#174. American disequilibrium


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.

A1 Fig 6

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.

A2 Fig 8

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.

A3 Fig 7

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.

A4 Fig 9

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.



#152: Stuffed


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.

#149: The big challenges


As regular readers will know, this site is driven by the understanding that the economy is an energy system, and not (as conventional thinking assumes) a financial one. Though we explore a wide range of related issues (such as the conclusion that energy supply is going to need monetary subsidy), it’s important that we never lose sight of the central thesis. So I hope you’ll understand the need for a periodic restatement of the essentials.

If you’re new to Surplus Energy Economics, what this site offers is a coherent interpretation of economic and financial trends from a radically different standpoint. This enables us to understand issues that increasingly baffle conventional explanations.

This perspective is a practical one – nobody conversant with the energy-based interpretation was much surprised, for instance, when Donald Trump was elected to the White House, when British voters opted for “Brexit”, or when a coalition of insurgents (aka “populists”) took power in Rome. The SEE interpretation of prosperity trends also goes a long way towards explaining the gilets jaunes protests in France, protests than can be expected in due course to be replicated in countries such as the Netherlands. We’re also unpersuaded by the exuberant consensus narrative of the Chinese economy. The proprietary SEEDS model has proved a powerful tool for the interpretation of critical trends in economics, finance and government.

The aim here, though, isn’t simply to restate the core interpretation. Rather, there are three trends to be considered, each of which is absolutely critical, and each of which is gathering momentum. The aim here is to explore these trends, and share and discuss the interpretations of them made possible by surplus energy economics.

The first such trend is the growing inevitability of a second financial crisis (GFC II), which will dwarf the 2008 global financial crisis (GFC), whilst differing radically from it in nature.

The second is the progressive undermining of political incumbencies and systems, a process resulting from the widening divergence between policy assumption and economic reality.

The third is the clear danger that the current, gradual deterioration in global prosperity could accelerate into something far more damaging, disruptive and dangerous.

The vital insight

The centrality of the economy is the delivery of goods and services, literally none of which can be supplied without energy. It follows that the economy is an energy system (and not a financial one), with money acting simply as a claim on output which is itself made possible only by the availability of energy. Money has no intrinsic worth, and commands ‘value’ only in relation to the things for which it can be exchanged – and all of those things rely entirely on energy.

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

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

The trend in ECoE is determined by four main factors. Historically, ECoE has been pushed downwards by broadening geographical reach and increasing economies of scale. Where oil, natural gas and coal are concerned, these positive factors have been exhausted, so the dominating driver of ECoE now is depletion, a process which occurs because we have, quite naturally, accessed the most profitable (lowest ECoE) resources first, leaving costlier alternatives for later.

The fourth driver of ECoE is technology, which accelerates downwards tendencies in ECoE, and mitigates upwards movements. Technology, though, operates within the physical properties of the resource envelope, and cannot ‘overrule’ the laws of physics. This needs to be understood as a counter to some of the more glib and misleading extrapolatory assumptions about our energy future.

The nature of the factors driving ECoE indicates that this critical factor should be interpreted as a trend. According to SEEDS – the Surplus Energy Economics Data System – the trend ECoE of fossil fuels has risen exponentially, from 2.6% in 1990 to 4.1% in 2000, 6.7% in 2010 and 9.9% today. Since fossil fuels continue to account for four-fifths of energy supply, the trend in overall world ECoE has followed a similarly exponential path, and has now reached 8.0%, compared with 5.9% in 2010 and 3.9% in 2000.

For fossil fuels alone, trend ECoE is projected to reach 11.8% by 2025, and 13.5% by 2030. SEEDS interpretation demonstrates that an ECoE of 5% has been enough to put prosperity growth into reverse in highly complex Western economies, whilst less complex emerging market (EM) economies hit a similar climacteric at ECoEs of about 10%. A world economy dependent on fossil fuels thus faces deteriorating prosperity and diminishing complexity, both of which pose grave managerial challenges because they lie wholly outside our prior experience.

Mitigation, not salvation

This interpretation – reinforced by climate change considerations – forces us to regard a transition towards renewables as a priority. It should not be assumed, however, that renewables offer an assured escape from the implications of rising ECoEs, still less that they offer a solution that is free either of pain or of a necessity for social adaption.

There are three main cautionary factors around the ECoE capabilities of solar, wind and other renewable sources of energy.

The first cautionary factor is “the fallacy of extrapolation”, the natural – but often mistaken – human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. It’s easy to assume that, because the ECoEs of renewables have been falling over an extended period, they must carry on falling indefinitely, at a broadly similar pace. But the reality is much more likely to be that cost-reducing progress in renewables will slow when it starts to collide with the limits imposed by physics.

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

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

But we are certainly, at present, nowhere near such a breakthrough. Until and unless this point is reached, the danger exists that that the ECoE of renewables may start to rise, pushed back upwards by the rising ECoE of the fossil fuel sources on which so many of their inputs rely.

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

Global prosperity stopped growing before ECoE hit 6%. British prosperity has been in decline ever since ECoE reached 3.6%, and an ECoE of 5.5% has been enough to push Western prosperity growth into reverse. As recently as the 1960s, in what we might call a “golden age” of prosperity growth, ECoE was well below 2%. Even if renewables could stabilise ECoE at, say, 8% – and that’s an assumption which owes much more to hope than calculation – it wouldn’t be low enough to enable prosperity to stabilise, let alone start to grow again.

SEEDS projections are that overall world ECoE will reach 9% by 2025, 9.7% by 2030 and 11% by 2040. These projections are comparatively optimistic, in that progress with renewables is expected to blunt the rate of increase in trend ECoE. But we should labour under no illusion that the downwards tendency in prosperity can be stemmed, less still reversed. Renewables can give us time to prepare and respond, but are not going to take us back to a nirvana of low-cost energy.

This brings us to the three critical issues driven by rising ECoE and diminishing prosperity.

Challenge #1 – financial shock

An understanding of the energy basis of the economy puts us in possession of a coherent narrative of recent and continuing tendencies in economics and finance. Financially, in particular, the implications are disquieting. There is overwhelming evidence pointing towards a repetition of the 2008 global financial crisis (GFC), in a different form and at a very much larger scale.

From the late 1990s, with ECoEs rising beyond 4%, growth in Western prosperity began to peter out. Though “secular stagnation” was (and remains) the nearest that conventional interpretation has approached to understanding this issue, deceleration was noticed sufficiently to prompt the response known here as “credit adventurism”.

This took the form of making credit not only progressively cheaper to service but also much easier to obtain. This policy was also, in part, aimed at boosting demand undermined by the outsourcing of highly-skilled, well-paid jobs as a by-product of ‘globalization’. “Credit adventurism” was facilitated by economic doctrines which were favourable to deregulation, and which depicted debt as being of little importance.

The results, of course, are now well known. Between 2000 and 2007, each $1 of reported growth in GDP was accompanied by $2.08 of net new borrowing, though ratios were far higher in those Western economies at the forefront of credit adventurism. The deregulatory process also facilitated a dangerous weakening of the relationship between risk and return. These trends led directly to the 2008 global financial crisis.

Responses to the GFC had the effect of hard-wiring a second, far more serious crash into the system. Though public funds were used to rescue banks, monetary policy was the primary instrument. This involved slashing policy rates to sub-inflation levels, and using newly-created money to drive bond prices up, and yields down.

This policy cocktail added “monetary adventurism” to the credit variety already being practiced. Since 2007, each dollar of reported growth has come at a cost of almost $3.30 in new debt. Practices previously confined largely to the West have now spread to most EM economies. For example, over a ten-year period in which growth has averaged 6.5%, China has typically borrowed 23% of GDP annually.

Most of the “growth” supposedly created by monetary adventurism has been statistically cosmetic, consisting of nothing more substantial than the simple spending of borrowed money. According to SEEDS, 66% of all “growth” since 2007 has fallen into this category, meaning that this growth would cease were the credit impulse to slacken, and would reverse if we ever attempted balance sheet retrenchment. As a result, policies said to have been “emergency” and “temporary” in nature have, de facto, become permanent. We can be certain that tentative efforts at restoring monetary normality would be thrown overboard at the first sign of squalls.

Advocates of ultra-loose monetary policy have argued that the creation of new money, and the subsidizing of borrowing, are not inflationary, and point at subdued consumer prices in support of this contention. However, inflation ensuing from the injection of cheap money can be expected to appear at the point at which the new liquidity is injected, which is why the years since 2008 have been characterised by rampant inflation in asset prices. Price and wage inflation have been subdued, meanwhile, by consumer caution – reflected in reduced monetary velocity – and by the deflationary pressures of deteriorating prosperity. The current situation can best be described as a combination of latent (potential) inflation and dangerously over-inflated asset prices.

All of the above points directly to a second financial crisis (GFC II), though this is likely to differ in nature, as well as in scale, from GFC I. Because “credit adventurism” was the prime cause of the 2008 crash, its effects were concentrated in the credit (banking) system. But GFC II, resulting instead from “monetary adventurism”, will this time put the monetary system at risk, hazarding the viability of fiat currencies.

In addition to mass defaults, and collapses in asset prices, we should anticipate that currency crises, accompanied by breakdowns of trust in currencies, will be at the centre of GFC II. The take-off of inflation should be considered likely, not least because no other process exists for the destruction of the real value of gargantuan levels of debt.

Finally on this topic, it should be noted that policies used in response to 2008 will not work in the context of GFC II. Monetary policy can be used to combat debt excesses, but problems of monetary credibility cannot, by definition, be countered by increasing the quantity of money. Estimates based on SEEDS suggest that GFC II will be at least four orders of magnitude larger than GFC I.

Challenge #2 – breakdown of government

Until about 2000, the failure of conventional economics to understand the energy basis of economic activity didn’t matter too much, because ECoE wasn’t large enough to introduce serious distortions into its conclusions. Put another way, the exclusion of ECoE gave results which remained within accepted margins of error.

The subsequent surge in ECoEs, however, has caused the progressive invalidation of all interpretations from which it is excluded.

What applies to conventional economics itself applies equally to organisations, and most obviously to governments, which use it as the basis of their interpretations of policy.

The consequence has been to drive a wedge between policy assumptions made by governments, and underlying reality as experienced by individuals and households. Even at the best of times – which these are not – this sort of ‘perception gap’ between governing and governed has appreciable dangers.

Recent experience in the United Kingdom illustrates this process. Between 2008 and 2018, GDP per capita increased by 4%, implying that the average person had become better off, albeit not by very much. Over the same period, however, most (85%) of the recorded “growth” in the British economy had been the cosmetic effect of credit injection, whilst ECoE had risen markedly. For the average person, then, SEEDS calculates that prosperity has fallen, by £2,220 (9%), to £22,040 last year from £24,260 ten years previously. At the same time, individual indebtedness has risen markedly.

With this understood, neither the outcome of the 2016 “Brexit” referendum nor the result of the 2017 general election was much of a surprise, since voters neither (a) reward governments which preside over deteriorating prosperity, nor (b) appreciate those which are ignorant of their plight. This was why SEEDS analysis saw a strong likelihood both of a “Leave” victory and of a hung Parliament, outcomes dismissed as highly improbable by conventional interpretation.

Simply put, if political leaders had understood the mechanics of prosperity as they are understood here, neither the 2016 referendum nor the 2017 election might have been triggered at all.

Much the same can be said of other political “shocks”. When Mr Trump was elected in 2016, the average American was already $3,450 (7%) poorer than he or she had been back in 2005. The rise to power of insurgent parties in Italy cannot be unrelated to a 7.9% deterioration in personal prosperity since 2000.

As well as reframing interpretations of prosperity, SEEDS analysis also puts taxation in a different context. Between 2008 and 2018, per capita prosperity in France deteriorated by €1,650 which, at 5.8%, isn’t a particularly severe fall by Western standards. Over the same period, however, taxation increased, by almost €2,000 per person. At the level of discretionary, ‘left-in-your-pocket’ prosperity, then, the average French person is €3,640 (32%) worse off now than he or she was back in 2008.

This makes widespread popular support for the gilets jaunes protestors’ aims extremely understandable. Though no other country has quite matched the 32% deterioration in discretionary prosperity experienced in France, the Netherlands (with a fall of 25%) comes closest, which is why SEEDS identifies Holland as one of the likeliest locales for future protests along similar lines. It is far from surprising that insurgent (aka “populist”) parties have now stripped the Dutch governing coalition of its Parliamentary majority. Britain, where discretionary prosperity has fallen by 23% since 2008, isn’t far behind the Netherlands.

These considerations complicate political calculations. To be sure, the ‘centre right’ cadres that have dominated Western governments for more than three decades are heading for oblivion. Quite apart from deteriorating prosperity – something for which incumbencies are likely to get the blame – the popular perception has become one in which “austerity” has been inflicted on “the many” as the price of rescuing a wealthy “few”. It doesn’t help that many ‘conservatives’ continue to adhere to a ‘liberal’ economic philosophy whose abject failure has become obvious to almost everyone else.

This situation ought to favour the collectivist “left”, not least because higher taxation of “the rich” has been made inescapable by deteriorating prosperity. But the “left” continues to advocate higher levels of taxation and public spending, an agenda which is being invalidated by the erosion of the tax base which is a concomitant of deteriorating prosperity.

Moreover, the “left” seems unable to adapt to a shift towards prosperity issues and, in consequence, away from ideologically “liberal” social policy. Immigration, for example, is coming to be seen by the public as a prosperity issue, because of the perceived dilutionary effects of increases in population numbers.

The overall effect is that the political “establishment”, whether of “the right” or of the “the left”, is being left behind by trends to which that establishment is blinded by faulty economic interpretation.

The discrediting of established parties is paralleled by an erosion of trust in institutions and mechanisms, because these systems cannot keep pace with the rate at which popular priorities are changing. To give just one example, politicians who better understood the why of the “Brexit” referendum result would have been better equipped to recognize the dangers implicit in being perceived as trying to thwart or divert it.

The final point to be considered under the political and governmental heading is the destruction of pension provision. One of the little-noted side effects of “monetary adventurism” has been a collapse in rates of return on invested capital. According to the World Economic Forum, forward returns on American equities have fallen to 3.45% from a historic 8.6%, whilst returns on bonds have slumped from 3.6% to just 0.15%. It is small wonder, then, that the WEF identifies a gigantic, and rapidly worsening, “global pension timebomb”. As and when this becomes known to the public – and is contrasted by them with the favourable circumstances of a tiny minority of the wealthiest – popular discontent with established politics can be expected to reach new heights.

In short, established political elites are becoming an endangered species – and, far from knowing how to replace them, we have an institutionally-dangerous inability to appreciate the factors which have already made fundamental change inevitable.

Challenge #3 – an accelerating slump?

Everything described so far has been based on an interpretation which demonstrates an essentially gradual deterioration in prosperity. That, in itself, is serious enough – it threatens both a financial system predicated on perpetual growth, and political processes unable to recognise the implications of worsening public material well-being.

For context, SEEDS concludes that the average person in Britain, having become 11.5% less prosperous since 2003, is now getting poorer at rates of between 0.5% and 1.0% each year. EM economies, including both China and India, continue to enjoy growing prosperity, though this growth is now decreasing markedly, and is likely to go into reverse in the not-too-distant future.

Is it safe to assume, though, that prosperity will continue to erode gradually – or might be experience a rapid worsening in the rate of deterioration?

For now, no conclusive answer can be supplied on this point, but risk factors are considerable.

Here are just some of them:

1. The worsening trend in fossil fuel ECoEs is following a track that is exponential, not linear – and, as we have seen, there are likely to be limits to how far this can be countered by a switch to renewables.

2. The high probability of a financial crisis, differing both in magnitude and nature from GFC I, implies risks that there may be cross contamination to the real economy of goods, services, energy and labour.

3. Deteriorating prosperity poses a clear threat to rates of utilization, an important consideration given the extent to which both businesses and public services rely on high levels of capacity usage. Simple examples are a toll bridge or an airline, both of which spread fixed costs over a large number of users. Should utilization rates fall, continued viability would require increasing charges imposed on remaining users, since this is the only way in which fixed costs can be covered – but rising charges can be expected to worsen the rate at which utilization deteriorates.

4. Uncertainty in government, discussed above, may have destabilizing effects on economic activity.

There is a great deal more that could be said about “acceleration risk”, as indeed there is about the financial and governmental challenges posed by deteriorating prosperity.

But it is hoped that this discussion provides useful framing for some of the most important challenges ahead of us.



#146: Fire and ice, part three


The project entitled Fire & Ice has had two very definite objectives. One is to make a synopsis of the economic and financial situation. The other is to start a debate about what the most appropriate responses might be. By “responses”, I wasn’t thinking of what individuals might do in preparation, though suggestions on this could be most valuable. Rather, the focus is on how the authorities might react to circumstances as they develop.

Of course, who “the authorities” might be when the challenge arises is less obvious than it might once have seemed. After more than three decades in the ascendancy, the ‘liberal globalist’ elites are in retreat. Political insurgents – a term which I prefer to the more loaded “populist” label – are bringing fresh ideas and new energy to the debate.

But it is far from clear that these newcomers have a grasp of economic reality that is any better than that of their ‘establishment’ opponents. They’re good at knowing what the public doesn’t like, but sketchy, at best, about what can realistically be offered instead.

I like to think that energy-based analysis of the economy provides answers to questions which baffle ‘conventional’ economic interpretation. I also like to think that we have both a coherent narrative and an effective model.

But where do we go from here?

The best place to start might be with a short list of the issues most demanding current attention. Five subjects dominate this list, and these are:

– The almost tangible pace of economic deterioration, most obviously (though by no means exclusively) in China.

– The complete bafflement of ‘the powers that be’ about the processes that are dismantling the established economic, social and political world-view.

– The looming crisis of a financial structure built on reckless credit and monetary adventurism.

– The rising anger of ‘ordinary’ people who, without knowing exactly how or why, suspect that they’ve been ‘taken for a ride’ by ‘the establishment’.

– The impending revelation that’s likely to boost popular anger to levels dwarfing anything yet experienced.

The big one – ‘hidden in plain sight’

The latter, highly incendiary issue is the unfolding failure of the ability to provide pensions to any but a super-wealthy minority. The collapse of returns on investment has crippled the viability of most employer and individual savings provision. Meanwhile, Tier 1 provision (which is financed directly out of taxation, rather than funded like private schemes) is already well on the way to becoming unaffordable, not least because – as we’ve seen in a previous discussion – tax revenues are leveraged to the ongoing deterioration in prosperity in almost all Western economies.

The disintegration of pension provision is a crisis ‘hidden in plain sight’. Back in 2017, the World Economic Forum called attention to a “global pensions timebomb”, calculating that, for a group of eight countries, a gap already standing at $67 trillion was set to reach $428tn by 2050. (You can find the WEF press release here, and it links to the report itself. Both should be mandatory reading).

The WEF made various worthy suggestions – including delaying retirement ages, and enhancing popular understanding of pensions systems – but these can do no more than scratch the surface of a problem caused by a collapse in returns which is itself a direct consequence of deliberate (though not necessarily voluntary) economic policy.

Broadly speaking, people in Western countries have a long-established expectation, which is that they’ll retire in their early 60s, and then receive a pension equivalent to about 70% of their final in-work incomes. We’re close to a point at which retirement before the age of 70 will become impossible to finance and, even then, it’s unlikely that the 70%-of-income benchmark will be affordable.

We’ll return to this subject later in this discussion. But the critical point is that the anger that will erupt when the public finds out about this is likely to be extreme.

The central issue

The best way to impose a structure on these disparate issues is to start with their common cause – a deterioration in prosperity that’s becoming impossible to disguise, and which the authorities themselves seem wholly unable to comprehend.

If you’re a regular visitor to this site, you’ll know that the central contention here is that the economy is an energy system, not a financial one. This interpretation is so obviously in keeping with the facts that it can be hard to comprehend the inability of ‘conventional’ thinkers to understand it.

For example, anyone who thinks that energy is ‘just another input’ should try picturing what would happen if the supply of energy to an economy was cut off, just for a few days, let alone for several months. Even an outage lasting days would bring the economy to a halt – and a few months without energy would induce economic and social collapse.

Those who contend that energy is ‘just a small percentage’ of economic output might reflect, first, that the foundations are ‘just a small percentage’ of a tower-block, but we wouldn’t build one without them. They might also try to name anything within the gamut of goods and services that can be produced without energy. Moreover, if energy did absorb a large proportion of the economy, the obvious inference is that the non-energy remainder would have to have shrunk dramatically. Additionally, of course, it’s becoming ever harder to believe that GDP numbers swelled by the spending of borrowed money are any kind of realistic denominator for calculating the proportionate role played by energy.

To be sure, it’s highly unlikely that energy supply to an economy would be cut off in its entirety (though it’s rather less unlikely that an economy could lose the ability to pay for it). But the point here is the centrality of energy to literally all economic activity. Equally, it’s surely obvious that the energy which drives all economic activity (other than the supply of energy itself) is surplus energy – that is, the energy to which we have access after we’ve deducted the energy consumed in the access process.

That equation is measured here using ECoE (the energy cost of energy). It is no coincidence at all that an exponential rise in the trend ECoEs of fossil fuels has paralleled the increasing use of financial adventurism –  the less generous might call it ‘manipulation’ – in futile efforts to stave off economic stagnation.

Of course, you can’t fix the ECoE problem by pouring cheap credit and cheaper money into the system, but what you can achieve is the creation of enormous bubbles which are destined to burst, scattering debris right across the financial and economic landscape.

Optimists assert that we needn’t worry about the ECoE problem with oil, gas and coal, because we can transition to renewable energy sources. This claim might be a valid one, though the weight of evidence strongly suggests otherwise. Where the optimists do depart completely from reality is in the assertion that this transition can happen seamlessly, without any check to “growth”, without any noticeable disruption and, needless to say, without any hardship which might weaken the economic or social status quo.

Irrespective of where transition to renewables might take us in the future, the issues now are twofold. The first is that the rising trend in ECoEs is being reflected in a squeeze in prosperity, a process which is often labelled “secular stagnation”, but which is proving impossible to counter using the conventional tool of financial stimulus.

The second is that exercises in denial have created ever-growing imbalances within the financial system, imbalances which are manifesting themselves, not just in asset price bubbles and in excessive indebtedness, but in credit dependency, and in the destruction of pension provision.

These constitute specific risks, which are modeled by SEEDS, and might be addressed in a subsequent analysis. For now, though, here are the risk categories identified by the model:

Debt risk. This is calibrated by comparing debt with prosperity, rather than with the increasingly unrealistic GDP benchmark.

Credit dependency. This is a measure of annual rates of borrowing, and identifies exposure to any squeeze in, or cessation of, the continuity of credit.

Systemic exposure. This assesses contagion risk by measuring the scale of financial assets in proportion to prosperity.

Acquiescence risk. This measure looks at how rapidly personal prosperity has fallen, and is continuing to fall. The aim here is to assess the extent to which arduous ‘rescue plans’, which might be labelled ‘restorative austerity’, are likely to meet with popular opposition.

Primed to detonate

The pensions problem is critical here, for two quite distinct reasons. The first is that the creation of the pensions “timebomb” tells us a very great deal about economic abnormality, and the grotesque failure of policy.

The second is that this “timebomb” might detonate in the foundations of the current system of governance. It certainly has the potential to dwarf all other popular grievances.

According to the WEF study, the pensions gap in the United States stood at $27.8tn in 2015. It is growing at a real compound rate of about 4.7% annually, and is likely to have reached almost $32tn by the end of last year. In Britain, a number stated at $8tn (£5.25tn) for 2015 is growing by more than 4% each year, and is likely now to be well over £7tn. In both instances, the rate at which the gap is widening far exceeds any remotely realistic rate of growth in GDP.

As regular readers know, reported GDP is flattered by the spending of huge amounts of borrowed money, and ignores the critical issue of ECoE. For 2018, SEEDS estimates American aggregate prosperity at $14.7tn, significantly smaller than GDP of $20.5tn. British prosperity is calculated at £1.47tn last year, compared with GDP of £2tn.

This means that, in the United States, the pension gap has already reached 210% of prosperity (and 155% of GDP), and is likely to reach 300% of prosperity by 2026.

In Britain, it’s likely that the gap is already over 470% of prosperity, and will reach 660% by 2026. This financial ‘hostage to the future’ is in addition to debt put at 365% of prosperity. Moreover, financial assets (a measure of the size of the financial system) are estimated at close to 1600% of British prosperity (and about 1125% of GDP). This looks a potentially lethal cocktail for any economy founded on ultra-cheap credit and a fiat monetary system

There are two main reasons for the truly frightening rates at which pension gaps have emerged, and the equally worrying rates at which they are increasing. First, the ability to fund state-provided pensions is coming under tightening pressure because of the leveraged impact of adverse prosperity trends on the scope for taxation.

The second is the collapse of returns on invested capital. According to the WEF report, historic returns of 8.6% on US equities and 3.6% on bonds have now slumped to, respectively, 3.45% and just 0.15% on a forward basis. This makes it wholly impossible, not just in America but across the world, for private investment to fill any part of the widening chasm in state provision.

The collapse in rates of return is the clincher here, and is a direct consequence of the adoption of ZIRP (zero interest rate policy). Put simply, the pensions “timebomb” is something that we’ve wished on ourselves through monetary policy. Introduced back in 2008, the supposedly “temporary” and “emergency” policy expedient of ZIRP has already long-outlasted the duration of the Second World War, and there’s no prospect, now or later, of a return to “normal” rates (which can be thought of as rates exceeding inflation by at least 2.5%).

Policies like ZIRP need to be interpreted as economic signals, sometimes (as now) determined less by voluntary policy decision than by the force of circumstances. The ‘force of circumstances’ which dictated the adoption of ZIRP was a debt mountain which borrowers had become wholly unable to service at normal rates of interest.

It’s vital to note that ZIRP wasn’t something chosen capriciously by the authorities. Rather, it was an expedient forced upon them by economic conditions. Behind the apparent “borrow, don’t save” signal represented by ZIRP lies a structural signal, which is that “the economy can no longer afford saving”. When that happens, it’s the economic equivalent of the way in which some ships or aeroplanes can be kept operational by cannibalizing others.

Politically, there’s no way out of this which doesn’t inflame popular anger. Historically, as mentioned earlier, people in Western countries have assumed that they will retire in their early 60s, receiving, in retirement, roughly 70% of the income they earned at the close of their working lives. The sums here suggest that even raising retirement ages to 70 won’t keep the 70% target affordable.

I’ll leave you to reflect on what the reaction is likely to be when the plight of the “ordinary” person becomes known, and is contrasted with the circumstances of a privileged minority. However, any political establishment which supposes that, whilst pensions become unaffordable for most, a minority can continue retire on generous incomes, and with the cushion of substantial accumulated wealth, is guilty of very dangerous self-deception.

Crunch point

The harsh reality is that we’ve built systems – financial, economic, social and political – which can only function when prosperity is growing. These systems can survive recessions, or even depressions, presupposing that neither is unduly protracted, and is followed by a return to growth. When – as now – that doesn’t happen, the promises that we made to ourselves in order to weather the bad times rapidly become incapable of being honoured.

Ultimately, any financial system is a set of promises, and functions only if those promises can be kept.

It has to be glaringly obvious, too, that the historic cushion of growing prosperity has enabled us to indulge in luxuries that are now becoming unaffordable. The term “luxuries” doesn’t refer to trinkets like gadgets, expensive holidays and the two- or three-car family. Rather, it refers to assumptions and practices that can no longer be afforded.

High on this list lies the indulgence of ideological extremism in economic organisation. If there was ever a time when society could afford either the fanaticism of “nationalising everything”, or the contrary fanaticism of “privatising everything”, that time passed at least two decades ago. What is required now is the pragmatism which surely leads to the “horses for courses” preference for a mixed economy, in which both the state and private enterprise concentrate on what each does best.

Other luxuries that we can no longer afford include massive gaps between the poorest and the wealthiest. This was an affordable luxury when everyone was getting a little more prosperous with each passing year. When your own circumstances are improving, it’s not difficult to accept the extreme wealth of your neighbour – but this tolerance will dissolve very quickly indeed when exposed to the solvent of generally deteriorating prosperity.

This, through its direct link to political insurgency (aka “populism”), brings us back to the immediate situation. Public dissatisfaction has thus far been fueled by discontents likely to be dwarfed by anger yet to come, as inflated asset prices explode and the reality of deteriorating prosperity can no longer be disguised. The Chinese economy, which has accounted for 36% of all global growth since 2008, is now deteriorating markedly, the inevitable fate of any system founded on truly reckless rates of borrowing. “Growth” of 6-7% ceases to impress when you have to borrow about 25% of GDP each year to make it happen.

Few Western economies are in much better condition, yet politicians continue to promise “growth”, and remain in ignorance about the trends that are making such promises an absurdity. Perhaps the greatest risk of all is that lessons not learned in 2008 will be no better understood in the next (and much larger) crisis described here as GFC II.

Stir the pensions reality into that mix and the result is an inflammable cocktail. We may know that current incumbencies cannot adapt to the new realities, but the insurgents have yet to demonstrate a better grasp of reality.

Where we need to go next is to start helping craft a programme which, whilst it cannot remove impending challenges, might at least enable us to adjust to them.

= = = = =

#146 pensions returns 03