I am sitting here in Casa Interloper relying on the fact that influidity’s Steve Randy Waldman is orders of magnitude brighter than I am because I really, really hope I have this wrong. Because, if I don’t, the medium term for assets markets looks far more depressing than I thought when I woke up this morning.
Today’s influidity post, a discussion on whether the “natural” level of real interests rates can be negative, could be interpreted as academic esoterica at first glance. But it’s not, or at least might not be. Mr Waldman writes:
it is the marginal productivity of investment to existing lenders [ie investors] that sets the floor beneath market rates.
By this, he stakes the position that real rates are in no way limited by 0% at the lower end and could theoretically fall to -100% if the investing public determined that there was no use in investing for the future. Indeed, Mr. Waldman makes the argument that only the desperate shenanigans of Wall Street financial engineers has prevented real rates from averaging below 0% since 2007, and that the engineering process has proven a failure anyway.
To understand why this concerns me so much, refer to the chart below from the Federal Reserve Bank of San Francisco, showing the historical effects of demographics on S&P 500 price/earnings ratios (Using M/O (red line): ratio 18-34 group/60-69) . Yes, that looks to be a seven or eight handle predicted for the average bottoming of multiples, after a steady decline until 2020. And, unfortunately this makes intuitive sense – retired Boomers will inevitably consume less in almost every area beyond health care and vacation cruises, dramatically downsizing the world’s largest market for goods. Perhaps more importantly for our purposes, the aging Boomers will also invest less, becoming a net drain on investable assets as retirement continues. Following investment theory, what they do remain invested in will be fixed income or fixed income-like investments and this in turn will support the trend of negative real interests by assuring steady demand for savings.
In looking at Waldman’s argument and the market effects of demographics in tandem, the financial crisis can be seen as just the tip of a miserable iceberg. Demographics, not just in the United States but also Western Europe (particularly Italy, just in case you were not worried enough), insures high enough demand for savings to keep real rates negative. At the same time, declining aggregate consumption levels will negatively affect “the marginal productivity of investment to existing lenders”, the younger population, who will increasingly see fewer and fewer investment opportunities likely to generate returns.
The Keynesian interpretation of the current economic malaise is lack of aggregate demand and I suspect they are correct. The means by which this drag can be sustainably addressed in the face of demographic factors escapes me. It may just be one more area of dependence on the Chinese, with the hope that the rise of the Sinoconsumer can help offset this western structural drag. In the shorter and mid-term, however, the export-dependent Chinese economy is going to have to figure out somewhere to sell their goods.
This is a pretty dire macro picture and, as I said, I’m hoping I have this wrong in some fundamental way. As always, sane comments and feedback are more than welcome.
I don’t have anything like a firm opinion on this subject yet, but two other sources of information worth considering follow.
CBO’s (different) take: http://www.cbo.gov/ftpdocs/105xx/doc10526/09-08_Baby-Boomers.pdf
A 2002 paper in general agreement: http://cowles.econ.yale.edu/P/cd/d13b/d1380.pdf
Good piece, thanks. Part of the premise is interesting – the 1% could save us from an 7 PE.
great discussion interloper. since your talking about the natural rates of interest, you should check out this short little pdf (just a few pages) from hedge fund manager and economist Warren Mosler. It’s called, “The Natural Rate of Interest is Zero.” Here’s a link:
http://moslereconomics.com/mandatory-readings/the-natural-rate-of-interest-is-zero/
I love what you’re talking about here and am going to forward this to Warren to see what he thinks about it as well. You can check out his blog here:
http://moslereconomics.com/
I completely agree with you about this and about aggregate demand. How is it mathematically possible at all for austerity to do anything in this environment? Especially when our interest rates are not effected by a downgrade by the S&P? I mean what are we so scared of to start spending or increasing deficits?
The means by which this drag can be sustainably addressed in the face of demographic factors escapes me.
how does a 100% FICA holiday sound for both employee and employer? We can still pay out social security b/c the government is not revenue constrained. If that doesn’t make any sense to you, read the first few pages of this book (also by Warren Mosler):
http://moslereconomics.com/2009/12/10/7-deadly-innocent-frauds/
There are many other ideas that can be done operationally as well. Things like a jobs program to anyone willing and able to work (again the Federal government is not revenue constrained), a per capita revenue injection to the states, tax cuts, and no skimping on necessary and already-running federal expenditures like teachers, NASA, government agencies, Boeing contracts, etc. In fact why not hire some more forensic accountants and FBI agents to nail some of these fradusters on Wall Street (joking aside).
It may just be one more area of dependence on the Chinese, with the hope that the rise of the Sinoconsumer can help offset this western structural drag.
just to be clear the Chinese don’t “fund” the US when they buy our bonds if that’s what you’re referring to or thinking. That’s also in the link to Warren Mosler above. They simply have money in a deposit account at the Fed and we mark it up with interest via a spreadsheet on maturity. That’s all. China probably won’t be able to prop up our economy either b/c we run a trade deficit them…financially speaking we run their economy more than they run ours. Imports are a net gain to any economy and exports a net drain.
The only way out of what you are seeing (and I agree with you completely and see it too) is through larger federal deficits. That means either lower taxes or increased spending or a combo-job…it really just depends on your political preferences. But politics aside, this is economics and those numbers need to flow in the sectoral balances accounting equation properly however we do it otherwise there just won’t be as much consumption in this economy. How could there be with all that’s going on and dragging us down and all the slack? But in order to accomplish such a goal we need to get people to realize that the US government cannot go bankrupt, nor can it operationally default on debts in its own currency, and that our “debt to gdp ratio” is no scarier or a threat to our nation than the numbers on all the excel spreadsheets in the nation combined and then multiplied by itself. The only concern with deficits for our sovereign nation is inflation….and I don’t see that as a concern right now and apparently you are looking at similar data points too.
Great post here Interloper. You got me all excited. Sorry for the long-ish comment here!
Cheers!
Mr. Waldman’s point that worried me is that there is no natural level for rates, the demand for savings vs prospective investments determines. I was discussing China as a source of demand for DM goods, not as the world’s largest example of vendor financing.
got it. I see. But it appears you’re still approaching this in terms of a loanable funds market and it actually doesn’t work like that…not with banks and the government at least. It would if you were going to a corporation or a state or municipality or an individual for a loan, b/c those loans come from savings by those institutions. However banks and the government don’t have to “save” before they can spend. For banks loans come BEFORE reserves. As long as they have the Fed’s capital requirements they qualify to make loans. If a borrower walks in, and is accepted, that loan is made. It is only AFTER that transaction that the Fed deposits the appropriate reserves into that bank’s account at the Fed. Loanable funds is just not an operational reality in our economy today. China’s US debt holdings are really only a mathematical mirror of their current account surplus with the US, it’s not vendor financing or anything like that (as it appears you realize…which is great!).
see this and this for more on loanable funds and other “myths” of economics:
http://pragcap.com/harvard-the-mankiw-revolt
http://seekingalpha.com/article/175009-investment-makes-saving-possible
This is pretty heady stuff. If understood correctly, there seems to be a conflict in the argument.
Premise 1: “retired Boomers will inevitably consume less in almost every area beyond health care and vacation cruises, dramatically downsizing the world’s largest market for goods.”
As all Boomers die off, where will their wealth go? Government and beneficiaries should take care of that and, as they each usually do, spend it or invest it.
This also assumes immigration doesn’t resolve this issue. If the US follows Western Europe’s past, that may be the case. History and geography suggest that it won’t be.
Premise 2: “the aging Boomers will also invest less, becoming a net drain on investable assets as retirement continues”
I’ve studied this and used to parrot what the pension consultants say as better relayed in Premise 2. It was viewed that around 2015, Boomers would start hitting retirement and equity markets would enter a secular bear market. The economic reality though belies this.
Yes, financial assets in the short- and intermediate-terms (and occasionally long-term) are impacted by financial supply-demand dynamics, AKA investor preferences. Overvalued assets can stay overvalued for an indefinite period—even decades. Undervalued assets, unless strong deterrents persist, eventually get purchased for higher prices of get wasted away by competition, again, unless strong deterrents persist.
Looking at that FRB-SF chart again, notice the slump in equities in the ‘70s. The labor pool in the US actually expanded during this period as Boomers, especially women, entered the workforce.
Why was there not an equities boom then as demand for goods increased? Inflation. So here’s the conflict: if the argument is that retiring Boomers will be net-suppliers of their equities holdings and watch their valuations drop to low-tide and their passing will result in decreased goods demand, where will inflation come from that will result in negative real rates?
Also, many US companies have financial tools today that they didn’t have or use in the ‘70s such as mezzanine financing and stock repurchases. (By the way, the ‘70s slump resulted in a mini-boom for foreign acquirers of US companies.)
Various demographic factors certainly affect a nation’s future outcomes and wealth. Not to be dismissive, the “Boomer retirement era” fears seem overblown and their fires may continue to be fanned by the press.
Last point is one that few footnote when using the S&P500 as a proxy of US domestic wealth or earnings. The index is increasingly a global one (like the UK’s FTSE 100) as more than half of the index’s weighted net earnings are from abroad; and that geographic base is widening and those earnings should increase if and when the dollar declines.
There are a few other factors missing as well such as the impact of tax policy (why incur capital gains taxes for your taxable accounts and then pay have beneficiaries incur inheritance taxes on the balance?).
At best, Boomer’s retirement impact seems ambiguous. Economics would suggest that the impact will be marginal. If it however were to be great, it may be a gift to private equity.
Am I missing something?
interesting points. I definitely agree with you about inflation or a lack thereof these days to threaten real rates…however all it takes is one more ME war or some other supply shock for that happen real fast.
I think your points are totally valid about governments and beneficiaries, but the govs will get taxes and the benes with get likely homes more than cash as that cash will be used as savings on the boomers and health issues and perhaps even nursing care, etc. The real issue is the economy at large and how will those beneficiaries handle that inheritance….if UE is still high, taxes are high, and federal spending low and Wall Street still monopolizing I just don’t see people really wanting to let go of that savings…not to mention they probably have their own underwater mortgage to deal with. People have been hit hard….so hard that they are now thinking about how they spend and allocate their cash (and family planning)…in fact they are getting so obsessed about it that they think the government should “hunker down” with them! Not a good idea.
losing the boomers will definitely have a huge impact on the economy like a big rock moving through a hose. For sure. In fact I bet the best prospects for many beneficiaries is the fact that “one day” they’ll at least get the home their parents have or something like that….there really isn’t too much else to look forward to these days in this economy. Hence deflation and deflationary pressures abound in my view….and definitely supply-side inflation could side-swipe us at the drop of a hat any day which is just pouring gas on a fire.
and don’t forget about educational debts that need to be paid off too with that inheritance, etc.
I guess my question is simpler: if Boomers entering the workforce didn’t lead to a boom in equities as the inverse occurred, why will their exit lead to a bust?
The three-decade boom in US equities markets is strongly correlated with a decline in government borrowing costs concomitant with domestic inflation. Unless someone has a working crystal ball and can accurately forecast inflation (even the Great Buffett has failed this test–numerous times–with his and his company’s cash), it remains to be seen how anyone can credibly project where inflation or, for that matter, real rates and equity valuations will be.
But even aside from this cynicism towards forecasters, why will the Boomers’ exit lead to a bust when the mirror experience did not?
I’m not so sure I agree with you that boomers didn’t greatly contribute to the booms of the past 30 years though. I think they did as it’s all about aggregate demand, spending practices, work trends, population trends, etc. Clearly the boomers were quite literally “booming.” They were the economy for the past 20 years in very large part.
When they go away whose replacing them and in what type of environment will they exist in? For me it’s less about the causal relationships and more about the synergistic effect of these variables colliding at one time/place. Will the lack of boomers “cause” a drop in the economy? I am not so sure about that. But will a drop in the economy occur? If we keep going the way we are AND the boomers fall away, then the I see the likelihood of that only increasing.
Sure there’s tons of immigrants….and how much money do you think our economy is drained of by them sending it back home regularly? And what type of job prospects can the next generation look forward to in austerity land + school loans + oligarchies all over?
I’m just saying that the boomers had almost a self-fulfilling success story. They were at the right place at the right time but they WERE that time. We need to be our time but it appears that it has been hijacked. If we subscribe to the neo-thoughts of today we’re doomed. Even Nixon said in 1973, “We’re all Keynesians now.” Without leaders like that on both sides of the aisle there will be no progress, there will be no change (for the better at least).
It’s all about aggregate demand. And now Bloomberg just gave a ridiculous stupid speech about austerity today….and the EU is talking about hyper-inflation…I mean these are insanely stupid speeches and comments to make and these people contradict and confuse themselves in their own speeches, personal life histories, and very policies they have.
As for forecasting inflation, you won’t be too far off if you just follow the Fed Funds Rate and where do you they see the rate going in the next 2 years? Yeah…nowhere. Interest rates and the “expectations fairies” all follow the FFR close enough for some pretty good estimations.
plus there was already an economic slump going on the early 70′s at that time and the boomers were only just beginning to enter the work force then…look at that equities chart in 10 years time (when the boomers are basically in their 30′s) and you see a very different picture.
I think the boomers did create the equities rally or at least were a large contributing factor since I’m not so big on “tying up” correlations like that. None the less I think the figures do speak to the bullish effect boomers brought (that’s alot of B’s!! LOL)
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