perfect storm energy, finance and the end of growth Dr Tim Morgan Global Head of Research

strategy insights | issue nine perfect storm energy, finance and the end of growth summary part one: the end of an era 5 the four factors which are bringing down the curtain on growth 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. part two: this time is different 17 the implosion of the credit super-cycle The 2008 crash resulted from the bursting of the biggest bubble in financial history, a ‘credit super-cycle’ that spanned three decades. Why did this happen? part three: the globalisation disaster 29 globalisation and the western economic catastrophe The Western developed nations are particularly exposed to the adverse trends explored in this report, because globalisation has created a lethal divergence between burgeoning consumption and eroding production, with out-of-control debt used to bridge this widening chasm. part four: loaded dice 43 how policies have been blind-sided by distorted data The reliable information which policymakers and the public need if effective solutions are to be found is not available. Economic data (including inflation, growth, GDP and unemployment) has been subjected to incremental distortion, whilst information about government spending, deficits and debt is extremely misleading. part five: the killer equation 59 the decaying growth dynamic The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the has resulted from the harnessing of ever-greater quantities of energy. But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.

strategy insights | issue nine 3 perfect storm | energy, finance and the end of growth

4 strategy insights | issue nine part one: the end of an era the four factors which are bringing down the curtain on growth summary 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 tackled well in advance, could the denouement of a broadly-based and through economic and political have devastating effects. The relentless process which had lasted for thirty change, society is more -term shortening of media, social and years, and is described here as “the in nature now than at any time in political horizons has resulted in the great credit super-cycle”. recorded history. Financial market establishment of self-destructive participants can carry out transactions economic patterns which now threaten The credit super-cycle process is in milliseconds. With 24-hour news to undermine economic viability. exemplified by the relationship coverage, the media focus has shifted between GDP and aggregate credit inexorably from the analytical to the We date the acceleration in market debt in the immediate. The basis of politicians’ short-termism to the early 1980s. (see fig. 1.1). In 1945, and despite calculations has shortened to the point Since then, there has been a relentless the huge costs involved in winning where it can seem that all that matters shift to immediate consumption as the Second World War, the aggregate is the next sound-bite, the next part of something that has been indebtedness of American businesses, headline and the next snapshot of called a “cult of self-worship”. individuals and government equated public opinion. The corporate focus The pursuit of instant gratification to 159% of GDP. More than three has moved all too often from has resulted in the accumulation decades later, in 1981, this ratio was strategic planning to immediate of debt on an unprecedented scale. little changed, at 168%. In real terms, profitability as represented by the The , which began in total debt had increased by 214% next quarter’s earnings. 2008 and has since segued into the since 1945, but the economy had deepest and most protracted economic grown by 197%, keeping the debt ratio This report explains that this slump for at least eighty years, did remarkably static over an extended acceleration towards ever-greater not result entirely from a short period period which, incidentally, was far from immediacy has blinded society to of malfeasance by a tiny minority, shock-free (since it included two major a series of fundamental economic comforting though this illusion may oil crises). trends which, if not anticipated be. Rather, what began in 2008 was

strategy insights | issue nine 5 perfect storm | energy, finance and the end of growth

Fig. 1.1: The debt-GDP ratio in the United States since 1945*

Total credit market debt as % GDP 400% 2009: 381%

300% 1981: 1945: 168% 159% 200%

100%

0% 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President

Fig. 1.2: US real GDP and debt since 1945*

$ trillion at 2011 values $60 Debt GDP $50

$40

$30

$20

$10

$0 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President

6 strategy insights | issue nine From the early 1980s, as figs. 1.1 individually or collectively, have trend #1 – the madness of crowds and 1.2 show, an unmistakeable and already started to throw more than The first of the four highly dangerous seemingly relentless upwards trend two centuries of economic expansion trends identified here is the creation, in indebtedness became established. into reverse. over three decades, of the worst Between 1981 and 2009, debt grew financial bubble in history. In his Before the financial crisis of 2008, by 390% in real terms, far out-pacing 1841 work Extraordinary Popular this analysis might have seemed the growth (of 120%) in the American Delusions and the Madness of Crowds, purely theoretical, but the banking economy. By 2009, the debt ratio had Charles Mackay (1814-89) identified catastrophe, and the ensuing reached 381%, a level unprecedented a common thread of individual and slump, should demonstrate that the in history. Even in 1930, when GDP collective idiocy running through such dangerous confluence described here collapsed, the ratio barely topped follies of the past as alchemy, witch- is already underway. Indeed, more 300%, and thereafter declined very hunts, prophecies, fortune-telling, than two centuries of near-perpetual rapidly indeed. magnetizers, phrenology, poisoning, growth probably went into reverse as the admiration of thieves, duels, the This report is not, primarily, about debt, much as ten years ago. imputation of mystic powers to and neither does it suggest that the relics, haunted houses, crusades problems identified here are unique to Lacking longer-term insights, today’s – and financial bubbles. the United States. Rather, the massive policymakers seem bewildered about many issues. Why, for instance, has escalation in American indebtedness A clear implication of Mackay’s work there been little or no recovery from is one amongst a host of indicators was that all of these follies had been the post-2008 economic slump? Why of a state of mind which has elevated consigned to the past by intelligence, have traditional, tried-and-tested immediate consumption over prudence experience and enlightenment. For fiscal and monetary tools ceased to throughout much of the world. the most part, he has been right. function? Why have both austerity Intelligent people today do not put This report explains that we need and stimulus failed us? faith in alchemy, fortune-telling, only look beyond the predominant witchcraft or haunting, and – with the short-termism of contemporary The missing piece of the economic arguable exception of the invasion of thinking to perceive that we are at equation is an appreciation of four Iraq – crusades have faded into the the confluence of four extremely underlying trends, each of which history books. dangerous developments which, renders many of the lessons of the past irrelevant.

strategy insights | issue nine 7 perfect storm | energy, finance and the end of growth

But one folly remains alive and well. point where even some forms of debt term to describe what happened to Far from confining financial bubbles counted as shock-absorbing equity). Britain under Brown – it was a collapse to historical tales of Dutch and in returns on capital employed. British South Sea stock, the last three Former Federal Reserve boss Alan decades have witnessed the creation Greenspan has been ridiculed for No other major economy got it quite and the bursting of the biggest bubble believing that would always as wrong as Britain under Brown, but in financial history. act in the best interests of their much the same was happening across shareholders, and that the market the Western world, most notably in Described here as ‘the credit super- would sort everything out in a benign those countries which followed the cycle’, this bubble confirmed that one way. But regulators more generally disastrous Anglo-American philosophy aspect, at least, of the idiocy identified bent over backwards to ignore the of “light-touch” . by Mackay continues to wreak havoc. most obvious warning signs, such as Insane though historic obsessions with escalating property price-to-incomes trend #2 – the globalisation disaster bulbs and south seas riches may ratios, soaring levels of debt-to-GDP, The compounding mistake, where the appear, they are dwarfed by the latter- and such obviously-abusive practices Western countries were concerned, was day, ‘money for nothing’ lunacy that, as sub-prime mortgages, NINJA1 a wide-eyed belief that ‘globalisation’ through the credit super-cycle, has loans and the proliferation of unsafe would make everyone richer, when mired much of the world in debts from financial instruments. the reality was that the out-sourcing which no escape (save perhaps hyper- of production to emerging economies inflation) exists. Where idiocy and naïveté were was a self-inflicted disaster with few concerned, however, regulators and parallels in . One would Perhaps the most truly remarkable the general public were trumped have to look back to a Spanish empire feature of the super-cycle was that it by policymakers and their advisors. awash with bullion from the New World endured for so long in defiance of all Gordon Brown, for example, proclaimed to find a combination of economic logic or common sense. Individuals in an end to “boom and bust” and gloried idiocy and minority self-interest equal their millions believed that property in Britain’s “growth” despite the way to the folly of globalization. prices could only ever increase, such in which debt escalation was making that either borrowing against equity it self-evident that the apparent The big problem with globalisation (by taking on invariably-expensive expansion in the economy was neither was that Western countries reduced credit) or spending it (through equity more nor less than the simple spending their production without making release) was a safe, rational and even of borrowed money. corresponding reductions in their normal way to behave. consumption. ’ Between 2001-02 and 2009-10, Britain outsourcing of production to Regulators, meanwhile, believed added £5.40 of private and public debt emerging economies boosted their that there was nothing wrong with for each £1 of ‘growth’ in GDP (fig. 1.3). earnings (and, consequently, the loosening banking reserve criteria (both Between 1998 and 2012, real GDP incomes of the minority at the very by risk-weighting assets in ways that increased by just £338bn (30%) whilst top) whilst hollowing out their masked leverage, and by broadening debt soared by £1,133bn (95%) (fig. domestic economies through the definitions of capital to the 1.4). Asset managers have a very simple export of skilled jobs.

8 strategy insights | issue nine 1 No Income No Job or Assets Fig. 1.3: Changes in UK real debt and GDP*

£bn at 2011-12 values +£200 Change in debt** Change in GDP +£150

+£100

+£50

+£0

-£50

-£100 97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12

* Source: Tullett Prebon UK Economic & Fiscal Database 2012 ** Government and private individual debt

Fig. 1.4: UK real debt and GDP*

£bn at 2011-12 values £2,500 GDP Debt: £2,480bn Total debt** £2,000

£1,500 Debt: £1,196bn GDP: £1,521bn

£1,000 GDP: £1,142bn

£500

£0 97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12

* Source: Tullett Prebon UK Economic & Fiscal Database 2012 ** Government and private individual debt

strategy insights | issue nine 9 perfect storm | energy, finance and the end of growth

This report uses a measure called unsustainable. Talk of Western of accretive changes has been much ‘globally-marketable output’ economies modernising themselves by the same. In America, for example, the (GMO) as a metric for domestic moving from production into services benchmark measure of inflation (CPI-U) production, a measure which contained far more waffle than logic has been modified by ‘substitution’, combines manufacturing, agriculture, – Western consumers sold each other ‘hedonics’ and ‘geometric weighting’ construction and mining with net ever greater numbers of hair-cuts, ever to the point where reported numbers exports of services. By definition, greater quantities of fast food and seem to be at least six percentage activities falling outside this category ever more zero-sum financial services points lower than they would have consist of services provided to whilst depending more and more on been under the ‘pre-tinkering’ basis of each other. imported goods and, critically, on the calculation used until the early 1980s. debts used to buy them. Corporate US unemployment, reported at At constant (2011) values, consumption executives prospered, as did the gate- 7.8%, excludes so many categories of by Americans increased by $6,500bn holders of the debt economy, whilst people (such as “discouraged workers”) between 1981 and 2011, whilst the vast majority saw their real wages that it hides very much higher consumption on their behalf by decline and their indebtedness spiral. levels of inactivity. the government rose by a further $1,700bn, but the combined output For our purposes, what matters here is The critical distortion here is clearly of the manufacturing, construction, that reducing production, increasing inflation, which feeds through into agricultural and extractive industries consumption and taking on escalating computations showing “growth” even grew by barely $600bn. At less than debt to fill the gap was never a when it is intuitively apparent (and $200bn in 2011, net exports of services remotely sustainable course of action. evident on many other benchmarks) did almost nothing to bridge the chasm What this in turn means is that no that, for a decade or more, the between consumption and production. return to the pre-2008 world is either economy has, at best, stagnated, not possible or desirable. just in the United States but across This left two residuals – domestically- much of the Western world. Distorted consumed services, and debt – with trend #3 – an exercise in inflation also tells wage-earners that debt the clincher. Between 1981 and self-delusion they have become better off even 2011, and again expressed at constant One explanation for widespread public though such statistics do not accord values, American indebtedness soared (and policymaker) ignorance of the with their own perceptions. It is from $11 trillion to almost $54 trillion. truly parlous state of the Western arguable, too, that real (inflation-free) economies lies in the delusory nature interest rates were negative from as Fundamentally, what had happened of economic and fiscal statistics, many long ago as the mid-1990s, a trend here was that skilled, well-paid jobs of which have been massaged out of which undoubtedly exacerbated an had been exported, consumption all relation to reality. escalating tendency to live on debt. had increased, and ever-greater quantities of debt had been used to There seems to have been no ‘grand Fiscal figures, too, are heavily distorted, fill the gap. This was, by any definition, conspiracy’ here, but the overall effect most noticeably in the way in which

10 strategy insights | issue nine quasi-debt obligations are kept off the labour, labour which would cost 80:1 to 20:1 do not seem particularly official balance sheet. As we explain perhaps $6,500 if it were paid for at disruptive but, once returns ratios in this report, the official public debts prevailing rates. Of the energy – a term have fallen below about 15:1, there of countries such as the United States coterminous with ‘work’ – consumed in is a dramatic, ‘cliff-edge’ slump in and the exclude Western societies, well over 99% comes surplus energy, combined with a sharp truly enormous commitments from exogenous sources, and probably escalation in its cost. such as pensions. less than 0.7% from human effort. Research set out in this report suggests trend #4 – the growth dynamo Energy does far more than provide that the global average EROEI, having winds down us with transport and warmth. In fallen from about 40:1 in 1990 to One of the problems with economics modern societies, manufacturing, 17:1 in 2010, may decline to just is that its practitioners preach a services, minerals, food and even 11:1 by 2020, at which point energy concentration on money, whereas water are functions of the availability will be about 50% more expensive, in money is the language rather than of energy. The critical equation here real terms, than it is today, a metric the substance of the real economy. is not the absolute quantity of energy which will carry through directly into Ultimately, the economy is – and available but, rather, the difference the cost of almost everything else – always has been – a surplus energy between energy extracted and energy including food. equation, governed by the of consumed in the extraction process. crisis, culpability and consequences thermodynamics, not those of This is measured by the mathematical the market. equation EROEI (energy return on If the analysis set out in this report energy invested). is right, we are nearing the end of a Society and the economy began when period of more than 250 years in which agriculture created an energy surplus For much of the period since the growth has been ‘the assumed normal’. which, though tiny by later standards, Industrial Revolution, EROEIs have There have been setbacks, of course, liberated part of the population to been extremely high. The oil fields but the near-universal assumption engage in non-subsistence activities. discovered in the 1930s, for example, has been that is provided at least 100 units of extracted the usual state of affairs, a rule to A vastly larger liberation of surplus energy for every unit consumed in which downturns (even on the scale energy occurred with the discovery extraction (an EROEI of 100:1). For of the 1930s) are the exceptions. That of the heat engine, meaning that some decades now, though, global comfortable assumption is now in the the energy delivered by human average EROEIs have been falling, as process of being over-turned. labour could be leveraged massively energy discoveries have become both by exogenous sources of energy smaller and more difficult (meaning The views set out here must provoke such as coal, oil and natural gas. A energy-costly) to extract. a host of questions. For a start, if we single US gallon of gasoline delivers really are nearing a cliff-edge economic work equivalent to between 360 The killer factor is the non-linear crisis, why isn’t this visible already? and 490 hours of strenuous human nature of EROEIs. As fig. 1.5 shows, the Second, who is to blame for this? effects of a fall-off in EROEI from, say,

strategy insights | issue nine 11 perfect storm | energy, finance and the end of growth

Fig. 1.5: Nearing the energy returns cliff-edge*

100% 2020 EROEI 1990 2010 80%

60%

40% Declining EROEI

20% Energy cost as % GDP 0% 100 90 80 70 60 50 40 30 20 10 0

* Source: Tullett Prebon analysis

Third, how bad could it get? Last, but guilty of wilful blindness. Such a state scale of debt – and, relevantly in this surely most important, can anything of affairs was only ever viable on the context, of quasi-debt commitments be done about it? insane assumption that debt could as well – surely should have sounded go on increasing indefinitely. Charles warning bells. From Liverpool to Los Where visibility is concerned, our belief Mackay chronicled many delusions, Angeles, from Madrid to Matsuyama, is that, if the economy does tip over but none – not even the faith placed in the developed world is mired in debts in the coming few years, retrospect – witchcraft – was ever quite as irrational that can never be repaid. In addition which always enjoys the 20-20 vision as the belief (seldom stated, but to formal debt, governments have of hindsight – will say that the signs of always implicit in Western economic entered into pension and welfare the impending crash were visible well policy) that there need never be an commitments which are only before 2013. end to a way of life which was wholly affordable if truly heroic assumptions dependent on ever-greater debt. are made about future prosperity. For a start, anyone who believed that a globalisation model (in which the West Even to those who were happy to At the same time, there is no real unloaded production but expected swallow the nonsense of perpetually- evidence that the economy is to consume as much, or even more, expanding indebtedness, the sheer recovering from what is already than ever) was sustainable was surely

12 strategy insights | issue nine 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 ‘debt- fuelled, immediate gratification’ ethos established across Western societies as a whole.

strategy insights | issue nine 13 perfect storm | energy, finance and the end of growth

Governments have been ejected or regulators and central bankers who The magic bullet, of course, would be by their electorates, but their failed to “take away the punch-bowl” the discovery of a new source of energy replacements have tended to look very long after the party was self-evidently which can reverse the winding-down similar indeed to their predecessors. out of control. of the critical energy returns equation. Some pin their faith in nuclear fusion The real reason for the seeming lack But blaming any of these really means (along lines being pioneered by ITER2) of retribution is that culpability is far blaming ourselves – for falling for but this, even if it works, lies decades too dispersed across society as a whole. the consumerist message of instant in the future – that is, long after the If, say, society was to punish senior gratification, for buying imported global EROEI has fallen below levels bankers, what about the thousands goods, for borrowing far more than which will support society as we know of salesmen who knowingly pushed was healthy, and for electing glib and it. Solutions such as biofuels and millions of customers into mortgages vacuous political leaders. shales are rendered non-workable by that were not remotely affordable? The their intrinsically-low EROEIs. suspicion lingers that there has been Beyond visibility and culpability, the a ‘grand conspiracy of culpability’, but two big questions which need to be Likewise, expecting a technological even the radical left has failed to tie this addressed are ‘how bad can it get?’ solution to occur would be extremely down to specifics in a convincing way. and ‘is there anything that we can do unwise, because technology uses about it?’ energy – it does not create it. To expect The real causes of the economic crash technology to provide an answer Of these, the first question hardly needs are the cultural norms of a society that would be equivalent to locking the an answer, since the implications seem has come to believe that immediate finest scientific minds in a bank- self-evident – economies will lurch into material gratification, fuelled if vault, providing them with enormous hyper-inflation in a forlorn attempt to necessary by debt, can ever be a computing power and vast amounts escape from debt, whilst social strains sustainable way of life. We can, if we of money, and expecting them to will increase as the vice of resource wish, choose to blame the advertising create a ham sandwich. industry (which spends perhaps $470bn (including food) shortages tightens. annually pushing the consumerist In the absence of such a breakthrough, In terms of solutions, the first message), or the cadre of corporate really promising energy sources (such imperative is surely a cultural change executives who have outsourced as concentrated solar power) need to away from instant gratification, a skilled jobs in pursuit of personal be pursued together, above all, with change which, if it is not adopted gain. We can blame a generation of social, political and cultural adaptation willingly, will be enforced upon policymakers whose short-termism to “life after growth”. society anyway by the reversal has blinded them to underlying trends, of economic growth.

2 International Thermonuclear Experimental Reactor, a multinational 14 strategy insights | issue nine research project based at Cadarache in strategy insights | issue nine 15 perfect storm | energy, finance and the end of growth

16 strategy insights | issue nine part two: this time is different the implosion of the credit super-cycle summary The 2008 crash resulted from the bursting of the biggest bubble in financial history, a ‘credit super-cycle’ that spanned more than three decades. How did this happen?

As Carmen Reinhart and Kenneth to a process of sequential bubbles, a “tulips from ” Rogoff have demonstrated in their process in which the bursting of each One of the most famous historical magisterial book This Time Is Different, bubble was followed by the immediate bubbles is the which asset bubbles are almost as old as creation of another. gripped the United Provinces (the money itself. The Reinhart and Rogoff ) during the winter Though the sequential nature of book tracks financial excess over eight of 1636-37. Tulip bulbs had been the pre-2008 process marks this as centuries, but it would be no surprise introduced to Europe from the something that really is different, we at all if the Hittites, the Medes, the by Obier de Busbeq can, nevertheless, learn important Persians and the Romans, too, had in 1554, and found particular favour lessons from the bubbles of the past. bubbles of their own. All you need in the United Provinces after 1593, First, bubbles follow an approximately for a bubble is ready credit and when Carolus Closius proved that symmetrical track, in which the spike collective gullibility. these exotic plants could thrive in the in asset values is followed by a collapse harsher Dutch climate. Some might draw comfort from the of roughly similar scale and duration. If observation that bubbles are a long- this holds true now, we are in for a very The tulip was a plant whose beauty established aberration, arguing that long and nasty period of retreat. and novelty had a particular appeal, the boom-and-bust cycle of recent but tulip mania would not have Second, easy access to leverage is years is nothing abnormal. Any such occurred without favourable social critical, as bubbles cannot happen if comfort would be misplaced, for two and economic conditions. The Dutch investors are limited to equity. Third, main reasons. had been engaged in a long war for most bubbles look idiotic when seen independence from Spain since 1568 First, the excesses of recent years have with hindsight. Fourth – and although and, though final victory was still some reached a scale which exceeds any- institutional arrangements are critical years away, the original Republic of the thing that has been experienced before. – the real driving dynamic of bubbles Seven Provinces of the Netherlands is a psychological process which declared independence from Spain Second, and more disturbing still, combines greed, the willing suspension in 1581 This was the beginning of the developments which led to the of disbelief and the development the great . In this financial crisis of 2008 amounted of a herd mentality.

strategy insights | issue nine 17 perfect storm | energy, finance and the end of growth

remarkable period, the Netherlands tulip market in 1634, setting the scene valuable as a mansion, or equivalent to underwent some fundamental and for tulip mania. 17 years of skilled wages? pioneering changes which included the establishment of trading dominance, The tulip bubble did not revolve around Second, trading in these ludicrously great progress in science and invention, a physical trade in bulbs but, rather, overvalued items took place in then- and the creation of , involved a paper market in which novel forms (such as futures), and as well as the accumulation of people could participate with no were conducted on unregulated fringe vast wealth, the accession of the at all. Indeed, the tulip bubble markets rather than in the recognised Netherlands to global power status, followed immediately upon the heels exchanges. and great expansion of industry. of the creation by the Dutch of the first futures market. Bulbs could change Third, participants in the mania lost This was a period in which huge hands as often as ten times each day the use of their critical faculties. Many economic, business, scientific, trading but, because of the abrupt collapse people – not just speculators and the and naval progress was partnered of the paper market, no physical wealthy, but individuals as diverse by remarkable achievements in art deliveries were ever made. as farmers, mechanics, shopkeepers, (Rembrandt and Vermeer), architecture maidservants and chimney-sweeps and literature. The prosperity of this Price escalation was remarkable, with – saw bulb investment as a one-way period created a wealthy bourgeoisie single bulbs reaching values that street to overnight prosperity. Huge which displayed its affluence in grand exceeded the price of a large house. A paper fortunes were made by people houses with exquisite gardens. Viceroy bulb was sold for 2,500 florins whose euphoria turned to despair as Enter the tulip. at a time when a skilled worker might they were wiped out financially. earn 150 florins a year. Putting these For the newly-emergent Dutch absurd values into modern terms is The story that a sailor ate a hugely bourgeoisie, the tulip was the “must- almost impossible because of scant valuable bulb, which he mistook for an have” consumer symbol of the , data, but the comparison with skilled onion, is probably apocryphal (because particularly since selective breeding earnings suggests values of around it would have poisoned him), but had produced some remarkably exotic £500,0003, which also makes some there can be little doubt that this was new plants. Tulips cannot be grown sense in relation to property prices. In a period of a bizarre mass psychology overnight, but take between seven any event, a bubble which began in verging on collective insanity. and twelve years to reach maturity. mid-November 1636 was over by the all at sea Moreover, tulips bloom for barely a end of February 1637. week during the spring, meaning that The South Sea Bubble of 1720 bulbs can be uprooted and sold during Though tulip mania was extremely commands a special place in the litany the autumn and winter months. brief, and available data is very limited, of lunacy that is the history of bubbles. we can learn some pertinent lessons A thriving market in bulbs developed from this strange event. The was in the Netherlands even though established in 1711 as a joint short-selling was outlawed in 1610. For a start, this bubble looks idiotic government and private entity created Speculators seem to have entered the from any rational perspective – how on to manage the national debt. Britain’s earth could a humble bulb become as involvement in the War of the Spanish

3 A bulb worth 2,500 florins in 1637 was equivalent to 16.7x an annual skilled wage of 150 florins. Assuming a skilled wage 18 strategy insights | issue nine today of £30,000, the bulb would be worth £500,000 Succession was imposing heavy costs but worthless, and company shares in high places. Even Sir , on the exchequer, and the Bank of remained below their issue price, a presumably a man of common England’s attempt to finance this situation not helped by the resumption sense, lost £20,000 (equivalent to through two successive lotteries had of war with Spain in 1718. perhaps £2.5m today) in the pursuit not been a success. The government of the chimera of vast, but nebulous, therefore asked an unlicensed bank, Even so, shares in the company, unearned riches. the Hollow Sword Blade Company, effectively backed by the national to organise what became the first debt, began to rise in price, a process Any rational observer, even if unaware successful national lottery to be floated characterised by insider dealing and of the insider dealing and other forms in Britain. The twist to this lottery was boosted by the spreading of rumours. of corruption in which the shares were that prizes were paid out as annuities, mired, should surely have realised that Between January and May 1720, thus leaving the bulk of the capital in an eight-fold escalation in the stock the share price rose from £128 to government hands. price based entirely on implausible £550 as rumours of lucrative returns was, quite literally, ‘too After this, government set up the from the monopoly spread amongst good to be true’. South Sea Company, which took over speculators. What, many argued, could £9m of national debt and issued be better than a government-backed In his Extraordinary Popular Delusions shares to the same amount, receiving company with enormous leverage and the Madness of Crowds, Charles an annual payment from government to monopolistic profits in the fabled Mackay ranked the South Sea Company equivalent to 6% of the outstanding Americas? Legislation, passed under and other bubbles with alchemy, debt (£540,000) plus operating costs the auspices of Company insiders and witch-hunts and fortune-telling as of £28,000. As an added incentive, banning the creation of unlicensed instances of collective insanity. Whilst government granted the company a joint stock enterprises, spurred the other such foibles have tended to monopoly of trade with , share price to a peak of £890 in early retreat in the face of science, financial a monopoly which would be without June. This was bolstered by Company credulity remains alive and well, which value unless Britain could break the directors, who bought stock at means that we need to know how Spanish hegemony in the Americas, an inflated prices to protect the value of and why these instances of collective event which, at that time, was wildly investments acquired at much lower insanity seem to be hard-wired into implausible. levels. The share price peaked at £1,000 human financial behaviour. in August 1720, but the shares then The potentially-huge profits from lost 85% of their inflated market value this monopoly grabbed speculator in a matter of weeks. attention even though the real likelihood of any returns ever actually Like the Dutch tulip mania, the South accruing was extremely remote. Sea Bubble was an example which Despite very limited concessions fused greed and crowd psychology secured in 1713 at the end of the war, with novel market practices, albeit the trading monopoly remained all compounded by rampant corruption

strategy insights | issue nine 19 perfect storm | energy, finance and the end of growth

made in Japan decades after 1945 was thus export- bars in New York and . Boosted In some respects, the Japanese asset driven, and led by firms which had by the diversion of still-cheap capital bubble of the 1980s provided a ‘dry access to abundant, low-cost capital. from industry into real estate, property run’ for the compounded bubbles values in Japan soared, peaking at By the early 1980s, Japan’s economic of the super-cycle. Japan’s post-war $215,000 per square metre in the success was beginning to lead to economic miracle was founded on prized Ginza district of Tokyo. unrealistic expectations about future comparatively straightforward policies. prosperity. Many commentators, Comforted by inflated property values, Saving was encouraged, and was abroad as well as at home, used the banks made loans which the borrowers channelled into domestic rather than ‘fool’s guideline’ of extrapolation to were in no position to repay. The foreign capital markets, which meant contend that Japan would, in the theoretical value of the grounds of that investment capital was available foreseeable future, oust America as the Imperial Palace came to exceed very cheaply indeed. Exports were the world’s biggest economy. The the paper value of the entire state of encouraged, imports were deterred international expansion of Japanese California. Meanwhile, a soaring yen by tariff barriers, and consumption at banks and securities houses was was pricing Japanese exports out of home was discouraged. The economic reflected in the proliferation of sushi world markets. transformation of Japan in the four

Fig. 2.1: From miracle to disaster – Japanese GDP growth since 1955*

15% “Economic miracle” “Lost decade(s)”

10%

5%

0%

Financial crisis -5% 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Source: Tullett Prebon calculations based on data from IMF

20 strategy insights | issue nine Though comparatively gradual – event, we need to distinguish between from the on-sale of mortgage debt. mirroring, in true bubble fashion, the tangible components of the bubble The way in which banks were keeping the relatively slow build-up of asset and its underlying psychological and the true scale of potential liabilities off values – the bursting of the bubble cultural dimensions. their balance sheets completely eluded was devastating. Properties lost more regulators, and Alan Greenspan’s belief than 90% of their peak values, and Conventional analysis argues that that banks would always act in the the government’s policy of propping tangible problems began with the best interests of shareholders was up insolvent banks and corporations proliferation of subprime lending in breathtakingly naive. In America, as for created “zombie companies” of the United States. Perhaps the single that matter in Britain and elsewhere, the type that exist today in many biggest contributory factor to the central banks’ monetary policies were countries. Having peaked at almost subprime fiasco was the breaking concentrated on retail inflation (which 39,000 at the end of 1989, the Nikkei of the link between borrower and had for some years been depressed 225 index of leading industrial stocks lender. Whereas, traditionally, banks both by benign commodity markets deteriorated relentlessly, bottoming at assessed the viability of the borrower and by the influx of ever-cheaper 7,055 in March 2009. in terms of long-term repayment, the goods from Asia), and ignored asset creation of bundled MBSs (mortgage- price escalation. The Japanese economy was plunged backed securities) severed this link. into the “lost decade” which, in Astute operators could now strip risk Meanwhile, banks’ capital ratios had reality, could now be called the ‘lost from return, pocketing high returns expanded, in part because of ever- two decades’. In 2011, Japanese whilst unloading the associated high looser definitions of capital and assets stood at 208% of risk. The securitisation of mortgages and in part because of sheer regulatory GDP, a number regarded as sustainable was a major innovative failing in the negligence. Just as Greenspan’s Fed only because of the country’s historic system, as was the reliance mistakenly believed that bankers were the best high savings ratio (though this placed on credit-rating agencies which, people to determine their shareholders’ ratio is, in fact, subject to ongoing of course, were paid by the issuers interests, British chancellor Gordon deterioration as the population ages). of the bundled securities. Another Brown took pride in a “light touch” contributory innovation was the use regulatory system which saw British 2008 – the biggest bust of ARM (adjustable rate mortgage) banks’ total risk assets surge to more With hindsight, we now know that products, designed to keep the than £3,900bn on the back of just the Japanese asset bust was an early borrower solvent just long enough for £120bn of pure loss-absorbing capital manifestation of the ‘credit super- the originators of the mortgages to or TCE (tangible common equity). cycle’, which can be regarded as ‘the divest the packaged loans. biggest bubble in history’. The general outlines of the super-cycle bubble The authorities (and, in particular, are reasonably well understood, even the Federal Reserve) must bear a big if the underlying dynamic is not. To share of culpability for failing to spot understand this enormous boom-bust the mispricing of risk which resulted

strategy insights | issue nine 21 perfect storm | energy, finance and the end of growth

It does not seem to have occurred to assumption that potential losses on huge subprime default losses inevitable anyone – least of all to the American, debt instruments were covered by unless property prices rose indefinitely, British and other regulatory authorities insurance overlooked the fact that all which was a logical impossibility. – that a genuine capital reserve such insurances were placed with a Subprime defaults would in turn of less than 2% of assets could be small group of insurers (most notably undermine the asset bases of banks overwhelmed by even a relatively AIG) which were not remotely capable holding the toxic assets that the sliced- modest correction in asset prices. of bearing system-wide risk. and-diced mortgage-based instruments were bound to become as soon as Both sides of the reserves ratio Meanwhile, innovative definitions property price escalation ceased. equation were distorted by regulatory allowed banks’ reported capital to negligence. On the assets side, expand from genuine TCE to include The second obvious trigger was a banks were allowed to risk-weight book gains on equities, and provisions seizure in liquidity. The escalation in their assets, which turned out to for deferred tax and impairment. the scale of debt had far exceeded be a disastrous mistake. Triple-A Even some forms of loan capital were domestic depositor funds, not least rated government bonds were, not allowed to be included in banks’ because savings ratios had plunged unnaturally, regarded as AFS (‘available reported equity. as borrowing and consumption had for sale’) and accorded a zero-risk displaced saving and prudence in rating, but so, too, in practice, were Together, the risk-weighting of assets, the Western public psyche. Unlike the AAA portions that banks, with and the use of ever-looser definitions depositors – a stable source of funding, the assistance of the rating agencies, of capital, combined to produce in the absence of bank runs – the managed to slice out of MBSs seemingly-reassuring reserves ratios wholesale funding markets which had (mortgage-backed securities) and which turned out to be wildly provided the bulk of escalating leverage CDOs (collateralised debt obligations). misleading. Lehman Brothers, for were perfectly capable of seizing up example, reported a capital adequacy virtually overnight. For this reason, a Mortgages of all types were allowed ratio of 16.1% shortly before it liquidity seizure crystallised what was to be risk-weighted downwards to collapsed, whilst the reported pre- essentially a leverage problem. 50% of their book value which, at best, crash ratios for Northern Rock and reflected a nostalgic, pre-subprime Kaupthing were 17.5% and 11.2% At this point, three compounding understanding of mortgage risk on respectively5. problems kicked in. The first was the part of the regulators. In the US, the termination of a long-standing banks were allowed to net-off their Well before 2007, the escalation in the ‘monetary ratchet’ process – low rates derivatives exposures, such that J.P. scale of indebtedness had rendered created bubbles, and the authorities Morgan Chase, for example, carried a crash inevitable. Moreover, the two countered each ensuing downturn by derivatives of $80bn on its balance triggers that would bring the edifice cutting rates still further, but, this time sheet even though the gross value crashing down could hardly have been around, prior rate reductions left little of securities and derivatives was more obvious. First, the resetting of scope for further relaxation. close to $1.5 trillion4. The widespread ARM mortgage interest rates made

4 See James Ferguson, ‘What went wrong?’, Patrick Young (ed.), The Gathering Storm, Derivatives Vision Publishing, 2010 22 strategy insights | issue nine 5 Ferguson, op cit strategy insights | issue nine 23 perfect storm | energy, finance and the end of growth

Figs. 2.2 & 2.3: The relationship between borrowing and growth in the US*

Increments in real $bn $2,000 $2.00 Government borrowing GDP growth per incremental Household borrowing dollar of household debt $1,500 GDP

$1,000 $1.00

$500

$0 $0.00

-$500

-$1,000 -$1.00 1996 1998 2000 2002 2004 2006 2008 2010 1996 1998 2000 2002 2004 2006 2008 2010

* Sources: Federal Reserve and Economic Report of the President

Second, economies had become Third, some countries – most familiar features dependent upon debt-fuelled notably the United Kingdom – Though, as we shall see, the bursting consumption, and any reversal in debt had compounded consumer debt of the super-cycle in 2008 had some availability was bound to unwind the dependency by mistaking illusory novel aspects, the process nevertheless earlier (and largely illusory) ‘growth’ (debt-fuelled) economic expansion for embraced many features of created by debt-fuelled consumer ‘real’ growth, and had expanded public past bubbles. spending. As figs. 2.2 and 2.3 show, spending accordingly, a process which the relationship between borrowing created huge fiscal deficits as soon as A number of points are common to and associated growth had been leverage expansion ceased. these past bubbles, factors which worsening for some years, such that include easy credit, low borrowing the $4.1 trillion expansion in nominal Ultimately, the leverage-driven ‘great costs, (in the US economic output between 2001 bubble’ in pan-Western property form of activities which take place and 2007 had been far exceeded by an values had created the conditions for outside established markets, and/or increase of $6.7 trillion in consumer a deleveraging downturn, something are unregulated, and/or are outright debt, and the growth/borrowing for which governments’ previous illegal), weak institutional structures, equation had slumped. experience of destocking recessions opportunism by some market had provided no realistic appreciation. participants, and the emergence of some form of mass psychology in

24 strategy insights | issue nine Figs. 2.4 & 2.5: The relationship between borrowing and growth in the UK*

$bn at 2011-12 values £300 £1.50 Government borrowing GDP growth per incremental £ of debt Individual borrowing £250 GDP £1.00 £200

£0.50 £150

£100 £0.00

£50 -£0.50 £0

-£50 -£1.00 1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

which fear is wholly ousted by greed. Of course, the characteristics of earlier Credit became available in excessive Often, the objects of speculation are excesses have not been absent in amounts, and the price of credit items which can seem wholly irrational contemporary events. As with tulip was far too low (a factor which, with the benefit of hindsight (how on bulbs, South Sea stock and Victorian we believe, may have been earth could tulip bulbs, for instance, railways, recent years have witnessed exacerbated by a widespread have become so absurdly over-valued?) the operation of mass psychologies in under-reporting of inflation). which rational judgement has been A further important point about suspended as greed has triumphed why this time is different bubbles is that they can inflate over fear. Innovative practices, often Whilst it shared many of the apparent prosperity, but the post-burst lying outside established markets, characteristics of previous such events, effects include the destruction of have abounded. Examples of such the credit super-cycle bubble which value and the impairment of economic innovations have included subprime burst in 2008 differed from them in output for an extended period. In and adjustable-rate mortgages, and at least two respects, and arguably reality, though, the bursting of a the proliferation of an ‘alphabet soup’ differed in a third dimension as well. bubble does not destroy capital, but of the derivatives that Warren Buffett simply exposes the extent to which famously described as “financial value has already been destroyed by weapons of mass destruction”. rash investment.

strategy insights | issue nine 25 perfect storm | energy, finance and the end of growth

The first big difference was that the Though smaller bubbles (such as scale and scope of the 2008 crash far Poseidon) occurred in between, the exceeded anything that had gone next really big bubble did not occur before. Though it began in America until the 1980s, when Japanese asset (with parallel events taking place in a values lost contact with reality. number of other Western countries), globalisation ensured that the crash In recent years, however, intervals was transmitted around the world. The between bubbles have virtually total losses resulting from the crash disappeared, such that the decade are almost impossible to estimate, prior to the 2008 crash was not least because of notional losses characterised by a series of events created by falling asset prices, but which overlapped in time. Property even a minimal estimate of $4 trillion price bubbles were the greatest single equates to about 5.7% of global GDP, cause of the financial crisis, but there with every possibility that eventual were complementary bubbles in a losses will turn out to have been far variety of other asset categories. greater than this. The dotcom bubble (1995-2000) The second big difference between the reflected a willing suspension of super-cycle and previous bubbles lay critical faculties where the potential in timing. A gap of more than 80 years for supposedly ‘high tech’ equities elapsed between the tulip mania of were concerned, and historians of 1636-37 and the South Sea bubble of the future are likely to marvel at the 1720, though the latter had an overseas idiocy which attached huge values corollary in the Mississippi bubble of to companies which lacked earnings, the same year. The next major bubble, cash flow or a proven track record, and the British of the 1840s, were often measured by the bizarre followed an even longer time-gap, metric of “cash-burn”. Other bubbles and a further interval of about seven occurred in property markets in the decades separated the dethroning of United States, Britain, Ireland, Spain, the crooked “railway king” (George China, Romania and other countries, Hudson) in 1846 from the onset of as well as in commodities such as the ‘roaring twenties’ bubble which uranium and rhodium. Economy-wide culminated in the Wall Street Crash. bubbles developed in countries such as

26 strategy insights | issue nine Iceland, Ireland and Dubai. Perhaps the • Institutional weaknesses which which has become a hostage to future most significant bubble of the lot – for have undermined regulatory growth assumptions at precisely reasons which will become apparent oversight whilst simultaneously the same time that the scope for later – was that which carried the price facilitating the provision of excessive generating real growth is deteriorating. of oil from an average of $25/b in 2002 credit through the creation of The second critical issue is the to a peak of almost $150/b in 2008. high-risk instruments. undermining of official economic This rash of bubbles suggests that • Mispricing of risk, compounded and fiscal data, a process which has recent years have witnessed the by false appreciation of economic disguised many of the most alarming emergence of a distinctive new trend, prospects and by the distortion of features of the super-cycle. which is described here as a credit essential data. super-cycle, a mechanism which Third, there has been a fundamental compounds individual bubbles into • A political, business and consumer misunderstanding of the dynamic a broader pattern. mind-set which elevates the which really drives the economy. Often importance of the immediate whilst regarded as a monetary construct, This report argues that a third big under-emphasising the longer term. the economy is, in the final analysis, difference may be that the super-cycle an energy system, and the critical bubble coincided with a weakening in • A distortion of the capitalist model supply of surplus energy has been in the fundamental growth dynamic. which has created a widening chasm seemingly-inexorable decline for at between ‘capitalism in principle’ and least three decades. What we need to establish is the ‘capitalism in practice’. ‘underlying narrative’ that has compressed the well-spaced bubble- Before we can put the credit forming processes of the past into the super-cycle into its proper context, single, compounded-bubble dynamic however, we need to appreciate of the credit super-cycle. three critical issues, each of which is grossly misunderstood. It is suggested here that this narrative must include: The first of these is the vast folly of globalisation. This has impoverished • A mass psychological change which and weakened the West whilst has elevated the importance of ensuring that few countries are immediate consumption whilst immune from the consequences of weakening perceptions both of risks the unwinding of a and of longer-term consequences.

strategy insights | issue nine 27 perfect storm | energy, finance and the end of growth

28 strategy insights | issue nine part three: the globalisation disaster globalisation and the western economic catastrophe summary The Western developed nations are particularly exposed to the adverse trends explored in this report, because globalisation has created a lethal divergence between burgeoning consumption and eroding production, with out-of-control debt used to bridge this widening chasm.

Our collective understanding of trends Despite these major handicaps, of $350, and sold it for $400, earning informing recent and impending policymakers, analysts, strategists and a margin of $50. The company then economic developments has been investors really should have developed became able, courtesy of globalisation, undermined by at least three a much better understanding of the to manufacture the same television conceptual shortcomings. stagnation and deterioration of the in China for $50, boosting its profit Western economies, not least because margin dramatically. First, insufficient attention has one of the most prominent drivers has been devoted to the behavioural been happening in plain sight. This outsourcing of manufacturing in and psychological dimensions of this way boosted corporate profitability economics, a blind-spot which That driver is globalisation. Put very enormously, and created big cash allowed policymakers to watch the bluntly, the process of globalisation inflows that were placed in the creation and subsequent bursting has distorted the normal relationships banking system. At the same time, of the biggest bubble in economic between production, consumption there was a hemorrhaging of skilled history without taking preventative and debt beyond the point of jobs from the United States and other or corrective action, despite the clear sustainability. The West is in deep Western economies, and countervailing and unequivocal lessons that can be (and perhaps irreversible) trouble increases in skilled employment learned from history. because it has consumed more, just in China and in other emerging as it has produced less. countries. In terms of the West, it is a Second, policymakers and the general simplification, but also a truism, that public have been misled by data globalisation – dangerously corporate profits expanded whilst which, in many important respects, simple, simply dangerous wages deteriorated. has become ever less representative of The globalisation process is pretty what is really happening. easy to describe (which makes the As globalisation gained traction, ignorance of policymakers and Chinese workers, though still very Third, there has been a failure to grasp their advisors even less excusable). poorly paid by Western standards, the most critical point of all, which Suppose that an American company enjoyed big increases in their earnings, is that the economy is an energy manufactured a television at a cost increases which, partly for cultural dynamic, not a financial one.

strategy insights | issue nine 29 perfect storm | energy, finance and the end of growth

reasons, they chose to save rather were advanced to borrowers who were simpler by the disastrous 1999 repeal than to spend. Just as production was not remotely capable of keeping up of the Glass-Steagall legislation which, declining and consumption increasing repayments, particularly when initial hitherto, had separated retail banking in the West, the reverse was happening low “teaser” interest rates reset to from investment activities – appeared in the emerging economies, where much higher levels under the terms to be boosting banks’ profits (and, of production outstripped much smaller of ARMs (adjustable-rate mortgages). course, the remuneration of many of increases in consumption. Interest rates fell, reflecting both their employees), but the apparent surplus cash and a policy decision to uptrend in returns actually consisted Like Western companies profiting boost consumer spending in pursuit of of earnings created at the expense of from globalisation, Chinese and other economic growth. balance sheets. Worse still, much of emerging-country manufacturers, the newly-created securitised debt was too, had swelling profits to bank, as credit market distortion actually being bought by the banks had many of their governments. Cash Of course, as Western savings ratios themselves through off-balance-sheet piles were now expanding both in the collapsed, developing nations’ net special purpose vehicles (SPVs). emerging economies and in the West. surpluses became dominant, but Western banks nevertheless retained So far, so logical – companies were As with the dislocating influx of access to these funds in a process acting rationally by outsourcing petrodollars in an earlier era, the which saw the rapid replacement of production to cheaper locations and accumulation of huge cash sums internally-generated savings with could, indeed, argue that a failure initially presented banks with a capital sourced from wholesale to do this would have put individual problem, in that they needed to lend markets, another development which corporations at an insurmountable this money profitably. Fortunately was to have a very nasty sting in its competitive disadvantage. But what for the banks, they found ready tail. Banks financed primarily from was really happening here, on a takers amongst Americans and wholesale rather than from depositor macroeconomic scale, was that, in other Westerners who, having lost funding stand at far greater risk of America and in the West generally, well-paid jobs and taken lower- sudden creditor flight, particularly production was declining just as wage employment instead, became where wholesale funds are being used consumption was increasing, a process increasingly dependent on debt to on a short-term, recycling basis. which made individuals ever more maintain their standards of living. dependent on debt. Meanwhile, and largely unnoticed Next, bankers, trying to establish an by regulators who were either inept Seen from a national, macro rather even larger borrowing market beyond or complaisant, banks were moving than a corporate perspective, of this group, created the ultimately- out of the pure lending business and course, increasing consumption whilst disastrous phenomenon known as finding a new metiér as packagers of reducing production is, by definition, subprime, in which mortgage funds lending. This process – made much an unsustainable course of action.

30 strategy insights | issue nine As other manufacturers got in on American government bond yields with marketable’ category, not least the globalisation act, the prices of real (rather than officially-reported) because, if they were not competitively imported manufactured goods fell inflation suggests that effective rates priced, consumers would be likely to steadily (though margins remained probably turned negative as long ago purchase imports instead. The same high). The declining prices of such as 1996. can be said of services which are goods led policymakers to worry about actually sold on the global market, deflation, and to act accordingly by The Western response to diminishing net, of course, of services purchased cutting policy rates still further. production was to expand service from abroad. industries, but there has to be “taking in each others’ washing” significant doubt about how much This gives us two output categories. – the shift to internal services real value is created by doing each The first is ‘Globally-Marketable The deflation concern was misplaced, others’ washing, eating more fast food Output’ (GMO), which represents primarily because the expansion or having more frequent manicure output potentially capable of of activity in China (and in other sessions. Meanwhile, the relationship sale at world market values, and emerging economies) was boosting between debt and incomes was consists of production activities demand for raw materials. This getting ever further out of control. (where ‘production’ includes not just had countervailing, inflationary manufacturing but the extractive In order to illustrate these trends, effects, since surges in the costs of industries and agriculture as well) we need to be able to compare commodities more than outweighed plus net exports of services. movements in production, declines in the prices of manufactured consumption and borrowing. Our The second, residual category – goods. Indeed, and as we shall see, methodology for identifying a measure ‘Internally-Consumed Services’ (ICS) it was the surge in commodity of ‘internal production’ lies in dividing – comprises services which citizens costs which was to stop the debt/ economic output between: provide to each other, a number which consumption party in its tracks. Long can be divided further into private before this, however, the steady 1. Output which is globally and government provision. increase in credit-fuelled consumption marketable; and in the West had tipped the balance decisively in favour of inflation rather 2. Services which citizens than deflation. (including their government) provide to each other. Unfortunately, this rise in inflation was masked by ever-more-misleading Manufactured goods, plus the products official data, such that real interest of the extractive and agricultural rates turned negative. Comparing industries, clearly fall into the ‘globally

strategy insights | issue nine 31 perfect storm | energy, finance and the end of growth

Fig. 3.1: The switch from production in the United States, 1980-2011*

In 2011 $ trillion $16 Private IS** $14 Govt IS*** Service exports $12 Production $10 GMO**** GDP $12.2 trn $8

$6 $4.6 trn $4

$2 $2.0 trn $2.9 trn $0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition ** Private internally-consumed services *** Government internally-consumed services **** Globally marketable output

Imperfect though these measures The remaining $7.6 trillion resulted non-monetised (but undoubtedly are, they do provide an insight into from increases in the services which important) services such as the care the structural changes happening in Americans provide to each other, that parents provide for children. Even the American economy as production either privately (+$6.4 trillion) or so, there has been an unmistakable was out-sourced and displaced by through government (+$1.2 trillion). trend within the Western economies internally-consumed service activities This represented a massive shift in the – particularly since the onset of (fig. 3.1). centre of gravity of the US economy globalisation – towards the expansion away from production and towards of GDP through the monetisation Between 1980 and 2011, the output which can only be consumed of previously-informal or peripheral American economy expanded by $8.5 internally. activities, combined with the trillion (128%) in real terms. Within expansion of services whose only this expansion, however, only $0.9 There is always scope for legitimate market value is a domestic one. trillion (10% of the total increase) debate about the “production was provided by Globally-Marketable boundary” which divides monetised, Fig. 3.2 shows the relationship Output (‘production’) activities. GDP-included activities from between consumption and production

32 strategy insights | issue nine Fig. 3.2: The production-consumption gap in America, 1980-2011*

$ trillion at 2011 values $16 Government consumption Private consumption GMO** $12

$8

$4

$0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition ** Globally marketable output

in the United States since 1980, where Put colloquially, Americans were “the workshop of the world”. The oil ‘production’ is represented by the “taking in each others’ washing” at price spikes of the early and late 1970s Globally-Marketable Output (GMO) a huge and unprecedented scale. pushed the US into deficit, but the real measure. There has been a relentless It should be emphasised that this acceleration in this trend coincided increase in private consumption over pattern was by no means unique to the with globalisation. three decades even though there has United States but was replicated across been very little growth in production. the Western economies, and was The US trade in goods is set out in fig. particularly noticeable in Britain. 3.3, which, it should be noted, shows In 1980, the ratio of private real (inflation-adjusted) values. In consumption to GMO production Needless to say, these trends exerted 2011, the United States ran a deficit of was 2.1:1, but by 2010 this ratio had a steadily worsening effect on Western $765bn in goods, only partially offset almost doubled, to 3.8:1, meaning that trade in goods and commodities. At by net services exports of $187bn. individual Americans were consuming the end of the Second World War, the $3.84 for every $1 of the country’s United States could be described – as globally-marketable output. Britain had been, a century earlier – as

strategy insights | issue nine 33 perfect storm | energy, finance and the end of growth

Fig. 3.3: US net trade in goods, 1963-2011*

$bn at 2011 values $2,000 Exports $1,500 Imports $1,000 Balance $500 $0 -$500 -$1,000 -$1,500 -$2,000 -$2,500 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition

Fig. 3.4: US real debt and GDP, 1963-2011*

$ trillion at 2011 values $60 Government debt Other private debt $50 Household debt GDP $40

$30

$20

$10

$0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President (GDP and deflators) and the Federal Reserve Board (debt)

34 strategy insights | issue nine debt – deep in the hole expanded by a real-terms $2.2 trillion driven rewiring of America and Long before the banking crisis, the over a ten-year period in which debt from a temporarily-benign oil price relationships between production, had increased by $17.4 trillion environment. There was a sharp consumption and debt had become (see fig. 3.4). deterioration in the fiscal balance in completely unsustainable throughout the 2000s, of course, since the Bush As fig. 3.5 reveals, it took $2.95 most of the Western world. In the administration saw no contradiction of incremental debt to add $1 to United States, for example, total credit between cutting taxes and waging American real GDP during the 1980s. market debt had soared to $54 trillion two major wars. The overall figure during the 1990s was by the end of 2011, up from $29 trillion higher (at $3.20), despite a pause in just ten years previously. the escalation of federal government Even on an inflation-adjusted basis, debt. This reflected temporary fiscal debt was 48% higher in 2011 than it improvements resulting both from had been in 2001. By contrast, GDP had capital investment in the internet-

Fig. 3.5: Changes in American debt and GDP*

1960s 1970s 1980s 1990s 2000s

Change in:

GDP +$1.00 +$1.00 +$1.00 +$1.00 +$1.00

Private debt +$1.42 +$1.50 +$2.37 +$2.99 +$4.36

Government debt** +$0.12 +$0.25 +$0.59 +$0.21 +$1.31

Total debt +$1.55 +$1.74 +$2.95 +$3.20 +$5.67

* Source: Tullett Prebon calculations based on data from The Economic Report of the President (GDP) and the Federal Reserve funds flow statements (debt) ** Federal debt

strategy insights | issue nine 35 perfect storm | energy, finance and the end of growth

The deterioration in the relationship indebtedness. Arguably, and as we between GDP and non-government shall see, the real total, including borrowing continued in the 1990s, huge government off-balance-sheet with the private debt required for each quasi-debt obligations, was (and is) incremental dollar of GDP continuing very much higher still. Banks were to increase, to $2.99 in the 1990s from exposed to a massive pool of lethally- $2.37 during the 1980s. extended mortgage debt, and the true scale of indebtedness was disguised by After 2000, deterioration accelerated the various forms of securitised debt, markedly. The decade to 2010 much of it actually held by the banks witnessed a dramatic escalation in the themselves through off-balance-sheet amount of debt required ($5.67) for SPVs (special purpose vehicles). each incremental dollar of economic output. Between 2000 and 2010, and crisis onset – the debt pile after adjustment for inflation, the topples over indebtedness of individual Americans At this point, the merest whiff of increased by $4.35 trillion (52%), suspicion about the impossibility most of which was accounted for by of servicing (let alone repaying) the growth in mortgage commitments at mountain of debt was all that it took to a time when stagnating real incomes spook credit markets and, by reversing coincided with ever-easier access to the surge in the prices of collateral mortgage funding. assets, to expose gaping holes in banks’ balance sheets. This was a process The sheer quantitative scale (not to which occurred during 2007-08, first mention the qualitative weakness) freezing wholesale debt markets and of the banks’ massively-expanded then, with utter inevitability, taking mortgage books showed how the the entire banking system to the over-valued property sector acted as brink of collapse. a conduit for feeding consumption with borrowing. The central banks were forced to step in to rescue the banking system, a By 2007, non-government debt had process evident in the explosion in the risen above 300% of GDP, a figure balance sheets of, for example, the that increases to 360% inclusive of Federal Reserve (fig. 3.6) and the Bank Federal, state and local government of England. With central banks, too,

36 strategy insights | issue nine now reaching the limits of sustainable The newly-emerging trend was “toxic can be portrayed merely as a balance leverage, no remained but to asset transference” or TAT. When debts sheet operation, but this defence is resort to quantitative easing (QE). became too onerous to be sustained valid only to the extent that QE really by borrowers, debt ‘black holes’ were will be unwound. It is worth noting that, in addition transferred from customers to banks. to the sheer quantum of debt, the When banks, too, became over- Logically, the next sequential stage financial crisis saw the termination burdened by toxic assets, governments – one which probably lies in the very of one financial trend and the stepped in, completing a process near future – is a market realisation inauguration of another. whereby bad debts had transitioned that the claimed reversibility of QE is from borrowers, via the banks, to nonsense. The idea that, say, the Bank The trend which reached its end was the state. of England can ever reverse £375bn the “monetary ratchet”. Over time, a of money creation seems extremely cyclical process had emerged in which Though various shifts and sleights of far-fetched. excessively low interest rates created hand are used to support claims that bubbles, and the bursting of each QE does not equate to the creation If – or rather, when – the credibility bubble led to another reduction in (“printing”) of money, the only real of eventual reversal is lost, a dire policy rates as central bankers sought difference between the two is the chapter of recklessness is likely to to stave off recession. From 2008-09, claimed intention of reversing QE at end in money-printing, this process ended because rates were some point in the future. To the extent and collapse. now effectively zero. that eventual reversal is intended, QE

Fig. 3.6: The expansion of the Federal Reserve balance sheet, 2007-12*

$bn

$3,500 Long term treasury purchases $2,920bn Fed agency debt mortgage-backed securities purch $3,000 Liquidity to key credit markets $2,238bn Lending to financial institutions $2,500 Traditional security holdings Total $2,000

$1,500 $892bn $1,000

$500

$0 2007 2008 2009 2011 2012

* Source: Federal Reserve

strategy insights | issue nine 37 perfect storm | energy, finance and the end of growth

38 strategy insights | issue nine compounding errors holdings into physical assets in the have been diverted from productive Two further points are particularly form of natural resources. What is investment and ploughed instead worthy of note. The first of these is the truly breathtaking is the way in which into inflating the value of nations’ way in which the West compounded Western countries have overlooked existing stocks of housing. Houses its problems by pursuing gravely the obviously-competitive nature of an – which, after all, are non-earning inefficient courses of action, and the ultimately-finite resource set. assets – have thus acted as capital second is the role that tightening sinks, denying investment to genuinely The West seems to have been seduced energy resource constraints played in productive (and often vital) areas, by the philosophy of “comparative bringing down the Western house most notably infrastructure. Just as it advantage” associated with the of cards. has been hugely wasteful of capital, British economist David Ricardo property price inflation has fostered a As we have seen, the economic crisis in (1772-1823). According to Ricardian ‘something for nothing’ culture which, the West has been created, above all, logic, the general wealth will increase in itself, has undermined economic by the way in which globalisation has if all countries specialise in those productiveness. driven a wedge between weakening activities in which they possess the production and soaring consumption, greatest competitive advantage over If this were not bad enough, the creating a gap which has been filled by others. This logic is valid if – but only West has also diverted capital a reckless accumulation of debt. But if – the scope for growth is infinite. into vanity projects. Few Western other mistakes, almost as serious, have Unfortunately, an unlimited capability countries have avoided the allure contributed to a disastrous weakening for growth can only exist if the supply of building new sports stadia even of the Western economies. of resources is infinite as well. as roads are crumbling and bridges are deteriorating. The neglect of These mistakes fall into various Based on the false assumption of the infrastructure has gone largely categories, of which the first has been an infinite capability for growth, the unnoticed just as gleaming new a wilful ignorance of the competitive West has followed Ricardian rationale soccer, baseball and athletics nature of the global economy. and ceded entire areas of economic venues have proliferated. Fundamentally, the aim of economic activity to emerging economies, and management is to sustain and increase has done little or nothing to compete Labour efficiency has been undermined the well-being of an ever-increasing for finite reserves of natural resources. by gravely mistaken social policies. population on a planet whose Another by-product of the seductive Whereas schools in China are tasked resources, ultimately, are finite. logic of Ricardo has been a Western with identifying and nurturing commitment to free trade, even when those brightest children from whom Since the implicitly competitive it has been clear beyond peradventure future leaders in science, technology, character of this situation is an obvious that other countries are not playing by innovation and government will be one, no great credit need be accorded the same set of rules. drawn, the West has deliberately to China and others for recognising it eschewed all forms of merit selection, and acting upon it, most notably by Meanwhile, a second compounding retaining parental affluence as the only endeavouring to convert the waning error has been the way in which basis on which any form of selectivity and dubious value of Western currency the West has been extraordinarily is allowed to operate. profligate with capital. Huge sums

strategy insights | issue nine 39 perfect storm | energy, finance and the end of growth

Incentives have been skewed to the them at an ever greater competitive $97/b in 2008. We estimate that the point at which the American higher disadvantage which has been increase in the price of oil alone cost education system produces 41 exacerbated by well-meaning labour American consumers an incremental graduates for each graduate engineer. legislation in which considerations of $460bn between those years, of which The inflation of housing values has profitability and efficiency are also-rans more than $300bn was accounted for contributed to the impoverishment of when measured against supposedly by imports of petroleum. Between Western nations’ own young people. ‘progressive’ social objectives. 2002 and 2008, meanwhile, OECD oil Immigration policy, which logically consumers’ costs increased by about should aim to attract the brightest and Worst of all, Western countries and $1.14 trillion, including an import most industrious people, has instead their citizens have behaved as though component of around $730bn been characterised by a policy of their affluent lifestyles are some kind (see figs. 3.7 and 3.8). oscillating sentimentality and populist of divine entitlement rather than the toughness, tempered by incompetence. reward of productiveness. Of course, increases in the prices of other fuels (such natural gas and Alongside wasteful investment energy takes away the punch-bowl coal) exacerbated these huge liquidity allocation and disastrous labour Though much attention has been paid drains, which were more than enough market policies, the West has allowed to the role of the banking system in the to stop the debt-consumption binge the rise of two extremely damaging creation of the post-2008 economic in its tracks. cultural norms. The first of these is slump, there has been a widespread the unchecked rise of consumerism, failure to appreciate the role that was The role of central banks is – or should fostered by an advertising industry played by the emergence of energy be – to stop excesses by being ready which spends close to $470bn annually resource constraint. As emerging to “take away the punch bowl just as (and about $143bn in the United economies increased their production the party gets going”, in the inimitable 7 States alone)6. whilst the West continued to ramp up phrase of William McChesney Martin . its consumption, demand for energy When central bankers duck this The second is a sense of entitlement, escalated to a point at which resource obligation, markets will do it for them. both at the individual and at the constraint became a major contributor Financial recklessness (including national level. Welfare systems, to the unwinding of an always- globalisation) and energy constraint originally intended as safety nets, unsustainable effort to use debt to are the two most important factors have been allowed to price Western put off the inevitable implications which have created the current workers out of international markets. of a divergence between production economic slump, so it is perhaps fitting Benefits systems, even if they are not and consumption. (as is often claimed) “lifestyle choices” that it was energy markets which for the recipients of benefits, certainly Reflecting the combination of real drove the first, disastrous wedge into have been exactly that for the armies growth in the emerging economies the debt structure which had been of administrators that flourish in and debt-sustained consumption in created in an attempt to bridge the almost all such systems. The rise of the West, a surge in energy prices widening chasm between the West’s welfarism has imposed huge social saw the annual average price of Brent diminishing production and its ever- costs and taxes on businesses, placing crude oil rise from $25/b in 2002 to growing propensity to consume.

6 http://www.wpp.com/wpp/press/press/default.htm?guid={23ebd8df-51a5-4a1d-b139-576d711e77ac} 40 strategy insights | issue nine 7 William McChesney Martin (1906-98) was chairman of the Federal Reserve from 1951 to 1970 Fig. 3.7: US oil costs*

$bn $800 Imports $700 Total $600

$500

$400

$300

$200

$100

$0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

* Source: Tullett Prebon estimates derived from data in the BP Statistical Review of World Energy 2012

Fig. 3.8: OECD oil costs*

$bn $1,800 $1,600 Imports Total $1,400 $1,200 $1,000 $800 $600 $400 $200 $0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

* Source: Tullett Prebon estimates derived from data in the BP Statistical Review of World Energy 2012

strategy insights | issue nine 41 perfect storm | energy, finance and the end of growth

42 strategy insights | issue nine part four: loaded dice how policies have been blind-sided by distorted data summary The reliable data which policymakers and the public need if effective solutions are to be found is not available. Economic data (including inflation, growth, GDP and unemployment) has been subjected to incremental distortion, whilst information about government spending, deficits and debt is extremely misleading.

This report describes an impending imperative need for reliably accurate the worst culprit where misleading economic crisis. Although, and as data if they are to stand any chance of statistics are concerned. Rather, the we have already seen, the post-2008 finding least-bad solutions. But this raw data required for an unravelling slump is the denouement of the reliable data is precisely what they do of statistical distortion is more readily biggest financial bubble in history, not have. Both economic and fiscal available in the US than in other this is, in many ways, the least of the reporting have been subjected to countries which lack America’s data problems faced by the global economy incremental massage and deliberate transparency. Additionally, the United collectively, and by the Western obfuscation to the point where States is fortunate in that it possesses economies in particular. policymakers, investors and the public analysts willing and able to untangle really have no accurate conception of the statistical mess (even if few As we shall see in the final part this our economic predicament. policymakers are any more prepared report, the fundamental problem is than their overseas counterparts that the surplus energy dynamic which Data distortion can be divided into to listen to the uncomfortable has propelled economic development two categories. Economic data conclusions resulting from these since the Industrial Revolution is now has been undermined by decades analysts’ labours). unwinding very rapidly indeed. From a of methodological change which Western perspective, these trends have have distorted the statistics to Concentrating mainly on the United been exacerbated by the globalisation the point where no really accurate States, we begin here by looking at disaster, which has driven an ever- data is available for the critical how the principal economic metrics widening wedge between diminishing metrics of inflation, growth, output, have been distorted over time, production and burgeoning unemployment or debt. Fiscal data, beginning with inflation before turning consumption, and has then attempted meanwhile, obscures the true scale of to growth, output and unemployment. to bridge this gap using ever-less- government obligations. We then examine fiscal accounts to sustainable mountains of debt. reveal quite how misleading both Much of the detailed analysis provided government obligations and budget In this situation, it seems self-evident here is drawn from the United States, balances have become. that policymakers, business leaders but this requires a cautionary note. and the general public alike have an It is not our contention that the US is

strategy insights | issue nine 43 perfect storm | energy, finance and the end of growth

We should be clear that the million out-of-work Americans dropped (fig. 4.1). But the reported rate of debauching of US official data did not out of the unemployment totals under overall inflation between those years result from any grand conspiracy to a redefinition of “discouraged workers” seems strangely at odds with dramatic mislead the American people. Rather, introduced in 1994. increases in the costs of essentials such it has been an incremental process as petrol (+59%), water charges (+63%), which has taken place over more economic distortion #1 – the high electricity (+97%) and gas (+168%). than four decades. price of understated inflation Though the undermining of data Those who question the accuracy of In the early 1960s, the Kennedy quality has been widespread, few official inflation measures in Britain administration tampered with series have been distorted more than have nothing much more upon which unemployment numbers to exclude published numbers for inflation, to base their suspicions than intuition, “discouraged workers”. The Johnson and few if any economic measures experience and the known escalation administration introduced the “unified are of comparable importance. In of the prices of essentials. In the United budget”, which incorporated what the United States, CPI-U inflation States, this situation is quite different, was then a big Social Security surplus reported at 3.2% in 2011 probably and far greater data transparency to hide part of the underlying federal masked real price escalation which has enabled analysts to reverse out over-spend. Richard Nixon tried, was very much higher than that. This the methodological changes of the with only limited success, to peddle is hugely significant, because inflation last three decades. The scale of the the concept of “core inflation”, an is central to calculations of economic distortions which have been identified inflationary measure which excluded growth, wages, pensions and benefits. is truly shocking. energy and food (the very items whose Moreover, understated inflation The biggest single undermining of prices were rising most strongly at undermines calculations of the ‘real’ official inflation data results from the that time). cost of credit as represented by interest application of “hedonic adjustment”. rates and bond yields, a factor which, “Owner-equivalent rent”, a concept The aim of hedonic adjustment is to as we shall see, may have played a very to be explained later, was introduced capture improvements in product significant role in the escalation of under Ronald Reagan. Convoluted quality. The introduction of, say, a indebtedness during the credit changes to the measurement of CPI better quality screen might lead the super-cycle. inflation, recommended by the Boskin Bureau of Labor Statistics (BLS) to Commission, were drafted under British inflation data, too, seems pretty deem the price of a television to have George Bush Sr. but implemented by optimistic Between 2001 and 2011, fallen even though the price ticket the Clinton administration (and, as average weekly wages increased by in the shop has remained the same, renowned strategist Kevin Phillips 38%, which ought to have been a more or has risen. The improvement in the 8 has remarked , there is a certain than adequate rise when set against quality of the product is equivalent, BLS irony to the introduction of “hedonic official CPI (consumer price index) statisticians argue, to a reduction in adjustment” by the Oval Office’s inflation of 27% over the same period price, because the customer is getting ultimate hedonist). A further four more for his or her money.

44 strategy insights | issue nine 8 See “Numbers Racket”, Kevin Phillips, Harper’s Magazine, 1 May 2008 Fig. 4.1: Beyond belief? UK inflation, 2001-11*

+168% Gas +97% Electricity +66% Property prices +63% Water +59% Council tax & rates +59% Petrol +39% Food +28% Rent -5% Consumer durables +38% Average income +27% CPI

-50% +0% +50% +100% +150% +200%

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

A big problem with hedonic critics claim, the official statisticians A second area of adjustment to adjustment is that it breaks the link are all too likely to incorporate the inflation concerns ‘substitution’. If between inflation indices and the former whilst ignoring the latter. the price of steak rises appreciably, actual (in-the-shop) prices of the ‘substitution’ assumes that the measured goods. Another is that The failure to incorporate hedonic customer will purchase, say, chicken hedonic adjustment is subjective, negatives may be particularly pertinent instead. As with hedonic adjustment, and seems to incorporate only where home-produced goods are the use of substitution not only breaks improvements in product quality, replaced by imports, a process which the link with actual prices (a process not offsetting deteriorations. A new has been ongoing for more than two exacerbated by ‘geometric weighting’), telephone might, for example, offer decades. A Chinese-made airbrush but it also, as Chris Martenson explains, improved functionality (a hedonic might be a great deal cheaper than means that CPI has ceased to measure positive), but it might also have a one made in America, but is the lower the cost of living but quantifies “the shorter life (a hedonic negative) and, quality of the imported item factored cost of survival” instead9. in to the equation?

9 Chris Martenson, The Crash Course, John Wiley & Sons Inc, 2011 strategy insights | issue nine 45 perfect storm | energy, finance and the end of growth

Fig. 4.2: Smoke and mirrors – the distortion of US CPI-U inflation*

10% Official 8% Underlying? Understatement? 6%

4%

2%

0%

-2%

-4%

-6% 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

* Sources: Bureau of Labor Statistics and Tullett Prebon estimates

Geometric weighting, too, plays a Instead of the 3.2% number reported underlying data stripped of hedonics, significant role in the distortion of for 2011, for example real inflation was substitution and geometric weighting. American inflation data. In any case, probably at least 7%. Worse still, the some of the weightings used in the official numbers probably understate The ramifications of understated official indices look strange, one the sharp pick-up in inflation which inflation are huge. First, of course, example being medical care, which America has been experiencing. A and since pay deals often relate to accounted for 16% of consumer realistic appreciation of the inflationary reported CPI, wage rises for millions spending10 in 2011 but is weighted at threat would be almost certain to of Americans have been much smaller just 7.1% in the CPI-U.11 have forced very significant changes in than they otherwise would have been. . Small wonder, then, that millions of Since the process of adjustment Americans feel much poorer than began in the early 1980s, the Taken in aggregate, the extent to official figures tell them is the case. officially-reported CPI-U number which the loss of dollar purchasing By the same token, those Americans has diverged ever further from the power has been understated is almost in receipt of index-related pensions underlying figure calculated on the certainly enormous. Between 1985 and benefits, too, have seen the real traditional methodology. Fig. 4.2 gives and 2011, official data shows that the value of their incomes decline as a an approximate idea of quite how dollar lost 53% of its value, but the result of the severe (and cumulative) distorted US inflation data seems decrease in purchasing power might understatement of inflation. to have become over three decades. stand at more like 75% on the basis of

10 Source: Economic Report of the President 46 strategy insights | issue nine 11 Source: Bureau of Labor Statistics strategy insights | issue nine 47 perfect storm | energy, finance and the end of growth

Fig. 4.3: The smoking gun – did negative real interest rates fuel the killer bubble?*

10% Based on official inflation 8% Based on underlying inflation? 6%

4%

2%

0%

-2%

-4%

-6% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

* Sources: Economic Report of the President, Bureau of Labor Statistics and Tullett Prebon estimates. Chart shows annual average real yields on 10-year Treasuries, based on official and on underlying inflation rates, see text

48 strategy insights | issue nine This process, of course, has saved the have played a hugely important role had been subjected to incremental government vast sums in benefit in the creation of America’s debt distortion, their everyday experience payments. Rebasing payments for bubble, is that real interest rates may may very well have led them to act the understatement of inflation since have been negative ever since the on an intuitive understanding that the early 1980s suggests that the late 1990s (fig. 4.3). Taking 2003 as borrowing was cheap. We believe that Social Security system alone would an example, average nominal bond distorted inflation data may, together have imploded many years ago had rates12 of 4.0% equated to a real rate with irresponsible interest rate policies payments matched underlying rather of 1.7% after the deduction of official and woefully lax regulation, have been than reported inflation. In other words, CPI-U inflation (2.3%), but were almost a major contributor to the reckless the use of ‘real’ inflation data would certainly heavily negative in real terms wave of borrowing which so distorted have overwhelmed the federal budget if adjustment is made on the basis of the US economy in the decade prior to completely or, conversely, might have underlying inflation instead. the financial crisis. forced government to come clean on what levels of welfare spending really Logically, it makes perfect sense to can be afforded. borrow if the cost of borrowing is lower than the rate of inflation. Whilst most Another implication of distorted Americans may not have been aware inflation, an implication that may of the way in which inflation numbers

12 Annual average interest rate for 10-year Treasuries. Source: Economic Report of the President, 2011 datasets strategy insights | issue nine 49 perfect storm | energy, finance and the end of growth

economic distortion #2 – grossly 4.4. The largest single such imputation those with mortgages. For example, distorted prosperity – worth over $1.2 trillion in 2011 – a person with 50% equity in his home Gross domestic product (GDP) is concerns “owner-equivalent rent”. If a is assumed to pay rent on 100% of it usually accepted as defining the person owns his or her home outright, rather than, as is actually the case, output of an economy. In 2011, the no mortgage or rent is payable, and mortgage interest on half of it. GDP of the United States was reported no money changes hands in respect The second-largest imputation at $15.1 trillion, a figure which most of the property. But the reporting concerns employee benefits (principally Americans probably assume consists methodology for American GDP medical insurance, but also items such entirely of ‘real’ dollars which can be assumes that such a property has as meals and accommodation) which counted. This is, in fact, very far from a utility which a purely cash-based are provided to workers either freely or being the case, because close to 16% measure fails to capture. Therefore, on a subsidised basis. A sum of $601 of the reported number consists of GDP contains a sum representing the billion was imputed in this category in ‘imputations’. These imputations rent which the owner would have paid 2011. Financial services (for example, are dollars which do not really exist. (presumably to himself) if he had not checking accounts) which are provided Stripped of them, GDP totalled $12.7 owned the property. Interest expense is free of charge by banks are treated trillion in 2011, which automatically backed out, but the net result remains similarly. Here, the imputation (of $497 means that all debt ratios are a great a major, non-cash uplift to GDP. The billion in 2011) reflects what the cost deal higher than they look. replacement of actual expenditure with a notional (‘imputed’) rent applies to the customer would have been if The most important of these not just to those Americans who the bank had charged him for services imputations are summarised in fig. own their homes outright, but also to which, in reality, were provided free.

Fig. 4.4: GDP – the impact of imputations*

$bn 2006 2007 2008 2009 2010 2011

Reported GDP $13,377 $14,029 $14,292 $13,974 $14,499 $15,076

Including imputations of:

Imputed rental income $1,125 $1,153 $1,191 $1,214 $1,217 $1,236

Financial services not charged $391 $426 $451 $441 $499 $497

Employment-related imputations $543 $565 $581 $592 $601 $628

Other imputations, net -$78 -$50 $9 -$1 -$32 -$17

Total imputations $1,980 $2,093 $2,231 $2,245 $2,285 $2,343

GDP excluding imputations $11,397 $11,935 $12,061 $11,728 $12,214 $12,733

Imputations as % GDP 14.8% 14.9% 15.6% 16.1% 15.8% 15.5%

* Source: Bureau of Economic Analysis

50 strategy insights | issue nine There is a legitimate debate about a long period in which the American picture (fig. 4.5). In effect, the United the “production boundary”, which economy has really been shrinking, States has been in almost permanent refers to the inclusion, or otherwise, not growing. recession since 2000, with real GDP of services provided free of charge, falling year after year, and declining a good example being care provided According to official figures, the GDP sharply over a ten-year period. to children, to the elderly and to the of the United States increased by infirm by family members. But the 16.6%, in real terms, between 2001 The growth-enhancing impact of sheer scale at which “imputations” and 2011. But these numbers are a distorted inflation has not been unique are now used in the compilation of function of two calculations which, as to the United States, of course. As we American GDP surely introduces grave we have seen, are not in themselves have seen, the prices of essentials have distortions into the generally-accepted reliable. First, the reported 2011 GDP far out-stripped reported inflation in number for US economic output. number (of $15.1 trillion) is highly Britain, suggesting that underlying questionable, because it includes inflation may have been significantly Moreover, non-existent (imputed) non-cash “imputations” totalling higher than the reported number. dollars obviously cannot be taxed, $2.3 trillion. Second (and much more Raising the annual GDP deflator by which means that imputations make seriously), since the way in which just 1.55% would have been sufficient the American incidence of taxation official inflation is calculated is open to wipe out all reported economic look a great deal lower than it really to very serious question, so, too, is the growth in the United Kingdom is. At $4.7 trillion, general government GDP deflator, the adjustment which between 2001 and 2011 (“growth” revenue absorbed 31% of reported GDP is employed to back out the effects which, as we have seen, was in 2011, but this ‘tax take’ rises to 37% of inflation from changes in the essentially borrowed anyway). when imputations are stripped out of nominal monetary value of economic the GDP denominator. output. Ritual claims that the deflator The picture of economic deterioration is worked out by comparing simple in the United States is reflected in the economic distortion #3 – what chained volumetric (that is, non- unemployment statistics or, rather, it growth, what jobs? monetary) measurements of GDP would be, if these were not so heavily Understated inflation, then, has need not be taken too seriously, as the massaged by reporting methodologies. depressed wage growth, impoverished reality is that it is impossible to de-link The official (U-3) number, currently those in receipt of benefits, masked the GDP deflator from other measures 7.9%, excludes the millions of the decline in the purchasing power of of inflation. unemployed Americans who are the dollar, and probably contributed to defined as “discouraged workers”. a reckless monetary policy which has Once adjustment is made for the mired the United States in excessive distortion of inflation, growth in debt. But it may also have resulted in American real GDP since over the last economic growth being reported over decade presents a gravely disturbing

strategy insights | issue nine 51 perfect storm | energy, finance and the end of growth

Fig. 4.5: What growth?* Fig. 4.6: What jobs?*

8% 20% U-6 Official 18% 6% Real? U-3 4% 16% 14% 2% 12% 0% 10% -2% 8% -4% 6% -6% 4% -8% 2% -10% 0% 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 1981 1985 1989 1993 1997 2001 2005 2009

* Sources: Bureau of Economic Analysis and Tullett Prebon estimates * Source: Bureau of Labor Statistics

If these people were included, together In the face of persistently high levels economic data, it will surprise no-one with other “marginally attached” of unemployment (even on the basis that government reporting all too workers, and those who are in part- of the understated U-3 definition), often plays fast and loose with reality. time work because they cannot find Americans have been asked to believe full-time employment, the BLS itself in the concept of “jobless growth” as British citizens were treated to an concedes (on its broader U-6 measure) a way of reconciling weak job data on example of this in April 2012 when that the unemployment rate would the one hand with reported growth in the government, in taking over postal have been over 14% in October 2012, GDP on the other. The real explanation workers’ pension funds, used fund drastically higher than the 9.6% is simpler. It is that the economic assets (of £28bn) to reduce reported recorded ten years previously (fig. 4.6). growth of the last decade seems to debt (and the published deficit as Analysts who have unpicked all of have been illusory. well) whilst conveniently assigning the the various methodological changes associated liabilities (£38bn) to off- (including alterations to sampling fiscal distortion #1 – fast and loose balance-sheet “contingent liabilities”. techniques) argue that the real rate If statisticians (people of integrity who The reality, of course, is that there of unemployment is even higher, are at least nominally independent is nothing remotely “contingent” particularly where this is defined to from government) have been drawn about the liabilities of a pension include under-employment as well. into the accretive distortion of fund to pay the sums to which it is contractually committed.

52 strategy insights | issue nine The International Monetary Fund has done the same, at a cost probity – securitised pension payments (IMF) is not known for producing (in annual payments) equivalent to 1% from Deutsche Post, Deutsche controversial analyses of its member of GDP. At £8.7bn, British PFI payments Postbank and Deutsche Telekom, governments’ activities, but a report13 in 2011-12 equated to 0.57% of GDP, receiving €15.5bn whilst at the same published in March 2012 shed a great or 1.5% of government revenue, and time eliminating purchaser risk by deal of light on some of the ways in these payments are projected to rise to guaranteeing future payments. which government debts and fiscal £10bn by 2015-16. deficits are massaged. Governments, Pensions payable to state employees the IMF said, “can be tempted to Between 2001 and 2007, Greece used constitute huge off-balance-sheet replace genuine spending cuts or tax swaps to hide €5.3bn of borrowing. liabilities for many governments, increases with accounting devices that Belgium, Italy, and Poland including the United Kingdom give the illusion of change without have made similar debt-deferring (perhaps £1,000 bn, or 66% of GDP) 14 its substance”. use of swaps. Governments have and the United States ($5.8 trillion , also manipulated debt and deficits or 38% of GDP). Just as important, “In retrospect,” the IMF said, “it is clear using sale-and-leaseback deals, annual increments to these obligations that accounting devices contributed whilst privatisation, too, can have are excluded from reported deficits. to the fiscal problems that many a manipulative effect when future Aggregate 2010 liabilities for selected countries are now experiencing”. The income streams are divested for a governments are set out in fig. 4.7, IMF report makes it clear that “hidden single payment which is booked which shows how massively Britain (in borrowing” has been rife, examples immediately. Similarly, Greece particular) is burdened by off-balance- cited including Portugal, Austria, securitised and sold lottery proceeds, sheet commitments. Importantly, this , France and , to air traffic control fees and, remarkably, table excludes welfare obligations which, of course, could be added the European Union grants, whilst both which, particularly in the case of the Private Finance Initiative (PFI) device Belgium and Portugal securitised tax US, are enormous. extensively used in Britain to defer receivables. During 2005-06, Germany the cost of new hospitals and schools. – so often regarded as a model of fiscal

Fig. 4.7: Liabilities in 2010, selected governments*

% of GDP Debt Civil service pensions Other liabilities Total liabilities

Australia 14% 10% 8% 32%

Canada 37% 13% 8% 58%

New Zealand 36% 5% 25% 66%

United Kingdom 69% 81% 23% 173%

United States 62% 39% 12% 113%

* Source: IMF

13 Accounting Devices and Fiscal Illusions, IMF Staff Discussion Note, 28th March 2012 14 Source: Financial Report of the United States Government 2011 strategy insights | issue nine 53 perfect storm | energy, finance and the end of growth

fiscal distortion #2 – vanishing acts The commendable transparency trillion was attributable to Medicare Governments are also well practised provided by the government of and $18.6 trillion to OASDI (old age, at the arts of making things disappear. the United States gives analysts a survivors and disability insurance), In Britain, for example, the failure probably-unparalleled amount of with the balance relating to railroad of Railtrack was handled in such a insight into the true balance sheet pensions ($140bn) and black lung way that its successor company’s position of a major government, provisions ($6bn). debts were kept off the government though commentators still disagree During FY 2010, the outstanding balance sheet, even though Network about the true scale of Washington’s Medicare liability was reduced Rail had no private shareholders. It indebtedness. by about $15 trillion, reflecting was created as a company “limited by At the end of fiscal year (FY) 2011, the assumption that the Obama guarantee”, a status which precludes official statistics16 showed debt “owed healthcare package will result in a very the need to consolidate its debts into to the public” – that is, excluding material reduction in future claims on the government total. Current debt debt held by other departments of Medicare. Whilst this is true, it is also stands at £29bn, though borrowing government – at $10,174bn, a figure somewhat disingenuous, in that the plans (of £46bn) suggest that this which in itself reveals a huge increase funding for healthcare will still need total might expand very significantly. over five years, since the equivalent to be sourced from taxpayers, such Network Rail’s government guarantee figure was $4,868bn at the end of that the future financial obligation has is described as “unconditional”, FY 2006. But the reported number been shifted further off-balance-sheet, “irrevocable” and “unlimited”, which excludes two very material lines of not eliminated altogether. At the end gives the company’s debts “the same quasi-debt. The first of these, included of FY 2011, net liabilities were $46.2 credit ratings as the UK sovereign”15. in the official balance sheet, is a trillion, offset by anticipated future Large though it is, Network Rail’s $5,792bn commitment to pay pensions receipts of $12.4 trillion. contribution to the British state’s to government employees. The second What, then, is the true level of off-balance-sheet liabilities pales into is a $4,711bn pool of federal debt owed American federal government debt insignificance when set against the to other parts of government. and quasi-debt? Inclusion of the entire guarantees which Britain (and other The significance of the latter number is off-balance-sheet liabilities associated countries) provided to the banking that it forms the principal asset of the with OASDI and Medicare would be system during the 2008 crisis. Official Social Security and Medicare systems, excessive, because these sums are UK public debt (of £1,068bn, or 68% of both of which have liabilities which far calculated on the basis of liabilities GDP) rises to £2,169bn (138%) including exceed their accumulated assets. At stretching 75 years into the future. financial interventions. Inclusive of the end of FY 2009, net liabilities were Few governments (or other banking support, Network Rail, PFI stated at $52.2 trillion in respect of institutions) measure their commitments (which we estimate at closed system claimants, a figure offset commitments that far ahead. £170bn) and public sector pension by $6.3 trillion which, it was assumed, obligations, the true scale of British will be the net positive contribution If we apply standard net present value government debt and quasi-debt of future scheme participants. Within (NPV) techniques to the official net probably stands at about 215% of GDP. the $52.2 trillion FY 2009 figure, $33.5 liabilities for FY 2009 but limit the

15 http://www.networkrail.co.uk/investor-relations/uk-government-guarantee/ 54 strategy insights | issue nine 16 Financial Report of the United States Government capture to 30 rather than 75 years, the 344%, depending upon whether the quasi-debt total for closed scheme imputed component of GDP is left participants declines from the reported in or excluded. $52 trillion to about $41 trillion. This figure falls further, to $36 trillion, Just as an assessment of federal off- based on the FY 2011 computation in balance-sheet commitments produces which the Obama healthcare system debt ratios large enough to scare small is assumed to eliminate major forward monkeys, much the same can be said Medicare liabilities. of the federal deficit. This number was reported at $1.29 trillion in FY 2011, This number, of course, is net of the equivalent to 8.6% of official GDP. But assets held by OASDI and Medicare, increases in quasi-debt commitments comprising federal debt of $4.7 trillion are running at an underlying rate which OASDI, at least, is likely to start of about $2.7 trillion, meaning that drawing upon in the near future. It also the real deficit is arguably $4 trillion, excludes forward pension and welfare equivalent to 27% of official GDP, or commitments to federal employees. 31% if imputations are excluded from the GDP denominator. Taken in aggregate, then, federal debt and quasi-debt can be put realistically An underlying federal debt and quasi- at $57.1 trillion, comprising debt owed debt total of some $57 trillion, on to the public ($10.2 trillion), debt top of private, bank, state and local held by other government agencies government debt of $44 trillion, could ($4.7 trillion), pension commitments be used by America’s critics to argue to employees ($5.8 trillion) and the that the United States is bankrupt. Any 30-year portion of net quasi-debt such inference, if not fundamentally commitments ($36.5 trillion)17. mistaken, most certainly would be premature. America may be technically Based on the official number for 2011 insolvent (in the sense that her economic output ($15.1 trillion), this collective liabilities far exceed any estimate of federal debt and quasi- remotely realistic calculation of the net debt equates to 379% of GDP. If we present equivalent of future income strip out the non-cash “imputations” streams), but she is not illiquid. component of GDP ($2.3 trillion), the federal debt and quasi-debt ratio rises to 449% of a smaller GDP denominator. Both numbers exclude private, corporate, bank and state debt, which total either 291% of GDP or

17 The detailed numbers are: - debt owed to the public: $10,174bn - debt held by other government agencies: $4,711bn - pension commitments to employees: $5,792bn strategy insights | issue nine 55 - estimated 30-year portion of net quasi-debt commitments: $36,472bn Total: $57,149bn perfect storm | energy, finance and the end of growth

56 strategy insights | issue nine Fig. 4.8: US GDP, debt and quasi-debt, 2011*

$ trillions $57.1 $60

$40 Welfare

$20 $15.1 Pensions Imputations Intra-agency

Ex-imputations Official debt $0 GDP Debt & quasi-debt

* Sources: Financial Report of the United States Government and Tullett Prebon estimates

The bulk of America’s obligations are enormous official debt, but carry even That these payments will be subject quasi-debts owed to the American larger, off-balance-sheet commitments either to massive devaluation or to people, which essentially means as well. outright repudiation seems inevitable, that forward welfare and pension in that the American, British and many commitments cannot be honoured Of course, these obligations are not, other Western governments simply (though few politicians are likely technically, the same as debt, in that cannot afford to honour the promises to admit this). In the nearer-term, they are political rather than contractual made by their predecessors. the blue-chip rating of American commitments which, in theory at least, government paper, reinforced by can be cancelled by a simple vote in As we shall see, the deterioration in the reserve status of the US dollar, Congress or Parliament. This said, it is energy productivity alone almost probably means that Washington can difficult to envisage a situation in which guarantees that economies are continue to live beyond its means for Congress tells contributors to Social poised to deteriorate. Where Western some years yet. Security or Medicare schemes that countries are concerned, there is the “we’re sorry, folks, but you’re not going additional problem that they have The broader point, though, is that to get paid after all”, any more than crippled their own viability through the the United States – and many other one can picture a British government policy disaster known as globalisation. Western countries, most notably publically reneging on its public sector Britain – are not only burdened with pension promises.

strategy insights | issue nine 57 perfect storm | energy, finance and the end of growth

58 strategy insights | issue nine part five: the killer equation the decaying growth dynamic summary The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy. But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.

If one asked a representative sample is expressed – lies at the heart of the natural gas, coal and renewables – of the public what economics is all current economic malaise. In essence, are dimensions of the same thing. about, there is a very strong likelihood an ever-widening wedge has been We term this vital concept the that the consensus answer would driven between the monetary and the commonality of energy. be “money”. The vast majority of ‘real’ economies. A central argument economists do indeed frame the set out in this report is that economic The fundamental fact of energy debate in monetary terms. The problems will remain insoluble for so commonality is often obscured by the problem with this is that the economy long as policymakers concentrate on use of different units to describe and is not, fundamentally, a monetary monetary issues rather than on the measure different forms of energy. construct at all. Economics is really ‘real’ economy. We go further than this, For instance, food is measured in about the art of combining tangible arguing that the physical economy nutritional calories; work can be components (such as labour and is, in essence, an energy system or, to measured as kilowatt-hours (kwh); natural resources) to meet needs. be somewhat more precise, a surplus and fossil fuels tend to be expressed Ultimately, money is a convenient energy equation. as gallons (of gasoline or distillate way of tokenising this process. The fuel), barrels or tonnes (of oil), cubic process itself, on the other hand, is the commonality of energy feet or cubic metres (of natural an energy equation. If one is to understand the essentially gas) and tonnes (of coal). But these energy-based nature of the economy, differing calibrations should not be The basic misunderstanding over this it needs to be appreciated from the allowed to disguise the fundamental point – the treatment of money as the outset that all forms of energy – commonality of all forms of energy. substantive challenge, rather than as including food and work as well as the language in which that challenge such ‘obvious’ types of energy as oil,

strategy insights | issue nine 59 perfect storm | energy, finance and the end of growth

As an illustration of the commonality corresponds to between 74 and 100 of energy, imagine filling the tank watts, the labour-equivalent of the of a car with one gallon of gasoline, gasoline is in the range 364 to 492 driving it until the fuel runs out, hours of work. Taking the average of and then paying someone to push these parameters (428 hours), and it back to the start-point. The ability assuming that the individual is paid of this person to do this depends, of $15 per hour for this strenuous and course, upon sufficiency of nutrition, tedious activity, it would cost $6,420 itself an energy equation. Obviously to get the car back to the start-point. enough, the energy contained in food On this rough approximation, then, a is converted by the human being into gallon of fuel costing $3.50 generates a capability for work, is exhausted, and work equivalent to between $5,460 requires continuous replacement. But and $7,380 of human labour. this process is a circular one, in that the cultivation of food is a process which One could come to a similarly- itself requires energy inputs, be they leveraged calculation of the energy the labour of human beings (most cost-to-price mismatch by measuring simply in planting and harvesting), the the cost of employing workers labour of animals, the employment of pedalling dynamo-connected exercise machinery or the direct use of energy bicycles to generate the energy inputs such as fertilizers. used by electrical appliances in the typical Western home, and then The exercise of putting one gallon of comparing the result with the fuel into a car, driving it until the fuel average electricity bill. runs out and paying someone to push it back to the start-point also illustrates the great breakthroughs – the huge difference between the price agriculture and the heat-engine of energy and its value in terms of The development of society and of the work done. economy is, in reality, a story of how mankind overcame the limitations According to the US Energy imposed by the energy equation. In 18 Information Administration , one the pre-agrarian, hunter-gatherer era (US) gallon of gasoline equates to (which lasted for at least 40,000 years), 124,238 BTU of energy, which in turn there was an approximate energy 19 corresponds to 36.4 kwh . Since balance, in that the energy which one hour of human physical labour each person derived from his food

18 http://www.eia.gov/kids/energy.cfm?page=about_energy_conversion_calculator-basics 19 124,238 (BTU per US gallon of gasoline) divided by 3,412 60 strategy insights | issue nine (BTUs per kilowatt-hour) = 36.412 kwh per gallon was roughly equivalent to the energy be engaged in making agricultural of the second breakthrough. As that he or she expended in finding implements, bridges to improve Daniel Webster put it, “When tillage or catching that food. Put simply, access to fields, or mills which could begins, other arts follow. The farmers, there was no energy surplus, and grind grain into flour. Investment, therefore, are the founders of consequently no society. Each person properly considered, began when the human civilization.” had to be self-sufficient, or perish. energy surplus created by agriculture was deployed into the creation of Following the discovery of agriculture, The first of the two great breakthroughs capital goods instead of products for the second (and vastly greater) in human development was the immediate consumption. breakthrough in the development discovery of agriculture. Farming seems of society and the economy was the to have begun in the “fertile crescent”, Of course, the energy surplus created invention of the heat engine, which an area which stretched from the Upper by agriculture was extremely modest enabled mankind to access the vast Nile through modern-day Lebanon, by later standards. It was sufficient to energy resources contained in coal, Israel and Syria to the basins of the create a very limited range of specialist oil, natural gas and other exogenous Tigris and the Euphrates in what is now trades (such as smiths, millers and (non-human) sources. Iraq, and to the upper coastal regions cobblers) and to provide rudimentary on both sides of the Persian Gulf. This structures of government and law. Although, in antiquity, Archytas of region is also known as “the cradle The most complex organisations Tarentum and Hero of Alexandria of civilisation”. Evidence of cultivated of the pre-industrial age – religious seem to have played around with grain suggests that the transition from establishments, and the shipping and jets of steam – and gunpowder was a hunter-gatherer to an agrarian way trading industries – were extremely discovered in China almost a thousand of life may first have occurred in about simple by later standards, though years ago – it is generally accepted 9,500BC, though millennia were to trading companies did begin to point that the invention of the true heat elapse before some of the staples of the way towards later corporate engine occurred in 1769, when Scottish organised agriculture (such as crop enterprises (in England, the East engineer James Watt (1736-1819) rotation and the domestication of India Company and the Hudson’s Bay patented his steam engine. Although it animals) were discovered. Company received their Royal Charters is arguable that the truly efficient heat in 1600 and 1670, respectively, whilst engine did not arrive until 1799 – when From an economic standpoint, the the Dutch East Indies Company was English inventor Richard Trevithick significance of the development of established in 1602). (1771-1833) built a high-pressure agriculture lay in the liberation of steam engine, and applied it to drive surplus energy. If twenty individuals or The importance of the discovery of the first locomotive – the industrial family units could now be supported agriculture lay in the creation of the revolution was well under way by the by the labour of nineteen, the first energy surplus, because it would end of the eighteenth century. twentieth was freed to undertake non- be this surplus that would make subsistence activities. He or she might possible the vastly greater advances

strategy insights | issue nine 61 perfect storm | energy, finance and the end of growth

Fig. 5.1: World fossil fuel consumption since 1750*

Million tonnes of oil-equivalent per year 12,000 Gas Oil 10,000 Coal

8,000

6,000

4,000

2,000

0 1750 1800 1850 1900 1950 2000

* Source: Tullett Prebon calculations and estimates from various sources

Fig. 5.2: American real GDP since 1790*

$bn at constant 2011 values $16,000

$12,000

$8,000

$4,000

$0 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

* Source: Tullett Prebon estimates from various sources

62 strategy insights | issue nine The real importance of the industrial complexity and specialisation that exponential population, revolution lay in harnessing exogenous are an accepted part of the modern exponential energy energy resources to apply vast leverage economy. In the agrarian era, the A glance at figs. 5.1 and 5.2 reveals a to the economy. Fig. 5.1 shows the truly overwhelming majority of people distinctive common feature, which is enormous increase in the consumption laboured on the land, and non- that the trajectories both of energy of fossil fuels since the onset of the agricultural trades were not only few consumption and real economic industrial revolution. Fig. 5.2 shows in number but, for the most part, output display clear exponential how, as typified by the United States, were closely associated with farming. characteristics, something which is this expansion has been reflected in an In today’s developed economies, equally apparent in fig. 5.3, which equally-dramatic increase in economic agricultural labour occupies only a charts global population numbers output measured as real GDP. very small minority of the workforce, since 2000BC. with the majority engaged in an As well as contributing to a massive almost bewildering array of specialised Historians estimate that the population quantitative increase in the economy, occupations, trades and professions, of the world totalled about 27 million the energy dynamic has resulted in the vast majority of which have no in 2000BC, and grew only very gradually the extraordinary social and economic relationship whatsoever to agriculture. thereafter, rising to 170 million two

Fig. 5.3: Exponential population growth, 2000BC to 2050AD*

10,000,000,000 Maximum capacity range

7,500,000,000 2010

5,000,000,000

2,500,000,000

0 2000BC 1500BC 1000BC 500BC 0 500 1000 1500 2000

* Sources: US Census Bureau & United Nations

strategy insights | issue nine 63 perfect storm | energy, finance and the end of growth

millennia later. As recently (historically from agoraphobia. Since resources are and therefore impossible to measure, speaking) as 1400, the population of not infinite, however, some experts but it was also too small to show the world still totalled only 350 million, postulate a maximum global carrying up. In 1750, annual consumption of and did not reach the first billion until capacity somewhere within the 8.5 fossil-based energy (consisting at that 1840, by which time the Industrial and 11 billion range shown on the time entirely of solid fuels) was about Revolution was well under way. chart (though others believe that, 3 million tonnes of oil-equivalent. under certain conditions, even the (mmtoe), rising, pretty dramatically, Thereafter, however, population lower end of this range may become to about 52 mmtoe by 1850. growth accelerated very rapidly, wildly over-optimistic). reaching 2 billion by 1930, 3 billion by Oil did not become a measurably- 1960, and 6 billion by 2000. The total The striking feature of the exponential significant component of the energy recently passed 7 billion, should reach growth in the global population over total until 1870, by which time fossil 8 billion well before 2030, and could be the past two-and-a-half centuries fuel consumption had reached an 9.3 billion (or more) by 2050. is the way in which it parallels estimated 142 mmtoe. Thereafter, similarly exponential growth in the this total escalated, to 200 mmtoe by If resources were infinite, this consumption of energy (fig. 5.4). 1880 and 400 mmtoe by 1895. The progression would be of little or no Before about 1750, the consumption of total exceeded 1,000 mmtoe in the late significance other than to sufferers energy was almost entirely untraded, 1920s, reaching 2,000 mmtoe by the

Fig. 5.4: Energy and the population*

12,000 Population (million) Energy (mmtoe) 10,000

8,000

6,000

4,000

2,000

0 0 250 500 750 1000 1250 1500 1750 2000

* Source: Tullett Prebon calculations from various sources

64 strategy insights | issue nine mid-1950s and almost 4,500 mmtoe unless there were things that could energy used in the economy. In other by 1970. By the end of the 1980s – and be purchased with it, and the physical words, all goods and services on which despite intervening energy price shocks economy formalised by money was, as money can be spent are the products – consumption exceeded 7,000 mmtoe. we have seen, an energy dynamic of of energy inputs either past, present Energy consumption broke through inputs and outputs. or future. the 8,000 mmtoe barrier in 2000, and exceeded 9,000 mmtoe just four years It is important to note that, in the The appreciation of the true nature after that. In 2010, and despite the agrarian age, anything that could of money as a tokenisation of energy onset of the economic slump in 2008, be purchased with money was the also enables us to put debt into its total fossil fuel consumption exceeded product of human (or animal) labour, proper context. Fundamentally, debt 10,000 mmtoe. be that labour past, present or future. can be defined as ‘a claim on future Purchasing, say, a plough amounted money’. However, since we have seen the subservient role of money to paying for a product of past labour. that money is a tokenisation of energy, Though economists, policymakers, Employing someone to plant a field it becomes apparent that debt really investors and the general public involved payment for current labour. amounts to ‘a claim on future energy’. customarily think in terms of Commissioning someone to build an Our ability, or otherwise, to meet money, this conventional thinking item of furniture meant paying for existing debt commitments depends is profoundly mistaken because, future labour. upon whether the real (energy) ultimately, the economy is a physical economy of the future will be big As we have seen, however, the terms rather than a financial construct. enough to make this possible. ‘labour’ and ‘energy’ are coterminous Rather than being in any sense through the commonality of energy, Therefore, the viability (or otherwise) fundamental, money serves to tokenise so anything which could be purchased of today’s massively-indebted output into a convenient form. After with money was the product of energy, economies depends upon the outlook all, the world economy has survived past, present or future. for energy supply. If one chooses to the demise of an estimated 3,800 believe that the exponential expansion different paper currencies.20 With the broader term ‘energy’ in energy use that has powered the replacing ‘labour’, exactly the The roles of money can be defined as a growth of the economy (and the global same relationship prevails in the medium of exchange, a unit of account population) since the dawn of the industrial societies of today, except and a store of value. The development industrial age can continue into the that exogenous energy inputs of money paralleled the emergence of future, debts may be serviceable and (overwhelmingly dominated by fossil agriculture, the role of money being to repayable out of the economic (for fuels) now provide the vast majority tokenise the output of the economy which read ‘energy’) enlargement of of the energy used in the economy. So into a convenient form. Obviously, the the future. If such enlargement cannot overwhelming is this preponderance creation of money was a secondary be relied upon, however, then the that, in Britain today, human labour stage in the economic process, as debt burden can only be regarded probably accounts for less than 0.5% there was no point in having money as unsustainable. of the aggregate human-plus-inputs

20 See Crash Course, chapter six, http://www.peakprosperity.com/video/222/playlist/153/chapter-6-what-money strategy insights | issue nine 65 perfect storm | energy, finance and the end of growth

Where debt is concerned, individuals resilient currencies that the world threat to this anticipatory economic and businesses have only two possible has ever known – lost 87% of its system would arise if the availability courses of action – they can repay purchasing power between 1961 of energy were to diminish (or even their debts, or they can default. and 2011. To regard money as the simply cease to increase in the way Governments, however, have a third building-block of the economy is that anticipatory finance necessarily option, which is to repay debts profoundly mistaken. assumes). Since the 1950s, this threat using money newly created for the has acquired a name – “peak oil”. purpose. Instead of the ‘hard’ default at Hubbert’s Peak? of reneging on debt obligations, As we have seen, then, the economy This peak oil concept – pioneered by M. government can opt for the ‘soft’ is, in reality, an energy dynamic onto King Hubbert and accordingly known default of ‘repaying’ their debts in a which has been grafted not just a as ‘Hubbert’s Peak’ – contends that, currency which has been devalued by system of monetary tokenisation but, at some time in the relatively near inflation. much more seriously, a system of future, we will have consumed half of anticipatory finance which is viable all originally-available reserves of oil. In any case, the real value of money if (but only if) it can be assumed that This concept is illustrated in fig. 5.5, is subject to a constant process of there will be no significant check to which combines past consumption destruction as its value is eroded by the process of exponential economic data with a representative subsequent inflation. According to official figures, growth. Of course, the most obvious downwards curve. even the US dollar – one of the most

66 strategy insights | issue nine Fig. 5.5: The concept of peak oil*

mmtoe 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 1900 1920 1940 1960 1980 2000 2020 2040 2060 2080 2100 2120 2140

* Source: Tullett Prebon estimates from various sources, see text

strategy insights | issue nine 67 perfect storm | energy, finance and the end of growth

Fig. 5.6 & 5.7: Oil – feature …or blip?

mmtoe mmtoe 4,500 4,500 4,000 4,000 3,500 3,500 3,000 3,000 2,500 2,500 2,000 2,000 1,500 1,500 1,000 1,000 500 500 0 0 1900 1950 2000 2050 2100 2150 010002000 3000 4000

* Source: Tullett Prebon estimates from various sources, see text

At that point, Hubbertians argue, the has declined relentlessly. Since the more than a one-off event in which supply of oil will decline, in pretty global peak discovery rate occurred in mankind has squandered a multi- much a mirror-image of the increase the mid-1960s, it has been argued, a million-year energy inheritance in an in consumption which has taken place similar time-lag implies that global evolutionarily-brief moment of history. since the 1850s. Much the same, peak oil is now imminent. they argue, will eventually happen As we have seen, a distinct exponential to supplies of natural gas and of Advocates of the peak oil pattern links global population, energy coal, with depletion of these sources interpretation argue that, seen on consumption and, it should be added, accelerating as a result of substitution a timescale of social evolution, the a host of other linked parameters from oil. era of the petroleum-based society including economic output and food is not so much a manageable trend supply. If the availability of energy is The peak oil process can already be (fig.5.6) as a one-off event (fig.5.7, the critical exponential driver in this discerned in the context of individual which depicts exactly the same data as agglomeration, might a reversal in the provinces such as the UK North Sea, 5.6, but extends the time-scale from energy exponential bring all of the or of multi-province plays such as two hundred to four thousand years). others crashing down? the Lower Forty-Eight (L48) States of Again, it has been argued that this the US. Annual rates of petroleum same interpretation applies to other To be sure, reversing any of the critical discovery in America peaked in 1930, fossil fuels such as coal and natural exponential progressions (be it energy and peak production occurred forty gas, and that the current chapter in availability, economic growth or years later, in 1970, since when output economic history amounts to nothing population expansion) will be painful.

68 strategy insights | issue nine Indeed, society has absolutely no prior overstatement where conventional move that might yet be rendered guide to how to manage successive reserves are concerned, most notably necessary anyway by environmental (and perhaps rapid) decreases in in OPEC countries, where, for many considerations. The thirstiest vehicles population and in economic output. years, the quota allocation process (such as SUVs22) would be consigned A mass collapse of exponentials could incentivised the over-statement of rapidly to the scrap-heap, and private be catastrophic. reserves. But the overall picture is one car ownership would be displaced of relative abundance of reserves of oil by public transport. The second The classic Hubbertian argument is of all types. effect of very high oil prices would that oil production must soon enter be to incentivise exploration for, an inexorable decline, because half The second error within the Hubbert’s and development of, resources of the world’s originally-recoverable Peak theory is that it tends to ignore currently rendered uneconomic by petroleum has already been extracted. economics. A scarcity of oil would their geological nature or their The first flaw in this argument is that cause prices to rise massively. As we inaccessible location. it is simply not true. The application of have seen, a US gallon of gasoline the Hubbert thesis at this point implies costs about $3.50 but, in energy These arguments – and the apparent that reserves were of the order of 2,200 terms, displaces human labour worth scale of remaining recoverable bn bbls (billion barrels). Ample evidence perhaps $6,400. Scarcity-induced reserves – have generally enabled exists to suggest that the originally- price escalation could be expected to peak oil sceptics (sometimes known recoverable reserves base was at change this equation in at least two as ‘cornucopians’) to counter the least 3,000 to 3,500 bn bbls, and very material respects. Hubbertians and thereby, in general, to possibly much larger. The Hubbertian win the public debate. case has considerable merit if it is First, a dramatic escalation in prices applied to conventional oil, by which is would reduce demand by causing In so doing, they are providing the meant light, sweet crudes which can greater frugality in the use of oil. right answers to the wrong question. be extracted relatively easily. But there As world-leading energy expert The critical issue with peak oil does is seemingly incontrovertible evidence Robert Hirsch argued (in a thesis that not hinge around remaining reserves. that huge quantities of unconventional essentially leant towards the concept Rather, the critical issues are energy oils remain to be extracted. of an oil production peak), there is a returns on energy invested (EROEI) great deal that can be done to mitigate and deliverability. In North America, tar sands reserves in the economic impact of oil shortages, Canada are estimated at no less than always presupposing that action is The best way to illustrate the 170 bn bbls (billion barrels), whilst taken at least ten years ahead of deliverability issue is to compare oil shales in the US alone may hold as the event21. sands reserves in Canada (about 170 much as 1,400 bn bbls of oil, though bn bbls) with conventional reserves in the extraction of much of that oil may A society threatened by oil scarcity Saudi Arabia (about 270 bn bbls). Given be, to put it mildly, problematical. In would be required to change that Saudi production capacity is about South America, reserves of very heavy fundamentally. Suburbs – the 12 mmb/d (million barrels per day), crudes in Venezuela are thought to quintessential characteristic of a one might, on a simple pro-rata basis, be well in excess of 350 bn bbls. To be car-based society – would be replaced expect Canadian oil sands output to sure, there seem to be many cases of by denser forms of habitation in a reach perhaps 7 mmb/d. But the reality

21 See Robert Hirsch et al, Peaking of World Oil Production: Impacts, Mitigation, and Risk Management. This groundbreaking report was written for, but then largely rejected by, the US Department of Energy 22 Sports-Utility Vehicles strategy insights | issue nine 69 perfect storm | energy, finance and the end of growth

is that output is most unlikely to reach replace natural declines from already- significance of these figures is that even 3.5 mmb/d. Deliverability from producing fields. As the industry moves the downgrading of OPEC’s future the Canadian resource, will, then, be from higher- to lower-deliverability demand forecasts resulted from the less than half of that attained from fields, maintenance of existing sharp lowering in economic growth conventional reserves in Saudi Arabia. production levels, let alone growth, expectations that occurred between becomes ever more difficult. 2007 and 2012. Not surprisingly, and for perfectly logical economic reasons, oil reserves In the 2007 issue of the World Oil Though appreciably lower than the have been ‘cherry-picked’, meaning Outlook, OPEC predicted that global cartel’s estimate five years ago (114 that the cheapest, highest-quality consumption of oil would rise to mmb/d), the current projection for and most accessible reserves have 114 mmb/d by 2030, amounting to oil demand in 2030 nevertheless been exploited first. What this in turn a 31% increase over expected 2010 represents a big (19%) increase from means is that, even if reserves remain demand of 87.5 mmb/d. Five years the outturn in 2010 (84.9 mmb/d). substantial, production levels might hit on, the demand projection for 2030 a ceiling in the relatively near future. had been reduced from 114 mmb/d Is this achievable? We doubt it, not It also needs to be remembered that to 101 mmb/d, whilst consumption least because supply from existing net changes in output represent a in 2010 turned out to be a lot lower sources of oil is declining by about two-piece equation – substantial new (84.9 mmb/d) than OPEC had expected 6.7% annually. On this basis, an sources are needed each year simply to in 2007 (87.5 mmb/d)23 (fig. 5.8). The overall supply increase of 14.4 mmb/d

Fig. 5.8: Oil demand – falling expectations*

millions of barrels per day 120 WOO 2007 WOO 2012 110 114 mmb/d

100 101 mmb/d 90

80

70

60 2005 2010 2015 2020 2025 2030

* Sources: OPEC, World Oil Outlook, 2007 and 2012 versions. Demand shown in millions of barrels per day, net of processing effects

70 strategy insights | issue nine 23 Consumption data sourced from OPEC, adjusted to exclude processing effects between 2012 and 2030 would require the source of about half of the based on abundant and ever-increasing the development of new sources kingdom’s production. hydrocarbon inputs might be running delivering 76.4 mmb/d (more three out of road. quarters of all output) by the latter Another way to look at the date (fig. 5.9). This seems extremely deliverability issue is that reserves Neither should policymakers be fooled improbable, not least because of the need to be quality-weighted. We may by the cornucopians’ argument that deliverability issue described earlier. have used up much less than half technology will necessarily ride to of the world’s originally-recoverable the rescue. As remarked earlier, this Moreover, future supply projections reserves of oil, but we have, necessarily, argument is essentially equivalent to assume that a large proportion of all resorted first to those reserves which the statement that, if one locked some future net gains in production will are most readily and cheaply recovered. boffins up in a bank vault with enough have to come from OPEC countries. The reserves that remain are certain to cash and a powerful enough computer, This might be difficult to achieve, be more difficult and costlier to extract. they would eventually materialise a particularly given that Saudi Aramco ham sandwich. Technology is not the admits that it is injecting 13 mmb/d of Production may not ‘peak’ just yet, Seventh Cavalry, poised to ride to treated seawater, most of it to sustain but a new concept (which we term the rescue. production at its giant (but ageing) ‘resource constraint’) may soon kick Al Ghawar field, historically in, implying that an economic model

Fig. 5.9: The oil supply challenge*

mmb/d

120 New supply Existing sources 100

80

60 76.4

40

20 24.9 0 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030

* Source: Tullett Prebon estimates from various sources

strategy insights | issue nine 71 perfect storm | energy, finance and the end of growth

Fig. 5.10: The energy returns cliff*

100%

Cost energy 80% Profit energy

60%

40%

Deteriorating EROEI 20% % ‘profit’ of gross energy extracted 0% 100 90 80 70 60 50 40 30 20 10 0 EROEI

* Source: Tullett Prebon estimates, see text energy returns – the killer equation of the economy is that it is a surplus ‘energy cost of energy’ is 0.99% (1/101) An absolute decline in available energy energy dynamic, driven by the at an EROEI of 100:1, 3.8% (1/26) at volumes, serious though that would difference between energy extracted 25:1 and 9.1% (1/11) at 10:1. be, is not the immediate concern. The and energy consumed in the extraction The best form of graphical truly critical issue is the relationship process. As we have seen, society and presentation of EROEI is the “cliff between energy extracted and the the economy began when agriculture chart” (fig. 5.10). The horizontal axis amount of energy consumed in the liberated the first energy surplus. shows EROEI as a multiple, running extraction process. Known as the Subsequent economic history has been in this instance from 100:1 to zero. Energy Return on Energy Invested a process of increasing that surplus by The vertical axis divides gross energy (EROEI), this is the ‘killer equation’ harnessing ever-larger quantities of produced into “profit” (the dark, lower where the viability of the economy is surplus energy. area on the chart) and “cost” energy concerned. Put very simply, there is The mathematics of EROEI are pretty (the light area). At an EROEI of 100:1, no point whatsoever in producing straightforward. If the EROEI is 50:1, the picture is overwhelmingly one of 100 barrels of oil (or its equivalent in this means that 50 units are extracted “profit”, in a profit-to-cost percentage other forms of energy) if 100 barrels for each unit invested in the extraction ratio of 99:1. The percentage ratio (or more) are consumed in the process. The division here is 50:1 remains very strong (98:2) at 50:1, extraction process. between ‘profit’ and ‘cost’ energy, and is still robust (96:4) at 25:1. Though described earlier as an energy meaning that the net ‘cost’ of energy is equation, a more precise definition 1.96% (1 divided by 51). Similarly, the

72 strategy insights | issue nine strategy insights | issue nine 73 perfect storm | energy, finance and the end of growth

Below an EROEI of about 15:1, which were both smaller and bituminous and even sub-bituminous however, the “profit” element falls off costlier, an increasing proportion coals, the latter offering barely half a cliff, because there is an exponential being offshore. the energy content per tonne of increase in the “cost” component, bituminous coal. which rises from 4.8% at an EROEI of The petroleum industry has shown 20:1 to 6.3% at 15:1, 9.1% at 10:1 and enormous resourcefulness in Newer energy sources display a 16.7% at 5:1. This process of “cost” developing techniques such as water- similarly disturbing trend. At first escalation is illustrated in fig. 5.11, and gas-injection, horizontal drilling, glance, the claimed EROEIs for onshore which shows that energy cost is yet remote production and various wind power look pretty reasonable at another addition to the collection of forms of advanced oil recovery (AOR) perhaps 17:1. However, the returns exponential progressions (including as discoveries have become ever claimed for wind seem to make some population, energy consumption and more technically and geographically pretty heroic assumptions about the economic output) which dominate challenging, but the underlying trend longevity of generating plant and, the world as we know it. This time, has been a relentless deterioration in in any case, wind turbines produce however, the exponential progression EROEIs as costs have risen and average electricity, not the highly-concentrated is a negative one. field sizes have declined. transport fuels upon which the economy depends. It is important to emphasise that the Believers in peak oil have seen this cliff chart depicted in fig. 5.10 is not progression as an indication of ever- Other energy sources look even worse time-linear. Even so, and as fig. 5.12 growing reserves stress, which indeed in EROEI terms. Biofuel EROEIs seldom makes clear, the progression in energy it is. But the real economic significance exceed 3:1, and some are negative. The sourcing is moving unmistakably and of this progression lies in a rapid much-vaunted “hydrogen economy” inexorably towards ever-lower EROEIs. deterioration in EROEIs rather than in is a myth, because hydrogen acts as an exhaustion of absolute reserves. The a store (not a source) of energy, and Oil discoveries in the 1930s offered overall EROEI of the North Sea today is very inefficient in the way in which EROEIs well in excess of 100:1, whereas may be no higher than about 5:1, a it converts energy obtained from this ratio had declined to about 30:1 far cry from ratios in excess of 100:1 conventional sources. About 40% of by the 1970s, and few discoveries yielded by the pioneering discoveries the initial energy is lost in conversion, today offer an EROEI of much better in the sands of Arabia. perhaps another 15% is lost in the than 10:1. In the heroic pre-War days collection process and, if the hydrogen of the oil industry, the ratio was high, Much the same applies to other fossil energy is reconverted into electricity, because a small energy investment fuels such as coal and natural gas. the process losses mean that one (often consisting of little more than Where coal is concerned, fuel quality finishes with barely 15% of the energy rudimentary onshore drilling and has deteriorated just as costs have put into the process in the first place. wellhead equipment) could access risen. Almost all of the world’s original extremely large oil fields. By the 1970s, reserves of anthracite (the best coal Policymakers who pin their hopes on these ‘easy’ (low-cost) sources were in terms of energy content per tonne) unconventional hydrocarbon sources well on the way to being exhausted, have already been exhausted, pushing are guilty of a quite extraordinary and the industry was developing fields miners into ever greater reliance on degree of self-delusion.

74 strategy insights | issue nine Fig. 5.11: EROEI and energy costs*

60%

50%

40%

30%

20%

Energy cost as % of GDP 10%

0% 100 80 60 40 20 0 EROEI

* Source: Tullett Prebon, see text

Fig. 5.12: EROEI and energy sources*

100% d

acte 80% Coal (at mine) 1970s oil & gas finds Wind power xtr 1930s oil & gas finds Current oil & gas finds 60% Hydroelectricity Nuclear Photovoltaic solar

oss energy e 40% of gr

fit’ EROEI 20% Tar sands Shale gas % ‘p ro Biofuels 0% 100 90 80 70 60 50 40 30 20 10 0

* Source: Tullett Prebon, see text

strategy insights | issue nine 75 perfect storm | energy, finance and the end of growth

The EROEI of surface-mined tar sands is In an excellent discussion published in intervening inflation, this would be probably little better than 3:1 (if that), 2010, analyst Andrew Lees suggests equivalent to the annual average and those sands (accounting for about that the overall EROEI, having declined reference price of Brent crude oil four-fifths of the total) which cannot from 40:1 in 1990 to 20:1 in 2010, having soared from $79.50/bbl to be surface-mined can only be extracted might fall to as little as 5:1 by 202024. almost $280/bbl. using massively energy-intensive Though Mr Lees does not cite sources techniques such as SAGD (steam- for these numbers, his figures for 1990 Our own analysis begins with an assisted gravity drive), such that EROEIs and 2010 accord pretty closely with our estimate of the overall cost of energy are minimal, or even negative. own estimates. as a percentage of global GDP, which is plotted for the period since 1965 in The latest fashion in collective delusion Policymakers must hope that he is fig. 5.13. Energy costs, historically concerns shale gas and oil. These may very wrong indeed, however, about the very low before 1973, were driven indeed exist in vast quantities, but global average EROEI in 2020 because, to extremely high levels by the oil EROEIs of barely 5:1 should make it if this ratio does indeed decline to just crises of the 1970s before falling back abundantly clear that shales most 5:1 over the coming seven years, the markedly in response both to demand emphatically are not the quick-fix economy as we know it is finished. It is destruction and to the incentivisation that many governments (and their as simple as that. of previously non-commercial sources electorates) might like to suppose. of supply. The cost point here is critical. At the where are we now? 40:1 ratio cited by Andrew Lees for As a result, energy was remarkably As we have seen, then, there is an 1990, the theoretical cost of energy cheap during the 1980s and 1990s, unmistakable trend towards lower would have been 2.43% (1/41) of averaging perhaps 3.1% of GDP energy returns on energy invested, GDP. If the correct figure for 2010 was between 1986 and 1999, compared with EROEIs falling within the indeed 20:1, then the ratio in that with an estimated peak of almost fossil fuels slate just as society is year would have been 4.76% (1/21), 15% in 1979. turning both to renewables (such a painful increase since 1990 but, Of course, and as we have seen, the as wind power and biofuels) and to nevertheless, a ratio at which the value and the cost of energy are very unconventional sources of hydrocarbon surplus energy economy can different concepts, and short- and energy (including tar sands and shale still function. medium-term cost oscillation can gas). The critical question (though it is At a ratio of 5:1, however, energy be created by political and economic one to which scandalously little official would absorb 16.67% (1/6) of GDP, events largely unrelated to underlying attention has been devoted) has to meaning that energy costs would have fundamentals. Even so, we believe be that of where the world is in terms increased by 250% (16.67 compared that there is sufficient alignment over of the overall EROEI, and where this with 4.76) over just ten years. Put the longer term in the relationship critical equation may be heading. very simply, and ignoring (for now) between EROEI and cost for us to plot

24 Andrew Lees, ‘In search of energy’, Patrick Young (ed.), 76 strategy insights | issue nine The Gathering Storm, Derivatives Vision Publishing, 2010 Fig. 5.13: The underlying trend of EROEI?*

Energy cost as % of GDP 16% Estimated cost 14% EROEI cost curve? 12%

10%

8%

6%

4%

2%

0% 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030

* Source: Tullett Prebon estimates, see text

an estimated EROEI trend (in its cost- for 1990 (40:1) and 2010 (17:1) are Though our forecasts and those of equivalent form) on a ‘best-fit’ basis. reasonably close to the numbers cited Mr Lees may differ in detail, the for those years by Andrew Lees. For essential conclusion is the same. It is Remember that what is being 2020, our projected EROEI (of 11.5:1) is that the economy, as we have known it measured here is not the value of not as catastrophic as 5:1, but would for more than two centuries, will cease energy, but its cost as a proportion of nevertheless mean that the share of to be viable at some point within the the value that we derive from it. Cost GDP absorbed by energy costs would next ten or so years unless, of course, and value could only be the same if have escalated to about 9.6% from some way is found to reverse the trend. no surplus existed, which would also around 6.7% today. Our projections mean that the economy could not further suggest that energy costs could This point requires further explanation. exist either. absorb almost 15% of GDP (at an EROEI of 7.7:1) by 2030. Our assessment of the trend in EROEIs is shown as the red line in fig. 5.13. On this basis, our calculated EROEIs both

strategy insights | issue nine 77 perfect storm | energy, finance and the end of growth

EROEI decline – the road Let’s start with the straightforward this, some – shown in light blue – is from wealth to poverty EROEI equation by comparing a high- used for essential purposes, such as When looking at how a sharp decline and a low-EROEI economy, represented food production and the provision of in EROEI affects the economy, we need here by figs. 5.14 and 5.15. Each chart healthcare, law and government. to take note of two key points. The first subdivides the totality of produced The remainder, shown in dark blue of these is that the slump in energy energy into three streams. The red and substantial in the high-EROEI returns means that an ever-higher component is the proportion of the economy, powers all discretionary share of total output will be absorbed extracted energy which has to be activities, including all other forms by the cost of energy, meaning reinvested into the extraction process, of consumption and investment. that less value remains for all other whether as infrastructure (capital) or in If EROEI falls sharply, as in fig. 5.15, purposes. The second is that energy is extraction (operating) expense. much more of the gross energy is central to the entire economy, and that In a high-EROEI economy (fig. 5.14), consumed in the extraction process, its effects go far beyond the obvious the reinvestment requirement is small, resulting in a corresponding squeeze ‘costs’ of energy-related activities leaving most of the produced energy on the energy available to the such as transport and the generation to be used to power the economy. Of economy. The essentials may still of power.

Fig. 5.14: High EROEI Fig. 5.15: Low EROEI

Discretionary – consumption Discretionary – consumption and investment and investment

Volume of Volume of energy energy

Essentials – food, welfare, government, law Reinvested in Essentials – energy extraction food, welfare, government, law Reinvested in energy extraction

* Source: Tullett Prebon estimates, see text

78 strategy insights | issue nine be affordable, but the leverage in the equation is such that energy available for discretionary uses diminishes very rapidly indeed. There, through the EROEI squeeze, goes the car, the holiday, the bigger home, the MP3, the meal out, toys for the children, the afternoon at the golf club or the soccer match. If EROEI falls materially, our consumerist way of life is over.

There are two really nasty stings in the tail of a declining EROEI. First, net energy availability may fall below the amount required for essential purposes including healthcare, government and law. It is hardly too much to say that a declining EROEI could bomb societies back into the pre-industrial age.

Indeed, a decrease in net energy below subsistence levels is an implicit consequence of EROEI decline beyond a certain point – one which is difficult to estimate, but is likely to occur within the next decade – which means that this is when the nastiest results of all start happening.

Second, of course, a decline in net energy availability could (indeed, almost certainly will) result in conflict driven by competition for access to diminishing surplus energy resources.

strategy insights | issue nine 79 perfect storm | energy, finance and the end of growth

80 strategy insights | issue nine an unfolding collapse? The second is to increase output per constraint as to continuing increases As we have seen, energy is completely hectare, which is what the “green in the global population. Of course, the central to all forms of activity, so the revolution” has achieved – between cultivation of crops for fuels worsens threat posed by a sharp decline in net 1950 and 1984, for example, global the squeeze on food availability and, as energy availability extends into every grain production increased by we have seen, offers such low EROEIs aspect of the economy, and will affect about 250%. that it is a wholly futile response to the supplies of food and water, access squeeze on energy supplies. The snag with this, of course, is to other resources, and structures of that the green revolution has, The knock-on effects of energy government and law. overwhelmingly, been the product constraint go far beyond food The story of modern agriculture of energy inputs. Most obviously, issues, serious though these are. The is one of feeding an ever-growing planting, harvesting, processing and production of most minerals would global population from an essentially- distribution have been made possible be uneconomic without access to finite resource base. At the time by fossil fuels, principally oil. Fertilizers relatively inexpensive energy. The of population theorist Thomas have been sourced from natural gas, giant Bingham Canyon mine in Utah, Malthus (1766-1834), it would have whilst most pesticides are made from for example, produces copper at seemed inconceivable that the world petroleum. The impact of energy concentrations of about 0.25%, which population could increase from 870 inputs on agricultural productivity means that some 400 tonnes of rock million in 1810 to 6,900 million in cannot be calculated exactly, but some must be shifted for each tonne of 2010. That this has been achieved estimates suggest that these inputs copper produced, a process that is has been solely due to the application have increased output per hectare by hugely energy-intensive. Most plastics of exogenous energy to agriculture, at least 85%. The apparent implication are derived from either oil or natural a process which has created an – which is that food production might gas. Desalination is extremely energy- expansion in food production which decline by almost half if these inputs intensive, which means that any sharp has exceeded the 7.9x increase in became unavailable – is almost escalation in energy costs will undercut human numbers over the same period. certainly a severe understatement, an increasingly important source of because it ignores both the leeching fresh water. Current plans call for Essentially, there are two ways in of naturally-occurring nutrients and the quantities of water produced which agricultural output can be the conditioning of the land to input- by desalination to increase from increased. The first is to bring more intensive monoculture. 68 mmc3 (million cubic metres) in land into production, which has indeed 2010 to 120 mmc3 in 2020, a plan happened, but virtually all viable It seems highly probable that recent which looks wildly unrealistic if the farmland was under cultivation food crises are directly linked to rising availability of net energy is declining at by 1960. energy costs, and that escalating food anything like the rate that our analysis prices owe at least as much to energy of trends in EROEI suggests.

strategy insights | issue nine 81 perfect storm | energy, finance and the end of growth

The logic of a deteriorating EROEI annual rate of 7.4% whilst the rest of - Energy sprawl. Investment in the suggests that investment in energy the economy shrinks by 0.5% per year. energy infrastructure will absorb a infrastructure will grow much more steadily-rising proportion of global rapidly than the economy as a whole knowing the score capital investment. in a process that has been called Where the surplus energy equation ‘energy sprawl’. In essence, declining is concerned, one question remains – - Economic stagnation. As the decline productivity means that the energy how will we know when the decline in EROEIs accelerates, the world infrastructure must increase more sets in? economy can be expected to become rapidly than the volume of produced increasingly sluggish, and to fail to energy, and this process is clearly The following are amongst the most recover from setbacks as robustly as under way, though principally in the obvious decline-markers: it has in the past. emerging economies (where energy - Energy price escalation. The - Inflation. A squeezed energy surplus demand continues to increase) inflation-adjusted market prices of can be expected to combine with an rather than in the developed world. energy (and, most importantly, of oil) over-extended monetary economy This is most evident in the massive move up sharply, albeit in a zig-zag to create escalating inflation. investment that is being poured into all fashion as price escalation chokes aspects of the energy chain in China. off economic growth and imposes With the exception (thus far) of inflation, each of these features has The calculations here are daunting. If short-term reverses in demand. become firmly established in recent we assume (for the sake of simplicity) - Agricultural stress. This will be most years, which suggests that the energy- that real GDP remains constant over obvious in more frequent spikes in surplus economy has already reached a ten-year period in which the overall food prices, combined with food its tipping-point. EROEI declines from 20:1 to 10:1, shortfalls in the poorest countries. energy costs must rise at a compound

82 strategy insights | issue nine Disclaimer The information in this communication is provided for informational and demonstrational purposes only and neither is it intended as an offer or solicitation with respect to the purchase or sale of any security nor should it serve as the basis for any investment decisions. In the UK, this material is intended for use only by persons who have professional experience in matters relating to investments falling within Articles 19(5) and 49(2)(a) to (d) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (as amended), or to persons to whom it can be otherwise lawfully distributed. Any reference to ‘Tullett Prebon’ refers to Tullett Prebon plc and/or its subsidiaries and affiliated companies as applicable. Neither Tullett Prebon plc, nor any of its subsidiaries (collectively, “Contributors”) guarantees the accuracy or completeness of the information or any analysis based thereon. Neither Tullett Prebon plc nor Contributors make any warranties, express or implied, with respect to the information (including without limitation any warranties of merchantability or fitness for particular purposes) and neither Tullett Prebon plc, nor Contributors shall in any circumstances be liable for economic loss or any indirect, or consequential loss or damages including without limitation, loss of business or profits arising from the use of, any inability to use, or any in accuracy in the information. Tullett Prebon provides a wholesale broking service only. It does not provide services to private clients. Tullett Prebon (Securities) Limited and Tullett Prebon (Europe) Limited are authorised and regulated by the Financial Services Authority (“FSA”). This publication is produced and distributed in accordance with ‘COB 12.2 – Investment Research’ of the FSA Handbook. Recipients should note that all such publications are objective and impartial in their content unless clearly notified otherwise. The author(s) act in accordance with Tullett Prebon’s ‘Conflict Management Policy’, full details of which can be viewed on our website at www.tullettprebon.com.

TPSI 009 | January 2013 Tullett Prebon Group Ltd 155 Bishopsgate London EC2M 3TQ Tel: +44 (0)20 7200 7000 Fax: +44 (0)20 7200 7176 www.tullettprebon.com