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perfect storm

energy, finance and the

end of growth
Dr Tim Morgan Global Head of Research

strategy insights | issue nine

perfect storm
energy, finance and the end of growth


part one: the end of an era 5

the four factors which are bringing down the curtain on growth
The economy as we know it is facing a lethal confluence of four critical factors – the fall-out
from the biggest debt bubble in history; a disastrous experiment with globalisation; the
massaging of data to the point where economic trends are obscured; and, most important of
all, the approach of an energy-returns cliff-edge.

part two: this time is different 17

the implosion of the credit super-cycle
The 2008 crash resulted from the bursting of the biggest bubble in financial history, a ‘credit
super-cycle’ that spanned three decades. Why did this happen?

part three: the globalisation disaster 29

globalisation and the western economic catastrophe
The Western developed nations are particularly exposed to the adverse trends explored in this
report, because globalisation has created a lethal divergence between burgeoning consumption
and eroding production, with out-of-control debt used to bridge this widening chasm.

part four: loaded dice 43

how policies have been blind-sided by distorted data
The reliable information which policymakers and the public need if effective solutions are to
be found is not available. Economic data (including inflation, growth, GDP and unemployment)
has been subjected to incremental distortion, whilst information about government spending,
deficits and debt is extremely misleading.

part five: the killer equation 59

the decaying growth dynamic
The economy is a surplus energy equation, not a monetary one, and growth in output
(and in the global population) since the Industrial Revolution has resulted from the
harnessing of ever-greater quantities of energy. But the critical relationship between
energy production and the energy cost of extraction is now deteriorating so rapidly that
the economy as we have known it for more than two centuries is beginning to unravel.

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perfect storm | energy, finance and the end of growth

4 strategy insights | issue nine

part one:

the end of an era

the four factors which are bringing down the curtain on growth

The economy as we know it is facing a lethal confluence of four critical
factors – the fall-out from the biggest debt bubble in history; a disastrous
experiment with globalisation; the massaging of data to the point where
economic trends are obscured; and, most important of all, the approach
of an energy-returns cliff-edge.

Through technology, through culture and tackled well in advance, could the denouement of a broadly-based
and through economic and political have devastating effects. The relentless process which had lasted for thirty
change, society is more short-term shortening of media, social and years, and is described here as “the
in nature now than at any time in political horizons has resulted in the great credit super-cycle”.
recorded history. Financial market establishment of self-destructive
participants can carry out transactions economic patterns which now threaten The credit super-cycle process is
in milliseconds. With 24-hour news to undermine economic viability. exemplified by the relationship
coverage, the media focus has shifted between GDP and aggregate credit
inexorably from the analytical to the We date the acceleration in market debt in the United States
immediate. The basis of politicians’ short-termism to the early 1980s. (see fig. 1.1). In 1945, and despite
calculations has shortened to the point Since then, there has been a relentless the huge costs involved in winning
where it can seem that all that matters shift to immediate consumption as the Second World War, the aggregate
is the next sound-bite, the next part of something that has been indebtedness of American businesses,
headline and the next snapshot of called a “cult of self-worship”. individuals and government equated
public opinion. The corporate focus The pursuit of instant gratification to 159% of GDP. More than three
has moved all too often from has resulted in the accumulation decades later, in 1981, this ratio was
strategic planning to immediate of debt on an unprecedented scale. little changed, at 168%. In real terms,
profitability as represented by the The financial crisis, which began in total debt had increased by 214%
next quarter’s earnings. 2008 and has since segued into the since 1945, but the economy had
deepest and most protracted economic grown by 197%, keeping the debt ratio
This report explains that this slump for at least eighty years, did remarkably static over an extended
acceleration towards ever-greater not result entirely from a short period period which, incidentally, was far from
immediacy has blinded society to of malfeasance by a tiny minority, shock-free (since it included two major
a series of fundamental economic comforting though this illusion may oil crises).
trends which, if not anticipated be. Rather, what began in 2008 was

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perfect storm | energy, finance and the end of growth

Fig. 1.1: The debt-GDP ratio in the United States since 1945*

Total credit market debt as % GDP




1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President

Fig. 1.2: US real GDP and debt since 1945*

$ trillion at 2011 values






1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Sources: Federal Reserve, Bureau of Economic Analysis and Economic Report of the President

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From the early 1980s, as figs. 1.1 individually or collectively, have trend #1 – the madness of crowds
and 1.2 show, an unmistakeable and already started to throw more than The first of the four highly dangerous
seemingly relentless upwards trend two centuries of economic expansion trends identified here is the creation,
in indebtedness became established. into reverse. over three decades, of the worst
Between 1981 and 2009, debt grew financial bubble in history. In his
by 390% in real terms, far out-pacing Before the financial crisis of 2008,
1841 work Extraordinary Popular
the growth (of 120%) in the American this analysis might have seemed
Delusions and the Madness of Crowds,
economy. By 2009, the debt ratio had purely theoretical, but the banking
Charles Mackay (1814-89) identified
reached 381%, a level unprecedented catastrophe, and the ensuing
a common thread of individual and
in history. Even in 1930, when GDP slump, should demonstrate that the
collective idiocy running through such
collapsed, the ratio barely topped dangerous confluence described here
follies of the past as alchemy, witch-
300%, and thereafter declined very is already underway. Indeed, more
hunts, prophecies, fortune-telling,
rapidly indeed. than two centuries of near-perpetual
magnetizers, phrenology, poisoning,
growth probably went into reverse as
the admiration of thieves, duels, the
This report is not, primarily, about debt, much as ten years ago.
imputation of mystic powers to
and neither does it suggest that the
Lacking longer-term insights, today’s relics, haunted houses, crusades
problems identified here are unique to
policymakers seem bewildered about – and financial bubbles.
the United States. Rather, the massive
escalation in American indebtedness many issues. Why, for instance, has
A clear implication of Mackay’s work
is one amongst a host of indicators there been little or no recovery from
was that all of these follies had been
of a state of mind which has elevated the post-2008 economic slump? Why
consigned to the past by intelligence,
immediate consumption over prudence have traditional, tried-and-tested
experience and enlightenment. For
throughout much of the world. fiscal and monetary tools ceased to
the most part, he has been right.
function? Why have both austerity
Intelligent people today do not put
This report explains that we need and stimulus failed us?
faith in alchemy, fortune-telling,
only look beyond the predominant
The missing piece of the economic witchcraft or haunting, and – with the
short-termism of contemporary
equation is an appreciation of four arguable exception of the invasion of
thinking to perceive that we are at
underlying trends, each of which Iraq – crusades have faded into the
the confluence of four extremely
renders many of the lessons of history books.
dangerous developments which,
the past irrelevant.

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perfect storm | energy, finance and the end of growth

But one folly remains alive and well. point where even some forms of debt term to describe what happened to
Far from confining financial bubbles counted as shock-absorbing equity). Britain under Brown – it was a collapse
to historical tales of Dutch tulips and in returns on capital employed.
British South Sea stock, the last three Former Federal Reserve boss Alan
decades have witnessed the creation Greenspan has been ridiculed for No other major economy got it quite
and the bursting of the biggest bubble believing that banks would always as wrong as Britain under Brown, but
in financial history. act in the best interests of their much the same was happening across
shareholders, and that the market the Western world, most notably in
Described here as ‘the credit super- would sort everything out in a benign those countries which followed the
cycle’, this bubble confirmed that one way. But regulators more generally disastrous Anglo-American philosophy
aspect, at least, of the idiocy identified bent over backwards to ignore the of “light-touch” financial regulation.
by Mackay continues to wreak havoc. most obvious warning signs, such as
Insane though historic obsessions with escalating property price-to-incomes trend #2 – the globalisation disaster
tulip bulbs and south seas riches may ratios, soaring levels of debt-to-GDP, The compounding mistake, where the
appear, they are dwarfed by the latter- and such obviously-abusive practices Western countries were concerned, was
day, ‘money for nothing’ lunacy that, as sub-prime mortgages, NINJA1 a wide-eyed belief that ‘globalisation’
through the credit super-cycle, has loans and the proliferation of unsafe would make everyone richer, when
mired much of the world in debts from financial instruments. the reality was that the out-sourcing
which no escape (save perhaps hyper- of production to emerging economies
inflation) exists. Where idiocy and naïveté were was a self-inflicted disaster with few
concerned, however, regulators and parallels in economic history. One would
Perhaps the most truly remarkable the general public were trumped have to look back to a Spanish empire
feature of the super-cycle was that it by policymakers and their advisors. awash with bullion from the New World
endured for so long in defiance of all Gordon Brown, for example, proclaimed to find a combination of economic
logic or common sense. Individuals in an end to “boom and bust” and gloried idiocy and minority self-interest equal
their millions believed that property in Britain’s “growth” despite the way to the folly of globalization.
prices could only ever increase, such in which debt escalation was making
that either borrowing against equity it self-evident that the apparent The big problem with globalisation
(by taking on invariably-expensive expansion in the economy was neither was that Western countries reduced
credit) or spending it (through equity more nor less than the simple spending their production without making
release) was a safe, rational and even of borrowed money. corresponding reductions in their
normal way to behave. consumption. Corporations’
Between 2001-02 and 2009-10, Britain outsourcing of production to
Regulators, meanwhile, believed added £5.40 of private and public debt emerging economies boosted their
that there was nothing wrong with for each £1 of ‘growth’ in GDP (fig. 1.3). earnings (and, consequently, the
loosening banking reserve criteria (both Between 1998 and 2012, real GDP incomes of the minority at the very
by risk-weighting assets in ways that increased by just £338bn (30%) whilst top) whilst hollowing out their
masked leverage, and by broadening debt soared by £1,133bn (95%) (fig. domestic economies through the
definitions of bank capital to the 1.4). Asset managers have a very simple export of skilled jobs.

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No Income No Job or Assets
Fig. 1.3: Changes in UK real debt and GDP*

£bn at 2011-12 values

Change in debt**
Change in GDP





97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

** Government and private individual debt

Fig. 1.4: UK real debt and GDP*

£bn at 2011-12 values

Total debt**
Debt: £2,480bn


£1,500 Debt: £1,196bn GDP: £1,521bn

GDP: £1,142bn


97-98 99-00 01-02 03-04 05-06 07-08 09-10 11-12

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

** Government and private individual debt

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perfect storm | energy, finance and the end of growth

This report uses a measure called unsustainable. Talk of Western of accretive changes has been much
‘globally-marketable output’ economies modernising themselves by the same. In America, for example, the
(GMO) as a metric for domestic moving from production into services benchmark measure of inflation (CPI-U)
production, a measure which contained far more waffle than logic has been modified by ‘substitution’,
combines manufacturing, agriculture, – Western consumers sold each other ‘hedonics’ and ‘geometric weighting’
construction and mining with net ever greater numbers of hair-cuts, ever to the point where reported numbers
exports of services. By definition, greater quantities of fast food and seem to be at least six percentage
activities falling outside this category ever more zero-sum financial services points lower than they would have
consist of services provided to whilst depending more and more on been under the ‘pre-tinkering’ basis of
each other. imported goods and, critically, on the calculation used until the early 1980s.
debts used to buy them. Corporate US unemployment, reported at
At constant (2011) values, consumption executives prospered, as did the gate- 7.8%, excludes so many categories of
by Americans increased by $6,500bn holders of the debt economy, whilst people (such as “discouraged workers”)
between 1981 and 2011, whilst the vast majority saw their real wages that it hides very much higher
consumption on their behalf by decline and their indebtedness spiral. levels of inactivity.
the government rose by a further
$1,700bn, but the combined output For our purposes, what matters here is The critical distortion here is clearly
of the manufacturing, construction, that reducing production, increasing inflation, which feeds through into
agricultural and extractive industries consumption and taking on escalating computations showing “growth” even
grew by barely $600bn. At less than debt to fill the gap was never a when it is intuitively apparent (and
$200bn in 2011, net exports of services remotely sustainable course of action. evident on many other benchmarks)
did almost nothing to bridge the chasm What this in turn means is that no that, for a decade or more, the
between consumption and production. return to the pre-2008 world is either economy has, at best, stagnated, not
possible or desirable. just in the United States but across
This left two residuals – domestically- much of the Western world. Distorted
consumed services, and debt – with trend #3 – an exercise in inflation also tells wage-earners that
debt the clincher. Between 1981 and self-delusion they have become better off even
2011, and again expressed at constant One explanation for widespread public though such statistics do not accord
values, American indebtedness soared (and policymaker) ignorance of the with their own perceptions. It is
from $11 trillion to almost $54 trillion. truly parlous state of the Western arguable, too, that real (inflation-free)
economies lies in the delusory nature interest rates were negative from as
Fundamentally, what had happened
of economic and fiscal statistics, many long ago as the mid-1990s, a trend
here was that skilled, well-paid jobs
of which have been massaged out of which undoubtedly exacerbated an
had been exported, consumption
all relation to reality. escalating tendency to live on debt.
had increased, and ever-greater
quantities of debt had been used to There seems to have been no ‘grand Fiscal figures, too, are heavily distorted,
fill the gap. This was, by any definition, conspiracy’ here, but the overall effect most noticeably in the way in which

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quasi-debt obligations are kept off the labour, labour which would cost 80:1 to 20:1 do not seem particularly
official balance sheet. As we explain perhaps $6,500 if it were paid for at disruptive but, once returns ratios
in this report, the official public debts prevailing rates. Of the energy – a term have fallen below about 15:1, there
of countries such as the United States coterminous with ‘work’ – consumed in is a dramatic, ‘cliff-edge’ slump in
and the United Kingdom exclude Western societies, well over 99% comes surplus energy, combined with a sharp
truly enormous commitments from exogenous sources, and probably escalation in its cost.
such as pensions. less than 0.7% from human effort.
Research set out in this report suggests
trend #4 – the growth dynamo Energy does far more than provide that the global average EROEI, having
winds down us with transport and warmth. In fallen from about 40:1 in 1990 to
One of the problems with economics modern societies, manufacturing, 17:1 in 2010, may decline to just
is that its practitioners preach a services, minerals, food and even 11:1 by 2020, at which point energy
concentration on money, whereas water are functions of the availability will be about 50% more expensive, in
money is the language rather than of energy. The critical equation here real terms, than it is today, a metric
the substance of the real economy. is not the absolute quantity of energy which will carry through directly into
Ultimately, the economy is – and available but, rather, the difference the cost of almost everything else –
always has been – a surplus energy between energy extracted and energy including food.
equation, governed by the laws of consumed in the extraction process.
This is measured by the mathematical crisis, culpability and consequences
thermodynamics, not those of
the market. equation EROEI (energy return on If the analysis set out in this report
energy invested). is right, we are nearing the end of a
Society and the economy began when period of more than 250 years in which
agriculture created an energy surplus For much of the period since the growth has been ‘the assumed normal’.
which, though tiny by later standards, Industrial Revolution, EROEIs have There have been setbacks, of course,
liberated part of the population to been extremely high. The oil fields but the near-universal assumption
engage in non-subsistence activities. discovered in the 1930s, for example, has been that economic growth is
provided at least 100 units of extracted the usual state of affairs, a rule to
A vastly larger liberation of surplus energy for every unit consumed in which downturns (even on the scale
energy occurred with the discovery extraction (an EROEI of 100:1). For of the 1930s) are the exceptions. That
of the heat engine, meaning that some decades now, though, global comfortable assumption is now in the
the energy delivered by human average EROEIs have been falling, as process of being over-turned.
labour could be leveraged massively energy discoveries have become both
by exogenous sources of energy smaller and more difficult (meaning The views set out here must provoke
such as coal, oil and natural gas. A energy-costly) to extract. a host of questions. For a start, if we
single US gallon of gasoline delivers really are nearing a cliff-edge economic
work equivalent to between 360 The killer factor is the non-linear crisis, why isn’t this visible already?
and 490 hours of strenuous human nature of EROEIs. As fig. 1.5 shows, the Second, who is to blame for this?
effects of a fall-off in EROEI from, say,

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perfect storm | energy, finance and the end of growth

Fig. 1.5: Nearing the energy returns cliff-edge*

EROEI 1990


Declining EROEI

Energy cost as % GDP
100 90 80 70 60 50 40 30 20 10 0

* Source: Tullett Prebon analysis

Third, how bad could it get? Last, but guilty of wilful blindness. Such a state scale of debt – and, relevantly in this
surely most important, can anything of affairs was only ever viable on the context, of quasi-debt commitments
be done about it? insane assumption that debt could as well – surely should have sounded
go on increasing indefinitely. Charles warning bells. From Liverpool to Los
Where visibility is concerned, our belief Mackay chronicled many delusions, Angeles, from Madrid to Matsuyama,
is that, if the economy does tip over but none – not even the faith placed in the developed world is mired in debts
in the coming few years, retrospect – witchcraft – was ever quite as irrational that can never be repaid. In addition
which always enjoys the 20-20 vision as the belief (seldom stated, but to formal debt, governments have
of hindsight – will say that the signs of always implicit in Western economic entered into pension and welfare
the impending crash were visible well policy) that there need never be an commitments which are only
before 2013. end to a way of life which was wholly affordable if truly heroic assumptions
dependent on ever-greater debt. are made about future prosperity.
For a start, anyone who believed that a
globalisation model (in which the West Even to those who were happy to At the same time, there is no real
unloaded production but expected swallow the nonsense of perpetually- evidence that the economy is
to consume as much, or even more, expanding indebtedness, the sheer recovering from what is already
than ever) was sustainable was surely

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a more prolonged slump than the
Great Depression of the 1930s. We
are now more than four years on from
the banking crisis and, under anything
approaching normal conditions, there
should have been a return to economic
expansion by now. Governments
have tried almost everything, from
prolonged near-zero interest rates and
stimulus expenditures to the creation
of money on a gigantic scale. These
tools have worked in the past, and the
fact that, this time, they manifestly
are not working should tell us that
something profoundly different
is going on.

The question of culpability has been

the equivalent of Sherlock Holmes’
“dog that did not bark in the night”,
in that very few individuals have been
held to account for what is unarguably
the worst economic disaster in at
least eighty years. A small number of
obviously-criminal miscreants have
been prosecuted, but this is something
that happens on a routine basis in
normal times, so does not amount to
an attribution of blame for the crisis.

There has been widespread public

vilification of bankers, the vast majority
of whom were, in any case, only acting
within the parameters of the ‘debt-
fuelled, immediate gratification’ ethos
established across Western societies
as a whole.

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perfect storm | energy, finance and the end of growth

Governments have been ejected or regulators and central bankers who The magic bullet, of course, would be
by their electorates, but their failed to “take away the punch-bowl” the discovery of a new source of energy
replacements have tended to look very long after the party was self-evidently which can reverse the winding-down
similar indeed to their predecessors. out of control. of the critical energy returns equation.
Some pin their faith in nuclear fusion
The real reason for the seeming lack But blaming any of these really means (along lines being pioneered by ITER2)
of retribution is that culpability is far blaming ourselves – for falling for but this, even if it works, lies decades
too dispersed across society as a whole. the consumerist message of instant in the future – that is, long after the
If, say, society was to punish senior gratification, for buying imported global EROEI has fallen below levels
bankers, what about the thousands goods, for borrowing far more than which will support society as we know
of salesmen who knowingly pushed was healthy, and for electing glib and it. Solutions such as biofuels and
millions of customers into mortgages vacuous political leaders. shales are rendered non-workable by
that were not remotely affordable? The their intrinsically-low EROEIs.
suspicion lingers that there has been Beyond visibility and culpability, the
a ‘grand conspiracy of culpability’, but two big questions which need to be Likewise, expecting a technological
even the radical left has failed to tie this addressed are ‘how bad can it get?’ solution to occur would be extremely
down to specifics in a convincing way. and ‘is there anything that we can do unwise, because technology uses
about it?’ energy – it does not create it. To expect
The real causes of the economic crash technology to provide an answer
are the cultural norms of a society that Of these, the first question hardly needs
would be equivalent to locking the
has come to believe that immediate an answer, since the implications seem
finest scientific minds in a bank-
material gratification, fuelled if self-evident – economies will lurch into
vault, providing them with enormous
necessary by debt, can ever be a hyper-inflation in a forlorn attempt to
computing power and vast amounts
sustainable way of life. We can, if we escape from debt, whilst social strains
of money, and expecting them to
wish, choose to blame the advertising will increase as the vice of resource
create a ham sandwich.
industry (which spends perhaps $470bn (including food) shortages tightens.
annually pushing the consumerist In the absence of such a breakthrough,
In terms of solutions, the first
message), or the cadre of corporate really promising energy sources (such
imperative is surely a cultural change
executives who have outsourced as concentrated solar power) need to
away from instant gratification, a
skilled jobs in pursuit of personal be pursued together, above all, with
change which, if it is not adopted
gain. We can blame a generation of social, political and cultural adaptation
willingly, will be enforced upon
policymakers whose short-termism to “life after growth”.
society anyway by the reversal
has blinded them to underlying trends,
of economic growth.

International Thermonuclear Experimental Reactor, a multinational
14 strategy insights | issue nine research project based at Cadarache in France
strategy insights | issue nine 15
perfect storm | energy, finance and the end of growth

16 strategy insights | issue nine

part two:

this time is different

the implosion of the credit super-cycle

The 2008 crash resulted from the bursting of the biggest bubble in financial
history, a ‘credit super-cycle’ that spanned more than three decades.
How did this happen?

As Carmen Reinhart and Kenneth to a process of sequential bubbles, a “tulips from Amsterdam”
Rogoff have demonstrated in their process in which the bursting of each One of the most famous historical
magisterial book This Time Is Different, bubble was followed by the immediate bubbles is the tulip mania which
asset bubbles are almost as old as creation of another. gripped the United Provinces (the
money itself. The Reinhart and Rogoff Netherlands) during the winter
book tracks financial excess over eight Though the sequential nature of
of 1636-37. Tulip bulbs had been
centuries, but it would be no surprise the pre-2008 process marks this as
introduced to Europe from the
at all if the Hittites, the Medes, the something that really is different, we
Ottoman Empire by Obier de Busbeq
Persians and the Romans, too, had can, nevertheless, learn important
in 1554, and found particular favour
bubbles of their own. All you need lessons from the bubbles of the past.
in the United Provinces after 1593,
for a bubble is ready credit and First, bubbles follow an approximately
when Carolus Closius proved that
collective gullibility. symmetrical track, in which the spike
these exotic plants could thrive in the
in asset values is followed by a collapse
harsher Dutch climate.
Some might draw comfort from the of roughly similar scale and duration. If
observation that bubbles are a long- this holds true now, we are in for a very The tulip was a plant whose beauty
established aberration, arguing that long and nasty period of retreat. and novelty had a particular appeal,
the boom-and-bust cycle of recent but tulip mania would not have
years is nothing abnormal. Any such Second, easy access to leverage is
occurred without favourable social
comfort would be misplaced, for two critical, as bubbles cannot happen if
and economic conditions. The Dutch
main reasons. investors are limited to equity. Third,
had been engaged in a long war for
most bubbles look idiotic when seen
independence from Spain since 1568
First, the excesses of recent years have with hindsight. Fourth – and although
and, though final victory was still some
reached a scale which exceeds any- institutional arrangements are critical
years away, the original Republic of the
thing that has been experienced before. – the real driving dynamic of bubbles
Seven Provinces of the Netherlands
is a psychological process which
Second, and more disturbing still, declared independence from Spain
combines greed, the willing suspension
the developments which led to the in 1581 This was the beginning of
of disbelief and the development
financial crisis of 2008 amounted the great Dutch Golden Age. In this
of a herd mentality.

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perfect storm | energy, finance and the end of growth

remarkable period, the Netherlands tulip market in 1634, setting the scene valuable as a mansion, or equivalent to
underwent some fundamental and for tulip mania. 17 years of skilled wages?
pioneering changes which included the
establishment of trading dominance, The tulip bubble did not revolve around Second, trading in these ludicrously
great progress in science and invention, a physical trade in bulbs but, rather, overvalued items took place in then-
and the creation of corporate finance, involved a paper market in which novel forms (such as futures), and
as well as the accumulation of people could participate with no were conducted on unregulated fringe
vast wealth, the accession of the margin at all. Indeed, the tulip bubble markets rather than in the recognised
Netherlands to global power status, followed immediately upon the heels exchanges.
and great expansion of industry. of the creation by the Dutch of the first
futures market. Bulbs could change Third, participants in the mania lost
This was a period in which huge hands as often as ten times each day the use of their critical faculties. Many
economic, business, scientific, trading but, because of the abrupt collapse people – not just speculators and the
and naval progress was partnered of the paper market, no physical wealthy, but individuals as diverse
by remarkable achievements in art deliveries were ever made. as farmers, mechanics, shopkeepers,
(Rembrandt and Vermeer), architecture maidservants and chimney-sweeps
and literature. The prosperity of this Price escalation was remarkable, with – saw bulb investment as a one-way
period created a wealthy bourgeoisie single bulbs reaching values that street to overnight prosperity. Huge
which displayed its affluence in grand exceeded the price of a large house. A paper fortunes were made by people
houses with exquisite gardens. Viceroy bulb was sold for 2,500 florins whose euphoria turned to despair as
Enter the tulip. at a time when a skilled worker might they were wiped out financially.
earn 150 florins a year. Putting these
For the newly-emergent Dutch absurd values into modern terms is The story that a sailor ate a hugely
bourgeoisie, the tulip was the “must- almost impossible because of scant valuable bulb, which he mistook for an
have” consumer symbol of the 1630s, data, but the comparison with skilled onion, is probably apocryphal (because
particularly since selective breeding earnings suggests values of around it would have poisoned him), but
had produced some remarkably exotic £500,0003, which also makes some there can be little doubt that this was
new plants. Tulips cannot be grown sense in relation to property prices. In a period of a bizarre mass psychology
overnight, but take between seven any event, a bubble which began in verging on collective insanity.
and twelve years to reach maturity. mid-November 1636 was over by the
all at sea
Moreover, tulips bloom for barely a end of February 1637.
week during the spring, meaning that The South Sea Bubble of 1720
bulbs can be uprooted and sold during Though tulip mania was extremely commands a special place in the litany
the autumn and winter months. brief, and available data is very limited, of lunacy that is the history of bubbles.
we can learn some pertinent lessons
A thriving market in bulbs developed from this strange event. The South Sea Company was
in the Netherlands even though established in 1711 as a joint
short-selling was outlawed in 1610. For a start, this bubble looks idiotic government and private entity created
Speculators seem to have entered the from any rational perspective – how on to manage the national debt. Britain’s
earth could a humble bulb become as involvement in the War of the Spanish

A bulb worth 2,500 florins in 1637 was equivalent to 16.7x an
annual skilled wage of 150 florins. Assuming a skilled wage
18 strategy insights | issue nine today of £30,000, the bulb would be worth £500,000
Succession was imposing heavy costs but worthless, and company shares in high places. Even Sir Isaac Newton,
on the exchequer, and the Bank of remained below their issue price, a presumably a man of common
England’s attempt to finance this situation not helped by the resumption sense, lost £20,000 (equivalent to
through two successive lotteries had of war with Spain in 1718. perhaps £2.5m today) in the pursuit
not been a success. The government of the chimera of vast, but nebulous,
therefore asked an unlicensed bank, Even so, shares in the company, unearned riches.
the Hollow Sword Blade Company, effectively backed by the national
to organise what became the first debt, began to rise in price, a process Any rational observer, even if unaware
successful national lottery to be floated characterised by insider dealing and of the insider dealing and other forms
in Britain. The twist to this lottery was boosted by the spreading of rumours. of corruption in which the shares were
that prizes were paid out as annuities, mired, should surely have realised that
Between January and May 1720, an eight-fold escalation in the stock
thus leaving the bulk of the capital in
the share price rose from £128 to price based entirely on implausible
government hands.
£550 as rumours of lucrative returns speculation was, quite literally, ‘too
After this, government set up the from the monopoly spread amongst good to be true’.
South Sea Company, which took over speculators. What, many argued, could
£9m of national debt and issued be better than a government-backed In his Extraordinary Popular Delusions
shares to the same amount, receiving company with enormous leverage and the Madness of Crowds, Charles
an annual payment from government to monopolistic profits in the fabled Mackay ranked the South Sea Company
equivalent to 6% of the outstanding Americas? Legislation, passed under and other bubbles with alchemy,
debt (£540,000) plus operating costs the auspices of Company insiders and witch-hunts and fortune-telling as
of £28,000. As an added incentive, banning the creation of unlicensed instances of collective insanity. Whilst
government granted the company a joint stock enterprises, spurred the other such foibles have tended to
monopoly of trade with South America, share price to a peak of £890 in early retreat in the face of science, financial
a monopoly which would be without June. This was bolstered by Company credulity remains alive and well, which
value unless Britain could break the directors, who bought stock at means that we need to know how
Spanish hegemony in the Americas, an inflated prices to protect the value of and why these instances of collective
event which, at that time, was wildly investments acquired at much lower insanity seem to be hard-wired into
implausible. levels. The share price peaked at £1,000 human financial behaviour.
in August 1720, but the shares then
The potentially-huge profits from lost 85% of their inflated market value
this monopoly grabbed speculator in a matter of weeks.
attention even though the real
likelihood of any returns ever actually Like the Dutch tulip mania, the South
accruing was extremely remote. Sea Bubble was an example which
Despite very limited concessions fused greed and crowd psychology
secured in 1713 at the end of the war, with novel market practices, albeit
the trading monopoly remained all compounded by rampant corruption

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perfect storm | energy, finance and the end of growth

made in Japan decades after 1945 was thus export- bars in New York and London. Boosted
In some respects, the Japanese asset driven, and led by firms which had by the diversion of still-cheap capital
bubble of the 1980s provided a ‘dry access to abundant, low-cost capital. from industry into real estate, property
run’ for the compounded bubbles values in Japan soared, peaking at
By the early 1980s, Japan’s economic $215,000 per square metre in the
of the super-cycle. Japan’s post-war
success was beginning to lead to prized Ginza district of Tokyo.
economic miracle was founded on
unrealistic expectations about future
comparatively straightforward policies.
prosperity. Many commentators, Comforted by inflated property values,
Saving was encouraged, and was
abroad as well as at home, used the banks made loans which the borrowers
channelled into domestic rather than
‘fool’s guideline’ of extrapolation to were in no position to repay. The
foreign capital markets, which meant
contend that Japan would, in the theoretical value of the grounds of
that investment capital was available
foreseeable future, oust America as the Imperial Palace came to exceed
very cheaply indeed. Exports were
the world’s biggest economy. The the paper value of the entire state of
encouraged, imports were deterred
international expansion of Japanese California. Meanwhile, a soaring yen
by tariff barriers, and consumption at
banks and securities houses was was pricing Japanese exports out of
home was discouraged. The economic
reflected in the proliferation of sushi world markets.
transformation of Japan in the four

Fig. 2.1: From miracle to disaster – Japanese GDP growth since 1955*

“Economic miracle” “Lost decade(s)”




Financial crisis
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

* Source: Tullett Prebon calculations based on data from IMF

20 strategy insights | issue nine

Though comparatively gradual – event, we need to distinguish between from the on-sale of mortgage debt.
mirroring, in true bubble fashion, the tangible components of the bubble The way in which banks were keeping
the relatively slow build-up of asset and its underlying psychological and the true scale of potential liabilities off
values – the bursting of the bubble cultural dimensions. their balance sheets completely eluded
was devastating. Properties lost more regulators, and Alan Greenspan’s belief
than 90% of their peak values, and Conventional analysis argues that that banks would always act in the
the government’s policy of propping tangible problems began with the best interests of shareholders was
up insolvent banks and corporations proliferation of subprime lending in breathtakingly naive. In America, as for
created “zombie companies” of the United States. Perhaps the single that matter in Britain and elsewhere,
the type that exist today in many biggest contributory factor to the central banks’ monetary policies were
countries. Having peaked at almost subprime fiasco was the breaking concentrated on retail inflation (which
39,000 at the end of 1989, the Nikkei of the link between borrower and had for some years been depressed
225 index of leading industrial stocks lender. Whereas, traditionally, banks both by benign commodity markets
deteriorated relentlessly, bottoming at assessed the viability of the borrower and by the influx of ever-cheaper
7,055 in March 2009. in terms of long-term repayment, the goods from Asia), and ignored asset
creation of bundled MBSs (mortgage- price escalation.
The Japanese economy was plunged backed securities) severed this link.
into the “lost decade” which, in Astute operators could now strip risk Meanwhile, banks’ capital ratios had
reality, could now be called the ‘lost from return, pocketing high returns expanded, in part because of ever-
two decades’. In 2011, Japanese whilst unloading the associated high looser definitions of capital and assets
government debt stood at 208% of risk. The securitisation of mortgages and in part because of sheer regulatory
GDP, a number regarded as sustainable was a major innovative failing in the negligence. Just as Greenspan’s Fed
only because of the country’s historic system, as was the reliance mistakenly believed that bankers were the best
high savings ratio (though this placed on credit-rating agencies which, people to determine their shareholders’
ratio is, in fact, subject to ongoing of course, were paid by the issuers interests, British chancellor Gordon
deterioration as the population ages). of the bundled securities. Another Brown took pride in a “light touch”
contributory innovation was the use regulatory system which saw British
2008 – the biggest bust of ARM (adjustable rate mortgage) banks’ total risk assets surge to more
With hindsight, we now know that products, designed to keep the than £3,900bn on the back of just
the Japanese asset bust was an early borrower solvent just long enough for £120bn of pure loss-absorbing capital
manifestation of the ‘credit super- the originators of the mortgages to or TCE (tangible common equity).
cycle’, which can be regarded as ‘the divest the packaged loans.
biggest bubble in history’. The general
outlines of the super-cycle bubble The authorities (and, in particular,
are reasonably well understood, even the Federal Reserve) must bear a big
if the underlying dynamic is not. To share of culpability for failing to spot
understand this enormous boom-bust the mispricing of risk which resulted

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It does not seem to have occurred to assumption that potential losses on huge subprime default losses inevitable
anyone – least of all to the American, debt instruments were covered by unless property prices rose indefinitely,
British and other regulatory authorities insurance overlooked the fact that all which was a logical impossibility.
– that a genuine capital reserve such insurances were placed with a Subprime defaults would in turn
of less than 2% of assets could be small group of insurers (most notably undermine the asset bases of banks
overwhelmed by even a relatively AIG) which were not remotely capable holding the toxic assets that the sliced-
modest correction in asset prices. of bearing system-wide risk. and-diced mortgage-based instruments
were bound to become as soon as
Both sides of the reserves ratio Meanwhile, innovative definitions property price escalation ceased.
equation were distorted by regulatory allowed banks’ reported capital to
negligence. On the assets side, expand from genuine TCE to include The second obvious trigger was a
banks were allowed to risk-weight book gains on equities, and provisions seizure in liquidity. The escalation in
their assets, which turned out to for deferred tax and impairment. the scale of debt had far exceeded
be a disastrous mistake. Triple-A Even some forms of loan capital were domestic depositor funds, not least
rated government bonds were, not allowed to be included in banks’ because savings ratios had plunged
unnaturally, regarded as AFS (‘available reported equity. as borrowing and consumption had
for sale’) and accorded a zero-risk displaced saving and prudence in
rating, but so, too, in practice, were Together, the risk-weighting of assets, the Western public psyche. Unlike
the AAA portions that banks, with and the use of ever-looser definitions depositors – a stable source of funding,
the assistance of the rating agencies, of capital, combined to produce in the absence of bank runs – the
managed to slice out of MBSs seemingly-reassuring reserves ratios wholesale funding markets which had
(mortgage-backed securities) and which turned out to be wildly provided the bulk of escalating leverage
CDOs (collateralised debt obligations). misleading. Lehman Brothers, for were perfectly capable of seizing up
example, reported a capital adequacy virtually overnight. For this reason, a
Mortgages of all types were allowed ratio of 16.1% shortly before it liquidity seizure crystallised what was
to be risk-weighted downwards to collapsed, whilst the reported pre- essentially a leverage problem.
50% of their book value which, at best, crash ratios for Northern Rock and
reflected a nostalgic, pre-subprime Kaupthing were 17.5% and 11.2% At this point, three compounding
understanding of mortgage risk on respectively5. problems kicked in. The first was
the part of the regulators. In the US, the termination of a long-standing
banks were allowed to net-off their Well before 2007, the escalation in the ‘monetary ratchet’ process – low rates
derivatives exposures, such that J.P. scale of indebtedness had rendered created bubbles, and the authorities
Morgan Chase, for example, carried a crash inevitable. Moreover, the two countered each ensuing downturn by
derivatives of $80bn on its balance triggers that would bring the edifice cutting rates still further, but, this time
sheet even though the gross value crashing down could hardly have been around, prior rate reductions left little
of securities and derivatives was more obvious. First, the resetting of scope for further relaxation.
close to $1.5 trillion4. The widespread ARM mortgage interest rates made

See James Ferguson, ‘What went wrong?’, Patrick Young (ed.),
The Gathering Storm, Derivatives Vision Publishing, 2010
22 strategy insights | issue nine 5
Ferguson, op cit
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perfect storm | energy, finance and the end of growth

Figs. 2.2 & 2.3: The relationship between borrowing and growth in the US*

Increments in real $bn

$2,000 $2.00
Government borrowing GDP growth per incremental
Household borrowing dollar of household debt
$1,500 GDP

$1,000 $1.00


$0 $0.00


-$1,000 -$1.00
1996 1998 2000 2002 2004 2006 2008 2010 1996 1998 2000 2002 2004 2006 2008 2010

* Sources: Federal Reserve and Economic Report of the President

Second, economies had become Third, some countries – most familiar features
dependent upon debt-fuelled notably the United Kingdom – Though, as we shall see, the bursting
consumption, and any reversal in debt had compounded consumer debt of the super-cycle in 2008 had some
availability was bound to unwind the dependency by mistaking illusory novel aspects, the process nevertheless
earlier (and largely illusory) ‘growth’ (debt-fuelled) economic expansion for embraced many features of
created by debt-fuelled consumer ‘real’ growth, and had expanded public past bubbles.
spending. As figs. 2.2 and 2.3 show, spending accordingly, a process which
the relationship between borrowing created huge fiscal deficits as soon as A number of points are common to
and associated growth had been leverage expansion ceased. these past bubbles, factors which
worsening for some years, such that include easy credit, low borrowing
the $4.1 trillion expansion in nominal Ultimately, the leverage-driven ‘great costs, financial innovation (in the
US economic output between 2001 bubble’ in pan-Western property form of activities which take place
and 2007 had been far exceeded by an values had created the conditions for outside established markets, and/or
increase of $6.7 trillion in consumer a deleveraging downturn, something are unregulated, and/or are outright
debt, and the growth/borrowing for which governments’ previous illegal), weak institutional structures,
equation had slumped. experience of destocking recessions opportunism by some market
had provided no realistic appreciation. participants, and the emergence of
some form of mass psychology in

24 strategy insights | issue nine

Figs. 2.4 & 2.5: The relationship between borrowing and growth in the UK*

$bn at 2011-12 values

£300 £1.50
Government borrowing GDP growth per incremental £ of debt
Individual borrowing
£250 GDP




-£50 -£1.00
1998 2000 2002 2004 2006 2008 2010 2012 1998 2000 2002 2004 2006 2008 2010 2012

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

which fear is wholly ousted by greed. Of course, the characteristics of earlier Credit became available in excessive
Often, the objects of speculation are excesses have not been absent in amounts, and the price of credit
items which can seem wholly irrational contemporary events. As with tulip was far too low (a factor which,
with the benefit of hindsight (how on bulbs, South Sea stock and Victorian we believe, may have been
earth could tulip bulbs, for instance, railways, recent years have witnessed exacerbated by a widespread
have become so absurdly over-valued?) the operation of mass psychologies in under-reporting of inflation).
which rational judgement has been
A further important point about suspended as greed has triumphed why this time is different
bubbles is that they can inflate over fear. Innovative practices, often Whilst it shared many of the
apparent prosperity, but the post-burst lying outside established markets, characteristics of previous such events,
effects include the destruction of have abounded. Examples of such the credit super-cycle bubble which
value and the impairment of economic innovations have included subprime burst in 2008 differed from them in
output for an extended period. In and adjustable-rate mortgages, and at least two respects, and arguably
reality, though, the bursting of a the proliferation of an ‘alphabet soup’ differed in a third dimension as well.
bubble does not destroy capital, but of the derivatives that Warren Buffett
simply exposes the extent to which famously described as “financial
value has already been destroyed by weapons of mass destruction”.
rash investment.

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perfect storm | energy, finance and the end of growth

The first big difference was that the Though smaller bubbles (such as
scale and scope of the 2008 crash far Poseidon) occurred in between, the
exceeded anything that had gone next really big bubble did not occur
before. Though it began in America until the 1980s, when Japanese asset
(with parallel events taking place in a values lost contact with reality.
number of other Western countries),
globalisation ensured that the crash In recent years, however, intervals
was transmitted around the world. The between bubbles have virtually
total losses resulting from the crash disappeared, such that the decade
are almost impossible to estimate, prior to the 2008 crash was
not least because of notional losses characterised by a series of events
created by falling asset prices, but which overlapped in time. Property
even a minimal estimate of $4 trillion price bubbles were the greatest single
equates to about 5.7% of global GDP, cause of the financial crisis, but there
with every possibility that eventual were complementary bubbles in a
losses will turn out to have been far variety of other asset categories.
greater than this.
The dotcom bubble (1995-2000)
The second big difference between the reflected a willing suspension of
super-cycle and previous bubbles lay critical faculties where the potential
in timing. A gap of more than 80 years for supposedly ‘high tech’ equities
elapsed between the tulip mania of were concerned, and historians of
1636-37 and the South Sea bubble of the future are likely to marvel at the
1720, though the latter had an overseas idiocy which attached huge values
corollary in the Mississippi bubble of to companies which lacked earnings,
the same year. The next major bubble, cash flow or a proven track record, and
the British railway mania of the 1840s, were often measured by the bizarre
followed an even longer time-gap, metric of “cash-burn”. Other bubbles
and a further interval of about seven occurred in property markets in the
decades separated the dethroning of United States, Britain, Ireland, Spain,
the crooked “railway king” (George China, Romania and other countries,
Hudson) in 1846 from the onset of as well as in commodities such as
the ‘roaring twenties’ bubble which uranium and rhodium. Economy-wide
culminated in the Wall Street Crash. bubbles developed in countries such as

26 strategy insights | issue nine

Iceland, Ireland and Dubai. Perhaps the • Institutional weaknesses which which has become a hostage to future
most significant bubble of the lot – for have undermined regulatory growth assumptions at precisely
reasons which will become apparent oversight whilst simultaneously the same time that the scope for
later – was that which carried the price facilitating the provision of excessive generating real growth is deteriorating.
of oil from an average of $25/b in 2002 credit through the creation of
to a peak of almost $150/b in 2008. The second critical issue is the
high-risk instruments.
undermining of official economic
This rash of bubbles suggests that • Mispricing of risk, compounded and fiscal data, a process which has
recent years have witnessed the by false appreciation of economic disguised many of the most alarming
emergence of a distinctive new trend, prospects and by the distortion of features of the super-cycle.
which is described here as a credit essential data.
super-cycle, a mechanism which Third, there has been a fundamental
compounds individual bubbles into • A political, business and consumer misunderstanding of the dynamic
a broader pattern. mind-set which elevates the which really drives the economy. Often
importance of the immediate whilst regarded as a monetary construct,
This report argues that a third big under-emphasising the longer term. the economy is, in the final analysis,
difference may be that the super-cycle an energy system, and the critical
bubble coincided with a weakening in • A distortion of the capitalist model supply of surplus energy has been in
the fundamental growth dynamic. which has created a widening chasm seemingly-inexorable decline for at
between ‘capitalism in principle’ and least three decades.
What we need to establish is the ‘capitalism in practice’.
‘underlying narrative’ that has
compressed the well-spaced bubble- Before we can put the credit
forming processes of the past into the super-cycle into its proper context,
single, compounded-bubble dynamic however, we need to appreciate
of the credit super-cycle. three critical issues, each of which is
grossly misunderstood.
It is suggested here that this narrative
must include: The first of these is the vast folly of
globalisation. This has impoverished
• A mass psychological change which and weakened the West whilst
has elevated the importance of ensuring that few countries are
immediate consumption whilst immune from the consequences of
weakening perceptions both of risks the unwinding of a world economy
and of longer-term consequences.

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perfect storm | energy, finance and the end of growth

28 strategy insights | issue nine

part three:

the globalisation disaster

globalisation and the western economic catastrophe

The Western developed nations are particularly exposed to the adverse
trends explored in this report, because globalisation has created a lethal
divergence between burgeoning consumption and eroding production,
with out-of-control debt used to bridge this widening chasm.

Our collective understanding of trends Despite these major handicaps, of $350, and sold it for $400, earning
informing recent and impending policymakers, analysts, strategists and a margin of $50. The company then
economic developments has been investors really should have developed became able, courtesy of globalisation,
undermined by at least three a much better understanding of the to manufacture the same television
conceptual shortcomings. stagnation and deterioration of the in China for $50, boosting its profit
Western economies, not least because margin dramatically.
First, insufficient attention has one of the most prominent drivers has
been devoted to the behavioural been happening in plain sight. This outsourcing of manufacturing in
and psychological dimensions of this way boosted corporate profitability
economics, a blind-spot which That driver is globalisation. Put very enormously, and created big cash
allowed policymakers to watch the bluntly, the process of globalisation inflows that were placed in the
creation and subsequent bursting has distorted the normal relationships banking system. At the same time,
of the biggest bubble in economic between production, consumption there was a hemorrhaging of skilled
history without taking preventative and debt beyond the point of jobs from the United States and other
or corrective action, despite the clear sustainability. The West is in deep Western economies, and countervailing
and unequivocal lessons that can be (and perhaps irreversible) trouble increases in skilled employment
learned from history. because it has consumed more, just in China and in other emerging
as it has produced less. countries. In terms of the West, it is a
Second, policymakers and the general simplification, but also a truism, that
public have been misled by data globalisation – dangerously corporate profits expanded whilst
which, in many important respects, simple, simply dangerous wages deteriorated.
has become ever less representative of The globalisation process is pretty
what is really happening. easy to describe (which makes the As globalisation gained traction,
ignorance of policymakers and Chinese workers, though still very
Third, there has been a failure to grasp poorly paid by Western standards,
their advisors even less excusable).
the most critical point of all, which enjoyed big increases in their earnings,
Suppose that an American company
is that the economy is an energy increases which, partly for cultural
manufactured a television at a cost
dynamic, not a financial one.

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perfect storm | energy, finance and the end of growth

reasons, they chose to save rather were advanced to borrowers who were simpler by the disastrous 1999 repeal
than to spend. Just as production was not remotely capable of keeping up of the Glass-Steagall legislation which,
declining and consumption increasing repayments, particularly when initial hitherto, had separated retail banking
in the West, the reverse was happening low “teaser” interest rates reset to from investment activities – appeared
in the emerging economies, where much higher levels under the terms to be boosting banks’ profits (and, of
production outstripped much smaller of ARMs (adjustable-rate mortgages). course, the remuneration of many of
increases in consumption. Interest rates fell, reflecting both their employees), but the apparent
surplus cash and a policy decision to uptrend in returns actually consisted
Like Western companies profiting boost consumer spending in pursuit of of earnings created at the expense of
from globalisation, Chinese and other economic growth. balance sheets. Worse still, much of
emerging-country manufacturers, the newly-created securitised debt was
too, had swelling profits to bank, as credit market distortion actually being bought by the banks
had many of their governments. Cash Of course, as Western savings ratios themselves through off-balance-sheet
piles were now expanding both in the collapsed, developing nations’ net special purpose vehicles (SPVs).
emerging economies and in the West. surpluses became dominant, but
Western banks nevertheless retained So far, so logical – companies were
As with the dislocating influx of acting rationally by outsourcing
access to these funds in a process
petrodollars in an earlier era, the production to cheaper locations and
which saw the rapid replacement of
accumulation of huge cash sums could, indeed, argue that a failure
internally-generated savings with
initially presented banks with a to do this would have put individual
capital sourced from wholesale
problem, in that they needed to lend corporations at an insurmountable
markets, another development which
this money profitably. Fortunately competitive disadvantage. But what
was to have a very nasty sting in its
for the banks, they found ready was really happening here, on a
tail. Banks financed primarily from
takers amongst Americans and macroeconomic scale, was that, in
wholesale rather than from depositor
other Westerners who, having lost America and in the West generally,
funding stand at far greater risk of
well-paid jobs and taken lower- production was declining just as
sudden creditor flight, particularly
wage employment instead, became consumption was increasing, a process
where wholesale funds are being used
increasingly dependent on debt to which made individuals ever more
on a short-term, recycling basis.
maintain their standards of living. dependent on debt.
Meanwhile, and largely unnoticed
Next, bankers, trying to establish an Seen from a national, macro rather
by regulators who were either inept
even larger borrowing market beyond than a corporate perspective, of
or complaisant, banks were moving
this group, created the ultimately- course, increasing consumption whilst
out of the pure lending business and
disastrous phenomenon known as reducing production is, by definition,
finding a new metiér as packagers of
subprime, in which mortgage funds an unsustainable course of action.
lending. This process – made much

30 strategy insights | issue nine

As other manufacturers got in on American government bond yields with marketable’ category, not least
the globalisation act, the prices of real (rather than officially-reported) because, if they were not competitively
imported manufactured goods fell inflation suggests that effective rates priced, consumers would be likely to
steadily (though margins remained probably turned negative as long ago purchase imports instead. The same
high). The declining prices of such as 1996. can be said of services which are
goods led policymakers to worry about actually sold on the global market,
deflation, and to act accordingly by The Western response to diminishing net, of course, of services purchased
cutting policy rates still further. production was to expand service from abroad.
industries, but there has to be
“taking in each others’ washing” significant doubt about how much This gives us two output categories.
– the shift to internal services real value is created by doing each The first is ‘Globally-Marketable
The deflation concern was misplaced, others’ washing, eating more fast food Output’ (GMO), which represents
primarily because the expansion or having more frequent manicure output potentially capable of
of activity in China (and in other sessions. Meanwhile, the relationship sale at world market values, and
emerging economies) was boosting between debt and incomes was consists of production activities
demand for raw materials. This getting ever further out of control. (where ‘production’ includes not just
had countervailing, inflationary manufacturing but the extractive
In order to illustrate these trends, industries and agriculture as well)
effects, since surges in the costs of
we need to be able to compare plus net exports of services.
commodities more than outweighed
movements in production,
declines in the prices of manufactured
consumption and borrowing. Our The second, residual category –
goods. Indeed, and as we shall see,
methodology for identifying a measure ‘Internally-Consumed Services’ (ICS)
it was the surge in commodity
of ‘internal production’ lies in dividing – comprises services which citizens
costs which was to stop the debt/
economic output between: provide to each other, a number which
consumption party in its tracks. Long
can be divided further into private
before this, however, the steady 1. Output which is globally and government provision.
increase in credit-fuelled consumption marketable; and
in the West had tipped the balance
decisively in favour of inflation rather 2. Services which citizens
than deflation. (including their government)
provide to each other.
Unfortunately, this rise in inflation
was masked by ever-more-misleading Manufactured goods, plus the products
official data, such that real interest of the extractive and agricultural
rates turned negative. Comparing industries, clearly fall into the ‘globally

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perfect storm | energy, finance and the end of growth

Fig. 3.1: The switch from production in the United States, 1980-2011*

In 2011 $ trillion
Private IS**
$14 Govt IS***
Service exports
$10 GMO****
GDP $12.2 trn

$4.6 trn

$2.0 trn $2.9 trn
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition
** Private internally-consumed services
*** Government internally-consumed services
**** Globally marketable output

Imperfect though these measures The remaining $7.6 trillion resulted non-monetised (but undoubtedly
are, they do provide an insight into from increases in the services which important) services such as the care
the structural changes happening in Americans provide to each other, that parents provide for children. Even
the American economy as production either privately (+$6.4 trillion) or so, there has been an unmistakable
was out-sourced and displaced by through government (+$1.2 trillion). trend within the Western economies
internally-consumed service activities This represented a massive shift in the – particularly since the onset of
(fig. 3.1). centre of gravity of the US economy globalisation – towards the expansion
away from production and towards of GDP through the monetisation
Between 1980 and 2011, the output which can only be consumed of previously-informal or peripheral
American economy expanded by $8.5 internally. activities, combined with the
trillion (128%) in real terms. Within expansion of services whose only
this expansion, however, only $0.9 There is always scope for legitimate market value is a domestic one.
trillion (10% of the total increase) debate about the “production
was provided by Globally-Marketable boundary” which divides monetised, Fig. 3.2 shows the relationship
Output (‘production’) activities. GDP-included activities from between consumption and production

32 strategy insights | issue nine

Fig. 3.2: The production-consumption gap in America, 1980-2011*

$ trillion at 2011 values

Government consumption
Private consumption



1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition
** Globally marketable output

in the United States since 1980, where Put colloquially, Americans were “the workshop of the world”. The oil
‘production’ is represented by the “taking in each others’ washing” at price spikes of the early and late 1970s
Globally-Marketable Output (GMO) a huge and unprecedented scale. pushed the US into deficit, but the real
measure. There has been a relentless It should be emphasised that this acceleration in this trend coincided
increase in private consumption over pattern was by no means unique to the with globalisation.
three decades even though there has United States but was replicated across
been very little growth in production. the Western economies, and was The US trade in goods is set out in fig.
particularly noticeable in Britain. 3.3, which, it should be noted, shows
In 1980, the ratio of private real (inflation-adjusted) values. In
consumption to GMO production Needless to say, these trends exerted 2011, the United States ran a deficit of
was 2.1:1, but by 2010 this ratio had a steadily worsening effect on Western $765bn in goods, only partially offset
almost doubled, to 3.8:1, meaning that trade in goods and commodities. At by net services exports of $187bn.
individual Americans were consuming the end of the Second World War, the
$3.84 for every $1 of the country’s United States could be described – as
globally-marketable output. Britain had been, a century earlier – as

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perfect storm | energy, finance and the end of growth

Fig. 3.3: US net trade in goods, 1963-2011*

$bn at 2011 values

$1,500 Imports
1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011

* Source: Tullett Prebon calculations based on data from The Economic Report of the President, 2012 edition

Fig. 3.4: US real debt and GDP, 1963-2011*

$ trillion at 2011 values

Government debt
Other private debt
$50 Household debt




1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

* Source: Tullett Prebon calculations based on data from The Economic Report of the President (GDP and deflators) and the Federal Reserve Board (debt)

34 strategy insights | issue nine

debt – deep in the hole expanded by a real-terms $2.2 trillion driven rewiring of America and
Long before the banking crisis, the over a ten-year period in which debt from a temporarily-benign oil price
relationships between production, had increased by $17.4 trillion environment. There was a sharp
consumption and debt had become (see fig. 3.4). deterioration in the fiscal balance in
completely unsustainable throughout the 2000s, of course, since the Bush
As fig. 3.5 reveals, it took $2.95 administration saw no contradiction
most of the Western world. In the
of incremental debt to add $1 to between cutting taxes and waging
United States, for example, total credit
American real GDP during the 1980s. two major wars.
market debt had soared to $54 trillion
The overall figure during the 1990s was
by the end of 2011, up from $29 trillion
higher (at $3.20), despite a pause in
just ten years previously.
the escalation of federal government
Even on an inflation-adjusted basis, debt. This reflected temporary fiscal
debt was 48% higher in 2011 than it improvements resulting both from
had been in 2001. By contrast, GDP had capital investment in the internet-

Fig. 3.5: Changes in American debt and GDP*

1960s 1970s 1980s 1990s 2000s

Change in:

GDP +$1.00 +$1.00 +$1.00 +$1.00 +$1.00

Private debt +$1.42 +$1.50 +$2.37 +$2.99 +$4.36

Government debt** +$0.12 +$0.25 +$0.59 +$0.21 +$1.31

Total debt +$1.55 +$1.74 +$2.95 +$3.20 +$5.67

* Source: Tullett Prebon calculations based on data from The Economic Report of the President (GDP) and the Federal Reserve funds flow statements (debt)
** Federal debt

strategy insights | issue nine 35

perfect storm | energy, finance and the end of growth

The deterioration in the relationship indebtedness. Arguably, and as we

between GDP and non-government shall see, the real total, including
borrowing continued in the 1990s, huge government off-balance-sheet
with the private debt required for each quasi-debt obligations, was (and is)
incremental dollar of GDP continuing very much higher still. Banks were
to increase, to $2.99 in the 1990s from exposed to a massive pool of lethally-
$2.37 during the 1980s. extended mortgage debt, and the true
scale of indebtedness was disguised by
After 2000, deterioration accelerated the various forms of securitised debt,
markedly. The decade to 2010 much of it actually held by the banks
witnessed a dramatic escalation in the themselves through off-balance-sheet
amount of debt required ($5.67) for SPVs (special purpose vehicles).
each incremental dollar of economic
output. Between 2000 and 2010, and crisis onset – the debt pile
after adjustment for inflation, the topples over
indebtedness of individual Americans At this point, the merest whiff of
increased by $4.35 trillion (52%), suspicion about the impossibility
most of which was accounted for by of servicing (let alone repaying) the
growth in mortgage commitments at mountain of debt was all that it took to
a time when stagnating real incomes spook credit markets and, by reversing
coincided with ever-easier access to the surge in the prices of collateral
mortgage funding. assets, to expose gaping holes in banks’
balance sheets. This was a process
The sheer quantitative scale (not to
which occurred during 2007-08, first
mention the qualitative weakness)
freezing wholesale debt markets and
of the banks’ massively-expanded
then, with utter inevitability, taking
mortgage books showed how the
the entire banking system to the
over-valued property sector acted as
brink of collapse.
a conduit for feeding consumption
with borrowing. The central banks were forced to step
in to rescue the banking system, a
By 2007, non-government debt had
process evident in the explosion in the
risen above 300% of GDP, a figure
balance sheets of, for example, the
that increases to 360% inclusive of
Federal Reserve (fig. 3.6) and the Bank
Federal, state and local government
of England. With central banks, too,

36 strategy insights | issue nine

now reaching the limits of sustainable The newly-emerging trend was “toxic can be portrayed merely as a balance
leverage, no option remained but to asset transference” or TAT. When debts sheet operation, but this defence is
resort to quantitative easing (QE). became too onerous to be sustained valid only to the extent that QE really
by borrowers, debt ‘black holes’ were will be unwound.
It is worth noting that, in addition transferred from customers to banks.
to the sheer quantum of debt, the When banks, too, became over- Logically, the next sequential stage
financial crisis saw the termination burdened by toxic assets, governments – one which probably lies in the very
of one financial trend and the stepped in, completing a process near future – is a market realisation
inauguration of another. whereby bad debts had transitioned that the claimed reversibility of QE is
from borrowers, via the banks, to nonsense. The idea that, say, the Bank
The trend which reached its end was of England can ever reverse £375bn
the state.
the “monetary ratchet”. Over time, a of money creation seems extremely
cyclical process had emerged in which Though various shifts and sleights of far-fetched.
excessively low interest rates created hand are used to support claims that
bubbles, and the bursting of each QE does not equate to the creation If – or rather, when – the credibility
bubble led to another reduction in (“printing”) of money, the only real of eventual reversal is lost, a dire
policy rates as central bankers sought difference between the two is the chapter of recklessness is likely to
to stave off recession. From 2008-09, claimed intention of reversing QE at end in money-printing, hyperinflation
this process ended because rates were some point in the future. To the extent and collapse.
now effectively zero. that eventual reversal is intended, QE

Fig. 3.6: The expansion of the Federal Reserve balance sheet, 2007-12*

$3,500 Long term treasury purchases
$2,920bn Fed agency debt mortgage-backed securities purch
$3,000 Liquidity to key credit markets
Lending to financial institutions
$2,500 Traditional security holdings



2007 2008 2009 2011 2012

* Source: Federal Reserve

strategy insights | issue nine 37

perfect storm | energy, finance and the end of growth

38 strategy insights | issue nine

compounding errors holdings into physical assets in the have been diverted from productive
Two further points are particularly form of natural resources. What is investment and ploughed instead
worthy of note. The first of these is the truly breathtaking is the way in which into inflating the value of nations’
way in which the West compounded Western countries have overlooked existing stocks of housing. Houses
its problems by pursuing gravely the obviously-competitive nature of an – which, after all, are non-earning
inefficient courses of action, and the ultimately-finite resource set. assets – have thus acted as capital
second is the role that tightening sinks, denying investment to genuinely
The West seems to have been seduced productive (and often vital) areas,
energy resource constraints played in
by the philosophy of “comparative most notably infrastructure. Just as it
bringing down the Western house
advantage” associated with the has been hugely wasteful of capital,
of cards.
British economist David Ricardo property price inflation has fostered a
As we have seen, the economic crisis in (1772-1823). According to Ricardian ‘something for nothing’ culture which,
the West has been created, above all, logic, the general wealth will increase in itself, has undermined economic
by the way in which globalisation has if all countries specialise in those productiveness.
driven a wedge between weakening activities in which they possess the
production and soaring consumption, greatest competitive advantage over If this were not bad enough, the
creating a gap which has been filled by others. This logic is valid if – but only West has also diverted capital
a reckless accumulation of debt. But if – the scope for growth is infinite. into vanity projects. Few Western
other mistakes, almost as serious, have Unfortunately, an unlimited capability countries have avoided the allure
contributed to a disastrous weakening for growth can only exist if the supply of building new sports stadia even
of the Western economies. of resources is infinite as well. as roads are crumbling and bridges
are deteriorating. The neglect of
These mistakes fall into various Based on the false assumption of the infrastructure has gone largely
categories, of which the first has been an infinite capability for growth, the unnoticed just as gleaming new
a wilful ignorance of the competitive West has followed Ricardian rationale soccer, baseball and athletics
nature of the global economy. and ceded entire areas of economic venues have proliferated.
Fundamentally, the aim of economic activity to emerging economies, and
management is to sustain and increase has done little or nothing to compete Labour efficiency has been undermined
the well-being of an ever-increasing for finite reserves of natural resources. by gravely mistaken social policies.
population on a planet whose Another by-product of the seductive Whereas schools in China are tasked
resources, ultimately, are finite. logic of Ricardo has been a Western with identifying and nurturing
commitment to free trade, even when those brightest children from whom
Since the implicitly competitive it has been clear beyond peradventure future leaders in science, technology,
character of this situation is an obvious that other countries are not playing by innovation and government will be
one, no great credit need be accorded the same set of rules. drawn, the West has deliberately
to China and others for recognising it eschewed all forms of merit selection,
and acting upon it, most notably by Meanwhile, a second compounding retaining parental affluence as the only
endeavouring to convert the waning error has been the way in which basis on which any form of selectivity
and dubious value of Western currency the West has been extraordinarily is allowed to operate.
profligate with capital. Huge sums

strategy insights | issue nine 39

perfect storm | energy, finance and the end of growth

Incentives have been skewed to the them at an ever greater competitive $97/b in 2008. We estimate that the
point at which the American higher disadvantage which has been increase in the price of oil alone cost
education system produces 41 law exacerbated by well-meaning labour American consumers an incremental
graduates for each graduate engineer. legislation in which considerations of $460bn between those years, of which
The inflation of housing values has profitability and efficiency are also-rans more than $300bn was accounted for
contributed to the impoverishment of when measured against supposedly by imports of petroleum. Between
Western nations’ own young people. ‘progressive’ social objectives. 2002 and 2008, meanwhile, OECD oil
Immigration policy, which logically consumers’ costs increased by about
should aim to attract the brightest and Worst of all, Western countries and $1.14 trillion, including an import
most industrious people, has instead their citizens have behaved as though component of around $730bn
been characterised by a policy of their affluent lifestyles are some kind (see figs. 3.7 and 3.8).
oscillating sentimentality and populist of divine entitlement rather than the
toughness, tempered by incompetence. reward of productiveness. Of course, increases in the prices of
other fuels (such natural gas and
Alongside wasteful investment energy takes away the punch-bowl coal) exacerbated these huge liquidity
allocation and disastrous labour Though much attention has been paid drains, which were more than enough
market policies, the West has allowed to the role of the banking system in the to stop the debt-consumption binge
the rise of two extremely damaging creation of the post-2008 economic in its tracks.
cultural norms. The first of these is slump, there has been a widespread
the unchecked rise of consumerism, failure to appreciate the role that was The role of central banks is – or should
fostered by an advertising industry played by the emergence of energy be – to stop excesses by being ready
which spends close to $470bn annually resource constraint. As emerging to “take away the punch bowl just as
(and about $143bn in the United economies increased their production the party gets going”, in the inimitable
States alone)6. whilst the West continued to ramp up phrase of William McChesney Martin7.
its consumption, demand for energy When central bankers duck this
The second is a sense of entitlement, escalated to a point at which resource obligation, markets will do it for them.
both at the individual and at the constraint became a major contributor
national level. Welfare systems, Financial recklessness (including
to the unwinding of an always-
originally intended as safety nets, globalisation) and energy constraint
unsustainable effort to use debt to
have been allowed to price Western are the two most important factors
put off the inevitable implications
workers out of international markets. which have created the current
of a divergence between production
Benefits systems, even if they are not economic slump, so it is perhaps fitting
and consumption.
(as is often claimed) “lifestyle choices” that it was energy markets which
for the recipients of benefits, certainly Reflecting the combination of real drove the first, disastrous wedge into
have been exactly that for the armies growth in the emerging economies the debt structure which had been
of administrators that flourish in and debt-sustained consumption in created in an attempt to bridge the
almost all such systems. The rise of the West, a surge in energy prices widening chasm between the West’s
welfarism has imposed huge social saw the annual average price of Brent diminishing production and its ever-
costs and taxes on businesses, placing crude oil rise from $25/b in 2002 to growing propensity to consume.

40 strategy insights | issue nine 7
William McChesney Martin (1906-98) was chairman of the Federal Reserve from 1951 to 1970
Fig. 3.7: US oil costs*

$700 Total






2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

* Source: Tullett Prebon estimates derived from data in the BP Statistical Review of World Energy 2012

Fig. 3.8: OECD oil costs*

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

* Source: Tullett Prebon estimates derived from data in the BP Statistical Review of World Energy 2012

strategy insights | issue nine 41

perfect storm | energy, finance and the end of growth

42 strategy insights | issue nine

part four:

loaded dice
how policies have been blind-sided by distorted data

The reliable data which policymakers and the public need if effective solutions
are to be found is not available. Economic data (including inflation, growth,
GDP and unemployment) has been subjected to incremental distortion,
whilst information about government spending, deficits and debt is
extremely misleading.

This report describes an impending imperative need for reliably accurate the worst culprit where misleading
economic crisis. Although, and as data if they are to stand any chance of statistics are concerned. Rather, the
we have already seen, the post-2008 finding least-bad solutions. But this raw data required for an unravelling
slump is the denouement of the reliable data is precisely what they do of statistical distortion is more readily
biggest financial bubble in history, not have. Both economic and fiscal available in the US than in other
this is, in many ways, the least of the reporting have been subjected to countries which lack America’s data
problems faced by the global economy incremental massage and deliberate transparency. Additionally, the United
collectively, and by the Western obfuscation to the point where States is fortunate in that it possesses
economies in particular. policymakers, investors and the public analysts willing and able to untangle
really have no accurate conception of the statistical mess (even if few
As we shall see in the final part this our economic predicament. policymakers are any more prepared
report, the fundamental problem is than their overseas counterparts
that the surplus energy dynamic which Data distortion can be divided into to listen to the uncomfortable
has propelled economic development two categories. Economic data conclusions resulting from these
since the Industrial Revolution is now has been undermined by decades analysts’ labours).
unwinding very rapidly indeed. From a of methodological change which
Western perspective, these trends have have distorted the statistics to Concentrating mainly on the United
been exacerbated by the globalisation the point where no really accurate States, we begin here by looking at
disaster, which has driven an ever- data is available for the critical how the principal economic metrics
widening wedge between diminishing metrics of inflation, growth, output, have been distorted over time,
production and burgeoning unemployment or debt. Fiscal data, beginning with inflation before turning
consumption, and has then attempted meanwhile, obscures the true scale of to growth, output and unemployment.
to bridge this gap using ever-less- government obligations. We then examine fiscal accounts to
sustainable mountains of debt. reveal quite how misleading both
Much of the detailed analysis provided government obligations and budget
In this situation, it seems self-evident here is drawn from the United States, balances have become.
that policymakers, business leaders but this requires a cautionary note.
and the general public alike have an It is not our contention that the US is

strategy insights | issue nine 43

perfect storm | energy, finance and the end of growth

We should be clear that the million out-of-work Americans dropped (fig. 4.1). But the reported rate of
debauching of US official data did not out of the unemployment totals under overall inflation between those years
result from any grand conspiracy to a redefinition of “discouraged workers” seems strangely at odds with dramatic
mislead the American people. Rather, introduced in 1994. increases in the costs of essentials such
it has been an incremental process as petrol (+59%), water charges (+63%),
which has taken place over more economic distortion #1 – the high electricity (+97%) and gas (+168%).
than four decades. price of understated inflation
Though the undermining of data Those who question the accuracy of
In the early 1960s, the Kennedy quality has been widespread, few official inflation measures in Britain
administration tampered with series have been distorted more than have nothing much more upon which
unemployment numbers to exclude published numbers for inflation, to base their suspicions than intuition,
“discouraged workers”. The Johnson and few if any economic measures experience and the known escalation
administration introduced the “unified are of comparable importance. In of the prices of essentials. In the United
budget”, which incorporated what the United States, CPI-U inflation States, this situation is quite different,
was then a big Social Security surplus reported at 3.2% in 2011 probably and far greater data transparency
to hide part of the underlying federal masked real price escalation which has enabled analysts to reverse out
over-spend. Richard Nixon tried, was very much higher than that. This the methodological changes of the
with only limited success, to peddle is hugely significant, because inflation last three decades. The scale of the
the concept of “core inflation”, an is central to calculations of economic distortions which have been identified
inflationary measure which excluded growth, wages, pensions and benefits. is truly shocking.
energy and food (the very items whose Moreover, understated inflation
prices were rising most strongly at The biggest single undermining of
undermines calculations of the ‘real’
that time). official inflation data results from the
cost of credit as represented by interest
application of “hedonic adjustment”.
rates and bond yields, a factor which,
“Owner-equivalent rent”, a concept The aim of hedonic adjustment is to
as we shall see, may have played a very
to be explained later, was introduced capture improvements in product
significant role in the escalation of
under Ronald Reagan. Convoluted quality. The introduction of, say, a
indebtedness during the credit
changes to the measurement of CPI better quality screen might lead the
inflation, recommended by the Boskin Bureau of Labor Statistics (BLS) to
Commission, were drafted under British inflation data, too, seems pretty deem the price of a television to have
George Bush Sr. but implemented by optimistic Between 2001 and 2011, fallen even though the price ticket
the Clinton administration (and, as average weekly wages increased by in the shop has remained the same,
renowned strategist Kevin Phillips 38%, which ought to have been a more or has risen. The improvement in the
has remarked8, there is a certain than adequate rise when set against quality of the product is equivalent, BLS
irony to the introduction of “hedonic official CPI (consumer price index) statisticians argue, to a reduction in
adjustment” by the Oval Office’s inflation of 27% over the same period price, because the customer is getting
ultimate hedonist). A further four more for his or her money.

44 strategy insights | issue nine 8

See “Numbers Racket”, Kevin Phillips, Harper’s Magazine, 1 May 2008
Fig. 4.1: Beyond belief? UK inflation, 2001-11*

+168% Gas
+97% Electricity
+66% Property prices
+63% Water
+59% Council tax & rates
+59% Petrol
+39% Food
+28% Rent
-5% Consumer durables
+38% Average income
+27% CPI

-50% +0% +50% +100% +150% +200%

* Source: Tullett Prebon UK Economic & Fiscal Database 2012

A big problem with hedonic critics claim, the official statisticians A second area of adjustment to
adjustment is that it breaks the link are all too likely to incorporate the inflation concerns ‘substitution’. If
between inflation indices and the former whilst ignoring the latter. the price of steak rises appreciably,
actual (in-the-shop) prices of the ‘substitution’ assumes that the
measured goods. Another is that The failure to incorporate hedonic customer will purchase, say, chicken
hedonic adjustment is subjective, negatives may be particularly pertinent instead. As with hedonic adjustment,
and seems to incorporate only where home-produced goods are the use of substitution not only breaks
improvements in product quality, replaced by imports, a process which the link with actual prices (a process
not offsetting deteriorations. A new has been ongoing for more than two exacerbated by ‘geometric weighting’),
telephone might, for example, offer decades. A Chinese-made airbrush but it also, as Chris Martenson explains,
improved functionality (a hedonic might be a great deal cheaper than means that CPI has ceased to measure
positive), but it might also have a one made in America, but is the lower the cost of living but quantifies “the
shorter life (a hedonic negative) and, quality of the imported item factored cost of survival” instead9.
in to the equation?

Chris Martenson, The Crash Course, John Wiley & Sons Inc, 2011 strategy insights | issue nine 45
perfect storm | energy, finance and the end of growth

Fig. 4.2: Smoke and mirrors – the distortion of US CPI-U inflation*

8% Underlying?






1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

* Sources: Bureau of Labor Statistics and Tullett Prebon estimates

Geometric weighting, too, plays a Instead of the 3.2% number reported underlying data stripped of hedonics,
significant role in the distortion of for 2011, for example real inflation was substitution and geometric weighting.
American inflation data. In any case, probably at least 7%. Worse still, the
some of the weightings used in the official numbers probably understate The ramifications of understated
official indices look strange, one the sharp pick-up in inflation which inflation are huge. First, of course,
example being medical care, which America has been experiencing. A and since pay deals often relate to
accounted for 16% of consumer realistic appreciation of the inflationary reported CPI, wage rises for millions
spending10 in 2011 but is weighted at threat would be almost certain to of Americans have been much smaller
just 7.1% in the CPI-U.11 have forced very significant changes in than they otherwise would have been.
monetary policy. Small wonder, then, that millions of
Since the process of adjustment Americans feel much poorer than
began in the early 1980s, the Taken in aggregate, the extent to official figures tell them is the case.
officially-reported CPI-U number which the loss of dollar purchasing By the same token, those Americans
has diverged ever further from the power has been understated is almost in receipt of index-related pensions
underlying figure calculated on the certainly enormous. Between 1985 and benefits, too, have seen the real
traditional methodology. Fig. 4.2 gives and 2011, official data shows that the value of their incomes decline as a
an approximate idea of quite how dollar lost 53% of its value, but the result of the severe (and cumulative)
distorted US inflation data seems decrease in purchasing power might understatement of inflation.
to have become over three decades. stand at more like 75% on the basis of

Source: Economic Report of the President
46 strategy insights | issue nine 11
Source: Bureau of Labor Statistics
strategy insights | issue nine 47
perfect storm | energy, finance and the end of growth

Fig. 4.3: The smoking gun – did negative real interest rates fuel the killer bubble?*

Based on official inflation
8% Based on underlying inflation?







1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

* Sources: Economic Report of the President, Bureau of Labor Statistics and Tullett Prebon estimates. Chart shows annual average real yields
on 10-year Treasuries, based on official and on underlying inflation rates, see text

48 strategy insights | issue nine

This process, of course, has saved the have played a hugely important role had been subjected to incremental
government vast sums in benefit in the creation of America’s debt distortion, their everyday experience
payments. Rebasing payments for bubble, is that real interest rates may may very well have led them to act
the understatement of inflation since have been negative ever since the on an intuitive understanding that
the early 1980s suggests that the late 1990s (fig. 4.3). Taking 2003 as borrowing was cheap. We believe that
Social Security system alone would an example, average nominal bond distorted inflation data may, together
have imploded many years ago had rates12 of 4.0% equated to a real rate with irresponsible interest rate policies
payments matched underlying rather of 1.7% after the deduction of official and woefully lax regulation, have been
than reported inflation. In other words, CPI-U inflation (2.3%), but were almost a major contributor to the reckless
the use of ‘real’ inflation data would certainly heavily negative in real terms wave of borrowing which so distorted
have overwhelmed the federal budget if adjustment is made on the basis of the US economy in the decade prior to
completely or, conversely, might have underlying inflation instead. the financial crisis.
forced government to come clean on
what levels of welfare spending really Logically, it makes perfect sense to
can be afforded. borrow if the cost of borrowing is lower
than the rate of inflation. Whilst most
Another implication of distorted Americans may not have been aware
inflation, an implication that may of the way in which inflation numbers

 nnual average interest rate for 10-year Treasuries.
Source: Economic Report of the President, 2011 datasets strategy insights | issue nine 49
perfect storm | energy, finance and the end of growth

economic distortion #2 – grossly 4.4. The largest single such imputation those with mortgages. For example,
distorted prosperity – worth over $1.2 trillion in 2011 – a person with 50% equity in his home
Gross domestic product (GDP) is concerns “owner-equivalent rent”. If a is assumed to pay rent on 100% of it
usually accepted as defining the person owns his or her home outright, rather than, as is actually the case,
output of an economy. In 2011, the no mortgage or rent is payable, and mortgage interest on half of it.
GDP of the United States was reported no money changes hands in respect
of the property. But the reporting The second-largest imputation
at $15.1 trillion, a figure which most
methodology for American GDP concerns employee benefits (principally
Americans probably assume consists
assumes that such a property has medical insurance, but also items such
entirely of ‘real’ dollars which can be
a utility which a purely cash-based as meals and accommodation) which
counted. This is, in fact, very far from
measure fails to capture. Therefore, are provided to workers either freely or
being the case, because close to 16%
GDP contains a sum representing the on a subsidised basis. A sum of $601
of the reported number consists of
rent which the owner would have paid billion was imputed in this category in
‘imputations’. These imputations
(presumably to himself) if he had not 2011. Financial services (for example,
are dollars which do not really exist.
owned the property. Interest expense is checking accounts) which are provided
Stripped of them, GDP totalled $12.7
backed out, but the net result remains free of charge by banks are treated
trillion in 2011, which automatically
a major, non-cash uplift to GDP. The similarly. Here, the imputation (of $497
means that all debt ratios are a great
replacement of actual expenditure billion in 2011) reflects what the cost
deal higher than they look.
with a notional (‘imputed’) rent applies to the customer would have been if
The most important of these not just to those Americans who the bank had charged him for services
imputations are summarised in fig. own their homes outright, but also to which, in reality, were provided free.

Fig. 4.4: GDP – the impact of imputations*

$bn 2006 2007 2008 2009 2010 2011

Reported GDP $13,377 $14,029 $14,292 $13,974 $14,499 $15,076

Including imputations of:

Imputed rental income $1,125 $1,153 $1,191 $1,214 $1,217 $1,236

Financial services not charged $391 $426 $451 $441 $499 $497

Employment-related imputations $543 $565 $581 $592 $601 $628

Other imputations, net -$78 -$50 $9 -$1 -$32 -$17

Total imputations $1,980 $2,093 $2,231 $2,245 $2,285 $2,343

GDP excluding imputations $11,397 $11,935 $12,061 $11,728 $12,214 $12,733

Imputations as % GDP 14.8% 14.9% 15.6% 16.1% 15.8% 15.5%

* Source: Bureau of Economic Analysis

50 strategy insights | issue nine

There is a legitimate debate about a long period in which the American picture (fig. 4.5). In effect, the United
the “production boundary”, which economy has really been shrinking, States has been in almost permanent
refers to the inclusion, or otherwise, not growing. recession since 2000, with real GDP
of services provided free of charge, falling year after year, and declining
a good example being care provided According to official figures, the GDP sharply over a ten-year period.
to children, to the elderly and to the of the United States increased by
infirm by family members. But the 16.6%, in real terms, between 2001 The growth-enhancing impact of
sheer scale at which “imputations” and 2011. But these numbers are a distorted inflation has not been unique
are now used in the compilation of function of two calculations which, as to the United States, of course. As we
American GDP surely introduces grave we have seen, are not in themselves have seen, the prices of essentials have
distortions into the generally-accepted reliable. First, the reported 2011 GDP far out-stripped reported inflation in
number for US economic output. number (of $15.1 trillion) is highly Britain, suggesting that underlying
questionable, because it includes inflation may have been significantly
Moreover, non-existent (imputed) non-cash “imputations” totalling higher than the reported number.
dollars obviously cannot be taxed, $2.3 trillion. Second (and much more Raising the annual GDP deflator by
which means that imputations make seriously), since the way in which just 1.55% would have been sufficient
the American incidence of taxation official inflation is calculated is open to wipe out all reported economic
look a great deal lower than it really to very serious question, so, too, is the growth in the United Kingdom
is. At $4.7 trillion, general government GDP deflator, the adjustment which between 2001 and 2011 (“growth”
revenue absorbed 31% of reported GDP is employed to back out the effects which, as we have seen, was
in 2011, but this ‘tax take’ rises to 37% of inflation from changes in the essentially borrowed anyway).
when imputations are stripped out of nominal monetary value of economic
the GDP denominator. output. Ritual claims that the deflator The picture of economic deterioration
is worked out by comparing simple in the United States is reflected in the
economic distortion #3 – what chained volumetric (that is, non- unemployment statistics or, rather, it
growth, what jobs? monetary) measurements of GDP would be, if these were not so heavily
Understated inflation, then, has need not be taken too seriously, as the massaged by reporting methodologies.
depressed wage growth, impoverished reality is that it is impossible to de-link The official (U-3) number, currently
those in receipt of benefits, masked the GDP deflator from other measures 7.9%, excludes the millions of
the decline in the purchasing power of of inflation. unemployed Americans who are
the dollar, and probably contributed to defined as “discouraged workers”.
a reckless monetary policy which has Once adjustment is made for the
mired the United States in excessive distortion of inflation, growth in
debt. But it may also have resulted in American real GDP since over the last
economic growth being reported over decade presents a gravely disturbing

strategy insights | issue nine 51

perfect storm | energy, finance and the end of growth

Fig. 4.5: What growth?* Fig. 4.6: What jobs?*

8% 20%
Official U-6
6% 18% U-3
4% 16%
-6% 4%
-8% 2%
-10% 0%
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
1981 1985 1989 1993 1997 2001 2005 2009

* Sources: Bureau of Economic Analysis and Tullett Prebon estimates * Source: Bureau of Labor Statistics

If these people were included, together In the face of persistently high levels economic data, it will surprise no-one
with other “marginally attached” of unemployment (even on the basis that government reporting all too
workers, and those who are in part- of the understated U-3 definition), often plays fast and loose with reality.
time work because they cannot find Americans have been asked to believe
full-time employment, the BLS itself in the concept of “jobless growth” as British citizens were treated to an
concedes (on its broader U-6 measure) a way of reconciling weak job data on example of this in April 2012 when
that the unemployment rate would the one hand with reported growth in the government, in taking over postal
have been over 14% in October 2012, GDP on the other. The real explanation workers’ pension funds, used fund
drastically higher than the 9.6% is simpler. It is that the economic assets (of £28bn) to reduce reported
recorded ten years previously (fig. 4.6). growth of the last decade seems to debt (and the published deficit as
Analysts who have unpicked all of have been illusory. well) whilst conveniently assigning the
the various methodological changes associated liabilities (£38bn) to off-
(including alterations to sampling fiscal distortion #1 – fast and loose balance-sheet “contingent liabilities”.
techniques) argue that the real rate If statisticians (people of integrity who The reality, of course, is that there
of unemployment is even higher, are at least nominally independent is nothing remotely “contingent”
particularly where this is defined to from government) have been drawn about the liabilities of a pension
include under-employment as well. into the accretive distortion of fund to pay the sums to which it
is contractually committed.

52 strategy insights | issue nine

The International Monetary Fund Portugal has done the same, at a cost probity – securitised pension payments
(IMF) is not known for producing (in annual payments) equivalent to 1% from Deutsche Post, Deutsche
controversial analyses of its member of GDP. At £8.7bn, British PFI payments Postbank and Deutsche Telekom,
governments’ activities, but a report13 in 2011-12 equated to 0.57% of GDP, receiving €15.5bn whilst at the same
published in March 2012 shed a great or 1.5% of government revenue, and time eliminating purchaser risk by
deal of light on some of the ways in these payments are projected to rise to guaranteeing future payments.
which government debts and fiscal £10bn by 2015-16.
deficits are massaged. Governments, Pensions payable to state employees
the IMF said, “can be tempted to Between 2001 and 2007, Greece used constitute huge off-balance-sheet
replace genuine spending cuts or tax swaps to hide €5.3bn of borrowing. liabilities for many governments,
increases with accounting devices that Belgium, Italy, Germany and Poland including the United Kingdom
give the illusion of change without have made similar debt-deferring (perhaps £1,000 bn, or 66% of GDP)
its substance”. use of swaps. Governments have and the United States ($5.8 trillion14,
also manipulated debt and deficits or 38% of GDP). Just as important,
“In retrospect,” the IMF said, “it is clear using sale-and-leaseback deals, annual increments to these obligations
that accounting devices contributed whilst privatisation, too, can have are excluded from reported deficits.
to the fiscal problems that many a manipulative effect when future Aggregate 2010 liabilities for selected
countries are now experiencing”. The income streams are divested for a governments are set out in fig. 4.7,
IMF report makes it clear that “hidden single payment which is booked which shows how massively Britain (in
borrowing” has been rife, examples immediately. Similarly, Greece particular) is burdened by off-balance-
cited including Portugal, Austria, securitised and sold lottery proceeds, sheet commitments. Importantly, this
Denmark, France and Sweden, to air traffic control fees and, remarkably, table excludes welfare obligations
which, of course, could be added the European Union grants, whilst both which, particularly in the case of the
Private Finance Initiative (PFI) device Belgium and Portugal securitised tax US, are enormous.
extensively used in Britain to defer receivables. During 2005-06, Germany
the cost of new hospitals and schools. – so often regarded as a model of fiscal

Fig. 4.7: Liabilities in 2010, selected governments*

% of GDP Debt Civil service pensions Other liabilities Total liabilities

Australia 14% 10% 8% 32%

Canada 37% 13% 8% 58%

New Zealand 36% 5% 25% 66%

United Kingdom 69% 81% 23% 173%

United States 62% 39% 12% 113%

* Source: IMF

Accounting Devices and Fiscal Illusions, IMF Staff Discussion Note, 28th March 2012
Source: Financial Report of the United States Government 2011 strategy insights | issue nine 53
perfect storm | energy, finance and the end of growth

fiscal distortion #2 – vanishing acts The commendable transparency trillion was attributable to Medicare
Governments are also well practised provided by the government of and $18.6 trillion to OASDI (old age,
at the arts of making things disappear. the United States gives analysts a survivors and disability insurance),
In Britain, for example, the failure probably-unparalleled amount of with the balance relating to railroad
of Railtrack was handled in such a insight into the true balance sheet pensions ($140bn) and black lung
way that its successor company’s position of a major government, provisions ($6bn).
debts were kept off the government though commentators still disagree
about the true scale of Washington’s During FY 2010, the outstanding
balance sheet, even though Network
indebtedness. Medicare liability was reduced
Rail had no private shareholders. It
by about $15 trillion, reflecting
was created as a company “limited by
At the end of fiscal year (FY) 2011, the assumption that the Obama
guarantee”, a status which precludes
official statistics16 showed debt “owed healthcare package will result in a very
the need to consolidate its debts into
to the public” – that is, excluding material reduction in future claims on
the government total. Current debt
debt held by other departments of Medicare. Whilst this is true, it is also
stands at £29bn, though borrowing
government – at $10,174bn, a figure somewhat disingenuous, in that the
plans (of £46bn) suggest that this
which in itself reveals a huge increase funding for healthcare will still need
total might expand very significantly.
over five years, since the equivalent to be sourced from taxpayers, such
Network Rail’s government guarantee
figure was $4,868bn at the end of that the future financial obligation has
is described as “unconditional”,
FY 2006. But the reported number been shifted further off-balance-sheet,
“irrevocable” and “unlimited”, which
excludes two very material lines of not eliminated altogether. At the end
gives the company’s debts “the same
quasi-debt. The first of these, included of FY 2011, net liabilities were $46.2
credit ratings as the UK sovereign”15.
in the official balance sheet, is a trillion, offset by anticipated future
Large though it is, Network Rail’s $5,792bn commitment to pay pensions receipts of $12.4 trillion.
contribution to the British state’s to government employees. The second
is a $4,711bn pool of federal debt owed What, then, is the true level of
off-balance-sheet liabilities pales into
to other parts of government. American federal government debt
insignificance when set against the
and quasi-debt? Inclusion of the entire
guarantees which Britain (and other
The significance of the latter number is off-balance-sheet liabilities associated
countries) provided to the banking
that it forms the principal asset of the with OASDI and Medicare would be
system during the 2008 crisis. Official
Social Security and Medicare systems, excessive, because these sums are
UK public debt (of £1,068bn, or 68% of
both of which have liabilities which far calculated on the basis of liabilities
GDP) rises to £2,169bn (138%) including
exceed their accumulated assets. At stretching 75 years into the future.
financial interventions. Inclusive of
the end of FY 2009, net liabilities were Few governments (or other
banking support, Network Rail, PFI
stated at $52.2 trillion in respect of institutions) measure their
commitments (which we estimate at
closed system claimants, a figure offset commitments that far ahead.
£170bn) and public sector pension
by $6.3 trillion which, it was assumed,
obligations, the true scale of British If we apply standard net present value
will be the net positive contribution
government debt and quasi-debt (NPV) techniques to the official net
of future scheme participants. Within
probably stands at about 215% of GDP. liabilities for FY 2009 but limit the
the $52.2 trillion FY 2009 figure, $33.5

54 strategy insights | issue nine 16
Financial Report of the United States Government
capture to 30 rather than 75 years, the 344%, depending upon whether the
quasi-debt total for closed scheme imputed component of GDP is left
participants declines from the reported in or excluded.
$52 trillion to about $41 trillion. This
figure falls further, to $36 trillion, Just as an assessment of federal off-
based on the FY 2011 computation in balance-sheet commitments produces
which the Obama healthcare system debt ratios large enough to scare small
is assumed to eliminate major forward monkeys, much the same can be said
Medicare liabilities. of the federal deficit. This number was
reported at $1.29 trillion in FY 2011,
This number, of course, is net of the equivalent to 8.6% of official GDP. But
assets held by OASDI and Medicare, increases in quasi-debt commitments
comprising federal debt of $4.7 trillion are running at an underlying rate
which OASDI, at least, is likely to start of about $2.7 trillion, meaning that
drawing upon in the near future. It also the real deficit is arguably $4 trillion,
excludes forward pension and welfare equivalent to 27% of official GDP, or
commitments to federal employees. 31% if imputations are excluded from
the GDP denominator.
Taken in aggregate, then, federal debt
and quasi-debt can be put realistically An underlying federal debt and quasi-
at $57.1 trillion, comprising debt owed debt total of some $57 trillion, on
to the public ($10.2 trillion), debt top of private, bank, state and local
held by other government agencies government debt of $44 trillion, could
($4.7 trillion), pension commitments be used by America’s critics to argue
to employees ($5.8 trillion) and the that the United States is bankrupt. Any
30-year portion of net quasi-debt such inference, if not fundamentally
commitments ($36.5 trillion)17. mistaken, most certainly would be
premature. America may be technically
Based on the official number for 2011 insolvent (in the sense that her
economic output ($15.1 trillion), this collective liabilities far exceed any
estimate of federal debt and quasi- remotely realistic calculation of the net
debt equates to 379% of GDP. If we present equivalent of future income
strip out the non-cash “imputations” streams), but she is not illiquid.
component of GDP ($2.3 trillion), the
federal debt and quasi-debt ratio
rises to 449% of a smaller GDP
denominator. Both numbers exclude
private, corporate, bank and state debt,
which total either 291% of GDP or

 he detailed numbers are:
- debt owed to the public: $10,174bn
- debt held by other government agencies: $4,711bn
- pension commitments to employees: $5,792bn strategy insights | issue nine 55
- estimated 30-year portion of net quasi-debt commitments: $36,472bn
Total: $57,149bn
perfect storm | energy, finance and the end of growth

56 strategy insights | issue nine

Fig. 4.8: US GDP, debt and quasi-debt, 2011*

$ trillions


$20 $15.1 Pensions

Imputations Intra-agency
Ex-imputations Official debt
GDP Debt & quasi-debt

* Sources: Financial Report of the United States Government and Tullett Prebon estimates

The bulk of America’s obligations are enormous official debt, but carry even That these payments will be subject
quasi-debts owed to the American larger, off-balance-sheet commitments either to massive devaluation or to
people, which essentially means as well. outright repudiation seems inevitable,
that forward welfare and pension in that the American, British and many
commitments cannot be honoured Of course, these obligations are not, other Western governments simply
(though few politicians are likely technically, the same as debt, in that cannot afford to honour the promises
to admit this). In the nearer-term, they are political rather than contractual made by their predecessors.
the blue-chip rating of American commitments which, in theory at least,
government paper, reinforced by can be cancelled by a simple vote in As we shall see, the deterioration in
the reserve status of the US dollar, Congress or Parliament. This said, it is energy productivity alone almost
probably means that Washington can difficult to envisage a situation in which guarantees that economies are
continue to live beyond its means for Congress tells contributors to Social poised to deteriorate. Where Western
some years yet. Security or Medicare schemes that countries are concerned, there is the
“we’re sorry, folks, but you’re not going additional problem that they have
The broader point, though, is that to get paid after all”, any more than crippled their own viability through the
the United States – and many other one can picture a British government policy disaster known as globalisation.
Western countries, most notably publically reneging on its public sector
Britain – are not only burdened with pension promises.

strategy insights | issue nine 57

perfect storm | energy, finance and the end of growth

58 strategy insights | issue nine

part five:

the killer equation

the decaying growth dynamic

The economy is a surplus energy equation, not a monetary one, and growth
in output (and in the global population) since the Industrial Revolution
has resulted from the harnessing of ever-greater quantities of energy. But
the critical relationship between energy production and the energy cost
of extraction is now deteriorating so rapidly that the economy as we have
known it for more than two centuries is beginning to unravel.

If one asked a representative sample is expressed – lies at the heart of the natural gas, coal and renewables –
of the public what economics is all current economic malaise. In essence, are dimensions of the same thing.
about, there is a very strong likelihood an ever-widening wedge has been We term this vital concept the
that the consensus answer would driven between the monetary and the commonality of energy.
be “money”. The vast majority of ‘real’ economies. A central argument
economists do indeed frame the set out in this report is that economic The fundamental fact of energy
debate in monetary terms. The problems will remain insoluble for so commonality is often obscured by the
problem with this is that the economy long as policymakers concentrate on use of different units to describe and
is not, fundamentally, a monetary monetary issues rather than on the measure different forms of energy.
construct at all. Economics is really ‘real’ economy. We go further than this, For instance, food is measured in
about the art of combining tangible arguing that the physical economy nutritional calories; work can be
components (such as labour and is, in essence, an energy system or, to measured as kilowatt-hours (kwh);
natural resources) to meet needs. be somewhat more precise, a surplus and fossil fuels tend to be expressed
Ultimately, money is a convenient energy equation. as gallons (of gasoline or distillate
way of tokenising this process. The fuel), barrels or tonnes (of oil), cubic
process itself, on the other hand, is the commonality of energy feet or cubic metres (of natural
an energy equation. If one is to understand the essentially gas) and tonnes (of coal). But these
energy-based nature of the economy, differing calibrations should not be
The basic misunderstanding over this it needs to be appreciated from the allowed to disguise the fundamental
point – the treatment of money as the outset that all forms of energy – commonality of all forms of energy.
substantive challenge, rather than as including food and work as well as
the language in which that challenge such ‘obvious’ types of energy as oil,

strategy insights | issue nine 59

perfect storm | energy, finance and the end of growth

As an illustration of the commonality corresponds to between 74 and 100

of energy, imagine filling the tank watts, the labour-equivalent of the
of a car with one gallon of gasoline, gasoline is in the range 364 to 492
driving it until the fuel runs out, hours of work. Taking the average of
and then paying someone to push these parameters (428 hours), and
it back to the start-point. The ability assuming that the individual is paid
of this person to do this depends, of $15 per hour for this strenuous and
course, upon sufficiency of nutrition, tedious activity, it would cost $6,420
itself an energy equation. Obviously to get the car back to the start-point.
enough, the energy contained in food On this rough approximation, then, a
is converted by the human being into gallon of fuel costing $3.50 generates
a capability for work, is exhausted, and work equivalent to between $5,460
requires continuous replacement. But and $7,380 of human labour.
this process is a circular one, in that the
cultivation of food is a process which One could come to a similarly-
itself requires energy inputs, be they leveraged calculation of the energy
the labour of human beings (most cost-to-price mismatch by measuring
simply in planting and harvesting), the the cost of employing workers
labour of animals, the employment of pedalling dynamo-connected exercise
machinery or the direct use of energy bicycles to generate the energy
inputs such as fertilizers. used by electrical appliances in the
typical Western home, and then
The exercise of putting one gallon of comparing the result with the
fuel into a car, driving it until the fuel average electricity bill.
runs out and paying someone to push
it back to the start-point also illustrates the great breakthroughs –
the huge difference between the price agriculture and the heat-engine
of energy and its value in terms of The development of society and of the
work done. economy is, in reality, a story of how
mankind overcame the limitations
According to the US Energy imposed by the energy equation. In
Information Administration18, one the pre-agrarian, hunter-gatherer era
(US) gallon of gasoline equates to (which lasted for at least 40,000 years),
124,238 BTU of energy, which in turn there was an approximate energy
corresponds to 36.4 kwh19. Since balance, in that the energy which
one hour of human physical labour each person derived from his food

124,238 (BTU per US gallon of gasoline) divided by 3,412
60 strategy insights | issue nine (BTUs per kilowatt-hour) = 36.412 kwh per gallon
was roughly equivalent to the energy be engaged in making agricultural of the second breakthrough. As
that he or she expended in finding implements, bridges to improve Daniel Webster put it, “When tillage
or catching that food. Put simply, access to fields, or mills which could begins, other arts follow. The farmers,
there was no energy surplus, and grind grain into flour. Investment, therefore, are the founders of
consequently no society. Each person properly considered, began when the human civilization.”
had to be self-sufficient, or perish. energy surplus created by agriculture
was deployed into the creation of Following the discovery of agriculture,
The first of the two great breakthroughs capital goods instead of products for the second (and vastly greater)
in human development was the immediate consumption. breakthrough in the development
discovery of agriculture. Farming seems of society and the economy was the
to have begun in the “fertile crescent”, Of course, the energy surplus created invention of the heat engine, which
an area which stretched from the Upper by agriculture was extremely modest enabled mankind to access the vast
Nile through modern-day Lebanon, by later standards. It was sufficient to energy resources contained in coal,
Israel and Syria to the basins of the create a very limited range of specialist oil, natural gas and other exogenous
Tigris and the Euphrates in what is now trades (such as smiths, millers and (non-human) sources.
Iraq, and to the upper coastal regions cobblers) and to provide rudimentary
on both sides of the Persian Gulf. This structures of government and law. Although, in antiquity, Archytas of
region is also known as “the cradle The most complex organisations Tarentum and Hero of Alexandria
of civilisation”. Evidence of cultivated of the pre-industrial age – religious seem to have played around with
grain suggests that the transition from establishments, and the shipping and jets of steam – and gunpowder was
a hunter-gatherer to an agrarian way trading industries – were extremely discovered in China almost a thousand
of life may first have occurred in about simple by later standards, though years ago – it is generally accepted
9,500BC, though millennia were to trading companies did begin to point that the invention of the true heat
elapse before some of the staples of the way towards later corporate engine occurred in 1769, when Scottish
organised agriculture (such as crop enterprises (in England, the East engineer James Watt (1736-1819)
rotation and the domestication of India Company and the Hudson’s Bay patented his steam engine. Although it
animals) were discovered. Company received their Royal Charters is arguable that the truly efficient heat
in 1600 and 1670, respectively, whilst engine did not arrive until 1799 – when
From an economic standpoint, the the Dutch East Indies Company was English inventor Richard Trevithick
significance of the development of established in 1602). (1771-1833) built a high-pressure
agriculture lay in the liberation of steam engine, and applied it to drive
surplus energy. If twenty individuals or The importance of the discovery of the first locomotive – the industrial
family units could now be supported agriculture lay in the creation of the revolution was well under way by the
by the labour of nineteen, the first energy surplus, because it would end of the eighteenth century.
twentieth was freed to undertake non- be this surplus that would make
subsistence activities. He or she might possible the vastly greater advances

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perfect storm | energy, finance and the end of growth

Fig. 5.1: World fossil fuel consumption since 1750*

Million tonnes of oil-equivalent per year

10,000 Coal





1750 1800 1850 1900 1950 2000

* Source: Tullett Prebon calculations and estimates from various sources

Fig. 5.2: American real GDP since 1790*

$bn at constant 2011 values





1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010

* Source: Tullett Prebon estimates from various sources

62 strategy insights | issue nine

The real importance of the industrial complexity and specialisation that exponential population,
revolution lay in harnessing exogenous are an accepted part of the modern exponential energy
energy resources to apply vast leverage economy. In the agrarian era, the A glance at figs. 5.1 and 5.2 reveals a
to the economy. Fig. 5.1 shows the truly overwhelming majority of people distinctive common feature, which is
enormous increase in the consumption laboured on the land, and non- that the trajectories both of energy
of fossil fuels since the onset of the agricultural trades were not only few consumption and real economic
industrial revolution. Fig. 5.2 shows in number but, for the most part, output display clear exponential
how, as typified by the United States, were closely associated with farming. characteristics, something which is
this expansion has been reflected in an In today’s developed economies, equally apparent in fig. 5.3, which
equally-dramatic increase in economic agricultural labour occupies only a charts global population numbers
output measured as real GDP. very small minority of the workforce, since 2000BC.
with the majority engaged in an
As well as contributing to a massive almost bewildering array of specialised Historians estimate that the population
quantitative increase in the economy, occupations, trades and professions, of the world totalled about 27 million
the energy dynamic has resulted in the vast majority of which have no in 2000BC, and grew only very gradually
the extraordinary social and economic relationship whatsoever to agriculture. thereafter, rising to 170 million two

Fig. 5.3: Exponential population growth, 2000BC to 2050AD*

Maximum capacity range




2000BC 1500BC 1000BC 500BC 0 500 1000 1500 2000

* Sources: US Census Bureau & United Nations

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perfect storm | energy, finance and the end of growth

millennia later. As recently (historically from agoraphobia. Since resources are and therefore impossible to measure,
speaking) as 1400, the population of not infinite, however, some experts but it was also too small to show
the world still totalled only 350 million, postulate a maximum global carrying up. In 1750, annual consumption of
and did not reach the first billion until capacity somewhere within the 8.5 fossil-based energy (consisting at that
1840, by which time the Industrial and 11 billion range shown on the time entirely of solid fuels) was about
Revolution was well under way. chart (though others believe that, 3 million tonnes of oil-equivalent.
under certain conditions, even the (mmtoe), rising, pretty dramatically,
Thereafter, however, population lower end of this range may become to about 52 mmtoe by 1850.
growth accelerated very rapidly, wildly over-optimistic).
reaching 2 billion by 1930, 3 billion by Oil did not become a measurably-
1960, and 6 billion by 2000. The total The striking feature of the exponential significant component of the energy
recently passed 7 billion, should reach growth in the global population over total until 1870, by which time fossil
8 billion well before 2030, and could be the past two-and-a-half centuries fuel consumption had reached an
9.3 billion (or more) by 2050. is the way in which it parallels estimated 142 mmtoe. Thereafter,
similarly exponential growth in the this total escalated, to 200 mmtoe by
If resources were infinite, this consumption of energy (fig. 5.4). 1880 and 400 mmtoe by 1895. The
progression would be of little or no Before about 1750, the consumption of total exceeded 1,000 mmtoe in the late
significance other than to sufferers energy was almost entirely untraded, 1920s, reaching 2,000 mmtoe by the

Fig. 5.4: Energy and the population*

Population (million)
Energy (mmtoe)





0 250 500 750 1000 1250 1500 1750 2000

* Source: Tullett Prebon calculations from various sources

64 strategy insights | issue nine

mid-1950s and almost 4,500 mmtoe unless there were things that could energy used in the economy. In other
by 1970. By the end of the 1980s – and be purchased with it, and the physical words, all goods and services on which
despite intervening energy price shocks economy formalised by money was, as money can be spent are the products
– consumption exceeded 7,000 mmtoe. we have seen, an energy dynamic of of energy inputs either past, present
Energy consumption broke through inputs and outputs. or future.
the 8,000 mmtoe barrier in 2000, and
exceeded 9,000 mmtoe just four years It is important to note that, in the The appreciation of the true nature
after that. In 2010, and despite the agrarian age, anything that could of money as a tokenisation of energy
onset of the economic slump in 2008, be purchased with money was the also enables us to put debt into its
total fossil fuel consumption exceeded product of human (or animal) labour, proper context. Fundamentally, debt
10,000 mmtoe. be that labour past, present or future. can be defined as ‘a claim on future
Purchasing, say, a plough amounted money’. However, since we have seen
the subservient role of money to paying for a product of past labour. that money is a tokenisation of energy,
Though economists, policymakers, Employing someone to plant a field it becomes apparent that debt really
investors and the general public involved payment for current labour. amounts to ‘a claim on future energy’.
customarily think in terms of Commissioning someone to build an Our ability, or otherwise, to meet
money, this conventional thinking item of furniture meant paying for existing debt commitments depends
is profoundly mistaken because, future labour. upon whether the real (energy)
ultimately, the economy is a physical economy of the future will be big
As we have seen, however, the terms enough to make this possible.
rather than a financial construct.
‘labour’ and ‘energy’ are coterminous
Rather than being in any sense
through the commonality of energy, Therefore, the viability (or otherwise)
fundamental, money serves to tokenise
so anything which could be purchased of today’s massively-indebted
output into a convenient form. After
with money was the product of energy, economies depends upon the outlook
all, the world economy has survived
past, present or future. for energy supply. If one chooses to
the demise of an estimated 3,800
believe that the exponential expansion
different paper currencies.20 With the broader term ‘energy’ in energy use that has powered the
replacing ‘labour’, exactly the growth of the economy (and the global
The roles of money can be defined as a
same relationship prevails in the population) since the dawn of the
medium of exchange, a unit of account
industrial societies of today, except industrial age can continue into the
and a store of value. The development
that exogenous energy inputs future, debts may be serviceable and
of money paralleled the emergence of
(overwhelmingly dominated by fossil repayable out of the economic (for
agriculture, the role of money being to
fuels) now provide the vast majority which read ‘energy’) enlargement of
tokenise the output of the economy
of the energy used in the economy. So the future. If such enlargement cannot
into a convenient form. Obviously, the
overwhelming is this preponderance be relied upon, however, then the
creation of money was a secondary
that, in Britain today, human labour debt burden can only be regarded
stage in the economic process, as
probably accounts for less than 0.5% as unsustainable.
there was no point in having money
of the aggregate human-plus-inputs

 ee Crash Course, chapter six,
S strategy insights | issue nine 65
perfect storm | energy, finance and the end of growth

Where debt is concerned, individuals resilient currencies that the world threat to this anticipatory economic
and businesses have only two possible has ever known – lost 87% of its system would arise if the availability
courses of action – they can repay purchasing power between 1961 of energy were to diminish (or even
their debts, or they can default. and 2011. To regard money as the simply cease to increase in the way
Governments, however, have a third building-block of the economy is that anticipatory finance necessarily
option, which is to repay debts profoundly mistaken. assumes). Since the 1950s, this threat
using money newly created for the has acquired a name – “peak oil”.
purpose. Instead of the ‘hard’ default at Hubbert’s Peak?
of reneging on debt obligations, As we have seen, then, the economy This peak oil concept – pioneered by M.
government can opt for the ‘soft’ is, in reality, an energy dynamic onto King Hubbert and accordingly known
default of ‘repaying’ their debts in a which has been grafted not just a as ‘Hubbert’s Peak’ – contends that,
currency which has been devalued by system of monetary tokenisation but, at some time in the relatively near
inflation. much more seriously, a system of future, we will have consumed half of
anticipatory finance which is viable all originally-available reserves of oil.
In any case, the real value of money if (but only if) it can be assumed that This concept is illustrated in fig. 5.5,
is subject to a constant process of there will be no significant check to which combines past consumption
destruction as its value is eroded by the process of exponential economic data with a representative subsequent
inflation. According to official figures, growth. Of course, the most obvious downwards curve.
even the US dollar – one of the most

66 strategy insights | issue nine

Fig. 5.5: The concept of peak oil*

1900 1920 1940 1960 1980 2000 2020 2040 2060 2080 2100 2120 2140

* Source: Tullett Prebon estimates from various sources, see text

strategy insights | issue nine 67

perfect storm | energy, finance and the end of growth

Fig. 5.6 & 5.7: Oil – feature …or blip?

mmtoe mmtoe
4,500 4,500
4,000 4,000
3,500 3,500
3,000 3,000
2,500 2,500
2,000 2,000
1,500 1,500
1,000 1,000
500 500
0 0
1900 1950 2000 2050 2100 2150 0 1000 2000 3000 4000

* Source: Tullett Prebon estimates from various sources, see text

At that point, Hubbertians argue, the has declined relentlessly. Since the more than a one-off event in which
supply of oil will decline, in pretty global peak discovery rate occurred in mankind has squandered a multi-
much a mirror-image of the increase the mid-1960s, it has been argued, a million-year energy inheritance in an
in consumption which has taken place similar time-lag implies that global evolutionarily-brief moment of history.
since the 1850s. Much the same, peak oil is now imminent.
they argue, will eventually happen As we have seen, a distinct exponential
to supplies of natural gas and of Advocates of the peak oil pattern links global population, energy
coal, with depletion of these sources interpretation argue that, seen on consumption and, it should be added,
accelerating as a result of substitution a timescale of social evolution, the a host of other linked parameters
from oil. era of the petroleum-based society including economic output and food
is not so much a manageable trend supply. If the availability of energy is
The peak oil process can already be (fig.5.6) as a one-off event (fig.5.7, the critical exponential driver in this
discerned in the context of individual which depicts exactly the same data as agglomeration, might a reversal in the
provinces such as the UK North Sea, 5.6, but extends the time-scale from energy exponential bring all of the
or of multi-province plays such as two hundred to four thousand years). others crashing down?
the Lower Forty-Eight (L48) States of Again, it has been argued that this
the US. Annual rates of petroleum same interpretation applies to other To be sure, reversing any of the critical
discovery in America peaked in 1930, fossil fuels such as coal and natural exponential progressions (be it energy
and peak production occurred forty gas, and that the current chapter in availability, economic growth or
years later, in 1970, since when output economic history amounts to nothing population expansion) will be painful.

68 strategy insights | issue nine

Indeed, society has absolutely no prior overstatement where conventional move that might yet be rendered
guide to how to manage successive reserves are concerned, most notably necessary anyway by environmental
(and perhaps rapid) decreases in in OPEC countries, where, for many considerations. The thirstiest vehicles
population and in economic output. years, the quota allocation process (such as SUVs22) would be consigned
A mass collapse of exponentials could incentivised the over-statement of rapidly to the scrap-heap, and private
be catastrophic. reserves. But the overall picture is one car ownership would be displaced
of relative abundance of reserves of oil by public transport. The second
The classic Hubbertian argument is of all types. effect of very high oil prices would
that oil production must soon enter be to incentivise exploration for,
an inexorable decline, because half The second error within the Hubbert’s and development of, resources
of the world’s originally-recoverable Peak theory is that it tends to ignore currently rendered uneconomic by
petroleum has already been extracted. economics. A scarcity of oil would their geological nature or their
The first flaw in this argument is that cause prices to rise massively. As we inaccessible location.
it is simply not true. The application of have seen, a US gallon of gasoline
the Hubbert thesis at this point implies costs about $3.50 but, in energy These arguments – and the apparent
that reserves were of the order of 2,200 terms, displaces human labour worth scale of remaining recoverable
bn bbls (billion barrels). Ample evidence perhaps $6,400. Scarcity-induced reserves – have generally enabled
exists to suggest that the originally- price escalation could be expected to peak oil sceptics (sometimes known
recoverable reserves base was at change this equation in at least two as ‘cornucopians’) to counter the
least 3,000 to 3,500 bn bbls, and very material respects. Hubbertians and thereby, in general, to
possibly much larger. The Hubbertian win the public debate.
case has considerable merit if it is First, a dramatic escalation in prices
applied to conventional oil, by which is would reduce demand by causing In so doing, they are providing the
meant light, sweet crudes which can greater frugality in the use of oil. right answers to the wrong question.
be extracted relatively easily. But there As world-leading energy expert The critical issue with peak oil does
is seemingly incontrovertible evidence Robert Hirsch argued (in a thesis that not hinge around remaining reserves.
that huge quantities of unconventional essentially leant towards the concept Rather, the critical issues are energy
oils remain to be extracted. of an oil production peak), there is a returns on energy invested (EROEI)
great deal that can be done to mitigate and deliverability.
In North America, tar sands reserves in the economic impact of oil shortages,
Canada are estimated at no less than always presupposing that action is The best way to illustrate the
170 bn bbls (billion barrels), whilst taken at least ten years ahead of deliverability issue is to compare oil
shales in the US alone may hold as the event21. sands reserves in Canada (about 170
much as 1,400 bn bbls of oil, though bn bbls) with conventional reserves in
the extraction of much of that oil may A society threatened by oil scarcity Saudi Arabia (about 270 bn bbls). Given
be, to put it mildly, problematical. In would be required to change that Saudi production capacity is about
South America, reserves of very heavy fundamentally. Suburbs – the 12 mmb/d (million barrels per day),
crudes in Venezuela are thought to quintessential characteristic of a one might, on a simple pro-rata basis,
be well in excess of 350 bn bbls. To be car-based society – would be replaced expect Canadian oil sands output to
sure, there seem to be many cases of by denser forms of habitation in a reach perhaps 7 mmb/d. But the reality

 ee Robert Hirsch et al, Peaking of World Oil Production: Impacts, Mitigation,
and Risk Management. This groundbreaking report was written for, but then
largely rejected by, the US Department of Energy
Sports-Utility Vehicles strategy insights | issue nine 69
perfect storm | energy, finance and the end of growth

is that output is most unlikely to reach replace natural declines from already- significance of these figures is that
even 3.5 mmb/d. Deliverability from producing fields. As the industry moves the downgrading of OPEC’s future
the Canadian resource, will, then, be from higher- to lower-deliverability demand forecasts resulted from the
less than half of that attained from fields, maintenance of existing sharp lowering in economic growth
conventional reserves in Saudi Arabia. production levels, let alone growth, expectations that occurred between
becomes ever more difficult. 2007 and 2012.
Not surprisingly, and for perfectly
logical economic reasons, oil reserves In the 2007 issue of the World Oil Though appreciably lower than the
have been ‘cherry-picked’, meaning Outlook, OPEC predicted that global cartel’s estimate five years ago (114
that the cheapest, highest-quality consumption of oil would rise to mmb/d), the current projection for
and most accessible reserves have 114 mmb/d by 2030, amounting to oil demand in 2030 nevertheless
been exploited first. What this in turn a 31% increase over expected 2010 represents a big (19%) increase from
means is that, even if reserves remain demand of 87.5 mmb/d. Five years the outturn in 2010 (84.9 mmb/d).
substantial, production levels might hit on, the demand projection for 2030
a ceiling in the relatively near future. had been reduced from 114 mmb/d Is this achievable? We doubt it, not
It also needs to be remembered that to 101 mmb/d, whilst consumption least because supply from existing
net changes in output represent a in 2010 turned out to be a lot lower sources of oil is declining by about
two-piece equation – substantial new (84.9 mmb/d) than OPEC had expected 6.7% annually. On this basis, an
sources are needed each year simply to in 2007 (87.5 mmb/d)23 (fig. 5.8). The overall supply increase of 14.4 mmb/d

Fig. 5.8: Oil demand – falling expectations*

millions of barrels per day

WOO 2007
WOO 2012
110 114 mmb/d

101 mmb/d



2005 2010 2015 2020 2025 2030

* Sources: OPEC, World Oil Outlook, 2007 and 2012 versions. Demand shown in millions of barrels per day, net of processing effects

70 strategy insights | issue nine 23

Consumption data sourced from OPEC, adjusted to exclude processing effects
between 2012 and 2030 would require the source of about half of the based on abundant and ever-increasing
the development of new sources kingdom’s production. hydrocarbon inputs might be running
delivering 76.4 mmb/d (more three out of road.
quarters of all output) by the latter Another way to look at the
date (fig. 5.9). This seems extremely deliverability issue is that reserves Neither should policymakers be fooled
improbable, not least because of the need to be quality-weighted. We may by the cornucopians’ argument that
deliverability issue described earlier. have used up much less than half technology will necessarily ride to
of the world’s originally-recoverable the rescue. As remarked earlier, this
Moreover, future supply projections reserves of oil, but we have, necessarily, argument is essentially equivalent to
assume that a large proportion of all resorted first to those reserves which the statement that, if one locked some
future net gains in production will are most readily and cheaply recovered. boffins up in a bank vault with enough
have to come from OPEC countries. The reserves that remain are certain to cash and a powerful enough computer,
This might be difficult to achieve, be more difficult and costlier to extract. they would eventually materialise a
particularly given that Saudi Aramco ham sandwich. Technology is not the
admits that it is injecting 13 mmb/d of Production may not ‘peak’ just yet, Seventh Cavalry, poised to ride to
treated seawater, most of it to sustain but a new concept (which we term the rescue.
production at its giant (but ageing) ‘resource constraint’) may soon kick
Al Ghawar field, historically in, implying that an economic model

Fig. 5.9: The oil supply challenge*


New supply
Existing sources


60 76.4

2012 2014 2016 2018 2020 2022 2024 2026 2028 2030

* Source: Tullett Prebon estimates from various sources

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perfect storm | energy, finance and the end of growth

Fig. 5.10: The energy returns cliff*

% ‘profit’ of gross energy extracted

Cost energy
80% Profit energy



Deteriorating EROEI

100 90 80 70 60 50 40 30 20 10 0

* Source: Tullett Prebon estimates, see text

energy returns – the killer equation of the economy is that it is a surplus ‘energy cost of energy’ is 0.99% (1/101)
An absolute decline in available energy energy dynamic, driven by the at an EROEI of 100:1, 3.8% (1/26) at
volumes, serious though that would difference between energy extracted 25:1 and 9.1% (1/11) at 10:1.
be, is not the immediate concern. The and energy consumed in the extraction
process. As we have seen, society and The best form of graphical
truly critical issue is the relationship
the economy began when agriculture presentation of EROEI is the “cliff
between energy extracted and the
liberated the first energy surplus. chart” (fig. 5.10). The horizontal axis
amount of energy consumed in the
Subsequent economic history has been shows EROEI as a multiple, running
extraction process. Known as the
a process of increasing that surplus by in this instance from 100:1 to zero.
Energy Return on Energy Invested
harnessing ever-larger quantities of The vertical axis divides gross energy
(EROEI), this is the ‘killer equation’
surplus energy. produced into “profit” (the dark, lower
where the viability of the economy is
area on the chart) and “cost” energy
concerned. Put very simply, there is
The mathematics of EROEI are pretty (the light area). At an EROEI of 100:1,
no point whatsoever in producing
straightforward. If the EROEI is 50:1, the picture is overwhelmingly one of
100 barrels of oil (or its equivalent in
this means that 50 units are extracted “profit”, in a profit-to-cost percentage
other forms of energy) if 100 barrels
for each unit invested in the extraction ratio of 99:1. The percentage ratio
(or more) are consumed in the
process. The division here is 50:1 remains very strong (98:2) at 50:1,
extraction process.
between ‘profit’ and ‘cost’ energy, and is still robust (96:4) at 25:1.
Though described earlier as an energy meaning that the net ‘cost’ of energy is
equation, a more precise definition 1.96% (1 divided by 51). Similarly, the

72 strategy insights | issue nine

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perfect storm | energy, finance and the end of growth

Below an EROEI of about 15:1, which were both smaller and bituminous and even sub-bituminous
however, the “profit” element falls off costlier, an increasing proportion coals, the latter offering barely half
a cliff, because there is an exponential being offshore. the energy content per tonne of
increase in the “cost” component, bituminous coal.
which rises from 4.8% at an EROEI of The petroleum industry has shown
20:1 to 6.3% at 15:1, 9.1% at 10:1 and enormous resourcefulness in Newer energy sources display a
16.7% at 5:1. This process of “cost” developing techniques such as water- similarly disturbing trend. At first
escalation is illustrated in fig. 5.11, and gas-injection, horizontal drilling, glance, the claimed EROEIs for onshore
which shows that energy cost is yet remote production and various wind power look pretty reasonable at
another addition to the collection of forms of advanced oil recovery (AOR) perhaps 17:1. However, the returns
exponential progressions (including as discoveries have become ever claimed for wind seem to make some
population, energy consumption and more technically and geographically pretty heroic assumptions about the
economic output) which dominate challenging, but the underlying trend longevity of generating plant and,
the world as we know it. This time, has been a relentless deterioration in in any case, wind turbines produce
however, the exponential progression EROEIs as costs have risen and average electricity, not the highly-concentrated
is a negative one. field sizes have declined. transport fuels upon which the
economy depends.
It is important to emphasise that the Believers in peak oil have seen this
cliff chart depicted in fig. 5.10 is not progression as an indication of ever- Other energy sources look even worse
time-linear. Even so, and as fig. 5.12 growing reserves stress, which indeed in EROEI terms. Biofuel EROEIs seldom
makes clear, the progression in energy it is. But the real economic significance exceed 3:1, and some are negative. The
sourcing is moving unmistakably and of this progression lies in a rapid much-vaunted “hydrogen economy”
inexorably towards ever-lower EROEIs. deterioration in EROEIs rather than in is a myth, because hydrogen acts as
an exhaustion of absolute reserves. The a store (not a source) of energy, and
Oil discoveries in the 1930s offered overall EROEI of the North Sea today is very inefficient in the way in which
EROEIs well in excess of 100:1, whereas may be no higher than about 5:1, a it converts energy obtained from
this ratio had declined to about 30:1 far cry from ratios in excess of 100:1 conventional sources. About 40% of
by the 1970s, and few discoveries yielded by the pioneering discoveries the initial energy is lost in conversion,
today offer an EROEI of much better in the sands of Arabia. perhaps another 15% is lost in the
than 10:1. In the heroic pre-War days collection process and, if the hydrogen
of the oil industry, the ratio was high, Much the same applies to other fossil energy is reconverted into electricity,
because a small energy investment fuels such as coal and natural gas. the process losses mean that one
(often consisting of little more than Where coal is concerned, fuel quality finishes with barely 15% of the energy
rudimentary onshore drilling and has deteriorated just as costs have put into the process in the first place.
wellhead equipment) could access risen. Almost all of the world’s original
extremely large oil fields. By the 1970s, reserves of anthracite (the best coal Policymakers who pin their hopes on
these ‘easy’ (low-cost) sources were in terms of energy content per tonne) unconventional hydrocarbon sources
well on the way to being exhausted, have already been exhausted, pushing are guilty of a quite extraordinary
and the industry was developing fields miners into ever greater reliance on degree of self-delusion.

74 strategy insights | issue nine

Fig. 5.11: EROEI and energy costs*


Energy cost as % of GDP





100 80 60 40 20 0


* Source: Tullett Prebon, see text

Fig. 5.12: EROEI and energy sources*

% ‘profit’ of gross energy extracted

80% Coal (at mine) 1970s oil & gas finds Wind power
1930s oil & gas finds Current oil & gas finds
60% Hydroelectricity Nuclear
Photovoltaic solar

EROEI Tar sands

Shale gas
100 90 80 70 60 50 40 30 20 10 0

* Source: Tullett Prebon, see text

strategy insights | issue nine 75

perfect storm | energy, finance and the end of growth

The EROEI of surface-mined tar sands is In an excellent discussion published in intervening inflation, this would be
probably little better than 3:1 (if that), 2010, analyst Andrew Lees suggests equivalent to the annual average
and those sands (accounting for about that the overall EROEI, having declined reference price of Brent crude oil
four-fifths of the total) which cannot from 40:1 in 1990 to 20:1 in 2010, having soared from $79.50/bbl to
be surface-mined can only be extracted might fall to as little as 5:1 by 202024. almost $280/bbl.
using massively energy-intensive Though Mr Lees does not cite sources
techniques such as SAGD (steam- for these numbers, his figures for 1990 Our own analysis begins with an
assisted gravity drive), such that EROEIs and 2010 accord pretty closely with our estimate of the overall cost of energy
are minimal, or even negative. own estimates. as a percentage of global GDP, which is
plotted for the period since 1965 in
The latest fashion in collective delusion Policymakers must hope that he is fig. 5.13. Energy costs, historically
concerns shale gas and oil. These may very wrong indeed, however, about the very low before 1973, were driven
indeed exist in vast quantities, but global average EROEI in 2020 because, to extremely high levels by the oil
EROEIs of barely 5:1 should make it if this ratio does indeed decline to just crises of the 1970s before falling back
abundantly clear that shales most 5:1 over the coming seven years, the markedly in response both to demand
emphatically are not the quick-fix economy as we know it is finished. It is destruction and to the incentivisation
that many governments (and their as simple as that. of previously non-commercial sources
electorates) might like to suppose. of supply.
The cost point here is critical. At the
where are we now? 40:1 ratio cited by Andrew Lees for As a result, energy was remarkably
As we have seen, then, there is an 1990, the theoretical cost of energy cheap during the 1980s and 1990s,
unmistakable trend towards lower would have been 2.43% (1/41) of averaging perhaps 3.1% of GDP
energy returns on energy invested, GDP. If the correct figure for 2010 was between 1986 and 1999, compared
with EROEIs falling within the indeed 20:1, then the ratio in that with an estimated peak of almost
fossil fuels slate just as society is year would have been 4.76% (1/21), 15% in 1979.
turning both to renewables (such a painful increase since 1990 but,
nevertheless, a ratio at which the Of course, and as we have seen, the
as wind power and biofuels) and to
surplus energy economy can value and the cost of energy are very
unconventional sources of hydrocarbon
still function. different concepts, and short- and
energy (including tar sands and shale
medium-term cost oscillation can
gas). The critical question (though it is
At a ratio of 5:1, however, energy be created by political and economic
one to which scandalously little official
would absorb 16.67% (1/6) of GDP, events largely unrelated to underlying
attention has been devoted) has to
meaning that energy costs would have fundamentals. Even so, we believe
be that of where the world is in terms
increased by 250% (16.67 compared that there is sufficient alignment over
of the overall EROEI, and where this
with 4.76) over just ten years. Put the longer term in the relationship
critical equation may be heading.
very simply, and ignoring (for now) between EROEI and cost for us to plot

Andrew Lees, ‘In search of energy’, Patrick Young (ed.),
76 strategy insights | issue nine The Gathering Storm, Derivatives Vision Publishing, 2010
Fig. 5.13: The underlying trend of EROEI?*

Energy cost as % of GDP

Estimated cost
EROEI cost curve?






1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 2030

* Source: Tullett Prebon estimates, see text

an estimated EROEI trend (in its cost- for 1990 (40:1) and 2010 (17:1) are Though our forecasts and those of
equivalent form) on a ‘best-fit’ basis. reasonably close to the numbers cited Mr Lees may differ in detail, the
for those years by Andrew Lees. For essential conclusion is the same. It is
Remember that what is being 2020, our projected EROEI (of 11.5:1) is that the economy, as we have known it
measured here is not the value of not as catastrophic as 5:1, but would for more than two centuries, will cease
energy, but its cost as a proportion of nevertheless mean that the share of to be viable at some point within the
the value that we derive from it. Cost GDP absorbed by energy costs would next ten or so years unless, of course,
and value could only be the same if have escalated to about 9.6% from some way is found to reverse the trend.
no surplus existed, which would also around 6.7% today. Our projections
mean that the economy could not further suggest that energy costs could This point requires further explanation.
exist either. absorb almost 15% of GDP (at an EROEI
of 7.7:1) by 2030.
Our assessment of the trend in EROEIs
is shown as the red line in fig. 5.13. On
this basis, our calculated EROEIs both

strategy insights | issue nine 77

perfect storm | energy, finance and the end of growth

EROEI decline – the road Let’s start with the straightforward this, some – shown in light blue – is
from wealth to poverty EROEI equation by comparing a high- used for essential purposes, such as
When looking at how a sharp decline and a low-EROEI economy, represented food production and the provision of
in EROEI affects the economy, we need here by figs. 5.14 and 5.15. Each chart healthcare, law and government.
to take note of two key points. The first subdivides the totality of produced The remainder, shown in dark blue
of these is that the slump in energy energy into three streams. The red and substantial in the high-EROEI
returns means that an ever-higher component is the proportion of the economy, powers all discretionary
share of total output will be absorbed extracted energy which has to be activities, including all other forms
by the cost of energy, meaning reinvested into the extraction process, of consumption and investment.
that less value remains for all other whether as infrastructure (capital) or in
extraction (operating) expense. If EROEI falls sharply, as in fig. 5.15,
purposes. The second is that energy is
much more of the gross energy is
central to the entire economy, and that
In a high-EROEI economy (fig. 5.14), consumed in the extraction process,
its effects go far beyond the obvious
the reinvestment requirement is small, resulting in a corresponding squeeze
‘costs’ of energy-related activities
leaving most of the produced energy on the energy available to the
such as transport and the generation
to be used to power the economy. Of economy. The essentials may still
of power.

Fig. 5.14: High EROEI Fig. 5.15: Low EROEI

Discretionary – consumption Discretionary – consumption

and investment and investment

Volume of Volume of
energy energy

Essentials –
food, welfare,
government, law
Reinvested in Essentials –
energy extraction food, welfare,
government, law
Reinvested in
energy extraction

* Source: Tullett Prebon estimates, see text

78 strategy insights | issue nine

be affordable, but the leverage in the
equation is such that energy available
for discretionary uses diminishes
very rapidly indeed. There, through
the EROEI squeeze, goes the car, the
holiday, the bigger home, the MP3,
the meal out, toys for the children, the
afternoon at the golf club or the soccer
match. If EROEI falls materially, our
consumerist way of life is over.

There are two really nasty stings in

the tail of a declining EROEI. First, net
energy availability may fall below the
amount required for essential purposes
including healthcare, government and
law. It is hardly too much to say that a
declining EROEI could bomb societies
back into the pre-industrial age.

Indeed, a decrease in net energy

below subsistence levels is an implicit
consequence of EROEI decline beyond
a certain point – one which is difficult
to estimate, but is likely to occur within
the next decade – which means that
this is when the nastiest results of all
start happening.

Second, of course, a decline in net

energy availability could (indeed,
almost certainly will) result in conflict
driven by competition for access to
diminishing surplus energy resources.

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perfect storm | energy, finance and the end of growth

80 strategy insights | issue nine

an unfolding collapse? The second is to increase output per constraint as to continuing increases
As we have seen, energy is completely hectare, which is what the “green in the global population. Of course, the
central to all forms of activity, so the revolution” has achieved – between cultivation of crops for fuels worsens
threat posed by a sharp decline in net 1950 and 1984, for example, global the squeeze on food availability and, as
energy availability extends into every grain production increased by we have seen, offers such low EROEIs
aspect of the economy, and will affect about 250%. that it is a wholly futile response to the
supplies of food and water, access squeeze on energy supplies.
The snag with this, of course, is
to other resources, and structures of
that the green revolution has, The knock-on effects of energy
government and law.
overwhelmingly, been the product constraint go far beyond food
The story of modern agriculture of energy inputs. Most obviously, issues, serious though these are. The
is one of feeding an ever-growing planting, harvesting, processing and production of most minerals would
global population from an essentially- distribution have been made possible be uneconomic without access to
finite resource base. At the time by fossil fuels, principally oil. Fertilizers relatively inexpensive energy. The
of population theorist Thomas have been sourced from natural gas, giant Bingham Canyon mine in Utah,
Malthus (1766-1834), it would have whilst most pesticides are made from for example, produces copper at
seemed inconceivable that the world petroleum. The impact of energy concentrations of about 0.25%, which
population could increase from 870 inputs on agricultural productivity means that some 400 tonnes of rock
million in 1810 to 6,900 million in cannot be calculated exactly, but some must be shifted for each tonne of
2010. That this has been achieved estimates suggest that these inputs copper produced, a process that is
has been solely due to the application have increased output per hectare by hugely energy-intensive. Most plastics
of exogenous energy to agriculture, at least 85%. The apparent implication are derived from either oil or natural
a process which has created an – which is that food production might gas. Desalination is extremely energy-
expansion in food production which decline by almost half if these inputs intensive, which means that any sharp
has exceeded the 7.9x increase in became unavailable – is almost escalation in energy costs will undercut
human numbers over the same period. certainly a severe understatement, an increasingly important source of
because it ignores both the leeching fresh water. Current plans call for
Essentially, there are two ways in of naturally-occurring nutrients and the quantities of water produced
which agricultural output can be the conditioning of the land to input- by desalination to increase from
increased. The first is to bring more intensive monoculture. 68 mmc3 (million cubic metres) in
land into production, which has indeed 2010 to 120 mmc3 in 2020, a plan
happened, but virtually all viable It seems highly probable that recent which looks wildly unrealistic if the
farmland was under cultivation food crises are directly linked to rising availability of net energy is declining at
by 1960. energy costs, and that escalating food anything like the rate that our analysis
prices owe at least as much to energy of trends in EROEI suggests.

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perfect storm | energy, finance and the end of growth

The logic of a deteriorating EROEI annual rate of 7.4% whilst the rest of - E nergy sprawl. Investment in the
suggests that investment in energy the economy shrinks by 0.5% per year. energy infrastructure will absorb a
infrastructure will grow much more steadily-rising proportion of global
rapidly than the economy as a whole knowing the score capital investment.
in a process that has been called Where the surplus energy equation
‘energy sprawl’. In essence, declining is concerned, one question remains – - E conomic stagnation. As the decline
productivity means that the energy how will we know when the decline in EROEIs accelerates, the world
infrastructure must increase more sets in? economy can be expected to become
rapidly than the volume of produced increasingly sluggish, and to fail to
energy, and this process is clearly The following are amongst the most recover from setbacks as robustly as
under way, though principally in the obvious decline-markers: it has in the past.
emerging economies (where energy - Energy price escalation. The - I nflation. A squeezed energy surplus
demand continues to increase) inflation-adjusted market prices of can be expected to combine with an
rather than in the developed world. energy (and, most importantly, of oil) over-extended monetary economy
This is most evident in the massive move up sharply, albeit in a zig-zag to create escalating inflation.
investment that is being poured into all fashion as price escalation chokes
aspects of the energy chain in China. off economic growth and imposes With the exception (thus far) of
short-term reverses in demand. inflation, each of these features has
The calculations here are daunting. If
become firmly established in recent
we assume (for the sake of simplicity) - Agricultural stress. This will be most years, which suggests that the energy-
that real GDP remains constant over obvious in more frequent spikes in surplus economy has already reached
a ten-year period in which the overall food prices, combined with food its tipping-point.
EROEI declines from 20:1 to 10:1, shortfalls in the poorest countries.
energy costs must rise at a compound

82 strategy insights | issue nine

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TPSI 009 | January 2013

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