Friday, June 25, 2010

A New Economic Era

Here's a simplistic description of the North American economy since 1945:

Late forties, fifties, sixties: Post-war boom due to pent-up demand (forced saving during the war), rebuilding in Europe. Artificially extended into the 60s by overly lax monetary policy.

Seventies, early eighties: Instability due to inflation - it's a hangover from the 60s' overheating - compounded by the oil shock. Would have been much more painful if it weren't for favourable demographic circumstances (baby boomers trickling into the labor market).

Mid and late eighties, nineties, naughties: Boom due to favourable demographics (baby boomers form a large experienced workforce) and a large technological shock. Moderated in Canada by sky-high federal deficits, which hurt investment. Artificially extended into the 00s by debt run-up.

So what happens now? Just like during 1970-1983, we'll have to mop up a mess. Except this time, it's not inflation, but debt. The issue is different, so the policies will differ as well, but the big picture is the same: we've front-loaded growth in the past decade, and now's the time to pay for it. On the plus side, we won't necessarily have to endure a crisis like the Oil Shock to make things worse. But the minus side dominates: rather than favourable demographics, we'll have terrible ones, as baby boomers start retiring.

Some random predictions - surely some of them will be wrong, but the big picture should hold:

- 3% growth will not be standard anymore: the new normal will be closer to 2%. (To be sure, during the recovery, we may grow for a while at 3% or more, but it won't be sustained.) In Europe, it may be 1-1.5%.

- Health care costs will keep exploding for a decade or so, but will eventually slow. This is because eventually, governments around the world will not be able to afford year after year the slew of new expensive treatments we now invent annually. Health care innovation will therefore slow due to lack of demand, or at least partly shift from seeking to prolong life to seeking to cut costs. So while the current catastrophic long-term cost projections won't come true, neither will the long-term life expectancy projections.

- Current government pension and/or health care promises cannot be fulfilled to their full extent (maybe not in Canada, where the pension system is on relatively firm footing, but in many other Western countries). One or more of the following types of political upheaval will occur in most countries:
1. Prescient politicians try to prevent this, and encounter fierce resistance (e.g. France, even though the proposed rise in retirement age is actually just a timid first step);
2. Young workers realize this, and there is a generational struggle, possibly causing a political realignment;
3. Crisis point is reached, and these benefits are abruptly reduced, causing much pain to those that didn't see it coming.

- Unless we end up like Japan, real interest rates will rise sharply at some point: in the next 20 years, a lot more people will be running down their retirement savings in the West. Moreover, in China, the coming generation of workers at the top of their earning potential will save less due to cultural change, and the Central Bank will (very gradually) let its currency rise and stop buying foreign assets as quickly as now. As that happens, stocks will do poorly, until interest rates stabilize at their new, higher level. At that point, stocks should turn up, but that might be too late for some.

- Once interest rates rise (or if we end up like Japan), investment, and therefore innovation will slow. That 2% growth norm may endure even after we finish mopping up this debt mess.

- There will be another bubble, but it won't be as big because there will be less easy money floating around.

- Some governments will be tempted to inflate their (and their citizens') debt away. Those that do so modestly may get away with it. Those that are too overt about it may lose control over inflation, though the countries most at risk of doing that are in the Eurozone, so they can't do it. The U.S. has some leeway due to its reserve currency status, and if inflation returns while unemployment stays high, the Fed will likely let inflation rise to 3-4% (instead of 2-3% as it has done over the past 20 years).

How places around the world might do in the next decade:

- The U.S. will have persistent high unemployment, a slow recovery that won't feel like one, followed by slow growth that will feel like a prolonged recession.
- Canada's growth will also be slow, but a bit less so than America's, and the gap in GDP per capita may diminish.
- Québec leaders will try some timid reforms, encounter disproportionate public protests, and back down some of the time.
- French leaders will try some ridiculously timid reforms, encounter completely disproportionate public protests, and back down most of the time.
- Italy, Greece and Portugal will stagnate.
- The British Isles will stagnate for a few years, but then slow growth will resume.
- It's a crapshoot whether Spain will look like Italy or the UK.
- Germany shouldn't stagnate, but might anyway due to their obsession with austerity.
- Japan will have a third lost decade.
- Korea, Taiwan, Hong Kong and Singapore will keep growing smartly (if a bit slower than before). By the end of the decade, HK and Singapore will be richer than the US (on a per capita basis - some say Singapore already is), while Korea and Taiwan will be richer than Western Europe for the first time since at least the Middle Ages.
- Australia will also keep growing at a healthy clip, and will become richer than Canada.
- China's growth will slow. It will also still be among the fastest in the world. China's trade balance will narrow, the yuan will very slowly appreciate, and in 10 years, the phrase "Chinese consumers" will often be heard in Western newscasts.

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