#66. The Ponzi economy, part 2

THE END OF LIVING-ON-TICK?

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.

 

 

 

13 thoughts on “#66. The Ponzi economy, part 2

  1. Thanks, Tim. It’s good to see all those figures! One question; Which debts are included in the studies? Is it the private debt [mortgages, credit cards other loans] or is the Government debt factored in as well? What about the net crediting done by the central bank into the economy and as well is the tax receipts deducted from that net credit? Are the off balance sheet derivatives markets excluded?
    Re the Government debt, it’s only a debt from the CB point of view. The same as your bank considerers your savings account as its debt/ CB Treasuries are not debts seen from outside the CB, but savings accounts. But these savings accounts are bank etc assets of the banks,which may have come from fiat loans[?]

    • The debt figures are aggregates from the BIS, as of mid-2015 unless otherwise stated, but I do make one adjustment.

      The national totals include government debt at market value – I adjust this using the BIS nominal values, which are the amount actually owed by the government, rather than the traded value of government bonds.

      The numbers exclude the interbank or “financial” sector, and I assume that derivatives are not included (there are separate datasets for those, I think).

      There have been some interesting comments of late that I couldn’t really work into the piece, but may interest you. William White, chairman of the OECD review committee and formerly chief economist at the BIS, has said that “It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something,” The Telegraph paraphrases his comments as warning of an “avalanche of bankruptcies that will test social and political stability”. My point exactly!

      Raghuram Rajan, head of the Indian central bank, has warned today that central banks “have distorted some [asset prices] to the extent that the markets are not sure of what pricing is”, going on to suggest that central banks might not intervene this time even if “prices plummet”.

  2. Hi Tim

    A very good and somewhat sobering analysis.

    When you say that there has always been an “excess claims” element in the financial economy is this because most debt was of the self liquidating type (true investment in that it was spending which is expected to benefit future periods) rather than the converse (pure consumption) which simply drags output from the future to the present?

    You could of course run a high debt economy for a period if you were investing in, say, new industries but at some point these will start to pay off by returning more output. Putting it another way you might say that there has been a deterioration in the capital (debt)/ output ratio due to the relatively higher level of non self liquidating borrowing.

    I remember the start of the “live now pay later” meme which was a purely domestic matter at the beginning but has now grown into the destructive monster you describe.

    • There has always been an anticipatory element, sometimes in investment which will pay off later, and within reasonable bounds – and, of course, this is less of a potential problem when growth is strong. And yes, there has been a shift from self-liquidating to consumption borrowing. That is parly a reflection of globalisation, where the West has exported previously well-paid jobs but has not reduced consumption accordingly.

      You are right, of course, about “live now pay later” – the psychology has changed (more in some countries than others), globalisation plays into this, and so does deregulation.

  3. HI Tim
    Yes it seems that the big problem post ponzi will be the lack of new debt, which Im guessing will mean commodity prices will struggle to lift sufficiently (or be propped up sufficiently) so that producers stay solvent, with big flow on effects. The crashing of capital values seems more of a “book” issue in comparison. Its seems to me this is a natural outcome of overshoot, where our living beyond our means has allowed too many people putting too much pressure on limited resources…The feedback loops in the system have been manipulated and we are about to pay the price. Thoughts?

    • Exactly – those accustomed to living-on-tick will no longer be able to do so.

      There are two distinct issues to oil, with knock-on effects to other commodities. Near-term, there is oversupply, and demand can’t grow much with the economy in the state it’s in. Longer term, however, the previous realities remain – new discoveries keep getting smaller, big fields keep depleting without replacement, and the economics of shale remain tied to rapid depletion rates. Plus, the current slump is slashing investment – projects deferred now total $400bn – and undermines the pricing of renewables.

      So this isn’t a new era of cheap energy – it’s something I’ve described previously here as “the oscillating trap”, a distinct cycle of high prices = weak economy = price slump = underinvestment = accelerated depletion = future price hike….

    • Hi Tim

      Wouldn’t the deferment of projects you mention together with a secular downtrend in supply potential lead to a very sharp “snap back” in prices should demand come back, the implication being that it might not require a huge recovery in demand for prices to rise substantially and very quickly?

  4. Hi Tim

    I was wondering if you could explain the reasons behind the collapse in energy prices? And how these may affect the global economy in the near future?

    • There are both cyclical and “other” factors involved, the latter meaning Iran. But the cyclical issue is critical.

      Prices had been high for a very long time, and were respected to remain so if Chinese growth carried on at its established rate. This attracted capital and investment into the industry, notably into high-cost projects that had not been developed when prices were lower. This high investment thus pushed production up. Then demand growth deteriorated, and so – just as importantly – did expectations for future demand growth. Add in a price war between Saudi and US shale producers, and the price crash became inevitable. In fact I was surprised it didn’t begin earlier.

      This will correct, indeed is likely to reverse – but not for some time yet. In many instances, capital costs are very high, but day-to-day operating costs are low. So producers prefer to keep on producing, even at a loss, rather than abandon a huge investment – the logic being that one day prices will recover.

      I don’t see a correction coming from strong demand growth, but other things are happening. US shale costs have been cut to the bone and big losses of production seem increasingly likely (even official forecasts are beginning to show this) – and shale wells deplete very rapidly, meaning a sharp decline when investment in drilling dries up, which happens when money is tight AND commitments have been met.

      In the rest of the “non-OPEC” world, output would normally decline by about 8% annually in the absence of new development – so with $400bn of development already slashed, we can expect output to fall – but not until the pipeline of “too late to cancel” projects dries up.

      So we can expect production to start falling once late-stage projects are completed and commitments have been met. This might mean 2017 rather than 2016.

      Meanwhile, the economics of renewables are rather different when oil is $30/b rather than $130/b…..

  5. Hello Tim

    In your previous post (#65 Ponzi part 1) you include a graph of projected real economic output up to 2030 for the world and several individual nations. From 2025 Germany is expected to buck the
    general trend and deliver increasing output . Could you explain this please – Germany is after all reliant on export volumes.

    • Though Germany benefits from exports, I wouldn’t say it is reliant on them.

      Second, Germany has a pretty well-balanced economy, and isn’t as hostage as others to debt-based industries like real estate and financial services.

      Third, much of Germany’s export success comes from having a cheapish euro rather than a premium-priced DM, so that doesn’t change (the benefit will still be there, even if it is smaller).

      Looking at my model, there are no outlandish forecasts for productivity etc, so it seems to be mainly a case of comparative efficiency.

  6. Tim, first off, thanks for the article and also for keeping the focus on the UK. I’ve been trying to think of something to say but I’m just stunned into silence by the figures.

    • You are very welcome. The current government isn’t achieving rebalancing – any growth still comes from eating out and flogging our houses to each other – but should be credited for at least recognising the imblance. Official forecasts keep predicting an improved current account, but they’ve been predicting this all along. Lower energy and food import prices will help, though maybe only temporarily.
      Meanwhile, I hope you enjoy reading my next piece – which I have rather enjoyed writing……

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