Sunday, February 3, 2013

Energy is the substance of the economy

“The compounding mistake, ... was a wide-eyed belief that ‘globalisation’ would make everyone richer, when the reality was that the out-sourcing of production to emerging economies was a self-inflicted disaster with few parallels in economic history. One would have to look back to a Spanish empire awash with bullion from the New World to find a combination of economic idiocy and minority self-interest equal to the folly of globalization.”

 This was not written by Naomi Klein or Vandana Shiva but by Dr. Tim Morgan at Tullet Prebon, one of the largest inter-dealer money brokers in the world, in the report The Perfect Storm. It has a certain extra tang and interest when you get damning opinions about our economic system from those that profit from it and have inside insights, even if they don’t say so much different than the anti-capitalists.

The report is one of the most damning analysis of where the global economic system is headed and in particular where “the West” has gone. For coming from the finance sector it has also good insights in how important (cheap) energy is and has been in the capitalist saga. I probably helps that Dr Morgan studied history and political science.  The four interrelated trends that have brought us where we are, according to Dr Morgan are: 

First, the Western world is still mired in the fall-out from the ‘credit super-cycle’, a financial bubble so vast that it makes Dutch tulips, British south sea stock, the 1840s railway boom and “the roaring twenties” look like “little local difficulties.

Second, globalisation is now being exposed as a disaster which has driven a critical wedge between Western nations’ consumption and their production.

Third, policymakers and the public do not even have access to data reliable enough for an accurate appraisal of the predicament.

Most important – given that the economy is an energy dynamic, not a monetary construct – the critical surplus energy component is now in rapid and seemingly-irreversible decline.

“Reducing production, increasing consumption and taking on escalating debt to fill the gap was never a remotely sustainable course of action. What this in turn means is that no return to the pre-2008 world is either possible or desirable”.

The folly of the ever increasing indebtedness has been explained by many others. The reports states that: “Between 1981 and 2009, debt grew by 390% in real terms, far out-pacing the growth (of 120%) in the American economy. By 2009, the debt ratio had reached 381%, a level unprecedented in history. Even in 1930, when GDP collapsed, the ratio barely topped 300%.” Dr Morgan says that it is not the debt itself that is remarkable but how long this could go on. A main mechanism to have it going and supported by the public was the extended period of ever increasing property prices, reaching its highest level of folly in Japan where one square meter in Ginza in Tokyo fetched up to US$ 215,000, which is what you pay for 100,000 square meters of the best agriculture lands in the world (and those prices are also inflated!). Adding to the illusions was the innovation of new financial instruments, which supported lending also to those who could not afford it. While US economic growth was $4.1. trillion between 2001 and 2007, consumers increased their debt with an enormous $6.7 trillion.

The damning account of the follies of globalization was what surprises me most in the report. Dr Morgan dismisses the talk of Western economies modernizing themselves by moving from production into services as obscuring the fact that “Western consumers sold each other ever greater numbers of hair-cuts, ever  greater quantities of fast food and ever more zero-sum financial services whilst depending more and more on imported goods and, critically, on the debts used to buy them.”

Consumption by Americans increased by $6,500bn between 1981 and 2011, while consumption by their government rose by a further $1,700bn. Meanwhile, the combined output of the manufacturing, construction, agricultural and extractive industries grew by barely $600bn. Net exports of services was worth $200bn in 2011, i.e. far from sufficient in bridge the gap between consumption and production.

Dr Morgan delivers an interesting critique of the theory of competitive advantage (originating from David Ricardo) which has underpinned the globalization “project”. According to the theory, the general wealth will increase if all countries specialize in those activities in which they possess the greatest competitive advantage over others. “This logic is valid if – but only if – the scope for growth is infinite. Unfortunately, an unlimited capability for growth can only exist if the supply of resources is infinite as well.” says Dr Morgan.

I am not able to judge the accuracy of the third major cause of the mess, the distortion of data, but it is certainly remarkable. Dr Morgan claims that inflation figures, GDP figures and several other key economic data are inaccurate. The US GDP is inflated by 15% through various “imputations”, such as the “owner-equivalent rent” which includes the estimated “rent” that a house-owner would have paid for his house were it rented in the commercial market.  

”All goods and services on which money can be spent are the products of energy inputs either past, present or future.”

Many have claimed that our economy is mainly an energy equation. For example, I write in Garden Earth:
”A barrel of oil represents the energy of 25,000 hours of human toil, that is, 14 persons working round the year with normal Western labour standards. The cost for pumping the oil is not more than a few dollars per barrel, and even with an oil price of many hundred dollars per barrel, it is very cheap[...] From this perspective, our current wealth can be easily understood and demystified. Even hundreds of years ago, long before industrial society and capitalism, the person who had hundreds of others working solely for him or her could lead a comfortable life. ”

It is more unusual that persons submerged in the financial system have these insights. But Dr Morgan certainly has. He states that the economy is a physical construct based on energy rather than a financial construct based on money. We have been blinded by the fetish money (read more on this on The business plan of the factory is to produce externalities): “money is the language rather than the substance of the real economy. Ultimately, the economy is – and always has been – a surplus energy equation”.  From there he continues to discuss the huge impact on the economy that a declining Energy Return on Energy Invested (EROEI) will have. I explain EROEI in this recent post

Dr Morgan states that the average EROEI has gone down from 40:1 in 1990 to 17:1 in 2010 and might decline to just 11:1 by 2020. This would cause an average increase of energy costs with 50%. In this perspective it is worth noting that the EROEI of the famed US shale oil is somewhere around 4-5:1. With an EROEI the direct energy share of the GDP would go from 6.7% to 9.6%, and perhaps reach 15% by 2030. Notably, increased energy costs cascade through the whole economy, and will cause cumulative effects. 

Clearly, cheap energy has been one of the major drivers not only for our increasing wealth, but also for globalization and for the debt economy, “debt really amounts to ‘a claim on future energy”. Similarly, the end of cheap energy will mark a tectonic shift in our society.
I am a strong believer of the huge importance of energy for our society, but perhaps Dr Morgan goes just a bit too far here. The fact that a lot of development has used cheap energy as its main driver is not necessarily a proof that energy itself constitutes the essence of human society. He claims, for instance that it is likely that food production will decline with half if energy becomes scarce. True, energy has a very important role in today’s agriculture system (read for instance Why oil price and grain price follow each other or Agriculture: How cheap energy (and capitalism) increased the gaps between rich and poor), but this is also an effect of that energy is cheap.

Choosing between several options for increasing production and productivity, methods involving high energy use are likely to dominate when energy is cheap. It is cheap fossil energy that has made the widespread use of nitrogen fertilizers a cornerstone in the farming systems, but if chemical fertilizers become uneconomic to use, farmers will use more biological nitrogen fixation, nutrients that are now flushed to the waterways will be recycled etc. Cheap energy has also driven globalization and increasing international trade in foods, but many countries could produce more food if global competition was less, and prices higher. 

I missed an analysis of the effect of the demographic transition. It seems to me be a fifth important trend to consider.I also missed an analysis of which role capital accumulation and capitalism play in the system.

The report is worth while reading, and it has a number of provoking statements and amusing one-liners. 

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