The 3-D Hurricane Hurtling Toward the Economy

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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Burns: Right.

Arnott: OK, that's not going to happen. So, can you mitigate the problem through immigration? Absolutely. That's going to be a part of the solution. Politically there is a huge polarity in the discussions about immigration, but at some stage we have to welcome workers who are A, willing to do work that we don't want to do, or B, bring special skills or C, bring assets. We've got to welcome them, and we should welcome them.

It's a nation of immigrants; it should continue to be one. But it only makes a dent in the problem. The demographic problem is very simply addressed by people working longer; we're living longer and healthier than our parents and grandparents. We ought to quite happily be willing to work longer.

Burns: Right. I was at the Milken Institute earlier this year and that was a big push for them. To put maybe a positive spin on it, one of the greatest achievements in human history is the fact that we live as long as we do now.

Arnott: The fact that we can retire.

Burns: The fact that we can retire, right.

Arnott: I mean before Bismarck put the retirement on the books in Germany in the late 1800s, the notion of retiring didn't exist in the entire sweep of human history you work until you die. Well, that is wonderful that we don't have to do that. But we do have to rethink the notion of, "OK, we can work from age 20 to age 55, take early retirement, and be retired as many years as we worked."

Burns: Right.

Arnott: No.

Burns: Well, that's the thing. Social security when it was created, retire at the age of 65. The average life expectancy then was...

Arnott: Was 61.

Burns: 61, right.

Arnott: So, basically, we were saying don't worry when you get to be old, which 65 was back then, we'll take care of you. You will have been dead for four years, but we will take care of you.

Burns: Right, and with life expectancy climbing so much. So, do you have a view on that? From an economical standpoint, I think that deals with two of the Ds, the demographics and the deficit a bit. Where do you think the retirement age should be?

Arnott: Well, I think if the retirement age is indexed to 90% of life expectancy so that as life expectancy goes up, retirement age automatically goes up, and everyone understands that's the deal that you qualify for Social Security at 90% of life expectancy. That would work beautifully.

I think the deficit will disappear. We can either choose to phase it out, or we can have it imposed on us by capital markets saying, "No, no more U.S. debt." The debt will stabilize at some level by choice or not. The demographics are what they are. The big issue for the deficit and the debt is entitlement programs. The entitlement programs are totally unaffordable. These are going to be a whole sweep of broken promises. Promises made for generations, broken for generations of people. That's the reality.

So, how do we get from here to there politically? Who knows. Where are we going to be in 10 years? Within 10 years, we're going to have higher age of eligibility. We're going to have means testing. If you don't need the support, you're not going to get the support. And we're going to have rationing. If you need a heart transplant and you are 72, bye-bye.

Burns: I think it's interesting, whenever I go on CNBC for some reason, what's preceding me in my earpiece is some yelling match about entitlements and Social Security. And I always just kind of chuckle to myself, thinking this is the biggest nonthird rail out there: Who thinks they're going to collect social security; who under the age of 50 thinks that that's going to be there?

Arnott: Yet, if you are running for office and you say this is stupid, it's not going to work, it has to change. Do we want to consciously choose how to change it? Do we want to start debating that? Bingo.

Burns: Right.

Arnott: You're out of the political dialogue.

Burns: You're out of it.

Arnott: So, what's likely to happen is we reach a series of walls where changes become necessary, and with each wall a change is made. It might be: First, eligibility slides back to 70. Second, if you have income, you don't qualify. Third, if you have liquid assets or a pension you don't qualify. Fourth, rationing comes into play. And what order those comes in, I don't know.