It’s the energy, stupid!
By: Stanislas Berton
Tags: Crisis, Economics, Energy, Oil

It is dawning, even on economists, that the situation might be serious: recession is looming, banks are virtually bankrupt and negative interest rates are destroying the financial system as well as the very concept of savings.

However, most of them have still not figured out the real cause of this crisis and, by extension, the fact that this is not a just some part of the economic cycle but truly the end of an era.

To understand this, it is necessary to go back to basics, meaning economic models.

For centuries, these models have been ignoring the most basic laws of physics, a fact that did not seem to bother them that much. The lack of scientific training prevents most economists from understanding that every economic process is about transforming matter and that this transformation requires energy. Our modern world was born with the Industrial Revolution which was a scientific revolution but also a revolution of the way we exploited fossil sources of energy: coal, then oil. If we wanted to be rigorous, economic output, as measured by the GDP, should be a linear function of the energy used.

Oil output and growth (source: the Shift Project)

For over two centuries, a flash-in-the pan compared to humanity’s economic history, we have regarded natural resources oil, coal, but also wood, water, copper, zinc, sand, phosphate and a lot of elements found in the periodic table as infinite resources. Unfortunately, they are not and since the beginning of the industrial revolution, their stocks have been steadily declining.

Rather than admitting this fact and accepting that growth would mechanically experience a slowdown in the late 20th-early 21st centuries, governments decided to pretend that everything was fine and embarked on a flight forward whose dire consequences are catching up to us now. This flight took the form of debt, I’ll go back to this, and the increasingly costly exploitation of natural resources which are getting more and more difficult to obtain. As an example, fracking and shale gas enabled the USA to buy itself twenty years of respite but the activity itself is not profitable and can only exist because it is heavily subsidized by the US government.

When talking about energy, one should not look at the volume or the price but at something called “Energy Return On Investment” (EROI). EROI represents the amount of energy necessary to extract a given quantity of energy. The lower the EROI, the higher the cost of extracting the energy and the less profitable the activity is, as it is the case with shale gas. Even if a lot of fields of one given resource still exist, if it costs you more, energetically speaking, to get it out of the ground than what you get energetically out of it, it is useless. To summarize: as your EROI diminishes, the economy contracts in real terms and so does your discretionary income.

Truth be told, debating whether or not natural resources are declining is absurd because we are actually already suffering from the decline of the EROI and the reality of dwindling natural resources’ stocks. In fact understanding the decline of the EROI is the key to understanding the trajectory of the economy since the 1970’s.

In fact the first oil crisis in 1973 is actually a direct manifestation of the decline of the EROI (see graph). If a factory worker could raise a whole family on his salary and can no longer do so in 2019, it is ultimately because of the decline of the EROI. If the subprime crisis happened in 2008, it is ultimately because of the decline of the EROI ( overlending and junk bonds are just ploys to temporarly delay the inevitable contraction, see below)

The decline of the EROI is a physical hard fact: the energy we extract from the environment and use to make the wheels of great economic machine turn is getting scarcer and of a lower quality. As a result, the economy is contracting in real terms.

Our governments found a solution to sweep the problem under the rug: massive debt creation, i.e. transferring the cost of the adjustment to future generations. For decades, monetary creation has been used to offset the decline of the EROI and maintain the illusion of prosperity as well as supporting the economic take-off of countries such as China. Problem is, this strategy is no longer working.

Governments, banks and financial institutions are currently finding themselves between a rock and a hard place: massive monetary creation is currently destroying the global financial system thanks to the negative interest rates it triggered but at the same time, putting an end to this policy would bring about a global economic crash of epic proportions. One can only escape the decline of the EROI for so long and the system will find balance again but at a huge cost.

The collapse of the EROI does not mean the end of civilization or a return to the Stone Age.

If you are making $10 000 a month but still spend like when you were earning $20 000, you are by no means poor but you are living well beyond your means and it is the discrepancy between what you earn and what you spend that will make you bankrupt. The same logic applies to world economies.

All our productive systems, infrastructure but also standards of living are oversized compared to the energy “budget” we have and the huge inequalities brought about by globalization and the secession of the “elite” are only making things worse.

Instead of flying forward, we could have acknowledged the reality of declining energy stocks and gradually reduced our standards of living accordingly.

We could have:

-done away with the dogma of economic and demographic growth and stabilized our societies at sustainable levels

-let economies and population shrink naturally rather than trying to force them to grow through debt creation and immigration

-defined what we consider acceptable standards of living, public services and infrastructures and downsized accordingly, reducing waste, bureaucracy and public spending in the process

-discouraged the creation of massive amounts of household and corporate debt as well as excessive risk-taking from investors rather than supporting the lax monetary policies of Centrals Banks

-developed an economic system that recycles, repairs and produces locally rather than one who encourages mass consumption, goods renewal and import/export.

-anticipated the energy transition by investing in nuclear energy not renewables, sustainable habitat not big city hubs and suburban sprawls and energy efficient petrol-engines not electric cars.

These adjustments will happen in any case but they will painful, chaotic and hasty rather than benign, anticipated and gradual. We are about to witness the greatest economic contraction in history and we are, all of us, economically, politically and psychologically unprepared to face it.

This is why you have to laugh out of the room and call a charlatan any politician who promise you growth and to increase your standards of living, same thing with an economist or an “expert” who does not know the first thing about the EROI and its implications for economic systems. Growth is not coming back and no silver bullet or miracle technology is going to come to save the day. It’s stone cold physics. The future will be about frugality and limits. It’s not going to be the end of the world but it’s going to be the end of a world.

Let’s make sure we take better care of the new one than those before us did with the old.

Further reading: Enery and the Wealth Of Nations, Charles A.S Hall, Kent Klitgaard.

Translated from French by the author

The original article can be found here