HOW THE SYSTEM REALLY WORKS

According to conventional interpretation, the world economy faces no problems more serious than sluggish growth and rising tensions over trade. Though debt is high and asset prices are inflated, these issues are manageable within a monetary context that remains “accommodative” (meaning cheap).

Surplus Energy Economics offers a radically different and far more disturbing interpretation. Fundamentally, it states that global prosperity per person is now declining. This is a game-changer in terms not just of economics and finance but of politics and government, too. Deteriorating prosperity means that current debt levels are wholly unsustainable, and makes an asset market crash inescapable, even if the authorities persist with policies of ultra-cheap money.

This take on the economy could hardly be more starkly at odds with the consensus position. With due apologies to those regular readers for whom much of this is familiar fare, what follows is a synopsis of how the economic system is understood here. In stark contrast to conventional interpretations which portray the economy as a financial system, this article explains how, in reality, all economic activity is a function of energy.

As you will see, this simple observation turns the key in the door to an understanding of how the economy has evolved in recent times, and where it is likely to go next.

Ever since the millennium, we have been engaged in trying to apply futile financial fixes to a deteriorating secular trend in energy-based prosperity. That’s akin to trying to fix an ailing pot-plant with a spanner. These efforts have bought us some time, but have caused serious economic, political and social harm without in any way changing the economic fundamentals.

Where planning and policy are concerned, we are in a truly peculiar situation. Those of us who understand prosperity know that the ongoing downturn is going to have profound consequences – but, as societies, we cannot even start crafting responses whilst consensus interpretation remains in a state of profound denial.

The energy economy

Surplus Energy Economics is a radically different interpretation which recognises that the economy is driven by energy, not by money. Energy is required for the supply of literally all of the goods and services that constitute the economy. Money, on the other hand, acts simply as an exchangeable claim on the products of the energy-based system.

Unfortunately, long habituation to economic expansion has led us into the false assumption that growth is a perpetual phenomenon on which the physical limitations of our planet have no bearing. The harder reality is that the characteristics of the earth as a resource package are the envelope which imposes boundaries on the scope for growth.

Human activity has always been an energy system, starting with the simple balancing of the inputs of nutritional energy with the outputs of labour energy required to obtain this nutrition. This equation was leveraged in our favour by the greater efficiencies introduced by agriculture, though the vast majority of labour remained dedicated to the supply of food. Only when the heat-engine enabled us to harness the vast energy potential of fossil fuels did we create conditions in which the securing of nutrients and other essentials became a minority activity.

The equation governing the value obtained from exogenous (non-human) forms of energy has two components.

The first is the total or gross quantity of energy to which we have access.

The second is the proportion of that total energy which is consumed in the process of accessing it, and therefore is not available for other purposes. The quantity consumed in the access process is described in Surplus Energy Economics as the Energy Cost of Energy (ECoE).

The difference between the gross energy quantity and ECoE is surplus energy. Because this is the source of all goods and services other than the supply of energy itself, this surplus determines prosperity.

We can, of course, deploy this surplus with greater or lesser efficiency. But we cannot escape from the prosperity parameters imposed by the surplus energy dynamic.

The energy cost equation

The quantity of surplus energy-based prosperity available to us is determined by the relationship between energy resources and the technology we apply to them.

At the gross level, the limits to potential are determined, not by the resources available, but by the quantities which can be accessed in ways where ECoE is less than the total energy value obtained. This means that the concept of “running out of” oil, gas or coal is not meaningful. Rationally, reserves of oil, gas or coal whose ECoE exceeds their gross energy value are not worth accessing, so will remain in the ground.

Where fossil fuels are concerned (though the principle is universal), four factors determine ECoE. Over an extended period, ECoE was driven downwards by geographical reach and economies of scale. Once these processes had been maximised, however, the new governing factor became depletion, a consequence of having accessed lowest-cost resources first, and leaving costlier alternatives for later.

The fourth determinant, technology, operates within the physical envelope of resource characteristics. During the phase where reach and scale dominated, technology accelerated the downwards trend in ECoE. Now that depletion has become the primary factor, technology acts to mitigate the rate at which ECoE is rising.

It must clearly be understood, however, that technology cannot breach the resource envelope determined by physical characteristics. For example, new techniques have made shale oil cheaper to extract now than that same resource would have been at an earlier time. But what technology has not done is to imbue shale reservoirs with the same characteristics as a simple, giant oil field like Saudi Arabia’s Al Ghawar. Technology works within the laws of physics, but it cannot change those laws.

It is mathematically demonstrable that, like any type of linear progression, the ECoE curve is exponential. Population numbers illustrate the exponential function. If a population of 1,000,000 people increases by 5% in any given period, the addition in that period is 50,000. Once the base number rises to 10,000,000, however, the increment is 500,000, even though the rate of change remains 5%. When charted, exponential progressions appear as ‘j-curve’ or ‘hockey-stick’ patterns, their apparent shapes determined only by the scale of the quantity axis.

The ECoE trap

Energy sources such as oil, gas and coal have matured to the point where the maximum benefits of reach and scale have been attained, and depletion has become the dominating driver. Fossil fuel ECoEs reached the low point of their parabola in the two decades after 1945, and have since been rising exponentially.

According to the SEEDS model, the fossil fuel ECoE progression has been as follows:

1980: 1.7%

1990: 2.6%

2000: 4.1%

2010: 6.7%

2020E: 10.5%

2030E: 13.5%

Renewable energy sources remain at an immature stage at which ECoEs are falling. Taken together, the ECoE progression for renewables is stated by SEEDS at:

1980: 16.7%

1990: 14.2%

2000: 13.3%

2010: 12.1%

2020E: 11.1%

2030E: 10.2%

In pure calorific terms, the ECoEs of renewables are likely to become lower than those of fossil fuels at some point within the early 2020s.

This does not, however, mean that transitioning to renewables will enable us to escape from the fossil fuel “ECoE trap”. There are three main factors which make this unlikely.

First, renewables account for just 3.6% of all primary energy consumption, with fossil fuels continuing to contribute 85% (and the remaining 11% coming from nuclear and hydroelectric power).

Second, renewables remain to a large extent derivates of the fossil fuel economy, requiring inputs which can be supplied only with the use of energy from oil, gas or coal. This imposes a linkage between the ECoEs of renewables and those of fossil fuels.

Third, and relatedly, it is unlikely that the ECoEs of renewables can fall far enough to restore the efficiencies enjoyed in the early stages of fossil fuel abundance. The overall ECoE of renewables is projected by SEEDS to fall to 10.2% by 2030, but this remains drastically higher than the ECoE of fossil fuels as recently as 2000 (4.1%), let alone back in 1980 (1.7%).

The world ECoE trend for all form of primary energy is as follows:

1980: 1.7%

1990: 2.6%

2000: 3.9%

2010: 5.9%

2020E: 8.3%

2030E: 9.8%

Economic implications

With the economy understood as a surplus energy equation, the history of economic development fits a logical pattern.

Throughout the period from 1760 to 1965 – roughly speaking, from the start of the Industrial Revolution to the post-1945 low-point of the ECoE parabola – the world economy was characterised by rapid growth in aggregate prosperity. This translated into steady improvement in personal prosperity despite the huge growth in population numbers over that period.

This era was characterised by (i) expansion in the gross amounts of energy consumed, and (ii) reductions in ECoE caused by reach, scale and technology. Surplus energy per person was thus on a strongly rising trajectory, growing at rates faster than the expansion in aggregate energy supply. The world became accustomed to growth, which came to be regarded as a natural phenomenon, even though some economists have conceded that our understanding of what makes growth happen is imperfect.

After about 1965, though the bottom of the cost parabola had been passed, ECoEs remained very low, rising from about 1.0% in the mid-1960s to 1.7% in 1980. This rise was modest enough not to impair the trajectories of growth in energy use, economic output, aggregate prosperity and population numbers.

Latterly, however, as the upwards trend in ECoE has become exponential, the scope for further expansion in prosperity has been undermined. It is probable that the rise in trend ECoE between about 1990 (2.6%) and 2000 (3.9%) marked a significant turning-point after which growth became ever harder to attain.

Because the 1990s had been regarded as a propitious period in economic terms – with expansion robust and inflation low – the onset of deteriorating growth was improperly understood. Indeed, this misunderstanding was inevitable given the absence of the ECoE factor from mainstream economic interpretation.

Responses to secular deceleration were required, for two main reasons. First, the public has long regarded growing prosperity as both a norm and an entitlement. Second, the world financial system is entirely predicated on perpetual expansion in the economy. Debt can only ever be repaid if the prosperity of the borrower increases over time.

With the consensus firmly established that the economy was a financial system, it was inevitable that financial solutions would be sought to address secular deceleration. This process began with making credit ever easier to obtain, a process furthered both by deregulation and by reducing real interest rates.

For some years, this expedient appeared to have been successful, as reported economic output boomed between 2000 and 2007. It transpired, of course, that this was a credit-induced boom, a familiar phenomenon, though one in which, this time, inflation was concentrated in asset markets rather than in consumer prices.

When this process led, inevitably, to the 2008 global financial crisis (GFC), the response once again was a financial one. In fairness to decision-makers, this response was largely forced upon them by the rapid expansion of debt – the only way in which a debt default crash could be prevented was by making debt ultra-cheap, both to service and to roll over.

Accordingly, policy rates were slashed to sub-inflation levels, whilst huge amounts of newly-created QE money were used to force up the prices of bonds, thus driving yields to extremely low levels.

It was always predictable – and is now becoming evident – that the monetary expedients adopted after the GFC would be no more effective than the ones which caused that crisis. Debt has continued to expand, asset prices have continued to inflate, and a series of adverse economic consequences have emerged as side-effects of the process.

In short, just as the process of credit adventurism operative between 2000 and 2007 led directly to the GFC, the subsequent policy of monetary adventurism must lead inevitably to a second financial crisis (“GFC II”).

Because the mechanism leading to GFC II has been different from the mechanism operative before the 2008 crisis, GFC II is likely to differ in important respects from its predecessor, with money, rather than just the banking (credit) system, at the eye of the storm. GFC II is likely, also, to be much larger than GFC I, with SEEDS indicating that exposure now is roughly four times the size of exposure in 2007.

The financial dimension

One of the most important lessons of recent economic history is that it is impossible to alter the course of an energy-determined economy using purely financial tools.

The reason for this mismatch is quite straightforward. Having no intrinsic worth, money commands value only as a claim on the goods and services supplied by a physical economy driven by energy. Though financial claims can be created at will, the creation of additional claims does not expand the quantities of goods and services for which these claims can be exchanged.

Inflation has long been understood as a monetary phenomenon, in which prices are forced upwards where the supply of money (“claims”) expands at rates faster than the pace of growth in economic output. Two significant qualifications are required to this statement. The first is that the velocity of money (the speed at which it changes hands) is as important as the stock of money in circulation. The second is that inflation may occur in a variety of locations, including asset prices as well as consumer prices. With these caveats stated, inflation is indeed “always and everywhere a monetary phenomenon”.

The relationship between two quantities – (i) the output of the physical economy, and (ii) the quantum of claims exercisable against that output – plays a critical role in determining financial conditions.

The economic experience since 2000 has been one in which claims have been created at levels far in excess of the rate of expansion in output. This statement has profound economic and financial implications.

Initially, excess claims were created primarily in the form of debt. Latterly, this process has been compounded by the creation of excessive monetary amounts. Stated in PPP-converted US dollars at constant 2017 values (the convention used throughout this discussion), aggregate debt expanded by $53 trillion between 2000 and 2007, and by $99tn between 2007 and 2017.

The increase in debt since 2007 has been accompanied by a rise of similar magnitude in the deficiency of pension provision, a process driven by the collapse of returns on investment which has itself been a function of ultra-cheap money. According to a study published by the World Economic Forum, real returns on US bond holdings have slumped to just 0.15% from a historic norm of 3.6%, whilst returns on equities have fallen from a historic 8.6% to only 3.45%.

This has more than doubled the rate of savings required to achieve any given level of pension provision at retirement. For the vast majority, levels of saving required to deliver pension adequacy have become unaffordable. The pension gap “timebomb” is likely, in due course, to become a hugely important economic and political issue.

These developments, most obviously the escalation in debt levels, have created huge increases in the prices of assets such as bonds, stocks and property. Put simply, bond prices are the inverse of the market yield requirement established by the cost of money, whilst equity pricing is driven by considerations similarly linked to interest rates. Property prices, too, are largely determined by the equation of inverse interest rates applied as a multiple to the median payment capabilities of purchasers.

That bubble conditions prevail across asset markets seems beyond dispute. But the mere existence of a bubble does not on its own imply an imminent crisis. The scale of risk associated with a bubble depends primarily on two issues, not one.

The first of these is the monetary context going forward (a bubble may be sustainable, and may indeed continue to inflate, so long as credit remains both cheap and easy to access). The second is the prosperity of borrowers. The latter, ultimately, is a function of the energy-based economy.

Another way to look at this is that, if monetary conditions tighten, asset prices are likely to fall, perhaps rapidly. Meanwhile, if the prosperity of borrowers diminishes, so does their ability both to service existing debts and to take on additional indebtedness, even if credit remains cheap. Under these conditions, supportive monetary policy is not guaranteed to prevent asset price falls

What this means is that forecasting the future cost of money is not a sufficient way of anticipating crashes in asset prices. In addition, we have to understand trends in borrower prosperity – but this metric is not provided by conventional econometrics.

Calibrating the energy economy

During the period between 2000 and 2007, aggregate debt expanded by $53tn whilst world GDP rose by $25tn. Between 2007 and 2017, growth in GDP was $29.7tn whereas debt increased by $99tn. In the earlier period, therefore, $2.08 was borrowed for each $1 of recorded growth, whilst the ratio in the latter period was $3.33 of borrowing for each growth dollar.

Over the last decade, credit has expanded at the rate of 9% of GDP, roughly three times the pace at which GDP has increased.

Conventional interpretation of the relationship between debt and GDP omits a critical connection between the two. Within any given amount of money borrowed, a significant proportion necessarily finds its way into economic activity. An economy which takes on substantial additional debt will, therefore, experience apparent “growth” in GDP, created by the spending of that borrowed money.

This credit effect is artificial, in the sense that (i) the apparent rate of growth would not continue in the absence of continued increases in debt, and (ii) growth would be put into reverse if the incremental debt was paid down.

This interpretation is reinforced by observation of the type of “growth” supposedly enjoyed. The experience of the United States in the decade between 2007 and 2017 illustrates this point.

Over that period, reported GDP expanded by $2.5tn, to $19.4tn in 2017 from $16.9tn (at 2017 values) in 2007. The combined output of manufacturing, construction, agriculture and the extractive industries contributed just 1.9% of that growth ($48bn). A further 7% came from increased net exports of services. But the vast majority – 91% – of all growth came from services that Americans can sell only to each other.

We need to be clear about what this means. The products of manufacturing, farming and extraction are traded globally and are priced by world market competition, so these activities can be grouped together as GMO (globally marketable output). But internally consumed services (ICS) are priced locally, so are residuals of consumer spending capability.

In short, what was happening during this decade was that American GMO was stagnant, not even increasing in line with population numbers. But ICS activities – residuals which Americans sell only to each other – increased markedly. This is wholly consistent with the fact that, during this period in which GDP increased by $2.5tn, debt expanded by $10.2tn. Money pushed into the economy by cheap borrowing shows up almost entirely in residual ICS activities.

The credit effect is so important that, in order to measure prosperity, it is necessary to arrive at a ‘clean’ measure of output from which this effect has been excluded. The ultra-loose credit conditions of recent years have created a large and widening gap between ‘clean’ (or financially sustainable) output, and recorded GDP numbers inflated by the credit effect.

For instance, within global growth of $25.3tn between 2000 and 2007, the SEEDS algorithms identify clean growth of $10.3tn and a credit effect of $15tn. The $29.7tn of growth recorded between 2007 and 2017 comprised a credit effect of $19.4tn and clean growth of $10.3tn. Therefore, the credit effect accounted for 59% of all reported growth in the earlier period, and 65% in the latter.

Once clean GDP has been identified by the exclusion of the credit effect, what results is a measure of sustainable output, something which equates to the aggregate of financial resources available for deployment. But the first call on these resources is the cost of energy supply because, if this economic rent is not paid, energy supply dries up, and activity grinds to a halt.

Therefore, prosperity is identified by deducting trend ECoE from clean GDP. This calibration is the primary purpose of SEEDS, the Surplus Energy Economics Data System.

Principal findings

Aggregate prosperity furnishes us with personal prosperity data, and also provides a critical denominator against which all other financial metrics can be measured. Here are some of the most important conclusions emerging from this process.

First, prosperity is already in marked decline in almost all Western economies, typically having peaked between 2000 and 2007. The only significant exception to this pattern is Germany, largely because of the benefits conferred on the Germany economy by the euro system.

Deteriorating prosperity, in conjunction with monetary manipulation adopted in failed efforts to counter it, have built huge risk into the financial system. The Western economies where risk is most acute are Ireland, the United Kingdom and Italy.

Most emerging market (EM) economies are at an earlier stage in the prosperity curve, and continue to enjoy increasing personal prosperity. But progress is now slowing markedly, not least because of the impoverishment of Western trading partners. China has grown its debt at a particularly dramatic pace in order to sustain activity and employment, and must be regarded as extremely risky.

Prosperity deterioration is already having a palpable effect on political sentiment in most Western countries. Popular dissatisfaction is eroding support for the ‘globalist liberal’ elites which have been in government for most of the last thirty years, and insurgent (sometimes called “populist”) movements have been the main beneficiaries of this process. At the same time, the decline in prosperity has started to erode the tax base.

Future domestic policy directions are likely to focus on (i) redistribution and (ii) opposition to immigration. We should assume that voters will turn increasingly to parties committed to these policies. We should also anticipate growing opposition to globalisation.

These, of course, are just some of the more important consequences of the downturn in prosperity. Critically, an understanding of the energy basis of the economy explains issues which necessarily baffle conventional interpretation which remains predicated on purely financial assumptions.