Thursday, October 30, 2008

10 year outlook for investors: U.S. dollar Inflation, Devaluation, and Structural economic changes

It's notoriously difficult to predict the future of complex systems like human societies, and betting hard-earned money on predictions is not my idea of investing. Nonetheless, long term investing requires us to have a long term view of the economy, to allow us to think through investing possibilities and to test our investment ideas. As Eisenhower is reputed to have said, "the plan is useless, but planning is essential".

So here's my thought exercise on the outlook for the future:

Outlook for 2008 to 2010
(Immediate future)

In the immediate future (2008-2010) or so, we will likely see a severe recession as the misallocation of savings invested into unproductive assets starts to work itself out. The misallocation of resources brought about by excessively cheap credit was extreme. The excessive growth in credit (reflected as M3 money supply growth) relative to GDP growth over the last decade strongly suggests this.

The fact that core inflation was low during this period of M3 growth suggests that most of this credit was used for capital asset formation (e.g. housing, machinery and equipment) and/or channeled into financial assets. Cheap imports from China may have had some impact on keeping inflation low, but imports are actually a relatively small component of the US economy, and cannot completely explain the lack of inflation in consumption goods (products and services). 

It is beginning to look like that the recent U.S. fixed capital formation was mostly in housing, and not productive assets like machinery. This could make the recession a longer and deeper one, as the U.S. economy may not have a whole lot of spare productive capacity (capital assets such as machinery) to form the foundation for economic growth. There isn't a lot of spare machinery lying around that we can just turn on when demand sentiment picks up. This can slow the recovery process because businesses will need to invest in new machinery before they can increase economic output. And they will only do if they see sustained customer demand or a general improvement in the mood of the country. This means there is an "energy barrier/step-function" to cross before the overall economy will start growing again. Without an uptick in consumer demand, businesses won't invest in capital assets. And without investments in capital assets, there is one less mechanism to get people back to work and earning income.

On the other hand, if businesses had spare machinery, it would be an easier decision to reactivate one of the idle machines and cater to minor increases in demand. The economy wouldn't have a step-function barrier to economic growth, but rather would be able to inch its way forward and slowly increase overall economic activity. While this chicken-and-egg catch-22 is an unfortunate hurdle to economic recovery, it also means that once the step-function is crossed, the economy will likely experience strong and sustained growth as economic activity lurches forward to produce both capital and consumption goods.

The sheer quantum of the misallocation of resources (manifested as credit losses) in the boom leading up to 2007 also suggest that it will take a prolonged period of time for the economy to untangle the web of work wasted on building white elephants. A large amount of claims on future work will not be honored, because the economy did not build enough productive capacity to honor these future claims. The work was wasted on creating white elephants instead, and it will take some time for economic participants to get over this and move forward. The sheer size of the problem also makes it likely that consumer demand will drop a lot in the short term, which may lead to deflation as businesses cutprices to cover their fixed costs.

Outlook for 2010 - 2020
(Long term)

In the longer term, over the next decade (2010-2020) or so, I believe there is a significant probability that we will see (1) monetary (forex and pricing) instability, (2) the general reduction (reversion to mean) in corporate profits as a % of GDP, and (3) structural changes in the factors of production.

(1) Monetary instability may come about because:
  • To combat the current credit crisis, central bankers around the world are injecting money into the banking system to counteract the destruction of money caused by the massive debt writeoffs. While some economists might argue that this merely delays the reallocation of credit to productive resources, I agree with the current approach because a reduction in money supply would cause the flow of money to freeze as banks try to bring themselves back into solvency. This would push the real economy into a depression, which could bring about a change in social and political outlook that would steer us away from free market capitalism.

    But over the longer term, this massive injection of money into the money supply base will cause a strong inflationary bias in the economy. While the Treasury was sterilizing some of the money supply injections earlier, I believe it will ultimately stop doing so, or sterilize less than the amount of money injected, to allow for a net quantitative increase in money supply. In other words, the Fed will turn on its printing press and print out money.

  • The U.S. government has huge, unfunded social security and medicare obligations to the baby boomer generation who will be retiring over the next 15 years. By some accounts, the unfunded obligations total up to 35 trillion dollars, which more than twice the GDP of the United States. The government can issue Treasury debt to fund these obligations, but the size of the government existing debt ($10 trillion) combined with the sheer size of the unfunded obligations, suggests that there simply won't be enough people to buy the debt that the Treasury will need to issue. Given the short-term focus of the political process, political expediency would likely pressure the Federal Reserve into buying this debt from the Treasury, in effect printing money for the government. This will cause further money-supply inflation, and effectively short change the beneficiaries of Social Security and Medicare.
Both these factors will cause the money supply to grow in excess of the underlying productive capacity of the U.S. economy. This will in turn, lead to a sustained depreciation of the US dollar against many other currencies. While Asian central banks will try to stem this depreciation to support their economies, which are structured to rely on exports to keep running, it is probable that they will eventually reduce their buying of US dollars as (1) it becomes politically difficult to keep buying US dollars as US inflation destroys the value of their dollar holdings, (2) this attempt to fix currency exchange rates starts importing inflation into the local economy, and (3) the continued monetary sterilization carried out to balance the sale of local currency (through selling government bonds or increasing banking reserve requirements) leads to rising local interest rates that distort the domestic economy. If central banks do not manage this process well, there is a potential for currency and monetary instability as currencies see-saw and whiplash repeatedly. 

Unfortunately, the odds are that central bankers will not be able to manage this process as they would like, because as long as political systems reward short-term results, governments in export-oriented economies will favor the central banks' continued currency intervention because it supports jobs in their export-oriented economies. The depreciation of the US dollar will be a long term trend, but there is a high probability is that it will take place in a lurching, see-saw fashion, with bursts of rapid devaluation offset by periods of appreciation or sideways movement.

The US dollar will only stop its long term depreciation when the U.S. economy's productive capacity allows it to produce excess goods, and its depreciated currency makes its goods attractive in international markets. The turning point will be reached when the US export machine starts firing up on all cylinders. Such a period of changing expectations and changes in the direction of capital flows will probably also cause volatile currency movements.

(2) Reversion to mean of Corporate Profits as % of GDP

This will happen because of the continuing economic growth of China and India. As their workforces become fully employed and linked up to the global economy, the source of cheap labor will gradually dry up. The labor surplus over the last 2 decades which depressed wages and allowed companies to earn outsized profits will go away. The result is that more of the US GDP income will accrue to labor as opposed to corporate profits.

(3) Structural Changes in the Factors of Production

The Earth's increasingly affluent consumers will put strains on the planet's capacity to supply these basic resources. If this is simply a problem of increasing supply capacity, then any jump in commodity prices will be temporary since it will induce additional investments in commodity extraction capacity.

However, if we are hitting the planet's resource limits (e.g. peak oil), then it means that each unit of resource may require more capital intensity to produce (e.g. difficult-to-extract oil located in geographically challenging areas). This would mean that higher real commodity prices may be here to stay, and it implies that we will face structural shifts in the economy as more of GDP income needs to be diverted to pay for basic resources which require more effort / technology to extract. For example, each hour of work we put in now buys less products, because more of that effort has to put into pumping hard-to-reach oil out of the ground instead of making the products we want.

This could make a whole host of products that we currently enjoy economically unfeasible to produce. This could radically alter the economic landscape. Companies which have existed since the dawn of the automotive age could go out of business as their economic models become impractical. For example, will big box stores be practical in a world where oil is ultra-expensive? For that matter, the concept of suburbia itself could be threatened as the cost of living in spread out spaces becomes prohibitive. We could return to an era of living in high-density living, like in Victorian England.

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