MONEY, CREDIT AND THE DECLINE OF DISCRETIONARY PROSPERITY
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.
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%.
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.
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.
THE CONCLUSIONS OF THE SEEDS MAPPING PROJECT
What follows is one of the longest articles ever to appear here, and certainly one of the most ambitious. The aim is to take readers all the way through the Surplus Energy Economics interpretation of the economy, from principles and background, via energy supply and cost, to environmental implications, economic output and prosperity, and the circumstances and prospects of individuals, the financial system, business and government.
Because what follows includes some commentary on business, readers are reminded that this site does not provide investment advice, and must not be used for this purpose. It is, as ever, to be hoped that issues of politics and government can be discussed in a non-partisan way, and that the principle of “play the ball, not the man” can be respected.
The reason for presenting this synopsis at this time is that the second phase of the SEEDS programme – the mapping of the economy from an energy-based perspective – is now all but complete. Three components of this programme remain at the development phase, but provide sufficient indicative information for use here. One of these is the calculation of “essential” calls on household resources; the second is conversion from average per capita to median prosperity; and the third is the SEEDS-specific concept of the excess claims embodied in the financial economy.
SEEDS began as an investigation into whether it was possible to model the economy on the right principles (those of energy) rather than the wrong ones (that the economy is simply a financial system). It was always going to be essential that results should for the most part be expressed in monetary language, even though the model itself operates on energy principles.
With prosperity calibrated, it then made sense to extend the model into comprehensive economic mapping. Aside from the three components still in need of further refinement, this mapping project is now complete.
For the most part, mapping as presented here is global in extent, though some national and regional data is used. If SEEDS is to continue, a logical next step would be to extend the mapping process to individual economies.
Lastly, by way of preface, this article is the most comprehensive guide to SEEDS and the Surplus Energy Economy yet published here, and it would be marvellous if readers were to see fit to pass it on to others as a way of ‘spreading the word’ about how the economy really works.
Long before the coronavirus crisis, we had been living in a world suffering from a progressive loss of the ability to understand its own economic predicament. This lack of comprehension results directly from unthinking acceptance of the fundamentally mistaken orthodoxy that the economy is ‘simply a matter of money’.
If this were true – and given that money is a human artefact, wholly under our control – then there need be no obstacle to economic growth ‘in perpetuity’. This never-ending ‘future of more’ is nothing more than an unfounded assumption, yet it is treated as an article of faith by decision-makers in government, business and finance.
‘Growth in perpetuity’ is a concept which, though seldom challenged, is really an extrapolation from false principles. At the same time, those mechanisms which orthodox economics is pleased to call ‘laws’ are, in reality, nothing more than behavioural observations about the human artefact of money. They are not remotely equivalent to the real laws of science.
The fact of the matter, of course, is that the belief that economics is simply ‘the study of money’ is a fallacy, and defies both logic and observation. At its most fundamental, wholly financial interpretation of the economy is illogical, because it tries to explain a material economy in terms of the immaterial concept of money.
Logic informs us that all of the goods and services that constitute economic output are products of the use of energy. Other natural resources are important, to be sure, but the supply of foodstuffs, water, minerals and so on is wholly a function of the availability of energy. Energy is critical, too, as the link which connects economic activity with environmental and ecological degradation. Without access to energy, the environment would not be subject to human-initiated risk – and the economy itself would not exist.
Observation reveals an indisputable connection between the rapid material (and population) expansion of the Industrial Age and the use of ever-increasing amounts of fossil fuel energy since the first efficient heat-engines were developed in the late 1700s.
Two further observations are important here. The first is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. We cannot drill a well, build a refinery or a pipeline, construct wind turbines or solar panels, or create and maintain an electricity grid, without using energy. This ‘consumed in access’ component is known in Surplus Energy Economics as the Energy Cost of Energy, or ECoE.
The second critical observation is that money has no intrinsic worth, but commands value only as a ‘claim’ on the goods and services made available by the use of energy. Money can only fulfil its function as a ‘medium of exchange’ if there is something of economic utility for which an exchange can be made. Just as money is a ‘claim on energy’, so debt – as a claim on future money – is in reality a ‘claim on future energy’.
False premises, mistaken decisions
Critical trends in recent economic history can only be understood on the basis of energy, ECoE and exchange. ECoEs, which had fallen throughout much of the Industrial Age, turned upwards in the years after 1945 but, until the 1990s, remained low enough for their omission not to impose a visibly distorting effect on orthodox economic interpretation.
The point at which ECoEs became big enough to start invalidating conventional models was reached during the 1990s. The resulting phenomenon of economic deceleration was noted, and indeed labelled (“secular stagnation”), but it was not traced to its cause.
An orthodoxy resolutely bound to the fallacy of wholly financial interpretation naturally sought monetary explanations and monetary ‘fixes’. The idea that financial tools can overcome physical constraints can be likened to attempting to cure an ailing house-plant with a spanner. Its pursuit pushed us into ‘credit adventurism’ in the years preceding the 2008 global financial crisis, and then into the compounding and hazardous futility of ‘monetary adventurism’ during and after the GFC.
This has left us relying on false maps of a terrain that we do not understand. Almost all of our prior certainties have disappeared. We turned away from market principles by choosing financial legerdemain over market outcomes during 2008-09 and, at the same time, we abandoned the ‘capitalist’ system by destroying real returns on capital. The aim here is to present an alternative basis of interpretation that accords both with logic and with observation.
Beyond vacuous phrases which echo earlier certainties, governments no longer have ‘economic policies’ as such. Even the pretence of economic strategy was ditched when governments abdicated from the economic arena, and handed over the conduct of macroeconomics to central bankers. Asset markets have become wholly dysfunctional – they no longer price risk, and have been stripped of their price discovery function. The relationship between asset prices and all forms of income (wages, profits, dividends, interest and rents) has been distorted far beyond the bounds of sustainability.
Unless real incomes can rise – which is in the highest degree unlikely – asset prices must correct sharply back into an equilibrium with incomes that was jettisoned through the gimmickry of 2008-09. Efforts to prevent asset price slumps can only add to the strains already inflicted upon fiat currencies.
Ultimately, our manipulation of money has had the effect of tying the viability of monetary systems to our ability to go on ignoring and denying the realities of an economy being undermined by a deteriorating energy dynamic.
The energy driver
Our analysis necessarily starts with energy, a topic covered in more detail in the previous article. The informed consensus position, immediately prior to the coronavirus crisis, was that total energy supply would continue to expand, increasing by about 19% between 2018 and 2040.
Within this overall trajectory, renewable energy sources (REs) would grow their share of primary energy use, and the combined contributions of hydroelectric and nuclear power, too, would expand.
Even so, it was projected that quantities of fossil fuels consumed would rise, with about 10-12% more oil, 30-32% more natural gas, and roughly the same amount of coal being used in 2040 as in 2018.
These consensus views were (and in all probability still are) starkly at variance with a popular narrative which sees us replacing most, perhaps almost all, use of fossil fuels by 2050. The rates of RE capacity expansion that the popular narrative implies would require vast financial investment and, more to the point, would call for a correspondingly enormous amount of material inputs whose availability is, for the foreseeable future, dependent on the continuing use of fossil fuels.
SEEDS uses an alternative energy scenario which projects a decline in the supply of fossil fuels, a trajectory dictated by the rising ECoEs of oil, gas and coal. Essentially, the costs of supplying oil, gas and coal have already risen to levels above consumer affordability. The SEEDS scenario anticipates a pace of growth in RE supply which, whilst outpacing the 2019 consensus, necessarily falls short of a popular narrative which is as weak on practicalities as it is strong on good intentions.
The result of this forecasting is that the total supply of primary energy is unlikely to be any larger in 2040 than it was in 2018.
What this in turn means is that energy supply per person will decline. Such a downturn has only been experienced twice (to any meaningful extent) in the Industrial Age – once during the Great Depression of the 1930s, and again during the oil crises of the 1970s.
Neither of these downturns was physical in causation – they resulted from mismanagement, rather than changes in energy supply fundamentals – but both were associated with serious economic hardship and severe financial dislocation. Furthermore, what happened in the 1930s and the 1970s wasn’t really a downturn but, rather, no more than a pause in the upwards trajectory of energy use per person.
These parameters are illustrated in Fig. A. All of the charts used here can be enlarged for greater clarity, and all of them are sourced from the SEEDS mapping system.
It will be appreciated, then, that we have entered a phase – of declining energy availability per person – which can be expected to have a profoundly adverse effect on economic well-being and financial stability.
These effects will be compounded by a relentless rise in ECoEs that is most unlikely to be stemmed by the volumetric expansion of REs As we shall see, prosperity per person turned down at ECoEs of between 3.5% and 5.0% in the advanced economies of the West, and at rather higher (8-10%) thresholds in EM (emerging market) countries. But we cannot realistically expect that the ECoEs of wind and solar power will fall much below 10%. This means that they cannot replicate the economic value delivered by fossil fuels in their heyday.
Accordingly, surplus energy per person – that is, the aggregate amount of energy less the ECoE deduction – is set to decline, and would do so even if the over-optimistic consensus projection for aggregate energy supply could be realised.
Anticipated trends in ECoEs and the availability of surplus energy are summarised in Fig. B.
Cleaner, but poorer
This does at least mean that annual emissions of climate-harming CO² can be expected to decrease. Unfortunately, this welcome trend will be a function, not of a seamless transition to an RE-based economy, but of deteriorating prosperity.
On the SEEDS energy scenario, annual emissions of CO² are likely to fall by 10% between 2019 and 2040, rather than rising by about 11% over that period. This, however, will correspond to a projected decline of 27% in global average prosperity per capita.
Some of the environmental projections that emerge from SEEDS mapping are set out in Fig. H. It need hardly be said that the relationship between the economy and the environment cannot meaningfully be interpreted until energy, rather than money, is placed at the centre of the equation.
Promises of a cleaner future are realisable, then, but assurances of a cleaner future combined with sustained (let alone growing) material prosperity are not.
When we note that each dollar of reported economic expansion between 1999 and 2019 was accompanied by the creation of $3 of net new debt – and that GDP “growth” of 3.2% was supported by annual borrowing averaging 9.6% of GDP – we are in a position to appreciate that most (indeed, almost two-thirds) of all reported increases in GDP over the past two decades have been the cosmetic effect of credit and monetary expansion. If credit expansion were ever to cease, rates of growth in GDP would fall to barely 1.0% – and, if we ever tried to roll back prior credit expansion, GDP would fall very sharply.
Stripping out the credit effect enables us to identify a “clean” rate of growth in economic output that turns out to have averaged 1.4% (rather than the reported 3.2%) during the twenty years preceding 2019. As can be seen in Fig. C, the driving of a “wedge” between debt and GDP has inserted a corresponding wedge between GDP itself and its underlying or “clean” (C-GDP) equivalent.
With underlying economic output established, prosperity – both aggregate and per capita – can be identified through the application of trend ECoE. This reflects the fact that ECoE is the component of energy supply which, being consumed in the process of accessing energy, is not available for any other economic purpose. In terms of their relationships with energy, C-GDP corresponds to total energy supply, whilst prosperity corresponds to surplus (ex-ECoE) energy availability. SEEDS identifies the ratio at which energy use converts into economic value, and applies ECoE to establish the relationship between energy consumption and material prosperity.
As well as providing our central economic benchmark, the calibration of prosperity enables us to establish the relationship between material well-being and trends in ECoE. In Western advanced economies, SEEDS analysis shows that prosperity per capita turned down at ECoEs of between 3.5% and 5.0%. In the less complex, less ECoE-sensitive EM countries, the corresponding threshold lies between ECoEs of 8% and 10%.
These relationships, identified by SEEDS, are wholly consistent with what we would expect from a situation in which energy costs are linked directly to the maintenance costs of complex systems.
Illustratively, prosperity per capita in the United States turned down back in 2000, at an ECoE of 4.5% (Fig. D). Chinese prosperity growth appears to have gone into reverse in 2019, at an ECoE of 8.2%, though, had it not been for the coronavirus crisis, the inflection point for China might not have occurred until the point – within the next two or so years – at which the country’s trend ECoE rises to between 8.7% (2021) and 9.1% (2023).
Globally, average prosperity per person has been flat-lining since the early 2000s, but has now turned down in a way that means that the “long plateau” in world material prosperity has ended.
This conclusion is wholly unidentifiable on the conventional, money-only basis of economic interpretation.
The identification of aggregate prosperity enables us to recalibrate measurement of financial exposure away from the customary (but wholly misleading) denominator of GDP. Four such calibrations are summarised in Fig. E.
Conventional measurement states that world debt rose from 160% to 230% of GDP between 1999 and 2019 – essentially, a real-terms debt increase of 177% was moderated by a near-doubling (+95%) of recorded GDP, leaving the ratio itself higher by only 42% (230/160).
This, though, is a misleading measurement, because it overlooks the fact that GDP was itself pushed up by the breakneck pace of borrowing.
Rebased to aggregate prosperity – which was only 28% higher in 2019 than it had been in 1999 – the ratio of debt-to-output climbed from 168% to 363% over that same period. Preliminary estimates for 2020 suggest that an increase of around 10% in world debt has combined with a 7.4% fall in prosperity to push the ratio up to 430%.
The second measure of financial exposure generated by SEEDS relates prosperity to the totality of financial assets. SEEDS uses data from 23 of the countries for which financial assets information is available, countries which together equate to just over 75% of the world economy,
On this basis, systemic exposure has exploded, from 326% of prosperity in 2002 (when the data series begin) to 620% at the end of 2019. Extraordinarily loose fiscal and monetary policy during 2020 suggests that this ratio may already exceed 730% of prosperity.
Gaps in pension provision are a further useful indicator of financial unsustainability. Back in 2016, the World Economic Forum calculated pension gaps for a group of eight countries – Australia, Canada, China, India, Japan, the Netherlands, Britain and America – at $67tn, and projected an increase to more $420tn by 2050.
Converting these numbers from 2015 to 2019 values, and then expressing their local equivalents in dollars on the PPP (purchasing power parity) rather than the market basis of exchange rates, puts the number for the end of 2020 at $112 trillion, which equates to 290% of the eight countries’ aggregate prosperity (and 180% of their combined GDPs). Pension gaps are growing at annual rates of close to 6%, a pace that not even credit-fuelled GDP – let alone underlying prosperity – can be expected to match.
The fourth measure of financial exposure produced by SEEDS is specific to the model. As we have seen, monetary systems embody ‘claims’ on a real (energy) economy that has grown far less rapidly than its financial counterpart. This has resulted in the accumulation of very large excess claims.
Calibration of this all-embracing measure, which is known in the model as E4, remains at the development stage. Indicatively, though, it informs us that the world has been piling on financial claims that cannot possibly be met ‘at value’ from the economic prosperity of the future.
From this it can be inferred that a process of systemic ‘claims destruction’ has become inevitable, suggesting that the process known conventionally as ‘value destruction’ cannot now be prevented from happening at a systemically hazardous scale. The most probable process by which this will happen is the degradation of the value of money, meaning that claims can only be met with monetary quantities whose purchasing power is drastically lower than it was at the time that the claims were created.
Measurement of excess claims forms part of a SEEDS national risk matrix which combines purely financial exposure with a number of other factors, one of which is ‘acquiescence risk’. This calculation references growing popular dissatisfaction induced by deteriorating overall and discretionary prosperity.
The ultimate purpose of economics is, or should be, the measurement, interpretation and (where possible) the betterment of the prosperity of the individual. Situations and projections can be expressed either as an average per capita number, or in amounts weighted to the median on the basis of the distribution of incomes. Average calibration is the primary focus of the model, but a new SEEDS capability (‘FW’) – being developed in response to reader interest in this subject – provides some insights into distributional effects.
As we have seen, the prosperity of the average person has been on a downwards trend in almost all of the Western advanced economies since well before the 2008 GFC. In ‘top-level’ prosperity terms, however, declines thus far have appeared pretty modest, even in the worst-affected countries – in 2019, British citizens were 10.4% poorer than they had been in 2004, with Italians poorer by 10.2% since 2001, and Australians worse off by 10.0% since 2003.
But top-line prosperity, like income, isn’t ‘free and clear’ for the individual to spend as he or she sees fit. Rather, prosperity is subject to prior calls, of which “essentials” are the most significant. Only after these essential outlays have been deducted do we arrive at the average person’s discretionary prosperity, meaning the resources that he or she can use to pay for things that they “want, but do not need”.
Measurement of discretionary prosperity produces rates of decline that are much more pronounced, and are distributed differently between countries, than the equivalent top-line calibrations. British citizens have again fared worst, seeing their discretionary prosperity fall by 32% between 2000 and 2019. The average Spaniard had 26.7% less discretionary prosperity in 2019 than he or she enjoyed back in 1999, whilst the decline in the Netherlands (also since 1999) was 26.5%. This decrease in the value of the discretionary “pound (or dollar, or euro, or yen) in your pocket” correlates directly to rising indebtedness and worsening insecurity, but does so in ways that are not recognised by policy-makers tied to conventional interpretation.
Of course, discretionary consumption has, at least until quite recently, continued to increase, even though discretionary prosperity has fallen. The difference between the two equates to rising per-person shares of government, business and household debt.
Calibration of discretionary prosperity obviously requires measurement of the cost of “essentials”. As mentioned earlier, this is one of the three components of the SEEDS mapping system that are still subject to further development. The conclusions which follow should, therefore, be regarded as indicative.
For our purposes, “essentials” are defined as those things that the individual has to pay for. This means that “essentials” include two components. One of these is household necessities, and the other is government expenditure on public services. These services qualify as “essentials” on the “has to pay for” definition, whatever the individual might happen to think about the services which he or she is obliged to fund. The government component of “essentials” relates only to public services, and does not include transfers (such as pension and welfare payments), which simply move money between people and so wash out to zero at the aggregate or the per capita level of calculation.
SEEDS analyses of prosperity per capita are summarised in Fig. F. In the AE-16 group of advanced economies, taxation (and transfers), being more cyclical, have tended to fluctuate more than spending on public services.
Together, the two components of “essentials” have moved up in real terms, even as prosperity has deteriorated, exerting a tightening squeeze on discretionary prosperity. Because of the credit effects which are interposed between GDP and prosperity, this squeeze cannot – despite its profound commercial, financial and political implications – be identified by conventional interpretation. It can be corroborated, though, by analysis of per capita indebtedness and of broader financial commitments.
As the charts show, relatively modest declines in the overall prosperity of citizens in America, Britain and Japan are leveraged into much sharper falls in their discretionary prosperity.
The median individual
Of course, a country’s ‘average’ person is a somewhat theoretical figure, and one of the remaining SEEDS development projects addresses weighting for the difference between the average and the median person.
Because data for income distribution is intermittent, median prosperity per person is illustrated as dashed red lines in Fig. FW. These charts compare median with average prosperity per capita in four countries, and include the household (but, as yet, not the public services) component of “essentials”.
They show a comfortable margin in comparatively egalitarian Denmark (though the cost of public services in Denmark is relatively high). America remains a “rich” country – albeit less rich than she once was – in which household necessities remain affordable within the prosperity of the median person or household. But the situation in South Africa – and even more so in Brazil – must give rise to considerable concern.
Obviously enough, the compression being exerted on discretionary prosperity is of great importance to businesses, which are in danger of working to false premises when they rely on the promise of ‘perpetual growth’ provided by orthodox economic interpretation. Companies in discretionary sectors may not realise the extent to which their fortunes are tied to the continuity of credit and monetary expansion.
There are two critical (and related) points of context here. The first is that, as societies become less prosperous, they will also become less complex, rolling back much of the increase in complexity that has accompanied the dramatic economic growth of the Industrial Age. The second is that the proportion of prosperity subject to the prior calls of essentials will rise.
A logical outcome of de-complexification is simplification, both of product ranges and of supply processes. This will be accompanied by de-layering, whereby some functions are eliminated.
Two further factors which can be expected to change the business landscape are falling utilization rates and a loss of critical mass. The former occurs where a decline in volumes increases the per-customer (or unit) equivalent of fixed costs. Efforts to pass on these increased unit costs can be expected to accelerate the decline in customer purchases, creating a downwards spiral.
Critical mass is lost when important components or services cease to be available as suppliers are themselves impacted by simplification and utilization effects. It is important to note that falling utilization rates and a loss of critical mass can be expected to occur in conjunction with each other, combining to introduce a structural component into future declines in prosperity.
These considerations put various aspects of prevalent business models at risk, and this should be considered in the context both of worsening financial stress and of deteriorating consumer prosperity. One model worthy of note is that which prioritizes the signing up of customers over immediate sales. Previously confined largely to mortgages, rents and limited consumer credit, these calls on incomes now extend across a gamut of purchase and service commitments which can be expected to degrade as consumer prosperity erodes. This has implications both for business models based on streams of income and for situations in which forward income streams have been capitalized into traded assets.
The SEEDS database reveals a striking consistency between levels of government revenue and recorded GDP. In the AE-16 group of advanced economies, government revenues seldom varied much from 36-37% of GDP over the period between 1995 and 2019. Accordingly, government revenues have expanded at real rates of about 3.2% annually. We can assume that similar assumptions inform revenue expectations for the future.
As we have seen, though, reported GDP has diverged ever further from prosperity, meaning that there has been a relentless increase in taxation when measured as a proportion of prosperity. In the AE-16 countries, this ratio has risen from 38% in 1995 to 49% in 2019, and is set to hit 55% of prosperity by 2025 based on current trends (see Fig. G4A).
It is reasonable to suppose that, as prosperity deterioration continues, as the leveraged fall in discretionary prosperity worsens, and as indebtedness starts to hit unsustainable levels, the attention of the public is going to focus ever more on economic (prosperity) issues. Politically, this means that what has long been a broad ‘centrist consensus’ over economic and political issues can be expected to fracture.
We can further surmise, either that the ‘Left’ in the political spectrum will revert towards its roots in redistribution and public ownership, and/or that insurgent (‘populist’) groups will campaign on issues largely downplayed by the established ‘Left’ since the ‘dual liberal’ strand emerged as the dominant force in Western government during the 1990s.
In practical terms, governments may need to adapt to a future in which deteriorating prosperity changes the political agenda whilst simultaneously reducing scope for public spending.
A ‘wild card’ in this situation is introduced by the likelihood that the deteriorating economics of energy supply may connect with the ECoE effect on the cost of essentials to create demands for intervention across a gamut of issues. These might include everything from subsidisation (and/or nationalisation) of essential services to control over costs, with energy supply and housing likely to be near the top of the list of demands for government action.
These considerations on the challenges facing governments bring us to the end of what can only be an overview of the economic situation as presented by the SEEDS mapping project.
What has been set out here is a future, conditioned by energy trends, which is going to diverge ever further from what is anticipated both by decision-makers and by the general public. The view expressed here is that, to shape a better and more harmonious world as the prior drivers of cheap energy and increasing complexity go into reverse, it is a matter of urgency that the real nature of the economy as an energy dynamic should gain the broadest possible recognition.
WHY THE RENMINBI COULD BE ‘THE LAST FIAT STANDING’
“It’s easy to be the last man standing – if all the others commit suicide”.
Although this isn’t one of the sayings of Confucius, it applies now with particular force to the Chinese renminbi – after all, to what currency, other than the RMB, can the world turn when each of its major rivals seems determined on self-immolation?
In Britain and America, economic and financial policy have long had all the hallmarks of self-destructive intent. Both countries believe that it makes sense to ship value-productive industries (such as manufacturing) out to lower-cost countries overseas, whilst trying to turn themselves into low-wage economies whose main profitable activity involves moving money around. The UK has driven debt upwards relentlessly, for the sole and senseless purpose of buttressing property prices which have already been over-inflated far beyond the point of affordability. America has binged on credit in an equally self-destructive effort to replace shock-absorbing corporate equity with inflexible debt, the result being a stock market which has become nothing more than a proxy for Fed monetary largesse.
Both countries seem now to have been driven to the point of policy despair. The American government is bent on injecting yet another $1.9 trillion of borrowed-out-of-nowhere money into the economy, whilst the Bank of England seems to be giving serious consideration to committing a symbolic currency surrender through the introduction of negative nominal interest rates. Both are deluding themselves about the real condition of their economies, with Britain, at least, seemingly persuaded that all will be well if consumers can only be induced to go on a spending-spree with money that they don’t have.
Britain and America have been described as “two countries divided by a common language”, but the operative definition now is that they are united in a shared commitment to economic fanaticism. It’s one thing to believe, mistakenly, that the economy is a wholly monetary system unconstrained by natural resources, but quite another to believe, as well, that the road to prosperity lies through the perpetual spending of borrowed and newly-created money.
Donald Trump may have coined the phrase “Make America Great Again”, but nobody can beat the British authorities when it comes to fatuous slogans. First there was the abolition of “boom and bust” during the biggest asset bubble in history. Next came “help to buy”, whose real meaning was ‘help young people to get deeply into debt to prop up the housing market’. Original thinking may be at a premium in Britain’s corridors of power, but the slogans keep coming.
In current circumstances, there’s something almost prurient in using the energy-based SEEDS economic model to evaluate the British and American economies, so let’s keep this brief. In the United States, prosperity per person turned down twenty years ago, falling from $48,850 (at 2019 values) in 2000 to $45,460 in 2019. Over that period, each person’s share of government, corporate and household debt rose, again at constant values, from $96,000 to $163,000. The ratio of debt to prosperity in America had risen to 360% at the end of 2019 – and probably at least 425% now – from 196% back in 2000. Government expenditures, on a per capita basis, rose by nearly $6,000 (37%) over a period in which prosperity per person declined by $3,240 (-6.6%).
Estimates for 2020 suggest that the prosperity of the average American declined by 8% last year, with only the most modest recovery in prospect before the gradual – but relentless – downtrend resumes. Using fiscal and monetary policy to boost financial demand whilst the supply of prosperity erodes is a recipe for inflation.
Financial recklessness is something in which Britain is fully competitive with the United States. Prosperity per person turned down later in the UK than in America, but has deteriorated more rapidly, falling by 10% between 2004 (£26,280) and 2019 (£23,560). Over the same period, debt per capita rose by £23,000 (38%) in real terms, and public expenditures per person by 14%. Worse still, British exposure to the global financial system, as of the end of 2019, stood at 10.8x GDP, equivalent to 15.2x prosperity. Aside from Ireland and Holland (both of which are far smaller economies), anyone in search of more extreme exposure to the world financial system would have to look at financial asset ratios in tiny economies like Singapore and the Cayman Islands.
This is the situation in which Washington is committing itself to yet more borrowed stimulus, whilst London thinks it makes great sense to proceed with a vastly expensive new rail project, together with anything else that can absorb huge amounts of money that can be conjured out of the ether, quite possibly at the cost of even more saver-punitive rates of interest.
Neither the US nor the UK seems to realise that boosting demand (through stimulus) at a time when you can do little or nothing to replace lost supply is an implicitly inflationary form of behaviour. Both Britain and America have multi-trillion gaps in future pension provision, which we can estimate at about £8tn in the UK, and $37tn in the US. Both have student debt on which large-scale default (politely known as ‘forgiveness’) seems highly likely. Neither government seems to realise that granting rent and debt payment ‘holidays’ creates huge strains for lenders and landlords. Both are watching their commercial property sectors spiralling into an abyss. In an ominous portent of the shape of things to come, the British regulator has now approved an increase of 9% in the ceiling on the combined cost of domestic gas and electricity.
If, just for a moment, we put tact aside, we can remind ourselves that Britain (with its obsession with “light-touch” regulation) and America (with the creation of “weapons of financial mass destruction”) were the main architects of the “global” financial crisis. Both now favour a “reset”, seemingly unaware that the opportunity to reset the system came – and went – during 2008-09. That was when adherence to market principles would have preserved monetary credibility at the cost of sharp falls in the (purely notional) prices of assets such as stocks and property.
To be sure, this would have been accompanied by defaults, which would have been very costly to remedy. Even so, recapitalisation of the banking system might have been cheaper than what has happened since, and what still lies in the future – after all, the debts which were kept in the ‘performing’ category in 2008-09 are no more capable of repayment now than they were back then.
It would have been far better, of course, if neither Britain nor America had embarked on the preceding, decade-long debt binge without which the GFC wouldn’t have happened at all.
The situation now is one in which both countries have handed themselves over to the theory of the magic money tree, seemingly unaware that money itself commands value only as a ‘claim’ on the goods and services for which it can be exchanged. The recipe of ‘produce less, spend more, and delude ourselves by inflating asset prices’ has never been a formula for success. An objective observer, perhaps visiting from a distant planet, would see no logic whatsoever in owning American dollars or British pounds. Both countries seem to have persuaded themselves that soaring stock and property prices aren’t signs of systemic inflation, and don’t understand that pouring new credit and new money into faltering economies can have only one possible outcome.
If our interplanetary visitor was looking for a viable alternative to USD and GBP, he or she might be tempted by EUR or JPY. Neither, though, really holds up under objective scrutiny. The euro is a political dream-currency, built on the economically-illiterate idea that one can combine a single, “one size fits all” monetary policy with nineteen different sovereign budget processes. This means that the role normally played within currency areas by ‘automatic stabilisers’ has to be filled by contentious, ad-hoc aid and a dysfunctional clearing system. Even before the onset of the pandemic crisis, the BoJ had used newly-created money to buy up more than half of all JGBs (Japanese government bonds) in existence, to the effect that central bank assets already exceeded 100% of GDP by the end of 2017.
During 2020, it seems that QE equated to about 29% of prior-year GDP in Japan, 25% in the Euro Area, 15% in the United States and 14% in Britain, for an average of 20%, which compares with barely 3% in China. We can be certain that there’s a lot more money creation to come from the Fed, the BoE, the ECB and the BoJ – but not from the PBOC.
With the US and the UK seemingly bent on “print to oblivion”, the EUR resembling the financial equivalent of a camel (“a horse designed by a committee”) and Japan deeply committed to ‘monetisation to the nth degree’, our imaginary visitor from outer space might seem to be running out of options. Having rejected cryptos – and after casting a considering eye at precious metals – his or her choices seem to have narrowed to just one.
That “last fiat standing” is the renminbi.
It seems quite clear that China, alone amongst the major currency areas, is committed to sound money. Beijing appears determined to mute the siren calls of Anglo-American style financial “innovation”, and even to allow SOEs to default at scale, if that’s the price that sound money now carries.
OF WEDGE AND EXCESS
If the world economy is – as both logic and observation indicate – heading into involuntary ‘de-growth’, there is a choice to be made. Do we enter the era of economic contraction with a functioning monetary system available to help us manage it, and to mitigate its worst effects? Or do we sacrifice monetary viability in a futile effort at denial?
The former might be a great deal more rational, but probability increasingly favours the latter.
The coronavirus pandemic has not so much created as accelerated tendencies towards the use of financial expansion as a cure-all for both real and imagined economic ills. This puts two facets of monetary observation into conflict. On the one hand, we know that fiscal and monetary stimulus can help us to moderate economic downturns. On the other, though, we also know that too much monetary intervention carries the risk of undermining the all-important credibility of fiat money.
If ‘too much debt’ is one risk, ‘too much monetization of debt’ is another, and both seem to have gone into overdrive since the start of the coronavirus crisis. SEEDS data and estimates indicate that, during 2020, a group of sixteen advanced economies (AE-16) are likely to have run fiscal deficits of about $8.8 trillion, or 20% of their combined GDPs, a figure pretty much matching the $8.9tn that the four main Western central banks deployed in net asset expansion (QE) during the year.
Even if vaccination does indeed quickly bring the pandemic under control, continuing fiscal intervention – and the need to alleviate burdens placed on lenders and landlords by debt and rent payment ‘holidays’ – imply further big increases in public debt, and central bank monetization, during the current year.
Does this put the viability of fiat money itself at risk?
It’s certainly starting to look that way.
Not measured, not managed
Part of the problem is that orthodox economic interpretation cannot quantify what “too much” monetary intervention actually means. In the absence of such calibration, the authorities are at the mercy of short-term thinking and political pressures. Accordingly, those who express dark forebodings about the fate of fiat in a context of unprecedented financial intervention may very well be right.
The original intention here had been to concentrate wholly on monetary issues. But the better plan is to locate the role of money within broader economic processes, and then to ask whether there can be better calibration of the concept of monetary “excess”.
The conclusion reached here is that we can use energy-based measurement of prosperity as an independent benchmark against which to measure the economic claims embodied in the financial system. This measurement indicates that we have already travelled too far down the road of creating excess claims to turn back without making enormous, hugely unpopular adjustments to the system.
As the old saying goes, “if it isn’t measured, it isn’t managed”. This describes our current monetary predicament very well indeed – if credit creation and monetary policy seem out of control, the lack of meaningful measurement is a major factor in what has become an unmanaged problem.
The inability of monetary measurement to calibrate “excess” in a meaningful way is a consequence of the use of equations whose components are not discrete (that is, they are not independent of each other).
The often-used ratio which compares debt with GDP is a case in point. If, for instance, additional credit is put into the economy, the effect is to increase the economic activity that is counted as GDP, meaning that both the numerator (debt) and the denominator (GDP) are inter-connected. Indeed, and in situations where the debt/GDP ratio already exceeds 100% – where, that is, debt already exceeds GDP – it is perfectly possible for a rise in the quantity of debt to cause a fall in the ratio between debt and GDP. This results in a systemic underestimation of the proportionate extent of debt, a process of understatement which becomes more pronounced as indebtedness increases.
In this knowledge vacuum – in which the term “excessive” cannot be defined – decision-makers find it very hard to resist pressures for ever more fiscal and monetary intervention. Those urging support, whether for their own sector or for the economy as a whole, can call in aid Keynes’ observations about stimulus, omitting to add that the Keynesian calculus addresses the smoothing of cycles, not a perennial stimulation of economic activity on a continuing basis, and envisages periods of financial tightening which offset periods of stimulus.
As remarked earlier, it’s likely that fiscal stimulus injected into sixteen Western economies totaled 20% of their combined GDPs last year, and may be of the order of 10% in 2021, with the former number essentially monetized by central bank money creation. This, on the face of it, looks like “excess”.
So at what point, then, does financial intervention become “excessive”? Conventional ratios such as debt/GDP cannot tell us this, and neither, in a market distorted by huge intervention, can interest rates answer this question either. Another non-discrete measure – that which compares asset prices with liabilities – cannot help us to know where the “point of excess” lies. For various reasons – which include the conventional exclusion of asset prices from the calculation of inflation – we can’t even rely on inflation numbers for warning that the point of excess looms.
A claim on energy – the real meaning of money
To understand these issues, we need first to place money in its economic context. Conventional explanation ascribes three roles to money. One of these is as store of value, a function which fiat currencies cannot, historically, be said to have fulfilled. A second is that money can be used as a unit of measurement, but this, as we’ve seen, is an extremely flawed concept, primarily because there exist no recognized non-monetary benchmarks against which monetary numbers can be measured. This leaves us with the third – actually, the all-important – function of money, which is as a “means of exchange”.
Of “exchange”, though, for what? Clearly, the only meaningful process of exchange is one which involves the use of money to buy goods and services. This in turn defines money as a ‘token’. As such, money has no intrinsic worth, meaning that it commands value only in terms of the things for which it can be exchanged. This is why, in Surplus Energy Economics, money is defined as a ‘claim’ on goods and services.
Money can usefully be likened to the ticket or ‘check’ given to a person handing in a hat or coat when attending an event. Printing more of these checks doesn’t increase the number of hats or coats available when the exchange process is reversed at the end of the function. Likewise, the ‘check’ cannot, of itself, keep its owner warm or dry – for this, it needs to be exchanged for an actual (physical) coat or hat.
With due apologies to those who already know this, the role of money as claim is one of the three core principles of the surplus energy economy. The first of these is that all of the goods and services which constitute economic output are products of the use of energy, such that nothing of any economic utility whatsoever can be supplied without it. This defines money as a ‘claim on energy’, with the corollary being that debt, as a ‘claim on future money’, really functions as a ‘claim on future energy’.
The second core observation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. We can’t put oil to use without drilling a well or building a refinery, access gas without investing in wells and processing systems, make use of coal without excavating a mine, or harness solar or wind power without constructing solar panels, wind turbines and distribution systems. All of these processes are themselves functions of the use of energy. The “used in access” component is known here as ECoE (the Energy Cost of Energy).
This enables us to refine our definitions, such that money is ‘a claim on surplus (ex-ECoE) energy’, and debt ‘a claim on future surplus energy’. A logical question to ask ourselves is: what has happened to money, debt and broader obligations, in relation to surplus energy, in recent times?
Comparing 2019 with 1999, and using financial data adjusted for inflation, money GDP expanded by 95%, and debt by 177%, over a period in which global surplus energy increased by less than 50%. Throughout this period, these ratios became progressively worse.
What this means for underlying economic output, and its relationship with debt, is illustrated in the following charts. Since the mid-1990s, aggregate global debt (shown in red in the left-hand chart) has expanded far more rapidly than reported GDP. The central chart shows how, expressed at constant 2019 values, annual borrowing (in red) has been far larger than increments to GDP (blue).
The right-hand chart shows how the development of a ‘wedge’ between debt and GDP has inserted a corresponding wedge between reported GDP and underlying or ‘clean’ output (C-GDP).
This interpretation is wholly ignored by orthodox approaches, which fail to recognize the connection between the non-discrete (that is, the connected) entities of debt and reported GDP. Properly understood, though, the ‘wedge’ concept can provide important insights into the way in which the interaction between debt and GDP distorts both the real level of economic output and the extent of leverage built in to the system.
Prosperity as process
The identification of ECoE divides the supply of energy into two components. One of these is the cost element (ECoE), and what remains is surplus energy. Since this surplus energy powers all economic activity other than the supply of energy itself, surplus energy is coterminous with the material prosperity delivered by the economy. If monetary measurement of the economy departs in any meaningful way from this definition of prosperity, we can be said to be practicing financial self-delusion.
Though ignored by orthodox economics, the ECoE process is reasonably well understood. In the early stages, ECoEs are driven downwards by geographic reach, economies of scale and advances in technology, with the proviso that the scope of technology is circumscribed by the physical characteristics of the energy resource. In the case of fossil fuels – which continue to supply more than four-fifths of global primary energy consumption – the potential of reach and scale has been exhausted, introducing depletion as the primary (and upwards) driver of ECoEs. The meaning of depletion is that, quite naturally, we have used lowest-cost sources of oil, gas and coal first, leaving costlier alternatives for a “later” which has now arrived. Technology can mitigate the ensuing rise in ECoEs, but cannot overturn the laws of physics such as to push ECoEs back downwards.
This has always meant that the end of fossil-fuel-powered economic growth wasn’t going to be a matter of “running out of” oil, gas or coal, but of encountering rising costs (ECoEs) which erode the economic value of each unit of energy accessed. Cost and volume parameters are interconnected, of course, so that rising costs must inevitably, in due course, result in decreasing volumes.
The great hope, reinforced by urgent environmental imperatives, is that we can replace rising-ECoE fossil fuels with falling-ECoE renewable sources of energy (REs). Imperative though the development of RE capacity is, some of the more glib assurances of seamless transition have always been something of a triumph of hope over analysis.
There are two main snags with the ‘seamless transition’ thesis. The first is that, though falling, the ECoEs of REs might never fall far enough to replace low-ECoE fossil fuels as drivers of economic expansion. The second is that, because RE expansion relies on inputs whose supply depends in turn on the use of fossil fuels, we may not be able to de-link the ECoEs of REs from the (rising) ECoEs of fossil fuels.
REs are already close to offering ECoEs that are competitive with, or below, those of fossil fuels today. What we require of REs, though, are ECoEs that replicate the ultra-low levels of fossil fuels, not now, but in their heyday. For reference, SEEDS analysis indicates that prosperity in the advanced economies turned down at ECoEs of between 3.5% and 5%, with the same happening to less-complex, less ECoE-sensitive emerging market (EM) economies in an ECoE range between 8% and 10%.
What we require of REs, then, are ECoEs that are certainly less than 5% and, ideally, ECoEs which replicate those of fossil fuels – between 1% and 2% – back when oil, gas and coal were capable of driving real and sizable increases in material prosperity.
The reality, though, is that it seems unlikely that the ECoEs of REs are ever going to fall much below about 10%. On that basis, the global economy – with an overall trend ECoE of 9.3% – has already entered a phase of deteriorating prosperity, a trend from which not even EM countries such as China and India can be expected to be exempt.
We can call this process “de-growth”, but with the proviso that this is not the voluntary contraction advocated by those who contend that the world would be a better place if we ditched our obsession with material “growth”. Rather, what we’re experiencing now is involuntary “de-growth”, imposed upon us by a deterioration in the energy equation which determines trends in prosperity.
Where reported GDP – inflated both by credit effects and by a failure to allow for ECoE – exceeds prosperity, the situation is one in which we are creating “excess claims”. Simply stated, this means that financial behaviour is creating (and distributing) monetary claims that the surplus energy of today and tomorrow will be incapable of meeting. If that’s the case, the destruction of the “value” contained in these “excess claims” becomes inescapable. To revert to an earlier metaphor, a lot of people are going to present ‘checks’ for which no economic hat or coat exists for the purpose of exchange.
The following charts set out the “excess claims” interpretation of the relationship between prosperity (measured on an energy basis) and financial ‘promises’.
The left-hand chart illustrates the process by which reported GDP has departed from underlying prosperity. Whilst monetary expansion has – as we have seen – driven a wedge between reported (GDP) and underlying (C-GDP) output, the inclusion of rising ECoEs tracks a further divergence between C-GDP and prosperity.
The result is that a steadily widening divergence between GDP and prosperity has created successive annual increments of excess claims within the financial representation of the economy.
It must be emphasized that the central chart reflects ongoing development work on the SEEDS model. This project has reached a point at which we can produce a realistic illustration of the cumulative build-up of ‘excess claims’ over time. In the chart, this is set against global debt to show how the accumulation of excess claims has progressed far beyond the relatively straightforward expansion of debt, and now embraces many other and substantial forms of liability.
The left-hand and central charts are calibrated in international dollars PPP – this is the preferred convention in SEEDS, and converts other currencies into dollars on the basis of purchasing power parity. To facilitate comparison with debt and other statistics, the right-hand chart shows the global equivalents of debt and excess claims on the basis of market dollars.
The broad picture
This SEEDS analysis, as expressed in market-converted dollars, suggests that cumulative excess claims already exceeded $360tn by the end of 2019, a number far larger than formal debt at that time. With prosperity hit by the pandemic crisis, whilst financial claims are being created at a seemingly unprecedented rate, we can only assume that we are experiencing a big expansion in the ongoing (and the cumulative) gaps between real economic output and financial claims.
We can further describe how this process is likely to unwind. Fundamentally, a big ‘excess claims’ gap means that borrowers will have no option but to default, and that asset prices will fall in line with the deterioration in future value that these prices are supposed to represent.
The question then becomes one of how this default takes place. One way is formal default, where borrowers are unable to meet their commitments. The alternative is informal or soft default, where obligations are met, but in money devalued by inflation. History reveals an almost invariable preference – wherever the choice exists – for the for informal (‘soft’) over formal (‘hard’) default.
Thus seen, the situation is clear, albeit disturbing. Over time, we have created monetary ‘claims’ which have diverged ever further from the prosperity generated by the energy-determined ‘real’ economy of goods and services. Evidences of this excess are to be seen across the board, not just in debt but in broader categories of commitment (which include huge unfunded and un-fundable gaps in pension commitments). Asset prices have been inflated, in part by the cheap money reflected in excess claims, and in part by the persistence of unrealistic expectations for the future.
Our responses to this emerging situation have had all the predictability of a badly-scripted film. Faced with “secular stagnation” (a precursor to de-growth, and ultimately traceable to rising ECoEs), we responded with credit adventurism, based on the illogical premise that credit creation could somehow invigorate a ‘real’ economy which converts energy, resources and labour into economic utility. Whilst fiscal and monetary policy can smooth temporary peaks and troughs, it cannot change the underlying trend in value creation determined by thermodynamics.
This in turn pushed us, during the ensuing 2008-09 crisis, into monetary adventurism, a short-term response to credit excesses which, in reality, cannot be countered within any set of policies which aim, at the same time, to preserve the value of money.
It’s wholly unsurprising, then, that the coronavirus crisis has pushed us a long way further down the road to the discrediting of fiat money. A combination of short-term thinking, well-intentioned intervention, self-interest and fundamental misunderstanding has led us to believe that credit and fiscal stimulus can supply a cost-free ‘fix’ for underlying economic issues which, properly understood, are not responsive to monetary manipulation.
What the authorities have been doing during the pandemic amounts to a rapid acceleration of established policies which assume that, by injecting cheap credit and cheaper money into the system, we can go beyond the reasonable moderation of cycles into the unreasonable creation of perpetual growth.
This misunderstanding of economic fundamentals might be likened to the way in which trainee pilots are sometimes warned that “Isaac [Newton] is always waiting”. What sages of aviation – who tend also to remark that “there are old pilots, and bold pilots, but no old bold pilots” – mean by this is that gravity always lies in wait to punish aviators who allow hubris and ignorance to outweigh prudence and a proper respect for the laws of aerodynamics.
The corollary here is that excessive self-assurance, and a failure to understand the thermodynamic basis of economic activity, have led us to play ducks-and-drakes with the viability of fiat money.
Conceptually, the existence of fiat has always made it possible for us to create monetary claims which exceed the capabilities of the real economy. The events and fallacies of recent years seem, beyond question, to have led is into precisely this fundamental mistake. We are – to paraphrase a former pilot – trying to fly under economic conditions in which “even the birds are walking”.
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.
CRAFTING THE FUTURE
Behind most complex issues lies a stark simplicity which, once grasped, imposes logic on seemingly-baffling situations. That’s certainly true of our economic and broader predicament.
Ultimately, the economy is an energy system, and energy, though abundant, cannot be ‘had for free’. Whenever energy is accessed, some of that energy is always consumed in the access process. This input-output equation – known here as the Energy Cost of Energy (ECoE) – has now turned against us, undermining the dynamic which has driven economic growth ever since the late 1700s, when the invention of the efficient heat-engine first enabled us to harness the power of fossil fuels.
The fossil fuel dynamic worked in our favour for far longer than it takes to become complacent, and to assume – on the basis, not of analysis, but simply of past experience and extrapolation – that economic growth must continue in perpetuity.
A second stark simplicity is that we cannot ‘fix’ an energy problem with monetary tools, any more than one could ‘fix’ an ailing house-plant with a spanner. If we switch our metaphors and picture rising ECoEs (and dwindling surplus energy) as an oncoming truck, our responses over the past quarter-century have amounted to throwing the financial system under the wheels.
Since the economy is a product of the energy dynamic, changes in that dynamic affect not just the size of the economy, but its shape and character as well. Having spent more than two centuries building an energy-profligate dissipative-landfill system, we now face reversion to a more energy-frugal economy in which the relationship between (a) exogenous energy inputs, and (b) the human component tilts back towards the latter. A useful shorthand term for this human component is ‘craft’, a word which captures skills as much as, or more than, it references physical labour.
This tilt in the equation does not portend a return to some romantically-imagined past, and neither does it imply that we can make ‘by hand’ products supplied today by energy-intensive mass production.
Rather, it means that the production and purchasing of these products will dwindle, a process which is already under way. As we’ve seen, demand for discretionary (non-essential) goods and services has already become dependent on a necessarily finite process of credit expansion.
Changes in consumer purchasing will be accompanied by changes of supply processes. These changes – which will include de-layering and simplification, and will be spurred by falling utilization rates and progressive losses of critical mass – can be summarised as “de-complexification”, which involves the reversal of the economic and broader complexity that has been created by abundant, ECoE-cheap energy.
At the very start of his 1929 novel The Good Companions, J.B. Priestly puts the reader high above the Pennine hills in the northern English county of Yorkshire. From there, we descend gradually, concentrating first on a town, then on a street, then on a sea of cloth-capped men walking home from a football match, and finally on a single man, Jess Oakroyd, one of the central characters in the narrative.
Looking down from a similarly elevated position, the World economy has become a dissipative-landfill system, using energy-profligate processes to transform raw materials into products which, for the most part, are rapidly abandoned to landfill or other methods of disposal. This is in stark contrast to the craft model which prevailed before the Industrial Age, when the balance between energy-derived inputs and human skills was very different, and in which the quality of goods, and certainly their durability, was rated a lot more highly than it is today.
Three hundred years ago, people were far likelier to maintain, repair and reuse artefacts than they are now. These are skills that we’re going to need to re-learn.
Properly understood as an energy system, the economy has reached the end-point of a phase in which material prosperity has expanded massively because of the abundant availability of cheap energy from oil, gas and coal.
One of the factors which is bringing this long chapter to an end is the dawning recognition that the environment can no longer tolerate the further expansion, or even the continuity, of a system based on the profligate use of fossil fuels.
The other factor, as yet largely unrecognized, is that oil, gas and coal have ceased to be ‘cheap’ in the only meaningful sense, which is the Energy Cost of Energy (ECoE). After all, abundance of energy supply would be completely meaningless if we were ever to find ourselves using 101 units of energy to access 100 units.
Where supply systems are concerned, the fundamental issue at stake is the changing relationship between exogenous energy inputs and the human contribution.
This human contribution has always had two components. In past times, human physical labour, sustained by farming and augmented by the use of wind, water and animals, supplied the bulk of the energy used by the economy.
But the second (and arguably the more important) human function has always been the direction and application of energy, however that energy is sourced. In pre-industrial times, skills known as crafts played a very important role in a context of resource and energy scarcity.
As the balance tilts away from energy profligacy, we should anticipate a greater reliance, not just on human labour itself, but even more on the application of craft, a term which needs to be understood as a combination of design and skill.
The importance of ‘craft’ is simply stated. Starting with the same materials, and expending the same amount of labour, one person might produce an artefact of quality and durability, whilst the efforts of another might result in failure. The difference between the two is the meaning of ‘craft’ as the word is used here.
This tilting balance does not imply a return to some halcyon rustic age of craftsmanship, let alone to a bucolic existence which looks far better to nostalgic hindsight than ever it felt to the vast majority at the time. Rather, it suggests profound changes along lines which this article aims to explore.
Properly understood, we can anticipate some, at least, of the economic processes involved, and this should give us a reasonable level of visibility on what the post-dissipative economy is going to look like.
Context – the end of energy profligacy
The necessary parameters here – which are familiar to regular visitors to this site, and can be stated briefly – start with recognition that the economy is an energy system, and not the financial one as which it is so often misrepresented.
All goods and services which have any economic utility at all are products of the use of energy. Properly understood, and although it is used for many other purposes, money operates primarily as a medium of exchange. This means that money has no intrinsic worth, and commands value only as a ‘claim’ on the goods and services produced by the energy economy. This interpretation was set out in more detail in part one of this series.
The critical factor in the energy economy is the observation that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This component is known here as the Energy Cost of Energy (ECoE), and the level of ECoE determines how much remaining (surplus) energy is available for all economic purposes other than the supply of energy itself.
Analysis undertaken using the SEEDS model indicates that sensitivities to ECoE are inverse functions of complexity. In the highly-complex Western advanced economies, prosperity per capita turns downwards at ECoEs of between 3.5% and 5.0%, thresholds which were passed between 1997 and 2005. Since then, the average person in these economies has been getting poorer, a trend which no amount of financial gimmickry can reverse.
The equivalent threshold for less complex emerging market (EM) economies lies at ECoEs between 8% and 10%, a band which the World entered in 2017. Accordingly, global prosperity per person has now turned down from a long plateau, and our efforts to use credit and monetary adventurism to disguise and deny (since we cannot change) this trajectory explain the increasingly surreal character of the global financial system.
Critically, and as we discussed in part two, the process of deteriorating prosperity takes place through a hierarchy of calls on incomes. First calls are made by taxation, and by the cost of household essentials. These prior calls leverage the way in which a deterioration in prosperity reduces the residual capability to make discretionary (non-essential) purchases. SEEDS analysis indicates that, in a growing number of countries, discretionary prosperity has already been squeezed almost out of existence within recent years.
Of course, this doesn’t mean that no discretionary purchases are made by the average person. But it does mean that such purchases are now, for the most part, financed using credit. Moreover, and reflecting deviations in income around the average, some households can still make discretionary purchases without resorting to debt, whereas others are already using credit to fund part of the cost of essentials. This is a variance which points strongly towards growing popular demands for redistribution.
Since debt is ‘a claim on future money’, whilst money is ‘a claim on energy’, debt can be defined as ‘a claim on future energy’. If, when credit falls due for payment, the presupposed level of applicable surplus (ex-ECoE) energy is found not to exist, neither conventional debt or other financial promises (such as pensions) can be met. At this point, the only choice which remains is between ‘hard’ default (where we renege on commitments) or ‘soft’ default (where commitments are met, but in money devalued by inflation). Historically, the preference has tended to be for the latter.
A further complicating factor is that the financial and corporate sectors have created liens on income which are the household counterparts of the streams of income on which so many business models now depend. Once confined largely to rent and mortgage payments, these liens have since extended into a gamut of payment streams which include credit, staged purchases and subscriptions. Additionally, many of these streams of income have been capitalized into traded assets, originally exemplified by the mortgage backed securities (MBSs) which became so prominent during the 2008-09 global financial crisis (GFC).
How it happens
These considerations form the essential context for how the transition from the dissipative-landfill model to a more craft-based economy can be expected to take place.
It is, of course, extremely implausible that we will start selling hand-assembled cars, and even less likely that we’ll switch over to man-made gadgetry, or craft-produced computers. But this isn’t the way that change is going to happen.
Rather, we will simply make and buy less of these energy-dissipative products over time. Since we know that the scope for discretionary consumption is subject to a relentless squeeze – a trend that currently is being staved off by credit expansion alone – we can further infer that transition will involve falling sales of consumer products manufactured along energy-intensive, dissipative-landfill lines. This can be expected to begin in discretionary product classes.
There are already several pointers towards such trends. First, hindsight seems likely to confirm that sales volumes in a string of product areas – including cars, smartphones, computer chips and electronic components – peaked during 2017-18.
Second, plans to replace internal combustion engine (ICE)-powered cars and lorries with electric vehicles (EVs) are likely to happen on a less than one-for-one basis, resulting in decreasing fleet sizes, with ICE vehicles disappearing more rapidly than EVs arrive to replace them.
Third, various ideas are being canvassed that would see people renting items which, hitherto, they would have owned. These ideas raise important issues about ownership, about the distribution of income and wealth, and about income streams, but they do point towards reduced ownership, implying smaller quantities and falling sales in a gamut of product categories.
Because the economy is characterized by complex inter-connectedness, it’s not too difficult to describe how these processes will unfold. These have been discussed here before as part of the “taxonomy of de-growth”.
First, we should anticipate a reversal of the process by which, as the real economy of prosperity grew larger, it also became progressively more complex. Even an industry as seemingly basic as the supply of food has expanded from a relatively limited number of trades into a host of specializations, whilst whole sectors of the economy exist as service adjuncts of others.
As this process goes into reverse, we will witness both simplification and de-layering. Whilst the latter term is self-explanatory, describing the shrinkage and elimination of whole tiers of activity, ‘simplification’ refers both to products (with customer choice reducing towards more basic ranges) and to processes, where methods of production will become less complex, whilst supply chains are shortened.
Meanwhile, we should anticipate the compounding effects of two further processes. One of these is falling utilization rates. This can be considered using the example of a bridge, whose economic viability relies on spreading the fixed costs of operations over a large number of users. As user numbers decrease, the share of fixed costs needing to be allocated to each user increases, pushing prices upwards, and accelerating the rate at which user numbers fall. This effect applies to any activity whose viability relies on economies of scale, which means that exposure to this downwards pressure is going to be virtually ubiquitous across the economy.
A second and related process is the loss of critical mass. This occurs where some of the many components or other inputs required by a production process cease to be available. Some such gaps can be worked around, and will indeed form part of the simplification process. But others either cannot be surmounted cost-effectively, or cannot be overcome at all. Accordingly, products cease to be made because some necessary inputs can no longer be sourced.
Importantly, loss of critical mass and falling utilization rates can be expected to interact in a compounding process (for which provision is now made in the SEEDS economic model). We can, for instance, picture a manufacturer ceasing to make a product because critical inputs cannot be obtained. This reduces the purchasing of other components, whose supply then ceases because suppliers’ own utilization rates have fallen below the threshold of viability.
Services – rapid shrinkage
It makes sense to pause here and recap what we’ve observed so far. Energy-based analysis indicates that, because of deterioration in the energy dynamic, past growth in prosperity has gone into reverse, which makes the average person poorer over time. We also know that, because of the hierarchy of calls on incomes, we’re witnessing a leveraged squeeze on the scope for discretionary purchasing, to the point where much, perhaps most, of the ‘discretionary economy’ has become hostage to the ultimately-finite process of credit expansion.
We can further note that, as consumer discretionary purchases contract, we will witness de-layering, product and process simplification, and the compounding effects of falling utilization rates and losses of critical mass. Together, these processes point towards a shift away from energy-profligate, dissipative-landfill production methods towards smaller, more local and more ‘crafted’ supply processes which rely less on exogenous energy inputs and more upon human skills.
Thus far, we’ve concentrated primarily upon physical goods, though it must be emphasized that the whole “de-complexification” process will affect services at least as much as (and probably more than) it affects the supply of goods. Service sectors are prime candidates for de-layering, are likely to be amongst the first casualties of simplification, and are particularly exposed to the adverse effects of falling utilization rates.
There is, though, an additional, quite fundamental point to be noted about the diminishing role of services in an economy transitioning away from the dissipative-landfill model to which we have long become accustomed.
Ultimately, service industries are adjuncts of the supply of goods, and are a product of the complexity and the efficiencies created by the energy-profligate system.
This is not a conclusion that a perusal of conventional economic data would reveal. Official statistics indicate that services account for 63% of World economic activity (as of 2017), and that the proportions are even higher in the United States (80%), Britain (79%), the European Union and Australia (both 71%).
Since ‘industry’ (of all kinds) accounts for 30% of World GDP, and for lower proportions still in the advanced economies, one could easily conclude that services are ‘at least twice as important’ to the economy as manufacturing, and all other production activities, put together.
This is a wholly misleading interpretation, in much the same way as similar statistics could be used to ‘prove’ that, since agriculture is ‘only’ 6% of World economic output, 94% of the economy could continue unscathed even in a situation in which the production of food had become impossible.
The reality is that, in the pre-industrial economy, services were few in number, and rudimentary in character, and a retreat from an energy-profligate system can be expected to drive their role back towards that situation. Historically, the availability of low-cost fossil fuel energy starkly and relentlessly reduced the numbers of people required for the supply both of food and of physical goods, which meant that the numbers no longer required for these activities soared. This was the dynamic which drove the expansion and proliferation of service activities, and the consequent reallocation of financial activity is reflected in statistics which seem to show that services are now ‘more important’ than production.
The obvious corollary is that service activities will shrink more rapidly than the supply of goods as the economy moves away from the dissipative-landfill model.
A final conclusion – for now – is that many of the giants of the commercial and financial landscape will fade from prominence as the economy rebalances away from the dissipative-landfill system.
This, at least, should not cause undue surprise to anyone who has a knowledge of commercial history – after all, global trade is no longer dominated by businesses like the Honourable East India Company and the Hudson’s Bay Company, any more than the Dow Jones Industrial Average is populated by former stalwarts such as the Distilling & Cattle Feeding Co., the United States Leather Co., the Remington Typewriter Co., or the Victor Talking Machine Co..
ARE DISCRETIONARY PURCHASES NO LONGER AFFORDABLE?
When somebody makes a discretionary (non-essential) purchase – pays for a leisure activity, for instance, or a consumer gadget, or a holiday – the assumption is that he or she ‘can afford it’. But the World economy runs on continuous infusions of credit, which makes the world “afford” subject to increasingly severe qualification.
This discussion presents an analysis of prosperity (as opposed to credit-financed ‘consumption’), in conjunction with assessments of taxation, and of the cost of household essentials. It indicates that the average person can not now afford discretionary purchases. Moreover, his or her ability to afford liens on income – the household counterparts of the streams of income now so critically embedded in an increasingly financialized economy – has to be open to very serious question.
As we near the point where we exhaust our ability to inflate economic ‘activity’ with perpetual credit injection, we are poised to make two very disturbing discoveries. The first is that swathes of discretionary activity are no longer affordable on a sustainable basis, to the point where sectors supplying these purchases are to a large extent living on the life-support of financial manipulation.
The second is that a large proportion of asset valuations – where they involve discretionary suppliers, capitalized streams of income, and property – are hanging by a thread.
In the previous article, we went in some depth into the workings of the economy as an energy system, concluding that prior growth in prosperity has gone into reverse as the energy equation has deteriorated. The aim here is to explore some selected implications of the onset of “de-growth”.
This can best be done, not by looking only in a ‘top-down’ way at institutions, systems and enterprises, but by following a ‘bottom-up’ rationale which starts with the circumstances of the ‘average’ or ‘ordinary’ person.
The central realities are (a) that this ordinary person’s prosperity is shrinking, and (b) that conventional definitions of economic output and individual income greatly overstate the economic resources to which he or she has access.
There is a sequence of hierarchy in how the ‘average’ person spends his or her income. The first calls are taxation, and the cost of household essentials. Next come various liens on income owed to the financial and corporate system – these are the household counterparts of the streams of income on which so much corporate activity and capital asset value now depend. ‘Discretionary’ (non-essential) spending – everything from leisure and travel to the purchase of durable and non-durable consumer goods – is funded out of what remains, after these various prior calls have been met.
Putting these two facts together leads to some striking conclusions. Because discretionary consumption comes last in the pecking-order of spending – and because a large and growing slice of apparent ‘income’ is no more than a cosmetic product of financial manipulation – then it follows that the underlying and sustainable level of discretionary expenditures is far lower than is generally assumed.
In essence, discretionary sectors of the economy are now on life-support, kept in being only by the drip-feed of credit and monetary stimulus. Additionally, the ability of households to sustain the stream-of-income payments to the financial and corporate sectors is hanging by a thread.
This means, first, that, as and when credit and monetary adventurism reach their practical limits, whole sectors of the economy will contract very severely.
Second, it means that we have reasonable visibility on the processes by which asset prices will slump into a new equilibrium with much-reduced economic prosperity.
These findings have profound implications, so much so that it’s important to understand the analytical route by which they have been reached. This discussion follows a path which starts with a top-down examination of how the ‘real’ economy of goods and services actually functions, translates this into what it means for the ‘average’ or ‘ordinary’ person, and proceeds from there to various findings relevant to business, finance and government. This analysis is informed by the proprietary SEEDS economic model, which presents energy-based analysis in the financial ‘language’ in which, by convention, debates over these issues are conducted.
If you’re new to energy-based interpretation of the economy, the ‘big picture’ is simply stated.
Essentially, the dramatic growth in economic output (and in the numbers of people supported by that output) since the 1760s has been a function of cheap energy from coal, oil and natural gas.
More recently, three trends have undermined this dynamic. First, fossil fuel energy has ceased to be ‘cheap’, in meaningful, energy-margin terms.
Second, this cost increase is taking away our ability to maintain (let alone to further increase) the supply of fossil fuels.
Third, we have reached – or passed – the limits of environmental tolerance of an economy powered by fossil fuel energy.
This means, either that we find an economic replacement for oil, gas and coal, or that we adapt ourselves to the ending of the fossil fuel prosperity dynamic. The authorities, who are aware of the environmental but not the economic implications of this situation, are pinning their hopes on transition to renewable energy sources (REs).
The environmental case for transition to REs is undoubtedly compelling. But the belief that REs can replicate the economic impetus of fossil fuels, far from being ‘proven’, is simply an assumption, based primarily on wishful thinking, and, far from success being assured, the probability of it happening is actually very low.
Considered in ECoE terms, whilst the costs of RE supplies are falling, they are unlikely ever to be low enough to replace the fossil fuel growth dynamic. The building out of RE capacity continues to rely on inputs which only the use of fossil fuels can provide. We cannot – yet, anyway – build solar panels using only solar energy, or construct wind-turbines using wind power alone.
Moreover, we should not assume that REs can ever be a like-for-like replacement for oil, gas and coal. An economy powered by REs will not replicate the one built on fossil fuels. The push to replace internal combustion engine (ICE) transport with electric vehicles (EVs) is a case in point. Whereas the properties of petroleum favoured the development of cars, RE-provided electricity is likely to work far more effectively as a power source for public transport.
Even if (and it’s a big ‘if’) RE electricity can replace the quantity of energy used by ICE vehicles, batteries cannot replicate the characteristics of the fuel-tank. If we try to ‘buck the physics’ on this – if we insist on clinging on to cars, rather than switching to trains and trams – then we risk, not only a costly failure, but also an environmental disaster caused by mining the materials necessary for the requisite supply of batteries.
In parenthesis, it’s only fair to note that the authorities very probably don’t anticipate like-for-like replacement of ICE cars with EVs, but they can hardly tell voters that car ownership is set to fall markedly.
Economic conditions – the personal factor
Where this top-down situation leaves our ‘average’ person is with deteriorating prosperity. It might not look that way to him or her, but this is because both macro and micro perceptions have been obscured by the use of financial ‘innovation’, which has included sub-zero real interest rates (by which people are paid to borrow), and monetary expansion (which back-stops this escalation in debt and other obligations).
Wages and other forms of income have continued to increase, but only because we have been taking on between $3 and $5 of new commitments in exchange for each dollar of apparent “growth” in GDP and, therefore, in incomes. A point will, inevitably, soon be reached at which we have to renege on some of these promises, either by walking away from them (‘hard default’) or by devaluing them through inflation (‘soft default’). The idea that this somehow ‘doesn’t matter’ is a fiction, because one person’s debt is another person’s asset, and because broader promises (such as pensions) form the real basis on which people plan their lives.
The deterioration in prosperity has been experienced first in the Advanced Economies, and prosperity per capita has been falling in almost all Western countries since the early 2000s. The high levels of complexity in these economies carry extensive maintenance costs, meaning that prior growth in prosperity goes into reverse at comparatively low levels of ECoE (between 3.5% and 5.0%). Less complex EM (emerging market) economies enjoy greater ECoE tolerance, but they, too, have now reached the ECoE inflexion-points (between 8% and 10%) at which prior growth in their prosperity, too, goes into reverse.
This, of course, means that the average person – first in the West, latterly in the EM countries – gets poorer. So far, at least, the rate of deterioration in top-line prosperity has been pretty gradual, but its effects on the average person are leveraged by taxation; by the priority that must be given to household essentials; and by the liens on income created by the increasing financialization of the economy.
Here’s a simple illustration of this leverage effect. A person has an income of $100. Of this, $35 goes in tax, $40 must be spent on essentials, and a further $15 goes out in interest, rent and various subscriptions and stage-payments. This leaves $10 of discretionary income for the person to spend as he or she wishes.
If this representative person’s income falls by $5, from $100 to $95, it’s mathematically true to say that he or she is worse off by ‘only’ 5%. But, because of the leverage in the equation, his or her discretionary spending capability has slumped by 50%, from $10 to $5.
This person may – and, in the real world, increasingly does – counteract this ‘discretionary squeeze’ by taking on extra debt, or by stringing out (staging) payments for purchases that hitherto would have been paid for up-front.
But all that this does is to increase the future cost of debt service and other liens on income.
Where fiscal issues are concerned, the prosperity problem for households is leveraged by governments’ failure to set policy based on the realities of prosperity.
In the group of sixteen Advanced Economies (AE-16) modelled by SEEDS, aggregate taxation increased by an estimated 40% in real terms between 1999 and 2019. Since recorded GDP rose by a very similar 41% over this period, the apparent incidence of taxation – measured conventionally against GDP – has been remarkably static, seldom varying much above or below 36% over the past two decades.
When we look past credit-inflated GDP to prosperity, however, the burden of tax has risen from 39% in 1999 to 49% last year.
As this pincer effect has rolled on – with taxes rising whilst prosperity erodes – relatively modest decreases in prosperity per capita have been leveraged into much more extreme falls at the level of disposable (“left in your pocket”) prosperity.
The most striking illustration of this effect is France, where prosperity per capita peaked in 2004, at €30,910. Since then, this number has declined by a comparatively modest 6.2% (€1,910) in real terms, to €29,000. But tax per capita has increased (by €3,000 per person) over that same period. Accordingly, the disposable prosperity of the average French citizen has fallen by a dramatic 34% (€4,920), from €14,700 in 2004 to just €9,570 last year. Popular anger at this state of affairs is palpable.
In few other countries has this leverage effect been quite so extreme, but declines in disposable prosperity per person have, nevertheless, been pretty striking, falling by 28.2% in Spain since 2001, by 28.0% in Britain since 2004, and by 17.4% in the United States since 2000 (see table 1).
The adverse leveraging effect of taxation has fiscal and political implications, of course, though what interests us here is its impact on consumers.
This impact is, moreover, compounded by the growing slice of prosperity accounted for by the cost of household essentials.
SEEDS doesn’t monitor essentials spending on a country-by-country basis, but does carry out this exercise in the single instance of the United Kingdom. Over a twenty-year period ending in December 2019, average wages in Britain increased by a nominal 77%, outstripping CPI inflation (of 49%) such that, in theory, the wage-earner was better off by nearly 10% over that period.
However, the essentials index (TMUKEPI) rose by 96%, such that wages measured against household essentials decreased by almost 10% between 1999 and 2019. It’s also noteworthy that, whilst the average cost of domestic rent rose by 8% in real terms, the real cost of mortgages fell by almost 20%.
Since a sizeable part of the cost of household essentials is linked to commodities traded globally – most obviously, to foodstuffs, materials and, above all, energy – it’s a reasonable inference that these broad patterns have been replicated elsewhere in the Advanced Economies. From this, we can deduce that non-discretionary purchases, whilst they account for perhaps 37% to 40% of household expenditures, already absorb somewhere between 50% and 55% of prosperity.
If this calculation is correct, it would mean that the combined burdens of tax and household essentials are already close to, and may in a number of instances exceed, per capita prosperity. If these costs seem to remain affordable within incomes – but not within prosperity – the explanation lies in the credit effect of inflating incomes (and aggregate GDP) by purchasing “growth” using incremental debt in a ratio of 3:1.
In short, indicative numbers suggest that, over the past five or so years, the combined burdens of taxation and essentials have come to absorb all of the prosperity of the average person in a growing number of Western economies.
What this in turn means is that the average household increasingly relies on credit expansion to fund all discretionary (non-essential) purchases. In this context, ‘debt’ includes the individual’s share of all government and corporate (as well as household) borrowing. Albeit at one remove, government borrowing pays for services that would otherwise have to be funded by taxation, whilst corporate borrowing helps fund the incomes of employees, and may also serve to reduce the end-user cost of purchases.
As set out in table 2, perhaps the most extreme example of this credit effect is Ireland. Since 2004, the annual pre-tax prosperity of the average Irish citizen has decreased by €3,000 which, at 7.4% and spread over fifteen years, may seem a comparatively modest decline. Over the same period, though, his or her share of the country’s debt has soared from €82,000 to €198,000. This means that, on average, the average person’s share of debt has increased by nearly €7,700 in each of the past fifteen years.
It’s a reasonable guess that the central conclusions of this analysis will not contradict many readers’ intuitive perceptions of what has been happening.
We know that increases in income have been more than matched by increases in debt. We know that, increasingly, households are taking on financial commitments in addition to traditional obligations such as mortgages and rent. We know that taxes on the ‘typical’ household haven’t fallen to mitigate these pressures. We know that the real cost of household essentials has risen, and it will come as no great surprise that there is a corollary between rising household credit and continuing expenditures on non-essential purchases such as leisure, travel and gadgets. We also know that many other indicators of hardship chime with these observations.
In this context, it’s necessary to be clear about what we know, and what we infer. Observation over time confirms that financial ‘innovation’, and outright increases in debt and other obligations, are being used to sustain increasingly illusory ‘growth’. Our understanding of the energy basis of all economic activity should reinforce our confidence that rising ECoEs lie at the root of what began as “secular stagnation”, but has since turned into something a great deal more serious. SEEDS monitors real-terms taxation in countries accounting for about 80% of the World economy and, if we cannot calculate the costs of household essentials on a country-by-country basis, we have data sufficient for reasonable inference on this component.
We need to be somewhat nuanced in the conclusions that we draw from a diminishing, and perhaps vanishing, aggregate capability to fund discretionary purchases without resort to spiraling credit.
For one thing, inequalities between households affect the overall situation. Whilst the ‘average’ person might not be able to make discretionary purchases without using credit, there will be some below this average who already rely on credit to pay for the essentials, whilst others are in a better position, and can still make discretionary purchases without going into debt to do so. To take just one example, the interpretation presented here doesn’t imply that air travel will ‘collapse’, but does indicate that it will contract, suggesting that providers will need to carry fewer passengers, and charge them higher fares.
This said, there can be no disguising the underlying trends, which point towards overall contraction in discretionary sectors, and also highlight the vulnerability of any activity or asset which depends on income streams derived from increasingly squeezed household prosperity. Logically, the industrial landscape can be expected to rebalance away from discretionary activities, whilst a sharp correction in asset prices is likely to be led both by decay in discretionary components and by a degradation in the scale and reliability of ‘income streams’.
IN PURSUIT OF THE EVIDENCE
The title of this article has two meanings. First, it signifies that the economy is a physical entity – indeed, is an energy system – rather than an immaterial construct based on the human artefact of money.
Second, it underlines an imperative need to examine evidence objectively. This is particularly important at a time when both of the contentions that vie for our acceptance – ‘continuity’ and ‘collapse’ – are so very far from persuasive. The aim here is to apply the principles of the energy economy, and the SEEDS economic model, to examine the real economic situation, free from assumption, denial and wishful-thinking.
Enormous changes do indeed lie ahead, and were underway well before the coronavirus pandemic struck a body-blow at the economy. The narrative of continuity – of indefinite economic growth, and of the perpetual preservation of current assumptions, systems and power structures – has been holed below the waterline.
But it does not follow, from this, that economic and social collapse has become inevitable. Big changes can happen without amounting to ‘collapse’. After all, history is peppered with dramatic, supposedly ‘World-ending’ events – including financial crashes, revolutions and the ousting of entire established elites – which did not, in reality, amount to ‘collapse’.
Our imperatives now fall into two categories. First, we need to understand how the economy really works, abandoning notions that purely financial expedients can overcome physical realities, and basing our interpretations on the evidence.
Second, we need to anticipate, and to be prepared for, the challenges posed by the invalidation of the established (though unfounded) notion of ‘economic growth in perpetuity’.
Additionally, we need to accept that the changes which lie ahead dwarf party politics into comparative irrelevance. To this end, the aim here is to leave discussion of politics and politicians to others, concentrating instead on economic and related fundamentals. Much as war-gamers enjoy re-fighting Waterloo or Jutland, there are places for debating the minutiae and meaning of elections – but these are not our priorities here.
In part one of Gulliver’s Travels, Jonathan Swift uses the neighbouring islands of Lilliput and Blefuscu to satirize the Europe of the early eighteenth century. The English political rivalry between Whigs and Tories is represented by people who favour shoes with low or high heels, whilst arguments about the right way to crack an egg (at the large end or the small?) correspond to the distinction between Catholicism and Protestantism. Matters of supposedly huge contemporary political and religious importance are thus reduced to trivialities at which readers are invited to laugh.
They have been doing so ever since 1726.
If a latter-day Swift was writing now, he could do worse than satirize the debate over ‘continuity’ or ‘collapse’ in much the same way. Continuity, of course, is the line taken by governments, business and much of the mainstream media. Collapse, though a fringe persuasion, is a remarkably widespread one. Even commentators who do not avowedly endorse the thesis of collapse often produce interpretations which point emphatically in that direction.
In a time of such polarized expectation, it’s as well to remember that continuity and collapse are not the only possibilities on the table. Whilst the continuity thesis owes a great deal to wishful thinking and denial, prophecies of collapse overlook the fact that, historically, such events have been extremely rare. Stock market crashes, national defaults, changes of governments and even the ousting of incumbent elites in their entirety have occurred pretty frequently, and haven’t resulted in economic or social collapse.
In short, the evidence either for continuity or for collapse is scant. Something new is happening, but we can only anticipate what that is likely to be by weighing the evidence. Doing so produces conclusions which, though they might be startling, are a long way short of collapse.
Taking ‘perpetual growth’ off the table will itself create profound changes. We can anticipate sharp downwards adjustments in asset prices, the fall from grace of many activities now regarded as gold-plated, and the overturning of many political arrangements and assumptions. But none of this, necessarily, amounts to collapse.
The economy – an energy system
To get anywhere at all with our investigation, we need to start by recognizing that the economy is an energy system, and not a financial one. Money is a human artefact used to exchange the goods and services that constitute economic output, but all of these are products of energy. Our economic history is a narrative of how we have applied energy to improve our material conditions.
This is illustrated by the way in which energy consumption, on the one hand, and, on the other, population numbers and their economic means of support, have related to each other over the centuries (fig. 1). It is no coincidence at all that population numbers took off exponentially when, from the 1760s, the discovery of the first efficient heat-engine enabled us to harness vast amounts of fossil fuel energy, starting with coal before moving on to oil and natural gas.
Just as importantly, the use of energy has grown even faster than population numbers throughout the Industrial Age. Expressed as tonnes of energy consumed per person, this ratio has moved steadily upwards, rising particularly quickly in the half-century before 1914, and in the years after 1945. This ratio flat-lined (but did not decrease) during the oil crises of the 1970s, and resumed its upwards trajectory in a period that correlates with the rise of China and other EM (emerging market) economies.
Today, and pending further evidence to be considered here, we can postulate a decline in the quantity of energy consumed per person. Whilst prior trends of the growth in the use of oil, gas and coal are ceasing to look sustainable, it is by no means clear that renewable energy (RE) sources can grow rapidly enough to take up the baton from fossil fuels (FFs).
There’s a compelling case for believing that the aggregate supply of primary energy may not grow as rapidly in the future as it has in the past. Population numbers, meanwhile, are continuing to increase, albeit at decelerating rates.
The peaking of energy supply per capita is not recognized by believers in perpetual growth. Consensus supply expectations – as of late 2019, but probably not too different now – see us using about 20% more primary energy in 2040 than we did in 2018. Of course, RE supplies are projected to increase particularly rapidly, expanding by about 80%. But, because RE supply starts from a low base, this big percentage increment would still account for only about 16% of the assumed net increase in total energy supply.
If we are indeed to increase annual supply by about 2.8 bn tonnes of oil equivalent (toe) between 2018 (13.9 bn toe) and 2040 (16.6 bn toe), we are still going to need a projected 16% more fossil fuels, including an increase of between 10% and 12% in the supply of oil.
There are various reasons for supposing that this consensus view might be mistaken, but the main one is that the costs of fossil fuel supply are rising, an issue to which we shall return. The widely-canvassed view that REs can supplant FFs – such that the need for oil, gas and coal decreases rapidly – is very largely a product of wishful thinking. Independent estimates have put the cost of energy transition at between $95 trillion and $110tn, and even if such sums were affordable, numerous technical issues remain, amongst them the material resources required for such a programme.
This is put into context in fig. 2, from which you can see quite how much more RE (shown in green) would be required if we were to replace all or even most of our continued reliance on FFs (blue).
As fig. 2 also shows, the SEEDS model has ceased using consensus projections for forward energy supply, employing instead a more cautious analysis in which declines in the availability of fossil fuels are, at best, matched by increases in supply from REs, nuclear power and hydroelectricity.
The resulting projection is that primary energy supply changes very little between now and 2040. SEEDS does not postulate a material decline in aggregate supplies of primary energy, but does suggest that energy use per capita may now be on a downwards trajectory.
ECoE – of cost and quantity
The calculation of economic value at any particular time isn’t, unfortunately, a simple matter of dividing the quantity of energy supply by the number of people using it.
For one thing, the various sources of primary energy are unequal, in terms of the economic utility that they provide. A ton of feathers might, by definition, weigh the same as a ton of lead, but their characteristics are otherwise very different. Likewise, an oil-equivalent tonne of petroleum and an oe tonne of solar or wind power have quite different economic characteristics.
For another, the supply of energy for economic use is never ‘free’ of cost. Rather, whenever energy is accessed for our use, some of that energy is always consumed in the access process. We need wells and refineries to put petroleum to use, pipelines and processing plants to access natural gas, mines and power-stations to make use of coal, and solar panels and wind turbines to channel the energy provided by the sun and the winds. Creating these facilities – and, just as important, maintaining them, and replacing them as they wear out – uses energy.
This equation divides any given stream of energy supply into two components. One of these, the ‘consumed in access’ part, is known here as the Energy Cost of Energy, or ECoE. What remains, and is available for all other economic purposes, is surplus energy.
Clearly, and within any given quantity of energy, the higher the ECoE, the lower the surplus. An ECoE of 1% leaves 99% of accessed energy available for us to use. If ECoE rises to 10%, however, the surplus shrinks to 90%.
Properly considered, the cost of energy supply isn’t measured by the number of dollars needed to bring energy to the consumer. What matters is the energetic equation between the ECoE cost, and the residual (surplus) utility, of energy that we access.
This has a direct bearing on the quantity of energy that can be supplied, which is why the rise in trend ECoEs is reflected in SEEDS projections that the aggregate supply of energy to the economy is unlikely to rise as rapidly in our higher-ECoE future than it did in our lower-ECoE past.
This is illustrated in fig. 3, which compares ECoE trends with projected supplies of primary energy in aggregate, and fossil fuels in particular. As overall ECoEs rise, growth in aggregate energy supply can be expected to taper off – and, as the ECoEs of fossil fuels rise particularly rapidly, available quantities are likely to decrease
What emerges here is an equation in which the level of ECoE influences economic output in two ways, not one. First, ECoEs affect the economics of energy supply itself, influencing how much energy is available. Second, ECoEs determine, within that available quantity of energy, how much is absorbed in access cost, and how much remains for those economic purposes which constitute prosperity.
It should not concern us unduly that established interpretations of economics, and the methods used to forecast future energy availability, take no notice of ECoE. After all, spherical trigonometry, vital to navigators over the centuries, could not be understood or applied until Flat Earth interpretations had been confined to the history-books.
Where energy supply forecasting is concerned, the approach appears to be to take assumed levels of economic activity in the future and only then to calculate the energy required by an economy of that assumed future size. This, of course, is to put things in the wrong order – energy supply determines economic output, not the other way around.
ECoE trends – the relentless squeeze
These considerations make it imperative that we understand the ways in which ECoEs evolve.
In essence, four factors determine the evolution of ECoEs. Two of these act to reduce ECoEs; one pushes them upwards; and the fourth operates in ways which are, in general, misunderstood.
ECoEs are driven downwards by geographic reach and economies of scale. Until comparatively recently, the fossil fuel industries pursued the search for new, low-cost resources in locations which had not previously been explored, and which, in some cases, had been politically inaccessible. Economies of scale operate where increasing the size of operations enables the numerator of fixed costs to be spread over a larger denominator of units of output.
With both ‘reach’ and ‘scale’ exhausted, the driving factor now is depletion, which describes the way in which, quite naturally, lowest-cost energy sources are exploited first, leaving costlier alternatives for a ‘later’ which has now arrived.
The potentialities of the fourth determinant, technology, are often overstated, because technological progress cannot change the physical characteristics of the resource.
Fracking, for instance, has reduced the cost of accessing shale hydrocarbons in comparison with the cost of accessing that same resource at an earlier time. What technology has not done is to put the economics of shales onto the same footing as giant, technically-straightforward fields in the sands of Arabia. This is rendered impossible by the starkly differing physical qualities of the two resources.
These principles can be presented diagrammatically as in fig. 4. The evolution of ECoEs follows a parabolic course, turning upwards as the downwards pressures of reach and scale are exhausted, and depletion takes over. Technology operates to accelerate the downwards trend in the early progress of ECoEs, and then to mitigate the upwards tendencies of depletion.
The right-hand, up-trending side of the parabola conforms to the observable exponential rate of increase in ECoEs since they reached their nadir in the immediate decades after 1945.
Measured in money
Thus far we have followed an interpretation of the economy which, though it lacks many of the complications of ‘conventional’ schools of thought, is surely far more persuasive. Describing the economy in solid, material terms – rather than in abstract, financial ones – accords with what we know about the importance of physical goods and services. Tying the economy to the demonstrable laws of thermodynamics makes far more sense than trying to link it to the behavioural observations of the artefact of money which conventional economics is pleased to call ‘laws’.
Thus presented, the economic history of the Industrial Age starts with the invention of the first heat-engine and the unlocking of the energy contained in fossil fuels. We have seen how – over time, and aided by technology – geographic reach and economies of scale have pushed ECoEs downwards, driving up material (meaning energy) economic output, and thereby enabling exponential increases in population numbers.
Latterly, as depletion has taken over from reach and scale, fossil fuel ECoEs have risen relentlessly, pushing us ever further into financial gimmickry in a futile effort to portray a continuation of ‘business [meaning growth] as usual’.
When dealing with the World as it is, though, any case presented in thermodynamic terms must remain at the margins, excluded from debates which are conducted almost entirely in the idiom and nomenclature of money. To play any part in this debate, our conclusions need to be translated into financial language, and this is what the SEEDS model is designed to accomplish.
We need to be clear from the outset that money has no intrinsic worth, commanding value only as a ‘claim’ on the physical output of the energy economy. Obviously, parachuting food or water to a person adrift in a lifeboat or lost in a desert would help them, but an air-drop of money would not alleviate their plight in the slightest degree. Money, as a medium of exchange, has no utility unless there are things for which it can be exchanged.
What is ‘output’?
The conventional measure of economic activity is GDP (gross domestic product), but one of the many problems with this metric is that it measures flow (the equivalent of a company’s income statement) in a way that is largely de-linked from stock (which corresponds to the balance sheet). You could not, in practice, manage a business by concentrating entirely on income, and treating the balance sheet as of little or no account.
This distorted interpretation means that, within certain prescribed (but very wide) limits, GDP can be pretty much ‘whatever you want it to be’, at least to the extent that you can push net new credit into the system.
The injection of credit has the effect, of course, of inflating asset prices, but such movements are excluded from definitions of inflation, which concentrate entirely on consumer (retail) prices. If the prices of food, cars, computers and other consumer purchases soar, we say that inflation has surged, but the same is not said of escalation in the prices of equities and property.
We can see some of these distorting effects in action if we compare, as examples, the United States and China over the past twenty years (fig. 5).
Between 1999 and 2019, Chinese GDP increased at an average annual rate of 8.3%, far higher than the 2.1% averaged in America. What is left out of this equation, though, is that annual borrowing averaged 23.7% of GDP in China, compared with 7.8% in America. The point here isn’t the absolute scale (or wisdom) of the borrowing undertaken in either country, but the direct relationship between borrowing and reported growth.
The same analysis applied to the World economy – and calibrated in constant international dollars – is set out in fig. 6. Between 1999 and 2019, reported growth of $64.5 trillion (or 95%) in GDP was far exceeded by a $193tn (177%) increase in debt.
One way to look at this is that, during two decades in which reported GDP “growth” averaged 3.3%, annual borrowing averaged 9.9% of GDP. This, very obviously, is not a sustainable relationship. Another way to look at it is that each reported “growth” dollar was accompanied by $3 of net new debt, to which, for a fully rounded interpretation, might be added truly enormous increases in pension and other unfunded commitments.
We might choose to believe that debt – since we can default on it, or inflate it out of existence – ‘doesn’t matter all that much’. We might even extend such a rationale to pension promises, though that would be a hard sell to people whose pensions don’t turn up, or have been devalued enormously by inflation.
This dismissal of debt certainly seems to have been the policy logic during the decade before 2008, though the outcome of that state of mind can hardly be regarded as a positive one. The view taken here is that debt and pension commitments do matter, very much indeed, not least because one person’s liability is another person’s asset.
This debate over the meaningfulness of debt as a capital liability, though, misses the immediate point, which is that reported “growth” – and recorded GDP itself – are inflated artificially by the injection of credit.
If, for instance, annual net borrowing was to fall to zero, growth, too, would slump, to barely 1%. Likewise, if we actually paid down debt to its level at an earlier date, much of the intervening “growth” since that date would go into reverse, and recorded GDP would shrink.
For our purposes, this ‘credit effect’ needs to be stripped out if we’re to arrive at a financial calibration that can be used in a meaningful appraisal of economic performance. The SEEDS model calculates that underlying or ‘clean’ output, known here as ‘C-GDP’, grew by an annual average rate of only 1.6% (rather than 3.3%) between 1999 and 2019. Furthermore, it reveals that even this lower rate of underlying growth has been fading, at the same time as ever more credit injection has been used to buttress reported “growth”.
There are three points to be noted from fig. 6. First, reported GDP has long been far exceeded by increments to debt. Second, exclusion of this credit effect reveals far lower levels of trend growth.
Third, these divergences have had compounding effects. The insertion of a wedge (shown in pink) between aggregate debt and recorded GDP has introduced a corresponding divergence between the reported (GDP) and the underlying (C-GDP) levels of economic output.
ECoE and prosperity
What emerges, then – from behind the smoke-and-mirrors of credit and monetary adventurism – is a deceleration in economic growth which accords with a deterioration in the energy equation that has driven the economy since the start of the Industrial Age, and was at its most dynamic in the decades immediately after the Second World War.
Deceleration has been particularly marked since the second half of the 1990s, when confidence in the “great moderation” turned pretty rapidly to concern about the onset of (seemingly inexplicable) “secular stagnation”.
This is where we need to bring in ECoE to complete the prosperity picture. By stripping out the ‘credit effect’ to identify underlying C-GDP, we have calibrated what might be thought of as ‘gross’ economic output, but, as we’ve seen, not all of the value obtained from the use of energy is ‘free and clear’ – some of it (ECoE) is consumed in the process of accessing energy, reducing what remains for all other economic purposes.
To express prosperity in financial terms, then, the required equation can be defined as C-GDP minus ECoE. This gives us an aggregate prosperity number that can then be divided by the population total to tell us the prosperity per capita of the average individual at any particular time.
When this calculation is undertaken on a consistent basis across the 30 national economies covered by the SEEDS model, a striking trend emerges.
In almost all Western advanced economies, prosperity per capita peaked and then turned down between 1997 (Japan) and 2007 (Canada and Greece). But, until quite recently, prosperity per person has continued to improve in the emerging market (EM) countries covered by the system.
This is not, of course, remotely coincidental.
In fig. 7, we compare prosperity per capita with national trend ECoE for America, China and the World as a whole. Where prosperity per person reaches its zenith (as referenced on the left-hand axis of each chart), a vertical line is taken down to ECoE at that time, and is read across to the scale on the right.
Thus, American prosperity reached its high-point back in 2000, when ECoE was 4.5%, whilst Chinese prosperity was still rising in 2019, at an ECoE of 8.2%. In the latter case, prosperity might, in the absence of the pandemic, have continued to improve, but not for much longer. Prior to the coronavirus crisis, SEEDS was indicating that Chinese prosperity was going to turn downwards during the period 2020-22.
What emerges from SEEDS analysis is that Western and EM economies have different ECoE climacterics at which prosperity per capita ceases to grow and turns downwards. In the Advanced Economies, this climacteric occurs at ECoEs of between 3.5% and 5.0%. By virtue of their lesser complexity, which in turn means that energy maintenance costs are lower, EM countries can continue to expand prosperity per capita until ECoEs are between 8% and 10%.
This, incidentally, explains why EM economies have so often been described as being more ‘dynamic’ than Western countries. Many theories have been advanced in an effort to ‘explain’ the supposedly greater dynamism of, say, China or India in comparison with America and Europe.
The reality, though, is much simpler. It is that EM nations had yet to reach an ECoE threshold which, for them, was structurally higher than the one which had already put prosperity expansion in the West into reverse.
For many years now, global prosperity has reflected deterioration in the West, offset by continuing progress in the EM countries. As a result, World prosperity per capita has been on a long plateau – expressed in constant dollars converted on the PPP (purchasing power parity) convention, the average has seldom varied much from $11,000 per person since the early 2000s. This is why, in the right-hand chart in fig. 7, the climacteric in global prosperity, and the associated levels of ECoE, are shown as ranges rather than as a specific point.
Now, though, it has become apparent that the long plateau has ended, such that the prosperity of the World’s average person has gone into decline. Even before the coronavirus crisis, it had looked likely that 2018-19 was going to be the turning-point in global prosperity.
The view from where we are
The aim in this analysis has been to move step by step along a logical path to reach conclusions which, whilst they invalidate the promise of ‘continuity of perpetual growth’, fall well short of endorsing prophecies of inevitable economic and social collapse.
We have seen how, as an energy system, the economy has grown rapidly on the basis of rising quantities of energy supply and – until relatively recently – falling ECoEs. Latterly, the rise in ECoEs has undermined the capability for further expansion, turning complex Western economies ex-growth before moving on to impose the same effects on lower-maintenance, less ECoE-sensitive EM countries.
Two expedients have been used, if not to halt this process, then at least to disguise it. First, we’ve been using ever-larger quantities of energy at the gross level to counteract a deterioration in the prosperity yielded by each unit of energy consumed.
Second, we’ve resorted to increasingly extreme exercises in financial gimmickry on the false premise that making money both cheaper and more abundant can somehow ‘fix’ trends that conventional, money-based interpretation cannot explain. Along the way, we’ve managed to persuade ourselves that policies such as ZIRP, NIRP and QE are somehow ‘normal’ and ‘sustainable’, when the obvious reality is that they are neither.
Looking ahead, we can anticipate that both of these expedients will fail.
It seems increasingly unlikely that we can carry on growing supplies of primary energy at rates that have been accomplished in the past, and are assumed to be possible in the future. The switch to renewable energy sources, imperative though it is on environmental and economic grounds, might not enable us to replace lost quantities of fossil fuels, and cannot be expected to push ECoEs back downwards to levels at which prior levels prosperity can be sustained.
At the same time, financial adventurism has rendered the financial economy very largely dysfunctional, introducing ever greater risk into the system.
Financial dislocation, which might well include slumps in asset prices, and/or the deliberate introduction of high inflation, has now moved from the ‘probable’ to the ‘virtually inescapable’. As hardship worsens, popular priorities can be expected to change, whilst political, commercial and financial models based on the false predicate of perpetual growth will come under increasing strains.
To be sure, the economy is an extensively interconnected system, and compounding effects – to be discussed in a subsequent instalment – are capable of accelerating the pace at which prosperity erodes. Indeed, the latest version of the SEEDS model now incorporates a facility for including these compounding effects into analysis and projection.
From where we are, though, we cannot assume that the outcome must be collapse. For those caught on the wrong side of fundamental changes in the past, it must have seemed that, for them, the World had ‘come to an end’. Examples from history are abundant, and include craft workers overtaken by the “dark satanic mills”, French and Russian aristocrats and functionaries swept aside by revolution, and investors destroyed by the Wall Street Crash.
Objectively, none of these events amounted to collapse. Each, moreover, included winners as well as losers, and gains, as well as losses, for the quality of life.
In the next instalment, we’ll start an analysis of how these ‘profound-but-short-of-collapse’ changes are likely to play out.