#176. Protect and Survive

THE AUTHORITIES’ ‘RACE AGAINST TIME’

Before we can assess the outlook for the economy after the Wuhan coronavirus pandemic, we need to be familiar with the measures adopted by the authorities to tackle the crisis itself. Whilst these measures themselves are reasonably well-known, it seems that some of the associated risks are by no means so clearly understood.

Critically, governments and central banks face an imprecise (but undoubtedly critical) time-deadline which, if missed, could create an extraordinarily hazardous combination of circumstances.

The ‘standard model’ response

The coronavirus crisis, and the use of lockdowns in an effort to curb the spread of the virus, have posed two different challenges to the economy, and these have been met by two different types of response.

The more obvious and immediate impact has been the sharp fall in economic activity itself.

The second is the risk that households may lose their homes, and that otherwise-viable enterprises might be put out of business, by an inability to keep up with rent payments and debt servicing due to the temporary impairment of their incomes.

Official responses to these problems have involved, respectively, support and deferral.

Support has been provided by governments running extraordinary (and, in anything but the very short term, unsustainable) fiscal deficits in order to replace incomes, with these deficits essentially monetised by central banks’ use of newly-created QE money to acquire pre-existing government debt. The alternative, of course, would be for central banks to sit this out, and let government debts soar, but monetisation seems to have been judged, perhaps correctly, as the lesser of two evils.

Deferral, meanwhile, has taken the form of rent, debt and interest ‘holidays’, whose effect is to push such costs out into the future.

Fiscal support programmes are exemplified by the British situation, in which a deficit of £48bn limited, to ‘only’ 20.4%, a decline in April GDP which would otherwise have been a slump of close to 50%. A further deficit of £55bn during May pushed the two-months’ total to £103bn, a number remarkably (and surely by no means coincidentally) similar to the £100bn of QE thus far undertaken by the Bank of England.

A time-constrained expedient

Though there have been variations around this theme – most notably in the United States, where the Fed seems to have attached inordinate importance to the prevention of slumps in asset prices – there has been an identifiable ‘standard model’ of responses which combines deficit-funded support for the economy with central bank monetisation of equivalent amounts of existing public debt. Over the course of three months, the three main Western central banks – the Fed, the ECB and the Bank of Japan – have increased their assets by $4.5 trillion, or 31%, a sum equivalent to 10.5% of their aggregate annual GDPs.

Essentially, and despite some variations in the types of assets purchased, this amounts to the back-door monetisation of the new debts incurred to support economic activity. Although Japan has been getting away with wholesale debt monetisation for many years, this process nevertheless carries very real risks. If markets, and indeed the general public, ever came to think that the monetisation of deficits had become the ‘new abnormal’, the credibility and purchasing power of fiat currencies would be put at very serious risk.

This risk most certainly should not be underestimated – after all, the $2.9tn of asset purchasing undertaken by the Fed between February and May equates, on an annualised basis, to 55% of American GDP, with the equivalent ratios for other areas being 39% in Japan, 32% in the Euro Area and 23% in Britain.

If any of these central banks actually did monetise debt at these ratios to GDP over a whole year, currency credibility would suffer grievous impairment.

A race against time

This ‘standard model’ of support response, then, is a time-constrained process, viable for a single quarter, and perhaps for as much as six months, but not for longer.

Meanwhile, there are obvious time constraints, too, on a deferral process which imposes income delays on counterparties such as lenders and landlords.

If all goes well, a reasonably rapid economic recovery will enable governments and central banks to scale back deficits and monetisation before this process risks impairing credibility. An optimistic scenario would postulate that, by the time that this normalization has been concluded, the authorities will also have worked out how to wind up the deferrals process in ways that protect households and businesses without imperilling landlords and lenders.

There is, though, an all-too-plausible alternative in which deficit support is still being provided at a point when deferral is no longer feasible. This is a ‘nightmare scenario’ in which, as well as continuing to monetise high levels of fiscal deficits, central banks also have to step in to rescue lenders and landlords.

Thus understood, governments and central bankers are engaged in a race against time. They cannot carry on monetising deficit support for more than a few months, and neither can they prolong rent and interest deferrals to the point where landlords and lenders are put at risk. This makes it all the more surprising (and disturbing) that some countries are acting in ways that seem almost to invite a crisis-prolonging “second wave” of coronavirus infections.

 

 

#174. American disequilibrium

THE IMBALANCE MENACING THE US ECONOMY

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

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

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

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

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

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

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

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

At a crossroads

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

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

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

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

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

The economy – in search of reality

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

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

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

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

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

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

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

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

The faltering dynamic

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

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

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

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

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

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

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

Struggling in a trap

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

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

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

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

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

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

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

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

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

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

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

Faking it

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

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

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

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

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

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

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

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

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

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

The lethal disequilibrium

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

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

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

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

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

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

What now?

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

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

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

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

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

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

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

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

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

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

 

 

#168. Polly and the sandwich-man

SCOPING FINANCIAL RISK

By their very nature, events like the Wuhan virus epidemic (or whatever the history-books end up calling it) polarise opinions, some of which become ever more extreme as the crisis unfolds.

At one end of the spectrum, those who claimed that the coronavirus was just some kind of minor variant on ‘normal’ seasonal ailments are being taught a harsh lesson in reality.

At the other extreme, though, many continue to insist that this is an ‘existential’ event, from which neither the economy nor the financial system (or anything else that we hitherto took for granted) is going to emerge, at least in any recognizable form.

If you believed either of these things, you probably wouldn’t bother trying to plan, or, as is the case here, to try to ‘scope’ the course that economic and financial trends might take.

Generally, though, extremes, whether of optimism or of pessimism, usually turn out to be wrong. Neither the Pollyanna nor the Sandwich-Board Man approach is going to help. Whistling a cheerful tune isn’t going to give us greater visibility on the post-crisis situation, but neither is walking around wearing a placard proclaiming that “The End is Nigh”.

The rational and practical response is to reason from what we do know to what we need to know. This is why, in economics and finance, we do need to try to scope this crisis.

To do this effectively, it makes sense to adopt two working principles.

One of these is that we bring new thinking to bear, so that we’re not just playing new tunes on the broken fiddle of ‘conventional’ economics.

The other is that we’re clear about the limitations imposed by the uncertainties implicit in the situation.

This is where ‘scoping’ differs from prediction. What follows doesn’t try to forecast what will happen, just to set some parameters on what might.

From troubled skies

Though the epidemic itself couldn’t have been anticipated, many of us have long recognised that trends and conditions pointing towards “GFC II” – a different and more extreme sequel to the 2008 global financial crisis (GFC) – were already in place.

A condensed version of this narrative is that the authorities responded to the “secular stagnation” of the late 1990s, first with ‘credit adventurism’, and latterly with ‘monetary adventurism’ as well. Where the former put the credit (banking) system at risk, the latter called into question the viability of the entire fiat monetary structure. Beyond buying some time (at a very hefty price), neither expedient has achieved anything worthwhile, but has inflicted an enormous amount of damage along the way.

It is, indeed, reasonable to conclude that we’ve spent more than two decades packing dynamite into the foundations of the financial structure.

Signs that economic reality might have started to break through had become apparent well before the current crisis erupted. Sales of everything from cars and smartphones to chips and components had already turned down, world trade in goods was already shrinking, and severe financial stresses were already emerging, particularly in China, and in some of the more irrational parts of the global ‘cheap money’ economy.

This is why, rather than having hit us out of blue skies, this crisis is really a bolt from the grey. Whether people had noticed these gathering dark clouds largely depended on whether they were looking at the situation from a point of view founded in reality, or were still persuaded by the ‘conventional’ tarradiddle that there was nothing too abnormal in the situation (or, at any rate, nothing so abnormal that it couldn’t be handled by our omnipotent, omniscient central bankers).

The energy perspective

These past exercises in ‘adventurism’ have had a shared assumption, which has resulted from a fundamental misconception about how the economy really works.

In order to believe that we can boost the performance of the economy by financial gimmickry – whether by pouring cheap credit into the system, or by flooding it with even cheaper liquidity – you’d have to start by assuming that the economy is a wholly financial system. If this assumption was correct, you could conclude that fiscal and monetary policy are the effective levers of control.

In reality, of course, these assumptions are mistaken. An economy that exists wholly in the realm of the human artefact of money – and is unrelated to the physical world in which we live – is a fiction.

As regular readers will know, my approach is based on the understanding that the economy is not a financial system, but an energy dynamic.

Briefly stated, the surplus energy interpretation of the economy has three central tenets.

The first is that nothing of any economic utility whatsoever can be produced without the use of energy.

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

The third part of this “trilogy of the blindingly obvious” is that money has no intrinsic worth, and commands value only as a ‘claim’ on the output of the ‘real’ (energy) economy.

The credit connection

From this understanding, we can start with the observation that financial ‘claims’ have grown far more rapidly than the ‘real’ economy on which such claims can be honoured. Comparing data for 2018 with the numbers from 2008 reveals that each $1 of reported “growth” in the global economy over that decade was accompanied by $3 of net new borrowing.

The crucial interconnectedness in this situation is that pouring money and credit into the system doesn’t just increase the aggregate of financial claims, but also inflates the apparent size of the economy itself.

The ways in which this happens can be re-visited at a later date, but what we need to know now is that it happens.

The chart below illustrates this relationship. The vertical axis shows percentage growth in GDP during the years since the 2008 global financial crisis (GFC), whilst the horizontal shows annual borrowing, as a percentage of GDP, over the same period.

The clear outlier here is China, whose annual growth has been around 7%, but whose annual rate of borrowing has been about 25% of GDP. This is why slightly more than doubling Chinese GDP (+115%) required a near-quadrupling of debt (+290%), and why borrowing has exceeded growth in the ratio 3.6:1.

The numbers for India look a lot better (though they’ve been worsening for some time), because the country has achieved strong growth without a dramatic recourse to borrowing. Both France and Japan are on the negative side of the trend-line, borrowing a lot, but getting precious little growth in return.

Fig. 1

Individual economies aside, though, the critical observation which emerges from this is that ‘the more you borrow, the more apparent growth you can report’.

Most of the countries shown on the chart – and the world and regional aggregates, too – are at, or close to, a trend-line which connects the extent of borrowing with the quantity of GDP growth that has been reported.

What this means, as it applies to current circumstances, is that the numerator of debt (and, for that matter, of broader commitments), and the denominator of GDP, are not discrete, but are linked together.

Upwards tendencies in debt have had an inflationary effect on apparent GDP. This means that a straightforward ratio which compares debt with GDP is extremely misleading because, when you increase the one, you simultaneously increase the other.

This in turn means that debt/GDP ratios operate in ways which tend towards complacency.

The prosperity benchmark

Energy-based calibration of prosperity, as undertaken by the SEEDS model, is designed to provide a measure of economic output which, as well as taking ECoE into account, is distinct from this ‘credit pull’.

The result is to revise the interpretation of economic trends, indicating that, rather than ‘an economy of $87tn, growing at 3% annually’, we entered this crisis with ‘an economy of $53tn, that is hardly growing at all’.

Taking non-government debt as an example, let’s examine the implications of this approach.

During 2009, nominal world GDP was $60tn, whilst private debt was $85tn, for a debt/GDP ratio of 141%. Since then, both debt and GDP are supposed to have grown by just over 20% in real terms, which means that the ratio between them (shown in blue in fig. 2) seems hardly to have changed at all.

When we shift the basis of calibration from GDP to prosperity, though, the resulting calculus is both very different, and a great deal more cautionary.

Compared with a real increase of 23% in private debt, aggregate world prosperity hasn’t actually grown at all since the GFC. One reason why this is so different from the narrative of “growth” is that most of the headline increases in GDP have been the simple consequence of spending borrowed money.

The other is that ECoEs have risen relentlessly, long since passing levels at which prior growth in Western prosperity goes into reverse, and, more recently, entering a band where the same thing starts to happen to the EM (emerging market) economies as well.

This means that the ratio which expresses GDP as a percentage of prosperity (shown in red) has expanded markedly, from 183% in 2009 (and 125% back in 2000) to a current level of just over 230%.

A reasonable inference from this is that the debt-to-prosperity ratio has moved a long way out of equilibrium, leaving it poised to fall back to a prior, much lower level.

Departure from debt equilibrium is, of course, exactly what you would expect to have happened after more than a decade in which people have been paid to borrow. But quirks in the calculations which use GDP as a measure of debt exposure have served to disguise this critical trend.

Indeed, when you take this enormous process of subsidised borrowing into account, any suggestion that proportionate indebtedness hasn’t increased becomes wholly counter-intuitive.

An understanding of this principle enables us to scroll back across the years of financial excess in search of ratios which might represent a sustainable equilibrium.

This same calculation, when expressed as debt aggregates in constant dollars (as in the right-hand chart), suggests that a sharp decrease in outstanding non-government debt might have become inescapable.

Unless we’re prepared to assume that dramatic inflationary effects will destroy the real value of debt (a ‘soft default’), the implication is that we may be facing a process of extensive default, for which the term used here is a default cascade.

Fig. 2

The bigger picture

Before we move on (in future discussions) to consider what a default cascade might look like in practice, it’s important to note that formal debt doesn’t, by any means, capture the full extent of financial exposure. A better way to look at this is to reference financial assets or, more specifically, the aggregate of such assets excluding those of the central banks.

Financial asset exposure, always important, has taken on renewed significance during the uncertainties of the epidemic, and a causal link can be identified between, for example, the extremity of British financial exposure and recent sharp falls in the value of Sterling. Private financial assets stand at 1100% of British GDP, whereas the ratio for the United States is only 460%, so a fall in the value of the pound against the dollar is a wholly logical response to extreme financial uncertainty.

At the global level, financial assets data for countries accounting for about 80% of the world economy is available, and this data puts private financial assets at 450% of GDP. This a number which, like the debt/GDP ratio, hasn’t worsened since 2009.

Expressed against prosperity, however, this metric has expanded, because real financial assets have grown (by about 15%) over a decade in which prosperity hasn’t increased at all.

If, as we did with debt, we track back across the years of excess in search of the equilibrium ratios towards which a return might seem likely, the inference is that, like debt, the broader class of financial assets may face a severe retrenchment and this, again, points to various forms of default.

Clear and present danger

In what is intended as a scoping exercise, attaching numbers to these interpretations requires the caveat that our conclusions must recognise the extremity of uncertainty implicit in current conditions.

Indications from SEEDS-based analysis suggest that we should not be too surprised if debt of $60tn, and broader financial assets of an additional $100tn, are at risk.

These, as stated earlier, are scoping numbers, not forecasts.

Even so – and given the sheer scale of what we know is happening to the economy – these numbers need not seem all that surprising. The Pollyannas out there might say that little or none of this is actually going to happen, whilst the words “Told you so!” might be added to the doomsters’ sandwich-boards. The strong likelihood is that, in finance at least, the sandwich-boarders are a lot nearer the reality than the ditty-whistlers.

On the basis of this scoping exercise, we can anticipate that the global financial system could be facing a hit of $160tn, which is 185% of GDP.

That might be something from which the economy itself could recover, albeit in a battered and bruised form.

But you’d have to be a long way towards the Pollyanna end of the axis of optimism to think that the financial system could survive without either severe inflationary effects or a systemically-dangerous process of default.

CORONAVIRUS – THE SCOPE OF FINANCIAL RISK

 

#167. Tests and correctives

VALUE AT RISK, OIL PRICES CRUSHED – A SYSTEM ON TRIAL

In any moment of crisis, it’s easy to be pulled two ways, between the immediate and the fundamental. But it helps when, as now, we can recognise that both themes meet at the same point.

In this sense, “the 2020 Wuhan crisis” (or whatever it ends up being called) has acted as a catalyst for severe risks built into the system over a protracted period of mismanagement, incomprehension, self-interest, hubris and sheer folly.

Just so that you know what’s coming, this discussion is going to concentrate on two issues.

The first of these is the scope for value destruction in the current situation. Here I believe that the use of an independent benchmarking system – based on energy economics – provides an advantage over the monocular, ‘the economy is money’, way of looking at these things.

The main theme here, though, is energy in general, and oil in particular.

On the one hand, the consensus assumption is that we’ll be doing more of every sort of activity (including driving and flying) that depends on having more energy (and more petroleum) in the future than we have now.

On the other, however – and even before the recent slump in oil markets – crude prices simply can’t support even the maintenance of oil supply, let alone the 10-12% increase seemingly required by consensus expectations.

What I aim to do here is to explore this contradiction.

Before we start, though, I’d like to apologise to anyone who, over the past two weeks or so, has wondered why their comments seem to have vanished into the ether, or why there seems to have been much less debate here than usual. What appears to have happened – for no apparent reason, and wholly outside my control – has been that most notifications of comments awaiting approval have ceased to reach me. For the time being, and as frequently as possible, I’m going to review the list of outstanding comments manually.

Short shock, long folly, value exposed

Right now, as markets and sentiment gyrate wildly, we’re watching a fascinating intersection between the immediate and the fundamental playing out before our eyes.

The system that’s being shocked by the coronavirus crisis was a system that was already in very bad shape, and we can be pretty certain that, if the catalyst hadn’t (or maybe hasn’t yet) come from Wuhan, it would have (or assuredly will) come from somewhere else.

As somebody might have said, ‘if you build a monster, don’t be surprised if it bites you’ – and as somebody once did say, “some days you eat the bear, some days the bear eats you, and other days you both go hungry”. I’ll leave it to you to decide what roles greed, incomprehension and sheer folly have played in the building of the financial monster.

One of the critical issues now has to be the potential for ‘value destruction’ in the current crisis. Amongst the advantages of having an alternative, non-financial (energy) approach to economics is that it provides a second basis of measurement (in this case, the SEEDS prosperity benchmark) for just this kind of contingency.

‘Value’ really falls into two categories. The first is largely ‘notional’, and covers assets such as equities and property. Since nobody could ever monetise the entirety of either asset class, these ‘values’ are functions of the changing narratives that we tell ourselves about what things are ‘worth’. No money actually leaves somebody’s bank account because of a slump in the market price of his or her property or share portfolio.

‘Real’ value, on the other hand, consists of defined commitments which may become incapable of being honoured. The obvious example now is debt, on which businesses or households may be forced to default because their sources of income have dried up.

My approach here has been to use the Surplus Energy Economics Data System (SEEDS) to scroll back through the long years of financial excess in search of reference point ratios more sustainable than those of today.

Without burdening you with too much detail on this, SEEDS-based calculations suggest that up to 60% of the world’s private debt could be at risk, with the exposure of the broader structure of other financial assets at about 70%. My calculations are that up to $70 trillion of debts, and as much as $190tn of broader financial commitments, may be exposed.

Huge though they are, it must be emphasised that these are estimates of the scope for ‘value destruction’ – and how much of this scope turns into real losses depends upon many variables, chief amongst them being the duration and severity of the virus crisis, and the policies adopted by the monetary and fiscal authorities.

Assuming that these authorities act with more wisdom than they’ve exhibited so far – and stop firing off their scant remaining rate policy ammunition before the target comes over the hill – then the outcome isn’t likely to be anywhere nearly this bad, and a full-blown cascade of defaults can be avoided. Meanwhile, it’s possible to see stock markets settling perhaps 40% below their pre-crisis levels, with property prices down by 30%.

This, of course, presupposes that decision-makers don’t resort to putting so much gas back into the balloon that it really does detonate, leaving us scattered with the fragments of exploded hubris. In essence, do we use this event to re-group, or do we insist on ‘irrationality as usual’, regardless of cost?

After all, with the levers of the system in the hands of people who actually think that over-inflated stock markets, and over-priced property markets, are both ‘good’ things, there’s almost no degree of folly that can wholly be ruled out.

Energy – cutting away the foundations

Properly considered, there are two separate market crises happening now, both of them linked to the Wuhan coronavirus event.

One of these is the wave of falls in global stock markets, which the Fed and other central banks are trying, Canute-style, to stem. It would be far better if markets were left to get on with it, with the official effort concentrated on getting businesses and households through the hiatus in their cash flows.

The other crisis – linked to the epidemic by the anticipated sharp fall in petroleum demand, though triggered by a spat between major producers – is the sharp fall in the price of crude oil.

Some observers have suggested that the fall in oil prices will offer some relief for consuming economies, whilst others point out that the oil sector itself is going to be hit by a wave of financial failures, just as much the same thing might be poised to happen across vast swathes of the rest of the economy. The real issue, though, is how much damage this is going to inflict on the oil and gas industry, and where it leaves the industry’s ability to invest.

For those of us who understand that the economy is an energy system, the link between these events takes on a fundamental significance. Oil may be “only” 34% of global primary energy consumption, but it continues to account for a lot more than 90% of all energy used in transport applications. Fossil fuels (FFs), meanwhile, still provide more than four-fifths of world energy supply, a number that has changed only fractionally over decades.

Enthusiasts and idealists might talk about a post-fossil economy, just as the airline industry tells us that it can continue to grow whilst moving towards zero net carbon emissions. But, in both of these instances, as in others, there’s a very big gap between aspiration and actuality.

In search of neutral ground, we can do worse than look at long-range energy demand projections from the International Energy Agency (IEA), the U.S. Energy Information Administration (EIA) and OPEC.

All three publish central case forecasts, essentially mixing consensus-based economic assumptions with the mix of policies in place around the world. In broad terms, all three are agreed that, unless there are changes to these central parameters, we’re going to be using 10-12% more oil in 2040 than we use today.

‘Please sir, can I have some more?’

If you look at these projections in greater detail, it further emerges that we’re going to be doing a lot more of the things for which oil, and energy more broadly, are pre-requisites.

We are, for example, going to be driving more, even though electrification should keep the rise in oil demand for road use pegged at single-digit percentages. By 2040, there are expected to be more than a billion (74%) more vehicles on the world’s roads than there are today. It seems to be assumed that, by then, about 40% of the global fleet will have been converted to EVs, but that will still see us using more oil on our roads – not less.

We’re also, it seems, going to be flying a lot more than we already do, requiring a lot more petroleum, despite an assumed pace of energy efficiency gains seemingly running at about 1.5% annually. My interpretation suggests that passenger-miles flown are expected to rise by about 90% over that same period, though, thanks to compounding efficiency gains, petroleum use in aviation is expected to rise by “only” about 38%.

Within the overall energy position, the expectation is that our consumption of primary energy will be about 28% greater in 2040 than it was in 2018. Within this increment (of 3,900 million tonnes of oil equivalent), about 12% (450 mmtoe) is expected to come from hydro, and 44% (1,720 mmtoe) from wind, solar and other forms of renewable energy (RE). Nuclear might chip in another 5% of the extra energy that we’re going to need.

But the remaining 39% or so of the required increase is going to have to come from expanded use of fossil fuels, some of it from oil though most of it from gas (though it’s also noteworthy that no reduction in our consumption of coal seems to be anticipated). From the above, it will hardly be a surprise (though it is certainly disturbing) that annual rates of CO2 emissions from the use of energy are expected to carry on rising.

If any of this is remotely likely, though, why are oil prices languishing around $30/b?

To be sure, we know that demand is going to be impacted by Wuhan, and that producers including Saudi and Russia are scrapping over who should absorb this downside. But oil prices were hardly robust, typically around $65/b, even before the epidemic became a significant factor.

The fact of the matter is that we simply cannot square oil prices of $30, or $60, or even $100, for that matter, with any scenario calling for increases in supply.

We all know that global oil supply has been supported by American shale production, which has in turn relied on subsidies from investors and lenders. Now, though, it’s becoming ever more apparent (as was set out in a recent official report from Finland) that even ‘conventional’ oil supply is in big economic trouble.

It’s a sobering thought that, were capital flows to dry up to the point where there was a complete cessation of new drilling, US shale liquids output would fall by about 50% within twelve months. But it’s an even more disturbing thought that, unless capital investment can be ramped up dramatically, conventional oil supply is going to erode, less spectacularly, perhaps, but relentlessly.

So here’s the question – how, under this scenario, are we supposed to find sources for an increase in oil supply going forward? More broadly, and with oil and gas generally produced by the same companies, can we really increase the supply of natural gas by more than 30% over the coming twenty years? And can we – and, for that matter, should we – be using just as much coal in 2040 as we do now?

No ‘get out of gaol free’ cards

Two suggestions tend to be offered in answer to such questions, so let’s get both of them out of the way now.

One of these is that the use of renewables – whose output is currently projected to rise from 560 mmtoe in 2018 to more than 2,280 mmtoe by 2040 – can grow even more rapidly than is currently assumed.

But the reality seems to be that meeting current assumptions – boosting hydro-electricity supply by 50%, and quadrupling power from other renewable sources – is already a tough ask. The unlikelihood of these ambitious targets being beaten is underscored in the figures.

Energy transition has been costed by IRENA at between $95 trillion and $110tn, the latter equivalent to 720x today’s equivalent of what it cost America to put a man on the Moon. This time, of course, it isn’t just rich countries that have somehow to find this level of investment, but poorer and middle-income nations, too.

Annual capital investment in REs was, in real terms, lower in 2018 than it had been back in 2011, mainly because prior subsidy regimes have tended not to be scalable in line with expansion. Yearly capacity additions, too, stalled in 2018.

The really critical snag with “big bang” transition is simple, but fundamental. RE technology has yet to prove itself truly “renewable”, because capacity creation, and the building of the related infrastructure, cannot yet be undertaken without the extensive use of fossil fuel energy in the supply of materials and components.

The second notion – which is that we can somehow “de-couple” the economy from the use of energy – is risible, even in an era in which we often seem to have “de-coupled” economic policy from reality. The EEB was surely right to liken the search for “de-coupling” to “a haystack without a needle”.

Until somebody can demonstrate how we can drive more, fly more, manufacture more goods and ship them around the world, build more capital equipment, and supply more of basics such as food and water, without using more energy, “de-coupling” will continue to look like a punch-line in search of a gag.

This is really a matter of physical limitations – and there’s no “app” for that.

Stand back………….

On the principle that “what can’t happen won’t happen”, we need to stand back and consider the strong possibility that the consensus of expectations for future energy supply is simply wrong.

Let’s assume, for working purposes, that RE supply does, as expected, expand by 2,170 mmtoe by 2040, and that hydro and nuclear, too, perform in line with consensus projections. In this scenario, supply of non-fossil fuel energy would, as specified, be higher by about 2,370 mmtoe in 2040 than it was in 2018.

At the same time, though, let’s make some rather more cautious assumptions, well supported by probabilities, about fossil fuels.

For starters, let’s assume that shale oil production doesn’t slump, and that other forms of oil production remain robust enough to keep total supplies roughly where they are now. This would mean that oil supply won’t have fallen by 2040, but neither will it have delivered the widely-assumed increase of 10-12%. Let’s further assume that gas availability rises by 15%, rather than by 30%, and that the use of coal falls by 10%.

In this illustrative scenario, fossil fuels supply remains higher in 2040 than it was in 2018, but by only about 300 mmtoe (+3%), instead of the generally-expected increase of 1,540 mmtoe (+13%). This in turn would mean that, comparing 2040 with 2018, total energy supply would be higher, not by the projected 28%, but by only about 19%.

…..and do less?

My belief is that this is a more realistic set of parameters than the ‘more of everything’ consensus about our energy future. If energy supply does grow by less than is currently assumed, growth in many of the things that we do with energy is going to fall short of expectations, too.

Let’s unpack this somewhat, to see where it might lead. First, if expectations for RE are achieved, we can carry on using more electricity, though not at past annual rates of expansion.

But less-than-expected access to oil would have some very specific consequences. With population numbers still growing, we’ll need to keep on increasing the supply of petroleum products to essential activities, such as the production, processing and distribution of food. You’ll know that my expectations for “de-growth” anticipate a lot of simplification and ‘de-layering’ of industrial processes, and there’s no reason why this shouldn’t apply to food supply. But it remains hard to see how we can supply more food from less oil.

In short, there are reasons to suppose that oil supply constraint is going to have a disproportionate and leveraged impact on the discretionary (non-essential) applications in which petroleum is used. At the same time, faltering energy supply – and a worsening trend in surplus energy, reflecting the rise in ECoEs – is likely to leave us a lot less prosperous than conventional, ‘economics is money’ projections seem to assume.

From here, it’s a logical progression to question, in particular, whether the assumption of continued rapid expansion in travel might, in reality, not happen. We could take – but, so far, haven’t taken – ameliorative actions, including limiting car engine sizes, and promoting a transition to public transport. My conclusion – which is tentative, but firming – is that we might be a lot nearer to ‘peak travel’ than anyone yet supposes.

The assumption right now seems to be that, as and when the virus crisis is behind us, we’ll go back to buying more cars and using them more often, flying more each year than we did the year before and, perhaps, rediscovering a taste for taking cruise-ship holidays.

Let’s just say that such an assumption might well prove to be a long way wide of the mark.

 

#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

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

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

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

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

Fig. 2

Response – going for broke

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

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

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

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

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

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

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

Conclusions and context

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

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

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

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

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

#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.

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.

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

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

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

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.   

 

#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.

#151: The Great (brick) Wall of China

HOW SERIOUS IS THE CHINESE DOWNTURN?

For more than ten years, capital markets have had one perennial obsession, with Wall Street, in particular, rising or falling with the latest change of sentiment over Fed rate policy. Now, though, a new fixation has taken over, with stock markets reacting to every slightest positive or adverse nuance in trade talks between China and the United States.

These obsessions share an irony, which is that the outcome of neither has ever been in much doubt.

On rate policy, and even when Fed comments have been at their most bullish, there’s never been much real chance of rates rising back towards what, pre-2008, was considered “normal”. After a ten-year-long debt binge, followed by more than a decade of ultra-loose monetary policy, the American and world economies are locked into an abnormality which must continue until it reaches its culminating failure.

Pushing rates up to, say, 250bps above inflation would crash the economy, and everybody knows it. At each and every downturn in sentiment and performance, central banks are going to reach for the taps, until either credit exhaustion, and/or the loss of faith in money, puts the experiment of ‘financial adventurism’ out of its misery – and, if we’re lucky, triggers ‘the great reset’.

With Sino-American trade, the probabilities are equally loaded, and there’s never been any real chance at all of a meaningful agreement being reached between Washington and Beijing. The reality is that, for reasons seldom understood by Western observers,  but explained here, China simply cannot agree to terms that would satisfy the White House.

Through the wrong lens

Part of the perception problem is that outsiders habitually look at China through Western eyes, assuming that, like Western countries, China concentrates on the pursuit of profitable growth. This, unfortunately, simply isn’t the case. China’s priorities in economic policy are wholly different, with profitability mattering hardly at all, and the focus emphatically on volume.

The basis of government in China is “the mandate of heaven”, a term which translates as government by consent. To be sure, China has impressively comprehensive surveillance and coercion capabilities, but nobody should assume that these could keep the party (the CPC) in power if the public turned against it.

Rather, the relationship between governing and governed rests on a “grand bargain”. The public’s side of this bargain is the acceptance of civil rights which are a lot more restricted than has been the norm in the West. In return, the authorities are required to deliver prosperity.

This, undoubtedly, they have thus far succeeded in doing. According to SEEDS (the Surplus Energy Economics Data System), the average Chinese person is 44% more prosperous now than he or she was just ten years ago. This achievement is all the more remarkable when set against the gradual but relentless deterioration of prosperity in the West.

Nobody should assume, though, that continuation of improvements in prosperity is assured. Rather, the bar keeps getting higher, and one of the themes explored here is the growing extent to which China has had to resort to increasingly dangerous financial expedients to keep prosperity growth on track.

The litmus-test of whether the government is keeping its side of the bargain is employment, especially in urban areas. Both theory and evidence illustrate that, whilst rural unemployment seldom brings about unmanageable unrest, urban unemployment both can, and has. The spectre which stalks the nightmares of the Chinese leadership is mass unemployment in the cities, a problem whose potential risk has grown steadily as millions have migrated from the countryside.

At all costs, then, China must sustain and grow urban employment. This in turn points to two criteria seldom recognized in the West – an emphasis on activity (rather than profit), and a single-minded concentration on volume (rather than value).

If China were to agree to restrict her exports of goods to the United States, her volume priority would take a huge hit – and meeting America stipulations on technology transfer could risk China’s goods falling so far behind competitor product specs that they would be barely saleable, almost irrespective of quite how far prices were allowed to fall.

These considerations indicate that China simply cannot afford to agree to the most important American demands over trade, which makes a deal implausible unless Washington backs down. The view taken here is that, whilst the United States can ‘win’ a trade war with China, such a victory could be Pyrrhic at best. Based on the analysis outlined here, the Chinese economy is already in very big trouble, and America can only lose if this predicament is worsened.

The paramount emphasis on volume goes along way towards explaining why China has built huge capacity, even where there are already excesses. Building residential property where there are no residents, shopping centres without retailers, unnecessary infrastructure and unneeded factory capacity may look irrational in the West, but what to Westerners may be a white elephant looks, in China, like a valuable source of employment.

Emphasis on volume does, though, come at a hefty cost. In industry, the creation of excess capacity necessarily crushes margins. As a result, profitability often falls to levels below the cost of capital, whilst cash flow is nowhere near sufficient to finance investment in additional capacity.

This, in turn, has forced a reliance on debt, which is used not just to fund capacity expansion, but to cover losses as well.

Overseas observers customarily ignore China’s reliance on debt, sometimes because they are simply dazzled by reported “growth”. Many people overseas marvel that China has more than doubled her GDP (+114%) since 2008, but far fewer recognize that doing this has required a near-quadrupling of debt (+284%) over the same period.

In the years since the 2008 global financial crisis (GFC), annual net borrowing in China has averaged 24% of GDP, a ratio to which not even Ireland has come close.

Stated at constant 2018 values, a RMB 47.3 trillion expansion in GDP has been accompanied by RMB 162 tn escalation in debt. Tellingly, almost 60% of that borrowing has been undertaken by businesses, whose debt at constant values has climbed to RMB 134 tn, now from just RMB 38 tn ten years ago.

The cracks appear

Unfortunately, both in activity and in finance, China seems to have hit a brick wall in the second half of last year.

Financially, the first cracks in the system showed up with a catastrophe in P2P (peer-to-peer) lending, a boom-to-bust event with distinct parallels to the subprime mortgage disaster experienced in the US and in other Western countries in the lead-up to 2008.

Like subprime, P2P offers high-cost loans to borrowers unable to obtain credit from conventional (and much less expensive) sources. The very fact that borrower quality is so low ought to warn investors off these platforms, but the allure of high yields has proved irresistible to many Chinese savers.

First legalized in 2015, numbers of P2P platforms exploded, to a peak of over 8,000 by mid-2018, by which point the sums invested had reached the equivalent of $190bn. Then, with grim inevitability, P2P began to disintegrate, with some borrowers defaulting, whilst others simply absconded. By the end of July last year, after regulators had started to involve themselves, more than 4,700 P2P platforms had ceased to exist.

This in turn has had seriously adverse economic effects, some of which put the first visible dent into Chinese volumetric progression. The sectors hit first by the P2P crash have been the sales of vehicles and domestic appliances, both of which had benefited from P2P-funded purchasing.

Within corporate borrowing, China has followed the West in making ever greater use of bond finance rather than bank lending. From negligible levels ten years ago, Chinese corporate bond issuance soared to $590bn in 2016, and has remained at very high levels since then, dwarfing all other emerging market (EM) issuance put together. The number of issuers has soared to 1,451 from just 68 ten years earlier, whilst the outstanding aggregate has climbed from $4tn to almost $20tn.

Of course, China hasn’t been the only reckless user of bond issuance – indeed, the American use of bond finance for stock buybacks belongs in its own category of insanity – but, once again, cracks are starting to emerge, and are showing up in defaults.

According to US credit rating agency Fitch, defaults by Chinese companies soared to record levels last year, with 45 companies defaulting on a total of 117 bond issues. Of these companies, six were state-owned entities (SOEs), whose failures give the lie to the long-standing investor assumption that Beijing would never allow an SOE to default.

A particular complication in China is that domestic credit rating agencies seem to be ‘generous’ in the ratings that they confer. The inferred claim that most Chinese corporate bond issues are rated AA or above – with very few in junk territory – simply defies logic. A significant number of Chinese corporates enjoy AAA ratings, something that only two American companies have been accorded.

The risk here is not simply that rates of default will continue to accelerate, but that companies will face escalating debt service costs as their status slides from investment grade into junk.

An additional twist has been defaults by companies which, according to reported numbers, should have had cash holdings far exceeding the sums on which they defaulted. One company defaulted on bonds worth RMB 139 million despite supposedly having cash of about RMB 4 billion in cash holdings. A second, supposedly sitting on RMB 4.9 bn in cash, defaulted on a bond worth just RMB 300m. A third defaulted on a RMB 1bn bond even though cash had been reported at RMB 15bn.

Thus far in 2019, default rates are continuing to soar. In the first four months of this year, Chinese companies have defaulted on RMB 39.2 bn ($5.78bn) of domestic bonds, 3.4 times the total for the same period in 2018.

Tumbling volumes

These disturbing financial trends are showing up in some dramatic reversals in economic activity.

First to suffer were sales of vehicles and domestic appliances, both of which had hitherto been funded extensively with P2P credit. In comparison with year-earlier figures, sales of cars in China fell by nearly 12% in September and October last year, by 13.9% in November and by 13.0% in December. These falls constituted a dramatic reversal in hitherto uninterrupted, multi-year expansion in annual car purchasing, which had soared from 5.2 million units in 2006 to 24.7 million in 2017. Though foreign car-makers have suffered sharp decreases in sales, domestic manufacturers have borne the brunt of the slump, an event which has had very severe consequences for businesses which supply the vehicle industry.

Industries in China have also suffered from a sharp downturn in the market for consumer goods, ranging from smartphones to domestic appliances, the latter being hit further by tightened regulations on multiple home ownership. Overseas investors started to notice these trends when they were reported by companies operating in China, though, for the more observant, the sharp deterioration had been flagged already by troubled component suppliers.

Apple was one of many companies caught flat-footed by the reversal in the Chinese market, admitting ruefully that “we did not foresee the magnitude of the economic deceleration, particularly in Greater China”.

Even more significantly, suppliers of industrial components started to suffer from sharp falls in orders. The CEO of Nidec – a Japanese supplier of electric motors to manufacturers of products which include disc-drives, vehicles, robotics and domestic appliances – has said that “[w]hat we witnessed in November and December was just extraordinary”. In a letter to shareholders, Nidec called recent events “a real punch in the gut”.

FedEx, another company shocked by the Chinese turndown, has said that “no markets will be able to absorb more than a fraction of what China produces”.

The magnitude of the downturn in China is now showing up in global macroeconomic indicators – trade volumes have slumped with a rapidity not seen since 2008, whilst flows of FDI (foreign direct investment) have fallen far more sharply than can be explained by US tax changes alone.

There is growing evidence, too, that Chinese investors have started pulling out of property and other investments in overseas markets. Even before trade disputes really heated up, Chinese FDI in the United States had collapsed, whilst Chinese investors were also scaling back their investments in Europe. Towards the end of last year, in a clear reflection of economic deterioration, Chinese equity markets fell sharply, tumbling to levels last seen before the 2008 crash.

Turning on the taps

Inevitably – and despite prior commitments to do no such thing – the Chinese authorities have been pouring eye-watering amounts of new liquidity into the system since the start of this year. This has helped Chinese capital markets recover, of course, but seems to have done nothing more than buy some time for the economy itself, with key volume indicators (such as vehicle sales) continuing to fall sharply.

These interventions are starting to get noticed, puncturing much long-standing overseas complacency about China as an ‘unstoppable growth engine’. Pointedly, Forbes magazine recently asked why, if the Chinese economy really is growing at over 6%, “is the People’s Bank of China (PBOC) pumping money into the market like a drunken sailor?”

It may not be at all fanciful to detect a sense of near-panic in Beijing. Having already called on state banks to lend more to SMEs (small- and medium-sized enterprises), Premier Li Keqiang has now called for greater “flexibility” in the use of monetary policy to encourage lending. The word “flexibility”, of course, has a particular meaning when applied to monetary policy.

As well as implementing stock purchases, the PBOC has loosened reserve requirements – enabling banks to increase lending against any given amount of capital – and seems to be relaxing some of the rules previously put in place to restrain the bubble in residential property prices. Credit stimulus totalled RMB 4.64tn – more than 5% of annual GDP – in January alone, and has continued throughout the year so far at rates suggesting that 2019 will witness another big leap in Chinese indebtedness.

What now?

What we’re seeing, then, is the first major setback to an economic model targeted on volume and supported by ultra-rapid credit expansion. Though some of us have been warning about the pace of Chinese debt expansion over an extended period, Western markets seem only to have become aware of these risks since volumetric indicators turned down, a trend whose impact has been highlighted by its consequences for a string of overseas companies which, hitherto, had been riding the expansionary wave in Chinese economic activity.

Perhaps the single most disturbing feature of the Chinese predicament has been the sheer scale of the downturn across a string of product categories ranging from cars and smartphones to industrial components. What we’ve been witnessing, across a diverse and representative cross-section of activity, hasn’t been a minor reversal, still less a slowing of growth, but an alarmingly deep fall in activity.

It need hardly be said that China has played an absolutely pivotal role in the world economy since 2008, not just providing growth but acting as a hugely important market for everything from manufactured goods to critical commodities, including energy, minerals and food. Additionally, Chinese overseas investment has been hugely important for overseas asset prices, most obviously in real estate.

The risks from here are (a) that activity continues to fall rapidly, and (b) that the financial system that has funded the push for volume starts to decay.

We can be pretty sure that, in terms of stimulus, China will do anything and everything possible to arrest the downwards lurch. Even on a comparatively optimistic reading, however, trade, investment and demand, worldwide, are going to take a major hit from what has already happened in China.

The really big question, in China as elsewhere, is whether the efficacy of financial stimulus will weaken, something which could happen if credit exhaustion kicks in, or if faith in money is undermined.

It’s worth reminding ourselves of quite how far we have already gone in reliance on cheap debt and abundant liquidity. Over five years, only stock buybacks of $2.95tn, mostly debt-financed, have kept Wall Street buoyant in the face of net investor selling of $1.1tn, whilst the Bank of Japan has now acquired more than half of all outstanding JGBs (Japanese government bonds) using money newly created for the purpose.

Stirring Chinese economic and financial risk into the mix suggests that we may be measurably close to the point at which the seaworthiness of the ‘perpetual cheap money lifeboat’ meets its toughest test.