Perfect storm

Today I want to take up the theme of why assumptions of economic normalcy for the rest of the present decade are misplaced.  It’s a big subject and this is a long post.  Even so, much of the weight of the argument is carried by referenced articles.

Cassandra had a credibility problem.  So it’s interesting that the editors of the New York Times, those august arbiters of elite public discourse, gave prominence in the Sunday editorial section to a long jeremiad (and prophecy of economic doom) by David Stockman, Reagan’s first budget director (“State-Wrecked: the Corruption of Capitalism in America,” March 30, 2013).

Given the prominence of Stockman’s op-ed, I’ll start there.

In my view Stockman got a lot right in that essay, much of which (certainly not all) reads pretty well from the left side of the political spectrum.  I wonder if his libertarian streak and pure-market faith make his comments about class war (by the rich against the poor) and his dark prognosis for the U.S. economy and polity palatable to the Times.  His own right-wing history made his essay far more interesting than if Noam Chomsky or Chris Hedges or Gaius Publius (e.g. here, on the predator class) had said something similar.  As of yesterday, three days later, it was still the most frequently blogged of recent Times articles.

There are plenty of liberal economists happy to jump all over Stockman for what I would consider the less important parts of his essay, or to make ad hominem comments about Stockman and the economic blood on his hands.  That’s easy; there’s plenty of it.  It is much less easy to dismiss Stockman’s indictment of the long-running class war or his critique of current official fantasy predictions, or his forecast of where today’s government failures will lead: to massive asset deflation, “zero-sum austerity,”[1] and virulent political conflict.

Stockman writes:

Since the S&P 500 first reached its current level, in March 2000, the mad money printers at the Federal Reserve have expanded their balance sheet sixfold (to $3.2 trillion from $500 billion). Yet during that stretch, economic output has grown by an average of 1.7 percent a year (the slowest since the Civil War); real business investment has crawled forward at only 0.8 percent per year; and the payroll job count has crept up at a negligible 0.1 percent annually. Real median family income growth has dropped 8 percent, and the number of full-time middle class jobs, 6 percent. The real net worth of the ‘bottom’ 90 percent has dropped by one-fourth. The number of food stamp and disability aid recipients has more than doubled, to 59 million, about one in five Americans.

On the left, Robert Sheer (“It Wasn’t David Stockman Who Wrecked the Economy,” 04/02/13) takes note of this passage and approves:

For all of the strident attacks on Stockman’s column, I have yet to read a serious critique of his most brazen claim, that the bailouts and quantitative easing that have saved Wall Street and brought the stock market back to historic heights represent class warfare with the vast majority of Americans on the losing side.

Marcus Brauchli (‘The Great Deformation: The Corruption of Capitalism in America’ by David Stockman,” 3/29/13) assesses Stockman’s ideas and new book for the Washington Post, concluding (like his fellow Times editorial peers) that the warning flame is well worth the candle.

But here’s the thing: Even as he indulges his spleen, Stockman produces a persuasive and deeply relevant indictment of a system dangerously akilter.

Over the past 40 years, the United States has become a strange fantasy land where many politicians think deficits don’t matter, regulators are closely entwined with their charges, and the Federal Reserve manages the economy through high-stakes, high-risk experimentation. The financial turmoil of the past few years is just a glimpse of what lies at the end of the road we’re on, Stockman warns.

It is no surprise that fellow polemicist and iconoclast James Kunstler is also quite positive about Stockman’s book (“Are You Going To Entropy Faire?”, 4/1/13).  He is inimitable.  I quote at length because I think the future of the country would be brighter if more people read Kunstler.

Things are breaking loose. Holes have appeared in the fabric of fraud and lies that passes for the world money system. They are black holes, gravitationally sucking in the things breaking loose, and as these things cross their event horizons, they will never be seen again. These things I speak of are the collateral for vast nebulae of falsely generated debts and obligations that were never intended to be honored (i.e. regarded as real). As they vanish down the wormholes of time, they take with them their pretenses of money value, meaning they leave reverberations of impoverishment in the shadowy place that the real world has become….

Stockman is out with a new book, The Great Deformation, that manages to concentrate all the requisite outrage in one gale of rectified objurgation. It is a pleasure to read Stockman – former budget director under Reagan and Michigan congressman – call out the villains from Reagan to Bernanke to Paulson to Rubin and scores of others in the most opprobrious terms. Stockman characterizes the financial action of recent decades as a “leveraged buyout of the USA” and it sure looks that way. If you travel around the towns of the upper Hudson Valley – once an industrial corridor full of Jimmy Stewart type burgs – it’s beginning to look like the country Borat grew up in. Everything of value that wasn’t nailed down was taken, and everything that remains is broken, including the ragged population.

On Sunday night, wire stories had Cyprus close to “going Icelandic,” that is, hoisting the middle finger to Brussels and repudiating the money owed. That option may end up seeming more attractive to virtually everybody in the broke world, including even the young college loan debt donkeys of the USA, groaning under their loads as they stand idle in the barren fields of unemployment.

So here’s the point.  If Stockman is generally right about our present condition, what prospect is there for real economic growth anytime soon?

And if there isn’t real economic growth, and so also greatly increased tax revenues, what will become of all the current spending and deficit reduction plans?

In particular, what will happen to multi-hundred-billion-dollar plans to build new nuclear submarines, bombers, missiles, warheads, and the like?

As Stockman put it, “America will descend into an era of zero-sum austerity.”  If he means austerity as economic reality, the future tense doesn’t apply.  We’re there now, but much worse is coming.  If he means austerity as a fiscal policy in which growth in some programs can only occur if there are corresponding offsets in others – that too is our current reality.

The  Congressional Budget Office (CBO), by contrast, sees boom times just ahead (“The Budget and Economic Outlook: Fiscal Years 2013 to 2023;” economic projections here in .xls).  The CBO predicts that the U.S. GDP growth for the current year and ensuing decade will average 4.8% (nominal) and 2.75% (real).  These averages are achieved by a nominal GDP growth that climbs to up to 6.6% by 2016 at the peak of a predicted three-year boom before slowly settling back to steady, recession-free growth henceforth.  As Stockman notes, CBO is counting on the U.S. economy producing 16.4 million new jobs in the next decade even though it produced only 2.5 million in the last one.

Federal revenues will grow wonderfully under such conditions, the CBO predicts.

Federal revenues will increase by roughly 25 percent between 2013 and 2015 under current law, CBO projects. That increase is expected to result from a rise in income because of the growing economy, from policy changes that are scheduled to take effect during that period, and from policy changes that have already taken effect but whose full impact on revenues will not be felt until after this year (such as the recent increase in tax rates on income above certain thresholds).

As a result of those factors, revenues are projected to grow from 15.8 percent of GDP in 2012 to 19.1 percent of GDP in 2015—compared with an average of 17.9 percent of GDP over the past 40 years. Under current law, revenues will remain at roughly 19 percent of GDP from 2015 through 2023, CBO estimates.

I think these CBO predictions are worthless.

Officially, we are roughly at “zero-sum austerity” in fiscal policy right now, using current-law, inflation-corrected spending caps.[2]  Using more realistic inflation measures (i.e. ones that include a measure of “dark inflation”) as will be shortly discussed, federal spending is now shrinking in real dollar terms and will shrink further in the coming years.

If the CBO-predicted revenue growth does not materialize all federal budgets and all plans based on them, including NNSA and DoD nuclear weapons modernization plans, incorporate a considerable degree of political risk.  Would dramatically increasing deficits over the coming decade to accommodate these spending plans, rather than deficit reductions as current law and political consensus requires, be politically tenable?  It is not unrealistic to suppose that federal budgets might shrink this decade, even in nominal terms, if tax revenues decline.  In real terms, especially if “dark inflation” is considered, actual purchasing power could then rapidly decline, posing great risks to NNSA projects.  Potential offsetting cuts in non-defense federal programs could be electorally untenable, and if enacted could, through their greater Keynesian macroeconomic leverage,[3] throw the country into (yet deeper) recession and thus lower federal tax revenues even further.  This is more or less what “austerity” programs seem to be achieving elsewhere.

Neither do I believe the official portrait of our present condition.  John Williams (Shadow Government Statistics) has been keeping spreadsheets of headline economic data calculated using a constant methodology, rather than one that changes through the years.  This is how Williams’ analysis portrays recent real GDP growth in comparison to the official history (graph hyperlinked to original).

 

Thus in Williams’ view, the U.S. has been in a double-dip recession since 2000.  There was no “jobless recovery” because there was no recovery, in this view, and I submit it accords with most peoples’ experience.

The official illusion of real growth in any current quarter is created by subsequent revisions of prior quarters and more so by the hedonic adjustments, substitutions, geometric weighting, “owner-equivalent rent,” and other adjustments that have distorted the consumer price index (CPI).   Williams:

 

The difference between the red and blue lines above is a measure of “dark,” or hidden, inflation.

Besides creating the illusion of economic growth when there is none, another effect of grossly underreporting inflation is to cloak real negative interest rates for borrowers.  Why not borrow, if loans will be repaid in deflated currency?  This reality considerably fueled the pre-2008 speculative bubble, according to Tim Morgan, Global Head of Research for Tullet Prebon, in a remarkable report (“Perfect Storm: Energy, Finance and the End of Growth,” pdf) to which we now turn.[4]

In the report’s words:

This report explains that we need only look beyond the predominant short-termism of contemporary thinking to perceive that we are at the confluence of four extremely dangerous developments which, individually or collectively, have already started to throw more than two centuries of economic expansion into reverse.

Before the financial crisis of 2008, this analysis might have seemed purely theoretical, but the banking catastrophe, and the ensuing slump, should demonstrate that the dangerous confluence described here is already underway. Indeed, more than two centuries of near-perpetual growth probably went into reverse as much as ten years ago.  [emphasis in original]

From the executive summary:

• • • • • The economy as we know it is facing a lethal confluence of four critical factors – the fall-out from the biggest debt bubble in history; a disastrous experiment with globalisation; the massaging of data to the point where economic trends are obscured; and, most important of all, the approach of an energy-returns cliff-edge.
        • The 2008 crash resulted from the bursting of the biggest bubble in financial history, a ‘credit super-cycle’ that spanned more than three decades.  How did this happen?
        • The Western developed nations are particularly exposed to the adverse trends explored in this report, because globalisation has created a lethal divergence between burgeoning consumption and eroding production, with out-of-control debt used to bridge this widening chasm.
        • The reliable data which policymakers and the public need if effective solutions are to be found is not available. Economic data (including inflation, growth, GDP and unemployment) has been subjected to incremental distortion, whilst information about government spending, deficits and debt is extremely misleading.
        • The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy. But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.

I believe this is all pretty much spot-on. [5]  This report is really worth a close read, not just for the ideas but for the clarity of presentation.

It is in this last bullet that we dimly see a potent macroeconomic cause for rising, intentionally “darkened,” inflation.  Take a look at Morgan’s rough estimate of the underlying trend in energy returned over energy invested (EROEI) (his Figure 5.13):[6]

From the report:

Remember that what is being measured here is not the value of energy, but its cost as a proportion of the value that we derive from it. Cost and value could only be the same if no surplus existed, which would also mean that the economy could not exist either.

Our assessment of the trend in EROEIs is shown as the red line in fig. 5.13. On this basis, our calculated EROEIs both for 1990 (40:1) and 2010 (17:1) are reasonably close to the numbers cited for those years by Andrew Lees. For 2020, our projected EROEI (of 11.5:1) is not as catastrophic as 5:1, but would nevertheless mean that the share of GDP absorbed by energy costs would have escalated to about 9.6% from around 6.7% today. Our projections further suggest that energy costs could absorb almost 15% of GDP (at an EROEI of 7.7:1) by 2030.

Though our forecasts and those of Mr. Andrew Lees [‘In search of energy’, in Patrick Young (ed.), The Gathering Storm, Derivatives Vision Publishing, 2010] may differ in detail, the essential conclusion is the same. It is that the economy, as we have known it for more than two centuries, will cease to be viable at some point within the next ten or so years unless, of course, some way is found to reverse the trend. (emphasis added)

(For the way to reverse the ominous trend, keep reading.)

Chris Martenson’s prognosis is similar to Morgan’s; his final conclusion is the same as ours here at the Study Group.  (“The Real Reason the Economy Is Broken (and Will Stay That Way): More and more economic sinkholes,” 2/12/13).

We are far enough and deep enough into the most heroic monetary and fiscal efforts ever undertaken to finally ask, why aren’t these measures working?

Or at least we should be.  Oddly, many in DC, on Wall Street, and the Federal Reserve continue to steadfastly refuse to include anything in their approaches and frameworks other than “more of the same.”

…

The framework we operate from around here is simply encapsulated in the observation that there has never been global economic recovery with oil prices above $100 over barrel.  That is shorthand for the idea that oil is the primary lubricant of economic growth and that it is not just the amount of oil one has to burn but also the quality, or net energy, of the oil that matters.

If we want to understand why all of the tried-and-true monetary and fiscal efforts have failed, we have to appreciate the headwinds that are offered by both a condition of too-much-debt and expensive energy.  Neither alone can account for the economic malaise that stalks the world.

…

We could similarly look at the Federal Reserve balance sheet, or excess reserves, or a dozen other indicators that all say the same thing: The money supply has been expanded enormously.

And what do we have to show for it?

Not much.

Since 2005 real – that is, inflation-adjusted – GDP has only expanded by 0.9% on an annualized basis.  On a nominal basis (not inflation-adjusted), the number is only 2.9%, far below the 5%-6% required to sustain a banking system dependent on exponential growth in that range.

…

As I see it, the economy is broken and it will stay that way.  Our only hope for an alternative would be to immediately cut our losses in those enterprises that do not make sense in a world of increasingly expensive liquid fuels, and invest heavily in those things that will help us transition to a future without fossil fuels.  (emphasis added)

Eric Janszen, writing before the depth of the 2008 crash, anticipated Martenson’s last point and is also worth quoting in detail (“The Next Bubble: Priming the markets for tomorrow’s next big crash,” February 2008, Harper’s).

Our economy is in serious trouble. Both the production-consumption sector and the FIRE sector know that a debt-deflation Armageddon is nigh, and both are praying for a timely miracle, a new bubble to keep the economy from slipping into a depression.

We have learned that the industry in any given bubble must support hundreds or thousands of separate firms financed by not billions but trillions of dollars in new securities that Wall Street will create and sell. Like housing in the late 1990s, this sector of the economy must already be formed and growing even as the previous bubble deflates. For those investing in that sector, legislation guaranteeing favorable tax treatment, along with other protections and advantages for investors, should already be in place or under review. Finally, the industry must be popular, its name on the lips of government policymakers and journalists. It should be familiar to those who watch television news or read newspapers.

There are a number of plausible candidates for the next bubble, but only a few meet all the criteria. Health care must expand to meet the needs of the aging baby boomers, but there is as yet no enabling government legislation to make way for a health-care bubble; the same holds true of the pharmaceutical industry, which could hyperinflate only if the Food and Drug Administration was gutted of its power. A second technology boom—under the rubric “Web 2.0”—is based on improvements to existing technology rather than any new discovery. The capital-intensive biotechnology industry will not inflate, as it requires too much specialized intelligence.

There is one industry that fits the bill: alternative energy, the development of more energy-efficient products, along with viable alternatives to oil, including wind, solar, and geothermal power, along with the use of nuclear energy to produce sustainable oil substitutes, such as liquefied hydrogen from water. (emphasis added)

Janszen doesn’t mention climate in this passage, but climate considerations alone require this emphasis, all else aside.

By the way, Janszen’s nuclear hydrogen idea didn’t pan out.  It was never practical.  To its great shame, Sandia National Laboratories, ostensibly full of smart engineers, peddled this notion for some years when an hour or a day with a pencil and calculator would have shown it to be a fantasy.

I don’t know if the White House, or anybody in Congress, actually believes that current economic policies are going to bring about real economic growth, let alone the sudden boom over the next five years predicted by CBO.  I don’t know to what extent policymakers have absorbed the nagging disconnect between reported inflation and what people actually experience when they go to the grocery store, the doctor’s office, and the gas station, and what that discrepancy really means for economic and fiscal policy.

One thing that it means, as Stockman of all people points out, is that there is a huge flow of money from wage-earners to the investing class.

Another is that we are in economic decline, not growth.  It means there is no economic recovery now, jobless or otherwise, and there won’t be one.

The illusion of economic “growth” couldn’t be more finely-tuned for public consumption if it were invented by George Orwell himself.

I am the last person who would know how to prevent an economic or financial crash.  But I can add and subtract and so must conclude, with Janszen, for the reasons he mentions and others, that the only economic frontier big enough and rich enough to make a difference in the U.S. economy – given the energy quality crisis which besets us, and with the correct political and social alignment to liberate our society’s creative energies, and with a large enough local component that cannot be off-shored – lies in the process of weaning ourselves from fossil fuels.  To save what our economy, or rather to save what we can of it, we need to invest in renewable energy, energy conservation, and dramatic fuel economies in transportation.

The opportunity does not lie in an “all of the above” energy strategy, which would destroy our climate and therefore our country and civilization; that’s really more an electoral strategy than an energy strategy.

The opportunity does not lie in nuclear energy, which is in effect parasitic on the present fossil fuel economy (as discussed here, at note 2), and is strongly affected not just by ordinary “dark inflation” of cost but another kind of “dark inflation” – of risk.  Both were mentioned here.

The conditions for successful massive investment in this new frontier are more ripe than is usually appreciated, as Paul Gilding notes (“Victory at Hand for the Climate Movement?” March 2013).  They could be made riper, fast, by concerted, revenue-neutral government action.  On the other hand, they will be forestalled by the (DOE-supported) belief that a Magic Technology Innovation Fairy will come and make everything easy.  It won’t be easy – far from it.  It will be austere.  Economic changes of great magnitude are always accompanied by great social changes, and this one would be too, the nature of which is in our hands.  The no-action alternative is massive deleterious social change. 

To repeat: our economic, energy, and climate problems are huge.  Only huge Schumpeterian change on the scale of World War II has any hope of realistically addressing them with the alacrity needed.  Timid efforts will be OBE (“overtaken by events”), most likely in this decade.

The economic decline described by Stockman, Morgan, Martenson and others may be very intense and very sudden, as David Korowicz has pointed out in two important analyses (“Tipping Point: Near-Term Systemic Implications of a Peak in Global Oil Production: An Outline Review,” Feasta & The Risk/Resilience Network, 2010 and “Trade-Off: Financial System Supply-Chain Cross-Contagion: A study in global systemic collapse,” David Korowicz, Feasta, 2012).  “Degrowth,” in the sense of a soft landing, is unlikely.  Our backs are truly to the wall.

As financial and underlying economic systems grow more stressed, their sensitivity increases to possible triggers for the collapse described by the above authors.  The trust necessary to do business may be an early casualty, as Erich Kuerschner pointed out to me.

One such trigger could be federal budget cuts.  As Richard Heinberg reminds us, current deficit spending is about 7% of GDP (“Deficit Reduction = Recession,” Feb. 26, 2013).  Any significant effort to reduce the deficit will likely decrease GDP by roughly that same amount, throwing it into negative territory.  Heinberg concludes that a recession in 2013 is a “mathematical near-certainty.”[7]

Another trigger is oil prices, increases in which have been precursors to 10 out of 11 post- World War II episodes of recession in the U.S. (good references and commentary by Gail Tverberg here).

Many geopolitical events, e.g. war, could be precursors to a spike in global oil prices.  The U.S. economy is now made of glass.

An excellent analysis by the new economics foundation (“The economics of oil dependence: A glass ceiling to recovery,” 2012) using two somewhat distinct analytical approaches points to the 2014-2015 period as the likely time-frame for a (further) economic downturn, barring any oil price shocks in the meantime.  Recession could delay impact with the “glass ceiling.”

And so this long blog post concludes.  My conclusions include something like the following.

• A permanent economic downturn is inevitable and imminent if indeed it has not been underway for some years now;
• Only a massive, urgent investment in moving away from fossil fuels can mitigate or adapt to this downturn – which will otherwise steepen, perhaps precipitously;
• “Dark inflation” and increasing economic and political risks should predispose decisionmakers to “front-load” renewable energy, energy conservation, and non-or minimal-fossil fuel infrastructure investments;
• All plans and budgets which ignore the coming storm are unrealistic and will be subject to highly-contested political “re-baselining;” this includes the current highly-optimistic, but diplomatically tone-deaf, plans for modernizing the U.S. nuclear arsenal; and
• Given the severity and imminent nature of the economic crisis, citizens should where possible devote themselves immediately and strenuously to it, whether by bold forms of political action or by direct construction of mitigating infrastructure, businesses, and institutions.

Thank you for your attention.