LONG-ODDS BET OR A PORTFOLIO OF SCENARIOS?
EXPLORING THE ‘PRECURSOR ZONE’
These are hard times for what British politicians ritually call “hard-working families”. Taxes have been raised to levels not seen since the post-War years. The ‘cap’ on the costs of electricity and gas has been increased by 23% so far this year.
Our focus here is on global economic issues, not local political ones, so this isn’t the place to debate whether the tax increases could have been implemented more equitably (which probably they could), or whether the additional revenues will be sufficient to fund the cost of social care for the elderly (which very probably they won’t).
The point is that paying more tax – and having to spend more on electricity and gas – leaves less money in the pockets of “hard-working families”.
Inflated asset prices may enable statisticians to claim that Britain has ‘never been wealthier’, and official figures continue to show “growth” in the economy.
But the inflated prices of property, equities and other assets are functions of the ultra-low cost of money, whilst “growth” in GDP is a conjuring-trick – comparing 2020 with 2000, aggregate British debt has increased by £2.8 trillion in real terms, whilst GDP has “grown” by just £400bn. Even this ratio – of £6.90 borrowed for each £1 of “growth” – understates the true extent to which “growth” has been bought with credit. Asset prices, meanwhile, cannot be monetized in aggregate, because the only people to whom an entire asset class can ever be sold are the same people to whom it already belongs.
GDP measures economic activity, whether as money spent and invested, or received as incomes. It doesn’t concern itself with where this money comes from, or connect recorded “activity” to a balance sheet showing forward commitments.
GDP thus measured can always be inflated by pouring credit into the economy. Within the parameters of currency credibility, GDP can be ‘pretty much whatever you want it to be’, so long as you can pour enough liquidity (which conventional economics calls demand) into the system.
In 2020, the year of the coronavirus crisis, British GDP fell by 9.9%, or £230bn, but that’s after the authorities had pushed more than £280bn of additional liquidity – borrowed by the government, and monetized by the Bank of England – into the system.
What we’re describing here is a flagging economy, with GDP juiced using credit expansion, at an adverse rate of exchange where nearly £7 of borrowing gets you £1 of “growth”. Meanwhile, the cost of essentials – whether purchased by households or provided by the state – is rising, whilst underlying prosperity is not. The overhang of liabilities – debt, other financial commitments and forward pension promises – keeps getting bigger.
We need to be clear that these problems are by no means unique to the United Kingdom, and are worse in other countries, including the United States. The situation may look better in some of the EM (emerging market) economies, but all this really means is that the West has already encountered problems which, for some Asian countries, still lie in the future.
What we’re experiencing, at least in economic terms, is the approach of The Limits to Growth (LtG), as forecast back in 1972 by Donella Meadows, Dennis Meadows, Jørgen Randers and William Behrens. Recent analysis by Gaya Herrington has used intervening data to demonstrate, first, that the authors of LtG got it right, and, second, that we may be within “a decade or so” of the point at which growth comes to an end.
If this is indeed the case, it’s highly unlikely that the ending – and, in all probability, the reversal – of growth will be an event, narrowly identifiable in time. It’s always been likelier that this would be a process, characterised by (a) economic deceleration, and (b) increasing stress on all systems that are – like the global financial system – wholly predicated on growth.
This is exactly where we are now. To be more specific, the world economy entered what we can call a precursor zone back in the 1990s. That was when observers began to worry about “secular stagnation”, and the authorities embarked on ‘credit adventurism’ – and, latterly, on ‘monetary adventurism’ as well – in an effort to ‘fix’ a problem that they didn’t understand.
Once we’re clear about the real dynamics of the economy, we can see why growth has been tipping over into involuntary “de-growth”, and we can also understand the lead-indicator mechanics of the “precursor zone”. Growth has flagged for reasons which have little or nothing to do with money, and everything to do with the energy dynamic which really determines prosperity.
Unable to understand this process, and shackled to the imperative of delivering ‘growth in perpetuity’, decision-makers have poured ever more credit into the system, much of it monetized by central banks. Though efforts have been made to improve regulation of the banking system since the 2008-09 global financial crisis (GFC), much of the subsequent expansion in credit has occurred in the unregulated ‘shadow banking’ system.
For a group of twenty-three economies (G23) for which fully comprehensive data is available – and which, between them, account for 80% of the global economy – aggregate financial assets (which, for the most part, are the liabilities of the non-financial economy) now stand at an estimated 495% of GDP, up from 300% back in 2002.
Even this ratio increase is a severe understatement of the real extent of exposure, because credit and monetary expansion has inflated GDP to levels far ahead of underlying economic prosperity. If we measure the financial assets of the G23 countries against prosperity, the ratio already stands at about 700%.
Regular readers will be familiar with the concept of prosperity, and how it differs from the increasingly misleading conventional measure that is GDP. The first point to be understood is that economic output is a function of the use of energy, because nothing that has any economic utility at all can be supplied without the use of energy. The history of the Industrial Age has been one of using ever larger amounts of energy to deliver economic value at rates of growth which, until quite recently, exceeded the rates at which population numbers were increasing.
The second critical point is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy). The role played by ECoE is that it’s the difference between economic output (a function of the use of energy) and prosperity (which is what remains after the deduction of ECoE).
This understanding provides us with an equation which, in principle at least, is comparatively straightforward. Prosperity is a function of the quantity of energy used, the value and cost of that energy, and the number of people between whom the resulting aggregate is shared. Money isn’t an intrinsic part of the prosperity equation, but acts as a proxy and a medium of exchange – money has no intrinsic worth, but commands value only as a ‘claim’ on the products of the energy economy.
In recent times, the prosperity calculus has become a constrained equation, in which the constraints are (a) the rising ECoEs of energy supply, and (b) the limits to environmental tolerance of the use of fossil fuels.
The only way of breaking out of these constraints would be to find an alternative source of energy which delivers low and falling (rather than high and rising) ECoEs, and can be utilized without causing environmental harm. Desirable though their expansion undoubtedly is, renewable sources of energy (REs) such as wind and solar power cannot meet these requirements. Their expansion, maintenance and replacement are dependent on legacy energy from fossil fuels, and their ECoEs are highly unlikely ever to be low enough to support current levels of prosperity, let alone allow for a resumption of “growth”.
As the following charts show, even the rapid expansion of RE capacity cannot be expected to do more than blunt the rate at which overall ECoEs rise. The pace at which global aggregate prosperity has been growing has decelerated markedly since we entered the precursor zone in the 1990s, and we are now at or very near the point where aggregate prosperity starts to shrink. Because aggregate prosperity growth has fallen below the rates at which population numbers have continued to increase, prosperity per capita has already turned down.
As this ‘top-line’ measure of prosperity per person has turned downwards, the cost of essentials has continued to rise, in part because many necessities are at the high end of the energy intensity spectrum. This means that the discretionary (ex-essentials) prosperity of the average person in each of the Western economies is already under increasing pressure, as typified in the charts for Japan, the United States and the United Kingdom.
‘Essentials’ are defined here as the estimated total of household necessities and public services provided by the government. The British situation exemplifies the rising trend in essentials – taxes have had to be increased to fund public services (in the current instance, health and social care), whilst rises in the costs of electricity and gas reflect trends which can be expected to extend to other energy-intensive necessities, not just in Britain but across the world.
As well as a deterioration in prosperity which is adversely leveraged at the discretionary level, this situation also leaves us trying to support an ever-growing burden of financial commitments on a static and, in due course, contracting basis of aggregate prosperity.
The final set of charts illustrates this process with reference to the G23 countries which represent four-fifths of the global economy.
Since we entered the precursor zone in the 1990s, both debt and broader financial assets have grown much more rapidly than GDP. Output reported as GDP has itself been inflated by credit expansion, and now far exceeds both underlying output (C-GDP) and prosperity.
Measured against prosperity, both debt and broader liabilities have become unsustainably large, pointing towards either the ‘hard’ default of repudiation or the ‘soft’ default of inflationary devaluation.
Asset prices, meanwhile, have been driven to highly over-inflated levels, primarily because the prices of assets move inversely with the cost of money. We might suppose that asset prices will remain at inflated levels until the liability side of the equation reaches the nemesis of hard or soft default.
Examination of the precursor zone and the dynamics of falling discretionary prosperity do, though, suggest that another process might trigger asset price slumps. Equity markets are dominated by the suppliers of discretionary goods and services, which is likely to worry investors once they realise that the scope for discretionary consumption, already propped up by the continuity of credit expansion, is shrinking. At the same time, the affordability of property is linked to incomes on a post-essentials, credit-adjusted basis.
PUTTING IT TOGETHER – HOUSEHOLDS AND THE FINANCIAL SYSTEM
In the previous article, we sought out a logical and evidential alternative to the continuity assumption that the economy can shrug off resource and environmental limitations in order to grow in perpetuity.
We demonstrated that the economy is an energy system – not a financial one – and that the fossil fuel dynamic on which the vast and complex economy of modern times was built is fading away, with no fully sufficient alternative in sight. The equation which calibrates prosperity in terms of energy use, value and cost has become a constrained equation, the constraints being (a) the relentless rise in the ECoEs of fossil fuels, and (b) the limits of environmental tolerance.
This does not, of itself, vindicate collapse theories, but it does mean that the world is getting poorer. The downturn in prosperity per person was preceded by a long period of deceleration, first identified (though not explained) in the 1990s, when it was labelled “secular stagnation”. Much of our economic experience in the intervening quarter-century has been characterized by failed efforts to use financial policies to ‘fix’ an economic problem which is not financial in nature, and thus cannot be countered using credit or monetary adventurism.
The onset of involuntary “de-growth” has profound implications for the four components of the economy which we can categorize as the household, business, government and financial sectors. Of these, the most important – and the easiest to project into the future using the SEEDS model – is the household sector. Simply stated, the average person will get poorer, on a continuing rather than a temporary basis, and his or her discretionary prosperity will be eroded by relentless rises in the real cost of essentials. At the same time, he or she enters this era with uncomfortably elevated levels of debt and quasi-debt commitments.
Through its effects on households as consumers, producers, savers, borrowers and voters, this process will shape the future development of the financial system, business and government.
The faith mistakenly placed in the ‘perpetual growth’ assumption has been strong enough to ensure that there has, thus far, been little awareness of, and even less planning for, the downtrend in global prosperity. Decision-makers in government, business and finance still seem to think that we can muddle through using denial, wishful thinking and a cocktail of things that Smith and Keynes didn’t actually say.
Financial – the high price of failed fixes
The immediate battleground for the conflict between continuity and reality is the financial system. Efforts to use financial policies to ‘fix’ the process of economic deceleration and decline have driven an enormous wedge between the ‘real’ economy of goods and services and the ‘financial’ economy of money and credit. Between 2000 and 2020, each dollar of reported “growth” was accompanied by more than $3 of net new debt creation and an increase of nearly $4 in broader financial commitments – and even these numbers exclude the emergence of enormous “gaps” in the adequacy of pension provision. Buying $1 of largely cosmetic “growth” with upwards of $7 of forward financial promises is not a sustainable way of managing an economy.
This has put the authorities between the Scylla of runaway inflation and the Charybdis of sharp rises in the cost of money. To be clear, finance ministries can run enormous fiscal deficits, and central banks can monetize the ensuing increases in debt, but neither can create the new sources of low-ECoE energy without which the economy must contract.
When we understand money as a claim on the output of the real economy, it becomes clear that the rampant creation of money and credit can only result in the accumulation of excess claims. These cannot, by definition, be met ‘at value’ by a contracting economy. This means that the value supposedly incorporated in these excess claims must be eliminated, either through the soft default of inflation or the hard default of repudiation.
The conundrum facing the authorities is simply stated. If they continue with negative real interest rates, which deter saving and encourage borrowing – and if they carry on believing that ever-larger injections of stimulus can somehow return the real economy to “growth” – they will drive the system into an inevitable process by which inflation destroys the purchasing power of money.
If, on the other hand, they decide to defend the value of money by raising rates into positive real territory, they will trigger slumps in the values of assets, and set a cascade of defaults running through the system.
The current policy is one of ‘hoping for the best’, assuring the public that the current spike in inflation is a “transitory” phenomenon caused by the coronavirus pandemic.
There are two main reasons for knowing that this explanation is false. First, ‘we’ve heard it all before’. The term “transitory” is the 2021 equivalent of the promise that the introduction of QE and ZIRP back in 2008-09 were “temporary” and “emergency” expedients. The more direct analogy is with the 1970s, when inflation was deemed a “temporary” problem, and governments even introduced the concept of “core” inflation, which excluded those very items (energy and food) whose prices were rising most dramatically at that time.
The second factor arguing against the “transitory” description of inflation is that soaring prices take on a momentum of their own. Rises in the cost of living prompt demands for higher wages, which in turn raise producer costs and push prices higher. To a significant extent, inflation is a product of expectation, a form of self-fulfilling prophecy that gives the authorities a rationale for understating what’s really happening in an effort to damp down public expectations. This, though, cannot work when consumers can see the prices of goods and services rising. This time around, the long-standing inflation in the prices of assets reinforces perceptions of inflation at the consumer level.
Where the inflationary issue is concerned, we need to be clear about causation. The chain of events began with a deterioration in the energy equation which determines prosperity. The authorities sought to counter this deterioration in ways which have led, with grim inevitability, to where we are now.
The policy of ‘credit adventurism’ – of making debt more readily available than at any time in the past – started a rise in asset prices, and created a surge in debt. When these trends crystalized in the 2008-09 GFC, the authorities responded with ‘monetary adventurism’, taking the real cost of money into negative territory.
This boosted asset prices still further, and created yet more debt, much of it channelled through the shadow banking system rather than through the more regulated channel of mainstream banking. Now we are in the grip of reckless stimulus, being carried out in the desperate hope that injecting ever more deficit finance, and persuading central banks to monetize most or all of it, will somehow reinvigorate the real economy (which it won’t), without triggering runaway inflation (which it will).
The outcome of the inflationary conundrum is likely to follow the pattern set in the late 1970s and the early 1980s. First, the authorities dismiss inflation as a passing phase, and refuse to raise rates to counter it. Latterly, they take a reluctant and belated decision to act, raising rates in a macho demonstration of resolve.
That’s when asset prices collapse, and a wave of defaults rips through the system.
Back in the 1980s, this process triggered a sharp recession, but this proved temporary, because ECoEs remained low, and the economy remained capable of growth.
Neither condition prevails today. ECoEs have risen from 1.8% in 1980 to 9.2% now. Recovery in the 1980s involved the restoration of positive trends which had driven prosperity steadily upwards between 1945 and the disruptive and inflationary first oil crisis of 1973-74. Today, by contrast, inflation risk comes in the context of a long period of economic deceleration which, in the West, segued into deterioration between 1997 and 2007.
The first set of charts illustrates the magnitude of financial imbalances, comparing debt – and broader financial assets, which include the shadow banking system – with reported GDP and underlying prosperity. Full financial assets data isn’t available for the global economy as a whole, so the left-hand chart illustrates a group of 23 countries for which numbers are available and which, between them, represent four-fifths of the World economy.
Households – leveraged hardship
In any case, the financial system faces challenges which are far broader than the comparatively straightforward (though daunting) choice between inflation and rises in rates. This is where trends in the critically-important household sector shape the outlook.
The average person in the West has been getting poorer over an extended period, though this reality has been masked by financial manipulation. Trends in prosperity, set against debt per capita, illustrate this situation as it has affected France, Britain and Canada (see fig. 2). Debt, it must be emphasised, has to be considered in the aggregate, including the government and business sectors, not just household indebtedness. Even these debt numbers exclude per capita shares both of broader financial assets and of off-balance-sheet commitments such as the underfunding of pensions.
In France, prosperity per person reached its zenith in 2000, since when the average person has become poorer by 8% (€2,540), whilst his or her share of debt has increased by 91% (€59,500). The inflexion-point in Britain occurred in 2004, since when prosperity has fallen by £4,600 (16%) whilst debt per person has increased by £23,800 (39%). The average Canadian has become 12% poorer, and 60% deeper in debt, since 2007.
One of the myths of the contemporary economy is that sharp increases in indebtedness are cancelled out by rises in the prices of assets.
The reality, of course, is that increases in the supposed value of property and financial assets cannot be monetized, because the only people to whom a nation’s property or asset stock can be sold are the same people to whom they already belong.
The individual property owner can monetize the gain in property values, but even he or she then needs to obtain alternative accommodation. But homeowners in aggregate cannot do this, and reported aggregate ‘valuations’ are an error rooted in the use of marginal transaction prices to put a ‘value’ on housing stock in its entirety. Essentially, asset prices are functions of the cost of money, and of the quantum of credit in the system. As the economy moves further into de-growth, and as the inflationary spiral has to be countered by raising rates, inflated asset valuations can be expected to melt away like snow on the first warm morning of spring.
The decreases in prosperity cited here may seem pretty modest – the average French person has become 8% poorer over twenty years, the average British person’s prosperity has fallen by 16% over sixteen years, and Canadian prosperity has deteriorated by 12% over thirteen years. People in these countries have, then, been getting poorer at rates at or below about 1% per annum.
In terms of living standards, though, these rates of deterioration have been leveraged by relentless increases in the cost of essentials. In the SEEDS model, the calibration of essentials remains at the development stage, where ‘essentials’ are defined as the sum of household necessities and public services provided by the government. The definition of ‘essential’ varies over time and between countries, such that essentials may defy detailed calibration.
This said, the overall picture seems clear. As prosperity has fallen, the share of prosperity accounted for by essentials has risen. Moreover, the real cost of essentials is being driven upwards, because the energy-intensive character of many necessities creates a linkage between their real costs and rises in ECoEs.
What this leverage means is that, over a twenty-year period in which French top-line prosperity has fallen by 8%, discretionary prosperity – what remains after essentials have been paid for – has slumped by 23%. British discretionary prosperity has fallen by 34% (rather than 16%) since 2004, and the decline of 12% in Canadian prosperity since 2007 has seen discretionary prosperity fall by 24% (fig. 3).
These sharp falls in discretionary prosperity have not been reflected in actual discretionary consumption – but the gap between the two (which SEEDS can quantify) has been filled by continuous expansions in credit.
In some sectors this effect has been a direct one, and few people now buy a new car, for example, as a one-off purchase. Households may borrow on their own account to pay for, say, a holiday, but the broader effect is that household credit increases are supplemented by government and business borrowing – the former reduces the tax burden on households, whilst, in the absence of business borrowing, employment and wages would be lower, and consumer goods and services would be either more expensive and/or less readily available.
There is, of course, a direct connection between an over-inflated financial system and deteriorating household prosperity. As and when a halt has to be called on perpetual credit and broader financial expansion, discretionary consumption will slump.
This of itself will impact the perceived values of discretionary sector businesses, and this trend will be compounded as businesses respond to de-growth tendencies including de-complexification, simplification (of product ranges and processes), adverse utilization effects and the loss of critical mass. At the same time, households will be forced to relinquish many of the outgoings which form streams of income for the corporate sector.
Ultimately, there are adverse feedback loops which connect deteriorating prosperity with a degradation of the financial economy. At the same time, the public is likely to be distressed, not just by the loss of cherished discretionary products and services, but by the widening hardship which occurs as falling prosperity draws ever nearer to the rising cost of necessities. The implications of this dynamic for government and the corporate sector are certain to be profound, but these implications must await another stage in our journey from ‘what we know’ about the present to ‘what we want to know’ about the future.
In the meantime, here’s a reminder – if a reminder were needed – of how rising ECoEs drive prosperity downwards in a way that is frighteningly not understood by decision-makers in government, business and finance.
THE CONSTRAINED EQUATION
Most of us, for one reason or another, want to know “what comes next”. There are many wrong ways of going about this. We can, for instance, take our expectations for the future ‘on trust’ from others, or we can simply assume (meaning hope) that the future will be what we want it to be.
The only effective way of forming rational expectations, though, is to follow a ‘path of reason’ from “what we know” (about the present) to “what we want to know” (about the future).
The original plan here was to try to encompass this within a single discussion. Practicality, though, suggests that we tackle this in two or three stages.
This first instalment starts with “what we know”.
This turns out to be rather a lot.
We know, for example, that the economy is an energy system. This knowledge identifies an equation which expresses the conversion of energy into material prosperity.
We know, further, that this is a constrained equation. The constraints on our conversion of energy into prosperity are set (a) by the physical characteristics of energy resources, and (b) by the limits of environmental tolerance.
This knowledge enables us to clear the ground by dismissing the fallacy of the infinite. Infinite growth isn’t feasible on a finite planet and within a finite ecosphere.
Far too much of our thinking, and far too many of our economic and broader systems, are based on this ‘infinity fallacy’. We assume, for instance, that economic growth can continue in perpetuity, and that a sustainable financial system can be built on this false assumption. We assume that businesses can offer perpetual expansion to their shareholders, and that governments can promise never-ending “growth” to their electorates.
We’ve reached a point at which the reality of constraint is discrediting the fallacy of the infinite. Environmental constraint is demonstrating itself to us with shocking force. Resource constraint has pushed us into a self-deluding falsification of economic “growth”.
Effective planning for the future requires recognition of the realities of constraint.
At the end of certainty
As well as casting a long shadow over society and the economy, the coronavirus pandemic has created a remarkably extreme ‘dialogue of the deaf’ between competing certainties.
On the one hand, the authorities present vaccines as a ‘magic bullet’, whose efficacy and safety are questioned only by the anti-social and the deranged.
On the other, critics insist, with equal certainty, that the whole ‘covid and vaccine show’ is some kind of nefarious plot by malign agents of ‘the elites’.
Those of us who don’t have specialist knowledge of life sciences cannot determine where reality resides within this shouting-match. Even the experts may not, as yet, have all the requisite information.
But the extremes of the debate about the coronavirus are echoed in similarly extreme views on the economy, finance and government. On the economy, opinions range all the way from ‘assured growth in perpetuity’ to ‘imminent collapse’.
We are entitled to be sceptical, in an impartial way, about certainties.
Excessive certainty, after all, is close kin to extremism, which has seldom served us well. Entrusting everything to the state worked out very badly in the Soviet Union. Handing everything over to ‘the market’ – or, in reality, to unfettered “animal spirits” – is turning out to have been an even bigger mistake.
It’s a reasonable presupposition that ‘all isn’t well’ in the economy, in finance, in government and in the broader categories of trust and social cohesion.
To enquire further than this, it’s necessary to proceed by logical steps from what we know (about the present) to what we want to know (about the immediate and longer-term future).
From what we know
For those who like their conclusions up front, “what we know” can be summarized as follows.
First, the economy is an energy system, whose historic dynamic – fossil fuels – is winding down.
Second, we face severe environmental and ecological threats. These are linked to a significant extent to energy use, which means that our economic and environmental “best interests” are not opposed to each other but, rather, are connected dimensions of a shared predicament rooted in energy.
Third, the world is becoming more confrontational. Wars and revolutions, of course, are recurrent features of history, but a notable feature of modern times is internal antagonism, based in (and further contributing to) suspicions of the motives of others.
Our fourth problem is a widespread lack of understanding of these issues. This might be simple ignorance of the realities around energy, the economy and the environment. It might, alternatively, be some form of denial, in which groups of any size (ranging from ‘elites’ or governments to the public generally) don’t wish to understand, or choose not to accept, the reality of our economic and environmental predicament.
The energy dynamic
In reasoning from “what we know” to “what we want to know”, the place to start is with the economy as an energy system.
As regular visitors to this site will appreciate, the evidence for this interpretation is overwhelming. Apart from anything else, nothing of any economic utility at all can be produced without the use of energy. Interruption to the continuity of energy supply would, and over a pretty short period, result in economic collapse.
Historical evidence affirms both this linkage and its causal direction. The exponential take-off in population numbers (and in their economic means of support) from the late 1700s paralleled a similarly exponential increase in the use of energy, the vast bulk of which, hitherto, has been sourced from fossil fuels.
These exponential take-offs occurred from the 1770s, when ‘what changed’ was the development of the first efficient heat-engines, which enabled us to put coal, oil and natural gas to economic use. So the causal linkage is clear enough – access to fossil fuel energy drove population and economic expansion, not the other way around.
A second, parallel and important observation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This is the principle of ECoE (the Energy Cost of Energy).
We know this to be a factual observation because, at the most basic level, we know that we cannot drill an oil well, lay a gas pipeline, manufacture a solar panel or a wind turbine, or install an electricity distribution grid without using energy. Just as energy has to be used to create energy-accessing assets, further energy has to be consumed in their maintenance, and in their eventual replacement. ECoE, then, comprises both initial investment and subsequent upkeep.
These observations form an equation which, in principle, is comparatively simple.
Economic output is a function of the use of energy. The economic value derived from energy use is a function of the surplus energy which remains after the ECoE proportion has been deducted. The resulting material prosperity is a function of the number of people between whom this surplus energy value is shared.
To understand economic prosperity, therefore, we need to know about trends in (a) total energy supply, (b) the ECoE deduction and the residual surplus energy, and (c) population numbers.
In passing, any economic interpretation or model which excludes any of these three components is founded on a fallacy which renders it worthless.
The realization of constraint
Recent times have seen the emergence of two constraints to continued reliance on fossil fuel energy.
The first of these constraints is the environment. We know that emissions from the burning of fossil fuels threaten to raise atmospheric temperatures, and we also know that “global warming” and “climate change” are short-hand for a much broader set of challenges. Pollution alone would be harmful, even if it wasn’t associated with temperature change. Ecological degradation is a consequence, not just of the use of oil, gas and coal, but of the economic growth made possible by fossil fuels.
We can accept, then, that fossil fuel consumption and broader economic expansion have moved us to a point of environmental and ecological constraint.
The second, less-recognized constraint is that the ECoEs of fossil fuels are rising relentlessly. This alone would, in due course, degrade and then destroy an economy wholly reliant on oil, gas and coal.
This means that the environment isn’t the only constraint on the use of fossil fuels. Anyone minded to oppose transition away from fossil fuels needs to be aware that, even if we were so unwise as to ignore environmental issues, rising fossil fuel ECoEs would, in any case, ultimately destroy the economy.
Put another way, those campaigning for greater environmental responsibility and a reduction in fossil fuel use have a “second string to their bow” in the form of ECoE.
The factors which drive ECoEs are – with one exception – reasonably well understood, and can be depicted as an ECoE parabola (see fig. 2).
In the initial stages of energy resource use, ECoEs are driven downwards by economies of scale and geographic reach. Once these drivers are exhausted, ECoEs are pushed back upwards by depletion, a natural consequence of using low-cost resources first, and leaving costlier alternatives for later.
The limits of technology and the reality of the finite
The exception to general understanding of ECoE is the role of technology. In the energy sphere, positive technological progress involves improvements in the efficiency with which energy is accessed and put to use. This progress accelerated the downwards trend in ECoEs and, latterly, has acted to mitigate the rise in energy costs.
But there are two other things that we need to know about technology.
First, its scope is constrained by the laws of physics. Technology has, for instance, lowered the cost of extracting tight oil and gas in the United States, but it hasn’t transformed American shale reserves into the equivalent of the conventional resources of Saudi Arabia.
That this has been impossible illustrates that technology operates within the confines of the characteristics of the resource itself. We cannot, by ignoring these physical constraints, extrapolate past technological trends indefinitely into the future.
Second, most technology doesn’t help us to use energy more efficiently but, rather, finds more ways to put energy to use. This isn’t ‘bad’ in itself, but it can contribute to a mindset which both (a) exaggerates the potential of technology as a ‘fix’, and (b) disguises the important dimension of energy efficiency within the loose category of ‘technology for the sake of technology’.
This consideration of constraints reminds us of another point which is too often forgotten. Economic growth, properly understood, is a matter of using the Earth’s resources to deliver material economic prosperity. These resources are not infinite.
We can debate the extent of the natural resources that were in place originally, and which remain today. These resources include energy, minerals and environmental tolerance.
What we can’t do with any credibility, though, is to claim that these resources aren’t, ultimately, finite. Any philosophy which ignores this reality, and which claims that economic growth can continue in perpetuity on a finite planet, is based on a fallacy of infinity.
The constrained equation
As we’ve seen, then, there’s an equation which relates energy use to the delivery of material prosperity. We’ve also seen that this is a constrained equation, whose limits are set (a) by resource characteristics (availability and ECoE-cost), and (b) by environmental and ecological boundaries.
Unfortunately, we’ve managed to disguise from ourselves the meaning, and even the existence, of this “constrained equation”. We’ve developed an economic philosophy which presupposes that “growth” can continue in perpetuity. We’ve allowed this infinity fallacy to influence our thinking about the world around us, and we’ve embedded this same fallacy into systems.
It’s important to be aware of the extent to which our economy and society are shaped by the “infinity fallacy”. Our financial system is entirely predicated on growth in perpetuity. Businesses, too, are conducted on the basis of a never-ending pursuit of expansion. Governments are assumed – by themselves and by the public – to have a mandate to deliver, in perpetuity, the ‘benefits of growth’.
Politicians and the public may, and do, argue about how growth should be used, and how it should be distributed between people and groups.
But nowhere – in finance, business, government or amongst the general public – is there any kind of preparation for an alternative to an assumed context of perpetual growth. If you ask a financier, a business leader or a politician about his or her plans if “growth” ceases – let alone if it goes into reverse – you’ll be met by a blank stare of incomprehension.
Everything that government, business and finance endeavours to achieve is informed by the assumption of growth. In response to environmental risk, proposals are almost always expressed in terms such as ‘green growth’, ‘responsible growth’, ‘sustainable growth’ and ‘equitable growth’.
To use a hackneyed term, there’s no “plan B” for an ex-growth economy, let alone for an economy whose prior growth has gone into reverse.
The fallacy of the infinite economy
Proceeding step by step, we’ve learned a great deal that conventional thinking fails (or refuses) to encompass.
To recap, the energy economy provides us with a prosperity equation that is constrained both by resource characteristics and by the limits of environmental tolerance. It is further constrained by the ultimately finite character of the Earth, both as a ‘resource set’ and as an ecosphere.
At no point, in reaching these conclusions, have we needed to consider money.
Money itself is a human artefact. As such, the creation of money isn’t bounded by the physical finality that limits material economic activity. But the only value of money is as a proxy for material goods and services whose supply is subject to these limits.
We can study the operation of money, and this study yields certain worthwhile insights. But the findings which orthodox economics is pleased to call “laws” are, in fact, simply behavioural observations about money. They are not remotely analogous to the laws of physics. Economics, as conventionally understood, may or may not be “gloomy”, but it certainly isn’t a “science”.
The central fallacy of orthodox economics is that it portrays the economy as a monetary system, when the reality, of course, is that it’s an energy dynamic.
The misconception here is huge. Observation and logic inform us that economic prosperity is the product of a physical dynamic that is subject to constraint. Conventional economics seeks to persuade us, instead, that the economy is an immaterial system shaped by the use of the unlimited human artefact of money.
As well as being a misconception, this is also a conceit. If it were true that economic activity was wholly a product of the use of money, then we, as the creators of money, would be in full control of what might grandiloquently be called our ‘economic destiny’.
Our actual position is a more modest one, in that our degree of control is strictly circumscribed by physical factors that we can’t control.
The human artefact of money is claimed to have three qualities. However, it’s an extremely poor ‘store of value’, and how well it functions as a ‘unit of account’ really depends on what it is that we’re trying to quantify.
The fundamental role of money is as a ‘medium of exchange’. Exchange, of course, is a process that depends upon there being something that people are able and willing to exchange. This is why no amount of money, in any form, would be of the slightest use to somebody lost in a desert, or cast adrift in a lifeboat.
Money, then, is validated by exchange, and the “something” for which it can be exchanged is the material value provided by the energy economy.
What this in turn means is that money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the energy economy.
To be clear about this, our control over the supply of money and credit enables us to create financial ‘claims’ that exceed the current or future delivery capability of the economy itself. When we do this, we create excess claims.
When we assign the concept of ‘value’ to the aggregate of claims, we create a situation in which the excess component of this supposed ‘value’ must be destroyed. This value destruction can take the form of repudiation (otherwise called hard default), or of the inflationary erosion of the value of money itself (soft default).
It has to be one, or both, of the above because, by definition, excess claims cannot be honoured, which means that supposed ‘value’ attached to these excess claims must be eliminated.
Of two economies
Given the relationship that exists between the constrained equation of the energy economy and the seemingly unconstrained scope for creating monetary claims, it’s helpful to think in terms of ‘two economies’ – the ‘real’ economy of goods and services, and the proxy or ‘financial’ economy of money and credit.
An understanding of the interface between the energy and the financial economies is critical to effective interpretation of the economy that we see around us.
This interface isn’t addressed by orthodox economic interpretation, because conventional economics is based on the false assumption that money is the economy. The objective of the SEEDS economic model is to understand the economy as an energy system, but to present conclusions in the financial idiom in which, by convention, economic issues are debated.
SEEDS analysis indicates that, in the advanced economies of the West, growth in energy-based economic output slowed during the 1990s, and went into reverse in the first decade of the twenty-first century. Modelling of the constrained equation indicates that prosperity per capita turned down in Japan from 1997, in America from 2000, and in Britain from 2004.
These inflexion-points correlate with the rise of trend ECoEs into a range between 3.5% and 5.0%. By virtue of their lesser complexity and their correspondingly lower system maintenance requirements, the equivalent climacterics for EM (emerging market countries) occur at higher levels of ECoE, levels which SEEDS places between 8% and 10%.
The downturn in prosperity which impacted the West between 1997 and 2007, then, isn’t something from which EM countries are immune. Rather, their inflexion-points happen in the same way, but at a later stage on the ECoE curve.
The relationship between ECoEs and prosperity per capita – in America, China and globally – is illustrated in fig. 3.
In the United States, prosperity per person turned down after 2000, when trend ECoE was 4.5%. The equivalent climacteric in China is projected to occur in 2026, when China’s ECoE is likely to be just below 10%.
For the world as a whole, prosperity has been on a long plateau, reflecting the interaction between Western countries (where people have been getting poorer over a lengthy period) and EM economies (where prosperity has continued to improve).
Perhaps the single most important economic event of our times is the ending of this plateau and the onset of de-growth on a global basis.
Exercises in denial
Recognition of this energy-constrained reality was, and remains, denied to those who believe in the infinity fallacy born of the mistaken assumption that the economy is a wholly monetary system. When deceleration – then labelled “secular stagnation” – started to be noted during the 1990s, the natural (though wholly mistaken) assumption was that there must exist a financial ‘fix’ for this unwelcome trend.
Briefly, the history of the intervening period is that the authorities tried, first, to restore growth by pouring abundant credit into the system, a process known here as credit adventurism. The fallacy here was the assumption that the creation of demand must, by some immaterial process, be met by increased supply, an assumption which is invalid in any situation governed by material constraints.
When, as was always inevitable, this gambit took the credit (banking) system to the brink of collapse, a resort was made to monetary adventurism. This process threatens to do to money what credit adventurism so nearly did to the banking system.
The policy of pricing money at sub-zero real levels has had a string of consequential effects. One of these has been an escalation in debt, and another has been rapid growth in the shadow banking system, known more formally as the ‘non-bank financial intermediation’ sector.
Over the past twenty years, we’ve been using credit and monetary policy to ‘buy’ economic “growth” at an adverse rate of exchange. Each dollar of “growth” reported since 2000 has been accompanied by more than $3 of net new debt, and by getting on for $4 of broader financial liabilities. Even these metrics exclude the emergence of huge “gaps” that have emerged in the adequacy of pension provision.
Using SEEDS, we can quantify the deterioration in prosperity, identify the correlation between rising ECoEs and the inflexion-points in underlying economic activity, and map the relationships between liabilities and the maintenance of a simulacrum of “growth”.
But the central issue here is the widening gap between (a) the real economy (of energy, value and prosperity), and (b) the proxy financial economy and its excess claims against non-existent future economic value.
Any article with the professed aim of preferring reasoned interpretation over received certainties must leave readers to determine how sure we can be about the conclusions that are reached here.
This said, there is very substantial evidence – logical and observational – for the proposition that the economy is a physical dynamic, driven by an energy equation that we can identify, and limited by the constraints both of resource characteristics and of environmental tolerance.
We can observe, too, that there is a general ignorance around this proposition, and an insistence, instead, on perpetual growth, driven by the immaterial processes of money within a context of assumed infinity.
If our interpretation is correct, then there exists a serious disconnect between the economy as it is and the economy as it is mistakenly assumed to be. A misunderstanding as fundamental as this goes quite far enough to explain the insistence on assumed certainties in the context of the emergence of a very different reality.
MEASURING THE USD PREMIUM
How big is the Chinese economy? On one level, that question is easily answered – last year, China’s GDP was RMB 91 trillion.
For comparative purposes, though, what’s that worth in dollars? Authoritative sources will tell you that China’s dollar GDP in 2020 was $14.7tn. Those same sources will also inform you that it was $24.1tn. That’s a huge difference. On the first basis, the Chinese economy remains 30% smaller than that of the United States ($20.9tn). On the second, it’s already 15% bigger.
The explanation for this very big difference lies, of course, in the two ways in which economic data from countries other than the United States can be converted into dollars. One of these is to apply average market exchange rates for the period in question. For convenience, we can call this market conversion.
The alternative is PPP, meaning “purchasing power parity”. To apply this conversion, statisticians compare the prices of the same products and services in different countries. (One such common product is a hamburger, which is why, in its early days, PPP was sometimes called “the hamburger standard”).
The differences between market and PPP calibrations of GDP are enormous. Last year, world GDP was $85tn on the market convention, but $132tn in PPP terms. At the same time, the use of PPP conversion diminishes America’s share of the global economy. Last year, the United States accounted for 25% of global GDP in market terms, but only 16% on the PPP basis.
Using PPP instead of market conversion doesn’t make the economy ‘bigger’, of course. It just means that a higher dollar value is ascribed to economic activity outside the United States.
There’s no ‘right’ or ‘wrong’ way of converting non-American economic numbers into dollars. To a certain extent, it’s case of selecting the convention best suited to the topic being examined. Market conversion is appropriate for transaction values, such as trade, and cross-border assets and liabilities. PPP provides a better measure of the comparative sizes of economies around the world. (The SEEDS economic model produces parallel output on both conventions, though with a preference for PPP).
For macroeconomic purposes, the PPP convention is arguably more meaningful than market conversion, because it better reflects the economic scale of countries like China and India. Additionally, it leaves both market sentiment and short-term vicissitudes out of the process. PPP conversion has been with us for decades, and is carried out by reputable authorities, such that we can accept it as a valid and consistent alternative basis of currency comparison.
Market rates are determined by many factors other than economic comparison. FX market players have multifarious reasons for liking or disliking various currencies. Their opinions do not constitute economic ‘facts’.
An obvious example here is the reaction to the “Brexit” vote. British citizens obviously didn’t wake up 20% poorer on the morning after the referendum, but that’s what market dollar valuation of the UK economy implied. By the same token, market-rate conversion asks us to believe that the economy of resource-rich Russia is a lot smaller (at $1.4tn) than that of Italy ($1.9tn).
People in Russia, China, India and elsewhere are not poorer because FX markets don’t, relatively speaking, like their currencies. Currency undervaluation against PPP equivalence does make these countries’ imports more expensive, but it also gives their exports a competitive advantage.
Benchmarking the market dollar premium
For present purposes, the importance of having two FX conversion conventions is that it enables us to benchmark the dollar itself. Using world economic data going back over four decades, we can examine the relationship between the PPP and the market valuations of the dollar.
In 2020, for example, the GDP of the world outside the United States (WOUSA) was $63tn on the market basis, but $111tn in PPP terms. From this we can infer, either that market conversion undervalues the WOUSA economy, or that the market dollar trades at a premium to its PPP equivalent.
For convenience, we can call this difference the market dollar premium, and calculate the ratio for 2020 at 1.74:1. Put another way, the market dollar commanded a 74% premium over the PPP dollar last year.
There’s nothing abnormal about the dollar enjoying a valuation premium over other currencies. The dollar’s pre-eminence can be traced back to 1945, when America accounted for half of the global economy, and was the world’s biggest creditor. The dollar, after all, is the world’s reserve currency, and the benchmark against which other currencies are measured. Most oil trade continues to take place in dollars, providing a ‘petro-prop’ for the USD, because anyone wanting to purchase oil must first buy dollars.
This being so, it’s no surprise that PPP comparison reveals a market dollar premium.
What’s interesting, though, is the upwards trend in this premium.
In 1980, it stood at 30%. It reached 40% in 2001, and 50% during 2005-06. The market dollar premium reached 60% in 2009, and 70% in 2015. Based on consensus projections, the premium is expected to carry on rising, from 74% last year to 79% by 2026. Perhaps most strikingly, the dollar premium is twice as big now (74%) as it was in 1999 (37%).
Does the market’s attachment of a widening premium to the dollar make economic sense? It’s at least arguable that it doesn’t. Quite aside from the rise of economies such as China – and America’s falling share of world GDP – there are reasons to suppose that the economic pre-eminence of the United States is eroding, and that the market dollar premium, far from widening, should be contracting.
The most obvious negatives for the market dollar premium are to be found in the fiscal and monetary spheres. Starting in 2008, the Fed has operated monetization policies on a gargantuan scale, lifting the Fed’s assets from $0.8tn in June 2008 to $8.1tn today. Interest rates have been below any realistic estimate of inflation since the 2008-09 global financial crisis (GFC) and, with inflation now rising, are negative to the tune of at least 4.0%, and probably more. With the administration seemingly addicted to fiscal stimulus, and with the Fed apparently willing to go on monetizing deficits, these trends seem set to continue.
Scaling back or reversing QE – or, for that matter, raising rates to head off inflation – would prompt a greatly-amplified repeat of the 2013 “taper tantrum”, and tightening monetary policy could harm the US economy, would trigger sharp falls in asset prices, and would push up the cost of government borrowing. Neither monetization, large scale money creation or negative real rates can be considered positive for the value of a currency.
There’s a clear danger, then, that the US could push the dollar’s “exorbitant privilege” too far.
Meanwhile, the Fed also has to be mindful of the shadow banking system, sometimes called “non-bank financial intermediation”. This isn’t the place for a detailed consideration of shadow banking, but the system resembles an inverted pyramid, with very large assets (which have been put at $200tn) resting on a narrow base of collateral. Government bonds in general, and American bonds in particular, play a central role in this collateral.
Simply stated, a battle royal is likely to be waged between not-so-“transitory” inflation, on the one hand, and, on the other, pressing reasons for not raising the cost of money.
This might not matter all that much if the market dollar premium hadn’t risen as far as it has. The use of PPP for benchmarking isn’t common practice, but the calculations required for calibrating the market dollar premium aren’t exactly rocket-science – and the implications of this calculation are stark.
The conclusion seems to be that the dollar now trades at a more-than-exorbitant premium to other currencies – just as America is getting mired in a tug-of-war between stimulus and inflation.
THE PURSUIT OF GROWTH IS THE FASTEST ROAD TO DECLINE
An odd paradox emerges when we consider our economic objectives, and question the priority routinely accorded to “growth”.
If we continue our obsession with growth, we will accelerate the deterioration of the energy-driven economy, worsen our environmental predicament and squander the resources which might otherwise have formed the basis of a sustainable economy. If, further, we continue to see the financial system as an adjunct of our pursuit of “growth”, we invite systemic collapse.
The irony here, of course, is that the pursuit of growth is, in any case, the pursuit of a chimera.
Conversely, if we aim for stability, and redesign our failing financial system accordingly, we might yet succeed in combining prosperity with sustainability.
Context – failure on two fronts
If – just for a moment – we ignore financial issues, and concentrate wholly on material metrics such as resources, the environment, population numbers, food supply and the physical output of goods and services, it soon becomes clear that we are either at, or very near, the end of “growth”, unless indeed we have already passed the point of down-turn. Essentially, the modern industrial economy is the product of the use of abundant, low-cost energy from fossil fuels. These fuels are ceasing to be cheap at the same time that their use is colliding with the limits of environmental tolerance.
Conversely, if we focus entirely on the financial, it becomes equally clear that a system reliant on QE and other forms of monetary gimmickry is at existential risk. We can trace the origins of this process back to the 1990s, and the recognition (though not the explanation) of “secular stagnation”. The authorities’ chosen ‘fix’ for this perceived problem was to use debt to stimulate demand, on the assumption that cheap and abundant credit would prove to be a magic elixir for the restoration of growth to the economy. From there, it was a dangerously easy step from credit expansion to the back-stopping of debt (and asset markets) with monetization.
What we have, then, is (a) a material, physical or real economy that has reached or passed peak output, and (b) a counterpart financial economy which, barring a drastic change of direction, is heading towards collapse.
We’re not yet at the point where there are “no fixes” for these issues, but the odds seem stacked against the determined and effective efforts that would be required to achieve sustainability in the aftermath of growth. Might we yet be forced, kicking and screaming, into wiser decisions?
These situations are set out in fig. 1, using data sourced from the SEEDS economic model. Aggregate prosperity has continued to increase (but is nearing the point of down-turn), whilst prior growth in prosperity per capita has already gone into reverse. Both debt and the broader and much bigger category of financial assets (in effect, the liabilities of the household, corporate and government sectors) have soared, and seem destined to carry on doing so, unless and until the financial system implodes.
Two excellent, must-read recent papers have reached stark conclusions about the ‘real’ and the ‘financial’ economies. Gaya Herrington, in a report which concentrates on physical, non-financial metrics such as population numbers, natural resources and the environment, concludes that, under any BAU (“business as usual”) scenario, we face “a collapse pattern” which can only be softened (into “moderate decline”) by advances in technology far beyond historic rates of innovation and adoption.
In Quantitative easing: how the world got hooked on magicked-up money, published by Prospect, Ann Pettifor says that “[g]oing cold turkey would finish off a dysfunctional global financial system that’s now hopelessly addicted to emergency infusions”.
Neither paper gives us no hope at all, but both point to the need for radical change. On the financial situation, Ms Pettifor concludes that “[t]he only solution is surgery on the system itself”. Ms Herrington sets out an alternative SW (“sustainable world”) scenario which, whilst it cannot restore growth, does at least offer stability. Unfortunately, SW does not correlate well with what’s actually happening.
We can put these ‘potential positives’ into a single conclusion. The best, indeed the only way to achieve economic sustainability is to abandon all aspects of BAU that are geared towards the attainment of growth, and to shift our objectives from growth to resilience. The financial system, likewise, needs to transition way from an obsession with expansion, and aim instead for functional effectiveness in a non- or post-growth World.
In short, the precondition both for economic and for financial stability is that we ditch our obsession with “growth”. The same, of course, applies to our environmental best interests. The biggest single threat to environmental sustainability is our worship of “growth”.
Difficult, straightforward, paradoxical
Simply stated, the required transition is from a state of mind which obsesses over growth to a state of mind which prioritizes stability.
Attaining this transition is at once difficult, straightforward and paradoxical.
It’s difficult, because the desirability of “growth” is deeply entrenched both in institutions and in the collective mind-set. Political leaders routinely promise growth, businesses strive to achieve it, and the financial system is entirely predicated on it. Advocates of voluntary “de-growth” have never managed to make meaningful inroads into this obsession with “growth”.
It’s straightforward, in the sense that growth is already over. The continued pursuit of growth is the pursuit of the unattainable. As the ECoEs (the Energy Costs of Energy) of coal, oil and gas have risen, the economic value that we derive from the use of fossil fuels has started to diminish. Assertions that we can replace all of this value using renewable sources of energy (REs) are based on little more than wishful thinking and mistaken extrapolation. Apart from anything else, RE expansion requires inputs which, at least for the present, can only be provided by the use of energy from fossil fuels.
To be clear about this, we must make every effort to develop renewable energy supply, but we shouldn’t delude ourselves into the belief that REs can replicate the economic characteristics of fossil fuels. Well-managed, a transition to REs can contribute to stability. What REs cannot do is deliver a return to growth.
As well as being both difficult and straightforward, the required transition is paradoxical, because the pursuit of growth is the best way to ensure economic decline. If sustainability is set as the primary objective, this aim might be achievable. But the biggest obstacle to the attainment of sustainability is our obsession with growth.
Measuring our predicament
The purpose of the SEEDS economic model is to provide holistic interpretation by putting together the ‘real’ and the ‘financial’ economies. SEEDS does this by calibrating prosperity from energy principles, and delivering results in a monetary format which enables us to benchmark the financial system.
SEEDS demonstrates a clear linkage between ECoEs and prosperity. For much of the industrial age, ECoEs trended downwards. This meant that, for so long as aggregate energy supply at least kept up with increases in population numbers, the material prosperity of the average person improved.
The fundamental change occurred when ECoEs stopped declining, and started to rise. At first, this happened only gradually. However, the upwards trend in the ECoEs of fossil fuels is an exponential one.
During the 1980s, a rise in trend all-sources ECoEs of 0.8% – from 1.8% in 1980 to 2.6% in 1990 – didn’t matter all that much, and was, in any case, well within margins of error that are accepted in economic calibration. In short, this early rise in ECoEs wasn’t large enough to force itself upon our attention.
What happened during and after the 1990s, however, was far more serious. In the 1990s, ECoEs rose by 1.5%, from 2.6% in 1990 to 4.1% in 2000. Trend ECoEs then increased by 2.2% between 2000 and 2010, and by a further 2.6% between 2010 and 2020. This put ECoEs at 8.9% last year, compared with 1.8% back in 1980.
Since an ECoE of 8.9% still leaves surplus (ex-ECoE) energy at more than 90% of total energy supply, it might at first sight seem surprising that prior growth in per capita prosperity should already have gone into reverse.
The explanation for this sensitivity lies in the complexity, and the correspondingly high maintenance demands, of the modern economy. The vast bulk of the economic value derived from energy is required for the upkeep and renewal of systems. Even under the best of circumstances, the scope for growth is constrained by the ‘burden of maintenance’.
SEEDS analysis reveals two very strong correlations here. One of these is between ECoE and prosperity, and the other connects complexity with ECoE-sensitivity. In the advanced economies of the West, prior growth in prosperity goes into reverse at ECoEs between 3.5% and 5.0%. Less complex EM economies can carry on increasing their prosperity until ECoEs are between 8% and 10%.
The latter connection helps explain the apparent divergence between the advanced and the emerging economies over the past twenty years. As of 2000, global trend ECoE was, at 4.1%, well within the threshold at which Western prosperity starts to contract. At that level of ECoE, however, EM countries remained capable of growth. This is why, whilst people in countries like America and Britain have been getting poorer since the early 2000s – and using financial gimmickry to delude themselves to the contrary – Chinese, Indian and other EM citizens have continued to get better off.
A failure to recognize the differing effects of ECoEs on differing economies has led to a great deal of mistaken interpretation of the divergence between growth in countries like China and “stagnation” (in reality, de-growth) in the West. Westerners haven’t become uniformly lazy or complacent over the past two or three decades, any more than EM citizens have been uniformly more industrious and productive.
Rather, the greater complexity of the Western economies has resulted in their earlier exposure to the consequences of rising ECoEs. With ECoEs set to exceed 9% this year, we are well into the ‘zone of inflection’ in which EM prosperity, too, starts to decline.
An accommodation with de-growth?
In this sense, then, growth is over, and “de-growth” has begun. But there’s a world of difference between an economy getting gradually poorer and an economy careering towards a cliff-edge. If we continue our frantic pursuit of growth, the likelihood is that our options will diminish, as resources are exhausted, population numbers continue to increase, environmental and ecological deterioration accelerates and a rickety, Heath Robinson financial system reaches the point of self-destruction.
Of course, nobody would expect political leaders to stop promising growth, or businesses to stop pursuing it. No president or prime minister is likely to proclaim, like the fictional Duke of Omnium, that the country is fine how it is, and the job of government is to keep it that way. No business leader is likely to tell shareholders that corporate strategy is to turn away from expansion, and instead to maintain the company as a reliable generator of value for its owners.
But to concentrate on stated intentions is to overlook mechanisms. If the Holy Grail of “transition to renewables” fails to replace the energy value hitherto derived from fossil fuels, then it will be futile to carry on denying the reality of de-growth.
As we’ve seen in previous discussions, prosperity is declining, whilst the real cost of estimated essentials is rising. As you can see in fig. 2, it’s clear that discretionary prosperity is being compressed, and that continued increases in discretionary consumption have been made possible only by continued credit expansion.
Three processes – prosperity deterioration, the rising cost of essentials and the approach of credit exhaustion – are likely to force businesses into the adoption of policies consistent with the Surplus Energy Economics taxonomy of de-growth.
Some companies, for instance, will work out that switching from a ‘high-volume, low-margin’ to a ‘high-margin, low-volume’ model can support revenues and earnings as the discretionary prosperity of the median consumer declines. Producing less, whilst charging more for it, is one way of maintaining profitability whilst also driving down emissions of CO2.
A de-growing economy is also a de-complexifying one, and this trend is likely to encourage, or indeed to compel, businesses to simplify both their product offerings and their production processes, at the same time tightening their supply lines in pursuit of resilience. Of course, the continuing contraction of discretionary prosperity may shrink or eliminate some sectors, whilst others will be de-layered by customer pursuit of simplification.
Governments, too, will not be immune from these processes. As bridging the ‘discretionary prosperity gap’ by taking on yet more debt ceases to be feasible, the public is likely to become increasingly discontented about the increasing slice of their resources being taken by essentials, be these household necessities or the services provided by government. We should anticipate demands for intervention, particularly over the rising cost of energy.
In other words, businesses and governments might not disavow the pursuit of “growth” – it would be remarkable if they did – but trends are likely to push them in this same direction. If we’re looking for some encouragement, scant though it is, we might note that governments, in promising to “build back better”, have not promised to “build back bigger”.
INTERPRETING THE FUTURE ECONOMY
Anyone seeking a view about the probable shape of the economy of the future has a choice between two schools of thought. The version favoured by governments, businesses, the financial sector and orthodox economists can be labelled ‘continuity’, and amounts, essentially, to ‘growth in perpetuity’. The alternative – very much a minority view, though gaining in influence – warns of imminent economic and broader “collapse”.
It probably won’t surprise you that the evidence supports neither point of view. Properly understood, meaningful “growth” ceased a long time ago, starting in the West, and the World’s average person is now getting poorer.
This does mean that discretionary (non-essential) consumption will decrease, as a rising share of resources is required for necessities. But it doesn’t make a proven case for systemic “collapse”. This isn’t to say, of course, that collapse can be staved off indefinitely, if we keep on making the wrong decisions.
The future scenario set out here differs from both of the ‘continuity’ and ‘collapse’ extremes, primarily because SEEDS – the Surplus Energy Economics Data System – models the economy as an energy system. The outlook projected by SEEDS modelling combines “discretionary deterioration” with “pockets of collapse”. Parts of the economy will contract, and parts of the financial system will implode, but that describes neither continuity nor a general collapse.
If you want this in the proverbial nutshell, “continuity is finished, but collapse needn’t be inevitable”.
As so often in economic affairs, we need to be wary of extremes. For example, the collapse of the Soviet economy did demonstrate that extreme collectivism doesn’t work, but it didn’t prove that the opposite extreme – a deregulated “liberal” free-for-all – was necessarily the best way to run an economy.
The same caution applies to economic “-isms”. We can leave it to polemicists to decide whether the USSR was, or was not, a ‘communist’ or a ‘socialist’ system, but we do need to be quite clear that what we have now is not, by any stretch of the imagination, either a ‘capitalist’ or a ‘market’ economy.
A ‘capitalist’ system, after all, requires real, risk-weighted returns on capital, whilst a ‘market’ economy presupposes that losers – victims either of folly or of bad luck – are not bailed out by the state.
Extreme collectivism brought down Soviet Russia, but China escaped this fate by opting for the pragmatic course of ‘allowing capitalism to serve China without letting China serve capitalism’.
An equivalent choice needs to be made now, between following the ultra-“liberal” road to localized collapse, or adopting pragmatic alternatives which can, in short-hand, be called ‘the mixed economy’ of optimized private and public provision. This, of course, would require both effective regulation and the acceptance of a new ethic.
With hindsight (though some observers said this at the time), it would almost certainly have been better if, during the GFC (global financial crisis) of 2008-09, market forces had been allowed to run to their natural conclusions. If this had happened, we might well have benefited from the kind of “reset” which has now become an impossibility. It would have been better still, of course, if we hadn’t made the colossal mistakes which caused the GFC in the first place.
The ‘chronology of error’ merits more than the passing attention it can be given here. As regular readers will know, the economy is, self-evidently, an energy system, and today’s large and complex economy is a product of our development of the heat-engine, which gave us access to the vast (but not infinite) reserves of energy contained in coal, petroleum and natural gas. For the first time, economic activity escaped from the constraints of a cycle comprising the labour of humans and animals and the nutritional energy which made this labour possible.
Remarkably, this connection seems to have been ‘hidden in plain sight’, enabling generations of economists to contend that growth has been a property, not of energy, but of money. Extreme collectivists might argue that money should be directed by the state, and their equally extreme opponents that it should be directed entirely by markets, but neither side has seriously questioned the illogical belief that money, rather than energy, determines the performance of the economy.
When – because of depletion – the fossil fuel dynamic began to falter, decision-makers leapt to the fallacious conclusion that “secular stagnation” could be ‘fixed’ with monetary tools. Accordingly, they poured abundant credit into the system from the mid-1990s, and expressed genuine surprise when this largesse brought the banking system to the brink of collapse. The ‘fix’ for credit excess, they then decided, was monetary excess, and they will no doubt express equally genuine surprise when it transpires that this can result only in cascading defaults, the hyperinflationary destruction of the value of money, or a combination of the two.
The outlook, quantified by the SEEDS economic model, is that the average person will become less prosperous over time. When we look behind the financial gimmickry of credit and monetary “adventurism”, this is already an established trend in the complex economies of the West. The average person in many EM (emerging market) economies, too, is already getting poorer, though a small number of Asian economies may not experience this climacteric for another five or so years.
What happens after that – when gimmickry fails, and deteriorating prosperity can no longer be disguised – is that households, and entire economies, will have to concentrate their diminishing resources on the provision of the essentials. These are hard to define, and harder still to quantify, but SEEDS modelling demonstrates that, in the Western world. the scope for discretionary (non-essential) consumption not supported by borrowing has already fallen markedly.
As well as absorbing a larger share of prosperity, “essentials” are very likely to become steadily more expensive in real terms, to the point where we may be forced to re-define what we mean by “essential”. This results from the high energy-intensity of necessities, including the supply of food and water, utilities and the provision of housing, health care and education.
An obvious implication is that energy-intensive discretionaries will be the first sectors to experience contraction, as soon as the ‘credit prop’ ceases to be tenable. The public won’t like this, of course, but will be far more concerned about the rising cost of necessities. The challenges for governments include (a) ensuring that the essentials are available and affordable for everyone, and (b) managing both expectations and the retreat of discretionary sectors.
These trends can be expected to take place within a ‘taxonomy of de-growth’ that we have discussed before. Briefly, the retreat of prosperity can be expected to involve a process of de-complexification, as we start to relinquish some of the economic and social complexity which, in the past, has developed in tandem with the expansion of prosperity.
Astute businesses will opt for simplification, both of product lines and of production processes. Part of this will be forced upon them by utilization effects (where diminishing sales volumes push unit fixed costs upwards), and by loss of critical mass (where necessary inputs cease to be available through loss of supplier viability).
These, then, are the factors that can be expected to drive “discretionary retreat”. The contraction of discretionary sectors will, of course, involve job losses, but this will be happening in a context in which economic activity becomes more dependent on human labour and skills as the supply of high-value exogenous energy decreases.
What, though, of “pockets of collapse”? This term is used here to describe the financial consequences of an economy that is contracting, and is doing so in a way leveraged against discretionary sectors.
Hitherto, a financial system wholly predicated on growth has continued to become both larger and more complex even as the underlying economy has been moving in the opposite direction. Parts of the financial system will implode as the sectors to which they are linked enter irreversible decline.
But the big challenge for finance will come when we are forced to recognize that we can neither ‘stimulate’ our way to prosperity nor borrow (or print) our way out of a debt problem. Like the economy of goods and services, the financial system will need to be simplified back into alignment with a ‘de-growing’ economy.
The challenge now – for households, governments and businesses – is to unlearn some harmful preconceptions, and to understand, quantify and prepare for what is happening in the ‘real’ economy of energy.
Wishful thinking, petulance, gimmickry, ideological inflexibility and the placing of blind faith in the ability of technology to trump physics form no basis for effective preparation.
DISCRETIONARY DISTRESS AND THE DYNAMIC OF REALIGNMENT
Even those who continue to think of the economy as a financial system must be feeling, at the least, bafflement and concern over a situation characterised by massive stimulus, worsening monetization of debts, negative real returns on capital, and clear signs of surging inflation, certainly in asset markets, and very probably in consumer prices as well.
For those of us who understand the economy as an energy system, none of these symptoms is at all surprising. We know that the energy dynamic that has driven growth and complexity since the start of the Industrial Age is deteriorating, because of relentless rises in the ECoEs (the Energy Costs of Energy) of fossil fuels.
We also know that there’s no ‘fix’ for this situation.
From this perspective, it’s easy to see that the financial economy of money and credit is becoming ever further detached from the underlying, material or ‘real’ economy of goods and services. This divergence is intrinsically unstable, and is – as the old saying puts it – ‘unlikely to end happily’.
Two immediate questions naturally follow. First, when will this instability culminate in some kind of crisis? Second, how will this come about, and what are the processes that are likely to shape it?
Nobody can be sure about timing, but we can, at least, be reasonably clear about process. With or without a surge in inflation – and/or tumbling markets and a cascade of defaults – what’s likely to happen is that the cost of essentials will carry on rising, whilst top-line prosperity continues to erode.
Being slightly more technical about this, we can call this a squeeze on the discretionary (non-essential) sectors of the economy.
The issue around discretionary prosperity – defined as the difference between top-line prosperity and the cost of essentials – is scoped, using the SEEDS economic model, in fig.1.
Less than a century ago, even in the World’s most prosperous countries, most of the incomes of ‘average’ people were spent on necessities. Car ownership was a luxury, and the typical holiday was likely to be spent in a boarding-house at a seaside resort, reached by train. Indeed, domestic appliances now taken for granted only started to reach the status of normality from the 1930s.
Historians of the future might well describe the post-1945 era as ‘the Age of Discretion’, with economic growth channelled into a rapid expansion of discretionary (non-essential) consumption. One of the clearest implications of the onset of deteriorating prosperity is that the scope for discretionary consumption will now contract, a trend as yet almost wholly unanticipated by governments, businesses and households.
As we shall see, it’s difficult to draw a hard-and-fast line between the essential and the discretionary, but non-essential – ‘want, but not need’ – goods and services probably account for at least two-thirds of the economic activities of Western countries. The idea that this part of the economy might contract will come as a great surprise, and an extremely unwelcome one.
In fact, though, the continuity of discretionary consumption has already, and over an extended period, become a function of credit expansion. Borrowing, whether by households, businesses or governments, has become the ever more important prop supporting everything from travel and leisure to the purchase of non-essential goods.
The ability of the average Western person to afford discretionary consumption without recourse to borrowing ceased growing, and started to shrink, between fifteen and twenty years ago.
Anyone trying to understand how involuntary “de-growth” is likely to unfold can best focus on two issues – the contraction of discretionary activity, and the failure of a financial system manipulated to sustain growth in discretionary consumption long after organic growth in prosperity went into reverse.
Context – the onset of “de-growth”
If you’ve been visiting this site for any length of time, you’ll know that there are two, diametrically-opposite ways in which we can endeavour to make sense of the economy.
One of these is the ‘conventional’, ‘orthodox’ or ‘classical’ school of economics, which states that the economy is wholly a monetary system, not constrained by resource limitations, and assured of ‘growth in perpetuity’ through our control of the human artefact of money.
Quite aside from its lack of logic, this interpretation is discredited by the truly extraordinary financial and intellectual gymnastics that have been required in order to try to square this comforting thesis with what we see happening around us. The “temporary” (since 2008) expedient of negative real interest rates is just the most extreme (and arguably the most harmful) of the many exercises in gimmickry that have been necessary to sustain the myth of an ever-expanding economy, shaped entirely by money.
The alternative – advocated here, and modelled using SEEDS – is to interpret the economy as an energy system. From this perspective, growth in economic output since the 1770s has been the product of huge increases in the use of low-cost fossil fuels. Now, though – and quite apart from harming the environment – these fuels are losing the ability to support the complex modern economy as they cease to be ‘low-cost’.
In this context – in which energy is the economy, with money a medium of exchange – the only meaningful definition of ‘cost’ is the proportion of accessed energy that is consumed in the access process, and hence is not available for any of the other economic uses that constitute prosperity. Known here as ECoE – the Energy Cost of Energy – this equation is the primary determinant of economic prosperity.
Driven by depletion – since the earlier benefits of geographic reach and economies of scale have reached their limits – the ECoEs of fossil fuels are rising relentlessly. Assertions that this trend can be reversed using renewable energy sources (REs) such as wind and solar power – let alone that we can somehow “de-couple” the energy economy from the use of energy – are exercises in wishful thinking.
REs are indeed vitally important for the future, but we need to recognize that they are highly unlikely to provide like-for-like – scale and economic value – replacements for oil, gas and coal.
SEEDS modelling indicates that prior growth in the prosperity of complex, high-maintenance advanced economies goes into reverse at ECoEs of between 3.5% and 5.0%, territory that was traversed by global ECoEs between 1997 (3.6%) and 2005 (5.0%). Trend ECoEs have now entered the equivalent range (between 8% and 10%) at which prosperity turns down in less-complex, lower-maintenance EM countries. The lower bound of this range was reached in 2017, and the average person in some EM economies is already getting poorer.
The following charts, familiar to regular readers, show the correlation between trend ECoEs (in black) and prosperity per person (blue) in America, Britain and Australia. In these versions, though, discretionary prosperity has been superimposed (in purple), revealing the extent to which changes in this critical indicator are leveraged by the relatively invariable (and, in general, rising) cost of essentials.
It should be emphasised that discretionary prosperity, as calculated for these charts, makes two assumptions about essentials. The first is that we do not, going forward, tame the rate at which the cost of essentials is rising, perhaps by redefining what we think of as ‘essential’. The second is that there is no acceleration in the rate of increase in this cost.
The role of discretion
In order to anticipate the probable chain of events, we need to start by looking at how we use prosperity. A critical distinction needs to be drawn between essentials and discretionaries, the latter perhaps best described as “things that people want, but don’t need”. Even this distinction involves judgement calls, in that everyone needs food, but nobody necessarily needs caviar.
The first call on economic resources is made by essentials. These are defined here in two parts. One of these is household necessities, and the other is public services provided by the government.
The latter qualify as ’essential’, at least in the sense that the citizen has no choice (‘discretion’) about paying for them. The public service and household categories of essentials overlap, particularly where services like health care and education are provided by the government in some countries, but are purchased privately in others.
The definition of essentials changes over time, and varies by location. Televisions, for example, were still luxuries in most Western countries in 1950, but were regarded as necessities by the 1970s. Cars made a similar transition from luxury to necessity over a not-dissimilar period.
Something regarded as essential in contemporary America might be regarded as a discretionary purchase in less affluent countries. Another example of geographical variation is state-funded health-care, which is seen as vital in most of Europe, but is still no more than an aspiration (and a matter of debate) in the United States, where Obamacare was and remains controversial, and where implementation of a worthy ambition seems to have been surprisingly ill-judged.
Variability, both over time and between locations, makes the calculation of ‘essentials’ a complicated issue, and it might not even be possible to arrive at a universally-applicable calibration meeting both sets of requirements.
Calibrating the essential
Where SEEDS modelling is concerned, “essentials” are a development project, and the model applies formulae whose results are to be regarded as indicative, not precise. The aims are (a) to calibrate an approximate and consistent measurement, and (b) to assess changes in the cost of essentials over time.
Public services are the more straightforward of the two components of ‘essentials’. Governments spend money in two main ways. One of these is the transfer of resources between people, in the form of benefits such as welfare and pensions payments. These transfers net out to zero at the aggregate and at the average per capita levels, so are not part of essentials for our purposes.
The other part of government spending, sometimes known as ‘government consumption’ or ‘own account’ spending, is used to provide public services. Whatever the individual’s opinion about the merits of various forms of service provision, these outlays rank as ‘essentials’ for our purposes, because the citizen has no choice about paying for them. This means that they are ‘non-discretionary’ outlays.
Household ‘necessities’ are the second – and the harder-to-define – component of ‘essentials’. It’s obvious that everyone needs food, water, accommodation, health care, education, some forms of transport and, of course, energy for direct consumption. Beyond this, what we regard as ‘necessary’ varies geographically and over time.
Amongst ‘obvious’ necessities like food, water and shelter, most are very energy-intensive, such that household energy use far exceeds amounts purchased directly for heating, cooking and fuel.
Critically, the deterioration of the energy equation caused by rising ECoEs makes it probable that the real (ex-inflation) cost of household necessities will continue to rise over time.
Tracking the discretionary squeeze
The group of charts shown earlier (fig. 1) sets estimates of essentials against SEEDS calibrations of prosperity per capita for America, Britain and Australia. The common tendency is for the real cost of essentials to rise, whilst prosperity per person has been declining in America since 2000, and in both Britain and Australia since 2004.
In most cases, these declines in top-line prosperity have, thus far, been fairly modest. In America, the average person was (as of 2019) 6.6% worse off than he or she had been back in 2000. Comparing 2019 with 2004, both British and Australian citizens were poorer by about 10.5%. Spread over lengthy periods – nineteen years in America, fifteen in Australia and Britain – these rates of deterioration have been relatively gradual.
At the same time, though, the estimated cost of essentials has been on an upwards trend in all three countries. This means that, since its highest point in each country, discretionary prosperity has fallen by far more than the top-line equivalents.
In America, discretionary (ex-essentials) prosperity fell by 31% (rather than 6.6%) between 2000 and 2019. Decreases in discretionary prosperity since 2004 have been 30% (rather than 10.6%) in Australia, and 27.5% (rather than 10.5%) in the United Kingdom.
You’ll notice that, in each of these charts, there comes a point – typically in the late 2030s – when prosperity per capita is projected to fall below the cost of essentials. This is the moment at which, at least in theory, discretionary prosperity ceases to exist at the average level. This makes it imperative that we find ways of managing the cost of essentials if we’re to ensure the well-being of the ‘average’ person.
In practice, the likelihood is that deteriorating economic conditions will change our definitions of what is “essential”, at the levels both of household necessities and of public services. It might be, for instance, that car ownership ceases to be regarded as “essential” well before 2040, and that governments will be pressured into imposing tighter priority criteria on the services that they provide.
There are two particularly disturbing aspects of the trends modelled by SEEDS and set out here.
First, per capita averages are not the same as median numbers, and even the latter might not fully reveal widespread and worsening hardship – better-off citizens may continue to enjoy discretionary prosperity long after even the essentials have ceased to be affordable (other than through ever-deepening indebtedness) for many others.
Second, there is little or no sign that these trends are gaining the necessary recognition – and may not do so until governments and others have been compelled to realize that ‘perpetual growth on a finite planet’ is a fallacy (though, if they were to look at trends now – in debt, monetization and the cost of necessities – they could be disabused of this false perception).
‘Indications and warnings’
As we have seen, discretionary prosperity is being squeezed between deteriorating top-line prosperity and the rising real cost of essentials. At the same time, discretionary consumption has continued to increase.
This situation reflects two important linkages. The first is rising ECoEs, which are pushing up the cost of essentials at the same time as driving prosperity downwards.
The second is that the divergence between discretionary prosperity and actual consumption of non-essential goods and services links directly to the economy’s worsening dependency on credit and monetary stimulus. If this stimulus were to contract for any reason, discretionary consumption would fall very sharply indeed.
Where stimulus is concerned, the authorities presumably realize that a balance has to be struck between full-bore, ad infinitum monetization, with its inescapable inflationary risks, and counter-inflationary monetary tightening, which would be likely to drive markets sharply lower, and trigger cascading defaults.
The point is that, whichever way this goes, discretionary consumption has to fall back towards affordable (discretionary prosperity) levels. If inflation takes off, the cost of necessities will rise more rapidly than the price of discretionaries. If, alternatively, monetary policies are tightened, this would have a leveraged, adverse effect on discretionary purchasing.
This is going to have far-reaching effects. Commercially, entire sub-sectors and large fortunes have been built on discretionary consumption supported by credit. Financially, both the capital values and the balance sheet viabilities of large swathes of the economy would be undermined by any check to credit-funded discretionary spending by consumers.
Business planning and investment perceptions remain firmly rooted in the false paradigm of ever-growing discretionary consumption, yet SEEDS analysis reveals that this paradigm is founded on the fallacious premise of perpetual growth, a premise whose fallacy has thus far been masked by credit and monetary activism. Politically, the rising real cost of necessities can be expected to cause a switch of focus towards alleviating the hardship caused by the rising prices of essentials.
This, then, is where the denouement occurs – and, if we want to understand how events are going to unfold, we need to keep a keen eye on the nominal and the real cost of essentials, whether purchased by households or funded through taxation.
In recent discussions here, it’s been suggested that we need a brief explanation of Surplus Energy Economics (SEE). This is an interpretation which states that the economy is an energy system, not a financial one. This is the understanding which informs the SEEDS economic model.
The timing is certainly appropriate, as established economic conventions are being confounded by adverse trends which financial tools are proving wholly unable to counter. In this context, it’s not at all surprising that interest in SEE and SEEDS continues to increase.
Energy-based analysis reveals that, where the West is concerned, the scope for further economic expansion disappeared between 1997 and 2007, and that the same thing is now happening in the EM (emerging market) economies.
The principle SEEDS metric for economic well-being is prosperity, which the model calibrates both in aggregate and in per capita form. On the latter basis, the average American was (as of 2019) 6.6% poorer than he or she had been back in 2000, British prosperity had declined by 10.6% since 2004, and Canadians had become 8.6% poorer since 2007.
These findings are, of course, quite different from the conventional line, mainly because governments and central banks have resorted, perhaps in all good faith, to credit and monetary policies which have sustained a simulacrum of “growth” even though prosperity is now deteriorating.
The economic narrative of modern times is that, ever since “secular stagnation” was first noted (but not traced to its energy causation) back in the 1990s, the authorities have tried successive financial ‘fixes’ which have succeeded only in confirming that the economy, being an energy system, cannot be revitalized by monetary ‘innovation’.
‘Credit adventurism’, which led directly to the 2008-09 global financial crisis (GFC), has since been compounded by ‘monetary adventurism’, which has put the monetary system itself at great and increasing risk. We can be certain that the search is on for ‘gimmick 3.0’ – and equally certain that this, too, will fail.
The greatest single error made by conventional economics is the assumption that, if we understand money, we also understand the economy. This fallacy has driven an ever-widening gap between a financial system that has been growing exponentially, and an economy that has ceased expanding, and has started to contract.
In the interests of brevity, some of the implications of SEEDS analysis can only be noted here in outline. First, as prosperity per capita declines, so will the scope for funding public spending without recourse to ever-increasing government debt.
Second, just as prosperity has deteriorated, the cost of essentials has continued to increase, leveraging relatively gradual declines in top-line prosperity into far steeper falls in discretionary prosperity. This in turn means that a large and growing proportion of discretionary consumption has become dependent on continuing increases in debt.
Third, the calibration of prosperity reveals that levels of financial risk are far more severe than they appear on conventional metrics which use credit-inflated, ECoE-ignoring GDP as the denominator.
Each of these factors makes it seem unlikely that the energy basis of the economy will gain official recognition any time soon. Properly understood, the last real opportunity for a “reset” came – and went – back in 2008-09, when we opted to side-step the market implications of dangerously excessive credit.
The only practical alternative now is to try to buy a bit more time before ultra-loose monetary policies trigger a hyperinflationary slump in the value of money, and/or attempts to head off surging inflation trigger asset price collapses and a cascade of defaults.
Fundamentally, the aim now must be to minimize the economic consequences of a seemingly inescapable failure of the financial system.
Two interpretations, one reality
Essentially, there are two ways in which the working of the economy can be explained. One of these is the conventional or orthodox explanation, which states that the economy can be understood wholly in terms of money. The alternative, summarised here, is that the economy is an energy system.
If it were true, the monetary explanation would mean that there need be no end to economic growth, because money is a human artefact which is wholly under our control. Some proponents of traditional, money-based economics have been explicit about the absence of physical or resource limits to economic expansion.
It might be contended that the economy has indeed expanded enormously since the publication, in 1776, of Adam Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations, the founding treatise of Classical Economics.
The alternative explanation is that it wasn’t Smith’s magnum opus, but the completion of James Watt’s radically more efficient steam engine – also in 1776, and also in Scotland – that really triggered two centuries of rapid economic growth, because it gave us access to the vast quantities of energy contained in coal, oil and natural gas.
The contest between these two schools of thought is reaching a climax now, because two factors are undermining the fossil fuels dynamic. One of these is the recognition that continued reliance on oil, gas and coal threatens to inflict irretrievable damage to the environment.
The other is that depletion – the practice of using highest-value energy resources first, and leaving costlier alternatives for a ‘later’ which has now arrived – is eliminating the ability of fossil fuels, not just to drive further growth, but even to maintain the economy at its current scale and complexity.
The view set out here is that this contest is already all but over, and that increasingly desperate reliance on financial gimmickry – plus the increasingly blind faith placed in technology – demonstrate the failure of an interpretation which insists that money, rather than energy, determines the size and shape of the economy.
The energy-based interpretation of the economy is founded on three principles, each of which is validated both by logic and observation.
The first is that the economy is an energy system, because nothing that has any economic utility (value) at all can be supplied without the use of energy.
The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as ECoE (the Energy Cost of Energy).
The third principle is that money has no intrinsic worth, but commands value only as a ‘claim’ on the output of the energy economy.
Each of these principles seems incapable of refutation. We know, for example, that an economy deprived of energy would grind to a halt within days, and would collapse within months. We know that we can’t drill an oil well, manufacture a wind turbine or a solar panel, or build an electricity grid without using the products of energy. We know that no amount of money will help someone adrift in a lifeboat, lost in a desert, or in any other way cut off from the process of exchange.
The first set of charts puts these issues into context. The left-hand chart shows how dramatic increases in population numbers (from less than 0.7 billion in 1776 to 7.8 billion now) – and in the economic means of their support – have been driven by an even more dramatic increase in energy use. For most of that period, energy supply has grown more rapidly than population numbers, enabling prosperity to improve.
The situation now, though, is that trend ECoEs are rising rapidly, which has two adverse consequences for prosperity. The first is that rising ECoEs reduce the economic value obtained from each unit of energy consumed.
The second is that growth in energy supply is likely to cease, because producer costs are rising just as the prosperity of consumers is being undermined. This suggests that increased output of renewables and other non-fossil forms of energy will, at best, do no more than offset a decline in supplies of fossil fuels, leaving total energy availability broadly flat.
This means that, for the first time since the start of the Industrial Age, energy use per person will trend downwards. The deterioration is set to be even more marked at the level of surplus (ex-ECoE) energy per capita, which is the real driver of prosperity.
Financial consequences – the high price of denial
Perhaps the strongest evidence for the deterioration of the energy-based economy is the sheer extent – indeed, the outright desperation – of the financial gimmickry that has been necessary in order to sustain a simulacrum of “growth” as rising ECoEs have undermined economic prosperity.
As we shall see, prior growth in the prosperity of the advanced Western economies goes into reverse at ECoEs between 3.5% and 5.0%. Globally, these effects started to undermine growth between 1990 (an ECoE of 2.6%) and 2000 (4.1%). This was the period in which observers first identified a deceleration which they labelled “secular stagnation”.
This phenomenon has not, of course, been understood in energy terms. Rather, decision-makers have resorted to increasingly desperate, dangerous and futile financial innovations in an effort to counter it.
The first recourse was to ‘credit adventurism’, making debt easier to access than it had ever been before. Since 1995, reported “growth” (of 116%, or $71 trillion) in GDP has been far exceeded by a 247% ($235tn) escalation in debt. This means that each dollar of “growth” has been accompanied by $3.30 of net new debt.
Another way of looking at this is that, whilst annual “growth” averaged 3.3% between 2000 and 2020, annual borrowing averaged 10.8% of GDP. What was happening was that output and growth were being inflated artificially by the pouring of increasing amounts of credit into the system.
SEEDS analysis reveals that underlying or ‘clean’ output – known here as C-GDP – increased at an annual rate of only 1.6%, rather than 3.3%, through this period. Even this average number masks a steady deterioration in clean growth.
These compounding effects mean that reported economic output has now been inflated far above its underlying equivalent. Essentially, the insertion of a ‘wedge’ between debt and GDP has driven a corresponding wedge between reported (GDP) and underlying (C-GDP) economic output.
Needless to say, ‘credit adventurism’ has exacerbated financial risk. The artificial inflation of reported output has resulted in the understatement of risk calibrations, such as the ratio of debt to GDP, meaning that risk has become more opaque just as it has become more extreme. At the same time, the deregulatory processes involved in credit expansion have combined with ultra-loose monetary policy to weaken the link between risk and return.
This exercise in ‘credit adventurism’ necessarily culminated in the global financial crisis (GFC) of 2008-09. Rather than accept the market consequences of this process, the authorities opted to compound credit with ‘monetary adventurism’, through the adoption of supposedly “temporary” expedients including QE and ZIRP.
It does not require hindsight to recognize that, during the GFC, the last chance of a meaningful “reset” came and went. The adoption of ‘monetary adventurism’ has created a wholly unsustainable situation, in which real (ex-inflation) interest rates have been pushed permanently into negative territory – which means that people and businesses are paid to borrow – whilst saving is deterred. Other consequences of this process have included a dramatic, artificial inflation of asset markets, and the creation of a severe disequilibrium between asset prices and all forms of income.
Fundamentally, this has suspended the operation of a ‘capitalist’ system which, of course, requires positive real returns on capital. The necessary process of ‘creative destruction’ has been halted by a dynamic which keeps non-viable (‘zombie’) businesses afloat.
The effects of these processes extend far beyond debt itself. Since 2002, the broader category of financial assets – essentially, the liabilities of the government, household and corporate sectors – has expanded at a rate of $7.20 for each dollar of “growth” in GDP. Meanwhile, the crushing of returns on invested capital has contributed to the emergence of huge shortfalls (“gaps”) in the adequacy of pension provision.
In overall terms – and well before the onset of the coronavirus crisis – we had reached a point at which each “growth” dollar is being bought with $3.30 of new debt, $3.90 of other incremental financial liabilities and $2.50 of additional shortfalls in pension provision.
It would not be too much of an over-simplification to assert that we are taking on close to $10 of new liabilities in order to manufacture each $1 of “growth”.
The irony is that, of the supposed $71tn “growth” recorded since 2000, fully 60% ($40tn) has been purely cosmetic, with real economic expansion totalling only $26tn over that period.
The decisive factor – ECoE
From the foregoing, it will be obvious that the critically important dynamic has been the relentless rise in ECoEs, a trend that has put an end to economic expansion, and has already started putting prior growth in prosperity into reverse.
The history of the economy in recent times can best be understood as an attempt to use financial policy in a failed effort to ‘fix’ an economy hamstrung by a factor – rising ECoEs – that conventional economic interpretation wholly fails even to recognize.
For most of the Industrial Age, ECoEs have trended downwards. We don’t know what ECoEs were back in the 1770s, but we do know that they were high. They declined steadily over time, reflecting three operative processes.
The first of these was geographic reach, exemplified by the way in which the petroleum industry, from its origins in the Pennsylvania of the 1850s, expanded in pursuit of lower-cost supplies around the World.
The second was economies of scale, a facet of the rapid expansion of the coal, oil and natural gas industries.
The third driver was technology, which progressed from the simple extraction, processing and transport methods of the early Industrial Revolution to the far greater sophistication of the modern energy industries.
The ECoEs of the fossil fuel industries probably reached their nadir in the two decades after the Second World War, when ECoEs seem to have been at or below 1%. This drove the particularly rapid economic expansion of that period.
Latterly, however, the benefits of reach and scale have been exhausted, and depletion has started to drive ECoEs back upwards. Fossil fuel ECoEs reached 2% in 1984, 3% in 1993 and 5% in 2003, and are now close to 12%.
Since fossil fuels still dominate energy supply, overall ECoEs have risen relentlessly, from 2.6% in 1990, and 4.1% in 2000, to just above 9% now. As we shall see, complex advanced economies need ECoEs that are below 5%, and EM (emerging market) countries require ECoEs that are no higher than 10%.
It’s abundantly clear that there can be no financial ‘fix’ for rising ECoEs. Equally, we cannot overcome higher ECoEs by using ever larger gross (pre-ECoE) quantities of energy, because rising ECoEs undermine the economics of energy supply itself. Unless the rise in ECoEs can somehow be halted and reversed, economic prosperity must follow a path of continuing decline.
Supposed solutions to the ECoE problem fall into three categories, none of which is persuasive.
The least feasible of all is that we can somehow “de-couple” economic activity from the use of energy. This is impossible, of course, because the economy is an energy system. The evidence for “de-coupling” has been described by the European Environmental Bureau as “a haystack without a needle”. Only in the kind of alternative universe described by conventional, ‘money-only’ economics can we live on money, detached from physical (meaning energy-based) goods and services for which money can be exchanged.
The second delusion is that ‘there’s a technological solution to everything’. This is an era in which extravagant (and generally extrapolatory) claims are made for technology. The hard reality, of course, is that the scope of technology is limited by the envelope of physics. This is why, for instance, efforts to use shale resources to turn the United States into “Saudi America” have been such a costly failure.
Third, it’s asserted – and often simply assumed – that transition to renewable sources of energy (REs) can push overall ECoEs back downwards. Whilst there are compelling environmental and economic reasons for promoting RE expansion, the ECoEs of REs are unlikely to fall much below 10%, which is nowhere near low enough to prevent deterioration in an economic system built on ECoEs at or below 2%. Apart from anything ese, transition to REs will require enormous resource inputs, most of which can only be made available through the use of legacy energy from fossil fuels.
The prosperity connection
The SEEDS economic model enables us to identify the levels of ECoE at which Western prosperity turned down, and to measure and predict the equivalent inflexion-points for EM economies.
In the Advanced Economies, prior growth in prosperity per capita went into reverse at ECoEs between 3.5% and 5.0%. This happened in Japan in 1997 (at an ECoE of 4.4%), in the United States in 2000 (4.5%), in Italy in 2001 (4.8%%), in Britain in 2004 (4.5%) and in Canada in 2007 (4.0%).
Latterly, the same thing has started happening in EM countries, too, including Mexico in 2007 (at an ECoE of 5.1%), South Africa in 2008 (6.1%) and Turkey in 2018 (8.7%). SEEDS analysis shows that, in general, EM prosperity turns down at ECoEs of between 8% and 10%.
Latest data indicates that Chinese prosperity may not now turn down until 2025-26 – by which time ECoE is likely to be between 9.6% and 9.9% – though intervening increases in prosperity are likely to be very modest. The greater ECoE-resilience of the EM economies reflects a lesser degree of complexity, which means that upkeep of existing systems can be accomplished at lower levels of surplus energy.
There are, of course, local nuances around the connection between different countries’ ECoEs and their prosperity inflexion-points, but the ranges cited here – 3.5% to 5.0% for Western countries, and 8-10% for EM economies – are validated by comprehensive analysis.
For the World as a whole – and as the following charts illustrate – prosperity per person has been on a long plateau, during which continued growth in the EM economies has cancelled out Western deterioration. This helps explain the widespread perception that EM countries have been ‘carrying’ global growth since the GFC.
It would be a mistake, though, to assume that this EM resilience can be a continuing facet of the global economy. Rather, lesser complexity explains why countries like China and India have been able to carry on improving their prosperity pending their arrival at higher (and hence later) inflexion points.
Critically – and with most economies now past their economic climacterics – global prosperity per capita seems now to have turned down decisively from a plateau that has lasted since the early 2000s.
As the third of the following charts shows, the essence of the situation is that the World’s average person is now getting poorer, a problem compounded by an unfounded, blind faith insistence that no such thing can possibly be happening.
SCENARIO PLANNING AND THE ENERGY ECONOMY