#195. The unrelenting squeeze

MONEY, CREDIT AND THE DECLINE OF DISCRETIONARY PROSPERITY 

Henry Ford may have said that “history is bunk”, but a glance backwards can sometimes help us to focus on the future. Though they are not the subject of this discussion, fiat currencies are an example of this.

The world monetary system moved on to a fiat or “command” basis back in 1971. For the following quarter-century, this worked reasonably well, and it seems likely that historians of the future will date the decline of fiat from the second half of the 1990s.

That was when we embarked on the financial excesses which culminated in the global financial crisis (GFC) of 2008-09. The rest – as the saying goes, and with apologies to Mr Ford – “is history”, with the ultimate fate of fiat determined from the moment when the world’s ‘market’ economies decided to turn their backs on market forces, and to ‘make it up as we go along’.

The aim here isn’t to revisit the subjects discussed in the previous article, but it’s worth considering why a monetary system that previously had worked pretty well then turned on to a dangerous path.

What, fundamentally, changed in the 1990s?

The answer, of course, was that ECoEs – the Energy Costs of Energy – reached what was, for Western economies, the climacteric zone that lies between 3.5% and 5.0%. SEEDS dates this ECoE climacteric to the period between 1996 (a global ECoE of 3.4%) and 2005 (5.0%).

From 1997, the prosperity of the average Japanese citizen turned downwards. The same fate overtook Americans in 2000, and the British in 2004, and most other Westerners by 2008.

Well before then, baffled observers had started to wonder about the phenomenon of “secular stagnation”, something which they could identify, but could not explain.

The rest is indeed “history”, because money-based systems of economic interpretation could propose only futile financial solutions for a trend rooted, not in money, but in energy.

Why, then, did the ECoE inflexion-point in Western prosperity put “the writing on the wall” for fiat currencies? The answer seems to lie in the flexibility that is at once fiat money’s greatest virtue and its fundamental weakness.

So long as the underlying economy keeps growing, fiat money can expand at a roughly commensurate rate, and that’s its virtue.

Once the economy turns down, however, a divergence begins, because fiat systems are incapable of a corresponding contraction, and that’s the system’s inherent vice.

Unless you understand the economy as an energy system, though, you couldn’t – and still can’t – see what’s happening.

Monetary expansion in a contracting economy can only create excesses of those financial ‘claims’ that, customarily, are called “value”. From that point on, the only real question is whether the instrument of “value destruction” is going to be a series of market crashes and debt defaults, or a hyperinflationary debasement of the value of money.

Here, history again provides a pointer, suggesting that decision-makers will almost always avoid formal or ‘hard’ default if the ‘soft’ alternative of inflationary value destruction is available.

So much for history, and the rise and fall of fiat. Turning to the future, here are some charts that ought to (but, of course, won’t) act as a wake-up call for decision-makers.

Fig. 1

Though extended out to 2040, these charts will be familiar to regular readers. What they show is the SEEDS calibration of prosperity per capita, set against the cost of essentials. The latter, defined as the sum of public services and household necessities, remains a development project, but the bottom line is clear enough.

In essence, the prosperity of the average person in America, in Britain and – now – even in China is deteriorating. The cost of essentials is continuing to rise. Accordingly, the scope for discretionary (non-essential) expenditure, within the parameters of prosperity, is eroding fast.

People will still undertake discretionary spending in excess of this shrinking capability, of course, as indeed they are doing now. But they can only do this by resorting to borrowing for this purpose. Discretionary consumption within the affordability of prosperity is undergoing rapid contraction.

More worryingly still, there seems to be every likelihood that the cost of essentials will, in due course, rise above prosperity per capita. As you can see, this might not happen until some time in the 2030s, but that doesn’t mean that we can ignore it until then.

For one thing, these are average numbers, not medians. For every person whose discretionary prosperity remains comfortably positive, there’s another who’s already near, or at, the point of reliance on credit to pay for the essentials.

Here is where we’re entitled to ask some questions. Are governments aware of this situation, as they continue to plan on the basis of rising revenues, and carry on investing in sectors geared towards discretionary consumption?

Do they, and central bankers, really think we can somehow overcome these fundamental, energy-driven trends by pouring yet more cheap credit and cheaper money into the system? Do businesses selling discretionary goods and services realise that they’re becoming hostages to the fortunes of credit expansion? And do those companies and investors reliant on assumed increases in consumer income streams understand the dynamic that is squeezing consumer discretionary prosperity?

In most cases, the answer, very probably, is “no”.

Have political leaders looked ahead to the very different agendas that will concern voters once the gravy-train of cheap credit either hits the deflationary buffers or crashes off the inflationary rails?

Again, probably not.

 

#187. A new kind of New Year

NEAR-TERM BETS AND THE BIGGER WAGER

“Horse-sense” has been defined as “that innate wisdom which stops horses from betting on people”.

Perhaps that’s why I’m not a betting man.

There’s a sense, though, in which we’re all involved in some pretty big wagers right now. Essentially, governments, on our behalf, are betting that vaccines will triumph over the covid coronavirus; that economies will then bounce back strongly; and that all of this will happen before the financial system buckles under the truly enormous stresses imposed by the crisis.

These bets are linked. They correspond to what afficionados of ‘the sport of kings’ call an “accumulator”, in which the punter only wins if each and every horse comes good. If we can’t defeat the coronavirus, we can’t reopen the economy – and, unless the economy bounces back, it will become increasingly difficult to resource the fight against the virus.

Behind this near-term bet, though, is another and bigger wager, albeit one of which few are aware.

It is that we can win out by backing the mystical powers of money to triumph over the physical determinants of resources and the environment.       

Reflections on a challenging year

With this preamble, I’d like to wish you all a happy and prosperous New Year, and to thank you for your interest, your support, and your many helpful, original, informed and informative contributions to our discussions. The quality of debate here has been higher than ever in 2020, and I’m pleased to record that there’s been another big increase in the number of people visiting the site.

A personal view is that we’ve accomplished a great deal here this year. Amongst many other things, we’ve put emerging trends into a logical structure (the “taxonomy of de-growth”), examined issues such as the tilt away from an energy-profligate “dissipative-landfill” economic system, and identified the importance of fast-falling “discretionary prosperity”.

The SEEDS economic model has performed remarkably well under conditions of extreme uncertainty. I’m more persuaded than ever that we are right (a) to interpret the economy as an energy system, and (b) to model it on that basis. It’s been well said that “if something isn’t measured, it isn’t managed”.  

I’m convinced, too, that the model has helped us to avoid extremes. Thanks in large part to SEEDS, we haven’t endorsed implausible theses like “a V-shaped recovery” and a “great re-set”, but neither have we been panicked into bemoaning ‘the end of the World’, or seeing conspiracies on every hand.

For me, much of 2020 has felt like walking a tightrope, with winds gusting from both sides. On the one hand there’s been what we might call the ‘conventional’ line, which is that everything is under control, and that economic growth can continue in perpetuity. On the other is the persuasion that the World economy is on the brink of collapse, and that we’re subject to nefarious plots by a cast of characters straight out of a James Bond epic.

The reality, as usual, is more prosaic. A deteriorating economic dynamic and an over-stressed environment are quite new (and very real) problems. But the basic challenge – which is to confront obstacles, and to find ways around them – is ‘as old as the hills’.   

“Do they know?”

A question which often arises is whether decision-makers in government, big business and finance either (a) don’t understand the economy as a decelerating energy system; (b) do understand it, but, having no solutions, prefer to ignore it; or (c) do understand it, but only at some esoteric level which does not inform day-to-day policy.

I’m as convinced as one can be that the answer is (a). Around the World, governments’ policies show every characteristic of being shaped by ‘conventional’ economic interpretation. On an almost daily basis, businesses undertake expansionary investments which only make sense on the basis of a firm belief in perpetual growth. The coronavirus pandemic has been treated as a temporary hiatus – albeit a bad one – rather than as the harbinger of something wholly different.

On the principle that “actions speak louder than words”, we can conclude that what we might call “the decision-makers” do subscribe to the tenets of classical economics, with its insistence that economics is ‘the study of money’, and that, in the words of Robert Solow, “[t]he world can, in effect, get along without natural resources”.

You might think, as I do, that this is a strange situation. After all, the classical interpretation of the economy can readily be de-bunked, as has been explained, with admirable clarity, here. The classical presentation of the economy as a purely financial system is, as we know, perfectly capable of assuring us, absurdly, that, because agriculture is ‘only’ about 6% of global GDP, 94% of the economy would carry on unimpaired even if some natural catastrophe destroyed our ability to produce food.

A purely personal view, offered constructively and based on best available evidence, is that governments do realise that economic events ‘aren’t going according to plan’, but don’t recognize that their economic terms of reference are mistaken.

Most politicians – and, for that matter, business leaders, too – aren’t experts on macroeconomics. Instead, they’re accustomed to taking ‘best advice’ from those ‘best qualified’ to provide it.

You and I may see it differently from this, but nowhere in the lexicon of conventional economics will you find – for example – the term “ECoE”. Ministers and officials, after all, are very busy people, tend to be generalists rather than specialists, and necessarily focus more on the immediate and the “practical” than on the longer-term and the “theoretical”.   

When we compare our energy-based perspective with the situation as it is seen conventionally – and, for purposes of comparative interpretation, SEEDS encompasses both – we have pretty good visibility on how things are likely to unfold.

Governments and central banks will continue to be persuaded that the “fix” for a struggling economy is, ‘always and everywhere’, ever-cheaper credit and ever-more stimulus. When pandemic-related bills for stimulus, deferred debt service and rents turn up, they will feel obligated to step in. They will – mistakenly, but in good faith – proclaim ultra-low bond yields as evidence for the view that government indebtedness can continue to expand almost indefinitely.

It’s probable, too, that they will continue to ignore the fact that – in asset prices – hazardous inflation has already arrived. Again, current incumbents of office cannot be blamed for a historic convention which decrees that, whilst rising food prices are evidence of inflation, rising stock or property prices are not. Logic may tell us that neither high house prices nor low wages are economically beneficial, but both fallacies are deeply embedded in established (though mistaken) lines of thinking. 

From this same logical point of view, it might seem perfectly obvious to you and I that the current uneasy economic situation can end in only one of two ways. If we’re right about deteriorating prosperity, the authorities have to either (a) recognize this, and respond accordingly, or (b) keep pulling the fiscal and monetary levers to and beyond the point of fiat credibility.   

Worth the effort?

In this context, you won’t misunderstand me, I’m sure, if I say that what we try to do here is important. I’m convinced that we need to adhere to reasoned and evidential interpretation, steering, so far as we can, a course which avoids both the complacency of ‘continuity’ and the defeatism of despair.

By way of background, it’s been my experience that no presentation of ideas – whether to colleagues, clients, officials or anyone else – will ever be persuasive unless it’s backed up by evidence, and, further, that this evidence must be statistical, and based on modelling. After all, you wouldn’t expect to convince a confectionary manufacturer to go ahead with a new line of chocolate-bars if you had nothing to say about sales, costs and market penetration.

That, essentially, was why I set out to see if it was possible to model the economy from an energy perspective, but to present its output in financial language. But there’s a big gap between modelling as an exercise – ‘to see if it could be done’ – and practical application, in the sense of contributing, constructively and persuasively, to the broader debate.          

Like it or not, we’re in a situation where our view of the economy, as an energy dynamic running out of momentum, is in stark contrast to the orthodox view, which sees it as a monetary system capable of infinite expansion. In so far as we can, we need to progress our interpretation calmly and co-operatively. To reiterate, governments do not employ philosophers and, even where they make long-range statements, they concentrate, of necessity, on the near-term.

Looking ahead, I do have some ideas for future projects, just one of which is to calibrate discretionary prosperity, an issue which seems increasingly likely to be an important lead-indicator. There’s a case for setting out the surplus energy interpretation in a form which is both accessible and comprehensive. There may well be a case for collaborative activity.

As ever, I will warmly welcome any and all suggestions, and I feel that I can, at least, wish you a constructive and progressive New Year.