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Stagflation has begun

The deception of the past decade is that central banks have been “printing money” via quantitative easing.  This may have helped boost confidence in the real economy that it was safe to borrow once more.  But other than the printing of the tiny volumes of cash, which account for less than two percent of transactions, central banks have no means of directly creating currency.  They may create “central bank reserves” – although the impact of these is overstated.  And by using them to purchase the unsafe “assets” held by commercial banks in the aftermath of the 2008 crash, they could encourage new bank lending.  Nevertheless, the fact that several rounds of quantitative easing, coupled to real negative interest rates, failed to generate even modest inflation gives the lie to the “money creation” fallacy.

What QE actually did was to create a desperate search for yield, in which financial institutions and big investors sought assets which would give higher rates of return.  And so, in the course of the decade between the Crash and the Covid, they helped to inflate the financial “everything bubble,” in which unproductive assets – which are excluded from official inflation measures – across the economy inflated in price at an astronomical rate.

Not that investors fare particularly well, since there is no means of realising the theoretical value of the assets themselves, because the institutions which own them are the only ones who could realistically buy them.  In a sense, they are trading real returns for the illusion of appreciating assets… we have plenty of examples of what happens when shareholders seek to sell at the same time, or when bank depositors all try to withdraw their cash… it isn’t pretty.

So long as most of the currency created indirectly as a result of quantitative easing remained in assets not included in the official inflation data, then we could pretend all was well.  And to the extent that there was not enough currency in the real economy to unduly impact consumer prices, ordinary people could muddle along reasonably well… even if prosperity continued to decline in the bottom half of the income distribution…  And then came Covid.

The decision by governments around the world to take the leap into the unknown which was lockdown – effectively shutting down whole swathes of the discretionary economy while simultaneously shattering the global just-in-time supply chains – while borrowing vast quantities of new currency to throw around like a drunken sailor, had the twin effect of generating both supply-pull and demand-push price increases the moment they attempted to unlock.

Had it not been for the supply shock – which partly pre-dated Covid, following the global peak of oil production in late 2018 – the central bankers would likely have been correct in their diagnosis of “transitory” inflation.  That is, once the initial consumer spending spree following two years of lockdown had run its course, and once supply chains had adjusted to new patterns of consumption, much of the additional currency spent into the real economy would have left again via debt repayments and taxes.  The supply shock though, made sharp price increases inevitable as the cost of essentials like fuel, fertiliser and food forced prices up to an economy-damaging level.

The problem was compounded, of course, by the western neocons’ insane decision to fight an economic war against the last energy and resource rich state on the planet – backed up, it would seem, by the world’s greatest manufacturing state… what could possibly go wrong?  Nevertheless, self-harming sanctions on essentials has merely accelerated a crisis which was already baked-in.

The problem with the somewhat schizophrenic policy response – central banks trying to stem the money supply even as governments are borrowing and spending even more – is that it is based on ungrounded economic theories that assume the economy to be entirely monetary.  As such, policy makers failed to stop and question the maxim that, “inflation is everywhere and always a monetary phenomenon.”  In an anti-eulogy to recently deceased Tory Chancellor Nigel Lawson – who presided over the British side of the financial deregulation which led to the 2008 crash – Adam Ramsey at Open Democracy explains how this erroneous view of the economy came to dominate the politics of the past four decades:

“The conventional story goes like this: in the 1970s, there was too much social democracy. The rich were taxed too much, workers were paid too much, too many industries were nationalised and the unions were too powerful. Inflation got out of control and everyone got poorer.

“In the 1980s, supposedly, Margaret Thatcher and her wizard chancellor Nigel Lawson came along. They slashed taxes, smashed the unions, and dashed nationalised industries on the rocks of privatisation. The City of London swelled in what was dubbed ‘The Lawson Boom’ and ‘the Big Bang’. Suddenly, so the story goes, the country got richer.”

In reality though, inflation is always and everywhere an energetic phenomenon, since, with access to sufficient, low-cost surplus energy, there is always enough productive capacity in an economy to absorb the excess currency that states and bank borrowers spend into it.  As Ramsey points out:

“The crisis of the 1970s wasn’t a product of Britain’s economy being ‘too nationalised’. It was a global crash, produced by two main factors. On the one hand, oil-rich former European colonies, having shaken off their imperial masters, had formed the OPEC cartel and raised the price of oil.

“On the other, the costs of the Vietnam War to the US, and the rise of the German and Japanese economies after WW2, led to a surge in inflation, which Richard Nixon dealt with through a set of policies known as the ‘Nixon shock’. This effectively ended the global financial system established after WWII, with reverberations around the world.

“By the end of the 1970s, though, North Sea oil started to come on stream. By the mid-1980s, when Lawson was chancellor, 10% of annual government revenue, or £18bn a year, came directly from North Sea oil.

“Just as significantly, the oil boom played a vital role in delivering the Big Bang in the City of London, for which Lawson usually gets both credit and blame, with money flooding in to invest in Britain’s new hydrocarbon glut…”

It is not clear whether Ramsey understands the enormity of the point he is making.  It is not just that the North Sea oilfields were a large oil resource.  It is that they could be recovered at a low-enough cost to underwrite a large part of the UK economy over and above the tax revenues returned to the UK government.  This is where so many commentators and activists go wrong in assuming that (on the left) expensive non-renewable renewable energy-harvesting technologies (NRREHTs) and/or (on the right) expensive fracked shale gas formations and/or (in the neoliberal centre) expensive imported liquified natural gas – each with or without a side-helping of expensive nuclear power – will somehow save the day because of the potential quantity of energy they might return.

By “cost,” I am not referring to the day-to-day price, but to the energy cost – the amount of energy we must divert away from the wider economy in the first place, just to have that energy available to us in future.  It is notable, for example, that the European wind turbine industry was one of the first to collapse once the price of gas rose following the sanctions on Russia.  Far from providing the promised “energy too cheap to meter,” it turned out that absent government subsidies and cheap Russian hydrocarbons, wind turbines are a non-starter.  Nor is this just a problem with NRREHTs.  Much of what remains of the oil and gas in the North Sea is largely stranded because the energy cost of producing it is greater than the value of the energy it might return.  The same is true for UK shale gas deposits which, according to some geologists may no longer contain gas anyway.

Pumping more currency into the economy isn’t going to lower that energy cost – only some yet to be discovered new source of low-cost energy can do that.  And so, even if the price of energy fluctuates as demand and supply race each other down the decline side of the production bell curve, the rising energy cost will make it increasingly unaffordable to the wider economy.

While we cannot know in detail how this will play out, we do know the broad contours of the unfolding crisis.  As the energy cost of energy continues to rise, so the energy available to power the economy falls.  And since the energy cost of essentials such as food, fertiliser and fuel is most impacted by the rising energy cost, we will inevitably see a shift in consumption away from discretionary goods and services as consumers and businesses rebalance their spending to meet the rising cost of essentials.

One of the earliest rebalancing is a deflationary shift away from borrowing.  Whereas in a monetary inflation, spending is brought forward – far better to buy that new TV for £200 today than £220 next month – as people struggle to meet the rising cost of essentials, so paying down debt becomes more important.  At the same time, the growing threat of recession tends to discourage new borrowing – a process amplified by the rapid rise in interest rates.  And so, the main way in which new currency is created – by banks lending it into existence – stalls.  The result, as reported By Bloomberg and in a summary from Capital Market Laboratories is that we now have an unprecedented money supply collapse across the western economies, pointing to a rapid deflation.

This puts us broadly where we were in the early 1970s according to Ramsey’s – correct – energy-based version of events.  That is, the price of essentials – which are most tightly coupled to the cost of energy – is stubbornly increasing despite central bank policies which have already caused a major recession, even if the wave of bankruptcies and redundancies – which always follow the collapse in the supply of currency – have yet to put in an appearance.   It goes without saying that – as happened in 2006-08 – by the time the central banks realise they have a problem, it will be far too late to do anything to stop it.

The stagnation side of the unfolding stagflation, then, results from a declining supply of currency which forces discretionary spending to collapse.  The inflationary side, in contrast, comes from the increasing cost of essentials which also forces businesses and households to abandon discretionary spending.  And since most of the economy in developed states like the UK is discretionary, stagflation becomes a vicious circle as falling discretionary spending causes even more bankruptcies and redundancies which cause even less discretionary spending.

Relatively cheap energy, not monetarist voodoo economics, was what dug us out of depression last time around.  The production of new oil and gas from Alaska, the North Sea and the Gulf of Mexico providing an injection of cheaper energy with which to squeeze the last drop of productivity – using new computing and communications technologies – out of the western economies.  Arguably, in the wake of the 2008 crash, the US shale oil blip, together with European imports of Russian oil and gas did something similar, although on a much smaller scale and at a far greater cost.  But notice that there was no boost to technology or to infrastructure after 2008 in the way there had been in the 1980s.  Far from being the herald of a fourth industrial revolution, digital technologies and the associated infrastructure turn out to be the final gasp of an industrial economy which cannot function without the fossil fuels it was built upon.

And that, of course, is a major headache in 2023, because this time around there is no cheap and easy energy to bail us out.  So that much of the way of life we have come to take for granted – like clean drinking water, a firm supply of electricity, a national health service or global food imports – is going to break down.  It’s likely replacement – once the dust has settled – will likely be more labour-intensive, smaller, localised and far less material…  Perhaps only then will economists come to acknowledge the benefits that access to cheap energy conferred upon us.

As you made it to the end…

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