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What's next: surviving the 'lost decade.' (Viewpoint)

It will soon be three years since the U.S. economy exhibited any meaningful forward momentum, representing the longest lapse in economic growth since World War II. Many economists--and politicians--have been predicting recovery early and often. But the credibility of their frequent sightings of recovery has begun to sink below even those of die-hard Elvis fans. Indeed, many professional economists seem to be ignoring some weighty basic evidence that may account for their chronic state of disappointment.

We've been digging through a huge amount of data on the long-term fundamentals of the U.S. economy in search of a framework more satisfactory than the "macroeconomic cycle as usual." We found what might be called a long-term "balance-sheet cycle," which points to a slow, halting economic recovery through the mid-1990s.

We started this search by quantifying the most obvious dimensions of the 1980s' over-borrowing and over-spending binge. Our combined public and private debt now stands at nearly $12 trillion compared to only $4 trillion in 1980. More importantly, this represents more than 200 percent of GNP--a ratio that contrasts sharply with the stable 140- to 150-percent leverage ratio during the three decades before 1980. In practical terms, the U.S. economy today is lugging about $2.8 trillion more in debt than it would have had pre-1980 leverage ratios remained unchanged.

Likewise, the consumption share of GNP soared in the 1980s, rising from a 25-year average of about 64 percent to nearly 69 percent. The consequence of this sharp departure from previous long-term trends added about $200 billion per year in consumption spending.

By now, of course, these points about the 1980s' overhang of unsustainable borrowing and consumption are familiar. But we found in the basic national balance sheet data a possible explanation for these excesses that may break some new ground.

In fact, some apologists for the 1980s may have inadvertently identified one key to the future when they argued that swelling debt was not a problem because asset values had risen even more sharply. Up to a point, the facts are on their side. While consumer mortgage and revolving debt nearly tripled in the 1980s, from $1.4 trillion to $4.1 trillion, the sum total of household assets--stocks, bonds, money funds, residential property and pension investments--doubled from $12 to $24 trillion during the same period.

But we know that private savings rates collapsed in the last 10 years. And we also know that ultimately net worth represents the long-term accumulation of savings. So how did household net worth grow so spectacularly--as implied by $24 trillion in assets against $4.1 trillion in debt--during a period when Americans virtually went on a savings holiday?

Our analysis demonstrates that the annual savings rate fluctuates incessantly year after year. By contrast, the ratio of household net worth to annual consumption spending exhibits only microscopic change. Indeed, it has averaged exactly 5.3 times consumption nearly every year since 1954, and this includes the last 10 years of anemic savings and turbo-charged consumption.

How can one reconcile volatile savings with a constant ratio of net worth to consumer spending? The answer, of course, is extraordinary capital gains. By our reckoning, American households received nearly a $2-trillion capital gain windfall in the 1980s by virtue of the same financial anomalies that so badly distorted our overall economy. And it was this unprecedented windfall on assets already owned that permitted the ultimate 1980s' free lunch.

Take the case of common stocks and mutual funds owned by households. The public was a big net seller of these assets throughout the decade through corporate takeovers, LBOs, leveraged recapitalizations, and so forth. Yet after a decade of selling their stock and using the cash for consumption or alternative investments, households owned $3.1 trillion in equities by 1991--a level three times more than their holdings in 1980. The magic of P/E multiple expansion obviously accounts for much of this anomaly, with the S&P 500 P/Es more than doubling over the course of the decade.

The resulting annual return on common stock was 18 percent, a level roughly twice the historical average and, more importantly, a return on old savings so rich that new savings were hardly necessary.

Likewise, households own about $6 trillion in bonds and money funds. Due to the nation's distorted fiscal policies for much of the 1980s, the real rate of interest on these holdings averaged three times the historical return of the last 50 years.

So again, windfall gains on old savings permitted a hiatus in new savings. But when these asset windfalls stop, household net worth will have to start growing once again the old-fashioned way--by the postponement of current consumption and the resumption of normal savings rates. And the fact is stock market multiples are not going to keep expanding, and after-inflation yields on money market accounts and medium-term bonds have already plummeted toward historic P/E norms. Furthermore, with residential housing prices stagnant or even declining in many markets for the first time in 40 years, we have a scenario that is almost the mirror image of the 1980s: the prospect of very subdued growth in household net worth, resulting in cautious consumption spending and an upward trend in savings rates. And, I might add, the rapid aging of the post-war baby boom generation will reinforce these trends.

The implications of such a scenario for economic growth are obvious. If consumption--which accounts for two-thirds of GNP---is in the throes of a major balance-sheet correction cycle, the arithmetic of GNP growth will be fundamentally weaker until the cycle has completed itself.

U.S. consumers stopped saving because of the greatest one-time financial asset appreciation in modem history. As the American consumer confronts a rising public-sector tax burden and continues to scrimp and postpone consumption in order to restore his balance sheet, aggregate job creation and economic growth will be slower, corporate earnings growth and P/E multiples will come under pressure, and the accustomed high returns on financial assets will become harder and harder to find. Old-fashioned virtues like balanced asset allocation, sound money management and patient, well-developed investment strategies may once again obtain the premium value they deserve.

When you think about the overall investment outlook, the intensifying challenge posed by the globalization of both economic activity and asset markets becomes well nigh inescapable. For example, the U.S. faces an inevitable, significant rise in its petroleum import bill over the next decade. That, in turn, means substantially more manufacturing export gains will be necessary to stabilize the current account and put some minimal floor under the dollar exchange rate. We know that the manufactured goods sector of the trade account collapsed from a $2O-billion surplus in 1980 to a shocking $140-billion deficit in 1986. That $160-billion negative swing represented 4 percent of the GNP and fully 15 percent to 20 percent of our total industrial output. We have a long way to go to get back to where we were in 1980.

Likewise, one of the terrible hidden costs of our 1980s dream world was the shocking fact that over the entire decade there was no net increase in the real capital stock--equipment and factories--of the entire U.S. tradable goods sector. Consequently, some industries have become hopelessly uncompetitive after a "lost decade."

As for the large number of companies that are not overleveraged, they will still have to confront the likelihood that domestic consumption and GNP growth could be curtailed for a considerably longer period than the typical, post-war downturn while several forces play themselves out: the bloated domestic-services sector downsizes, taxes rise to meet deficits and otherwise unsustainable borrowing demands, household savings rebound and families rebuild their balance sheets the old-fashioned way (i.e., through new savings), and consumers live off their extraordinarily high discretionary goods purchases of the 1980s.

Consequently, sales and earnings growth for successful companies operating in the U.S. market will depend not on overall growth but more than ever on increasing market share, more aggressive, speeded-up product innovation, and increased value, both from cost reduction and quality increases.

Under all these circumstances, well-managed companies will also actively seek to enter appropriate new markets within the U.S. where growth prospects are brighter than average. Some that come to mind might include environmental services, physical infrastructure, asset management, and telecommunications.

Finally, we know that the much higher projected growth rates for certain regions of the world suggest an increasing portfolio weighting for these regions. Let's take Southeast Asia, for example. The economies of a number of countries in this region will benefit from a low-cost, skilled workforce, high savings rates, rapid industrialization and a positive investment climate. IMF data for 1991 suggest a growth rate of about five times that of Europe. Indeed, certain regions of the southern part of China are experiencing overall growth rates of 13 percent in the first half of 1992 with industrial output growing at twice that pace. Serious people are now saying by the year 2000, these provinces could be as rich as Southern Europe.

THE ROLE OF POLITICS

At bottom, our long-term economic problems are, in fact, political problems. One of the cliches in the American political dialogue today is that our economy is starved for investment. The political left, right, and center say that we simply must invest more--in underclass children, in the crumbling infrastructure, in plant and equipment.

Wherever we look at our competitors' success stories--Japan, Germany, South Asia--all are seriously outdoing us in productivity growth, and out-investing us by big margins. In order to increase our productivity growth by 1 percent which would return the American economy to its historic average and make an extraordinary difference in our private and public standard of living--our experts tell us we would need to invest 5 percent to 8 percent more of the GNP annually.

But where are we going to get the savings to make these investments? Whose consumption is going to be temporarily cut so that our people's future income can start growing again and so that we can be more competitive in a harsh and increasingly competitive global economy?

Have we told our kids that we now have $17 trillion of unfunded liabilities for Social Security, Medicare, civil service and military pensions, and that by the year 2020, they will have to pay 29 to 37 percent of their taxable payroll just for Social Security and Medicare? Have we told them that the GAO recently announced that iyf we stay on the current path with the debt service growing and entitlements going up, our annual deficit will be an unsustainable and unthinkable 21 percent of the GNP in the year 2020?

If we don't start doing something about these problems now, not only could we consume all of the potential savings in the world, but we will end up in serious risk of an inter-generational war.

What is our notion of morality? Is it the morality expressed by Dietrich Banhoffer: "The ultimate test of a moral society is the kind of world it leaves to its children"? Or is it the morality of the German philosopher who said, "The duty of the old is to lie to the young"? At some point, the young people of today are going to understand what these unfunded liabilities mean. Do we really want to wait for our own kids to find out that we are slipping them a huge check for our free lunch?

If we think only in terms of sacrifice, or pain, it will be very difficult to convince people that reductions in spending are necessary. Unless we have a positive vision of what kind of country we're going to have, how we are all going to benefit, this talk about sacrifice won't work. We will need to spell out what an American looks like that saves and invests more. Had America kept its productivity growth where it was from 1947 to 1973, the average worker would be earning $10,000 a year more than at present, and we could have almost $500 billion in our federal coffers to eliminate deficits while meeting our public needs.

If we visualize an America that increases its productivity growth by 1 percent a year, our average worker would double his or her income every generation. If, by contrast, we visualize an America that defaults and accepts its current, stalled, stagnating productivity growth level, it will take 150 years to double their income, not to mention the critical differences that added public revenues would make in the quality of our public lives, our environment, our infrastructure, and the very viability and quality of our society.

Our current long-term economic outlook is totally unacceptable. There is no alternative but to try.

Mr. Peterson, chairman and founding partner of The Blackstone Group, was Secretary of Commerce during the Nixon Administration. Mr. Peterson is the founding president of The Concord Coalition, a citizens' group dedicated to America's long-term economic health.
COPYRIGHT 1992 Financial Executives International
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Peterson, Peter G.
Publication:Financial Executive
Date:Nov 1, 1992
Words:2162
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