Perfect storm energy, finance and the end of growth Dr Tim Morgan Global Head of Research - Financial Times
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perfect storm
energy, finance and the
end of growth
Dr Tim Morgan Global Head of Research
strategy insights | issue nine
perfect storm
energy, finance and the end of growth
summary
part one: the end of an era 5
the four factors which are bringing down the curtain on growth
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.
part two: this time is different 17
the implosion of the credit super-cycle
The 2008 crash resulted from the bursting of the biggest bubble in financial history, a ‘credit
super-cycle’ that spanned three decades. Why did this happen?
part three: the globalisation disaster 29
globalisation and the western economic catastrophe
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.
part four: loaded dice 43
how policies have been blind-sided by distorted data
The reliable information 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.
part five: the killer equation 59
the decaying growth dynamic
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.
strategy insights | issue nine 3
perfect storm | energy, finance and the end of growth 4 strategy insights | issue nine
part one:
the end of an era
the four factors which are bringing down the curtain on growth
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.
Through technology, through culture and tackled well in advance, could the denouement of a broadly-based
and through economic and political have devastating effects. The relentless process which had lasted for thirty
change, society is more short-term shortening of media, social and years, and is described here as “the
in nature now than at any time in political horizons has resulted in the great credit super-cycle”.
recorded history. Financial market establishment of self-destructive
participants can carry out transactions economic patterns which now threaten The credit super-cycle process is
in milliseconds. With 24-hour news to undermine economic viability. exemplified by the relationship
coverage, the media focus has shifted between GDP and aggregate credit
inexorably from the analytical to the We date the acceleration in market debt in the United States
immediate. The basis of politicians’ short-termism to the early 1980s. (see fig. 1.1). In 1945, and despite
calculations has shortened to the point Since then, there has been a relentless the huge costs involved in winning
where it can seem that all that matters shift to immediate consumption as the Second World War, the aggregate
is the next sound-bite, the next part of something that has been indebtedness of American businesses,
headline and the next snapshot of called a “cult of self-worship”. individuals and government equated
public opinion. The corporate focus The pursuit of instant gratification to 159% of GDP. More than three
has moved all too often from has resulted in the accumulation decades later, in 1981, this ratio was
strategic planning to immediate of debt on an unprecedented scale. little changed, at 168%. In real terms,
profitability as represented by the The financial crisis, which began in total debt had increased by 214%
next quarter’s earnings. 2008 and has since segued into the since 1945, but the economy had
deepest and most protracted economic grown by 197%, keeping the debt ratio
This report explains that this slump for at least eighty years, did remarkably static over an extended
acceleration towards ever-greater not result entirely from a short period period which, incidentally, was far from
immediacy has blinded society to of malfeasance by a tiny minority, shock-free (since it included two major
a series of fundamental economic comforting though this illusion may oil crises).
trends which, if not anticipated be. Rather, what began in 2008 was
strategy insights | issue nine 5
perfect storm | energy, finance and the end of growth
Fig. 1.1: The debt-GDP ratio in the United States since 1945*
Total credit market debt as % GDP
400%
2009:
381%
300%
1981:
1945:
168%
159%
200%
100%
0%
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President
Fig. 1.2: US real GDP and debt since 1945*
$ trillion at 2011 values
$60
Debt
GDP
$50
$40
$30
$20
$10
$0
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President
6 strategy insights | issue nine
From the early 1980s, as figs. 1.1 individually or collectively, have trend #1 – the madness of crowds
and 1.2 show, an unmistakeable and already started to throw more than The first of the four highly dangerous
seemingly relentless upwards trend two centuries of economic expansion trends identified here is the creation,
in indebtedness became established. into reverse. over three decades, of the worst
Between 1981 and 2009, debt grew financial bubble in history. In his
by 390% in real terms, far out-pacing Before the financial crisis of 2008,
1841 work Extraordinary Popular
the growth (of 120%) in the American this analysis might have seemed
Delusions and the Madness of Crowds,
economy. By 2009, the debt ratio had purely theoretical, but the banking
Charles Mackay (1814-89) identified
reached 381%, a level unprecedented catastrophe, and the ensuing
a common thread of individual and
in history. Even in 1930, when GDP slump, should demonstrate that the
collective idiocy running through such
collapsed, the ratio barely topped dangerous confluence described here
follies of the past as alchemy, witch-
300%, and thereafter declined very is already underway. Indeed, more
hunts, prophecies, fortune-telling,
rapidly indeed. than two centuries of near-perpetual
magnetizers, phrenology, poisoning,
growth probably went into reverse as
the admiration of thieves, duels, the
This report is not, primarily, about debt, much as ten years ago.
imputation of mystic powers to
and neither does it suggest that the
Lacking longer-term insights, today’s relics, haunted houses, crusades
problems identified here are unique to
policymakers seem bewildered about – and financial bubbles.
the United States. Rather, the massive
escalation in American indebtedness many issues. Why, for instance, has
A clear implication of Mackay’s work
is one amongst a host of indicators there been little or no recovery from
was that all of these follies had been
of a state of mind which has elevated the post-2008 economic slump? Why
consigned to the past by intelligence,
immediate consumption over prudence have traditional, tried-and-tested
experience and enlightenment. For
throughout much of the world. fiscal and monetary tools ceased to
the most part, he has been right.
function? Why have both austerity
Intelligent people today do not put
This report explains that we need and stimulus failed us?
faith in alchemy, fortune-telling,
only look beyond the predominant
The missing piece of the economic witchcraft or haunting, and – with the
short-termism of contemporary
equation is an appreciation of four arguable exception of the invasion of
thinking to perceive that we are at
underlying trends, each of which Iraq – crusades have faded into the
the confluence of four extremely
renders many of the lessons of history books.
dangerous developments which,
the past irrelevant.
strategy insights | issue nine 7
perfect storm | energy, finance and the end of growth
But one folly remains alive and well. point where even some forms of debt term to describe what happened to
Far from confining financial bubbles counted as shock-absorbing equity). Britain under Brown – it was a collapse
to historical tales of Dutch tulips and in returns on capital employed.
British South Sea stock, the last three Former Federal Reserve boss Alan
decades have witnessed the creation Greenspan has been ridiculed for No other major economy got it quite
and the bursting of the biggest bubble believing that banks would always as wrong as Britain under Brown, but
in financial history. act in the best interests of their much the same was happening across
shareholders, and that the market the Western world, most notably in
Described here as ‘the credit super- would sort everything out in a benign those countries which followed the
cycle’, this bubble confirmed that one way. But regulators more generally disastrous Anglo-American philosophy
aspect, at least, of the idiocy identified bent over backwards to ignore the of “light-touch” financial regulation.
by Mackay continues to wreak havoc. most obvious warning signs, such as
Insane though historic obsessions with escalating property price-to-incomes trend #2 – the globalisation disaster
tulip bulbs and south seas riches may ratios, soaring levels of debt-to-GDP, The compounding mistake, where the
appear, they are dwarfed by the latter- and such obviously-abusive practices Western countries were concerned, was
day, ‘money for nothing’ lunacy that, as sub-prime mortgages, NINJA1 a wide-eyed belief that ‘globalisation’
through the credit super-cycle, has loans and the proliferation of unsafe would make everyone richer, when
mired much of the world in debts from financial instruments. the reality was that the out-sourcing
which no escape (save perhaps hyper- of production to emerging economies
inflation) exists. Where idiocy and naïveté were was a self-inflicted disaster with few
concerned, however, regulators and parallels in economic history. One would
Perhaps the most truly remarkable the general public were trumped have to look back to a Spanish empire
feature of the super-cycle was that it by policymakers and their advisors. awash with bullion from the New World
endured for so long in defiance of all Gordon Brown, for example, proclaimed to find a combination of economic
logic or common sense. Individuals in an end to “boom and bust” and gloried idiocy and minority self-interest equal
their millions believed that property in Britain’s “growth” despite the way to the folly of globalization.
prices could only ever increase, such in which debt escalation was making
that either borrowing against equity it self-evident that the apparent The big problem with globalisation
(by taking on invariably-expensive expansion in the economy was neither was that Western countries reduced
credit) or spending it (through equity more nor less than the simple spending their production without making
release) was a safe, rational and even of borrowed money. corresponding reductions in their
normal way to behave. consumption. Corporations’
Between 2001-02 and 2009-10, Britain outsourcing of production to
Regulators, meanwhile, believed added £5.40 of private and public debt emerging economies boosted their
that there was nothing wrong with for each £1 of ‘growth’ in GDP (fig. 1.3). earnings (and, consequently, the
loosening banking reserve criteria (both Between 1998 and 2012, real GDP incomes of the minority at the very
by risk-weighting assets in ways that increased by just £338bn (30%) whilst top) whilst hollowing out their
masked leverage, and by broadening debt soared by £1,133bn (95%) (fig. domestic economies through the
definitions of bank capital to the 1.4). Asset managers have a very simple export of skilled jobs.
8 strategy insights | issue nine 1
No Income No Job or Assets
Fig. 1.3: Changes in UK real debt and GDP*
£bn at 2011-12 values
+£200
Change in debt**
Change in GDP
+£150
+£100
+£50
+£0
-£50
-£100
97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12
* Source: Tullett Prebon UK Economic & Fiscal Database 2012
** Government and private individual debt
Fig. 1.4: UK real debt and GDP*
£bn at 2011-12 values
£2,500
GDP
Total debt**
Debt: £2,480bn
£2,000
£1,500 Debt: £1,196bn GDP: £1,521bn
£1,000
GDP: £1,142bn
£500
£0
97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12
* Source: Tullett Prebon UK Economic & Fiscal Database 2012
** Government and private individual debt
strategy insights | issue nine 9
perfect storm | energy, finance and the end of growth
This report uses a measure called unsustainable. Talk of Western of accretive changes has been much
‘globally-marketable output’ economies modernising themselves by the same. In America, for example, the
(GMO) as a metric for domestic moving from production into services benchmark measure of inflation (CPI-U)
production, a measure which contained far more waffle than logic has been modified by ‘substitution’,
combines manufacturing, agriculture, – Western consumers sold each other ‘hedonics’ and ‘geometric weighting’
construction and mining with net ever greater numbers of hair-cuts, ever to the point where reported numbers
exports of services. By definition, greater quantities of fast food and seem to be at least six percentage
activities falling outside this category ever more zero-sum financial services points lower than they would have
consist of services provided to whilst depending more and more on been under the ‘pre-tinkering’ basis of
each other. imported goods and, critically, on the calculation used until the early 1980s.
debts used to buy them. Corporate US unemployment, reported at
At constant (2011) values, consumption executives prospered, as did the gate- 7.8%, excludes so many categories of
by Americans increased by $6,500bn holders of the debt economy, whilst people (such as “discouraged workers”)
between 1981 and 2011, whilst the vast majority saw their real wages that it hides very much higher
consumption on their behalf by decline and their indebtedness spiral. levels of inactivity.
the government rose by a further
$1,700bn, but the combined output For our purposes, what matters here is The critical distortion here is clearly
of the manufacturing, construction, that reducing production, increasing inflation, which feeds through into
agricultural and extractive industries consumption and taking on escalating computations showing “growth” even
grew by barely $600bn. At less than debt to fill the gap was never a when it is intuitively apparent (and
$200bn in 2011, net exports of services remotely sustainable course of action. evident on many other benchmarks)
did almost nothing to bridge the chasm What this in turn means is that no that, for a decade or more, the
between consumption and production. return to the pre-2008 world is either economy has, at best, stagnated, not
possible or desirable. just in the United States but across
This left two residuals – domestically- much of the Western world. Distorted
consumed services, and debt – with trend #3 – an exercise in inflation also tells wage-earners that
debt the clincher. Between 1981 and self-delusion they have become better off even
2011, and again expressed at constant One explanation for widespread public though such statistics do not accord
values, American indebtedness soared (and policymaker) ignorance of the with their own perceptions. It is
from $11 trillion to almost $54 trillion. truly parlous state of the Western arguable, too, that real (inflation-free)
economies lies in the delusory nature interest rates were negative from as
Fundamentally, what had happened
of economic and fiscal statistics, many long ago as the mid-1990s, a trend
here was that skilled, well-paid jobs
of which have been massaged out of which undoubtedly exacerbated an
had been exported, consumption
all relation to reality. escalating tendency to live on debt.
had increased, and ever-greater
quantities of debt had been used to There seems to have been no ‘grand Fiscal figures, too, are heavily distorted,
fill the gap. This was, by any definition, conspiracy’ here, but the overall effect most noticeably in the way in which
10 strategy insights | issue ninequasi-debt obligations are kept off the labour, labour which would cost 80:1 to 20:1 do not seem particularly
official balance sheet. As we explain perhaps $6,500 if it were paid for at disruptive but, once returns ratios
in this report, the official public debts prevailing rates. Of the energy – a term have fallen below about 15:1, there
of countries such as the United States coterminous with ‘work’ – consumed in is a dramatic, ‘cliff-edge’ slump in
and the United Kingdom exclude Western societies, well over 99% comes surplus energy, combined with a sharp
truly enormous commitments from exogenous sources, and probably escalation in its cost.
such as pensions. less than 0.7% from human effort.
Research set out in this report suggests
trend #4 – the growth dynamo Energy does far more than provide that the global average EROEI, having
winds down us with transport and warmth. In fallen from about 40:1 in 1990 to
One of the problems with economics modern societies, manufacturing, 17:1 in 2010, may decline to just
is that its practitioners preach a services, minerals, food and even 11:1 by 2020, at which point energy
concentration on money, whereas water are functions of the availability will be about 50% more expensive, in
money is the language rather than of energy. The critical equation here real terms, than it is today, a metric
the substance of the real economy. is not the absolute quantity of energy which will carry through directly into
Ultimately, the economy is – and available but, rather, the difference the cost of almost everything else –
always has been – a surplus energy between energy extracted and energy including food.
equation, governed by the laws of consumed in the extraction process.
This is measured by the mathematical crisis, culpability and consequences
thermodynamics, not those of
the market. equation EROEI (energy return on If the analysis set out in this report
energy invested). is right, we are nearing the end of a
Society and the economy began when period of more than 250 years in which
agriculture created an energy surplus For much of the period since the growth has been ‘the assumed normal’.
which, though tiny by later standards, Industrial Revolution, EROEIs have There have been setbacks, of course,
liberated part of the population to been extremely high. The oil fields but the near-universal assumption
engage in non-subsistence activities. discovered in the 1930s, for example, has been that economic growth is
provided at least 100 units of extracted the usual state of affairs, a rule to
A vastly larger liberation of surplus energy for every unit consumed in which downturns (even on the scale
energy occurred with the discovery extraction (an EROEI of 100:1). For of the 1930s) are the exceptions. That
of the heat engine, meaning that some decades now, though, global comfortable assumption is now in the
the energy delivered by human average EROEIs have been falling, as process of being over-turned.
labour could be leveraged massively energy discoveries have become both
by exogenous sources of energy smaller and more difficult (meaning The views set out here must provoke
such as coal, oil and natural gas. A energy-costly) to extract. a host of questions. For a start, if we
single US gallon of gasoline delivers really are nearing a cliff-edge economic
work equivalent to between 360 The killer factor is the non-linear crisis, why isn’t this visible already?
and 490 hours of strenuous human nature of EROEIs. As fig. 1.5 shows, the Second, who is to blame for this?
effects of a fall-off in EROEI from, say,
strategy insights | issue nine 11perfect storm | energy, finance and the end of growth
Fig. 1.5: Nearing the energy returns cliff-edge*
100%
2020
EROEI 1990
2010
80%
60%
40%
Declining EROEI
20%
Energy cost as % GDP
0%
100 90 80 70 60 50 40 30 20 10 0
* Source: Tullett Prebon analysis
Third, how bad could it get? Last, but guilty of wilful blindness. Such a state scale of debt – and, relevantly in this
surely most important, can anything of affairs was only ever viable on the context, of quasi-debt commitments
be done about it? insane assumption that debt could as well – surely should have sounded
go on increasing indefinitely. Charles warning bells. From Liverpool to Los
Where visibility is concerned, our belief Mackay chronicled many delusions, Angeles, from Madrid to Matsuyama,
is that, if the economy does tip over but none – not even the faith placed in the developed world is mired in debts
in the coming few years, retrospect – witchcraft – was ever quite as irrational that can never be repaid. In addition
which always enjoys the 20-20 vision as the belief (seldom stated, but to formal debt, governments have
of hindsight – will say that the signs of always implicit in Western economic entered into pension and welfare
the impending crash were visible well policy) that there need never be an commitments which are only
before 2013. end to a way of life which was wholly affordable if truly heroic assumptions
dependent on ever-greater debt. are made about future prosperity.
For a start, anyone who believed that a
globalisation model (in which the West Even to those who were happy to At the same time, there is no real
unloaded production but expected swallow the nonsense of perpetually- evidence that the economy is
to consume as much, or even more, expanding indebtedness, the sheer recovering from what is already
than ever) was sustainable was surely
12 strategy insights | issue ninea more prolonged slump than the
Great Depression of the 1930s. We
are now more than four years on from
the banking crisis and, under anything
approaching normal conditions, there
should have been a return to economic
expansion by now. Governments
have tried almost everything, from
prolonged near-zero interest rates and
stimulus expenditures to the creation
of money on a gigantic scale. These
tools have worked in the past, and the
fact that, this time, they manifestly
are not working should tell us that
something profoundly different
is going on.
The question of culpability has been
the equivalent of Sherlock Holmes’
“dog that did not bark in the night”,
in that very few individuals have been
held to account for what is unarguably
the worst economic disaster in at
least eighty years. A small number of
obviously-criminal miscreants have
been prosecuted, but this is something
that happens on a routine basis in
normal times, so does not amount to
an attribution of blame for the crisis.
There has been widespread public
vilification of bankers, the vast majority
of whom were, in any case, only acting
within the parameters of the ‘debt-
fuelled, immediate gratification’ ethos
established across Western societies
as a whole.
strategy insights | issue nine 13perfect storm | energy, finance and the end of growth
Governments have been ejected or regulators and central bankers who The magic bullet, of course, would be
by their electorates, but their failed to “take away the punch-bowl” the discovery of a new source of energy
replacements have tended to look very long after the party was self-evidently which can reverse the winding-down
similar indeed to their predecessors. out of control. of the critical energy returns equation.
Some pin their faith in nuclear fusion
The real reason for the seeming lack But blaming any of these really means (along lines being pioneered by ITER2)
of retribution is that culpability is far blaming ourselves – for falling for but this, even if it works, lies decades
too dispersed across society as a whole. the consumerist message of instant in the future – that is, long after the
If, say, society was to punish senior gratification, for buying imported global EROEI has fallen below levels
bankers, what about the thousands goods, for borrowing far more than which will support society as we know
of salesmen who knowingly pushed was healthy, and for electing glib and it. Solutions such as biofuels and
millions of customers into mortgages vacuous political leaders. shales are rendered non-workable by
that were not remotely affordable? The their intrinsically-low EROEIs.
suspicion lingers that there has been Beyond visibility and culpability, the
a ‘grand conspiracy of culpability’, but two big questions which need to be Likewise, expecting a technological
even the radical left has failed to tie this addressed are ‘how bad can it get?’ solution to occur would be extremely
down to specifics in a convincing way. and ‘is there anything that we can do unwise, because technology uses
about it?’ energy – it does not create it. To expect
The real causes of the economic crash technology to provide an answer
are the cultural norms of a society that Of these, the first question hardly needs
would be equivalent to locking the
has come to believe that immediate an answer, since the implications seem
finest scientific minds in a bank-
material gratification, fuelled if self-evident – economies will lurch into
vault, providing them with enormous
necessary by debt, can ever be a hyper-inflation in a forlorn attempt to
computing power and vast amounts
sustainable way of life. We can, if we escape from debt, whilst social strains
of money, and expecting them to
wish, choose to blame the advertising will increase as the vice of resource
create a ham sandwich.
industry (which spends perhaps $470bn (including food) shortages tightens.
annually pushing the consumerist In the absence of such a breakthrough,
In terms of solutions, the first
message), or the cadre of corporate really promising energy sources (such
imperative is surely a cultural change
executives who have outsourced as concentrated solar power) need to
away from instant gratification, a
skilled jobs in pursuit of personal be pursued together, above all, with
change which, if it is not adopted
gain. We can blame a generation of social, political and cultural adaptation
willingly, will be enforced upon
policymakers whose short-termism to “life after growth”.
society anyway by the reversal
has blinded them to underlying trends,
of economic growth.
2
International Thermonuclear Experimental Reactor, a multinational
14 strategy insights | issue nine research project based at Cadarache in Francestrategy insights | issue nine 15
perfect storm | energy, finance and the end of growth 16 strategy insights | issue nine
part two:
this time is different
the implosion of the credit super-cycle
summary
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?
As Carmen Reinhart and Kenneth to a process of sequential bubbles, a “tulips from Amsterdam”
Rogoff have demonstrated in their process in which the bursting of each One of the most famous historical
magisterial book This Time Is Different, bubble was followed by the immediate bubbles is the tulip mania which
asset bubbles are almost as old as creation of another. gripped the United Provinces (the
money itself. The Reinhart and Rogoff Netherlands) during the winter
book tracks financial excess over eight Though the sequential nature of
of 1636-37. Tulip bulbs had been
centuries, but it would be no surprise the pre-2008 process marks this as
introduced to Europe from the
at all if the Hittites, the Medes, the something that really is different, we
Ottoman Empire by Obier de Busbeq
Persians and the Romans, too, had can, nevertheless, learn important
in 1554, and found particular favour
bubbles of their own. All you need lessons from the bubbles of the past.
in the United Provinces after 1593,
for a bubble is ready credit and First, bubbles follow an approximately
when Carolus Closius proved that
collective gullibility. symmetrical track, in which the spike
these exotic plants could thrive in the
in asset values is followed by a collapse
harsher Dutch climate.
Some might draw comfort from the of roughly similar scale and duration. If
observation that bubbles are a long- this holds true now, we are in for a very The tulip was a plant whose beauty
established aberration, arguing that long and nasty period of retreat. and novelty had a particular appeal,
the boom-and-bust cycle of recent but tulip mania would not have
years is nothing abnormal. Any such Second, easy access to leverage is
occurred without favourable social
comfort would be misplaced, for two critical, as bubbles cannot happen if
and economic conditions. The Dutch
main reasons. investors are limited to equity. Third,
had been engaged in a long war for
most bubbles look idiotic when seen
independence from Spain since 1568
First, the excesses of recent years have with hindsight. Fourth – and although
and, though final victory was still some
reached a scale which exceeds any- institutional arrangements are critical
years away, the original Republic of the
thing that has been experienced before. – the real driving dynamic of bubbles
Seven Provinces of the Netherlands
is a psychological process which
Second, and more disturbing still, declared independence from Spain
combines greed, the willing suspension
the developments which led to the in 1581 This was the beginning of
of disbelief and the development
financial crisis of 2008 amounted the great Dutch Golden Age. In this
of a herd mentality.
strategy insights | issue nine 17perfect storm | energy, finance and the end of growth
remarkable period, the Netherlands tulip market in 1634, setting the scene valuable as a mansion, or equivalent to
underwent some fundamental and for tulip mania. 17 years of skilled wages?
pioneering changes which included the
establishment of trading dominance, The tulip bubble did not revolve around Second, trading in these ludicrously
great progress in science and invention, a physical trade in bulbs but, rather, overvalued items took place in then-
and the creation of corporate finance, involved a paper market in which novel forms (such as futures), and
as well as the accumulation of people could participate with no were conducted on unregulated fringe
vast wealth, the accession of the margin at all. Indeed, the tulip bubble markets rather than in the recognised
Netherlands to global power status, followed immediately upon the heels exchanges.
and great expansion of industry. of the creation by the Dutch of the first
futures market. Bulbs could change Third, participants in the mania lost
This was a period in which huge hands as often as ten times each day the use of their critical faculties. Many
economic, business, scientific, trading but, because of the abrupt collapse people – not just speculators and the
and naval progress was partnered of the paper market, no physical wealthy, but individuals as diverse
by remarkable achievements in art deliveries were ever made. as farmers, mechanics, shopkeepers,
(Rembrandt and Vermeer), architecture maidservants and chimney-sweeps
and literature. The prosperity of this Price escalation was remarkable, with – saw bulb investment as a one-way
period created a wealthy bourgeoisie single bulbs reaching values that street to overnight prosperity. Huge
which displayed its affluence in grand exceeded the price of a large house. A paper fortunes were made by people
houses with exquisite gardens. Viceroy bulb was sold for 2,500 florins whose euphoria turned to despair as
Enter the tulip. at a time when a skilled worker might they were wiped out financially.
earn 150 florins a year. Putting these
For the newly-emergent Dutch absurd values into modern terms is The story that a sailor ate a hugely
bourgeoisie, the tulip was the “must- almost impossible because of scant valuable bulb, which he mistook for an
have” consumer symbol of the 1630s, data, but the comparison with skilled onion, is probably apocryphal (because
particularly since selective breeding earnings suggests values of around it would have poisoned him), but
had produced some remarkably exotic £500,0003, which also makes some there can be little doubt that this was
new plants. Tulips cannot be grown sense in relation to property prices. In a period of a bizarre mass psychology
overnight, but take between seven any event, a bubble which began in verging on collective insanity.
and twelve years to reach maturity. mid-November 1636 was over by the
all at sea
Moreover, tulips bloom for barely a end of February 1637.
week during the spring, meaning that The South Sea Bubble of 1720
bulbs can be uprooted and sold during Though tulip mania was extremely commands a special place in the litany
the autumn and winter months. brief, and available data is very limited, of lunacy that is the history of bubbles.
we can learn some pertinent lessons
A thriving market in bulbs developed from this strange event. The South Sea Company was
in the Netherlands even though established in 1711 as a joint
short-selling was outlawed in 1610. For a start, this bubble looks idiotic government and private entity created
Speculators seem to have entered the from any rational perspective – how on to manage the national debt. Britain’s
earth could a humble bulb become as involvement in the War of the Spanish
3
A bulb worth 2,500 florins in 1637 was equivalent to 16.7x an
annual skilled wage of 150 florins. Assuming a skilled wage
18 strategy insights | issue nine today of £30,000, the bulb would be worth £500,000Succession was imposing heavy costs but worthless, and company shares in high places. Even Sir Isaac Newton,
on the exchequer, and the Bank of remained below their issue price, a presumably a man of common
England’s attempt to finance this situation not helped by the resumption sense, lost £20,000 (equivalent to
through two successive lotteries had of war with Spain in 1718. perhaps £2.5m today) in the pursuit
not been a success. The government of the chimera of vast, but nebulous,
therefore asked an unlicensed bank, Even so, shares in the company, unearned riches.
the Hollow Sword Blade Company, effectively backed by the national
to organise what became the first debt, began to rise in price, a process Any rational observer, even if unaware
successful national lottery to be floated characterised by insider dealing and of the insider dealing and other forms
in Britain. The twist to this lottery was boosted by the spreading of rumours. of corruption in which the shares were
that prizes were paid out as annuities, mired, should surely have realised that
Between January and May 1720, an eight-fold escalation in the stock
thus leaving the bulk of the capital in
the share price rose from £128 to price based entirely on implausible
government hands.
£550 as rumours of lucrative returns speculation was, quite literally, ‘too
After this, government set up the from the monopoly spread amongst good to be true’.
South Sea Company, which took over speculators. What, many argued, could
£9m of national debt and issued be better than a government-backed In his Extraordinary Popular Delusions
shares to the same amount, receiving company with enormous leverage and the Madness of Crowds, Charles
an annual payment from government to monopolistic profits in the fabled Mackay ranked the South Sea Company
equivalent to 6% of the outstanding Americas? Legislation, passed under and other bubbles with alchemy,
debt (£540,000) plus operating costs the auspices of Company insiders and witch-hunts and fortune-telling as
of £28,000. As an added incentive, banning the creation of unlicensed instances of collective insanity. Whilst
government granted the company a joint stock enterprises, spurred the other such foibles have tended to
monopoly of trade with South America, share price to a peak of £890 in early retreat in the face of science, financial
a monopoly which would be without June. This was bolstered by Company credulity remains alive and well, which
value unless Britain could break the directors, who bought stock at means that we need to know how
Spanish hegemony in the Americas, an inflated prices to protect the value of and why these instances of collective
event which, at that time, was wildly investments acquired at much lower insanity seem to be hard-wired into
implausible. levels. The share price peaked at £1,000 human financial behaviour.
in August 1720, but the shares then
The potentially-huge profits from lost 85% of their inflated market value
this monopoly grabbed speculator in a matter of weeks.
attention even though the real
likelihood of any returns ever actually Like the Dutch tulip mania, the South
accruing was extremely remote. Sea Bubble was an example which
Despite very limited concessions fused greed and crowd psychology
secured in 1713 at the end of the war, with novel market practices, albeit
the trading monopoly remained all compounded by rampant corruption
strategy insights | issue nine 19perfect storm | energy, finance and the end of growth
made in Japan decades after 1945 was thus export- bars in New York and London. Boosted
In some respects, the Japanese asset driven, and led by firms which had by the diversion of still-cheap capital
bubble of the 1980s provided a ‘dry access to abundant, low-cost capital. from industry into real estate, property
run’ for the compounded bubbles values in Japan soared, peaking at
By the early 1980s, Japan’s economic $215,000 per square metre in the
of the super-cycle. Japan’s post-war
success was beginning to lead to prized Ginza district of Tokyo.
economic miracle was founded on
unrealistic expectations about future
comparatively straightforward policies.
prosperity. Many commentators, Comforted by inflated property values,
Saving was encouraged, and was
abroad as well as at home, used the banks made loans which the borrowers
channelled into domestic rather than
‘fool’s guideline’ of extrapolation to were in no position to repay. The
foreign capital markets, which meant
contend that Japan would, in the theoretical value of the grounds of
that investment capital was available
foreseeable future, oust America as the Imperial Palace came to exceed
very cheaply indeed. Exports were
the world’s biggest economy. The the paper value of the entire state of
encouraged, imports were deterred
international expansion of Japanese California. Meanwhile, a soaring yen
by tariff barriers, and consumption at
banks and securities houses was was pricing Japanese exports out of
home was discouraged. The economic
reflected in the proliferation of sushi world markets.
transformation of Japan in the four
Fig. 2.1: From miracle to disaster – Japanese GDP growth since 1955*
15%
“Economic miracle” “Lost decade(s)”
10%
5%
0%
Financial crisis
-5%
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
* Source: Tullett Prebon calculations based on data from IMF
20 strategy insights | issue nineThough comparatively gradual – event, we need to distinguish between from the on-sale of mortgage debt.
mirroring, in true bubble fashion, the tangible components of the bubble The way in which banks were keeping
the relatively slow build-up of asset and its underlying psychological and the true scale of potential liabilities off
values – the bursting of the bubble cultural dimensions. their balance sheets completely eluded
was devastating. Properties lost more regulators, and Alan Greenspan’s belief
than 90% of their peak values, and Conventional analysis argues that that banks would always act in the
the government’s policy of propping tangible problems began with the best interests of shareholders was
up insolvent banks and corporations proliferation of subprime lending in breathtakingly naive. In America, as for
created “zombie companies” of the United States. Perhaps the single that matter in Britain and elsewhere,
the type that exist today in many biggest contributory factor to the central banks’ monetary policies were
countries. Having peaked at almost subprime fiasco was the breaking concentrated on retail inflation (which
39,000 at the end of 1989, the Nikkei of the link between borrower and had for some years been depressed
225 index of leading industrial stocks lender. Whereas, traditionally, banks both by benign commodity markets
deteriorated relentlessly, bottoming at assessed the viability of the borrower and by the influx of ever-cheaper
7,055 in March 2009. in terms of long-term repayment, the goods from Asia), and ignored asset
creation of bundled MBSs (mortgage- price escalation.
The Japanese economy was plunged backed securities) severed this link.
into the “lost decade” which, in Astute operators could now strip risk Meanwhile, banks’ capital ratios had
reality, could now be called the ‘lost from return, pocketing high returns expanded, in part because of ever-
two decades’. In 2011, Japanese whilst unloading the associated high looser definitions of capital and assets
government debt stood at 208% of risk. The securitisation of mortgages and in part because of sheer regulatory
GDP, a number regarded as sustainable was a major innovative failing in the negligence. Just as Greenspan’s Fed
only because of the country’s historic system, as was the reliance mistakenly believed that bankers were the best
high savings ratio (though this placed on credit-rating agencies which, people to determine their shareholders’
ratio is, in fact, subject to ongoing of course, were paid by the issuers interests, British chancellor Gordon
deterioration as the population ages). of the bundled securities. Another Brown took pride in a “light touch”
contributory innovation was the use regulatory system which saw British
2008 – the biggest bust of ARM (adjustable rate mortgage) banks’ total risk assets surge to more
With hindsight, we now know that products, designed to keep the than £3,900bn on the back of just
the Japanese asset bust was an early borrower solvent just long enough for £120bn of pure loss-absorbing capital
manifestation of the ‘credit super- the originators of the mortgages to or TCE (tangible common equity).
cycle’, which can be regarded as ‘the divest the packaged loans.
biggest bubble in history’. The general
outlines of the super-cycle bubble The authorities (and, in particular,
are reasonably well understood, even the Federal Reserve) must bear a big
if the underlying dynamic is not. To share of culpability for failing to spot
understand this enormous boom-bust the mispricing of risk which resulted
strategy insights | issue nine 21perfect storm | energy, finance and the end of growth
It does not seem to have occurred to assumption that potential losses on huge subprime default losses inevitable
anyone – least of all to the American, debt instruments were covered by unless property prices rose indefinitely,
British and other regulatory authorities insurance overlooked the fact that all which was a logical impossibility.
– that a genuine capital reserve such insurances were placed with a Subprime defaults would in turn
of less than 2% of assets could be small group of insurers (most notably undermine the asset bases of banks
overwhelmed by even a relatively AIG) which were not remotely capable holding the toxic assets that the sliced-
modest correction in asset prices. of bearing system-wide risk. and-diced mortgage-based instruments
were bound to become as soon as
Both sides of the reserves ratio Meanwhile, innovative definitions property price escalation ceased.
equation were distorted by regulatory allowed banks’ reported capital to
negligence. On the assets side, expand from genuine TCE to include The second obvious trigger was a
banks were allowed to risk-weight book gains on equities, and provisions seizure in liquidity. The escalation in
their assets, which turned out to for deferred tax and impairment. the scale of debt had far exceeded
be a disastrous mistake. Triple-A Even some forms of loan capital were domestic depositor funds, not least
rated government bonds were, not allowed to be included in banks’ because savings ratios had plunged
unnaturally, regarded as AFS (‘available reported equity. as borrowing and consumption had
for sale’) and accorded a zero-risk displaced saving and prudence in
rating, but so, too, in practice, were Together, the risk-weighting of assets, the Western public psyche. Unlike
the AAA portions that banks, with and the use of ever-looser definitions depositors – a stable source of funding,
the assistance of the rating agencies, of capital, combined to produce in the absence of bank runs – the
managed to slice out of MBSs seemingly-reassuring reserves ratios wholesale funding markets which had
(mortgage-backed securities) and which turned out to be wildly provided the bulk of escalating leverage
CDOs (collateralised debt obligations). misleading. Lehman Brothers, for were perfectly capable of seizing up
example, reported a capital adequacy virtually overnight. For this reason, a
Mortgages of all types were allowed ratio of 16.1% shortly before it liquidity seizure crystallised what was
to be risk-weighted downwards to collapsed, whilst the reported pre- essentially a leverage problem.
50% of their book value which, at best, crash ratios for Northern Rock and
reflected a nostalgic, pre-subprime Kaupthing were 17.5% and 11.2% At this point, three compounding
understanding of mortgage risk on respectively5. problems kicked in. The first was
the part of the regulators. In the US, the termination of a long-standing
banks were allowed to net-off their Well before 2007, the escalation in the ‘monetary ratchet’ process – low rates
derivatives exposures, such that J.P. scale of indebtedness had rendered created bubbles, and the authorities
Morgan Chase, for example, carried a crash inevitable. Moreover, the two countered each ensuing downturn by
derivatives of $80bn on its balance triggers that would bring the edifice cutting rates still further, but, this time
sheet even though the gross value crashing down could hardly have been around, prior rate reductions left little
of securities and derivatives was more obvious. First, the resetting of scope for further relaxation.
close to $1.5 trillion4. The widespread ARM mortgage interest rates made
4
See James Ferguson, ‘What went wrong?’, Patrick Young (ed.),
The Gathering Storm, Derivatives Vision Publishing, 2010
22 strategy insights | issue nine 5
Ferguson, op citstrategy insights | issue nine 23
perfect storm | energy, finance and the end of growth
Figs. 2.2 & 2.3: The relationship between borrowing and growth in the US*
Increments in real $bn
$2,000 $2.00
Government borrowing GDP growth per incremental
Household borrowing dollar of household debt
$1,500 GDP
$1,000 $1.00
$500
$0 $0.00
-$500
-$1,000 -$1.00
1996 1998 2000 2002 2004 2006 2008 2010 1996 1998 2000 2002 2004 2006 2008 2010
* Sources: Federal Reserve and Economic Report of the President
Second, economies had become Third, some countries – most familiar features
dependent upon debt-fuelled notably the United Kingdom – Though, as we shall see, the bursting
consumption, and any reversal in debt had compounded consumer debt of the super-cycle in 2008 had some
availability was bound to unwind the dependency by mistaking illusory novel aspects, the process nevertheless
earlier (and largely illusory) ‘growth’ (debt-fuelled) economic expansion for embraced many features of
created by debt-fuelled consumer ‘real’ growth, and had expanded public past bubbles.
spending. As figs. 2.2 and 2.3 show, spending accordingly, a process which
the relationship between borrowing created huge fiscal deficits as soon as A number of points are common to
and associated growth had been leverage expansion ceased. these past bubbles, factors which
worsening for some years, such that include easy credit, low borrowing
the $4.1 trillion expansion in nominal Ultimately, the leverage-driven ‘great costs, financial innovation (in the
US economic output between 2001 bubble’ in pan-Western property form of activities which take place
and 2007 had been far exceeded by an values had created the conditions for outside established markets, and/or
increase of $6.7 trillion in consumer a deleveraging downturn, something are unregulated, and/or are outright
debt, and the growth/borrowing for which governments’ previous illegal), weak institutional structures,
equation had slumped. experience of destocking recessions opportunism by some market
had provided no realistic appreciation. participants, and the emergence of
some form of mass psychology in
24 strategy insights | issue nineFigs. 2.4 & 2.5: The relationship between borrowing and growth in the UK*
$bn at 2011-12 values
£300 £1.50
Government borrowing GDP growth per incremental £ of debt
Individual borrowing
£250 GDP
£1.00
£200
£0.50
£150
£100
£0.00
£50
-£0.50
£0
-£50 -£1.00
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012
* Source: Tullett Prebon UK Economic & Fiscal Database 2012
which fear is wholly ousted by greed. Of course, the characteristics of earlier Credit became available in excessive
Often, the objects of speculation are excesses have not been absent in amounts, and the price of credit
items which can seem wholly irrational contemporary events. As with tulip was far too low (a factor which,
with the benefit of hindsight (how on bulbs, South Sea stock and Victorian we believe, may have been
earth could tulip bulbs, for instance, railways, recent years have witnessed exacerbated by a widespread
have become so absurdly over-valued?) the operation of mass psychologies in under-reporting of inflation).
which rational judgement has been
A further important point about suspended as greed has triumphed why this time is different
bubbles is that they can inflate over fear. Innovative practices, often Whilst it shared many of the
apparent prosperity, but the post-burst lying outside established markets, characteristics of previous such events,
effects include the destruction of have abounded. Examples of such the credit super-cycle bubble which
value and the impairment of economic innovations have included subprime burst in 2008 differed from them in
output for an extended period. In and adjustable-rate mortgages, and at least two respects, and arguably
reality, though, the bursting of a the proliferation of an ‘alphabet soup’ differed in a third dimension as well.
bubble does not destroy capital, but of the derivatives that Warren Buffett
simply exposes the extent to which famously described as “financial
value has already been destroyed by weapons of mass destruction”.
rash investment.
strategy insights | issue nine 25perfect storm | energy, finance and the end of growth
The first big difference was that the Though smaller bubbles (such as
scale and scope of the 2008 crash far Poseidon) occurred in between, the
exceeded anything that had gone next really big bubble did not occur
before. Though it began in America until the 1980s, when Japanese asset
(with parallel events taking place in a values lost contact with reality.
number of other Western countries),
globalisation ensured that the crash In recent years, however, intervals
was transmitted around the world. The between bubbles have virtually
total losses resulting from the crash disappeared, such that the decade
are almost impossible to estimate, prior to the 2008 crash was
not least because of notional losses characterised by a series of events
created by falling asset prices, but which overlapped in time. Property
even a minimal estimate of $4 trillion price bubbles were the greatest single
equates to about 5.7% of global GDP, cause of the financial crisis, but there
with every possibility that eventual were complementary bubbles in a
losses will turn out to have been far variety of other asset categories.
greater than this.
The dotcom bubble (1995-2000)
The second big difference between the reflected a willing suspension of
super-cycle and previous bubbles lay critical faculties where the potential
in timing. A gap of more than 80 years for supposedly ‘high tech’ equities
elapsed between the tulip mania of were concerned, and historians of
1636-37 and the South Sea bubble of the future are likely to marvel at the
1720, though the latter had an overseas idiocy which attached huge values
corollary in the Mississippi bubble of to companies which lacked earnings,
the same year. The next major bubble, cash flow or a proven track record, and
the British railway mania of the 1840s, were often measured by the bizarre
followed an even longer time-gap, metric of “cash-burn”. Other bubbles
and a further interval of about seven occurred in property markets in the
decades separated the dethroning of United States, Britain, Ireland, Spain,
the crooked “railway king” (George China, Romania and other countries,
Hudson) in 1846 from the onset of as well as in commodities such as
the ‘roaring twenties’ bubble which uranium and rhodium. Economy-wide
culminated in the Wall Street Crash. bubbles developed in countries such as
26 strategy insights | issue nineIceland, Ireland and Dubai. Perhaps the • Institutional weaknesses which which has become a hostage to future
most significant bubble of the lot – for have undermined regulatory growth assumptions at precisely
reasons which will become apparent oversight whilst simultaneously the same time that the scope for
later – was that which carried the price facilitating the provision of excessive generating real growth is deteriorating.
of oil from an average of $25/b in 2002 credit through the creation of
to a peak of almost $150/b in 2008. The second critical issue is the
high-risk instruments.
undermining of official economic
This rash of bubbles suggests that • Mispricing of risk, compounded and fiscal data, a process which has
recent years have witnessed the by false appreciation of economic disguised many of the most alarming
emergence of a distinctive new trend, prospects and by the distortion of features of the super-cycle.
which is described here as a credit essential data.
super-cycle, a mechanism which Third, there has been a fundamental
compounds individual bubbles into • A political, business and consumer misunderstanding of the dynamic
a broader pattern. mind-set which elevates the which really drives the economy. Often
importance of the immediate whilst regarded as a monetary construct,
This report argues that a third big under-emphasising the longer term. the economy is, in the final analysis,
difference may be that the super-cycle an energy system, and the critical
bubble coincided with a weakening in • A distortion of the capitalist model supply of surplus energy has been in
the fundamental growth dynamic. which has created a widening chasm seemingly-inexorable decline for at
between ‘capitalism in principle’ and least three decades.
What we need to establish is the ‘capitalism in practice’.
‘underlying narrative’ that has
compressed the well-spaced bubble- Before we can put the credit
forming processes of the past into the super-cycle into its proper context,
single, compounded-bubble dynamic however, we need to appreciate
of the credit super-cycle. three critical issues, each of which is
grossly misunderstood.
It is suggested here that this narrative
must include: The first of these is the vast folly of
globalisation. This has impoverished
• A mass psychological change which and weakened the West whilst
has elevated the importance of ensuring that few countries are
immediate consumption whilst immune from the consequences of
weakening perceptions both of risks the unwinding of a world economy
and of longer-term consequences.
strategy insights | issue nine 27You can also read
