A FINANCIAL CRISIS PRIMER
Amongst the world’s decision-makers, French president Emmanuel Macron has come closer than anyone to spelling out the reality of the current economic situation, saying that “we are in the process of living through a tipping point or great upheaval”, and referencing “the end of abundance” (my emphasis).
If his words are taken seriously – as they should be – a major crisis looms. The global financial system is entirely predicated on perpetual economic growth.
As important as what Mr Macron has said is what he didn’t say. He didn’t say that abundance is over ‘for a year or two’, or that we’ll have to live through this ‘until better times return’. He didn’t make fatuous promises of ‘sunlit uplands’ or ‘a new golden age’.
Some of us have long known that an age of abundance made possible by low-cost energy was coming to an end. Until now, though, decision-makers have fought shy of this conclusion, taking refuge in the tarradiddle of ‘infinite growth on a finite planet’ proffered by a deeply flawed economic orthodoxy.
What should concern us now isn’t when, or whether, other leaders will arrive at this same conclusion. The trend of events is going to impose that emerging reality upon them.
Rather, we need to be prepared for what happens when market participants arrive at the same conclusion as Mr. Macron.
The nature of the crisis
Preparedness requires clarity, and we need to be in no doubt that what we’re witnessing now is an unfolding affordability crisis. This means two things – and both of them point towards a major financial slump.
First, the ability of consumers to make discretionary (non-essential) purchases is in structural decline. This spells relentless contraction, not just in obvious discretionary sectors like leisure, travel and entertainment, but in ‘tech’ and consumer durables as well.
Second, households will find it increasingly difficult to ‘keep up the payments’ on everything from mortgages and credit to subscriptions and staged-payment purchases.
All of this has obvious negative implications for stock and property markets. But the real risk to the financial system resides, not in asset prices, but on the liabilities side of the equation.
The problems here are inter-connectedness, scale and opacity. Globally, private sector debt totalled $144 trillion at the start of the year, of which $85tn was owed to banks. But these numbers are dwarfed by broader private sector exposure. Analysis carried out for this report puts this number at $513tn, but this is no more than an informed estimate, because available data is neither complete nor timely. The probabilities are that $513tn understates the real scale of the problem.
Most disturbingly of all, the majority of this credit exposure isn’t subject to reporting and regulatory rules of the sort that apply to deposit-taking banks.
With hindsight, the causes of the global financial crisis (GFC) – sub-prime lending, securitization, imprudent lending and inadequate regulatory oversight – should have been apparent long before 2008.
Likewise, historians of the future can be expected to marvel at the subsequent further break-neck growth of an enormous network of interconnected commitments based on the false premise of infinite economic expansion.
Fig. 1 – whose constituent parts are discussed later – provides an overview of the scale of world financial exposure, comparing, at constant dollar values, the situation today with that of 2007, on the eve of the GFC.
At the end of abundance
Regular visitors to this site will know why material abundance is ending, and will also know that this turning point hasn’t hit us like a thunderbolt from cloudless skies. In fact, we’re at (or very near) the end of an end-of-growth precursor zone which we can trace right back at least as far as the 1990s.
It is surely self-evident that the economy is an energy system, not a financial one. But material prosperity isn’t a simple function of the quantitative availability of primary energy. Rather, the flow of economic value generated by the use of energy divides into two streams.
One of these is cost, meaning the proportion of accessed energy that, being consumed in the access process, is not available for any other economic purpose. This ‘consumed in access’ component is known here as the Energy Cost of Energy. Material prosperity is a function of the surplus energy that remains after ECoE has been deducted from the aggregate (or ‘gross’) amount of energy available.
Rising ECoEs affect the energy-prosperity dynamic in two ways. First, they reduce prosperity by decreasing the quantity of surplus energy available. Second, they make it ever harder to strike prices which meet the needs of both producer and consumer. In this equation, prices are an interface between producers’ costs and consumers’ prosperity. As costs rise and consumer affordability diminishes, aggregate supply starts to contract.
ECoEs have been rising over a very extended period, driven primarily by the effects of depletion on fossil fuels. Quite naturally, we have used lowest-cost resources first, leaving costlier alternatives for a ‘later’ that has now arrived.
This trend is a global one, and not even energy-rich countries like Russia or Saudi Arabia are exempt from it. Those who blame the current energy crisis on “Putin’s war” are victims of self-deception. The conflict in Ukraine has, at most, brought the end of energy abundance forward by a small number of years. Neither Saudi nor anyone else can ‘rescue’ us from the effects of rising ECoEs.
After the hope that trade with Russia will resume, the second consolation offered to the public – offered, perhaps, in full sincerity – is that transition to renewable energy sources will recreate the economic abundance hitherto bestowed by oil, natural gas and coal.
The reality, though, is that this is most unlikely to happen. The expansion of renewables depends upon the use of enormous quantities of materials including steel, concrete, copper, cobalt and lithium. These material requirements can only be made available by the use of legacy energy from fossil fuels.
The case for ‘seamless’ transition to renewables is based on three sources of self-delusion. One of these is mistaken extrapolation from past decreases in cost. The second is a failure to recognize that the capabilities of technology are bounded by the laws of physics. The third is simple wishful-thinking.
Advocates of transition to renewables are right to emphasise the critical importance of wind and solar power. A “sustainable economy” may indeed be possible, though it’s being made harder to achieve by our insistence on modelling the future on an adaptation of the processes of today (which is why we’re promoting electric vehicles, when trams and trains make a lot more sense).
But “sustainable growth” is a myth – there’s no reason to suppose that an economy powered by renewables will be as large as the fossil fuel economy of today, and every reason to expect that it will be smaller.
Understanding affordability compression
Just as prosperity decreases, the real costs of energy-intensive essentials will continue to rise. This is part of a broader pattern best understood by dividing economic resources into three functional segments.
These are the provision of essentials, capital investment in new and replacement productive capacity, and discretionary (non-essential) consumption.
These patterns are illustrated in fig. 2. These charts are designed to facilitate comparisons with other forecasts, so they accept latest-year (2021) GDP as a start-point, but use SEEDS prosperity calculations to restate prior trends, and to project future outcomes. Each is stated in national currencies at constant 2021 values.
As you can see, whilst aggregate prosperity is deteriorating, the costs of essentials are rising. This means that both capital investment capability and discretionary affordability are falling.
What this means at the household level is illustrated in fig. 3, where prosperity per capita is compared with trends in the estimated costs of essentials. These charts show average per capita numbers, meaning that the situations of those on below-average incomes are worse than these graphs might suggest.
Of course, decision-makers have never acted on any assumption other than ‘growth in perpetuity’. When rising ECoEs began to bear down on economic performance in the 1990s, the concept of energy causation was disregarded, and it was assumed that the material deceleration involved in “secular stagnation” could be fixed with financial tools.
Accordingly, access to credit was expanded, causing debt to rise rapidly. At least until 2008, this appeared to be working. In fact, though, what we had been doing was creating cosmetic “growth” with liability escalation.
The GFC should have laid bare the fallacy that we can create material supply with financial demand. Instead, decision-makers doubled down on this fallacy by supplementing “credit adventurism” with “monetary adventurism”. Negative real interest rates are a dangerous anomaly, incentivising borrowing whilst discouraging investment. The capitalist economy, after all, relies upon positive returns being earned by the owners of capital. It also depends on allowing markets to price risk without undue interference.
This means that, in 2022, we’re discovering what many have known (or at least suspected) all along – that we’ve been sacrificing the stability of the financial system, and the effective working of a market economy, in pursuit of a chimera of “growth”.
Go figure – the scale of exposure
Let’s start putting some numbers on the magnitude of global financial exposure. This is complicated, and fig. 1 (shown earlier) is intended to set out the broad structure of financial liabilities – at constant values – comparing the current situation with the equivalent position on the eve of the global financial crisis (GFC) in 2007.
Please note that the data set out in fig. 1 is stated in constant (2021) dollars converted from other currencies at market rates, not on the PPP (purchasing power parity) convention generally preferred here.
Conventional debt data is available from the Bank for International Settlements. BIS data shows that, at the end of last year, governments owed $81tn whilst, within private sector debt totalling $144tn, $85tn was owed to commercial banks.
The real issue, though, isn’t debt, but broader financial exposure. These “financial assets” – which are the liabilities of the government, household and private non-financial corporate (PNFC) sectors – are reported by the Financial Stability Board.
Financial assets fall into four broad categories. Three of these – central banks, public financial institutions and commercial banks – are self-explanatory, though it’s noteworthy that the total exposure of commercial banks (estimated here at $224tn) far exceeds the conventional debt owed to them by households and PNFCs ($85tn). The fourth is NBFIs, which means ‘non-bank financial intermediaries’.
We need to be clear that the FSB data is neither timely nor complete. The data covers 29 countries which, between them, account for about 85% of the world economy when measured as GDP. The most recently-available data, published on 16th December 2021, relates to the situation at the end of 2020.
To assess the current global position, then, we need to make informed estimates, brought forward to the present, based on the data that is available.
At this point, it’s vital to note that the FSB is not a regulatory authority. Generally speaking, deposit-taking institutions are regulated, but other credit providers are not. This is a huge gap in the ability of the authorities to maintain, or even to monitor, macroeconomic stability.
This lack of regulation is particularly important when we look at NBFIs. This sector is commonly referred to as the “shadow banking system”. NBFI exposure is enormous, and can be estimated at about $290tn as of the end of 2021. This exceeds the combined total of global government and private debt ($225tn).
The NBFI sector comprises various components, which include pension funds, insurance corporations, financial auxiliaries and OFIs (other financial intermediaries). This latter category includes money market funds, hedge funds and REITs.
In an article published in 2021, Ann Pettifor provided a succinct description of the shadow banking system. She traces the rise of the sector to the privatisation of pension funds, which happened in 30 countries between 1981 and 2014, and which, she says, “generated vast cash pools for institutional investors”.
Shadow banking participants “exchange the savings they hold for collateral”, generally in the form of bonds, usually government bonds. Instead of charging interest, they enter into repurchase (repo) agreements whereby the borrower undertakes to buy back the bonds at a higher price.
She points out that securities “are swapped for cash over alarmingly short periods”, and that “operators in the system have the legal right to re-use a security to leverage additional borrowing. This is akin to raising money by re-mortgaging the same property several times over. Like the banks, they are effectively creating money (or shadow money, if you like), but they are doing so without any obligation to comply with the old rules and regulations that commercial banks have to follow”.
Measuring the shadow
How much risk attaches to this depends, of course, on the scale at which it exists, and this is where we run into difficulties. As remarked earlier, FSB reporting covers only 29 economies, though these do account for about 85% of the global economy.
What we need are informed estimates of global financial exposure. The approach used here is to divide the financial assets universe into three parts.
One of these comprises the 23 (of 29) FSB reporting countries that are also covered by the SEEDS economic model.
The second group comprises specialist financial centres, of which two – Luxembourg and the Cayman Islands – are covered by FSB data.
As of 2020, Luxembourg had financial assets of $19.3tn, and a GDP of $79bn. The equivalent numbers for the Caymans were $8.9tn and $4.9bn. Accordingly, their respective ratios of financial assets to GDP were 23,678% (Luxembourg) and 253,485% (the Caymans).
The third group consists of all countries other than the 23 SEEDS-covered economies and the two specialist financial centres.
Together, these calculations suggest that aggregate financial assets totalled $520tn at the end of 2020, rising to an estimated $589tn last year. The deduction of the central bank and PFI (public financial institution) component puts private sector exposure at an estimated $513tn, most of which is unregulated.
The composition of available data and estimates is illustrated in fig. 4. (Like the other charts used here, fig. 4 can be expanded by opening it in a new tab).
Assets and liabilities – “the future is almost gone”
There’s no absolute “right” or “wrong” level of financial exposure. What matters is the relationship between monetary commitments and the underlying economy.
Those of us who understand the economy as an energy system are at a unique advantage when it comes to assessing the level and tendency of financial risk. The concept of “two economies” enables us to recognize the true nature of money – in short, we know that money isn’t ‘the economy’, but exists instead as an aggregate of ‘claims on the economy’, which is a wholly different proposition.
As you may know, money has no intrinsic worth, but commands value only as a ‘claim’ on the products and services supplied by the ‘real’ or material economy of products and services.
Three useful distinctions can be made here. First, current monetary activity is a financial representation of the underlying economy of goods and services. Second, liabilities are a claim on the material economy of the future. Third, asset pricing represents a collective perception of what the material economy of the future will be able to deliver.
As we’ve seen, the representation of the economy has become distorted by the use of monetary expansion to create cosmetic “growth”. Liabilities at their current size, meanwhile, could only be honoured “for value” if the underlying economy were to continue to expand indefinitely which, as we’re beginning to discover, cannot happen. Asset prices have been inflated, not just by ultra-low interest rates, but also on the basis of a collective misconception about the future size and shape of the economy.
Let’s clarify this a little by recognizing that both asset prices and liabilities are embodiments of collective futurity. By “futurity”, we mean common expectations for the future.
If forward expectations are positive, investors assume growing corporate profitability, whilst lenders assume an ability to service and honour expanding debt and quasi-debt commitments. If the expectations embodied in collective futurity are downgraded, asset prices become vulnerable to sharp corrections and, more importantly, assumptions about borrower viability are called increasingly into question.
The current economic crisis is causing an increasing resort to credit by struggling households and businesses. These ‘borrowers from need’ are a far greater default risk than ‘borrowers from choice’, but this worsening risk profile hasn’t – yet, anyway – been reflected in the availability and cost of credit.
Lenders’ collective insouciance about providing credit to high-risk borrowers may reflect a general assumption that credit providers will be bailed out ‘if the worst comes to the worst’.
We need to be absolutely clear that systemic-scale rescues aren’t possible, which is surely obvious to anyone who compares over $500tn of non-government liabilities with a $96tn economy.
This isn’t 2008, when “toxic assets” were largely confined to securitized sub-prime mortgages and reckless real estate-related lending. What we face now is the culling of large swathes of the discretionary economy, combined with degradation of the income streams which flow from households to the corporate and financial sectors. If the authorities attempted to backstop all of this with newly-created money, the result would be hyperinflation.
So the real problem now is – in the words of Mickey Newbury – that “the future’s not what it used to be”. We might also reference a newly-released song by Monkey House – “the future is almost gone”.
The essentially-positive collective futurity that has shaped both asset prices and the cost and supply of capital is turning out to have been wrong. This has a direct read-across to the expectations and attitudes, not just of investors, but of lenders as well.
If we’re making a list of critical interpretational phrases to help us understand changing conditions, we can add “a futurity reset” to “affordability compression”. Both are compatible with Mr Macron’s “end of abundance”.
A process of implosion
As we’ve seen, the long-established positive collective futurity is being undermined by a dawning recognition of the reality that we cannot rely on perpetual economic growth. We can’t know what the sequence of events is likely to be as this reality sinks in, but we do know some of its critical components.
One of these is a slump in capital markets, led by an investor flight from discretionary sectors. This can be expected to occur as soon as investors realize that affordability compression isn’t temporary but is, rather, an intrinsic component of the ending of abundance.
Another is a sharp fall in property prices, reflecting impaired affordability, compounded both by rate rises and by the prospect of distressed sales. People who can no longer afford to service the mortgages they already have are in no position to take on ever larger commitments. We have no systems in place for coping with collapsing property prices, even though such systems would not be difficult to design.
Governments can be expected to act, even before the financial system starts to implode, because of the need to address the hardship now being suffered by the public. But this is where the authorities are brought to a recognition of quite how limited their options really are. If they resort to full-on monetary intervention, the effects would be to drive inflation higher – particularly in the categories of necessities – which would make household hardship worse.
We need to be clear, meanwhile, that there is no single “right answer” to the rate policy conundrum. The Fed seems to think that rate rises, and the reversal of QE into QT, will defend the purchasing power of the dollar.
The Bank of England has been much criticized for raising rates, and is likely to face more flak over future rate hikes. In fact, it’s highly unlikely that the Bank is naïve enough to think that it can counter double-digit inflation with 0.5% increases in rates. Rather, the Bank can be presumed to be endeavouring to demonstrate to the markets that it’s not indifferent to defending the value of the pound. The very worst thing that could happen to the British economy would be a “Sterling crisis”, and the independence of the Bank is the single strongest defence against this happening.
The biggest danger of the lot, though, is an implosion within the credit sector, affecting not just banks but NBFIs as well. Here, market participants may – for some time, at least – hold their nerve, placing their trust in the (actually impossible) assumption that, as in 2008-09, governments and central banks will intervene to backstop the system.
Eventually, though, the network of interconnected liabilities will start to unravel, in a similar (though vastly larger) re-run of the ‘credit crunch’ of 2007. At this point, credit flows dry up, because nobody knows which counter-parties are or are not viable.
“All roads”, it’s said, “lead to Rome”, but all of the discernible trends in the financial system point to financial implosion.
As abundance ends, so, too, must any system that is predicated entirely on its infinite continuance.