https://consciousnessofsheep.co.uk/2024/05/31/nowhere-to-run/

In the mythology of the 2008 crash, the global economy was rescued by farsighted politicians setting aside party, and even national interests to work with the experts at the central banks to inject much needed liquidity into the banking and financial sector in order to restart a seized economy. With this done, governments around the world enacted new laws and regulations to ensure that it could not happen again.

It should go without saying that the myth bears little resemblance to what actually happened. Sure, new government debt coupled to ultra-low interest rates helped to get the banks lending (i.e., creating new currency) again, and regulation to protect ordinary deposits and to ban the misselling of mortgages made sure that next time around, the details of the crash would be different. But the fundamentals remained the same.

Depressingly – this being an election year across much of the west – politicians continue to spout the magic money tree economics that was discredited by events in 2008. That is, they continue to believe that there is a magic money tree somewhere which creates money, and that governments can only spend after they have obtained this magic money by taxing businesses and households. What anyone who was paying attention in 2008 now understands is that there is no magic money tree… only banks. Banks create new currency when they make loans. And this applies internationally as well as domestically. If, for example, a business needs a loan to purchase goods from another country, it can borrow in that country’s currency from an international bank. Crucially, just as with domestic banks, the international banks don’t lend deposits but simply create the new currency at the stroke of a keyboard. Billions of dollars, for example, circulate around the global economy without ever having been issued by the Federal Reserve or the US Treasury.

This didn’t change after the 2008 crash. Nor did the means by which banks seek to offset their liabilities. In the olden days (which were never quite as rosy as nostalgia would have it) a loan was like a millstone around a bank manager’s neck. It is true that, by the time it was repaid, the bank would have earned far more than it loaned. But the income dripped in month-by-month, with the ever-present danger of default. But computerisation, along with the neoliberal deregulation of the 1980s, allowed the banks to resurrect one of the deadliest practices ever invented… securitisation. Put simply, if accurate bank data makes it possible to predict the proportion of loans which will turn bad, then a bank can create a savings vehicle based on the income from its loans with the default rate built in. For example, if three percent of loans are expected to go bad, the bank can create savings vehicles offering 97 percent of the income. Building on this, banks might separate different loans according to their quality… offering a better return on AAA loans than on BBB ones. And as an extra level of security, the banks might insure the income to protect against unforeseen defaults.

The securities created by the banks were originally considered as good as gold and were snapped up by pension and insurance funds as the next best thing to government bonds. They also proved to be good collateral for other banks when making interbank loans, including internationally, where they provided the collateral required to offset the creation of new dollars, euros, pounds, and yen. And so long as the banks didn’t abuse the system, major crises could be avoided.

Abusing the system though, is what banks do. Not least because securitisation appeared to pass all of the risk to other people. Instead of having to wait years for a loan to be repaid, banks could securitise and sell on their loans almost as soon as they were issued. Which is why during the 1990s, we witnessed small regional banks being transformed into global behemoths with turnovers greater than most countries. In the UK we also experienced the building societies engaging in mass bribery to persuade their members to allow them to become banks. And as the feeding frenzy continued, householders struggled to open their front doors because of the mountain of pre-approved loan junk mail arriving daily. It seemed for all the world that Labour chancellor Gordon Brown really had found a way to put an end to the cycles of boom and bust.

There was no secret sauce though. The western economies were simply experiencing a kind of monetary equal and opposite upswing to the depression of the 1970s and 1980s. Back then, when governments had exercised far greater control over bank lending, governments and central banks had engineered a depression by dramatically cutting the volume of currency in circulation. The UK was particularly badly hit, with more than five million highly paid manual jobs being destroyed in just two years. And every western country saw the beginnings of what in the USA came to be known as the rust belt during the period. From the mid-1980s, in contrast, it was as if someone had taken their foot off the currency brake and slammed it hard on the accelerator. Since currency is created when banks make loans, and banks had a new – and apparently risk free – incentive to make new loans, the western economies gradually began to flood with new currency.

If the western economies had been structured more or less as they had been in the 1970s, the result of all of this new currency would have been inflation. But the neoliberal economic policies of the 1980s had restructured everything. Manufacturing had been offshored, so that the new currency quickly moved abroad where wages and overheads were cheaper. The result was that import prices remained low. At the same time, economies like the UK switched to retail and hospitality, together with financial services… the nation of shopkeepers became a nation of low-paid shop workers, which also served to keep inflation in check. The only place where inflation appeared was the one place where it is considered acceptable… in asset prices. Most obviously, in the UK during the 1990s and early 2000s, people’s houses were “earning” more money than they were paid from their jobs. But assets of all kinds, including stocks and bonds, were rising at breakneck speed.

“Something” brought the good times to a crashing halt in 2008 – although even those who understand the risks from debt-based currency struggle to explain what that something which pulled the rug from beneath the global economy actually was. However, in attempting to provide a psychological explanation – a loss of confidence – they came close to asking the correct set of questions (although most never did).

The idea of a “business cycle” has been around for as long as people have called themselves “economists.” The idea is simple enough and is broadly observable in the GDP data. At the end of a recession, the economy enters a new growth phase lasting some three to five years. After this, the economy begins to slow, and enters a new recession. The role of banks within this is key, because the transition from depression to growth begins with a loosening of bank lending. This, in turn, is self-fulfilling because as the new currency stimulates further growth, so fewer loans go bad… causing banks to loosen lending standards further. But soon enough, we reach a point of “peak lending” beyond which the banks begin to tighten lending standards. As the volume of new currency falls, so more loans go bad, causing banks to tighten lending still further… thus driving the economy into the next recession.

Since, however, economics is a science (sic) of transactions rather than a science of human activity (i.e., the economy) this is about as far as explanations of economic cycles get. And so, we are still left with some magical “something” which brings the growth and recession phases to an end. This is why we have to shift our attention to the real – material – economy to understand what is actually happening. And perhaps the best material explanation comes from the oil industry, where they talk about the production “choke chain.”

The analogy here is with a dog on a leash. Initially, the leash is loose, and the dog can run off. But eventually, the choke chain tightens, and the dog is forced to slow down. In the oil production cycle, we begin with a surplus of oil which can be put to use in the economy. As the economy grows so does demand for oil, and so, the oil companies ramp up production. But eventually, demand overshoots production causing the oil price to rise. The higher oil price causes prices across the economy to rise, causing businesses and households to adjust their spending accordingly. Economic demand falls until it creates a new oil surplus, allowing a new period of growth to begin.

Oil is important here because it is the primary energy for the western economies. But a similar and related process occurs with all commodities and, indeed, with goods and services. When energy is cheap and abundant, the economy can grow. In a growing economy more goods are produced and more services delivered. But to enable this, resources of all kinds must be mined, refined and produced. Any one of these might hit a peak, causing prices to rise. But few resources are so ubiquitous as to cause price rises across the economy. Copper, cement, and some plastics might, as did the shortage of computer chips two years ago. But oil is the one resource whose price impacts prices across the economy as a whole.

Of course, oil was not always our primary energy source. Indeed, for most of human existence, oil was merely an unwanted pollutant in water sources. Nevertheless, we find the same cycle in economies based around wood/charcoal burning and, indeed, during the coal age. When the Spanish Empire began importing gold and silver from the Americas, for example, its rulers anticipated a new age of prosperity. Instead, they undermined their empire with runaway inflation and revolt. Why? Because precious metals, along with any form of money or currency, are merely a claim on wealth. In and of themselves, they have no value at all. And crucially, if you double or quadruple the amount of claims on wealth without increasing the wealth itself, then all you succeed in doing is devaluing the claims. This appears to be rising prices, but it is really the devaluation of the currency. In sixteenth century Europe, this happened because the influx of precious metals made claims on the continent’s supply of timber that simply couldn’t be met locally. Timber had to be shipped from ever farther afield – Poland and Russia to begin with, North America later – and at ever increasing cost. And as the cost of primary energy increased, so too did the price of everything else – a process not helped by using the last supplies of good timber to build an Armada which you proceed to wreck around the coast of Britain.

The coal economy was more complex and far more globalised. By the end of the nineteenth century, for example, while the British and French Empires could be drawn on a world map, the majority of the home countries’ trade was outside their respective empires. And in the wake of the First World War, during which five empires (China, Ottoman, Russian, German, and Austrian) drew their final breath, globalisation was far deeper – not least because Britain and France had pawned the family silver with the Wall Street banks… one reason why Europe experienced a depression while the USA enjoyed the roaring twenties.

Therein though, lay the seeds of the Great Depression. The American post-war boom was based on the anticipated income from European debt repayment (a considerable portion of which was based on German war reparations). But these, in turn, were based on the restoration of economic growth as the economies switched from their war footing. With this process dependent upon access to cheap and abundant energy in the form of coal (only in the USA had the civilian economy begun the switch from coal to oil in the 1920s).

To talk about “peak coal” is difficult in this context because once we entered the oil age, we were able to produce coal on a scale that would have been impossible in an economy solely driven by coal. To give an example of this, consider that China burned more coal in the last two decades than Britain has burned since the dawn of the Industrial Revolution. British coal production peaked in 1913 and had to be subsidised for military reasons thereafter. But global coal production continued to increase during the first half of the 1920s. The peak of coal-based coal production came in 1927, causing a big spike in world coal prices (which were later blamed on the Welsh miners’ strike of 1926). In its way, this had a similar effect as the Spanish timber shortages in the sixteenth century – causing prices to rise and economic activity to slow.

The same banking and finance process that we see in ordinary business cycles followed. The roaring twenties were largely debt-based, with people borrowing to buy shares which – like British houses in the 1990s – were expected to rise in price at a faster rate than the interest on the loan. In the apocryphal story, Joseph Kennedy realised the boom was about to bust when a shoeshine boy started talking about share prices – if a shoeshine boy had bought shares, then there was no one else left, and so prices would have to fall. Either way, Kennedy sold up just before the Wall Street Crash.

The run on the banks followed as people realised that the banks had also invested in the stock market. And since, in any case, banks hold only a fraction of the currency nominally on deposit, bank failures were inevitable. Suddenly, households were without cash even to pay for essentials while businesses could no longer meet the wage bill. In Europe – which was still struggling to kickstart growth while trying to meet the payments on its wartime debt – the depression was even deeper and gave rise to waves of collectivist movements which regarded state control of the economy as the only way out. But even in the more economically liberal USA, Roosevelt took government intervention in the economy to a level unthinkable prior to the crash.

It took the switch to a new source of primary energy – itself driven by the demands of an even bloodier war – to pull the western economies into a new energy cycle of growth. In the USA, this meant merely expanding oil age technologies which already existed on a small scale. In Europe, it meant the wholesale switch from coal to oil in the post-war years. And instead of the depressed economies of the 1920s, once the immediate war damage had been repaired, the result was the unprecedented economic boom from 1953 to 1973 – something, by the way, which caused western policy makers to wrongly believe that war is good for the economy.

The 1970s were marred by stagflation resulting from a combination of a series of oil shocks and a crisis in the global (Bretton Woods) currency system. This shared the features of the earlier coal-based crisis. Over-exuberance in the banking and financial system during a period when oil production was growing exponentially had led to over-creation of currency. Oil production had begun to slow in the late-1960s (although on nothing like the scale following the OPEC oil embargo), and inflation was taking hold in Europe. To address this, first Germany and then France, demanded that balance of payments be settled in gold rather than paper dollars. This though – despite gold being ferried across the Atlantic in destroyers – exposed the extent to which successive American governments had abused the “exorbitant privilege” of creating the world’s reserve currency to fund wars abroad and social programs at home. By the summer of 1971, the USA had reimported much of the inflation, causing Nixon to “temporarily” end the gold standard in August 1971.

To make matters much worse, partly in retaliation for US support for Israel and partly to exert their growing monopoly power, the OPEC states imposed an oil embargo on the western states in October 1973. For the first time, western people caught a glimpse of what might happen were the world to run out of oil (this at a time when we consumed far fewer oil products). Then, just when the effects of the 1973 shock had begun to ebb, the west was hit with another oil shock resulting from the Iranian revolution and the ensuing Iran-Iraq war (it was this, rather than the beatified Paul Volcker, which generated the depression which appeared to bring inflation under control).

The 1970s though, were not the end point for oil-based growth. Rather, they marked an inflection point between exponential and incremental growth. Indeed, far more oil was produced between 1975 and 2000 than had been produced between 1950 and 1975. The difference was that the energy cost of production was rising remorselessly:

This may sound technical, but what it meant was that an increasing proportion of our total energy had to be consumed in energy production, leaving ever less to power the much wider non-energy sectors of the economy:

In effect, an increasing volume had to be produced to offset the loss to the rising cost of production. And if ever production were to peak, the full impact of the rising energy cost would be felt. This was widely understood in the 1970s, when governments sought alternative energy sources and implemented energy efficiency measures. But with new oil deposits being produced – including North Alaska, the North Sea, and the Gulf of Mexico – the price of oil fell, and the sense of urgency faded.

The result was the debt-based boom of the 1990s and early 2000s, which came to such a tragic end in 2008. And we begin to understand what the “something” that caused its demise might have been. In 2005, the world’s conventional (i.e., cheap and easy) oil production peaked. The oil price spiked, and price increases rippled through the rest of the economy. Totally misunderstanding the economic history of the 1970s and early 1980s, the central bankers attempted to control prices by raising interest rates. This did nothing for prices, but it added an additional cost burden to households and businesses. Some of these turned out to be “sub-prime,” but some of these were only sub-prime because of the interest rate rises – they had been meeting their payments up until that point.

Insofar as the central bankers sought to lower inflation, they are to be congratulated. Their actions generated a period of some 15 years during which inflation barely rose above one percent. The impact on everything else was far less successful of course. But the influx of bank credit together with negative real-terms interest rates unexpectedly allowed the western economies to play a game of “extend and pretend.”

In the post-crash low interest environment, investors had to take risks to gain returns. And in this “search for yield,” a growing industry producing oil by hydraulically fracturing shale deposits in the USA appeared to be a good bet. The problem, once again, was with the energy cost of fracking. To remain viable, the fracking companies needed oil prices to stay high – ideally, and widely predicted, to rise above $200-per-barrel. But in the post-crash depression, economies shrank and demand for oil fell accordingly. By 2015, the world oil price was down to just $35… far below the price needed by the frackers and, indeed, by most of the OPEC+ states.

Fracking came with three additional problems. First, and most obviously, it suffers from “red queen syndrome” – well production falls rapidly, so more and more drilling is needed to keep production growing. Second – as would-be shale gas drillers in Europe discovered – you can’t frack any old shale, you must have good geology and geography… Europe (and much of the rest of the world) has neither. Third, the oil produced is much lighter than conventional oil – great for producing polythene bags but not good for producing the essential middle distillates that power the world’s critical machinery and transport.

Peak middle distillates may have occurred in the mid-2010s, although the blending of light oil from fracking with heavy oil from tar sands may have delayed the peak. Either way, world oil production peaked in November 2018, causing the western economies to tip into recession the following year. Not that any of us really got to notice because the western states went completely insane in the spring of 2020 and have yet to restore any semblance of sanity… adding self-destructive sanctions to the broken supply chains and resource shortages caused by locking down economies – the combination of both creating the energy shortages and eye-watering price increases of the past two years.

This though, has been no ordinary business cycle. Rather, in addition to periodic business cycles lasting roughly a decade, there are also long energy cycles in which a prolonged upward trend (punctuated by the ups and downs of business cycles) begins with the switch from one primary energy source to another, more energy-dense, cheaper, and abundant alternative. The transition from charcoal and renewable energy to coal, enabled and powered the massive expansion of the nineteenth and early twentieth centuries. The transition from coal to oil in the mid-twentieth century powered the modern world. But just as, from the 1970s, we had to keep increasing the volume of oil to offset the impact of the rising energy cost of the oil, globally we have also been increasing the volume of coal and gas consumption (mostly in Asia, allowing the western states to pretend they are “green”) to further offset a rising energy cost of energy. Indeed, even the so-called “renewables” are merely being added to the mix to keep energy consumption growing, rather than meeting their stated aim of replacing fossil fuels.

What we are missing – which is why this time is different – is a cheap, abundant and more energy dense replacement for oil. Nuclear has the theoretical potential for this (although naturally occurring Uranium is in short supply). A kilogram of uranium in a breeder reactor can provide roughly 1,500 times the energy provided by a kilogram of oil in a diesel engine. The problem, however, is that nobody has figured out how to harness even a fraction of that potential. Instead, for all of the complexity of a nuclear reactor, it is coupled to a nineteenth century steam turbine.

Non-renewable renewable energy-harvesting technologies (NRREHTs) harness energy which is far too diffuse for them ever to replace fossil fuels (which is the main reason why they haven’t). Hydroelectric dams offer far more power, but there are few places left on Earth to dam on the required scale. Biomass is a non-starter because of the acreage required – and is already competing with food production. So, while all of these “green” energy sources might play some role in future, they cannot enable a new energy cycle or even prevent the next crash.

Which brings us back to why we know broadly what is coming. The banking and financial sectors – including so called shadow banking – have generated mountains of derivative debt on the back of lending across the economy. And while post-2008 legislation is in place to protect ordinary bank balances and personal household mortgage debt, most of the rest of the banking and financial system is still living in the financial wild west. Nevertheless, the same sub-prime issues are in place today as were in 2008. The entire currency system requires that outstanding debt continues to be serviced. But debt servicing is only possible in a growing economy. And since the energy and resource production required for growth is no longer present, sooner or later the debt mountain is going to turn into a default avalanche.

Aided by central bank interest rate rises, the banks have already tightened lending standards. But less clear is what is happening in international banking, where the nominal value of currencies is decided. This may be where that which was too big to fail becomes too big to save this time around. Because as the coming Great Default gathers pace, governments too will be unable to repay the nominal value of the mountain of debt they have created. For debt denominated in their own currencies, governments can accept devaluation and simply create the additional currency – effectively inflating the debt away. But for governments like the UK which are heavily dependent on imports, devaluing their own currency makes it far harder to raise the foreign currency required to repay international debts and to settle balance of payments (current) accounts.

When the debt-currency crisis first hit in the dotcom bust, companies were bailed out by banks at the cost of inflating an even bigger bubble. In 2008, that bubble burst and banks had to be bailed out by governments. This time around it is going to be companies, banks, and governments which need to be bailed out. And in the absence of space aliens, there is nobody big enough to do so. This, no doubt, is a key driver behind the growth of the BRICS trading system. It is very likely also why the UK Tory Party are going out of their way to lose the general election. But in the economic storm that is about to break there is nowhere to run.