They called them the Baby Boomers, history’s most prosperous and powerful generation. With the first members of this vaunted generation now transitioning into their retirement years, there have been numerous documentaries produced recently (CBNC’s Boomers, PBS’s Frontline, etc.) reporting on the challenges that many Boomers will face going forward. In the course of American economic history, the heyday of the Boomers in the workforce ran alongside the greatest economic expansion ever. Indeed, Boomers contributed directly to its rise and fall, whether via the secular trend of buying stocks for retirement or conspicuous consumption, assisting to create the stereotypical mold of the American consumer. With these trends ending, catalyzed by the recession and subsequent need to save for retirement, the economy finds itself at a crossroads. Does the economy need the Boomers as much as they need it, and vice versa? Both statements may be correct.
The typical period that most people consider their “adult” life (roughly the time they exit college to retirement) is about 40 years in length. History is a collection of long and short term trends, and economic trends in particular are driven by a nation’s position within the world and demographics. When an individual’s lifestyle has been driven by these trends, it is reasonable to think that they, and indeed their entire generation, would come to recognize what had transpired to be normal. For the Boomers, I fear that many have yet to recognize that within the context of economic history, the past 40 years were anything but normal, driven by the rise and fall of their own, prosperous generation. Fiat money and expansion-friendly demographics resulted in four decades of successive booms and busts in many markets. Put together, it can be argued that they all fed into a larger, secular bubble that was demographically-fueled at its heart. We have found ourselves unprepared for the fallout from this bubble with no easy answers, especially for those in my generation.
Before the Boomers even got out of college, Lyndon Johnson was shaping their economic future without them knowing it. The budgetary strain of the Great Society programs and Vietnam were the final nails in the coffin for the Bretton Woods monetary system. This directly led to Nixon taking the US off the Gold Standard in August 1971. Even though the US was one of the last economic powers to do so, the system was widely regarded among economists as a relic that constrained economic growth. The significance of the move lay in the advantage that it gave to the Baby Boomers; it eventually would enable them, in middle age, to take on debt unlike any previous generation.
The shorter-term consequence of the brand-new era of fiat currency, when added to the oil embargoes of the 1970’s, was stagflation and the subsequent boom in commodities. Detroit kept producing gas guzzlers for Americans even as US oil production peaked early in the decade, and the Middle Eastern crises sent oil prices on an upward trajectory from an inflation-adjusted $15-17 a barrel to over $100 a barrel in 1981. In 1974, private ownership of gold was made legal for the first time since the Great Depression. Gold rose from its $35/oz fixed value to $850/oz (non inflation-adjusted) in 1980. This was the peak of an uptrend in commodities, with an accompanying secular low in the value of stocks. Things began to change when Paul Volcker replaced Arthur Burns as Chairman of the Federal Reserve.
Besides his well-known accomplishment of breaking the back of inflation, what is lesser known is that the Fed under Volcker also changed the definitions of inflation. Aiding the rise of inflation during the late 1970’s was the subsequent bidding up of wages by then-stronger unions and retirement systems alike. Many economists, including Yale economist Robert Shiller, have argued that the removal of the actual cost of home ownership within the CPI, replaced by the Owner’s Equivalent Rent, has created a distortion that has in turn contributed subdued inflation since then. Thus, once interest rates began to fall and the economy picked up in 1982, inflation did not follow due to the combination of new inflation definitions and a worldwide oil glut.
For the next decade, Boomers entered the heyday of their wage earning. Having retained the robust savings rate of their parents up until that time, Boomers began to invest those savings into the stock market and into other safe fixed-income investments. Simultaneously, the credit markets began to innovate and expand at an unprecedented pace. As the number of home-buying Boomers increased, Congress passed new regulations that enabled mortgage-backed securities to explode. Bonds, a backwater during the inflationary 1970’s, suddenly were the best department in which to work at the investment banks amongst the mortgage- and junk-bond booms. The trend of debt was not limited to Wall Street. US household debt began to rise above 20% around 1985, the first time this had occurred in the Boomer’s lifetimes. This initiated a secular increase in US household debt that would not be broken until 2008. At the time, it only served to further buttress economic growth.
The 1980’s ended with a few localized real estate bubbles popping in California, Arizona, and a few other locales across the US. Michael Milken’s Drexel Burnham Lambert went bankrupt in February 1990, bringing the junk bond’s glory days to a close. However, the biggest bubble of them all during the 1980’s was across the Pacific in Japan. All Japanese assets, with real estate dwarfing everything else, soared to unprecedented heights. It was not uncommon to see Japanese companies trading at P/E ratios of over 100 in 1989. By late 1989, even respected fund managers such as Fidelity’s Peter Lynch bought into the idea, albeit temporarily, that this Japanese growth was permanent. “The total value of Japanese stocks actually surpassed that of US stocks in April 1987,” he noted in his 1989 book One Up on Wall Street. After peaking the week after Christmas in 1989, the bubble burst. Few lessons appeared to be learned, and it was a preview of what would transpire the next decade on this side of the Pacific.
Despite the US stock market’s crash on Black Monday (10/19/87), and the pesky, multi-year Savings and Loan Crisis, the Baby Boomers kept on earning. After a recession in 1990-91 (which, more than any other factor, cost George H.W. Bush the 1992 election), the market steadily increased through the first four years of the decade. With the help of a few interest rate cuts by Greenspan and relatively new forms of retirement planning (401(k)’s, etc.), the Boomers continued to invest their money in the stock market. After a fixed-income crisis in 1994 that claimed the investment bank Kidder Peabody, Greenspan once again began lowering interest rates. This contributed to a 28% increase in the Dow Jones Industrial Average in 1995, clearing the way for the final stage of the bubble. Then the final ingredient was introduced: the internet.
In 1996, Greenspan gave his famous “irrational exuberance” speech, warning of what he viewed as excesses in many areas of the economy. The next year, many internet companies began to go public. Simultaneously, the percentage of the public with access to the internet increased by more than 50% each year from 1995-1999. The recipe was perfect for the technology bubble that took the Dow, NASDAQ, and S&P 500 along for the ride. The Asian Financial Crisis in 1997 and the Russian Debt/LTCM crisis in 1998 did little to stir the tide, though it did produce a mini-crash on October 27, 1997, and again in August/September 1998. As Amazon, Yahoo, eBay, Qualcomm, and many other internet stocks began to see 400% increases, the NASDAQ soared 84% in 1999 to just over 5000 in March 2000. Not a peep was heard from Greenspan, who began to make speeches around this time embracing what was being referred to as the “new economy.”
Americans soon found out that for every Amazon, there were at least three examples of “dot-compost” such as Webvan, Pets.com, and Kozmo. Like what had happened in Japan, Americans failed to realize that companies trading at P/E ratios of over 50 are more often than not overvalued. There were stories of a few select Baby Boomers investing sizable portions of their wealth into IPO’s of companies that were nowhere close to breaking even, losing everything in the process. In the broader picture, after spending the 1990’s watching their portfolios appreciate, many Baby Boomers saw dreams of early retirement put on hold. It wasn’t over yet. A key difference existed between the Japanese bubble and post-tech bubble America. Japan in the 1990’s saw two major bubbles deflate at once. For Americans, the other, more destructive half of the bubble would come later.
With the economy already struggling in the wake of the deflating tech bubble, the 9/11 terrorist attacks shocked the nation. Alan Greenspan said in a 2008 interview that 9/11 was the kind of event that “historically could result in the undoing of a nation.” Whether that statement was a stretch or not, he immediately began a series of sharp interest rate cuts (refer to Chart 1). The results came within a year. With the credit spigot wide open, Americans began to shop again and to buy and develop real estate. (I remember that when I went on college visits in July 2002, nearly every campus that I visited was initiating a major construction project. Not surprisingly, this was more pronounced at the well-endowed colleges in the Northeast.)
Chart 1 – Federal Reserve Prime Rate 1954 - 2009
Although the stock market had been in a secular bull mode since 1982, the US housing market had (albeit in hindsight) experienced only a few localized bubbles. Occasionally, the corrections took down an overzealous investor or developer who leveraged themselves too much; Donald Trump’s difficulty during the early 1990’s is perhaps the most famous example. Regardless, nobody, not even the nation’s best economists, foresaw the magnitude to which Greenspan’s interest rate cuts would juice the housing market. Signs of a bubble were being pointed at by skeptics as early as 2002-03, but typical bubble behavior took over as annual refinancing by homeowners to tap into home equity became commonplace in 2003-06. Baby Boomers and Generation X’ers alike got into this habit. Such frequent refinancing was symptomatic of the expansion of all forms of credit, not just housing. Consequently, 2004-07 saw the biggest leveraged buyouts since the 1980’s and a subsequent second golden age for private equity. Real estate prices peaked in 2006, and by late 2007 were in serious decline. We all know what subsequently happened in 2008.
That brings us to today. For the past 40 years, the Baby Boomers’ earning power helped to fuel, and therefore ran concurrently with, a large secular bubble of US assets. Was it all an aberration, or was it the new normal? A March 9, 2010, article in the Wall Street Journal offered some insight as to whether stock valuations for the past generation have been normal. In short, they have not (refer to Chart 2). Those who called for a bottom in stocks in early 2009, saying it was a once in a lifetime low, have looked like geniuses in the interim. They are likely to be disappointed. The market may not fall back to those lows, but the inevitable devaluation of the dollar will have the same effect in terms of real money (refer to Chart 3).
Chart 2: This chart appeared in the Wall Street Journal on 3/9/10. Even after the 2008 crash, stocks are still historically overvalued as measured by multiples of company profits.
Chart 3: S&P 500 priced in Gold 1980-2009
As mentioned earlier, it has been almost 40 years since Nixon ended the dollar’s peg to gold. The era of fiat money, running parallel with the adult life of the Baby Boomers, brought with it a series of successive mini-bubbles, first in commodities, then real estate, and then stocks. Eventually, each mini-bubble repeated itself on a grander scale than before. All the bubbles were connected by the free flow of credit, directed by Maestro Greenspan, and subsequently came to an end in 2007-08. The US, and indeed the rest of the western world, finds itself trapped with debt from entitlements and cleaning up the mess of the past two years. A verdict on the fiat era is yet to be returned, but it is safe to say that many have doubts about the merits of this system that they would not have entertained the thought of 10 years ago.
With the population of the world continuing to increase, many investors are caught between anticipation and fear of a future bubble in commodities. As consumers, the fixed supply of our planet’s natural resources meeting an endless stream of paper money is a scenario about which we should not be excited. Alas, many questions and possibilities remain. At the least, a positive trend will be the resurgence of the debate with regard to what sound money is and is not. I am not saying we are going to have a return to the Gold Standard. After all, as mentioned earlier, by 1971 the Bretton Woods Gold Standard was looked upon as a relic that clamped down economic growth. However, the concept of free flowing credit within a fiat money system is clearly far from perfect as well. Facing an uncertain future, cooperation will be required in the next decade to work toward a new, sound financial system for the entire world. Asia will provide the Baby Boomers of the future. Even though they may not be as wealthy on a per capita basis, the numbers will result in the aggregate economic effect being just as big, or even bigger. Therefore, ideally a new monetary system that addresses the needs of American Baby Boomers, Generation X’ers, Millenials, and indeed the new, emerging middle classes in Asia can hopefully be devised. Whether that can actually be accomplished is yet another debate.
Respectfully Yours,
Matthew R. Green
April 8, 2010
