What caused the Global Financial Crisis?

Trans-Alaska Pipeline - Atigun Pass

August 10th, 2012

 

Summary

 

There were several contributory causes:

 

  • The banking industry became consumed by greed and got carried away with making paper profits in a fiat currency world,
  • Political leaders behaved in an excessively self-centred and amoral manner, forgetting whose interests they were supposed to be representing
  • The pace of the rise in Sovereign debt levels accelerated following the implosion of the sub-prime mortgage market, and later spiralled out of control as more troubled banks and businesses held out their begging bowls. Now the debt levels are so large as to be unsustainable.
  • Vested interests in the coal and oil industries, mindless of social consequences, moved to entrench their competitive advantage in the energy industry.
  • Bonus-oriented captains of industry developed a mental fixation that next quarter’s profits should be higher than last quarter’s – even if this meant taking short cuts that would risk sabotaging the long term future of the business.

 

Overarching all of the above, the most important cause traces back to “energy” and to the fact that “Energy Return on Energy Invested” (EROEI) has been deteriorating since the 1980s across the planet.

 Explanation: If one converts all energy production (coal, oil, natural gas, nuclear,  hydroelectric, other) to barrels of oil equivalent (boe) one discovers that whilst the gross global production of boe per capita has been flat since 1980, the reality was that, because of deteriorating EROEI, the net production of energy was actually declining on a per capita basis. This is ultimately what “drove” the switch in emphasis of the authorities – from allowing value-add economic activity to be market driven, to encouraging credit-funded consumer demand to “force” economic growth.

 But such a strategy was bound to have consequences that might have been foreseen if the decisions of politicians and financiers had been constrained by ethics: Clearly, if one consumes more wealth than one generates then, eventually, one lands up with unsustainable debt levels.

 From a high level perspective, “energy” is what ultimately facilitates value-add activity. Without energy and the technologies that are empowered by this energy, entrepreneurs are impotent to build primary and secondary industry businesses. Without vibrant primary and secondary industry sectors, service industries are left with nothing to service. That is why the bankers and others in the finance industry are now relying on trading pieces of paper (currencies and derivatives) amongst themselves to create a mirage of economic growth.

 

**************

 Economists have known for many years that technological innovation and entrepreneurial initiatives are ultimately what drive economic growth.  Historically, they have thought of the links in the chain as follows:

 Technological Innovation → Industrial/Commercial opportunities → Entrepreneurial initiatives to capitalise on those opportunities → Formation of businesses → Investment of capital → Creation of employment opportunities → Additional purchasing power of the newly employed → Increase in the velocity of money → Economic Growth.

 Central banking and fiat money to one side, the origins of the problems that have manifested in today’s global economy can be traced back to the late 1970s.

 In its May 2nd, 1985 edition, the New Scientist Magazine published an article entitled “Swings, cycles and the global economy”. It was written by a physicist, Dr. Cesare Marchetti, who identified two additional links in the value-add wealth creation chain. He demonstrated that:

  1.  Successive (core) energy paradigms emerge in such a predictable manner that their emergence can be mathematically modelled with a high degree of confidence, and
  2. The technological innovations that drive the economy are spawned as a direct consequence of the emergence of these emerging energy paradigms

 

By implication, all economic activity – indeed, the very civilisation of humanity – is/was ultimately facilitated by energy.

 Chart 1 below shows Dr. Marchetti’s model dating back to the year 1860. The solid lines are the model and the actual history is represented by the squiggly lines. It can be seen that the fit was extraordinarily tight.

 Importantly, what was being modelled was the percentage of the energy market that each new energy paradigm was expected to win, and by when.

 

Chart #1: Emergence of new energy paradigms over time

 

 

 

 What drives the emergence of the new energy paradigms is debatable, but it is arguably as simple a concept as a combination of population growth and market saturation of the technologies that fed off the preceding energy paradigm. Indeed, using other models, Dr. Marchetti demonstrated that market saturation was very likely a significant factor, but let’s not get ahead of ourselves.

 A simplistic formula that allows ordinary people to understand how the Gross Domestic Product of an economy can be “managed” is as follows:

 Money supply (the amount of money available) X Velocity of money (the number of times the money turns over in any one year) = Gross Domestic Product. 

 A serious mistake the economists have made in recent years is that they have attempted to stimulate economic growth by growing the money supply and/or they have attempted to stimulate the velocity of money by making cheap credit available. Logically (they reasoned) if a consumer has easier access to money and/or can borrow money at low interest rates, then he/she will be more highly motivated to borrow and spend. The problem with this logic is that it takes no account of the relationship between the amount of consumption and the amount of value added.  Clearly, if more wealth is consumed than is contributed by the borrower then capital will be depleted and borrowings (debt) will rise. Since the 1980s, that is exactly what has happened in industrialised countries, until the point was reached where the debt levels can no longer be sustained.

 By way of example, the economy in the USA was in danger of imploding because of excessive real estate debts – that came about largely as a consequence of home mortgage loans to people who could not afford to make the repayments. Initially, the lending banks tried to mask these toxic loans by “bundling” them with good quality loans and selling parcels of the mixture of good and bad. Then, when the poison seeped through to become visible through the packaging, rather than allow the lending institutions to declare bankruptcy, the United States Federal Reserve reasoned that these institutions were “too big to be allowed to fail” because their failure would cause the entire economy to collapse. Therefore, the Fed took almost a trillion dollars of what came to be euphemistically describes as “troubled assets” onto its own balance sheet. 

 In simplistic terms, the Central Bankers disrespected the concept of value- add; and this was essentially how the world has landed up with around US$45 trillion of sovereign debt, as more and more governments bailed out more and more troubled companies that they deemed were “too big to be allowed to fail”.  But it didn’t end there.

 In turn, the financial institutions in particular, emboldened by the now demonstrable proof that they had a license to behave irresponsibly because governments would ultimately act as their safety nets, continued to behave ever more irresponsibly. Right now, as these words are being written, the open outstanding contracts in the derivatives markets (both buy and sell) have an estimated value of US$700 trillion. This is more than ten times the combined annual Gross Domestic Product of the entire planet.  We are living in a world where the politicians and bankers have taken leave of their senses. Pure logic dictates that this situation is not sustainable.

 Is the situation retrievable? Maybe, but let’s get one thing straight: It is not “money” that drives economic growth, it is value-add activity. Without value-add activity it makes no difference whether the medium of exchange is fiat money backed by nothing at all, or paper certificates backed 100% by gold (for example). Putting it another way: The world’s economic problems have not been caused (and therefore cannot be solved) by whatever monetary system we happen to have. They have been caused by a loss of momentum of value-add activities on a per capita basis. The explosion of fiat money and debt levels are “results”. They are not causes.

 This conclusion will be validated below. In the meantime, let’s take a closer look at the first chart above. It clearly showed that oil was projected to reach a maximum market share of around 50% somewhere around 1980. At that point, the world should have had a recession as the economic lungs breathed out. Thereafter the model was predicting that, in around 1990, natural gas would take over from oil as the dominant energy paradigm and the dominant facilitator of value-add activity.

 This brings us to the link between the emergence of new energy paradigms and the emergence of new “bunches” of innovations.

 

 Chart # 2 – Historical Innovation Waves

 

 

 What this chart shows is that innovations emerge in waves – as depicted by the straight trend lines that have emerged at increasingly acute angles since the first wood-related wave commenced at the beginning of the Industrial Revolution in the late 1700s.  The emergence of coal as an energy paradigm gave rise to a coal related innovation wave (a wave of inventions) that commenced in around 1850. (For example, steel rails for trains were invented in1857). The point where 50% of the innovations in the bunch intersected the energy curve is the year when those coal related innovations began to drive the world’s economic growth (1880). Oil finally began to “drive” world economic growth in 1937 and natural gas was forecast to take over from oil from 1993. This expectation never happened.

 How do we know that it never happened?

 We know because energy production per capita as measured in barrels of oil equivalent (boe) was flat between 1980 and 2008, as can be seen from line #3 in the chart below.

 

 Chart #3 – Global Energy output

 

 

 The above chart was reproduced by the author hereof in his novel, Beyond Neanderthal, as a means of illustrating the possible consequences of the failure of an expanding human population to either embrace significantly more powerful energy paradigm/s than fossil fuels, or modify the way we conduct our affairs. In this context, Beyond Neanderthal might be classified as a “power of positive thinking book” rather than a “science fiction book” or a “Bermuda Triangle book” as some might be predisposed to describe it. The chart was reproduced with permission of Dr Richard Duncan, author of the Olduvai Theory.

 It has already been observed that line 3 in the chart above has been flat for nearly 30 years. But does that portray a misleading picture?

 If one looks at the chart of Energy Return On Energy Invested below – source http://en.wikipedia.org/wiki/File:EROI_-_Ratio_of_Energy_Returned_on_Energy_Invested_-_USA.svg  – one makes a very disturbing discovery:

 

Chart #4 – Energy Return on Energy Invested

 

 

 In 1990, the EROEI of oil imports to the USA was around 40:1 – i.e It took one unit of energy investment to produce oil that contained 40 units of energy output.  However, by 2005, this number had fallen to around 15:1. Even more concerning, the EROEI of natural gas in 2005 was also around 15:1.

 With this latter mindset regarding a need to modify the way we behave, the question needs to be asked: Why did natural gas not take over from oil when it was forecast to do so, in around 1992?

 There were two reasons:

  1.  The coal and oil lobbies had become too well entrenched and this served to inhibit the emergence of the natural gas energy paradigm. In any event, from their perspective, there would have been no “net” energy benefit flowing from the production of natural gas. i.e. Other than lower CO2 emissions, there would have been no purpose served in investing large sums of money in natural gas production.
  2. “Control” of the economy had been hijacked by the financial authorities, who undermined the market’s emphasis on value-add by shifting the emphasis to control of money and credit.

 The chart below provides evidence of 2 above. It is reproduced from http://www.usgovernmentspending.com/spending_chart_1950_2015USp_13s1li011lcn_H0t   and it shows what has happened to US debt levels over the years. Note that Gross Public Debt began to rise in 1981/2, at almost exactly the point at which Dr. Marchetti’s model forecast that oil should have peaked in its market share. The conclusion that can be drawn from this is that, by 1982, the full (per capita) economic benefits of oil and related technologies had been realised. The chart also shows that by 1992, when natural gas should have taken over according to Dr. Marchetti’s model, instead of falling Gross Public Debt began to rise in earnest.  Although the so-called “dot.com boom” created a sort of Indian Summer for a few years, the supposed underlying growth wasn’t real. Information Technology advances enabled corporations to show growing profits by hollowing themselves out and thereby cutting costs. This was unmasked when the Global Financial Crisis emerged, which caused public debt to exploded to above 100% of GDP.

  

Chart # 5 – US Gross Public Debt

 

 

 

 Is there any evidence that the oil and coal lobbies were also exerting undue influence over the markets’ natural mechanisms?

 The answer to this question is not as obvious because the influence was very subtle. For example, many of the oil companies now own significant gas assets. i.e. It was not really up to the market to decide. Further, let’s have a look at this question in context of climate change.

 Source: http://www.cru.uea.ac.uk/cru/data/temperature/

 

Chart # 6 – Hadcrut Temperature anomalies chart

 

 

 

 Note how, coincidentally with the date at which oil was being forecast to lose its potency (in 1980) Global ambient temperatures began to rise. That was the point that scientists began to worry about Carbon Dioxide emissions. i.e. In addition to any reasons that Dr. Marchetti may have put forward, the pressure on the oil and coal lobbies to make way for cleaner energy technologies was rising.

 Indeed, by 1997, the “lobby” to do something about carbon emissions had reached a crescendo, and that was the year when the Kyoto Protocols were adopted by 37 industrialised countries and the European Union. Significantly, two countries failed to ratify the protocols: The USA, which at that time was heavily dependent on oil imports, in particular for its transport sector; and Australia, whose economy was, and still is, heavily dependent on coal exports.

 Quite apart from its impact on carbon emissions, the failure of these two countries to ratify the Kyoto protocols sent a message to the markets that the energy status quo would be maintained for the foreseeable future, and this effectively blocked the march-to-market of natural gas related innovations.

 It follows that 1 and 2 above together effectively sabotaged the free market forces, and below is evidence of one of the consequences. When the natural gas mining industry finally got its act together and started to produce gas, there was a paucity of demand because the technologies that would be applied to consume natural gas in large quantities hadn’t yet been commercialised.

 The chart below shows what happened to the price of natural gas. (Source: http://www.tradingeconomics.com/commodity/natural-gas )

 

Chart # 7 – Natural Gas Prices ($US per million btu)

 

 

 Note how the price began to rise in 2002, in anticipation of buoyant economic conditions, but that since the emergence of the Global Financial Crisis it has been falling, as supply availability increased and demand did not materialise. The position has been exacerbated by the fact that modern gas fracking – which only began to be used for the first time in 1997 (arguably several years after it should have) – has been seen to contaminate both groundwater with chemicals and the air with escaping methane. Presumably, it will take some time to address the technology issues and, in the meantime, many gas fracking sites have been put into limbo even as car and truck manufacturers are gearing up to adapt their designs for natural gas usage.

 The challenge we now face is that if debt levels are too high, and the world only began to seriously address the need to embrace alternative energies following the GFC, which implies that almost 18 years of catch-up is still required (2008 minus 1990, which was the year when natural gas should have taken over from oil) then how might we stimulate the economy to pay down the debt levels?

 On the one hand, if the central banks insist on continuing down the path of monetary stimulus or so-called “quantitative easing” then the likely result will be price inflation. In turn, if prices rise faster than value can be added, then consumers will buy fewer goods and services. Therefore, the velocity of money will fall and the “stimulation” will be ineffective. Real GDP may even shrink. On the other hand, if the debts are written off, and the natural gas paradigm is still too immature to take over, then the world will likely not have the ability to grow via the application of value-add that is focussed on technologies that hang off the natural gas. Some might argue that a world depression is inevitable because we’re damned if we do “stimulate” and we’re damned if we don’t.

 But all is not lost. It seems that unexpected solutions to the current debt problem will emerge because of some possible implications of an odd phenomenon that has been manifesting on chart #2:

  1.  The angle of the trend lines associated with the emergence of new bunches of innovations has become ever more acute – implying that the market now has the capacity to respond almost instantaneously to both challenges and opportunities.
  2. Another implication is that the linkage between any particular energy paradigm and the emergence of innovations is becoming less relevant. i.e. Going forward, innovations and value-add activity will no longer be as tightly bound to the emergence of any particular energy paradigms as they once were.
  3. Although it is drawing long bow at this stage, a third implication may be that the era of the industrial revolution is drawing to a close. It is conceivable that the emphasis on “growth” will begin to lose relevance to be replaced by an emphasis on “quality of life”.

 There are various conceptual reasons for this latter observation but they fall outside the scope of this essay. Suffice it to say that this outcome may not be long in coming given the recent quote attributed to Dr. Ben Bernanke, Chairman of the US Federal Reserve Board: “”We should seek better and more-direct measurements of economic well-being, the ultimate objective of our policy decisions”. It was reported in the media that he pointed to the Himalayan kingdom of Bhutan’s Gross National Happiness index, which underscores the truism in rich countries that money doesn’t buy happiness. (Source: http://finance.fortune.cnn.com/2012/08/07/bernanke-happiness-index/ )

 

Conclusion

 

 The evidence suggests that the Global Financial Crisis was caused by a shift in emphasis from value-add activities to stimulating demand by means of money and credit management which actions, in turn, finally careened out of control. It is crystal clear that the economy cannot be managed in this latter manner and that humanity absolutely needs to manage its affairs with a value-add orientation. Intriguingly, this orientation is now becoming disconnected from its historical links with successive energy paradigms. Therefore, it seems that the Industrial Era which has prevailed since the mid 1700s may be drawing to a close. Conceptually, humanity may be facing a new era of existence where “value” will be measured in terms of quality as opposed to quantity. 

 Author note:

 The question of “How do we get from where we are to where we want to be?” is outside the scope of this essay but the recognition of a need to redefine our values may be a critically important condition-precedent to any progress being made. Ultimately, that understanding was at the back of my mind when I wrote my novels. We are going to need “outside-the-box” thinking to get from where we are to where want/need to be.

Brian Bloom

Author, Beyond Neanderthal and The Last Finesse

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10 Comments


  1. Asher, 5 months ago Reply

    Great book, keep up the good work….already waiting for the next one.


    • Alexandre, 3 months ago Reply

      Would you rather spend our dlorals trying to figure out ways to clean oil spills?Sept. 11 made terrorism and the Middle East No. 1 on every American’s agenda, The oil spill has not made oil and energy a priority as it should have. To use existing technology is not true, that is misleading. 2 billion in grant funding for the manufacturing of advanced battery systems and components and vehicle batteries produced in the U.S.So your editorial on your question is misleading.


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    • Isabelle, 3 months ago Reply

      In awe of that aswenr! Really cool!


  2. Susi, 3 months ago Reply

    Am I the only one who feels that there is a large amount of price gouigng going on. The taking advantage of the fact that we have no say on how much we use,, we dont make the cars,,and thoiugh we try to avoid thelong drives,,and traffic,,we are still expected to bare the cost, and responsibility. We all know that expecting thegovernment to actually do,,or even say anything that would upset the fuel providers is rediculous,,their revenueis only benifited by the fact the price goes up. The government do something to reduce,,or control their ownincome,,fat chance. This whole thing is nothing but profiteering,,,using any and all outlandish excuses toraise prices,,,


  3. Yona, 3 months ago Reply

    Green technology tends to save more money in the long run, deiptse being more expensive to begin with for example, motion-sensing light fixtures that only turn on when someone walks into a room are more expensive than regular lights, but after a few years the reduced power usage saves money. What examples of green energy are you looking at that are so cost-inefficient? Around here (Midwest) people have been installing windmills, which are quite green that have consistently proven profitable.


  4. http://anwierzbicki75.tumblr.com, 1 month ago Reply

    Incredible points. Sound arguments. Keep up the good spirit.


  5. vehicle app, 4 weeks ago Reply

    Informative piece.
    You never fail to come up with the best subjects and Brian Bloom:
    Global economy is fixable is absolutely no exception to this rule.


  6. Transaction costs accounting, 1 week ago Reply

    Hi there! This post couldn’t be written any better! Reading this post reminds me of my old room mate! He always kept talking about this. I will forward this write-up to him. Pretty sure he will have a good read. Many thanks for sharing!


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