end-game - Tullett Prebon the denouement of exponentials Dr Tim Morgan Global Head of Research...

end-gamethe denouement

of exponentials Dr Tim Morgan Global Head of Research

strategy insights | issue six

1strategy insights | issue six

contents

about this report 2

summaries i. overview – a system in crisis 5 ii. fundamental drivers – the exponential economy 6 iii. smoke and mirrors – a denouement disguised 7 iv. end-game – the denouement of exponentials 8

sources and recommended reading 10

part one: overview – a system in crisis 15 afundamentalchange? 17 smokeandmirrors 18 wherearewenow? 20 whathappensnext? 24

part two: fundamental dynamics – exponential drivers 27 exponentialenergyuse,finiteresources 28 exponentialmoney,escalatingdebt 34

part three: smoke and mirrors – a denouement disguised 43 misplacedfaith 44 officialdata,underlyingreality 44 ‘Pollyannacreep’ 47 inflation–thecostofliving,orthepriceofsurvival? 48 economicoutput–aGrosslyDistortedPicture 52 debtandthedeficit 56

part four: end-game – the denouement of exponentials 65 thefirstlinkage–aweakeningenergyequation 70 thesecondlinkage–recklessfinance 74 avoidingdisaster–canwebreakthelinkages? 75

end-gamethe denouement of exponentials

strategy insights | issue six2

end-game | the denouement of exponentials

about this report

WiththeWesterneconomiesmiredineconomicstagnationandburdenedbyunprecedentedlevelsofdebt,itisnotatallsurprisingthattheeconomicdebatehasbecomepolarisedbetweendebt-cuttersandfiscalstimulators.Ferventthoughthisdebateis,it completely misses the point.ThisreportidentifiesfundamentalissuesthatareneglectedbyKeynesiansandfreemarketeersalike,andcallsforawhollynewmethodofeconomicinterpretation.

Intellectually,thehighgroundisupforgrabsforonlythesecondtimesincetheSecondWorldWar.Inthethreedecadesafter1945,Keynesianorthodoxyruled.Fromthemid-1970s,afree-marketphilosophyvariouslylabelled‘monetarism’,‘laissez-faire’and‘theWashingtonconsensus’

becametheneworthodoxy.Thoughitsadherentshavebeenfightingavaliantrearguardaction,therealityisthattheultra-free-marketsystemisdeadinthewater,discreditedbytheeventsof2008-09.Keynesiansarehopingthattheirparadigmwillregainitsformerpre-eminence,buttheyaremistaken.

Both approaches are outmoded.Freemarketorthodoxycreatedprofoundweaknessesintheglobaleconomy,andtookthefinancialsystemtothebrinkofcollapse.TheKeynesiansolutionsofthepastarenoanswertothechallengesofthepresentandthefuture,notleastbecauseitisimpossibletoborrowone’swayoutofadebtproblem.Somethingwhollynewwillemergefromthecauldronofthefinancialcrisis.

That new paradigm is very likely to be “exponential economics”,ourtermforanewphilosophywhichtakesaccountofthelong-runtrendsthatgoverneconomicevolution.Thefirstaimofthisreportistoexplainwhat“exponentialeconomics”is.

Exponentialeconomicsisamethodofinterpretationwhichuseslong-runanalysistobuilduponanidentificationofthetwokeydriversofsocietyandtheeconomy.

Thefirstofthesekeydriversisthatthe economy is an energy equation.Societyasweknowittodayisaproductoftheuseofextraneousenergytoleveragethelimitedcapabilitiesofhumanlabour.Theleveragingeffectofabundant

strategy insights | issue six 3

extraneousenergyalonepermitstheearthtosupportapopulationofalmostsevenbillionpeople.

Ultimately,money and debt are quantifications of the energy leveraging effect.Ifonesingleequationmattersmostinunderstandinganenergy-basedeconomicsystem,itisEnergyReturnsOnEnergyInvested(EROEI),whichcomparesenergyoutputswithenergyconsumedintheextractionprocess.

Thesecondkeydriverhasbeentheerectionofan ever more extended anticipatory financial superstructure on top of the fundamental surplus energy equation.Sincetheadventofthefree-marketorthodoxy,thissuperstructurehasbecomesuccessivelymoreexponentialand

dangerous,toanextentthatwasnotfullyappreciateduntiltheentiresystemteeteredonthebrinkofcollapsein2008-09.

Theproblemnowisthat,evenifsuppliesofextraneousenergyremaincomparativelyabundant,energyreturns–thecriticalsurpluspartoftheenergyequation–areweakening,particularlyintheWesterneconomies.Thistendencysuggeststhatthefoundationsoftheelaboratefinancialsuperstructurearecrumbling,andthatthisprocessrendersunprecedentedeconomicandsocialchangeinevitable.

Policymakersaresingularlyill-equippedtounderstand,letalonetoanticipateandtomanage,thecomingperiodoffundamentalchange.Theirdatabasesarefartooshort-term

foranappreciationofexponentialchange,andthereexistsnoagreedcalibrationofthecriticalenergyreturnsequation.

Wehopethatthisreportwillprovokedebateovertheseissues,andwewelcomeallcontributionstothebetterunderstandingofexponentialeconomics.

Dr Tim MorganGlobalHeadofResearchTullettPrebonplc

November2010

“[W]ho profits from a low-growth U.S. economy hidden under statistical camouflage [?] Might it be

Washington politicos and affluent elites, anxious to mislead voters, coddle the financial markets, and

tamp down expensive cost-of-living increases for wages and pensions?”

Kevin Phillips1


4 strategy insights | issue six1 Kevin Phillips, “Numbers racket – why the economy is worse

than we know”, Harper’s Magazine, 1st May 2006


• Thoughtheglobaleconomypulledbackfromthebrinkofcatastrophein2008-09,OECDcountriesremainburdenedbyhugedebts.

• Thoughsomeeconomicdatasuggestsrelativeresilience,adeeperlookattheglobaleconomysuggeststhatproblemshavebeenmanagedratherthanresolved.

• Officialdataisatoddsbothwiththerealityofmassivedebtsandwithsubjectiveinterpretationsonissuessuchasoutput,inflationandgrowth.

• Themonetaryratchet–aprocesswherebylowinterestratescreatebubbles,whosedamagingburststhenprovokeproblemswhicharecounteredbyyetlowerrates–hasreacheditslogicalconclusion,neutralisingratepolicyandencouragingaresorttoquantitativeeasing(QE),thecontemporaryeuphemismfortheprintingofmoney.

• Canawhollynewapproachtoeconomicinterpretation–exponential economics–providebetterinsightsintothetrueconditionof,andoutlookfor,theWesterneconomicsystem?

summariesi. overview – a system in crisis



ii. fundamental drivers – the exponential economy

• Along-termassessmentoftheglobaleconomyrevealsthatitisgovernedbytwocategoriesof‘exponentials’.

• Thefirstoftheseistheexponentialexpansionofphysicalmetricssuchaspopulationandresourceuse.

• Thesecondisanexponentialfinancialsystemcharacterisedbyacceleratingexpansionindatasetssuchasdebtandinflation.

• Ultimately,theeconomyisanenergysurplusequation,andsocialsophisticationisaproductofthewayinwhichexogenousenergyhasleveragedhumanefforts.

• Theexponentials-basedfinancialsystemfacestwolinkedthreats.Thefirstoftheseisthepotentialforacollisionbetween,ontheonehand,aneconomicsystemwhichrequiresperpetualgrowthand,ontheother,afiniteresourceset.

• Thesecond,moreimminentthreatcomesfromtheinternalmathematicalcontradictionsofaneconomicsystemwhichisincreasinglyturningtodebttosustainconsumptioninthefaceofstaticrealoutput.

Fig. 1: The exponential economy – a conceptualised representation*

Exponentials – a conceptualised representation

1750 2010 2050

Exponential – tip-over?

Anticipated – debt and financialisation

Leveraged – energy & industry

Basic – population

*Sources:TullettPrebonanalysis


iii. smoke and mirrors – a denouement disguised

• Inmostwalksoflife,deferential,unquestioningacceptanceofgovernmentpronouncementsisathingofthepast,andinvestors,inparticular,usuallyexercisehealthyscepticism.Itisstrikinglyanomalous,therefore,thatmarketstendtoacceptgovernmentmacroeconomicdataatfacevalue.

• Therealityisthatmuchgovernmentdataisextremelyunreliable.Ahistoryofincremental‘adjustment’hasdistortedmanymeasures–suchasunemployment,inflation,growth,deficitsanddebt–tothepoint

wherethestatisticalpictureisdrasticallydifferentfromtheunderlyingeconomicreality.

• FocusingontheUS,weexplainandstripawaythreedecadesof‘Pollyannacreep’torevealaneconomywhichisdrasticallyweakerthanisgenerallysupposed.

• Unemployment,reportedat9.7%,actuallyexceeds21%.Inflation,saidtobeatnear-zerolevels,isabove7%.

• RealGDPgrowthoverthelastdecade,reportedtohaveaveraged1.7%,hasactuallybeennegative.

• Publicdebtisoutofcontrol,exceeding$69trillion(or540%ofGDP)onceoff-balance-sheetobligationsareincluded.

• ThedeficitforFY2009wasreportedat$1.47trillion,butthisexcludesincrementstooff-balance-sheetwelfareobligations.Theannualdeficitinclusiveoftheseincrementalcommitmentstotalled$4.5trillionlastyear.

Fig. 2: Smoke and mirrors – the US economy*

Smoke and mirrors – the US economy

Off balance sheetFormal

official underlying official underlying official underlying official underlying official underlying

Growth, 2000-09** Inflation, 2000-09** Deficit, 2009*** Public debt, 2009 Unemployment, 2010

+1.7% 9.4%

2.6%

-2.0%

$7.6 trn $1.47 trn

$69.4 trn $4.44 trn

9.7%

21.7%

Sources: *OfficialdataandTullettPreboncalculationsbasedondatafromShadowstats.com,seetext

**GrowthandCPIdatashowcompoundratesbetween2000and2009

***Atendoffiscalyear



iv. end-game – the denouement of exponentials

• TheprocessoflookingbehindPollyannadatarevealsaUSeconomywhichisex-growth,hasstronginflationarytendencies,andismassivelyindebt.ThesecharacteristicsseemtobesharedbymanyotherWesterneconomies.

• Ineffect, theWestern economic system is being crippled by the unwinding of exponential debt-and-obligation finance as the core energy dynamic erodes.Itmaybesimplyamatteroftimebeforethesystemtopplesover,withultra-highinflationseemingalmostinevitable.

• Verylittlehasbeendonetoaddress(orevenrecognise)theseintrinsicunsustainabilities.Intheprivatesector,banksremainatlibertytoinflatefuturesequentialdebt-drivenassetbubbles,whilstgovernments’futurewelfarecommitmentscannotconceivablybedelivered.

• Inthissituation,neitherKeynesianstimulusnorlaissez-fairemarketliberalismoffersanyanswers.Betweenthem,theseideologiesarethecausesofthedeparturefromsoundfinance.

• Thekeyissueforpolicymakersisdamage-limitingmanagementoftheunwindingprocess,withconditionssettogettougherdueto(a)demographicchange,and(b)theweakeningofthesurplusenergyequation.

• Formaldebtwillbedestroyedviathe‘softdefault’routeofinflation,sincenoothersolutionexists.Atthesametime,governmentsneedtoacceptthatmostwesternwelfaresystemsarebecomingcompletelyunaffordable.


Fig. 3: Deep in the hole: total US debt and quasi-debt*

US debt & quasi-debt, 1990-2009 ($ trillion)

$100

$80

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$0

Individual & corporateState & localFederal owed to publicFederal off-balance sheet**

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$bn 2000 2003 2006 2009

Individual & corporate $14,480 $18,063 $23,910 $26,262

State & local $1,198 $1,568 $2,008 $2,355

Federal debt to the public $3,385 $4,033 $4,885 $7,805

Federal off-balance-sheet $21,780 $29,608 $47,808 $56,536

Total $40,843 $53,273 $78,611 $92,958

Sources: *FederalReserve,www.federalreserve.gov/releases/z1/current/z1.pdf.Latestdata:1Q2010,andFinancial Report of the United States Government,2000through2009

**NPVoffutureoff-balance-sheetwelfareobligations,sourcedfromFinancial Report of the United States Government,2000through2009



Thisresearchprojecthasdrawnupondataandinterpretationsfromaverywiderangeofsources.Someofthesearelistedbelow,togetherwithselectedrecommendationsforfurtherreading.

three sources have been of huge importance to this project:

ThefirstoftheseisJohn Williams,whoseShadow Government Statisticsservicelooksbehindthe“PollyannaCreep”inUSofficialdata,andpublishesconsistentlong-rundata,briefingsandanalyses.WebelievethattheSGSsubscriptionserviceisanimperativesourceforanyinvestororpolicymakerwhowishestounderstandtheeconomyandgovernmentoftheUnitedStates.Manyofthecharts

andtablesusedinthisreportarebasedondatafromthissource,andareacknowledgedas‘Shadowstats’throughout.Shadow Government Statisticscanbecontactedatwww.shadowstats.com

Chris Martensonhassetoutabrilliantandpersuasiveanalysisofthesocialandeconomicexponentialsprocess.HisCrash CourseisavailableasaDVD,andcanbeaccessedonlineatwww.chrismartenson.com

OurthirdkeysourcehasbeentheworksofKevin Phillips,oneofAmerica’sleadingpoliticalstrategists.WhenworkingfortheNixonteam,MrPhillipspublishedThe Emerging

Republican Consensus,inwhichhecorrectlyidentifiedthelikelyswinginthecentreofgravityofAmericanpoliticsfromtheindustrialNorthEasttothe“SunBelt”oftheSouthandWest.Latterly,MrPhillipshasbecomeincreasinglyconcernedaboutpoliticalandeconomicdevelopmentsintheUnitedStates,andhaspublishedseveralsuperbanalysesincludingAmerican Theocracy and Bad Money.

Thesethreesourceshavebeenindispensable(thoughweareofcourseresponsibleforallinterpretationspresentedinthisreport).

sources andrecommended reading


sources of information

1. AdamSmithInstitute(UK)

2. AlbertBartlett,ProfessorEmeritusofPhysics

3. BankforInternationalSettlements

4. BankofEngland(UK)

5. BBConline(UK)

6. BP Statistical Review of World Energy

7. BureauofEconomicAnalysis(US)

8. CentralIntelligenceAgency(US)

9. CongressionalBudgetOffice(US)

10. USCensusBureau

11. The Daily Telegraph

12. DebtManagementOffice(UK)

13. DepartmentforBusinessInnovationandSkills(UK)

14. USDepartmentofAgriculture

15. USDepartmentoftheTreasury

16. The Economist

17. EnergyInformationAdministration(US)

18. EuropeanCommission

19. Eurostat(EU)

20. FederalReserveBoard(US)

21. FederalReserveBankofSt.Louis(US)

22. The Financial Times

23. GovernmentPrintingOffice(US)

24. InternationalEnergyAgency

25. InternationalLabourOrganisation

26. InternationalMonetaryFund

27. JohnMauldin’sThoughts from the Front Line

28. NationalBureauofStatisticsofChina

29. TheNationalBureauofEconomicResearch(US)

30. The New York Times

31. OfficeofManagementandBudget(US)

32. OfficeforNationalStatistics(UK)

33. OrganisationforEconomicCooperationandDevelopment(OECD)

34. OrganisationofthePetroleumExportingCountries(OPEC)

35. WilliamH.Gross,Investment Outlook,PIMCO

36. MohamedEl-Erian,Economic Outlook,PIMCO

37. StatistischesBundesamtDeutschland(Germany)

38. H.M.Treasury(UK)

39. UnitedNations

40. TheWhiteHouse,CouncilofEconomicAdvisers(US)

41. TheWorldBank



recommended reading: a selected bibliography

1. EamonnButler,The Rotten State of Britain: How Gordon Brown Lost a Decade and Cost a Fortune(2009)

2. JohnCassidy,How Markets Fail: The Logic of Economic Calamities(2010)

3. NiallFerguson,The Ascent of Money: A Financial History of the World(2009)

4. JohnGray,False Dawn: The Delusions of Global Capitalism(2009edition)

5. BillHoustonandRobinGriffiths,Future Storm: The Dynamics Unlocking the Future(2006)

6. PaulKrugman,The Return of Depression Economics(2008)

7. PaulMason,Meltdown: The End of the Age of Greed(2009)

8. RobertPeston,Who Runs Britain? And Who’s to Blame for the Economic Mess We’re in(2008)

9. KevinPhillips,American Theocracy: The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century (2007)

10. KevinPhillips,Bad Money(2009edition)

11. RaghuramG.Rajan,Fault Lines: How Hidden Fractures Still Threaten the World Economy(2010)

12. CarmenM.Reinhart,KennethRogoff,This Time is Different: Eight Centuries of Financial Folly(2009)

13. NourielRoubini,StephenMihm,Crisis Economics: A Crash Course in the Future of Finance (2010)

14. GeorgeSoros, The Crash of 2008 And What It Means: The New Paradigm For Financial Markets (2009)

15. JosephE.Stiglitz,The Stiglitz Report: Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis(2010)

16. JosephE.Stiglitz,et al, Mismeasuring Our Lives: Why GDP Doesn’t Add Up (2010)

17. JosephStiglitz,Freefall: Free Markets and the Sinking of the Global Economy(2010)

18. GillianTett,Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe(2009)


“ [M]ost economic theories have little practical use in the real world. Concepts such as free trade being a boon to the world’s economy, a weak currency helping turn a nation’s trade deficit, or personal income including what the average homeowner would receive from himself in rental income if he charged himself to live in his own house, fall in to the “not in the real world” category”.

John Williams2

2 John Williams, Gross Domestic Product, briefing paper, Shadowstats.com



“What we are describing is an economy that is essentially “running on empty” – moving

money around, borrowing, expanding the money supply, incurring huge debt

obligations and mortgaging the future in an ever more frenetic attempt to maintain at

least the illusion of the status quo in the face of underlying economic deterioration”.


Haveinvestorsbecomeschizophrenic,oraretheyjustintwomindsaboutit?Ifasingletermcandescribethetenorofinvestmentmarketinrecentmonths,‘uncertain’issurelythatword.Thisuncertaintyinturnreflectssomeremarkabledivergenceswithintheavailableinformation,combinedwithsomeseriousdisconnectsbetweenstatisticaldataontheonehandandlogicalperceptionsontheother.

Onthefaceofit,thereseemtobesubstantialreasonsforoptimism.LookingattheUS–which,despiteglobalisationandpartialdecoupling,remainsthecentreofgravityoftheworldeconomy–thegoodnews

outweighsthebad,doesn’tit?Tobesure,growthisweakening,andadouble-diprecessioncannotberuledout.But,giventhescaleofthe2008-09bankingcrisisandthesubsequenteconomicdown-turn,Americanoutputhasheldupprettywell.Accordingbothtoofficialdataandtoconsensusassessments,realGDP(grossdomesticproduct)mighthavefallenbyabout6%frompeaktotrough,butthispalesintoinsignificanceincomparisonwiththeone-thirdfallinoutputexperiencedduringtheGreatDepression.

Likewise,USunemployment,at9.7%,isfarbelowthescary25%recordedin1933.Inflationislow,andexpectations

seemwellanchored–indeed,deflationremainsapossibility.Globally,interestratesareultra-lowand,withtheobviousexceptionsofcertainfiscalmiscreants,governmentbondmarketsarerobust.Corporateearningstrendsseemgenerallypositive.Ahandfulofmaverickcommentatorsaside,no-oneseemstoexpecteitherinflationorinterestratestotakeoffanytimesoon.Aboveall,theglobalfinancialsystemseemstohaveescapedfromthemelt-downwhichappearedaveryrealpossibilityinSeptemberandOctober2008.

part one:overview – a system in crisis

Fig. 4: Out of whack – US debt and GDP*

US total debt and GDP, 1947-2010 (trillions of 2010 dollars)

$60

$50

$40

$20

$30

$10

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Credit market debtGDP

1947

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Debt take-off beganin the early 1980s

*Sources:USBureauofEconomicAnalysis,USFederalReserve,andTullettPreboncalculations



Andyet,andyet.Forastart,someoftheharddatamustgiveinvestorsnaggingdoubts.Taketotal(public,corporateandprivate)debtintheUnitedStates,forinstance(seefig.1).Sincetheearly1980s,aggregateAmericanindebtednesshasincreasedbyroughly4.7x,inrealterms,whichcompareswithadrasticallysmaller(2.25x)reportedexpansioninrealGDPoverthesameperiod.At350%,thedebt-to-GDPratiohasreachedlevelsforwhichthereisnoprecedent,eveninthecrisis-hit1930s(about290%).

Federaldebt,measuredasapercentageofGDP,maynotbeallthatlarge,butdeficitsarehuge,andno-oneexpectsthemtodeclineanytimesoon.TheBankforInternationalSettlements(BIS)haswarnedthatpublicdebtinmostOECDeconomiesthreatenstotakeoffexponentially3.

Moresubjectively–thoughsurelyjustasimportantly–does published data agree with logical perceptions, with intuitive assessments, or with investors’ everyday experience?Ifwestandbackandconsiderthepromptingsofwhatmightbecalledcommonsense,certainthingsbegintojar.

Startingwithdebt,investorsandpolicymakersmustbeuncomfortablyawarethatbothgovernmentandthebroadereconomyarepilingcolossalobligationsontofuturegenerations

(aprocessthatwehavedescribedas“generationaltheft”4).Deficitsseemintractable,andmaywellgetworseasdemographicchanges–suchasbaby-boomerretirement,andtheageingofthepopulation–kickin.Iftheneedtofinancedeficitsremainsatanywherenearcurrentlevels,caninterestratesreallyremainatrock-bottomlevels?Intheprivatesector,propertypricescontinuetolookveryexposedintermsofhistoricearningsmultiples.Evenmodestfurtherfallsinhousepricescouldputmillionsofborrowersunderwater5.Whatwillhappentohomeownerbudgetsifinterestratesrisewhich,givenpersistenthighstructuraldeficits,theyverywellmight?

Andwhataboutgovernments’informalliabilities?Wehavebeenwarningforalongtimeaboutcertaincountries’off-balance-sheetobligations,whichincludefuturecommitmentssuchaspublicsectorpensionsandaccumulatedwelfareentitlements.

Thenlet’sconsiderinflation,bothhistoricallyandinthefuture.Accordingtoofficialdata,theaverageAmericanconsumer’scostoflivinghasincreasedby29%–anannualaverageof2.6%–overthepastdecade6,butmostpeoplesurelyfeelthatinflation,asitappliestothemselves,hasbeenfar,farhigherthanthis.

Lookingahead,isthestill-vauntedfearofdeflationremotelyrealisticwhengovernmentscanprintmoney?Tobesure,theUSsufferedcripplingdeflationinthe1930s,butthecrucialdifferencewasthatthedollarwasstillgold-linkedatthattime.Now,governmentcansimplycreatemoney(and,indeed,alreadyhas,onahugescale).Iftheworstcomestotheworst,Washingtoncanmailchequestoindividuals,orsimplyaskthechairmanoftheFedtodropmoneyfromhishelicopter.Doesn’ttherecenthugescaleofquantitativeeasing(QE)–today’seuphemistictermfortheprintingofmoney–suggestthatthosepeskyCassandrasmighthaveapointwhentheywarnaboutfutureinflationarysurges?

Andthenthere’sthebankingsystem.Despiteallofthepoliticalposturing,andtheBaselrecommendationsnotwithstanding,notmuchhasreallychangedontheregulatoryfront.ArestorationofGlass-Steagallseparationseemsasfarawayasever,andthespiritofinternationalco-operationforgedintheheatofthebankingcrisishasmeltedaway.Asaresult,thebankingsystemisstillatlibertytoinflatemoreoftheworryinglysequential bubbleswhichhaveplaguedtheglobaleconomyoverthelastdecadeorso7.

3 See The Bank for International Settlements, The future of public debt: prospects and implications, BIS Working Papers No. 300, March 2010, and Tullett Prebon Strategy Notes, issue six, Out of Control, May 2010

4 See Tullett Prebon Strategy Notes, issue one, The Dick Turpin Generation, March 20105 In UK terms, ‘in negative equity’

6 CPI-U, 2009 compared with 1999


a fundamental change?

Someofthismayseemprettysubjective,butthere’ssolid,tangiblelogichere,too.Inahighlyperceptiverecentarticle,The Economistwarnedthata“monetaryratchet”hasnowreached“itslogicalconclusion”8.Thisprocessisprettysimple,atleastintheory.Regulatorypolicyisrelaxed,ratesarelow,borrowingexpands,andanassetbubbleispumpedup.Afteritbursts,fearsofeconomicslowdownprompttheauthoritiestocutrates,creditbecomescheapandplentiful,anotherbubbleemerges,thenbursts…andsoitgoeson.Now,though,weseemtobereachingtheendofthis

spiral.Ratesareaboutaslowastheycanget,whichessentiallyneutralisesrate-settingasapolicytool.Instead,governmentsareprintingmoney,whichsurelyrepresentsthe pre-inflationary end-game of the “monetary ratchet”.

Tous,andtothosewhoshareourcorephilosophy,there’sanotherissuetobeconsideredhere,whichistheprocessof‘dangerousexponentials’.“Thefartherbackwelook”,asWinstonChurchillsaid,“thefartherforwardwecansee”.Ourresearchphilosophyisthat,tounderstandreallyimportantdynamictrends,investorsneedto

escapefromthestraitjacketofshort-termanalysisandlookinsteadatultra-long-termeconomicevolution.

Seenfromthisperspective,itbecomesapparentthattheeconomyisdominatedbyaseriesofexponentialprogressionswhichconcernbothfinancialindicators(suchasinflationanddebt)andastringofcriticalnon-financials(includingpopulationgrowth,energyconsumptionandresourcedepletion).Theexponentialnatureofjustfourofthesedataseriesisveryevidentinfig.5.

7 We addressed the issue of sequential bubbles in Tullett Prebon Strategy Insights, issue three, Forever Blowing Bubbles, February 2010

8 The Economist www.economist.com/blogs/buttonwood/2010/06/economic_growth_money_supply_and_energy

Fig.5: Ever upwards? – ‘dangerous exponentials’*

Examples of exponentials, 1750-2010

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Population (world, millions)Fossil fuels (world, mmtoe/y)US Federal debt ($bn)US inflation (1666=100)

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*Source:TullettPreboncalculationsfromvarioussources



Our‘dangerousexponentials’thesisidentifiestwocriticalmacroeconomicissues,bothofwhichappeartobehiddenfrominvestorsandpolicymakersbytheirownshort-termtimereferencing.First,thefinancialsystemseemstobefirmlyinthegripofaseriesofexponentialprocesseswhicharesurelyreachingtheirlimits(aninterpretationwhichexactlydovetailswiththe“monetaryratchet…logicalconclusion”pointmadebyThe Economist).

Second, the economy is essentially an energy construct,withaccesstoexogenousenergycreatingtheeconomicsurplus(asurplus,thatis,overandabovetherequirementforbaresurvival)whichiswhatthemodern,specialisedeconomyisreallyallabout.Whilstwedonotbelieveina‘PeakOil’doomthesis,wedobelievethatthecriticalequation,whichisthe relationship between energy extracted and energy consumed in the extraction process,isdeterioratingmarkedly.

Ifadeteriorationintheenergyreturnsequationisclearlyoneofthetwogreatthreatsfacingtheeconomygoingforward,theotheristheintrinsiccontradictionimplicitinexponentially-growingfinancialaggregateswhich,logically,cannotgoongrowingindefinitely.Aneconomicsystemwhich,byits

nature,mustgrow,seemstobeapproachingacollision,notjustwithsimplemathematics,butalsowithafiniteresourcesetwhichcannotgrow.

This,wemustemphasise,doesnotmakeusinanysenseMalthusians.Farfrombelievingthatsolutionscannotbefound,weareconfidentthattheycanbe.Butwhatwedocontendisthatwe are entering a period of unprecedented change,inwhichallpriorassumptions,allstructuresandallpoliticalandsocialrelationshipswillneedtobereconfigured,rethoughtand,inmanycases,completelyreplaced.

smoke and mirrors

Theexponentialsprocessshouldbeseeninthecontextofapointmadeearlier,whichisthat,evenintheshortterm,thereseemstobeahugedisconnectbetween,ontheonehand,generallypositiveofficialmacroeconomicdata(onoutput,growth,inflationandunemployment)and,ontheother,botheverydayexperienceandeconomiclogic.Howcanwereconcilethisapparentmismatch,whatconclusionscanwearriveat,andhowmightthisrelatetoapossible‘denouementofexponentials’?

AsSherlockHolmesfamouslysaid,“whenyouhaveeliminatedtheimpossible,whateverremains,

however improbable,mustbethetruth”9.Theseeminglyimprobabletruthintheconundrumidentifiedhereisthatofficial data is by no means as reliable as investors generally assume.Indeed,thewidespreadassumptionthat‘thisinformationmustbeaccurate,becauseitcomesfromthegovernment’showsanalmostchildlikefaith(indeed,surelyanaiveté)thatisalientoinvestorsineveryotherfacetoftheiractivities.

YetadetailedperusaloftheevolutionofUSofficialdata,summarisedinpartthreeofthisreport,showsthatthisdataisnotremotelyasreliableasseemstobealmostuniversallyassumed.Throughanaccretionofincrementaldistortions,governmentstatisticsverymateriallyflattertheunderlyingreality.Innovationssuchashedonics,substitutionandgeometricweighting–eachofwhichisexplainedlater–havedistortedreportedinflationsuchthatpublishednumbersunderstatetherealpositionbyatleastsixpercentagepoints(soyes,wecanindeeddismissanynotionofdeflation).

Ifinflationdataisthisheavilydistorted,calculationsofrealGDPgrowthwouldbewayoffbeameveniftheGDPnumeratoritselfdidnotinclude,asitdoes,itsownheftydistortions.These,collectively,aretermed‘imputations’,andinclude

9 Sir Arthur Conan Doyle, The Sign of Four, 1890


“ownerequivalentrent”.Ifyouownyourpropertyoutright,andhencemakenomortgageorrentpayments,youmightassumethatnothingrelatingtoyourpropertyappearsinGDP.Thisisn’tthecase,becausetheBureauofEconomicAnalysis(BEA)calculatesandincludestherentthatyouwouldhavebeenpaying(presumablytoyourself)ifyoudidn’towntheproperty.(Smallwonderthatthetaxbase,asrecordedbytheIRS10,bearseverlessresemblancetooutputsupposedlymeasuredbyGDP).

Debtishugelyunderstatedinthatitexcludesenormousoff-balance-sheetobligations,andtherateatwhichtheseobligationsarebeing

accumulateddwarfsthepublishedfiscaldeficit.Unemploymenthasbeenroutinelyunderstatedsincethe1960s,notleastbecause“discouragedworkers”areexcludedfromthetotals.

Strippedofthesevariousdistortions,thepicturewhichemergesisextremelydisconcerting.Indeed,the underlying reality is barely recognisable to anyone who customarily bases his assessment of the American economy on official data.

USunemployment,forexample,thoughreportedat9.7%,actuallyexceeds21%whenweaddbackartificially-excludedcategoriessuchas“discouragedworkers”.Inflation,despitetrendinglower,continuesto

exceed7%,makinganinflationarytake-offlookverylikelyindeed.RealgrowthintheAmericaneconomywasminimalinthe1990s,andhas been negative over the last decade.Accordingtosomeestimates,Federalobligationsexceed$69trillion(5.4xGDP),andarerisingbymorethan$4trillionannually.

Justoneexampleoftheextrememismatchbetweenofficialandunderlyingdataissetoutinfig.6,whichindexesrealGDPfrom1980.Instarkcontrasttopublisheddata,underlyingcalculationssuggestthatAmericaneconomicgrowthwasprettyminimalinthe1990sandhas,sincethen,gone into reverse.

10 US Internal Revenue Service

Fig. 6: Statistical distortion? US real GDP since 1980*

US real GDP, 1980-2010, Indexed: 1980=100

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*Source:TullettPreboncalculationsbasedondatafromShadowstats.com



LestitbethoughtthattheUSisinanywayuniquewheretheseratherfrighteningnumbersareconcerned,wemustemphasisethatdistortionofofficialdataalmostcertainlyoccursinmanyothercountries.

Rather,wefocusontheUSinthisstudyfortwomainreasons.Thefirstoftheseisthetransparencythatsomediligent,public-spiritedanalystshavemanagedtobringtothesituation.ThesecondisthesheerimportanceoftheUSwhich,quiteapartfromhavingtheworld’sreservecurrencyandaccountingforaquarterofglobaleconomicoutput,isthestandard-bearerforthedominantlaissez-faireeconomicorthodoxy.

Followingarecapitulationofourexponentialsthesis,andadetailedinvestigationofthereliability(orotherwise)ofofficialeconomicdata,partfourofthisreportposestwoquestionswhichareagreatdealeasiertoaskthantheyaretoanswer.First,where are we now? Second, what comes next?

where are we now?

Theanswertothe‘where’questionisprettydisconcerting,thoughweareconvincedthatthereisnothingwhatevertobegainedbyburyingourheadsinthesandandhopingthattheseissueswillgoaway.Theywon’t.

Essentially,webelievethatthedangersintrinsicintheexponentialsprocess,farfromlyingatsomeunspecifiedpointinthefuture,have already begun to kick in.Accordingtothisinterpretation,severalWesterneconomieshavegoneex-growth,andmayhavereachedthisstageasmuchastenyearsago.Sincethen,theseeconomieshavebeenmaintaininganillusionofcontinuingexpansion,with‘real’productivegrowthincreasinglysupplantedbyescalatingindebtedness,supplementedinsomecasesbymisleadingpresentation.

Inunderlyingterms,whathasbeenhappeningisthatthe logical end-point of the exponentials process has been reached,atleastwherethemaineconomicaggregatesareconcerned.Forastart,andbynomeansjustintheUS,officialdatahasbeenunderstatinginflationand,consequently,overstatinggrowth.Thisdistortionprocesswouldnot,ofitself,havebeensufficienttomaintaintheillusionofcontinuity,becausetherearereal,physicalcomponentstoanyeconomy–wecannotimport,say,foodorenergyusingmisleadingpercentages.So,asacounterparttoillusorydata,Westerneconomieshavebeenincurringtwolinkedformsofdebtescalation,eachofwhichisfundamentallydishonest.

Tounderstandhowthisworks,wemustdrawadistinctionbetweenformalborrowing(instruments,likebonds,whichspecifyprecisemonetarydebtswithdefinedcontractualtermsforrepayment)andinformalborrowing(typifiedbyfuturepensionandwelfarecommitments).Afurtherimportantdistinctionneedstobedrawnbetweeninternalandexternaldebt,withthelatterposingfarmoreofaproblemthantheformer.

First,Westerncountrieshavebeenincreasingtheirformalindebtedness,borrowingthesurplusesofemergingnations(mostnotablyChinaandotherAsiancountries).Thisborrowinghasbeenusedtosustainlevelsofconsumptionwhichhavebecomeincreasinglydisconnectedfromproductiveoutput.(WecouldputthismuchmoresimplybysayingthatWesternconsumershavebeenlivingfarbeyondtheirmeans).WhenAmericanpoliticiansbemoan–asMrObamadidduringhiscampaign–theultimatelyfutilepracticeofborrowingfromAsiatobuyoilfromtheMiddleEast,whattheyareidentifying,andquiterightly,isborrowed consumption.



Thisformofborrowingispalpablydishonest,becauseitisbasedonanimpliedwillingnessandabilitytorepaythesedebtsatsomefuturestage,eventhoughitissurelyprettyobviousthatfullrepaymentisalmostcertainlyimpossible,meaningthatsoft default (throughinflation) is the overwhelmingly likely outcome.

Second,andjustasinsidiously,Westerneconomiesarepilinginformalborrowingsontofuturegenerations,promisingfuturewelfareandpensionbenefitsthatcannotconceivablybedeliveredwithoutmassivetax

increases.Thisisadouble-con of future generations,whowillbeexpectedtoshouldertheirpredecessors’debtburdenswhilstatthesametimediscoveringthattheycannotconceivablyexpectthesamestandardsoflivingthatthosepredecessorsenjoyed.

Accordingtoeconomicsconventions,grossdomesticproductconsistsofthesumofprivateconsumption,governmentconsumption,investmentandnetexports(GDP=C+G+I+E),butthisequationleavesoutborrowings,whichhavemassively

supplementedconsumptionoverthelastdecade.Evenifallotherthingsweretoremainequal–which,ofcourse,theyhavenot–thenasimplereductionintherateatwhichdebtsarebeingaccumulatedwillreduceconsumptionandhenceeconomicoutput,withanymovementtowardsnetdebtreductionobviouslyhavinganevenmoremarkedimpact.A fundamental difference between the latest recession and all of its post-War predecessors is the deleveraging nature of the most recent downturn.

Fig. 7: Borrowed growth – British GDP and external debt, 1997-2009*

UK GDP and external debt, 1997-2009

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*Sources:OfficeforNationalStatisticsandHMTreasury


Allpreviousrecessionssince1945havebeende-stockingevents,inwhichbusinessescutbacktheirinventoriesandtheircapacityinresponseto(orinanticipationof)lowerdemand.Inthissituation,Keynesiandemandstimuluscanindeedsmooththeperformanceoftheeconomy.Butwhentheissueisdeleveraging–consumptionweakeningasindividualsandbusinessesretreatfromover-borrowedpositions–thetraditionalKeynesianstimulusapproachwillnotwork,andcouldexacerbatethesituation,sinceoneobviouslycannotborrowone’swayoutofexcessivedebt.

ThoughthisreportlooksmostcloselyattheUS,theBritishexperiencehasbeenastrikingexampleofthe‘borrowedgrowth’process(seefig.7).Between1997and2008,theUKborrowedalmost£4trillionfromoverseas,equivalentto29%ofnominalGDPoverthesameperiod.Atitspeakin2007,theincreaseinexternalborrowingsequatedto70%ofGDPduringthesameyear.Reflectingthisprocess,grossexternaldebtincreasedfrom181%ofGDPto441%inthespaceoftenyears.

Whatwashappeningherewasthat,fromtheturnofthecentury,theUKoperatedanexcessivelyrelaxedfinancialregulatoryregimewhilstatthesametimemaintainingirresponsiblylowinterestrates.

Givenminimalincentivestosave–notjustbecauseoflowrates,butalsobecauseofpunitiveimbecilitiesinthefiscalregime11–Britainnaturallysuckedinhugequantitiesofoverseasborrowings.

Muchofthiswasinturnchannelledintoirresponsiblemortgagelending,whichfedthroughintoapparentGDPintwomainways.First,itgaveahuge(though,ofcourse,anunsustainable)boosttoagamutofproperty-relatedtrades,includingbuilding,furnishing,realestateagencyandlegalservices.Second,itfedthroughintoconsumptionviaequityrelease,withhomeownersincreasinglyusingtheirpropertiesascash-cardmachines(ATMs).In2007,forinstance,only35%ofnewmortgageissuancewasactuallybeingusedforthepurchaseofhomes12.

Forthosepreparedtolookattheappropriatedata,allofthiswasclearenoughallalong,becauseeach year’s nominal increase in sterling GDP was exceeded by the same year’s increase in overseas indebtedness.Atthesametime,thethengovernmentseemstohavebelievedthatthisborrowedgrowthwasgenuineandsustainable–that“boomandbust”hadbeenabolished–sincethisrationaleseemstohaveunderpinnedtherecklessincreaseinpublicexpenditureoverthesameperiod.

Whenthisunsustainableprocessunravelled–whichitwouldinduecoursehavedone,bytheway,evenwithoutthecatalystoftheglobalbankingcrisis–theBritishgovernmentfounditselfinacleftstick.Reductionsinratesseemedimperative,inordertotrytokeepacredit-and-consumptioneconomygoing.Publicspending,meanwhile,couldnotbecut,becausetheautomaticstabiliserswouldhavedrivenitupwardsevenifKeynesiancalculationhadnot.

Thisprocesshasnecessarilyreacheditsdenouement,withthenewcoalitiongovernmentconfrontinganunsustainabledeficitviaspendingcutsintheknowledgethatthealternativeswouldundoubtedlybeevenworse.Therehavebeenvictimsallalong,ofcourse,includingsavers,butthe main effect has been to burden future generations with huge levels of formal and informal debt.Theultra-short-term,ideologicalandincompetentmanagementoftheBritisheconomybetween2000and2008wasadeeplyunedifyingspectacle,butoneforwhichconsumerswerenearlyasmuchtoblameasthethengovernment.

11 Such as the long-established practice of taxing interest as “income”, exacerbated by the notorious 1997 tax “raid” on pension funds

12 Of the remainder, 39% went into equity release and 26% was invested in buy-to-let. Source: Financial Services Authority (FSA), Address by Adair Turner – The Mortgage Market: Issues for Debate, 12th May 2009



Ofcourse,theUKwasbynomeansaloneinthisprocess,andthequantitativelylargestfoul-upshavebeenmadeintheUS.LikeLondon,Washingtonseemstohaveexhibitedtotaleconomicmyopiainthe2000-08period,believing,againonthebasisofillusoryeconomicstrength,thatitcouldcombinetaxcuttingwiththehugelyexpensiveconductoftwoessentiallyunwinnablewars.MistakesofthemagnitudeofthosewhichhaveoccurredintheUS,theUK,Ireland,Icelandandelsewheredon’t‘justhappen’,bytheway–bringingthissortofsituationintobeingrequiresalmostsurreallevelsofincompetenceandmyopia.

AnotherprocesshasbeendisturbinglyevidentintheUS,theUKandseveralotherWesterneconomies,aprocesswhichhasbeentermed“financialization”.Lookingbackatpast‘end-of-Empire’examples–suchasSpaininthesixteenthcentury,HollandinthelateseventeenthandBritainintheearlytwentieth–highlyregardedpoliticalanalystKevinPhillipshasidentified,ineachinstance,aconsistentpatterninwhichproductiveactivitiesaredisplaced,withintheeconomicmix,byvariousformsofmovingmoneyaround.InthecaseofSpain,thevastinfluxofbullionfrom

theNewWorldwaslargelyresponsible,butmuchthesamethinghappenedbothintheNetherlandsandinBritainatsimilardevelopmentalstages.

Asimilarprocess,MrPhillipsexplains,hasnowhappenedintheUS,wheretheproportionateimportanceofindustryhasdeclinedjustastheroleoffinancehasexpanded.In1950,manufacturingaccountedforalmost30%ofAmericanGDP,andfinanceforlessthan11%.Thishascompletelyreversed,suchthatfinancenowprovidesafifth,andmanufacturinglessthan12%,ofUSeconomicoutput13.

ThistrendpresentsanotherdimensionoftheuneasyrelationshipbetweenWallStreetandMainStreet.Moreimportantly,ittellsusagreatdealaboutthenatureoftheAmericaneconomyjustastheexponentialsprocessstartstounwind.

what happens next?

Thisreportsetsoutthefindingsofwhathasbeen,byaverywidemargin,themostchallengingstrategyresearchprojectthatwehavethusfarundertaken.InDangerous Exponentials,wesetouttoexplorethecoredynamicsdrivingtheglobaleconomy,explainingthatthe economy comprises an exponential progression founded upon what is essentially an energy

dynamic.Inthatreport,weconcludedthattheseexponentialswereindeeddangerous,firstbecausethe energy foundation is weakening(asenergyreturnsdeteriorate),and,second,becauseofthe intrinsic mathematical impossibilityofextendingfinancialexponentialsindefinitely.Weconcluded,somewhattentatively,that,atsomeindeterminatepointinthenot-too-distantfuture,theexponentialsprocesscouldgointoreverse,fracturingthefragileeconomicandsocialconstruct.

Here,wegoagreatdealfurther,explainingourbeliefthatthedenouement of exponentials has already begun,atleastinmanyleadingWesterneconomies.Thefactthatmostinvestorsandpolicymakersareblissfullyunawareofthissituationcanbeexplainedintermsoftheultra-short-termbasisonwhichtheyassesssituationsandplanfuturestrategies,combinedwiththeweaknessesofthedatauponwhichtheirassessmentsarefounded.Providedonlythatthemuch-vauntedspectreof‘PeakOil’isn’tanimminentthreat–which,expressed simply as a reserves equation,itisn’t–thenpolicymakerslooknofurtherwherefundamentaldynamicsareconcerned.Tobesure,theyareawareofescalatingdebt,butbelievethatthis

13 Financialization’ – percentage contributions to US GDP, 1950-2008*

1950 1960 1970 1980 1990 2000 2005 2008

Manufacturing 29.3% 26.9% 23.8% 20.0% 16.3% 14.5% 11.9% 11.5%

Finance 10.9% 13.6% 14.0% 15.9% 18.0% 19.7% 20.4% 20.0%

*Sources: Economic Report of the President, 2010, table B-12, and Kevin Phillips, Bad Money, 2009 edition, page 31


canbemanagedor,attheveryleast,canbeputontheback-burnerwhilsttherearemoreimmediately-pressingissuestobetackled.

Asaresult,stop-gapexpedients–suchasunsustainable(andfundamentallydishonest)borrowingbothfromforeignersandfromposterity,haveenabledtheillusionofnormalitytobesustainedeventhoughthe exponentials process has already begun toppling over.Strippedbothofdistortionandofborrowing,realeconomicoutputinmanyWesterneconomieshasbeeneitherflatorindeclineforatleastadecade.Continuingincreasesinconsumptionhavebeensimplythe greatest-ever example of entire societies living beyond their means.

The‘normalitydelusion’doesnotpreventsome,atleast,oftheunpleasantrealitiesfilteringthroughintotheWesternconsciousness.Mostofusareuneasilyawareofseveralsirenfactors.OneoftheseisthatthereallivingstandardsofthemajorityofWesternconsumersaredeclining,whateverthepublishedstatisticsmaysay.

AnotheristhatWesterneconomicinfluenceisinsteepdecline,somethingwhichitisalltooeasytoattribute

simplytogrowthinemergingcountries.The West’s commercial, political and even militarily superiority seems to be ebbing away.WhenBarackObamanotestheabsurdityoftheUSborrowingfromChinatobuyMiddleEasternoil,orwhenDavidCamerongoestoIndiaasasupplicantfora‘specialrelationship’,weareseeingevidencenotjustofunder-performancebutofabsolutedecline.

Yetdelusionsstillabound.MostWesterncitizens,liketheWhiteQueeninThrough The Looking Glass,continueto“believeinsiximpossiblethingsbeforebreakfast”14.Amongstthese‘believedimpossibilities’arethemistakenbeliefsthat:

1. Western economies are getting richer,wheninrealitytheyarenot.

2. Western welfare systems can continue indefinitely in their present form,whichisnotremotelyfeasible.

3. The escalation of public and private debt can continue indefinitely,whichobviouslyitcannot.

4. Each successive generation will enjoy higher living standardsthantheirforebears,whichhasalreadyceasedtobethecase.

5. Western countries’ elected leaders have a long-term planfoundedonrealisticdataandexpectations,whereaswe see no evidence of any such fundamental preparedness.

6. Technology will ride to the rescue,whichcannothappenwithoutmajorstructuralchange.(Itisevenbelieved,bymany,thattechnologywillsomehowovercomeglobalpressuresonfoodsupplies,onenergyavailabilityandontheenvironment).

Thereisasurfeitofeconomictheoriesandprescriptions,butmostseemtoassumeessentiallystaticfundamentals–inotherwords,thatwhatisrequiredisbettermanagementofthesamestructure,notfundamentalchangestobasicassumptions.

If,aswearguehere,each of the above assumptions is profoundly mistaken,weneedtolooktowardsafutureeconomicstructurewhichisstaticratherthangrowing,whereneitherKeynesiandemandmanagementnor laissez-faireeconomicliberalismworksastheorysaysthatitshould,andwheredeleveraging becomes debt destruction.

14 Lewis Carroll, Through The Looking Glass (1871), chapter five



“Nos numeros sumus et fruges consumere nati”.(We are just statistics, born to consume resources)

Horace15

15 Epistles, I ii 27


fundamental dynamics – exponential drivers

• Afundamentalassessmentoftheglobaleconomyrevealsthatitisgovernedbytwocategoriesof‘exponentials’–theexponentialexpansionofphysicalmetrics(suchaspopulationandresourceuse),andanexponentialfinancialsystemcharacterisedbyacceleratingexpansionindatasetssuchasdebtandinflation.

• Ultimately,the economy is an energy surplus equation,andsocialsophisticationisaproductofthewayinwhichexogenousenergyhasleveragedhumanefforts.

• Theexponentials-basedeconomicsystemfacestwolinkedthreats.Thefirstoftheseisthepotentialforacollisionbetween,ontheonehand,aneconomicsystemwhichrequiresperpetualgrowthand,ontheother,afiniteresourceset.

• Thesecond(andmoreimminent)threatcomesfromtheinternalmathematicalcontradictionsofasystemwhichisincreasinglyturningtodebttosustainconsumptioninthefaceofstaticrealoutput.

Atitsverysimplest,theexponentialfunctionstatesthatanychartofalinearpercentageprogressioneventuallyturnsintoanexponential,‘hockey-stick’or‘J’curve.

Oneofthebestexamplesofanexponentialprogressionistheglobalpopulation(fig.8).Historiansestimatethattheworldpopulationwasabout170millionin2000BC,andthatthisnumberincreasedonlyverygraduallythereafter,reaching254millionby1000AD.Bythelateeighteenthcentury,theglobalpopulationwasapproaching700million,butdidnotreachthefirstbillionuntilthe1830s16.

part two:

16 Source: US Census Bureau

Fig. 8: Going exponential – world population

Population, 2000 BC to 2050 AD (Millions)

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*Sourceofpopulationdata:USCensusBureau



Thereafter,populationgrowthreallytookoff.Whilstithadtakenthousandsofyearstoreachthefirstbillion,thesecondbillionwasachievedinthe1920s–thatis,addingthesecondbilliontookaboutninetyyears.Thethirdbillionwasaddedinthirtyyears,thefourthinlessthantwentyyears,andsoon.Fromthemid-nineteenthcentury,thepopulationgrowthchartturnsintoacharacteristicexponential‘hockey-stick’shape.Thecurrentpopulationtotalisabout6.85bn,andthisisexpectedtoincreaseto7.6bnby2020,and9.3bnby2050,thelatterrepresentinganincreaseofmorethanonethirdfromacurrentnumberwhichhasitselfdoubledsincethelate1960s.

Sincetheearth’sresources–suchasland,foodproductioncapacity,energyand,perhapsmostimportantofall,freshwater–arenotinfinite,itislogicaltowonderwhetherthepopulationtrajectorymightatsome

pointcollidewithaphysicalconstraint,andsomespecialistsbelievethattheearth’s‘carryingcapacity’maybelimited,withestimatesvaryingbetweenperhaps8.5bnand11bn.Thisrangeissuperimposedonfig.8.

Ofcourse,suchconcernsarebynomeansnew,andexperienceoverthelasttwocenturieshasbeenthatfoodproductioncapacityhasexpandedevenmorerapidlythantheglobalpopulation.Optimistswouldthereforemaintainthattherapidexpansionofthepopulationneednotposeaproblem,eveniftheabsoluterateofgrowth(about70millionannually)seemsdaunting.Moreover,optimistscontend,fertilityratesaredroppingaslivingstandardsandlevelsofeducationimprove,suchthattheglobalpopulationmaytopoutatsomewherebetweennineandtenbillionsomewhereinthemiddleofthiscentury.

exponential energy use, finite resources

Unfortunately,thisinterpretationmaybeatoddswithanother,potentiallyunsustainableexponential,whichistherapidexpansionintheglobalconsumptionoffossilfuels,assummarisedinfig.9.Thoughshownonamuchshortertime-scalethanthechartofpopulation,energy usage nevertheless displays a distinctive ‘J-curve’ exponential trajectory.Fig.10makestherelationshipbetweenthetwocurvesexplicit,showinghowbothglobalpopulationandtheconsumptionoffossilfuelshaverisen,intandemandexponentially.Infact,energyconsumptionhasincreasedmore rapidlythanthepopulation,reflectingarisingenergyintensitywhichparallels–again,quiteun-coincidentally–increasinglivingstandards,albeitveryunevenlydistributed.


Fig. 9: The energy exponential*

Global consumption of fossil fuels

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Fig. 10: No coincidence – the population and energy exponentials*

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Therearetwowhollyvalidexplanations–asimpleone,andamorefundamentalversion–whichexplaintherelationshipbetweenpopulationnumbersandtheconsumptionoffossilfuels.Thesimpleexplanationisthatthe ‘green revolution’–thedramaticexpansioninfoodproductionoverthelasttwocenturies–has been almost wholly energy-driven.Acrossthegamutofitsactivities,modernagricultureismassively(andincreasingly)energy-intensive,relyinghugelyonmechanisedplanting,cultivation,processinganddistribution,andonextraneousinputssuchasfertilisersandpesticides.Alloftheseinputsareenergy-dependent(throughextractionanddelivery)evenwhentheyarenotsourceddirectlyfromhydrocarbons.Theabilityoftheearthtofeed6,900millionpeople,wheretwohundredyearsagoitfedlessthan900million,isadirectfunctionoftheavailabilityofenergy-derivedinputs.

Buttheenergy-populationnexusgoesmuchdeeperthanthesimpleenergydependencyofmodernagriculture.Essentially,the entire economy is an energy equation.

Tounderstandthisconcept,weneedtogobacktothemostprimitiveformofhumanexistence,whichwas

thehunter-gatherersystempriortotheinventionofagriculture.Alloftheenergyderivedfromfoodwasconsumedincatchingandfindingthatfood.Therewasnoenergysurplusatanindividualleveland,sinceeverysingleindividual(orfamilyunit)wasfullyengagedintheobtainingoffood,therewasnospecialisation,andnosociety.

Thedevelopmentofagriculture,whichprobablybeganinthe‘fertilecrescent’inabout9,500BC,wasoneofthetwogreateststepsforwardinhumanexistence.Inadditiontoallowingpopulationdensitiestoincreasefromthemaximumofaboutonepersonperkm²underthehunter-gatherersystem,agricultureliberatedsurplusenergy.Thoughnearlyasenergy-intensiveasthehunter-gathererformofexistence,agriculturedeliveredproportionatelymajorimprovementsinenergyefficiencyby(a)utilisingtheenergyofanimals,and(b)harnessingeconomiesofscale.

Essentially,becausethelabouroffourindividualsorfamiliescouldnowsupportfiveindividualsorfamilies,agriculturecreatedthefirst‘energysurplus’.Thisinturnmadepossiblesomeverymodestformsofspecialisation,whichincludedrudimentarystructuresofgovernment

andlawtogetherwithalimitednumberofspecialisttradessuchasmiller,smithandshoemaker.

Progressoverthesubsequentmillenniawasevolutionaryratherthanrevolutionary,withagradualenhancementofagriculturalefficiencydrivingslowincreasesinsocialspecialisationandcomplexity.Societywasstilloverwhelminglyagrarian,andboastedverylittlespecialisation,inthelateeighteenthcentury,whenthesecondgreatstepforwardoccurred–thediscoveryoftheheatengine,initiallyintheformofsteam-powerderivedfromcoal.Thecrucialpointtonoteabouttheharnessingofcoal–andlatterlyofotherfossilfuelssuchasoilandnaturalgas–wasthatthe energy equation altered drastically from the agricultural model.

Agricultureitselfwasmadevastlymoreefficient,initiallythroughtheuseofmotivepowerandlatterlythroughtheintroductionofhydrocarbon-basedfertilisersandpesticides.Withinahundredyearsofthefirstcommercialuseofsteam-power,theproportionofthepopulationsofmostdevelopedcountriesengagedinfarminghadfallentolessthantenpercent.Specialisationhadarrived,courtesyoftheharnessingoftheenergycontainedinfossilfuels.


Theoverwhelminglyimportantpointtograspfromthislightningtourofsocialandeconomicevolutionisthatthere is an essential connection between all forms of energy,whichincludefoodandhumanlabouraswellasexogenousformsofenergysuchasfossilfuels.Thereis,asweshallsee,afurtherdirectlinkagebetweenenergyandthemonetaryeconomy.Beforethat,however,weneedtolookalittlefurtherintotheenergydynamic,bearinginmindthatsocial specialisation and complexity are direct functions of surplus energy.

Whatwouldhappen,then,iftheexponentialprogressionofenergyconsumptionceasedtofunction?Mightspecialisationandsocialcomplexity–andthereforetheeconomyasawhole–unravelandstartgoingbackwardsiftheexponentialenergyequationweretogointoreverse?Afterall,andasweshallseelater,wehavenowbuiltatoweringfinancialsuperstructureontopofanessentiallyenergy-basedsocialandeconomicdynamic.

Someanalystsbelievethatthisunravellingisexactlywhatisinstorefortheeconomyif–orrather,intheiranalysis,when–wehit‘PeakOil’.Thisconcept,pioneeredbyAmericangeologistM.KingHubbert,contendsthat,atsometimeintherelativelynearfuture,wewillhaveconsumedhalf

ofalloriginally-availablereservesofoil.Atthatpoint,Hubbertiansargue,thesupplyofoilwilldecline,inprettymuchamirror-imageoftheincreaseinconsumptionwhichhastakenplacesincethe1850s.Muchthesame,theyargue,willeventuallyhappentosuppliesofnaturalgasandofcoal,withdepletionoftheseresourcesacceleratingasaresultofsubstitutionfromoil.

AdvocatesofthePeakOilthesisarguethatthereisadirecttime-linkagebetweenratesofdiscoveryandsubsequenttrendsinproduction.Forexample,petroleumdiscoveryratesinAmerica’slowerforty-eightstatespeakedin1930,andpeakproductionoccurredfortyyearslater,in1970,sincewhenoutputhasdeclinedrelentlessly.Sincetheglobalpeakdiscoveryrateoccurredinthemid-1960s,itisargued,asimilartime-lagimpliesthatglobalPeakOilisnowimminent.

WhetherornotoneagreeswiththeHubbertianthesis,weareinnodoubtthatthefutureoutlookforfossilfuelavailabilityiscritical,becausetheeconomyis,ultimately,anenergy-drivenconstruct.Arethe‘Peakniks’righttoarguethatwhen,intheverynearfuture,wereachthepointatwhichhalfofoiloriginally-recoverableoilhasbeenproduced,productionmustgointoinevitabledecline?

Thefirstflawinthe‘half-way’argumentisthatitissimplynottrue.TheapplicationoftheHubbertthesisatthistimeimpliesthattheoriginalreservesbasewasoftheorderof2.2tnbbls(trillionbarrels),whereasampleevidenceexiststosuggestthattheoriginally-recoverablereservesbasewasoftheorderof3.0to3.5tnbbls,andpossiblymuchlarger.WhilsttheHubbertiancasehasmeritifitisappliedtoconventionaloil–light,sweetcrudeswhichcanbeextractedrelativelyeasily–itsadherentstendtooverlooktheseeminglyincontrovertibleevidencethathugequantitiesofunconventionaloilsremaintobeextracted.

TheseincludetarsandsinCanada,whichareestimatedatnotlessthan170bnbbls(billionbarrels),shalesintheUS(perhaps800bnbbls),andperhaps350bnbblsofultra-heavycrudesinVenezuela.Theremayindeedbesignificantoverstatementsofreservesinothercountries(andmostnotablyamongstOPECnations,thelegacyofaperiodinwhichproductionquotaswereallocatedpro-ratatoclaimedreserves),buttheoverallpicture,when non-conventionals are included,isoneofacomparativeabundanceofrecoverablereserves.



IfthereservesnumbersareoneweaknessinthePeakOilargument,theotheristheinevitabilitythatasupplysqueezewould,viathepricemechanism,promptverymajorchangesinconsumerbehaviour.Inagovernment-sponsoredanalysisthatessentiallyleanttowardstheconceptofanoilproductionpeak,RobertHirscharguedthatthereisagreatdealthatcanbedonetomitigatetheeconomicimpactofoilshortages,always presupposing that action is taken at least ten years ahead of the event.17Oilscarcitywouldtriggerfundamentalsocialandeconomicchanges,whichincludethereversalofatrendtowardssuburbanisationandareversiontodenserformsofhabitation.Thethirstiestvehicleswouldrapidlybeconsignedtothescrap-heap,andthetransportbalancewouldswingdecisivelyfromprivatecarownershiptowardsgreateruseofpublictransport.

PeakOilisnot,webelieve,anear-ormedium-termthreat,butno-one should be lulled into complacency by seemingly-abundant oil reserves.Rather,theissueisoneofresource constraint,whichislikelytobereflectedindeliverabilityandcostratherthanintheabsoluteavailabilityofproduciblereserves.

AcomparisonbetweenconventionaloilproductioninSaudiArabiaandtarsandsinCanadaillustratesthis

point.GiventhatSaudiproductioncapacityisabout12mmb/d(millionbarrelsperday)fromreservesofsome270bnbbls,onemight,onasimplepro-ratabasis,expect170bnbblsofCanadianoilsandsreservestoproduceperhaps7mmb/d.Buttherealityisthatoutputismostunlikelytoreacheven3.5mmb/d.DeliverabilityfromtheCanadianresource,will,then,belessthanhalfofthatattainedfromconventionalreservesinSaudiArabia.

Essentially,oilreserveshavebeencherry-picked,withthecheapest,highest-qualityandmostaccessibleresourcesexploitedfirst.Thismeansthatproductionlevelsmighthitaceilingintherelativelynearfutureevenifreservesremainsubstantial.Italsoneedstoberememberedthatnetchangesinoutputrepresentatwo-pieceequation–substantialnewsourcesareneededeachyearsimplytoreplacenaturaldeclinesfromalready-producingfields.Astheindustrymovesfromhigher-tolower-deliverabilityfields,maintenanceofexistingproductionlevels,letalonegrowth,becomesevermoredifficult.Furtherimplicationsnaturallyincludehighercostsandgreaterrisks,astheexplorationanddevelopmentfocusswingstowardsreservesinevermoretechnically-challenginglocations.

AccordingtoOPEC,globalconsumptionofoilislikelytoriseto108mmb/dby2030,a27%increasefromthe

outturnin2009(84mmb/d)18.Wearebynomeansconvincedthatthisisachievable,withourresearchincliningustoagreewithM.ChristophedeMargerie,CEOofTotal,whohasquestionedtheabilityoftheindustrytoexceed100mmb/d19.Withinaprojected24mmb/dincreaseinsupply,itisassumedthatnolessthan16.9mmb/dwillcomefromOPECcountries,butanetincreaseofthismagnitudemightbedifficulttoachievegiventhatSaudiAramconowadmitsthatitisinjecting13mmb/doftreatedseawater,mostofittosustainproductionatitsgiant(butageing)AlGhawarfield,historicallythesourceofabouthalfofthekingdom’sproduction.20

Anotherwaytolookatthedeliverabilityissueisthatreservesneedtobequality-weighted.Wemayhaveusedupmuchlessthanhalfoftheworld’soriginally-recoverablereservesofoil,butwehave,necessarily,resortedfirsttothosereserveswhicharemostreadilyandcheaplyrecovered.Thereservesthatremainarecertaintobemoredifficultandcostliertoextract.

Andthisissueofqualityweightinglinksdirectlytothekeydeterminant,whichisnotvolumeintheabsolutebut,rather,the relationship between energy produced and energy consumed in the production process.Althoughtheemergenceofresourcescarcityislikelytotriggerbigincreases

17 See Robert Hirsch et al, Peaking of World Oil Production: Impacts, Mitigation, and Risk Management18 www.opec.org/home/

All figures used here exclude processing effects


indollaroilprices,price-basedanalysisisinadequateinthiscontext–wecanalwaysprintdollars,buttherealissuesherearehardphysicalconstraints.Thesameistrueofsupposedsubstitutesforoil,suchasbiofuels.Aneffectiveassessmentofthefutureoutlookforenergyinputsneedstobecalibratedintermsofanenergyratherthanamonetaryequation.

Itisevidentthatweneedanewparadigmifwearetointerpretenergyconstraintinaneconomyofexponentials.Theappropriateenergy-basedequationalreadyexists,andisknownasEROEI(energyreturnonenergyinvested).Thetheoryof

EROEIisextremelysimple,butitsapplicationiscomplicated.Thebasicrequirementisthattheamountofenergyextractedshouldbedividedbytheamountofenergyinvolvedinextractingit.Theproblemhereishowfarthecalculationshouldbecarriedbackupthesupplychain.

Ourbeliefisthatthe lack of a consistent basis of EROEI calculation is a huge flaw in our understanding of economics.Indeed,wethinkthatthelackofadefinitiveandstandardisedEROEImethodologyisthe greatest single shortcominginthewayinwhicheconomictrendsareinterpreted.

Notwithstandingthelackofaccuratecalibration,wecandevelopanapproximationoftheEROEIlandscape,andthiscanbestbedepictedintheformofa‘cliffchart’(fig.11).Thehorizontalandverticalaxesarelinked–thehorizontalaxisiscalibratedtoEROEIasamultiple,whilsttheverticalaxisexpressesthesamecalculationbydividingenergyoutputintopercentagesof‘cost’(energyin)and‘profit’(thesurplusofenergyoutminusenergyin).

19 As reported in the Financial Times, www.ft.com/cms/s/0/1d725e64-c8d2-11de-8f9d-00144feabdc0.html20 See www.saudiaramco.com/irj/portal/anonymous?favlnk=%2FSaudiAramcoPublic%2Fdocs%2FOur+

Business%2FOil+Operations%2FProduction+Facilities%2FWater+Injection&ln=en Until quite recently, the figure cited was only 7 mmb/d

Fig. 11: Going off a cliff? Energy return on energy invested



Thegeneralpatternwhichemergesfromthisapproachishighlyinstructive.Withintheoilindustryitself,EROEIsaredeterioratingaseasy-accesssourcesdepleteandarereplacedbyevermorechallengingalternatives.Althoughthecliffchartisnottime-linear,thebroaderenergypictureshowssteadymovementfromlefttorightalongtheEROEIcurve,with newer sources of energy delivering ever lower returns.AtEROEIsoflessthanabout15,theenergyreturnsequationdropsoffacliff,andtheoverallaverageisclearlyworseningastraditionalhigh-returnssourcesaredisplacedbyresourceswhichoffersuccessivelylowerEROEIs.Tarsands,oilshalesandbiofuelsareonthelow-returnsendoftheequation.Aneconomycharacterisedbyever-worseningEROEIsiscertaintobeavastlyweakergeneratorofvalue,anditsabilitytosustaincurrentsocialcomplexitywouldbe,atbest,debateable.

SlippagealongtheEROEIcurve–andnotthesimpleissueof‘runningoutofoil’,assomefear–istheclearandpresentthreattoaneconomybasedondangerouslyenergy-dependentexponentials.Tounderstandhowthisprocessmightmanifestitself,weneedtoexaminethesecondcategoryofexponentialprogressions,whichisthetoweringsuperstructureoffinancialsystemswhichhasbeenconstructedontopofanessentiallyenergy-driveneconomicequation.

exponential money, escalating debt

InDangerous Exponentials,weexplainedtheexponentialnatureofthefinancialsysteminconsiderabledepth.Inthecontextofthisreport,therearetwokeypointswhichneedtoappreciated.Thefirstoftheseisthatthefinancialsystemisasuperstructurebuiltuponanenergyequation,andthatthedevelopmentoffinancialexponentialshasdevelopedintandemwithexponentialexploitationofexogenousenergy.Thesecondisthat the financial system itself has developed exponential characteristics which look increasingly unsustainable.

Thehistoryofmoney–asamediumofexchangeandastoreofvalue–beginsmillenniabeforetheIndustrialRevolution,andmoneyinpre-industrialtimeswasinessenceaclaimonhumanlabour.Moneywas,ofcourse,usedinpaymentforwork,andthosethingswhichcouldbepurchasedwithitwerealltheproductsofhumanlaboureitherinthepast,thepresentorthefuture.Thefundamentalnatureofmoneyasaclaimonlabourremainedtrueaftertheharnessingofexogenousenergy,thebigdifferencebeingthatenergy drastically leveraged the quantum of labour.

Toappreciatethispoint,thereaderneedonlyputonegallonoffuelinhisorhercar,driveituntilthefuelrunsout,andthenpaysomeonetopushthecarbacktothestart-point.ChrisMartensonhascalculatedthat,at


thefar-from-generousrateof$15perhour,thiswouldcost$7,50021.Sinceagallonofgasolinecanbepurchasedforabout$3,itisclearthattheabundanceofexogenousenergyhasmassivelyleveragedtheeconomyinrelationtohumanlabour.Asafurtherexample,onecanenvisagetryingtopowerdomesticappliancesusingdynamoslinkedtoexercisebicyclespropelledbyemployees.The energy used in a typical modern home equates to the full-time labour of perhaps a hundred people.Sooureconomicsystemismassivelyleveragedbyexogenousenergy,thekeypartofthewholeequationbeingtherelationshipbetweenenergyextractedandtheenergyconsumedintheextractionprocess.

Inotherwords,the economy is a function of surplus energy, and money is the medium with which this energy surplus is quantified.Fromitsoriginsasaclaimonhumanenergy(intheformoflabour),money has become a claim on energy,past,presentorfuture.Atthesametime,debtisbydefinitiona claim on future money.Sothe ultimate nature of debt is that it is a claim on future energy.Adebt-drivensystemisthusviableif–andonlyif–theenergyofthefutureissufficienttomeettheclaimsthatexistonit.Andthepaymentofinterestinturnrequiresthatthemoney(thatis,theenergy-claim)ofthefuturehastobegreaterthanitistoday.Thebignuancetothisequationisinflation,a

processbywhichtherealvalueofmoney–andhencethevalueofdebtasaclaimonfutureenergy–isdiminished.

Asfig.12shows,inflationhastakenonitsownexponentialtrajectory.ThroughmuchofAmericanhistory,inflationwasminimal,withinflationaryspikes(causedbyconflictssuchastheWarofIndependence,theWarof1812andtheCivilWar)reversedduringyearsofpeace.Inperiodsofwar,thegovernmenttendedtoprintmoneytomeetcostswhichfarexceededavailablebudgets,butthegoldlinkagealwayscausedapost-warreversiontosomethingclosetopre-warvalues.

21 See Chris Martenson, Crash Course

Fig. 12: The destruction of value – the history of US inflation

US RPI index, 1666 = 100

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Thefirstbigbreakfromreliablegoldlinkageoccurredin1933,whenPresidentRooseveltconfiscatedallprivately-ownedgoldintheUnitedStates.Americanscouldbuytheirgoldback,butatapriceof$35/oz,significantlyhigherthanthe$21/ozpaidtothemincompensation.Thisamountedtoaone-offinflationaryburstand,althoughitsimmediateinflationaryeffectwascancelledoutbythegeneraldeflationaryconditionsoftheperiod,itisneverthelessa striking example of the use of inflation to devalue outstanding debts.Atthesametime,MrRooseveltalsounilaterallycancelledallgovernment

obligationspayableingold.Thougharguablynecessary,thesemovesshowedapreparednesstoplaceexpediencyfirmlyaheadofprinciple.

Thiswasfollowed,inthepost-waryears,bytheremovalofthegoldstandardbyRichardNixonin1971.Asfig.12shows,thisopenedthefloodgatesforamassivedepreciationinthepurchasingpowerofthedollar,whichhaslostmorethan80%ofitsvalueovertheinterveningfourdecades.Forourpurposes,however,thekeypointtonoteisthatinflation has taken on unmistakeably exponential characteristics.

Inflationisbynomeanstheonlyfinancialexampleofexponentialprogressions.Indeed,theentirefinancialsystemhasexponentialcharacteristics,ascanbeseenfromthechartsofAmericanM3moneysupply(fig.13)andFederaldebt(fig.14).TheauthoritiesceasedpublishingM3datain2006–justwhenitmighthavealertedinvestorstothesheerscaleofthefinancialbubblewhichwasthendeveloping–butJohnWilliamsofShadowstatshascontinuedtocalculateandpublishit.Thoughnowinretreat(becauseAmericaisgrippedbyanessentiallydeleveragingrecession),thechartof

Fig. 13: Exponential money – US M3 since 1959*

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M3neverthelessrevealsadistinctivelyexponentialprogression,albeitonethatnowseemstohavehitthebuffers.

Expansionsinthemoneysupplyare,clearly,partoftheexponentialsequation,andmonetaristtheory,aschampionedbyMiltonFriedman,arguesthat,iftherateofexpansioninthemoneysupplybecomesexcessive,theinevitableresultisinflation.Ofthe3,800orsopapercurrencieswhichhavegoneintothedustbinoffinancialhistory,almostallhavebeendestroyedbyhyperinflationwhichwasitselftriggeredbyexcessivegrowthinthesupplyofmoney.

“ The economy is a function of surplus energy, and money is the medium with which this energy surplus is quantified”.



Fig. 14: Exponential government – US Federal debt since 1791*

Federal debt, 1791-2009 (trillions of dollars)

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Historically,destructiveinflationhasbeenaccomplishedbythe‘printing’ofmoney,aprocessofwhichWeimarGermanyandmodern-dayZimbabwearejusttwoexamplesamongverymany.Sincethefinancialcrisisof2008-09,theprintingofmoneyhasreturnedintheformof‘quantitativeeasing’(QE).IntheUS,QEhasboostedthemoneysupplybysome$1.2trillion,whilsttheBankofEnglandhasinjected£200bnthroughQE.MoreQEcanbeexpected,atleastintheUS.

Willprintingmoney–forwhichQEisaeuphemism–leadtoatake-offininflation?Accordingtoclassicalmonetaristtheory,thisisexactlywhatshouldhappen,becauseanincreaseinthemoneysupply,ifitoccurswithoutacorrespondingincreaseintheoutputofgoodsandservices,necessarilycreatesinflation.

Fortunately,conventionalmonetaristtheoriesaresomewhatoversimplified,becausetheyleaveanimportantitemoutoftheequation.Thisomitteditemisthevelocityofmoney–inotherwords,therapiditywithwhichmoneyisspent.Whereinflationarypressuresareconcerned,the‘effectivemoneysupply’canbedefinednotsimplyas

thestockofmoneybut,rather,asthecombinationofthequantityofmoneyandthe velocity with which it circulates.

Intheimmediateaftermathofthecrisisof2008,thevelocityofmoneydroppeddramatically.Notsurprisingly,fearanduncertaintypromptedbanks,businessesandindividualstohoardtheircashholdings.Atthesametime,theusualprocessofcreditcreationreversed,andbecameaprocessofcreditdestruction.Optimistically,therefore,QEcanberegardedasanappropriateexpansionofthequantityofmoneyinordertooffsetarapiddeteriorationinitsvelocity.

However,thequantity-velocityinterpretationofthemoneysupplycanprovideonlyshort-termreassurancewhereQEisconcernedbecause,assoonastheeconomybeginstorecover,itwillbecomeimperativethattheearlierprocessofQEisreversed.Otherwise,arecoveryinvelocitywillcombinewithanexpandedstockofmoneytoboostthe‘effectivemoneysupply’,andthistrulywouldleadtohighinflation.Giventhatinflationreallyamountstoadevaluationofmoney,aninflationaryprocesspromptedbyafailureto

reverseQEwouldraiselegitimateinvestorconcernsaboutthefuturevalueofsterlingandthedollar,thecurrenciesmostaffectedbyQE.

SoQEonlyrepresentsaninflationarythreatifitisnotreversed.Butis the reversal of QE a realistic possibility?Weverymuchdoubtit,notleastbecauseitwouldgreatlyexacerbatebudgetarystrains.Thetemptation,surely,willbetoleavetheQEexpansioninplace,oreventoaddtoit,intheknowledgethatinflationisprobablytheonlywayoutofthedebtbindinwhichmostwesterneconomiesnowfindthemselves.So,inanswertothequestion‘willQEsparkveryhighinflation?’,theshortansweris‘almostcertainlyyes’.

Forheavilyindebtedgovernments,asweshallsee,therenowexistsanalmostirresistibletemptationtodestroyoutstandingdebtthroughinflation,thoughthisislikelytobepursuedinafairlycovertway.Theimperativecanbeseeninthesheerscaleofgovernmentdebt.



Whilsttherehavebeensignificantcontractionsinprivateindebtedness,therehasbeennosimilarreversalsinpublicdebt.Asfig.14shows,USFederaldebtisanotherextremelydistinctiveexponential.Whenconsideringtheexponentialtrajectoriesofinflation,themoneysupplyanddebt,weneedtobearinmindthattheseareallaspectsofasingleexponential,andshowan out-of-control propensity for living on printed money and accumulated debt.

Wheregovernmentindebtednessisconcerned,theUSisbynomeansalone,eitherintheexponentialtrendofborrowingsorintheexistenceofdisguisedaswellasdisclosedindebtedness.AstheBankforInternationalSettlements(BIS)explainedinarecentreport,thesovereigndebtsofmostOECDcountriesareindangerofturningintoexponentialtrajectories,becauseofacombinationofstructuraldeficitsanddemographicchange22.

Wheretheexponentialexpansionofpublicdebtisconcerned,twoprocesseshaveaccelerateddebtaccumulationsince2008.Thefirstoftheseis‘toxicassettransference’,aprocesswherebythestate,inanefforttostaveoffasystemiccollapseofthebanking

system,takesovertheburdenofdebtsirresponsiblycreatedduringthebubble-buildingphase.Thisisbynomeansanewphenomenon–ithappened,forexample,duringtheSavingsandLoan(S&L)crisisofthe1980sand1990s–butthetransferencewhichhasoccurredinrecentyearsdwarfsallprevioussuchepisodes.

Laterinthisreport,weshalllookathowadebt-expanding,sequentialbubbleprocesshascomeintoexistence,howverylittlehasbeendoneaboutit,andhowdiretheconsequencescouldbeifthisstructuralweaknessisnotaddressed.Forourpurposeinthischapter–whichistoreviewtheessentiallyexponentialnatureoftheeconomy–itissufficienttonotethatallformsofdebtareexpandingexponentially.ThisisastrueofaggregateAmericanindebtedness(fig.17)asitisofFederaldebt,withsimilarexponentialphenomenaevidentacrosstheOECDeconomies.

Withtheconceptofexponentialeconomicsnowunderstood,wecanmoveontolookatwhentheunsustainablenatureofthismightimpactthesystem,andhowwemightrecogniseitwhenithappens.

22 See The Bank for International Settlements, The future of public debt: prospects and implications, BIS Working Papers No. 300, March 2010, and Tullett Prebon

Strategy Notes, issue six, Out of Control, May 2010


Fig. 15: Exponential debt risk – the US*

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*Sourceforfigs.15and16:The future of public debt: prospects and implications,BISWorkingPapersNo.300,March2010

Fig. 16: Exponential debt risk – the UK*

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Fig. 17: Deep in the hole – US debt, 1945-2010*

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*Source:FederalReserve,www.federalreserve.gov/releases/z1/current/z1.pdf.Latestdata:2Q2010


“There are three kinds of lies: lies, damned lies and statistics”.

Benjamin Disraeli



smoke and mirrorsa denouement disguised

• Inmostwalksoflife,deferential,unquestioningacceptanceofgovernmentpronouncementsisathingofthepast,andinvestors,inparticular,customarilyexercisehealthyscepticism.Itisstrikinglyanomalous,therefore,thatinvestorstendtoacceptgovernmentmacroeconomicdataatfacevalue.

• Therealityisthatmuchgovernmentdataisextremelyunreliable.Ahistoryofincremental‘adjustment’hasdistortedmanymeasures–suchasunemployment,inflation,growth,deficitsanddebt–tothepointwherethestatisticalpictureisdrasticallydifferentfromtheunderlyingeconomicreality.

• FocusingontheUS,weexplainandstripawaythreedecadesof‘Pollyannacreep’torevealaneconomywhichisverymuchweakerthanisgenerallysupposed.Unemployment,reportedat9.7%,mayactuallyexceed21%.Inflation,saidtobeatnear-zerolevels,isabove7%.Growthoverthelastdecadehasbeennegative.Debtisoutofcontrol.

Asoutlinedearlier,webelievethattheglobaleconomyisfirmlyinthetalonsofanexponentialsprocesswhichwill,induecourse,putthecurrenteconomicsysteminjeopardy.Essentially,exponentials-based

analysisshowsthattheeconomyfacestwodistinctthreats–athreatfrominternalcontradictions(becauseexponentialfinancialprogressionsmaybecomeunsustainable),andathreatfromaworseningintheenergyequation(asaneconomicmodelwhichreliesupongrowthcollideswiththerealitiesofafiniteresourceset).

Aquestionwhichnaturallyarisesatthispointisthis–‘howwillwerecognisethedenouementprocesswhenitbeginstohappen?’Thenaiveanswertothisquestionwouldbethattheunravellingofthesystemwillbecomeapparentinheadlinemacroeconomicnumbers.Butthisanswerwouldbecorrectif–andonlyif–twoessentialpre-conditionsbothapplied.Thefirstofthesevitalpre-conditionsisthatinvestorsarewatchingtherightheadlinenumbers.Thesecond(andevenmoreimperative)pre-conditionisthatthedatathatinvestorsarewatchingisaccurate.

Infact,neither pre-condition applies.Thoughhabituallyscepticalinmostotherareasoftheiractivities,investorsdisplayanalmostchildliketrustandnaivetéwhereofficialdataisconcerned.Theyplaceimplicitfaithinthevalidityofofficialstatistics.Thealmostuniversalassumption–whichisthat‘thesefiguresmustbeaccurate,becausetheycomefrom

thegovernment’–revealsahugelymisplacedfaithinthequalityofofficialdata.

Giventhat–asweshallsee–public faith in the accuracy of official data is very seriously misplaced,twocoursesofactionareessential.First,weshouldlookatthe‘structuralcontext’–ingeneralterms,whatistheeconomicenvironmenttellingus,anddoesitaccordwithofficialdata?Second,andmoreobviously,canweaccessandinterpretamoreaccuratestatisticalpictureofwhatisreallyhappeningtotheeconomy?

The‘structuralcontext’issurelyextremelycautionary.Forastart,themacroenvironmentischaracterisedbyaveryobvious“monetaryratchet”.Asremarkedearlier,thishasbeendescribedbyThe Economistasaprocessinwhich“lowerinterestratesleadstomoredebt,whichleadstoassetbubbles,whichthenpop;whentheypop,authoritiescutratesagainandthewholecyclestartsagain.Thisprocesshasreacheditslogicalconclusionwithratesatzero.TheauthoritieshaverespondedbyresortingtoQE,moneyprinting.Thishasnotresultedinhighinflation(yet)becausethevelocityofmoneyhascollapsed(ifyoulike,themoneyhasbeenhoarded)”23.

part three:

23 ‘Energy In, Energy Out’, The Economist, 9th June 2010 www.economist.com/blogs/buttonwood/2010/06/economic_growth_money_supply_and_energy



Whenaprocessasfundamentalasa“monetaryratchet”reaches“itslogicalconclusion”,investorsneedtoposetwoquestions–‘why has this happened?’and‘what comes next?’.Ouranswertothe‘why’questionaboutthemonetaryratchetisthatthe‘implicitgrowth’systemhascollidedwithitsintrinsiccontradictions.Asto‘whatcomesnext?’,ourbeliefisthat,atleastwheretheWesterneconomiesareconcerned,an exponentials-based economic system is unravelling.Moreover,webelievethatthesystemhasbeenunravellingforatleastadecade.

misplaced faith

Despitethefinancialcrisisof2008-09,thewidespreadperceptionseemstobeoneof‘businessasusual’–thatcatastrophehaseitherbeenavertedoratleastdelayed,andthattheresilienceofthesystemhasbeenprovenunderextremestress.Thebankingsystemdidnot,afterall,collapseintheautumnof2008.Althougheconomicoutputhasfallen,thedeclinehasbeenbynomeansassevereasitwasduringtheGreatDepression.Neitheremploymentnorlivingstandardshavecrateredastheydidinthe1930s.Whilstmanyinvestorsacceptthepossibilityeitherofa‘double-dip’recessionorofanextendedperiodofflat-lining,theoverwhelmingperceptionisthatthe

fall-outfromthebankingcrisishasbeencomparativelymodest,andthateconomicgrowthhasresumed,albeitatasubduedrate.

Evenbeforewegointothereliability(orotherwise)ofthedatauponwhichsuchcomfortingconclusionsarebased,therearesurelyatleasttwohighlycautionaryindicators.First,debt–bothformalandinformal–hasescalated,andcontinuestodoso,inmannerwhichlooksverylikeavortexprocess,andfromwhichthereisnoobviousexitrouteinsight.Theimplication,therefore,isthattheeconomyisproceedingontheassumptionthatwecancontinuetopileadditionalobligationsontofuturegenerationsad infinitum.Anysuchassumptionisillogical,asalimitmustbereached(indeed,webelievethatithasbeenreachedalready).Second,itissurelyobviousthatcontinuousprogressionissurelyimpossibleifthemonetaryratchethasindeedalreadyreached“itslogicalconclusion”.At that point, something new has to happen.

Theconclusionssuggestedhereareasfollows:

• Ifwelookbehindtheofficialdata,wecanperceiveareality-setwhichaccordsmuchmorecloselywiththesubjectiveindicatorsprovidedbythe

out-of-controlaccumulationofforwardobligationsandbythecompletionofthemonetaryratchetprocess.

• Thoughtheexacttimingoftheprocessisneitherpossiblenoressential,theprobabilityisthattheWesterneconomicsystemcollidedwithitsinternalcontradictionsnolaterthantheendofthe1990s.

• Whathasbeenhappeningsincethenistheincreasinglyunsustainablecontinuationofthesystemthroughintrinsicallytime-limitedexpedients,ofwhichbyfarthemostimportant,unsustainableanddangerousistheaccumulationofevergreaterformalandinformalindebtedness.

official data, underlying reality

Torelatethisinterpretationtoseemingly-comfortingofficialdata,weneedtolookathowreliablethatdatais.Weconcludethat,sincethisdataisnotreliable,anycomfortwhichinvestorsorpolicymakersderivefromitisdangerouslymisplaced.Oncewehaveexposedthestructuralinaccuraciesofofficialmacroeconomicnumbers,wethenneed,asamatterofurgency,toaccessanalternativedatasetwhichshowsusthetruepicture.

24 Total credit market debt25 Kevin Phillips is one of America’s most respected political analysts. As a young strategist working for

Richard Nixon, he published The Emerging Republican Consensus, which correctly predicted the benefits which the party could reap from the swing in America’s centre of economic gravity away from the industrial

north-east towards the “Sun Belt” States of the south and west. Recent seminal works by Mr Phillips include American Theocracy and Bad Money


Thisexercise,summarisedhere,revealssomeextraordinarilystarkandworryingconclusions.Forastart,theUSeconomy,farfromhavinggrownbytwo-thirdsinrealtermssince1990,hasactuallybeenflat,atbest,overthatperiod,withthetrendinrealoutputworseningsince2000(seefig.6inpartoneofthisreport).Second,Americaninflationhas,formorethanadecade,beenunderstatedintheheadlinenumbersbyatleastsixpercentagepoints,whichsupportsourconclusionthat,incontrasttothelargelydelusionalthreatofdeflation,therealforwardriskliesinverymuchhigherinflation.

Third,andinstarkcontrasttotheofficially-reported$7.8trillion,thetruescaleofFederalobligationsstandsataneye-watering$69trillion.Likewise,thefiscaldeficit,at$1,417billion,dramaticallyunderstatestherealrateatwhichformalandinformalobligationsareaccumulating.Fourth,USunemployment,currentlyquotedat9.7%(ontheU-3definition),mayactuallyexceed21%oftheworkforce.

Allofthis,ofcourse,isin additiontoknownaggregateformalAmericanindebtedness24which,at350%ofGDP,iscompletelywithoutprecedent.

Inthissectionofourreport,theemphasisisplacedoverwhelminglyonthestatisticaldistortionofadireeconomicstatusandoutlookintheUnitedStates.Thisbeingthecase,wecannotemphasisetoostronglythattheUSisnottheworst(andismostcertainlynottheonly)exampleofunderlyingweaknessesbeingmaskedbyunreliableofficialdata.

ThefocusisplacedontheUSherefortworeasons.First,AmericanfigurescanbeunmaskedbecauseofthesheerqualityoftheeconomicdebateintheUS,inwhichtheunreliabilityofofficialdatahasbeenunmaskedbytheeffortsofanalystssuchasKevinPhillips25,ChrisMartenson26and,aboveall,JohnWilliams27.

26 Chris Martenson is the author of the eye-opening Crash Course, which was mentioned extensively in Tullett Prebon Strategy Insights, issue five, Dangerous Exponentials, May 2010

27 John Williams’ Shadow Government Statistics (Shadowstats.com) is the source for data which looks beyond the distorted data supplied by American government agencies. We regard Mr Williams’ subscription service as the imperative source for anyone wishing to understand the real state of the American economy



28 As measured by 2009 GDP. Source: CIA World Factbook29 The term ‘Pollyanna’, meaning resolute optimism in the face of the facts, derives

from Pollyanna: The First Glad Book, by Eleanor H. Porter (1868-1920) 30 Kevin Phillips, Harper’s Magazine, 1st May 2008


Second,andwhilstAmericaisbynomeanstheonlyWesterncountryinwhicha‘denouementcrisis’ismaskedbyunreliabledata,itisbyfarthemostimportant,intermsbothofsheerscale(theUSaccountsfor25%oftheglobaleconomy28)andasthestandard-bearerforthedominant‘Anglo-Americaneconomicmodel’,alaissez-fairesystemwhichisalsoknownas‘TheWashingtonConsensus’.Clearly,any emergence of an ‘exponentials denouement’ in the United States would have hugely far-reaching implications for the global economy.

‘Pollyanna creep’29

Asweexplainhere,theinvestorcannolongerrelyontheaccuracyofabroadswatheofAmericanofficialeconomicdata.Here,weexaminethisprocess,lookinginturnatinflation,growth,grossdomesticproduct(GDP),debtandthedeficit.Butitisimportanttoemphasisefromtheoutsetthattherevelationofthedistortionprocessdoesnotunmaskanykindofgrandconspiracy.Rather,thedistortionofUSofficialdatahasbeenapiecemeal,

incrementalandbipartisanprocess.AsKevinPhillipshasputit,“thedeceptionarosegradually,atnostagestemmingfromanyconcertedorcynicalscheme.Therewasnograndconspiracy,justaccumulatingopportunisms”30.

Thefirstsetoffigurestofallvictimtothedistortionprocesswasunemployment,which,earlyinthepresidencyofJohnF.Kennedy,wasinconvenientlyhigh,andmarredthe“Camelot-on-the-Potomac”31imagethattheKennedyteamwishedtoportray.Henceforward,unemployedAmericanswhohadgivenuplookingforworkwouldbeclassifiedas“discouragedworkers”andexcludedfromtheunemploymentstatistics.Kennedy’ssuccessor,LyndonJohnson,mayhavesupervisedand‘fine-tuned’GNP32numbersbeforetheirpublication,andhecertainlyintroducedthe“unifiedbudget”,whichcombinedSocialSecurity33datawithbroaderFederalnumbers.Thelattermovewassignificant,becausetheinclusionoftheSocialSecuritysurplushas,since1969,improvedtheapparentstandingoftheoverallbudget.

Asmightbeexpected,Richard‘TrickyDickey’Nixonwasnotabovetinkeringwitheconomicdata.Heproposedthatgovernmentshouldchoosebetweenseasonally-adjustedandnon-adjustedunemploymentnumbersonamonth-by-monthbasis,publishingwhicheverhappenedtobetheloweratthetime.Althoughthisblatantpieceoffinaglingwasopposedsuccessfully,MrNixondidsucceedincreatingtheconceptof“coreinflation”,fromwhichthefastest-risingpricecategoriesoftheperiod–energyandfood–wereexcludedtocreateanumberwhichhasbeendescribedas“inflationex-inflation”.Byusingthiscorenumber,governmentshaveatvarioustimesbeenabletoclaimthatinflationislowevenwhenconsumersareexperiencingveryrapidincreasesinthecostofliving.

31 Kevin Phillips, Harper’s Magazine, op cit32 Gross National Product, a measure of output which was used until 1991, when government

opted for the more flattering GDP measure instead33 In the United States, Social Security refers to the Federal Old-Age, Survivors,

and Disability Insurance (OASDI) program



UnderRonaldReagan,theprocessof“Pollyannacreep”continuedwhenthegovernmentdecidedthat,likeenergyandfood,therisingcostofhousing,too,wasbiasinginflationupwards.Consequently,from1983,“owner-equivalentrent”wasintroducedinsteadoftheactualcostofhousing.Essentially,theBureauofLaborStatistics(BLS)wouldhenceforthcalculate,insteadofactualhousingcosts,therentthatahomeownermightpayifheorsherentedapropertywhichtheyactuallyowned.Asweshallsee,thisdubiousmethodologyisstillusedtoday,andimpactsGDP(asan“imputation”)aswellasdistortingthemeasurementofCPI.Becauselowreportedinflationhelpsinfluenceinterestratepolicies,itcanbearguedthattheunder-reportingofCPIcontributedtoalowinterestrateenvironmentwhichinturnfosteredanartificialpropertypriceboomwhichcontributedverysignificantlytothesavings-and-loan(S&L)34andjunkbondscandalsoftheera.

UnderGeorgeH.W.Bush,itwasdecidedthateconomicdatashouldberedesignedtoshiftreportingawayfromoldindustrial-eramethodologiestowardsamoremodern,service-basedeconomicpattern.Whatevertherealmotivation,theresult,whenimplementedbytheClinton

administration,wasafurtherreductioninreportedCPIinflation,oneeffectofwhichwasareductionintheannualincreasesreceivedbyrecipientsofSocialSecurity.Clinton’sgovernmentalsofurtherunderminedthereliabilityofunemploymentdata,as“discouragedworkers”–ofwhomtherewereaboutfourmillion–wouldhenceforthberemovedentirelyfromthelargerworkforce.Samplingsizeswerereducedfrom60,000householdsto50,000.Sinceadisproportionatenumberofthedroppedhouseholdswerelocatedininnercities,thischangemayhaveresultedintheunder-reportingofunemploymentamongstblackAmericans.

FewfurtherchangeswereintroducedbyunderGeorgeW.Bush(whowasperhapstoobusyfightingunwinnablewars).Intheeconomicsphere,policybunglinginthisperiodwaslargelylefttotheFederalReserve,whoseinterestratepoliciescontributedtothespectacularboom-bustrollercoasterinrealestatemarkets.Anew“experimental”CPIcalculation(C-CPI-U)wasintroduced,whichfurtherreducedreportedinflation.From2006,thegovernmentceasedpublicationofM3moneysupplydata,whichwasbeginningtorevealthedangerousnatureofthebanklendingbubble.

Asaresultofthisconvolutedandincrementalprocess,inflation,unemployment,deficitsanddebtareroutinelyunder-reported,whilstbothgrowthandabsoluteGDPareover-stated.BeforeconsideringtherealnatureofanAmericaneconomymaskedbymisleadingdata,weneedtolookmorecloselyatreportingdistortion,startingwithinflation.

inflation – the cost of living, or the price of survival?

Withthepossibleexceptionofdebt,noothermacroeconomicindicatorisasimportantasinflation.Ineverydaylife,inflationdetermineshowwellaperson’sincomekeepsupwiththecostofliving.Thecalculationofrealeconomicgrowthisafunctionofthereverseinflator35appliedtomeasuresofnationaloutputsuchasGDP.Inflationdeterminesgrowthnotjustinnationaloutputbutintherealprofitabilityofcompanies,andisthusofgreatimportancetoinvestors.Therelationshipbetweeninterestratesandinflationdeterminestherealreturnonsavings.Inflationmeasuresareingeneraluseinthecalculationofwagesettlementsingovernmentandindustry.Inflationcalculationsinformrateofreturnsassessmentsonmajorcapitalprojects.Andthepaymentsmadeunderwelfareprogrammes(such

34 S&Ls are the American name for institutions also known as ‘thrifts’ and, in the UK, ‘Building Societies’

35 The GDP deflator


asSocialSecurityintheUS)aresetinrelationtoofficialstatementsofinflation.

TheinflationmeasuremostcommonlyusedinAmericaistheConsumerPriceIndex(CPI),whichiscalculatedandpublishedbytheBLS.TheBLSactuallypublishesthreeprincipalCPImeasures,butthemostcommonlyusedisCPI-U(theconsumerpriceindexforurbanconsumers).CPIhasalonghistory–butwhetheritsmorerecenthistoryisalsoanhonourableoneisopentoverysignificantdoubt.

TheoriginsofCPIcanbetracedbacktothe1880s,whentheBureauofLabour–thepredecessoroftheBLS–usedittocalculatetheeffectsoftariffs.DuringtheFirstWorldWar,itwasusedtodeterminewageratesinshipyards.Thoughpublishedregularlyfrom1921,CPIdidnotbecomeawidespreadtoolofmeasurementuntilaftertheSecondWorldWar,whenitbecameanintegralpartofwagesettlementsbetweenemployersandunions.ItsusehaslongsincespreadintoagamutofcommercialcontractsaswellasintosuchmainstreameconomicindicatorsasgrowthinrealGDP.

Atvarioustimes,inflationhasdestroyedpapercurrenciessuchastheWeimarmarkandtheZimbabwean

dollar.Infact,morethan3,800differentpapercurrencieshavebeendestroyedbyhyperinflation,affectedcountrieshavingincludedArgentina,Austria,Brazil,China,Greece,Hungary,Japan,Poland,RussiaandYugoslaviaaswellasinter-warGermanyandmodern-dayZimbabwe.Ifwegobackfarenoughintohistory,eventheUnitedStateshasnotbeenimmune,asrapidinflation(exacerbatedbyBritishcounterfeiting)destroyedAmerica’sfirstpapercurrency,the“continental”,duringtheWarofIndependence,whilstmuchthesamethinghappenedtothecurrencyoftheConfederacyduringtheCivilWar.EconomistsmaydisputeMiltonFriedman’sfamousobservationthat“inflationisalwaysandeverywhereamonetaryphenomenon”36,buttherecanbenodoubtthatacurrencycanbedestroyedifhyperinflationisletloosebytheexcessivecreationofmoney.

ThelasttimethatmajorWesterneconomieswerethreatenedbyrapidinflationwasinthe1970s,whentwosuccessiveoilcrisesdroveannualinflationwellintodoubledigits.Thehighinflationofthe1970swasdrivenoutofthesystem,successfullybutathugecost,byresoluteactionbycentralbankers,andmostnotablybythenFedchairmanPaulVolcker.Ironically,

thedebauchingoftheAmericanCPImeasureseemstohavebegunjustasMrVolcker’seffortswerebearingfruit.

AmongstthefirstofthemeasureswhichunderminedCPIwastheadoptionof“ownerequivalentrent”(OER)insteadoftheactualcostofhousing.OERiscalculatedbysubstitutingthenotionalrentthatahomeownerwouldhavetopayhim-orherselfiftheydidnotownthepropertyfortheactualmortgagecoststhatheorshepays.Inadditiontoitsdirectdistortioneffects,OERissignificantintwootherrespects.First, it introduced a notional element into an equation that had previously been based on strictly cash-based computations.Second,andaswellshallsee,OERisalsousedasan“imputation”incalculatingnominalGDP.

Intheearly1990s,somefinancialluminaries(includingGeorgeH.W.Bush’schiefeconomistMichaelBoskin,andFedchairmanAlanGreenspan)begantoarguethatCPIactuallyoverstatedinflationand,asaresult,artificiallyincreasedthecosttogovernmentofprogrammessuchasSocialSecurity.AlthoughplannedchangestothesystemfailedtogetthroughCongress,theywereimplementedanywayunderBillClinton.

36 Milton Friedman, The Counter Revolution in Monetary Theory, 1970



Thesechangesincludedtheeffectiveabandonmentofatried-and-testedsystemwherebyCPIwasmeasuredbycalculatingthepricesofadefined“basket”ofgoods.Twooftheprincipalassumptionsintroducedintothesystemwere“substitution”and“hedonics”.“Substitution”meansthat,whenthepriceofoneitemrises,consumersmightnotgoonbuyingit,butmightswitchtosomethingelseinstead.“Hedonics”,derivedfromtheGreekwordfor“enjoyment”,endeavourstoadjustpricesfortheincreasedbenefittoconsumerswhichmayariseifthequalityofanitemimproves.(Itis,asKevinPhillipshasremarked37,richlyironicthattheuseofhedonicsshouldhavebegunwhilsttheOvalOfficewasoccupiedbyitsultimatehedonist,WilliamJeffersonClinton).

ChrisMartensonillustratestheinsidioususeofhedonicsbycitingtheexampleofatelevisionwhich,bothin2003andin2004,soldfor$329.99.Butthe2004versionhadabetterscreen.Becauseofthis,theBLSestimatedthattheequivalentcostoftheTVhadfallenby29%,eventhoughthepriceintheshopwasstill$329.99.(ThisanomalyhasledMrMartensontowonderwhetherAmericansmightbeabletobuytheirtelevisionsattheBLS,sincetheyarecheapertherethananywhereelse).

Therearemanyproblemswiththeuseofhedonics.Forastart,hedonicscalculationsarenotback-dated–whatwouldhappenifhedonicswereappliedretroactively,suchthatthebenefitsof,say,airconditioningandautomatictransmissionswereinsertedattheappropriatemomentsinhistory?Second,andmoreseriously,hedonicsonlyseemtobeappliedwhentheyreducetheCPIcalculation,theassumptionbeingthatallchangesareimprovements.Inreality,thisisbynomeansnecessarilythecase.Anewtelephoneorwashingmachinemayhavemorefeaturesthantheoldone–abeneficialhedonicwhichtheBLScalculationwouldcapture–butwhatifthenewproductlastsforfarlesstimethantheoldonedid,whichalsotendstobethecase?Thecontinuingprocessofimprovementmayactuallyaccelerateratesofobsolescence.Athirdproblemwithhedonics,criticsargue,isthatisappliedinreverseinthecalculationofGDP.Improvementsmightreducetheequivalentpriceof,say,acomputerwhenCPIisbeingcalculated,butthesamehedonicimprovementmightactuallyincreasethecontributionthatthesamecomputerissupposedtohavemadetonationalincome.

Theapplicationofhedonicscancertainlyappearhighlysubjective.WhentheintroductionofaFederally-

mandatedfueladditiveincreasedgasolinepricesby10centspergallon,thisincreasewasdeemedtorepresentahedonicimprovement,andhencewasnotreflectedintheCPIstatistics.(ThismoveledJohnWilliamstoponderquitehowmuchofahedonicthrillmotoristsactuallyderivedfromhavingthisadditiveintheirvehicles).

CriticsallegethattheuseofsubstitutionenablestheBLStotakesteakoutofthebasketandreplaceitwithhamburger–willdogfoodbenext?,musesJohnWilliams–whilstofficialsourcesdisputethis,arguingthatsubstitutionislimitedtomoreclosely-comparablecategories,oneexamplethathasbeengivenbeingaswitchfromsteaktochicken.ChrisMartensonhaspointedoutthat,throughtheuseofsubstitution,CPI has changed from a measure of the cost of living to one of the price of survival38.

ThefourthchangewhichhasunderminedtheaccuracyofCPIistheuseofgeometricweightinginsteadoftheearlierarithmeticcalculation.Undergeometricweighting,thoseitemswhosepricehasincreasedbythemostautomaticallybecomeasmallercomponentoftheoverallbasket,amethodofcalculationwhichnecessarilyservestoreducerecordedinflation.

37 Kevin Phillips, Harper’s Magazine, op cit38 Chris Martenson, Crash Course, chapter 16


Theoverallresultofthesevariousadjustments,criticsrightlyclaim,hasbeentounderstateCPItothepointatwhichithasbecomegrosslyinaccurate,quiteapartfrombeingtransformedfromarealisticmeasureofthecostoflivingintoadescendingbarometerofthepriceofsurvival.Fig.18comparestheofficialandunderlyingratesforUSinflationsince1980,showingthatthespreadbetweentheofficialandtheunderlyingnumberhaswidenedwitheachsuccessivemethodologicalchange,andnowexceedssevenpercentagepoints.

Overthelastdecade,underlyingCPIinflationhasaveraged9.4%,comparedwithanofficialfigureofjust2.6%.Thisisprettytoughonmanypeople,particularlythoseSocialSecurityrecipientswho,ifthemethodsofcalculatingCPIhadremainedunchangedsincethe1980s,wouldnowbereceivingabouttwiceasmuchtodayastheyactuallydo.

Mostimportantly,ofcourse,theunderminingofthecalculationofinflationmeansthatthoseanalysts,investorsandpolicymakerswhobasetheirdecisionsonofficialinflationdata

arelivinginathrough-the-looking-glasscountrywhichbearslittleornoresemblancetotheUnitedStatesasitreallyis.Fearsofdeflation–whichare,ofcourse,ratherimplausibleanywayinanycountrywhichcansimplyprintmoney–lookparticularlyimprobablewhen,asfig.18shows,underlyinginflationremainsatsevenpercent.Ofevengreatersignificance,wherethisanalysisisconcerned,isafurtherimplicationwhichflowsfrommassivelyunderstatedinflation,whichisthatreportedGDP“growth”isclearlyawhollyunreliablenumber.Howstrongistoday’sAmericaneconomy?

Fig. 18: Smoke & mirrors #1 – unmasking American inflation*

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*Source:TullettPreboncalculations,basedondatasourcedfromShadowstats.com



economic output – a Grossly Distorted Picture

Grossdomesticproduct(GDP)–orrather,thequarterlyorannualrateofchangeinthisnumber–isoneofthemostimportantindicatorsstudiedbyanalysts,investorsandpolicymakers.Afterall,GDPissupposedtoquantifyacountry’stotaleconomicoutput,andthechangeinthisnumber–adjusted,ofcourse,forinflationaryeffects–shouldtelluswhethertheeconomyisgrowingand,ifso,howrapidly.Indeed,arecessioniscustomarilydefinedas‘twoconsecutivequartersofnegativegrowth’.

Theoretically,atleast,thisrateofgrowthalsodeterminesthescopeforexpansioninbusinessprofitability.ThewelfareofmillionsofindividualsandfamiliesisdeterminedbyGDPgrowth.Agrowingeconomyboostsgovernmenttaxrevenues,reduceswelfarecosts(theso-called‘automatic

stabilisers’),anddeterminestheaffordabilityofdebt.LevelsofGDP,whetherinabsoluteorinper-capitaterms,areroutinelyusedtocomparethewealthofnations.Androbustgrowthiscertainlygoodforgovernmentsseekingre-election.

Thoughtherateofgrowthinamatureeconomyclearlycannotrivalthatofanemergingcountrywhichstartsfromalowbase,theAmericaneconomycontinuestogrowatarespectablerate–ifgovernmentnumbersaretobebelieved.Accordingtoofficialdata,USoutputexpandedby38%(acompoundaverageof3.25%peryear)duringthe1980s,by40%(3.4%annually)duringthe1990s,andbyabout18%(0.3%peryear)inthedecadesince2000.

Butthese seemingly-comfortable numbers might be wildly inaccurate.Alternativecalculations,summarisedinfig.19,suggestthatAmericanreal

GDPgrowthmighthaveaveraged2.1%duringthe1980sand0.3%duringthe1990s,andthatUSoutputmightactuallyhavefallen(byabout2%annually)sincetheturnofthecentury.Iftrue,thiskindofcalculationwouldputawhollynewcomplexionontheperformanceoftheAmericaneconomy.Doessuchaninterpretationaccordwiththefacts?

Therearetworeasonsforsupposingthatthisgloomypicturemightindeedbeaccurate.Forastart,GDPdoesnot–asmostAmericansprobablyassumethatitdoes–representamonetaryquantificationofnationaloutputmeasuredin‘actual’dollars.Rather,itincludessubstantial“imputations”.Second,thewayinwhichinflationisdeductedtoarriveat“real”growth–thatis,theGDPdeflator–mightbecontaminatedbythesamedistortionswhichafflictthemeasurementofconsumer(CPI)inflation.

Fig. 19: Divergent numbers – US economic growth, 1980-2010e*

1980-90 1990-2000 2000-2010e Since 1980

Aggregate Annual Aggregate Annual Aggregate Annual Aggregate

Official 38% 3.3% 40% 3.4% 18% 1.7% 127%

Alternate 23% 2.1% 3% 0.3% -18% -2.0% 4.1%

*Source:TullettPrebonestimatesbasedonofficialandShadowstats.comdata,seetext


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Oneofthedistorting“imputations”,describedearlierwhenwelookedatinflation,is“owner-equivalentrent”.Ifyouownyourhouseoutright,younaturallymakenomortgageorrentpayments,soyouwouldassumethatnofigurecouldpossiblyshowupinthenationaloutputaccountsinrespectofyourproperty.ButthisisnotthecaseasfarastheBureauofEconomicAnalysis(BEA)isconcernedwhenGDPisbeingcalculated.Rather,theBEAcalculatestherentthatyouwouldotherwisebepaying(toyourself,presumably)ifyoudidnotowntheproperty.

Likewise,yourbankmightprovideafreebankingservice.Beingfree,obviouslynomoneychangeshandsinrespectofthisservice,buttheBEAcalculateswhatyouwouldhavetopayifyourbankdidchargeyouforit.Theseandotherimputationsstackuptoatleast15%of‘nominal’GDP,meaningthatthisfigureisnot–asmostpeopleprobablyassumethatitis–anactualcountednumberof‘real’dollars.

Imputations(andthedubiousnatureofinflationreporting)shouldofthemselvespromptanalyststolookcloselyatthevalidityofGDPdata,

whichJohnWilliamsdescribesasbeingboth“themostwidelyfollowedbusinessindicatorreportedbytheUSgovernment”and“nearlyworthlessasanindicatorofeconomicactivity”39.

GDPisalargecomponentoftheNationalIncomeandProductAccounts(NIPA),developedbytheNationalBureauofEconomicResearch(NBER),aprivateorganisationestablishedin1920.Today,GDPreportingisundertakenbytheBEA.

Forastart,investorsshouldnotethatGDPisnotasbroadameasureofnationaleconomicoutputasGNP(grossnationalproduct),thehistoricbenchmarkusedfordecadesincalculatingAmericaneconomicdata.However,thebroaderGNPmeasureincludesinternationalflowsofinterestanddividends,whichareanegativeiteminAmericasincetheUSisamajordebtornation.Consequently,reportingswitchedfromGNPtothemoreflatteringGDPin1991.Sincethen,andreflectingarelentlessincreaseinAmericanoverseasindebtedness,therehasbeenevergreaterdivergencebetweenoutputandgrowthasmeasuredonaGDPoraGNPbasis.

39 Gross Domestic Product, briefing paper by John Williams, Shadowstats.com


Mostusersofnationaloutputdata,beitGNPorGDP,probablyassumethatitisapredominantlycash-basednumber,whichcountstransactionsinmuchthesamewayas,say,thetradedeficitiscomputed.Butthisisnotthecase.Forastart,andasmentionedearlier,itincludesverylargeimputations(suchasowner-equivalentrentandfreebanking,ofwhichthelatteristreatedas“imputedinterestincome”).Criticsallegethatfreebankingaccountsformorethanhalfofaggregatepersonalinterestincome,andthatowner-equivalentrentrepresentswelloverhalfofallrentalflows.

DefendersofGDPcalculationsdrawcomfortfromtheobservationthattheGDPdeflatorisappliedinreversethroughachain-weightedvolumetricmeasure,andisthereforedistinctfrompotentially-understatedconsumerinflationmeasuressuchastheCPI.

Butamoment’sreflectionwillindicatethatthe change in GDP between one period and the next cannot, in fact, conceivably be measured volumetrically–thatis,inanon-financialway–inordertobackouttheeffectsofpricechanges.Evenifthenumbersofpaper-clipsandcarsproducedintheUSintwocomparative

periodscouldbecounted,thenature,qualityandlongevityofthecars,ifnotofthepaperclips,arecertaintohaveevolved.Andthen,ofcourse,thereisthehugevolumeofpurelyfinancialtransactions–involvedinfinancialservicesactivitiessuchasinsurance,bankingrealestateandsoon–thatcannotpossiblybemeasuredinanon-financialandpurelyvolumetricway.Soitisself-evidentthatthedistortedmeasurementofconsumerinflationnecessarilyimpactsthecalculationof‘real’economicgrowth.

Quiteapartfromthesetheoreticalweaknesses,GDPdataisoftenstarklyatoddsbothwithlogicandwithalternativedatareferencepoints.Wherealternatedataisconcerned,thereisapersistentandwideningmismatchbetweensoliddata(suchasthatpublishedbythetaxauthorities)andreportedeconomicactivity.Therentpaidtoanon-existentlandlordforthe“rent”ofawholly-ownedpropertydoesnotactuallyexistindollarform,ofcourse,whichmeansthattheInternalRevenueService(IRS)obviouslycannottaxit.

Asaresult,incometrendsreportedbytheIRSareoftenstarklyatoddswithapparentchangesinGDP.Butfew

analystsseemtoaskthemselveswhytheefficiencyoftheIRS–measured,thatis,againstchangesinreportedGDP–seemstodeteriorateovertime.Theanswertothisconundrumliestoasignificantextentwithinimputationswhich,sincetheydonotactuallyexistinrealterms,obviouslycannotbetaxed.

Ofcourse,anycomputationofnationaloutputrequiresajudgementaboutthe“productionboundary”,becausesomeservicesnaturallylieoutsidetheformaleconomy.Agoodexampleofthisischildcarecarriedoutbyparents–thisserviceisofundoubtedvalue,butnodollarsumisattachedtoit.Theproductionboundarynecessarilycomplicatestheassessmentprocess.Evenso,thesteadilyincreasingscaleofimputationsdoesseemtohaveboostednominalGDPprettyappreciably,andinamannerstarklyandincreasinglyatoddswithnationalincomeasmeasuredfortaxpurposes.Thesevariationsaremoststarkinareassuchasrentalandinterestincome,the same categories in which imputations are most extensive.



EvenifwecouldsomehowsquareGDPandIRSreporting(whichwecannot),subjectiveassessmentwouldsurelyconformthatofficialdataoverstatesoutputandgrowth.Onseveraloccasions,officialGDPdatahasproducedaso-called“joblessrecovery”,whichmanycriticsregardasacontradictioninterms.Evenassumingthemostbenigncomputationprocedures,GDPis,amongstallofthefront-linemacroeconomicmeasures,theonemostdependentuponeconomictheoryratherthanthesimplecountingofmonetarysums.Onbalance,weleanheavilytowards

theviewthatGDPsignificantly(andincreasingly)overstatesoutputbothintheUnitedStatesandelsewhere.

Fig.20showsareconstructionofhowextensivelyofficialGDPdatamayhaveoverstatedAmericaneconomicgrowthsincethe1980s.

debt and the deficit

AccordingtoofficialdatafromtheFinancial Report of the United States Governmentforthe2009fiscalyear(FRUSG09),theFederalgovernmentincurredadeficitof$1,417billioninthatyear,andoweddebtof$7.58

trillionat30thSeptember.Criticsallegethatthesefiguresaredrasticunderstatementsofthegovernment’sfinancialobligationsandoftherateatwhichtheseobligationsareaccruing.Significantly,intheaccompanyinglettertothePresidentandtheleadersofbothhousesofCongress,theOfficeoftheComptrollerGeneralreportedthatthereportcontainedsome“majorimpediments”which“continuedtopreventusfromrenderinganopinionontheFederalgovernment’saccrual-basedconsolidatedfinancialstatements”40.Inthetermsinwhichsuchmattersareexpressedinthecorporatesector,

Fig. 20: Smoke & mirrors #2 – unmasking American economic growth*

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*Source:TullettPreboncalculations,basedondatasourcedfromShadowstats.com

40 Financial Report of the United States Government for the 2009 fiscal year (FRUSG 09)


the government’s own auditor again refused to sign off the accounts.Criticsofgovernmentreportingcertainlyseemtohaveapoint.

TounderstandtheaccuracyorotherwiseofthereportedFederaldebtanddeficitnumbers,investorsneedtoappreciatethattheAmericangovernment–likemanyothers,amongstthemthatoftheUK–doesnotaccountforforwardcommitments(sometimesknownas‘off-balance-sheet’obligations)inthewaythatcorporationsareroutinelyrequiredtodo.Theseobligationsaretypicallyhuge,andcanincludeundertakingstopaypensionstoitsemployeesandtoprovidemoregeneralpensionsandotherbenefitstomembersofthepublic.TheUSgovernmentisbynomeansalonewheretheseoff-balance-sheetobligationsareconcerned.Indeed,weexplainedinanApril2010report41thatBritishpublicsectorpensioncommitmentsaloneconstituteda£1,000billionundisclosedobligation.

ThenumbersintheUnitedStatesaremuchlargerthanthoseoftheUK,byordersofmagnitudegreaterthanthesimplecomparisonsofpopulationoreconomicscale.Takingoff-balance-sheetUSobligationsintotheequation,criticshavearguedthatthetruefederaldeficitinthe2009fiscalyearwas$4.4trillion,or35%ofnationalincome,

andthatoutstandingliabilitiesattheyear-endexceededaterrifying$69trillion,whichisabout5.4xAmericanGDP. If these figures are even remotely accurate, the US government is in very, very deep trouble.

Thoughwebelieve–forreasonstobeexplainedshortly–thatoutsidecritics’terrifyingnumbersmaybesomewhatexaggerated,weconcurintheirbeliefthatthe revenue and capital accounts of the American government are drastically worse than official numbers imply.Moreover,seniorofficialsnotonlyknowthisbutperiodicallydotheirverybesttowarntheirelectedmasters(andtheAmericanpublic)abouttheimplicationsofundisclosedandescalatingindebtedness.What,then,istherealsituationregardingdebtandthedeficit?

Thedebtanddeficitstoryreallybeginsinthe1960s,whentheJohnsonadministrationbegantheobfuscationprocessbycombiningnetSocialSecuritypaymentswithothergovernmentaccountsinthe“unifiedbudget”.BecauseinMrJohnson’sday(andsince),SocialSecurityreceiptshaveexceededpayments,thisprocesshasflatteredthereporteddeficit,butisnowpoisedtoreverseas‘babyboomer’retirementbeginstoexertsignificantupwardspressureonnetpaymentsbygovernment.

Intheearly1970s–ataboutthesametimethatRichardNixondetachedthedollarfromgold,therebyenablingtheUS,atleastintheory,toprintasmanygreenbacksasitcouldgetawaywith–thetenthen-largestAmericanaccountancyfirmsproposedthatthegovernmentshouldreportitsfinancialperformanceunderUSgenerallyacceptedaccountingprinciples(USGAAP),thesamebenchmarkusedbycorporations.Suchaccounts,whichbegantobepublishedfrom1974,showedthegovernment’soff-balance-sheetobligationsaswellasitsformalindebtedness.ButtheReaganadministrationdisliked(andthereforeceased)thepracticeofdisclosingtheseaccruedamounts.Tohiscredit,GeorgeW.BushreinsertedthesesumsintheFRUSGfrom2002,inthatoff-balance-sheetobligationsaredisclosedinanotetotheaccounts(thoughtheydonotappearinthegovernment’sbalancesheetorcashflowstatement).

Criticsarguethat,ifthesesumswerefullyincorporatedintoGAAPaccounts,reporteddeficitswouldbeverymuchlarger,whilsttheAmericanpublicwouldbecomeconsciousofthehugescaleofunderlyingFederaldebtandquasi-debt.

41 Tullett Prebon Strategy Insights, issue four, Britain at the Crossroads, April 2010



Publishednumberscertainlyappeartobearthisout.Attheendofthe2009fiscalyear,thenetpresentvalueoffutureSocialSecurityandMedicarecommitmentsexceededschemeassetsby$52.1trillion.Moreover,reportedFederaldebt(of$7.6trillion)excludes$4.4trillionofintra-governmentaldebtswhich,sincetheyareowedtothewelfarefunds,havealreadybeenexcludedfromthenetpresentvaluecalculationwhichresultsinthe$52trillionoutstandingwelfarecomputation.Finally,obligationsto

paypensionstofederalemployeesshouldbeincluded,too.Together,thesesumstotal$69,403billion,equivalentto540%ofGDP(seefig.21).BoththeaggregatesumandtheGDPmeasurehaveexpandeddramaticallyinrecentyears,withtotal obligations rising from 248% to 540% of GDP between fiscal years 2000 and 2009.

Similarcalculations,criticscontend,haveimplicationsforthedeficitwhichareeverybitasgruesomeastheyareforthedebtcalculation.During2009,thedeficitwasreportedat

$1.47trillion,inclusiveofanunusual(buthighlysignificant)reversaloftheSocialSecuritybalancefromcredittodebit(seefig.22).Butoff-balance-sheetliabilitiesincreasedbyalmost$3trillionduringtheyear,andcriticscontendthattheunderlyingFederaldeficitwasactuallycloseto$4.5trillion,withinawhiskerof35%ofGDP(eveniftheanalystacceptsaGDPdenominatorswelledbyimputations).Inshort,someargue,both Federal debt and the deficit are completely unaffordable and out of control,a

Fig. 21: Smoke & mirrors #3 – hidden Federal debt*

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

80

70

60

50

40

30

20

10

0

US Federal debt and obligations ($ trillion)

Off balance sheet**IntragovernmentDebt held by public

$28.0$32.2 $33.9

$37.4

$48.7$52.5

$57.4 $59.4$64.5

$69.4

Sources: *Financial Report of the United States Government (FRUSG),2000through2009.Dataisatend-September

**Futurenetpresentvalueofwelfareandpensionprogrammes


grimrealitythatisbeinghiddenfromtheAmericanpeoplebydistortedaccounting.

Andthereisonefurther,evenmorefrighteningcalculationwhichcanbemadehere.Theaggregateindebtednessfigure(whichtotalled$69.4trillionattheendofthe2009fiscalyear)isgrowingatacompoundannualrateofalmost11%.Sincetheseobligationsalsoequateto5.4xGDP,therateofnominalnationalincomegrowthrequiredeven to maintain

the multiple at this frightening levelisaludicrous58%.Therefore,the underlying indebtedness ratio must continue to grow under any realistic economic scenario.

Finally,inflationcan(anddoubtlesswill)destroyconventionaldebtovertime,butitcannotworkthesamemagicwhereoff-balance-sheetobligationsareconcerned,becausethesecommitmentstendtoexpandatleastasrapidlyasthecostofliving.ConcludingthattheFederal

governmentisbankruptinallbutname,criticscallinaidformerFedbossAlanGreenspan,whowarnedalmosttenyearsagothatWashingtonoughttocomecleanaboutitsinabilitytodeliveroncurrentSocialSecurityandMedicarecommitments,addingthatthereisnopossibilitywhatsoeverofthesecommitmentsbeingrenderedaffordablebyeconomicorproductivitygrowth.Perhapsunsurprisingly,analystJohnWilliamswarnsofan“unfolding fiscal disaster”42.

42 Federal Deficit Reality briefing paper, and Commentary Number 282, by John Williams, Shadowstats.com

Fig. 22: Smoke and mirrors #4 – the hidden Federal deficit*

Fiscal year 2002 2003 2004 2005 2006 2007 2008 2009

$ billions:

Basic deficit $365 $668 $616 $760 $450 $276 $1,009 $1,254

Social Security -$207 -$293 -$203 -$442 -$202 -$113 -$554 $217

Reported deficit $158 $375 $412 $319 $248 $163 $455 $1,471

Welfare & Pension obligations $1,316 $2,929 $10,711 $3,191 $4,293 $1,547 $4,083 $2,975

Total deficit $1,473 $3,303 $11,123 $3,509 $4,541 $1,710 $4,538 $4,446

As % GDP:

Reported deficit 1.4% 3.1% 3.4% 2.5% 1.9% 1.2% 3.4% 11.4%

Welfare & Pension obligations 11.3% 24.5% 87.1% 25.2% 33.1% 11.7% 30.9% 23.1%

Total deficit 12.7% 27.7% 90.4% 27.7% 35.0% 12.9% 34.3% 34.6%

*Sources:TullettPrebonestimatesbasedonofficialdata



Atthispoint,weneedtostandbackandrememberfourverysignificantamelioratingfactors.First,theoff-balance-sheetdebtsreportedintheFRUSGrepresentthedifferencebetweentheassetsofthevariousschemesandthenetpresentvalue(NPV)oftheirobligationsovera75-yearperiod.This,wethink,pullstoomuchofthefuturecommitmentintothepresent-daybalancesheet.UsingparameterspublishedintheFRUSG,wehavecalculatedtheoutstandingnetliabilitybasedonamorereasonable25-yearhorizon(seefig.23).

Thissuggeststhattheoutstandingobligationisoftheorderof$46trillion–comprisingdebtof$12trillion,employeebenefitsof$5.3trillionandfuturewelfarecommitmentsof$28.9trillion–whilsttheunderlyingdeficitinfiscalyear2009wasoftheorderof$3.5trillion.Sincetheunderlyingobligationsanddeficitequateto359%and27.4%ofGDPrespectively,thesenumbersareonlymarginallylessappallingthanthefull-inclusioncalculations.Thesenumbersaresummarisedinfig.24.


Fig. 23: Still daunting – the time-scaling of unfunded US welfare commitments*

Estimated timescaling of future Federal welfare costs

$3,000

$2,000

$1,000

$0

2010

2012

2014

2016

2018

2020

2022

2024

2026

2028

2030

2032

2034

2036

2038

2040

2042

2044

2046

2048

2050

2052

2054

2056

2058

2060

2062

2064

2066

2068

2010-35 – NPV – $28.9 trillion After 2035-84 – NPV – $23.3 trillion

NPVAnnual cost

Total outstanding liability– $52.1 trillion

*Source:TullettPreboncalculationsbasedontheFinancial Report of the United States Government(FRUSG),2000through2009

Sources: *Financial Report of the United States Government(FRUSG),2000through2009.Dataisatend-September

**BasedonestimatedNPVof25–ratherthan75yearforwardcommitments

Fig. 24: Smoke and mirrors #5 – the hidden federal obligations*

Fiscal year in $ trillion 2002 2003 2004 2005 2006 2007 2008 2009

Federal debt (gross) $6.2 $6.8 $7.4 $8.0 $8.5 $9.0 $10.1 $12.0

Federal employee benefits $3.6 $3.9 $4.1 $4.5 $4.7 $4.8 $5.3 $5.3

Welfare commitments** $13.4 $14.8 $20.6 $22.2 $24.4 $25.2 $27.2 $28.9

Aggregate indebtedness $23.2 $25.5 $32.1 $34.6 $37.7 $39.1 $42.6 $46.1

As % GDP 200% 214% 261% 273% 290% 294% 322% 359%

Effective deficit $1.3 $2.3 $6.6 $2.5 $3.0 $1.4 $3.6 $3.5

As % GDP 10.8% 19.3% 53.7% 19.9% 23.3% 10.6% 26.9% 27.4%


Second,Americahassignificantleewaywheretaxationisconcerned.AccordingtodatasourcedfromtheCIA World FactBook,governmentrevenuesequatedtojust15%ofAmericanGDPlastyear,farlowerthancompetitorssuchasJapan(35%),Britain(40%),Germany(45%)orFrance(48%)(fig.25).Onepossibility,therefore,isthattheUScouldraisetaxesverymaterially.Thissolutionwouldbehugelyunpopular–as,indeed,wouldanycutbacksinforwardwelfareobligations–butitdoesgiveAmericamoreroomformanoeuvrethanmanyotherheavily-indebtedcountries.

Third,thevastbulkofthesedebtsareinternal–thatistosay,theyareobligationswhichsomeAmericansowetootherAmericans.Aswehaveexplainedinseveralpreviousresearchreports,internaldebtsmatterfarlessthanexternalobligations.Bythiscriterion,America,withgrossexternaldebtsof$44,000percapita,isinfarbettershapethanGermany($63,000),France($78,000)ortheUK($149,000).

Finally,andperhapsmostpivotally,theAmericandollaristheworld’sreservecurrency.ThishasenabledtheUStoenjoyinternational(thoughoftengrudging)acceptanceforexpansions

ofdebtandthemoneysupply.WhethertheAmericandollarcanretainitsreservestatusinthefuture,however,hastobeopentoquestion–asubjecttowhichweshallreturninpartfourofthisstudy,whenwelookattheimplicationsofanAmerican(andWestern)economicsysteminthegripofunwindingexponentials.

Fig. 25: Room for manoeuvre? – the US as a low-tax economy*

China UnitedStates

UnitedKingdom

Spain Japan Germany Italy France

60%

40%

20%

0%

Comparative taxation and expenditure, 2009

RevenueExpenditure

11% 12%

35%

42% 40%

52%

45% 48%

46%

51% 48%

56%

15%

25% 29%

37%

*Source:CIA World FactBook



“America has indulged in a debt binge which, whilst adding hugely to the burdens of

median earners whose real earnings have been declining anyway, has benefited

only a tiny minority of the very rich”.

part four:


end-game – the denouement of exponentials

• AllavailableevidencesuggeststhattheWesterneconomiesarealreadyinthetalonsofanexponentialsdenouementprocess.Thecriticalenergyequationisweakening,andanexponentialfinancialsystemhascreatedunsustainabledebtburdens.

• Ifwearetounderstandandmanagethisprocess,weneedtorealisethatneitherKeynesiannorfree-marketeconomicscanprovidethenecessarypolicytools.Investorsandpolicymakersalikeneedtoembracethenewparadigmofexponential economics.

• Thereisanimperativeneedforastandardisedcalibrationoftheenergysurplusequation(EROEI),andforaconsistent,accurateandlong-termeconomicdatabase,whichcanfacilitateabreakawayfromfaultyandshort-terminterpretationandplanning.

• Specifically,investorsandpolicymakersalikeneedtopreparethemselvesforhigherinflation,andforagrowingrecognitionthatthecurrentbasisofglobalisedfree-tradeisextremelydetrimentaltotheWesterneconomies.

Beforelookingattheimplicationsoftheexponentialsend-game,let’sreviewwherethisresearchprojecthasledusthusfar.First,we’vereviewedthetwo-partexponentialsequation,comprisingasurplus-energyeconomydrivenbyfossilfuels,ontopofwhichhasbeenconstructedanincreasinglyexponentialfinancialsuperstructure.Andwehaveexplainedthatreportedmacroeconomicdatapresentsahugelydistortedpicture,certainlyintheUnitedStatesandveryprobablyelsewhereinOECD.

ConcentratingontheUS,wehaveseenthattheeconomyappearstobeessentiallyex-growth,asituationdisguisedbyunderstatedinflationandoverstatedGDP.Meanwhile,andinadditiontohugedisclosedformaldebts,theFederalgovernmenthasaccumulatedtrulyenormousforwardobligations,principallyintheformofwelfarecommitments.Inclusionoftheannualincrementtothese‘informal’debtspresentsafarworseongoingpicturethancanbeappreciatedbythereportedfiscaldeficit,withtheAmericangovernmentincurringwelfareobligationswhichcannotconceivablybemetwithouttrulymassiveincreasesintaxation.Totalcreditmarketdebt,whichincludesindividualsandthecorporatesectoraswellasStateandFederalgovernment,standsatanunprecedented350%ofGDP(seefig.26).



Fig. 26: Uncharted waters – US debt as a percentage of GDP*

450%

350%

250%

150%

50%

1945

1947

1949

1951

1953

1955

1957

1963

1959

1961

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

157%

353%

171%

US credit market debt as % of GDP, 1945-2010

*Source:Officialdata

Fig. 27: Smoke and mirrors #6 – America’s hidden jobless*

25%

15%

20%

10%

5%

0%

21.7%

16.5%

9.5%

US unemployment rates – reported and underlying, 1994-2010

Official U-3Official U6Underlying

*Source:OfficialdataandShadowstats.com


Moreover,unemploymentisextremelyhigh,andhasrisensharplyinrecentyears,withthereported(U3)figure(9.7%)disguisingafarworseunderlyingsituation(seefig.27).ThereseemseverylikelihoodthattheunderlyingeconomicweaknessandtheexcessiveindebtednessoftheUSisreplicatedthroughouttheOECDeconomies.

Doesthisdisturbingstateofaffairstiebacktoanunravellingofexponentials?Inordertorelatethesituationtothesetwofactors–anunsustainableexponentialdynamic,andaweaker-than-reported,massivelyindebtedeconomy–weneedtoconsiderwhat we would expect to seeiftheeithertheresourceorthefinancialdimensionoftheexponentialsprocessweretoreachend-game.

Essentially,wewouldexpecttoseeaneconomythatisincreasinglymonetaryratherthanproductive.Thismeans,first,thatthecurrencylosesitsvalueasthemoneysupplyexpandsmuchmorerapidlythanrealproductivecapacity(bywhichwemeantheaggregateofmanufacturing,agriculture,theextractiveindustriesandgenuinelyvalue-addingservicessuchasretailinganddistribution).Second,itmeansthatthecentreofgravityoftheeconomyswingssuccessivelyawayfromproductiveactivities,withanever-largerproportionofGDPbeingaccountedforbytheultimatelyunproductiveactivityofsimplymovingmoneyaround.



Third,wewouldexpecttoseedebtofalltypesrisetoever-higherandultimatelyuntenablelevels.Inaddition,wewouldexpectunemploymenttorise,reflectingthedecliningroleofproductiveactivities.Next,wewouldexpectpolicymakersandinstitutionstoresorttoevermoredesperateexpedientsinanendeavourtopreventthesystemfromtopplingover.Theseeffortscouldbeexpectedtoincludethecreationofsuccessiveassetbubbles,andanextensiveresorttoQE.Lastly,wewouldexpecttheseeffortstoprovefutile,resultinginsomekindofdefaultonunsustainableforwardobligations.Alongtheway,wewouldexpectmostpeopletobecomepoorerwellbeforetheultimatedenouement.

This,webelieve,isexactly the process that we are witnessing both in the United States and in a number of other OECD economies.Evenifwebaseourcalculationsonofficial(andveryunderstated)inflationdata,theUSdollarhaslost92%ofitspurchasingpowersince1945.Ifwetake1980asourbaseyear,thepurchasingpowerofthedollarhasdeclinedby63%onthebasisofofficialdata,orby89%onthemorerealisticinflationcalculationssuppliedbyShadowstats(fig.28).

Thetiltawayfromproductiveactivitiestowardsprofitingfromtheprocessofsimplymovingmoneyaroundcontinuesapace.In1950,Americawasaneconomydominatedbymanufacturing,whichaccountedforalmost30%ofeconomicoutput.Now,thisshareisjust11.5%,whilsttheproportionofGDPattributabletofinancehasrisenfrom10.9%to20%overthesameperiod(seefig.29).Thisyear,webelievethatfinancialservices–includingbanking,investment,insuranceandrealestate–arelikelytoaccountforabout$3trillionwithinaprobableAmericanGDPtotalofsome$14.3trillion.Thisprocesshasbeencalled“financialization”,andithasanhistoricalsignificance(asamarkerofdecline)whichishighlypertinenttoday–exactlythesamephenomenonoccurredinotherinstancesofgreatpowerdecline,insixteenthcenturySpain,eighteenthcenturyHollandandearlytwentiethcenturyBritain.Now it seems to be happening to the economies of the United States and other Western countries.


Fig. 28: Crumbling? – the purchasing power of the dollar*

Purchasing power of the US dollar, 1980-2010

$1.00

$0.90

$0.80

$0.70

$0.60

$0.50

$0.40

$0.30

$0.20

$0.10

$0.00

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

$1.00

$0.38

$0.13

OfficialUnderlying

*Source:TullettPreboncalculationsbasedonofficialCPI-UandShadowstatsalternateCPIdata

Fig. 29: ‘Financialization’ – America swings from making to moving*

1950 1960 19901970 1980 2000 2008

30%

40%

10%

20%

0%

Manufacturing and finance shares of US GDP, 1950-2008

ManufacturingFinance

29.3%26.9%

23.8%

14.0%

20.0%

15.9%18.0%

16.3%14.5%

19.7%

11.5%

20.0%

10.9%13.6%

*Source:Economic Report of the President, 2010,tableB-12,andKevinPhillips,Bad Money,2009edition,page31



Another‘denouementmarker’–anescalationinallformsofdebt–isextremelyvisible,againintheUSandinotherOECDcountries.Sowhatwearedescribingisan economy that is essentially “running on empty” – moving money around, borrowing, expanding the money supply, incurring huge debt obligations and mortgaging the future in an ever more frenetic attempt to maintain at least the illusion of the status quo in the face of underlying economic deterioration.

the first linkage – a weakening energy equation

Intheautumnof1941,whentheRooseveltadministrationfinallylostpatiencewithJapaneseincursionsintoIndo-China,theUSimposedanoilexportembargoonJapan.ThispresentedtheTokyogovernmentwithtwounpalatablealternatives–losefacebybackingdowninthefaceofpressurefromWesternerswidelyregardedinJapanasracists43,orstartawarthatmanyintheImperialhighcommandknewtobeunwinnable.Intheend,Japangambled,creatingtheultimateeuphemism–the“GreaterEastAsianCo-ProsperitySphere”–aspartofadashtosecureaccesstooilsuppliesfromtheDutchEastIndies.Togivetheprojecteventhefaintestchanceofsuccess,theUSbattlefleetat

PearlHarbor(andespeciallyitsaircraftcarriers44,thoughtheJapanesefailedtoappreciatethis)neededtobetakenout.Thecarriersweremissed(theywereatsea),amightyindustrialpowerhadbeenprovokedtoanger,andtheendresultwasneverinmuchdoubt.

Thoughthesailors,soldiersandairmenoftheUSandheralliesdefeatedtheJapanese,thewarwasreallywonbyindustrialmight.OilwasthebasisofAmerica’sindustrialmuscle–anarmymighthavemarchedonitsstomachinNapoleon’sday,butthemechanisedforcesofthemid-twentiethcenturywerepoweredbyoil,notjustatseaandintheairbutinthefactoriesandtheshipyardsthatmadevictorypossible.

Changesintheenergybalancecreateshiftsinglobalpower.Asenergypre-eminenceshiftedfromcoaltooil,theUnitedStates,withherthen-hugepetroleumsupplies,overtookBritainasthemajorindustrialpower,adisplacementthatBritaintriedunsuccessfullytoforestallbytryingtoparcelouttheMiddleEastbetweenherselfandFranceintheimmediateaftermathoftheFirstWorldWar.OilpoweredAmericanindustrial,economic,politicalandmilitarysuperiorityformuchofthetwentiethcentury.

ButdomesticoilproductionintheUnitedStateshasbeenindeclinesincetheearly1970s,andnowmeetsbarely40%ofAmericanrequirements(seefig.30).Since1970,USconsumptionofoilhasincreasedby62%,whilstproductionhasfallensteadilydespitemajorexplorationanddevelopmentinvestmentinAlaskaandtheoffshoreGulfofMexico.

Lastyear,Americaconsumed18.7mmb/dofoilandproducedonly7.2mmb/d,withthebiggestsharesofimportsbeingsourcedfromCanada,fromMexico(whereproductionisinrapiddecline),fromVenezuela(whosegovernmentistrenchantlyanti-American),fromWestAfrica(whereWesternoilcompaniesareinfiercecompetitionwithoil-hungryChineseplayers)and,ofcourse,fromtheperenniallyunstableMiddleEast.

Thefundamentalproblem,fortheUSasfortheotherOECDeconomies,isamassiveimbalancebetweenconsumptionandreservesofoil.Lastyear,theUSconsumed22%ofworldoilsuppliesonthebasisofjust2%ofreserves,whilstEuropeaccountedforafurther17%ofconsumptionyethasbarely0.5%ofglobalprovedreserves(fig.31).

43 Propaganda designed to reassure expatriate residents in British Singapore seems to bear out the accusation. British residents were informed that an invasion was improbable because the Japanese were baffled by complex

machinery, made their aeroplanes out of bamboo, and were prevented from flying at night by bad eyesight 44 USS Enterprise, Lexington and Saratoga


Fig. 30: Running out of gas? – the US petroleum balance, 1965-2009*

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

20

25

10

5

15

0

75%

100%

25%

50%

0

US oil production, consumption and imports, 1965-2009

Imports (%, RH scale)ProductionConsumption

mm

b/d

*Source:BP Statistical Review of World Energy 2010

Fig. 31: Over a barrel #1 – shares of oil reserves and consumption, 2009*

United States European Union OECD China Russia Africa Other countries Middle East

40%

60%

20%

0%

Oil consumption and reserves, 2009

ConsumptionReserves

22%

2.1%

17%

0.5%

54%

7%11%

1.1% 3%6% 4%

10%

20% 20%

8%

57%

*Source:BP Statistical Review of World Energy 2010



Onewaytolookattheoil-economyequationistostateAmericanincomenotindollarsbutinbarrelsofoil,assetoutinfig.32.Inthiscalculation,USpercapitaGDPforeachyearisdividedbytheoilpriceprevailingatthattime.Forexample,percapitaGDPin1970was$5,090andthepriceofoilwas$1.80perbarrel,sopercapitaincomeequatedto2,828barrels.

Duringtheoilcrisesofthe1970s,thesoaringpriceofcrudeoilreducedthisnumbertojust361barrels.Bytheendofthe1990s,theequationhad

improved,thoughnottothe1970leveleveninthespikeyearof1999(whensharpfallsinoilpricespushedthenumberupto2,507barrels).Despiteasmallrespitein2009–whenslackdemandreducedoilprices–thetrajectorysince1999hasbeenrelentlesslyadverse.

Thistypeofcalculationdoesnottellthewholestory,forwhichtwoothercriticalfactorsneedtobetakenintoaccount.First,andincontrasttothenot-too-distantpast,Americanowcontrolsonlyasmallproportionof

globaloilsupplies,andthiscanbeexpectedtodeclinefurtherinthefuture.Second,andasestablishedearlier,absolutevolumesofoil(orofanyotherformofenergy)arenotthecriticalissue,whichisthe relationship between energy extracted and energy consumed in the extraction process(EROEI).IntheUS,thisequationhasweakenedsuccessivelyas‘easy’sourcesofoilhavebeendepletedandhavebeensupplantedbyfieldswhicharecostlier(inenergyaswellasinmonetaryterms)toproduce.

Fig. 32: Over a barrel #2 – US income measured in barrels of oil*

0

1945

1947

1949

1951

1953

1955

1957

1963

1959

1961

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2,828

361

2,507

753

3,000

2,500

2,000

1,500

1,000

500

US GDP per capita expressed in barrels of oil, 1945-2010

Per capita GDP in bbls

*Source:USCensusBureau,BureauofEconomicAnalysis&BP Statistical Review of World Energy 2010,andTullettPrebonestimates


Ofcourse,American(andbroaderWestern)EROEIhasbeendeterioratingformanydecades,buttwogeopoliticalchangeshavetightenedthescrew.ThefirstofthesehasbeenlossofWesterncontroloversourcesofoil.Priorto1960,productionofoilincountriessuchasSaudiArabia,IraqandIranwascontrolledbyWesterncompanies,principallytheso-called“SevenSisters”.ThesecompaniesextractedcheapoilintheMiddleEastandelsewhereandshippedittoberefinedathomefortheirdomesticmarkets.Asaresult,any weakening in the domestic EROEI was cancelled out by access to high EROEI sources overseas.Thisadvantagedpositionwasundercutbytheprocessesfirstofindependenceandlatterlyofnationalisation.

Second,thereare,increasingly,competingpurchasersforhighEROEIenergysupplies,principally(butbynomeansonly)inAsia.TheproblemposedbyAmerican(andEuropean)energydependencyisamuch-discussedtopic,butthe role of exponential energy in leveraging the economyhasnotbeenproperlyunderstoodbecausecertainkeylinkageshavebeenneglected.

Inshort,then,the US economy was for many decades an economic powerhouse partly because of American access to high EROEI energy supplies from both domestic and foreign sources.Asthisadvantagedpositionhaseroded,theleveragingeffecthasbeenundermined.

AwarenessofAmerica’spetroleumvulnerabilityhasledmanyobserverstobelievethattheinvasionofIraqwasmotivatedbyadesiretotakeoverthatcountry’shugepetroleumreserves.Ourinterpretationisthatoilwasindeedcritical,butthattheexplanationissomewhatmorenuancedthanasimple‘resourcegrab’,andhasadirectbearingoneconomicpolicy.

Intheyearspriorto2003,SaddamHusseinhadbeenundertakingastrategywhich,ifithadbeenimplementedsuccessfully,couldhavehadseverelyadverseimplicationsfortheAmericaneconomy.Essentially,SaddamwasofferingaccesstoIraqioiltocompaniesfromChina,RussiaandFrance,withtwoprincipalobjectivesinview.First,hewantedthesecountriestohaveavestedinterestinlifting

UNsanctionsonIraqioilexports.Second,andevenmoresignificantly,heplannedtopriceIraqioilin a currency other than American dollars(probablyineuros).

ThestatusofthedollarastheglobalreservecurrencyisvitaltotheUS,andhaslookedvulnerableforanumberofyears.ReservestatuseffectivelyallowsWashingtontoissuedebtsandtogrowthemoneysupplywithoutprovokingasharpdeclineintheinternationalvalueofthedollar.Ifthedollarwereevertoloseitsreservestatus,itsvaluecouldbeexpectedtofallsharply,triggeringveryhighinflationwhilstmassivelyunderminingAmerica’sinfluenceintheglobaleconomy.AsgrowingUSindebtednesshasputthedollar’sreservestatusunderevergreaterpressure,the‘petroleumprop’–theroleofthedollarasthecurrencyinwhichoilistraded–hasbecomesuccessivelymoreimportant.This,webelieve,mayhavepromptedtheBushadministrationtoseektopreventIraq’sgovernmentfrominvitingcompetitorparticipationandsimultaneouslyweakeningtheoilmarketroleofthedollar.



the second linkage – reckless finance

Ononeofthetwodimensionsoftheexponentialsequation–energyleverage–itseemsclearthattheUnitedStatesandotherWesterncountriesarebeingadverselyaffectedbyalossofaccesstopremium(thatis,highEROEI)sourcesofenergy.ThattheUSisalsobecomingavictimoftheotherexponentialprocess–thatofanexcessaccumulationofunsustainableforwardobligations–seemsequallyclear,mostobviouslyinthetrulymassivescaleofformalandinformaldebtsaccumulatedbyindividuals,businessesandgovernment.

Totalcreditmarketdebt–includingthatportionofFederaldebtowedtothepublic–totals350%ofGDP.Inaddition,wehaveidentified–usingofficialsourcesofdata–afurther$61.8trillionofobligations,whichtakesthecombinedtotalto$112trillion,or770%ofGDP.Thisnumbercompareswith$50.9trillionnineyearsago($24.6trillionofcreditmarketdebtplus$26.3trillionofFederaloff-balance-sheetliabilities).Overthatperiod,therefore,aggregateindebtednesshasincreasedby9.1%annually,whereasthegrowthratefornominalGDPhasbeen4.3%.

Thisdescribesasituationwhichlookstobetoallintentsandpurposesoutofcontrol.Whyhasithappened?

Essentially,twofactorshavebeenatworkhere.First,profitingfromthesimpleprocessofmovingmoneyaroundhasgrowninpartbecauseofthedecliningrealproductivityofaneconomysqueezedbyasharpdeteriorationinavailableEROEIs.

Second,the US–likeanumberofotherWesterncountries,mostnotablytheUK–has bought into recklessly excessive deregulation.Itisbynomeanscoincidentalthatthe‘financialization’oftheUSeconomyhasacceleratedinapost-Glass-Steagallerainwhichmassiveintegratedfinancehouseshavecreatedinstruments(suchasMBSs45)whichhaveoutpacedthecapabilitiesofaregulatorysystemwhichhasitselfbeengivenlowpriorityinapoliticalsystemexcessivelyattachedto–toborrowaBritishphrase–“light-touch”regulation.

Thesystemhaspusheda relentlessly consumerist ethos–toparaphraseDescartes,“IbuythereforeIam”–andhassimultaneouslyusedlowinterestratestomakeavailableconsumerfinanceonseeminglyattractiveterms.Legislationhasbeenpassedwhichtightenscreditcardcompanies’holdoverdebtorstoanextentthatatleastoneAmericanobserverhaslikenedtoindenturedlabour.

Inshort,Americahasindulgedinadebtbingewhich,whilstaddinghugelytotheburdensofmedianearnerswhoserealearningshavebeendeclininganyway,hasbenefitedonlyatinyminorityoftheveryrich.Thisisthe‘WallStreetversusMainStreet’divergencewhichMrObamapromisedtoaddress,buthasbeenabletodopreciouslittleabout.

Inhisfarewelladdress46,PresidentEisenhowertoldAmericansthatthey“mustguardagainsttheacquisitionofunwarrantedinfluence,whethersoughtorunsought,bythemilitary-industrialcomplex”.Perhapsheshouldhavewarnedinsteadabouta“credit-industrialcomplex”,becausethatiswhattheUnitedStatesnowhas.

Theintellectualunderpinningforthisprocesshasbeenthelaissez-faire,monetaristphilosophysometimesalsocalled‘theWashingtonconsensus’.Webelievethatanysystemicextreme(suchasexcessivestatecontrol,excessivesocialismorexcessivetheocracy)canproveextremelydamaging.Unbridledfreemarketeconomics,bydrivingacultureofgreedandshort-termism,hasexposedtheUS(andmanyotherWesterncountries)tothedenouementofexponentials.

45 Mortgage-Backed Securities46 17th January 1961


Onequestionremains–whathappensnext?Isanexponentials-drivencollapseinevitable,orcanpolicymakerscraftasuitableresponse?

avoiding disaster – can we break the linkages?

Thusfarinthisreport,wehaveexplainedourviewthattheWesterneconomiesareinthegripofexponentialsprocessesthatareweakeningtheenergyleverageequationwhilstbuildingunsustainabletendenciesintothefinancialsystem.Thissituationisnotirremediable,solongasitisrecognisedthatfundamentalchangeisinevitable,that‘businessasusual’isnotanoption,andthateconomicandsociallifeastheWesthasknownthemformorethanacenturyarenolongersustainable.

Changethatisnotunderstoodcannotbemanaged,andchangethatcannotbemanagedcanbeextraordinarilyunpleasantanddisruptive.Whatfollowscanatbestbeasetofoutlinepolicysuggestions.

Firstandforemost,weneedtounderstandthatneither Keynesian demand management nor free-market laissez-faire economics is an effective management tool for the future.Bothareoutdated.Thefreemarketassumptionsof‘theWashington

consensus’werediscreditedduringthe2008-09crisis,evenifpolicymakersandvestedinterestsareunableorunwillingtorecognisethisfundamentalchange.Atthesametime,areversiontopre-1980sKeynesianmanagementisnotanoption,sincewhatisrequirednowisfundamentalchange,notsimplythemorecompetentmanagementoftheexistingsystem.Instead,whatisneededisthedevelopmentofawhollynewapproachtoeconomicissues.Inshort,weneedanewdiscipline–exponential economics.

Forthistohappen,weneedsomethingmorethananunderstandingofexponentialissues,imperativethoughthatis.Twoessentialtoolsarerequiredifthenewdisciplineofexponentialeconomicsistoinformamoreaccuratereadingoftheoutlook.

Thefirstofthesetoolsisaneffectivecalibrationofthe critical economic equation,whichisEnergyReturnOnEnergyInvested(EROEI).Agreatdealofinterestingworkhasbeendoneonthisissueinacademiccircles,butthisnowneedstogomainstream,withagreedmethodologiesandconsistentcalibration.RichardFeynmanoncereferredto“theidiocyofallthedifferentunitswhich[physicists]useformeasuringenergy”47Suchvaguenessisnolongeraffordable.

Atthesametime,thereisahugeneedfordatawhichisbothreliable(inthatitisaccurate)andsuitable(inthatitusestheultra-longtimescaleswhichareimperativeforanunderstandingofexponentials).Thereisanurgentneedforthecreationofaneconomicdatabasewhichprovidesexponentialeconomistswithdatawhichisbothlong-termandfreefromPollyannadistortions.

Inbothareas,webelievethatacombinationofprivatesectorandgovernmentwillprovethebestroutetotheprovisionofthisessentialintellectualandinterpretativeresource.

Bothprivateenterpriseandgovernmentinstitutionshaveastrongvestedinterestindevelopingtheessentialtoolsforanunderstandingofthisrevolutionaryapproachtoeconomicinterpretation.Ifwearerightabouttheinterpretativemeritsofexponentialeconomics,itcanprovideinvestorsandcorporatemanagerswithacompetitiveedgebecauseitoffersabasisforinterpretationandpredictionwhichisfarsuperiortoanythingelseavailable.Astheprocessofchangeaccelerates,policymakershaveanimperativeneedtoaccesstheinsightsthatexponentialeconomicscanprovide.

47 Richard Feynman, The Character of Physical Law, 1964



Specifically,itisevidentthatinflationrepresentsahugethreatgoingforwards.Inflation is implicit in printing money, and is likely to impact the economic system as soon as the velocity of money recovers.Inanycase,inflationislikelytobecomeunstatedpolicy,asdevaluationistheonlyway(shortofoutrightdefault)inwhichexcessiveformaldebtscanbeeliminated.

Together,acceleratinginflationandresourceconstraintimplysteady rises in the values of physical commodities,mostnotablyintheenergyfield.Somecountries(suchasChina)alreadyrecognisethistrend,andcanbeexpectedtouseeveryefforttoconverttheirdevaluingcurrency(andespeciallydollar)holdingsintophysicalresources.

Whilstinflationcanerodetherealvalueofformaldebts,itcannotworkthesamealchemyforinformalobligationssuchasfuturewelfarepayments.Thesefutureobligations,whicharealreadyimpossiblylarge,aresettoworsenastheboomergenerationretires.Governments need to come clean on the fact that the delivery of benefits promised for the future has become impossible,andwouldbelikelytoremainsoeveniftaxesweretorisedramatically.Meanwhile,acombinationofdemographicchangeandweakeningproductivity–thelatterdrivenbyadeterioratingenergyleverageequation

–meanthatsomecurrentwelfaresystemsarenolongeraffordable,mostnotablyinEurope.

Aftertheeventsof2008-09,itshouldhardlyneedtobeexplainedthatafinancialsystemwhichhasbeenfreetogeneratesequentialassetbubblesneedstobecurbed,bytighterregulationoverproductssuchasmortgagesandthroughspecificmeasuressuchasthereintroductionofabsoluteseparationbetweenretailandinvestmentbankingactivities,thekindofseparationthatwasimposedbytheUSGlass-SteagallActbetweenitsintroductionin1933anditsdisastrousrepealin1999.

One of the delusions that the West needs to rethink is globalisation.ThefirstorganisationstoquestionthisprocesswereUSlabourunions–whichfeared,quiterightly,thatitwasamechanismforexportingAmericanjobs–butthereisalotmoretoitthanthat.CertainemergingeconomiesareexploitingtheglobalisationprocessbymanipulatingtheircurrencieswhilstatthesametimeoperatingtariffsystemsexpresslydesignedtoinhibitexportsfromOECDcountries.This process not only enriches the emerging countries at the expense of the OECD economies, but also hollows out Western nations’ economic structures by destroying their indigenous manufacturing industries.

Studentsofeconomicsareroutinelyinstructedthatfreetradeis“good”becauseitmakeseveryonericherthroughoptimisationoftheircapabilities,butthisisthetypeofpurelytheoreticalinterpretationthatgetseconomistsabadname.“Freetradetheory”,JohnWilliamsexplains,“assumesallinvolvednationsareatfullemployment.Whenthatisnotthecasethewealthiestandhighestsalariedcountriesendupwithadecliningstandardoflivingandredistributingtheirwealthtotheotherfree-tradeparticipants,asisthecurrentcircumstancefortheUnitedStates”48.

Inthelongerterm,exponentialsanalysisindicatesthattheentireWesternconsumeristethos,withitsresourceprofligacyanditsshort-termism,isnolongersustainable.Beforethatpointarrives,however,thereisanimperativeneedtorethinkourfinancialinstitutionsandourtraderelationswhilstdevelopingtheintellectualanddataresourcesneedediftheWestistounderstandandtomanagethedenouementofexponentials.

48 John Williams, Gross Domestic Product, briefing paper, Shadowstats.com

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end-game - Tullett Prebon the denouement of exponentials Dr Tim Morgan Global Head of Research...

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