Stratfor: The US Economy & The Next "Big One"

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
March 11, 2008

IN THIS ISSUE:

1. Revisiting Stratfor’s Previous Forecast

2. Stratfor’s Latest Economic Outlook

3. Recession, Maybe – But No Depression

4. My Analysis And Conclusions

Introduction

There is a growing chorus that we are already in a full-blown recession, even though we’ll have to wait several more months before we can see an “official” declaration via the actual GDP numbers due out in late April and again in late July. These reports may, or may not, confirm that we are now in a recession (defined as two back-to-back quarters of negative growth).

Nevertheless, everyone from Warren Buffet to Fed Chairman Ben Bernanke to Hillary and Obama assure us that we are already in a recession. Even some national opinion polls now show that many in the general public no longer have any question as to whether or not there’s a recession underway.

As the mindset of the American public seems to have accepted these widespread conclusions that we are now in a recession, the next logical progression among the political pundits and public opinion might well be a further assumption that this will be no ordinary recession, but possibly the beginning of a 1930’s era depression. Stratfor recently produced an article that discusses why many tend to assume each recession is the next “big one.” In addition, Stratfor goes even further and discusses the various economic expansions over the last century or so, and tries to put this most recent economic malaise in proper perspective.

You will recall in my January 15, 2008 E-Letter I analyzed Stratfor’s 2008 Global Outlook, including their economic forecast. Unlike almost everyone else, Stratfor approached the current economic situation from a geopolitical perspective that also considered global issues that affect our economy. The bottom line was that Stratfor predicted another strong year for the US economy. This view was based on their expectation of moderating energy prices and a falling dollar that will make US exports more attractive.

Needless to say, they didn’t have much company at the time. In light of the continued disappointing economic reports, subprime and housing woes, $100+ per barrel oil and a declining stock market, how could anyone still have a positive outlook on the US economy?

Perhaps in anticipation of that question, Stratfor recently issued a follow-up report on the US economy, which I have reprinted below. While acknowledging that we may be entering a time of recession, Stratfor forces us to refocus on the longer-term economic cycles and not just short-term contractions. I think you will find it to be interesting reading, and I’ll add my own comments at the end.

As always, I want to thank Stratfor founder Dr. George Friedman for allowing me to share his wisdom and analysis with my clients and readers from time to time. In light of the increasingly complex and dangerous world we live in, I highly recommend that you consider subscribing to Stratfor on your own. CLICK HERE (https://www.stratfor.com/join) to obtain more information about the various Stratfor membership options.

Stratfor - Economic Déjà Vu?

QUOTE:

A few months ago, in a piece entitled “Subprime Geopolitics,” we addressed two questions. The first was whether the U.S. economy was heading into recession. The second was whether such a recession would represent anything more than the normal business cycle, or whether it would represent a fundamental, long-term shift in the way the American economy works. We answered that while the economy could reasonably go into recession – and we would not be surprised if it did – in our view, a recession did not seem imminent. As for whether such a recession would represent a fundamental shift in U.S. economic life, we answered, no, this would not be “the big one.”

Americans have been waiting for the big one ever since 1929. In many ways, the Great Depression should not have come as a surprise. Some sectors of the U.S. economy — particularly agriculture — had been in a depression for years, and the global economy was deeply troubled. Nevertheless, there was a sense of euphoria in the 1920s, unjustified by circumstances. Indeed, euphoria is the classic sign of an economic peak, and one of the warnings of an impending collapse.

Still, the market crash — followed by a prolonged depression — stunned the country and permanently scarred it. The contrast between the euphoric expectations of the 1920s and the grim reality of the 1930s imbued Americans with a fundamental fear. That fear is this: Underneath the apparent stability and prosperity of the economy, things are terribly wrong, and there suddenly will be a terrible price to pay. It is the belief that prosperity is all an illusion. This was true in 1929, and the American national dread is that 1929 is about to repeat itself. Every recession evokes the primordial fear that we are living in a fool’s paradise.

There is now an emerging consensus that the United States has entered a recession. In a technical sense, this may or may not be true. Whether the economy will contract for two successive quarters or be considered a recession by some other technical measure, clearly the U.S. economy has shifted its behavior from the relatively strong expansion it has enjoyed for the past six years.

But whether there is a recession now is not the question. Rather, the question should be whether what we are experiencing is a cyclical downturn on the order of 1991 or 2001 — which were passing events — or whether the economy is entering a different pattern of performance, a shift that could last decades. The dread of hidden catastrophe is one thing. Quite another thing is whether the economic expansion that began in 1982 and has lasted more than a quarter-century is at an end.

The United States has had three economic eras since World War II. The first was the period from about 1948 until about 1968. It was marked by tremendous economic growth and social transformations, rising standards of living and cheap money. Then, there was the period between 1968 and about 1982. This period was marked by intensifying economic problems, including much slower growth, increasing commodity prices, high interest rates and surplus labor. The third period, which began in 1982, saw extremely high growth rates, rapid technological change, increasingly cheap money and low commodity prices. The first era lasted 20 years. The second lasted 14 years. The third has lasted 26 years. None of these eras moved in a straight line; each had cycles. But when we look back, each had a distinct character.

The important question is this. Have we really been in a single era since 1948, with the 1968-1982 period representing merely a breathing space in a long-term, multigenerational expansion? Or are we in a period of alternating eras, in which expansionary periods alternate with periods of relative dysfunction and economic stagnation?

If the former, then 1968-1982 was simply a period of preparation for an intensification of the 1948-1968 era, and the extremely long 26-year cycle makes complete sense: The United States has just resumed the long-term growth of the first era. If we are stuck in alternating eras, however, then the 26-year cycle is overdue for a profound cyclical shift. In confronting this question, of course, we are not only talking about the United States; we are talking about the very structure of the international system. If the United States periodically will be shifting into periods such as 1968-1982, we are facing a very different world than if the United States is in a long-term expansion with shorter down cycles.

To answer this question, we need to consider why the United States underwent the 1948-1968 expansion in the first place. To begin with, the United States has been in a massive economic expansion since about 1880. The basis of that expansion was the massive inflow of labor through immigration coupled with intense foreign investment. That plus American land completed the triad of land, labor and capital.

In a world of expanding population, the demand for American industrial and agricultural products always grew, as did the available labor force. The gold standard put in place at the time the American expansion began also accelerated the process by encouraging domestic investment and limiting consumption. Indeed, it was this combination that temporarily caught up with the United States in 1929: Surplus capacity combined with a shortage of demand and credit crippled the economy.

World War II, not the New Deal, began solving the problem by using the industrial and agricultural plant while constraining consumer demand due to war production. It put people back to work and put money into their hands — money that could not easily be spent during the war. The war also created two other phenomena. The first was the GI Bill, which created massive credit supplies for veterans buying homes and cheap or free educations, increasing the quality of the labor pool. The children and grandchildren of immigrants became professionals, able to drive the economy through a variety of forms of increased productivity.

The second phenomenon was the Interstate Highway System. That not only increased economic activity in itself, it decreased the cost of transportation, making hitherto inaccessible land usable for homes and later businesses. While the system devastated the inner cities by shifting population and business to the newly accessible suburbs, the availability of cheap land allowed for a construction boom that went on for decades. You could now live many miles from where you worked, which led to two-car families and so on. So where the expansion in 1880 was heavily dependent on foreign labor, capital and markets, the expansion in 1948-1968 depended instead on domestic forces.

The first postwar era (1948-1968) also was driven by deficit financing during World War II and the creation of consumer credit systems; it was then disciplined by somewhat tighter economic policies in the 1950s. The basic principle remained encouraging consumption. This led to the use of the existing industrial plant, thus putting people to work in it and in building new businesses.

The era ran out of steam in a crisis of overconsumption and underinvestment. During the late 1960s and early 1970s, the desire to stimulate consumption created massive disincentives for investment. Low interest rates and high marginal tax rates shrank the investment pool. As time went on, the industrial plant became less modern and therefore less competitive globally. Demand for money drove interest rates up, while the inefficiency of the economy drove inflation.

Moreover, the baby boomers became adults and began to use credit and social services at an increasing rate. Using an increasingly undercapitalized industrial plant meant greater inefficiency as usage increased. Inflation resulted, paradoxically along with unemployment. The attempt to solve the problem through techniques used in the first era — more credit and more deficit spending — ultimately created the crises of the late 1970s and early 1980s — high interest rates, increased unemployment and high inflation.

The third era began when high interest rates forced massive failures and restructurings in American business. The Gordon Gekkos of the world (for those who have seen the 1980s movie “Wall Street”) tore the American economy apart and rebuilt it. Global commodity prices fell simply because the money not being invested in the United States was being invested in primary commodity production since the prices were so high. Therefore, they plunged inevitably. Finally— and this will be controversial — the Reagan administration’s slashing of the marginal tax rate increased available investment capital while increasing incentives to be entrepreneurial. Low marginal tax rates weaken the hand of existing wealth and strengthen the possibility of creating new wealth.

This kicked off the massive boom that emerged in the 1990s. It drove existing corporations to the wall and broke them (Digital Equipment) and created new corporations out of nothing (Microsoft, Apple, Dell). The highly capable workforce, jump-started in the 1950s by the GI Bill, evolved into a large class of professionals and entrepreneurs. The American economy continued to rip itself apart and rebuild itself. America was indeed the place where the weak were killed and eaten, but for all the carnage of the U.S. economy, the total growth rate and the rise in overall standards of living were as startling as what happened in the first era.

Now we get to the big question. The first postwar era culminated in a crisis of overconsumption and underinvestment that took almost a generation to work through. Are the imbalances of the last quarter-century such that they necessitate a generational solution, too, or can they be contained in an ordinary recession? Behind all of the discussions of the economy, the question ultimately boils down to that. To put it another way, the first era contained many leftover structural weaknesses of the Great Depression. It could not proceed without a pause and restructuring. Was the restructuring of the second era sufficient to give the third era the ability to proceed without anything more than an ordinary recession?

There are certainly troubling signs. The return of commodity prices to real levels last seen in the late 1970s is one. The size of the U.S. trade imbalance with the rest of the world is another. Most troubling is the relative decline of the dollar, not so much because it directly affects the operation of the American economy but because it represents new terrain. When we take all these things together, it would appear that something serious is afoot.

U.S. Deficits as a Percentage of GDP

But there are the things that are not troubling, too. In spite of high commodity prices for several years, the inflation rate has remained quite stable. Interest rates have moved around, but actually are quite low, certainly by the standards of the 1970s when mortgage rates were in the high teens. The budget deficit in 2007 ran at 2.5 percent of gross domestic product, which is not any bigger than it has been since those Reagan tax cuts. Unemployment is higher than it was, but certainly is not soaring. And we are not seeing any of the combination of conditions we saw in the late 1970s, nor any of the conditions that led Richard Nixon to impose wage and price controls in the early 1970s.

The most remarkable thing is the ability of the U.S. economy to absorb record-high oil prices without going inflationary. This is because oil consumption in the United States today is not much higher than it was in the 1970s. It is not simply a matter of efficiency; it is also a reward for de-industrialization. By shifting from an industrial to a technological/service-based economy, the United States insulated itself from commodity-driven inflation.

The key to the U.S. economy is the service sector — which comprises everything from computer programmers to physicians to Stratfor employees. The service sector has high levels of productivity driven by technology. Productivity continues to grow, which is not historically what you would find as you enter a recession. So long as productivity grows and inflation and unemployment remain under control, the total wealth of a society increases. The transformation of the economy that occurred as a result of the pain of 1968-1982 is creating a situation in which massive economic disequilibrium has not yet interfered with productivity growth. The historical hallmark of the beginning of a recession is declining productivity due to overutilization of the economy. Productivity continues to rise. And that means, in the long term, wealth will continue to rise.

As a result, while disequilibriums in the financial system require serious recalibration that must limit growth or even cause a decline, it is our view that we are not facing an end to the expansion that began in 1982. The old dread that this is the big one, the depression we all deserve, is actually a positive sign. The dread causes caution, and caution is the one thing that can control and shape a recession, since lack of caution is usually the proximate cause. Therefore, the effects of the changes forced in the second postwar era remain intact. The financial crisis is cyclical. And growing productivity rates indicate that while this will hurt like hell, it is not the big one — it is not even going to be like 1982. This is 1991 and 2001 all over again. END QUOTE

Analysis

The first and most obvious conclusion is that Stratfor seems to be backing off somewhat from their previous forecast of a strong economy in 2008. While they still maintain that we “may or may not” be in a recession, it’s clear that our economic prospects for 2008 have diminished. Thus, the tendency for many to think that this is the “big one” is natural, considering our past economic history going back to the Great Depression, but Stratfor is confident that such a scenario is just not in the cards right now.

I also think Stratfor’s analysis about long-term vs. short-term cycles is important to keep in mind. The short-term difficulties are providing a large amount of headwind and may force us into a recession, but the underlying strength of the economy will eventually overcome these short-term challenges.

Think of it like this: Two things that can slow the progress of an airplane are significant headwinds or the loss of the engine. As a former pilot, I can attest that the latter condition is far more serious than the former. If we think of the headwinds as our current economic challenges, and an engine stall as a 1929-type economic breakdown, Stratfor is telling us that it’s only headwinds that are currently impeding our progress for a while, but our economic engine is still running just fine.

I also found it interesting how Stratfor discusses the tendency for us to think of each recession as a return of the Great Depression. As I have written in the past, the field of behavioral finance is finding that many of our reactions to detrimental economic and investment news have deep psychological roots. Stratfor seems to have uncovered yet another way that our emotions can lead to irrational behavior, even in regard to economic recessions.

Unfortunately, there are many who prey upon these emotional responses to recessions and the stock market losses that often accompany them. I call them the “gloom-and-doom crowd,” and they always seem to have seemingly logical reasons that the latest economic and market challenges will result in utter chaos.

But the gloom-and-doom crowd and their followers have been wrong a half century, the US economy has seen the strongest growth in history, and stocks have exploded to the upside over the last 50 years. That is why I have continually recommended for many years that you ignore these perma-bears.

In light of Stratfor’s analysis above, I hope that you can see there’s a light at the end of the tunnel, and it’s not an oncoming train.

Political Analysis

Since we’re in an election year, I can’t address Stratfor’s recent article without adding a bit of political analysis. Though Stratfor doesn’t say that we’re definitely in a recession, they certainly leave that door open. If a recession or even a major economic slowdown comes to pass, how will the news affect the upcoming presidential election?

I think you probably already know the answer to that question. The old adage in politics is that “people vote their pocketbooks.” Another quirk about the American electorate is that they tend to associate current economic conditions with whoever is sitting in the White House. These two factors could combine to produce a major problem for McCain in the upcoming election.

If we indeed fall into a recession, or if public opinion is that we are in one, then McCain is likely to have a hard time convincing voters that the economy will have better times under his administration. This is especially true in light of his support for extending the Bush tax cuts, which liberals like to demonize as part of the reason for the current economic malaise.

Unfortunately, McCain’s loss will be the Democratic nominee’s gain if a recession comes about. Whether it’s Hillary or Obama, either could rail against the pro-business and pro-investment policies of the Republicans. You can already hear the familiar tune of class warfare, especially in Obama’s ads.

If voters reject McCain in favor of either of the Democratic candidates, then it could spell real trouble for the economy going forward. In last week’s E-Letter, I noted how each supports either scaling back or eliminating the Bush tax cuts. Yet, as I noted in last week’s E-Letter, there are a number of experts who feel that these tax cuts were a big reason the economy was able to surprise to the upside in recent years.

Staying with my airplane analogy from above, taking away the tax benefits for investing in the economy could mean shutting off the economic engine that has served us so well in recent years, and I don’t have to tell you how serious that problem could be. The end result might be that the “change” that the Democrats promise may not be the kind their followers envision.

Conclusions

I hope that you enjoy and appreciate my bringing you a variety of opinions from my various sources of information on the economy, investments, geopolitics, etc. I find that having a number of different sources helps me to see all sides of an issue, rather than just picking one source and making that my position.

Stratfor’s upbeat long-term outlook is a breath of fresh air among the voices of economic doom in the financial media and on the Democratic campaign trail.

In closing, I also want to mention our Venture Investment Program (“VIP”) to you again. You will recall that I announced this new program for very aggressive investors in my January 29 E-Letter. Since then, we have had literally hundreds of indications of interest in this program, but we have also encountered some misconceptions that I would like to address:

1. First, some readers who expressed an interest in this program asked whether it was only available to wealthy investors. The answer is a definite “No.” The programs that we have put together so far are available to any investor who has a very aggressive risk tolerance and can meet the applicable minimum investment amounts, typically $25,000.

In fact, one of the motivations we had in creating VIP was to bring sophisticated investment strategies to those who were not wealthy enough to qualify for private hedge funds. Thus, there is no need to have a $1 million net worth to participate in this program, though anyone at that level is certainly welcome to check out VIP as well.

2. Next, some have expressed concern about the qualification process we go through before you can participate in these programs. I want to clarify that we do this qualification as a service to you, and not to just get more information about our readers. You see, almost any investor will show an interest in an investment program that has high historical returns, often without considering the significant amount of risk that accompanies the investment. We do not want the lofty historical returns in some of the VIP investments to overshadow the considerable amount of risk that they also carry.

In our qualification process, all we’re doing is verifying that your risk tolerance is up to the very volatile performance of the VIP investments. Gains are not guaranteed, and losses could be considerable. Wouldn’t it be better for us to help you find out that such investments may not be a fit for you before you actually invest in them? We think it is, and the qualification process simply allows us to accomplish this task. My staff tells me that investors who go through the qualification process often say how it has been a positive learning experience for them.

3. Another question we got pertained to the relatively few programs we currently have in VIP. I addressed this in my discussion of the program, but it’s simply a matter of the time it takes to do the due diligence on the investment programs we have on our VIP “radar screen.” While we had originally entertained the idea of waiting to introduce VIP until we had a larger selection of investment programs, we eventually decided that it would be better for our very aggressive clients to review a limited initial selection of investments right away, and then evaluate new programs as they are added later on.

4. Finally, we got lots of comments regarding our Confidential Investor Profile questionnaire, and the process for submitting it to us. When I announced VIP in the E-Letter, the only way we had to offer the questionnaire was for you to download it using Adobe Acrobat. Unfortunately, not all readers have the same version of the Adobe Acrobat Reader, so some could not save their completed questionnaire and e-mail it back to us. Many had to print it out and mail or fax it to us, which was a hassle, to say the least.

Fortunately, we have fixed that. If you are interested in the VIP investment programs and would like to complete and submit one of our Confidential Investor Profile questionnaires online, just CLICK HERE to access a web page that allows you to select the way you would like to complete the questionnaire. You can either download a copy like before and mail it to us, or now you can complete it online and send it to us by simply hitting the “Submit” button. Also remember that your personal information always remains confidential. We will never sell, rent or otherwise share your personal information with anyone.

If you would like to get more information about VIP before submitting a questionnaire, feel free to call one of our Investment Consultants at 800-348-3601 or send us an e-mail at info@halbertwealth.com.

Wishing you profits,

Gary D. Halbert

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