FINANCIALIZATION, ANOMALY AND RISK IN AN INFLECTING ECONOMY
It’s been said that, when events turn fast, furious and frightening, and civilians are panicking, the professionals get ever cooler and more calmly calculating.
If this is so, we’ll need to be very professional indeed in 2024.
One of our most serious challenges is that economic and financial forces are pulling in opposite directions. Transactional activity, and the aggregates of assets and liabilities, are continuing to expand, even as the underlying material economy is inflecting from growth into contraction.
Our interest, in this first article of 2024, is in the process of financialization which is driving this divergence. We need to know why parallel forces are driving us to a state of simultaneous affluence and destitution, and why trends increasingly obvious to investors in energy are still invisible to those investing in almost everything else.
Just one consequence of this disconnect is the ludicrous proposition that fossil fuel assets – without which we cannot possibly transition to renewables – are somehow “stranded” and valueless, when the reality is the polar opposite of this exercise in absurdity.
Where wealth is concerned, capital theory tells us that, as the authorities continue to prop up the flow side of the economy by wrecking the stock side of the equation, the resort to ever-looser monetary policies should result in continuing rises in asset prices.
At the same time, though, a point will soon be reached at which the sheer magnitude of our mountainous debt and quasi-debt liabilities induces confidence-snapping vertigo.
Soaring asset prices are, logically, going to make us rich, then, just as escalating liabilities are going to land us in the poor-house. Since logic baulks at the concept of affluent bankruptcy, it’s hard to avoid the conclusion that we’re going to end up owning vast amounts of worthless money.
We’re going to need every analytical skill at our disposal, and every piece of innovative thinking we can lay our hands on, to come out on the right side of this progression.
Meanwhile, in the markets, and indeed in industry, we’re seeing the emergence of a remarkable anomaly.
On the one hand, investors, and energy industry decision-makers too, are reluctantly coming to terms with a material reality, which is that renewables aren’t going to deliver the much-vaunted abundance of low-cost energy after all.
We’re not going to get rich, then, by investing in wind, solar or hydrogen companies, and the development of these energy sources is going to be much costlier, and far less profitable, than had hitherto been assumed. Indeed, it’s hard to escape the conclusion that transition to renewables, if it’s going to happen at all, is going to need subsidy, which can only come from consumers, taxpayers, or both.
On the other hand, though, nobody is yet making the connection from the suppliers to the users of energy. If renewable energy isn’t going to be cheap for those who produce it, neither can it power a tech-and-leisure utopia in which the broader market still believes.
Our need, as I see it, is to deepen our understanding of a series of complex dynamics – the material and the monetary in economics, flow-stock equations in finance, and the energy-prosperity relationship in the material economy.
So let’s get started.
What is financialization?
Technically speaking, the term “financialization” references growth in the absolute and proportionate size of the financial services sector of the economy, a process that carries with it increases in intermediation, and rises in debt-to-equity ratios in business. It’s a term used to describe the rise of ‘financial capitalism’, a variant of, or a successor to, the industrial capitalism of the past.
One can easily see why the term financialization is used pejoratively. Critics allege, for example, that the manufacture and sale of a car needs to be no more than a bilateral transaction between the manufacturer and the purchaser of the vehicle, and that both parties lose out through the unnecessary insertion, for profit, of financial intermediation into such transactions. A riposte to this might be that, without the availability of finance, the car could neither be made nor purchased at all.
The aim here, though, is to be analytical rather than judgemental.
Leaving the politics out of things, financialization has two primary effects. The first is the insertion of more transactional activity into the exchanging of any given quantity of material products and services. The second is that debts and quasi-debts (debt-equivalents) have to increase in order to fund this increased transactional activity or churn.
To emphasise – because this is critical to understanding – the analytical significance of financialization is that it increases transactional activity without adding material economic value. Why this matters will become apparent shortly.
Financialization has been moving on from the established definition of increasing the use of financial services, and hence of credit, within the economy. For example, when a person’s information is garnered for sale to advertisers, his or her data has been financialized. When our otherwise-unvalued time spent waiting to be served at a post office or a delicatessen is used as a marketing opportunity by putting a screen in front of us, that waiting time, too, has been financialized.
This extension of financialization feeds into a new business model. Historically, the aim of businesses has been to sell products or services to customers. Increasingly, this aim has shifted towards the development of streams of income, most commonly as ad-supported or subscription services. There has been a parallel rise in staged payment purchases – in shorthand, BNPL (buy-now, pay-later) – which is a process that comes nearer to the standard definition of financialization.
The streams-of-income model has carried over from the flow side of the financial equation to the stock side, which is what happens when such hypothecated revenue streams are capitalised.
This presents two specific challenges. First, this business model is likely to turn out to be far more fragile than has yet been recognised – ad spending and subscriptions are amongst the easiest savings possible for hard-pressed businesses and households.
Second, its failure could trigger interconnected detonations across the financial system.
Before we get into that, though, let’s remind ourselves about some little-known fundamentals of finance and, first, the economy itself.
Financialization in context
As you may know, there is an essential prerequisite for the effective understanding of finance and the economy.
This is the conceptual necessity of two economies.
One of these two economies is the “real economy” of material products and services, and the other is the parallel “financial economy” of money, transactions and credit.
We can, if we choose, stick to the old Flat Earth notion of a materially unconstrained economy, capable of perpetual expansion, and explicable in terms of money alone. But, in an age of increasingly apparent material and environmental boundaries, the classical immaterial straightjacket to economic thinking, with its assurances of infinite growth on a finite planet, is going the way of the dodo.
The material has arrived, in the sense that physical and environmental limitations are forcing themselves upon our unwilling attention. Environmental deterioration can’t be bought off with money. Central bankers can’t conjure low-cost energy, or high-density mineral resources, out of the ether.
It transpires that most processes – including inflation/deflation, asset price bubbles and liability-driven crises – are ultimately traceable to distortions within the relationship between these “two economies”.
As the fossil fuel impetus fades away, and with no real (as opposed to mistakenly suppositional) complete alternative in sight, the material “real” economy is inflecting from growth into contraction.
At the same time, the parallel financial economy has been expanding at an accelerating pace.
This divergence is dangerous, because it moves the system away from the fundamentally necessary equilibrium between the financial and the material.
This equilibrium is a necessity because, properly understood, money has no intrinsic worth, and its value resides entirely in its role as an exercisable claim on the material economy. If the aggregate of these claims outgrows the wherewithal to honour them, the resulting body of “excess claims” mustbe diluted or destroyed. We can try to push the restoration of equilibrium out into the future, but we can’t eliminate the dynamic.
Financialization, as we’re looking at it here, is driving this worsening disequilibrium because, as we’ve noted, it involves the attachment of additional financial transactional activity to any given quantity of material economic value in the form of goods or services.
The necessary accompaniments of this form of financialization are (a) the inflating and subsequent bursting of asset price bubbles, (b) the parallel accumulation and destruction of enormous financial liabilities, and (c) the monetary degradation that may attend efforts to prevent these reversions to equilibrium from playing out.
We cannot trace this process through conventional metrics, because, contrary to widespread misunderstanding, GDP is a measure, not of material economic output, but of transactional activity. Accordingly, financialization creates a comforting illusion of growth in ways that serve to disguise the real hazards of super-rapid liability and asset market expansion.
This is why we need to use our own tools and insights, based here on “two economies” and the SEEDS economic model.
A big anomaly
One of the skills we’re going to need going forward is an enhanced ability to spot internal contradictions.
One such anomaly is the divergence between the energy-supplying and the energy-consuming sides of the capital markets.
In energy supply, one myth remains intact, and one is now succumbing to reality.
The intact myth is that fossil fuel assets are somehow “stranded”, and of little or no value. As we shall see, this must be one of the daftest conclusions ever reached in investment analysis.
The myth that’s now succumbing to reality is the notion that renewable energy can only get less expensive over time.
This is where an anomaly of perceptions – a failure to link up the fortunes of energy suppliers with those of energy users – is coming to the fore.
Energy users don’t come any bigger, in simple financial terms, than the Big Seven tech stocks. These continue to storm ahead – their aggregate market value increased by about 75% in 2023, and now matches the combined market capitalisations of the Japanese, British, Chinese, French and Canadian exchanges.
But nobody seems to be asking the hard questions about what’s going to power tech activities (or anything else) in an energy-constrained future.
The almost universally-proffered answer is that Big Tech – and pretty much everything else – will be powered by cheap renewable energy. The only fly in this ointment is that renewables aren’t going to be cheap. Their lesser energy-densities, in comparison with fossil fuels, make this impossible.
Some people, though, are asking this question rather than simply assuming a comfortable answer to it. These are the people who manage, and invest in, the renewable energy supply sector of the market.
A little forensic analysis gives us a clue to this big anomaly that’s emerging in the financial markets, albeit as yet seemingly unnoticed by asset allocators.
As the always-insightful Goehring & Rozencwajg have pointed out, the prices of a host of renewable energy stocks – including Orsted, Nextera and Plug Power – have plunged from previously-exuberant highs, whilst the corporate appetite for investment in renewables projects has been decreasing markedly.
The stock price examples cited by G&R are not exceptions to an otherwise positive trend. On the contrary, as of mid-December, the S&P Global Clean Energy Index and the S&P Global Clean Energy Select Index had fallen by 21% and 28%, respectively, since the start of 2023. This contrasts very starkly indeed with a rise of about 25% in the S&P 500 itself over that same period.
To be clear about this, renewables development is still happening, but it’s turned into an uphill slog. Power prices have to rise to keep it viable, and subsidy may be the only way to stop the wheels from falling off.
Ultimately, business and domestic consumers will have to pay for that, either as customers or as taxpayers, because there’s nobody else who can. And, by definition, if people have to spend more on one thing, they have less to spend on something else.
The advance of non-cheap renewables
The underlying problem is that ‘cheap’ renewable energy is turning out not to be cheap after all. Some of us have never believed it would be.
For a start, cheap wind and solar power requires cheap fossil fuel energy to deliver all the steel, cement, copper, lithium, cobalt and other raw materials needed to build, operate, maintain and replace the system.
This linkage dictates that, if the material (ECoE) costs of fossil fuels are rising relentlessly, which they are, those of renewables cannot decrease. This linkage also makes the very idea of “stranded” or ‘valueless’ fossil fuel assets an absurdity.
To return to a point made earlier, the rationale informing the impossibility of cheap renewable energy is a straightforward matter of energy density. The densities of renewables are lower than those of fossil fuels, and technology can’t overturn the laws of physics in order to change this material relationship. The lower the density of an energy source is, the larger – the more material-intensive, and the more costly – the delivery infrastructure has to be.
The message clearly being taken on board by energy investors is that, contrary to what had previously been received wisdom, wind and solar power are not going to deliver enormous profits through the supply of ultra-cheap energy for sale at healthy margins to domestic and business customers.
Where investors in energy itself are concerned, then, this penny seems to have dropped. But, if renewables aren’t going to be highly-profitable or low-cost for those who supply them, what about those who use them?
Is it feasible that non-cheap energy can power us to an ultra-profitable tech and leisure nirvana?
Can consumers really become more prosperous when the material cost of the energy embedded in everything they buy carries on rising?
Somebody, somewhere, has got their wires crossed.
With that noted, let’s get back to financialization, and the disequilibrium between the “two economies”.
The credit engine
With financialization, of necessity, goes credit expansion. When seen through the prism of “two economies”, it’s readily apparent that there’s no other way of financing the churn.
Over the past twenty years – and stated in real (ex-inflation) terms in international PPP dollars – global debt has increased by $265 trillion, but this doesn’t include broader financial liabilities, such as those of “shadow banking” (the non-bank financial intermediary or NBFI sector).
Because of glaring gaps in the availability of data, we can only estimate growth in these broader liability aggregates, put here at about $320tn, which is almost certainly a pretty conservative calculation. Beyond this again lie rapid rises in the “gaps” in unfunded pension commitments, and the potential nightmare that is derivatives.
Global broad liabilities, then, have increased by about $585tn in real terms over twenty years. which is roughly 7X the expansion in reported real GDP (+$83tn).
That ratio, in itself, is wholly unsustainable. But the real sting in the tail here is that three-quarters of that supposed “growth” has been the cosmetic effect of financialization itself.
By backing out the growth-inflating “credit effect”, and deducting the first call on output made by the Energy Cost of Energy, SEEDS analysis reveals that world material economic prosperity increased by only $20.6tn (rather than $83tn) between 2002 and 2022. We should never forget that, as mentioned earlier, gross domestic product isn’t a measure of material economic output, but of financial transactions, which is a very different thing, and the creation of non-value-additive transactional activity is a necessary statistical product of financialization.
What the numbers tell us is that, in annual, inflation-adjusted terms, we have become, over twenty years, materially better off by less than $21tn, having ramped up our collective liabilities by getting on for $600tn.
We can see the sleight-of-hand of financialization in numerous instances. If IMF data published in October is confirmed by final outcomes, for example, the American economy, measured as real GDP, will have grown by about 2.1% in 2023. But the same data puts ‘general government net borrowing’ – the fiscal deficit – at 8.2% of GDP.
This means that about US$530bn of growth will have been bought with upwards of US$2.1tn of government borrowing, the latter confirmed by American public debt breaking the US$34tn barrier. This is even before we include increases in household and corporate debt (and, of course, in their NBFI and other quasi-debt exposures).
It’s an often-remarked fact that the American consumer has been extremely resilient in recent times, comfortably out-spending inflation – but it’s hard to see how he or she could have been anything less than resilient, when being handed this much additional liquidity, borrowed on his or her behalf by the government.
Another anomaly – the concept of wealthy bankruptcy
Part of the contradiction in the financialized morass in which we have become entangled is that the same factors that seem ‘good’ for asset prices are simultaneously ‘bad’ for economic stability.
Within capital theory, there’s a valid debate to be had about which – interest rates or liquidity? – is the primary driver of asset prices. A reasonable conclusion might be that asset prices are a function of the supply and the cost of capital, because these are linked – an increase in the quantity of money (a rise in liquidity) is consistent with a decrease in its price (interest rates).
On this basis, expansionary fiscal and monetary policies point towards continuing rises in the prices of stocks and property. To prop up GDP, and pretend to deliver “growth”, the authorities will have to carry on driving public (and, for that matter, private) debt upwards.
Some observers think that the central banks’ real motivation in pushing rates upwards was to create headroom for cutting them again when exigencies require. The logic of ever-rising public debt points towards both lower rates (to keep government debt servicing affordable) and a reversion from QT to QE, to create enough debt-rollover liquidity in the system and, perhaps, to fund public borrowing if other sources fail.
So far, so good. But the same dynamics that seem destined to make us wealthy (by driving asset prices upwards) also seem destined to put us in a Marshalsea debtors’ gaol (by pushing debt and quasi-debt to ever more stratospheric levels).
We are, then, going to be both (a) rich beyond the dreams of avarice, and simultaneously (b) bankrupt, defined as having liabilities that we can’t possibly honour. (We can’t, collectively, pay off the debts by selling the assets, because any amount of asset sales requires a matching quantity of purchases).
A twisting road to reality
Just as surely as nature abhors a vacuum, logic abhors the concept of wealthy bankruptcy.
There are two ways – though they are not mutually exclusive – in which this contradiction can be resolved. First, the mountain of liabilities could collapse, taking asset values down with it. The second is that runaway money-creation could destroy the purchasing power of currencies.
We might, then, find ourselves the possessors of vast amounts of worthless money. If this is how things turn out, financialization, in all of its various forms, will have been ‘a road to ruin, paved with bad incentives’.
Before it quite gets to this, though, some other processes can be expected to kick in. These are best considered pictorially, using charts sourced from SEEDS.
The first chart shows how rapidly debts and broader liabilities have been outstripping even GDP, let alone underlying prosperity.
At the same time, risk itself has been rising as the disequilibrium between the real and the financial economies has become progressively more extreme (Fig. 1B).
In short, the quantum of liabilities has been rising, just as their risk profile has been worsening.
If we retrofit transactional activities to the prosperity curve (Fig. 1C), we can see how much prior “growth” has been inflated artificially.
The further introduction of segmental analysis – dividing output into essentials, capital investment and discretionary consumption – enables us see an emerging dynamic in which consumers’ ability to afford non-essential products and services is coming under relentless pressure.
What Fig. 1D does is to reveal to us those economic processes which are being experienced as the ‘cost of living crisis’. We’re at the start of a steep downwards incline, not just in the affordability of discretionaries, but also in the ability of the household sector to service its ever-growing mountain of financial commitments.
Meanwhile, and just as financial investment is increasing, capital investment – that’s to say, investment in the creation and replacement of productive capacity – is on a declining path.
Fig. 1
Where now?
Looking at our predicament, whether as description or as charts, a number of critical points become apparent.
First, the same financialization process which is creating a simulacrum of “growth” is driving debt and broader liabilities to a point at which vertigo sets in. A clear implication is that the “everything bubble” in asset prices must explode, and that decision-makers must adopt ever looser fiscal and monetary policies in an effort to keep the show on the road.
Analysis of the material economy, meanwhile, reveals a background process in which certain sectors – led by discretionaries, and by those over-invested in the supposedly-perpetual miracle of financialization – either contract or disappear.
Your guess is as good as mine as to whether the economy contracts gradually, or a financial collapse burns out the wiring linking the components of the material economy.
All we can really do is work out the pattern of stresses in the system, thereby trying to push the odds in directions favourable for ourselves.
It’s an old adage that ‘the most dangerous part of a car is the nut holding the steering wheel’.
Where decision-making is concerned, we can only hope that the arrival of materiality brings wisdom where the progression of financialization has brought folly.
As 2023 draws to a close, I’d like to take this opportunity to thank everyone for their informed, constructive and courteous contributions to our debates over the past twelve months, as well as wishing you the very best for the Festive Season and the year ahead.
I don’t know what you’re hoping for in 2024, but I’d settle for a bit of old-fashioned reality. Like Alice in both of her famous adventures, we seem to have stumbled into a parallel world where nothing is quite what it seems.
The economy carries on growing, even though it isn’t. In this Wonderland that we’ve created out of whole cloth, debt doesn’t matter, creating money out of the ether isn’t inflationary, and we can borrow our way to prosperity whilst money-printing our way to financial sustainability.
Technology has abolished the laws of physics, and we can enhance our prosperity by reducing the density of the energy inputs that drive the economy. Carl Benz, Gottlieb Daimler, the Wright Brothers and Frank Whittle got it wrong when they decided to power their cars and aeroplanes with petroleum rather than windmills. W. Heath Robinson and Salvador Dalí painted reality much better than Rembrandt van Rijn and Nicholas Pocock.
Delusion may sometimes be preferable to reality, but reality, when it returns, tends to have sharp edges. In short, I have a nagging feeling that, when Alice steps back Through the Looking-Glass, she’s going to find that somebody has stolen most of the furniture. I don’t know how much longer we can sustain the illusions of the moment, but my sense is that the factual is waiting in the wings.
To solve or to deny?
If there’s a theme to this discussion, it’s the gulf, not so much between the real and the imaginary, but between knowing something and being willing to accept it. After all, a retreat into fantasy usually results from an unwillingness to see the world as it is.
The emergence of this gap between reality and perception isn’t all bad news, of course – it gives realists a competitive edge over fantasists. I’m not going to go into investment decisions, career options or political choices here, except to say that the realists have the odds stacked in their favour. Suffice it to say that challenge and opportunity are the different faces of the same coin.
In the real world that some of us still inhabit, there are proven techniques for problem-solving. First, we find out what the problem actually is. Then, we dismantle the problem into its constituent parts. If we follow this procedure, we usually find two kinds of solution, or a combination of both. One of these is to work around the difficulty and resolve it. The other is to adapt to those bits of the difficulty that we can’t resolve, and learn to live with them.
When these problem-solving techniques go wrong, it’s usually because we don’t like the explanations that we’re finding, and aren’t prepared to accept the solutions that present themselves. If this happens, the likelihood is that we’ll miss-define the problem, and rule out from consideration those solutions that might actually prove successful.
Though there are many other matters of concern in our material world, our two biggest challenges today are a faltering economy and a deteriorating natural environment.
How real are these problems? Well, when we’re taking on anywhere from $3 to $7 of new liabilities for each dollar of “growth”, have no proposed fixes that don’t involve either borrowing or money-printing, have commitments that we can’t possibly honour and an “everything bubble” in asset prices that’s destined to burst, then there’s a prima facie case that the economy is in very big trouble.
When global temperatures are rising, and are being accompanied by worsening floods, droughts, storms, heatwaves and agricultural disruption, then it’s reasonable to conclude that the environment, too, is in trouble.
This needn’t drive us into despair, but should urge us to think.
In search of definition
An objective approach to these conjoined economic and environmental challenges recognises energy as the factor common to both. Even the briefest interruption to the supply of energy would stop the economy in its tracks. Climate science has identified the burning of carbon fuels as a major contributory factor in environmental deterioration.
Energy is where our quest for explanations and solutions must start.
With this point established, the logical next step is to define how these various processes work. On this fundamental basis, the economy functions by using energy to access raw materials and convert them into products and services.
This is a creation-diffusion equation – at the same time that energy is used to convert raw materials into products, energy itself is converted from dense into diffuse forms.
Add in our penchant for the rapid disposal and replacement of products and this becomes a dissipative-landfill economic system. The outputs of the creative process, together with their raw materials and embedded energy, are jettisoned with almost indecent haste. The output of the thermal side of the equation is waste heat and, when fossil fuels are used as the dense inputs to the system, this waste heat contains climate-harming gases.
This tells us that there are two possible solutions to our environmental challenge, not one.
One of these is to change the form of dense energy inputs to the system, moving from climate-harming fossil fuels to less harmful alternatives.
But the other potential solution is to slow the creation-disposal-replacement cycle itself.
A rational society would be addressing both of these possible solutions, not just one of them – we’d be looking at alternatives to fossil fuels, but we’d also be giving constructive thought to behavioural change.
There can be no guarantee that we can effect a wholly successful transition from carbon fuels to cleaner alternatives. In fact, an economy powered by renewables is highly likely to be smaller than the fossil-powered economy of today.
Accordingly, we should at least be investigating the idea of slowing the creation-disposal-replacement cycle, seeking to get more value from the energy and other resources that we consume. Effective solutions to environmental degradation might very well involve doing both.
It’s perfectly possible, should we so choose, for us to put the brakes on the dissipative-landfill cycle of rapid resource extraction, product creation, disposal and replacement, and doing so needn’t, in and of itself, make us poorer.
We could step up our re-use of raw materials by reconfiguring products, with recycling designed into them from the outset. We could demand products that are capable of viable repair, and have longer design-lives. We could subsidise longevity as well as taxing landfill. We could introduce strengthened recycling credits into the tax system. We could further this strategy by marketing it effectively to consumers.
With the appropriate use of incentives as well as regulations, we could make a decelerated resource cycle profitable. Opportunities will undoubtedly exist for those who choose to ‘go with the flow’ of material reality rather than persisting with the easier (but time-limited) conventions of the past and present.
A self-selected blind-spot
Thus far, though, the dissipative-landfill, extraction-creation-disposal economic system has been almost entirely off-limits for debate. Whether our countries are fossil fuel producers or consumers, we’re agreed on not challenging the system itself.
We have opted to fight our very real environmental challenges with one hand tied behind our backs.
Even the most environmentally concerned haven’t spotted the duality of the challenge. In recent times, climate activists have vented their anger on the producers of oil, natural gas and coal. Whatever its merits may or may not be, this approach lets off scot-free businesses whose activities accelerate the disposal cycle. If you produce oil or gas, your head office is likely to become the target of vocal protest. But if you use energy from oil, gas or coal to manufacture throwaway products, there won’t be an angrily-worded placard in sight.
This, it should be stressed, isn’t an anti-corporate argument. Private enterprise is essential to a balanced economy. The opposite extreme, which is state control of everything, is something that no sensible person should desire. “If we’re so awful, we’re so bad”, sang a famous American musician in the 1980s, “go and try the nightlife in Leningrad”.
Rather, what we need is a differently-configured corporate sector, which really means that we need to shift the basis of incentives to favour quality, repairability, reusability and longevity.
I’m not so naïve as to suppose that the corporate sector is going to opt for cycle-slowing processes of its own volition, and neither do I imagine that our leadership cadres are going to undertake the recalibration of incentives that could promote and accelerate such a switch.
In any case, political leaders have been left far behind the curve of environmental and economic evolution, and still see no problems that can’t be fixed with a bucket of greenwash, breezy public optimism and a further recourse to borrowing. There’s something very bizarre about hopping on to a kerosene-powered jet to attend a pow-wow about global warming.
But the economy itself is already pushing us in a different direction. The global economy is in the process of inflecting from growth into contraction. No amount of waffle about the possibility of ‘infinite growth on a finite planet’ can change this reality. We can’t fix energy and resource depletion with money, any more than we can cure an ailing house-plant with a spanner. Energy-intensive necessities are already becoming costlier. Discretionary affordability is under the cosh.
Under these conditions and pressures, it’s perfectly possible that pricing trends, and changing patterns of consumer preference, could drive this constructive evolution.
To understand why this is happening, we need to go back to fundamentals.
Children at play
The development of the industrial economy followed directly from our discovery of the ability to harness the vast quantities of energy contained in fossil fuels.
From that point on we, collectively, started behaving like irresponsible youngsters let loose in a chocolate-factory. The transformative benefits of abundant low-cost energy came without limits or obligations. There were no adults in the room. Nobody stopped us from becoming fixated with the new and shiny. We were free to consume, reject, replace and pollute at will. As well as polluting the land and the seas, we’ve even taken to using space as a backyard dumping-ground.
There was, and remains, little or no likelihood that we would choose to turn aside from this reckless form of behaviour. But material parameters – those conditions which determine the boundaries of possibility within which we have freedom of choice – are already starting to impinge on our capacity for recklessness. The clue to this lies in a matter already noted – the density of available energy.
Fossil fuels are the densest forms of energy yet harnessed by society. We’re not ‘running out of’ fossil fuels, but their costs are rising, and their abundance no longer remains a given. Quite naturally, we’ve used lowest-cost resources first, leaving costlier alternatives for later. The typical new discovery or development is smaller, more remote or more technically challenging – that is to say, more expensive – than the one that it replaces.
As these costs – measured here as the Energy Cost of Energy, or ECoE – carry on rising, the ex-cost value of each unit of fossil fuel energy decreases. This material cost has already risen five-fold since 1980, and there’s no way of putting the genie of rising ECoEs back into the bottle.
If climate campaigners grasped this, they could reinforce their environmental advocacy with powerful economic arguments. Continued reliance on carbon energy might or might not destroy the environment, but relentless rises in the material costs of fossil fuels would certainly destroy the economy.
An awkward legacy
This is where the choice between reality and self-deception becomes critical. Where alternatives to fossil fuels are concerned, renewables seem to be the best options on the table. Scaling them upwards requires vast amounts of everything from steel and concrete to copper, lithium and cobalt. Accessing and processing these materials requires correspondingly vast amounts of energy, and this can only come from legacy fossil sources.
Far from being “stranded” and somehow ‘useless’, fossil fuel assets are the only resource that exists to make energy evolution possible. The question becomes one of the wisdom, or folly, with which we choose to employ this resource.
This energy legacy is finite, meaning that it has limiting characteristics. One of these is the energy value that remains, and the other is the limit set by the envelope of climatic tolerance.
Like any legacy, this comes with choices – we can blow it now, or invest it, in this case in renewables, and in changing the character of the economy. We can’t put the same gallon of petroleum into a vehicle and use it to extract minerals and build wind-turbines. But we can make that energy unit go further if we tame our penchant for disposal.
The snag with all of this, of course, is that the lesser density of wind and solar power means that they are going to provide a smaller net-of-cost input to the creative-dissipative process. To believe that the wonders of technology are going to overcome the handicap of lesser density is to suppose that technology can circumvent the laws of physics.
Because of their lesser energy density, renewables are going to need a proportionately larger infrastructure – that is to say, more input resources, meaning more energy – than fossil fuels in their heyday. The necessity of using legacy energy to develop, operate, maintain and replace renewable capacity is an umbilical link tying the ECoE costs of renewables to those of fossil fuels.
In conclusion
I don’t want to end this article – or 2023 – on a depressing note. Change brings opportunities as well as challenges. There’s a lot that we might like about a society with a decelerated extraction-disposal cycle. A financial crash has become inescapable, but will be the product of delusion, not the consequence of reality.
Where all of this leaves us is, undoubtedly, with hard choices. We can choose to pretend that everything will turn out fine if we whistle a cheerful ditty, ignore the realities of energy and physics, and rely on monetary fixes for material problems.
Alternatively, we can take a hard look at the fundamentals, which is what I’ve been endeavouring to do over the decade since Perfect Storm and Life After Growth were published, this site was created, and work on the SEEDS economic model began.
“Hard choices” sounds gloomy, but that needn’t be our sole conclusion as we head into 2024. The economy is changing, with global material prosperity inflecting and the costs of energy-intensive necessities continuing to rise. Accordingly, the affordability of discretionary (non-essential) products and services faces ongoing compression.
The concept of involuntary economic de-growth has been shifting inexorably from left-field prophecy towards real-world reality.
But spooks imagined in the darkness can become less frightening when we examine them in the light. There’s no reason why we shouldn’t respond constructively to this challenge. Creation and rapid disposal is a choice, not the diktat of Holy Writ, and alternatives can be profitable as well as sustainable – especially for those who get there first.
The aim with what follows is to set out the Surplus Energy Economics interpretation of the economy with maximum clarity, laying out, in the most straightforward way, the interconnectedness of the economy, finance and the environment.
Here’s why.
In our discussions around the previous article, a reader mentioned a marked reluctance on the part of those unfamiliar with the energy basis of the economy to give open-minded consideration to this explanation.
This reluctance is understandable. Some of the conclusions reached here are unpalatable to many, and we might ourselves sometimes wish that the evidence pointed in different directions.
The official or consensus line is certainly more comforting, with its promise of a return to never-ending economic growth, and its assurances that our various leaderships ‘know what they’re doing’, at least where the economy is concerned. These notions are attractive, even if they don’t stand up to objective scrutiny.
To be sure, none of us wants to be perceived as a “doom and gloom merchant”, but it does seem difficult to deny the gravity of our economic, financial and environmental predicaments. Ignoring these issues, and simply hoping for the best, is hardly a practical strategy.
Much as we might regret the lack of open-mindedness in some, the task is surely obvious. It is to strive to make our thesis as clear as it can possibly be, at the same time remaining open to constructive criticism.
There’s no explanation that can’t be improved upon with greater clarity, greater emphasis on logical sequences, and an enhanced availability of data.
One thing seems certain, which is that we cannot hope to understand economic, financial and environmental issues by seeing them in isolation. Rather, the emphasis needs to be on examining and explaining material, environmental and financial interconnectedness.
If a mixed metaphor can be permitted, what we need is a logical pathway through the thickets of inter-related systems.
The proper study
According to Alexander Pope, “the proper study of mankind is man”. Likewise, the proper study of the economist is – or should be – prosperity. We need to know what prosperity actually IS, how it’s created, and how it can be measured.
As we shall see, prosperity certainly isn’t money. Rather, prosperity consists of the material products and services that the economy supplies to society. Money is simply the medium by which we acquire these components of prosperity, and exchange them with others.
This material prosperity provides two things to individuals, households and economies. First, it supplies the necessities, those things that make life possible, and which can help hold poverty at bay.
Second, it provides an ability to enjoy discretionary (non-essential) products and services.
The study of prosperity leads inexorably to the intersection of three systems. One of these is the material economy. A second is the financial system, which distributes material prosperity through exchange. The third is the environment, considered, not just as climatic conditions, but also as the source of the energy and other raw materials without which the economy cannot function.
It seems futile to deny that we face serious problems on all three fronts. Growth in the material economy has long been decelerating towards contraction. The financial system, which is the monetary counterpart of the material economy, has been overloaded towards the point of inevitable fracture. We face grave environmental and ecological dangers, in large part related to our economic activities.
It would be equally futile to isolate one of these systems from the other two. Indeed, this kind of ‘silo thinking’ makes it harder than it needs to be to understand intersecting issues, and to find practical solutions to our difficulties.
The mythology and reality of money
One of our ‘silo thinking’ problems is rooted in those tenets of orthodox economics that many of us learned about at school, college and university. This orthodoxy is shot through with fallacies, but has one defining error which leads to one disastrously inaccurate conclusion.
The central fallacy is that the economy can be understood in terms of money alone. The absurd conclusion is that money can enable us to enjoy ‘infinite economic growth on a finite planet’.
What orthodox economics claims is that there are no material obstacles that cannot be circumvented by financial means. Demand, prices and incentives confer upon us an ability to break free from the bounds of the physical.
Far from being ‘true’, the promise of ‘infinite growth on a finite planet’ isn’t even logical. It’s a fallacy which fundamentally misunderstands the role and character of money.
If we think that ‘money’ and ‘the economy’ are the same thing, we have zero chance of understanding either.
It’s surely clear beyond debate that we can’t use financial tools to overturn physical limits. We know that the banking system can’t lend low-cost energy (or any other natural resource) into existence. Central banks can’t conjure resources out of the ether. We can’t ‘fix’ climatic and ecological degradation by sending money to the environment.
Neither, for that matter, would any amount of money be of the slightest use to a person stranded on a desert island.
And this takes us to the heart of what money actually is.
Irrespective of its format – fiat currency, precious metals, cryptocurrencies, data entries in a digital ledger, or humble cowrie shells – money has no intrinsic worth. We can’t eat gold, or power our cars with bank-notes. Money commands value only in terms of those material things for which it can be exchanged.
Money is “a human artefact, validated only by exchange”. You might like to think of money as an ‘exchangeable token’. The terminology preferred here is that of money as ‘claim’.
There are two ways in which money is used. The first, known as flow, is the exercise of claims in the present. The other is stock, meaning claim entitlements that are set aside for exercise in the future.
Comparisons are often made between stock and flow – this is what we do when we express debt as a percentage of GDP. But there is a fundamental commonality here between stock and flow – they are different facets of the same thing. A person who has saved money for the future might change his or her mind, choosing instead to spend these savings now.
What, then, provides the value that enables monetary ‘claims’ to be honoured?
The answer is energy. Ultimately, the economy is an energy system, because nothing that has any economic value at all can be supplied without the use of energy.
This, at least, should not be a ‘hard sell’. We know that cutting off the supply of energy even for an hour would bring the modern economy to a halt. A week without energy would plunge the economy into chaos. A longer interruption would destroy it.
Accordingly, if money is a claim on products and services, it’s a claim on the energy needed to supply them. Debt, as ‘a claim on future money’ is, therefore, a claim on future energy. Money set aside for the future is another form of claim on future energy.
If, when the future arrives, there’s enough energy for all of these claims to be honoured in their entirety, everything is well. If, on the other hand, the future availability of energy is smallerthan the claims previously established upon it, the claim value of money cannot be honoured in full, meaning that the value of money is impaired, and might even, in extremis, be destroyed.
The inflationary devaluation of money is what happens when we create financial claims which exceed what the material economy of energy can honour, either now or in the future.
With this understood, we can move on from the textbook fallacies of the orthodoxy to describe how the economy really works. This, in turn, will lead us into environmental as well as financial considerations.
Duality of the economy, duality of process
Once we understand the relationship between the material and the monetary, the existence of two economies becomes a conceptual necessity, meaning that there’s no other way of explaining the economy satisfactorily.
One of these is the “real economy” of material products and services. The other is the parallel “financial economy” of money and credit. The “financial” economy is a body of claims on the “real” economy of material substance.
How, then, is this material substance supplied?
The “real” economy operates by using energy to convert raw materials into products. This process connects directly to the environmental effects of human activity. The supply of services works in a parallel way, but let’s concentrate, in the interests of clarity, on physical products.
The critical point here is the dual material equation. As energy is used to convert raw materials into products, so a parallel – and inseparable – thermal process converts energy from dense into diffuse forms.
The positive outputs of this dual process are the products and services which meet our needs and wishes.
There are two negative outputs. One is material waste, which occurs when products wear out, or we choose to dispense with them, and when raw materials are wasted in the production process.
The other is waste heat, which is the consequence of the energy dissipative process.
Environmentalists are right to state that, when oil, natural gas and coal are used as the dense energy inputs to the dual process of production and dissipation, the resulting waste heat contains climate-harming gases.
This observation, though, doesn’t go far enough, because it can lead to the conclusion that we can overcome this environmental negative simply by replacing fossil fuels with a matching amount of alternative energy inputs, most obviously renewables, giving us the same (or more) economic output at lesser levels of environmental harm.
This view seems to be based on purely quantitative measurement of energy, whereas the reality is a lot more complicated than this.
To understand these questions effectively, we need to include the related issues of energy density and cost in the equation.
The productive process is driven by its dissipative thermal parallel. If we shift to energy inputs of lesser density, we shorten the dissipative process, simultaneously resulting in less material output, and a smaller economy.
The unfortunate reality is that wind and solar energy are less dense than fossil fuels. These renewables can power an economy, but not this economy. An economy powered by renewables might – though equally might not – be more sustainable than the economy that we have now, but lesser energy density decrees that it will also be a smaller economy.
We should not be blinded by the allure of technology to the fact that human ingenuity cannot overcome the problems posed by lesser density. Technology can’t over-rule the laws of physics – rather, the potential scope of technology is bounded by the limits of physical possibility.
Clearly, therefore, the energy source must come before the applications to be powered by it. This is why Orville and Wilbur didn’t invent the aeroplane first, and then sit around waiting for somebody to discover petroleum.
Of cost and value
Consideration of energy density leads straight to the question of the costs of energy. Fundamentally, these costs are material, not financial.
We need, first, to be quite clear that energy is never ‘free’.
Oil, gas and coal aren’t ‘free’ because they exist beneath our territory – they can only be put to use by constructing an infrastructure including mines, wells, refineries, pipelines and filling stations.
Renewables aren’t ‘free’ because the sun shines and the wind blows – rather, we can’t harness this energy without wind turbines, solar panels, distribution grids and storage systems.
Putting any kind of energy to use therefore requires an energy supply infrastructure. This infrastructure consists of physical things, meaning that making this infrastructure available requires that we access raw materials, and process them into the equipment that the energy industries need.
We can’t access or process raw materials without using energy. In short, the supply of energy is, by definition, a circular ‘in-out’ process in which we use energy to get energy.
It follows that, whenever we access energy for our use, some of that energy is always consumed in the energy access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, or ECoE.
Because the same unit of energy cannot be used twice, ECoE is a deduction from the amount of energy available for all other economic purposes.
Two things happen when ECoEs rise, which is what we’ve been experiencing in modern times.
First, the economic value obtained from each unit of energy supplied to the system decreases.
Second, it becomes harder to strike prices which, whilst covering the (rising) costs of suppliers, also remain affordable within the (decreasing) resources of consumers.
The latter leads, in due course, to a reduction in total energy supply. This happens when energy suppliers can no longer earn satisfactory returns on their investment, and/or when purchasers become unable to afford energy at the higher prices dictated by material cost trends.
In short, ECoEs are a critical component of prosperity. Economic output is a function of the use of energy. Prosperity is what remains after the ECoE cost of energy has been deducted from energy supply.
Prosperity, in short, is a product of ex-cost surplus energy.
What, then, has happened to ECoEs through the industrial era?
The arc of the industrial age
The short answer is that ECoEs fell for a very long time, but have since turned upwards.
Far from coming as a surprise, this trend of ECoE decline, followed by a reversal into increase, has always been an implicit characteristic of fossil fuel energy. From a theoretical standpoint, the evolution of ECoEs follows a logical path, and observation confirms that this is what has happened.
Over a long period, the ECoEs of oil, gas and coal decreased. These costs were lowered by three positive processes. One of these is global exploration. As the search for oil, for example, spread out from Pennsylvania to embrace the world, this expansion of geographical reach led us to find successively lower-cost resources, most obviously in the Middle East.
Second, the growth of the fossil fuel industries harvested economies of scale.
Third, the technology used to access fossil fuels has improved over time, albeit incrementally rather than dramatically.
This process, though, has always had a built-in point of reversal. This occurred when the benefits of reach and scale had reached their limits, and depletion – first use of lowest-cost resources – took over as the primary driver of ECoEs.
Accordingly, it has always been predictable that the fossil-based economy would, after a slow start, grow dramatically, before plateauing ahead of contraction as the trend in ECoEs turned from decrease to increase. Though data gets patchier as we go back in time, there are reasons to suppose that fossil fuel ECoEs were at their lowest in the quarter-century after 1945.
At this juncture, it’s instructive to compare what we might have anticipated with what we have actually experienced, as set out in the following charts. (Please note that charts used here can be opened in a new tab for enhanced visibility).
The first and third charts are stylized representations illustrating what we would have expected to happen to ECoEs and economic prosperity, based on what our analysis tells us.
The second and fourth charts show what has been happening (and can be anticipated for the future) based on the more recent data, and the projections, that are available to us.
First, and as illustrated by the left-hand chart, our understanding of the processes of scale and reach would lead us to expect trend ECoEs to have fallen for a long time, but then to turn upwards as these drivers are exhausted, and the effects of depletion take over. Available information, shown in the second chart, confirms the latter part of this expectation.
Likewise, and as the third chart shows, our knowledge of the energy and cost basis of the economy would lead us to anticipate that accelerating growth would eventually give way to deceleration, stagnation and contraction. This, again, conforms with experience, as illustrated in the right-hand chart.
Fig. 1
Uncomfortable realities
The foregoing considerations lead us to some unpalatable conclusions.
One of these is that the prosperity of the industrial age is traceable to the moment at which we learned how to harness the enormous energy contained in coal, oil and natural gas. These fossil fuels have provided energy at a density that no alternative source of energy has matched.
The subsequent process has been that of ‘cherry-picking’ these energy resources. Quite naturally, we have used the lowest-cost (meaning lowest-ECoE) resources first, leaving costlier alternatives for later.
This sequence of ‘using the best first’ is known as depletion. As this trend progresses, each new source of fossil fuel energy is costlier than the one it replaces. New discoveries become successively smaller, more remote and more technically challenging than the ones that went before.
Without wishing to labour this critical point, what history, data and logic tell us is that the harnessing of fossil fuels was the start of a predictable arc or parabola. From the moment of fossil fuel discovery onwards, the economy would enter an accelerating growth phase, as the quantities of fossil fuels consumed increased, and as reach and scale pushed their ECoE costs downwards.
In due course, however, the onset of depletion would start to push ECoEs back upwards. The result would be that the pace of economic expansion would first decelerate, then fall to zero, and then turn negative.
We are, then, living through the moment when the impetus initially imparted to the economy by the harnessing of fossil fuels is fading out.
This parabola is dictated by the characteristics of oil, gas and coal. The only event that could prevent the eventual downwards trajectory – known here as the inflexion from growth to contraction – would be the discovery of a new source of low-cost primary energy.
We cannot know whether some low-cost energy successor to fossil fuels may be found at some point in the future. We do know, however, that renewables such as wind and solar power cannot provide this successor.
Since this runs contrary to consensus assurances, we need to know why this is.
The limits of renewables
First, renewables cannot match the energy density of fossil fuels. No electricity storage system can ever replicate the ratio of power-to-weight of the humble fuel tank. This ratio of power to weight is a critical limitation. It’s why we cannot use batteries to propel large aircraft, or build electricity-powered ships with the same cargo-carrying capabilities as vessels fuelled by oil.
Second, this lesser density creates a dependency relationship between renewables and fossil fuels.
The lesser density of wind and solar power, in comparison with fossil fuels, means that these energy systems require a correspondingly larger material infrastructure.
This in turn results in a disproportionately large requirement for material resources. Energy transition will demand vast quantities of everything from concrete and steel to copper, lithium, cobalt and the numerous other metals that renewables systems require.
Accessing these raw materials and using them to make equipment in turn requires huge quantities of energy. The most efficient sources of this energy are oil, gas and coal.
Moreover, we are trying to do this at a time when the prior economy of fossil fuels has already depleted the non-energy resource base. For example, the ore density of copper has fallen successively, and is far lower now than it was one or two hundred years ago. This means that the long era of fossil fuels has, in some important ways, made the development of renewables even more difficult than it might have been at some earlier time.
We should at this point dismiss the idea that technology can allow us to circumvent these material obstacles. The potential conversion efficiencies of wind and solar power are determined by physics, with Betz’ Law setting the limit for wind turbine efficiency, and the Shockley-Quiesser Limit doing the same thing for solar. Starting from low levels of efficiency, best practice has advanced rapidly, and is already close to both of these physical maxima.
None of this means that we should not pursue the development of these renewable sources of energy. Environmental sustainability is a worthy objective, and renewables are the only option on the table.
But the concept of “sustainable growth” is highly implausible.
Neither should we allow the supposedly “green” credentials of renewables to pass unquestioned. The ripping out of yet more raw materials from our lands and seas can have extremely adverse environmental, social and human consequences.
Confirmation, perception, projection
It would be natural for anyone confronted for the first time with the energy-economy thesis to require confirmatory evidence. This can be provided using data, because the economy is capable of statistical analysis along the lines set out here. This, indeed, is why the SEEDS economic model has been developed.
But there is a simpler, less theoretical way of confirming an analysis which points towards economic deceleration into contraction. This lies in observed behaviour. Essentially, no other construction can be placed on policy choices over the past twenty-five years.
From no later than the mid-1990s, decision-makers embarked on a sequence of policies which, considered in isolation, make absolutely no sense at all.
They began by making credit easier to obtain than it had ever been before. This led directly to the global financial crisis (GFC) of 2008-09. During and after this crisis, they then drove the real (ex-inflation) cost of capital into negative territory, a process in which the slashing of policy rates was reinforced by the creation of new money (QE) on a gargantuan scale.
Only now, confronted by a surge in headline inflation, have central banks started raising rates, and putting monetary expansion into reverse (as QT).
Policy preferences over the past quarter-century have been full-blown gimmickry, and three things should be noted about this.
First, it has run entirely contrary to all prior policy orthodoxy. Indeed, the principles of the market capitalist system itself have been directly contradicted by these policies. A system cannot be ‘capitalist’ if investors are unable to earn real returns on their capital. The levels of distortion introduced in twenty-first century monetary policy have had the effect of sidelining market processes.
Second, these policies have had disastrous effects.
Financially, they have resulted in debts rising at 3X the claimed rate of “growth” in the world economy. Latterly, growth in conventional debt has been compounded by super-rapid expansion in unconventional credit, most obviously in the NBFI or “shadow banking” sector, for which – and this should sound warning-bells – we don’t even have complete or timely data. Based on what we do know, we can infer that around $7 has been borrowed for each dollar of reported “growth” over the past twenty years.
We have, in short, saddled ourselves with debts (and broader liabilities) that we cannot possibly honour. Meanwhile, and as the World Economic Forum has pointed out, we have witnessed the emergence of enormous “gaps” in the adequacy of provision for future pensions.
Side-by-side with reckless liability expansion we have created an unprecedented “everything bubble” in the prices of assets. Markets have been turned into speculative casinos as participants chase the latest actual (or rumoured) tranche of monetary largesse from the authorities. Like all bubbles before it, this one will burst and it is, if anything, surprising that investors in stocks and property haven’t already stampeded for the exits.
Some of these trends are illustrated in the first two of the following charts, with the underlying reality pictured in the third and fourth.
But much more interesting is the ‘why?’ of these compounding exercises in apparent lunacy.
We might conclude that those in charge have submitted to some form of collective hallucination. Alternatively, this might have been a cynical exercise in the further enrichment of the already wealthy. The snag with this, though, is that these have been paper gains only, and cannot survive the inevitable bursting of the “everything bubble”.
We are left with a simpler, if chilling, explanation, which is that decision-makers have been acting as they have for reasons which, to themselves at least, have seemed rational.
This explanation divides into two possible motivations.
First, decision-makers have noted material economic deceleration without understanding its cause. If this has been so – and if they still believe in the orthodox tarradiddle that the material economy can be re-energised towards infinite growth using financial tools – then these might have been successively more extreme and desperate exercises in the impossible.
Conversely, they may be well aware that the economy has been decelerating towards contraction, for the reasons set out in this article. If that’s the case, then decision-makers have been buying time, in the hope that ‘something will turn up’.
In either case, we need to start looking at the economy in new ways, placing economics and finance in their material and environmental context
The idea that the authorities don’t know what’s really happening is every bit as disturbing as the notion that they understand this perfectly well, and are simply playing for time.
Imagine – it couldn’t happen, but imagine – that Congress agreed that it wouldn’t impose a future debt ceiling if the administration promised henceforth to balance the budget. To do this, somewhere between USD 1.6 trillion and USD 2.0 trillion, depending how we calculate it, would have to be pulled out of the budget – taxes would have to rise, public expenditures would have to fall, or a combination of both.
Likewise, and equally impossibly, the Fed committed itself to maintaining interest rates, in perpetuity, at positive real (ex-inflation) levels.
Under these imaginary conditions, capitalism would, at least in part, be restored, because one of the two essential predicates of market capitalism is that investors earn a real return on their capital. (The other is that markets are allowed the unfettered capacity for price discovery, meaning they can put a price on risk). It’s likely that these processes would help tame inflation, thereby defending the value – meaning the purchasing power – of the dollar.
The point of this fictional scenario is that, if it happened, American real GDP would contract, and would carry on doing so for as long as balanced budgets and positive real rates prevailed. Put another way, there would be no growth at all – rather, there would be negative growth – if government was prevented from piling up yet more debt through deficit budgeting, whilst households and businesses could no longer finance expenditures by borrowing at sub-inflation rates.
Then turn to China. Roughly a quarter of the Chinese economy is accounted for by real estate. Much of the real estate sector has been exposed as a scam, a Ponzi scheme, or both. There’s no other way to describe a sector that takes people’s money for homes that haven’t yet been built, and that might never be completed, as part of a broader, gigantic debt binge that has brought much of the sector to the brink of collapse.
The point of this is that, behind the veils of financial camouflage, the global economy has started to shrink. “Growth” has become a story we tell ourselves to keep the economic nightmares at bay. Orthodox economics it itself a fairy-tale, in which the protagonists, instead of “living happily ever after”, enjoy ‘infinite economic growth on a finite planet’.
Looking down the barrel
The reality is staring us in the face – “growth”, whether in America, China or anywhere else – has become sleight-of-hand. If you look for real growth – growth, that is, not manufactured using super-rapid debt and quasi-debt expansion, itself enabled by sub-inflation interest rates – you won’t find it anywhere. Behind various schemes in which the speed of the hand deceives the eye, the global economy has inflected from growth into contraction.
Let’s remind ourselves about the two ways in which money is created. First, it can be conjured out of the ether by central banks. Second, most of it is loaned into existence by the banking system. Regulation is one check on the latter, and the need for collateral is the other. Lenders won’t hand you $1m on your word alone, but will if you can show them an asset which guarantees your ability to honour at least part of your new obligation.
But this is circular, because asset prices, which provide this collateral, are an inverse function of the cost and availability of capital. Accordingly, a credit mountain must create a super-bubble in asset prices, and vice versa.
The medium of control, if indeed there really is one, is interest rates. If these are set at levels below inflation, borrowing becomes profitable. This incentive drives both credit and asset values upwards, with the latter appearing to provide a collateral guarantee for the former. We can, supposedly, be comfortable about adding $X trillion to our debt pile if we’ve also added $X trillion to the collateral value of assets.
But these aggregate asset valuations are no more than notional. At the national level, the aggregate ‘value’ of a country’s housing stock is meaningless, because the only people to whom the entirety of that stock could ever be sold are the same people to whom it already belongs. Globally, the same principle applies to stocks, bonds and other asset classes. This principle is that we deceive ourselves when we apply marginal transaction prices to the aggregates of existing assets.
There are, in fact, two main ways in which assets can be valued. One is the price which the owner could realise by selling the asset to somebody else. The other is utility value – on this basis, a property has value in that it provides the owner with somewhere to live, saving him or her from having to pay rent. The utility value of a stock is the value that will come to the owner in the future, through dividends but, ultimately, through profits.
There is no way that current stock or property values could be justified on a utility basis, even if the economy was still capable of growth. In short, what we have is a confection – you might liken it to a soufflé – in which an excessive credit burden is backed up by inflated asset values which are themselves a function of over-extended credit.
The sleight-of-hand of ‘output’
Moreover, when we pour credit into the economy, this money is spent, which is what it’s for. This shows up as transactional activity, which is what we measure as GDP.
The direct functional relationship between credit and the transactional activity (recorded as GDP) can be measured.
Over the past twenty years, each $1 of “growth” in reported real GDP has been accompanied by $3.20 of net new borrowing, and even that ratio excludes broader liability increases which include the “shadow banking” (NBFI) sector. Buying $1 of “growth” by borrowing and spending upwards of $3.20 is self-deluding fakery, pure and simple.
Beyond being simply unsustainable, it leads us to the paradoxical condition of being both wealthy and bankrupt. We’d be wealthy because the paper value of our assets would have soared, and simultaneously bankrupt because our debts would be so big that they could never be repaid.
GDP, meanwhile, is inflated artificially by the pouring of ever more credit into the economy. Since money can (and routinely does) change hands without value being added, there is no correlation between transactional GDP and the creation of material economic value. And, if GDP losses its validity as a measure of output, so do all metrics based upon it. This means that the ratio of debt to GDP becomes unreliable, and we can’t effectively measure the velocity of money.
The same fakery at the heart of reported “growth” is all around us. Some jurisdictions are thinking about super-long mortgages, which could spread the cost of house purchase to, and beyond, the average person’s working life. This amounts to a confession that the ratio between property prices and disposable incomes has become dysfunctional. We can’t admit this, though, because doing so would crash property markets, blowing a gigantic hole in the supposed value of collateral.
The business model de jour is the garnering of consumers’ information in order to flog it to advertisers so they can offer the same products to the same people, a model which adds no real economic value at all.
Another gambit is that of reducing costs by casualizing labour through ‘gig’ employment and zero-hours contracts. These workers, at least, aren’t going to be increasing their purchases of advertised products, or ‘signing up’ to those subscriptions which the same business model portrays as a way of generating valuable new streams of income from the household sector.
Corporates use cheap debt to buy back stock in a process that, far from being accretive to value, provides the sugar-rush of a brief rise in stock prices whilst saddling businesses with ever larger burdens of debt, thereby making them increasingly vulnerable to any shift away from sub-inflation interest rates.
The blanket term for all of this, and more, is gimmickry. This has a lengthening and dishonourable history. It began, back in the 1990s, with making debt easier to access than ever before – seldom did a day pass without credit offers padding the mail-box of the Western householder. Then, when this process of “credit adventurism” detonated in 2008-09, we switched to outright “monetary adventurism”, essentially subsidising credit by setting the real cost of capital at negative levels.
Doing this has put the value of money itself at hazard. We have thrown, first, the viability of the banking system and, second, the sustainability of our currencies themselves, under the wheels of an unstoppable juggernaut. The name painted on the side of that juggernaut is ‘inflexion’, meaning that the economic growth of the past is turning into the economic contraction of the present and future.
Where this all ends is predictable, at least in part. The super-fast money creation scheme fails, asset prices plunge, and defaults rip through the system.
Publicly-reported debt, both state and private, is a huge understatement of the true magnitude of liabilities, which include both the credit assets of the “shadow banking” system and the can’t-be-honoured pension promises which governments have made to the public. NBFI lending is a horror-story of its own, with a sizeable part of this credit channelled to households through BNPL and other non-bank forms of credit.
The truth that mustn’t be told
Indeed, BNPL – ‘buy now, pay later’ – is as good a moniker as any for an economy clinging on to unaffordable lifestyles, and reporting cosmetic (meaning ‘fake’) growth, by ramping up financial promises that cannot possibly be honoured.
The inevitable (though not necessarily imminent) destination of all this self-delusion is a collapse of the financial soufflé. Debts and quasi-debts become unpayable out of material economic flow, and the supposed insurance provided by collateral disappears as asset prices collapse.
All of this, by the way, is happening at the same time as ‘global warming’ is, according to some, turning into ‘global boiling’. The latter term might, or might not, be somewhat hyperbolic, but our environmental and ecological predicament is dire, and we’re now getting the wildfires, heatwaves and floods to prove it. There’s no net positive in any of this – the possibility of successful viticulture in a warming England comes with creeping salination of a large and increasing proportion of rice-producing low-lying lands.
To say that a re-think is in order would be one of the greatest under-statements of all time. I’ve never believed that this site, and others like it, are going to change the climate of opinion. Collectively, people do what suits them, until they are forced by events into responses that we would never choose of our own volition.
Rather, and beyond the value of knowledge for its own sake, the best that we can hope for is that we ourselves can understand what’s happening before others, including decision-makers in the higher echelons of government and business, arrive at the same conclusions.
Those behaviour-changing events are now starting to happen. The promise of ‘infinite economic growth’ is in the process of being exposed as fictional, and this ought to turn us away from the fairy-tale economics which has always assured us of this impossible outcome. The equally fictitious notion that “growth” will enable us to honour our gargantuan debts and quasi-debts is heading into a reality wall.
Two things could happen to government, and both might happen at the same time. The first is that states take sweeping new powers in an attempt to control events that are getting out of hand. The second is a growth of localism as the public loses faith in any supposed ‘solutions’ coming from the centre.
The core problem facing governments is that they’re being called on their unwise promises. The promise of unending growth is being exposed as fallacious, and the promise of an equitable sharing out of this growth is no longer honoured in anything but name. The old agenda has failed, and the powers-that-be have yet to find a new one to put in its place.
Life after soufflé?
We, if not governments, need to remind ourselves that there’s a core of nutritional substance at the heart of even the most inflated culinary confection. Here, in the economy, is what this core comprises.
For starters, the fundamental purpose of the economy is to supply material products and services to society. The physical or “real” economy does this by using energy to convert raw materials into products.
As this happens, a parallel thermal process involves the conversion of energy from dense to diffuse formats. The latter is waste heat and, when fossil fuels are used as the dense energy inputs to the system, this waste-heat contains climate-harming gases.
This energy-material process is driven by a cycle of creation, disposal and replacement – we acquire something, it wears out, and we need to obtain a new one to take its place. Our current economic system accelerates this disposal process, meaning that the material economy is a dissipative-landfill system.
At the same time, the length of the energy-dissipative process determines the size of the productive process. If we switch to lesser-density energy inputs, the dissipative process is truncated, and the material economy is smaller.
The assertion that we can transition from climate-harming oil, natural gas and coal to “green” wind and solar energy without the economy shrinking is based on the assumption that these renewables are, or can be made, as dense as fossil fuels. The only flies in this ointment are the lesser density of renewables, and the inability of technology to over-rule the laws of physics.
The bad news, then, is that financial soufflé is nearing collapse. The good news, if we choose to see it as such, is that the “financial economy” has reached this point because of comparatively gradual, but relentless, contraction in the underlying “real economy” of energy.
This could be “good news” because it might impose upon us environmentally-responsible behavioural changes which we might never get round to making on a voluntary basis.
In the spring of 1940, as the phoney war came to an end, Allied military commanders were wondering quite how they were supposed to stop the German advance into France and the Low Countries. For the more realistic amongst them – those who understood the inability of static defences to halt the new mobility of blitzkrieg – the question became one of where and when, rather than how or if, the Wehrmacht and the Luftwaffe were going to make their decisive breakthrough.
The big question now is which part of the economic and financial Maginot Line is going to fracture first. Will decision-makers reach the inescapable conclusion that phoney growth – our equivalent of the “phoney war” – can’t last much longer? Will the financial system, considered both as over-inflated assets and as liabilities that can’t possibly be honoured, succumb to a sudden attack of vertigo?
Or will businesses, and those who own and run them, be the first to recognise, and respond to, the reality of irreversible economic contraction?
The latter point is considered here. As tends to happen when the ‘old’ economy is in trouble, we – and businesses – are being offered ‘new economy’ alternatives. One proposition sees us “happy” whilst owning nothing. Another, more mainstream version – which is similar, though differently nuanced – sees us consuming rather than buying. Both variants promise greater efficiency in the use of energy and raw materials. Can either, or any, of these ‘new economy’ models live up to their supposed promise?
The big change
If you’ve been visiting this site for any length of time, you’ll know why the inevitability of fracture has arisen. The initial impetus imparted to the economy by the harnessing of fossil fuel energy has been fading out – gradually, but relentlessly – over a protracted period. With no complete replacement source of energy value available, material prosperity has inflected from growth into contraction, a process exacerbated by rises in the costs of energy-intensive necessities.
Far from coming to terms with this, or even recognising the underlying dynamic, we’ve tried to counter the inflexion process by pouring vast quantities of cheap credit, and even cheaper money, into the system. If the material economy can be likened to a beast of burden, we’ve been piling on ever-larger burdens just as the animal itself has been getting weaker.
In the past, the ‘big call’ required of the investment strategist was the one between ‘cyclicals’ and ‘counter-cyclicals’. The latter, which might also be called staples, are those sectors which don’t gain much in a boom, but hang in solidly through a slump. Cyclicals, by contrast, are those activities which prosper in the good times, but suffer disproportionately in the bad.
Historically, if you thought a recession was coming, you’d load up on energy, utilities, pharmaceuticals, food retailers, and anything else which households were still going to need, however bad things got. If, on the other hand, you expected a boom, you’d switch into hospitality, travel, leisure, construction and those discretionary products on which consumers would spend much of their newly-enhanced prosperity.
Now, though, this big call – based upon assumed cyclicality around a positive economic trend – has been changed by the onset of economic inflexion. The postulated alternative to the inflecting economy is some kind of ‘new economy’ of diminished materiality.
Is this feasibility, or fig-leaf?
Essentially, the strategist has to decide whether or not this reinvented economy can work, and then make a choice between sectors and businesses which are, or are not, signed up to the consensus vision of a ‘new economy’. Investors, for the most part, have made their choice – they’ve decided to back ‘new economy’ players, meaning anything ‘tech’, ‘disruptive’, or linked to the new consumer lifestyles promised by the exponents of the ‘new economy’.
Decisions seldom come much bigger than this.
A new “new economy”?
The promise of a ‘new economy’, or even of ‘a new industrial revolution’, is by no means a novel idea, and has a pretty undistinguished track-record. Beyond the ritual attachment of the label “green” to the contemporary versions of such promises, nothing fundamental has changed since then-premier Harold Wilson’s famous reference, back in 1963, to the “white heat of technology” that was, supposedly, going to revolutionise British industry.
There are three distinguishing features of almost all ‘new economy’ promises. The first is that they place excessive faith in the potential of new technologies, and of new offerings to the consumer.
The first shot at a ‘new economy’ paradigm in modern times ended in the dotcom boom and bust. Can the current boom – in anything new, shiny and technological – end differently, defying past precedent?
The second common factor is that these promises tend to be made at times of economic underperformance. When the term “new economy” came to prominence in America in the 1990s, the United States – along with many other countries – was stuck in a low-growth, flat-productivity trap. Wilson’s promise was made in a period of structural decay in British industry.
Today, we know – or at least we sense – that the economy is floundering, and that’s why we’re trying to reinvent it. The American economy is running on the fumes of deficit. China’s real estate chickens have come home to roost.
If no nation can buck this decelerating trend, can technology ‘fix’ it? Technology is all too often tasked with pulling our economic chestnuts out of the fire.
The third and most obvious characteristic of ‘new economy’ promises is their almost invariable failure to deliver. This failure happens for two main reasons. First, technology cannot live up to what we’ve been told to expect of it. Second, nobody looks too closely into how these promised wonders are to be paid for.
The broader context here is the seductiveness of the new and shiny. Back in the 1630s, Dutch investors came to believe that tulips were the new and unstoppable must-have for the affluent classes in Holland. The supposedly new – though in fact valueless – appeal of the South Sea Company in the early eighteenth century was its promised ability to establish a monopoly of British trade in markets wholly controlled by Spain.
The human tendency towards financial gullibility was well explained by Charles McKay in Extraordinary Popular Delusions and the Madness of Crowds, published in 1841. Neither McKay, his successors nor painful experience have ever overcome our fascination with the ability of ‘the new’ to deliver wealth beyond the dreams of avarice.
Now, though, ‘new economy’ thinking goes a long way beyond simple matters of profit. The current version of ‘new economy’ thinking, with its obligatory “green” tag, is based on the same, time-honoured template of technology driving everything from consumer betterment to ever-growing profitability, but it also promises an ability to combine economic growth with responsible stewardship of the environment. It’s a “get out of gaol free” card that will deliver environmental virtue with no need for sacrifice.
This time, moreover, three new factors are in play. First, though in no particular order, we’ve reached the apparent end of a long period of reckless and destructive ‘money printing’. After the banquet comes the banquet of consequences. The banquet has left society more than a little befuddled – so can we believe what we think we see?
Second, and as mentioned earlier, the underlying material economy has been inflecting from growth into contraction.
Third, we are at last – or at least for public consumption – starting to take belated note of environmental degradation. Previously, the concept of harmful climate change resided, almost entirely theoretically, in the prognoses of the experts, which many chose to disregard. Now, though, we have the heatwaves, wildfires and floods to prove the validity of these warnings.
The joys of non-ownership?
A thesis allied to the concept of a ‘new economy’ is the idea that we might “own nothing, and be happy”. The obvious question is that of who will own everything if we – the public – own nothing. Even so, it’s still worth reflecting on how the ‘non-ownership’ economy is supposed to work.
Essentially, the thinking is that there’s no point in owning, say, a lawnmower, if we’re going to use it only a handful of times each year, and it spends the vast majority of its time shut away in a shed. The proposed alternative is that we simply hire a lawnmower on those few occasions when we actually need one. Likewise, why go to the expense and inconvenience of owning a car which we’re going to use for, at the very most, two or three hours in every twenty-four? Wouldn’t most of us be better off hiring a car, or calling a taxi, when we need to go somewhere?
The superficial appeal of this notion is that increased utilization rates might imply that society would need fewer lawnmowers, and fewer cars, and less of anything else that is only used intermittently. If this were true, it would mean that we could dematerialize the economy, by having the same number of completed journeys – and neatly trimmed lawns – whilst using a lesser quantity of material-intensive equipment. The consumer, meanwhile, would be better off by paying for these things only when he or she actually needs them.
There are at least two obvious snags with this superficially-persuasive notion. The first is that a car – or a lawnmower – used in this intensive way would wear out, and require replacement, far more quickly than one which spends most of its time on a driveway or in a shed.
The second is that this far greater rate of depreciation would have to be amortised into rental charges, whilst the insertion of a lending intermediary would eliminate all, and more, of any supposed gains that the consumer might enjoy from this ‘only when needed’ model.
In short, we can only “own nothing” and “be happy” if happiness means paying more for less.
Variation on a theme
The ‘new economy’ variant on this theme also points towards dematerialisation. If we switched to e-books from the traditional “tree-ware” version, we’d use less pulp and paper. Streaming or downloading music or movies would require fewer material inputs than owning CDs, DVDs and the equipment needed to enjoy them. We wouldn’t need to visit a sports stadium to watch a football match, or travel to a cinema to take in the latest Hollywood blockbuster, because we could watch them in the comfort of our homes. More broadly, the consumer of the future will spend less on products, and more on “experiences”, than he or she does today.
This model has already made significant inroads into traditional business practice, most notably with on-line shopping displacing traditional (“bricks-and-mortar”) retailing. What is euphemistically called the “sharing” economy has progressed in everything from bicycles and cars to garden-use and accommodation. Already, comparatively few motorists actually “buy” a car, in the sense of handing over the purchase price in full, and taking unencumbered ownership of the vehicle. Hire-purchasing – through leasing products – has become the new normal for access to a private car.
Dating has shifted from meeting potential partners in pubs or clubs to an on-line model. We can even do a virtual tour of the house we’re thinking of buying – or renting – without the hassle of actually having to go there. We can’t – yet – provide a virtual reality-equivalent experience for physically travelling from Birmingham to Barbados, but something along these lines might, eventually, become feasible.
In short, what the ‘non-ownership’ and the ‘new economy’ models have in common is a promise of de-materialization, which is the ultimate economic selling-point of systems where we no longer need to own anything, from a DVD player to a lawnmower, but pay for films, music and domestic appliances only when required.
In macroeconomic terms, this looks like an alchemist’s stone, turning the base metal of material-intensive ownership into the gold of a bigger economy that uses less raw materials and, critically, less energy.
Where this fails
As we’ve seen, the basic snag with the ‘own nothing’ model is the accelerated deterioration (and the consequently higher amortization rates) of “shared” equipment. This problem also includes the energy consumed in taking our humble lawnmower from customer A to customer B, as well as taking it back to a depot if this is required, either logistically or for maintenance.
In short, and with little or no net material gain likely to be realised, the actual appeal of the non-ownership model is to those who will own those things that the consumer no longer owns.
The problems with the ‘new economy’ model, on the other hand, are more nuanced, but the first critique is that the model is tilted emphatically towards the discretionary. We might replace our books, CDs and DVDs with their virtual or streamed equivalents, but none of these products is a necessity. On-line grocery purchasing offers tangible advantages, accounting for its rapid growth in popularity, though the energy requirements of the storage and distribution system need to be deducted from any energy reduction achieved through fewer customer journeys to supermarkets.
There is, then, a net energy balance to be calculated in respect of any proposed ‘non-ownership’ or ‘new economy’ economic system. Technology is more energy-intensive than is widely recognised, and older patterns of consumption aren’t quite as energy-intensive as we’re invited to assume – after all, the music-lover doesn’t buy a new CD player every time he adds a disc to his collection, nor buy a new CD to listen again to the same set of tracks.
Accordingly, and if the energy balance is far from decisive, what we need to know is where the discretionary affordability of the consumer is heading.
If he or she is going to enjoy a rate of growth in prosperity which exceeds any increase in the real costs of necessities, then the latest version of the ‘new economy’ might just succeed, where most of its predecessors have failed. If this were an accurate prognosis, people would indeed be leasing, streaming and subscribing, as well as travelling and ‘experiencing’, like never before.
If, though, the costs of essentials are going to out-grow contracting prosperity, people won’t have to choose between CDs or streamed music, or subscription sports-watching and going to the stadium. Rather, they’ll have to choose between music and sports, on the one hand, and necessities (like food and warmth), on the other.
We have the ability, which we may consider valuable, to order food – groceries or prepared meals – on-line, rather than travelling to a supermarket or a restaurant. But we are never going to be able to use technology to supply an immaterial, virtual equivalent of a hamburger.
Put another way, if the exponents of new economic thinking are right to believe that consumer prosperity in general, and discretionary prosperity in particular, are going to grow in the future, then the associated business model might work.
If, though, prior growth in material prosperity has gone into reverse, and the real costs of essentials are going to carry on rising, then any such model, predicated on mistakenly-positive assumptions about consumer-discretionary prosperity, isn’t going to be transformative after all.
If this is the case – and, as we already know, it is – then businesses need a major rethink about what might work for the enterprises of the future.
The search for the fabled “elixir of life” goes back at least as far as the second millennium BC. Right now, though, many would settle for the elixir of alternative.
For investors, that would be somewhere safe to park their money when the “everything bubble” in asset prices bursts, as, of course, it will. For many more, the “elixir of alternative” would be the discovery of replacements for the tired, self-serving, failed incumbency systems that have been making the wrong decisions on our behalf for a very long period of time.
These issues are, of course, connected – a financial crash will have profound effects on the distribution and nature of wealth and power.
Whatever else might be said about them, the markets have turned into sources of harmless entertainment for non-participants of all ages. No fad seems to be too wild for hapless investors to pour money into it. Numerous over-hyped stocks have collapsed from absurdly inflated prices. Manias for cryptos, NFTs and – most recently – ‘anything AI’ are symptoms of investors’ quest for the ‘elixir of alternative’.
It’s one thing to make a case for selling stocks and real estate, but quite another to find something else to buy instead. What sector, or stock, or alternative asset class, can offer protection against the crunch that we know is coming, and what investment can be “as safe as houses” when all the conditions for a property price crash are in place?
The prices of traditional but ‘unsexy’ safe haven assets – such as gold – may yet turn out to be the best available lead-indicator for the onset of the market vertigo which precedes all-out panic.
Many investors probably sense the essential fragility of stock and property markets driven to unsustainable levels by the “everything bubble”. Some may think that, when the bubble bursts – as all bubbles do – they’ll be ‘made good’ by the authorities, which is pretty much what happened – at the price of enormous moral hazard – during the GFC of 2008-09.
Still others may recognize the mathematical impossibility of governments and central banks handing back all of their money to those who have thrown it away in reckless gambles. The ‘create [“print”] money’ fix used during the GFC is the kind of “get out of gaol free” card that can only be played once. It’s been said that “death is there to keep us honest” – in economics, that role is fulfilled by inflation, which is the inescapable nemesis for anyone tempted into the debasement of money.
The fable of the conventional
The “elixir of life” isn’t the only fable crafted for our comfort. Another is orthodox economics, with its central proposition that the economy can be understood in terms of money alone. If there was indeed ‘a financial fix for everything’, we could ask the banking system to lend low-cost, environmentally-friendly energy into existence, and command central banks to conjure it out of the ether. If all else failed, we could overcome our climatic and ecological problems by clubbing together to send money to the environment.
In other words, the material matters. Infinite economic growth on a finite planet isn’t possible. Two centuries of abundant (but now fast-depleting) fossil fuel prosperity haven’t changed that.
If you’ve been visiting this site for any length of time, you’ll know that the “financial” economy is an operating system for the “real” or material economy of products and services.
We ignore the material at our peril, and should not conflate the “laws” of economics with the real scientific laws of physics. The so-called “laws” of economics are really nothing more than behavioural observations about the human artefact of money. We must, as a matter of necessity, be selective and sceptical in our use of the tenets of the economic orthodoxy.
Where the economy is concerned, the applicable laws are those of thermodynamics. Energy cannot be created or destroyed, but it can be transformed from a dense to a diffuse state.
That’s how the material economy works. We use energy to convert raw materials into products, a process which is paralleled by diffusion of energy from dense forms into waste heat, the latter containing climate-harming gases when the dense input is sourced from carbon fuels. Given that most products are destined for rapid disposal, the material economy is thus a dissipative-landfill system.
We can speculate, of course, about our ability, or otherwise, to replace energy-dense oil, natural gas and coal with renewable energy alternatives of lesser density. The dynamic of deteriorating energy density has been called “energy sprawl”, where the energy-delivering infrastructure becomes ever larger in proportion to the economy itself. In short, we may need to put more material resources into wind turbines, solar panels, grids and storage systems than are presently invested in wells, refineries, pipelines and filling stations.
On the money
Our interest here, though, is in money. This being so, we need to be clear about what money actually is. As you may know, money has no intrinsic worth, but commands value only in terms of the material products and services for which it can be exchanged. This is why no amount of currency – or of any kind of money – would be of any use at all to a person adrift in a lifeboat, or stranded on a desert island. Money detached from the possibility of exchange is worthless. The resulting SEE nomenclature is that of money as claim.
Within this claim conception, we have wriggle-room in the distinction between the flow of monetary claims exercised in the present and the stock of these claims set aside for later. ‘Later’ is the operative term here – the primary reason for investment is that spending relinquished now will be exceeded by the value to be received later. There’d be no point in going without that new $1000 gadget now if setting that money aside would yield only $900 at some future date.
At the macro level, appreciation over time can only work if two predicates are honoured – the economy must carry on expanding, and money mustn’t lose its value through the devaluation of inflation.
Neither of those predicates still holds. Over a long period, most reported “growth” in the global economy has been cosmetic, a function of super-rapid credit expansion. With everything stated at constant 2022 values for convenience, world real GDP increased by $83tn PPP between 2002 and 2022. Unfortunately, global debt expanded by $266tn over that same period.
Most of the “growth” of modern times has thus been a sleight-of-hand trick based on credit expansion. The giveaway here is that GDP doesn’t measure economic output, but the very different concept of the transactional use of money. Moreover, formal debt increasingly understates the true scale of liabilities, as it excludes the NBFI (“shadow banking”) component, and the ever-rising “gaps” in the adequacy of pension provision.
Inflation, meanwhile, has routinely been understated over a long period, most obviously through the convention which states that asset price escalation ‘doesn’t count’ as inflation. If we calibrate material economic prosperity, and compare it with transactional activity measured as GDP, we can calculate that systemic inflation, known here as RRCI, has long been substantially higher than the official GDP deflator measure.
Why not obvious?
If you’re new to Surplus Energy Economics, much of the foregoing may seem self-evident. There’s nothing terribly controversial about a material economy of energy-created products and services sitting alongside a parallel financial economy of money and credit understood as claims. Given that prices are financial values ascribed to material products, prices and inflation must, of necessity, be functions of the relationship between these “two economies”.
If this much is obvious, why haven’t decisions been made on this basis? The straight answer is that the real and the palatable aren’t necessarily the same thing.
Moreover, we no longer have an intellectual framework for government. Collectivism, in its purist Marxist-Leninist form, disappeared with the fall of the Soviet Union.
Its traditional antithesis, market capitalism, has since been abandoned as inconvenient – markets are no longer allowed to set prices, and put a price on risk, without undue interference, and it’s been a long time since the owners of capital have been able to earn a solid real (ex-inflation) return on their investments.
Back in 2008-09, we didn’t like what market forces were about to do, so we put them on hold.
Without a rationale of government, the conduct of economic affairs has degenerated into a condition of ‘make-it-up-as-we-go-along’, ‘grab-what-we-can’ opportunism. The ‘powers that be’ adopted ultra-loose credit supply policies (“credit adventurism”) from the 1990s, hoping that this would cure “secular stagnation”. When, as of 2008, its failure had led us into systemic crisis, the resort to “monetary adventurism” was made without any consideration of what this might mean for inequalities of wealth and income.
The realities now are that economic trends – ludicrous asset valuations, debts and quasi-debts at stratospheric levels, the deceleration (and unfolding inflexion) of the energy-powered material economy, and rises in the real costs of energy-intensive necessities – are pointing straight towards a combination of financial crash and worsening social dysfunction. This is more “Versailles-on-Thames” than “Camelot on the Potomac”.
Meanwhile, the search for the elixir of alternative goes on.
There’s a plausible case to be made that we’re living in a “post-truth” age, and have been doing so since well before that term was “word of the year” for 2016 in the Oxford English Dictionary.
This is certainly true of the economy. The consensus narrative – propounded by decision-makers in government and business, supported by the economic orthodoxy, seldom questioned by the mainstream media and seemingly accepted by a majority of the general public – is that we can rely on an infinite continuity of economic growth.
Today’s economic problems, we are told, stem from the simple bad luck of a pandemic and a war in Eastern Europe. There is, then, no connection to a quarter-century of economic deceleration which we have tried to counter with ever more reckless financial policies.
It’s important to note that, whilst increasing numbers of people question the fairness, and indeed the honesty, with which the proceeds of growth are distributed, few seem to doubt the supposed underlying reality of economic growth itself.
This ‘consensus narrative’ is based on four propositions, each of which is false. The first of these ‘props’ is the assurance of the economic orthodoxy that sustained (as opposed to temporary) economic contraction not only isn’t happening, but can’t happen. The second prop, backing up the first, is the assertion that, aside from temporary interruptions, we’ve been experiencing near-continuous growth for as long as anyone can remember, and are still enjoying this same growth today.
The third prop is that renewable energy will carry on getting cheaper almost indefinitely, enabling us to transition away from climate-harming fossil fuels without any impairment to economic prosperity. Much of this assurance rests on the fourth prop, which is unbounded faith in the limitless potential of technology.
Kicking out the props, #1 – orthodox economics and ‘infinite expansion’
It is, as regular visitors to this site will know, far from difficult to demolish all four of these props. Let’s start with the economic orthodoxy, which, on the false premise that control of money gives us control of the economy, dismisses the very concept of material limits, and promises infinite economic expansion. This is a proposition with which only “an economist or a madman” would concur.
For what it’s worth – which isn’t very much – conventional economics insists that the economy can be explained in terms of money alone, a presumption which over-rates the capabilities of money almost as much as it under-rates the importance of the material. Any shortage, it asserts, can be overcome by higher prices, which incentivise suppliers to increase their deliveries to the market. Higher prices encourage substitution – expensive coffee might prompt consumers to buy tea instead – and act as a spur to technological innovation.
At the macroeconomic level, all of this, of course, is nonsense. No rise in prices can deliver something that does not exist in nature. The banking system can’t lend low-cost energy into existence, and neither can central bankers conjure it, ex nihilo, out of the ether. If money had unlimited powers, we could ‘fix’ climatic and ecological problems by sending money to the environment.
Rather like the cynic as defined by Oscar Wilde, orthodox economics assumes that price and value are the same thing. If one industry generates sales of $1bn, whilst another achieves only $500m, the former is twice as important as the latter. On this basis, agriculture – accounting for “only” 6.7% of the global economy – isn’t very important at all, and its complete loss could be offset, statistically, by a modest increase in the supply of services.
As regular readers will know, any reliance on an entirely monetary explanation of the economy is completely fallacious. There is a conceptual necessity, known here as the “two economies”, the purpose of which is to connect the monetary with the material. One of these two economies is the “real economy” of physical products and services, and the other is the parallel “financial economy” of money and credit.
The material economy is determined by energy, because nothing that has any economic value at all can be supplied without it.
Money, meanwhile, has no intrinsic worth, but commands value only as an exercisable ‘claim’ on the products and services made available by the material economy of energy. This why no amount of money – be it fiat currency, precious metals, crypto or, for that matter, cowrie shells – would be of any use at all to someone cast adrift in a lifeboat, or stranded on a desert island.
Kicking out the props, #2 – credit and the fabrication of “growth”
The claim that we have been enjoying continuous (and largely consistent) economic growth over an extended period amounts to sleight-of-hand.
To be sure, reported global real GDP slightly more than doubled between 2002 ($81 trillion PPP, at constant 2022 values) and 2022 ($164tn). This “growth” (of $83tn), though, was far exceeded by a $266tn real-terms increase in debt between those same years. Put another way, $3.20 was borrowed for each $1 of reported “growth”. Even these numbers exclude rapid expansion in other financial commitments, and in the “gaps” in the adequacy of pension provision.
We need to be quite clear that GDP doesn’t measure economic output, but is simply an aggregation of financial transactions, which is a very different concept. It is perfectly possible, indeed commonplace, for transactions to take place with no economic value being added.
At the same time, financialization – the monetization of activities hitherto undertaken without charge, and hence outside the ‘production boundary’ – has proceeded relentlessly.
The expansion in credit creates an increase in transactions in a way that artificially inflates reported GDP. If we back out this credit effect, we can calculate underlying or ‘clean’ economic output, known in SEEDS terminology as C-GDP. Globally, this increased by only 36%, rather than 103%, between 2002 and 2022. Within reported “growth” of $83tn between those years, fully $56tn, or 67% of the total, was a purely cosmetic effect of credit expansion.
This trajectory is, of necessity, unsustainable. As the stock of credit is continuously ratcheted up to boost the supposed flow of transactional activity, a point is reached at which it becomes apparent that debts cannot ever be honoured for value.
Kicking out the props, #3 – ever-cheaper energy
Earlier this month, it emerged that there had been no bidders at allin Britain’s latest round of licensing for offshore wind-power projects. The reason for this was that the contract prices on offer had not been increased from the previous licensing round by a government wedded to the notion that the costs of renewables can only ever decline.
A more competent government would have seen this coming. In July, energy company Vattenfall called a halt to the Norfolk Boreas wind-farm project, and wrote off the SEK 5.5bn (£415m) invested in it. This resulted from a 40% increase in costs over the year since the licence was awarded, which rendered the project non-viable. The primary driver of this dramatic increase in costs was the rising price of natural gas, which made manufacturing and procurement more expensive. This effect was compounded by higher costs of capital.
Both of these factors are instructive. Renewables expansion makes huge demands on energy and raw materials for manufacturing, and we have reached the end of a long period in which the prices of fossil fuels have been low. That same period was characterised by unsustainably depressed interest rates. These conditions, which have boosted the development of renewables, cannot be expected to return.
The likelihood of cost increases might well have informed the thinking that resulted in the huge renewable energy subsidies contained in the Biden administration’s oddly-named Inflation Reduction Act. This largesse is likely to attract to America investment that might otherwise have gone elsewhere, but there may also be an implicit recognition that the expansion of renewables is likely to require subsidy.
Comparing this with what has happened in Britain is interesting. As costs rise, either the taxpayer or the consumer must pay more. If, as in the UK, neither is required to do so, development doesn’t happen.
The reasons why the costs of renewables must rise have long been obvious. Transition to renewables is going to be hugely expensive, and the price-tag of USD 115 trillion put on this process might now require substantial upwards revision.
The point about such costings is that they represent vast quantities of everything from steel and concrete to copper, cobalt, lithium and a host of other required raw material inputs. Creating (“printing”) the money to pay for this would do no more than trigger rapid inflation in the prices of all of these necessary inputs.
Accessing these materials, and processing them into everything from wind turbines and solar panels to supply grids and storage systems, requires a correspondingly enormous amount of energy, which can only come from the legacy source of fossil fuels.
No decision has yet been made – or is even likely to be made – about which other uses of fossil fuel energy are going to be scaled-back or relinquished to free up this energy for transition. If we need energy to extract and process, say, large amounts of copper, are we going to drive less, or fly less, to make this possible? Or, put another way, what other uses of copper are going to be cut back to make copper available for transition?
Kicking out the props, #4 – the magic of technology
The standard answer to legitimate questions about the resource costs of energy transition is that these will be reduced, pretty much ad infinitum, by technological progress. This shows a remarkably inaccurate perception of technological possibility where real-world, material factors are involved.
There can be no quantum leap in the efficiency of wind and solar energy. The maximum potential efficiency of wind power is determined by Betz’ Law, with the Shockley-Quiesser Limit doing the same for solar. In both cases, current best practice is already close to these theoretical limits.
If efficiency gains are constrained, the only way to expand the supply of renewable power is the scaling up of the industry, which brings in the vast need for both raw materials and energy mentioned above. It’s one thing to increase the data capacity of a chip, or to bombard the public with yet more advertising, but quite another to overturn efficiency limits determined by the laws of physics.
Ultimately, the economy needs to be understood in the material terms of a two-part process. On the one hand, energy is used to access raw materials and convert them into products. On the other, this activity converts energy from a dense to a diffuse format. Because the vast majority of the products thus created are destined for disposal, this can be termed the dissipative-landfill economic model.
These linked processes are inseparable, so we cannot have the production process without the parallel process of thermal dissipation. If we replace the energy inputs used now with lower-density alternatives, the effect is to truncate the productive-dissipative process, which means less output and a smaller economy. Renewables are less dense than oil, gas and coal, meaning that an economy based on wind and solar power, though feasible, will be smaller than an economy powered by high-density fossil fuels.
Suspension of disbelief
Most of the foregoing is surely self-evident and is, it should be stressed, non-partisan.
Accordingly, one of the interesting questions about the tenacity of the “post-reality” narrative of infinite economic growth is that of why so many people believe it. After all, the very idea of infinite economic expansion on a finite planet is illogical. This can’t be entirely a matter of propaganda, because comparatively few people take on trust much of what they’re told by the authorities.
The explanation for mass acquiescence in the implausible seems to reside in a phenomenon known to novelists as “the willing suspension of disbelief”.
The accomplished writer of fiction achieves this suspension of disbelief in his or her readers, who accept the improbable as part of their engagement with the author. For example, generations of crime novel afficionados have swallowed plots in which murders are solved by little old ladies, eccentric peers and university dons – there was even a blind detective, Ernest Bramah’s Max Carrados – despite knowing all along that, in reality, crimes are solved, not by eccentric members of the public, but by police officers.
Of course, this suspension of disbelief is temporary. If a reader’s enjoyment of a Golden Age crime novel was rudely interrupted by the advent of a real burglar, he or she wouldn’t try to contact a blind detective or an eccentric old lady, but would call the police.
As well as being temporary, this suspension of disbelief is willing. The reader allows his or her awareness of reality to be over-ruled in order to enjoy a work of fiction, and doesn’t apply the same critical eye with which he or she would – or at least should – view a story purporting to be ‘true’.
This suspension of disbelief shouldn’t happen in real world affairs, but it routinely does so, certainly where economics is concerned. The fact of the matter is that most people want to believe in the possibility of infinite economic growth. Being open-minded about the alternative is simply far too uncomfortable.
We need to be clear that this “willing suspension of disbelief” applies, not just to the general public, but to decision-makers and ‘the elites’ as well. If this were not so, then, at the moment at which the wealthiest and most influential investors became aware of the inevitability of economic inflexion, the markets would have collapsed. Being wealthy or influential doesn’t eliminate – indeed, it may strengthen – the desire to believe what one wants to believe.
The inevitability of real
“Post-real” economics is, of necessity, a time-limited phenomenon. Eventually, in a direct analogy to Hans Christian Andersen’s tale about The Emperor’s New Clothes, reality will rudely interrupt the comforting fiction of infinite growth on a finite planet. A point must come at which the excuses run out, and the reality of a contracting economy becomes undeniable.
We cannot know when this moment of shocked recognition will happen – we only know that it will.
Analysis of the material and the financial economies points in two directions. At the material level, managed contraction is feasible, at least in theory. The trends which are driving prosperity downwards – and which, through rises in the real costs of energy-intensive necessities, are simultaneously undermining the affordability of discretionary (non-essential) products and services – are developing in ways which, though relentless, are comparatively gradual.
The financial system, on the other hand, is incapable of gradual contraction, because it is entirely predicated on the presumption of growth in perpetuity. The moment at which we realise that infinite growth is mythical is the same moment at which we recognise that our gargantuan financial commitments can never be honoured.
We can only hope that this moment – one at which defaults cascade through the system, and asset prices crash – won’t occur until we’ve arrived at two decisions. One of these is a political and social arrangement which can manage economic contraction. The other is the development of a financial system which does not depend for its viability on the myth of infinite economic growth.
At the top-down level, collectivism failed in the Soviet Union, whilst market capitalism has been suspended because its essential predicates – real returns on capital, and unfettered price discovery by the markets – no longer apply. Those who propose replacing the top-down with the bottom-up may have a valid case.
All that the individual can really do is to develop an understanding, informed by material realities and backed up by statistical analysis, of why and how “post-truth” economics is destined to succumb to reality.
In the previous article, I said that I intended to mark the tenth anniversary of the Surplus Energy Economics project by setting out a summary of what I think we now know about the functioning of the economy, understood as an energy system. I have chosen to call this “Known knowns”, not in the sense that everyone does understand the economy stated in these terms, but because everyone can so understand it if they choose, which is a rather different proposition.
The narrative here commences with three principles. These are the energy basis of the economy, the critical role played by the proportionate cost of energy, and the character of money as a “claim” on material products and services.
This leads to some equally obvious inferences. One of these is the conceptual necessity of “two economies”, which are the “real economy” of material products and services and the parallel “financial economy” of money and credit. Another is that the general level of pricing is a function of the relationship between these “two economies”.
Our situation now is that the enormous impetus given to the economy by the application of coal, petroleum and natural gas is fading out – stated simplistically, we’ve worked our way through lowest-cost fossil fuel resources and are now having to resort to increasingly costlier alternatives.
This trend has been apparent for at least a quarter of a century. For much of that time, we tried to sidestep this reality on the fallacious idea that monetary innovation could drive material expansion. When the first such exercise – termed here “credit adventurism” – detonated in 2008-09, our recourse was to “monetary adventurism”. This hasn’t, of course, changed the trend of energy deterioration, but it has had several, very adverse consequences.
First, it has created enormous risk in the financial economy, which has racked up forward commitments that a deteriorating real economy cannot possibly honour ‘for value’. Simultaneously, it has created an “everything bubble” in asset prices, a bubble which, other than in its comprehensiveness and sheer scale, is no different from the bubbles of the past, and will end in the same way.
A third adverse effect of monetary recklessness has been the abandonment of the principles of market capitalism. This system requires that markets, though regulated, should be allowed to price risk. It also requires that investors earn a real (above inflation) return on their capital.
This repudiation of capitalist principles is regrettable, because a properly-functioning market sector is crucial to the operation of a mixed economy, in which the respective strengths of private enterprise and state provision are harnessed to the benefit of the public.
Those who remain in denial over the reality of economic contraction are now scraping the barrel of explanation. This site excludes discussion of conspiracy theories around the pandemic and the war in Eastern Europe, but neither can possibly explain away a structural deceleration visible over a period traceable back to the 1990s, and perhaps even further.
Likewise, and although there is a compelling economic (as well as an environmental) case for expanding the use of renewable sources of energy, these lesser-density energy inputs cannot act as a complete replacement for fossil fuels. The wholly commendable pursuit of sustainability is being parlayed as “sustainable growth”, something which would only be possible if technological ingenuity could repeal the laws of physics.
The reader can interpolate for himself or herself how this scenario unfolds in its broader dimensions. I have yet to decide what to do after reaching the conclusions set out here, but I am enormously grateful to everyone who has furthered our knowledge through constructive, informed, objective and, above all, civilized participation in our debates here at Surplus Energy Economics.
PART ONE – THEORY
1.1. The foundations of rational interpretation
There are, in essence, two ways in which we can try to make sense of the economy. One of these – the orthodox approach, still generally accepted by decision-makers and the consensus – portrays the economy as entirely a monetary system.
Because money is an artefact over which we have complete control, this orthodoxy denies that there need ever be any limit to economic growth. The supposition is that any shortages can be overcome through the pricing mechanism, whereby price rises either incentivise new supply, promote substitution, or encourage the development of alternatives. The consequence is that we can circumvent any and all material constraints to economic expansion. We are thus assured of economic growth in perpetuity, and can use monetary tools to ‘fix’ any material economic problem.
This orthodox interpretation does not survive contact with reality. No rise in price can produce the supply of something which does not exist in nature. The banking system cannot lend low-cost energy (or any other resource) into existence, and neither can central banks create them, ex nihilo, out of the ether. As Kenneth E. Boulding famously put it, nobody but “a madman or an economist” would believe in the possibility of infinite, exponential economic growth on a finite planet.
The alternative interpretation recognises the existence of material limits, a concept which extends from finite energy and other natural resources to finite environmental tolerance of economic activities.
1.2. Starting with principle
When we apply this concept, three principles, each of which is surely undeniable, quickly emerge.
The first of these principles is that the economy is an energy system, because literally nothing that has any economic utility at all can be created without the use of energy.
The second principle is that energy is never ‘free’. Oil, gas or coal aren’t ‘free’ because they exist beneath a nation’s territory – they cannot be put to use without an infrastructure including wells, refineries, pipelines and mines. Likewise, renewable energy isn’t ‘free’ because the wind blows and the sun shines – this energy can only be harnessed by constructing wind turbines, solar panels, distribution grids and storage systems.
All of these necessary components require raw materials, and no part of this infrastructure can be provided without the use of energy. Energy is needed, not just to access minerals and other raw materials, but to process them, and use them for the construction of everything from a refinery to a wind turbine. In short, the application of energy is an ‘in-out’ process, in which we ‘use’ energy to ‘get’ energy. This is only worthwhile when what we get exceeds what we use.
What this necessarily means is that, whenever energy is accessed for our use, some of this energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy, giving us the principle of ECoE.
The last of our three principles is that of money as claim. Money has no intrinsic worth, but commands value only in terms of those material things for which it can be exchanged. This is why no amount of money – be it fiat currency, precious metals, cryptocurrencies or, for that matter, cowrie shells – would be of the slightest use to a person stranded on a desert island.
This definition of money, as “a human artefact, validated by exchange”, applies, not just to currencies, but to any form of money. We can, of course, create as much money as we choose, but we cannot similarly create the material products and services without which money has no value.
1.3. Logical inferences
From these surely indisputable principles, certain observations necessarily follow. One of these is the concept of “two economies” – a “real economy” of material products and services, and a parallel “financial economy” of money and credit. This is the only basis on which we can make sense of the economy.
This concept in turn dictates a tendency towards equilibrium. Since the material economy alone can validate money – that is to say, monetary claims can only be honoured by a matching sufficiency of material products and services – it is apparent that the material economy and its monetary proxy must tend towards alignment.
If we create monetary claims that cannot be honoured by the material economy of today or tomorrow, these “excess claims” must, by definition, be destroyed. To the extent that these claims are regarded as ‘value’ by their owners, this tendency towards equilibrium can be described as ‘value destruction’.
The creation of excess claims results in the formation of bubbles. John Stuart Mill famously said that the bursting of a bubble does not, of itself, destroy value, but, rather, exposes the preceding period of malinvestment during which the bubble was formed.
Within the ‘two economies’ conception, we can define this process as a period in which excess claims have been created. Today’s “everything bubble” in asset prices is a case in point. This bubble has been created by the excessive expansion of the monetary economy in relation to its material counterpart.
The elimination of excess claims can happen in one or both of two ways. The first of these is repudiation, where a debtor’s limited resources compel failure to meet the entitlements of the creditor. The second is inflationary degradation, whereby the creditor is repaid, but in money that has less value than it had at the time when the obligation was created.
The latter is termed “soft” default, to distinguish it from the “hard” default of repudiation, but the effect on the creditor is, functionally, the same – he or she does not receive the full value to which they are entitled.
The concepts of inflation (or deflation) – meaning rises or falls in prices – require us to define prices, a definition which our concept of “two economies” provides. Properly understood, a price is “the financial value attached to a material product or service”.
What this means is that prices are the interface between the material and the monetary economies. The general level of prices reflects the relationship between the “real” and the “financial economies”, whilst changes in pricing are functions of changes in this relationship.
This makes possible the measurement of price mechanisms through the independent calibration of the “real” and the “financial” economies. The SEEDS economic model calculates systemic inflation, thus defined, as RRCI, meaning the Realised Rate of Comprehensive Inflation.
Two further observations complete our overview of central economic processes.
First, money can be used now, as flow, or put aside for later, as stock. There is no difference of concept in the continuum of flow and stock – both are claims, validated only by exchange, and a saver can change his or her mind, spending in the present money previously set aside for the future – but this introduces into the “financial economy” a temporal (over time) characteristic largely absent from the “real economy”.
We can create monetary claims whose exercise may be set to occur decades in the future, and we can also extend these claims by recycling them (paying off a short-duration financial claim by replacing it with a longer-dated alternative). We can, of course, stockpile energy or material products, but only for comparatively short periods – stocks of fossil fuels are measured in months, and those of electricity in minutes, whilst there is little rationale for businesses to incur the carrying costs of stockpiling products for sale years into the future.
We cannot, then, underpin the stock of monetary claims by setting aside a corresponding stock of material products or services. The “real” and the “financial” economies, though ultimately tending to equilibrium, operate on differing time-scales.
Second, the process of product creation has two, interlinked equations. One of these is that energy is used to access raw materials and convert them into products. The accompanying, inescapable corollary is thermal, involving the conversion of energy from dense into diffuse forms. Because most products are destined, usually quickly, for disposal, we can describe this as dissipative-landfill system.
We can observe that the dissipative-landfill economic model isn’t enshrined in Holy Writ, and was largely absent before we harnessed fossil fuel energy to create the industrial economy. The dissipative-landfill system, and its consumerism corollary, are choices, made possible by the availability of abundant dense energy. In no sense is the continuity of these processes guaranteed.
Critically, the scale of the production process is determined by the density of the initial energy input. If a dense source of energy is replaced with a less dense alternative, the truncation of the thermal process necessarily truncates the parallel productive process – in short, if the density of energy inputs is reduced, the resulting economy is smaller.
Before we move on to application, we need to note some definitional implications which follow from the above. Whilst economic output is a function of the quantum of energy use, and the efficiency with which this energy is converted into material products and services, prosperity is a function of the energy cost (ECoE) needing to be deducted from this output.
What this means is that, whilst output correlates with the aggregate use of energy, prosperity is a function of the surplus (ex-ECoE) energy available to the economy.
PART TWO – APPLICATION
2.1. Measuring the “two economies”
It follows from the foregoing that effective calibration of the economy requires that we make calculations for the “real economy” that can be set alongside those for the “financial economy”. A suitable point of commencement for this process is the measurement of economic output, which we can then compare with the use of energy, and employ as the basis for calculating prosperity.
Unsurprisingly, we can expect little help from orthodox economics, and GDP is a case in point. Though often taken to be a measure of economic output, gross domestic product is, in reality. no such thing. Rather, it is an aggregation of financial transactions, which is a very different concept, and it is perfectly possible, indeed commonplace, for money to change hands without economic value being added.
As can be seen in Fig. 1A, reported global real GDP doubled, growing by 103%, or $83 trillion, between 2002 and 2022. Over the same period, though, real-terms debt trebled, expanding by 209%, or $266tn, meaning that each dollar of reported “growth” was accompanied by $3.20 of net new debt.
Given the flow-stock continuum, we certainly cannot disregard credit expansion – that is to say, we cannot acquiesce in the bizarre view that debt somehow ‘doesn’t really matter’ – and neither can the trajectories illustrated in Fig. 1A be regarded as in any way sustainable.
What has really been happening, over a very extended period, is that credit has been poured into the system, and the spending of this money has been counted as ‘activity’ for the purposes of measuring GDP.
Another way to look at the relationship between borrowing and growth is illustrated in Fig. 1B. Between 2002 and 2022, when annual GDP growth averaged 3.5%, borrowing averaged 11.1% of GDP. Regional analyses confirm this equation. Between 2002 and 2022, average growth in China (7.4%) was far higher than in the United States (2.0%), reflecting the fact that China borrowed at an average rate of 31% of GDP, compared with just 8.3% in America.
What this means is that, where GDP is concerned, growth can be pretty much whatever we want it to be, limited only by the willingness and ability to borrow.
When we strip out this ‘credit effect’, a very different rate of growth emerges, averaging 1.5% (rather than 3.5%) over the past twenty years (Fig. 1C). The resulting series is known here as underlying or ‘clean’ economic output, annotated C-GDP in SEEDS terminology.
The difference between 1.5% and 3.5%, compounded over twenty years, is enormous. As illustrated in Fig. 1D, aggregate growth in C-GDP was only 36%, or $27tn, between 2002 and 2022, far lower than the reported expansion of $83tn. In effect, less than one-third of the “growth” reported over that period was organic, and the remaining 67% was no more than the cosmetic, statistical effect of pouring ever-larger amounts of credit into the system.
Fig. 1
2.2. The energy connection
The level of C-GDP, and the extent of its departure from reported GDP, depends upon the date at which the calculation of underlying growth commences. Because the necessary data becomes increasingly patchy as we scroll back through the 1990s and beyond, standard practice is for the SEEDS calculation of C-GDP to begin in 2000. This provides more than enough comparative data for most analytical purposes.
In a recent exercise, though, the clock on global C-GDP was started, not in 2000, but in 1980. This earlier series, annotated ‘C-GDP base-1980’, is illustrated alongside the ‘base 2000’ version, and reported GDP, in Fig. 2A. Because it begins earlier, the base-1980 run commences from a lower starting value than the base-2000 equivalent.
What’s really interesting about this long-term calibration is the closeness of the relationship, shown in Fig. 2B, between C-GDP, stated financially, and the consumption of energy, stated in billions of tonnes of oil equivalent (bn toe). Remarkably, over a 43-year period containing many economic and energy supply vicissitudes, annual ratios of conversion between energy use and economic value seldom varied (Fig. 2C). Indeed, in no single year did this ratio vary by as much as +/- 5% from the period average (Fig. 2D).
This constancy of this ratio might seem surprising, given the assumption that efficiencies can be expected to improve over time. The explanation seems to be that, just as technology has advanced, the quality of non-energy resources, including farmland as well as mineral deposits, has degraded. We might, for example, have improved copper extraction techniques somewhat over the past four decades, but the effects of any such advances have been cancelled out by degradation of ore grades.
Be that as it may, this analysis confirms the impossibility of “de-coupling” economic output from the use of energy. This same conclusion has been reached by the European Environmental Bureau, whose report – entitled “Decoupling debunked” – described the case for decoupling as “a needle without a haystack”. As we would expect – though this conclusion runs contrary to much widespread supposition – the economy grows where we use more energy, and will contract if the supply of energy decreases.
Fig. 2
2.3. The dynamics of ECoE
Output, of course, is not the same thing as prosperity, and the difference between them is determined by ECoEs. Between 2002 and 2022, when C-GDP output increased by 36%, global trend ECoE rose from 4.5% to 9.8%. Reflecting this, aggregate prosperity expanded by only 29%, rather than 36%, between those years. Moreover, increases in population numbers have meant that the world’s average person was only 2% more prosperous in 2022 than he or she had been back in 2002.
As well as widening the gap between economic output and prosperity, rising ECoEs also have adverse effects on the quantity of energy available to the system. At low ECoEs, it is a comparatively easy matter to set energy prices at levels which meet the needs both of producers and of consumers. As ECoEs rise, not only do the costs of producers increase, but there is a simultaneous decline in the prosperity of consumers. The narrowing of the gap between supplier costs and consumer affordability can be expected to drive supply volumes downwards.
It will be readily apparent that trends in ECoEs are critically important for economic outcomes, reinforcing the observation that rising ECoEs are the mechanism by which the deterioration of the fossil fuel dynamic is being reflected in the economic transition from growth into contraction. Accordingly, we need to understand the factors that determine trends in ECoEs, as well as anticipating how these trends are likely to develop in the future.
Though recent experience has been characterised by relentless rises in ECoEs, much of the earlier history of the industrial era was characterised by the opposite trend. We do not have the data required to calculate ECoEs in the distant past, but we can be sure that these fell over a very lengthy period.
The lengthy decline in ECoEs for much of the early history of the industrial era can be traced to three identifiable factors. First, the energy industries expanded their geographic ‘reach’ by exploring the world in search of lowest-cost reserves. Second, these industries benefited from economies of scale as their activities expanded. Third, costs fell through advances, generally incremental rather than dramatic, in energy technology.
It seems probable that ECoEs reached their nadir in the quarter-century after the Second World War, explaining the rapid economic growth enjoyed in that period.
Latterly, though, ECoEs have been rising. As we have exhausted the benefits of reach and scale, a new factor – depletion – has become the primary driver of fossil fuel ECoEs, this time in an upwards direction. ‘Depletion’ describes the natural process of using lowest-cost resources first, and leaving costlier alternatives for a later. Our problem today is that this ‘later’has now arrived.
Technology is likely to continue to progress, but we should never forget that technology cannot step outside the limits set by the physical characteristics of the resource in question.
2.4. The ECoE trap
Forward energy projections are set out in Fig. 3. Overall ECoEs from all sources of primary energy can be expected to carry on rising exponentially (Fig. 3A), whilst the total supply of energy is likely to trend downwards, with increases in the supply of renewables, nuclear power and hydroelectricity failing to offset, in full, the rate of decline in fossil fuels (Fig. 3B).
This means that a modest fall in total energy availability will be exceeded by the rate at which surplus energy decreases (Fig. 3C). Reflecting this, both total and surplus energy availability per capita can be expected to decline markedly (Fig. 3D).
Fig. 3
These projections run counter to consensus expectations, which are that increases in the supply of renewable energy sources (REs) will outpace the reduced availability of fossil fuels, whilst the costs of REs will carry on falling in perpetuity.
It’s important that we understand why these expectations are unrealistic.
The first point to note – and one that is not, in itself, subject to much dispute – is that the cost of transition from fossil fuels to REs is likely to be substantial. According to IRENA (the International Renewable Energy Agency), limiting the rise in temperatures to 1.5°C will require the investment of USD131 trillion in energy transition. This might be affordable, though it would require the making of sacrifices – since simply creating (“printing”) the money to make this possible would prove self-defeating, because it would inject severe inflation into the prices of all inputs required for RE expansion.
More importantly, RE expansion on the scale widely envisaged would make enormous demands on the supply of everything from concrete and plastics to steel, copper, lithium, cobalt and numerous other minerals. Even where these inputs exist in the requisite quantities, accessing them and putting them to use would require truly gigantic quantities of energy, which can only be obtained from legacy fossil fuel sources. As well as raising the question of what other uses of energy might have to be relinquished to make this happen, this has the effect of tying the ECoEs of renewables to those of fossil fuels.
The usual answers to such questions involve extrapolation from recent trends, and assumptions of very rapid technical advances, of which the effect will be to increase energy conversion efficiencies.
Extrapolation – assuming that the future must be an infinite prolongation of recent trends – has been called ‘the fool’s guideline’, a label that certainly applies in this instance. Past efficiency gains have occurred from a very low base, and have also benefited from historic lows in the costs of capital and the prices of fossil fuel inputs.
The assumption of infinite cost-lowering advances in technology is equally misleading because – as has been mentioned before, and is all too often overlooked – technology cannot over-rule the laws of physics.
According to Betz’ Law, the maximum rate at which wind turbines can convert kinetic energy into power is 59.3%, whilst the Shockley-Quiesser limit similarly sets the maximum potential efficiency of solar panels at 33.7%. Best practice is already close to these maxima, meaning that there remains very little scope for significant further gains in efficiency.
Ultimately, though, the principal physical restriction to the economic value of renewables is that their densities are markedly less than those of fossil fuels. Intermittency, the consequent need for excess capacity, and the problems involved in the storage of electricity, are reflections of this lesser density.
With their ECoEs rising, and supply availability likely to decrease, continued reliance on fossil fuels makes no economic sense, quite apart from the generally-recognised dangerous environmental and ecological effects of fossil fuel use. In this situation, it makes sense to maximise the potential of wind and solar power. A “sustainable” economy might indeed be possible, albeit at far lower levels of material prosperity and, perhaps, requiring a reduction in global population numbers.
But anyone who promises “sustainable growth” on the basis of energy transition is either disingenuous or remarkably ill-informed, particularly on the critical issue of energy density.
The unfolding inflexion from economic growth to contraction may be unpalatable, but it is a trend that has to be faced and managed, and there’s no practical merit in denial, particularly when this denial is founded on the false premise that technological ingenuity can somehow over-rule the laws of thermodynamics.
2.5. Material contraction, financial exposure
The economic effects of the deteriorating energy dynamic are illustrated in the next set of charts. The continuing rise in ECoEs will drive a widening wedge between economic output and prosperity, whilst output itself can be expected to turn downwards in line with the availability of energy (Fig. 4A).
Meanwhile, the disequilibrium between the “real” economy and its “financial” counterpart has become extreme, because we have engaged in the breakneck expansion of monetary claims even as the underlying material economy has been decelerating towards contraction (Fig. 4B).
The 43% downside calculated by SEEDS gives some idea of the scale at which “excess claims” can be expected to be eliminated, a metric which, as a rule-of-thumb guide, can be applied to the liability situation illustrated in Fig. 4C. We would not be too far wide of the mark if we expected the liabilities illustrated in Fig. 4C to degrade by at least the 43% rate of disequilibrium shown in Fig. 4B.
The extent of financial exposure is shown here in two forms. The first of these is the aggregate debt of the government, household and private non-financial corporate (PNFC) sectors. Financial assets – which are the liabilities of these three sectors to the financial system – further include the NBFI (non-bank financial intermediary) sector, sometimes known as “shadow banking”. At the global level, financial assets totals have to be estimated, because disclosure is incomplete, provided by jurisdictions which correspond to about four-fifths of the global economy.
A useful additional metric is the relationship between year-end debt and the primary energy consumed during the year. This is illustrated in Fig. 4D, from which it is readily apparent that we have been trying to carry ever rising amounts of debt for each unit of energy consumed in the economy.
Fig. 4
2.6. Regional variation
As we have seen, there is an intimately close relationship between ECoEs and prosperity, a relationship which is explored in the next set of charts, in which prosperity per capita is compared with trend ECoEs for the territory in question.
In the United States (Fig. 5A), prosperity per capita inflected back in 2000, when American trend ECoE was 5.1%. Something very similar happened in Britain, where prosperity per person turned down after 2004, when ECoE was 4.7% (Fig. 5B). But Chinese prosperity per capita has continued to improve, and isn’t projected to inflect until next year, at an ECoE of slightly below 12% (Fig. 5C).
We need to be clear that these varying relationships are structural. Advanced economies like America and the United Kingdom are highly complex, resulting in correspondingly high maintenance demands. EM economies like China enjoy greater ECoE-resilience by dint of their lesser complexity and correspondingly lower maintenance costs.
SEEDS studies of 29 different economies confirm that, whilst prior growth in prosperity in advanced Western economies goes into reverse at ECoEs of around 5%, prosperity can continue to increase in EM countries until ECoEs are between 8% and 12%.
This structural explanation should enable us to dispense with notions that the disparity of performance between regions reflects ‘indolence’, ‘laziness’ and ‘complacency’ in Westerners, whereas the citizens of EM countries are more ‘energetic’ or ‘motivated’ than those in the advanced economies. Like most stereotypes, these labels are misleading.
Likewise, we can similarly dispense with the notion that, whilst Western economies will continue to stagnate and contract, the EM world will carry on growing indefinitely.
What has really happened is that the lower ECoE inflexion-points already encountered by the West are now being reached, at higher levels, by the EM economies. Moreover, a growing number of EM countries have reached or passed their points of inflexion in recent years.
Globally, continued expansion in EM countries has, until recently, offset deterioration in the West, such that prosperity per capita in the World as a whole has been on a long plateau (Fig. 5D). This plateau seems to have ended in 2019 though, given events in subsequent years, this conclusion must remain somewhat provisional.
Fig. 5
2.7. The mechanics of economic contraction
The ending of the plateau in global average prosperity per capita, repeated in Fig. 6A, coincides with continuing rises in the costs of essentials (Fig. 6B).
Calculations of essentials can only ever be estimates, not least because the definition of “essential” varies over time. Car ownership, for example, is now widely regarded as essential in the West, but was deemed to be a “luxury” in the not-too-distant past, and could return to the ‘non-essential’ category as the economy contracts.
Definitions of “essential” vary, not just over time, but between countries, with products and services regarded as essential in wealthier economies not so regarded in poorer nations.
SEEDS calculations of essentials have two components. One of these is public services provided by government, which are non-discretionary in the sense that the citizen has no ‘discretion’ about paying for them. (This expenditure does not include inter-group transfers, such as state pensions and benefits, since these net-off to zero at the overall level). The second component is an estimated cost of household necessities.
The point about these necessities is that they tend to be energy-intensive, examples including the provision of water, food, housing and the necessary transport of people and products. As a result, rising ECoEs can be expected to drive the real costs of necessities upwards, even as top-line prosperity is declining. The cross-over illustrated in Fig. 6B is unlikely to be experienced in this way, but, rather, through successive downwards redefinitions of what is understood by the word “essential”.
Even so, we can anticipate relentless affordability compression over time. This has two consequences. Most obviously, there will be a steady contraction in the amounts that people can afford to spend on discretionary (non-essential) products and services (Fig. 6C).
Less obviously, households are going to find it ever harder to carry the financial burdens which range from secured and unsecured credit at once end of the spectrum to staged-payment purchases and subscriptions at the other.
The latter consideration feeds into the way in which “excess claims”, illustrated in Fig. 4, will be eliminated as the tendency towards equilibrium forces both transactions and the stock of claims back into line with the underlying “real economy”. The degradation of streams of income from the household to the corporate and financial sectors will be a significant operative process within the elimination of “excess claims”.
As mentioned earlier, the concept of “two economies” enable us to calculate systemic pricing and price changes, known in SEEDS terminology as RRCI, or the Realised Rate of Comprehensive Inflation. This forms the subject of the final chart, Fig. 6D, in which global RRCI is compared with the broad-basis GDP deflator, used to back-out the effects of inflation in the calculation of real GDP and growth.
As you can see, RRCI has long been above the official GDP deflator number, and is calculated at 9.3%, rather than 6.9%, for 2022. On this basis, the purchasing power of the international dollar – calculated on the more meaningful basis of purchasing power parity (PPP) rather than market rates – declined by 57% (rather than the official 31%) between 2002 and 2022.
Going forward – and assuming, for our purposes, no recourse to extreme monetary recklessness – systemic inflation is likely to run at between 5% and 6%, capped by the deflationary effects of rapid contraction in discretionary sectors of the economy.
“Simultaneous harvest failures across major crop-producing regions are a threat to global food security”, according to a new report published by Nature. The technical jargon here references a “meandering jet stream” but, for non-specialists, what this means is that we can no longer rely on worse-than-average crop conditions in some places being cancelled out by better-than-average conditions in others.
Commenting on this in The Guardian, George Monbiot says that only five stories about this have appeared in the global media, which he contrasts with “more than 10,000 stories this year about Phillip Schofield, the British television presenter who resigned over an affair with a younger colleague”.
“In mediaworld, a place that should never be confused with the real world, celebrity gossip is thousands of times more important than existential risk”, says Monbiot.
This is a conundrum that affects issues beyond climate change, critically important though this obviously is. We can imagine busy people, with lives to lead and issues to confront, switching off in droves when the media turns to economics.
Moreover, they’re right to do this, if all that’s being presented to them is an outdated, fallacious doctrine which promises infinite growth on a finite planet, and claims that there’s a financial fix for every economic ill.
If it’s difficult for people to find time to think about a real issue like climate change, how can we expect them to take an interest in nonsense about infinite growth and the cure-all characteristics of money?
To be candid about it, I don’t know exactly what I’m going to do next, but I can tell you my immediate plan.
This is the first of two planned articles to appear here. The second will try to sum up what I think we now know about the economy, understood as an energy system.
Here, I’m going to reflect on some of the implications that we can draw from what we know about the economy.
Of reality and perception
There are, of course, two ways in which we might explain the disparity of coverage between hard and important scientific news and the doings of people in the “mediaworld”. One is that ‘the powers that be’ who control the world’s media don’t want us to hear about – or worry and get angry about – threats to global food security.
The other is that the general public is simply more interested in stories about ‘slebs’ than in the complicated science and gloomy prognostications of the experts, and the media have a commercial interest in covering those stories which attract the greatest attention.
As I’m writing this, Southern Europe is in the grip of a searing heatwave, with similar conditions occurring in the United States and China. The media have a choice about how they present this news. They can show images of people suffering from extreme heat in Rome, Athens or Malaga, or they can delve into the back-story of climate change. Some media opt for the latter, but far more choose the former.
Climate science does at least have aspects that can interest the general public, who are able to experience heatwaves and flooding at first-hand, as well as seeing images of these and other phenomena.
Economics has no such appeal. The so-called “gloomy science” is indeed gloomy more often than not, but it can’t remotely be called a “science”. Once we understand the concept of two economies – the “real economy” of products and services, and the parallel “financial economy” of money and credit – it becomes apparent that the so-called “laws” of economics are no more than behavioural observations about the human artefact of money, and are in no way analogous to the laws of science.
Orthodox economics has always promised infinite growth, an absurdity which, at least until recently, has appeared to be true, simply because we’ve been continually ramping up the use of fossil fuels. Last year, we consumed 42% more oil, natural gas and coal – and 50% more primary energy in total – than we did back in 2002. No wonder economic output has increased over that period (though a real-terms tripling of debt between those same years ought to give us serious pause for thought).
The general public seems to have been becoming aware that meaningful improvement in their own economic conditions has petered out, a process characterised, for many of them, by worsening insecurity, ever-growing burdens of debt and other commitments and, latterly, the combination of surging inflation and sharply rising interest rates.
Yet officialdom, supported by economists and reported in the media, keeps insisting that “growth” is continuing.
For many, the understandable suspicion is that, in reality, growth may indeed be continuing as the experts claim, but that they’re not benefiting because a greedy, unprincipled minority is cornering all and more of the growth in which ‘ordinary’ people do not participate. Inequality statistics strongly reinforce such suspicions.
Small wonder, then, that, in a recent British opinion poll, 38% agreed that “the world is controlled by a secretive elite”, outnumbering the 33% who disagreed. It seems a reasonable supposition that such suspicions are by no means unique to the United Kingdom, and would have been far less pronounced, there or elsewhere, had equivalent polling been conducted thirty, twenty or even ten years ago.
We cannot know whether these suspicions are well grounded, and it’s worth remembering that different elites in different countries could respond to the same issues in the same ways without a necessity for co-ordination. Moreover, if this un-co-ordinated process did happen, its effects on the experiences of ordinary people would be much the same as if central plotting did exist.
We can’t, then, know whether the conspiracy theorists are right or not – but we can conclude that ever-increasing numbers of people suspect that they are.
At the end of growth
The reality of the situation is both simpler and more disconcerting. The proper target of popular suspicion should be anyone, including but not limited to politicians, who promises them economic growth in perpetuity.
The “hoax” that we’ve been subjected to isn’t climate change, for which there’s compelling scientific evidence, but the continuity of “growth”, which, consciously or not, is being faked.
Simply stated, the fossil fuel dynamic, which has powered economic expansion ever since James Watt unveiled the first really efficient steam engine in 1776, is fading out. Naturally enough, the easiest, most accessible and lowest-cost sources of fossil fuel energy were used first, and are being replaced by ever-costlier alternatives.
This is a surprise only to those – seemingly a majority – who’ve never been prepared to recognize the obvious. The warnings set out in The Limits to Growth (LtG), published back in 1972, have been reinforced by those who have found close correlation between subsequent data and the LtG projections. Kenneth E. Boulding, co-founder of general systems theory, famously pointed out that only “a madman or an economist” would believe in the possibility of infinite, exponential economic expansion on a finite planet.
In recent times, we’ve become aware of the environmental and ecological risks posed by reliance on carbon fuels.
But we have yet to recognize the parallel economic threat, which is that, through relentless rises in energy costs, the fossil-based economy has deteriorated from growth, via stagnation, into contraction.
We’re assured that a solution exists to climate hazard in the form of renewable energy, principally from wind and solar power. We’ve addressed this issue here before, but many critical questions remain unanswered in the wider world.
Here are some of them:
1. If transitioning to renewables is undoubtedly going to be costly – USD 130 trillion seems a reasonable estimate – what are we going to do without in order to pay for it?
2. This sort of money equates to enormous amounts of raw materials, most obviously steel, copper, lithium, cobalt and other minerals – do they even exist in the requisite quantities, and how much environmental damage are we going to cause by mining and processing them?
3. What source of energy are we going to use to access and utilize these raw materials, and, again, what other uses of energy are we going to relinquish in order to make this possible?
The economics of process
The critical issue here is the nature of the material economy itself. Essentially, the economy functions by using energy to extract raw materials and convert them into products, most of which are destined rapidly for landfill. The necessary parallel thermal process involves the conversion of energy from concentrated into diffuse forms, the latter being waste heat.
In short, this dissipative-landfill system relies on the availability, not simply of energy itself, but of dense energy. To replace fossil fuels without suffering economic contraction, alternatives would need to match, not just the quantity of energy sourced from oil, gas and coal, but the density of these fuels as well.
This is something that wind and solar power simply cannot do. Accordingly, a transition to renewables will truncate the dissipative process on which material production depends, the result of which will be a smaller material economy.
This doesn’t for one moment mean that we should scale back the pursuit of sustainability, still less abandon this quest altogether. Barring some wholly new discovery in the field of energy supply, wind and solar are the best options on the table.
The problem, rather, lies with unrealistic expectations. A “sustainable economy” may be feasible, but “sustainable growth” is not. Our lives may become cleaner, and might also become immaterially ‘better’, in a post-carbon, post-consumerist economy, but we’re also likely to be materially poorer.
Can we handle this reality, and stop deluding ourselves that we can ‘fix’ economic contraction? How is the world reacting, or likely to react, to the ending and reversal of “growth”?
And what, come to that, will the future economy look like?
A future unfolds
For large and increasing numbers of people, economic hardship has already arrived. For many, the “cost of living” has been rising more rapidly than incomes. This problem is compounded, not just by rises in the costs of mortgages and rents, but also by the debts and other financial burdens that households already carry.
Promises that conditions will improve if people ‘just hold their nerve’ are ceasing to convince. We’re told that inflation was triggered by war in Eastern Europe, but – quite apart from the fact that inflation took off before the invasion – the immediate effects of the conflict have now dropped out of the year-on-year figures. There’s scant evidence of a wage-price spiral, but plenty of support for the concept of a margin-price effect, a phenomenon known as “greedflation”.
As you’ll read in the companion article when it arrives, we know a great deal about the unfolding energy dynamics of the material economy. Rises in trend ECoEs – the Energy Costs of Energy – are making it ever harder to strike prices which meet the needs of producers and consumers. This makes it likely that the availability of energy will decrease, led downwards by fossil fuels.
Analysis of prior trends makes it clear that the rate of conversion between energy and material economic value is remarkably invariable. This means that, if energy supply decreases, economic output goes into decline. At the same time, rising ECoEs are widening the gap between output and prosperity, the latter being a function of the surplus energy that remains after ECoE has been deducted.
This has two specific consequences. The first is that, just as prosperity declines, the costs of energy-intensive necessities will carry on rising. The world’s average person is, according to the SEEDS model, going to be 10% less prosperous by 2030, and fully 27% worse off by 2040, than he or she was back in 2019.
Rises in the real costs of essentials are likely to mean that the average person’s PXE – Prosperity eXcluding Essentials – will have fallen by 20% by 2030, and 50% by 2040.
The outlook for discretionary (non-essential) products and services, and for those businesses and employees who provide them, is almost unrelievedly grim. The employees affected might be absorbed into a more labour-intensive economy, but this transition will undoubtedly be disruptive. This trend is already emerging, as consumers cut non-essential spending as the costs of necessities rise.
The second implication is that the financial burdens carried by households – including mortgages, rents, credit commitments, staged-purchases and subscriptions – are going to become impossible to sustain as PXE, the equivalent of disposable incomes, contracts. The “real economy” of products and services is already 43% smaller than the “financial economy” of money and credit. We seem to be heading straight towards a cascade of defaults and a crash in asset prices.
Tantrum time?
How is the public, already highly suspicious of the leadership cadres in government and beyond, likely to react to a relentless deterioration in prosperity which is so strikingly at odds with so many promises of “growth”?
I think we can get some idea by imagining a youngster returning home from school to find that all his shiny toys are being dumped into a skip. Unless he’s a remarkably philosophical child, his reactions are likely to be tantrums, outrage, grief and denial.
The adult world seems to behave in much the same way. The ultra-rich are determined, at all costs, to hang on to the trinkets and trappings of wealth and power, irrespective of what that might mean for everyone else, or for the climate.
But ‘ordinary people are likely to react in very similar ways. Anyone doubting this should try standing for election on a platform of ‘saving the planet’ by replacing cars with buses and trams, and restricting or prohibiting overseas flights.
We might, collectively, want to tackle environmental and ecological hazard, but very few, whether wealthy or not, seem willing to make real sacrifices to this end.
This could very easily become a home run, not just for conspiracy theorists but for agitators as well. There are numerous historic examples of economic hardship, particularly when allied to perceptions of unfairness, leading to social unrest.
Governments, whose own resources face relentless compression, could try to tough this out, though history, again, suggests that this won’t work.
A more rational course, it seems to me, would be to find out what the economic outlook is likely to be, and start to prepare the public accordingly.
On a glorious summer’s day towards the end of the Second World War, a German fighter ace, his squadron grounded for lack of fuel, sat in a deck-chair watching the vapour trails of American bombers write the end of the Third Reich across azure skies.
Metaphorically, a similar message is being sky-written now. According to Goehring & Rozencwajg – who are as good as it gets where energy analysis is concerned – Hubbert’s peak is finally here. Only hindsight, of course, can conclusively determine the moment at which “peak oil” became a reality, but G&R are very probably right.
With conventional oil production in decline since 2016, the only source of unconventional supply which remains capable of further increase is the Permian basin, located in six counties in West Texas.
This basin, say G&R, is within a year of its own peak, and we know how rapidly shale production declines once a basin slips onto the down-slope of the ‘drilling treadmill’. The rates of decline of individual shale wells tend to be very rapid, and a point inevitably arrives at which operators can no longer drill enough new wells to stop overall output declining.
OPEC claims to have 4 mmb/d of spare production capacity, but this – even if true, which is highly debateable – wouldn’t tide us over for long, with demand growing, and other sources of supply in relentless decline.
The peaking and impending decline of oil supply is sky-writing dramatic changes to activities hitherto taken for granted. It’s almost impossible to overstate the importance of oil for so many aspects of daily life.
Some examples are obvious, though many others are less so. Unless you believe, for instance, we can replace avgas with recycled cooking-oil, mass air travel is finished, not necessarily imminently, but inevitably. Flying may remain an option for the well-to-do, but huge economies of scale will be lost, and industries structured around low-cost flights will be left high and dry.
Much the same applies to motoring, despite the euphoria around EVs. Again, the better off will be able to transition to these, particularly in the world’s more prosperous countries. But we don’t have enough raw materials (or the energy to extract, process and deliver them) to replace all of the world’s 2 billion cars and commercial vehicles with electric alternatives and, even if we did, we’d have to power a large proportion of them with coal.
Technology – do not pass go
This, of course, is where those of a cornucopian persuasion play their supposed trump card, which is technology. The limitless potential of technological innovation is – alongside infinite growth, and the boundless beneficial potential of neoliberal economics – one of the three great myths of the age.
We have indeed taken enormous technological strides over the past two centuries, but that has been possible because the supply of low-cost energy has always, hitherto, been abundant. Technologies evolve to suit the energy available to power them, and the contrary proposition is ludicrous.
The critical issue, so often dismissed or ignored by the high priests of the new and shiny, is that the capabilities of technology are bounded by the laws of physics. The fact of the matter is that we can’t repeal Betz’ Law (which sets the maximum potential efficiency of wind turbines), or set aside the Shockley-Quiesser limit (which does the same for solar power).
With these limits understood, transformational improvements in conversion efficiencies are off the table, leaving us with the hard, costly and resource-intensive heavy slog of building capacity sufficient, not just to replace fossil fuel energy, but to offset intermittency as well.
This is where the term “renewable” ought to be subjected to far more critical examination than it has tended to receive so far. We can’t source the plastics required for the renewables sector without hydrocarbon feedstocks. Renewables can’t, of themselves, power the extraction, processing and delivery of the vast amounts of concrete, steel, copper, cobalt, lithium and a host of other resources required for the development, maintenance and eventual replacement of wind and solar power.
In short, “renewables” would merit that label only if they were capable of renewing – that is to say, replacing – themselves over time. This isn’t possible now, and there are few reasons to suppose that it will become so in the future.
Any pilot worth his or her licence knows that “Isaac (Newton) is always waiting” if they get something wrong. The starry-eyed visionaries of energy transition need to develop an equivalent awareness of the hard limits of physics.
Investors, incidentally, have their own version of tech mystique, which is the concept of infinite profitable growth vouchsafed by technology. Some of today’s technologies, such as online retailing, are of undoubted value, and a sizeable (though niche) future role exists for EVs.
But a large proportion of “tech” relies on a business model mistakenly assumed to be invulnerable to economic change. Huge swathes of “tech” are funded from the twin sources of subscriptions and advertising revenues, both of which are capable of rapid contraction as household discretionary prosperity shrinks, and as businesses endeavour to adapt to a less prosperous world. The ‘technology of “tech”’ may have moved on, but the business model has not.
A different kind of innovation
Those of us who favour a strong private enterprise component within a mixed economy recognize the stimulus to innovation provided by the competitive pursuit of increased profitability. There is no reason to suppose that innovation will decelerate, let alone cease, in a post-growth economy.
But the emphasis can be expected to shift fundamentally, as businesses seek cost control and resilience through the simplification of product and process, delayering, shortening supply-lines and circumventing ‘critical mass risk’. Leadership cadres don’t, as yet, have a body of knowledge about the management of contraction – and the necessary learning curve is likely to be steep – but, as ever, the innovative will lead the pack.
The coming decline in oil and broader fossil fuel supply, coupled with continuing cost increases and the lack of full-replacement alternatives, provides significant visibility on future trends. The world’s average person will become gradually less prosperous, a process exacerbated by rises in the real costs of energy-intensive necessities including food, water, housing and essential travel.
The result will be a leveraged contraction in the affordability of discretionary (non-essential) products and services. Labour intensity in the economy will reverse its long decline, absorbing workers released by contraction in the discretionary sectors.
To this extent, economic contraction is capable, at least in theory, of happening gradually. The same, though, cannot be said of the financial system. If the current financial system was a car, you wouldn’t buy it – it has no reverse gear, no brakes worthy of the name, steering that is rudimentary at best, a near-opaque windscreen giving almost no forward visibility, and a tendency to accelerate of its own volition.
As you may know, I believe that we can only seek to understand economic trends effectively if we embrace the concept of “two economies” – a “real economy” of material products and services, and a parallel “financial economy” of money and credit.
From this, it follows that money, having no intrinsic worth, commands value only as a ‘claim’ on the goods and services made available by the “real economy”. These “claims” exist in two forms – those that we exercise, transactionally, in the present, and those which we set aside for exercise in the future. Measured in relation to material prosperity, the exercise of excessive claims in the present is mediated by inflation, but the real problem resides in a huge excess of monetary ‘claims on the future’.
Buy now, crash later
This problem, too, might be arbitraged by inflation, but only if the inflationary degradation of forward claims isn’t cancelled out by the continuing creation of new excess claims to replace them. The authorities have considerable oversight and regulatory powers where orthodox, deposit-taking banks are concerned, but the locus of the problem has now shifted from conventional banking to the largely unregulated (and even largely unquantified) “shadow credit” sector.
Whenever somebody buys, say, a new refrigerator, a new car or an expensive holiday which he or she cannot afford – and which conventional banks would be unwilling to finance – we see the “shadow credit” system in action. Even if nothing more dramatic happens – and the dramatic is actually a great deal likelier to happen than not – the probability is that the system will be sunk by the unsustainable burden of continuing financial outflows imposed on households by the irresponsible funding of the unaffordable.
We aren’t, it should be emphasised, about to ‘run out of’ oil. Rather, what we face is a comparatively gradual decrease in supply, compounded by a continuing rise in ECoEs (the Energy Costs of Energy). Oil prices are unlikely to give us much in the way of forewarning – they might rise, in response to scarcity, but equally they might fall, driven lower by consumer impoverishment. The decline in oil supply is likely to accelerate, through switching, similar dynamics in other fuels.
It may seem obvious that less oil means less driving and less flying, but the real significance of oil contraction lies in what it means for ‘behind the scenes’ activities such as food production, petrochemical supply, and the distribution of products and raw materials.
The moment, as well as the implications, of “peak oil” have been debated over decades, and there is no particular practical significance attached to the precise date of its arrival. Moreover, surplus oil – that is, supply less its ECoE-cost of delivery – has already turned down, both on an aggregate and a per-capita basis.
But the symbolic meaning of the peak oil “moment” could hardly be more profound.
Surplus Energy Economics 