Authored by Gail Tverberg via Our Finite World blog,

Why is the economy headed for a financial crash? It appears to me that the world economy hit Limits to Growth about 2018 because of a combination of diminishing returns in resource extraction together with rising population. The Covid-19 pandemic and the accompanying financial manipulations hid these problems for a few years, but now, as the world economy tries to reopen, the problems are back with a vengeance.

Figure 1. World primary energy consumption per capita based on BP’s 2022 Statistical Review of World Energy. Same chart shown in post, Today’s Energy Crisis Is Very Different from the Energy Crisis of 2005.

In the period between 1981 and 2022, the economy was lubricated by a combination of ever-rising debt, falling interest rates, and the growing use of Quantitative Easing. These financial manipulations helped to hide the rising cost of fossil fuel extraction after 1970. Even more money supply was added in 2020. Now central bankers are trying to squeeze the excesses out of the system using a combination of higher interest rates and Quantitative Tightening.

After central bankers brought about recessions in the past, the world economy was able to recover by adding more energy supply. However, this time we are dealing with a situation of true depletion; there is no good way to recover by adding more energy supplies to the system. Instead, the only way the world economy can recover, at least partially, is by squeezing some non-essential energy uses out of the system. Hopefully, this can be done in such a way that a substantial part of the world economy can continue to operate in a manner close to that in the past.

One approach to making the economy more efficient in its energy use is by greater regionalization. If countries can start trading almost entirely with nearby neighbors, this will reduce the world’s energy consumption. In parts of the world with plentiful resources and manufacturing capability, the economy can perhaps continue without major changes. Another way of squeezing out excesses might be through the elimination (at least in part) of the trade advantage the US obtains by using the dollar as the world’s reserve currency. In this post, I will also mention a few other ways that non-essential energy consumption might be reduced.

I believe that a financial crash is likely sometime during 2023. After the crash, the system will start squeezing down on the less necessary parts of the economy. While these changes will start in 2023, they will likely take place over a period of years. In this post, I will try to explain what I see happening.

[1] The world economy, in its currently highly leveraged state, cannot withstand both higher interest rates and Quantitative Tightening.

With higher interest rates, the value of bonds falls. With bonds “worth less,” the financial statements of pension plans, insurance companies, banks and others holding those bonds all look worse. More contributions are suddenly needed to fund pension funds. Governments may find themselves needing to bail out many of these organizations.

At the same time, individual borrowers find that debt becomes more expensive to finance. Thus, it becomes more expensive to buy a home, vehicle, or farm. Debt to speculate in the stock market becomes more expensive. With higher debt costs, there is a tendency for asset prices, such as home prices and stock prices, to fall. With this combination (lower asset prices and higher interest rates) debt defaults are likely to become more common.

Quantitative Tightening makes it harder to obtain liquidity to buy goods internationally. This change is more subtle, but it also works in the direction of causing disruptions to financial markets.

Other stresses to the financial system can be expected, as well, in the near term. For example, Biden’s program that allows students to delay payments on their student loans will be ending in the next few months, adding more stress to the system. China has had huge problems with loans to property developers, and these may continue or get worse. Many of the poor countries around the world are asking the IMF to provide debt relief because they cannot afford energy supplies and other materials at today’s prices. Europe is concerned about possible high energy prices.

This is all happening at a time when total debt levels are even higher than they were in 2008. In addition to “regular” debt, the economic system includes trillions of dollars of derivative promises. Based on these considerations alone, a much worse crash than occurred in 2008 seems possible.

[2] The world as a whole is already headed into a major recession. This situation seems likely to get worse in 2023.

The Global Purchasing Managers Index (PMI) has been signaling problems for months. A few bullet points from their site include the following:

• Service sector output declined in October, registering the worst monthly performance since mid-2020.

• Manufacturing output meanwhile fell for a third consecutive month, also declining at the steepest rate since June 2020.

• PMI subindices showed new business contracting at the quickest rate since June 2020, with the weak demand environment continuing to be underpinned by declining worldwide trade.

• The global manufacturing PMI’s new export orders index has now signaled a reduction in worldwide goods exports for eight straight months.

• Price inflationary pressures remained solid in October, despite rates of increase in input costs and output charges easing to 19-month lows.

The economic situation in the US doesn’t look as bad as it does for the world as a whole, perhaps because the US dollar has been at a relatively high level. However, a situation with the US doing well and other countries doing poorly is unsustainable. If nothing else, the US needs to be able to buy raw materials and to sell finished goods and services to these other countries. Thus, recession can be expected to spread.

[3] The underlying issue that the world is starting to experience is overshoot and collapse, related to a combination of rising population and diminishing returns with respect to resource extraction.

In a recent post, I explained that the world seems to be reaching the limits of fossil fuel extraction. So-called renewables are not doing much to supplement fossil fuels. As a result, energy consumption per capita seems to have hit a peak in 2018 (Figure 1) and now cannot keep up with population growth without prices that rise to the point of becoming unaffordable for consumers.

The economy, like the human body, is a self-organizing system powered by energy. In physics terminology, both are dissipative structures. We humans can get along for a while with less food (our source of energy), but we will lose weight. Without enough food, we are more likely to catch illnesses. We might even die, if the lack of food is severe enough.

The world economy can perhaps get along with less energy for a while, but it will behave strangely. It needs to cut back, in a way that might be thought of as being analogous to a human losing weight, on a permanent basis. On Figure 1 (above), we can see evidence of two temporary cutbacks. One was in 2009, reflecting the impact of the Great Financial Crisis of 2008-2009. Another related to the changes associated with Covid-19 in 2020.

If energy supply is really reaching extraction limits, and this is causing the recent inflation, there needs to be a permanent way of cutting back energy consumption, relative to the output of the economy. I expect that changes in this direction will start happening about the time of the upcoming financial crash.

[4] A major financial crash in 2023 may adversely affect many people’s ability to buy goods and services.

A financial discontinuity, including major defaults that spread from country to country, is certain to adversely affect banks, insurance companies and pension plans. If problems are widespread, governments may not be able to bail out all these institutions. This, by itself, may make the purchasing of goods and services more difficult. Citizens may find that the funds they thought were in the bank are subject to daily withdrawal limits, or they may find that the value of shares of stock they owned is much lower. As a result of such changes, they will not have the funds to buy the goods they want, even if the goods are available in shops.

Alternatively, citizens may find that their local governments have issued so much money (to try to bail out all these institutions) that there is hyperinflation. In such a case, there may be plenty of money available, but very few goods to buy. As a result, it still may be very difficult to buy the goods a family needs.

[5] Many people believe that oil prices will rise in response to falling production. If the real issue is that the world is reaching extraction limits, the problem may be inadequate demand and falling prices instead.

If people have less to spend following the financial crash, based on the reasoning in Section [4], this could lead to lower demand, and thus lower prices.

It also might be noted that both the 2009 and 2020 dips in consumption (on Figure 1) corresponded to times of low oil prices, not high. Oil companies cut back on production if they find that prices are too low for them to expect to make a profit on new production.

We also know that a major problem as limits are reached is wage disparity. The wealthy use more energy products than poor people, but not in proportion to their higher wealth. The wealthy tend to buy more services, such as health care and education, which are not as energy intensive.

If the poor get too poor, they find that they must cut back on things like meat consumption, housing expenses, and transportation expenses. All these things are energy intensive. If very many poor people cut back on products that indirectly require energy consumption, the prices for oil and other energy products are likely to fall, perhaps below the level required by producers for profitability.

[6] If I am right about low energy prices, especially after a financial discontinuity, we can expect oil, coal, and natural gas production to fall in 2023.

Producers tend to produce less oil, coal and natural gas if prices are too low.

Also, government leaders know that high energy prices (especially oil prices) lead to high food prices and high inflation. If they want to be re-elected, they will do everything in their power to keep energy prices down.

[7] Without enough energy to go around, more conflict can be expected.

Additional conflict can be expected to come in many forms. It can look like local demonstrations by citizens who are unhappy about their wages or other conditions. If wage disparity is a problem, it will be the low-wage workers who will be demonstrating. I understand that demonstrations in Europe have recently been a problem.

Conflict can also take the form of wide differences among political parties, and even within political parties. The difficulty that the US recently encountered electing a Speaker of the House of Representatives is an example of such conflict. Political parties may splinter, making it difficult to form a government and get any business accomplished.

Conflict may also take the form of conflict among countries, such as the conflict between Russia and Ukraine. I expect most wars today will be undeclared wars. With less energy to go around, the emphasis will be on approaches that require less energy. Deception will become important. Destruction of another country’s energy infrastructure, such as pipelines or electricity transmission, may be part of the plan. Another form of deception may involve the use of bioweapons and supposed cures for these bioweapons.

[8] After the discontinuity, the world economy is likely to become more disconnected and more regionally aligned. Russia and China will tend to be aligned. The US seems likely to be another center of influence.

A major use of oil is transporting goods and people around the globe. If there is not enough oil to go around, one way of saving oil is to transport goods over shorter distances. People can talk by telephone or video conferences to save on oil used in long distance transportation. Thus, increased regionalization seems likely to take place.

In fact, the pattern is already beginning. Russia and China have recently been forging long-term alliances centered on providing natural gas supplies to China and on strengthening military ties. Being geographically adjacent is clearly helpful. Furthermore, major US oil companies are now focusing more on developments in the Americas, rather than on big international projects, according to the Wall Street Journal.

Countries that are geographically close to Russia-China may choose to align with them, especially if they have resources or finished products (such as televisions or cars) to sell. Likewise, countries near the US with suitable products to sell may align with the United States.

Countries that are too distant, or that don’t have resources or finished products to sell (goods, rather than services), may largely be left out. For example, European countries that specialize in financial services and tourism may have difficulty finding trading partners. Their economies may shrink more rapidly than those of other countries.

[9] In a regionally aligned world, the US dollar is likely to lose its status as the world’s reserve currency.

With increased regionalization, I would expect that the US dollar’s role as the world’s reserve currency would tend to disappear, perhaps starting as soon as 2023. For example, transactions between Russia and China may begin to take place directly in yuan, without reference to a price in US dollars, and without the need for US funds to allow such transactions to take place.

Transactions within the Americas seem likely to continue taking place using US dollars, especially when they involve the buying and selling of energy-related products.

With the US dollar as the reserve currency, the US has been able to import far more than it exports, year after year. Based on World Bank data, in 2021 the US imported $2.85 trillion of goods (including fossil fuels, but excluding services) and exported $1.76 trillion of goods, leading to a goods-only excess of imports over exports of $1.09 trillion. When exports of services are included, the excess of imports over exports shrinks to “only” $845 billion. It is hard to see how this large a gap can continue. Such a significant difference between imports and exports would tend to shrink if the US were to lose its reserve currency status.

[10] In a disconnected world, manufacturing of all kinds will fall, especially outside of Southeast Asia (including China and India), where a major share of today’s manufacturing is performed.

A huge share of today’s manufacturing capability is now in China and India. If these countries have access to oil from the Middle East and Russia, I expect they will continue to produce goods and services. If there are not enough of these goods to go around, I would expect that they would primarily be exported to other countries within their own geographic region.

The Americas and Europe will be at a disadvantage because they have fewer manufactured goods to sell. (The US, of course, has a significant quantity of food to export.) Starting in the 1980s, the US and Europe moved a large share of their manufacturing to Southeast Asia. Now, when these countries talk about ramping up clean energy production, they find that they are largely without the resources and the processing needed for such clean energy projects.

Figure 2: New York Times chart based on International Energy Agency data. February 22, 2022.

In fact, ramping up “regular” manufacturing production of any type in the US, (for example, local manufacturing of generic pharmaceutical drugs, or manufacturing of steel pipe used in the drilling of oil wells) would not be easy. Most of today’s manufacturing capability is elsewhere. Even if the materials could easily be gathered into one place in the US, it would take time to get factories up and running and to train workers. If some necessary items are lacking, such as particular raw materials or semiconductor chips, transitioning to US manufacturing capability might prove to be impossible in practice.

[11] After a financial discontinuity, “empty shelves” are likely to become increasingly prevalent.

We can expect that the total quantity of goods and services produced worldwide will begin to fall for several reasons. First, regionalized economies cannot access as diverse a set of raw materials as a world economy. This, by itself, will limit the types of goods that an economy can produce. Second, if the total quantity of raw materials used in making the inputs declines over time, the total amount of finished goods and services can be expected to fall. Finally, as mentioned in Section [4], financial problems may cut back on buyers’ ability to purchase goods and services, limiting the number of buyers available for finished products, and thus holding down sales prices.

A major reason empty shelves become can be expected to become more prevalent is because more distant countries will tend to get cut out of the distribution of goods. This is especially the case as the total quantity of goods and services produced falls. A huge share of the manufacturing of goods is now done in China, India, and other countries in Southeast Asia.

If the world economy shifts toward mostly local trade, the US and Europe are likely to find it harder to find new computers and new cell phones since these tend to be manufactured in Southeast Asia. Other goods made in Southeast Asia include furniture and appliances. These, too, may be harder to find. Even replacement car parts may be difficult to find, especially if a car was manufactured in Southeast Asia.

[12] There seem to be many other ways the self-organizing economy could shrink back to make itself a more efficient dissipative structure.

We cannot know in advance exactly how the economy will shrink back its energy consumption, besides regionalization and pushing the US dollar (at least partially) out of being the reserve currency. Some other areas where the physics of the economy might force cutbacks include the following:

• Vacation travel

• Banks, insurance companies, pension programs (much less needed)

• The use of financial leverage of all kinds

• Governmental programs providing payments to those not actively in the workforce (such as pensions, unemployment insurance, disability payments)

• Higher education programs (many graduates today cannot get jobs that pay for the high cost of their educations)

• Extensive healthcare programs, especially for people who have no hope of ever re-entering the workforce

In fact, the population may start to fall because of epidemics, poor health, or even too little food. With fewer people, limited energy supply will go further.

Governments and intergovernmental agencies may start to fail because they cannot get enough tax revenue. Of course, the underlying issue for the lack of tax revenue is likely to be that the businesses within the governed area cannot operate because they cannot obtain enough inexpensive energy resources for operation.

[13] Conclusion.

If the world economy experiences major financial turbulence in 2023, we could be in for a rough ride. In my opinion, a major financial crash seems likely. This is could upset the economy far more seriously than the 2008 crash.

I am certain that some mitigation measures can be implemented. For example, there could be a major push toward trying to make everything that we have today last longer. Materials can be salvaged from structures that are no longer used. And some types of local production can be ramped up.

We can keep our fingers crossed that I am wrong but, with fewer oil and other energy resources available per person, moving goods shorter distances makes sense. Thus, the initial trends we are seeing toward regionalization are likely to continue. The move away from the US dollar as the reserve currency also looks likely to continue. Moreover, if the changes I am talking about don’t occur in 2023, they are likely to begin in 2024 or 2025.