Outlook 2020: The Economy

This is the second in a series of blogs on the likely events of the next 10 years.

If we’re lucky, 2010 could be a lousy year. If we’re unlucky, 2010 could be a disastrous year, worse than 2008, because there are potential nasty surprises lurking out there. Such surprises could precipitate another, even worse financial crisis, and dump us into a global depression, instead of the recession from which we are now emerging. I’m going to deal with the issue of the nasty surprises in a later blog, so just for the moment, I’m going to assume that none of them will happen, and the economic future will unfold about as it looks now. And, although I’m looking out to the year 2020, I’m going to start by looking at 2010 on its own before moving beyond there.

The Prospects for 2010

America is out of its recession, but I would hesitate to call what we have now a recovery. It’s true, U.S. GDP grew by a reported 3.5% in the third quarter of 2009, but that was, in many ways, misleading. In the first place, it was heavily influenced by government stimulus, especially the “cash for clunkers” program. Since government stimulus will be tapering off in 2010, and the car incentives are finished, this source of economic strength will be missing. But even more revealing, barely was the ink dry on the reports of 3.5% GDP growth when they were revised downwards to 2.8% – an unusually large and rapid downward revision.

To see what’s ahead for the U.S. economy, let’s start with public sentiment. One of my favorite indicators of economic strength is the frequency with which the word “recession” appears in the mainstream media (“MSM”). This indicator has been known and used for decades, but before the Internet, you had to be in the MSM to have the ability to perform this count. In 1995, I realized that I could do it myself using Googles’ news website, and since September of 1995, I’ve done just that every week, and then graphed the results. Here’s how this graph looks today (the X-axis has been inverted since “recession” is inherently a negative idea):

© Copyright, Richard Worzel, December 2009.

One of the interesting things about this indicator is the date when it said we felt the best about the world, which was July 30th, 2007. This was just five months before the indicator dropped suddenly at the beginning of 2008, indicating that concerns were rising. This subsided in the Spring of 2008, but then collapsed in earnest in October of last year – a trough from which we haven’t yet recovered. Clearly, we were all feeling fat, dumb, and happy in mid-2007, without realizing how bad the underlying fundamentals were. And the most important lesson to draw from this is that sentiment indicators are not good predictors of problems, only feelings.

Yet sentiment is important. It embodies what economists call the “animal spirits” of an economy, being the courage to go out and do things, like take risks to make and spend money, and the willingness to trust that the other side of a transaction can and will fulfill their part of an agreement. Without these feelings of courage and trust, people hunker down in a hole, don’t spend money, and the economy’s heartbeat stops, which pretty much describes what happened last year.

Now, looking at the chart again, we can see that although our “animal spirits” have recovered from the depths, we are nowhere near where we were at the beginning of 2008. We’ve climbed back, but seem stuck halfway – and that’s a pretty fair estimate of what I expect for 2010. The economy will grow – but slowly. Unemployment will stop exploding, but employment will be painfully slow in coming back. Indeed, employment typically is slow to return at the beginning of a recovery because business owners are still wary of potential problems, and because they can increase working hours, through additional shifts and overtime, without hiring additional staff. This increases productivity and profits without increasing risks – a good bet in perilous times, but tough on those out of work. So, the prospects for America’s economy in 2010 are weak, at best.

Despite this, the outlook for inflation is dismayingly bad. I consider the price of oil to be the bellwether of rising prices, because of its pivotal position in the global economy. The price of a barrel of oil dropped from $147 to $30, and has bounced back to over $70. Now, it’s true that $30 a barrel was clearly an overreaction by a market that was wondering if the world was coming to an end, but you still have to ask why it would bounce back so far and so fast. The answer, as it often is in this day and age is simple: China, India, Brazil, and the other Rapidly Developing Countries (RDC’s). They barely went into recession, or merely experienced growth slowdowns, which were over relatively quickly. As their economies bounced back, their thirst for oil began growing again. And when the developed country economies begin growing again, all of the bottlenecks that caused the price of oil to spurt upwards in 2006 & 2007 will come into play again, and the price of oil will, once again, spurt upwards, stoking the next inflation cycle. And because of the growing relative importance of the RDC’s in the global economy, we will all experience more inflation much earlier than we would normally expect in this economic cycle.

This same combination of RDC growth and developed world recovery will play out again and again beyond oil. Food will be one of the next places it will happen, followed by other commodities and resources. The net result is that we will start hearing about an indicator that went out of fashion in the 1980s: the “Misery Index.” The Misery Index is the unemployment rate plus the inflation rate, and reached an annual high of 20.76% in 1980[1]. For comparison, it reached a modern low in 1998 at 6.05%, and its post-World War II low was in 1953, when it was 3.74% If America’s unemployment rate sticks somewhere around 10%, which I expect it will, and inflation reaches 5%, which it might despite the weak U.S. economy, then the Misery Index will reach 15% – a level not seen since 1982 when Ronald Reagan was president. All of which is why I say that if we’re lucky, 2010 will be a lousy year.

Canada’s 2010 – Canada will have an uneven year, which is to say that some parts of Canada will do quite well, while others will continue to suffer. Most of the suffering will be done in Central Canada – Ontario & Quebec – because of their reliance on manufacturing, especially in cars, their overwhelming ties to the United States, and the strength of the Canadian dollar. All of these mean that the two former powerhouses of the Canadian confederation will now lag most of the rest of the country in recovery. Indeed, if the loonie continues to strengthen against the greenback, Central Canada could have an even worse year than the United States.

Meanwhile, those provinces that supply natural resources, particularly Alberta and Saskatchewan, and to a lesser extent B.C. and Newfoundland, will do much better. With oil strengthening, and food following, the two Prairie provinces will build on their previous strengths and outperform the rest of Canada, as well as the United States, and their strength could continue to boost the price of the loonie. The resource provinces will also increase their trade with the developing countries of the world, notably China. Indeed, I would suspect that we will see a return of corporate takeovers of Canadian resource companies that could cause the Toronto Stock Exchange to outperform most developed world counterparts in 2010.

All of this will add political friction between the new “have” and “have-not” provinces that will make life testy and interesting in Parliament in Ottawa.

RDCs – Meanwhile, the RDCs, again lead by China and India, but also including Brazil and to a lesser extent Mexico, Malaysia, and Indonesia, are bouncing back from a fairly traditional inventory-led recession or growth slowdown.

There is more to RDC growth than China. Everyone has heard of India, and India will continue to try to accelerate its growth. However, watch Brazil as well, which is becoming the next powerhouse after having settled its long-standing problems of political and economic stability. We will be hearing more and more about the giant emerging in South America.

China’s ambitions – One particularly important issue for the future is China’s pegging of its currency to the U.S. dollar, which means that it has effectively executed a competitive devaluation against the Euro, Yen, and other currencies while maintaining its undervalued status against the greenback. This will cause the U.S. trade deficit to continue to run unsustainably high, and will inflict even more damage on other developed country economies. This is not the behavior of a player concerned about its image in the world, or even in its own long-term enlightened self-interest, but it does accord with my beliefs about what motivates China.

I believe that China has two primary objectives that trump all other concerns; one immediate, and the other long-term. The immediate one is the Chin’s leaders are desperate need to keep economic growth high in order to keep employment growing. If they aren’t able to achieve at least 8% growth in real GDP per year, then by their own reckoning, unemployment will rise, and with it, social and political unrest. And, from what I’ve seen, China’s leaders are more concerned about hanging on to their political power – which means political stability – than anything else. The welfare of its trading partners pales into insignificance in comparison to this critical domestic need, especially when you consider that in 2007 – the last year of strong global growth – China experienced a reported (but unverified) 10,000 spontaneous demonstrations about economic and living conditions around the country. The Red Army may be large, and it may be strong, but it can’t be everywhere, so political instability scares China’s leaders like nothing else. Accordingly, if China’s economy needs exports for strong growth, then it will contrive to have exports at any cost, especially if someone else pays that cost. China is not the first country, or the only country to play the trade game entirely selfishly. Indeed, you could say they’ve stolen Japan’s playbook from the post-war era. But China is playing it very well, if cheating for narrow self-interest is your yardstick.

The second motivation is long-term: China wants to dominate the world, replacing America as the only superpower. This again is supposition on my part, but is, I think, pretty obvious. And if they want to supplant the U.S. as the only global superpower, than inflicting economic damage on your principal geopolitical competitors is not a bad long-term strategy, even if it costs you something in lost trade along the way. It reduces the amount of money your competitor has for military and diplomatic strength. It focuses their attention on domestic issues. And it creates friction between domestic political parties. All of these are helpful to a China that is eyeing the top spot, and would prefer to get there without military conflict.

Beyond 2010

If we assume, once again, that none of the terrible “what-if” scenarios happen, then what happens after 2010?

America’s economy will continue to recover, but more slowly than desirable, and more slowly than in earlier recessions. This was not a typical recession, but was precipitated by too much debt accumulated by consumers, state governments, and, ultimately, the U.S. federal government. It takes time to pay off debts and recover spending power after the excesses of the last 25 years, which is why this recovery will be so anemic. Moreover, with so much of the U.S. housing market still under water, with mortgages bigger than current property values, it will take a long time for home owners and mortgage lenders alike to recover from the scars. This means that 2011 and 2012 are likely to continue to be less than robust.

Beyond 2012, I expect that the U.S. economy, pulled along by the global economy, the Rapidly Developing Economies, and American ingenuity and grit, will begin to pick up speed. And unless some additional shocks or surprises occur, I would expect the economy to continue to grow, and prosperity to return, through the balance of the 2010’s. It will also be accompanied by persistent high inflation – perhaps not high by 1970s standards, but higher than we’ve been used to in the past 20 years or more. This may make it tempting, beyond 2012, for central banks, lead by the U.S. Federal Reserve Bank, to put on the brakes, raising interest rates significantly in order to slow inflation. However, higher interest rates will actually have relatively little effect, because this bout of inflation will be driven primarily by bottlenecks and shortages, particularly in oil production and food, as mentioned earlier. This is going to pose a real quandary for central banks: How can they temper inflation when it’s mostly caused by too little supply rather than by too much money? The only way to lower inflation in that kind of environment is to lower economic growth – and that won’t be very appealing to any central government after years of soft growth.

All told, then, this is going to be a fragile decade for America and her mature trading partners, and the potential for bad things to happen will remain high for quite some time.

RDC’s – The RDCs will continue to grow rapidly, boosting each other’s growth, and gradually pulling the rest of the global economy with them. They will be the principal drivers of the global economy this time around, not the U.S. The bigger question, and one worth watching carefully, is whether their consumers begin to increase their consumption, taking the place of consumption-happy Americans. And how the RDCs deal with the challenges of rising, and persistent, inflation will also tell a great deal about how mature their governments and central banks are.

Canada – Canada’s economy will continue to be uneven, with Ontario and Quebec lagging behind, and the resource economies moving forward with the prices of their resources. However, both Ontario and Quebec are committing significant resources to capture some of the new industrial strength of the green economy. This, along with the slowly improving automotive market, will gradually allow Central Canada to begin strengthening with the advent of the ‘teens of this decade. Meanwhile, low interest rates, kept in place to stimulate economic growth, may produce a bubble in real estate prices in Canada, especially in the major cities, that may threaten Canada’s stability. It would be ironic, indeed, if Canada dodged the bullet that knocked off the American economy in the financial crisis of 2008, only to get hit by it in the next economic cycle. And yet, that is, implicitly, what Mark Carney, the Governor of the Bank of Canada, has been warning for some time. As well, the leading edge of Canada’s baby boom will be entering their 70s by 2020, and that will lead to lower economic growth, and shortages of skilled labor in many areas of the economy. The next 10 years will be a decade of real potential combined with real challenges for Canada.

Europe – In theory, Europe should be the strongest region of economic growth in the developed world. Yet, it is going to struggle at least as much as America, if for different reasons. Britain’s housing market and mortgage market went through pretty much the same wringer as America, and it’s government ran persistent deficits through the fat years that leave it without much ammunition to face the challenges ahead. China has instituted what amounts to a competitive devaluation by pegging its currency to the U.S. dollar, which has been persistently weak compared to the Euro, and will make it harder for Europe to compete with China in world markets. But the clincher really is that Europe is old, and the labor forces of its member countries offer either no-growth or are shrinking. Since, simplistically, GDP growth is composed of labor force growth plus productivity growth, this means the either Europe must massively improve its productivity, or it is going to see its economic growth stagnate, and its share of global output shrink throughout the next 10 years.

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[1] See, for instance, the website http://www.miseryindex.us/customindexbyyear.asp