The New Economic Normal And What's Ahead

As this piece went to press, we have just had a huge post-U.S. fiscal cliff deal global rally. The deal was a disaster as far as fiscal prudence or friendliness to capital was concerned. Republicans and investors (the evil “rich”) got rolled. The market exuberance was a case of the man who thought he would be executed and now learned that he will only get life. So he celebrated.

But that’s the short term. I want to examine some long-term issues in this piece. So many of the economic problems and conditions the United States and the world are facing today are new. The markets may not be worried about them now but they will. That in itself presents a big problem. All economic forecasts are implicitly based on one theory or another. But economic theories in turn are inspired by or based on events or institutions that existed in the past. This means that a great deal of what everybody learned about economics and finance may be of limited use in understanding the economic and investment challenges that we face today.

New Phenomenon #1 -- Print Money And There’s No Inflation?
Under a concept of relatively recent vintage called quantitative easing, the central banks of the world are printing high powered money (the monetary base) with wild abandon. Alarmist forecasts of hyperinflation can be heard around the world, based essentially on monetarist economic reasoning. But so far, we have only modest inflation in countries with “decadent” central banks. Not only that, central banks around the world are actually targeting modest inflation.

The basis of monetarist economics is an ancient doctrine called the quantity theory of money, or MV=PY. If you double the quantity of money (M), hold the velocity of money (V) constant, PY (the price level times real GDP) doubles. The equation doesn’t differentiate between real(Y) and price effects (P) but doubling M is bound to wind up mostly affecting P. Money in the quantity theory’s original formulations did not allow for fractional reserve banking systems. Money and the monetary base were the same thing in the original quantity theory. In the post WWII fractional reserve environment monetarists have had problems defining whether money is the monetary base or M2, M3 or some other measure of bank liabilities. Milton Friedman, the god of modern monetarism, was a little slippery on this issue. But it didn’t matter that much because until the advent of quantitative easing and the financial crisis of 2008, growth of the monetary base in most countries had exhibited a high correlation with the growth of the various Ms. But no longer. The reserves created by the central banks and the so-called money multiplier that relates the monetary base to the Ms has collapsed. The Ms have grown much more slowly than the base. Bernanke would argue that it’s the Ms that count and that he isn’t wildly printing money. But most monetarists are uncomfortable with this explanation.

Economic history provides countless examples of countries which printed money and suffered massive inflation as a result. So why hasn’t it happened again? One answer might be that it just hasn’t happened yet. Be patient. Another is that the world is in the midst of chronic oversupply of tradable goods, thanks to globalization and productivity gains. Real supply side factors are overwhelming demand side money stimuli. A third argument is that the huge debt overhang of the advanced countries is inhibiting an expansion of demand and therefore inflation. I personally believe all three factors are at work.

Of course there is the question of whether inflation is as low as the conventional CPI indexes suggest. John Williams of Shadow Government Statistics has argued that the U.S. government has rigged the numbers by replacing earlier more conservative inflation measuring techniques and choosing methodological options which understate inflation. A lot of the public would agree with him. The prices of food and non-tradable services have risen even if computers get cheaper by the minute. But Williams remains an outlier among economists.

New Phenomenon #2 -- Can We Do Quantitative Easing And Have No Capital Allocation Distortions?
Bernanke and the other central bankers have driven the so called “risk free” rate to near zero and have driven long rates to relatively low levels. Most observers would agree this has given a big boost to the stock market and I think it will continue to do so in the near term. Where else can investors put their money? But interest rates and stock prices -- the cost of capital -- are supposed to ration capital. Low interest rates have helped bring about a stock market rally. Quantitative easing has weakened or even eliminated the capital market’s main capital allocation tool. Should the stock market be going up in the face of a limp U.S. recovery, recession in Europe and Japan and the massive distortions in China’s economic system?

What are the long term effects of this distortion caused by quantitative easing? I can’t find any good answers on this and I don’t remember this problem being discussed when, somewhere back in the last century, I was in graduate school. If rates rise to more normal levels, will housing go bust again? If interest rates rise to more normal levels, how many governments will go bust?

Residents of Singapore and Hong Kong point to the Fed’s quantitative easing as the cause of house price inflation in their cities. It’s the current ultra-low interest rates that Singapore and Hong Kong worry about. No doubt they have a point. So there is one distortion. (But Singapore and Hong Kong are low tax, capital friendly places. There are no Obamas or Hollandes in charge of these cities. It’s no surprise money is flowing into these places, with or without quantitative easing. Quantitative easing hasn’t produced an influx of money into French real estate.)

Phenomenon # 3 -- What Happens When Population Growth In Advanced Countries Turns Negative And There Are So Many Old People?
The last five centuries have witnessed phenomenal growth in the standard of living in so-called advanced countries. This has been accompanied by -- driven by? -- an equally phenomenal growth in population. But what happens to GDP growth when population growth turns negative? When countries become dominated by senior citizens? Is Japan the future for all the advanced countries with their declining birthrates? Again demographics are not incorporated into the main body of economic theory. Economist Alfred Hansen worried about declining birthrates in the Depression 1930s but the subsequent baby boom and the global expansion of population pushed Hansen into the dustbin of forgotten economists. Maybe he will enjoy a revival.

Japan has experienced twenty years of stagnation. Is this due to its low birthrate and now actually declining population? The current Japanese population is about 128 million and projections are that if current trends continue it will be just over half that by the end of this century. The Japanese population is increasingly an older population. So the demographic future for Japan is less people and an ever older population -- a double whammy. Is quantitative easing and fiscal stimulus a total waste of time in Japan? I have argued that the protectionist and industrial policy driven Japanese East Asian Economic model are at least partly responsible for the poor Japanese economic performance. But it’s hard not to wonder that the aging and now declining numbers of the Japanese population are not at least partly responsible for Japan’s decline. We have no history to go on.

Economist Harry Dent has written extensively on this subject as it applies to the United States. In Dent’s view, baby boomers -- the dominant group in American population -- are now reaching retirement age. Dent argues that their spending will decline and they will dissave, thus depressing the stock market and the economy. Dent has predicted a stock market crash. So far, he’s been wrong. So far. Of course there’s a silver lining in the Dent cloud. Stocks of companies that cater to old people -- health care, biotechnology, drugs, even robots -- may do well.

Phenomenon # 4 -- Will It Ever Matter that the United States’ Debt/GDP Ratio Is Likely To Get Substantially Worse?
According to the IMF, the General Government Net Debt/GDP ratio for the United States is now at the 80% level. This IMF net debt number is the most conservative estimate of the United States’ government debt/GDP ratio. Other organizations have higher estimates and the IMF’s own General Government Gross Debt/GDP ratio estimate is up at 103%. With official deficits of one trillion plus per year and the outlook for sluggish economic growth at best, it’s all but a certainty that the U.S. government debt/GDP ratio -- if it hasn’t already -- is going to soar well beyond the ninety percent level where Reinhart and Rogoff have concluded economic growth is likely to be negatively affected. The U.S. is a poor prospect to grow its way out of its fiscal mess. The just concluded fiscal cliff deal was, for want of a better word, a joke as far as fiscal prudence goes since there were no serious cuts in spending. Moreover, I believe the costs of Obamacare and the probable tax avoidance behavior of the evil “rich” in response to higher taxes have been underestimated.

Moreover, according to a recent Wall Street Journal article by Chris Cox and Bill Archer, unfunded U.S. entitlement obligations total some $86 trillion. Shadow Government Statistics comes up with similar statistics. The real U.S. government deficit, if computed on an accrual basis as the private sector does its accounting, might be several trillion higher.

The fatal attraction of populism, whereby the populace votes itself ever more unaffordable benefits, is catching up with the U.S. and the rest of the advanced countries as well. The U.S. Founding Fathers preferred a republic dominated by property holders over a universal suffrage democracy. They wanted the basic rights of all citizens respected but they feared that in a universal suffrage democracy the more numerous less affluent would vote to expropriate the wealth of the less numerous more affluent. They wanted a world safe from democracy. The trend towards universal suffrage and a more populist government began as early as 1828 in the United States with the election of Andrew Jackson. It accelerated in the United States and Europe with the advent of the Progressive Movement, WWI and the abandonment of the gold standard.

Be that as it may, however dismal the outlook for the U.S. fiscal situation, the world continues to love U.S. government debt. Does this make sense? Like Japan, the worse the U.S. does on the fiscal front, the more government bond prices go up.

Of course this cannot go on forever. But when and how will it end? Will the bond markets eventually turn on the U.S. and Japan as they have already with Greece? Will Fed printing become the sole means of government debt funding and hyperinflation wipe out the government debts in real terms? My own view is that it certainly will end in government defaults broadly defined for both the U.S. and Japan. Defaults perhaps not in the legal sense but “defaults” or reneging on a whole host of obligations and entitlements that governments have made to their citizens.

In the sense I am using the term, means testing would be a type of default. For example means testing for Medicare benefits is simply a polite way of telling more affluent people that the medical retirement benefit they had paid in for and thought they would receive would no long be available. It’s a reneging on an obligation and equivalent to a tax increase.

I regard the recent Republican attempt to trade means testing of Medicare benefits for tax increases as economic black comedy. Tax increases in return for tax increases? In the last election the Republicans “dissed” Hispanics. Now they are dissing upper income groups. Who do they represent?

Question: Can the stock market keep rising with all this going on?

Phenomenon # 5 -- Will the Changing Racial/Ethnic Composition Of The United States Have Investment/Economic Implications?
I believe the fatal attraction of populism in the United States is being intensified by changing demographic and ethnic/racial balance of the country. This has investment significance and, however sensitive this subject, investors have to face it. The relative demographic decline of the essentially educationally and income wise successful European origin people in the U.S. and the relative rise of a more government dependent, educationally and income lagging Hispanic and African American population has investment implications.

The core body of economic theory makes no assumptions or conclusion about racial or ethnic differences. All groups are assumed to on average have equal talents and goals. Discrimination of any sort is regarded as a market imperfection and is undesirable. The history of the United States shows that for some, America has been a land of opportunity and have benefited from the free market. Millions of white European and now non-white Asian immigrants -- Irish, Jews, Italians, Poles, Chinese and Indians etc. -- have come to the United States and they or their descendants have prospered.

Projections are that African Americans and Hispanics will constitute an ever larger proportion of the American population. By 2050, demographers tell us that there will be no racial or ethnic majority among the general population of the United States. It is projected that the Hispanic population will double to 30%. It’s dangerous to generalize about African Americans and Hispanics since there are major differences between them, and within the Hispanic category itself. But it’s a matter of statistics that overall these groups have not prospered compared to whites and Asians.

For example, regarding educational achievement despite all kinds of government programs to improve their performance, African American children have consistently lagged behind white and Asians. Over the last twenty years, the gap has remained. African American family incomes and employment rates compare unfavorably with all other groups. Most Americans would support all reasonable efforts to improve the academic performance of African American (and Hispanic) children. This is in investors’ and the national interest. But I must note that so far throwing government money at the problem has not worked. Hopefully a solution to this problem will be found but from the viewpoint of economic and financial forecasting, wishful thinking cannot substitute for analysis.

Hispanics offer a more complicated picture. Mexican Americans make up an estimated 63% of the Hispanic population with the bulk of the remainder probably of mixed African/white Caribbean origins. The predominantly white, largely professional and better educated Miami Cuban population is atypical of the Hispanic population as a whole. The typical Hispanic, unlike the often highly educated Asian immigrant, arrives in the United States with a low level of education. I have seen statistics showing 50% of Mexican immigrants arrive with less than a high school education. That in itself is a manageable problem. But I have also seen statistics showing that education and income wise the majority of Hispanics show a big improvement from first to second generation and then level off still behind whites and Asians. This is worrisome.

This raises two questions. First, in the global knowledge economy, how will the United States compete when a substantial portion of its children are educational underperformers. Second, the underperforming groups exhibit a greater tendency to depend on government and its services. (I mention here Charles Murray’s latest book, which identifies similar problems of education and income on the lower end of the white population.) Obviously, fiscal reform and entitlement cutting will not be a major concern for these groups.

The Republicans in the last election kept reciting the high unemployment rate and how that would bring them victory. What were they thinking of? Obama has dramatically expanded the food stamp program, continuously extended unemployment benefits and reopened the welfare door by executive fiat. Obamacare favors Medicaid, whose primary constituency is younger and poorer minority groups, over Medicare, whose primary constituency is older, relatively more affluent whites. It would seem that Obama’s plan is to make underperforming groups more dependent on the government and vote Democratic. An irresistible road to serfdom. And reelection.

If you were a single parent, without a job and marketable skills, and you were receiving all these government handouts, whom would you vote for? The political party that would maintain or even increase your benefits or the political party that would set you “free” in an economy where you are under skilled and undereducated compared to your competition and are bound to lose? The Republicans, no surprise, did poorly in states where unemployment was the highest.

I seriously doubt we will see another Ronald Reagan type free market president elected in the United States in our lifetimes. If the Republicans manage to pull themselves together and do get back in power, they will be more like European “conservatives” and not like Ronald Reagan or Margaret Thatcher. These are serious negatives for the American economy in the years to come.