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. 

Increase happiness productivity

Compare a litre of water in the swimming pool of a rich person with a litre used for drinking or for cooking in the house of a poor person. To make things worse, the cost of a litre of water that one has to carry by hand is often higher in the slums in developing countries than a litre conveniently poured from the tap by the rich, and the quality of the water is also mostly better for the rich. So the poor are discriminated against thrice over. Isn’t this perspective in itself enough to make one argue in favour of global redistribution of resources?

An increase in the absolute income by a certain sum does a lot more good—results in more well-being—for a poor person than for a rich person. One could discuss the ‘happiness productivity’ of a certain resource, that is, how to use a resource to deliver as much happiness or satisfaction or well-being as possible. 

Diener and Seligman 2005

There is no direct correlation between an individual’s or a country’s economic (material) wealth and their sense of happiness, satisfaction or well-being. This is an old observation. The more balanced defendants of capitalism also agree; for example, the economist Joseph A. Schumpeter says that people in industrial societies don’t have to be happier or experience more well-being than people in the Middle Ages. An American study from 2004 states that while economic wealth has increased threefold in 50 years (see figure), people’s feeling of well-being has been constant; in fact, mental health has deteriorated and social networks are weaker. Between 1958 and 1991, the average income of the Japanese increased sixfold; still, in 1991 they were as satisfied (or as little satisfied) as their parents were in 1958.

Material wealth doesn’t lead to more well-being; on the contrary, it appears that the human quest for more things is threatening not only our space on earth but, ultimately, also our own well-being. There is no reason to moralize over this; considering that scarcity has been the norm for millennia, no built-in barriers exist against over-consumption of food or things. But now the damage is evident, for the physical environ­ment, for society as a whole and for individual human beings. Both the values that hail consumption and the economic system that is driven by this consumption and that, at the same time, amplifies consumption have to be changed. And these two are strongly linked, one feeds on the other, therefore they need to be tackled simultaneously. Inequality adds to the equation by leading to people being more frustrated than they would be in a more just society. To compensate for this frustration they consume. Not only that, inequality itself drives comparison and competition, which had growth as its main expression.

(based on Garden Earth -From Hunter and Gatherer to Global Capitalism and Thereafter, my book that will be published next week)

We get richer also without growth

World manufacturing output grows much quicker than GDP. This is shown quite convincingly by Peter Marsh in his recent book "The New Industrial Revolution" which I am currently reading. His main point is that manufacturing is still very important, contrary to what we may believe when we live in a post-industrial society. He also states that the notion of "de-industrialization" of western econonmies is exaggerated.

While I agree with his point, the book raised some other thoughts. I picked the graph above from the book. Between 1800 and 2010, world manufacturing increased 200 times, while the GDP increased "only" some 60 times (for those interested in the effect of rather small differences in growth rate, this means that manufacturing output grew with 2.6% per year against 2% for GDP - not a big difference is it?)

This means that we don't only have more money today than ever before, we also get a lot more "stuff" for that money. E.g. between 1900 and 2000 US residential prices fell by approximately 94 %, adjusted for inflation - and people say energy has become expensive!
In the early industrialization of textile manufacturing productivity in spinning increased 1000-fold in two generations from the end of the eighteenth century in England (Ayres 1989). The increase in productivity is not unique for manufacturing. As a matter of fact the productivity gains in farming are equally impressive if not more. In the areas with lowest productivity, where farmers produce with more or less the same technology as 200 years ago, one person can produce not even 1 ton of grain per year, whereas the most productive farms exceed 2000 tons per person-year (Rundgren, Garden Earth, 2012). 150 years ago it took Swedish farms 250 hours of work to get one ton of barley from the field into the barn - today it takes five minutes with a combine harvester (Jordbruk och skogsbruk i Sverige sedan år 1900).

 

Endless fields of corn in Mato Grosso

There are many different observations possible from this. 

1) One obvious observation is that manufacturing will go in the same direction of farming, albeit slower. That is, the relative importance of manufacturing in the GDP will continue to decrease.Our needs of manufactured good certainly is not as easily saturated as our needs for food, but clearly there are limits to how many new "things" we need, and want to buy all the time.

A farmer in Zambia working manually

2) Because of productivity gains quicker than economic growth we can actually increase our standard of living (measured in "things") even without any economic growth, we get richer even if we don't get more money. Every year the same money buys us more things. This seams to be a rather strong argument for a non-growth economy.


3) Because of saturation in markets for manufacturing, and increasing competition, there are small possibilities to make profit from manufacturing:

"Stagnating demand will affect large segments of the industry in a similar way as agriculture suffered from lack of demand and falling prices for 100 years, despite an enormous population growth. The combination of increased competition, increased productivity and automation means constantly falling prices up to point where there is no profit to be made." (Garden Earth). Capital and capitalists need to find new arenas, and they find them today in three areas: 

• In privatization of society functions (schools, utilities, railroads etc.). I don't think i need to give any examples, they are everywhere in European countries and elsewhere
• In financial capital. The value of swaps and derivatives at the end of 2007 was US$ 454 trillion (ISDA 2009). This corresponded to some eight times the world GDP and around four times the global household wealth (Davies et al. 2008). The value of stocks in the 54 biggest markets in 2007 was more or less on par with the world GDP and the value of currency trading amounted to more than US$ 2 trillion per day (Reuters 2007), that is, more than 10 times the world GDP in a year.
• and in ecosystem services - measures to reduce carbon emissions or to compensate for emissions already represented a market worth US$ 143 billion in 2009 (World Bank 2010b). Following this path, we see more and more ecosystem services being regulated by market mechanisms, which is a euphemism for privatization.

4) That manufacturing output grows quicker than GDP contributes to the understanding why there is still such a strong link between GDP and use of energy and other nature resources. It is the production side of the so called "rebound effect" or "Jevons paradox", i.e. that saving are offset by increased consumption.

How we measure

Our society is obsessed with indexes and rankings. One of the most pervasive measures has been the Gross Domestic Product, GDP, supposedly a measure of economic wealth. There is perhaps no one that claims that it is a perfect index and many think it is not even a good index even for economic things. For example, while GDP is supposed to measure the value of output of goods and services, in one key sector—government—we typically have no way of doing it, so we often measure the output simply by the inputs. If government spends more—even if inefficiently—output goes up. In the last 60 years, the share of government output in GDP has increased from 21.4 percent to 38.6 percent in the United States, from 27.6 percent to 52.7 percent in France, from 34.2 percent to 47.6 percent in the United Kingdom, and from 30.4 percent to 44.0 percent in Germany (Stiglitz 2009). We also know that even directly harmful things, like a car accident will increase the GDP, and if I chose not to cook my own dinner, but go out, suddenly our ”wealth” has increased. We have discussed how the costs for curbing green house gas emissions also will become a plus in the GDP, and how the exploitation of limited resources is reflected as a GDP increase. The GDP is sometimes used as a statement of ”standard of living”, but there is no such direct correlation. GDP doesn't reflect inequalities, so some people can be dead poor even in a country with high GDP. The GDP also understates the benefits sometimes, because GDP is a measure in monetary values; the price of goods or services. A lot of consumer items, such as electronics and food has long-term falling prices, which means that we will get more and more ”stuff” for the same money, so even with a stagnant GDP materials wealth can improve considerably. Even when it was first developed, its main architect, Simon Kuznets, said that ”...the welfare of a nation can, therefore, scarcely be inferred from a measure of national income (Talberth and others 2006)” and later on he said ”Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what" (Kuznets 1962). One would wish that politicians and economists would follow that advice more often.
Clearly, GDP is not an appropriate measure of progress of human societies. A number of alternatives have been promoted such as:
- Human development index (HDI) promoted by the UN Development Program (UNDP). HDI uses GDP as a part of its calculation and then factors in indicators of life expectancy and education levels. Notably it doesn't include anything on ecological sustainability. Scandinavia “scores” well in the HDI (UNDP 2005).
- Genuine progress indicator (GPI) or Index of Sustainable Economic Welfare (ISEW) - The GPI and the ISEW attempt to address many of the above criticisms by taking the same raw information supplied for GDP and then adjust for income distribution, add for the value of household and volunteer work, and subtract for crime, pollution and depletion of national resources. E.g. loss of farm land, erosion and compaction of farm land are joined together to be one of the 29 indicators. The GDP of Australia grew with 3.9% between 1950 and 2000, while the GPI only grew with 1.47%, and the disconnect between GDP and GPI growth has increased (Talberth and others 2007).

Talberth, John, Clifford Cobb and Noah Slattery 2007, The Genuine Progress Indicator 2006, Redefining Progress, www.rprogress.org

- Gross National Happiness – the country of Bhutan is working on a complex set of subjective and objective indicators to measure "national happiness" in various domains, such as living standards, health, education, ecosystem diversity and resilience, cultural vitality and diversity, time use and balance, good governance, community vitality and psychological well-being.
- Happy Planet Index - The happy planet index (HPI) is an index of human well-being and environmental impact, introduced by the New Economics Foundation (NEF) in 2006. It measures the environmental efficiency with which human well-being is achieved within a given country or group. Human well-being is defined in terms of subjective life satisfaction and life expectancy while environmental impact is defined by the Ecological Footprint. In the Happy Planet Index, Latin America and the Caribbean scores very well (Abdallah and others 2009).
-The Ecological Wealth of Nations compares a nations “bio-capacity” with its “ecological foot” print. This measure can be combined with other measures, e.g. the Human Development Index (Global Footprint Network 2009).

Seeing the whole

There are reasons to question measurements that come up with one single figure. For instance, it is not really meaningful to combine current well-being and sustainability into a single indicator. That amounts to mixing up the profit and loss statement with the balance sheet, or have one combined speedometer and gas meter in a car. Even when speaking about sustainability to treat natural and social capital as interchangeable is dangerous. Once we passed a certain threshold of erosion of a nature resource, the loss of that resource can't be balanced by any other resource. All in all the various indexes have their strength and weaknesses. It is not my task here to sort out which one is the best one. Most people seem to be very impressed by these rankings and it is certainly a good way to make people more aware of the complexities in this world to adopt some other measures beside the GDP. Introducing other indexes and measurements has the benefit of using another perspective.

While it would be good to find other measures, we should also not exaggerate the effects of doing so. We have measured the number of hungry people in the world for many decades and the numbers are still appalling. We measure climate change, but it hasn't impressed politicians or citizens enough the take radical action. We need to keep separate the efforts to analyse our economy with alternative measures and terms and possibilities to manage our economy in that way. These various measures and indicators don't change the reality of economic agents, in particular companies. Companies are not trying to grow the GDP, they try to increase their profit or simply survive the competition. Even when they speak about "triple bottom line" and other niceties, increasing the profit will always be the overarching driver. And this will remain the same even if societies trash GDP as a measure. I have explained earlier how the market and technology logic by themselves drive (GDP) growth. Similarly, consumers don't buy more stuff to contribute to the GDP, they buy more stuff because it gives status or satisfaction or simply because they have money to spend, "money burning a hole in my pocket" as the saying goes. The effect of these measurements is on the political discourse mainly. 

(Extract from Garden Earth, update latest 1 May 2011)