#174. American disequilibrium

THE IMBALANCE MENACING THE US ECONOMY

At a time when tens of millions of Americans are unemployed, with millions more struggling to make ends meet, it‘s been well noted that the response of the Federal Reserve has been to throw $2.9 trillion in financial subsidies, not at the economy itself, but at a tiny elite of the country’s wealthiest. Another astute observer has set out reasons why Fed intervention couldn’t – even if so intended – pull the US economy out of its severe malaise.

The discussion which follows assesses the American situation from a perspective which recognises that the economy is an energy system. It concludes that the US has responded particularly badly to the onset of de-growth, something which has been induced, not by choice, but by a deteriorating energy equation.

An insistence on using financial manipulation as a form of denial of de-growth has increased systemic risk whilst exacerbating differences between the “haves” and the “have-nots”.

De-growth has, of course, been a pan-Western trend, one which has now started to extend to the emerging market (EM) economies as well. But few if any other countries have travelled as far as the US down the road of futile and dangerous denial.

Whatever view might be taken of Fed market support policy on grounds of equity, the huge practical snag is that this approach has created a dangerously unsustainable imbalance between the prices of assets and all forms of income.

If the Fed withdraws incremental monetary support to the markets, the prices of stocks, bonds and property will crash back into equilibrium with wages, dividends and returns on savings. If, on the other hand, the Fed persists with monetary distortion of asset prices, the resulting inflation will push nominal wages and other forms of income upwards towards the re-establishment of equilibrium.

Either way, the apparent determination to sustain asset prices at inflated levels can only harm the US economy through an eventual corrective process that cannot escape being hugely disruptive.

The irony is that, whether the outcome is a market crash or an inflationary spiral, the biggest losers will include the same wealthy minority whose interests the Fed seems so determined to defend and promote.

At a crossroads

Critics have spent the best part of two centuries writing premature obituaries for the United States, and that certainly isn’t the intention here. Along the way, various candidates have been nominated as potential inheritors of America’s world economic, financial and political ascendancy, but the latest nominee, China, looks no more credible a successor than any of the others, having severe problems of her own. These lie outside the scope of this analysis, but can be considered every bit as acute as those facing the United States.

This said, it would be foolish to deny that America faces challenges arguably unprecedented in her peacetime history. The Wuhan coronavirus pandemic has struck a severe blow at an economy which was already seriously dysfunctional. Anger on the streets is a grim reminder that, 155 years on from the abolition of slavery, and half a century after the civil rights movement of the 1960s, American society continues to be blighted by racial antagonism. In the political sphere, party points-scoring continues to be prioritised over constructive action, whilst even the most inveterate opponent of Donald Trump would be hard-pressed to name any question to which “Joe Biden” is an answer.

The focus here is firmly on the economy, and addresses issues which, whilst by no means unique to the United States, are perhaps more acute there than in any other major economy. By way of illustration, the last two decades have seen each additional dollar of manufacturing output dwarfed by $11.60 of increased activity in the FIRE (finance, insurance and real estate) sectors. Moreover, each dollar of reported growth has come at a cost, not just of $3.80 in new debt, but of a worsening of perhaps $3.40 in pensions provision shortfalls.

Most strikingly of all, America’s economic processes no longer conform to any reasonable definition of a market economy. Nowhere is this more apparent than in capital markets, which have been stripped of their price-discovery and risk-calibration functions by systematic manipulation by the Fed.

Another way of putting this is that America has been financialised, with the making of money now almost wholly divorced from the production of goods and services. There are historical precedents for this financialization process – and none of them has ended well.

The economy – in search of reality

What, then, is the reality of an economy which, in adding incremental GDP of $7 trillion (+51%) since 1999, has plunged itself deeper in debt to the tune of $27tn (+105%), and is likely to have blown a hole of about $25tn in its aggregate provision for retirement?

To answer this, we need to recognise that economies are energy systems. They are not – contrary to widespread assumption – monetary constructs, which can be understood and managed in financial terms.

For those not familiar with this interpretation, just three observations should suffice to make things clear.

The first is that all of the goods and services which constitute economic output are the products of energy. Nothing of any utility whatsoever can be produced without it.

The second is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process (a component known here as the Energy Cost of Energy, or ECoE).

Surplus energy (the total, less the ECoE component) drives all economic activity other than the supply of energy itself. This surplus energy is, therefore, coterminous with prosperity.

The third is that, lacking intrinsic worth, money commands value only as a ‘claim’ on the output of the ‘real’ (energy) economy. Creating ‘new’ money does nothing to increase the pool of goods and services against which such claims can be exercised. If, as has been the case in the US, newly-created money is injected into capital markets, the result is the creation of unsustainable escalation in the prices of assets.

Once these processes are appreciated, the mechanics of economic prosperity become apparent, as does the futility of trying to tackle them with financial gimmickry. This understanding provides insights denied to ‘conventional’ economic thinking by its obsession with money, and its treatment of energy as ‘just another input’.

The faltering dynamic

Ever since their low-point in the two decades after 1945, worldwide trend ECoEs have been rising exponentially, a process reflecting rates of depletion of low-cost energy from oil, gas and coal. SEEDS analysis indicates that, in highly complex advanced economies, prosperity ceases to grow, and then turns downwards, at ECoEs between 3.5% and 5.0%. By virtue of their lesser complexity, emerging market (EM) countries are more ECoE-tolerant, hitting the same prosperity climacteric at ECoEs of between 8% and 10%.

These trends are illustrated in the following charts, each of which compares economies’ trend ECoEs with prosperity per capita, calibrated in thousands of dollars, pounds or renminbi at constant (2018) values.

In the United States, prosperity has been deteriorating ever since ECoE hit 4.5% back in 2000. A similar fate overtook the United Kingdom in 2003 (when ECoE was 4.2%), and – pre-crisis – was expected to impact China during 2021-22, when ECoE was projected to reach 8.8%.

Critically, there is nothing that can be done to circumvent this physical equation. Prosperity can, of course, be managed more effectively, and distributed more equitably, but it cannot be increased once the energy equation turns against us. Though their development is highly desirable, renewable energy (RE) sources are not going to restore overall ECoEs to the ultra-low levels at which then-cheap fossil fuels powered prior increases in prosperity.

Technology, such as the fracking techniques used to extract oil and gas from US shale formations, cannot overturn cost parameters set by the physical characteristics of the resource. The idea that we can somehow “de-couple” economic activity from the use of energy is a definitional absurdity, and efforts to prove otherwise have rightly been described as “a haystack without a needle”.

For these reasons, the onset of “secular stagnation” in the Western economies from the mid-1990s had a perfectly straightforward explanation, albeit one wholly lost on those who, having coined this term, were unable to understand the processes involved.

The narrative over the subsequent twenty-five years – in the United States as elsewhere – has been one of trying to manufacture “growth” where the capability for continued increases in prosperity has ceased to exist.

Struggling in a trap

The situation from the mid-1990s, then, was that theory and reality were pulling apart. Conventional thinking stated that growth could continue in perpetuity, but this thinking had never taken into account the energy basis of economic activity. Hitherto, ECoE had been small enough to pass unnoticed within normal margins of error, and only now was it starting to act as an insuperable block to expansion. In their contention that the world would never ‘run out of’ oil, opponents of the ‘peak oil’ thesis had supplied the right answer to the wrong question.

This, moreover, was a period of remarkable hubris. The collapse of Soviet communism seemed to demonstrate the final victory of the ‘liberal’ economic model over its collectivist rival, so much so that some even opined that history was now ‘over’. “De-regulation”, it was argued, could be equated with economic vibrancy and, together with enlightened monetary policy, could prolong, in perpetuity, the “great moderation” which, in a brief sweet-spot in the early 1990s, had seemingly combined robust growth with low inflation.

Those who remained critical had, in any case, another target for their invective – globalisation. This was indeed a faulted model, and was always bound to use cheap credit to fill the gap between Western production (which had been outsourced), and consumption (which had not). But globalisation remained a symptom, whilst the malaise itself, which was a deteriorating energy dynamic, went almost wholly unnoticed.

Accordingly, ‘solutions’ to the problem of “secular stagnation” were sought in monetary and regulatory policy. From the late 1990s, the Fed embarked on a process of credit adventurism, keeping rates low, and making credit easier to obtain than it had ever been in living memory.

Between 1999 and 2007, American GDP grew at rates of close to 3%, which seemed pretty satisfactory. Unfortunately, borrowing was growing a lot more quickly than recorded output. Through the period between 1999 and 2019 as a whole, when US growth averaged 2.1%, annual borrowing averaged 7.8% of GDP, whilst aggregate debt increased by $27tn to support economic growth of just $7.1tn.

Along the way, de-regulation weakened and, in many cases, severed altogether the necessary linkages between risk and return. Risk became both mis-priced and increasingly opaque, leading directly, of course, to the global financial crisis (GFC) of 2008.

This presented the authorities with two alternative courses of action. One of these, which was rejected, was to accept a ‘reset’ to the conditions which preceded the debt-fuelled boom of the pre-GFC years. The other, adopted enthusiastically by the Fed and other central banks, was to compound credit adventurism with its monetary counterpart.  As well as slashing policy rates to all but zero, QE was used to bid bond prices up, and thus force yields downwards. The result was ZIRP (zero interest rate policy), effectively negative (NIRP) in ex-inflation terms.

Remarkably, nobody in a position of authority seems to have thought it in any way odd that people and businesses should be paid to borrow.

The result, inevitably, has been increasing financial and economic absurdity. The necessary process of creative destruction has been stymied by the supply of credit cheap enough to keep technically defunct ‘zombie’ companies in being, whilst investors and lenders have seen merit in using ultra-cheap capital to finance ‘cash-burners’, confident that any losses will be handed back to them by a beneficent Fed.

Another, barely noticed consequence has been the emergence of huge gaps in the adequacy of pension provision. In a report appropriately dubbed the Global Pension Timebomb, the World Economic Forum calculated that the shortfall in US retirement provision stood at $28tn as of 2015, and was set to reach a mind-boggling $137tn by 2050.

Though other factors have been involved, a critical role has been played by a collapse in returns on invested capital. The WEF stated that forward real returns on American equities had slumped to 3.45% from a historic 8.6%, whilst bond returns had crashed from 3.6% to just 0.15%. On this basis, we can calculate that a person who hitherto had invested 10% of his or her income in a pension would now need to save about 27% to attain the same result at retirement, a savings ratio which, for the vast majority, is wholly impossible.

Faking it

Analytically, though, by far the most important aspect of US economic mismanagement has been the manufacturing of “growth” by the injection of cheap credit and cheaper money. The direct corollary of this process has been the driving of a wedge between asset prices and all forms of income.

This process goes far beyond the simple “spending of borrowed money”, which creates activity that could not have been afforded had consumers’ expenditures been limited to their own resources. Since asset prices are, to a very large extent, an inverse function of the cost of money, revenues in all asset-related activities, most obviously in financial services such as banking, insurance and real estate, have been inflated, directly and artificially, by ultra-loose monetary policies. Even the few who have not been sucked into this borrowing binge are almost certain to have benefited from employers or customers who have.

Using the SEEDS model, the following charts illustrate how monetary manipulation has driven a wedge between reported GDP and underlying or “clean” levels of output. In the absence of this manipulation, growth between 1999 and 2019 wouldn’t have averaged 2.1%, but just 0.8%.

At the household level, this means that increases in the average American’s income have been far exceeded by an escalation in his or her liabilities. These liabilities embrace not just personal credit but the individual’s share of corporate and government indebtedness, and include the pensions gap as well.

This process helps explain why mortgage, consumer, auto and student loans have soared, and why cheap (but inflexible) debt has been used to destroy costlier (but shock-absorbing) equity in the corporate sector.

The popular notion that these increases in liabilities have been offset by rises in the values of homes and equities is wholly mistaken, because it ignores the fact that these are aggregate values calculated on the basis of marginal transactions.

An individual can sell his or her home, or unload a stock portfolio, but the entirety of the housing stock, or the whole of the equity market, cannot be monetised, because the only possible buyers are the same people to whom these assets already belong.

By applying the ECoE deduction to the ‘clean’ level of output (C-GDP), we can identify what has really happened to the prosperity of the average American over the past two decades. In 2019, prior to the current pandemic crisis, his or her annual prosperity stood at an estimated $44,385, which was $3,660 (8%) lower than it had been back in 2000. Over the same period, taxation per capita increased by $3,485, so that the average person’s discretionary (‘left in your pocket’) prosperity is lower now by more than $7,100 (22%) than it was in 2000.

Meanwhile, each person’s share of America’s household, business and government debt has risen from $94,000 to more than $160,000 (at constant values), and nobody has yet proposed a workable solution to a rapidly rising pension gap which probably stands at more than $35tn, or $107,000 per person.

This predicament, which is summarised in the final set of charts, is beyond uncomfortable – and even this, of course, preceded the economic hurricane of the coronavirus pandemic.

The lethal disequilibrium

As well as understanding what these circumstances mean in practical terms, we need to note another consequence of using financial adventurism in the face of deteriorating prosperity. This is the way in which the relationship between incomes and assets has been bent wholly out of shape.

It’s an essential prerequisite of a properly functioning economy that there is a stable and workable balance between, on the one hand, all forms of income and, on the other, the valuation of assets, including equities, bonds and property. The problem facing anyone trying to calculate this relationship is that financial adventurism has falsified some forms of income in much the same way that it has distorted GDP. This is where prosperity, calibrated using an energy-based model such as SEEDS, is particularly important.

Essentially, equity prices need to be low enough to give stockholders a satisfactory real return on their investment, with much the same applying to bonds. Meanwhile, if typical property prices become too high in relation to median earnings, the market becomes dysfunctional, because it prices out new buyers, leaving owners vulnerable to any weakening in monetary support.

When – as has happened in the United States and elsewhere – monetary manipulation distorts these relationships, one of three things must happen. First, the authorities need to carry on, indefinitely, making incremental additions to their monetary largesse. Second, and if ever they cease to do this, then asset prices must correct downwards into equilibrium with all forms of income. Third, nominal incomes must be increased to restore equilibrium, something which, with prosperity no longer increasing, can only happen through rising inflation.

For as long as a disequilibrium between asset prices and incomes continues, the effect is to benefit asset owners to the detriment of those depending on incomes (which may be wages, dividends, profits, pensions or returns on savings). Accordingly, a wealthy elite becomes the beneficiary of processes whose outcomes are negative for those with little or no ownership of assets.

Put another way, inequalities will continue to widen – even if the authorities don’t adopt policies aimed deliberately at such an outcome – until a financial pendulum effect restores equilibrium.

What now?

From the foregoing, it will be apparent that America’s current predicament is by no means wholly a function of the coronavirus pandemic, or of the latest upsurge in racial tensions. Rather, the US is at the culminating point of a series of adverse trends:

First, the energy dynamic which determines prosperity has turned down, and a failure to recognise this climacteric has driven the authorities, in the US as elsewhere, into a chain-reaction of mistaken policies.

Second, the financialization of the economy has hidden underlying fundamentals from view, whilst simultaneously creating enormous systemic risk.

Third, failed monetary policies have driven a wedge between those who own assets, and those who depend either on wages or on other forms of income.

Fourth, and most dangerously of all, policy has created a dangerous disequilibrium between asset prices and incomes. It is no exaggeration to say that this disequilibrium is poised over the US economy like the Sword of Damocles.

Along the way, America has allowed market principles to be over-ruled by financial engineering, something typified by the way in which markets have become extensions of monetary policy.

The danger implicit in the latter point, in particular, is that monetary manipulation will be relied upon to resolve issues that lie outside its competence. There are strong reasons to believe that the US has reached a point of ‘credit exhaustion’, after which households refuse to take on any more debt, however cheap and accessible it may become. That is the point at which monetary policy becomes akin to “pushing on a string”.

This futility implies that either (a) the authorities give up on monetary stimulus, at which point asset markets crash, or, and more probably, (b) they ramp up injections of liquidity to a point at which dollar credibility implodes.

This creates a very realistic possibility that deflationary pressures push the Fed into the creation of new money on such a scale that inflation accelerates.

It is particularly worrying that a combination of self-interest and the polarisation of opinions prevents the adoption of pragmatic policies which, even at this very late stage, might manage the economy back into equilibrium.

 

 

#165. To catch a falling knife

AT THE END OF TWO ERAS, HOT MARKETS NEED COOL THINKING  

Unless you’ve been in a dealing-room on Wall Street or in the City of London (or, as in my own case, in both) during a market crash, it’s almost impossible to imagine quite how febrile and frenetic the atmosphere becomes. Rumours flourish and wild theories proliferate, whilst facts are scarce. Analysts are expected to provide instant answers, perhaps on the principle that even an answer which turns out to be wrong is of more immediate use than no answer at all.

It’s a sobering thought that the only financial market participants with any prior crash experience at all are those who’ve been working there for at least twelve years – and even they may have been lulled into complacency by a decade and more in which the working assumption has been that, thanks to the omnipotence and the omniscience of central bankers, ‘stock prices only ever go up’.

This complacency, a dozen years in the making, is a resilient force, and showed signs of staging a come-back in the final trading minutes of a tumultuous week. The logic, if such it can be called, is that the Federal Reserve and the other major central banks will spend the weekend concocting a solution.

For once, this rumour is almost certainly founded in reality, and my strong hunch is that the central banks will have announced co-ordinated measures before the weekend is over. These measures are likely to include further rate cuts, a resumption of the Fed’s $400bn “not QE” programme that ended in December, and statements of intent by all of the central bankers. The likelihood of something along these lines, even if it achieves nothing of substance, will have raised expectations to fever pitch by the time that the markets reopen.

We should be in no doubt that this central bank intervention will be ultra-high-risk. For starters, there are plenty of reasons why it might not work. The Fed, for instance, cannot “print antibodies”, as someone remarked on the superb Wolf Street blog, in which Wolf Richter reminded us that “if you don’t want to get on a plane in order to avoid catching the virus, you’re not going to change your mind because T-bill yields dropped 50 basis points”.

Critically, if the central bankers try something and – beyond a brief “dead cat bounce” – it doesn’t work, then their collective credibility as supporters of equity markets will be shot to pieces, which would overturn market assumptions to such an extent that a correction could turn into a full-blown crash. Their only real chance of success will rest on persuading investors that whatever happens in the real economy has no relevance whatsoever for the markets.

My own preference would be for central bankers decide to do nothing, or, as they might express it themselves, ‘conserve their limited ammunition for a more apposite moment’. This, though, is a preference based almost wholly on hope rather than expectation. We might or might not over-estimate the powers of the central bankers, but we should never underestimate their capacity for getting things wrong.

The double dénouement      

From personal experience, analysts are pulled in two directions at once in circumstances like these. Whilst one part of you wants to provide the instant answers which everyone demands, the other wants to find a physically and mentally quiet space in which to think through the fundamentals. It’s fair to say that, at times like this, it’s enormously important to step back and produce a coldly objective interpretation.

Seen from this sort of ‘top-down’ perspective, current market turmoil is symptomatic of the uncertainty caused by the simultaneous ending of two eras, not one.

The first of these ‘ending eras’ is a chapter, four-decades long, that we might label ‘neoliberal’ or ‘globalist’.

The other, which we can trace right back to the invention of the first effective heat-engine in 1760, is the long age of growth powered by the enormous amount of energy contained in fossil fuels.

Whilst environmental issues are the catalyst bringing our attention to ‘the end of growth’, the Wuhan coronavirus is acting, similarly, to crystallise an understanding that ‘the chapter of globalist neoliberalism’, too, is drawing to a close.

The best way to understand and interpret these intersecting dénouements is to start with some principles, and then apply them to the narrative of how we got to where we are.

Here, with no apology for brief reiteration, are the three core principles of surplus energy economics.

First, the energy economy principle – all economic activity is a function of energy, since literally nothing of any economic utility whatsoever can be produced without it.

Second, the ECoE principle – whenever energy is accessed for our use, some of that energy is always consumed in the access process.

Third, the claim principle – having no intrinsic worth, money commands value only as a ‘claim’ on the output of the energy economy.

Together, these principles – previously described here as “the trilogy of the blindingly obvious” – provide the essential insights required if we’re to make sense of how the economy works, how it got to where it is now, and where it’s going to go in the future.

The ECoE trap

Critically, the energy cost component (known here as the Energy Cost of Energy, or ECoE) has been rising relentlessly since its nadir in the two decades after 1945. Since surplus energy, which is the quantity remaining after the deduction of ECoE, drives all economic activity other than the supply of energy itself, rising ECoEs necessarily compress the scope for prosperity.

The way in which we handle this situation in monetary terms determines the distribution of prosperity, and informs the economic narrative that we tell ourselves, but it doesn’t  – and can’t – change the fundamentals.

Where fossil fuels are concerned (and these still account for more than four-fifths of all energy supply), the factors determining trend ECoE are geographical reach, economies of scale, the effects of depletion and the application of technology.

These can usefully be expressed graphically as a parabola (see fig. 1). As you can see, the beneficial effects of geographical reach and economies of scale have long since been exhausted, making depletion the main driver of fossil fuel ECoEs. Technology, which hitherto accelerated the downwards trend, acts now as a mitigator of the rate at which ECoEs are rising. But we need to recognise that the scope for technology is bounded by the envelope of the physical properties of the primary resource.

Fig. 1

Analysis undertaken using the Surplus Energy Economics Data System (SEEDS) indicates that, where the advanced economies of the West are concerned, prior growth in prosperity goes into reverse when ECoEs reach levels between 3.5% and 5.0%. Less complex emerging market (EM) economies are more ECoE-tolerant, and don’t encounter deteriorating prosperity until ECoEs are between 8% and 10%.

With these parameters understood, we’re in a position to interpret the true nature of the global economic predicament. The inflexion band of ECoEs for the West was reached between 1997 (when world trend ECoE reached 3.5%) and 2005 (5.0%). For EM countries, the lower bound of this inflexion range was reached in 2018 (7.9%), and it’s set to reach its upper limit of 10% in 2026-27, though prosperity in most EM countries is already at (or very close to) the point of reversal.

Desirable though their greater use undoubtedly is, renewable energy (RE) alternatives offer no ‘fix’ for the ECoE trap, since the best we can expect from them is likely to be ECoEs no lower than 10%. That’s better than where fossil fuels are heading, of course, but it remains far too high to reverse the trend towards “de-growth”.  In part, the limited scope for ECoE reduction reflects the essentially derivative nature of RE technologies, whose potential ECoEs are linked to those of fossil fuels by the role of the latter in supplying the resources required for the development of the former.

The energy-economic position is illustrated in fig. 2, in which American, Chinese and worldwide prosperity trends are plotted against trend ECoEs. Whilst the average American has been getting poorer for a long time, Chinese prosperity has reached its point of reversal and, globally, the ‘long plateau’ of prosperity has ended.

Fig. 2

Response – going for broke

As well as explaining what we might call the ‘structural’ situation – where we are at the end of 250 years of growth powered by fossil fuels – the surplus energy interpretation also frames the context for the ending of a shorter chapter, that of ‘globalist neoliberalism’.

Regular readers will know (though they might not share) my view of this, which is that the combination of ‘neoliberalism’ with ‘globalization’ (in the form in which it has been pursued) has been a disaster.

Whilst there’s nothing wrong with spreading the benefits of economic development to emerging countries, this was never the aim of the ‘globalizers’. Rather, the process hinged around driving profitability by arbitraging the low production costs of the EM nations and the continuing purchasing power of Western consumers, the clear inference being that this purchasing power could only be sustained by an ever-expanding flow of credit.

The other, ‘neoliberal’ component of this axis was based on an extreme parody which presents the orderly and regulated market thesis as some kind of justification for a caveat emptor, rules-free, “law of the jungle” system which I’ve called “junglenomics”.

From where we are now, though, what we need is analysis, not condemnation. As we’ve seen from the foregoing energy-based overview of the economy, ‘neoliberalism’ was as much an inevitable reaction to circumstances as it was a malign and mistaken theory.

Essentially, and for reasons which energy-based interpretation can alone make clear, a process of “secular stagnation” had set in by the late 1990s, as the Western economies moved ever nearer to ECoE-induced barriers to further growth. At this juncture, policymakers were compelled to do something because, just as never-ending growth is demanded by voters, the very viability of the financial system is wholly predicated on perpetual growth. The contemporary penchant for ‘globalist neoliberalism’ simply determined the form that this intervention would take.

Since our interest here is in the present and the immediate future rather than the past, we can merely observe that, after the failure of ‘credit adventurism’ culminated in the 2008 global financial crisis (GFC), the subsequent adoption of ‘monetary adventurism’ simply upped the stakes in a gamble that couldn’t work. What this in turn means is that the probability of truly gargantuan value destruction is poised, like Damocles’ sword, over the financial system. If it hadn’t been the Wuhan coronavirus which acted as a catalyst, it would have been something else.

Conclusions and context

As we await the next twists in some gripping economic and financial dramas, it’s well worth reminding ourselves that stock markets, and the economy itself, are very different things. High equity indices are not hall-marks of a thriving economy, least of all at a time when market processes have been hijacked by monetary intervention.

In so far as there’s an economic case for propping up markets, that case rests on something economists call the “wealth effect”. What this means is that, whilst stock prices remain high, the accompanying optimistic psychology makes people relaxed about taking on more credit. The inverse of this is that, if prices slump, the propensity to borrow and spend can be expected to fall sharply.

The snag with this is straightforward – unless you believe that debt can expand to infinity, perpetual expansion in credit is a very dubious (and time-limited) plan on which to base economic policy. If the central banks do succeed in reversing recent market falls, the only real consequence is likely to be a deferral, to a not-much-later date, of the impact of the forces of disequilibrium which must, in due course, redress some of the enormous imbalances between asset prices, on the one hand, and, on the other, all forms of income.

Ultimately, we don’t yet know how serious and protracted the economic consequences of the coronavirus will turn out to be. My belief is that these consequences are still being under-estimated, even if, as we all hope, the virus itself falls well short of worst-case scenarios. It’s hard to see how, for example, Chinese companies can carry on paying workers, and servicing their debts, with so much of the volume-driven Chinese economy in lock-down.

Within the broader context, which includes environmental considerations in addition to the onset of “de-growth” in prosperity, we may well have reached ‘peak travel’, which alone would have profound consequences. Other parts of the financial system – most of which are far more important than equity markets – seem poised for a cascade. If it isn’t ‘Wuhan, and now’, the likelihood is that it will be ‘something else, and soon’.

#164. A bolt from the grey

WHY “BUSINESS AS USUAL” WILL NOT BE RESTORED

Where the purely biological prognosis for the Wuhan coronavirus is concerned, there’s at least a ton of speculation for every pinch of fact, and there would be no merit at all in adding to that speculation here. One of the few things that can be said about this with any confidence at all is that somehow, sometime, the epidemic will end.

The expectation then will be that, in the purely economic and financial spheres, what the economic and financial consensus likes to call “normality” will be restored.

As people and businesses go back to work, as the flow of goods and services resumes, and as ravaged supply lines are repaired, the economy will be expected to stage a full recovery. People wary of travelling will, we’ll be told, start boarding aircraft again, and even the cruise liner industry might start to shrug off the tag of “floating petri-dishes”.

Capital markets, too, will be expected to bounce back, even if takes a long time to restore them to their full pomp, hubris and folly. Investors will be expected to go back to wasting their money propping up “cash-burners” again, and queueing up to get a piece of the latest moonbeam IPO.

But the reality, from a surplus energy perspective, is that this definition of “normality” is highly unlikely to be restored. In economic terms, the relentless rise in the energy cost of energy (ECoE) had already started making people poorer, long before the name ‘Wuhan’ had any connotation beyond the geographical.

It cannot be stressed too strongly that global trade in goods had already turned down, as had sales of everything from cars and smartphones to chips and components. Financial stresses had already become severe, and investors had already started to view cash-burning and over-hyped sectors with new caution.

Nasty though it is in purely human terms, and real though its economically disruptive effects undoubtedly are, the coronavirus didn’t strike out of cloudless economic skies.

Rather, it’s been a bolt from the grey.

It’s too soon to say whether the epidemic will act as a catalyst for a full-blown financial crash but, if it does, the authorities will have tough decisions to make, and we can only hope that the disastrous mistakes made during the 2008 global financial crisis (GFC) will not be repeated.

In the sound and fury of that crisis, the imbecility of ‘monetary adventurism’ was piled on top of the prior folly of ‘credit adventurism’. The blithe assumption was made that, left to its own devices – and, of course, bailed out by taxpayers from the consequences of its previous failures – ‘de-regulated’ finance could get back to driving economic progress.

Back in 2008, the ‘global’ crisis was presented as something that somehow had happened out of the blue, without human agency, and that ‘nobody could have known’ that a credit-driven bubble was going to end in a bust. The reality, though, was that we’d been using $2 of new debt to buy each $1 of highly dubious “growth”.

Since then, and whilst reported “growth” has become even more cosmetic and insubstantial, the debt cost of each dollar of it has risen to over $3. Along the way, the worsening imbalance between asset prices, on the one hand, and all forms of income, on the other, has inflicted enormous damage. This imbalance has blown huge holes in pension and other saving provision, has prevented the proper functioning of markets in pricing risk, has stripped the economy of “creative destruction” and has saddled us with far too much of the speculative and the outright exploitative.

Siren voices to the contrary, spending borrowed money has never been a cure-all for a process of “secular stagnation” driven by a structural deterioration in an economy in which the prior spurt in prosperity delivered by fossil fuels was coming to an end, and had started to go into reverse.

Nobody would envy the choices that are going to imposed on governments and central banks if – or, to be realistic about it, when – the 2008 crisis is repeated, but this time in the much larger and more menacing shape that has always been a virtual inevitability.

But the analogy that can most usefully be made here might be one which compares 1945 with 1918. After the first “war to end all wars”, the rallying-cry was “business as usual”, but no equivalent delusion could persuade the people of 1945 that there were merits in re-creating the inter-war world, be it the financial the excesses of the 1920s or the mass misery of the Great Depression.

This time, a similar catharsis might – just might – persuade us to start taking a realistic view of the economy, not as a monetary construct capable of perpetual growth through financial manipulation, but as an energy system whose prior ability to make us more prosperous has gone into reverse.

 

 

 

#162. The business of de-growth

ENTERPRISE IN A DE-GROWING, DE-LAYERING ECONOMY

We start the 2020s with the political, economic, commercial and financial ‘high command’ quite remarkably detached from the economic and financial reality that should inform a huge variety of policies and decisions.

This reality is that the relentless tightening of the energy equation has already started putting prior growth in prosperity into reverse. No amount of financial gimmickry can much longer disguise, still less overcome, this fundamental trend, but efforts at denial continue to add enormously to financial risk.

This transition into uncharted economic waters has huge implications for every category of activity and every type of player. Just one example is government, for which the reversal of prior growth in prosperity means affording less, doing less, and expecting less of taxpayers (with the obvious corollary that the public should expect less of government).

Governments, though, do at least have alternatives. ‘Doing less’ could also mean ‘doing less better’ – and, if the public cannot be offered ever-greater prosperity, there are other ways in which the lot of the ‘ordinary’ person can be improved.

At first sight, no such alternatives seem to exist for business. The whole point of being in business, it can be easy to assume, is the achievement of growth. Whether it’s bigger sales, bigger profits, a higher profile, a growing market value or higher dividends for stockholders, every business objective seems tied to the pursuit of expansion.

None of this, in the aggregate at least, seems compatible with an economy in which the prosperity of customers is shrinking.

In reality, though, both de-growth and de-layering offer opportunities as well as challenges. The trick is to know which is which.

For those of us not involved in business, the critical interest here is that, driven as they are by competition, businesses are likely to be quicker than other sectors to recognise and act upon the implications of the post-growth economy.

Getting to business

How, then, are businesses likely to position themselves for the onset of de-growth? The answer begins with the recognition of two realities.

The first of these is that prosperity is deteriorating, and that there is no ‘fix’ for this situation.

The second is that ‘price isn’t value’.

As regular readers will know, prosperity in most of the Western advanced economies (AEs) has been in decline for more than a decade, and a similar climacteric is nearing for the emerging market (EM) nations.

This fundamental trend is, as yet, unrecognised, whether by ‘conventional’ economic interpretations, governments, businesses or capital markets. It is already felt, though, if not necessarily yet comprehended, by millions of ordinary people.

‘Conventional’ economics, with its fixation on the financial, fails to recognise the deterioration of prosperity because it overlooks the critical fact that all economic activity is driven by energy. There is no product or service of any economic utility which can be supplied without it. Money and credit are functions of energy because, being an artefact wholly lacking in intrinsic worth, money commands value only as a ‘claim’ on goods and services – all of which, of course, are themselves products of the use of energy.

The complicating factor in the prosperity equation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. This consumed proportion is known here as ECoE (the Energy Cost of Energy), a concept related to previously-defined concepts such as net energy and EROI.

Critically, what remains after the deduction of ECoE is surplus energy. The aggregate of available energy thus divides into two components. One of these is ECoE, and the other is surplus energy, which drives all economic activity other than the supply of energy itself.

This makes surplus energy coterminous with prosperity.

The relentless (and unstoppable) rise in ECoEs has now squeezed aggregate prosperity to the point where the average person is getting poorer. There is nothing that can be ‘done about’ this, so the necessity now is to adapt.

SEEDS – the Surplus Energy Economics Data System – has been built and refined to model the economy on this basis. Its identification of deteriorating prosperity accords with numerous ‘on the ground’ observations, whether in economics, finance, politics or society.

But general recognition of this interpretation has yet to occur, and, in its absence, the economic history of recent years has been shaped by efforts to use the financial system to deny (since we cannot reverse) this process. The main by-product of this exercise in denial has been excessively elevated risk.

Conclusions come later, but an important point to be noted from the outset is that, as the economy gets less prosperous, it will also get less complex, resulting in the phenomenon of ‘de-layering’. An understanding of this and related processes will be critical to success in an economic and business landscape entering unprecedented change.

The reality of deteriorating prosperity

A necessary precondition for the formulation of effective responses is the recognition of where we really are, and there are two observations with which this needs to start.

The first is the ending and reversal of meaningful “growth” in prosperity. Any businessman or -woman who believes that economic “growth” is continuing ‘as usual’, or can somehow be restored, needs to reframe his or her interpretation radically. Indeed, it’s been well over a decade (and, in many instances, nearer two decades) since the advanced economies of the West last achieved genuine growth in economic prosperity.

For illustration, the deterioration in average personal prosperity in four Western countries, both before and after tax, is set out in the following charts. Examination of the trend in post-tax (“discretionary”) prosperity in France, in particular, does much to explain widespread popular discontent.

Worse still, from a business perspective, a similar downturn is now starting in the hitherto fast-growing EM economies, including China, India and Brazil.

To be sure, the authorities have done a superficially plausible job of hiding the reality of falling prosperity, first by pumping cheap credit into the system and, latterly, by doubling down on this and turning the real cost of money negative. The only substantive products of these exercises in credit and monetary adventurism, though, have been enormous increases in financial exposure.

The cracks are now beginning to show, and in ways that should be particularly noticeable to business leaders.

Sales of a broadening number of product categories, from cars and smartphones to chips and components, have turned down. Debt continues to soar (which is hardly surprising in a situation in which people are being paid to borrow), and questions are starting to be asked about credit ratings, debt servicing capability and the possible onset of ‘credit exhaustion’ (the point at which borrowers no longer take on any more credit, however cheap it may be).

Whole sectors (such as retailing and air travel) are already being traumatised. Returns on invested capital have collapsed, and this has had knock-on effects in many areas, but nowhere more so than in the adequacy of pension provision (where the World Economic Forum has warned of a “global pensions timebomb”). Even before this pensions reality strikes home to them, ordinary people are becoming increasingly discontented, whether this is shown on the streets of Paris and other cities, or in the elections whose outcomes have included Donald Trump, “Brexit” and a rising tide of “populism” (for which the preferred term here is insurgency) and nationalism.

There are, of course, those who contend that falling sales of cars and chips ‘don’t matter very much’, because we can continue to sell each other services which, even where they are of debateable value, can still be monetised, so will continue to generate revenues. These assurances tend to come from the same schools of thought which previously told us that debt, too, ‘doesn’t matter very much”.

This wishful thinking, arguably most acute in the ‘tech’ sector, ignores the fact that, as the average consumer gets poorer, he or she is going to be become more adept, or at least more selective and demanding, in the ranking of value. In a sense, the failure to recognise this trend repeats some of the misconceptions of the dot-com bubble – and the answer is that you can only be happy about ‘virtual’ and ‘intangible’ products and sales if you’re equally relaxed about earning only virtual and intangible profits. But business is, or should be, about cash generation – nobody ever bought lunch out of notional profits.

Let’s put this in stark terms. If someone is in the business of selling holidays, he or she makes money when people actually travel to the facility, and pay to use its services. They could, of course, sell them computer-generated virtual tours of the facility as a sort of proxy-residency – but does anyone really think that that’s a substitute for the revenue that is earned when they actually visit in person?

Another way to look at this is that businesses are likely to become increasingly wary of middle-men and ‘agencies’. This reflects de-layering, an issue to which we shall return later. But the general proposition is that, in de-growth, businesses will prosper best when they capture as much of the value-chain as possible, ensuring that ‘value’ predominates over ‘chain’.

Ancillary services, and ancillary layers, are set to be refined out, and businesses are likely to become increasingly wary of others trying to monetise parts of their chain.

Understanding value

The second reality requiring recognition is that the prices of capital assets, including stocks, bonds and property, have risen to levels that are both (a) wholly unrelated to fundamental value, and (b) incapable of being sustained, under present or conceivable economic conditions.

Statements like “the Fed has your back” are illustrative of quite how irrational this situation has become. The idea that inflated asset prices can be supported indefinitely by the perpetual injection of newly-created liquidity is puerile beyond any customary definition of that word.

We may not know how long asset prices can continue to defy economic gravity, or how the eventual reset will take place, but the definition of ‘unsustainable’ is ‘cannot be sustained’.

A general point needing to be made is that is called “value” by Wall Street and its overseas equivalents is of little relevance to what the word should mean in business. The interests of business and of the capital markets are by no means coterminous, since the objectives of each are quite different. The astute business leader might listen to the opinions of those in the financial markets, but acts only on his or her own informed conclusions.

From a business perspective, the value of an asset is the current equivalent of its future earning capability. No apology is made to those who already understand this universal truism, because, though fundamental, it is all too often overlooked. This principle can be best be illustrated by looking at a simple example such as a toll bridge.

To the owner (or potential acquirer) of a toll bridge, various future factors are known, though with varying degrees of confidence. He or she should know, at high levels of confidence, appropriate rates of depreciation and costs of maintenance. He has an informed opinion, albeit at a somewhat lesser level of confidence, about what the future toll charges and numbers of users are likely to be.

This information enables him to project into the future annual levels of revenue and cost. He can, moreover, divide the cost component into cash and non-cash components, the latter including depreciation and amortisation. From this, he can create a numerical forward stream of projected cash flows and earnings.

The question which then arises is that of what value today can be ascribed most appropriately to the income stream to be realised in the future.

This process requires risk-weighting. Costs and taxes may turn out to be higher or lower than the central case assumptions, and the same is true of revenue projections. Customer numbers and unit revenues may be influenced by factors outside either the control of the owner or of his ability to anticipate. Degrees of variability can and should be factored in to the calculation of appropriate risk.

What happens now is that a compounding discount factor is created by combining risk, inflation, cost of capital and the time-value of money. Application of this factor turns future projections into numbers for discounted cash flow (DCF) as a net present value (NPV).

There is nothing at all novel about DCF-NPV calculation, and it is used routinely by those valuing individual commercial assets. It is, incidentally, far more reliable than ROI (return on investment) or ROC (return on capital) methodologies, let alone IRR (internal rate of return).

Importantly, though, this valuation procedure is applicable to all business ventures. The process becomes increasingly complex as we move from the simple asset to the diversified, multi-sector business, and increasingly conjectural where rising levels of uncertainty (over, for instance, future rates of growth) are involved.

But the principle – that the worth of a business asset is coterminous with what it will earn in the future – remains central.

The nearest that capital markets tend to get to this is to price a company on the basis of its future earnings, which is where the P/E ratio (and its various derivatives) fit into the process. A more demanding (but more useful) approach substitutes cash flow for earnings, and generates the P/CF ratio. P/FCF (price/free cash flow) is a still better approach, though all cash flow-based calculations need to ensure that a tight definition and a robust methodology are involved.

Where P/E ratios are concerned, both growth potential and risk should be (though often aren’t) reflected in multiples. When one company is priced at, say, 10x earnings whilst another is priced at 20x, it’s likely that the latter is valued more aggressively than the former because growth expectations are higher (though it is also possible that the lower-rated company is considered to be riskier).

Much of the foregoing will be well-known to any competent business leader or analyst. It is referenced here for two reasons – first, because it produces valuations which typically bear little or no resemblance to today’s hugely inflated financial market pricing of assets and, second, because an understanding of fundamental value needs to be placed at the centre of any informed response to the onset of de-growth.

Markets are driven by many factors beyond the trinity of ‘fear, greed and [sometimes] value’. Supplementary, non-fundamental market factors, whether or not they are of meaningful relevance to investors and market professionals, should not exert undue influence on the decisions made by business leaders. “What will my share price be in a year from now?” may be an interesting subject for speculation, but should play little or no part in planning.

This point is stressed here because deteriorating prosperity will invalidate almost all market assumptions. This deterioration is an extraneous factor not yet known to the market. It destroys the credibility of the ‘aggregate growth’ assumption which informs the pricing both of individual companies and of sectors. It impacts customer behaviour, and customer priorities, in ways that markets could not anticipate, even if they were aware of the generalised concept of de-growth.

This is why business strategy needs to incorporate a concept which may be called ‘de-complexifying’ or, more succinctly, de-layering.

The critical understanding – the de-layering driver

It’s useful at this point to reflect on the way in which our economic history can be defined in surplus energy terms.

Our hunter-gatherer ancestors had no surplus energy, because all of the energy that they derived from nutrition was expended in the obtaining of food. Agriculture, because it enabled twenty individuals or families to be fed from the labour of nineteen, created the first recognizable economy and society because of the surplus energy which enabled the twentieth person to carry out non-subsistence tasks. This economy was rudimentary, reflecting the fact that the energy surplus was a slender one. Latterly, accessing the vast energy contained in fossil fuels leveraged the surplus enormously, which meant that only a very small proportion of the population needed now to be engaged in subsistence activities, with the vast majority now doing other things.

This process made the economy very much larger, of course, but it’s more important, especially from a business perspective, to note that it also made it very much more complex. Where once, for example, we had only farmers and grocers, with very few layers in between, food supply has since become vastly more diverse, involving an almost bewildering array of trades and specialisations. The linkage between expansion and complexity holds true of all sectors.

The most pertinent connection to be made here is that, just as prior growth in prosperity has driven growth in complexity, the deterioration in prosperity is going to have the opposite effect, initiating a trend towards a reduction in complexity. One term for this is ‘simplification of the supply chain’. Another, with applications far beyond commerce, is de-layering.

This has two stark and immediate implications for businesses.

First, a business which can front-run de-layering, simplifying its operations before others do so, can gain a significant competitive advantage.

Second, if a business is one that might get de-layered, it would be a good idea to get into a different business.

First awareness

In this discussion we have established three critical understandings:

– Prosperity is deteriorating, for reasons which mainstream interpretation has yet either to recognise or to understand.

– Attempts to ‘fix’ this physical reality by means of financial gimmickry have resulted only in increases in risk, many of them associated with the over-pricing of assets.

– As prosperity decreases, the economy will de-complexify.

These points describe a situation whose reality is as yet largely unknown, but one reason for selecting business (rather than, say, government, the public sector or finance) for this first examination of the sector implications of deteriorating prosperity is that businesses are likely to discover this new reality more quickly than other organisations.

Whilst by no means free from the assumptions, conventions, ‘received wisdoms’ and internal group interests that operate elsewhere, businesses are driven by competition – and this means that, should a small number of enterprises discover and act upon the implications of de-growth, de-layering and disproportionate risk, others are likely to follow.

We cannot, of course, discuss here the many practical steps which are likely to follow from recognition of the new realities and, in some cases, it might be inappropriate to do so.

It seems obvious, though, that a business which becomes familiar with the situation as it is described here will seek to take advantage of inappropriately elevated asset prices, and to test its value-chain and its operations in the light of future de-layering. Ultimately, the aim is likely to be to front-run both de-layering and revaluation. Moreover, awareness of those countries in which prosperity deterioration is at its most acute is likely to sharpen the focus of multi-regional companies.

 

#161. A welcome initiative

MR CUMMINGS’ BOLD ENDEAVOUR

As we’ve been discussing here, Dominic Cummings, senior policy advisor to British premier Boris Johnson, has issued a clarion call for “data scientists, project managers, policy experts, assorted weirdos” and others to join an effort to transform the workings of government.

Here is how Mr Cummings defines his objectives:

“We want to improve performance and make me much less important — and within a year largely redundant. At the moment I have to make decisions well outside what Charlie Munger calls my ‘circle of competence’ and we do not have the sort of expertise supporting the PM and ministers that is needed. This must change fast so we can properly serve the public”.

Let me start by making two points about this initiative. The first is to commend Mr Cummings for taking it. New thinking is needed as never before in government, not just in Britain but around the World.

The second is that I think Mr Cummings has a better-than-evens chance of success. He’s not the first person in government to try to think “the unthinkable” or “outside the box”, but conditions do look propitious.

The long-running political guerrilla war over “Brexit” has had a numbing effect in numerous important areas, not just on policy but on constructive debate, so there’s a lot of catching up to do. My hunch (and it’s not much more than that) is that Mr Johnson is more open than his predecessors to genuinely new thinking. Additionally, of course, his large Parliamentary majority will help very considerably.

So, too, will the fact that his Labour opponents are in such disarray that they might even replace Mr Corbyn with somebody who still thinks that trying to stymy the voters’ decision over leaving the EU was a good idea. Labour, it should be said, has a vital part to play in the political discourse, but cannot do this effectively until it reinstalls issues of economic inequality at the top of its agenda.

Lastly, and notwithstanding the kind (and beyond-my-merits) encouragement of some contributors here, I’m not going to be sending my CV to Downing Street. This, at least, frees me to muse on what I would be saying if I were submitting an application.

First and foremost, I’d urge Mr Cummings to recognize that the economy is an energy system. This will require no explanation to regular visitors here, but I would add that this interpretation can enable us to place our thinking about economics on a scientific footing. The ‘conventional’ form of economics which portrays the economy in purely financial terms may or may not be “gloomy”, but it certainly isn’t a “science”. We’ve spent the best part of two decades finding out that ‘tried and tested’ financial paradigms range from the incomplete to the outright mistaken, and that pulling financial levers doesn’t work.

Mr Cummings won’t need me to tell him that paying people to borrow (as we’ve been doing ever since 2008), whilst penalising savers, is a very bad idea. I’m sure he will appreciate, too, that trying to run a supposedly “capitalist” system without positive returns on capital is a contradiction in terms. Moreover, those of us who believe in the proper working of markets cannot applaud a situation in which asset prices are propped up by intervention. Any country which deliberately supports over-inflated property prices ought to face tough questioning from the younger members of the electorate.

Second, I’d suggest to Mr Cummings that recognition of the energy-determined character of the economy reframes the debate about the environment. I would steer him towards sources which debunk the illogical notion that we can “de-couple” the economy from the use of energy. Economic prosperity, and the broader well-being embodied in environmental and ecological issues, share the common axis of energy.

Getting into the nitty-gritty, and being wholly candid about the situation, I would go on to contend that the energy equation, which hitherto has driven our prosperity upwards, has turned against us. That, after all, is why we’ve been trying one financial gimmick after another in an effort to convince ourselves that “growth” in our prosperity is continuing, when a huge amount of evidence surely demonstrates that it is not.

In the United Kingdom, “growth” (of 26%) between 2003 and 2018 added £430 billion to GDP, but at the cost of £2.16 trillion in net borrowing. You don’t need a degree in advanced mathematics to recognize that borrowing £5 in order to purchase “growth” of £1 isn’t a sustainable plan.

In Britain, as in most other Western countries, a very large part of the “growth” recorded in recent years has been a simple function of spending borrowed money. If we stopped borrowing (leaving debt where it is now), rates of growth would gravitate to somewhere barely above zero. Trying to reduce debt to its level at some earlier time would eliminate a lot of the “growth” recorded in the past into reverse, leaving GDP a lot lower than it is today.

Adding rising ECoEs into the equation, I would seek to demonstrate that the prosperity of the average Western citizen has been deteriorating for more than a decade. Increasing taxation, meanwhile, has been making this worse. Over a fifteen-year period in which the average British person has become £2,570 (10%) less prosperous, his or her burden of tax has increased by £2,240.

Of course, one cannot expect statistical, model-based numbers to make a wholly persuasive case, especially when the techniques involved avowedly ditch conventional notations. But I would urge Mr Cummings to look at a range of other indicators in order to triangulate some conclusions. Such indicators would include homelessness, the relentless rise of consumer credit, the dependency of the economy on credit-funded consumption, the associated symptoms of debt distress, and the millions generally recognized to be “just about managing”. He could reflect, too, on correlations that can be drawn between adverse trends in prosperity and rising public discontent, whether on the streets of Paris or in the voting booths of the United States and much of Europe.

Finally, none of this would be presented as a cause for despair. Accepting that government cannot make people richer doesn’t involve concluding that it cannot make them more contented.

The smart move at this point is to recognize what’s really happening, steal a march on those still in ignorance and denial, and work out how to improve the quality, both of people’s lives and of the society in which they live.

#156. Actual fantasy

OUR URGENT NEED FOR RATIONAL ECONOMICS

Everyone knows the quotation, of course, which says that “when it gets serious, you have to lie”.

Actually, when it gets even more serious, we have to face the facts.

I’m indebted to Dutch rock music genius Arjen Lucassen for the observation that the counterpart to “virtual reality” is actual fantasy – and that’s where the world economy seems to be right now.

You may think it’s imminent, or you might believe that it still lies some distance in the future, but I’m pretty sure you know that we’re heading, inescapably, for “GFC II”, the much larger (and very different) sequel to the 2008 global financial crisis (GFC).

SEEDS 20 – the latest iteration of the Surplus Energy Economics Data System – has a new module which calculates the scale of exposure to “value destruction”. This exposure now stands at $320 trillion, compared with $67tn (at 2018 values) on the eve of GFC I at the end of 2007.

How this number is reached, and what it means, can be discussed later. Additionally, potential for value destruction needn’t mean that this is the quantity of value which actually will be destroyed when a crash happens. Rather, it gives us a starting order-of-magnitude.

For now, though, we can simply note that risk exposure seems now to be at least four times what it was back in 2008. Moreover, interest rates, now at or close to zero, cannot be slashed again, as they were in 2008-09. Neither can governments again put their now-stretched balance sheets behind their banking systems, even if global interconnectedness didn’t render such actions by individual countries largely ineffective.

Finally – in this litany of risk – two further points need to be borne in mind. First, global prosperity is weakening, and has been falling in most Western economies for at least a decade, so any new crash will test an already-weakened economic resilience.

Second, and relatedly, any attempt to repeat the rescues of 2008 would be unlikely to be accepted by a general public which now – and, in general, correctly – characterises those rescues as ‘bail-outs for the wealthy, and austerity for everyone else’.

The high price of ignorance

It’s tempting – looking at a world divided between struggling, often angry majorities, and tiny minorities rich beyond the dreams of avarice – to think the surreal state of the world’s financial system reflects some grand scheme, driven by greed. Alternatively, you might feel that far too many countries are run by people who simply aren’t up to the job.

Ultimately, though – and whilst greed, arrogance, incompetence and ambition have all been present in abundance – the factor driving most of what has gone wrong in recent years has been simple ignorance. For the most part, disastrous decisions have been made in good faith, because thinking has been conditioned by the false paradigm which states that ‘economics is the study of money’, and which adds, to compound folly still further, that energy is ‘just another input’.

I don’t want to labour a point familiar to most regular readers, so let’s wrap up recent history very briefly.

From the late 1990s, as “secular stagnation” kicked in (for reasons which very few actually understood, then or now), the siren voices of conventional economics argued that this could be ‘fixed’ by making it easier for people to borrow than it had ever been before. This created, not just debt escalation, but a lethal proliferation and dispersal of risk, which led directly to 2008.

In response, the same wise people, those whose insights caused the crisis in the first place, now counselled yet more bizarre gimmicks, the worst of which was that we should pay people to borrow, whilst simultaneously destroying the ability to earn returns on capital. Nobody seems to have wondered (still less explained) how we were supposed to operate a capitalist economy without returns on capital – and that, by the way, is why what we have now isn’t remotely a capitalist system based on properly-functioning markets.

When GFC II turns up, it’s as predictable as night following day that the zealots of the ‘economics is money’ fraternity will come up with yet more hare-brained follies. We already know what some of these are likely to be. There are certain to be strident calls for yet more money creation (but this time with a label saying that “it’s not QE – honest”). Some will advocate ‘helicopter money’, perhaps calling it ‘peoples’ QE’. There will be calls for negative nominal interest rates, with the necessary concomitant of the banning of cash. Ideas even more barking mad than these are likely to turn up, too.

Ultimately, what’s likely to happen is that the authorities will respond to GFC II by pouring into the system more additional money than the credibility of fiat currencies can withstand.

We know, of course, that any new gimmicks, just like the old ones, won’t ‘fix’ anything, and can be expected to make a bad situation even worse.

So the question facing everyone now – but especially decision-makers in government, business and finance, and those who influence their decisions – is whether we abandon conventional economics before, or after, the next mad turn of the roulette wheel.

Put another way, should the creators of “deregulation”, QE and ZIRP – and the facilitators of sub-prime and “cash-back” mortgages, collateralised debt obligations and the alphabet soup of “financial weapons of mass destruction” – be allowed to introduce yet more insanity into the system?

Before making this decision, there’s one further point that everyone needs to bear in mind. In 2008, financial gimmickry nearly, but not quite, destroyed the banking system. The only reason why this didn’t happen was that fiat money retained its credibility. But, whilst the follies which preceded the GFC imperilled only the credit (banking) system, those which have followed have put the credibility of money itself at risk.

This is perhaps the most powerful reason of all for not letting the practitioners of ‘conventional’ economics have another swing at the wrecking-ball.

I hope that, reflecting on this, you’ll agree with me that we can no longer afford the folly of financial economics.

Moreover, we need to say so, making fundamental points forcefully, and resisting any temptation to wander off into esoteric by-ways.

A scientific alternative?

If there can be no doubt at all that money-based interpretation of the economy has ended in abject failure, there can be very little doubt that a workable alternative is ready and waiting. That alternative is the recognition that the economy is an energy system.

This idea is by no means a new one and, though I’d prefer not to particularize, it’s been pioneered by some truly brilliant people. If those of us who base our interpretations on the energy-economics paradigm can see a long way into the future, it’s because we’re “standing on the shoulders of giants”.

Moreover, much of the work of the pioneers is rooted in solid science, meaning that, for the first time, there is the prospect of a genuine science of economics, firmly located within the laws of thermodynamics. This has to be a more rational option than continuing to rely on economic ‘laws’ which try to impute immutable patterns to the behaviour of money – something which is, after all, no more, than a human construct.

I like to think that my much more modest role in this direction of travel has been to recognize that, if energy economics is going to transition from the side-lines of the debate to its centre, it needs to tackle conventional economics on its own turf.  That means that, whilst as purists we might prefer to set out our findings in calories, BTUs and joules, we have to talk in dollars, euros and yen if we’re to secure a hearing. It also means that we need models of the economy based firmly on energy principles.

If you’re a regular visitor to this site then the basics of what I call surplus energy economics will be familiar. Even so, and with new visitors in mind, a brief summary of its main principles seems apposite.

Core principles

The first principle of surplus energy economics is that everything that constitutes the economy is a function of energy. Literally nothing – goods, services, infrastructure, travel, information – can be supplied without it. Even in the most basic aspects of our lives, everything that we need – including somewhere to live, food and water – is a product of the application of energy. The more complex a society becomes, the more energy it requires, even if this is sometimes masked when energy-intensive activities are outsourced to other countries. The idea that we can somehow “decouple” economic activity from the use of energy has been debunked comprehensively by the European Environmental Bureau as “a haystack without a needle”.

You need only picture a society even temporarily deprived of energy to see the reality of this. Without energy, food cannot be grown, processed or delivered, water fails when the pumps stop working, our homes and places of work become cold and dark, and schools and hospitals cease to function. Without continuity of energy, machinery falls silent, nothing can move from where it is to where it is needed, individuals lose the mobility that we take for granted, and, in a pretty short time, social order fails and chaos reigns.

Ironically, financial systems are amongst the first to collapse when the energy plug is pulled. People cannot even write learned papers telling us that energy is ‘just another input’ when their computer screens have just gone down.

The second principle of surplus energy economics is that, whenever energy is accessed, some of that energy is always consumed in the access process. Stated at its simplest, you cannot drill an oil or gas well, excavate a mine, or manufacture a wind turbine or a solar panel without using energy. Much of this energy goes into the provision of materials, of which just one example is copper. This is now extracted at ratios as low as one tonne of copper from five hundred tonnes of rock. Supplying copper, then, cannot be done with human or animal labour – and, of course, even if this were possible, the need for nutritional energy would keep the circular, ‘in-out’ energy linkage wholly in place.

Taken together, these principles dictate a division of available energy into two streams or components.

The first is the energy consumed in the access process, known here as the Energy Cost of Energy (ECoE).

The second – constituting all available energy other than ECoE – is known as surplus energy. This powers all economic activity, other than the supply of energy itself.

This makes ECoE an extremely important component, because, the higher ECoE is, the less surplus energy remains for those activities which constitute prosperity.

Four main factors drive trends in ECoEs. Taking oil, gas and coal as examples, these energy sources benefited in their early stages from economies of scale and expanding geographic reach. Latterly, though, with these drivers exhausted – and as a consequence of the natural process of using the most attractive sources first, and leaving costlier alternatives for later – ECoEs have been driven upwards relentlessly by depletion.

A fourth factor, technology, accelerates movement along the early, downwards ECoE trajectory, and then acts to mitigate subsequent increases. Mitigation, though, is all that technology can accomplish, because the scope for technological improvement is bounded by the envelope of the physical properties of the energy resource itself.

Lastly on this, because the four factors driving ECoEs – reach, scale, depletion and technology – all act gradually, ECoEs evolve, and need to be measured as trends.

Application – the money complication

With the basic principles established, and the role of ECoE understood, it might seem that, to arrive at a measure of prosperity, all we need do now is to subtract ECoE from economic activity. That would indeed be the case – if we had a reliable data series for output.

But this is something that we simply don’t possess, least of all in reported GDP. Essentially, GDP has been manipulated for the best part of two decades, and, arguably, for even longer than that.

By manipulation, I’m not referring to tinkering at the production boundary, or understating the deflator necessary for making comparisons over time.

The kind of manipulation I have in mind is the simple matter of pillaging the future to inflate perceptions of the present.

Expressed in PPP-converted dollars at constant 2018 values, reported world GDP increased by 36% between 2000 and 2008, and has grown by a further 34% since then. During those same periods, though, world debt increased by, respectively, 50% and 58%. Each $1 of incremental GDP between 2000 and 2008 was accompanied by $2.30 of net new borrowing, a number that has increased to more than $3 in the decade since then. Sustaining annual “growth” of about 3.5% in recent years has required annual borrowing of about 9% of GDP.

In short, GDP and growth have been faked by the simple spending of borrowed money. This exercise in cannibalising the future to sustain the present would look even more extreme were we to include in the equation the creation of huge holes in pension provision.

In this context, we need to answer two questions before we can calculate a useful output metric against which ECoE can be applied.

First, what would happen now, if we stopped piling on yet more debt?

Second, where would GDP be today if we hadn’t embarked on a massive borrowing spree?

You’ll understand, I’m sure – with government, business and finance still hamstrung by the failed economic methodologies of the past – why I won’t go into details here about the SEEDS algorithms which provide answers to these questions.

What I can say, though, is that, in the absence of further net borrowing, growth in world GDP would fall from a reported level of around 3.5%, to about 1.2% now, decreasing to just 0.6% by 2030.

On the second question, setting growth since 2000 of $61tn against borrowing of $167tn over the same period puts in context quite how far reported GDP has been inflated by the spending of borrowed money – and, if this borrowing binge hadn’t happened, GDP now would be 30% below the numbers actually recorded. Instead of “GDP of $135tn PPP, growing at 3.5% annually”, we’d have “GDP of $94tn, growing at barely 1%”.

Prosperity – the ECoE connection

When we set growth in real, “clean” GDP (C-GDP) of 31% since 2000 against a global trend ECoE that has risen from 4.1% to 7.9% over the same period – and stir a 23% increase in population numbers into the pot as well – you’ll readily understand why people have started to become poorer.

This is set out in fig. 1. In the left-hand chart, the gap between reported GDP (in blue) and C-GDP (black) represents the compound rate of divergence in a period when debt of $167tn has been injected into the system, together with large amounts of ultra-cheap liquidity.

If we were now to unwind these injections, GDP would fall to (or below) the black C-GDP line, over whatever period of time the debt reduction was spread. The gap between C-GDP (black) and prosperity (red) shows the impact of rising ECoEs, and illustrates how the worsening ECoE trend is set to turn low (and faltering) growth in C-GDP into a deteriorating prosperity trend.

The middle chart adds debt, to set these trends in context. In the right-hand chart, per capita equivalents illustrate how the average person has been getting poorer, albeit – so far – pretty gradually.

Fig. 1

Comparing 2000 with 2018 (in constant PPP dollars), a rise of 31% in C-GDP has been offset by an ECoE deduction that has soared from $2.7tn to $7.4tn. Aggregate prosperity has thus increased from $69tn ($71.9tn minus ECoE of $2.7tn) in 2000 to $86tn ($93.5tn minus $7.4tn) last year.

This is a rise of 26%, only slightly greater than the increase (of 23%) in world population numbers between those years. In fact, SEEDS indicates that global prosperity per capita peaked in 2007, at $11,720, and had fallen to $11,570 by last year.

On the cusp of degrowth

This, to be sure, has been a very small decrease, essentially meaning that per capita prosperity has plateaued for slightly more than a decade. Before drawing any comfort at all from this observation, though, the following points need to be noted.

First, the post-2007 plateau contrasts starkly with historic improvements in prosperity. The robust growth of the first two decades after 1945, for instance, coincided with a continuing downwards trend in overall ECoE, as the ECoEs of oil, gas and coal moved towards the lowest points on their respective parabolas.

Second, the deterioration in prosperity, though gradual, has taken place at the same time that debt has escalated. Back in 2007, and expressed at 2018 values, the prosperity of the average person was $11,720, and his or her debt was $27,000. Now, though prosperity is only $140 lower now than it was then, debt has soared to $39,000.

Third, these are aggregated numbers, combining Western economies – where prosperity has been falling over an extended period – with emerging market (EM) countries, where prosperity continues to improve. Once EM economies, too, pass the climacteric into deteriorating prosperity – and that is about to start happening – the global average will fall far more rapidly than the gradual erosion of recent years.

Fourth, as these trends unfold we can expect the rate of deterioration to accelerate, not least because our economic system is predicated on perpetual expansion, and is ill-suited to managing degrowth. In a degrowth phase, in which utilization rates slump and trade volumes fall, increasing numbers of activity-types will cease to be viable (a process that has already commenced). Additionally, of course, we ought to expect the process of degrowth to damage the financial system and this, amongst other adverse effects, will put the “wealth effect” – such as it is – into reverse.

The differences between Western and EM economies is illustrated in fig. 2, which compares the United States with China. On both charts, prosperity per person is shown in blue, and ECoE in red.

In America, prosperity turned down from 2005, when ECoE was 5.6%. In China, on the other hand, SEEDS projects a peaking of prosperity in 2021, by which time ECoE is expected to have reached 8.8%. The reason for this difference is that complex Western economies have far less ECoE-tolerance than less sophisticated EM countries.

As a rule of thumb, prosperity turns downwards in advanced economies at ECoEs of between 3.5% and 5.5%, with the United States far more resilient than weaker Western countries, most notably in Europe. The equivalent band for EM countries seems to lie between 8% and 10%, a threshold that most of these countries are set to cross within the next five or so years.

Where China is concerned, it’s noteworthy that, with ECoE now hitting 8%, there are very evident signs of economic deterioration, including debt dependency, increasing liquidity injections, and falling demand for everything from cars and smartphones to chips and components.

Fig. 2

The energy implications

In conjunction with the SEEDS 20 iteration, the system has adopted a new energy scenario which differs significantly from those set out by institutions such as the U.S. Energy Information Administration and the International Energy Agency.

Essentially, SEEDS broadly agrees with EIA and IEA projections showing increases, between now and 2040, of about 38% for nuclear and 58% for renewables, with the latter defined to include hydroelectricity.

Where SEEDS differs from these institutions is over the outlook for fossil fuels. Using the median expectations of the EIA and the IEA, oil consumption is set to be 11% higher in 2040 than it is now, gas consumption is projected to grow by 32%, and the use of coal is expected to be little changed.

Given the strongly upwards trajectories of the ECoEs of these energy sources, it’s becoming ever harder to see where such increases in supply are supposed to come from. With the US shale liquids sector an established cash-burner, and with most non-OPEC countries now at or beyond their production peaks, it may well be that far too much is being expected of Russia and the Middle East. The oil industry may, in the past, have ‘cried wolf’ over the kind of prices required to finance replacement capacity, but we cannot assume that this is still the case.

The implication for fossil fuels isn’t, necessarily, that worsening scarcity will cause prices to soar but, rather, that it will become increasingly difficult to set prices that are at once both high enough for producers (whose costs are rising) and low enough for consumers (whose prosperity is deteriorating). It’s becoming an increasingly plausible scenario that the supply of oil, gas and coal may cease to be activities suited to for-profit private operators, and that some form of direct subsidy may become inescapable.

Conclusions

It is to be hoped that this discussion has persuaded you of two things – the abject failure of ‘conventional’, money-based economics, and the imperative need to adopt interpretations based on a recognition of the (surely obvious) fact that the economy is an energy system.

Until and unless this happens, we’re going to carry on telling ourselves pretty lies about prosperity, and acting in ways characterised by an increasingly desperate impulse towards denial. Many governments are already taxing their citizens to an extent that, whilst it might seem reasonable in the context of overstated GDP, causes real hardship and discontent when set against the steady deterioration of prosperity.

Meanwhile, risk, as measured financially, keeps rising, and the cumulative gap between assumed GDP and underlying prosperity has reached epic proportions. Expressed in market (rather than PPP) dollars, scope for value destruction has now reached $320tn.

Only part of this is likely to take the form of debt defaults, though these could take on a compounding, domino-like progression. Just as seriously, asset valuations look set to tumble, when we are forced to realise that unleashing tides of cheap debt and cheaper money provides no genuine “fix” to an economy in degrowth, but serves only to compound the illusions on which economic assumptions and decisions are based.

 

#154. An autumn nexus

A CONVERGENCE OF STRESS-LINES

If you’ve been following our discussions here for any length of time, you’ll know that the main focus now is on the need for energy transition. This is a challenge made imperative, not just by environmental considerations but, just as compellingly, by the grim outlook for an economy which continues to rely on energy sources – oil, gas and coal – whose own economics are deteriorating rapidly.

These, of course, are long-term themes (though that’s no excuse for the gulf between official and corporate rhetoric and delivery). But the short term matters, too, and an increasing number of market participants and observers have started to notice that a series of significant stress-lines are converging on the months of September and October, much as railway lines converge on Charing Cross station.

The context, as it’s understood from an energy economics perspective, is that a fracture in the financial system is inevitable (though ‘inevitable’ isn’t the same thing as ‘imminent’). Properly understood, money has no intrinsic worth, but commands value only as a claim on the output of the ‘real’ economy of goods and services. Whilst the mountain of monetary claims keeps getting bigger, the real economy itself is being undermined by adverse energy economics.

Ultimately, financial crises happen as correctives, when the gap between the financial and the ‘real’ economies becomes excessive.

This is what happened with the 2008 global financial crisis (GFC), which followed a lengthy period of what I call “credit adventurism”. A sequel to 2008, known here as “GFC II”, is the seemingly inevitable consequence of the “monetary adventurism” adopted during and after 2008. This, incidentally, is where the parallels end because, whilst credit adventurism put the banking system in the eye of the storm in 2008, the subsequent adoption of monetary recklessness implies that GFC II will be a currency event.   .

An understanding of the inevitability of GFC II doesn’t tell us when it’s likely to happen. All that I’ve ventured on this so far is that a ‘window of risk’ has been open since the third quarter of 2018. Whether that window has yet opened wide enough to admit GFC II is a moot point. But the converging stresses are certainly worthy of consideration.

Chinese burns

Three of the most important lines of stress originate in China.

As we’ve seen – and with the country’s Energy Cost of Energy (ECoE) now in the climacteric range at which prosperity growth goes into reverse – there’s no doubt at all that the Chinese economy is in trouble. After all (and expressed at constant 2018 values), China has added debt of RMB 170 trillion (+288%) over a period in which reported GDP has expanded by RMB 47 tn (+114%), and no such pattern can be sustained in perpetuity.

This is complicated by Sino-American trade tensions, and, given the huge divergence between Chinese and American priorities, there seems little prospect that these can be resolved in any meaningful way.

The third and newest component of the Chinese risk cocktail is unrest in Hong Kong. Few think it likely that Beijing would be reckless enough to make a forceful intervention there, but it’s a risk whose relatively low probability is offset by the extremity of consequences if it were to happen.

In this context, it’s interesting to note that markets initially responded euphorically to Mr Trump’s delaying of new sanctions, seemingly interpreting it as some kind of ‘wobble’ on his part. It looks a lot more like a Hong Kong-related cautionary signal, seasoned with a twist of gamesmanship and soupçon of characteristic showmanship.

Whilst I’m not one of Mr Trump’s critics, it does seem undeniable that he makes too much of the (actually very tenuous) relationship between economic performance and the level of the stock market. This adds his voice to the chorus of those advocating ever cheaper money.

When the next crash does, come, of course, this chorus will rise to a crescendo, but central bankers will in any case have started pouring ever larger amounts of liquidity into the system in an effort to prop up tumbling asset prices. This, in turn, is likely to lead to a flight to perceived safe havens, one of which is likely to be the dollar, whilst other currencies come under the cosh.

But this is to look too far ahead.

“Brexit” blues

The focus in Europe, of course, is on “Brexit”. I’m neither an admirer nor a critic of Boris Johnson, any more than I’m a supporter or an opponent of “Brexit” itself (a subject on which I’ve been, and remain, studiously neutral).

This said, Mr Johnson is surely right to assert that you’ll never get anything out of negotiations if you start off by committing yourself to accept whatever the other side deigns to offer. This does indeed look like brinkmanship on his part, but it’s remarkable how often negotiations, be they political or commercial, do go “right down to the wire”, being settled only when time presses hard enough on the parties involved.

I’ve said before that the EU negotiators worry me more than their British counterparts in this process. The British side has, of course, mishandled the “Brexit” situation, but this can have come as no great surprise to anyone familiar with Britain’s idiosyncratic processes of government.

Unfortunately, British floundering has been compounded by remarkable intransigence on the EU side of the table. The attitude of the Brussels apparatchiks, all along, has been ‘take it or leave it’, and this seems to have been based on two false premises.

The first is that the British have to be ‘punished’ to deter other countries from following a similar road. This is a false position, because influencing how French, Spanish, Italian and other citizens cast their votes in domestic elections is wholly outside Brussels’ competence.

In any case, ‘punishment’ should not be part of the lexicon of any adult participant in statesmanship.

The second false premise is that Britain attends the negotiating table as a supplicant, because a chaotic “Brexit” will inflict far more economic harm on the United Kingdom than on the other EU member countries.

My model suggests that this is simply not true. The country at single greatest risk is Ireland, whose economy is far weaker than its “leprechaun economics” numbers suggest, and whose exposure, both to debt and to the financial system, is as worrying as it is extraordinary.

Ireland is followed, probably in this order, by France, the Netherlands, Italy and Germany. The French economy looks moribund, despite its relentlessly-increasing debt, and the prosperity of the average French person has been subjected to a gradual but prolonged deterioration, a process so aggravated by rising taxes that it has led to popular unrest.

Though its economy is stronger, the Netherlands is exposed, by the sheer scale of its financial sector, to anything which puts the global financial system at risk.

Germany, whose own economy is stuttering, must be wondering how quite much of the burden of cost in the wider Euro Area it might be asked to bear.

Moreover, the European Central Bank’s actions endorse the perception that the EA economy is performing poorly. The ECB has made it clear that there is no foreseeable prospect of the EA being weened off its diet of ultra-cheap liquidity.

This makes it all the more remarkable (in a macabre sort of way) that none of the governments of the most at-risk EA countries have sought to demand some pragmatism from Brussels. What we cannot know – though it remains a possibility – is whether the ever-nearer approach of ‘B-Day’ will energise at least, say, Dublin or Paris into action.

Madness, money and moods

Long before the markets took fright at the inversion of the US yield curve, the financial system (in its broadest sense) has looked bizarre.

In America, the corporate sector is engaged in the wholesale replacement of flexible equity with inflexible debt, whilst investors queue up to support “cash burners”, and buy into the IPOs of deeply loss-making debutants. The BoJ (the Japanese central bank) now owns more than half of all Japanese Government Bonds (JGBs) in issue, acquired with money newly created for the purpose.

Around the world, more than $15 trillion of bonds trade at negative yields, meaning that investors are paying borrowers for the privilege of lending them money. The only logic for holding instruments this over-priced is the “greater fool” theory. This states that you can profit from buying over-priced assets by selling them on to someone even more optimistic than yourself. There’s something deeply irrational about anything whose logic is founded in folly.

The same ultra-low interest rates that have prompted escalating borrowing have blown huge holes in pension provision – and have left us in a sort of Through the Looking Glass world in which we’re trying to operate a ‘capitalist’ system without returns on capital.

Until now, markets seem to have been insouciant about the bizarre characteristics of the system, for two main reasons.

First, they seem to assume that, whatever goes wrong, central banks will come to the rescue with a monetary lifeboat. To mix metaphors, this attitude portrays the system as some kind of kiddies-fiction casino, in which winners pocket their gains, but losers are reimbursed at the door.

If, as seems increasingly likely, we’ve started a ‘race to the bottom’ in currencies, this should act as a reminder that the value of any fiat currency depends, ultimately, entirely on confidence – and central bankers, at least, ought to understand that excessive issuance can be corrosive of trust.

The markets’ second mistake is a failure to recognize the concept of “credit exhaustion”. The assumption seems to be that, just so long as debt is cheap enough, people will load up on it ad infinitum. What’s likelier to happen – and may, indeed, have started happening now – is that borrowers become frightened about how much debt they already have, and refuse to take on any more, irrespective of how cheap it may have become.

A measured way of stating the case is that, as we look ahead to autumn, we can identify an undeniable convergence of stress-lines towards a period of greatly heightened risk.

This perception is compounded by a pervading mood of complacency founded on the excessive reliance placed on the seaworthiness of the monetary lifeboat.

I’m certainly not going to predict that a dramatic fracture is going to occur within the next two or three months at the nexus of these stress lines. We simply don’t know. But it does seem a good time for tempering optimism with caution.

 

#150: The management of hardship

GOVERNMENT AND POLITICS IN AN AGE OF DETERIORATING PROSPERITY

Though just over a month has passed since the previous article (for which apologies), work here hasn’t slackened. Rather, I’ve been concentrating on three issues, all of them important, and all of them topics where a recognition of the energy basis of the economy can supply unique insights.

The first of these is the insanity which says that no amount of financial recklessness is ever going to drive us over a cliff, because creating new money out of thin air is our “get out of gaol free card” in all circumstances.

This isn’t the place for the lengthy explanation of why this won’t work, but the short version is that we’re now trying to do for money what we so nearly did to the banks in 2008.

The second subject is the very real threat posed by environmental degradation, where politicians are busy assuring the public that the problem can be fixed without subjecting voters to any meaningful inconvenience – and, after all, anyone who can persuade the public that electric vehicles are “zero emissions” could probably sell sand to the Saudis.

And this takes us to the third issue, the tragicomedy that it is contemporary politics – indeed, it might reasonably be said that, between them, the Élysée and Westminster, in particular, offer combinations of tragedy, comedy and farce that even the most daring of theatre directors would blush to present.

From a surplus energy perspective, the political situation is simply stated.

SEEDS analysis of prosperity reveals that the average person in almost every Western country has been getting poorer for at least a decade.

Governments, which continue to adhere to outdated paradigms based on a purely financial interpretation of the economy, remain blind to the voters’ plight – and, all too often, this blindness looks a lot like indifference. Much of the tragedy of politics, and much of its comedy, too, can be traced to this fundamental contradiction between what policymakers think is happening, and what the public knows actually is.

Nowhere is the gap in comprehension, and the consequent gulf between governing and governed, more extreme than in France – so that’s as good a place as any to begin our analysis.

The French dis-connection

Let’s start with the numbers, all of which are stated in euros at constant 2018 values, with the most important figures set out in the table below.

Between 2008 and 2018, French GDP increased by 9.4%, equivalent to an improvement of 5.0% at the per capita level, after adjustment for a 4.2% rise in population numbers. This probably leads the authorities to believe that the average person has been getting at least gradually better off so, on material grounds at least, he or she hasn’t got too much to grumble about.

Here’s how different these numbers look when examined using SEEDS. For starters, growth of 9.4% since 2008 has increased recorded GDP by €201bn, but this has been accompanied by a huge €2 trillion (40%) rise in debt over the same decade. Put another way, each €1 of “growth” has come at a cost of €9.90 in net new debt, which is a ruinously unsustainable ratio. SEEDS analysis indicates that most of that “growth” – in fact, more than 90% of it – has been nothing more substantial than the simple spending of borrowed money.

This is important, for at least three main reasons.

First, and most obviously, a reported increase of €1,720 in GDP per capita has been accompanied by a rise of almost €27,500 in each person’s share of aggregate household, business and government debt.

Second, if France ever stopped adding to its stock of debt, underlying growth would fall, SEEDS calculates, to barely 0.2%, a rate which is lower than the pace at which population numbers are growing (about 0.5% annually).

Third, much of the “growth” recorded in recent years would unwind if France ever tried to deleverage its balance sheet.

Then there’s the trend energy cost of energy (ECoE), a critical component of economic performance, and which, in France, has risen from 5.9% in 2008 to 8.0% last year. Adjustment for ECoE reduces prosperity per person in 2018 to €27,200, a far cry from reported per capita GDP of €36,290. Moreover, personal prosperity is lower now than it was back in 2008 (€28,710 per capita).

Thus far, these numbers are not markedly out of line with the rate at which prosperity has been falling in comparable economies over the same period. The particular twist, where France is concerned, is that taxation per person has increased, by €2,140 (12%) since 2008. This has had the effect of leveraging a 5.3% (€1,510) decline in overall personal prosperity into a slump of 32% (€3,650) at the level of discretionary, ‘left in your pocket’ prosperity.

At this level of measurement, the average French person’s discretionary prosperity is now only €7,760, compared with €11,410 ten years ago.

And that hurts.

Justified anger

Knowing this, one can hardly be surprised that French voters rejected all established parties at the last presidential election, flirting with the nationalist right and the far left before opting for Mr Macron. Neither can it be any surprise at all that between 72% and 80% of French citizens support he aims of the gilets jaunes (yellow waistcoat) protestors. “Robust” law enforcement, whilst it might just temper the manifestation of this discontent, will have the almost inevitable side-effect of exacerbating the mistrust of the incumbent government.

Because energy-based analysis gives us insights not available to the authorities, we’re in a position to understand the sheer folly of some French government policies, both before and since the start of the protests.

From the outset, there were reasons to suspect that the gloss of Mr Macron’s campaign hid a deep commitment to failed economic nostrums. These nostrums include the bizarre belief that an economy can be energized by undermining the rights and rewards of working people – the snag being, of course, that the circumstances of these same workers determine demand in the economy.

After all, if low wages were a recipe for prosperity, Ghana would be richer than Germany, and Swaziland more prosperous than Switzerland.

Handing out huge tax cuts to a tiny minority of the already very wealthiest, though always likely to be at the forefront of Mr Macron’s agenda, looks idiotically provocative when seen in the context of deteriorating average prosperity. Creating a national dialogue over the protestors’ grievances might have made sense, but choosing a political insider to preside over it, at a reported monthly salary of €14,666, reinforced a widespread suspicion that the Grand Debat is no more than an exercise in distraction undertaken by an administration wholly out of touch with voters’ circumstances.

Whilst Mr Macron has appeared flexible over some fiscal demands, he has ruled out increasing the tax levied on the wealthiest. This intransigence is likely to prove the single biggest blunder of his presidency.

Even the tragic fire at Notre Dame has been mishandled by the government, in ways seemingly calculated to intensify suspicion. Rather than insisting that the restoration of the state-owned Cathedral would be funded by the government, the authorities made the gaffe of welcoming offers of financial support from some of the most conspicuously wealthy people in France.

This prompted some to wonder when corporate logos would start to appear on the famous towers, and others to ask why, if the wealthiest wanted to make a contribution, they couldn’t have been asked to do so by paying more tax. It didn’t help that the authorities rushed to declare the fire an accident, long before the experts could possibly have had evidence sufficient to rule out more malign explanations. After all, in an atmosphere of mistrust, conspiracy theories thrive.

The broader picture

The reason for looking at the French predicament in some detail is that the problems facing the authorities in Paris are different only in degree, and not in direction or nature, from those confronting other Western governments.

The British political impasse over “Brexit”, for instance, can be traced to the same lack of awareness of what is really happening to the prosperity of the voters – whilst “Brexit” itself divides the electorate, there is something far closer to unanimity over a narrative that politicians are as ineffectual as they are self-serving, and are out of touch with real public concerns. Similar factors inform popular discontent in many other European countries, even when this discontent is articulated over issues other than the deterioration in prosperity.

At the most fundamental level, the problem has two components.

The first is that the average person is getting poorer, and is also getting less secure, and deeper into debt.

The second is that governments don’t understand this issue, an incomprehension which, to increasing numbers of voters, looks like indifference.

It has to be said that governments have no excuses for this lack of understanding. The prosperity of the average person in most Western countries began to fall more than a decade ago, and any politician even reasonably conversant with the circumstances and opinions of the typical voter ought to be aware of it, even if he or she lacks the interpretation or the information required to explain it.

Governments whose economic advisers and macroeconomic models are still failing to identify the slump in prosperity need new advisers, and new models.

A disastrous consensus

Though incomprehension (and adherence to failed economic interpretations) is the kernel of the problem, it has been compounded by the mix of philosophies adopted since the 1990s. Following the collapse of the Soviet Union, an informal consensus was created in which the Left accepted the market economics paradigm, and the centre-Right tried to be ‘progressive’ on social issues.

Both moves robbed voters of choices.

Though the social policy dimension lies outside our focus on the economy, the creation of a pro-market ‘centre-Left’ has turned out to have been nothing less than a disaster. Specifically, it has had two, woefully adverse consequences.

The first was that the Left’s adoption of its opponents’ economic orthodoxy destroyed the balance of opposing philosophies which, hitherto, had kept in place the ‘mixed economy’, a model which aims to combine the best of the private and the public sector provision. The emergence of Britain’s “New Labour”, and its overseas equivalents, eliminated the checks and balances which, historically, had acted to rein in extremes.

Put another way, the traditional ‘Left versus Right’ debate created constructive tensions which forced both sides to hone their messages, as well as preventing a lurch into extremism which, whilst it might sometimes be good politics, is invariably very bad economics.

The second, of course, was that the new centre-ground – variously dubbed the “Washington consensus”, the “Anglo-American model” and “neoliberalism” – has proved to be an utterly disastrous exercise in economic extremism. One after another, its tenets have failed, creating massive indebtedness, huge financial risk and widening inequality before finally presiding over the wholesale replacement of market principles with the “caveat emptor” free-for-all of what I’ve labelled “junglenomics”.

As well as undermining economic efficiency, these developments have created extremely harmful divisions in society. Whilst Thomas Piketty’s thesis about the divergence of returns on capital and labour is not persuasive, the reality since 2008 has been that asset prices have soared, whilst incomes have stagnated. This process, which has been the direct result of monetary policy, has rewarded those who already owned assets in 2008, and has done nothing for the less fortunate majority.

There is a valid argument, of course, which states that the authorities’ adoption of ultra-cheap money during and after the 2008 global financial crisis (GFC I) was the only course of action available.

But the role of policymakers is to pursue the overall good within whatever the economic and financial context happens to be. So, when central bankers launched programmes clearly destined to create massive inflation in asset prices, governments should have responded with fiscal measures tailored to capture at least some of these gains for the unfavoured majority.

Simply put, the unleashing of ZIRP and QE made a compelling case for the simultaneous introduction of higher taxes on capital gains, complemented by wealth taxes in those countries where these did not already exist.

Failure to do this has hardened incompatible positions. Those whose property values have soared insist, often with absolute sincerity, that their paper enrichment is the product entirely of their own diligence and effort, owes nothing to the luck of being in the right place at the right time, has had nothing whatever to do with the price inflation injected into property markets (in particular) by ultra-cheap monetary policies, and hasn’t happened at the expense of others.

For any younger person, often unable to afford or even find somewhere to live, it is necessarily infuriating to be lectured by fortunate elders on the virtues of saving and hard work.

It’s a bit like a lottery winner criticizing you for buying the wrong ticket.

A workable future

The silver lining to these various clouds is that future policy directions have been simplified, with the paramount objectives being (a) the healing of divisions, and (b) managing the deterioration in prosperity in ways that maximise efficiency and minimise division.

Any government which understands what prosperity is and where it is going will also reach some obvious but important conclusions.

The first is that prosperity issues have risen higher on the political agenda, and will go on doing so, pushing other issues down the scale of importance.

The second conclusion, which carries with it what is probably the single most obvious policy implication, is that redistribution is becoming an ever more important issue. There are two very good reasons for this hardening in sentiment.

For starters, popular tolerance of inequality is linked to trends in prosperity – resentment at “the rich” is muted when most people are themselves getting better off, but this tolerance very soon evaporates when subjected to the solvent of generalised hardship.

Additionally, the popular narrative of the years since 2008 portrays “austerity” as the price paid by the many for the rescue of the few. The main reason why this narrative is so compelling is that, fundamentally, it is true.

The need for redistribution is reinforced by realistic appraisal of the fiscal outlook. Anyone who is aware of deteriorating prosperity has to be aware that this has adverse implications for forward revenues. By definition, only prosperity can be taxed, because taxing incomes below the level of prosperity simply drives people into hardships whose alleviation increases public expenditures.

In France, for example, aggregate national prosperity is no higher now (at €1.76tn) than it was in 2008, but taxation has increased by 17% over that decade. Looking ahead, the continuing erosion of prosperity implies that rates of taxation on the average person will need to fall, unless the authorities wish further to tighten the pressure on the typical taxpayer.

Even the inescapable increase in the taxation of the very wealthiest isn’t going to change a scenario that dictates lower taxes, and correspondingly lower public expenditures, as prosperity erodes.

A new centre of gravity?

The adverse outlook for government revenues is one reason why the political Left cannot expect power to fall into its hands simply as a natural consequence of the crumbling of failed centre-Right incumbencies. Those on the Left keen to refresh their appeal by cleansing their parties of the residues of past compromises have logic on their side, but will depart from logic if they offer agendas based on ever higher levels of public expenditures.

With prosperity – and, with it, the tax base – shrinking, promising anything that looks like “tax and spend” has become a recipe for policy failure and voter disillusionment. This said, so profound has been the failure of the centre-Right ascendancy that opportunities necessarily exist for anyone on the Left who is able to recast his or her agenda on the basis of economic reality.

Tactically, the best way forward for the Left is to shift the debate on equality back to the material, restoring the primacy of the Left’s traditional concentration on the differences and inequities between rich and poor.

On economic as well as fiscal and social issues, we ought to see the start of a “research arms race”, as parties compete to be the first to absorb, and profit from, the recognition of economic realities that are no longer (if they ever truly were) identified by outdated methods of economic interpretation.

Historically, the promotion of ideological extremes has always been a costly luxury, so is likely to fall victim to processes that are making luxuries progressively less affordable. Voters can be expected to turn away from the extremes of pro- public- or private-sector promotion, seeing neither as a solution to their problems.

This, it is to be hoped, can lead to a renaissance in the idea of the mixed economy, which seeks to get the best out of private and public provision, without pandering to the excesses of either. Restoration of this balance, from the position where we are now, means rolling back much of the privatization and outsourcing undertaken, often recklessly, over the last three decades.

Both the private and the public sectors will need to undergo extensive reforms if governments are to craft effective agendas for using the mixed economy to mitigate the worst effects of deteriorating prosperity.

In the private sector, governments could do a lot worse than study Adam Smith, paying particular attention to the explicit priority placed by him on promoting competition and tackling excessive market concentration, and recognizing, too, the importance both of ethics and of effective regulation, both of which are implicit in his recognition that markets will not stay free or fair if left to their own devices.

For the public sector, both generally and at the level of detail, there will need to be a renewed emphasis on the setting of priorities. With resource limitations set not just to continue but to intensify, health systems, for example, will need to become a lot clearer on which services they can, and cannot, afford to fund.

Starting from here

Though this discussion can be no more than a primer for discussion, there are two points on which we can usefully conclude.

First, a useful opening step in the crafting of new politics would be the introduction of “clean hands” principles, designed to prove that government isn’t, as it can so often appear, something conducted “by the rich, for the rich”.

Second, it would be helpful if governments rolled back their inclinations towards macho posturing and intimidation.

A “clean hands” initiative wouldn’t mean that elected representatives would be paid less than currently they are. There is an essential public interest in attracting able and ambitious people into government service, so there’s nothing to be said for hair-shirt commitments to penury. In most European countries, politicians are not overpaid, and it’s arguable that their salaries ought, in some cases at least, to be higher.

There is, though, a real problem, albeit one that is easily remedied. This problem lies in the perception that politics has become a “road to riches”, with policymakers retiring into the wealth bestowed on them by the corporate sponsors of ‘consultancies’ and “the lecture circuit”. This necessarily creates suspicion that rewards are being conferred for services rendered, a suspicion that is corrosive of public trust, even where it isn’t actually true.

The easy fix for this is to cap the earnings of former ministers and administrators at levels which are generous, but are well short of riches. The formula suggested here in a previous discussion would impose an annual income limit at 10x GDP per capita, which is about £315,000 in Britain, with not-dissimilar figures applying in other countries. It seems reasonable to conclude that anyone who thinks that £300,000, or its equivalent, “isn’t enough” is likely to have gone into politics for the wrong reasons.

Where treatment of the “ordinary” person is concerned, there ought, in the future, be no room for the intimidatory practices which have become ever more popular with governments whose real authority has been weakened by failure.

One illustrative example is the system by which council tax (local taxation) arrears are collected in Britain. At present, the typical homeowner pays £1,671 annually, in ten monthly instalments. If someone misses a payment, however, he or she is then required to pay the entire annual amount almost immediately, compounded by court costs of £84 and bailiff fees of £310. Quite apart from the inappropriateness of involving the courts or employing bailiffs, it’s hard to see how somebody struggling to pay £167 is supposed to find £2,067.

This same kind of intimidation occurs when people are penalized for staying a few minutes over a parking permit, or for exceeding a speed limit by a fractional extent. Here, part of the problem arises from providing financial incentives to those enforcing regulations, a practice that should be abandoned by any government aware of the need to start narrowing the chasm between governing and governed.

We cannot escape the conclusion that the task of government, always a thankless one even when confined to sharing out the benefits of growth, is going to become very difficult indeed as prosperity continues to deteriorate.

There might, though, be positives to be found in a process which ditches ideological extremes, uses the mixed economy as the basis for the equitable mitigation of decline, and seeks to rebuild relationships between discredited governments and frustrated citizens.

#148: Where now for energy?

WHY SUBSIDY HAS BECOME INESCAPABLE

What happens when energy prices are at once too high for consumers to afford, but too low for suppliers to earn a return on capital?

That’s the situation now with petroleum, but it’s likely to apply across the gamut of energy supply as economic trends unfold. On the one hand, prosperity has turned down, undermining what consumers can afford to spend on energy. On the other, the real cost of energy – the trend energy cost of energy (ECoE) – continues to rise.

In any other industry, these conditions would point to contraction – the amount sold would fall. But the supply of energy isn’t ‘any other industry’, any more than it’s ‘just another input’. Energy is the basis of all economic activity – if the supply of energy ceases, economic activity grinds to a halt. (If you take a moment to think through what would happen if all energy supply to an economy were cut off, you’ll see why this is).

Without continuity of energy, literally everything stops. But that’s exactly what would happen if the energy industries were left to the mercies of rising supply costs and dwindling customer resources.

This leads us to a finding which is as stark as it is (at first sight) surprising – we’re going to have to subsidise the supply of energy.

Critical pre-conditions

Apart from the complete inability of the economy to function without energy, two other, critical considerations point emphatically in this direction.

The first is the vast leverage contained in the energy equation. The value of a unit of energy is hugely greater than the price which consumers pay (or ever could pay) to buy it. There is an overriding collective interest in continuing the supply of energy, even if this cannot be done at levels of purchaser prices which make commercial sense for suppliers.

The second is that we already live in an age of subsidy. Ever since we decided, in 2008, to save reckless borrowers and reckless lenders from the devastating consequences of their folly, we’ve turned subsidy from anomaly into normality.

The subsidy in question isn’t a hand-out from taxpayers. Rather, supplying money at negative real cost subsidizes borrowers, subsidizes lenders and supports asset prices at levels which bear no resemblance to what ‘reality’ would be under normal, cost-positive monetary conditions.

In the future, the authorities are going to have to do for energy suppliers what they already do for borrowers and lenders – use ‘cheap money’ to sustain an activity which is vital, but which market forces alone cannot support.

How they’ll do this is something considered later in this discussion.

If, by the way, you think that the concept of subsidizing energy supply threatens the viability of fiat currencies, you’re right. The only defence for the idea of providing monetary policy support for the supply of energy is that the alternative of not doing so is even worse.

Starting from basics  

To understand what follows, you need to know that the economy is an energy system (and not a financial one), with money acting simply as a claim on output made possible only by the availability of energy. This observation isn’t exactly rocket-science, because it is surely obvious that money has no intrinsic worth, but commands value only in terms of the things for which it can exchanged.

To be slightly more specific, all economic output (other than the supply of energy itself) is the product of surplus energy – whenever energy is accessed, some energy is always consumed in the access process, and surplus energy is what remains after the energy cost of energy (ECoE) has been deducted from the total (or ‘gross’) amount that is accessed.

From this perspective, the distinguishing feature of the world economy over the last two decades has been the relentless rise in ECoE. This process necessarily undermines prosperity, because it erodes the available quantity of surplus energy. We’re already seeing this happen – Western prosperity growth has gone into reverse, and growth in emerging market (EM) economies is petering out. Global average prosperity has already turned down.

From this simple insight, much else follows – for instance, our recent, current and impending financial problems are caused by a collision between (a) a financial system wholly predicated on perpetual growth in prosperity, and (b) an energy dynamic that has already started putting prosperity growth into reverse. Likewise, political changes are likely to result from the failure of incumbent governments to understand the worsening circumstances of the governed.

Essential premises – leverage and subsidy

Before we start, there are two additional things that you need to appreciate.

The first is that the energy-economics equation is hugely leveraged. This means that the value of energy to the economy is vastly greater than the prices paid (or even conceivably paid) for it by immediate consumers. Having (say) fuel to put in his or her car is a tiny fraction of the value that a person derives from energy – it supplies literally all economic goods and services that he or she uses.

The second is that, ever since the 2008 global financial crisis (GFC I) we have been living in a post-market economy.

In practice, this means that subsidies have become a permanent feature of the economic landscape.

These issues are of fundamental importance, so much so that a brief explanation is necessary.

First, leverage. The energy content of a barrel of crude oil is 5,722,000 BTU, which converts to 1,677kwh, or 1,677,022 watt-hours. BTUs and watt-hours are ‘measures of work’ applicable to any source or use of energy. Human labour equates to about 75 watts per hour, so a barrel of crude equates to 22,360 hours of labour. At the (pretty low) rate of $10 per hour, this labour would cost an employer $223,603. Yet crude oil changes hands for just $65 which, undeniably, is a bargain. If the price of oil soared to $1,000/b, it would wreck the economy – but it would still be an extremely low price, when measured against an equivalent amount of human effort.

The economy, then, could be crippled by energy prices that would still be ultra-cheap in purely energy-content terms. More to the point, this could happen at prices that were still too low to ensure profitability in the business of energy supply.

The comparison between petroleum and its labour equivalent is meant to be solely illustrative – the relevant point is that the economy is gigantically leveraged to the ‘work value’ contained in all exogenous energy sources.

Second, the end of the market economy. The market economy works on a system of impersonal rewards and penalties. If you make shrewd investments, you’re likely to make a profit – but, if you act recklessly (or simply have a run of bad lack), you stand to lose everything. Failure, as penalised impersonally by market forces, is the flip-side of reward, itself (in theory) equally impersonal. Logically, market forces don’t allow you to have reward without the risk of failure. Using debt to leverage your position acts to increase both the scope for profit and the potential for loss.

The 2008 crisis was a culminating failure of reckless financial behaviour, by individuals, businesses, banks, regulators and policymakers. Left simply to the workings of the market, the penalties would have been on a scale commensurate with the preceding folly. Individuals and businesses which had taken on too much debt would have been bankrupted, as would those who had lent recklessly to them. If market forces had been allowed to work through to their logical conclusions, 2008 would have seen massive failures, bankruptcies and defaults – spreading out from those who ‘deserved’ to be wiped out to take in ‘bystanders’ with varying degrees of ‘innocence’ – whilst asset prices would have collapsed, and much of the banking system, as the primary supplier of credit, would have been destroyed.

Some economic purists have argued that this is exactly what should have happened, and that we will in due course pay a huge price for the ‘moral hazard’ of rescuing the reckless from the consequences of their actions.

They might well be right.

Be that as it may, though,  the point is that market forces were not allowed to work out to their logical conclusions. As well as simply rescuing the banks, the authorities set out on the wholesale rescue of anyone who had taken on too much debt. This was done primarily by slashing interest rates to levels that are negative in real terms (lower than inflation). Though described at the time as “temporary” and “emergency” in nature, these interventions are, for all practical purposes, permanent.

There’s irony in the observation that, though idealists of ‘the Left’ have dreamed since time immemorial of overthrowing the ‘capitalist’ system, the market economy has not been destroyed by its foes, but abandoned by its friends.

The Age of Subsidy

Critically for our purposes, what began in 2008 and continues to this day is wholesale subsidy. ZIRP has provided emergency and continuing sustenance for everyone who had borrowed recklessly in the years preceding the crash. It has also multiplied the incentive to borrow. Negative real interest rates are nothing more nor less than a hand-out to distressed borrowers, not only sparing them from debt service commitments that they could no longer afford, but inflating the market value of their investments, too.

Though less obvious than its beneficiaries, this subsidy has turned huge numbers into victims. Savers, including those putting resources aside for pensions, have been only the most visible of these victims. We cannot know who might have prospered had badly-run, over-extended businesses gone to the wall rather than continuing, in subsidised, “zombie” form, to occupy market space that might more productively have gone to new entrants. We do know that the young are victims of deliberate housing cost inflation.

There’s nothing new about subsidies, of course, and governments have often subsidised activities, either because these are seen to be of national importance, or because they have pandered to the influential interests on whom the subsidies have been bestowed.

Purists of the free market persuasion have long castigated subsidies as distortions of economic behaviour and they are, theoretically at least, quite right to think this.

The point, though, is that, since 2008, the entire economy has been made dependent on the subsidy of money priced at negative real levels.

Anyone who is ‘paid to borrow’ is, of necessity, in receipt of subsidy.

That we live in ‘the age of subsidy’ has a huge bearing on the outlook for energy. With this noted, let’s return to the role of energy in prosperity.

Prosperity in decline – turning-points and differentials

As we’ve noted, once the Energy Cost of (accessing) Energy – ECoE – passes a certain point, the remaining energy surplus becomes insufficient to grow prosperity, or even to sustain it. This point has now been reached or passed in almost all Western economies, so prosperity in those countries has turned down. Efforts to use financial adventurism to counter this effect have done no more than mask (since they cannot change) the processes that are undercutting prosperity, but have, in the process, created huge and compounding financial risks.

In the emerging market (EM) economies, prosperity continues to improve, but no longer at rates sufficient to offset Western decline. Global prosperity per person has now turned downwards from an extremely protracted plateau, meaning that the world has now started getting poorer. Amongst many other things, this means that a financial system predicated on the false assumption of infinite growth is heading for some form of invalidation. It also poses political and social challenges to which existing systems are incapable of adaption.

How, though, does the energy-prosperity equation work – and what can this tell us about the outlook for energy itself?

According to SEEDS (the Surplus Energy Economics Data System), global prosperity stopped growing when trend ECoE hit 5.4%. It might, at first sight, seem surprising that subsequent deterioration has been very gradual, even though ECoE has carried on rising relentlessly, now standing at 8.0%. This apparent contradiction is really all about the changing geographical mix involved – until recently, deterioration in Western prosperity had been offset by progress in EM countries, because the ECoE/growth thresholds differ between these two types of system.

Essentially, EM economies seem to be capable of continuing to grow their prosperity at levels of ECoE a lot higher than those which kill prosperity growth in Western countries.

The following charts illustrate the comparison, and show prosperity per capita (at constant 2018 values) on the vertical axis, and trend ECoE on the horizontal axis. For comparison with America, the China chart shows prosperity in dollars, converted at market exchange rates (in red) and on the more meaningful PPP basis of conversion (blue). For reference, ECoE at 6% is shown as a vertical line on both charts.

As you can see, American prosperity had already turned down well before ECoE reached 6%. Chinese prosperity has carried on growing even though ECoE is now well above the 6% level.

How can China carry on getting more prosperous at levels of ECoE at which prosperity has already turned down, not just in America but in almost every other advanced economy?

There seem to be two main reasons for the different relationships between prosperity and ECoE in advanced and EM economies.

First, prosperity isn’t exactly the same thing in a Western or an EM economy – put colloquially, how prosperous you feel depends on where you live, and where you started from.

In America, SEEDS shows that prosperity per person peaked in 2005 at $48,660 per person (at 2018 values), and had fallen to $44,830 (-7.9%) by 2018. Over the same period, prosperity per person in China rose by an impressive 84% – but was still only $9,670 per person last year. Even that number is based on PPP conversion to dollars – converted into dollars at market exchange rates, prosperity per person in China last year was just $5,130.

Both numbers are drastically lower than the equivalent number for the United States. Not surprisingly, Chinese people feel (and are) more prosperous than they used to be, even at levels of prosperity that would amount to extreme impoverishment in America. Before anyone says that “America is a more expensive place to live”, conversion at PPP rates is supposed to take account of cost differentials – and, even in PPP terms, the average Chinese citizen is 78% poorer than his or her American equivalent.

The second critical differential lies in relationships between countries. Historically, trade relationships favoured Western over EM economies, though this has been changing, perhaps helping to explain the gradual narrowing in personal prosperity between developed and emerging countries.

Moreover, there are often quirks in the relationships between countries, even where they belong to the same broad ‘advanced’ or ‘emerging’ economic grouping. Germany is an example of this, having benefited enormously from a currency system which has been detrimental to other (indeed, almost every other) Euro Area country. For some time, Ireland, too, was a beneficiary of EA membership, though those benefits have eroded since the period of “Celtic Tiger” financial excess.

The conclusion, then, is that there’s no ‘one size fits all’ answer to the question of ‘where does ECoE kill growth?’, just as prosperity means different things in different types of economy.

It should also be noted that China’s ability to keep on growing prosperity at quite high levels of ECoE is not necessarily a good guide to the future. As things stand, China’s economy, driven as it by extraordinary levels of borrowing, is looking ever more like a Ponzi scheme facing a denouement.

The situation so far

Given how much ground we’ve covered, let’s take stock briefly of where we are.

We’ve observed, first, that the rise in trend ECoEs is in the process of undermining prosperity. Much of this has already happened – prosperity in most Western economies has now been deteriorating for at least a decade, whilst continued progress in EM economies is no longer enough to keep the global average stable. As ECoEs continue to rise, what happens next is that EM prosperity itself turns down, a process which will accelerate the rate at which global prosperity declines. SEEDS already identifies one major EM economy (other than China) where strong growth in prosperity will soon go into reverse.

Second, a world financial system predicated entirely on perpetual ‘growth’ in prosperity has become dangerously over-extended. Again, this observation isn’t something new. The inauguration, more than ten years ago, of mass subsidy for borrowers and lenders surely tells us that we’ve entered a new ‘era of abnormality’, in which subsidy is normal, and where historic principles (such as positive returns on capital) no longer apply.

If you stir energy leverage into this equation, an inescapable conclusion emerges. It is that we’re going to have to extend our current acceptance of ‘financial adventurism’ to the point where energy supply, just like borrowers and lenders, becomes supported by monetary subsidy.

The only way in which this might not happen would be if we could somehow escape from the implications of rising ECoE. Some believe that renewables will enable us to do this – after all, just as trend ECoEs for oil, gas and coal keep rising, those of wind and solar continue to move downwards.

This situation is summarised in the first of the following charts, which shows broad ECoE trends over the period (1980-2030) covered by SEEDS. As recently as 2000, the aggregate trend ECoE of renewables (shown in green) was above 13%, compared with only 4.1% for fossil fuels (shown in grey). Renewables are already helping to blunt the rise in ECoE, such that the overall number (in red) is lower than that of fossil fuels alone. We’re now pretty close to the point where the ECoE of renewables will be below that of fossil fuels.

On this basis, it’s become ‘consensus wisdom’ to assume that renewables will, like the 7^th Cavalry, ‘ride to the rescue in the final reel’. Unfortunately, this comforting assumption rests on three fallacies.

The first is “the fallacy of extrapolation”, which is a natural human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. (One of my mentors in my early years in the City called this “the fallacy of the mathematical dachshund”). The reality is much likelier to be that technical progress in renewables (including batteries) will slow when it starts to collide with the limits imposed by physics.

The second fallacy is that projections for cost reduction ignore the derivative nature of renewables. Building, say, a solar panel, a wind turbine or an electrical distribution system requires inputs currently only available courtesy of the use of fossil fuels. In this specialised sense, solar and wind are not so much ‘primary renewables’ as ‘secondary applications of primary fossil input’.

We may reach the point where these technologies become ‘truly renewable’, in that their inputs (such as minerals and plastics) can be supplied without help from oil, gas or coal.

But we are certainly, at present, nowhere near such a breakthrough. Until and unless this point is reached, the danger exists that that the ECoE of renewables may start to rise, pushed back upwards by the rising ECoE of the fossil fuel sources on which so many of their inputs rely. This is illustrated in the second chart, which looks at what might happen beyond the current time parameters of SEEDS. In this projection, progress in reducing the ECoEs of renewables goes into reverse because of the continued rise in fossil-derived inputs.

The third problem is that, even if renewables were able to stabilise ECoE at, say, 8% or so, that would not be anywhere near low enough.

Global prosperity stopped growing before ECoE hit 6%. British prosperity has been in decline ever since ECoE reached 3.6%, and an ECoE of 5.5% has been enough to push Western prosperity growth into reverse.

As recently as the 1960s, in what we might call a “golden age” of prosperity growth – when economies were expanding rapidly, and world use of cheap petroleum was rising at rates of up to 8% annually – ECoE was well below 2%.

In other words, even if renewables can stabilise ECoE at 8% – and that’s a truly gigantic ‘if’ – it won’t be low enough to enable prosperity to stabilise, let alone start to grow again.

Energy and subsidy –  between Scylla and Charybdis

The idea that we might need to subsidise energy ‘for the greater economic good’ is a radical one, but is not without precedent. Though the development of renewables has been accelerated in various countries by subsidies provided either by taxpayers or by consumers, the important precedent here doesn’t come from the solar or wind sectors, but from the production of oil from shales.

There can be no doubt that shale liquids, primarily from the United States, have transformed petroleum markets – without this production, it’s certain that supplies would have been lower, and prices could well have been a lot higher. Yet the supply of shale has owed little or nothing to the untrammelled working of the market. Rather, shale has received enormous subsidy.

Repeated studies have shown that shale liquids production isn’t ‘profitable’, because cash flow generated from the sale of production has never been sufficient to cover the industry’s capital costs, let alone to provide a return on capital as well. The economics of shale are too big a subject to be examined here, but the critical point is the rapidity with which production declines once a well is put on stream. This means that any company wanting to expand (or even to maintain) its level of production needs to keep drilling new wells – this is the “drilling treadmill” which, critically, has always needed more investment than cash flow from operations can supply.

Yet shale investment has continued, despite its record of generating negative free cash flow. It’s easy to attribute this to the support provided by gullible investors, but the broader picture is that shale producers, like ‘cash burners’ in other sectors, have been kept afloat by a tide of ultra-cheap capital made available by the negative real cost of capital.

In all probability, this is the pattern likely to be followed by the energy industries more generally, as profitability is crushed between the Scylla of rising costs and the Charybdis of straitened consumer circumstances.

In short, we’re probably going to have to ‘create’ the money to keep energy supplies flowing. If the argument becomes one in which energy is described as ‘too important to be left to the market’, energy will join a growing cast of characters – including borrowers, lenders and ‘zombie’ companies – kept in existence by the subsidy of cheap money.

 

#143: Fire and ice, part one

TRAUMA FOR THE TAX-MAN

Is 2019 the year when everything starts falling apart?

It certainly feels that way.

The analogy I’m going to use in this and subsequent discussions is ‘fire and ice’.

Ice, in the potent form of glaciers, grinds slowly, but completely, crushing everything in its path. Whole landscapes have been shaped by these icy juggernauts.

Fire, on the other hand, can cause almost instantaneous devastation, most obviously when volcanoes erupt. Back in 1815, the explosion of Mount Tambora in the Dutch East Indies (now Indonesia) poured into the atmosphere quantities of volcanic ash on such a vast scale that, in much of the world, the sun literally ceased to shine. As a result, 1816 became known as “the year without a summer”. As low temperatures and heavy rain destroyed harvests and killed livestock, famine gripped much of Europe, Asia and North America, bringing with it soaring food prices, looting, riots, rebellions, disease and high mortality. Even art and literature seem to have been influenced by the lack of a summer.

The economic themes we’ll be exploring here have characteristics both of fire and of ice. The decline in prosperity is glacial, both in its gradual pace and its ability to grind assumptions, and systems, into the ground. Other events are likelier to behave like wild-fires or volcanoes, given to rapid and devastating outbursts, with little or no prior warning.

Fiscal issues, examined in this first instalment of ‘fire and ice’, have the characteristics of both. The scope for taxing the public is going to be subjected to gradual but crushing force, whilst the hard choices made inevitable by this process are highly likely to provoke extremely heated debate and resistance.

Let’s state the fiscal issue in the starkest terms:

– Massive credit and monetary adventurism have inflated GDP to the point where it bears little or no resemblance to the prosperity experienced by the public.

– But governments continue to set taxation as a percentage of GDP.

– As GDP and prosperity diverge, this results in taxation exacting a relentlessly rising share of prosperity.

– Governments then fail to understand the ensuing popular anger.

France illustrates this process to dramatic effect. Taxation is still at 54% of GDP, roughly where it’s been for many years. This no doubt persuades the authorities that they’ve not increased the burden of taxation. But tax now absorbs 70% of French prosperity, leading to the results that we’ve witnessed on the streets of Paris and other French towns and cities.

Few certainties

It’s been said that the two certainties in life are “death and taxes”, but ‘debt and taxes’ hold the key to fiscal challenges understood improperly – if at all – by most governments. The connection here is that debt (or rather, the process of borrowing) affects recorded GDP in ways which provide false comfort about the affordability of taxation – and therefore, of course, about the affordability of public services.

The subject of taxation, seen in terms of prosperity, leads straight to popular discontent, though that has other causes too. In order to have a clear-eyed understanding of public anger, by the way, we need to stick to what the facts tell us. I’ve never been keen on excuses like “the dog ate my homework” or “a space-man from Mars stole my wallet” – likewise, we should ignore any narrative which portrays voter dissatisfaction as wholly the product of “populism”, or of “fake news”, or even of machinations in Moscow or Beijing. All of these things might exist – but they don’t explain what’s happening to public attitudes.

The harsh reality is that, because prosperity has deteriorated right across the advanced economies of the West, we’re facing an upswell of popular resentment, at the same time as having to grapple with huge debt and monetary risk.

If you wanted to go anywhere encouraging, you wouldn’t start from here.

The public certainly has reasons enough for discontent. In the Western world, prosperity has been deteriorating for a long time, a process exacerbated by higher taxation. The economic system has been brought into disrepute, mutating from something at least resembling ‘the market economy’ into something seemingly serving only the richest. As debt has risen, working conditions, and other forms of security, have been eroded. We can count ourselves fortunate that the public doesn’t know – yet – that the pensions system has been sacrificed as a financial ‘human shield’ to prop up the debt edifice.

This at least sets an agenda, whether for 2019 or beyond. The current economic paradigm is on borrowed time, whilst public support can be expected to swing behind parties promoting redistribution, economic nationalism and curtailment of migration. Politicians who insist on clinging on to ‘globalised liberalism’ are likely to sink with it. The tax base is shrinking, requiring new priorities in public expenditure.

If you had to tackle this at all, you wouldn’t choose to do it with the “everything bubble” likely to burst, bringing in its wake both debt defaults and currency crises. But this process looks inescapable. With its modest incremental rate rises, so derided by Wall Street and the White House, the Fed may be trying to manage a gradual deflation of bubbles. If so, its intentions are worthy, but its chances of success are poor.

And, when America’s treasury chief asks banks to reassure the markets about liquidity and margin debt, you know (if you didn’t know already) that things are coming to the boil.

Tax – leveraging the pain

If it seems a little odd to start this series with fiscal affairs, please be assured that these are very far from mundane – indeed, they’re likely to shape much of the political and economic agenda going forward. The biggest single reason for upsets is simply stated – where prosperity and the ability to pay tax are concerned, policymakers haven’t a clue about what’s already happening.

Here’s an illustration of what that reality is. Expressed at constant values, personal prosperity in France decreased by €2,060, or 7.5%, between 2001 (€29,315) and 2017 (€27,250).

At first glance, you might be surprised that this has led to such extreme public anger, something not witnessed in countries where prosperity has fallen further. Over the same period, though, taxation per person in France has increased by €2,980. When we look at how much prosperity per person has been left with the individual, to spend as he or she chooses, we find that this “discretionary” prosperity has fallen from €13,210 in 2001 to just €8,230 in 2017.

That’s a huge fall, of €4,980, or 38%. Nobody else in Europe has suffered quite such a sharp slump in discretionary prosperity – and tax rises are responsible for more than half of it.

This chart shows how increases in taxation have leveraged the deterioration in personal prosperity in eight Western economies. The blue bars show the change in overall prosperity per capita between 2001 and 2017. Increases in taxation per person are shown in red.

In the United Kingdom, for example, economic prosperity has deteriorated by 9.8% since 2001, but higher taxation has translated this into a 29.5% slump in discretionary prosperity. Interestingly, economic prosperity in Germany actually increased (by 8.2%) over the period, but higher taxes translated into a fall at the level of discretionary prosperity per person.

Prosperity and tax – Scylla and Charybdis

The next pair of charts, which use the United Kingdom to illustrate a pan-Western issue, show a problem which is already being experienced by the tax authorities, but is not understood by them.

The left-hand chart (expressed in sterling at constant 2017 values) shows a phenomenon familiar to any regular visitor to this site, but not understood within conventional economics. Essentially, GDP (in blue) and prosperity (in red) are diverging.

This is happening for two main reasons. One is the underlying uptrend in the energy cost of energy (ECoE). The second is the use of credit and monetary adventurism to create apparent “growth” in GDP in the face of secular stagnation. This, of course, helps explain why people are feeling poorer despite apparent increases in GDP per capita. Total taxation is shown in black, to illustrate the role of tax within the prosperity picture.

The right-hand chart shows taxation as percentages of GDP (in blue) and prosperity (in red). In Britain, taxation has remained at a relatively stable level in relation to GDP, staying within a 34-35% band ever since 1998, before rising to 36% in 2016 and 37% in 2017.

Measured as a percentage of prosperity, however, the tax burden has risen relentlessly, from 35% in 1998, and 44% in 2008, to 51% in 2017.

Simply put, the authorities seem to be keeping taxation at an approximately constant level against GDP, not realising that this pushes the tax incidence upwards when measured against prosperity. The individual, however, understands this all too well, even if its causes remain obscure.

What this means, in aggregate and at the individual level, are illustrated in the next set of charts. These show the aggregate position in billions, and the per capita equivalent in thousands, of pounds sterling at 2017 values.

As taxation rises roughly in line with GDP – but grows much more rapidly in terms of prosperity – discretionary prosperity, shown here in pink, becomes squeezed between the Scylla of falling prosperity and the Charybdis of rising taxation. The charts which follow are annotated to highlight how this ‘wedge effect’ is undermining discretionary prosperity.

Finally, where the numbers are concerned, here’s the equivalent situation in France. As far back as 1998, tax was an appreciably larger proportion of GDP in France (51%) than in the United Kingdom (34%). By 2017, tax was absorbing 54% of GDP in France, compared with 37% in Britain.

This means that taxation in France already equates to 70% of prosperity, up from 53% in 1998. Even though the squeeze on overall prosperity (the pink triangle) has been comparatively modest so far (since 2001, a fall of 7.5%), the impact on discretionary prosperity (the blue triangle) has been extremely severe (39%). This is why so many French people are angry – and why their anger has crystallised around taxation.

The political fall-out

When you understand taxation in relation to prosperity, you appreciate a challenge which the authorities in Western countries (and beyond) have yet to comprehend. Most of them probably think that, going forward, they can carry on pushing up taxation roughly in line with supposed “growth” in GDP. Presumably, they also assume that the public will accept this fiscal trajectory.

If they do make these assumptions, they’re in for a very rude awakening. The modest tax tinkering implemented in France, for instance, is most unlikely to quell the anger, even though it’s set to widen the deficit appreciably.

Politically, the leveraging effect of rising taxation feeds into a broader agenda which, so far, is either misinterpreted, or just not recognised at all, by the governing establishment.

Here, simply stated, are some of the issues with which governments are confronted:

– Prosperity per person is continuing to deteriorate, typically at annual rates of between 0.5% and 1.1%, across the Western economies.

– Rising taxation is worsening this trend, leading increasingly to popular resistance.

– The public believes (and not without reason) that immigration is exacerbating the decline in prosperity, both at the total and at the discretionary levels.

– Perceptions are that a small minority of “the rich” are getting wealthier whilst almost everyone else is getting poorer.

Politicians are seen as both heedless of the majority predicament and complicit in the enrichment of a minority.

The popular demands which follow from this are pretty clear.

Voters are going to be angered by the decline in their prosperity, and will become increasingly resistant to taxation. The greatest resentment will centre around “regressive” taxes, such as sales taxes and flat-rate levies, which hit poorest taxpayers hardest.

They’re going to demand more redistribution, meaning higher taxes on “the rich”, not just where income taxes are concerned, but also extending to taxes on wealth, capital gains and transactions.

Popular opposition to immigration is likely to intensify, as prosperity deteriorates and tax bites harder.

Finally, public anger about former ministers and administrators retiring into very lucrative employment is going to go on mounting.

A challenge – and an opportunity?

In terms of electoral politics, most established parties are singularly ill-equipped to confront these issues. Some on “the Left” do embrace the need for redistribution, but almost invariably think this is going to fund increases in public expenditures, which simply isn’t going to be possible.

Others oppose increasing taxes on the wealthiest, and fail to appreciate that fiscal mathematics, quite apart from public sentiment, are making this process inescapable.

On both sides of the conventional political divide there is, as yet, no awareness that economic trends are going to exert glacier-style downwards pressure on public spending. Nowhere within the political spectrum is there recognition of the consequent need to set new, more stringent priorities. In areas such as health and policing, declining real budgets mean that policymakers face hard choices between which activities can continue to be funded, and those which will have quietly to be dropped.

It seems almost inconceivable that established parties are going to recognise what faces them, and adapt accordingly. The “Left” is likely to cling to dreams of higher public expenditures, whilst the “Right” will try to fend off higher taxation of the wealthiest. Even insurgent (aka “populist”) parties probably have no idea about the tightening squeeze on what they can afford to offer to the voters. It’s likely that very few people in senior positions yet realise that an ultra-lucrative retirement into “consultancies” and “the lecture circuit” is set to become electorally toxic.

Politically, of course, problems for some can be opportunities for others. It wouldn’t be all that hard to craft an agenda which capitalises on these trends, promising, for example, much greater redistribution, ultra-tight limits on immigration, and capping the retirement earnings of the policy elite.

If you did promise these things, you’d probably be elected. Unfortunately, though, that’s the easy bit. The hard part is going to be grappling with the continuing decline in prosperity at the same time as fending off a financial crash.

How, having been voted into power, are you going to tell the voters that we’re all getting poorer, and that some public services are ceasing to be affordable within an ever more rigorous setting of priorities? And are they going to believe you when you tell them that the destruction of pensions is entirely the work of your predecessors? Finally, what are you going to do when one of the big endangered economies fails?