Communications

The present U.S. economic expansion is now seven years old. Only three of the twelve economic expansions since the end of the second world war have lasted longer, and none exceeded ten years. So, is the handwriting on the wall, so to speak, for this economic expansion? Not necessarily, according to a recent article in The Economist .

A recent study by the San Francisco Federal Reserve Bank found a marked distinction between the longevity of economic expansions before and after World War II. Prior to World War II, economic expansions seemed to die of old age, following a business cycle that traditionally went from boom to bust over a rather predictable number of years. Yet things changed after 1945 largely because of increasing government intervention in managing the economy via active monetary and fiscal policy. Since the end of World War II, unexpected external shocks - such as a massive spike in oil prices - or man-made internal shocks - such as 20% interest rates or unlimited financing for residential real estate - explain the demise of economic expansions. In other words, old age was not the culprit as it had been decades ago.

If economic expansions do not die of old age these days, the present U.S. economic expansion may continue on somewhat indefinitely. After all, the Dutch enjoyed a 26 year economic expansion that only terminated in 2008. And the Australians are on course to break that record with their current economic expansion.

However, there are potential external and internal man-made shocks looming on the horizon that may derail the present U.S. economic expansion. Pressing economic issues in China represent the potential external shock of sufficient magnitude to halt the U.S. expansion while a premature increase in interest rates engineered by the Federal Reserve represents the potential internal man-made shock. Yet how events unfold in both countries depends, in large part, on the judgment and action of its central bankers in this present age of active government intervention in economic affairs.

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By all accounts China has a massive debt problem that will trigger a financial and economic crisis in the near future, given domestic public and private debt that approaches 260% of gross domestic product (GDP). As The Economist reports, the pressing question is not whether a crisis will occur, but, rather, the extent of the ripple effects, at home and abroad, following the onset of a near-certain crisis.

According to The Economist , approximately 40% of all new debt is used to meet debt service. A decade ago, it took the equivalent of one dollar of new credit to create one dollar of output. Today it takes four dollars of new credit to produce a single dollar of output, reflecting the increasing role of new credit to meet existing debt service and, presumably, operating expenses. And debt is still expanding twice as fast as the economy itself in spite of the present debt level at 260% of GDP.

So, when the crisis emerges, how will it likely affect the U.S. economy? The most direct impact will be on U.S. exports as China’s demand abruptly decreases for U.S. goods and services. In 2015, U.S. exports of goods and services to China were roughly $162 billion or about 11% of our global exports of goods and services. If the U.S. lost half this amount as a result of a severe downturn in China, it would represent less than one-half of one percent of U.S. gross domestic product.

The impact on the U.S. financial sector would be equally as marginal. The Chinese financial system is relatively insulated, which means that domestic borrowers rely little on external financial sources. Although precise data is somewhat elusive, it appears that U.S. bank loans to domestic borrowers in China are somewhere in the range of $60 billion. Direct U.S. investment in China - dollars invested in hard assets such as plants and equipment in China - were about $66 billion at the end of 2015.

The direct impact of a Chinese financial and economic crisis would be felt, certainly, but it would not directly damage the U.S. economy significantly. The greater threat and fear is the psychological impact of a Chinese crisis, which may turn emerging U.S. optimism about the economy to overnight pessimism, thereby dampening internal spending and demand as consumers and businesses hunker down to ride out the Chinese storm.

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A recent dispatch in The Atlantic examines the role of immigration in China and the U.S. in supporting and sustaining economic growth as each country’s population ages and leaves the workforce.

A country’s workforce can, of course, be replenished by indigenous population growth, reflecting a high birth rate, or by immigration - or by some combination of the two. But the key to sustainable economic growth and increasing living standards in both China and the U.S. is the maintenance of a high ratio between active workers and retirees. The greater the number of active workers in the workforce per retiree, the greater the financial resources available to pay the health and pension costs of the retirement community -in general.

In China today there are approximately five active workers for every retiree. In the U.S., the ratio is less attractive at roughly three active workers for every retiree. Yet if demographic trends hold up, by 2040 - twenty four years from now - there will be 1.6 active workers for every retiree in China while the active worker-to-retiree relationship in the U.S. will likely remain at its present level. Further, the median age in China is on course to increase from less than 30 years to over 46 years by mid-century, which will make China one of the older societies in the world. And by mid-century, China will have more than 300 million retirees to support.

In China the birthrate is insufficient to replenish the workforce, and there is no evidence it will change in future years. In addition, as the Chinese population ages and workers leave the workforce, the country has no viable source of foreign workers or potential immigrants since the demographics in all surrounding countries generally match those of China.

In the U.S., on the other hand, immigrants play a critical role in perpetually replenishing and expanding the workforce, as well as maintaining an acceptable active worker-to-retiree relationship. If demographic trends hold up in the U.S., immigrants and their children and grandchildren will account for almost 90% of the U.S. population growth over the next half century. However, the jury is still out on whether such a phenomenon is politically acceptable.

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On June 15th and on June 29th, Shockproof! Training offers a two-part webcast on Understanding and Analyzing Contractor Financial Statements.

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