NOT GROCERIES, NOT WAGES – SYSTEMIC EXPOSURE

Right now, the outlook for inflation – or, conversely, for deflation – is one of the hottest topics of economic debate. Some observers contend that the sheer scale of financial intervention triggered by the coronavirus crisis has made soaring inflation inevitable. Others argue that, on the contrary, the weakness of the underlying economy makes deflation the greater risk.

The real threat, without a doubt, is inflation. This isn’t, though, going to be a re-run of the world’s last brush with hyperinflation in the 1970s and early 1980s.

Back then, soaring oil prices triggered sharp rises in consumer costs and an associated surge in wages. The problem now is that the financial system has out-grown the underlying economy to a dangerous extent. This means that hyperinflationary risk lies not in consumer prices, or in wages, but in the matrix of assets and liabilities created by an increasingly financialised economy.

What this also means is that conventional measures of inflation aren’t going to provide much, if any, forewarning of inflationary risk. This in turn is going to give policymakers every reason for not courting unpopularity by raising interest rates.

Rates will have to rise, of course, and the real prices of traded assets will fall, but it’s likely to be a case of slamming the policy door after the inflationary horse has bolted.

Two economies, one problem

This is an unusually complex issue, so we need to follow a clear analytical path to reach useful conclusions. The best way to start is by drawing a conceptual distinction between ‘two economies’ – a real economy of goods and services, and a financial economy of money and credit.

These ‘two economies’ have grown dangerously far apart. As we’ll see when we get into the numbers, the economy of goods and services had, even before 2020, been growing at barely 2% annually, whilst the financial aggregates of assets and liabilities had been expanding at rates in excess of 6%.

Prices act as an interface between these ‘two economies’, so it’s likely that inflation will mediate the restoration of equilibrium between the financial system and the underlying economy.

The fundamental issues are simply stated, and involve three essential principles.

First, nothing of any economic value or utility can be produced without the use of energy. This means that the economy is an energy system, and is not, as is so routinely and so mistakenly assumed, a financial one.

Second, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This ‘consumed in access’ component is known here as the Energy Cost of Energy (ECoE). Because this fraction of accessed energy is required for energy supply itself, it is not available for any other economic purpose. This means that surplus (ex-ECoE) energy is the basis of economic prosperity.

Third, money has no intrinsic worth. It commands value only as a ‘claim’ on the material or ‘real’ economy of goods and services.

With these principles understood, we can examine the ‘real’ economy (of goods, services and energy) and the ‘financial’ or ‘claims’ economy (of money and credit) independently of each other.

If, through monetary expansion, we create present or future financial claims which exceed what the underlying economy of today or tomorrow can deliver, the result is an overhang of excess claims. Since these excess claims cannot be honoured, they must, by definition, be destroyed.

Of assets and liabilities

Before we can get into the mechanics of where we are now, we need to be clear about the meaning of ‘assets’ and ‘liabilities’.

Let’s start with the ‘real’ economy, comprising governments, households and businesses. From this point of view, assets can be divided into two categories.

Defined or ‘formal’ assets are monetary sums, such as cash holdings, and money owed by others.

Equities, bonds and property are undefined or notional assets. Their aggregate ‘valuations’ are meaningless – these asset classes cannot, in aggregate, be monetised, because the only people to whom they could ever be sold are the same people to whom they already belong.

In fact, the prices of traded assets of stocks, bonds and property are an inverse function of the cost of money, so rises in these prices are a wholly predictable consequence of pricing money at low nominal (and negative real) levels.

Unless the authorities are prepared to countenance the hyperinflationary destruction of the value of money, its price – meaning rates – will have to rise.

This, in turn, must cause asset prices to plunge.

It’s axiomatic, though scant comfort, that the bursting of bubbles doesn’t, of itself, destroy value. Rather, it exposes the destruction of value that has already taken place during the period of malinvestment in which the bubble was created.

Furthermore, if the value of a house slumps, or a company’s share price crashes, the house and the company retain their underlying value or utility. The real problems created by an asset price crash are problems of collateral.

This is why our focus needs to be on liabilities rather than assets.

The nomenclature here can be a little confusing. Debts and other financial commitments are the liabilities of the government, household and business sectors, but they are the assets of the financial system itself. This is why, during the 2008-09 global financial crisis, non-performing or at-risk debts were known as “toxic assets”.

The crisis in figures

With these basics clarified, we can analyse trends in the ‘real’ and ‘financial’ economies. For this purpose, we’ll be looking at a group of twenty-three countries for whom comprehensive information is available. Between them, this group of countries accounts for three-quarters of the global economy, so can be considered representative of the overall situation.

As you can see in fig. 1, energy used in these economies increased by 49% between 2002 and 2019. Over the same period, however, their trend ECoE rose from 4.5% to 8.3%. Accordingly, surplus energy increased by 43%.

This was mirrored in a 39% increase in these countries’ aggregate prosperity. Throughout this period, rising ECoEs steadily undercut the rate of increase in prosperity. Accordingly, annual rates of growth in aggregate prosperity have fallen below the rate at which population numbers have continued to increase. This, as the centre chart shows, has resulted in a cessation of growth in prosperity per capita.

This has happened despite the inclusion in this group of China, India and ten other EM countries. In more complex, more ECoE-sensitive Western economies, prosperity per person turned down a long time ago. The average American has been getting poorer since 2000, the inflexion-point in Britain occurred in 2004, and Japanese prosperity per capita stopped growing back in 1997.

Critically, though, aggregates of financial claims have grown much more rapidly than the pedestrian expansion in aggregate prosperity. Between 2002 and 2019, when prosperity increased by 39%, debt grew by 136%, and non-debt financial assets by 234%.

The result, as shown in the right-hand chart, has been the insertion of an enormous wedge between financial claims and the underlying economy. If you wanted to find hyperinflationary risk on a map, this chart gives you the co-ordinates.

At constant values, the increase in prosperity during this period was $19 trillion. Debt expanded by $116tn, and total financial assets by $262n. In effect, then, each dollar of incremental prosperity was accompanied by $6 of net new debt and $7.60 of additional other financial assets.

This is a good point at which to remind ourselves that these ballooning financial “assets” are the liabilities of the ‘real’ economy of governments, households and businesses.

Fig. 1

The following charts amplify the picture by showing rates of change, in the real economy metric of prosperity, and in the debt and assets components of the financial economy. Annual growth in prosperity averaged just under 2% between 2002 and 2019, and has been on a declining trend. Financial assets, on the other hand, expanded at an annual average rate of 6.2%.

Fig. 2

To be sure, we haven’t – yet – seen a replication of the dramatic rates of expansion in financial commitments witnessed during the GFC. Now, though, the response to the coronavirus crisis is likely to have accelerated the pace at which we’re taking on financial obligations at the same time that prosperity has taken a beating.

The financial support provided by governments is only one part of the crisis picture. At the same time that governments have incurred enormous deficits to support the incomes of households and businesses, the granting of interest and rent ‘holidays’ has created enormous deferred financial obligations, which in our terms are ‘excess claims’.

Back in 2002, financial assets equated to 298% of prosperity. By the end of 2019, this ratio had expanded to 598%. Taking together both the pandemic hit to prosperity and the rapid expansion in financial commitments, it would be by no means surprising, pending final data, if this ratio was now in excess of 700%.

Ultimately, what we’ve been witnessing is a dramatic escalation in financial claims on what is now a contracting economy. This, rather than consumer price or wage pressure, is the source of the inflationary pressure that jeopardises the system.

How will we know?

As we’ve seen, then, inflation risk isn’t going to be flagged in advance by conventional measures such as CPI and RPI. These measures are sometimes criticised on the grounds that innovations such as hedonic adjustment, substitution and geometric weighting result in the understatement of changes in the cost of living. The big problem with these indices, though, is that they exclude both changes in asset prices and the effects of asset price changes.

The conventional broad-basis measure, the GDP deflator, is really no better than these consumer prices indices. In theory, system-wide inflation is meant to be captured by comparing a volumetric with a financial calibration of economic output. Like GDP itself, though, this deflator is subject to the cosmetic inflation of apparent ‘activity’ by the expansion of financial claims.

In an effort to measure comprehensive inflation, a system is under development, based on the SEEDS economic model and known as RRCI.

Preliminary indications are that RRCI averaged 4.1% through the period between 1999 and 2019, markedly exceeding a GDP deflator of just under 2%. This differential (of 220 bps) may not sound huge, but its application to a global economy said to have expanded at 3.4% through this period leaves precious little “growth”. Last year, estimated RRCI inflation worldwide was 5.5%, markedly higher than the GDP deflator (1.2%).

Preliminary data for 2020 indicates that RRCIs moved up dramatically in a small number of countries, such as Britain and Ireland, which also happen to be ultra-high-risk in terms of the relationships between their financial exposure and their underlying economies.

More broadly, RRCI suggests that systemic inflation has been rising markedly, both in the sixteen advanced economies (AE-16) and the fourteen EM countries (EM-14) covered by SEEDS.

Fig. 3

What and how?

Even RRCI, though, isn’t likely to give us a clear warning about the true magnitude of hyperinflationary risk. To get a handle on the scale and possible timing of this risk, we need to think about two issues. One of these is spill-over, and the other is futurity.

Where spill-over is concerned, the risk is that rises in the prices of traded assets may induce consumers to increase their recourse to credit in order to boost their spending to levels commensurate with their perception of increased wealth.

If someone’s home has increased in theoretical value from, say, $400,000 to $600,000, is there any reason why he or she shouldn’t ‘cash in’ part of that gain’ using secured or unsecured credit, which, in any case, remains cheap?

Likewise, is there any reason why a company whose stock price has soared shouldn’t go on an acquisition spree, preferably buying lower-rated companies to enhance ‘growth’ perceptions, and boost earnings per share?

These spill-over risks are additional to the basic risk of supply and demand imbalances in the market for everything from stocks and houses to classic cars and works of art.

The more fundamental issue, though, is futurity, which for our purposes means our collective or ‘consensus’ picture of the economic future. This is far too big a topic for detailed examination here. What it means, though, is that investors might favour seemingly costly stocks if they anticipate brisk growth in earnings; house-buyers may be prepared to bid up prices if they anticipate perpetual expansion in property markets; and lenders might be relaxed about extending loans to borrowers whose incomes, they assume, are going to grow markedly.

Despite the coronavirus crisis, faith in a ‘future of more’ seems unshaken, and there are assumed to be ‘fixes’ for all issues. The consensus assumption remains that everything from vehicle numbers and passenger flights to corporate earnings and automation are poised to go on growing indefinitely, and that there are technological solutions even for environmental risk and energy constraint.

Looking ahead, it isn’t difficult to see asset price inflation carrying over, first into consumer prices and then into wage demands. This is the point at which policymakers realise, belatedly, that policies of ultra-cheap money are, by their nature, inflationary.

The real risk, then, isn’t just that reactive (rather than anticipatory) rate rises cause asset prices to slump, but that these blows to confidence simultaneously expose the delusions of false futurity.

MAPPING THE STAGFLATION TRAP

Governments in general – and finance ministries in particular – face a tricky dilemma.

Simply stated, the dilemma runs like this. If governments don’t keep pouring liquidity into the economy, activity will slump, numerous businesses will collapse and voters will face extreme hardship.

But if they do carry on with gargantuan financial largesse they risk, not just a surge in inflation but, quite possibly, an associated rise in interest rates.

The only practicable line for finance ministers (and central bankers) to try to walk is a “Goldilocks” one, avoiding the extremes both of an overheating financial system and of an excessive cooling of the economy.

The theory is that, if they can tread this course adroitly, economies will enjoy the benefits of a return to growth, with inflation in due course falling back into a preferred range somewhere between 1% and 2%. If achieved, this would amount to a return to what was, in the 1990s, sometimes called “the great moderation”, describing a combination of solid growth and subdued inflation.

If conventional, ‘money-only’ economic interpretations were valid, it might just about be possible for them to walk this line – in reality more like a tightrope – and find solid ground on the other side of the crevasse opened up by the coronavirus crisis.

But energy-based interpretation reveals that no such solid ground exists. Rather, something not unlike stagflation has long been hard-wired into the system. Whilst global GDP expanded at a trend rate of 3.4% between 1999 and 2019, growth in underlying prosperity trended at only 1.25%, and has now ceased to grow at all. This disparity of itself suggests that broad inflation has long been far higher than reported levels.

None of this should really come as too much of a surprise. After all, pouring cheap credit and cheaper money into the system has been going on for more than twenty-five years, and energy-referenced analysis, as provided by the SEEDS model, reveals that this has done no more than disguise the reality that relentless rises in ECoEs (the Energy Costs of Energy) have put prior growth in material prosperity into reverse.

The aim here is to start by explaining the fiscal and monetary dilemma as it appears on the surface before moving on to use SEEDS analysis to explain why the problems are in fact both structural and insurmountable. In doing so, we need to refer to market expectations, which makes it appropriate to remind readers that this site does not provide investment advice, and must not be used for this purpose

Loaded for inflation

We should be clear that the balance right now is heavily tilted towards inflation. Throughout the coronavirus crisis, governments have been able to replace the incomes but not the output of idled workers and businesses.

This amounts to supporting demand at a time of extreme contraction in supply.

This is why we’re already seeing inflation spiking in a number of categories, affecting anything that might be in short supply during a vaccine-driven economic rebound. We can infer that official expectations are that this is a transitional effect, likely to ease as capacity is restored, and demand-side stimulus fades. Be that as it may, significant inflationary pressures are showing up across the board.

This perception may have influenced asset market participants, who have bought in to the “Goldilocks” plan but with a distinct bias towards the inflationary side of the equation.

If investors were to factor higher inflation into their calculations, we would expect them to favour those asset classes (such as equities and property) which could be counted on to – at the least – ride the rising inflationary tide. They would steer clear of cash, and be wary of bonds, because, in an inflationary climate, interest rates might rise enough to drive bond yields upwards (though not by enough to make cash a viable preference). They might look favourably on assets such as cryptocurrencies and precious metals which could be perceived as hedges against inflation.

This, by and large, is what has been happening. Markets, it seems, are expecting policymakers to ‘talk hard and act soft’, combining hawkish homilies about debt and inflation with a continuation of generous support for households and businesses.

This stance echoes the prayer of St. Augustine, who called on the deity to make him virtuous – “but not yet”.

Furthermore, investors, no less than the authorities, must be aware of the delayed price-tags attached to some of governments’ covid response initiatives. For instance, granting interest and rent “holidays” has inflicted substantial losses on counterparties such as lenders and landlords, and these costs must in due course be made good, unless we’re prepared to accept failures in counterparty sectors.

We should, then, anticipate some virtue-signalling tax rises which, in sum, amount to little more than small down-payments on the enormous costs of combating the pandemic. Not for nothing has inflation been called “the hard drug of the capitalist system” – it offers a beguiling short-term alternative to painful and unpopular adjustment to economic stresses.

The energy point meets the expectation bubble

Guided by conventional interpretation – whose faith in ‘perpetual growth’ is, as yet, unshaken by events or anomalies – governments and investors alike believe that there exists a ‘promised land’ which, if we can once reach it, combines real growth of at least 3% with inflation of less than 2%.

The fatal error on which this supposed nirvana is based is the belief that economics is nothing more than ‘the study of money’, such that energy and broader resource limits to material prosperity do not exist.

The reality, of course, is that everything (including other natural resources) which constitutes economic output is a product of the use of energy, whilst money is nothing more than a medium for the exchange of energy-enabled economic goods and services. The fly in this ointment isn’t that we might ‘run out of’ any form of primary energy, but that energy supply costs (measured as ECoEs) might undermine the dynamic by which energy is translated into economic value.

As regular readers know, the undermining of this energy dynamic is exactly what we’ve been experiencing over a protracted period. Global trend ECoE has risen from 2.6% in 1990 to 9.2% now. Along the way, this pushed prior prosperity growth in the advanced economies of the West into reverse from 2006 (at an ECoE of 5.7%), and is now doing the same to less complex, less ECoE-sensitive EM countries. There’s a whole raft of flaws in the thesis that we can transition, seamlessly and painlessly, from increasingly costly (and climate-harming) fossil fuels to renewable sources of energy.

The weakening energy dynamic is precisely why, globally, we’ve spent two decades borrowing $3 in order to deliver $1 of “growth”, and why the ratio of borrowing to GDP has averaged 9.6% to support “growth” of just over 3%.

We’re at the point now where, if they wish to sustain a simulacrum of ‘growth as usual’, the authorities will find it necessary to pour ever-increasing amounts of liquidity into the system. In so doing, they will be creating financial ‘claims’ on economic output that the economy of the future will be unable to meet at value.

At the point at which the ‘real’ economy of energy can no longer support even the illusory sustainability of the ‘financial’ economy of money and credit, the value supposedly contained in these financial “excess claims” will have to be destroyed. Whilst “hard” defaults cannot be ruled out, the balance of probability favours the “soft” default of rampant inflation.

Optimistic investors might, if they were aware of this, think that ‘real’ assets, like equities and property, can still maintain their real value by rising by at least as rapidly as inflation destroys the purchasing power of money.

This, though, is to ignore the effects of the involuntary de-growth induced by the decay of the energy dynamic. As prosperity recedes, consumers will be forced to choose between sinking into a quagmire of debt or adapting to the rising real cost of necessities by cutting back on discretionary purchases.

Whole sectors will suffer utilization rate erosion as prior gains from economies of scale go into reverse. De-complexification of the system will strip some sectors of critical mass, whilst simplification of products and processes will de-layer entire sub-sectors out of existence. Even the Fed cannot sustain the stock prices of businesses whose profitability has ebbed away.

It was once famously said that inflation is “always and everywhere a monetary phenomenon”. In our current situation, inflation is likelier to be a ‘denial phenomenon’, if we insist on trying, financially, to engineer “growth” when the critical energy equation is heading in the opposite direction.