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Why energy prices are deflationary

Common sense tells us that rising energy prices must be inflationary.  After all, energy is the lifeforce which drives everything we do.  As Steve Keen famously remarked, “Capital without energy is a statue, labour without energy is a corpse.”  So, when the price of electricity, gas, or oil – which power the industrial economy – increases, not only does it make energy more expensive, but everything we do with energy must also rise in cost.  Moreover, since businesses tend to pass on their increased costs, then rising energy prices translate into rising costs across the economy.

As is so often the case though, common sense turns out to be wrong.  Originally, inflation meant solely monetary inflation – an expansion of the currency supply which, if too great, would result in a devaluation of the currency that would manifest as rising prices.  But over time, the imprecise use of the word inflation resulted in it becoming shorthand for any form of rising prices, even where this had nothing to do with money.  While this may sound like mere semantics, the confusion caused can have massive negative impacts in the real world.  Not least because when governments and central banks respond to non-money price increases as if they were monetary inflation – by cutting the supply of currency in circulation – they can turn a recession into a full blown and prolonged depression like the one in the early 1980s.

Consider what happens to your own household spending when energy prices rise.  Few of us have sufficient income to carry on as before.  Most of us have to change our spending patterns.  You might be able to cut back on your energy costs – turning the thermostat down to save on heating costs, or only using the car for essential journeys to save on fuel.  Most likely though, you will be obliged to make cuts to your discretionary spending – having a takeaway rather than going to a restaurant, or buying beer from the supermarket rather than going to the pub.  Now consider what happens to businesses.  Again, there may be some scope for consuming less energy, but most likely the business will have to cut its costs or raise its prices.  But here’s the thing, consumers (households) are already cutting their spending, so raising prices may increase income per sale but if sales fall accordingly, then total income remains the same… or may even fall. 

In almost every business, the biggest cost by far is the wage bill.  And so, as energy prices go up, forcing households and businesses to cut their spending, eventually businesses must cut their wage bill.  Within the neoliberal western economies this doesn’t automatically translate into unemployment as it did in the 1930s and the 1980s but has tended to manifest as fewer hours being worked as businesses cut workers’ hours to save on wages – this has the advantage that if the economy picks up, the business won’t have the cost of re-hiring.  But if things don’t pick up, lay-offs become inevitable – further shrinking the spending power of consumers.  Ultimately then, the loss of demand across the economy translates into less demand for energy too, thereby creating a surplus and bringing prices down again.

Government is different and should never be compared to a household… unless you know of a household that has its own money-printing press.  And governments can, and do, interfere in economies in ways that obscure what would otherwise be a straightforward deflationary process in which, as the cost of energy rises so economic activity as a whole has to shrink.  Governments though, might print or borrow additional currency – like they did during the lockdowns – and central banks might make new currency easier to create by lowering interest rates and providing banks with additional reserves – like they did during the lockdowns.  This, of course, complicates matters because instead of having to make immediate cuts to spending in response to rising energy prices, businesses and households can use the additional currency to delay the day when they are forced to, in the hope that in future energy prices will have fallen.  If, however, energy prices do not fall, then we get the worst of all worlds because all of that additional currency will have to be repaid – either through insolvencies and debt defaults or through inflation – and cost cutting will have to happen anyway.

If this sounds a little familiar, it is because it describes the situation we find ourselves in here in the UK.  In the autumn of 2021, the UK economy was struck by two separate economic forces which triggered the ongoing cost-of-living crisis.  However, because establishment media, politicians and economists themselves had, almost unconsciously, redefined the meaning of the word “inflation,” almost everyone believed that just one economic force was at play.

The difficulty in the autumn of 2021 was that we faced both monetary inflation and non-money – “supply-side” – price increases.  The first had been the consequence of the government spending new currency into the locked-down economy in the form of grants and loans to businesses, increased social security benefits to those without work, and generous furlough payments to those whose work was not deemed essential.  Much of this was no doubt necessary to prevent widespread business failure and mass unemployment.  But with a large part of the discretionary economy shut down for the duration, the inflationary problem was that a large part of the newly created currency went unspent.

When the economy finally opened up in the autumn of 2021, a large part of the pent-up currency was spent into the discretionary economy, as people bought new clothes, took last minute holidays, enjoyed meals in restaurants, went to the pub to meet friends, etc.  In short, they engaged in all of the things that even today it is impossible to do online.  And the result was an inflow of currency greater than the economy had the capacity to supply.  Businesses – which had also been locked down for the best part of two years – struggled to find employees and to source supplies.  Put simply, in the autumn of 2021 there was too much money chasing too few goods and services… the classic definition of monetary inflation.

There was though, a far more powerful economic force at work at the same time.  A large part of global fossil fuel production was also locked down after the oil futures market briefly turned negative in the spring of 2020.  Coming on top of rising production costs and an increasingly hostile ESG investment climate, the economic uncertainty caused by state responses to the pandemic served to curtail new production and to cut existing output.  And contrary to the popular imagination, multi-billion-dollar oil and gas fields and oil refineries cannot simply be turned on and off like a tap.  The result, in the autumn of 2021 was that the world economy was short of some five million barrels of oil per day, along with similar shortages of natural gas.

While energy was – and is – by far the most damaging of the supply chain disruptions caused by lockdowns, it was not the only one.  Goods of all kinds were in short supply because global just-in-time supply chains had broken down.  In container ports across the consuming western states, container bays were stacked full of containers full of imported goods which had not been moved due to truckers being locked down and stores being closed.  Outside these ports, even more loaded containers sat on the decks of ships which couldn’t get into the ports to unload.  Less obviously, there was no space for empty containers to be brought back to the port or to be loaded onto those ships when they finally docked.  And so, in ports across the exporting states, goods sat on the quayside, on the back of trucks or in the factories, for want of empty shipping containers to load them into.  At the height of this supply chain crisis, UK shipping rates rose tenfold, putting massive pressure on UK retailers who had to choose between absorbing the additional costs or attempting to pass them on to increasingly hard-pressed consumers.

The energy and supply chain price increases were what the Bank of England correctly referred to as “temporary.”  The difficulty was that nobody had actually defined what they meant by “temporary.”  So that as prices kept rising through 2022 – not least because of the burst of discretionary spending using the additional lockdown currency – the central bankers blinked, and what followed was the fastest increase in interest rates since the 1980s… something which also takes time to work its way through an economy.

Official UK sales data in 2023 has been extremely flattering, and has been further amplified by establishment media outlets, giving the impression that all is well.  But what looks at first glance like rising consumption is solely an artifact of increased prices.  What has actually been happening for more than a year in the UK is that consumers have been purchasing fewer goods and services but paying more and more for them.  In short, the official data is counting higher prices as growth.  Moreover, the details within the data show that despite stubbornly high official inflation, the price of discretionary goods and services has already plummeted.  The two items which are now keeping UK inflation high are energy prices and housing costs.  And the thing which is primarily responsible for the latter is the Bank of England interest rate rises intended as a futile attempt to curb the former.

Rather like the period prior to the 2008 crash, in 2022 economists had confidently predicted oil prices above $100-per-barrel.  Instead, the price has fallen back to around $85, despite ongoing sanctions on Russia together with OPEC+ production cuts which ought to have sent prices soaring.  The reason, quite simply, is demand destruction.  Germany is already in recession, absent cheap oil and gas the eurozone is a basket case, and the UK government has only avoided an official recession by including the overseas production of UK firms in its revised GDP data.  Meanwhile, the reality on the ground for tens of millions of people across the European continent is of crashing standards of living as rising energy, food and rent or mortgage payments leave little or nothing to spend on discretionary (or even what were until recently – like showering – essential) items.

Prior to the second half of 2023, this collapse in discretionary spending – which was already causing widespread insolvencies and growing under-employment and unemployment – was solely the result of these supply-side cost increases.  This is because the rises in interest rates take years to have an impact on the economy.  Most mortgages and most business loans are taken out for a two- or three-year period, so that it is only in the second half of 2023 that loans taken out when the interest rate was just 0.1% had to be rolled over.  Until now, that is, the main impact of interest rate rises has been on short-term credit card and overdraft debt – which, alarmingly, increasing numbers of households have been using in a doomed attempt to bridge the gap between income and spending.

Data from UK Finance showed a seven percent increase in mortgage arrears in Q2 of 2023, with 81,900 households in arrears.  More worrying though, was a 28 percent increase in arrears among buy-to-let landlords, with 8,980 in arrears.  No doubt most people’s knee-jerk reaction to this latter data will be “fuck ‘em… who cares about landlords.”  Except that as landlords have faced higher mortgage costs, they have increased rents.  And when the rents no longer cover the costs, they have been selling the properties.  The result being that rents have risen even further as fewer rental properties are available.

This is occurring before the 1.4 million mortgages taken out two years ago when the interest rate was just 0.1% have to be renewed.  In practice, those mortgages will have had an interest rate of around 1.5%, which will rise to six percent or more, assuming the banks – which have tightened lending standards – are prepared to offer a new mortgage at all.  If not, households will be forced onto an even higher standard variable rate.  What this translates to on an average house bought with an average mortgage in 2020, is an increase of more than £900-per-month when the mortgage rolls over in the course of the next three quarters… an increase which few households will be able to afford from some combination of savings and spending cuts.  Nor, with tighter lending standards and house prices already falling, is selling up likely to be sufficient to cover the debt.  By the middle of 2024, the term “negative equity” will likely have become widespread again.

The broad point here is that the economic slowdown, mortgage arrears, business insolvencies, and rising under-employment that we have seen thus far, has almost nothing to do with the Bank of England’s interest rate rises.  Rather, they are primarily the result of millions of households and thousands of businesses adjusting and curbing their spending in response to higher energy costs, together with a decline in the volume of currency in circulation as the additional lockdown currency has now returned – via debt repayments and taxes – to the banking and financial circle of Hell from whence it was conjured into existence in the first place.

If the Bank of England had stuck with its original assessment that higher prices were temporary – albeit that temporary likely meant three or four uncomfortable years – we might now be facing a reasonably normal – i.e., within the bounds of historical data – recession, as discretionary spending crashes because households and businesses are obliged to spend more on energy and so less on everything else.  Instead, as happened in 2008, higher interest rates are about to add a housing, business insolvency and unemployment crisis to an already recessionary economy.  At which point, we will likely find out once again, just how many trillions of dollars’ worth of derivatives the banks have created on the back of all the now unrepayable debt.  More importantly, with even developed western governments having difficulty servicing their own dollar-denominated debt, we might just be about to discover that things that were considered too big to fail last time around have now become too big to save.

As you made it to the end…

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