the use of energy.

The complicating factor in the prosperity equation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This consumed proportion is known here as ECoE (the Energy Cost of Energy), a concept related to previously-defined concepts such as net energy and EROI.

Critically, what remains after the deduction of ECoE is surplus energy. The aggregate of available energy thus divides into two components. One of these is ECoE, and the other is surplus energy, which drives all economic activity other than the supply of energy itself.

This makes surplus energy coterminous with prosperity.

The relentless (and unstoppable) rise in ECoEs has now squeezed aggregate prosperity to the point where the average person is getting poorer. There is nothing that can be ‘done about’ this, so the necessity now is to adapt.

SEEDS – the Surplus Energy Economics Data System – has been built and refined to model the economy on this basis. Its identification of deteriorating prosperity accords with numerous ‘on the ground’ observations, whether in economics, finance, politics or society.

But general recognition of this interpretation has yet to occur, and, in its absence, the economic history of recent years has been shaped by efforts to use the financial system to deny (since we cannot reverse) this process. The main by-product of this exercise in denial has been excessively elevated risk.

Conclusions come later, but an important point to be noted from the outset is that, as the economy gets less prosperous, it will also get less complex, resulting in the phenomenon of ‘de-layering’. An understanding of this and related processes will be critical to success in an economic and business landscape entering unprecedented change.

The reality of deteriorating prosperity

A necessary precondition for the formulation of effective responses is the recognition of where we really are, and there are two observations with which this needs to start.

The first is the ending and reversal of meaningful “growth” in prosperity. Any businessman or -woman who believes that economic “growth” is continuing ‘as usual’, or can somehow be restored, needs to reframe his or her interpretation radically. Indeed, it’s been well over a decade (and, in many instances, nearer two decades) since the advanced economies of the West last achieved genuine growth in economic prosperity.

For illustration, the deterioration in average personal prosperity in four Western countries, both before and after tax, is set out in the following charts. Examination of the trend in post-tax (“discretionary”) prosperity in France, in particular, does much to explain widespread popular discontent.

Worse still, from a business perspective, a similar downturn is now starting in the hitherto fast-growing EM economies, including China, India and Brazil.

To be sure, the authorities have done a superficially plausible job of hiding the reality of falling prosperity, first by pumping cheap credit into the system and, latterly, by doubling down on this and turning the real cost of money negative. The only substantive products of these exercises in credit and monetary adventurism, though, have been enormous increases in financial exposure.

The cracks are now beginning to show, and in ways that should be particularly noticeable to business leaders.

Sales of a broadening number of product categories, from cars and smartphones to chips and components, have turned down. Debt continues to soar (which is hardly surprising in a situation in which people are being paid to borrow), and questions are starting to be asked about credit ratings, debt servicing capability and the possible onset of ‘credit exhaustion’ (the point at which borrowers no longer take on any more credit, however cheap it may be).

Whole sectors (such as retailing and air travel) are already being traumatised. Returns on invested capital have collapsed, and this has had knock-on effects in many areas, but nowhere more so than in the adequacy of pension provision (where the World Economic Forum has warned of a “global pensions timebomb”). Even before this pensions reality strikes home to them, ordinary people are becoming increasingly discontented, whether this is shown on the streets of Paris and other cities, or in the elections whose outcomes have included Donald Trump, “Brexit” and a rising tide of “populism” (for which the preferred term here is insurgency) and nationalism.

There are, of course, those who contend that falling sales of cars and chips ‘don’t matter very much’, because we can continue to sell each other services which, even where they are of debateable value, can still be monetised, so will continue to generate revenues. These assurances tend to come from the same schools of thought which previously told us that debt, too, ‘doesn’t matter very much”.

This wishful thinking, arguably most acute in the ‘tech’ sector, ignores the fact that, as the average consumer gets poorer, he or she is going to be become more adept, or at least more selective and demanding, in the ranking of value. In a sense, the failure to recognise this trend repeats some of the misconceptions of the dot-com bubble – and the answer is that you can only be happy about ‘virtual’ and ‘intangible’ products and sales if you’re equally relaxed about earning only virtual and intangible profits. But business is, or should be, about cash generation – nobody ever bought lunch out of notional profits.

Let’s put this in stark terms. If someone is in the business of selling holidays, he or she makes money when people actually travel to the facility, and pay to use its services. They could, of course, sell them computer-generated virtual tours of the facility as a sort of proxy-residency – but does anyone really think that that’s a substitute for the revenue that is earned when they actually visit in person?

Another way to look at this is that businesses are likely to become increasingly wary of middle-men and ‘agencies’. This reflects de-layering, an issue to which we shall return later. But the general proposition is that, in de-growth, businesses will prosper best when they capture as much of the value-chain as possible, ensuring that ‘value’ predominates over ‘chain’.

Ancillary services, and ancillary layers, are set to be refined out, and businesses are likely to become increasingly wary of others trying to monetise parts of their chain.

Understanding value

The second reality requiring recognition is that the prices of capital assets, including stocks, bonds and property, have risen to levels that are both (a) wholly unrelated to fundamental value, and (b) incapable of being sustained, under present or conceivable economic conditions.

Statements like “the Fed has your back” are illustrative of quite how irrational this situation has become. The idea that inflated asset prices can be supported indefinitely by the perpetual injection of newly-created liquidity is puerile beyond any customary definition of that word.

We may not know how long asset prices can continue to defy economic gravity, or how the eventual reset will take place, but the definition of ‘unsustainable’ is ‘cannot be sustained’.

A general point needing to be made is that is called “value” by Wall Street and its overseas equivalents is of little relevance to what the word should mean in business. The interests of business and of the capital markets are by no means coterminous, since the objectives of each are quite different. The astute business leader might listen to the opinions of those in the financial markets, but acts only on his or her own informed conclusions.

From a business perspective, the value of an asset is the current equivalent of its future earning capability. No apology is made to those who already understand this universal truism, because, though fundamental, it is all too often overlooked. This principle can be best be illustrated by looking at a simple example such as a toll bridge.

To the owner (or potential acquirer) of a toll bridge, various future factors are known, though with varying degrees of confidence. He or she should know, at high levels of confidence, appropriate rates of depreciation and costs of maintenance. He has an informed opinion, albeit at a somewhat lesser level of confidence, about what the future toll charges and numbers of users are likely to be.

This information enables him to project into the future annual levels of revenue and cost. He can, moreover, divide the cost component into cash and non-cash components, the latter including depreciation and amortisation. From this, he can create a numerical forward stream of projected cash flows and earnings.

The question which then arises is that of what value today can be ascribed most appropriately to the income stream to be realised in the future.

This process requires risk-weighting. Costs and taxes may turn out to be higher or lower than the central case assumptions, and the same is true of revenue projections. Customer numbers and unit revenues may be influenced by factors outside either the control of the owner or of his ability to anticipate. Degrees of variability can and should be factored in to the calculation of appropriate risk.

What happens now is that a compounding discount factor is created by combining risk, inflation, cost of capital and the time-value of money. Application of this factor turns future projections into numbers for discounted cash flow (DCF) as a net present value (NPV).

There is nothing at all novel about DCF-NPV calculation, and it is used routinely by those valuing individual commercial assets. It is, incidentally, far more reliable than ROI (return on investment) or ROC (return on capital) methodologies, let alone IRR (internal rate of return).

Importantly, though, this valuation procedure is applicable to all business ventures. The process becomes increasingly complex as we move from the simple asset to the diversified, multi-sector business, and increasingly conjectural where rising levels of uncertainty (over, for instance, future rates of growth) are involved.

But the principle – that the worth of a business asset is coterminous with what it will earn in the future – remains central.

The nearest that capital markets tend to get to this is to price a company on the basis of its future earnings, which is where the P/E ratio (and its various derivatives) fit into the process. A more demanding (but more useful) approach substitutes cash flow for earnings, and generates the P/CF ratio. P/FCF (price/free cash flow) is a still better approach, though all cash flow-based calculations need to ensure that a tight definition and a robust methodology are involved.

Where P/E ratios are concerned, both growth potential and risk should be (though often aren’t) reflected in multiples. When one company is priced at, say, 10x earnings whilst another is priced at 20x, it’s likely that the latter is valued more aggressively than the former because growth expectations are higher (though it is also possible that the lower-rated company is considered to be riskier).

Much of the foregoing will be well-known to any competent business leader or analyst. It is referenced here for two reasons – first, because it produces valuations which typically bear little or no resemblance to today’s hugely inflated financial market pricing of assets and, second, because an understanding of fundamental value needs to be placed at the centre of any informed response to the onset of de-growth.

Markets are driven by many factors beyond the trinity of ‘fear, greed and [sometimes] value’. Supplementary, non-fundamental market factors, whether or not they are of meaningful relevance to investors and market professionals, should not exert undue influence on the decisions made by business leaders. “What will my share price be in a year from now?” may be an interesting subject for speculation, but should play little or no part in planning.

This point is stressed here because deteriorating prosperity will invalidate almost all market assumptions. This deterioration is an extraneous factor not yet known to the market. It destroys the credibility of the ‘aggregate growth’ assumption which informs the pricing both of individual companies and of sectors. It impacts customer behaviour, and customer priorities, in ways that markets could not anticipate, even if they were aware of the generalised concept of de-growth.

This is why business strategy needs to incorporate a concept which may be called ‘de-complexifying’ or, more succinctly, de-layering.

The critical understanding – the de-layering driver

It’s useful at this point to reflect on the way in which our economic history can be defined in surplus energy terms.

Our hunter-gatherer ancestors had no surplus energy, because all of the energy that they derived from nutrition was expended in the obtaining of food. Agriculture, because it enabled twenty individuals or families to be fed from the labour of nineteen, created the first recognizable economy and society because of the surplus energy which enabled the twentieth person to carry out non-subsistence tasks. This economy was rudimentary, reflecting the fact that the energy surplus was a slender one. Latterly, accessing the vast energy contained in fossil fuels leveraged the surplus enormously, which meant that only a very small proportion of the population needed now to be engaged in subsistence activities, with the vast majority now doing other things.

This process made the economy very much larger, of course, but it’s more important, especially from a business perspective, to note that it also made it very much more complex. Where once, for example, we had only farmers and grocers, with very few layers in between, food supply has since become vastly more diverse, involving an almost bewildering array of trades and specialisations. The linkage between expansion and complexity holds true of all sectors.

The most pertinent connection to be made here is that, just as prior growth in prosperity has driven growth in complexity, the deterioration in prosperity is going to have the opposite effect, initiating a trend towards a reduction in complexity. One term for this is ‘simplification of the supply chain’. Another, with applications far beyond commerce, is de-layering.

This has two stark and immediate implications for businesses.

First, a business which can front-run de-layering, simplifying its operations before others do so, can gain a significant competitive advantage.

Second, if a business is one that might get de-layered, it would be a good idea to get into a different business.

First awareness

In this discussion we have established three critical understandings:

– Prosperity is deteriorating, for reasons which mainstream interpretation has yet either to recognise or to understand.

– Attempts to ‘fix’ this physical reality by means of financial gimmickry have resulted only in increases in risk, many of them associated with the over-pricing of assets.

– As prosperity decreases, the economy will de-complexify.

These points describe a situation whose reality is as yet largely unknown, but one reason for selecting business (rather than, say, government, the public sector or finance) for this first examination of the sector implications of deteriorating prosperity is that businesses are likely to discover this new reality more quickly than other organisations.

Whilst by no means free from the assumptions, conventions, ‘received wisdoms’ and internal group interests that operate elsewhere, businesses are driven by competition – and this means that, should a small number of enterprises discover and act upon the implications of de-growth, de-layering and disproportionate risk, others are likely to follow.

We cannot, of course, discuss here the many practical steps which are likely to follow from recognition of the new realities and, in some cases, it might be inappropriate to do so.

It seems obvious, though, that a business which becomes familiar with the situation as it is described here will seek to take advantage of inappropriately elevated asset prices, and to test its value-chain and its operations in the light of future de-layering. Ultimately, the aim is likely to be to front-run both de-layering and revaluation. Moreover, awareness of those countries in which prosperity deterioration is at its most acute is likely to sharpen the focus of multi-regional companies.