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armageddon usa?america at the crossroads
Dr Tim Morgan Global Head of Research
strategy insights | issue eight
strategy insights | issue eight 3
america at the crossroads
contentsarmageddon usa? america at the crossroads 5
introduction: powers of darkness 7
part one: what is the American problem? 11
economicdata–pollyannacreep 13
whatgrowth,whatjobs? 18
“anotherdayolder,deeperindebt…..” 20
part two: why did this happen? 25
afailedparadigm 25
un-americanactivities:havecompetitorstrategiesunderminedtheUS? 26
domesticerrors–thefolliesofideologicalextremes 28
capitalsinkinvestment:bettingthehouse 28
part three: how should america respond? 33
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strategy insights | issue eight4 strategy insights | issue eight4 1 http://www.globaltimes.cn/NEWS/tabid/99/ID/691074/Pentagon-plan-changes-game-in-Asia.aspx
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“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
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america at the crossroads
CommentingonPresidentObama’snewdefencestrategy,theChinesenewspaperGlobal TimeslambastedthenewemphasisreportedlybeingplacedbytheUSonSouthEastAsia,andconcludedthatAmerica“cannotstoptheriseofChina”.
WhilsttheriseofChinamaybesubjecttocaveats,thedeclineoftheUSseemsundeniable.Accordingtoofficialfigures,Americaismiredindebtand,despitearecentmodestupturn,hereconomictrendgrowthislacklustre.Thereality,strippedofstatisticalobfuscation,isevenworsethanthis.Reportedfederaldebtexcludesenormousoff-balance-sheetquasi-debts.Thereporteddeficitexcludeshugeannualincrementstotheseobligations.Reportedgrossdomesticproduct(GDP)includes$2.3trillionofnon-cash“imputed”dollarsthatdonotreallyexist.Bothinflationandunemploymentareunderstatedintheofficialnumbers,andtherealitymaybethattheeconomyhasbeendriftingforadecade.
Whyhasthishappened?Theexplanationsarebothforeignanddomestic.Athome,America
iswrestlingwiththeendingofaquarter-century“creditsuper-cycle”.Americanshaveborrowed,notforproductiveinvestment,buttoinflatethevalueofthenation’shousingstock.Sincehousesarenon-earningcapitalsinks,thisprocesshasgravelyunderminedtheproductivenessoftheeconomy.CapitalhasbeenpouredintovanityprojectsandpropertypriceescalationwhilstAmerica’sdecayinginfrastructureneedsatleast$2trillioninrestorativeinvestment.WhereChina’sbrightestyoungpeoplestudyengineeringandtechnologybeforemovingintoindustry,America’sbrighteststudylawbeforemovingintoWallStreet.
Abroad,Americaisthenaïvevictimofblatantlyone-sidedglobalisationwhichdestroysAmericanjobswhilstrackingupeverhigherlevelsofprivateandgovernmentdebt.AmericahasboughtintotheRicardianlogicof“comparativeadvantage”withoutrealisingthatthismodelispredicatedonothersplayingbytherules,andonassumedscopeforinfinitegrowth.Today,neitherassumptionisvalid.
Inadditiontocuttingwaste,ditchingunaffordablefederalprogrammesandowningupaboutun-payablepensionandwelfarepromises,theUnitedStatesneedstotakeimmediateactionontwofronts.Athome,regulationneedstobetightenedtopreventthemispricingofriskwhichunderpinnedthesubprimedisaster.Abroad,Americaneedstogetreal,andgettough.TheUSneedstodemandthefreefloatoftherenminbi,theeliminationofalltariffandinformaltradebarriers,andthecessationofalltechnologyappropriation.Ifthesedemandsarenotmet,Washingtonshouldhavenocompunctionaboutthreateningselectivedefaultandtheintroductionofprotectivetariffs.ItishightimethattheUSwokeuptotherealitiesofaone-sidedglobalisationprocesswhichhasimpoverishedAmericaandhasresultedinthehaemorrhagingofAmericanjobs.
TheUnitedStatesremainstheworld’smostinnovativeeconomy,buttimeisrunningout.
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strategy insights | issue eight62 Talking about the Federal deficit, December 2010.
http://www.bbc.co.uk/blogs/thereporters/markmardell/2010/12/simpson_slaps_washington_with.htmlstrategy insights | issue eight
“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
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powers of darkness
strategy insights | issue eight 73 The American fiscal year ends on 30th September
CommentingonthenewdefencestrategyoutlinedonJanuary5thbyBarackObama,theChinesenewspaperGlobal TimeslambastedthenewemphasisreportedlybeingplacedbythePentagononSouthEastAsia.ThenewspaperarguedthatcompetitionbetweenChinaandAmericawasonascale“unprecedentedinhistory”.ItaddedthatChinashould“strengthenitslong-rangestrikecapabilitiesandputmoredeterrenceontheUS”.ThwartingUSpolicyonIranmightbeseenasavalidtactic,itsuggested,concludingthatAmerica“cannotstoptheriseofChina”.
TheriseofChinamaybesubjecttocaveats,butthedeclineoftheUnitedStatesseemsundeniable.Threequestionsneedtobeaddressed:
• WhatistheAmericanproblem?
• Whydidthishappen?
• HowcanAmericarespond?
FollowingthepublicationofthefinalreportofourProject ArmageddonanalysisoftheeconomicoutlookforBritain,itwassuggestedthatweshouldconductasimilarassessmentoftheUnitedStates.Bothcountries,itwaspointedout,arecaughtinthesamebasichigh-debt,low-growthtrap,andinneithercountryhasgovernmentproducedwhollycredibleanswerstothegravityofthenationaleconomicmalaise.
BritainandAmericahavebeendescribedas“twocountriesdividedbyacommonlanguage”,andthisisparticularlytruewheremetaphorsareconcerned.WhereanEnglishmanprocrastinatesby“knockingtheballintothelonggrass”,anAmerican“kicksthecandowntheroad”.
Theidiomsmaydiffer,butthemeaningscoincide.And,beitacricketballoracan,procrastinationispreciselywhatthegovernmentsofbothcountrieshavebeendoingabouttheirhugeeconomicchallenges.InBritain,2010’schangeofgovernmenthasbroughtatleastsomeresolvetotheissue,thoughtimealonewilltellwhetherthisresolvewillprevail.Bycontrast,Americanpolicymakersseemparalysed.
Thislackofactionisnotforwantofwarning.InDecember2010,formerSenator(R)AlanSimpson,co-chairman(withformerClintonchief-of-staffErskineBowles)ofthePresident’sbi-partisancommitteeonfiscalresponsibility,didnotmincehiswordswhenhewarnedthecommitteethattheFederaldeficitwasa“cadaver[that]willrisefromthecrypt”
“Thisisit”,continuedSen.Simpson.“Nomorefunandgames.Nomoresmokymirrors.They[theAmericanpeople]havewisedup.They’remad.They’retiredoftheblusterandtheblatherandtheegoandtheBSthat
hasworkedsowellforallofus,includingme,amasterofit.Soyes,timeshavechanged.”
Simpsonwaswarningthecommittee,inthestarkestpossibleterms,thatthefederaldeficitwhich,atanofficial$1.4trillion,equatedto8.9%ofAmerica’sreportedgrossdomesticproduct(GDP)infiscalyear(FY)20103,wasnolongersustainable.Needlesstosay,SimpsonandBowlesareright.And,equallyneedlesstosay,no-oneseemstobelisteningwithintheAmericancorridorsofpower.
Beyondpoliticalparalysis,oneofthereasonsforthefailuretoaddressAmerica’seconomicproblemsisalackofappreciationofquitehowbadthoseproblemsreallyare.Underaprocesswhichbeganintheearly1980s,reportingmethodologieshavebeenmassagedtothepointwherethetruescaleoftheeconomicmalaiseismaskedfrommostAmericans.Asthisreportexplains,debt,thedeficit,inflationandunemploymentareunderstated,whilstbothgrowthandabsoluteGDPareflattered,andnottoaminorbuttoafundamentaldegree.ThefirstimperativeforanyonewhowantsacomprehensiveunderstandingoftheUSeconomicandfiscalsituationistolookbehindthestatisticalcamouflage.
introduction
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Evenonthereportedfigures,thesituationisbadenough.Critically,theUSisattheendofaquarter-century“creditsuper-cycle”whichhasseenaggregatedebtsoarto358%ofGDP,alevelwhichisunprecedentedinmoderntimes.Overthelastdecade,theUShasadded$5.58ofdebtforeach$1ofexpansioninGDP.Tobesure,theUS–unlikemostotherOECDcountries–hasmadesomeverymodestinroadsintothisdebtratio,butthereductionachievedthusfarmakesnosignificantdifferencetotheoverallposition.
TheUS,then,isstuckinahigh-debt,low-growtheconomictrap.Howdidthishappen?Inpart,America’swoesreflectanaïveapproachtoglobalisation.The‘comparativeadvantage’paradigmwhichunderpinseconomicopennessassumes,first,thatothersplaybytherules,and,second,thatthescopeforexpansionislimitless,suchthatthegrowthofonecountryneednotbeattheexpenseofanother.Neither assumption is true.Chinaandothershavenotplayedbytherules–afterall,internationalcompetitionisnotaparlourgame–andresourceconstraintsarenowdemonstratingthatthescopeforglobaleconomicgrowthisnotinfinite.
ButAmerica’swoescannotbeblamedwholly,orevenprimarily,onothers.TheregulatoryclimateintheUSseems,withhindsight,tohavebeenundulyrelaxedduringthelatterstagesofthecreditsuper-cycle.TheauthoritiesignoredthestarkestpossiblewarningsinsupinelyallowingtheproliferationofinstrumentswhichnolessaluminarythanWarrenBuffetthadlongwarnedwere“weaponsoffinancialmassdestruction”.TheFederalReserve’sdefaultassumption,whichwasthatregulationcanbeminimisedbecausebankscanbetrustedtoactresponsiblyinthelong-terminterestsoftheirshareholders,wasbreathtakinglynaïve.AllofthiswascompoundedbyallowinglowinterestratestodriveAmericaintoadownwardsmonetaryratchet.
Thisreportiswrittenfromapro-marketperspective,butwecannotbutconcludethatanexcessiverelianceoninadequately-regulatedmarketshascompoundedmanyotheradversetrendsintheAmericaneconomy.Thebuild-upofdebthasreflectedagrowingconsumptionrecklessnesswhichtheauthoritieshavedonenothingtocounter.Investmenthasbeendivertedintocapitalsinks,
mostnotablyproperty,whilstvanityprojectshavechannelledfurthercapitalawayfromvitalinfrastructurereconstruction.America’seducationsystemproducesfartoomanylawyersandfartoofewengineers,whilstthecreamofthecountry’syoungpeoplehavebeendrawnintoWallStreetandthelawratherthanintomoreeconomically-productivesectors.
PoliticianshaveallowedAmerica’sonce-famedcapabilitiesinR&Dtobeundermined,andhavestoodbyandwatchedmuchofthenation’sknowledgecapitalbeingeitherappropriatedbyothercountriesor,worsestill,handedtothemonaplateinpursuitofnarrowshort-termgain.MuchofAmericanindustry(exemplifiedbytheauto-makers)hasfollowedblindalleys.
And,whilstallofthishasbeenhappening,America’spoliticalleadershavedone……well,nothingconstructiveaboutit.GeorgeW.Bushsomehowmanagedtobelievethathecouldcombinetwohugelycostly(and,webelieve,mistaken)warswithtax-cutsfortheveryrichwhilstnotcreatingafiscaldeficit.Healsopresidedoverthebuild-upoftheshadowbanking
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strategy insights | issue eight 9strategy insights | issue eight 94 The Tennessee Valley Authority strategy insights | issue eight 9
systemandthenear-fatalunderminingofthecapitalmarkets,tothepointwhereCongresshadtobearm-twistedintohandingover$700bnoftaxpayers’moneytobailoutthebankingsystem.ItistooearlytojudgetheObamapresidency,buttheeconomyisflat-lininganddebtcontinuestoescalate,whilstgrid-locksinCongressdonotencourageustobelievethatresoluteandeffectiveactionwillbetaken.
Whatshouldthatactionbe?Firstandforemost,thejobofleadersistolead.Thegreatestsinglerequirementnowisforhonesty.ManyofAmerica’sfiscalpromises,suchasthoseonpensionsandwelfare,areun-payable–certainlywithoutmassivetaxincreases–anditisabouttimethatsomeoneadmittedit.Thecurrentfiscaldeficitiswhollyunsustainable,whichprobablymeansthatbothspendingcutsandtaxincreasesareinevitableifdisasteristobeaverted.Thewidespreaddislikeofgovernment,whilstunderstandable,ratheroverlooksaprettycreditablehistoricrecordonnationally-ledprojects,fromtheTVA4tovictoryintheSecondWorldWarandtheApolloprogramme.Thereisanurgentneedtochannelinvestmentintoessentialinfrastructureand
awayfromcapital-sinksandvanityprojects.Thereneedstobetougherregulationofthefinancialmarkets,includingderivatives.
Abroad,America needs to toughen up,mostnotablywithregardtoChina.Americaisentitledtomakealengthylistofdemandsand,forthetimebeing,remainsstrongenoughtobacktheseup.Americashouldrequireafreefloatfortherenminbi,theremovalofalltariffandotherimportbarriers,andanimmediateandcompletecessationofalltechnologyappropriation.
TheUShastwobigstickswhichitcanthreatentowield.SelectivedefaultcouldhitChinawhereithurts.China’semployment-drivenpursuitofvolumemaximisationoverprofitiscriticallydependentonfreeaccesstoAmerican(andotherWestern)consumermarkets.ProtectionismcoulddealChina’sleadersadevastatingblow,andAmericashouldnotbeafraidtousethisasathreatinthenationalinterest.SinceglobalisationhasinanycaseworkedtothedetrimentofmiddleAmerica,theUSshouldhavenocompunctionwhatsoeveraboutwavingaverybigstickinpursuitofafairerdeal.Forsolongasthisisnot
done,Americawillwatchhereconomicpowerdrainaway.
HastheUStheleadership,atalllevels–federal,congressional,localandcorporate–toturnaroundatrulydireeconomicsituation?Itcanonlybehopedthatithas,becausethealternativeisfrightening.
Dr Tim MorganGlobalHeadofResearchTullettPrebonplc
strategy insights | issue eight10 5 “Numbers Racket”, Harper’s Magazine v.316, n.1896 1st May 2008
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“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
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what is the American problem?
Oneofthecentralchallengesidentifiedinthisreportisthatthe United States has been accumulating debts at a rate which now threatens to overwhelm the carrying capacity of the American economy.Atalllevels–federalandlocalgovernment,corporationsandindividuals–debthasbeenaddedatrateswhichhavefarexceededexpansionineconomicoutput.Goingforward,thefundamentalproblemlieslessintheabsolutelevelofindebtedness,frighteningthoughitis,thanintheweaknessesofaneconomywhichlooksincapableofgeneratingrobustgrowth.
Thoughthemarketstendtofocusonfederal(public)indebtedness,therealproblemisverymuchdeeperthanthis.Overthelasttenyears,whilstfederaldebthasincreasedby$6.7trillionotherformsofAmericanindebtednesshaverisenbyanaggregateof$17.8trillion,liftingtheoveralltotalfrom$29trillionto$54trillion(seefig.1).
Withinthetotalincreaseindebtoverthatten-yearperiod,thefederalgovernmenthasaccountedfor27%,andstateandlocalgovernmentforafurther7%.Almosttwo-thirdsoftheincreaseinAmericanindebtedness
hasbeenaccountedforbybanks,bybusinessesandbyindividuals.Americandebtisnot,then,apurelygovernmentphenomenon.BorrowinghasbecomethenewAmericanwayoflife.
Noparticularlevelofdebtis,initself,‘abadthing’.Borrowingcanbeacost-effectivesourceofproductiveinvestment,andaffordablegrowthinprivatedebtcanbeeconomicallybeneficial.ButtheescalationinUSborrowingshasfarexceededthesesafeparameters.
part one
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:FederalReserveBoard,Dataexcludesquasi-debtobligations
**3Q2011
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Asfig.2shows,totalUSdebthasexpandedmuchmorerapidlythanGDP,suchthatcurrentdebt(of$53.9trillion)equatestoalmost360%ofGDP($15trillion).Justasimportantly,itisclearthatadecisivenewtrendemergedfromtheearly1980s(fig.3).Between1945and1980,theratioofdebttoGDPwasremarkablyconsistent,rangingbetween130%and170%.Thereafter,however,thedebtratiotookoff,reaching200%ofGDPin1985,250%in1996and300%in2003.Thecurrent(358%)debt-to-GDPratioisunprecedented,exceedingeventhelevelsreachedintheGreatDepression
(whentheratiowasdrivenupwardsnotbydebtescalationbutbydeflationandbyaslumpineconomicoutput).
Webelievethatthe period since the early 1980s–inotherWesterncountriesaswellasintheUS–represents a “credit super-cycle”,anoverallpatternwhichlurksbehind,andinforms,successivebubblesinassetclassesrangingfromequitiesandrealestatetocommodities.ThedrivinglogicoftheUSeconomyseemstohaveswitchedfrommoderationandbalancetoexcessivedebt-fuelledconsumption.LikemanyotherWesterneconomies,
theUShasnowreachedthepointatwhichfurtherdebtescalationhasbecomeimpossibletosustain.But no-one seems to have worked out how to manage an economy that is not debt-propelled.
Thesnagswithsoaringdebtarethree-fold,andAmericahasallthreekindsofproblem.First,debtcanbeaproblemifitout-growstheabilityoftheborrower’sincometosustainit.ThishascertainlybeenthecaseintheUS.Overthesameten-yearperiodinwhichdebtgrewby$24.5trillion,nominalGDPincreasedby$4.4trillion.
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Figs. 2 and 3: America and the credit super-cycle*
*Sourcesofdata:BureauofEconomicAnalysisandFederalReserveBoard
US debt and GDP
$52.6
$14.7
$0
$10
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$30
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1950
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US total debt US GDP
$ trn
Total debt as % US GDP358%
0%
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400%
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strategy insights | issue eight 13strategy insights | issue eight 136 Source: Federal Reserve Flow of Funds z1 report, 2nd quarter 2011
The last decade, then, has seen $5.55 of debt taken on for every $1 increase in economic output.Asaresult,totaldebthasrisenfrom275%ofGDPin2001to358%today.
Thesecondwayinwhichdebtescalationcanbedamagingisiftheextentofleverageisdisguisedinthebalancesheetoftheborrower.This,too,hasbeenthecaseintheUnitedStates.Theofficialnumberforfederaldebtexcludeshugeoff-balance-sheet‘quasi-debts’suchascommitmentstofutureemployeepensionsandtopublicbenefitssuchashealthandsocialsecurity.Corporations,too,arecommittedtoenormous,unfundedforwardemployeewelfarecommitments.
Thethirdwayinwhichdebtcanposeaproblemisiftheproceedsareinvestedinunproductiveways.Thejargonheredividesborrowingsinto‘self-liquidating’and‘non-self-liquidating’debt.Borrowingtoexpandasuccessfulbusinessisanexample,attheindividuallevel,of‘self-liquidating’debt,whichcanbepaidoffusingincomefromtheexpandedenterprise.Borrowingtopayforanewcaroraholiday,ontheotherhand,areexamplesof‘non-self-liquidating’debt,becausethesedonotaddtothefutureincomeoftheborrower.
America’sborrowingshave,overwhelmingly,fallenintotheunproductive,‘non-self-liquidating’category.LittleofAmerica’shugeborrowinghasgoneintoinfrastructureimprovementorinvestmentinproductivecapacity.Governmenthasborrowedforpurposeswhichhaveincludedfightingwarsandhandingtaxcutstotheveryrich.Individualshaveborrowedforperhapsthemostfutilepurposeofall,whichistoinflatethevaluesofexisting,unproductiveassets,inthisinstanceAmerica’shousingstock.
Atthesametime,America’seconomyhaslanguished,growingatfarlowerratesthanthoseatwhichdebthasexpanded.TheUSeconomyisnowdoinglittlebetterthanflat-lining,anditistheprospectofsluggishgrowthwhichthreatenstocrystaliseexcessiveindebtednessfromatheoreticalintoadangerouslypressingproblem.
Almostallmacroeconomiclevershavebeentried,andhavefailed.Giventhehighlevelsofexistingdebt,Washingtonhasnorealisticscopeforfiscalstimulus.Interestrateshavebeenkeptatminimallevelssince2008,negatinganyfurtherabilitytoinjectconventionalmonetarystimulus.That“quantitativeeasing”(QE),whichisthecontemporaryeuphemismfortheprintingofmoney,hasnowbeentried
notoncebuttwiceisanindicationofthedesperatestraitsinwhichpolicymakersnowfindthemselves.
Oneoftheside-effectsofthecreditsuper-cyclehasbeenthecreationofa ‘monetary ratchet’ which has now reached end-game.Themonetaryratchetprocessissimpleinprinciple–ratesarekepttoolow,adebt-drivenbubbleensues,thebubblecollapses,andratesarecutagaintoshoreuptheeconomy.Whilsttheratchetprocessiscapableofstraightforwarddescription,whatno-oneseemstoknowiswhathappenswhentheprocessreachesitszero-ratetermination,whichiswheretheUS(andmostoftherestoftheOECD)havenowarrived.
economic data – pollyanna creep
Takenatfacevalue,then,America’seconomicandfiscalproblemslookprettybad.Federaldebtowedtothepublicstandsat$10.1trillion,or67%ofreportedGDP.Statesandlocalgovernmentsoweafurther$3trillion(20%),andhouseholds$13.2trillion(88%)withintotalcreditmarketdebtwhichstandsat$53.8trillion,or358%ofGDP6.Unemploymentisstubbornlyhigh,atareported8.5%oftheworkforce.Controversially,ratingsagencyStandard&PoorslastyearstrippedtheUnitedStatesofitsAAAcreditrating.Aftersomeunedifying
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strategy insights | issue eight 15strategy insights | issue eight 157 See “Numbers Racket”, Kevin Phillips, op cit.
brinkmanshipbetweentheWhiteHouseandCongress,thefederaldebtceilingwasliftedjustintimetostopgovernmentgrindingtoahalt,butno-onehascomeupwithareallyconvincingplanforcurbingthedeficitorstimulatinggrowth.
IfthiswasatruedescriptionofthesituationinwhichAmericafindsherself,itwouldbebadenough.Buttherealityisevenworse,becausethedataonwhichthisgenerally-believedsnapshotisbasedareveryfarfromreliable.Aprocessofincrementalobfuscation,stretchingoverdecades,hasmadeofficialeconomicdataextremelyunrealistic.
WeshouldbeclearthatthedebauchingofUSofficialdatadidnotresultfromanygrandconspiracytomisleadtheAmericanpeople.Rather,ithasbeenanincrementalprocesswhichhastakenplaceovermorethanfourdecades.ItalsoseemstohavehappenedinotherWesterncountries,thoughonlyintheUSistheunderlyingdatasufficientlytransparentfortheeffectstobequantified.
Intheearly1960s,JFKtamperedwithunemploymentnumberstoexclude“discouragedworkers”.TheJohnsonadministrationintroducedthe“unifiedbudget”,whichincorporatedwhat
wasthenabigSocialSecuritysurplustohidepartoftheunderlyingfederalover-spend.RichardNixontried,withonlylimitedsuccess,topeddletheconceptof“coreinflation”,aninflationarymeasurewhichexcludedenergyandfood(theveryitemswhosepriceswererisingmoststronglyatthattime).
“Owner-equivalentrent”,aconcepttobeexplainedlater,wasintroducedunderRonaldReagan.ConvolutedchangestothemeasurementofCPIinflation,recommendedbytheBoskinCommission,weredraftedunderGeorgeH.W.BushbutimplementedbytheClintonadministration(and,asrespectedstrategistKevinPhillipshasremarked7,thereisacertainironytotheintroductionof“hedonicadjustment”bytheOvalOffice’sultimatehedonist).Afurtherfourmillionout-of-workAmericansdroppedoutoftheunemploymenttotalsunderaredefinitionof“discouragedworkers”introducedin1994.
Thoughstatisticalmanipulationhasbeengradual,ithasreachedthepointatwhichmostofficialeconomicdataisnowverymisleading.TheanalystwhowishestounderstandwhatisreallygoingoninAmericaneedstounwindthesedistortions.Theresultsaredisturbing.
Let’sstartwithgross domestic product,thenumberusuallyacceptedasdefiningtheoutputoftheeconomy.In2010,theGDPoftheUnitedStateswasreportedat$14.53trillion,afigurewhichmostAmericansprobablyassumeconsistsentirelyof‘real’dollarswhichcanbecounted.This,infact,isveryfarfrombeingthecase,becausecloseto16%ofthereportednumberconsistsof“imputations”.Theseimputationsaredollarswhichdonotreallyexist.Strippedofthem,GDPtotalled$12.3trillionin2010,whichautomaticallymeansthatalldebtratiosareevenworsethantheylook.
Themostimportantoftheseimputationsaresummarisedinfig.4.Thelargestsinglesuchimputation–worthover$1.2trillionin2010–concerns“owner-equivalentrent”.Ifapersonownshisorherhomeoutright,nomortgageorrentispayable,andnomoneychangeshandsinrespectoftheproperty.ButthereportingmethodologyforAmericanGDPassumesthatsuchapropertyhasautilitywhichapurelycash-basedmeasurefailstocapture.Therefore,GDPcontainsasumrepresentingtherentwhichtheownerwouldhavepaid(presumablytohimself)ifhehadnotownedtheproperty.Interestexpenseisbackedout,butthenetresultremainsamajor(andnon-cash)uplifttoGDP.
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Thereplacementofactualexpenditurewithanotional(‘imputed’)rentappliesnotjusttothatminorityofAmericanswhoowntheirhomesoutright,butalsotothemanymillionswithmortgages.Forexample,apersonwith50%equityinhishomeisassumedtopayrenton100%ofitratherthan,asisactuallythecase,mortgageinterestonhalfofit.
Thesecond-largestimputationconcernsemployeebenefits(principallymedicalinsurance,butalsoitemssuchasmealsandaccommodation)whichareprovidedtoworkerseitherfreelyoronasubsidisedbasis.Asumof$594billionwasimputedinthiscategoryin
2010.Financialservices(forexample,checkingaccounts)whichareprovidedfreeofchargebybanksaretreatedsimilarly.Here,the2010imputation(of$501billion)reflectswhatthecosttothecustomerwouldhavebeenifthebankhadchargedhimorherforserviceswhich,inreality,wereprovidedfree.
Thereisalegitimatedebateaboutthe‘productionboundary’,whichreferstotheinclusion,orotherwise,ofservicesprovidedfreeofcharge,agoodexamplebeingcareprovidedtochildren,totheelderlyandtotheinfirmbyfamilymembers.Butthesheerscaleatwhich“imputations”arenowusedinthecompilationofAmericanGDP
surelyintroducesgravedistortionsintothegenerally-acceptednumberforUSeconomicoutput.Moreover,non-existent(imputed)dollarsobviouslycannotbetaxed,whichmeansthatimputationsmaketheAmericanincidenceoftaxationlookagreatdealsmallerthanitreallyis.
Seriousthoughitis,theimputationsdistortionofGDPisaprettyminormattercomparedtothedebauchingof inflationdataoverthelastthreedecades.Imputations,usedtoincreasereportedeconomicoutput,alsohaveasignificantimpactonreportedinflation,becausetheyedgeoutrealratesofincreaseinthecostofhousing.
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:BureauofEconomicAnalysis
Thebiggestsingledistortionofofficialinflationdataresultsfromtheapplicationof“hedonicadjustment”.Theaimofhedonicadjustmentistocaptureimprovementsinproductquality.Theintroductionof,say,abetterqualityscreenmightleadtheBureauofLaborStatistics(BLS)todeemthepriceofatelevisiontohavefalleneventhoughthepriceticketinthestorehasremainedthesame,orhasrisen.Theimprovementinthequalityoftheproductisequivalent,BLSstatisticiansargue,toareductioninprice,becausethecustomerisgettingmoreforhismoney.
Oneproblemwithhedonicadjustmentisthatitbreaksthelinkbetweeninflationindicesandtheactual(in-the-store)pricesofthemeasuredgoods.Anotheristhathedonicadjustmentissubjective,andseemstoincorporateonlyimprovementsinproductquality,notoffsettingdeteriorations.Anewtelephonemight,forexample,offerimprovedfunctionality(ahedonicpositive),butitmightalsohaveashorterlife(ahedonicnegative)and,criticsallege,theofficialstatisticiansarealltoolikelytoincorporatetheformerwhilstignoringthelatter.
Thefailuretoincorporatehedonicnegativesisparticularlypertinentwherehome-producedgoodsare
replacedbyimports,aprocesswhichhasbeenongoingfortwodecades.AnimportedairbrushmightbeagreatdealcheaperthanonemadeinAmericabut,iftheimporteditemisoflowerquality,isthisfactoredintotheequation?
Asecondareaofadjustmenttoinflationconcerns‘substitution’.Ifthepriceofsteakrisesappreciably,‘substitution’assumesthatthecustomerwillpurchase,say,chickeninstead.Aswithimputations,theuseofsubstitutionbreaksthelinkwithactualprices(aprocessexacerbatedby‘geometricweighting’),butitalsoturnstheindexfromacalibrationofthecostoflivingtoameasurementofthepriceofsurvival.
Sincetheprocessofadjustmentbeganintheearly1980s,theofficially-reportedCPI-Unumberhasdivergedeverfurtherfromtheunderlyingfigurecalculatedonthetraditionalmethodology.Someofthosewhohaveresearchedtheissuesofhedonicadjustment,geometricweightingandsubstitutionreckonthatthesemethodologiesnowstripoutatleastsixpercentagepointsfrominflationcalculatedonthetraditionalbasis.Onthisbasis,trueinflationmightbeatleast9%,ratherthanthe3.4%reportedinDecember.
Ifcriticsareright–andweareconvincedthattheyare–thentheimplicationsareenormous,becauseinflationcalculationsreachintoeveryaspectofeconomiclife.Thesignificanceofdistortedinflationreportinghasimpactson:
• Americans’costofliving,andthepurchasingpowerofthedollarovertime.
• Wageratesandsettlements.
• Benefitlevels,andthecostofsocialpaymentstogovernment.
• Economicgrowth.
• Realinterestrates.
Accordingtoofficialfigures,aggregateinflationbetween2001and2011was27%,meaningthatthedollarlost21%ofitspurchasingpoweroverthatperiod.But,ifweacceptthatrealinflationmayhaveexceededtheofficialnumberby6%ineachofthoseyears,thelossofdollarpurchasingpowerwasabout55%between2001and2011.Betweenthethirdquartersof2001and2011,averageweeklywagesincreasedby31%,fineifthedollarlost21%ofitspurchasingpoweroverthatperiodbutevidenceofverysevereimpoverishmentifthedollarin2011wasworthonly45%ofits2001
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value.Inshort,if millions of Americans feel poorer now than they did ten years ago, the probable explanation for this is that they are.
Bythesametoken,thoseAmericansinreceiptofindex-relatedpensionsandbenefits,too,haveseentherealvalueoftheirincomesdeclineasaresultofthesevere(andcumulative)understatementofinflation.Thisprocess,ofcourse,hassavedthegovernmentvastsumsinbenefitpayments.RebasingpaymentsfortheunderstatementofinflationsuggeststhattheSocialSecuritysystemalonewouldhaveimplodedmanyyearsagohadpaymentsmatchedunderlyingratherthanreportedinflation.
Inotherwords, the use of ‘real’ inflation data would have overwhelmed the federal budget completely.
Anotherimplicationofdistortedinflation,animplicationthatmayhaveplayedahugelyimportantroleinthecreationofAmerica’sdebtbubble,isthatreal interest rates may have been negative ever since the mid-1990s.Taking2007asanexample,averagenominalbondrates8of4.6%equatedtoarealrateof1.8%afterthedeductionofofficialCPI-Uinflation(2.9%),butwereheavily(4.2%)negative
inrealtermsifadjustmentismadeonthebasisof+6%-underlyinginflation(of8.9%)instead.
Logically,itmakesperfectsensetoborrowifthecostofborrowingislowerthantherateofinflation.WhilstmostAmericansmaynothavebeenawareofthewayinwhichinflationnumbershadbeensubjectedtoincrementaldistortion,theireverydayexperiencemayverywellhaveledthemtoactonagutinstinctthatborrowingwascheap.
Webelievethatmisreportedinflation,togetherwithirresponsibleinterestratepoliciesandwoefullylaxregulation,mayhavebeenamajorcontributortotherecklesswaveofborrowingwhichsodistortedtheUSeconomyinthedecadepriortothefinancialcrisis.Indeed,understated inflation may have been the smoking gun where the flood of cheap money was concerned.
what growth, what jobs?
Understatedinflation,then,hasdepressedwagegrowth,impoverishedthoseinreceiptofbenefits,maskedthedeclineinthepurchasingpowerofthedollar,andveryprobablycontributedtoarecklessmonetarypolicywhichhasmiredtheUnitedStatesinexcessive
debt.Butitmayalsohaveresultedineconomicgrowthbeingreportedwhen,inreality,theAmericaneconomyhasreallybeenshrinking,notgrowing.
Accordingtoofficialfigures,theGDPoftheUnitedStatesincreasedby18%,inrealterms,between2001and2011.Butsuchnumbers,ofcourse,areafunctionoftwocalculationswhich,aswehaveseen,arenotinthemselvesreliable.First,thereportedGDPnumber(of$14.5trillionin2010)ishighlyquestionable,becauseitincludesnon-cash“imputations”totalling$2.3trillion.Second,andmuchmoreseriously,sincethewayinwhichofficialinflationiscalculatedisopentoveryseriousquestion,so,too,istheGDPdeflator,theadjustmentwhichisemployedtobackouttheeffectsofinflationfromchangesinthenominalmonetaryvalueofeconomicoutput.Ritualclaimsthatthedeflatorisworkedoutbycomparingsimplechainedvolumetric(thatis,non-monetary)measurementofGDPshouldnotbetakentooseriously,becausetherealityisthatitisimpossibleentirelytode-linktheGDPdeflatorfromothermeasuresofinflation.
strategy insights | issue eight18 strategy insights | issue eight188 Annual average interest rate for 10-year Treasuries. Source:
Economic Report of the President, 2011 datasets
Onceadjustmentismadeforthedistortionofinflation,theevolutionofAmericanrealGDPoverthelastdecadepresentsagravelydisturbingpicture.Adjustingreportedgrowthdownwardstoreflecttheunderstatementofinflationsuggeststhatthe United States has been in almost permanent recession for ten years,withrealGDPfallingyearafteryear,anddecliningverymateriallysince2001.
Thispictureofeconomicdeteriorationisreflectedintheunemploymentstatisticsor,rather,itwouldbe,ifthesewerenotsoheavilymassagedbyreportingmethodologies.Theofficial(U-3)number,currently8.4%,excludesthemillionsofunemployedAmericanswhoaredefinedas“discouragedworkers”.
Ifthesepeoplewereincluded,togetherwithother“marginallyattached”workers,andthosewhoareinpart-timeworkbecausetheycannotfindfull-timeemployment,the BLS itselfconcedes(onitsbroaderU-6measure)thattheunemploymentratewouldbeover15%.Analystswhohaveunpickedallofthevariousmethodologicalchanges(includingalterationstosamplingtechniques)arguethattherealrateofunemploymentisevenhigher.
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Inthefaceofpersistentlyhighlevelsofunemployment(evenonthebasisoftheunderstatedU-3definition),Americanshavebeenaskedtobelieveintheconceptof“joblessgrowth”asawayofreconcilingweakjobdataontheonehandwithreportedgrowthinGDPontheother.Therealexplanationissimpler.Itisthatmost of the economic growth of the last decade has been illusory.
Theexplanationsfornegativegrowth,combinedwithhighunemployment,arenotparticularlydifficulttoascertain.First,America’sacceptanceofone-sidedglobalisationhasseenAmericanjobstransferredtolower-costlabourpoolsintheemergingeconomies,apointsoobviousthatitisremarkablethatanyoneeventriestodenyit.
Second,relatedstructuralchangehasseentheincreasingdisplacementoflabour-intensiveindustries(suchasmanufacturing)withactivitieswhich,intrinsically,haveverylowlabourintensity.
“another day older, deeper in debt…..”
ThestatisticalmanipulationwhichhasdistortedGDP,growth,inflationandunemploymenthasimplications,too,forfederaldebtandthedeficit,
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bothofwhicharemuchworsethantheyatfirstsightappear.ThemainreasonforthisisthattheAmericangovernmenthastakenonhugequasi-debtcommitments,mostofwhichareexcludedfromthefederalbalancesheet(thoughitistothecreditoftheUSthattransparencyoverthisissueisfarbetterthanitisinBritain,letaloneintheEurozone).
AttheendofFY(fiscalyear)2010,officialstatisticsshoweddebt“owedtothepublic”–thatis,excludingdebtheldbyotherdepartmentsofgovernment–at$9,060bn,afigurewhichinitselfrevealsahugeincreaseoverfouryears,sincetheequivalentfigurewas$4,868bnattheendofFY2006.FederalReservedatashowsthatdebtowedtothepublichasrisenstillfurther,nowexceeding$10trillion.Butthereportednumbersexcludetwoverymateriallinesofquasi-debt.Thefirstofthese,includedintheofficialbalancesheet,isa$5,720bncommitmenttopaypensionstogovernmentemployees.Thesecondisa$4,577bnpooloffederaldebtowedtootherpartsofgovernment.
ThesignificanceofthelatternumberisthatitformstheprincipalassetoftheSocialSecurityandMedicaresystems,bothofwhichhaveliabilities
whichfarexceedtheiraccumulatedassets.AttheendofFY2009,netliabilitieswerestatedat$52.2trillioninrespectofclosedsystemclaimants,afigurewhichisoffsetby$6.3trillionwhich,itisassumed,willbethenetpositivecontributionoffutureschemeparticipants.Withinthe$52.2trillionFY2009figure,$33.5trillionwasattributabletoMedicareand$18.6trilliontoOASDI(oldage,survivorsanddisabilityinsurance),withthebalancerelatingtorailroadpensions($140bn)andblacklungprovisions($6bn).
DuringFY2010,theoutstandingMedicarecommitmentwasreducedbyabout$15trillion,reflectingtheassumptionthattheObamahealthcarepackagewillresultinaverymaterialreductioninfutureclaimsonMedicare.Whilstthisistrue,itissomewhatdisingenuous,inthatthefundingforhealthcarewillstillneedtobesourcedfromtaxpayers,suchthatthefuturefinancialobligationhasbeenshiftedfurtheroff-balance-sheet,noteliminatedaltogether.
What,then,isthetrueleveloffederalgovernmentdebtandquasi-debt?Inclusionoftheentireoff-balance-sheetliabilitiesassociatedwithOASDIandMedicarewouldbeexcessive,becausethesesumsarecalculatedon
thebasisofliabilitiesstretchingout75yearsintothefuture.Fewgovernments(orotherinstitutions)measuretheircommitmentsthatfarahead.
Ifweapplystandardnetpresentvalue(NPV)techniquestotheofficialnetliabilitiesforFY2009butlimitthecaptureto30ratherthan75years,thequasi-debttotalforclosedschemeparticipantsdeclinesfromthereported$52trillionto$41trillion.Thisnumberfallsfurther,to$34trillion,basedontheFY2010computationinwhichtheObamahealthcaresystemisassumedtoeliminatemajorforwardMedicareliabilities.Thisnumber,ofcourse,isnetoftheassetsheldbyOASDIandMedicare,comprisingfederaldebtof$4.6trillionwhichOASDI,atleast,islikelytostartdrawinguponinthenearfuture(someestimatessuggestassoonasFY2013).Italsoexcludesforwardpensionandwelfarecommitmentstofederalemployees.
Takeninaggregate,then,federaldebtandquasi-debtcanbeputrealisticallyat$53.3trillion,comprisingdebtowedtothepublic($9.1trillion),debtheldbyothergovernmentagencies($4.6trillion),pensioncommitmentstoemployees($5.7trillion)andthe30-yearportionofnetquasi-debtcommitments($34trillion)9.
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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 • 30-year portion of net quasi-debt commitments: $33,977bn Total: $53,334bn
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Basedontheofficialnumberfor2010economicoutput($14.5trillion),thisestimateoffederaldebtandquasi-debtequatesto367%ofGDP.Ifwestripoutthenon-cash“imputations”componentofGDP($2.3trillion),thefederaldebtandquasi-debtratiorisesto435%.Bothnumbersexcludeprivate,corporate,bankandstatedebt,whichtotaleither300%ofGDPor356%,dependinguponwhethertheimputedcomponentofGDPisleftinorexcluded.
Weshouldbeclearthatoff-balance-sheetliabilitiesarenotthesamethingasdebts.Congresscouldeliminatefutureliabilitiesbyasimplelegislativeinitiative.ButisCongresslikelyatanypointtoadmitthatfuturebenefitspromisedtothepubliccannotbepaid?Wedonotenvisagethatthiswillhappenanytimesoon.
Justasanassessmentoffederaloff-balance-sheetcommitmentsproducesdebtratioslargeenoughtoscaresmallmonkeys,muchthesamecanbesaidofthefederaldeficit.Thisnumberwasreportedat$1.29trillioninFY2010,equivalentto8.9%ofofficialGDP.
Butannualincreasesinquasi-debtcommitmentsarerunningatanunderlyingrateofabout$2.1trillion,meaningthattherealdeficitisarguably$3.4trillion,equivalentto23%ofofficialGDP,or28%ifimputationsareexcludedfromtheGDPdenominator.
Anunderlyingfederaldebtandquasi-debttotalofsome$53trillion,ontopofprivate,bank,stateandlocalgovernmentdebtof$44trillion,couldbeusedbyAmerica’scriticstodemonstratethattheUnitedStatesisbankrupt.Anysuchinference,ifnotfundamentallymistaken,mostcertainlywouldbepremature.Americamaybetechnicallyinsolvent(inthesensethathercollectiveliabilitiesfarexceedanyremotelyrealisticcalculationofthenetpresentequivalentoffutureincomestreams),butsheisnotilliquid.ThebulkofAmerica’sobligationsarequasi-debtsowedtotheAmericanpeople,whichessentiallymeansthatforwardwelfareandpensioncommitmentscannotbehonoured(thoughfew
politiciansarelikelytoadmitthis).Inthenearer-term,theblue-chipratingofAmericangovernmentpaper,reinforcedbythereservestatusoftheUSdollar,meansthatWashingtoncancontinuetolivebeyondAmerica’smeansforsomeyearsyet.
TherearethreechinksinAmerica’sarmourwhichinvestorsneedtowatch.Thefirstoftheseisthefederalcreditrating,whichlastyear(andcontroversially,thoughsurelyrealistically)wasdowngradedfromtriple-AbyS&P.Thesecondisthereservestatusofthedollarwhich,again,isbeginningtolookincreasinglyanomalous.Butthethird–andbyfarthemostworrying–dimensionofAmerica’sparlousfiscalandeconomicstateistheseverityofeconomicunderperformance.
Accordingly,asweturntoanassessmentofquitehowAmericagotintohercurrentparlouscondition,theprimaryfocusmustbeonthecausesofthefundamentalweakeningoftheUSeconomy.
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strategy insights | issue eight24 10 Bloomberg, June 16, 2010
“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
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why did this happen?
Aswehaveseen,then,theeconomicandfiscalstatusoftheUnitedStatesliessomewherebetweenbad(ifyoubelievetheofficialdata)andhorrendous(if,likeus,youdonot).Thisisnot,oratanyratenotyet,causefordespair.Americaremainsnotjusttheworld’slargesteconomybutalsoitsmosttechnologically-innovative.
But,toparaphraseSen.Simpson,thisistheendoftheline.TheUnitedStatesneedstoconductathoroughandforthrightappraisalofitseconomicweaknesses,andtotakeurgentremedialaction.Failuretodosowouldbearecipeforabsoluteaswellasrelativeeconomicdeclineand,soonerorlater,forafull-blowndebtdisaster.
OuranalysissuggeststhattherearefourprincipaleconomicproblemswhichconfronttheUS:
1. Faultycapitalmarkets,compoundedbyweakregulation.
2. Anexcessiveemphasisonconsumptionoverinvestment.
3. Gravemisallocationofcapital.
4. BlitheacceptanceofaformofglobalisationwhichworkstothedetrimentofAmerica.
TheWestern(and,inparticular,theAmerican)economicsystemhasbecomechronicallydebt-andbubble-prone.Consumptionhasbeenfavouredoverinvestment,and,withintheinvestmentpoolitself,capitalhasbeendisastrouslymisallocated,withfundsbeingsteerednotintoproductiveusesbutintovanityprojectsand,worstofall,intotheinflationofthevalueofexisting,unproductiveassets.
Justasimportantly,Americaneedstowakeuptotherealityofcompetitionfromemergingcountries,mostnotablyChina.Thelong-standingeconomicassumptionof‘comparativeadvantage’hasledtheUS,andtheWestingeneral,intoanacceptanceofaformofglobalisationthathasworkedtoitsgravedisadvantage.
Theeconomicmodelhasfailed,bothathomeandabroad.Howhasitfailed?Andwhy?
a failed paradigm
Essentially,theUS,andtheWestmoregenerally,have,certainlysincethecollapseoftheSovietUnionandarguablysincetheendoftheSecondWorldWar,operatedavariantofthefree-marketsystembasedontheRicardianassumptionof‘comparativeadvantage’.AssociatedwiththeBritish
economistDavidRicardo(1772-1823),thecomparativeadvantagemodelarguesthateveryonebecomesbetteroffifeachcountryspecialisesinthoseactivitiesatwhichitenjoysthegreatestcomparativeadvantage.Ifthelogicofthismodelisaccepted,itisnaturalthatAmericashouldcedemanufacturingtolower-costcompetitorssuchasChina,concentratinginsteadonhigher-added-valuesectorssuchastechnologyandfinancialservices.TheRicardianmodelassumesthatsuchspecialisationenricheseveryonebecauseitmaximisestheefficiencyoftheglobaleconomicsystem.Geopolitically,theeconomicinterdependencyofnationsisalsoassumedtomaketheworldmoresecure.
Onpaper,thelogicofthisargumentseemscompelling.Inreality,however,Ricardiancomparativeadvantagemakestwobasicassumptions,bothofwhicharefundamentallyflawed.First,itassumesthateveryoneplaysbytherules,whichmanifestlyhasnotbeenthecaseinrecenttimes.Second,itassumesinfinitescopeforgrowth,sothattheeconomicsuccessofonecountryisnotachievedattheexpenseofanother.Inaworldwhichisbeginningtobuttupagainstresourceconstraints,the‘infinitegrowthcapability’assumptionisn’ttrue,either.
part two
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TheUShasfollowedaRicardianmodelsincetheBrettonWoodsconferencewhichestablishedthepost-Wareconomicsettlement.Thedollar,thenpeggedtogold,becametheglobalreservecurrencywithinanassumedpreferenceforfreetradeandtheunrestrictedmovementofcapital.Essentially,BrettonWoodstiedtheglobalfinancialsystemtoagoldstandardviathedollar.In1971,RichardNixonfamously“slammedthegoldwindow”,endinggoldconvertibility(thoughthedollarremainedthereservecurrency).Latterly,afterthecollapseoftheSovietUnion,theUSledtheWestintotheacceptanceofaglobalisedfreetrademodelinwhichUS,EuropeanandJapanesemarketswerealmostwhollyopentotradeandinvestmentfromemergingcountries.
Overthelasttwentyyears,thismodelhasworkedtoAmerica’sgravedisadvantage,becauseoneofthetwoRicardianassumptions–freeandfaircompetition–hasbeenabrogated,mostconspicuously(thoughbynomeansonly)byChina.Withthesecondassumption–unlimitedscopeforgrowth–nowabouttoproveunfoundedaswellbecauseofresourceconstraints,thecontinuationofunfettered,one-sidedglobalisationcanonlyexacerbateAmerica’seconomicproblems.
Fundamentally,Chinarealisesthatsheisinacompetitivesituation.America does not.
un-american activities: have competitor strategies undermined the US?
China,andotheremergingcountries,operatearadicallydifferenteconomicmodelfromthatacceptedintheUS.Incontrasttothenegligently-regulatedvariantofcapitalismthatdidmorethananythingelsetoleadAmerica,Britain,Ireland,Icelandandothersintofinancialdisaster,China’sversionofcapitalismisastate-directedhybrid,aimedatmaximisingnationaladvantageratherthantheincomeofindividualcorporations.Chinahaskepttherenminbiatanartificially-depressedlevelinorderbothtoboostexportsandtodeterimports.Chinaalsooperatesblatanttariffandinformalbarriersagainstmanufacturedimports.
WhereAmericanbusinessesareprofit-maximisers,China’smainaimisvolume-maximising,theobjectivebeingtoboostlevelsofemployment,notcorporateprofitability.Logically,avolume-maximiserwillalwaysout-competeaprofit-maximiser,particularlywherewagecostsarelowandthetermsoftradearedistorted.
Furthermore,ChinaisengagedinthewholesaleappropriationofAmericanandotherWesterntechnologies–often with Western connivance.
Chinaisoftenaccused,probablyrightly,ofusingcyber-espionage,butweneedtobeclearthatinternational competition is not a parlour-game for children organised under playground rules.Chinaisentitledtopursuewhatsheregardsasthepoliciesmostadvantageoustoherowninterests.TherealquestionhastobewhyAmerica,andtheWestmoregenerally,havefailedtoreact.
Inanycase,the transfer of American technology to China and other emerging countries has been at least as much the result of home-grown negligence as of competitor strategy.Luredbymarketsizeandcheaplabour,Americancompanieshavealltoooftenenteredintoinwardinvestmentagreementswithtechnologytransferstrings.Though,atleastintheshortterm,thesedealscanbebeneficialtocompaniesthemselves,theyhavebeenextremelyharmfultotheoverallcompetitivepositionoftheUnitedStates.ThisunderlinesthepointthatWesternshort-sightednesshasplayedasmuchofaroleascompetitorbehaviourinunderminingWesterneconomicinterests.
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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.
BylendinghugesumstotheUS,Chinahasfunded,andtherebyencouraged,excessiveconsumptionandthemisallocationofcapitalintheUS,whilstatthesametimeexertinganevertightergripasAmerica’screditor-in-chief.ButitistheUSwhichhasallowedthistohappen.
AstheChineseeconomyhasgrown,andasglobalresourceconstraintshaveemergedacrossarangeofcommoditiesincludingenergy,minerals,foodandwater,Chinaandotheremergingcountrieshaveengagedinapolicyofusingtheirhugedollarreservestobuyupresourcesacrosstheglobe,oftenco-operatingwithregimesregardedasdistastefulintheWest.TherecentcommissioningofChina’sfirstaircraftcarrierishighlysymbolic,indicatingthatChinaintendstodeveloptheglobalmilitaryreachrequiredtodefenditscommercialinterests11.
Blitheacceptanceofthisone-sidedformofglobalisationhasharmedAmericainmanyways.First,ofcourse,ithasmadepossiblethehugebuild-upofdebt,andhasencouragedatendencytowardscapitalmisallocationwhichwasalreadyimplicitintheAmericanfinancialsystem.
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Second,ithascontributedbothtoever-wideningincomeinequalitiesintheUS,andtostubbornlyhigh(thoughunder-reported)unemployment.
Third,itwouldnotbetoomuchtostatethatone-sidedglobalisationhashollowedouttheAmericaneconomy,strippingtheUSofmanyofitsformerstapleindustries.
domestic errors – the follies of ideological extremes
ItwouldbealltooeasyforpolicymakerstoattributeAmerica’seconomicwoestounfaircompetitionfromChinaandotherlow-costeconomies,andtoleaveitatthat.Butthiswouldbeafundamentallymistakenstance,becauseitwouldmeanoverlookingthefactthattheeconomicdeclineoftheUSowesatleastasmuchtomistakesathomeastoforeigncompetitorbehaviour.
Aswehavebeenatpainstoexplaininseveralpreviousreports,economicoutcomesresultfromdecisions,notfromthevagariesofacapriciouseconomicdeity.ThecurrentweaknessesintheAmericaneconomyresultfromamultiplicityoffaileddecisions.Investmenthasbeenwasteful,boththefinancialsystemandstructureofcorporategovernancearefaulty,regulationhasbeennegligent,andpoliticalleadershiphasalltoooftenbeenwanting.
TherootcauseofsomuchofAmerica’sfailingshasbeenblindrelianceontheassumptionthatmarketforcesarealwaysbenign.UnderAlanGreenspan,theFedassumedthatbankswouldbehaveresponsiblysimplybecauseitisinthebestinterestsoftheirshareholdersthattheydoso.Thiswasbreathtakinglynaive,notleastbecauseitignored“thedivorcebetweenownershipandcontrol”whichmeansthatbanks(andcorporationsmoregenerally)arerunbytheirmanagers,notbytheirlargelypassiveowners.Apreferenceforriskisin-built,particularlyinabankingsectorwhereagovernmentback-stopwasalwaysimplicitandhas,since2008,becomeexplicitaswell.Interestrateswerekeptfartoolowforfartoolong,evenwhenthereexistedunmistakableevidenceofanasset(property)bubble.Trendsoverthelastdecadeandmoreamounttoagravemispricingofrisk.
Additionally,aspecificmistakehasbeenstirredintothemix.ThiswasthefailureofregulatorstopreventboththeemergenceoftheshadowbankingsystemandtheproliferationofdangerousinstrumentswhichnolessaluminarythanWarrenBuffetthadcalled“weaponsoffinancialmassdestruction”aslongagoas2003.BearinginmindthewayinwhichEnron(andothers)werebroughtdownbyoff-balance-sheetleverageandbyfailuresofoversight,itisgravely
disturbingthattheregulatorswereasleepatthewheelduringthecreationofwhatwasalmostcertainlytheworstbubbleinfinancialhistory.
Wherefollyisconcerned,theproliferationofsubprimelendingisinaclassofitsown.Italmostbeggarsbeliefthatregulatorscouldallowanappetiteformispricedrisktospreadtothepointwheremortgagescouldbepedalledtothosewhowerebothtoopoortoaffordthemandtoounsophisticatedtoresisttheblandishmentsofbonus-motivatedsalesmen.Farfromregulatingthisdistortionofthesystem,governmentactuallyexacerbatedit,notleastbyforcinglenderstodirectmorethanhalfofallnewmortgagesatthoseonlowincomes.
capital sink investment: betting the house
Inpart,thesubprimecrisisreflectedalong-standing,misplacedobsessionwithspreadinghomeownership.ThisobsessionhadlongenteredtheAmericanpsyche,andperhapsnothingsymbolisesthisstateofmindmorethanthe1946JimmyStewartmovieIt’s A Wonderful Life,inwhichS&LbossGeorgeBailey(Stewart)islaudedforhismotivatingdesiretohelpAmericansgetontothepropertyladder.Politiciansofbothpartieshavelongarguedthathomeownershipisasocialgood,andhavebackstoppedthemortgagesystemwithfederalguarantees.
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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.
Fromastrictlypragmaticperspective,governmentsshouldcultivatelowratherthanhighpropertyvalues.Lowpriceswouldenableyoungpeopletofindhomes,wouldprecludethecreationofdamagingbubbles,woulddrivemiddleclassAmericansintogreaterinvestmentdiversityand,mostimportantofall,wouldliberatecapitalformoreproductiveinvestment.
Fromafixationwithhomeownershipitisjustashortsteptoabeliefthatrisinghousepricesarepositiveforsociety.Infact,thisisveryfarfrombeingthecase,foratleastfourreasons.First,ofcourse,risingpropertyvaluescanpriceyoungpeopleoutofaccesstohomes,andcanimpairlabourmobility.Second,risingpropertyvaluescan,andoftenhave,createdspeculativebubbles.Third,middleclassAmericanshavetendedincreasinglytohavetheirassetsover-allocatedtothehousingsector.Fourth,andworstofallfromaneconomicperspective,housesarecapitalsinks,which absorb investment without generating a return.
Inotherwords,tyingupcapitalinpropertyreducesnationalproductivity.Borrowingtodothisisfolly,andborrowingfrom abroadforthispurposeistheeconomicsofthemad-house.Thereisnothingimplicitlywrongwithborrowing,particularlyiftheborrowedfundsareinvested
productively.Also,borrowingforconsumptioncan,withinreason,boosteconomicactivityandhelpcreatejobs.But,tragically,thisisnotwhatAmericahasbeendoingoverthelastdecadeandmore.Borrowedcapitalhasbeenputintoassetvalueescalation,notintoproductiveinvestment,whilstborrowedconsumptionhascreatedjobsinShanghai,notinSchenectady.
ThehighproportionofAmericans’wealthwhichisinvestedinpropertyposesamajorsocialandeconomicriskgoingforward,becauseoftheongoingretirementofthebabyboomgeneration.Thefirstboomershavenowreachedtheageof66,whilsteventheyoungestwillreachretirementoverthecomingtwentyyears.Millionsofthesepeopleexpecttorelyfortheirsecurityinoldageonmonetisingtheirassets,butno-onehasexplainedquitehowthisissupposedtohappenwhenthefollowinggenerationisnotonlyfewerinnumberbutindividuallypoorer.Thisarguesforafurtherseculardowntrendinpropertyprices,undercuttingmillionsofAmericans’assumedabilitytoenjoyagoodqualityoflifeinretirement.
Evenwherethelimitedpoolofnon-housinginvestmentisconcerned,fundshavealltoooftenbeenchannelledintovanityprojectsratherthanintoessentialinvestment.
Accordingtovariousexpertstudies,thelevelofinvestmentrequiredtorestoreAmerica’sinfrastructuretoasafeandcompetitiveconditioniswellinexcessof$2trillion.Littlehasbeendonedespitethetragic2007collapseoftheI-35WbridgeovertheMississippi,inwhichthirteenpeopledied.
NewYork,forexample,hasitsshareofageingpowersupplysystems,roadsandbridges,andhasnorealideaabouthowtopayforreplacements,yet,withinthelastdecade,hasfound$2.5billiontobuildnewstadiaforitsprincipalsportsteams(theMets,theJetsandtheGiants12).ThetragedyofNewOrleansinpartreflectedafailuretoinvestinimprovingtheleveesbuiltbyearliergenerationstoprotectthecityfromdevastatingfloodsofthetypetragicallyunleashedbyHurricaneKatrinain2005.
IfAmericahasgraveproblemswithcapitalallocation,ithasequallysignificantproblemswithitslabourpool.BoththepresidentandtheprimeministerofChinaaregraduateengineers,whereasBarackObamaisalawyer.Americancollegesproduce41lawgraduatesforeveryengineer.Eachyear,thebrightestyoungAmericansareluredintocareersininvestmentbankingandthelaw,ratherthanintoactivitiessuchastechnologyandmanufacturing.
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ThesetrendsarereflectedinthegrowingfinancializationoftheAmericaneconomy,bywhichismeanttheincreasingshiftfromproductiveactivities(suchasmanufacturing)intotheessentiallyunproductiveactivityofsimplymovingmoneyaround.
Thisprocessof‘financialization’isanestablishedend-of-eraphenomenon,andwasassociatedwiththelatterdaysofglobalsupremacyinSpain,theNetherlandsandGreatBritain.InSpain,theaccumulationandmovementofNewWorldbullionandofgovernmentpaperbecamemore
importantthanproductiveactivities,puttingthecountryintoinexorabledecline.MuchthesamehappenedwheninternationalfinancingactivitiesdisplacedindustryandtradeinnineteenthcenturyBritain.
Isthis‘endofera’processnowtakingplaceinAmerica?Itcertainlyseemsthatway.Asfig.5shows,manufacturinghasdeclinedfrom29%ofGDPin1950tojust11%in2009,whilstthebanking,realestateandinsurancesectors’sharehasincreasedfrom11%to22%overthesameperiod.
Ofcourse,financialservicesplayahugelyimportantroleintheeconomy,andmarketsarebyfarthebestmechanismfortheeffectiveallocationofcapital.ButAmericansmayberighttowonderwhetheranappropriatebalancehasbeenlostwhenthefinancialsectorbecomesalmosttwiceaslargeasthemanufacturingindustrywhichpropelledAmericatoglobaleconomicandpoliticalpre-eminence.Thesolution,ofcourse,isnottodownsizefinancialservices,buttosupportotherpartsoftheeconomy.
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,tableB-12,andKevinPhillips,Bad Money,2009edition,page31
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strategy insights | issue eight32 13 Farewell Address to the Nation, 17th January 1961
“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
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how should america respond?
Unlessradicalandtimelychangesareimplemented,historiansofthefuturearelikelytoregardthe2008bankingcrisisasadecisivetipping-point,themomentatwhichAmericalostherlong-standingglobalprimacyaseconomicpowerlurcheddramaticallyfromacomplacentWesttoabrashlyconfidentEast.IfAmericadoesindeedsurrendertheeconomicpoweruponwhichallotherformsofglobalinfluencearebased,thosesamefuturehistoriansarelikelytoincludeafailedeconomicmodel,failedfinancialregulation,failedcorporatestructuresand,aboveall,afailureofleadershipamongstthefactorswhichallowedAmerica’sprimacytogobydefault.
Thusfarinthisreport,wehaveaddressedtwokeyissues.First,wehavesoughttolookbehindthestatisticalcamouflagetorevealquitehowdireAmerica’seconomicandfiscalproblemsreallyare.Second,wehaveexplainedthekeyweaknesseswhichhaveledAmericaintoitscurrentparlousstate.Here,weconcludebysettingoutsomeofthosemeasureswhich,webelieve,canreversetheadversetrendswhichhavebeenunderminingtheUnitedStatesforatleasttwodecades.
Noanalysissuchasthisiswrittenfromapositionofperfectneutrality.Theviewtakenhereisthatprosperityandcohesionareproductsofbalanceandofresponsibility,andthatchecks-and-balancesareimperative.Capitalismisthemostpotentwealth-generatingsystemevercreated,andfreemarketscanalonedelivertheoptimumallocationofcapital.Butacompletely unfetteredfreemarketsystemcanalsoproducedistortionsandanomalies,notjustinthedistributionofeconomicrewardsbutalsoinstructuresandinstrategicdirections.
Attheinstitutionallevel,America’sfoundingfathersincorporatedtheirrecognitionoftheneedforchecks-and-balancesintotheConstitutionoftheUnitedStates,whichestablishedthecriticalseparationofpowerbetweentheexecutive,thelegislatureandthejudiciary.Bondmarketsoperateasafinancially-equivalentbalancingmechanism,checkingthewilderirresponsibilityofgovernments.Butinternaleconomicandfinancialbalancingmechanismsarenecessarytoo,andalackofsuchbalancehasbeenthesinglemostdamagingfactorintheweakeningoftheAmericaneconomy.TheobjectivenowshouldbetorestorebalanceanddirectiontotheAmericaneconomicsystem.
WhenDwightD.EisenhowerwarnedAmericansabout“thedisastrousriseofmisplacedpower”,thethreatthathehadinmindwas“themilitary-industrialcomplex”.Hewouldhaveshownmoreprescienceifhehadhewarnedinsteadabouta“finance-industrialcomplex”.JustaslaxcorporateregulationledtotheEnronandWorldComscandals,excessivederegulationofthebankingsystemleddirectlytothefinancialcatastrophewhicheruptedin2008andwhich,inourview,hasyettoreachafinaldenouementwhichnowmaybeimminent.
America’s single most pressing domestic need is to restore the balance between probity and innovation in its banking system.Theessentialproblemhasbeenadisastrousmispricingofrisk.Itwassurelyobviousfromtheoutsetthatregulators’failureeventonotice,letalonetoprevent,theweakeningofthelinkbetweenlenderandborrowerwouldhavecatastrophicconsequences.
Historically,mortgagelendersexercisedcautionbecauseeventualrepaymentdependedupontheviabilityoftheborrower.Overthelastfifteenyearsorso,thisall-importantlinkhasbeenallowedtoweaken,enablinglenderstoissuemortgages
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armageddonusa? | america at the crossroads
inthecomfortingknowledgethat,iftheborrowerfailedtomeethiscommitments,someoneelsewouldbeartheloss.Thisdistortionoftherelationshipbetweenlenderandborrowerlednotjusttothemispricingbuttothereversepricingofrisk,suchthatlendingtotheriskiestborrowersbecameahigh-returnsprocessbecauseriskcouldbeunloaded.Thisprocessranitswhollypredictablecourseinthesubprimedisaster.Inthefuture,fargreatertransparencyisimperative.Akeyrecommendationofthisreportisthatthesecuritizationofmortgagesshouldbesubjected to tighter regulation.
Americaalsoneedstoaddressissuesoffinancializationbyencouragingindustries,suchasmanufacturing,whichincreasinglyhavebeenoutsourcedtocheapercompetitors.Thefreefunctioningofthemarketsystemisaneconomicimperative,butsomethinghasbecomemisbalancedwhenthemanufacturingsectorhasdwindledtobarelyhalfthesizeoffinancialservices.Neithersixteenth-centurySpainnornineteenth-centuryBritainlearnedthiscriticallesson,andtheeconomiesofbothwereunderminedwhentheybecamedominatedbyrentiersratherthanbyentrepreneursandproducers.
Curbingtheexcessesofthebankingsystemwill,ofcourse,requireconcertedactionbygovernment,anditisimperativeinthiscontextthatAmerica’sleaderstaketheelectoratewiththem.Thoughsimpleinprinciple,tighterregulationwouldneedtobeimplementedintheteethofformidably-fundedopposition.
Inthiscontext,thecontemptinwhichgovernment(irrespectiveofparty)isheldbyAmericansisbothremarkableanddisturbing.Afterall,thegovernmentoftheUnitedStatesimplementedsuchfar-reachinginitiativesastheTennesseeValleyAuthority,wontheSecondWorldWar,andputNeilArmstrongandBuzzAldrinonthemoon.ButAmericaseemsnowtohavelostalmostallbeliefinnational,collectiveaction.America’sleadersneed,asamatterofurgency,togaingreatercredibilitybyputtingtheinterestsofthecountryabovetheirownpartisanambitions.
Americacanaffordtogettough,becauseChina’sstabilitydependsentirelyuponthecreationandmaintenanceofhundredsofmillionsofjobs,andthishasbeenaccomplishedalltoooftenattheexpenseofbusinessesandjobsinAmerica.
JustasAmerica’sgovernmentneedstogettoughabroad,itneedstogettruthfulathome.LikeotherWesterncountries,anAmericalulledintocomplacencybypost-Warprosperitygotintothehabitofmakingforwardpromisestoitscitizenswhich,itisnowclear,cannotbehonoured.Itisabouttimethatsomeoneadmittedthis.Americaalsoneedstocutbureaucracy,eliminatewastefulprogrammesandcontemplatetaxincreasesinordertobringitsbudgetbackintobalance.
Thetriple-AquestionnowiswhetherAmericahastheleadershipwhichwillenablethistohappen.
America’sfriendsmusthopethatshehas.
Dr Tim MorganGlobalHeadofResearchTullettPrebonplc
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about the author
TimMorganreadhistoryandpoliticalphilosophyatEmmanuelCollege,CambridgebeforejoiningstockbrokersWoodMackenzieasatraineein1982.HemovedtoMontaguLoeblStanleythefollowingyear,shortlythereafterassumingresponsibilityforthefirm’soilandgasresearch.
In1985,hejoinedthestockbrokersWICarr,whichbecamepartofBanqueIndosuezin1986.Afterashortperiodwithaboutiquebroker,heestablishedanenergysectorresearchconsultancyin1990.Duringthe1980s,hehadmadetwoimportantdecisions.First,thattheprevalentearnings-basedinvestmentanalysiswasout-dated,andthattheemphasisofresearchneededtoshifttocash-basedmeasurementofshareholdervaluecreation.Thesecondwasthatsingle-countryresearchwasinappropriateinanincreasinglyglobalisedeconomy.Thesedecisionsledhimtodevelopthevalue-basedVVM™analysissystem.
Between1995and2006,TimwasconsultantenergyanalystatCollinsStewart,astockbrokingfirmwhichachievedrapidgrowthonaplatformofresearchoriginalityandtechnologicalexcellence.HejoinedShoreCapitalGroup,againasaconsultantenergyanalyst,inMay2007,but,inFebruary2009,wasinvitedtoformalisearolethathehadbeencarryingoutforsometime–thatofeconomicandmarketstrategist.
Inthisrole,heattractedconsiderablenoticeforareportinwhichhewarnedthatadecadeofeconomicmismanagementhadtakenBritaintothebrinkofa“debtvortex”.ThisbuiltuponanearlierreportwhichcontendedthatrecentUKeconomicgrowthhadbeenlargelyillusory,beingbasedupondebtescalationandtheunderstatementofinflation.Healsopioneeredthethree-partMatrix™approachtoinvestinginperiodsofhighsystemicrisk.
Whilstretainingakeeninterestinenergy,hiscurrentresearchfocusisontheimplicationsofanacceleratingprocessofchangeintheglobaleconomy.Hebelievesthatthisprocessisexposingaseriesofmajoreconomic,financialandpoliticalimbalances,andthatitisimperativethatfinancialmarketparticipantsbekeenlyawareofthestructuralimplicationsofthisprocess.
Tim’sextra-curricularinterestsfocusondefenceissues,theenvironment,musicandcommunityinvolvement.Hehasaparticularinterestinwarships,haspublishedabookonthesubject,andhasrelishedtimespentatseawiththeRoyalNavy,believingthatfewexperiencescanequaltakingofffromanaircraftcarrierorparticipatinginamphibiousexerciseswiththeRoyalMarineCommandos.
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