#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

#144: “Brexit” and the wait for Godot

WHY EU NATIONAL LEADERS SHOULD INTERVENE

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

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

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

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

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

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

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

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

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

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

Needed – Godot

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

#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.

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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.

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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?

 

#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.

= = = = = = = = = =

Germany vs EA7

Prosp per capita DE EA7 UK

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

BRITAIN, EUROPE AND GFC II

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

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

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

Some updates

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

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

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

On “Brexit”

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

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

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

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

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

The British predicament

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

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

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

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

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

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

“Stalling between two fools”

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

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

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

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

On the horizon – GFC II

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

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

The narrative can be expressed as three very simple propositions:

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

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

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

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

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

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

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

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

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

Abroad thoughts from home

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

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

 

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#136 prosperity & governmentjpg_Page1

#131: Not about “Brexit”

PROSPERITY AND RISK IN THE UNITED KINGDOM

What follows is an analysis of the British economy, from the perspectives of performance and risk.

It is not a discussion of “Brexit”.

Readers are, of course, welcome to discuss any pertinent issue, “Brexit” included. But a non-“Brexit” focus has to be stated clearly, because one of the most regrettable effects of the whole “Brexit” process has been to divert attention away from the economic fundamentals. Distractions don’t come much bigger than “Brexit”.

Perhaps the most striking characteristic of the British economic situation is the stark divergence between two different views. One of these is an official and consensus interpretation, founded on conventional economics, which portrays performance as no worse than lacklustre. There is, however, a raft of other indicators which paints a much less satisfactory picture.

Analysis undertaken using SEEDS – the Surplus Energy Economics Data System – indicates that prosperity peaked as long ago as 2003, and that the consequent strains are now becoming ever more apparent. Declining prosperity, of course, characterises most advanced Western economies. The United Kingdom stands out, though, for the rate at which prosperity is deteriorating, and for the elevated level of risk associated with this trend.

The great dichotomy

According to conventional metrics, the economy of the United Kingdom continues to grow, albeit at a less than sparkling pace. GDP is expected to increase by about 1.4% this year which, though hardly impressive, at least outpaces the 0.6% trend rate at which population numbers are expanding. People are, then, getting gradually better off, whilst unemployment remains low.

The problem with this interpretation is that it is hard – arguably, impossible – to square with a host of other indicators. First, wage growth is very subdued, barely keeping up with CPI inflation, and falling steadily further adrift of the cost of household essentials.

Second, productivity growth has fallen to virtually zero, having averaged just 0.2% since the 2008 global financial crisis (“GFC I”).

The labour market is characterised by increasing casualization and insecurity of employment, factors which contribute to depressed wage levels despite officially-low unemployment.

There is every reason to suppose that consumers’ ability to spend is in rapid retreat. Customer-facing businesses (including shops, restaurants and pubs) are going through a fire-storm of closures, failures and job losses. Consumer credit has climbed to potentially dangerous levels, with anecdotal evidence that this credit is being used, not for discretionary purchases, but simply to meet living expenses. There is also reason to suppose that big-ticket purchases are in decline. Surveys indicate that large and increasing numbers of households are struggling to make ends meet.

Government, too, seems strapped for cash, not really knowing how to provide necessary increases in funding for areas such as health, defence and care for the elderly. Local as well as central government looks resource-constrained.

Broader indicators of economic stress include homelessness, with young people, in particular, finding accommodation to be costly, often of poor quality, and hard to obtain. Seemingly-rapid rises in violent crime – including a dramatic surge in moped offences, of which there were 23,000 in London alone last year, compared with just 827 five years earlier – do not seem consistent with a prospering society.

In short, there is an abundance of evidence that, far from getting better off, the average British person is getting poorer. At first glance, this is impossible to square with any level of reported “growth” in economic output.

The SEEDS interpretation

An answer to this conundrum is supplied by SEEDS, which indicates that prosperity per person in the United Kingdom has been declining relentlessly since as long ago as 2003.

Over the period since then, reported GDP has risen by £386bn (23%), to £2.04 trillion last year from £1.65tn (at 2017 values) in 2003. Against this, however, aggregate debt increased by £2tn (62%).

This means that each £1 of reported growth has been accompanied by £5.20 in new borrowing. It also means that, against current growth expectations of about 1.4%, the UK typically borrows 5.7% of GDP each year.

The stark implication is that, like many other Western countries, Britain has been pouring cheap credit into the economy to shore up consumption. In short, most of the supposed “growth” of recent times has been nothing more substantial than the simple spending of borrowed money.

Stripped of this borrowing effect, SEEDS calculates that, within recorded growth of £386bn since 2003, only £77bn can be considered organic and sustainable. This puts ‘clean’ (borrowing-adjusted) GDP for 2017 at £1.59tn, barely ahead of the 2003 number of £1.53tn. On this basis, underlying growth has not kept up with increases in the population, so that ‘clean’ GDP per capita has decreased by 5.1% since 2003.

The compounding headwind has been a sharp rise in the energy cost of energy (ECoE). This, of course, is a worldwide problem, but has been particularly acute in the United Kingdom. Back in 2003, Britain’s ECoE (3.4%) was lower than the global average (4.5%). Today, though, ECoE is markedly higher in the UK (9.2%) than in the world as a whole (8.0%).

On a post-ECoE basis, prosperity per capita in Britain has fallen by 10.3% (£2,540), to £22,020 last year from a peak of £24,550 in 2003. Prosperity has declined in other Western countries over the same period, but Italy is the only major economy where the fall has been as rapid as in the UK.

SEEDS shows no sign of this downwards trend slackening, and projects that British prosperity will be a further 4.2% lower in 2022, at £21,090, than it was in 2017. In short, the average person is getting poorer at rates of between 0.5% and 1.0% each year.

Meanwhile, of course, his or her share of aggregate debt continues to increase.

Elevated risk

Deteriorating prosperity necessarily increases risk, because the ability to carry any given level of financial burden is a function of prosperity. Falling prosperity also impairs the ability to fund public services.

Trends in debt ratios reflect deteriorating prosperity. Aggregate debt at the end of 2017 (£5.25tn) equates to 258% of GDP but 361% of prosperity, the latter number having risen markedly since 2007 (283%).

More worryingly, the rise in debt exposure has been matched by sharp increases in proportionate financial assets, a measure of the size of the banking system. The most recent figure, for the end of 2016, puts Britain’s financial assets at 1124% of GDP, but this rises to 1547% when prosperity, rather than GDP, is used as the denominator. The SEEDS estimate of financial assets in relation to prosperity at the end of last year is 1577%, again sharply higher than the level on the eve of the financial crisis in 2007 (1285%).

Measuring debt and financial assets in relation to prosperity are two of the four risk yardsticks used by SEEDS. The UK looks high-risk on the debt measure, and extreme-risk in terms of the scale of its banking exposure.

On the third risk criterion, which is dependency on the continuing availability of credit, the British score is no worse than that of most comparable economies. The United Kingdom does, though, also depend on a continuing ability to borrow from abroad, to sell assets to overseas investors, and to attract inward flows of capital. This dependency looks risky, because the severe travails of customer-facing businesses, and the implied hardship of consumers, necessarily impair the attractiveness of Britain as a place in which to invest.

Finally, Britain has a high score on what SEEDS calls “acquiescence risk”. Put simply, the less prosperous people become, the less likely they are to back painful recovery plans should these be required in a future financial crisis. Worsening prosperity has already had a marked effect on political outcomes in America, France, Italy and elsewhere, and the same factor is likely to have tilted the balance decisively in the referendum on “Brexit”. Should it become necessary for Britain to repeat the 2008 rescue of the banks, popular acquiescence in such a measure should be no means be taken for granted.

 

SEEDS 2.15 United Kingdom 21072018

 

#129: Why, what, how?

SEEDS AND THE CHASM IN ECONOMIC UNDERSTANDING

Regular visitors will know that, since the recent completion of the development programme, SEEDS – the Surplus Energy Economics Data System – forms the basis of almost every subject that we discuss here. For anyone new to this site, though, what is SEEDS? What does it do, and how important might it be?

The aim in this longer-than-usual article is to explain SEEDS, starting with some of what it tells us before examining how it reaches these conclusions. The methodologies of the system are discussed here, with the exception of a small number of technical points of which detailed disclosure would be unwise.

Before we start, new visitors need to know that the divergence between SEEDS and “conventional” economics has now become so wide that it’s almost impossible to place equal faith in both. If SEEDS is right – and that’s for you to decide – then much of the conventional economics approach is simply wrong.

The question thus becomes that of which interpretation best fits what we see happening around us.

“Shocks” that are no surprise

A picture is supposed to be worth a thousand words, and the following charts demonstrate quite how radically SEEDS differs from conventional economic interpretation.

These charts set prosperity (as calculated by SEEDS) against published GDP per capita for the United Kingdom and the United States. With this information, you can see that, for SEEDS, the so-called “shocks” of the “Brexit” vote, and the election of Donald Trump, were no surprise at all.

Rather, popular discontent with the political establishment is to be expected when the prosperity of the average person has been declining relentlessly, and over an extended period. In Britain, the voters’ decision to leave the European Union reflected a deterioration of 9.7% (£2,380 per person) in prosperity since 2003. In the US, the decline in prosperity began later than in the UK, but the average American was still 7.3% ($3,520) poorer in 2016 than he or she had been back in 2005.

Brexit Trumpjpg_Page1

Obviously, economic hardship wasn’t the only issue at stake in either case. But it has to be highly likely that it tipped the balance. Similarly, recent events in Italy must in large part reflect a big (12.1%, or €3,300) slump in average prosperity per person since 2001 – which, coincidentally (or not?) was the year before Italy joined the euro.

In short, the SEEDS interpretation is that the rise of so-called “populism” across much of the West reflects a deterioration in prosperity which conventional economics is wholly unable to capture.

This means that policymakers are trying to make decisions in a context quite different from the information that they have to go on.

The main purpose of SEEDS isn’t political prediction, though the system’s track-record in this field is rather impressive. Rather, the aim is to calibrate prosperity – something which conventional economics has become increasingly unable to do – and to draw economic and financial conclusions on this basis.

China – some warning signs

The next pair of charts, which look at China, display SEEDS’ interpretative capability on an issue of current importance. The first chart illustrates that, whilst GDP per capita continues to grow at rates of over 6% per annum, prosperity is increasing at a much more sedate pace, trending higher at rates of around 2% annually.

China sustainablejpg_Page1

Meanwhile, and as shown in the second chart, China is paying a huge price for growth in GDP, having added RMB 4.30 of net new debt for each RMB 1.00 of reported growth over the last ten years. Put another way, a large proportion of “growth” in recorded GDP amounts to nothing more than the simple spending of borrowed money.

This is by no means unique to China, of course. Before 2008, pouring credit into the economy, and calling the result “growth”, was a practice largely confined to the West. Since GFC I, this practice has spread to much of the emerging world.

Meanwhile, the West has moved on to new follies. To the “credit adventurism” which preceded the first crash has been added the even more dangerous “monetary adventurism” which is likely to trigger the second.

Watching this progression, you might well conclude that those deciding policy are ‘making it up as they go along’. That, of course, is about all they can do, if the interpretations on which they base their thinking have ceased to be valid.

Risk recalibrated

Where China is concerned, SEEDS puts a wholly different slant on risk exposure. The ratio of debt to prosperity has climbed from 217% back in 2007 to 613% now, and is set to reach 660% by the end of this year. These compare with debt-to-GDP ratios of 162% in 2007, and 309% now.

You don’t need to be unduly pessimistic to appreciate that this trajectory has become wholly unsustainable – and by no means just in China. Yet this scale of risk is something that the preferred conventional measure – the ratio of debt to GDP – simply fails to capture. Much the same applies to the measurement of systemic risk in banking, where comparing financial assets with prosperity shows levels of risk far higher than are indicated by ratios based on GDP.

This is a subject for a future discussion, but we can observe here that countries whose banking systems are disproportionately large are living with exposure whose severity cannot be measured realistically with established techniques.

Debt mis-measured

The explanation for the mismatch in debt ratios, by the way, is pretty simple. Much of any increase in debt finds its way into expenditure, thus pushing up apparent GDP in a way which damps down the measured implications of debt escalation. As we’ll see, where SEEDS differs is that it uses underlying or “clean” output numbers, adjusted to exclude the way in which GDP is boosted by the simple spending of borrowed money.

Given the sheer scale of worldwide borrowing in recent years, understanding how the conventional debt-to-GDP measure is flawed helps us to appreciate why the next financial crisis (“GFC II”), when it comes, will doubtless be regarded as just as much of an ‘unpredictable’ event as the 2008 global financial crisis (GFC). Though there are many ‘popular misconceptions’ in this area (including the ‘safety’ supposedly conferred on the banking system by higher reserve ratios), the debt-to-GDP ratio remains one of the most misleading of the lot.

The reality is that, far from taking us by surprise, many events and trends are eminently predictable. Looking back at the British chart, for instance, you’ll readily appreciate why customer-facing sectors such as retailing, pubs and restaurants are going through a fire-storm of failures and closures. Contrary to ‘expert’ opinion, this melt-down owes very little to “Brexit” (yet, anyway), and almost everything to the erosion of customers’ ability to spend.

Globally, SEEDS reveals levels of risk exposure that are very different from anything you can glean from conventional econometrics. Taking debt as an example, the ratio of debt to world GDP now stands at 215% of GDP, a ratio not dramatically worse than it was in 2007 (179%). For SEEDS, though, the ratio of debt to prosperity is not only much higher (327%) than the conventional measure, but has worsened very markedly since 2007 (229%).

How, then, does SEEDS arrive at these conclusions?

“Something missing”

Put simply, SEEDS fills a gaping hole in how the economy is understood. It’s become increasingly clear, over an extended period, that the ability of conventional economics to provide interpretation and guidance has been breaking down. Policy levers that once worked pretty well seem now to have lost their effectiveness. This means that individuals and businesses, no less than governments, are unable to grasp what is really going on in the economy and finance.

Since the interpretive and predictive abilities of conventional economics are failing, it’s clear that “something is missing” from accepted thinking. Equally clearly, this missing component has now assumed greater importance than it had in the past. So what we’re for looking is a gap in understanding which is more important today than it was, say, twenty years ago.

The view taken here is that the missing ‘something’ is energy. There are at least two reasons why this ought to come as no surprise at all.

First, it’s observable, throughout history, that three data series have progressed in something very close to lock-step. These series are: energy consumption; population numbers; and the economic output that supports that population. From the late 1700s, when first we accessed the huge amounts of energy tied up in fossil fuels, all three series have become exponential. This is illustrated in the next chart, which compares population and energy consumption over two millenia. (For much of the early period, energy wasn’t traded, so we can’t quantify exactly how much was used, but we do know that the numbers were extremely small).

Population and energyjpg_Page1

Second, you only have to picture an economy suddenly starved of power to appreciate quite how utterly dependent all economic, financial, social and political systems are on the continuity of energy supply. Cut off this supply in its entirety for as little as 24 hours and chaos would ensue. It’s likely that a relatively short period without energy would be enough to turn chaos into collapse.

Both observations are so obvious that the absolute primacy of energy in the economy should be clear to everyone. The idea that energy is somehow ‘just another input’ is facile in the extreme. There is literally no service or commodity than can be supplied without it. Clearly, energy is much more important than just one a part of a sub-set of materials, itself one of the five inputs to economic activity (the others being labour, capital, knowledge and management).

What has changed?

We can be confident, then, that energy is the ‘something’ that is missing from the conventional understanding of the economy. Equally, though, if it’s missing now, then it was missing in the past, too – yet its absence has become more important over time.

So it’s not just energy itself that has been left out of the equation, but something dynamic (changing) within energy itself.

A long-standing interpretation of the energy economy has been scarcity. It’s logical that reserves of fossil fuels are finite; that consumption has increased exponentially over time; and that we’ve exploited the most economically attractive resources first, leaving less profitable alternatives for later. This process is known as depletion, and is the logic informing ‘peak oil’ – a thesis that ‘cornucopians’ dispute, but which may yet turn out to have been right all along.

The critical issue – cost

SEEDS, though, isn’t based on resource exhaustion. Where the critical role of energy is concerned, the alternative (though not necessarily conflicting) interpretation is that it’s cost, rather than quantity, which is critical.

Whenever we access energy, some of that energy is always consumed in the access process, and what remains – surplus energy – is the enabler of all economic activity, other than the supply of energy itself.

This relationship is often measured as a ratio known as EROEI (the Energy Return on Energy Invested, sometimes abbreviated EROI). The scientific argument supporting EROEI is compelling, and is stated superbly here.

SEEDS uses an alternative measure, ECoE (the Energy Cost of Energy), which expresses cost as a percentage of the gross energy accessed.

Because the world economy is a closed system, ECoE is not directly analogous to ‘cost’ in the usual financial sense. Rather, it is an economic rent, limiting the choice we exercise over any given quantity of energy. If we have 100 units of energy, and the ECoE is 5%, we exercise choice (or ‘discretion’) over 95 units. If ECoE rises to 10%, we now have discretion over only 90 units, even though the gross amount remains 100.

This is loosely analogous to personal prosperity. If someone’s income remains the same, but the cost of essentials rises, that person is worse off, even though income itself hasn’t changed.

Understanding ECoE

ECoE evolves over time. In the early stages of any given resource, ECoE is driven downwards by geographic reach, and by economies of scale. Once maturity is reached, depletion takes over as the driver, pushing ECoE upwards.

In the pre-maturity phase, technology accelerates the fall in ECoE driven by reach and scale. Post-maturity, technology acts to mitigate the rise caused by depletion. But – and this is often misunderstood – the capabilities of technology are limited to the envelope of the physical characteristics of the resource.

Over time, the trend in ECoE is parabolic (see illustration). Today, renewables remain on the downwards slope, but the ECoEs of fossil fuels are now emphatically on the upwards curve.

The same is true of overall ECoE, because fossil fuels still account for nearly 90% of energy supply, whilst renewables contribute less than 4%.

Parabolajpg_Page1

Even though renewables’ share of total energy supply is rising, it’s unlikely that this will stem, let alone reverse, the upwards trend in overall ECoE. Critically, technologies such as wind and solar power remain substantially dependent on inputs sourced from ‘legacy’ energy. We have yet to demonstrate that we can build solar panels, wind turbines or their associated infrastructure without recourse to energy from oil, gas or coal.

To this extent, the outlook for ECoEs in the renewables sector remains geared to the ECoEs of fossil fuels.

A critical point here is that, once on the upwards slope of the parabola, the rise in ECoE is exponential. According to SEEDS, global ECoE has risen from 3.5% in 1998 to 5.4% in 2008 and 8.0% now, and is projected to reach 10% by 2028.

For obvious reasons, details of the ECoE calculations used by SEEDS are not disclosed. This said, separate trajectories for fossil fuels and renewables are published, as are the global ECoE curve, and its national equivalents. (The aim is to give readers the maximum information consistent with not enabling any organisation to build a SEEDS-type system).

Some pointers, however, can be provided.

First, ECoEs are calculated on a fuel-by-fuel basis over time.

Second, and reflecting the nature of the main drivers, ECoEs evolve gradually, so SEEDS always cites trend ECoEs.

Third, the ECoE for any given country at any given moment, and the way in which this number changes over time, are determined by the mix of energy sources used, and by trade effects, where the country is a net importer or exporter of energy.

Relating ECoE to output – clean GDP

With ECoE established, it might appear that all we need to do now is deduct this number from GDP to arrive at prosperity, which is the corollary of surplus energy, expressed in monetary units.

Unfortunately, things are not this simple.

As we’ve seen, the tendency over an extended period has been to boost apparent GDP though processes known here as credit and monetary adventurism. The adoption of these policies can be seen, in part at least, as a response to a deterioration in rates of growth which began to take effect in or around the late 1990s, as rising ECoEs started to bite.

Comparing 2008 with 2000, reported “growth” of $26 trillion was accompanied by a $58tn increase in debt. The ratio between the two was thus $2.20 of new debt for each $1 of reported growth, though ratios were far higher than this in most Western economies.

Between 2008 and 2017, the ratio of borrowing to growth rose to 3.26:1, with $94tn of debt added alongside growth of $29tn. Furthermore, the latter period also witnessed the emergence of enormous shortfalls in the adequacy of pension provision, which have worsened by close to $100tn since 2008. This destruction of pension value is almost wholly attributable to a policy-induced collapse in returns on investment.

It almost defies credulity that we are asked to accept “growth” of $29tn as genuine whilst ignoring $94tn of net new debt, $28tn of newly-created QE liquidity and the destruction of almost $100tn of pension value.

According to SEEDS, real growth over that period wasn’t $29tn but $9.9tn, and even this calculation might be generous when set against the scale at which the aggregate balance sheet has been trashed over that period.

This calculation also means that GDP, reported at $127tn for 2017, falls to just $90tn on a clean, ex-manipulation basis – and even this, of course, is before we allow for ECoE, whose global cost has increased by 58%, from $4.5tn in 2008 to $6.9tn last year.

The following charts illustrate this situation, expressed in PPP-converted dollars at constant 2017 values. The left-hand chart shows GDP, both as reported and as adjusted by SEEDS to exclude the impact of the simple spending of borrowed money. The second chart shows debt, both as actual numbers and as the trend that would have occurred had debt grown at the same annual rates as reported GDP.

The difference between the red and black debt lines thus corresponds to debt growth in excess of percentage increases in GDP.

GDP & clean debtjpg_Page1

When examining these charts, it’s important to note the differences in the vertical axes, meaning that we’re dealing with movements at different orders of magnitude.

Between 2000 and 2017, GDP (as reported) increased by $55tn (76%) in real terms. But debt more than doubled, growing by 126%, or $152tn, from $121tn in 2000 to $273tn in 2017.

Borrowing $152tn to achieve growth of $55tn is not only unsustainable, but surely makes it clear beyond doubt that most of the supposed “growth” in GDP is simply the effect of pouring borrowed liquidity into the economy.

Implications of credit-fuelled GDP

From this, two things follow. The first is that a cessation of debt escalation would reduce growth dramatically – if debt ratios remained at current levels, no longer increasing, then GDP might continue to expand, but probably at rates of barely 1% annually, compared to the 3% and more claimed by reported numbers. Without continued increases in indebtedness, GDP could be expected to fall in most Western economies, whilst rates of growth in the emerging economies would slow markedly.

The second is that, if the excessive borrowing of recent years were to be reversed, GDP would slump, laying bare the extent to which the “growth” recorded since 2000 has been debt-inflated. On this latter point, debt stood at 168% of GDP in 2000, and now stands at 215%. Getting back to the 168% level would require deleveraging of almost $60tn, and the consequences of this for GDP are best left to the imagination.

If you put this $60tn figure alongside the scale of QE (about $28tn) – and add the massive (perhaps $100tn) of pension adequacy impairment, too – you’ll see how far out of reach any definition of financial ‘normality’ really is.

For all practical purposes, we are stuck with negative (sub-inflation) interest rates, ultra-cheap credit and negligible returns on invested capital until this combination of forces reaches its logical conclusion.

Corroboration

The calculation of ‘clean’ – ex-borrowing – output is undertaken using an algorithm which it would be folly to disclose, because to do so would be to hand an important methodology to those who don’t have an equivalent (though, pretty obviously, they need one).

But this doesn’t mean that we’re without at least three forms of corroborative evidence.

The first is to be found in the content of the “growth” reported in recent years. Data for the United States for the period between 2006 and 2016 illustrates this point.

Over that period, the American economy grew by $2.3tn at constant values. Of this growth, increases in the net export of services contributed 7%, or $159bn. The remaining 93% ($1.97tn) came from internally-consumed services (ICS), including finance and real estate (+$628bn) and government activity (+$272bn, excluding transfer payments).

Together, the combined contribution to this growth from globally-marketable output (GMO) – that is, manufacturing, construction, agriculture and the extractive industries, all of which are traded on a worldwide basis – was zero.

In other words, virtually all growth has occurred in activities where Americans pay each other for services that cannot be marketed to foreign customers. This is the classic profile of an economy relying for growth on ramping up its debt.

This has by no means been a phenomenon limited to the United States. Rather, it’s been visible across the West. In the emerging economies, and especially in China, the pattern has been different, with borrowed funds being channelled into the creation of capacity. But this borrowing, too, inflates consumption, because these activities act as conduits which push borrowed money into the pockets of those employed building capacity.

A second way of corroborating the debt-funded nature of reported “growth” is to examine the circumstances of the average person. If GDP growth (and, therefore, its per capita equivalent) was organic and sustainable, prosperity would be rising as well. That this isn’t the case is apparent in various metrics. One of these is real wages, and another is the comparison between incomes and the cost of essentials.

Critically, debt per person has risen by much more than per capita GDP, something which isn’t consistent with the improving prosperity implied by reported GDP. Again using the United States as an example, and stating all numbers at 2017 values, GDP per capita increased by 6.5%, or $3,620, between 2007 and 2017. But debt per capita was $22,400 (18%) higher at the end of 2017 than it had been ten years earlier.

Prosperity

To get from GDP to prosperity, then, two stages are involved. The first is to arrive at a ‘clean’ GDP number by removing the distortions introduced by pouring cheap credit into consumption. The second is to deduct ECoE from this underlying number.

The results show a deterioration in prosperity across all major Western economies other than Germany. Typically, Western citizens are getting poorer at rates of between 0.5% and 1% annually.

Moreover, the share of debt – personal, business and government – that these citizens are required to support on the back of dwindling prosperity has grown markedly. Because servicing this debt at normal (above-inflation) interest rates has become impossible, we are locked into monetary policies which are themselves destructive.

Though the citizens of emerging economies continue to enjoy increasing prosperity, their debt, too, is rising. For example, the average Chinese person is 41% more prosperous than he or she was back in 2007 – but the per capita equivalent of debt has quadrupled over the same period.

Worldwide, continued growth in EM prosperity has matched the deterioration in the developed West, meaning that average prosperity has flat-lined – but the ratio of debt to world prosperity has continued to rise markedly.

So, globally, we’re not getting richer, and we’re not getting poorer – but we are getting ever further into debt, whilst pension provision is falling ever further away from where it ought to be.

In short, SEEDS concludes that a string of observations often taken for granted are simply misleading. Output per capita isn’t growing, and most Westerners are getting poorer, not richer.

Take these observations on board and a lot of things that might have seemed inexplicable – including political outcomes, rising trade conflicts and many other stresses – all of a sudden fit into a logical pattern.

And it’s a pattern that‘s looking ever less sustainable.

 

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#129 stats annex 20062018