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A lack of humility but correct, for the wrong reasons

The technocrats at the Bank of England have come in for more criticism as a result of Chief Economist Huw Pill’s remarks during an American podcast.  As Michael Race and Vishala Sri-Pathma at the BBC report, the former Goldman Sachs banker told listeners that:

“Somehow in the UK, someone needs to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether through higher wages or passing energy costs on to customers etc…

“What we’re facing now is that reluctance to accept that, yes, we’re all worse off and we all have to take our share…”

Understandably, critics have pointed to the lack of self-awareness of a man apparently paid more than £200,000 per year (the most recent Bank of England annual accounts have him being paid £88,154 plus £7,029 for his first five months in the job between September 2021 and February 2022) telling an army of new foodbank users and insolvent business creditors that, in effect, they need to suck it up.

Superficially though, Pill has a point.  The corporations most responsible for jacking up prices are mostly the big multinationals which are less concerned about driving customers away, rather than small family businesses which have had little option but to absorb the increasing costs of doing business.  In a similar way, most of the workers who have taken to the picket lines to demand higher pay are what used to be called “the aristocracy of labour” – those who already enjoy above average wages.  At a time when millions of people across ex-industrial, rundown seaside and small-town rural Britain have been driven into a growing precariat whose livelihoods depend upon low-paid, zero-hours, part-time and gig working, it is really hard to muster sympathy for train drivers (average 2022 salary £48,000 per year) teachers (£42,400) or junior doctors (£29,384 to £34,012).  Not least because their strike action provides cover for further government austerity measures (such as last year’s breaking of the “triple lock” on the state pension, and the refusal to raise means-tested benefits in line with inflation) which have the greatest impact on those at the very bottom of the income distribution.

As with almost all economists though, Pill is simply wrong.  He is working from ungrounded econometric models based on politically-biased theory.  Moreover, like a general fighting the last war, Pill – along with the other western central bankers – seems to believe he has been transported back to the 1970s.  And so, the story he is running, at its simplest, goes something like this:

The adults gave the children too much pocket money.  The children went and binge-spent the extra on sweets.  As a result, the children had a kind of sugar-induced ADHD episode which impinged on the quiet lives of the adults.  The only way to deal with it was to take the children’s pocket money off them until such time as they could not afford sweets anymore.  Okay, the economists don’t put it quite that way – they use esoteric terms like gross domestic product, consumer price index, M2 money index and the velocity of money – but the broad outline is the same.  For “adults” read governments and central bankers, for “children” read ordinary people, and for “sweets” read the various things that make life a bit more bearable, and you have the basics of monetarist economics.

So, here’s why these mainstream economists almost always get it wrong.  First, they have no understanding of money.  Yes, I really did say that.  As contrarian Steve Keen explained (or perhaps complained) in the wake of the previous financial crash:

“It may astonish non-economists to learn that conventionally trained economists ignore the role of credit and private debt in the economy – and frankly, it is astonishing.  But it is the truth.  Even today, only a handful of the most rebellious of mainstream ‘neoclassical’ economists – people like Joe Stiglitz and Paul Krugman – pay any attention to the role of private debt in the economy, and even they do so from the perspective of an economic theory in which money and debt play no intrinsic role.  An economic theory that ignores the role of money and debt in a market economy cannot possibly make sense of the complex, monetary, credit-based economy in which we live.  Yet that is the theory that has dominated economics for the last half-century.”

In fairness, the Bank of England has gone further than most to explain the way most currency is created by commercial banks when they make loans.  However, even they maintain the fiction that there is a token at the base of the money system – the historical pound (in weight) of Sterling Silver upon which the original pound note was based, or more recently the post war ounce of gold which backed every $35 in the Bretton Woods system.  The supposed token today takes the form of “central bank reserves” aka “M0 money” which can only be created by central banks, and which central bankers delude themselves form the basis of a fractional reserve system which died decades ago.

The reality today is that the only limit on bank lending is the perceived future value of the collateral against which loans are made.  When all is said and done – as we have seen since 2008 – the central banks will print reserves (quantitative easing) in whatever quantity is needed to prevent commercial banking from collapsing.  That is, far from setting a theoretical limit on bank lending, the true role of the central bank is to bail out the system when its loans go bad.

This brings us to the second – and least understood – reason why economists mostly get things wrong… they are “energy-blind.”  That is – and the history of the past four centuries or so appears to bear this out – the core assumption in economics is that if there is enough currency in the system, it can grow forever.  Mostly, this progress results from the human ingenuity which creates new technology.  There is some recognition – in the form of the supposed “productivity puzzle” – that there are times when technological progress stalls.  But the reason for this is assumed to be monetary – either governments have printed too much money, causing inflation and disinvestment, or they have printed too little, causing deflation and under-consumption.  Either way, the role of the state and central banks is to bring the money supply back into balance – most often via austerity measures (lower wages and public spending cuts) which target the poor, while just happening to ignore the massive volumes of corporate welfare doled out to corporations (that’s why they used to call economics “political economy”).

 If we understand that the real limit on the supply of currency is the perceived future value of the collateral against which commercial banks – both within nations and throughout the international banking system – loan new currency into existence, then an obvious – but seldom asked – question arises.  Why should collateral which was previously believed to be good – like sub-prime mortgages prior to 2008 – come to be seen as poor or even negative value?

This gets to the point at which what we think of as almost two separate entities, the “financial economy” and the “real economy” meet.  This is analogous to the relays which form the point within a computer where the software connects to the underlying hardware.  We can do almost anything we like within a software programme, and it tells us nothing about the hardware other than that it is switched on.  In the same way, we might forensically deconstruct every hardware component for analysis, but it will never reveal the content of the documents within the word-processing program.  Only where those relays switch on and off – creating the strings of zeros and ones of the binary language upon which the software for everything from a basic word processor to the international banking system is based – does the real and the ethereal meet.

In the real economy, where we mere mortals live out our days, energy is the real medium of exchange.  Without energy (in the form of food calories) you don’t even get to breathe.  Without energy (in the form of fuels and electricity) all but the most basic economies of the modern world grind to a halt.  As Steve Keen famously put it, “capital without energy is a statue, labour without energy is a corpse.”

If surplus energy is the equivalent of the power flowing through the computer relays (technology) then value is the corresponding string of zeros and ones which underpins the software of the financial economy.  And what gives the collateral against which new currency is loaned into existence its value, is the confidence that the value being generated in the real economy will continue to grow.  This confidence is based upon a twofold process which has broadly worked out over several centuries.

The first process is what we might call a series of broad energy transitions.  Go back to the largely agrarian European and North American economies of the eighteenth century, and beyond food-powered human labour (which even then was relatively trivial) and we have mostly charcoal and wood fuel, animal (horse and ox) power together with a growing use of renewable energy – particularly with the use of improved metallurgy providing for bigger and stronger water wheels.  From around 1720 the first steam-powered beam engines come into use, although it is not until 1776 that Watt’s first condensing engine is demonstrated (coincidentally, when we think about links between economic hardware and software, Adam Smith, who published The Wealth of Nations in the same year, was from Kirkcaldy, the same Scottish town where Watt invented his steam engine).

Although “industrialisation” had begun earlier, with the deployment of various technologies to make cloth from the cotton returning to England from the slave-powered American cotton plantations, it is after 1776, with the growing use of coal-powered steam engines that the “industrial revolution” really gathered place.  That is, from the point at which the energy which powered the economy began the transition from renewables to the first fossil fuel.

The second process – in part embodied in Watt’s version of the steam engine – is the process of productivity.  That is, of using various technological – in the broadest sense of the word – innovations and improvements to combat the thermodynamic tendency to lose energy as waste heat.  It is a battle which cannot be won, of course.  Nevertheless, since the prototypes of most technologies tend to be highly inefficient, there remains a considerable amount of useful energy which can be harnessed from the waste heat.  In practical terms, for example, Trevithick’s 1802 steam locomotive is the same technology as Gresley’s 1936 Mallard, it is just that the latter had been improved beyond the real economy limits of coal-power.

In the increasingly computerised economy of the decades after 1980, Moore’s Law – the process by which computing power appeared to be able to double every year, a popular myth developed around the belief that the same applied to all technologies.  That is, the technological progress could continue onward and upward forever.  But that is not really how productivity works.  In practice there is a fairly low thermodynamic limit on the energy available from any source which can be converted into useful work – even the most efficient technologies lose more heat than they provide useful energy.  But to begin with, most technologies are so energy-inefficient that a series of relatively cheap and simple productivity improvements can have a huge impact upon the power available for work.

Problems begin though, once all of the cheap and easy gains have been made.  The closer scientists and engineers came to the thermodynamic limits of coal-power, the more difficult and expensive it became to keep delivering additional useful energy aka value.  Like Concorde, the Saturn V rocket and the automated car wash a generation later, Mallard had passed an energy/value economic limit.  Seen through the lens of the financial economy, these technologies required a subsidy from elsewhere in the economy to make them viable.  In energetic terms, this meant that a – probably relatively small – proportion of the surplus energy – that remaining after energy production is accounted for – available to the wider economy had to be diverted to these energy-excessive technologies to keep them running.  In practical terms, poor taxpayers were required to fund modes of transport which mainly benefited the already wealthy.

Eventually of course, the coal limits of coal-power were reached – in Europe from the 1890s and across the developed world in the late 1920s.  Growth stalled simply because further productivity improvements could only be achieved at a huge energy cost… which meant that the financial returns on loans and investments were too low for all but the most reckless investors to risk.  The USA might have enjoyed the final, debt-fuelled “roaring twenties” of the coal age, but for most Europeans, the inter-war years were marred by unemployment and stagnation.

Just as some coal had been in use even before the first beam engines were developed in the preindustrial economies of Europe, some oil had been in use – mostly as a replacement for whale oil in lighting – in the USA long before the technologies of the First World War (tanks, trucks, aeroplanes, etc.) ushered in the technologies of the oil age.  It was the additional potential energy locked up in oil, together with the relative ease with which it could be stored and moved, which allowed for the giant leap in productivity and living standards across the western economies in the years which followed the reconstruction after the Second World War.  It is not just that oil made older, coal-powered technologies (such as transatlantic liners) more efficient.  It was that the new power source allowed for entirely new technologies (such as transatlantic airliners) which would not have been possible in the coal age.

Perhaps because we cannot see energy, but only its effects, those who follow primitive religions believe that it is the man who sits upon the cart who is responsible for animating it.  More developed thinkers at least credit the harness which connects the cart to the horse.  But almost nobody sees the horse which does the actual work.  And so, just as economists wrongly believe that so long as we print just the right amount of currency, then the economy can grow forever, so a wider part of the population tends to believe that technology will provide us with infinite growth in the real economy so that we might pay off all of those loans which created the currency in the financial economy.

Energy though, is a fickle friend, as it places us all on a treadmill from which there is no easy exit.  Just as Europe began to experience the economic consequences of bumping up against the thermodynamic limits of coal power from the 1890s, so the western economies began bumping up against the thermodynamic limits of oil in the 1970s.  In the two, almost magical decades 1953 to 1973, world oil production had grown exponentially.  And this explosion in the availability of surplus energy allowed for as much economic growth in those 20 years than had occurred in the 150 years which preceded them.  It is for this reason that we can look back on the post-war boom as a time when an ordinary American or Western European worker could afford to buy a house, support a family, run a car and take an annual holiday.

By the 1970s, the former colonies and protectorates of the western powers had gained independence.  And not unreasonably, they felt that at least some of the value generated by the oil they produced ought to go to raising living standards in their own countries rather than supporting the exorbitant privilege which cheap oil conferred on westerners.  And so, OPEC closed ranks just at the point when US oil production had peaked… and the global price of oil rose to economy-crushing levels.  In short, and contrary to the belief of today’s central bank donkeys, it was the rising energy cost of energy, not profligate governments and greedy trades unions, which was responsible for the stagflationary crisis of the 1970s.  And it was the arrival of cheap(ish) new oil production in Alaska, the North Sea and the Gulf of Mexico, rather than 1980s politicians and central bankers genuflecting at the altar of monetarism, which brought the brief, debt-fuelled respite of the 1990s and early 2000s.

This of course, is the war that Huw Pill, Andrew Bailey, Jerome Powell and all the other central bankers are trying to fight today.  But if the 1970s was the oil age equivalent of the coal economy’s 1890s doldrums, then the gathering collapse since 2005 is the oil age equivalent to the financial crash and great Depression of the late-1920s and 1930s.  That is, where the European economies of the late nineteenth century gained partial respite by the development of additional coal deposits around the world, by the late 1920s, the entire world was running into the thermodynamic limits of coal power.  The saving grace though, was that oil and oil-based technologies were already available to enable – albeit in the worst possible fashion – a new energy age in which another period of growth could be ushered in.

This time around, there is no obvious new energy source with which to pull us out of an ongoing – and worsening – depression.  Worse still, while the volume of oil being produced globally is holding up, its energy content has fallen dramatically.  This means that what few technology/productivity gains which remain to us have to be used to offset the declining value we derive from the energy source itself, rather than providing the means for further economic growth.

Those within the commercial banking sector may not know this, but they do seem to sense it.  That is, just as after 2005, declining conventional oil production led to declining and more energy-expensive surplus energy to the real economy, so the post-2018 peak and the ensuing disruption to production has produced rising real economy input costs which render previously acceptable collateral worthless… or at least, no longer worthy of further investment.  And as happened after 2005, the central bankers’ purely monetary response – raising interest rates – to price rises which they – wrongly – believe to be a solely monetary problem makes the problem worse by further devaluing collateral and by making banks tighten their lending standards…  a process which is gradually crushing the discretionary economy even as the cost of essentials such as food, fertiliser and fuel remain stubbornly high.

Most likely, given past performance, once business closures, unemployment and bank failures gather enough pace, the central bankers will slam the system into reverse via more and bigger quantitative easing and possibly even below-zero interest rates. At the same time, governments, fearing a public revolt, may resort to some version of “helicopter money” in an attempt to buy public support. But while this may alter who gets crushed first, it does nothing to ward off economic depression so long as we lack a new and more energy-dense source of surplus energy to replace oil.

In this respect, Huw Pill is absolutely right to say that we are just going to have to get used to being worse off… especially within financialised western economies which have used access to the dollar as a means to grab far more than their fair share of the global output.  But being correct for an entirely wrong reason makes nonsense of Pill’s belief that we are going to get through this without some spectacular economic and political upheavals.  The precariat may be too poor and too downtrodden to overthrow the system and to separate the wealthy from their wealth.  But the gathering revolt of our “energy slaves” is not so easily overcome… and just as obese people notice hunger first, so wealthy westerners are likely to be worst-hit by our growing real economy energy withdrawal symptoms.

As you made it to the end…

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