#131: Not about “Brexit”


What follows is an analysis of the British economy, from the perspectives of performance and risk.

It is not a discussion of “Brexit”.

Readers are, of course, welcome to discuss any pertinent issue, “Brexit” included. But a non-“Brexit” focus has to be stated clearly, because one of the most regrettable effects of the whole “Brexit” process has been to divert attention away from the economic fundamentals. Distractions don’t come much bigger than “Brexit”.

Perhaps the most striking characteristic of the British economic situation is the stark divergence between two different views. One of these is an official and consensus interpretation, founded on conventional economics, which portrays performance as no worse than lacklustre. There is, however, a raft of other indicators which paints a much less satisfactory picture.

Analysis undertaken using SEEDS – the Surplus Energy Economics Data System – indicates that prosperity peaked as long ago as 2003, and that the consequent strains are now becoming ever more apparent. Declining prosperity, of course, characterises most advanced Western economies. The United Kingdom stands out, though, for the rate at which prosperity is deteriorating, and for the elevated level of risk associated with this trend.

The great dichotomy

According to conventional metrics, the economy of the United Kingdom continues to grow, albeit at a less than sparkling pace. GDP is expected to increase by about 1.4% this year which, though hardly impressive, at least outpaces the 0.6% trend rate at which population numbers are expanding. People are, then, getting gradually better off, whilst unemployment remains low.

The problem with this interpretation is that it is hard – arguably, impossible – to square with a host of other indicators. First, wage growth is very subdued, barely keeping up with CPI inflation, and falling steadily further adrift of the cost of household essentials.

Second, productivity growth has fallen to virtually zero, having averaged just 0.2% since the 2008 global financial crisis (“GFC I”).

The labour market is characterised by increasing casualization and insecurity of employment, factors which contribute to depressed wage levels despite officially-low unemployment.

There is every reason to suppose that consumers’ ability to spend is in rapid retreat. Customer-facing businesses (including shops, restaurants and pubs) are going through a fire-storm of closures, failures and job losses. Consumer credit has climbed to potentially dangerous levels, with anecdotal evidence that this credit is being used, not for discretionary purchases, but simply to meet living expenses. There is also reason to suppose that big-ticket purchases are in decline. Surveys indicate that large and increasing numbers of households are struggling to make ends meet.

Government, too, seems strapped for cash, not really knowing how to provide necessary increases in funding for areas such as health, defence and care for the elderly. Local as well as central government looks resource-constrained.

Broader indicators of economic stress include homelessness, with young people, in particular, finding accommodation to be costly, often of poor quality, and hard to obtain. Seemingly-rapid rises in violent crime – including a dramatic surge in moped offences, of which there were 23,000 in London alone last year, compared with just 827 five years earlier – do not seem consistent with a prospering society.

In short, there is an abundance of evidence that, far from getting better off, the average British person is getting poorer. At first glance, this is impossible to square with any level of reported “growth” in economic output.

The SEEDS interpretation

An answer to this conundrum is supplied by SEEDS, which indicates that prosperity per person in the United Kingdom has been declining relentlessly since as long ago as 2003.

Over the period since then, reported GDP has risen by £386bn (23%), to £2.04 trillion last year from £1.65tn (at 2017 values) in 2003. Against this, however, aggregate debt increased by £2tn (62%).

This means that each £1 of reported growth has been accompanied by £5.20 in new borrowing. It also means that, against current growth expectations of about 1.4%, the UK typically borrows 5.7% of GDP each year.

The stark implication is that, like many other Western countries, Britain has been pouring cheap credit into the economy to shore up consumption. In short, most of the supposed “growth” of recent times has been nothing more substantial than the simple spending of borrowed money.

Stripped of this borrowing effect, SEEDS calculates that, within recorded growth of £386bn since 2003, only £77bn can be considered organic and sustainable. This puts ‘clean’ (borrowing-adjusted) GDP for 2017 at £1.59tn, barely ahead of the 2003 number of £1.53tn. On this basis, underlying growth has not kept up with increases in the population, so that ‘clean’ GDP per capita has decreased by 5.1% since 2003.

The compounding headwind has been a sharp rise in the energy cost of energy (ECoE). This, of course, is a worldwide problem, but has been particularly acute in the United Kingdom. Back in 2003, Britain’s ECoE (3.4%) was lower than the global average (4.5%). Today, though, ECoE is markedly higher in the UK (9.2%) than in the world as a whole (8.0%).

On a post-ECoE basis, prosperity per capita in Britain has fallen by 10.3% (£2,540), to £22,020 last year from a peak of £24,550 in 2003. Prosperity has declined in other Western countries over the same period, but Italy is the only major economy where the fall has been as rapid as in the UK.

SEEDS shows no sign of this downwards trend slackening, and projects that British prosperity will be a further 4.2% lower in 2022, at £21,090, than it was in 2017. In short, the average person is getting poorer at rates of between 0.5% and 1.0% each year.

Meanwhile, of course, his or her share of aggregate debt continues to increase.

Elevated risk

Deteriorating prosperity necessarily increases risk, because the ability to carry any given level of financial burden is a function of prosperity. Falling prosperity also impairs the ability to fund public services.

Trends in debt ratios reflect deteriorating prosperity. Aggregate debt at the end of 2017 (£5.25tn) equates to 258% of GDP but 361% of prosperity, the latter number having risen markedly since 2007 (283%).

More worryingly, the rise in debt exposure has been matched by sharp increases in proportionate financial assets, a measure of the size of the banking system. The most recent figure, for the end of 2016, puts Britain’s financial assets at 1124% of GDP, but this rises to 1547% when prosperity, rather than GDP, is used as the denominator. The SEEDS estimate of financial assets in relation to prosperity at the end of last year is 1577%, again sharply higher than the level on the eve of the financial crisis in 2007 (1285%).

Measuring debt and financial assets in relation to prosperity are two of the four risk yardsticks used by SEEDS. The UK looks high-risk on the debt measure, and extreme-risk in terms of the scale of its banking exposure.

On the third risk criterion, which is dependency on the continuing availability of credit, the British score is no worse than that of most comparable economies. The United Kingdom does, though, also depend on a continuing ability to borrow from abroad, to sell assets to overseas investors, and to attract inward flows of capital. This dependency looks risky, because the severe travails of customer-facing businesses, and the implied hardship of consumers, necessarily impair the attractiveness of Britain as a place in which to invest.

Finally, Britain has a high score on what SEEDS calls “acquiescence risk”. Put simply, the less prosperous people become, the less likely they are to back painful recovery plans should these be required in a future financial crisis. Worsening prosperity has already had a marked effect on political outcomes in America, France, Italy and elsewhere, and the same factor is likely to have tilted the balance decisively in the referendum on “Brexit”. Should it become necessary for Britain to repeat the 2008 rescue of the banks, popular acquiescence in such a measure should be no means be taken for granted.


SEEDS 2.15 United Kingdom 21072018


#130: Grand Bargains, dangerous choices?


One of the most ill-informed critiques of China says that, as a one-party Communist state, the government need take no notice of public opinion. The reality is quite different. It is that a ‘grand bargain’ exists between the state and the public. For their part, citizens accept the denial of certain rights which are taken for granted in many Western countries. In return, the government delivers steady improvements in prosperity.

There’s a striking parallel to this in the United States, because the presidency of Donald Trump is founded on a very similar ‘grand bargain’. Voters disaffected with a self-serving establishment have trusted Mr Trump to restore prosperity. Just like Beijing, he has to deliver.

It’s a measure of America’s political disconnect that, right from the start of his campaign, self-styled ‘experts’ dismissed Mr Trump as a “joke candidate” with no chance whatsoever of making it to the White House. This mis-reading of Mr Trump – and the consequent shock of his victory – was more than just wishful thinking. It was based on a misunderstanding of the central issue at stake.

This issue was, and is, prosperity. Whatever conventional economic statistics may say, Americans have been getting poorer over an extended period. This, plus anger at the perceived enrichment of a tiny minority, was the driver behind the Trump victory. It helped, of course, that his opponent seemed to many symbolic of an entrenched and privileged elite. Ultimately, though, “make America great again” translates as ‘make Americans prosperous again’.

In the same box

This interpretation puts America and China in the same box. Both are regimes whose imperative is the delivery of prosperity for the average citizen. In America, SEEDS analysis indicates that Mr Trump cannot deliver (and, in fairness, neither could anybody else), because trends that have made the average American 7.5% poorer since 2005 look irreversible. For China, average prosperity has increased – by 41% over the last ten years – but continuing to deliver has already become very hard indeed, and isn’t going to get any easier.

The parallel goes at least two stages further, the operative terms being energy and debt. Chinese energy consumption has increased by 46% over a decade (and it’s far from coincidental that prosperity has expanded by a similar 41% over the same period). But sustaining this critical growth-driver is looking distinctly problematic. Whilst China will seek out every oil supply deal it can get its hands on – helped, perhaps, by the mutual hostility between Washington and Tehran –  switching towards coal seems the favoured strategy. America, too, may re-emphasise coal. In neither instance, though, is coal likely to be an effective fix.

Thus far, America has benefited enormously from the dramatic expansion in shale oil output. In this, the United States can be grateful for the irrationality of investors, who have been prepared to pour enormous quantities of capital into a sector which is, by definition, a cash-burner, never having covered its capital costs from operating cash flows even when oil prices were well above $100/b. Tolerance of cash-burning is, of course, a direct corollary of ultra-cheap money.

The fundamental problem with shales is the ultra-rapid rate at which production from individual wells declines. This puts operators on a ‘drilling treadmill’ which requires ever more drilling just to sustain output, never mind increasing it.

It helps shales, of course, that investor generosity looks almost limitless. Anyone who can ignore the mismatch between record equity values and deteriorating prosperity – and who can meanwhile buy in to the issuance of perhaps $1 trillion of debt for no better reason than stripping equity out of corporate capital structures – isn’t likely to baulk quickly at cash-burning by shale companies. Even so, there must be limits to how quite much more capital shale drillers will be allowed to burn their way through.

Fortunately or not – and from what we can judge from their actions – America’s military leaders seem more realistic, certainly where shales are concerned. Service chiefs, it seems, have never bought in to the “Saudi America” narrative of energy independence. The Navy’s carrier groups, costly assets whose main functions include both power projection and the defence of seaborne energy supplies, have not been sent to the scrap-yards. Neither has America de-emphasised the policy importance of the Middle East.

Fundamentally, both Beijing and the Trump administration need to deliver prosperity – and energy is the greatest single threat to their ability to do so. The real issue here isn’t just the maintenance of supplies, but cost. The relentless rise in ECoEs is felt first in the cost of essentials, not just energy itself but utility bills and all the other non-discretionary outlays which drive a wedge between income and prosperity. ECoE is the big problem, for Mr Trump as much as for Beijing.

Debt and self-deception

If energy is one problem facing both America and China, another is debt. More specifically, it’s dependency on a continuing process of credit creation, a dependency which lies at the heart of the “monetary adventurism” which has characterised the economic landscape since the 2008 global economic crisis (‘GFC I’).

Here, time-sequencing has differed between China and the United States. Between 2000 and 2007, America (and most other Western economies) went on a debt binge. In the US, and stated at constant 2017 values, debt grew by $12 trillion over a period in which GDP expanded by only $2.6tn. This – helped, of course, by acquiescence in increasingly dangerous practices – led straight to GFC I.

Prior to 2008, Chinese policy on debt had been fairly conservative. What we’ve witnessed since has been a truly breath-taking change. Stated at 2017 values, Chinese GDP and debt in 2007 were, respectively, RMB 37 trillion and RMB 60tn. Today, those numbers are RMB 81tn (a 120% rise in GDP) and RMB 251tn (a 320% leap in debt). Whilst GDP has expanded by RMB 44tn, debt has soared by RMB 191tn.

Even more strikingly, the rate at which China has been borrowing over the last decade has averaged RMB 19tn annually. GDP has averaged RMB 60tn over the same period. So, on average, China borrows close to 32% of GDP each year.

Nobody else comes anywhere near. America typically borrows 5.8% of GDP annually. That’s more than twice the rate of the most optimistic interpretation of growth, so it’s not sustainable, and highlights how much “growth” has been nothing more than the simple spending of borrowed money. But it’s nowhere near the 31.8% of GDP borrowed annually by China since 2007. The global equivalent is 9%, but that, of course, is heavily skewed by China.

It has been suggested that China is throttling back on its propensity to pile up debt. There’s limited truth in this, in that China borrowed “only” 30% of GDP last year, compared with 38% in 2016 and 35% in 2015. But the numbers continue to look bizarre, unsustainable, and – potentially – lethal.

The United States, meanwhile, looks increasingly likely to revert to pre-2008 borrowing patterns. The budget outlook is for much higher levels of annual borrowing by government, whilst there seems to be no end in sight to the irrationality of converting corporate capital from equity into debt, not to mention the continued willingness of investors to finance cash-burners.

(In fairness to investors, it should be recognised that ultra-cheap monetary policy has presented them with ‘no good choices’, only bad ones or worse ones).

Both public and private borrowing – and especially the latter – keep injecting yet more leverage into a system already awash with risk.

China – the why?

As we’ve seen, the sheer rate at which China borrows looks reckless in the extreme. But ‘reckless’ isn’t an adjective that many would apply to the government in Beijing. Why, then, has China seemingly turned into a debt-junkie?

The answer lies in the prosperity imperative of the ‘grand bargain’. For the average Chinese citizen, prosperity has three main meanings – employment, wages and household expenses (which include housing itself). Of these, employment predominates. What this means for the government is that employment must continue to grow. It must grow at rates which not only exceed the rate at which population numbers are expanding, but must also increase at least as quickly as workers migrate from the countryside to the cities.

In stark contrast to Western profit orientation, this makes China a volume-seeker. If employment is the overriding objective, profit matters less. For businesses heavily influenced by state objectives, expanding employment (and hence growing output volumes) is an imperative, almost irrespective of profitability. An enterprise succeeds by this criterion if it grows employment, even if this achieved at a loss.

This shows up in the figures, where business has accounted for most (68%) of all of the RMB 191tn borrowed over the last ten years. Essentially, business has borrowed for the twin purposes of financing losses and expanding capacity. The latter, of course, has the by-product of depressing margins, often pushing returns on assets to levels well below the cost of capital. China is therefore in something of a vortex, where new capacity requires borrowing whilst simultaneously undermining the ability to service existing debt. An apparent effort to convert debt into equity failed pretty spectacularly, when it came close to crashing Chinese equity markets.

In one sense, this use of debt to sustain and grow volumes has a direct corollary in the West, where “zombie” companies have been kept alive both by ultra-low interest rates and by the willingness of banks to roll over (by adding interest to capital) debts which would otherwise have had to be recognised to be non-performing.

In another way, using debt to finance capital investment may seem very different from the West’s use of credit to bolster consumption. The difference narrows, though, when it is recognised that the Chinese version, too, uses debt to underpin the incomes of working people.

Moreover, the priority placed on volumes over profits has implications for trade, where Washington, at least, isn’t prepared to accept the continued influx of products seemingly produced ‘at a loss’.

Any way out of the box?

As we’ve seen, America and China are in the same box, both having an imperative need to deliver prosperity at a time when this is becoming ever harder to achieve. In both instances, debt is simply a time-buying expedient, creating apparent prosperity in the short term, but at severe expense and risk to the collective balance sheet.

These debt-based responses are not just unsustainable but are highly risky, too. According to SEEDS, the sheer scale of indebtedness – and the truly shocking rate of ongoing credit dependency – puts China in the highest-risk category, along with Ireland, Britain and Canada. America’s level of risk isn’t quite so elevated, and it’s no coincidence at all that the energy challenge, too, is less acute for the United States (for now, anyway) than it is for China. Another big difference is that China’s ills are the product of circumstances, whereas much of the escalation in American risk is self-inflicted.

It’s interesting to speculate on quite how far the parallel risks of America and China are recognised at the level of policy. From the Chinese side, we can be very confident that the energy challenge is recognised, and we can assume, too, that Beijing is well aware of the debt problem. Here, it cannot be emphasised too strongly that the issue isn’t simply the absolute quantum of debt but the extent of dependency on the supply of credit continuing at quite extraordinary levels. (This is why SEEDS measures these two risks independently).

The combination of risk and sheer size must put China near the top of the watch-list for those monitoring the likeliest epicentre for the start of GFC II. Whilst we cannot rule out, for instance, market slumps in the United States, a property price crash in Canada, debt problems and instability in the Euro Area, and further rapid economic deterioration in Britain, the combination of energy and debt risk in China dwarfs these threats, serious though they are.

It is sometimes observed that China’s banks are, in effect, under state control, as though this makes a potential rescue a simple and painless matter. In reality, the difference between the Chinese and Western positions is far less than it appears. Western governments, no less than Beijing, would have to stand behind their banks in the event of a wave of cascading defaults. It’s pretty easy to envisage a Western government having to nationalise (by whatever name) a bank whose equity value has disappeared.

The obvious solution might appear to be for the Chinese government to simply take bank debt onto the public balance sheet. The snag is that this involves issuing RMB to the extent of the banks’ uncovered liabilities. This reminds us of the observation that, in the end, the world’s debt problem is going to turn into a currency credibility problem.

The claim that money creation through QE ‘isn’t inflationary’ rests on a narrow definition of inflation. If your definition of inflation includes only CPI, this assertion may be true. But, if it is recognised that asset price inflation matters at least as much as retail prices, QE has already been extremely inflationary. Using monetary issuance to tackle stratospheric debt levels and bloated banking systems cannot be undertaken without severe currency risk.

What we are left with is that, on a worldwide basis, we have compounded “credit adventurism” with “monetary adventurism” in trying to square the circle of deteriorating prosperity. The snag is that neither credit nor money can resolve a problem which has its roots in energy.

Ultimately, rising ECoE is making us poorer, and is doing so in ways that may not be acceptable politically, but which cannot, without grave and compounding risk, be wished or manipulated away with monetary tinkering.

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SEEDS 2.19 China 030718