#82. Backlash, part 1

IS THIS THE TWILIGHT OF THE “LIBERAL ELITES”?

Following “Brexit” (the British referendum decision to leave the European Union), the election of Donald Trump as President of the United States is another severe blow to the self-styled “liberal elites” that have governed the West since the early 1980s.

In both instances, voters defied the wishes of the vast majority of the political, corporate and financial elite, and made decisions that “experts”, and much of the mainstream media, regarded as dangerously misguided.

These outcomes can be baffling, until one point is noted – each establishment endorsement of Hillary Clinton delivered more votes for Mr Trump, just as each political, corporate or “expert” speech supporting “remain” won more votes for “leave”.

What is happening is a revolution, in the sense that society is engaged in the rolling repudiation of established elites. The significance of this is obvious, even though interpretation is made more difficult by an establishment mind-set of denial that is reflected, too, in much of the mainstream media.

Understanding the popular rejection of the elites is complicated, and this article has been through far more “rough drafts” than most. The best course of action is to set out a central point of view, and then discuss the reasoning behind that view. The focus here is on political change – part 2 will explore the economic implications.

The tide of events

We need to start by being clear that “Brexit”, and the election of Mr Trump, are not freak events, and that they were completely predictable. To those of us who have expected a popular backlash against the elite, the only real surprise is how long it has taken.

Just as these choices are not aberrational, neither are they reversible. Much of the British establishment hopes that someone – Parliament, the courts, the Scots, but even Batman and Robin would do – can either stop “Brexit” altogether, or water it down into meaninglessness. If this did happen, public anger would be likely to explode. Likewise, many in the United States hope that office will moderate Mr Trump. But, if the new president does not do most of what he has said he will do, voters will elect somebody else who will.

With hindsight, the 2008 global financial crisis (GFC) was the high-water-mark of the “liberal elites”. Incumbent governments succeeded in preventing the collapse of the banking system, but, in the process, surrendered so much of their political capital – in other words, their credibility with the public – that their demise became inevitable.

Historical inevitability?

Are the “liberal elites” due for repudiation by the public? History suggests that three conditions are required for “regime change” of this nature.

First, an incumbent regime has to be seen as self-serving and exploitative.

Second, it needs to be regarded as arrogant, complacent and out of touch with the general population.

Third, it needs to be seen as having failed.

The public will tolerate self-enrichment, arrogance and incompetence, or even two of these in combination – but will not tolerate all three.

As a rider to this, regimes due for the chop are usually the last to know, and react to a popular challenge by retreating into denial. In deriding the population as misguided dupes, blaming “populist” agitators, and dismissing defeats as just “a little local difficulty”, today’s establishments are doing nothing that wasn’t done by Communist apparatchiks in 1989, Tsar Nicholas II in 1917 or the court of King Louis XVI in 1789. For this reason, we need to ignore the protestations of the elites, and disregard much of what is said in the mainstream media.

Two valid indictments

On two of the three “criteria of unfitness” listed above, incumbent regimes have already been convicted in the court of public opinion. The case against the elites on these issues does seem so self-evident as to need little comment.

Where being “self-serving” is concerned, the evidence is surely overwhelming. In terms both of income and of wealth, the gap between the rich and everyone else has widened dramatically. There is scant evidence that this is linked to merit, because “the system” has played far too big a role in the enrichment of a minority for this defence to be valid.

Big corporations are perceived by the public to have become too powerful, in that they stifle competition, interpret the tax regulations to suit themselves, treat both customers and employees with disdain, and exert undue influence over the political process.

The “revolving doors” between government and business have not been blocked, and the public is entitled to be more than suspicious of the generous remuneration of former politicians and administrators through consultancies and the “lecture circuit”. It defies popular credibility that the burblings of politicians in their dotage, or even their consultancy services, are remotely worth the huge sums paid to many of them. This being so, the suspicion is fostered that the enrichment of retired government figures is linked to influence. This inference may be unfair, of course – but appearances are often decisive.

The second pre-condition for repudiation, too – which is that the elite has become arrogant – also seems beyond dispute. This has been evident, first, in their imposition of their own values on the public through increasingly coercive enforcement of what is known as “political correctness”. Governments are entitled to take a moral lead on issues, but go too far when they start denying the right of free expression to those who disagree.

Second, there have been all too many instances of what looks like systemic unfairness. Bankers are rescued, but steelworkers, shop employees and pension savers are not. The vigour with which benefits cheats are pursued contrasts with very few prosecutions of wealthy tax-evaders. Behaviour treated as “fraud” when engaged in by individuals or small businesses seems to become “miss-selling” when practised by big companies. When corporations break the rules, it is always the shareholders, and seldom, if ever, the responsible executives, who are held to blame.

Policy has favoured the wealthy, both in inflating asset values and in failing to tax “unearned” capital gains more demandingly. Little is seen to be done to close tax loopholes from which only the wealthy benefit, whilst governments seem loathe to tackle “offshore financial centres” which are widely regarded as tax-havens. The latter would, in fact, be pretty easy to implement.

On the charges of being self-serving and arrogant, then, the case seems to be unarguable. What about the third, decisive charge – that of failure?

An exercise in failure?

Regimes which are both self-serving and arrogant can remain in power if they deliver economic success – the public may be prepared to accept a great deal of downside if this is seen as the price of growing prosperity. The public mood today, however, seems unconvinced by the elites’ claim that they are good at managing the economy to the collective benefit.

There are really two dimensions to this issue. First, has the validity of the economic principles and policies of the elites been proven by experience? Second, have ends justified means? In the current instance, this question re-frames as “has improvement in the general economic conditions vindicated the management of the incumbent regime?” The distinction here is that the public may be prepared to tolerate current hardship if they believe that this will result in longer-term improvement (an obvious example being public support for austerity during war). What they will not tolerate is unfairness that does not also serve the general well-being.

And this, essentially, brings us to one core issue – “globalisation”.

Globalisation – vision, or scam?

If “globalisation” simply meant spreading the benefits of development to emerging market economies (EMEs), few would have much reason to complain. The popular criticism of “globalisation” as it has been practised is that, far from seeking global development, it has been nothing more than a grubby exercise in profiteering through the reduction of wages.

Globalisation, its critics say, depresses wages at home, both by exporting well-paid jobs and by allowing immigrants to compete for less-skilled work. This accusation might not have been true had the aim of globalisation been to spread the benefits of development by boosting both production and consumption in the EMEs.

In fact, this was never the objective – the aim of globalisation, as it has been practised, was simply to reduce the cost of production, widening margins on goods and services still sold to Western consumers.

This has had two detrimental effects on the global economy. First, it has failed to grow demand in the EMEs, something which is necessary for balanced development. Second, it has driven debt levels sharply higher, initially in the West, but latterly in the rest of the world as well.

The linkage between globalisation and the escalation of debt is quite simple – with wages under downwards pressure, consumption could only be sustained by encouraging Western consumers to borrow the difference. A cynic would argue that this is why, over a period of decades, banking regulation has been relaxed, whilst credit has become ever cheaper.

On the facts

It would be hard to deny that the combined effect of regulatory and monetary policy has been to supply the debt needed to sustain consumption in the face of stagnant or declining wages.

This process of using borrowing to support consumption is evident in the data. Between 2000 and 2007, global debt (excluding the inter-bank or “financial” sector) rose by $38 trillion, or $2.20 for each $1 of nominal growth in GDP. Between 2007 and 2014, debt increased even more rapidly, growing by $49 trillion, or $2.90 for each growth dollar.

Even the “growth” denominator is suspect, of course, amounting to nothing more than the spending of borrowed money.

Closer analysis shows that the escalation in debt has taken place in distinct stages. Between 2001 and 2008, the brunt of new borrowing was borne by Western households, whose indebtedness increased from $16 trillion to $34 trillion. These households’ ability to borrow was maxed-out by 2008, despite the use of ever-riskier lending techniques (such as sub-prime, and the on-sale of packaged securities), which involved separating risk from return in ways that previous regulatory norms would not have facilitated.

Since 2008, the further increase in global debt has come from Western governments, and from the EMEs. The retreat from the borrowing-based “boom” of 2001-08 impaired tax revenues whilst increasing welfare demands. This, and the need to rescue an over-extended banking sector, forced Western governments to increase their debt from $26 trillion in 2007 to $46 trillion in 2014. Meanwhile, EME borrowing has surged, with China alone seeing its debt total rise from $7 trillion in 2007 (and just $2 trillion in 2000) to well over $30 trillion today.

Because, by 2008, servicing this global debt mountain – let alone ever repaying it – had become all but impossible, the authorities responded with ultra-low interest rates, pursuing ZIRP (zero interest rate policies), flirting with NIRP (negative rates), and even contemplating outlandish ideas such as “helicopter money” and the banning of cash.

All along, ordinary people have suffered, with wages falling behind even official inflation, let alone the cost of essentials. Though net household borrowing in the West effectively ceased in 2007, debt levels still remain far higher than in 2001. Some of the adverse side-effects of ultra-low rates are now becoming apparent, most conspicuously in the emergence of dangerous deficits in pension provision. The wealthy alone have prospered, most conspicuously from the inflation of asset values, and from generous tax treatment of capital gains created by monetary policy. Young people have particular reasons for feeling aggrieved at a system that has increased costs (such as housing) whilst exporting well-paid jobs.

Justified responses?

If it is obvious – to everyone except the elites themselves, of course – that what is happening is a global repudiation, not a series of isolated events, it is equally obvious that solid logic informs the popular backlash. Self-serving, arrogance and a failure to promote the general good are valid accusations against the “liberal elites”.

For those elites, denial is as pointless as it is predictable. What is needed now is thorough-going, self-denying reform, whilst the scope for implementing reform still exists.

This does not, of course, mean that the “populist” agenda is the right one. In particular, protectionism is the wrong answer to the right question. A switch from monetary to fiscal stimulus does make sense, but isn’t as easy as it may sound, whilst the likelihood of higher taxes on the wealthy is, in itself, nothing more than the swinging-back of a political pendulum that had gone a very long way in the opposite direction.

In part 2, we’ll look at how the populist revolution could improve the economy – but only if its leaders and supporters are clear about what works……..and what doesn’t.

 

 

 

#81. Constitutional crisis?

WHY THE BRITISH ESTABLISHMENT MUST ACCEPT “BREXIT”

Only in a perfect world would the interests of governing and governed be perfectly aligned. What is happening in Britain today, though, threatens to widen this difference into a dangerous estrangement. Latest twists over “Brexit” call for the establishment to submit to the popular will, and to do so with good grace.

On 3rd December, the High Court ruled that the government could not trigger Article 50 (the formal preliminary for the “Brexit” process) by royal prerogative, but must put the matter to a vote in Parliament, a ruling which will stand unless overturned on appeal to the Supreme Court.

This decision prompted a backlash, not just among pro-“Brexit” politicians but in much of the national press as well. The Daily Mail pictured the three High Court judges above the headline “Enemies of the People”, whilst the Daily Express lamented “the day that democracy died”. The Daily Telegraph warned of a “constitutional crisis”.

This raises three profound questions. First, have the judges made a political intervention, with the courts blocking the wishes of the voters? Second, are anti-“Brexit” interests in the establishment plotting to subvert those wishes? Third, what happens now?

Due process

The vilification of the judges is unfair. Their ruling is not political, but concerns a point of law – can a major constitutional change (and “Brexit” is surely that) be made by the executive alone, or must Parliament be consulted?

This decision is surely correct. With an unelected upper chamber, and a voting system skewed towards established parties, British democracy is weak enough as it is, without handing more powers to the executive. Had the court ruled for the government, what further constitutional changes might be imposed on the country without Parliamentary scrutiny?

If it is right that Parliament should be consulted, it is surely right, too, that it should pass a single, “one-line” Act empowering premier Theresa May to trigger Article 50. The public, consulted directly on a major issue for the first time in four decades, has decided. Those MPs and Peers – a substantial majority – who disagree with the voters’ decision should abstain, not try to tack weakening or qualifying amendments on to the legislation.

It is imperative that this is done – and done quickly. Anything else will spell trouble, reinforcing the fear that “the establishment” is trying to subvert the will of the people.

Justified mistrust

This suspicion of trickery flourishes because the British establishment has a truly shocking record of pursuing its own interests at the expense of the public.

Trust in elected politicians, already very low, was driven to new depths by the expenses scandal. Phone-hacking tarnished the reputation of the press, and did nothing for trust in the police. The House of Lords has scant respect because it is nominated by ministers, not elected, as upper chambers are in most democratic countries. The permanent administration is seen as unaccountable, few if any senior heads having rolled even after scandals like Stafford and Rotherham. Controversial rulings (including the grant of “super-injunctions” to the wealthy) have undermined faith in the courts.

Successive administrations have done nothing to counter a feeling that government has been “captured” by two powerful interest groups – big business, and a “liberal elite” whose aims have been labelled “political correctness”. When the state bails out bankers, but not steelworkers or employees of failed retailer BHS – and when the rigorous pursuit of benefits cheats contrasts with few prosecutions of wealthy tax-evaders – the public is entitled to smell a rat.

Estrangement – the price of failed economics

Though successive administrations’ policies on energy, foreign affairs and defence have been shockingly misguided, the real failure of governments has been the economy.

Since 2000, a £0.8 trillion rise in nominal GDP has come at the expense of £2.3 trillion in additional debt. The current account – Britain’s financial relationship with the rest of the world – has plunged into a shocking deficit, reflecting the outflow of profits and interest on past asset sales and borrowing as Britain has sold assets, and borrowed from abroad, to finance consumption. Over the same period, the cost of household essentials has risen by far more (75%) than average wages (51%).

In short, an “anything goes” philosophy of neoliberalism has benefited the wealthy and the powerful to an extent that looks intentional, not accidental.

In this context, the public are right to harbour deep suspicions of the establishment. That establishment now faces its greatest test and one which, if mishandled, will have grave consequences.

What must happen now

Mrs May needs to put forward simple Article 50 enabling legislation on her stated basis that “Brexit means Brexit”. MPs need to pass it without adding amendments. Peers need to deliver a simple assent.

Britain does not yet – quite – face a constitutional crisis, but anything less than the straightforward implementation of the voters’ choice of “Brexit” could rapidly create one.

Regimes isolated from the general population are a recurring historical phenomenon, frequent enough for us to know what happens to powerful elites which seek to preserve their wealth, privileges and prejudices in the face of a rising tide of public anger.

There is a time to retreat with good grace. For the British establishment, that time has arrived.

 

#80. Grossly Distorted Prosperity

ECONOMIC DECELERATION – AND HOW TO MEASURE IT

One of the quirks of economics is that, within GDP (gross domestic product), all output is included, irrespective of what it really adds to prosperity. GDP, like Oscar Wilde’s cynic, knows “the price of everything, but the value of nothing”. If government paid 100,000 people to dig holes, and another 100,000 to fill them in, the cost of this activity would be included in GDP.

Is there a better way of measuring prosperity? Well, consider two people who both earn $30,000. Theoretically, their circumstances match. However, if the first has to spend $20,000 on household essentials, leaving him $10,000 to spend as he chooses – whilst the second spends only $5,000 on essentials, leaving him $25,000 for “discretionary” spending – then clearly the second is much more prosperous.

This is analogous to what has been happening to the economy. The long-run trend towards higher energy costs is feeding through into essentials such as food, water, chemicals, minerals, plastics, construction and virtually every other essential purchase. This is undermining the scope for discretionary spending, leaving the economy poorer even if the headline statistics do not seem to bear this out.

On the ground data bears this out. In the United Kingdom, for example, average wages increased by 25% between 2005 and 2015, but the cost of essentials rose by 48%. This process is happening around the world.

For the economy as a whole, it can be illustrated like this:

Fig. 1: “Growth”? – the impact of higher energy costs80-1

GDP is higher in the second picture, but far more is spent on energy and essentials, leaving a smaller surplus available for everything else. This surplus – and not the recorded total of GDP – determines prosperity.

Where this leaves the economy is with two pictures that do not match – raw growth numbers imply a prosperity that people seem not to experience. As a result, we – whether as individuals or as governments – have been using borrowing to supplement a diminished capability for discretionary expenditures.

This in turn accounts for the escalation in debt. Between 2000 and 2007, world debt (1) escalated from $87 trillion to $142 trillion, triggering the global financial crisis. Slashing interest rates to all-but-zero has enabled us to co-exist with this debt, but the amount outstanding has continued to soar, now exceeding $200 trillion – whilst near-zero rates have been very far from cost-free.

How does the cost of essentials, and the resulting impact on prosperity measured as capability for discretionary spending, help us to explain this?

The energy economy

As most readers will know, the interpretation which guides all of my work is that the “real” economy of goods and services is an energy equation and not, as is so generally supposed, a monetary one.

Everything that we buy or sell, produce or consume is a product of energy. Far back in history, this energy came entirely from human or animal labour. This changed fundamentally with the Industrial Revolution, when we began supplementing this labour with inputs such as coal, oil and gas. This process triggered a dramatic escalation in economic output which has totally transformed our society over more than two centuries.

The modern economy is entirely a function of energy. As well as obvious uses such as transport fuels and plastics, energy is critical in access to minerals – without energy inputs, we could not possibly extract 1 tonne of copper from 500 tonnes of rock (and doing this using manual labour would make copper impossibly costly).

That the earth now supports 7 billion people, compared with just 0.8 billion back in 1800, is entirely due to the use of energy in agriculture, both as indirect inputs as well as directly in planting, harvesting, transport, processing and distribution. Water, too, could be not accessed without energy inputs.

If you doubt any of this, imagine how farming and the food chain would operate without energy inputs. Planting and harvesting would rely on large numbers of labourers and animals, all of whom would have to be fed. Inputs like phosphates would not be available without the energy needed to extract and transport them. Processing and transporting crops would be incredibly costly and difficult, as would storage without refrigeration. In short, without energy inputs, food supply as we know it today would collapse.

Taking this a stage further, it is obvious that the cost of food must reflect the cost of energy at each stage of the process.

Correlation between energy costs (here represented by crude oil) and other essentials is illustrated in the next chart, which shows how the prices of wheat, rice, vegetable oils and copper have all tracked oil prices in recent years. This is far from surprising, since energy is the key input in the supply of these resources. They have tracked not just the increase in oil prices but also the post-2014 decline – but remain about twice as costly as they were in 2000, which compares with broad inflation of about 38%, globally, over the same period (2).

Fig. 2: Commodity prices – the energy connection (3)80-2

Ultimately, the physical economy can be defined like this – it is a process of applying power inputs (rather than human labour) to raw materials which are themselves accessed using energy.

Our homes, roads, schools, factories, railways, ships and hospitals could not possibly have been built by manual labour alone, or by relying on materials accessed without energy inputs.

A key point will have occurred to you from the foregoing, which is this – an increase in GDP can correspond to a decrease in prosperity, if the proportion of GDP which has to be spent on energy (and energy-linked essentials) grows.

We know that energy has a cost, which in fact is an opportunity cost – money spent on oil platforms, refineries, pipelines and solar panels is money that we cannot spend instead on hospitals and schools. The more expensive energy is, the less we have to spend on everything else.

The cost equation

Energy is never free. The human capacity for physical work derives from energy gained from food, and obtaining food requires the use of energy. Likewise, accessing the energy contained in oil, gas, coal or renewables requires the expenditure of energy. Oil platforms, refineries, pipelines, wind turbines and solar panels cannot be built without spending energy. Extracting iron from ore requires energy, as does converting it into steel – and, on top of this, there is the energy expended in building the steel works itself in the first place. This applies to all components used in the energy access process.

So the equation which determines prosperity is the relationship between, on the one hand, the amount of energy accessed and, on the other, the proportion of this energy consumed in the access process.

This equation can be expressed in two ways. EROEI – the Energy Return On Energy Invested – expresses the gross amount as a multiple of the cost. My preferred measure is ECoE – the Energy Cost of Energy – which expresses the cost as a fraction of the gross amount of energy accessed.

These equations change over time, through the interplay of two factors. The first of these, which pushes costs (ECoEs) up, is depletion. Naturally, we have exploited the lowest-cost energy sources first – just as you would always choose to develop a large oil field before a neighbouring small one, you would not extract costly oil from deep water fields, from shales or from bitumen if you could instead tap giant, simple reservoirs of high quality crude. As the most economical sources of energy deplete, we turn to successively costlier resources which push overall costs upwards.

The second determinant, offsetting the depletion effect, is technology, where the advance of knowledge enables us to access energy more efficiently, and thus at lower cost, than in the past.

The critical point about technology is that its limits are set by the physical characteristics of the resource. For example, the advance of technology has made shale oil far cheaper to produce than shale oil was ten years ago. What is has not done – and cannot do – is to transform shale resources into the equivalent of a giant conventional oil field like Al Ghawar in the sands of Saudi Arabia.

Likewise, renewables are cheaper to produce now than the same renewables were ten or even five years ago. This has, in many instances, made renewables cost-competitive with oil, gas and coal. But this is a two-part process – the competitiveness of renewables has benefitted both from cost-lowering technology and from rises in the cost of fossil fuels. Renewables can compete with oil or gas developed today – but they could not compete with giant oil fields like Al Ghawar.

Thus seen, the driver of costs is depletion (determining the physical envelope of energy access), with technology acting as a mitigating factor (improving efficiency within that envelope).

Cost trends

It will be obvious from the above that we are studying comparatively gradual processes. Depletion is something that happens over time. Technology can advance more quickly than this, but the pace at which technology is applied is dictated both by capital investment and by the depreciation of earlier plant.

Because the cost change process is gradual, it should be equally obvious that longer-term trends are critical. The immediate cost of energy to end-users can oscillate very rapidly through market forces, but these are oscillations around a longer term trend.

Fig. 3 illustrates my analyses of where the ECoE costs of various energy sources now are. Obviously, these are broad-brush estimates, but should suffice for at least a general interpretation.

The process of depletion has driven the ECoE of oil sharply higher. If we could go back to the 1950s and 1960s, we would see that oil production costs were extraordinarily low, which helps account for the very rapid annual consumption growth rates (as high as 8%) experienced at that time. But there has been a profound rise in oil costs in recent years. Coal costs, too, have been rising sharply, not least because the energy content per tonne has been falling markedly as the highest-quality resources are depleted. Gas costs, too, have been rising, though it remains markedly cheaper than oil or coal.

Fig. 3: Estimated ECoEs by fuel80-3

The good news, of course, is that the ECoE of renewables has fallen sharply, making them cost-competitive with oil and coal, and no longer markedly more expensive than gas. The factors involved in reducing the ECoEs of renewables are technology and economies of scale. As little as ten years ago, renewables were a lot costlier to produce than oil, but this is no longer the case.

A cautionary note is needed here, however. In 2015, renewables accounted for just 2.9% of primary energy consumption. As a still-small industry, renewables can be assumed to have cherry-picked the best sites first, just as oilmen developed the cheapest oil fields first. Rates of growth which are easily achieved from a low base become progressively harder to sustain as the base enlarges. Renewables can be expected to go on increasing their penetration of electricity supply very markedly, though the nature of solar and renewables suggests that some fossil- or nuclear-powered capacity will still be required.

Other applications will be harder to crack, particularly where the sheer density of oil (measured as energy per unit of weight) remains critical. The gigantic petroleum-powered machines that hack minerals out of rock at concentrations of less than 0.5% might be hard to replace with electric alternatives, and an electric-powered aircraft of anything approaching the size of a 747 remains a pipe-dream.

The overall picture

What we have, then, is a changing mix in which the overall ECoE is rising because of the uptrend in costs in the still-dominant fossil fuels sector. The next chart, comparing the annual cost of energy with the long-term trend, reflects this.

Fig. 4: Trend and current energy costs80-4

The current cost of energy to end-users oscillates dramatically over comparatively short periods and, historically, oil has been the pivotal component. In the 1970s, OPEC drove oil prices sharply higher, where they stayed for a decade until weak demand, and a surge in non-OPEC supply, broke the cartel’s grip. From 2000, oil prices began to move up sharply, largely due to demand growth in China and other emerging market economies (EMEs). High prices invited massive investment in new supply, which has now pushed prices sharply downwards. This is an essentially cyclical process, and the slump in investment since 2014 suggests that supply shortages will in due course push prices back upwards.

These price movements occur on timescales far shorter than the cost trends dictated by the interplay of depletion and technology. Depletion has for decades been driving the trend costs of fossil fuels upwards, in a way that can only be mitigated, not reversed, by technology. Technology is making renewables cheaper, but these account for just 2.9% of current global consumption. So the underlying trend cost of energy is rising relentlessly.

Counting the cost

Where, though, does this show up in our measurement of the economy? If energy costs more, we have less to spend on other things – but money spent on obtaining energy still forms part of GDP. After all, energy expenditures show up in activity measures, and money spent by an energy company provides business for suppliers and wages for those working in the energy and related industries.

So the bottom line is that rising energy costs do not necessarily impair GDP, but do undermine prosperity, by reducing how much we have to spend on everything else. Rising energy costs will eventually impact GDP as we record it, because they will reduce our capacity for investing in other things. This makes GDP a trailing indicator of the economic impact of higher trend energy costs.

If we want to anticipate this, and measure the current impact, there are two routes open to us. Both are based on the recognition that prosperity is a function, not of income in the absolute, but of discretionary spending capacity (the income that remains after the cost of essentials, really meaning the cost of energy, has been deducted).

The first way of measuring the current impact of trend energy costs is a bottom-up measure of prosperity which factors in the cost of essentials at the individual level. The second, far more practical approach is to deduct the trend (not the current) cost of energy from reported GDP. Since the cost of all essentials – such as food, water, minerals, plastics and transport – is dictated by energy costs, deduction of the trend energy cost essentially identifies discretionary GDP.

The global situation and outlook is set out in fig. 5. As trend ECoEs have risen, a widening gap has emerged between the financial and the real economies. This shows up within individual experience as an increase in the proportion of incomes absorbed by essentials. For the economy as a whole, the proportion of GDP that has to be spent on energy and its derivatives – including food, water and basic materials – has been rising, crowding out scope for discretionary expenditures even where total GDP is supposedly increasing.

To picture what this means in practice, imagine a government health system whose share of GDP is constant, so that cash resources increase in line with GDP. This ought to make it possible for health provision to be enhanced – but the opposite happens, because the cost of essentials absorbs a growing proportion of its budget.

In due course, this “crowding out” will impact investment in discretionary areas, meaning that headline GDP itself will start to fall. But prosperity – as it is experienced both individually and in the aggregate – will fall before the deterioration in the underlying situation is reflected in GDP.

Fig. 5: World financial and real economies80-5

Finally – and whilst not wishing to intrude on private grief – fig. 6 shows what is happening to the real economy of the United Kingdom, and links it to trends in ECoE.

From 1980 to about 2005, the UK enjoyed a lower ECoE than the global average, mainly because Britain was a major net exporter of oil and gas. But energy production has fallen sharply, from 249 mmtoe (million tonnes of oil-equivalent) in 2002 to 108 mmtoe last year, and the UK now has to import almost half of its energy requirements, despite a decrease in demand.

This is a mathematical calculation delivered by SEEDS, and is reflected in a precipitate decline in real economic output. But what does this mean in practice – and can we see it in action?

What it ought to mean, first, is that the comparative (through-cycle) cost of energy in the UK is rising – which it is because, since 2005, the cost of energy to British consumers has risen by far more (90%) than general inflation (27%). It ought to mean that the cost of essentials is absorbing a growing proportion of incomes – which, again, is the case, the cost of essentials having grown by far more (48%) than average wages (25%). It ought to mean that government budgets buy less services, even where those budgets have at least kept pace with inflation – as is palpably the case with health care. It ought to undermine ability to provide for the future, something which is reflected in huge pension fund deficits.

That these trends are set to continue seems equally evident. Energy costs in Britain are rising, as reflected in the ultra-high contract price for electricity from the new Hinkley C nuclear plant. The cost of essentials will continue to rise (which the slump in the value of Sterling ensures). This will continue to make people feel poorer, as the cost of essentials continues to out-pace incomes. And it will further stretch public services (such as health), even where budgets rise at least in line with inflation.

I rather doubt whether planners and policymakers, in Britain or elsewhere, understand this dynamic. If they don’t, they must be baffled by the phenomenon of more money buying less.

Fig. 6: UK economy and comparative ECoE80-6

The concluding point, generally applicable, is that the rising trend cost of energy – and hence of energy-derivatives such as food and minerals – is squeezing discretionary spending capability even before it exerts major downwards pressure on gross output. The latter is beginning to happen as well, though, through a squeeze on discretionary investment capacity.

What this all means is that we should take headline GDP figures with the proverbial pinch of salt. What really matters is prosperity, meaning scope for discretionary spending after the cost of essentials (really meaning energy) has been deducted from incomes.

By this critical measure, we are at the end of growth – and no amount of borrowing, or of mortgaging the future, can change this, or even long disguise it.

 

Notes:

  1. Includes financial sector. Debt excluding the financial sector was $67 trillion in 2000 and $105 trillion in 2007, and is about $155 trillion now.
  2. Source: SEEDS database
  3. Source of data: IMF

 

#79. “Don’t you know there’s an excuse on?”

BRITAIN, BREXIT AND THE FAILURE OF NEOLIBERALISM

The Second World War was a time of enormous hardship for the British public. But there were some people for whom it was manna from heaven, and I’m not talking about black-marketeers. Poor service in a restaurant? “Don’t you know there’s a war on?” Shoddy workmanship? “Don’t you know there’s a…….” There seemed to be hardly anything that couldn’t be blamed on the war.

“Brexit” – the ugly label for the voters’ decision to leave the European Union (EU) – is being used similarly, as a stock excuse for any and all weaknesses in the British economy.

Behind the Brexit bluster, what is really happening in Britain is the culminating failure of a faulty economic model. The theory of “neoliberal” economics has been openness to foreign investment even in strategic areas, the adoption of mantras of deregulation and privatisation, and a willingness to surrender decision-making to the market. The practical outcome has been sluggish growth, an escalation in debt, widening inequality and a dangerous dependency on foreign creditors. If Brexit tells us anything, it is that critical scrutiny of the British economy has revealed some dangerous weaknesses.

When British voters defied the establishment by voting to leave the EU, then they were doing more than simply rejecting supposed European incursions on their sovereignty – they were rejecting an economic system whose failures have been manifested in the British economy.

Brexit caveats

Though regrettable, the use of Brexit as a catch-all excuse is understandable. Brexit, after all, is the first decision in decades to be taken directly by the public, rather than on their behalf by politicians. No-one grounded in reality would expect politicians to miss such a golden opportunity for wholesale blame-shifting.

This being so, we should be wary about “the Brexit excuse”. We should remember that America, Japan, China and others trade perfectly satisfactorily with the EU without being members of it. We should also note that many of Britain’s glaring economic weaknesses long pre-date the EU referendum.

Of course, there has been at least one direct result of Brexit – a sharp fall in the value of Sterling. Even here, though, politics has influenced markets. Overwhelmingly, government, big business, finance and the mainstream media urged a “remain” vote, so the voters’ “leave” decision was a ringing rejection of an arrogant establishment. It also, of course, created immediate uncertainty, with the departure of premier David Cameron and chancellor George Osborne.

Consequently, markets have had to recalibrate political risk, recognising that the British are not, after all, grumbling-but-resigned followers of their leaders’ diktats. Despite an electoral system (known as “first past the post” or FPTP) designed to entrench the incumbency, the public proved themselves far from supine when given a first-in-a-generation directly proportional consultation.

From a global standpoint, you might think that Britain doesn’t matter all that much in the grand scheme of things. But we do need to note two significant points. First, Britain remains important enough – particularly in finance – for her travails to influence global developments.

The demise of a paradigm

Second, the UK, even more than the United States, has been the poster-child for neoliberal economics – not for nothing is this called “the Anglo American model” – so Brexit may accelerate the demise of an increasingly discredited orthodoxy.

For three decades and more, the UK has championed an extreme variant of “laissez faire”. Britain has welcomed overseas investment even where that has meant strategic industries, protected in most other countries, falling into foreign hands. The UK has supported the deregulation of finance, championing the now-derided “light touch” regulatory system which helped lay the foundations for the 2008 banking crisis. Privatisation, though it began with industry, has now penetrated deep into public services, and few restraints have been exercised over immigration. To a significant extent, British failure constitutes the failure of an economic philosophy as well.

Mind the gap

The critical metric for the British economy is the current account, where the deficit has widened alarmingly – to 5.2% of GDP last year, from 1.2% in 2005. It hit 7% in the final quarter of 2015.

Within this, the trade shortfall has been a relatively stable component, being somewhat better in 2015 (at 2.0% of GDP) than in 2005 (2.7%).

The slump in the current account has instead reflected a collapse in the net flow of income. Back in 2005, this flow was positive, contributing £20bn (1.5% of GDP) to the current account, and usefully offsetting the trade gap. In 2015, however, income was in deficit to the tune of £60bn (3.2% of GDP), a sharp and dangerous reversal in a comparatively short time.

The disturbing connection here is that current account shortfalls have become a vicious circle. Each deficit, when met by asset sales or borrowing from overseas, sets up increased future outflows in the form of profits and interest.

To this extent, Britain has been trashing her balance sheet to sustain consumption in excess of current output. British GDP and, with it, British viability, has become increasingly dependent on what central bank chief Mark Carney has dubbed “the kindness of strangers”.

This is a misnomer, of course, because lending and investment are determined by calculation, not altruism – and here lies the immediate problem. The slump in Sterling means that those who lent to or invested in Britain last year are now sitting on losses of about 20%. If they decide that putting further capital into Britain would amount to “throwing good money after bad”, the UK will be in very, very deep trouble. The harsh reality is that about 6% of British GDP, or £120bn, comes courtesy of foreign creditors.

Deep in the hole

If selling assets and taking on debt to subsidise consumption looks feckless (which it is), further evidence to the same effect can be found in Britain’s aggregates of debt and quasi-debt.

Between 2000 and 2007 – but expressed at constant 2015 values – growth of £354bn in GDP came at a debt cost of £1.34 trillion, or £3.80 of borrowing for each £1 of growth. Since then, the ratio has worsened dramatically, with £127bn in net growth requiring £1.24 trillion of new debt, a borrowing-to-growth ratio of £9.70 per £1 (see chart). Even these numbers exclude borrowing in the “financial” or inter-bank sector.

uk-growth-borrowing-since-2000jpg_page1

Of course, this very strongly suggests that “growth” has really amounted to nothing more than the very inefficient spending of borrowed money.

This addiction to borrowing has ravaged the British balance sheet. Whilst a 268% ratio of debt to GDP (1) may not look too serious, inclusion of the banking sector (2) increases this to around 450%. On top of this, the most recent, knee-jerk cut in policy rates worsened the deficit in private pension provision to £945bn (52% of GDP) (3), whilst unfunded public sector pension commitments are generally put at £1,000bn (55%).

This has three disturbing implications for the British economy. First, it is becoming ever clearer that past irresponsibility has undermined Britain’s future financial security. Second, it has turned Britain increasingly into a supplicant for the goodwill of China and others.

Third, the UK is in no condition to cope with increases in interest rates, yet such rises may become inevitable if international markets continue to take a tougher stance on British risk.

No quick fix

Some believe that the slump in Sterling might itself start to improve things, making imports more expensive whilst boosting the competitiveness of British exports.

One obvious snag with this is that a weaker currency increases the cost of essential imports, which include food, raw materials, components, the consumer iFads to which many in Britain seem addicted and, thanks to serious policy failures, rapidly increasing quantities of energy. A second is that it is by no means clear what Britain has to export – or that exporters will use a cheaper pound to boost volumes, rather than simply pocketing fatter margins.

Above all, of course, the British external problem does not lie in her trade deficit so much as in a rapidly-worsening income balance – and this will continue to worsen, until and unless the UK ceases relying on foreign creditors to subsidise consumption.

Two things are clear. The first is that, as exemplified by Britain, neoliberalism has failed, widening inequalities whilst sacrificing the balance sheet on the altar of immediate self-gratification.

The second is that Britain must reform to survive, specifically by shifting incentives from speculation to innovation. In short, innovation has weakened – and productivity with it – because riding state-backed inflated asset markets has been made into a surer and less risky route to prosperity than developing new products and services.

Here, some of the early statements of new PM Theresa May are encouraging, but the really tough calls – such as increasing capital gains taxation, and extending it to all property gains, in order to reduce the tax burdens on small and medium enterprises (SMEs) – still lie in the future.

She may be helped in this, ironically enough, by the very same “baby boomer” generation which hitherto has ridden the wave of asset inflation and demographic unfairness.

Boomers, sitting complacently on inflated property values, might soon begin to wonder to whom they are going to sell their property when they need to turn it into cash. Well, they won’t be selling to a younger generation that they have helped to impoverish. That they might have to monetise it at all has been made much more likely, and more imminent, by the undermining of pension investment.

Historically, the impetus for reform has seldom come from smugly comfortable beneficiaries of the system. This time, though, might just be different.

 

Notes:

  1. Source: BIS data for end-2015
  2. Based on financial sector debt of 183% of GDP as at mid-2014
  3. Source: FT

 

 

#78. The fragility of the “new abnormal”

AN UPDATE

For reasons largely outside my control, there’s been a bit of a hiatus here in recent weeks. This said, I’m working on a paper that I think could be very interesting indeed, examining how we measure prosperity, something which reported GDP data conspicuously (and increasingly) fails to do. That paper is work in progress. Meanwhile, what is the state of play?

As it happens, not a lot has changed during my absence. Fundamentally, the world financial system continues to look bizarre, with ultra-low rates destroying both returns on capital and pension provision whilst failing conspicuously to deliver the much-vaunted “stimulus”.

So abnormal have things become that I’m waiting on “the great reset”, and the turbulence that will necessarily accompany it.  An essentially stagnant global economy simply cannot go on accumulating ever more debt without the system toppling over.

Finance – waking up to reality?

There does seem to be a dawning comprehension, amongst supra-national organisations at least, that a point may rapidly be approaching when we can no longer live on an endless tide of cheap credit. Though there remains much talk of growth, “secular stagnation” is probably the best gloss we can put on the underlying economy.

Western central bankers, I suspect, may waking be up to the fact that, if you wanted to go somewhere progressive, you wouldn’t start from here. I’m pretty certain that, had they access to a time-machine, central bankers would go back and make some significant changes.

Slashing interest rates in 2008 and 2009 did make sense, as did using QE to – as I see it – depress yields by driving bond markets upwards. But these were emergency measures, and should have been temporary. The central bankers’ big mistake, influenced no doubt by Wall Street, was to allow ZIRP to become permanent. With hindsight, they should have started to push rates back upwards pretty soon, starting no later than 2010.

A policy of normalisation, had it been pursued, might have driven GDP lower, but an immediate, one-off hit could have been a lot better than allowing denial to push us into a tunnel of the surreal. A policy of interest rate normalisation would, no doubt, have triggered some big losses – but this, too, would have been manageable, and a “back to normal” approach would have staved off an escalation in debt which is now looking very dangerous indeed.

Thanks to the prolonging of ultra-loose monetary policy, debt has escalated. Back in 2008, debt of $140 trillion was enough to frighten the system. Now, debt has soared beyond $200 trillion, where I suspect that fear has been replaced by outright paralysis.

Politics – left behind by change

Politicians and most commentators, meanwhile, remain way off the pace, not just of economic fundamentals, but of public feeling as well. The same experts who told us that Donald Trump was a “joke candidate” with no chance of winning the Republican nomination, and that the “out” campaigners couldn’t possibly win Britain’s “Brexit” referendum on EU membership, continue to misunderstand how rapidly the political landscape is changing.

These experts now think that revelations about Mr Trump’s deplorable attitudes to women will kill off his campaign, and that Jeremy Corbyn’s only chance of winning power in Britain is to shift to the centre-ground. They are wrong on both counts, and wrong, too, if they underestimate the pivotal, pan-EU importance of the Italian referendum on constitutional reform set for 4th December.

American angst

What, then, is the reality that politicians, pollsters and pundits are missing? In a word, that reality is anger. In America, surveys show a rapidly rising tide of consumer discontent which increasingly merits the label “rage”. This is directed against utilities, cell-phone providers, airlines and other sectors in which the market dominance of a handful of players enables them to ignore consumer anger. Rather than helping customers – who in reality have nowhere else to go – these corporates concentrate instead on influencing Washington, to ensure the maintenance of barriers to entry.

Voters and consumers are the same people, and consumer anger against corporate arrogance feeds into a mood of rebellion against the establishment. This, for many, makes Mr Trump, whatever his faults, an attractive proposition. It also makes voting for the quintessentially-establishment Hillary Clinton almost unthinkable.

British disillusion

Likewise, the anti-establishment anger which delivered “Brexit” also informs strong support for Labour’s Jeremy Corbyn. What pollsters and pundits seem unable to grasp is that this support does not come from the comfortable, those people who are satisfied with “politics as usual”, and whose voting intentions can be measured.

It comes instead from the ranks of the insecure, generally younger and often non-voting millions who are the victims of depressed incomes, employment insecurity (the “gig economy”), the high cost of housing and, above all, the sense that nothing is ever going to get any better for them unless society changes drastically.

Because these people do not respond to telephone surveys, and have better things to do with their time than take part in focus groups, they tend to fall beneath the pollsters’ radar. But they are numerous enough, and motivated enough, to swing an election – provided that Mr Corbyn does not try to become another centrist in the Blair mould.

At the moment, the Western governing establishment relies on the votes of the so-called “baby boomer” generation, people who seem to be sitting pretty on hugely inflated property values. This, though, is likely to change when the boomers – or the market on their behalf – starts to ask two very awkward questions.

First, what’s happened to your pension? (answer: thanks to ZIRP, its value has cratered).

Second, to whom do you think you’re going to sell your highly valued property, when you need to monetise it? (hint: not to a younger generation that has been deeply impoverished by demographic imbalances).

The irony here is that Theresa May is shaping up to be the first British leader in a very long time who really understands the issues of isolation and sheer unfairness which are bubbling beneath the surface of formal politics. It is her misfortune that her premiership seems to have coincided – if the exchange rate is any guide – with the fundamental flaws in the British economy being rumbled.

Brexit blues?

Those who blame the slump in sterling (along with pretty much everything else) on “Brexit” seem to have overlooked Britain’s horrendous current account deficit, which long pre-dates the EU referendum. Anyone who believes that “Brexit” is alone responsible for the slump in GBP has to believe something else, which strains credulity to the limit – which is that, in or out of the EU, Britain could have gone on living beyond its means to an extent sustainable only on the basis of foreign capital injections of £100bn annually, and rising.

Those who lent to or invested in the UK during 2015 are sitting on losses averaging about 20%. They must now be running their slide-rules over the British economy, and not liking what they see. If they decide that advancing further capital would amount to throwing good money after bad, the game really is up.

Looking ahead – regime-change and bad numbers

Events in Britain and America – even without bringing the Eurozone, China and Japan into the equation – make the economic and political outlook fascinating, albeit rather frightening. What we are witnessing in the West is the start of regime-change, with the neoliberal orthodoxy, which has ruled the roost for three decades and more, destined for the shredder.

The global economy has become unsustainably addicted to borrowing, and has created a mountain of debt that would imperil even a strong economy, let alone one that is flat-lining. But where and how are we going to see the economic implications of this mess feed through into data?

Well, SEEDS – the Surplus Energy Economics Data System – can supply some answers, by distinguishing between the “financial” and the “real” economies. The current SEEDS projection is that the global “real” economy, expressed at constant 2015 values, will grow very gradually, from $67 trillion last year to $69 trillion in 2019, before commencing a decline that will reduce it to $66 trillion in 2025 and $64 trillion by 2030. This does not amount to a crash, but it does mean that growth is over.

This looks rather worse when you take some other issues into account. First, the global population continues to increase, so growth at the per-capita level is poised to reverse significantly. This seems certain to feed into the politics of insurgency, because inequalities of wealth and income become very much harder to defend when per-capita average prosperity is shrinking.

Second, “excess claims” – that is, claims created by the financial economy that cannot be met by the real one – have already climbed to $80 trillion, from $55 trillion as recently as 2010, and look set to top $100 trillion by 2019.

If you’re familiar with surplus energy economics, you’ll know exactly why all of this is happening. However, GDP, as we measure it, is unlikely to capture the plateauing of real economic output, whilst the accumulation of “excess claims” – effectively, the proportion of global debt that is incapable of repayment – cannot be measured using conventional methodologies.

For those of us familiar with surplus energy economics, this isn’t entirely disadvantageous, as it should give us an edge in terms of anticipation.

What we do need, however, is a way of reconciling the SEE-based measurement of the real economy with data in common usage – and this is my current work-in-progress.

#77. The picture refined

ENERGY AND THE ECONOMY

After a long concentration on financial issues, the focus of this discussion is on energy.

The issues of energy and the economy are, of course, intimately connected. As a stagnant global economy goes on piling up debt to no useful purpose, it is reasonable to ask, not just why economic policy is turning into such a grotesque failure, but whether energy trends are contributing to that process. One conclusion of this discussion is that they are.

In this context, the explanation for policy failure seems breathtakingly simply. Ultimately, the economy isn’t a monetary system, but an energy equation – so trying to fix the real economy using monetary manipulation is like trying to fix an ailing pot-plant with a spanner.

It is not surprising, then, that the economy simply has not performed as the authorities have expected. Ever since 2000, debt has grown much more rapidly than economic output, giving rise to a strong presumption that reported “growth” has, in reality, been nothing more than the simple spending of borrowed money. Experimental, “unconventional” monetary policy has failed to deliver the expected stimulus. We face a world that is awash with debt, whilst pension and other provisions for the future are being destroyed before our eyes.

Where does energy fit into this picture?

Critical connections

In a bizarre economic situation, it is imperative to point out two things, both illustrated in fig. 1.

First, there is a remarkably close correlation between energy supply and economic output.

Second the rising energy cost of energy – the proportion of accessed energy that is consumed in the access process – correlates very closely indeed with the explosion in borrowing. In other words, the rising trend in the real cost of energy is pushing us ever deeper into debt. Recognition of this linkage enables us to distinguish between debt taken on out of choice before 2008, and borrowing now being undertaken out of necessity.

Fig. 1: energy, growth and debt77-1

These issues will be addressed later – but we should note, from the outset, that policy failure will continue for as long as the authorities persist in seeking monetary rather than energy-based explanations for what is happening to the economy.

Myth-busting

A review of energy requires a lot of myth-busting. A widely-accepted narrative today is that there is nothing to worry about, because the world will make a seamless transition from fossil fuels to renewables. Some even argue that the oil, gas and coal industries are already all but dead-and-buried.

The facts simply do not square with this facile interpretation. Renewables, despite very welcome progress, still account for just under 3% of global primary energy consumption, whilst fossil fuels supply 86%. A transition to renewables will happen, and must – but it is going to take a lot longer than the glib popular narrative tends to assume. Looking ahead to 2030, the renewables component will, of course, be very much larger – but the workhorses of the economy will remain oil, gas and coal.

Within the overall energy slate, the cost of energy (measured as the proportion of accessed energy consumed in the access process) remains on a strong uptrend. This means that, even if gross energy supply can be maintained, the net amount of energy available for us to use is poised to decline, presenting major economic challenges.

Energy prices – extended cyclicality and the myth of “seamless transition”

The slump in oil and other energy prices since 2014 is widely misunderstood. The price crash is cyclical, and followed directly from a lengthy period of enormous investment, which necessarily created a big supply surplus as soon as the economy faltered.

Now, though, investment has collapsed, such that depletion of supply will in due course restore equilibrium, even if the economy does not improve.

An improvement in the economy actually looks pretty unlikely. The economy remains in “secular stagnation” despite the use of truly extraordinary monetary gymnastics in order to produce a semblance of “business as usual”. Surplus energy – that is, the difference between energy accessed and the energy consumed in the access process – continues to deteriorate, yet few recognise the connection between this erosion and the deterioration in economic growth, the weakening in productivity and the ever-growing reliance on the spending of borrowed money.

Perhaps because we live in an age of sound-bites, so-called “social media” and diminished attention-spans, there is a tendency to leap to glib conclusions that do not stack up under proper analysis. Nowhere is this more striking than in the widespread assumption that a quick and painless transition to renewables beckons. Renewables are indeed the future – but it is not a future to which we can transition quickly, let alone painlessly.

Some cautions against exuberance and complacency are needed. First, replacing today’s fossil fuel consumption with solar power would require carpeting an area the size of Austria with solar panels. Second, electric vehicles do not eliminate the dependency on primary energy, but simply displace it, at significant cost in terms of system losses. Petroleum, in particular, offers a concentration of energy-to-weight and energy-to-volume that will, for the foreseeable future, remain unrivalled. Producing a 747-sized aircraft powered by electricity remains a pipe-dream.

Price dynamics

The impression that a quick transition is taking place has been fostered by the slump in oil prices which, at around $47/b, are more than 50% below their 2013 average of $109/b.

The reality, as fig. 2 shows, is that this slump fits into an extended cyclical pattern spanning decades. The crisis-induced oil price excesses of the 1970s (1) prompted both demand reduction and huge investment in exploration and development, resulting in oversupply and a lengthy period of low prices (2). Debt-fuelled economic expansion, together with rapid growth in China and the Far East, then brought about a new era of high prices (3). This era has been ended decisively by a combination of massive energy investment (most obviously in shales) and economic weakness (4).

Fig. 2: real crude oil prices since 1965

77-2

Today, investment in exploration and development has collapsed, with well over $400bn of previously-planned investment now either deferred, or cancelled altogether. The outlook for shale investment is particularly significant, because the ultra-fast depletion rates characteristic of shales dictate a continuing need for investment capital. This has already become difficult to obtain, and could become even more so if there is a major correction away from inflated values and minimal yields in debt and equity markets.

At current prices, neither shales, nor hydrocarbons more generally, can earn the kind of returns normally required by capital markets.

Though economic weakness may make this period of low prices a prolonged one, it is a pretty safe assumption that under-investment will in due course create the conditions for a sharp rise in prices. Until profitability is restored by higher prices, capital investment will continue to languish – and, until investment can be increased, the erosion of supply capacity will continue.

Energy prices and costs – underlying trends

Fig. 3 imposes a trend-line onto the cyclical pattern of oil prices, a trend calibrated in terms of the rising Energy Cost of Energy (ECoE) of the global oil production slate.

The concept of ECoE recognises the fact that energy is never free, but comes at a cost. Though this cost can be expressed in money, it makes far more sense to examine, within any given quantity of energy accessed, how much of that energy is consumed in the access process. This, expressed as a percentage of the gross amount, is the Energy Cost of Energy.

Fig. 3: actual and trend oil prices since 1965

77-3 The secular trend in ECoE is upwards, as it has been for decades. The reason for this is that, as huge, ultra-low-cost sources of fossil fuels are exhausted, costlier and often unconventional supplies account for an ever-growing proportion of total energy consumption.

Technology can blunt this progression, but cannot stop the underlying rise in costs, let alone reverse it. Shale development typifies this equation. Innovation has made shale oil much cheaper to extract today than shale oil would have been ten or even five years ago. What technology cannot – ever – do is make shales cheaper than the super-giant conventional fields of the past.

Much the same can be said of renewables. Prior to the collapse in crude prices, the best renewables were capable of producing energy at costs lower than oil and gas being brought on stream today.  Commercially, that is all they need to do. But what they will not do is bring back an age of super-abundance.

Fig. 4 completes the price cyclicality picture by showing estimated aggregates for all primary energy, calibrated in constant dollars per barrel of oil-equivalent in order to facilitate comparisons with earlier charts. Again, a trend has been superimposed, based on estimated ECoE

Fig. 4: actual and trend energy prices since 1965

77-4

If this trend is correct, energy prices are now drastically below underlying replacement cost, a situation explicable in terms of two factors – a long (roughly 2000-14) investment boom, resulting in excess capacity; and the weakness of the economy.

This suggests that a sharp upward move in energy prices – to or beyond the trend – is inevitable. What it does not tell us, given the weakness of the economy, is how long this might take.

Energy cost – gross and net supply

Since energy is never “free”, there has always been a cost of energy, and this is expressed here as ECoE.

In times past, a super-abundance of cheap-to-produce energy made this cost small enough to ignore. More recently, however, the upwards progression of trend ECoEs has become the true “elephant in the room”, the missing factor which explains the supposed “mystery” of decelerating growth. Moreover, the trend rise in ECoEs is an exponential progression, as depicted in figs. 3 and 4.

ECoE can be factored in to the supply equation by expressing energy volumes in two forms – the gross amount of energy accessed, and the net amount which is available for us to use once ECoE has been deducted.

This equation is pictured in fig. 5, which shows estimates of gross and net energy supply since 1965, including projections out to 2030.

Fig. 5: gross and net energy supply since 1965 (I)

77-5As you can see, the difference between gross and net supply has only started to become meaningful in comparatively recent years. In 2000, for instance, gross supply of 9.4 billion tonnes of oil equivalent (bn toe) equated to a net amount of 9.2 bn toe, the difference (ECoE) being pretty modest at 0.2 bn toe. By 2015, this gap had widened to the point where a gross quantity of 13.4 bn toe yielded net supplies of 12.6 bn toe, with ECoE now equivalent to 0.8 bn toe.

This divergence between gross and net is hugely important going forward. As fig. 6 shows, it is likely that gross supplies of energy can be maintained out to 2030, with growth in renewables matching, and perhaps exceeding, a decline in the gross availability of fossil fuels, a decline which – courtesy in part of an investment slump – looks likely to commence pretty soon.

By 2030, gross energy output may be about 13.7 bn toe, up from 13.4 bn toe last year. Over that period, the renewables contribution is likely to rise briskly, accounting for 7.1% of total supply in 2030 up from 3% last year.

On a net basis, however, the trend in overall energy supply is downwards – even if gross supply can be pushed up, the rising trend in ECoEs is set to more than cancel out any such growth at the net level.

Fig. 6: gross and net energy supply since 1965 (II)

77-6

Within the gross energy “mix”, these forecasts equate to a compound annual rate of growth of 5.5% in renewables output over the coming fifteen years. This may seem low – and is an easy-to-beat number now (when growth rates are appreciably higher, but from a very low base) – but will become progressively more demanding as the denominator gets ever larger. Renewables output might grow faster than this, of course, but by the same token the rate of decline in fossil fuels output might be more pronounced than is assumed here.

This is put into context in fig. 7, which divides gross and net supply into separate components.

Fig. 7: composition of gross and net energy supply 77-7

Between today and 2015, aggregate gross energy supply is projected broadly flat (B), despite an assumed gradual erosion in the fossil fuels component (B). Growth in renewables output looks pretty spectacular (C) – until it is rebased (D) onto the same vertical (quantity) axis as the aggregate and fossil fuels charts.

The outlook, then, is for stable or slightly higher gross energy supply, with renewables gradually displacing fossil fuels. On a net basis, however, the outlook is very challenging – and, where the economy is in concerned, it is net supply that matters.

Economic implications

The main focus of this discussion has been energy, so that comments on economic issues must necessarily be kept brief, at least pending a planned comprehensive review of this issue. The key points to note, however, are as follows:

  1. There is a close relationship between economic output and the consumption of primary energy, as set out in fig. 8. The curve in real GDP has seemed to move ahead of the aggregate supply of energy over the last decade or so, but this reflects, at least in part, the impulse temporarily imparted to GDP by the spending of borrowed money.
  2. Looking ahead, the likelihood that the gross availability of primary energy will be flat makes a return to brisk economic growth look difficult.

Fig. 8: energy and economic output since 1980 (I)

77-8

  1. This difficulty is reinforced if we shift our assessment from gross to net energy availability, which is what really matters. This is set out in fig. 9.

Fig. 9: energy and economic output since 1980 (II)

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  1. The rise in the trend cost of energy correlates pretty closely with annual borrowing, as illustrated in fig. 10. This chart portrays both the trend cost of energy and estimated annual net borrowing in constant dollars. The clear implication is that, whilst debt growth before 2008 was a discretionary choice, borrowing since then has been forced on the system by the need to accommodate the drag effect of rising trend ECoEs.

Fig. 10: Borrowing and the trend cost of energy

77-10

Some technical points need to be made before concluding this article. First, global GDP expressed in US dollars is surprisingly tricky to calculate, as data is reported on two bases of currency conversion – market and PPP (purchasing power parity) – which produce extremely divergent results. The basis used here is Standard Constant GDP, a methodology designed to overcome these difficulties.

Second, GDP calculation includes the cash cost of energy access – not least because one company’s cost is someone else’s revenue – but fails to incorporate the economic rent imposed by rising ECoEs. Another way to look at this is to observe that GDP does not capture what else money could have been spent on if it were not required for investment in energy access.

In conclusion, we can state that economic stagnation and rising trend ECoEs are by no means coincidental events.

We can also conclude that rising ECoEs are, by cramping the scope for non-energy expenditures, forcing us to increase debt. The best metric for examining this relationship is probably that between average incomes and the cost of essentials, since these essentials are the prime means of whereby changes trend energy costs impact prosperity.

Finally, rising ECoEs, and the likely erosion of net energy availability in the future, indicate that there can be no easy or pain-free way of escaping from the combination of stagnating output and rising debt.

 

#76. The point of no returns

HOW THE MONETARY MAGI ARE WRECKING THE FUTURE

Bonds trading at negative yields now equate to almost half of all Western sovereign debt. Government bonds, offering both safety and a reliable income, have traditionally been the bedrock of pension systems, so the elimination of returns is destroying the provision of pensions across the world.

In Britain alone, pension scheme deficits are reported to have reached almost 50% of GDP after the latest knee-jerk cut in policy interest rates.

The destruction of pension provision is just one example of how reckless monetary policy is undermining the real economy. By keeping otherwise-failed businesses afloat, monetary largesse has undermined the essential “creative destruction” required to free up both market share and capital for new entrants. Markets are no longer able to put a price on risk.

Markets distorted by reckless polices are no longer capable of meeting the business investor’s key needs, which are to weigh risk and return.

Making an epic disaster

A couple of years ago, I was contacted from Hollywood with a somewhat unusual request – a scriptwriter was looking for help with the plot of a disaster-movie on the theme of economic catastrophe. I was on holiday at the time, and I don’t know if my cursory thoughts helped him.

But I realise now that no flights of imagination were necessary – all he needed to do was watch the conduct of the economy under today’s powers-that-be, and then extrapolate into a not-very-distant future.

After this beginning, you might expect me to remind you that an addiction to debt, and to countering the dangers of excessive indebtedness with cheap money, have turned the global financial system into a gigantic Ponzi scheme which is destined to end as all such schemes do. You might expect me to point out the consequences of deliberately-induced hyperinflation in asset markets.

I’m not, though, because readers know all this. It is surely obvious that the financial system is heading for policy-induced disaster. It is equally obvious that potential crash-triggers are proliferating across the system.

Instead, my focus here is on the consequences for the real economy of the grotesque mismanagement of the financial system. The mad magicians of monetary policy, not content with trashing their own financial bailiwick, are wreaking havoc in the real economy of goods and services as well. A string of mechanisms, vital to the functioning of the real economy, are being destroyed.

Killing the future

Here are two striking figures which illustrate the consequences of monetary madness. First, and according to the Financial Times, the $12.6 trillion of bonds now trading at negative yields equate to almost half of all Western sovereign debt. This sovereign debt is the bedrock of private (including employer) pension schemes around the world, because pension schemes require both the security provided by government debt, and the regular and predictable income received from fixed-income investments.

Amplifying this point, one consequence of the Bank of England’s latest (and surely unnecessary) rate cut has been to increase the deficit in British private pension provision to £945bn (which, incidentally, is about 50% of GDP).

Both of these numbers are gigantic. If half of all sovereign debt delivers negative returns, pension provision right across the West is no longer viable. The British private pensions deficit is in addition to a shortfall, generally put at about £1,000bn, in unfunded public employee pension provision. In theory – though the practice might be problematic – the taxpayers of the future are likely to be bled white just to keep the pension promises that governments have made to their employees. This may or may not be possible, but it surely rules out any taxpayer bail-out of private pension provision.

The British pensions issue is part of a broader national malaise which is looking increasingly existential. A forthcoming article will explain why, in my analysis, the British economy as a whole is looking increasingly unsustainable. Here, I focus on the global (or, at least, the pan-Western) consequences of monetary madness. One of these consequences is the destruction of our ability to provide for old age.

We are not simply dismantling the system of pension provision, which is bad enough in itself. Even worse, policy madness is stealing the future security in which millions of people have already invested.

The point of no returns

This problem is a wholly logical, direct and entirely predictable consequence of “low or no” interest rate policies. Interest rates determine the returns that investors make on fixed-income instruments. Pension schemes rely on these returns to meet future pay-out requirements. So “no returns” means “no pay-outs”. Well done, policymakers – you have just destroyed the futures of millions of people.

Some of this was already pretty obvious. For a start, annuity rates collapsed when rates were first slashed in 2008-09, and monetary policy has been destroying savers’ wealth ever since. But only now are the full implications for pension provision emerging.

Obviously, if someone buys a bond yielding 5%, his return is pretty much 5%, plus or minus any capital gain or loss that he makes on the principal. So a 0.5% yield equates to a 0.5% return – and you cannot run a pension system on that. A zero yield means a zero return, putting the final nail into the lid of the pensions coffin. A negative yield means that capital is being cannibalised.

Adios, pensions.

Of course, an investor in a nil- or negative-return instrument can still make a profit, but he can only do so on the basis of “greater fool” theory. This says that buying something overvalued can be profitable if you can sell it on to someone else (the “greater fool”) at an even more overvalued price. Buying a bond yielding -0.1% can be profitable, then, if you can sell it on to someone else at a yield of -0.5%.

This profit, however, is purely fortuitous, and is not the same thing as a return. It is not a reliable, predictable and continuing return on investment, on which stable pay-outs can be based. Rather, it is a purely incidental gain delivered by the continuity of policy excess.

Forgive me if I seem to be labouring the point, but we do need to be clear about this. If a pension fund (or any other investor, for that matter) is deprived of returns, it cannot meet a requirement for income. The ability to make a capital gain depends entirely on the indefinite continuity – indeed, implicitly the acceleration – of monetary looseness. This distinction between investment returns and investment profits is absolutely critical to what is happening.

Investors? Kindly get lost

Destruction of future pension provision around the world is only one aspect of the massive real-economy distortions being introduced by the mad monetary magi whose only answer to every challenge is to pour in more liquidity.

For a start, this policy is making rational investment impossible. Just like pension funds, both financial and industrial investors need returns, and they need at least some visibility on future returns. This they do not have in a situation of induced hyperinflation in asset-markets. They know that capital put into existing paper assets will continue to escalate in nominal value for as long as the one-trick ponies control the monetary system. They cannot predict the date of the eventual implosion, even if they are aware that this must happen. Critically, though, they cannot project returns on investment in new business ventures either.

One reason why they cannot do this is that monetary madness has undermined “creative destruction”. In the normal course of events, over-leveraged, out-dated or simply badly-run businesses go bust, which both creates space and frees up capital for new entrants. This isn’t happening, because ultra-cheap money keeps throwing lifelines to businesses which, under normal conditions, would have failed.

In this sense, the monetary authorities have created a gigantic welfare system for the world’s worst-run businesses. Like any welfare system, somebody has to pay for it, the “somebody” in this instance being both the owners of viable businesses and the would-be entrepreneurs who should be creating the next generation of enterprises.

A market which cannot supply returns, and which keeps failed businesses in being, obviously cannot fulfil its required function of putting a price on risk. The investor’s main objective, which is weigh risk against potential return, is thus stymied on both sides of the equation. He cannot realistically anticipate returns in an environment in which returns have virtually ceased to exist – and he cannot calculate risk in markets which have priced risk down virtually to zero.

On top of this, the investor might well wonder what happens when the ageing demographic collides with the inability to provide retirement income. Of course, people denied retirement incomes may well have to stay in work for longer – but all this is likely to do is to put further downwards pressure on productivity, especially in the feeblest economies.

The final question (for now)

Since we have seen how lethally destructive the central banks’ addiction to ultra-cheap money has become, one question remains. Why are they doing this?

(Or perhaps there is a second question – are these people complete idiots?)

Beyond following a momentum that they themselves have created, central bankers seem to be behaving in this nihilistic way for three main reasons.

First, they are trying to help the financial system cope with a global debt mountain that has become far too big even to service, let alone ever repay. They are doing this because they are – probably wrongly – more fearful of a one-off cascade of defaults than they are of the on-going destruction of the value of money.

Second, they really believe that stimulus can shock the world’s real economy back into sustainable growth. No amount of evidence or logic, it seems, can cure them of this delusion.

Third, they are delivering monetary stimulus – the only weapon in their arsenal – because the alternative of fiscal stimulus is not being provided by global policymakers. The explanations for this inaction by governments are, first, that they entered the post-2008 world with fiscal deficits that were already gigantic and, second, that politicians have largely abdicated from the economic arena, dropping the whole mess into the laps of central bankers.

Conclusions

Though I regard central bankers and their associated cheerleaders as “the mad magi” of monetary largesse, it is pretty clear that they are acting as they are as much out of lack of alternatives as out of an ideological commitment to recklessness.

The reasons for this madness, however, are secondary to its consequences. For so long as this recklessness continues, people will be robbed of the ability to provide for retirement, whilst the economy will be undermined by the inability of investors to project returns and put a price on risk.

On the capital side, we are caught between Scylla and Charybdis or, in the modern idiom, between a rock and a hard place. If asset market hyperinflation continues, it will inflict ever greater damage on an economy already trying to function with a concept of returns, without the vital pricing of risk, and without critically-important “creative destruction”.

If (meaning when), on the other hand, asset market hyperinflation ceases, it will crash the system in a tidal-wave of defaults.

Pension savers in particular, most of whom have yet to realise that their futures have been stolen, desperately need the restoration of returns – and so does the broader economy.