#21 Fear of the future

“A week”, as Harold Wilson famously remarked, “is a long time in politics”. It’s can be a long time in economics, too, when it embraces a revolution in pension provision, an enquiry into energy supply and the major geopolitical challenge posed by Russia’s latest bid for “lebensraum” in eastern Europe.

Where matters of saving, pension provision and energy are concerned, those of us who recognise that money IS energy start with an in-built advantage, because we already recognise the connections between these issues.
What I’m going to do here is to examine, in a holistic way, the fundamentals behind the savings and pensions question.

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Where saving and pensions are concerned, the single most important point is that the British economy has stagnated – indeed, has gone backwards – for more than a decade. Even in the supposedly “good” years between 2000 and 2008, each £1 of “growth” was purchased at a cost of more than £9 of incremental borrowing, and the fundamentals have weakened even further since the 2008 financial crisis.

Severe indebtedness is compounded by a glaring current account imbalance, because the financial services industry is no longer able to earn enough foreign exchange to pay for our escalating energy imports and our long-standing deficiency in food supply.

It is sometimes said that the coalition government inherited a “weak” economy in 2010. This is incorrect, because the reality is that the economy handed over by Labour wasn’t simply “weak”. Rather, it was a basket-case, an economy addicted to the Ponzi model of using an artificially-inflated housing market to channel ever greater quantities of debt into consumption.

For an economy, as for an individual or a family, the ability to save is determined by the difference between income and consumption. Where pension provision is concerned, we can point at the vast sums lost to pension schemes through Gordon Brown’s notorious 1997 tax “raid”, or at the similarly huge amounts filched from savers by negative real interest rates and QE since 2009. But to concentrate on these issues is to miss the fundamental point, which is that Britain is no longer affluent enough to save for its future.

This is what negative (below-inflation) interest rates really mean, the clear economic signal being that we need every penny (and more) of our income just to keep ourselves ticking over.

The equally nasty flip-side of this, of course, is that a country which cannot afford to save for its future cannot afford to invest either.

So, in order to keep the consumption gravy-train on the rails, we have resorted both to cannibalising our asset base (through a lack of replacement investment) and to burdening the young people of today and tomorrow with ever greater amounts of debt.

In this sense, George Osborne’s reform of pension provision is nothing more than a recognition of reality. Forced conversion into annuities doesn’t provide adequately for the future because interest rates are too low, and interest rates are too low because Britain is simply too poor to live with rates high enough to incentivise saving and encourage investment.

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Here’s the situation in a nutshell.

In times past, if you saw a large house with smart cars parked in the drive, you could conclude that the occupiers were wealthy. Now, the same house and the same cars are much likelier to indicate that the occupiers, far from being wealthy, are up to their ears debt. That, in microcosm, is what has happened to the British economy.

In the short term, critics may be right to fear that the abolition of compulsory annuity purchase may further inflate the housing market by encouraging more “investment” in buy-to-let (BTL) properties. In anything other than the short term, however, all that this will do is to amplify the property-and-debt crash when it comes.

At the heart of the problem is a fundamental national misunderstanding of the property sector. Regarding property as “an investment” is profoundly mistaken. Since the only people to whom we can sell our houses are ourselves, the “value” supposedly incorporated in the national housing stock is mythical. House prices are a simple function of the stock of mortgage finance divided by the number of properties available. So, if we borrow more money, property prices rise, but all that this really means is that we’re deeper in debt.

What it also means, of course, is that capital that could have been used for investment has been diverted into a wasteful and dangerous “capital sink” instead.

After reading this, you might fear for the future. Well, so do I.

#20. Janet, normality and the end-game

America and the World Economy

Janet Yellen is nothing if not bold. As well as seeming to confirm that quantitative easing (QE) will be wound down (“tapered”) by $10bn each month, the new Fed chief has indicated that American interest rates may begin to move upwards about six months after the termination of QE, heading towards an eventual level of about 4%.

What Yellen is trying to do here is to set out a road-map back to economic normality. Can the US (and, by extension, the world as a whole) follow this route successfully? In other words, is this “the beginning of the end” of the Great Recession, or is it “the end of the beginning” of the post-growth denouement?

I’d like ask for your indulgence as, in a longer-than-usual post, I (a) summarise the economic state-of-play as I see it, (b) set out the principal risk factors, and (c) try to reach some conclusions about what happens next – and when.

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If successful, the Yellen Plan (as I’ll call it) would restore a measure of normality to a US economy that has been anything but normal since the 2008 banking crisis. You see, normal economies do not depend on printing money (which, if it is not reversed, is what QE really amounts to). Normal economies also have real (above-inflation) interest rates, because negative real rates largely preclude capital formation by disincentivising savers.

If Yellen’s bold move is successful, the normality to which the American economy would return would be “a new normal”, quite unlike that of most of the post-1945 era. Like much of the West, America is heavily indebted, and has become dependent on debt-financed consumer spending. Moreover, globalisation has gone a long way towards turning the US into a low-wage service economy.

Longer term, these weaknesses could be overcome, by expanding manufacturing, by driving productivity upwards, and by improving real wages so that American consumers (for which also read American workers) no longer have to depend on borrowing to sustain their standards of living.

But none of this can happen without capital investment, which in turn means that it cannot happen without saving. This is why, on anything other than a short-term perspective, the restoration of positive real interest rates is so important.

Yellen’s policy objectives, then, are emphatically the right ones. But what are the odds on her plan succeeding?       

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To answer this, we need to look first at where we’re starting from. The 2008 banking crisis was partly psychological, in that it resulted from an almost-overnight panic at the sheer scale of debt in the financial system. But the underlying problem was that the escalation in the cost of energy had undermined the forward growth assumptions in which the system’s previously-relaxed attitude to the debt mountain had been founded. Debt isn’t a problem if your income is rising – but the equation changes completely if the price of oil surges from $20/bbl to $100/bbl. Significantly, oil prices haven’t slumped (or even fallen at all) since then, despite the worst economic downturn for at least 80 years.

The response to the 2008 crisis amounted to the rescue of the banking system by governments; the slashing of policy interest rates by central banks; and the cranking up of the printing presses. Debt has been transferred from the banks to the balance sheets of governments, savers’ returns have been pulverised by the low rates which have bailed out borrowers, and huge amounts of money have been added to the system.

The reality, though, is that hardly anything has really changed. Despite huge cash injections, the economy has done nothing more than limp along. QE hasn’t created inflation – yet, anyway – but it hasn’t created growth either. Total debt remains as high as ever, and quasi-debt commitments (such as pension and welfare promises) remain wildly unrealistic. Banks’ reserve ratios remain dangerously slender. With the solitary exception of US natural gas, the energy cost screw continues to tighten.

QE has had severely distorting effects. Japan has almost doubled its money supply (whilst simultaneously running a huge fiscal deficit), and the effect has been the opposite of what was intended (the trade balance has crashed, not improved, and growth hasn’t been restored).

Newly-minted US dollars have kept capital markets buoyant (in defiance of economic gravity) and have also flowed into emerging economies, but a string of these countries (including India, Turkey, Indonesia and South Africa) have now had to hike interest rates, sometimes to economically-crippling levels, to prevent that money flowing back out again in response to the Fed’s “taper”. Britain has returned to growth, but seemingly on the back of borrowing a lot more than £1 for each £1 of GDP increase.

In short, this looks like a case of “falling over a cliff in slow motion”. First it was the debt-addicted US and UK that got into trouble, as the “Anglo-American model” of unfettered credit creation detonated. Next came the Eurozone, where the economic illiteracy of the single currency (one monetary policy, seventeen budgets) was exposed by debt escalation and default risk. Now it’s the turn of the emerging economies, caught up in taper back-wash, and next could be China, where debt could turn out to be as much as US$24 trillion.  

In this situation, risks abound. In Japan, Abenomics could end in disaster. Renewed debt escalation might undermine markets’ faith in the UK. The scale of Chinese debt could spook the markets. The severe over-valuation of capital markets could be undermined either by the taper or by a long-overdue global re-pricing of risk. One or more major currencies could crash. Recognition that the shale boom is a case of hype over substance could undercut economic confidence in the US. Finally, there is the risk of external shocks (at the moment, the Ukraine situation obviously comes to mind).

In other words, risks to the system are multiplying. If someone is walking through a field with one land mine in it, he might get lucky, but plant enough land mines in the field and the likelihood of at least one going off rises exponentially.   


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In this situation – and Janet Yellen’s good intentions notwithstanding – about the most that the authorities globally can hope for is to keep plodding forward in the hope that we’ll learn new bomb-disposal techniques before we actually tread on a land mine.

Yellen may want to restore real interest rates, but that may not seem a realistic option for the UK, the Eurozone countries or many other economies, where the introduction of higher rates could be very painful indeed. If the US goes it alone on rates, the dollar could strengthen, with adverse effects on American trade.

In this situation, there are two ways that this could end. First, governments around the world could accept the need for higher rates, and could co-ordinate their monetary policies with the Yellen Plan – even though this would cause significant pain in the near-term, it could create a softer landing than the second option, which is to carry on with artificially-low rates in an effort to co-exist with excessive debt.

In fact, I think, the decisive factor here could be capital markets. At the moment, many asset classes (including equities and bonds) are defying economic gravity, resulting in a severe under-pricing of risk. The law of equilibrium suggests to me that, if risks are huge but the price of risk is abnormally low, risk pricing has to rise sharply, bringing markets tumbling down.

That, at any rate, is my conclusion. Something – Japan, perhaps, or Chinese debt, or political developments in Ukraine or elsewhere – could spook the markets.

At that point, Janet Yellen may have to execute a manoeuvre that, in the Vietnam war, was famously described as “a strategic advance to the rear”.        



#19. A grim tale

The UK Economy

This week, with the chancellor presenting the penultimate budget of this Parliament, we are going to be inundated with economic and fiscal analysis and commentary. I don’t know about you, but I’m usually put off by this deluge of comment, because most of it belongs in the realm of what I have called “flat-earth economics”.

As an antidote, I’m going to stand back and give you the big picture as I see it. Here’s a necessary warning for those of a nervous disposition – this isn’t going to be a fun read. In fact, it’s going to be very, very nasty indeed.

There’s really only one positive, so I’ll give you that right now. This positive is that George Osborne is a first-rate finance minister. There are those – myself included – who wish that he had cut public spending even further. But we need to remember that, with a single exception, Osborne is the only post-War chancellor who has reduced state outlays at all. The only other administration which has cut expenditures was Labour in the late 1970s, and this hardly counts because cuts were imposed by the International Monetary Fund (IMF). This aside, the trend in public spending has been a one-way street since 1945, and even Mrs Thatcher could do little more than stem this rise.

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The bad news, of course, is that Britain is going to need all of Osborne’s determination and more if a near-helpless economic situation is to be turned around.

In his budget, the chancellor will tell the public that, whilst the situation is improving, much more needs to be done, and that, by implication at least, this is no time to put the nation’s affairs back into the hands of the profligates of the Labour party.

In fact, the chancellor could hardly overstate the magnitude of the problems that remain to be overcome. The reality is that the British economy remains in very, very deep trouble, and that the public has virtually no idea at all about the real state of affairs.

Let’s start with the public perception, which, roughly speaking, is this:

       The British economy grew strongly between 2000 and 2008;

       Output slumped in 2008-09;

       The economy flat-lined after that; but

       A recovery is now under way.

This perception is wrong in virtually every particular. Properly understood, the economy did not grow at all during 2000-08; the 2008-09 slump inflicted far more damage than is usually recognised; and the recovery that we are supposed to be experiencing now is almost entirely illusory.

To understand why, we need to appreciate, first, that gross domestic product (GDP) is an extremely misleading measure of prosperity. As a measure of income, GDP is analogous to a company’s profit and loss account, and no sensible person would assess a company’s performance on this basis alone. The shrewd investor looks not just at profits and losses, but at cash flow and the balance sheet as well. What this in turn means is that you cannot arrive at a realistic analysis of Britain’s economic performance without taking debt into the equation.  

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Let’s start with some debt numbers. At the end of 2000, Britain’s debt totalled £2.99 trillion, or 307% of GDP, comprising government debt of £328bn (34% of GDP), household indebtedness of £677bn (69%) and corporate (including financial sector) borrowings of £1.99 trillion (204%).

Move forward to the end of 2008 and the debt-to-GDP ratio had risen from 307% of GDP to 501%, where it remains today. Whilst nominal GDP had grown by £466bn (from £975bn to £1.44 trillion), there had been a vastly larger increase in debt, which had risen by £4.22 trillion (from £2.99 trillion to £7.22 trillion).

Just think about this for a moment. Adding £4.22 trillion of debt to achieve a GDP increase of £466bn means that each £1 of economic “growth” had been purchased at a cost of more than £9 in new debt.

That isn’t growth.

It isn’t even, stricto senso, an economy.

It’s a Ponzi scheme.

Of course, the subsequent slump made these ratios look even worse. Between 2008 and 2012, nominal GDP increased by £120bn, but debt expanded by a further £600bn.

Now, let’s consider the “growth” that we’re likely to experience in 2014. If the optimists are right, GDP will grow at a real rate of perhaps 2.5% this year, a nominal increase of 4.5% if we add back inflation of 2%. In money terms, this would add about £70bn to GDP, which is less than the government alone is likely to borrow. Add in the probable increases in private debt as well (as mortgage funding expands) and you can see that the “recovery” is a case of “same old same old”, with each £1 increment in economic output purchased at a cost of far more than £1 in additional borrowings.

Nor is this all. As things stand, Britain is running a current account deficit of about £60bn, because our exports no longer cover the cost of essential purchases such as food and fuel. Our “growth”, then, is being financed not just by lenders but by trade creditors as well.

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Before finishing this grim litany, there are two other points to consider.

The first of these is that the absolute scale of British indebtedness is even worse than the formal number (of 501% of GDP, or £7.8 trillion). This number includes government debt on the domestic definition, rather than the more demanding Maastricht one. It excludes potential exposure resulting from the banking bail-out. It also excludes quasi-debt commitments such as public sector pensions (about £1 trillion), PFI contracts, nuclear decommissioning and the debts of state-owned corporations.

Second, any impression of economic normality is surely countered by interest rates which, at 0.5%, are far lower than inflation. Five years of negative real interest rates have been terrible for savers, of course, but the implications go much further than that. Without positive returns on savings, a country cannot invest. And, without investment at levels which at least match depreciation, a country’s asset base deteriorates in a process that is tantamount to cannibalisation of the economy.

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So there you have it. Debts are astronomical, the “growth” of the last decade and more has amounted to nothing other than the spending of borrowed money, the asset base is deteriorating through a lack of investment, and creditor forbearance is keeping us in food and energy.

Good luck, Mr Osborne.

You’re going to need it.   

#18. Japan’s road to ruin

The Japanese Economy

First there was Mellonomics, associated with inter-war US Treasury Secretary Andrew W. Mellon. Then there was Reaganomics, essentially a 1980s version of the same thing. Simultaneously there was Rogernomics, attributed to New Zealand finance minister Roger Douglas. In the 1990s, inevitably, came Clintonomics.

All of this left me wondering whether I might earn immortality by inventing the next such term. I wondered about Pharaoh-nomics – an ancient Egyptian philosophy based on turning the entire economy into a pyramid scheme – until I realised that this is already being practised across much of the developed world.

I dismissed both Santa-nomics (a policy based on free gifts) and Popeye-nomics (adopting spinach as a currency) on the grounds that they were just too silly. Little did I know that something even sillier than Santanomics or Popeyenomics was waiting to stake its claim to fame.

Enter Abenomics…………

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Whilst I’m pretty sure I wasn’t the first to predict the disastrous failure of Japan’s off-the-wall economic experiment, I doubt if many have been more emphatic about it than I have. The latest flow of news from the Land of the Sinking Economy Rising Sun confirms that Japan is moving ever closer to the precipice. It’s easier for me than for others to take this view, of course, because I have access to a surplus energy economics model which shows that there is absolutely no way out for the Japanese economy.

For any student of economics, Abenomics is a marvellous example of how to get absolutely everything wrong at exactly the same time. It’s also a classic case of “be careful what you wish for”. Japanese Prime Minister Shinzo Abe has made it clear all along that he wants higher inflation and a weaker yen. As soon as the markets come to understand what is really happening to the Japanese economy, he’s going to get plenty of both. 

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As everyone surely knows, Abenomics is a response to Japan’s so-called “lost decade”, a period of stagnation which, in fact, has lasted for well over twenty years.

In the 1980s, Japanese asset values soared to truly absurd levels, with the grounds of Tokyo’s imperial palace once being worth more, on paper, than the entire State of California. After the bubble burst, economic output stagnated, and inflation gave way to deflation, whilst government debt soared to levels which would long since have bankrupted the country were it not for Japan’s traditionally very high savings ratio.

Described as a series of “arrows” (there’s nothing like being abreast of the latest military technology, is there?), Abenomics involves injecting huge stimulus into the economy whilst simultaneously boosting net exports by creating a sharp reduction in the value of the yen. The fiscal stimulus programme was expected to increase the budget deficit to 11.5% of GDP, whilst money printing quantitative easing of at least US$1.4 trillion effectively doubles the money supply.  

Theoretically, these policies could work in tandem, because expanding both public spending and the deficit, whilst also running the printing presses on such a gargantuan scale, is indeed very likely to undermine the value of the currency.

This, it was argued, would stimulate consumption as well as boosting exports, thus injecting two forms of growth into the economy whilst also creating some healthy inflation.

Unfortunately, it hasn’t worked out in quite the way that Mr Abe thought it would. For a start, modest increases in exports have been far exceeded by the escalating cost of imports – instead of creating a strong net surplus, Abenomics has just delivered the worst trade deficit in Japanese economic history. Growth, too, has fallen far short of expectations, coming in at just 1% in the latest quarter, a long way adrift of the 2.8% that the markets had been encouraged to anticipate.

All the time, of course, there has been further escalation in a mountain of government debt that was at eye-popping levels even before Japan implemented its exercise in economic insanity.

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There were, you see, one or two little snags that the Japanese government had somehow failed to notice when it designed its Abenomics policy. The first of these was that Japan, already one of the world’s biggest importers of energy, shut down its nuclear industry in response to the 2011 Fukushima disaster.

This is likely to have pushed Japan’s net imports of energy up from 412 mmtoe (million tonnes of oil equivalent) in 2010 to 445 mmtoe last year, equivalent to 95% of the country’s consumption. Combining this volume increase with the slump (of about 20%) in the value of the yen not only increased Japan’s import bill but also piled a lot of extra costs onto consumers – the very people, of course, who were supposed to boost economic activity by hiking their discretionary spending……

Second – and, again, apparently unnoticed by Mr Abe – the Japanese population continues to age. Reflecting this, Japan’s historically super-robust savings ratio is trending steadily downwards as people reach the age at which they need to draw on their savings instead of adding to them.

I must admit that I am baffled by the government’s apparent ignorance both of the post-Fukushima situation and of Japan’s demographic trends. Be this as it may, the combined result has involved soaring public debt, a widening deficit, a diminishing ability to fund borrowing from domestic savings, a yawning trade gap, a far smaller increase than might have been expected in consumer spending, and, needless to say, a shortfall in growth even at a time when huge stimulus has been poured into the economy.

Who’d’ve thought it?

Now, cognisant (at last….) of the limits to the ability of the state to borrow, the government is increasing its sales tax from 5% to 8%, effective 1st April. Since this tax hike was announced well in advance, it is highly likely that consumers have brought forward their spending, flattering recent figures whilst positioning the economy for a sharp fall once the higher tax takes effect.

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Modest though it may seem, the increase in sales tax marks the beginning of the end of Abenomics.

This, you see, is the first time that Mr Abe has moved his foot from the throttle to the brake. It certainly won’t be the last retreat for a government which, having put its policy foot to the floor in pursuit of higher growth and improved trade, has found itself contemplating instead an evil brew of economic stagnation, debt escalation and widening trade deficits. Factor-in the diminishing ability (and, presumably, the decreasing willingness) of the Japanese public to fill the budget deficit and you have all the ingredients for a disaster.    

This should come as no surprise, of course, to anyone familiar with surplus energy economics. If you download the chart below, you will see that Japan’s real economy, already far adrift of a financial economy inflated by borrowing, is poised to slump alarmingly.

Essentially, this is game-over.

Basically, Japan has three critical problems:

       It is a major importer of energy at a time when the energy cost of energy (ECOE) is moving inexorably upwards.

       It entered this era with far too much debt.

    It has a government which thinks that you can borrow and print your way to prosperity.

Where Japan is concerned, the writing is already on the wall. For the rest of us, the impending collapse of an economy which still accounts for close to 6% of global GDP ought to concentrate minds wonderfully.

Japan & Global