A LANDSCAPE OF BROKEN CERTAINTIES
Looking at the conduct of economic and related affairs in recent years, it would be all too easy to conclude that the world’s leadership cadres have (in the quaint English phrase) ‘lost their marbles’.
For the most part, they haven’t. But they have lost their bearings.
Policy and evaluation operate within parameters. These are determined by paradigms, which are based partly on experience, and partly on theory. When theory doesn’t work out as expected, the validity of these paradigms breaks down. What results is a vacuum in which literally almost anything can happen.
The aim here is a tightly-focused examination of paradigm breakdown. Put simply, have crucial formulae, supported both by logic and by prior experience, ceased to function?
If they have, much of the basis of policy, and of economics itself, loses validity.
We can cite several examples of where exactly this seems to have happened. Most important, policy responses to the 2008 global financial crisis (GFC) followed a tried-and-tested Keynesian formula, but they haven’t worked out as theory says they should. Long before now, those policies should have caused the economy to overheat and inflation to take off, setting the conditions for a return to normality. This simply hasn’t happened. This seems to be part of a broader paradigm breakdown which is particularly visible, too, in business and in capital markets.
When astronomers find anomalies between expectation and observation, this often reflects the gravitational pull of an object whose presence is unknown. One way of detecting this object can be to work backwards from the gravitational effects to the object that causes them. At that point, a new influence is posited, and calculations are recalibrated accordingly.
In much the same way, this discussion posits a factor hitherto excluded from mainstream economic theory, and examines whether this can explain the breakdown of theory. That factor is energy, and it is concluded that its gravitational pull has become large enough to invalidate much that has hitherto been assumed about the economy.
First, though, we need to examine the evidence for the crumbling of paradigms – and there is no better place to start with what’s happened to the world economy since the GFC.
Case-study #1: Post-crash policy – a theory overturned
The response of the authorities worldwide to the crisis of 2008 made sense within established paradigms. During late 2008 and early 2009, the authorities reacted by slashing policy rates, and using QE (quantitative easing) to drive bond yields sharply lower. This created a situation in which nominal interest rates were negligible, and real (inflation-adjusted) rates were negative.
This was monetary stimulus on a vast scale.
In the circumstances, it was a text-book response. Received wisdom said that this policy mix would be effective, and that it would be short-lived. Instead, it has mutated into what is known here as monetary adventurism – a seemingly-permanent state of monetary recklessness which can only end badly.
How did this happen?
The thinking behind ultra-cheap monetary policy was clearer than you might suppose, and was derived from Keynesian calculus. When demand weakens, the Keynesian prescription is stimulus, essentially meaning that the authorities inject money into the system. This boosts demand, thereby promoting economic activity.
Most commonly, this stimulus is fiscal. But this was hardly a viable choice in 2008. Fiscal deficits were already enormous – and fiscal stimulus takes time to operate, time that the authorities didn’t think they had.
Instead, then, they opted for monetary stimulus, which, theory tells us, works in much the same way. Access to cheap credit, it is reasoned, boosts demand, countering downwards and deflationary tendencies in the economy.
Of course, there are consequences to stimulus, consequences which will either restore equilibrium, or cause over-shoot. As well as promoting demand, stimulus is likely to push inflation upwards, and can make the economy overheat. That’s when the Keynesian formula calls either for moderation or reversal, including running fiscal surpluses, and raising interest rates.
In 2008-09, the authorities clearly thought that monetary stimulus would act as a short, sharp shock, and could be withdrawn (or reversed) when inflation and overheating showed up.
This goes a long way towards explaining ‘austerity’, too. The logic was that, if you’ve injected huge monetary stimulus, you hardly need vast fiscal stimulus as well. Whilst monetary stimulus was boosting demand, fiscal tightening could be used both as a regulator and as a way of rebuilding sovereign balance sheets. Cheap credit was expected to enable much of the debt that had migrated from the private to the public to be transferred back to where it began.
Yet none of this has worked out the way theory (and prior experience) say it should.
Monetary stimulus has been vast – quite how vast is almost incalculable, but certainly running into tens of trillions of dollars. This should have injected huge demand into the system. Within a year or, at most, two years, inflation should have been rising, and the economy showing unmistakeable signs of overheating. At that point, the stimulus could be withdrawn, or indeed reversed.
But this hasn’t happened. Asset markets have been inflated, but this hasn’t translated into broad inflation. The economy, far from overheating, has remained sluggish. There has been no opportunity for deleveraging the balance sheets of governments (and remember that deficit reduction simply slows the rate at which debt keeps growing).
At a point which – statistically, at least – is nearer in time to the next recession than it is to the last one, growth remains fragile, real wages remain depressed, both public and private debt are higher than ever, and some of the really nasty by-products of cheap money are showing up in forms that are as disturbing as they are unmistakeable.
So, does this experience prove Keynes ‘wrong’? Hardly. The Keynesian model, taken in its objective sense rather than in its political form, is mathematically demonstrable. It would have worked in the Great Depression of the inter-war years, and it ought to have worked now.
That it hasn’t worked tells us that something new must have entered into the equation.
Conventional theory cannot tell us what this new element is.
It is baffled.
The paradigm has failed.
Case-study #2: Britain – a productivity paradox
A further, briefer example underlines the breakdown of paradigms. In the years preceding 2008, British productivity grew at a trend rate of 2.1%. Ever since its inception in 2010, the Office for Budget Responsibility (OBR), which advises government, has expected this pre-crash trajectory to resume.
It hasn’t. Instead, it has remained obstinately low, at just 0.2%. This has confounded OBR forecasts and calculations, and has contributed to policy failures. Only now, seven years on, has the OBR conceded that it isn’t going to happen. The results have been sharp downwards revisions to growth projections, and acceptance of the grim (and, to some, “astonishing”) reality that real wages will remain lower in 2022 than they were back in 2008.
This does not, it must be stressed, make the OBR idiots. Rather, they are extremely able people, and their expectations were soundly rooted in theory. As we have seen, productivity, being based on the GVA subset of GDP, is a proxy for growth. Stimulus, both fiscal and monetary, has been enormous. This should have pushed demand sharply upwards, driving up growth and, therefore, productivity. The problems that chancellor (finance minister) Philip Hammond should be facing now ought to be an overheating economy, and a spike in inflation.
But this is exactly what hasn’t happened. Instead, growth (after necessary statistical adjustments) has become negligible, and the only source of inflation has been currency weakness.
Once again, the theoretical paradigm, within its own parameters, and reinforced by prior experience, is demonstrably correct. The divergence of outcome from theory can only mean that some new element has entered into the equation.
It’s a fair bet that the authorities have no idea what this unexpected, paradigm-busting element is. The pursuit of explanations for a non-existent “puzzle” around productivity is a textbook example of groping blindly in the dark.
To be quite clear about this, weak productivity is a symptom. Locally, as globally, the malady is the failure of the economy to react to enormous fiscal and monetary stimulus.
Policymakers don’t know why this happened – and their advisers are powerless to tell them.
Asset markets – accumulating disconnects
Governments and central bankers are by no means the only consumers of economic interpretation. It has a huge role to play in business and finance, too. In financial markets, most participants have enjoyed the fruits of monetary largesse, a policy which has inflated asset prices to giddying heights. Only the most astute, however, are likely to have pondered the implications of economics, and markets, failing to behave as theory says they should.
For those willing to look, there is no shortage of anomalies in asset markets. An obvious example is property, where inflated prices have become all but impossible to square with falling real incomes. This, at least, can be explained away by reference to cheap money and expanding multiples. These explanations may seem satisfying, even though they are very likely to prove wrong.
Bond and equity markets offer more intriguing anomalies. In equities, there are at least five phenomena which should be causing the wisest to wonder.
In no particular order, the first of these is cash-burn. Whole sectors, as well as significant individual companies, are characterised by rates of cash-burn reminiscent of the dot-com boom – yet these stocks and sectors are often amongst those most cherished by investors.
Second, some highly-rated stocks depend for their revenues on sectoral income streams which, locally as well as globally, are both comparatively narrow and potentially vulnerable.
Third, there is the phenomena of stock buy-backs, a highly influential trend in which cheap debt is used to deliver accretion (reverse-dilution) for stockholders, to the particular benefit of anyone owning options. Though the metrics seem to work well with debt so cheap, it’s most unlikely that the large-scale replacement of equity with debt is a positive trend. Any cessation of the practice could take a big buying presence out of the market – and rate rises could cripple companies which have loaded up on debt.
Next, there is the ongoing migration of client funds from active to passive management. This may or may not be a positive trend for clients, but the subtext seems to be one of giving up on analysis – and giving up on analysis doesn’t seem all that far from giving up on rationality.
Finally, there is real-world disconnect, where asset prices seem increasing difficult to square with the realities of customer circumstances.
To be sure, there is nothing new about ‘negative’ economic news being seen positively by markets. A deterioration in growth can be seen as a market positive because it softens the outlook for rates. The same can happen in reverse, where good economic news can be interpreted negatively by markets.
But inverse responses shouldn’t cancel out logic to the extent that now seems to be happening. Beyond some embattled retailers (whose woes are customarily explained away by technological disruption), the stock prices of most customer-facing businesses are high, even (or especially) in the case of stocks whose sectors are intrinsically risky. This seems impossible to reconcile with the all-too-obvious travails of the average consumer, faced, as he or she is, with stagnant or deteriorating real wages, increasing insecurity of employment, rising indebtedness, and growing uncertainty over pensions.
In the bond markets, British government debts (“gilts”) are an instructive example. Sovereign debt yields are supposed to include, where appropriate, a risk premium. In the British instance, this risk premium component ought, logically, to be pretty hefty – this is a sovereign borrower with rising debt, acute political uncertainty, a vulnerable currency and an economy in very big trouble. Yet the British government remains able to access funds at rates historically associated with ultra-low-risk, robust borrowers.
Missing in action – consequences of paradigm failure
Both in macroeconomics and in capital markets, then, the list of disconnects keeps growing, meaning that the validity of theory seems to be breaking down. Numerous demonstrable, historically-referenced ‘truisms’ have gone ‘missing in action’.
The landscape of economics and policy is littered with the corpses of dead paradigms.
The implications, both for policy and for commercial and financial strategy, can hardly be overstated.
Following the failure of stimulus to conform to theory, macroeconomics has moved into a new abnormal. Some of the numbers make this abnormality strikingly obvious, a point underlined by the following chart.
Since 2008, and expressed in constant (2016) PPP dollars, GDP growth of $24 trillion has been accompanied by an $84tn net increase in debt, meaning that $3.50 has been borrowed for each $1 of growth.
This is a lot worse than in the pre-crash borrowing bubble, when the ratio of borrowing to growth was 2.2:1. One reason for worsening of the ratio is that emerging market economies (EMEs) – and most obviously China – are now doing what the developed West alone was doing before 2008.
Meanwhile, the crushing of returns on investment has created a vast shortfall in pension provision worldwide. Globally, these deficiencies probably total around $125tn, and are growing at a real annual compound rate in excess of 5%.
There’s every reason to suppose that much, perhaps most, of the apparent “growth” in GDP has been nothing more substantial than the simple spending of borrowed money. A person does not become more prosperous by running up an ever bigger overdraft, or by pillaging his or her pension fund. Yet, globally, that’s exactly what we’re doing.
Apparent improvements in per capita GDP simply aren’t showing up in prosperity, quite aside from the rapid increases both in households’ own debt and in their share of government and commercial indebtedness. Anyone – and this includes far too many policymakers – who thinks that inflated asset values provide a cushion is guilty of naivety on a breath-taking scale, because we cannot monetize the notional ‘value’ of assets by selling them to each other.
Politics and business – cut adrift from paradigms
The purely political consequences of deteriorating prosperity have long been obvious to virtually everyone (except, apparently, the self-styled ‘experts’). “Brexit”, the election of Mr Trump, the defeat of all established parties in France, the travails of Mrs Merkel and the rise of “populism” have all been entirely predictable events. Even in countries like Britain, the public seem to be giving up on “capitalism”, within polls revealing striking levels of support for nationalisation even amongst erstwhile centre-right voters.
Though the political Left has failed to capitalise on this so far, it is now busily positioning itself for success by purging itself of a generation of “centrists” who bought in to the economic logic of the centre-right.
Commercial behaviour seems equally at odds with the reality of consumer deterioration. In business, as in economics and government, logic suggests that strategy should be framed by awareness of deteriorating consumer discretionary incomes, rising debt and the approaching implosion of pension provision, with all that that logically means for customer behaviour and sentiment.
Self-evidently, it is not. Businesses appear to be throwing ever-bigger advertising budgets at consumers who are getting ever poorer. There are strong reasons why consumers are likely to become a great deal more cautious. The biggest single factor is likely to be the impending recognition of the pensions “time-bomb”, which ought to push savings ratios back up from historic lows, to the detriment of consumption. A second strong possibility is that inflated property markets might crash if the law of gravity reasserts itself in income multiples.
The gravitational pull – energy
What we are witnessing, then, is an economic, political and commercial landscape in which players have been cut adrift from past paradigms without, yet anyway, finding any new ones. As regular readers will be well aware, the ‘gravitational pull’ which is wrecking past paradigms is the energy basis of the economy.
It should be unnecessary to stress that energy is the basis of all economic activity. This was true back in an agrarian economy which depended on human and animal energy, and is every bit as true now, when extraneous sources (and principally fossil fuels) have taken over almost entirely from human energy.
Energy is central to a resource chain which, most obviously, supplies food, water, minerals and chemicals. Add in the critical importance of electricity and it becomes apparent that economic activity is entirely a function of energy availability.
Over the comparatively short period between 2001 and 2016, consumption of primary energy increased by 40%, or by 18% on a per capita basis reflecting the increase in the world population over the same timeframe. It is a moot point as to whether this rate of increase can be sustained, and a logical certainty that the economy cannot continue to deliver genuine growth if it is not.
Absolute quantities of energy, however, are not the critical issue. Whenever energy is accessed, some energy is always consumed in the access process, and the real driver of economic activity is the surplus energy available after this access cost has been deducted.
Access cost is measured here using ECoE (the energy cost of energy), expressed as a percentage of the gross amount, and measured as a trend. The main driver of ECoE is depletion, moderated by technology.
According to SEEDS (the Surplus Energy Economics Data System), worldwide trend ECoE has risen from 4% in 2001 to 7.5% last year. Put another way, this means that, in order to have access to 100 units of energy for all purposes other than energy supply itself, we needed 108.1 units in 2016, compared 104.2 units back in 2001. That number is projected to reach 110.1 units in 2020, 112.2 units in 2025, and 115.3 units by 2030.
In measuring this impact, the key metric is surplus (net-of-ECoE) energy availability. Whilst gross access increased by 40% between 2001 and 2016, the increase at the net (“surplus”) level was only 35%. In per capita terms, surplus energy was only 13% higher in 2016 than in 2001.
Most important of all, this per capita number has now started to decline. This is something which, almost certainly, is wholly unprecedented. Even more importantly, it is likely to be irreversible, because ECoE is now rising a lot more rapidly than we can hope to increase gross energy supply.
To understand the implications of this trend, we really need only two charts, which are set out below. If these are compared with the GDP and liabilities chart shown earlier, the role of energy in the paradigm-busting process becomes entirely clear.
The question now is whether economists, government and business can become aware of what has been destroying their certainties – and can find new paradigms to replace the old.