Chapter 1

Introduction

Avoiding Californication

Once a proud and vibrant state that exercised such strong influence to be called a “hegemon,” it now slides downhill in genteel, sclerotic decline. Its generous welfare system is supported by an ever-shrinking number of taxpayers, because high taxes and regulations have driven most young, ambitious entrepreneurs to greener pastures, leaving behind the old and the dependent. The government is experiencing declining tax revenues, despite raising tax rates several times and imposing taxes on products and activities that previously were exempt. Government makes up for inadequate revenue by borrowing more and more, spooking investors who have downgraded its bonds and who demand ever-higher interest to loan the state their funds. Escalating debt payments magnify the vicious cycle of borrow, tax, spend, and decline.

The American empire that has been a dominant fact of life in world politics and finance for three generations is slowly waning. This book outlines the main trends that are driving this decline. The so-called Great Moderation of the past generation (1982 to 2007)¹—when inflation and unemployment were both low, and the stock and bond markets responded with double digit increases for many years in a row—will not be repeated in the coming decades.

This means that every Baby Boomer who counts on a benign investment environment like the past 25 years to compensate for insufficient savings needs a new retirement plan. This book also describes steps you can take to protect your nest egg from rough seas ahead: higher taxes, higher inflation, and slower growth.

California’s Cautionary Tale

Any book that purports to outline what will happen in the economy and asset markets over several decades deserves to be taken with several trillion grains of salt. But the future is already here, in several European countries (e.g., Greece) and in at least one U.S. state: California. As you probably know, California has faced a mammoth “structural” deficit—that is, a deficit that persists even in boom times—because it chronically spends more than it collects in taxes. State leaders have made multiple attempts to plug the gap with gimmicks and sometimes with higher tax rates. I say “tax rates,” not “taxes,” because somehow, mysteriously, the added revenues predicted by tax increase supporters never materialize.

The reason? Entrepreneurs and others who are unwilling to pay high taxes find ways to avoid them. A phalanx of accountants exists to help them. But once available tax shelters have been exhausted, there is always another option: leaving.

In the past few years, California has gone from a state that received the largest number of immigrants to a “sending” state: More California residents moved out than moved in. In an increasingly globalized world, voting with your feet to leave behind dysfunctional, poorly governed homelands will become an increasingly common lifestyle choice. Emigration is a rational response of anyone whose ambitions are stifled by cultural or political circumstances at home. Such economic refugees will not only be Third World peasants but First World professionals, working or retired.

So while the trends and events outlined herein still lie in America’s future, you can see them unfold in the present in the travails of the Golden State. (California received that name in an era when the appellation wasn’t ironic.)

I have a unique perspective on California’s self-inflicted wounds and their power to predict America’s eroding position in the world. In the 1990s, I served as chief economist to California’s last successful governor, Pete Wilson. My role was, essentially, to help turn back the tide of excessive taxes, regulation, and spending so that California’s once-vibrant private sector could again create jobs and prosperity. The state’s economy transformed from last in the nation to first—from losing 1,000 jobs per day to creating 1,000 new jobs each day. I spent the 1980s at the Rand Corporation, conducting studies for the Pentagon and the intelligence community about methods to reduce threats to American security. So I have experience with how domestic politics affects international relations and vice versa.

I am also a Boomer, one who was too heavily invested in equities (common stocks) when the market crashed in late 2008. In effect, my portfolio was allocated as if I was still in my 30s (when I first began investing); I had not become gradually more conservative as my investing horizon shortened.

The Great Recession was a very powerful wake-up call, for families and for nations. Historians will probably look back on it as the end (or at least the beginning of the end) of the American Century, and a transition to whatever will replace it. I will not label the new century; that would be presumptuous at so early a date, and in any case, this is a book about personal finance more than the international system. But any Boomer who fails to recognize the new realities will ensure that their financial future is a disappointment or worse.

You should view anyone’s confident predictions about the future, including mine, with skepticism. But you can see America’s future unfolding today in California’s present. Pay close attention, because my goal is to help you avoid having your savings Californicated.

How Empires—and Nest Eggs—End

Whether you know it or not, you are living through the peak and decline of the American empire. It was an empire of economic and financial power, not political conquest. Many called it a “hegemony.” Its demise was long predicted but slow to arrive. The Great Recession that began in 2007 not only started in the United States but also signaled the crest of its imperial wave—a good run of arguably about four generations. The next generation will be a historic transition into an unknowable era in which other nations may assume global economic leadership—or no one may lead at all.

Historians of the 22nd century will chronicle this passage, which will repeat similar transitions that have occurred over the centuries. Citizens of the declining power may not be able to take such a long view. In particular, Baby Boomers have much more immediate concerns. Boomers came of age in an era of unprecedented affluence and counted on the good times to last forever, or at least through their retirements. Boomers, chastened by the financial meltdown of the past few years, have thrown their spendthrift habits of the last decade into sharp reverse, turning a savings rate that was negative (i.e., households borrowed to spend more than they earned) into one provoking worry it will dampen the recovery. Anyone whose retirement plan is premised on a return to the Great Moderation of 1982 to 2007—when inflation and unemployment were quiescent, and asset markets earned double digit returns year after year—needs another course correction.

This book arms you for the rougher seas ahead. It outlines two major trends, both domestic and international, that will make the next few decades far less benign for savers than the last few.

In a word, stagflation. Those with long memories will recall the late 1970s, when unemployment averaged 8%, inflation reached 13%, and the prime rate topped 21%. Dust off your leisure suit: the ’70s will be back.

Many investment books sensationalize possible economic threats. This book will not warn you of “the next great depression,” “the end of the dollar,” or any other such apocalypse. The future will be more challenging than the past, but the challenges can be coped with, especially if you use the next few years to prepare. In particular, opportunities are opening in the near future that can preserve hundred of thousands of dollars of your nest egg’s purchasing power.

The End of the American Empire

Rome ended, according to Gibbon,² when its decadence caused it to rot from within, so that bands of primitive nomads could push their way in through an open front door. The Ottoman Empire met a similar fate, after centuries as the “sick man of Europe.” In both cases, there was no single turning point, no instant in time that clearly delineated the beginning of the empire’s collapse. The peak and decline required centuries. Often an empire’s end was briefly forestalled by some miracle that offered a temporary new lease on life, such as the discovery of rich gold deposits in Latin America that kept the Spanish empire on life support for centuries. Amy Chua³ argues that in these and other cases the fatal disease was insularity and intolerance. Nations that had thrived by opening to the outside world—inviting in foreigners and their ideas, learning from other cultures, and improving by competition with them—rotted from within once they closed their doors, and their minds. Avoiding hubris and xenophobia is very difficult for a dominant company—ask General Motors’ shareholders—or a dominant empire, and none have managed it for long by historical standards.

The most successful empire in recent history, that of the United Kingdom (its very name connoting imperial reach), fell more swiftly, but not in an instant. Britain had invented and prospered from the Industrial Revolution, but other countries—particularly its erstwhile colony the United States and Germany—perfected it. Although labor productivity (value produced per hour of worker’s labor) in the United Kingdom had grown faster than the European average from the beginning of industrialization and throughout the 19th century, that lead began evaporating by early in the 20th century, as more productive competitors overtook Great Britain (most of all, the United States, and more malevolently, Germany). Productivity is the fundamental determinant of prosperity: individuals, or societies, can’t earn more over the long term than the value of what they produce. Englishmen were no longer the richest citizens of the planet, and the empire on which “the sun never set” was, by the 1920s, becoming rapidly less affordable.

Two wars killed the British Empire: the Great War (World War I) to preserve the European balance of power, at a vastly higher cost than dozens of Britain’s past wars had required, and World War II, to ensure the survival of democracy itself. Britain financed these wars through generous loans from allies, most of all the United States. Arguably, the final chapter of the empire began soon after World War II in 1946, when Britain was refused one more loan from the United States. But the empire did not fully collapse until decades later, when Britain withdrew from most of its possessions east of Suez in the early 1960s.

Two key themes emerge from the history of empires. First, they do not rise or fall in an instant, but gradually. Second, the seeds of decline are economic—the overextended imperial economy cannot support its commitments—as well as cultural and political, and they take generations to germinate.

This book applies these lessons to examine the state of the U.S. economy today and for the next generation, in order to guide those who are planning for their own financial futures. No group craves such information more than Boomers, a population of roughly 75 million whose leading edge is reaching the traditional retirement age of 65 years, and whose trailing edge may be sending their last child to college. All Boomers need to accumulate assets (i.e., save), because they have witnessed the demise of defined benefit pensions, but few have saved adequately.

The recent recession has caused Boomers to put their spendthrift habits of the early years of the decade into sharp reverse: Savings rates that were near zero—even negative in mid-decade—have now climbed back toward (but still below) historic averages. Having belatedly regained the saving habit, Boomers need every possible advantage to preserve the purchasing power of whatever they have managed to accumulate and to grow it to meet the needs of lengthening life spans. They are understandably very interested in what will happen to their late-acquired wealth.

This book will outline the main forces that will affect developed economies’ (especially American) economic performance over the investment horizon of most Baby Boomers, roughly the next 25 or 30 years:

Together, these two forces, as well as their second order and side effects, will mean a very different savings and investment climate in the next decades compared to that of the past generation.

This book will not delve in detail into any of these trends. My job is to review that specialized literature and synthesize its implications for your financial planning. For those readers who wish to go deeper, the bibliography and resources sections suggest places you can start.

Plan for the Book

After this introduction, this book is divided into two main parts. Part I, the “macro” section, summarizes these forces and their broad economic implications. Part II, the “micro” section, outlines responses to the macro trends: steps you can take to begin to prepare so that you can preserve your wealth in the more challenging times ahead.

In Part I, some chapters include a scenario that illustrates its main themes.

“Scenarios” are essentially short stories: miniature works of fiction, usually written as future news stories or historians’ articles, about the trajectory of hypothetical future events, which will make abstract economic themes more tangible. The first scenario, which illustrates how the United States may be taught a dramatic lesson about its fiscal vulnerability, follows immediately after this introduction.

Will the future play out exactly as these scenarios suggest? Almost certainly not. But these trends are powerful and virtually inevitable. Although the world of 2025 won’t look exactly like that described in these scenarios, a reader from that time should recognize his present in my accounts of our future.

Although I have deliberately tried to keep the unavoidable economic and financial jargon on a short leash, readers unfamiliar with any phrases or concepts may find it helpful to consult one of the appendices: a primer on retirement planning and investing; a primer on international economics and finance; and a glossary. In each, I’ve tried not to merely define terms, but interpret them and explain why you should care.

Nagging Worries: Boomer FAQs

The recession has forced Boomers to relearn the virtues of thrift, in a hurry. This book can help them keep what they’ve saved. It can help answer questions such as

What Inflation?

As I write this in early 2010, the greater immediate challenge is deflation, not inflation. There is still considerable slack in the American economy—we are only using about 70% of our manufacturing capacity. Unemployed workers, and businesses, aren’t in the habit of raising prices, because they know their competitors will undercut them and keep them unemployed.

But within a few years, even what is expected to be a very anemic recovery will gain momentum, and that slack will be reabsorbed. When banks finally begin lending again to private businesses, the increase in the money supply will fuel inflation. This may be a 2015, not a 2010, problem, but it will persist for many years, including the duration of many Boomers’ retirement.

You should approach any book containing predictions, including this one, with more than a dollop of salt. But most of the developments described herein are highly likely to occur at some point in the next 20 or 30 years. Long life spans mean that the period once called “retirement”—when we no longer rely on a full-time job as our primary means of economic support—can easily last at least as long.

My aspiration is that Your Macroeconomic Edge will differ from most current affairs and economics books in being accessible to readers with no grounding in technical fields, and by giving you specific recommendations for steps you can take to protect your savings and your future. Boomers have a second chance to build the assets they will need to support a fulfilling lifestyle in the decades to come. I want to help you keep whatever you’ve accumulated.

Chapter 1 Summary