Decoding the Fourth Law of Thermodynamics and Its Impact on the Economy

Jed Dorsheimer sits down with Andy Lees, founding partner of MacroStrategy Partnership, to explore the critical role of energy in our economy, touching on topics from renewables to inflation and the upcoming U.S. elections, and diving deep into the ways in which energy systems, economic growth, and social hierarchy intersect.

Podcast Transcript

00:03
Jed D
Welcome. My name is Jed Dorsheimer and I'll be your host of the Plugged In Podcast, brought to you by William Blair.

Today I have the privilege of having Andy Lees with me to discuss the role of energy in our economy. Andy has held various different positions on both buy side and sell side, and is one of the founding partners of Macro Strategy Group.

He's best known for his work on understanding the relationship between energy and the economy, something we find particularly important, as well as his work on total factor productivity and interpreting what's going on in the real economy. We'll talk about several topics, some of which are controversial, but all of which are topical. The role of energy and the real economy, and how energy can signal growth or de-growth. The role of renewables in our energy systems. And Odom's law of transformity, which is often posited as the fourth law of thermodynamics. And what this reveals about capital, role of energy systems and our social hierarchy. Inflation and rate cuts. And I should note that this was recorded roughly three weeks ago, but, quite topical. And lastly, we'll finish out with capital allocators and the role of Western governments, which also is topical going into US elections.

So hope you enjoyed as much as I enjoyed the discussion and recording. Thanks.

01:30
Jed D
All right. So, Andy, thank you for being here. You know, I am an avid reader and subscriber to, your Macro Strategy pieces. Actually, for those listeners that that don't get Andy Lees and his colleagues, his partners, research and work, how you treat, energy… and this is one of my big, you know, issues with our, economic theory is that, you know, our neoclassical, heterodox, ignores or treats energy as infinitely substitutable. And I can understand why that is because of the time that it was created and we didn't have to focus like a fish didn't focus on the water around it, but unfortunately, it can end up really misunderstanding or being more correlatory versus causational in terms of what's going on in the market. And you guys take a look at that cost of capital in terms of the cost of things to pay for themselves to stand up and, you know, and I think this timing's perfect. I'll shut up in a second. But, you know, just coming back from this solar conference that I was at, and we published a lot of work recently on, you know, the impact of renewables, the actual impact in terms of what it's doing to pricing. And, the one conclusion is prices, energy prices are going to continue to go up. Electricity prices in the US and Europe because of solar and wind, the variability, and that becomes a regressive tax on people. And so, you know, coming from this conference, I think there was a lot of hope that, well, you know, rate cuts and cost of capital coming down is just going to throw us back into a bull market for that sector.

And I thought it appropriate to have this discussion with you because there's a lot there. So maybe just start, frame. You know, I look at energy inputs and the productive function is two of the main drivers of the real economy. I'm curious what you think on that and sort of, you know, maybe we'll find out on, you know, how what I just said resonate for you, right?

04:02
Andy
Yeah, certainly. Okay. So for me, energy accounts for 100% of GDP. Now, let me explain that. Everything requires energy. Move your arm. Thought. Every single thing we do is just an energy conversion or exergy consumption. If you want to be technical. Now, the problem with that is if we look at energy is percentage of GDP, it appears to be five, six, 7% of GDP.

That's just primary energy, not food, etcetera. But that's missing the point. As I say, every single thing we do is just an energy conversion. So what is GDP? It's a measure of that energy consumed or converted. What does energy do? Does it work on capital stock, tangible capital? So, resources that are out of the ground, etc. refine them, combine them, what have you.

And at the same stage, by combining those resources in different ways, etc., you get information of what those combinations do. That's your intangible capital. So, from my perspective, the whole economy can be explained by three identities. So, like a balance sheet it's got an asset and a liability. This has got three lines. So, you can explain it 100% of GDP by energy or by tangible capital or by intangible capital information.

There is not one third, one third, one third. They are identities. So where does that five of 6% of energy come from? And GDP being energy. Well, that's just the cost of getting it out of the ground. You know, it's the cost of digging it. Once you got it out of the ground, you've got to then transport it, you've got to refine it, you've got to switch it into electricity. You use it to make machines. You use it to operate machines, you use it to refine everything. So, we're measuring that percentage of GDP, 5 or 6% is just a, it's just the cost of getting it out of the ground. And this comes to something that I think one of your friends, Professor Charles Halls, has said, which I think is very important. He basically talks about an energy, a pyramid of energetic needs, where he says that the minimum EROI that the economy can support is 14.

Now, given what I've just said, what I would say is the EROI is always one, but that's energy to the economy. What we're talking about in his figure is the percentage of that energy that goes to getting energy out of the ground. So what you're really saying is within that pyramid of energy needs, right? You don't just want energy, you want to transport it to somewhere, you want to refine it, you want to make technologies, etcetera.

What energy can only be literally limited to about the reciprocal of that 7% of GDP. So that's what I would say on, on that sort of score of things. So yeah, GDP is 100% explained by energy, but then energy start to explain some very interesting aspects of this, which comes to my favorite guy, Howard T. Odum, and his laws, which is let's take the simple identity that every bit of output must create the utility to pay for itself or that, there is a real cost to everything, and that real cost is energy.

So that means that every time you, make a conversion, every time you, let's say, go downstream from energy to higher and higher levels of technology, you lose energy in that process. So, you've got to become more productive to pay for that energy loss. So, this tells you that at every single conversion, you've got to have a higher level of productivity, which we can come on to is really just a high level of capital to pay for it.

And therefore that starts to tell you how wages and things should be allocated. You have a what I call a productive, natural hierarchy. And that basically that is not an inequality system. It's a system of everyone getting paid for the quality of work they are doing effectively.

So coming back to renewables, your solar comment, the problem with solar is it's very low quality energy.

09:04
Jed D
So can I interrupt for one second? For the audience. That was fantastic. And you went through a lot of detail. I just want to unpack a couple things so that audience members can catch up. So when you say early energy return on energy invested is the idea that, that there is a cost. Let's just use oil because its an easy one, there's a cost to extract that barrel of oil for from the ground.

And that cost from, in energy terms, is roughly, the equivalent of about $50 per barrel. And there's a, a price which the market sets in terms of, what, what we can sell that for supply demand. But then there's a value in terms of how you can convert that energy kinetically into work, which leads to, I think, what you were saying in terms of the tangible and intangible value associated with that, that transformity of that energy into our economy.

10:05
Andy
Yeah, it's the value, the value of those joules of energy effectively.

10:09
Jed D
Which in a, in a barrel of oil, that equates to about $350,000 of value for something that costs, you know, $50. So that that has led to, you know, that logarithmic, you know, curve that we've seen in terms of industrial revolution. And, you know, some may push back and say, yeah, but there's negative externalities. But the premise of that is kind of what you're saying has led to, you know, a, a cost of cash that's embedded within the capital.

Is that the right way for the audience to think about it?

10:43
Andy
So the way I look at that is, as you say, it's the amount of energy needed to get that barrel of oil out of the ground. So, let's say the euro is 100. You put one barrel of oil in the ground in terms of work effort to get 100 barrels out of the ground.

Of course, that one barrel going in is not just energy, it's technology and all the various other things, which comes back to that's why energy has to be a certain percentage of GDP. If it's beyond that, the economy won't have the technology to basically be able to find that energy to get it out of the ground, etc.

So that's how I look at that side of things. In terms of the, the transformity, this is, it is it is it's not a complicated thing, but it is, something that most people don't know about. Have you heard of embedded water? I mean, most people have heard of that. To get a a pair of jeans, there's, I don't know, 5000l of oil, water embedded in it.

Well, that's the same concept with energy that the more low quality, low transformative energy, which obviously all comes initially from the sun, the more energy that's gone into the manufacture, into the making of the product, the more the high quality that product is, and therefore the better quality of work it can do. So, for example, a ton of, it's a joule of coal, an energy that's effectively, chemical capital.

So you've taken your base energy of solar and that's basically you. The theory actually goes, it's the energy through history. So effectively, the energy required to design that tree and manufacture that tree and then decay. So, all the energy that's required in the sort of, lifetime of that tree, etc., etc. And that's what then creates a higher transformative energy.

So you can start with solar as the base, or you can start with at any level of, energy transformative and go to the next level. So, what we're really doing is saying the energy embedded within capital stock. So that's why I say coal is chemical capital. Or you could say the energy embedded in steel or in solar, or in any technology, etc. it's the number of energy conversions and therefore the amount of total energy through history that's gone into that design.

Now, as I say, you can go right back to the very basic of solar and therefore how long it took to build trees, etc., etc. Or you can start from another point, you know, where we are today, etc. So, this is where it becomes very, very difficult to use solar to replace coal. Coal has a transformity of I think it's 41,000 units compared with solar - one - and wind something around 600 or so. So, if you're replacing something that's got 40,000, you know, the quality of its energy is that. And that's then basically servicing the whole of the capital stock, including us. I mean, remember, without fossil fuels or the equivalent, the carrying capacity, Earth is said to be about a billion people. It's only the fossil fuels that have created the ability to grow more food, to have the technologies to do all this, etc.

So, when you go back to using solar energy as your primary source, you're not going to be able to service it. You're not going to even be able to maintain building wind turbines as we have today, because the low-quality solar energy, because it's intermittent variable, etc., you cannot basically use it to create anything really other than through using time.

The renewable energy story basically says to us that there's so much incoming solar irradiance that we would only be taking something like two hours' worth of solar irradiance to power the whole world's economy. So, it's peanuts. You obviously, then, you know, if you want to look at it that side, you've got to adjust for the amount of land that we've got available rather than oceans, the amount of land that's growing food, etc., etc. and that brings it up to 40, 50 days.

But if you want to just look at it properly, you have to adjust the transformity. And if we take the figures, it would mean we would have to have seven and a half years' worth of solar energy to power to meet our annual, industrial energy consumption. Because of it's such low quality. Now, obviously, that, capital stock that we got - humans, the plants and equipment, etc., the energy that's embedded within it won't degrade immediately. It won't go away immediately, but it will decay on a, you know, standard sort of scale. So, the more we switch to renewables, the less that capital stock, the more that capital stock will gradually disappear. That's what's happening in Europe. And this is with, you know, with the solar energy or the renewables subsidized by fossil fuels, even with these energies subsidized by fossil fuels, they work out at about five times the price of fossil fuel-based electricity.

So, we're told that they're at grid parity, and they are in the sense that if we take that expected lifetime supply of electricity divided by the capital cost, I don't think they even include the operating cost. It's about the same sort of level as fossil fuels. But of course, it doesn't come all in a nice steady level.

It's intermittent is variable. It needs to be backed up. So, when you actually work out the real cost. And the way I do this is I take Europe, or the world and you basically chart the percentage of electricity that comes from renewables against the price of the energy. And you get a very clear line, and it basically shows that the renewables is about five times the price of fossil fuel electricity.

Now, that has come down a little bit over the last few years. It's come down from I think it was about 6.5% 7 or 8 years ago. To about three and a half now. However, when you then adjust back for the carbon credits and all these various things where they're raising the cost of fossil fuel, electricity and it's massively subsidizing the cost of renewable electricity, we're back to five, five and a half, six times sort of thing.

So that's the moment. It's sort of resulting in the deindustrialization of Europe, which is very, very clear for anyone. See, I often put it one of my reports in the daily, the German industrial production figures, and I think they're now down. I think it's 16% since the peak in 2017. But I was looking the other day. French industrial production is down a bit more since the peak in 2007.

Italian production industrial production is down about 25% since 2007. It is lower than it was in 1990. European total factor productivity is lower than it was in 1990. We are seeing massive deindustrialization imposed on us by governments. And then what's the other side of that? Is this renewables, are we causing global warming through fossil fuels? Well, possibly.

I don't really know. I mean, I have my own opinions. I don't personally think it's, anywhere near as bad as people suggest. From what I understand, if you look properly, the, when you include temperature stations that are not just in the northern cities, but that are spread around the world properly, or should I say that slightly differently?

If you take out those stations which are in the northern cities, which are benefiting from the heat island effect, then the temperature increase over the last century is about .5 of a degree, of which 90% is explained by solar radiation. So, it's nothing to do with CO2, but let's say it was to do with CO2. Are we doing the right thing? Well, again, the problem for humans from, global warming is presumably that it will burn us or, you know, it will destroy us. I.E., the industrial economy is a subset of the environmental economy. So okay, that's what I would expect. It's a subset of that. So therefore, we've got to look at the price of energy, the price of energy with fossil fuels is cheaper than the price from renewables.

That tells us that renewables are doing more damage to the environment than fossil fuel energy is because, you know, if we were causing that much damage, then that would come back and it would slow GDP, etc. Reality is, it's not. It's the switch to renewables that is damaging. It. As you know, you know, fossil fuels is not going to be around for that long anyway.

We've got to find some alternative. As you know, I've sort of invested heavily in fusion. I think that's the only viable alternative. But certainly, renewables is just a total it's the total wrong thing to be doing as far as I can see.

21:31
Jed D
Well, I want to come back. So, you've mentioned a lot there. I want to come back to Charlie's hierarchical pyramid and the economy because I think this is really important, particularly as you mentioned, fusion. So, innovation comes from a surplus of energy. The ability to take risk is going to be if you're in a tighter environment, i.e. you have more debt, which is a lean on future energy.

22:11
Andy
Can I butt in for a moment because I think this is actually quite important what you're saying. It comes back to effectively what I would describe as energy efficiency. From what I've said, 100% of GDP is explained by energy. That means there's no such thing as energy efficiency. What there is things like subsets of that.

So, the car is more fuel efficient. Why is a car more fuel efficient? Because there's more capital stock in the car, more technology in the car. That makes it more fuel efficient. But energy is not more energy efficient. So that means take it to the economy side. There's no such thing as total factor productivity. You can have productivity of labor or productivity of other things.

But what there isn't is total factor productivity. So therefore, to grow the economy, as you say, you need a surplus to be able to invest in more capital. And when I say capital, we've got to be careful, because planting equipment is not capital if it's not creating the utility to pay for itself, you know, you put too much plant and equipment it ends up as a drag.

So again, that's why you've got to leave the pricing to the to the free system to basically tell you whether that thing is creating utility to pay for itself or not.

23:36 Jed D So, kind of coming back, if we have that hierarchical pyramid, much like Maslow's hierarchy of needs at the top is going to be arts, health. You know, so at the basic would be shelter, etc. I think Charlie has published this, but that the greater your surplus of energy, the more, you know, and so no surprise, if we actually plotted, published patents and innovations, there's an error that is consistent with your production of energy. And if you looked at that, EROI, is EROI going to be highest.

You're going to get more. There might be a lag there, but you're going to get, more innovation. So if we actually take our energy systems and we move that lower either naturally or by force, it actually becomes a self-reinforcing function where you're going to get less innovation, which creates this cycle, that you're going further and further down, which the byproduct should actually be, I would think, what we're seeing now, which would be larger government, where you would have less, you know, poorer allocation of that, that capital. Where would you disagree or agree with, that.

24:54
Andy
Well, I'm, I'm pretty much in agreement. If we're not getting the return that we need, then the economy, again, go back to that fourth law of thermodynamics. Everything self-orders to optimize degradation of the energy gradient within the constraints of the system. However, if there's no external energy gradient to degrade, it will degrade its internal energy gradient.

So, the capital will start to decay effectively. And that's where we effectively are going. We're consuming, we're not allowing the capital to be allocated productively. So, we're not investing in new capital. Yes. In the states there's investment in tech, but there's not the investment in the broader economy, in my opinion. So that's why you see - is it solo residual that made the comment that, you know, the computer age is everywhere except in the productivity statistics.

I'm just looking at a paper at the moment. I've written before about OECD reports and various others saying that every one percentage point increase in tax reduces the GDP per capita by about 50 to 100 basis points. Now, obviously, this is an opportunity cost, a slower growth. But, just reading a report at the moment about regulations and it's saying exactly the same thing. And it says that with the US, if you took the regulations in 1949 and took them up to 2008, the report was issued in 2013. So that's why we've not gone further. The US economy is only about 28% where it would otherwise be.

And whilst that sounds ridiculous, when you sit down and start to think about it, it's not at all. It's very, very obvious. You know, banks have been allocate, forced to allocate capital by capital rules, which has meant, you know, targeting certain areas.

But again, back to this simple reality of everything must create utility to pay for itself. And, by setting one price, government sets all prices. As soon as it creates one boundary, then all everything else has to adjust to that to optimize itself within that constraint. And that's the problem that they do not have the information, and they can never have the information to make that decision based on productivity.

They can never know what the system will evolve to. So, they should not be doing it.

27:40
Jed D
So, I was in LA last week and Elon Musk made the comment, in a conference there that which I thought was really interesting. It's one that I haven't thought of before. But he gave the comparison of North Korea to South Korea and East Berlin to West Berlin during the Cold War, and arguing that same people, very different, productivity output is a function of a different operating system.

And so, looking at that in the context of an operating system, one being large government, the other being smaller government. But I think kind of coming back, if I tie this back to your comments that I'm hearing, it's really a function of capital allocation, capital allocators. So, you know, I think the argument for North Korea is you have huge military government, very poor, capital allocator, almost 100% to government, right? Closed system versus an open system, greater freedom, better capital allocation. So, you have capital that's able to, that has a lower cost than the output that it's, it's creating and therefore greater productivity. So in that context, it seems like, you know, and he was saying this, that, you know, in the, in the that really...

29:14
Andy
Look at it slightly, slightly different way. You mean the same but slightly different. Under a managed system, no one would have identified, Elon Musk to be this brilliant guy that he is that can, you know, invent this, that and the other. He would have just been told, go and dig. That failed. That's the problem. So, you know, this is where China used to be.

And remember, you know, in 19, late 1960s, wasn't it. The farmers basically faced with either starvation, death through starvation or actually the potential of being killed for growing their own plants. They opted for the latter. And suddenly it was realized that, wow, we can be productive. And that's what changed, you know, China sort of thing that suddenly, Deng, Deng Xiaoping or whatever his name was basically said, okay, we'll, we'll allow some sort of freedom. And that's what allowed the economy to, to become the monster. It is. Unfortunately, over the more recent years, that freedom has been a road right back. And that's why China's slowing aggressively.

30:26
Jed D
So, Andy, I want to take a pivot here as we've kind of laid the groundwork because I think that it's important to, you know, again, coming back to this solar conference, renewable energy plus that I was at, there was a lot of hope of well, the Fed's about to cut rates. And I think today being, you know, the 13th of September that we're recording, this is somewhat historic because I believe it's the first time that we've actually ticked over the interest payments are over a trillion in the U.S on the debt.

So, as we look at it, I want to get your take on well, if the fed just lowers rates, doesn't that solve the problem? So, I have some thoughts on that, but I'd like to get your thoughts on this.

31:12
Andy
So first of all, yes, I think the fed is going to cut rates. I think it's probably going to, I think it should have cut rates a long time ago. But if you analyze the last 4 or 5 years, we've had obviously very substantial inflation caused by massive base monetary expansion while it's closing down the economy. So, allocating caps, creating artificial demand where that demand wasn't creating the utility to pay for itself.

So, all that inflation was, was really a consumption of capital. That's how it came out, that now that inflation had already started to slow aggressively by early 2022, you've gone into, sorry, late 21. It had slowed aggressively. But then we went, we had the energy prices spike and the US went into that recession. That wasn't a recession. And it was responded to with the fed inflation addition act….

32:17
Jed D
Inflation reduction ironically titled yes.

32:20
Andy
Which again created indirectly massive or an increase in money supply. What happened was whilst it was not the fed creating the money, the Treasury basically said we're going to spend, and we don't mind paying whatever interest rates required for that spending. So you had, it was actually money came out of the fed for but technical reasons rather than the commercial banks creating it. It was a drawdown in reverse repo. But that created the second sort of inflation bubble, and you know, extended it further, that you've got a third one going on at the moment, I would say through the…

33:04
Jed D
The whole point is, though, the energy, the, energy systems didn't change at all. And if anything, the gradient actually came down, right?

33:13
Andy
What you would have done because you were creating demand in excess of the productive the utility was creating, you would be reducing that supply of capital and therefore the supply of energy, etc. And that's the central problem of all this government spending that basically creating something that's artificial by borrowing from the future. Now, now, you know, if you think about debt rising relative to GDP, clearly that is not creating the utility to pay for itself because the GDP is what pays for the debt.

But what it's really reflecting is the consumption of capital. That's what it's really reflecting. And that's what your high taxes do because it misallocates capital, etc. So, on all this, you're lowering your potential growth further and further, but you're creating an artificial demand. So, you're holding up growth but at the expense of lower future growth. So, at the moment US GDP, if you adjust it for the net national savings deficit, which is just the personal savings rate, plus the government savings rate, corporate savings is included within personal savings.

So basically, the savings of the economy is about -3% at the moment. You know, 6% budget deficit and 2% savings rate. So, a bit worse. So, your potential GDP is going down. I think in the states now it's about 0%. The issue now though, is you've got rates at 5.5%, clearly unsustainable there at a record ever rate relative to the neutral rate.

But you're going to bring them down. But the potential growth is so much lower. But what you're going to try and do is to stimulate that unproductive growth. You're going to try. So, you're going to have to take rates very down aggressively to do so. And in doing so, yes, you will boost GDP but at the expense of slower, potentially slower future growth.

So, you're just running this cycle. The Road to Serfdom, as it were. You're adding imbalances to pay for existing imbalances.

35:37
Jed D
I want to come back to, there is a silver lining with all of this, because the conclusion would be getting to better capital allocation could stimulate greater innovation. So, if your inputs are going to be, if energy explains that everything. So how do you get to an energy system that creates more abundance? If we looked at fusion just as an example, my entire energy footprint would fit in a thermos right from a, so the density is, is massive.

And so but if we're if we're continuing to plot down a path where, on that hierarchy of, of needs or, energy needs, we stifle innovation because of poor capital allocation, then the, the outcome looks a lot like China in terms of the misallocation of capital in a very deflationary...

36:39
Andy
Well, I mean, you just need to look across the pond to us, to Europe. We are deindustrializing, and we're deindustrializing on a rapid scale. Standards of living in the UK have been falling for a number of years. Yeah, GDP may just have been flat, but GDP per capita is going down. Which is why you got all these riots and what have you. Realistically, the issue is you've got to reduce government and there's two ways of doing that. You either freeze it as it is and let the economy gradually grow out of it, or you actually cut big government.

37:17
Jed D
And that's the that would be the reboot in operating system. So, the change of operating system is kind of the key to leading to these. So, kind of coming back to rates though, if you just cut rates you will boost growth. But then aren't you wouldn't you then be if you're not changing the actual inputs, aren't you then of risk of just a rebound effect.

37:42
Andy
You've got to basically, if you, if the fed was wanting to clear the system to the right sort of to a productive system. It would probably lower rates to say 3% something, something like that and stick with that rate, and let the economy gradually clear around that, i.e. get rid of everything that doesn't create a return at 3% and then gradually use that capital that capital, that resource, that human resource, and redeploy it more productively.

The problem is I don't expect that to happen. I think the fed will gradually cut rates a lot lower, effectively supporting, you know, government spending.

38:26
Jed D
Andy, thank you very much for taking the time. I know, you know, I'd like to have you back. But we've got a lot to digest here for the listeners. And, appreciate the great work that you're doing. You know, we, we read it avidly. So, thank you very much.

38:43
Andy
My pleasure. Thank you.

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