Nicole Foss

Jul 122018

Russell Lee Gas station, Edcouch, Texas 1939

Ilargi: Someone linked to this almost 8 year old article from Nicole (July 19 2010), on Twitter. And yes, it’s even more relevant now than it was when she wrote it. So here’s a re-run:


… the Smoot-Hawley Tariff Act of 1930 in the US, which drastically raised tariffs on imports, lead to retaliation by trading partners, and the resulting trade war dropped global trade by 66% between 1929 and 1934.

One more comment from me: Trump may be on to something with some of his tariff actions, but he risks having the US run headfirst into the brittleness of just-in-time supply lines.



Nicole Foss: As the world has become a smaller and smaller place over the last few decades, we think less about the differences between locations. Global trade has allowed us to circumvent many local constraints, evening out surpluses and shortages in a more homogenized world.

We have a just-in-time world built on comparative advantage, in the name of economic efficiency. Under this economic principle, every location should specialize in whatever activity it executes most efficiently and the resulting products from all areas would then be traded. The idea is that all will then be better off than they would have been had they attempted to cover all bases themselves for reasons of self-sufficiency.

Where countries had been inclined towards more expensive self-sufficiency, market forces have often made this approach untenable, as large cost differences can make countries or industries uncompetitive. Local production has been progressively out-sourced as a result.

By ‘better off’, economists mean that goods will be cheaper for all, thanks to global wage arbitrage and economies of scale. Globalization has indeed delivered falling prices for many consumer goods, particularly electronics. In an era of massive credit expansion (effectively inflation), such as we have lived through for decades, one would normally have expected prices to rise, as a lagging indicator of money supply expansion, but prices do not always follow money supply changes where other major complicating factors exist.

In recent years, the major complicating factors have been the ability to produce goods in places where wages are exceptionally low, the ability to transport those goods to consumer markets extremely cheaply and ready access to letters of credit.

For nominal prices (unadjusted for changes in the money supply) to fall during an inflationary period, real (inflation adjusted) prices must be going through the floor. This has been the effect of trade as we have known it, and it is all many of us have known. What we are not generally aware of is the vulnerability of the global trade system, due to the fragility of the critical factors underpinning it.


By producing goods, particularly essential goods, in distant locations, we create long and potentially precarious supply lines. While relative stability reigns, this vulnerability does not cause trouble and we enjoy cheap and plentiful goods. However, if these supply lines are disrupted, critical shortages could result. In a very complex just-in-time system, this may not take very long at all. Such as system is very brittle, as it has almost no redundancy, and therefore almost no resilience. When Jim Kunstler refers to efficiency as “the straightest path to hell”, it is this brittleness he is referring to.

The most ephemeral critical factor for trade is the availability of letters of credit. These became scarce during the first phase of the credit crunch in 2008, and the result was goods stuck in port even though there was robust demand for them elsewhere. Goods simply do not move without letters of credit, and these can dry up extremely quickly as a systemic loss of confidence results in a systemic loss of liquidity. In a very real way, confidence IS liquidity.

The Baltic Dry shipping index fell 96% in 2008 as a result, meaning that shipping companies were suffering. Although the index has recovered slightly during the recent long rally, it is still very depressed in comparison with its previous heights. Now that the rally appears to be over, on the balance of probabilities, letters of credit for shipping will come under renewed pressure, and goods will once again have difficulty moving. As demand also starts to fall, due to the loss of purchasing power in the depressionary era we are moving into, this will get far worse.




In a depression, trade is very adversely affected. One reason for this a highly protectionist beggar-thy-neighbour economic policies. For instance, the Smoot-Hawley Tariff Act of 1930 in the US, which drastically raised tariffs on imports, lead to retaliation by trading partners, and the resulting trade war dropped global trade by 66% between 1929 and 1934.




Thanks to globalization, we are much more dependent on trade than people were in the 1930s. The combination of credit drying up on the one hand and global trade wars on the other is an extreme threat to our vulnerable supply lines. Add to that the general upheaval created by severe economic disruption, which can easily lead to increased physical risks to transporting goods, and the longer term potential for much higher energy prices, and we could see an outright collapse of global trade in the approaching years.

The benefits of self-sufficiency will be seen in places where it still exists. So long as the whole supply chain is local, localized production means being able to maintain access to essential goods at a time when obtaining them from overseas may be difficult or impossible. It is currently more expensive, but the relative security it can provide can be priceless in a dangerous world. The ability to produce locally does not arise overnight however, especially where there are no stockpiles of components. In places where it has been lost, it will take time to regain. There is no time to lose.

We will be returning to a world of much greater diversity as we lose the homogenizing effect of trade. That means the existing disparities between areas will matter far more in the future than they have in the recent past. We will need to think again about the pros and cons of our local regions – what they can provide and what they cannot, and for how many people. Some areas will be in a great deal of trouble when they lose the ability to compensate for deficiencies through trade. As the global village ceases to exist, the world will once again be a very large and variable place.



May 182017

Pablo Picasso Bull plates I-XI 1945


Nicole Foss has completed a huge tour de force with her update of the Automatic Earth Primer Guide. The first update since 2013 is now more like a Primer Library, with close to 160 articles and videos published over the past -almost- 10 years, and Nicole’s words to guide you through it. Here’s Nicole:



The Automatic Earth (TAE) has existed for almost ten years now. That is nearly ten years of exploring and describing the biggest possible big picture of our present predicament. The intention of this post is to gather all of our most fundamental articles in one place, so that readers can access our worldview in its most comprehensive form. For new readers, this is the place to start. The articles are roughly organised into topics, although there is often considerable overlap.

We are reaching limits to growth in so many ways at the same time, but it is not enough to understand which are the limiting factors, but also what time frame each particular subset of reality operates over, and therefore which is the key driver at what time. We can think of the next century as a race of hurdles we need to clear. We need to know how to prepare for each as it approaches, as we need to clear each one in order to be able to stay in the race.

TAE is known primarily as a finance site because finance has the shortest time frame of all. So much of finance exists in a virtual world in which changes can unfold very quickly. There are those who assume that changes in a virtual system can happen without major impact, but this assumption is dangerously misguided. Finance is the global operating system – the interface between ourselves, our institutions and our resource base. When the operating system crashes, nothing much will work until the system is rebooted. The next few years will see that crash and reboot. As financial contraction is set to occur first, finance will be the primary driver to the downside for the next several years. After that, we will be dealing with energy crisis, other resource limits, limitations of carrying capacity and increasing geopolitical ramifications.

The global financial system is rapidly approaching a Minsky Moment:

“A Minsky moment is a sudden major collapse of asset values which is part of the credit cycle or business cycle. Such moments occur because long periods of prosperity and increasing value of investments lead to increasing speculation using borrowed money. The spiraling debt incurred in financing speculative investments leads to cash flow problems for investors. The cash generated by their assets is no longer sufficient to pay off the debt they took on to acquire them.

Losses on such speculative assets prompt lenders to call in their loans. This is likely to lead to a collapse of asset values. Meanwhile, the over-indebted investors are forced to sell even their less-speculative positions to make good on their loans. However, at this point no counterparty can be found to bid at the high asking prices previously quoted. This starts a major sell-off, leading to a sudden and precipitous collapse in market-clearing asset prices, a sharp drop in market liquidity, and a severe demand for cash.”

This is the inevitable result of decades of ponzi finance, as our credit bubble expanded relentlessly, leaving us today with a giant pile of intertwined human promises which cannot be kept. Bubbles create, and rely on, building stacks of IOUs ever more removed from any basis in underlying real wealth. When the bubble finally implodes, the value of those promises disappears as it becomes obvious they will not be kept. Bust follows boom, as it has done throughout human history. The ensuing Great Collateral Grab will reveal just how historically under-collateralized our supposed prosperity has become. Very few of the myriad claims to underlying real wealth can actually be met, leaving the excess claims to be exposed as empty promises. These are destined to be rapidly and messily extinguished in a deflationary implosion.

While we cannot tell you exactly when the bust will unfold in specific locations, we can see that it is already well underway in some parts of the world, notably the European periphery. Given that preparation takes time, and that one cannot be late, now is the time to prepare, whether one thinks the Great Collateral Grab will manifest close to home next month or next year. Those who are not prepared risk losing everything, very much including their freedom of action to address subsequent challenges as they arise. It would be a tragedy to fall at the first hurdle, and then be at the mercy of whatever fate has to throw at you thereafter. The Automatic Earth has been covering finance, market psychology and the consequences of excess credit and debt since our inception, providing readers with the tools to navigate a major financial accident.


Ponzi Finance

Nicole: From the Top of the Great Pyramid
Nicole: The Infinite Elasticity of Credit
Nicole: Look Back, Look Forward, Look Down. Way Down
Nicole: Ragnarok – Iceland and the Doom of the Gods
Ilargi: Iceland To Take Back The Power To Create Money
Ilargi: The Only Thing That Grows Is Debt
Ilargi: Central Banks Are Crack Dealers and Faith Healers
Nicole: Promises, Promises … Detroit, Pensions, Bondholders And Super-Priority Derivatives
Nicole: Where the Rubber Meets the Road in America
Ilargi: How Our Aversion To Change Leads Us Into Danger
Ilargi: Debt In The Time Of Wall Street
Ilargi: The Contractionary Vortex Of The Lumpen Proletariat
Ilargi: Hornswoggled Absquatulation


Fred Stein Evening, Paris 1934


The Velocity of Money and Deflation

Nicole: The Resurgence of Risk
Nicole: Inflation Deflated
Nicole: The Unbearable Mightiness of Deflation
Nicole: Debunking Gonzalo Lira and Hyperinflation
Nicole: Dollar-Denominated Debt Deflation
Nicole: Deflation Revisited: The Studio Version
Nicole: Stoneleigh Takes on John Williams: Deflation It Is
Ilargi: US Hyperinflation is a Myth
Ilargi: Everything’s Deflating And Nobody Seems To Notice
Ilargi: The Velocity of the American Consumer
Ilargi: Deflation, Debt and Gravity
Ilargi: Debt, Propaganda And Now Deflation
Ilargi: The Revenge Of A Government On Its People


Markets and Psychology

Nicole: Markets and the Lemming Factor
Ilargi: You Are Not an Investor
Nicole: Over the Edge Lies Fear
Nicole: Capital Flight, Capital Controls and Capital Fear
Nicole: The Future Belongs to the Adaptable
Nicole: A Future Discounted
Ashvin Pandurangi: A Glimpse Into the Stubborn Psychology of 'Fish'
Ashvin Pandurangi: A Glimpse Into the Self-Destructive Psychology of 'Sharks'
Ilargi: Institutional Fish
Ilargi: Optimism Bias: What Keeps Us Alive Today Will Kill Us Tomorrow
Nicole: Volatility and Sleep-Walking Markets


Real Estate

Ilargi: Our Economies Run On Housing Bubbles
Nicole: Welcome to the Gingerbread Hotel
Nicole: Bubble Case Studies: Ireland and Canada
Ilargi: Don’t Buy A Home: You’ll Get Burned


Berenice Abbott Murray Hill Hotel, New York 1937


Metals, Currencies, Interest Rates, and the War on Cash

Nicole: Gold – Follow the Yellow Brick Road?
Nicole: A Golden Double-Edged Sword
Ilargi: Square Holes and Currency Pegs
Nicole: The Special Relativity of Currencies
Nicole: Negative Interest Rates and the War on Cash
Ilargi: This Is Why The Euro Is Finished
Ilargi: The Broken Model Of The Eurozone
Ilargi: Central Banks Upside Down
Ilargi: The Only Man In Europe Who Makes Any Sense


China’s Epic Bubble

Nicole: China And The New World Disorder
Ilargi: Meet China’s New Leader: Pon Zi
Ilargi: China Relies On Property Bubbles To Prop Up GDP
Ilargi: Deflation Is Blowing In On An Eastern Trade Wind
Ilargi: China: A 5-Year Plan And 50 Million Jobs Lost
Ilargi: The Great Fall Of China Started At Least 4 Years Ago
Ilargi: Time To Get Real About China
Ilargi: Where Is China On The Map Exactly?


Commodities, Trade and Geopolitics

Nicole: Et tu, Commodities?
Nicole: Commodities and Deflation: A Response to Chris Martenson
Nicole: Then and Now: Sunshine and Eclipse
Nicole: The Rise and Fall of Trade
Nicole: The Death of Democracy in a Byzantine Labyrinth
Nicole: The Imperial Eurozone (With all That Implies)
Ilargi: The Troika And The Five Families
Ilargi: Globalization Is Dead, But The Idea Is Not
Nicole: Entropy and Empire
Ilargi: There’s Trouble Brewing In Middle Earth


Giotto Legend of St Francis, Exorcism of the Demons at Arezzo c.1297-1299


The second limiting factor is likely to be energy, although this may vary with location, given that energy sources are not evenly distributed. Changes in supply and demand for energy are grounded in the real world, albeit in a highly financialized way, hence they unfold over a longer time frame than virtual finance. Over-financializing a sector of the real economy leaves it subject to the swings of boom and bust, or bubbles and their aftermath, but the changes in physical systems typically play out over months to years rather than days to weeks. 

Financial crisis can be expected to deprive people of purchasing power, quickly and comprehensively, thereby depressing demand substantially (given that demand is not what one wants, but what one can pay for). Commodity prices fall under such circumstances, and they can be expected to fall more quickly than the cost of production, leaving margins squeezed and both physical and financial risk rising sharply. This would deter investment for a substantial period of time. As a financial reboot begins to deliver economic recovery some years down the line, the economy can expect to hit a hard energy supply ceiling as a result. Financial crisis initially buys us time in the coming world of hard energy limits, but at the expense of worsening the energy crisis in the longer term.

Energy is the master resource – the capacity to do work. Our modern society is the result of the enormous energy subsidy we have enjoyed in the form of fossil fuels, specifically fossil fuels with a very high energy profit ratio (EROEI). Energy surplus drove expansion, intensification, and the development of socioeconomic complexity, but now we stand on the edge of the net energy cliff. The surplus energy, beyond that which has to be reinvested in future energy production, is rapidly diminishing. We would have to greatly increase gross production to make up for reduced energy profit ratio, but production is flat to falling so this is no longer an option. As both gross production and the energy profit ratio fall, the net energy available for all society’s other purposes will fall even more quickly than gross production declines would suggest. Every society rests on a minimum energy profit ratio. The implication of falling below that minimum for industrial society, as we are now poised to do, is that society will be forced to simplify.

A plethora of energy fantasies is making the rounds at the moment. Whether based on unconventional oil and gas or renewables (that are not actually renewable), these are stories we tell ourselves in order to deny that we are facing any kind of future energy scarcity, or that supply could be in any way a concern. They are an attempt to maintain the fiction that our society can continue in its current form, or even increase in complexity. This is a vain attempt to deny the existence of non-negotiable limits to growth. The touted alternatives are not energy sources for our current society, because low EROEI energy sources cannot sustain a society complex enough to produce them.

We are poised to throw away what remains of our conventional energy inheritance chasing an impossible dream of perpetual energy riches, because doing so will be profitable for the few in the short term, and virtually no one is taking a genuine long term view. We will make the transition to a lower energy society much more difficult than it need have been. At The Automatic Earth we have covered these issues extensively, pointing particularly to the importance of net energy, or energy profit ratios, for alternative supplies. We have also addressed the intersections of energy and finance.


Energy, EROEI, Finance and ‘Above Ground Factors’

Nicole: Energy, Finance and Hegemonic Power
Ilargi: Cheap Oil A Boon For The Economy? Think Again
Ilargi: We’re Not In Kansas Anymore
Ilargi: Not Nearly Enough Growth To Keep Growing
Ilargi: Why The Global Economy Will Disintegrate Rapidly
Ilargi: The Price Of Oil Exposes The True State Of The Economy
Ilargi: More Than A Quantum Of Fragility
Ilargi: (Re-)Covering Oil and War
Nicole: Oil, Credit and the Velocity of Money Revisited
Nicole: Jeff Rubin and Oil Prices Revisited
Charlie Hall: Peak Wealth and Peak Energy
Ken Latta: When Was America’s Peak Wealth?
Ken Latta: Go Long Chain Makers
Euan Mearns: The Peak Oil Paradox – Revisited
Ilargi: At Last The ‘Experts’ Wake Up To Oil
Ilargi: Oil, Power and Psychopaths
Nicole: A Mackenzie Valley Pipe-Dream?


Unconventional Oil and Gas

Nicole: Get Ready for the North American Gas Shock
Nicole: Shale Gas Reality Begins to Dawn
Nicole: Unconventional Oil is NOT a Game Changer
Nicole: Peak Oil: A (Short) Dialogue With George Monbiot
Nicole: Fracking Our Future
Nicole: The Second UK Dash for Gas: A Faustian Bargain
Ilargi: Jobs, Shale, Debt and Minsky
Nicole (video): Sucking Beer Out Of The Carpet: Nicole Foss At The Great Debate in Melbourne
Ilargi: Shale Is A Pipedream Sold To Greater Fools
Ilargi: The Darker Shades Of Shale
Ilargi: Debt and Energy, Shale and the Arctic
Ilargi: London Is Fracking, And I Live By The River
Ilargi: And On The Seventh Day God Shorted His People
Ilargi: The Oil Market Actually Works, And That Hurts
Ilargi: Drilling Our Way Into Oblivion
Ilargi: Who’s Ready For $30 Oil?
Ilargi: US Shale And The Slippery Slopes Of The Law


Electricity and Renewables

Nicole: Renewable Energy: The Vision and a Dose of Reality
Nicole: India Power Outage: The Shape of Things to Come
Nicole: Smart Metering and Smarter Metering
Nicole: Renewable Power? Not in Your Lifetime
Nicole: A Green Energy Revolution?
Nicole: The Receding Horizons of Renewable Energy
Euan Mearns: Broken Energy Markets and the Downside of Hubbert’s Peak


Underwood&Underwood Chicago framed by Gothic stonework high in the Tribune Tower 1952


In the aftermath of the Fukushima disaster, TAE provided coverage of the developing catastrophe, drawing on an earlier academic background in nuclear safety. It will be many years before the true impact of Fukushima is known, both because health impacts take time to be demonstrable and because the radiation releases are not over. The destroyed reactors continue to leak radiation into the environment, and are likely to do so for the foreseeable future. The vulnerability of the site to additional seismic activity is substantial, and the potential for further radiation releases as a result is similarly large. The disaster is therefore far worse than it first appeared to be. The number of people in harms way, for whom no evacuation is realistic despite the risk, is huge, and the health impacts will prove to be tragic, particularly for the young.


Fukushima and Nuclear Safety

Nicole: How Black is the Japanese Nuclear Swan?
Nicole: The Fukushima Fallout Files
Nicole: Fukushima: Review of an INES class 7 Accident
Nicole: Fukushima: Fallacies, Fallout, Fundamentals and Fear
Nicole: Welcome to the Atomic Village


The Automatic Earth takes a broad view of the context in which finance, energy and resources operate, looking at issues of how society functions at a macro level. Context is vital to understanding the bigger picture, particularly human context as it relates to the critical factor of scale and the emergent properties that flow from it. We have continually emphasised the importance of the trust horizon; in determining what functions at what time, and what kind of social milieu we can expect as matters evolve.

Expansions are built upon the optimistic side of human nature and tend to lead to greater inclusiveness and recognition of common humanity over time. Higher levels of political aggregation, and more complex webs of trading relationships, come into being and achieve popular support thanks to the benefits they confer. In contrast, contractions tend to reveal, and be driven by, the darker and more pessimistic side of human collective psychology. They are social and are political as well as economic. In both directions, collective attitudes can create their own self-fulfilling prophecies at the societal level.

Trust determines effective organisational scale, extending political legitimacy to higher levels of political organisation during expansions and withdrawing it during periods of contraction, leaving political entities beyond the trust horizon. Where popular legitimacy is withdrawn, organisational effectiveness is substantially undermined, and much additional effort may go into maintaining control at that scale through surveillance and coercion.

The effort is destined to fail over the longer term, and smaller scale forms of organisation, still within the trust horizon, may come to hold much greater significance. The key to effective action is to know at what scale to operate at any given time. As we have said before, while one cannot control the large scale waves of expansion and contraction that unfold over decades or centuries, understanding where a given society finds itself within that wave structure can allow people and their communities to surf those waves.


Scale and Society

Nicole: Scale Matters
Nicole: Economics and the Nature of Political Crisis
Nicole: Fractal Adaptive Cycles in Natural and Human Systems
Nicole: Entropy and Empire
Nicole: The Storm Surge of Decentralization
Ilargi: When Centralization Scales Beyond Our Control
Ilargi: London Bridge is (Broken) Down
Ilargi: The Great Divide
Ilargi: Quote of the Year. And The Next
Nicole: Corruption, Culpability and Short-Termism
Ilargi: The Value of Wealth
Ilargi: The Most Destructive Generation Ever
Ilargi: Ain’t Nobody Like To Be Alone


Trust and the Psychology of Contraction

Nicole: Beyond the Trust Horizon
Nicole: Bubbles and the Titanic Betrayal of Public Trust
Ilargi: Why There Is Trump
Ilargi: Who’s Really The Fascist?
Ilargi: Ungovernability
Ilargi: Comey and the End of Conversation
Ilargi: Eurodystopia: A Future Divided
Nicole: War in the Labour Markets
Nicole: An Unstable Tower of Breaking Promises
Ilargi: Libor was a criminal conspiracy from the start


Affluence, Poverty and Debt and Insurance

Nicole: Trickles, Floods and the Escalating Consequences of Debt
Nicole: Crashing the Operating System: Liquidity Crunch in Practice
Ilargi: The Impossible and the Inevitable
Nicole: The View From the Bottom of the Pyramid
Ilargi: The Lord of More
Ilargi: The Last of the Affluent, the Carefree and the Innocent
Ilargi: The Worth of the Earth
Nicole: Risk Management And (The Illusion Of) Insurance


Fred Stein Streetcorner, Paris 1930s


Finally, TAE has provided some initial guidance as to how to position one’s self, family, friends and community so as to reduce vulnerability to system shocks and increase resilience. The idea is to reduce the range of dependencies on the large scale, centralised life-support systems that characterise modernity, and also to reduce dependency on the solvency of middle men. The centralised systems we take so much for granted are very likely to be much less reliable in the future. For a long time we have uploaded responsibility to larger scale organisational entities, but this has led to a dangerous level of complacency.

It is now time to reclaim responsibility for our own future by seeking to understand our predicament and take local control of efforts to mitigate its effects. While we cannot prevent a bubble from bursting once it has been blown, we can make a substantial difference to how widely and deeply the impact is felt. The goal is to provide a sufficient cushion of basic essentials to allow as many people as possible to preserve the luxury of the longer term view, rather than be pitched into a state of short term crisis management. In doing so we can hope to minimise the scale of the human over-reaction to events beyond our control. In the longer term, we need to position ourselves to reboot the system into something simpler, more functional and less extractive of the natural capital upon which we and subsequent generations depend.


Solution Space, Preparation and Food Security

Nicole: The Boundaries and Future of Solution Space
Nicole: Facing the Future – Mitigating a Liquidity Crunch
Nicole: 40 Ways to Lose Your Future
Nicole: How to Build a Lifeboat
Nelson Lebo: Resilience is The New Black
Nelson Lebo: What Resilience Is Not
Nicole: Sandy: Lessons From the Wake of the Storm
Nicole: Crash on Demand? – A Response to David Holmgren
Nicole: Finance and Food Insecurity
Nicole: Physical Limits to Food Security – Water and Climate
Ilargi: Basic Income in The Time of Crisis
Nelson Lebo: (Really) Alternative Banking Systems
Nicole (video): Interview Nicole Foss for ‘A Simpler Way: Crisis as Opportunity’
Happen Films: A Simpler Way: Crisis as Opportunity (full video)



Jan 092014
 January 9, 2014  Posted by at 1:44 pm Finance Tagged with: , , , , ,  33 Responses »

Dorothea Lange “Mr. Dougherty and kid. Warm Springs, Malheur County, Oregon” October 1939

David Holmgren, for whom I have the utmost respect, is best known as one of the co-originators of the permaculture concept. Permaculture is an ecological design method for regenerative agriculture, where the principles of natural systems are employed in order to create a self-sustaining means for food production while building soil fertility.

I am increasingly involved with permaculture (teaching it in Belize this February), as it represents one of the most important paths towards building workable life-support systems in our era of limits to growth. We are rapidly running out of options as we deplete our natural capital worldwide. While we badly need to make some informed hard choices, we collectively do not, as our consumptive system has tremendous inertia. As we reach the limits that lie in our not too distant future, permaculture can be of tremendous use, for those who implement it, in mitigating the impacts and facilitating rebuilding from the bottom-up.

David Holmgren’s Future Scenarios

Aside from his main body of work, Holmgren has also devoted significant consideration to exploring possible future energy descent scenarios, grounded in the twin threats of peak oil and climate change. See Future Scenarios from 2009. His thought modelling looks at how these limiting factors might intertwine with sociopolitical responses to create four classes of potential outcome.

The Brown Tech scenario was seen as one of modest energy supply decline combined with rapid climate change, in a centrally controlled, corporatist context emphasizing the development of unconventional fossil fuels and nuclear power. The impact of climate disruption and other discontinuities would lead to a greater need, and support, for large-scale government intervention. This scenario summarized as top down constriction of consumption.

The Green Tech route was envisaged as gradual energy descent, gradual climate impact, and would be typified by a controlled powerdown based on a shift towards renewable energy and electrification. The minimally disruptive move towards smaller-scale, relocalized, and distributed adaptations was seen as leading to greater egalitarianism.

Earth Steward describes a situation of rapid energy supply decline leading to economic collapse and major upheaval, reducing emissions sufficiently to address climate change, but eliminating larger political power structures. A rebuild from the bottom up would be required and would allow for design principles such as permaculture to be applied.

The final scenario – Lifeboats – involves both rapid energy supply collapse and severe climate impacts. Violent collapse would result in civilizational triage in isolated locations, with small-scale attempts to preserve knowledge through a long dark age.

Holmgren points out that these scenarios operate at inherently different scales in terms of energy density and organizational power, with Brown Tech operating at national scale, followed by Green Tech at city state scale, Earth Steward at the level of local community and finally Lifeboat at household scale. As such they can be described as nested. This is interesting as it is analogous to the nested adaptive cycles inherent in a fractal view of human and natural systems that we have described at The Automatic Earth . Scale is indeed a critical factor, and is primarily a function of energy availability. Holmgren argues that to some extent all scenarios are emerging simultaneously, operating at their different scales.

The initial scenario work was followed up in 2010 by a new essay, Money vs Fossil Energy: The battle for control of the world, looking at the financial system, and its interactions with the energy sector, as an additional important and limiting factor in models of how the future might play out in practice.  This perspective has recently been combined with an updated version of the scenario paper in Crash on Demand: Welcome to the Brown Tech Future. In this latest essay, Holmgren acknowledges he draws on our work here at The Automatic Earth, particularly in relation to projections for the global financial system and its role as a driver of global economic contraction. As such it seems appropriate to respond in order to extend the discussion.

In his recent essay, Holmgren says that he had initially been expecting a more rapid contraction in available energy, and with it a substantial fall in greenhouse gas emissions. Instead, new forms of unconventional fossil fuels have been exploited, sustaining supply for the time being, but at the cost of raising emissions, since these fuels are far more carbon intensive to produce. Holmgren understands perfectly well that unconventional fossil fuels are no answer to peak oil, given the terribly low energy profit ratio, but the temporary boost to supply has postponed the rapid contraction he, and others, had initially predicted. In addition, demand has been falling in major consuming countries as a result of the impact of financial crisis on the real economy since 2008, further easing energy supply concerns. For this reason, the Green Tech and Brown Tech scenarios, based on modest energy decline, appear more plausible to him than the Earth Steward and Lifeboat scenarios predicated upon rapid energy supply collapse. However, Green Tech would have required a major renewable energy boom sufficient to revitalize rural economies, and he recognizes that there appears to be no time for that to occur. Nor is there the collective political will to take actions to power-down or reduce emissions.

He concludes that the Brown Tech scenario appears by far the most likely, and is, in fact, already emerging. Rather than geological, biological, energetic or climate limits striking first, he suggests, in line with our view at TAE, that perturbations in the highly complex global financial system are likely to shape the future in the shorter term. As such he has become far more interested in finance, recognizing that the world has been pushed further into overshoot by throwing money at the banks, while transferring risk to the public on a massive scale, which is setting us up for a major financial reset. In combination with the climate chaos Holmgren anticipates that governments will need to assume control, moving from a market to a command economy.

Finance, Energy and Complexity

There is much I agree with here, most notably the primacy of financial collapse as a driver of short term change. The situation we find ourselves in is at such an extreme in terms of comparing the enormous overhang of virtual wealth in the form of IOUs with the actual underlying collateral that the reset could be both rapid and devastating. This could produce a number of cascading impacts on supply chains in a short space of time, as Holmgren acknowledges in citing David Korowicz’s excellent essay on the subject – Trade Off. This is likely to make governments choose to take control, but also likely to make that very difficult, and therefore very unpleasant. In some places control may win out, leading to a Brown Tech type of outcome after the dust has settled, and in others a more chaotic state may dominate, leading to more of a Lifeboat scenario. The difference may not hinge on energy supply alone, although this may well be a significant factor in some places.

It is our view at TAE that for a time energy limits are not likely to manifest, as lack of money will be the limiting factor in a major financial crisis. At the present time, with modestly increasing energy supply, the delusion of far greater increases to come, and falling demand, energy is already ceasing to be a pressing concern. As liquidity dries up, and demand falls much further as a result of both lack of purchasing power and plummeting economic activity, this will be even more the case. The perception of glut lowers prices, and this will hit the energy industry very hard due to its rapidly increasing cost base, and therefore its dependency on high prices. As prices fall and the business case disappears, much of the expensive supply will dry up, including most, if not all, of the unconventional fossil fuels currently touted as the solution.

Prices are likely to fall faster than the cost of production, leaving profit margins fatally squeezed. While money remains the limiting factor, few may worry about the energy future, but the demand collapse will lead to a supply collapse in the future due to lack of investment for a long time, the concurrent decay of existing infrastructure no one can afford to maintain, transport disruption due to a lack of letters of credit, and the impact of intentional damage inflicted by angry people. Financial crisis takes the pressure off temporarily, but a the cost of aggravating the energy shortfall, and the impact of that shortfall, in the longer term.

Producing energy from “low energy profit ratio” energy sources requires a financial system capable of providing copious amounts of affordable capital, and is dependent on the availability of cheap conventional fossil fuels in order to supply the up-front energy necessary for what are highly energy intensive processes. In energy terms, low energy profit ratio energy sources are nothing more than an extension of the current high energy profit ratio conventional fossil fuel era, which is what sustains the current level of socioeconomic complexity. The financial system is one of its most complex manifestations, and therefore one of its most vulnerable.

Once the financial system has the accident that is clearly coming, we will be looking at a substantial fall in societal complexity, but that fall in complexity will eliminate the possibility of engaging in such highly complex activities as fracking, horizontal drilling, exploiting the deep offshore or producing solar photovoltaic panels and inverters. “Low energy profit ratio” energy sources cannot by themselves maintain a level of socioeconomic complexity necessary to produce them, hence they will never be a meaningful energy source.

This is true of both unconventional fossil fuels and renewable power generation. The development of low energy profit ratio energy sources rests largely on Ponzi dynamics, and Ponzi schemes tend to come to an abrupt end.

Once this becomes clear, the gradual fall in supply is likely to morph into a rapid one. As the ability to project power at a distance depends on energy supply, and that may be compromised, perhaps within a decade, maintaining any kind of large scale command economy may not be possible for that long. However, consolidating access to a falling energy supply at the political centre under a command scenario, at the expense of the population at large, may sustain that centre for somewhat longer.

Seen through an energy profit ratio and complexity lens, a Green Tech scenario appears increasingly implausible. Green Tech – the use of technology to capture renewable energy and convert it into a concentrated form capable of doing work – is critically dependent on the fossil fuel economy to build and maintain its infrastructure, and also to maintain the level of socioeconomic complexity necessary for it, and the machinery it is meant to run, to function. A renewable energy distant future is certainly likely, but not a technological one. One can have green or tech, but ultimately not both.

Scale, Hierarchy and ‘Functional Stupidity’:

A substantial point of agreement between Holmgren’s work and ours here at TAE is that the scale Brown Tech would operate on in a constrained future would be national rather than international. There are many who worry about One World Government under a fascist model. This may have been the trajectory we have been on taken to its logical conclusion, but if crisis is indeed proximate, then we are very unlikely to reach this point. We have likened layers of political control to trophic levels in an ecosystem, as all political structures concentrate wealth at the centre at the expense of the periphery which they ‘feed upon’:

The number of levels of predation a natural system can support depends essentially on the amount of energy available at the level of primary production and the amount of energy required to harvest it. More richly endowed areas will be able to support -more- complex food webs with many levels of predation. The ocean has been able to support more levels of predation than the land, as it requires less energy to cover large distances, and primary production has been plentiful. A predator such as the tuna fish is the equivalent, in food chain terms, of a hypothetical land predator that would have eaten primarily lions. On land, ecosystems cannot support that high a level predator, as much more energy is required to harvest less plentiful energy sources.

If one thinks of political structures in similar terms, one can see that the available energy, in many forms, is a key driver of how complex and wide-ranging spheres of political control can become. Ancient imperiums achieved a great deal with energy in the forms of wood, grain and slaves from their respective peripheries. Today, we have achieved a much more all-encompassing degree of global integration thanks to the energy subsidy inherent in fossil fuels. Without this supply of energy (in fact without being able to constantly increase this supply to match population growth), the structures we have built cannot be maintained.

The international level of governance is comparable to a top level predator. When the energy supply at the base of the pyramid is reduced, and the energy required to obtain it increases, as will inevitably be the case in this era of sharply falling energy profit ratios, the system will lose the ability to support as many layers of ‘predation’. We are very likely to lose at least the top level, if not more levels on the way down as energy descent continues. A national level of Brown Tech may last for a while, but as energy descent continues, so will the diminution of the scale and complexity at which society can operate.

Living on an energy income, supplemented with limited storage in the form of grain or firewood or water stored high in the landscape, and also limited ability to physically leverage effort with slavery or the use of draft animals, does not provide the same range of possibilities as living on our energy inheritance has done. Without fossil fuels, the technology of the ancient world (Rome for instance) is probably the most that an imperial degree of energy concentration can provide. Greater concentration is possible when a wide geographical area comes under a single political hegemony and feeds a single political centre at a high level of political organization. Lower levels of political organization (ie during the inter-regnem in between successive imperiums) would provide for less resource concentration and therefore would sustain a lower level of socioeconomic complexity and ‘technology’.

Energy is not the only factor determining effective organizational scale, however. The functionality of the financial system is a major determinant of the integrity of supply chains, and hence social stability. Societal trust is vital, and can be extremely ephemeral. The more disruptive a future of limits to growth, across a range of parameters, the further downward through Holmgren’s nested scenarios we are likely to go.

In building scenarios, I would add rapid versus gradual financial crisis as a separate parameter. Personally, I believe a rapid financial crash combined with an initially slow, but then increasingly rapid fall in energy supply is the most likely scenario. Financial crisis can cause many of the effects Holmgren discusses in his scenario work in relation to energy and climate impacts.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

As for the climate change portion of the analysis, Holmgren points out that mainstream policy is shifting from mitigation to adaptation, in recognition of the failure to achieve any kind of progress on emissions control at the international level. Substantive action to reduce emissions is seen, for obvious reasons, as precipitating economic contraction, and no government is prepared to take that risk, especially when so many are on the edge financially in any case. Holmgren also addresses the growing realizations that reductions in emissions in one region may be bought at the expense of increases in another, with no net decrease overall, and that no decoupling between resource use and economic growth is feasible.

This is very much a position I would agree with. Decoupling is nothing but an illusion. There has always been a very close correlation between energy use in particular and economic growth. In the era of globalization we claim to have reduced the energy intensity of our developed economies, but we have in fact merely displaced the energy used to the new manufacturing centres. We import goods manufactured on some other economy’s energy budget (and water budget and other resources as well). The prospects for any kind of international agreement on emissions reduction, or any kind of efficacious top-down policy response at all, seem to be bleak to non-existent.

Internationally, no one party will agree to disadvantage itself in a competitive global economy when it does not trust that others will do the same. Nationally, policies favour growth and profit. Even policies ostensibly conceived to increase energy efficiency and reduce emissions may well be implemented in a manner having the opposite effect because some aspect of that implementation was profitable for some well connected party. For instance, a policy mandating high-tech smart metering for electricity requires complex manufacturing facilities a great cost in terms of both money and energy, but can deliver only minor load shifting, leading likely to a net increase in both energy use and emissions. Low-tech metering with consumer feedback could achieve far more in terms of energy savings at far less energy cost up front, but is less profitable, and so is not implemented.

Expecting governments to deliver any improvement whatsoever in this regard appears to be quite unrealistic. Governments achieve the exact opposite of their stated policy goals with remarkable regularity, all too often making bad situations worse as expensively as possible. Dimitri Orlov quotes, and further develops, a convincing explanation for this phenomenon or large scale ‘functional stupidity’:

Mats Alvesson and André Spicer, writing in Journal of Management Studies (49:7 November 2012) present “A Stupidity-Based Theory of Organizations” in which they define a key term: functional stupidity. It is functional in that it is required in order for hierarchically structured organizations to avoid disintegration or, at the very least, to function without a great deal of internal friction. It is stupid in that it is a form of intellectual impairment: “Functional stupidity refers to an absence of reflexivity, a refusal to use intellectual capacities in other than myopic ways, and avoidance of justifications.” Alvesson and Spicer go on to define the various “…forms of stupidity management that repress or marginalize doubt and block communicative action” and to diagram the information flows which are instrumental to generating and maintaining sufficient levels of stupidity within organizations.

Hence any meaningful change will need to come from the bottom-up.


I do not focus on climate change in my own work, partly because top-down policies vary between useless and counter-productive, and partly because, in my opinion, the science is far more complex and less predictable than commonly thought, and finally because success in generating a genuine fear of climate change is likely to produce human responses that achieve far more harm than good.

Many people seem to believe there is a linear relationship between carbon dioxide as a driver and increasing temperature as the result, but if there is one thing we know about climate it is that it is not linear. The models, while complex, have not been accurate predictors of the current situation and are therefore incomplete. As for the future, the models do not include factors such as the impact of an economic collapse or a large fall in energy use. There are multiple complex feedback loops that are not well enough understood, all of which interact with each other in highly complex ways. There is also a very long term cycle of natural forcings (note the time scale in thousands of years) providing the backdrop to anthropogenic impacts, and that is also not well enough understood. The net effect of the the very long term natural cycle and the much shorter term anthropogenic impacts is unknown. Global dimming, due to particulate matter in the atmosphere, affects incident solar radiation reaching the Earth. This could change on a much faster time scale than carbon dioxide, which has a very long residence time in the atmosphere, under conditions of economic collapse. This is also not adequately modelled.

In my view the situation is too complex and chaotic to make reliable predictions. In some ways what we think we know, on the basis of assuming a system to be simpler than it actually is, can be more dangerous than what we acknowledge we do not know, as we may take entirely the wrong actions and end up compounding the problem. See for instance Allan Savory’s excellent lecture on the attempt to reverse desertification (a major source of greenhouse gas emissions) through culling fauna, finding it had the opposite effect, and now attempting to remedy the situation while haunted by regret. His talk illustrates both a very important, but mostly ignored, factor in relation to climate change, and also the dangers inherent on relying on received wisdom. Overly simplistic models are often flawed, and applying them can easily cause, or fail to avoid, substantial harm that may then be difficult to reverse.

Apocalyptic predictions of near term human extinction have been made by some commentators, and drastic ‘solutions’ proposed as a result. I would regard such predictions as unlikely, disempowering and dangerous, in the sense that they could, when fear is in the ascendancy anyway, provoke a disproportionate fear response that could in itself be very destructive. When people become collectively fearful, they tend to over-react as a crowd, potentially causing more damage through that over-reaction than might have been caused by the circumstance itself. Fear can be exploited to provide a political mandate for extremists who would then be able to wreak havoc on the fabric of society. Fear needs no encouragement at such times. It will get more than enough traction, and do more than enough damage, all by itself. Actively undermining it is a better approach, as may keep more people in a constructive headspace.

If fear of apocalyptic climate change did grab the collective imagination, there are a number of outcomes which seem particularly plausible. All of them are counter-productive in some way. The first we have already seen – carbon trading system ponzi schemes. This involves financializing yet another aspect of reality, when over-financialization, and the consequent ballooning of virtual wealth, are what have led to our current debt crisis. Financialization is popular with the powerful, because it generates substantial, and concentrable, profits, feeding greater central control by Big Capital. It would probably also generate far more greenhouse gas emissions. Carbon trading allows the wealthy to continue business as usual while paying the poor to address the problems caused, but there is no guarantee that doing so would be effective. Perverse incentives would probably see the funds used for very different purposes.

The second predictable action is massive infrastructure investment in adaptation, which could consume large amounts of finite resources and generate substantial emissions. Large scale public procurement contracts are profitable, secure sources of on-going corporate income and are highly sought-after, as we have seen in Iraq for instance. Companies able to exploit the fear could benefit very handsomely today by building things that may or may not have any value in the future. They would have an incentive to play up the fear in order to extract contracts, and this would be harmful in itself.

The third possibility is widespread geo-engineering – the deliberate release of particulate matter into the atmosphere in order to increase global dimming. This amounts to interfering in a complex and delicate system with a blunt instrument, but it fits with the prevailing technological hubris and would probably generate substantial profits for someone, hence it is all too likely to catch on. The mentality behind it is that the problems of complexity can always be addressed with greater complexity, or in other words, business as usual must continue at any price, and the consequences can always be dealt with through technological intensification. Those consequences are unpredictable and could be disastrous.

The fourth plausible response is eco-fascism, along the lines of Holmgren’s Brown Tech scenario, but with a greenwash. Times of economic contraction tend to be times when people seek control over others, and control over access to the remaining supply of resources. Any excuse will do as a pretext for establishing command and control. Eco-fascism is simply fascism at the end of the day – a mechanism for depriving the masses and consolidating, and generally abusing, tight control in the hands of the few. It would make quality of life immeasurably worse and probably not reduce carbon emissions significantly, as control mechanisms are energy intensive.

Finally, we could see a mood of collective self-flagellation take hold, with the impulse to destroy what we have built on the grounds that it is purely destructive of the natural world. Being destructive in order to remedy destructiveness seems perverse, but is already being presented as a serious imperative in some circles. If implemented it would probably lead to the general demonization of environmentalists and the full range of ideas they propose, as well as do great harm to those least able to get out of the way.

Given that these five possibilities seem the most likely responses to real fear of climate change, and that all of them are likely to make the situation worse in some way, generating fear of climate change seems to be a counter-productive strategy. We could even see several of them at once, for a truly ghastly outcome causing harm on many fronts, and at many scales, simultaneously.

Where awareness is raised without visceral fear, climate change still does not seem to be a motivator for the kind of constructive behaviours that might make a difference in the aggregate. The scale is too large for people to feel that individual actions could ever be useful, which is disempowering. The time-frame is too remote, leading to complacency, and the consequences are not perceived as personal. As humans we are not typically very good at addressing problems which are neither personal nor immediate.

The economic contraction that is coming is very likely to have a far more substantial impact on emissions than any deliberate policy or collective action. The combination of this contraction and constructive collective action could be very powerful indeed, but achieving the latter action is not best done on the grounds of climate change. The same actions that would best address climate change in the aggregate are also the prescription for dealing with financial crisis and peak oil – hold no debt, consume less, relocalize, increase community self-sufficiency, reduce dependency on centralized life-support systems.

The difference is that both financial crisis and peak oil are far more personal and immediate than climate change, and so are far bigger motivators of behavioural change. For this reason, addressing arguments in these terms is far more likely to be effective. In other words, the best way to address climate change is not to talk about it.

Grass Roots Initiatives

Holmgren argues that time is running out for bottom-up initiatives to blunt the impact of falling fossil fuel supply. While simpler ways of doing things at the household and community level could sustain a less energy dependent world, uptake is limited and time is short. Holmgren points out that during the Soviet collapse, the informal economy was the country’s saving grace, allowing people to survive the collapse of much of the larger system. For instance, when the collective farms failed, the population fed themselves on 10% of the arable land by gardening in every space to which they had access. This kind of self-reliance can be very powerful, but the ability to adapt is path-dependent. Where a society finds itself prior to collapse – in terms of physical capacity, civil society and political culture – determines how the collapse will be handled. Dale Allen Pfeiffer’s excellent book Eating Fossil Fuels, comparing the Cuban and North Korean abrupt loss of energy supplies, makes this point very clearly. Cuba, with its much better developed civil society and greater flexibility was able to adapt, albeit painfully, while the rigidly hierarchical North Korea saw very much larger impacts.

Dimitri Orlov has argued very persuasively that the Soviet Union was far better prepared than the western world to face such circumstances, as the informal economy was much better developed. The larger system was so inefficient and ineffectual that people had become accustomed to providing for themselves, and had acquired the necessary skills, both physical and organizational. Their expectations were modest in comparison with typical westerners, and their system was far less dependent on money in circulation. One would not be thrown out of a home, or have utilities cut off, for want of payment, hence people were able to withstand being paid months late if at all and were still prepared to perform the tasks which kept supply chains from collapsing.

The economic efficiency of western economies, with very little spare capacity in a system operating near its limits, is their major vulnerability. As James Howard Kunstler has put it, “efficiency is the straightest path to hell”, because there is little or no capacity to adapt in a maxed out system. The combination of little physical resilience, enormous debt, substantial vulnerability even to small a small rise in interest rates, the potential for price collapse on leveraged assets, a relatively small skill base, legal obstacles to small scale decentralized solutions, an acute dependence on money in circulation and sky high expectations in the context of widespread ignorance as to approaching limits is set to turn the collapse of the western financial system into a perfect storm.

Time is indeed short and there will be a limit to what can possibly be accomplished. However, whatever people do manage to achieve could make a difference in their local area. It is very much worth the effort, even if the task at hand appears overwhelming. Given that a top-down approach stands very little chance of altering the course of the Titanic, we might as well direct our efforts towards things that can potentially be successful as there is no better way to proceed. Reaching limits to growth will impose severe consequences, but these can be mitigated. Acting to create conditions conducive to adaptation in advance can make a difference to how crises are handled and the impact they ultimately have.

Holmgren argues that collapse in fact offers the best way forward, that a reckoning postponed will be worse when the inevitable limit is finally reached. The longer the expansion phase of the cycle continues, the greater the debt mountain and the structural dependence on cheap energy become, and the more greenhouse gas emissions are produced. Considerable pain is inflicted on the masses by the attempt to sustain the unsustainable at any cost. If we need to learn to live within limits, we should do so sooner rather than later. Holmgren focuses particularly on the potential for collapse to sharply reduce emissions, thereby perhaps preventing the climate catastrophe built into the Brown Tech scenario.

He raises the possibility that concerted effort by a large enough minority of middle class westerners to convert from dependent consumers to independent producers could derail an already over-stretched and vulnerable financial system which requires perpetual growth to survive. He suggests that a 50% reduction in consumption and a 50% conversion of assets into building resilience by 10% of the population of developed countries would create a 5% reduction in demand and savings capital available for banks to lend.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

An involuntary demand collapse is, in any case, characteristic of periods of economic depression. Conversion of assets from the virtual wealth of the financial world to something tangible would have to be done well in advance of financial crisis, as the value of purely financial assets is likely to evaporate in a large scale repricing event, leaving nothing to convert. There are far more financial assets that constitute claims to underlying real wealth than there is real wealth to be claimed, and only the early movers will be able to make a claim. This is already well underway among the elite who are aware that financial crisis is approaching. In a world where banks create money as debt at the stroke of a pen, a pool of savings is not actually necessary for lending. Lending rests to a much greater extent on the perception of risk in the financial system. The impacts of proposed actions would not be linear, as the financial system is not mechanistic, meaning that quantitative outcomes would not necessarily be predictable. Holmgren recognizes this in his acknowledgement that small changes in the balance of supply and demand can have a disproportionate impact on prices.

Holmgren realizes the risks inherent in explicitly advocating such an approach, both at a personal level and in terms of the permaculture movement as a whole. These concerns are very valid. Permaculture has a very positive image as a solution to the need for perpetual growth, and this might be put at risk if it became associated with any deliberate attempt to cause system failure. While I understand why Holmgren would open a discussion on this front, given what is at stake, it is indeed dangerous to ‘grasp the third rail’ in this way. This approach has some aspects in common with Deep Green Resistance, which also advocates bringing down the existing system, although in their case in a more overtly destructive manner. In a command economy scenario, which seems at least temporarily likely, such explicitly stated goals become the focus, regardless of the least-worst-option rationale and the positive means by which the goals are meant to be pursued. A movement best placed to make a difference could find itself demonized and its practices uncomprehendingly banned, which would be simply tragic.

Decentralization initiatives already face opposition, but this could become significantly worse if perceived to be even more of a direct threat to the establishment. While they hold the potential to render people who disengage from the larger system very much better off, on the grounds of increased self-reliance, they also hold the potential to make targets of the early adopters who would be required to lead the charge. Much better, in my opinion, to continue the good work with the declared, and entirely defensible, goals of building greater local resilience and security of supply while preserving and regenerating the natural world. While almost any form of advance preparation for a major crisis of civilization would have the side-effect of weakening an existing system that increasingly requires total buy-in, there is a difference between side-effect and stated goal.

The global financial system is teetering on the brink of a major crisis in any case. It does not need any action taken to bring it down as it has already had easily enough rope to hang itself. Inviting blame for an inevitable outcome seems somewhat reckless given the likelihood that many will be casting about for scapegoats. Holmgren argues that, as those who warn of a crash are likely to be blamed for causing it anyway, they might as well be proactive about it. Personally, I would rather not provide a convenient justification for misplaced blame.

Holmgren discusses the case for seeking disinvestment from fossil fuel industries, citing the report Unburnable Carbon 2013: Wasted Capital and Stranded Assets. The premise of this report is that 60-80% of the fossil fuel reserves on the books of energy companies could become worthless stranded assets if governments implemented decisive action on climate change. If this perception caught on, the authors suggest it might cause investors to dump the sector rapidly, causing a proportionate loss of share value as a result. Financial markets do not work this way. Prices are not based on the fundamentals, and the prevailing positive feedback dynamics cause disproportionate reactions in both directions. Shares in fossil fuel companies will never be valued rationally in accordance with the supposedly predictable impacts of government regulation. Just as they are over-valued at times when commodities are prices peaking on fear of imminent shortages, they become undervalued in the following bust. First they are bid up beyond what the fundamentals would justify, then they crash to far below.

Personally, I regard the probability of governments acting to actually constrain emissions as negligible in any case, for reasons already discussed. Comprehensive regulatory capture has ensured that Big Capital writes the rules by which it is regulated. It is not going to impose controls which harm its own profitability. Energy is inherently valuable, and will only become more so in an energy constrained future. (However, the value of energy and the value of energy companies are not the same thing.) While low energy profit ratio energy sources are only a manifestation of the current bubble, and will eventually be abandoned out of necessity, remaining high energy profit ratio energy sources are highly unlikely to be left underground in the longer term, whatever the impact of burning them might be.

Their exploitation may well be delayed during a period of economic depression where demand would be low, financial risk would be high as price would fall faster than the cost of production, and economic visibility would be low. Very little investment occurs during contractionary times, but as the economy eventually moves into a form of limited recovery, demand would pick up and resource constraints would reassert themselves as limiting factors. At that point, anything which could be exploited almost certainly would be, and there may well be conflict over the right to exploit resources. Oil remains liquid hegemonic power and adequately accessible reserves will never become stranded assets.

In a world of short term priorities, longer term considerations are not taken into consideration, and the destabilization inherent in a period of crisis only aggravates short-termism by causing discount rates to spike. Unfortunately, environmental concerns are longer term.

Holmgren emphasizes the need to prioritize local investment in the real economy, with which I very much agree. He points out that affluent nations have a long history of extracting wealth from the informal household and community sectors for the benefit of the formal, monetized economy, but that we have little experience of reversing that trend. Michael Shuman’s excellent book Local Dollars, Local Sense makes the case for the substantial benefits that could be achievable if such a shift were to take place. Of course, as already discussed, time is short, but still, any informed action taken in advance of crisis could have disproportionately beneficial effects later on. For instance, promoting business entities with a cooperative structure can be a powerful tool for maintaining relatively local control.

One way to promote local spending is to introduce a local currency. While it may well be impossible to persuade people to spend national currency only locally if it meant paying more or limiting choices, a local currency must be spent locally as it would not be accepted elsewhere. Every monetary unit spent, and therefore circulating, locally has far more beneficial effect than one spent outside the area. External spending siphons wealth away from communities, and we have been encouraged to spend almost everything externally in recent years. Cheaper alternatives operating with economies of scale have deprived local business of a market for their goods and services, often eliminating those local options over time. This is how the centre thrives at the expense of the periphery. Reversing this trend may well require instituting a monetary system which removes the option to spend it elsewhere. This, if it can persist for long enough, should act as a driver for the provision of local goods and services.

Local currencies can run in tandem with national currencies and can act to expand the money supply in a defined area. As such they can be particularly useful to address the artificial scarcity of a liquidity crunch, where people and resources still exist, but cannot be deployed for lack of money in circulation. Local currencies can be designed to depreciate, which acts as an explicit support for the velocity of money. However, this may cause difficulties if local and national currency are convertible and the national currency does not depreciate. On the other hand, lack of convertibility could make it more difficult to confer value and full acceptability on the local currency. An alternative currency which can be used to pay local taxes will have a distinct advantage in terms of acceptability as was the case in the classic example – the depression-era Austrian town of Wörgl.

Of course a money monopoly is a very significant power, and as such is very likely to be defended, as indeed it was in depression-era Austria. This limits the prospects, and likely the duration, for alternative currencies, but they nevertheless achieve a great deal while they operate, as they currently are doing in Greece. Eventually, in a period of sufficient upheaval, a money monopoly may be impossible to sustain, then local currencies would be freer to operate. They would still be subject to distortions for political gain, money printing and ponzi dynamics over the longer term, given that they would still be operated by corruptible human beings, but at least these would exist on a smaller scale, not representing systemic risk as the flaws in the larger financial system currently do. Essentially there is no such thing as an inflation-proof, peer to peer system which would be expected to be stable over the long term, as monetary systems move in cycles of boom and bust. It is our job to navigate the waves of expansion and contraction which we cannot eliminate.

Any initiative which reduces our dependence on national currency in circulation is going to be useful in this regard, including barter networks, time-banking, tool and seed libraries, and gifting. There are already well established barter networks in some countries operating at a national scale, for instance Barter Card in New Zealand and the WIR network in Switzerland. Additional networks at a local scale could also be very useful, although more inherently limited in scope. Time-banking, libraries and gifting are more profoundly local, and act not just as means of exchange without the need for money, but also as mechanisms to build trust and community cohesiveness. This is a tremendous benefit in its own right, as a major boost for local resilience.

Holmgren points out that holding cash under one’s own control, outside of the banking system can greatly increase resilience by reducing dependency on the solvency of middle men. This is very much in accordance with our position at TAE, as cash is king in a period of deflation. People who spend in cash tend to spend less as it feels more like spending than electronic payments do. They tend therefore to be less likely to be overstretched and vulnerable to a financial collapse.

Building Parallel Systems

Holmgren stresses the urgent need to opt out of the increasingly centralized and destructive mainstream though building parallel systems prior to the advent of a Brown Tech future, which he feels could last many decades before descending further into a low-energy Lifeboat scenario. He points out that at the moment we have the luxury of keeping one foot in each camp, so that we have the opportunity to develop alternatives before we have to rely on the results. We can experiment, but with a safety net.

I am in agreement, with the exception of the timeframe for the longevity of a Brown Tech system. The scale of the coming disruption, albeit initially due to financial rather than energy crisis, is likely to be large enough to shorten the length of time the political centre can maintain the ability to project power at a distance. Learning curve time for opt-out solutions, short as it may be, could be very valuable. Unfortunately, attempting to straddle two worlds simultaneously can involve all the work of both with few of the benefits of either, hence moving over as far as possible to concentrate on the opt-out position is probably more adaptive.

As Buckminster Fuller said, “You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” In other words, change comes incrementally and organically from the bottom-up, rather than by fighting to change top-down policies. Initially, pushing for grass roots change can require considerable human energy input, but once a critical mass is reached the movement can take on a life of its own very rapidly, especially if it suddenly coincides greater advantage as prevailing circumstances shift. The proactive phase is difficult, as people rarely prepare in advance for approaching change, but proactive can become reactive as the change is reached, and the earlier effort can help to shape the direction that eventual reactive response will take.

Ideas that hit the zeitgeist can become fashionable, and this imparts much greater momentum. For instance, the tiny house movement is making it a matter of pride to live in smaller and simpler dwellings, with greater emphasis on good design than physical space. More and more young people are choosing to opt out of the path taken by their peers, as that path towards debt slavery becomes ever more obviously disadvantageous. The non-passive portion of this  group is looking for direction, and is prepared to find it in non-mainstream places. Providing this could amount to seeding very fertile ground.

Being beneath the notice of larger powers hoping to maintain monopolies and control can be protective. Hence working at small scale, but in many locations simultaneously, could allow systems conferring greater local independence and resilience to become established with a lower likelihood of being suppressed as a threat by the powers-that-be.  

Permaculture should be a major building-block of any kind of system reboot following the operating system crash that a financial crisis represents. After all, once we navigate that period of artificial scarcity, we will have to address the real scarcity inherent in looming resource limits. We will have to deal with the fact we are far into overshoot in comparison with the carrying capacity of the Earth, even with the artificially boosted carrying capacity we have thanks to fossil fuels (where about half of the nitrogen in the food supply comes from the artificial fixation of nitrogen from fossil fuels for instance). We have been strip mining soil fertility with intensive agri-business, disrupting the critical nitrogen cycle and poisoning the soil micro-organisms critical for fertility with pesticides such as round-up. We will have to undo all of the damage, but it will take us a very long time, and in the meantime we have over 7 billion mouths to feed. Permaculture, with its emphasis on soil regeneration, is the best possible way (click for video) to do this. If we are ever to approximate, at least temporarily, an Earth Steward scenario (in the distant future, once the dust has settled), this is the path we must take.

As Holmgren says, “A permaculture way of life empowers us to take responsibility for our own welfare, provides endless opportunities for creativity and innovation, and connects us to nature and community in ways that make sense of the world around us.” Motivated by enlightened self-interest, and operating at a manageable human scale, we can apply our knowledge of natural and human systems in the real world, without being overwhelmed by the task of feeling we are personally responsible for saving the whole world. It can be difficult to let go of the top-down approach, to stop putting all our efforts into trying to change government policies or get the ‘right’ people elected, as if this would somehow solve our problems.

We need to get down to the business of doing the things on the ground that matter, and to look after our own local reality. We can expect considerable opposition from those who have long benefited from the status quo, but if enough people are involved, change can become unstoppable. It won’t solve our problems in the sense of allowing us to continue any kind of business as usual scenario, and it won’t prevent us from having to address the consequences of overshoot, but a goal to move us through the coming bottleneck with a minimum amount of suffering is worth striving for.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

Dec 262013
 December 26, 2013  Posted by at 2:12 pm Finance Tagged with: , , ,  19 Responses »

Lewis Wickes Hine Indianapolis Market 1908

Despite the media talking up optimism and recovery, people are not seeing the supposed good news playing out in their own lives. As we have discussed here many times before, the squeeze continues on Main Street, while QE has generated asset bubbles at the top of the financial food chain. Complacency reigns, but this is the endgame. Increasingly delusional collective optimism, based on illusory wealth for the few, has ben the driving force for 2013, even as the smart money has been selling everything not nailed down for most of the year – cheerfully handing the empty bag to a public that demands it. It’s been a five year long party, where, demonstrably, no lessons were learned from the excesses preceding the previous peak, and the consequences that followed from it.

Now, as a result of throwing caution to the wind again (mostly with other people’s money of course), we face another set of consequences, but this time the hangover will be worse. Timely warnings are rarely credible, as they contradict the prevailing wisdom of the time, but it is exactly at this time that warnings are most needed – when we are collectively irrationally exuberant on a grand scale. We need to understand the situation we are facing, in order to see why this period of global excess will resolve itself as a global credit implosion, what this means for ourselves and our societies, and what we can hope to do about it, both in terms of preparing in advance and mitigating the impact once we are confronted with a new, sobering, reality.

We are facing an acute liquidity crunch, not the warning shot across the bow that was the financial crisis of 2008/2009, but a full-blown implosion of the house of cards that is the global credit pyramid. Not that it’s likely to disappear all at once, but over the next few years, credit will undergo a relentless contraction, punctuated by periods of both rapid collapse and sharp counter-trend rallies, in a period of exceptionally high volatility. The primary impact will stem from the collapse of the money supply, the vast majority of which is credit – a mountain of IOUs constituting the virtual wealth of the world.

This has happened before, albeit not on this scale. Since humanity reached civilizational scale we have lived through cycles of expansion and contraction. We tend to associate these with the rise and fall of empire, but they typically have a monetary component and often involve a credit boom. Bust follows boom as the credit ponzi scheme collapses. Mark Twain commented on one such episode in 1873:

“Beautiful credit! The foundation of modern society. Who shall say that this is not the golden age of mutual trust, of unlimited reliance upon human promises? That is a peculiar condition of society which enables a whole nation to instantly recognize point and meaning in the familiar newspaper anecdote, which puts into the mouth of the speculator in lands and mines this remark: — ”I wasn’t worth a cent two years ago, and now I owe two million dollars.””

Few recognized at the time that the ensuing financial panic of 1873, at the culmination of a period of speculative excess, was going to lead to a long and grinding depression. The signs were there, as they are today, but few connected the dots in advance and understood what was about to unfold and why. Few ever do at comparable points in time.

Unfortunately, humans are not good at remembering, let alone learning from, and applying, the lessons of history. The information is available for those who care to look – far more information than people had access to at previous junctures – but not in the mainstream media. The media’s role is to reflect and amplify the mood of the time, spinning events in accordance with it in a self-reinforcing feedback loop. Real information – the kind we need if we are to face a future more challenging than anything most of us have ever experienced – is found elsewhere, with independent voices contradicting received wisdom when it most needs to be contradicted. That has been our task at The Automatic Earth for the last six years. We cover the events of the day, placing them in the context of the bigger picture we have developed since January 2008.

We aim to make complexity comprehensible, so that people can identify the most immediate and most significant threats and prepare themselves to face them. At the present time, the threat people most need to appreciate is a liquidity crunch, hence this is a major focus of our most recent Video Download release – Facing the Future. It is well underway in some parts of the world already and many more countries will find themselves affected in the not too distant future.

Essentially, a liquidity crunch creates a situation of artificial scarcity. People hold on to what money they have when they are unsure when they might earn any more of it, as makes perfect sense from an individual perspective. However, when a large number of people do so, the amount of money in circulation falls sharply, leaving an insufficient supply to sustain anything like the same amount of economic activity. Not just actual unemployment, but the fear of future unemployment can be enough to cause spending to plummet, drastically reducing money in circulation. When money is not available to change hands in exchange for goods and services, those goods and services are not exchanged. In the Great Depression of the 1930s, observers noted that “they had everything but money”. The people and resources were still there, but were not able to connect.

As an artificial construct, one might think that a loss of money would have little impact if other factors remained, but this is not the case. As we have explained before, finance is the global operating system, and crashing the operating system has severe consequences in terms of disrupting supply chains – with cascading effect – at both local and global levels. Since this is the major risk we face, and the consequences are likely to be severe, we need to take steps to prepare ourselves and our communities.

The more cohesive and close-knit a community, the better it is likely to be able to withstand external shocks, so all manner of community-building initiatives can be extremely valuable. In our new Facing the Future Video Download series, Laurence Boomert describes a wide range of demonstrably effective possibilities in considerable detail, explaining how and why they work. Such efforts address a liquidity crunch indirectly, through increased resilience.

However, there are also means to address the scarcity of money directly, and these are likely to have a very important role to play. Alternative currencies can go some distance towards filling the void left by a lack of money in circulation, albeit at a local level. These have been used in many places faced with an economic seizure at the national level, notably Austria, during the Great Depression of the 1930s, Argentina, following the financial crisis of 2001, and Greece today. They are very likely to arise spontaneously in times of crisis, but have the potential to be more effective more quickly if established in advance. A range of them is covered in our new Facing the Future Video Download material.

Nicole Foss and Laurence Boomert with Peak Moment TV’s Janaia Donaldson (center) in Vancouver, Canada

The best known, and arguably most effective, example of local currency in action is the Austrian town of Wörgl in the early 1930s. In the depths of the depression, with over 30% unemployment, the mayor, Michael Unterguggenberger, did not have the funds to cover projects he wanted to build to put his constituents back to work. Rather than use his reserves of 40,000 schillings, he deposited these in the bank and in 1932 issued local stamp scrip backed by his reserves. The scrip required a stamp each month, at a cost of 1% of its face value (a feature called demurrage), hence there was an incentive to spend the money rather than to hoard it. Although the incentive was small, the psychological effect was disproportionately large, keeping the money in circulation at a substantial rate. Although only a small quantity of scrip was issued, it circulated quickly enough to support a great deal of economic activity in a town previously caught in the grip of an economic seizure:

They not only re-paved the streets and rebuilt the water system and all of the other projects on Mayor Unterguggenberger’s long list, they even built new houses, a ski jump and a bridge with a plaque proudly reminding us that ‘This bridge was built with our own Free Money’. Six villages in the neighborhood copied the system, one of which built the municipal swimming pool with the proceeds. Even the French Prime Minister, Édouard Dalladier, made a special visit to see first hand the “miracle of Wörgl.”

It is essential to understand that the majority of this additional employment was not due directly to the mayor’s projects…..The bulk of the work was provided by the circulation of the stamp scrip after the first people contracted by the mayor spent it. In fact, every one of the schillings in stamp scrip created between 12 and 14 times more employment than the normal schillings circulating in parallel. The anti-hoarding device proved extremely effective as a spontaneous work-generating device.

The use of scrip enabled approximately 100,000 schillings worth of local government spending to occur on projects without the need to deplete reserves of national currency at all. In addition, a multiple of this amount in private spending occurred, even though only some 8000 schillings worth of scrip was ever in circulation. Altogether, it has been estimated that some 2.5 million schillings worth of economic activity was financed in one year.

As the stamp scrip was a creation of local government, people were allowed to pay their taxes using it. As there were substantial tax arrears, this was an effective tool for encouraging the acceptance of the currency. People were, in fact, paying their taxes early in order to avoid the 1% monthly loss due to the stamp fee:

On July 31, 1932 the town administrator purchased the first lot of Bills from the Welfare Committee for a total face value of 1,800 Schillings and used it to pay wages. These first wages paid out were returned to the community on almost the same day as tax payments. By the third day it was thought that the Bills had been counterfeited because the 1000 Schillings issued had already accounted for 5,100 Schillings in unpaid taxes. Michael Unterguggenberger knew better, the velocity of money had increased and his Wörgl money was working.

Mayor Unterguggenberger understood the nature of the crisis he was addressing and how is stamp scrip acted to mitigate it. Each Wörgl note was printed with the following justification:

“To all whom it may concern! Sluggishly circulating money has provoked an unprecedented trade depression and plunged millions into utter misery. Economically considered, the destruction of the world has started. – It is time, through determined and intelligent action, to endeavour to arrest the downward plunge of the trade machine and thereby to save mankind from fratricidal wars, chaos, and dissolution. Human beings live by exchanging their services. Sluggish circulation has largely stopped this exchange and thrown millions of willing workers out of employment. – We must therefore revive this exchange of services and by its means bring the unemployed back to the ranks of the producers. Such is the object of the labour certificate issued by the market town of Wörgl: it softens sufferings dread; it offers work and bread.”

It was not necessary for the stamp scrip to replace the national currency, only to supplement it. Local currency in Wörgl was always exchangeable for Austrian schillings, at a cost of 2%, but the scrip was so well accepted that few sought to covert it. One observer, Claude Bourdet, master engineer from the Zürich Polytechnic, reported on the success of the stamp scrip at the time:

“I visited Wörgl in August 1933, exactly one year after the launch of the experiment. One has to acknowledge that the result borders on the miraculous. The roads, notorious for their dreadful state, match now the Italian Autostrade. The Mayor’s office complex has been beautifully restored as a charming chalet with blossoming gladioli. A new concrete bridge carries the proud plaque: “Built with Free Money in the year 1933.” Everywhere one sees new streetlights, as well as one street named after Silvio Gesell [originator of the concept of Freigeld, or Free Money]. The workers at the many building sites are all zealous supporters of the Free Money system. I was in the stores: the Bills are being accepted everywhere alongside with the official money. Prices have not gone up.”

Local goods and services could be purchased with scrip, allowing scarce national currency to be used for non-local essentials and national taxes. If spread widely enough, this model could potentially have protected both local and national supply chains, at least to some extent. However, the central bank decided to assert its money monopoly, shutting down the Wörgl experiment in late 1933 after 13 months. The town then sank back into economic depression. The deprivation across the country set the stage for an unfortunate choice of ‘solutions’:

Only a central authority saviour can help people who are not allowed to help themselves locally. And as all economists will point out, when there is enough demand, supply always manifests in some way. Even if you have to import it. During the Anschluss of 1938, a large percentage of the population of Austria welcomed Adolf Hitler as their economic and political saviour. The rest is well known history.

The power inherent in a money monopoly is tremendous. As far back as the late eighteenth century, the patriarch of the Rothschild banking family, Mayer Amschel Rothschild, acknowledged the extent of power over money in saying ,”Permit me to issue and control the money of a nation, and I care not who makes its laws!” This was acknowledged in the early days of the United states, when debt enslavement was recognized as the power to conquer. Thomas Jefferson wrote of his concern in 1816:

“And I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property — until their children wake-up homeless on the continent their fathers conquered.”

We have had the inflation, in the form of a money supply expansion, largely based on credit creation, that has proceeded virtually uninterrupted for decades. Now we stand of the verge of the deflation that follows all credit expansions as night follows day.

Given its significance, it is no surprise to find the power of money monopoly defended. The ability to do so depends, however, on being able to project power at a distance through strong central control. As this in turn depends on the extent of chaos, the state of supply lines and the availability of sufficient energy, defence will not always be possible, and a money monopoly is not likely to stand the test of time. We will need to develop alternative trading arrangements, both for the present and for the future, as we will be faced with rebooting our financial operating system.

Given the potential for local currencies to mitigate the coming liquidity crunch, it is very much worth the effort to create one. They exist in many locations already, some with a history measured in decades. Emergency currencies have also been recently created in order to address the liquidity crisis already hitting the European periphery. For instance, the Greek town of Volos holds a market where all goods and serviced are denominated in TEM (Τοπική Εναλλακτική Μονάδα, meaning Alternative Monetary Unit):

In this bustling port city at the foot of Mount Pelion, in the heart of Greece’s most fertile plain, locals have come up with a novel way of dealing with austerity – adopting their own alternative currency, known as the Tem. As the country struggles with its worst crisis in modern times, with Greeks losing up to 40% of their disposable income as a result of policies imposed in exchange for international aid, the system has been a huge success. Organisers say some 1,300 people have signed up to the informal bartering network.

For users such as Ioanitou, the currency – a form of community banking monitored exclusively online – is not only an effective antidote to wage cuts and soaring taxes but the “best kind of shopping therapy”. “One Tem is the equivalent of one euro. My oil and soap came to 70 Tem and with that I bought oranges, pies, napkins, cleaning products and Christmas decorations,” said the mother-of-five. “I’ve got 30 Tem left over. For women, who are worst affected by unemployment, and don’t have kafeneia [coffeehouses] to go to like men, it’s like belonging to a hugely supportive association.”

Greece’s deepening economic crisis has brought new users. With ever more families plunging into poverty and despair, shops, cafes, factories and businesses have also resorted to the system under which goods and services – everything from yoga sessions to healthcare, babysitting to computer support – are traded in lieu of credits. “For many it plays a double role of supplementing lost income and creating a protective web at this particularly difficult moment in their lives,” says Yiannis Grigoriou, a UK-educated sociologist among the network’s founders.

Such networks clearly have significant social value in bringing people together to face hard times. Much can be gained through mitigating the psychological effects of deprivation in isolation, and the resulting relationships of trust can be enduring. Providing the ability to purchase goods and services, including essential staples, without the requirement for scarce euros, is also critical for those without any other means of support:

Back at the market, I’m told the TEM network in Volos is growing quickly. More than 1,000 people have joined or are waiting to join in this city of 150,000. Katarina, who joined a month and half ago, is selling homemade liqueurs, jams and sweets. For her, the network isn’t just about creating an alternative social structure. It’s about survival. She uses her credits to buy staples – vegetables, fruits and eggs – from others in the network. She said she wishes the TEM network were bigger – she wants to be able to buy things like olive oil and meat. Katarina said she’s been unemployed for five months now. When I asked if she’s received any help from the local government, she laughed. “The state is completely absent.”

The Greek government approves of this limited form of monetary creativity and has passed legislation encouraging “entrepreneurship and local development” as a substitute for the welfare state it is no longer able to provide. So far nothing more ambitious that might challenge the money monopoly has been attempted. The TEM system of electronic barter only goes so far, as it does not involve local government and cannot be used as a means to meet tax obligations. Local government has only been able to offer moral support:

The city has been hit hard by the crisis, said Volos Mayor Panos Skotiniotis. When construction fell off, the region’s cement and metal industries suffered. Unemployment is rising, and local funding from the Greek state is down 40 percent over the past three years. Skotiniotis said the municipality can’t support the TEM network in any official way. But he certainly sees its value. “It goes without saying that this currency is not substituting for the official state currency, the euro,” said the mayor. “But it’s a supplement for people who can’t meet their own needs.”

It is probably only a matter of time before a more ambitious form of alternative currency, along the lines of the Wörgl experiment, is tried in some of the regions of the European periphery where suffering is particularly acute. This may occur before or after these countries give up their doomed attempt to stay in the eurozone, but would probably be more successful if tried during a transition away for the euro, as this would amount to less of a direct challenge to the global money monopoly. Experiences gained in such an experiment would be valuable if communicated to other locations, many of which will be facing similar difficulties in their turn.

An alternative currency interchangeable with the national currency and usable for local tax obligations, as in Wörgl, is not necessarily a panacea, nor even a permanent solution, but it can make a significant difference mitigating the effects of a liquidity crunch in the short to medium term. Had the Wörgl experiment been allowed to continue, it is possible it would have run its natural course before the local economy could have become self-sustaining:

The activity would not have been sustainable. Once the taxes in arrears were completely paid and when people had paid enough taxes in advance to feel safe and comfortable (at some point they would stop paying forward), the scrip would lose a key part of its attractiveness. One way a government can ensure the demand for its currency is to mandate that taxes be paid in the government-issued currency. The other way is through monopoly legal tender laws. Wörgl could not legislate or enforce monopoly legal tender, so the demand for the scrip is partially attributable to the need to pay taxes.

Nevertheless, the monetary experiment allowed for many municipal projects to be completed and for local economic activity to be supported for a period of time. This was clearly beneficial. As with the TEM currency in Greece, part of the effect of local initiatives like this is psychological – alleviating a prevailing sense of isolated deprivation and brining a community together. This has value in its own right, independent of the monetary effect. Such a course of action should be tried again, and permitted to run for longer, but it is not clear that this will happen once we find ourselves facing widespread economic depression again. The money monopoly is even more powerful today than it was in the 1930s, and even more likely to defend its powerbase, at least while it remains capable of doing so.

Alternative currency can mitigate a situation of artificial scarcity caused by a liquidity crunch, but there are other limits that are not artificial. We were not facing resource limits, or a skills shortage, in the 1930s, but we are today. For a time, money will be the limiting factor, and local currencies may come into their own if allowed to do so, but beyond that financial crunch we will have to face physical curbs to growth. Energy will probably be the next hurdle we have to address. The future will be challenging and we must face it fully informed.

For those who are interested, I will be teaching, along with Albert Bates, Marisha Auerbach and Christopher Nesbitt, on a Permaculture Design Certificate course in Belize in 2014. The course will be the 9th annual event held at Maya Mountain Research Farm between Feb 10-22nd. Click here for details and registration .

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

Dec 162013
 December 16, 2013  Posted by at 2:52 pm Finance 8 Responses »

Unknown Molten Lava And Papaya Trees 1960
Kilauea eruption near Kapoho, Hawaii

Nicole Foss: Countries caught in the grip of financial crisis, with austerity measures compounding their problems, are continually being told to follow Iceland’s example. The assumption is that if a state can disregard the claims of the banking sector, it can address the threat of financial crisis relatively painlessly and get back to ‘normal’ quite quickly. Iceland is held up as an example, but the situation is actually far more complex. As such, it is worth exploring the situation in Iceland in all its complexity. It is an example in some sense, but not necessarily in ways which are transferable. It does, however, illustrate a number of lessons for post-bubble economies, and there will be many of those over the next few years.

Iceland, which achieved independence from Denmark in 1944, was once a relatively poor country of primary producers – fishermen and farmers – but it reinvented itself in the era of globalization under its longest serving Prime Minister, Davíd Oddsson:

It was Oddsson who engineered Iceland’s biggest move since NATO: its 1994 membership in a free-trade zone called the European Economic Area. Oddsson then put in place a comprehensive economic-transformation program that included tax cuts, large-scale privatization, and a big leap into international finance. He deregulated the state-dominated banking sector in the mid-1990s, and in 2001 he changed currency policy to allow the króna to float freely rather than have it fixed against a basket of currencies including the dollar. In 2002 he privatized the banks. When he stepped down as Prime Minister in 2004, he did a stint as Foreign Minister before becoming governor of the central bank in 2005.

The economy expanded and diversified in many ways, attracting ecotourists, moving into new technologies, taking advantage of its abundance of renewable to expand manufacturing and developing a more comprehensive service sector. It became a highly internationalized economy, with the means to import goods from all over the world thanks to a strong currency. With GDP growth running at 4-6% for a number of years, the average family’s wealth increased markedly, with much of it invested in property. As a result, house prices in Iceland saw greater than 10% annual price appreciation from 2003-2007.

The financial sector took off following privatization:

But the principal fuel for Iceland’s boom was finance and, above all, leverage. The country became a giant hedge fund, and once-restrained Icelandic households amassed debts exceeding 220% of disposable income – almost twice the proportion of American consumers.

Very large amounts of money were loaned were to the public, allowing them to further bid up the price of property. The fact that many of these loans were denominated in foreign currency (Japanese yen, Swiss francs etc) added currency risk to the resulting speculative mania. Three large banks – Glitnir, Landsbanki and Kaupthing – grew to dwarf the size of the island’s real economy in a financial bubble of unprecedented size (in comparison with a host economy based on only 320,000 people). Total debt to GDP peaked at over 1200%, reflecting the grossly disproportionate nature of the financial sector. This had been a cause for concern at the central bank as far back as 2005, but nothing was done to reign in credit expansion. At the peak of this period of great affluence, the Icelandic population was lauded as the richest people in the world, but it was not to last:

A visitor seeking a sense of how Iceland’s clique of powerful financiers saw themselves before their empire came tumbling down need look no further than Reykjavik’s Harpa concert hall. The extravagant steel and glass structure, which has more seats than London’s Royal Opera House, looks like a futuristic beehive glowing above the grey buildings that make up most of the capital. It was commissioned by Bjorgolfur Gudmundsson, one of the “Icelandic oligarchs” who exploited cheap credit following the aggressive financial deregulation of the early 2000s to create a billion-dollar empire. He set out in 2007 to build a cultural venue to match the country’s new found wealth – but when the global financial crisis hit the next year, and Iceland’s over-leveraged banks collapsed, he went bankrupt, leaving the state to complete the project.


The structural instabilities upon which the illusion of prosperity was based proved fatal in late 2008. Maturity mismatching (issuing short-term debt in order to invest in long term assets) was rife, requiring that short term liabilities be continually rolled over until long term assets matured. Reserve requirements were reduced, increasing the money multiplier. The huge increase in the effective money supply, much of the credit denominated in foreign currencies, combined with a 35% fall in the value of the Icelandic króna relative to the euro, led to substantial price increases – 14% in the year before the system reached its limit. As mortgage principle is typically indexed to CPI in Iceland, this price inflation was compounding the effect of a housing bubble.

The central bank had been attempting to reign in ‘price inflation’ by maintaining interest rates much higher than those in neighbouring jurisdictions. This encouraged overseas investors to hold deposits in Icelandic krónur, leading to an even greater money supply expansion relative to GDP. During the expansion years the stock market made record gains, increasing by a factor of nine between 2001-2007, or a 44% average annual increase for six years in a row. The profitability of the speculative financial sector was so much greater than that of the real economy that resources inexorably shifted away from traditional marine industries towards banking and finance, leading to a great misallocation of capital.

It was clear, to anyone who cared to look, months before the final curtain fell, that Iceland was in a huge bubble and that the over-extended banks were going to fail. We drew readers’ attention to the problems early in 2008, with Fire and Iceland. Icelanders’ status as the richest people in the world was a temporary artifact of the bubble – simply a result of borrowing the most money and therefore temporarily having the most financial freedom to consume. Household debt had reached 213% of disposable income, leaving people highly over-stretched. Real wealth is not built on pathological over-borrowing, but illusory wealth can appear real enough for a time. It can certainly shape people’s perceptions as to what they consider a normal, and deserved, state of affairs.

The country hit a financial brick wall in the fall of 2008, when Iceland’s banks ran into difficulties rolling over the large amount of short term debt, provoking a liquidity crisis. British and Dutch depositors in Landsbanki’s high-yielding internet banking subsidiary, Icesave, also lost confidence and began to withdraw deposits. Unable to call on the central bank as lender of last resort, due to the disproportionate size of the banks in comparison with the $13 billion local economy, all three banks were placed into receivership, defaulting on some $85 billion.

Domestic deposits were guaranteed in full, but overseas internet banking deposits were not protected. These were bailed out by the depositors’ own countries (Britain and the Netherlands), which then attempted to recover the cost from Icelandic taxpayers. The government would have been prepared to sanction this, but by referendum the people overwhelmingly declined to accept public responsibility for the private debts of the banking system. The considerable international pressure to do so, including the freezing of £4 billion of Icelandic assets under anti-terrorism legislation in Britain (Sections 4 and 14 and Schedule 3 of the Anti-terrorism, Crime and Security Act 2001) only made the Icelanders more determined.

The immediate consequences for the Icelandic economy were severe. The banks had accounted for almost three quarters of the value of the Icelandic stock exchange, and with these shares set to zero, and the contingent contagion, the market capitalization of the index plummeted by over 90% (relative to the 18 July 2007 peak). The economy promptly went into recession, with GDP contracting significantly in real terms. Unemployment more than tripled, albeit from a low level, and many workers had either their pay or working hours reduced. The króna fell sharply, raising the cost of imported goods upon which the country had become dependent. The burden of the large amount of debt denominated in foreign currencies, or indexed to CPI, rose enormously. In the following two years the economy would go on to contract by some 10%. After four years, people were still facing a approximately a 25% loss in earnings, while attempting to manage debts which had doubled.

Capital Controls:

Iceland became the first industrial country since Britain in 1976 to receive an IMF loan, with additional funds provided by other nordic countries. The loans came with strings attached in the form of capital controls to support the currency. A free-floating exchange rate had become far too much of a liability:

For countries with a minor-league currency (every currency except for the US dollar, the euro and the yen), an open capital account will always be a mixed blessing. The joys of an open capital account – the undoubted benefits from decoupling domestic capital formation from national saving and from unrestricted international portfolio diversification and risk trading – cannot be enjoyed without the pain; the risk of its domestic financial institutions, capital markets, non-financial enterprises, consumers and public finances becoming the flotsam and jetsam on massive and mindless killer waves propelled by an out-of-control global financial storm.

In an effort to prevent being exposed to the full effects of a short term over-reaction to events, the movement of funds in and out of the country without a licence from the central bank was prohibited.  Risk-tolerant foreigners had been borrowing Japanese yen or Swiss francs at very low interest rates, buying krónur, and depositing them in high interest accounts in Iceland, or purchasing Icelandic government bonds. This carry trade had been very profitable, and had been responsible for much of the increase in the value of the króna during the bubble years (87% between 2001-2007). Capital controls prevented these funds being withdrawn, as this would have had a disastrous effect on the currency. Funds of foreign investors (including some €2.9 billion in króna-denominated securities), still trapped in the country as a result, are commonly know as ‘glacier bonds’.

Capital controls are an imperfect stop-gap measure to take pressure off the currency, slow the speed of a financial crisis by damping down extreme fluctuations, and allow attention to be focused on stabilizing the economy. However, they distort relative values in a non-transparent way, undermining trust in an economy through the maintenance of an artificial exchange rate. This can lead to a risk premium being imposed on loans and investments. They generate incentives to circumvent them, and over time the political control, and potential for favouritism, that they create can lead to corruption, or the perception of corruption. Hence they are intended to be temporary. Once in place it can be very difficult to remove them without experiencing a renewed crisis of confidence, but while they endure they create on going economic dislocations that can have significant effects on the real economy:

In an interview on the news program Spegillinn on RÚV’s radio station Rás 2 yesterday, CEO of CCP Hilmar Veigar Pétursson talked about how the currency restrictions, or capital controls, are obstructing his company. CCP’s employees in Iceland who get paid in foreign currency can neither withdraw their money in foreign currency nor transfer it to foreign accounts, he explained. The company itself is barred from trading with a foreign bank because of the currency restrictions, he added, Icelandic banks are too small for such a large company—but they shouldn’t be any larger. When asked whether this means CCP will relocate its headquarters, Pétursson replied, “Let’s hope for the best.” The currency restrictions should have been lifted by now, according to schedule, and hopefully it will happen in the near future, he added.

Capital controls were originally mandated until August 2012, but the central bank, in its spring 2012 Capital Account Liberalisation Strategy report, recommended that they remain in place until 2015. Controls were in fact tightened at that time, as foreign investors had been circumventing them while the country was still vulnerable to a liquidity crisis:

The strengthening is mainly in the form of including certain payments from the receiverships of the old banks. Repayments of bonds in the ownership of foreigners are also included. It doesn’t matter if the bonds are issued by private or public enterprises. Recently, foreigners have been moving into the bonds on the short end of the maturity, waiting to be able to get repaid in order to get their funds out of the country. Also, since there is a difference of the value of the Icelandic krona is 30-40% (or thereabouts) between the Icelandic currency market and outside it, there is a massive incentive to buy krona outside the economy, bring it to Iceland, buy bonds with short maturity, wait for the day of repayment and get paid according to the exchange rate in Iceland. One has to make hefty losses for the gamble not to be profitable.

Other forms of circumvention are more difficult to prevent. It is unclear, for instance, the extent to which exporters chose not to repatriate their foreign exchange earnings. Others may purchase expensive, yet small and portable, items at home and resell them abroad in order to obtain foreign currency. A form of ‘arms race’ can develop, with a downward spiral of new regulations and innovative ways round them. That way typically lies corruption. Ultimately, capital controls undermine confidence in a currency to its long term detriment, hence the view that they should be removed as soon as practicable.

Capital controls can become addictive for governments, however. With the possibility of investment overseas removed, investors, including pension funds, must look for opportunities at home where choices are very limited. Their consequent purchase of government bonds allows the government to finance its budget deficit, reducing pressure to cut deficit spending. Real estate investments made as one of a limited range of options provide artificial price support to the housing market, maintaining the illusion of greater value than would normally exist, both for the property itself and for the loan used to purchase it, reducing write-downs of what might otherwise be bad debt. Support for the property market also amounts to support for property tax revenues, again strengthening the government’s position. Removing these measures subsequently can be very risky, as relative values can adjust quickly to the downside when allowed to do so, and government revenues could be hard hit in a short space of time.

When capital controls were imposed in Iceland in the 1930s, they were not removed until 1993 – an indication of just how difficult it can be to back away from this type of policy response. The reality on the ground in Iceland is a major curtailment of freedom for both companies and individuals. Almost all currency transactions require explicit permission from the central bank. Firms seeking to invest abroad require permission to do so, and this is rarely granted. Individuals are not allowed to invest abroad at all. They require permission from the central bank for foreign travel, as access to foreign currency is very tightly controlled. The purchase of foreign currency within Iceland is restricted, and Icelanders are required to deposit any new foreign currency they received with an Icelandic bank. There is a strict limit of €2,150 on cash for foreign travel, with citizens expected to convert anything left over back into krónur on their return. Icelanders are only limitedly permitted to support relatives studying abroad. Those who might wish to emigrate would not have the freedom to bring their assets with them.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

Currency Options and Sovereignty:

The concern is that with capital controls in place, there is no real way to increase investment, and without investment unemployment will remain high and disposable income low. It has been suggested that one way out of this dilemma would be for Iceland to give up the króna in favour of another currency. As a very small currency with relatively few users, the króna was always volatile. This complicates life for businesses by reducing economic visibility. The increased risk translates into higher interest rates, burdening the economy. However, adopting another currency would come at a high price in terms of loss of sovereignty and loss of any control over monetary policy. The alternative of introducing a currency board and pegging the króna to another currency at a fixed exchange rate would be possible, but currency pegs tend not to fare well in periods of instability, as they provide a tempting target for speculative attack.

In the immediate aftermath of the crisis, Iceland considered joining the European Union and adopting the euro, on the grounds that this would lower interest rates, increase capital investment, labour productivity and trade, as well as possibly lowering prices (due to the ability to directly compare prices with European countries). Joining the EU would come with consequences in the form of loss of control over fishing rights – a very sensitive issue in Iceland – hence there were discussions about the possibility of adopting the single currency without joining the EU. However, since then the eurozone has experienced its own structural problems, dampening enthusiasm for Iceland to join that sphere of influence.

Other possibilities noted were for Iceland to join either the Norwegian or Canadian currencies. The latter option, somewhat surprisingly, appears to have achieved some serious consideration. Arguments in favour of adopting the Canadian dollar include stability, liquidity, similar business cycles between resource exporting countries and ‘Arctic sovereignty’ (increasing clout on the Arctic Council). Part of the attraction arises from historical connections between the two countries:

In a 45-year period from 1870 to 1914, up to a quarter of the Icelandic population moved to North America, most of them going to Canada, where they founded “New Iceland” on the shores of Lake Winnipeg in 1875, as an independent state. In 1887 this colony joined Manitoba and the capital of New Iceland, Gimli, retains strong connections to Iceland. The diaspora in Canada is called West-Icelanders.

However, abandoning the króna would come at a price:

“The Bank of Canada and the embassy declined to comment, but the Canadian official says, “I think they only heard what they wanted to hear.” If Iceland ditched its currency, it wouldn’t have control over monetary policy to boost the economy, leaving layoffs as the primary way to deal with downturns. That’s tricky in Iceland. “It’s a very closed, tight-knit system,” says the official. “Everybody is somebody’s second cousin.” The devalued króna is also a key reason the country is crawling out of its hole: exports, predominately fish, are cheap.”

Restructuring and ‘Recovery’:

In the aftermath of the banking collapse, the three failed banks were divided into old and new components. The new banks serving the domestic market were recapitalized, at a cost of some 25% of GDP, and granted the guaranteed domestic deposit base.  Two are now owned by their foreign creditors, while the Icelandic state holds majority ownership of the third. Within the country, banking services continued uninterrupted. The old banks were left primarily with estates composed of distressed assets and the foreign debts destined for liquidation.

Iceland was sued in the European Free trade Association court (E-16/11, EFTA Surveillance Authority v. Iceland) by the governments of the United Kingdom and the Netherlands over its default on the Icesave deposits, leaving the country in a state of uncertain limbo over the level of government debt. If the case had gone against the country, between 6-13% of GDP would have been added overnight (some 335 billion krónur in principle and interest according to IMF estimates). However, in early 2013 the court ruled in Iceland’s favour, setting an important precedent that governments in the European Economic Area (EEA) are not liable to cover the cross-border depositor guarantee obligations of their banks. This is seen as a factor favouring currency stability, and, as such, an foundational element for the eventual removal of capital controls. It also means Icelanders can be spared some of the crippling austerity measures already imposed, and still to come, in countries that did offer a public guarantee for private banking debt.

In 2010 the government declared foreign-currency-indexed mortgages to be illegal, as the crash of the króna had caused the value of these loans to skyrocket, often to far beyond what people were capable of paying. Government also facilitated the write down of a portion of mortgage debt, but only to 110% of property value, meaning that the large number of people in negative equity did not fall, but the extent of their indebtedness was reduced. Foreign currency indexed loans had been attractive to many as the interest rate on these was lower than on króna-denominated mortgages, but after indexed mortgages were banned, banks retroactively set interest rates higher from the beginning of the loan, claiming back payments for the difference. This is being challenged in the courts. In the meantime, the household debt burden remained stubbornly high – 270% of disposable income by the end of 2010 (compared to 217% prior to the banking collapse). Indexing to CPI has been upheld by the Supreme Court, meaning that rising prices are greatly diminishing the effect of debt relief.

Iceland’s three year IMF programme came to an end in August 2011, with 3% growth for the year as a whole. In early 2012 its government bonds were promoted back to investment grade by the ratings agencies, albeit on the lowest rung of the ladder (BBB-minus up from BB-plus). June saw a return to the international capital markets, with a US$1 billion 10-year bond offering at 5%. This was used for early repayment of emergency loans of $483.7 million from the IMF and €674 million to Nordic nations, for loans maturing between 2013 and 2018. With growth accelerating, Iceland plans further early repayments.

The country has proven to be an interesting test case for a set of policy options opposite to those employed in the struggling periphery of the eurozone. Rather than bailing out the banks and imposing austerity to the extent that the European periphery did, Iceland has attempted to protect its welfare state during the period of crisis. The agreement with the IMF involved postponing cuts for a year, then imposing both tax increases (corporation tax increased to 18% from 12%, increased income tax and VAT and also a wealth tax) and spending cuts simultaneously, rather than favouring primarily spending cuts as was done in countries like Ireland.

Cuts there have been, and these, as always, have hit the poor the hardest. The pension system has been raided and healthcare provision has been scaled back, with sharply increased co-payments required. However, public systems in Iceland still function enviably well in comparison with many parts of the world. Targeted household debt relief, even as limitedly practiced in Iceland, mitigated the impact that debt overhang, and consequent household deleveraging, would otherwise have had on aggregate demand. This helped to keep unemployment relatively low by international comparison. The IMF is now considering the experience in formulating its plans.

The effect of a currency devaluation on exports has been very significant. Because exports constitute 59% of GDP, and they are now very competitively priced, employment in exporting industries, notably fishing, has received considerable support:

“This is probably one of our best years,” said Arnthor Einarsson, a fisherman readying his boat for his next catch as seagulls circle huge piles of fishing nets on a rocky peninsula about one hour south of the capital Reykjavik.

Only a few years ago, a banking boom in which the sector’s assets grew to 10 times the country’s GDP lured many of Iceland’s 320,000 population from traditional industries into the world of finance, where returns to speculation were far higher than returns in the real economy. Fisherman got into banking and sailors speculated on booming real estate. Those heady days have gone. Gas-guzzling Land Rovers have been replaced with fuel-efficient Volkswagens, a sign perhaps of a more sober consumer mood in which economic growth is based on a steady expansion of exports rather than flash-in-the-pan speculation.

Despite the higher expenses for equipment and fuel, which must be paid in foreign currency, the sharply falling cost of labour makes the business far more attractive:

Before the currency collapse, an Icelandic fish plant on average paid workers the equivalent of nearly €20 an hour, said Sigurgeir Kristgeirsson, chief executive of VSV, one of Vestmannaeyjar’s two big fishing companies. “Now it is close to 10 euros an hour,” Mr. Kristgeirsson said, over a dinner of garlicky langoustines and immaculately white cod. “That is a driving force of our profit line.”

It is also driving jobs. VSV now employs 365 people, up from 276 in 2010, a big jump for a town of 4,200 people. Plant workers earn around €10 an hour, but fishermen, who earn a percentage of the catch, do far better: the equivalent of €60,000 a year or more for a deckhand. One captain in VSV’s fleet made €243,000 last year.

Healthier corporate profits mean more investment. Mr. Palsson, who started working langoustines at age 10, opened the Godthaab i Nof fish plant with four partners a decade ago. In 2005, when the krona was at its peak, it lost money every month, he said. “From that time to 2008, nobody wanted to work fish,” he said. Now that money is rolling in, he and his partners have invested 220 million kronur, nearly $2 million, to take over a failing plant at the edge of town that dries heads and bones for shipment to Nigeria, where they are used for soup.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

In addition to the revival of its traditional industry, Iceland has the advantage of being able to rely on domestic geothermal energy for home heating and electricity, meaning it does not have to find foreign currency to pay for imports. The relative autonomy afforded by a sovereign currency and relative energy independence has been a major factor in Iceland fortunes. The fact that Iceland was first to go over the edge in the context of an international economic system still largely intact, despite the 2008/2009 crisis, is also a positive factor. As Japan discovered when their bubble burst in 1989, it is possible to mitigate the internal effects of economic depression if one is an exporting powerhouse exporting into healthy international demand, and with the capacity to service that demand.

Now in 2013, optimism abounds, in Iceland as in many other places. There is a widespread sense of relief, stemming from the perception that the global financial crisis is over and recovery is underway. Looking beneath the surface though yields a different picture. Perceptions are not always realistic or correct, and an optimistic gloss can be covering up a more troubling set of fundaments:

Today, a visitor to Reykjavik would have no idea this happened. Range Rovers, which became a popular status symbol, still bulldoze their way through the narrow streets. A sparkling performing arts centre under construction when the crisis hit opened this summer to rave reviews in the international press. And though McDonald’s abandonment of Iceland in 2009 was mildly humiliating, a local fast-food chain moved right in to its three locations….

….But calling this a recovery might get you branded by Icelanders as “very 2007,” a term coined after the crash to describe an overly optimistic view or something ostentatious, like those Range Rovers. Look closely at Reykjavik, and you’ll see a gleaming office tower completed when the banks imploded is half empty. A local economist estimates the country has the highest office vacancy rate outside of Ireland….

….While the country dredges up the past to seek closure, it also has to think about how to fill the void once assumed by the banking industry. It became a huge presence starting around 2003, paying fat salaries and providing a reason for the young, educated workforce not to go abroad. For now, Iceland has returned to its roots: fishing and aluminium production.

It has been a sobering experience:

“Did Icelanders have an identity crisis? Yes,” said Egill Helgason, one of Iceland’s best-known television commentators. “They thought they were financial wizards, but it was all an illusion … Now it’s back to books, music, and well, fish.”

One side effect of the capital controls in place since the crash has been the re-emergence of a housing bubble. Some $8 billion worth in krónur of overseas investors funds is trapped in the country with few investment options for the foreseeable future. That money is now looking for relatively long term ‘parking’ in order to wait out capital controls, and a significant amount of it is being deployed in the real estate market, speculatively bidding up the price of property:

The fundamental reason for the surge in house prices in Iceland is not the economic recovery but the expansion of new mortgages, i.e. debt. Those new mortgages spur the economic growth since the debt creation becomes somebody’s income (first the seller’s and then who ever gets the money from him as he spends it). In the meanwhile, investment is lagging and furthermore, 60,000 households (40% of the total, year end 2010) are in negative equity on their balance sheet. None of those 60,000 households are thinking of speculating in the property market in at the moment, I presume, since they are busy paying down their debts.

The speculators are more likely to be high net-financial-wealth holders, looking for income and yield on their financial assets. The nominal yield on the rental market is around 7-9%, depending on which part of Reykjavik we’re talking about. Unindexed mortgages carry 5-7% interest rates. If you have the net-cash to cover the need for equity, leveraging it up with a mortgage only “makes sense”.The money that is spurring the growth of the Icelandic economy is therefore not coming from investment in capital assets and the subsequent production of goods and services, but speculation with properties.

Newly created mortgages are driving the property market in Iceland, as they do in other countries. The resulting income from debt-creation is what is then spurring economic growth, but not investment in real capital.

The so-called ‘Icelandic miracle’ recovery is not quite so simple. Creating a new debt ponzi scheme does not constitute a sustainable basis for recovery. The consequence of taking that path  – another round of painful future losses – is quite predictable. This time a larger percentage of those losses are going to be felt domestically, given the indebtedness of the population and the extent of negative equity. A housing bubble collapse will affect people far more personally and immediately than a banking collapse where the losses were largely borne by foreigners.

In terms of international purchasing power, Icelanders are very much poorer than they were, due to the collapse of the króna. For instance, the housing prices that show such a strong rebound denominated in króna look very different in euros. The large devaluation (an option not available to struggling eurozone countries) has made labour and exports more competitive. Combined with allowing the banks to fail (with the majority of the losses taken by foreigners), rather than bailing them out at public expense, it has allowed Iceland to stem what could otherwise have been a fatal financial hemorrhage. Given that people judge their situation in terms of nominal wages in local currency, rather than in relation to global purchasing power, the situation is perceived differently than in the troubled countries of the eurozone, and therefore the consequences are different. There banks were bailed out by the taxpayer, leading to government debt. A currency devaluation to boost competitiveness is not possible under the single currency. The resulting ‘internal devaluation’ through austerity is far more painful and far less politically acceptable than Iceland’s “money illusion”.

Calling to Account:

During the months following the banking collapse, there was public rage at the handling of the crisis. The Kitchenware Revolution, so-called because of the banging of pots and pans by thousands of protestors outside the Alþingi (parliament), disrupted governance. In a city with a population of 120,000 people, some protests attracted 10,000 demonstrators. The government of Prime Minister Geir Haarde and his Independence Party was forced to resign in January 2009, more than two years before the end of his electoral mandate. The task of navigating the aftermath of crisis fell to his successor, Social Democrat Jóhanna Sigurðardóttir.

Protesters burn effigy of Iceland PM Geir Haarde during financial crisis demonstration. Photograph: Thorvaldur Kristmundsson/AP

An 18 month investigation commissioned by the Alþingi, reported its findings in the fall of 2010. Its 9-volume, 2,400-page Special Investigation Commission Report of 2010 identified corruption, incompetence and criminal misconduct, recommending that Geir Haarde stand trial, along with the former minister of commerce, Björgvin Sigurdsson, and the former finance minister, Árni Mathiesen. The conclusion was that the ministers “lacked both the power and the courage to set reasonable limits to the financial system”.

In 2012, Haarde was acquitted by the specially convened Landsdómur criminal court of impeachments in Reykjavik of gross negligence, of failure to prevent the contagion from spreading to the internationally, by not insisting that Icelandic banks ringfence their overseas operations and of failing to act upon the government’s 2006 report on financial stability. He was, however, convicted of failing to keep his cabinet informed of major developments during the 2008 crisis period. Haarde was the first individual to stand trial at the 15-judge court, created in 1905 to hear any charges brought against ministers on matters of accountability. The court set no punishment and allowed for his legal expenses to be covered, in a judgment reflecting a common view that one person should not shoulder the blame for a systemic failure:

Vilhjalmur Arnason, a philosophy professor at Iceland University who worked on the [Special Investigation Commission Report], described the exercise as “very important for reasons of justice and for reconciliation” in a society traumatized by a crash so severe that it threatened to capsize the country. But, he added, bankers alone were not responsible, as “the whole society was so intoxicated” by values that put profit ahead of morality, the law and even common sense…..

….”There is cohesive guilt, because only so much anger can be directed at the bankers,” he said. “It’s like looking in the mirror and asking ‘did I do that’? It comes back to haunt us.”

In addition to the political prosecution, Iceland has also been conducting an in-depth criminal investigation, by special prosecutor Olafur Hauksson, of the bankers involved in the run up to the crisis. In late 2012 Lárus Welding, former chief executive officer of Glitnir, and Guðmundur Hjaltason, former director at the bank, were each jailed for nine months for fraud, although six have been suspended for two years. The Reykjavik District Court ruled that they had “misused their position and grossly endangered the bank’s funds”, but sentences were less than the minimum of five years the special prosecutor had been seeking.

Other convictions have been obtained, but sentences are typically very short. More than 120 people are under investigation for possible financial crimes, with over a hundred cases opened, and the special prosecutor’s office has grown from five staff to over a hundred investigators, lawyers and financial experts. Most recently, tougher sentences were handed down to four former executives of Kaupthing, who had been accused of concealing that a Qatari Sheikh had purchased a 5.1% stake in the bank with money illegally lent by the bank itself. Among the four are Hreidar Mar Sigurdsson, former chief executive, and Sigurdur Einarsson, former chairman of the board, who received the longest sentences for financial fraud to date (five and a half years and five years respectively). The other two received sentences of three years and three and half years. Their legal costs alone will run into millions of dollars. Another case against Kaupthing is pending.

An indictment has also been issued against corporate raider, and arguable the principle architect of the ponzi banking expansion, Jón Ásgeir Jóhannesson (click for short video documentary).

Prosecuting financial crime is a significant challenge, especially in a small country where almost everyone in Reykjavik has personal connections with people in banking and finance. The first advertisement for the job of special prosecutor received no applicants, and in a second round an outsider with no personal connections in the capital had to be urged to apply. The process is slow and results do not reflect how seriously the public views the offences committed, leading to considerable frustration in a country which holds bankers in lower esteem than drug dealers:

As chief of police in a tiny fishing town for 11 years, Olafur Hauksson developed what he thought was a basic understanding of the criminal mind. The typical lawbreaker, he said, recalling his many encounters with small-time criminals, “clearly knows that he crossed the line” and generally sees “the difference between right and wrong.” Today, the burly, 48-year-old former policeman is struggling with a very different sort of suspect. Reassigned to Reykjavik, the Icelandic capital, to lead what has become one of the world’s most sweeping investigation into the bankers whose actions contributed to the global financial crisis in 2008, Mr. Hauksson now faces suspects who “are not aware of when they crossed the line” and “defend their actions every step of the way.”….

….Mr. Hauksson said he was frustrated by the slow pace but thought it vital that his office scrupulously follow legal procedure. “Revenge is not something we want as our main driver in this process. Our work must be proper today and be seen as proper in the future,” he said. Part of the difficulty in prosecuting bankers, he said, is that the law is often unclear on what constitutes a criminal offence in high finance. “Greed is not a crime,” he noted. “But the question is: where does greed lead?”

Mr. Hauksson said it was often easy to show that bankers violated their own internal rules for lending and other activities, but “as in all cases involving theft or fraud, the most difficult thing is proving intent.” And there are the bankers themselves. Those who have been brought in for questioning often bristle at being asked to account for their actions. “They are not used to being questioned. These people are not used to finding themselves in this situation,” Mr. Hauksson said. They also hire expensive lawyers.

As for the fortunes of the Icelandic oligarchs, it is not clear at all that bankers are generally being held to account in a meaningful way for the consequences of their actions:

Thor Bjorgolfsson was part-owner of Landsbanki, the island’s second-biggest lender by assets until its collapse in 2008. He was also Iceland’s first billionaire and its richest man. He lives in a multimillion-pound house in west London with his wife and three children and still owns a private jet, although it is up for sale. He refuses to disclose his current wealth. Mr Bjorgolfsson still leads Novator Partners, a London-based investment firm, sits on several boards and holds shares in companies including Actavis, a Swiss drugmaker, and CCP, an Icelandic computer games company. His representative says any dividends from his shares, or future gains from their sale, will go towards settling debts to creditors following Landsbanki’s decline…

….Perhaps the most famous “Viking raider” is Jon Asgeir Johannesson, who bought chunks of the UK high street through Baugur, his investment company. He owned stakes in groups such as toy store Hamleys, House of Fraser department stores, Iceland Foods supermarkets and fashion retailer Oasis. Mr Johannesson now estimates his own wealth to be about $2m, down from more than $1bn before the crisis. He is being sued by Glitnir, the third-biggest lender until its 2008 collapse, in which he was the biggest shareholder. The bank lent him much of the cash for his acquisitions. But in a recent interview with Bloomberg, he said he was planning to return to the UK and build a “little kingdom” once his legal troubles subside.

This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

Politics and Constitution Building:

In the run up to 2008, the Independence Party had dominated Icelandic politics for nearly twenty years. Following the resignation of the Haarde government in January 2009, a ruling coalition between the Social Democratic Alliance, the Left-Green Movement, the Progressive Party and the Liberal Party was asked to form a government, under the leadership of Jóhanna Sigurðardóttir, Iceland’s longest serving member of parliament. The coalition was then formally elected in April, with a parliamentary majority. The first issue was discussion of the repayment of $5.3 billion in losses from the Icesave debacle. The government’s position was put to a national referendum was rejected by over 90% of the population. A second agreement with foreign creditors was made, but the president, Ólafur Ragnar Grímsson, refused to sign it, and it too failed on referendum.

The coalition sought to involve the population, which had been extensively demonstrating and lobbying for a substantial change of governance, in the process of creating a new constitution. Between the government and a citizens’ group referred to as ‘the Anthill’, a National Forum was organized in late 2009, with 1500 people invited to participate in the assembly, the majority of whom were chosen at random from the national population registry. The Forum, convened in mid 2010, proceeded, with much public involvement, to elect twenty-five members to a constitutional council. The constitution-writing process was conducted entirely in public, with a global observation and commenting involvement in a form of social-media-based crowd-sourcing model. The process was not without its critics.

The draft, comprised of 114 articles divided into 9 chapters, was presented to the Al?ingi in mid 2011, with a strong emphasis on open government, transparency and accountability, and also public ownership of natural resources. A one-person-one-vote system was to be introduced, which would effectively reduce the power of the rural vote, and with it the influence of the powerful fishing vessel owners. The parliament voted in favour of putting the new constitution to a national referendum, which approved the document, albeit with a low turnout among voters. This low turnout allowed opponents of constitutional reform to question the legitimacy of the vote.

Changes to the constitution are required to be passed by two successive parliaments either side of an election, hence the coalition introduced it in the spring of 2013. Political opposition in the Alþingi was considerable, particularly among the political allies of well connected and traditionally favoured special interest groups, notably the fishing vessel owners, whose power rested on the previous allocation, by high-placed friends, of fishing quota on highly advantageous terms. Constitutionally protected public ownership of natural resources threatened this power base. Parliamentary manoeuvres were conducted in order to thwart passage of the bill, with one pro-constitution member of parliament comparing trying to make progress in parliament to “trying to file her income tax return with monkeys at the kitchen table”. A successful filibuster by the opposition parties prevented the passage of the bill prior to the election in April 2013. Jóhanna Sigurðardóttir called the day the constitution bill died as her saddest day in parliament in thirty-five years.

The government had reason to be concerned about their fortunes in the run up to the April election. The previous October had seen street protests, in an echo of the movement that had forced the previous government to resign. The people were dissatisfied that their lives remained heavily impacted by the crisis, blaming the government for a litany of failures, including prioritizing the IMF over the welfare of the population. Some dissident parliamentarians from the Left-Green party denounced the actions of their own ruling coalition as being incompatible with their founding principles, and others left the party altogether.

The coalition was soundly defeated in the largest reversal by any government since Icelandic independence in 1944, losing half their seats in the Al?ingi. The Independence Party, in coalition with the Progressives, were elected with a small majority, and Progressive Party leader Sigmundur Davíð Gunnlaugsson is the new Prime Minister. Debt relief was promptly organized for fishing quota owners, and multinational owners of aluminium smelters are hopeful that environmental controls on geothermal power developments will be eased. As the old power structures are revived, crony capitalism appears poised to make a return, with economic and environmental priorities in conflict:

We now have three aluminium smelters in Iceland belonging to multinational corporations. They get power at a fraction of the rate that regular citizens of this country have to pay. That includes greenhouse farmers, who nevertheless are trying hard to maintain some level of sustainability in this country. The vast majority of the wealth generated by smelters is exported abroad, of course. And heavy industry wreaks havoc on our nature. The previous government, with the Left-Greens in the Environment Ministry, did a very good job of protecting many areas that were pegged for power harnessing. Now that the IP/PP are back, all that looks likely to change. Indeed, Century Aluminum, which is just jonesing to start up a new smelter on the Reykjanes peninsula, said last week that they are putting a lot of hope in the new government. Incidentally, the power for that smelter doesn’t exist, which means boreholes all over Reykjanes as they try to harness steam to power it. And it would not surprise me if the new government tried to kick-start the economy by attracting yet another smelter.

Fringe parties and protest groups attracted serious attention. The Pirate Party (described as “a disparate group of hackers, anarchists and digital rights campaigners”) actually won three (out of sixty-three) parliamentary seats:

The Pirate Party was built in Sweden in 2006 by hackers and freespeech activists hoping to fight the flood of online censorship bills being enacted in the name of preventing “piracy”. It is now a global movement, with branches in 60 countries and 250 elected representatives, including two members of the European Parliament. Its demographic is young, educated and precariously employed, mostly in programming, with a taste for lots of black clothing. “I’m a Pirate in my heart,” says Jón Thór Ólafsson, 36, one of the movement’s leading candidates. “The Pirates are for freedom and direct democracy. That means that people have the right to participate in decisions that affect them. It changes the rules of the game, and those who have been benefiting from playing the game aren’t very happy about changing the rules.

The constitution is effectively dead. The electoral platform of the new coalition rested on “correcting household debt burdens” through mortgage debt relief. This promise was made doubly popular by the Prime Minister’s pledge to provide this debt relief from frozen foreign investments, despite the longer term threat this may pose to the króna if capital controls are ever to be lifted. While they remain in place, investment will be limited, and companies and skilled professionals will continue to leave the country. (Two percent of the population has already emigrated, and many more are considering doing so.)

The longer term considerations matter less, however, than the short term popularity of debt relief. 150 billion krónur is to be eliminated, through a combination of outright cancellation (80 billion krónur) and allowing, and incentivizing, people to use their tax-free pension savings to pay down household debt (70 billion krónur). The measures will be paid for through taxation of the estates of the old banks, in other words with foreign funds trapped behind capital controls. Short term impact is all that can be expected from debt relief under circumstances where mortgage debt continues to be indexed to CPI, and CPI is continuing to rise on economic and currency weakness. For the time being the ponzi scheme continues, after being bought a little more time with other people’s money. A concern is that current debt relief could encourage further debt expansion down the line, in the expectation that it too will be written down.

Clearly the previous coalition had failed to meet public expectations, but those expectations were patently unrealistic:

Iceland’s response to the financial crisis has been taken as a model for how a country should react to a dramatic economic shock. However, international observers should also take note of our country’s recent election result. Despite guiding the country through a difficult but impressive recovery, the governing parties were ousted. The parties that were blamed for the financial crisis won a slim majority. This raises a fundamental question: in our age of austerity and slower growth, can politicians maintain popularity without the proceeds of a bubble economy? Put differently: can any politician meet the unrealistic expectations of Europe’s voters?

Unfortunately the problem was that there were no solutions that could have avoided the pain people continue to face, no matter who was in power, and any government trying to do anything under circumstances of inflated expectations, copious spending priorities and very little money is going to upset almost everyone. When anger and fear are in control, and the there are inevitably going to be far more losers than winners, whatever one does tends to be seen in a negative light, even if it was the best possible action under the circumstances. Nothing within the scope of what is actually possible looks like success to anyone.

Periods of contraction consume the politicians who attempt to lead through them, and who therefore preside over comprehensively dashed expectations. The electorate uses its votes to express anger at hardship and austerity, punishing the politicians they associate with the the tough decisions that had to be made. The Icelandic government could not give the people what they wanted, which was essentially to be the richest people in the world again, and quickly too. People get used to advantageous circumstances very rapidly, and come to see their good fortune as the new normal, or as a baseline from which things should only improve further.

Unfortunately, at the peak of a bubble, the only way to go is down, and the larger the bubble, the larger the correction. The political task of guiding recovery is made very much more difficult by being unable to hold power for long enough in a democracy to see through the measures that need to be taken. Failure to do so has a tendency to deliver power right back into the hands of the bubble architects and established elites, who happen be the least likely to want to move away from established power structures. These are votes cast, by association, for the memory of life at the peak of the bubble, not for a new future based on different governance principles. As such, further disappointment is guaranteed. Over the long life of a major financial crisis, the entire political elite can be consumed in successive waves.

The Icelandic bubble was exceptionally large in comparison with its host economy, suggesting that the period of adjustment back towards what has traditionally been normal for Iceland will be long and very painful. The country is far closer to the beginning of this trend change than to the end, despite the fairytale recovery portrayed in the mainstream media. At this point, the ‘recovery’ is merely a counter trend bounce within a larger downtrend, and that downtrend is very likely to be amplified significantly once the global context shifts in the same direction, as it appears poised to do. At a global level we have a very similar predicament, but on a much larger scale, that Iceland found itself in just prior to the crash of 2008. The lessons Iceland is painfully learning are ones many more of us will be experiencing over the next few years:

The Iceland of the future seems set to be a quieter place than in the first decade of the 21st century. It will, perhaps, be less about power and ambition – and less worthy of the kind of opera that might be performed at the Harpa.

“All this used to be filled with private jets,” says Mr Johannsson, with a sweeping gesture towards the empty runway overlooked from his corner office at Icelandair’s headquarters in Reykjavik’s domestic airport. “But it was easy when you are spending other people’s money,” he says. “Now we work with real things – with fish and with tourists.”

The article above addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!

Nov 282013
 November 28, 2013  Posted by at 2:08 pm Finance 26 Responses »

Arthur Siegel 2nd Avenue Rush Hour, Detroit 1942

There has been a lot of attention focused on shenanigans at the federal level in the USA this year, with games of brinkmanship and political theatre over the fiscal cliff, the debt ceiling and the government shutdown. Cheap political points were scored in a series of unedifying spectacles, but there was no serious risk of default, despite the dramatic rhetoric. It is not at the federal level that the rubber meets the road in the US, but at the state and municipal level, where many states and municipalities are poised to hit a financial brick wall at a hundred miles an hour, as Detroit spectacularly did on July 18th.

They can neither print money nor monetize debt, meaning that tax hikes and service cuts are on the cards, along with the wholesale breaking of financial promises in some jurisdictions. Both pensions and bonds are at risk, along with the services residents depend on. One group of stakeholders – residents – is currently shouldering all the losses while others remain whole, for the time being. The losses suffered by residents, in the form of tax hikes and service cuts rarely make headlines, allowing a form of slow motion financial train wreck to occur on Main Street without the attention that would come with formal default on ‘protected’ obligations like pensions and bonds.

There is a great deal of variety in the financial health of states and municipalities, so the crunch will be very unevenly distributed both spatially and temporally. The process has already begun in many places, however the long rally has distracted from the realization of local government in crisis that was dawning in 2010, and has postponed, but not prevented, the day of reckoning. The fundamentals have continued to deteriorate, but the perception of the situation has changed in the direction of far greater optimism, in line with the prevailing sentiment peak.

Back in 2010, CBS’s 60 Minutes dared to shine a light in dark places with the programme “State Budgets: Day of Reckoning” (Click to Play Video). This proved highly controversial, particularly the interview with Meredith Whitney, an analyst who had recently compiled an in-depth report on the state of municipal finances. Meredith herself was vilified for supposedly making a prediction on the programme that 50-100 municipalities would default on their bonds within 12 months, which sparked a panic. Investors subsequently withdrew $14 billion from muni bond funds in just over a month, dropping fourth quarter returns to the lowest level for 16 years.

What people think she predicted clearly did not happen. However, she was misquoted and misinterpreted. She said that the issue would become a concern within that timeframe, and indeed it already was a concern, as the data in her report demonstrated. Since then we may not have seen a rash of bond defaults, but we have seen as far more complex scenario of broken promises unfold, with over-burdened municipalities desperately trying to keep faith with bondholders and pensioners at the expense of residents, who face a downward spiral of tax rises and service cuts. The squeeze is well underway and is destined to worsen until it becomes impossible to keep any class of promises.

Commentators are frequently criticized if their predictions do not play out immediately, as if that renders their analysis completely wrong. Investors place short term bets on one dimension of what they thought they heard, and when those bets do not pay off, they are angry. Never mind the bigger, far more complex picture and the enormous implications for ordinary people’s lives. The ability to deliver short term, and short-sighted, gain appears to be what analysts are judged by, as if the longer term could look after itself or is somehow irrelevant. So-called investment becomes nothing more than a speculative game under these circumstances – a game that is being played with real people’s lives and livelihoods.

State and municipal finances are every bit as significant an issue as Meredith Whitney pointed out three years ago. In fact it is quite possible she may prove over time to have erred on the side of optimism, particularly in relation to the prospects for states currently benefitting from a temporary energy boom destined to be proven a misallocation of capital (see our body of coverage on unconventional oil and gas). Nevertheless, she has been subjected to substantial criticism and ridicule, much of it highly personal:

Wall Street analysts make bad calls all the time, but among the worst made at least in recent history has to be Meredith Whitney’s prediction back in 2010 that the municipal-bond market was set for an epic implosion …

… The result was investor panic with small investors dumping their holdings at a time they probably should have been buying muni bonds. The reason: munis are tax exempt. The smart money knew that in a time of rising taxes (particularly in states like New York and California) muni’s would be a pretty good investment. Whitney should have known that.

She should have also known that since she works on Wall Street (which underwrites the bonds of states and cities) that muni defaults occur all the time even if for the most part muni bonds are pretty safe. “Sizable” defaults (as opposed to some fiscally distressed municipality or a tax-exempt hospital bond) are almost non existent — which made her prediction so scary and when you think about it for a few moments so utterly absurd.

If you took Whitney at her word, the financial crisis that swept Wall Street was now about to sweep state and local government. This sounds plausible but like most of what Whitney predicts the kernel of truth obscures a larger absurdity. Yes cities and states face enormous pressures since the financial crisis because of lower employment levels, and thus lower tax collections. But one of the triggers of the financial crisis was that Wall Street firms that had limited access to capital to run their operation. But states and cities have access to their own form of capital; even basket cases like California have raised taxes to meet budget demands since the 2008 financial crisis. They can also cut their budgets, which they have doing as well. In other words, there was no immediate crisis that investors needed to react to as they did in ’08 when bank stocks crashed. Again Whitney should know all of this.

Whitney was not actually predicting an immediate, acute crisis, but a longer term, chronic structural predicament in relation to local government finances. Mr Gasparino, author of the above quote, completely failed to appreciate that.

Even this Lunch with the FT interview, from earlier this year, paints a very ambivalent picture (the full article being peppered as well with personal references to clothing and appearance, which detract from the real issues):

Whitney can afford to whisper: people go to great lengths to listen to what she has to say, even if they sometimes regret it afterwards. In 2007 she predicted that Citibank would cut its dividend – and it did. But then in 2010 she predicted that 50 to 100 municipal bonds would default – and they didn’t. Call #1 had Michael Lewis saying she was “the closest thing Wall Street has to an oracle”. Call #2 had Fox TV commentator Charlie Gasparino saying she “didn’t possess a single brain cell” …

It is odd how cross people are with Whitney about that municipal bond call she made two and a half years ago. Her initial bearish view was shared by such financial luminaries as Bill Gross and Nouriel Roubini; she only departed from them by being specific and saying defaults would run into hundreds of billions dollars within a year. When the defaults didn’t happen, she made everyone even crosser by declining to say sorry.

“Hundreds of billions [of defaults] is still absolutely possible,” she goes on. “You hope it’s not – but Detroit is a matchstick away from going bankrupt.” Meanwhile, any apparent improvement in California’s finances is an illusion. She rehearses again her central argument with an intensity that is slightly scary: taxpayers are getting fed up with footing the bill while bondholders get paid in full. Something’s got to give.

I want to know if she feels bad about the people who followed her and lost money. She shakes her head and insists it wasn’t like that. It was year-end, and there were technical factors behind the fall in bond prices …

“It was math, it wasn’t personal. Some people make all this stuff personal and it’s not.” And yet the way people have gone for her has been very personal indeed. They’ve made death threats. They call out mockingly in the street.

Whitney’s position is clearly deeply threatening to many, particularly because it is a construct of actual objective data and number crunching that is very difficult to argue with. As such the reaction is often unthinking dismissal and personal condemnation, rather than any rational attempt to provide a counter argument. Denial is strong in a financial world drunk on its own elixir of irrational exuberance and determined to believe that systemic risk could not possibly be real.

The implications are stark, as Detroit’s pensioners and bond-holders are beginning to discover following its trailblazing bankruptcy on July 18th. We commented on the bankruptcy at length back in the summer in Promises, Promises … Detroit, Pensions, Bondholders And Super-Priority Derivatives, pointing out the extent to which residents have been squeezed for years in order to keep promises to pensioners and bond holders.

Bankruptcy is a final admission that the process cannot continue, and that previously ‘protected’ promises cannot in fact be kept. It is time for the city to start again with a clean slate. Pensioners and bond-holders face 90% haircuts on what they believed to be secure commitments. At the moment they are attempting to defend supposed legal protections for the promises made to them in court, and seem to think those protections will be upheld. This is highly unlikely, as that which cannot be paid will not be paid, whatever legal niceties may be called upon.

This is the point where the on-going financial contraction at the local government level jumps from relative obscurity to grabbing the headlines. A plethora of small cuts does not register, but one or two very large cuts do. Once it sinks in that the ground rules have changed, and that protections can be very flimsy indeed, a contagion effect is highly likely. For the time being the buoyant mood of prevailing optimism leads people to gloss over negative news, perceiving it to be insignificant, or believing a situation to be unique rather than demonstrative of a widespread problem.

The real implications of bad news are only likely to sink in once the mood shifts towards fear. Once fear is in control, the perception of circumstances can change very rapidly, and people act on perception. At this point I would expect to see the media begin to grasp the new reality quite abruptly. That will be when the issue of state and municipal finance gets very much more visibility and traction.

Whitney has predicted ‘staggering aftershocks’ from the bankruptcy of Detroit – a position with which we at TAE would strongly agree. These have yet to materialize, but it is still early days. Still, others are beginning to agree that there is a structural problem:

“When U.S. banking analyst Meredith Whitney warned of problems in the $3-trillion U.S. municipal bond market as far back as 2010 she was widely decried by most of Wall Street for being alarmist and had been widely ridiculed for most of the last few years; however nearly three years later her concerns look like being very prophetic,” said senior analyst Michael Hewson of CMC Markets in London …

… Ms. Whitney is not alone in now citing the pension and debt troubles of other cities in the wake of the biggest municipal bankruptcy in U.S. history. Earlier this week, for example, chief economist David Rosenberg of Gluskin Sheff + Associates warned that Detroit is just the “open act,” though he noted that many of the city’s issues are unique. Still, that didn’t stop him from citing Chicago as the “next culprit,” though he wouldn’t make a call on a similar bankruptcy filing, noting only the similarities in the troubles plaguing both cities.

Ms. Whitney, in turn, notes that city bankruptcies have been rare, but things are different now as municipalities struggle to survive. “As jarring as the reality may be to accept, Detroit’s decision last week to declare bankruptcy should not be regarded as a one-off in the U.S. municipal market – which is what the bond-peddlers are now telling their clients,” she writes. “The aftershocks of the largest municipal bankruptcy in U.S. history will be staggering, and Detroit will set important precedents.”

Those will be precedents regarding how losses will be shared out under conditions where very few previous promises can be kept. There are many competing constituencies, with different levels of formal protection in a tangled web of commitments. It will be necessary to prioritize competing claims, striking down many protections in the meantime, as those selective protections would unfairly promote the interests of one class of claim over other equally deserving ones. This will be highly divisive. As difficult as it is to share out gains fairly, it is far harder to share out losses in any way perceived to be equitable. As Meredith Whitney has pointed out, everyone loses:

“The fact is everybody loses and everybody is going to have to make a concession,” said Whitney, who earlier this year published her book “Fate of the States.” “In Detroit’s case, it was in near-third world operating conditions in the richest country in the world,” she said. “Finally, the city said enough’s enough.”

Detroit’s problems aren’t isolated either. Whitney said local governments across the country will continue to struggle with heavy debt loads, a problem that will trickle down to average Americans. “I think you’re going to see a real issue of neighbor against neighbor on these very issues,” she said. “That has been glossed over for years. What’s at stake are social services we count on.”…

“There are five more towns like Detroit in Michigan alone,” Whitney wrote in the FT. “There are many more municipalities across the country in similar positions. Detroit’s decision last week paves the way for other elected or non-elected officials to make decisions to save their cities and towns, decisions that probably involve politically unpopular actions that may secure their long-term viability.”

Because the impact of this precedent-setting case has yet to be felt, the knee-jerk critics have felt justified in excoriating Whitney again, in commentary ridden with hyperbole, sarcasm and schadenfreude. See this for example:

Famous fear-generator Meredith Whitney is once again generating fear about a coming fiery apocalypse for state and local governments. Fortunately, she is just as wrong about this as she always is.

Or this:

Less than four years after breaking out on her own, Meredith Whitney is shuttering her advisory shop. It’s a stunning defeat for one of Wall Street’s most recognizable faces. But as I’ve suggested before, that’s what bad advice will get you. Whitney, who achieved fame for an over-hyped banking forecast in 2007, was taken down after she predicted at the end of 2010 as many as 50 to 100 municipal defaults. Even by the most forgiving standards, we’re about 45 to 100 defaults away.

Whitney, with her made-for-CNBC looks and cocky and combative demeanor, overplayed her hand. Now, it appears her clients, if she had any at all, have moved on … ..Whitney’s 50- to 100-defaults prediction on “60 Minutes” at the end of 2010 may be the biggest blunder that market has ever seen. Panicked investors bailed out on the call, but municipal bond’s inherent safeguards quickly became apparent. The bonds rallied, leaving many investors who followed Whitney behind.

And then, of course, there was Detroit’s bankruptcy. Whitney called it a “game changing” event. She seemed almost giddy, stirring up the fear that others may follow in an op-ed piece called “Detroit Will Start A Wave Of Municipal Bankruptcies.” As Michael Aneiro at Barron’s put it July 23, Whitney couldn’t resist. That’s why she’s the “biggest alarmist in the history of public finance.” All of this raises the question: What will come first: 50 to 100 muni defaults or Whitney admitting she was just plain wrong?

Or this:

You knew it was coming. The biggest municipal bankruptcy in history was too big an opportunity to pass up for the biggest alarmist in the history of public finance. And this afternoon it happened: Meredith Whitney emerged to pen an opinion piece in the Financial Times under the headline (brace yourself) “Detroit Will Start A Wave Of Municipal Bankruptcies.”

Whitney, you recall, is the one-time one-hit bank analyst who astutely predicted Citi‘s demise in the lead-up to the financial crisis. After fading out of the limelight for a couple of years, she turned her attention to public finance, infamously warning of “hundreds of billions of dollars” of municipal defaults within 12 months during an appearance on “60 Minutes” in late 2010, a prediction that didn’t even come remotely close to being accurate, but sparked a months-long muni-market rout as spooked investors pulled money from muni funds. In her attempt to recast herself as a muni-market Cassandra rather than just a muni-market pariah, Whitney once again finds herself in the familiar position of saying just about the exact opposite of what most longtime muni-market experts are saying …

… For anyone with a decades-long investing time horizon, who prefers to go years at a time without making any portfolio adjustments, read Whitney’s piece and by all means consider pulling some money from muni funds. For the rest of us not easily alarmed by extremely slow-moving objects far off in the distance, stick to the advice of other experts, who almost unanimously call Detroit’s situation unique, and possibly precedent-setting for how the city and the court treat general obligation bonds compared to other creditors, but by no means the start of a cascading muni-market disaster.

Anyone even vaguely familiar with the financial history of the last few years will be able to think of far larger financial blunders, not to mention major incidents of malfeasance and fraud which have cost far more people far more money than anything Meredith Whitney ever said. As for being the ‘biggest alarmist in the history of public finance’, she is optimistic in comparison with our position.

There is a great deal in the world of finance, both public and private, to be alarmed about at the current juncture. Comments like those above are typical of the extreme complacency and disregard for risk that characterize a market top. It would be difficult to find a greater example of complacency than describing the municipal finance issue as an “extremely slow-moving object far off in the distance”. That is simply a way of saying that the obvious long term risks can be ignored, indeed it indicates contempt for the very notion of paying attention to the longer term in a rational and objective manner. Risks appear benign at the peak of a bubble, when sentiment is at an optimistic extreme, but we would do well to remember what follows. Risk has a way of staging a dramatic resurgence in a short stretch of time.

Many of those risks are clear already to anyone minded to look. Both states and municipalities (not all to be sure, but a significant number) are facing hard limits, and those limits will get tighter as the pie shrinks. Competition for a slice of the remaining pie will get fiercer. States and municipalities are very likely to find themselves in increasingly complex competition with each other. This has already been going on, as higher levels of government have been downloading responsibilities without the funding to go with them, hence states have been improving their own finances at the expense of municipalities, which in turn have no choice but to further squeeze residents for the cost or to fail to deliver on the responsibilities:

All you have to do is look to Detroit—or any of the nearby auto towns named after a Buick model of one sort or another—and you see fiscal crisis playing out right now. Look in your own backyard—or at the potholes on your neighborhood roads—and you will likely find the same.

Consider the email I received on March 7 from former New York State Assemblyman Richard Brodsky about Yonkers Mayor Mike Spano’s recently formed Commission of Inquiry into what he refers to as that city’s “Great Unraveling.” (Brodksy is serving on the commission.) “[Yonkers has] a budget of about $1 billion and a budget gap in the upcoming year that looks like it can’t be bridged. There are reasons aplenty. Like many urban centers the Yonkers manufacturing base disappeared, the middle-class moved out and the people simply can’t afford the property and sales tax burden that ensured. Anti-tax fervor hit and elected officials refused to raise recurring revenues. Gimmicks, one-shots, borrowing for operating expenses, assets sales, and assorted maneuvers ‘kicked the can down the road’ for a couple of years…The city has now run out of gimmicks.”

And then he sounds very Whitney-like: “It’s as though we stand on the shore and watch a tsunami gather and shrug and hope we’ll get through it…That needs to change, and if the list of endangered cities gets larger this will force itself onto the national stage. [For now] the great national battle about the size of government and the level of taxation will be played out in the streets of small cities across America, with school kids, garbage pick-up, fire-protection, and safe streets competing with each other for inadequate resources. It’s an ugly way to solve a problem.”

This is why the rubber meets the road at the local level, and why we should be paying far more attention to what is going on beneath the surface in America, far from Wall Street and the distracting political theatre at the federal level. Warning signs exist in many places and it would be instructive to look at a few of them. Many have similar structural problems to Detroit:

While few municipalities are as economically depressed or dilapidated as Detroit, many have borrowed heavily, raised taxes and hollowed out services to pay retirement and debt obligations. Some like Detroit may soon decide that clipping bondholders and pensioners is a better option than to keep whacking taxpayers.

Take Oakland, which is Detroit’s doppelganger on the West Coast. The run-down Bay Area city, which has the highest crime rate in California, recently laid off more than 100 police to fund retirement benefits and pension-obligation bonds. Murders and robberies shot up by nearly 25% last year. To avert steeper cuts, the city borrowed an additional $210 million to finance pensions.

Philadelphia and Chicago have been less scrupulous about financing pensions and are now having to make balloon payments to prevent their retirement funds from going broke. Philadelphia is spending about 20% of its budget on pensions to make up for years of short-changing the system. In 1999, it issued $1.3 billion in bonds to invest in the pension fund, but it has paid more in interest than it has earned on its pension investments. The city has recently raised sales, property and business taxes. The city council is now discussing using revenues from a one-percentage-point sales tax hike in 2009 intended for schools to finance pensions. Its sale tax rate is now 8%, the limit under state law.

Chicago is also fast approaching a day of reckoning. Chicago Public Schools last week announced 2,100 layoffs, which Mayor Rahm Emanuel blamed on a $400 million spike in pension payments. “The pension crisis is no longer around the corner,” he said. “It has arrived at our schools.” Moody’s downgraded the city’s general-obligation bonds last week due in large part to rising retirement and debt service costs, which comprise about a third of its operating budget. Chicago plans to dump 30,000 retirees on Medicare and the ObamaCare exchanges in 2017. Yet all savings will go toward pension payments, which will triple in 2015. The mayor has warned that the bill could force a 150% spike in property taxes.

Smaller cities may present an even greater default risk because they have lower borrowing limits, and retirement costs tend to consume a larger share of their operating budgets.

Even declaring bankruptcy, as San Bernardino did, does not necessarily give a city a fresh start unless the thorny issue of legal protections for some classes of promises  – notably pensions – is addressed. If the class of promise in question is also the major financial problem facing a city, as it often is, nothing is really solved by bankruptcy. It merely amounts to another in a long series of stop-gap attempts to kick the can down the road:

When this sun-drenched exurb east of Los Angeles filed for bankruptcy protection in August, the city attorney suggested fraudulent accounting was the root of the problem. The mayor blamed a dysfunctional city council and greedy police and fire unions. The unions blamed the mayor …

… Yet on close examination, the city’s decades-long journey from prosperous, middle-class community to bankrupt, crime-ridden, foreclosure-blighted basket case is straightforward — and alarmingly similar to the path travelled by many municipalities around America’s largest state. San Bernardino succumbed to a vicious circle of self-interests among city workers, local politicians and state pension overseers. Little by little, over many years, the salaries and retirement benefits of San Bernardino’s city workers — and especially its police and firemen — grew richer and richer, even as the city lost its major employers and gradually got poorer and poorer.

Unions poured money into city council elections, and the city council poured money into union pay and pensions. The California Public Employees’ Retirement System (Calpers), which manages pension plans for San Bernardino and many other cities, encouraged ever-sweeter benefits. Investment bankers sold clever bond deals to pay for them. Meanwhile, state law made it impossible to raise local property taxes and difficult to boost any other kind. No single deal or decision involving benefits and wages over the years killed the city. But cumulatively, they built a pension-fueled financial time-bomb that finally exploded.

In bankrupt San Bernardino, a third of the city’s 210,000 people live below the poverty line, making it the poorest city of its size in California. But a police lieutenant can retire in his 50s and take home $230,000 in one-time payouts on his last day, before settling in with a guaranteed $128,000-a-year pension. Forty-six retired city employees receive over $100,000 a year in pensions. Almost 75% of the city’s general fund is now spent solely on the police and fire departments, according to a Reuters analysis of city bankruptcy documents – most of that on wages and pension costs.

San Bernardino’s biggest creditor, by far, is Calpers, the public-employee pension fund. The city says it owes Calpers US$143-million; using a different calculation, Calpers says the city would have to pay US$320-million if it left the plan immediately. Second on the city’s list of creditors are holders of US$46-million worth of pension bonds — money borrowed in 2005 to pay off Calpers. The total pension-related debts are more than double the $92 million owed to the city’s next 18 largest creditors combined …

… Yet even in bankruptcy, reducing pension costs by cutting benefits is not an option – at least according to Calpers. The pension agency says the benefits are carved in stone, arguing that from the day a worker is hired, the pension plan in place on that day for that person can never be reduced in value under any circumstances, including municipal bankruptcy. That argument has never been tested in court: When the Bay Area city of Vallejo went bankrupt in 2008, it declined to challenge the pension payments to Calpers, in part because of the daunting legal costs involved. But the pension-bond insurers who are now on the hook for defaulted bonds in both Stockton and San Bernardino have signaled their intention to do battle with Calpers in bankruptcy court. San Bernardino, in an unprecedented move, has already stopped making payments to Calpers …

… San Bernardino and Stockton are hardly alone. A handful of other small California cities, including Atwater, Hercules and Compton, are teetering near bankruptcy. Big California cities that run their own pension plans also have deep problems. San Jose, hub of Silicon Valley, and San Diego, biotech center of California, both passed pension reforms in June in the face of unmanageable retirement benefits. They are now defending those measures in court against public-employee lawsuits …

… The chronic mismanagement in San Bernardino, though, is a common feature of local government in California and around the United States. Much power over municipal finance lies in the hands of those with the most at stake — city employees, elected officials and others who depend directly on government for their livelihood.

Recently, however, San Bernardino has decided to tackle the elephant in the room, while other municipalities have preserved pension contribution at the cost of bond haircuts:

In what could presage a groundbreaking showdown with America’s largest public pension fund, San Bernardino officials will challenge Calpers’ calculations and also seek a longer repayment term on the debt. Calpers says that after San Bernardino halted its employer contribution to the fund for an entire year after filing for bankruptcy protection in August last year – the first time a California city has ever paid less than its full dues – its arrears stand at just under $16.5 million, plus growing interest … It will be the first time the city has had substantive negotiations with its creditors since it declared bankruptcy on August 1, 2012.

The San Bernardino case is taking a much different course than that of Stockton, another California city that filed for bankruptcy last year. Stockton has kept current on all payments to Calpers and decided not to take on the pension fund in its bankruptcy, while bondholders have agreed to accept substantially reduced repayments. Calpers has supported Stockton’s bankruptcy, but has fought San Bernardino’s quest for Chapter 9 protection at every turn. In San Bernardino, the stakes are high for the pension fund because it has strenuously argued that all cities and other local entities must always pay it in full, and on time, even in a bankruptcy …

… San Bernardino resumed paying Calpers in July, but has reneged on its debt to bondholders and other creditors since August 2012, including the holders of $50 million in pension obligation bonds …

… Many California cities are struggling to meet growing pension costs, which are typically by far their biggest expense.

The related issue of retiree healthcare is also a highly emotive issue tightly bound up with the municipal financial crisis:

The man in charge of the biggest U.S. city ever to file for bankruptcy is clear about the root of the crisis. It was a decision that gave firefighters full healthcare in retirement starting on January 1, 1996, said Bob Deis, the city manager of Stockton, California. At the time, the move seemed cheaper than giving pay raises sought by unions, officials involved in the decision said. When other Stockton employees demanded the same healthcare deal in following years, the city agreed. Deis, who signed Stockton’s bankruptcy filing last Thursday, slammed the decision to provide free healthcare to retirees as a “Ponzi scheme” that eventually left the city with a whopping US$417 million liability …

… To counter demands for wage hikes from city workers in the 1990s, Stockton offered to extend their health insurance in retirement past age 65 – a benefit they embraced and assumed to be rock solid until the insolvent city’s officials put it on the chopping block in a bankruptcy plan last week. “It was a balancing act,” said Dwane Milnes, Stockton’s city manager at the time. “The unions wanted retiree medical … We said if you want to continue your medical for current employees and retirees, you’ll have to do it through wage containment.” Milnes, who represented Stockton’s retirees in recent talks with City Hall, said the strategy was sound at the time.

“We were satisfied that based on a conservative view of the economy and based on the medical inflation rate we were experiencing in the 1990s, the city could adequately fund retiree medical.” Detective Mark McLaughlin said Stockton’s labor unions embraced the trade-off, which in the police department’s case helped with recruiting and retention. “It was an easy sell,” he said, adding that city workers believed the money they gave up in pay increases would be able to pay for the health benefit …

… Axing retiree medical benefits is now central to efforts to restructure Stockton’s finances, Deis said. Many retirees are in a state of shock about that. “I believed the city would honor its commitments,” said Geri Ridge, 56. The former clerk retired last year after 26 years with Stockton’s police following a second heart attack. Ridge lives off a monthly pension of US$1,895. She learned on Friday that she now faces a US$576 monthly premium for her health coverage – or US$1,277 a month if she keeps her daughter on her plan. She has no idea of how to pay for the coverage, which the city will fully eliminate in a year.

Many cities across the US are going to have to tackle these issues head on as it ceases to be possible to kick the can down the road. Residents cannot bear the burden of all the cuts forever. The pensions crisis is very real, and the underfunding is compounded by completely unrealistic rate of return assumptions, typically 8% per year, when 2% would be more defensible. If pension projections were based on anything remotely realistic, the underfunding would be far more obvious.

As it is, the gap is partially concealed by accounting assumptions, allowing people to hold on to their belief in the promises made to them. They not only hold on to that belief, but defend against any attempt to address the funding gap. They cling to the pie-in-the-sky notion that they will receive the full amount, while preventing any kind of reform that might actually deliver a partial payment, thereby raising the risk of receiving nothing:

Voters in Cincinnati last week soundly defeated a ballot initiative which would have overhauled the pension system for public workers, leaving the city without a plan to deal with $872 million in unfunded liabilities. Cincinnati is not alone. Across the nation, cities and states are finding funding for basic services being crowded out of their budgets by the rising cost of retirees’ pensions and healthcare. The Cincinnati initiative would have turned the public pension system into a 401(k) style-plan and require the city to pay off its unfunded liabilities in 10 years …

…A study by the Pew Center earlier this year looked at 61 cities — those with populations over 500,000 plus the largest city in each state — and found a total gap of $217 billion between pension and retiree healthcare obligations and the funding saved to pay those costs. According to Pew, those cities had a total pension liability of $385 billion, with 74 percent funded, leaving a $99 billion shortfall. The situation regarding retiree healthcare benefits in those cities is far worse, with a total of $126.2 billion of liabilities that are only 6 percent funded.

But here’s the real rub: experts are warning that many pension systems, those claiming they are well funded and those who say they aren’t, have all been using rosy projections about future investment returns …

Many localities are seeing their operating budgets squeezed to pay for pension and healthcare retirement benefits. The country’s 250 largest cities saw spending for pensions increase to 10 percent of their general budgets in 2012, an increase of 7.75 percent since 2007, according to The Wall Street Journal.

The pension issue can no longer be ignored. Sooner or later (and probably sooner), unreformed plans will collapse and suffer Detroit-style losses:

No sooner had the Chicago teachers’ strike been settled than a new crisis emerged last week in the Windy City. The Chicago Teachers’ Pension Fund was reported to be on the brink of collapse. That fund is not alone. Although the troubles that plague the Social Security system get the most attention, similar dangers now threaten many other kinds of retirement funds. Some plans are being inadequately funded, some have earned unexpectedly low returns, and some suffer from a Baby Boom bulge in the number of retirees. Moreover, the problems facing these funds will in many cases be harder to fix than those for Social Security. And the scale of the total potential shortfall is immense.

Chicago is one of the worst examples of municipal finance, and is probably one of the leading contenders to follow Detroit’s lead. The level of debt there is staggering:

Cook County encompasses Chicago and some of its surrounding suburbs. This week, the Cook County Treasurer discovered “stunning” debt. This debt isn’t new, but apparently our officials are now properly terrified. Our total debt for the municipality, education, county, sanitary, park, fire, township, library and special services is now $108 billion. That means the debt per person in Chicago exceeds $23,700 (corrected assuming 2.67 average per household) or more than $63,500 per household, and that is just local debt.

The other problem is that the Illinois economy isn’t growing. Many of those households have no income coming in other than government subsidies, and some have no income at all. Unofficial unemployment numbers top 20%. State of Illinois taxes increased from 3% to 5%, an increase of around 67%. Taxes on real estate, utilities, sales, and more are expected to skyrocket. Businesses like the Chicago Mercantile Exchange are being courted by low income tax states (at least the income taxes are currently low) like Florida.

The budget choices being made have consequences for real people in their daily lives. While there has not yet been a formal default, the relentless cuts elsewhere are well underway:

Thousands of Chicago children will be walking a different route to school as they begin the new academic year on Monday morning after the city closed about 50 elementary schools to help plug a projected $1bn education budget gap. Last month the district laid off more than 2,000 teachers and staff on top of the roughly 1,000 culled as part of the school closings. Chicago’s measures are some of the more drastic being taken by a school district. But the city is not alone and, as the US braces for another round of budget battles in Washington …

… This month Philadelphia was forced to borrow $50m just to be able to start school on time. That came after the district closed 24 schools in June and cut nearly 4,000 employees. Last week Detroit’s school system issued $92m in one-year debt to cover operating expenses for the new school year. It has lost more than 33,000 students, or 40 per cent of those enrolling, since 2010 as Detroit’s population has shrunk and charter schools have grown.

Chicago’s budget problems are driven in part by the teachers’ pension fund, which faces a $404m increase in its required pension contribution during this school year. The city’s schools that are remaining open are cutting services and facing hard decisions, according to Clarice Berry, head of the Chicago Principals & Administrators Association. “You have to decide ‘Do we go all year without textbooks so I can have an extra staff person?’”

Most of Chicago’s cuts have taken place in the predominantly poor, African-American and Latino south and west sides, which is also where the majority of the city’s 506 murders occurred last year. The city has created 600 “safe passage” routes manned by adults and meant to try to ensure the safety of students crossing gang territories. But in recent weeks at least two people have been killed on those paths. One incident saw four injured and one dead after a shooting in front of a church. Another saw a 54-year-old man shot on the safe passage route that leads to Drake Elementary in Bronzeville.

The situation in Detroit is not looking so unique these days. Debts and long term obligations have been piling up for years, and debt/obligation servicing has been increasingly consuming the substance of the municipalities required to honour these commitments. Additional debts are taken on in the bond market in order to make good, in the short term, on older obligations. Many are approaching a hard limit to their ability to repay and are very likely to follow  Detroit’s lead:

Detroit, once the emblem of the growing U.S. economy, had no other options than to file for bankruptcy. Other cities in California, and cities like Jefferson County, Alabama, have done the same for very similar reasons: registering a budget deficit year-after-year as revenues declined and costs rose—especially pension costs … Cities across the U.S. economy are experiencing rising budget deficits, and contrary to popular belief, it’s not just smaller cities; major cities are in the same situation. In fact, two major American cities are in big fiscal trouble.

Chicago, the “Windy City,” is expected to incur a budget deficit of $338.7 million next year. By 2015, this budget deficit will increase to $1.0 billion, moving up to $1.15 billion by 2016. The city is in deep trouble as pension liabilities are soaring—police and fire pensions are in a cash crunch. (Source: Chicago Sun Times, August 1, 2013.) The city has received credit rating cuts and warnings from credit rating agencies. It owes billions of dollars to its suppliers and it can’t pay them.

Baltimore is in a similar situation. In February of this year, the city’s long-term budget deficit was projected to be $750 million. In a desperate attempt to fix the issue at hand—to reduce the budget deficit—the city cut about 2,200 dependants from the health insurance plan it provides to its employees. (Source: Baltimore Sun, August 2, 2013.)

In the first six months of this year (January to June), more than $176 billion worth of municipal bonds were issued. (Source: Securities Industry and Financial Markets Association web site, last accessed August 5, 2013.) It is foolish to think investors won’t see some problems with some of these bonds.

It is increasingly difficult to see how Meredith Whitney’s projection for a wave of municipal bankruptcies could fail to materialize over the next few years. There are simply too many obligations to service and not nearly enough resources to go around. For decades promises were made in the present that would have to be paid for by future taxpayers. Now the future is here and exceptionally hard choices will have to be made. Already basic social services have been highly eroded in many places and infrastructure has been left to decay for want of fund for maintenance. That has led to a downward spiral that has depressed home prices and driven away viable businesses, therefore impacting on tax revenues. That in turn has compounded the original deficits in a vicious circle of decline. The weak get weaker, and as they become more obviously risky, their borrowing costs are rising, further increasing the pressure upon them.

So far, however, the effect has been muted, since investors desperate for yield are blindly chasing risk for want of other viable alternatives. Where there are few to no good options, they settle for what they perceive to be least worst options, however incorrect that perception may prove to be:

Today and Monday, individual investors have a unique opportunity to “benefit” from the greatest bond bubble in history, even before institutional investors get to jump in, and buy sewer bonds – yup, that’s where they belong – issued by a county that landed in bankruptcy court because it defaulted on its prior sewer bonds. The money will go to the existing bondholders who’ll get a fashionable haircut as part of the deal – a deal made in bond-bubble heaven.

Jefferson County, which includes Alabama’s largest city, Birmingham, filed for Chapter 9 bankruptcy protection in 2011 when it defaulted on $3.1 billion in sewer bonds. At the time, it was the largest municipal bankruptcy. That record was crushed when Detroit filed in July. In the olden days before the Fed repressed interest rates to near zero, back when it was a little harder for banks to fleece depositors on a daily basis, and when risk still had a price – a steep price – and when yield investors were less desperate, this deal would have been DOA. No conservative investor – and that’s what muni buyers are – would have lent to a municipality that had just ripped off its existing bondholders. There would have been a penalty for its reckless financial behavior. And it would have been exacted by the market: no more new debt, not for a long time, or only at a prohibitive cost, with yields deeply into the double digits.

But now yield investors are desperate, driven to the edge of sanity by the Fed, their patience wrung out of them by years of QE, and in their search for yield, they’re turning over stones, and whatever squiggly toxic malodorous thing they see there, it entices them, and they hold their nose and take the risk, any kind of risk, and pick it up, hoping for a little bit of income above the rate of inflation, and they’re so desperate that they even buy this Jefferson County sewer debt …

…There used to be a fear that once a municipality had stiffed bondholders in bankruptcy court, it would have trouble accessing the credit market again for a while, that it would be frozen out by investors who recognized the risk of reckless behavior and wanted to be compensated for it. But now, instead of forcing the municipality to get its financial house in order, bankruptcy offers an efficient method to live beyond your means and do dubious deals, then slough off that debt and get more money from new bondholders without even a pause. And start all over again.

Other cities are already trying it. Vallejo, a Bay Area city of 115,000, emerged from bankruptcy two years ago and is still struggling with soaring pension costs that had been left untouched. Yet, about a month ago, it was able to sell some bonds that will keep it afloat a while longer. And Stockton, another California city that went bankrupt, was able to borrow $55 million in new money to pay off some old water debt. These pale in comparison to Jefferson County’s $1.8 billion in bonds, sold while still in bankruptcy …

… But what will it do to the many deeply troubled municipalities? The lack of penalty and the availability of new money will encourage them to file for bankruptcy to wipe off in one fell swoop the sins of the past – only to commit more sins with new money, even more freely! More and more muni investors will be sacrificed on the altar of the Fed’s policies. And the Jefferson County bond deal might just be what it takes to open the floodgates.

Of course there are always financial players enthusiastic about profiting from the distress of others, while assuming they are immune from the consequences of that distress. For instance, municipal bond insurers expect more investors to require bond insurance, which they expect to profit from selling. At the same time they believe the losses they will incur from actual bankruptcies will be low – yet another case of short term profit seekers failing to appreciate long term structural risks:

Bond insurers exposed to billions of dollars of Detroit debt expect to emerge as long-term winners from the largest municipal bankruptcy in US history. Executives at MBIA and Assured Guaranty have relaunched their municipal bond insurance businesses, arguing that losses in Detroit will be small and that the risks highlighted by the city’s fall from grace could drive more bond investors to demand payment protection. Insurers cover losses if a local government borrower defaults, something that had appeared a safe and sleepy business until Detroit …

… On a conference call with analysts last week, Jay Brown, chief executive of MBIA, said that he saw a “silver lining” in the reaction to Detroit’s bankruptcy. “Muni bond defaults have historically resulted in a greater appreciation of the value of bond insurance,” he said. “So we will continue to remind the market that there will be no losses of principal and interest payments to?.?.?.?insured bondholders.”

Before the financial crisis, more than half of the $3.7tn of US municipal bonds bought were wrapped with insurance from Assured, FGIC, MBIA and Berkshire Hathaway Berkshire among others, a business model based on a kind of arbitrage. By providing insurance, a bond that was rated at a less than optimal level became a much more highly rated piece of debt, enabling a city to borrow more cheaply. The city was happy to pay the insurer with the money saved while the insurer pocketed the fee, confident that the city would always raise taxes rather than default. However, the insurance companies lost their gold-plated credit ratings after making a disastrous move into insuring mortgage-related derivatives. Now the proportion of municipal bonds wrapped with insurance has fallen below 5 per cent …

… Detroit’s woes are “an advertisement for the bond insurance space”, he said. “Any losses that the insurers face in Detroit might turn out to be a small price to pay for a revival of their industry.”

Bond insurance was one of the mechanisms that facilitated excessive borrowing by municipalities, by allowing them to achieve a credit rating they would not have merited on their own statistics. The assumption seemed to have been that the bond insurers faced no risk of not being able to make good on their own promise to back the municipal borrowers, or any other class of borrower. This assumption was clearly not borne out, as the losses taken by the insurers on their foray into mortgage back securities demonstrated.

Since there is no capital adequacy regulation for derivatives, there cannot be said to have been a solid guarantee of municipal debt either, yet the ratings agencies acted as if this was the case. They may do so again if the municipal bond insurance game reignites, even though this would allow over-burden borrowers to get themselves into deeper trouble. At some point that risk is going to be realized. After all, insurance is just another class of protection that may or may not be worth the paper it is written on when push comes to shove, and as we have seen in the case of Detroit, supposed protections can be ephemeral.

At least in the case of municipal bankruptcy there is an established legal mechanism to follow – Chapter 9 Municipal Bankruptcy. However, it is not just municipalities that are teetering on the brink, it is also states, and there is no legal mechanism for state bankruptcy. A look at the state of Illinois suggests one is going to have to be developed in the not too distant future:

It’s not quite fair to say that Illinois officials are doing nothing to defuse the most threatening pension time bomb in America. Darn close to nothing, that’s fair, which explains why the ratings agencies Fitch and Moody’s have put the state on their negative watch lists. The Land of Lincoln is heading toward yet another downgrade of its battered bond ratings if this near-paralysis keeps up … .Illinois Gov. Pat Quinn took to the ether last year to explain why underfunding the state pension system (the deficit is deepening by more than half a million bucks per hour) is not a good idea. When the state has to pay promised pensions even though the coffers are empty, said the governor, other priorities get squeezed—like schools, roads, and law enforcement …

… Awareness of the pension mess is not really the problem in Illinois. Everyone has known for years that the state is a fiscal wreck, with Exhibit A being the smoking crater in the pension fund. Thanks in large part to the rapidly growing slice of state spending that goes to pensions, Illinois has gone ten years without a genuinely balanced budget, and the state was essentially broke even before the Great Recession hit. Now it is roughly 300 days behind in its payments to vendors—despite having tried every accounting trick in the book to hide the red ink. In fact, awareness of the problem inspired the state legislature to raise taxes and deposit some actual money in the pension fund last year, rather than toss in the usual IOUs …

… The problem is … well, there are several problems, the first of which is leadership. Illinois did not have much during the period when former Gov. Rod Blagojevich followed his predecessor, former Gov. George Ryan, out of office and into federal prison on corruption charges. As the Chicago Tribune has amply documented, Illinois labor leaders, lobbyists, legislators, aldermen—even longtime Chicago Mayor Richard M. Daley—have been more likely to pad pensions than to properly manage them, starting with their own comfy retirement cushions.

Lawmakers promised more and more benefits to retired teachers, police officers, firefighters, and other government workers over the past decade; meanwhile, the pool of money to pay these pledges was neglected. The estimated shortfall of nearly $100 billion between now and 2045 is, believe it or not, a rosy scenario, given that a) it assumes robust investment returns and b) doesn’t include local pension disasters, like the estimated $20 billion hole in the City of Chicago system …

… The Pew Center on the States, which tracks the pension funding problem nationwide, says Illinois now faces the worst mess in the country, with less than half of its pension obligations currently covered. But other states are suffering from symptoms of the same disease. According to Pew, 34 states were short in 2010 of the recommended 80-percent funding level considered safe for pension systems. (That is the most recent year for which data is available; defenders of public pensions argue that 2010 figures exaggerate the problem because they  collected near the bottom of the bad economy.) In all, Pew estimates the total shortfall in state pensions to be $1.38 trillion.

Fixing problems of this scale, where the political price is immediate while the benefits are stretched out over decades, is never easy. The widely acclaimed reforms passed in Rhode Island last year are bogged down in litigation, as unions fight to preserve the deals they negotiated. But each day that passes without major reforms, the mathematics of the Illinois crisis grind on: ever more retirees, collecting steadily larger checks, as tumbling bond ratings make it more and more expensive to borrow money to mask the hole.

As with municipalities, a state verging on insolvency also has to make hard choices that have a tremendous impact on the lives and livelihoods of ordinary people:

Even by the standards of this deficit-ridden state, Illinois’s comptroller, Daniel W. Hynes, faces an ugly balance sheet. Precisely how ugly becomes clear when he beckons you into his office to examine his daily briefing memo. He picks the papers off his desk and points to a figure in red: $5.01 billion. “This is what the state owes right now to schools, rehabilitation centers, child care, the state university — and it’s getting worse every single day,” he says in his downtown office. Mr. Hynes shakes his head. “This is not some esoteric budget issue; we are not paying bills for absolutely essential services,” he says. “That is obscene.”…

… In Illinois, the fiscal pain is radiating downward. From suburban Elgin to Chicago to Rockford to Peoria, school districts have fired thousands of teachers, curtailed kindergarten and electives, drained pools and cut after-school clubs. Drug, family and mental health counseling centers have slashed their work forces and borrowed money to stave off insolvency. In Beardstown, a small city deep in the western marshes, Ann Johnson plans to shut her century-old pharmacy. Because of late state payments, she could not afford to keep a 10-day supply of drugs.

In Chicago, a funeral home owner wonders whether he can afford to bury the impoverished, as the state has fallen six months behind on its charity payments, $1,103 a funeral. In Peoria — where the city faced a $14.5 million gap this year and could face an additional $10 million budget hole next year — Virginia Holwell, a trainer of child welfare caseworkers, lost her job when the state cut payments to her agency. She sits in her living room high above the Illinois River and calculates the months of savings left before the bank forecloses on her house … The city of Rockford plans to close fire stations and lay off firefighters, and in Decatur, 180 impoverished seniors have lost their delivered meals. The lakeshore condo towers in Chicago bespeak affluence, but there are so many foreclosures on the bungalow blocks of southern and western Chicago that “for sale” signs sprout like sunflowers …

… “We are a fiscal poster child for what not to do,” said Ralph Martire of the Center for Tax and Budget Accountability, a liberal-leaning policy group in Illinois. “We make California look as if it’s run by penurious accountants who sit in rooms trying to put together an honest budget all day.”

Mr. Hynes walked into his child’s elementary school recently and learned that kindergarten hours were being cut because of the state budget. “Everything is triage now,” he said. “We work to avoid outright disaster.”

So what has Illinois been doing to tackle its acute financial crisis? Other than musing publicly about expecting an eventual federal bailout of its pension fund, mostly it has been engaging in desperation measures designed to kick the can down the road a little longer, even though some of these actually aggravate the longer term problem substantially:

Lawmakers meeting in Springfield will consider spending cuts, an expansion of casino gambling and a proposal from Democratic Governor Pat Quinn to borrow $15 billion to pay overdue bills and help fill the budget hole. The bill before the House would create five new casinos, including one in Chicago, and authorize electronic gaming at horse-racing tracks and nine existing casinos. The measure has passed the Senate …

… The governor needs Senate approval of a borrowing plan to make this year’s payment into the pension funds. The Illinois State Board of Investments will start buying back assets sold to pay benefits if lawmakers approve the debt sale, William Atwood, executive director of the panel, said in an interview on Bloomberg Television today. The three pensions run by the board, which manages $10 billion, have been selling assets to pay retirees since Illinois failed to contribute for the fiscal year that began July 1

… Borrowing to pay bills continues. In November the state sold $1.5 billion of bonds backed by tobacco settlement payments to help pay vendors. “We have seen a lot of the budgetary tools that really don’t qualify as real solutions used, whether it’s short-term borrowing, pension borrowing, delays in payments, the sale of future revenues,” Hynes said … .”The state has been spending $3 for every $2 it takes in, and borrowing to cover its current operating expenses,” said White, chairman of the Civic Committee of the Commercial Club of Chicago.

State bankruptcy raises the issue of state versus federal power. A bankrupt state would essentially be surrendering to a federal take over, which poses constitutional difficulties as state jurisdiction is protected from national government. Even though states cannot formally declare bankruptcy, they can become insolvent, as Illinois arguably already is. Without bankruptcy provision, however, the default process is likely to be unstructured and chaotic. It would be preferable to have worked through in advance what the priorities should be, how to protect vital supply chains, and how to mitigate the pain where possible. Of course this is a huge task and there may well not be time to devise and implement such a plan.

State and municipal government stakeholders are increasingly in competition with each other. Will residents, taxpayers, unions, pensioners or bondholders be relatively favoured? Will there be any winners at all? In a negative sum game where they will be fighting over a continually shrinking pie, this cannot help but be exceptionally divisive, and corrosive of the fabric of society. Those who ignore the well-founded warnings of this predictable crisis are nevertheless likely to find themselves caught up in it, as it is basic social cohesion that will be under threat when facing Detroit-style cuts in so many places. This is indeed where the rubber meets the road.

Feb 192013
 February 19, 2013  Posted by at 7:55 pm Finance Comments Off on Risk Management And (The Illusion Of) Insurance

The expansionist post war era has been characterized by the development of the FIRE economy (finance, insurance and real estate), with a greater and greater dependence on leveraged risk. A necessary consequence has been increasingly sophisticated mechanisms for operating at financially rarified levels far removed from any basis in real wealth. As the network of economic and financial connections has broadened exponentially, and become increasingly complex, greater attention had been paid to apportioning and diverting risk, and to anticipating and avoiding losses through insurance.

Insurance is the equitable transfer of the risk of a loss, from one entity to another in exchange for payment. It is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss…The transaction involves the insured assuming a guaranteed and known relatively small loss in the form of payment to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in the case of a financial (personal) loss.

The use of, and dependence on, insurance has spread throughout society in developed countries, and has led to changes in the perception of risk. Rather than addressing risk directly through prudent behaviour or due diligence, risk management has become highly abstract. Being able to pay to officially offset risk can lead to the perception that risk has somehow disappeared. The supposed insulation, or buffer, adds to the comfort level of operating at high levels of leverage, in the same way that driving a vehicle with many safety features can lead to people driving more recklessly, because they feel more secure in taking risks they feel they control, or have paid to minimize.

To pursue the driving analogy, if we are interested in controlling driver behaviour for the benefit of all, perhaps instead of more car safety features, we should consider installing a large spike in the middle of the steering wheel, pointed directly at the driver's chest. Making risk apparent and personal makes us pay attention to it and adapt our behaviour accordingly. Faced with an obvious an immediate threat, we would drive in such a way as to avoid the consequences. If everyone were driving slowly and cautiously, road safety would improve significantly, although the frenetic pace at which our society operates would have to slow down as well.

The point is that human beings appear to have an internal risk set point, which will vary from person to person. When we perceive external factors to have reduced the risk we face, we adjust our risk-taking behaviour upwards. When we perceive external factors to be magnifying our risk, our actions become much more risk averse. It is the combination of actual external risks and our perception of them that determines where our collective risk set point lies at any given time.

Unfortunately, spreading risk around on paper and in the virtual world does not make it disappear, whatever our perception may tell us. Instead it makes risk systemic. Expansion eras are typified by risk insulation and complacency, while the contractions that follow are characterized by risk aversion. The knock on consequences of risk perception skewed in one direction or the other can be considerable, and are a major factor in creating self-fulfilling prophecies, or spirals of positive feedback, first in one direction, then in the other.

Insurance is a ubiquitous feature of life in modern societies, in the ordinary lives of citizens and between large organizations and institutions. It operates at all scales simultaneously. Insurance premiums paid for risk indemnification are set based on a combination of the probability of an adverse event and the cost of the consequences should it occur.

Complex risk models are used to quantify both factors, and risk may then be shared among many parties, depending on how much capital is required to back a given risk. Chains of reinsurance cover may be necessary, which of course increases the impact of counterparty risk. Coverage fails if the weakest link in the chain cannot meet its obligations when called upon to do so. Counterparty risk has been growing substantially behind the scenes as systemic leverage has increased.

Not all risks are insurable, as some are far too likely and others have potentially catastrophic consequences too expensive to back. The nuclear industry is a case in point. States must act as insurers of last resort for risks on that scale, and even they may not be able to do much if those risks are realized (witness Fukushima). A risk is privately insurable if an insurance provider can make a profit while charging a premium that enough people can afford to pay, so that a large enough pool of premium payments comes in to be invested and generate income to cover potential payouts plus profits.


If circumstances change, and covering a specific risk is no longer profitable (or not longer acceptably profitable from the point of view of the insurer), insurers are going to have a problem. They could stop issuing policies covering that risk, or they could limit payouts on policies, or both. In recent years, insurance payouts have been considerable, at least partly due to very costly natural disasters, but also increasingly due to fraud.

Certain risks are ceasing to be insurable, such as hurricane damage on the Gulf coast, and insurers are deeming some aspects of their business to be unacceptably profitable. Getting out of the business of issuing cover means limiting premiums coming in, whereas merely tightening conditions for payouts allows incoming premiums to be maintained while limiting out-goings. Unless a risk is clearly uninsurable, this has to be a tempting option.

It is indeed becoming more difficult to extract payouts on existing policies in many fields of insurance. Many people are continuing to pay premiums, either because insurance is required, or on the expectation that cover will be available if needed, but more and more often, when risks are realized, payments are not forthcoming as expected.

Caveat emptor when it comes to purchasing insurance cover. Insurance is not a substitute for personal risk management. Often it will be sold in a manner seemingly designed to be confusing, so that people may fail to fill in the form correctly, or may make understandable mistakes in doing so, or may leave out a triviality that can later be used as a pretext to deny a claim. It is instructive to look at a few cases.


Home Insurance:

Contents insurance may hinge on the insured having a detailed list of their possessions, complete with photos and receipts for their purchase:

A couple whose belongings were stolen from their downtown Vancouver condominium garage can't understand why TD Insurance denied their claim — despite video surveillance evidence, police reports and witnesses that all attest to the crime. "We're left in the hole," said Daniel Parlee, a certified commercial transport mechanic. "My life savings of tools are gone — and we are denied every single penny of our loss."

TD Insurance records indicate the claim was refused because Daniel and wife, Sepide, couldn't prove they owned the tools and other items they claim were stolen…Daniel said he had several thousand dollars worth of specialized tools collected over a 20-year period in the back of his truck. "I don't have any receipts, because the tools are so old. I don't keep receipts for that long ago," he said….

The Insurance Bureau of Canada (IBC) said it's common for claims to be denied when claimants have no documentation to prove they owned what they lost. "You have to be able to bring yourself within the contract to say that I had these specific items," said IBC spokesperson Lindsay Olson.

"It's not enough to say 'I had 50 pieces of tools'. You have to be able to say these are the specific items I had – and here are the receipts or the instruction manuals for those, or here are the photographs of them."

Most people would not be in a position to justify their claims in this way, and would not even be able to rectify the situation of lack of receipts. Many may well be paying for insurance cover that will not pay out when needed.

Weather damage to property is increasingly problematic for insurers, particularly in areas prone to experiencing such damage. Exclusions and deductibles are increasing, and damage from multiple causes may not be covered, even if one of those causes is:

After Hurricane Irene hit in August 2011, more insurers tucked hefty wind and hurricane deductibles into their policies. They run 2 percent to 5 percent of the insured value of your home, says Charles Hahn, an insurance agent in Little Falls, New Jersey, where "we're known for flooding a lot."

Keep in mind that many insurers have "anti-concurrent causation clauses" in policies now that say if you have damage from multiple causes, say wind and flooding, where wind is covered but flooding is not – they won't cover anything at all.

Some major classes of home risks may not be insurable at all, even if one has insurance for related issues. People may not realize the exclusions that apply to their policies:

Amidst the power outages, gas shortages, mass transit shutdowns and school closures left behind in Superstorm Sandy's wake, there's one issue few people are talking about, and that's the cost that homeowners will incur from mold damage. Aside from the health risks associated with mold from flooding, mold removal is extremely costly and is not covered by most home insurance policies, according to the San Francisco Chronicle.

The average homeowner could be forced to shell out anywhere from $200 to $30,000 for mold removal. In a recent report on Sandy's destruction obtained by Business Insider, Citi strategist Jeffrey Berenbaum wrote, "mold damage could likely be the largest risk to properties that remain flooded for weeks."


Travel Insurance:

The success of travel insurance claims can rest on minute details:

Complaints about seemingly arbitrary rejections cross my desk at regular intervals. No surprise: Travel insurance is a $1.8 billion-a-year industry, according to the US Travel Insurance Association (, an industry trade group. And it has been growing steadily, from $1.3 billion in 2006 to $1.6 billion two years later to the latest figure, from 2010.

It's no shocker in another sense, too: The travel insurance business is generally profitable, the occasional volcanic eruption or tsunami notwithstanding, and critics say that the only way it stays that way is by rejecting most claims, particularly the expensive ones.

The most trivial or irrelevant discrepancies in filling out the paperwork can be used to deny a claim:

When it comes to travel insurance claims, Hannah Yun was about as sure as anyone that hers would be successful. She'd bought a gold-plated "cancel for any reason" policy for a trip to South Korea. When her boyfriend proposed and she decided to call off the trip to start planning her wedding, she thought that collecting a check would be just a formality. Travel Guard, the company she'd purchased the policy through, turned down her claim on a technicality. Yun, a college student in Salt Lake City, had originally told the company that her plane ticket had cost $1,090; she'd actually paid $1,092.50.

Failure to board a flight to a destination where one knows in advance something bad is about to happen counts as grounds for forfeiting the cost of the trip despite insurance, as it amounts to 'disinclination to travel' unless a specific government travel warning has been issued:

It was meant to be the family holiday of a lifetime, an expensive, but much anticipated, half-term five-night trip to see the sights of New York with our two children, aged 18 and 14. But it turned into the holiday from hell as we were virtually confined to our hotel, in a city in lock-down, with all public transport systems, tourist attractions and virtually all shops and restaurants, closed as Hurricane Sandy did its worst…

…What was really galling was that we knew before leaving the UK that this was going to happen, yet could find no way of cancelling and rescheduling without losing all our money – despite having paid £90 for comprehensive travel insurance.

Where insurance companies have been found not to be liable to make payouts, courts are sometimes looking for other parties to cover passenger losses, where or not those parties were in any way responsible for the losses. For instance, airlines have been found liable for the costs of passengers stranded by the ash cloud following the eruption of Eyjafjallajökull:

The volcanic eruption left millions of passengers unable to return home because it was deemed too dangerous to fly through the ash clouds. Today's ruling could leave airlines open to a raft of future claims. The court recognized compensation claims could have 'substantial negative economic consequences' for airlines, but said a high level of protection must be afforded to passengers …. Mr O'Leary [of Ryanair] said the court's decision made the airlines 'insurers of last resort' and said whoever was responsible for cancellations should pay compensation.

He blamed the Government for closing British airspace in 2010, even though 'there was clearly no ash cloud over the UK.' He said: 'We now have a position that when the next time there's an ash cloud or the skies are closed by Europe's governments, the travel insurance companies will walk away and wash their hands and say it was an act of God and the airlines will become the insurers of last resort.' 'Somebody who has paid us fifty quid to travel to the Canaries, who may be stuck there for two weeks, two months, six months, will now sue the airlines and you will have airlines going out of business, and the ones who stay in business will be putting up the air fares to recover these crazy claims.'

The fight over who must bear the consequences of realized risks is hotting up. We can expect both the base cost of travel and the premiums for travel insurance to rise. As people's ability to pay is going to be heavily compromised over the next few years, travel will be very much less frequent than today. Already, older people are increasingly priced out of travel, as the insurance premium can be significantly higher than the cost of the trip. Travel for the elderly is becoming an uninsurable risk.


Medical Insurance:

Out of country emergency medical expenses can be extraordinarily high if uninsured risks materialize:

Australia’s foreign affairs minister is looking into the case of a Sydney couple stuck with a million-dollar hospital bill after their daughter was born in Vancouver last August. John Kan and Rachel Evans had taken out travel insurance and extra cover for Ms. Evans’ pregnancy without realizing the policy would not cover birth or the baby. They were about to return to Australia after their B.C. vacation when Ms. Evans went into premature labour at the airport.

Piper Kan stayed in the neo-natal ward of the B.C. Women’s Hospital and Health Centre for three months and the bill ended up being about $1-million. Australian media reports the couple negotiated a payment plan with the hospital at about $300 a month, which would take 278 years to pay off.

In terms of medical coverage, 'pre-existing conditions' people did not know they had are an increasing barrier to claims, even where the insured had been cleared to travel by a doctor:

Gojevic came down with what he thought was a bad cold just days before heading to Las Vegas to celebrate his wife Arleatha’s birthday in February. An X-ray suggested he might have pneumonia, so an emergency doctor prescribed him a 10-day course of antibiotics. The doctor said he was good to go on vacation….But the 53-year-old started having difficulty breathing on the plane as the Las Vegas strip came into sight. He was administered oxygen on the plane and was met on the jet runway by paramedics.

He was rushed to Desert Springs hospital in Las Vegas….After the couple was flown home via B.C. Air Ambulance they received a double whammy of horrible news: Mike was not suffering from pneumonia, but a life-threatening lung disease called pulmonary fibrosis. He was put on the list for a double lung transplant. Then One World Assist denied the travel insurance claim, saying he was on the hook for $140,000 in medical expenses.

The company said he didn't qualify because he was treated stateside for a "pre-existing condition.”….But Mike Gojevic argued that it was the pulmonary fibrosis that was the health problem that kept him in hospital, and he hadn’t been diagnosed with the serious lung condition at the time. He had only been diagnosed with pneumonia — a condition considered minor by the insurance company.

Discrepancies between doctors' definitions of diagnosis and treatment and those used by insurance companies can be a major obstacle to making a claim:

A B.C. couple on a fixed income is facing a $50,000 US hospital bill, despite buying travel health insurance for their last trip….Last year, they bought full medical coverage as usual, through their broker, from Prime Link Travel Medical Insurance. While in California, Anna had to go to hospital with a blood clot in her leg.

The Friesens struggle to understand English, so said they relied on broker Barrie Cartmell to fill out their application. He read them several questions from the form, including: "In the last 36 months, have you received treatment for kidney disorder (including stones)?" Anna answered no. She's had weak kidneys for several years, but has not actively been treated….Despite letters submitted since from doctors, insisting she is not receiving any treatment for her kidney condition, the insurance claim denial letter reads, "You do have a chronic kidney disease for which you have undergone investigations which is considered treatment."…

The Friesens are now getting calls from a U.S. collection agency and are afraid to go south for their usual trip…."I don't even lift up the phone anymore. I see it's a number from outside, I don't even lift up the phone anymore," said Anna. "Because [the collection agent] told me last time I am supposed to pay him $5,000 a month."…

Bullock says the forms are ambiguous, and he thinks that is intentional. "I've come to the conclusion that it's a deliberate tactic," he said, citing several examples of what he calls "trivial" denials. "A lady didn't disclose that she had an ear infection four years ago. Another lady didn't disclose that she had hemorrhoids during her pregnancy two years ago. A fellow didn't disclose that his brother had a heart attack. He didn't know his brother had a heart attack. That didn't matter. He didn't disclose it," said Bullock….He said seniors should realize insurers can and will look at all medical records, so it's best to disclose everything, even if it costs more for coverage. He said some medical conditions trigger premium increases of 300%….

David Rivelis of Prime Link, the Friesens' insurance agent, said even when a customer's doctor states they are not being treated for a condition, the adjuster's interpretation can supersede that. "The insurance company ultimately determines the term of the contract," said Rivelis. "How the doctor defines something may be different from how it's defined by an insurance company."

Coverage can be denied on the basis of pre-existing conditions documented only in medical files the insured did not have access to, even if those pre-existing conditions were unrelated to the problem that required treatment.

In Florida, Bill had chest pains and numbness in his arm. He discovered he had suffered a heart attack and needed emergency surgery to remove five blockages in his heart….Recovering back home, Bill was stunned to receive a letter six months later, saying his travel health insurance claim was denied and he owed $346,000 US in medical bills. Manulife says Bill should have answered yes to this question about two conditions:

"In the last two (2) years, have you been prescribed or received treatment for and/or been hospitalized (as an in-patient or seen in the emergency department) and/or been prescribed or taken medication for any of the following conditions: diverticular disorder or gastrointestinal bleeding?"

Bill insists that he didn’t know what was spelled out in his medical file or that he’d been diagnosed with those two conditions. He thought all his symptoms were related to the colon cancer he’d had surgery for 19 months earlier. "Most importantly to me would be the question, 'What does anything, what does anything related to this have to do with Bill’s heart?'" Tracy said. "Absolutely nothing. Absolutely nothing."

Susan Eng of CARP, a Canadian advocacy group for people over 50, says the system is set up for claims to be denied. "Ordinary people are out thousands and thousands of dollars because they did not get the protection they thought they had — only because they made a mistake on the form that they could not possibly have done correctly," she said.


Life Insurance:

Failure to disclose trivial health details and indulging normal behaviour can be used as a pretext to deny claims from critical illness and death due to completely unrelated conditions:

Nic Hughes, 44, died in October after battling cancer of the gall bladder leaving his wife Susannah Hancock, 44, and twin eight-year-old son and daughter. But insurance company Friends Life have refused to honour Mr Hughes’ critical illness policy saying he did not give full disclosure of his health. The insurers say Mr Hughes should have told them his GP suggested he cut down his alcohol intake – and that he experienced pins and needles. But medical records show he drank just 10 to 20 units of alcohol a week – below the NHS recommended weekly allowance of 21 units. Nic’s consultant oncologist Dr Rubin Soomal, from The Ipswich Hospital, said neither alcohol, nor pins and needles were linked to his death.

Pre-existing conditions can even be used to deny a life insurance claim for a victim of murder:

The widow of a man killed last year when he was shot in the back is suing the life insurance company that refuses to pay a claim because the man had a "pre-existing condition," unrelated to the cause of his death. According to the lawsuit filed by Stephanie McCraw, widow of Curtis McCraw, who was gunned down by unknown assailants last April in Knoxville, Tenn., Settlers Life Insurance denied her claim because her husband had Hepatitis C.

(In this case it appears there were extenuating circumstances that probably meant paying a claim would have been inappropriate, but nevertheless, the basis for the official denial of the claim is clearly problematic.)


Car Accident Insurance:

Insurers may deny, or seek to reduce, a claim if they can place some, or all, of the responsibility for an accident on to the victim:

An insurance giant is appealing against paying up to £5million compensation to a schoolgirl left brain damaged in a car accident – because she wasn’t wearing a high-visibility jacket at the time. Bethany Probert was 13 when she was hit by a car while was walking home from riding stables along a country lane on a December evening.

The schoolgirl, now 16, suffered a broken collarbone, lung damage, and devastating head injuries which have caused permanent brain damage. A High Court judge found the driver 100 per cent liable for the crash but his insurers, Churchill, have appealed, claiming it was partly Bethany’s fault….The test case will decide to what extent children can be held responsible for their injuries in road accidents.

Outrageously, insurance companies may decide it is in their financial interests to avoid a payout to relatives of a victim by defending an accused perpetrator in an attempt to avoid liability:

Baltimore resident Kaitlynn Fisher, 24, was involved in an automobile accident which stole her life on June 19, 2010. She was struck at an intersection by Ronald Kevin Hope III, who ran a red light. Hope had minimal insurance, but Fisher's policy had a special clause which called for her insurer, Progressive Insurance, to cover the difference if and when she was involved in an accident with someone who was under insured. Rather than pay Fisher's $100,000 life insurance policy Progressive opted to aid in the defence of her killer, in hopes that if found innocent they would not be required to pay out her policy. This is despite a witnesses account that Hope struck Fisher.

The Fisher family has been reeling for over two years in disbelief that their trusted insurance company would behave in such a way, while having to absorb court costs all along.

'Bad Faith' and the Insurers Perspective

Denying a claim is usually all an insurance company needs to do in order to avoid making a payment. Alternatively they can make a low offer to settle the claim. Most individuals lack the resources to take on giant insurers in court, or find the prospect far too intimidating. If the insured walks away on denial of claim or accepts a low offer as being better than nothing, then the case is over. People can take a legal case, but it generally requires legal representation that knows how to secure a fair offer.

If claimants do take a legal case, courts have been known to punish insurers who appear to have acted in 'bad faith' by allowing the insured to make a larger claim than they had been asking for under their policy:

Until about 22 years ago, it seemed that the idea of real discipline and punishment for the general insurance fraud against policyholders was a real joke. Interestingly enough in California the courts provided policyholders and those who represented them a very powerful legal weapon: the "bad faith" concept.

From that point, many other states adopted some sort of bad faith law. As stated simply by William Shernoff, the crusading consumer rights lawyer who has halted big insurance companies for years and won, the law of bad faith states that if policyholders' claim have been unreasonably denied they can sue for more than the amount of their benefits. The insured can collect damages for mental suffering and all economic loss caused by the company's refusal to honour legitimate claims.

If it can be shown that the insurance company's conduct demonstrated a conscious disregard for the rights of a policyholder, then the policyholder can sue and recover for punitive damages. The purpose of punitive damages is to punish and make examples of companies that engage in outrageous behaviour.

In states with a 'bad faith' precedent on the books, peace of mind can be regarded as a deliverable of an insurance contract, and the lack of it as a breach of duty of care.

In its judgment in McQueen v. Echelon General Insurance Co. on Nov. 16, the Court of Appeal refused to overturn an award of $25,000 for mental distress caused by the denial of benefits.

The case involved a plaintiff who had been in a motor vehicle accident in which she sustained injuries. Prior to the accident, she was already suffering from bipolar disorder and upper back pain. After the incident, the defendant insurer refused to pay for some of the benefits applied for and limited the plaintiff’s access to medical assessments. In fact, there were 21 denials of 16 separate benefits over a period of three years.

As well as the benefits, the plaintiff claimed extra contractual damages, bad faith, mental distress, aggravated damages, and punitive damages. In supporting the trial court’s finding that the mental distress warranted compensation, the Court of Appeal declared: “People purchase motor vehicle liability policies to protect themselves from financial and emotional stress and insecurity.

An object of such contracts is to secure a psychological benefit that brought the prospect of mental distress upon breach within the reasonable contemplation of the parties at the time the contract was made. As an insured person entitled to call on the policy, Ms. McQueen was entitled to that peace of mind and to damages when she suffered mental distress on breach.”

Naturally, insurers take a different view of claims denied. They would say that there are clear rules to be followed and clear distinctions between what is covered and what is not covered:

The folks I met were proud of their product and could offer case studies of the many customers they've helped. But because of the way travel insurance policies are written, they often see the world in a binary way: yes or no, covered or not covered. Every exception to that worldview must be approved at a high level. When customers grumble about having their claims denied, these insiders are genuinely baffled. "Didn't you read the policy?" they ask.

As I stood in the understated suburban headquarters where every Allianz claim is processed, it all made perfect sense. Rules are rules, after all. Mark Cipolletti, an Allianz vice president, says that his company has no choice in the matter. Insurance providers are strictly regulated by the states where they do business. "We're subject to scheduled and unscheduled audits or reviews of our products and claims," he says. "When we adjudicate a customer's claim, we must follow the policy, or the contract with the customer, because if we deviate from the contract or treat one customer differently from another, then we become subject to fines and other punitive actions — like not being able to sell in that state any longer."

At the end of the day, private insurance is a business, and it will act in such a way as to maximize profitability. What constitutes a reasonable level of profitability to expect, is, however, set to change. We have all come to expect historically very high levels of return on investments in the rentier economy, but the rate of return depends on the health of the economy, and on people's ability to pay premiums in sufficient numbers to make a risk insurable. The rate of return on invested premiums is set to fall as the economy slips into contraction, and many financial asset investments are very likely revalued at a substantially lower level in the approaching era of historic financial upheaval. Ability to pay premiums will also be heavily impacted as people lose purchasing power.

This is a deadly combination from the point of view of the insurance model. If relatively few people can pay premiums, there are few secure investments and the rate of return on those investments is low, then very few risks will be insurable in comparison with today. Loss will increasingly lie where they fall, and risk management will once again hinge on prudent behaviour and due diligence.

Derivatives and Large Scale Risk Management:

Insurance extends well beyond the individual and company level. Financial risk management is an enormous business that has facilitated the development of the derivatives market. Credit default swaps, a market worth tens of trillions of dollars, are effectively insurance contracts against a fall in asset values. Like an ordinary insurance contract, a regular premium is paid to a party offering to indemnify its contractual partner should a loss occur.

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994. In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.

At this scale, the risk management business is based on highly complex, probabilistic value at risk models seeking to predict the likelihood and consequence of a given adverse financial event. As long as a reasonably smooth expansion is underway, a measure of consistency tends to hold, and the quantitative models develop a track record of apparent reliability. However, they have not been fully tested following a major trend change. The events of 2007-2009 were a preliminary test, but the level of defaults was relatively contained. In a larger crisis, such as we are headed for over the next few years, far more financial assets will be marked to market and trigger credit events requiring payouts.

In recent years, more events outside of the 'normal range' have been occurring. During the expansionist bubble era, the risk management models generated a false sense of security through creating the perception that risk was under control and not therefore a concern. Risk control is an illusion, but human beings are good at placing faith in quantitative models (that most do not understand) when there are profits to be made. Suspension of disbelief is much easier when it is profitable, and the longer the models appear to be reliable, the more complacent people become. The quants themselves become a sort of priesthood, in the sense they only they have access to how the 'black box' risk calculations work. Others must simply accept their opinion.

As expansion morphs into contraction, the full extent of counterparty risk is going to be revealed. There is no trading transparency, nor capital adequacy requirement, in the derivatives market, hence one can make promises to indemnify without having to prove it to be possible to keep those promises. This can amount to a licence to sit back and collect premiums for years, in the full knowledge that meeting promises, should that be necessary, would not be possible. It becomes yet another form of the pervasive financial fraud our global ponzi finance is grounded in. In addition, it is possible to 'insure' against a failure of an asset one does not actually own. This is akin to allowing people to take out fire insurance on their neighbours' homes, giving them a perverse incentive to burn the home down for profit.

Rather than genuine insurance, CDS are just another vehicle for excessive speculation. Where a credit event is triggered, but the losses cannot be paid by the counterparty, those losses can cascade through the financial system. Winning and losing bets do not net out under such circumstances. The combination of lack of transparency, huge counterparty risk and perverse incentives is toxic.

Essentially the CDS market has a built in meltdown mechanism which poses a major systemic risk. Warren Buffet once called derivatives 'financial weapons of mass destruction', and they are exactly that. Extending the concept of insurance to the level of covering global speculative flows is a bridge too far. Even the relatively plain vanilla insurance industry is on the verge of seeing its business model fracture, but the significant impact of that will be dwarfed by the consequences of the wholesale failure of global-scale risk management.

Continue reading »

Feb 042013
 February 4, 2013  Posted by at 4:42 pm Primers Comments Off on The World According to The Automatic Earth – A 2013 Primer Guide

Dorothea Lange River Food June 1936
Memphis, Tennessee. Original caption: "Coon dawgling."

The Automatic Earth (TAE) is now five years old (as of January 22). That's five years of wide-ranging discussion on a huge range of issues, in the process of developing the biggest possible big picture of our present predicament. We are reaching limits to growth in so many ways at the same time, but it isn't enough to understand which are the limiting factors, but also what time frame each particular subset of reality operates over, and therefore which is the key driver at what time.

Our job has been to explore those subsystems, how they fit together, and which will be the key driver in the short, medium and longer term, in order to prioritize action. We can think of the next century as a race of hurdles we need to clear. We need to know how to prepare for each as it approaches, as we need to clear each one in order to be able to stay in the race.

We are known primarily as a finance site because finance has the shortest time frame of all, hence we focus on it. So much of finance is virtual that changes can unfold very quickly. There are those who assume that changes in a virtual system can happen without major impact, but this assumption is dangerously wrong. Finance is the operating system – the interface between ourselves, our institutions and our resource base. When one crashes the operating system, nothing much will work until the system is rebooted.


Dorothea Lange Wayfarers May 1937
Mother and child of Arkansas flood refugee family near Memphis, Texas. These people, with all their earthly belongings, are bound for the lower Rio Grande Valley, where they hope to pick cotton

The next few years will see that crash and reboot. As financial contraction will occur first, before other limits are reached, finance will be the primary driver to the downside for the next several years. After that, we will be dealing with energy crisis, other resource limits, limitations of carrying capacity and geopolitical ramifications. Finance is the first hurdle in the race – the one we must clear if we want to be able to tackle the other challenges to come.

I am very much inclined to agree with Bill Gross' latest assessment that we stand on the brink of a Minsky moment, or as he describes it, a Credit Supernova. This is the inevitable result of decades of ponzi finance as our credit bubble expanded relentlessly, leaving us today with a giant pile of intertwined human promises which cannot be kept. Bubbles create, and rely on, building stacks of IOUs ever more removed from any basis in underlying real wealth.

When they implode, as they always do, the value of those promises disappears as it becomes obvious they will not be kept. Bust follows boom, as it has done throughout human history. The ensuing Great Collateral Grab reveals just how under-collateralized our boom has become, and just few claims to underlying real wealth can actually be met with the available resources. The rest of the outstanding claims will fail to be honoured, and will be rapidly and messily extinguished in a deflationary implosion.


Dorothea Lange Starting Over December 1935
Resettled farm child. From Taos Junction to Bosque Farms project, New Mexico

Despite the current extreme of market optimism, this will be the reality we will have to address. Things never look so good as they do at the top of a bubble, when there is nowhere to go but down. While we cannot tell you exactly when the bust will unfold in specific locations, we can see that it is already well underway in some parts of the world, notably the European periphery. The fear that is driving contraction in countries like Greece and Spain is highly contagious, and the contractionary dynamic is set to spread.

Given that preparation takes time, and that one cannot be late, now is the time to prepare, whether one thinks the Great Collateral Grab will manifest close to home next month or next year. Those who are not prepared risk losing everything, very much including their freedom of action to address subsequent challenges as they arise. It is a tragedy to fall at the first hurdle and then be at the mercy of whatever fate has to throw you. The Automatic Earth has been covering finance, market psychology and the consequences of excess credit and debt since our inception, providing readers with the tools to navigate a major crisis.

Ponzi Finance:



Dorothea Lange Migrant Mother February 1936
Destitute pea pickers living in tent in migrant camp. Mother of seven children. Age 32, Nipomo, California

Markets and Psychology:

Real Estate, Commodities, Metals, Currencies and Trade:


Dorothea Lange Family Travel June 1938
Family walking on highway, five children. Started from Idabel, bound for Krebs. In 1936 the father farmed on thirds and fourths at Eagleton, McCurtain County. Was taken sick with pneumonia and lost farm. Was refused relief in county of 15 years' residence because of temporary residence elsewhere. Pittsburg County, Oklahoma

Affluence, Poverty and Debt:

The second hurdle is likely to be energy. Changes in supply and demand for energy are very much grounded in the real world, albeit in a highly financialized way, hence they unfold over a longer time frame. Over-financializing a sector of the real economy leaves it subject to the swings of boom and bust, or bubbles and their aftermath, but the changes typically play out over months to years rather than days or months. Financial crisis can be expected to deprive people of purchasing power, quickly and comprehensively, thereby depressing demand substantially (given that demand is not what one wants, but what one can pay for).

Commodity prices fall under such circumstances, and they can be expected to fall more quickly than the cost of production, leaving margins squeezed and both physical and financial risk rising sharply. This would deter investment for a substantial period of time. As a financial reboot begins to deliver economic recovery some years down the line, the economy can expect to hit a hard energy supply ceiling as a result. Financial crisis initially buys us time, but at the expense of worsening the energy crisis in the longer term.


Dorothea Lange On The Road September 1939
On the road with her family one month from South Dakota. Tulelake, Siskiyou County, California

Energy is the master resource – the capacity to do work. Our modern society is the result of the enormous energy subsidy we have enjoyed in the form of fossil fuels, specifically fossil fuels with a very high energy profit ratio (EROEI). Energy surplus drove expansion, intensification, and the development of socioeconomic complexity, but now that we stand on the edge of the net energy cliff, that surplus (above that which has to be reinvested in energy production) is rapidly diminishing. We would have to greatly increase gross production to make up for reduced energy profit ratio, but production is flat to falling. Net energy available for all society's other purposes will fall even more quickly. The implication is that society will inevitably be simpler.

A plethora of energy fantasies is making the rounds at the moment. Whether based on unconventional oil and gas or renewables (that are not actually renewable), these are stories we tell ourselves in order to deny that we are facing any kind of energy scarcity, or that supply could be in any way a concern. They are an attempt to maintain the fiction that our society can continue in its current form, or even increase in complexity – an attempt to deny the existence of non-negotiable limits to growth. The touted alternatives are not energy sources for our current society, because low EROEI energy sources cannot sustain a society complex enough to produce them.

We are poised to throw away what remains of our conventional energy inheritance chasing an impossible dream of perpetual energy riches, because doing so will be profitable for the few in the short term, and virtually no one is taking a genuine long term view. We will make the transition to a lower energy society much more difficult than it need have been. At The Automatic Earth we have covered these issues extensively, pointing particularly to the importance of net energy, or energy profit ratios, for alternative supplies. We have also addressed the intersections of energy and finance.

Energy and Finance:

Unconventional Oil and Gas:

Electricity and Renewables:


Dorothea Lange Better Than It Was February 1939
Farm Security Administration emergency migratory labor camp. Calipatria, Imperial Valley. Daughter of ex-tenant farmers on thirds and fourths in cotton. "Back in Oklahoma, we are sinking. You work your head off for a crop and then see it burn up. You live in debts that you can never get out of. This isn't a good life, but I say that it's a better life than it was."

In the aftermath of the Fukushima disaster, TAE provided coverage of the developing catastrophe, drawing on an earlier academic background in nuclear safety. It will be many years before the true impact of Fukushima is known, both because health impacts take time to be demonstrable and because the radiation releases are not over. The destroyed reactors continue to leak radiation into the environment, and are likely to do so for the foreseeable future. The vulnerability of the site to additional seismic activity is substantial, and the potential for further radiation releases as a result is similarly large. The disaster is therefore far worse than it first appeared to be. The number of people in harms way, for whom no evacuation is realistic despite the risk, is huge, and the health impacts will prove to be tragic, particularly for the young.

Fukushima and Nuclear Safety:

The Automatic Earth takes a broad view of the context in which finance, energy and resources operate, looking at issues of how society functions at a macro level. Context is vital to understanding the bigger picture, particularly human context as it relates to the critical factor of scale and the emergent properties that flow from it. We have continually emphasized the importance of the 'trust horizon' in determining what functions at what time, and what kind of social milieu we can expect as matters evolve.

Expansions are built upon the optimistic side of human nature and tend to lead to greater inclusiveness and recognition of common humanity over time. Higher levels of political aggregation, and more complex webs of trading relationships, come into being and achieve popular support thanks to the benefits they confer. In contrast, contractions tend to reveal, and be driven by, the darker and more pessimistic side of human collective psychology. They are social and are political as well as economic. In both directions, collective attitudes can create their own self-fulfilling prophecies at the societal level.


Dorothea Lange The past looking at the future July 1937
Thirteen-year old sharecropper boy near Americus, Georgia

Trust determines effective organizational scale, extending political legitimacy to higher levels of political organization during expansions and withdrawing it during periods of contraction, leaving political entities beyond the trust horizon. Where popular legitimacy is withdrawn, organizational effectiveness is substantially undermined, and much additional effort may go into maintaining control at that scale through surveillance and coercion.

The effort is destined to fail over the longer term, and smaller scale forms of organization, still within the trust horizon, may come to hold much greater significance. The key to effective action is to know at what scale to operate at any given time. As we have said before, while one cannot control the large scale waves of expansion and contraction that unfold over decades or centuries, understanding where a given society finds itself within that wave structure can allow people and their communities to surf those waves.

Scale, Society and Trust:


Dorothea Lange No money, ten children March 1937
Stalled in the Southern California desert. 'No money, ten children'. From Chickasaw, Oklahoma

Finally, TAE has provided some initial guidance as to how to position one's self, family, friends and community so as to reduce vulnerability to system shocks and increase resilience. The idea is to reduce the range of dependencies on the large scale, centralized life-support systems that characterize modernity, and also to reduce dependency on the solvency of middle men. The centralized systems we take so much for granted are very likely to be much less reliable in the future. For a long time we have uploaded responsibility to larger scale organizational entities, but this has led to a dangerous level of complacency.

It is now time to reclaim responsibility for our own future by seeking to understand our predicament and take local control of efforts to mitigate its effects. While we cannot prevent a bubble from bursting once it has been blown, we can make a substantial difference to how widely and deeply the impact the impact is felt. The goal is to provide a sufficient cushion of basic essentials to allow as many people as possible to preserve the luxury of the longer term view, rather than be pitched into a state of short term crisis management. In doing so we can hope to minimize the scale of the human over-reaction to events beyond our control.


Over the years of crisis, we intend to continue bringing our readers the biggest possible big picture in order to help us all to navigate a world of change. We very much appreciate your support in this endeavour.


Dorothea Lange Try The Train California, March 1937
"Toward Los Angeles"


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Jan 112013
 January 11, 2013  Posted by at 4:10 pm Finance Comments Off on Scale Matters

Scale matters. When it changes, other things change as a function of it, often in unpredictable ways. Emergent properties are system characteristics that come into existence as a result of small and simple units of organization being combined to form large and complex multi-unit organizational structures. One can know everything there is to know about the original simple units and yet be unable to predict the characteristics of the larger system that emerges as many units come together to interact as a larger whole.

For instance, knowing everything about an individual cell sheds no light on the behaviour of a sophisticated multicellular organism. At a higher level of organization, knowing everything about an organism does not predict crowd behaviour, the functioning of an ecosystem, the organization of stratified societies, or the dynamics of geopolitics as societies interact with one another. The complex whole is always far more than just the sum of its parts.

Human social organization is particularly flexible when it comes to changes in scale. It can function in a myriad forms – from simple, generalist tribal associations, where everyone knows everyone else and interactions are grounded in established personal relationships, to the most complex, specialized and hierarchical imperial civilizations, where emergent connections and institutional structures must inevitably transcend the personal.

Where human societies find themselves along that continuum will depend on many local factors, including the nature, extent, accessibility and storability of the resource base over time, as well as the potential for leveraging human labour, historically using animals. Energy, and particularly energy returned on energy invested (ie the potential to control substantial energy surpluses) is critical. The greater the extent to which substantial, storable resource surpluses can be amassed and centrally controlled, the more likely a complex hierarchical organizational structure is to emerge. Where surpluses are small, resources cannot be stored, human efforts cannot be leveraged, or key resources are less subject to control, much smaller scale, simpler and more horizontally structured groups would be expected instead.

Forms of organization based on agriculture are inherently both expansionist and catabolic. Existing ecosystems are destroyed to make way for patches of monocrop, rapidly converting the productive potential of the land into human biomass at the expense of biodiversity and soil fertility. Many hands are needed to work the land, so many children are produced, but as they grow up, more land must be cultivated every generation, because the existing land cannot accommodate the rapidly rising number of mouths to feed. Carrying capacity is, however, limited.

This in-built need to expand, sometimes to the scale of an imperium in the search for new territory, means that the process is grounded in ponzi dynamics. Expansion stops when no new territories can be subsumed, and contraction will follow as the society consumes its internal natural capital. Previous agricultural societies have left desert in their wake when that natural capital has been exhausted.

Limits to growth are not a new phenomenon, nor is collapse when expansion is no longer possible. The difference this time is that we are approaching hard limits at a global scale, there is nowhere left to expand to, modernity has greatly increased the scope and the rate of our catabolic potential, and therefore the collapse will be the most widespread human civilization has faced.

Some societies are more despotic than others. Elite control over resources, distribution of surpluses, or monolithic infrastructure, such as major dams, confers power and strengthens hierarchy. Where surpluses are substantial, controllable and storable, and can support a large percentage of the population not required to work the land directly, a great deal of societal differentiation and complexity may develop, with a substantial gap between haves and have nots. The haves are typically part of the rentier economy, or otherwise in a position to cream off the surpluses from the labour of lower social strata.

The degree of general freedom probably depends on the extent to which it is in the interests of the powerful. If it is more profitable for the elite to grant economic freedom, and then reap a large share of the proceeds, than to control society directly from the centre, then freedom is far more likely. When circumstances change, however, that may no longer be the case. Relative freedom is associated with economic boom times, when there is an explosion of economic activity to feed off. When boom turns to bust, and there is little economic activity for a prolonged period, direct control of what if left is likely to be of greater appeal. As we stand on the verge of a very substantial economic contraction, this is a major concern. Freedom is addictive, and taking it away has consequences for the fabric of society.

In our own modern situation, the freedom enjoyed in first world countries is arguably both a direct and an indirect a result of the enormous energy surplus we have benefited from. Energy surplus has allowed us to substitute energy slaves directly for the forced labour that has been a prevalent feature of so many previous societies, and it has allowed us to intensify complexity in order to create many opportunities for innovation and advantage. It has also enabled an increase of scale to the global level, so that hard work for low pay, and unpleasant externalities, could be off-shored while retaining the benefits in the first world, albeit very unevenly distributed within it.

The size of the global energy surplus is likely to fall very substantially in the coming years. This will inevitably have a major impact on global socioeconomic dynamics, as it will undermine the ability to maintain both the scale and degree of complexity of the global economy. The expansion of effective organizational scale on the way up is a relatively smooth progression of intensification and developing complexity, but the same cannot be said for its contraction. As we scaled up we built structural dependencies on the range of affordable inputs available to us, on the physical infrastructure we built to exploit them, on the trading relationships formed through comparative advantage, and on the large scale institutional framework to manage it all. Scaling down will mean huge dislocation as these dependencies must give way. There is simply no smooth, managed way to achieve this.

A foundational ingredient in determining effective organizational scale is trust – the glue holding societies together. At small scale, trust is personal, and group acceptance is limited to those who are known well enough to be trusted. For societies to scale up, trust must transcend the personal and be grounded instead in an institutional framework governing interactions between individuals, between the people and different polities, between different layers of governance (municipal, provincial, regional, national), and between states on the international stage.

This institutional framework takes time to scale up and relies on public trust for its political legitimacy. That trust depends on the general perception that the function of the governing institutions serves the public good, and that the rules are sufficiently transparent and predictably applied to all. This is the definition of the rule of law. Of course the ideal does not exist, but better and worse approximations do at each scale in question.

Over time, the trust horizon has waxed and waned in tandem with large cycles of socioeconomic advance and retreat. Trust builds during expansionary times, conferring political legitimacy on larger scale forms of organization. Trust takes a long time to build, however, and much less time to destroy. The retreat of the trust horizon in contractionary times can be very rapid, and as trust is withdrawn from governing institutions, so is political legitimacy. This process is already underway, as a litany of abuses of public trust previously obscured by expansion is coming to light. Contraction will rapidly lift the veil from far more trust-destroying scandals than almost anyone anticipates.

Even at the peak of expansion, international scale institutions struggled to achieve popular legitimacy, due to the obvious democratic deficit, lack of transparency, lack of accountability and insensitivity to local concerns. Even under the most favourable circumstances, true internationalism appears to be a bridge too far from a trust perspective. For this reason, world government and a global currency were never a realistic prospect, as much as some may have craved and others dreaded them. Even a transnational European single currency has suffered from a fatal disparity between the national level of primary loyalty and the international level of currency governance, and as such has no future.

As the circumstances supporting economic globalization and attempts at global governance evaporate, and the process goes into reverse, smaller and smaller scale governance structures are likely to join international institutions as stranded assets from a trust perspective – beyond the trust horizon – and lose legitimacy as a result. International structures are likely to fade away, or be torn apart by strife between disparate members who no longer see themselves are part of a larger whole. The socioeconomic impact of the latter process, for which Europe is the prime example, is likely to be enormous. For a time this may strengthen national institutions, but this is likely to be temporary as they too are subject to being undermined by the withdrawal of trust.

Where people no longer internalize and follow rules, because they no longer see those rules as in the general interest, existing national institutions would have to devote far more energy to surveillance and compliance enforcement. The difference in effort required is very significant, and that effort further alienates the governed population in a socially polarizing downward spiral of positive feedback. It also renders governance far less effective. The form of the institutional framework may still appear outwardly the same, but the function can be both undermined from below and overwhelmed from within by an obsession with enforcement until it ceases to be meaningful. This shift is already well underway.

As contraction picks up momentum, the combination, on the one hand, of a desire to control remaining resources and the benefits from remaining economic activity, and on the other the loss of trust and compliance, and consequent movement towards enforcement, is likely to lead to far more authoritarian forms of government in many places. While central control can occasionally facilitate useful responses to crisis, such as rationing of scarce resources, the power is far more likely to be abused for the benefit of the few, as has so often been the case throughout history.

It is within this general context that society will have to function, although considerable path-dependent local variation can be expected. Trust has a very long way to withdraw, especially in places where some form of totalitarianism develops, as this malignant form of governance actively undermines trust among the populace for the purpose of maintaining control through fear. Even in luckier locations, trust is likely to contract enough to undermine the efficacy of any institution beyond municipal scale, and possibly smaller.

Contractions as large as the one ahead lead to a major trust bottleneck through which society must pass before any kind of recovery can begin to get traction, but the narrowness of that bottleneck will vary considerably between societies. Societies with well developed, close-knit communities are likely to find that far more trust survives, and that in turn will mitigate the impact of contraction and hasten the recovery that will involve rebuilding trust from the bottom up.

Given that trust is a major determinant of effective organizational scale, and that the trust horizon is set to contract substantially, the scale at which it makes most sense to work will be much smaller and more local than previously. The future will, eventually, be one of decentralization by necessity. The odds of making a positive impact at smaller scale will be substantially higher, particularly if the actions undertaken are predicated upon a simpler society rather than based on current complex systems. It makes sense to focus scarce resources – money, energy, materials, effort, emotional intensity – where they can achieve the most. An understanding of scale and its determinants is critical in this regard.

It is interesting to look at the role of money in relation to trust and societal scale. Very small and simple societies grounded in personal relationships can function on a gift basis, as the high level of trust in a small number of well-known others is enough to mean that keeping track of favours done for one another is not necessary. Favours may simply be performed when necessary and reciprocity taken for granted. Resources may be 'owned' by the group, or made generally available to the group, rather than owned privately and subject to specific exchange.

Scaling up from this point requires interacting with people less well known, where there is less faith that favours done will be reciprocated, so that keeping track becomes necessary. Larger societies are more likely to be hierarchical, with resources privately owned. Exchange of goods or services would then require some form of relative value quantification. It could be decided that everyone's time is of equivalent worth and therefore that, at the simplest level of value accounting, keeping track of hours contributed would be sufficient. Further scaling up would require greater sophistication in both time and resource accounting. Money is the value abstraction that evolves to perform this function, hence the development of a monetary economy is an emergent property of scale. The paradox of money is that even as it allows trust to scale up beyond the personal, its use is fundamentally a measure of distrust in reliable interpersonal reciprocity.

As scaling up continues, along with increasing socioeconomic differentiation, it becomes necessary to interact constantly with completely unknown individuals. For this to function, the necessary trust must vest in the institutional framework itself, in the abstract representation of value that becomes a store of value in its own right in addition to being a medium of exchange, and in the complex web of rules by which it operates in large scale societies. These rules grow progressively more complex with expanding societal scale and increasing complexity, as the nature of money itself becomes increasingly abstract and derivative.

Money in the form of precious metals was replaced by promissory notes based on precious metals, then promissory notes backed by faith alone, virtual representations of promissory notes, promises to repay promissory notes, or bets on the abstract price movements (denominated in promissory notes) of underlying assets, which could themselves by abstract. Trust in the value of these abstractions in turn gives them value, and each extension of monetary equivalence creates the foundation of confidence for the next step.

The initial physical monetary commodity would have been chosen to be relatively scarce and not creatable, facilitating central control over a limited money supply. However, when an expansionary dynamic is underway, and a larger money supply is called for in order to lubricate the engine of a growing economy, a rapidly expanding supply of increasingly abstract monetary equivalents may serve that need, at the cost of the loss of any semblance of control over the supply of what is accepted as constituting money. In other words, inflationary times are grounded in an exponentially exploding supply of human promises, backed by assets that are increasingly over-pledged as collateral even as their price is bid up by the expanding purchasing power granted by confidence in promises to repay. This is another self-reinforcing dynamic.

Our history has experienced many credit-fuelled cycles of expansion, going back to antiquity. Positive feedback spirals continue, relatively smoothly, until they can no longer do so. A limit is reached, and there is typically a rapidly spreading realization that the pile of human promises is very heavily under-collateralized. The trust which had conferred value in abstract promises dissipates very quickly, taking the erstwhile value with it.

The credit which had gained monetary equivalence during the expansion is deprived of it, and the resulting abrupt contraction of the effective money supply becomes a major factor in a positive feedback loop in the deflationary direction – the collapse of the money supply removes the lubricant from the engine of the economy, the fall in purchasing power undermines asset prices and promises consequently become even less well collateralized, driving further contraction.

The last thirty years have seen the latest incarnation of a major expansion cycle, reaching unprecedented heights in terms of trust in the value of abstractions as the exponential growth of the shadow banking system has overwhelmed official monetary channels and control mechanisms. We are now on the verge of the implosion that will inevitably follow as trust evaporates and virtual value disappears. The contraction will proceed until the small amount of remaining credit/debt is acceptably collateralized to the few remaining creditors.

At that point we can begin to rebuild trust in a new monetary system, and by extension a new form of societal organization. It will likely be one with a strong emphasis on central monetary supply control, with little or not scope for the monetization of expansionary promises. The successive 'financial innovations' that built the bubble will be outlawed, as similar phenomena have been before in the aftermath of collapse. Unfortunately, the controls do not last, and a new generation will eventually make similar mistakes once the experience of boom and bust passes once again from living memory.

While there is nothing we can do to prevent the bubble from bursting, or the contraction of the trust horizon that will inevitably occur, we can attempt to cushion the blow and limit the extent of contraction. Understanding the critical role of trust, how to nurture it, how it determines effective organizational scale, and therefore what scale to operate at at what time will allow us to maximize the effectiveness of our actions. In terms of rebuilding a monetary system, it will be necessary in many places to operate at a profoundly local level initially, with the reintroduction of the simplest forms of trust extension above a gift economy – keeping track of hours traded in a time banking process, and local currencies operating within the trust horizon. It will be necessary to build community interconnections actively in order to establish, maintain and increase the necessary trust.

If the process succeeds in halting and reversing the contraction of the trust horizon in places, then new monetary arrangements can be scaled up in those locations when necessary. There will be no need to do so rapidly, as the artificial demand stimulation of the bubble years will have disappeared, inevitably leaving much less economic activity during a period of economic depression, and therefore much less demand for a large money supply to lubricate the engine of the economy.

Governance arrangements operating at a scale in line with local monetary provision will be necessary, and can expect to be more effective than larger institutions substantially beyond the trust horizon. The latter, where they still exist and can exercise power at a distance, are most likely to make it more difficult for society to be able to function rather than less, as they can be expected to resist the decentralization that could allow localities to establish resilience.

Operating at a local scale to build local supply chains and resilience is far more compatible with the human psyche. At times when social organization has expanded to the point where it dwarfs individual actions, and may control them either directly or indirectly, individuals are disempowered by scale. Many feel they have no control over the critical factors of their own lives, which often leads to psychological disturbances such as depression, at present widely addressed with medication. Increasing scale can reduce both empowerment and civic engagement, as it fosters the perception that one can achieve nothing through individual action.

The increasing complexity that accompanies scaling up also occupies time, money and individual energies, leaving little in the way of personal resources to contribute to the public sphere. Of course for the few in positions of control, scale translates into leveraging power, which can effectively become a drug in its own right, but for the masses it is much less conducive to functioning effectively and meaningfully. For a while the masses can be bought off with bread and circuses, and, for some, with aspirations to achieving a position of power and leverage themselves.

This only works while it remains possible to supply sufficient bread and circuses, and while people still believe that higher aspirations may be realistic. Expansions do shake up up established orders enough to open doors for a few to exploit the new niches that open up with increasing complexity, but in the latter stages of expansion, the social strata typically reform and solidify again, so that upward mobility becomes harder or impossible. The combination creates a dangerous situation, where financial implosion and social explosion can happen in a simultaneous dislocation.

The shift to operating at a local scale, over the longer term at least (once the dust has settled), can be expected to improve the balance between individuals and society, albeit at the cost of living in a much simpler, lower energy and less resource intensive manner. The implications of this shift are huge. Almost every aspect of our lives will change profoundly. We can expect the transition to be traumatic, as the dislocation of major contractions has always been. What large scale and extreme complexity have given us only appear to be normal, as they have persisted for much or all of our lifetimes. In fact we stand at the peak of an unprecedentedly abnormal period in human history – the largest in a long series of financial bubbles, thanks to the hydrocarbons that allowed it to develop over decades.

Things look good at the peak of a bubble, as if we could extrapolate past trends forward indefinitely and reach even higher heights. However, the trend is changing as the enabling circumstances are crumbling, and the bubble is already bursting as a result. Our task now is to navigate a changing reality. We cannot change the waves of expansion and contraction, as their scale is beyond human control, but we can learn to surf.

Artwork: Ilargi for The Automatic Earth


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Dec 212012
 December 21, 2012  Posted by at 6:33 pm Energy Comments Off on The Second UK Dash for Gas – A Faustian Bargain

Artwork: Ilargi

The UK is set to embark on its second dash for gas. The first, beginning in the early 1990s, occurred when gas was first permitted to be used for power generation. Prior to that it had been considered a premium fuel too valuable to be used in this way. The regulatory change initiated a substantial building programme for combined cycle gas plants, fuelled by North Sea gas. Very quickly gas generation became a major component of baseload in the UK, despite warnings that North Sea gas was a temporary bonus and its depletion would leave a structural dependency on Russian gas.

Twenty years later, now that those warnings have been borne out, the UK is increasingly concerned about security of gas supply. The extent of the gas dependency has been greatly increased in the meantime by the housing bubble years, during which many very large, open plan homes were constructed, requiring gas for heating. Also, many more existing homes than previously have installed gas or electric central heating systems, and often these homes are poorly insulated.

As the years of cheap gas are over and gas prices rise inexorably, the structural dependency on cheap gas begins to cause real pain. Household energy bills are at record levels, having risen between 6-11% in 2012 and predicted to rise again in early 2013.

Fuel poverty is sharply increasing:

At the Fair Energy summit today, hosted by The Independent and Policy Review Intelligence, Ed Davey, the Energy Secretary, will remind energy companies about new rules which mean they will have to be more open about the reason why electricity and gas bills are increasing. He says companies are exaggerating the expense of the Government's energy efficiency measures.

His comments will follow the shocking claim from the Government's Fuel Poverty Advisory Group that 300,000 homes will be pushed into fuel poverty by Christmas. A household is considered to be in fuel poverty if it needs to spend more than 10 per cent of its income on fuel for adequate heating.

The group also warns that unless the Government tackles the problem of people being forced to choose between heating and eating, nine million households could fall into fuel poverty by 2016. It is estimated that six million households are already in fuel poverty.

The timing is particularly unfortunate, as the gas crunch is hitting at the same time as the credit bubble is bursting, falling house prices are leading to negative equity, austerity measures are being imposed, including welfare cuts for many of the poorest, unemployment is rising and household budgets are being considerably squeezed. The UK is also facing its third cold winter in a row. Estimates suggest that for every 1% increase in energy prices, about 40,000 households are pushed into fuel poverty.

In response, the British government has mandated The Energy Company Obligation to improve the energy efficiency of the housing stock, but there are concerns that these measures would initially add to energy bills:

The Energy Company Obligation (ECO), designed to cut bills of poor households by forcing suppliers to fit solid wall insulation, offer energy efficient boilers and other energy-saving measures, could add up to £116 to the average bill and push families that did not receive support further into fuel poverty. It said that while there were 2.7m fuel poor households in England alone, it expected the measure to help between 125,000 and 250,000 households out of fuel poverty by 2023.

Previous governments, going back at least twenty years, had been repeatedly advised to address the poor energy efficiency of the housing stock, particularly for public housing. They could have done this when mitigation would have been readily affordable, but chose to wait until the transition, if it can be afforded at all in a period of financial crisis, will be far more painful.

The current government has taken the fateful decision to pin its hopes, and much of the energy future of the country, on trying to prop up falling conventional gas supplies with unconventional alternatives. The second dash for gas has been launched with the lifting of the interim ban on fracking (imposed after minor seismic events in fracked areas) and plans to build 30 new gas plants. In his recent autumn statement, Chancellor George Osborne has announced the creation of a new Office for Unconventional Oil and Gas, along with plans for a system of generous tax incentives.


A wholesale commitment has been made to the 'shale gas revolution', with the promise of decades worth of affordable gas, and that the American experience of falling gas prices can be replicated in the UK. The Chancellor has indicated that he "does not want British families and business to be left behind as gas prices tumble on the other side of the Atlantic". The hype has been considerable, despite the acknowledgement that, even if the gas is plentiful and the technology successful in extracting it, unconventional gas could not make a substantial contribution to current levels of gas demand for at least a decade. Britain will be in energy difficulties long before that.

Matt Ridley, former chairman of Northern Rock and author of Genome and The Rational Optimist, offered this hyperbolic, but ill-informed, endorsement:

As recently as 10 years ago, there was a consensus that gas was going to run out in a few decades and grow ever more expensive in the meantime. Such pessimism is now a distant memory everywhere, except perhaps in the forecasting models of the Department of Energy and Climate Change. Gas, the most abundant fossil fuel, is going to last at least a century, probably much longer.

London Mayor Boris Johnson is on the record with even more over-the-top pronouncements:

We are…increasingly and humiliatingly dependent on Vladimir Putin’s gas or on the atomic power of the French state. And then in the region of Blackpool – as if by a miracle – we may have found the solution. The extraction of shale gas by hydraulic fracture, or fracking, seems an answer to the nation’s prayers. There is loads of the stuff, apparently – about 1.3 trillion barrels; and if we could get it out we could power our toasters and dishwashers for the foreseeable future. By offering the hope of cheap electricity, fracking would make Britain once again competitive in sectors of industry – bauxite smelting springs to mind – where we have lost hope…

…In their mad denunciations of fracking, the Greens and the eco-warriors betray the mindset of people who cannot bear a piece of unadulterated good news. Beware this new technology, they wail. Do not tamper with the corsets of Gaia! Don’t probe her loamy undergarments with so much as a finger — or else the goddess of the earth will erupt with seismic revenge. Dig out this shale gas, they warn, and our water will be poisoned and our children will be stunted and our cattle will be victims of terrible intestinal explosions.


Clearly the mayor has no idea of the energy intensity of bauxite smelting, and no understanding of net energy, along with very little respect for the very real concerns surrounding shale gas. Still, he is really only propagating the exceptionally optimistic forecasts of Cuadrilla Resources, which has been doing the preliminary drilling in the Blackpool area:

The huge scale of a natural gas field discovered under the north-west of England has been revealed, potentially revolutionising the UK's energy outlook and creating thousands of jobs, but environmental groups are alarmed at the controversial method by which the gas is extracted.

Preliminary wells drilled around Blackpool have uncovered 5.6tn cubic metres (200tn cubic ft) – equal to the kind of recoverable reserves of big energy exporting countries such as Venezuela, according to Cuadrilla Resources, a small energy company which has the former BP boss Lord Browne on its board. It said up to 800 more wells might be drilled in the region, creating 5,600 jobs and promising a repeat of the "shale gas revolution" that swept the US, sending local energy prices spinning downwards.

To compare shale gas in in Lancashire to Venezuela is simply laughable, especially on the basis of a handful of exploratory wells in one small region of the country, but then so is suggesting that the US will be the next Saudi Arabia based on shale energy resources. It seems the shale hype is rife on both sides of the Atlantic. Estimates such as 120 years UK supply, and a £1.5 trillion injection into the economy, are being enthusiastically bandied about, albeit with minor acknowledgement that not all of it may be recoverable.


Protesters demand blanket ban on fracking. Photo: PA

We have covered the shale energy situation in the US at TAE before in detail, both with regard to gas and to oil. To recap, the energy profit ratio is extremely low, meaning that scarcely any more energy is produced than had to be invested in production. Depletion rates are very high, setting producers on a drilling treadmill that runs ever faster. Fracking is both capital and energy intensive, requiring a substantial surplus of both, well in advance of needing a return on either one.

As we have pointed out before, prices are set by perception, not by reality. The perception of a gas glut is what has depressed gas prices in the US, not realistic long term prospects of producing gas in meaningful quantities. The reality is quite different, as the insiders know perfectly well:

Geologist and official from Anglo-European Energy:

After buying production for over 20 years, hopefully I know the characteristics of great wells (flat decline curves, low operating costs, large production), and as you know, the shale plays have none of these. The herd mentality into the shale will eventually end possibly like the sub-prime mortgage did. In the meantime it is very difficult to sell any kind of prospect that is not a shale play.

Analyst from PNC Wealth Management (2011):

Money is pouring in from investors even though shale gas is inherently unprofitable. Reminds you of dot-coms.

Analyst from IHS Drilling Data (2009):

The word in the world of independents is that the shale plays are just giant Ponzi schemes and the economics just do not work.

Retired geologist for major oil and gas company (2011):

As I think you would agree, we are looking at a bubble here with caveats. The caveats are how corporate hubris and bad science have caused a lot of folks to think that gas is nearly too cheap to meter. And now these corporate giants are having an Enron moment, they want to bend light to hide the truth. The bubble will burst, folks will get run over, reason will be restored, if only temporarily.

Official from Bold Minerals LLC (2010):

The ‘bait and switch’ where one massive set of capital outlays in the ‘best’ shale uncovered was soon to be eclipsed by the recognition of even better shales which required even more outlays before a thorough technical assessment of existing shale positions had been obtained could only be classified as a type of ‘mania’. It has no precedent in financial scale to any of the previous lease plays that experienced a speculative frenzy in domestic onshore petroleum history.

Official at Phoenix Canada Oil Company (2010):

It is my strong view that we will see a near collapse of that play, probably sooner rather than later. Perhaps we will see a repeat of the coal bed methane (CBM) play 'disappearance' — where that 'exciting' development faded into history 'without a trace'!

Official from Schlumberger (2010):

All about making money. I'm working on a shale gas well that was just drilled in Europe. Looks like crap, but the operator will flip it based on ‘potential’ and make some money on it. Always a greater sucker….


The low gas prices seen in the US have been a financial disaster for the production companies, although in a classic ponzi move they have made money flipping land leases even as they lost it on producing gas at a higher cost than they could sell it for. Drilling rigs are already deserting shale gas plays in the US in favour of shale oil – the next great white hope (which happens to suffer from all the same deficiencies as shale gas).

Rig count is a leading indicator of production, so we can expect shale gas production in the US to fall substantially. As production falls, we could see the US shift from perceived glut into real shortage, given the dependence there on affordable gas for both heating and electricity. We could then see a major price spike.

This is exactly the boom and bust dynamic the UK is proposing to set itself up for as North sea depletion rates pick up steam and desperation sets in. After all, it was a similar desperation over conventional gas prospects that drove the industry in the US into trying to develop unconventional supplies. However, the UK is unlikely to experience the full upward and downward swing seen in the US. It is far more likely the reserves will prove to have been overstated, and opposition to fracking in the UK countryside will be huge – far larger than the already substantial protests against on-shore windfarms.

Unlike the US, where landowners are paid royalties for the gas under their land, in the UK, mineral rights are the property of the government. The disparity between where costs and impacts would lie and where benefits would accrue increases the odds of opposition even further. The inevitable protests could delay the process well into the era of financial crisis, at which point it would not be realistically affordable.

The choice to pursue the shale option has been labelled a dangerous gamble:

Professor John Stevens, Senior Research Fellow in Energy, Environment and Resources at independent analysis organization Chatham House, opposes the government's promotion of shale gas as a viable energy alternative.

"Osborne's view of the future of energy is misleading and dangerous. It is misleading because it ignores the very real barriers to shale gas development in the U.K. and Europe more generally," he said this week.

"The U.S. revolution was triggered by favorable factors such as geology, tax breaks and a vibrant service industry among many others. However, in Western Europe the geology is less favorable, notably with the shale containing a higher clay content making it more difficult to use hydraulic fracturing (fracking)," he said. He called the U.K's "dash for shale gas" a"dangerous gamble."

Stevens added that the government's hope that shale would reduce the rising costs of energy in the U.K. were flawed.

"[The government's view] assumes that gas will be cheaper in the future and, as already explained, while this could be the case it will certainly not be the result of any shale gas revolution in U.K. or Europe in the next five to ten years."

As Professor Stevens points out, circumstances in the US and the UK are not at all similar. The UK is far more densely populated, and land-use in the countryside is tightly controlled. Fracking requires space and infrastructure:

Melissa Stark, Managing Director of Accenture's Clean energy group, said shale gas can require a number of wells over one site. Even if the number of wells can be reduced by horizontal drilling, the site will need roads, machinery and storage facilities.

"One of the biggest challenges for the UK is probably going to be the population density. The UK is much more densely populated than the US making the management of movements more challenging.

"The sharp influx of logistics activity during the drilling and fracking phases can have a significant impact on the local community. Increased traffic congestion, damage to local roads, noise and air pollution are among the most commonly cited concerns."

Ms Stark pointed out that fracking is extremely water intensive, requiring around 5m gallons per well. Although the UK is not a water stressed area, she pointed out that in certain areas in certain years, industrial water use can be restricted. Also the waste water from fracking needs to be transported off the site and treated or injected into wells deep underground. She said the UK will have to find disposal sites or build enough treatment works.

"As the volume grows, the question is can the used water treatment works keep up?"

In anticipation of substantial opposition, the government is preparing to remove planning control for fracking from local municipalities:

Under new laws, Government ministers, rather than local authorities, could have the final say on more "nationally significant infrastructure" projects, including onshore gas extraction. Proposals in the Growth and Infrastructure Bill would would exempt shale gas plans from some local planning procedures and consultations. The laws are aimed at stopping local blockages in the planning system to fast-track infrastructure and boost economic growth. Campaigners, who warn that fracking could cause "major damage" to the landscape, could have less opportunity to challenge unwanted developments.


Photo: AFP

Vague promises of 'community benefits', particularly if these come in the form of "voluntary contributions by developers to an area where their business has a long–term impact on local resources and the environment" are unlikely to appease anyone. However, if proposals to share business rates with local councils are, in fact, enacted, then councils, which a very squeezed financially, and set to become far more so, could effectively be bought off.

Apparently over 60% of England is currently under 'license block' consideration for the development of shale gas, much of it under the Home Counties. It is ironic that Conservative Party politicians are the most ardent champions of shale gas development, yet the land that would be affected is home to much of their key powerbase.

This does seem to be an obvious form of political suicide, and the fact that the present government seems blind to that is a measure of the level of concern over Britain's energy future. The powerful impulse to deny reality in order to cling to business as usual is understandable, but terribly misguided.

Under such circumstances, it is natural human behaviour to look for a saviour. Given our ghastly choices, it wouldn’t be surprising if we were susceptible to false dawns….With the West on its economic uppers, and losing power relative to the rest of the world, a home-grown energy bonanza sounds appealing…

When the big energy companies and Western governments push in the same direction, they can, for a while anyway, create any conventional wisdom they like, even one with little regard for the facts.

Unfortunately for proponents of the appealing fantasy, reality wins in the end. We are not destined to see the geo-strategic map redrawn in favour of the West as a result of shale energy. Instead, we are going to be facing some very hard decisions on rationing scarce resources for the foreseeable future, and we are going to be doing it in a time of deepening financial crisis. Britain will be critically short of both money and energy, and sadly those twin deficits can be expected to aggravate each other significantly.

Shale gas is a Faustian bargain meant to kick the energy can down the road, but it amounts to nothing more than a cruel deception.


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