#34. “A poisonous combination”


Six years on from the global financial crisis, is the economy returning to normality, or are we simply playing “extend and pretend”? Have we tackled the leverage dynamic that brought the financial system to the brink of collapse, or are we simply moving from one short-term fix to another, piling up ever more debt along the way? Have we really “got away with it”, or are we facing a second and perhaps worse meltdown? If the latter, where will it come from this time?

These are the questions that dominate – or most certainly should dominate – strategic thinking about where the economy is going. Readers familiar with my surplus energy economics analysis will know where I stand on this – the winding down of cheap energy availability has stripped the economy of growth, making our enormous debt exposure unsustainable, and meanwhile we’re playing “extend and pretend”.

What we really need here is objective data, and this is where an authoritative new report is so invaluable. Deleveraging? What Deleveraging? – number 16 in a series of Geneva Reports on the World Economy – reveals that global debt levels have continued to increase unchecked since the 2008 crisis, and that the much-vaunted process of deleveraging simply hasn’t happened at all.

The report supplies interesting data on indebtedness, dividing debt into two categories. The first is ex-financials, and comprises the debt of households, governments and businesses other than banks. The second category is total debt, and includes debt within the banking system. Both categories are important.

Globally, ex-financials debt rose from about 160% of world GDP in 2001 to almost 200% in 2008, with a big surge perceptible in the last three years of the period as the world manufactured its coming crisis. Since 2008, debt has carried on climbing, nearing 215% in 2013. So much for “deleveraging”.

Within this global trend, there has been a clear shift. Prior to 2008, most of the debt escalation was happening in the developed world, but now it is the developing world that is driving debt levels upwards.

China is a case in point. Since 2008, ex-financial debt – that is, the aggregate of households, businesses and government – has increased from 143% of GDP to 217%. This means that China has borrowed an average of 14% of GDP each year since 2008, something not dissimilar to Britain’s record under Gordon Brown between 2002 and 2008.

Moreover, charts of moving averages suggest that China’s economic growth is decelerating far more rapidly than is generally recognised. Other developing economies – including India, Russia, Brazil and Turkey – are in much the same predicament, albeit with lower debt ratios than China.

As part of something which the report calls “a poisonous combination”, the global capacity for growth is diminishing just as debt levels continue to escalate. Essentially, this means that “potential output” – basically a measure of future growth capability – is diminishing. This may reflect two things – first, that we have suffered permanent damage from the crisis, and, second, that high debt levels are undermining our ability to grow.

A reduced capability for growth means, of course, that our ability to carry debt is weakening just as debt itself is increasing.

The figures for all of this are stark, and the clear implication is that another crash is coming, the epicentre this time probably being the developing economies. Small wonder that central bankers are beginning to mutter about the over-extended valuations of global capital markets.

Of course, and as I have explained previously, over-inflated capital markets are themselves part of the “extend and pretend” game, because inflating capital markets has been a device for keeping yields (and therefore interest rates) low.

The Geneva 16 report should prompt us all to sit back and factor the following into our mental computers:

– continuing increases in debt

– clear deceleration in growth

– an ongoing deterioration in potential output

– a diminishing carrying capacity for debt

– the over-extension of capital markets as part of “extend and pretend”

You won’t need me to spell out for you how this must end.

15 thoughts on “#34. “A poisonous combination”

  1. Tim,

    Thanks for yet another enlightening article. For your info, the link in the article to the wider report needs the front ‘http://’ to be removed.


    • Dan

      Thank you – now corrected.

      Incidentally, the same source has an interesting report on “secular stagnation”, a title which, to me, sounds a lot like “life after growth”…..

    • This is ultra-tricky. In investment terms, the problem with holding, say, gilts or equities is that capital markets are over-valued. Property could be a bad idea for the same reason. Holding a lot of cash in a bank would obviously be risky, whilst govts might well tax deposits anyway, if desperate for revenue after a crash. There may be no sure-fire defences.

      What we can do is minimise risk. Farm land looks an ultra-safe investment, as wee always need food whatever happens. The only bank I would trust in “crisis part 2” would be HSBC, because bail-outs (and deposit protection) might not be possible next time.

      Essentials (a.k.a. counter-cyclicals) look better than discretionaries – in ordinary English this means companies which produce things we must have (like food) are a better bet than those producing things that we do not need but simply want (like gadgets). If you can diversify currencies (some people can), then buy USD and avoid GBP (because Britain’s exposure to crisis part 2 is extreme). Renewable energy capacity at home (i.e. solar panels) appeals to me. Gold could make sense, but only if you have the physical gold rather than simply a paper entitlement. Keep cash on hand (in a safe!) in case the system crashes (we were within hours of that in 2008).

  2. Meanwhile, back at the ranch, the real news (supposedly) is that a couple of RAF jets bombed a truck somewhere in the middle-east (Islamic State jihadists will be shuddering in their flip-flops). Is it just me, or has the British political class lost the plot? The matter of the moment is not, in fact, warfighting; it is the looming global economic meltdown and the truly dismal condition of the British economy vis-a-vis the deficit trajectory and, consequently, the national debt against a backdrop of the diminishing prospects of economic growth, still less sustainable economic growth. Apart from a few ‘underground’ sources of analysis and information such as that proffered by your website, Tim, we could be forgiven for thinking that it is, by and large, business-as-usual economically speaking. How wrong we would be … presumably like 90% or more of the population?

    • Indeed. With total debt close to 500% of GDP, a dreadful current account deficit and a system of govt no longer fit for purpose, we’re in the firing line if (or really ‘when’) crash #2 happens. Of course, we can’t know if there is any secret contingency planning, but I would doubt it. We only just coped in 2008, and govt cannot afford a second rescue of the banks. Even without crash #2, our sovereign creditworthiness will deteriorate unless we tackle the current account gap.

      Still, I suppose the powers that be can move a few deck-chairs….

  3. I agree with moraymint – but isn’t this true of “everything” we read or hear these days from establishment sources? That the looming crisis is totally ignored. As an example, I was reading a report recently, related to the future of robotics, with contributions by eminent people – http://www.pewinternet.org/files/2014/08/Future-of-AI-Robotics-and-Jobs.pdf

    Maybe those of us who agree with Tim’s model just have to put up with the fact that most of the rubbish we read is written by people whose mindsets have underlying vested interests, in the perpetuation of the conventional pre-2008 model.

    Our mindsets are so different that meaningful communication is impossible.

    We should adopt knowing smiles, rather than trying to change mindsets.

    • All political systems have inertia, and all countries have elites. But on both counts our situation is now pretty bad – inertia has become unpunished incompetence, and the country seems to be run not only BY but also FOR an elite.

      At a lesser scale (i.e. a sterling crisis caused by the current account), some kind of shock might even be desirable, if it shatters the complacency.

      But a crash #2 is different, because there may be no way back from that for a country with our combination of debt and ineptitude.

  4. Tim,

    It certainly seems that some sort of endgame might be approaching. The marginal productivity of debt has been declining in the developed world for some time now, and it seems that the developing countries are following the same trend. The Chinese housing market seems as likely a candidate as any other to tip things over, but frankly the oil price is doing funny things at the moment which might well lead to a future price shock. Hard to know where to look.

    Also, in addition to the advice you give in your post above about where to stick your money, might I suggest that it would also be an idea to perhaps try and put some food and means of accessing clean water aside, alongside perhaps a store of other useful hard goods if possible. A guy called David Korowicz published a study the other year on the potential for supply chain contagion in the event of a further financial system breakdown (http://www.feasta.org/2012/06/17/trade-off-financial-system-supply-chain-cross-contagion-a-study-in-global-systemic-collapse/) and it doesn’t make for pretty reading. I know that sounds a bit doomsday-prepperish, but I feel his arguments are solid enough to at least invest in an insurance policy of sorts should the worst come to pass, while such items remain abundant and cheap.

    • Indeed so. I try to avoid anything “survivalist”, though I can’t disagree with the logic. I would add that our economic system is designed to run at or near full capacity – if our trains, roads, aircraft, hotels etc etc had to run at only 80% of capacity, they would cease to be viable. So we are ill-equipped to handle any significant downturn.

      I see that Geneva 16 is being picked up elsewhere – business insider is the latest to report it and warn about it (see http://www.businessinsider.com/geneva-report-2014-2014-9).

      To me, this looks like the precursor to a crash. I would certainly take an ultra-conservative (small ‘c’) stance right now.

  5. Thanks Dr Morgan,
    I was reading this comment today from a supporter of Modern monetary economics which seemed to put in a nutshell the relaxed attitude of many senior economists and politicians to debt and the deficit. My own view is this is the ‘logic of pulling yourself up by your own bootstraps’. Have you any thoughts on this ?.

    ‘There far too much doom and gloom about the deficit.

    The way the economy works is really not that difficult to understand. Government creates money when it spends. When it taxes it destroys it. A surplus means it destroys more than it creates which is logically impossible except over a short time-scale.

    All money created by government must eventually come back to be destroyed after it is trapped in the government’s very efficient tax net. Where else can it go? It can be temporarily reprieved from its eventual fate if it is saved, either by ‘prudent’ individuals or companies, or in the central banks of the big exporting countries.

    Any politician wanting to “balance the books” needs to stop us saving or buying imports. To do that they need to make us all very poor. If that’s their plan they should tell us before the election , not afterwards’.

    • Kenneth: Thank you. Let me answer this with a short tale or two.

      At the time of the dot-com bubble I was an analyst in the City. The dot-com boom seemed, to me, the height of madness. But fans of the dot-coms told me my approach was out-dated. People like me, who wanted to see cash flows, assets and dividends, were living in the past. There was a “new paradigm” in which such mundane things no longer mattered. Well, we know how that turned out………

      I was a young analyst in the 80s. The logic then was that Japanese growth would never stop. Japan had cracked it. There was a “wall of liquidity” coming from Japan. There would never be a crash…..well, I was in NY when the ’87 crash happened….

      Then the ASEAN tigers were the new unstoppable force. Those of us who doubted it were old-world……

      …and so on. Well, what I’ve found in my experience is that there are certain basics to this. The investor puts money in to get more money back. The markets are about fear and greed and, when greed gets excessive, “this time is different”. It’s always “different this time”, except it never is.

      Modern monetary theory may have some insights, but I’m not sold on it. For instance, the argument that QE hasn’t created inflation (yet) is wrong because it overlooks ultra-low monetary velocity. The reality is that the Keynesian tools we’ve lived with for decades have ceased to function. Running huge fiscal deficits no longer stimulates the economy. Cutting interest rates isn’t an option either.

      Let me leave you with one thought. If real interest rates are negative – i.e. rates are lower than inflation – there is no point in saving. Without saving, the economy does not create capital. Negative real interest rates, then, are destructive. The only reason we have negative real rates is to bail out those with too much debt.

    • Thanks for your insights Dr Morgan, There does seem to be a strong ‘group-think’ type situation in which dissenting voices are not welcomed. How this can be overcome I do not know – perhaps it will take a second financial crash.

      Just a thought on negative real interest rates – without a yield on saved money doesn’t this make companies more likely to invest in new machinery etc. to generate future capital… so in this sense low interest rates are helpful…

  6. Just a thought on the banks and debt Dr Morgan – when the Uk banks are returned to the private sector this should reduce government debt considerably. Are the banks with the destruction of Browns old regulatory structure better able to withstand crash 2 ?. I understand they are required to hold larger capital reserves.

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