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December 23, 2004

The Soft Landing Scenario

Macroblog fills in the outlines of its soft-landing scenario:

macroblog: Exactly What Was I Thinking?: Actually, the story I was telling was all about reversing the big capital inflows and trade deficits, one that starts with the presumption that foreigner's taste for absorbing ever more dollar-denominated assets has come to an end.  The current account side of ending the capital account surpluses -- that is, the accumulation by foreigners of U.S. Treasury securities and the like -- is a shrinking trade deficit, as the weaker dollar stimulates export demand and restrains the demand for imports.

In this scenario, spending by American consumers and businesses will have to be satisfied by domestic production.  That will almost certainly result in upward pressure on interest rates, which ought to work in the direction of restraining domestic consumption and increase saving rates (and business investment on plant and equipment, of course), as required.

To restate: (1) the dollar falls, (2) as a result net exports rise, (3) export and importing-competing industries hire workers, (4) unemployment falls, (5) wages start rising and bring rising inflation with them, (6) the Federal Reserve raises interest rates to stop any inflationary spiral, (7) the economy cools off as higher interest rates reduce construction and investment spending and raise unemployment back to its natural rate.

It could happen--if exports react rapidly and substantially to the falling dollar, and if the rising long-term interest rates that diminish employment in construction and investment-goods production are somewhat delayed...

Posted by DeLong at December 23, 2004 01:05 PM

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So how exactly does; "spending by American consumers and businesses will have to be satisfied by domestic production" happen? I've been in manufacturing industry for the last 20 years and all I see is a loss of U.S. infrastructure for manufactured products.

If a product doesn't have high margins , or high shipment related costs (cars/trucks) U.S. manufacturers have been moving production elsewhere. The U.S. facilities and knowledge base is lost, and it will take a long time before we could get it back. I don't see how that "reality" could lead to a soft landing.

I can see; "purchases by American consumers and businesses will have to be reduced, because of higher import prices and limited domestic growth"

Posted by: Steve at December 23, 2004 01:25 PM


Let's stop right away at the link between [1] and [2]. Thus far we have had nearly three years of [1] and not a bit of [2]. From Feb. 2002 to Dec. 2004 the dollar has fallen 16% in real terms (broad dollar index) while the trade deficit has grown in real terms about 60%. What if the US is the global price-setting market and thus rather than importing inflation via a falling dollar which would cut into import consumption, exports deflation instead and maintains import consumption?

The key mechanism is not a falling dollar, but rising savings. A little protectionism (via maintaining existing tariffs/quotas) wouldn't hurt, either.

Gen'l Glut

Posted by: General Glut at December 23, 2004 01:27 PM

This is exactly what the Bush Admin wants to happen, correct? And they are sticking it to the rest of the world two ways, right?

1) Value of those foreign-held dollars declines, so the states holding them lose purchasing power for, eg., crude oil.

2) Countries that export to the U.S. theoretically face price competition from domestic vendors and thus (again theoretically) can expect their U.S. sales to decrease.

So the logical response of the rest of the world would be to dump the dollar as reserve currency.
Is there another currency that is ready? Euro? RMB? Basket of currencies? It seems to me the only logical "backing" now would be (unexaggerated) in-the-ground oil reserves. Those are the closest thing in our current world to old-style "real" money, and they are finite. The fact that this "money" is, unlike gold, consumable, should help model the real world economic situation in the marketplace.

Posted by: Ralph at December 23, 2004 01:28 PM

Is there any way we can accurately predict how fast some jobs will vanish and other jobs will be created? This, I would imagine, is the most important thing politically. You've indicated this, Brad.

Posted by: Brian at December 23, 2004 01:32 PM

Don't interest rates rise for a simpler reason (rather than this story via falling unemployment, rising wages and then Fed action): the dollar is sliding presumably because foreigners are losing interest in financing so much of our gargantuan current account deficits. Their demand for US dollars and US treasuries falls. Falling bond prices mean rising rates (unless the Fed takes countermeasures).

Posted by: zzi at December 23, 2004 02:37 PM

There were actually three soft landings, but two of them should never have happened.

Posted by: cloquet at December 23, 2004 02:49 PM

As I keep pointing out, the flaw in this soft-landing scenario is that the U.S. no longer has any manufacturing base to speak of, and thus cannot take advantage of the falling dollar by increasing exports. We're not making anything here, so we can't export anything.

Also, if recent history is any indication, the few U.S. companies that do export have found that they can simply raise their prices as the dollar falls. Their sales volume remains the same, but the per-unit profit rises. Thus, our few exporters do not make more to meet rising demand, and so have no need to employ more people.

In all, I'd say there are three chances for a soft landing: Fat, Slim, and None.

Posted by: Derelict at December 23, 2004 03:25 PM

Going from step one to step two would take years, since the manufacturing facilities in the U.S. for most imports no longer exist. Somehow I don't think there would be that much time available.

Posted by: Tim H. at December 23, 2004 03:36 PM


That there may even now be possible economic solutions now to prevent a hard landing is encouraging in the abstract. But it would I fear take a sea change in the attitude of the general public and in the administration they chose to lead this country for the next four years.
The members of the general public seem to have a collective addiction to material things. People juggle charge card accounts to afford a plasma TV Or take out second mortgages to vacation and get mammouth SUVs. This addiction needs be dealt with. The fact that the economy got such short shrift this fall suggests that such change will not be voluntary. I fear that as a nation we will have to "hit bottom" before change can occur. De-tox may not be pleasent.
Perhaps some Savonarola will appear and instigate a "bonfire of our vanities" to end this materialism, but perhaps not.
I do that deep within the groves of thinktanks and acedemia there are those planning economic triage
for the aftermath.

Posted by: aeolus at December 23, 2004 03:40 PM

Doesn’t China function as the 13th Federal Reserve District? In a world were the Renminbi is pegged to the declining dollar how can American manufacturing compete against the 51st state with its cheap labor? I don’t see how we can gain enough to close the gap on the twin deficits.

Posted by: bellumregio at December 23, 2004 04:07 PM

When war and reckless spending caused this problem before, Richard Nixon instituted WAGE AND PRICE CONTROLS.

Soon afterwards, he was eliminated, so to speak.

Letting the dollar plummet never ever works alone. Never. Won't happen now nor in the future.

Posted by: Elaine Supkis at December 23, 2004 04:30 PM

steve -- your point worries me. it suggests it will take a much bigger fall in the $ than anyone thinks to change the titanic's course, and convince folks to invest in the US to produce for a global market ... something that we eventually have to do, or we have to start importing less (which either requires a fall in income, or US production displacing foreign production).

Glut -- earlier experience working with some trade models leads me to think that if you had the $ at its 2002 peak and US demand growth comparable to what we have observed, the trade deficit would have expanded by much, much more. the $ at its 97 levels, using elasticities estimated over the preceding twenty years, tended to lead to trend expansion of the deficit (see some of catherine mann's work). Right now the Euro is still basically where it was in 90-96, not substantially stronger. I don't think there is any reason to expect the dollar's fall from the high level of 02 would on its own lead the trade deficit to correct. To get that to happen, with standard elasticities, you probably need the dollar to fall from its current levels ... (or some slowdown in US demand growth)

Posted by: theotherbrad at December 23, 2004 04:42 PM


Leave No Truffle Behind?

[A]part from truffles, a variety of other imported foods and a handful of specialized European products, the sinking dollar has so far had a relatively modest impact on the prices paid by American consumers. Excluding oil, import prices rose by 0.7 percent in November, the fastest pace since January. The average price American importers pay for nonoil foreign goods has increased 3.4 percent over the last 12 months.

That is significantly above the 2.3 percent rise in the general price index, excluding energy, but still quite modest. And most consumers have not yet felt much of a pinch. While the prices of commodities like steel and plastic have risen sharply, the products they go into have not become much more costly.

Imported automotive vehicles and parts, for instance, inched up merely 2.1 percent over the last 12 months. As a whole, the consumer prices of all imported manufactured durable goods, excluding cars, actually fell 0.1 percent.

'Price trends have remained generally the same as in the past few years,' said Abe Brown, a spokesman for J&R Music and Computer World, which runs a suite of stores in downtown Manhattan. That is, electronic gadgets are either cheaper or they cost the same but have more bells and whistles.

The main reason for this moderation is that while the dollar has declined substantially against several major currencies - besides European currencies, the Canadian dollar and the Japanese yen have also strengthened considerably - it has depreciated much less against the currencies of the Asian countries from which the United States imports many popular consumer items.

'In most consumer goods categories, China is the top supplier to the U.S.,' said Erik Autor, international trade counsel for the National Federation of Retailers. The price of the PC's, DVD players and sneakers imported from China and other low-wage countries in Asia are not rising because the yuan has been kept fixed against the dollar by the Chinese government. Countries that compete with China also tend to keep their currencies relatively stable against the dollar....

Posted by: anne at December 23, 2004 05:26 PM

Leaving aside the structural issue -- we have more than 20 years of shifting AWAY from the production of tradeables under our belt -- I still don't see how any soft landing scenario works without a corresponding, and dramatic, shift in the savings-investment balance. Nor have I seen any soft landing exponent describe the mechanism that will bring about that shift.

If the US is going to have a personal savings rate in the neighborhood of, well, 0%, and a net national savings rate in the barely 2% range, we ARE going to run a current account deficit - and probably a very large one - under just about any plausible economic scenario I can imagine. The only question is whether we're going to do it with a dollar that's overvalued in nominal terms (as in the '80s and presently) or one that's overvalued in real terms because the depreciation of the currency never quite keeps up with inflation (as in the late 70's).

Posted by: billmon at December 23, 2004 05:32 PM


"If the US is going to have a personal savings rate in the neighborhood of, well, 0%, and a net national savings rate in the barely 2% range, we ARE going to run a current account deficit - and probably a very large one - under just about any plausible economic scenario I can imagine."


Posted by: anne at December 23, 2004 05:58 PM

Well, I mean the math here is pretty simple: If you have a net national savings rate of 2%, and a fiscal balance of -3% or -4%, then even if higher interest rates bring net investment down to ZERO, you're STILL going to run a current account deficit of 1% to 2%.

But of course, interest rates high enough to crowd out investment entirely would also push growth way below trend, producing larger budget deficits, a smaller GDP - and larger current account deficits.

The problem, I think, is that conventional soft landing scenarios aren't designed for countries with a goose egg for a personal savings rate.

Posted by: billmon at December 23, 2004 06:35 PM

There is some puzzle that currency traders have not made a substantial run against the dollar. I wonder why?

Posted by: anne at December 23, 2004 07:17 PM

They keep testing to see where the intervention levels are. But it's like a variation on the old joke: Where does King Kong sleep? Anywhere he wants to. Nobody wants to get in the way of the Bank of Japan or the Bank of China - or the ECB for that matter - if they decide to come into the market and really hurt people. This isn't like dragging down the Bank of England in 1992: These guys aren't defending their own currencies, they're SELLING them. Currency traders are like most predators - they prefer to target the weak, the sick and the old.

[So where does the tipping point come? Yes, the BOJ and the BOC can always print up bonds and trade them for dollar-denominated securities to keep their currency values down. But when the exchange rate does move the dollar interest payments earned on their assets won't match the yen and renminbi payments owed on their liabilities: they'll have to tax someone, and tax them relatively heavily...]

Posted by: billmon at December 23, 2004 07:29 PM

Soft landing?

When did we take off?

Posted by: Jon H at December 23, 2004 07:54 PM

"if the rising long-term interest rates that diminish employment in construction and investment-goods production are somewhat delayed..."

caroline baum brings up a good point that james bianco makes tho, which would make this unlikely given (6)...


namely that hedge funds have been living on the curve and are the major buyers of long-term treasuries. if the fed takes the curve away, they will exit the carry trade, sending long rates up... it also implies that long rates DO NOT presently provide an accurate gauge of inflation expectations...

Posted by: glory at December 23, 2004 09:48 PM

"But when the exchange rate does move the dollar interest payments earned on their assets won't match the yen and renminbi payments owed on their liabilities: they'll have to tax someone, and tax them relatively heavily..."

U.S. interest rates are twice (?) those in Japan so wouldn't the forex rate have to be halved for the BOJ to lose money on the interest payments ?

Posted by: Andrew Boucher at December 23, 2004 10:13 PM

The US has no inefficient manufacturing facilities left. The ones we have now are pretty good. All the modern factory (that is, the modern machinery) makers will sell to the US for our gold reserves and we will use our construction laborers to build factories instead of houses.
Then we will be able to export again as the dollar drops to the point that we prefer to pay the higher American wages rather than the higher Chinese prices. The dollar will drop a long way before we will be competitive with China. But it will drop to a competitive level eventually.
Of course, that assumes that we have any gold reserves and the administration hasn't sold them off to support the dollar through the election and now is hoping merely not to be jailed after being impeached...

Posted by: wkwillis at December 23, 2004 10:19 PM

wow. i am totally confounded to learn that the U.S has exports. where do those come from?

oh, wait. you mean Hollywood?

Posted by: bryan at December 24, 2004 02:34 AM

Then, given these worries, how are we to allocate an investment portfolio on which our retirement depends in the coming year? There were easy choice during the bear market, and through the last 2 years, but where now when domestic stock and bond funds all seem pricey? International stock funds?

Posted by: lise at December 24, 2004 04:22 AM


In Roaring China, Sweaters Are West of Socks City

DATANG, China - You probably have never heard of this factory town in coastal China, and there is no reason why you should have. But it fills your sock drawer.

Datang produces an astounding nine billion pairs of socks each year - more than one set for every person on the planet. People here fondly call it Socks City, and its annual socks festival attracts 100,000 buyers from around the world.

Southeast from here is Shenzhou, which is the world's necktie capital. To the west is Sweater City and Kid's Clothing City. To the south, in the low-rent district, is Underwear City.

This remarkable specialization, one city for each drawer in your bureau, reflects the economies of scale and intense concentration that have helped turn China into a garment behemoth. On Jan. 1, a new trade regime will end the decades-old system of country-by-country quotas that divide the world's exports among roughly 150 countries. Now, China is banking on its immense size and efficient operators to grab an even larger share of the world's clothing orders.

Neither Adam Smith nor Karl Marx could possibly have imagined that this kind of capitalism would evolve from a communist system in quite this way, with an obscure town in the middle of nowhere becoming the world's socks capital. But these days, buyers from New York to Tokyo want to be able to buy 500,000 pairs of socks all at once, or 300,000 neckties, 100,000 children's jackets, or 50,000 size 36B bras. And increasingly, the places that best accommodate those kinds of orders are China's giant new specialty cities.

The abolition of quotas is expected to accelerate this trend over the next decade or so, particularly under the guidance of China's visible hand. The niche cities reflect China's ability to form 'lump' economies, where clusters or networks of businesses feed off each other, building technologies and enjoying the benefits of concentrated support centers - like the button capital nearby, which furnishes most of the buttons on the world's shirts, pants and jackets.

Posted by: anne at December 24, 2004 06:22 AM

The point that always seems to be missing in these discussion is relative prices.

For US manufacturing to expand and especially to do import substitution relative prices have to shift significantly. But so far prices of consumer good imports -- excluding autos and oil-- have not gone up so there is still no reason to expect significant import substitution from this source. We are seeing it in industrial raw materials where prices are soaring and Alcoa has actually announced that they are going to build a new facility. However, it will be in Trinidad,
not the US. But how can we have the shift in relative prices needed without much higher inflation?

Posted by: spencer at December 24, 2004 06:26 AM


Hedge Funds, Once Daring, Trim Their Currency Bets

The fall in the dollar this year has been severe - the currency reached a low against the euro yesterday - but few of the best-known hedge funds have made a killing off the dollar's decline.

That is a big change from years past, when the largest hedge funds made or lost fortunes by gambling on shifts in currencies. George Soros made $1 billion for his investors by anticipating a decline in the British pound in 1992, and Julian H. Robertson Jr.'s funds lost $2 billion in a single day in 1998 after betting the wrong way on the value of the yen against the dollar.

The apparent absence of any big gains from large-scale speculative plays on the dollar says more about the state of hedge funds than it does about the currency markets. Hedge funds, once the last word in speculation, have become more timid as pension managers and other investors with some aversion to risk increasingly put money into the funds....

To be sure, some investors have made a fortune by betting against the dollar in 2004, including Warren E. Buffett, the chief executive of Berkshire Hathaway.

"In 2002, we entered the foreign currency market for the first time in my life," Mr. Buffett said in a letter to Berkshire investors in last year's annual report, "and in 2003 we enlarged our position as I became increasingly bearish on the dollar."

Berkshire owned $12 billion in foreign currency contracts at the end of last year; by the end of September, that had increased to $20 billion. It reported a $412 million gain on those contracts in the third quarter, reversing a loss from the quarter before.

Posted by: anne at December 24, 2004 06:33 AM

THe twin deficits make any "soft landing" scenario chimeral at best.

I was talking to a Republican the other day, who was "explaining" to me how our trade deficit was about to disappear because of the falling dollar. He could not accept the fact that a 7% drop in the international value did not mean we were 7% more competitive. It took forever for me to get him to concede that because raw materials and "energy" have to be imported to manufacture and transport goods destined for export---and that the decline in the dollar makes those expenses greater---there is no "one to one" correspondence between the dollar decline and competitiveness.

One other point---investment in new productive capacity to take advantage of a lower dollar will not occur until the dollar falls WELL BELOW the price where US goods become competitive again. As the trade deficit shrinks, the dollar will strengthen---making US products less competitive again. So nobody is going to build a new factory unless and until they know that the dollar will STAY low enough for them to remain competitive long enough to recover capital costs.

Posted by: paul_lukasiak at December 24, 2004 07:03 AM


"The point that always seems to be missing in these discussion is relative prices."

Anne: NYTimes -

"Imported automotive vehicles and parts, for instance, inched up merely 2.1 percent over the last 12 months. As a whole, the consumer prices of all imported manufactured durable goods, excluding cars, actually fell 0.1 percent."

We are seeing little consumer price movement as the dollar falls.

Posted by: lise at December 24, 2004 07:08 AM


I'd fall back on a very conservative, broadly-diversified portfolio.

If you are retiring in a year, I'd suggest about 10% of your portfolio in a money market account (ingdirect.com is paying 2.25% now and it will probably go up a bit next month).

Of the remaining portion of your portfolio, I would suggest 80% bonds and 20% stocks.

For the stocks portion, put half in a total US market index fund like Vanguard Total Stock Market Index. Put the other half of the stocks portion in a broad foreign index fund like Vanguard Total International Stock Index.

The bond portion is a bit less clear cut. I'd put the majority of it in an index fund like Vanguard Total Bond Market Index, and possibly some of it in TIPS or I-bonds (if you have a Roth IRA go for TIPS, otherwise I-bonds). I'd also put a bit in an unhedged foreign bond fund. Possibly the closed-end Templeton Global Income (GIM) or mutual fund American Century International (BEGBX).


10% money-market
9% US total stock market index
9% International stock market index
14% International unhedged bonds
58% US total bond market index

Posted by: Erik at December 24, 2004 07:08 AM

Thank you, Erik:

Bouncing off your ideas, here is my current thinking for my Vanguard Portfolio. I am thinking of finally taking profits in the REIT Index, and will move this week from the Long Term Bond Index to lower duraion bond funds.

10% Value Index
10% Energy Fund
20% Mid Cap Index
20% International Value Fund
10% Short Term Bond Index
30% Intermediate Term Bond Index

10% money-market
9% US total stock market index
9% International stock market index
14% International unhedged bonds
58% US total bond market index

Posted by: lise at December 24, 2004 07:24 AM


That looks rather agressive to me for 1 year from retirement. Even if you expect to be retired for 30 years, I wouldn't go above 30% in equities. Domestic stock with dividends less than 2% are priced to deliver less than 7% nominal, and possibly considerably less if we have a recession with contracting P/E ratios (I'm betting they return less than 6% over the next 10 years). With 20 year TIPS yielding almost 2% real (I guess the nominal rate will be above 5% over the next 20 years), I just don't see the attraction for equities right now. I think 60% equities only makes sense if you believe that equities will do as well in the next 20 years as they have in the past 20, and that seems very unlikely.

Posted by: Erik at December 24, 2004 07:45 AM

The plan is to increase the US savings rate through consumption taxes and mandated retirement savings plans. Combine that with a dropping dollar and increased interest rates and you've got your soft landing scenario.

There are a number of reasons why I suspect it won't work, but there is a plan.

Posted by: Ian Welsh at December 24, 2004 07:48 AM

The problem with bond funds, is lack of yield. The more you cut back on stock funds, the more you are protected but the more you resign yourself to low return indefinitely. The last 5 years, the long term bond index has averaged more than 9.5%. We will likely not have another such year soon. Difficult. Cutting the REIT Index will be hard enough, but the valuation makes no sense to me. Sell the Energy Fund as well? Can I even go to 40% stock and 60% bonds?

10% Value Index
20% Mid Cap Index
20% International Value Fund
10% Short Term Bond Index
40% Intermediate Term Bond Index

Posted by: lise at December 24, 2004 08:13 AM


Steel Shortage Squeezes Asia's Manufacturers

TOKYO - It has been a long time since Japan has experienced shortages of any kind. So it came as something of a surprise last month when Nissan Motor was forced to briefly suspend much of its production because it could not get hold of enough steel.

Since then, Suzuki Motor has said a lack of steel would force it, too, to shut down assembly lines for a few days this month, and to reduce production from January to March. Even the giant Toyota Motor said Thursday that it has had to make adjustments in the kind of steel it buys to ensure steady supplies.

The shortfall in steel is unusual in a country that for most of the last decade has been dealing with problems of excess - too many workers, unused plants and more banks than needed - but analysts and executives say it is a problem that could become increasingly common.

Posted by: anne at December 24, 2004 08:30 AM


How much do you think your stock funds will return over the next 20 years?

Posted by: Erik at December 24, 2004 08:31 AM

If productivity stays high and price/earning ratios stay about 20, why can we not make 7% in earnings, and another 1.5% in dividends, for a return of 8.5%. Better than bonds. Earnings have averaged 7% for several decades, why should this not continue?

Fine question, Erik.

Posted by: lise at December 24, 2004 08:42 AM

billmon -- nice comments, as usual. national savings thankfully includes business savings as well as personal savings, so our overall national savings rate is -- fortunately -- a bit above 2%. Business savings has gone up recently, leading to a puzzle: business is good, profits are up, so why so (comparatively) little investment?

Posted by: theotherbrad at December 24, 2004 08:46 AM

Long term bond funds at Vanguard have far bettered the returns of the S&P for 5 years. But, with yields so low it is hard to think this can long continue.

Five Year Average Annual Return

S&P - 1.9%
Long Term Bond Index + 9.7%

Posted by: anne at December 24, 2004 08:48 AM

Other Brad

"Business savings has gone up recently, leading to a puzzle: business is good, profits are up, so why so (comparatively) little investment?"

Could the reason be, there are better investment opportunities abroad for now?

Posted by: lise at December 24, 2004 08:52 AM


Stock returns can be broken down into three components: changes in P/E multiple, changes in earnings, and dividend yield.

Historically, real earnings per share in the US have grown at something less than 2% per year, slower than real GDP. (In the really long term, EPS cannot grow faster than GDP).

Historically, a bit more than half of earnings have been paid out as dividends. Today it is much less (~30%), but perhaps share buybacks make up some of the gap. But 50% COULD be paid out, I assume.

Current P/E is about 21 and yield about 1.6% for US total stock market.

Optimistic scenario: With a P/E of 20 and a payout of 50%, stocks COULD be paying about 2.5% in dividends. If multiples stay the same, we could expect 2% EPS growth and 2.5% in dividends for 4.5% real. If inflation is 3%, nominal return is 7.5%. This is using very optimistic assumptions.

Baseline scenario: If P/E's return to historical average of about 16 (assume it happens all at once next year), and stocks payout 50% of earnings then they can yield about 3%. Over 20 years, the P/E change comes to -1.3%. If EPS growth is at a historical average of 1.6%, then with a 3% dividend we would expect -1.3% + 1.6% + 3% = 3.3% real return, or 6.3% nominal assuming 3% inflation.

In a pessimistic scenario, I'll assume that multiples contract to 16 but dividend yields do not increase. Then we have -1.3% from multiples, 1.6% from EPS growth, 1.6% from dividend yield, and 3% inflation for a total of 4.9% nominal (1.9% real).

So, a 20 year TIPS yielding 2% real, or 5% nominal doesn't look so bad to me in comparison. I understand that it looks bad to you because you are expecting much higher stock returns than I am. But I think you are in for a disappointment.

Not only that, but if your portfolio is down 20% in 5 years, are you prepared to cut down on your expenditures a great deal in the down years? If you don't reduce your withdrawals in bad years, you drastically increase the chances of outliving your savings.

Posted by: Erik at December 24, 2004 09:14 AM


Thank you so much for taking me to school. I am not about to argue only think through your reasoning. I expect your reasoning will hold.

John Bogle has always used the 7% growth in earnings number, which would be about 3.5% real earning growth. Add a 4% dividend to 7% earnings growth and you get an S&P return of about 11%. Since the p/e has risen, Bogle adds a small amount to returns.

Now, dividends are not 4% but 1.5%. So, if earnings growth is 7%, and the p/e ratio stays about the same we might expect an 8.5% S&P return over an extended period.

We are not that far apart from your optimistic return, and 8.5% for an S&P return is far below the historical return. The Vanguard S&P opened in September 1976, and has returned about 12.5% a year. But, the p/e ratio was about 10 when the index fund opened.

Brad has often told us the risk premium for stocks is oddly high. Suppose then the p/e does stay about 20. The problem is not that stock returns may be 8.5%, but that we must consider variability of returns. The question then is to keep enough in bonds to live comfortably through a difficult marklet period.

Again, I am thinking. The answer for bonds may be to buy the extra yield and simply stay in Vanguard Long Term Index or High Yield Tax Free. Why go short term or intermediate and give up the income, as long as you intend to stay in a bond fund through a duration period?

Still thinking.

Posted by: lise at December 24, 2004 11:40 AM

"national savings thankfully includes business savings as well as personal savings, so our overall national savings rate is -- fortunately -- a bit above 2%."

Yes, my math may have been simple but it was also wrong -- net national savings is, duh, NET of the federal budget position. So if NNS is a bit more than 2%, we can continue to run a budget deficit of +/- 3%, and still have a couple of percentage points left over to fund private investment (assuming a balanced current account.)

I think the larger point still stands, though, since squeezing investment down to even 2% of GDP would imply very high interest rates and/or a very slow rate of GDP growth, with inevitable feedback effects upon both the budget deficit and the external debt-to-GDP ratio. In other words, it's STILL hard to reconcile a smooth adjustment process with a 0% personal savings rate.

It's also hard to imagine that any policy deus ex machina, like a consumption tax or personal accounts, will magically restore the personal savings rate to a sustainable level. I don't see any reason to believe American consumers wouldn't simply save less and/or borrow more to sustain desired levels of spending in the face of a VAT. I think that's almost certainly true at the upper end, where most of the spending growth is now anyway. In the end, it probably will just feed into the inflation rate, which the Fed will have decide whether to tolerate.

We also have enough experience with IRAs to know that savers usually just substitute them for non-tax-favored forms of saving. Why should we assume that Shrub's social insecurity plan would produce a different result?

P.S. The riddle of business savings doesn't seem all that hard to solve: business may be up, profits may be good, but until recently at least, capacity utilization was still way below trend. In a sense, we're only now coming out of the recovery phase, if you define recovery as the return to the trend in potential GDP. Presumably, with profit margins apparently narrowing and capacity bottlenecks emerging, we'll soon see an upswing in externally financed cap spending, which will probably be when the fireworks start in the bond market.

Posted by: billmon at December 24, 2004 12:01 PM


In the long term, corporate earnings cannot grow faster than GDP, otherwise you would eventually have all the money in the country going to corporate earnings. So that sets an upper limit to earnings growth.

In fact, it turns out that corporate earnings growth tracks GDP growth extremely well. However, earnings PER SHARE growth, EPS, has not grown as quickly as GDP. This is due to dilution (companies issuing more shares). See, for example:


for a discussion of the dilution. Bill Bernstein finds that historically there has been about 2% dilution per year.

I just did a quick calculation using Robert Shiller's data from


I divided 1871-2004 into 7 non-overlapping periods of about 19 years each. (I "smoothed" the data a little bit by choosing the maximum earnings for each year, so not every interval was exactly 19 years). Then I calculated annualized dividend and EPS growth rates, and looked at GDP growth rates. All are nominal values:

Dividends: -0.895%, 3.542%, 3.526%, -0.062%, 6.68%, 5.512%, 4.833%

EPS: -1.55%, 4.792%, 3.189%, 0.815%, 6.73%, 6.231%, 6.574%

GDP: 2.296%, 4.274%, 6.361%, 5.012%, 6.365%, 9.215%, 5.466%

Here are the average annualized growth rates (and Standard Deviations):

DIV: 3.3% (2.8%)
EPS: 3.8% (3.2%)
GDP: 5.6% (2.1%)

DIV - GDP : -2.3% (1.9%)
EPS - GDP : -1.7% (2.3%)

As you can see, the uncertainties are large, but EPS has trailed GDP growth by 1.7% and dividend growth has trailed GDP growth by 2.3%.

So, an optimistic assumption for the next 19 years would be a GDP growth rate of 6.6% nominal, which is 1% above the average, since some people are claiming that we have a permanent increase in productivity growth (I tend to doubt it, but let's be optimistic).

If we subtract 1.7% for the average amount EPS has trailed GDP, then we would expect a nominal EPS growth of 4.9% for the next 19 years. Add in the current dividend yield of 1.6% and you get a total return (nominal) of 6.5% for the next 19 years.

And this is extremely optimistic, assuming a full 1% higher growth in GDP than historical, and assuming multiples do not contract to their historical values.

Posted by: Erik at December 25, 2004 07:26 AM