#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.

#143 01

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.

#143 02

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.

#143 03

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.

#143 04

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.

#143 05

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?

 

#142: Past, present and future

LOOKING BACK AND LOOKING FORWARD

As we near the end of a year that can certainly be called ‘interesting’, I’d like to reflect on what’s happened, what’s happening now, and what we might expect to happen going forward. I can’t be sure that this is the last article for 2018 but, in case it is, I’d like to thank everyone for their interest, their comments and their many invaluable contributions to the themes we discuss here – and, of course, to wish you a very merry Christmas and a happy and successful New Year.

Where Surplus Energy Economics, this site and SEEDS are concerned, this has been a memorable year. SEEDS – the Surplus Energy Economics Data System – was finally completed in early 2018, and, amongst other things, this has freed up time for more thematic analysis. It’s both humbling and gratifying to know that about 44,000 people have visited the site this year, another big increase over the preceding twelve months. Most importantly – though this is for you to judge – I like to think we’ve developed a pretty persuasive narrative of how the economy works, and how things are trending.

We can take less satisfaction in what we see around us. According to SEEDS, most of the Western economies have now been getting poorer for at least a decade – and, ominously, the ability of the emerging market economies to grow enough to offset this deterioration, and keep global prosperity static, seems to have ended. World prosperity per person has been on a remarkably long plateau at around $11,000 (constant values, PPP-converted), but has now started to erode.

Deteriorating prosperity might be ‘a new fact’ in the world as a whole, but it’s an established reality in the West – with the single exception of Germany (rather a special case), no developed economy covered by SEEDS has enjoyed any improvement in prosperity at all since 2007. In most cases, the decline in personal prosperity has been happening for longer than that. But our societies seem to have learned almost nothing about what’s going on – and, until the processes are understood, crafting effective responses is impossible.

Historians of the future are likely to be bemused by our futile efforts to escape from the energy dynamic in the economy. From the turn of the millennium, we started pouring ever larger amounts of debt into the system. This led, with utter inevitability, to the 2008 global financial crisis (GFC I).

Undeterred, we then compounded cheap and abundant debt with ever cheaper money, yet the inevitable consequences of this process will still, no doubt, be declared both ‘a surprise’ and ‘a shock’ when they happen. We surely should know by now that we have an “everything bubble” propped up by ultra-cheap money, and that bubbles always burst. If there’s any sense in which “this time is different”, it is that, since 2008, we’ve taken risks not just with the banking system, but with money itself.

The death of debt?

There’s one theme which, though we’ve touched on it before, really needs to be spelled out. Throughout the era of growth, we’ve come to accept the process of borrowing and lending as a natural component of our economic system. Indeed, this practice long pre-dates the industrial age, when borrowing and lending, which then was more commonly called “usury” (the lending of money for interest), began to be de-criminalised after Christian Europe had been shaken up by the Reformation.

Leaving theological and ethical issues aside, we need to be clear that the process of borrowing and lending is a product of growth, because debt can only ever be repaid (and, indeed, serviced) where the prosperity of the borrower grows over time.

For simplicity, we can divide debt into two categories. If someone borrows money to expand a successful business, it is the growth in the income of the business which alone enables interest to be paid and the capital amount, too, to be reimbursed in due course. This is termed “self-liquidating debt”.

“Non-self-liquidating debt”, on the other hand, is typified by the loans consumers take out to pay for a holiday, buy a car or replace a domestic appliance. Here, the borrower is buying something which he or she cannot afford out of current income, and the only way in which this can be repaid is if the borrower’s prosperity increases over time.

Take away the assumed growth in prosperity, however, and both forms of borrowing cease to be viable. “Self-liquidating” debt assumes that an expanded business can earn greater profits, but it’s hard to count on this when potential customers are getting poorer. As for “non-self-liquidating” debt, the all-important rise in the borrower’s means can no longer be relied upon when people generally are getting poorer.

In short, the very process of borrowing and lending is likely to be stripped of its viability as prosperity declines. This should be an extremely sobering thought in a world which is awash with debt, and where supplying cheap credit is seen as a panacea for economic stagnation.

You might well ponder at least two things about this. First, what happens to the large quantities of debt owed by those Western economies whose prosperity has already moved significantly along the downwards curve? Second, what happens to asset prices in a world where the credit impetus goes into reverse?

Reflecting on the essential linkage between debt and growth, you might also wonder why we’re not already seeing the debt edifice crumbling. There are two main answers to this. The first is that the debt structure has been buttressed by de-prioritising another form of futurity – simply put, we’ve already created huge (and burgeoning) gaps in pension provision as part of the price of preserving the edifice of debt.

The second answer is simpler still – we’ve not seen the debt edifice start to crumble yet……

Feeling the pain

People across the Western world certainly seem to know that their prosperity is eroding, and they’re far from happy about it. We can see the effects both in political choices and in rising popular discontent. If you understand deteriorating prosperity, then you understand political events in America, Britain, Italy, France and far beyond – events which, if you didn’t understand the economic process, must seem both baffling and malign.

Though understandable, anger isn’t a constructive emotion, and what we really need is coolly analytical interpretation, understanding and planning. If it’s true that we’re not getting this from government, then it’s equally true that government reflects the climate of opinion. We can hardly expect governments to understand the economic realities when opinion-formers stick resolutely to conventional interpretation. It’s more surprising that conventional methods still command adherence as outcomes continue to diverge ever further from expectations.

Making glib promises is part and parcel of politics and, in fairness, those who don’t do this can expect to lose out to those who do. What is more disturbing is the continued promotion of economic extremism. Nationalising everything in sight won’t work, and neither will dismantling the state and turning the economy into a deregulated, ‘law of the jungle’ free-for-all.

Over the years, we’ve tried both, and should know by now that the lot of the ‘ordinary person’ isn’t bettered by these extremes. At least, when prosperity was still growing, we could live with the price of ideological purity – now that prosperity (in the West, at least) has turned down, though, these consequences are something that we can no longer afford.

If you think about it, the extremes either of collectivism or of ‘laissez faire’ have always been absurdly simplistic. Have we ever really believed that benign apparatchiks can manage things better than people can do for themselves? Or that unfettered ‘capitalism’, which concentrates wealth and power just as surely as collectivism, can do things better? Perhaps most importantly, why do so many of us persist in the view that possessions, material wealth and nebulous ideas of relative ‘status’ are a definition of happiness?

Logically, deteriorating prosperity means that we concentrate on necessities and dispense with some luxuries. Amongst the luxuries that we can no longer afford are ideological extremes, and an outlook founded wholly or largely on ownership and consumerism.

The need for ideas

The good news is that we’re not going into this new era wholly lacking in knowledge. The trick is to understand what that knowledge really is. Keynes teaches us how to manage demand – or can teach us this, so long as we don’t turn him into a cheerleader for ever bigger public spending. Likewise – if we can refrain from caricaturing him as a rabid advocate of unregulated and unscrupulous greed – Adam Smith tells us that competition, freely, fairly and transparently conducted, is the great engine of innovation. More humbly, or perhaps less theoretically, but surely more pertinently, experience tells us that the “mixed economy” of optimised private and public provision works far better than any extreme.

Going forward, we should anticipate the collapse of the “everything bubble” in asset prices, and should hope that we don’t, this time, go so far into economic denial as to think we can cure this with a purely financial “fix”. I’m fond of saying that “trying to fix an energy-based economy with financial fixes is like trying to cure an ailing pot-plant with a spanner”. We should understand popular concerns, which seem to point unequivocally towards a mixed economy, extensive redistribution and an economic nationalism that needs to be channelled, not simply vilified.

Another, positive point on which to finish is that a deterioration in prosperity needn’t prevent us – indeed, should compel us – to make better use of the prosperity that we do have. There’s no situation which can’t be made worse by rash decisions, or made better by wise ones. The forces described here – economic trends, and their political and social corollaries – all contain the seeds (no pun intended…) of divisiveness. This being so, cohesion and common purpose have never been so important.

Togetherness, and concern for the welfare of others, are, and certainly should be, part of the fabric of Christmas. Seldom can these characteristics have been more important than they are now.