2016 Financial Crisis

So far 2016 has been a year of worldwide economic turmoil. Although impossible predict when it would start, we’ve been preparing for such times. If there’s an insight as to why and how we started ‪#‎1MillionMinutes‬, it’s in this this post.

The intertwined mechanics of global economies are so enormously complex that trying to predict the behaviour of any one part is impossible. It’s like trying to predict weather by tracking individual air molecules.

Despite not being able observe things as small as atoms, we do know that atoms behave in ways dictated by natural laws. These laws govern everything that moves and changes in our universe.

When we aggregate large numbers of otherwise unpredictable elementary particles, their behaviours average out, making the direction of a whole system quite predictable. If we take enough atoms to create something as large as a planet, we can predict its motion through the universe with phenomenal accuracy.

Whether it’s an atom, a falling leaf or a supernova, everything abides by the same fundamental, immutable natural laws. They govern every second of our lives yet most people don’t even know they exist.

The two laws we’re interested in are the First and Second Laws of Thermodynamics. Firstly, energy cannot be created or destroyed and secondly, when energy changes form, it always becomes more dispersed. Not once has anyone observed or even see evidence of these laws being broken. Energy use follows strict, self-imposed rules. That’s all we really need to know.

Despite their massive complexities and innumerous parts, world economies also behave predictably at a large scale because, for the same reason, each of its tiniest elements are governed by these same natural laws.

Economies are systems for trading the things we value, those objects or services we need and want. What is common in everything we value is that energy is required to create them. Long ago, humans introduced money as more convenient medium to facilitate trade which means money has a direct equivalency with energy. Economic prosperity is created by either accessing new sources of concentrated energy or by more efficiently using the energy we currently have.

Great leaps in human progress were made when we began accessing new sources of energy. For the longest time, humans only used energy from what they digested and metabolized. A major step was taken when we started harnessing the energy stored in wood with fire and from wind. Coal, a far more concentrated form of energy, drove the industrial revolution. Not long after, people like Henry Ford pioneered processes to more efficiently make the things we value. We built trains that drove on low friction steel rails and made ships to transport what we wanted more efficiently. In the last 100 years we’ve benefited massively from the enormous amounts of energy released from fossil fuels.

As we gain access to more energy and create more things of value, the amount of money required to facilitate trade needs to grow accordingly. The way this occurs is through a somewhat disconcerting method of banking known as “fractional reserve lending”. You may be surprised to learn that a bank doesn’t actually hold the money you save with them. A large proportion of your money is lent out and becomes debt, that once spent, is then deposited into another bank. The process continues, creating an exponential increase in the amount of money in circulation. The total amount depends on the “reserve fraction” of savings a bank must hold and the prevailing interest rate. The lower the interest rate, the less it costs people and companies to borrow money, which encourages them to go deeper into debt. Debt is an obligation to pay back money in the future which means its effectively a promise to pay back future energy.

Debt itself is not a major problem. The problem is that not all debt is equal. Good debt is productive debt. It leads to more efficient production or access to new sources of concentrated energy. Bad, unproductive debt doesn’t achieve either of these things.

Not all debt has to be productive. People make mistakes, business fail. Freedom to take risks is a necessary part of a prospering society. For long term prosperity, there simply needs to be more productive debt than unproductive debt. And today, this is where we have a serious problem.

In the last thirty years, monetary policy has been continuously loosened in response to economic downturns. Central banks and governments have been creating more debt in the hope that it stimulates economic growth and prosperity. But rather than being used for productive purposes, we’ve ended up with increased levels of bad debt.

Too much easy money encourages investment in assets that aren’t productive. We get over supply of iron ore, oil and vacant buildings. Financial bubbles are inflated where ‘greater fools’ bids up prices on unproductive assets and companies. Organizations borrow money to buy their own stock. Governments capitalize (buy) unproductive organizations with more debt that taxpayers become accountable for.

The problem is that bad debt doesn’t pay for itself. It gets spent on things that do not unlock new sources of energy or improve the efficiency of current production. This debt becomes a burden that cannot be repaid. Instead of accepting this and defaulting on the debt, we have been doing the complete opposite. We have been effectively paying for current bad debt obligations with even more bad debt. The energy that is owed is being paid for with the promises of even more future energy.

This debt growth is encouraged by further inflating the money supply and lowering interest rates. But this simply encourages more unproductive debt. Fundamentally we cannot escape the fact that we’re promising ever increasing amounts of future energy and this energy cannot be created out of nothing. Anything else would directly violate the Laws of Thermodynamics.

Capitulation is inevitable but the process continues so long as debt levels become larger and money gets cheaper. The longer the process continues, the larger the reversal will be. While we can intuitively understand there’s a limit, how and when this limit will be reached is like tracking atoms. What we can see for sure at a macro level is that the system is heading for a wall. Promises of future energy must mean-revert to a more reasonable level. We simply cannot increase prosperity by using unproductive debt to pay for previous unproductive debt.

In reality, there are only a few logical outcomes for the predicament global economies find themselves in;
1. Currency devaluation. By reducing the value of the currency that the debt is denominated in, the real cost in terms of energy required to repay it becomes less. Effectively a dollar of currency used today buys fewer units of energy tomorrow. This is achieved by either inflating the money supply by increasing debt (governments selling treasuries etc.) or reducing interest rates. Politically, this is by far the preferred option. People get upset when the cost to buy the same things increase. This has been somewhat muted in recent years by limiting accesses to the additional debt. The money that gets borrow has inflated prices but rather than bread and milk, it’s stocks and bonds. The wealth gap between those who have access to the game and those that don’t has consequently grown. The other reason prices haven’t increased more significantly is because no one currency is being devalued in isolation. Every country is doing it.
2. The second outcome is outright collapse. Given that it is impossible to repay the amount of promised future energy in dollars of today, the most logical option is to simply default and not pay it back. When this happens things quickly spiral out of control. People quickly lose trust in the credit worthiness of their financial counterparties and are forced to call in loans. Money supply grows exponentially but can also shrink exponentially. Companies go bankrupt, followed by the banks who lent them the money. History tells us that in order to avoid the political ramifications of this, governments quickly revert back to Option 1. They borrow money and buy the companies considered “too big to fail”. In order to clean house, a failure and loss of unproductive companies needs to happen and their debt written off.
3. The third and highly unlikely outcome I only mention for completeness. That is, the future energy debt actually gets repaid. In order to achieve this there would need to be a discovery of very cheap, easy to access energy. Dreams of technology such as fusion are one of the few possibilities but this technology has been “ten years away for the last 60 years”. We already know it will be enormously expensive to build even if it returns more energy (money) then what gets put in. I’d hate to dismiss it because the next major step in the progress of humankind will be dependent on something like this. It’s just highly unlikely it will avail itself to us in time to pardon the energy debt we’ve currently created.

So what now? What to do in these times of ever increasing levels of unproductive debt? It’s actually very hard to know exactly. Picking a stock or financial option to trade is a bit like tracking a single atom. We should be cautious around leveraged assets and loss of wealth through currency manipulation. We’re entering an era where negative interest rates may become normal but this too will only further exacerbate the problems and size of the reversal when it begins.

In the last fifteen years I’ve lived by the principal that if you want to create prosperity, you have to align your actions with the laws of thermodynamics. You need to be either gaining access to new sources of energy or creating the things people value by using less energy. Our choice to take 2 years off work was partly in response to witnessing the increased difficulty of accessing future sources of energy. As a result, we chose to look for places where we can increase efficiency like in the construction of a house,http://www.1millionminutes.com/catego…/shelter-construction/

Anger will be an unproductive use of your energy. What will happen is an inevitable outcome based on the way our monetary systems have evolved. It will collapse and when it does we will learn and make improvements.

In the aftermath I hope that the relationship between thermodynamics and economics will be given more consideration. If we were to trade on the basis of Joules (units of energy) rather than fiat currencies, we may well find the foundation for our next evolution as a species. Our prosperity always has and always will be, dependent on accessing new sources of energy and using what we have more efficiently. Maybe, in the post-mortem of the next financial crisis, a lot more people will think so too.

#1MillionMinutes, 12th Feb 2016

Posted on February 12, 2016 in Energy & Evolution

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