THE NOTIONAL VALUE TRAP

Foreword

Just as growth in the “real” economy of material products and services has been decelerating towards contraction, so aggregates of financial wealth have carried on increasing relentlessly.

Since the widening disequilibrium between the monetary and the material must eventually crash the financial system, the probability is that notional wealth will reach its peak at the same moment at which the monetary system collapses.

We can see this unfolding effect in microcosm in the United Kingdom, where the most recent official calculation put national “net worth” at a near-record £12.2 trillion, or 450% of GDP. Yet you don’t need SEEDS analysis to know that the British economy itself is at an advanced stage of disintegration.

Two key factors explain the apparent paradox between soaring wealth and the onset of increasingly chaotic economic decline.

First, every failed effort made to stem material economic decline using monetary tools increases wealth, as it is measured financially.

Second, most of this wealth is purely notional, in the sense that none of its aggregates are capable of conversion into material value. Put another way, very little of the world’s supposedly enormous wealth actually exists in any meaningful sense.

A very possible final scenario is that, after an initial correction caused by a dawning realization of economic crisis, asset markets will rebound to a last peak before entering outright collapse.

To make sense of these issues, we need a clear understanding of the nature of money and wealth in relation to material economic supply.

1

As many readers will know, there’s no great mystery about the ending and reversal of material economic expansion.

Briefly stated, the “real” economy of physical goods and services is only proxied – and with ever-diminishing fidelity – in the published aggregates of financial flow.

Far from being a measure of the supply of material value to the system, gross domestic product is nothing more than a summation of transactional activity taking place in the economy. It’s perfectly possible, indeed commonplace, for money to change hands without any material economic value being added.

The way in which material value is supplied to society is, in principle, comparatively straightforward. In a continuous process of creation, consumption, disposal and replacement, energy is used to convert other natural resources (including minerals, non-metallic mining products, biomass and water) into products, and into those artefacts and infrastructures without which no worthwhile service can be supplied.

This is a dual equation in which, as energy is used for the conversion of raw materials into products, so energy itself is converted from a dense to a diffuse state. This makes energy-to-mass density, and the portability of energy, important considerations in the resource conversion process of economic supply.

Given that energy is used in the creation, operation, maintenance and replacement of energy-supplying infrastructures, we can state that “whenever energy is accessed for our use, some of this energy is always consumed in the access process, and is not available for any other economic purpose”.

This proportionate “consumed in access” component is measured in SEEDS as the Energy Cost of Energy. ECoEs have long been on an exponentially climbing trend, and have risen from 2.0% in 1980 to 11.3% today.

Renewables, and for that matter nuclear power as well, cannot materially slow, let alone reverse, the relentless rise in ECoEs caused by the depletion of oil, natural gas and coal. Neither can technology halt this trend, since the potential of technology, far from being infinite, is bounded by the limits imposed by the laws of physics.

The other determinant of the supply of physical economic value is the rate at which non-energy raw materials are converted into economic value through the use of energy. This conversion ratio is on a gradually declining trajectory, because resource depletion is occurring at a rate slightly more rapid than that at which the broad swathe of conversion methodologies can advance.

On this basis, global material prosperity has grown by 25% since 2004, which is nowhere near claimed “growth” of 96% in real GDP over that period. Moreover, the 25% rise in aggregate prosperity has been matched by the rise in population numbers over those twenty years.

The ongoing rate of deceleration is such that aggregate material prosperity is projected to be 17% lower in 2050 than it is now, which is likely to make the “average” person about 31% poorer than he or she is today.

At the same time, the costs of energy-intensive necessities – including food, water, accommodation, domestic energy, essential transport and distribution – are rising markedly. The “cost of living crisis”, far from being the temporary phenomenon that the word “crisis” is intended to imply, is a firmly established trend.

Since all of these process are both knowable and incapable of being “fixed”, why is monetary value continuing to increase?

The answer lies in the fundamental nature of money, and of how the monetary relates to the material.

2

As we know, no amount of money, irrespective of its format, would be of the slightest use to a person stranded on a desert island, or cast adrift in a lifeboat. If this castaway had an extremely large amount of money, his or her only (and very dubious) comfort would be the prospect of ‘dying rich’.

That’s an appropriate analogy for a world destined to experience financial collapse at the moment of record paper wealth. The financial system, like our castaway, is going to ‘die rich’.

There’s an instructive twist that we can add to the narrative of the castaway. At his or her greatest extreme of privation, a package is seen descending on a parachute. Opening this package with avid hopes of food or other life-saving material supply, the castaway finds only very large quantities of banknotes, gold coins and precious stones, all of which are wholly valueless in his or her predicament.

Decision-makers in society have made this exact same mistake, pouring huge amounts of money into a world whose deficiencies are material. They have done this, not out of idiocy or dishonesty, but because, whilst they cannot be seen to be ‘doing nothing’, no other possible policy response exists.

Governments and central banks can create money and wealth in almost limitless quantities, but they cannot similarly conjure energy, or any other material resource, into existence at the touch of a key-stroke.

The essential point, of course, is that, as our castaway swiftly discovers, money has no intrinsic worth. It commands value only in terms of those physical goods and services for which it can be exchanged. Money is thus an “exercisable claim” on the material.

Warren Buffett alluded to this when he said that “[t]he way I see it is that my money represents an enormous number of claim checks on society. It is like I have these little pieces of paper that I can turn into consumption”.

Various conclusions follow from this principle of money as claim. One of the most important, as regular readers will know, is the imperative need to think conceptually in terms of two economies. One of these is the “real” economy of material products and services, and the other is the parallel “financial” economy of money, transactions and credit.

Another is the absolute futility of any attempt to explain the economy by disregarding the material and concentrating entirely on money. This fallacious line of thinking leads inevitably to the deranged proposition of ‘infinite, exponential economic growth on a finite planet’.

3

None of this means, though, that money is “unimportant”, or that a collapse of the financial system would have no adverse consequences for material economic prosperity.

The most effective approach to economics doesn’t involve the disregard of the material or of money.

Rather, what we need to do is to calibrate the physical economy such that we can benchmark the monetary against the material. This enables us to avoid the futility of measuring the monetary only against itself.

It’s true that, at the moment when the monetary system collapses, we will still have the same amounts of the energy and other natural resources which are the basis of material economic prosperity.

But money is a critical enabler in the processes by which we use energy to convert raw materials into products, artefacts and infrastructures.

This is why not even the poorest person can view the impending collapse of the financial system with equanimity. Without money, how can nations trade products and resources, and how can the individual conduct his or her daily affairs?

Since money – unlike energy and raw materials – is a human construct, it’s perfectly possible, at least in theory, for us to create a new (and perhaps more intelligently-designed) form of money to replace the old.

But the chaos that monetary collapse will cause is hardly capable of over-statement.

4

Within our overall understanding of the principle of money as claim, money itself divides into two functional categories, which are the flow of money in the economy and the stock of monetary claims set aside for exercise in the future.

This “stock of claims” further subdivides into two components. One of these is immediate money, which can be spent without having to go through any preliminary enabling process. Most of this “immediate” money exists as fiat currencies, since it’s difficult to buy our groceries or pay our electricity bills using precious metals or cryptocurrencies.

But by far the largest component of the stock of claims is inferred rather than immediate. This “inferred” money exists as stocks, bonds, real estate and numerous other asset classes.

Before this claim value can be spent, it must be monetised – converted, that is, from an inferred to an immediate state. This means, simply stated, that the assets which comprise inferred value must be sold before they can be spent.

5

The aggregates of these inferred forms of wealth are enormous. Global stock markets, for instance, currently stand at about 160% of world GDP, which is far higher than this metric was in 2007, on the eve of the global financial crisis (114%). Total debt is about 240% of global GDP, and broader financial assets, in those countries which report this information, are about 470%.

If, to these, were added other asset classes, including real estate, promised pensions, precious metals, cryptos and derivatives, we could undoubtedly calculate that global wealth is at all-time record highs.

All of this is a very far cry from the oil crisis years of the 1970s. In 1975, stock markets equated to only 27% of world GDP. At its nadir, in January of that year, the S&P averaged just 72.6, from which point the index has advanced almost continuously – with few and brief interruptions – to a level today of about 6850.

Fig. 1

This has, in fact, been a near-uninterrupted, fifty-year progression. This road from “once-in-a-lifetime cheap” to the vastly higher valuations of today certainly merits some reflection.

It transpires that very little of this accession of paper wealth has happened by accident.

Starting in 1975, the initial advance in stock markets did follow processes that can be ascribed to market forces alone. In that year, the astute investor had little to lose, and much to gain, by putting his or her money, itself subject to severe inflation, into stocks.

Together, an economic rebound from the oil-crises-slump of the 1970s, the gradual taming of inflation and the euphoria created by the policies of the new “neoliberal” incumbencies combined to help to drive markets sharply higher during much of the “decade of greed” of the 1980s.

But everything changed in October 1987.

On “Black Monday”, the markets crashed, with the Dow losing 508 points, or 22.6%, in a matter of hours.

What was really significant, though, was that the authorities stepped in to shore up the markets. One of the most important players was the Federal Reserve, which had itself been created in 1913 in response to another such crash, the Knickerbocker crisis of 1907.

6

The authorities might well have been wise to have intervened as they did in 1987, but, in doing so, they conveyed the strong impression that, if ever things once more went badly enough wrong, they could again be counted upon to ride to the rescue like the fabled 7th Cavalry.

This back-stopping – variously known over the years as the “Greenspan put”, the “Bernanke put”, the “Yellen put” or, more generically, the “Fed put” – remained implicit until 2008.

Then, with the swift, no-holds-barred response to the global financial crisis, the authorities made their support for the market explicit.

Some felt at the time that these interventions were necessary and proportionate, others that they “bailed out Wall Street at the expense of Main Street”. Both points of view had their shares of validity.

But the most astute observers fretted instead about what is called moral hazard.

In the normal course of events, as envisaged by free market purists, the authorities do not intervene in the markets. If things go well, the wise (or simply fortunate) investor makes big profits but, if things go badly, the reckless (or unlucky) investor gets wiped out. Thus the antithetical forces of “fear and greed” are kept in balance.

Intervention dangerously upsets this balance. An investor rescued once naturally assumes that, if things go badly enough wrong again, another bail-out is certain to follow. This provides an enormous incentive to risk-taking, and undermines the important restraint exercised, through prudence, by fear.

7

Behind all of this, though – and seldom noticed by observers – lies the fact that all “values” routinely ascribed to wealth aggregates are fundamentally bogus.

At no point can any of the reported aggregates of wealth be monetized. The only people to whom the stock market could ever be sold in its entirety are the same people to whom it already belongs. The same applies to the global or national housing stock, and to every other asset class.

Whenever we’re told that huge amounts of value – in October 1987, for instance, $1.7 trillion – have been “wiped out” by a market fall, we’re being asked to disregard the fact that at no point, either before or after the event, could the whole market have been sold at its supposed value. The same applies to any statement of how much wealth billionaires have “gained” through rises in the market.

The £12.2tn official calculation of British aggregate “net worth” is similarly meaningless, in the absence of anyone who actually has £12.2tn to spend (and is also daft enough to invest it in Britain)

The fatal error made here is that of using marginal transaction prices to put a “value” on aggregate quantities of assets.

We might think that, were all global stock markets to fall to zero, about $180tn of wealth would have been eliminated.

In fact, that supposed “value” was only ever notional, and never existed in any meaningful form in the first place, because at no point was it ever capable of monetization.

8

This inability ever to monetize even a significant proportion of this inferred wealth enables commentators to write lurid, fact-free articles about aggregate wealth being “destroyed” or “boosted”.

But it also enables the authorities to pursue their cherished “wealth effect” without much danger of all of this largesse being converted into immediate monetary value, and then spent in ways that trigger runaway inflation in the economy.

Central banks’ use of QE is a case in point. So long as this liquidity injection was contained within the capital markets, it could not cross the boundary into spendable money and trigger severe inflation. During the pandemic of 2020, though, when QE was channelled not into the markets but directly to households, severe consumer price inflation did indeed follow.

9

What we have been exploring here is a paradox that is no paradox at all. The world will keep setting new wealth records until the financial system collapses.

Investors have lived with supportive intervention from the authorities ever since 1987, which means that very few of them have ever experienced anything else. Throughout this period – and certainly since official support became explicit in 2008 – the “momentum trade” has been the only game in town. It’s been like gambling in a casino where the house stacks the deck in favour of the punter.

So ingrained has this thinking become that there are likely to be many still determined to “buy the dip” even as the financial system goes finally into the blender. This, in short, is why wealth is destined to collapse – swiftly, not gradually – from an all-time peak.

Our necessary insight here is that, since any value contained in money exists only as a “claim” on a material economy that is now contracting, there must come a point of fatal disequilibrium between claim and substance.

The sheer scale and complexity of the aggregates of claim stock are now so extreme that the authorities will be powerless to backstop the next big crash.

It’s scant consolation to know that these enormous aggregates never, in any meaningful sense, actually existed in the first place.

Thus understood, it might not seem to matter all that much if aggregate (and individual) values collapse. Your house, for instance, will still fulfil its essential function of providing somewhere to live, even if its supposed value slumps from $1m to $200k. Even if you’d decided to sell at the highest price, buying a replacement would have been equally costly.

But this comfort only applies if you hadn’t used the property as security for a large mortgage.

And the financial system as a whole has done exactly that. The entirety of the system is enormously cross-collateralized, and this is where the destruction of “meaningless” aggregate asset values becomes enormously meaningful.

The real comfort, if any is to be found, is that anyone who can find a way of preserving value will have the opportunity of buying utility value at pennies on the dollar. The term “utility” is the watch-word here, because essentials will remain essential even as society is picking over the wreckage of discretionary sectors.

Fig. 3