The Great Crash Ahead CHAPTER 1 Deflation Is the Trend—and It Changes Everything
It wasn’t supposed to be like this. For over 30 years Patti, the godmother of my [Rodney Johnson’s] children and wonderful friend, took the steps that were supposed to ensure not only her success, but also her financial security. She graduated from Tulane University and worked her way up in several organizations, in which she consistently beat client expectations. She earned six figures, of which she saved and invested quite a bit. She worked overtime and weekends and traveled exhaustively. She was a “hot property.” Then she was fired in the summer of 2010.

Fired, laid off, downsized—whatever it was called, the latest company where she worked was acquired by another. During the process of integrating her unit into the succeeding firm, she and other executives were dismissed. It was typical. You get called into a meeting with higher-ups, at which you are told that the company is moving in a direction for which your services are no longer necessary. You are escorted to your office and a human resources representative watches you pack your things to ensure that you do not steal from or harm the company that you poured your life into for years—the company that you helped to make a success story and an acquisition target. Finally, you are marched off the premises like any other nondesirable who might have wandered in off the streets. Such is the way of corporate life.

If this had happened during the ordinary course of company evolutions in normal times, when mergers and acquisitions typically create gains and losses for investors and employees, perhaps it would not have been such a blow. But these are not what most of us would consider normal times. Patti walked out of that company in the summer of 2010 as a 50-year-old woman and into a job market that already held over 14 million unemployed people. She left with her savings and investments greatly diminished after the crash of 2008–2009, and she carries the burden of a home that continues to fall in value. It wasn’t supposed to be like this, but it is. Patti is just one of millions of casualties in what is a continuing economic catastrophe. The economic meat grinder is taking its toll, reducing not only what we as consumers and workers have in terms of gainful employment and assets, but also taking away some of our ideas of what we can achieve. In short, for many, tomorrow looks grim.

As we sat around Patti’s kitchen table discussing this state of affairs, she was downtrodden but defiant about her employment. This stint of work was over, for all intents and purposes, but she would live to work again. Like the mythical phoenix, she would rise up in perhaps a different form, developing a niche to service groups like her previous clients, writing a book about her area of expertise—on-boarding large corporate clients for complex services—or simply find a similar position in another company. This was not her first rodeo. She had successfully reinvented herself before. While the work situation definitely caused her concern, it was nothing compared to the financial loss in her portfolio and her sheer lack of clarity about her financial future, which caused something closer to despair.

“I should have spent it,” she said. “Instead of socking it away, meeting with my financial advisor on a regular basis, and tweaking my investments, I should have blown it on all the vacations I wanted to take. Even though I was responsible, saving and paying my own bills, never spending beyond my means, I’m suffering for it. Other people blew up their own situations, and at the same time the government did absolutely nothing to stop financial institutions run amok. Here I am paying the price.”

We just witnessed the greatest credit and real estate bubble in modern history. Just as debt, housing, stocks, commodity, and business values skyrocketed, they will now collapse and create the greatest deflationary environment since the 1930s. Do you know how to invest and navigate your business and career in an environment that you have never seen before?

Patti’s points are well taken, and her sentiments are shared by many across the country and around the globe. While most people understand some of the events and trends that led us here, it is still hard to grasp why this situation has become so much bigger, so much more encompassing, than anything since the Great Depression.

Patti not only can survive, but she can thrive, as will a minority of Americans and citizens around the world. Even everyday citizens in China and India will feel this global deflationary crisis. Patti will continue to keep her financial house in order, working more and saving more than she would have otherwise. But the questions and doubts she raises deserve answers. We have just lived through the greatest economic bubble in the history of the world, and now we are dealing with the aftermath as that bubble deflates. The bones and debris are scattered everywhere—investments, jobs, education, retirement, politics—nothing is left untouched. Our net worth has been greatly reduced. The median family earns less income today than 10 years ago. We are going backward.

As we go through what will be a long and difficult period of adjustment, we have choices. We can choose to bury our heads in the sand, ignoring the changing world around us and hoping for the best but doing nothing. Or we can choose to recognize that the era we just left—that time of growth and seemingly easy prosperity that marked most of the past three decades—is over. What lies ahead will be difficult, but through education and proactive efforts, we not only can see what lies ahead but also can profit from it. As you might expect, this book is all about choosing education and prosperity!

The trends for the coming decade are crystal clear: we are going to experience a deeper downturn and deflation in prices, not inflation. We call this the Winter Season; it comes predictably once in a lifetime, currently every 80 years, which means that very few people will understand what is happening.

• The largest generation in history will be spending less and saving more for retirement, which are trends that follow aging. The continued aging of our population as well as of the populations of developed countries around the world is deflationary—just ask Japan.

• The greatest credit and real estate bubble in history will continue to deleverage and deflate. The US government and most world governments have implemented extreme stimulus measures to prevent financial systems from melting down as they began to do in late 2008. These measures will fail, probably by early to mid-2013 forward and certainly by early 2014. We will undergo the first extreme deflationary crisis since 1930–1933, with all major investments crashing. We will suffer business, bank, and job losses unlike anything we have ever dealt with in our lifetimes. Crashes of this magnitude won’t be repeated for another 60 years or more.

• China is leading a global bubble by greatly overbuilding industrial capacity, real estate, and infrastructure. Most of the emerging world, along with Canada, Australia, and New Zealand, is feeding China’s bubble with materials and energy. The bursting of China’s bubble together with the peaking of a very reliable 29- to 30-year commodity cycle will make this a global downturn despite long-term rising demographic trends in the emerging world.

We’re here to wake you up to the greatest financial crisis of your lifetime and to get you onto our lifeboat to save your family and business from financial ruin before it’s too late!

This book can be thought of as having four sections. The first part (Chapters 1 and 2) discusses how we got here, including the driving forces of demographics and consumption. Starting in the Roaring Twenties boom, demographics quickly became the key driving force in the world economy, as middle-class living standards spread. This force will continue to accelerate among emerging countries as billions of people see their income and consumption levels grow. Economists do not understand the impacts of this most critical factor, which is why they did not predict the magnitude of the global boom and why they now do not perceive the magnitude of the inevitable global slowdown ahead.

The second section of the book (Chapters 3 through 5) describes where we are now: in an economic Winter Season, with a massive debt overhang that must be worked out. We are referring to the debt bubble that occurred primarily in the private sector, not to the US federal debt, which is huge on its own. From 2000 to 2008, private debt more than doubled, from $20 trillion to $42 trillion, whereas government debt grew from $5 trillion to $10 trillion over the same period. Unfortunately, government debt, which has since grown to $16 trillion, continues to rise. The most pressing problem in the government sector is $46 trillion to $66 trillion in unfunded liabilities for Social Security and Medicare/Medicaid. Our system cannot continue to function and certainly cannot make any real attempt at a recovery with all of this debt! In the next decade, particularly between 2012 and 2015, we will undergo the greatest debt restructuring in history, and that destruction of debt will actually cause deflation, not inflation. This is what makes the coming economic Winter Season so different from the last extended downturn in our economy, from 1969 to 1982. That period represented an economic Summer Season, in which we experienced a wave of inflation and innovation. The investment and business strategies that work in a deflationary period are very different from and are often the exact opposite of what works during inflation.

The third part (Chapters 6 through 8) illustrates why we will not be coming out of this crisis anytime soon. We identify that the emerging world, led by China, has its own bursting bubble, which includes commodity prices. We also look at why the seemingly successful policies of the government have only “kicked the can down the road,” making the debt crisis and mortgage crisis worse. These policies cannot work against the massive downward trends in demographics and debt deleveraging.

In the final section (Chapters 9 through 11), we discuss how we as a nation, as investors, as business owners, and as citizens can best position ourselves in order not just to survive the next several years, but to thrive! The adversity we face today is simply a different set of opportunities and challenges than those of yesterday. As the weather reflects the seasons, we see winter coming and prepare by stocking up on firewood, buying coats, et cetera. We store away the water skis and bring out the snow skis! Every season has its opportunities and challenges. You simply need to change your strategies for each season. We finish in Chapter 12 with a look at not just big changes, but sweeping, revolutionary-type changes that are occurring here and around the world. Just as the Industrial Revolution radically changed the world starting in the late 1700s, the Information Age is not even close to finishing what was started in the 1970s and 1980s.

Twenty years ago we forecast an economic Winter Season that would stretch from 2008 to 2023. The season has arrived, and it brings with it great challenges and great opportunities. Once we understand what is possible and let go of yesterday, we can begin rebuilding.
How We Got Here: 25 Years of Economic History in a Few Short Pages
Looking back, the trajectory of the “bubble economy” is obvious, but at its height, many people were describing it as unprecedented progress. The typical way of describing how we got here is usually done by chronicling business and policy developments of the last 25 years. It goes something like this:

In the mid-1990s our economy was doing well, as we had moderate interest rates, rising government revenue, and a well-functioning capital market. The United States had shaken off the problems of the 1970s and early 1980s and was riding the wave of productivity and earnings that came from the invention of desktop computing and the advent of the internet. The possibilities seemed limitless.

As the internet craze took off, there was a mad rush to take companies public, which was met with an equally mad rush on the part of investors to get in on the speculative investment boom. This was fueled not only by the obvious game-changing nature of the internet, but also by what the internet brought us: day trading and instant access to our investments. Suddenly, people were discussing stocks to buy just like they would discuss dinner choices at a restaurant (“I think I’ll have some Cisco and Yahoo!, but I’m torn because the Intel and the JDS Uniphase sound so good!”). Yields on bonds were falling, so equities seemed to be the overwhelming choice for growing wealth.

After languishing through the 1970s virtually unchanged, the Dow Jones Industrial Average (Dow) shot higher over the next two decades. The index increased by 325% in the 1980s and then by over 400% in the 1990s. By 1998 and 1999, CNBC was a household name, Amazon no longer was just a river in South America, and a sock puppet (Pets.com) was quickly becoming the most reviled figure on television. The rush to capitalize on the internet and investment frenzy led to the dot.com bubble and eventually to the bust of 2000–2002, which ended with many portfolios in shambles and a recession to boot. Fortunes were lost, and retirement plans were wiped out. To help the economy recover, the Fed lowered interest rates in early 2001. It didn’t help much. The economy did not fall much further, but it also did not make big gains. The year 2001 was spent eating through excess capacity and dealing with a short, shallow recession. Then tragedy struck: 9/11.

The markets were closed for four days. The world was in a panic. There were wild estimates as to what would happen when the markets did reopen. One thing was sure: interest rates would be dramatically lower. The Federal Reserve took swift, dramatic steps to flood the US economy with enough buying power to keep a questionable situation from turning into a cascade of bad events.1 The Fed had already lowered short-term rates from 6% to 3.5% over the course of 2001 leading up to 9/11. After that fateful day, the Fed lowered short-term rates another 1.75% in a matter of months and yet another 0.75% during 2002 and 2003, finally allowing short-term rates to bottom at 1% in that cycle. In just over two short years, the Federal Reserve lowered interest rates from 6% to 1%. It was determined to make our economy move, and move it did—although perhaps not in the way that the Fed intended.

As the Fed was aggressively lowering interest rates, lenders were aggressively stepping up their efforts to shovel money out of the door. Cheap dollars meant that loans were easy to afford, so borrowers could take out bigger and bigger loans. What to do with all of those borrowed dollars? Buy the biggest leveraged asset possible, of course! Americans went on a home-buying, condo-buying, investment-property buying binge, especially after they had lost in tech stocks and were looking for what seemed to be more solid investments. Although a family might be able to afford a $1,500 mortgage payment, the total size of their loan would change depending on the interest rate. At a 7% mortgage, the family could afford to borrow $250,000. At 5%, the same family, for the same $1,500 monthly mortgage payment, could afford to borrow over $350,000! It seemed like magic! Suddenly Americans were flush to buy the highest priced, most leveraged asset they would ever own! The housing boom was on!

Lenders were competing with US government–backed lending institutions Federal National Mortgage Association (FNMA, or Fannie Mae) and Federal Home Loan Mortgage Corp. (FHLMC, or Freddie Mac), which could get really cheap dollars because of their implicit, and later explicit, government backing. FNMA and FHLMC got most of the prime loans, those loans taken out by borrowers with good credit who were purchasing traditional homes to live in and who were putting down 20%. Other lenders charged a slightly higher interest rate but made loans to people who had lesser credit scores, who were buying investment properties, who were making a smaller down payment, or who had some other nontraditional aspect to their loan.

As time went on, the falling interest rate environment had a curious impact on the value of homes. As buyers could afford bigger sale prices, they bid up the price of homes. This caused the development and sale of real estate to become the hot industry and caused existing real estate to shoot up in value. Loans that were backed by real estate were seemingly bulletproof, as the default and foreclosure rate plummeted. Who would default on a mortgage when the property had increased in value? Just sell it! At one point Wells Fargo actually had a negative cost of foreclosure, meaning that the bank made money on homes they took back from borrowers.

Through the impact of lower interest rates and lenient standards, the traditional ratio of income to borrowing power for home mortgages was expanded dramatically, as we show in Chart 1-1.

Are you aware that the average household’s borrowing capacity for a mortgage went from 3.3 times household income to 9.2 times income in just the 6 years between 2000 and 2006? We have never seen anything remotely like that in modern history!

At the same time, the lending industry took the opportunity to greatly expand the cash-out refinance business so that current homeowners could unlock the value of their homes and use the funds for anything they wanted. Homes no longer were just long-term investments or places to live, but also were really big ATMs.

The beauty was that anyone could play the game. As values continued to climb, lenders fought over borrowers. Lending standards went out the window; ever more exotic loans were developed to allow more borrowers to qualify for bigger and bigger loans. Of course, banks no longer really financed loans. They simply originated loans and then sold them to other institutions. Because the banks did not hold the loans, there was no limit on how many loans could be made. Also, the motivation for making loans was not to ensure repayment but to get as many loans out of the door as possible.

The Federal Reserve began raising rates in 2004, but the snowball was already rolling downhill, gaining in speed and size. The housing market juggernaut, with all of its baggage, was moving at light speed. Then, in late 2005, it started to slow down. The pool of borrowers was not growing as rapidly, and the building industry had ramped up its efforts to the point that inventory was coming online very quickly at higher and higher prices. By 2007 there were questions about many of the subprime mortgages and about the ability of the borrowers to pay.

Chart 1-1: Borrowing Power of a Typical Home Purchaser, 1995–2008



Data Source: Amherst Securities

In early 2008, when the music stopped, large financial companies began to shudder: first Bear Stearns, which was followed by FNMA and FHLMC, Lehman Brothers, and too many banks to mention. The US government got in on the act in May 2008 with a $168 billion stimulus plan and then took over FNMA and FHLMC that summer. At the height of the credit crisis the government implemented the Troubled Asset Recovery Program, or TARP. The White House changed hands, Congress passed an $800 billion stimulus program, and in March 2009 the United States became the largest shareholder of General Motors and AIG.

So far, this narrative posits credit—the creation of it, the access to it, and the misuse of it—as the genesis of our current crisis. If that were true, then a simple correction to our credit markets would be able to put the United States back on a sustainable economic path. This is exactly the type of policy that the United States has pursued, seeking to make dollars even easier to get through interest rates that are now at zero, creating tremendous reserves at banks ($1.5 trillion on hand), and trying to force lenders to make loans. But it’s not working. Instead of taking on more debt in order to buy more things, consumers have turned away. Those who are creditworthy have chosen a more frugal path and are no longer swayed by the idea of a bigger home, a fancier car, or simply more stuff. What happened? To hear typical economists describe it, consumers are fearful. Their current lack of trust in the future is causing them to hold back on purchases, which slows down the business cycle and causes the economy to drag.

There is a reason that consumers are fearful: their gut tells them that something is very wrong. The entire debt of the United States has more than doubled in the last decade to well over $100 trillion, as Chart 1-2 shows. Our total debt as a percentage of GDP is roughly 5 times as great as it was in 1929 before we entered the Great Depression!

Chart 1-2: US Debt Creation, 1980–2009



Data Source: The Chart Store, St. Louis Fed, Treasury Direct, US Treasury

We will cover the topic of debt in great depth in Chapter 3, but to summarize, the greatest problem is not the Fed’s stimulus of $2 trillion plus or even our federal debt, which is approaching $15 trillion and forecast to reach $20 trillion to $25 trillion even in a rosy economy in the next decade (which won’t happen). The greatest problem is a double whammy of the private debt of $42 trillion in our economy (more than double the level of debt we had in 2000) and the unfunded entitlement programs of Social Security and Medicare/Medicaid, which have increased more than three times since 2000.
There Is More to the Story: What You Will Not Hear from the Mainstream Media
Is this really what happened, and is it an accurate picture of where we are? Did we simply get pulled into a debt-fueled spending spree and then get scared? If only it were so simple. Like so many things, the reasons are more complex, and the time frame is much longer. This was indeed a bubble—in fact, the greatest bubble in history; however, the bubble did not start with stocks in the 1990s or home prices in the 2000s; it started with people. In particular, it started with little people, babies, over 60 years ago.

The incredible surge in births from about 1937 to 1961 was called a baby boom, and those children came to be called baby boomers, particularly those born from 1946 through 1964. They also became known for their behaviors and views on society. This huge group of people came of age in the 1960s and 1970s and then went about the rest of their lives. At every single stage of life, this outsized group has turned markets and institutions on their head. When this group was going to elementary school in the 1950s and 1960s, we could not build schools fast enough. When they entered the workforce in the late 1960s and 1970s, there were not enough jobs. We saw the greatest inflation in modern history because it is expensive to raise kids and then integrate new workers into the workforce (a severe, prolonged lack of productivity growth). In the 1980s, they started families, bringing about the term “soccer moms” and driving demand for SUVs to carry all of those people and all of that stuff. As this bubble of people, the boomers, went about living their lives, they drove demand for goods and services in very predictable ways at very predictable ages and stages of life. This generational explosion eventually fueled demand and consumption approximately 46 years later, when the typical household is at the height of its family spending.

The reason the spending patterns of this group of consumers, or any group of consumers for that matter, are so important is that personal consumption makes up 70% of gross domestic product (GDP) in the US and a similar percentage in most developed countries. Over two-thirds of our economic activity in any given year is directly related to the choices made by consumers. When consumers spend more, businesses make investments to expand their capacity to satisfy the increasing demand. This also leads to rising tax revenues for governments (sales tax, income tax, property tax, fees, etc.), which allow for greater government spending. So when the largest group of people (boomers) inside the largest spending group (consumers) makes a change, everyone pays attention. The remainder of the GDP is split among businesses (15%), government (20%), and the net of imports/exports (–5%). (Currently we bring more into the country than we sell to other people, so this last number is negative.) Recently, businesses have been spending much less and the government has been spending much more. Even so, it is changes to personal consumption that are the most important, as consumers drive the entire train over time.

We will explain this in greater depth in Chapter 2. Our economy rises and falls on an approximately 46-year lag to the birth index, as greater numbers of people in a new generation such as the baby boom generation reach their average predictable peak in spending, which we show in Chart 1-3.

As the largest group of consumers in our society reached the peak of their personal demand for consumption around late 2007 (as we forecast 20 years ago that they would), they were desperate for the “fuel” needed to spend, which was credit. The industry responsible for creating credit was working overtime to meet the incredible demand. When the credit bubble—which was an outcome rather than the cause of the rise in demand—fell in on itself, the consumption demand of the boomers was already starting to flatten out. This trend line of demand will naturally decline for many years. The credit crisis just accelerated the slowdown in baby boom spending that was already in the cards, because it was put in place almost 50 years ago. The first phase of the slowdown demographically was a flattening in spending that has already begun, similar to what occurred from 1966 to 1970 in the last generational peaking process 40 years ago. Back then we saw more serious recessions in 1970 and 1973–1974. The last of the baby boomers’ kids are likely to leave the nest by late 2011, creating the next serious economic downturn between 2012 and 2014.

Chart 1-3: The Spending Wave, Births Lagged for Peak in Spending



Data Source: HS Dent Research, US Census Bureau, Bloomberg, 2012

This is an important point. Although spending peaks at age 46 on average, there is a plateau into age 50 while the kids are leaving the nest. The average kid is born to the average parent around age 28. The kids who enter the workforce after high school will leave the nest when their parents are about age 46. The kids who go to college won’t leave until their parents are age 50. It is this 4-year plateau in baby boom spending that we have seen from late 2007 through late 2011. From 2012 forward, we should see a more serious decline in income and spending by baby boomers, especially after the top 10% peak in 2012.

The last time a generation peaked in its spending and a long downturn and stock decline followed was in 1968. That was a 44-year lag on births for the Bob Hope generation, which got married a bit earlier. There was a major stock crash and recession into 1970, but then the Fed stimulated the economy as Keynesian economics had finally come into vogue. The economy and market bounced, with stocks going to slight new highs in late 1972. Then the largest crash occurred in 1973–1974. There is a plateau in spending as people’s kids get out of either high school or college. After that plateau wears off, then stimulus programs fail to keep the economy going as spending drops off dramatically as it did in 1973. This time there is an added twist. The top 10% of households have risen to a dramatic 40% of income and spending, as you can see in Chart 1-4. And they peak in spending about 5 years later than the average household. We have an economy where most people have peaked, but this small segment is still spending. However, they should drop off more dramatically after 2012. Hence, we expect government stimulus programs to fail increasingly from 2013 forward.

Chart 1-4: Dow Adjusted for Inflation, Comparison of 1968–1974 with 2007–2013



Data Source: Yahoo Finance, 2012

Now we are in a completely different type of environment. No longer are we working in an economy with an ever-growing appetite for consumption. Things have changed. The boomers are now focused on saving and paying down debt, although they splurged a bit in late 2010 and early 2011 after cutting back so much from late 2008 into the summer of 2010. They have taken their credit cards and gone home. The boomers have followed a very predictable path, spending more incrementally as their children got older and peaking in their spending just as their children were getting old enough to leave home. From that point forward, the game becomes all about preparing for retirement. The boomers may take the occasional vacation, refurbish the bathroom or kitchen, or throw a big party, but by and large the focus of those in their 50s is to save enough to retire comfortably. Achieving that savings is possible because as their kids leave the nest, they do not have to spend as much on daily living; fewer people are in the house to support. So what happens when the largest group in your economy changes from being spenders to being savers? Suddenly, your economy goes slack. Just ask the Japanese, who went through this transition in the early to mid-1990s. As that large generation moves on to the saving phase, what’s left behind is a marketplace with too much capacity and too few consumers. There are not enough people in the next generation, Generation X, to fill the shoes of the boomers—especially in housing, the largest and most debt-intensive purchase.

This type of economic analysis, based on demographics, is exactly what we do at HS Dent. For over 20 years we’ve been explaining to audiences and readers how our economy changes based on people. As much as we would like for people to do what we want, it is much more likely that they will do what they want. This is critical to understanding our economy, and yet economists pay little attention to demographics!

Much of the economic theory used by the US government to try to grow our economy is based on consumers behaving rationally. Unfortunately, the government’s idea of rational behavior is reacting to interest rates and price movements in a vacuum, with no regard for the current situation of the individual consumer! What person decides to spend more or less without thinking about things like raising their kids, saving for retirement, or job security? This makes no sense! When creating incentives, government should try to assess where consumers are in their lives, but it doesn’t. This is the biggest failure of economic theory and government intervention today!

Most people are going to make a decision based on what’s happening in their household, not on what’s going on in the larger economy. This is why we can go through so many difficult things in our economy, like wars or terrorist attacks, and yet people will continue to spend. No one likes these types of events, of course, but if we still want guitar lessons or new clothes for our children, or if the tuition for after-school care is due, we are going to pay for it. As the children leave home and we’re no longer burdened with these responsibilities, we begin to focus on the next change in our future, which is retirement. Let the savings begin!
But China and the Emerging World Will Save Us, Right? Think Again!
Many claim that the rising demographic trends of younger populations in the emerging world and the spectacular growth of China will keep worldwide growth more robust, offsetting the slowdown from demographics and debt deleveraging in the developed world. First, note that over 65% of world GDP is still generated in the developed world, despite the remarkable growth in the emerging world. Our standard of living in the United States is more than six times the standard of living in China, even adjusted for purchasing power. As we will cover in more depth in Chapter 8, China’s government has been creating the last great bubble in this unprecedented global bubble boom. To keep its populace happy with an unelected government, it has been building roads, railways, and real estate developments, including cities like Ordos, a complex that can house up to one million people but is completely empty! China’s capacity for major industries, from cement to aluminum to steel, has expanded to 20% to 40% more than its current production and world demand. China’s economy is not driven largely by growing consumer demand like it is in the United States. Instead, in China 35% of the GDP is driven by exports and 50% or more is driven by fixed-capital investment, largely by the government.

In short, China is building at a hurried pace for a future that will not materialize as a result of a slowing world economy and the rapid aging of its own population. China will be the last bubble to burst. That bursting will slow down the emerging countries in Asia, Latin America, the Middle East, and Africa that are supplying China’s unprecedented infrastructure boom with materials and energy. Excess capacity and an eventual slowdown in China’s purchase of commodities will bring the next commodity price collapse between 2012 and 2015, which will hurt the economies of most emerging countries. This will be a bust and deflation crisis worldwide, not just in the developed world.

You can get free access to Harry’s very popular webinar “Understanding the Economy and What Lies Ahead” by visiting and registering at http://www.hsdent.com/webinar.

Demographic cycles peak around every 39 to 40 years, as we show in Chapter 2. However, commodity cycles, which are more likely to drive economies and exports in most emerging countries, occur every 29 to 30 years on average. Our reliable 29- to 30-Year Commodity Cycle, shown in Chart 1-5, is set to peak between mid-2008 and late 2011 or so. This cycle is not likely to turn upward again until the early 2020s, which indicates a slowdown in most emerging countries in the decade ahead, despite continued growth in demographic trends. We will cover this topic, along with the very different factors that drive emerging country economies and growth, in Chapter 8.

Chart 1-5: The 29- to 30-Year Commodity Price Cycle

CRB Index (PPI before 1947) 1913–2040



Data Source: Bloomberg, 2012

Emerging countries from Asia and Latin America to the Middle East and Africa will be the clear growth areas of the world for decades to come after the developed countries age and slow demographically. However, the next concerted growth surge for the world and emerging countries is not likely to reemerge until 2020–2023. India is more likely than China to be the rising star of the next global boom as time moves forward.
The Government’s Response: Anything But Pain
For consumers in the United States and most developed economies, the change from an economy based on consumption to one based on savings might sound reasonable (especially given the aging of the baby boomers). However, such change is not what governments want, especially not the US government. Why? Because it’s economically painful to the nation as a whole in the short term—just look at what happened in the United States from 1930 to 1933! As we shrink our economy or deleverage the credit outstanding, there will be a dramatic slowdown and even a temporary decline in the standard of living. This shows up in many ways—such as higher unemployment, failing banks, falling business activity, and falling asset prices—that impact household net worth. While everyone supports more financial responsibility, they support it more in theory than in reality. When these undesirable side effects arise, there is an outcry for the government to fix the situation. When unemployment runs high, people always ask what the government will do to fix it.

While it might strike you as odd for anyone to suggest that more borrowing and more spending are the answer to a situation that arose from too much borrowing and too much spending, that is exactly what the government is doing, in addition to using the other tools at its disposal. The government can and has directly intervened in many ways throughout history and in the present downturn, but its most useful tools are still interest rates, taxes, and spending plans. To ease the pain that many people are feeling because they are unemployed, as their homes decline in value, or both, the government is doing its best to raise the level of economic activity and to bring back jobs as well as increase home prices. As we will explain later, these governmental actions ultimately will not work. No government has ever been able to prevent a major bubble from deflating or to stop an aging generation from saving, but it can slow the process and ease the pain temporarily—however, only at great expense, as Japan has proven over two decades of economic malaise.

The government is taking on more debt through its own borrowing and its own activities in an effort to stimulate lending and spending. In short, the US government wants us to do a lot more of what got us into trouble in the first place. This does not mean that our representatives do not understand the situation. Instead, what we have been told is that we should work toward an economic recovery quickly and then work on our fiscal responsibility later. What if “later” never comes, as has been the case for the Japanese economy for the last two decades?

The hope is that you and I as consumers and business owners will suddenly feel more confident and will spend more of our money as well as grow our businesses. However, that assumes that the reason we’re not spending today is because of a lack of confidence, which isn’t true. The reason we are not spending is because our kids are leaving the nest and we as consumers are now more interested in saving for the next stage of our lives: retirement. This trend of kids leaving the nest will accelerate from 2012 forward, making the demographic downtrend more obvious and the government’s efforts to fight it more difficult. Businesses, having recognized that our spending patterns have changed, have lowered their output to match the new level of demand. Stimulus programs were begun back in May 2008 and have taken several forms over the past two years. None of the stimulus programs so far has had lasting effects. While some have had a dramatic immediate impact (think of the Car Allowance Rebate System, aka “cash for clunkers,” or the First-Time Home Buyer Credit), none has done the job that it was intended to do, which was to stimulate greater demand that would last well beyond the program.

Regarding the larger stimulus plan, which was passed in spring 2009, $800 billion has flowed to many different corners of the country and the world. Unfortunately, much of that money has gone to entities such as cities and states that were poorly run to begin with. Cities and states not only are facing annual budget deficits, but also are under contract to fund tremendous obligations, such as pensions and health care for retired workers. Local governments simply do not have the money to fund such obligations fully. Many states borrow money just to balance their books on an annual basis. Sending even more funds to entities that were running deficits to begin with does not solve the issue; it simply pushes it down the road to be dealt with another day.

To handle our current economic situation more effectively, the US government should instead look toward reducing the amount of debt outstanding in the private sector. While economic activity has slowed of its own accord due to the changing situation and goals of the boomers, the depth and breadth of the downturn have been made dramatically worse because of the explosion in debt that occurred in the 2000s.

In order to erase the unprecedented bubble of the Roaring 2000s, we anticipate devastating losses in housing and business values. Bringing down debt to match this decline would require a write-off of up to $20 trillion in private debt (roughly the amount incurred in the United States from 2000 to 2008). Such a write-off would create savings of well over $1 trillion in interest and principal payments a year for consumers and businesses; now that’s a stimulus program that keeps paying off year after year for decades! That level of debt deleveraging is greater than the entire federal debt, which is now approaching $15 trillion.

This overhang of debt and its eventual deleveraging will make the next economic downturn even more painful, just like a detox program is for a drug addict. However, it is the only long-term solution. If the government does not deal with the problem and allow these debts to be written off, as occurred in the early 1930s, we will experience a very-long-term economic malaise, just as the Japanese have experienced for 22 years. Japan still has a weak economy and ever-rising government debt and debt ratios. History will not look kindly on Japan for its unwillingness to make hard decisions about major debt restructuring after its massive real estate and debt bubble of the 1980s!

The US economy and stock market are on “crack.” Government stimulus has been a major factor in fueling the greatest credit and real estate bubble in history, and now the government is desperately trying to keep the bubble going at all costs. Funds from the even more desperate second quantitative easing stimulus program (QE2), which the federal government put in place from late 2010 into 2011 (and a third likely in 2012), have not been going to consumers or into bank lending, but have been flowing directly into higher yielding bonds, commodities, and stocks. This misdirection of funds has led to a third and final bubble that will burst between early 2012 and early 2015 but is likely to burst the most between early 2013 and late 2014.

On the employment side, we should pursue activities that would help to rebuild America. That rebuilding is not just about building roads and bridges and shoring up physical infrastructure, although that is important to do. It is also about rebuilding our electronic data infrastructure, including health records and educational reform. The idea is to help those who are currently unemployed through this difficult economic Winter Season while at the same time providing tangible results that improve the nation over time and generate revenues that can pay off the debts required for the investment. This is infinitely more attractive than temporary stimulus programs that create debt for only short-term results at best.
Businesses and Consumers: What We Can Do Right Now
The government has a lot on its plate, but so do business owners. Is now the time to expand? Should you be taking out a loan? What about that office building that suddenly got cheaper? All of these are questions that business owners are asking themselves. Our advice is to remain very conservative through at least 2013 and possibly through 2014 if the government drags out the artificial recovery a bit longer. This is a time to conserve your assets, meaning cash and credit lines. Create a business plan as to which competitors you would like to buy or which clients you would like to have. In the months and years ahead, you should be able to expand your business using your cash and credit to buy those competitors that overextended or that were inefficient to begin with. Expanding in good times is easy; there is plenty of growth for you and your competitors to share. Living and managing a business during a downturn with a shrinking economic pie is very difficult and comes with hard decisions, such as firing long-term employees and shedding lower-performing businesses and assets. Business owners who make it through such bad times should be well prepared when the next season of growth begins and are likely to gain market share, dominating their markets for decades to come.

The personal side is not much different—each of us is running a business: our personal household. During the current economic Winter Season you should not be looking for as much growth in your portfolio and assets, because this season is marked by deflation and low returns, especially on the typical fixed-income investments that are best for retirement. Instead, you should be using the time to generate and cultivate streams of income. The idea is first to preserve the capital and assets you have, and then to receive or create as much income as possible, thereby growing your capital base as prices fall. This will set you up to buy assets at even lower prices in the years to come, which will prepare you for the next economic season.

Now is a crucial time for those who are close to college age. Unfortunately, much of the advice that you will receive will be based on the recent past. Many vocations or career paths that will be suggested will follow the assumption that our economy is going to bounce back quickly. You should call into question even the basic determination of whether to go to college. Is it worth it for what you want to do? Is an Ivy League education worth pursuing if it means accruing hundreds of thousands of dollars of debt? These questions become more important when the possibility of high-income growth in your working years is less certain.

As we contemplate the previous two decades, we should recognize them for what they were: a period of high growth that was driven by the concerted earning and spending patterns of the baby boom generation, exaggerated by an unprecedented debt bubble. We have since moved to a period that is marked by greater savings, less spending, and the deleveraging of debt and that could last well into the next decade. This change in economic season will have profound effects in many areas of life, including employment, income, personal portfolios, business valuations, health care, and education. If we understand what led us to this point, we may be able to manage the situation not only to protect what we have, but also to assist those who are in need. If we do not recognize the factors at work, which are mostly driven by individual demands and desires, then we risk throwing the wealth of the nation into programs and efforts that are doomed to fail. Just as “China will save us” is not the answer, neither is hoarding gold or Swiss francs. Investors who have done well in these investments are simply projecting out recent returns and could end up meeting the same fate as those who thought real estate couldn’t go down in the 2000s. We are likely to see gold start to decline, as we warned in March 2011. It may rise once more in 2012 over the Iran conflict before collapsing for years ahead, much as oil did from 2008 onward.

The aging of massive baby boom generations among nations across the wealthy developed world and the deleveraging of the greatest credit bubble in history will lead to deflation in prices. The 1970s was what we call the economic Summer Season, characterized by rising inflation (like rising temperatures) because of the sluggish productivity that accompanies the integration of large numbers of young adults into our economy. We are entering an economic Winter Season, similar to that of the 1930s, in which deflation (or falling temperatures) is the trend, as populations age rapidly in the still-dominant developed countries from Europe to North America to East Asia.

While some analysts and forecasters see this debt crisis for what it really is, most still think that the massive stimulus from the government is going to create inflation due to the unprecedented printing of money and low interest rates. They are wrong, and their strategies for the future likewise will be wrong. Deflation requires personal and business strategies that are entirely different from strategies used during other economic trends—and that is what we will be talking to you about in this book.

In Chapter 2 we look at the primary argument that we have been making for over 20 years: that the main trend that drives economic growth, inflation, home buying, and almost everything else is demographics. We will show how people do predictable things as they age, affecting every facet of our economy, and why the largest generation in history will be saving more, spending less, and causing deflationary trends as they increasingly retire.

1. Historical Changes of the Target Federal Funds and Discount Rates: 1971 to Present. Online chart, updated December 12, 2008. Federal Reserve Bank of New York. Accessed March 2, 2011. Available at http://www.newyorkfed.org/markets/statistics/dlyratesfedrate.html.