Baby Boomers Gift to Their Children - Bleak Economic Future?

Economic meltdowns are difficult to predict as they seldom follow the path of previous meltdowns.  But the policies the US has pursued the last 30+ years has created conditions that suggest an economic meltdown, triggered by Corporate debt, that will have crippling long term consequences may be hard to avoid.

It will start with the stock market.  Historically you paid an average of $16 for each $1 of corporate earnings when you buy stock (called the price earnings ratio, or P/E ratio).  For much of the last 100 years analysts developed a P/E ratio by averaging up to 10 years of earnings to avoid relying too heavily on unusual events.  Today financial analysts look only at the earnings from the prior year.  Looking at just the prior year the average P/E ratio for stocks currently is about $24 - you pay $24 for each $1 worth of earnings the corporation generates.  This is 1/3 higher than historical average so only makes sense if earnings continue to grow relatively rapidly. 

If you use the old measure of P/E ratio by looking back at average profits of stocks over the last decade you get a P/E ratio somewhere between $30 and $40 to a $1 of earnings.  By this measure current stock prices are probably 50 to 75% overpriced.  That will be a long fall if the market starts sinking.  

The peculiar characteristics of our current economy suggest that long fall is not unlikely.  For the last decade corporations have loaded up on debt.  Corporate debt has gone from $49 trillion a decade ago to $89 trillion today.  Currently the vast majority of corporations have only about $12 of available cash to pay back every $100 of debt.  It's not just the US. Global debt is nearing $250 trillion, over 300% higher than global GDP.

How did this explosion in corporate debt happen?  Historically low interest rates put in place to keep the Great Recession from becoming a Great Depression allowed corporations to pump up earnings with debt for a decade.  They borrowed money and used the money to do things that otherwise would have had to be paid out of earnings, and thereby boosted earnings reported to shareholders.  Works great as long as you can keep rolling over the debt and just pay cheap interest.  On top of that last year corporate tax cuts gave corporations another short term boost unrelated to operating profitability.  For a decade stock prices have been on the equivalent of a sugar high.

Now interest rates are going up.  The lid is going on the sugar jar.  As Corporations refinance debt at higher rates it will undermine the supports propping up stock prices.  Some Corporations will not be able to pay or refinance their debts, those that do will not be able to generate the profits investors expect as they pay higher interest or try to pay off the debt.   So the stock market will sink (as it has already started to do).

A sinking stock market isn't necessarily a huge problem for the rest of the economy, but this one may be.  Remember in the Great Recession all the hand wringing about both public and private pension funds being underfunded?  As the debt fueled bull market took off in the last decade all that hand wringing went away as the higher stock prices made the pension funds balance sheets look a lot better so everybody ignored the basic underfunding.   But as stock prices sink more and more pension funds will face obligations that exceed their assets.

10 years ago it was a potential future problem.  But now with a big chunk of the population moving into retirement and starting to draw on their pensions it is no longer a future funding problem.  Either less money is going to be available for paying pensions, or taxpayers are going to have to put up a lot of money to cover the shortfalls.   Neither course of action will produce a good result.

If a lot of pensioners find they have less money in retirement than they thought they would, they will spend less dragging the economy down.

A Government bailout is equally bad.  Decades ago Congress created a Pension Benefit insurance fund to step in to rescue workers whose pension fund went bankrupt.  But a decade ago the hand-wringers had realized that it was clear the Pension Benefit Fund would not be capable of dealing with all of underfunded Pensions.  The 10 year debt funded stock market rise made pension fund balance sheets less scary, so we allowed the problem to stagnate instead of dealing with it. 

With the National debt over 100% of GDP the government is not in a position to step in to bail out the pension funds without massive problems with the US credit rating.  We could be heading down a path similar to the path Japan has been bogged down in since 1990, an economic wilderness of enormous government debt, deflation and stagnant growth.  Nearly 30 years later they are still struggling to restore fiscal sanity.

So the conundrum - either you raise taxes on consumers to cover pension fund shortfalls and thereby further undermine the consumer spending that underpins the economy, or government borrows more money, undermining our credit rating and making paying off our National debt almost impossible.  Without even considering President Trump's ill-advised trade wars, the future we leave for our children has more pitfalls than promise.   

While it is easy to be a pessimist and see all the things that could go wrong, and hard to predict the good things that could keep us on an even keel, the nature of our current problems makes a path to safety difficult to imagine.