#148: Where now for energy?

WHY SUBSIDY HAS BECOME INESCAPABLE

What happens when energy prices are at once too high for consumers to afford, but too low for suppliers to earn a return on capital?

That’s the situation now with petroleum, but it’s likely to apply across the gamut of energy supply as economic trends unfold. On the one hand, prosperity has turned down, undermining what consumers can afford to spend on energy. On the other, the real cost of energy – the trend energy cost of energy (ECoE) – continues to rise.

In any other industry, these conditions would point to contraction – the amount sold would fall. But the supply of energy isn’t ‘any other industry’, any more than it’s ‘just another input’. Energy is the basis of all economic activity – if the supply of energy ceases, economic activity grinds to a halt. (If you take a moment to think through what would happen if all energy supply to an economy were cut off, you’ll see why this is).

Without continuity of energy, literally everything stops. But that’s exactly what would happen if the energy industries were left to the mercies of rising supply costs and dwindling customer resources.

This leads us to a finding which is as stark as it is (at first sight) surprising – we’re going to have to subsidise the supply of energy.

Critical pre-conditions

Apart from the complete inability of the economy to function without energy, two other, critical considerations point emphatically in this direction.

The first is the vast leverage contained in the energy equation. The value of a unit of energy is hugely greater than the price which consumers pay (or ever could pay) to buy it. There is an overriding collective interest in continuing the supply of energy, even if this cannot be done at levels of purchaser prices which make commercial sense for suppliers.

The second is that we already live in an age of subsidy. Ever since we decided, in 2008, to save reckless borrowers and reckless lenders from the devastating consequences of their folly, we’ve turned subsidy from anomaly into normality.

The subsidy in question isn’t a hand-out from taxpayers. Rather, supplying money at negative real cost subsidizes borrowers, subsidizes lenders and supports asset prices at levels which bear no resemblance to what ‘reality’ would be under normal, cost-positive monetary conditions.

In the future, the authorities are going to have to do for energy suppliers what they already do for borrowers and lenders – use ‘cheap money’ to sustain an activity which is vital, but which market forces alone cannot support.

How they’ll do this is something considered later in this discussion.

If, by the way, you think that the concept of subsidizing energy supply threatens the viability of fiat currencies, you’re right. The only defence for the idea of providing monetary policy support for the supply of energy is that the alternative of not doing so is even worse.

Starting from basics  

To understand what follows, you need to know that the economy is an energy system (and not a financial one), with money acting simply as a claim on output made possible only by the availability of energy. This observation isn’t exactly rocket-science, because it is surely obvious that money has no intrinsic worth, but commands value only in terms of the things for which it can exchanged.

To be slightly more specific, 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.

From this perspective, 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 growth in emerging market (EM) economies is petering out. Global average prosperity has already turned down.

From this simple insight, much else follows – for instance, our recent, current and impending financial problems are caused by a collision between (a) a financial system wholly predicated on perpetual growth in prosperity, and (b) an energy dynamic that has already started putting prosperity growth into reverse. Likewise, political changes are likely to result from the failure of incumbent governments to understand the worsening circumstances of the governed.

Essential premises – leverage and subsidy

Before we start, there are two additional things that you need to appreciate.

The first is that the energy-economics equation is hugely leveraged. This means that the value of energy to the economy is vastly greater than the prices paid (or even conceivably paid) for it by immediate consumers. Having (say) fuel to put in his or her car is a tiny fraction of the value that a person derives from energy – it supplies literally all economic goods and services that he or she uses.

The second is that, ever since the 2008 global financial crisis (GFC I) we have been living in a post-market economy.

In practice, this means that subsidies have become a permanent feature of the economic landscape.

These issues are of fundamental importance, so much so that a brief explanation is necessary.

First, leverage. The energy content of a barrel of crude oil is 5,722,000 BTU, which converts to 1,677kwh, or 1,677,022 watt-hours. BTUs and watt-hours are ‘measures of work’ applicable to any source or use of energy. Human labour equates to about 75 watts per hour, so a barrel of crude equates to 22,360 hours of labour. At the (pretty low) rate of $10 per hour, this labour would cost an employer $223,603. Yet crude oil changes hands for just $65 which, undeniably, is a bargain. If the price of oil soared to $1,000/b, it would wreck the economy – but it would still be an extremely low price, when measured against an equivalent amount of human effort.

The economy, then, could be crippled by energy prices that would still be ultra-cheap in purely energy-content terms. More to the point, this could happen at prices that were still too low to ensure profitability in the business of energy supply.

The comparison between petroleum and its labour equivalent is meant to be solely illustrative – the relevant point is that the economy is gigantically leveraged to the ‘work value’ contained in all exogenous energy sources.

Second, the end of the market economy. The market economy works on a system of impersonal rewards and penalties. If you make shrewd investments, you’re likely to make a profit – but, if you act recklessly (or simply have a run of bad lack), you stand to lose everything. Failure, as penalised impersonally by market forces, is the flip-side of reward, itself (in theory) equally impersonal. Logically, market forces don’t allow you to have reward without the risk of failure. Using debt to leverage your position acts to increase both the scope for profit and the potential for loss.

The 2008 crisis was a culminating failure of reckless financial behaviour, by individuals, businesses, banks, regulators and policymakers. Left simply to the workings of the market, the penalties would have been on a scale commensurate with the preceding folly. Individuals and businesses which had taken on too much debt would have been bankrupted, as would those who had lent recklessly to them. If market forces had been allowed to work through to their logical conclusions, 2008 would have seen massive failures, bankruptcies and defaults – spreading out from those who ‘deserved’ to be wiped out to take in ‘bystanders’ with varying degrees of ‘innocence’ – whilst asset prices would have collapsed, and much of the banking system, as the primary supplier of credit, would have been destroyed.

Some economic purists have argued that this is exactly what should have happened, and that we will in due course pay a huge price for the ‘moral hazard’ of rescuing the reckless from the consequences of their actions.

They might well be right.

Be that as it may, though,  the point is that market forces were not allowed to work out to their logical conclusions. As well as simply rescuing the banks, the authorities set out on the wholesale rescue of anyone who had taken on too much debt. This was done primarily by slashing interest rates to levels that are negative in real terms (lower than inflation). Though described at the time as “temporary” and “emergency” in nature, these interventions are, for all practical purposes, permanent.

There’s irony in the observation that, though idealists of ‘the Left’ have dreamed since time immemorial of overthrowing the ‘capitalist’ system, the market economy has not been destroyed by its foes, but abandoned by its friends.

The Age of Subsidy

Critically for our purposes, what began in 2008 and continues to this day is wholesale subsidy. ZIRP has provided emergency and continuing sustenance for everyone who had borrowed recklessly in the years preceding the crash. It has also multiplied the incentive to borrow. Negative real interest rates are nothing more nor less than a hand-out to distressed borrowers, not only sparing them from debt service commitments that they could no longer afford, but inflating the market value of their investments, too.

Though less obvious than its beneficiaries, this subsidy has turned huge numbers into victims. Savers, including those putting resources aside for pensions, have been only the most visible of these victims. We cannot know who might have prospered had badly-run, over-extended businesses gone to the wall rather than continuing, in subsidised, “zombie” form, to occupy market space that might more productively have gone to new entrants. We do know that the young are victims of deliberate housing cost inflation.

There’s nothing new about subsidies, of course, and governments have often subsidised activities, either because these are seen to be of national importance, or because they have pandered to the influential interests on whom the subsidies have been bestowed.

Purists of the free market persuasion have long castigated subsidies as distortions of economic behaviour and they are, theoretically at least, quite right to think this.

The point, though, is that, since 2008, the entire economy has been made dependent on the subsidy of money priced at negative real levels.

Anyone who is ‘paid to borrow’ is, of necessity, in receipt of subsidy.

That we live in ‘the age of subsidy’ has a huge bearing on the outlook for energy. With this noted, let’s return to the role of energy in prosperity.

Prosperity in decline – turning-points and differentials

As we’ve noted, once the Energy Cost of (accessing) Energy – ECoE – passes a certain point, the remaining energy surplus becomes insufficient to grow prosperity, or even to sustain it. This point has now been reached or passed in almost all Western economies, so prosperity in those countries has turned down. Efforts to use financial adventurism to counter this effect have done no more than mask (since they cannot change) the processes that are undercutting prosperity, but have, in the process, created huge and compounding financial risks.

In the emerging market (EM) economies, prosperity continues to improve, but no longer at rates sufficient to offset Western decline. Global prosperity per person has now turned downwards from an extremely protracted plateau, meaning that the world has now started getting poorer. Amongst many other things, this means that a financial system predicated on the false assumption of infinite growth is heading for some form of invalidation. It also poses political and social challenges to which existing systems are incapable of adaption.

How, though, does the energy-prosperity equation work – and what can this tell us about the outlook for energy itself?

According to SEEDS (the Surplus Energy Economics Data System), global prosperity stopped growing when trend ECoE hit 5.4%. It might, at first sight, seem surprising that subsequent deterioration has been very gradual, even though ECoE has carried on rising relentlessly, now standing at 8.0%. This apparent contradiction is really all about the changing geographical mix involved – until recently, deterioration in Western prosperity had been offset by progress in EM countries, because the ECoE/growth thresholds differ between these two types of system.

Essentially, EM economies seem to be capable of continuing to grow their prosperity at levels of ECoE a lot higher than those which kill prosperity growth in Western countries.

The following charts illustrate the comparison, and show prosperity per capita (at constant 2018 values) on the vertical axis, and trend ECoE on the horizontal axis. For comparison with America, the China chart shows prosperity in dollars, converted at market exchange rates (in red) and on the more meaningful PPP basis of conversion (blue). For reference, ECoE at 6% is shown as a vertical line on both charts.

#148 energy comp US CH

As you can see, American prosperity had already turned down well before ECoE reached 6%. Chinese prosperity has carried on growing even though ECoE is now well above the 6% level.

How can China carry on getting more prosperous at levels of ECoE at which prosperity has already turned down, not just in America but in almost every other advanced economy?

There seem to be two main reasons for the different relationships between prosperity and ECoE in advanced and EM economies.

First, prosperity isn’t exactly the same thing in a Western or an EM economy – put colloquially, how prosperous you feel depends on where you live, and where you started from.

In America, SEEDS shows that prosperity per person peaked in 2005 at $48,660 per person (at 2018 values), and had fallen to $44,830 (-7.9%) by 2018. Over the same period, prosperity per person in China rose by an impressive 84% – but was still only $9,670 per person last year. Even that number is based on PPP conversion to dollars – converted into dollars at market exchange rates, prosperity per person in China last year was just $5,130.

Both numbers are drastically lower than the equivalent number for the United States. Not surprisingly, Chinese people feel (and are) more prosperous than they used to be, even at levels of prosperity that would amount to extreme impoverishment in America. Before anyone says that “America is a more expensive place to live”, conversion at PPP rates is supposed to take account of cost differentials – and, even in PPP terms, the average Chinese citizen is 78% poorer than his or her American equivalent.

The second critical differential lies in relationships between countries. Historically, trade relationships favoured Western over EM economies, though this has been changing, perhaps helping to explain the gradual narrowing in personal prosperity between developed and emerging countries.

Moreover, there are often quirks in the relationships between countries, even where they belong to the same broad ‘advanced’ or ‘emerging’ economic grouping. Germany is an example of this, having benefited enormously from a currency system which has been detrimental to other (indeed, almost every other) Euro Area country. For some time, Ireland, too, was a beneficiary of EA membership, though those benefits have eroded since the period of “Celtic Tiger” financial excess.

The conclusion, then, is that there’s no ‘one size fits all’ answer to the question of ‘where does ECoE kill growth?’, just as prosperity means different things in different types of economy.

It should also be noted that China’s ability to keep on growing prosperity at quite high levels of ECoE is not necessarily a good guide to the future. As things stand, China’s economy, driven as it by extraordinary levels of borrowing, is looking ever more like a Ponzi scheme facing a denouement.

The situation so far

Given how much ground we’ve covered, let’s take stock briefly of where we are.

We’ve observed, first, that the rise in trend ECoEs is in the process of undermining prosperity. Much of this has already happened – prosperity in most Western economies has now been deteriorating for at least a decade, whilst continued progress in EM economies is no longer enough to keep the global average stable. As ECoEs continue to rise, what happens next is that EM prosperity itself turns down, a process which will accelerate the rate at which global prosperity declines. SEEDS already identifies one major EM economy (other than China) where strong growth in prosperity will soon go into reverse.

Second, a world financial system predicated entirely on perpetual ‘growth’ in prosperity has become dangerously over-extended. Again, this observation isn’t something new. The inauguration, more than ten years ago, of mass subsidy for borrowers and lenders surely tells us that we’ve entered a new ‘era of abnormality’, in which subsidy is normal, and where historic principles (such as positive returns on capital) no longer apply.

If you stir energy leverage into this equation, an inescapable conclusion emerges. It is that we’re going to have to extend our current acceptance of ‘financial adventurism’ to the point where energy supply, just like borrowers and lenders, becomes supported by monetary subsidy.

The only way in which this might not happen would be if we could somehow escape from the implications of rising ECoE. Some believe that renewables will enable us to do this – after all, just as trend ECoEs for oil, gas and coal keep rising, those of wind and solar continue to move downwards.

This situation is summarised in the first of the following charts, which shows broad ECoE trends over the period (1980-2030) covered by SEEDS. As recently as 2000, the aggregate trend ECoE of renewables (shown in green) was above 13%, compared with only 4.1% for fossil fuels (shown in grey). Renewables are already helping to blunt the rise in ECoE, such that the overall number (in red) is lower than that of fossil fuels alone. We’re now pretty close to the point where the ECoE of renewables will be below that of fossil fuels.

On this basis, it’s become ‘consensus wisdom’ to assume that renewables will, like the 7th Cavalry, ‘ride to the rescue in the final reel’. Unfortunately, this comforting assumption rests on three fallacies.

The first is “the fallacy of extrapolation”, which is a natural human tendency to assume that what happens in the future will be an indefinite continuation of the recent past. (One of my mentors in my early years in the City called this “the fallacy of the mathematical dachshund”). The reality is much likelier to be that technical progress in renewables (including batteries) will slow when it starts to collide with the limits imposed by physics.

The second fallacy is that 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. This is illustrated in the second chart, which looks at what might happen beyond the current time parameters of SEEDS. In this projection, progress in reducing the ECoEs of renewables goes into reverse because of the continued rise in fossil-derived inputs.

#148 energy comp segments

The third problem 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 – when economies were expanding rapidly, and world use of cheap petroleum was rising at rates of up to 8% annually – ECoE was well below 2%.

In other words, even if renewables can stabilise ECoE at 8% – and that’s a truly gigantic ‘if’ – it won’t be low enough to enable prosperity to stabilise, let alone start to grow again.

Energy and subsidy –  between Scylla and Charybdis

The idea that we might need to subsidise energy ‘for the greater economic good’ is a radical one, but is not without precedent. Though the development of renewables has been accelerated in various countries by subsidies provided either by taxpayers or by consumers, the important precedent here doesn’t come from the solar or wind sectors, but from the production of oil from shales.

There can be no doubt that shale liquids, primarily from the United States, have transformed petroleum markets – without this production, it’s certain that supplies would have been lower, and prices could well have been a lot higher. Yet the supply of shale has owed little or nothing to the untrammelled working of the market. Rather, shale has received enormous subsidy.

Repeated studies have shown that shale liquids production isn’t ‘profitable’, because cash flow generated from the sale of production has never been sufficient to cover the industry’s capital costs, let alone to provide a return on capital as well. The economics of shale are too big a subject to be examined here, but the critical point is the rapidity with which production declines once a well is put on stream. This means that any company wanting to expand (or even to maintain) its level of production needs to keep drilling new wells – this is the “drilling treadmill” which, critically, has always needed more investment than cash flow from operations can supply.

Yet shale investment has continued, despite its record of generating negative free cash flow. It’s easy to attribute this to the support provided by gullible investors, but the broader picture is that shale producers, like ‘cash burners’ in other sectors, have been kept afloat by a tide of ultra-cheap capital made available by the negative real cost of capital.

In all probability, this is the pattern likely to be followed by the energy industries more generally, as profitability is crushed between the Scylla of rising costs and the Charybdis of straitened consumer circumstances.

In short, we’re probably going to have to ‘create’ the money to keep energy supplies flowing. If the argument becomes one in which energy is described as ‘too important to be left to the market’, energy will join a growing cast of characters – including borrowers, lenders and ‘zombie’ companies – kept in existence by the subsidy of cheap money.

 

#147: Primed to detonate

THE “WHAT?” AND “WHERE?” OF GLOBAL RISK

After more than a decade of worsening economic and financial folly, it can come as no surprise that we’re living with extraordinarily elevated levels of risk.

But what form does that risk take, and where is it most acute?

According to SEEDS – the Surplus Energy Economics Data System – the riskiest countries on the planet are Ireland, France, the Netherlands, China, Canada and the United Kingdom.

The risks vary between economies. Some simply have debts which are excessive. Some have become dangerously addicted to continuing infusions of cheap credit. Some have financial systems vastly out of proportion to the host economy. Some have infuriated the general public to the point where a repetition of the 2008 “rescue” would inflame huge anger. Many have combinations of all four sorts of risk.

Here’s the “top six” from the SEEDS Risk Matrix. Of course, the global risk represented by each country depends on proportionate size, so China (ranked #4 in the Matrix) is far more of a threat to the world economy and financial system than Ireland, the riskiest individual economy. It’s noteworthy, though, that the three highest-risk countries are all members of the Euro Area. It’s also noteworthy that, amongst the emerging market (EM) economies, only China and South Korea (ranked #9) make the top ten.

Risk 01 matrix top

Risk and irresponsibility

Before we get into methodologies and detailed numbers, it’s worth reflecting on why risk is quite so elevated. As regular readers will know, the narrative of recent years is that prosperity has been coming under increasing pressure ever since the late 1990s, mainly because trend ECoE (the energy cost of energy) has been rising, squeezing the surplus energy which is the source of all economic output and prosperity.

This is a trend which the authorities haven’t understood, recognizing only a vague “secular stagnation” whose actual root causes elude them.

Even “secular stagnation” has been unacceptable to economic and financial systems wholly predicated on “growth”. Simply put, there‘s been too much at stake for any form of stagnation, let alone deterioration, to be acceptable. The very idea that growth might be anything less than perpetual, despite the finite nature of the planet, has been treated as anathema.

If there isn’t any genuine growth to be enjoyed, the logic goes, then we’d better fake it. Essentially, nobody in authority has been willing to allow a little thing like reality to spoil the party, even if enjoyment of the party is now confined to quite a small minority.

Accordingly, increasingly futile (and dangerous) financial expedients, known here as adventurism, have been tried as “solutions” to the problem of low “growth”. In essence, these have had in common a characteristic of financial manipulation, most obvious in the fields of credit expansion and monetary dilution.

These process are the causes of the risk that we are measuring here, but risk comes in more than one guise. Accordingly, each of the four components of the SEEDS Risk Matrix addresses a different type of exposure.

These categories are:

– Debt risk

– Credit dependency risk

– Systemic financial risk

– Acquiescence risk

One final point – before we get into the detail – is that no attempt is made here to measure political risk in its broader sense. Through acquiescence risk, we can work out which populations have most to complain about in terms of worsening prosperity. But no purely economic calculation can determine exactly when and why a population decides to eject the governing incumbency, or when governments might be tempted into the time-dishonoured diversionary tactic of overseas belligerence. We can but hope that international affairs remain orderly, and that democracy is the preferred form of regime-change.

Debt risk

This is the easiest of the four to describe, and comes closest to the flawed, false-comfort measures used in ‘conventional’ appraisal. The SEEDS measure, though, compares debt, not with GDP but with prosperity, a very different concept.

Ireland, markedly the riskiest economy on this criterion, can be used to illustrate the process. At the end of 2018, aggregate private and public debt in Ireland is estimated at €963bn, a ratio of 312% to GDP (of €309 bn). Expressed at constant 2018 values, the equivalent numbers for 2007 (on the eve of the 2008 global financial crisis, which hit Ireland particularly badly) were debt of €493bn, GDP of €198bn and a debt/GDP ratio of 249%.

In essence, then, debt may be almost twice as big (+95%) now as it was in 2007, but the debt ratio has increased by ‘only’ 25% (to 312%, from 249%), because reported GDP has expanded by 56%.

Unfortunately, this type of calculation treats GDP and debt as discrete items, with the former unaffected by changes in the latter. The reality, though, is very different. Whilst GDP has increased by €111bn since 2007, debt has expanded by €470bn. Critically, much of this newly-borrowed money has flowed into expenditures, which serves to drive up the activity measured as GDP.

According to SEEDS, growth without this simple spending of borrowed money would have been only €13bn, not €111bn. Put another way, 89% of all “growth” reported in Ireland since 2007 has been nothing more substantial than the effect of pouring cheap credit into the system, helped, too, by the “leprechaun economics” recalibration of GDP which took place in 2015.

Of course, the practice of spending borrowed money and calling the result “growth” didn’t begin after the 2008 crash. Back in 2007, adjusted (“clean”) GDP in Ireland (of €172bn) was already markedly (13%) lower than headline GDP (€198bn), and the gap is even wider today, with “clean” GDP (of €184bn) now 40% lower than the reported number.

Even “clean” GDP isn’t a complete measure of prosperity, though, because it excludes ECoE – that proportion of output that isn’t available for other purposes, because it’s required to fund the supply of energy itself.

Where ECoE is concerned, Ireland is a disadvantaged economy whose circumstances have worsened steadily in recent years. Back in 2007, Ireland’s ECoE (of 6.7%) was already markedly worse than the global average (5.4%). By 2018, the gap had widened from 1.3% to 3.2%, with Ireland’s ECoE now 11.2% (and the world average 8.0%). An ECoE this high necessarily kills growth, which is why aggregate prosperity in Ireland now is only fractionally (2%) higher than it was in 2007, even though population numbers have grown by 10%.

The results of this process, where Ireland is concerned, have been that personal prosperity has declined by 7% since 2007, whilst debt per person has risen by 78%. The conclusion for Ireland is that debt now equates to 589% of prosperity (compared with 308% in 2007), and it’s hard to see what the country can do about it. If – or rather, when – the GFC II sequel to 2008 turns up, Ireland is going to be in very, very big trouble.

These are, of course, compelling reasons for the Irish authorities to bend every effort to ensure that Britain’s “Brexit” departure from the European Union happens as smoothly as possible. If the Irish government really understood the issues at stake, ministers would be exerting every possible pressure on Brussels to step back from its macho posturing and give Mrs May something that she can sell to Parliament and the voters.

There’s a grim precedent for Dublin not understanding this, though – in the heady “Celtic tiger” years before 2008, nobody seems to have batted an eyelid at the increasingly reckless expansion of the Irish banking system.

Risk 02 debt

Credit dependency

As we’ve seen, adding €111bn to Irish GDP since 2007 has required adding €470bn to debt. This means that each €1 of “growth” came at a cost of €4.24 in net new borrowing. It also means that annual net borrowing averaged 14% of GDP during that period. This represents very severe credit dependency risk – in short, the Irish economy would suffer very serious damage in the event even of a reduction, let alone a cessation, in the supply of new credit to the economy.

Remarkably, though, there is one country whose credit dependency problem is far worse than that of Ireland – and that country is China.

The Chinese economy famously delivers growth of at least 6.5% each year, and reported GDP has more than doubled since 2008, increasing by RMB 51 trillion, from RMB37.7tn to an estimated RMB89tn last year.

Less noticed by China’s army of admirers has been a quadrupling of debt over the same period, from RMB53tn (at 2018 values) in 2008 to RMB219tn now. There also seem to be plausible grounds for thinking that China’s debts might be even bigger than indicated by published numbers.

This means that, over the last ten years, annual borrowing has averaged an astonishing 23% of GDP. No other economy comes even close to this, with Ireland (14.1%) placed second, followed by Canada (9.5%) in third, and South Korea (8.6%) a distant fourth. To put this in context, the ratios for France (8.1%) and Australia (7.5%) are quite bad enough – the Chinese ratio is as frightening as it is astonishing.

The inference to be drawn from this is that China is a ‘ponzi economy’ like no other. The country’s credit dependency ratio represents, not just extreme exposure to credit tightening or interruption, but an outright warning of impending implosion.

There are signs that the implosion may now be nearing. As well as slumping sales of everything from cars to smartphones, there are disturbing signs that industrial purchases, of components ranging from chips to electric motors, are turning downwards. Worryingly, companies have started defaulting on debts supposedly covered very substantially by cash holdings, the inference being that this “cash” was imaginary. Worse still, the long-standing assumption that the country could and would stand behind the debts of all state-owned entities (SOEs) is proving not to be the case. In disturbing echoes of the American experience in 2008, there are reasons to question why domestic agencies accord investment grade ratings to such a large proportion of Chinese corporate bonds.

How has this happened? The answer seems to be that the Chinese authorities have placed single-minded concentration on maintaining and growing levels of employment, prioritizing this (and its associated emphasis on volume) far above profitability. Put another way, China seems quite prepared to sell products at a loss, so long as volumes and employment are maintained. This has resulted in returns on invested capital falling below the cost of servicing debt capital – and an attempt to convert corporate bonds into equity was a spectacular failure, coming close to crashing the Chinese equity market.

Risk 03 credit

Systemic exposure

Debt exposure and credit dependency are relatively narrow measures, in that both concentrate on indebtedness. Critical though these are, there is a broader category of exposure termed here systemic risk, and this is particularly important in terms of the danger of contagion between economies.

The countries most at risk here are Ireland (again), the Netherlands and Britain. All three have financial sectors which are bloated even when compared with GDP. But the true lethality of systemic risk exposure only becomes fully apparent when prosperity is used as the benchmark.

At the most recent published date (2016), Dutch financial assets were stated at $10.96tn (€10.4tn), or 1470% of GDP. The SEEDS model assumes that the ratio to GDP now is somewhat lower (1360%), which implies financial assets unchanged at €10.4tn.

As we’ve seen with Ireland, measurement based on GDP produces false comfort, because GDP is inflated by the spending of borrowed money, and ignores ECoE. In the Netherlands, growth in GDP of €82bn (12%) between 2007 and 2018 needs to be seen in the context of a €600bn (32%) escalation in debt over the same period. This means that each €1 of reported “growth” has required net new borrowing of €7.40. Without this effect, SEEDS calculates that organic growth would have been just €8bn (not €82bn), and that ‘clean’ GDP in 2018 was €619bn, not €767bn.

The further deduction of ECoE (in 2018, 10.5%) reduces prosperity to €554bn. This is lower than the equivalent number for 2007 (€574bn), and further indicates that the prosperity of the average Dutch person declined by 8% over that period.

Though aggregate prosperity is slightly (3.5%) lower now than it was in 2007, financial assets have expanded by almost 40%, to €10.4tn now from €7.47tn (at 2018 values) back in 2007. This means that financial assets have grown from 1303% of prosperity on the eve of GFC I to 1881% today.

As the next table shows, this puts Holland second on this risk metric, below Ireland (3026%) but above the United Kingdom (1591%). Japan (924%) and China (884%) are third and fourth on this list.

Needless to say, the Irish number looks lethal but, since Ireland is a small economy, equates to financial assets (of €4.9tn) that are a lot smaller than those of the Netherlands (€10.4tn). Likewise, British financial assets are put at £23.3tn, a truly disturbing number when compared with GDP of £2tn, let alone prosperity of £1.47tn.

The conclusion on this category of risk has to be that Ireland, Holland and Britain look like accidents waiting to happen. Something not dissimilar might be said, too, of Japan and China. Japan’s gung-ho use of QE has resulted in half of all JGBs (government bonds) being owned by the BoJ (the central bank), whilst huge financial assets (estimated at RMB417tn) underscore the risk perception already identified by China’s dependency on extraordinary rates of credit creation.

Risk 04 systemic

Acquiescence risk

The fourth category of risk measured by SEEDS concentrates on public attitudes rather than macroeconomic exposure. Simply put, we can assume that, when the GFC II sequel to the 2008 global financial crisis (GFC I) hits, governments are likely to try to repeat the “rescue” strategies which bought time (albeit at huge expense) last time around. But will the public accept these policies? Or will there be a huge popular backlash, something which could prevent such policies from being implemented?

It’s not difficult to envisage how this happens. If we can picture some politicians announcing, say, a rescue of the banks, we can equally picture some of their opponents pledging to scrap the rescue at the earliest opportunity, and take the banks into public ownership, pointing out that stockholder compensation will not be necessary because, in the absence of  a taxpayer bail-out, the worst-affected banks have zero equity value anyway. Simply put, this time around there could be more votes in the infliction of austerity on “the wealthy” than there will be in bailing them out. It’s equally easy to picture, at the very least, public demonstrations opposing such a rescue.

Even at the time, and more so as time has gone on, the general public has nurtured suspicions, later hardening into something much nearer to certainties, that the authorities played the 2008 crisis with loaded dice. One obvious source of grievance has been the management of the banking crash. The public may understand why banks were rescued, but cannot understand why the rescue included the bankers as well, whose prior irresponsibility is assumed by many to have been the cause of the crisis – especially given the unwillingness of governments to rescue those in other occupations, such as manufacturing, retail and hospitality.

The 2008 crisis was followed by a fashion for “austerity”, in which the public was expected to accept lean times as part of a rehabilitation of national finances after debts and deficits had soared during GFC I. Unfortunately, the imposition of “austerity” has looked extremely one-sided. Whilst public services budgets have been cut, the authorities have operated policies which have induced extraordinary inflation in asset prices. These benefits, for the most part enjoyed by a small minority, haven’t even been accompanied by fiscal changes designed to capture at least some of the gains for the taxpayer.

The word ‘hypocrisy’ has been woven like a thread into the tapestry of post-2008 trends, which are widely perceived as having inflicted austerity on the many as the price of rescuing the few. It hardly helps when advocates of “austerity” seem not to practice it themselves. Policies since 2008 have been extraordinarily divisive, not just between “the rich” and the majority, but also between the old (who tend to own assets) and the young (who don’t).

In short, the events of 2008 have created huge mistrust between governing and governed. This might not have mattered quite so much had the prosperity of the average person continued to grow, but, in almost all Western countries, this has not been the case. Whatever might be claimed about GDP, individuals sense – rightly – that they’re getting poorer. We’ve already seen the results of this estrangement, in the election of Donald Trump, the “Brexit” vote in Britain and the rise of insurgent (aka “populist”) parties in many European countries. Latterly, France has witnessed the eruption of popular anger in the gilets jaunes movement, something which might well be replicated in other countries.

For reasons which vary between countries – but which have in common a complete failure to understand deteriorating prosperity – established policymakers have seemed blinded to political reality by “the juggernaut effect”.

Where, though, is acquiescence risk most acute? The answer to this seems to lie less in the absolute deterioration in average prosperity than in the relentless squeeze in discretionary (“left in your pocket”) prosperity – simply put, how much money does a person have left at the end of the week or month, after taxes have been paid, and essential expenses have been met?

This discretionary effect helps to explain why the popular backlash has been so acute in France. At the overall level, the decline in French prosperity per person since 2007 has been a fairly modest 6.3%, less severe than the experiences of a number of other countries such as Italy (-11.6%), Britain (-10.3%), Norway (-8.4%) and Greece (-8..0%). Canadians (-8.1%) and Australians (-9.0%), too, have fared worse than the French.

Take taxation into account, though, and France comes top of the league. Back in 2007, prosperity per person in France was €28,950, which after tax (of €17,350) left the average person with €11,600 in his or her pocket. Since then, however, whilst prosperity has declined by €1,840 per person, tax has increased (by €1,970), leaving the individual with only €7,790, a 33% fall since 2007.

In no other country has this rapidity of deterioration been matched, though discretionary prosperity has fallen by 28% in the Netherlands, by 24% in Britain, by 23% in Australia and by 18% in Italy. If this interpretation makes sense of the popularity of the gilets jaunes (and makes absolutely no sense of the French authorities’ responses), it also suggests that the Hague, London and perhaps Canberra ought to be preparing themselves for the appearance of yellow waistcoats on their streets.

Risk 05 acquiescence

#146: Fire and ice, part three

SHAPING THE AGENDA

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

 

#145: Fire and ice, part two

“THE JUGGERNAUT EFFECT”

Although it was something of a detour from the theme of fire and ice, our previous discussion about “Brexit” does have one point of relevance to that theme. Here’s why.

All things considered, there seems to be an utterly compelling case for intervention in the dysfunctional “Brexit” process by the “adults” in European governments. Yet, even at this very late stage, no such intervention has happened. Governments seem to see no alternative to letting London and Brussels – but mostly Brussels – make a complete hash of the whole process. Indeed, only now do the governments of the countries most affected (Ireland and France) seem even to be implementing contingency plans for an adverse outcome.

Of course, you might jump to the conclusion that irrationality reigns in European capitals, and especially in Dublin and Paris. But it’s surely obvious that this is part of a much wider process, one which we can think of as a form of shock-paralysis.

Essentially, the idea explored here is that governments around the world have been paralysed into inaction, not so much by fear alone as by a simple inability to understand what’s happening around them. Nothing, it seems to them, is happening rationally. They don’t really understand why so many amongst the general public are so angry – and they certainly don’t even begin to understand what’s happening to the economy.

I call this shock-paralysis “the juggernaut effect”.

Shock-paralysis

The word “juggernaut” seems to derive from Sanskrit, and refers to an enormous waggon carrying the image of a Hindu god. The figurative meaning is of an irresistible force, flattening anyone foolish enough to stand in its way.

Rationally, you’d think that anybody standing in the path of a “juggernaut” ought to be making every effort to escape. But it’s quite likely that shock, fear and incomprehension will have a paralysing effect, overwhelming rational faculties, leaving him or her rooted to the spot.

That’s a useful way to describe the effects that current economic (and broader) trends are having. It doesn’t just apply to governments, of course, and it’s prevalent amongst the general public, too.

Just as the person standing in front of the “juggernaut” is all too well aware of its lethality, today’s leaders and opinion-formers surely know at least something about the financial, economic, political and social forces converging on them.

But they seem incapable of doing anything about it.

A big part of this paralysis is incomprehension – any problem becomes infinitely harder to tackle if you don’t understand why it’s happening. And there are reasons enough for policy-makers, and ‘ordinary’ people too, to feel completely baffled.

The irrational economy

You don’t need to be a committed Keynesian – indeed, you need only numeracy – to understand the basic principles of economic stimulus.

If economic performance is sluggish, activity can be stimulated by pushing liquidity into the system, either through fiscal or through monetary policy. If too much stimulus is injected, though, there’s a risk that the economy will overheat, with growth exceeding the sustainable trend. Rising inflation is one of the most obvious symptoms of an over-heating economy.

Here, though, is the conundrum, for anyone trying to understand how the economy is performing.

Since the 2008 global financial crisis (GFC I), the authorities have pushed unprecedentedly enormous amounts of stimulus into the system.

We ought, long before now, to have experienced overheating, with growth rising to levels far above trend.

This simply hasn’t happened.

This should have been accompanied by surging inflation, most obviously in commodities like energy, minerals and food, but across the whole gamut of goods and services, too, with wage rates rising rapidly as prices soar.

Again, this simply hasn’t happened.

To be sure, there’s been dramatic inflation in asset prices, and that’s both important and dangerous. But the broader point is that neither super-heated growth, nor a surge in price and wage inflation, have turned up, as logic, experience and basic mathematics all tell us that they should.

Pending final data for 2018, it’s likely that global GDP last year will have been about 34% higher than it was back in 2008. Allowing for the increase in population numbers, GDP per capita is likely to have been about 20% larger in 2018 than it was ten years previously. This isn’t exactly super-heated growth. According to SEEDS, world inflation stands at about 2.5% which, again, is nowhere near the levels associated with an over-heating economy. Far from soaring, the prices of commodities such as oil are in the doldrums.

Price (and other) data is telling us that the economy has stagnated. But the quantity of stimulus injected for more than a decade says that it should be doing precisely the opposite.

There can be no doubt whatsoever about the scale of stimulus. The usual number attached to sums created through QE by central banks is in the range $26-30 trillion, but that’s very much a narrow definition of stimulus. Ultra-loose monetary policy, combined with not inconsiderable fiscal deficits, have been at the heart of an unprecedented wave of stimulus.

Expressed in PPP-converted dollars at constant values (the convention used throughout this analysis), governments have borrowed about $39tn, and the private sector about $71tn, since 2008. On top of that, we’ve wound down pension provision in an alarming way, as part of the broader effects of pricing money at negative real levels, which destroys returns on invested capital.

Even if we confine ourselves to QE and borrowing, however, stimulus since 2008 can be put pretty conservatively at $140tn.

That’s roughly 140% of where world PPP GDP was back in 2008. You might think of it as the injection of 12-14% of GDP each year for a decade.

That’s an unprecedentedly gigantic exercise in stimulus.

And the result? In contrast to at least $140tn of stimulus, world GDP is perhaps $34tn higher now than it was ten years previously. Price and wage inflation is subdued, and the prices of sensitive commodities have sagged. The prices of assets such as stocks, bonds and property have indeed soared – but one or more crashes will take care of that.

By now – indeed, long before now – anyone in government ought to have been asking his or her expert advisers to explain what on earth is going on. Assuming that Keynes wasn’t mistaken (and simple mathematics proves that he wasn’t), the only frank answer those advisers can give is that they just don’t understand what’s been happening.

Questions without answers?

The utter failure of gigantic stimulus to spur the economy into super-heated growth (and surging inflation) is reason enough for baffled paralysis. But there are plenty of other irrationalities to add to the mix.

If you were in government, or for that matter in business or finance, then as well as asking your advisers about the apparent total breakdown in the stimulus mechanism, you might want to put these questions to them, too:

– Why has a capitalist economic system become dependent on negative real returns on capital?

– Why, since the shock therapy of the 2008 global financial crisis (GFC I), have we accelerated the pace at which we’re adding to the debt mountain?

– Why, seemingly heedless of all past experience, have we felt it necessary to pour vast amounts of cheap money into the system?

– Why have the prices of assets (including stocks, bonds and property) soared to levels impossible to reconcile with the fundamentals of valuation?

– Why has China, reputedly the world’s primary engine of growth, found it necessary to resort to borrowing on a gargantuan scale?

This last question deserves some amplification. Pending final data, we can estimate that Chinese debt has increased to about RMB 220tn now, from less than RMB 53tn (at 2018 values) at the start of 2008. These numbers exclude what are likely to be very large quantities of debt created in what might most politely be called the country’s “informal” credit system.

So, why does an economy supposedly growing at between 6% and 7% annually need to do much borrowing at all?  Put another way, how meaningful is “growth” in GDP of 6-7%, when you have to borrow about 25% of GDP annually, just to keep it going?

And this prompts several more questions. For starters, why are the Chinese authorities, hitherto esteemed for their financial conservatism, presiding over the transformation of their economy into a debt-ponzi? Second, can ‘the mystique of the east’ explain why the world’s markets are seemingly either ignorant, and/or complacent, about the creation of a financial time-bomb in China?

The juggernaut effect

Even these questions don’t exhaust the almost endless list of disconnects in our increasingly surreal economic plight, but they surely give us more than enough explanations for the paralysing “juggernaut effect” in the corridors of power.

Put yourself, if you will, into the shoes of someone trying to formulate policy. Two things are obvious to you, and either one of them would be a grave worry. Together, they’re enough to overwhelm rational calculation.

First, you know that there are some very, very dangerous trends out there. In the purely financial arena, you’re aware that debt has become excessive, whilst the system seems to have become reliant on a never-ending tide of cheap credit.

If your intellectual leanings are towards market economics, you’ll also have realised that pricing money at rates below inflation amounts to an enormous subsidy. Politically, that subsidy is going to the wrong people. If you came into government with business experience, you’ll also know that we’ve witnessed the destruction of returns on capital, which makes no kind of sense from any business or investment point of view.

You might know, too, that the viability of pension provision has collapsed, creating what the World Economic Forum has called “a global pensions timebomb”. If the public ever finds out about that, the reaction could dwarf whatever political travails you might happen to have at the moment.

Lastly – on your short-list of nightmares – is the strong possibility that some event, as yet unknown, will trigger a wave of defaults and a collapse in the prices of property and other assets.

Your second worry, perhaps even bigger than your list of risks, is that you don’t really understand any of this. Your economic advisers can’t explain why stimulus, though carried to (and far beyond) the point of danger, hasn’t worked as the textbooks (and all prior experience) say it should. If there’s anything worse than a string of serious problems and challenges, it’s a complete lack of understanding.

Without understanding, the policy cupboard is bare. You don’t know what to do next, because anything you do might have results that don’t match expectations, making matters worse rather than better.

It might be better to do nothing.

In short, you feel as though you’re making it up as you go along, in the virtual certainty that something horribly unpleasant is going to hit you, with little or no prior warning.

Welcome to “the juggernaut effect”.

#143: Fire and ice, part one

TRAUMA FOR THE TAX-MAN

Is 2019 the year when everything starts falling apart?

It certainly feels that way.

The analogy I’m going to use in this and subsequent discussions is ‘fire and ice’.

Ice, in the potent form of glaciers, grinds slowly, but completely, crushing everything in its path. Whole landscapes have been shaped by these icy juggernauts.

Fire, on the other hand, can cause almost instantaneous devastation, most obviously when volcanoes erupt. Back in 1815, the explosion of Mount Tambora in the Dutch East Indies (now Indonesia) poured into the atmosphere quantities of volcanic ash on such a vast scale that, in much of the world, the sun literally ceased to shine. As a result, 1816 became known as “the year without a summer”. As low temperatures and heavy rain destroyed harvests and killed livestock, famine gripped much of Europe, Asia and North America, bringing with it soaring food prices, looting, riots, rebellions, disease and high mortality. Even art and literature seem to have been influenced by the lack of a summer.

The economic themes we’ll be exploring here have characteristics both of fire and of ice. The decline in prosperity is glacial, both in its gradual pace and its ability to grind assumptions, and systems, into the ground. Other events are likelier to behave like wild-fires or volcanoes, given to rapid and devastating outbursts, with little or no prior warning.

Fiscal issues, examined in this first instalment of ‘fire and ice’, have the characteristics of both. The scope for taxing the public is going to be subjected to gradual but crushing force, whilst the hard choices made inevitable by this process are highly likely to provoke extremely heated debate and resistance.

Let’s state the fiscal issue in the starkest terms:

– Massive credit and monetary adventurism have inflated GDP to the point where it bears little or no resemblance to the prosperity experienced by the public.

– But governments continue to set taxation as a percentage of GDP.

– As GDP and prosperity diverge, this results in taxation exacting a relentlessly rising share of prosperity.

– Governments then fail to understand the ensuing popular anger.

France illustrates this process to dramatic effect. Taxation is still at 54% of GDP, roughly where it’s been for many years. This no doubt persuades the authorities that they’ve not increased the burden of taxation. But tax now absorbs 70% of French prosperity, leading to the results that we’ve witnessed on the streets of Paris and other French towns and cities.

Few certainties

It’s been said that the two certainties in life are “death and taxes”, but ‘debt and taxes’ hold the key to fiscal challenges understood improperly – if at all – by most governments. The connection here is that debt (or rather, the process of borrowing) affects recorded GDP in ways which provide false comfort about the affordability of taxation – and therefore, of course, about the affordability of public services.

The subject of taxation, seen in terms of prosperity, leads straight to popular discontent, though that has other causes too. In order to have a clear-eyed understanding of public anger, by the way, we need to stick to what the facts tell us. I’ve never been keen on excuses like “the dog ate my homework” or “a space-man from Mars stole my wallet” – likewise, we should ignore any narrative which portrays voter dissatisfaction as wholly the product of “populism”, or of “fake news”, or even of machinations in Moscow or Beijing. All of these things might exist – but they don’t explain what’s happening to public attitudes.

The harsh reality is that, because prosperity has deteriorated right across the advanced economies of the West, we’re facing an upswell of popular resentment, at the same time as having to grapple with huge debt and monetary risk.

If you wanted to go anywhere encouraging, you wouldn’t start from here.

The public certainly has reasons enough for discontent. In the Western world, prosperity has been deteriorating for a long time, a process exacerbated by higher taxation. The economic system has been brought into disrepute, mutating from something at least resembling ‘the market economy’ into something seemingly serving only the richest. As debt has risen, working conditions, and other forms of security, have been eroded. We can count ourselves fortunate that the public doesn’t know – yet – that the pensions system has been sacrificed as a financial ‘human shield’ to prop up the debt edifice.

This at least sets an agenda, whether for 2019 or beyond. The current economic paradigm is on borrowed time, whilst public support can be expected to swing behind parties promoting redistribution, economic nationalism and curtailment of migration. Politicians who insist on clinging on to ‘globalised liberalism’ are likely to sink with it. The tax base is shrinking, requiring new priorities in public expenditure.

If you had to tackle this at all, you wouldn’t choose to do it with the “everything bubble” likely to burst, bringing in its wake both debt defaults and currency crises. But this process looks inescapable. With its modest incremental rate rises, so derided by Wall Street and the White House, the Fed may be trying to manage a gradual deflation of bubbles. If so, its intentions are worthy, but its chances of success are poor.

And, when America’s treasury chief asks banks to reassure the markets about liquidity and margin debt, you know (if you didn’t know already) that things are coming to the boil.

Tax – leveraging the pain

If it seems a little odd to start this series with fiscal affairs, please be assured that these are very far from mundane – indeed, they’re likely to shape much of the political and economic agenda going forward. The biggest single reason for upsets is simply stated – where prosperity and the ability to pay tax are concerned, policymakers haven’t a clue about what’s already happening.

Here’s an illustration of what that reality is. Expressed at constant values, personal prosperity in France decreased by €2,060, or 7.5%, between 2001 (€29,315) and 2017 (€27,250).

At first glance, you might be surprised that this has led to such extreme public anger, something not witnessed in countries where prosperity has fallen further. Over the same period, though, taxation per person in France has increased by €2,980. When we look at how much prosperity per person has been left with the individual, to spend as he or she chooses, we find that this “discretionary” prosperity has fallen from €13,210 in 2001 to just €8,230 in 2017.

That’s a huge fall, of €4,980, or 38%. Nobody else in Europe has suffered quite such a sharp slump in discretionary prosperity – and tax rises are responsible for more than half of it.

This chart shows how increases in taxation have leveraged the deterioration in personal prosperity in eight Western economies. The blue bars show the change in overall prosperity per capita between 2001 and 2017. Increases in taxation per person are shown in red.

#143 01

In the United Kingdom, for example, economic prosperity has deteriorated by 9.8% since 2001, but higher taxation has translated this into a 29.5% slump in discretionary prosperity. Interestingly, economic prosperity in Germany actually increased (by 8.2%) over the period, but higher taxes translated into a fall at the level of discretionary prosperity per person.

Prosperity and tax – Scylla and Charybdis

The next pair of charts, which use the United Kingdom to illustrate a pan-Western issue, show a problem which is already being experienced by the tax authorities, but is not understood by them.

The left-hand chart (expressed in sterling at constant 2017 values) shows a phenomenon familiar to any regular visitor to this site, but not understood within conventional economics. Essentially, GDP (in blue) and prosperity (in red) are diverging.

This is happening for two main reasons. One is the underlying uptrend in the energy cost of energy (ECoE). The second is the use of credit and monetary adventurism to create apparent “growth” in GDP in the face of secular stagnation. This, of course, helps explain why people are feeling poorer despite apparent increases in GDP per capita. Total taxation is shown in black, to illustrate the role of tax within the prosperity picture.

The right-hand chart shows taxation as percentages of GDP (in blue) and prosperity (in red). In Britain, taxation has remained at a relatively stable level in relation to GDP, staying within a 34-35% band ever since 1998, before rising to 36% in 2016 and 37% in 2017.

Measured as a percentage of prosperity, however, the tax burden has risen relentlessly, from 35% in 1998, and 44% in 2008, to 51% in 2017.

#143 02

Simply put, the authorities seem to be keeping taxation at an approximately constant level against GDP, not realising that this pushes the tax incidence upwards when measured against prosperity. The individual, however, understands this all too well, even if its causes remain obscure.

What this means, in aggregate and at the individual level, are illustrated in the next set of charts. These show the aggregate position in billions, and the per capita equivalent in thousands, of pounds sterling at 2017 values.

#143 03

As taxation rises roughly in line with GDP – but grows much more rapidly in terms of prosperity – discretionary prosperity, shown here in pink, becomes squeezed between the Scylla of falling prosperity and the Charybdis of rising taxation. The charts which follow are annotated to highlight how this ‘wedge effect’ is undermining discretionary prosperity.

#143 04

Finally, where the numbers are concerned, here’s the equivalent situation in France. As far back as 1998, tax was an appreciably larger proportion of GDP in France (51%) than in the United Kingdom (34%). By 2017, tax was absorbing 54% of GDP in France, compared with 37% in Britain.

This means that taxation in France already equates to 70% of prosperity, up from 53% in 1998. Even though the squeeze on overall prosperity (the pink triangle) has been comparatively modest so far (since 2001, a fall of 7.5%), the impact on discretionary prosperity (the blue triangle) has been extremely severe (39%). This is why so many French people are angry – and why their anger has crystallised around taxation.

#143 05

The political fall-out

When you understand taxation in relation to prosperity, you appreciate a challenge which the authorities in Western countries (and beyond) have yet to comprehend. Most of them probably think that, going forward, they can carry on pushing up taxation roughly in line with supposed “growth” in GDP. Presumably, they also assume that the public will accept this fiscal trajectory.

If they do make these assumptions, they’re in for a very rude awakening. The modest tax tinkering implemented in France, for instance, is most unlikely to quell the anger, even though it’s set to widen the deficit appreciably.

Politically, the leveraging effect of rising taxation feeds into a broader agenda which, so far, is either misinterpreted, or just not recognised at all, by the governing establishment.

Here, simply stated, are some of the issues with which governments are confronted:

Prosperity per person is continuing to deteriorate, typically at annual rates of between 0.5% and 1.1%, across the Western economies.

Rising taxation is worsening this trend, leading increasingly to popular resistance.

– The public believes (and not without reason) that immigration is exacerbating the decline in prosperity, both at the total and at the discretionary levels.

– Perceptions are that a small minority of “the rich” are getting wealthier whilst almost everyone else is getting poorer.

Politicians are seen as both heedless of the majority predicament and complicit in the enrichment of a minority.

The popular demands which follow from this are pretty clear.

Voters are going to be angered by the decline in their prosperity, and will become increasingly resistant to taxation. The greatest resentment will centre around “regressive” taxes, such as sales taxes and flat-rate levies, which hit poorest taxpayers hardest.

They’re going to demand more redistribution, meaning higher taxes on “the rich”, not just where income taxes are concerned, but also extending to taxes on wealth, capital gains and transactions.

Popular opposition to immigration is likely to intensify, as prosperity deteriorates and tax bites harder.

Finally, public anger about former ministers and administrators retiring into very lucrative employment is going to go on mounting.

A challenge – and an opportunity?

In terms of electoral politics, most established parties are singularly ill-equipped to confront these issues. Some on “the Left” do embrace the need for redistribution, but almost invariably think this is going to fund increases in public expenditures, which simply isn’t going to be possible.

Others oppose increasing taxes on the wealthiest, and fail to appreciate that fiscal mathematics, quite apart from public sentiment, are making this process inescapable.

On both sides of the conventional political divide there is, as yet, no awareness that economic trends are going to exert glacier-style downwards pressure on public spending. Nowhere within the political spectrum is there recognition of the consequent need to set new, more stringent priorities. In areas such as health and policing, declining real budgets mean that policymakers face hard choices between which activities can continue to be funded, and those which will have quietly to be dropped.

It seems almost inconceivable that established parties are going to recognise what faces them, and adapt accordingly. The “Left” is likely to cling to dreams of higher public expenditures, whilst the “Right” will try to fend off higher taxation of the wealthiest. Even insurgent (aka “populist”) parties probably have no idea about the tightening squeeze on what they can afford to offer to the voters. It’s likely that very few people in senior positions yet realise that an ultra-lucrative retirement into “consultancies” and “the lecture circuit” is set to become electorally toxic.

Politically, of course, problems for some can be opportunities for others. It wouldn’t be all that hard to craft an agenda which capitalises on these trends, promising, for example, much greater redistribution, ultra-tight limits on immigration, and capping the retirement earnings of the policy elite.

If you did promise these things, you’d probably be elected. Unfortunately, though, that’s the easy bit. The hard part is going to be grappling with the continuing decline in prosperity at the same time as fending off a financial crash.

How, having been voted into power, are you going to tell the voters that we’re all getting poorer, and that some public services are ceasing to be affordable within an ever more rigorous setting of priorities? And are they going to believe you when you tell them that the destruction of pensions is entirely the work of your predecessors? Finally, what are you going to do when one of the big endangered economies fails?

 

#142: Past, present and future

LOOKING BACK AND LOOKING FORWARD

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

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

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

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

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

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

The death of debt?

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

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

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

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

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

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

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

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

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

Feeling the pain

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

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

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

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

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

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

The need for ideas

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

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

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

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

 

#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.

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Germany vs EA7

Prosp per capita DE EA7 UK