Arnott: 3-D Hurricane Coming

Greg Brown: Another topic I want to discuss is the feeling that most investors feel like we are out of the woods in terms of the financial crises. The worst is behind us since March 6, 2009. And I won't say it's anywhere near euphoria, but a lot of people do think that that's behind us. And you have some different views on that. I was hoping you could talk about that.

Robert Arnott: I sure do. We had a global financial crisis built on the back of a housing bubble, an over-leveraged economy and excessive use of debt-financed consumption. So where are we now? We have aggressive interventions to prop up housing. That's what got us into trouble in the first place.

We have aggressive leverage. The leverage has shifted a little bit out of private sector and into public sector, but the aggregate leverage in the U.S. economy is higher than it was two years ago. And as for debt, our debt is higher than it's ever been in history.

Brown: Right.

Arnott: And so, I look at this situation with a certain measure of alarm. We wrote a piece last fall entitled the '3-D Hurricane,' in which we looked at deficit, debt, and demographics. And the short story on that is, our deficit last year was 10% of GDP. But that was using accounting standards that would have made Enron executives blush. If you factor in off-balance-sheet spending, deferred spending like Social Security and Medicare unfunded.

The GSE is now backed by full faith and credit of the U.S. government. The aggregate debt last fiscal year on a GAAP accounting basis – companies are required to use GAAP accounting; government by writing laws, can exempt itself from GAAP. And so, on a GAAP basis, our deficit was 18% of GDP. Greece got into trouble with 13.

Our aggregate public debt widely publicly acknowledged to be high 80s, high 80s percent of GDP; add in GSEs, add in state and local debt, which is legitimately public debt, we're at a 143% of GDP.

Greece is in trouble with 120%. Add in unfunded Social Security and Medicare, and we're at 450% of GDP. I don't worry about that because that can go away with a stroke of a pen, it will.

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Brown: Right.

Arnott: It will. Sometime in the next 10 years, Social Security and Medicare will be means-tested. So that, in effect, my generation's kids and grandkids will say these maybe sacred promises that you've made to yourselves, but they're sacred promises that you failed to fund; why don't you deplete your bank account before you deplete ours?

It will be a perfectly reasonable reaction of our kids and grandkids' generations. It will be imposed on my generation. And right now, it's politically impossible for that to happen; five to 10 years from now, it won't be. It will be politically impossible to avoid it,

...Which leads into demographics. Eight years ago there were 10 new entrants into the workforce for every one new retiree, 10-to-1 ratio. Why so high on entrance into the workforce? Baby boomers kids were turning 20. You've got this big bulge of new entrants to the workforce. At that same time, the number of new senior citizens was at record lows. Why? Because they were born in the great depression. People couldn't afford kids; they didn't have kids. So there weren't many new retirees.

Today that 10-to-1 ratio has shrunk to 2-to-1. Two years from now, it reaches parity; one new worker for each new retiree. 10 years after that, it goes 10-to-1 the other direction; 10 new retirees for each new worker.

The deal will change. And what does all of this have to do with investments? It means our debt is too high and our debt – if your debt is too high, your choices are: tighten your belt really tight and rein in excessive borrowed spending until you get the debt under control. That could take decades.

Two, default. Most of our external debt is owed to Russia, China, and the Middle East. I don't think those would be pleasant phone calls.

The third is, if you own a printing press, run it. So I think the U.S. has been helped by the fact that it is the world's reserve currency and the world's largest economy. Absent that, we'd be Greece. With those, we're not.

But roll the clock forward, and inflation, high odds, will raise its ugly head in inflationary bursts in the years ahead. They won't be expected well in advance of when they strike. You buy the protection against the inflation when the inflation protection is cheap. When is that? When there is a lot of talk about deflation.

So if we get a rollover into a second dip of the recession, that's the time to buy inflation protection.