Every time the U.S. economy has seem poised to break out of its slow-growth, low-inflation trend, something has undercut its momentum.
The federal fiscal-cliff and debt-limit fights, an oil patch recession, the global financial market spillovers from China, and a pullback from peak auto sales all have taken a turn as the economic headwind du jour.
Yet what some have called "secular stagnation" or "the new normal" is largely about America — along with much of the rich world — turning gray. Aging has cut 1.25 percentage points from both trend GDP growth and the neutral real interest rate in the U.S. since 1980, with most of that coming since the early 2000s, according to Federal Reserve researchers.
So far, sluggish growth has been overcome by persistence. As the current economic expansion enters its ninth year, the jobless rate is at a 16-year low while the S&P 500 index and other major averages are up sharply so far this year. Yet GDP growth likely will continue to slow. Meanwhile, big institutional investors and policymakers increasingly worry about what lies ahead as an inevitable battle plays out over how to pay for massive retirement promises to baby boomers and how much to raise taxes on Gen Xers and millennials.
It won't help that today's slow growth may soon look like the good old days. David Doyle, North American economist at Macquarie Research, notes that the oldest baby boomers are in their 70s, when workforce participation rapidly dwindles. "Demographics will soon act as a severe constraint on potential output growth," Doyle wrote recently.
America aged gracefully early this century, with the working-age population (20-64) expanding much more than the senior population. But the tide shifted in 2012. Over the coming two decades, the senior population is projected to swell by 30 million vs. just 15 million for working-age adults.
In 20 years, the whole country will look like Florida — only older. Now 20% of Floridians are 65 and older vs. 15% for the country as a whole. Two decades from now, 21% of Americans will be seniors, according to Social Security Administration projections.
Retiree Reckoning
Economic headwinds will intensify as government budgets are swamped. While jobs should be plentiful for Gen Xers and millennials, there will be fewer workers per retiree to meet all of those trillions of dollars in off-budget pension and health care promises.
A decade ago, 3.3 workers paid into Social Security for every beneficiary. By 2037, that will fall to 2.1 workers. The situation is already far worse for local governments like Chicago, which has 47,000 retirees drawing pensions and only 34,000 current government workers (excluding Chicago Public Schools).
That portends "unsustainable pressure on future taxpayers," Citi analysts wrote in a 2016 report that pegged the scope of pension underfunding at $78 trillion among the 20 Organization for Economic Co-operation and Development (OECD) nations.
Despite an eight-year bull market, unfunded state and local pension liabilities have ballooned to an estimated $4 trillion. Moody's figures that the total value of benefits promised to current and future U.S. retirees but not paid for tops $23 trillion — bigger than gross domestic product. That includes unfunded promises for federal employees ($3.5 trillion), Social Security ($13.4 trillion) and Medicare's Hospital Insurance program ($3.2 trillion).
Paying off retirement promises will be even harder with a sluggish economy. The 2.2% average growth since mid-2009 has made this the slowest expansion since World War II. Federal Reserve policymakers expect growth to slow to 1.9% by 2019. Doyle of Macquarie Research sees 1.4% growth by 2020.
"We see no major economic risks on the horizon for the next year or two," Ray Dalio, founder of Bridgewater Associates, the world's largest hedge fund, wrote in May on LinkedIn. Yet the "longer term looks scary."
"We see an intensifying financing squeeze emerging from a combination of slow income growth, low investment returns and an acceleration in liabilities coming due both because of the relatively high levels of debt and because of large pension and health care liabilities," Dalio wrote.
John Mauldin of Mauldin Economics sees major implications for financial markets: "A time is coming when the market and voters will realize that these obligations cannot be met. Will voters decide to tax 'the rich' more? Will they increase their VAT rates and further slow growth? Will they reduce benefits? No matter what they decide, hard choices will bring political turmoil, which will mean market turmoil."
Peak Borrowing
In Dalio's view, the economy is approaching the end of a long-term borrowing cycle. Soon debt levels will be too high to keep rising, putting economic growth at risk. Yet fiscal and monetary authorities will have largely exhausted their policy arsenals, leaving insufficient ammunition to combat a downturn.
Since 2007, debt-to-GDP has more than doubled to 77%. It's expected to keep soaring amid a structural federal deficit that's projected to exceed $1 trillion in 2023 and approach $1.5 trillion in 2027.
Already, political populism has flared, with globalization and immigration both losing support. Prepare for more of the same, Dalio says. "We fear that whatever the magnitude of the downturn that eventually comes, whenever it eventually comes, it will likely produce much greater social and political conflict than currently exists," he said.
Fed policymakers don't speak so forcefully. But their vision isn't exactly calming.
San Francisco Fed President John Williams explained in a June 27 speech that "demographic waves and slower growth have driven down the longer-term normal or 'natural' real rate of interest — or r-star — to historic lows in country after country."
With interest rates near zero, "central banks will face daunting challenges in stabilizing their economies in response to negative shocks," Williams said. The "global slump" in growth will test fiscal policymakers too, he added. They'll be asked to do more with less — "in some cases much less" — as unfunded liabilities in pensions and safety-net programs multiply.
All that adds pressure on the Fed to keep the current expansion going as long as possible. Recent drops in the jobless rate, even as inflation has subsided, suggest the expansion can keep running without the Fed having to hit the brakes.
But some economists worry that the unemployment-inflation link hasn't vanished. They fear the Fed may fall behind the curve, forcing it to react abruptly. Once unemployment hits bottom and starts creeping up, recessions usually aren't far behind.
A recent analysis by Moody's Investors Service drove home just how fast pressures will build if the economy sags or financial markets turn lower. If state and local pensions suffered a 5% decline in one year and flat returns for the next two, unfunded liabilities would soar 59%, from $4 trillion to $6.4 trillion.
Governments Avoid Hard Choices
Meanwhile, state and local governments face pressure from the rising cost of retiree health benefits, which are underfunded by $862 billion, according to a report last year from the Center for State & Local Government Excellence.
Public pension funds typically assume investment returns above 7% when calculating their unfunded liabilities. The Los Angeles City Employees' Retirement System board met in July to consider lowering its return assumption from 7.5%. A 7.25% assumed return would increase L.A.'s required contribution by $38 million next year, and a 7% rate would require $93 million, according to the Los Angeles Times. Already pension costs take up about $1 billion, or 20% of the budget.
So what did L.A. decide to do? Punt.
States and municipalities around the country have been doing the same. But many experts think that public pensions should assume returns of about 3%, more like governments outside the U.S. This would provide certainty for taxpayers and pensioners, matching the seeming certainty of the costs, since courts have largely said that the benefits can't be taken away. But that would require governments to sharply increase pension contributions now.
Productivity Weak
The "growth slump" that the Fed's Williams cites reflects smaller gains in the labor force and in productivity. They may be connected. Fed researchers believe that "a current abundance of capital relative to labor" has depressed the return on capital and caused aggregate investment to decline. Doyle notes that workers over 55 are less likely to increase their productivity, while workers near retirement may still be more productive than their young replacements.
The Census forecasts that the U.S. working-age population will grow just 0.3% per year through 2026, with immigration providing most of the increase. Nonfarm productivity growth has averaged just 0.6% over the past five years, a far cry from the post-World War II average of 2.1%. Productivity fell 0.1% in 2016, the first annual drop since 1982.
"It becomes clear that a sea change is taking shape," Williams said. "What's less clear is how global policymakers will respond to these shifts — whether they will make the necessary long-term investments in priorities like education, job training, science and infrastructure that can break this slump, or whether they will allow this slump to break them."
Policymakers can try to boost the workforce by improving incentives, such as lowering marginal tax rates, or raising the age at which workers retire by restructuring pension promises.
One big uncertainty is whether federal, state and local governments will adjust their pension promises. If not, government retirees will have more to spend and low-inflation pressures may subside. But how governments pay for those promises will create another set of troubling circumstances.
Illinois has seen population declines amid tax hikes and a pileup in unpaid bills as it wrestles with massive pension liabilities. Construction materials provider Vulcan Materials (VMC) noted this month that the state budget crisis had delayed public infrastructure projects.
Such problems are expected to mount, and not only in Illinois. "We are now at a point where the assets of the pension fund are being liquidated to meet current retiree benefits," Gordon MacInnes of left-leaning New Jersey Policy Perspective told the Tax Notes publication. "All you need is one more recession and you are wiped out. Then you are going to have to take tax receipts that are intended for schooling, and you're going to have warfare."
More cities and counties will likely be pushed into bankruptcy. States haven't had that option, but it's possible that will change.
Japan is furthest along in facing an end to its long-term debt cycle, Dalio notes. It got hit first with aging demographics, with the total population rapidly shrinking.
Japan hasn't restructured promises but instead allowed debt to swell to 200% of GDP. Eventually, the Bank of Japan ended up taking on massive amounts of Japanese government debt and even buying loads of equities.
To some, Japan is a cautionary tale. But to some on the political left, it shows what's possible. After all, Japan's economy hasn't fallen apart and interest rates haven't spiked. Despite all the Fed did to revive the economy after the financial crisis, it's possible that we haven't seen anything yet.
