Research Affiliates sees high inflation, low growth in the developed world. BlackRock looks for companies with strong cash flow. Gold prices rise.

Jason Hsu, Research Affiliates

The 3-D Hurricane and the New Normal*

Debt, deficit, and demographics—the 3-D hurricane— is heading to the shores of all developed economies. It threatens to derail the lukewarm economic recovery and to alter forever the heretofore path of robust growth for the developed world. In a sense, debt, deficit, and demographics will reset the world to a “New Normal”—an extended period of lower economic and return expectations for the aging and debt-ridden developed world.

In contrast, emerging economies with healthy government and household balance sheets, responsible fiscal policies, and young labor forces will be the drivers for global growth and will compete with their developed counterparts for economic and political leadership. More importantly, the emerging economies will demand their fair share in the consumption of resources and goods. That competition for resources and goods will lead to higher prices at a time when developed countries are less able to further finance their consumption. Finance plays a critical role in the real economy, though only an intermediation activity. Shocks to financing for the developed economies—whether through high interest rates due to poor sovereign credit risk or through the crowding out effect from government deficit financing—would have long-term effects on economic growth and the unemployment rate.

By comparison, emerging countries have low debt-to-GDP ratios. Specifically, the Asian EM countries generally maintain trade surpluses and, therefore, also act as suppliers of global capital to the debt-laden developed economies. These healthier balance sheets, over time, mean that emerging economies would represent lower credit risk than many of their developed counterparts. The trend of declining credit spread for EM debt has been occurring for many years. In the New Normal, emerging countries will not only converge with the developed countries, but in fact are likely to overtake many of them in short order. From the credit spread for developed sovereign debt versus emerging sovereign debt, capital markets may not have fully comprehended this pending reversal of fortune between the developed and developing economies. Emerging economies currently are assessed higher credit spreads versus developed economies, although they often have significantly better underlying collateral quality and debt capacity. This reflects an irrational bias on the part of investors; it is not unfathomable that a re-pricing of developed market sovereign credit risk is forthcoming for even the most stalwart of the developed economies—Germany and the United States.

 When Deficit becomes Odious Debt

The extensive literature exploring the effects of deficit driven stimulus programs provides strong evidence that short-term growth, financed by deficit spending, rarely translates into sustained long-term growth.2 The argument is that government-directed investments are often zero or even negative net present value (NPV) projects—that is, they tend to be suboptimal investments. From that perspective, government stimulus programs are more about creating make-work jobs than investing in infrastructure and education that will drive future growth. The short-term increase in economic activity does not translate into future increases in production of valuable goods and services.

In a true Keynesian sense, government recessionary expenditure aims purely to smooth temporary shocks; it cannot substitute for private sector investments which are necessary to drive long-term growth. Insofar that the government stimulus is financed by more debt, it necessarily translates into higher future tax burdens, which then drains future private sector consumption and investments. By backward induction, a higher future tax burden decreases expected (after-tax) return on investments, which then reduces private sector investments today. Crowding out future and current private sector activities by the public sector growth today bodes ominously for future growth. Indeed, under standard economic theory, the government either borrows to invest for future growth, and therefore drive future tax revenue, or it borrows to shift future consumption to the present in an attempt to ameliorate shocks to the economy.

In reality, deficits have a tendency to become ever-increasing debt. We have been all too willing to believe the story that future growth driven by indomitable American ingenuity will deliver us from our debt. Unfortunately, unless another decade-long period of explosive technology innovation is in the cards for us, we may have just now hit a wall: The debt-to-GDP ratios for many developed countries have become untenable; additional borrowing capacity is small. In hindsight, the policy of persistent deficit spending seems utterly irrational and short-sighted. On the other hand, one might argue that this outcome is exactly rational in the context of baby boom demographics prevalent in the developed countries. Deficit spending gives an instant and immediate boost to GDP, which can feel like prosperity and good government stewardship. The natural conflict between the future non-taxpayers and the future taxpayers means that Boomers, who have controlled the elections and politics, have rationally chosen a path of more consumption today at the expense of the future generations. Whether deficit spending truly has any significant impact on subsequent growth is rather irrelevant to the discussion; voters and politicians alike would simply misinterpret the economic literature and assume more consumption today will drive more growth tomorrow. In other words, and as scientific as one can put it—the Boomers have screwed Generation X.