#166. Lines of contagion

COULD THIS BECOME A BANKING CRISIS?  

Whilst the world watches the wild gyrations in stock markets, and investors try to absorb the economic implications of the Wuhan coronavirus, it’s important to remember that market falls are neither the only, nor indeed the most important, financial effects of this situation.

It doesn’t take all that much joined-up thinking to spot the lines of financial contagion that threaten to transition this from an industrial problem into a threat to the banking system.

What matters now isn’t how much theoretical asset value investors may have lost, but the real, cash-flow consequences for businesses and, by extension, to their lenders.

Essentially, slumps in equity prices simply reduce the amount that owners could get for their shares now, compared with those that they could have realised a week or so ago. Except where stocks have been acquired using debt, there are few immediate, cash-outflow effects. Shares that were once worth $50 might now be worth only $40, but no money has actually flowed out of the typical investor’s bank account.

The real (and systemically-hazardous) damage being inflicted by the epidemic is happening, not in stock prices, but in business activities ‘at ground level’. With systems in lock-down, workers idled and supply-chains ruptured, a large and growing proportion of the world’s businesses are unable to produce, sell or deliver goods and services – which also means that they don’t get paid.

Just because revenues dry up, obligations do not. These include wages, rents, administrative overheads, sums owed to trade creditors, maintenance costs, tax payments and – in this context, most critically of all – the servicing of debt. Fundamentally, then, what looks to a watching world like an asset pricing drama is, in reality, a cash flow or liquidity crisis.

This in turn puts the banking system in the eye of the storm.

What affected businesses need now is financial support. They need lenders to give them more time to pay and, for the duration of what might turn out to be a very protracted loss of revenue, they also need additional funds to cover their various outgoings.

Firms which do not get this support face collapse, either because they can’t meet their debt service obligations, or because they simply run out of money. This is where the notional losses of value on the market’s ticker-boards turn into a real, systemically-damaging destruction of value.

This doesn’t mean that firms are powerless supplicants over whose fortunes their lenders sit in judgment. If businesses do start to fail, the banks could face rapid and crippling losses. Slashing interest rates, the central bankers’ prior preferred tool, can do little or nothing to resolve this issue.

Rather, governments and central banks have to find ways to ‘support the support’ that businesses need from commercial lenders, and they need to do it urgently.

A reduction in the rate of interest that you’ll be paying in the future doesn’t help you to pay wages, creditors, taxes and overheads now, and neither does it solve a liquidity crisis compounded by scheduled debt service outgoings.

It may be obvious that lower borrowing costs aren’t going to tempt frightened travellers back on to aeroplanes or into the shops, but it’s equally true, and even more important, that the simple lowering of rates doesn’t, and can’t, keep businesses going. Banks, then, need to be lending more – and this at the very time when both inclination and prudence might be counselling them to lend less.

Decision-makers in government and central banking need now to be asking themselves two critical questions.

The first of these, of course, involves working out ways to push support through the commercial banking system to the businesses that need it.

But the second is what do to if ‘operation support’ either fails, or is only a partial success. If cash-strapped companies start to fail to any significant extent, the inevitable consequence will be a compounding cascade of defaults.

This isn’t a problem that can be solved by putting yet more borrowers into the limbo of “zombie-ism” – being allowed to add owed interest to outstanding capital balances doesn’t enable firms to meet their ongoing cash needs.

The likeliest outcome at this point is that the authorities will recognise and react to the business liquidity crisis, but won’t be able to do so in ways that are sufficiently comprehensive, and which meet the urgency of the situation.

This, I suspect, is when a lot of recent history starts to be regretted. The scale of stock buy-backs in the United States, for example, has effectively replaced large amounts of shock-absorbing equity capital with inflexible debt. China has spent ten years almost quadrupling its debt in order to slightly more than double its GDP. Globally, monetary policies adopted during the GFC, and then kept in place for far too long, have paid people (and businesses) to borrow. Cheap liquidity has created huge areas of exposure, with stock markets just one example amongst many.

Anyone who thought that over-inflated asset prices were the only hostages handed to fortune by credit and monetary adventurism could now be drawn face to face with an uncomfortable reality.

= = = = = = =

PLEASE NOTE

11th March 2020

As you’ll have seen, there’s been a big jump in the number of comments posted here.

This has happened because I’ve just found out that the system which notifies me of comments awaiting approval has stopped working, seemingly a couple of weeks or so ago.

Please accept my apologies for this (and my grateful thanks go to the person who worked out what was causing this glitsch).

Until this is sorted, I’m going to do the approvals process manually, looking regularly at the list rather than waiting to be notified. I hope this won’t be much slower than the normal process.

#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

Fig. 4 parabola

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

Fig. 6a regional & world prosperity & ECoE

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’.

#159. The perils of equilibria

‘INDICATIONS AND WARNINGS’

Putting together what might turn out to be the last article published here this year has been one of two main items on my agenda. (I’m hoping to slip a third, pre-Christmas article into the list but, should this not happen, please accept my premature good wishes for the season).

In back-to-front order, the second ‘agenda item’ is a much-updated guide to the principles of Surplus Energy Economics, and to the latest – SEEDS 20 Pro – version of the model. The Surplus Energy Economics Data System has now evolved into a very powerful analytical tool, and I plan to make even greater use of it to inform discussions here in the future.

You can download at the end of this discussion, or from the Resources, page a summarised statistical guide to selected EM economies, whose prospects are one of the issues discussed here.

Two disequilibria

The aim here is to set out two of the trends that I suspect are going to ‘go critical’ in the year ahead.

The first of the two narrative-shaping issues that I’m anticipating for 2020 is a marked slowdown in the emerging market (EM) economies.

We can say what we like about the advanced economies (AEs), where monetary adventurism seeks to disguise (since it cannot reverse) an economic stagnation that has morphed into a gradual (but perceptible) deterioration in prosperity.

But, all along, we’ve known that our trading partners in the EM countries have been “doing stuff” – churning out widgets, building infrastructure, ‘going for growth’, and doing a quite remarkable job of improving the economic lot of their citizens.

This positive trend is, in my analysis, starting to top-out and then go into reverse. Even ‘conventional’ numbers are now starting to reveal what SEEDS has been anticipating for quite some time. The cresting and impending reversal of the wave of prosperity growth in countries like China and India – and the consequent financial strains – are likely to inform much of the economic narrative going forward.

The implications of what I’ll “the EM crest” will be profound.

We will no longer be able to say that ‘the Western economies may be stagnating, but the emerging nations are driving the global economy forward’. Their less complex, less ECoE-sensitive economies now face the self-same issues that have plagued the West ever since the onset of ‘secular stagnation’ from the late 1990s.

The second critical issue is financial disequilibrium, and the ‘devil or the deep blue sea’ choice that it poses.

Here’s an example of what this ‘disequilibrium’ means. In nominal terms, the value of equities around the World increased by 139% in a decade (2008-18) in which nominal World GDP expanded by 33%. Applying inflation to both reduces the numbers, of course, but it leaves the relationship unchanged. What’s true of equities is also true, to a greater or lesser extent, of the prices of other assets, including bonds and property.

What matters here is the relationship between asset prices and incomes, with ‘incomes’ embracing everything from wages and pensions to dividends, corporate earnings and coupons from bonds.

This divergence is, of course, a direct result of monetary policy. But the effect has been to stretch the relationship to a point from which either surging inflation (by driving up nominal incomes), or a crash in asset prices, is a necessary element of a return to equilibrium.

We may have to choose between these, with inflation the price that might need to be paid to prevent a collapse in asset markets.

Our industrious friends

A critical issue in the near-term is likely to be the discrediting of the increasingly fallacious assumption that, whilst much of the “growth” (and, indeed, of the economic activity) reported in the West is cosmetic, emerging market (EM) economies really can go on, indefinitely,  producing more “stuff” each year, so a big part of the World remains genuinely more and more productive.

Westerners, the logic runs, might increasingly be making their living by using a ‘churn’ of newly-created money to sell each other ever-pricier assets and ever more low-value incremental services, but the citizens of Asia, in particular, remain diligent producers of everything from cars and smartphones to chips and components.

This, unfortunately, is a narrative whose validity is eroding rapidly. China’s pursuit of volume (driven by the imperative of providing employment to a growing urban workforce) has driven the country into a worsening financial morass, whilst a former Indian finance minister has warned of “the death of demand” in his country.

Figures amply demonstrate the development of these adverse trends, not just in China and India but in other members of the EM-14 group that is monitored by SEEDS.

On the principle that a picture is worth a thousand words, here are SEEDS charts showing that, whilst Western prosperity is already in established decline, something very similar is looming for the EM-14 economies. Of these, some – including Brazil, Mexico, South Africa and Turkey – have already started getting poorer, and many others are nearing the point of inflexion.

159 prosperity

And, as the next pair of charts shows, you don’t need SEEDS interpretation to tell you that the divergence between GDP and debt in the EM countries doesn’t augur well.

159 EM divregence

What’s starting to happen to the EM economies has profound, global implications. Perhaps most significantly, the dawning recognition that the World’s economic ‘engine’ is no longer firing on all cylinders is likely to puncture complacency about global economic “growth”.

When this happens, a chain reaction is likely to set in. With the concept of ‘perpetual growth’ discredited, what happens to the valuations of companies whose shares are supposedly priced on their own ‘growth potential’?

More important still, what does this mean for a structure of debt (and broader obligations) predicated on the assumption that “growth” will enable borrowers to meet their obligations?

In short, removing ‘perpetual assured growth’ from the financial calculus will equate to whipping out the ace of diamonds from the bottom tier of a house of cards.

Timing and equilibrium

This brings me to my second theme, which is the relationship between assets and income.

Just like ratios of debt to prosperity – and, indeed, mainly because of cheap debt – this relationship has moved dramatically out of kilter.

The market values of paper assets put this imbalance into context.

Globally, data from SIFMA shows that the combined nominal value of stocks and bonds increased by 68% between 2008 and 2018, whilst recorded GDP – itself a highly questionable benchmark, given the effects of spending borrowed money – expanded by a nominal 33%.

Equities, which were valued at 79% of American GDP in 2008 after that year’s slump, rose to 148% by the end of 2018, the equivalent global percentages being 69% and 124%.

For the United States, a ‘normal’ ratio of stock market capitalisation to GDP has, historically, been around 100% (1:1), so the current ratio (about 1.5:1) is undoubtedly extreme.

Prices of other assets, such as residential and commercial property, have similarly outstripped growth in recorded GDP.

Whilst this isn’t the place to examine the mechanisms that have been in play, it’s clear that monetary policy has pushed asset prices upwards, driving a wedge between asset values and earnings.

This equation holds true right across the system, typified by the following relationships:

– The prices of bonds have outstripped increases in the coupons paid to their owners.

– Share values have risen much more sharply either than corporate earnings or dividends paid to stockholders.

– The wages of individuals have grown very much more slowly than the values of the houses (or other assets) that they either own or aspire to own.

This in turn means that people (a) have benefited if they were fortunate enough (which often means old enough) to have owned assets before this process began, but (b) have lost out if they were either less fortunate (and, in general, were too young) when monetary adventurism came into play.

The critical point going forward is the inevitability of a return to equilibrium, meaning that the relationship between incomes and asset values must revert back towards past norms.

You see, if equilibrium isn’t restored – if incomes don’t rise, and prices don’t fall – markets cease to function. Property markets run out of ‘first-time buyers’; equity markets run out of private or institutional new participants; and bond markets run out of people wishing to park some of their surplus incomes in such instruments.

To be sure, markets might be kept elevated artifically, even in a state of stasis, without new money being put into them from the earnings of first-time buyers and new investors. But the only way to replace these new income streams would be to print enough new money to cover the gap – and doing that would destroy fiat currencies.

This means either that incomes – be they wages, bond coupons or equity dividends – must rise, or that asset prices must fall.

In a World in which growth – even as it’s reckoned officially – is both subdued and weakening, the only way in which nominal incomes can rise is if inflation takes off, doing for wages (and the cost of living) what it’s already done for asset prices.

With inflation expectations currently low, you might conclude, from this, that asset prices must succumb to a ‘correction’, which is the polite word for a crash.

But that ‘ain’t necessarily so, Joe’. It’s abundantly clear that the authorities are going to do their level best to prevent a crash from happening. It seems increasingly apparent that, as Saxo Bank has argued so persuasively, the Fed’s number one priority now is the prevention of a stock market collapse.

Additionally, of course, and for reasons which presumably make political sense (because they make no economic or social sense whatsoever), many governments around the World favour high property prices.

The linkage here is that the only way in which the authorities can prevent an asset price slump is ‘more of the same’ – the injection of ever greater amounts of new money at ever lower cost. This is highly likely to prove inflationary, for reasons which we can discuss on a later occasion.

My conclusions on this are in two parts.

First, the authorities will indeed do ‘whatever it takes’ to stop an asset price collapse (and they might reckon, too, that the ‘soft default’ implicit in very high inflation is the only route down from the pinnacle of the debt mountain).

My second conclusion is that it won’t work. Investors, uncomfortably aware that only the Fed and ‘unconventional’ monetary policy stand between them and huge losses, might run for the exits.

They know, of course, that when everyone rushes in a panic for the door labelled ‘out’, that door has a habit of getting smaller.

There’s an irony here, and a critical connection.

The irony concerns the Fed, the President and the stock market. Opinions about Mr Trump tend to be very polarised, but even his admirers have expressed a lot of scepticism about his assertion that a strong stock market somehow demonstrates the vibrancy of the American economy.

So it would indeed be ironic if the Fed – in throwing everything and the kitchen sink into stopping a market crash – found itself acting on the very same precept.

The connection, of course, is that equity markets, just like bonds and other forms of debt, are entirely predicated on a belief in perpetual growth. If, as I suspect, trends in the EM economies are set to destroy this ‘growth belief’, we may experience what happens when passengers in the bus of inflated markets find out that the engine has just expired.

EM 14 December 7th 2019

#157. Trending down

THE ANATOMY OF DEGROWTH – A SEEDS ANALYSIS

Unless you’ve been stranded on a desert island, cut off from all sources of information, you’ll know that the global economy is deteriorating markedly, whilst risk continues to increase. Even the most perennially optimistic observers now concede that the ultra-loose policies which I call ‘monetary adventurism’, introduced in response to the 2008 global financial crisis (GFC), haven’t worked. Popular unrest is increasing around the world, even in places hitherto generally regarded as stable, with worsening hardship a central cause.

As regular readers know, we’ve seen this coming, and have never been fobbed off by official numbers, or believed that financial gimmickry could ‘fix’ adverse fundamental trends in the economy. Ultimately, the economy isn’t, as the established interpretation would have us believe, a financial system at all. Rather, it’s an energy system, driven by the relationship between (a) the amount of energy to which we have access, and (b) the proportion of that energy, known here as ECoE (the Energy Cost of Energy), that is consumed in the access process.

Properly understood, money acts simply as a ‘claim’ on the output of the energy economy, and driving up the aggregate of monetary claims only increases the scope for their elimination in a process of value destruction.

We’ve been here before, most recently in 2008, and still haven’t learned the brutal consequences of creating financial claims far in excess of what a deteriorating economy can deliver.

The next wave of value destruction – likely to include collapses in the prices of stocks, bonds and property, and a cascade of defaults – cannot much longer be delayed.

What, though, is happening to the real, energy-driven economy? My energy-based economic model, the Surplus Energy Economics Data System (SEEDS), is showing a worsening deterioration, and now points to a huge and widening gap between where the economy really is and the narrative being told about it from the increasingly unreal perspective of conventional measurement.

The latest iteration, SEEDS 20, highlights the spread of falling prosperity, with the average person now getting poorer in 25 of the 30 countries covered by the system, and most of the others within a very few years of joining them..

To understand why this is happening, there are two fundamental points that need to be grasped.

First, the spending of borrowed money doesn’t boost underlying economic output, but simply massages reported GDP into apparent conformity with the narrative of “perpetual growth”.

Second, conventional economics ignores the all-important ECoE dimension of the energy dynamic that really drives the economy.

Overstated output – GDP and borrowing

Ireland is an interesting (if extreme) example of the way in which the spending of borrowed money, combined in this case with changes of methodology dubbed “leprechaun economics”, has driven recorded GDP to levels far above a realistic appraisal of economic output.

According to official statistics, the Irish economy has grown by an implausible 62% since 2008, adding €124bn to GDP, and, incidentally, giving the average Irish citizen a per capita GDP of €66,300, far higher than that of France (€36,360), Germany (€40,340) or the Netherlands (€45,050).

What these stats don’t tell you is that, over a period in which Irish GDP has increased by €124bn, debt has risen by €316bn. It’s an interesting reflection that, stated at constant 2018 values, Irish debt is 85% higher now (at €963bn) than it was on the eve of the GFC in 2007 (€521bn).

When confronted with this sort of mix of GDP and debt data, two questions need to be asked.

First, where would growth be if net increases in indebtedness were to cease?

Second, where would GDP have been now if the country hadn’t joined in the worldwide debt binge in the first place?

Where Ireland is concerned, the answers are that trend growth would fall to just 0.4%, and that underlying, ‘clean’ GDP (C-GDP) would be €212bn, far below the €324bn recorded last year.

In passing, it’s worth noting that this 53% overstatement of economic output has dramatic implications for risk, driving Ireland’s debt/GDP ratio up from 297% to 454%, and increasing an already-ludicrous ratio of financial assets to output up from 1900% to a mind-boggling 2890%.

These ratios are rendered even more dangerous by a sharp rise in ECoE, but we can conclude, for now, that the narrative of Irish economic rehabilitation from the traumas of 2008 is eyewash. Indeed, the risk module incorporated into SEEDS in the latest iteration rates the country as one of the riskiest on the planet.

Though few countries run Ireland close when it comes to the overstatement of economic output, China goes one further, with GDP (of RMB 88.4tn) overstating C-GDP (RMB 51.1tn) by a remarkable 73%. Comparing 2018 with 2008, Chinese growth (of RMB 47.2tn, or 115%) has happened on the back of a massive (RMB 170tn, or 290%) escalation in debt. SEEDS calculations put Chinese trend growth at 3.1% – and still falling – versus a recorded 6.6% last year, and put C-GDP at RMB 51tn, 42% below the official RMB 88.4tn. Essentially, 62% (RMB 29tn) of all Chinese “growth” (RMB 47tn) since 2008 has been the product of pouring huge sums of new liquidity into the system.

In each of the last ten years, remarkably, Chinese net borrowing has averaged almost 26% of GDP, a calculation which surely puts the country’s much-vaunted +6% rates of “growth” into a sobering context. After all, GDP can be pretty much whatever you want it to be, for as long as you can keep fuelling additional ‘activity’ with soaring credit. Even second-placed Ireland has added debt at an annual average rate of ‘only’ 13.5% of GDP over the same period, with Canada third on this risk measure at 11.5%, and just three other countries (France, Chile and South Korea) exceeding 9%. China and Ireland are the countries where cosmetic “growth” is at its most extreme.

Fig. 1 sets out a list of the ten countries in which GDP is most overstated in relation to underlying C-GDP. The table also lists, for reference, these countries’ annual average borrowing as percentages of GDP over the past decade, though it’s the relationship between this number and recorded growth which links to the cumulative disparity between GDP and C-GDP.

Fig. 1

#157 SEEDS C-GDP

Of course, C-GDP is a concept unknown to ‘conventional’ economics, to governments or to businesses, which is one reason why so much “shock” will doubtless be expressed when the tide of credit-created “growth” goes dramatically into reverse.

Those of us familiar with C-GDP are likely to be unimpressed when we hear about an “unexpected” deterioration in, and a potential reversal of, “growth” of which most was never really there in the first place.

The energy dimension – ECoE and prosperity

Whilst seeing through the use of credit to inflate apparent economic output is one part of understanding how economies really function, the other is a recognition of the role of ECoE. The Energy Cost of Energy acts as a levy on economic output, earmarking part of it for the sustenance of the supply of energy upon which all future economic activity depends.

As we have discussed elsewhere, depletion has taken over from geographic reach and  economies of scale as the main driver of the ECoEs of oil, gas and coal. Because fossil fuels continue to account for four-fifths of the total supply of energy to the economy, the relentless rise in their ECoEs dominates the overall balance of the energy equation.

Renewable sources of energy, such as wind and solar power, are at an earlier, downwards point on the ECoE parabola, and their ECoEs are continuing to fall in response to the beneficial effects of reach and scale. The big difference between fossil fuels and renewables, though, is that the latter are most unlikely ever to attain ECoEs anywhere near those of fossil fuels in their prime.

Whereas the aggregated ECoEs of oil, gas and coal were less than 2% before the relentless effects of depletion kicked in, it’s most unlikely that the ECoEs of renewables can ever fall below 10%. One of the reasons for this is that constructing and managing renewables capacity continues to depend on inputs from fossil fuels. This makes renewable energy a derivative of energy sourced from oil, gas and coal. To believe otherwise is to place trust in technology to an extent which exceeds the physical capabilities of the resource envelope.

This, it must be stressed, is not intended to belittle the importance of renewables, which are our only prospect, not just of minimizing the economic impact of rising fossil fuel ECoEs, but of preventing catastrophic damage to the environment.

Rather, the error – often borne of sheer wishful thinking – lies in believing that renewables can ever be a like-for-like replacement for the economic value that has been provided by fossil fuels since we learned to harness them in the 1760s. The vast quantities of high-intensity energy contained in fossil formations gave us a one-off, albeit dramatic, economic impetus. As that impetus fades away, it would be foolhardy in the extreme to assume that the economy can, or even must, continue to behave as though that impetus can exist independently of its source.

For context, SEEDS studies show that the highly complex economies of the West become incapable of further growth in prosperity once their ECoEs enter a range between 3.5% and 5.5%.

As fig. 2 shows, the first major Western economy to experience a reversal of prior growth in prosperity per capita was Japan, whose deterioration began in 1997. This was followed by downturns in France (from 2000), the United Kingdom (2003), the United States (2005) and, finally, Germany, with the deterioration in the latter deferred to 2018, largely reflecting the benefits that Germany has derived from her membership of the Euro Area.

Fig. 2

#157 SEEDS ECoE prosp advanced

Less complex emerging economies have greater ECoE tolerance, and are able to continue to deliver growth, albeit at diminishing rates, until ECoEs are between 8% and 10%. These latter levels are now being reached, which is why prosperity deterioration now looms for these economies as well.

As fig. 3 illustrates, two major emerging economies, Mexico and Brazil, have already experienced downturns, commencing in 2008 and 2013 respectively. Growth in prosperity per person is projected to go into reverse in China from 2021, with South Korean citizens continuing to become more prosperous until 2029. The latter projected date, however, may move forward if the Korean economy is impacted by worldwide deterioration to a greater extent than is currently anticipated by SEEDS.

Fig. 3

#157 SEEDS ECoE prosp emerging

Consequences – rocking and rolling

As we’ve seen, then – and for reasons simply not comprehended by ‘conventional’ interpretations of the economy – worldwide prosperity has turned down, a process that started with the more complex Western economies before spreading to more ECoE-tolerant emerging countries.

For reasons outlined above, no amount of financial tinkering can change this fundamental dynamic.

At least three major consequences can be expected to flow from this process. Though these lie outside the scope of this analysis, their broad outlines, at least, can be sketched here.

First, we should anticipate a major financial shock, far exceeding anything experienced in 2008 (or at any other time), as a direct result of the widening divergence between soaring financial ‘claims’ and the reality of an energy-driven economy tipping into decline. SEEDS 20 has a module which provides estimates of exposure to value destruction, though its indications cannot do more than suggest orders of magnitude. Current exposure is put at $320tn, far exceeding the figure of less than $70tn (at 2018 values) on the eve of the GFC at the end of 2007. This suggests that the values of equities, bonds and property are poised to fall very sharply indeed, something of a re-run of 2008, though with the critical caveat that, this time, no subsequent recovery is to be anticipated.

Second, we should anticipate a rolling process of contraction in the real economy of goods and services. This subject requires a dedicated analysis, but we are already witnessing two significant phenomena.

Demand for “stuff” – ranging across a gamut from cars and smartphones to chips and components – has started to fall, a trend likely to be followed by falling requirements for inputs.

Meanwhile, whole sectors of industry, including retailing and leisure, have experienced severe downturns in profitability. Utilization rates and interconnectedness are amongst the factors likely to drive a de-complexifying process that is a logical concomitant of deteriorating prosperity. This in turn suggests that a widening spectrum of sectors will be driven to and beyond the threshold of viability.

Finally, the political challenge of deteriorating prosperity is utterly different from anything of which we have prior experience, and it seems evident that this is already contributing to worsening unrest, and to a challenge to established leadership cadres. This process is likely to relegate non-economic agendas to the lower leagues of debate, and has particular implications for policy on redistribution, migration, taxation and the provision of public services.

My intention now is to use SEEDS to provide ongoing insights into some of the detail on issues discussed here. If we’re right about the economic direction of travel, what lies ahead lies quite outside the scope of past experience or current anticipation.   

 

#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

#1567 Global

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

#1567 US vs China

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.

 

#152: Stuffed

WHY THE MONETARY LIFEBOAT WON’T FLOAT

The global financial system has come to rest on a single complacent assumption, one which is seldom put explicitly into words, but is remarkably implicit in actions.

This assumption is that the authorities have, and are willing to deploy, a monetary ‘fix’ for all ills.

Accordingly, the system has come to be seen as a bizarre casino, in which winning punters keep their gains, but losers are sure that they’ll be reimbursed at the exit-door.

So ingrained has this assumption become that it’s almost heresy to denounce it for the falsity that it is.

The theme of this discussion is simply stated. It is that the complacent assumption of a monetary fix is misplaced. The authorities, faced with a crash, might very well try something along these lines, and might even adopt one or more of its most outlandish variants.

But it won’t work.

The reason why no monetary expedient can provide a “get out of gaol free” card is that the economy and the financial system are quite different things.

The complacent rush in  

You can see financial manifestations of mistaken complacency wherever you look.

It emboldens those who have lent most of the $2.9 trillion that, over the last five years, American companies have ploughed into the insane elimination of flexible equity in favour of inflexible debt.

It informs those who pile into the shares of cash-burners, or queue up to buy into overpriced IPOs.

It reassures those long of JPY, despite the monetization of more than half of all outstanding JGBs by the BoJ.

It tranquilizes those who, unable to see the contradiction between gigantic financial exposure and a stumbling economy, remain long of GBP.

It blinds those to whom the Chinese economic narrative remains a miracle, not a credit-fueled bubble.

The aim here is a simple one. It is to counter this complacency by explaining why economic problems cannot be solved with monetary tools, and to warn that efforts to do so risk, instead, the undermining of the credibility of currencies.

A casino which hands back losers’ money belongs in the realm of pure myth.

The secondary status of money

Money has no intrinsic worth. Someone adrift in a lifeboat in mid-Atlantic, or stranded in the Sahara, would benefit from an air-drop of food or water, but even a gigantic amount of money descending on a parachute would do nothing more than allowing him or her to die rich.

Conventionally, money has three roles, but only one of these is relevant. Fiat money has been an atrociously bad ‘store of value’, and money is a very flawed ‘unit of account’. Money’s only relevant role is as a ‘medium of exchange’.

For this to work, there has to be something for which money can be exchanged.

This means that money has no intrinsic worth, but commands value only as a claim on the products of the economy. If you build up a structure of claims that the economy cannot honour, then that structure must – eventually, and in one way or another – collapse.

Conceptually, it’s useful to think in terms of ‘two economies’. One of these is the ‘real’ economy of goods and services, its operation characterised by the use of labour and resources, but its performance ultimately driven by energy.

The other is the ‘financial’ economy of money and credit, a parallel or shadow of the ‘real’ economy, useful for managing the real economy, but wholly lacking in stand-alone substance.

To be sure, the early monetarists oversimplified things with the assertion that inflation could be explained in wholly quantitative monetary terms. The price interface between money and the real economy isn’t determined by the simple division of the quantity of economic goods into the quantity of money.

Rather, it’s the movement or use of money that matters. The quantitative recklessness of Weimar would not have triggered hyperinflation had the excess been locked up in a vault, or in some other way not put to use. It’s not hair-splitting, but an important distinction, that Weimar’s true downfall was not that excess money was created, but that it was created and spent.

The process of exchange, which really defines the role of money, makes the interface dynamic, and, as such, introduces behavioural considerations. The creation of very large amounts of new money needn’t destabilize the price equilibrium if people hoard it, but a lesser increment can be extremely destabilizing if is spent with exceptional rapidity. This is why the simple quantitative interpretation needs to be modified by the inclusion of velocity, making Q x V a much more useful monetary determinant.

Behaviourally, velocity falls when people turn cautious – they did this during and after the 2008 global financial crisis (GFC), a tendency which reduced the inflationary risk of the loose money responses deployed at that time.

Even so, claims that the monetary adventurism unleashed at that time did not trigger inflation are simply untrue, unless you accept a narrow definition of inflation. To be sure, retail prices haven’t surged since 2008, but asset prices most certainly have, the truism being that the inflationary effects of the injection of money turn up at the point at which the money is injected.

Additionally, inflation is influenced by expectations – which have been low in an era of ’austerity’ – and by the performance of the economy. An economy which is performing weakly puts downwards pressure on inflation.

What it does not do, though, is to eliminate latent inflation. Any erosion of faith in the reliability of money would cause velocity to spike, as people rush out to spend it whilst it still has value.

Fiat fallacy

One of the analytically adverse side-effects of monetary manipulation is that it inflates apparent activity. Globally, and expressed in constant 2018 PPP dollars, the $34tn increase in recorded GDP since 2008 cannot be unrelated to the $110tn escalation in debt over the same period. According to SEEDS, most (67%) of the “growth” recorded over that period was nothing more than the simple effect of spending borrowed money.

This matters, first because a cessation in credit injection would undermine supposed rates of “growth” and, second, because a reversal would put much prior “growth” into reverse.

By falsifying GDP, this ‘credit effect’ also falsifies any relationships based on it – so the ‘comfortable’ 218% global ratio of debt-to-GDP masks a real ratio which is nearer to 340%, and higher by more than 100% than it was ten years ago (236%). It also distorts the measurement of financial exposure, so lulling us into misplaced insouciance about those countries (such as Ireland and Britain) whose financial assets stand at huge multiples to the real value of their economies.

Behind the mask of ‘the credit effect’, global economic performance is at best lacklustre, growing at about 0-9-1.3% annually whilst population numbers are growing by 1.0%.

Moreover, these numbers disguise regional disparities – whilst the average Chinese or Indian citizen continues to become more prosperous (for now, anyway), the average Westerner has been getting poorer for at least a decade.

Of course, there’s a countervailing ‘wealth effect’, giving false comfort to those whose assets have soared in price – and few, if any, of them appear to wonder what would happen if there was a rush to monetize inflated values.

But the drastic distortion in the relationship between asset values and incomes has real downsides exceeding its (illusory anyway) upside. Policymakers and their advisers may remain ignorant of the deterioration in Western prosperity, but to voters it is all too real, something which has been a major contributor to those changes in voter responses which have informed “Brexit”, Mr Trump’s ascent to the White House, and the rolling repudiation of established political parties across much of Europe.

The decline of “stuff”

The weakness of the underlying picture has now started showing up unmistakeably in weakening in demand for everything from cars, domestic appliances and smartphones to chips and drive-motors. Logically, deterioration in the economy of “stuff” will extend next into commodities because, if you’re making less “stuff”, you need less minerals, less plastics and, critically, less energy with which to make it.

Whilst all of this is going on in plain view, markets and policymakers alike are failing to recognize the risks implicit in the widening gap between a stumbling economy and escalating financial exposure. As well as borrowing an additional $110tn since 2008, we’ve blown a not-dissimilar-sized hole in pension provision, because the same low cost of capital which has incentivized borrowing has also crippled the rates of return on which pension accrual depends.

Additionally, of course, the prices of equities and property have reached heights from which any descent into rationality would have devastating direct and collateral consequences.

When the next crisis (GFC II) shows up, the complacent expectation is that everything can be ‘fixed’ with even looser monetary policy. Some of the more bizarre suggestions aired in 2008 – including ‘helicopter money’, and NIRP (negative interest rate policy, with its implicit need to outlaw cash) – will doubtless come to the fore again, accompanied by a whole crop of new ‘innovations’. The authorities are likely, in the stark despair which follows protracted denial, to act on at least some of these follies.

The trouble is that it won’t work.

You might as well try to rescue an ailing pot-plant with a spanner as try to revive an ailing economy with monetary innovation.

The form that failure takes need not necessarily involve massive inflation, though this is the only non-default route down from the debt mountain. Authorities capable of believing that EVs are “zero emissions”, or that we can overcome the environmental challenge with some form of “sustainable growth” (rather than degrowth), are perfectly capable of also believing that we can fix economic problems with monetary recklessness.

If inflation doesn’t spoil the party, two other factors might. One is credit exhaustion, in which massively indebted borrowers refuse to take on yet more debt, irrespective of how cheap the offer may be.

The other factor might well be a loss of faith in money, which might also be accompanied by a ‘flight to quality’, perhaps favouring the dollar (as ‘the prettiest horse in the knackers’ yard’), whilst hanging weaker currencies out to dry.

However it pans out, though, we know that an economy whose prosperity is faltering cannot indefinitely sustain an ever-growing burden of financial promises. By definition, whatever is unsustainable eventually fails, and this is as true of monetary systems as of anything else.