The Problem of Debt as We Reach Oil Limits

(This is Part 3 of my series – A New Theory of Energy and the Economy. These are links to Part 1 and Part 2.)

Many readers have asked me to explain debt. They also wonder, “Why can’t we just cancel debt and start over?” if we are reaching oil limits, and these limits threaten to destabilize the system. To answer these questions, I need to talk about the subject of promises in general, not just what we would call debt.

In some sense, debt and other promises are what hold together our networked economy. Debt and other promises allow division of labor, because each person can “pay” the others in the group for their labor with a promise of some sort, rather than with an immediate payment in goods. The existence of debt allows us to have many convenient forms of payment, such as dollar bills, credit cards, and checks. Indirectly, the many convenient forms of payment allow trade and even international trade.

Figure 1. Dome constructed using Leonardo Sticks

Figure 1. Dome constructed using Leonardo Sticks

Each debt, and in fact each promise of any sort, involves two parties. From the point of view of one party, the commitment is to pay a certain amount (or certain amount plus interest). From the point of view of the other party, it is a future benefit–an amount available in a bank account, or a paycheck, or a commitment from a government to pay unemployment benefits. The two parties are in a sense bound together by these commitments, in a way similar to the way atoms are bound together into molecules. We can’t get rid of debt without getting rid of the benefits that debt provides–something that is a huge problem.

There has been much written about past debt bubbles and collapses. The situation we are facing today is different. In the past, the world economy was growing, even if a particular area was reaching limits, such as too much population relative to agricultural land. Even if a local area collapsed, the rest of the world could go on without them. Now, the world economy is much more networked, so a collapse in one area affects other areas as well. There is much more danger of a widespread collapse.

Our economy is built on economic growth. If the amount of goods and services produced each year starts falling, then we have a huge problem. Repaying loans becomes much more difficult.

Figure 2. Repaying loans is easy in a growing economy, but much more difficult in a shrinking economy.

Figure 2. Repaying loans is easy in a growing economy, but much more difficult in a shrinking economy.

In fact, in an economic contraction, promises that aren’t debt, such as promises to pay pensions and medical costs of the elderly as part of our taxes, become harder to pay as well. The amount we have left over for discretionary expenditures becomes much less. These pressures tend to push an economy further toward contraction, and make new promises even harder to repay.

The Nature of Debt

In a broad sense, debt is a promise of something of value in the future. With this broad definition, it is clear that a $10 bill is a form of debt, because it is a promise that at some point in the future you, or the person you pass the $10 bill on to, will be able to exchange the $10 bill for something of value. In a sense, even gold coins are a promise of value in the future. This is not necessarily a promise we can count on though. At times in the past, gold coins have been confiscated. Derivatives and other financial products have characteristics of debt as well.

To understand how important debt is, we need to think about an economy without debt. Such an economy might have a central market where everyone brings goods to exchange. But even in such an economy, there will be a problem if there is not a precise matching of needs. If I bring apples and you bring potatoes, we could exchange with each other (“barter”). But what if I don’t have a need for potatoes? Then we might need to bring a third person into the ring, so each of us can receive what we want. Because barter is so cumbersome, barter was never widely used for everyday transactions within communities.

An approach that seemed to work better is one mentioned in David Graeber’s book, Debt: The First 5,000 Years. With this system, a temple would operate a market. The operator of the market would provide a “price” for each object, in terms of a common unit, such as “bushels of wheat.” Each person could bring goods to the market (and perhaps even services–I will work for a day in your vineyard), and have them exchanged with others based on value. No “money” was really needed because the operator would take a clay tablet and on it make a calculation of the value in “bushels of wheat” of what a person brought in goods, The operator would also calculate the value in “bushels of wheat” that the same person was receiving in return, and make certain that the two matched.

Of course, as soon as we start allowing “a day’s worth of labor ” to be exchanged in this way, we get back to the problem of future promises, and making certain that they really happen. Also, if we allow a person to carry over a balance from one day to another–for example, bringing in a large quantity of goods that cannot be sold in one day–then we get into the area of future promises. Or if we allow a farmer to buy seed on credit, with a promise to pay it back when harvest comes in a few months, we again get into the area of future promises. So even in this simple situation, we need to be able to handle the issue of future promises.

Future Promises Even Before Debt

Whenever there is division of labor, there needs to be some agreement as to how that division will take place–what are the responsibilities of each participant. In the simplest case, we have hunters and gatherers. If there is a decision that the men will do the hunting and the women will do the gathering and care for children, then there needs to be an agreement as to how the arrangement will work. The usual approach seems to have been some sort of “gift economy.” In such an economy, everyone would share whatever they were able to obtain with others, and would gain status by the amount they could offer to share.

Instead of a formal debt being involved, there was an understanding that if people were to participate in the group, they had to follow the rules that the particular culture dictated, including, very often, sharing everything. People who didn’t follow the rules would be thrown out. Because of the difficulty in living in such an environment alone, such people would likely die. Thus, participants were in some sense bound together by the customs that underlay gift economies.

At some point, as more of an economy was built up, there would be a need for one or more leaders, as well as some way of financially supporting those leaders. Thus, there would need to be some sort of taxation. While taxation to support the leader would not be considered debt, it has many of the same characteristics as debt. It is an ongoing payment obligation. The leader and the other members of the group plan their lives as if this situation is going to continue. In a way, the governmental services and the resulting taxation help bind the economy together.

Benefits of Debt

The benefits of debt are truly great, including the following:

  1. Debt allows transactions to take place that are not precisely at the same time and place. I can order goods and have them delivered to my home. An employer can pay me for a month’s work with a check, rather than needing to give me food or some other barter item corresponding to each hour I work. There is no need to have billions of gold coins (or other agreed up metal currency) to facilitate each and every transaction, and to transport around. We can each have bank accounts. From the bank’s perspective, the amount in a bank account is a liability (debt) owed to the depositor.
  2. Additional debt gives additional purchasing power to individuals, governments or businesses. The additional funds available can be spent immediately. Very often, repayment (with interest) is spread over several years, making goods that would not be affordable, affordable. Thus debt raises “demand” for goods and also for the commodities used to create these goods.
  3. Because debt makes goods more affordable, additional debt tends to “pump up” the price of commodities. These higher prices make it worthwhile for businesses to extract more minerals (including fossil fuels) from the earth, and make it worthwhile to plant more acres of food. Debt, particularly cheap debt, makes building new factories and opening new mines more affordable for businesses.
  4. Debt allows a steep step-up in standard of living, such as that obtained by adding coal or oil to an economy. Debt allows goods to be purchased that will substantially change a person’s future, such as transit to a new country, or purchase of a college education, or purchase of a delivery vehicle that can be used to start a business. Without debt, it is unlikely that fossil fuels could ever have been extracted; consumers would never have been able to afford the goods provided by fossil fuels, and businesses would have had difficulty financing the many new factories required to make goods using these fuels. See my post, Why Malthus Got His Forecast Wrong.
  5. Adding debt is self-reinforcing. Suppose a considerable amount of debt is added for what is deemed a good purpose, such as extracting oil in North Dakota. Oil companies will use the debt they receive for many different purposes–including paying employees, paying royalties to land owners, and paying taxes to the state. Employees will buy new houses and cars, taking out loans in the process. North Dakota residents who receive royalty payments may decide to take out home improvement loans to fix up their homes, expecting that the royalties will continue. The state may fix its roads with its revenue, giving additional income (which may lead to more debt) to road workers. A grocery chain may decide to build a new store (borrowing money to do so), further pushing the chain along. What happens is that indirectly, the new oil company debt makes a lot of people at least temporarily wealthier. These temporarily wealthier individuals can then “qualify” for more in loans than would otherwise be the case, giving them more to spend, and allowing yet others to qualify for loans.
  6. Arrangements that are not debt, but more of the nature of contingent debt, make people feel more confident of the current system. There are insurance programs for pension programs and for bank accounts, up to a selected balance per account. These insurance programs generally don’t have very much money in them, relative to what they are insuring. But they make people feel good, especially if there is a government that might come in and take over, beyond the actual funding of the insurance program.

What Goes Wrong with Debt and Other Financial Promises

1. As mentioned at the beginning of the post, debt works very badly if the economy is contracting.

It becomes impossible to repay debt with interest, without reducing discretionary income. Government programs, such as health care for the elderly, become more expensive relative to current incomes as well.

2. Interest payments on debt tend to transfer wealth from the poorer members of society to the richer members of society.

Economists have tended to ignore debt, because it represents a more or less balanced transaction between two individuals. The fact remains, though, that the poorer members of society find themselves especially in need of debt, and many pay very high interest rates. The ones lending money tend to be richer. Because of this arrangement, over time, interest payments tend to increase wealth disparities.

3. All too often, the payment stream upon which debt depends proves unsustainable.

In the example given above, everyone thinks the North Dakota oil will continue for a while, so takes out loans as if this is the case. If it doesn’t, then this is an “Oops” situation.

In the case of US student loans, many students are never able to get jobs with high enough wages to pay back the loans they were given.

4. Governments tend to put programs into place that are more expensive than they really can afford, for the long term.

As an economy gets wealthier (because of more fossil fuel use), there is a tendency to add more programs. Representative government is used instead of a monarch. Medical care and pensions for the elderly are added, as are unemployment benefits, and more advanced levels of schools.

Unfortunately, it is hard to properly estimate what long-run cost of these programs will be. Also, even if the programs were affordable with a high level of fossil fuels, they almost certainly will not be affordable if energy availability declines. It is virtually impossible to roll programs back, even if they are not guaranteed, once people plan their lives on the new programs.

Figure 3 shows a graph of US government spending (all levels) compared to wages (including amounts paid to proprietors, including farmers). I use this base, rather than GDP, because wages have not been keeping up with GDP in recent years. The amounts shown include programs such as Social Security and Medicare for the elderly, in addition to spending on things such as schools, roads, and unemployment insurance.

Figure 3. Comparison of US Government spending and receipts (all levels combined) based on US Bureau of Economic Research Data.

Figure 3. Comparison of US Government spending and receipts (all levels combined) based on US Bureau of Economic Research Data.

Clearly, government spending has been rising much faster than wages. I would expect this to be true in many countries.

5. There is no real tie between amounts of debt issued and what will actually be produced in the future. 

We are told that money is a store of value, and that it transfers purchasing power from the present to the future. In other words, we can count on balances in our bank accounts, and in fact, in all of the paper securities that are outstanding.

This story is only true if the economy can continue to create an increasing amount of goods and services forever. If, in fact, the production of goods and services drops off dramatically (most likely because prices cannot rise high enough to encourage enough extraction of commodities), then we have a major problem.

In any year, all we have available is the actual amount of resources that can be pulled out of the ground, plus the actual amount of food that can be grown. Together, these amounts determine how many goods and services are available. Money acts to distribute the goods that are available. Presumably, the people who work at extraction and production of these goods and services need to be paid first, or the whole process will stop. This basically leaves the “leftovers” to be shared among those who are now being supported by tax revenue and by those who hold paper securities of some sort or other. It is hard to see that anyone other than the workers producing the goods and services will get very much, if we lose the use of fossil fuels. Workers will become less efficient, and production will drop by too much.

6. Derivatives and other financial products expose the financial system to significant risks.

Certain large banks have found that they can earn considerable revenue by selling derivatives and other financial products, allowing people or businesses to essentially gamble on certain outcomes–such as the price of oil falling below a certain price, or interest rates rising very rapidly, or a certain company failing. As long as everything goes well, there is not a huge problem. The concern now is that with rapidly changing commodity prices, and rapidly changing levels of currencies, companies may fail and there may be major payouts triggered.

In theory, some of these payments may be offsetting–money owed by one client may offset money owed to another client. But even if this is the case, these defaults can sometimes take years to settle. There may also be issues with one of the parties’ ability to pay.

One particular problem with many of the products is the use of the Black-Scholes Pricing Model. This model is applicable when events are independent and normally distributed. This is not the case, when we are approaching oil limits and other limits of a finite world.

 7. Governments tend to be badly affected by a shrinking economy, so may be of little assistance when we need them most.

As noted previously, payments to governments act very much like debt. As an economy shrinks, programs that seemed affordable in the past become less affordable and badly need to be cut. Thus, governments tend to have problems at the exactly same time that banks and other lenders do.

Governments of “advanced” countries now have debt levels that are high by historical standards. If there is another major financial crisis, the plan seems to be to use Cyprus-like bail-ins of banks, instead of bailing out banks using government debt. In a bail-in, bank deposits are exchanged for equity in the failing bank. For example, in Cyprus, 37.5% of deposits in excess of 100,000 euros were converted to Class A shares in the bank.

This approach has a lot of difficulties. Businesses have a need for their funds, for purposes such as paying employees and building new factories. If their funds are taken in a bail-in, the ability of the business to continue may be damaged. Individual consumers depend on their bank balances as well. As noted above, deposit insurance is theoretically available, but the actual amount of funds for this purpose is very low relative to the amount potentially at risk. So we get back to the issue of whether governments can and will be able to bail out banks and other failing financial institutions.

8. More debt is needed to hide the lack of economic growth in an ailing world economy. This debt becomes increasingly difficult to obtain, as wages stagnate because of diminishing returns. 

If wages are rising fast enough, wages by themselves might be used to pump demand for commodities, and thus raise their prices. Our wages are close to flatmedian wages have been falling in the US. If wages aren’t rising sufficiently, increasing debt must be used to raise demand. Debt is growing slowly in the household sector, according to figures compiled by McKinsey Global Institute. Household debt has grown by only 2.8% per year between Q4 2007 and Q4 2014, compared to 8.5% per year in the period between Q4 2000 and Q4 2007.

Even with business demand included, debt isn’t rising rapidly enough to keep commodity prices up. This lack of sufficient growth in debt (and lack of growth in demand apart from growing debt) seems to be a major reason for the drop in prices since 2011 in many commodity prices.

9. Differing policies with respect to interest rates and quantitative easing seem to have the possibility of tearing the world financial system apart.

In a networked economy, not moving too far from the status quo is a definite advantage. If the US’s policies have the effect of raising the value of the dollar, and the policies of other countries have the tendency to lower their currencies, the net effect is to make debt held in other countries but denominated in US dollars unpayable. It also makes goods sold by American companies unaffordable.

The economy, as it exists today, has been made possible by countries working together. With sanctions against Iran and Russia, we are already moving away from this situation. Low oil prices are now putting the economies of oil exporters at risk. As countries try different approaches on interest rates, this adds yet another force, pulling economies apart.

10. The economy begins to act very strangely when too much of current income is locked up in debt and debt-like instruments.

Economic models suggest that if oil prices drop, demand for oil will grow robustly and supply will drop off quickly. If oil producers are protected by futures contracts that lock in a high price, they may not respond in the manner expected. In fact, if they are obligated to make debt payments, they may continue drilling even when it may not otherwise make financial sense to do so.

Likewise, consumers are also affected by prior commitments. If much of consumers’  income is tied up with condominium payments, auto payments, and payment of taxes, they may not have much ability to respond to lower oil prices. Instead of increasing discretionary spending, consumers may pay off some of their debt with their newfound income.


If the current economic system crashes and it becomes necessary to create a new one, the new system will have to deal with having an ever-smaller amount of goods and services available for a fairly long transition time. This is one chart I have shown in the past of how the growth in energy products, and thus growth in goods and services, might look.

Figure 4. Estimate of future energy production by author. Historical data based on BP adjusted to IEA groupings.

Figure 4. Estimate of future energy production by author. Historical data based on BP adjusted to IEA groupings.

Because of this, the new system will have to be very different from the current one. Most promises will need to be of short duration.  Transfers among people living in a particular area might still be facilitated by a financial system, but it would be hard to have long-term or long-distance contracts. As a result, the new economy will likely need to be much simpler than our current economy. It is doubtful it could include fossil fuels.

Many people ask why we can’t just cancel all debt, and start over again. To do so would probably mean canceling all bank accounts as well. Most of our current jobs would probably disappear. We would probably be without grid electricity and without oil for cars. It would be very difficult to start over from such a situation. We would truly have to start over from scratch.

I have not talked about a distinction between “borrowed funds” and “accumulated equity”. Such a distinction is important in terms of the rate of return investors expect, but it is not as important in a crash situation. Similarly, the difference between stocks, bonds, pension plans, and insurance contracts becomes less important as well. If there are real problems, anything that is not physical ends up in the general category of “paper wealth”.

We cannot count on paper wealth (or for that matter, any wealth) for the long term. Each year, the amount of goods and services the economy can produce is limited by how the economy is performing, given limits we are reaching. If the quantity of these goods and services starts falling rapidly, governments may fail in addition to our problems with debts defaulting. Those holding paper wealth can’t count on getting very much. Workers producing whatever goods and services are actually being produced will likely need to be paid first.


About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to financial problems for oil producers and for oil exporting countries. We are really dealing with a physics problem that affects many parts of the economy at once, including wages and the financial system. I try to look at the overall problem.
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506 Responses to The Problem of Debt as We Reach Oil Limits

  1. Pingback: The Problem Of Debt As We Reach Oil Limits | State of Globe

  2. MG says:

    The debt is the distance that needs to be to overcome so that the man-made system can continue functioning depending on external resources.

    That is why the role of the communication technology is so important now: it is needed for reassuring that the promises will be kept, as it takes longer and longer to keep the promises. Which means that various promises gradually become obsolete as they will never come true.

    We live in the world of more and more fantastic marketing of the future that will be much different than advertised, as there are more and more promises, but, at the same time, less and less energy available.

    We will see what happens when the debt to be paid is dependent on the real creditors as regards the Greece, i.e. not “anonymous money”, but “money of somebody”:

    Slovakia mulls referendum on Greek debt

    The countries in colder regions are more sensitive to debt, as their inhabitants need to have stocks for worse times, i.e. surviving the winter. I think that this is something that Greeks do not fully realize, which means, that the Greeks have less and less space for further debt from the Northern Europe.

    • MG says:

      Can we say that the currency issued by the countries in colder regions has to be more stable, as this currency must “endure bad weather”, i.e. longer periods when the soil is not providing food, or the crops are lower due to cold and lower fertility of the soil?

      We can see that the countries in warmer regions are more prone to inflation:

      • MG,

        hi there from Slovakia, even if I work in Czech Republic. In my country, debt is also a huge problem and if you are a young person and want to have a family, you are surely going to go into debt. Debt is a refusal to accept the limits to growth, and declining living standards. I try to avoid debt, but I have no children, nor house…


        • MG says:

          Hi Alex,

          we have already communicated regarding one of your blogs on via e-mail. I find Gails blog a great place for exchanging deep ideas for true insiders…

      • I haven’t really studied inflation. Rising “demand” = more inflation. Adding more high priced fuel, if an economy can afford the higher price, leads to inflation. High oil prices cycle through to higher food prices.

        The cold countries have not been doing well–wages are stagnant, and “real” growth rate is low. This may contribute to low inflation rates.

        • “I haven’t really studied inflation. Rising “demand” = more inflation. Adding more high priced fuel, if an economy can afford the higher price, leads to inflation. High oil prices cycle through to higher food prices.”

          Inflation has different understandings in different schools of economics; some say it is rising CPI (price of goods excluding food and energy) while others use inflation to mean dilution of the currency.

          In the second case, rising CPI is simply an indication that the purchasing power of the currency may be being diluted. Prices can rise for other reasons, such as shortages. A bad year for corn leading to higher corn prices does not indicate a change in money supply and velocity.

          Defining what you mean when you say inflation seems to really reduce the amount of time people spend arguing in circles when they are in fact both agreeing.

          • richard says:

            Inflation in its purest sense is an expansion in the quantity of money, akin to a bubble inflating. The common use of the word inflation is “price inflation”, the visible sign of more money circulating in the economy. Government needs standardised measurements of the quantity of money, and its effects, typically referred to as Consumer Price Inflation and Retail Price inflation, within the economy.
            Everyone in an economy sees price inflation differently. Some spend most of their income on food, others spend more on shelter, and so on, but the expansion of the money supply affects the entire economy.

    • John Doyle says:

      The monetary sovereign EU can pay for Greece. Other countries are not involved, nor need to be involved, in spite of all the false opinions by know-nothing politicians and journalists. Just don’t believe the crap.

      • MG says:

        Dear John Doyle,

        yes, the monetary sovereign EU can pay for Greece, which means that there is less resources for others, as these are consumed by the life-support of the Greece, which is heavily dependent on energy imports.

        You must take resources from somebody in order to give it to somebody else. And you need energy for the economic growth. The debt from the past is a kind of brake here: you have less money to buy resources and spend them at home (i.e. in Greece).

        Is there a will to allow the Greeks spend more resources instead of others?

        • John Doyle says:

          It does indeed depend on what resources are available across the Eurozone. IMO there is plenty of untapped capacity space for supporting such a plan.
          I don’t know the EU data, but using US data for a comparison the spare capacity is at least 1/3rd of the potential GDP for the EU. with full employment.
          Do you have any figures to support your concern?
          The debt from the past is a non event, irrelevant.
          Remember Greece is now just a state like say Kansas is within the USA.

          • MG says:

            I think that the big players in the EU, who are in the similar situation as the Greeks (Italy, France and Spain) want their share, too and that is why I do not see much space for the creative ideas of the Greeks. The common policy is common policy. Enough is enough. It is childish to think that France, Italy or Spain with their millions of the unemployed would be glad to hear about the debt jubilee for the Greeks…

            • John Doyle says:

              You have gone off target. Greece is now just one state in the EU. Why are you imagining what’s good for Greece won’t apply to every other state when and if such necessity arises? But it will apply across the EU. It has to. You childish comment is pure rubbish

          • edpell says:

            With the full rights to succeed just like Kansas. Regardless of the dictatorial self justifications offered by Lincoln or Barroso.

          • “Remember Greece is now just a state like say Kansas is within the USA.”

            Europe is not a true federation, it does not have the fiscal and monetary structure in place to have a single currency. It is halfway between being a United States of Europe, and being a bunch of independent countries.

            • John Doyle says:

              Maybe, but it is a currency union and if some structures are missing, which I have heard of then they need to be sorted. In any event only Brussels can create Euros, just the way we do in Oz or you in the US or UK. So they can still buy, QE style if they choose, toxic assets from any member country.

          • A lot of the spare capacity in Euorpe is for making cars that people can’t afford, and operating refineries that no longer have enough oil coming into them. They really represent assets that need to be written off. They are not true untapped capacity–they cannot provide goods cheaply enough that citizens can buy them.

    • I think EROEI calculations missed the important point about time being very important in energy payback. It is precisely as you said-there is more and more lag between investment and return, so more investments won’t work out. This also true for things like electric cars–longer payback period than gasoline powered, unless subsidized, or high price for gasoline.

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  6. Stefeun says:

    Thank you very much Gail, for your post that helps me better understand how debt is bounding the system together, how it is connected to specialization, and why it has to grow.

    As for money, I agree with Matthew that it’s a claim on energy, but it definitely is a kind of debt by itself: when I have money it means that someone owes me some good or service for it. I can “unstore its value” (value = energy) now or in the future, or even in the past, if I’m using this money to pay back a loan.

    Moreover, it seems to me that today most part of the money exists only in the form of debt, with no real -or even realistic- counterpart in real stuff. This is due to the possibilities of leveraging, cumulated with coumpounded interest (that pumps money up the wealth pyramid).

    So from this point of view we can avoid talking about money, as monetary tricks can help improve the situation in one place (thus making it worse elsewhere) but don’t change the picture in the aggregate.

    Then, because of diminishing returns, the real cost of things is increasing, ie the amount of energy needed for extraction is raising (also for production but for other reasons), and less energy is available to flow into the system, in the form of wages for example.

    With low wages the demand/consumption weakens and debt is getting more difficult to obtain (if we force private debt to increase artificially we eventually get 2008 GFC). Unsufficient increase of debt can’t keep up the price levels, which then have to decrease in order to match the affordability level. Low prices tend to stop new investments and make it more difficult to pay back the loans, leading to defaults that have to be absorbed by the rest of the system (in 2008 the loss has been reported on governments, but taxpayers have hard time paying back huge interests; that also adds to decreasing demand/consumption).

    At some point the benefits of the debt disappear, letting only the burden of rolling it (borrow to pay back old loans) whilst paying neverending interests. As if the real cost of things (linked to accessibility to the resource) becomes bigger than max affordable selling price (linked to emergy). The surplus is becoming negative.

    The debt is then used -no longer to increase production earlier- to borrow from the future, thus making increasing promises on decreasing possibilities of pay-back. It cannot go on forever, because once all the money goes for paying interests, we have nothing left to live (I remember someone has calculated that more than 40% of any sales price goes into payment of interests; that was few years ago, can’t find the link). The debt cannot be repaid, only the interests keep going on, sucking the real economy’s depleting blood into the financial sphere.

    Writing off ALL debt is clearly not an option, as it would mean suppressing money itself, but I don’t know if SOME debt could be canceled, in order to give some oxygen to the real economy and get BAU to last a bit longer (I can see John Doyle, RobM and others here are making good points about that). Since confidence (blind faith?) is playing a big role in holding the -increasingly brittle- system together, I fear a write-off could trigger a fatal avalanche of defaults, unfortunately. We don’t seem to be heading for such direction, though ; as Ben Van Beurden declared 2 weeks ago:
    “The dividend is an iconic item at Shell and I will do everything to protect it.”
    (“everything” means cut capex, lay-off people, pressurize suppliers, buy-back shares, etc… ie take the money and run, what a nice sacrificial religion!)

    Sorry if this long comment repeats most of what is already better said in Gail’s post, but the implications of debt are difficult to grasp, for me. Do not hesitate to discuss if there’s something wrong in my interpretation.

    • RobM says:

      nice summary

    • I think you are pretty much right. I am sure that the powers that be will try to do anything they can to keep things going. Writing off debt for some countries that would fail otherwise might possibly be helpful. It is hard to see anything that will really fix the system. Diminishing returns is a formidable opponent. It has been operating in force since about the year 2000–from the time we hit “trough” oil prices, and also maximum employment as a percentage of the population. I need to write about this as well.

    • richard says:

      “Writing off ALL debt is clearly not an option”
      I’d question your ‘clearly’. A bank’s loans (debts) are its assets, so writing off all debt would make every bank in the world insolvent. It is arguable that in a world of zero interest rates (set aside NIRP for now) banks, as we know them cannot survive. Solvency for some banks seems to depend entirely on government paper, and some have commented that depositors are no longer essential for banks to function. So some of the concepts being tossed about imply exactly wiping out the banks and extinguishing debt.
      That cannot happen. More precisely, it cannot happen in time to significantly ease the incoming problems of the finite world.
      Before all that can happen it would be wise to cancel all derivatives. Derivatives are bets, and usually appear as a ‘net’ position in those darkets of papers, bank balance sheets. So just cancel all the bets? by 2016? That would take one or more international trade agreements, good luck getting that done within ten years.

      • Stefeun says:

        Richard, you write:
        “Derivatives are bets, and usually appear as a ‘net’ position in those darkets of papers, bank balance sheets. So just cancel all the bets? by 2016? That would take one or more international trade agreements, good luck getting that done within ten years.”

        Until 1885 the speculation was forbidden in France, by a simple law that prohibited the bets (with a few exceptions); I don’t know for other countries but I guess the situation was similar. Then the law was abrogated (by Jules Ferry, the same who made school mandatory for all kids), probably in order to accelerate the process of colonization.

        Technically-wise, it’s very simple and the whole law holds on 1 page. With sufficient and coordinated political will, “closing the casino” could be made overnight.
        Now, I don’t think it’s realistic because we’re so interdependant that you cannot bring down one part of the system without -at least- damaging the others, and anyway we’re running short of net energy, which prevents us from re-buiding some different structure that would give same output.

        So yes, we can imagine to cancel derivatives and money itself or any other part of our obese system, and that will happen soon anyway (but not because of our will, IMO), but we must be aware that next system (if ever) will be totally different, based on the ruins of the current one, and will have to operate under a much much lower “carrying capacity”.

        • richard says:

          Derivatives : A thought experiment.
          Have you ever made a will? If like me, you decided who will inherit your house, your car, the money in your bank account, and what to do if the foreseeable happens. But suppose before you sat down to write your will you had been out drinking with some friends, Ann and Bert (you are Charlie), all sports fans, though you favour different sports, and you decided to each bet on the Superbowl, the Grand National, and the Tour de France. You each decided, among yourselves to place US$1000 on accumulator bets that each winner in 2020 would win each successive year until 2040. How are you going to write that into your will? That when you die no property can be transferred until Ann and Bert find another Charlie to take on your bet?
          That may sound absurd, but as far as I know, that is a reasonable approximation to the legal position of derivatives.
          The “problem” here is that without this “guarantee” there would be fewer and more costly derivatives. Hence you may pay more for your iPhone6, or you may not be able to get it at all.
          So, iPhone6, or your children’s inheritance, which will it be?

          • Stefeun says:

            The smartest phone NOW, undoubtedly. Tomorrow is another day and the kids will have to deal with the world as it will be then, not my business, I already got my share of struggle (speaking in general, not for myself).

            The maximum power is needed in the present time, according to the Max Power Principle (see Jay Hanson’s “Overshoot”:

            For example, just look at the choices we made with respect to nuclear. If we were reasonable, we’d never have decided to go for it (see e.g. Charles Perrow’s “Normal Accidents”, tight coupling and complexity lead to inevitable accidents)

            It requires a very strong determination to make reasonable choices, as well as some kind of strategy because by doing this you put yourself in weak position. IMO it’s possible for small communities and under particular conditions, but not scalable, unfortunately.

            • richard says:

              “For example, just look at the choices we made with respect to nuclear. If we were reasonable, we’d never have decided to go for it”
              I’m old enough th remember to promise of “electricity too cheap to meter” when Calder Hall went online. That was “propaganda” to conceal the production of fissile material, but there was some truth, the electricity was just a useful by-product of the process.

  7. Don Stewart says:

    Dear Gail and All
    Your article and several commenters have touched very lightly on the subject of the mountain of derivatives. I would like to look more closely at the mountain.

    In a world of globalized supply chains, there is not a true global currency. The dollar comes closest, but there are still many local currencies which play important roles.

    If you look at how much money FoxConn gets for making an iPhone, it is less than 5 dollars. While I am not privy to the contract between Apple and FoxConn, I would expect that it stipulates the production of the iPhone, in return for which FoxConn will receive, let’s say, 5 US dollars. But FoxConn has to deal with suppliers all over the globe. The prices of the inputs that FoxConn uses are constantly changing. The profit margin on the 5 dollars is very low, as there is intense competition in manufacturing.

    Some minor fluctuations in the relative values of currencies, and in the price of commodities, can easily wipe out all the anticipated profit for the manufacture of the phone. Therefore, FoxConn buys a huge volume of futures covering themselves against FX and commodity fluctuations. The financial industry makes money by matching those who do something real (such as FoxConn) with those who like to speculate and have billions in assets.

    My point is that the derivatives, and the systemic risk they pose, are inevitable by-products of globalization of supply lines with localized currencies and volatile commodity markets. If a supply chain is entirely inside one monetary system (the Euro, the US dollar, the Ruble, etc.), then the risk of FX fluctuations is greatly reduced. What would be left is commodity fluctuations, such as agricultural crops.

    Therefore, the costs and the systemic risk posed by the gargantuan derivatives market should be seen as a cost of doing business the way we are doing it. IF governments cared about it, I suppose they would impose a small tax on such financial transactions to supply a reserve which could be used to bail the system out in the inevitable eventual failure. But we all know that won’t happen.

    Don Stewart

    • Great post, and I’d add it is not just about the FX.
      For the midterm, meaning next 2-3decades, global financial crash/rest would still leave in its wake “intact” factories, mass transit, natural resources and skilled people, especially in places like Russia and China. They could barter energy resources for goods and or even cooperate on some projects where both parties add knowhow to the final outcome etc. Wait a minute, they are already doing it on some scale and perhaps might scale it up against a drop of export in to non-aligned countries i.e. their former import markets in the west..

      Consult Orlov, financial crash will at least in the begining take much different path in US/W. Europe than elsewhere. It could be speculated that some of TPTB in the US/W. Europe will have to after some basic consolidation of order adopt some similar strategies how to govern after the event.

      Powerfull people and the giant inertia of past many centuries won’t simply go into the night quickly, it will be a bumpy process. I’m not saying this attempt won’t be temporary fix, but for sure will be tried at least for the time scale major energy infrustructure could be maintained, coal, large hydro and nuclear are for several big players nearly 100% domesticaly sourced affairs.

      • Addendum, yep for the formerly pretending affluent countries the drop of scale in international market/demand will be horrific in very short time.. avoid such places like a plague..

    • I suppose the derivatives program could be considered a cost of doing business, but if that was its role, it could have been set up as an insurance program, with true reserves in place. Also, with insurance, there needs to be an “insurable interest.” There doesn’t need to be an insurable interest–people who want an “inflation hedge” can buy ETF’s and the ETF’s can invest in derivatives. Or folks who think the ruble is collapsing can bet against the ruble.

      In many ways, I think we would have been better off without a derivatives program. There would need to be larger margins in cost structures, admittedly, but I think a lot of this was done to squeeze margins to the limit, and to be able to borrow as much as possible (by somewhat insulating the lender from risk). The problem with this approach is that it interferes with the normal relationship between supply and demand, making demand pretty much independent of what happens with prices. It hides problems for a while, until they reappear in a much bigger form and explode.

      • Don Stewart says:

        ‘derivatives as a cost of doing business’

        The bulk of derivatives are in the FX markets and interest rates. The amount of derivatives traded in two days exceeds the GDP of the world for one year. Why are FX and interest rates such crucial items? With FX, it’s clearly because those companies in the supply chain want to offload the risk of currency fluctuations. With farmers, it’s because they want to offload the risk of commodity fluctuations. A few producers think they are smarter than the markets (Southwest Airlines, for example) and actively gamble (SWA on the price of jet fuel).

        A few years ago my sister, who worked for an automobile company, said that the company made more money by selling premium seats than it made on the automobile. Since the automobile is assembled from raw materials and intermediate products from all over the world, with a hundred different monetary systems or more, small fluctuations in FX can have disastrous effects on profitability. Many companies would rather simply pay a percent or two to get ‘certainty’. The ‘certainty’, of course, is problematic. Governments have tried to increase the ‘certainty’ by putting derivatives in front of deposits in a crisis…but there are real questions about the hugeness of the derivatives against the relatively small amount of deposits.

        I am not sure that insurance companies have the financial strength to provide reliable insurance for derivatives. Consider AXA, the French insurance giant, which bought Equitable Life of New York some years ago. AXA offered retirement accounts which were ‘guaranteed’ not to lose value, even as the depositor withdrew 6 percent per year from the principal. Needless to say, AXA no longer sells those products, but they sold a lot of them. So consider the risks…stock market crashes, the possible crash of the Euro, the possible disappearance of the Euro, the risk that the dollar will continue to rise. Such concerns are a long way from finding out someone’s age and looking at a mortality table to figure out how much insurance you can sell them.

        These AXA policies are guaranteed by the State of North Carolina (in my case), which state hasn’t got a nickel to its name.

        Don Stewart

        • I understand that an awfully lot of derivatives have been sold with respect to municipal bonds, guaranteeing that the rates wouldn’t go up. Those selling the guarantees pocketed a lot of money from municipalities that, in retrospect, would have been better off not buying the derivative. But it is hard to know, and a guarantee sounds good in advance.

          There have been a lot of guaranteed accounts sold over the years. Actuaries looked at past patterns, and were certain they knew how to forecast the future. If things go down slowly, things like this will be harder to sort out than if they go down quickly.

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  9. edpell says:

    Francis Fukuyama wrote a book “Trust”. His point, societies with high levels of trust become wealthy societies. Debt is powered by trust. When that breaks the debt tool becomes less effective maybe even useless.

    Finance has become a quagmire of unregulated deception. We just have to wait to see what gives first.

    • Not having economic growth also makes debt payback difficult. Even if the trust was there initially, as economic growth disappears (even on a per-capita basis), more defaults take place, making trust disappear.

  10. richard says:

    Hi Gail, and thanks for another interesting post. I think I can simplify some of it, and the comments to date:
    What the economy is.
    What is going to happen if nothing is changed.
    What might be achieved if the best choices are made.
    Taking just the first topic, you describe economic growth and economic contraction as if they were different systems. The system is exactly the same. The initial conditions are different, particularly the amount of debt. Take any of the ancient civilisations that grew, matured and died. Initial and final conditions were not that different once debt disappeared. Today we see problems with finite resources, but we need to see that somewhat as a separate issue as todays resources could have been available to earlier civilisations. We have fewer, if any, good choices, and we need to be clear what the choices are. The immediate problem is Debt. Is there good debt and bad debt? What is the difference? Can “we” dump the bad and keep the good?
    After these are answered we can move on …

    • edpell says:

      You mean give people who borrow money and are stupid and lazy a pass while we hold borrowers who are thrifty, frugal, smart and disciplined to pay back their loans. That does seem to be the government of corny capitalism.

      • “You mean give people who borrow money and are stupid and lazy a pass while we hold borrowers who are thrifty, frugal, smart and disciplined to pay back their loans. That does seem to be the government of corny capitalism.”

        You are a reckless gambler. You bet you would get paid back more than you lent out, and you lost, because the other party is unable or unwilling to pay. All debts have risk. Perhaps you miscalculated the risk, or perhaps you thought you could beat the odds. Either way, you were wrong. Take your loss and move on.

      • richard says:

        “You mean give people who borrow money and are stupid and lazy a pass”
        And you have a better, and less judgemental proposal for NINJA (no income, no job or assets) debtors? Also, arguing from the specific to the general prejudges the matter, so I suggest that you should look at the system, not the components. If, for example you find that the system is designed to fail, then does it matter if some loans are fraudulent?

      • richard says:

        “You mean give people who borrow money and are stupid and lazy a pass”
        Just as a thought experiment, think back to a time when your employer would give you your wages in gold or silver coins contained in a stiff brown envelope at the end of the week. Do you really want to lend this money that you worked hard for, to a potentially “lazy and stupid” bank?

      • Richard D Devorch says:

        “You mean give people who borrow money and are stupid and lazy a pass while we hold borrowers who are thrifty, frugal, smart and disciplined to pay back their loans. That does seem to be the government of corny capitalism.”

        The virtuous deserve the money? The dark evil lords of crony capitalism have clouded the waters but the virtuous smart and hard working remain? The chief reason the term “crony capitalism” exists is to imply that there is a pure and virtuous system of non crony capitalism that exists

        If you want to reward the hard working then the oil fields should have all the $. Oil has done all the work.

        Not that there isnt virtue in hard work. IMHO there is. Making it the primary issue while disregarding the fact that all wealth derives from exploitation of resources is a very common justification for various behaviors.

        • richard says:

          In the time of Magna Carta, it was the barons that held the King to account. Today those barons would be described as crony capitalists. The point I am making here is not about today, it is that if or when collapse comes, it would be better to have the robber barons on our side rather than the King’s.

    • The issue, both in prior civilizations that collapsed and now, is diminishing returns. Diminishing returns can come simply from rising population relative to a fixed amount of arable land–the amount of land per farmer starts dropping. Or it can come from a combination of factors, such as rising population and eroding soil, or rising cost of producing fossil fuels. Any of these things makes per capita wages tend to drop, especially for the common workers. It is the drop in per capita wages that causes the system to collapse. This will happen regardless of whether the best choices are made–at best they might push off the inevitable. The debt makes the system very brittle. It is impossible for the system to shrink back, when it needs to.

      • bwhill says:

        Hi Gail

        Don’t know if you have seen Rune Likvern latest article, but I thought it was very good:

        This is the reply we gave to it at PO News:

        The reality becoming that the costlier oil gradually becomes less affordable for them.

        The author seems to have hit most of the bases. The last graph gives “growth fueled by credit/debt expansion”, “consumer affordability”, “cost for the incremental barrel” and “slow down”. Sort of looks like this graph:

        The one area he misses is what happens when producers begin to shut-in as a result of lower prices. Half of the demand for oil is now generated by the production process itself. As production goes into decline, so will half of the demand for oil. A significant portion of the credit formation over the last decade has been created by the producers themselves. Shale has required over $1 trillion in new credit formation. Without that credit creation what happens to the debt based monetary system, and what happens to interest rates if no one wants to, or can borrow money?

        Demand has actually already started to fall, as published numbers are greatly influenced by the amount of oil that is now going into storage. That oil shows up as demand. When the demand from producers themselves begins to fall, as they start to shut-in operations as credit disappears, the credit markets will be crushed. It seems likely that interest rates will plummet as Central Banks use their only tool for response; they will continue to print. Thus flooding the economy with more money that no one can, or will want to borrow.

        The article is a good start, but it is not the end of the story!

        I think that the monetary system is much more dependent on oil than is commonly believed. Petroleum directly powered $6.22 trillion of economic activity in the US in 2012. Even a 10% decline in that number would have a crushing effect on the monetary system. It might be enough to completely crush the credit markets as the CBs money printing is now having little, or no impact. At ZIRP you are left with no place to go, and negative rates would eventually bring down the whole debt based system.

        Good luck on your trip. You will be missed.

        • Don Stewart says:

          Dear bwhill
          I think both Rune Likvern’s article and your response are important articles to read and ponder. In addition, it seems to me that this article describing the risk averse behavior of consumers is important:

          I have lost the reference, but the only two categories of household debt which are higher now than they were in 2007, in the US, are student debt and auto loans. Both those categories have, I think, some peculiarities which have kept them growing.

          If we combine a high debt level for consumers with risk averse behavior because of suspicions about the stability of the economy, with the addition of higher interest rates and the steady erosion of low cost oil. then it seems that the stage for a financial collapse is set.

          Don Stewart

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