JUNE 30, 2011
Happy Canada Day to my Canadian readers!
Readers may be interested in an interesting and timely essay by Jason Hsu, Chief Investment Officer at Research Affiliates. I consider it the ‘must-read’ report of the week:
On future economic growth:
Debt, deficit, and demographics—the 3-D hurricane— is heading to the shores of all developed economies. It threatens to derail the lukewarm economic recovery and to alter forever the heretofore path of robust growth for the developed world. In a sense, debt, deficit, and demographics will reset the world to a “New Normal”—an extended period of lower economic and return expectations for the aging and debt-ridden developed world
Well said. As I have often warned here, the next decade will look nothing like the last. Investment returns in many asset classes will pale in comparison to the prior decade, unfortunately. In particular, real estate looks like it will be in for one rough ride in most parts of the country based on the fundamentals we have extensively reviewed here.
But it’s not just real estate that is vulnerable. Understanding the appreciation in real estate is key to understanding the unprecedented expansion in consumer debt, which has bloated as CMHC has loosened mortgage qualifications and removed the maximum mortgage amount since the early 2000s and as home owners have found that they have access to a great deal of cheap credit by tapping home equity lines of credit. The growth in such lines of credit has been staggering:
As has our overall consumer debt growth:
We’ve also discussed debt at the national level. While our federal government has done a great job of reining in spending through the late 90s and early 2000s, the aggregate debt levels across Canadian society are nevertheless troubling as they now measure over 280% of GDP, an all-time high.
And, as I have been warning for some time now, there is little doubt that the future will be one of increasing austerity, either embraced by politicians, as seems to be the case now that Harper has his majority, or forced on us by a bond market rebuke that sends borrowing costs higher.
Finally, demographics have been examined here several times before, both with regards to housing and with regards to other asset classes as well. The bottom line is that despite increasing population growth, which has been predicted at less than 2% nationally over the next two decades, will be entirely insufficient to prevent the ageing of the population. The implications are clear. You can read about them here:
On emerging economies:
In contrast, emerging economies with healthy government and household balance sheets, responsible fiscal policies, and young labor forces will be the drivers for global growth and will compete with their developed counterparts for economic and political leadership.
I entirely agree....with the exception of China, whose centrally-planned economy which has thrived as the government has been busy building empty cities and railroads to nowhere, seems to be poised for a hard landing.
Nevertheless, investors are unwise to pass up exposure to emerging markets. There are some excellent ETFs that enable you to gain access to these markets.
On stimulus spending:
The extensive literature exploring the effects of deficit-driven stimulus programs provides strong evidence that short-term growth, financed by deficit spending, rarely translates into sustained long-term growth.... The short-term increase in economic activity does not translate into future increases in production of valuable goods and services.
Insofar that the government stimulus is financed by more debt, it necessarily translates into higher future tax burdens, which then drains future private sector consumption and investments. By backward induction, a higher future tax burden decreases expected (after-tax) return on investments, which then reduces private sector investments today. Crowding out future and current private sector activities by the public sector growth today bodes ominously for future growth.
We have been all too willing to believe the story that future growth driven by indomitable American ingenuity will deliver us from our debt. Unfortunately, unless another decade-long period of explosive technology innovation is in the cards for us, we may have just now hit a wall: The debt-to-GDP ratios for many developed countries have become untenable; additional borrowing capacity is small.
Can I get an ‘Amen’?! Nothing to add here...
On the politics of deficit spending:
In hindsight, the policy of persistent deficit spending seems utterly irrational and short-sighted. On the other hand, one might argue that this outcome is exactly rational in the context of baby boom demographics prevalent in the developed countries. Deficit spending gives an instant and immediate boost to GDP, which can feel like prosperity and good government stewardship.
The natural conflict between the future non-taxpayers and the future taxpayers means that Boomers, who have controlled the elections and politics, have rationally chosen a path of more consumption today at the expense of the future generations.
...In other words, and as scientific as one can put it—the Boomers have screwed Generation X.
Democracy is one of the great equalizers for income inequality in the cross-section of population. The poor have a mechanism to instigate wealth transfers by voting for welfare and public goods production and to avoid exploitation by voting for pro-labor regulations.
Democracy seems to serve quite the opposite role, however, when it comes to equalizing the inequality between generational cohorts. There is no doubt that our future generations have become extremely poor...
...It appears that democracy has facilitated the exploitation of our future poor by the current rich and indeed has been a strong contributor to what will become the Boomer’s legacy of odious debt.
Wow that’s well said.
On the impact of shifting demographics:
As the country prepares for retiring Boomers (and the debt and deficits associated with them), it will also need to prepare for changing demographics—specifically, the adverse effects driven by the dramatic decline in the support ratio associated with an aging population.
People consume goods and services which are produced by workers. A sharp decline in the United States and developed country workforce means that Americans, and their European and Japanese counterparts, must either reduce consumption drastically or increase reliance on imports from emerging countries.
Thus, the trade deficit between developed countries and the emerging countries must continue to widen aggressively or the standard of living for developed countries must decline precipitously. However, the only way for most developed countries to maintain (and increase) their trade deficit against the emerging countries is to borrow heavily from the emerging countries.
On the unpreparedness of the Boomers as they face retirement:
Boomers should have anticipated the untenable support ratios in their retirement. They were supposed to save aggressively during their working years (delaying pre-retirement consumption) and then convert their large and plentiful retirement assets into retirement consumption...
Instead, what we observe today is inadequate retirement savings. It is long understood that the pay-as-you-go social security scheme cannot work effectively as a credible mechanism for intergenerational risk-sharing in the face of declining support ratios; as the population ages and fewer workers enter the workforce relative to workers exiting into retirement. There are insufficient numbers of young people paying into the system to support the social security payments for those who have retired. Pension schemes, or forced retirement savings, should have protected workers from the problems associated with aging demographics.
Unfortunately, low contributions, high costs, and poor governance and institutional design have generally led to poor funding and adequacy ratios.
The 3-D hurricane is coming. With it will come high inflation rates, high costs for credit, low growth rates, and weakening developed country currency value. Ben Bernanke in a helicopter will not stop the hurricane’s devastating path. More stimulus packages will not stop it. Blaming the Chinese for lending us too much money will not stop it. Pretending that the storm isn’t coming will most assuredly not stop it. I wish I had a better weather forecast for you.
The report specifically deals with the US. In Canada, we have to acknowledge that our national balance sheet, while deteriorating, is not as bad as other developed economies, most notably the US, UK, and Japan. Furthermore, we are blessed with an abundance of natural resources that can and will be monetized in the future to help offset some of the imbalances discussed in the paper. We are not the US. We are not the PIIGS. But while we may not face a ‘hurricane’, our future may yet be stormy.