#66. The Ponzi economy, part 2


In the first part of this series, I explained, in outline, why the global economy resembles a giant Ponzi scheme. Here, I look at exposure to the unwinding of this unsustainable state of affairs.

The start of 2016 has witnessed sharp falls in equity markets around the world. It is much too early to say whether this marks the beginning of the end for Ponzi economics, so I must emphasise that the focus here is the fundamental issue of an economy built on passing off the spending of borrowed money as “growth”.

As there are two main dimensions to the global economic Ponzi, there are likely to be two main categories of economic impact when it implodes.

The first of these is the capital side, where two things have happened. We have created a debt mountain, much of which can never be repaid, and indeed can only be serviced thanks to extreme manipulation of the monetary system. At the same time, this borrowing binge has pushed up asset values (including equities, bonds and property) to extremely inflated levels

Pretty obviously, the collapse of “Ponzi economics” is likely to cause extensive defaults, combined with sharp falls in capital values.

This discussion looks at the second, perhaps less obvious consequence of the ending of the global economic Ponzi scheme. Logically, the ending of Ponzi economics may mean that those countries which are accustomed to living beyond their means may no longer be able to do so.

First, though, let’s recap, very briefly, on how the world economy has become a giant Ponzi scheme.

The Ponzi economy

As regular readers will know, I have long argued that we are living in a global economy that has mutated into a giant Ponzi scheme. Here, in brief, is why I believe this.

Between 2000 and 2007, global “real economy” debt (which excludes the inter-bank or “financial” sector) increased by $38 trillion, which equated to $2.20 of new debt for each $1 of reported “growth” in the economy.

In 2008, when the debt mountain brought the system close to collapse, the authorities worldwide responded with policies based on ultra-cheap money. Part of this strategy included the use of newly-created money to inflate capital markets, thereby driving down yields.

Between 2007 and 2014, and far from retrenching, the world borrowed a further $49 trillion which, at $2.90 for each “growth” dollar, was even worse than what had been happening before the crisis.

As the old saying has it, when you find you’re in a hole, you should stop digging. Where the global economy is concerned, however, this advice has been turned on its head.

Our response to finding ourselves in a hole has been to carry on digging – and the response of the authorities has been to hand out bigger shovels.

After excess borrowing created systemic risk, central banks responded by distorting monetary policy to support an over-indebted system. All along, we have routinely passed off the spending of borrowed money as “growth”, which in turn means that the growth-to-borrowing equation is, in reality, even worse than the numbers set out above.

Borrowing has become addictive, whilst speculation has extensively displaced investment and innovation as a way to make money.

After all, why would you bother to invest in starting a business – exposing yourself to risk, delay, uncertainty, regulation and taxation – when you could simply put money into assets and watch the authorities increase its value for you?

Meaningful downside – the end of living on tick

Pretty obviously, the Ponzi characteristics of the global economy imply a tendency to live beyond our means. I use two, essentially complementary methods of gauging the extent to which this is happening.

The first of these is the SEEDS system, a surplus energy economics tool which calculates underlying value created in the “real” economy of goods and services. The second is a “conventional” measure which compares economic growth with net changes in outstanding debt, to reveal the relationship between borrowing and growth.

To understand what is going on, it helps to distinguish between “two economies” – one of these is the “real economy” of goods and services, labour and resources, and the other is the “financial economy” of credit and debt. The gap between the two is the extent to which we are mortgaging the future. Since SEEDS categorises all money and credit as “claims” on the output of the real economy, the term “excess claims” is used to describe the gap between the “financial” and the “real” economies.

There has probably always been an “excess claims” element in the financial economy. It has become customary for us to live beyond our means to a limited extent, and there is nothing necessarily wrong with this anticipatory practice, so long as the excess is modest, which in turn means that “mortgaging the future” takes place at a level which is reasonable, and does not place an unrealistic burden on the economy of the future.

What has happened in recent years, however, has departed a long way from any definition of reasonable behaviour. In 2000 – but expressed at constant 2014 values – the financial economy exceeded the real one by almost $2 trillion, which meant that the world was “living beyond its means” to the tune of about 4% of global GDP. By 2008, and reflecting big growth in debt in the intervening years, this gap had widened, to $4.1 trillion, or 5.9% of GDP.

Far from retrenching in response to the banking crisis, the gap between the financial and the real economies has widened, according to SEEDS, to $5.9 trillion, which means that, in 2015, 7.8% of global GDP came from mortgaging the future. On current trends, this figure is set to reach 9.6% of GDP by 2020, and 11.8% by 2025, though the likelihood of the Ponzi economy surviving even until 2020 looks pretty remote.

The problem with this, of course, is not just that it is not sustainable, but also that the size of the “mortgage” taken out on the economic future keeps growing. Back in 2000, this accumulated “mortgage on the future” stood at $24 trillion, or 53% of global GDP. My estimate for the end of 2015 is $85 trillion, or 112% of GDP. Were the Ponzi economy to continue to 2020, the future would probably have been mortgaged to the tune of $120 trillion, or 150% of GDP.

Measuring impacts

Of course, within global totals, not every country lives beyond its means. Prior to the collapse in energy prices, major oil exporters (including the Gulf countries and Norway) were living within their means, something which was reflected in the Sovereign Wealth Funds (SWFs) that some of these countries had been able to accumulate.

Against this, some countries live beyond their means to an extent which far exceeds the global average.

One of the more striking examples of this is the United Kingdom. For 2014, the SEEDS system estimates the value of the UK real economy at £1.49 trillion, about £300bn smaller than reported GDP. This in turn implies that some 17% of British GDP is sourced from mortgaging the future.

Such numbers are not difficult to cross-reference to national data. In the British case, 2014 GDP was swelled by a near-£100bn current account deficit, which means that almost 6% of UK GDP in that year came courtesy of foreign creditors. A rather larger (£126bn) chunk of GDP resulted from a reporting component known as “imputed” rent – this may or may not be a legitimate way of measuring housing utility, but the important point is that it is a “non-cash” form of income. Most importantly, British borrowers took on an additional £107bn in debt during 2014, which exceeded the reported increase in nominal GDP.

The current government has tried to reduce the dependency on borrowing, but the structure of the economy remains biased towards activities financed by borrowing.

For many countries, borrowing at rates which far exceed reported growth has become a way of life (see table). Over the decade from 2004 to 2014, Britain borrowed £2.2 trillion for an increase in nominal GDP of £537bn, a borrowing-to-growth ratio of 4.0:1. The United States economy expanded by $5.1 trillion whereas debt increased by $19.7 trillion, a ratio of 3.9:1. The ratio for the Eurozone was 4.8:1, though this masked a range running from Germany’s 1.6:1 to Ireland’s double-digit ratio. The use of borrowing to create growth was markedly more modest in Russia (1.1:1), India (1.3:1), Brazil (1.6:1) and China (2.65:1).

66 Ponzi exposure 02

These ratios do not necessarily correspond to the downside that countries can anticipate after the Ponzi economy has crashed, but they are useful indicators. Countries which habitually live far beyond their means face a rude awakening when this ceases to be viable modus vivendi.

How exposed?

In order to indicate the downside that economies may face if living on credit ceases to be a viable practice, the next table sets out indicative data for selected countries. These are ranked by estimated proportionate exposure.

Against reported GDP for 2014 is set the SEEDS calculation of the size of the real economy. Since this calculation includes estimates of economic rent for energy consumed, it tends to be lower than GDP, except where countries are major energy exporters, in which case they may be “owed” economic rent by importers. It is also adjusted for current account deficits or surpluses.

Taking France simply as an example, the difference between GDP (€2.13 trillion) and the real economy (€1.88 trillion) is €248bn. Of this, €20bn is the current account deficit, and the remaining €229bn is the estimated economic rent on energy consumed. The implied adjustment from the financial economy to the real economy is thus 12% of GDP.

For further comparison – and to reassure anyone who does not want to place undue reliance on SEEDS estimates of the underlying real economy – the table also includes the current account balance, and the relationship between growth and borrowing. Thus, foreign creditors contributed €20bn to French GDP in 2014, whilst nominal growth (of €16bn) was far exceeded by net new borrowing (€216bn).

The assumption being measured here is that the collapse of Ponzi economics means that it ceases to be feasible for countries to run a current account deficit, or to go on borrowing, either from abroad or with internally-created credit. On this basis, the French economy would shrink by 12% in a post-Ponzi environment.

66 Ponzi exposure 01

As the table shows, Britain and Japan face the biggest potential downside amongst the economies listed here. In neither case is this altogether surprising. The UK runs a very large current account deficit, and has been a big net seller of assets, as well as a big borrower, over a lengthy period. Though the fiscal deficit is shrinking, official projections are predicated on an offsetting increase in private borrowing, and show widening deficits in the household sector.

The Japanese authorities, meanwhile, have opted for policies of exchange rate depreciation and huge QE in what might be regarded as a rather desperate attempt to escape from more than twenty years of economic stagnation.

It must be stressed that these estimates are indicative only, and that countries might well continue with internal debt creation in a post-Ponzi environment. Of course, these calculations are based on on-going wealth generation, not balance sheets, so do not include vulnerability to default.

This focus on income is intentional – heavily indebted countries might need to move into some form of default, but the really big and immediate problem likely to be posed by the implosion of Ponzi economics is the ending of an ability to run the economy on incremental credit.

In a post-Ponzi situation, pleasing creditors (by keeping to debt repayment schedules) is likely to be a much smaller and far less pressing challenge than living within straitened consumption, slumping investment, sharply reduced tax revenues and an inability to go on adding yet more debt. Sharp falls in capital markets, and especially in property prices, are also likely to have a severe chilling effect, especially in countries where price-to-earnings multiples are most extreme.

The conclusion, then, is that countries which have habitually run their economies on the basis of passing off borrowing as “growth” could be in for a rude awakening when the global economic Ponzi implodes.

How many governments, businesses or, indeed, individuals are aware of this risk is an interesting matter for conjecture.




#65. The Ponzi economy, part 1


It has become customary, as each New Year begins, for analysts and commentators to rush into print with forecasts of what they think is going to happen in the coming twelve months.

In wishing you all the very best for 2016, I have no intention of conforming to this pattern. Instead, I plan to investigate the structure of a global economy which has become addicted to borrowing.

In any case, where the economy is concerned, I do not claim to know when things are going to happen. After all – to quote Keynes – “markets can remain irrational longer than you can remain solvent”.

But I do think we know what has to happen, even if the timing is uncertain.

At some point, a global economy which has turned into a giant Ponzi scheme has to implode.

The Ponzi economy

That the world has turned its economy into a gigantic Ponzi scheme is surely beyond doubt. There seems no other way to describe a system that, as well as being massively indebted, can only function by adding yet more debt. The big problem isn’t so much the debt mountain itself as the inability to function without an uninterrupted diet of new credit.

During 2000-07, and excluding the purely inter-bank or “financial” sector, the world took on $38 trillion of new “real economy” debt, meaning that $2.20 had been borrowed for each $1 of reported “growth”. Since then, and despite a banking crisis which ought surely to have caused at least a pause for thought, we have borrowed $49 trillion, or $2.90 for each “growth” dollar.

Even these ratios, scary though they are, flatter to deceive, because the “growth” denominator is itself phoney. Such “growth” as has been reported has really amounted, of course, to nothing more than the spending of borrowed money.

What is striking is quite how inefficient and wasteful this is, and the waste is easy to see if you look at the main “borrow-to-grow” culprits.

Not all borrowing is wasteful, and a rational observer might have thought that the world’s biggest borrowers would at least have something to show for their borrowing binge. This new debt might have been invested in productive capacity or infrastructure, for example, or it might have been spent in pursuit of greater equality, or the improvement of social conditions.

In reality, the vast majority of this new debt has, instead, been wasted. The biggest borrower of recent years – China – has lavished borrowed money on capacity that nobody needs, whilst the Americans and the British, amongst many others, have poured money into inflating their property markets, and boosting consumption beyond what they can really afford.

As the old English song reminds us, “the Grand Old Duke of York” marched his 10,000 men up to the top of a hill, only to march them down again. This was a comparatively innocuous piece of futility – so far as we know, none of his men came to any harm, and the physical exercise may even have done them some good.

What the Duke’s modern successors have done, by contrast, has more in common with Humpty Dumpty – they have marched their economic troops up to a precipice from which the only way down is to fall.

The debt addicts’ club – open to all

In order to set the Ponzi economy into some context, let’s put some figures on it. In the United States, total “real economy” debt (which excludes inter-bank borrowing) increased by $19.4 trillion – in real, inflation-adjusted terms – between 2000 and 2014, whilst real GDP expanded by only $3.7 trillion. Britain, meanwhile, added £1.9 trillion of new debt for less than £400bn on “growth” over the same period.

I spent part of the holiday period unearthing quite how much debt countries added for each dollar of “growth” over a period starting at the end of 2000 and ending in mid-2015. Unsurprisingly, the league is topped by Portugal ($5.65 for each $1 of growth), Ireland ($5.42) and Greece ($5.39). Britain’s ratio ($3.46) is somewhat flattering, in that the UK has used asset sales as well as borrowing to sustain its consumption. The average for the Eurozone ($3.54) covers ratios as diverse as Germany (just $1.87) and France ($4.22). China’s $2.56 looks unexceptional until you note that the more recent (post-2007) number is much worse. Economies which seem to have been growing without too much borrowing (such as Brazil and Russia) are now experiencing dramatic worsening in their ratios, generally in the wake of tumbling commodity prices.

In the proverbial nutshell, then, the world has become addicted to borrowing money, spending it, and passing this off as “growth”. This is a copybook example of a pyramid scheme, which in turn means that the world’s most influential economic mentor is neither Keynes nor Hayek, but Charles Ponzi.

The descent into irrational economics

The stages in which this madness has developed are instructive in themselves. In the 1990s, when growth was quite robust, the main formative influences were ultra-cheap energy, technological innovation and the opening up of the former Soviet economies. From 2000 to 2007, a deceleration in underlying growth was masked by escalating indebtedness, with countries like America, Britain, Ireland, Greece and many others blatantly using borrowed money to boost consumption.

By 2008, debt had become so excessive that the world economy ground to a halt. This was when, on any rational analysis, deleveraging was required. However, and far from retrenching, the world adopted cheap money policies instead, most notably by using money created out of the ether to inflate capital markets and thus manipulate yields (the market cost of borrowing) down to artificially low levels.

Clearly, there are two main aspects to this collective madness. The first of these is a deterioration in underlying (that is, non-borrowed) economic expansion, whilst the second is a propensity to try to rig the growth equation by borrowing.

We have pondered the lack-of-growth issue here before, and the main factors in the deterioration seem to have been higher energy and commodity prices, and a growing preference for speculative rather than earned gain.

On the former, expansion in the emerging economies – and Western economic consumption increasingly funded by debt – created big rises in commodity demand, which in turn drove the prices of energy, minerals and food sharply higher.

As for the latter, why bother with the effort and risk of investing and innovating when, with the full encouragement of the government, you could make money effortlessly, and seemingly without risk, just by making leveraged bets on property and other asset markets?

To put it another way, it would be illogical to expect innovation-based growth in a system which instead promotes the speculative.

Where borrowing is concerned, several causal factors can be identified. One of these is globalisation. Let me be clear that there is nothing wrong in principle in transferring production from costly, increasingly-inefficient Western countries to more innovative and cost-effective locations in the emerging world.

What was gravely mistaken, however, was trying to reduce production in the mature economies whilst maintaining, or even increasing, those same countries’ consumption. The big corporates that drove globalisation wanted the inherent contradiction of low-paid workers who are also big-spending consumers, a paradox that Henry Ford, for one, knew to be nonsense.

In an effort to tackle the disconnect between poorly-paid workers and big-spending consumers, a resort to debt became inevitable, at least in the absence of far-sighted restraint exercised by the authorities. This process began with the recycling of emerging economies’ surpluses into the pockets of Western consumers, something which was promoted not only by a profit-hungry banking system but also by policymakers whose creed of “light-touch” regulation blinded them to the implications of basing growing consumption on ever-increasing debt.

By the time of the banking crisis, the practice of borrowing-to-consume – in macroeconomic terms, passing off the spending of borrowed money as “growth” – had become not just habitual but addictive. Such was the scale of global debt in 2008 that cutting the cost of borrowing became the only way of staving off mass default. Of course, making borrowing ever cheaper might be intended to keep already-overstretched debtors afloat, but it also makes further borrowing virtually inevitable.

No way down?

In short, Ponzi economics has taken on a momentum of its own, and today’s economic troops keep marching up the debt hill because, unlike the Grand Old Duke, no-one knows how to march them back down again.

The world’s capital markets mirror a global economy in which debt is enormous and real growth is in very short supply. The market value of capital assets looks inflated on any rational analysis which equates the value of an asset to the stream of income to be expected from that asset over time.

The global economic problem is analogous to the old lady who lives in a big house but has very little money coming in. Like her, the global economy is “asset-rich, income-poor”. The old lady could, of course, sell her large property, but this option is not open to a global economic system whose assets can only be sold to their existing owners.

Property markets are a classic instance of this problem. If you multiply the average price of a nation’s properties by the number of those properties, you can come up with a very impressive asset value for the housing stock as a whole. The snag, of course, is that the only people to whom this housing stock could be sold are the people who already own it.

This makes the supposed aggregate “value” of the housing stock purely notional or, to be more blunt about it, all but non-existent.

Obvious though this is, it has not prevented many countries and many millions of people from believing themselves to be wealthy when this is simply not the case.

Britain is a good – by which, of course, I mean a bad – example of this delusion. Property prices have escalated, which can make a theoretical national balance sheet (and the balance sheets of individual households) look comfortingly impressive. Take away the purely notional and unrealisable value of the housing stock, however, and you arrive at a situation in which most of the asset side of the equation does has no saleable value, whilst the debts and other liabilities are all too real.

I use Britain as an example of this situation because the illusion of prosperity founded on inflated, unrealisable asset values masks a very hazardous reality, in which debts are enormous, reported output numbers flatter to deceive, the structure of the economy is seriously unbalanced, and a dependency on sustaining consumption by selling assets and borrowing from abroad is not sustainable within any realistic definition of that term.

But the UK is simply a microcosm of a much broader economic problem. Periodic wobbles in global capital markets are an inevitable symptom of a situation in which asset values are inflated whilst, at the same time, the global economy’s only real engine of growth – China – has certainly decelerated, even if it has not come off the rails altogether.

A bang, not a whimper

How, in the absence of growth, can inflated capital values be sustained? The answer, of course, is that they can’t. Like all Ponzi schemes, this ends with a bang, not a whimper.

This is why I find forecasts of a ‘big fall’ or ‘sharp correction’ in markets hard to swallow. Ponzi schemes don’t end gradually, any more than someone can fall off a cliff gradually, or be “slightly pregnant”. The Ponzi economy simply continues for as long as irrationality prevails, and then implodes.

Capital markets, though, are the symptom, not the cause. The fundamental problem is an inability to escape from an addictive practice of manufacturing supposed “growth” on the basis of borrowed money.

The authorities – like the much-maligned Duke – might find a way of marching the economy back down the hill.

But such rational retreats are rarely, if ever, how Ponzi schemes end