#112: Will things go bang soon?

A BUBBLE AND A SPIKE, PART 2

We may not be clear yet about when the next crash will come, but we understand a very great deal about the mechanism that will make it happen. Put another way, we have a narrative that puts all the pieces in the right places.

This narrative is telling us that a crash is highly likely – and that it may happen a lot sooner than we think.

Let’s start with the fundamentals. Contrary to conventional thinking, the economy isn’t really a monetary system at all, but a surplus energy dynamic. What drives the output of goods and services is the quantity of energy we can access, less the energy consumed in the access process. If the available quantity is constrained – or the energy cost of accessing it increases – the output of the economy will decrease.

Money, having no intrinsic worth, has value only as a “claim” on the output of the real economy, which means, ultimately, that money is a claim on surplus energy. Debt, as a ‘claim on future money’, is really a claim on future energy.

For more than two centuries, there has been sustained growth in available surplus energy. This has enabled total financial claims – the aggregate of money and credit – to increase as well, without toppling the financial system.

What we’ve been witnessing since the turn of the century, though, has been an increase in the energy cost of energy (ECoE), combined with emerging constraints on the quantity of accessible energy. This process makes the continued growth in aggregate money and credit dangerous, because we are creating claims that the real economy will not be able to meet.

Once understood, this process makes sense of what has been happening. Between 2000 and 2008, credit creation soared, but debt-financed growth drove up energy demand in a way that eventually brought the system to the brink of collapse. In 2001, when prices averaged $24/bbl, OECD consumers spent about $430bn on oil, of which around $240bn went on imports. By 2008, when oil averaged $97/bbl, these numbers had increased to $1,700bn and $1,050bn. Oil was now costing OECD customers $1,270bn more than it had just seven years earlier – and $810bn of that increase was being spent on the higher cost of imports.

Moreover, these huge liquidity drains are only those related to oil. Other forms of energy also soared in cost, as did energy-intensive commodities such as minerals and foodstuffs.

This was what brought the debt-financed party to an end.

Looking a little more closely at this, the increase in the cost of oil to the OECD quadrupled between 2001 and 2008. The increase in ECoE over the same period was much smaller than this. According to SEEDS, global ECoE for all energy sources rose from 4% in 2001 to 5.4% in 2008, a rise of one-third.

So the rise in market prices vastly over-cooked the underlying trend in ECoEs. In relation to this fundamental benchmark, oil was underpriced in 2001, and overpriced in 2008.

This tells us that something else was going on.

That ‘something else’ was supply constraint.

Just as westerners were bingeing on credit, emerging market economies (EMEs) were consuming more energy and other commodities, notably as exports ramped up. Rising energy demand was colliding with more pedestrian growth in supply. Investment in supply tracked market prices higher. When demand dropped after 2008, the ensuing fall in prices became inevitable.

In retrospect, we “got away with it” in 2008, for three main reasons.

First, governments’ balance sheets were strong enough for them to bail out the banks without forfeiting their own credibility, and that of their currencies.

Second, the authorities bought time by adding monetary adventurism to the established credit adventurism.

Third, the cooling of the economy took the heat out of energy markets.

To know when and if a second crash may happen, and what its results are likely to be, we need to test these three “get-outs” as they now are.

First, government balance sheets. On the basis of amounts owed (rather than the market value of bonds), the aggregate debt of advanced country governments was 67% of GDP in 2007. Now it is 102%, and still rising. Bailing out the banks now would be a lot harder than it was back in 2008. Not only are government balance sheets weaker, but bank exposure has increased as global debt has grown. To be sure, reserves ratios are higher now than they were back in 2007. But, because banks borrow short and lend long, no amount of reserving can render them immune from the consequences of a loss of faith.

Second, “monetary adventurism”. Back in 2008, typical rates were 5.25% in the United States and 4.3% in the European Union. Now, the equivalent numbers are around 1% and -0.25%. There’s no scope, then, for further monetary adventurism, unless central banks are prepared to go for deeply negative nominal rates, a policy which would be barking mad, even if it didn’t, very probably, necessitate helicopter money and the banning of cash.

So that leaves us with our third component, which is energy. Essentially, a big rise in oil prices would crash the system.

Is this likely? On balance, it is. Oil demand is growing at around 1.4 mmb/d each year. Supply has kept pace, mainly thanks to increased shale and other unconventional output, plus an increase in supply from OPEC. Neither may be sustainable. Shales are extremely capital intensive, because of the “drilling treadmill” caused by ultra-rapid decline rates. Few OPEC countries have much scope to deliver increased supplies. Underlying ECoE, SEEDS says, is 42% higher now than it was in 2007.

Put this higher ECoE together with the slump in investment caused by the fall in crude prices, and the implication is that crude prices could spike, and do so rather more quickly than is generally expected.

That, then, is what we should be watching for when looking out for another crash. All the other conditions are in place, including excessive debt, weak underlying growth (reflecting rising ECoEs), overstretched government balance sheets, and an inability to repeat the monetary adventurism of 2008-09.

All that we’re waiting for is an oil price spike, and a trigger equivalent to the “Lehman moment”.

Both may come sooner rather than later.

 

#112 Oil price & energy ECoEjpg_Page1

#111: A spike to puncture the bubble?

OIL PRICES

Anyone living in a bubble should beware of spikes.

Between 2001 and 2008, world debt (at current market values) increased from $60tn to $117tn.

There’s a bubble.

In 2001, the price of oil averaged $24/bbl. In the summer of 2008, it peaked at $147/bbl.

There’s a spike.

Though the connection isn’t drawn perhaps as often as it should be, there can be little doubt that the massive spike in oil prices punctured the equally massive debt bubble, leading directly to the global financial crisis (GFC).

The connection seems inescapable. Dramatically higher oil prices, in themselves, drained enormous amounts of liquidity out of the same oil-importing Western economies which were merrily bingeing on debt. Just as importantly, the surge in oil prices also drove up the cost of energy-intensive commodities, including minerals and food.

Could the same thing happen again, triggering a second (and probably much worse) global financial crash?

The bubble is certainly there – and is even bigger than the last one.

Since 2008, world debt (at current values) has expanded from $117tn to $160tn. But these headline numbers are converted to dollars at market exchange rates. Converted using the more realistic PPP (purchasing power parity) convention, debt has already reached 235% of world GDP, or $260tn. The equivalent figure in 2008 was $153tn.

On top of that, there are truly gargantuan shortfalls in pension provision, shortfalls which are “set to dwarf world GDP”.

In the period before 2008, the authorities had confined themselves to deregulatory recklessness, which facilitated a big increase in aggregate debt, and an equally big proliferation in risk.

Since then, monetary recklessness has been stirred into the mix, turbocharging debt escalation as well as bending returns on capital completely out of shape. That, ultimately, is why it has become impossible to provide adequately for retirement.

So there is certainly a bubble. Should we expect a spike?

Thus far in the bubble, a saving grace has been cheap oil. The price of oil averaged $44/bbl last year, down from $109/bbl as recently as 2013.

Demand for oil has continued to grow. Between 2007 and 2009, world oil demand decreased by 1.8 mmb/d (million barrels per day). But demand in 2016 (93.2 mmb/d) was 10.4 mmb/d, or 13%, higher than it was back in 2009 (82.8 mmb/d).

By and large, supply has kept pace. Since 2009, supplies from non-OPEC countries have increased by 5.7 mmb/d. OPEC countries have chipped in an additional 1.8 mmb/d of unconventional liquids, not subject to the cartel’s quota. The world’s need for quota crude from OPEC has therefore grown only modestly, from 29.3 mmb/d in 2009 to 32.3 mmb/d last year.

But this could now change. Much of the increase in non-OPEC supply has come from shale oil production in the United States. There are now some pretty persuasive reasons for thinking that US shale output might be at or near a peak, from which it could fall away quite quickly.

Readers will be familiar with some of the weaknesses of the shale story. Where output from conventional oil wells typically declines at between 5% and 10% annually, depletion rates for shale are dramatically more severe, with rates of 60%, and above, by no means uncommon.

This puts operators on a “drilling treadmill”, having to keep drilling new wells to offset declines from old ones. This has been fine so long as investors, convinced of the eventual profitability of “Saudi America”, keep stumping up capital. The day has to come, however – and probably sooner rather than later – when investors cease to oblige.

Where the petroleum industry is concerned, the picture is becoming clearer. The world’s appetite for oil is continuing to grow at around 1.4 mmb/d (1.5%) each year. Supplies of conventional crude have already peaked, and shale supply seems fairly close to doing the same.

Logically, this points to another spike in prices. One reservation has to be the ability of the world’s consumers to pay higher prices. But these consumers will probably do what they did at the same point in the previous cycle – which is to grumble, pay up, and add the cost to their already enormous debts.

We certainly have the bubble. We may, pretty confidently, anticipate the spike.

= = = =

Crude purchasing cyclejpg_Page1

 

#110: Diverging fortunes

SEEDS PROSPERITY REPORT, OCTOBER 2017

Now that SEEDS – the Surplus Energy Economics Data System – is fully functional, it is possible to review prosperity in what may be the first of a series of regular reports.

The general conclusion, which is unlikely to surprise anyone, is that the emerging market economies (EMEs) are performing far better than the developed Western nations where prosperity is concerned. What might surprise you is quite how marked some of these differences are.

SEEDS defines prosperity as ‘real discretionary incomes’, a term which requires some explanation. The starting point is GDP per capita, but two critical adjustments are then made.

First, GDP data is adjusted to eliminate ‘borrowed consumption’. Anyone can have a lavish lifestyle if he or she is prepared to go ever deeper into debt, and has a bank sufficiently accommodative to let them do so. This is precisely what many countries have been doing. The accommodative suppliers of credit have been the authorities. They started by making debt easily accessible and comparatively cheap, and have (since 2008) been even more obliging, by making credit even cheaper.

Second, the resulting ‘ex-borrowing’ numbers are further adjusted for the trend cost of energy. This cost acts as an economic rent, which means that it diminishes the incomes over which we can exercise choice (‘discretion’).  Where the individual or household is concerned, this shows up primarily in above-inflation increases in the cost of essential (‘non-discretionary’) expenditures.

The results are summarised in the table, in which the eagle-eyed will spot the first appearance of Russia in SEEDS data.

 Prosperity data, October 2017SEEDS PROsperityjpg_Page1

The table shows per capita prosperity, in local currency and at constant (2016) values, for the years 2006, 2016 and 2025. There are three columns of percentage comparisons, with results ranked by the third of these columns, which compare projections for 2025 with calculations for 2006.

Some of the results have obvious explanations. Prosperity in the United Kingdom is in relentless decline because the economy is in very deep trouble. Through-period comparisons for Australia, Norway and Canada are adverse because commodity prices, important to these economies, were close to extreme cyclical highs back in the start year of 2006.

Greece, obviously, has had a severe decline in prosperity over the past decade, but can now anticipate a very gradual recovery, albeit reversing only a very small proportion of the preceding decrease in prosperity.

At the other extreme, citizens of India continue to enjoy rapid improvement. The average Indian was 58% better off in 2016 than he or she had been in 2006, but we do need to note relative values here – in 2016, per capita prosperity (at PPP rates of conversion) was only $4,820 in India, compared with $43,700 in the United States.

China, too, continues to deliver impressive growth in prosperity, but there is a caveat here – per-capita debt is rising a lot more rapidly than prosperity. In 2016, the average Chinese citizen was 58% more prosperous than in 2006, but China also had four times as much per capita debt than a decade earlier.

The robust performance of Russia needs to be seen in context. In 2006, the Russian economy was still showing the ravages of the 1990s, and progress from here on is likely to be much more sedate.

 

 

 

#109: Still the Orient Express?

CHINA – a SEEDS APPRAISAL

The development of SEEDS – the Surplus Energy Economics Data System – enables us to put individual economies under the magifying glass, and this discussion responds to reader requests by looking at China.

Before we start, it’s necessary to remind ourselves that China remains a one-party state in which the authorities exercise considerable influence over the private sector. This matters, because the over-riding concern of the government is to avoid the unrest which would be likely to result from unemployment.

This objective can be a tough call. Despite family control policies sometimes criticized by outsiders, the population of China does continue to expand, and has increased by an estimated 68 million – more than the entire population of Britain – since 2006. Additionally, Chinese citizens continue to migrate from the countryside in search of better-paid work in the cities. Together, these trends make it imperative that employment growth continues unchecked.

For this reason, China is far more concerned with maintaining and growing activity than she is with profitability. This difference of objectives is profound, and can confuse observers accustomed to thinking in terms of the corporate profit motive which drives so much policy in the West.

Over an extended period, China has achieved breath-taking rates of growth in headline GDP. In 2016, the Chinese economy grew by 6.7%, and reported GDP has risen by 136% over a decade, from RMB 22.1 trillion in 2006 to RMB 74.6tn last year. The consensus expectation is that headline growth rates are set to remain in the range 6.5% to 7.0% for the foreseeable future.

In the past, some sceptics have questioned the reliability of reported growth figures, comparing them unfavourably with slower rates of increase in volumetric measures (such as the consumption of electricity). It is true that there seem to be continuity issues (where methods of calculation are changed, but without earlier numbers being restated).

But the really challenging issue now isn’t how much growth China delivers. It is how that growth is achieved.

The first chart puts this question into context. Growth in GDP has continued in a linear way, almost unchecked even by the global financial crisis (GFC) of 2008. But what has changed, radically, since the GFC has been the rate at which Chinese debt increases.

The numbers make this quite clear. Between 2008 and 2016, China’s GDP increased by RMB 35tn, or 88%. But economic debt – that is, the combined indebtedness of government, households and business – expanded by RMB 135tn (242%) over the same eight-year period. This equates to net new borrowing of RMB 3.86 for each RMB 1.00 of growth in GDP.

China debt and GDP Oct 2017jpg_Page1

Nor is this all. In addition to economic debt, China has very high levels of inter-bank or ‘financial’ sector debt. This debt increased from 24% of GDP (RMB 6.5tn) in 2007 to 65% (RMB 42tn) in 2014, and is likely to be about RMB 64tn (86% of GDP) today. Inter-bank debt is often omitted from debt/GDP calculations, because – in theory – it would net off to zero if all banks cleared their debts to each other.

As we learned in 2008, however, netting-off is not a safe assumption under all circumstances. So any assessment of China’s escalating debt position needs to take this into account.

Within the rapid build-up of economic debt, it is corporate borrowing which predominates. Of the RMB 135tn of net borrowing since 2008, government and households accounted for only 18% and 19% respectively.

The remaining 63% – net borrowing of RMB 85tn – was undertaken by private non-financial corporations (PNFCs). These businesses, then, have borrowed a lot more (RMB 85tn) than growth in the entire economy (RMB 35tn) since the GFC. Additionally, banks’ indebtedness to each other increased by about RMB 53tn – again, a lot more than total GDP growth – during that period.

Unlike Western countries, then – where most borrowing is carried out by government and households – the majority of debt growth in China comes from businesses. These businesses use this new debt primarily to grow capacity, often to levels far ahead of domestic or foreign demand.

This creation of excess capacity sustains growth in activity – in keeping with the government’s priority – but it exerts major downwards pressure on margins and profits. This has resulted in returns on capital often being depressed below the cost of debt capital. One obvious course of action would be to convert relatively costly debt into cheaper equity. But, when this was tried, it came close to crashing the Chinese equity market.

Rising levels of indebtedness – both corporate and inter-bank – are a clear cause for concern. From a SEEDS perspective, though, what matters more is that debt-financed capacity creation has boosted activity and recorded GDP to levels which simply would not be sustainable if access to ever-expanding debt was curtailed.

Stripped of this “borrowed growth”, underlying GDP is estimated to be nearer RMB 48tn than the recorded RMB 75tn (see next chart). Accordingly, underlying growth seems to be nowhere near 6.8%, but closer to 3.1% instead, equivalent to 2.5% on a per capita basis.

China underlying GDP Oct 2017jpg_Page1

Of course, this needs to be kept in context, and growth of 3.1% is impressive by Western standards.

But the risk attending the “borrowing effect” is considerable. If  lenders were to become cognizant of quite how much growth is being ‘juiced’ by the spending of borrowed money, the consequences could be distinctly unpleasant. To be sure, and even if capital flight and higher rates followed, China could probably sustain its debt-funded growth from within its own banking system. But there are, obviously, limits to quite how long any economy can keep on growing its aggregate debt by about 13% annually.

Additionally, the sheer pace of expansion in inter-bank debt has to be a matter of concern.

Meanwhile, China remains an energy-hungry economy, relying on imports for 68% of its primary energy needs.  Renewables still account for less than 3% of energy consumption, so are not, even remotely, a near-term fix.

This energy situation is being reflected in a rising trend ECoE (energy cost of energy). SEEDS estimates China’s current ECoE at 14.4%, which is drastically higher than a world average of 7.5%. According to SEEDS, China’s surplus energy position is already looking perilous, and could derail growth in less than a decade.

The final chart shows per capita prosperity, calibrated in constant (2016) RMB 000s per person. The downwards impact of ECoE (the red arrow) looks small, but this is deceptive – the ECoE effect only looks small because it is dwarfed by the borrowing effect.

Unlike many Western countries, China does still enjoy increasing prosperity on a per capita basis.

But the two threats to Chinese economic prospects – superheated debt expansion, and high-and-rising ECoE – should not be underestimated.

Whilst the former carries an elevated risk of financial shock, the latter suggests that Chinese citizens may face uncomfortably rapid increases in the real cost of household essentials in the not-too-distant future.

China prosperity Oct 2017jpg_Page1

 

 

 

#108: SEEDS goes public

Dear reader

As you will know if you are a regular visitor, surplus energy economics is an interpretation which says that the economy is, fundamentally, an energy system, not a financial one. More specifically, it is a surplus energy system, because, whenever energy is accessed, some energy is always consumed in the access process. Our prosperity is the surplus, or difference, between the amount of energy accessed and the quantity used up in getting it.

Where the surplus energy approach differs most fundamentally from ‘conventional’ economics is in its recognition that there are two economies, not one.

The first of these is the ‘real’ economy of goods and services, labour and resources, and this is an energy system.

In parallel with it is a second or ‘financial’ economy of money and credit.

Conventional economics goes wrong in thinking that this ‘financial’ economy is the entirety of our economic system. In fact, it is in a subservient relationship with the energy economy. This ought to be obvious. After all, money has no intrinsic worth. It commands value only as a “claim” on the output of the real economy.

Back in 2013, when Life After Growth was first published, I was uncomfortably aware that it would be hard to put numbers on this relationship. This is where the SEEDS project – the Surplus Energy Economics Data System – began. One of the biggest challenges has been to use monetary units to calibrate the ‘real’ economy which is the substance behind the ‘financial’ economy with which we are all familiar. This is one of the reasons why developing SEEDS has taken so long.

During this period, I have become ever more aware of a striking and dangerous reality in our situation. This is the way in which the ‘financial’ economy has become estranged from the ‘real’ economy which it is supposed to represent.

The real economy began to decelerate in or around 2000, but we have been unable or unwilling to accept this. Instead, we’ve sought to fake a “normality” of growth by ‘mortgaging the future’.

At first, we did this by creating an ever larger mountain of debt. This led to the global financial crisis (GFC) of 2008.

So large had debt become by then that the only way in which we could co-exist with it was to make it cheap to service. This is where “monetary adventurism” began.

We have toyed with some extremely silly ideas since then, such as ‘helicopter drops’ of money, negative interest rates, and the banning of cash.

The powers that be haven’t been sufficiently irresponsible to adopt some of the more extreme expedients. But what they have done has been bad enough. Ultimately, we have adopted a policy of ultra-cheap money, slashing policy interest rates to all-but-zero, and using vast amounts of newly-created money to drive asset values up, and yields down.

Only now are we becoming aware of quite how disastrous this policy of ultra-cheap money really is. Naturally, it has accelerated the pace at which we borrow – after all, why would you not borrow, when you are being paid to do so by interest rates which are negative (they are less than inflation)? And why would you save, when the real value of your savings falls year on year?

But the downsides of monetary adventurism don’t end there. I’ll pick just one of these downsides for special mention here. It is pensions. By driving returns on capital down into negative territory, we have destroyed returns on capital and, with them, our ability to provide for retirement. For all but a tiny minority of the very wealthiest, it has become impossible to save enough to give us a decent income in retirement.

The naïve answer to this is that we needn’t worry about pensions, or other future issues like paying back debts, because we have the comfort of the hugely inflated values of assets such as stocks, bonds and property.

This ‘comfort blanket’ is foolish in the extreme – because the only way we can turn these assets into money is by selling them to each other.

In politics and society, there are two things which we must hope that the general public never finds out. The first is what has happened to their ability to provide for retirement. The second is that selling houses to each other cannot get them out of this predicament.

The SEEDS system – in its SEEDS Snapshots version, freely available to the public – can now be downloaded from the resources page. The SEEDS Professional version will be announced at a later date.

We will doubtless have many discussions here about what SEEDS does, how it does it, and what it can tell us.

For now, though, such discussions can wait. Please download the very first published version – and enjoy it.

 

Yours,

 

Tim Morgan

 

 

 

#107: War-games

WHY SOMEONE IN BRITAIN NEEDS TO GET A GRIP

Britain’s opposition Labour party incurred a lot of media displeasure with the recent disclosure that it had contingency plans to cope with a run on sterling. In fact, such “war gaming” was nothing more than prudent. Indeed, it is to be hoped that the authorities, too, have such plans (though, of course, it would be madness to say so).

The thinking behind Labour’s plans was that, were left-leaning party leader Jeremy Corbyn to become premier, some of his policies (and especially his commitment to nationalization) might panic international markets, causing GBP to crash in a welter of capital flight. On this scenario, it seemed – even a couple of weeks ago – that there would, at least, be plenty of time to prepare. After all, few expected an election to be called in the near future.

As things now stand, and if you were taking bets on why a GBP crash might happen, a hostile market reaction to the election of Mr Corbyn would be an outsider in the betting. The much graver risk now is that a GBP slump might occur far sooner than Labour can come to power, and for fundamental rather than political reasons.

To be quite blunt about it, investors would now have very good reasons for concluding that Britain, both economically and politically, is falling apart.

The economic situation is truly parlous. Almost every sector – construction, production and services – seems to be turning down. The sole previous driver of economic growth, which was debt-fuelled consumption, has hit the buffers because consumer credit is maxed out. Even car sales – perhaps the ultimate debt-financed component – have taken on an ominous downwards trajectory.

Rising inflation has put great pressure on activity, because average wages have fallen steadily further adrift of prices. The Bank of England has hinted about rises in interest rates, essentially creating a hostage to fortune – if, after these hints, an increase doesn’t happen after all, the investor appetite for holding GBP could test new lows.

The Bank has also warned that the financial services industry faces adverse consequences unless the terms of a post-“Brexit” deal on trade with the EU can be reached by Christmas. Since Britain’s Brexit preparedness has recently been scored at just 9% – and, in the economic sphere alone, more or less zero – there seems precious little chance of that.

To cap it all, new information suggests that trends in productivity are even worse than previously thought, gravely impairing financial ‘wriggle-room’ in responding to “Brexit” uncertainties. This adds to the woes of finance minister Philip Hammond ahead of a budget which is likely to prove problematic anyway, not least because of increasingly strident demands for easing a policy of austerity which has fallen particularly heavily on public sector employees.

This, of course, brings in the issue of politics, which is a second area characterised by disintegration. Many Conservative politicians probably want rid of hapless premier Theresa May, and are deterred from ousting her only by two things – fear of the consequences if an election ensues, and the simple lack of a credible successor.

The Conservatives’ woes are being exacerbated by a clearly antagonistic drift in public opinion. When asked about “capitalism”, the most popular responses are “greedy”, “selfish”, “corrupt”, “divisive” and “dangerous”. Majorities, even amongst Conservative voters, now favour nationalising water, electricity, gas and railways.

In the face of this, government responses have seemed truly woeful. Both Mrs May and Mr Hammond have delivered trenchant defences of ‘the market economy’, but these have not persuaded voters increasingly hostile to “capitalism”.

The irony here is that there isn’t much free market economics around, in Britain or elsewhere, or not so that you’d notice. In 2008, governments defied the markets by rescuing banks, when market forces alone would have let them fail. Central banks then ditched market forces altogether by imposing a policy of ultra-cheap money. This, of course, crippled returns on capital – and, once returns on capital turn negative (that is, are less than inflation), it’s almost a logical impossibility to run an economy on capitalist lines.

Meanwhile, we must hope that the public, throughout the world, don’t find out what ZIRP has done to their prospects in retirement.

Mr Hammond’s own plan to expand “help to buy” is yet another policy which defies market forces (as well as being a gravely faulty policy in itself). There doesn’t seem to be much that is “free market” about Mrs May’s plans to cap energy prices, either.

Energy policy, in fact, neatly encapsulates the overthrow of the markets. Where the big energy utilities are concerned, Mr Corbyn wants to nationalize them, whilst Mrs May wants to cap their prices.

Neither proposal is, even remotely, a market-based policy. Any adherent of Adam Smith-style market economics would propose neither nationalization nor price control, but would instead advocate breaking up these over-mighty players, in the interests both of competition and of consumer value. Yet no-one, anywhere within the British political cadre, seems even to have considered the break-up option.

The British public, confronted with political fragility, policy imbecility and a deteriorating economy spelled out in a succession of adverse developments and statistics, must by now be feeling pretty punch-drunk. Unless someone gets a grip, the next blow could be a knock-out.

 

#106: Crisis – a forum

IDENTIFYING FORWARD RISK

The previous article suggested that money, rather than banks, might be in the eye of the next storm. That discussion produced a great deal of comment, and many questions and predictions. Here, and perhaps in society more generally, there does seem to be a widespread feeling that some kind of crisis looms, though opinions differ widely on what kind of crisis this might be.

The aim of this article is to invite discussion on what kind of crisis event we might face – always supposing that there is a crisis, of course. Naturally, the focus here will be on economics, finance and energy, but readers are welcome to drive the conversation in different directions. National and global politics, social unrest and climate change are amongst the more obvious areas in which a crisis might happen.

What follows here isn’t – and cannot be – a comprehensive assessment of crisis risk. Rather, it is simply “a canter over the ground”. It is a sketch, intended as a framework for discussion.

Background

It seems clear that, in or around 2000, organic growth in the world economy began to peter out. The explanation favoured here is that this was caused by increases in the trend energy cost of energy (ECoE). An alternative (or complementary) thesis might be that globalization, which began by giving Western consumers cheaper goods and services, then started to undermine their wages.

Whatever the cause, an increasing recourse was made to credit in order to sustain living standards. Between 2000 and 2007, when global GDP (at 2016 prices) expanded by $25 trillion, debt increased by $52tn. This meant that, worldwide, $2.08 of debt was added for each $1 of growth, though ratios were a lot worse than this in the developed economies of the West. This process was facilitated by financial deregulation, which also contributed to the increase and dispersal of risk.

As a result of escalating debt and diffuse risk, confidence in banks wavered during the “credit crunch” of 2007 and, briefly, collapsed altogether in 2008. This triggered the global financial crisis (GFC), which was only resolved (temporarily, anyway) when governments intervened to prevent the collapse of the banking system.

A critical policy since 2008 has been ZIRP (zero interest rate policy), implemented both by lowering policy rates and by using QE to drive bond prices up, and yields down.

Partly in response to the policy of ultra-cheap money, debt has continued to escalate, and the rate at which we borrow has accelerated markedly. Comparing 2016 with 2007, debt has increased by a further $89tn, or $3.62 for each $1 of the $25tn of growth recorded since then.

In contrast to the pre-2008 period, debt escalation is no longer solely a Western phenomenon. Emerging market economies (EMEs), most obviously China, are now piling on debt, though a few (including India) have not been sucked into the debt treadmill.

Financial risk

Given the accelerated pace of debt creation, it is tempting to suppose that ultra-cheap money has raised the spectre of a repeat of the banking crisis. This may indeed be the case. Banks’ reserve ratios have been increased, but not by very much – and, because banks are in the business of lending long but borrowing short, there is no level of reserves which guarantees safety in the face of a bank run triggered by a loss of confidence.

But monetary adventurism also carries risks specific to itself. This is necessarily the case when the stock of money expands much more rapidly than underlying economic activity. This policy has boosted asset prices (including bonds, stocks and property), whilst depressing returns. Essentially, there exists a clear risk that trust in one or more currencies may have been put at risk by reckless monetary policies.

We should never forget that the viability of fiat currencies, just like the solvency of banks, rests entirely on confidence.

The crushing of returns has created huge shortfalls in the provision for pensions. A recent study of just eight countries identified pension shortfalls of $67tn, which are rising at $28bn per day, and are set to reach $428tn (at constant values) by 2050.

SEEDS analysis suggests that the global pension shortfall today might be of the order of $114tn, and could reach $177tn by 2026. By the latter date, global debt could have reached $390tn, compared with $259tn today.

Additionally, and not included in the debt aggregates, inter-bank or “financial” sector debt is a lot higher now ($109n) than it was in 2007 ($72tn, at 2016 values), and might reach $181tn by 2026. This debt component is often excluded from “real economy debt” aggregates, probably because of the assumption that it would net off to zero if each bank paid what it owed. This ceases to be the case, though, if significant banks fail.

In total, then, over the coming decade we could expect aggregate forward liabilities to increase by perhaps $260tn. This number comprises about $130tn of additional debt, an increase of around $70tn in financial debt, and at least $60tn in incremental pension deficits.  Against this, GDP might grow by perhaps $46tn.

For each dollar of that growth, then, we can anticipate:

  • new debt of about $2.80
  • incremental financial debt of $1.60; and
  • additional pension shortfalls of $1.35.

These ratios are, of course, completely unsustainable. Given current tendencies towards acceleration, they might also prove to be unduly conservative projections.

Finally, where financial risk is concerned, it is necessary to dismiss the false comfort that is sometimes derived from an escalation in the theoretical value of assets such as stocks, bonds, property and – even – cash.

Taking property as an example, establishing the gross value of a nation’s housing stock by multiplying up from marginal transactions is entirely misleading. In practice, the only people to whom the housing stock can be sold are the same people to whom it already belongs.

This means that this stock cannot be monetized – and any attempt to convert even a modest proportion of the stock into cash would cause prices to collapse.

The same applies to stocks and bonds.

Even cash holdings are of limited relevance. Unless we postulate that cash is held by the same people who are in debt – or that the holders of cash would be willing to donate it to those in debt – cash cannot be netted off against debt.

Economic risk

Given the scale of financial risk outlined above, it might seem inevitable that a financial shock would have economic consequences. This is indeed the case. Although, in the aggregate, the values of stocks, bonds and property are meaningless, sharp changes in asset prices undoubtedly affect, for good or ill, the willingness of consumers to spend (the “wealth effect”).

Moreover, financial shocks also depress the velocity of money, meaning how long each dollar, euro or pound is held by the consumer before it spent.

But, quite aside from damage that might be inflicted by a financial shock, there are fundamental factors, too, which might drive economic output downwards.

The most important of these is underlying weakness. Since 2008 – and as we have seen – growth of $25tn has come at a cost of $89tn in net new borrowing. This raises the legitimate suspicion that much of the “growth” recorded in recent years has in fact amounted to nothing more than the simple spending of borrowed money.

Data for 2016 illustrates this issue. At constant prices, global GDP increased by $3.9tn, or 3.4%. But debt increased by $12.6tn during the year. Even if, say, only 20% of that new debt was used for consumption, then $2.5tn of the $3.9tn of “growth” was funded by borrowing. Logically, therefore, if – for any reason – consumers had been unable (or simply unwilling) to borrow in order to spend, then growth would have been only $1.38tn, or just 1.2%.

This problem is compounded by the fact that “borrowing to spend” didn’t start last year – SEEDS analysis of the GDP and debt data suggests that this phenomenon has been in place since at least 2000. So, if we ceased to take on additional debt for consumption, it wouldn’t be just the 2016 increment to growth that would be lost.

A counter-argument, of course, might be that activity is activity, irrespective of how it is funded. But consideration surely reveals that this isn’t the case. For a start, as – and it really is as, not “if” – people become aware, not just of how much debt they have, but of quite how precarious their old age is likely to be, we can expect them to become a great deal less willing to spend borrowed money.

The structure of the economy underpins this observation. Consumer spending, which in Western countries typically accounts for between 60% and 70% of GDP, divides into two broad categories. The first are things we must have, which are essential or “non-discretionary” purchases. These remain a minority share of the economy, though their share is increasing.

The other, larger category are “discretionaries”, which are things that we want, but don’t need.

In hard times, consumers are able to scale back on these discretionary purchases. People must eat, but they needn’t go to restaurants to do so. They need transport, but they needn’t replace their cars as often as they do now. They might want to move to a larger house, but they can choose to stay where they are. A British holidaymaker might choose Margate instead of Monaco. In short, the structure of the modern economy permits a great deal of retrenchment on discretionary purchases.

A reluctance to go further into debt, combined with misgivings about retirement, are not the only reasons why discretionary spending is capable of shrinking. Another is an increase in the cost of non-discretionary, essential purchases. Ever since 2000, the cost of essentials has tended to rise a lot more rapidly either than wages or general inflation. One reason for this is the rising real cost of energy, to which many essentials are extensively leveraged.

Taken together, a rising cost of essentials plus a reluctance (or an inability) to go on borrowing could exert very serious downwards pressure on demand. In some of the weaker economies, there are already clear signs that non-discretionary spending may be decreasing.

Energy risk

Quite apart from finance and structural weaknesses in the economy, energy is an area in which crisis is perfectly possible. This isn’t a matter of “running out of” any particular form of energy. Rather, it’s a matter of cost. This cost needs to be measured, not in money – which we can always create – but in terms of energy.

Whenever energy is accessed, some of that energy is consumed in the access process. This cost is described in Surplus Energy Economics as ECoE (the energy cost of energy).

What matters here is the trend, which is determined by the interaction of depletion and technology. Depletion reflects the way in which the lowest-cost resources are accessed first, leaving higher-cost sources until the cheaper ones have been exhausted. Technology can counter the process of depletion, but cannot overcome it, because technology operates within the envelope of what is physically possible within the resource context.

ECoE is not a “cost” in the conventional sense of ‘money going out’, because the global economy is a closed system. Rather, it is an economic rent – put simply, the more resources we are forced to spend on energy, the less we have to spend on other things.

This economic rent, incidentally, is why Surplus Energy Economics concentrates, not on incomes, but on the more fundamental issue of prosperity. This is defined as how much discretionary spending capacity we have. Even a seemingly-massive income doesn’t make someone prosperous, if all of it has to be spent on essentials.

The long-term trend in ECoE is almost wholly unrelated to market prices at any given time. These prices are cyclical, and are driven primarily by investment cycles. After 2000, high prices led to very large investment in capacity. Since 2014, the capacity created by this investment has resulted in over-supply. This over-supply will, in due course, be eroded by a combination of depletion and under-investment.

But the trend in ECoEs remains emphatically upwards. Furthermore, this upwards trend is exponential. A doubling of ECoE from, say, 1% to 2% doesn’t have much of an impact. Doubling ECoE from 7% to 14% is a very much more serious matter.

According to SEEDS, global trend ECoE doubled between 1980 and 1998, rising from 1.8% to 3.5%. It doubled again between 1998 and 2015, but this time to 7%, which is much more serious. By 2026, global ECoE is likely to rise to 10.5%. Well before this date, the effects of this economic rent are likely to force themselves on our attention. The numbers are already much worse in most developed economies than they are at a global average level.

There is a widespread assumption that society can transition pretty smoothly and painlessly from carbon-based to renewable energy sources. This assumption is almost certainly over-sanguine. The share of global consumption provided by renewables will undoubtedly continue to rise, but currently stands at barely 3%. The impact of renewables can be exaggerated by reference to capacities rather than actual output. Petroleum alone still accounts for 97% of all energy used for transport.

Scenarios

Thus far, we’ve looked at three broad categories of risk – finance, the economy and energy – but this by no means exhausts even reasonably plausible risk.

These three problems themselves could bring others in their wake. Downwards pressure on living standards could create political change or social unrest at the national level. Resource competition could heighten geopolitical conflict, particularly if diminishing prosperity has helped put extremists in power.

Current inequalities of income and wealth, tolerable when most people are getting better off, may quickly become politically toxic if general prosperity deteriorates. Migration flows seem likely to increase as prosperity weakens, and this may in turn prompt discontent and unrest in the migrants’ destination countries.

On top of these risks, there is the issue of climate change. We do not need to predicate any kind of environmental disaster to see how the economic rent of climate-dictated restrictions to human activities are piled on top of the increasing economic rent created by rising trend ECoEs.

To conclude, it’s reasonable to mention, in outline, just some scenarios in the economic and financial sphere.

One, of course, is a re-run of the banking crisis.

Another is the collapse of one or more major currencies. In this event, the affected countries would have little option but to default on foreign loans, increasing stresses on other currency areas in a rolling “domino effect”.

Both of these are reasonably likely events. So too, are political radicalism and social unrest, both of which have strong correlations with precisely the situation we have now.

That situation blends resource stresses with diminishing prosperity, severe inequality, over-extended credit, and monetary recklessness.

Historically, even one or two of these characteristics has been enough to trigger a crisis.