The End of an Era

2008 marked the end of an Economic and Political Era. The Reagan Era that just ended had several important characteristics:

1) Financial Innovation and higher debt levels. (more leverage)
2) Good demographic trends
3) Increasing consumer spending
4) Strong International Trade
5) Strong Global Economic Growth
6) Relative Political Stability

By contrast the new era we are entering may have the following characteristics:

1) Liquidation and lower debt levels (less leverage)
2) Negative demographic trends
3) Higher consumer savings
4) International trade limited
5) Weak to negative global economic growth
6) Political Instability

The Reagan Era started in the 1980s with the Reagan Revolution and a change in the regulation of the financial sector. The Reagan Era has seen a large increase in the flexibility of the financial system. In this Era the financial system created so much flexibility that many projects that otherwise would not be built, were able to find financing. But, the creative financial instruments became too fragile to withstand an economic downturn. This era ended with the failure of many sub-prime mortgages and related financial derivatives. The sub-prime mortgages were not the only asset class impacted by these factors, but just the first. Almost every type of asset was securitized in some way. The securitization of assets allows a much higher leverage and a higher price for the underlying asset. Thus, you had home prices rising to very high levels because of the securitization of mortgages. But with all the Wall Street firms becoming commercial banks, this unregulated activity is coming to a swift halt. The amount of securitization is falling rapidly and with new regulations on the horizon, the size of the market will be significantly smaller than in the prior years.

Besides the increase in asset prices, a second impact of the securitization was an increase in leverage. By allocating the risk of a security to different people, loans that otherwise would not be possible, become commonplace. Thus, the total amount of lending increased and total leverage increased. Many people, firms and banks found the advantages to leverage. When you borrow money you can gain huge personal profits by investing the money at higher rates of return than the interest rate. But if the economy faces some road bumps, you can go bankrupt. When everyone faces the same road bumps, the result is a severe recession. The more leverage in the system the higher the profits in good times AND the higher the losses in the bad times. Thus, the higher leverage has created a deeper and longer recession than lower levels of leverage would have created. In the new Era, the higher cost of leverage will be a factor in the slower growth and slower recovery from the recession.

Yet financial innovation was not the only key factor in the Era. Demography and increased consumer spending were very important. Some age groups spend more on things and save less than other age groups. For example, people in their late twenties and thirties are building households and tend to spend far more than other age groups on household items. People in their fifties tend to save for retirement and already have a household. Thus, the amount of consumer spending per capita is dependent on both the society’s culture and the age profile. Look at the age profile for the 1990’s:


You can see the bulge of people in their late twenties and early thirties.
Now compare that to the profile from 2015:

See the dramatic increase in 50-60 year old people?  They have different amounts of consumer spending than the 25-35 age group.   In addition, the culture may have hit a point were conspicuous consumption is less desired.  Overall, consumer spending will fall and savings will rise.

Other key factors were the lowing of trade barriers and the increasing global growth.   Both of these added significantly to the GNP of India, China and other countries outside the “First World”.  But with the economic slowdown and lower consumer spending in the US, the world trade and economic growth is under fire.  While we don’t know how much trade will be restricted, the NAFTA has come under attack and China is likely to feel the pressure of the environmental movement.  The trend of free trade has been reversed and will result in lower global economic growth.

Lastly, if global economic growth slows, then more countries will face political instability.  Recently the Baltic States have had riots and other signs of political instability.  With a global recession just starting, the pressure on many countries will be enormous.  This will in turn feed less economic growth around the world and higher prices for goods and services. 

While the extreme of the Roaring Twenties and the Depression of the Thirties may not occur, the Reagan Era will be followed by an Era of recession and low economic growth.   Adjusting the system for the new levels of leverage will take time.  This new Era may last 10 years, but could last longer.