Chapter 6

Surprise Bailouts

What if I’m Wrong?

In 1989 Yale historian Paul Kennedy published The Rise and Fall of the Great Powers.¹ For a work that was primarily historical, it elicited great controversy, because it predicted that the American leadership position among nations would erode, at least on a relative basis. From a historian’s perspective, this forecast seemed indisputable: hegemonies are impermanent, as this book has confirmed. At the time, Japan was the rising power: its lower cost of capital and apparently invincible industrial policy fostered companies that produced goods—cars, electronics, appliances—better and cheaper than Western competitors. And the Soviet Union had been a rising military threat less than 10 years earlier.

What terrible timing. Japan’s economy fell into a deep postbubble torpor soon after in 1990, and the Soviet empire imploded between 1989 and 1991. The 1990s were, in fact, a time of unparalleled American economic, military, and cultural global dominance, leading by the early 2000s to a growing backlash against American “hyperpower” (the word “superpower” no longer captured it). This was expressed in French resistance to American designs in the Middle East and, most tragically, in al-Qaeda’s deadly attacks in 2001.

Even a casual review of long-term forecasts will reveal that many “inevitable” events never happened or unfolded very differently from earlier projections. Anyone with the hubris to describe the future needs to leaven their presumption with the recognition that surprises may occur that will overcome the supposed inevitable they predict. This chapter outlines some possible surprises that could intrude.

Economic Surprises

Productivity Revolution

American anxiety about “Japan as Number One” (another popular book from the early 1980s) occurred against a backdrop of sharp differences in comparative labor productivity. Recall that, on average, improvements in living standards are limited by improvements in productivity: employers can’t pay workers more than the value of what they produce. American productivity, which had grown at about 3% per year for the generation following World War II—fast enough to allow incomes to double in less than 25 years—had fallen into a deep stupor in 1973, along with the rest of the West. Japan, by contrast, accelerated, easily outstripping American productivity growth. This was the economic backdrop of a pervasive angst that preoccupied observers of the U.S. economy in the 1980s.

There was precedent: the U.S. had overtaken Britain 75 years earlier, for the same reason: American industrial productivity leaped ahead of Britain’s in the late 19th and early 20th centuries. The two World Wars supplied the coup de grace that ended British global dominance.

Around the same time (1980) that American economic anxiety reached its peak, a new invention came to market: the personal computer. Knowledge workers became much more effective, as software programs replaced legions of pink-collar staff (receptionists, bookkeepers, file clerks, etc.). While those surviving professionals produced far more value per hour than they could before, for a decade and a half those gains were not visible to economists. A wag noted that “you can see the effects of computers everywhere…except in the productivity statistics.”

All this finally began to change in the mid-1990s. The productivity revolution began in 1995 and, for the most part, has not let up since. It is likely that it took a decade and a half for firms to reengineer their business processes to take full advantage of the new technology. Another possibility is that the full potential of PCs could not be harnessed until they were netted together by the millions, that is, until the Internet was widely used.

Productivity improved in America first and then quickly spread to other countries as their companies strived to remain competitive. In the meantime, Japan botched its attempts to reinflate its postbubble economy, which has remained in a crypto-recession for most of the past two decades.

This book has argued that an aging population will be less productive, and the high tax rates necessary to cover the government’s promises will suppress investment and hence productivity. These trends should occur in every aging country that has huge unfunded liabilities—that is, almost every country, developed and developing. But some new technology or technique may be invented that has as pervasive an impact as did the personal computer and the Internet.

What might that breakthrough be? Venture capitalists the world over are investing to make it a reality. Here are a few possibilities:

Here are a few other “breakthroughs” that are much talked about but not so likely to have broad economic impact:

Another productivity revolution is entirely possible and, like its predecessors, thoroughly unpredictable. If one occurs, it will probably start in the economy with the most entrepreneurs who see the commercial potentials in new scientific breakthroughs. In the last century, the United States clearly had an unbeatable advantage in creating new businesses and, therefore, in economic dynamism. America will still have a better position than many other developed nations, but its position is far less assured as “the rest” rises.

Revitalization Through Immigration

America’s relative openness to immigrants has undoubtedly been one of its great sources of economic strength for more than a century. In his book The Next Hundred Million: America in 2050, Joel Kotkin shows that he believes this will continue.² Certainly the United States is less grudging in its hospitality to immigrants than Western Europe, where open anti-immigrant discrimination is a fact of life, or Japan, which is effectively closed to immigrants.

This difference may be an example of the innate common sense and pragmatism of Americans. But attitudes can change with economic and demographic conditions. Anti-immigrant sentiment tends to be countercyclical (i.e., moves opposite the business cycle): It tends to peak with unemployment and fall as jobs become more available. However, demographic changes are longer lasting.

Judging by Europe and Japan’s examples, as a population ages, it becomes less receptive to immigration. Such a trend is manifestly irrational, since younger immigrants can revitalize an aging population. As individuals become more cautious and less open to outside ideas as they age, not surprisingly, so do whole populations.

In 2003, The Economist magazine reported on an international poll conducted by the Pew Foundation. It asked the question, “Which is more important for government: To guarantee that no one is in need; or to provide individuals freedom to pursue their goals?” The proportion that chose redistribution over opportunity correlated exactly with the country’s median age. In Italy, the oldest of the countries surveyed, “need” was chosen over “opportunity” by more than 3 to 1. In the United States, the youngest of the countries, the proportions were nearly reversed (“opportunity” was chosen over “need” by well more than 2 to 1). Britain, France, and Germany—with older populations—each had attitudes much more like Italy’s than like America’s.

So while optimists like Kotkin count on continued high levels of immigration to renew America as they have done for over a century, that cheery prediction depends on avoiding a backlash against those immigrants. However, it is fair to say that if any large developed nation has a chance of keeping its doors open, it is the United States.

The limits of immigration as a demographic solution are taken up in more detail in chapter 7.

Great Depression 2.0

The world recently avoided a repeat of the 1930s Great Depression because policy makers—most of all Fed chairman Ben Bernanke—had studied its lessons and knew what to avoid: not doing enough. Avoiding a deflationary spiral like the 1930s, or like Japan’s in the 1990s, required desperate and aggressive measures. As of this writing in early 2010, the developed world seems to have avoided a catastrophe but still endured a near-record downturn. While GDP seems to have stabilized, employment may not have yet bottomed out and will take years to recover. A great backlash has emerged as critics such as the Tea Party argue that many antirecessionary policies were actually counterproductive.

Leaders and financial functionaries fight the last war, so the next time the world faces into the chasm of a deep recession, central banks may not do too much but too little. The resulting deflation will aggravate the tendencies toward stagnation described elsewhere in this book, but they may overcome the tendencies toward inflation.

The Flight to Safety

In troubled times, investors flee risk toward safety. In late 2008 as markets crashed, money rushed from stocks and bonds into the world’s purportedly “safest” asset, treasuries. Spreads, or differences in interest rates, between other types of bonds and treasuries reached record levels.

A geopolitical crisis or severe economic downturn could certainly see a repeat of this pattern. Generally, such a flight lasts no longer than—often even less than—the crisis that precipitated it. Credit spreads that widened to historic proportions in late 2008 were already returning to normal levels by mid-2009.

Arguably, this flight to safety occurred in spring 2010 when hundreds of billions in capital left Europe for the dollar. Greece’s misfortunes were America’s temporary good fortune and forestalled the day when many of this book’s predictions will come to pass.

Skeptics will respond to my thesis by arguing, correctly, that many other developed nations have accumulated even more debts than the United States, on top of a faster-aging population (see Greece). But as long as some countries in the world are reasonably well-managed—with a rule of law to protect investors, transparent and liquid markets, and a modest government sector that siphons away resources from the private economy—dollar assets will be less attractive by comparison.

There undoubtedly will be crosscurrents to the basic trend of dollar devaluation this book describes. But long-term trends described herein seem to have a much higher chance of occurring than not.

Capital Controls

The U.S. government may try to mandate away the trends described here by imposing controls on the flow of capital out of the country. This is highly unlikely at present because it would kill Wall Street. Investors will not invest in a place unless they are confident they can repatriate their money when they need it. But as capital increasingly moves overseas as foreigners diversify their investments, it will become less unthinkable as a desperate measure to protect the dollar. It will probably be presented as a tool to thwart and prevent “speculators,” as it was in several Asian countries in the late 1990s and again more recently.

Capital controls have a checkered history, most recently as used by some Southeast Asian nations during their currency crises in 1997–1998. The problem with capital controls is that the cure is often much worse than the disease: Investors who can’t get their money out of a country will never put more money into it. Capital controls may help a nation’s currency in the short run but harm it—by drying up supplies of foreign investment—for many years to come.

Such controls are nearly unthinkable in American practice. But be warned: if you hear the treasury secretary protest too much, as he did in early February 2010 about America’s AAA bond rating, it is often the sign of a failing rearguard action.

Geopolitical Surprises

Even if the American economy performs better than expected, the empire will still fade, unless the geopolitical world evolves in very different ways. Here are some possibilities that would change our forecast.

Collapse of China Into Civil War

The primary alternative to the United States for global leadership is China, for good reason: China has more than 4 times America’s population, a rapidly rising GDP that will overtake the United States’ early in the next decade at current rates, and significant financial reserves (i.e., it is a massive creditor, not a debtor). If you believe Chinese economic statistics, its own stimulus—the world’s largest in proportion to the country’s GDP—seems to have kept GDP growth robust even in the face of a crash in exports because of deep recessions in its main markets. By early 2010, China was cooling off its economy to deflate a growing Japanese-style property bubble.

As noted in the Three Day War scenario, China has some significant structural problems. It also has a history of fragmenting away from central government. Any number of sinologists have speculated about the remaining life span of the current communist regime. Within the next few decades, the frustrations of a population no longer satisfied with material progress without democracy could lead to violence and separatism, with ambitious politicians and military leaders all too willing to get in front of the parade. A hundred years ago, such men were known as “warlords.”

An implosion in China by no means guarantees the preservation of American dominance, because several other members of the so-called BRIC nations—in particular, Brazil and India, both vibrant and rowdy democracies—may be able to surpass China’s position in the future.

Aging Competitors

The United States is hardly the only country aging. In fact, it is the youngest developed country now, and its margin may soon widen if it maintains relatively high levels of immigration. Most major developing countries are likewise aging rapidly as they grow more prosperous, although from a much younger starting point. China, for example, will have a median age higher than the United States by late in this decade.

If America’s competitors age faster than the United States (because of lower birthrates and immigration rates), their chance for greater dynamism will evaporate. Essentially, they will experience a slow motion version of Japan’s relative decline and fall since the 1990s.

However, even if America’s relative position is favorable, its absolute position will not be. Japan’s or China’s eclipse will not make American commitments any more affordable (in fact, it may exacerbate their costs). Even if a “multipolar” world does not come into being in 2025 because of lost economic vitality in a wide range of countries, that will not mean the “unipolar” world will be sustained.

Crisis or War

A geopolitical crisis would likely drive investors into the arms of whichever seems to be the strongest and safest currency. In late 2008, that was the dollar and the euro. In late 2009, it was gold. In early 2010, it was the dollar and gold. Future crises and wars will trigger further flights to safety.

Climate Change

Although there is a fierce dispute about whether gradually warming temperatures are anthropogenic (caused by human actions) or a natural trend, there is little disagreement that the climate is changing. Like any major change, it will produce winners and losers. Losers will include nations grouped near the equator, which generally are poor and have few resources to help adapt. Winners are less clear, but will probably include nations at high latitudes, and nations with large concentrations of industries that can exploit the changing climate, such as renewable energy systems manufacturers, foresters, nuclear power manufacturers and operators, and utilities that can cost-effectively sequester carbon. New industries will cluster in countries with a hospitable business climate. Increasingly, such a benign policy environment is increasingly found in well-managed developing economies.

Climate change will remake the world’s geopolitical map in ways that are difficult to predict. America has some advantages (a relatively innovative economy) and some disadvantages (a large share of its population and industry located in arid environments). It is difficult to say whether climate change will help or hurt Americans’ hegemony.

Delaying the Inevitable?

No one today can say what date historians will ascribe to the end of the American empire. This book has argued the historical chapter began closing in the great recession of the late 2000s. But there are at least two reasons the close of the American century may be postponed a little longer.

Slow Recovery From the Recession

Paradoxically, the very event—the recent recession—that signaled the empire’s eclipse may sustain American dominance a little longer. If the recovery is as slow and anemic as most economists in early 2010 expect, the considerable slack capacity will be deflationary and continue to counteract the inflationary effects of loose money and government overspending. In the argot of the investment markets, the Fed may not be able to execute its “exit strategy” very quickly. As of spring 2010, the Fed appears to have postponed that exit by at least 1 year compared with its original schedule.

This scenario is a repeat of 2009. Massive fiscal and monetary stimulus did not have their “normal” effect of bringing fast growth and inflation, because they were countervailing equally strong forces of stagnation and deflation due to the deleveraging many firms and households were forced to implement.³ That stimulus arrested the economy’s slide downward, but as of early 2010, it has not been enough to turn recession into a strong recovery.

Continued strong headwinds from deleveraging—as many economists expect—will postpone the inflationary effects of rising government expenditures. The suppressing effects of tax increases to pay for those expenditures make such an anemic recovery likely. But this will only delay, not prevent, the inflation predicted in this book. It will occur whenever the economy returns to full employment, more likely in 2015 than in 2011.

The (Over)Privileges of a Reserve Currency

Reinhart and Rogoff’s extensive historical research has indicated that economies begin experiencing severe stagflationary effects when the ratio of government debt to GDP exceeds 90%. According to the Congressional Budget Office, federal debt will exceed that threshold by late this decade. If state and local debt is added, we have crossed it already.

Controlling the world’s primary reserve currency has its privileges. Because so many international transactions are denominated in dollars, there is an “artificially” strong demand for our currency. (This is in addition to the artificial demand associated with Asian efforts to suppress their own currencies by bidding up ours.) For example, American importers have been able to buy foreigners’ exports by paying in their own currency. Most importers overseas cannot do this. As long as the dollar maintains that favored status, lenders will offer the United States some extra latitude. So the threshold for the dollar before stagflation sets in may not be a debt of 90% of GDP but 100% or 105%. At predictable rates of spending, this more permissive limit only delays the day of economic reckoning by 1 or 2 years.

It is for exactly this reason that increasingly foreign investors—government and private—have begun diversifying their holdings away from the dollar, as discussed elsewhere. The 90% threshold should not be shrugged off. America might hit its “wall” even sooner.

All but Certain

I am a congenital optimist about the American economy, and our history has borne me out thus far. The “end of the American dream” obituary has been prematurely written many times before, including in the late 1930s during a decade-long depression and in the late 1970s when we had our first brush with stagflation.

America always seems to pull itself out of its slumps. The United States attracts the ambitious risk takers of the world and offers them an environment in which they can pursue their opportunities—if we don’t tax or regulate them away.

I don’t see the future described here, in which the late 1970s repeats itself 50 years later, as a permanent condition. Eventually, the great good sense of the American electorate will propel into leadership the 2020s versions of Ronald Reagan and Paul Volcker. In the meantime, it will be rough seas ahead, especially for Boomers who are already behind in the race to accumulate enough assets to retire comfortably. Historians may write that the period of high debt, high inflation, and slow growth was temporary, but Boomers preparing for their futures cannot take such a long view.

Any sweeping prediction for several decades in the future cannot be considered certain. Any of the above events could nullify, or at least delay, this book’s predictions. Even some of these apparent game changers are less than they seem. I would never suggest betting all of your investments based on the trends outlined in this book, but I will be redeploying the majority of mine.

Chapter 6 Summary