#137: Malice in Wonderland

A SHARP LESSON IN ENERGY ECONOMICS

“Show me a man who can join in a laugh at his own expense,” says a character in Nicolas Blake’s 1940 novel Malice in Wonderland “and [you] show me one of nature’s gentlemen”. Blake’s writing often hits the spot – not surprisingly, perhaps, since ‘Nicholas Blake’ was the pseudonym of poet laureate Cecil Day-Lewis – and I hope that my experiences over the last week or so pass this particular test. Laughing, as the saying goes, was the only alternative to tears.

Though few articles here are composed in the first person, what follows necessarily runs from the personal to the general. Whilst the “wonderland” of the title refers to the island where I live, the “malice” has no human agency, referring instead to the workings of the weather, and of inanimate objects.

This story begins with an inanimate object – recognition that my computer, which gets extremely heavy use, was in the process of falling to bits. Its replacement having arrived, I set aside last Saturday for installation, only to discover that the new machine was faulty, and required return and replacement.

So far, so bad, but much worse was to come. On Sunday, the temperature here dropped from a balmy 25°C to an unseasonal 11°, accompanied both by torrential rain and by winds which, over the coming week, were seldom to fall below gale force. Midway through that morning, a tornado took out a key part of the electricity distribution system, leaving most of the island without power. By Tuesday, the authorities had installed generators in some of the main conurbations, though even this was hardly trouble-free, with several of the generators reportedly bursting into flames, apparently under stress of excessive demand.

Obviously enough, this event denied me, not just light and power, but music, hot water, computing and hobbies. Things didn’t end there, though. Water supplies failed through lack of pumping, and even the front gates remained shut until I could figure out how to open them manually. First task after that was to find out which, if any, shops (one) and restaurants (none) had backup power supplies. The presence of mind of one bar-owner enabled locals to revel in Barcelona’s 5-1 annihilation of Real Madrid, though this generator didn’t extend to hot drinks, let alone meals. Fuel in cars had to be used sparingly, because lack of power shut down the filling stations.

Put simply, normal life ground to an almost complete halt. Almost all business and official premises remained shut, depriving the public of postal, banking and most other services. Loss of internet connection deprived me of contact with the outside world. I didn’t miss television (since I never watch it), but I did miss my music, my DVDs, my books, and working on my latest project (a 1/72nd exact scale model of a Type 12 frigate). All that one could really do was to eat snacks, fight an impending cold with soluble vitamin C, sit around in the cold darkness – and think.

Since I’ve contended for very many years that the economy is an energy system with an artificial financial adjunct, I should have been less surprised than most at the near cessation of all normal activity by the simple interruption to the supply of electricity. Even so, the lesson taught by this event was the sheer totality, and the rapidity, too, with which the absence of energy brings normal life to a halt.

Let’s, then, summarise the predicament of the population of the island during the power hiatus. The immediate effects were loss of domestic electricity supply (and, with it, light, power, cooking facilities, refrigeration, water supply and communications). In the business sector, activities in almost all categories ceased, most obviously including financial services, retailing, distribution and the supply of energy. Most aspects of government, including administration, revenue raising, defence, policing, health care and social services, seem to have kept going, but only by courtesy of generators.

The nearest generator to me had to be refuelled at intervals of between five and six hours. This particular generator was kept supplied with fuel by tankers small enough to negotiate some very narrow streets, and generators sited in broader thoroughfares might have been serviced by larger vehicles, extending the resupply interval somewhat. Presumably, the generating capacity itself was supplied, by sea, either from the mainland or from a much larger neighbouring island, neither of which was affected by the outage.

Ultimately, three factors made the situation survivable. First, the community here has particularly strong social cohesion. Second, the loss of power was always known to be temporary, and unlikely to extend for as much as a week. Third, and critically, outside help was available, because the power loss was strictly localised to most of one small island.

It doesn’t take much imagination, though, to picture what might have ensued if none of these favourable conditions had prevailed. Even with outside support, the duration over which anything approximating to normality would prove sustainable is strictly limited – and this brief and incomplete sustenance of normality could not have happened had the rest of the country been affected simultaneously. It takes little imagination, either, to envisage the erosion of social cohesion had neither limited duration nor nearby support characterised the outage.

Let’s be quite clear about this. If energy supply is cut off, and is cut off in way that is of unknowable duration, and for which there is no outside help, economic and other normal life ceases to be possible.

Could money solve this problem? Well, if you will, imagine that, whilst unable to offer physical succour, Madrid or Barcelona had been able to supply the island with money – you might even picture airdrops of bank notes by the air force, or the delivery of millions of euros by naval auxiliaries. You will appreciate that this purely financial support would have had absolutely no positive effect on the situation. All that it might, conceivably, have achieved would have been to trigger massive inflation, with more money chasing an extremely small supply of goods and services.

Let’s be clear that weather-related outages like the one experienced here are not going to deprive even a sizeable national economy of energy, and neither are we, in any meaningful sense, going to “run out of” energy. There are, though, two very real threats which we should consider.

The first of these is a simple inability to purchase energy, even if global supplies remain generally accessible. This is what happens to an economy if the value of its currency collapses. Picture, if you will, a country relying on imported energy (or, for that matter, imported food, itself an energy product), and imagine that the country’s currency experiences a sudden 75% fall in its international value. What this means is that the local cost of energy has quadrupled. A variation on this theme is a situation in which the country’s currency ceases to be acceptable to foreign suppliers, who perhaps see reason to question its viability. Both scenarios are distinctly possible, given the sheer scale of credit and monetary risk adopted, as a sequential matter of policy, over the period since the late 1990s.

The second (and likelier) scenario involves an erosion of surplus energy, a situation which arises when, within any given quantity of accessible energy, the amount available for all purposes other than energy supply itself becomes squeezed by a rise in ECoE (the energy cost of energy). We don’t have to imagine this scenario, because it’s already happening – according to SEEDS, world ECoE has now risen to the point where global average prosperity per person is in decline.

Thus far, we’ve done a pretty good job of collective and official denial over this reality. We have poured huge amounts of debt – and, latterly, of cheap money as well – into the system in order to retain a misleading semblance of economic normality. We’ve told ourselves, along the lines of a bedtime story for frightened children, that renewables will rescue us from the economic and environmental follies of burning up fossil fuels at the maximum rate possible, heedless of the future.

In short, what happened here this week may, in itself, have been a freak occurrence – but it is no less unreal than the stories we tell ourselves about infinite growth on a finite planet.

 

 

#136: The challenge for government

THE POLITICS OF DECLINING PROSPERITY

The underpinning assumption of continuous growth has framed the entirety of the economic debate in politics since long before current systems of Western governance came into being.

Now, with the economies of the West characterised by an ongoing deterioration in prosperity, wholly new rules apply. Whilst sharing out the benefits of growth has seldom been easy, allocating hardship is going to be a very much harder call. As things stand, the incumbent elites have no answer to a question that they do not even know they need to ask – how do we govern societies that are getting poorer?

This puts us in a strange situation in which the general public knows more than the political elites. The official line is that people are continuing to enjoy growing prosperity, but people themselves recognise increasingly that this isn’t the case. The elites believe that traditional parties, and established ideologies and methods of conducting government, remain valid, but the public is well advanced in the process of repudiating all of them. Where elections are conducted proportionately, insurgent parties are making huge inroads – but where, most obviously in America and Britain, the system is structured in ways which entrench established parties, those parties are becoming the target for capture from within

Two humdrum issues in fiscal policy illustrate quite how dramatic the economic change is going to be. For a start, there’s no point in anyone proposing to increase public spending, because this is ceasing to be affordable. Likewise, there’s no point in asking whether or not governments should “tax the rich” more than they do now, because doing so is becoming unavoidable.

This change invalidates much of the economic thinking of the respective ‘conservative’ and ‘Left’ political persuasions. Additionally, the conservative side is now about to discover the price of two disastrous mistakes made within the last decade, whilst the Left is losing the ability to present a viable alternative to “austerity”.

Politics and government – the children of growth   

Although the American Constitution dates from 1787, most forms of government operating around the world today are of much more recent origin – and, even in the United States, governance has undergone huge changes since the Founding Fathers put quill to paper.

What this means is that virtually all Western systems of government and politics are products of an age of growth, and this history frames the policy debate, in economics and in much else. The Industrial Revolution is generally dated from about 1760 and, though it took a long time to spread around what we now call ‘the West’, it’s fair to say that no system of government in the advanced economies pre-dates the start of growth.

This is not to assert that there has been an uninterrupted continuity of growth because, of course, there have been periodic downturns, some of them deep and protracted. However, even in the midst of the best-known slump – the Great Depression of the 1930s – the assumption of expansion remained, stated in a consensus faith in the eventual restoration of growth.

The dominance of distribution

If, for now, we ignore the purely ideological dimension, economic management in an era of expansion becomes fundamentally a question of distribution. This poses one basic question: ‘if economic output is going to grow by X over the coming Y number of years, how are we going to share out this growth?’

Generally speaking, those on what we might term the ‘conservative’ side have tended to favour letting the fruits of growth fall where they may, which is to say in an unequal and somewhat haphazard fashion, not unrelated to the ‘lottery of life’. Those on the ‘Left’, on the other hand, have favoured skewing the distribution to favour those at the lower end of the prosperity spectrum. For the Left, this then poses a subsidiary question. Should redistribution mean taking from the better off and handing it to the less prosperous, much as Robin Hood is said to have done? Or are the resources to be redistributed better bestowed in kind (in the form of public services) rather than as a simple financial transfer?

It’s in the nature of popular discourse that both sides have endeavoured to construct a moral case buttressing their persuasions. For the Left, allowing extreme wealth for some in the midst of grinding poverty for others is morally unacceptable. For conservatives, taking money from the energetic, successful or simply lucky and handing it to those who may lack ability, or may be feckless, or are just plain unfortunate, encroaches unacceptably into private preference.

The aim here is to avoid this moral stand-off, not because it doesn’t matter, but because it’s largely insoluble. If someone feels that it’s morally wrong for the state to take his money and give it to others – or, conversely, if he finds it offensive that some people own multiple palatial dwellings whilst home for others is a cardboard box under a railway bridge – it is unlikely that he or she is persuadable to the other point of view.

Moreover, it’s of diminishing relevance if, as is argued here, ‘sharing out growth’ has ceased to be the decisive political issue in politics.

With growth come choices – but de-growth replaces them with imperatives.

The game-changer

As you’ll know if you’re a regular visitor to this site, a central finding of Surplus Energy Economics is that two centuries and more of increasing prosperity are in the process of going into reverse. The main reason why this is happening is that the energy-based economy is being undercut by an upwards trend in ECoE (the Energy Cost of Energy). To observe how this is taking place, it’s necessary to see past financial gimmicks which are designed, if not to affect, then at least to disguise what is going on.

This, it must be stressed, is an interpretation, not a prediction, at least as far as almost all Western economies are concerned. According to SEEDS, prosperity has already declined markedly in most advanced economies, having peaked at various points between 2000 and 2007. Italian prosperity, for example, has declined by 13% since 2001, British people are typically 11% poorer now than they were in 2003, and Americans have become 7.5% less prosperous since 2005.

America, the United Kingdom and Italy are used as exemplars here because of circumstances specific to each. In Britain, where prosperity is deteriorating particularly rapidly, voters have decided to defy the establishment and pull their country out of the European Union. Nationalism has certainly come to the fore in the United States, where it’s plausible that the Trump administration is the first government to understand that prosperity is becoming a zero-sum game. Italy’s new insurgent coalition clearly plans to challenge EU strictures on spending and deficits.

Trends in prosperity and GDP per capita for these economies are illustrated in the first set of charts. In each case, the official line is that GDP is growing, but, in each instance, this perception has been sustained only by the spending of huge amounts of borrowed money. People in all three countries are getting poorer, and, politically, this is exerting mounting pressure for change.

Critically, this downturn isn’t temporary, so there’s no point in waiting for prosperity growth to resume.

#136 prosperity & governmentjpg_Page1

The authorities in these and other countries have tried to circumvent the deterioration in prosperity using credit and monetary adventurism. But all that this has done has been to create a first global financial crisis in 2008 (GFC I) and, now, to set in motion a process that will bring about a second and much larger crash (GFC II) in the near future.

Where politics is concerned, the ending and reversal of the upwards trend in prosperity is a game-changer – instead of debating the sharing out of growth, politics is now becoming the much tougher matter of allocating hardship.

The establishment’s existential errors

The ending of prosperity growth is something that the existing structure of politics will struggle to address, even when the reality of shrinking prosperity becomes so obvious that it can no longer be denied or ignored. The problem for incumbent regimes is exacerbated because, during and after GFC I, the establishment managed to shoot itself in both feet.

First, the powers-that-be underestimated the popular anger that would be triggered when they combined the necessary rescue of the banks with the arguably unnecessary rescue of the bankers. Second, they introduced monetary policies which handed huge gains to those who already owned assets in 2008, and made asset accumulation very much harder for those – a majority – not in that fortunate position.

Both problems were compounded by supplementary errors. Where inflating asset values was concerned, no measures were introduced to even try to capture at least some of the winners’ upside in order to compensate the losers. Since the winners tended to come from an older demographic than the losers, this gaffe set in motion a process of change that is corroding away popular support for the established system.

The compounding problem with rescuing the bankers was that this was done by governments whose default position is opposition to intervention, which is why they find reasons not to act whenever the idea of rescuing, say, steel-workers or retail employees is proposed. Bankers, apparently, are worthier of rescue than manual or clerical workers. This is a view for which there is little or no popular support.

Put simply, then, the authorities made two existentially bad calls in 2008. If these mistakes are added to a deterioration in prosperity – denied by the authorities, but experienced by ‘ordinary’ voters – it becomes very easy indeed to see why insurgent or “populist” parties are enjoying steadily growing support. Part, at least, of the explanation for this shift lies in the establishment’s spectacular failure to recognise the consequences of making itself unpopulist.

How bad?

As we’ve seen, prosperity is declining markedly in Britain, America, Italy and most other Western economies. By 2025, people are likely to be a further 6.0% poorer than they are now in Britain, 5.4% poorer in America and 3.1% poorer in Italy.

This necessarily impinges on the ability to pay tax. Though taxes tend to be levied on incomes, consumption and returns on investment, the only thing that can really be taxed is prosperity.

To understand why, picture somebody whose income is £30,000, but whose prosperity is only £22,000. (In SEEDS terms, two components explain the difference between these numbers. One is the proportion of income financed by financial adventurism, and the other is the trend cost of ECoE, experienced by the individual primarily through the cost of household essentials).

If the state imposes taxes totalling 40% of this person’s income, the resulting £12,000 tax represents 55% of his or her prosperity. Now, move this on to a point where income has increased to £35,000, but prosperity has deteriorated to £20,000. If tax is still being levied at 40% of income, the proportion of prosperity now going in tax has climbed to 70%.

The starting figures are not dissimilar to the actual situation in Britain. In 2017, government primary expenditures (which exclude interest on debt) totalled 37% of GDP, but this was already more than half (52%) of aggregate prosperity. If the government is, in 2025, still spending 37% of GDP, it will need to tax 60% of prosperity to finance it. The numbers for Italy are similar, and, whilst America has rather more fiscal elbow-room, the trend towards the government seeking an ever-growing share of national prosperity is just as firmly in place there.

Another way to look at this is that, taking the UK as an example, tax equated to 51.8% of national aggregate prosperity in 2017. If that ratio is maintained, the tax take (at constant values) in 2025 is likely to be about £736bn, rather less than the £760bn likely to be raised this year.

These points are illustrated by the next charts, which illustrate government primary expenditures as percentages both of GDP and of prosperity.

#136 prosperity & government 2jpg_Page1

Less room for choice

A clear implication of SEEDS analysis is that no government, irrespective of its political colour, is going to be able to increase public spending to any material extent – and, in the longer term, is going to have to push expenditures down, not up – unless it wants to appropriate an unacceptably large proportion of national prosperity. Yet both the Left and much of the insurgent sides of politics predicate their policies on higher state spending, whilst the only parties favouring restraint seem already to be heading towards political irrelevance.

Before conservatives draw any comfort from the conclusion that public spending cannot realistically be pushed upwards as prosperity falls, they need to recognise that their own resistance to higher taxes on “the rich” is becoming equally untenable.

The reason for this is that, whilst the deterioration in prosperity is a generalised phenomenon, its effects are felt from the bottom up. This observation is already writ large in the visible widening of hardship, not so much amongst those in absolute poverty but amongst the large and growing numbers variously described as “just about managing” and “struggling to keep their heads above water”. As the number struggling increases, the ability to collect taxes from these people declines. Before very long, only those described in varying degrees as “rich” will be able to pay much in the way of tax.

Lastly, there is a nasty budgetary sting in the tail contained within the ECoE process and the consequent deterioration in prosperity. Ultimately, these processes mean that each pound, dollar or euro delivers a declining quantity of discretionary spending capability over time, as the cost of essentials absorbs a growing proportion of income.

But this doesn’t just affect households – it affects government as well. Accordingly, the amount of activity that public services can deliver from any given budget is on a decreasing trend.

Conclusions

If SEEDS is correct in identifying diminishing prosperity, the implication is a total game-changer in politics and government. Increasing government spending is ceasing to be a viable option, whilst “the rich” are going to have to pay much more in tax, however just, or unjust, one happens to think this is.

No existing party is equipped to handle this new reality, and neither, for that matter, are the insurgent movements sometimes dubbed “populist”. Political conservatives cannot hope to preserve the economic status quo, whilst the Left’s dreams of bigger state spending are becoming ever less realistic.

If “populism” means anything, it means giving the voters what they want – but this, too, in hard economic terms, is ceasing to be plausible. The spread of insurgent politics is likely to put a growing emphasis on “taxing the rich”, which, apart from being something that government can do, is going to become inevitable in the future. Conversely, though, insurgent promises to counter “austerity” by increases in public spending are rapidly ceasing to dwell in the realms of the possible.

This in turn suggests that insurgent, “populist” politicians are likely to put greater emphasis, not just on “taxing the rich”, but on non-fiscal issues including nationalism and immigration. As both the ‘Left’ and the ‘conservative’ persuasions struggle to come to terms with new realities, the insurgents can be expected to move in new and more radical directions.

 

#135: Still not (wholly) about “Brexit”

BRITAIN, EUROPE AND GFC II

A little less than two months ago, we made an effort here to look past the sound and fury of the “Brexit” debate to assess the real state of prosperity and risk in the United Kingdom.

Now, as the world marks the tenth anniversary of the 2008 global financial crisis (GFC I), it’s being reported that Mark Carney, governor of the Bank of England, has warned government that “a chaotic no-deal Brexit could crash house prices and send another financial shock through the economy”.

Risks identified by Mr Carney apparently include a slump in the value of GBP, sharp rises in interest rates and a 35% fall in property prices. Whilst he is right about these risks – and right, too, to warn about the consequences of a mishandled “Brexit” – we need to reiterate that these risks are likely to eventuate anyway, because British prosperity is continuing to deteriorate, whilst financial risk remains highly elevated.

Some updates

As I’m off travelling for much of next week, what I’d like to do here is to pause, as it were, and posit a few things for thought and comment. “Brexit” risk, and the likelihood of GFC II, have to be high on that list.

First, though, I’d like to thank the first two followers of Surplus Energy Economics who’ve made donations towards the upkeep and development of the project. I’m new to the donation process, so I don’t know what the courtesies are for expressing gratitude – but I really do appreciate your support.

While I’m away, please do carry on posting your comments, but please also note that moderation is going to be intermittent for the next week or so. The best way to get comments posted is to leave out links, as any comment including them is automatically placed in the moderation queue.

On “Brexit”

Throughout the debate about Britain leaving the European Union, no view has been taken here about the merits and demerits of “Brexit” itself. There are, though, a number of points which do need to be made.

First, the debate about “Brexit” was extraordinarily nasty and divisive.

Second, it’s vital that the expressed view of the voters is respected.

Third, surplus energy analysis gave us a strong lead on how the referendum was likely to turn out. According to SEEDS, per capita prosperity in Britain was already 10% lower by 2016 than it had been at its peak in 2003. This has to have been a major factor motivating the anti-establishment component of the vote.

Finally, “Brexit” is best considered as a ‘situation’ rather than an ‘event’. A ‘situation’ is something which creates a multiplicity of possible outcomes. The biggest risk with “Brexit” has always been that the British and EU negotiating teams would agree (or disagree) to choose the worst possible result. As things stand, that outcome is looking ever more ominously likely, thoroughly justifying Mark Carney’s warnings.

The British predicament

It would be a mistake, though, to assume, either that “Brexit” alone has created these risks, or that an alternative decision by the voters would have taken these threats away. Neither should risk on the EU side be downplayed.

Expressed at constant values, British GDP was £386bn larger in 2017 than it had been back in 2003. This translates to a gain of 11% at the per capita level, after adjustment for the increase (also 11%) in population numbers over that period.

But any suggestion that British citizens are 11% better off now than they were fourteen years ago is obviously bogus, an observation surely self-evident in a range of indicators spanning real incomes, the cost of household essentials, spiralling debt, sharp downturns in customer-facing sectors such as retailing and hospitality, maxed-out consumer credit and the worsening and widening hardship of the millions struggling to make ends meet. The national housing stock might be ‘worth’ £10 trillion, but that number is meaningless when the only potential buyers of that stock are the same people to whom it already belongs.

SEEDS analysis shows how we can reconcile claimed “growth” with evident hardship. First, growth of £386bn (23%) between 2003 and 2017 was accompanied by a 62% (£2 trillion) increase in aggregate debt. Put simply, Britain has been pouring credit into the system at a rate of £5.20 for each £1 of “growth”.

In the short term, you can have pretty much any amount of statistical “growth” in GDP if you’re prepared to pour this much credit into the system. The problem comes when you cannot carry on doing this, and this is especially the case when you’ve also been a huge net seller of assets to overseas investors as part of a process of consuming at levels far in excess of economic output.

Compounding this, of course, has been an escalating trend energy cost of energy (ECoE) and this, in Britain, has soared from 3.4% in 2003 to a projected 9.2% this year. The latter number is close to a level at which increasing prosperity becomes impossible.

“Stalling between two fools”

This makes Mr Carney’s risks all too real. According to SEEDS, aggregate prosperity in the UK last year was £1.45tn, a number 29% below recorded GDP of £2.04tn. When measured against prosperity rather than GDP, the British debt ratio rises to 361% (rather than 258%), whilst financial assets now stand at 1577% of prosperity (compared with about 1130% of GDP).

Bearing these exposure ratios in mind – and noting the ongoing deterioration in per capita prosperity – the likelihood of a currency slump, spiralling interest rates and a severe fall in property prices has to be rated very highly indeed.

But “Brexit” is by no means the only possible catalyst for a crash. Perhaps the single most depressing aspect of the British predicament is the paucity of understanding of, and response to, structural economic weaknesses.

This is not to say, of course, that EU negotiators have played this situation well. The assumption that the EU holds all the high cards in “Brexit” talks is absurd, and the extreme risk to Ireland is just one of many reasons for caution. The guiding principle, which seems to be to punish British voters’ temerity as a warning to others, appears not just pompous but, given the spread of support for insurgent (a.k.a. “populist”) parties, extremely short-sighted.

On the horizon – GFC II

For the British and the Europeans, “Brexit” has been a massive distraction from broader financial and economic risk. Though we cannot know when GFC II will eventuate, there can be very little doubt that a crash, of greater-than-2008 proportions, is looming ever closer.

As regular readers will know, there is a clear narrative which points unequivocally to GFC II. This narrative is so important, and so seemingly absent from mainstream interpretation, that little apology seems required for reiterating it in brief.

The narrative can be expressed as three very simple propositions:

1. From the late 1990s, the secular capability for growth began to erode.

2. Instead of accepting (or even recognising) this deceleration, the authorities embarked on credit adventurism, making debt cheaper, and easier to obtain, than at any previous time in modern history. Not surprisingly, this led directly to GFC I, and ensured that it would be a debt-centred event, primarily threatening the banks.

3. Rather than take the hit for reset, the authorities then moved on to monetary adventurism, pouring huge amounts of ultra-cheap liquidity into the system. This must lead to GFC II, and GFC II must be a monetary event.

There are plenty of things to debate about this sequence. First, what caused the secular deceleration which triggered the whole process? The explanation favoured here is the rising trend in the energy cost of energy (ECoE), but there are certainly some candidates for ‘best supporting actor’. These include ideological commitment to reckless deregulation, badly mishandled globalisation, and the impact of climate change.

Second, why didn’t we choose reset in 2008? With hindsight, the choice made was the wrong one, as many experts pointed out at the time. By playing ‘extend and pretend’, the authorities made huge mistakes, which included moral hazard, creating massive asset bubbles, all but halting creative destruction, and destroying returns on investment (to the particular detriment of pension provision).

One of the lesser-known consequences was that the market economy, properly understood, became inoperable – after all, positive returns on capital are something of a prerequisite in any ‘capitalist’ economy.

Likewise, when the relationship between asset prices and income was bent completely out of shape, immense divisions were created between those who already owned assets and those (generally younger) people whose aim is to accumulate them.

Lastly, is there anything we can do now about GFC II? Frankly, prevention now looks impossible, but there might still be quite a lot of mitigation that we can implement (without going to the extremes of stockpiling tinned food, bottled water and ammunition).

We cannot know whether the coming explosion is going to be ‘chemical’ (requiring a catalyst) or ‘nuclear’ (requiring only critical mass). But there’s plenty of combustible material around, a huge array of potential catalysts – and an inexorable progression towards critical mass.

Abroad thoughts from home

I hope that, despite a short hiatus in moderation and response, readers can carry on debating these and other issues, and will forgive this brief restatement – which to me seems necessary on grounds of imminence and importance – of issues around “Brexit” and GFC II.

It is hoped that, after the intermission, we can get back to pushing the boundaries.

 

= = = = =

#136 prosperity & governmentjpg_Page1

#134: An extremity of risk

A SEEDS VIEW OF THE IRISH ECONOMY

Last year, GDP per capita in the Republic of Ireland was €62,560, far higher than in Germany (€39,450) or the Netherlands (€42,820), let alone France (€35,310).

If you find this rather hard to take seriously, you’re right. And, whilst you’re in disbelief mode, you should forget any idea that Ireland has made a spectacular recovery since the 2008 global financial crisis (GFC I), or that the country is less at risk now than it was back then. Likewise, you might note that Ireland is at even greater risk from a mishandled “Brexit” than is Britain herself (though you’d never guess this from watching the course of the negotiations).

Let’s clear the decks by getting the official numbers out of the way first. In 2017, Ireland reported GDP of €296 billion, up 50% since 2007 (€197bn at 2017 values). The per capita equivalent for last year was €62,560, a real-terms improvement of 41% over a decade.

At the end of last year, debt totalled €938bn (or a hefty 317% of GDP) – lower than in 2016 (€1,021bn) but still €449bn (92%) higher than it was in 2007, on the eve of the 2008 global financial crisis (GFC I). Financial assets (a key measure of the size of a country’s banking system) totalled 1751% of GDP at the end of 2016, but might be down to about 1500% – or €4.4tn – now. The latter compares with €3.44tn in 2008, the most recent year for which data is available.

Even on a reported basis, there are some negatives here. Quantitatively, both debt and financial assets are a lot bigger now than they were when GFC I struck. Neither a debt ratio of 317% of GDP, nor banking exposure anywhere near 1500%, is remotely comfortable. The saving grace, of course, is GDP, and the robust pace at which it seems to be growing.

Put simply, we can be moderately relaxed about Ireland if – but only if – we accept recorded GDP as an accurate reflection of economic output and prosperity, which are the criteria which really determine the ability of an economy to carry any given level of debt or banking exposure.

Exposing the reality

Unfortunately, official GDP isn’t a meaningful reflection of either. According to SEEDS, GDP (of €296bn) seriously overstates real economic output (€193bn), and is dramatically higher than prosperity (just €173bn).

Obviously, such a drastic overstatement of output means that reported rates of growth are correspondingly meaningless. More seriously, it disguises exposure ratios that are drastically worse than official numbers which, even in themselves, are risky enough. For instance, debt may be ‘only’ 317% of GDP, but equates to about 544% of prosperity. More seriously still, financial assets rise from an estimated 1493% of GDP to 2560% of prosperity, a number which, as well as being truly scary – and unmatched by any other significant economy – means that Ireland has bloated banking exposure from which seemingly there can be no escape.

Put bluntly, Ireland is one setback away from disaster – just as both Britain and her European partners are in the process of crystallising “Brexit” risk……

Seeing through the numbers

How, then, can GDP so drastically misrepresent Ireland’s economic output, her prosperity and her resilience in the event of a shock?

There are three main explanations for the divergence between Irish GDP and the country’s prosperity, as the latter is calculated by SEEDS.

First, the basis on which Ireland calculates GDP was changed in 2015, creating single-year growth of more than 25%, and helping to push reported GDP per capita to levels which are, frankly, ludicrous.

Second, and in keeping with the widespread practice of “credit adventurism”, Ireland has pushed huge amounts of debt into the system, boosting recorded activity in ways which are wholly a function of an unsustainable expansion in credit.

Third – and particularly seriously where Ireland is concerned – reported GDP takes no account of the trend energy cost of energy (ECoE), a trend whose exponential rate of increase has already put Western prosperity growth into reverse.

Leprechauns and lenders

Back in 2015, Ireland adopted a new method for incorporating into GDP the activities of the multinational corporations which form such a big component of the Irish economy. Reflecting this, real GDP (expressed at 2017 values) increased by 25.5%, or €53bn, in a single year, from €208bn in 2014 to €261bn in 2015.

Dubbed “leprechaun economics” by Paul Krugman, this methodological change remains controversial. It is seldom noted that, reflecting this change, the €53bn increase in GDP was accompanied by a much bigger (€204bn) rise in debt, with PNFC (private non-financial corporate) indebtedness actually increasing by €242bn in a year in which both government and households were deleveraging.

A side-effect of “leprechaun economics” was a small decrease in the ratio of debt-to-GDP, which happened because reported GDP grew by slightly more (25.4%) than the increase in debt (24.2%). When debt expands by this much – and when almost €4 of debt is added for each €1 of claimed “growth” – it is clear, beyond a doubt, that any apparent fall in this widely-watched ratio has to amount to a mathematical quirk.

“Leprechaun economics” aside, the reported increase of 50% in GDP between 2007 and 2017 equated to incremental activity of €99bn, a number dwarfed by the €449bn (92%) escalation in debt over the same period.

Borrowing just over €4.50 for each €1 of “growth” is not a particularly outlandish number by the standards of Western economies (though it remains a lot higher than a global average of 3.3:1). Even so, it is clear that, in addition to helpful statistical restatement, Ireland has boosted GDP through a process of spending very large amounts of borrowed money.

This process of credit-created “growth” did not start in 2007, of course. In the seven years preceding GFC I, growth (at 2017 values) of €62bn (46%) in Irish GDP was accompanied by an expansion in debt of €267bn (120%), meaning that Ireland was already habituated to borrowing well over €4 for each incremental euro of “growth”.

According to SEEDS, GDP in 2007 (of €197bn) already materially overstated ‘clean’ (credit-adjusted) output of €181bn. By 2017, the gap had widened to the point where reported GDP (of €296bn) overstated clean output (€193bn) by more than 50%.

And this is even before we take the all-important matter of energy trends into account.

The energy dimension

As regular readers will know, the central working premise of surplus energy economics is that, ultimately, the economy is an energy system, not a financial one – money and credit are simply claims on the output of the energy-driven economy.

Rather than the absolute quantity of energy available, the really critical issue is how much of any energy accessed is consumed in the access process. Put simply, the higher this cost is, the less energy that remains for all purposes other than the supply of energy itself.

Globally, ECoE – the energy cost of energy – is on an exponentially rising trend, having climbed from 4% in 2000 to 5.4% in 2007 (just before GFC I) and 7.7% last year. Across developed economies as a group, ECoE has already risen to levels high enough to put previous growth in prosperity into reverse.

This, ultimately, is why these economies have adopted credit and monetary adventurism in an ultimately futile attempt to maintain a semblance of ‘growth as usual’.

Ireland is more affected than most by the relentless escalation in ECoEs, mainly because of the paucity of indigenous energy resources. Last year, consumption of energy totalled 16.8 million tonnes of oil equivalent, but production was just 3.6 mmtoe, forcing Ireland to rely on imports for almost 80% of her primary energy needs. All of Ireland’s petroleum and gas requirements are imported, making the country particularly exposed both to rising world ECoEs and to energy supply risk.

According to SEEDS, Ireland’s ECoE as long ago as 2000 (4.8%) was already higher than the global average (4.0%). By 2007, this differential had widened, to 6.7% versus a global 5.4%. Today, Ireland’s trend ECoE is put at 11.2%, far higher than a world average of 8.0%.

In other words, the gap keeps getting worse.

Levels of ECoE above 10% make growth in prosperity almost impossible, and Ireland’s high ECoEs are already having a swingeing impact on prosperity. Deducting 2017 ECoE (of 10.7%) from clean GDP of €193bn leaves aggregate prosperity at just €173bn. This number is barely (2%) higher than it was in 2007, but population numbers increased by 6.4% between those years.

This means that prosperity per person last year was €36,510, nowhere remotely near reported GDP per capita of €62,560. Irish prosperity actually peaked in 2005, at €38,780, and it is a sobering thought that debt per capita is 134% (€114,000) higher now (at €198,440 per person) than it was back then (€84,830).

The extremity of risk

What we have seen is that the Irish economy is an extreme, amplified version of adverse trends observable across most of the developed economies. For over a decade, high and rising energy costs have been driving prosperity downwards – indeed, Ireland is fortunate that the post-peak fall in prosperity has been just 5.9%, rather than the 10.8% decline experienced by Britain, or the 12.3% fall suffered by Italy. At the same time, debt has soared.

Quite aside from the “leprechaun” recalibration of GDP, this relentless weakening in prosperity has been masked from reported numbers by the infusion of huge amounts of credit-funded activity into the Irish economy. Since prosperity hit its peak in 2005, aggregate debt has expanded from €356bn to €938bn, and only in the last two years has there been evidence of meaningful efforts at deleveraging. How far these efforts can continue – with prosperity deteriorating at rates of between 0.6% and 0.8% annually – has to be conjectural.

It is only when prosperity (rather than increasingly meaningless GDP) is used as the denominator that the full magnitude of Ireland’s financial risk becomes apparent. Debt of €938bn might be ‘only’ 317% of GDP, but it is 544% of prosperity. More disturbingly still, banking exposure, as measured by financial assets, now stands at an estimated (and truly frightening) 2560% of prosperity.

With a per-capita share of debt of more than €198,000 – and with prosperity continuing to erode – the very last thing that Irish citizens need now is a “Brexit” process mishandled by British vacillation and European posturing.

 

 

#133: An American hypothesis

IS DONALD TRUMP THE FIRST ‘ECONOMIC REALIST’?

When the historians of the future get around to writing up our current era, one of the things likeliest to strike them will be the difference between what is actually happening and what most decision-makers think is happening. Historically, it is fascinating to speculate on how many of the worst decisions of governments have sprung from false interpretation and incorrect information.

From a contemporary perspective, what is evident now is an ever-widening chasm between conventional economic evaluation and the actual trend of events. Where conventional interpretation sees growing prosperity and contained financial risk, you don’t have to step very far outside the box to see a process of economic deterioration, elevated risk and, most seriously of all, a growing threat to the stability of currencies.

For regular readers, of course, this is familiar fare. We know that an economy hampered by a rising trend in the energy cost of energy (ECoE) is being subjected to an ultimately-futile process of denial based on credit and monetary adventurism.

Rather than revisiting this strategic theme, the aim here is to pose a theoretical question, and see where it leads.

Here is the question – what would a government do if it did recognise these realities, and came to understand that prosperity is already declining in the West, and may, before long, turn downwards in the emerging market (EM) economies, too?

It is beyond doubt that such a recognition would bring about drastic changes, both in assumptions and in policy. What follows is an examination of what those changes might be. It’s also safe to assume that these changes would be resented by those still wedded to the conventional, and that their mystification would lead rapidly to anger, suspicion and hostility.

It is suggested here that, if any government anywhere in the world is behaving in ways which are consistent with this pattern, it is the Trump administration. To what extent can Mr Trump be credited with – or, by some, accused of – acting on the basis of ‘new reality’?

What if understanding dawned somewhere?

If a government did discover the processes that are at work in the economy, the first conclusion that such a government would reach is that prosperity has become, at best, a zero-sum game. This would mean that, instead of the world becoming more prosperous in shared progression, the prosperity of one country can only be enhanced at the expense of others.

This, of course, is anathema to conventional economics, which pins its faith in David Ricardo’s “comparative advantage” theory. Essentially, Ricardo argues that we all get richer if we all concentrate on what we’re, so to speak’, ‘most best at’. From this, it follows that maximising trade between nations is to the benefit of all. This has long been an article of faith for economists.

What Ricardo did not have to consider, though, was the concept of a world with finite characteristics. It’s a reasonable hypothesis that constraints on the maximum availability of resources (such as land, water and, above all, energy) might render the law of comparative advantage inoperable. In short, once you postulate limits to potential prosperity, ‘all in it together’ quickly becomes ‘every man for himself’.

Trade, currencies and national advantage

If a government did arrive at the ‘zero-sum prosperity’ conclusion, it would concentrate on pursuing national advantage in trade. Governments already do this, of course, but they are in general influenced sufficiently by the Ricardian calculus to pursue national advantage in a mutual context. Whilst they want to skew trade agreements in their own favour, they do so from an assumption that there are mutual benefits to be accrued from such agreements.

The various trade deals pursued by the Obama administration illustrate this. Though these deals undoubtedly had a pro-American bias, they were nevertheless framed in an ‘internationalist’ way, based on assumptions of potential mutual benefit.

Our imaginary zero-sum prosperity government would differ radically, because its disbelief in mutual advantage would result in an instinctive preference, if not for outright protectionism, then at least for blatantly one-sided arrangements. The result would be a more aggressive stance on trade, characterised by an undisguised pursuit of national benefit, almost heedless of what the consequences for other countries might be.

This government would also want to leverage whatever benefits it might get from the relative strength of its currency. Under normal circumstances, a strong currency is bad for trade, making home-produced goods costlier than foreign alternatives. That matters a lot less, though, if you use tariffs to decide what you do and do not want to buy from overseas. For example, you might decide that a strong currency helps you purchase resources from abroad, but the strength of the currency needn’t suck in more manufactured goods because, if this starts to happen, you simply stick tariffs on them.

It need hardly be stated that the politics and the rhetoric accompanying this stance would be nationalist in tone. Moreover, this nationalist approach towards trade would be certain to show up, too, in other, non-trade aspects of foreign policy, including areas such as diplomacy and the management of alliances. Neither is it at all fanciful to assume that this nationalism would be replicated in domestic policies. Politicians often ‘wave the flag’ in pursuit of votes – the only difference about a government founded on a zero-sum prosperity assumption would be that the nationalism invoked would be the real thing.

The emphasis on nationalism described here need not, though, result in bellicosity. Indeed, it is likelier to take the form of isolationism or, at least, of a reluctance to expend “blood and treasure” in ways that do not benefit the country’s prosperity.

Thus far, we have envisaged a government determined to use trade to pursue national prosperity – and, implicitly, broader national advantage as well – on the basis of zero-sum world potential. As well as being implicitly inimical to free trade in goods and services, this argues for an equally restrictive attitude towards the movement of capital and labour.

For a start, the government we are envisaging would not want foreign investors acquiring domestic assets. At the same time, it would not want to see its businesses investing overseas rather than at home, something which they might well be inclined to do if costs elsewhere were lower, a differential that would be exaggerated by a strong currency.

Likewise, such a government would be inimical to the free movement of labour. If its preference was for businesses to invest at home – rather than moving their operations to lowest-cost locations – then it would be equally opposed to that cheap labour being imported through immigration. It would see large-scale immigration as the domestic face of a globalist calculus that it wished to disrupt.

Battle lines

What we are envisaging here is a government which – by interfering with the flow of trade, capital and labour – is challenging the most treasured objectives of the ‘globalists’.

In critical ways, some demarcations are being drawn here between our theoretical government and those who, either in principle or in pursuit of profit, work from diametrically opposite assumptions. A nationalist stance, reinforced by opposition to immigration, plays to a domestic audience often branded “populist” by its increasingly unpopulist opponents.

Essentially, then, any government operating on the premise of nationalism founded on a zero-sum prosperity calculus would face fervent opposition, both at home and abroad. Opponents would fall into two main categories – those who benefit from the globalist model, and those who are internationalist out of conviction. Those persuaded by internationalism out of conviction overlap extensively with those whose policies are self-defined as ‘liberal’.

What emerges from this is that the opponents of our theoretical government might be defined as ‘liberal globalists’. Since this essentially defines the long-established political and economic consensus of the Western world’s ruling elites, the government that we are envisaging would, of necessity, be ‘anti-establishment’, challenging both the vested interests and the conventional assumptions which favour globalism.

Donald Trump – theory into practice?

Just to recap, then, a government which became persuaded about zero-sum global prosperity could be expected to ditch huge swathes of what has been the economic consensus for more than three decades.

It would pursue policies of national advantage which would be hostile to free trade, and opposed to the free movement of capital and labour. It would abandon the substance (and, very probably, the rhetoric, too) of mutuality. It would face very stiff, often visceral opposition both from internationalist and from globalist persuasions.

So much for theory – what about practice?

The government which comes closest to our theoretical outline is the Trump administration. Mr Trump’s political platform can be described as ‘populist-nationalist’, and his opposition to globalisation is palpable. If Mr Trump has an identifiable enemy, that enemy resides, not in Beijing or in Moscow, but in Davos.

This interpretation has been influenced by a two-part essay by analyst Thierry Meyssan. His argument is that Mr Trump’s political stance, developed over the fifteen years before he entered the White House, is based on opposition to American ‘imperial’ behaviour and a renewed focus on domestic prosperity alone. As Mr Meyssan puts it, Mr Trump is “a politician who refuse[s] to engage his country in the service of transnational elites”.

It is certainly striking that, unlike his predecessors, Mr Trump shows no appetite for military interventions, in the Middle East or anywhere else. He certainly does not want America to be ‘the world’s policeman’, especially if what is being policed benefits globalist corporates a lot more than it benefits Americans

Ideologically, some of this puts Mr Trump in some positions which, at first sight, can look pretty bizarre. For example, it seems unlikely in the extreme that Lenin was ever one of the President’s favourite authors, but Thierry Meyssan is surely on to something when he cites this passage by the Soviet leader at the start of his second essay:

 

“Imperialism is capitalism which has arrived at a stage of its development where domination by monopolies and financial capital has been confirmed, where the export of capital has acquired major importance, where the sharing of the world between international trusts has begun, and where the sharing of all the territories of the globe between the greatest capitalist countries has been achieved”

 

Brought forward into the circumstances of today, references to monopolies, the dominant role of international capital and the free flow of capital between countries are indeed redolent of what Davos likes, and Mr Trump, instinctively and perhaps calculatedly, does not.

According to Mr Meyssan, the President’s election was based on a “promise to return to the earlier state of Capitalism, that of the ‘American dream’, by free market competition”. Thus interpreted, Mr Trump opposes the small number of “multinational companies [which] gave birth to a global ruling class which gathers every year to congratulate itself, as we watch, in Davos, Switzerland. These people do not serve the interests of the US population, and in fact are not necessarily United States citizens themselves, but use the means of the US Federal State to maximise their profits”.

Synthesis

Thus far, we have been examining two distinct issues.

The first is an interpretation of what a government might do, if it became persuaded that the scope for growth in global prosperity has been exhausted.

The second is Thierry Meyssan’s acute interpretation of Donald Trump as a nationalist opponent of globalisation and its attendant ideologies and policies.

What is surely very striking is how these two strands intersect. It’s doubtful if Mr Trump and his advisors are familiar with the energy-based interpretation of economics, certainly as discussed here, and modelled by SEEDS. But it’s by no means improbable that he has arrived at similar conclusions by different routes.

It certainly seems apparent that the consensus symbolised by Davos is vehemently opposed to Mr Trump’s apparent agenda. Moreover, if he has indeed picked a fight with “Davos man”, he could hardly have chosen a more formidable opponent. What we do know is that he has already thrown some big spokes into the wheel of a model which favours the global flow of goods, capital and labour on a basis geared towards the maximisation of the share of GDP which goes into corporate profits rather than labour.

If this interpretation is correct, we should anticipate efforts to break up some of the most powerful global corporations with large shares in their respective markets. Mr Trump might not have read Lenin, but he certainly seems to understand Adam Smith’s emphasis on the primary importance of competition, free, fair, and unfettered by excessive concentration. Once that is understood, trust-busting becomes logical.

Outcomes

Fascinating though the politics of all this undoubtedly are, the decisive issue is likely to be economic. Essentially, can nationalism deliver more for American voters than globalisation has achieved?

The reality is that, in pure economic terms, globalisation isn’t a hard act to follow. The essential premise of globalisation is that profits can be increased by locating production in the cheapest places, whilst continuing to sell goods and services in the (relatively) wealthy West.

There was always a huge contradiction at the heart of this philosophy – essentially, if well-paid jobs are shipped out of Western markets, how are Western wage-earners supposed to carry on with high levels of consumption? Thus far, the answer has been to make credit cheaper, and more readily accessible, than it has ever been before. This strategy has landed us with extraordinary levels of debt, unprecedentedly cheap money, and all of the risks associated with financial adventurism.

According to SEEDS, the United States has not bucked the trend towards lower prosperity in the West. Whilst not as badly affected as, say, Britain or Italy, SEEDS indicates that the average American is 7.7% ($3,380) poorer than he or she was back in 2005.

Though GDP data appears to contradict this calculation, two factors can be cited to support it. First, an overwhelming majority (93%) of all growth in American GDP in recent years has come from internally-consumed services (ICS) – such as finance, real estate and government – whilst the aggregate contribution to growth of hard-priced, globally marketable output (GMO), such as manufacturing, construction, agriculture and the extractive industries, has been zero. (The other 7% came from increased exports of services).

Second, growth in GDP has been far exceeded by an ongoing escalation in debt. Comparing 2017 with 2005, GDP has grown by $3.25tn, but debt has expanded by $14tn, a ratio of $4.30 of new debt for each $1 of reported growth. By definition – and, latterly, based on experience as well – pouring cheap credit into the system to sustain consumption in the face of deteriorating wages is not a sustainable way of running the economy.

In short, there is a compelling case to be made that Americans are significantly poorer now than they were twelve years ago – and, were this not the case, there has to be a strong possibility that Mr Trump would not have become President.

The first conclusion we can reach seems to be that, in linking prosperity with nationalism, Mr Trump has been pushing at an open door. We cannot know whether his policies can deliver more for Americans than globalisation, but it won’t be all that long before we find out. Obviously, nobody should underestimate the opposition that Mr Trump will go on encountering from those whose economic interests he threatens.

 

#132: The revenge of the spider

ECONOMIC RECKLESSNESS AND GFC II

If you’re a regular visitor to this site, you’ll know that we’ve covered a lot of themes, varying from the plight of individual economies to the madness of economic policy both before and – especially – since the 2008 global financial crisis (“GFC I”). You’ll probably know, too, that the expectation here is for “GFC II”, a far larger sequel to the events of 2008.

You might also know that the coming autumn sees the opening of a window in which this second crisis might take place (though, in their very nature, the timing of such events cannot be predicted). So the aim now, with autumn approaching, is to summarise how things stand.

Let’s start with the economy. Ever since the late 1990s there have been clear signs of deceleration in the pace at which underlying economic output has been growing. The interpretation put forward here is that this deceleration has been caused by an exponential uptrend in ECoE (the energy cost of energy). At least two other material headwinds can be identified – environmental stress, and mistaken economic policy – but a worsening in the energy equation has been the critical factor undercutting the potential for growth.

As modelled by SEEDS, these trends in energy have already put prosperity growth into reverse in the majority of Western economies, where prosperity per person generally peaked between 2000 and 2007. On this basis, the average Italian has become 12.3% poorer since 2001, the average American is 7.7% less prosperous now than he or she was back in 2005, and prosperity in the United Kingdom has fallen by 10.3% since 2003.

Where the West is concerned, the outlook is for more of the same. Mr Trump may or may not be able to “make America great again”, but neither he nor anybody else can ‘make Americans prosperous again’. Much the same, varying only in rapidity of deterioration, applies to virtually all developed economies.

In recent years, the Emerging Market economies (EMs) have become more prosperous, though sometimes at rates nowhere near claimed expansions in GDP per capita. According to SEEDS, this improvement in EM prosperity looks likely to continue, albeit at fading rates. In theory, this leaves global prosperity pretty flat, with progress in the EMs offsetting impoverishment in the West. In practice, though, EMs may not be able to carry on growing their prosperity at all in a world in which their Western trading partners are becoming poorer.

Unfortunately, policymakers have never understood the processes undermining prosperity. Worse still, any concept of coming to terms with deceleration is wholly unacceptable, not least because the financial system is predicated entirely on perpetual growth. Of course, you might think that basing anything on perpetual economic expansion in a finite world is pretty crazy – but whoever said that either politics or finance has to be limited by rationality?

A direct consequence of the collision between resource reality and a commitment to growth in perpetuity has been an attempt to ‘cheat’, using financial adventurism in an ultimately futile attempt to get around the ending of growth.

This has taken two main forms. The first, adopted in the years before GFC I, was “credit adventurism”, making credit cheaper, and easier to obtain, than ever before. Since GFC I, this has been compounded by “monetary adventurism”, which has involved pouring mind-boggling amounts of liquidity into the system.

To a certain extent, the latter was a consequence of the former. By 2008, “credit adventurism” had created debt of a magnitude that was impossible to service under “normal” monetary conditions. Barring “reset” – ruled out because of the short-term pain that it would have caused – the only way to cope with such gargantuan debts was to make them ultra-cheap both to service and to roll-over.

Just as there have been two forms of adventurism, there are two forms of crisis. “Credit adventurism” led naturally to a credit (debt) crisis, which was why banks were in the eye of the storm in 2008. “Monetary adventurism”, on the other hand, leads to a monetary crisis, which is why fiat currencies will be at risk in GFC II.

These forms of adventurism have succeeded in creating an illusion of growth, convincing enough so long as we wear blinkers where underlying fundamentals are concerned. World GDP increased by 35% in the seven years between 2000 and 2007, and by 31% in the decade between 2007 and 2017.

But the escalation in debt alone gives the lie to any claim that this “growth” has been genuine or sustainable. Between 2000 and 2007, growth of $25.5 trillion (at 2017 values) was accompanied by a $52tn increase in debt, meaning that just over $2 was borrowed for each $1 of “growth”. Since 2007, the ratio has worsened markedly, with “growth” of $29.8tn accompanied by $99tn in borrowing, a ratio of $3.30 of new debt for each growth dollar.

Escalating indebtedness has not been the only consequence of financial adventurism, of course. The crushing of returns on invested capital has created huge shortfalls against the amounts that we ought to have put aside for retirement, all but destroying the viability of pension provision for all but a wealthy minority. Monetary adventurism may not – yet, anyway – have created a spike in consumer inflation, but it has led directly to massive bubbles in asset prices.

Critically, the worsening ability of the economy to carry these excesses has been disguised by the phoney “growth” created by the simple spending of borrowed money. Everyone appreciates that an individual does not become more prosperous simply because he or she runs up an ever-bigger overdraft, and spends it. Unfortunately, observers – including policymakers – do seem to believe that economies can prosper by racking up ever bigger debts, and mortgaging the future, and then pushing the proceeds through consumption.

There are even those who believe that the inflated prices of stocks, bonds and property constitute “wealth”, even though the only people to whom such assets can be sold are the same people to whom they already belong.

If we strip away the simple spending of borrowed money, SEEDS calculates that claimed “growth” (of $55tn, or 76%) since 2000 falls to less than $21tn, with the remaining $34tn an illusion conjured out of adventurism. Meanwhile, the deterioration in trend ECoE, from 4.0% back in 2000 to almost 8% now, means that aggregate prosperity increased by just $16.4tn, or 24%, over the period as a whole.

Unfortunately, world population numbers expanded by 22% over the same period, so growth in average prosperity has been just 2.3%, over seventeen years. All and more of that increase has gone to the EMs, leaving the average Western citizen poorer.

What we are left with, then, is deteriorating Western prosperity, faltering underlying output in the world as a whole, unprecedented levels of debt, grotesquely inflated asset markets, and huge hostages to fortune, not least in the destruction of pension provision.

In simple mathematical terms, SEEDS estimates that “reset” in 2008 would have required ‘value destruction’ – a fall in the aggregate prices of assets – of the order of $84tn, equivalent to almost $100tn today. Of course, monetary adventurism was used to avoid reset in GFC I – carrying that value overhang forwards – and we’ve gone on adding to it, at steadily rising rates, ever since. SEEDS puts scope for value destruction today at over $400tn, which should be treated as a (very approximate) order of magnitude of the extent to which asset values have to fall.

This, of course, is ‘first order’ value destruction. If the prices of your shares, bonds and property fall, you still own them, and no money has actually flowed out of your bank account. The real problem is ‘second order’ value destruction, which is what happens when the value of your assets falls to a level lower than the sum you borrowed to acquire them.

Though the scale of the sums involved is almost impossible to calculate, we can conclude that the world will face vast ‘second order’ value destruction when GFC II happens.

We can be equally certain that, rather than accept the necessity of value destruction on a scale roughly four times larger than 2008, the authorities will resort again to adventurism, pouring liquidity into the economy at rates which dwarf anything experienced during and after GFC I. The strong likelihood has to be that adventurism on this scale will undermine the value of fiat currencies, destroying many whilst inflicting hyperinflation on those which survive.

The public, on the other hand, can hardly be expected to like getting ever poorer, especially whilst the distortion of the relationship between incomes and asset values seems to have made a minority wealthier whilst imposing austerity on everyone else. Whether, during GFC II, they will turn increasingly towards insurgent (“populist”) politicians, or opt instead for the collectivist offer of a Left made resurgent by popular adversity, is a second-order question. What we can anticipate, with high levels of confidence, is political and social change at least commensurate with the scale of economic and financial upheaval.

Those with long memories might remember a song for children called “there was an old lady who swallowed a fly”. After the fly, she swallowed a spider (“that wriggled and jiggled and tickled inside her”), the point being that she swallowed the spider in order to catch the fly. Thereafter, ever larger animals were ingested to catch the one swallowed previously – “she swallowed the bird to catch the spider”, and so on – finishing up with swallowing a horse (“she’s dead – of course”).

By this analogy, the system “swallowed a fly” in the years before 2008, then “swallowed a spider” during GFC I in an attempt to deal with it. In real life, swallowing a fly can happen to anyone, and swallowing a spider is at least feasible. Swallowing a bird, however, is not.

In this sense, GFC II is set to be the spider’s revenge.

#131: Not about “Brexit”

PROSPERITY AND RISK IN THE UNITED KINGDOM

What follows is an analysis of the British economy, from the perspectives of performance and risk.

It is not a discussion of “Brexit”.

Readers are, of course, welcome to discuss any pertinent issue, “Brexit” included. But a non-“Brexit” focus has to be stated clearly, because one of the most regrettable effects of the whole “Brexit” process has been to divert attention away from the economic fundamentals. Distractions don’t come much bigger than “Brexit”.

Perhaps the most striking characteristic of the British economic situation is the stark divergence between two different views. One of these is an official and consensus interpretation, founded on conventional economics, which portrays performance as no worse than lacklustre. There is, however, a raft of other indicators which paints a much less satisfactory picture.

Analysis undertaken using SEEDS – the Surplus Energy Economics Data System – indicates that prosperity peaked as long ago as 2003, and that the consequent strains are now becoming ever more apparent. Declining prosperity, of course, characterises most advanced Western economies. The United Kingdom stands out, though, for the rate at which prosperity is deteriorating, and for the elevated level of risk associated with this trend.

The great dichotomy

According to conventional metrics, the economy of the United Kingdom continues to grow, albeit at a less than sparkling pace. GDP is expected to increase by about 1.4% this year which, though hardly impressive, at least outpaces the 0.6% trend rate at which population numbers are expanding. People are, then, getting gradually better off, whilst unemployment remains low.

The problem with this interpretation is that it is hard – arguably, impossible – to square with a host of other indicators. First, wage growth is very subdued, barely keeping up with CPI inflation, and falling steadily further adrift of the cost of household essentials.

Second, productivity growth has fallen to virtually zero, having averaged just 0.2% since the 2008 global financial crisis (“GFC I”).

The labour market is characterised by increasing casualization and insecurity of employment, factors which contribute to depressed wage levels despite officially-low unemployment.

There is every reason to suppose that consumers’ ability to spend is in rapid retreat. Customer-facing businesses (including shops, restaurants and pubs) are going through a fire-storm of closures, failures and job losses. Consumer credit has climbed to potentially dangerous levels, with anecdotal evidence that this credit is being used, not for discretionary purchases, but simply to meet living expenses. There is also reason to suppose that big-ticket purchases are in decline. Surveys indicate that large and increasing numbers of households are struggling to make ends meet.

Government, too, seems strapped for cash, not really knowing how to provide necessary increases in funding for areas such as health, defence and care for the elderly. Local as well as central government looks resource-constrained.

Broader indicators of economic stress include homelessness, with young people, in particular, finding accommodation to be costly, often of poor quality, and hard to obtain. Seemingly-rapid rises in violent crime – including a dramatic surge in moped offences, of which there were 23,000 in London alone last year, compared with just 827 five years earlier – do not seem consistent with a prospering society.

In short, there is an abundance of evidence that, far from getting better off, the average British person is getting poorer. At first glance, this is impossible to square with any level of reported “growth” in economic output.

The SEEDS interpretation

An answer to this conundrum is supplied by SEEDS, which indicates that prosperity per person in the United Kingdom has been declining relentlessly since as long ago as 2003.

Over the period since then, reported GDP has risen by £386bn (23%), to £2.04 trillion last year from £1.65tn (at 2017 values) in 2003. Against this, however, aggregate debt increased by £2tn (62%).

This means that each £1 of reported growth has been accompanied by £5.20 in new borrowing. It also means that, against current growth expectations of about 1.4%, the UK typically borrows 5.7% of GDP each year.

The stark implication is that, like many other Western countries, Britain has been pouring cheap credit into the economy to shore up consumption. In short, most of the supposed “growth” of recent times has been nothing more substantial than the simple spending of borrowed money.

Stripped of this borrowing effect, SEEDS calculates that, within recorded growth of £386bn since 2003, only £77bn can be considered organic and sustainable. This puts ‘clean’ (borrowing-adjusted) GDP for 2017 at £1.59tn, barely ahead of the 2003 number of £1.53tn. On this basis, underlying growth has not kept up with increases in the population, so that ‘clean’ GDP per capita has decreased by 5.1% since 2003.

The compounding headwind has been a sharp rise in the energy cost of energy (ECoE). This, of course, is a worldwide problem, but has been particularly acute in the United Kingdom. Back in 2003, Britain’s ECoE (3.4%) was lower than the global average (4.5%). Today, though, ECoE is markedly higher in the UK (9.2%) than in the world as a whole (8.0%).

On a post-ECoE basis, prosperity per capita in Britain has fallen by 10.3% (£2,540), to £22,020 last year from a peak of £24,550 in 2003. Prosperity has declined in other Western countries over the same period, but Italy is the only major economy where the fall has been as rapid as in the UK.

SEEDS shows no sign of this downwards trend slackening, and projects that British prosperity will be a further 4.2% lower in 2022, at £21,090, than it was in 2017. In short, the average person is getting poorer at rates of between 0.5% and 1.0% each year.

Meanwhile, of course, his or her share of aggregate debt continues to increase.

Elevated risk

Deteriorating prosperity necessarily increases risk, because the ability to carry any given level of financial burden is a function of prosperity. Falling prosperity also impairs the ability to fund public services.

Trends in debt ratios reflect deteriorating prosperity. Aggregate debt at the end of 2017 (£5.25tn) equates to 258% of GDP but 361% of prosperity, the latter number having risen markedly since 2007 (283%).

More worryingly, the rise in debt exposure has been matched by sharp increases in proportionate financial assets, a measure of the size of the banking system. The most recent figure, for the end of 2016, puts Britain’s financial assets at 1124% of GDP, but this rises to 1547% when prosperity, rather than GDP, is used as the denominator. The SEEDS estimate of financial assets in relation to prosperity at the end of last year is 1577%, again sharply higher than the level on the eve of the financial crisis in 2007 (1285%).

Measuring debt and financial assets in relation to prosperity are two of the four risk yardsticks used by SEEDS. The UK looks high-risk on the debt measure, and extreme-risk in terms of the scale of its banking exposure.

On the third risk criterion, which is dependency on the continuing availability of credit, the British score is no worse than that of most comparable economies. The United Kingdom does, though, also depend on a continuing ability to borrow from abroad, to sell assets to overseas investors, and to attract inward flows of capital. This dependency looks risky, because the severe travails of customer-facing businesses, and the implied hardship of consumers, necessarily impair the attractiveness of Britain as a place in which to invest.

Finally, Britain has a high score on what SEEDS calls “acquiescence risk”. Put simply, the less prosperous people become, the less likely they are to back painful recovery plans should these be required in a future financial crisis. Worsening prosperity has already had a marked effect on political outcomes in America, France, Italy and elsewhere, and the same factor is likely to have tilted the balance decisively in the referendum on “Brexit”. Should it become necessary for Britain to repeat the 2008 rescue of the banks, popular acquiescence in such a measure should be no means be taken for granted.

 

SEEDS 2.15 United Kingdom 21072018