#196. The price of self-delusion

MYTH & MONEY, TECHNOLOGY & PHYSICS

It can’t be emphasised too often that GDP, which is the preferred measure of economic output and “growth”, has become progressively less meaningful over time.

Essentially, GDP mistakes money for prosperity. It counts the spending of money as economic “activity”, drawing no distinctions between how the money is spent, or whether the money itself has been earned, borrowed, airily promised for the future, or simply created out of the ether.

Worst of all, GDP ignores the deterioration of the cost-value equation which determines how the economy converts the use of energy into material prosperity. It invites us to believe that the economy exists in complete isolation from physical resources such as energy, minerals, plastics, food and water. If we once let ourselves believe that the economy does indeed exist independently of natural resources, ‘growth forever’ becomes a plausible fantasy.

If we follow the logic of GDP, the complete destruction of the Earth’s ability to produce food wouldn’t be too serious, because it would leave the other 94% of the economy intact. If the economy really is independent of material resources, we could colonise Mars by sending nothing more than some starry-eyed pioneers and a printing-press. A more prosaic – as it were, a more ‘down to Earth’ – example would be that survivors of a ship-wreck could live indefinitely in a lifeboat, just so long as their supply of bank-notes didn’t run out.

You might be familiar with how the economy of money has disguised real trends in the underlying economy of material prosperity. In the twenty years preceding the coronavirus crisis, each $1 of reported “growth” in global GDP was the product of nearly $3 of net new borrowing. Even this understates the extent of our self-deception, because it ignores the creation of huge non-debt liabilities. These include both formal commitments and informal assumptions, the latter typified by enormous gaps in promised (but unfunded) pension expectations.

In America, manufacturing accounted for just 0.2% of all reported economic growth between 2000 and 2020. Even adding construction, agriculture and the extractive industries leaves the growth contribution of globally-marketable, ‘hard’-priced activities at only 5%. The remaining 95% of growth came from services.

These services can be important, and valuable, but they can also act as residuals, sinks for liquidity injected into the system. The FIRE (finance, insurance and real estate) sectors alone accounted for almost 30% of all recorded growth – but how much value do we actually derive from moving money around? – with a further 12% coming from government. Both FIRE activities and government spending are obvious conduits for the injection of borrowed or newly-created money into the system.      

The flip-side of this process is the creation of hugely inflated asset “values”, which are products (a) of the abundance (and hence the cheapness) of money, and (b) of the discounting to the present of forward streams of income which reflect expectations wholly detached from any realistic appraisal of the material economy of the future.

What this in turn means is that most asset “values” are no more than a function of our self-delusion about the true size of the economy of today and tomorrow. Many of them, including the aggregate “values” ascribed to equities and property, are purely notional, in that they can never be monetised. Even defined, committed assets – such as debts owed by others – are only as valuable as debtors’ ultimate ability to pay.

The joys of self-delusion

This situation raises two obvious questions. The first is that, as this is collective self-delusion, does it really matter? After all, we’re not trying to measure ourselves against alternative worlds where economic activity is reported more intelligently.

Second, can those of us who understand this situation – and who can, furthermore, put numbers on it – profit from this knowledge?      

The answer to the second question is that yes, we can.

The answer to the first is that, in economics as in so much else, self-delusion does matter. You wouldn’t expect to win a battle by lying to yourself about how many soldiers or warships your enemy had at his disposal. You wouldn’t expect to drive safely by lying to yourself about how much alcohol you’d consumed.

So why would we expect to become more prosperous by deluding ourselves about the size, shape and direction of the economy?

In economics, self-delusion matters because plans based on false information seldom, if ever, turn out well.

Here’s one example of the dangers implicit in economic self-delusion. Between 1999 and 2019, emissions of climate-harming CO² increased by 48%. If we believe official GDP numbers, economic output grew by 110% over that same period. From this, we can infer that economic output per tonne of CO² increased by 42%. Conversely, we could conclude that each dollar of economic activity now produces 30% less CO² than it did twenty years ago.

If we were to believe this, we could also believe that further such progress could, in due course, tame environmental risk, or even eliminate it altogether, without requiring economic sacrifices.

This sort of calculation helps explain why governments’ seemingly sincere (if belated) commitments to environmental reform aren’t accompanied by measures that, in purely physical terms, might appear necessary. We can, we’re told, overcome environmental risk without having fewer cars, limiting engine sizes, insisting on hybrid-only model slates, or rationing air travel.

Much the same applies to the use of energy. Over twenty years in which GDP increased by 110%, consumption of primary energy expanded by only 54%. Accordingly, the economic value created by the use of a single unit of energy seemingly improved by 36%.

The inference is that, in the future, economic output can grow whilst our use of energy decreases. This where the fantasy of “de-coupling” the economy from energy use comes from, and remains persuasive even though experts at the EEB have described the case for de-coupling as “a haystack without a needle”.

It is, after all, surely obvious that literally nothing of any economic value (utility) whatsoever can be produced without the use of energy – so why would we expect to grow the economy without increasing our consumption of energy?

So any theory which postulates indefinite divergence between energy use and economic prosperity affronts the laws of physics. Suggesting that “technology” can somehow over-rule the constraints of physics simply produces ‘self-delusion squared’.     

Cold reality

When we step away from self-deluding convention (and starry-eyed faith in technology), and look behind the fallacy of GDP, very different conclusions emerge.

For starters, stripped of what we can call ‘the credit effect’, world economic output increased by only 40% (rather than by 110%) between 1999 and 2019.

This means that we delivered 5% less economic value for each tonne of CO² emitted, and 9% less economic output from each unit of energy consumed.

Nor is this all. The Energy Cost of Energy (ECoE) is the critical dynamic determining how much economic value we derive from each unit of energy consumed. Driven primarily by fossil fuel depletion, ECoEs have been (and are) rising relentlessly.

If we include ECoE escalation in our calculation, each unit of emitted CO² yielded 10% less material prosperity in 2019 than in 1999, whilst the relationship between prosperity and energy use worsened by 14% over that same period.

The latter point, in particular, is self-evident – if, from any given quantity of energy supplied, more has to be consumed in the supply process, less remains for any other economic purpose.

These inconvenient observations tell us, amongst other things, that we can’t overcome environmental challenges without changing our behaviour, and that we can’t shrink energy consumption without shrinking the economy.

If we factor ECoE into the equation, two further critical points emerge.

First, CO² emissions are a function of the total energy that we use, whilst material prosperity is linked to surplus (ex-ECoE) energy quantities. As ECoEs rise, they load this equation against us

Therefore, a sizeable – and rising – proportion of CO² emissions is tied, not to the economic value that energy use creates, but to the energy that is used only to make energy supply available. We’re never going to combat climate change and ecological degradation effectively until we take this ‘variable geometry’ into account.

Second, realistic appraisal also tells us that we’re nowhere near a point at which we can use renewable energy sources (REs) as a “fix” for the environmental and economic consequences of rising ECoEs.

Transitioning to technologies such as solar and wind power will require huge investment, which has been costed at between $95 and $110 trillion. The money involved isn’t that important in itself. But it corresponds to vast amounts of steel, copper, plastics, lithium and numerous other resource input requirements. Most of these can only be made available through the use of fossil fuels, meaning that the ECoEs of REs are tied to those of oil, gas and coal.

Western societies’ prior growth in prosperity goes into reverse at or below ECoEs of 5%. Less complex EM countries start getting poorer before their ECoEs reach 10%. The latter level of ECoE might, just, be feasible for REs, but the lower level of ECoEs required to maintain (let alone to grow) Western prosperity is a pipe-dream.

Here, once again, we encounter the chimera of technology. The technological progress of the past has enriched us by increasing the efficiency with which we use both energy itself and those other resources whose availability is energy-dependent.

Critically, though, the scope for technological progress is confined within the envelope of the physical characteristics of the resource itself, and, ultimately, is bounded by the laws of thermodynamics.

Simply put, far too many of our expectations for what technology can deliver in the future are based on a fallacious assumption that we can extrapolate technological progress to the point where it trumps physics.

Anyone who believes that to be possible would be better employed writing science fiction, or running a government department. 

Practical implications

If we once free ourselves from the alluring embraces of financial and technological self-delusion, we’re in a position to recognise fundamental challenges that won’t go away just because we bury our heads in the sand.

Our first observation has to be that prosperity consists of those material things – goods and services – whose provision is a function of energy, not of our ability to pour ever more money into the system.

This linkage to energy is particularly important in the provision of essentials, including food and water, housing, health care, education, necessary transport and, of course, energy itself.

Even the most cursory examination tells us that, as prosperity continues to deteriorate in defiance of our economic self-delusion, so the proportion of our prosperity available for all discretionary (non-essential) purposes will diminish.

If, understanding this, you were in government, your forward planning would surely centre on ensuring the availability and affordability of essentials for everyone. This has already become a critical factor, as ever larger numbers are sucked into poorly-paid, insecure forms of employment, just as the cost of necessities continues to rise.

This is where plans for the universal provision of essentials should be front and centre of the policy process, much as – in some countries – universal provision for health care was the flagship objective for an earlier generation of political leaders. 

If you were in business, and applied this same understanding, you wouldn’t be banking on growth. Rather, you’d be working out how best to insulate yourself from a relentless squeeze on discretionary consumption, and how to safeguard your business from the coming technological disillusionment. 

Many people fear that an economic crisis will be brought about by the inflationary consequences of the endless injection of liquidity on the false premise that ‘money equals prosperity’.

They might very well be right.

It’s equally possible, though, that we might see markets brought down by a sudden, dawning recognition that discretionary consumption is destined to contract (as, excluding debt-funded purchasing, it already is); that perpetual growth in future income streams from consumers is a figment of self-delusion; that property prices must fall back into equilibrium with incomes; and that our fascination with technology has been blinding us to the laws of physics as they apply to prosperity, the economy and the environment.  

#180. In search of competitive edge

LOGIC, ‘CONTINUITY BIAS’ AND THE BALANCE OF IMPROBABILITIES

Those of us who understand the economy as an energy system know that fundamental change, long overdue, is being crystallised by the coronavirus crisis. Can that knowledge be the basis for establishing ‘competitive edge’?

The conclusion here is that it can, but realising this requires more than just knowing the difference between the logical (energy-driven) and the accepted-but-illogical (wholly financial) ways of interpreting the economy. We also need to recognise the ways in which continuity bias and extrapolation inhibit the application of logic and knowledge.  

This understanding reveals scenarios which, whilst they may appear improbable, are far more plausible than consensus lines of thinking which have become impossible.

Government – right by default?

It’s been well said that governments will “always do the right thing, after exhausting all other possibilities first”.

The Wuhan coronavirus crisis illustrates this axiom to good effect. For many years, scientists have warned (a) that the world is likely to experience some kind of viral pandemic, and (b) that no country would be able to counter such an outbreak unless it closed its borders to international travel until such time as the virus had been eliminated globally. In other words, no amount of lockdown or physical [“social”] distancing is going to work, if the virus can simply return on the next inbound flight.

Governments are under all sorts of conflicting pressures, so their reluctance to follow this logic is, perhaps, understandable. But this interpretation seems vindicated – certainly in Europe, and probably elsewhere – by a sequence in which the re-opening of passenger flights has been followed by “second waves” of infection.

Unless we’re prepared to assume the early development of a vaccine which is effective, safe and trusted by the public, then, it seems prudent to anticipate that the coronavirus is going to turn out to be a process rather than an event. Governments are likely to act when the gravity of the situation compels them to do so, but are equally likely, as soon as the situation eases, to roll back, prematurely, on unpopular policies.

Inferences of process

If we understand the pandemic as ‘a process rather than an event’, certain economic and financial inferences can be drawn from this conclusion. Equally important, though, is the evidence of what we might call a ‘continuity bias’ at work. There is, in a strictly non-political sense, a conservatism which impels organisations and individuals to lean towards continuity, not just in their expectations, but in their decisions, too.

This ‘continuity bias’ opens up a disconnect between perception and reality, and anyone seeking to progress – in the realms of ideas, of politics or of business – can benefit from a recognition of the way in which ‘continuity bias’ creates ‘perception deficiency’.

One aspect of this process is a susceptibility to extrapolation, the assumption that the future must be a continuation of the recent past. If, for example, the price of, or demand for, something has risen by X% over, say, the past ten years, the tendency is to assume that it must rise by a further X% over the next ten years. This extrapolatory assumption can be called ‘the fools’ guideline’, in that it blinds us to the possibility (and, under certain conditions, the probability) of a fundamental change of direction, even when logical examination ought to persuade us that fundamental change is likely.

Dynamic interpretation

As regular readers will know, the general thesis followed here is that infinite growth is implausible in an economy governed by a physical energy dynamic. We can, indeed, go further than this. We can (and without being guilty of unjustified extrapolation) compare (a) the trend in the rate at which energy is converted into economic value, with (b) the trend rate at which the ECoE (energy cost of energy) deduction from this value is increasing.

And, since the supply of energy is itself determined by a relationship between value and cost, we can also develop pretty good visibility on future trends in the quantum of energy supply.

What this means is that a per-unit progression of energy value (V minus ECoE) can be applied to a linked projection of quantity (Q) to produce an equation which interprets and predicts trends in the aggregate supply of economic value.

If the present position is termed ‘point zero’, we can then look either forwards (to points +1, +2, +3 and so on) or backwards (points -1, -2, -3). The value of forward visibility will be obvious, but backwards visibility can be of at least equal importance, because it can tell us the extent to which current interpretations of direction and value are mistaken.

Competitive edge

If our aim is to identify competitive edge, the best way to do this is likely to involve triangulating (a) accurate fundamental analysis, (b) prevalent false perceptions of current value, and (c) the effects of ‘continuity bias’.

Here’s an example of how, in the near future, such an equation might function.

We know that the Wuhan coronavirus pandemic has involved the provision of support for household and business incomes, together with the deferral of various household and business expenses (such as interest and rent payments). We can put these together mathematically to calculate a progression of fiscal shortfalls, and we can further postulate a point at which this progression becomes critical, requiring, perhaps, state ‘rescues’ of embattled lenders and landlords, and/or central bank money creation to support these initiatives.

This much, though, can be done by anyone, provided he or she has access to the numbers and the methodology required to calculate this progression. Accordingly, it does not, of itself, constitute ‘competitive edge’, other than in relation to those who are unable to carry out these same calculations.

This is where the equation of energy value, false perceptions of value and ‘continuity bias’ comes into play. The person who can calculate a fiscal progression with reasonable accuracy can be led astray by referencing this to a false perception of where the economy really is now, and where it can be expected to go in the future. Competitive edge arises when the background to this progression can be calibrated correctly.

More broadly, the ‘generality’ – governments, businesses, investors and the general public – has perceptions of how the economy has got to where it is and of where it will progress from here, and accepts current valuations imputed by these trends, all of which are mistaken.

These ‘mistaken perceptions of the generality’ define a situation of risk and opportunity. If, for example, you were in business, the ability to draw on accurate interpretation, plus your understanding of others’ extrapolation and ‘continuity bias’, would tell you to invest in certain areas, to divest from others, to buy certain undervalued assets and to sell some overvalued ones, to alter your slate of products and services, and to change your methods and practises in ways recommended by economic and financial knowledge not available to your competitors.

Without, of course, straying into investment specifics, it will be obvious that assets are priced in relation to current appreciations and forward expectations, both of which are founded in these same ‘mistaken perceptions of the generality’. 

On the road – theory in practice

From what we might term a ‘top-down’ standpoint, we can observe that a prior belief in ‘a future of more’ has, under pressure of circumstances, segued into ‘a certainty of recovery’. Some examples of this mindset are instructive, not because they are ‘right’, or even because they were ‘wrong before’, but because they ‘remain wrong now’.

Future sales of vehicles are an interesting example. As of 2018, there were 1,130 million cars on the world’s roads, and 236 million commercial vehicles. The consensus view, as of 2019, was that these numbers would, by 2040, have risen to about 1,970 million cars (+74%) and 460 million commercial vehicles (+94%). This view has been maintained despite evidence that sales of both classes of vehicles had started to deteriorate during 2018. The overall perception was (and probably still is) that the numbers of vehicles of all types was set to increase by 1.06 billion units (+77%) by 2040.

Under current, extreme circumstances, of course, sales of cars and commercial vehicles have slumped. Rationally, you might ask (a) whether pre-existing adverse probabilities have been crystallised by the crisis, and (b) whether consensus longer-term expectations are being invalidated.

What seems actually to be happening, though, is that the question has become, not ‘was our prior expectation wrong?’, but ‘how long will it take to get back on track?’. We should be clear that this latter question is based on assumption, not on logic.

Finding the ‘right’ answer to such questions is very far from being purely theoretical. It would have a critical bearing on your current actions and your future plans, if you manufacture vehicles or components, if you supply materials for these processes, or if you’re a government trying to plan forward infrastructure investments. If you’re an environmental campaigner, or an advocate of conversion from internal combustion (ICE) to electric vehicles (EVs), these issues are fundamental to how you frame and conduct your current activities.

Understanding of energy-economic principles would, in this instance, already have told you that ‘77% more vehicles’ was an implausible outcome. That in turn would provide a valid point of reference for the effects of the current crisis.  

It would, in other words, give you a competitive edge.

Flying blind – of aviation and technology

A second and a third instance are provided by aviation and technology.

In the former instance, the pre-crisis consensus – welcomed by the industry, disliked by environmentalists, but seemingly accepted by almost everyone, and used as a planning assumption by governments – was that passenger flights would increase by roughly 90% between 2018 and 2040. The coronavirus crisis has inflicted huge damage to the sector, but the ‘continuity bias’ assumption seems now to be that the prior trajectory will be restored, and that a worst-case scenario is the likelihood of a lengthy delay in returning to that prior trajectory.

It seems to be accepted that the duration of a recovery may be protracted, given the unknowns around travel restrictions and customer caution, but it also seems that no consideration is being given to the possibility that the prior (upwards) trajectory might not be restored at all.   

A third and final example is provided by the assumption that the future will comprise ever more technology, ranging from more ‘big data’, more AI and more gadgets to self-driving cars and ever-increasing industrial automation. Downturns in sales of smartphones, chips and electronic components, again dating from 2018, seem to have been dismissed as aberrational ‘noise’ around a robustly, indeed an unquestionably upwards trend.

Once again, energy-based interpretation of the economy suggests that this is a combination of ‘continuity bias’ and unquestioned extrapolation, seemingly at very considerable variance from economic probability.

Stated at its simplest, if consumers become poorer, and rebalance their priorities accordingly, whilst businesses emphasise cost control and concentrate on simplification, the balance of probability swings against the assumed future of unending automation.

The ‘improbable’ versus the ‘impossible’

Many more examples could be cited, but let’s finish by applying an acid test to these questions.

If you believe in ‘a future of more’ (more cars, more flights, more automation and so on) – or are persuaded by the theory that we will witness a ‘recovery’ (of whatever duration) back to the prior growth trajectory – then it follows that the economy of the future is going to need more energy than the economy of the present.

On this basis, expert forecasters have projected global primary energy supply rising by 18% between 2019 and 2040, adding roughly 2,500 mmtoe to our annual requirement. The experts think they can find just over 70% of this required increase from a combination of nuclear, hydro and the various forms of renewable energy (RE). This leaves them (and us) needing an extra 720 mmtoe or so from fossil fuel (FF) sources. It’s assumed, not only that this can be found, but that doing so will increase annual emissions of climate-harming CO² from 34.2 million tonnes in 2019 to about 38.4 mmt by 2040.   

Meeting the required increment to fossil fuel supply means that, comparing 2040 with 2019, we’ll be using roughly 11% more oil, at least 30% more gas and roughly the same amount of coal. If you look realistically at the state of the FF industries, though, you can see that any such expectations are pretty implausible, not least because the delivery of such gains would require price increases that would move far beyond the affordable.

Here, then, is the conundrum. Meeting assumed economic needs in the future requires quantities of oil, gas and coal whose provision seems implausible. Faced with this, do we conclude (a) that we’ll somehow ‘find a way’ to supply this much additional energy, or (b) that the foundation growth assumption might itself be wrong?

That the experts are wrong about the size of the future economy may seem improbable, but logic suggests that supplying the required amount of additional fossil fuel energy looks very nearly impossible.

In this situation, we could do worse than reflect on the axiom of Sherlock Holmes – “[w]hen you have eliminated the impossible, whatever remains, however improbable, must be the truth”.