Follow by Email

Saturday, November 5, 2011

How Bad Is It?

How bad is it? The simple answer: "pretty bad!"

Since the early eighties and extending almost 20 years our economy and equity markets experienced a golden period; then things started to go a little sour. We had the dotcom bust in 2001 and the financial meltdown of 2008. Equity values have not really risen at all this past decade. My explanation for our current problems is that this seemingly outsized growth beginning in 1980 was a bit of a mirage; and can be pretty much explained by us citizens and our government just borrowing our way to today. Consider the following.

Our Federal Debt and the sovereign debt of other countries (think “PIGS”) has gotten the most attention, but it doesn’t illuminate the full state of affairs; it’s better to focus on all four debt components: that of governments, households, banks and corporations; in aggregate, the Total Debt.
For the longest time, America’s Total Debt was about 150% (1.5 times) the nation’s GDP. An exception was the Great Depression, when it increased to 300% (3.0 times), however this rapidly returned to normal. Around 1980 this long term trend of 150%, stable since the 1940s, began to climb. In 2011, we are now over Depression Era levels; estimates are as high as 360% (3.6 times GDP). The government, financial and non-financial companies, and households have a Total Debt of about $57 trillion (it looks worse when you actually include the zeros: $57,000,000,000,000). If we had maintained the 150% norm during this period, we would have a Total Debt of only $24 trillion. So an extra $33 trillion in consumption and investment (GDP) over the last thirty years was “put on the card” so to speak. This isn’t a trivial amount; it’s about 10% of total GDP for the period.
Some might say this is because a greater percentage of households now own their home, rather than renting. The fact is home ownership has hardly moved; in 1980 it was 65%, now it is 67%. Home equity historically had been above 50% in the United States, as of 2011 it is 38%. Housing is a big part of the problem, far from the fulfillment of the American Dream.

We most likely will not grow out of our debt problem as easily or as quickly as we did in the Thirties.
In the ten years from 1933 to 1942 our nominal GDP bounced by 187% ($56.4B to $161.9B). Unfortunately consensus estimates of our future growth are much more anemic, 2.5% annually on the high end (the economy thus taking almost 30 years to double).
Another negative staring at us is our demographics. As the Baby Boomers started reaching working age in the early Sixties there were relatively fewer children because of lower fertility and also fewer elderly as extended longevity hadn’t kicked in with full force. Academics call this phenomenon a “demographic dividend.”The number of Americans too young or old to work, compared to the number of working age adults (the “dependency ratio”) started to erode in 2010, going from 50% (5 dependents for every 10 working adults), to a forecasted 65% in 2050 (6.5 dependents for every 10 working adults). The tsunami of retiring Boomers is just beginning and it will be another unfunded and growing tug on productivity for the country.

The linked power of high economic growth and the demographic dividend are not present for us in this latest crisis. We are going to have to pay down a big chunk of this debt along with greater interest payments, analysts antiseptically call this an extended period of “deleveraging.”
And this rather gloomy scenario assumes we start accepting the truth about our current situation and get public policy and individual responsibility mostly right; which at this moment seems a bit farfetched. American politicians are bickering with themselves to distraction; the Euro Zone is balancing on the brink of collapse. China faces wrenching shifts away from its very successful export led growth and is also burdened with the worst dependency ratio trend in the world (rising from 38% today to 64% by 2050). It’s hard to see much to smile about. 

Michael Lewis’ new book, “Boomerang: The Meltdown Tour” has a wonderful quote that captures the moment: “leverage buys you a glimpse of prosperity you haven’t really earned.” We are in some big trouble. Interest payments and debt reduction will be a real and yet necessary drag on all our lives for perhaps decades. I think it would be foolish to plan for something else; better to dampen expectations and modify behavior now, perhaps to be pleasantly surprised later.

After all, there’s always an “upside case” that might be realized.