Three-Handed, Two-Faced Economists

10/24/2011 8:15 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Sometimes when the same information paints two radically different pictures of our economic future, you have to split the difference, writes Paul Justice of Morningstar ETFInvestor.

In Roman mythology, Janus is the god of beginnings and transitions, depicted with two faces—one looking to the past, and one to the future. Of course, Janus is blessed with 20/20 vision in both directions.

The modern-day contemporaries to Janus could be economists…but, unfortunately, their vision seems to be constantly blurred

We just wrapped up our 2011 ETF Invest Conference in Chicago where, as its name would suggest, we focus more on investing than we do on differences between ETFs and other fund structures.

We kicked the conference off with two hour-long presentations from some notable economists: Brian Wesbury from First Trust and Rob Arnott from Research Affiliates. The most interesting part of these presentations is that they both looked at the same data, over the same timeframes, and came up with drastically different outlooks for the future.

It’s common for economists to reach differing conclusions, but it’s remarkable just how far apart Wesbury’s and Arnott’s messages were at the ETF Invest Conference.

Perhaps I’m holding economists to a standard much too lofty, because we should at least be able to agree on the past before we prognosticate the future. Alas, we can’t even agree there.

I would definitely say Brian Wesbury is an optimist, and he brings a lot of data to back up his outlook. In his presentation, he gave an energetic argument that irrational fear is creating unfounded pessimism around the economy.

Macroeconomic indicators such as corporate price-to-earnings ratios, personal-consumption levels, and projected decreases in government spending, he said, actually paint a picture of an economy on the brink of a major boom.

The First Trust Advisors chief economist and frequent media contributor said conventional wisdom believes the 2008 economic collapse and struggles since were the fault of predatory mortgage lending and the resulting derivative investment vehicles. Conventional wisdom also holds, he said, that the United States’ response, including TARP, is all that saved the US and global economies from an irreversible catastrophe.

Conventional wisdom is wrong on both counts, Wesbury argued. For decades, policymakers have aggressively pursued creative initiatives to improve Americans’ ability to own homes, cultivating a culture of personal debt waiting for an eventual collapse. And as much as government efforts contributed to the collapse, he said, they’re impeding recovery.

Wesbury predicted that legislative efforts to reduce government spending are the start of a major downshift in public expenditures. The commercial sector will swell to replace the reduced government role in GDP, simultaneously stimulating job and income growth.

While his points were compelling, I’m not completely on board with him.

First, like so many economists who frequent the media outlets these days, he established his overarching viewpoint with a catchphrase more than a year ago: “It’s not as bad as you think.”

In order to maintain that line of thinking, he relies on “high frequency indicators,” a slew of often-updated economic data points that tell us how the economy is performing. My issue with this type of analysis is that it is akin to showing a few trees and declaring you’ve identified a forest.

It’s too easy to become overconfident in your analysis. I’d put him in the camp with Morningstar’s own economist, Bob Johnson, whose analysis reaches the same point: that there is nothing in the regularly published data that shows we are entering another recession.

NEXT: The ‘Run and Hide’ Camp


The ‘Run and Hide’ Camp
Of course, any good analyst knows that if you put garbage into a calculation, you’ll get garbage out. That’s precisely how Rob Arnott feels. He argues that if you adjust the fudged data to a more realistic picture, you’d be entitled to feel depressed.

Arnott’s long-running pitch, going on several years now, is titled the “3D Hurricane,” with the Ds denoting deficits, debts, and demographics.

He laid out a powerful case that the United States and other rich-world nations are in deep trouble. His thinking is largely in line with, though perhaps more pessimistic than, PIMCO’s Bill Gross (“The New Normal”) and Jeremy Grantham (“Seven Lean Years”).

Both Arnott’s conclusion and framework are vastly different from Wesbury’s, and focus on the inadequacy of reported data. On deficits, Arnott said US government deficits have been understated for decades: Under GAAP accounting, the kind applied to corporations, the US has been running yearly deficits of 10% of GDP over the past several decades. He likened the US government’s accounting to Enron’s.

On debts, the picture gets scary. Almost every developed nation has run up massive debts. Emerging markets are creditors. In the US, Social Security, Medicare, and Medicaid bring up government liabilities to more than 500% of GDP.

One reason why liabilities are so high is because many Americans are going to hit retirement age soon—an issue of demographics, the final leg of his doomsday trinity. Arnott argues age distribution strongly affects GDP growth, drawing upon a paper he published with Denis Chaves.

The rich world is losing its most productive workers as baby boomers retire. The sweet spot for GDP growth is when the share of 20- to 40-year-olds increases, as they go from GDP consumers to increasingly productive workers.

Brazil and India are hitting their sweet spots. China is going to run into a demographic wave of elderly because of the one-child policy, but it’s a ways off and not as bad as the United States.

Politicians take a lot of heat from Arnott. They probably won’t rise up to the challenge of tackling these problems head-on.

We’ll probably default by hook or crook, via inflation and straight-up abrogation. He pegs the risk of double-digit inflation over the next ten years at 50%. Implicit in his argument is that he thinks the end game won’t play out as long as it has for Japan.

His recommendations for this aging, debt-ridden world? Get inflation protection. However, his record on inflation forecasting isn’t great; he was calling for inflation protection three years ago, while the break-even rate has fallen.

My Take
My view is that we are nearly in the middle of the two bold claims made by Wesbury and Arnott. I agree with Wesbury that it isn’t as bad as the markets appear to think, and that’s mainly due to the incredible volatility we’ve witnessed over the past few months. There are certainly some major obstacles to overcome in developed markets over the next few years, but they are surmountable with enough political will.

I disagree with Wesbury in that I believe it will require some government intervention by some parties to keep everything well. Without intervention, Europe is in trouble. Let’s just hope that intervention comes with structural changes, as opposed to simply more debt.

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