Wednesday, September 25, 2013

Rapid US Growth Is Missing, Not Gone Forever

We are now about five years into the deleveraging, and the related slow global growth, that followed the 2008 financial crisis. My forecast is for another five years of unwinding the excess borrowing by banks worldwide, U.S. consumers and many other sectors.

The private sector deleveraging has been so severe that it overwhelms all the federal tax cuts and spending increases undertaken in response to the recession, as well as the central bank interest-rate cuts and quantitative easing that piled up immense excess member-bank reserves at the Federal Reserve.

If you need proof of the drag of deleveraging, look no further than the subpar 2.2 percent average real gross domestic product growth in the recovery that started in the second quarter of 2009 and the 1.7 percent growth in the second quarter of this year.

Most forecasters, however, initially thought that after the very deep 2007-2009 recession, the recovery would be equally robust. After all, that had been the norm. In the 15 quarters of this economic recovery, through the first quarter of this year, real GDP has risen 8.1 percent. Excluding the recovery after the 1980 recession that only lasted one year, the only other recovery this weak was the 7.5 percent gain after the 1973-1975 recession.

Most forecasters also yearned for the 3.7 percent average growth of the 1982 to 2000 salad days, when the economy was driven by declining inflation and falling interest rates as well as the consumer borrowing-and-spending binge that drove the household saving rate to about 1 percent from 12 percent in the early 1980s. Furthermore, that was an era of business restructuring, and as a result, stocks soared.

Nevertheless, as slow economic growth persisted in this recovery, many seers joined me in forecasting continuing slow growth rates of about 2 percent. They cited many of the causes discussed in my recent book, “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” Among them are the shift by U.S. consumers from borrowing and spending to saving and financial deleveraging. This trend was compounded by the aging of the population, rising health-care costs, growing income inequality, high government debt and a faltering education system for many Americans.

Nevertheless, any phenomenon that lasts long enough generates theories that it will last forever. The average real GDP of just 2.2 percent since the recovery started, and of only 1.6 percent over the last 12 years, has spawned a number of such theories.

Harvard University economists Carmen Reinhart and Kenneth Rogoff, authors of the 2009 book “This Time Is Different: Eight Centuries of Financial Folly,” suggested in a 2010 paper that when central government debt exceeds 90 percent of GDP, the economy contracts at a 0.1 percent annual rate. Their findings became gospel.

In a 2011 speech to the Council on Foreign Relations in New York, the European Union Economic and Monetary Affairs Commissioner Olli Rehn said: “Carmen Reinhart and Kenneth Rogoff have coined the 90 percent rule. Huge debt levels can crowd out economic activity and entrepreneurial dynamism, and thus hamper growth. This conclusion is particularly relevant at a time when debt levels in Europe are now approaching the 90 percent threshold, which the U.S. has already passed.”

I’ve argued that net debt, or borrowing from outsiders, is the important metric, not the gross amount that also includes borrowing and lending among government divisions. But let’s not quibble. Even on a net basis, U.S. federal government debt is almost 90 percent of GDP.

Glenn Hubbard, dean of the Columbia Business School and a former chairman of the Council of Economic Advisers, and Tim Kane, chief economist of the Hudson Institute, in their new book, “Balance: The Economics of Great Powers From Ancient Rome to Modern America,” express even more basic concerns. They say great powers fall into the trap of “denying the internal nature of stagnation, centralizing power and shortchanging the future to overspend on their present.”

They see “the storm clouds of history” gathering on the horizon because of the U.S.’s political inertia, anti-growth policies, the erosion of economic vigor and, especially, excess government spending.

Niall Ferguson, a Scottish historian who teaches at Harvard and is a fellow at the Hoover Institution, joins in with his new book, “The Great Degeneration.” He thinks government encroachment is strangling private initiative, especially in the U.S., threatening representative government, the free market, the rule of law and civil society. He focuses on the explosion of public debt in the U.S. as well as in Europe, the destruction of free markets by excessive regulation and the rule of law being replaced by the “rule of lawyers,” exemplified by complicated laws such as the 2,700-page first draft of the Dodd-Frank Act.

Ferguson worries that the U.S. civil society, with its many volunteer organizations that impressed Alexis de Tocqueville in the 1830s, is being replaced by the nanny state that promises cradle-to-grave security.

Then there’s Robert J. Gordon of Northwestern University who thinks that the big growth-driven technologies are fully exploited. He cites past marvels such as Thomas Edison’s electric light bulb (1879) and power station (1882), which led to other innovations, such as consumer appliances and elevators. He sees nothing to rival the economic impact of the automobile, the telephone, phonograph, motion pictures and radio, or the post-World War II developments such as TV, air conditioning, jet planes and the interstate highway system.

Computers and the Internet are essentially fully exploited, he says, and as a result, the 2 percent annual output growth per capita of the years from 1891 to 2007 are over. And with the retiring postwar baby boomers leaving the workforce, America’s lousy education system and growing income inequality, real yearly GDP growth of only 1 percent is likely and “the overwhelming majority of Americans will see their incomes grow just 0.5 percent annually.”

Some of these very negative arguments for future economic growth and structure have merit. Increased government regulation and involvement in major economies does stifle innovation and reduce efficiency and, therefore, economic growth. Then there’s the growing percentage of Americans who depend on government at some level for meaningful economic support -- from government civilian and military jobs to Social Security to food stamps recipients.

My company’s research shows that in 1950, 28.7 percent of Americans received meaningful financial support from the government. That share reached 52.4 percent in 1970 and jumped to 58.2 percent in 2007. As the retiring baby boomers draw Social Security and Medicare benefits, and with chronic high unemployment pushing government job-creation efforts, I see the total reaching 67.3 percent in 2018.

When more than half the population is receiving government aid, you might think there would be no end to the largesse they would demand at the ballot box. But that 50 percent level was breached by 1970, 43 years ago. The voters’ self-restraint reflects the U.S. character of deep-seated self-sufficiency. People apparently still believe that they can get further on their own merit than by pushing government to redistribute income in their favor.

None of the pessimists cited earlier expressed concerns about the growing role of finance in the economy in the past 20 years, which has occurred to the detriment of education and productivity-enhancement. Total stock market capitalization as a percentage of GDP traditionally ran 40 percent to 60 percent, but it exploded during the dot-com bubble in the 1990s, to 147 percent in the first quarter of 2000, exposing the degree to which speculation and dreams of quick riches had supplanted saving and serious investment. Investors told startups to burn through their capital as fast as possible to build name recognition, with no concern for profit prospects.

After the dot-com collapse, the ratio fell to 73 percent, still high. The housing bubble, another nonproductive investment area, propelled it to 109 percent in the second quarter of 2007. The housing collapse caused another decline, but the market capitalization-to-GDP ratio has since revived to 107 percent amid what I call the Grand Disconnect. Investors, at least until the last month or so, have had no concern for the reality of most economies, which are limping along at best, and were focused instead on the Fed pumping out money through quantitative easing.

The still-high ratio of stock market capitalization to GDP suggests that speculation remains preferable to productive work or investment. Many on Wall Street still seem to view it as an adversarial trading arena where the objective is to obtain money at the expense of others. Such get-rich-quick hopes aren’t new, but the idea that the financial sector exists to grease the wheels of commerce and not as an end in itself seems to have largely disappeared.

Another way of looking at the increasing role of finance for its own sake is the declining dollars of GDP associated with each dollar of new debt in the entire economy. Of course, this ratio, like any statistic, doesn’t prove causality. Nevertheless, in the 1947-1952 years, each new dollar in debt in the entire economy was associated with a $4.62 increase in GDP. Recently, that figure has dropped to 9 cents because derivatives and other layers of financing do little to promote economic growth.

Yet, even with all these caveats, I disagree with the long-term pessimists who, in this age of deleveraging and persistent slow growth, find increasing acceptance. I’ll discuss why I lean toward a return to rapid U.S. economic growth in the longer run in my next column.

(A. Gary Shilling is a Bloomberg View columnist and president of A. Gary Shilling & Co. He is the author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” This is the first in a three-part series. Read Part 2.)