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armageddon usa?america at the crossroads

Dr Tim Morgan Global Head of Research

strategy insights | issue eight

strategy insights | issue eight 3

america at the crossroads

contentsarmageddon usa? america at the crossroads 5

introduction: powers of darkness 7

part one: what is the American problem? 11

economicdata–pollyannacreep 13

whatgrowth,whatjobs? 18

“anotherdayolder,deeperindebt…..” 20

part two: why did this happen? 25

afailedparadigm 25

un-americanactivities:havecompetitorstrategiesunderminedtheUS? 26

domesticerrors–thefolliesofideologicalextremes 28

capitalsinkinvestment:bettingthehouse 28

part three: how should america respond? 33

armageddon usa?

armageddonusa? | america at the crossroads

strategy insights | issue eight4 strategy insights | issue eight4 1 http://www.globaltimes.cn/NEWS/tabid/99/ID/691074/Pentagon-plan-changes-game-in-Asia.aspx


“The US and China are carrying out competition unprecedented in history.

The US must realize that it cannot stop the rise of China”

The Global Times, 6th January 20121


america at the crossroads

CommentingonPresidentObama’snewdefencestrategy,theChinesenewspaperGlobal TimeslambastedthenewemphasisreportedlybeingplacedbytheUSonSouthEastAsia,andconcludedthatAmerica“cannotstoptheriseofChina”.

WhilsttheriseofChinamaybesubjecttocaveats,thedeclineoftheUSseemsundeniable.Accordingtoofficialfigures,Americaismiredindebtand,despitearecentmodestupturn,hereconomictrendgrowthislacklustre.Thereality,strippedofstatisticalobfuscation,isevenworsethanthis.Reportedfederaldebtexcludesenormousoff-balance-sheetquasi-debts.Thereporteddeficitexcludeshugeannualincrementstotheseobligations.Reportedgrossdomesticproduct(GDP)includes$2.3trillionofnon-cash“imputed”dollarsthatdonotreallyexist.Bothinflationandunemploymentareunderstatedintheofficialnumbers,andtherealitymaybethattheeconomyhasbeendriftingforadecade.

Whyhasthishappened?Theexplanationsarebothforeignanddomestic.Athome,America

iswrestlingwiththeendingofaquarter-century“creditsuper-cycle”.Americanshaveborrowed,notforproductiveinvestment,buttoinflatethevalueofthenation’shousingstock.Sincehousesarenon-earningcapitalsinks,thisprocesshasgravelyunderminedtheproductivenessoftheeconomy.CapitalhasbeenpouredintovanityprojectsandpropertypriceescalationwhilstAmerica’sdecayinginfrastructureneedsatleast$2trillioninrestorativeinvestment.WhereChina’sbrightestyoungpeoplestudyengineeringandtechnologybeforemovingintoindustry,America’sbrighteststudylawbeforemovingintoWallStreet.

Abroad,Americaisthenaïvevictimofblatantlyone-sidedglobalisationwhichdestroysAmericanjobswhilstrackingupeverhigherlevelsofprivateandgovernmentdebt.AmericahasboughtintotheRicardianlogicof“comparativeadvantage”withoutrealisingthatthismodelispredicatedonothersplayingbytherules,andonassumedscopeforinfinitegrowth.Today,neitherassumptionisvalid.

Inadditiontocuttingwaste,ditchingunaffordablefederalprogrammesandowningupaboutun-payablepensionandwelfarepromises,theUnitedStatesneedstotakeimmediateactionontwofronts.Athome,regulationneedstobetightenedtopreventthemispricingofriskwhichunderpinnedthesubprimedisaster.Abroad,Americaneedstogetreal,andgettough.TheUSneedstodemandthefreefloatoftherenminbi,theeliminationofalltariffandinformaltradebarriers,andthecessationofalltechnologyappropriation.Ifthesedemandsarenotmet,Washingtonshouldhavenocompunctionaboutthreateningselectivedefaultandtheintroductionofprotectivetariffs.ItishightimethattheUSwokeuptotherealitiesofaone-sidedglobalisationprocesswhichhasimpoverishedAmericaandhasresultedinthehaemorrhagingofAmericanjobs.

TheUnitedStatesremainstheworld’smostinnovativeeconomy,buttimeisrunningout.

armageddon usa?


strategy insights | issue eight62 Talking about the Federal deficit, December 2010.

http://www.bbc.co.uk/blogs/thereporters/markmardell/2010/12/simpson_slaps_washington_with.htmlstrategy insights | issue eight

“The heat is on you. Poised outside this chamber are the denizens of darkness.

Those are the groups waiting out there in the temples of this city, waiting to

shred this baby to bits.”Former Senator (R) Alan Simpson2


powers of darkness

strategy insights | issue eight 73 The American fiscal year ends on 30th September

CommentingonthenewdefencestrategyoutlinedonJanuary5thbyBarackObama,theChinesenewspaperGlobal TimeslambastedthenewemphasisreportedlybeingplacedbythePentagononSouthEastAsia.ThenewspaperarguedthatcompetitionbetweenChinaandAmericawasonascale“unprecedentedinhistory”.ItaddedthatChinashould“strengthenitslong-rangestrikecapabilitiesandputmoredeterrenceontheUS”.ThwartingUSpolicyonIranmightbeseenasavalidtactic,itsuggested,concludingthatAmerica“cannotstoptheriseofChina”.

TheriseofChinamaybesubjecttocaveats,butthedeclineoftheUnitedStatesseemsundeniable.Threequestionsneedtobeaddressed:

• WhatistheAmericanproblem?

• Whydidthishappen?

• HowcanAmericarespond?

FollowingthepublicationofthefinalreportofourProject ArmageddonanalysisoftheeconomicoutlookforBritain,itwassuggestedthatweshouldconductasimilarassessmentoftheUnitedStates.Bothcountries,itwaspointedout,arecaughtinthesamebasichigh-debt,low-growthtrap,andinneithercountryhasgovernmentproducedwhollycredibleanswerstothegravityofthenationaleconomicmalaise.

BritainandAmericahavebeendescribedas“twocountriesdividedbyacommonlanguage”,andthisisparticularlytruewheremetaphorsareconcerned.WhereanEnglishmanprocrastinatesby“knockingtheballintothelonggrass”,anAmerican“kicksthecandowntheroad”.

Theidiomsmaydiffer,butthemeaningscoincide.And,beitacricketballoracan,procrastinationispreciselywhatthegovernmentsofbothcountrieshavebeendoingabouttheirhugeeconomicchallenges.InBritain,2010’schangeofgovernmenthasbroughtatleastsomeresolvetotheissue,thoughtimealonewilltellwhetherthisresolvewillprevail.Bycontrast,Americanpolicymakersseemparalysed.

Thislackofactionisnotforwantofwarning.InDecember2010,formerSenator(R)AlanSimpson,co-chairman(withformerClintonchief-of-staffErskineBowles)ofthePresident’sbi-partisancommitteeonfiscalresponsibility,didnotmincehiswordswhenhewarnedthecommitteethattheFederaldeficitwasa“cadaver[that]willrisefromthecrypt”

“Thisisit”,continuedSen.Simpson.“Nomorefunandgames.Nomoresmokymirrors.They[theAmericanpeople]havewisedup.They’remad.They’retiredoftheblusterandtheblatherandtheegoandtheBSthat

hasworkedsowellforallofus,includingme,amasterofit.Soyes,timeshavechanged.”

Simpsonwaswarningthecommittee,inthestarkestpossibleterms,thatthefederaldeficitwhich,atanofficial$1.4trillion,equatedto8.9%ofAmerica’sreportedgrossdomesticproduct(GDP)infiscalyear(FY)20103,wasnolongersustainable.Needlesstosay,SimpsonandBowlesareright.And,equallyneedlesstosay,no-oneseemstobelisteningwithintheAmericancorridorsofpower.

Beyondpoliticalparalysis,oneofthereasonsforthefailuretoaddressAmerica’seconomicproblemsisalackofappreciationofquitehowbadthoseproblemsreallyare.Underaprocesswhichbeganintheearly1980s,reportingmethodologieshavebeenmassagedtothepointwherethetruescaleoftheeconomicmalaiseismaskedfrommostAmericans.Asthisreportexplains,debt,thedeficit,inflationandunemploymentareunderstated,whilstbothgrowthandabsoluteGDPareflattered,andnottoaminorbuttoafundamentaldegree.ThefirstimperativeforanyonewhowantsacomprehensiveunderstandingoftheUSeconomicandfiscalsituationistolookbehindthestatisticalcamouflage.

introduction


strategy insights | issue eight8 strategy insights | issue eight8

Evenonthereportedfigures,thesituationisbadenough.Critically,theUSisattheendofaquarter-century“creditsuper-cycle”whichhasseenaggregatedebtsoarto358%ofGDP,alevelwhichisunprecedentedinmoderntimes.Overthelastdecade,theUShasadded$5.58ofdebtforeach$1ofexpansioninGDP.Tobesure,theUS–unlikemostotherOECDcountries–hasmadesomeverymodestinroadsintothisdebtratio,butthereductionachievedthusfarmakesnosignificantdifferencetotheoverallposition.

TheUS,then,isstuckinahigh-debt,low-growtheconomictrap.Howdidthishappen?Inpart,America’swoesreflectanaïveapproachtoglobalisation.The‘comparativeadvantage’paradigmwhichunderpinseconomicopennessassumes,first,thatothersplaybytherules,and,second,thatthescopeforexpansionislimitless,suchthatthegrowthofonecountryneednotbeattheexpenseofanother.Neither assumption is true.Chinaandothershavenotplayedbytherules–afterall,internationalcompetitionisnotaparlourgame–andresourceconstraintsarenowdemonstratingthatthescopeforglobaleconomicgrowthisnotinfinite.

ButAmerica’swoescannotbeblamedwholly,orevenprimarily,onothers.TheregulatoryclimateintheUSseems,withhindsight,tohavebeenundulyrelaxedduringthelatterstagesofthecreditsuper-cycle.TheauthoritiesignoredthestarkestpossiblewarningsinsupinelyallowingtheproliferationofinstrumentswhichnolessaluminarythanWarrenBuffetthadlongwarnedwere“weaponsoffinancialmassdestruction”.TheFederalReserve’sdefaultassumption,whichwasthatregulationcanbeminimisedbecausebankscanbetrustedtoactresponsiblyinthelong-terminterestsoftheirshareholders,wasbreathtakinglynaïve.AllofthiswascompoundedbyallowinglowinterestratestodriveAmericaintoadownwardsmonetaryratchet.

Thisreportiswrittenfromapro-marketperspective,butwecannotbutconcludethatanexcessiverelianceoninadequately-regulatedmarketshascompoundedmanyotheradversetrendsintheAmericaneconomy.Thebuild-upofdebthasreflectedagrowingconsumptionrecklessnesswhichtheauthoritieshavedonenothingtocounter.Investmenthasbeendivertedintocapitalsinks,

mostnotablyproperty,whilstvanityprojectshavechannelledfurthercapitalawayfromvitalinfrastructurereconstruction.America’seducationsystemproducesfartoomanylawyersandfartoofewengineers,whilstthecreamofthecountry’syoungpeoplehavebeendrawnintoWallStreetandthelawratherthanintomoreeconomically-productivesectors.

PoliticianshaveallowedAmerica’sonce-famedcapabilitiesinR&Dtobeundermined,andhavestoodbyandwatchedmuchofthenation’sknowledgecapitalbeingeitherappropriatedbyothercountriesor,worsestill,handedtothemonaplateinpursuitofnarrowshort-termgain.MuchofAmericanindustry(exemplifiedbytheauto-makers)hasfollowedblindalleys.

And,whilstallofthishasbeenhappening,America’spoliticalleadershavedone……well,nothingconstructiveaboutit.GeorgeW.Bushsomehowmanagedtobelievethathecouldcombinetwohugelycostly(and,webelieve,mistaken)warswithtax-cutsfortheveryrichwhilstnotcreatingafiscaldeficit.Healsopresidedoverthebuild-upoftheshadowbanking

strategy insights | issue eight8

strategy insights | issue eight 9strategy insights | issue eight 94 The Tennessee Valley Authority strategy insights | issue eight 9

systemandthenear-fatalunderminingofthecapitalmarkets,tothepointwhereCongresshadtobearm-twistedintohandingover$700bnoftaxpayers’moneytobailoutthebankingsystem.ItistooearlytojudgetheObamapresidency,buttheeconomyisflat-lininganddebtcontinuestoescalate,whilstgrid-locksinCongressdonotencourageustobelievethatresoluteandeffectiveactionwillbetaken.

Whatshouldthatactionbe?Firstandforemost,thejobofleadersistolead.Thegreatestsinglerequirementnowisforhonesty.ManyofAmerica’sfiscalpromises,suchasthoseonpensionsandwelfare,areun-payable–certainlywithoutmassivetaxincreases–anditisabouttimethatsomeoneadmittedit.Thecurrentfiscaldeficitiswhollyunsustainable,whichprobablymeansthatbothspendingcutsandtaxincreasesareinevitableifdisasteristobeaverted.Thewidespreaddislikeofgovernment,whilstunderstandable,ratheroverlooksaprettycreditablehistoricrecordonnationally-ledprojects,fromtheTVA4tovictoryintheSecondWorldWarandtheApolloprogramme.Thereisanurgentneedtochannelinvestmentintoessentialinfrastructureand

awayfromcapital-sinksandvanityprojects.Thereneedstobetougherregulationofthefinancialmarkets,includingderivatives.

Abroad,America needs to toughen up,mostnotablywithregardtoChina.Americaisentitledtomakealengthylistofdemandsand,forthetimebeing,remainsstrongenoughtobacktheseup.Americashouldrequireafreefloatfortherenminbi,theremovalofalltariffandotherimportbarriers,andanimmediateandcompletecessationofalltechnologyappropriation.

TheUShastwobigstickswhichitcanthreatentowield.SelectivedefaultcouldhitChinawhereithurts.China’semployment-drivenpursuitofvolumemaximisationoverprofitiscriticallydependentonfreeaccesstoAmerican(andotherWestern)consumermarkets.ProtectionismcoulddealChina’sleadersadevastatingblow,andAmericashouldnotbeafraidtousethisasathreatinthenationalinterest.SinceglobalisationhasinanycaseworkedtothedetrimentofmiddleAmerica,theUSshouldhavenocompunctionwhatsoeveraboutwavingaverybigstickinpursuitofafairerdeal.Forsolongasthisisnot

done,Americawillwatchhereconomicpowerdrainaway.

HastheUStheleadership,atalllevels–federal,congressional,localandcorporate–toturnaroundatrulydireeconomicsituation?Itcanonlybehopedthatithas,becausethealternativeisfrightening.

Dr Tim MorganGlobalHeadofResearchTullettPrebonplc

strategy insights | issue eight10 5 “Numbers Racket”, Harper’s Magazine v.316, n.1896 1st May 2008


“Who profits from a low-growth U.S. economy hidden under statistical camouflage[?] Might it be Washington politicos and affluent elites,

anxious to mislead voters, coddle the financial markets, and tamp down expensive cost-of-

living increases for wages and pensions?”Kevin Phillips5


what is the American problem?

Oneofthecentralchallengesidentifiedinthisreportisthatthe United States has been accumulating debts at a rate which now threatens to overwhelm the carrying capacity of the American economy.Atalllevels–federalandlocalgovernment,corporationsandindividuals–debthasbeenaddedatrateswhichhavefarexceededexpansionineconomicoutput.Goingforward,thefundamentalproblemlieslessintheabsolutelevelofindebtedness,frighteningthoughitis,thanintheweaknessesofaneconomywhichlooksincapableofgeneratingrobustgrowth.

Thoughthemarketstendtofocusonfederal(public)indebtedness,therealproblemisverymuchdeeperthanthis.Overthelasttenyears,whilstfederaldebthasincreasedby$6.7trillionotherformsofAmericanindebtednesshaverisenbyanaggregateof$17.8trillion,liftingtheoveralltotalfrom$29trillionto$54trillion(seefig.1).

Withinthetotalincreaseindebtoverthatten-yearperiod,thefederalgovernmenthasaccountedfor27%,andstateandlocalgovernmentforafurther7%.Almosttwo-thirdsoftheincreaseinAmericanindebtedness

hasbeenaccountedforbybanks,bybusinessesandbyindividuals.Americandebtisnot,then,apurelygovernmentphenomenon.BorrowinghasbecomethenewAmericanwayoflife.

Noparticularlevelofdebtis,initself,‘abadthing’.Borrowingcanbeacost-effectivesourceofproductiveinvestment,andaffordablegrowthinprivatedebtcanbeeconomicallybeneficial.ButtheescalationinUSborrowingshasfarexceededthesesafeparameters.

part one

Fig. 1: Deep in the hole – the escalation of American debt*

$bn 2001 2011** vs 2001

Federal $3,380 $10,123 +$6,744

State & local $1,303 $3,014 +$1,711

Corporate $6,963 $11,499 +$4,536

Mortgages $5,306 $9,875 +$4,570

Other individual $2,346 $3,333 +$986

Banking & other $10,021 $16,013 +$5,991

Total debt $29,319 $53,857 +$24,538

Memo:

GDP $10,642 $15,065 +$4,423

Debt/GDP 275% 358%

*Sources:FederalReserveBoard,Dataexcludesquasi-debtobligations

**3Q2011



Asfig.2shows,totalUSdebthasexpandedmuchmorerapidlythanGDP,suchthatcurrentdebt(of$53.9trillion)equatestoalmost360%ofGDP($15trillion).Justasimportantly,itisclearthatadecisivenewtrendemergedfromtheearly1980s(fig.3).Between1945and1980,theratioofdebttoGDPwasremarkablyconsistent,rangingbetween130%and170%.Thereafter,however,thedebtratiotookoff,reaching200%ofGDPin1985,250%in1996and300%in2003.Thecurrent(358%)debt-to-GDPratioisunprecedented,exceedingeventhelevelsreachedintheGreatDepression

(whentheratiowasdrivenupwardsnotbydebtescalationbutbydeflationandbyaslumpineconomicoutput).

Webelievethatthe period since the early 1980s–inotherWesterncountriesaswellasintheUS–represents a “credit super-cycle”,anoverallpatternwhichlurksbehind,andinforms,successivebubblesinassetclassesrangingfromequitiesandrealestatetocommodities.ThedrivinglogicoftheUSeconomyseemstohaveswitchedfrommoderationandbalancetoexcessivedebt-fuelledconsumption.LikemanyotherWesterneconomies,

theUShasnowreachedthepointatwhichfurtherdebtescalationhasbecomeimpossibletosustain.But no-one seems to have worked out how to manage an economy that is not debt-propelled.

Thesnagswithsoaringdebtarethree-fold,andAmericahasallthreekindsofproblem.First,debtcanbeaproblemifitout-growstheabilityoftheborrower’sincometosustainit.ThishascertainlybeenthecaseintheUS.Overthesameten-yearperiodinwhichdebtgrewby$24.5trillion,nominalGDPincreasedby$4.4trillion.


Figs. 2 and 3: America and the credit super-cycle*

*Sourcesofdata:BureauofEconomicAnalysisandFederalReserveBoard

US debt and GDP

$52.6

$14.7

$0

$10

$20

$30

$40

$50

$60

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

US total debt US GDP

$ trn

Total debt as % US GDP358%

0%

100%

200%

300%

400%

1945

1950

1955

1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

strategy insights | issue eight 13strategy insights | issue eight 136 Source: Federal Reserve Flow of Funds z1 report, 2nd quarter 2011

The last decade, then, has seen $5.55 of debt taken on for every $1 increase in economic output.Asaresult,totaldebthasrisenfrom275%ofGDPin2001to358%today.

Thesecondwayinwhichdebtescalationcanbedamagingisiftheextentofleverageisdisguisedinthebalancesheetoftheborrower.This,too,hasbeenthecaseintheUnitedStates.Theofficialnumberforfederaldebtexcludeshugeoff-balance-sheet‘quasi-debts’suchascommitmentstofutureemployeepensionsandtopublicbenefitssuchashealthandsocialsecurity.Corporations,too,arecommittedtoenormous,unfundedforwardemployeewelfarecommitments.

Thethirdwayinwhichdebtcanposeaproblemisiftheproceedsareinvestedinunproductiveways.Thejargonheredividesborrowingsinto‘self-liquidating’and‘non-self-liquidating’debt.Borrowingtoexpandasuccessfulbusinessisanexample,attheindividuallevel,of‘self-liquidating’debt,whichcanbepaidoffusingincomefromtheexpandedenterprise.Borrowingtopayforanewcaroraholiday,ontheotherhand,areexamplesof‘non-self-liquidating’debt,becausethesedonotaddtothefutureincomeoftheborrower.

America’sborrowingshave,overwhelmingly,fallenintotheunproductive,‘non-self-liquidating’category.LittleofAmerica’shugeborrowinghasgoneintoinfrastructureimprovementorinvestmentinproductivecapacity.Governmenthasborrowedforpurposeswhichhaveincludedfightingwarsandhandingtaxcutstotheveryrich.Individualshaveborrowedforperhapsthemostfutilepurposeofall,whichistoinflatethevaluesofexisting,unproductiveassets,inthisinstanceAmerica’shousingstock.

Atthesametime,America’seconomyhaslanguished,growingatfarlowerratesthanthoseatwhichdebthasexpanded.TheUSeconomyisnowdoinglittlebetterthanflat-lining,anditistheprospectofsluggishgrowthwhichthreatenstocrystaliseexcessiveindebtednessfromatheoreticalintoadangerouslypressingproblem.

Almostallmacroeconomiclevershavebeentried,andhavefailed.Giventhehighlevelsofexistingdebt,Washingtonhasnorealisticscopeforfiscalstimulus.Interestrateshavebeenkeptatminimallevelssince2008,negatinganyfurtherabilitytoinjectconventionalmonetarystimulus.That“quantitativeeasing”(QE),whichisthecontemporaryeuphemismfortheprintingofmoney,hasnowbeentried

notoncebuttwiceisanindicationofthedesperatestraitsinwhichpolicymakersnowfindthemselves.

Oneoftheside-effectsofthecreditsuper-cyclehasbeenthecreationofa ‘monetary ratchet’ which has now reached end-game.Themonetaryratchetprocessissimpleinprinciple–ratesarekepttoolow,adebt-drivenbubbleensues,thebubblecollapses,andratesarecutagaintoshoreuptheeconomy.Whilsttheratchetprocessiscapableofstraightforwarddescription,whatno-oneseemstoknowiswhathappenswhentheprocessreachesitszero-ratetermination,whichiswheretheUS(andmostoftherestoftheOECD)havenowarrived.

economic data – pollyanna creep

Takenatfacevalue,then,America’seconomicandfiscalproblemslookprettybad.Federaldebtowedtothepublicstandsat$10.1trillion,or67%ofreportedGDP.Statesandlocalgovernmentsoweafurther$3trillion(20%),andhouseholds$13.2trillion(88%)withintotalcreditmarketdebtwhichstandsat$53.8trillion,or358%ofGDP6.Unemploymentisstubbornlyhigh,atareported8.5%oftheworkforce.Controversially,ratingsagencyStandard&PoorslastyearstrippedtheUnitedStatesofitsAAAcreditrating.Aftersomeunedifying

strategy insights | issue eight 15strategy insights | issue eight 157 See “Numbers Racket”, Kevin Phillips, op cit.

brinkmanshipbetweentheWhiteHouseandCongress,thefederaldebtceilingwasliftedjustintimetostopgovernmentgrindingtoahalt,butno-onehascomeupwithareallyconvincingplanforcurbingthedeficitorstimulatinggrowth.

IfthiswasatruedescriptionofthesituationinwhichAmericafindsherself,itwouldbebadenough.Buttherealityisevenworse,becausethedataonwhichthisgenerally-believedsnapshotisbasedareveryfarfromreliable.Aprocessofincrementalobfuscation,stretchingoverdecades,hasmadeofficialeconomicdataextremelyunrealistic.

WeshouldbeclearthatthedebauchingofUSofficialdatadidnotresultfromanygrandconspiracytomisleadtheAmericanpeople.Rather,ithasbeenanincrementalprocesswhichhastakenplaceovermorethanfourdecades.ItalsoseemstohavehappenedinotherWesterncountries,thoughonlyintheUSistheunderlyingdatasufficientlytransparentfortheeffectstobequantified.

Intheearly1960s,JFKtamperedwithunemploymentnumberstoexclude“discouragedworkers”.TheJohnsonadministrationintroducedthe“unifiedbudget”,whichincorporatedwhat

wasthenabigSocialSecuritysurplustohidepartoftheunderlyingfederalover-spend.RichardNixontried,withonlylimitedsuccess,topeddletheconceptof“coreinflation”,aninflationarymeasurewhichexcludedenergyandfood(theveryitemswhosepriceswererisingmoststronglyatthattime).

“Owner-equivalentrent”,aconcepttobeexplainedlater,wasintroducedunderRonaldReagan.ConvolutedchangestothemeasurementofCPIinflation,recommendedbytheBoskinCommission,weredraftedunderGeorgeH.W.BushbutimplementedbytheClintonadministration(and,asrespectedstrategistKevinPhillipshasremarked7,thereisacertainironytotheintroductionof“hedonicadjustment”bytheOvalOffice’sultimatehedonist).Afurtherfourmillionout-of-workAmericansdroppedoutoftheunemploymenttotalsunderaredefinitionof“discouragedworkers”introducedin1994.

Thoughstatisticalmanipulationhasbeengradual,ithasreachedthepointatwhichmostofficialeconomicdataisnowverymisleading.TheanalystwhowishestounderstandwhatisreallygoingoninAmericaneedstounwindthesedistortions.Theresultsaredisturbing.

Let’sstartwithgross domestic product,thenumberusuallyacceptedasdefiningtheoutputoftheeconomy.In2010,theGDPoftheUnitedStateswasreportedat$14.53trillion,afigurewhichmostAmericansprobablyassumeconsistsentirelyof‘real’dollarswhichcanbecounted.This,infact,isveryfarfrombeingthecase,becausecloseto16%ofthereportednumberconsistsof“imputations”.Theseimputationsaredollarswhichdonotreallyexist.Strippedofthem,GDPtotalled$12.3trillionin2010,whichautomaticallymeansthatalldebtratiosareevenworsethantheylook.

Themostimportantoftheseimputationsaresummarisedinfig.4.Thelargestsinglesuchimputation–worthover$1.2trillionin2010–concerns“owner-equivalentrent”.Ifapersonownshisorherhomeoutright,nomortgageorrentispayable,andnomoneychangeshandsinrespectoftheproperty.ButthereportingmethodologyforAmericanGDPassumesthatsuchapropertyhasautilitywhichapurelycash-basedmeasurefailstocapture.Therefore,GDPcontainsasumrepresentingtherentwhichtheownerwouldhavepaid(presumablytohimself)ifhehadnotownedtheproperty.Interestexpenseisbackedout,butthenetresultremainsamajor(andnon-cash)uplifttoGDP.



Thereplacementofactualexpenditurewithanotional(‘imputed’)rentappliesnotjusttothatminorityofAmericanswhoowntheirhomesoutright,butalsotothemanymillionswithmortgages.Forexample,apersonwith50%equityinhishomeisassumedtopayrenton100%ofitratherthan,asisactuallythecase,mortgageinterestonhalfofit.

Thesecond-largestimputationconcernsemployeebenefits(principallymedicalinsurance,butalsoitemssuchasmealsandaccommodation)whichareprovidedtoworkerseitherfreelyoronasubsidisedbasis.Asumof$594billionwasimputedinthiscategoryin

2010.Financialservices(forexample,checkingaccounts)whichareprovidedfreeofchargebybanksaretreatedsimilarly.Here,the2010imputation(of$501billion)reflectswhatthecosttothecustomerwouldhavebeenifthebankhadchargedhimorherforserviceswhich,inreality,wereprovidedfree.

Thereisalegitimatedebateaboutthe‘productionboundary’,whichreferstotheinclusion,orotherwise,ofservicesprovidedfreeofcharge,agoodexamplebeingcareprovidedtochildren,totheelderlyandtotheinfirmbyfamilymembers.Butthesheerscaleatwhich“imputations”arenowusedinthecompilationofAmericanGDP

surelyintroducesgravedistortionsintothegenerally-acceptednumberforUSeconomicoutput.Moreover,non-existent(imputed)dollarsobviouslycannotbetaxed,whichmeansthatimputationsmaketheAmericanincidenceoftaxationlookagreatdealsmallerthanitreallyis.

Seriousthoughitis,theimputationsdistortionofGDPisaprettyminormattercomparedtothedebauchingof inflationdataoverthelastthreedecades.Imputations,usedtoincreasereportedeconomicoutput,alsohaveasignificantimpactonreportedinflation,becausetheyedgeoutrealratesofincreaseinthecostofhousing.

Fig. 4: GDP – the impact of imputations*

$bn 2005 2006 2007 2008 2009 2010

Reported GDP $12,623 $13,377 $14,029 $14,292 $13,939 $14,527

Including imputations of:

Imputed rental income $1,057 $1,125 $1,153 $1,191 $1,213 $1,215

Employment-related imputations $529 $543 $565 $581 $593 $594

Financial services not charged $371 $391 $426 $451 $443 $501

Other imputations, net ($69) ($78) ($50) $9 ($2) ($32)

Total imputations $1,888 $1,980 $2,093 $2,231 $2,246 $2,277

GDP excluding imputations $10,735 $11,397 $11,935 $12,061 $11,693 $12,249

Imputations as % GDP 15.0% 14.8% 14.9% 15.6% 16.1% 15.7%

*Source:BureauofEconomicAnalysis

Thebiggestsingledistortionofofficialinflationdataresultsfromtheapplicationof“hedonicadjustment”.Theaimofhedonicadjustmentistocaptureimprovementsinproductquality.Theintroductionof,say,abetterqualityscreenmightleadtheBureauofLaborStatistics(BLS)todeemthepriceofatelevisiontohavefalleneventhoughthepriceticketinthestorehasremainedthesame,orhasrisen.Theimprovementinthequalityoftheproductisequivalent,BLSstatisticiansargue,toareductioninprice,becausethecustomerisgettingmoreforhismoney.

Oneproblemwithhedonicadjustmentisthatitbreaksthelinkbetweeninflationindicesandtheactual(in-the-store)pricesofthemeasuredgoods.Anotheristhathedonicadjustmentissubjective,andseemstoincorporateonlyimprovementsinproductquality,notoffsettingdeteriorations.Anewtelephonemight,forexample,offerimprovedfunctionality(ahedonicpositive),butitmightalsohaveashorterlife(ahedonicnegative)and,criticsallege,theofficialstatisticiansarealltoolikelytoincorporatetheformerwhilstignoringthelatter.

Thefailuretoincorporatehedonicnegativesisparticularlypertinentwherehome-producedgoodsare

replacedbyimports,aprocesswhichhasbeenongoingfortwodecades.AnimportedairbrushmightbeagreatdealcheaperthanonemadeinAmericabut,iftheimporteditemisoflowerquality,isthisfactoredintotheequation?

Asecondareaofadjustmenttoinflationconcerns‘substitution’.Ifthepriceofsteakrisesappreciably,‘substitution’assumesthatthecustomerwillpurchase,say,chickeninstead.Aswithimputations,theuseofsubstitutionbreaksthelinkwithactualprices(aprocessexacerbatedby‘geometricweighting’),butitalsoturnstheindexfromacalibrationofthecostoflivingtoameasurementofthepriceofsurvival.

Sincetheprocessofadjustmentbeganintheearly1980s,theofficially-reportedCPI-Unumberhasdivergedeverfurtherfromtheunderlyingfigurecalculatedonthetraditionalmethodology.Someofthosewhohaveresearchedtheissuesofhedonicadjustment,geometricweightingandsubstitutionreckonthatthesemethodologiesnowstripoutatleastsixpercentagepointsfrominflationcalculatedonthetraditionalbasis.Onthisbasis,trueinflationmightbeatleast9%,ratherthanthe3.4%reportedinDecember.

Ifcriticsareright–andweareconvincedthattheyare–thentheimplicationsareenormous,becauseinflationcalculationsreachintoeveryaspectofeconomiclife.Thesignificanceofdistortedinflationreportinghasimpactson:

• Americans’costofliving,andthepurchasingpowerofthedollarovertime.

• Wageratesandsettlements.

• Benefitlevels,andthecostofsocialpaymentstogovernment.

• Economicgrowth.

• Realinterestrates.

Accordingtoofficialfigures,aggregateinflationbetween2001and2011was27%,meaningthatthedollarlost21%ofitspurchasingpoweroverthatperiod.But,ifweacceptthatrealinflationmayhaveexceededtheofficialnumberby6%ineachofthoseyears,thelossofdollarpurchasingpowerwasabout55%between2001and2011.Betweenthethirdquartersof2001and2011,averageweeklywagesincreasedby31%,fineifthedollarlost21%ofitspurchasingpoweroverthatperiodbutevidenceofverysevereimpoverishmentifthedollarin2011wasworthonly45%ofits2001



value.Inshort,if millions of Americans feel poorer now than they did ten years ago, the probable explanation for this is that they are.

Bythesametoken,thoseAmericansinreceiptofindex-relatedpensionsandbenefits,too,haveseentherealvalueoftheirincomesdeclineasaresultofthesevere(andcumulative)understatementofinflation.Thisprocess,ofcourse,hassavedthegovernmentvastsumsinbenefitpayments.RebasingpaymentsfortheunderstatementofinflationsuggeststhattheSocialSecuritysystemalonewouldhaveimplodedmanyyearsagohadpaymentsmatchedunderlyingratherthanreportedinflation.

Inotherwords, the use of ‘real’ inflation data would have overwhelmed the federal budget completely.

Anotherimplicationofdistortedinflation,animplicationthatmayhaveplayedahugelyimportantroleinthecreationofAmerica’sdebtbubble,isthatreal interest rates may have been negative ever since the mid-1990s.Taking2007asanexample,averagenominalbondrates8of4.6%equatedtoarealrateof1.8%afterthedeductionofofficialCPI-Uinflation(2.9%),butwereheavily(4.2%)negative

inrealtermsifadjustmentismadeonthebasisof+6%-underlyinginflation(of8.9%)instead.

Logically,itmakesperfectsensetoborrowifthecostofborrowingislowerthantherateofinflation.WhilstmostAmericansmaynothavebeenawareofthewayinwhichinflationnumbershadbeensubjectedtoincrementaldistortion,theireverydayexperiencemayverywellhaveledthemtoactonagutinstinctthatborrowingwascheap.

Webelievethatmisreportedinflation,togetherwithirresponsibleinterestratepoliciesandwoefullylaxregulation,mayhavebeenamajorcontributortotherecklesswaveofborrowingwhichsodistortedtheUSeconomyinthedecadepriortothefinancialcrisis.Indeed,understated inflation may have been the smoking gun where the flood of cheap money was concerned.

what growth, what jobs?

Understatedinflation,then,hasdepressedwagegrowth,impoverishedthoseinreceiptofbenefits,maskedthedeclineinthepurchasingpowerofthedollar,andveryprobablycontributedtoarecklessmonetarypolicywhichhasmiredtheUnitedStatesinexcessive

debt.Butitmayalsohaveresultedineconomicgrowthbeingreportedwhen,inreality,theAmericaneconomyhasreallybeenshrinking,notgrowing.

Accordingtoofficialfigures,theGDPoftheUnitedStatesincreasedby18%,inrealterms,between2001and2011.Butsuchnumbers,ofcourse,areafunctionoftwocalculationswhich,aswehaveseen,arenotinthemselvesreliable.First,thereportedGDPnumber(of$14.5trillionin2010)ishighlyquestionable,becauseitincludesnon-cash“imputations”totalling$2.3trillion.Second,andmuchmoreseriously,sincethewayinwhichofficialinflationiscalculatedisopentoveryseriousquestion,so,too,istheGDPdeflator,theadjustmentwhichisemployedtobackouttheeffectsofinflationfromchangesinthenominalmonetaryvalueofeconomicoutput.Ritualclaimsthatthedeflatorisworkedoutbycomparingsimplechainedvolumetric(thatis,non-monetary)measurementofGDPshouldnotbetakentooseriously,becausetherealityisthatitisimpossibleentirelytode-linktheGDPdeflatorfromothermeasuresofinflation.

strategy insights | issue eight18 strategy insights | issue eight188 Annual average interest rate for 10-year Treasuries. Source:

Economic Report of the President, 2011 datasets

Onceadjustmentismadeforthedistortionofinflation,theevolutionofAmericanrealGDPoverthelastdecadepresentsagravelydisturbingpicture.Adjustingreportedgrowthdownwardstoreflecttheunderstatementofinflationsuggeststhatthe United States has been in almost permanent recession for ten years,withrealGDPfallingyearafteryear,anddecliningverymateriallysince2001.

Thispictureofeconomicdeteriorationisreflectedintheunemploymentstatisticsor,rather,itwouldbe,ifthesewerenotsoheavilymassagedbyreportingmethodologies.Theofficial(U-3)number,currently8.4%,excludesthemillionsofunemployedAmericanswhoaredefinedas“discouragedworkers”.

Ifthesepeoplewereincluded,togetherwithother“marginallyattached”workers,andthosewhoareinpart-timeworkbecausetheycannotfindfull-timeemployment,the BLS itselfconcedes(onitsbroaderU-6measure)thattheunemploymentratewouldbeover15%.Analystswhohaveunpickedallofthevariousmethodologicalchanges(includingalterationstosamplingtechniques)arguethattherealrateofunemploymentisevenhigher.

strategy insights | issue eight 19strategy insights | issue eight 19


Inthefaceofpersistentlyhighlevelsofunemployment(evenonthebasisoftheunderstatedU-3definition),Americanshavebeenaskedtobelieveintheconceptof“joblessgrowth”asawayofreconcilingweakjobdataontheonehandwithreportedgrowthinGDPontheother.Therealexplanationissimpler.Itisthatmost of the economic growth of the last decade has been illusory.

Theexplanationsfornegativegrowth,combinedwithhighunemployment,arenotparticularlydifficulttoascertain.First,America’sacceptanceofone-sidedglobalisationhasseenAmericanjobstransferredtolower-costlabourpoolsintheemergingeconomies,apointsoobviousthatitisremarkablethatanyoneeventriestodenyit.

Second,relatedstructuralchangehasseentheincreasingdisplacementoflabour-intensiveindustries(suchasmanufacturing)withactivitieswhich,intrinsically,haveverylowlabourintensity.

“another day older, deeper in debt…..”

ThestatisticalmanipulationwhichhasdistortedGDP,growth,inflationandunemploymenthasimplications,too,forfederaldebtandthedeficit,



bothofwhicharemuchworsethantheyatfirstsightappear.ThemainreasonforthisisthattheAmericangovernmenthastakenonhugequasi-debtcommitments,mostofwhichareexcludedfromthefederalbalancesheet(thoughitistothecreditoftheUSthattransparencyoverthisissueisfarbetterthanitisinBritain,letaloneintheEurozone).

AttheendofFY(fiscalyear)2010,officialstatisticsshoweddebt“owedtothepublic”–thatis,excludingdebtheldbyotherdepartmentsofgovernment–at$9,060bn,afigurewhichinitselfrevealsahugeincreaseoverfouryears,sincetheequivalentfigurewas$4,868bnattheendofFY2006.FederalReservedatashowsthatdebtowedtothepublichasrisenstillfurther,nowexceeding$10trillion.Butthereportednumbersexcludetwoverymateriallinesofquasi-debt.Thefirstofthese,includedintheofficialbalancesheet,isa$5,720bncommitmenttopaypensionstogovernmentemployees.Thesecondisa$4,577bnpooloffederaldebtowedtootherpartsofgovernment.

ThesignificanceofthelatternumberisthatitformstheprincipalassetoftheSocialSecurityandMedicaresystems,bothofwhichhaveliabilities

whichfarexceedtheiraccumulatedassets.AttheendofFY2009,netliabilitieswerestatedat$52.2trillioninrespectofclosedsystemclaimants,afigurewhichisoffsetby$6.3trillionwhich,itisassumed,willbethenetpositivecontributionoffutureschemeparticipants.Withinthe$52.2trillionFY2009figure,$33.5trillionwasattributabletoMedicareand$18.6trilliontoOASDI(oldage,survivorsanddisabilityinsurance),withthebalancerelatingtorailroadpensions($140bn)andblacklungprovisions($6bn).

DuringFY2010,theoutstandingMedicarecommitmentwasreducedbyabout$15trillion,reflectingtheassumptionthattheObamahealthcarepackagewillresultinaverymaterialreductioninfutureclaimsonMedicare.Whilstthisistrue,itissomewhatdisingenuous,inthatthefundingforhealthcarewillstillneedtobesourcedfromtaxpayers,suchthatthefuturefinancialobligationhasbeenshiftedfurtheroff-balance-sheet,noteliminatedaltogether.

What,then,isthetrueleveloffederalgovernmentdebtandquasi-debt?Inclusionoftheentireoff-balance-sheetliabilitiesassociatedwithOASDIandMedicarewouldbeexcessive,becausethesesumsarecalculatedon

thebasisofliabilitiesstretchingout75yearsintothefuture.Fewgovernments(orotherinstitutions)measuretheircommitmentsthatfarahead.

Ifweapplystandardnetpresentvalue(NPV)techniquestotheofficialnetliabilitiesforFY2009butlimitthecaptureto30ratherthan75years,thequasi-debttotalforclosedschemeparticipantsdeclinesfromthereported$52trillionto$41trillion.Thisnumberfallsfurther,to$34trillion,basedontheFY2010computationinwhichtheObamahealthcaresystemisassumedtoeliminatemajorforwardMedicareliabilities.Thisnumber,ofcourse,isnetoftheassetsheldbyOASDIandMedicare,comprisingfederaldebtof$4.6trillionwhichOASDI,atleast,islikelytostartdrawinguponinthenearfuture(someestimatessuggestassoonasFY2013).Italsoexcludesforwardpensionandwelfarecommitmentstofederalemployees.

Takeninaggregate,then,federaldebtandquasi-debtcanbeputrealisticallyat$53.3trillion,comprisingdebtowedtothepublic($9.1trillion),debtheldbyothergovernmentagencies($4.6trillion),pensioncommitmentstoemployees($5.7trillion)andthe30-yearportionofnetquasi-debtcommitments($34trillion)9.


9 The detailed numbers are: • debt owed to the public: $9,060bn • debt held by other government agencies: $4,577bn • pension commitments to employees: $5,720bn • 30-year portion of net quasi-debt commitments: $33,977bn Total: $53,334bn


Basedontheofficialnumberfor2010economicoutput($14.5trillion),thisestimateoffederaldebtandquasi-debtequatesto367%ofGDP.Ifwestripoutthenon-cash“imputations”componentofGDP($2.3trillion),thefederaldebtandquasi-debtratiorisesto435%.Bothnumbersexcludeprivate,corporate,bankandstatedebt,whichtotaleither300%ofGDPor356%,dependinguponwhethertheimputedcomponentofGDPisleftinorexcluded.

Weshouldbeclearthatoff-balance-sheetliabilitiesarenotthesamethingasdebts.Congresscouldeliminatefutureliabilitiesbyasimplelegislativeinitiative.ButisCongresslikelyatanypointtoadmitthatfuturebenefitspromisedtothepubliccannotbepaid?Wedonotenvisagethatthiswillhappenanytimesoon.

Justasanassessmentoffederaloff-balance-sheetcommitmentsproducesdebtratioslargeenoughtoscaresmallmonkeys,muchthesamecanbesaidofthefederaldeficit.Thisnumberwasreportedat$1.29trillioninFY2010,equivalentto8.9%ofofficialGDP.

Butannualincreasesinquasi-debtcommitmentsarerunningatanunderlyingrateofabout$2.1trillion,meaningthattherealdeficitisarguably$3.4trillion,equivalentto23%ofofficialGDP,or28%ifimputationsareexcludedfromtheGDPdenominator.

Anunderlyingfederaldebtandquasi-debttotalofsome$53trillion,ontopofprivate,bank,stateandlocalgovernmentdebtof$44trillion,couldbeusedbyAmerica’scriticstodemonstratethattheUnitedStatesisbankrupt.Anysuchinference,ifnotfundamentallymistaken,mostcertainlywouldbepremature.Americamaybetechnicallyinsolvent(inthesensethathercollectiveliabilitiesfarexceedanyremotelyrealisticcalculationofthenetpresentequivalentoffutureincomestreams),butsheisnotilliquid.ThebulkofAmerica’sobligationsarequasi-debtsowedtotheAmericanpeople,whichessentiallymeansthatforwardwelfareandpensioncommitmentscannotbehonoured(thoughfew

politiciansarelikelytoadmitthis).Inthenearer-term,theblue-chipratingofAmericangovernmentpaper,reinforcedbythereservestatusoftheUSdollar,meansthatWashingtoncancontinuetolivebeyondAmerica’smeansforsomeyearsyet.

TherearethreechinksinAmerica’sarmourwhichinvestorsneedtowatch.Thefirstoftheseisthefederalcreditrating,whichlastyear(andcontroversially,thoughsurelyrealistically)wasdowngradedfromtriple-AbyS&P.Thesecondisthereservestatusofthedollarwhich,again,isbeginningtolookincreasinglyanomalous.Butthethird–andbyfarthemostworrying–dimensionofAmerica’sparlousfiscalandeconomicstateistheseverityofeconomicunderperformance.

Accordingly,asweturntoanassessmentofquitehowAmericagotintohercurrentparlouscondition,theprimaryfocusmustbeonthecausesofthefundamentalweakeningoftheUSeconomy.



strategy insights | issue eight24 10 Bloomberg, June 16, 2010

“We live in an economy that rewards someone who saves the lives of others on a battlefield with

a medal, rewards a great teacher with thank-you notes from parents, but rewards those who can

detect the mispricing of securities with sums reaching into the billions”.

Warren Buffett10



why did this happen?

Aswehaveseen,then,theeconomicandfiscalstatusoftheUnitedStatesliessomewherebetweenbad(ifyoubelievetheofficialdata)andhorrendous(if,likeus,youdonot).Thisisnot,oratanyratenotyet,causefordespair.Americaremainsnotjusttheworld’slargesteconomybutalsoitsmosttechnologically-innovative.

But,toparaphraseSen.Simpson,thisistheendoftheline.TheUnitedStatesneedstoconductathoroughandforthrightappraisalofitseconomicweaknesses,andtotakeurgentremedialaction.Failuretodosowouldbearecipeforabsoluteaswellasrelativeeconomicdeclineand,soonerorlater,forafull-blowndebtdisaster.

OuranalysissuggeststhattherearefourprincipaleconomicproblemswhichconfronttheUS:

1. Faultycapitalmarkets,compoundedbyweakregulation.

2. Anexcessiveemphasisonconsumptionoverinvestment.

3. Gravemisallocationofcapital.

4. BlitheacceptanceofaformofglobalisationwhichworkstothedetrimentofAmerica.

TheWestern(and,inparticular,theAmerican)economicsystemhasbecomechronicallydebt-andbubble-prone.Consumptionhasbeenfavouredoverinvestment,and,withintheinvestmentpoolitself,capitalhasbeendisastrouslymisallocated,withfundsbeingsteerednotintoproductiveusesbutintovanityprojectsand,worstofall,intotheinflationofthevalueofexisting,unproductiveassets.

Justasimportantly,Americaneedstowakeuptotherealityofcompetitionfromemergingcountries,mostnotablyChina.Thelong-standingeconomicassumptionof‘comparativeadvantage’hasledtheUS,andtheWestingeneral,intoanacceptanceofaformofglobalisationthathasworkedtoitsgravedisadvantage.

Theeconomicmodelhasfailed,bothathomeandabroad.Howhasitfailed?Andwhy?

a failed paradigm

Essentially,theUS,andtheWestmoregenerally,have,certainlysincethecollapseoftheSovietUnionandarguablysincetheendoftheSecondWorldWar,operatedavariantofthefree-marketsystembasedontheRicardianassumptionof‘comparativeadvantage’.AssociatedwiththeBritish

economistDavidRicardo(1772-1823),thecomparativeadvantagemodelarguesthateveryonebecomesbetteroffifeachcountryspecialisesinthoseactivitiesatwhichitenjoysthegreatestcomparativeadvantage.Ifthelogicofthismodelisaccepted,itisnaturalthatAmericashouldcedemanufacturingtolower-costcompetitorssuchasChina,concentratinginsteadonhigher-added-valuesectorssuchastechnologyandfinancialservices.TheRicardianmodelassumesthatsuchspecialisationenricheseveryonebecauseitmaximisestheefficiencyoftheglobaleconomicsystem.Geopolitically,theeconomicinterdependencyofnationsisalsoassumedtomaketheworldmoresecure.

Onpaper,thelogicofthisargumentseemscompelling.Inreality,however,Ricardiancomparativeadvantagemakestwobasicassumptions,bothofwhicharefundamentallyflawed.First,itassumesthateveryoneplaysbytherules,whichmanifestlyhasnotbeenthecaseinrecenttimes.Second,itassumesinfinitescopeforgrowth,sothattheeconomicsuccessofonecountryisnotachievedattheexpenseofanother.Inaworldwhichisbeginningtobuttupagainstresourceconstraints,the‘infinitegrowthcapability’assumptionisn’ttrue,either.

part two



TheUShasfollowedaRicardianmodelsincetheBrettonWoodsconferencewhichestablishedthepost-Wareconomicsettlement.Thedollar,thenpeggedtogold,becametheglobalreservecurrencywithinanassumedpreferenceforfreetradeandtheunrestrictedmovementofcapital.Essentially,BrettonWoodstiedtheglobalfinancialsystemtoagoldstandardviathedollar.In1971,RichardNixonfamously“slammedthegoldwindow”,endinggoldconvertibility(thoughthedollarremainedthereservecurrency).Latterly,afterthecollapseoftheSovietUnion,theUSledtheWestintotheacceptanceofaglobalisedfreetrademodelinwhichUS,EuropeanandJapanesemarketswerealmostwhollyopentotradeandinvestmentfromemergingcountries.

Overthelasttwentyyears,thismodelhasworkedtoAmerica’sgravedisadvantage,becauseoneofthetwoRicardianassumptions–freeandfaircompetition–hasbeenabrogated,mostconspicuously(thoughbynomeansonly)byChina.Withthesecondassumption–unlimitedscopeforgrowth–nowabouttoproveunfoundedaswellbecauseofresourceconstraints,thecontinuationofunfettered,one-sidedglobalisationcanonlyexacerbateAmerica’seconomicproblems.

Fundamentally,Chinarealisesthatsheisinacompetitivesituation.America does not.

un-american activities: have competitor strategies undermined the US?

China,andotheremergingcountries,operatearadicallydifferenteconomicmodelfromthatacceptedintheUS.Incontrasttothenegligently-regulatedvariantofcapitalismthatdidmorethananythingelsetoleadAmerica,Britain,Ireland,Icelandandothersintofinancialdisaster,China’sversionofcapitalismisastate-directedhybrid,aimedatmaximisingnationaladvantageratherthantheincomeofindividualcorporations.Chinahaskepttherenminbiatanartificially-depressedlevelinorderbothtoboostexportsandtodeterimports.Chinaalsooperatesblatanttariffandinformalbarriersagainstmanufacturedimports.

WhereAmericanbusinessesareprofit-maximisers,China’smainaimisvolume-maximising,theobjectivebeingtoboostlevelsofemployment,notcorporateprofitability.Logically,avolume-maximiserwillalwaysout-competeaprofit-maximiser,particularlywherewagecostsarelowandthetermsoftradearedistorted.

Furthermore,ChinaisengagedinthewholesaleappropriationofAmericanandotherWesterntechnologies–often with Western connivance.

Chinaisoftenaccused,probablyrightly,ofusingcyber-espionage,butweneedtobeclearthatinternational competition is not a parlour-game for children organised under playground rules.Chinaisentitledtopursuewhatsheregardsasthepoliciesmostadvantageoustoherowninterests.TherealquestionhastobewhyAmerica,andtheWestmoregenerally,havefailedtoreact.

Inanycase,the transfer of American technology to China and other emerging countries has been at least as much the result of home-grown negligence as of competitor strategy.Luredbymarketsizeandcheaplabour,Americancompanieshavealltoooftenenteredintoinwardinvestmentagreementswithtechnologytransferstrings.Though,atleastintheshortterm,thesedealscanbebeneficialtocompaniesthemselves,theyhavebeenextremelyharmfultotheoverallcompetitivepositionoftheUnitedStates.ThisunderlinesthepointthatWesternshort-sightednesshasplayedasmuchofaroleascompetitorbehaviourinunderminingWesterneconomicinterests.


11 It is particularly symbolic of the global power shift that, just as China is moving decisively into carrier aviation, Britain’s government has stripped the Royal Navy of its fixed-wing capabilities.

BylendinghugesumstotheUS,Chinahasfunded,andtherebyencouraged,excessiveconsumptionandthemisallocationofcapitalintheUS,whilstatthesametimeexertinganevertightergripasAmerica’screditor-in-chief.ButitistheUSwhichhasallowedthistohappen.

AstheChineseeconomyhasgrown,andasglobalresourceconstraintshaveemergedacrossarangeofcommoditiesincludingenergy,minerals,foodandwater,Chinaandotheremergingcountrieshaveengagedinapolicyofusingtheirhugedollarreservestobuyupresourcesacrosstheglobe,oftenco-operatingwithregimesregardedasdistastefulintheWest.TherecentcommissioningofChina’sfirstaircraftcarrierishighlysymbolic,indicatingthatChinaintendstodeveloptheglobalmilitaryreachrequiredtodefenditscommercialinterests11.

Blitheacceptanceofthisone-sidedformofglobalisationhasharmedAmericainmanyways.First,ofcourse,ithasmadepossiblethehugebuild-upofdebt,andhasencouragedatendencytowardscapitalmisallocationwhichwasalreadyimplicitintheAmericanfinancialsystem.



Second,ithascontributedbothtoever-wideningincomeinequalitiesintheUS,andtostubbornlyhigh(thoughunder-reported)unemployment.

Third,itwouldnotbetoomuchtostatethatone-sidedglobalisationhashollowedouttheAmericaneconomy,strippingtheUSofmanyofitsformerstapleindustries.

domestic errors – the follies of ideological extremes

ItwouldbealltooeasyforpolicymakerstoattributeAmerica’seconomicwoestounfaircompetitionfromChinaandotherlow-costeconomies,andtoleaveitatthat.Butthiswouldbeafundamentallymistakenstance,becauseitwouldmeanoverlookingthefactthattheeconomicdeclineoftheUSowesatleastasmuchtomistakesathomeastoforeigncompetitorbehaviour.

Aswehavebeenatpainstoexplaininseveralpreviousreports,economicoutcomesresultfromdecisions,notfromthevagariesofacapriciouseconomicdeity.ThecurrentweaknessesintheAmericaneconomyresultfromamultiplicityoffaileddecisions.Investmenthasbeenwasteful,boththefinancialsystemandstructureofcorporategovernancearefaulty,regulationhasbeennegligent,andpoliticalleadershiphasalltoooftenbeenwanting.

TherootcauseofsomuchofAmerica’sfailingshasbeenblindrelianceontheassumptionthatmarketforcesarealwaysbenign.UnderAlanGreenspan,theFedassumedthatbankswouldbehaveresponsiblysimplybecauseitisinthebestinterestsoftheirshareholdersthattheydoso.Thiswasbreathtakinglynaive,notleastbecauseitignored“thedivorcebetweenownershipandcontrol”whichmeansthatbanks(andcorporationsmoregenerally)arerunbytheirmanagers,notbytheirlargelypassiveowners.Apreferenceforriskisin-built,particularlyinabankingsectorwhereagovernmentback-stopwasalwaysimplicitandhas,since2008,becomeexplicitaswell.Interestrateswerekeptfartoolowforfartoolong,evenwhenthereexistedunmistakableevidenceofanasset(property)bubble.Trendsoverthelastdecadeandmoreamounttoagravemispricingofrisk.

Additionally,aspecificmistakehasbeenstirredintothemix.ThiswasthefailureofregulatorstopreventboththeemergenceoftheshadowbankingsystemandtheproliferationofdangerousinstrumentswhichnolessaluminarythanWarrenBuffetthadcalled“weaponsoffinancialmassdestruction”aslongagoas2003.BearinginmindthewayinwhichEnron(andothers)werebroughtdownbyoff-balance-sheetleverageandbyfailuresofoversight,itisgravely

disturbingthattheregulatorswereasleepatthewheelduringthecreationofwhatwasalmostcertainlytheworstbubbleinfinancialhistory.

Wherefollyisconcerned,theproliferationofsubprimelendingisinaclassofitsown.Italmostbeggarsbeliefthatregulatorscouldallowanappetiteformispricedrisktospreadtothepointwheremortgagescouldbepedalledtothosewhowerebothtoopoortoaffordthemandtoounsophisticatedtoresisttheblandishmentsofbonus-motivatedsalesmen.Farfromregulatingthisdistortionofthesystem,governmentactuallyexacerbatedit,notleastbyforcinglenderstodirectmorethanhalfofallnewmortgagesatthoseonlowincomes.

capital sink investment: betting the house

Inpart,thesubprimecrisisreflectedalong-standing,misplacedobsessionwithspreadinghomeownership.ThisobsessionhadlongenteredtheAmericanpsyche,andperhapsnothingsymbolisesthisstateofmindmorethanthe1946JimmyStewartmovieIt’s A Wonderful Life,inwhichS&LbossGeorgeBailey(Stewart)islaudedforhismotivatingdesiretohelpAmericansgetontothepropertyladder.Politiciansofbothpartieshavelongarguedthathomeownershipisasocialgood,andhavebackstoppedthemortgagesystemwithfederalguarantees.


12 The MetLife stadium, shared by the Jets and the Giants, was completed in 2010 at a cost of $1.6 billion. The Mets’ City $900m Field stadium was completed in 2009.

Fromastrictlypragmaticperspective,governmentsshouldcultivatelowratherthanhighpropertyvalues.Lowpriceswouldenableyoungpeopletofindhomes,wouldprecludethecreationofdamagingbubbles,woulddrivemiddleclassAmericansintogreaterinvestmentdiversityand,mostimportantofall,wouldliberatecapitalformoreproductiveinvestment.

Fromafixationwithhomeownershipitisjustashortsteptoabeliefthatrisinghousepricesarepositiveforsociety.Infact,thisisveryfarfrombeingthecase,foratleastfourreasons.First,ofcourse,risingpropertyvaluescanpriceyoungpeopleoutofaccesstohomes,andcanimpairlabourmobility.Second,risingpropertyvaluescan,andoftenhave,createdspeculativebubbles.Third,middleclassAmericanshavetendedincreasinglytohavetheirassetsover-allocatedtothehousingsector.Fourth,andworstofallfromaneconomicperspective,housesarecapitalsinks,which absorb investment without generating a return.

Inotherwords,tyingupcapitalinpropertyreducesnationalproductivity.Borrowingtodothisisfolly,andborrowingfrom abroadforthispurposeistheeconomicsofthemad-house.Thereisnothingimplicitlywrongwithborrowing,particularlyiftheborrowedfundsareinvested

productively.Also,borrowingforconsumptioncan,withinreason,boosteconomicactivityandhelpcreatejobs.But,tragically,thisisnotwhatAmericahasbeendoingoverthelastdecadeandmore.Borrowedcapitalhasbeenputintoassetvalueescalation,notintoproductiveinvestment,whilstborrowedconsumptionhascreatedjobsinShanghai,notinSchenectady.

ThehighproportionofAmericans’wealthwhichisinvestedinpropertyposesamajorsocialandeconomicriskgoingforward,becauseoftheongoingretirementofthebabyboomgeneration.Thefirstboomershavenowreachedtheageof66,whilsteventheyoungestwillreachretirementoverthecomingtwentyyears.Millionsofthesepeopleexpecttorelyfortheirsecurityinoldageonmonetisingtheirassets,butno-onehasexplainedquitehowthisissupposedtohappenwhenthefollowinggenerationisnotonlyfewerinnumberbutindividuallypoorer.Thisarguesforafurtherseculardowntrendinpropertyprices,undercuttingmillionsofAmericans’assumedabilitytoenjoyagoodqualityoflifeinretirement.

Evenwherethelimitedpoolofnon-housinginvestmentisconcerned,fundshavealltoooftenbeenchannelledintovanityprojectsratherthanintoessentialinvestment.

Accordingtovariousexpertstudies,thelevelofinvestmentrequiredtorestoreAmerica’sinfrastructuretoasafeandcompetitiveconditioniswellinexcessof$2trillion.Littlehasbeendonedespitethetragic2007collapseoftheI-35WbridgeovertheMississippi,inwhichthirteenpeopledied.

NewYork,forexample,hasitsshareofageingpowersupplysystems,roadsandbridges,andhasnorealideaabouthowtopayforreplacements,yet,withinthelastdecade,hasfound$2.5billiontobuildnewstadiaforitsprincipalsportsteams(theMets,theJetsandtheGiants12).ThetragedyofNewOrleansinpartreflectedafailuretoinvestinimprovingtheleveesbuiltbyearliergenerationstoprotectthecityfromdevastatingfloodsofthetypetragicallyunleashedbyHurricaneKatrinain2005.

IfAmericahasgraveproblemswithcapitalallocation,ithasequallysignificantproblemswithitslabourpool.BoththepresidentandtheprimeministerofChinaaregraduateengineers,whereasBarackObamaisalawyer.Americancollegesproduce41lawgraduatesforeveryengineer.Eachyear,thebrightestyoungAmericansareluredintocareersininvestmentbankingandthelaw,ratherthanintoactivitiessuchastechnologyandmanufacturing.



ThesetrendsarereflectedinthegrowingfinancializationoftheAmericaneconomy,bywhichismeanttheincreasingshiftfromproductiveactivities(suchasmanufacturing)intotheessentiallyunproductiveactivityofsimplymovingmoneyaround.

Thisprocessof‘financialization’isanestablishedend-of-eraphenomenon,andwasassociatedwiththelatterdaysofglobalsupremacyinSpain,theNetherlandsandGreatBritain.InSpain,theaccumulationandmovementofNewWorldbullionandofgovernmentpaperbecamemore

importantthanproductiveactivities,puttingthecountryintoinexorabledecline.MuchthesamehappenedwheninternationalfinancingactivitiesdisplacedindustryandtradeinnineteenthcenturyBritain.

Isthis‘endofera’processnowtakingplaceinAmerica?Itcertainlyseemsthatway.Asfig.5shows,manufacturinghasdeclinedfrom29%ofGDPin1950tojust11%in2009,whilstthebanking,realestateandinsurancesectors’sharehasincreasedfrom11%to22%overthesameperiod.

Ofcourse,financialservicesplayahugelyimportantroleintheeconomy,andmarketsarebyfarthebestmechanismfortheeffectiveallocationofcapital.ButAmericansmayberighttowonderwhetheranappropriatebalancehasbeenlostwhenthefinancialsectorbecomesalmosttwiceaslargeasthemanufacturingindustrywhichpropelledAmericatoglobaleconomicandpoliticalpre-eminence.Thesolution,ofcourse,isnottodownsizefinancialservices,buttosupportotherpartsoftheeconomy.

Fig. 5: Financialization – percentage contributions to US GDP, 1950-2009*

1950 1960 1970 1980 1990 2000 2005 2009

Manufacturing 29.3% 26.9% 23.8% 20.0% 16.3% 14.5% 11.9% 11.2%

Finance 10.9% 13.6% 14.0% 15.9% 18.0% 19.7% 20.4% 21.5%

*Sources:Economic Report of the President,2011,tableB-12,andKevinPhillips,Bad Money,2009edition,page31

strategy insights | issue eight32 13 Farewell Address to the Nation, 17th January 1961

“The potential for the disastrous rise of misplaced power exists and will persist. We must never let

the weight of this combination endanger our liberties or democratic processes”.

Dwight D. Eisenhower13



how should america respond?

Unlessradicalandtimelychangesareimplemented,historiansofthefuturearelikelytoregardthe2008bankingcrisisasadecisivetipping-point,themomentatwhichAmericalostherlong-standingglobalprimacyaseconomicpowerlurcheddramaticallyfromacomplacentWesttoabrashlyconfidentEast.IfAmericadoesindeedsurrendertheeconomicpoweruponwhichallotherformsofglobalinfluencearebased,thosesamefuturehistoriansarelikelytoincludeafailedeconomicmodel,failedfinancialregulation,failedcorporatestructuresand,aboveall,afailureofleadershipamongstthefactorswhichallowedAmerica’sprimacytogobydefault.

Thusfarinthisreport,wehaveaddressedtwokeyissues.First,wehavesoughttolookbehindthestatisticalcamouflagetorevealquitehowdireAmerica’seconomicandfiscalproblemsreallyare.Second,wehaveexplainedthekeyweaknesseswhichhaveledAmericaintoitscurrentparlousstate.Here,weconcludebysettingoutsomeofthosemeasureswhich,webelieve,canreversetheadversetrendswhichhavebeenunderminingtheUnitedStatesforatleasttwodecades.

Noanalysissuchasthisiswrittenfromapositionofperfectneutrality.Theviewtakenhereisthatprosperityandcohesionareproductsofbalanceandofresponsibility,andthatchecks-and-balancesareimperative.Capitalismisthemostpotentwealth-generatingsystemevercreated,andfreemarketscanalonedelivertheoptimumallocationofcapital.Butacompletely unfetteredfreemarketsystemcanalsoproducedistortionsandanomalies,notjustinthedistributionofeconomicrewardsbutalsoinstructuresandinstrategicdirections.

Attheinstitutionallevel,America’sfoundingfathersincorporatedtheirrecognitionoftheneedforchecks-and-balancesintotheConstitutionoftheUnitedStates,whichestablishedthecriticalseparationofpowerbetweentheexecutive,thelegislatureandthejudiciary.Bondmarketsoperateasafinancially-equivalentbalancingmechanism,checkingthewilderirresponsibilityofgovernments.Butinternaleconomicandfinancialbalancingmechanismsarenecessarytoo,andalackofsuchbalancehasbeenthesinglemostdamagingfactorintheweakeningoftheAmericaneconomy.TheobjectivenowshouldbetorestorebalanceanddirectiontotheAmericaneconomicsystem.

WhenDwightD.EisenhowerwarnedAmericansabout“thedisastrousriseofmisplacedpower”,thethreatthathehadinmindwas“themilitary-industrialcomplex”.Hewouldhaveshownmoreprescienceifhehadhewarnedinsteadabouta“finance-industrialcomplex”.JustaslaxcorporateregulationledtotheEnronandWorldComscandals,excessivederegulationofthebankingsystemleddirectlytothefinancialcatastrophewhicheruptedin2008andwhich,inourview,hasyettoreachafinaldenouementwhichnowmaybeimminent.

America’s single most pressing domestic need is to restore the balance between probity and innovation in its banking system.Theessentialproblemhasbeenadisastrousmispricingofrisk.Itwassurelyobviousfromtheoutsetthatregulators’failureeventonotice,letalonetoprevent,theweakeningofthelinkbetweenlenderandborrowerwouldhavecatastrophicconsequences.

Historically,mortgagelendersexercisedcautionbecauseeventualrepaymentdependedupontheviabilityoftheborrower.Overthelastfifteenyearsorso,thisall-importantlinkhasbeenallowedtoweaken,enablinglenderstoissuemortgages

part three


inthecomfortingknowledgethat,iftheborrowerfailedtomeethiscommitments,someoneelsewouldbeartheloss.Thisdistortionoftherelationshipbetweenlenderandborrowerlednotjusttothemispricingbuttothereversepricingofrisk,suchthatlendingtotheriskiestborrowersbecameahigh-returnsprocessbecauseriskcouldbeunloaded.Thisprocessranitswhollypredictablecourseinthesubprimedisaster.Inthefuture,fargreatertransparencyisimperative.Akeyrecommendationofthisreportisthatthesecuritizationofmortgagesshouldbesubjected to tighter regulation.

Americaalsoneedstoaddressissuesoffinancializationbyencouragingindustries,suchasmanufacturing,whichincreasinglyhavebeenoutsourcedtocheapercompetitors.Thefreefunctioningofthemarketsystemisaneconomicimperative,butsomethinghasbecomemisbalancedwhenthemanufacturingsectorhasdwindledtobarelyhalfthesizeoffinancialservices.Neithersixteenth-centurySpainnornineteenth-centuryBritainlearnedthiscriticallesson,andtheeconomiesofbothwereunderminedwhentheybecamedominatedbyrentiersratherthanbyentrepreneursandproducers.

Curbingtheexcessesofthebankingsystemwill,ofcourse,requireconcertedactionbygovernment,anditisimperativeinthiscontextthatAmerica’sleaderstaketheelectoratewiththem.Thoughsimpleinprinciple,tighterregulationwouldneedtobeimplementedintheteethofformidably-fundedopposition.

Inthiscontext,thecontemptinwhichgovernment(irrespectiveofparty)isheldbyAmericansisbothremarkableanddisturbing.Afterall,thegovernmentoftheUnitedStatesimplementedsuchfar-reachinginitiativesastheTennesseeValleyAuthority,wontheSecondWorldWar,andputNeilArmstrongandBuzzAldrinonthemoon.ButAmericaseemsnowtohavelostalmostallbeliefinnational,collectiveaction.America’sleadersneed,asamatterofurgency,togaingreatercredibilitybyputtingtheinterestsofthecountryabovetheirownpartisanambitions.

Americacanaffordtogettough,becauseChina’sstabilitydependsentirelyuponthecreationandmaintenanceofhundredsofmillionsofjobs,andthishasbeenaccomplishedalltoooftenattheexpenseofbusinessesandjobsinAmerica.

JustasAmerica’sgovernmentneedstogettoughabroad,itneedstogettruthfulathome.LikeotherWesterncountries,anAmericalulledintocomplacencybypost-Warprosperitygotintothehabitofmakingforwardpromisestoitscitizenswhich,itisnowclear,cannotbehonoured.Itisabouttimethatsomeoneadmittedthis.Americaalsoneedstocutbureaucracy,eliminatewastefulprogrammesandcontemplatetaxincreasesinordertobringitsbudgetbackintobalance.

Thetriple-AquestionnowiswhetherAmericahastheleadershipwhichwillenablethistohappen.

America’sfriendsmusthopethatshehas.

Dr Tim MorganGlobalHeadofResearchTullettPrebonplc


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TPSI 008 | February 2012

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about the author

TimMorganreadhistoryandpoliticalphilosophyatEmmanuelCollege,CambridgebeforejoiningstockbrokersWoodMackenzieasatraineein1982.HemovedtoMontaguLoeblStanleythefollowingyear,shortlythereafterassumingresponsibilityforthefirm’soilandgasresearch.

In1985,hejoinedthestockbrokersWICarr,whichbecamepartofBanqueIndosuezin1986.Afterashortperiodwithaboutiquebroker,heestablishedanenergysectorresearchconsultancyin1990.Duringthe1980s,hehadmadetwoimportantdecisions.First,thattheprevalentearnings-basedinvestmentanalysiswasout-dated,andthattheemphasisofresearchneededtoshifttocash-basedmeasurementofshareholdervaluecreation.Thesecondwasthatsingle-countryresearchwasinappropriateinanincreasinglyglobalisedeconomy.Thesedecisionsledhimtodevelopthevalue-basedVVM™analysissystem.

Between1995and2006,TimwasconsultantenergyanalystatCollinsStewart,astockbrokingfirmwhichachievedrapidgrowthonaplatformofresearchoriginalityandtechnologicalexcellence.HejoinedShoreCapitalGroup,againasaconsultantenergyanalyst,inMay2007,but,inFebruary2009,wasinvitedtoformalisearolethathehadbeencarryingoutforsometime–thatofeconomicandmarketstrategist.

Inthisrole,heattractedconsiderablenoticeforareportinwhichhewarnedthatadecadeofeconomicmismanagementhadtakenBritaintothebrinkofa“debtvortex”.ThisbuiltuponanearlierreportwhichcontendedthatrecentUKeconomicgrowthhadbeenlargelyillusory,beingbasedupondebtescalationandtheunderstatementofinflation.Healsopioneeredthethree-partMatrix™approachtoinvestinginperiodsofhighsystemicrisk.

Whilstretainingakeeninterestinenergy,hiscurrentresearchfocusisontheimplicationsofanacceleratingprocessofchangeintheglobaleconomy.Hebelievesthatthisprocessisexposingaseriesofmajoreconomic,financialandpoliticalimbalances,andthatitisimperativethatfinancialmarketparticipantsbekeenlyawareofthestructuralimplicationsofthisprocess.

Tim’sextra-curricularinterestsfocusondefenceissues,theenvironment,musicandcommunityinvolvement.Hehasaparticularinterestinwarships,haspublishedabookonthesubject,andhasrelishedtimespentatseawiththeRoyalNavy,believingthatfewexperiencescanequaltakingofffromanaircraftcarrierorparticipatinginamphibiousexerciseswiththeRoyalMarineCommandos.

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