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The New Normal

Jason Hsu from Research Affiliates released a nice whitepaper on our “3-D Hurricane and the New Normal” which refers to the three D’s of debt, deficit and demographics in the developed countries.  A nice little synopsis of our current debt and demographic dilemma along with a not so subtle slam against the baby boomer generation:

Historically, demographic shifts have had little impact on markets. However, the analysis could change dramatically at debt-to-GDP ratios above 100%, which is a phenomenon not seen in history. The linkage between demographics and debt cannot be overemphasized. Demographic shifts are generally considered to be non-risk events, in that they can be fully anticipated ahead of time. Economies with rational agents, saving, consumption, and investment decisions would allow individuals to largely manage the (adverse) effects of (unfavorable) demographic shifts. Boomers should have anticipated the untenable support ratios in their retirement. They were supposed to save aggressively during their working years (delaying pre-retirement consumption) and then convert their large and plentiful retirement assets into retirement consumption, particularly paying up for imported goods. Specifically, Boomers should have anticipated the weakening of their home currencies as their economies run greater trade deficits against the younger EM economies. Boomers should also have anticipated a significant rise in the cost of domestic services, which cannot be effectively imported from foreign labor markets.

Instead, what we observe today is inadequate retirement savings. It is long understood that the pay-as-yougo social security scheme cannot work effectively as a credible mechanism for intergenerational risk-sharing in the face of declining support ratios; as the population ages and fewer workers enter the workforce relative to workers exiting into retirement. There are insufficient numbers of young people paying into the system to support the social security payments for those who have retired. Pension schemes, or forced retirement savings, should have protected workers from the problems associated with aging demographics. Unfortunately, low contributions, high costs, and poor governance and institutional design have generally led to poor funding and adequacy ratios. The problem is further compounded by an inability to further borrow against the production of the future generation. This failure is not due to a lack of political will and mechanism to exploit the future, but by the inconvenient reality that the future has already been fully monetized—rating agencies and international lenders are starting to be uncomfortable with the debt capacity of the developed countries. What was a predictable inevitability—the reality of an aging population—that could have been managed will become a shock that surprises economies and markets. Instead of a gradual and smooth change in rates and prices corresponding with the gradual shift in demographics, the likely outcome is a volatile and violent transition from the old equilibrium to the new.

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