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.
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.
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.
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.
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.
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.