#154. An autumn nexus

A CONVERGENCE OF STRESS-LINES

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

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

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

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

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

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

Chinese burns

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

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

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

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

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

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

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

But this is to look too far ahead.

“Brexit” blues

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

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

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

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

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

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

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

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

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

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

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

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

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

Madness, money and moods

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

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

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

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

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

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

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

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

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

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

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

 

#144: “Brexit” and the wait for Godot

WHY EU NATIONAL LEADERS SHOULD INTERVENE

It is perhaps appropriate that Samuel Beckett’s play Waiting for Godot was written in French, and premiered in Paris in January 1953, not appearing in English until its London debut in 1955.

As you’ll know, Godot himself never appears, which some might say is the real point of the narrative. Certainly, his non-arrival has no serious consequences.

This is where drama and reality part company. Like Vladimir and Estragon in Beckett’s play, both sides of the “Brexit” impasse have been waiting for more than two years now, and are waiting still, for the political equivalent of Godot to turn up. This time, it’s going to be very serious indeed if the major character (or characters) fail to put in an appearance.

If you’re a regular visitor to this site, you’ll know that I steer well clear of taking sides over the outcome of the “Brexit” referendum. This said, those of us who understand the surplus energy basis of the economy had solid reasons for expecting the vote to turn out as it did.

Though GDP per person was slightly (4%) higher in 2016 than it had been in 2006, personal prosperity in Britain deteriorated by almost 9% over that decade. When the public went to the polls, the average person was £2,150 worse off than he or she had been ten years previously, and was, moreover, significantly deeper in debt.

These are not conditions in which the governing can expect the enthusiastic backing of the governed. There were other factors in play, of course – including widening inequality, and the lack of a national debate over immigration – but the “leave” vote was founded on popular dissatisfaction with an “establishment” seemingly unconcerned about deteriorating prosperity.

The authorities’ fundamental inability to understand the prosperity issue was by no means unique to the United Kingdom, and neither were its consequences confined to the 2016 referendum. Had the deterioration in prosperity been understood in the corridors of power, it’s highly unlikely, for instance, that premier Theresa May would have called the 2017 general election which robbed her of her Parliamentary majority.

Calling an early election – intended to “guarantee security for the years ahead” – was just one of many mistakes made by the British authorities before, during and after the referendum on withdrawal from the European Union. The vote itself  seems to have been called in the confident assumption that the “remain” side would win comfortably. The governing Conservatives then elected as their leader an opponent of the “Brexit” process. Perhaps worst of all, the British side negotiated as supplicants, accepting, seemingly without question, Brussels’ highly dubious assertion that the EU held all the high cards.

But it would be wrong to pin all (or even most) of the blame for the “Brexit” negotiations fiasco on the British side. Whatever mistakes Mrs May and her colleagues might have made, they at least have a democratic mandate for what they have been trying to do. Beset on one side by hard-line “Brexiteers”, and on the other by those opposed to carrying out what the public actually voted for, Mrs May had problems enough, even before her Brussels counterparts set out to play politics with the process.

Under these conditions, it’s hardly surprising that the British parliament seems to have reached an impasse, where the main alternatives to a flawed deal appear to involve either (a) leaving the EU without any agreement at all, or (b) disregarding the wishes of the voters, and perhaps inviting those voters to have another go, presumably in the hope that the electorate will ‘get it right this time’.

Needed – Godot

In considering what ought to happen next, we need to be absolutely clear that the stance adopted by the bureaucrats in Brussels has all along made it impossible for Mrs May to secure an agreement acceptable either to parliament or the voters.

Put bluntly, the point has long since been reached where the adults – meaning the elected governments of EU member nations, led by France and Ireland – should step in, forcing Brussels to offer terms which are both (a) mutually advantageous, and (b) acceptable to the United Kingdom. This really means that Paris and Dublin need to mount an eleventh-hour rescue, not just (or even mainly) of the British economy, but of the EU economy as well.

From the outset, Brussels has made three dangerously false assumptions.

The first is that, in terms of economics, a mishandled “Brexit” will hurt Britain far more than it would hurt other EU member states.

The second, flowing from this but extending well beyond economics, was that the EU side holds all the high cards – essentially, that Mrs May should expect nothing more than scraps from a bounteous continental table.

Third, Brussels assumed the role of punishing British voters in order to deter Italians (and others) from following a similar path out of the EU.

This third point is the easiest to counter. The role of Brussels, which in many other areas is carried out commendably, is to better the circumstances of EU citizens.

It is not to influence how those citizens cast their votes.

The economic point, though critical, is a bit more complicated, but needs to be outlined to explain why Ireland and France, in particular, ought now to be intervening to break the impasse.

Where Ireland is concerned, the assumption in Brussels that a mishandled “Brexit” would more dangerous for the British than for anyone else is gravely mistaken. Although Britain is a major trading partner for Ireland, the main problem for the Republic is a broader one. Essentially, Ireland is in no condition to withstand any major shock to the system – and a bungled “Brexit” would certainly be exactly that.

We’ve examined the Irish predicament before, so a brief summary should suffice here. Following statistical changes (dubbed “leprechaun economics”) introduced in 2015, reported GDP has become an even less meaningful measure of economic conditions. GDP grew by 49% between 2007 and 2017 (including a one-off 25% hike in 2015), adding €97bn (at constant 2018 values) to recorded output – but this occurred courtesy of a near-doubling in debt, such that each €1 of “growth” was bought with €4.85 of net new borrowing. Meanwhile, the all-important energy cost of energy (ECoE) now exceeds 11% in Ireland, at level at which growth is almost bound to go into reverse.

Fundamentally, reported GDP (of an estimated €309bn last year) grossly overstates real activity (adjusted for borrowed spending, €184bn), let alone prosperity (€164bn, or €33,550 per person).

Critically, over-stated GDP gives dangerously false comfort about financial exposure. Aggregate debt, for instance, might be “only” about 320% of GDP, but equates to well over 600% of prosperity.

Worse still, Ireland’s financial sector is grossly over-large in relation even to GDP, let alone prosperity. The most recent available numbers (for the end of 2016) put financial assets at 1750% of GDP, but this equates now to a frightening 3200% or so of prosperity.

Far from deleveraging after the disaster of 2007-08, both debt and financial assets are a lot bigger now than they were on the eve of the global financial crisis (GFC I) – in inflation-adjusted terms, debt has virtually doubled (+95%) since 2007, and financial assets have expanded by about 60%.

Moreover, the markets might know about the “leprechaun” factor in Irish GDP, but seem not – yet – to have applied the logic of that knowledge to the critical measures of national financial risk. On the assumption that the authorities in Dublin do know quite how dangerous Irish financial exposure really is, they have every incentive to strive for a form of “Brexit” which minimises economic and financial damage.

France has different, but equally compelling, reasons for intervening, and would have a lot more negotiating clout to bring to the table. As we’ve seen, there has been widespread unrest in France, unrest whose causes can be traced to deteriorating prosperity. Though personal prosperity as a whole is only about €1,650 (5.8%) lower now than it was ten years ago, the slump in discretionary (‘left-in-your-pocket’) prosperity has been leveraged to 32% by a near-€2,000 increase in the burden of taxation per person.

This has put Mr Macron’s government in an unenviable position. Neither the fiscal carrots offered by the president, nor the law enforcement sticks planned by his government, can address the fundamental issue, which is that a substantial majority of the population supports the grievances (if not necessarily the methods) of the ‘gilets jaunes’.

This seems to mean that Mr Macron can forget about his cherished labour market “reforms”, and further suggests that, unless something pretty dramatic happens, he can probably forget about re-election as well. The last thing his government needs right now is the economic harm likely to be inflicted on France by a bungled “Brexit”. It would be far, far better for the president to act in a conspicuously statesmanlike way to break the impasse.

In this situation, it’s unrealistic to expect Britain to resolve this issue unaided by Europe. If, as most observers believe, Mrs May’s deal is going to be shot down by parliament, neither of the remaining options looks palatable. Both those who support a “no deal” exit, and those who’d like to ignore (or re-run) the “Brexit” vote, are playing with fire. But neither can we expect the Brussels side of the talks to have a last minute conversion either to humility or to pragmatism.

In short, there are compelling reasons for European governments – led by France and Ireland – to enforce a rationality seemingly absent, on this issue, in Brussels.

#141: England’s Glory or ship of fools?

MAKING THE WORST OF A BAD THING

There used to be – and, as far as I know, still is – a brand of matches called England’s Glory, sold in iconic boxes featuring the battleship HMS Devastation. If tasked with updating that artwork, one could hardly do better than a rowing-boat full of squabbling fools.

There is, of course, no situation that can’t be made worse by a politicians’ witches’ brew of ambition and obstinacy. But the shambles now being inflicted on the British public is something new in the realms of idiocy.

I don’t intend, here, to go into the merits or otherwise of the voters’ “Brexit” decision itself, though readers are, of course, welcome to debate it. As for the political machinations at Westminster, it need only be remarked that the current imbroglio is consistent with a process that has been bungled right from the start.

What I think we can do here, though, is set out the purely economic context from the standpoint of surplus energy economics (SEE).

If you understand SEE – an interpretation of the economy summarised here – then you’ll know that prosperity in the United Kingdom has been deteriorating since 2003. Though this deterioration is by no means unique to Britain, it’s been more severe there than in most other countries. Properly understood, eroding prosperity has been as instrumental in the “Brexit” process as it has been in the election of Donald Trump, the handing of power to an insurgent (aka “populist”) coalition in Italy, and the elevation, and subsequent travails, of Emmanuel Macron in France.

And this, really, is the critical point. Policymakers right across the Western world simply don’t understand that prosperity is heading downwards. Because they (and their advisors, and most of the commentariat) remain wedded to conventional economic interpretations, they really believe that people are getting better off. In the British instance, they’re convinced that an increase of £3,220 (11.6%) in GDP per capita since 2003 means that people are prospering.

If you believe this, you can’t even begin understand what people in Britain – or, for that matter, in America, Italy or France – have got to complain about. Blind to the economic causes of discontent, politicians tend to fall back on more arcane explanations, many of which seek to pin the blame on unscrupulous “populist” politicians.

Where Britain is concerned, reported GDP increased by £390bn (24%) between 2003 and 2017. Unfortunately, this was accompanied by a £2 trillion (63%) increase in debt. This means that £5.19 was borrowed for each £1 of incremental GDP. It also means that, whilst GDP has grown by between 1.5% and 2% each year, debt has been added at rates of close to 10% of GDP annually.

Fundamentally, it means that most of the “growth” supposedly achieved since 2003 has been nothing more than the simple spending of borrowed money. If, for any reason, Britain lost the ability to carry on adding to its debt in this way, trend growth would fall to somewhere around 0.3%, a number lower than the rate at which population numbers are growing. If ever it became necessary to deleverage, then most of the “growth” of recent years would go into reverse. Anyone questioning this interpretation need only ask himself or herself one question – ‘what kind of economy needs to price credit at rates lower than inflation?’

The reason why financial adventurism has been adopted to create a simulacrum of “growth” is that the energy dynamic has turned negative. According to SEEDS (the Surplus Energy Economics Data System), Britain’s trend energy cost of energy (ECoE) has risen from 3.4% in 2003 to 9.2% now. The latter number is a growth-killer. This has been worse than the global increase (from 4.5% to 8.0%) over the same period, which is one of the main reasons why prosperity has fallen more rapidly in Britain than in most other countries. Part of the differential has been the unlucky timing of the maturing of the UK North Sea oil and gas province. But this has been exacerbated by energy policy, nowhere more obviously than in protracted vacillation over replacement nuclear capacity.

According to SEEDS, personal prosperity in the United Kingdom had, by 2017 (£22,050) fallen by £2,490 (10.2%) since 2003 (at 2017 values, £24,540). Moreover, each person now has 47% more debt than he or she had back in 2003.

The political logic here is that, by the time of the referendum in 2016, prosperity had fallen by more than enough to swing the “Brexit” vote against the perceived preference of “the establishment”. Politicians completely failed to understand this trend, and probably wouldn’t have called the referendum at all if they’d been better informed.

Once this essentially economic dimension is understood, what follows is pure tragi-comedy. The Conservatives chose, in succession to David Cameron, to put in charge of the “Brexit” process a leader who believed that the voters’ decision was the wrong one. Still unaware of the deterioration in prosperity, Mrs May called a general election, seemingly believing (along with the ‘experts’) that this would give her a Commons majority of well over 100, when the outcome was that she lost even the slender majority inherited from Mr Cameron. Meanwhile, the EU side opted to posture on a claim that they held all the high cards, and Mrs May and her officials fell for this line, going to Brussels as a supplicant, and so, necessarily, returning with an agreement so flawed that it had no real chance of Parliamentary acceptance.

What the British electorate are watching now is a culminating shambles. Having lost a referendum they expected to win, and been battered in an election they expected to be a triumph, Conservatives have opted now to challenge a leader who, because of her stance on “Brexit”, they should never have chosen in the first place. This has happened at the worst possible time, between the cup of a botched agreement with the EU and the lip of a departure date at the end of March. Some think that the leadership challenge process can be compressed, and it’s probably fair to say that one might as well make a mess of things in three weeks as in six.

Where this leaves the public is with a political class which doesn’t understand the fundamental issues around prosperity, and really believes that either ‘liberal’ or collectivist economic orthodoxy can restore “growth”. It seems hardly necessary to add that a ship of fools remains foolish, whether or not the captain is thrown overboard.

= = = = = = = = = =

#140: Are yellow jackets the new fashion?

POPULAR UNREST IN AN AGE OF FALLING PROSPERITY

This weekend, the authorities plan to field 89,000 police officers across France in response to anticipated further mass protests by the ‘gilets jaunes’. In the capital, the Eiffel Tower will be closed and armoured cars deployed, whilst restaurateurs and shopkeepers are being urged to close their businesses at one of the most important times of their trading year.

Though the government has climbed down on the original cause célèbre – the rises in fuel taxes planned for next year – there seems to be no reduction in the worst protests experienced in the country since the 1960s. Reports suggest that as many as 70% of French citizens support the protestors, and that the movement may be spreading to Belgium and the Netherlands.

For the outside observer, the most striking features of the protests in France have been the anger clearly on display, and the rapid broadening of the campaign from fuel prices to a wider range of issues including wages, the cost of living and taxation.

The disturbances in France should be seen in a larger context. In France itself, Emmanuel Macron was elected president only after voters had repudiated all established political parties. Italians have entrusted their government to an insurgent coalition which is on a clear collision-course with the European Union over budgetary matters. The British have voted to leave the EU, and Americans have elected to the White House a man dismissed by ‘experts’ as a “joke candidate” throughout his campaign.

Obviously, something very important is going on – why?

Does economics explain popular anger?

There are, essentially, two different ways in which the events in France and beyond can be interpreted, and how you look at them depends a great deal on how you see the economic situation.

If you subscribe to the conventional and consensus interpretation, economic issues would seem to play only a supporting role in the wave of popular unrest sweeping much of the West. You would concede that the seemingly preferential treatment of a tiny minority of the very rich has angered the majority, and that some economic tendencies – amongst them, diminishing security of employment – have helped fuel popular unrest.

Beyond this, though, you would note that economies are continuing to grow, and this would force you to look for explanations outside the purely economic sphere. From this, you might conclude that ‘agitators’, from the right or left of the political spectrum, might be playing a part analogous to the role of “populist” politicians in fomenting public dissatisfaction with the status quo.

If, on the other hand, you subscribe to the surplus energy interpretation of the economy professed here, your view of the situation would concentrate firmly on economic issues.

Though GDP per capita may be continuing to improve, the same cannot be said of prosperity. According to SEEDS (the Surplus Energy Economics Data System), personal prosperity in France has deteriorated by 7% since 2000, a trend starkly at variance with the growth (of 12%) in reported GDP over the same period.

Not only is the average French person poorer now than he or she was back in 2000, but each person’s share of the aggregate of household, business and government debt has increased by almost 70% since 2000. These findings are summarised in the following table, sourced from SEEDS.

Two main factors explain the divergence between the conventional and the surplus energy interpretations of the economy. One of these is the pouring of enormous quantities of cheap debt and cheap money into the system, a process which boosts recorded GDP without improving prosperity (for the obvious reason that you can’t become more prosperous just by spending borrowed money). The other is the exponential rise in the energy cost of energy (ECoE), a process which impacts prosperity by reducing the share of output which can be used for all purposes other than the supply of energy itself.

In France, and with all sums expressed in euros at constant 2017 values, GDP grew by 23% between 2000 and 2017. But this growth, whilst adding €433bn to GDP, was accompanied by a €3.07tn increase in aggregate debt. This means that each €1 of reported growth in the French economy has come at a cost of more than €7 in net new debt. Put another way, whilst French GDP is growing at between 1.5% and 2.0%, annual borrowing is running at about 9.5% of GDP.

Cutting to the chase here, SEEDS concludes that very little (about €100bn) of the reported €433bn rise in GDP since 2000 has been sustainable and organic, with the rest being a simple function of the spending of borrowed money. Shorn of this credit effect, underlying or clean GDP per capita is lower now (at €29,550) than it was in 2000 (€30,777).

Meanwhile, trend ECoE in France is put at 7.8%. Though by no means the worst amongst comparable economies, this nevertheless represents a relentless increase, rising from 4.6% back in 2000. At the individual or household level, rising ECoE is experienced primarily in higher costs of household essentials. In the aggregate, ECoE acts as an economic rent deduction from clean GDP.

Between 2000 and 2017, clean GDP itself increased by only 5.7%, and the rise in ECoE left French aggregate prosperity only marginally (2.2%) higher in 2017 than it was back in 2000. Over that same period, population numbers increased by 10%, meaning that prosperity per person is 7.1% lower now than it was at the millennium.

In France, as elsewhere, the use of credit and monetary adventurism in an effort to deliver “growth” has added markedly to the aggregate debt burden, which is €3.1tn (86%) higher now than it was in 2000. The per capita equivalent has climbed by 69%, making the average person €41,800 (69%) more indebted than he or she was back in 2000.

The prosperity powder-keg

To summarise, then, we can state the economic circumstances of the average French citizen as follows.

First, and despite a rise in official GDP per capita, his or her personal prosperity is 7.1% (€2,095) lower now than it was as long ago as 2000.

Second, he or she has per capita debt of €102,200, up from €60,400 back in 2000.

Third, the deterioration in prosperity has been experienced most obviously in costs of household essentials, which have outpaced both wages and headline CPI inflation over an extended period.

This is the context in which we need to place changes in the workplace, and a perceived widening in inequality.

On this latter point, part of the explanation for the anger manifested in France can be grasped from this chart, published by the Institut des Politiques Publiques.

In the current budget, policy changes hurt the disposable incomes of the poorest 10% or so (on the left of the scale), but ought to be welcomed by most of the rest – and perhaps might be, were it not for the huge handouts seemingly being given to the very wealthiest. Moreover, these benefits aren’t being conferred on a large swathe of “the rich”, but accrue only to the wealthiest percentile.

This is part of a pattern visible throughout much of the West. Unfortunately, perceptions of hand-outs to a tiny minority of the super-rich have arisen in tandem with a deteriorating sense of security. Security is a multi-faceted concept, which extends beyond security of employment to embrace prosperity, wages, living costs and public services.

Even in the euphoric period immediately following his election, it seemed surprising that French voters would back as president a man committed to ‘reform’ of French labour laws, a process likely to reduce workers’ security of employment. Add in further deterioration in prosperity, and an apparent favouring of the super-rich, and the ingredients for disaffection become pretty obvious.

Where next?

The interpretation set out here strongly indicates that protests are unlikely to die down just because the government has made some concessions over fuel taxes – the ‘gilet jaunes’ movement might have found its catalyst in diesel prices, but now embraces much wider sources of discontent.

Given the context of deteriorating prosperity, it’s hard to see how the government can respond effectively. Even the imposition of swingeing new taxes on the super-rich – a wildly unlikely initiative in any case – might not suffice to assuage popular anger. It seems likelier that the authorities will ramp up law enforcement efforts in a bid to portray the demonstrators as extremists. The scale of apparent support for the movement – if not for some of its wilder excesses – suggests that such an approach is unlikely to succeed.

Of course, it cannot be stressed too strongly that the French predicament is by no means unique. Deteriorating prosperity, a sense of reduced security and resentment about the perceived favouring of the super-rich are pan-European trends.

In the longer term, trends both in prosperity and in politics suggest that the West’s incumbent elites are fighting a rear-guard action. The credibility of their market economics mantra suffered severe damage in 2008, when market forces were not allowed to run to their logical conclusions, the result being a widespread perception that the authorities responded to the global financial crisis with rescues for “the rich” and “austerity” for everyone else.

This problem is exacerbated by the quirks of the euro system. In times past, a country like Italy would have responded to hardship by devaluation, which would have protected employment at the cost of gradual increases in the cost of living. Denied this option, weaker Euro Area countries – meaning most of them – have been forced into a process of internal devaluation, which in practice means reducing costs (and, principally, wages) in a way popularly labelled “austerity”. The combination of a single monetary policy with a multiplicity of sovereign budget processes was always an exercise in economic illiteracy, and the lack of automatic stabilisers within the euro system is a further grave disadvantage.

Finally, the challenge posed by deteriorating prosperity is made much worse by governments’ lack of understanding of what is really happening to the economy. If you were to believe that rising GDP per capita equates to improving prosperity – and if you further believed that ultra-low rates mean that elevated debt is nothing to worry about – you might really fail to understand what millions of ordinary people are so upset about.

After all, as somebody might once have said, they can always eat brioche.

= = = = = = =

#135: Still not (wholly) about “Brexit”

BRITAIN, EUROPE AND GFC II

A little less than two months ago, we made an effort here to look past the sound and fury of the “Brexit” debate to assess the real state of prosperity and risk in the United Kingdom.

Now, as the world marks the tenth anniversary of the 2008 global financial crisis (GFC I), it’s being reported that Mark Carney, governor of the Bank of England, has warned government that “a chaotic no-deal Brexit could crash house prices and send another financial shock through the economy”.

Risks identified by Mr Carney apparently include a slump in the value of GBP, sharp rises in interest rates and a 35% fall in property prices. Whilst he is right about these risks – and right, too, to warn about the consequences of a mishandled “Brexit” – we need to reiterate that these risks are likely to eventuate anyway, because British prosperity is continuing to deteriorate, whilst financial risk remains highly elevated.

Some updates

As I’m off travelling for much of next week, what I’d like to do here is to pause, as it were, and posit a few things for thought and comment. “Brexit” risk, and the likelihood of GFC II, have to be high on that list.

First, though, I’d like to thank the first two followers of Surplus Energy Economics who’ve made donations towards the upkeep and development of the project. I’m new to the donation process, so I don’t know what the courtesies are for expressing gratitude – but I really do appreciate your support.

While I’m away, please do carry on posting your comments, but please also note that moderation is going to be intermittent for the next week or so. The best way to get comments posted is to leave out links, as any comment including them is automatically placed in the moderation queue.

On “Brexit”

Throughout the debate about Britain leaving the European Union, no view has been taken here about the merits and demerits of “Brexit” itself. There are, though, a number of points which do need to be made.

First, the debate about “Brexit” was extraordinarily nasty and divisive.

Second, it’s vital that the expressed view of the voters is respected.

Third, surplus energy analysis gave us a strong lead on how the referendum was likely to turn out. According to SEEDS, per capita prosperity in Britain was already 10% lower by 2016 than it had been at its peak in 2003. This has to have been a major factor motivating the anti-establishment component of the vote.

Finally, “Brexit” is best considered as a ‘situation’ rather than an ‘event’. A ‘situation’ is something which creates a multiplicity of possible outcomes. The biggest risk with “Brexit” has always been that the British and EU negotiating teams would agree (or disagree) to choose the worst possible result. As things stand, that outcome is looking ever more ominously likely, thoroughly justifying Mark Carney’s warnings.

The British predicament

It would be a mistake, though, to assume, either that “Brexit” alone has created these risks, or that an alternative decision by the voters would have taken these threats away. Neither should risk on the EU side be downplayed.

Expressed at constant values, British GDP was £386bn larger in 2017 than it had been back in 2003. This translates to a gain of 11% at the per capita level, after adjustment for the increase (also 11%) in population numbers over that period.

But any suggestion that British citizens are 11% better off now than they were fourteen years ago is obviously bogus, an observation surely self-evident in a range of indicators spanning real incomes, the cost of household essentials, spiralling debt, sharp downturns in customer-facing sectors such as retailing and hospitality, maxed-out consumer credit and the worsening and widening hardship of the millions struggling to make ends meet. The national housing stock might be ‘worth’ £10 trillion, but that number is meaningless when the only potential buyers of that stock are the same people to whom it already belongs.

SEEDS analysis shows how we can reconcile claimed “growth” with evident hardship. First, growth of £386bn (23%) between 2003 and 2017 was accompanied by a 62% (£2 trillion) increase in aggregate debt. Put simply, Britain has been pouring credit into the system at a rate of £5.20 for each £1 of “growth”.

In the short term, you can have pretty much any amount of statistical “growth” in GDP if you’re prepared to pour this much credit into the system. The problem comes when you cannot carry on doing this, and this is especially the case when you’ve also been a huge net seller of assets to overseas investors as part of a process of consuming at levels far in excess of economic output.

Compounding this, of course, has been an escalating trend energy cost of energy (ECoE) and this, in Britain, has soared from 3.4% in 2003 to a projected 9.2% this year. The latter number is close to a level at which increasing prosperity becomes impossible.

“Stalling between two fools”

This makes Mr Carney’s risks all too real. According to SEEDS, aggregate prosperity in the UK last year was £1.45tn, a number 29% below recorded GDP of £2.04tn. When measured against prosperity rather than GDP, the British debt ratio rises to 361% (rather than 258%), whilst financial assets now stand at 1577% of prosperity (compared with about 1130% of GDP).

Bearing these exposure ratios in mind – and noting the ongoing deterioration in per capita prosperity – the likelihood of a currency slump, spiralling interest rates and a severe fall in property prices has to be rated very highly indeed.

But “Brexit” is by no means the only possible catalyst for a crash. Perhaps the single most depressing aspect of the British predicament is the paucity of understanding of, and response to, structural economic weaknesses.

This is not to say, of course, that EU negotiators have played this situation well. The assumption that the EU holds all the high cards in “Brexit” talks is absurd, and the extreme risk to Ireland is just one of many reasons for caution. The guiding principle, which seems to be to punish British voters’ temerity as a warning to others, appears not just pompous but, given the spread of support for insurgent (a.k.a. “populist”) parties, extremely short-sighted.

On the horizon – GFC II

For the British and the Europeans, “Brexit” has been a massive distraction from broader financial and economic risk. Though we cannot know when GFC II will eventuate, there can be very little doubt that a crash, of greater-than-2008 proportions, is looming ever closer.

As regular readers will know, there is a clear narrative which points unequivocally to GFC II. This narrative is so important, and so seemingly absent from mainstream interpretation, that little apology seems required for reiterating it in brief.

The narrative can be expressed as three very simple propositions:

1. From the late 1990s, the secular capability for growth began to erode.

2. Instead of accepting (or even recognising) this deceleration, the authorities embarked on credit adventurism, making debt cheaper, and easier to obtain, than at any previous time in modern history. Not surprisingly, this led directly to GFC I, and ensured that it would be a debt-centred event, primarily threatening the banks.

3. Rather than take the hit for reset, the authorities then moved on to monetary adventurism, pouring huge amounts of ultra-cheap liquidity into the system. This must lead to GFC II, and GFC II must be a monetary event.

There are plenty of things to debate about this sequence. First, what caused the secular deceleration which triggered the whole process? The explanation favoured here is the rising trend in the energy cost of energy (ECoE), but there are certainly some candidates for ‘best supporting actor’. These include ideological commitment to reckless deregulation, badly mishandled globalisation, and the impact of climate change.

Second, why didn’t we choose reset in 2008? With hindsight, the choice made was the wrong one, as many experts pointed out at the time. By playing ‘extend and pretend’, the authorities made huge mistakes, which included moral hazard, creating massive asset bubbles, all but halting creative destruction, and destroying returns on investment (to the particular detriment of pension provision).

One of the lesser-known consequences was that the market economy, properly understood, became inoperable – after all, positive returns on capital are something of a prerequisite in any ‘capitalist’ economy.

Likewise, when the relationship between asset prices and income was bent completely out of shape, immense divisions were created between those who already owned assets and those (generally younger) people whose aim is to accumulate them.

Lastly, is there anything we can do now about GFC II? Frankly, prevention now looks impossible, but there might still be quite a lot of mitigation that we can implement (without going to the extremes of stockpiling tinned food, bottled water and ammunition).

We cannot know whether the coming explosion is going to be ‘chemical’ (requiring a catalyst) or ‘nuclear’ (requiring only critical mass). But there’s plenty of combustible material around, a huge array of potential catalysts – and an inexorable progression towards critical mass.

Abroad thoughts from home

I hope that, despite a short hiatus in moderation and response, readers can carry on debating these and other issues, and will forgive this brief restatement – which to me seems necessary on grounds of imminence and importance – of issues around “Brexit” and GFC II.

It is hoped that, after the intermission, we can get back to pushing the boundaries.

 

= = = = =

#134: An extremity of risk

A SEEDS VIEW OF THE IRISH ECONOMY

Last year, GDP per capita in the Republic of Ireland was €62,560, far higher than in Germany (€39,450) or the Netherlands (€42,820), let alone France (€35,310).

If you find this rather hard to take seriously, you’re right. And, whilst you’re in disbelief mode, you should forget any idea that Ireland has made a spectacular recovery since the 2008 global financial crisis (GFC I), or that the country is less at risk now than it was back then. Likewise, you might note that Ireland is at even greater risk from a mishandled “Brexit” than is Britain herself (though you’d never guess this from watching the course of the negotiations).

Let’s clear the decks by getting the official numbers out of the way first. In 2017, Ireland reported GDP of €296 billion, up 50% since 2007 (€197bn at 2017 values). The per capita equivalent for last year was €62,560, a real-terms improvement of 41% over a decade.

At the end of last year, debt totalled €938bn (or a hefty 317% of GDP) – lower than in 2016 (€1,021bn) but still €449bn (92%) higher than it was in 2007, on the eve of the 2008 global financial crisis (GFC I). Financial assets (a key measure of the size of a country’s banking system) totalled 1751% of GDP at the end of 2016, but might be down to about 1500% – or €4.4tn – now. The latter compares with €3.44tn in 2008, the most recent year for which data is available.

Even on a reported basis, there are some negatives here. Quantitatively, both debt and financial assets are a lot bigger now than they were when GFC I struck. Neither a debt ratio of 317% of GDP, nor banking exposure anywhere near 1500%, is remotely comfortable. The saving grace, of course, is GDP, and the robust pace at which it seems to be growing.

Put simply, we can be moderately relaxed about Ireland if – but only if – we accept recorded GDP as an accurate reflection of economic output and prosperity, which are the criteria which really determine the ability of an economy to carry any given level of debt or banking exposure.

Exposing the reality

Unfortunately, official GDP isn’t a meaningful reflection of either. According to SEEDS, GDP (of €296bn) seriously overstates real economic output (€193bn), and is dramatically higher than prosperity (just €173bn).

Obviously, such a drastic overstatement of output means that reported rates of growth are correspondingly meaningless. More seriously, it disguises exposure ratios that are drastically worse than official numbers which, even in themselves, are risky enough. For instance, debt may be ‘only’ 317% of GDP, but equates to about 544% of prosperity. More seriously still, financial assets rise from an estimated 1493% of GDP to 2560% of prosperity, a number which, as well as being truly scary – and unmatched by any other significant economy – means that Ireland has bloated banking exposure from which seemingly there can be no escape.

Put bluntly, Ireland is one setback away from disaster – just as both Britain and her European partners are in the process of crystallising “Brexit” risk……

Seeing through the numbers

How, then, can GDP so drastically misrepresent Ireland’s economic output, her prosperity and her resilience in the event of a shock?

There are three main explanations for the divergence between Irish GDP and the country’s prosperity, as the latter is calculated by SEEDS.

First, the basis on which Ireland calculates GDP was changed in 2015, creating single-year growth of more than 25%, and helping to push reported GDP per capita to levels which are, frankly, ludicrous.

Second, and in keeping with the widespread practice of “credit adventurism”, Ireland has pushed huge amounts of debt into the system, boosting recorded activity in ways which are wholly a function of an unsustainable expansion in credit.

Third – and particularly seriously where Ireland is concerned – reported GDP takes no account of the trend energy cost of energy (ECoE), a trend whose exponential rate of increase has already put Western prosperity growth into reverse.

Leprechauns and lenders

Back in 2015, Ireland adopted a new method for incorporating into GDP the activities of the multinational corporations which form such a big component of the Irish economy. Reflecting this, real GDP (expressed at 2017 values) increased by 25.5%, or €53bn, in a single year, from €208bn in 2014 to €261bn in 2015.

Dubbed “leprechaun economics” by Paul Krugman, this methodological change remains controversial. It is seldom noted that, reflecting this change, the €53bn increase in GDP was accompanied by a much bigger (€204bn) rise in debt, with PNFC (private non-financial corporate) indebtedness actually increasing by €242bn in a year in which both government and households were deleveraging.

A side-effect of “leprechaun economics” was a small decrease in the ratio of debt-to-GDP, which happened because reported GDP grew by slightly more (25.4%) than the increase in debt (24.2%). When debt expands by this much – and when almost €4 of debt is added for each €1 of claimed “growth” – it is clear, beyond a doubt, that any apparent fall in this widely-watched ratio has to amount to a mathematical quirk.

“Leprechaun economics” aside, the reported increase of 50% in GDP between 2007 and 2017 equated to incremental activity of €99bn, a number dwarfed by the €449bn (92%) escalation in debt over the same period.

Borrowing just over €4.50 for each €1 of “growth” is not a particularly outlandish number by the standards of Western economies (though it remains a lot higher than a global average of 3.3:1). Even so, it is clear that, in addition to helpful statistical restatement, Ireland has boosted GDP through a process of spending very large amounts of borrowed money.

This process of credit-created “growth” did not start in 2007, of course. In the seven years preceding GFC I, growth (at 2017 values) of €62bn (46%) in Irish GDP was accompanied by an expansion in debt of €267bn (120%), meaning that Ireland was already habituated to borrowing well over €4 for each incremental euro of “growth”.

According to SEEDS, GDP in 2007 (of €197bn) already materially overstated ‘clean’ (credit-adjusted) output of €181bn. By 2017, the gap had widened to the point where reported GDP (of €296bn) overstated clean output (€193bn) by more than 50%.

And this is even before we take the all-important matter of energy trends into account.

The energy dimension

As regular readers will know, the central working premise of surplus energy economics is that, ultimately, the economy is an energy system, not a financial one – money and credit are simply claims on the output of the energy-driven economy.

Rather than the absolute quantity of energy available, the really critical issue is how much of any energy accessed is consumed in the access process. Put simply, the higher this cost is, the less energy that remains for all purposes other than the supply of energy itself.

Globally, ECoE – the energy cost of energy – is on an exponentially rising trend, having climbed from 4% in 2000 to 5.4% in 2007 (just before GFC I) and 7.7% last year. Across developed economies as a group, ECoE has already risen to levels high enough to put previous growth in prosperity into reverse.

This, ultimately, is why these economies have adopted credit and monetary adventurism in an ultimately futile attempt to maintain a semblance of ‘growth as usual’.

Ireland is more affected than most by the relentless escalation in ECoEs, mainly because of the paucity of indigenous energy resources. Last year, consumption of energy totalled 16.8 million tonnes of oil equivalent, but production was just 3.6 mmtoe, forcing Ireland to rely on imports for almost 80% of her primary energy needs. All of Ireland’s petroleum and gas requirements are imported, making the country particularly exposed both to rising world ECoEs and to energy supply risk.

According to SEEDS, Ireland’s ECoE as long ago as 2000 (4.8%) was already higher than the global average (4.0%). By 2007, this differential had widened, to 6.7% versus a global 5.4%. Today, Ireland’s trend ECoE is put at 11.2%, far higher than a world average of 8.0%.

In other words, the gap keeps getting worse.

Levels of ECoE above 10% make growth in prosperity almost impossible, and Ireland’s high ECoEs are already having a swingeing impact on prosperity. Deducting 2017 ECoE (of 10.7%) from clean GDP of €193bn leaves aggregate prosperity at just €173bn. This number is barely (2%) higher than it was in 2007, but population numbers increased by 6.4% between those years.

This means that prosperity per person last year was €36,510, nowhere remotely near reported GDP per capita of €62,560. Irish prosperity actually peaked in 2005, at €38,780, and it is a sobering thought that debt per capita is 134% (€114,000) higher now (at €198,440 per person) than it was back then (€84,830).

The extremity of risk

What we have seen is that the Irish economy is an extreme, amplified version of adverse trends observable across most of the developed economies. For over a decade, high and rising energy costs have been driving prosperity downwards – indeed, Ireland is fortunate that the post-peak fall in prosperity has been just 5.9%, rather than the 10.8% decline experienced by Britain, or the 12.3% fall suffered by Italy. At the same time, debt has soared.

Quite aside from the “leprechaun” recalibration of GDP, this relentless weakening in prosperity has been masked from reported numbers by the infusion of huge amounts of credit-funded activity into the Irish economy. Since prosperity hit its peak in 2005, aggregate debt has expanded from €356bn to €938bn, and only in the last two years has there been evidence of meaningful efforts at deleveraging. How far these efforts can continue – with prosperity deteriorating at rates of between 0.6% and 0.8% annually – has to be conjectural.

It is only when prosperity (rather than increasingly meaningless GDP) is used as the denominator that the full magnitude of Ireland’s financial risk becomes apparent. Debt of €938bn might be ‘only’ 317% of GDP, but it is 544% of prosperity. More disturbingly still, banking exposure, as measured by financial assets, now stands at an estimated (and truly frightening) 2560% of prosperity.

With a per-capita share of debt of more than €198,000 – and with prosperity continuing to erode – the very last thing that Irish citizens need now is a “Brexit” process mishandled by British vacillation and European posturing.