#113: Death of a high-fashion model

IS ‘SUSTAINABLE DEVELOPMENT’ A MYTH?

For a long time now, “sustainable development” has been the fashionable economic objective, the Holy Grail for anyone aiming to achieve economic growth without inducing catastrophic climate degradation. This has become the default position for two, very obvious reasons. First, no politician wants to tell his electorate that growth is over (even in countries where, very clearly, prosperity is now in decline). Second, policymakers prepared to invite ridicule by denying the reality of climate change are thin on the ground.

Accordingly, “sustainable development” has become a political article of faith. The approach seems to be to assume that sustainable development is achievable, and use selective data to prove it.

Where this comfortable assumption is concerned, this discussion is iconoclastic. Using the tools of Surplus Energy Economics, it concludes that the likelihood of achieving sustainable development is pretty low. Rather, it agrees with distinguished scientist James Lovelock in his observation that sustainable retreat might be the best we can expect.

This site is dedicated to the critical relationship between energy and economics, but this should never blind us to the huge threat posed by climate change. There seems no convincing reason to doubt either the reality of climate change science or the role that emissions (most obviously of CO²) are playing in this process. As well as counselling sustainable retreat, James Lovelock might be right, too, in characterising the earth as a system capable of self-regeneration so long as its regenerative capabilities are not tested too far.

False comfort

Economics is central to this debate. Here, comparing 2016 with 2001, are some of the figures involved;

Real GDP, 2016 values in PPP dollars:

2001: $73 trillion. 2016: $120tn (+65%)

Energy consumption, tonnes of oil equivalent:

2001: 9.5bn toe. 2016: 13.3bn toe (+40%)

Emissions of CO², tonnes:

2001: 24.3bn t. 2016: 33.4bn t (+37%)

If we accept these figures as accurate, each tonne of CO² emissions in 2001 was associated with $2,990 of GDP. By 2016, that number had risen to $3,595. Put another way, 17% less CO² was emitted for each $1 of GDP. By the same token, the quantity of energy required for each dollar of GDP declined by 15% over the same period.

This is the critical equation supporting the plausibility of “sustainable growth”. If we have really shown that we can deliver successive reductions in CO² emissions per dollar of GDP, we have options.

One option is to keep CO² levels where they are now, yet still grow the economy. Another is to keep the economy where it is now and reduce CO² emissions. A third is to seek a “goldilocks” permutation, both growing the economy and reducing emissions at the same time.

Obviously, the generosity of these choices depends on how rapidly we can continue our progress on the efficiency curve. Many policymakers, being pretty simple people, probably use the “fool’s guideline” of extrapolation – ‘if we’ve achieved 17% progress over the past fifteen years’, they conclude, ‘then we can expect a further 17% improvement over the next fifteen’.

Pretty lies

But what if the apparent ‘progress’ is illusory? The emissions numbers used as the denominator in the equation can be taken as accurate, as can the figures for energy consumption. Unfortunately, the same can’t be said of the economic numerator. As so often, we are telling ourselves comforting untruths about the way in which the world economy is behaving.

This issue is utterly critical for the cause of “sustainable development”, whose plausibility rests entirely on the numbers used to calculate recent trends.

And there are compelling reasons for suspecting the validity of GDP numbers.

For starters, apparent “growth” in economic output seems counter-intuitive. According to recorded numbers for per capita GDP, the average American was 6% better off in 2016 than in 2006, and the average Briton was 3% more prosperous. These aren’t big numbers, to be sure, but they are positive, suggesting improvement, not deterioration. Moreover, there was a pretty big slump in the early part of that decade. Adjustment for this has been used to suggest that people are growing more prosperous at rates faster than the trailing-10-year per capita GDP numbers indicate.

Yet the public don’t buy into the thesis of “you’ve never had it so good”. Indeed, it isn’t possible reconcile GDP numbers with popular perception. People feel poorer now than they did in 2006, not richer. That’s been a powerful contributing factor to Americans electing Donald Trump, and British voters opting for “Brexit”, crippling Theresa May’s administration and turning in large numbers to Jeremy Corbyn’s collectivist agenda. Much the same can be said of other developed economies, including France (where no established party made it to the second round of presidential voting) and Italy (where a referendum overwhelmingly rejected reforms proposed by the then-government).

Ground-level data suggests that the popular perception is right, and the per capita GDP figures are wrong. The cost of household essentials has outpaced both incomes and general inflation over the past decade. Levels of both household and government debt are far higher now than they were back in 2006. Perhaps worst of all – ‘though let’s not tell the voters’ – pension provision has been all but destroyed.

The pension catastrophe has been attested by a report from the World Economic Forum (WEF), and has been discussed here in a previous article. It is a topic to which we shall return in this discussion.

The mythology of “growth”

If we understand what really has been going on, we can conclude that, where prosperity is concerned, the popular perception is right, meaning that the headline GDP per capita numbers must be misleading. Here is the true story of “growth” since the turn of the century.

Between 2001 and 2016, recorded GDP grew by 65%, adding $47tn to output. Over the same period, however, and measured in constant 2016 PPP dollars, debt increased by $135tn (108%), meaning that each $1 of recorded growth came at a cost of $2.85 in net new borrowing.

This ratio has worsened successively, mainly because emerging market economies (EMEs), and most obviously China, have been borrowing at rates far larger than growth, a vice previously confined to the developed West.

This relationship between borrowing and growth makes it eminently reasonable to conclude that much of the apparent “growth” has, in reality, been nothing more substantial than the spending of borrowed money. Put another way, we have been boosting “today” by plundering “tomorrow”, hardly an encouraging practice for anyone convinced by “sustainable development” (or, for that matter, sustainable anything).

Nor is this all. Since the global financial crisis (GFC) of 2008, we have witnessed the emergence of enormous shortfalls in society’s provision for retirement. According to the WEF study of eight countries – America, Australia, Britain, Canada, China, India, Japan and the Netherlands – pension provision was deficient by $67tn in 2015, a number set to reach $428tn (at constant values) by 2050.

Though the study covers just eight countries, the latter number dwarfs current GDP for the entire world economy ($120tn PPP). The aggregate eight-country number is worsening by $28bn per day. In the United States alone, the annual deterioration is $3tn, equivalent to 16% of GDP and, incidentally, roughly five times what America spends on defence. Moreover, these ratios seem certain to worsen, for pension gaps are increasing at annual rates far in excess of actual or even conceivable economic growth.

For the world as a whole, the equivalent of the eight-country number is likely to be about $124tn. This is a huge increase since 2008, because the major cause of the pensions gap has been the returns-destroying policy of ultra-cheap money, itself introduced in 2008-09 as a response to the debt mountain which created the GFC. Finally, on the liabilities side, is interbank or ‘financial sector’ debt, not included in headline numbers for debt aggregates.

Together, then, liabilities can be estimated at $450tn – $260tn of economic debt, about $67tn of interbank indebtedness and an estimated $124tn of pension under-provision. The equivalent number for 2001 is $176tn, expressed at constant 2016 PPP values. This means that aggregate liabilities have increased by $274tn over fifteen years – a period in which GDP grew by just $47tn.

The relationship between liabilities and recorded GDP is set out in the first pair of charts, which, respectively, set GDP against debt and against broader liabilities. Incidentally, the pensions issue is, arguably, a lot more serious than debt. This is because the real value of existing debt can be “inflated away” – a form of “soft default” – by governments willing to unleash inflation. The same cannot be said of pension requirements, which are, in effect, index-linked.

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Where climate change is concerned, what matters isn’t so much the debt or broader liability aggregates, or even the rate of escalation, but what they tell us about the credibility of recorded GDP and growth.

Here, to illustrate the issues involved, are comparative annual growth rates between 2001 and 2016, a period long enough to be reliably representative:

GDP: +3.4% per year

Debt: +5.0%

Pension gap and interbank debt: +9.1%

To this we can add two further, very pertinent indicators:

Energy consumption: +2.2%

CO² emissions: +2.1%

The real story

As we have seen, growth of $47tn in recorded GDP between 2001 and 2016 was accompanied – indeed, made possible – by a vast pillaging of the balance sheet, including $135tn in additional indebtedness, and an estimated $140tn in other liabilities.

The only realistic conclusion is that the economy has been inflated by massive credit injections, and by a comparably enormous unwinding of provisions for the future. It follows that, absent these expedients, organic growth would have been nowhere near the 3.4% recorded over the period.

SEEDS – the Surplus Energy Economics Data System – has an algorithm designed to ex-out the effect of debt-funded consumption (though it does not extend this to include pension gaps or interbank debt). According to this, adjusted growth between 2001 and 2016 was only 1.55%. As this is not all that much faster than the rate at which the population has been growing, the implication is that per capita growth has been truly pedestrian, once we see behind the smoke-and-mirrors effects of gargantuan credit creation.

This isn’t the whole story. The above is a global number, which embraces faster-than-average growth in China, India and other EMEs. Constrastingly, prosperity has actually deteriorated in Britain, America and most other developed economies. Citizens of these countries, then, are not imagining the fall in prosperity which has helped fuel their discontent with incumbent governing elites. The deterioration has been all too real.

The second set of charts illustrates these points. The first shows quite how dramatically annual borrowing has dwarfed annual growth, with both expressed in constant dollars. The second sets out what GDP would have looked like, according to SEEDS, if we hadn’t been prepared to trash collective balance sheets in pursuit of phoney “growth”. You will notice that the adjusted trajectory is consistent with what was happening before we ‘unleashed the dogs of cheap and easy credit’ around the time of the millenium.

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Flagging growth – the energy connection

As we have seen, then, the very strong likelihood is that real growth in global economic output over fifteen years has been less than 1.6% annually, slower than growth either in energy consumption (2.2%) or in CO² emissions (2.1%). In compound terms, growth in underlying GDP seems to have been about 26% between 2001 and 2016, appreciably less than increases in either energy consumption (+40%) or emissions (+37%).

At this point, some readers might think this conclusion counter-intuitive – after all, if technological change has boosted efficiency, shouldn’t we be using less energy per dollar of activity, not more?

There is, in fact, a perfectly logical explanation for this process. Essentially, the economy is fuelled, not by energy in the aggregate, but by surplus energy. Whenever energy is accessed, some energy is always consumed in the access process. This is expressed here as ECoE (the energy cost of energy), a percentage of the gross quantity of energy accessed. The critical point is that ECoE is on a rising trajectory. Indeed, the rate of increase in the energy cost of energy has been rising exponentially.

As mature resources are depleted, recourse is made to successively costlier (higher ECoE) alternative sources. This depletion effect is moderated by technological progress, which lowers the cost of accessing any given form of energy. But technology cannot breach the thermodynamic parameters of the resource. It cannot, as it were, ‘trump the laws of physics’. Technology has made shale oil cheaper to extract than shale oil would have been in times past. But what it has not done is transform shales into the economic equivalent of giant, technically-straightforward conventional fields like Al Ghawar in Saudi Arabia. Any such transformation is something that the laws of physics simply do not permit.

According to estimates generated on a multi-fuel basis by SEEDS, world ECoE averaged 4.0% in 2001, but had risen to 7.5% by 2016. What that really means is that, out of any given $100 of economic output, we now have to invest $7.50, instead of $4, in accessing energy. The resources that we can use for all other purposes are correspondingly reduced.

In the third pair of charts, the left-hand figure illustrates this process. The area in blue is the net energy that fuels all activities other than the supply of energy itself. This net energy supply continues to increase. But the red bars, which are the energy cost of energy, are rising too, and at a more rapid rate. Consequently, gross energy requirements – the aggregate of the blue and the red – are rising faster than the required net energy amount. This is why, when gross energy is compared with economic output, the energy intensity of the economy deteriorates, even though the efficiency with which net energy is used has improved.

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Here’s another way to look at ECoE and the gross/net energy balance. Back in 2001, we needed to access 104.2 units of energy in order to have 100 units for our use. In 2016, we had to access 108.1 units for that same 100 units of deployable energy. This process, which elsewhere has been called “energy sprawl”, means that any given amount of economic activity is requiring the accessing of ever more gross energy in order to deliver the requisite amount of net (surplus) energy. By 2026, the ratio is likely to have risen to 112.7/100.

The companion chart shows the trajectory of CO² emissions. Since these emissions are linked directly to energy use, they can be divided into net (the pale boxes), ECoE (in dark grey) and gross (the sum of the two). Thanks to a lower-carbon energy slate, net emissions seem to be flattening out. Unfortunately, gross emissions continue to increase, because of the CO² associated with the ECoE component of gross energy requirements.

Shot down in flames? The “evidence” for “sustainable development”

As we have seen, a claimed rate of economic growth (between 2001 and 2016) that is higher (65%) than the rate at which CO² emissions have expanded (37%) has been used to “prove” increasing efficiency. It is entirely upon these claims that the viability of “sustainable development” is based.

But, as we have also seen, reported growth has been spurious, the product of unsustainable credit manipulation, and the unwinding of provision for the future. Real growth, adjusted to exclude this manipulation, is estimated by SEEDS at 26% over that period. Crucially, that is less than the 37% rate at which CO² emissions have grown.

On this basis, a claimed 17% “improvement” in the amount of CO² per dollar of output reverses into a deterioration. Far from improving, the relationship between CO² and economic output worsened by 9% between 2001 and 2016. In parallel with this, the amount of energy required for each dollar of output increased by 11% over the same period.

The final pair of charts illustrate this divergence. On the left, economic activity per tonne of CO² is shown. The second chart re-expresses this relationship using GDP adjusted for the artificial “growth” injected by monetary manipulation. If this interpretation is correct – and despite a very gradual upturn in the red line since 2010 – the comforting case for “sustainable development” falls to pieces.

In short, if growth continues, rising ECoEs dictate that both energy needs, and associated emissions of CO², will grow at rates exceeding that of economic output.

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We are back where many have argued that we have been all along. The pursuit of growth seems to be incompatible with averting potentially irreversible climate change.

There is a nasty sting-in-the-tail here, too. The ECoE of oil supplies is rising particularly markedly, and there seems a very real danger that this will force an increased reliance on coal, a significantly dirtier fuel. A recent study by the China University of Petroleum predicted exactly such a trend in China, already the world’s biggest producer of CO². As domestic oil supply peaks and then declines because of higher ECoEs, the study postulates a rapid increase in coal consumption to feed the country’s voracious need for energy. This process is most unlikely to be confined to China.

Where does this leave us?

The central contention here is that the case for “sustainable development” is fatally flawed, because the divergence between gross and net energy needs is more than offsetting progress in greening our energy mix and combatting emissions of harmful gases. “Sustainable development” is a laudable aim, but may simply not be achievable within the laws of physics as they govern energy supply.

If this interpretation is correct, it means that growth in the global economy can be pursued only at grave climate risk. A (slightly) more comforting interpretation might that the super-heated rate of borrowing, and the seemingly disastrous rate at which pension capability is being destroyed, might well crash the system before our obsession with ‘growth at all costs’ can inflict irreparable damage to the environment.

#112: Will things go bang soon?

A BUBBLE AND A SPIKE, PART 2

We may not be clear yet about when the next crash will come, but we understand a very great deal about the mechanism that will make it happen. Put another way, we have a narrative that puts all the pieces in the right places.

This narrative is telling us that a crash is highly likely – and that it may happen a lot sooner than we think.

Let’s start with the fundamentals. Contrary to conventional thinking, the economy isn’t really a monetary system at all, but a surplus energy dynamic. What drives the output of goods and services is the quantity of energy we can access, less the energy consumed in the access process. If the available quantity is constrained – or the energy cost of accessing it increases – the output of the economy will decrease.

Money, having no intrinsic worth, has value only as a “claim” on the output of the real economy, which means, ultimately, that money is a claim on surplus energy. Debt, as a ‘claim on future money’, is really a claim on future energy.

For more than two centuries, there has been sustained growth in available surplus energy. This has enabled total financial claims – the aggregate of money and credit – to increase as well, without toppling the financial system.

What we’ve been witnessing since the turn of the century, though, has been an increase in the energy cost of energy (ECoE), combined with emerging constraints on the quantity of accessible energy. This process makes the continued growth in aggregate money and credit dangerous, because we are creating claims that the real economy will not be able to meet.

Once understood, this process makes sense of what has been happening. Between 2000 and 2008, credit creation soared, but debt-financed growth drove up energy demand in a way that eventually brought the system to the brink of collapse. In 2001, when prices averaged $24/bbl, OECD consumers spent about $430bn on oil, of which around $240bn went on imports. By 2008, when oil averaged $97/bbl, these numbers had increased to $1,700bn and $1,050bn. Oil was now costing OECD customers $1,270bn more than it had just seven years earlier – and $810bn of that increase was being spent on the higher cost of imports.

Moreover, these huge liquidity drains are only those related to oil. Other forms of energy also soared in cost, as did energy-intensive commodities such as minerals and foodstuffs.

This was what brought the debt-financed party to an end.

Looking a little more closely at this, the increase in the cost of oil to the OECD quadrupled between 2001 and 2008. The increase in ECoE over the same period was much smaller than this. According to SEEDS, global ECoE for all energy sources rose from 4% in 2001 to 5.4% in 2008, a rise of one-third.

So the rise in market prices vastly over-cooked the underlying trend in ECoEs. In relation to this fundamental benchmark, oil was underpriced in 2001, and overpriced in 2008.

This tells us that something else was going on.

That ‘something else’ was supply constraint.

Just as westerners were bingeing on credit, emerging market economies (EMEs) were consuming more energy and other commodities, notably as exports ramped up. Rising energy demand was colliding with more pedestrian growth in supply. Investment in supply tracked market prices higher. When demand dropped after 2008, the ensuing fall in prices became inevitable.

In retrospect, we “got away with it” in 2008, for three main reasons.

First, governments’ balance sheets were strong enough for them to bail out the banks without forfeiting their own credibility, and that of their currencies.

Second, the authorities bought time by adding monetary adventurism to the established credit adventurism.

Third, the cooling of the economy took the heat out of energy markets.

To know when and if a second crash may happen, and what its results are likely to be, we need to test these three “get-outs” as they now are.

First, government balance sheets. On the basis of amounts owed (rather than the market value of bonds), the aggregate debt of advanced country governments was 67% of GDP in 2007. Now it is 102%, and still rising. Bailing out the banks now would be a lot harder than it was back in 2008. Not only are government balance sheets weaker, but bank exposure has increased as global debt has grown. To be sure, reserves ratios are higher now than they were back in 2007. But, because banks borrow short and lend long, no amount of reserving can render them immune from the consequences of a loss of faith.

Second, “monetary adventurism”. Back in 2008, typical rates were 5.25% in the United States and 4.3% in the European Union. Now, the equivalent numbers are around 1% and -0.25%. There’s no scope, then, for further monetary adventurism, unless central banks are prepared to go for deeply negative nominal rates, a policy which would be barking mad, even if it didn’t, very probably, necessitate helicopter money and the banning of cash.

So that leaves us with our third component, which is energy. Essentially, a big rise in oil prices would crash the system.

Is this likely? On balance, it is. Oil demand is growing at around 1.4 mmb/d each year. Supply has kept pace, mainly thanks to increased shale and other unconventional output, plus an increase in supply from OPEC. Neither may be sustainable. Shales are extremely capital intensive, because of the “drilling treadmill” caused by ultra-rapid decline rates. Few OPEC countries have much scope to deliver increased supplies. Underlying ECoE, SEEDS says, is 42% higher now than it was in 2007.

Put this higher ECoE together with the slump in investment caused by the fall in crude prices, and the implication is that crude prices could spike, and do so rather more quickly than is generally expected.

That, then, is what we should be watching for when looking out for another crash. All the other conditions are in place, including excessive debt, weak underlying growth (reflecting rising ECoEs), overstretched government balance sheets, and an inability to repeat the monetary adventurism of 2008-09.

All that we’re waiting for is an oil price spike, and a trigger equivalent to the “Lehman moment”.

Both may come sooner rather than later.

 

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#111: A spike to puncture the bubble?

OIL PRICES

Anyone living in a bubble should beware of spikes.

Between 2001 and 2008, world debt (at current market values) increased from $60tn to $117tn.

There’s a bubble.

In 2001, the price of oil averaged $24/bbl. In the summer of 2008, it peaked at $147/bbl.

There’s a spike.

Though the connection isn’t drawn perhaps as often as it should be, there can be little doubt that the massive spike in oil prices punctured the equally massive debt bubble, leading directly to the global financial crisis (GFC).

The connection seems inescapable. Dramatically higher oil prices, in themselves, drained enormous amounts of liquidity out of the same oil-importing Western economies which were merrily bingeing on debt. Just as importantly, the surge in oil prices also drove up the cost of energy-intensive commodities, including minerals and food.

Could the same thing happen again, triggering a second (and probably much worse) global financial crash?

The bubble is certainly there – and is even bigger than the last one.

Since 2008, world debt (at current values) has expanded from $117tn to $160tn. But these headline numbers are converted to dollars at market exchange rates. Converted using the more realistic PPP (purchasing power parity) convention, debt has already reached 235% of world GDP, or $260tn. The equivalent figure in 2008 was $153tn.

On top of that, there are truly gargantuan shortfalls in pension provision, shortfalls which are “set to dwarf world GDP”.

In the period before 2008, the authorities had confined themselves to deregulatory recklessness, which facilitated a big increase in aggregate debt, and an equally big proliferation in risk.

Since then, monetary recklessness has been stirred into the mix, turbocharging debt escalation as well as bending returns on capital completely out of shape. That, ultimately, is why it has become impossible to provide adequately for retirement.

So there is certainly a bubble. Should we expect a spike?

Thus far in the bubble, a saving grace has been cheap oil. The price of oil averaged $44/bbl last year, down from $109/bbl as recently as 2013.

Demand for oil has continued to grow. Between 2007 and 2009, world oil demand decreased by 1.8 mmb/d (million barrels per day). But demand in 2016 (93.2 mmb/d) was 10.4 mmb/d, or 13%, higher than it was back in 2009 (82.8 mmb/d).

By and large, supply has kept pace. Since 2009, supplies from non-OPEC countries have increased by 5.7 mmb/d. OPEC countries have chipped in an additional 1.8 mmb/d of unconventional liquids, not subject to the cartel’s quota. The world’s need for quota crude from OPEC has therefore grown only modestly, from 29.3 mmb/d in 2009 to 32.3 mmb/d last year.

But this could now change. Much of the increase in non-OPEC supply has come from shale oil production in the United States. There are now some pretty persuasive reasons for thinking that US shale output might be at or near a peak, from which it could fall away quite quickly.

Readers will be familiar with some of the weaknesses of the shale story. Where output from conventional oil wells typically declines at between 5% and 10% annually, depletion rates for shale are dramatically more severe, with rates of 60%, and above, by no means uncommon.

This puts operators on a “drilling treadmill”, having to keep drilling new wells to offset declines from old ones. This has been fine so long as investors, convinced of the eventual profitability of “Saudi America”, keep stumping up capital. The day has to come, however – and probably sooner rather than later – when investors cease to oblige.

Where the petroleum industry is concerned, the picture is becoming clearer. The world’s appetite for oil is continuing to grow at around 1.4 mmb/d (1.5%) each year. Supplies of conventional crude have already peaked, and shale supply seems fairly close to doing the same.

Logically, this points to another spike in prices. One reservation has to be the ability of the world’s consumers to pay higher prices. But these consumers will probably do what they did at the same point in the previous cycle – which is to grumble, pay up, and add the cost to their already enormous debts.

We certainly have the bubble. We may, pretty confidently, anticipate the spike.

= = = =

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#110: Diverging fortunes

SEEDS PROSPERITY REPORT, OCTOBER 2017

Now that SEEDS – the Surplus Energy Economics Data System – is fully functional, it is possible to review prosperity in what may be the first of a series of regular reports.

The general conclusion, which is unlikely to surprise anyone, is that the emerging market economies (EMEs) are performing far better than the developed Western nations where prosperity is concerned. What might surprise you is quite how marked some of these differences are.

SEEDS defines prosperity as ‘real discretionary incomes’, a term which requires some explanation. The starting point is GDP per capita, but two critical adjustments are then made.

First, GDP data is adjusted to eliminate ‘borrowed consumption’. Anyone can have a lavish lifestyle if he or she is prepared to go ever deeper into debt, and has a bank sufficiently accommodative to let them do so. This is precisely what many countries have been doing. The accommodative suppliers of credit have been the authorities. They started by making debt easily accessible and comparatively cheap, and have (since 2008) been even more obliging, by making credit even cheaper.

Second, the resulting ‘ex-borrowing’ numbers are further adjusted for the trend cost of energy. This cost acts as an economic rent, which means that it diminishes the incomes over which we can exercise choice (‘discretion’).  Where the individual or household is concerned, this shows up primarily in above-inflation increases in the cost of essential (‘non-discretionary’) expenditures.

The results are summarised in the table, in which the eagle-eyed will spot the first appearance of Russia in SEEDS data.

 Prosperity data, October 2017SEEDS PROsperityjpg_Page1

The table shows per capita prosperity, in local currency and at constant (2016) values, for the years 2006, 2016 and 2025. There are three columns of percentage comparisons, with results ranked by the third of these columns, which compare projections for 2025 with calculations for 2006.

Some of the results have obvious explanations. Prosperity in the United Kingdom is in relentless decline because the economy is in very deep trouble. Through-period comparisons for Australia, Norway and Canada are adverse because commodity prices, important to these economies, were close to extreme cyclical highs back in the start year of 2006.

Greece, obviously, has had a severe decline in prosperity over the past decade, but can now anticipate a very gradual recovery, albeit reversing only a very small proportion of the preceding decrease in prosperity.

At the other extreme, citizens of India continue to enjoy rapid improvement. The average Indian was 58% better off in 2016 than he or she had been in 2006, but we do need to note relative values here – in 2016, per capita prosperity (at PPP rates of conversion) was only $4,820 in India, compared with $43,700 in the United States.

China, too, continues to deliver impressive growth in prosperity, but there is a caveat here – per-capita debt is rising a lot more rapidly than prosperity. In 2016, the average Chinese citizen was 58% more prosperous than in 2006, but China also had four times as much per capita debt than a decade earlier.

The robust performance of Russia needs to be seen in context. In 2006, the Russian economy was still showing the ravages of the 1990s, and progress from here on is likely to be much more sedate.

 

 

 

#109: Still the Orient Express?

CHINA – a SEEDS APPRAISAL

The development of SEEDS – the Surplus Energy Economics Data System – enables us to put individual economies under the magifying glass, and this discussion responds to reader requests by looking at China.

Before we start, it’s necessary to remind ourselves that China remains a one-party state in which the authorities exercise considerable influence over the private sector. This matters, because the over-riding concern of the government is to avoid the unrest which would be likely to result from unemployment.

This objective can be a tough call. Despite family control policies sometimes criticized by outsiders, the population of China does continue to expand, and has increased by an estimated 68 million – more than the entire population of Britain – since 2006. Additionally, Chinese citizens continue to migrate from the countryside in search of better-paid work in the cities. Together, these trends make it imperative that employment growth continues unchecked.

For this reason, China is far more concerned with maintaining and growing activity than she is with profitability. This difference of objectives is profound, and can confuse observers accustomed to thinking in terms of the corporate profit motive which drives so much policy in the West.

Over an extended period, China has achieved breath-taking rates of growth in headline GDP. In 2016, the Chinese economy grew by 6.7%, and reported GDP has risen by 136% over a decade, from RMB 22.1 trillion in 2006 to RMB 74.6tn last year. The consensus expectation is that headline growth rates are set to remain in the range 6.5% to 7.0% for the foreseeable future.

In the past, some sceptics have questioned the reliability of reported growth figures, comparing them unfavourably with slower rates of increase in volumetric measures (such as the consumption of electricity). It is true that there seem to be continuity issues (where methods of calculation are changed, but without earlier numbers being restated).

But the really challenging issue now isn’t how much growth China delivers. It is how that growth is achieved.

The first chart puts this question into context. Growth in GDP has continued in a linear way, almost unchecked even by the global financial crisis (GFC) of 2008. But what has changed, radically, since the GFC has been the rate at which Chinese debt increases.

The numbers make this quite clear. Between 2008 and 2016, China’s GDP increased by RMB 35tn, or 88%. But economic debt – that is, the combined indebtedness of government, households and business – expanded by RMB 135tn (242%) over the same eight-year period. This equates to net new borrowing of RMB 3.86 for each RMB 1.00 of growth in GDP.

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Nor is this all. In addition to economic debt, China has very high levels of inter-bank or ‘financial’ sector debt. This debt increased from 24% of GDP (RMB 6.5tn) in 2007 to 65% (RMB 42tn) in 2014, and is likely to be about RMB 64tn (86% of GDP) today. Inter-bank debt is often omitted from debt/GDP calculations, because – in theory – it would net off to zero if all banks cleared their debts to each other.

As we learned in 2008, however, netting-off is not a safe assumption under all circumstances. So any assessment of China’s escalating debt position needs to take this into account.

Within the rapid build-up of economic debt, it is corporate borrowing which predominates. Of the RMB 135tn of net borrowing since 2008, government and households accounted for only 18% and 19% respectively.

The remaining 63% – net borrowing of RMB 85tn – was undertaken by private non-financial corporations (PNFCs). These businesses, then, have borrowed a lot more (RMB 85tn) than growth in the entire economy (RMB 35tn) since the GFC. Additionally, banks’ indebtedness to each other increased by about RMB 53tn – again, a lot more than total GDP growth – during that period.

Unlike Western countries, then – where most borrowing is carried out by government and households – the majority of debt growth in China comes from businesses. These businesses use this new debt primarily to grow capacity, often to levels far ahead of domestic or foreign demand.

This creation of excess capacity sustains growth in activity – in keeping with the government’s priority – but it exerts major downwards pressure on margins and profits. This has resulted in returns on capital often being depressed below the cost of debt capital. One obvious course of action would be to convert relatively costly debt into cheaper equity. But, when this was tried, it came close to crashing the Chinese equity market.

Rising levels of indebtedness – both corporate and inter-bank – are a clear cause for concern. From a SEEDS perspective, though, what matters more is that debt-financed capacity creation has boosted activity and recorded GDP to levels which simply would not be sustainable if access to ever-expanding debt was curtailed.

Stripped of this “borrowed growth”, underlying GDP is estimated to be nearer RMB 48tn than the recorded RMB 75tn (see next chart). Accordingly, underlying growth seems to be nowhere near 6.8%, but closer to 3.1% instead, equivalent to 2.5% on a per capita basis.

China underlying GDP Oct 2017jpg_Page1

Of course, this needs to be kept in context, and growth of 3.1% is impressive by Western standards.

But the risk attending the “borrowing effect” is considerable. If  lenders were to become cognizant of quite how much growth is being ‘juiced’ by the spending of borrowed money, the consequences could be distinctly unpleasant. To be sure, and even if capital flight and higher rates followed, China could probably sustain its debt-funded growth from within its own banking system. But there are, obviously, limits to quite how long any economy can keep on growing its aggregate debt by about 13% annually.

Additionally, the sheer pace of expansion in inter-bank debt has to be a matter of concern.

Meanwhile, China remains an energy-hungry economy, relying on imports for 68% of its primary energy needs.  Renewables still account for less than 3% of energy consumption, so are not, even remotely, a near-term fix.

This energy situation is being reflected in a rising trend ECoE (energy cost of energy). SEEDS estimates China’s current ECoE at 14.4%, which is drastically higher than a world average of 7.5%. According to SEEDS, China’s surplus energy position is already looking perilous, and could derail growth in less than a decade.

The final chart shows per capita prosperity, calibrated in constant (2016) RMB 000s per person. The downwards impact of ECoE (the red arrow) looks small, but this is deceptive – the ECoE effect only looks small because it is dwarfed by the borrowing effect.

Unlike many Western countries, China does still enjoy increasing prosperity on a per capita basis.

But the two threats to Chinese economic prospects – superheated debt expansion, and high-and-rising ECoE – should not be underestimated.

Whilst the former carries an elevated risk of financial shock, the latter suggests that Chinese citizens may face uncomfortably rapid increases in the real cost of household essentials in the not-too-distant future.

China prosperity Oct 2017jpg_Page1

 

 

 

#108: SEEDS goes public

Dear reader

As you will know if you are a regular visitor, surplus energy economics is an interpretation which says that the economy is, fundamentally, an energy system, not a financial one. More specifically, it is a surplus energy system, because, whenever energy is accessed, some energy is always consumed in the access process. Our prosperity is the surplus, or difference, between the amount of energy accessed and the quantity used up in getting it.

Where the surplus energy approach differs most fundamentally from ‘conventional’ economics is in its recognition that there are two economies, not one.

The first of these is the ‘real’ economy of goods and services, labour and resources, and this is an energy system.

In parallel with it is a second or ‘financial’ economy of money and credit.

Conventional economics goes wrong in thinking that this ‘financial’ economy is the entirety of our economic system. In fact, it is in a subservient relationship with the energy economy. This ought to be obvious. After all, money has no intrinsic worth. It commands value only as a “claim” on the output of the real economy.

Back in 2013, when Life After Growth was first published, I was uncomfortably aware that it would be hard to put numbers on this relationship. This is where the SEEDS project – the Surplus Energy Economics Data System – began. One of the biggest challenges has been to use monetary units to calibrate the ‘real’ economy which is the substance behind the ‘financial’ economy with which we are all familiar. This is one of the reasons why developing SEEDS has taken so long.

During this period, I have become ever more aware of a striking and dangerous reality in our situation. This is the way in which the ‘financial’ economy has become estranged from the ‘real’ economy which it is supposed to represent.

The real economy began to decelerate in or around 2000, but we have been unable or unwilling to accept this. Instead, we’ve sought to fake a “normality” of growth by ‘mortgaging the future’.

At first, we did this by creating an ever larger mountain of debt. This led to the global financial crisis (GFC) of 2008.

So large had debt become by then that the only way in which we could co-exist with it was to make it cheap to service. This is where “monetary adventurism” began.

We have toyed with some extremely silly ideas since then, such as ‘helicopter drops’ of money, negative interest rates, and the banning of cash.

The powers that be haven’t been sufficiently irresponsible to adopt some of the more extreme expedients. But what they have done has been bad enough. Ultimately, we have adopted a policy of ultra-cheap money, slashing policy interest rates to all-but-zero, and using vast amounts of newly-created money to drive asset values up, and yields down.

Only now are we becoming aware of quite how disastrous this policy of ultra-cheap money really is. Naturally, it has accelerated the pace at which we borrow – after all, why would you not borrow, when you are being paid to do so by interest rates which are negative (they are less than inflation)? And why would you save, when the real value of your savings falls year on year?

But the downsides of monetary adventurism don’t end there. I’ll pick just one of these downsides for special mention here. It is pensions. By driving returns on capital down into negative territory, we have destroyed returns on capital and, with them, our ability to provide for retirement. For all but a tiny minority of the very wealthiest, it has become impossible to save enough to give us a decent income in retirement.

The naïve answer to this is that we needn’t worry about pensions, or other future issues like paying back debts, because we have the comfort of the hugely inflated values of assets such as stocks, bonds and property.

This ‘comfort blanket’ is foolish in the extreme – because the only way we can turn these assets into money is by selling them to each other.

In politics and society, there are two things which we must hope that the general public never finds out. The first is what has happened to their ability to provide for retirement. The second is that selling houses to each other cannot get them out of this predicament.

The SEEDS system – in its SEEDS Snapshots version, freely available to the public – can now be downloaded from the resources page. The SEEDS Professional version will be announced at a later date.

We will doubtless have many discussions here about what SEEDS does, how it does it, and what it can tell us.

For now, though, such discussions can wait. Please download the very first published version – and enjoy it.

 

Yours,

 

Tim Morgan

 

 

 

#107: War-games

WHY SOMEONE IN BRITAIN NEEDS TO GET A GRIP

Britain’s opposition Labour party incurred a lot of media displeasure with the recent disclosure that it had contingency plans to cope with a run on sterling. In fact, such “war gaming” was nothing more than prudent. Indeed, it is to be hoped that the authorities, too, have such plans (though, of course, it would be madness to say so).

The thinking behind Labour’s plans was that, were left-leaning party leader Jeremy Corbyn to become premier, some of his policies (and especially his commitment to nationalization) might panic international markets, causing GBP to crash in a welter of capital flight. On this scenario, it seemed – even a couple of weeks ago – that there would, at least, be plenty of time to prepare. After all, few expected an election to be called in the near future.

As things now stand, and if you were taking bets on why a GBP crash might happen, a hostile market reaction to the election of Mr Corbyn would be an outsider in the betting. The much graver risk now is that a GBP slump might occur far sooner than Labour can come to power, and for fundamental rather than political reasons.

To be quite blunt about it, investors would now have very good reasons for concluding that Britain, both economically and politically, is falling apart.

The economic situation is truly parlous. Almost every sector – construction, production and services – seems to be turning down. The sole previous driver of economic growth, which was debt-fuelled consumption, has hit the buffers because consumer credit is maxed out. Even car sales – perhaps the ultimate debt-financed component – have taken on an ominous downwards trajectory.

Rising inflation has put great pressure on activity, because average wages have fallen steadily further adrift of prices. The Bank of England has hinted about rises in interest rates, essentially creating a hostage to fortune – if, after these hints, an increase doesn’t happen after all, the investor appetite for holding GBP could test new lows.

The Bank has also warned that the financial services industry faces adverse consequences unless the terms of a post-“Brexit” deal on trade with the EU can be reached by Christmas. Since Britain’s Brexit preparedness has recently been scored at just 9% – and, in the economic sphere alone, more or less zero – there seems precious little chance of that.

To cap it all, new information suggests that trends in productivity are even worse than previously thought, gravely impairing financial ‘wriggle-room’ in responding to “Brexit” uncertainties. This adds to the woes of finance minister Philip Hammond ahead of a budget which is likely to prove problematic anyway, not least because of increasingly strident demands for easing a policy of austerity which has fallen particularly heavily on public sector employees.

This, of course, brings in the issue of politics, which is a second area characterised by disintegration. Many Conservative politicians probably want rid of hapless premier Theresa May, and are deterred from ousting her only by two things – fear of the consequences if an election ensues, and the simple lack of a credible successor.

The Conservatives’ woes are being exacerbated by a clearly antagonistic drift in public opinion. When asked about “capitalism”, the most popular responses are “greedy”, “selfish”, “corrupt”, “divisive” and “dangerous”. Majorities, even amongst Conservative voters, now favour nationalising water, electricity, gas and railways.

In the face of this, government responses have seemed truly woeful. Both Mrs May and Mr Hammond have delivered trenchant defences of ‘the market economy’, but these have not persuaded voters increasingly hostile to “capitalism”.

The irony here is that there isn’t much free market economics around, in Britain or elsewhere, or not so that you’d notice. In 2008, governments defied the markets by rescuing banks, when market forces alone would have let them fail. Central banks then ditched market forces altogether by imposing a policy of ultra-cheap money. This, of course, crippled returns on capital – and, once returns on capital turn negative (that is, are less than inflation), it’s almost a logical impossibility to run an economy on capitalist lines.

Meanwhile, we must hope that the public, throughout the world, don’t find out what ZIRP has done to their prospects in retirement.

Mr Hammond’s own plan to expand “help to buy” is yet another policy which defies market forces (as well as being a gravely faulty policy in itself). There doesn’t seem to be much that is “free market” about Mrs May’s plans to cap energy prices, either.

Energy policy, in fact, neatly encapsulates the overthrow of the markets. Where the big energy utilities are concerned, Mr Corbyn wants to nationalize them, whilst Mrs May wants to cap their prices.

Neither proposal is, even remotely, a market-based policy. Any adherent of Adam Smith-style market economics would propose neither nationalization nor price control, but would instead advocate breaking up these over-mighty players, in the interests both of competition and of consumer value. Yet no-one, anywhere within the British political cadre, seems even to have considered the break-up option.

The British public, confronted with political fragility, policy imbecility and a deteriorating economy spelled out in a succession of adverse developments and statistics, must by now be feeling pretty punch-drunk. Unless someone gets a grip, the next blow could be a knock-out.