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Economic growth: keeping it real

Cover of  by Tim Morgan

The escalation in energy costs is not just a living standards issue. It poses a threat to growth, and undermines the expansion of the ?real economy?

That the recovery in the British economy is the exception rather than the rule was confirmed last month, when the IMF downgraded its global growth forecasts.

Even here in Britain, we must distinguish between growth and prosperity. Since 2007, average wages in Britain have grown by 10%, but the cost of essentials has increased by 33%, and the recent rises in gas and electricity prices indicate that this trend isn?t going to reverse any time soon. If we define prosperity as spending power after essential outgoings, as surely we should, then growth, even where it is happening at all, is not going to correct the deterioration in standards of living.

Since prosperity is still declining more than five years on from the financial crisis, you might think that policymakers, no less than bankers, have a lot to answer for. In fairness, they have tried. Interest rates have been kept at rock-bottom levels, governments have run enormous fiscal deficits, and quantitative easing has injected huge sums into a global economy that still appears moribund. In short, tried-and-tested policy responses have ceased to function as theory and experience say that they should.

The implication, which is that something fundamental has changed, is examined in my new book, Life After Growth. To understand what is really happening, you need to appreciate that there are two economies, not one.

The first of these is the ?financial economy? of money and credit. But this functions only as a tokenisation of the second, ?real? economy of labour, resources, goods and services. Since money and debt command value only to the extent that they represent ?claims? on goods and services, it is clear that our central concern should be with the performance of the real economy.

That ?real economy? is fundamentally a surplus energy equation, and its history can be traced right back to the liberation of the first energy surplus by the adoption of agriculture. In pre-industrial days, this energy surplus was a simple matter of nutrition and labour, but the equation changed fundamentally when the invention of the heat engine enabled us to apply enormous leverage to limited human capabilities by harnessing huge exogenous (external, non-human) energy inputs.

The snag, of course, is that we cannot access energy at zero cost. When we access energy, a certain amount of energy is used up in the process, because accessing energy requires an investment in an infrastructure whose creation itself requires extensive energy inputs.

The equation which measures this relationship is known as the Energy Return on Energy Invested (EROEI). Historically, this ratio has been so positive that the invested (?cost?) piece of the equation has been very modest. When the use of rudimentary equipment could access billions of barrels of oil in the sands of Arabia, EROEIs were in excess of 100:1, a ratio at which costs absorb just 0.99% (1 divided by 101) of gross available energy.

Over time, though, this ratio has weakened as we have exhausted the highest-return sources of energy. I estimate that the global average EROEI has declined from 37:1 in 1990 to barely 14:1 today, pushing the energy cost ?levy? on the economy up from 2.6% (1/38) to 6.7% (1/15).

You can see the effect of energy cost escalation, not just in fuel costs, but also in the prices of the most energy-intensive components of the economy, components which include food, water, minerals and plastics. Fundamentally, rising energy costs explain why prosperity is being undermined by the soaring cost of essential outgoings.

As this process continues, the real economy is set to go on weakening. At the level of the individual household, this means that essential spending will continue to absorb a steadily increasing proportion of incomes, diminishing our scope for ?discretionary? expenditures.

Much the same applies to the economy as a whole. People cannot pay taxes that exceed their discretionary incomes, and neither can they save more than the income that is left to them after deducting the cost of essentials. What this means is that an increase in the broad cost of energy is going to squeeze the national ?discretionary? (net of essentials) income, with obvious and disconcerting implications for taxation and public spending as well as for investment.

Here in Britain, this trend is already becoming visible. Just as the cost of household essentials continues to escalate, so we are faced with enormous forward requirements for investment in the energy infrastructure.

This trend poses issues of displacement, and questions of choice, that we would be foolhardy to ignore.

Tim Morgan was global head of research at Tullett Prebon from 2009 to 2013. His new book Life After Growth is published on 18 November.

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