The End Of An Era
Authored by Dr. Tim Morgan, Tullet Prebon,
The economy as we know it is facing a lethal confluence of four critical factors – the fall-out from the biggest debt bubble in history; a disastrous experiment with globalisation; the massaging of data to the point where economic trends are obscured; and, most important of all, the approach of an energy-returns cliff-edge.
Through technology, through culture and through economic and political change, society is more short-term in nature now than at any time in recorded history. Financial market participants can carry out transactions in milliseconds. With 24-hour news coverage, the media focus has shifted inexorably from the analytical to the immediate. The basis of politicians’ calculations has shortened to the point where it can seem that all that matters is the next sound-bite, the next headline and the next snapshot of public opinion. The corporate focus has moved all too often from strategic planning to immediate profitability as represented by the next quarter’s earnings.
This report explains that this acceleration towards ever-greater immediacy has blinded society to a series of fundamental economic trends which, if not anticipated and tackled well in advance, could have devastating effects. The relentless shortening of media, social and political horizons has resulted in the establishment of self-destructive economic patterns which now threaten to undermine economic viability. We date the acceleration in short-termism to the early 1980s.
Since then, there has been a relentless shift to immediate consumption as part of something that has been called a “cult of self-worship”. The pursuit of instant gratification has resulted in the accumulation of debt on an unprecedented scale. The financial crisis, which began in 2008 and has since segued into the deepest and most protracted economic slump for at least eighty years, did not result entirely from a short period of malfeasance by a tiny minority, comforting though this illusion may be. Rather, what began in 2008 was the denouement of a broadly-based process which had lasted for thirty years, and is described here as “the great credit super-cycle”.
The credit super-cycle process is exemplified by the relationship between GDP and aggregate credit market debt in the United States (see fig. 1.1). In 1945, and despite the huge costs involved in winning the Second World War, the aggregate indebtedness of American businesses, individuals and government equated to 159% of GDP. More than three decades later, in 1981, this ratio was little changed, at 168%. In real terms, total debt had increased by 214% since 1945, but the economy had grown by 197%, keeping the debt ratio remarkably static over an extended period which, incidentally, was far from shock-free (since it included two major oil crises).
From the early 1980s, as figs. 1.1 and 1.2 show, an unmistakeable and seemingly relentless upwards trend in indebtedness became established. Between 1981 and 2009, debt grew by 390% in real terms, far out-pacing the growth (of 120%) in the American economy. By 2009, the debt ratio had reached 381%, a level unprecedented in history. Even in 1930, when GDP collapsed, the ratio barely topped 300%, and thereafter declined very rapidly indeed.
This report is not, primarily, about debt, and neither does it suggest that the problems identified here are unique to the United States. Rather, the massive escalation in American indebtedness is one amongst a host of indicators of a state of mind which has elevated immediate consumption over prudence throughout much of the world.
This report explains that we need only look beyond the predominant short-termism of contemporary thinking to perceive that we are at the confluence of four extremely dangerous developments which, individually or collectively, have already started to throw more than two centuries of economic expansion into reverse.
Before the financial crisis of 2008, this analysis might have seemed purely theoretical, but the banking catastrophe, and the ensuing slump, should demonstrate that the dangerous confluence described here is already underway. Indeed, more than two centuries of near-perpetual growth probably went into reverse as much as ten years ago.
Lacking longer-term insights, today’s policymakers seem bewildered about many issues. Why, for instance, has there been little or no recovery from the post-2008 economic slump? Why have traditional, tried-and-tested fiscal and monetary tools ceased to function? Why have both austerity and stimulus failed us?
The missing piece of the economic equation is an appreciation of four underlying trends, each of which renders many of the lessons of the past irrelevant.
trend #1 – the madness of crowds
The first of the four highly dangerous trends identified here is the creation, over three decades, of the worst financial bubble in history. In his 1841 work Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay (1814-89) identified a common thread of individual and collective idiocy running through such follies of the past as alchemy, witchhunts, prophecies, fortune-telling, magnetizers, phrenology, poisoning, the admiration of thieves, duels, the imputation of mystic powers to relics, haunted houses, crusades – and financial bubbles.
A clear implication of Mackay’s work was that all of these follies had been consigned to the past by intelligence, experience and enlightenment. For the most part, he has been right. Intelligent people today do not put faith in alchemy, fortune-telling, witchcraft or haunting, and – with the arguable exception of the invasion of Iraq – crusades have faded into the history books.
But one folly remains alive and well. Far from confining financial bubbles to historical tales of Dutch tulips and British South Sea stock, the last three decades have witnessed the creation and the bursting of the biggest bubble in financial history.
Described here as ‘the credit supercycle’, this bubble confirmed that one aspect, at least, of the idiocy identified by Mackay continues to wreak havoc. Insane though historic obsessions with tulip bulbs and south seas riches may appear, they are dwarfed by the latterday, ‘money for nothing’ lunacy that, through the credit super-cycle, has mired much of the world in debts from which no escape (save perhaps hyperinflation) exists.
Perhaps the most truly remarkable feature of the super-cycle was that it endured for so long in defiance of all logic or common sense. Individuals in their millions believed that property prices could only ever increase, such that either borrowing against equity (by taking on invariably-expensive credit) or spending it (through equity release) was a safe, rational and even normal way to behave.
Regulators, meanwhile, believed that there was nothing wrong with loosening banking reserve criteria (both by risk-weighting assets in ways that masked leverage, and by broadening definitions of bank capital to the point where even some forms of debt counted as shock-absorbing equity).
Former Federal Reserve boss Alan Greenspan has been ridiculed for believing that banks would always act in the best interests of their shareholders, and that the market would sort everything out in a benign way. But regulators more generally bent over backwards to ignore the most obvious warning signs, such as escalating property price-to-incomes ratios, soaring levels of debt-to-GDP, and such obviously-abusive practices as sub-prime mortgages, NINJA loans and the proliferation of unsafe financial instruments.
Where idiocy and naïveté were concerned, however, regulators and the general public were trumped by policymakers and their advisors. Gordon Brown, for example, proclaimed an end to “boom and bust” and gloried in Britain’s “growth” despite the way in which debt escalation was making it self-evident that the apparent expansion in the economy was neither more nor less than the simple spending of borrowed money.
Between 2001-02 and 2009-10, Britain added £5.40 of private and public debt for each £1 of ‘growth’ in GDP (fig. 1.3). Between 1998 and 2012, real GDP increased by just £338bn (30%) whilst debt soared by £1,133bn (95%) (fig. 1.4).
Asset managers have a very simple term to describe what happened to Britain under Brown – it was a collapse in returns on capital employed.
No other major economy got it quite as wrong as Britain under Brown, but much the same was happening across the Western world, most notably in those countries which followed the disastrous Anglo-American philosophy of “light-touch” financial regulation.
trend #2 – the globalisation disaster
The compounding mistake, where the Western countries were concerned, was a wide-eyed belief that ‘globalisation’ would make everyone richer, when the reality was that the out-sourcing of production to emerging economies was a self-inflicted disaster with few parallels in economic history. One would have to look back to a Spanish empire awash with bullion from the New World to find a combination of economic idiocy and minority self-interest equal to the folly of globalization.
The big problem with globalisation was that Western countries reduced their production without making corresponding reductions in their consumption. Corporations’ outsourcing of production to emerging economies boosted their earnings (and, consequently, the incomes of the minority at the very top) whilst hollowing out their domestic economies through the export of skilled jobs.
This report uses a measure called ‘globally-marketable output’ (GMO) as a metric for domestic production, a measure which combines manufacturing, agriculture, construction and mining with net exports of services. By definition, activities falling outside this category consist of services provided to each other.
At constant (2011) values, consumption by Americans increased by $6,500bn between 1981 and 2011, whilst consumption on their behalf by the government rose by a further $1,700bn, but the combined output of the manufacturing, construction, agricultural and extractive industries grew by barely $600bn. At less than $200bn in 2011, net exports of services did almost nothing to bridge the chasm between consumption and production.
This left two residuals – domestically consumed services, and debt – with debt the clincher. Between 1981 and 2011, and again expressed at constant values, American indebtedness soared from $11 trillion to almost $54 trillion.
Fundamentally, what had happened here was that skilled, well-paid jobs had been exported, consumption had increased, and ever-greater quantities of debt had been used to fill the gap. This was, by any definition, unsustainable. Talk of Western economies modernising themselves by moving from production into services contained far more waffle than logic – Western consumers sold each other ever greater numbers of hair-cuts, ever greater quantities of fast food and ever more zero-sum financial services whilst depending more and more on imported goods and, critically, on the debts used to buy them. Corporate executives prospered, as did the gateholders of the debt economy, whilst the vast majority saw their real wages decline and their indebtedness spiral. For our purposes, what matters here is that reducing production, increasing consumption and taking on escalating debt to fill the gap was never a remotely sustainable course of action. What this in turn means is that no return to the pre-2008 world is either possible or desirable.
trend #3 – an exercise in self-delusion
One explanation for widespread public (and policymaker) ignorance of the truly parlous state of the Western economies lies in the delusory nature of economic and fiscal statistics, many of which have been massaged out of all relation to reality.
There seems to have been no ‘grand conspiracy’ here, but the overall effect of accretive changes has been much the same. In America, for example, the benchmark measure of inflation (CPI-U) has been modified by ‘substitution’, ‘hedonics’ and ‘geometric weighting’ to the point where reported numbers seem to be at least six percentage points lower than they would have been under the ‘pre-tinkering’ basis of calculation used until the early 1980s. US unemployment, reported at 7.8%, excludes so many categories of people (such as “discouraged workers”) that it hides very much higher levels of inactivity.
The critical distortion here is clearly inflation, which feeds through into computations showing “growth” even when it is intuitively apparent (and evident on many other benchmarks) that, for a decade or more, the economy has, at best, stagnated, not just in the United States but across much of the Western world. Distorted inflation also tells wage-earners that they have become better off even though such statistics do not accord with their own perceptions. It is arguable, too, that real (inflation-free) interest rates were negative from as long ago as the mid-1990s, a trend which undoubtedly exacerbated an escalating tendency to live on debt.
Fiscal figures, too, are heavily distorted, most noticeably in the way in which quasi-debt obligations are kept off the official balance sheet. As we explain in this report, the official public debts of countries such as the United States and the United Kingdom exclude truly enormous commitments such as pensions.
trend #4 – the growth dynamo winds down
One of the problems with economics is that its practitioners preach a concentration on money, whereas money is the language rather than the substance of the real economy. Ultimately, the economy is – and always has been – a surplus energy equation, governed by the laws of thermodynamics, not those of the market.
Society and the economy began when agriculture created an energy surplus which, though tiny by later standards, liberated part of the population to engage in non-subsistence activities.
A vastly larger liberation of surplus energy occurred with the discovery of the heat engine, meaning that the energy delivered by human labour could be leveraged massively by exogenous sources of energy such as coal, oil and natural gas. A single US gallon of gasoline delivers work equivalent to between 360 and 490 hours of strenuous human labour, labour which would cost perhaps $6,500 if it were paid for at prevailing rates. Of the energy – a term coterminous with ‘work’ – consumed in Western societies, well over 99% comes from exogenous sources, and probably less than 0.7% from human effort. Energy does far more than provide us with transport and warmth. In modern societies, manufacturing, services, minerals, food and even water are functions of the availability of energy. The critical equation here is not the absolute quantity of energy available but, rather, the difference between energy extracted and energy consumed in the extraction process. This is measured by the mathematical equation EROEI (energy return on energy invested).
For much of the period since the Industrial Revolution, EROEIs have been extremely high. The oil fields discovered in the 1930s, for example, provided at least 100 units of extracted energy for every unit consumed in extraction (an EROEI of 100:1). For some decades now, though, global average EROEIs have been falling, as energy discoveries have become both smaller and more difficult (meaning energy-costly) to extract.
The killer factor is the non-linear nature of EROEIs. As fig. 1.5 shows, the effects of a fall-off in EROEI from, say, 80:1 to 20:1 do not seem particularly disruptive but, once returns ratios have fallen below about 15:1, there is a dramatic, ‘cliff-edge’ slump in surplus energy, combined with a sharp escalation in its cost.
Research suggests that the global average EROEI, having fallen from about 40:1 in 1990 to 17:1 in 2010, may decline to just 11:1 by 2020, at which point energy will be about 50% more expensive, in real terms, than it is today, a metric which will carry through directly into the cost of almost everything else – including food.
crisis, culpability and consequences
If the analysis set out in this report is right, we are nearing the end of a period of more than 250 years in which growth has been ‘the assumed normal’. There have been setbacks, of course, but the near-universal assumption has been that economic growth is the usual state of affairs, a rule to which downturns (even on the scale of the 1930s) are the exceptions. That comfortable assumption is now in the process of being over-turned.
The views set out here must provoke a host of questions. For a start, if we really are nearing a cliff-edge economic crisis, why isn’t this visible already? Second, who is to blame for this? Third, how bad could it get? Last, but surely most important, can anything be done about it?
Where visibility is concerned, our belief is that, if the economy does tip over in the coming few years, retrospect – which always enjoys the 20-20 vision of hindsight – will say that the signs of the impending crash were visible well before 2013.
For a start, anyone who believed that a globalisation model (in which the West unloaded production but expected to consume as much, or even more, than ever) was sustainable was surely guilty of wilful blindness. Such a state of affairs was only ever viable on the insane assumption that debt could go on increasing indefinitely. Charles Mackay chronicled many delusions, but none – not even the faith placed in witchcraft – was ever quite as irrational as the belief (seldom stated, but always implicit in Western economic policy) that there need never be an end to a way of life which was wholly dependent on ever-greater debt.
Even to those who were happy to swallow the nonsense of perpetually expanding indebtedness, the sheer scale of debt – and, relevantly in this context, of quasi-debt commitments as well – surely should have sounded warning bells. From Liverpool to Los Angeles, from Madrid to Matsuyama, the developed world is mired in debts that can never be repaid. In addition to formal debt, governments have entered into pension and welfare commitments which are only affordable if truly heroic assumptions are made about future prosperity.
At the same time, there is no real evidence that the economy is recovering from what is already a more prolonged slump than the Great Depression of the 1930s. We are now more than four years on from the banking crisis and, under anything approaching normal conditions, there should have been a return to economic expansion by now. Governments have tried almost everything, from prolonged near-zero interest rates and stimulus expenditures to the creation of money on a gigantic scale. These tools have worked in the past, and the fact that, this time, they manifestly are not working should tell us that something profoundly different is going on.
The question of culpability has been the equivalent of Sherlock Holmes’ “dog that did not bark in the night”, in that very few individuals have been held to account for what is unarguably the worst economic disaster in at least eighty years. A small number of obviously-criminal miscreants have been prosecuted, but this is something that happens on a routine basis in normal times, so does not amount to an attribution of blame for the crisis. There has been widespread public vilification of bankers, the vast majority of whom were, in any case, only acting within the parameters of the ‘debtfuelled, immediate gratification’ ethos established across Western societies as a whole.
Governments have been ejected by their electorates, but their replacements have tended to look very similar indeed to their predecessors. The real reason for the seeming lack of retribution is that culpability is far too dispersed across society as a whole. If, say, society was to punish senior bankers, what about the thousands of salesmen who knowingly pushed millions of customers into mortgages that were not remotely affordable? The suspicion lingers that there has been a ‘grand conspiracy of culpability’, but even the radical left has failed to tie this down to specifics in a convincing way.
The real causes of the economic crash are the cultural norms of a society that has come to believe that immediate material gratification, fuelled if necessary by debt, can ever be a sustainable way of life. We can, if we wish, choose to blame the advertising industry (which spends perhaps $470bn annually pushing the consumerist message), or the cadre of corporate executives who have outsourced skilled jobs in pursuit of personal gain. We can blame a generation of policymakers whose short-termism has blinded them to underlying trends, or regulators and central bankers who failed to “take away the punch-bowl” long after the party was self-evidently out of control.
But blaming any of these really means blaming ourselves – for falling for the consumerist message of instant gratification, for buying imported goods, for borrowing far more than was healthy, and for electing glib and vacuous political leaders.
Beyond visibility and culpability, the two big questions which need to be addressed are ‘how bad can it get?’ and ‘is there anything that we can do about it?’
Of these, the first question hardly needs an answer, since the implications seem self-evident – economies will lurch into hyper-inflation in a forlorn attempt to escape from debt, whilst social strains will increase as the vice of resource (including food) shortages tightens. In terms of solutions, the first imperative is surely a cultural change away from instant gratification, a change which, if it is not adopted willingly, will be enforced upon society anyway by the reversal of economic growth.
The magic bullet, of course, would be the discovery of a new source of energy which can reverse the winding-down of the critical energy returns equation. Some pin their faith in nuclear fusion (along lines being pioneered by ITER) but this, even if it works, lies decades in the future – that is, long after the global EROEI has fallen below levels which will support society as we know it. Solutions such as biofuels and shales are rendered non-workable by their intrinsically-low EROEIs.
Likewise, expecting a technological solution to occur would be extremely unwise, because technology uses energy – it does not create it. To expect technology to provide an answer would be equivalent to locking the finest scientific minds in a bankvault, providing them with enormous computing power and vast amounts of money, and expecting them to create a ham sandwich.
In the absence of such a breakthrough, really promising energy sources (such as concentrated solar power) need to be pursued together, above all, with social, political and cultural adaptation to “life after growth”.
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