Get Used to It: There's a New Normal in Town

When towering debt collides with shrinking population growth, you get slowing economies.

Take NIS 2.4 million. Multiply it by 1,000. What do you get? You get NIS 2.4 billion. Now multiply that by 1,000. What do you get? You get the present value of the public portfolio of financial assets: NIS 2.4 trillion.

Is that a lot? A little? A moderate amount? Don't try to divide that by the population of Israel to get an answer. That won't help because of the vast gaps in society, which boil down not only to income, but to the distribution of wealth.

Bill Gross - Haaretz - Aug 24 2010

But one thing's sure: The public portfolio has been growing fast. In the last seven years it has grown by more than a trillion shekels. At year-end 2003 it was NIS 1.3 trillion, which means it's grown by 85% in seven years, or 9% a year. That's more than double the pace of economic growth (adjusted for inflation ) during that time.

The jump in economic activity is only part of the explanation. The rest of the increase in the public portfolio is apparently due to the steep drop in the price of money. The cheaper money is (the lower interest rates and the cost of borrowing ) - the more the value of the financial assets increased.

How cheap is money today? The cheapest ever. Short-term interest rates in the money market are 2% a year, meaning in real (inflation-adjusted ) terms, it's less than zero. Even longer-term interest rates, for five years, is below 1%.

The public portfolio of assets includes all the public's holdings in bank deposits, direct holdings of shares and bonds, and holdings through providential and mutual funds, insurance companies, pension funds and all the other savings vehicles. Each month the Bank of Israel calculates the value of the public portfolio of financial assets and reports on its breakdown.

Financial assets are one sort of holding: Property is another. The Bank of Israel does not report on the total value of homes and land owned by the bank. But based on the roughly 30% increase in home prices during the last three years, the total value of the public's portfolio of property has probably risen by even more than its portfolio of financial assets.

Now for the million-shekel question: Are all these trillions of collective wealth belonging to the people of Israel just numbers, or do they have actual economic significance?

Drat the R's

Analyses by the central bank, Finance Ministry and investment houses hardly ever relate to these trillions added to the public's asset value, and economists the world over are divided as to the impact of "the wealth effect" on the broad economy.

Alan Greenspan, former chairman of the U.S. Federal Reserve, is a great believer in the wealth effect. Last month he claimed that the quantum leap in the "wealth" of the American public because of the rising value of equities reduces the need for governmental incentive programs.

One thing's for sure: In the last 10 or 20 years, depending on the country, most of the world's people have become accustomed to their portfolios growing fast. Gains of 5% or even 10% a year seem natural to them by now.

But your faithful author has, for years, believed that this state of affairs is transient. The era of easy riches, in which public investment portfolios mushroomed, is over. The gigantic debts accrued by the citizens and nations of the world in the last decade, and the rock-bottom level of interest rates prevailing in the markets, promise a long period of significantly lower returns on the market than we are used to seeing.

Last week I was relieved to find that one of the biggest investment managers in the world has an explanation for the way things have developed. In his monthly letter to investors, "bond king" Bill Gross, manager of Pacific Investment Management Co., wrote that evidently, the pessimistic, and justified (in his view ) outlook on the economic future prevails only among economists whose names begin with the letter R. To wit: Roubini (first name Nouriel ); Rogoff (Kenneth ); Reinhart (Carmen ), Rosenberg (David ); and only off by one letter is (K )rugman (Paul ).

No wonder, therefore, that Rolnik (Guy ) is pessimistic too.

Gross' little joke may be a little puerile, but his point isn't: He believes there is a small group of people who understand the true significance of that mountain of debt, while the rest of the world is in denial. Returns in the financial markets are going to drop from the levels to which we'd become accustomed - meaning 8% to 12% a year - to 4% to 6%.

The figures Gross presents are nominal. If you factor in inflation of 2% to 3% a year, you reach real returns of around 3% at most over time. Now take away the management fees on assets and what you get is that Gross doesn't think the public will continue to accrue wealth like in the past.

He claims that in last 100 years we have become accustomed to living in a world where two parameters are increasing rapidly - debt and the population. Now the pace of population growth is slowing and the level of debt is sky-high. That means it is becoming impossible to generate economic growth through increasing debt.

Here are two of Gross' favorite graphs: the total U.S. debt as a percent of GDP from the start of the century, and the pace at which the global population has been growing. He thinks they mark the start of a "new nominal": slower growth by economies and stock markets.

In July, Gross wrote, "The danger today, as opposed to prior deleveraging cycles, is that the deleveraging is being attempted into the headwinds of a structural demographic downwave as opposed to a decade of substantial population growth. The danger today, as opposed to prior deleveraging cycles, is that the deleveraging is being attempted into the headwinds of a structural demographic downwave as opposed to a decade of substantial population growth. Japan is the modern-day example of what deleveraging in the face of a slowing and now negatively growing population can do.

Prior deleveraging periods such as what the U.S. and European economies experienced in the 1930s exhibited a similar demographic with the lowest levels of fertility in the 20th century and extremely low population growth. Things did not go well then."

The developed economies of today, Gross went on, seem to have much lower population growth than the 1.5% rate that typified the previous 50 years. He predicts that population growth over the next 10-20 years will be hardly greater than 1%.

And so? His analysis does not even begin to delve into the aging of the slower-growing population base. "Japan, Germany, Italy and of course the United States, with its boomers moving toward their 60s, are getting older year after year," Gross writes. "Even China with their previous one baby policy faces a similar demographic."

The elderly spend a bigger proportion of their income: They save less and eventually dissave, Gross explains. But in practice, they spend less per capita than younger people. Typically, they don't buy new homes or travel the world: They aren't in a race to outspend the Joneses. Their main expenditure is healthcare.

"These aging trends present a one-two negative punch to our New Normal thesis over the next 5-10 years: fewer new consumers in terms of total population, and a growing number of older ones who don't spend as much money. The combined effect will slow economic growth more than otherwise," Gross concludes.

Wait. What about China, India and all those other emerging markets that are supposed to compensate the global economy for the slowing West? They aren't up to the job, Gross feels.

Could we be wrong? Could share and property prices begin another boom in the next decade? Of course that's a possibility. I reserve the right to explain, with hindsight, how and why I got it wrong. As for Bill Gross, he can always comfort himself with the roughly $2 billion he's made to date at PIMCO from managing other people's money, and the hundreds of millions he'll probably make in the decade to come, even if his bearish forecasts don't come true.