#115: Paradigms lost

A LANDSCAPE OF BROKEN CERTAINTIES

Looking at the conduct of economic and related affairs in recent years, it would be all too easy to conclude that the world’s leadership cadres have (in the quaint English phrase) ‘lost their marbles’.

For the most part, they haven’t. But they have lost their bearings.

Policy and evaluation operate within parameters. These are determined by paradigms, which are based partly on experience, and partly on theory. When theory doesn’t work out as expected, the validity of these paradigms breaks down. What results is a vacuum in which literally almost anything can happen.

The aim here is a tightly-focused examination of paradigm breakdown. Put simply, have crucial formulae, supported both by logic and by prior experience, ceased to function?

If they have, much of the basis of policy, and of economics itself, loses validity.

We can cite several examples of where exactly this seems to have happened. Most important, policy responses to the 2008 global financial crisis (GFC) followed a tried-and-tested Keynesian formula, but they haven’t worked out as theory says they should. Long before now, those policies should have caused the economy to overheat and inflation to take off, setting the conditions for a return to normality. This simply hasn’t happened. This seems to be part of a broader paradigm breakdown which is particularly visible, too, in business and in capital markets.

When astronomers find anomalies between expectation and observation, this often reflects the gravitational pull of an object whose presence is unknown. One way of detecting this object can be to work backwards from the gravitational effects to the object that causes them. At that point, a new influence is posited, and calculations are recalibrated accordingly.

In much the same way, this discussion posits a factor hitherto excluded from mainstream economic theory, and examines whether this can explain the breakdown of theory. That factor is energy, and it is concluded that its gravitational pull has become large enough to invalidate much that has hitherto been assumed about the economy.

First, though, we need to examine the evidence for the crumbling of paradigms – and there is no better place to start with what’s happened to the world economy since the GFC.

Case-study #1: Post-crash policy – a theory overturned

The response of the authorities worldwide to the crisis of 2008 made sense within established paradigms. During late 2008 and early 2009, the authorities reacted by slashing policy rates, and using QE (quantitative easing) to drive bond yields sharply lower. This created a situation in which nominal interest rates were negligible, and real (inflation-adjusted) rates were negative.

This was monetary stimulus on a vast scale.

In the circumstances, it was a text-book response. Received wisdom said that this policy mix would be effective, and that it would be short-lived. Instead, it has mutated into what is known here as monetary adventurism – a seemingly-permanent state of monetary recklessness which can only end badly.

How did this happen?

The thinking behind ultra-cheap monetary policy was clearer than you might suppose, and was derived from Keynesian calculus. When demand weakens, the Keynesian prescription is stimulus, essentially meaning that the authorities inject money into the system. This boosts demand, thereby promoting economic activity.

Most commonly, this stimulus is fiscal. But this was hardly a viable choice in 2008. Fiscal deficits were already enormous – and fiscal stimulus takes time to operate, time that the authorities didn’t think they had.

Instead, then, they opted for monetary stimulus, which, theory tells us, works in much the same way. Access to cheap credit, it is reasoned, boosts demand, countering downwards and deflationary tendencies in the economy.

Of course, there are consequences to stimulus, consequences which will either restore equilibrium, or cause over-shoot. As well as promoting demand, stimulus is likely to push inflation upwards, and can make the economy overheat. That’s when the Keynesian formula calls either for moderation or reversal, including running fiscal surpluses, and raising interest rates.

In 2008-09, the authorities clearly thought that monetary stimulus would act as a short, sharp shock, and could be withdrawn (or reversed) when inflation and overheating showed up.

This goes a long way towards explaining ‘austerity’, too. The logic was that, if you’ve injected huge monetary stimulus, you hardly need vast fiscal stimulus as well. Whilst monetary stimulus was boosting demand, fiscal tightening could be used both as a regulator and as a way of rebuilding sovereign balance sheets. Cheap credit was expected to enable much of the debt that had migrated from the private to the public to be transferred back to where it began.

Yet none of this has worked out the way theory (and prior experience) say it should.

Monetary stimulus has been vast – quite how vast is almost incalculable, but certainly running into tens of trillions of dollars. This should have injected huge demand into the system. Within a year or, at most, two years, inflation should have been rising, and the economy showing unmistakeable signs of overheating. At that point, the stimulus could be withdrawn, or indeed reversed.

But this hasn’t happened. Asset markets have been inflated, but this hasn’t translated into broad inflation. The economy, far from overheating, has remained sluggish. There has been no opportunity for deleveraging the balance sheets of governments (and remember that deficit reduction simply slows the rate at which debt keeps growing).

At a point which – statistically, at least – is nearer in time to the next recession than it is to the last one, growth remains fragile, real wages remain depressed, both public and private debt are higher than ever, and some of the really nasty by-products of cheap money are showing up in forms that are as disturbing as they are unmistakeable.

So, does this experience prove Keynes ‘wrong’? Hardly. The Keynesian model, taken in its objective sense rather than in its political form, is mathematically demonstrable. It would have worked in the Great Depression of the inter-war years, and it ought to have worked now.

That it hasn’t worked tells us that something new must have entered into the equation.

Conventional theory cannot tell us what this new element is.

It is baffled.

The paradigm has failed.

Case-study #2: Britain – a productivity paradox

A further, briefer example underlines the breakdown of paradigms. In the years preceding 2008, British productivity grew at a trend rate of 2.1%. Ever since its inception in 2010, the Office for Budget Responsibility (OBR), which advises government, has expected this pre-crash trajectory to resume.

It hasn’t. Instead, it has remained obstinately low, at just 0.2%. This has confounded OBR forecasts and calculations, and has contributed to policy failures. Only now, seven years on, has the OBR conceded that it isn’t going to happen. The results have been sharp downwards revisions to growth projections, and acceptance of the grim (and, to some, “astonishing”) reality that real wages will remain lower in 2022 than they were back in 2008.

This does not, it must be stressed, make the OBR idiots. Rather, they are extremely able people, and their expectations were soundly rooted in theory. As we have seen, productivity, being based on the GVA subset of GDP, is a proxy for growth. Stimulus, both fiscal and monetary, has been enormous. This should have pushed demand sharply upwards, driving up growth and, therefore, productivity. The problems that chancellor (finance minister) Philip Hammond should be facing now ought to be an overheating economy, and a spike in inflation.

But this is exactly what hasn’t happened. Instead, growth (after necessary statistical adjustments) has become negligible, and the only source of inflation has been currency weakness.

Once again, the theoretical paradigm, within its own parameters, and reinforced by prior experience, is demonstrably correct. The divergence of outcome from theory can only mean that some new element has entered into the equation.

It’s a fair bet that the authorities have no idea what this unexpected, paradigm-busting element is. The pursuit of explanations for a non-existent “puzzle” around productivity is a textbook example of groping blindly in the dark.

To be quite clear about this, weak productivity is a symptom. Locally, as globally, the malady is the failure of the economy to react to enormous fiscal and monetary stimulus.

Policymakers don’t know why this happened – and their advisers are powerless to tell them.

Asset markets – accumulating disconnects

Governments and central bankers are by no means the only consumers of economic interpretation. It has a huge role to play in business and finance, too. In financial markets, most participants have enjoyed the fruits of monetary largesse, a policy which has inflated asset prices to giddying heights. Only the most astute, however, are likely to have pondered the implications of economics, and markets, failing to behave as theory says they should.

For those willing to look, there is no shortage of anomalies in asset markets. An obvious example is property, where inflated prices have become all but impossible to square with falling real incomes. This, at least, can be explained away by reference to cheap money and expanding multiples. These explanations may seem satisfying, even though they are very likely to prove wrong.

Bond and equity markets offer more intriguing anomalies. In equities, there are at least five phenomena which should be causing the wisest to wonder.

In no particular order, the first of these is cash-burn. Whole sectors, as well as significant individual companies, are characterised by rates of cash-burn reminiscent of the dot-com boom – yet these stocks and sectors are often amongst those most cherished by investors.

Second, some highly-rated stocks depend for their revenues on sectoral income streams which, locally as well as globally, are both comparatively narrow and potentially vulnerable.

Third, there is the phenomena of stock buy-backs, a highly influential trend in which cheap debt is used to deliver accretion (reverse-dilution) for stockholders, to the particular benefit of anyone owning options. Though the metrics seem to work well with debt so cheap, it’s most unlikely that the large-scale replacement of equity with debt is a positive trend. Any cessation of the practice could take a big buying presence out of the market – and rate rises could cripple companies which have loaded up on debt.

Next, there is the ongoing migration of client funds from active to passive management. This may or may not be a positive trend for clients, but the subtext seems to be one of giving up on analysis – and giving up on analysis doesn’t seem all that far from giving up on rationality.

Finally, there is real-world disconnect, where asset prices seem increasing difficult to square with the realities of customer circumstances.

To be sure, there is nothing new about ‘negative’ economic news being seen positively by markets. A deterioration in growth can be seen as a market positive because it softens the outlook for rates. The same can happen in reverse, where good economic news can be interpreted negatively by markets.

But inverse responses shouldn’t cancel out logic to the extent that now seems to be happening. Beyond some embattled retailers (whose woes are customarily explained away by technological disruption), the stock prices of most customer-facing businesses are high, even (or especially) in the case of stocks whose sectors are intrinsically risky. This seems impossible to reconcile with the all-too-obvious travails of the average consumer, faced, as he or she is, with stagnant or deteriorating real wages, increasing insecurity of employment, rising indebtedness, and growing uncertainty over pensions.

In the bond markets, British government debts (“gilts”) are an instructive example. Sovereign debt yields are supposed to include, where appropriate, a risk premium. In the British instance, this risk premium component ought, logically, to be pretty hefty – this is a sovereign borrower with rising debt, acute political uncertainty, a vulnerable currency and an economy in very big trouble. Yet the British government remains able to access funds at rates historically associated with ultra-low-risk, robust borrowers.

Missing in action – consequences of paradigm failure

Both in macroeconomics and in capital markets, then, the list of disconnects keeps growing, meaning that the validity of theory seems to be breaking down. Numerous demonstrable, historically-referenced ‘truisms’ have gone ‘missing in action’.

The landscape of economics and policy is littered with the corpses of dead paradigms.

The implications, both for policy and for commercial and financial strategy, can hardly be overstated.

Following the failure of stimulus to conform to theory, macroeconomics has moved into a new abnormal. Some of the numbers make this abnormality strikingly obvious, a point underlined by the following chart.

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Since 2008, and expressed in constant (2016) PPP dollars, GDP growth of $24 trillion has been accompanied by an $84tn net increase in debt, meaning that $3.50 has been borrowed for each $1 of growth.

This is a lot worse than in the pre-crash borrowing bubble, when the ratio of borrowing to growth was 2.2:1. One reason for worsening of the ratio is that emerging market economies (EMEs) – and most obviously China – are now doing what the developed West alone was doing before 2008.

Meanwhile, the crushing of returns on investment has created a vast shortfall in pension provision worldwide. Globally, these deficiencies probably total around $125tn, and are growing at a real annual compound rate in excess of 5%.

There’s every reason to suppose that much, perhaps most, of the apparent “growth” in GDP has been nothing more substantial than the simple spending of borrowed money. A person does not become more prosperous by running up an ever bigger overdraft, or by pillaging his or her pension fund. Yet, globally, that’s exactly what we’re doing.

Apparent improvements in per capita GDP simply aren’t showing up in prosperity, quite aside from the rapid increases both in households’ own debt and in their share of government and commercial indebtedness. Anyone – and this includes far too many policymakers – who thinks that inflated asset values provide a cushion is guilty of naivety on a breath-taking scale, because we cannot monetize the notional ‘value’ of assets by selling them to each other.

Politics and business – cut adrift from paradigms

The purely political consequences of deteriorating prosperity have long been obvious to virtually everyone (except, apparently, the self-styled ‘experts’). “Brexit”, the election of Mr Trump, the defeat of all established parties in France, the travails of Mrs Merkel and the rise of “populism” have all been entirely predictable events. Even in countries like Britain, the public seem to be giving up on “capitalism”, within polls revealing striking levels of support for nationalisation even amongst erstwhile centre-right voters.

Though the political Left has failed to capitalise on this so far, it is now busily positioning itself for success by purging itself of a generation of “centrists” who bought in to the economic logic of the centre-right.

Commercial behaviour seems equally at odds with the reality of consumer deterioration. In business, as in economics and government, logic suggests that strategy should be framed by awareness of deteriorating consumer discretionary incomes, rising debt and the approaching implosion of pension provision, with all that that logically means for customer behaviour and sentiment.

Self-evidently, it is not. Businesses appear to be throwing ever-bigger advertising budgets at consumers who are getting ever poorer. There are strong reasons why consumers are likely to become a great deal more cautious. The biggest single factor is likely to be the impending recognition of the pensions “time-bomb”, which ought to push savings ratios back up from historic lows, to the detriment of consumption. A second strong possibility is that inflated property markets might crash if the law of gravity reasserts itself in income multiples.

The gravitational pull – energy

What we are witnessing, then, is an economic, political and commercial landscape in which players have been cut adrift from past paradigms without, yet anyway, finding any new ones. As regular readers will be well aware, the ‘gravitational pull’ which is wrecking past paradigms is the energy basis of the economy.

It should be unnecessary to stress that energy is the basis of all economic activity. This was true back in an agrarian economy which depended on human and animal energy, and is every bit as true now, when extraneous sources (and principally fossil fuels) have taken over almost entirely from human energy.

Energy is central to a resource chain which, most obviously, supplies food, water, minerals and chemicals. Add in the critical importance of electricity and it becomes apparent that economic activity is entirely a function of energy availability.

Over the comparatively short period between 2001 and 2016, consumption of primary energy increased by 40%, or by 18% on a per capita basis reflecting the increase in the world population over the same timeframe. It is a moot point as to whether this rate of increase can be sustained, and a logical certainty that the economy cannot continue to deliver genuine growth if it is not.

Absolute quantities of energy, however, are not the critical issue. Whenever energy is accessed, some energy is always consumed in the access process, and the real driver of economic activity is the surplus energy available after this access cost has been deducted.

Access cost is measured here using ECoE (the energy cost of energy), expressed as a percentage of the gross amount, and measured as a trend. The main driver of ECoE is depletion, moderated by technology.

According to SEEDS (the Surplus Energy Economics Data System), worldwide trend ECoE has risen from 4% in 2001 to 7.5% last year. Put another way, this means that, in order to have access to 100 units of energy for all purposes other than energy supply itself, we needed 108.1 units in 2016, compared 104.2 units back in 2001. That number is projected to reach 110.1 units in 2020, 112.2 units in 2025, and 115.3 units by 2030.

In measuring this impact, the key metric is surplus (net-of-ECoE) energy availability. Whilst gross access increased by 40% between 2001 and 2016, the increase at the net (“surplus”) level was only 35%. In per capita terms, surplus energy was only 13% higher in 2016 than in 2001.

Most important of all, this per capita number has now started to decline. This is something which, almost certainly, is wholly unprecedented. Even more importantly, it is likely to be irreversible, because ECoE is now rising a lot more rapidly than we can hope to increase gross energy supply.

To understand the implications of this trend, we really need only two charts, which are set out below. If these are compared with the GDP and liabilities chart shown earlier, the role of energy in the paradigm-busting process becomes entirely clear.

The question now is whether economists, government and business can become aware of what has been destroying their certainties – and can find new paradigms to replace the old.

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#114: Déjà vu, all over again

THe REALITY BEHIND BRITAIN’S “PRODUCTIVITY PUZZLE”

Adjectives such as ‘shocking’ and ‘astonishing’ have been applied to the recognition, in Britain’s recent budget, that growth is going to be extremely weak well into the 2020s, and that real earnings will remain lower in 2022 than they were back in 2008.

The favoured explanation for this weakness is the so-called “puzzle” of poor productivity. Solving this mystery will, supposedly, restore robust growth and reverse the long years of deteriorating prosperity.

In fact, there’s nothing too ‘astonishing’ about any of this. For a start, productivity is really nothing more than economic output divided by hours worked. The calculation uses GVA (gross value added) rather than GDP (gross domestic product), but the former is a subset of the latter, differing only through some modest technical adjustments. Hours worked don’t oscillate dramatically over time. So saying that ‘productivity is poor’ is another way of saying that ‘economic performance is weak’.

The latest hand-wringing over prosperity really amounts to official recognition that the British economy is feeble. In the years prior to 2008, productivity grew at an average annual rate of 2.1%. Ever since its inception in 2010, the Office for Budget Responsibility (OBR), which advises government, has framed its forecasts on an assumed return to this previous rate.

In reality, trend growth in productivity since 2008 has been just 0.2%. The OBRs acceptance of this new reality was the cause of the sharp downgrades to growth assumptions announced by chancellor (finance minister) Philip Hammond in his budget.

If there’s a “puzzle” here at all, it is why the OBR has expected anything different, and why it has held to this assumption for so long. The shock and astonishment expressed about this by experts and the media is unlikely to be shared by the general public. They know all too well that prosperity has been deteriorating for a long time.

A second “puzzle”, far worthier of attention than the productivity conundrum, is why the-powers-that-be do not seem to understand the real issues involved. Essentially, the most constructive single thing that Britain could do would be to address serious imbalances in the economy.

And none of these is more important than the grave imbalance of incentives. Put another way, risk and return are extremely out-of-kilter, discouraging activities that would inject growth into the economy, and favouring those that do not.

Put yourself in the position of somebody with, say, £1m to invest. How does this person set out to increase this capital?

Essentially, there are two ways of doing this.

First, he or she can invest in an enterprise, bringing new goods or services to the market. This can be described as ‘innovation’, because the aim is to create value where it didn’t already exist.

The alternative is to buy existing assets, aiming to profit from a rise in their price. This can be termed ‘speculation’. This is not intended as a pejorative term. It simply means that anticipated rises in asset prices are speculative, because these increases might not happen, and prices might actually fall rather than rise.

For the investor, either strategy can prove equally efficacious. From a national, macroeconomic perspective, however, they are as different as chalk and cheese.

Investing in new goods and services adds value to the economy.

Investing in existing assets does not.

The trick for government is to favour the innovation route which delivers new streams of value, making it more attractive than the alternative, non-value-adding choice. By ‘more attractive’ is meant ‘offering a more favourable blend of risk and return’.

Britain, to a greater extent than most, has got this balance wrong. Moreover, successive governments, far from addressing this handicap, have gone to great efforts to make it even worse.

The person investing in a new enterprise necessarily faces significant risk. His new product might fail, or the economy might turn against him, making customers less willing or less able to buy his product. He might not have access to sufficient capital, at a low enough cost, to see him through the stages from research and development to marketing and impact. Competitors might undermine his efforts, perhaps through combination or predatory pricing, or perhaps simply by making a better offer to consumers.

Risk, then, is stacked against the innovator. It also requires a lot more effort than simply buying existing assets and hoping for a rise in prices.

Because of this, government needs to be pro-active in encouraging the innovative entrepreneur. This includes not making the alternative, speculative route too attractive.

This hardly describes British policy. The innovator faces hurdles at every stage of the process. He encounters a forest of regulation, some of which is necessary, a lot of which is simply gratuitous, and much of which bears proportionately more heavily on the entrepreneur than on larger, established competitors. Taxation is pretty onerous, including employment levies, the obligation to devote resources to collecting sales taxes, and the truly absurd Business Rates, absurd because it is unrelated even to turnover, let alone to profits.

The speculative route, on the other hand, gets a great deal of help from government. If asset prices, and most obviously those of property, threaten to fall, government will intervene with back-stops, most obviously with harmful gimmicks like “help to buy”, but more seriously with monetary policies calculated to inflate asset markets. No-one is going to back-stop the innovating entrepreneur in the same way. To cap it all, profits made on capital gains are taxed far more generously than income from creating new sources of value.

What successive British governments have said, in effect, is that ‘we favour speculative investment’. They have backstopped speculative activities, and have imposed low rates of tax, and pretty modest regulation, on those who want simply to buy existing assets and gain from increases in their price.

A more sensible route, surely, would be to redress the balance of incentives. This approach would favour innovation by granting some regulatory exemptions to small firms, removing some of the tax burdens imposed on them, perhaps providing advantageous lines of credit, and ensuring that bigger players do not act in ways detrimental to the small business, or otherwise benefit from a playing field that is far from level.

Complementary to this would be higher rates of tax on transactions and capital gains, combined with an avowed withdrawal from backstopping the prices of property and other assets.

These weaknesses are not unique to Britain, of course, but appear more serious there than in many comparable countries. Large allowances are given against taxes on capital gains, taxes which are often levied at rates lower anyway than on comparable amounts of income.

If a country sets out to favour the speculative over the innovative, it can hardly then complain if investors opt for speculation, and don’t put much effort into innovation.

The SEEDS model shows the real severity of the British economic malaise. Per capita prosperity, as measured by the system, has declined by 9.4% since it peaked in 2003, and continues to deteriorate. In the years since then, Britain has borrowed £5.50 for each £1 of recorded growth, and even the latter includes a sizeable component of simply boosting apparent output through the spending of borrowed money.

With energy costs rising, the crunch point of talks over post-“Brexit” trade looming, the currency at significant risk, and investors presumably questioning the wisdom of investing in an economy where customers are getting poorer, now is not the time to fiddle about with cosmetic incentives, and indulge in naval-gazing over a supposed “productivity puzzle” that is, in reality, no puzzle at all.

 

= = = =

Here’s how productivity looks on a basis adjusted for the “borrowed spending” impact on economic output:

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#113: Death of a high-fashion model

IS ‘SUSTAINABLE DEVELOPMENT’ A MYTH?

For a long time now, “sustainable development” has been the fashionable economic objective, the Holy Grail for anyone aiming to achieve economic growth without inducing catastrophic climate degradation. This has become the default position for two, very obvious reasons. First, no politician wants to tell his electorate that growth is over (even in countries where, very clearly, prosperity is now in decline). Second, policymakers prepared to invite ridicule by denying the reality of climate change are thin on the ground.

Accordingly, “sustainable development” has become a political article of faith. The approach seems to be to assume that sustainable development is achievable, and use selective data to prove it.

Where this comfortable assumption is concerned, this discussion is iconoclastic. Using the tools of Surplus Energy Economics, it concludes that the likelihood of achieving sustainable development is pretty low. Rather, it agrees with distinguished scientist James Lovelock in his observation that sustainable retreat might be the best we can expect.

This site is dedicated to the critical relationship between energy and economics, but this should never blind us to the huge threat posed by climate change. There seems no convincing reason to doubt either the reality of climate change science or the role that emissions (most obviously of CO²) are playing in this process. As well as counselling sustainable retreat, James Lovelock might be right, too, in characterising the earth as a system capable of self-regeneration so long as its regenerative capabilities are not tested too far.

False comfort

Economics is central to this debate. Here, comparing 2016 with 2001, are some of the figures involved;

Real GDP, 2016 values in PPP dollars:

2001: $73 trillion. 2016: $120tn (+65%)

Energy consumption, tonnes of oil equivalent:

2001: 9.5bn toe. 2016: 13.3bn toe (+40%)

Emissions of CO², tonnes:

2001: 24.3bn t. 2016: 33.4bn t (+37%)

If we accept these figures as accurate, each tonne of CO² emissions in 2001 was associated with $2,990 of GDP. By 2016, that number had risen to $3,595. Put another way, 17% less CO² was emitted for each $1 of GDP. By the same token, the quantity of energy required for each dollar of GDP declined by 15% over the same period.

This is the critical equation supporting the plausibility of “sustainable growth”. If we have really shown that we can deliver successive reductions in CO² emissions per dollar of GDP, we have options.

One option is to keep CO² levels where they are now, yet still grow the economy. Another is to keep the economy where it is now and reduce CO² emissions. A third is to seek a “goldilocks” permutation, both growing the economy and reducing emissions at the same time.

Obviously, the generosity of these choices depends on how rapidly we can continue our progress on the efficiency curve. Many policymakers, being pretty simple people, probably use the “fool’s guideline” of extrapolation – ‘if we’ve achieved 17% progress over the past fifteen years’, they conclude, ‘then we can expect a further 17% improvement over the next fifteen’.

Pretty lies

But what if the apparent ‘progress’ is illusory? The emissions numbers used as the denominator in the equation can be taken as accurate, as can the figures for energy consumption. Unfortunately, the same can’t be said of the economic numerator. As so often, we are telling ourselves comforting untruths about the way in which the world economy is behaving.

This issue is utterly critical for the cause of “sustainable development”, whose plausibility rests entirely on the numbers used to calculate recent trends.

And there are compelling reasons for suspecting the validity of GDP numbers.

For starters, apparent “growth” in economic output seems counter-intuitive. According to recorded numbers for per capita GDP, the average American was 6% better off in 2016 than in 2006, and the average Briton was 3% more prosperous. These aren’t big numbers, to be sure, but they are positive, suggesting improvement, not deterioration. Moreover, there was a pretty big slump in the early part of that decade. Adjustment for this has been used to suggest that people are growing more prosperous at rates faster than the trailing-10-year per capita GDP numbers indicate.

Yet the public don’t buy into the thesis of “you’ve never had it so good”. Indeed, it isn’t possible reconcile GDP numbers with popular perception. People feel poorer now than they did in 2006, not richer. That’s been a powerful contributing factor to Americans electing Donald Trump, and British voters opting for “Brexit”, crippling Theresa May’s administration and turning in large numbers to Jeremy Corbyn’s collectivist agenda. Much the same can be said of other developed economies, including France (where no established party made it to the second round of presidential voting) and Italy (where a referendum overwhelmingly rejected reforms proposed by the then-government).

Ground-level data suggests that the popular perception is right, and the per capita GDP figures are wrong. The cost of household essentials has outpaced both incomes and general inflation over the past decade. Levels of both household and government debt are far higher now than they were back in 2006. Perhaps worst of all – ‘though let’s not tell the voters’ – pension provision has been all but destroyed.

The pension catastrophe has been attested by a report from the World Economic Forum (WEF), and has been discussed here in a previous article. It is a topic to which we shall return in this discussion.

The mythology of “growth”

If we understand what really has been going on, we can conclude that, where prosperity is concerned, the popular perception is right, meaning that the headline GDP per capita numbers must be misleading. Here is the true story of “growth” since the turn of the century.

Between 2001 and 2016, recorded GDP grew by 65%, adding $47tn to output. Over the same period, however, and measured in constant 2016 PPP dollars, debt increased by $135tn (108%), meaning that each $1 of recorded growth came at a cost of $2.85 in net new borrowing.

This ratio has worsened successively, mainly because emerging market economies (EMEs), and most obviously China, have been borrowing at rates far larger than growth, a vice previously confined to the developed West.

This relationship between borrowing and growth makes it eminently reasonable to conclude that much of the apparent “growth” has, in reality, been nothing more substantial than the spending of borrowed money. Put another way, we have been boosting “today” by plundering “tomorrow”, hardly an encouraging practice for anyone convinced by “sustainable development” (or, for that matter, sustainable anything).

Nor is this all. Since the global financial crisis (GFC) of 2008, we have witnessed the emergence of enormous shortfalls in society’s provision for retirement. According to the WEF study of eight countries – America, Australia, Britain, Canada, China, India, Japan and the Netherlands – pension provision was deficient by $67tn in 2015, a number set to reach $428tn (at constant values) by 2050.

Though the study covers just eight countries, the latter number dwarfs current GDP for the entire world economy ($120tn PPP). The aggregate eight-country number is worsening by $28bn per day. In the United States alone, the annual deterioration is $3tn, equivalent to 16% of GDP and, incidentally, roughly five times what America spends on defence. Moreover, these ratios seem certain to worsen, for pension gaps are increasing at annual rates far in excess of actual or even conceivable economic growth.

For the world as a whole, the equivalent of the eight-country number is likely to be about $124tn. This is a huge increase since 2008, because the major cause of the pensions gap has been the returns-destroying policy of ultra-cheap money, itself introduced in 2008-09 as a response to the debt mountain which created the GFC. Finally, on the liabilities side, is interbank or ‘financial sector’ debt, not included in headline numbers for debt aggregates.

Together, then, liabilities can be estimated at $450tn – $260tn of economic debt, about $67tn of interbank indebtedness and an estimated $124tn of pension under-provision. The equivalent number for 2001 is $176tn, expressed at constant 2016 PPP values. This means that aggregate liabilities have increased by $274tn over fifteen years – a period in which GDP grew by just $47tn.

The relationship between liabilities and recorded GDP is set out in the first pair of charts, which, respectively, set GDP against debt and against broader liabilities. Incidentally, the pensions issue is, arguably, a lot more serious than debt. This is because the real value of existing debt can be “inflated away” – a form of “soft default” – by governments willing to unleash inflation. The same cannot be said of pension requirements, which are, in effect, index-linked.

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Where climate change is concerned, what matters isn’t so much the debt or broader liability aggregates, or even the rate of escalation, but what they tell us about the credibility of recorded GDP and growth.

Here, to illustrate the issues involved, are comparative annual growth rates between 2001 and 2016, a period long enough to be reliably representative:

GDP: +3.4% per year

Debt: +5.0%

Pension gap and interbank debt: +9.1%

To this we can add two further, very pertinent indicators:

Energy consumption: +2.2%

CO² emissions: +2.1%

The real story

As we have seen, growth of $47tn in recorded GDP between 2001 and 2016 was accompanied – indeed, made possible – by a vast pillaging of the balance sheet, including $135tn in additional indebtedness, and an estimated $140tn in other liabilities.

The only realistic conclusion is that the economy has been inflated by massive credit injections, and by a comparably enormous unwinding of provisions for the future. It follows that, absent these expedients, organic growth would have been nowhere near the 3.4% recorded over the period.

SEEDS – the Surplus Energy Economics Data System – has an algorithm designed to ex-out the effect of debt-funded consumption (though it does not extend this to include pension gaps or interbank debt). According to this, adjusted growth between 2001 and 2016 was only 1.55%. As this is not all that much faster than the rate at which the population has been growing, the implication is that per capita growth has been truly pedestrian, once we see behind the smoke-and-mirrors effects of gargantuan credit creation.

This isn’t the whole story. The above is a global number, which embraces faster-than-average growth in China, India and other EMEs. Constrastingly, prosperity has actually deteriorated in Britain, America and most other developed economies. Citizens of these countries, then, are not imagining the fall in prosperity which has helped fuel their discontent with incumbent governing elites. The deterioration has been all too real.

The second set of charts illustrates these points. The first shows quite how dramatically annual borrowing has dwarfed annual growth, with both expressed in constant dollars. The second sets out what GDP would have looked like, according to SEEDS, if we hadn’t been prepared to trash collective balance sheets in pursuit of phoney “growth”. You will notice that the adjusted trajectory is consistent with what was happening before we ‘unleashed the dogs of cheap and easy credit’ around the time of the millenium.

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Flagging growth – the energy connection

As we have seen, then, the very strong likelihood is that real growth in global economic output over fifteen years has been less than 1.6% annually, slower than growth either in energy consumption (2.2%) or in CO² emissions (2.1%). In compound terms, growth in underlying GDP seems to have been about 26% between 2001 and 2016, appreciably less than increases in either energy consumption (+40%) or emissions (+37%).

At this point, some readers might think this conclusion counter-intuitive – after all, if technological change has boosted efficiency, shouldn’t we be using less energy per dollar of activity, not more?

There is, in fact, a perfectly logical explanation for this process. Essentially, the economy is fuelled, not by energy in the aggregate, but by surplus energy. Whenever energy is accessed, some energy is always consumed in the access process. This is expressed here as ECoE (the energy cost of energy), a percentage of the gross quantity of energy accessed. The critical point is that ECoE is on a rising trajectory. Indeed, the rate of increase in the energy cost of energy has been rising exponentially.

As mature resources are depleted, recourse is made to successively costlier (higher ECoE) alternative sources. This depletion effect is moderated by technological progress, which lowers the cost of accessing any given form of energy. But technology cannot breach the thermodynamic parameters of the resource. It cannot, as it were, ‘trump the laws of physics’. Technology has made shale oil cheaper to extract than shale oil would have been in times past. But what it has not done is transform shales into the economic equivalent of giant, technically-straightforward conventional fields like Al Ghawar in Saudi Arabia. Any such transformation is something that the laws of physics simply do not permit.

According to estimates generated on a multi-fuel basis by SEEDS, world ECoE averaged 4.0% in 2001, but had risen to 7.5% by 2016. What that really means is that, out of any given $100 of economic output, we now have to invest $7.50, instead of $4, in accessing energy. The resources that we can use for all other purposes are correspondingly reduced.

In the third pair of charts, the left-hand figure illustrates this process. The area in blue is the net energy that fuels all activities other than the supply of energy itself. This net energy supply continues to increase. But the red bars, which are the energy cost of energy, are rising too, and at a more rapid rate. Consequently, gross energy requirements – the aggregate of the blue and the red – are rising faster than the required net energy amount. This is why, when gross energy is compared with economic output, the energy intensity of the economy deteriorates, even though the efficiency with which net energy is used has improved.

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Here’s another way to look at ECoE and the gross/net energy balance. Back in 2001, we needed to access 104.2 units of energy in order to have 100 units for our use. In 2016, we had to access 108.1 units for that same 100 units of deployable energy. This process, which elsewhere has been called “energy sprawl”, means that any given amount of economic activity is requiring the accessing of ever more gross energy in order to deliver the requisite amount of net (surplus) energy. By 2026, the ratio is likely to have risen to 112.7/100.

The companion chart shows the trajectory of CO² emissions. Since these emissions are linked directly to energy use, they can be divided into net (the pale boxes), ECoE (in dark grey) and gross (the sum of the two). Thanks to a lower-carbon energy slate, net emissions seem to be flattening out. Unfortunately, gross emissions continue to increase, because of the CO² associated with the ECoE component of gross energy requirements.

Shot down in flames? The “evidence” for “sustainable development”

As we have seen, a claimed rate of economic growth (between 2001 and 2016) that is higher (65%) than the rate at which CO² emissions have expanded (37%) has been used to “prove” increasing efficiency. It is entirely upon these claims that the viability of “sustainable development” is based.

But, as we have also seen, reported growth has been spurious, the product of unsustainable credit manipulation, and the unwinding of provision for the future. Real growth, adjusted to exclude this manipulation, is estimated by SEEDS at 26% over that period. Crucially, that is less than the 37% rate at which CO² emissions have grown.

On this basis, a claimed 17% “improvement” in the amount of CO² per dollar of output reverses into a deterioration. Far from improving, the relationship between CO² and economic output worsened by 9% between 2001 and 2016. In parallel with this, the amount of energy required for each dollar of output increased by 11% over the same period.

The final pair of charts illustrate this divergence. On the left, economic activity per tonne of CO² is shown. The second chart re-expresses this relationship using GDP adjusted for the artificial “growth” injected by monetary manipulation. If this interpretation is correct – and despite a very gradual upturn in the red line since 2010 – the comforting case for “sustainable development” falls to pieces.

In short, if growth continues, rising ECoEs dictate that both energy needs, and associated emissions of CO², will grow at rates exceeding that of economic output.

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We are back where many have argued that we have been all along. The pursuit of growth seems to be incompatible with averting potentially irreversible climate change.

There is a nasty sting-in-the-tail here, too. The ECoE of oil supplies is rising particularly markedly, and there seems a very real danger that this will force an increased reliance on coal, a significantly dirtier fuel. A recent study by the China University of Petroleum predicted exactly such a trend in China, already the world’s biggest producer of CO². As domestic oil supply peaks and then declines because of higher ECoEs, the study postulates a rapid increase in coal consumption to feed the country’s voracious need for energy. This process is most unlikely to be confined to China.

Where does this leave us?

The central contention here is that the case for “sustainable development” is fatally flawed, because the divergence between gross and net energy needs is more than offsetting progress in greening our energy mix and combatting emissions of harmful gases. “Sustainable development” is a laudable aim, but may simply not be achievable within the laws of physics as they govern energy supply.

If this interpretation is correct, it means that growth in the global economy can be pursued only at grave climate risk. A (slightly) more comforting interpretation might that the super-heated rate of borrowing, and the seemingly disastrous rate at which pension capability is being destroyed, might well crash the system before our obsession with ‘growth at all costs’ can inflict irreparable damage to the environment.

#112: Will things go bang soon?

A BUBBLE AND A SPIKE, PART 2

We may not be clear yet about when the next crash will come, but we understand a very great deal about the mechanism that will make it happen. Put another way, we have a narrative that puts all the pieces in the right places.

This narrative is telling us that a crash is highly likely – and that it may happen a lot sooner than we think.

Let’s start with the fundamentals. Contrary to conventional thinking, the economy isn’t really a monetary system at all, but a surplus energy dynamic. What drives the output of goods and services is the quantity of energy we can access, less the energy consumed in the access process. If the available quantity is constrained – or the energy cost of accessing it increases – the output of the economy will decrease.

Money, having no intrinsic worth, has value only as a “claim” on the output of the real economy, which means, ultimately, that money is a claim on surplus energy. Debt, as a ‘claim on future money’, is really a claim on future energy.

For more than two centuries, there has been sustained growth in available surplus energy. This has enabled total financial claims – the aggregate of money and credit – to increase as well, without toppling the financial system.

What we’ve been witnessing since the turn of the century, though, has been an increase in the energy cost of energy (ECoE), combined with emerging constraints on the quantity of accessible energy. This process makes the continued growth in aggregate money and credit dangerous, because we are creating claims that the real economy will not be able to meet.

Once understood, this process makes sense of what has been happening. Between 2000 and 2008, credit creation soared, but debt-financed growth drove up energy demand in a way that eventually brought the system to the brink of collapse. In 2001, when prices averaged $24/bbl, OECD consumers spent about $430bn on oil, of which around $240bn went on imports. By 2008, when oil averaged $97/bbl, these numbers had increased to $1,700bn and $1,050bn. Oil was now costing OECD customers $1,270bn more than it had just seven years earlier – and $810bn of that increase was being spent on the higher cost of imports.

Moreover, these huge liquidity drains are only those related to oil. Other forms of energy also soared in cost, as did energy-intensive commodities such as minerals and foodstuffs.

This was what brought the debt-financed party to an end.

Looking a little more closely at this, the increase in the cost of oil to the OECD quadrupled between 2001 and 2008. The increase in ECoE over the same period was much smaller than this. According to SEEDS, global ECoE for all energy sources rose from 4% in 2001 to 5.4% in 2008, a rise of one-third.

So the rise in market prices vastly over-cooked the underlying trend in ECoEs. In relation to this fundamental benchmark, oil was underpriced in 2001, and overpriced in 2008.

This tells us that something else was going on.

That ‘something else’ was supply constraint.

Just as westerners were bingeing on credit, emerging market economies (EMEs) were consuming more energy and other commodities, notably as exports ramped up. Rising energy demand was colliding with more pedestrian growth in supply. Investment in supply tracked market prices higher. When demand dropped after 2008, the ensuing fall in prices became inevitable.

In retrospect, we “got away with it” in 2008, for three main reasons.

First, governments’ balance sheets were strong enough for them to bail out the banks without forfeiting their own credibility, and that of their currencies.

Second, the authorities bought time by adding monetary adventurism to the established credit adventurism.

Third, the cooling of the economy took the heat out of energy markets.

To know when and if a second crash may happen, and what its results are likely to be, we need to test these three “get-outs” as they now are.

First, government balance sheets. On the basis of amounts owed (rather than the market value of bonds), the aggregate debt of advanced country governments was 67% of GDP in 2007. Now it is 102%, and still rising. Bailing out the banks now would be a lot harder than it was back in 2008. Not only are government balance sheets weaker, but bank exposure has increased as global debt has grown. To be sure, reserves ratios are higher now than they were back in 2007. But, because banks borrow short and lend long, no amount of reserving can render them immune from the consequences of a loss of faith.

Second, “monetary adventurism”. Back in 2008, typical rates were 5.25% in the United States and 4.3% in the European Union. Now, the equivalent numbers are around 1% and -0.25%. There’s no scope, then, for further monetary adventurism, unless central banks are prepared to go for deeply negative nominal rates, a policy which would be barking mad, even if it didn’t, very probably, necessitate helicopter money and the banning of cash.

So that leaves us with our third component, which is energy. Essentially, a big rise in oil prices would crash the system.

Is this likely? On balance, it is. Oil demand is growing at around 1.4 mmb/d each year. Supply has kept pace, mainly thanks to increased shale and other unconventional output, plus an increase in supply from OPEC. Neither may be sustainable. Shales are extremely capital intensive, because of the “drilling treadmill” caused by ultra-rapid decline rates. Few OPEC countries have much scope to deliver increased supplies. Underlying ECoE, SEEDS says, is 42% higher now than it was in 2007.

Put this higher ECoE together with the slump in investment caused by the fall in crude prices, and the implication is that crude prices could spike, and do so rather more quickly than is generally expected.

That, then, is what we should be watching for when looking out for another crash. All the other conditions are in place, including excessive debt, weak underlying growth (reflecting rising ECoEs), overstretched government balance sheets, and an inability to repeat the monetary adventurism of 2008-09.

All that we’re waiting for is an oil price spike, and a trigger equivalent to the “Lehman moment”.

Both may come sooner rather than later.

 

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#111: A spike to puncture the bubble?

OIL PRICES

Anyone living in a bubble should beware of spikes.

Between 2001 and 2008, world debt (at current market values) increased from $60tn to $117tn.

There’s a bubble.

In 2001, the price of oil averaged $24/bbl. In the summer of 2008, it peaked at $147/bbl.

There’s a spike.

Though the connection isn’t drawn perhaps as often as it should be, there can be little doubt that the massive spike in oil prices punctured the equally massive debt bubble, leading directly to the global financial crisis (GFC).

The connection seems inescapable. Dramatically higher oil prices, in themselves, drained enormous amounts of liquidity out of the same oil-importing Western economies which were merrily bingeing on debt. Just as importantly, the surge in oil prices also drove up the cost of energy-intensive commodities, including minerals and food.

Could the same thing happen again, triggering a second (and probably much worse) global financial crash?

The bubble is certainly there – and is even bigger than the last one.

Since 2008, world debt (at current values) has expanded from $117tn to $160tn. But these headline numbers are converted to dollars at market exchange rates. Converted using the more realistic PPP (purchasing power parity) convention, debt has already reached 235% of world GDP, or $260tn. The equivalent figure in 2008 was $153tn.

On top of that, there are truly gargantuan shortfalls in pension provision, shortfalls which are “set to dwarf world GDP”.

In the period before 2008, the authorities had confined themselves to deregulatory recklessness, which facilitated a big increase in aggregate debt, and an equally big proliferation in risk.

Since then, monetary recklessness has been stirred into the mix, turbocharging debt escalation as well as bending returns on capital completely out of shape. That, ultimately, is why it has become impossible to provide adequately for retirement.

So there is certainly a bubble. Should we expect a spike?

Thus far in the bubble, a saving grace has been cheap oil. The price of oil averaged $44/bbl last year, down from $109/bbl as recently as 2013.

Demand for oil has continued to grow. Between 2007 and 2009, world oil demand decreased by 1.8 mmb/d (million barrels per day). But demand in 2016 (93.2 mmb/d) was 10.4 mmb/d, or 13%, higher than it was back in 2009 (82.8 mmb/d).

By and large, supply has kept pace. Since 2009, supplies from non-OPEC countries have increased by 5.7 mmb/d. OPEC countries have chipped in an additional 1.8 mmb/d of unconventional liquids, not subject to the cartel’s quota. The world’s need for quota crude from OPEC has therefore grown only modestly, from 29.3 mmb/d in 2009 to 32.3 mmb/d last year.

But this could now change. Much of the increase in non-OPEC supply has come from shale oil production in the United States. There are now some pretty persuasive reasons for thinking that US shale output might be at or near a peak, from which it could fall away quite quickly.

Readers will be familiar with some of the weaknesses of the shale story. Where output from conventional oil wells typically declines at between 5% and 10% annually, depletion rates for shale are dramatically more severe, with rates of 60%, and above, by no means uncommon.

This puts operators on a “drilling treadmill”, having to keep drilling new wells to offset declines from old ones. This has been fine so long as investors, convinced of the eventual profitability of “Saudi America”, keep stumping up capital. The day has to come, however – and probably sooner rather than later – when investors cease to oblige.

Where the petroleum industry is concerned, the picture is becoming clearer. The world’s appetite for oil is continuing to grow at around 1.4 mmb/d (1.5%) each year. Supplies of conventional crude have already peaked, and shale supply seems fairly close to doing the same.

Logically, this points to another spike in prices. One reservation has to be the ability of the world’s consumers to pay higher prices. But these consumers will probably do what they did at the same point in the previous cycle – which is to grumble, pay up, and add the cost to their already enormous debts.

We certainly have the bubble. We may, pretty confidently, anticipate the spike.

= = = =

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#110: Diverging fortunes

SEEDS PROSPERITY REPORT, OCTOBER 2017

Now that SEEDS – the Surplus Energy Economics Data System – is fully functional, it is possible to review prosperity in what may be the first of a series of regular reports.

The general conclusion, which is unlikely to surprise anyone, is that the emerging market economies (EMEs) are performing far better than the developed Western nations where prosperity is concerned. What might surprise you is quite how marked some of these differences are.

SEEDS defines prosperity as ‘real discretionary incomes’, a term which requires some explanation. The starting point is GDP per capita, but two critical adjustments are then made.

First, GDP data is adjusted to eliminate ‘borrowed consumption’. Anyone can have a lavish lifestyle if he or she is prepared to go ever deeper into debt, and has a bank sufficiently accommodative to let them do so. This is precisely what many countries have been doing. The accommodative suppliers of credit have been the authorities. They started by making debt easily accessible and comparatively cheap, and have (since 2008) been even more obliging, by making credit even cheaper.

Second, the resulting ‘ex-borrowing’ numbers are further adjusted for the trend cost of energy. This cost acts as an economic rent, which means that it diminishes the incomes over which we can exercise choice (‘discretion’).  Where the individual or household is concerned, this shows up primarily in above-inflation increases in the cost of essential (‘non-discretionary’) expenditures.

The results are summarised in the table, in which the eagle-eyed will spot the first appearance of Russia in SEEDS data.

 Prosperity data, October 2017SEEDS PROsperityjpg_Page1

The table shows per capita prosperity, in local currency and at constant (2016) values, for the years 2006, 2016 and 2025. There are three columns of percentage comparisons, with results ranked by the third of these columns, which compare projections for 2025 with calculations for 2006.

Some of the results have obvious explanations. Prosperity in the United Kingdom is in relentless decline because the economy is in very deep trouble. Through-period comparisons for Australia, Norway and Canada are adverse because commodity prices, important to these economies, were close to extreme cyclical highs back in the start year of 2006.

Greece, obviously, has had a severe decline in prosperity over the past decade, but can now anticipate a very gradual recovery, albeit reversing only a very small proportion of the preceding decrease in prosperity.

At the other extreme, citizens of India continue to enjoy rapid improvement. The average Indian was 58% better off in 2016 than he or she had been in 2006, but we do need to note relative values here – in 2016, per capita prosperity (at PPP rates of conversion) was only $4,820 in India, compared with $43,700 in the United States.

China, too, continues to deliver impressive growth in prosperity, but there is a caveat here – per-capita debt is rising a lot more rapidly than prosperity. In 2016, the average Chinese citizen was 58% more prosperous than in 2006, but China also had four times as much per capita debt than a decade earlier.

The robust performance of Russia needs to be seen in context. In 2006, the Russian economy was still showing the ravages of the 1990s, and progress from here on is likely to be much more sedate.

 

 

 

#109: Still the Orient Express?

CHINA – a SEEDS APPRAISAL

The development of SEEDS – the Surplus Energy Economics Data System – enables us to put individual economies under the magifying glass, and this discussion responds to reader requests by looking at China.

Before we start, it’s necessary to remind ourselves that China remains a one-party state in which the authorities exercise considerable influence over the private sector. This matters, because the over-riding concern of the government is to avoid the unrest which would be likely to result from unemployment.

This objective can be a tough call. Despite family control policies sometimes criticized by outsiders, the population of China does continue to expand, and has increased by an estimated 68 million – more than the entire population of Britain – since 2006. Additionally, Chinese citizens continue to migrate from the countryside in search of better-paid work in the cities. Together, these trends make it imperative that employment growth continues unchecked.

For this reason, China is far more concerned with maintaining and growing activity than she is with profitability. This difference of objectives is profound, and can confuse observers accustomed to thinking in terms of the corporate profit motive which drives so much policy in the West.

Over an extended period, China has achieved breath-taking rates of growth in headline GDP. In 2016, the Chinese economy grew by 6.7%, and reported GDP has risen by 136% over a decade, from RMB 22.1 trillion in 2006 to RMB 74.6tn last year. The consensus expectation is that headline growth rates are set to remain in the range 6.5% to 7.0% for the foreseeable future.

In the past, some sceptics have questioned the reliability of reported growth figures, comparing them unfavourably with slower rates of increase in volumetric measures (such as the consumption of electricity). It is true that there seem to be continuity issues (where methods of calculation are changed, but without earlier numbers being restated).

But the really challenging issue now isn’t how much growth China delivers. It is how that growth is achieved.

The first chart puts this question into context. Growth in GDP has continued in a linear way, almost unchecked even by the global financial crisis (GFC) of 2008. But what has changed, radically, since the GFC has been the rate at which Chinese debt increases.

The numbers make this quite clear. Between 2008 and 2016, China’s GDP increased by RMB 35tn, or 88%. But economic debt – that is, the combined indebtedness of government, households and business – expanded by RMB 135tn (242%) over the same eight-year period. This equates to net new borrowing of RMB 3.86 for each RMB 1.00 of growth in GDP.

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Nor is this all. In addition to economic debt, China has very high levels of inter-bank or ‘financial’ sector debt. This debt increased from 24% of GDP (RMB 6.5tn) in 2007 to 65% (RMB 42tn) in 2014, and is likely to be about RMB 64tn (86% of GDP) today. Inter-bank debt is often omitted from debt/GDP calculations, because – in theory – it would net off to zero if all banks cleared their debts to each other.

As we learned in 2008, however, netting-off is not a safe assumption under all circumstances. So any assessment of China’s escalating debt position needs to take this into account.

Within the rapid build-up of economic debt, it is corporate borrowing which predominates. Of the RMB 135tn of net borrowing since 2008, government and households accounted for only 18% and 19% respectively.

The remaining 63% – net borrowing of RMB 85tn – was undertaken by private non-financial corporations (PNFCs). These businesses, then, have borrowed a lot more (RMB 85tn) than growth in the entire economy (RMB 35tn) since the GFC. Additionally, banks’ indebtedness to each other increased by about RMB 53tn – again, a lot more than total GDP growth – during that period.

Unlike Western countries, then – where most borrowing is carried out by government and households – the majority of debt growth in China comes from businesses. These businesses use this new debt primarily to grow capacity, often to levels far ahead of domestic or foreign demand.

This creation of excess capacity sustains growth in activity – in keeping with the government’s priority – but it exerts major downwards pressure on margins and profits. This has resulted in returns on capital often being depressed below the cost of debt capital. One obvious course of action would be to convert relatively costly debt into cheaper equity. But, when this was tried, it came close to crashing the Chinese equity market.

Rising levels of indebtedness – both corporate and inter-bank – are a clear cause for concern. From a SEEDS perspective, though, what matters more is that debt-financed capacity creation has boosted activity and recorded GDP to levels which simply would not be sustainable if access to ever-expanding debt was curtailed.

Stripped of this “borrowed growth”, underlying GDP is estimated to be nearer RMB 48tn than the recorded RMB 75tn (see next chart). Accordingly, underlying growth seems to be nowhere near 6.8%, but closer to 3.1% instead, equivalent to 2.5% on a per capita basis.

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Of course, this needs to be kept in context, and growth of 3.1% is impressive by Western standards.

But the risk attending the “borrowing effect” is considerable. If  lenders were to become cognizant of quite how much growth is being ‘juiced’ by the spending of borrowed money, the consequences could be distinctly unpleasant. To be sure, and even if capital flight and higher rates followed, China could probably sustain its debt-funded growth from within its own banking system. But there are, obviously, limits to quite how long any economy can keep on growing its aggregate debt by about 13% annually.

Additionally, the sheer pace of expansion in inter-bank debt has to be a matter of concern.

Meanwhile, China remains an energy-hungry economy, relying on imports for 68% of its primary energy needs.  Renewables still account for less than 3% of energy consumption, so are not, even remotely, a near-term fix.

This energy situation is being reflected in a rising trend ECoE (energy cost of energy). SEEDS estimates China’s current ECoE at 14.4%, which is drastically higher than a world average of 7.5%. According to SEEDS, China’s surplus energy position is already looking perilous, and could derail growth in less than a decade.

The final chart shows per capita prosperity, calibrated in constant (2016) RMB 000s per person. The downwards impact of ECoE (the red arrow) looks small, but this is deceptive – the ECoE effect only looks small because it is dwarfed by the borrowing effect.

Unlike many Western countries, China does still enjoy increasing prosperity on a per capita basis.

But the two threats to Chinese economic prospects – superheated debt expansion, and high-and-rising ECoE – should not be underestimated.

Whilst the former carries an elevated risk of financial shock, the latter suggests that Chinese citizens may face uncomfortably rapid increases in the real cost of household essentials in the not-too-distant future.

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