The Great Transformation
By Carl Steidtmann; Illustration By Tim Bower
The global economy is in the midst of a great transformation.
There is not a country, an industry, a company or an individual who will not be affected in some manner. On the global stage, the loss of the American consumer as the spender of last resort has pitched countries like Taiwan and Japan — which have thrived on exports to the United States — into deep recessions. While the short-term pain for exporters to the United States is severe, the realignment of both capital and trade flows that will come about as a result of this process will produce a global economy that is both more stable and more sustainable.
The global economy of the coming recovery may well look very different from the global economy of the last expansion. Every business cycle leaves its mark on both the nature of business and the role of government in the economy. Not since the 1930s have we seen the government policy response to a recession as transformative as the response by the U.S. government to the current recession. Going forward, the U.S. government is going to have a much larger role with the issues of governance, green economics, energy and transparency taking center stage.
Applying Stein’s Law: Eight Trends that Could Not Go on Forever
If something cannot go on forever, it will stop.
- Herbert Stein, Chairman of the Council of Economic Advisors, 1972-74
Herb Stein was a well respected economist who could coin a clever phrase. The transformation underway in the global economy is a broad application of Stein’s Law. It is the reversal of trends that simply could not go any farther. Some of these trend reversals are more obvious than others. All of them were in one way or another an important part of the fabric of the U.S. economy. Their reversal will create a real but very different economy in the future.
1. Debt Levels Can Not Grow to the Sky
If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.
—J Paul Getty
Debt in the United States reached levels in recent years that were simply not sustainable. The process of debt reduction has begun to take hold. Mortgage debt has declined sharply as foreclosures rise and the issuance of new debt slows. The reduction in debt is going to accelerate as the write-offs taken by the banks works thier way through the financial system.
Going forward, the banks have significantly tightened their lending standards. Lines of credit for everything from credit cards to commercial and industrial loans have been reduced. The cost of debt for both businesses and households will be greater even as the availability and terms of new debt will be much more stringent.
- The growth of the financial services industry over the past decade has been dependent on the massive expansion of business and household debt. The contraction of that debt is one of the factors that suggests a smaller financial services sector that is less profitable and has less ability to attract the kind of talent it has in the past.
- A reduction in the availability of credit for households means that households will no longer be able to spend at levels significantly greater than what they earn. For consumer businesses, this points to a smaller, slower growing industry that will be forced to cater to a consumer who is more income constrained and much more price driven.
- For non-financial businesses the restriction of credit means that growth will have to be financed through retained earnings and the raising of equity. Managing working capital will become more critical and costly.
- For merger and acquisition activity, the restriction of debt means that merger financing will have to come from cash or a swap of equity, a development that will result in mergers that will be smaller in size and done for strategic purposes.
2. U.S. Trade Deficits Could Not Continue to Deepen
No nation was ever ruined by trade.
— Benjamin Franklin
The debt binge of the past decade fueled the growth of consumer spending, which in turn fueled a massive growth in the U.S. trade deficit. As this debt binge unwinds, the trade imbalances it created will follow with consequences for both consumer and financial service businesses that manage the flow of goods and the counter flow of capital.
Following the Asian currency crisis of 1997-8, Asian countries that suffered the ill effects of rapid currency devaluation quickly began to build up their currency reserves to ensure such a debacle would never happen again. They did this by taking advantage of their depressed currencies to generate sizable trade surpluses, mostly with the United States.
The dependence on trade skewed the balance of growth in those countries away from satisfying the needs of local consumers and developing needed infrastructure to meeting the needs of U.S. consumers. In the United States, the influx of low cost imports gave a boost to consumer purchasing power at the expense of domestic manufacturers who found it difficult to compete with low cost Asian producers. Those who survived did so by moving more of their operations to low cost Asian locales.
The U.S. trade balance began to slowly improve in mid-2005. That improvement was due to slow repatriation of U.S. manufacturing capability due to a falling dollar and rising energy prices. That slow improvement turned into a dramatic shift with the intensification of the credit crisis in the fall of 2008. While U.S. exports have fallen, imports have declined at an even faster pace. Even when recovery does come, the U.S. trade balance is poised to continue the improvement that began in 2005.
- An improvement in the trade deficit will be a positive for the U.S. economy and for the U.S. dollar.
- Developing countries will be forced to shift their mix of growth away from trade and towards domestic consumption and domestic infrastructure investment.
- The United States will continue to shift the mix of U.S. growth away from consumption and towards government spending, trade and business investment.
- The change in the global mix of growth will shift the opportunities for manufacturing companies from overseas back to the United States and for consumer business companies from the United States back to overseas.
3. Foreign Appetite for U.S. Investment is Not Sustainable
Americans started believing that they can live on other people’s money. Okay, we’d love to support you guys — if it’s sustainable. But if it’s not, why should we be doing this?
— Gao Xiqing, president of China Investment Corporation, December 2008
The flip side of the U.S. trade deficit has been the growth in sovereign wealth funds, flush with cash. Originally created to defend their country’s currency, they have quickly evolved into major players in the global financial system. In many ways, they have become the world financial system’s lenders of last resort. With domestic savings flirting with zero, the United States has depended on foreigners to finance everything from the growing trade deficit to a widening government deficit to corporate takeovers.
Despite the need for foreign investment, the growing participation of foreigners in the U.S. economy began to create a populist backlash against the “selling of America”. First came the failure of the Chinese National Offshore Oil Corporation to purchase Unocal in 2005. The deal was withdrawn in the face of Congressional rumblings over national security concerns. The failure of the Dubai World company to take over management of six U.S. ports in 2006 confirmed protectionist momentum against foreign investment.
U.S. protectionism was not the only factor working against the growth in foreign investment. An improvement in the U.S. trade deficit has begun to reduce the availability of foreign capital in total. At some point in time, foreign investors may get their fill of dollar denominated assets. Simple demands for diversification of risk would limit the appetite of foreign investors. This recycling of capital earned from trade surpluses back into the United States could not go on forever. That inflection point came in August 2007. The onset of the credit crisis started a pull back in the flow of foreign capital into the United States.
Since hitting its peak in mid-2007, the inflow of net foreign investment has declined by nearly $600 billion at an annualized rate. The rise in U.S. domestic savings and the satiation of foreign demand coupled with the improvement in the U.S. trade deficit points to continued decline in foreign investment in the United States.
What is replacing foreign direct investment is investment by the U.S. Treasury and the Federal Reserve. The Treasury’s $700 billion Troubled Asset Relief Program (TARP) and the Fed’s $1.25 trillion investments in everything from mortgage backed securities to commercial paper to U.S. Treasury notes has made these two government institutions among the largest sovereign wealth funds in the world. The creation of these two funds will have significant and, at the moment, undecipherable long-term implications for both business investment and the functioning of the private sector.
- The reduction of foreign investment in the United States reduces another source of capital for future U.S. growth, resulting in higher interest rates and reduced capital availability.
- The backlash against foreign investment may make future cross-border deals more difficult.
- The reduction in the U.S. trade deficit may reduce capital flows in sovereign wealth funds, reducing their size and importance as a source of capital.
- The growth of U.S. government sovereign wealth funds has greatly expanded the role of the U.S. federal government into the capital markets, giving them the ability to pick winners over losers and to influence investment and personnel decisions of the financial and industrial institutions they have invested in.
- The size of the U.S. government investments in the U.S. economy will be a challenge to unwind once the economy begins to recover.
- The massive growth projected in U.S. government budget deficits is not sustainable, pointing to significant spending cuts and tax increases in the future.
4. Consumer Spending as a Share of U.S. GDP Could Not Continue to Grow
Shop till you drop, spend to the end, buy till you die.
— 1990s Bumper Sticker
The contraction in consumer spending as a share of the economy is being driven in large part by credit constrained consumers. With government spending growing rapidly, some other sector of the economy has to give ground, and that sector will be consumer spending. The share of the economy going to consumer spending soared in the first part of this decade as households cashed out their home equity through the mortgage refinancing process and headed to the mall.
The growth in consumer spending prompted a boom in mall and retail development. At its peak in late 2007, spending on new mall construction was up 30 percent from the previous year and 167 percent from its 2002 low. The overbuilding of mall space coupled with the contraction in retail spending has led to record high vacancy rates in malls and bankruptcy for several mall-oriented real estate investment trusts.
- U.S. consumers are no longer the consumers of last resort for the rest of the world.
- U.S. consumer business will consolidate into fewer, larger and better capitalized companies.
- U.S. mall owners will look for alternative uses for their real estate.
- Export countries that have depended on the U.S. consumer will have to stimulate local growth through the building of infrastructure and the development of a domestic consumer economy.
5. Consumer Savings Could Not Continue to Shrink
A penny saved is a penny earned.
— Benjamin Franklin
The United States faces an impending retirement crisis that will transform both the workforce and the way we view retirement. Even before the current credit crisis and recession, both the public and the private sectors had made promises with respect to retirement that most likely cannot be kept due to the lack of past funding coupled with the heavy burden these retirement plans impose on future generations. The decline in asset prices has left virtually all private pension funds underfunded. At the same time, the underfunded liability of the Social Security trust fund has grown by trillions of dollars as budget deficits have grown and tax revenues going into the fund have shrunk.
Consumers have responded to the deterioration in their balance sheets by boosting savings. This is but the first small step toward addressing this issue. While the rise in savings has had a negative impact on consumer spending, it has increased the pool of investable funds, reducing the need for foreign investment.
The Baby Boom generation has done everything later in life than previous generations, including saving for retirement. The asset price boom of the past 25 years created the perception that wealth could be generated without the sacrifice of savings. Having taken substantial losses through two major bear markets in addition to losses on their homes, Baby Boomers find themselves ill prepared for retirement. With both public and private pension systems coming up short, the Boomer generation is going to have to save more and work many more years in order to secure their retirement.
- Savings rates will continue to rise as the Boomer generation scrambles to rebuild their retirement nest eggs, adding downward pressure on consumer spending.
- Rising savings will not be enough to offset asset losses and declining pensions. Boomers’ labor force participation will have to rise.
- Social Security reform can no longer be delayed given the growing needs of the Boomers and the deteriorating finances of the U.S. government.
- Bankruptcy among companies with large legacy pension systems coupled with losses from solvent pension funds will force a reduction in promised benefits.
6. Home Ownership Levels in the U.S. Were Not Sustainable
The is no place like home.
— Dorothy, The Wizard of Oz
At the heart of the American Dream lies the hope of homeownership. For an increasing number of American households that is a fading dream, and for some it has turned into a nightmare. At the center of the financial system meltdown has been a dysfunctional mortgage banking system. The securitization of mortgage debt separated lenders from the consequences of bad loans, resulting in a destructive loosening of lending practices. This was a practice that could not continue once the true quality of the mortgages backing much of the securitized debt became widely known.
The results of these past lending practices have been twofold. First, there has been a significant increase in mortgage defaults and foreclosures. Secondly, there has been a sharp increase in mortgage lending standards and a significant reduction in mortgage lending. The reduction in mortgage debt availability coupled with rising foreclosures and the bad experiences that many households have had with homeownership will likely bring down the share of homeowners into the mid-to-low-sixties, a level not seen since the early 1990s.
The stability of many communities is anchored by homeownership. With the decline in homeownership, fewer households will feel a connection to their community than they once did.
- The decline in homeownership will reduce the importance and profitability of mortgage financing to financial service businesses.
- The decline in homeownership will eliminate an important source of wealth creation for many households.
- The reduction in homeownership will increase the rootlessness of many households and increase their geographic mobility.
- By reducing the sense of affiliation of some households with their communities, the drop in homeownership will diminish the level of social capital.
- The reduction in homeownership will hurt the future prospects of home-related businesses like homebuilding, home improvement and home furnishing.
7. Financial Services’ Share of Profitability Will Have to Rebound
Rumors of my death have been greatly exaggerated.
— Mark Twain
The same might be said of the financial services industry. While the industry had a near death experience in the second half of 2008, the foundations have already been put in place for its recovery. Financial services skated through the 2001 recession with profits relatively intact. Following the successful resolution of several financial crises in the 1990s, the banking industry began to believe in its own infallibility.
Risk management standards were relaxed. As risk spreads came down, bankers reached for additional yield by taking on risks for which they clearly were not being compensated. That was a fatal mistake. The first decade of this century has been less than kind to financial services. After peaking at 37 percent of total profits, financial services’ share steadily declined until the second half of 2008, when it totally collapsed.
The current share of profitability is at a level that is likely not sustainable. Either the profitability of the financial services sector will have to rebound sharply or the broader economy and the profitability generated from the rest of the economy will have to shrink. Given the recapitalization of the banks by the federal government through the Troubled Asset Relief Program and the wide margins the banks are currently enjoying, it seems much more likely that the reversion to mean levels of profitability will be achieved by a recovery in financial industry profitability. However, even with that recovery, the industry is going to look very different in terms of appetite for risk, industry structure, regulatory oversight, and return on capital.
- Financial services institutions will face substantially more regulatory oversight, reducing their ability to take on more institutional risk.
- Systemic risks are going to be reduced through regulatory means, resulting over the long term in a less consolidated business.
- The cost of capital for the rest of the economy is going to rise, generating a much greater need for businesses to reduce working capital and increase the return on invested capital.
- Industry growth will come from smaller non-traditional players that are able to avoid some of the regulatory oversight and that will be better positioned to attract talent.
8. Low Energy Prices are Not Sustainable
The Stone Age did not come to an end because we ran out of stones.
— Former Saudi OPEC Oil Minister Sheikh Yamani
As the global economy peaked in the summer of 2008, energy prices went through the roof, giving the world a peek at things to come. Oil prices soared to record highs. Some of the price action was speculative, but a lot of it came from rising demand from developing countries like China and India. In the United States, gasoline prices briefly rose above $4 per gallon. For all of its shortcomings, the global expansion from 2002 to 2007 produced the strongest five year pace of growth in the post-World War II era. More wealth was created and more households were pulled out of poverty than at any time in the history of the world.
With greater wealth come two historically conflicting demands: the demand for more energy and the demand for a cleaner environment. With an economic recovery, global demand for oil will make a comeback and with it will come higher prices. But even without the rising demand for oil that will come with a recovery, the price of all energy is headed higher.
The Stone Age ended because humans developed better tools. The age of oil will come to a similar end, with better alternatives that are cleaner, cheaper and easier to use. But the most probable path to those alternatives is for the price of oil to rise. Alternative energy is alternative because it is currently much more expensive than either oil or coal.
Oil and coal have externalities associated with them that make them less than ideal energy sources. Much oil comes from regions of the world that are politically unstable or ideologically hostile to the West. Both oil and coal generate high levels of greenhouse gases. Internalizing these externalities is one of the goals of the cap and trade system proposed by the Obama administration. Such a system would impose a tax on carbon, pushing the price of carbon-based energy higher. Much in the way information technology drove growth in the 1990s, investment in energy technology and conservation may be a growth engine of the next decade.
- Faced with higher energy prices, manufacturing will look to produce products closer to the point of consumption to reduce distribution costs.
- Consumers will look to live closer to work and shopping alternatives to reduce travel.
- Telecommuting will increase for work and school.
- Energy conservation will be a growth business.
- Alternative energy development will be a growth business.
A New Era
In the United States, we are witnessing a fundamental realignment of the relationship between government and the private sector and between the U.S. economy and the rest of the world. With government as the growth sector in the U.S. economy, both taxes and regulation are set to expand. These changes will create a financial services sector that is less leveraged, with business models that are much less prone to wide swings in earnings and losses. Increased government oversight of U.S. business may not be limited to financial services. Consumer businesses, energy and the environment all can expect significant changes. In energy we will likely see regulations and business models that will sustain new innovation and growth for the broader economy.
For the rest of the world, dependence on U.S. consumers as a source of demand is coming to an end. For the global economy, this will free up resources that can be used to expand domestic demand and build infrastructure. While the transition to this new economic dynamic will not be easy, the global economy that will emerge will be much more stable and have a lot fewer trends that are at risk of running into Stein’s Law. DR
Carl Steidtmann is the chief economist with Deloitte Research, Deloitte Services LP.