#264: The soufflé economy

AT THE LIMITS OF SELF-DECEPTION

Imagine – it couldn’t happen, but imagine – that Congress agreed that it wouldn’t impose a future debt ceiling if the administration promised henceforth to balance the budget. To do this, somewhere between USD 1.6 trillion and USD 2.0 trillion, depending how we calculate it, would have to be pulled out of the budget – taxes would have to rise, public expenditures would have to fall, or a combination of both.

Likewise, and equally impossibly, the Fed committed itself to maintaining interest rates, in perpetuity, at positive real (ex-inflation) levels.

Under these imaginary conditions, capitalism would, at least in part, be restored, because one of the two essential predicates of market capitalism is that investors earn a real return on their capital. (The other is that markets are allowed the unfettered capacity for price discovery, meaning they can put a price on risk). It’s likely that these processes would help tame inflation, thereby defending the value – meaning the purchasing power – of the dollar.

The point of this fictional scenario is that, if it happened, American real GDP would contract, and would carry on doing so for as long as balanced budgets and positive real rates prevailed. Put another way, there would be no growth at all – rather, there would be negative growth – if government was prevented from piling up yet more debt through deficit budgeting, whilst households and businesses could no longer finance expenditures by borrowing at sub-inflation rates.

Then turn to China. Roughly a quarter of the Chinese economy is accounted for by real estate. Much of the real estate sector has been exposed as a scam, a Ponzi scheme, or both. There’s no other way to describe a sector that takes people’s money for homes that haven’t yet been built, and that might never be completed, as part of a broader, gigantic debt binge that has brought much of the sector to the brink of collapse.

The point of this is that, behind the veils of financial camouflage, the global economy has started to shrink. “Growth” has become a story we tell ourselves to keep the economic nightmares at bay. Orthodox economics it itself a fairy-tale, in which the protagonists, instead of “living happily ever after”, enjoy ‘infinite economic growth on a finite planet’.

 

Looking down the barrel

The reality is staring us in the face – “growth”, whether in America, China or anywhere else – has become sleight-of-hand. If you look for real growth – growth, that is, not manufactured using super-rapid debt and quasi-debt expansion, itself enabled by sub-inflation interest rates – you won’t find it anywhere. Behind various schemes in which the speed of the hand deceives the eye, the global economy has inflected from growth into contraction.

Let’s remind ourselves about the two ways in which money is created. First, it can be conjured out of the ether by central banks. Second, most of it is loaned into existence by the banking system. Regulation is one check on the latter, and the need for collateral is the other. Lenders won’t hand you $1m on your word alone, but will if you can show them an asset which guarantees your ability to honour at least part of your new obligation.

But this is circular, because asset prices, which provide this collateral, are an inverse function of the cost and availability of capital. Accordingly, a credit mountain must create a super-bubble in asset prices, and vice versa.

The medium of control, if indeed there really is one, is interest rates. If these are set at levels below inflation, borrowing becomes profitable. This incentive drives both credit and asset values upwards, with the latter appearing to provide a collateral guarantee for the former. We can, supposedly, be comfortable about adding $X trillion to our debt pile if we’ve also added $X trillion to the collateral value of assets.

But these aggregate asset valuations are no more than notional. At the national level, the aggregate ‘value’ of a country’s housing stock is meaningless, because the only people to whom the entirety of that stock could ever be sold are the same people to whom it already belongs. Globally, the same principle applies to stocks, bonds and other asset classes. This principle is that we deceive ourselves when we apply marginal transaction prices to the aggregates of existing assets.

There are, in fact, two main ways in which assets can be valued. One is the price which the owner could realise by selling the asset to somebody else. The other is utility value – on this basis, a property has value in that it provides the owner with somewhere to live, saving him or her from having to pay rent. The utility value of a stock is the value that will come to the owner in the future, through dividends but, ultimately, through profits.

There is no way that current stock or property values could be justified on a utility basis, even if the economy was still capable of growth. In short, what we have is a confection – you might liken it to a soufflé – in which an excessive credit burden is backed up by inflated asset values which are themselves a function of over-extended credit.

 

The sleight-of-hand of ‘output’

Moreover, when we pour credit into the economy, this money is spent, which is what it’s for. This shows up as transactional activity, which is what we measure as GDP.

The direct functional relationship between credit and the transactional activity (recorded as GDP) can be measured.

Over the past twenty years, each $1 of “growth” in reported real GDP has been accompanied by $3.20 of net new borrowing, and even that ratio excludes broader liability increases which include the “shadow banking” (NBFI) sector. Buying $1 of “growth” by borrowing and spending upwards of $3.20 is self-deluding fakery, pure and simple.

Beyond being simply unsustainable, it leads us to the paradoxical condition of being both wealthy and bankrupt. We’d be wealthy because the paper value of our assets would have soared, and simultaneously bankrupt because our debts would be so big that they could never be repaid.

GDP, meanwhile, is inflated artificially by the pouring of ever more credit into the economy. Since money can (and routinely does) change hands without value being added, there is no correlation between transactional GDP and the creation of material economic value. And, if GDP losses its validity as a measure of output, so do all metrics based upon it. This means that the ratio of debt to GDP becomes unreliable, and we can’t effectively measure the velocity of money.

The same fakery at the heart of reported “growth” is all around us. Some jurisdictions are thinking about super-long mortgages, which could spread the cost of house purchase to, and beyond, the average person’s working life. This amounts to a confession that the ratio between property prices and disposable incomes has become dysfunctional. We can’t admit this, though, because doing so would crash property markets, blowing a gigantic hole in the supposed value of collateral.

The business model de jour is the garnering of consumers’ information in order to flog it to advertisers so they can offer the same products to the same people, a model which adds no real economic value at all.

Another gambit is that of reducing costs by casualizing labour through ‘gig’ employment and zero-hours contracts. These workers, at least, aren’t going to be increasing their purchases of advertised products, or ‘signing up’ to those subscriptions which the same business model portrays as a way of generating valuable new streams of income from the household sector.

Corporates use cheap debt to buy back stock in a process that, far from being accretive to value, provides the sugar-rush of a brief rise in stock prices whilst saddling businesses with ever larger burdens of debt, thereby making them increasingly vulnerable to any shift away from sub-inflation interest rates.

The blanket term for all of this, and more, is gimmickry. This has a lengthening and dishonourable history. It began, back in the 1990s, with making debt easier to access than ever before – seldom did a day pass without credit offers padding the mail-box of the Western householder. Then, when this process of “credit adventurism” detonated in 2008-09, we switched to outright “monetary adventurism”, essentially subsidising credit by setting the real cost of capital at negative levels.

Doing this has put the value of money itself at hazard. We have thrown, first, the viability of the banking system and, second, the sustainability of our currencies themselves, under the wheels of an unstoppable juggernaut. The name painted on the side of that juggernaut is ‘inflexion’, meaning that the economic growth of the past is turning into the economic contraction of the present and future.

Where this all ends is predictable, at least in part. The super-fast money creation scheme fails, asset prices plunge, and defaults rip through the system.

Publicly-reported debt, both state and private, is a huge understatement of the true magnitude of liabilities, which include both the credit assets of the “shadow banking” system and the can’t-be-honoured pension promises which governments have made to the public. NBFI lending is a horror-story of its own, with a sizeable part of this credit channelled to households through BNPL and other non-bank forms of credit.

 

The truth that mustn’t be told

Indeed, BNPL – ‘buy now, pay later’ – is as good a moniker as any for an economy clinging on to unaffordable lifestyles, and reporting cosmetic (meaning ‘fake’) growth, by ramping up financial promises that cannot possibly be honoured.

The inevitable (though not necessarily imminent) destination of all this self-delusion is a collapse of the financial soufflé. Debts and quasi-debts become unpayable out of material economic flow, and the supposed insurance provided by collateral disappears as asset prices collapse.

All of this, by the way, is happening at the same time as ‘global warming’ is, according to some, turning into ‘global boiling’. The latter term might, or might not, be somewhat hyperbolic, but our environmental and ecological predicament is dire, and we’re now getting the wildfires, heatwaves and floods to prove it. There’s no net positive in any of this – the possibility of successful viticulture in a warming England comes with creeping salination of a large and increasing proportion of rice-producing low-lying lands.

To say that a re-think is in order would be one of the greatest under-statements of all time. I’ve never believed that this site, and others like it, are going to change the climate of opinion. Collectively, people do what suits them, until they are forced by events into responses that we would never choose of our own volition.

Rather, and beyond the value of knowledge for its own sake, the best that we can hope for is that we ourselves can understand what’s happening before others, including decision-makers in the higher echelons of government and business, arrive at the same conclusions.

Those behaviour-changing events are now starting to happen. The promise of ‘infinite economic growth’ is in the process of being exposed as fictional, and this ought to turn us away from the fairy-tale economics which has always assured us of this impossible outcome. The equally fictitious notion that “growth” will enable us to honour our gargantuan debts and quasi-debts is heading into a reality wall.

Two things could happen to government, and both might happen at the same time. The first is that states take sweeping new powers in an attempt to control events that are getting out of hand. The second is a growth of localism as the public loses faith in any supposed ‘solutions’ coming from the centre.

The core problem facing governments is that they’re being called on their unwise promises. The promise of unending growth is being exposed as fallacious, and the promise of an equitable sharing out of this growth is no longer honoured in anything but name. The old agenda has failed, and the powers-that-be have yet to find a new one to put in its place.

 

Life after soufflé?

We, if not governments, need to remind ourselves that there’s a core of nutritional substance at the heart of even the most inflated culinary confection. Here, in the economy, is what this core comprises.

For starters, the fundamental purpose of the economy is to supply material products and services to society. The physical or “real” economy does this by using energy to convert raw materials into products.

As this happens, a parallel thermal process involves the conversion of energy from dense to diffuse formats. The latter is waste heat and, when fossil fuels are used as the dense energy inputs to the system, this waste-heat contains climate-harming gases.

This energy-material process is driven by a cycle of creation, disposal and replacement – we acquire something, it wears out, and we need to obtain a new one to take its place. Our current economic system accelerates this disposal process, meaning that the material economy is a dissipative-landfill system.

At the same time, the length of the energy-dissipative process determines the size of the productive process. If we switch to lesser-density energy inputs, the dissipative process is truncated, and the material economy is smaller.

The assertion that we can transition from climate-harming oil, natural gas and coal to “green” wind and solar energy without the economy shrinking is based on the assumption that these renewables are, or can be made, as dense as fossil fuels. The only flies in this ointment are the lesser density of renewables, and the inability of technology to over-rule the laws of physics.

The bad news, then, is that financial soufflé is nearing collapse. The good news, if we choose to see it as such, is that the “financial economy” has reached this point because of comparatively gradual, but relentless, contraction in the underlying “real economy” of energy.

This could be “good news” because it might impose upon us environmentally-responsible behavioural changes which we might never get round to making on a voluntary basis.

 

Tim Morgan