Wednesday, October 19, 2011

Kicking the Can: A Modern Fable

I was inspired after reading a letter to the editor at The daily reckoning

Once upon a time, a group of bankers dropped a magic debt-can on the road. The can was full of nasty debt and it was very ugly. A group of the town’s leaders decided they didn’t like the can, so they gave it a little squirt of stimulus money and
kicked it down the road towards the hill on the outskirts of town. It rolled up
the slight incline and came to rest then rolled slowly back towards the town.

The leaders discovered that they couldn’t kick the can over the hill – it just kept rolling slowly back down the hill towards the town. And this magic can didn't just roll along the road like an ordinary can – the stimulus money vanished in a puff of
smoke and appeared in the banker’s pockets and then the debt in the can got

The can quickly grew into an ugly debt-filled barrel as heavy as concrete and so big that it couldn't be kicked down the road anymore.

The leaders asked the bankers what to do, and the bankers explained that the can was now dangerously toxic. It had to be kept out of the town. They explained that it had
to be launched with a special kind of explosive called Economic Bailout. This
explosive was made of magical future-money which the leaders took from their
people before the people had even made the money.

Each time th can was launched it got bigger, and each time it got bigger the leaders had to take more money from the people’s future to launch it away from the town.

After each explosion the people were left a little poorer, but the bankers got a little richer.

Strangely, as the people got poorer, the hill in front of the can seemed to get steeper, making the job even harder.At first one stick of economic-bailout dynamite was enough to blow the barrel-sized debt a huge distance and all the leaders and bankers congratulated themselves on a job well done.But gradually the magic barrel grew larger and the cement inside transmuted into toxic lead.It required much more financial dynamite to move it.

Soon the Economic Bailout Explosive wasn’t enough, the leaders needed to use Quantitative Easing Explosive. This was a magical explosive, which made people’s money decrease in value without even touching it.As the cylinder's flight arc grew shorter, the self-congratulations grew more strained.

Eventually tons of Quantitative Easing TNT barely made it roll a few meters up
the incline before stopping and rolling back again.The drum got so big that it finally turned into a storage-tank of toxic debt that glowed like radio-active fuel-rods. It crept ominously downwards towards the town at the bottom of the hill.

The leaders conferred with the most expert bankers and came up with a solution: Nuclear financial explosives would be used to create a massive European Bailout Fund
Rocket, propelling the toxic debt-filled tank right to the top of the hill.They reasoned that if the huge tank was propelled to the top of the hill, it would roll down the other side, magically turning the toxic waste into gold for everyone!
All would be well!

The appointed date came and every country had contributed to the Bailout Fund. The explosive yield and trajectory had been precisely calculated by people with PhDs in
Economics - so their qualifications to avoid magical thinking and perform
rigorous mathematical calculations (based on the inviolate and well understood
rules governing the behavior of money and markets) were impeccable.

Crowds gathered at the base of the hill, waiting to sprint over the hill and collect their gold.

All of the people’s remaining future money had gone into the bailout rocket. They had no money, no future and no food, so they were really quite eager to see the gold.

The leaders in their bunker gave the order. Fire!

The huge cylinder lifted off! Higher and higher it went trailing flames as the bailout money was consumed by the ravening afterburners! The leaders cheered from their bunkers. The bankers cheered as they stood on their magically-increasing piles
of cash! The people looked upwards nervously as the huge tank of toxic waste was
lofted overhead, propelled by a steady stream of money. The bailout money finally came to an end. The afterburners flared out but the tank continued to fly towards the peak ahead.

The magical toxic storage tank flew onwards, seemingly invincible..... and then it stopped suddenly at the crest of the hill as if it had run into a magical wall of
mathematical impossibility. Then slowly, almost imperceptibly, it started to roll... backwards! With gathering speed the colossal tank came thundering back down the hill.

The shocked crowds tried to escape but there were too many people for all to get out of the way.

Finally the rolling, roaring tank slammed into the town. Exploding, it flew apart spewing its toxic contents far and wide.

The survivors looked in dismay at the remains of their town. In the center of town
they saw a distress flag being hoisted above a bunker. The leaders were
trapped in their bunker, surrounded by the toxic waste and unwilling to wade
through it to escape.

So the survivors turned away from the ruins, ate the bankers and walked off to found a new town, based on sound economic practices....

Well, I did say it was a fable. We all know that the real ending would involve the bankers using the toxic-smeared leaders to shepherd the toxic-averse survivors into
docile herds, so that they could fleece and then eat them.

Saturday, September 3, 2011

Energy and Society Part 2,

I am going to engage in some speculation. Let us accept the following assumptions as a premise for this argument,

1. The economy is a chaotic system.

2. Both our markets and our economy are displaying classic chaotic bifurcating behaviour (they are bouncing up and down).

Question: Why the bifurcating behaviour? What is driving the instability?

I am going to argue that the answer is blindingly simple and very obvious when you think about it, but a full understanding requires some background knowledge.

1. Mathematically, what does the economy look like?

To understand the driver of the instability, we need to tackle another issue: Mathematically, what does the economy look like – what drives the economy?

As a first order approximation, the answer is simple and obvious. The economy grows exponentially. The expansion is a requirement of the Fractional Reserve System. To quote Wikipedia : “Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply.” The amount of money in circulation (the money supply) each year MUST increase, in order to make the Fractional Reserve system work. This has a tendency to create inflation if it is not balanced by an equal increase in GDP.

In simple, non-maths terms the economy MUST grow by a few percent every year.

The reason for this is simple. If the amount of money in circulation increases, but goods produced do not increase, then you have more money chasing the same quantity of goods, so each “unit” of goods will be “worth” a higher amount of money. Actually it is much more complex than that (look up “Velocity of money” as a starting point) but that is a good first-order explanation.

So. The mathematical description of the economy is very simple – money supply must expand exponentially (driven by the nature of the Fractional Reserve system), and the underlying productivity that the money “maps” to must expand with it.

Failure of expansion in either the money supply or GDP will result in problems.

If money becomes unavailable (as occurred during the depression) then the Fractional Reserve System fails – there is no money available to pay debt so debts are defaulted on. Since money (in our system) is based on debt, the default causes the money to “disappear” (the debt is “written off” by the bank), and this reduces the amount of money in circulation, exacerbating the problem (as occurred in the Great Depression).

John Maynard Keynes had the insight that this problem can be fixed by central banks – they step in and inject money into the system to “re-inflate the economy”. Once the amount of money in circulation is once again in line with the required growth rate, the normal investments that businesses need to do (in order to grow) can be carried out, and growth returns. (Again, this is a grotesque simplification – but good enough for a first order understanding. For more detail read the Wiki article).

Since the 1980s our economy has been dogged by a series of recessions, which the Central banks have responded to by injecting cash (another simplification, but it will do).

The cash injections worked, but a pattern emerged: as a rough approximation, it is fair to say that each recession required more central banking intervention than the last – culminating in the 2007/2008 GFC, which required unprecedented intervention. The GFC was odd, in that the interventions don’t seem to have worked.

2. On Bubbles.

The injection of money into the economic system is meant to encourage investment in productive businesses and thus re-start growth. However recent decades have seen a different pattern. Injection of money has led to investment in a series of “bubbles” and in intangible “Financial Instruments” rather than investment in productive businesses (i.e. businesses that produce tangible things).

The most recent bubble was the housing bubble. A house has a limited “lifespan”, so the value of a house should depreciate as it ages. However, in recent years the value of a house has gone up, not down.

In common with other bubbles has been a faith in the “Greater Fool” theory: The theory that you can buy an object at an inflated price now and sell to a “Greater Fool” for an even more inflated price later – even though the value of the object should have depreciated.

Why would people invest in a depreciating asset - and thus implicitly trust to the “Greater Fool” theory? The answer is obvious. They do this if there is money to invest and no better investment available.

If you can’t invest in a sound business (a business that produces something new of tangible value) then you invest in a bubble (depend on a Greater Fool).

So a bubble requires two elements:
i) A supply of cash, looking for investments.
ii) Limited sound business investments.

3. Putting it together.

So suddenly Keynes isn’t working. Why not? The answer is obvious. The Economy has two parts which must “map” to each other:

i) Money supply

ii) GDP (a proxy for "stuff made" or productivity).

We have just said that it appears that productive investments don’t seem to be available – so any expansion of GDP is due to phantom bubble blowing, not real productivity.

Injecting money only works if it can engender “real” growth. If the production of tangible goods is not an option, the money leads to a bubble, which collapses. A fair description of the last 15 years.

The Dow Jones has collapsed to a level below where it was in 2000 (in real terms). US GDP should probably do the same and if the US dollar continues to decline the value of the US economy (in real terms) probably will drop to pre-2000 levels (it may have already, I haven’t done the maths).

So now we can answer the question: Why is the economy undergoing a chaotic bifurcation?

The Keynes strategy was designed to deal with a contraction in money supply. But money supply maps to underlying productivity. What if the problem is a contraction in the ability to grow? This won't be cured by adding money - the money needs to be invested in growth.

A few simple data points:

i) Growth of economies is correlated with growth of consumption of energy supplies. Recent studies that found a possible weakening in this correlation for developed nations failed to consider the fact that the energy consumption had simply been outsourced to the manufacturing nations. (See the Bundeswehr study referenced in Part 1 for more discussion and references).

ii) Oil production peaked and plateaued in around 2005. (See the Bundeswehr study referenced in Part 1 for more discussion and references).

iii) Energy and mineral resources required to extract energy and minerals is increasing exponentially as the quality of resources decreases (see here and here for discussion.).

Given these trends it is obvious that the quantity of resources available to do useful work for society is going to struggle to keep up with growth. This is reflected in an increase in prices for these resources – making investment in any resource-requiring production (i.e. any production of tangible goods) difficult. This clearly encourages investment in “phantom” productivity – bubbles and intangible “services” or products.

If the growth in money supply over recent years was invested in phantom bubbles, then of course it will collapse until it represents the value of the “real” economy.

This is seemingly well under way.

But there is an underlying issue: The Fractional Reserve System REQUIRES growth. If growth is not possible, then this system is fundamentally unsound.

So here is the issue in a nutshell: The Keynes policy approach addresses an issue with money supply. It would allow money to be invested in growth. But what we have is an issue with growth. The system is much more complex than I have indicated, but this fundamentasl mismatch is (I believe) at the core of the problem.

It is simple, and (when you think about it) obvious.

The bifurcation(s) must drive a decrease in complexity until a stable system evolves. If growth is less possible, a new system must evolve.

Energy and Society Part 1

A complete version of the Bundeswehr (German Army) study is now available. Amazingly, they seem to be interpreting things in quite interesting ways. In many ways it looks spookily familiar – first in their reference to a bifurcating chaotic system, and second in their comment that “All other subsystems have developed hand in hand with the economic system. A disintegration can therefore not be analysed based on today’s system. A completely new system state would materialise.”Excerpts from the Bundeswehr study:
The phenomenon of tipping points in complex systems has been known for a long time and is referred to as “bifurcation” in mathematics. Tipping points are characterised by the fact that when they are reached, a system no longer responds to changes proportionally, but chaotically. Currently, reference is made to potential “tipping processes” most notably in the field of climate research. At such a point, a minor change to one parameter – in the case of the climate, a change in temperature – would have a drastic effect on an ecosystem.At first glance, it seems obvious that a phase of slowly declining oil production quantities would lead to an equally slowly declining economic output.Peak oil would bring about a decline in global prosperity for a certain length of time, during which efforts could be made to develop technological solutions to replace oil. Economies, however, move within a narrow band of relative stability. Within this band, economic fluctuations and other shocks are possible, but the functional principles remain unchanged and provide for new equilibriums within the system. Outside this band, however, this system responds chaotically as well.From the perspective of economics, at least one border of the band can be identified: an economic tipping point exists where, for example as a result of peak oil, the global economy shrinks for an undeterminable period. In this case a chain reaction that would destabilise the global economic system and cause a clear shift in the analytical framework for all other security consequences would be imaginable. The course of this potential scenario could be as follows:[Short Term]1. Peak oil would occur and it would not be possible, at least in the foreseeable future (153), to entirely compensate for the decline in the production of conventional oil with unconventional oil or other energy and raw material sources. The expression “foreseeable” is very important in this context. Ultimately, it leads to a loss of confidence in markets.In the short term, the global economy would respond proportionally to the decline in oil supply (154).
  1.  Increasing oil prices would reduce consumption and economic output. This would lead to recessions.
  2.  The increase in transportation costs would cause the prices of all traded goods to rise (155). Trade volumes would decrease. For some actors, this would only mean losing sources of income, whereas others would no longer be able to afford essential food products.
  3.  National budgets would be under extreme pressure. Expenditure for securing food supplies (increasing food import costs) or social spending (increasing unemployment rate) would compete with the necessary investments in oil substitutes and green tech.
Revenues would decrease considerably as a result of recession and necessary tax reductions.[Medium Term]In the medium term, the global economic system and all market-oriented economies would collapse.
  1.  Economic entities would realise the prolonged contraction and would have to act on the assumption that the global economy would continue to shrink for a long time (156).
  2.  Tipping point: In an economy shrinking over an indefinite period, savings would not be invested because companies would not be making any profit (157). For an indefinite period, companies would no longer be in a position to pay borrowing costs or to distribute profits to investors. The banking system, stock exchanges and financial markets could collapse altogether (158)
  3.  Financial markets are the backbone of global economy and an integral component of modern societies. All other subsystems have developed hand in hand with the economic system. A disintegration can therefore not be analysed based on today’s system. A completely new system state would materialise.
Nevertheless, for illustration purposes here is an outline of some theoretically plausible consequences:
  •  Banks left with no commercial basis. Banks would not be able to pay interest on deposits as they would not be able to find creditworthy companies, institutions or individuals. As a result, they would lose the basis for their business.
  •  Loss of confidence in currencies. Belief in the value-preserving function of money would dwindle. This would initially result in hyperinflation and black markets, followed by a barter economy at the local level.
  •  Collapse of value chains. The division of labour and its processes are based on the possibility of trade in intermediate products. It would be extremely difficult to conclude the necessary transactions lacking a monetary system.
  •  Collapse of unpegged currency systems. If currencies lose their value in their country of origin, they can no longer be exchanged for foreign currencies. International value-added chains would collapse as well.
Mass unemployment. Modern societies are organised on a division-of labour basis and have become increasingly differentiated in the course of their histories. Many professions are solely concerned with managing this high level of complexity and no longer have anything to do with the immediate production of consumer goods. The reduction in the complexity of economies that is implied here would result in a dramatic increase in unemployment in all modern societies.
  •  National bankruptcies. In the situation described, state revenues would evaporate. (New) debt options would be very limited, and the next step would be national bankruptcies.
  •  Collapse of critical infrastructures. Neither material nor financial resources would suffice to maintain existing infrastructures. Infrastructure interdependences, both internal and external with regard to other subsystems, would worsen the situation.
  •  Famines. Ultimately, production and distribution of food in sufficient quantities would become challenging.
The report runs to 112 pages, a link to it is available from the Energy Bulletin review here.