More on the policy basin
(Editor’s note: This is the second of two parts. Read Part 1.)
I analyzed 45 historical episodes of deleveraging since the Great Depression in both developed and developing economies. Having specifically focused on the 32 episodes that followed financial crises, I found that deleveraging has been painful and long-lasting, generally lasting six to seven years, on average. As such, if history is a guide, I would expect several more years of debt reduction. This process will exert a significant drag on GDP growth.
However, some have suggested that a less painful pathway for reducing debt is to grow the economy at high enough rates to offset the negative impact of deleveraging as opposed to imposing fiscal austerity. This option seems unlikely in the current environment given the reduced tailwind from favorable demographics and accommodative fiscal policy going forward.
Some experts have argued the U.S. will experience a lost decade of low growth and deflation similar to Japan in the 1990s. From 1986 to 1991, Japan experienced rapidly increasing real estate and equity prices only to have the bubble burst in 1991. In contrast to normal recoveries, Japan’s asset prices showed no propensity to recover and actually continued to decline for more than a decade. Some of Japan’s lost decade story is starting to sound familiar, as the country implemented ineffective and/or inept economic policies that failed to revive the economy after a severe recession.
However, there are several important distinctions between Japan and the U.S. I would argue the most significant contributor to Japan’s lost decade was the dramatic deterioration in its demography in terms of the working age population. Japan’s working age population peaked in the mid 1990s before falling sharply. This is in contrast to the U.S., where according to U.N. projections, the pace of growth of the U.S. working-age population is expected to slow over the coming decades, but still grow.
Another meaningful divergence was regulatory forbearance afforded to the banks in Japan with respect to the recognition of bad loans. Japan’s banking system was festered with troubled loans for more than a decade, limiting the willingness of banks to make loans and thus clogging the monetary transmission mechanism. By comparison, the U.S. quickly purged the banking system of problem loans. Lastly, Japan experienced deflationary conditions for nearly a decade whereas U.S. inflation has been running consistently in the 2 percent range. Therefore, in my view, the U.S. will not experience a lost decade similar to Japan in terms of asset prices. That being said, I would suggest that the potential economic output in the U.S. is lower than in the past due to fiscal and monetary policies, deleveraging, and changing demographics. Thus, I anticipate slower and slower economic growth going forward – a basin.
Demographics are a critical variable in terms of potential growth in an economy. Our demographic situation will be challenging, but is not nearly as dire as that of Japan or even that of Europe. Between 1950 and 2000, the U.S. civilian labor force grew at an average annual rate of 1.6 percent. The growth rate has slowed since then and is expected to continue to do so as a result of the aging baby-boomers. Between 2000 and 2010, the annual growth rate of the labor force fell to 0.8 percent. Our labor force growth forecast for the next 10 years is 0.7 percent.
Productivity growth has ebbed and flowed over time. Between 1947 and 1973, productivity grew at a pace of 2.8 percent. From 1973 to 1995, productivity slowed to an annual rate of 1.4 percent. It re-accelerated to 2.9 percent from 1995 to 2005. Finally, it slowed, again, to 1.6 percent between 2005 and 2011.
Forecast long-term trend growth can be distilled into a simple formula:
Labor Force Growth + Productivity = Real Economic Growth
Checking the efficacy of the formula, since World War II, U.S. GDP growth has been 3.3 percent. Labor force growth has been 1.3 percent and productivity growth has been 2.2 percent. My formula would have forecasted a fairly accurate 3.5 percent economic growth.
Based on my forecast of 0.7 percent labor force growth rate and 1.6 percent in productivity growth, my long-term trend growth rate forecast is 2.3 percent, consistent with expectations of the Congressional Budget Office (CBO), which publishes projections of potential economic growth. Its most recent forecast suggests real GDP will not reach its potential, meaning real GDP growth less than 2.3 percent for the next 10 years – creating what I term the policy basin.
I think politicians will not allow the economy to go over the fiscal cliff and create the next recession. Rather, I believe a hybrid solution will be reached, generating a policy basin for protracted U.S. economic growth of less than 2.5 percent. The fiscal cliff is certainly a concern; however, it took us 40 years to create the problem, and I’m not convinced it can be resolved in a year or two.
It is important to note that this news may not be negative for the equity markets. In fact, I think corporations may be able to grow earnings in the 4 percent to 6 percent area in this environment, which has historically produced attractive total returns.
While there is lingering uncertainty about how the fiscal cliff situation will play out, I think the U.S. will continue to persevere, even if we remain in temporary period of slow or sinking growth. If a policy basin does in fact come to fruition, I believe we will still have an environment that is modestly supportive of the U.S. economy and its equity markets.