WHY THE RENMINBI COULD BE ‘THE LAST FIAT STANDING’
“It’s easy to be the last man standing – if all the others commit suicide”.
Although this isn’t one of the sayings of Confucius, it applies now with particular force to the Chinese renminbi – after all, to what currency, other than the RMB, can the world turn when each of its major rivals seems determined on self-immolation?
In Britain and America, economic and financial policy have long had all the hallmarks of self-destructive intent. Both countries believe that it makes sense to ship value-productive industries (such as manufacturing) out to lower-cost countries overseas, whilst trying to turn themselves into low-wage economies whose main profitable activity involves moving money around. The UK has driven debt upwards relentlessly, for the sole and senseless purpose of buttressing property prices which have already been over-inflated far beyond the point of affordability. America has binged on credit in an equally self-destructive effort to replace shock-absorbing corporate equity with inflexible debt, the result being a stock market which has become nothing more than a proxy for Fed monetary largesse.
Both countries seem now to have been driven to the point of policy despair. The American government is bent on injecting yet another $1.9 trillion of borrowed-out-of-nowhere money into the economy, whilst the Bank of England seems to be giving serious consideration to committing a symbolic currency surrender through the introduction of negative nominal interest rates. Both are deluding themselves about the real condition of their economies, with Britain, at least, seemingly persuaded that all will be well if consumers can only be induced to go on a spending-spree with money that they don’t have.
Britain and America have been described as “two countries divided by a common language”, but the operative definition now is that they are united in a shared commitment to economic fanaticism. It’s one thing to believe, mistakenly, that the economy is a wholly monetary system unconstrained by natural resources, but quite another to believe, as well, that the road to prosperity lies through the perpetual spending of borrowed and newly-created money.
Donald Trump may have coined the phrase “Make America Great Again”, but nobody can beat the British authorities when it comes to fatuous slogans. First there was the abolition of “boom and bust” during the biggest asset bubble in history. Next came “help to buy”, whose real meaning was ‘help young people to get deeply into debt to prop up the housing market’. Original thinking may be at a premium in Britain’s corridors of power, but the slogans keep coming.
In current circumstances, there’s something almost prurient in using the energy-based SEEDS economic model to evaluate the British and American economies, so let’s keep this brief. In the United States, prosperity per person turned down twenty years ago, falling from $48,850 (at 2019 values) in 2000 to $45,460 in 2019. Over that period, each person’s share of government, corporate and household debt rose, again at constant values, from $96,000 to $163,000. The ratio of debt to prosperity in America had risen to 360% at the end of 2019 – and probably at least 425% now – from 196% back in 2000. Government expenditures, on a per capita basis, rose by nearly $6,000 (37%) over a period in which prosperity per person declined by $3,240 (-6.6%).
Estimates for 2020 suggest that the prosperity of the average American declined by 8% last year, with only the most modest recovery in prospect before the gradual – but relentless – downtrend resumes. Using fiscal and monetary policy to boost financial demand whilst the supply of prosperity erodes is a recipe for inflation.
Financial recklessness is something in which Britain is fully competitive with the United States. Prosperity per person turned down later in the UK than in America, but has deteriorated more rapidly, falling by 10% between 2004 (£26,280) and 2019 (£23,560). Over the same period, debt per capita rose by £23,000 (38%) in real terms, and public expenditures per person by 14%. Worse still, British exposure to the global financial system, as of the end of 2019, stood at 10.8x GDP, equivalent to 15.2x prosperity. Aside from Ireland and Holland (both of which are far smaller economies), anyone in search of more extreme exposure to the world financial system would have to look at financial asset ratios in tiny economies like Singapore and the Cayman Islands.
This is the situation in which Washington is committing itself to yet more borrowed stimulus, whilst London thinks it makes great sense to proceed with a vastly expensive new rail project, together with anything else that can absorb huge amounts of money that can be conjured out of the ether, quite possibly at the cost of even more saver-punitive rates of interest.
Neither the US nor the UK seems to realise that boosting demand (through stimulus) at a time when you can do little or nothing to replace lost supply is an implicitly inflationary form of behaviour. Both Britain and America have multi-trillion gaps in future pension provision, which we can estimate at about £8tn in the UK, and $37tn in the US. Both have student debt on which large-scale default (politely known as ‘forgiveness’) seems highly likely. Neither government seems to realise that granting rent and debt payment ‘holidays’ creates huge strains for lenders and landlords. Both are watching their commercial property sectors spiralling into an abyss. In an ominous portent of the shape of things to come, the British regulator has now approved an increase of 9% in the ceiling on the combined cost of domestic gas and electricity.
If, just for a moment, we put tact aside, we can remind ourselves that Britain (with its obsession with “light-touch” regulation) and America (with the creation of “weapons of financial mass destruction”) were the main architects of the “global” financial crisis. Both now favour a “reset”, seemingly unaware that the opportunity to reset the system came – and went – during 2008-09. That was when adherence to market principles would have preserved monetary credibility at the cost of sharp falls in the (purely notional) prices of assets such as stocks and property.
To be sure, this would have been accompanied by defaults, which would have been very costly to remedy. Even so, recapitalisation of the banking system might have been cheaper than what has happened since, and what still lies in the future – after all, the debts which were kept in the ‘performing’ category in 2008-09 are no more capable of repayment now than they were back then.
It would have been far better, of course, if neither Britain nor America had embarked on the preceding, decade-long debt binge without which the GFC wouldn’t have happened at all.
The situation now is one in which both countries have handed themselves over to the theory of the magic money tree, seemingly unaware that money itself commands value only as a ‘claim’ on the goods and services for which it can be exchanged. The recipe of ‘produce less, spend more, and delude ourselves by inflating asset prices’ has never been a formula for success. An objective observer, perhaps visiting from a distant planet, would see no logic whatsoever in owning American dollars or British pounds. Both countries seem to have persuaded themselves that soaring stock and property prices aren’t signs of systemic inflation, and don’t understand that pouring new credit and new money into faltering economies can have only one possible outcome.
If our interplanetary visitor was looking for a viable alternative to USD and GBP, he or she might be tempted by EUR or JPY. Neither, though, really holds up under objective scrutiny. The euro is a political dream-currency, built on the economically-illiterate idea that one can combine a single, “one size fits all” monetary policy with nineteen different sovereign budget processes. This means that the role normally played within currency areas by ‘automatic stabilisers’ has to be filled by contentious, ad-hoc aid and a dysfunctional clearing system. Even before the onset of the pandemic crisis, the BoJ had used newly-created money to buy up more than half of all JGBs (Japanese government bonds) in existence, to the effect that central bank assets already exceeded 100% of GDP by the end of 2017.
During 2020, it seems that QE equated to about 29% of prior-year GDP in Japan, 25% in the Euro Area, 15% in the United States and 14% in Britain, for an average of 20%, which compares with barely 3% in China. We can be certain that there’s a lot more money creation to come from the Fed, the BoE, the ECB and the BoJ – but not from the PBOC.
With the US and the UK seemingly bent on “print to oblivion”, the EUR resembling the financial equivalent of a camel (“a horse designed by a committee”) and Japan deeply committed to ‘monetisation to the nth degree’, our imaginary visitor from outer space might seem to be running out of options. Having rejected cryptos – and after casting a considering eye at precious metals – his or her choices seem to have narrowed to just one.
That “last fiat standing” is the renminbi.
It seems quite clear that China, alone amongst the major currency areas, is committed to sound money. Beijing appears determined to mute the siren calls of Anglo-American style financial “innovation”, and even to allow SOEs to default at scale, if that’s the price that sound money now carries.
If the world economy is – as both logic and observation indicate – heading into involuntary ‘de-growth’, there is a choice to be made. Do we enter the era of economic contraction with a functioning monetary system available to help us manage it, and to mitigate its worst effects? Or do we sacrifice monetary viability in a futile effort at denial?
The former might be a great deal more rational, but probability increasingly favours the latter.
The coronavirus pandemic has not so much created as accelerated tendencies towards the use of financial expansion as a cure-all for both real and imagined economic ills. This puts two facets of monetary observation into conflict. On the one hand, we know that fiscal and monetary stimulus can help us to moderate economic downturns. On the other, though, we also know that too much monetary intervention carries the risk of undermining the all-important credibility of fiat money.
If ‘too much debt’ is one risk, ‘too much monetization of debt’ is another, and both seem to have gone into overdrive since the start of the coronavirus crisis. SEEDS data and estimates indicate that, during 2020, a group of sixteen advanced economies (AE-16) are likely to have run fiscal deficits of about $8.8 trillion, or 20% of their combined GDPs, a figure pretty much matching the $8.9tn that the four main Western central banks deployed in net asset expansion (QE) during the year.
Even if vaccination does indeed quickly bring the pandemic under control, continuing fiscal intervention – and the need to alleviate burdens placed on lenders and landlords by debt and rent payment ‘holidays’ – imply further big increases in public debt, and central bank monetization, during the current year.
Does this put the viability of fiat money itself at risk?
It’s certainly starting to look that way.
Not measured, not managed
Part of the problem is that orthodox economic interpretation cannot quantify what “too much” monetary intervention actually means. In the absence of such calibration, the authorities are at the mercy of short-term thinking and political pressures. Accordingly, those who express dark forebodings about the fate of fiat in a context of unprecedented financial intervention may very well be right.
The original intention here had been to concentrate wholly on monetary issues. But the better plan is to locate the role of money within broader economic processes, and then to ask whether there can be better calibration of the concept of monetary “excess”.
The conclusion reached here is that we can use energy-based measurement of prosperity as an independent benchmark against which to measure the economic claims embodied in the financial system. This measurement indicates that we have already travelled too far down the road of creating excess claims to turn back without making enormous, hugely unpopular adjustments to the system.
As the old saying goes, “if it isn’t measured, it isn’t managed”. This describes our current monetary predicament very well indeed – if credit creation and monetary policy seem out of control, the lack of meaningful measurement is a major factor in what has become an unmanaged problem.
The inability of monetary measurement to calibrate “excess” in a meaningful way is a consequence of the use of equations whose components are not discrete (that is, they are not independent of each other).
The often-used ratio which compares debt with GDP is a case in point. If, for instance, additional credit is put into the economy, the effect is to increase the economic activity that is counted as GDP, meaning that both the numerator (debt) and the denominator (GDP) are inter-connected. Indeed, and in situations where the debt/GDP ratio already exceeds 100% – where, that is, debt already exceeds GDP – it is perfectly possible for a rise in the quantity of debt to cause a fall in the ratio between debt and GDP. This results in a systemic underestimation of the proportionate extent of debt, a process of understatement which becomes more pronounced as indebtedness increases.
In this knowledge vacuum – in which the term “excessive” cannot be defined – decision-makers find it very hard to resist pressures for ever more fiscal and monetary intervention. Those urging support, whether for their own sector or for the economy as a whole, can call in aid Keynes’ observations about stimulus, omitting to add that the Keynesian calculus addresses the smoothing of cycles, not a perennial stimulation of economic activity on a continuing basis, and envisages periods of financial tightening which offset periods of stimulus.
As remarked earlier, it’s likely that fiscal stimulus injected into sixteen Western economies totaled 20% of their combined GDPs last year, and may be of the order of 10% in 2021, with the former number essentially monetized by central bank money creation. This, on the face of it, looks like “excess”.
So at what point, then, does financial intervention become “excessive”? Conventional ratios such as debt/GDP cannot tell us this, and neither, in a market distorted by huge intervention, can interest rates answer this question either. Another non-discrete measure – that which compares asset prices with liabilities – cannot help us to know where the “point of excess” lies. For various reasons – which include the conventional exclusion of asset prices from the calculation of inflation – we can’t even rely on inflation numbers for warning that the point of excess looms.
A claim on energy – the real meaning of money
To understand these issues, we need first to place money in its economic context. Conventional explanation ascribes three roles to money. One of these is as store of value, a function which fiat currencies cannot, historically, be said to have fulfilled. A second is that money can be used as a unit of measurement, but this, as we’ve seen, is an extremely flawed concept, primarily because there exist no recognized non-monetary benchmarks against which monetary numbers can be measured. This leaves us with the third – actually, the all-important – function of money, which is as a “means of exchange”.
Of “exchange”, though, for what? Clearly, the only meaningful process of exchange is one which involves the use of money to buy goods and services. This in turn defines money as a ‘token’. As such, money has no intrinsic worth, meaning that it commands value only in terms of the things for which it can be exchanged. This is why, in Surplus Energy Economics, money is defined as a ‘claim’ on goods and services.
Money can usefully be likened to the ticket or ‘check’ given to a person handing in a hat or coat when attending an event. Printing more of these checks doesn’t increase the number of hats or coats available when the exchange process is reversed at the end of the function. Likewise, the ‘check’ cannot, of itself, keep its owner warm or dry – for this, it needs to be exchanged for an actual (physical) coat or hat.
With due apologies to those who already know this, the role of money as claim is one of the three core principles of the surplus energy economy. The first of these is that all of the goods and services which constitute economic output are products of the use of energy, such that nothing of any economic utility whatsoever can be supplied without it. This defines money as a ‘claim on energy’, with the corollary being that debt, as a ‘claim on future money’, really functions as a ‘claim on future energy’.
The second core observation is that, whenever energy is accessed for our use, some of that energy is always consumed in the access process. We can’t put oil to use without drilling a well or building a refinery, access gas without investing in wells and processing systems, make use of coal without excavating a mine, or harness solar or wind power without constructing solar panels, wind turbines and distribution systems. All of these processes are themselves functions of the use of energy. The “used in access” component is known here as ECoE (the Energy Cost of Energy).
This enables us to refine our definitions, such that money is ‘a claim on surplus (ex-ECoE) energy’, and debt ‘a claim on future surplus energy’. A logical question to ask ourselves is: what has happened to money, debt and broader obligations, in relation to surplus energy, in recent times?
Comparing 2019 with 1999, and using financial data adjusted for inflation, money GDP expanded by 95%, and debt by 177%, over a period in which global surplus energy increased by less than 50%. Throughout this period, these ratios became progressively worse.
What this means for underlying economic output, and its relationship with debt, is illustrated in the following charts. Since the mid-1990s, aggregate global debt (shown in red in the left-hand chart) has expanded far more rapidly than reported GDP. The central chart shows how, expressed at constant 2019 values, annual borrowing (in red) has been far larger than increments to GDP (blue).
The right-hand chart shows how the development of a ‘wedge’ between debt and GDP has inserted a corresponding wedge between reported GDP and underlying or ‘clean’ output (C-GDP).
This interpretation is wholly ignored by orthodox approaches, which fail to recognize the connection between the non-discrete (that is, the connected) entities of debt and reported GDP. Properly understood, though, the ‘wedge’ concept can provide important insights into the way in which the interaction between debt and GDP distorts both the real level of economic output and the extent of leverage built in to the system.
Prosperity as process
The identification of ECoE divides the supply of energy into two components. One of these is the cost element (ECoE), and what remains is surplus energy. Since this surplus energy powers all economic activity other than the supply of energy itself, surplus energy is coterminous with the material prosperity delivered by the economy. If monetary measurement of the economy departs in any meaningful way from this definition of prosperity, we can be said to be practicing financial self-delusion.
Though ignored by orthodox economics, the ECoE process is reasonably well understood. In the early stages, ECoEs are driven downwards by geographic reach, economies of scale and advances in technology, with the proviso that the scope of technology is circumscribed by the physical characteristics of the energy resource. In the case of fossil fuels – which continue to supply more than four-fifths of global primary energy consumption – the potential of reach and scale has been exhausted, introducing depletion as the primary (and upwards) driver of ECoEs. The meaning of depletion is that, quite naturally, we have used lowest-cost sources of oil, gas and coal first, leaving costlier alternatives for a “later” which has now arrived. Technology can mitigate the ensuing rise in ECoEs, but cannot overturn the laws of physics such as to push ECoEs back downwards.
This has always meant that the end of fossil-fuel-powered economic growth wasn’t going to be a matter of “running out of” oil, gas or coal, but of encountering rising costs (ECoEs) which erode the economic value of each unit of energy accessed. Cost and volume parameters are interconnected, of course, so that rising costs must inevitably, in due course, result in decreasing volumes.
The great hope, reinforced by urgent environmental imperatives, is that we can replace rising-ECoE fossil fuels with falling-ECoE renewable sources of energy (REs). Imperative though the development of RE capacity is, some of the more glib assurances of seamless transition have always been something of a triumph of hope over analysis.
There are two main snags with the ‘seamless transition’ thesis. The first is that, though falling, the ECoEs of REs might never fall far enough to replace low-ECoE fossil fuels as drivers of economic expansion. The second is that, because RE expansion relies on inputs whose supply depends in turn on the use of fossil fuels, we may not be able to de-link the ECoEs of REs from the (rising) ECoEs of fossil fuels.
REs are already close to offering ECoEs that are competitive with, or below, those of fossil fuels today. What we require of REs, though, are ECoEs that replicate the ultra-low levels of fossil fuels, not now, but in their heyday. For reference, SEEDS analysis indicates that prosperity in the advanced economies turned down at ECoEs of between 3.5% and 5%, with the same happening to less-complex, less ECoE-sensitive emerging market (EM) economies in an ECoE range between 8% and 10%.
What we require of REs, then, are ECoEs that are certainly less than 5% and, ideally, ECoEs which replicate those of fossil fuels – between 1% and 2% – back when oil, gas and coal were capable of driving real and sizable increases in material prosperity.
The reality, though, is that it seems unlikely that the ECoEs of REs are ever going to fall much below about 10%. On that basis, the global economy – with an overall trend ECoE of 9.3% – has already entered a phase of deteriorating prosperity, a trend from which not even EM countries such as China and India can be expected to be exempt.
We can call this process “de-growth”, but with the proviso that this is not the voluntary contraction advocated by those who contend that the world would be a better place if we ditched our obsession with material “growth”. Rather, what we’re experiencing now is involuntary “de-growth”, imposed upon us by a deterioration in the energy equation which determines trends in prosperity.
Where reported GDP – inflated both by credit effects and by a failure to allow for ECoE – exceeds prosperity, the situation is one in which we are creating “excess claims”. Simply stated, this means that financial behaviour is creating (and distributing) monetary claims that the surplus energy of today and tomorrow will be incapable of meeting. If that’s the case, the destruction of the “value” contained in these “excess claims” becomes inescapable. To revert to an earlier metaphor, a lot of people are going to present ‘checks’ for which no economic hat or coat exists for the purpose of exchange.
The following charts set out the “excess claims” interpretation of the relationship between prosperity (measured on an energy basis) and financial ‘promises’.
The left-hand chart illustrates the process by which reported GDP has departed from underlying prosperity. Whilst monetary expansion has – as we have seen – driven a wedge between reported (GDP) and underlying (C-GDP) output, the inclusion of rising ECoEs tracks a further divergence between C-GDP and prosperity.
The result is that a steadily widening divergence between GDP and prosperity has created successive annual increments of excess claims within the financial representation of the economy.
It must be emphasized that the central chart reflects ongoing development work on the SEEDS model. This project has reached a point at which we can produce a realistic illustration of the cumulative build-up of ‘excess claims’ over time. In the chart, this is set against global debt to show how the accumulation of excess claims has progressed far beyond the relatively straightforward expansion of debt, and now embraces many other and substantial forms of liability.
The left-hand and central charts are calibrated in international dollars PPP – this is the preferred convention in SEEDS, and converts other currencies into dollars on the basis of purchasing power parity. To facilitate comparison with debt and other statistics, the right-hand chart shows the global equivalents of debt and excess claims on the basis of market dollars.
The broad picture
This SEEDS analysis, as expressed in market-converted dollars, suggests that cumulative excess claims already exceeded $360tn by the end of 2019, a number far larger than formal debt at that time. With prosperity hit by the pandemic crisis, whilst financial claims are being created at a seemingly unprecedented rate, we can only assume that we are experiencing a big expansion in the ongoing (and the cumulative) gaps between real economic output and financial claims.
We can further describe how this process is likely to unwind. Fundamentally, a big ‘excess claims’ gap means that borrowers will have no option but to default, and that asset prices will fall in line with the deterioration in future value that these prices are supposed to represent.
The question then becomes one of how this default takes place. One way is formal default, where borrowers are unable to meet their commitments. The alternative is informal or soft default, where obligations are met, but in money devalued by inflation. History reveals an almost invariable preference – wherever the choice exists – for the for informal (‘soft’) over formal (‘hard’) default.
Thus seen, the situation is clear, albeit disturbing. Over time, we have created monetary ‘claims’ which have diverged ever further from the prosperity generated by the energy-determined ‘real’ economy of goods and services. Evidences of this excess are to be seen across the board, not just in debt but in broader categories of commitment (which include huge unfunded and un-fundable gaps in pension commitments). Asset prices have been inflated, in part by the cheap money reflected in excess claims, and in part by the persistence of unrealistic expectations for the future.
Our responses to this emerging situation have had all the predictability of a badly-scripted film. Faced with “secular stagnation” (a precursor to de-growth, and ultimately traceable to rising ECoEs), we responded with credit adventurism, based on the illogical premise that credit creation could somehow invigorate a ‘real’ economy which converts energy, resources and labour into economic utility. Whilst fiscal and monetary policy can smooth temporary peaks and troughs, it cannot change the underlying trend in value creation determined by thermodynamics.
This in turn pushed us, during the ensuing 2008-09 crisis, into monetary adventurism, a short-term response to credit excesses which, in reality, cannot be countered within any set of policies which aim, at the same time, to preserve the value of money.
It’s wholly unsurprising, then, that the coronavirus crisis has pushed us a long way further down the road to the discrediting of fiat money. A combination of short-term thinking, well-intentioned intervention, self-interest and fundamental misunderstanding has led us to believe that credit and fiscal stimulus can supply a cost-free ‘fix’ for underlying economic issues which, properly understood, are not responsive to monetary manipulation.
What the authorities have been doing during the pandemic amounts to a rapid acceleration of established policies which assume that, by injecting cheap credit and cheaper money into the system, we can go beyond the reasonable moderation of cycles into the unreasonable creation of perpetual growth.
This misunderstanding of economic fundamentals might be likened to the way in which trainee pilots are sometimes warned that “Isaac [Newton] is always waiting”. What sages of aviation – who tend also to remark that “there are old pilots, and bold pilots, but no old bold pilots” – mean by this is that gravity always lies in wait to punish aviators who allow hubris and ignorance to outweigh prudence and a proper respect for the laws of aerodynamics.
The corollary here is that excessive self-assurance, and a failure to understand the thermodynamic basis of economic activity, have led us to play ducks-and-drakes with the viability of fiat money.
Conceptually, the existence of fiat has always made it possible for us to create monetary claims which exceed the capabilities of the real economy. The events and fallacies of recent years seem, beyond question, to have led is into precisely this fundamental mistake. We are – to paraphrase a former pilot – trying to fly under economic conditions in which “even the birds are walking”.
Surplus Energy Economics 