#178. The Ides of Autumn

SEEDS, STAGFLATION AND CRASH RISK

For anyone involved in economic interpretation, these are hectic times. They’re frustrating times, too, for those of us who understand that the economy is an energy system, but have to watch from the sidelines as huge mistakes are made on the false premise that economics is ‘the study of money’, and that energy is ‘just another input’.

Latest developments with the SEEDS model add to this frustration, because it’s becoming clear that energy-based interpretation can identify definite trends in the relationships between energy use, economic output, ECoE (the energy cost of energy), prosperity and climate-harming emissions. Cutting to the chase on this, the efficiency with which we convert energy into economic value is improving, but only very slowly, whilst the countervailing, adverse trend in ECoEs (which determine the relationship between output and prosperity) is developing more rapidly.

Where observing our decision-makers and their advisers is concerned, we’re in much the same position as the soldiers who “would follow their commanding officer anywhere, but only out of a sense of morbid curiosity”. Essentially, policy-makers who’ve long been following the false cartography of ‘conventional’ economics have now encountered a huge hazard that simply isn’t depicted on their maps.

Having used SEEDS to scope out the general shape of the economy during and (hopefully) after the Wuhan coronavirus pandemic, there seem to be two questions of highest immediate priority. The first is whether the crisis will usher in an era of recessionary deflation or monetarily-triggered inflation, and the second concerns the likelihood of a near-term ‘GFC II’ sequel to the global financial crisis (GFC) of 2008.

On the latter, it’s becoming ever harder to see any way in which a crash (which has been long in the making anyway) can be averted. Indeed, it could be upon us within months. The ‘inflation or deflation?’ question is more complicated, because it needs to be seen within drastic structural changes now taking place in the economy.

Let’s start with how governments have responded to the economic effects of the pandemic. The ‘standard model’ has involved a two-pronged response, because the crisis has posed two classes of threat to the system. The first is an interruption to the incomes of people and businesses idled by lockdowns, and the second is that households could be rendered homeless, and otherwise-viable enterprises put out of business, by a temporary inability to keep up with payment of interest and rent.

Accordingly, governments have responded with policies which are termed here support and deferral. ‘Support’ has meant replacing incomes, albeit in part, by running enormous fiscal deficits, which, in the jargon, means injecting fiscal stimulus on an unprecedented scale. ‘Deferral’ has been carried out by providing payment ‘holidays’ for borrowers and tenants.

Neither of these responses is remotely sustainable for more than a few months, but there’s a difference between them in terms of timescales. Whereas support has to be (and has been) provided now, deferral pushes problems forward to that point in the near future at which lenders and landlords can no longer survive the effects of the payment ‘holidays’ granted to household and business borrowers and tenants.

The most pressing risk now is that the need to exit ‘deferral’ will arrive before the provision of ‘support’ has ceased to be necessary. We can think of this as a vector pointing towards the near future.

In the United States, for example, unemployment payments are being reduced, and payment ‘holidays’ are being terminated, precisely because of the vector which these converging policy responses create. Simply put, government cannot afford to continue income support indefinitely, whilst payment ‘holidays’ are already posing grave risks to the survival of counterparties (lenders and landlords) – and this triangulation is just as much of a problem in other countries as it is in America.

Unfortunately, the gobbledegook of ‘conventional’ economics acts to disguise how serious our economic plight really is. For example, British GDP was reported to have deteriorated by ‘only’ (in the circumstances) 20% in April, because an underlying deterioration (of close to 50%) was offset by the injection of £48bn borrowed by the government. Whilst a further £55bn borrowed in May took the total increase in government debt to £103bn, the Bank of England, in parallel, created a very similar (and by no means coincidentally so) £100bn of new money with which to purchase pre-existing government debt.

In other words – and across much of the world, not just in Britain – central banks are monetising the stimulus being injected into the economy by governments. All other things being equal, too much of this would pose a threat to the credibility and the purchasing power of fiat currencies. It’s not quite that simple, of course – and all other things aren’t equal – but it would be folly to dismiss this very real potential hazard.

The effects of these processes on the ‘real’ economy of goods and services are instructive. Where household essentials are concerned, demand has been sustained (by income support), but supply has been reduced by lockdowns. What this has meant is that the prices of household essentials have started moving up, at rates that would appear to have annualised equivalents of roughly 8%. This, incidentally, has been happening even though energy prices have slumped. What’s driving inflation in the ‘essentials’ category is the divergence between supply (impacted by lockdowns) and demand (supported by governments).

Where discretionary (non-essential) purchases are concerned, an opposite trend has set in. Consumers’ incomes, though supported by governments, are nevertheless lower than they were before the crisis, meaning that demand for discretionaries has fallen. This has been compounded by consumer caution, caused in part by fear and uncertainty, but also by impaired incomes, rising debts and diminished savings. Similar trends are visible amongst businesses which, much like consumers, are continuing to spend on things that they must have, but are slashing their expenditures (including their investment) on anything discretionary or, to put it colloquially, ‘optional’.

These trends are going to have profound consequences, not just for the economy, but for businesses in the favoured and unfavoured sectors, a theme to which we might return at a later time, because it also feeds into the broader issue of what “de-growth” is going to mean for business.

With the cost of essentials rising whilst the prices of discretionaries are falling, broad inflation has remained at or close to zero, but these are early days in a fast-changing situation. Whilst the statisticians are still-playing catch-up, the ordinary person probably already knows that the cost of essentials is rising, whilst his or her reduced spending on discretionaries might serve to disguise the countervailing falls in their prices.

Where the slightly longer-term is concerned, one school of thought contends that prolonged recession will induce deflation, whilst another states that monetary intervention is likely, on the contrary, to trigger rising inflation.

Those who are dovish on the issue point out that the extensive use of newly-created QE money back in 2008-09 did not promote inflation, though that argument is weakened if we include asset prices, and not just consumer purchases, in our definition of inflation.

The essence of the dovish case is that money injected into asset markets can be ‘sanitised’, such that it doesn’t ‘leak’ into the broader economy.  There is some justification for this view, because asset aggregates are purely notional values – whilst the investor can sell his stock portfolio, or the homeowner his house, the entirety of these asset classes can never be monetised, because the only potential buyers of, say, a nation’s housing stock are the same people to whom that stock already belongs. When ‘valuations’ are placed on the entirety of an asset class, what’s really happening is that marginal transaction prices are being applied to produce an aggregate valuation, even though the asset class could never be sold in its entirety.

In practical terms, this limits the ability of investors to ‘pull their money out’, because they can only do this by finding other investors willing to buy. It also leverages intervention, such that, for instance, the value of an asset class may be increased by a large amount (or a fall of that magnitude prevented) by a comparatively small intervention at the margin, especially where the psychology of intervention has deterred potential sellers.

Where inflationary consequences are concerned, though, these are matters of degree. Back in the GFC, the four main Western central banks (the Fed, the ECB, the BoJ and the BoE) increased their assets by $3.2tn between July 2007 ($3.55tn) and December 2008 ($6.73tn). In the space of just four months between February and June this year, these central banks spent $5.6tn, a larger sum even when allowance is made for the changing values of money.

To be clear, asset purchases thus far have not been enough to shake confidence in currencies. Neither $230bn of purchases by the Bank of England, $590bn spent by the Bank of Japan, or even the $1.85 tn injected by the European Central Bank, is a large enough sum to put currency credibility at risk. The Fed, meanwhile, having spent $2.94tn between February and May, pulled its horns in slightly during June, reducing net purchases thus far to $2.89tn.

To draw comfort from these numbers, though, would be to reckon without a number of other significant factors. One of these is that economic activity is falling much more rapidly now than it did back in the GFC, even though the extent of this fall is being disguised by the effects of fiscal stimulus. Whilst reported global GDP might decrease by about 11% this year, SEEDS calculations suggest that the slump in underlying or ‘clean’ economic output (C-GDP) is likely to be around 17%, and could be worse than that.

Secondly, and more significantly, there is a clear danger that the monetisation of borrowing may come to be seen as a ‘new normal’ (though, of course, a new abnormal would describe it better). If the running of fiscal deficits, which are then monetised, ceases to be regarded as a temporary and emergency measure, and comes instead to be seen as standard practice, a very hefty knock will have been dealt to faith in currencies.

The third (and still worse) risk is something that we might term ‘the Ides of Autumn’. If governments have to keep on running deficits, and are still doing this at a point where deferral ‘holidays’ force them to bail out lenders and landlords, then we could enter wholly uncharted territory. Additionally, the Fed has taken upon itself the task of propping up asset markets, in theory just in the US but, in practice, around the world.

To put this in context, we need to think ahead to some future point, quite possibly in September or October, when things could well start to go horribly wrong. Governments and central banks, still supporting incomes through stimulus programmes, now have a choice to make. Do they stand back and watch lenders and landlords fail, accept a wave of massive defaults on household and business debt, and allow a crash in the prices of (for example) stocks and property?

The strong probability has to be that they would not sit back and just let these things happen. If to this is added the likelihood of permanent (or, at least, very long-lasting) falls in productive capacity, we have the ingredients for monetary intervention on a scale quite without precedent. To be sure, the Fed has pulled back from intervention in recent weeks, but we can by no means assume a continuation of such insouciance in a situation where banks are on the brink of failure, Wall Street is tumbling, property prices are slumping and borrowers are on the edge of mass default.

There are, then, very good reasons for drawing at least two inferences from the current situation. The first is that, in a reversal of what happened in 2008-09, a financial crash might very well follow (rather than precede) an economic slump. The second is that, faced with the frightening alternatives, central banks might decide that massive monetisation is ‘the lesser of two [very nasty] evils’.

To return to where we started, energy-driven interpretation reveals that the financial system, and policy more broadly, has been building a monster for at least twenty years. It is indeed ludicrous that people and businesses have been paid to borrow, by negative real rates, and by the narrative that the Fed and others will never let anyone pay the price of recklessness.  As ECoEs have risen, and prosperity growth has ceased and then started to go into reverse, policymakers have persuaded themselves that ‘growth in perpetuity’ can be sustained by ever-greater credit and monetary activism, and by an implicit declaration that the whole system is ‘too big to fail’. That trying to fix the ‘real’ economy with monetary gimmickry is akin to ‘trying to cure an ailing house-plant with a spanner’ seems never to have occurred to them. We may be very close to learning the price of ignorance and hubris.

 

 

#177. Poorer, angrier, riskier

MODELLING THE CRUNCH

It became clear from a pretty early stage that the Wuhan coronavirus pandemic was going to have profoundly adverse consequences for the world economy. This discussion uses SEEDS to evaluate the immediate and lasting implications of the crisis, some of which may be explored in more detail – and perhaps at a regional or national level – in later articles.

Whilst it reinforces the view that a “V-shaped” rebound is improbable, this evaluation warns that we should beware of any purely cosmetic “recovery”, particularly where (a) unemployment remains highly elevated (there is no such thing as a “jobless recovery”), and (b) where extraordinary (and high-risk) financial manipulation is used to create purely statistical increases in headline GDP.

The bottom line is that the prosperity of the world’s average person, having turned down in 2018, is now set to deteriorate more rapidly than had previously been anticipated.

Governments, which for the most part have yet to understand this dynamic, are likely inadvertently to worsen this situation by setting unrealistic revenue expectations based on the increasingly misleading metric of GDP, resulting in a tightening squeeze on the discretionary (“left in your pocket”) prosperity of the average person.

Exacerbated by crisis effects, the average person’s share of aggregate government, household and business debt is poised to rise even more rapidly than had hitherto been the case.

These projections are summarised in the first set of charts.

Fig. 1

Consequences

The implication of this scenario for governments is that revenue and expenditure projections need to be scaled back, and priorities re-calibrated, amidst increasing popular dissatisfaction.

Businesses will need to be aware of deteriorating scope for consumer discretionary spending, and could benefit from front-running some of the tendencies (such as simplification and de-layering) which are likely to characterise “de-growth”.

The environmental focus will need to shift from ‘big ticket’ initiatives to incremental gains.

Amidst unsustainably high fiscal deficits, and the extreme use of newly-created QE money to monetise existing government debt, we need also to be aware of the risk that, in a reversal of the 2008 global financial crisis (GFC) sequence, a financial crash might follow, rather than precede, a severe economic downturn.

Methodology – the three challenges

Regular readers will be familiar with the principles of the surplus energy interpretation of the economy, but anyone needing an introduction to Surplus Energy Economics and the SEEDS system can find a briefing paper at the resources page of this site. What follows reflects detailed application of the model to the conditions and trends to be expected after the coronavirus crisis.

Simply put, SEE understands the economy as an energy system, in which money, lacking intrinsic value, plays a subsidiary (though important) role as a medium of exchange. A critical factor in the calibration of prosperity is ECoE (the Energy Cost of Energy), which determines, from any given quantity of accessed energy, how much is consumed (‘lost’) in the access process, and how much (‘surplus’) energy remains to power all economic activities other than the supply of energy itself.

Critically, the depletion process has long been exerting upwards pressure on the ECoEs of fossil fuel (FF) energy, which continues to account for more than four-fifths of the energy used in the economy. The ECoEs of renewable energy (RE) alternatives have been falling, but are unlikely ever to become low enough to restore prosperity growth made possible in the past by low-cost supplies of oil, gas and coal.

Accordingly, global prosperity per capita has turned downwards, a trend which can be disguised (but cannot be countered) by various forms of financial manipulation.

This means that, long before the coronavirus pandemic, the onset of “de-growth” was one of three main problems threatening the economy and the financial system. The others are (b) the threat of environmental degradation – which will never be tackled effectively until the economy is understood as an energy system – and (c) the over-extension of the financial system which has resulted from prolonged, futile and increasingly desperate efforts to overcome the physical, material deterioration in the economy by immaterial and artificial (monetary) means.

On these latter issues, the slump in economic activity has had some beneficial impact on climate change metrics, whilst we can expect a crisis to occur in the financial system because its essential predicate – perpetual growth – has been invalidated. The global financial system has long since taken on Ponzi characteristics and, like all such schemes, is wholly dependent on a continuity that has now been lost.

Top-line aggregates

With these parameters understood, the critical economic issue can be defined as the rate of deterioration in prosperity, for which the main aggregate projections from SEEDS are set out in fig. 2. Throughout this report, unless otherwise noted, all amounts are stated in constant international dollars, converted from other currencies using the PPP (purchasing power parity) convention.

During the current year, world GDP is projected to fall by 13%, recovering thereafter at rates of between 3% and 3.5%. This rebound trajectory, though, assumes extraordinary levels of credit and monetary support, reflected, in part, in an accelerated rate of increase in global debt.

Within debt projections, the greatest uncertainties are (a) the possible extent of defaults in the household and corporate sectors, and (b) the degree to which central banks will monetise new government issuance by the backdoor route of using newly-created QE money to buy up existing debt obligations.

This is a point of extreme risk in the financial system, where a cascade of defaults – and/or a slump in the credibility and purchasing power of fiat currencies – are very real possibilities, particularly if the ‘standard model’ of crisis response starts to assume permanent characteristics.

Fig.2

Looking behind the distorting effects of monetary intervention, it’s likely that underlying or ‘clean’ output (C-GDP) will fall by about 17% this year and, after some measure of rebound during 2021 and 2022, will revert to a rate of growth which, at barely 0.2%, is appreciably lower than the rate (of just over 1.0%) at which world population numbers continue to increase. Additionally, ECoEs can be expected to continue their upwards path, driving a widening wedge between C-GDP and prosperity.

These effects are illustrated in fig. 3, which highlights, as a pink triangular wedge, the way in which ever-looser monetary policies have inflated apparent GDP to levels far above the underlying trajectory. This is the element of claimed “growth” that would cease if credit expansion stalled, and would go into reverse in the event of deleveraging. The gap between C-GDP and prosperity, meanwhile, reflects the relentless rise of trend ECoEs. This interpretation, as set out in the left-hand chart, is contextualised by the inclusion of debt in the centre chart.

Fig. 3

Fig. 3 also highlights, in the right-hand chart, a major problem that cannot be identified using ‘conventional’ methods of economic interpretation. Essentially, rapid increases in debt serve artificially to inflate recorded GDP, such that ratios which compare debt with GDP have an intrinsic bias to the downside during periods of rapid expansion in debt.

Rebasing the debt metric to prosperity – which is not distorted by credit expansion – indicates that the debt ratio already stands at just over 350% of economic output, compared with slightly under 220% on a conventional GDP denominator. As the authorities ramp up deficit support – and, quite conceivably, make private borrowing even easier and cheaper than it already is – the true scale of indebtedness will become progressively higher, thus measured, than it appears on conventional metrics.

Personal prosperity – a worsening trend

The per capita equivalents of these projections are set out in fig. 4, which expresses global averages in thousands of constant PPP dollars per person. After a sharp (-18%) fall anticipated during the current year, prosperity per capita is expected to recover only partially before resuming the decline pattern that has been in evidence since the ‘long plateau’ ended in 2018, and the world’s average person started getting poorer.

Meanwhile, each person’s share of the aggregate of government, household and business debt is set to rise markedly, not just in 2020 but in subsequent years. By 2025, whilst prosperity per capita is set to be 17% ($1,930) lower than it was last year, the average person’s debt is projected to have risen by nearly $17,900 (45%).

These, in short, are prosperity and debt metrics which are set to worsen very rapidly indeed. The world’s average person, currently carrying a debt share of $40,000 on annual prosperity of $11,400, is likely, within five years, to be trying to carry debt of $58,000 on prosperity of only $9,450.

This may simply be too much of a burden for the system to withstand. We face a conundrum, posed by deteriorating prosperity, in which either debt becomes excessive in relation to the carrying capability of global prosperity, and/or a resort to larger-scale monetisation undermines the credibility and purchasing power of fiat currencies.

Fig. 4

In fig. 5 – which sets out some per capita metrics in chart form – another adverse trend becomes apparent. This is the fact that taxation per capita has continued to rise even whilst the average person’s prosperity has flattened off and, latterly, has turned down.

What this means is that the discretionary (“left in your pocket”) prosperity of the average person has become subject to a squeeze, with top-line prosperity falling whilst the burden of tax continues to increase.

Fig. 5

This also means that, in addition to deteriorating prosperity itself, there are two leveraging processes which are accelerating the erosion of consumers’ ability to make non-essential purchases.

The first of these is the way in which taxation is absorbing an increasing proportion of household prosperity, and the second is the rising share of remaining (discretionary) prosperity that has to be allocated to essential categories of expenditure.

These are not wholly new trends – and they help explain the pre-crisis slumps in the sales of non-essentials such as cars and smartphones – but one of the clearest effects of the crisis is to increase the downwards pressure on consumers’ non-essential expenditures.

Governments – the hidden problem

This has implications for any business selling goods and services to the consumer, particularly where their product is non-essential. It also sets governments a fiscal problem of which most are, as yet, seemingly wholly unaware.

As can be seen in fig. 6, governments have, over an extended period, managed to slightly more than double tax revenues whilst maintaining the overall incidence of taxation at a remarkably consistent level of about 31% of GDP.

This has led them to conclude that the burden of taxation has not increased materially, even though their ability to fund public services has expanded at trend annual real rates of slightly over 3%. When – as has happened in France – the public expresses anger over taxation, governments seem genuinely surprised by popular discontent.

The problem, of course, is that, over time, GDP has become an ever less meaningful quantification of prosperity. When reassessed on the denominator of prosperity, the tax incidence worldwide has risen from 32% in 1999, and 39% in 2009, to 51% last year (and is higher still in some countries). On current trajectories, the tax ‘take’ from global prosperity per capita would reach almost 70% by 2030, a level which the public are unlikely to find acceptable, especially in those high-tax economies where the incidence would be even higher.

Conversely, if (as in the right-hand chart in fig. 6) taxation was to be pegged at the 51% of prosperity averaged in 2019, the resulting ‘sustainable’ path would see taxation fall from an estimated $43tn last year to $38tn (at constant values) by 2030. At -12%, this may not seem a huge fall in fiscal resources, but it is fully 27% ($14tn) lower than where, on the current trajectory, tax revenues otherwise would have been.

Fig. 6

Politically, there seems little doubt that the widespread popular discontent witnessed in many parts of the world during the coronavirus crisis has links to deteriorating prosperity. Historically, clear connections can be drawn between social unrest and the related factors of (a) material hardship and (b) perceived inequity.

At the same time, the sharp deterioration in prosperity seems certain to exacerbate international tensions, where countries competing for dwindling prosperity may also seek confrontation as a distraction technique. These are amongst the reasons why a world that is becoming poorer is also becoming both angrier and more dangerous.

#176. Protect and Survive

THE AUTHORITIES’ ‘RACE AGAINST TIME’

Before we can assess the outlook for the economy after the Wuhan coronavirus pandemic, we need to be familiar with the measures adopted by the authorities to tackle the crisis itself. Whilst these measures themselves are reasonably well-known, it seems that some of the associated risks are by no means so clearly understood.

Critically, governments and central banks face an imprecise (but undoubtedly critical) time-deadline which, if missed, could create an extraordinarily hazardous combination of circumstances.

The ‘standard model’ response

The coronavirus crisis, and the use of lockdowns in an effort to curb the spread of the virus, have posed two different challenges to the economy, and these have been met by two different types of response.

The more obvious and immediate impact has been the sharp fall in economic activity itself.

The second is the risk that households may lose their homes, and that otherwise-viable enterprises might be put out of business, by an inability to keep up with rent payments and debt servicing due to the temporary impairment of their incomes.

Official responses to these problems have involved, respectively, support and deferral.

Support has been provided by governments running extraordinary (and, in anything but the very short term, unsustainable) fiscal deficits in order to replace incomes, with these deficits essentially monetised by central banks’ use of newly-created QE money to acquire pre-existing government debt. The alternative, of course, would be for central banks to sit this out, and let government debts soar, but monetisation seems to have been judged, perhaps correctly, as the lesser of two evils.

Deferral, meanwhile, has taken the form of rent, debt and interest ‘holidays’, whose effect is to push such costs out into the future.

Fiscal support programmes are exemplified by the British situation, in which a deficit of £48bn limited, to ‘only’ 20.4%, a decline in April GDP which would otherwise have been a slump of close to 50%. A further deficit of £55bn during May pushed the two-months’ total to £103bn, a number remarkably (and surely by no means coincidentally) similar to the £100bn of QE thus far undertaken by the Bank of England.

A time-constrained expedient

Though there have been variations around this theme – most notably in the United States, where the Fed seems to have attached inordinate importance to the prevention of slumps in asset prices – there has been an identifiable ‘standard model’ of responses which combines deficit-funded support for the economy with central bank monetisation of equivalent amounts of existing public debt. Over the course of three months, the three main Western central banks – the Fed, the ECB and the Bank of Japan – have increased their assets by $4.5 trillion, or 31%, a sum equivalent to 10.5% of their aggregate annual GDPs.

Essentially, and despite some variations in the types of assets purchased, this amounts to the back-door monetisation of the new debts incurred to support economic activity. Although Japan has been getting away with wholesale debt monetisation for many years, this process nevertheless carries very real risks. If markets, and indeed the general public, ever came to think that the monetisation of deficits had become the ‘new abnormal’, the credibility and purchasing power of fiat currencies would be put at very serious risk.

This risk most certainly should not be underestimated – after all, the $2.9tn of asset purchasing undertaken by the Fed between February and May equates, on an annualised basis, to 55% of American GDP, with the equivalent ratios for other areas being 39% in Japan, 32% in the Euro Area and 23% in Britain.

If any of these central banks actually did monetise debt at these ratios to GDP over a whole year, currency credibility would suffer grievous impairment.

A race against time

This ‘standard model’ of support response, then, is a time-constrained process, viable for a single quarter, and perhaps for as much as six months, but not for longer.

Meanwhile, there are obvious time constraints, too, on a deferral process which imposes income delays on counterparties such as lenders and landlords.

If all goes well, a reasonably rapid economic recovery will enable governments and central banks to scale back deficits and monetisation before this process risks impairing credibility. An optimistic scenario would postulate that, by the time that this normalization has been concluded, the authorities will also have worked out how to wind up the deferrals process in ways that protect households and businesses without imperilling landlords and lenders.

There is, though, an all-too-plausible alternative in which deficit support is still being provided at a point when deferral is no longer feasible. This is a ‘nightmare scenario’ in which, as well as continuing to monetise high levels of fiscal deficits, central banks also have to step in to rescue lenders and landlords.

Thus understood, governments and central bankers are engaged in a race against time. They cannot carry on monetising deficit support for more than a few months, and neither can they prolong rent and interest deferrals to the point where landlords and lenders are put at risk. This makes it all the more surprising (and disturbing) that some countries are acting in ways that seem almost to invite a crisis-prolonging “second wave” of coronavirus infections.