#106: Crisis – a forum

IDENTIFYING FORWARD RISK

The previous article suggested that money, rather than banks, might be in the eye of the next storm. That discussion produced a great deal of comment, and many questions and predictions. Here, and perhaps in society more generally, there does seem to be a widespread feeling that some kind of crisis looms, though opinions differ widely on what kind of crisis this might be.

The aim of this article is to invite discussion on what kind of crisis event we might face – always supposing that there is a crisis, of course. Naturally, the focus here will be on economics, finance and energy, but readers are welcome to drive the conversation in different directions. National and global politics, social unrest and climate change are amongst the more obvious areas in which a crisis might happen.

What follows here isn’t – and cannot be – a comprehensive assessment of crisis risk. Rather, it is simply “a canter over the ground”. It is a sketch, intended as a framework for discussion.

Background

It seems clear that, in or around 2000, organic growth in the world economy began to peter out. The explanation favoured here is that this was caused by increases in the trend energy cost of energy (ECoE). An alternative (or complementary) thesis might be that globalization, which began by giving Western consumers cheaper goods and services, then started to undermine their wages.

Whatever the cause, an increasing recourse was made to credit in order to sustain living standards. Between 2000 and 2007, when global GDP (at 2016 prices) expanded by $25 trillion, debt increased by $52tn. This meant that, worldwide, $2.08 of debt was added for each $1 of growth, though ratios were a lot worse than this in the developed economies of the West. This process was facilitated by financial deregulation, which also contributed to the increase and dispersal of risk.

As a result of escalating debt and diffuse risk, confidence in banks wavered during the “credit crunch” of 2007 and, briefly, collapsed altogether in 2008. This triggered the global financial crisis (GFC), which was only resolved (temporarily, anyway) when governments intervened to prevent the collapse of the banking system.

A critical policy since 2008 has been ZIRP (zero interest rate policy), implemented both by lowering policy rates and by using QE to drive bond prices up, and yields down.

Partly in response to the policy of ultra-cheap money, debt has continued to escalate, and the rate at which we borrow has accelerated markedly. Comparing 2016 with 2007, debt has increased by a further $89tn, or $3.62 for each $1 of the $25tn of growth recorded since then.

In contrast to the pre-2008 period, debt escalation is no longer solely a Western phenomenon. Emerging market economies (EMEs), most obviously China, are now piling on debt, though a few (including India) have not been sucked into the debt treadmill.

Financial risk

Given the accelerated pace of debt creation, it is tempting to suppose that ultra-cheap money has raised the spectre of a repeat of the banking crisis. This may indeed be the case. Banks’ reserve ratios have been increased, but not by very much – and, because banks are in the business of lending long but borrowing short, there is no level of reserves which guarantees safety in the face of a bank run triggered by a loss of confidence.

But monetary adventurism also carries risks specific to itself. This is necessarily the case when the stock of money expands much more rapidly than underlying economic activity. This policy has boosted asset prices (including bonds, stocks and property), whilst depressing returns. Essentially, there exists a clear risk that trust in one or more currencies may have been put at risk by reckless monetary policies.

We should never forget that the viability of fiat currencies, just like the solvency of banks, rests entirely on confidence.

The crushing of returns has created huge shortfalls in the provision for pensions. A recent study of just eight countries identified pension shortfalls of $67tn, which are rising at $28bn per day, and are set to reach $428tn (at constant values) by 2050.

SEEDS analysis suggests that the global pension shortfall today might be of the order of $114tn, and could reach $177tn by 2026. By the latter date, global debt could have reached $390tn, compared with $259tn today.

Additionally, and not included in the debt aggregates, inter-bank or “financial” sector debt is a lot higher now ($109n) than it was in 2007 ($72tn, at 2016 values), and might reach $181tn by 2026. This debt component is often excluded from “real economy debt” aggregates, probably because of the assumption that it would net off to zero if each bank paid what it owed. This ceases to be the case, though, if significant banks fail.

In total, then, over the coming decade we could expect aggregate forward liabilities to increase by perhaps $260tn. This number comprises about $130tn of additional debt, an increase of around $70tn in financial debt, and at least $60tn in incremental pension deficits.  Against this, GDP might grow by perhaps $46tn.

For each dollar of that growth, then, we can anticipate:

• new debt of about $2.80
• incremental financial debt of $1.60; and
• additional pension shortfalls of $1.35.

These ratios are, of course, completely unsustainable. Given current tendencies towards acceleration, they might also prove to be unduly conservative projections.

Finally, where financial risk is concerned, it is necessary to dismiss the false comfort that is sometimes derived from an escalation in the theoretical value of assets such as stocks, bonds, property and – even – cash.

Taking property as an example, establishing the gross value of a nation’s housing stock by multiplying up from marginal transactions is entirely misleading. In practice, the only people to whom the housing stock can be sold are the same people to whom it already belongs.

This means that this stock cannot be monetized – and any attempt to convert even a modest proportion of the stock into cash would cause prices to collapse.

The same applies to stocks and bonds.

Even cash holdings are of limited relevance. Unless we postulate that cash is held by the same people who are in debt – or that the holders of cash would be willing to donate it to those in debt – cash cannot be netted off against debt.

Economic risk

Given the scale of financial risk outlined above, it might seem inevitable that a financial shock would have economic consequences. This is indeed the case. Although, in the aggregate, the values of stocks, bonds and property are meaningless, sharp changes in asset prices undoubtedly affect, for good or ill, the willingness of consumers to spend (the “wealth effect”).

Moreover, financial shocks also depress the velocity of money, meaning how long each dollar, euro or pound is held by the consumer before it spent.

But, quite aside from damage that might be inflicted by a financial shock, there are fundamental factors, too, which might drive economic output downwards.

The most important of these is underlying weakness. Since 2008 – and as we have seen – growth of $25tn has come at a cost of $89tn in net new borrowing. This raises the legitimate suspicion that much of the “growth” recorded in recent years has in fact amounted to nothing more than the simple spending of borrowed money.

Data for 2016 illustrates this issue. At constant prices, global GDP increased by $3.9tn, or 3.4%. But debt increased by $12.6tn during the year. Even if, say, only 20% of that new debt was used for consumption, then $2.5tn of the $3.9tn of “growth” was funded by borrowing. Logically, therefore, if – for any reason – consumers had been unable (or simply unwilling) to borrow in order to spend, then growth would have been only $1.38tn, or just 1.2%.

This problem is compounded by the fact that “borrowing to spend” didn’t start last year – SEEDS analysis of the GDP and debt data suggests that this phenomenon has been in place since at least 2000. So, if we ceased to take on additional debt for consumption, it wouldn’t be just the 2016 increment to growth that would be lost.

A counter-argument, of course, might be that activity is activity, irrespective of how it is funded. But consideration surely reveals that this isn’t the case. For a start, as – and it really is as, not “if” – people become aware, not just of how much debt they have, but of quite how precarious their old age is likely to be, we can expect them to become a great deal less willing to spend borrowed money.

The structure of the economy underpins this observation. Consumer spending, which in Western countries typically accounts for between 60% and 70% of GDP, divides into two broad categories. The first are things we must have, which are essential or “non-discretionary” purchases. These remain a minority share of the economy, though their share is increasing.

The other, larger category are “discretionaries”, which are things that we want, but don’t need.

In hard times, consumers are able to scale back on these discretionary purchases. People must eat, but they needn’t go to restaurants to do so. They need transport, but they needn’t replace their cars as often as they do now. They might want to move to a larger house, but they can choose to stay where they are. A British holidaymaker might choose Margate instead of Monaco. In short, the structure of the modern economy permits a great deal of retrenchment on discretionary purchases.

A reluctance to go further into debt, combined with misgivings about retirement, are not the only reasons why discretionary spending is capable of shrinking. Another is an increase in the cost of non-discretionary, essential purchases. Ever since 2000, the cost of essentials has tended to rise a lot more rapidly either than wages or general inflation. One reason for this is the rising real cost of energy, to which many essentials are extensively leveraged.

Taken together, a rising cost of essentials plus a reluctance (or an inability) to go on borrowing could exert very serious downwards pressure on demand. In some of the weaker economies, there are already clear signs that non-discretionary spending may be decreasing.

Energy risk

Quite apart from finance and structural weaknesses in the economy, energy is an area in which crisis is perfectly possible. This isn’t a matter of “running out of” any particular form of energy. Rather, it’s a matter of cost. This cost needs to be measured, not in money – which we can always create – but in terms of energy.

Whenever energy is accessed, some of that energy is consumed in the access process. This cost is described in Surplus Energy Economics as ECoE (the energy cost of energy).

What matters here is the trend, which is determined by the interaction of depletion and technology. Depletion reflects the way in which the lowest-cost resources are accessed first, leaving higher-cost sources until the cheaper ones have been exhausted. Technology can counter the process of depletion, but cannot overcome it, because technology operates within the envelope of what is physically possible within the resource context.

ECoE is not a “cost” in the conventional sense of ‘money going out’, because the global economy is a closed system. Rather, it is an economic rent – put simply, the more resources we are forced to spend on energy, the less we have to spend on other things.

This economic rent, incidentally, is why Surplus Energy Economics concentrates, not on incomes, but on the more fundamental issue of prosperity. This is defined as how much discretionary spending capacity we have. Even a seemingly-massive income doesn’t make someone prosperous, if all of it has to be spent on essentials.

The long-term trend in ECoE is almost wholly unrelated to market prices at any given time. These prices are cyclical, and are driven primarily by investment cycles. After 2000, high prices led to very large investment in capacity. Since 2014, the capacity created by this investment has resulted in over-supply. This over-supply will, in due course, be eroded by a combination of depletion and under-investment.

But the trend in ECoEs remains emphatically upwards. Furthermore, this upwards trend is exponential. A doubling of ECoE from, say, 1% to 2% doesn’t have much of an impact. Doubling ECoE from 7% to 14% is a very much more serious matter.

According to SEEDS, global trend ECoE doubled between 1980 and 1998, rising from 1.8% to 3.5%. It doubled again between 1998 and 2015, but this time to 7%, which is much more serious. By 2026, global ECoE is likely to rise to 10.5%. Well before this date, the effects of this economic rent are likely to force themselves on our attention. The numbers are already much worse in most developed economies than they are at a global average level.

There is a widespread assumption that society can transition pretty smoothly and painlessly from carbon-based to renewable energy sources. This assumption is almost certainly over-sanguine. The share of global consumption provided by renewables will undoubtedly continue to rise, but currently stands at barely 3%. The impact of renewables can be exaggerated by reference to capacities rather than actual output. Petroleum alone still accounts for 97% of all energy used for transport.

Scenarios

Thus far, we’ve looked at three broad categories of risk – finance, the economy and energy – but this by no means exhausts even reasonably plausible risk.

These three problems themselves could bring others in their wake. Downwards pressure on living standards could create political change or social unrest at the national level. Resource competition could heighten geopolitical conflict, particularly if diminishing prosperity has helped put extremists in power.

Current inequalities of income and wealth, tolerable when most people are getting better off, may quickly become politically toxic if general prosperity deteriorates. Migration flows seem likely to increase as prosperity weakens, and this may in turn prompt discontent and unrest in the migrants’ destination countries.

On top of these risks, there is the issue of climate change. We do not need to predicate any kind of environmental disaster to see how the economic rent of climate-dictated restrictions to human activities are piled on top of the increasing economic rent created by rising trend ECoEs.

To conclude, it’s reasonable to mention, in outline, just some scenarios in the economic and financial sphere.

One, of course, is a re-run of the banking crisis.

Another is the collapse of one or more major currencies. In this event, the affected countries would have little option but to default on foreign loans, increasing stresses on other currency areas in a rolling “domino effect”.

Both of these are reasonably likely events. So too, are political radicalism and social unrest, both of which have strong correlations with precisely the situation we have now.

That situation blends resource stresses with diminishing prosperity, severe inequality, over-extended credit, and monetary recklessness.

Historically, even one or two of these characteristics has been enough to trigger a crisis.

 

#105: Anticipating the next crash

THIS TIME IT COULD BE MONEY – NOT BANKS

Because the global financial crisis (GFC) was caused by a collapse of trust in banks, it can be all too easy to assume that the next crash, if there is one, must take the same form.

In fact, it’s more likely to be different. Whilst the idiocy-of choice before 2008 had been irresponsible lending, by far the most dangerous recklessness today is monetary adventurism.

So it’s faith in money, rather than in banks, that could trigger the next crisis.

Introduction – mistaken confidence

Whenever we live through a traumatic event, such as the GFC of 2008, the authorities ‘close the stable door after the horse has bolted’. They put in place measures that might have countered the previous crisis, if only they had they known its nature in advance.

The reason why such measures so often fail to prevent another crash is simple – the next crisis is never the same as the last one.

That’s where we are now. We might be slightly better-placed to combat a GFC-style event today than we were back in 2008, though even that is doubtful. But we are dangerously ill-prepared for what is actually likely to happen.

Put at its simplest, the GFC resulted from the reckless accumulation of debt over the previous 8-10 years. Debt creation has continued – indeed, accelerated – since 2008, but the new form of recklessness has been monetary adventurism.

So it’s likely to be money, not debt, which brings the house down this time. Where 2008 was triggered by a collapse of faith in banks, a loss of faith in currencies could be the trigger for the next crisis.

And, judging by their actions, the authorities seem not to have spotted this risk at all.

Unfinished business?

Where the likelihood of a sequel to 2008 is concerned, opinion divides into two camps.

Some of us are convinced that the GFC is unfinished business – and that another crisis has been made more likely by the responses adopted back then. That we’re in a minority shouldn’t worry us because, after all, change happens when the majority (‘consensus’) view turns out to be wrong.

Others, probably the majority, believe that normality has now been restored.

But this is view, frankly, is illogical. To believe that what we have now is “normality”, you would have to accept each of these propositions as true.

1. Current monetary conditions, with interest rates that are negative (lower than inflation), are “normal”

2. It is “normal” for people to be punished for saving, but rewarded for borrowing

3. It is also “normal” for debt to be growing even more rapidly now than it did before 2008

4. Buying $1 of “growth” with $3 or more of borrowing is “normal”

5. QE – the creation of vast sums of new money out of thin air – is also “normal”

6. Vastly inflated asset values, and extremely depressed incomes, are “normal”

7. Policies which hand money to the already-wealthy, at the expense of everyone else, are another aspect of “normal”

8. It is quite “normal” for us to have destroyed the ability to save for pensions, or for any other purpose.

To be sure, Lewis Carroll’s White Queen famously managed to believe “six impossible things before breakfast”, but even she would have struggled to swallow this lot with her croissants and coffee.

When we consider, also, the continued stumbling global economy – which, nearly a decade after the crisis, remains nowhere near “escape velocity” – the case for expecting a second crash becomes pretty compelling.

But this does not mean that we should expect a re-run of 2008 in the same form.

Rather, everything suggests that the sequel to 2008 will be a different kind of crisis. The markets won’t be frightened by something familiar, but will be panicked by something new.

This means that we should expect a form of crisis that hasn’t been anticipated, and hasn’t been prepared for.

2008 – a loss of trust in banks

We need to be clear that the GFC had two real causes, both traceable in the last analysis to reckless deregulation.

First, debt had escalated to unsustainable levels.

Second, risk had proliferated, and been allowed to disperse in ways that were not well understood.

Of these, it was the risk factor which really triggered the crash, because nobody knew which banks and other financial institutions were safe, and which weren’t. This put the financial system into the lock-down known as “the credit crunch”, which was the immediate precursor to the crash.

Ultimately, this was all about a loss of trust. Even a perfectly sound bank can collapse, if trust is lost. Because banks are in the business of borrowing short and lending long, there is no way that they can call in loans if depositors are panicked into pulling their money out.

This also means – and please be in no doubt about this – that there is no amount of reserves which can prevent a bank collapse.

So – and despite claims to the contrary – a 2008-style banking crisis certainly could take place again, even though reserve ratios have been strengthened. This time, though, banks are likely to be in the second wave of a crash, not in the front line.

Coming next – a loss of trust in money?

The broader lesson to be learned from the financial crisis is that absolute dependency on faith is by no means unique to banks.

Trust is a defining characteristic of the entire financial system – and is particularly true of currencies.

Modern money, not backed by gold or other tangible assets, is particularly vulnerable to any loss of trust. The value of fiat money depends entirely on the “full faith and credit” of its sponsoring government. If that faith and creditworthiness are ever called into serious question, the ensuing panic can literally destroy the value of the currency. It’s happened very often in the past, and can certainly happen again.

Loss of faith in a currency can happen in many ways. It can happen if the state, or its economy, become perceived as non-viable. In fact, though, this isn’t the most common reason for currency collapse. Rather, any state can imperil the trustworthiness of its currency if it behaves irresponsibly.

Again, we can’t afford to be vague about this. Currency collapse, resulting from a haemorrhaging of faith, is always a consequence of reckless monetary policy. Wherever there is policy irresponsibility, a currency can be expected to collapse.

In instances such as Weimar Germany and modern-day Zimbabwe, the creation of too much money was “route one” to the destruction of the trust. But this isn’t the only way in which faith in a currency can be destroyed. Another trust-destroying practice is the monetizing of debt, which means creating money to “pay” government deficits.

So the general point is that the viability of a currency can be jeopardized by any form of monetary irresponsibility. The scale of risk is in direct proportion to the extent of that irresponsibility.

The disturbing and inescapable reality today is that the authorities, over an extended period, have engaged in unprecedented monetary adventurism. As well as slashing interest rates to levels that are literally without precedent, they have engaged in money creation on a scale that would have frightened earlier generations of central bankers out of their wits.

Let’s be crystal clear about something else, too. Anyone who asserts that this adventurism isn’t attended by an escalation in risk is living in a fantasy world of “this time is different”.

Here is a common factor linking 2008 and 2017. In the years before the GFC, reckless deregulation created dangerous debt excesses. Since then, recklessness has extended from regulation into monetary policy itself. Now, as then, irresponsible behaviour has been the common factor.

A big difference between then and now, though, lies in the scope for recovery. In 2008, the banks could be rescued, because trust in money remained. This meant that governments could rescue banks by pumping in money. There exist few, if any, conceivable responses that could counter a haemorrhage of faith in money.

Obviously, you can’t rescue a discredited currency by creating more of it.

If a single currency loses trust, another country or bloc might just bail it out. But even this is pretty unlikely, because of both sheer scale, and contagion risk.

So there is no possible escape route from a systemic loss of trust in fiat money. In that situation, the only response would be to introduce wholly new currencies which start out with a clean bill of health.

An exercise in folly

To understand the current risk, we need to know how we got here. Essentially, we are where we are because of how the authorities responded to the GFC.

In 2008, the immediate threat facing the financial system wasn’t the sheer impossibility of ever repaying the debt mountain created in previous years. Most debt doesn’t have to be repaid immediately, and can often be replaced or rolled-over.

Rather, the “clear and present danger” back then was an inability to keep up interest payments on that debt. Because the spending of borrowed money had given an artificial boost to apparent economic activity, there was widespread complacency about how much debt we could actually afford to service. When the crash unmasked the weakness of borrowers, it became glaringly apparent that the debt mountain simply couldn’t be serviced at a ‘normal’ rate of interest (with ‘normal’, for our purposes, meaning rates in the range 4-6%).

The obvious response was to circumvent this debt service problem by slashing rates. Cutting policy rates was a relatively straightforward, administrative exercise for central bankers. But prevailing rates aren’t determined by policy alone, because markets have a very big say in rate-setting. This, ultimately, was why QE (quantitative easing) was implemented. QE enabled central banks to drive down bond yields, by using gigantic buying power to push up the prices of bonds.

Beyond the mistaken assurance that QE wasn’t the same as “printing money” – so wouldn’t drive inflation up – little or no thought seems to have been devoted to the medium- or longer-term consequences of monetary adventurism.

In essence, ZIRP (zero interest rate policy) was a medicine employed to rescue a patient in immediate danger. Even when responding to a crisis, however, the wise physician is cognisant of two drug risks – side-effects, and addiction.

The financial physicians considered neither of these risks in their panic response to 2008. The result is that today we have addiction to cheap money, and we are suffering some economic side-effects that are very nasty indeed.

The inflation delusion

Even the assurance about inflation was misleading, because increasing the quantity of money without simultaneously increasing the supply of goods and services must create inflation. This is a mathematical certainty.

Rather, the only question is where the inflation is going to turn up.

As has been well explained elsewhere, handing new money to everyone would drive up general inflation. Giving all of it to little girls, on the other hand, would drive up the price of Barbie dolls. Since QE handed money to capital markets, its effect was to drive up the price of assets.

That much was predictable. Unfortunately, though, when policymakers think about inflation, they usually think only in terms of high street prices. When, for example, the Bank of England was given a degree of independence in 1997, its remit was framed wholly in CPI terms, as though the concept of asset inflation hadn’t occurred to anyone.

This is a dangerous blind-spot. The reality is that asset inflation is every bit as ‘real’ as high street inflation – and can be every bit as harmful.

Massive damage

In itself, though, inflation (asset or otherwise) is neither the only nor the worst consequence of extreme monetary recklessness. Taken overall, shifting the basis of the entire economy onto ultra-cheap money must be one of the most damaging policies ever adopted.

Indeed, it is harmful enough to make Soviet collectivism look almost rational.

The essence of a cheap money is policy is to transform the relationship between assets and incomes through the brute force of monetary manipulation.

Like communism before it, this manipulation seeks to over-rule market forces which, in a sane world, would be allowed to determine this relationship.

By manipulating interest rates, and thereby unavoidably distorting all returns on capital, this policy has all but destroyed rational investment.

Take pensions as an example. Historically, a saver needing $10,000 in twenty-five years’ time could achieve this by investing about $2,400 today. Now, though, he would need to invest around $6,500 to attain the same result.

In effect, manipulating rates of return has crippled the ability to save, raising the cost of pension provision by a factor of about 2.7x.

Therefore, if (say) saving an affordable 10% of income represented adequate provision in the past, the equivalent savings rate required now is 27%. This is completely unaffordable for the vast majority.  In effect, then – and for all but the very richest – policymakers have destroyed the ability to save for retirement.

Small wonder that, for eight countries alone, a recent study calculated pension shortfalls at $67 trillion, a number projected to rise to $428 trillion (at 2015 values) by 2050.

What this amounts to is cannibalizing the economy. This is a good way to think about what happens when we subsidise current consumption by destroying the ability to provide for the future.

Savings, of course, are a flip-side of investment, so the destruction of the ability to save simultaneously cripples the capability to invest efficiently as well. The transmission mechanism is the ultra-low rate of return that can now be earned on capital.

A further adverse effect of monetary adventurism has been to stop the necessary process of “creative destruction” in its tracks. In a healthy economy, it is vital that weak competitors go under, freeing up capital and market share for new, more dynamic entrants. Very often, the victims of this process are brought down by an inability to service their debts. So, by keeping these “zombies” afloat, cheap money makes it difficult for new companies to compete.

Obviously, we also have a problem with inflated asset values in classes such as stocks, bonds and property. These elevated values build in crash potential, and steer investors towards ever greater risk in pursuit of yield. Inflated property prices are damaging in many ways. They tend towards complacency about credit. They impair labour mobility, and discriminate against the young.

More broadly, the combination of inflated asset values and depressed incomes provides adverse incentives, favouring speculation over innovation. And this is where some of the world’s more incompetent governments have stepped in to make things even worse.

In any economic situation, there’s nothing that can’t be made worse if government really works at it. The problems created by “zombie” companies are worsened where government fails to enforce competition by breaking up market domination. Though the EU is quite proactive over promoting competition, the governments of America and Britain repeatedly demonstrate their frail grasp of market economics when they fail to do the same.

Worse still, the US and the UK actually increase the shift of incentives towards speculation and away from innovation. Having failed to tax the gains handed gratuitously to investors by QE, these countries follow policies designed to favour speculation. Capital gains are often taxed at rates less than income, and these gains are sheltered by allowances vastly larger than are available on income.

The United Kingdom has even backstopped property markets using cheap credit, apparently under the delusional belief that inflated house prices are somehow “good” for the economy.

How will it happen?

As we’ve seen, monetary recklessness – forced on central bankers by the GFC, but now extended for far too long – has weakened economic performance as well as intensifying risk. In some instances, fiscal policy has made a bad problem worse.

In short, the years since the crash have been characterised by some of the most idiotic policies ever contemplated.

All that remains to consider is how the crash happens. The prediction made here is that, this time around, it will be currencies, rather than banks, which will be first suffer the crisis-inducing loss of trust (though this crisis seems certain to engulf the banks as well, and pretty quickly).

The big question is whether the collapse of faith in currencies will begin in a localized way, or will happen systemically.

The former seems likelier. Although Japan has now monetized its debt to a dangerous scale (with the Bank of Japan now owning very nearly half of all Japanese government bonds), by far the most at-risk major currency is the British pound.

In an earlier article, we examined the case for a sterling crash, so this need not be revisited here. In short, it’s hard to find any reason at all for owning sterling, given the state of the economy. On top of this, there are at least two potential pitfalls.  One of these is “Brexit”, and the other is the very real possibility than an exasperated public might elect a far-left government.

Given a major common factor – the fatuity of the “Anglo-American economic model” – it is tempting to think that the dollar might be the next currency at risk. There are, pretty obviously, significant weaknesses in the American economy. But the dollar enjoys one crucial advantage over sterling, and that is the “petro-prop”. Because oil (and other commodities) are priced in dollars, anyone wanting to purchase them has to buy dollars first. This provides support for the dollar, despite America’s economic weaknesses (which include cheap money, and a failure to break up market-dominating players across a series of important sectors).

Conclusion

Once the loss of trust in currencies gets under way, many different weaknesses are likely to be exposed.

The single most likely sequence starts with a sterling crash. By elevating the local value of debt denominated in foreign currencies, this could raise the spectre of default, which could in turn have devastating effects on faith in the balance sheets of other countries. Moreover, a collapse in Britain would, in itself, inflict grave damage on the world economy.

Of course, how the next crisis happens is unknowable, and is largely a secondary question. Right now, there are two points which need to be taken on board.

First, the sheer abnormality of current conditions makes a new financial crisis highly likely.

Second, and rather than assume that banks will again be in the eye of the storm, we should be looking instead at the most vulnerable currencies.

Losing faith in banks, as happened in 2007-08, was bad enough.

But a loss of faith in money would be very, very much worse.

 

#104. Why Mr Trump can’t raise American prosperity

 

THE US ECONOMY – A SEEDS APPRAISAL

With SEEDS – the Surplus Energy Economics Data System – nearing public release, this article has two purposes. It assesses the outlook for the American economy, and uses this investigation to demonstrate how SEEDS is applied to economic interpretation.

It concludes that American prosperity is in decline, and has been falling ever since it ‘peaked’ way back in 1999. This doesn’t make America unique – prosperity has long been falling across much of the developed West. But it does mean that the central economic task of President Trump, which is to make the average American more prosperous, simply is not possible.

Two main factors are driving the deterioration in prosperity. First, the underlying economy has been deteriorating, a trend disguised by the spending of borrowed money.

Second, in America as elsewhere, the trend cost of energy continues to increase markedly, even while market prices are trapped in a cyclical low. This cost acts as an “economic rent”, and translates into individual experience primarily through the cost of essentials, which are energy-intensive.

Essentially, two things are happening to the average American. First, his or her income is rising less rapidly than the cost of essentials, squeezing the “discretionary” income which is the real definition of prosperity. Second, increases in income are being far exceeded by increases in debt, and also by growing shortfalls in pension provision. So the citizen feels both less prosperous and less secure.

As SEEDS measures it, per capita prosperity was 10% lower in 2016 than it was back in 2000. Neither is this trend likely to reverse – by 2025, the average American is likely to have seen his or her prosperity decline by a further 8% in comparison with 2016. At the same time, per capita debt has increased by almost $54,000, in real terms, since 2000, a problem now being compounded by a rapidly-growing systemic shortfall in pension provision.

‘Conventional’ economics cannot capture any of this. A perspective which ignores both “borrowed consumption” and the trend cost of energy is baffled by popular discontent, in America and elsewhere. Moreover, ‘conventional’ analysis tends to be misled by the apparently-buoyant values of stocks, bonds and property. These values are misleading, because they cannot be monetized – the only buyers for homes, for example, are the same people to whom they already belong.

For as long as these issues are overlooked, popular anger is likely to go on taking ‘the experts’ by surprise.

Context – the politics of waning prosperity

There were two main factors which combined to put Donald Trump in the Oval Office last year. The first was widespread popular contempt for the political process, something which Mr Trump addressed with his promise to “drain the swamp”. The second was the economic hardship being experienced by millions of Americans in a system which they increasingly perceive as benefiting only a wealthy minority.

On this second point, the challenge for Mr Trump is crystal-clear – to be successful, he must improve the material well-being of the average American. But this analysis concludes that there is no possibility of Mr Trump – or, for that matter, of anyone else – increasing per capita prosperity in the United States.

Mr Trump could, of course, try to offset this by redistribution, but there is no indication whatsoever that he will even contemplate doing this. The danger is that, if he decides against ‘taking from the rich to give to the rest’, voters may opt for somebody else who will.

Economic conditions are only one input to political decisions, of course, but their role can often be decisive. If this analysis is correct in concluding that the decline in the prosperity of ‘Middle America’ cannot be reversed, Mr Trump is going to struggle to be re-elected. Though a challenge might be mounted by the self-same establishment that he defeated in 2016, a likelier scenario might be a leftward tilt in the centre of gravity of American politics.

The economy – an energy dynamic, not a financial one

The basis of the surplus energy approach is recognition that the economy is an energy dynamic, not a monetary one. This much should be obvious, because money has no intrinsic worth – it commands value only to the extent that it can be exchanged for goods and services. Energy is central to the supply of all these goods and services.

The value that the economy generates, therefore, is a function of how much energy we can access. But, whenever we access energy, some of that energy is consumed in the access process. The term ‘surplus energy’ describes the difference between the gross quantity of energy available, and the cost of accessing it. That difference or ‘surplus’ is the foundation of prosperity.

The concept of prosperity needs to be understood clearly. Prosperity is not simply the size of someone’s income. Rather, it is the sum left over after essentials have been paid for. This means that prosperity equates to “discretionary” income, which is the sum that he or she can choose how to spend.

The fundamentally energy-based nature of all output creates a natural distinction between “two economies” – the real economy of goods and services, and the financial economy of money and credit. Used properly, the financial system can deliver many benefits. Equally, though, it can be harmful, if it diverges too far from the real economy.

The potential for harm is simple. Money functions only as a “claim” on goods and services, which really makes it a claim on surplus energy. Likewise, since credit is a claim on future money, it is really a claim on future energy.

Financial “claims” – money and credit – can be manufactured out of thin air, and we can create as many of these claims as we like. But, if we create claims that exceed what the real economy can deliver, the excess cannot be honoured. Therefore, it must be destroyed. Inflation is one way of doing this, though default is another.

Energy in America

The consumption of primary energy in the United States has been in gentle decline for a number of years. In 2016, Americans consumed 2.28 bntoe (billion tonnes of oil-equivalent), 2% less than in 2006. Over that period, the population increased by 8%, so energy consumption per person is in a somewhat steeper decline. This is often assumed to indicate greater efficiency. But the alternative possibility – that it may simply reflect deteriorating prosperity – seems disturbingly consistent with the facts.

The supply of indigenous energy increased by 24% over the decade to 2016, and much of this increase has been supplied by unconventional oil and gas, extracted from shale formations using hydraulic fracturing. Reflecting this, the US imported only 11% of its energy needs in 2016, compared with 30% in 2006.

The dramatic increase in unconventional hydrocarbons production has created much hype, tending to disguise a rather more prosaic reality. Shales are costly to produce, not so much in operating expenses but, rather, in capital costs, which are themselves a function of depletion.

The output from shale wells declines far more quickly than conventional production, creating a constant need to drill new wells simply to sustain output, let alone increase it. This puts operators on a “drilling treadmill”, something evident both in huge capital expenditures, and in the inability of the industry to cover its capital costs from operating cash flow.

Moreover, a peak in shale output now looms, and this peak is assumed here to occur in 2021. If some of the more sanguine claims for shale were true, the United States would be scaling back its ability to ensure safe delivery of petroleum from the Middle East. It is clear that the Pentagon has no such intention, and the US remains as interested as ever in political developments in the oil-rich Persian Gulf.

What really matters, where the economy is concerned, isn’t the aggregate amount of energy available, but the cost of accessing it. This is cost expressed in energy terms, not financially. SEEDS estimates the ECoE – the Energy Cost of Energy – of the American demand mix in 2016 as 7.9%, which rises to 9.2% after adjustment for net energy trade. This latter number has been on a rising trend – it was 7.2% in 2006, and only 4.2% in 1996 – and is projected to reach 13.5% by 2026.

The 2016 number is higher than the global average (8.2%), but better than those of competitors including Britain (10.5%), France (11%), China (14.3%) and Germany (15%). So America does enjoy a significant energy advantage over some of its principal competitors, even if that advantage is not as great as is sometimes claimed.

The financial economy

American GDP in 2016 was $18.6 trillion, a real-terms increase of 33% since 2000. Over that period, however, the population has increased by 15%, so the gain in per capita terms has been rather more modest, at 16%. Theoretically, this should have made most Americans markedly more prosperous, but there is a big snag involved in accepting GDP numbers at face value.

Comparing 2016 with 2000, and using constant 2016 values throughout, American GDP increased by $4.6tn. But, and again at constant values, aggregate debt grew by $21trn over the same period. This means that each dollar of recorded growth was accompanied by $4.60 of new debt.

This issue is often overlooked, by economists and policymakers alike. But its relevance should be obvious because, if America goes on adding $4.60 of debt for every $1 of growth, a point must be reached, eventually, at which further growth becomes impossible, because debt has reached a practical maximum.

Another way to look at this is that a significant proportion of reported growth has really amounted to nothing more than the spending of borrowed money. If the ability to keep “borrowing to spend” was to be curtailed, this borrowed element would fall away, resulting in a sharp fall in GDP.

The scale of this problem is evidenced by the way in which America, like other countries, has effectively been forced into a policy of ultra-cheap money by the sheer impossibility of paying a ‘normal’ rate of interest on debts of this size.

ZIRP – meaning zero interest rate policy – has hefty economic costs. Just one of these is that it stymies the essential process of “creative destruction”, by keeping afloat weak players who, in a ‘normal’ interest rate environment, would have gone under, freeing up capital and market share for new, more innovative competitors. Cheap money also incentivizes speculative over innovative activities, as well as deterring saving, and encouraging borrowing.

Another consequence of cheap money is that it destroys the ability to provide for the future. Saving becomes pointless when interest earned is less than inflation. This has particular relevance for pensions. According to a recent report, the deficiency in American pension provision stood at $27.8tn in 2015, and is growing at a rate of $3tn per year.

To put this in context, it is about 5x what America spends on defence. In 2016, the US economy expanded by $0.3tn, a number obviously dwarfed by the deepening pension chasm, as well as by a net increase of $1.4tn in debt. When income is growing by $0.3tn annually, but liabilities are increasing by $4.4tn, something is clearly very wrong indeed.

The underlying economy

Since the “borrowing to spend” issue obviously cannot be ignored, SEEDS uses an algorithm to calculate how much economic output is accounted for by the simple spending of borrowed money. Of the $21tn borrowed since 2000, $4.0tn is deemed to be “borrowing for consumption”. This is only 19% of the total borrowed, so might be a conservative estimate. Even so, it has dramatic implications for underlying (borrowing-free) GDP.

According to SEEDS, American underlying GDP in 2016 was only $14.5tn, a number which is 22% below the reported $18.6tn. This underlying number is an estimate of where GDP would be if Americans ceased “borrowing to spend”. It represents an increase of only 7% (rather than the recorded 33%) since 2000. Moreover, it equates to a fall (of 6%) in underlying output per capita.

This analysis goes some way towards explaining a big political (as well as economic) conundrum – the reason why the average American feels poorer is that he or she really is poorer. This deterioration in underlying income, then, is extremely indicative. It becomes even more so when we consider the role of energy, which plays a critical part in determining prosperity.

The real economy

Thus far, we have looked at two measures of American economic output. One of these is recorded GDP, and the other is a borrowing-adjusted calculation of underlying GDP. The third stage in this process is to factor-in energy costs, described earlier as ECoE. This calculation is critical if we are to identify trends in prosperity, rather than simply in income.

The trend cost of energy is quite different from the market price at any given time. Whilst prices are cyclical, cost is a long-term trend, determined by the interplay between depletion and technology. Moreover, cost needs to be considered, not initially in monetary terms, but as the proportion of accessed energy that is consumed in the access process.

The term “cost” can be misleading, because it is not directly analogous to the costs incurred running a home or a business. Those costs leave the home or business but, globally, the energy economy is a closed system, so the cost of energy does not leave it.

Rather, energy cost is an “economic rent” – it is not a sum deducted from income, but an amount that we are forced to use in a particular way. This means that it reduces the amount that can be spent as we choose, and this “discretionary” income is what determines prosperity.

Where America is concerned, SEEDS estimates the 2016 ECoE of the United States at 9.2%, up from 5.5% back in 2000. The main impact of this energy cost “drag” on prosperity is experienced through escalation in the cost of essentials.

In per capita terms, this trend has paralleled the deterioration in underlying GDP. Stripped of borrowed spending, this underlying measure of income declined by 6% between 2000 and 2016. Adding the ECoE component into the mix indicates that per capita prosperity has declined at roughly the same rate. In the future, though, a continuing rise in ECoE is set to exacerbate the erosion of prosperity.

The future

In America, as elsewhere across much of the Western world, organic growth in economic output petered out around 2000. Since then, and again like many other countries, America has been ‘faking’ economic growth by spending borrowed money.

As a result, debt has grown much more rapidly than GDP. In the years between 2000 and the global financial crisis (GFC) in 2008, each $1 of reported growth was accompanied by a $5.20 rise in debt.

Since then, this ratio has improved, averaging $3.85 of borrowing for each growth dollar between 2008 and 2016. Unfortunately, though, this has been compounded by two other trends. First, the ratio of debt-to-GDP is higher now (251%) than it was at the end of 2008 (234%).

Worse still, the policy of ultra-cheap money has created huge and growing shortfalls in pension provision, a structural shortfall now standing at over $29tn, or 157% of GDP, and increasing by $3tn annually.

When we balance out trends in income with trends in debt and other forms of liability, the picture which emerges is one of steadily deteriorating prosperity. As trend ECoE continues to rise, the squeeze on prosperity will tighten further.

America is by no means unique in experiencing downwards pressure on prosperity – the same is happening in many other countries, often more severely than in the United States.

The problems posed for America are twofold. First, the deterioration in prosperity makes it impossible for the President to improve the material prosperity of the average American – in attempting to do so, he is about as powerless as was King Canute when he tried to turn back the tide.

Second, the use of cheap money to ‘manufacture’ nominal economic growth is already creating an escalating level of forward risk. Just as Americans are getting less prosperous, they are also becoming ever more indebted, and face ever greater insecurity as provision for pensions deteriorates.

The time cannot be too far off, for America as for the world more generally, where the future (represented by the collective balance sheet) overwhelms the present.