#154. An autumn nexus

A CONVERGENCE OF STRESS-LINES

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

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

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

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

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

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

Chinese burns

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

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

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

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

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

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

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

But this is to look too far ahead.

“Brexit” blues

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

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

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

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

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

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

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

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

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

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

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

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

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

Madness, money and moods

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

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

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

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

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

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

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

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

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

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

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

 

#149: The big challenges

HOW THE ECONOMICS OF ENERGY VIEWS THE AGENDA

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

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

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

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

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

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

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

The vital insight

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

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

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

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

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

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

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

Mitigation, not salvation

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

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

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

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

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

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

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

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

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

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

Challenge #1 – financial shock

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

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

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

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

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

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

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

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

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

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

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

Challenge #2 – breakdown of government

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Challenge #3 – an accelerating slump?

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

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

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

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

Here are just some of them:

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

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

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

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

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

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

 

 

#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 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.

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.

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.

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.