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The Potemkin economy

Image: Nicholas Eckhart

There is an old folk story concerning Grigory Potemkin, the governor of Russia’s southern provinces in 1774.  According to the tale, to hide high rates of poverty from the Russian Empress Catherine the Great, Potemkin ordered the construction of artificial villages along the banks of the Dnieper River as the Royal yacht cruised along it.  The village were no more than a façade, and would be quickly deconstructed once the Empress had passed by so that they could be reconstructed further down the river.

Like all folk myths, this one was primarily nonsense, but did contain a grain of truth at its heart.  The people of southern Russia were impoverished; and Russian courtiers went out of their way to hide this from the ruler.  Nevertheless, the term “Potemkin Village” has entered the lexicon as a description of anything – physical or otherwise – hidden behind a cheerful façade.

In this sense it is not unreasonable to regard the UK (and US) economy as a Potemkin economy – a fast decaying edifice hidden behind an artificially inflated stock market propped up by an increasingly unstable mountain of private and public debt.

The façade is meant to persuade us that something meaningful had been done in response to the 2008 crash.  However, as sociologist Joseph Tainter pointed out, crises are the product of prior solutions.  To a large extent, 2008 was the product of the solutions put in place to address the stagflationary crisis of the 1970s.  The response in 2008 – low interest rates and quantitative easing – was less a solution than a temporary fix designed to “extend and pretend” while economists and political advisors desperately searched for a way out.

Unfortunately, the economists and politicians charged with solving the problem had not the faintest idea what had gone wrong.  In consequence, the policies adopted since 2008 were the very opposite of those that were needed.  In addition to creating dangerous political instability, government austerity programmes aimed at cutting public spending have served only to cut the stock of money circulating in the economy.  Zero percent (in real terms) interest rates have helped the private sector (firms and households) to service their outstanding debt, but have done little to allow them to repay it.  Indeed, since almost all of the (electronic) money now in circulation is created by banks when they make loans, debt repayment would actually remove money from the economy despite being in the best interests of anyone with outstanding debt.

The debt overhang from 2008 has left a wide section of the population reluctant to take on new debt, with the result that the creation of new currency – to counter that being removed by the government – has fallen on the middle classes – via mortgages, autoloans and student debt – and large firms through share buybacks:

“Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason. Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn’t using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital…

“Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company’s earnings per share (EPS) ratio is automatically increased. In addition, short-term investors often look to make quick money by investing in a company right before a scheduled buyback. The rapid influx of investors artificially inflates the stock’s valuation and boosts the company’s price to earnings ratio (P/E).”

Politicians, of course, use the artificially high stock market indices that result from these policies to claim that their policies are working.  There is, however, growing awareness that economic indicators of this kind are completely detached from the lived experience of most ordinary people.  The same is true for official data on inflation – which measures the price of things we stopped buying (like the latest smartphone) while ignoring the things we do (like food and utilities).  Similarly, employment is inflated by a huge “gig-economy” of low-paid freelancers, part-timers and zero hours contractors who exist in the income gap between benefits and the minimum wage.  Even GDP figures have been inflated by the inclusion of the proceeds of prostitution and drug dealing which the poorest among us have been forced to resort to in order to keep their heads above water.

There comes a point, though, when the Potemkin façade begins to disintegrate and the true state of the economy is exposed for all but the cossetted elite to see.  The disintegration has been gathering pace for some time, manifesting in changes to spending patterns that have largely damaged product lines.  Expensive brands of personal hygiene products like shampoo and deodorants, for example, have taken a hit as middle class consumers switched to discount brands and poor people simply stopped washing their hair as often as they used to.

To understand what is happening, we have to separate discretionary and non-discretionary spending.  Over the last decade, as wages have stagnated and prices have risen, all of us to some degree have had to shift our spending from discretionary items to the non-discretionary purchases that we simply have to make, such as:

  • Rent/mortgage
  • Food
  • Energy
  • Water and sewage
  • Transport
  • Clothing

Underlying this shift in spending patterns are two forces – one a force of nature, the other of wrong-headed choices.  First, the cost of energy has been rising remorselessly since the mid-1970s.  This is hardly surprising, since the economy works on a “lowest-hanging-fruit-first” basis.  That is, to beat the competition, an enterprise must bring the cheapest resources, goods or services to market.  While the market price can be affected by technology and labour costs, when it comes to energy by far the biggest cost is fuel extraction – nobody drilled oil wells in the Arctic or beneath the sea when there was still abundant oil beneath accessible land.  Today, the coal, gas and oil that still powers more than four-fifths of the economy is considerably more expensive than it was in the 1970s (when car ownership began to become commonplace in the UK).

It is not just that the direct cost of energy has increased.  Indirect costs are passed on in the price of everything made from and/or transported using more expensive energy.  To some extent since the 1980s, this cost has been masked by a massive expansion of credit.  This allowed unaffordable goods to appear affordable provided that the economy could keep growing indefinitely.  However, in reality the rising cost of energy acts as a drag on the economy; first slowing it and then throwing it into reverse.

The place that we arrived at in 2008 was where it became obvious that there was insufficient real wealth to allow the mountain of debt that we had collectively run up to ever be paid off.  This predicament explains the central banks’ policy of “extend and pretend.”  Some kind of currency reset or “debt jubilee” might at least mitigate the problem by writing off the mountain of compound interest that has accumulated.  However, barring the discovery of some new liquid energy source more energy dense and far cheaper than diesel oil, the underlying truth is that in future our economy is going to shrink and our living standards are going to fall.

The way in which this occurs is where the second, wrong-headed political choices come into play.  Our economy is presided over by an increasingly distant elite than lacks insight into the state of the real economy.  Like Catherine the Great and her entourage cruising along the Dnieper River, the elite and the politicians, economists and journalists who serve them see only the façade of the Potemkin economy as they make their way from one gated and security-locked “Westminster Village” setting to the next.  Like so many elites before them, this one has chosen to maintain their privilege by attempting to recreate the conditions prior to 2008.

For a decade our political leaders have been using hypothetical taxes levied on future generations as the “asset” against which they have borrowed into existence billions of pounds (and dollars, euros and yen) to buy all of the bad (so-called “sub-prime”) debts from the banks.  This, in theory, was supposed to create a “trickle-down” effect as banks began to lend to businesses to finance economic growth.  That trick, however, only works when energy and resources are cheap enough to allow wages to rise.  But since businesses can see from their own balance sheets that wages are stagnant, there is no reason to borrow to invest.  Moreover, banks no longer believe that the real economy of households and firms buying and selling goods and services can ever generate the kind of returns they need to cancel all of the bad debt, they have instead opted to lend into asset speculation.  Everything from fine art to luxury housing and cryptocurrencies has been grossly inflated even as wages stagnate and companies struggle to return a profit.

The 2017 Christmas holiday may yet prove to be the point when the façade began to crumble – although it could be months or even years before the wall finally tumbles down.  As far back as September, Business Insider was reporting that:

“The UK economy is in pain and it is the retailers who have been crying out first.

“Major UK retailers John Lewis and Next became the latest shops to warn of a slowdown in consumer spending on Thursday, in yet another sign of a serious slowdown in household spending that could be disastrous for the UK economy.”

The article lists a range of distressed retailers that depend upon discretionary spending to remain profitable.  Against this, it contrasts the one part of the retail sector that is still growing – food!  Even as millions of emergency food handouts were being distributed to Britain’s poor, the middle class was switching its spending from such things as furniture, electronics, high fashion and meals out to simply keeping food on the family table.  Meanwhile, Britain’s retailers were praying to whatever gods they believe in for a Christmas spending spree to ward off the spectre of bankruptcy.  Their prayers, it seems, went unanswered.  As Oscar Williams-Grut at Business Insider reports, 2017 saw a 28 percent increase in shop bankruptcies even as Christmas non-food sales slumped by 4.4 percent:

“The figures came as data from the British Retail Consortium (BRC) showed the biggest slump in non-food spending since 2009. Spending grew by 1.1% in the final three months of 2017, a big drop off from the year’s average growth of 1.7%.

“The increase in administrations was driven by trouble for large retailers with a 55% rise in the number of large retailers — classed as any chain with more than 10 stores — going bust, according to Deloitte.”

For the last year, economic cheerleaders have peddled the myth that our collapsing high streets and shopping centres can be explained by the growth in online sales.  However, while online shopping has grown, it is only by a fraction of the losses that have hit physical stores.  The difference between the two is the amount that we, collectively, have shifted from discretionary to non-discretionary purchases.

The high street shops are, of course, the physical façade of our Potemkin economy.  They are the point at which the vital transactions between firms and consumers take place.  When the shops go bust, they are not alone.  The supply chains are hit.  The companies that make the goods are hit.  The utility companies that provide them with power, water and telecommunications are hit.  And if enough shops go down, then all of these suppliers go down with them.  And, of course, the purchasing power of all the people who used to be employed is lost to the economy; creating a vicious circle from which there is no escape.

We know full well where this is going.  We are facing a depression at least as bad (probably far worse) as the 1930s.  The only questions left to be settled are how long the Potemkin façade of asset bubbles and dodgy government statistics can be propped up and, of course, what political horrors will emerge after it all comes tumbling down.

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