The Financial System Is Not Immune To The Laws Of Physics
Most/all of the physics that is taught in schools has to do with the physics of closed/isolated systems. In the universe, however, the very predominant situation seems to be open systems, which include flows of energy.
For example, the economy indirectly gets flows of energy from the sun, through the food we eat. It also gets flows of energy from all of the fossil fuels we use, and the burned biomass we use. The way that our species seems to have differentiated itself from animals is by learning the controlled use of burning biomass, over 1,000,000 years ago, while still pre-humans. With the controlled use of burned biomass, pre-humans could use fire to cook some of their food, and to burn down forests, when doing so would increase food supply. Fire also increased the range where pre-humans could live. With fire, humans could evolves in a different way than other primates, with smaller teeth and jaws, smaller gut, and a bigger brain.
Anyhow, getting back to the physics, when there are flows of energy in an open system, the physics of the system demands that these flows be “dissipated” in some way or other.
One way is by creating “growing things.” These things grow only temporarily, as long as the flows are adequate to maintain the structures that are being built. These things include inanimate things, like hurricanes, as well as what we think of as living things. The fact that some small atoms eventually were succeeded by larger atoms seems to be the very long term result of energy flows. The fact that life could form, first as small structures, and then as larger more complex structures, is the result of energy flows. The fact that ecosystems can form is the result of energy flows.
A second way the energy is dissipated is by adding complexity. Little businesses join together to become bigger international businesses, for example, and international trade flourishes. The skills individual workers learn become more and more differentiated. Governments grow in size, and promise ever-more services to their citizens, such as retirement benefits, health coverage, and unemployment benefits. International governmental agencies flourish. More and more information becomes available. The highest level of this information is competitive prices and wages that can be afforded by companies, given the overall balance of the system.
The thing that is important about added complexity is that the process is not reversible if energy flows should decrease. The “dissipative structures” formed in this way have a tendency to collapse, if energy flows become inadequate.
Of course, the dissipative structures can come to an end for other reasons as well. For example, we know that humans die for reasons other than starving to death. In fact, all dissipative structures have a finite lifetime, even ecosystems. They tend to burn, for example.
But the key point here is that, on a finite planet, growth cannot last forever.
Less Energy, Less Demand
As growth dissipates, those running the system try to compensate by pulling future demand into the present using debt.
And for clarity's sake, as far as I am concerned, debt funding and equity funding are essentially equivalent, except for the ownership aspect. (I consider them both debt-like.) They both provide time-shifting capability. They both provide capital now, with a promise for something down the line -- as do many other kinds of promises, such as Social Security.
The Debt Trap
If the economy’s growth is fast enough, the currency can simply act to facilitate barter (in other words, trading of goods without time-shifting) to make certain that the Goods and Services being produced can go to pay the Resource Providers in Box 1:
The problem comes when economic growth slows.
The workarounds typically involve added complexity, with the use of more capital goods and skilled labor. In this case, there needs to be a lot of time-shifting, provided by debt-like devices. The time-shifting devices could be sales of stocks, or bonds, or unfunded government promises.
What the time-shifting does is to allow some payments to resource providers to be made in the form of promises of future goods and services, assuming that they really will be available:
At some point, this whole arrangement is likely to fail because too many promises are made (using many different debt-like devices) relative to the actual future output of the economy.
But before the economy actually collapses, what happens is that some of the Resource Providers in Box 1 get too little payment for their services, because there are not really enough goods and services available. This is the situation we seem to be in today.
Return on capital seems to be low; interest rates are chronically low. Governments have difficulty collecting enough tax revenue.
The Demand Trap
And importantly, another type of provider that gets shortchanged are the fairly unskilled workers, who sell their labor. The wages of these workers tends to fall too low, relative to what is needed to pay for a home, food, transportation, and the cost to raise a family. This is where we are now. I would describe this as “Return on Human Labor" (sold as labor) falling too low. Some would call the problem too much wage disparity. One of its causes in too many jobs being sent to countries with low labor costs. Another cause is mechanization taking the place of some of the jobs performed by the less-skilled laborers.
When the wages of this group fall too low, these “non-elite” workers (as I sometimes call them) cannot afford the output of the economy, in terms of new homes, cars, and foods. Indirectly, this translates to too little “Demand” for goods and services made with commodities. What happens is that prices for commodities fall below their cost of extraction. The problem ends up being a low price problem, and results in gluts of food and oil that the low-waged workers cannot afford. The situation looks like the Depression of the 1930s. One way people describe the problem is as too much wage disparity. The people at the bottom of the hierarchy become very unhappy, and elect radical leaders. We seem to be having some of these problems today.
History over nearly the last 200 years says that the way to keep the return on high human labor high enough to overcome diminishing returns problems is to LEVERAGE HUMAN LABOR WITH INCREASING AMOUNTS OF SUPPLEMENTAL ENERGY, such as burned biomass, burned fossil fuels, nuclear energy, or wind energy. Thus, energy consumption needs to rise, on a per-capita basis, to avoid collapse type problems.
When growth in energy consumption per capita is very low, all kinds of problems arise. The early 1860s was the time of the US Civil War. The 1930s was the US depression. The period between 1980 and 2000 doesn’t look as bad, but it includes the collapse of the Soviet Union in 1991. It also includes the end of Japan’s debt bubble, the Asian Financial Crisis, and the US Savings and Loan Crisis. Now, the trend line seems down as well. We don’t have a good substitute for the coal China was providing, either.
What really happens is that bigger debt bubbles need to be blown in order to accommodate higher commodity prices, whether they are caused by falling EROEI or temporary shortages. As long as interest rates can be dropped lower, or underwriting standards can be reduced farther, these debt bubbles can be blown bigger.
But ultimately, these debt bubbles pop, and prices fall way back down, as they did in 2008.
What I have been saying in my writings to date is that the current situation looks very much like we would expect just before an even bigger debt bubble collapse, even though oil prices aren’t terribly high right now. The fact that interest rates are being raised is also very damaging to the system.
So, what to expect from here?
In Part 2:
This is a companion discussion topic for the original entry at https://peakprosperity.com/the-debt-trap/