With Campaign 2004 finally over, it is time to look ahead and assess the economic challenges that are glossed-over in the heat of a presidential election. Our country has a rich tradition of hard work, innovation, and a can-do spirit that has pulled us through many difficult times. Unfortunately, politicians of all stripes today will not deliver the hard truths that require a collective sacrifice of the citizenry (and voters). What politician gets elected by saying no to spending? A Congressional re-election rate of 96% is ample evidence. And of course we citizens don’t really like hearing hard truths either. In the meantime, economic problems that beg to be addressed only get larger and more potent. As a nation, we must deal with reality or it will surely deal with us.
In a recent research article, Morgan Stanley Global Economist Stephen Roach sums up the situation we face when the post election smoke eventually clears.
“Our fixation on the here and now reflects both the difficulties of longer-term forecasting as well as the short-termism of the investment community. Each quarter that we escape a problem, the greater the comfort level as to what lies ahead. Such myopic risk assessment misses the forest for the trees. In my view, the US economy is an accident waiting to happen. That’s the message to be taken from a record shortfall in national saving, a record current-account deficit, record levels of household indebtedness, a record deficiency of personal saving, and outsize government budget deficits. The emphasis is on the word “record.” Never before has the United States pushed the envelope to this degree on such a wide array of economic imbalances. America will wake up the day after the election with the most daunting economic agenda it has faced in a generation. Then the real debate can begin.
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Naïve Optimists
....Terrorism has certainly shaken us to our core, but the economy has remained relatively buoyant. However, the immense and ongoing cost of the war on terror will be an undeniable factor in the future.
The hard truths are out there for those who wish to see them, and they aren’t going away for those who don’t.
The Personal Savings Rate and Net National Savings Rate - Both have plunged to all-time lows over the past two years. This historic lack of saving is a clear indication of a nation living beyond its means.
Current Account (Trade) Deficit – Lacking in domestic saving, America requires $2.6 billion of foreign capital inflows every business day to fund our economy. The U.S. is now absorbing 80% of the world’s surplus saving. This huge imbalance puts pressure on domestic job creation and may lead to protectionist policies. It also weakens the U.S. dollar, which will eventually mean higher prices and higher inflation.
Budget Deficit- Like its citizens, the government is spending much more than it is taking in, over $400 billion this year alone. This number could grow significantly in 2005.
Household Debt- The housing boom has allowed asset appreciation to be used as a means to fund current consumption, i.e., the home functioning as an ATM. As a result, household indebtedness is now at an all-time high.
Demographic Reality Check- It is a mathematical certainty that retiring Baby Boomers will wreak havoc with the Medicare and Social Security systems, given our current political reality. A recent government study on future Medicare and Social Security needs shows a present value “gap” of promised outlays and projected revenues of $51 trillion, and rising. To quote the obtuse Alan Greenspan, “significant structural adjustments will be necessary.” One has to wonder who will be able to make those adjustments, and when will they start? President Bush appears willing to address Social Security, but faces strong opposition. Even if successful, Medicare represents the lion’s share of the $51 trillion shortfall, which only grows larger.
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A repeat of the 1970’s, on steroids?
What has caused such horrendous imbalances to grow and flourish? There is sufficient blame to blanket all of Washington D.C., but the Federal Reserve appears to be the leading suspect. Looking back to the 1970’s, there were imbalances then as well (beyond platform shoes and disco). In the early 70’s the Fed was creating a great monetary expansion, in part to pay for a very expensive Vietnam War. As a result, money flowed into tangible assets as investors sought refuge from a depreciating dollar. The returns on tangible assets (including energy stocks) toward the end of the decade were staggering. By 1980, the energy sector was 25% of the S&P 500 Index. Today it is 7%.
Fast-forward thirty years and the Fed has once again created a monetary and credit bubble, this time of epic, perhaps biblical proportions. Scary things can happen to a highly leveraged economy, especially when nearly 50% of our outstanding Federal debt is held by foreign creditors. We don’t just “owe it to ourselves” any longer
Mark Twain once said, “History doesn’t repeat, but it does rhyme.” There are certainly differences from thirty years ago. On the positive side, our economy is more technology-based and not as reliant on petroleum. However, today we are a huge net importer of both oil and credit, unlike the 1970’s. We also have a personal savings rate closing in on zero, versus over 8% thirty years ago. If we are in for a variation of 1970’s style stagflation, or worse, many Americans will be ill prepared.
The U.S. debt structure is too large, and growing too fast to be repaid within the realities of our political system. The only politically palatable alternative is to inflate, i.e., pay off the debt in cheaper and cheaper dollars. The current debt on America’s balance sheet is approximately $34 trillion. This of course doesn’t include the roughly $51 trillion in unfunded mandates for Social Security and Medicare, growing at $1.6 trillion per year.
As higher inflation infiltrates the economy over the next few years, interest rates will be forced up. Rising interest rates have never helped the stock market, or the real estate market.
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