Predicting the 'Super GFC': two very different views

Two new books give very different pathways to the next financial collapse, one quite conservative and the other radical but both coming from a realist perspective, meaning they extrapolate from facts rather than pinning their faith in simplistic economic theory. Bringing them together provides some additional depth.

The Bankers' New Clothes: What's Wrong with Banking and What to Do about it (Anat Admati and Martin Hellwig)

The two authors are highly respected academics, Admati from the US and Hellwig from Europe. The book has endorsements from former central bank leaders, Paul Volker (US) and Mervyn King (UK), plus the well-known Kenneth S. Rogoff and many more.

The message is fairly straightforward. The GFC was caused by lax regulation of banks. After massively expensive bailouts of banks by governments nothing much has been done to change the controls on banking. In fact things have got worse, so we can expect an even more horrific crash unless governments quickly do some simple things to make the financial system safer. Their final point is that all we need is the political will, but that seems to be lacking.

Their most important prescription is for higher equity to debt ratios for banks, and they demolish all the arguments banks trot out as to why this can't or shouldn't be imposed. The simple point is that with more equity the banks shareholders stand to lose more in a downturn before they go running off to the government for a bailout.

Big changes are also recommended to the contractual bonus incentives that currently encourage bankers to take excessive risk. There are more good ideas in what is at times a fairly dry text.

But along the way some interesting points are made.

The authors point out that banks have incentives to merge, and get bigger in other ways, to achieve the status of 'too big to fail'. Their borrowing becomes cheaper at that point because lenders believe they will be bailed out by governments if it all goes wrong. However, the authors claim banks are going beyond 'too big to fail' and achieving the status of 'too big to save'. With government debts already enormous the bailout costs after another great crunch would be impossibly large.

On March 31, 2012, the debt of JP Morgan Chase was valued at $2.13 trillion and that of Bank of America at $1.95 trillion, more than three times the debt of Leman Brothers [when it collapsed]. The debts of the five largest banks in the United States totalled around $8 trillion. These figures would be even higher under the accounting rules used in Europe. [US GDP is generally believed to be around $15 trillion but see below.]

They go on to say that the situation is even worse in Europe.

The complex interconnection of banks and other financial institutions is outlined as part of the explanation of 'contagion', or how panic can close down the system even when losses are apparently manageable.

Total global banking assets are put at $80 trillion. It is worth remembering that total global domestic product, depending on how it is calculated, ranges between $70 and $85 trillion.

The book includes a quote from Adair Turner, chair of the Financial Services Authority of the UK, made in 2010. '"There is no evidence that the growth of the scale and complexity of the financial system in the rich developed world over the last twenty to thirty years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than deliver economic value." He continued, "We need to challenge radically some of the assumptions of the last thirty years and we need to be willing to consider radical policy responses."'

It would be nice if someone in Canberra was thinking about these problems. Our banks are better placed than most but that will not save us when the global crunch comes.

Life after Growth (Tim Morgan)

Tim Morgan is a Brit with decades of experience in the London finance world. He has built up a reputation for pessimistic predictions.

The central thesis of this book is that the real economy is based on energy availability and cost. The end of cheap energy means the end of growth, or, as he actually argues, the end of the economy as we know it. He goes beyond the 'peak oil' view to a more complex concept of 'surplus energy'. This refers to the amount of energy left after subtracting the energy expended to extract the new energy.

Hunter-gatherer society expended roughly as much energy in getting food as it got from that food. There was very little surplus. Agriculture enabled surplus energy to be produced, making civilisation possible. The industrial revolution was based on the capture of heat energy from burning wood and coal, which created a big surplus. For the last century or so we have leapt ahead by using the amazingly huge surplus energy derived from oil and gas.

The key problem we now face is not that energy sources are going to suddenly disappear but that the surplus energy after extraction is already declining rapidly and will certainly decline faster in coming years.

Morgan's measure is EROEI, or energy return on energy invested. He states that the oil fields discovered in the 1930s had EROEIs of 100:1. This wonderful number has dropped as we move to smaller fields that are much harder to extract from, such as undersea basins. He claims the global EROEI has dropped from 37:1 in 1990 to 15:1 in 2010 and worse is to come.

The killer point is that the decline is not linear. It compounds, meaning it will soon become very difficult to extract a significant surplus amount of energy.

Morgan dismisses the great hope of recent years, shale gas and oil, with the claim that its average EROEI is 5:1 or less, mainly due to the complexity of the process and the very high depletion rate of wells. Wind power he gives a ratio of 17:1, though it could go lower depending on the actual life span of windmills as opposed to the projections. Biofuels he writes off entirely with an EROEI of around 2:1. Hydrogen he claims is a very inefficient system of storing energy rather than creating it. Nuclear is better but can't be scaled up sufficiently to make a huge difference. He believes large scale solar has potential.

As the production of energy becomes more energy intensive it becomes much more expensive. But Morgan insists that the impact is far wider that the simple cost issue. Abundant energy has enabled our consumerist lifestyle and the end of abundant energy will mean the end of consumerism. Also, when energy was cheap workers could become relatively expensive. With energy expensive and workers in abundance, wages will drop.

As evidence of the impact of growing energy costs Morgan lists the inflation adjusted prices of various commodities between 2000 and 2012. Coal rose 183%, crude oil 174%, copper 223%, rice 110% and wheat 102%.

Beyond his view of energy as the fundamental base of the economy Morgan has some related points to make.

He distinguishes between the real economy and the monetary economy, describing money as a claim on the real economy, and debt as a claim on future money. Because energy is the basis of the economy, money comes to represent energy. Over recent decades the financial world in western nations has parted ways with the real economy and created massive debts in the expectation that future economic growth (based on a continuation of abundant energy) will enable repayment.

But the decreasing EROEI means these debts can never be repaid and will have to be written off at some stage. He estimates that trillions of dollars worth of value have been destroyed already through the Global Financial Crisis and its aftermath. He calculates the remaining notional value that must be destroyed for a return of the financial world to a solid base in the real economy to be $90 trillion in 2012 and increasing at around $7 trillion per year.

Morgan also regards globalisation as 'madness'. By this he means the process of rich nations outsourcing work to low wage nations, which involves cutting their production, while continuing to increase consumption and make promises of increased expenditure into the future, thus creating massive debts.

His last point is to argue that official statistics have been corrupted to minimise inflation and unemployment while inflating GDP. This process, which has spanned several decades, has reduced pressure for realistic action to remedy continuing economic decline in rich nations. The failure to act has made life worse for most workers in these countries while the rich have got even richer.

He names specific decisions by the relevant governments and assesses the impact on current figures. One example in the US is the imputation of owner-equivalent rent. This is the calculation of rent that would be paid on houses that are owned outright by owner-occupiers if they were in fact rented. The amount of imputed rent is then added to GDP even though no money actually changes hands. There are other imputations where cash values are given to transactions that are only imagined to happen. These together are equivalent to around 15% of US GDP.

If a more realistic calculation of GDP is made then the national debt to GDP ratio is much higher than currently calculated.

The minimisation of inflation enables governments to pay out less on indexed pensions and benefits, while the minimisation of statistical unemployment reduces pressure for job creation.

Morgan gives much more detail, with the conclusion that most of the rich world has been in recession for the last decade but hidden that fact from itself by manipulation of official statistics.

"Life After Growth" is only 159 pages long and a very easy read. The key projection is for a huge economic collapse when reality forces us to abandon self-deception and recognise increasing energy costs and the impossibility of continuing to debt-fund our life styles. The most likely timing is around 2020 but it could easily happen much sooner.

All those folk who believe in magic, such as primitive economists, will deride Morgan and claim the system will automatically fix itself as it always does. They will continue their deep fundamentalist faith that everything will get back to normal as long as we ignore all heretical thoughts.

For those interested in reality Morgan has some interesting concepts and views. The book is very broad brush and leaves open debate about many points, including how well-placed Australia would be in such a crisis situation.

Meanwhile all political parties argue about the insignificant and our so-called think tanks endlessly recycle old ideologies.