armageddon usa? america at the crossroads Dr Tim Morgan Global Head of Research
strategy insights | issue eight armageddon usa? america at the crossroads contents armageddon usa? america at the crossroads 5 introduction: powers of darkness 7 part one: what is the American problem? 11
economic data – pollyanna creep 13
what growth, what jobs? 18
“another day older, deeper in debt…..” 20 part two: why did this happen? 25
a failed paradigm 25
un-american activities: have competitor strategies undermined the US? 26
domestic errors – the follies of ideological extremes 28
capital sink investment: betting the house 28 part three: how should america respond? 33
strategy insights | issue eight 3 armageddon usa? | america at the crossroads
“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
4 strategy insights | issue eight 1 http://www.globaltimes.cn/NEWS/tabid/99/ID/691074/Pentagon-plan-changes-game-in-Asia.aspx armageddon usa? america at the crossroads
Commenting on President Obama’s is wrestling with the ending of a In addition to cutting waste, ditching new defence strategy, the Chinese quarter-century “credit super-cycle”. unaffordable federal programmes and newspaper Global Times lambasted the Americans have borrowed, not for owning up about un-payable pension new emphasis reportedly being placed productive investment, but to inflate and welfare promises, the United by the US on South East Asia, and the value of the nation’s housing States needs to take immediate action concluded that America “cannot stop stock. Since houses are non-earning on two fronts. At home, regulation the rise of China”. capital sinks, this process has gravely needs to be tightened to prevent the undermined the productiveness of mispricing of risk which underpinned Whilst the rise of China may be subject the economy. Capital has been poured the subprime disaster. Abroad, America to caveats, the decline of the US seems into vanity projects and property needs to get real, and get tough. undeniable. According to official price escalation whilst America’s The US needs to demand the free figures, America is mired in debt and, decaying infrastructure needs at least float of the renminbi, the elimination despite a recent modest upturn, her $2 trillion in restorative investment. of all tariff and informal trade barriers, economic trend growth is lacklustre. Where China’s brightest young people and the cessation of all technology The reality, stripped of statistical study engineering and technology appropriation. If these demands are obfuscation, is even worse than before moving into industry, America’s not met, Washington should have this. Reported federal debt excludes brightest study law before moving no compunction about threatening enormous off-balance-sheet quasi- into Wall Street. selective default and the introduction debts. The reported deficit excludes of protective tariffs. It is high time huge annual increments to these Abroad, America is the naïve victim of that the US woke up to the realities obligations. Reported gross domestic blatantly one-sided globalisation which of a one-sided globalisation process product (GDP) includes $2.3 trillion destroys American jobs whilst racking which has impoverished America and of non-cash “imputed” dollars that up ever higher levels of private and has resulted in the haemorrhaging do not really exist. Both inflation and government debt. America has bought of American jobs. unemployment are understated in the into the Ricardian logic of “comparative official numbers, and the reality may advantage” without realising that this The United States remains the world’s be that the economy has been drifting model is predicated on others playing most innovative economy, but time is for a decade. by the rules, and on assumed scope running out for infinite growth. Today, neither Why has this happened? The assumption is valid. explanations are both foreign and domestic. At home, America
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“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
2 Talking about the Federal deficit, December 2010. 6 strategy insights | issue eight http://www.bbc.co.uk/blogs/thereporters/markmardell/2010/12/simpson_slaps_washington_with.html introduction powers of darkness
Commenting on the new defence Britain and America have been tired of the bluster and the blather and strategy outlined on January 5th by described as “two countries divided the ego and the BS that has worked so Barack Obama, the Chinese newspaper by a common language”, and this is well for all of us, including me, a master Global Times lambasted the new particularly true where metaphors of it. So yes, times have changed.” emphasis reportedly being placed by are concerned. Where an Englishman the Pentagon on South East Asia. The procrastinates by “knocking the ball into Simpson was warning the committee, in newspaper argued that competition the long grass”, an American “kicks the the starkest possible terms, that between China and America was on can down the road”. the federal deficit which, at an official a scale “unprecedented in history”. It $1.4 trillion, equated to 8.9% of added that China should “strengthen its The idioms may differ, but the meanings America’s reported gross domestic 3 long-range strike capabilities and put coincide. And, be it a cricket ball or a product (GDP) in fiscal year (FY) 2010 , more deterrence on the US”. Thwarting can, procrastination is precisely what was no longer sustainable. Needless US policy on Iran might be seen as a the governments of both countries have to say, Simpson and Bowles are right. valid tactic, it suggested, concluding that been doing about their huge economic And, equally needless to say, no-one America “cannot stop the rise of China”. challenges. In Britain, 2010’s change of seems to be listening within the government has brought at least some American corridors of power. The rise of China may be subject to resolve to the issue, though time alone caveats, but the decline of the United will tell whether this resolve will prevail. Beyond political paralysis, one of the States seems undeniable. Three By contrast, American policymakers reasons for the failure to address questions need to be addressed: seem paralysed. America’s economic problems is a lack of appreciation of quite how bad • What is the American problem? This lack of action is not for want of those problems really are. Under a • Why did this happen? warning. In December 2010, former process which began in the early 1980s, Senator (R) Alan Simpson, co-chairman reporting methodologies have been How can America respond? • (with former Clinton chief-of-staff massaged to the point where the true Following the publication of the final Erskine Bowles) of the President’s scale of the economic malaise is masked report of our Project Armageddon bi-partisan committee on fiscal from most Americans. As this report analysis of the economic outlook for responsibility, did not mince his words explains, debt, the deficit, inflation Britain, it was suggested that we should when he warned the committee that and unemployment are understated, conduct a similar assessment of the the Federal deficit was a “cadaver [that] whilst both growth and absolute GDP United States. Both countries, it was will rise from the crypt” are flattered, and not to a minor but pointed out, are caught in the same to a fundamental degree. The first “This is it”, continued Sen. Simpson. “No basic high-debt, low-growth trap, and imperative for anyone who wants a more fun and games. No more smoky in neither country has government comprehensive understanding of the US mirrors. They [the American people] produced wholly credible answers to the economic and fiscal situation is to look have wised up. They’re mad. They’re gravity of the national economic malaise. behind the statistical camouflage.
3 The American fiscal year ends on 30th September strategy insights | issue eight 7 armageddon usa? | america at the crossroads
Even on the reported figures, the But America’s woes cannot be blamed whilst vanity projects have channelled situation is bad enough. Critically, the wholly, or even primarily, on others. further capital away from vital US is at the end of a quarter-century The regulatory climate in the US seems, infrastructure reconstruction. America’s “credit super-cycle” which has seen with hindsight, to have been unduly education system produces far too many aggregate debt soar to 358% of GDP, a relaxed during the latter stages of lawyers and far too few engineers, whilst level which is unprecedented in modern the credit super-cycle. The authorities the cream of the country’s young people times. Over the last decade, the US ignored the starkest possible warnings have been drawn into Wall Street and the has added $5.58 of debt for each $1 of in supinely allowing the proliferation of law rather than into more economically- expansion in GDP. To be sure, the US – instruments which no less a luminary productive sectors. unlike most other OECD countries – has than Warren Buffett had long warned made some very modest inroads into this were “weapons of financial mass Politicians have allowed America’s debt ratio, but the reduction achieved destruction”. The Federal Reserve’s once-famed capabilities in R&D to be thus far makes no significant difference default assumption, which was that undermined, and have stood by and to the overall position. regulation can be minimised because watched much of the nation’s knowledge banks can be trusted to act responsibly capital being either appropriated by The US, then, is stuck in a high-debt, in the long-term interests of their other countries or, worse still, handed low-growth economic trap. How did shareholders, was breathtakingly naïve. to them on a plate in pursuit of narrow this happen? In part, America’s woes All of this was compounded by allowing short-term gain. Much of American reflect a naïve approach to globalisation. low interest rates to drive America into a industry (exemplified by the auto- The ‘comparative advantage’ paradigm downwards monetary ratchet. makers) has followed blind alleys. which underpins economic openness assumes, first, that others play by the This report is written from a pro- And, whilst all of this has been rules, and, second, that the scope for market perspective, but we cannot but happening, America’s political leaders expansion is limitless, such that the conclude that an excessive reliance have done……well, nothing constructive growth of one country need not be at the on inadequately-regulated markets about it. George W. Bush somehow expense of another. Neither assumption has compounded many other adverse managed to believe that he could is true. China and others have not played trends in the American economy. The combine two hugely costly (and, we by the rules – after all, international build-up of debt has reflected a growing believe, mistaken) wars with tax-cuts for competition is not a parlour game consumption recklessness which the the very rich whilst not creating a fiscal – and resource constraints are now authorities have done nothing to deficit. He also presided over the build- demonstrating that the scope for global counter. Investment has been diverted up of the shadow banking system and economic growth is not infinite. into capital sinks, most notably property, the near-fatal undermining of the
8 strategy insights | issue eight capital markets, to the point where projects. There needs to be tougher done, America will watch her economic Congress had to be arm-twisted into regulation of the financial markets, power drain away. handing over $700bn of taxpayers’ including derivatives. money to bail out the banking system. Has the US the leadership, at all It is too early to judge the Obama Abroad, America needs to toughen up, levels – federal, congressional, local presidency, but the economy is flat- most notably with regard to China. and corporate – to turn around a truly lining and debt continues to escalate, America is entitled to make a lengthy dire economic situation? It can only whilst grid-locks in Congress do not list of demands and, for the time being, be hoped that it has, because the encourage us to believe that resolute remains strong enough to back these alternative is frightening. and effective action will be taken. up. America should require a free float for the renminbi, the removal of all What should that action be? First and tariff and other import barriers, and an foremost, the job of leaders is to lead. immediate and complete cessation of all The greatest single requirement now technology appropriation. is for honesty. Many of America’s fiscal promises, such as those on pensions The US has two big sticks which it can and welfare, are un-payable – certainly threaten to wield. Selective default Dr Tim Morgan without massive tax increases – and it could hit China where it hurts. China’s Global Head of Research is about time that someone admitted employment-driven pursuit of volume Tullett Prebon plc it. The current fiscal deficit is wholly maximisation over profit is critically unsustainable, which probably means dependent on free access to American that both spending cuts and tax (and other Western) consumer markets. increases are inevitable if disaster is to Protectionism could deal China’s leaders be averted. The widespread dislike of a devastating blow, and America should government, whilst understandable, not be afraid to use this as a threat in rather overlooks a pretty creditable the national interest. Since globalisation historic record on nationally-led projects, has in any case worked to the detriment from the TVA4 to victory in the Second of middle America, the US should have World War and the Apollo programme. no compunction whatsoever about There is an urgent need to channel waving a very big stick in pursuit of a investment into essential infrastructure fairer deal. For so long as this is not and away from capital-sinks and vanity
4 The Tennessee Valley Authority strategy insights | issue eight 9 armageddon usa? | america at the crossroads
“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
10 strategy insights | issue eight 5 “Numbers Racket”, Harper’s Magazine v.316, n.1896 1st May 2008 part one what is the American problem?
One of the central challenges identified Though the markets tend to focus on in American indebtedness has been in this report is that the United States federal (public) indebtedness, the real accounted for by banks, by businesses has been accumulating debts at a rate problem is very much deeper than this. and by individuals. American debt is not, which now threatens to overwhelm Over the last ten years, whilst federal then, a purely government phenomenon. the carrying capacity of the American debt has increased by $6.7 trillion (from Borrowing has become the new American economy. At all levels – federal and $3.4 trillion to $10.1 trillion), all other way of life. local government, corporations and forms of American indebtedness have individuals – debt has been added at risen by an aggregate of $17.8 trillion, No particular level of debt is, in itself, rates which have far exceeded expansion lifting the overall total from $29 trillion ‘a bad thing’. Borrowing can be a in economic output. Going forward, to $54 trillion (see fig. 1). cost-effective source of productive the fundamental problem lies less in investment, and affordable growth the absolute level of indebtedness, Within the total increase in debt in private debt can be economically frightening though it is, than in the over that ten-year period, the federal beneficial. But the escalation in US weaknesses of an economy which looks government has accounted for 27%, and borrowings has far exceeded these incapable of generating robust growth. state and local government for a further safe parameters. 7%. Almost two-thirds of the increase
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: Federal Reserve Board, Data excludes quasi-debt obligations ** 3Q 2011
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Figs. 2 and 3: America and the credit super-cycle*
US debt and GDP Total debt as % US GDP 358% $60 400% $ trn $52.6 $50 300% $40
$30 200%
$20 US total debt $14.7 100% US GDP $10
$0 0% 1980 1985 1990 1995 2000 2005 2010 1945 1950 1955 1960 1965 1970 1975 194 5 1950 195 5 196 0 1965 197 0 197 5 198 0 1985 199 0 199 5 2000 200 5 2010
* Sources of data: Bureau of Economic Analysis and Federal Reserve Board
As fig. 2 shows, total US debt has (when the ratio was driven upwards not other Western economies, the US has expanded much more rapidly than GDP, by debt escalation but by deflation and now reached the point at which further such that current debt (of $53.9 trillion) by a slump in economic output). debt escalation has become impossible equates to almost 360% of GDP ($15 to sustain. But no-one seems to have trillion). Just as importantly, it is clear We believe that the period since the worked out how to manage an economy that a decisive new trend emerged from early 1980s – in other Western countries that is not debt-propelled. the early 1980s (fig. 3). Between 1945 as well as in the US – represents a and 1980, the ratio of debt to GDP was “credit super-cycle”, an overall pattern The snags with soaring debt are three- remarkably consistent, ranging between which lurks behind, and informs, fold, and America has all three kinds of 130% and 170%. Thereafter, however, the successive bubbles in asset classes problem. First, debt can be a problem if debt ratio took off, reaching 200% of GDP ranging from equities and real estate to it out-grows the ability of the borrower’s in 1985, 250% in 1996 and 300% in 2003. commodities. The driving logic of the US income to sustain it. This has certainly The current (358%) debt-to-GDP ratio economy seems to have switched from been the case in the US. Over the same is unprecedented, exceeding even the moderation and balance to excessive ten-year period in which debt grew by levels reached in the Great Depression debt-fuelled consumption. Like many $24.5 trillion, nominal GDP increased by
12 strategy insights | issue eight $4.4 trillion. The last decade, then, has America’s borrowings have, tried not once but twice is an indication seen $5.55 of debt taken on for every $1 overwhelmingly, fallen into the of the desperate straits in which increase in economic output. As a result, unproductive, ‘non-self-liquidating’ policymakers now find themselves. total debt has risen from 275% of GDP in category. Little of America’s huge 2001 to 358% today. borrowing has gone into infrastructure One of the side-effects of the credit improvement or investment in super-cycle has been the creation of The second way in which debt escalation productive capacity. Government has a ‘monetary ratchet’ which has now can be damaging is if the extent of borrowed for purposes which have reached end-game. The monetary leverage is disguised in the balance included fighting wars and handing tax ratchet process is simple in principle sheet of the borrower. This, too, has been cuts to the very rich. Individuals have – rates are kept too low, a debt-driven the case in the United States. The official borrowed for perhaps the most futile bubble ensues, the bubble collapses, number for federal debt excludes huge purpose of all, which is to inflate the and rates are cut again to shore up the off-balance-sheet ‘quasi-debts’ such values of existing, unproductive assets, economy. Whilst the ratchet process is as commitments to future employee in this instance America’s housing stock. capable of straightforward description, pensions and to public benefits such as what no-one seems to know is what health and social security. Corporations, At the same time, America’s economy happens when the process reaches its too, are committed to enormous, has languished, growing at far lower zero-rate termination, which is where unfunded forward employee rates than those at which debt has the US (and most of the rest of the welfare commitments. expanded. The US economy is now OECD) have now arrived. doing little better than flat-lining, and The third way in which debt can pose a it is the prospect of sluggish growth economic data – pollyanna creep problem is if the proceeds are invested which threatens to crystalise excessive Taken at face value, then, America’s in unproductive ways. The jargon here indebtedness from a theoretical into a economic and fiscal problems look divides borrowings into ‘self-liquidating’ dangerously pressing problem. pretty bad. Federal debt owed to the and ‘non-self-liquidating’ debt. Borrowing public stands at $10.1 trillion, or 67% to expand a successful business is an Almost all macroeconomic levers have of reported GDP. States and local example, at the individual level, of been tried, and have failed. Given the governments owe a further $3 trillion ‘self-liquidating’ debt, which can be paid high levels of existing debt, Washington (20%), and households $13.2 trillion off using income from the expanded has no realistic scope for fiscal stimulus. (88%) within total credit market debt enterprise. Borrowing to pay for a new Interest rates have been kept at minimal which stands at $53.8 trillion, or 358% of car or a holiday, on the other hand, are levels since 2008, negating any further GDP6. Unemployment is stubbornly high, examples of ‘non-self-liquidating’ debt, ability to inject conventional monetary at a reported 8.5% of the workforce. because these do not add to the future stimulus. That “quantitative easing” (QE), Controversially, ratings agency Standard income of the borrower. which is the contemporary euphemism & Poors last year stripped the United for the printing of money, has now been States of its AAA credit rating.
6 Source: Federal Reserve Flow of Funds z1 report, 2nd quarter 2011 strategy insights | issue eight 13 armageddon usa? | america at the crossroads
14 strategy insights | issue eight After some unedifying brinkmanship then a big Social Security surplus to hide Let’s start with gross domestic product, between the White House and Congress, part of the underlying federal over- the number usually accepted as defining the federal debt ceiling was lifted just spend. Richard Nixon tried, with only the output of the economy. In 2010, the in time to stop government grinding to limited success, to peddle the concept GDP of the United States was reported a halt, but no-one has come up with a of “core inflation”, an inflationary at $14.53 trillion, a figure which most really convincing plan for curbing the measure which excluded energy and Americans probably assume consists deficit or stimulating growth. food (the very items whose prices were entirely of ‘real’ dollars which can be rising most strongly at that time). counted. This, in fact, is very far from If this was a true description of the being the case, because close to 16% situation in which America finds herself, “Owner-equivalent rent”, a concept of the reported number consists of it would be bad enough. But the reality is to be explained later, was introduced “imputations”. These imputations even worse, because the data on which under Ronald Reagan. Convoluted are dollars which do not really exist. this generally-believed snapshot is based changes to the measurement of CPI Stripped of them, GDP totalled $12.3 are very far from reliable. A process of inflation, recommended by the Boskin trillion in 2010, which automatically incremental obfuscation, stretching over Commission, were drafted under means that all debt ratios are even decades, has made official economic George H.W. Bush but implemented worse than they look. data extremely unrealistic. by the Clinton administration (and, as respected strategist Kevin Phillips The most important of these imputations We should be clear that the debauching has remarked7, there is a certain are summarised in fig. 4. The largest of US official data did not result from irony to the introduction of “hedonic single such imputation – worth over any grand conspiracy to mislead the adjustment” by the Oval Office’s $1.2 trillion in 2010 – concerns “owner- American people. Rather, it has been an ultimate hedonist). A further four equivalent rent”. If a person owns his incremental process which has taken million out-of-work Americans dropped or her home outright, no mortgage or place over more than four decades. out of the unemployment totals under rent is payable, and no money changes It also seems to have happened in a redefinition of “discouraged workers” hands in respect of the property. But the other Western countries, though only introduced in 1994. reporting methodology for American in the US is the underlying data GDP assumes that such a property has sufficiently transparent for the effects Though statistical manipulation has a utility which a purely cash-based to be quantified. been gradual, it has reached the point at measure fails to capture. Therefore, which most official economic data is now GDP contains a sum representing the In the early 1960s, JFK tampered with very misleading. The analyst who wishes rent which the owner would have paid unemployment numbers to exclude to understand what is really going (presumably to himself) if he had not “discouraged workers”. The Johnson on in America needs to unwind these owned the property. Interest expense is administration introduced the “unified distortions. The results are disturbing. backed out, but the net result remains a budget”, which incorporated what was major (and non-cash) uplift to GDP.
7 See “Numbers Racket”, Kevin Phillips, op cit. strategy insights | issue eight 15 armageddon usa? | america at the crossroads
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: Bureau of Economic Analysis
The replacement of actual expenditure accounts) which are provided free of the generally-accepted number for with a notional (‘imputed’) rent applies charge by banks are treated similarly. US economic output. Moreover, non- not just to that minority of Americans Here, the 2010 imputation (of $501 existent (imputed) dollars obviously who own their homes outright, but also billion) reflects what the cost to the cannot be taxed, which means that to the many millions with mortgages. customer would have been if the bank imputations make the American For example, a person with 50% equity had charged him or her for services incidence of taxation look a great deal in his home is assumed to pay rent on which, in reality, were provided free. smaller than it really is. 100% of it rather than, as is actually the case, mortgage interest on half of it. There is a legitimate debate about Serious though it is, the imputations the ‘production boundary’, which distortion of GDP is a pretty minor The second-largest imputation concerns refers to the inclusion, or otherwise, matter compared to the debauching employee benefits (principally medical of services provided free of charge, a of inflation data over the last three insurance, but also items such as good example being care provided to decades. Imputations, used to increase meals and accommodation) which are children, to the elderly and to the infirm reported economic output, also have a provided to workers either freely or on a by family members. But the sheer scale significant impact on reported inflation, subsidised basis. A sum of $594 billion at which “imputations” are now used because they edge out real rates of was imputed in this category in 2010. in the compilation of American GDP increase in the cost of housing. Financial services (for example, checking surely introduces grave distortions into
16 strategy insights | issue eight The biggest single distortion of ongoing for two decades. An imported reach into every aspect of economic life. official inflation data results from the airbrush might be a great deal cheaper The significance of distorted inflation application of “hedonic adjustment”. The than one made in America but, if the reporting has impacts on: aim of hedonic adjustment is to capture imported item is of lower quality, is this improvements in product quality. The factored in to the equation? • Americans’ cost of living, and introduction of, say, a better quality the purchasing power of the screen might lead the Bureau of Labor A second area of adjustment to inflation dollar over time. Statistics (BLS) to deem the price of a concerns ‘substitution’. If the price of • Wage rates and settlements. television to have fallen even though the steak rises appreciably, ‘substitution’ assumes that the customer will price ticket in the store has remained the • Benefit levels, and the cost of social purchase, say, chicken instead. As with same, or has risen. The improvement in payments to government. the quality of the product is equivalent, imputations, the use of substitution BLS statisticians argue, to a reduction in breaks the link with actual prices (a • Economic growth. price, because the customer is getting process exacerbated by ‘geometric Real interest rates. more for his money. weighting’), but it also turns the index • from a calibration of the cost of living to According to official figures, aggregate One problem with hedonic adjustment a measurement of the price of survival. inflation between 2001 and 2011 was is that it breaks the link between 27%, meaning that the dollar lost 21% inflation indices and the actual (in-the- Since the process of adjustment began of its purchasing power over that period. store) prices of the measured goods. in the early 1980s, the officially-reported But, if we accept that real inflation may Another is that hedonic adjustment is CPI-U number has diverged ever further have exceeded the official number by subjective, and seems to incorporate from the underlying figure calculated 6% in each of those years, the loss of only improvements in product quality, on the traditional methodology. Some dollar purchasing power was about 55% not offsetting deteriorations. A new of those who have researched the issues between 2001 and 2011. Between the telephone might, for example, offer of hedonic adjustment, geometric third quarters of 2001 and 2011, average improved functionality (a hedonic weighting and substitution reckon weekly wages increased by 31%, fine positive), but it might also have a that these methodologies now strip if the dollar lost 21% of its purchasing shorter life (a hedonic negative) and, out at least six percentage points from power over that period but evidence of critics allege, the official statisticians are inflation calculated on the traditional very severe impoverishment if the dollar all too likely to incorporate the former basis. On this basis, true inflation might in 2011 was worth only 45% of its 2001 whilst ignoring the latter. be at least 9%, rather than the 3.4% reported in December. value. In short, if millions of Americans The failure to incorporate hedonic feel poorer now than they did ten years negatives is particularly pertinent where If critics are right – and we are convinced ago, the probable explanation for this is home-produced goods are replaced that they are – then the implications are that they are. by imports, a process which has been enormous, because inflation calculations
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By the same token, those Americans in of the way in which inflation numbers reliable. First, the reported GDP number receipt of index-related pensions and had been subjected to incremental (of $14.5 trillion in 2010) is highly benefits, too, have seen the real value of distortion, their everyday experience questionable, because it includes non- their incomes decline as a result of the may very well have led them to act on a cash “imputations” totalling $2.3 trillion. severe (and cumulative) understatement gut instinct that borrowing was cheap. Second, and much more seriously, of inflation. This process, of course, has since the way in which official inflation saved the government vast sums in We believe that misreported inflation, is calculated is open to very serious benefit payments. Rebasing payments together with irresponsible interest rate question, so, too, is the GDP deflator, for the understatement of inflation policies and woefully lax regulation, the adjustment which is employed to suggests that the Social Security system may have been a major contributor to back out the effects of inflation from alone would have imploded many years the reckless wave of borrowing which so changes in the nominal monetary value ago had payments matched underlying distorted the US economy in the decade of economic output. Ritual claims that rather than reported inflation. prior to the financial crisis. Indeed, the deflator is worked out by comparing understated inflation may have been simple chained volumetric (that is, non- In other words, the use of ‘real’ inflation the smoking gun where the flood of monetary) measurement of GDP should data would have overwhelmed the cheap money was concerned. not be taken too seriously, because the federal budget completely. what growth, what jobs? reality is that it is impossible entirely to de-link the GDP deflator from other Another implication of distorted inflation, Understated inflation, then, has measures of inflation. an implication that may have played a depressed wage growth, impoverished hugely important role in the creation those in receipt of benefits, masked the Once adjustment is made for the of America’s debt bubble, is that real decline in the purchasing power of the distortion of inflation, the evolution of interest rates may have been negative dollar, and very probably contributed to American real GDP over the last decade ever since the mid-1990s. Taking 2007 a reckless monetary policy which has presents a gravely disturbing picture. as an example, average nominal bond mired the United States in excessive Adjusting reported growth downwards 8 rates of 4.6% equated to a real rate of debt. But it may also have resulted in to reflect the understatement of 1.8% after the deduction of official CPI-U economic growth being reported when, inflation suggests that the United States inflation (2.9%), but were heavily (4.2%) in reality, the American economy has has been in almost permanent recession negative in real terms if adjustment is really been shrinking, not growing. for ten years, with real GDP falling year made on the basis of +6%-underlying after year, and declining very materially inflation (of 8.9%) instead. According to official figures, the GDP since 2001. of the United States increased by 18%, Logically, it makes perfect sense to in real terms, between 2001 and 2011. This picture of economic deterioration is borrow if the cost of borrowing is lower But such numbers, of course, are a reflected in the unemployment statistics than the rate of inflation. Whilst most function of two calculations which, as or, rather, it would be, if these were Americans may not have been aware we have seen, are not in themselves
8 Annual average interest rate for 10-year Treasuries. Source: 18 strategy insights | issue eight Economic Report of the President, 2011 datasets not so heavily massaged by reporting methodologies. The official (U-3) number, currently 8.4%, excludes the millions of unemployed Americans who are defined as “discouraged workers”.
If these people were included, together with other “marginally attached” workers, and those who are in part-time work because they cannot find full-time employment, the BLS itself concedes (on its broader U-6 measure) that the unemployment rate would be over 15%. Analysts who have unpicked all of the various methodological changes (including alterations to sampling techniques) argue that the real rate of unemployment is even higher.
In the face of persistently high levels of unemployment (even on the basis of the understated U-3 definition), Americans have been asked to believe in the concept of “jobless growth” as a way of reconciling weak job data on the one hand with reported growth in GDP on the other. The real explanation is simpler. It is that most of the economic growth of the last decade has been illusory.
strategy insights | issue eight 19 armageddon usa? | america at the crossroads
The explanations for negative growth, combined with high unemployment, are not particularly difficult to ascertain. First, America’s acceptance of one-sided globalisation has seen American jobs transferred to lower-cost labour pools in the emerging economies, a point so obvious that it is remarkable that anyone even tries to deny it.
Second, related structural change has seen the increasing displacement of labour-intensive industries (such as manufacturing) with activities which, intrinsically, have very low labour intensity.
“another day older, deeper in debt…..” The statistical manipulation which has distorted GDP, growth, inflation and unemployment has implications, too, for federal debt and the deficit, both of which are much worse than they at first sight appear. The main reason for this is that the American government has taken on huge quasi-debt commitments, most of which are excluded from the federal balance sheet (though it is to the credit of the US that transparency over this issue is far better than it is in Britain, let alone in the Eurozone).
At the end of FY (fiscal year) 2010, official statistics showed debt “owed to the public” – that is, excluding debt held
20 strategy insights | issue eight by other departments of government During FY 2010, the outstanding Obama healthcare system is assumed – at $9,060bn, a figure which in itself Medicare commitment was reduced to eliminate major forward Medicare reveals a huge increase over four by about $15 trillion, reflecting the liabilities. This number, of course, is years, since the equivalent figure was assumption that the Obama healthcare net of the assets held by OASDI and $4,868bn at the end of FY 2006. Federal package will result in a very material Medicare, comprising federal debt of Reserve data shows that debt owed to reduction in future claims on Medicare. $4.6 trillion which OASDI, at least, is the public has risen still further, now Whilst this is true, it is somewhat likely to start drawing upon in the near exceeding $10 trillion. But the reported disingenuous, in that the funding future (some estimates suggest as soon numbers exclude two very material for healthcare will still need to be as FY 2013). It also excludes forward lines of quasi-debt. The first of these, sourced from taxpayers, such that the pension and welfare commitments to included in the official balance sheet, is a future financial obligation has been federal employees. $5,720bn commitment to pay pensions shifted further off-balance-sheet, not to government employees. The second is eliminated altogether. Taken in aggregate, then, federal debt a $4,577bn pool of federal debt owed to and quasi-debt can be put realistically other parts of government. What, then, is the true level of federal at $53.3 trillion, comprising debt owed government debt and quasi-debt? to the public ($9.1 trillion), debt held The significance of the latter number Inclusion of the entire off-balance-sheet by other government agencies ($4.6 is that it forms the principal asset liabilities associated with OASDI and trillion), pension commitments to of the Social Security and Medicare Medicare would be excessive, because employees ($5.7 trillion) and the 30-year systems, both of which have liabilities these sums are calculated on the basis portion of net quasi-debt commitments which far exceed their accumulated of liabilities stretching out 75 years ($34 trillion)9. assets. At the end of FY 2009, net into the future. Few governments liabilities were stated at $52.2 trillion (or other institutions) measure their Based on the official number for 2010 in respect of closed system claimants, commitments that far ahead. economic output ($14.5 trillion), this a figure which is offset by $6.3 trillion estimate of federal debt and quasi-debt which, it is assumed, will be the net If we apply standard net present value equates to 367% of GDP. If we strip out positive contribution of future scheme (NPV) techniques to the official net the non-cash “imputations” component participants. Within the $52.2 trillion liabilities for FY 2009 but limit the of GDP ($2.3 trillion), the federal debt FY 2009 figure, $33.5 trillion was capture to 30 rather than 75 years, the and quasi-debt ratio rises to 435%. Both attributable to Medicare and $18.6 quasi-debt total for closed scheme numbers exclude private, corporate, trillion to OASDI (old age, survivors and participants declines from the reported bank and state debt, which total either disability insurance), with the balance $52 trillion to $41 trillion. This number 300% of GDP or 356%, depending upon relating to railroad pensions ($140bn) falls further, to $34 trillion, based on whether the imputed component of GDP and black lung provisions ($6bn). the FY 2010 computation in which the is left in or excluded.
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 strategy insights | issue eight 21 • 30-year portion of net quasi-debt commitments: $33,977bn Total: $53,334bn armageddon usa? | america at the crossroads
We should be clear that off-balance- local government debt of $44 trillion, federal credit rating, which last year sheet liabilities are not the same thing could be used by America’s critics to (and controversially, though surely as debts. Congress could eliminate demonstrate that the United States realistically) was downgraded from future liabilities by a simple legislative is bankrupt. Any such inference, if not triple-A by S&P. The second is the initiative. But is Congress likely at any fundamentally mistaken, most certainly reserve status of the dollar which, point to admit that future benefits would be premature. America may be again, is beginning to look increasingly promised to the public cannot be technically insolvent (in the sense that anomalous. But the third – and by far paid? We do not envisage that this will her collective liabilities far exceed any the most worrying – dimension of happen any time soon. remotely realistic calculation of the net America’s parlous fiscal and economic present equivalent of future income state is the severity of economic Just as an assessment of federal off- streams), but she is not illiquid. The underperformance. balance-sheet commitments produces bulk of America’s obligations are quasi- debt ratios large enough to scare small debts owed to the American people, Accordingly, as we turn to an monkeys, much the same can be said which essentially means that forward assessment of quite how America of the federal deficit. This number welfare and pension commitments got into her current parlous condition, was reported at $1.29 trillion in FY cannot be honoured (though few the primary focus must be on the 2010, equivalent to 8.9% of official politicians are likely to admit this). In causes of the fundamental GDP. But annual increases in quasi- the nearer-term, the blue-chip rating of weakening of the US economy. debt commitments are running at an American government paper, reinforced underlying rate of about $2.1 trillion, by the reserve status of the US dollar, meaning that the real deficit is arguably means that Washington can continue $3.4 trillion, equivalent to 23% of official to live beyond America’s means for GDP, or 28% if imputations are excluded some years yet. from the GDP denominator. There are three chinks in America’s An underlying federal debt and armour which investors need to quasi-debt total of some $53 trillion, watch. The first of these is the on top of private, bank, state and
22 strategy insights | issue eight strategy insights | issue eight 23 armageddon usa? | america at the crossroads
“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
24 strategy insights | issue eight 10 Bloomberg, June 16, 2010 part two why did this happen?
As we have seen, then, the economic The Western (and, in particular, the economist David Ricardo (1772-1823), and fiscal status of the United States American) economic system has become the comparative advantage model lies somewhere between bad (if you chronically debt- and bubble-prone. argues that everyone becomes better believe the official data) and horrendous Consumption has been favoured over off if each country specialises in those (if, like us, you do not). This is not, or investment, and, within the investment activities at which it enjoys the greatest at any rate not yet, cause for despair. pool itself, capital has been disastrously comparative advantage. If the logic of America remains not just the world’s misallocated, with funds being steered this model is accepted, it is natural that largest economy but also its most not into productive uses but into America should cede manufacturing to technologically-innovative. vanity projects and, worst of all, into lower-cost competitors such as China, the inflation of the value of existing, concentrating instead on higher-added- But, to paraphrase Sen. Simpson, this is unproductive assets. value sectors such as technology and the end of the line. The United States financial services. The Ricardian model needs to conduct a thorough and Just as importantly, America needs to assumes that such specialisation forthright appraisal of its economic wake up to the reality of competition enriches everyone because it maximises weaknesses, and to take urgent remedial from emerging countries, most notably the efficiency of the global economic action. Failure to do so would be a China. The long-standing economic system. Geopolitically, the economic recipe for absolute as well as relative assumption of ‘comparative advantage’ interdependency of nations is also economic decline and, sooner or later, has led the US, and the West in assumed to make the world more secure. for a full-blown debt disaster. general, into an acceptance of a form of globalisation that has worked to its On paper, the logic of this argument Our analysis suggests that there are grave disadvantage. seems compelling. In reality, however, four principal economic problems which Ricardian comparative advantage confront the US: The economic model has failed, both makes two basic assumptions, both of at home and abroad. How has it failed? which are fundamentally flawed. First, 1. Faulty capital markets, compounded And why? it assumes that everyone plays by the by weak regulation. a failed paradigm rules, which manifestly has not been the 2. An excessive emphasis on case in recent times. Second, it assumes Essentially, the US, and the West consumption over investment. infinite scope for growth, so that the more generally, have, certainly since economic success of one country is not 3. Grave misallocation of capital. the collapse of the Soviet Union and achieved at the expense of another. arguably since the end of the Second In a world which is beginning to butt 4. Blithe acceptance of a form of World War, operated a variant of the up against resource constraints, the globalisation which works to the free-market system based on the ‘infinite growth capability’ assumption detriment of America. Ricardian assumption of ‘comparative isn’t true, either. advantage’. Associated with the British
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The US has followed a Ricardian Fundamentally, China realises that Furthermore, China is engaged in the model since the Bretton Woods she is in a competitive situation. wholesale appropriation of American conference which established the America does not. and other Western technologies – often post-War economic settlement. The with Western connivance. dollar, then pegged to gold, became un-american activities: the global reserve currency within have competitor strategies China is often accused, probably an assumed preference for free trade undermined the US? rightly, of using cyber-espionage, but and the unrestricted movement of China, and other emerging countries, we need to be clear that international capital. Essentially, Bretton Woods tied operate a radically different economic competition is not a parlour-game for the global financial system to a gold model from that accepted in the children organised under playground standard via the dollar. In 1971, Richard US. In contrast to the negligently- rules. China is entitled to pursue Nixon famously “slammed the gold regulated variant of capitalism that what she regards as the policies most window”, ending gold convertibility did more than anything else to lead advantageous to her own interests. (though the dollar remained the reserve America, Britain, Ireland, Iceland and The real question has to be why currency). Latterly, after the collapse of others into financial disaster, China’s America, and the West more generally, the Soviet Union, the US led the West version of capitalism is a state-directed have failed to react. into the acceptance of a globalised free hybrid, aimed at maximising national In any case, the transfer of American trade model in which US, European and advantage rather than the income of technology to China and other emerging Japanese markets were almost wholly individual corporations. China has kept countries has been at least as much open to trade and investment from the renminbi at an artificially-depressed the result of home-grown negligence emerging countries. level in order both to boost exports and as of competitor strategy. Lured by to deter imports. China also operates market size and cheap labour, American Over the last twenty years, this blatant tariff and informal barriers companies have all too often entered model has worked to America’s grave against manufactured imports. disadvantage, because one of the two into inward investment agreements Ricardian assumptions – free and fair Where American businesses are with technology transfer strings. competition – has been abrogated, profit-maximisers, China’s main aim Though, at least in the short term, these most conspicuously (though by no is volume-maximising, the objective deals can be beneficial to companies means only) by China. With the second being to boost levels of employment, themselves, they have been extremely assumption – unlimited scope for not corporate profitability. Logically, a harmful to the overall competitive growth – now about to prove unfounded volume-maximiser will always out- position of the United States. This as well because of resource constraints, compete a profit-maximiser, particularly underlines the point that Western short- the continuation of unfettered, one- where wage costs are low and the terms sightedness has played as much of a role sided globalisation can only exacerbate of trade are distorted. as competitor behaviour in undermining America’s economic problems. Western economic interests.
26 strategy insights | issue eight By lending huge sums to the US, China has funded, and thereby encouraged, excessive consumption and the misallocation of capital in the US, whilst at the same time exerting an ever tighter grip as America’s creditor-in- chief. But it is the US which has allowed this to happen.
As the Chinese economy has grown, and as global resource constraints have emerged across a range of commodities including energy, minerals, food and water, China and other emerging countries have engaged in a policy of using their huge dollar reserves to buy up resources across the globe, often co-operating with regimes regarded as distasteful in the West. The recent commissioning of China’s first aircraft carrier is highly symbolic, indicating that China intends to develop the global military reach required to defend its commercial interests11.
Blithe acceptance of this one-sided form of globalisation has harmed America in many ways. First, of course, it has made possible the huge build-up of debt, and has encouraged a tendency towards capital misallocation which was already implicit in the American financial system.
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. strategy insights | issue eight 27 armageddon usa? | america at the crossroads
Second, it has contributed both to ever- The root cause of so much of America’s leverage and by failures of oversight, it widening income inequalities in the US, failings has been blind reliance on the is gravely disturbing that the regulators and to stubbornly high (though under- assumption that market forces are were asleep at the wheel during the reported) unemployment. always benign. Under Alan Greenspan, creation of what was almost certainly the Fed assumed that banks would the worst bubble in financial history. Third, it would not be too much to behave responsibly simply because state that one-sided globalisation has it is in the best interests of their Where folly is concerned, the hollowed out the American economy, shareholders that they do so. This proliferation of subprime lending is in a stripping the US of many of its former was breathtakingly naive, not least class of its own. It almost beggars belief staple industries. because it ignored “the divorce between that regulators could allow an appetite ownership and control” which means for mispriced risk to spread to the point domestic errors – the follies of where mortgages could be pedalled to ideological extremes that banks (and corporations more generally) are run by their managers, those who were both too poor to afford It would be all too easy for policymakers not by their largely passive owners. A them and too unsophisticated to resist to attribute America’s economic woes to preference for risk is in-built, particularly the blandishments of bonus-motivated unfair competition from China and other in a banking sector where a government salesmen. Far from regulating this low-cost economies, and to leave it at back-stop was always implicit and has, distortion of the system, government that. But this would be a fundamentally since 2008, become explicit as well. actually exacerbated it, not least by mistaken stance, because it would mean Interest rates were kept far too low for forcing lenders to direct more than overlooking the fact that the economic far too long, even when there existed half of all new mortgages at those decline of the US owes at least as much unmistakable evidence of an asset on low incomes. to mistakes at home as to foreign (property) bubble. Trends over the last competitor behaviour. capital sink investment: decade and more amount to a grave betting the house mispricing of risk. As we have been at pains to explain In part, the subprime crisis reflected in several previous reports, economic Additionally, a specific mistake has a long-standing, misplaced obsession outcomes result from decisions, not been stirred into the mix. This was with spreading home ownership. from the vagaries of a capricious the failure of regulators to prevent This obsession had long entered the economic deity. The current weaknesses both the emergence of the shadow American psyche, and perhaps nothing in the American economy result from banking system and the proliferation of symbolises this state of mind more a multiplicity of failed decisions. dangerous instruments which no less a than the 1946 Jimmy Stewart movie Investment has been wasteful, both luminary than Warren Buffett had called It’s A Wonderful Life, in which S&L boss the financial system and structure “weapons of financial mass destruction” George Bailey (Stewart) is lauded for of corporate governance are faulty, as long ago as 2003. Bearing in mind the his motivating desire to help Americans regulation has been negligent, and way in which Enron (and others) were get on to the property ladder. Politicians political leadership has all too often brought down by off-balance-sheet of both parties have long argued that been wanting.
28 strategy insights | issue eight home ownership is a social good, and is the economics of the mad-house. vanity projects rather than into essential have backstopped the mortgage system There is nothing implicitly wrong with investment. According to various expert with federal guarantees. borrowing, particularly if the borrowed studies, the level of investment required funds are invested productively. Also, to restore America’s infrastructure to a From a strictly pragmatic perspective, borrowing for consumption can, within safe and competitive condition is well governments should cultivate low rather reason, boost economic activity and help in excess of $2 trillion. Little has been than high property values. Low prices create jobs. But, tragically, this is not done despite the tragic 2007 collapse of would enable young people to find what America has been doing over the the I-35W bridge over the Mississippi, in homes, would preclude the creation of last decade and more. Borrowed capital which thirteen people died. damaging bubbles, would drive middle has been put into asset value escalation, class Americans into greater investment not into productive investment, whilst New York, for example, has its share of diversity and, most important of borrowed consumption has created jobs ageing power supply systems, roads all, would liberate capital for more in Shanghai, not in Schenectady. and bridges, and has no real idea about productive investment. how to pay for replacements, yet, within The high proportion of Americans’ the last decade, has found $2.5 billion From a fixation with home ownership it wealth which is invested in property to build new stadia for its principal is just a short step to a belief that rising poses a major social and economic sports teams (the Mets, the Jets and the house prices are positive for society. In risk going forward, because of the Giants12). The tragedy of New Orleans fact, this is very far from being the case, ongoing retirement of the baby boom in part reflected a failure to invest in for at least four reasons. First, of course, generation. The first boomers have now improving the levees built by earlier rising property values can price young reached the age of 66, whilst even the generations to protect the city from people out of access to homes, and can youngest will reach retirement over the devastating floods of the type tragically impair labour mobility. Second, rising coming twenty years. Millions of these unleashed by Hurricane Katrina in 2005. property values can, and often have, people expect to rely for their security created speculative bubbles. Third, in old age on monetising their assets, If America has grave problems with middle class Americans have tended but no-one has explained quite how capital allocation, it has equally increasingly to have their assets over- this is supposed to happen when the significant problems with its labour allocated to the housing sector. Fourth, following generation is not only fewer pool. Both the president and the and worst of all from an economic in number but individually poorer. This prime minister of China are graduate perspective, houses are capital sinks, argues for a further secular downtrend engineers, whereas Barack Obama is a which absorb investment without in property prices, undercutting millions lawyer. American colleges produce 41 generating a return. of Americans’ assumed ability to enjoy a law graduates for every engineer. Each good quality of life in retirement. year, the brightest young Americans are In other words, tying up capital in lured into careers in investment banking property reduces national productivity. Even where the limited pool of non- and the law, rather than into activities Borrowing to do this is folly, and housing investment is concerned, funds such as technology and manufacturing. borrowing from abroad for this purpose have all too often been channelled into
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. strategy insights | issue eight 29 armageddon usa? | america at the crossroads
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, table B-12, and Kevin Phillips, Bad Money, 2009 edition, page 31
These trends are reflected in the paper became more important than Of course, financial services play a growing financialization of the productive activities, putting the country hugely important role in the economy, American economy, by which is meant into inexorable decline. Much the same and markets are by far the best the increasing shift from productive happened when international financing mechanism for the effective allocation activities (such as manufacturing) into activities displaced industry and trade in of capital. But Americans may be right to the essentially unproductive activity of nineteenth century Britain. wonder whether an appropriate balance simply moving money around. has been lost when the financial sector Is this ‘end of era’ process now taking becomes almost twice as large as the This process of ‘financialization’ is an place in America? It certainly seems that manufacturing industry which propelled established end-of-era phenomenon, way. As fig. 5 shows, manufacturing has America to global economic and political and was associated with the latter declined from 29% of GDP in 1950 to pre-eminence. The solution, of course, is days of global supremacy in Spain, the just 11% in 2009, whilst the banking, not to downsize financial services, but to Netherlands and Great Britain. In Spain, real estate and insurance sectors’ share support other parts of the economy. the accumulation and movement of has increased from 11% to 22% over the New World bullion and of government same period.
30 strategy insights | issue eight strategy insights | issue eight 31 armageddon usa? | america at the crossroads
“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
32 strategy insights | issue eight 13 Farewell Address to the Nation, 17th January 1961 part three how should america respond?
Unless radical and timely changes are cohesion are products of balance and had in mind was “the military-industrial implemented, historians of the future of responsibility, and that checks-and- complex”. He would have shown more are likely to regard the 2008 banking balances are imperative. Capitalism is prescience if he had he warned instead crisis as a decisive tipping-point, the the most potent wealth-generating about a “finance-industrial complex”. moment at which America lost her long- system ever created, and free markets Just as lax corporate regulation led to the standing global primacy as economic can alone deliver the optimum Enron and WorldCom scandals, excessive power lurched dramatically from a allocation of capital. But a completely deregulation of the banking system complacent West to a brashly confident unfettered free market system can also led directly to the financial catastrophe East. If America does indeed surrender produce distortions and anomalies, which erupted in 2008 and which, in our the economic power upon which all not just in the distribution of economic view, has yet to reach a final denouement other forms of global influence are rewards but also in structures and in which now may be imminent. based, those same future historians strategic directions. are likely to include a failed economic America’s single most pressing domestic model, failed financial regulation, At the institutional level, America’s need is to restore the balance between failed corporate structures and, above founding fathers incorporated their probity and innovation in its banking all, a failure of leadership amongst recognition of the need for checks-and- system. The essential problem has been the factors which allowed America’s balances into the Constitution of the a disastrous mispricing of risk. It was primacy to go by default. United States, which established the surely obvious from the outset that critical separation of power between regulators’ failure even to notice, let Thus far in this report, we have the executive, the legislature and alone to prevent, the weakening of the addressed two key issues. First, we have the judiciary. Bond markets operate link between lender and borrower would sought to look behind the statistical as a financially-equivalent balancing have catastrophic consequences. camouflage to reveal quite how dire mechanism, checking the wilder America’s economic and fiscal problems irresponsibility of governments. Historically, mortgage lenders exercised really are. Second, we have explained But internal economic and financial caution because eventual repayment the key weaknesses which have led balancing mechanisms are necessary depended upon the viability of the America into its current parlous state. too, and a lack of such balance has been borrower. Over the last fifteen years Here, we conclude by setting out some the single most damaging factor in the or so, this all-important link has been of those measures which, we believe, weakening of the American economy. allowed to weaken, enabling lenders can reverse the adverse trends which The objective now should be to restore to issue mortgages in the comforting have been undermining the United balance and direction to the American knowledge that, if the borrower failed States for at least two decades. economic system. to meet his commitments, someone else would bear the loss. This distortion No analysis such as this is written from When Dwight D. Eisenhower warned of the relationship between lender and a position of perfect neutrality. The Americans about “the disastrous rise borrower led not just to the mispricing view taken here is that prosperity and of misplaced power”, the threat that he but to the reverse pricing of risk, such
strategy insights | issue eight 33 armageddon usa? | america at the crossroads
that lending to the riskiest borrowers with them. Though simple in principle, countries, an America lulled into became a high-returns process because tighter regulation would need to be complacency by post-War prosperity risk could be unloaded. This process implemented in the teeth of formidably- got into the habit of making forward ran its wholly predictable course in the funded opposition. promises to its citizens which, it is now subprime disaster. In the future, far clear, cannot be honoured. It is about greater transparency is imperative. A key In this context, the contempt in which time that someone admitted this. recommendation of this report is that government (irrespective of party) is America also needs to cut bureaucracy, the securitization of mortgages should held by Americans is both remarkable eliminate wasteful programmes and be subjected to tighter regulation. and disturbing. After all, the government contemplate tax increases in order to of the United States implemented such bring its budget back into balance. America also needs to address issues far-reaching initiatives as the Tennessee of financialization by encouraging Valley Authority, won the Second World The triple-A question now is whether industries, such as manufacturing, War, and put Neil Armstrong and Buzz America has the leadership which will which increasingly have been Aldrin on the moon. But America seems enable this to happen. outsourced to cheaper competitors. The now to have lost almost all belief in free functioning of the market system is national, collective action. America’s America’s friends must hope an economic imperative, but something leaders need, as a matter of urgency, to that she has. has become misbalanced when the gain greater credibility by putting the manufacturing sector has dwindled to interests of the country above their own barely half the size of financial services. partisan ambitions. Neither sixteenth-century Spain nor nineteenth-century Britain learned America can afford to get tough, this critical lesson, and the economies because China’s stability depends of both were undermined when they entirely upon the creation and Dr Tim Morgan became dominated by rentiers rather maintenance of hundreds of millions of Global Head of Research than by entrepreneurs and producers. jobs, and this has been accomplished all Tullett Prebon plc too often at the expense of businesses Curbing the excesses of the banking and jobs in America. system will, of course, require concerted action by government, and Just as America’s government needs it is imperative in this context that to get tough abroad, it needs to get America’s leaders take the electorate truthful at home. Like other Western
34 strategy insights | issue eight strategy insights | issue eight 35 Tullett Prebon Group Ltd 155 Bishopsgate London EC2M 3TQ Tel: +44 (0)20 7200 7000 Fax: +44 (0)20 7200 7176 www.tullettprebon.com
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For more information please go to: www.tullettprebon.com about the author
Tim Morgan read history and political Between 1995 and 2006, Tim was Whilst retaining a keen interest in philosophy at Emmanuel College, consultant energy analyst at Collins energy, his current research focus is Cambridge before joining stockbrokers Stewart, a stockbroking firm which on the implications of an accelerating Wood Mackenzie as a trainee in 1982. achieved rapid growth on a platform of process of change in the global economy. He moved to Montagu Loebl Stanley research originality and technological He believes that this process is exposing the following year, shortly thereafter excellence. He joined Shore Capital a series of major economic, financial assuming responsibility for the firm’s oil Group, again as a consultant energy and political imbalances, and that it and gas research. analyst, in May 2007, but, in February is imperative that financial market 2009, was invited to formalise a role that participants be keenly aware of the In 1985, he joined the stockbrokers WI he had been carrying out for some time – structural implications of this process. Carr, which became part of Banque that of economic and market strategist. Indosuez in 1986. After a short period Tim’s extra-curricular interests focus on with a boutique broker, he established In this role, he attracted considerable defence issues, the environment, music an energy sector research consultancy notice for a report in which he and community involvement. He has in 1990. During the 1980s, he had warned that a decade of economic a particular interest in warships, has made two important decisions. First, mismanagement had taken Britain to published a book on the subject, and has that the prevalent earnings-based the brink of a “debt vortex”. This built relished time spent at sea with the Royal investment analysis was out-dated, and upon an earlier report which contended Navy, believing that few experiences can that the emphasis of research needed that recent UK economic growth had equal taking off from an aircraft carrier to shift to cash-based measurement been largely illusory, being based upon or participating in amphibious exercises of shareholder value creation. The debt escalation and the understatement with the Royal Marine Commandos. second was that single-country research of inflation. He also pioneered the three- was inappropriate in an increasingly part Matrix™ approach to investing in globalised economy. These decisions led periods of high systemic risk. him to develop the value-based VVM™ analysis system.
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TPSI 008 | February 2012