Exponential Finance

Stein's Law

"If something cannot go on forever, it will stop." Stein's Law is a tautology. It should go without saying, yet it needs to be said and oft repeated. Unsustainable trends end. Human intuition is biased towards the status quo. In a nutshell, we expect tomorrow to be like today, no matter how much experience we accumulate to the contrary:

• In 1990, how many people anticipated the Internet revolution?
• In 1980, how many people anticipated the collapse of communism?
• In 1960, how many people anticipated the energy crisis?
• In 1935, how many people anticipated the bombing of Pearl Harbor?
• In 1920, how many people anticipated the Great Depression?
• In 1910, how many people anticipated World War I?

Each time, the answer is very few people and even they could not predict dates. Chaos is hard to cope with. Psychologically, it's tempting to ignore chaos, or pretend that you've got it under control. Unfortunately, that type of thinking is very bad for investment portfolios.

We live in unsustainable times. How long can oil power the global economy? How long can interest rates stay at zero? How long can the global economy grow exponentially? The simple answer is: not forever. A better answer is that these trends could potentially go on for years, maybe a couple of decades, but given a spark, they could explode today. The transition does not need to be traumatic but burying your head in the sand ensures that it will be. To anybody willing to listen, to anybody willing to weigh the evidence for themselves: embrace the future, get sustainable and avoid getting wiped out.

This is the best information that I could compress into about 15 minutes. After reading this page, I recommend watching Chris Martenson's Crash Course. It's the best information that can be compressed into 3 hours and 20 minutes. Two thinking people will never find perfect agreement but I agree with Chris Martenson on an awful lot.

Exponential Growth

Exponential growth is something that cannot go on forever. The danger is that we live, and have grown up in, an exponential phase of the economy. The term exponential growth doesn't just mean "really fast." Journalists do disservice to a profoundly important idea when they use the term that way. Exponential growth precisely means that a thing grows by a ratio of itself each cycle. If mathematics makes you woozy, never fear. You'll understand the significance after taking a look at this popular illustration:

Imagine a magic eye dropper. It is magic because a drop¹ of water that comes out of it will double in size every minute. So, there is 1 drop in the first minute, 2 drops in the second minute, 4 drops in the third minute, 8 drops in the fourth minute and so on.²

This magic eye dropper is in the possession of a mad scientist, who wishes to give you a most macabre demonstration. He kidnaps you and brings you to a deserted baseball stadium.³ It is magically water-tight. He handcuffs you to the very top bleacher then heads down to the field. He squeezes a single drop of water from his magic eye dropper onto the field. It begins to multiply.

Question: How long do you have to free yourself before you drown?

Answer: about 49 minutes

Question: How long does it take for water to start spilling from the field into the first row of bleachers?

Answer: about 45 minutes, or just 4 minutes before water completely fills the stadium

Question: Suppose some of my estimates are off and the stadium actually has double the volume I originally calculated. How much time does that buy you?

Answer: 1 minute

Human intuition is not calibrated to understand exponential growth. Human intuition projects linearly into the future. Starting from drops of water, our intuition tells us that we will more likely starve to death than drown. Even as water spills into the first row of bleachers - with only minutes left - our intuition tells us that we have hours. We must train our intuition to identify and correctly assess exponential trends. Hmm, where might we find some of those?

What about pension funds?

The Illinois Teachers Retirement System assumes an 8.5% annual growth rate on its portfolio.

Question: According to the model, if a teacher makes a one-time contribution of $10,000 and retires 35 years later, how much money will she have?

Answer: $174,000

Question: But, what if the fund grows a little bit slower than planned, say at 5.5% per year?

Answer: $65,000

Wow! A mere 300 basis point adjustment results in retirement expectations being slashed by about 2/3. Defined benefit plans are disasters waiting to happen because a small error in predicting the rate of compounding results in huge funding shortfalls. This is why institutions are so eager to convert defined benefit plans into defined contribution plans, a euphemism for not promising anything. As an aside, assuming an 8.5% annual return for a pension fund is criminally optimistic. That is a return on par with allocating 100% into the stock market, which is far too risky for a pension fund!

What about oil?

In 2011, global oil production was 85 million barrels per day. Saudi Arabia had proven reserves of 265,000 million barrels.

Question: How many years of supply is that?

Answer: about 8.5

Suppose that global oil consumption increases by 2.5% per year.

Question: How many years of supply is that now?

Answer: about 7.5

Suppose that new oil reserves are proven equivalent to 10 Saudi Arabias. Keep assuming a 2.5% increase in consumption per year.

Question: How many years of supply is that now?

Answer: about 46

Question: What if we find 20 Saudi Arabias? How many years of supply would that give us?

Answer: about 67

Observe how doubling the number of Saudi Arabias only buys about half again as much time.

On the bright side, the world isn't likely to run out of oil in our lifetimes. On the other hand, it's hard to get too terribly excited about new oil discoveries, whether that be tar sands in Canada, shale oil in the United States, deep sea oil under the arctic or methane hydrate off the coast of Japan. Each of these discoveries buys the world only a few years of time, at successively greater costs of production.

The problem is not running out of oil per se. The problem is running out of cheap oil and gushing oil. Ultimately, the price and availability of oil will make it more expensive than renewable sources of energy. Transitioning to renewable energy is going to require rebuilding the world's energy infrastructure. It's no small task. We don't really know what that infrastructure will look like. We can either accept reality, discover what's cost effective and transition gracefully or get dragged kicking and screaming.

Exponential Finance

Let's visit the United States government balance sheet. As of March 2013, according to the US Debt Clock:

Spending:	$3,541,000,000,000
Tax Revenue:	$2,500,000,000,000
Budget Deficit:	$1,041,000,000,000
National Debt:	$16,689,000,000,000
Unfunded Liabilities (NPV):	$123,090,000,000,000
Sequester Cuts:	$85,400,000,000

The mainstream media tends to butcher these terms. For example, during the "Fiscal Cliff" drama of 2012, pundits routinely referred to looming budget cuts of $600 billion. However, that number was a summation of budget cuts over 10 years. The average annual budget cut was only $60 billion. The "Sequester" is the latest package of budget cuts under consideration. The Sequester drama is 2013's version of 2012's Fiscal Cliff drama.

Spending, tax revenue and the budget deficit are annual numbers. The national debt is the accumulation of deficit spending heretofore. Unfunded liabilities are benefits Congress has promised but for which no tax revenue has been allocated. Congress must pass additional taxes or Treasury must borrow the money to fund these programs. Estimates range from $60 trillion to $200 trillion and are often amended. It is an ungodly amount of money, even at the lower end of the range.

So, OK, great. What does it mean? The mind is repulsed by such large numbers. Let's shrink them to the context of an annual household budget by dividing some of the zeroes away.

Spending:	$35,410
Salary:	$25,000
New Credit Card Charges:	$10,410
Mortgage:	$166,890
Promises to the Kids:	$1,230,900
Proposed Cuts:	$854

Congress is like a family that, facing a shortfall of $10,000 over the coming year, proposes to make ends meet by cancelling their premium cable TV subscription. Their house is mortgaged and their credit cards will soon be maxed out yet Mom and Dad are promising their children college educations at private universities, sports cars, houses and plastic surgery. It's absurd.

When you or I get into debt, we work harder. We produce more. The government doesn't work that way. Other than delivering the mail, which it does at a loss, the government produces no goods nor provides any service. In fact, the government only has one product to sell: you!

Treasury gets money in 2 ways: It can tax or it can borrow. The problem with taxation is that voters don't like it. The problem with borrowing is that loans come due, with interest. If you thought voters didn't like being taxed, just wait until you tell them about all the new taxes needed to pay the interest.

So, what do you do when you dig yourself into a ditch? If you're Congress then you keep digging. Treasury never pays down the national debt. Treasury pays off maturing bonds with newly borrowed money. Let that sink in. Treasury just rolls the debt over, along with the interest. Recall that the definition of exponential growth is when a thing grows by a ratio of itself. In this case, the thing is debt and the ratio is interest. This is how finance becomes exponential finance. Here's a graph of the Federal debt since 1965. It's clearly exponential:

One can only borrow exponentially so long as the collateral against which one borrows also grows exponentially. The government derives income by taxing the economy. That makes the economy their collateral. Therefore, the government can only borrow exponentially so long as the economy also grows exponentially. So far, it's worked. Here is a graph of the Federal debt divided by GDP. It trends up over time but not exponentially:

The problem is that the economy can't grow exponentially forever, or even for very long. The earth is finite. The environment is going to force an equilibrium. Resource extraction can't long grow exponentially. Population can't long grow exponentially. The global population growth rate is already in decline. I think it's going to reach zero faster than the blue line suggests. In Japan and some European countries, population growth has gone negative. Population growth in the United States would be very close to zero if not for immigration.

I have singled out the United States government as an example but many economic actors are structured on indefinite, exponential growth. Governments are. Banks are. Pension funds are. Many so-called "growth stocks" are. When the transition from exponential growth to maintenance comes, things are liable to get sticky. The financial sector is going to explode. The Great Recession of 2008 was just a shot over the bow.

Humanity will adapt and prosper. It's just going to get a little scrambled up, first. Every person is going to have a story. Whether your story is graceful or tragic is going to depend on whether you plan for the future or get dragged along, kicking and screaming.

Footnotes

¹ one drop equals 0.05 ml

² water table

³ My figure for the volume of the stadium is taken from Chris Martenson's Crash Course which in turn references a paper by Dr. Albert Bartlett. The stadium is Fenway Park. I did a little back-of-the-envelope calculation. A quick lookup of Fenway Park has the distance to left field at 94.5m and deep field at 115m, which is very roughly a rectangle. Assuming the height of the first row of bleachers is 4m up, we get a volume of 43.47 megaliters, which would take 41 minutes to fill up. However, the field is only about a quarter of the stadium, so that takes us up to 43 minutes, which is "in the ballpark," so to speak.