The fork in the road — Part 1

The Strategic View
  
By Walter Kemmsies
  
   As economic data continues to show the recovery is gaining traction it is time to start looking farther down the road to see where major trends in place will lead the economy. 
   Unfortunately the conclusions one would draw from these trends are not encouraging. 
   This month the focus is on these trends and why they indicate the U.S. economy could suffer a prolonged period of combined elevated inflation and unemployment, often referred to as stagflation. However, as a prelude to the discussion next month, it is equally important to realize that such an outcome is not written in stone and with some changes in regulations and policies, the economy could be put on a better track toward prosperity. 
   The key trends to focus on are demographics, the trade deficit and the government deficit.
  
Demographics. Both the United States and the world are experiencing a historically unprecedented change in demographic structure. In 1950 people over the age of 65 represented 8.1 percent of the country’s population, while by 2010 this proportion had increased to 13 percent and by 2020 the Census Bureau projects this segment to increase further to 16
   percent. 
   Japan, Europe and Canada, on the other hand, have even higher proportions. Until the last half century or so, the world never had such a large proportion of its population old enough to be retired. There are no precedents to guide forecasts during this dramatic
   change.
   The demographic shift has dire implications for government finances. In 1950, there were eight people in the working age segment of the population for every one person over the age of 65, and by 2010 this had dropped to 5:1 and by 2020 the ratio is projected to decline to 4:1. 
   Adjusting the population estimates by labor force participation rates (since not everyone between the ages of 15 and 64 is employed), the statistics are more disconcerting. In1950 there were 3.7 people employed and paying into the Social Security fund for every person over the age of 65, and in 2010 only 3.2 were employed for every one person over 65. 
   Using the Census projections and average labor force participation rates, by 2020 there will only be 2.6 people employed for every one person over the age of 65. These 2.6 people will carry a heavy tax burden if the current level of Social Security and Medicare benefits will be maintained for those over 65 years of age. When the system was originally designed it wasn’t anticipated that the Baby Boom generation would come along and life expectancy would increase as much as it has.
   The increase in the share of the population that is retired has other implications besides government transfer payments.  U.S. Transportation Department surveys show vehicle miles traveled by people over the age of 65 is significantly less than that of younger people. This is likely due to less commuter driving and chauffeuring children to school and extracurricular activities. Along with more fuel efficient vehicles, this trend indicates that revenues from gasoline taxes will be insufficient to maintain the highway system.  And as we know, the Federal Highway Trust Fund already spends about 20-25 percent more than it takes in.
  
Trade Deficit. The U.S. population has been aging for a long time. Prior to 1967, consumers used to spend more on goods than on services, but since then the share of the consumer wallet going to services has been increasing. The service sector’s share of the labor force has also been increasing. As the service sector has drawn labor away from other sectors by bidding wages up, those sectors and industries that are footloose thanks to declining transportation costs and international trade agreements have moved to other lower production cost locations, such as China. As foreign imported goods were purchased in place of more expensive domestically produced goods, employment growth, particularly in the last decade, has slowed down
   significantly.
   Although employment and incomes grew slowly during the expansionary period of 2001-2007, consumer spending held up due to easy credit conditions. Interest rates were low and, as housing prices rose, many households were able to borrow against the estimated value of their homes. 
   Volumes of cheaper imported goods grew at double-digit rates each year. However, U.S. exports did not increase significantly despite the falling value of the dollar and the goods trade deficit increased dramatically from $421 billion in 2001 to $831 billion in 2007 as the economic expansion phase came to an end.
   Some of the workers who had been displaced by the outsourcing of manufacturing found jobs in services and construction. Exports should have been increasing and therefore absorbing workers who had been displaced by imports of manufactured consumer goods. While exports have risen in the last few years and oil imports have declined, the goods trade balance was still a lofty $737 billion in 2011.
   The U.S. dollar has significantly lost value against the currencies of developed and emerging economies that do not intervene in the foreign exchange market and even against the Chinese yuan. Unless U.S. foreign trade becomes more balanced this trend could continue. 
   Given that the United States is increasingly dependent on imported consumer goods, a declining value of the U.S. dollar means foreign goods will become more expensive. In other words inflation is likely to increase. With an increasing share of the population at retirement age and likely to be living on a fixed income, this could worsen the financial distress of the Social Security system and therefore increase government deficits.
  
Government Deficits. The U.S. government debt is already larger than GDP, something that has not occurred since World War II, and the deficit is over 10 percent of GDP. Some of the increase in the deficit since 2001 is related to military spending on the wars in Iraq and Afghanistan and the more recent increase is related to income maintenance and tax benefit payments due to the severe recession. Over time, military expenditures are likely to decrease. However, numerous government expenditures will increase.  
   U.S. infrastructure is not in good shape according to the American Society of Civil Engineers, which estimates it would take $2.4 trillion to return it to a state of good repair. The Highway Trust Fund is insolvent.  Furthermore, as the wave of Baby Boomers retire this decade, the Social Security and Medicare programs will come under stress. Interest payments on debt incurred since 2001 are growing faster than any major governmental program.
  
The Bottom Line. As exemplified by recent events in Europe, policymakers often take the easy way out if it’s too difficult to do the right thing. We can reliably predict political pressure to continue expanding the money supply to extend cheap credit to major financial institutions.  This could lead to a potential decline in the U.S. dollar and result in higher inflation than has been the case in the last 30 years.  It’s hard to believe that it has been three decades since the major economy central banks chose a path to reduce the high inflation and unemployment levels that characterized the 1970s. 
   If the United States does not increase its exports, employment growth is more likely to be stagnant. The alternative would be to wait until the dollar has lost enough value that it becomes viable to manufacture lower-value goods in the United States. However, with a growing population of retirees who are unlikely to spend a lot on lower-value goods, this would be a small consolation.
   This combination of elevated inflation and unemployment scenario is not by any means a foregone conclusion. Some trends, to be discussed next month, could result in a very different outcome. However, significant changes to regulations and policies are needed to achieve that.
   Walter Kemmsies is chief economist of Moffatt & Nichol, a marine infrastructure engineering firm. He can be reached at (212) 768-7454, or e-mail, wkemmsies@moffattnichol.com.