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By Scott Burns | 09-22-2011 01:18 PM

The 3-D Hurricane Hurtling Toward the Economy

A combination of deficits, debt, and demographics will weigh on the U.S. economy for the next 10-15 years, says Research Affiliates' Rob Arnott.

Scott Burns: The 3-D hurricane and fundamental indexing. Hi, there. I'm Scott Burns, Morningstar's director of exchange-traded fund research coming to you live from Morningstar's ETF Invest 2011 Conference. Joining me today is Research Affiliates' Rob Arnott.

Rob, thanks for joining me.

Rob Arnott: Thank you for the invitation.

Burns: So, Rob, earlier today, we had you up on stage talking about a combination of things; first, the 3-D hurricane, which by the way, really bummed me out. So, thank you for that news.

Arnott: You're very welcome.

Burns: But, it's true. For those who aren't unfamiliar with the three Ds of the 3-D hurricane, maybe you can talk about that a little bit and what your outlook is for the economy?

Arnott: Sure. Sure. We're facing some pretty serious headwinds in the coming years, and this is really long-horizon stuff. This isn't about this quarter, or this coming year, or this coming couple of years. This is about this coming 10 to 15 years. The three Ds are simply deficits, debt, and demographics.

Deficit is 10% of GDP. That's unsustainable, huge, and painful. It does sow seeds for a lot of damage down the road, except it's a lot worse than that. It's based on phony accounting. If the government were using GAAP accounting, the same as corporate America does, the deficit didn't peak at 10.5% or 11% of GDP a couple of years ago; it peaked at 19%. The average deficit for the last quarter century, on a GAAP accounting basis, is 10% of GDP.

That means the debt is bigger than it seems. The national debt crossing 100% of GDP this month; that's not good. But if you add in state and local debt and add in government-sponsored enterprises, it is 170%. If you add in unfunded Social Security and Medicare, it's 460%. If you add in unfunded Medicaid, it's more than 600% of GDP. That's like an individual or a family owing 6 times their annual income.

Burns: For perspective, where is Greece? I think everyone's agreed that country going to go bankrupt. Where is Greece at in terms of deficits?

Arnott: Greece  is in the ballpark of 150% of GDP. The country does have off-balance sheet debt. It does have entitlement programs. So, its aggregate debt is higher than that of the U.S.; it's probably 800. But Greece's formal contractual debt obligations are about same as the U.S., perhaps a tad smaller.

The third D is demographics. Really it's very simple. The baby boomers surprised everyone when they came into the workforce in the 1970s in unprecedented numbers and surprised everyone when they came into homeownership ages in the 80s and 90s and early part of this last decade. And they will be surprising everyone when they come into retirement ages in the coming two decades.

So, we have this swing from far more people coming into the labor force than retiring just a few years ago to about the same next year to a big imbalance with far more retiring than coming into the labor force in just 10 years. So, that's going to be a political, economic, and capital markets game changer. These are the headwinds. So, then the question is, how do you invest in that environment?

Burns: Yeah. One thing on the demographics I just want to ask you about is. I think everything you're saying, I mean those are the numbers; that's obvious. It's there a way out of our demographic problem, such as is immigration a solution? Are there other things, or do you think we're set in stone?

Arnott: Yeah, it's pretty set in stone. Immigration can be a partial answer. If you wanted to keep the median age in the United States unaltered, you could do that through immigration alone by having 1 million more people than today immigrate every two months for the next 30 years in the 20-35 age range, and they better not bring their parents.

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