The combination of massive fiscal stimulus and a monetary policy set to "full flood" did a lot of the heavy lifting but the real kicker was a flood of "hot money" driven by a carry trade by investment banks flush with bailout money looking for a yield differential and currency gains as the pound and buck dive. The Ruddster bought some time but it will end badly, imo.
Keen notes...
2010 will be a bad year for the Australian economy:
The combination of the RBA’s rate rises and the ending of the First Home Buyers Boost will in all likelihood prick the house price bubble inspired by the Boost in the first place—and lead as many as 175,000 households to be very angry that they were enticed into this speculative bubble in the first place. If this happens, there is little prospect of making the House Price Souffle rise twice by yet another foolish enticement into debt.
The political pressure on the government may lead it to unwind its stimulus, which will remove a key prop from the economy; and
Deleveraging, which has been the looming problem that government policy (especially the First Home Vendors Grant) has simply delayed, will kick in as it has in the USA. The most likely manifestation would be a decline in discretionary consumption and non-mining investment.
I therefore expect that the RBA won’t get to complete its intended program of raising interest rates, but will be forced to go into reverse in 2010 as it was in 2008. It shouldn’t be forgotten that the RBA was still raising rates in mid-2008 to fight inflation. They didn’t see the GFC coming, and I believe that they’re making a similar mistake this time—believing that it’s all behind us when the special factors that minimised the impact are terminating.
So no I don’t believe we have dodged the iceberg—we’ve merely pushed it below the surface, from where it will rise again to dent out economic hull once more. And all the while the neoclassical economists who didn’t realise they were in an ice field in the first place are busily rearranging the deckchairs on the Titanic.
http://www.debtdeflation.com/blogs/2009/11/02/debtwatch-no-40-november-2009-have-we-dodged-the-iceberg/
Showing posts with label recession. Show all posts
Showing posts with label recession. Show all posts
3 November 2009
9 August 2009
Temporary Recession or the End of Growth?
Temporary Recession or the End of Growth?
This is a guest post by Richard Heinberg. Richard is a Senior Fellow of the Post Carbon Institute and author of five books on resource depletion and societal responses to the energy problem. He can be found on the web at www.richardheinberg.com and www.postcarbon.org.
Everyone agrees: our economy is sick. The inescapable symptoms include declines in consumer spending and consumer confidence, together with a contraction of international trade and available credit. Add a collapse in real estate values and carnage in the automotive and airline industries and the picture looks grim indeed.
But why are both the U.S. economy and the larger global economy ailing? Among the mainstream media, world leaders, and America’s economists-in-chief (Treasury Secretary Geithner and Federal Reserve Chairman Bernanke) there is near-unanimity of opinion: these recent troubles are primarily due to a combination of bad real estate loans and poor regulation of financial derivatives.
This is the Conventional Diagnosis. If it is correct, then the treatment for our economic malady might logically include heavy doses of bailout money for beleaguered financial institutions, mortgage lenders, and car companies; better regulation of derivatives and futures markets; and stimulus programs to jumpstart consumer spending.
But what if this diagnosis is fundamentally flawed? The metaphor needs no belaboring: we all know that tragedy can result from a doctor’s misreading of symptoms, mistaking one disease for another.
Something similar holds for our national and global economic infirmity. If we don’t understand why the world’s industrial and financial metabolism is seizing up, we are unlikely to apply the right medicine and could end up making matters much worse than they would otherwise be.
To be sure: the Conventional Diagnosis is clearly at least partly right. The causal connections between subprime mortgage loans and the crises at Fannie Mae, Freddie Mac, and Lehman Brothers have been thoroughly explored and are well known. Clearly, over the past few years, speculative bubbles in real estate and the financial industry were blown up to colossal dimensions, and their bursting was inevitable. It is hard to disagree with the words of Australian Prime Minister Kevin Rudd, in his July 25 essay in the Sydney Morning Herald: “The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom…. However, as we later learnt, the global boom was built in large part on a … house of cards. First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: ‘For 25 years [the West] has been consuming more than we have been producing … living beyond our means.’” (1)
But is this as far as we need look to get to the root of the continuing global economic meltdown?
A case can be made that dire events having to do with real estate, the derivatives markets, and the auto and airline industries were themselves merely symptoms of an even deeper, systemic dysfunction that spells the end of economic growth as we have known it.
In short, I am suggesting an Alternative Diagnosis. This explanation for the economic crisis is not for the faint of heart because, if correct, it implies that the patient is far sicker than even the most pessimistic economists are telling us. But if it is correct, then by ignoring it we risk even greater peril.
Economic Growth, The Financial Crisis, and Peak Oil
For several years, a swelling subculture of commentators (which includes the present author) has been forecasting a financial crash, basing this prognosis on the assessment that global oil production was about to peak. (2) Our reasoning went like this:
Continual increases in population and consumption cannot continue forever on a finite planet. This is an axiomatic observation with which everyone familiar with the mathematics of compounded arithmetic growth must agree, even if they hedge their agreement with vague references to “substitutability” and “demographic transitions.” (3)
This axiomatic limit to growth means that the rapid expansion in both population and per-capita consumption of resources that has occurred over the past century or two must cease at some particular time. But when is this likely to occur?
The unfairly maligned Limits to Growth studies, published first in 1972 with periodic updates since, have attempted to answer the question with analysis of resource availability and depletion, and multiple scenarios for future population growth and consumption rates. The most pessimistic scenario in 1972 suggested an end of world economic growth around 2015. (4)
But there may be a simpler way of forecasting growth’s demise.
Energy is the ultimate enabler of growth (again, this is axiomatic: physics and biology both tell us that without energy nothing happens). Industrial expansion throughout the past two centuries has in every instance been based on increased energy consumption. (5) More specifically, industrialism has been inextricably tied to the availability and consumption of cheap energy from coal and oil (and more recently, natural gas). However, fossil fuels are by their very nature depleting, non-renewable resources. Therefore (according to the Peak Oil thesis), the eventual inability to continue increasing supplies of cheap fossil energy will likely lead to a cessation of economic growth in general, unless alternative energy sources and efficiency of energy use can be deployed rapidly and to a sufficient degree. (6)
Of the three conventional fossil fuels, oil is arguably the most economically vital, since it supplies 95 percent of all transport energy. Further, petroleum is the fuel with which we are likely to encounter supply problems soonest, because global petroleum discoveries have been declining for decades, and most oil producing countries are already seeing production declines. (7)
So, by this logic, the end of economic growth (as conventionally defined) is inevitable, and Peak Oil is the likely trigger.
Why would Peak Oil lead not just to problems for the transport industry, but a more general economic and financial crisis? During the past century growth has become institutionalized in the very sinews of our economic system. Every city and business wants to grow. This is understandable merely in terms of human nature: nearly everyone wants a competitive advantage over someone else, and growth provides the opportunity to achieve it. But there is also a financial survival motive at work: without growth, businesses and governments are unable to service their debt. And debt has become endemic to the industrial system. During the past couple of decades, the financial services industry has grown faster than any other sector of the American economy, even outpacing the rise in health care expenditures, accounting for a third of all growth in the U.S. economy. From 1990 to the present, the ratio of debt-to-GDP expanded from 165 percent to over 350 percent. In essence, the present welfare of the economy rests on debt, and the collateral for that debt consists of a wager that next year’s levels of production and consumption will be higher than this year’s.
Given that growth cannot continue on a finite planet, this wager, and its embodiment in the institutions of finance, can be said to constitute history’s greatest Ponzi scheme. We have justified present borrowing with the irrational belief that perpetual growth is possible, necessary, and inevitable. In effect we have borrowed from future generations so that we could gamble away their capital today.
Until recently, the Peak Oil argument has been framed as a forecast: the inevitable decline in world petroleum production, whenever it occurs, will kill growth. But here is where forecast becomes diagnosis: during the period from 2005 to 2008, energy stopped growing and oil prices rose to record levels. By July of 2008, the price of a barrel of oil was nudging close to $150—half again higher than any previous petroleum price in inflation-adjusted terms—and the global economy was beginning to topple. The auto and airline industries shuddered; ordinary consumers had trouble for buying gasoline for their commute to work while still paying their mortgages. Consumer spending began to decline. By September the economic crisis was also a financial crisis, as banks trembled and imploded. (8)
Given how much is at stake, it is important to evaluate the two diagnoses on the basis of facts, not preconceptions.
It is unnecessary to examine evidence supporting or refuting the Conventional Diagnosis, because its validity is not in doubt—as a partial explanation for what is occurring. The question is whether it is a sufficient explanation, and hence an adequate basis for designing a successful response.
What’s the evidence favoring the Alternative? A good place to begin is with a recent paper by economist James Hamilton of the University of California, San Diego, titled “Causes and Consequences of the Oil Shock of 2007-08,” which discusses oil prices and economic impacts with clarity, logic, and numbers, explaining how and why the economic crash is related to the oil price shock of 2008. (9)
Hamilton starts by citing previous studies showing a tight correlation between oil price spikes and recessions. On the basis of this correlation, every attentive economist should have forecast a steep recession for 2008. “Indeed,” writes Hamilton, “the relation could account for the entire downturn of 2007-08…. If one could have known in advance what happened to oil prices during 2007-08, and if one had used the historically estimated relation [between price rise and economic impact]… one would have been able to predict the level of real GDP for both of 2008:Q3 and 2008:Q4 quite accurately.”
Again, this is not to ignore the role of the financial and real estate sectors in the ongoing global economic meltdown. But in the Alternative Diagnosis the collapse of the housing and derivatives markets is seen as amplifying a signal ultimately emanating from a failure to increase the rate of supply of depleting resources. Hamilton again: “At a minimum it is clear that something other than housing deteriorated to turn slow growth into a recession. That something, in my mind, includes the collapse in automobile purchases, slowdown in overall consumption spending, and deteriorating consumer sentiment, in which the oil shock was indisputably a contributing factor.”
Moreover, Hamilton notes that there was “an interaction effect between the oil shock and the problems in housing.” That is, in many metropolitan areas, house prices in 2007 were still rising in the zip codes closest to urban centers but already falling fast in zip codes where commutes were long. (10)
Why Did the Oil Price Spike?
Those who espouse the Conventional Diagnosis for our ongoing economic collapse might agree that there was some element of causal correlation between the oil price spike and the recession, but they would deny that the price spike itself had anything to do with resource limits, because (they say) it was caused mostly by speculation in the oil futures market, and had little to do with fundamentals of supply and demand.
In this, the Conventional Diagnosis once again has some basis in reality. Speculation in oil futures during the period in question almost certainly helped drive oil prices higher than was justified by fundamentals. But why were investors buying oil futures? Was the mania for oil contracts just another bubble, like the dot.com stock frenzy of the late ’90s or the real estate boom of 2003 to 2006?
During the period from 2005 to mid-2008, demand for oil was growing, especially in China (which went from being self-sufficient in oil in 1995 to being the world’s second-foremost importer, after the U.S., by 2006). But the global supply of oil was essentially stagnant: monthly production figures for crude oil bounced around within a fairly narrow band between 72 and 75 million barrels per day. As prices rose, production figures barely budged in response. There was every indication that all oil producers were pumping flat-out: even the Saudis appeared to be rushing to capitalize on the price bonanza.
Thus a good argument can be made that speculation in oil futures was merely magnifying price moves that were inevitable on the basis of the fundamentals of supply and demand. James Hamilton (in his publication previously cited) puts it this way: “With hindsight, it is hard to deny that the price rose too high in July 2008, and that this miscalculation was influenced in part by the flow of investment dollars into commodity futures contracts. It is worth emphasizing, however, that the two key ingredients needed to make such a story coherent—a low price elasticity of demand, and the failure of physical production to increase—are the same key elements of a fundamentals-based explanation of the same phenomenon. I therefore conclude that these two factors, rather than speculation per se, should be construed as the primary cause of the oil shock of 2007-08.”
Aftermath of the Peak
There is also controversy over to what degree troubles in the automobile, trucking, and airline industries should be attributed to the oil price spike or the economic crash. Of course, if the Alternative Diagnosis is correct, the latter two events are causally related in any case. However, it may be helpful to review the situation.
Everyone knows that GM and Chrysler went bankrupt this year because U.S. car sales cratered. The current forecast is for sales of about 10.3 million vehicles in the U.S. for 2009, down from last year’s 13.2 million and 16.1 million in 2007. U.S. car sales have not been this low since the 1970s. Sales of light trucks, the most profitable vehicles, took the biggest hit during 2008, as fuel prices soared and car buyers avoided gas-guzzlers. It was at this point that the auto companies really began feeling the pain.
The airline industry’s ills are summarized in a recent GAO document: “After 2 years of profits, the U.S. passenger airline industry lost $4.3 billion in the first 3 quarters of 2008 [as jet fuel prices climbed]. Collectively, U.S. airlines reduced domestic capacity, as measured by the number of seats flown, by about 9 percent from the fourth quarter of 2007 to the fourth quarter of 2008…. To reduce capacity, airlines reduced the overall number of active aircraft in their fleets by 18 percent…. Airlines also collectively reduced their workforces by about 28,000, or nearly 7 percent, from the end of 2007 to the end of 2008…. The contraction of the U.S. airline industry in 2008 reduced airport revenues, passengers’ access to the national aviation system, and revenues for the Trust Fund.” (11)
For the trucking industry, fuel accounts for nearly 40 percent of total operational costs. In 2007, as diesel prices rose, carriers began losing money and added fuel price surcharges; meanwhile the volume of freight began falling. After July 2008, as oil prices crashed, tonnage continued to decline. Overall, the cumulative decrease in loads for flatbed, tanker, and dry vans ranged between 15 percent and 20 percent just in the period from June to December 2008. (12)
This last set of statistics raises a couple of questions crucial to understanding the Alternative Diagnosis: Why, if global oil production had just peaked, did petroleum prices fall in the last five months of 2008? And, if oil prices were a major factor in the economic crisis, why didn’t the economy begin to turn around after the prices softened?
Why Did Oil Prices Fall? And Why Didn’t Lower Oil Prices Lead to a Quick Recovery?
The Peak Oil thesis predicts that, as world oil production reaches its maximum level and begins to decline, the price of oil will rise dramatically. But it also forecasts a dramatic increase in the volatility of prices.
The argument goes as follows. As oil becomes scarce, its price will rise until it begins to undermine economic activity in general. Economic contraction will then result in substantially reduced demand for oil, which will in turn cause its price to fall temporarily. Then one of two things will happen: either (a) the economy will begin to recover, stoking renewed oil demand, leading again to high prices which will again undermine economic activity; or (b), if the economy does not quickly recover, petroleum production will gradually fall due to depletion until spare production capacity (created by lower demand) is wiped out, leading again to higher prices and even more economic contraction. In both cases, oil prices remain volatile and the economy contracts. (13)
This scenario corresponds very closely with the reality that is unfolding, though it remains to be seen whether situation (a) or (b) will ensue.
Over the past three years, oil prices rose and fell more dramatically than would have been the case if it had not been for widespread speculation in oil futures. Nevertheless, the general direction of prices—way up, then way down, then part-way back up—is entirely consistent with the Peak Oil thesis and the Alternative Diagnosis.
Why has the economy not quickly recovered, given that oil prices are now only half what they were in July 2008? Again, Peak Oil is not the only cause of the current economic crisis. Enormous bubbles in the real estate and finance sectors constituted accidents waiting to happen, and the implosion of those bubbles has created a serious credit crisis (as well as solvency and looming currency crises) that will likely take several years to resolve even if energy supplies don’t pose a problem.
But now the potential for renewed high oil prices acts as a ceiling for economic recovery. Whenever the economy does appear to show renewed signs of life (as has happened in May-July this year, with stock values rebounding and the general pace of economic contraction slowing somewhat), oil prices will take off again as oil speculators anticipate a recovery of demand. Indeed, oil prices have rebounded from $30 in January to nearly $70 currently, provoking widespread concern that high energy prices could nip recovery in the bud. (14)
A barrel of oil from newly developed sources costs in the neighborhood of $60 to produce, now that all of the cheaper prospects have been exploited: finding new oilfields today usually means drilling under miles of ocean water, or in politically unstable nations where equipment and personnel are at high risk. (15) So as soon as consumers demand more oil, the price will have to stay noticeably above that figure in order to provide the incentive for producers to drill.
Volatile oil prices hurt on the upside, but they also hurt on the downside. The oil price collapse of August-December 2008, plus the worsening credit crisis, caused a dramatic contraction in oil industry investment, leading to the cancellation of about $150 billion worth of new oil production projects—whose potential productive capacity will be required to offset declines in existing oilfields if world oil production is to remain stable. (16) This means that even if demand remains low, production capacity will almost certainly decline to meet those demand levels, causing oil prices to rise again in real terms at some point, perhaps two or three years from now. Volatile petroleum prices also hurt the development of alternative energy, as was shown during the past few months when falling oil prices led to financial troubles for ethanol manufacturers. (17)
One way or another, growth will be highly problematic if not unachievable.
Big Picture Diagnosis: Continuing the Trail of Logic
At this point in the discussion many readers will be wondering why alternative energy sources and efficiency measures cannot be deployed to solve the Peak Oil crisis. After all, as petroleum becomes more expensive, ethanol, biodiesel, and electric cars all start to look more attractive both to producers and consumers. Won’t the magic of the market intervene to render oil shortages irrelevant to future growth?
It is impossible in the context of this discussion to provide a detailed explanation of why the market probably cannot solve the Peak Oil problem. Such an explanation requires a discussion of energy evaluation criteria, and an analysis of many individual energy alternatives on the basis of those criteria. I have offered brief overviews of this subject previously and a much longer one is in press. (18)
My summary conclusions in this regard are as follows.
About 85 percent of our current energy is derived from three primary sources—oil, natural gas, and coal—that are non-renewable, whose price is likely to trend sharply higher over the next years and decades leading to severe shortages, and whose environmental impacts are unacceptable. While these sources historically have had very high economic value, we cannot rely on them in the future; indeed, the longer the transition to alternative energy sources is delayed, the more difficult that transition will be unless some practical mix of alternative energy systems can be identified that will have superior economic and environmental characteristics.
But identifying such a mix is harder than one might initially think. Each energy source has highly specific characteristics. In fact, it has been the characteristics of our present energy sources (principally oil, coal, and natural gas) that have enabled the building of an urbanized society with high mobility, large population, and high economic growth rates. Surveying the available alternative energy sources for criteria such as energy density, environmental impacts, reliance on depleting raw materials, intermittency versus constancy of supply, and the percentage of energy returned on the energy invested in energy production, none currently appears capable of perpetuating this kind of society.
Moreover, national energy systems are expensive and slow to develop. Energy efficiency likewise requires investment, and further incremental investments in efficiency tend to yield diminishing returns over time, since it is impossible to perform work with zero energy input. Where is there the will or ability to muster sufficient investment capital for deployment of alternative energy sources and efficiency measures on the scale needed?
While there are many successful alternative energy production installations around the world (ranging from small home-scale photovoltaic systems to large “farms” of three-megawatt wind turbines), there are very few modern industrial nations that now get the bulk of their energy from sources other than oil, coal, and natural gas. One example is Sweden, which obtains most of its energy from nuclear and hydropower. Another is Iceland, which benefits from unusually large domestic geothermal resources not found in most other countries. Even for these two nations, the situation is complex: the construction of the infrastructure for their power plants mostly relied on fossil fuels for the mining of the ores and raw materials, for materials processing, for transportation, for the manufacturing of components, for the mining of uranium, for construction energy, and so on. Thus a meaningful energy transition away from fossil fuels is still a matter of theory and wishful thinking, not reality.
My conclusion from a careful survey of energy alternatives, then, is that there is little likelihood that either conventional fossil fuels or alternative energy sources can be counted on to provide the amount and quality of energy that will be needed to sustain economic growth—or even current levels of economic activity—during the remainder of this century. (19)
But the problem extends beyond oil and other fossil fuels: the world’s fresh water resources are strained to the point that billions of people may soon find themselves with only precarious access to water for drinking and irrigation. Biodiversity is declining rapidly. We are losing 24 billion tons of topsoil each year to erosion. And many economically significant minerals—from antimony to zinc—are depleting quickly, requiring the mining of ever lower-grade ores in ever more remote locations. Thus the Peak Oil crisis is really just the leading edge of a broader Peak Everything dilemma.
In essence, humanity faces an entirely predictable peril: our population has been growing dramatically for the past 200 years (expanding from under one billion to nearly seven billion), while our per-capita consumption of resources has also grown. For any species, this is virtually the definition of biological success. And yet all of this has taken place in the context of a finite planet with fixed stores of non-renewable resources (fossil fuels and minerals), a limited ability to regenerate renewable resources (forests, fish, fresh water, and topsoil), and a limited ability to absorb industrial wastes (including carbon dioxide). If we step back and look at the industrial period from a broad historical perspective that is informed by an appreciation of ecological limits, it is hard to avoid the conclusion that we are today living at the end of a relatively brief pulse—a 200-year rapid expansionary phase enabled by a temporary energy subsidy (in the form of cheap fossil fuels) that will inevitably be followed by an even more rapid and dramatic contraction as those fuels deplete.
The winding down of this historic growth-contraction pulse doesn’t necessarily mean the end of the world, but it does mean the end of a certain kind of economy. One way or another, humanity must return to a more normal pattern of existence characterized by reliance on immediate solar income (via crops, wind, or the direct conversion of sunlight to electricity) rather than stored ancient sunlight.
This is not to say that the remainder of the 21st century must consist of a collapse of industrialism, a die-off of most of the human population, and a return by the survivors to a way of life essentially identical to that of 16th century peasants or indigenous hunter-gatherers. It is possible instead to imagine acceptable and even inviting ways in which humanity could adapt to ecological limits while further developing cultural richness, scientific understanding, and quality of life (more of this below).
But however it is negotiated, the transition will spell an end to economic growth in the conventional sense. And that transition appears to have begun.
How Do We Know Which Diagnosis Is Correct?
If the patient is an individual human and the cause of distress is uncertain, more diagnostic tests can be prescribed. But to what sorts of blood tests, x-rays, and CAT scans can we subject the national or global economy?
In a sense, the tests have already been done. During the past few decades thousands of scientific surveys of natural resources, biodiversity, and ecosystems have showed increasing rates of depletion and decline. (20) The continuing increase in human population, pollution, and consumption are likewise well documented. This information formed the basis for the Limits to Growth studies, previously mentioned, which use computer modeling to show how current trends are likely to play out—and most resulting scenarios show them leading to an end of economic growth and a collapse of industrial output some time in the early 21st century.
Why are the results of such diagnostic tests not universally accepted as a challenge to expectations of continued growth? Primarily because their conclusion runs counter to the beliefs and proclamations of most economists, who maintain that there are no practical limits to growth. They deny that resource constraints provide an eventual cap on production and consumption. And so their diagnostic efforts tend to ignore environmental factors in favor of easily measured internal features of the human economy such as money supply, consumer confidence, interest rates, and price indices.
Ecologist Charles Hall, among many others, has argued that the discipline of economics, as currently practiced, does not constitute a science, since it proceeds primarily on the basis of correlative logic rather than through the building of knowledge by a continuous, rigorous process of proposing and testing hypotheses. (21) While economics uses complex terminology and mathematics, as science does, its basic assertions about the world—such as the principle of infinite substitutability, which holds that for any resource that becomes scarce, the market will find a substitute—are not subjected to careful experimental examination. (It is worth noting that Hall and others have made the effort to lay the conceptual foundations for a new economics based on scientific principles and methods, which they call “biophysical economics.” (22)
Moreover, mainstream economists failed on the whole to foresee the current crash. There was no consistent or concerted effort on the part of Secretaries of the Treasury, Federal Reserve Chairmen, or “Nobel” prize-winning economists to warn policy makers or the general public that, sometime in the early 21st century, the global economy would begin to come apart at the seams. (23) One might think that this predictive failure—the inability to foresee so historically significant an event as the rapid contraction of nearly the entire global economy, entailing the failure of some of the world’s largest banks and manufacturing companies—would cause mainstream economists to stop and re-examine their fundamental premises. But there is little evidence to suggest that this is occurring.
At the risk of repetition: physical scientists from several disciplines have indeed foreseen an end to economic growth in the early 21st century, and have warned policy makers and the general public on many occasions.
Whom should we believe?
The specifics of the Alternative Diagnosis are falsifiable. If economic activity were to rebound above 2007 levels, or if oil production were to rise above the July 2008 high-water mark, then the attribution of the current economic crisis to resource-tied limits to growth may be considered at least partly disproven. However, even if these things were to occur, the underlying reasoning behind the Alternative Diagnosis might still be correct. If the world oil production peak is delayed until, let us say, 2015 or 2020, and if another—this time bottomless—global economic crash results then, the ultimate outcome will be essentially the same. But if, meanwhile, the Alternative Diagnosis were to be taken seriously and acted upon, the consequences of doing so would be beneficial: a decade would have been spent preparing for the event.
Could the Alternative Diagnosis be altogether wrong? That is, might conventional economists be right in thinking that growth can continue forever? It is often said that anything is possible, but some things are clearly much more possible than others. The perpetual growth of human population and consumption within the confines of a finite planet seems like a very long shot indeed, especially since warning signs are everywhere apparent that ecological limits are already being reached and surpassed. (24)
What Not to Do: Prescribe Punishingly Expensive Placebos
If the physical scientists who warn about limits to growth are right, confronting the global economic meltdown implies far more than merely getting the banks and mortgage lenders back on their feet. Indeed, in that case we face a fundamental change in our economy as significant as the advent of the industrial revolution. We are at a historic inflection point—the ending of decades of expansion and the beginning of an inevitable period of contraction that will continue until humanity is once again living within the limits of Earth’s regenerative systems.
But there are few signs that policy makers understand any of this. Their thinking appears to be shaped primarily by mainstream economists’ assurances that growth can and must continue into the indefinite future, and that the economic contraction the world is currently experiencing is only temporary--a problem that can and must be solved.
Still, the problem is not a minor one in the eyes of economists and policy makers. Consider the gargantuan size of the Treasury and Federal Reserve bailouts and stimulus packages that have been deployed in the possibly futile attempt to end contraction and restart growth. According to the special inspector general of the U.S. government’s Troubled Asset Relief Program (TARP), in remarks submitted to the House Committee on Oversight and Government Reform on July 21, $23.7 trillion have been committed in “total potential federal government support.” This is expensive medicine indeed. It takes a moment to even begin to comprehend the enormity of the figure. It represents about half of annual world GDP, and is over three times the total amount spent by the U.S. government, in inflation-adjusted dollars, on all wars combined, from 1776 to the present. It is nearly fifty times the cost of the New Deal.
Other nations, including Britain, China, and Germany have committed to paying for stimulus packages and bailouts that, while much smaller in absolute terms, represent an impressive (or should we say frightful?) share of national GDP.
If the Alternative Diagnosis is valid, none of this will work in the end, because existing financial institutions—with their basis in debt and interest and their requirements for constant expansion—cannot be made to function in a context where energy and resource constraints impose effective caps on manufacturing and transport.
Are the bailouts and stimulus packages working? Much evidence suggests that they are not, except in limited ways. In the U.S., unemployment continues to increase, while real estate values continue to fall. And most of the reputed “green shoots” in the economy so far sighted amount merely to an arguably temporary decline in the rate of contraction. For example, the home price index released July 28 of this year showed that in May, seasonally adjusted prices fell just 0.16 percent from the previous month. That represents an annual rate of decline of a little under 2 percent, which is a substantial improvement over the annualized rate of more than 20 percent that prevailed from September 2008 through March of 2009. Many commentators seized upon this news as a sign of an imminent turnaround. Nevertheless, new home sales are down from 1.4 million per year in 2005 to 350,000 per year today, and house prices are down 50 percent from the bubble peak and still declining in most places. Moreover, manufacturing is still shrinking, small businesses are in trouble, there are still significant danger signs on the horizon, including a new round of mortgage resets, a likely dive in commercial real estate values, and the looming reality that toxic assets at the center of the banking crisis have yet to be dealt with. (25)
President Obama has made the argument that bailouts are justified to stabilize the system long enough so that leaders can make fundamental changes to institutions and regulations, enabling the economy to then go forward healthier and more immune to similar crises in the future. But there is little to suggest that the kinds of systemic changes that are actually needed (ones that would enable the economy to function during a prolonged period of contraction) are under way or even contemplated. Meanwhile, as growth-based institutions are temporarily propped up, the ultimate scale of the damage is likely only to increase: when the inevitable collapse of those institutions does come, the consequences will likely be even worse because so much capital will have been squandered in attempting to salvage them.
In using up non-renewable resources like metals, minerals, and fossil fuels, we have stolen from future generations. Now in effect we are stealing from those generations the financial wherewithal that could have been used to build a bridge to a sustainable economy. The construction of a renewable energy infrastructure (including not only generating capacity, but distribution and storage systems, as well as post-petroleum transport and agriculture systems) will require enormous investments and decades of work. Where will the investment capital come from if governments are already buried in debt? If we have committed nearly $24 trillion to propping up an old economy with no real survival prospects, what’s left with which to finance the new one?
If the current prescription for our economic malady is wrong-headed, the same is true of many proposed cures for our energy problems. According to the Conventional Diagnosis, today’s high oil prices are due to speculation; the cure must therefore lie in the tighter regulation of oil futures trading (which may be a good idea, though it doesn’t get to the heart of the problem), while providing more opportunities to oil companies to explore for domestic oil (even though the likely production rates from currently off-limits reserves would be relatively paltry, and would have a negligible effect on oil prices). In fact, though, investing further in fossil fuel energy systems (including “clean coal” technology) will yield declining returns, given that the highest quality resources have already been used up; meanwhile, doing so takes investment capital away from the development of renewable energy, which we will have to rely on increasingly as fossil fuels deplete. (26)
What is required but is still utterly lacking is a fundamental recognition that circumstances have changed: what worked decades ago will not work now.
What To Do: Adapt to the New Reality
If the Alternative Diagnosis is correct, there will be no easy fix for the current economic breakdown. Some illnesses are not curable; they require that we simply adapt and make the best of our new situation.
If humanity has indeed embarked upon the contraction phase of the industrial pulse, we should assume that ahead of us lie much lower average income levels (for nearly everyone in the wealthy nations, and for high wage earners in poorer nations); different employment opportunities (fewer jobs in sales, marketing, and finance; more in basic production); and more costly energy, transport, and food. Further, we should assume that key aspects of our economic system that are inextricably tied to the need for future growth will cease to work in this new context.
What can we do to adapt most rapidly and successfully?
Rather than attempting to prop up banks and insurance companies with trillions in bailouts, it would probably be better simply to let them fail, however nasty the short-term consequences, since they will fail anyway sooner or later. The sooner they are replaced with institutions that serve essential functions within a contracting economy, the better off we will all be. (27)
Meanwhile the thought-leaders in society, especially the President, must begin breaking the news—in understandable and measured ways—that growth isn’t returning and that the world has entered a new and unprecedented economic phase, but that we can all survive and thrive in this challenging transitional period if we apply ourselves and work together. At the heart of this general re-education must be a public and institutional acknowledgment of three basic rules of sustainability: growth in population cannot be sustained; the ongoing extraction of non-renewable resources cannot be sustained; and the use of renewable resources is sustainable only if it proceeds at rates below those of natural replenishment.
Without cheap energy, global trade cannot increase. This doesn’t mean that trade will disappear, only that economic incentives will inexorably shift as transport costs rise, favoring local production for local consumption. But this may be a nice way of putting it: if and when fuel shortages arise, fragile globe-spanning systems of provisioning could be disrupted, with dire effects for consumers cut off from sources of necessary products. Thus a high priority must be placed on the building of community resilience through the preferential local sourcing of necessities and the maintenance of larger regional inventories—especially of food and fuel. (28)
It currently takes an average of 8.5 calories of energy from oil and natural gas to produce each calorie of food energy. Without cheap fuel for agriculture, farm production will plummet and farmers will go bankrupt—unless proactive efforts are undertaken to reform agriculture to reduce its reliance on fossil fuels. (29)
Obviously, alternative energy sources and energy efficiency strategies must be high priorities, and must be subjects of intensive research using a carefully chosen spectrum of criteria. The best candidates will have to be funded robustly even while fossil fuels are still relatively cheap: the build-out time for the renewable energy infrastructure will inevitably be measured in decades and so we must begin the process now rather than waiting for market forces to lead the way.
In the face of credit and (potential) currency crises, new ways of financing such projects will be needed. Given that our current monetary and financial systems are founded on the need for growth, we will require new ways of creating money and new ways of issuing credit. Considerable thought has gone into finding solutions to this problem, and some communities are already experimenting with local capital co-ops, alternative currencies, and no-interest banks. (30)
With oil becoming increasingly expensive in real terms, we will need more efficient ways of getting people and goods around. Our first priority in this regard must be to reduce the need for transport with better urban planning and re-localized production systems. But where transport is needed, rail and light rail will probably be preferable to cars and trucks. (31)
We will also need a revolution in the built environment to minimize the requirement for heating, cooling, and artificial lighting in all our homes and public buildings. This revolution is already under way, but is currently moving far too slowly due to the inertia of established interests in the construction industry. (32)
These projects will need more than local credit and money; they will also require skilled workers. There will be a call not just for installers of solar panels and home insulation: millions of new food producers and builders of low-energy infrastructure will be needed as well. A broad range of new opportunities could open up to replace vanishing jobs in marketing and finance—if there is cheap training available at local community colleges.
It is worth noting that the $23.7 trillion recently committed for U.S. bailouts and loan guarantees represents about $80,000 for each man, woman, and child in America. A level of investment even a substantial fraction that size could pay for all needed job training while ensuring universal provision of basic necessities during the transition. What would we be getting for our money? A collective sense that, in a time of crisis, no one is being left behind. Without the feeling of cooperative buy-in that such a safety net would help engender, similar to what was achieved with the New Deal but on an even larger scale, economic contraction could devolve into a horrific fight over the scraps of the waning industrial period.
However contentious, the population question must be addressed. All problems that have to do with resources are harder to solve when there are more people needing those resources. The U.S. must encourage smaller families and must establish an immigration policy consistent with a no-growth population target. This has foreign policy implications: we must help other nations succeed with their own economic transitions so that their citizens do not have to emigrate to survive. (33)
If economic growth ceases to be an achievable goal, society will have to find better ways of measuring success. Economists must shift from assessing well-being with the blunt instrument of GDP, and begin paying more attention to indices of human and social capital in areas such as education, health, and cultural achievements. This redefinition of growth and progress has already begun in some quarters, but for the most part has yet to be taken up by governments. (34)
A case can be made that after all this is done the end result will be a more satisfying way of life for the vast majority of citizens—offering more of a sense of community, more of a connection with the natural world, more satisfying work, and a healthier environment. Studies have repeatedly shown that higher levels of consumption do not translate to elevated levels of satisfaction with life. (35) This means that if “progress” can be thought of in terms of happiness, rather than a constantly accelerating process of extracting raw materials and turning them into products that themselves quickly become waste, then progress can certainly continue. In any case, “selling” this enormous and unprecedented project to the general public will require emphasizing its benefits. Several organizations are already exploring the messaging and public relations aspects of the transition. (36) But those in charge need to understand that looking on the bright side doesn’t mean promising what can’t be delivered—such as a return to the days of growth and thoughtless consumption.
Can We? Will We?
It is important to state the implications of all this as plainly as possible. If the Alternative Diagnosis is correct, there will be no full economic “recovery”—not this year, or the next, or five or ten years from now. There may be temporary rebounds that take us back to some fraction of peak economic activity, but these will be only brief respites.
We have entered a new economic era in which the former rules no longer apply. Low interest rates and government spending no longer translate to incentives for borrowing and job production. Cheap energy won’t appear just because there is demand for it. Substitutes for essential resources will in most cases not be found. Over all, the economy will continue to shrink in fits and starts until it can be maintained by the energy and material resources that Earth can supply on ongoing basis.
This is of course very difficult news. It is analogous to being told by your physician that you have contracted a systemic, potentially fatal disease that cannot be cured, but only managed; and managing it means you must make profound lifestyle changes.
Some readers may note that climate change has not figured prominently in this discussion. It is clearly, after all, the worst environmental catastrophe in human history. Indeed, its consequences could be far worse than the mere destruction of national economies: hundreds of millions of people and millions of other species could be imperiled. The reason for the relatively limited discussion of climate here is that (assuming the Alternative Diagnosis is correct) it is not climate change that has proven to be the most immediate limit to economic growth, but resource depletion. However, while there is not as yet general agreement on the point, climate change itself and the needed steps to minimize it both constitute limits to growth, just as resource depletion does. Moreover, if we fail to successfully manage the inevitable process of economic contraction that will characterize the coming decades, there will be no hope of mounting an organized and coherent response to climate change—a response consisting of efforts both to reduce climate impacts and to adapt to them. It is important to note, though, that the measures advocated here (including the development of renewable energy sources and energy efficiency, a rapid reduction of reliance on fossil fuels in transport and agriculture, and the stabilization of population levels) are among the steps that will help most to reduce carbon emissions.
Is this essay likely to change the thinking and actions of policy makers? Unfortunately, that is unlikely. Their belief in the possibility and necessity of continued growth is pervasive, and the notion that growth may no longer be possible is unthinkable. But the Alternative Diagnosis must be a matter of record. This essay, composed by a mere journalist, in many ways represents the thinking of thousands of physical scientists working over the past several decades on issues having to do with population, resources, pollution, and biodiversity. Ignoring the diagnosis itself—whether as articulated here or as implied in tens of thousands of scientific papers—may waste our last chance to avert a complete collapse, not just of the economy, but of civility and organized human existence. It may risk a historic discontinuity with qualitative antecedents in the fall of the Roman and Mayan civilizations. (37) But there is no true precedent for what may be in store, because those earlier examples of collapse affected geographically bounded societies whose influence on their environments was also bounded. Today’s civilization is global, and its fate, Earth’s fate, and humanity’s fate are inextricably tied.
But even if policy makers continue to ignore warnings such as this, individuals and communities can take heed and begin the process of building resilience, and of detaching themselves from reliance on fossil fuels and institutions that are inextricably tied to the perpetual growth machine. We cannot sit passively by as world leaders squander opportunites to awaken and adapt to growth limits. We can make changes in our own lives, and we can join with our neighbors. And we can let policy makers know we disapprove of their allegiance to the status quo, but that there are other options.
Is it too late to begin a managed transition to a post-fossil fuel society? Perhaps. But we will not know unless we try. And if we are to make that effort, we must begin by acknowledging one simple, stark reality: growth as we have known it can no longer be our goal.
Notes
1. “Pain on the Road to Recovery” (http://www.smh.com.au/national/pain-on-the-road-to-recovery-20090724-dw6...).
2. Here, for example, are a few relevant excerpts from the present author’s book The Party’s Over: Oil, War and the Fate of Industrial Societies (Gabriola Island, BC: New Society, 2003): “Our current financial system was designed during a period of consistent growth in available energy, with its designers operating under the assumption that continued economic growth was both inevitable and desirable. This ideology of growth has become embodied in systemic financial structures requiring growth…. Until now, this loose linkage between a financial system predicated upon the perpetual growth of the money supply, and an economy growing year by year because of an increasing availability of energy and other resources, has worked reasonably well—with a few notable exceptions, such as the Great Depression…. However, [when global oil production peaks] the financial system may not respond so rationally…. This might predictably trigger a financial crisis….”
3. See Albert Bartlett, “Arithmetic, Population and Energy” (lecture transcript), (http://www.globalpublicmedia.com/transcripts/645).
4. Donella H. Meadows, Dennis L. Meadows, Jorgen Randers, and William W. Behrens III, Limits to Growth (New York: Universe Books, 1972); Donella H. Meadows, Dennis L. Meadows, and Jorgen Randers, Beyond the Limits (Post Mills, VT: Chelsea Green, 1992); Donella H. Meadows, Dennis L. Meadows, and Jorgen Randers, Limits to Growth: The 30 Year Update (White River Junction, VT: Chelsea Green, 2003). See also the recent CSIRO study, “A Comparison of the Limits to Growth with Thirty Years of Reality” (2009) (www.csiro.au/files/files/plje.pdf).
5. See, for example, Robert U. Ayers and Benjamin Warr, The Economic Growth Engine: How Energy and Work Drive Material Prosperity (Cambridge, UK: Edward Elgar Publishing, 2005); and Robert Barro and Xavier Sala-i-Martin, Economic Growth (Cambridge, MA: MIT Press, 2003) (http://www.bookrags.com/research/economic-growth-and-energy-consumpt-mee...).
6. See Richard Heinberg, The Party’s Over: Oil, War and the Fate of Industrial Societies (2003, 2005); Powerdown: Options and Actions for a PostCarbon World (2004); and The Oil Depletion Protocol: A Plan to Avert Oil Wars, Terrorism, and Economic Collapse (2006); as well as books by Kenneth Deffeyes, Colin Campbell, and Matthew Simmons; and websites www.theoildrum.com and www.energybulletin.net. The Association for the Study of Peak Oil organizes international conferences to study issues related to oil and gas depletion (www.peakoil.net and www.aspo-usa.com), and the U.S. chapter of ASPO publishes a weekly survey of relevant news, “Peak Oil Review,” compiled by former CIA analyst Tom Whipple. At the annual Association for the Study of Peak Oil conference in Cork, Ireland, in September 2007, former U.S. Energy Secretary, James Schlesinger, said: “Conceptually the battle is over. The peakists have won. We’re all peakists now.” See also Steve Connor, “Warning: Oil supplies are running out fast,” The Independent, August 3, 2009 (http://www.independent.co.uk/news/science/warning-oil-supplies-are-runni...).
7. The declining rate of discovery of new oilfields, and the list of past-peak oil producing countries, are widely documented; e.g.: Roger D. Blanchard, The Future of Global Oil Production: Facts, Figures, Trends and Projections by Region (Jefferson, NC: McFarlane and Co., 2005).
8. A May 4, 2009 report from Raymond James Associates (“Stat of the Week”) argued that world oil production peaked in July 2008 (http://blogs.wsj.com/environmentalcapital/2009/05/04/peak-oil-global-oil...). In a subsequent interview, Marshall Adkins, author of the report, suggested that most knowledgeable players within the petroleum industry now accept the Peak Oil thesis in some form, whether or not they acknowledge it publicly (www.aspousa.org/index.php/2009/07/interview-with-marshall-adkins/).
9. Brookings Papers on Economic Activity, March 2009. www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2009_spr...
10. See Joe Cortright, “Driven to the Brink: How the Gas Price Spike Popped the Housing Bubble and Devalued the Suburbs,” Discussion paper, CEOs for Cities, 2008 (http://www.ceosforcities.org).
11. U.S. Government Accountability Office, “Commercial Aviation: Airline Industry Contraction Due to Volatile Fuel Prices and Falling Demand Affects Airports, Passengers, and Federal Government Revenues ,” April 21, 2009 (www.gao.gov/products/GAO-09-393). For a detailed discussion of the likely future impacts of high oil prices and oil shortages on the airline industry, see Charles Schlumberger, “The Oil Price Spike of 2008: The Result of Speculation or an Early Indicator of a Major and Growing Future Challenge to the Airline Industry?” Annals of Air and Space Law, Vol. XXXIV, [2009], McGill University (http://www.globalpublicmedia.com/the_oil_price_spike_of_2008).
12. American Trucking Association (www.truckline.com/Pages/Home.aspx).
13. This scenario is implied in Robert L. Hirsch, Roger Bezdek, and Robert Wendling, “Peaking of World Oil Production: Impacts, Mitigatin and Risk Management” (U.S. Department of Energy: 2005): “As peaking is approached, liquid fuel prices and price volatility will increase dramatically….” (http://www.netl.doe.gov/publications/others/pdf/Oil_Peaking_NETL.pdf).
14. See, for example, “Troubling Signs That Oil Prices Could Hamper Recovery,” Wall Street 24/7, May 8, 2009 (http://247wallst.com/2009/05/08/troubling-signs-that-oil-prices-could-ha...)
15. See, for example, James Herron, “Low Oil Prices, Credit Woes Could Spell Trouble for UK North Sea,” Rigzone, November 14, 2008 (www.rigzone.com/news/article.asp?a_id=69507).
16. Jad Mouawad, “Big Oil Projects Put in Jeopardy by Fall in Prices,” New York Times, December 15, 2008 (www.nytimes.com/2008/12/16/business/16oil.html)
17. See David R. Baker, “Low oil prices take wind out of renewable fuels,” San Francisco Chronicle, October 27, 2008 (www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/10/26/MNSK13NNK4.DTL).
18. See The Party’s Over, Chapter 4; Powerdown, Chapter 4; The Oil Depletion Protocol, pages 23-31. A longer treatment of the subject, tentatively titled Energy Limits to Growth, will be published by International Forum on Globalization and Post Carbon Institute in September.
19. This conclusion is echoed in, for example, Ted Trainer, Renewable Energy Cannot Sustain a Consumer Society (Dordrecht, The Netherlands: Springer, 2007); and (with some reservations), David J. C. McKay, Sustainable Energy Without the Hot Air (Cambridge, UK: UIK Cambridge, 2008), (www.withouthotair.com).
20. Just one example, from a press release April 20, 1998 describing the results of a poll commissioned by the American Museum of Natural History: “The American Museum of Natural History announced today results of a nationwide survey titled Biodiversity in the Next Millennium, developed by the Museum in conjunction with Louis Harris and Associates, Inc. The survey reveals that seven out of ten biologists believe that we are in the midst of a mass extinction of living things, and that this loss of species will pose a major threat to human existence in the next century.”
21. Charles A. S. Hall and Kent A. Klitgaard, “The Need for a New, Bioplysical-Based Paradigm in Economics for the Second Half of the Age of Oil,” International Journal of Transdisciplinary Research, Vo. 1, NO. 1 (2006), (http://74.125.155.132/search?q=cache:DtdKR2ZWgNoJ:www.peakoil.net/files/...); Charles A. S. Hall, D. Lindenberger, R. Kummell, T. Kroeger and W. Eichorn, “The Need to Reintegrate the Natural Sciences with Economics.” Bioscience 51:663-673, 2001.
22. Cutler J. Cleveland, “Biophysical Economics,” The Encyclopedia of Earth (www.eoearth.org/article/Biophysical_economics). See also the related field of Ecological Economics, especially the books of Herman Daly, including Toward a Steady State Economy (New York: Freeman, 1973); and, with Joshua Farley, Ecological Economics: Principles and Applications (Washington: Island Press, 2004).
23. The quotation marks around the Nobel name are justified because the Nobel family has never acknowledged economics as a science: the so-called “Nobel prize in economics” is awarded by a Swedish Bank.
24. See The Millennium Ecosystem Assessment (www.millenniumassessment.org/en/index.aspx).
25. See, for example, J. S. Kim, “Irrational Exuberance of the Green Shoots,” July 24, 2009 (http://seekingalpha.com/article/151101-irrational-exuberance-of-the-gree...).
26. See Richard Heinberg, Blackout: Coal, Climate and the Last Energy Crisis (Gabiola Island, BC: New Society, 2009), pages 137-143, 145-168.
27. The opinion that banks and insurance companies should be allowed to fail rather than being bailed out was voiced by many knowledgeable observers throughout late 2008 and early 2009. See for example Ambrose Evans-Pritchard, “Let banks fail, says Nobel economist Joseph Stiglitz,” London Daily Telegraph, Feb. 2, 2009 (www.telegraph.co.uk/finance/newsbysector/banksandfinance/4424418/Let-ban...).
28. See Jeff Rubin, Why Your World Is About to Get a Whole Lot Smaller: Oil and the End of Globalization. (New York: Random House, 2009).
29. See Richard Heinberg and Michael Bomford, “The Food and Farming Transition” (Sebastopol, CA: Post Carbon Institute, 2009), (http://postcarbon.org/food).
30. See Bernard Lietaer, “White Paper on All the Options for Managing a Systemic Bank Crisis” (www.lietaer.com/images/White_Paper_on_Systemic_Banking_Crises_final.pdf). JAK in Sweden is a cooperative, member-owned bank that operates without interest (http://en.wikipedia.org/wiki/JAK_members_bank).
31. See Richard Gilbert and Anthony Perl, Transport Revolutions: Moving People and Freight Without Oil (Gabriola Island, BC: New Society, 2009).
32. The Passivhaus Institute pioneers construction methods that reduce energy input to buildings in many cases to zero (www.passivehouse.us). Roughly 20,000 Passivhauses have been built in Europe, only about 12 in the U.S.
33. See websites of Population Media Center (www.populationmedia.org/issues/), and SUSPS (www.susps.org/overview/immigration.html).
34. The organization Redefining Progress has developed a Genuine Progress Indicator (GPI) that incorporates many such indices (www.rprogress.org/sustainability_indicators/genuine_progress_indicator.htm).
35. See, for example, “Understanding Human Happiness and Well-Being,” The Sustainable Scale Project (http://www.sustainablescale.org/AttractiveSolutions/UnderstandingHumanHa...).
36. The burgeoning Transition Town movement (www.transitiontowns.org) proceeds from the premise that “life can be better without fossil fuels.” YES! Magazine (www.yesmagazine.org) is a publication of the Positive Futures Network and highlights examples of low-impact ways of living that bring personal and social benefits. And the Simple Living Network (www.simpleliving.net) provides “resources, tools, examples and contacts for conscious, simple, healthy and restorative living.”
37. See Jared Diamond, Collapse How Societies Choose to Fail or Succeed (New York: Viking, 2005); Joseph Tainter, The Collapse of Complex Societies (Cambridge, UK: Cambridge University Press, 1988); and John Michael Greer, The Long Descent (Gabriola Island, BC: New Society, 2008).
This is a guest post by Richard Heinberg. Richard is a Senior Fellow of the Post Carbon Institute and author of five books on resource depletion and societal responses to the energy problem. He can be found on the web at www.richardheinberg.com and www.postcarbon.org.
Everyone agrees: our economy is sick. The inescapable symptoms include declines in consumer spending and consumer confidence, together with a contraction of international trade and available credit. Add a collapse in real estate values and carnage in the automotive and airline industries and the picture looks grim indeed.
But why are both the U.S. economy and the larger global economy ailing? Among the mainstream media, world leaders, and America’s economists-in-chief (Treasury Secretary Geithner and Federal Reserve Chairman Bernanke) there is near-unanimity of opinion: these recent troubles are primarily due to a combination of bad real estate loans and poor regulation of financial derivatives.
This is the Conventional Diagnosis. If it is correct, then the treatment for our economic malady might logically include heavy doses of bailout money for beleaguered financial institutions, mortgage lenders, and car companies; better regulation of derivatives and futures markets; and stimulus programs to jumpstart consumer spending.
But what if this diagnosis is fundamentally flawed? The metaphor needs no belaboring: we all know that tragedy can result from a doctor’s misreading of symptoms, mistaking one disease for another.
Something similar holds for our national and global economic infirmity. If we don’t understand why the world’s industrial and financial metabolism is seizing up, we are unlikely to apply the right medicine and could end up making matters much worse than they would otherwise be.
To be sure: the Conventional Diagnosis is clearly at least partly right. The causal connections between subprime mortgage loans and the crises at Fannie Mae, Freddie Mac, and Lehman Brothers have been thoroughly explored and are well known. Clearly, over the past few years, speculative bubbles in real estate and the financial industry were blown up to colossal dimensions, and their bursting was inevitable. It is hard to disagree with the words of Australian Prime Minister Kevin Rudd, in his July 25 essay in the Sydney Morning Herald: “The roots of the crisis lie in the preceding decade of excess. In it the world enjoyed an extraordinary boom…. However, as we later learnt, the global boom was built in large part on a … house of cards. First, in many Western countries the boom was created on a pile of debt held by consumers, corporations and some governments. As the global financier George Soros put it: ‘For 25 years [the West] has been consuming more than we have been producing … living beyond our means.’” (1)
But is this as far as we need look to get to the root of the continuing global economic meltdown?
A case can be made that dire events having to do with real estate, the derivatives markets, and the auto and airline industries were themselves merely symptoms of an even deeper, systemic dysfunction that spells the end of economic growth as we have known it.
In short, I am suggesting an Alternative Diagnosis. This explanation for the economic crisis is not for the faint of heart because, if correct, it implies that the patient is far sicker than even the most pessimistic economists are telling us. But if it is correct, then by ignoring it we risk even greater peril.
Economic Growth, The Financial Crisis, and Peak Oil
For several years, a swelling subculture of commentators (which includes the present author) has been forecasting a financial crash, basing this prognosis on the assessment that global oil production was about to peak. (2) Our reasoning went like this:
Continual increases in population and consumption cannot continue forever on a finite planet. This is an axiomatic observation with which everyone familiar with the mathematics of compounded arithmetic growth must agree, even if they hedge their agreement with vague references to “substitutability” and “demographic transitions.” (3)
This axiomatic limit to growth means that the rapid expansion in both population and per-capita consumption of resources that has occurred over the past century or two must cease at some particular time. But when is this likely to occur?
The unfairly maligned Limits to Growth studies, published first in 1972 with periodic updates since, have attempted to answer the question with analysis of resource availability and depletion, and multiple scenarios for future population growth and consumption rates. The most pessimistic scenario in 1972 suggested an end of world economic growth around 2015. (4)
But there may be a simpler way of forecasting growth’s demise.
Energy is the ultimate enabler of growth (again, this is axiomatic: physics and biology both tell us that without energy nothing happens). Industrial expansion throughout the past two centuries has in every instance been based on increased energy consumption. (5) More specifically, industrialism has been inextricably tied to the availability and consumption of cheap energy from coal and oil (and more recently, natural gas). However, fossil fuels are by their very nature depleting, non-renewable resources. Therefore (according to the Peak Oil thesis), the eventual inability to continue increasing supplies of cheap fossil energy will likely lead to a cessation of economic growth in general, unless alternative energy sources and efficiency of energy use can be deployed rapidly and to a sufficient degree. (6)
Of the three conventional fossil fuels, oil is arguably the most economically vital, since it supplies 95 percent of all transport energy. Further, petroleum is the fuel with which we are likely to encounter supply problems soonest, because global petroleum discoveries have been declining for decades, and most oil producing countries are already seeing production declines. (7)
So, by this logic, the end of economic growth (as conventionally defined) is inevitable, and Peak Oil is the likely trigger.
Why would Peak Oil lead not just to problems for the transport industry, but a more general economic and financial crisis? During the past century growth has become institutionalized in the very sinews of our economic system. Every city and business wants to grow. This is understandable merely in terms of human nature: nearly everyone wants a competitive advantage over someone else, and growth provides the opportunity to achieve it. But there is also a financial survival motive at work: without growth, businesses and governments are unable to service their debt. And debt has become endemic to the industrial system. During the past couple of decades, the financial services industry has grown faster than any other sector of the American economy, even outpacing the rise in health care expenditures, accounting for a third of all growth in the U.S. economy. From 1990 to the present, the ratio of debt-to-GDP expanded from 165 percent to over 350 percent. In essence, the present welfare of the economy rests on debt, and the collateral for that debt consists of a wager that next year’s levels of production and consumption will be higher than this year’s.
Given that growth cannot continue on a finite planet, this wager, and its embodiment in the institutions of finance, can be said to constitute history’s greatest Ponzi scheme. We have justified present borrowing with the irrational belief that perpetual growth is possible, necessary, and inevitable. In effect we have borrowed from future generations so that we could gamble away their capital today.
Until recently, the Peak Oil argument has been framed as a forecast: the inevitable decline in world petroleum production, whenever it occurs, will kill growth. But here is where forecast becomes diagnosis: during the period from 2005 to 2008, energy stopped growing and oil prices rose to record levels. By July of 2008, the price of a barrel of oil was nudging close to $150—half again higher than any previous petroleum price in inflation-adjusted terms—and the global economy was beginning to topple. The auto and airline industries shuddered; ordinary consumers had trouble for buying gasoline for their commute to work while still paying their mortgages. Consumer spending began to decline. By September the economic crisis was also a financial crisis, as banks trembled and imploded. (8)
Given how much is at stake, it is important to evaluate the two diagnoses on the basis of facts, not preconceptions.
It is unnecessary to examine evidence supporting or refuting the Conventional Diagnosis, because its validity is not in doubt—as a partial explanation for what is occurring. The question is whether it is a sufficient explanation, and hence an adequate basis for designing a successful response.
What’s the evidence favoring the Alternative? A good place to begin is with a recent paper by economist James Hamilton of the University of California, San Diego, titled “Causes and Consequences of the Oil Shock of 2007-08,” which discusses oil prices and economic impacts with clarity, logic, and numbers, explaining how and why the economic crash is related to the oil price shock of 2008. (9)
Hamilton starts by citing previous studies showing a tight correlation between oil price spikes and recessions. On the basis of this correlation, every attentive economist should have forecast a steep recession for 2008. “Indeed,” writes Hamilton, “the relation could account for the entire downturn of 2007-08…. If one could have known in advance what happened to oil prices during 2007-08, and if one had used the historically estimated relation [between price rise and economic impact]… one would have been able to predict the level of real GDP for both of 2008:Q3 and 2008:Q4 quite accurately.”
Again, this is not to ignore the role of the financial and real estate sectors in the ongoing global economic meltdown. But in the Alternative Diagnosis the collapse of the housing and derivatives markets is seen as amplifying a signal ultimately emanating from a failure to increase the rate of supply of depleting resources. Hamilton again: “At a minimum it is clear that something other than housing deteriorated to turn slow growth into a recession. That something, in my mind, includes the collapse in automobile purchases, slowdown in overall consumption spending, and deteriorating consumer sentiment, in which the oil shock was indisputably a contributing factor.”
Moreover, Hamilton notes that there was “an interaction effect between the oil shock and the problems in housing.” That is, in many metropolitan areas, house prices in 2007 were still rising in the zip codes closest to urban centers but already falling fast in zip codes where commutes were long. (10)
Why Did the Oil Price Spike?
Those who espouse the Conventional Diagnosis for our ongoing economic collapse might agree that there was some element of causal correlation between the oil price spike and the recession, but they would deny that the price spike itself had anything to do with resource limits, because (they say) it was caused mostly by speculation in the oil futures market, and had little to do with fundamentals of supply and demand.
In this, the Conventional Diagnosis once again has some basis in reality. Speculation in oil futures during the period in question almost certainly helped drive oil prices higher than was justified by fundamentals. But why were investors buying oil futures? Was the mania for oil contracts just another bubble, like the dot.com stock frenzy of the late ’90s or the real estate boom of 2003 to 2006?
During the period from 2005 to mid-2008, demand for oil was growing, especially in China (which went from being self-sufficient in oil in 1995 to being the world’s second-foremost importer, after the U.S., by 2006). But the global supply of oil was essentially stagnant: monthly production figures for crude oil bounced around within a fairly narrow band between 72 and 75 million barrels per day. As prices rose, production figures barely budged in response. There was every indication that all oil producers were pumping flat-out: even the Saudis appeared to be rushing to capitalize on the price bonanza.
Thus a good argument can be made that speculation in oil futures was merely magnifying price moves that were inevitable on the basis of the fundamentals of supply and demand. James Hamilton (in his publication previously cited) puts it this way: “With hindsight, it is hard to deny that the price rose too high in July 2008, and that this miscalculation was influenced in part by the flow of investment dollars into commodity futures contracts. It is worth emphasizing, however, that the two key ingredients needed to make such a story coherent—a low price elasticity of demand, and the failure of physical production to increase—are the same key elements of a fundamentals-based explanation of the same phenomenon. I therefore conclude that these two factors, rather than speculation per se, should be construed as the primary cause of the oil shock of 2007-08.”
Aftermath of the Peak
There is also controversy over to what degree troubles in the automobile, trucking, and airline industries should be attributed to the oil price spike or the economic crash. Of course, if the Alternative Diagnosis is correct, the latter two events are causally related in any case. However, it may be helpful to review the situation.
Everyone knows that GM and Chrysler went bankrupt this year because U.S. car sales cratered. The current forecast is for sales of about 10.3 million vehicles in the U.S. for 2009, down from last year’s 13.2 million and 16.1 million in 2007. U.S. car sales have not been this low since the 1970s. Sales of light trucks, the most profitable vehicles, took the biggest hit during 2008, as fuel prices soared and car buyers avoided gas-guzzlers. It was at this point that the auto companies really began feeling the pain.
The airline industry’s ills are summarized in a recent GAO document: “After 2 years of profits, the U.S. passenger airline industry lost $4.3 billion in the first 3 quarters of 2008 [as jet fuel prices climbed]. Collectively, U.S. airlines reduced domestic capacity, as measured by the number of seats flown, by about 9 percent from the fourth quarter of 2007 to the fourth quarter of 2008…. To reduce capacity, airlines reduced the overall number of active aircraft in their fleets by 18 percent…. Airlines also collectively reduced their workforces by about 28,000, or nearly 7 percent, from the end of 2007 to the end of 2008…. The contraction of the U.S. airline industry in 2008 reduced airport revenues, passengers’ access to the national aviation system, and revenues for the Trust Fund.” (11)
For the trucking industry, fuel accounts for nearly 40 percent of total operational costs. In 2007, as diesel prices rose, carriers began losing money and added fuel price surcharges; meanwhile the volume of freight began falling. After July 2008, as oil prices crashed, tonnage continued to decline. Overall, the cumulative decrease in loads for flatbed, tanker, and dry vans ranged between 15 percent and 20 percent just in the period from June to December 2008. (12)
This last set of statistics raises a couple of questions crucial to understanding the Alternative Diagnosis: Why, if global oil production had just peaked, did petroleum prices fall in the last five months of 2008? And, if oil prices were a major factor in the economic crisis, why didn’t the economy begin to turn around after the prices softened?
Why Did Oil Prices Fall? And Why Didn’t Lower Oil Prices Lead to a Quick Recovery?
The Peak Oil thesis predicts that, as world oil production reaches its maximum level and begins to decline, the price of oil will rise dramatically. But it also forecasts a dramatic increase in the volatility of prices.
The argument goes as follows. As oil becomes scarce, its price will rise until it begins to undermine economic activity in general. Economic contraction will then result in substantially reduced demand for oil, which will in turn cause its price to fall temporarily. Then one of two things will happen: either (a) the economy will begin to recover, stoking renewed oil demand, leading again to high prices which will again undermine economic activity; or (b), if the economy does not quickly recover, petroleum production will gradually fall due to depletion until spare production capacity (created by lower demand) is wiped out, leading again to higher prices and even more economic contraction. In both cases, oil prices remain volatile and the economy contracts. (13)
This scenario corresponds very closely with the reality that is unfolding, though it remains to be seen whether situation (a) or (b) will ensue.
Over the past three years, oil prices rose and fell more dramatically than would have been the case if it had not been for widespread speculation in oil futures. Nevertheless, the general direction of prices—way up, then way down, then part-way back up—is entirely consistent with the Peak Oil thesis and the Alternative Diagnosis.
Why has the economy not quickly recovered, given that oil prices are now only half what they were in July 2008? Again, Peak Oil is not the only cause of the current economic crisis. Enormous bubbles in the real estate and finance sectors constituted accidents waiting to happen, and the implosion of those bubbles has created a serious credit crisis (as well as solvency and looming currency crises) that will likely take several years to resolve even if energy supplies don’t pose a problem.
But now the potential for renewed high oil prices acts as a ceiling for economic recovery. Whenever the economy does appear to show renewed signs of life (as has happened in May-July this year, with stock values rebounding and the general pace of economic contraction slowing somewhat), oil prices will take off again as oil speculators anticipate a recovery of demand. Indeed, oil prices have rebounded from $30 in January to nearly $70 currently, provoking widespread concern that high energy prices could nip recovery in the bud. (14)
A barrel of oil from newly developed sources costs in the neighborhood of $60 to produce, now that all of the cheaper prospects have been exploited: finding new oilfields today usually means drilling under miles of ocean water, or in politically unstable nations where equipment and personnel are at high risk. (15) So as soon as consumers demand more oil, the price will have to stay noticeably above that figure in order to provide the incentive for producers to drill.
Volatile oil prices hurt on the upside, but they also hurt on the downside. The oil price collapse of August-December 2008, plus the worsening credit crisis, caused a dramatic contraction in oil industry investment, leading to the cancellation of about $150 billion worth of new oil production projects—whose potential productive capacity will be required to offset declines in existing oilfields if world oil production is to remain stable. (16) This means that even if demand remains low, production capacity will almost certainly decline to meet those demand levels, causing oil prices to rise again in real terms at some point, perhaps two or three years from now. Volatile petroleum prices also hurt the development of alternative energy, as was shown during the past few months when falling oil prices led to financial troubles for ethanol manufacturers. (17)
One way or another, growth will be highly problematic if not unachievable.
Big Picture Diagnosis: Continuing the Trail of Logic
At this point in the discussion many readers will be wondering why alternative energy sources and efficiency measures cannot be deployed to solve the Peak Oil crisis. After all, as petroleum becomes more expensive, ethanol, biodiesel, and electric cars all start to look more attractive both to producers and consumers. Won’t the magic of the market intervene to render oil shortages irrelevant to future growth?
It is impossible in the context of this discussion to provide a detailed explanation of why the market probably cannot solve the Peak Oil problem. Such an explanation requires a discussion of energy evaluation criteria, and an analysis of many individual energy alternatives on the basis of those criteria. I have offered brief overviews of this subject previously and a much longer one is in press. (18)
My summary conclusions in this regard are as follows.
About 85 percent of our current energy is derived from three primary sources—oil, natural gas, and coal—that are non-renewable, whose price is likely to trend sharply higher over the next years and decades leading to severe shortages, and whose environmental impacts are unacceptable. While these sources historically have had very high economic value, we cannot rely on them in the future; indeed, the longer the transition to alternative energy sources is delayed, the more difficult that transition will be unless some practical mix of alternative energy systems can be identified that will have superior economic and environmental characteristics.
But identifying such a mix is harder than one might initially think. Each energy source has highly specific characteristics. In fact, it has been the characteristics of our present energy sources (principally oil, coal, and natural gas) that have enabled the building of an urbanized society with high mobility, large population, and high economic growth rates. Surveying the available alternative energy sources for criteria such as energy density, environmental impacts, reliance on depleting raw materials, intermittency versus constancy of supply, and the percentage of energy returned on the energy invested in energy production, none currently appears capable of perpetuating this kind of society.
Moreover, national energy systems are expensive and slow to develop. Energy efficiency likewise requires investment, and further incremental investments in efficiency tend to yield diminishing returns over time, since it is impossible to perform work with zero energy input. Where is there the will or ability to muster sufficient investment capital for deployment of alternative energy sources and efficiency measures on the scale needed?
While there are many successful alternative energy production installations around the world (ranging from small home-scale photovoltaic systems to large “farms” of three-megawatt wind turbines), there are very few modern industrial nations that now get the bulk of their energy from sources other than oil, coal, and natural gas. One example is Sweden, which obtains most of its energy from nuclear and hydropower. Another is Iceland, which benefits from unusually large domestic geothermal resources not found in most other countries. Even for these two nations, the situation is complex: the construction of the infrastructure for their power plants mostly relied on fossil fuels for the mining of the ores and raw materials, for materials processing, for transportation, for the manufacturing of components, for the mining of uranium, for construction energy, and so on. Thus a meaningful energy transition away from fossil fuels is still a matter of theory and wishful thinking, not reality.
My conclusion from a careful survey of energy alternatives, then, is that there is little likelihood that either conventional fossil fuels or alternative energy sources can be counted on to provide the amount and quality of energy that will be needed to sustain economic growth—or even current levels of economic activity—during the remainder of this century. (19)
But the problem extends beyond oil and other fossil fuels: the world’s fresh water resources are strained to the point that billions of people may soon find themselves with only precarious access to water for drinking and irrigation. Biodiversity is declining rapidly. We are losing 24 billion tons of topsoil each year to erosion. And many economically significant minerals—from antimony to zinc—are depleting quickly, requiring the mining of ever lower-grade ores in ever more remote locations. Thus the Peak Oil crisis is really just the leading edge of a broader Peak Everything dilemma.
In essence, humanity faces an entirely predictable peril: our population has been growing dramatically for the past 200 years (expanding from under one billion to nearly seven billion), while our per-capita consumption of resources has also grown. For any species, this is virtually the definition of biological success. And yet all of this has taken place in the context of a finite planet with fixed stores of non-renewable resources (fossil fuels and minerals), a limited ability to regenerate renewable resources (forests, fish, fresh water, and topsoil), and a limited ability to absorb industrial wastes (including carbon dioxide). If we step back and look at the industrial period from a broad historical perspective that is informed by an appreciation of ecological limits, it is hard to avoid the conclusion that we are today living at the end of a relatively brief pulse—a 200-year rapid expansionary phase enabled by a temporary energy subsidy (in the form of cheap fossil fuels) that will inevitably be followed by an even more rapid and dramatic contraction as those fuels deplete.
The winding down of this historic growth-contraction pulse doesn’t necessarily mean the end of the world, but it does mean the end of a certain kind of economy. One way or another, humanity must return to a more normal pattern of existence characterized by reliance on immediate solar income (via crops, wind, or the direct conversion of sunlight to electricity) rather than stored ancient sunlight.
This is not to say that the remainder of the 21st century must consist of a collapse of industrialism, a die-off of most of the human population, and a return by the survivors to a way of life essentially identical to that of 16th century peasants or indigenous hunter-gatherers. It is possible instead to imagine acceptable and even inviting ways in which humanity could adapt to ecological limits while further developing cultural richness, scientific understanding, and quality of life (more of this below).
But however it is negotiated, the transition will spell an end to economic growth in the conventional sense. And that transition appears to have begun.
How Do We Know Which Diagnosis Is Correct?
If the patient is an individual human and the cause of distress is uncertain, more diagnostic tests can be prescribed. But to what sorts of blood tests, x-rays, and CAT scans can we subject the national or global economy?
In a sense, the tests have already been done. During the past few decades thousands of scientific surveys of natural resources, biodiversity, and ecosystems have showed increasing rates of depletion and decline. (20) The continuing increase in human population, pollution, and consumption are likewise well documented. This information formed the basis for the Limits to Growth studies, previously mentioned, which use computer modeling to show how current trends are likely to play out—and most resulting scenarios show them leading to an end of economic growth and a collapse of industrial output some time in the early 21st century.
Why are the results of such diagnostic tests not universally accepted as a challenge to expectations of continued growth? Primarily because their conclusion runs counter to the beliefs and proclamations of most economists, who maintain that there are no practical limits to growth. They deny that resource constraints provide an eventual cap on production and consumption. And so their diagnostic efforts tend to ignore environmental factors in favor of easily measured internal features of the human economy such as money supply, consumer confidence, interest rates, and price indices.
Ecologist Charles Hall, among many others, has argued that the discipline of economics, as currently practiced, does not constitute a science, since it proceeds primarily on the basis of correlative logic rather than through the building of knowledge by a continuous, rigorous process of proposing and testing hypotheses. (21) While economics uses complex terminology and mathematics, as science does, its basic assertions about the world—such as the principle of infinite substitutability, which holds that for any resource that becomes scarce, the market will find a substitute—are not subjected to careful experimental examination. (It is worth noting that Hall and others have made the effort to lay the conceptual foundations for a new economics based on scientific principles and methods, which they call “biophysical economics.” (22)
Moreover, mainstream economists failed on the whole to foresee the current crash. There was no consistent or concerted effort on the part of Secretaries of the Treasury, Federal Reserve Chairmen, or “Nobel” prize-winning economists to warn policy makers or the general public that, sometime in the early 21st century, the global economy would begin to come apart at the seams. (23) One might think that this predictive failure—the inability to foresee so historically significant an event as the rapid contraction of nearly the entire global economy, entailing the failure of some of the world’s largest banks and manufacturing companies—would cause mainstream economists to stop and re-examine their fundamental premises. But there is little evidence to suggest that this is occurring.
At the risk of repetition: physical scientists from several disciplines have indeed foreseen an end to economic growth in the early 21st century, and have warned policy makers and the general public on many occasions.
Whom should we believe?
The specifics of the Alternative Diagnosis are falsifiable. If economic activity were to rebound above 2007 levels, or if oil production were to rise above the July 2008 high-water mark, then the attribution of the current economic crisis to resource-tied limits to growth may be considered at least partly disproven. However, even if these things were to occur, the underlying reasoning behind the Alternative Diagnosis might still be correct. If the world oil production peak is delayed until, let us say, 2015 or 2020, and if another—this time bottomless—global economic crash results then, the ultimate outcome will be essentially the same. But if, meanwhile, the Alternative Diagnosis were to be taken seriously and acted upon, the consequences of doing so would be beneficial: a decade would have been spent preparing for the event.
Could the Alternative Diagnosis be altogether wrong? That is, might conventional economists be right in thinking that growth can continue forever? It is often said that anything is possible, but some things are clearly much more possible than others. The perpetual growth of human population and consumption within the confines of a finite planet seems like a very long shot indeed, especially since warning signs are everywhere apparent that ecological limits are already being reached and surpassed. (24)
What Not to Do: Prescribe Punishingly Expensive Placebos
If the physical scientists who warn about limits to growth are right, confronting the global economic meltdown implies far more than merely getting the banks and mortgage lenders back on their feet. Indeed, in that case we face a fundamental change in our economy as significant as the advent of the industrial revolution. We are at a historic inflection point—the ending of decades of expansion and the beginning of an inevitable period of contraction that will continue until humanity is once again living within the limits of Earth’s regenerative systems.
But there are few signs that policy makers understand any of this. Their thinking appears to be shaped primarily by mainstream economists’ assurances that growth can and must continue into the indefinite future, and that the economic contraction the world is currently experiencing is only temporary--a problem that can and must be solved.
Still, the problem is not a minor one in the eyes of economists and policy makers. Consider the gargantuan size of the Treasury and Federal Reserve bailouts and stimulus packages that have been deployed in the possibly futile attempt to end contraction and restart growth. According to the special inspector general of the U.S. government’s Troubled Asset Relief Program (TARP), in remarks submitted to the House Committee on Oversight and Government Reform on July 21, $23.7 trillion have been committed in “total potential federal government support.” This is expensive medicine indeed. It takes a moment to even begin to comprehend the enormity of the figure. It represents about half of annual world GDP, and is over three times the total amount spent by the U.S. government, in inflation-adjusted dollars, on all wars combined, from 1776 to the present. It is nearly fifty times the cost of the New Deal.
Other nations, including Britain, China, and Germany have committed to paying for stimulus packages and bailouts that, while much smaller in absolute terms, represent an impressive (or should we say frightful?) share of national GDP.
If the Alternative Diagnosis is valid, none of this will work in the end, because existing financial institutions—with their basis in debt and interest and their requirements for constant expansion—cannot be made to function in a context where energy and resource constraints impose effective caps on manufacturing and transport.
Are the bailouts and stimulus packages working? Much evidence suggests that they are not, except in limited ways. In the U.S., unemployment continues to increase, while real estate values continue to fall. And most of the reputed “green shoots” in the economy so far sighted amount merely to an arguably temporary decline in the rate of contraction. For example, the home price index released July 28 of this year showed that in May, seasonally adjusted prices fell just 0.16 percent from the previous month. That represents an annual rate of decline of a little under 2 percent, which is a substantial improvement over the annualized rate of more than 20 percent that prevailed from September 2008 through March of 2009. Many commentators seized upon this news as a sign of an imminent turnaround. Nevertheless, new home sales are down from 1.4 million per year in 2005 to 350,000 per year today, and house prices are down 50 percent from the bubble peak and still declining in most places. Moreover, manufacturing is still shrinking, small businesses are in trouble, there are still significant danger signs on the horizon, including a new round of mortgage resets, a likely dive in commercial real estate values, and the looming reality that toxic assets at the center of the banking crisis have yet to be dealt with. (25)
President Obama has made the argument that bailouts are justified to stabilize the system long enough so that leaders can make fundamental changes to institutions and regulations, enabling the economy to then go forward healthier and more immune to similar crises in the future. But there is little to suggest that the kinds of systemic changes that are actually needed (ones that would enable the economy to function during a prolonged period of contraction) are under way or even contemplated. Meanwhile, as growth-based institutions are temporarily propped up, the ultimate scale of the damage is likely only to increase: when the inevitable collapse of those institutions does come, the consequences will likely be even worse because so much capital will have been squandered in attempting to salvage them.
In using up non-renewable resources like metals, minerals, and fossil fuels, we have stolen from future generations. Now in effect we are stealing from those generations the financial wherewithal that could have been used to build a bridge to a sustainable economy. The construction of a renewable energy infrastructure (including not only generating capacity, but distribution and storage systems, as well as post-petroleum transport and agriculture systems) will require enormous investments and decades of work. Where will the investment capital come from if governments are already buried in debt? If we have committed nearly $24 trillion to propping up an old economy with no real survival prospects, what’s left with which to finance the new one?
If the current prescription for our economic malady is wrong-headed, the same is true of many proposed cures for our energy problems. According to the Conventional Diagnosis, today’s high oil prices are due to speculation; the cure must therefore lie in the tighter regulation of oil futures trading (which may be a good idea, though it doesn’t get to the heart of the problem), while providing more opportunities to oil companies to explore for domestic oil (even though the likely production rates from currently off-limits reserves would be relatively paltry, and would have a negligible effect on oil prices). In fact, though, investing further in fossil fuel energy systems (including “clean coal” technology) will yield declining returns, given that the highest quality resources have already been used up; meanwhile, doing so takes investment capital away from the development of renewable energy, which we will have to rely on increasingly as fossil fuels deplete. (26)
What is required but is still utterly lacking is a fundamental recognition that circumstances have changed: what worked decades ago will not work now.
What To Do: Adapt to the New Reality
If the Alternative Diagnosis is correct, there will be no easy fix for the current economic breakdown. Some illnesses are not curable; they require that we simply adapt and make the best of our new situation.
If humanity has indeed embarked upon the contraction phase of the industrial pulse, we should assume that ahead of us lie much lower average income levels (for nearly everyone in the wealthy nations, and for high wage earners in poorer nations); different employment opportunities (fewer jobs in sales, marketing, and finance; more in basic production); and more costly energy, transport, and food. Further, we should assume that key aspects of our economic system that are inextricably tied to the need for future growth will cease to work in this new context.
What can we do to adapt most rapidly and successfully?
Rather than attempting to prop up banks and insurance companies with trillions in bailouts, it would probably be better simply to let them fail, however nasty the short-term consequences, since they will fail anyway sooner or later. The sooner they are replaced with institutions that serve essential functions within a contracting economy, the better off we will all be. (27)
Meanwhile the thought-leaders in society, especially the President, must begin breaking the news—in understandable and measured ways—that growth isn’t returning and that the world has entered a new and unprecedented economic phase, but that we can all survive and thrive in this challenging transitional period if we apply ourselves and work together. At the heart of this general re-education must be a public and institutional acknowledgment of three basic rules of sustainability: growth in population cannot be sustained; the ongoing extraction of non-renewable resources cannot be sustained; and the use of renewable resources is sustainable only if it proceeds at rates below those of natural replenishment.
Without cheap energy, global trade cannot increase. This doesn’t mean that trade will disappear, only that economic incentives will inexorably shift as transport costs rise, favoring local production for local consumption. But this may be a nice way of putting it: if and when fuel shortages arise, fragile globe-spanning systems of provisioning could be disrupted, with dire effects for consumers cut off from sources of necessary products. Thus a high priority must be placed on the building of community resilience through the preferential local sourcing of necessities and the maintenance of larger regional inventories—especially of food and fuel. (28)
It currently takes an average of 8.5 calories of energy from oil and natural gas to produce each calorie of food energy. Without cheap fuel for agriculture, farm production will plummet and farmers will go bankrupt—unless proactive efforts are undertaken to reform agriculture to reduce its reliance on fossil fuels. (29)
Obviously, alternative energy sources and energy efficiency strategies must be high priorities, and must be subjects of intensive research using a carefully chosen spectrum of criteria. The best candidates will have to be funded robustly even while fossil fuels are still relatively cheap: the build-out time for the renewable energy infrastructure will inevitably be measured in decades and so we must begin the process now rather than waiting for market forces to lead the way.
In the face of credit and (potential) currency crises, new ways of financing such projects will be needed. Given that our current monetary and financial systems are founded on the need for growth, we will require new ways of creating money and new ways of issuing credit. Considerable thought has gone into finding solutions to this problem, and some communities are already experimenting with local capital co-ops, alternative currencies, and no-interest banks. (30)
With oil becoming increasingly expensive in real terms, we will need more efficient ways of getting people and goods around. Our first priority in this regard must be to reduce the need for transport with better urban planning and re-localized production systems. But where transport is needed, rail and light rail will probably be preferable to cars and trucks. (31)
We will also need a revolution in the built environment to minimize the requirement for heating, cooling, and artificial lighting in all our homes and public buildings. This revolution is already under way, but is currently moving far too slowly due to the inertia of established interests in the construction industry. (32)
These projects will need more than local credit and money; they will also require skilled workers. There will be a call not just for installers of solar panels and home insulation: millions of new food producers and builders of low-energy infrastructure will be needed as well. A broad range of new opportunities could open up to replace vanishing jobs in marketing and finance—if there is cheap training available at local community colleges.
It is worth noting that the $23.7 trillion recently committed for U.S. bailouts and loan guarantees represents about $80,000 for each man, woman, and child in America. A level of investment even a substantial fraction that size could pay for all needed job training while ensuring universal provision of basic necessities during the transition. What would we be getting for our money? A collective sense that, in a time of crisis, no one is being left behind. Without the feeling of cooperative buy-in that such a safety net would help engender, similar to what was achieved with the New Deal but on an even larger scale, economic contraction could devolve into a horrific fight over the scraps of the waning industrial period.
However contentious, the population question must be addressed. All problems that have to do with resources are harder to solve when there are more people needing those resources. The U.S. must encourage smaller families and must establish an immigration policy consistent with a no-growth population target. This has foreign policy implications: we must help other nations succeed with their own economic transitions so that their citizens do not have to emigrate to survive. (33)
If economic growth ceases to be an achievable goal, society will have to find better ways of measuring success. Economists must shift from assessing well-being with the blunt instrument of GDP, and begin paying more attention to indices of human and social capital in areas such as education, health, and cultural achievements. This redefinition of growth and progress has already begun in some quarters, but for the most part has yet to be taken up by governments. (34)
A case can be made that after all this is done the end result will be a more satisfying way of life for the vast majority of citizens—offering more of a sense of community, more of a connection with the natural world, more satisfying work, and a healthier environment. Studies have repeatedly shown that higher levels of consumption do not translate to elevated levels of satisfaction with life. (35) This means that if “progress” can be thought of in terms of happiness, rather than a constantly accelerating process of extracting raw materials and turning them into products that themselves quickly become waste, then progress can certainly continue. In any case, “selling” this enormous and unprecedented project to the general public will require emphasizing its benefits. Several organizations are already exploring the messaging and public relations aspects of the transition. (36) But those in charge need to understand that looking on the bright side doesn’t mean promising what can’t be delivered—such as a return to the days of growth and thoughtless consumption.
Can We? Will We?
It is important to state the implications of all this as plainly as possible. If the Alternative Diagnosis is correct, there will be no full economic “recovery”—not this year, or the next, or five or ten years from now. There may be temporary rebounds that take us back to some fraction of peak economic activity, but these will be only brief respites.
We have entered a new economic era in which the former rules no longer apply. Low interest rates and government spending no longer translate to incentives for borrowing and job production. Cheap energy won’t appear just because there is demand for it. Substitutes for essential resources will in most cases not be found. Over all, the economy will continue to shrink in fits and starts until it can be maintained by the energy and material resources that Earth can supply on ongoing basis.
This is of course very difficult news. It is analogous to being told by your physician that you have contracted a systemic, potentially fatal disease that cannot be cured, but only managed; and managing it means you must make profound lifestyle changes.
Some readers may note that climate change has not figured prominently in this discussion. It is clearly, after all, the worst environmental catastrophe in human history. Indeed, its consequences could be far worse than the mere destruction of national economies: hundreds of millions of people and millions of other species could be imperiled. The reason for the relatively limited discussion of climate here is that (assuming the Alternative Diagnosis is correct) it is not climate change that has proven to be the most immediate limit to economic growth, but resource depletion. However, while there is not as yet general agreement on the point, climate change itself and the needed steps to minimize it both constitute limits to growth, just as resource depletion does. Moreover, if we fail to successfully manage the inevitable process of economic contraction that will characterize the coming decades, there will be no hope of mounting an organized and coherent response to climate change—a response consisting of efforts both to reduce climate impacts and to adapt to them. It is important to note, though, that the measures advocated here (including the development of renewable energy sources and energy efficiency, a rapid reduction of reliance on fossil fuels in transport and agriculture, and the stabilization of population levels) are among the steps that will help most to reduce carbon emissions.
Is this essay likely to change the thinking and actions of policy makers? Unfortunately, that is unlikely. Their belief in the possibility and necessity of continued growth is pervasive, and the notion that growth may no longer be possible is unthinkable. But the Alternative Diagnosis must be a matter of record. This essay, composed by a mere journalist, in many ways represents the thinking of thousands of physical scientists working over the past several decades on issues having to do with population, resources, pollution, and biodiversity. Ignoring the diagnosis itself—whether as articulated here or as implied in tens of thousands of scientific papers—may waste our last chance to avert a complete collapse, not just of the economy, but of civility and organized human existence. It may risk a historic discontinuity with qualitative antecedents in the fall of the Roman and Mayan civilizations. (37) But there is no true precedent for what may be in store, because those earlier examples of collapse affected geographically bounded societies whose influence on their environments was also bounded. Today’s civilization is global, and its fate, Earth’s fate, and humanity’s fate are inextricably tied.
But even if policy makers continue to ignore warnings such as this, individuals and communities can take heed and begin the process of building resilience, and of detaching themselves from reliance on fossil fuels and institutions that are inextricably tied to the perpetual growth machine. We cannot sit passively by as world leaders squander opportunites to awaken and adapt to growth limits. We can make changes in our own lives, and we can join with our neighbors. And we can let policy makers know we disapprove of their allegiance to the status quo, but that there are other options.
Is it too late to begin a managed transition to a post-fossil fuel society? Perhaps. But we will not know unless we try. And if we are to make that effort, we must begin by acknowledging one simple, stark reality: growth as we have known it can no longer be our goal.
Notes
1. “Pain on the Road to Recovery” (http://www.smh.com.au/national/pain-on-the-road-to-recovery-20090724-dw6...).
2. Here, for example, are a few relevant excerpts from the present author’s book The Party’s Over: Oil, War and the Fate of Industrial Societies (Gabriola Island, BC: New Society, 2003): “Our current financial system was designed during a period of consistent growth in available energy, with its designers operating under the assumption that continued economic growth was both inevitable and desirable. This ideology of growth has become embodied in systemic financial structures requiring growth…. Until now, this loose linkage between a financial system predicated upon the perpetual growth of the money supply, and an economy growing year by year because of an increasing availability of energy and other resources, has worked reasonably well—with a few notable exceptions, such as the Great Depression…. However, [when global oil production peaks] the financial system may not respond so rationally…. This might predictably trigger a financial crisis….”
3. See Albert Bartlett, “Arithmetic, Population and Energy” (lecture transcript), (http://www.globalpublicmedia.com/transcripts/645).
4. Donella H. Meadows, Dennis L. Meadows, Jorgen Randers, and William W. Behrens III, Limits to Growth (New York: Universe Books, 1972); Donella H. Meadows, Dennis L. Meadows, and Jorgen Randers, Beyond the Limits (Post Mills, VT: Chelsea Green, 1992); Donella H. Meadows, Dennis L. Meadows, and Jorgen Randers, Limits to Growth: The 30 Year Update (White River Junction, VT: Chelsea Green, 2003). See also the recent CSIRO study, “A Comparison of the Limits to Growth with Thirty Years of Reality” (2009) (www.csiro.au/files/files/plje.pdf).
5. See, for example, Robert U. Ayers and Benjamin Warr, The Economic Growth Engine: How Energy and Work Drive Material Prosperity (Cambridge, UK: Edward Elgar Publishing, 2005); and Robert Barro and Xavier Sala-i-Martin, Economic Growth (Cambridge, MA: MIT Press, 2003) (http://www.bookrags.com/research/economic-growth-and-energy-consumpt-mee...).
6. See Richard Heinberg, The Party’s Over: Oil, War and the Fate of Industrial Societies (2003, 2005); Powerdown: Options and Actions for a PostCarbon World (2004); and The Oil Depletion Protocol: A Plan to Avert Oil Wars, Terrorism, and Economic Collapse (2006); as well as books by Kenneth Deffeyes, Colin Campbell, and Matthew Simmons; and websites www.theoildrum.com and www.energybulletin.net. The Association for the Study of Peak Oil organizes international conferences to study issues related to oil and gas depletion (www.peakoil.net and www.aspo-usa.com), and the U.S. chapter of ASPO publishes a weekly survey of relevant news, “Peak Oil Review,” compiled by former CIA analyst Tom Whipple. At the annual Association for the Study of Peak Oil conference in Cork, Ireland, in September 2007, former U.S. Energy Secretary, James Schlesinger, said: “Conceptually the battle is over. The peakists have won. We’re all peakists now.” See also Steve Connor, “Warning: Oil supplies are running out fast,” The Independent, August 3, 2009 (http://www.independent.co.uk/news/science/warning-oil-supplies-are-runni...).
7. The declining rate of discovery of new oilfields, and the list of past-peak oil producing countries, are widely documented; e.g.: Roger D. Blanchard, The Future of Global Oil Production: Facts, Figures, Trends and Projections by Region (Jefferson, NC: McFarlane and Co., 2005).
8. A May 4, 2009 report from Raymond James Associates (“Stat of the Week”) argued that world oil production peaked in July 2008 (http://blogs.wsj.com/environmentalcapital/2009/05/04/peak-oil-global-oil...). In a subsequent interview, Marshall Adkins, author of the report, suggested that most knowledgeable players within the petroleum industry now accept the Peak Oil thesis in some form, whether or not they acknowledge it publicly (www.aspousa.org/index.php/2009/07/interview-with-marshall-adkins/).
9. Brookings Papers on Economic Activity, March 2009. www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2009_spr...
10. See Joe Cortright, “Driven to the Brink: How the Gas Price Spike Popped the Housing Bubble and Devalued the Suburbs,” Discussion paper, CEOs for Cities, 2008 (http://www.ceosforcities.org).
11. U.S. Government Accountability Office, “Commercial Aviation: Airline Industry Contraction Due to Volatile Fuel Prices and Falling Demand Affects Airports, Passengers, and Federal Government Revenues ,” April 21, 2009 (www.gao.gov/products/GAO-09-393). For a detailed discussion of the likely future impacts of high oil prices and oil shortages on the airline industry, see Charles Schlumberger, “The Oil Price Spike of 2008: The Result of Speculation or an Early Indicator of a Major and Growing Future Challenge to the Airline Industry?” Annals of Air and Space Law, Vol. XXXIV, [2009], McGill University (http://www.globalpublicmedia.com/the_oil_price_spike_of_2008).
12. American Trucking Association (www.truckline.com/Pages/Home.aspx).
13. This scenario is implied in Robert L. Hirsch, Roger Bezdek, and Robert Wendling, “Peaking of World Oil Production: Impacts, Mitigatin and Risk Management” (U.S. Department of Energy: 2005): “As peaking is approached, liquid fuel prices and price volatility will increase dramatically….” (http://www.netl.doe.gov/publications/others/pdf/Oil_Peaking_NETL.pdf).
14. See, for example, “Troubling Signs That Oil Prices Could Hamper Recovery,” Wall Street 24/7, May 8, 2009 (http://247wallst.com/2009/05/08/troubling-signs-that-oil-prices-could-ha...)
15. See, for example, James Herron, “Low Oil Prices, Credit Woes Could Spell Trouble for UK North Sea,” Rigzone, November 14, 2008 (www.rigzone.com/news/article.asp?a_id=69507).
16. Jad Mouawad, “Big Oil Projects Put in Jeopardy by Fall in Prices,” New York Times, December 15, 2008 (www.nytimes.com/2008/12/16/business/16oil.html)
17. See David R. Baker, “Low oil prices take wind out of renewable fuels,” San Francisco Chronicle, October 27, 2008 (www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2008/10/26/MNSK13NNK4.DTL).
18. See The Party’s Over, Chapter 4; Powerdown, Chapter 4; The Oil Depletion Protocol, pages 23-31. A longer treatment of the subject, tentatively titled Energy Limits to Growth, will be published by International Forum on Globalization and Post Carbon Institute in September.
19. This conclusion is echoed in, for example, Ted Trainer, Renewable Energy Cannot Sustain a Consumer Society (Dordrecht, The Netherlands: Springer, 2007); and (with some reservations), David J. C. McKay, Sustainable Energy Without the Hot Air (Cambridge, UK: UIK Cambridge, 2008), (www.withouthotair.com).
20. Just one example, from a press release April 20, 1998 describing the results of a poll commissioned by the American Museum of Natural History: “The American Museum of Natural History announced today results of a nationwide survey titled Biodiversity in the Next Millennium, developed by the Museum in conjunction with Louis Harris and Associates, Inc. The survey reveals that seven out of ten biologists believe that we are in the midst of a mass extinction of living things, and that this loss of species will pose a major threat to human existence in the next century.”
21. Charles A. S. Hall and Kent A. Klitgaard, “The Need for a New, Bioplysical-Based Paradigm in Economics for the Second Half of the Age of Oil,” International Journal of Transdisciplinary Research, Vo. 1, NO. 1 (2006), (http://74.125.155.132/search?q=cache:DtdKR2ZWgNoJ:www.peakoil.net/files/...); Charles A. S. Hall, D. Lindenberger, R. Kummell, T. Kroeger and W. Eichorn, “The Need to Reintegrate the Natural Sciences with Economics.” Bioscience 51:663-673, 2001.
22. Cutler J. Cleveland, “Biophysical Economics,” The Encyclopedia of Earth (www.eoearth.org/article/Biophysical_economics). See also the related field of Ecological Economics, especially the books of Herman Daly, including Toward a Steady State Economy (New York: Freeman, 1973); and, with Joshua Farley, Ecological Economics: Principles and Applications (Washington: Island Press, 2004).
23. The quotation marks around the Nobel name are justified because the Nobel family has never acknowledged economics as a science: the so-called “Nobel prize in economics” is awarded by a Swedish Bank.
24. See The Millennium Ecosystem Assessment (www.millenniumassessment.org/en/index.aspx).
25. See, for example, J. S. Kim, “Irrational Exuberance of the Green Shoots,” July 24, 2009 (http://seekingalpha.com/article/151101-irrational-exuberance-of-the-gree...).
26. See Richard Heinberg, Blackout: Coal, Climate and the Last Energy Crisis (Gabiola Island, BC: New Society, 2009), pages 137-143, 145-168.
27. The opinion that banks and insurance companies should be allowed to fail rather than being bailed out was voiced by many knowledgeable observers throughout late 2008 and early 2009. See for example Ambrose Evans-Pritchard, “Let banks fail, says Nobel economist Joseph Stiglitz,” London Daily Telegraph, Feb. 2, 2009 (www.telegraph.co.uk/finance/newsbysector/banksandfinance/4424418/Let-ban...).
28. See Jeff Rubin, Why Your World Is About to Get a Whole Lot Smaller: Oil and the End of Globalization. (New York: Random House, 2009).
29. See Richard Heinberg and Michael Bomford, “The Food and Farming Transition” (Sebastopol, CA: Post Carbon Institute, 2009), (http://postcarbon.org/food).
30. See Bernard Lietaer, “White Paper on All the Options for Managing a Systemic Bank Crisis” (www.lietaer.com/images/White_Paper_on_Systemic_Banking_Crises_final.pdf). JAK in Sweden is a cooperative, member-owned bank that operates without interest (http://en.wikipedia.org/wiki/JAK_members_bank).
31. See Richard Gilbert and Anthony Perl, Transport Revolutions: Moving People and Freight Without Oil (Gabriola Island, BC: New Society, 2009).
32. The Passivhaus Institute pioneers construction methods that reduce energy input to buildings in many cases to zero (www.passivehouse.us). Roughly 20,000 Passivhauses have been built in Europe, only about 12 in the U.S.
33. See websites of Population Media Center (www.populationmedia.org/issues/), and SUSPS (www.susps.org/overview/immigration.html).
34. The organization Redefining Progress has developed a Genuine Progress Indicator (GPI) that incorporates many such indices (www.rprogress.org/sustainability_indicators/genuine_progress_indicator.htm).
35. See, for example, “Understanding Human Happiness and Well-Being,” The Sustainable Scale Project (http://www.sustainablescale.org/AttractiveSolutions/UnderstandingHumanHa...).
36. The burgeoning Transition Town movement (www.transitiontowns.org) proceeds from the premise that “life can be better without fossil fuels.” YES! Magazine (www.yesmagazine.org) is a publication of the Positive Futures Network and highlights examples of low-impact ways of living that bring personal and social benefits. And the Simple Living Network (www.simpleliving.net) provides “resources, tools, examples and contacts for conscious, simple, healthy and restorative living.”
37. See Jared Diamond, Collapse How Societies Choose to Fail or Succeed (New York: Viking, 2005); Joseph Tainter, The Collapse of Complex Societies (Cambridge, UK: Cambridge University Press, 1988); and John Michael Greer, The Long Descent (Gabriola Island, BC: New Society, 2008).
12 July 2009
Recovery is not unlikely, its impossible...
Got to agree with Robert
http://robertreich.blogspot.com/2009/07/when-will-recovery-begin-never.html
When Will The Recovery Begin? Never.
The so-called "green shoots" of recovery are turning brown in the scorching summer sun. In fact, the whole debate about when and how a recovery will begin is wrongly framed. On one side are the V-shapers who look back at prior recessions and conclude that the faster an economy drops, the faster it gets back on track. And because this economy fell off a cliff late last fall, they expect it to roar to life early next year. Hence the V shape.
Unfortunately, V-shapers are looking back at the wrong recessions. Focus on those that started with the bursting of a giant speculative bubble and you see slow recoveries. The reason is asset values at bottom are so low that investor confidence returns only gradually.
That's where the more sober U-shapers come in. They predict a more gradual recovery, as investors slowly tiptoe back into the market.
Personally, I don't buy into either camp. In a recession this deep, recovery doesn't depend on investors. It depends on consumers who, after all, are 70 percent of the U.S. economy. And this time consumers got really whacked. Until consumers start spending again, you can forget any recovery, V or U shaped.
Problem is, consumers won't start spending until they have money in their pockets and feel reasonably secure. But they don't have the money, and it's hard to see where it will come from. They can't borrow. Their homes are worth a fraction of what they were before, so say goodbye to home equity loans and refinancings. One out of ten home owners is under water -- owing more on their homes than their homes are worth. Unemployment continues to rise, and number of hours at work continues to drop. Those who can are saving. Those who can't are hunkering down, as they must.
Eventually consumers will replace cars and appliances and other stuff that wears out, but a recovery can't be built on replacements. Don't expect businesses to invest much more without lots of consumers hankering after lots of new stuff. And don't rely on exports. The global economy is contracting.
My prediction, then? Not a V, not a U. But an X. This economy can't get back on track because the track we were on for years -- featuring flat or declining median wages, mounting consumer debt, and widening insecurity, not to mention increasing carbon in the atmosphere -- simply cannot be sustained.
The X marks a brand new track -- a new economy. What will it look like? Nobody knows. All we know is the current economy can't "recover" because it can't go back to where it was before the crash. So instead of asking when the recovery will start, we should be asking when and how the new economy will begin. More on this to come.
http://robertreich.blogspot.com/2009/07/when-will-recovery-begin-never.html
When Will The Recovery Begin? Never.
The so-called "green shoots" of recovery are turning brown in the scorching summer sun. In fact, the whole debate about when and how a recovery will begin is wrongly framed. On one side are the V-shapers who look back at prior recessions and conclude that the faster an economy drops, the faster it gets back on track. And because this economy fell off a cliff late last fall, they expect it to roar to life early next year. Hence the V shape.
Unfortunately, V-shapers are looking back at the wrong recessions. Focus on those that started with the bursting of a giant speculative bubble and you see slow recoveries. The reason is asset values at bottom are so low that investor confidence returns only gradually.
That's where the more sober U-shapers come in. They predict a more gradual recovery, as investors slowly tiptoe back into the market.
Personally, I don't buy into either camp. In a recession this deep, recovery doesn't depend on investors. It depends on consumers who, after all, are 70 percent of the U.S. economy. And this time consumers got really whacked. Until consumers start spending again, you can forget any recovery, V or U shaped.
Problem is, consumers won't start spending until they have money in their pockets and feel reasonably secure. But they don't have the money, and it's hard to see where it will come from. They can't borrow. Their homes are worth a fraction of what they were before, so say goodbye to home equity loans and refinancings. One out of ten home owners is under water -- owing more on their homes than their homes are worth. Unemployment continues to rise, and number of hours at work continues to drop. Those who can are saving. Those who can't are hunkering down, as they must.
Eventually consumers will replace cars and appliances and other stuff that wears out, but a recovery can't be built on replacements. Don't expect businesses to invest much more without lots of consumers hankering after lots of new stuff. And don't rely on exports. The global economy is contracting.
My prediction, then? Not a V, not a U. But an X. This economy can't get back on track because the track we were on for years -- featuring flat or declining median wages, mounting consumer debt, and widening insecurity, not to mention increasing carbon in the atmosphere -- simply cannot be sustained.
The X marks a brand new track -- a new economy. What will it look like? Nobody knows. All we know is the current economy can't "recover" because it can't go back to where it was before the crash. So instead of asking when the recovery will start, we should be asking when and how the new economy will begin. More on this to come.
16 May 2009
Commercial real estate to drop dead next
Realpoint LLC has a chart showing commercial real estate defaults assesed by when the mortgages were originated. Much like the Markit charts for subprime. The most recent sour fast, but so do the older ones.
More here
23 April 2009
Last domino falls ~ Australian Economy in rapid decline
THE Australian economy will shrink faster than the global average this year, the International Monetary Fund said last night, foreshadowing another dire batch of revisions in next month's budget.
The predictions followed the release of mixed figures on inflation by the Bureau of Statistics. They showed inflation was falling, but perhaps not fast enough to trigger interest rate cuts by the Reserve Bank.
Australia's economy is set to contract by 1.4 per cent in 2009, the IMF said, before growing just 0.6 per cent next year.
The IMF's forecast is markedly worse than the 1 per cent growth for 2008-09 predicted by the Government in February, and is likely to be matched when revised figures are released in next month's budget. The Prime Minister, Kevin Rudd, told a business lunch in Perth that Australia was now in recession and the budget had been "ravaged".
Forecast revenue had plunged 63 per cent from that estimated in last May's budget and it would worsen further, he said.
Mr Rudd began setting the scene for Australia to go deeper into debt by saying "every responsible government around the world is being forced into greater levels of temporary borrowing". He said Malcolm Turnbull's promises had already committed the Opposition to a $177 billion debt and the Opposition Leader should "explain how he could provide economic stimulus while revenues are collapsing without undertaking further borrowing".
The Treasurer, Wayne Swan, said there had probably never been a more difficult time to put together a budget.
The budget would "support jobs, provide economic stimulus" and "make the necessary investments for the future so that when world growth returns we can take the maximum opportunities from that revival".
"Tough measures" are expected to include the means-testing of so-called middle-class welfare measures such as the Medicare safety net and the child care rebate.
The Government is also targeting tax loopholes such as using holiday homes and hobby farms as tax deductions.
In its latest World Economic Outlook, released ahead of its spring meetings in Washington this weekend, the IMF was far more gloomy about the outlook than its report in January.
Despite the efforts at stimulus worldwide, the IMF said global activity would decline 1.3 per cent in 2009. In January, it had predicted 0.5 per cent growth. "This downturn represents by far the deepest global recession since the Great Depression," it said.
It predicted Australia's economy would go backwards by 1.4 per cent this year and unemployment would hit 6.8 per cent, rising to 7.8 per cent in 2010.
The revisions have been driven by the severity of the slowdown in advanced economies since October 2008.
Advanced economies shrunk by an "unprecedented" 7.5 per cent in late 2008, the IMF said, and it is likely they contracted by a similar amount in the first three months of 2009. In advanced economies, GDP will contract by an average 3.8 per cent in 2009. But some nations - particularly those relying on manufactured exports such as Japan, Germany and Singapore - will be even more severely battered.
China is expected to maintain growth of 6.5 per cent in 2009.
The Bureau of Statistics said inflation increased by 0.1 per cent in the three months to the end of March, taking the yearly rate to a comfortable 2.5 per cent.
But the Reserve Bank's preferred measure of core inflation - which strips out volatile price swings - increased 1.1 per cent in the quarter, and remains above 4 per cent. Economists said the Reserve could use the relatively high result as an opportunity to wait before cutting rates further.
with Anne Davies
http://business.brisbanetimes.com.au/business/economy-in-rapid-decline-20090423-afkk.html
The predictions followed the release of mixed figures on inflation by the Bureau of Statistics. They showed inflation was falling, but perhaps not fast enough to trigger interest rate cuts by the Reserve Bank.
Australia's economy is set to contract by 1.4 per cent in 2009, the IMF said, before growing just 0.6 per cent next year.
The IMF's forecast is markedly worse than the 1 per cent growth for 2008-09 predicted by the Government in February, and is likely to be matched when revised figures are released in next month's budget. The Prime Minister, Kevin Rudd, told a business lunch in Perth that Australia was now in recession and the budget had been "ravaged".
Forecast revenue had plunged 63 per cent from that estimated in last May's budget and it would worsen further, he said.
Mr Rudd began setting the scene for Australia to go deeper into debt by saying "every responsible government around the world is being forced into greater levels of temporary borrowing". He said Malcolm Turnbull's promises had already committed the Opposition to a $177 billion debt and the Opposition Leader should "explain how he could provide economic stimulus while revenues are collapsing without undertaking further borrowing".
The Treasurer, Wayne Swan, said there had probably never been a more difficult time to put together a budget.
The budget would "support jobs, provide economic stimulus" and "make the necessary investments for the future so that when world growth returns we can take the maximum opportunities from that revival".
"Tough measures" are expected to include the means-testing of so-called middle-class welfare measures such as the Medicare safety net and the child care rebate.
The Government is also targeting tax loopholes such as using holiday homes and hobby farms as tax deductions.
In its latest World Economic Outlook, released ahead of its spring meetings in Washington this weekend, the IMF was far more gloomy about the outlook than its report in January.
Despite the efforts at stimulus worldwide, the IMF said global activity would decline 1.3 per cent in 2009. In January, it had predicted 0.5 per cent growth. "This downturn represents by far the deepest global recession since the Great Depression," it said.
It predicted Australia's economy would go backwards by 1.4 per cent this year and unemployment would hit 6.8 per cent, rising to 7.8 per cent in 2010.
The revisions have been driven by the severity of the slowdown in advanced economies since October 2008.
Advanced economies shrunk by an "unprecedented" 7.5 per cent in late 2008, the IMF said, and it is likely they contracted by a similar amount in the first three months of 2009. In advanced economies, GDP will contract by an average 3.8 per cent in 2009. But some nations - particularly those relying on manufactured exports such as Japan, Germany and Singapore - will be even more severely battered.
China is expected to maintain growth of 6.5 per cent in 2009.
The Bureau of Statistics said inflation increased by 0.1 per cent in the three months to the end of March, taking the yearly rate to a comfortable 2.5 per cent.
But the Reserve Bank's preferred measure of core inflation - which strips out volatile price swings - increased 1.1 per cent in the quarter, and remains above 4 per cent. Economists said the Reserve could use the relatively high result as an opportunity to wait before cutting rates further.
with Anne Davies
http://business.brisbanetimes.com.au/business/economy-in-rapid-decline-20090423-afkk.html
21 April 2009
One in four firms to cut staff ~ SMH
TWENTY-FIVE per cent of small to medium-sized businesses in NSW expect to sack staff within three months, a survey by the NSW Business Chamber has found.
The findings came as the Prime Minister, Kevin Rudd, conceded the economy would fall into recession for the first time in almost two decades.
"The severity of the global recession has made it impossible for Australia to avoid a further period of negative economic growth," Mr Rudd told a jobs forum in Adelaide.
"The worst global economic recession in 75 years means it's inevitable that Australia, too, will be dragged into recession."
Also yesterday, the Commonwealth Bank defied Government calls to pass on interest rate cuts and said it would raise its fixed rate mortgages by between 20 and 45 basis points from today.
NSW has the highest jobless rate in the country, at 6.9 per cent, but that is expected to increase.
Phone calls by business to the chamber seeking advice about about termination and redundancy have increased 60 per cent since the middle of last year.
One in four of the 440 companies surveyed said they had reduced staff hours in the first three months of this year.
Another 24 per cent say they expect to sack someone over the next three months while only 9 per cent expect to hire staff.
"Many employers are loyal to their employees and are doing their hardest to keep their staff on by altering work practices and reducing hours but it's an uphill battle in this economic environment," said the chamber's chief executive, Kevin MacDonald.
This is despite an official survey released yesterday which found prices paid by business fell sharply in the first three months of this year.
The Bureau of Statistics' "producer price index" found prices paid by firms fell 0.4 per cent - the second biggest drop in the survey's 10-year history. Prices were up 4 per cent over the year - although this is a slower pace than the 6.4 per cent growth rate clocked in the previous survey.
Yesterday was the first time Mr Rudd had used the word recession; it was an admission the Government now expects growth for the March quarter to be negative. The December quarter was negative and a recession is defined technically as two successive quarters of negative growth.
The Government will argue circumstances would be worse if not for the two stimulus packages, worth $52 billion.
"The challenge for government is to cushion the impact of the recession on business and jobs through the actions we take through our economic stimulus strategy," Mr Rudd said.
Inflation figures due tomorrow are expected to show the rate back in the Reserve Bank's target band of 2 to 3 per cent.
Falling prices mean companies are under less pressure to increase the prices consumers pay and open the way for discounting to tempt wary customers.
The NSW Business Chamber's survey confirms concern about growth have replaced concerns about rising costs.
Nearly half of firms surveyed believed business conditions had deteriorated in NSW in the previous three months.
"With nearly one in every two businesses reporting deteriorating business conditions, the need for us to kick-start the NSW economy has never been more urgent," Mr MacDonald said.
Lack of access to new credit remains a pressing issue, with one in three NSW companies saying they had trouble being able to borrow from their bank.
"These figures show that the financial crisis is far from over. More must be done to assist businesses in obtaining the finance they need to operate. The flow of credit is the lifeblood of the economy."
The Government has been softening up the electorate for a recession for some time. Chris Richardson, the director of Access Economics, said Mr Rudd had confirmed what the financial world had long known.
"It means nothing to markets," he said of Mr Rudd's declaration.
http://business.smh.com.au/business/one-in-four-firms-to-cut-staff-20090420-acp8.html
The findings came as the Prime Minister, Kevin Rudd, conceded the economy would fall into recession for the first time in almost two decades.
"The severity of the global recession has made it impossible for Australia to avoid a further period of negative economic growth," Mr Rudd told a jobs forum in Adelaide.
"The worst global economic recession in 75 years means it's inevitable that Australia, too, will be dragged into recession."
Also yesterday, the Commonwealth Bank defied Government calls to pass on interest rate cuts and said it would raise its fixed rate mortgages by between 20 and 45 basis points from today.
NSW has the highest jobless rate in the country, at 6.9 per cent, but that is expected to increase.
Phone calls by business to the chamber seeking advice about about termination and redundancy have increased 60 per cent since the middle of last year.
One in four of the 440 companies surveyed said they had reduced staff hours in the first three months of this year.
Another 24 per cent say they expect to sack someone over the next three months while only 9 per cent expect to hire staff.
"Many employers are loyal to their employees and are doing their hardest to keep their staff on by altering work practices and reducing hours but it's an uphill battle in this economic environment," said the chamber's chief executive, Kevin MacDonald.
This is despite an official survey released yesterday which found prices paid by business fell sharply in the first three months of this year.
The Bureau of Statistics' "producer price index" found prices paid by firms fell 0.4 per cent - the second biggest drop in the survey's 10-year history. Prices were up 4 per cent over the year - although this is a slower pace than the 6.4 per cent growth rate clocked in the previous survey.
Yesterday was the first time Mr Rudd had used the word recession; it was an admission the Government now expects growth for the March quarter to be negative. The December quarter was negative and a recession is defined technically as two successive quarters of negative growth.
The Government will argue circumstances would be worse if not for the two stimulus packages, worth $52 billion.
"The challenge for government is to cushion the impact of the recession on business and jobs through the actions we take through our economic stimulus strategy," Mr Rudd said.
Inflation figures due tomorrow are expected to show the rate back in the Reserve Bank's target band of 2 to 3 per cent.
Falling prices mean companies are under less pressure to increase the prices consumers pay and open the way for discounting to tempt wary customers.
The NSW Business Chamber's survey confirms concern about growth have replaced concerns about rising costs.
Nearly half of firms surveyed believed business conditions had deteriorated in NSW in the previous three months.
"With nearly one in every two businesses reporting deteriorating business conditions, the need for us to kick-start the NSW economy has never been more urgent," Mr MacDonald said.
Lack of access to new credit remains a pressing issue, with one in three NSW companies saying they had trouble being able to borrow from their bank.
"These figures show that the financial crisis is far from over. More must be done to assist businesses in obtaining the finance they need to operate. The flow of credit is the lifeblood of the economy."
The Government has been softening up the electorate for a recession for some time. Chris Richardson, the director of Access Economics, said Mr Rudd had confirmed what the financial world had long known.
"It means nothing to markets," he said of Mr Rudd's declaration.
http://business.smh.com.au/business/one-in-four-firms-to-cut-staff-20090420-acp8.html
15 April 2009
As Factories Vanish, Japan Seeks to Fashion a New Economy
The carry trade unwind is killing Japanese manufacturing..
"The weak yen made us lazy," says Junichi Suga, the company's executive managing director. "During those years, we shouldn't have eased our effort to shift production abroad." The company aims to boost overseas production to 60% of sales within the next year, from 40% in recent months.
For Japan, Nippon Chemi-Con's move realizes an inevitable shift: Its cherished tradition of manufacturing may finally move away from its high-cost market to lower-cost neighbors, leaving hundreds of thousands of Japanese workers jobless as the country struggles to reinvent its economy.
In the 1990s, as China took on more manufacturing work once done in Japan, many Japanese feared their industries would be "hollowed out," with executive offices remaining at home while jobs moved abroad. But the past six years sparked a manufacturing renaissance, helped by cheap temporary labor, surging demand for Japanese products and a weak yen -- which made the price of exports competitive.
Exports soared, reaching a record 16.5% of the overall economy in July-September 2008, after ranging between 8% and 10% during the 1980s and 1990s. Companies rushed to open factories at home, saying complex products, evolving technologies and the danger of manufacturing secrets leaking out made it important to keep factories close to headquarters.
http://online.wsj.com/article/SB123966524083015163.html
"The weak yen made us lazy," says Junichi Suga, the company's executive managing director. "During those years, we shouldn't have eased our effort to shift production abroad." The company aims to boost overseas production to 60% of sales within the next year, from 40% in recent months.
For Japan, Nippon Chemi-Con's move realizes an inevitable shift: Its cherished tradition of manufacturing may finally move away from its high-cost market to lower-cost neighbors, leaving hundreds of thousands of Japanese workers jobless as the country struggles to reinvent its economy.
In the 1990s, as China took on more manufacturing work once done in Japan, many Japanese feared their industries would be "hollowed out," with executive offices remaining at home while jobs moved abroad. But the past six years sparked a manufacturing renaissance, helped by cheap temporary labor, surging demand for Japanese products and a weak yen -- which made the price of exports competitive.
Exports soared, reaching a record 16.5% of the overall economy in July-September 2008, after ranging between 8% and 10% during the 1980s and 1990s. Companies rushed to open factories at home, saying complex products, evolving technologies and the danger of manufacturing secrets leaking out made it important to keep factories close to headquarters.
http://online.wsj.com/article/SB123966524083015163.html
26 September 2008
China recession ahead
"The collapse of emerging market economies will shake investors to the core. The great unwind has only just begun," said Albert Edwards, the bank's global strategist.
"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.
"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."
"The emerging market boom is totally tied up with a decade of ballooning current account deficits in the US. Put that into reverse and you'll be surprised what pops out of the woodwork."
Mr Edwards said the vast accumulation of foreign exchange reserves – led by China with $1.8 trillion – had provided the "rocket fuel" of liquidity for frontier markets. This virtuous circle has now turned vicious as America tightens its belt. Countries in Asia and Latin America are intervening to prop up their currencies, causing reserves to fall.
"We could see monthly trade surpluses in the US within a year. The emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander," he said.
The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.
The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble.
The agency's China team, Charlene Chu and Chunling Wen, said banks had used an "underground market" on a large scale to stoke up lending. "These types of credit and/or institutions fall outside the traditional structures of financial supervision, exposing banks to a growing amount of risk that is for the most part hidden By getting a portion of their credit off books, Chinese banks are able to comply with official loan quotas while in practice exceeding them," he said.
Under the mechanism, the loans are packaged into wealth products and sold to investors searching for bumper yields. The parallel with the US sub-prime debacle is striking, although Fitch avoids an explicit parallel.
Moreover, the banks issue "entrusted loans" in which they act as piggy-in-the-middle between two sets of clients, keeping the credits of the portfolio sheet. These loans have reached 1.5 trillion yuan ($220bn).
Even without such off-books liabilities, the banks are facing a crunch as the economy slows hard and the property market stalls. Shenzen house prices are already down 30pc.
"The Chinese banking system is nearing the point at which it can no longer sustain additional large net withdrawals of liquidity without generating further strains on banks' ability to lend," it said.
Morgan Stanley said this month that China's housing market was heading for a "melt-down". Data is patchy and rarely reliable, but it is clear that home sales in Beijing, Shanghai and other Eastern cities have fallen drastically over the summer.
"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.
"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."
"The emerging market boom is totally tied up with a decade of ballooning current account deficits in the US. Put that into reverse and you'll be surprised what pops out of the woodwork."
Mr Edwards said the vast accumulation of foreign exchange reserves – led by China with $1.8 trillion – had provided the "rocket fuel" of liquidity for frontier markets. This virtuous circle has now turned vicious as America tightens its belt. Countries in Asia and Latin America are intervening to prop up their currencies, causing reserves to fall.
"We could see monthly trade surpluses in the US within a year. The emerging market liquidity squeeze will intensify ferociously, and assets linked to the region will become toxic waste. That includes previously resilient banks such as HSBC, Standard Chartered and Banco Santander," he said.
The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.
The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble.
The agency's China team, Charlene Chu and Chunling Wen, said banks had used an "underground market" on a large scale to stoke up lending. "These types of credit and/or institutions fall outside the traditional structures of financial supervision, exposing banks to a growing amount of risk that is for the most part hidden By getting a portion of their credit off books, Chinese banks are able to comply with official loan quotas while in practice exceeding them," he said.
Under the mechanism, the loans are packaged into wealth products and sold to investors searching for bumper yields. The parallel with the US sub-prime debacle is striking, although Fitch avoids an explicit parallel.
Moreover, the banks issue "entrusted loans" in which they act as piggy-in-the-middle between two sets of clients, keeping the credits of the portfolio sheet. These loans have reached 1.5 trillion yuan ($220bn).
Even without such off-books liabilities, the banks are facing a crunch as the economy slows hard and the property market stalls. Shenzen house prices are already down 30pc.
"The Chinese banking system is nearing the point at which it can no longer sustain additional large net withdrawals of liquidity without generating further strains on banks' ability to lend," it said.
Morgan Stanley said this month that China's housing market was heading for a "melt-down". Data is patchy and rarely reliable, but it is clear that home sales in Beijing, Shanghai and other Eastern cities have fallen drastically over the summer.
22 July 2008
The Failure of the American Financial System
"Where are the leaders? Has our political process become so compromised by powerful interest groups and the threat of character assassination that even the best among us will not dare to speak honestly about the solutions that might bring us back to common sense and fundamental fairness?" Senator Jim Webb, A Time to Fight
One of the reasons we like Noriel Roubini is that he is an economist willing to dig into pertinent details, to get involved with current events, to take an intellectual stand and defend it, to tell it like it is, to borrow a phrase from another era.
This places him as a man apart from many of his economic peers, who lurk in obscure and largely irrelevant details, hiding behind rhetorical flourishes and courtly manners, lurking in the waiting rooms of universities and thinktanks, emerging every so often to speak for some vested interest with studies supporting pre-ordained conclusions. All of which of course is absolutely useless if not harmful to the real economy and legitimate achievement. But it does leave them open for research grants, and appointments, honorariums, and self-advancement within a corrupted system that rewards those who propagate it with the motto, go along to get along.
There is a management style in which achievement is rarely considered, although there is often an intricate if not baroque system of measures amenable to manipulation, but mistakes are penalized, and heavily. As one manager of a large business said in an interview, "If you do 99 things right, and one thing wrong, all they will remember is what you have done wrong and use it against you, depending on who you are."
And the shame is, he was right. The firm for which he worked had ceased to be a meritocracy, and instead had become an oligopoly in which influence-peddling and personal connections mattered above all, even as the business results deteriorated. Its vision and preoccupations turned increasingly inward on itself, almost obsessively. It eventually went bankrupt, formally, long after it had become functionally bankrupt. We saw this phenomenon at any number of mature companies we visited in the course of our consultancy.
Yes, there is that element of oligarchy in all societies, in all companies, in every organization, especially after they mature after a long period of relative stability, and unfortunately fall under the control of a few powerful people whose number one priority is self-perpetuation.
It is a matter of degree. When that modus operandi becomes predominant, pervasive, you have an organization that will surely soon be in trouble, and is headed towards a serious change of management, a major shakeup, a sometimes spectacular and precipitous failure, if it is subject to the forces of the markets.
So too it is with countries. This is what had happened to the former Soviet Union. And it is now happening to The United States and its financially-heavy economy. We have a bad case of the winner's curse. The dollar as the world's reserve currency fostered a deterioration of the American spirit that acted like slow poison on the vigor of the real economy.
The US is going to be passing through a purging of the system and its management for some time, measured in years but not decades, until it emerges again and can move forward.
The Coming Systemic Bust of the U.S. Banking System: “Dead Stocks Rallying”
Nouriel Roubini
Jul 20, 2008
RGE Monitor
This past week started with concerns about another systemic meltdown of the U.S. financial system as the insolvency of Fannie and Freddie was revealed and as IndyMac went bust (this third largest bank collapse in U.S. history). But the week ended with a remarkable rally of financial stocks as better than expected results from Wells Fargo, JP Morgan and Citi soothed the fears that major financial institutions were in even more distress than already predicted by market analysts.
Unfortunately, this massive rally of financial stocks in the latter part of the week is just another temporary bear market rally that will fizzle away once the onslaught of bad financial and macro news builds up again.
The views I presented in a recent blog that we will experience a severe financial and banking crisis received the support of many well respected commentators. Alan Abelson – at Barron’s – is one of the most senior and well known commentators on financial issues and on Wall Street. In his latest Barron’s column – aptly titled “Dead Stocks Rallying” he wrote:
WHY WE'RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don't hold that against him) and runs an economic
advisory firm called RGE Monitor that casts a knowing and clear eye on the
global financial and economic scene. We think he's top-notch (which means we
agree with him, a lot of the time).
The nub of his argument is that we're suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.
He reckons that, in a few years, there'll be no major independent broker-dealers left: They'll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.
The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won't cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.
The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won't escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there's plenty of room left on the downside. In fact, he feels the bear market won't end until equities are down a full 40% from their peaks.
We must say this vision is a mite too apocalyptic even for us. But Nouriel is not a
professional fear-monger out to make a splash with end-of-the-world
prognostications He's a sound guy with a solid record and an impressive résumé.
We obviously believe his views are worth pondering, even if they ruin your
appetite.
That was a very nice summary by Abelson of my views and a kind endorsement of them.
But how to square the views that a large fraction of the US financial system is in trouble with the apparently better than expected earnings results and lower than expected writedowns presented by financial institutions such as Wells Fargo, JP Morgan and Citi that led to the financials’ stocks most recent rally? There are many reasons why those earnings results are misleading and cosmetically retouched upward while the true financial conditions of the financial system are more dire than otherwise presented.
Let us discuss next in some detail the various reasons why financial conditions of financial firms and banks are much worse than those headline figures and why we the US will experience a systemic financial crisis…
First of all, in a week when only a massive and open ended bailout rescued Fannie and Freddie, when IndyMac went bust and when Merrill presented much worse than expected results it is very hard to be optimistic about the health of the US financial institutions. Reports in the next few days will reveal whether reality is closer to Fannie/Freddie/IndyMac/Merrill or rather closer to the Citi/JPMorgan/Wells Fargo outlook.
Most financial institutions are putting increasing numbers of assets in the illiquid buckets of Level 2 and Level 3 assets. While FASB 157 should prevent manipulation of the valuation of such illiquid assets, forbearance by the SEC, the Fed and other regulators allows a massive amount of fudging.
An insider told me that in a major financial institution the approach is as follows now: top management decide in advance what the announced writedowns should be and folks dealing with the toxic/illiquid assets come up with totally ad hoc assumptions to make sure that such illiquid assets are valued consistently with the decided-in-advance amount of writedowns and losses.
This is not earnings smoothing; this is active manipulation and falsification of financial results aimed at creating even more obfuscation of the true state of financial institutions. This obfuscation is actively abetted by the SEC, the Fed and all other regulators that are now in forbearance crisis management stage where the objective is to avoid at any cost anything that may trigger a financial meltdown. Thus, most of these earnings reports are not worth the paper they are written off.
This earnings manipulation occurs in a variety of ways. First, ad hoc assumptions still used to value and write down level 2 and level 3 assets. Second, banks are leaving aside less reserves for loan losses that are much less than necessary; they do that by using ad hoc assumptions about future losses on mortgages, credit cards, auto loans, student loans, home equity loans and other commercial real estate loans and industrial and commercial loans. Reserves for loan losses have been sharply lagging actual and expected losses, thus padding earnings as decided by the financial institutions' managers. Third, there is disposal of illiquid and toxic assets in ways that misleadingly reduces the amount of actual writedowns. An example is as follows: suppose a bank wants to dump illiquid MBS or leveraged loans that are worth – mark to market – 70 cents on the dollar rather than 100 cents on the dollar. Then, instead of selling these at a price of 70 and showing a 30% writedown these are sold to hedge funds and other investors to a price closer to par – and thus showing in the balance sheet a smaller writedown – by providing a subsidy to the buyer of the security: so a hedge fund will buy such toxic securities at 80 or 90 cents and receive a loan to finance the transaction at an interest well below the borrowing costs for the funds. Thus, writedowns are then shown smaller than the true underlying loss on the asset and the bank finances that fudged transaction with earning less revenues than otherwise on its credit portfolio. This is an accounting scam- bordering on the criminal - that auditors and regulators are abetting on a regular basis.
The bailout plan of Fannie and Freddie implies a direct bailout of financial institutions and helps them to report better than expected earnings in two ways. First, since these financial institutions hold massive amounts of agency debt the government bailout of the holders of such unsecured debt props the market price of the agency debt (reduces its spread relative to Treasuries) and thus allows financial institutions and investors to report less mark to market losses on the values of such assets. Second, after the bust of subprime, near prime and prime mortgage markets the market for private label MBS is dead with absolutely no origination of new MBS. Thus, today – as senior mortgage market participant put it – Fannie and Freddie are “THE mortgage market” as the only institutions that securitize and guarantee mortgages are Fannie and Freddie. Without the government bailout plan that last channel for mortgage securitization and insurance would be frozen and the ability of banks to originate even prime and conforming mortgages would be serious hampered and its cost sharply increased. Thus, the Fannie and Freddie bailout is actually a bailout of the mortgage market and of every institution that holds agency debt or the MBS issued by the two GSES and of every institution that is in the mortgage origination business. On top of this Fannie and Freddie have also been used as tools of public policy in order to further grease the mortgage market and the banks originating mortgages: their portfolio limits were increased; their capital requirement reduced; and the limit for what a conforming loans – the only ones that Fannie and Freddie can securitize – increased from about $420K to over $720K.
The Fed has been actively beefing up the earnings and balance sheet of financial institutions in four major ways.
First, a 325bps reduction in the Fed Funds rate sharply reduced the cost of
borrowing for banks and allowed them to enjoy a nice intermediation margin (the
difference between longer terms interest rates at which they lend and the much
lower short term interest rates at which they borrow). This steepening of the
yield curve is a major subsidy to financial institutions.
Second, the Fed has created a range of new liquidity facilities – the TAF,
the TSLF, the PDCF – that allow banks and now non-bank primary dealers to swap
their illiquid toxic asset backed securities for liquid Treasuries and that
provide access for non-banks – and now also Fannie and Freddie - to the Fed’s
discount window liquidity.
Third, the bailout of Bear Stearns creditors – JP Morgan and many other
counterparties of Bear – not only avoided a systemic meltdown and a certain run
on the other broker dealers but it has led the Fed to take on a significant
credit risk by taking off the balance sheet of Bear Stearns over $29 billion of
toxic securities. So the Fed has directly and indirectly systemically subsidized
and propped up the financial system and the earnings of bank and non-bank
financial institutions.
Fourth, a variety of forbearance regulatory actions – starting with the
waiver of Regulation W for some major banks – have been used to beef up the
profits and earnings of financial institutions and reduce their reported
writedowns.
The entire Federal Home Loan Bank system – another GSE system that is another effective arm of the government - has been used to prop hundreds of mortgage lenders. The insolvent Countrywide alone received more than $51 billion of funds from this semi-public system. This is a system that has increased its lending in the last 18 months by hundreds of billions of dollars: Citigroup, Bank of America and most other US mortgage lenders have also been beneficiaries of this public subsidy to the tune of dozens of billions of dollars each.
In 1990-91 at the height of that recession and banking crisis many major banks – in addition to 1000 plus S&L's that went bust – were effectively insolvent, including, as it was well known at that time, Citibank. At that time the Fed and regulators used instruments similar to those used today – easy money and steepening of the intermediation yield curve, aggressive forbearance, creative – i.e. liar – accounting, etc. – to rescue these major financial institutions from formal bankruptcy. But at that time the housing bust and the ensuing decline in home prices was much smaller than today: during that recession home prices – as measured by the Case-Shiller/S&P index – fell less than 5% from their peak. This time around instead such an index has already fallen 18% from its peak and it will most likely fall by a cumulative 30% before it bottoms sometime in 2010. If a 5% fall in home prices was enough to make Citi effectively insolvent in 1991 what will a 30% fall in home prices – and massive defaults on many other forms of credit (commercial real estate loans, credit cards, auto loans, student loans, home equity loans, leveraged loans, muni bonds, industrial and commercial loans, corporate bonds, CDS) - do to these financial institutions? It challenges the credulity of even spin masters to argue that financial firms are not in worse shape today than they were in 1990-91 when a significant number of major banks were technically insolvent. So, not only hundreds of small banks and a significant fraction of regional banks but also some major money center banks will become effectively insolvent during this crisis.
In spite of the headline figures that showed better than expected earnings at some major financial institutions – Citi, JPM, Wells Fargo - the details were utterly ugly. For one thing, Merrill announced massive writedowns and losses that were much worse than expected. Second, even JPMorgan’s results details were worrisome: for example the recognition of a significant amount of rising losses on prime mortgages. In the case of Citi – a firm that has a presence in over 100 countries and whose revenues come, to a great extent, from foreign operations - there was a sharp increase in the losses on its consumer credit operations, including a large increase in delinquencies on credit cards both in the US and other markets (Brazil, Mexico). Thus, after having already shut down its money losing consumer credit operations in Japan, Citi is now experiencing a surge of delinquencies on unsecured consumer debt both at home and abroad. And the reserves set aside to take care of such expected loan losses are still woefully insufficient as they are based on very optimistic assumptions about the level at which such delinquencies will peak; this is another way to pad earnings and not recognize early on such losses. Systematic use of creative accounting is at work in all of these institutions and other banks and other financial institutions to hide the extent of the incoming losses on assets and loans.
With the excuse of wanting to crack down on “manipulators” the SEC has now imposed restrictions on short sales on the stocks of 19 major financial institutions including Fannie and Freddie. Let us be clear about this new rule: this is a clear and naked attempt by the SEC to manipulate upwards the price of equities of financial firms. The SEC should start investigation and legal action against itself for actively manipulating the stock market. And shame on the SEC for this most un-capitalist and manipulative action: when there is an upward bubble in stock prices and 95% of investors/speakers on CNBC are talking their books in that most public forum to manipulate upwards their portfolio the SEC does nothing and allows this charade to go on. But when short sellers are shorting the stocks of firms that are likely to be bust that is considered manipulation. That is a pretty pathetic action by the SEC that has artificially boosted the equity valuations of US financial firms – now up 20% plus in the last part of the past week after the introduction of this manipulative rule. And of course this manipulated increase in financials’ equity prices reduces the mark to market losses that banks and other financial firms holding such equities would have incurred, another additional way to pad upwards earnings.
The few and rare banks and mortgage/MBS analysts that were willing to provide a realistic assessment of the mortgage market and the financial conditions of US banks and brokers have been effectively muzzled by upper management. With the partial exception of Meredith Whitney who benefits from being at an independent research firm, many other analysts have gone into the spin mode that the Fed, the regulators and the senior management of these financial institutions have dictated to them. Sell-side research that was never independent – even after the additional Chinese walls that the corporate scandals of the early part of the decade led to – is even less independent today. So you have financial institutions manipulating at will their earnings and analysts falling for this supreme baloney.
The FDIC will for sure run out of money as hundreds of banks will go bust and their depositors will have to be made whole given deposit insurance. With funds of only $53 billion, already up to 15% of such funds will be used to rescue the depositors of IndyMac alone. Thus, the FDIC is already requesting to Congress that the deposit insurance premia should be raised to compensate for this shortfall of funding. Too bad that this increase in insurance premia – that should be high enough in advance (not ex-post) to ensure that deposit insurance is incentive-compatible and not leading to gambling for redemption via risky lending in banks – is now too little and too late and is requested when the damage is already done as the biggest credit bubble in U.S. history is now going bust. Also the FDIC has done a mediocre job at identifying which banks are at risk. So far there are only about 90 banks on its watch list; and IndyMac was not put on that list until last month! So if the FDIC did not even identify IndyMac as in trouble until it was too late, how many other IndyMacs are out there that that the FDIC has not identified yet? Certainly a few hundred but such honest analysis of banks at risk is nowhere to be found.
As I have argued in previous work all independent broker dealers are in deep trouble and may not survive – in a few years’ times – as independent firms. And some of them are already walking zombies. In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure. I.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks. Indeed, firms that borrow liquid and short, highly leverage themselves and then lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and a formal permanent lender of last resort support from the central bank. (They did have quite a long run though - Jesse)
While a formal government bailout of most U.S. financial institutions has not occurred yet the U.S. government has avoided such bailout only by making sure that foreign government-owned institutions – the Sovereign Wealth Funds – did that job in lieu of the U.S. government. So instead of the U.S. government recapitalizing U.S. financial institutions we have seen foreign governments doing the job. Too bad that such SWFs have already lost 30% to 50% of their initial investments in such financial institutions. Thus, while U.S. financial firms will need hundreds of billions of additional capital injections to survive this crisis it is not obvious that foreign governments (SWFs) will not require conditions for such recapping (a percentage of equity that implies control, board membership, voting powers, common shares rather than preferred stock, etc.) that may not be politically acceptable in the U.S.
One could go on in more detail – as I have done in recent analyses – in discussing the severity of the current banking and financial crisis in the U.S. and how the official figures on earnings and balance sheets of financial institutions provide a misleading picture of the real financial state of such firms. As I argued before the $1 trillion of credit losses ($300-400 bn for mortgages and $600-700 bn for all the other non-mortgage credit) that I estimated last February are only a floor, not a ceiling, for such expected losses. Such losses are likely to end up being closer to my $2 trillion estimate. And such an estimate do not include the $200 to 300 billion that the rescue of Fannie and Freddie will entail. And such losses don’t even include scenarios where up to 50% of households who will end up underwater will walk away from their homes: that factor alone could entail mortgage losses of $1 trillion (average mortgage of $200k times the 50% loss that a foreclosure/walk away implies on that mortgage times 50% of the 21 million households that are underwater) rather than the $300-400 bn that I originally estimated.
So when you add it all up this will be the worst financial crisis since the Great Depression: not as severe as that episode but second only to it. And the real effects of this financial crisis will be severe and more severe if remedial policy action is not rapidly undertaken. Ditto for the US recession: this will be the worst of such U.S. recessions in decades.
One of the reasons we like Noriel Roubini is that he is an economist willing to dig into pertinent details, to get involved with current events, to take an intellectual stand and defend it, to tell it like it is, to borrow a phrase from another era.
This places him as a man apart from many of his economic peers, who lurk in obscure and largely irrelevant details, hiding behind rhetorical flourishes and courtly manners, lurking in the waiting rooms of universities and thinktanks, emerging every so often to speak for some vested interest with studies supporting pre-ordained conclusions. All of which of course is absolutely useless if not harmful to the real economy and legitimate achievement. But it does leave them open for research grants, and appointments, honorariums, and self-advancement within a corrupted system that rewards those who propagate it with the motto, go along to get along.
There is a management style in which achievement is rarely considered, although there is often an intricate if not baroque system of measures amenable to manipulation, but mistakes are penalized, and heavily. As one manager of a large business said in an interview, "If you do 99 things right, and one thing wrong, all they will remember is what you have done wrong and use it against you, depending on who you are."
And the shame is, he was right. The firm for which he worked had ceased to be a meritocracy, and instead had become an oligopoly in which influence-peddling and personal connections mattered above all, even as the business results deteriorated. Its vision and preoccupations turned increasingly inward on itself, almost obsessively. It eventually went bankrupt, formally, long after it had become functionally bankrupt. We saw this phenomenon at any number of mature companies we visited in the course of our consultancy.
Yes, there is that element of oligarchy in all societies, in all companies, in every organization, especially after they mature after a long period of relative stability, and unfortunately fall under the control of a few powerful people whose number one priority is self-perpetuation.
It is a matter of degree. When that modus operandi becomes predominant, pervasive, you have an organization that will surely soon be in trouble, and is headed towards a serious change of management, a major shakeup, a sometimes spectacular and precipitous failure, if it is subject to the forces of the markets.
So too it is with countries. This is what had happened to the former Soviet Union. And it is now happening to The United States and its financially-heavy economy. We have a bad case of the winner's curse. The dollar as the world's reserve currency fostered a deterioration of the American spirit that acted like slow poison on the vigor of the real economy.
The US is going to be passing through a purging of the system and its management for some time, measured in years but not decades, until it emerges again and can move forward.
The Coming Systemic Bust of the U.S. Banking System: “Dead Stocks Rallying”
Nouriel Roubini
Jul 20, 2008
RGE Monitor
This past week started with concerns about another systemic meltdown of the U.S. financial system as the insolvency of Fannie and Freddie was revealed and as IndyMac went bust (this third largest bank collapse in U.S. history). But the week ended with a remarkable rally of financial stocks as better than expected results from Wells Fargo, JP Morgan and Citi soothed the fears that major financial institutions were in even more distress than already predicted by market analysts.
Unfortunately, this massive rally of financial stocks in the latter part of the week is just another temporary bear market rally that will fizzle away once the onslaught of bad financial and macro news builds up again.
The views I presented in a recent blog that we will experience a severe financial and banking crisis received the support of many well respected commentators. Alan Abelson – at Barron’s – is one of the most senior and well known commentators on financial issues and on Wall Street. In his latest Barron’s column – aptly titled “Dead Stocks Rallying” he wrote:
WHY WE'RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don't hold that against him) and runs an economic
advisory firm called RGE Monitor that casts a knowing and clear eye on the
global financial and economic scene. We think he's top-notch (which means we
agree with him, a lot of the time).
The nub of his argument is that we're suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.
He reckons that, in a few years, there'll be no major independent broker-dealers left: They'll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.
The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won't cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.
The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won't escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there's plenty of room left on the downside. In fact, he feels the bear market won't end until equities are down a full 40% from their peaks.
We must say this vision is a mite too apocalyptic even for us. But Nouriel is not a
professional fear-monger out to make a splash with end-of-the-world
prognostications He's a sound guy with a solid record and an impressive résumé.
We obviously believe his views are worth pondering, even if they ruin your
appetite.
That was a very nice summary by Abelson of my views and a kind endorsement of them.
But how to square the views that a large fraction of the US financial system is in trouble with the apparently better than expected earnings results and lower than expected writedowns presented by financial institutions such as Wells Fargo, JP Morgan and Citi that led to the financials’ stocks most recent rally? There are many reasons why those earnings results are misleading and cosmetically retouched upward while the true financial conditions of the financial system are more dire than otherwise presented.
Let us discuss next in some detail the various reasons why financial conditions of financial firms and banks are much worse than those headline figures and why we the US will experience a systemic financial crisis…
First of all, in a week when only a massive and open ended bailout rescued Fannie and Freddie, when IndyMac went bust and when Merrill presented much worse than expected results it is very hard to be optimistic about the health of the US financial institutions. Reports in the next few days will reveal whether reality is closer to Fannie/Freddie/IndyMac/Merrill or rather closer to the Citi/JPMorgan/Wells Fargo outlook.
Most financial institutions are putting increasing numbers of assets in the illiquid buckets of Level 2 and Level 3 assets. While FASB 157 should prevent manipulation of the valuation of such illiquid assets, forbearance by the SEC, the Fed and other regulators allows a massive amount of fudging.
An insider told me that in a major financial institution the approach is as follows now: top management decide in advance what the announced writedowns should be and folks dealing with the toxic/illiquid assets come up with totally ad hoc assumptions to make sure that such illiquid assets are valued consistently with the decided-in-advance amount of writedowns and losses.
This is not earnings smoothing; this is active manipulation and falsification of financial results aimed at creating even more obfuscation of the true state of financial institutions. This obfuscation is actively abetted by the SEC, the Fed and all other regulators that are now in forbearance crisis management stage where the objective is to avoid at any cost anything that may trigger a financial meltdown. Thus, most of these earnings reports are not worth the paper they are written off.
This earnings manipulation occurs in a variety of ways. First, ad hoc assumptions still used to value and write down level 2 and level 3 assets. Second, banks are leaving aside less reserves for loan losses that are much less than necessary; they do that by using ad hoc assumptions about future losses on mortgages, credit cards, auto loans, student loans, home equity loans and other commercial real estate loans and industrial and commercial loans. Reserves for loan losses have been sharply lagging actual and expected losses, thus padding earnings as decided by the financial institutions' managers. Third, there is disposal of illiquid and toxic assets in ways that misleadingly reduces the amount of actual writedowns. An example is as follows: suppose a bank wants to dump illiquid MBS or leveraged loans that are worth – mark to market – 70 cents on the dollar rather than 100 cents on the dollar. Then, instead of selling these at a price of 70 and showing a 30% writedown these are sold to hedge funds and other investors to a price closer to par – and thus showing in the balance sheet a smaller writedown – by providing a subsidy to the buyer of the security: so a hedge fund will buy such toxic securities at 80 or 90 cents and receive a loan to finance the transaction at an interest well below the borrowing costs for the funds. Thus, writedowns are then shown smaller than the true underlying loss on the asset and the bank finances that fudged transaction with earning less revenues than otherwise on its credit portfolio. This is an accounting scam- bordering on the criminal - that auditors and regulators are abetting on a regular basis.
The bailout plan of Fannie and Freddie implies a direct bailout of financial institutions and helps them to report better than expected earnings in two ways. First, since these financial institutions hold massive amounts of agency debt the government bailout of the holders of such unsecured debt props the market price of the agency debt (reduces its spread relative to Treasuries) and thus allows financial institutions and investors to report less mark to market losses on the values of such assets. Second, after the bust of subprime, near prime and prime mortgage markets the market for private label MBS is dead with absolutely no origination of new MBS. Thus, today – as senior mortgage market participant put it – Fannie and Freddie are “THE mortgage market” as the only institutions that securitize and guarantee mortgages are Fannie and Freddie. Without the government bailout plan that last channel for mortgage securitization and insurance would be frozen and the ability of banks to originate even prime and conforming mortgages would be serious hampered and its cost sharply increased. Thus, the Fannie and Freddie bailout is actually a bailout of the mortgage market and of every institution that holds agency debt or the MBS issued by the two GSES and of every institution that is in the mortgage origination business. On top of this Fannie and Freddie have also been used as tools of public policy in order to further grease the mortgage market and the banks originating mortgages: their portfolio limits were increased; their capital requirement reduced; and the limit for what a conforming loans – the only ones that Fannie and Freddie can securitize – increased from about $420K to over $720K.
The Fed has been actively beefing up the earnings and balance sheet of financial institutions in four major ways.
First, a 325bps reduction in the Fed Funds rate sharply reduced the cost of
borrowing for banks and allowed them to enjoy a nice intermediation margin (the
difference between longer terms interest rates at which they lend and the much
lower short term interest rates at which they borrow). This steepening of the
yield curve is a major subsidy to financial institutions.
Second, the Fed has created a range of new liquidity facilities – the TAF,
the TSLF, the PDCF – that allow banks and now non-bank primary dealers to swap
their illiquid toxic asset backed securities for liquid Treasuries and that
provide access for non-banks – and now also Fannie and Freddie - to the Fed’s
discount window liquidity.
Third, the bailout of Bear Stearns creditors – JP Morgan and many other
counterparties of Bear – not only avoided a systemic meltdown and a certain run
on the other broker dealers but it has led the Fed to take on a significant
credit risk by taking off the balance sheet of Bear Stearns over $29 billion of
toxic securities. So the Fed has directly and indirectly systemically subsidized
and propped up the financial system and the earnings of bank and non-bank
financial institutions.
Fourth, a variety of forbearance regulatory actions – starting with the
waiver of Regulation W for some major banks – have been used to beef up the
profits and earnings of financial institutions and reduce their reported
writedowns.
The entire Federal Home Loan Bank system – another GSE system that is another effective arm of the government - has been used to prop hundreds of mortgage lenders. The insolvent Countrywide alone received more than $51 billion of funds from this semi-public system. This is a system that has increased its lending in the last 18 months by hundreds of billions of dollars: Citigroup, Bank of America and most other US mortgage lenders have also been beneficiaries of this public subsidy to the tune of dozens of billions of dollars each.
In 1990-91 at the height of that recession and banking crisis many major banks – in addition to 1000 plus S&L's that went bust – were effectively insolvent, including, as it was well known at that time, Citibank. At that time the Fed and regulators used instruments similar to those used today – easy money and steepening of the intermediation yield curve, aggressive forbearance, creative – i.e. liar – accounting, etc. – to rescue these major financial institutions from formal bankruptcy. But at that time the housing bust and the ensuing decline in home prices was much smaller than today: during that recession home prices – as measured by the Case-Shiller/S&P index – fell less than 5% from their peak. This time around instead such an index has already fallen 18% from its peak and it will most likely fall by a cumulative 30% before it bottoms sometime in 2010. If a 5% fall in home prices was enough to make Citi effectively insolvent in 1991 what will a 30% fall in home prices – and massive defaults on many other forms of credit (commercial real estate loans, credit cards, auto loans, student loans, home equity loans, leveraged loans, muni bonds, industrial and commercial loans, corporate bonds, CDS) - do to these financial institutions? It challenges the credulity of even spin masters to argue that financial firms are not in worse shape today than they were in 1990-91 when a significant number of major banks were technically insolvent. So, not only hundreds of small banks and a significant fraction of regional banks but also some major money center banks will become effectively insolvent during this crisis.
In spite of the headline figures that showed better than expected earnings at some major financial institutions – Citi, JPM, Wells Fargo - the details were utterly ugly. For one thing, Merrill announced massive writedowns and losses that were much worse than expected. Second, even JPMorgan’s results details were worrisome: for example the recognition of a significant amount of rising losses on prime mortgages. In the case of Citi – a firm that has a presence in over 100 countries and whose revenues come, to a great extent, from foreign operations - there was a sharp increase in the losses on its consumer credit operations, including a large increase in delinquencies on credit cards both in the US and other markets (Brazil, Mexico). Thus, after having already shut down its money losing consumer credit operations in Japan, Citi is now experiencing a surge of delinquencies on unsecured consumer debt both at home and abroad. And the reserves set aside to take care of such expected loan losses are still woefully insufficient as they are based on very optimistic assumptions about the level at which such delinquencies will peak; this is another way to pad earnings and not recognize early on such losses. Systematic use of creative accounting is at work in all of these institutions and other banks and other financial institutions to hide the extent of the incoming losses on assets and loans.
With the excuse of wanting to crack down on “manipulators” the SEC has now imposed restrictions on short sales on the stocks of 19 major financial institutions including Fannie and Freddie. Let us be clear about this new rule: this is a clear and naked attempt by the SEC to manipulate upwards the price of equities of financial firms. The SEC should start investigation and legal action against itself for actively manipulating the stock market. And shame on the SEC for this most un-capitalist and manipulative action: when there is an upward bubble in stock prices and 95% of investors/speakers on CNBC are talking their books in that most public forum to manipulate upwards their portfolio the SEC does nothing and allows this charade to go on. But when short sellers are shorting the stocks of firms that are likely to be bust that is considered manipulation. That is a pretty pathetic action by the SEC that has artificially boosted the equity valuations of US financial firms – now up 20% plus in the last part of the past week after the introduction of this manipulative rule. And of course this manipulated increase in financials’ equity prices reduces the mark to market losses that banks and other financial firms holding such equities would have incurred, another additional way to pad upwards earnings.
The few and rare banks and mortgage/MBS analysts that were willing to provide a realistic assessment of the mortgage market and the financial conditions of US banks and brokers have been effectively muzzled by upper management. With the partial exception of Meredith Whitney who benefits from being at an independent research firm, many other analysts have gone into the spin mode that the Fed, the regulators and the senior management of these financial institutions have dictated to them. Sell-side research that was never independent – even after the additional Chinese walls that the corporate scandals of the early part of the decade led to – is even less independent today. So you have financial institutions manipulating at will their earnings and analysts falling for this supreme baloney.
The FDIC will for sure run out of money as hundreds of banks will go bust and their depositors will have to be made whole given deposit insurance. With funds of only $53 billion, already up to 15% of such funds will be used to rescue the depositors of IndyMac alone. Thus, the FDIC is already requesting to Congress that the deposit insurance premia should be raised to compensate for this shortfall of funding. Too bad that this increase in insurance premia – that should be high enough in advance (not ex-post) to ensure that deposit insurance is incentive-compatible and not leading to gambling for redemption via risky lending in banks – is now too little and too late and is requested when the damage is already done as the biggest credit bubble in U.S. history is now going bust. Also the FDIC has done a mediocre job at identifying which banks are at risk. So far there are only about 90 banks on its watch list; and IndyMac was not put on that list until last month! So if the FDIC did not even identify IndyMac as in trouble until it was too late, how many other IndyMacs are out there that that the FDIC has not identified yet? Certainly a few hundred but such honest analysis of banks at risk is nowhere to be found.
As I have argued in previous work all independent broker dealers are in deep trouble and may not survive – in a few years’ times – as independent firms. And some of them are already walking zombies. In a few years time there will be no major independent broker dealers as their business model (securitization, slice & dice and transfer of toxic credit risk and piling fees upon fees rather than earning income from holding credit risk) is bust and the risk of a bank-like run on their very short term liquid liabilities is a fundamental flaw in their structure. I.e. the four remaining U.S. big brokers dealers will either go bust or will have to be merged with traditional commercial banks. Indeed, firms that borrow liquid and short, highly leverage themselves and then lend in longer term and illiquid ways (i.e. most of the shadow banking system) cannot survive without formal deposit insurance and a formal permanent lender of last resort support from the central bank. (They did have quite a long run though - Jesse)
While a formal government bailout of most U.S. financial institutions has not occurred yet the U.S. government has avoided such bailout only by making sure that foreign government-owned institutions – the Sovereign Wealth Funds – did that job in lieu of the U.S. government. So instead of the U.S. government recapitalizing U.S. financial institutions we have seen foreign governments doing the job. Too bad that such SWFs have already lost 30% to 50% of their initial investments in such financial institutions. Thus, while U.S. financial firms will need hundreds of billions of additional capital injections to survive this crisis it is not obvious that foreign governments (SWFs) will not require conditions for such recapping (a percentage of equity that implies control, board membership, voting powers, common shares rather than preferred stock, etc.) that may not be politically acceptable in the U.S.
One could go on in more detail – as I have done in recent analyses – in discussing the severity of the current banking and financial crisis in the U.S. and how the official figures on earnings and balance sheets of financial institutions provide a misleading picture of the real financial state of such firms. As I argued before the $1 trillion of credit losses ($300-400 bn for mortgages and $600-700 bn for all the other non-mortgage credit) that I estimated last February are only a floor, not a ceiling, for such expected losses. Such losses are likely to end up being closer to my $2 trillion estimate. And such an estimate do not include the $200 to 300 billion that the rescue of Fannie and Freddie will entail. And such losses don’t even include scenarios where up to 50% of households who will end up underwater will walk away from their homes: that factor alone could entail mortgage losses of $1 trillion (average mortgage of $200k times the 50% loss that a foreclosure/walk away implies on that mortgage times 50% of the 21 million households that are underwater) rather than the $300-400 bn that I originally estimated.
So when you add it all up this will be the worst financial crisis since the Great Depression: not as severe as that episode but second only to it. And the real effects of this financial crisis will be severe and more severe if remedial policy action is not rapidly undertaken. Ditto for the US recession: this will be the worst of such U.S. recessions in decades.
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