THE “WHAT?” AND “WHERE?” OF GLOBAL RISK
After more than a decade of worsening economic and financial folly, it can come as no surprise that we’re living with extraordinarily elevated levels of risk.
But what form does that risk take, and where is it most acute?
According to SEEDS – the Surplus Energy Economics Data System – the riskiest countries on the planet are Ireland, France, the Netherlands, China, Canada and the United Kingdom.
The risks vary between economies. Some simply have debts which are excessive. Some have become dangerously addicted to continuing infusions of cheap credit. Some have financial systems vastly out of proportion to the host economy. Some have infuriated the general public to the point where a repetition of the 2008 “rescue” would inflame huge anger. Many have combinations of all four sorts of risk.
Here’s the “top six” from the SEEDS Risk Matrix. Of course, the global risk represented by each country depends on proportionate size, so China (ranked #4 in the Matrix) is far more of a threat to the world economy and financial system than Ireland, the riskiest individual economy. It’s noteworthy, though, that the three highest-risk countries are all members of the Euro Area. It’s also noteworthy that, amongst the emerging market (EM) economies, only China and South Korea (ranked #9) make the top ten.
Risk and irresponsibility
Before we get into methodologies and detailed numbers, it’s worth reflecting on why risk is quite so elevated. As regular readers will know, the narrative of recent years is that prosperity has been coming under increasing pressure ever since the late 1990s, mainly because trend ECoE (the energy cost of energy) has been rising, squeezing the surplus energy which is the source of all economic output and prosperity.
This is a trend which the authorities haven’t understood, recognizing only a vague “secular stagnation” whose actual root causes elude them.
Even “secular stagnation” has been unacceptable to economic and financial systems wholly predicated on “growth”. Simply put, there‘s been too much at stake for any form of stagnation, let alone deterioration, to be acceptable. The very idea that growth might be anything less than perpetual, despite the finite nature of the planet, has been treated as anathema.
If there isn’t any genuine growth to be enjoyed, the logic goes, then we’d better fake it. Essentially, nobody in authority has been willing to allow a little thing like reality to spoil the party, even if enjoyment of the party is now confined to quite a small minority.
Accordingly, increasingly futile (and dangerous) financial expedients, known here as adventurism, have been tried as “solutions” to the problem of low “growth”. In essence, these have had in common a characteristic of financial manipulation, most obvious in the fields of credit expansion and monetary dilution.
These process are the causes of the risk that we are measuring here, but risk comes in more than one guise. Accordingly, each of the four components of the SEEDS Risk Matrix addresses a different type of exposure.
These categories are:
– Debt risk
– Credit dependency risk
– Systemic financial risk
– Acquiescence risk
One final point – before we get into the detail – is that no attempt is made here to measure political risk in its broader sense. Through acquiescence risk, we can work out which populations have most to complain about in terms of worsening prosperity. But no purely economic calculation can determine exactly when and why a population decides to eject the governing incumbency, or when governments might be tempted into the time-dishonoured diversionary tactic of overseas belligerence. We can but hope that international affairs remain orderly, and that democracy is the preferred form of regime-change.
Debt risk
This is the easiest of the four to describe, and comes closest to the flawed, false-comfort measures used in ‘conventional’ appraisal. The SEEDS measure, though, compares debt, not with GDP but with prosperity, a very different concept.
Ireland, markedly the riskiest economy on this criterion, can be used to illustrate the process. At the end of 2018, aggregate private and public debt in Ireland is estimated at €963bn, a ratio of 312% to GDP (of €309 bn). Expressed at constant 2018 values, the equivalent numbers for 2007 (on the eve of the 2008 global financial crisis, which hit Ireland particularly badly) were debt of €493bn, GDP of €198bn and a debt/GDP ratio of 249%.
In essence, then, debt may be almost twice as big (+95%) now as it was in 2007, but the debt ratio has increased by ‘only’ 25% (to 312%, from 249%), because reported GDP has expanded by 56%.
Unfortunately, this type of calculation treats GDP and debt as discrete items, with the former unaffected by changes in the latter. The reality, though, is very different. Whilst GDP has increased by €111bn since 2007, debt has expanded by €470bn. Critically, much of this newly-borrowed money has flowed into expenditures, which serves to drive up the activity measured as GDP.
According to SEEDS, growth without this simple spending of borrowed money would have been only €13bn, not €111bn. Put another way, 89% of all “growth” reported in Ireland since 2007 has been nothing more substantial than the effect of pouring cheap credit into the system, helped, too, by the “leprechaun economics” recalibration of GDP which took place in 2015.
Of course, the practice of spending borrowed money and calling the result “growth” didn’t begin after the 2008 crash. Back in 2007, adjusted (“clean”) GDP in Ireland (of €172bn) was already markedly (13%) lower than headline GDP (€198bn), and the gap is even wider today, with “clean” GDP (of €184bn) now 40% lower than the reported number.
Even “clean” GDP isn’t a complete measure of prosperity, though, because it excludes ECoE – that proportion of output that isn’t available for other purposes, because it’s required to fund the supply of energy itself.
Where ECoE is concerned, Ireland is a disadvantaged economy whose circumstances have worsened steadily in recent years. Back in 2007, Ireland’s ECoE (of 6.7%) was already markedly worse than the global average (5.4%). By 2018, the gap had widened from 1.3% to 3.2%, with Ireland’s ECoE now 11.2% (and the world average 8.0%). An ECoE this high necessarily kills growth, which is why aggregate prosperity in Ireland now is only fractionally (2%) higher than it was in 2007, even though population numbers have grown by 10%.
The results of this process, where Ireland is concerned, have been that personal prosperity has declined by 7% since 2007, whilst debt per person has risen by 78%. The conclusion for Ireland is that debt now equates to 589% of prosperity (compared with 308% in 2007), and it’s hard to see what the country can do about it. If – or rather, when – the GFC II sequel to 2008 turns up, Ireland is going to be in very, very big trouble.
These are, of course, compelling reasons for the Irish authorities to bend every effort to ensure that Britain’s “Brexit” departure from the European Union happens as smoothly as possible. If the Irish government really understood the issues at stake, ministers would be exerting every possible pressure on Brussels to step back from its macho posturing and give Mrs May something that she can sell to Parliament and the voters.
There’s a grim precedent for Dublin not understanding this, though – in the heady “Celtic tiger” years before 2008, nobody seems to have batted an eyelid at the increasingly reckless expansion of the Irish banking system.
Credit dependency
As we’ve seen, adding €111bn to Irish GDP since 2007 has required adding €470bn to debt. This means that each €1 of “growth” came at a cost of €4.24 in net new borrowing. It also means that annual net borrowing averaged 14% of GDP during that period. This represents very severe credit dependency risk – in short, the Irish economy would suffer very serious damage in the event even of a reduction, let alone a cessation, in the supply of new credit to the economy.
Remarkably, though, there is one country whose credit dependency problem is far worse than that of Ireland – and that country is China.
The Chinese economy famously delivers growth of at least 6.5% each year, and reported GDP has more than doubled since 2008, increasing by RMB 51 trillion, from RMB37.7tn to an estimated RMB89tn last year.
Less noticed by China’s army of admirers has been a quadrupling of debt over the same period, from RMB53tn (at 2018 values) in 2008 to RMB219tn now. There also seem to be plausible grounds for thinking that China’s debts might be even bigger than indicated by published numbers.
This means that, over the last ten years, annual borrowing has averaged an astonishing 23% of GDP. No other economy comes even close to this, with Ireland (14.1%) placed second, followed by Canada (9.5%) in third, and South Korea (8.6%) a distant fourth. To put this in context, the ratios for France (8.1%) and Australia (7.5%) are quite bad enough – the Chinese ratio is as frightening as it is astonishing.
The inference to be drawn from this is that China is a ‘ponzi economy’ like no other. The country’s credit dependency ratio represents, not just extreme exposure to credit tightening or interruption, but an outright warning of impending implosion.
There are signs that the implosion may now be nearing. As well as slumping sales of everything from cars to smartphones, there are disturbing signs that industrial purchases, of components ranging from chips to electric motors, are turning downwards. Worryingly, companies have started defaulting on debts supposedly covered very substantially by cash holdings, the inference being that this “cash” was imaginary. Worse still, the long-standing assumption that the country could and would stand behind the debts of all state-owned entities (SOEs) is proving not to be the case. In disturbing echoes of the American experience in 2008, there are reasons to question why domestic agencies accord investment grade ratings to such a large proportion of Chinese corporate bonds.
How has this happened? The answer seems to be that the Chinese authorities have placed single-minded concentration on maintaining and growing levels of employment, prioritizing this (and its associated emphasis on volume) far above profitability. Put another way, China seems quite prepared to sell products at a loss, so long as volumes and employment are maintained. This has resulted in returns on invested capital falling below the cost of servicing debt capital – and an attempt to convert corporate bonds into equity was a spectacular failure, coming close to crashing the Chinese equity market.
Systemic exposure
Debt exposure and credit dependency are relatively narrow measures, in that both concentrate on indebtedness. Critical though these are, there is a broader category of exposure termed here systemic risk, and this is particularly important in terms of the danger of contagion between economies.
The countries most at risk here are Ireland (again), the Netherlands and Britain. All three have financial sectors which are bloated even when compared with GDP. But the true lethality of systemic risk exposure only becomes fully apparent when prosperity is used as the benchmark.
At the most recent published date (2016), Dutch financial assets were stated at $10.96tn (€10.4tn), or 1470% of GDP. The SEEDS model assumes that the ratio to GDP now is somewhat lower (1360%), which implies financial assets unchanged at €10.4tn.
As we’ve seen with Ireland, measurement based on GDP produces false comfort, because GDP is inflated by the spending of borrowed money, and ignores ECoE. In the Netherlands, growth in GDP of €82bn (12%) between 2007 and 2018 needs to be seen in the context of a €600bn (32%) escalation in debt over the same period. This means that each €1 of reported “growth” has required net new borrowing of €7.40. Without this effect, SEEDS calculates that organic growth would have been just €8bn (not €82bn), and that ‘clean’ GDP in 2018 was €619bn, not €767bn.
The further deduction of ECoE (in 2018, 10.5%) reduces prosperity to €554bn. This is lower than the equivalent number for 2007 (€574bn), and further indicates that the prosperity of the average Dutch person declined by 8% over that period.
Though aggregate prosperity is slightly (3.5%) lower now than it was in 2007, financial assets have expanded by almost 40%, to €10.4tn now from €7.47tn (at 2018 values) back in 2007. This means that financial assets have grown from 1303% of prosperity on the eve of GFC I to 1881% today.
As the next table shows, this puts Holland second on this risk metric, below Ireland (3026%) but above the United Kingdom (1591%). Japan (924%) and China (884%) are third and fourth on this list.
Needless to say, the Irish number looks lethal but, since Ireland is a small economy, equates to financial assets (of €4.9tn) that are a lot smaller than those of the Netherlands (€10.4tn). Likewise, British financial assets are put at £23.3tn, a truly disturbing number when compared with GDP of £2tn, let alone prosperity of £1.47tn.
The conclusion on this category of risk has to be that Ireland, Holland and Britain look like accidents waiting to happen. Something not dissimilar might be said, too, of Japan and China. Japan’s gung-ho use of QE has resulted in half of all JGBs (government bonds) being owned by the BoJ (the central bank), whilst huge financial assets (estimated at RMB417tn) underscore the risk perception already identified by China’s dependency on extraordinary rates of credit creation.
Acquiescence risk
The fourth category of risk measured by SEEDS concentrates on public attitudes rather than macroeconomic exposure. Simply put, we can assume that, when the GFC II sequel to the 2008 global financial crisis (GFC I) hits, governments are likely to try to repeat the “rescue” strategies which bought time (albeit at huge expense) last time around. But will the public accept these policies? Or will there be a huge popular backlash, something which could prevent such policies from being implemented?
It’s not difficult to envisage how this happens. If we can picture some politicians announcing, say, a rescue of the banks, we can equally picture some of their opponents pledging to scrap the rescue at the earliest opportunity, and take the banks into public ownership, pointing out that stockholder compensation will not be necessary because, in the absence of a taxpayer bail-out, the worst-affected banks have zero equity value anyway. Simply put, this time around there could be more votes in the infliction of austerity on “the wealthy” than there will be in bailing them out. It’s equally easy to picture, at the very least, public demonstrations opposing such a rescue.
Even at the time, and more so as time has gone on, the general public has nurtured suspicions, later hardening into something much nearer to certainties, that the authorities played the 2008 crisis with loaded dice. One obvious source of grievance has been the management of the banking crash. The public may understand why banks were rescued, but cannot understand why the rescue included the bankers as well, whose prior irresponsibility is assumed by many to have been the cause of the crisis – especially given the unwillingness of governments to rescue those in other occupations, such as manufacturing, retail and hospitality.
The 2008 crisis was followed by a fashion for “austerity”, in which the public was expected to accept lean times as part of a rehabilitation of national finances after debts and deficits had soared during GFC I. Unfortunately, the imposition of “austerity” has looked extremely one-sided. Whilst public services budgets have been cut, the authorities have operated policies which have induced extraordinary inflation in asset prices. These benefits, for the most part enjoyed by a small minority, haven’t even been accompanied by fiscal changes designed to capture at least some of the gains for the taxpayer.
The word ‘hypocrisy’ has been woven like a thread into the tapestry of post-2008 trends, which are widely perceived as having inflicted austerity on the many as the price of rescuing the few. It hardly helps when advocates of “austerity” seem not to practice it themselves. Policies since 2008 have been extraordinarily divisive, not just between “the rich” and the majority, but also between the old (who tend to own assets) and the young (who don’t).
In short, the events of 2008 have created huge mistrust between governing and governed. This might not have mattered quite so much had the prosperity of the average person continued to grow, but, in almost all Western countries, this has not been the case. Whatever might be claimed about GDP, individuals sense – rightly – that they’re getting poorer. We’ve already seen the results of this estrangement, in the election of Donald Trump, the “Brexit” vote in Britain and the rise of insurgent (aka “populist”) parties in many European countries. Latterly, France has witnessed the eruption of popular anger in the gilets jaunes movement, something which might well be replicated in other countries.
For reasons which vary between countries – but which have in common a complete failure to understand deteriorating prosperity – established policymakers have seemed blinded to political reality by “the juggernaut effect”.
Where, though, is acquiescence risk most acute? The answer to this seems to lie less in the absolute deterioration in average prosperity than in the relentless squeeze in discretionary (“left in your pocket”) prosperity – simply put, how much money does a person have left at the end of the week or month, after taxes have been paid, and essential expenses have been met?
This discretionary effect helps to explain why the popular backlash has been so acute in France. At the overall level, the decline in French prosperity per person since 2007 has been a fairly modest 6.3%, less severe than the experiences of a number of other countries such as Italy (-11.6%), Britain (-10.3%), Norway (-8.4%) and Greece (-8..0%). Canadians (-8.1%) and Australians (-9.0%), too, have fared worse than the French.
Take taxation into account, though, and France comes top of the league. Back in 2007, prosperity per person in France was €28,950, which after tax (of €17,350) left the average person with €11,600 in his or her pocket. Since then, however, whilst prosperity has declined by €1,840 per person, tax has increased (by €1,970), leaving the individual with only €7,790, a 33% fall since 2007.
In no other country has this rapidity of deterioration been matched, though discretionary prosperity has fallen by 28% in the Netherlands, by 24% in Britain, by 23% in Australia and by 18% in Italy. If this interpretation makes sense of the popularity of the gilets jaunes (and makes absolutely no sense of the French authorities’ responses), it also suggests that the Hague, London and perhaps Canberra ought to be preparing themselves for the appearance of yellow waistcoats on their streets.
Surplus Energy Economics 