Debt: the endgame approaches

Something unusual, something historically significant is going on.

Epochal shifts do occur in history, but they usually only become clear in retrospect. One of my professors had a large print of Seurat's "A Sunday Afternoon on the Island of La Grande Jatte" hanging in his study. It is emblematic of a period (between 1871 and 1914) which came to be known as la belle époque, a time of prosperity and peace and scientific and technological advancement which preceded the horrors of the Great War. Never again would such naïve, unclouded optimism prevail.

Some would say that the post-World War 2 world was such a period. And, perhaps surprisingly in view of the threat of a world-destroying nuclear conflict, there was during those years both optimism and rising prosperity. This time it was not military conflict which broke the spell, however, but rather deep underlying economic and social problems which have only slowly become evident.

I want to focus on two indicators, one economic and one social: the first quantitative, the second qualitative.

The quantitative indicator I am referring to relates to debt-levels, especially government and household debt; boring, I know, but extremely important and relatively easy to grasp. The qualitative indicator relates to levels of trust between different societal groupings and individuals and their relationship to freedom, morality and social cohesion.

Internationally, sovereign debt is at historically very high, if not unprecedented, levels. In the U.S., the national debt currently stands at 20 trillion dollars, or about 100% of GDP. Household debt is also very high, having returned to the levels which preceded the 2008 crisis. Total U.S. debt (public and private) stands currently at about 350% of GDP.

The situation is quite obviously precarious, not least because a continuance of the status quo is dependent on the very low interest rates which the coordinated activity of central banks has engineered. But central banks don't have complete control of interest rates. Longer dated government bonds (seen as indicators of expected inflation, and also as a bellwether of commercial interest rates) will eventually rise, putting severe pressure on highly indebted governments and other borrowers.

Another way of seeing the problem is in terms of the relationship between economic growth and borrowing. Basically, for the last forty years or so, growth has been dependent on increasing levels of borrowing. For the last nine years, loose monetary policy, which has allowed rapidly increasing debt levels, may have forestalled a worldwide recession, but only anaemic growth rates have been achieved. The consequences should be obvious to anyone who thinks about it. There are limits to what borrowing can achieve, and responsible planners realize that levels of sovereign debt are unsustainably high.

In the case of the United States and many other Western countries, the looming problem of unfunded liabilities – especially relating to pensions and social security programs – dwarfs official national debt figures. These promises can never be delivered on, but admitting this would have a high political cost.

There are only two ways out in the longer term: default, or inflating away the debt/liabilities (by money printing). I don't know what the consequences of default (on sovereign debt, say) would be – not good, obviously – but the inflation road is also a dangerous one. Inflation, once it takes hold, is notoriously difficult to contain. Moreover, the sorts of anti-inflationary policies which have succeeded in the past may not be politically possible today.

Already, Western (and Eastern) economies seem to be stalling. Highly indebted households in the U.S. are cutting back on discretionary spending. The endgame – probably beginning with a deflationary crisis which would lead to widespread defaults – may well be approaching. I hope it is, because the longer this debt-based charade continues, the more serious the consequences will be.

No individual or country has a right to a certain standard of living, even if people living in rich countries all too often assume that they do. But, not only can continuing prosperity not be guaranteed, poverty is already with us – even in the still relatively prosperous West. Look at the youth unemployment levels in many European countries, for example. Or the stresses being faced by middle- and lower-income families in America and elsewhere. Or the bleak prospects facing many (most?) retirees.

The loose monetary policies pursued by central banks has had the (presumably unintended) consequence of enriching the few at the expense of the many, as the prices of financial assets and certain categories of real estate have been disproportionately inflated.

Moreover our collective memory of the two World Wars and the Great Depression is now fading. Such knowledge as we have of these times is based more on reading and films than on actual memories or family stories. Having grown up (in the West) during a time of peace and prosperity we might be tempted to assume that what we have experienced is the norm, to see war and poverty as some kind of aberration. But history teaches us otherwise.

Even the years immediately after World War 2 were very tough, especially in Europe. Many areas – including Britain, France, Germany and Scandinavia – were in dire financial straits. The material standard of living was much lower than it is today.

Who is to say, then, that our present levels of prosperity will persist? Why should they? Debt levels strongly suggest that we are living beyond our collective means and have been for some time.

So perhaps the question should be: how can present levels of prosperity persist, given the fact that we have been increasingly dependent on credit and deficit spending by governments to fund our lifestyles?

I will address the (qualitative) question of trust and social cohesion another time.

The end of the world as we know it

In respect of the economic prospects for Western economies, there have been doomsayers for as long as I can remember – and longer.

Moral and cultural critiques dominated in the early 20th century, economic/environmental ones in more recent times.

Many of the predictions (about oil availability, for instance) have proved to be spectacularly wrong. Nonetheless, Western countries like the United States and most of Europe are undoubtedly undergoing rapid relative economic decline (relative to most of East Asia, for instance); and we may be on the brink of something worse, something quite irreversible.

A particularly bad sign is that the doomsayers are becoming more mainstream.

For some years now we have had the rather too flamboyant and hyperbolic Marc Faber. But behind the media personality is a former investment banker with a good doctorate.

Jim Rogers (Yale and Oxford) is another. Though he projects a more conservative image, he agrees with Faber about most things economic. [Here is a good, relatively recent, interview.]

Dr. Tim Morgan, Head of Global Research at Tullett Prebon, is another commentator with grim tidings for Western countries. The Economist's Buttonwood reports that Morgan has just produced an 82-page 'note' (hah!) called 'Perfect storm: energy, finance and the end of growth'.

'The economy as we know it,' Morgan writes, 'is facing a lethal confluence of four critical factors – the fall-out from the biggest debt bubble in history; a disastrous experiment with globalization; the massaging of data to the extent that economic trends are obscured; and, most important of all, the approach of an energy-returns cliff-edge.'

As Buttonwood points out, very little, if any, progress has been made in bringing down debt-to-GDP ratios, but Morgan goes beyond the numbers and sees deep cultural factors at work here.

Since the 1980s 'there has been a relentless shift to immediate consumption as part of something that has been called a cult of self-worship. The pursuit of immediate gratification has resulted in the accumulation of debt on an unprecedented scale.'

Buttonwood notes that this theme 'was picked up way back in 1976 by Daniel Bell in his book The Cultural Contradictions of Capitalism. Bell's idea was that the driving force behind capitalism was puritanical – it relied on deferred gratification as entrepreneurs cut back on current consumption in order to accumulate capital and build businesses. From the 1950s onward, western societies became more interested in immediate consumption – the car in every garage, the kitchen stocked with white goods and so on. Since then, arguably, governments have been desparately trying to satisfy those needs, first with fiscal policy and then with debt-financed growth. Oddly enough, it is now the nominally communist Chinese who display the capitalist virtues of high savings and capital accumulation.'

The globalization arguments are more complex, but at the root of the problem is the fact that, while Western economies like the U.S. have switched from manufacturing to services, most of the services involved are internally consumed and not globally marketable, and so are not really adding value to the economy. Thus chronic U.S. trade deficits financed by debt from abroad.

The distorted statistics claim is one I have only recently become aware of (or taken seriously). In blissful ignorance, I had assumed that the professionalism and impartiality of the economists and bureaucrats charged with dealing with these sorts of things could be relied on, and suggestions of data being massaged or distorted were the sort of thing one expected only from know-nothings and conspiracy theorists. Not so.

As Buttonwood points out, 'inflation has been understated because of adjustments for quality improvements (hedonics); GDP growth has been overstated; and national debt totals omit the cost of contingent liabilities such as pensions.'

Morgan's last and central point is less well-known. It is that we have developed the easiest sources of energy already and that new sources are less efficient to produce as measured by the EROEI (or energy returns on energy invested) formula.

'High energy prices,' explains Buttonwood, 'have weighed on consumers ever since 2007. Normally prices slump during a U.S. recession but demand from emerging markets means that hasn't happened; the west has turned from being a price-setter to a price-taker.

'... Whereas Saudi oil had an original EROEI of 100:1, shale oil is just 5:1... If we depended entirely on shale, energy cost would consume 16.5% of GDP, compared with around 3% of GDP in the 1980s and 1990s. Cheap oil played a major part in that late 20th century boom just as expensive oil was a big factor in the turbulent 1970s.'

Frankly, I don't need the EROEI argument to be pessimistic. But adding it in does make the future look even more bleak than I had bargained for.

Morgan concludes that, if (as seems likely) EROEI measures fall materially, 'our consumerist way of life is over. It is hardly too much to say that a declining EROEI could bomb societies back into a pre-industrial age.'