Four scenarios for the US economy: damnation, inflation, reinvention or Japan

Recently I’ve decided to rebalance my investment portfolio but to do it effectively I had to ask myself a hard question: What’s likely to happen in the US economy in 2021 and beyond? This analysis led me to four scenarios with different probabilities of happening: damnation, inflation, reinvention and Japan. The scenario that seems more likely will drive the distribution of my portfolio between risky / high growth assets and safer / low growth ones.

Note: I live in Canada not in the US but the fate of both economies seems intertwined.

Scenario 1: Damnation

One reason for this scenario to unravel is for the Consumer Price Index (CPI, aka inflation) to start rising as a result of all the money being created by the FED (I’ve analyzed this situation before in this and this articles). To keep inflation rising out of control, the FED might require banks to increase their savings in the central bank (the “reserve requirement”) to decrease the amount of money they can lend. This will result in a reduction of the amount of money in circulation (the “m2” money supply) and an increase in the interest rate for borrowing. The consequence? An increase in the cost of paying back mortgages and the potential default of many households, similar to what we saw in 2008.

At the same time, and with the same purpose of controlling inflation, the FED might stop (or reduce) the creation of new money. Corporations and the government rely on this money creation by the FED to fund their deficit. Closing the “tap” will put these big companies in trouble and might lead to massive layoffs and even bankruptcies. In the case of the government, less money to fund their deficit, means less money for investing in social services and infrastructure. All this while the “real” economy is still shaken by the slowdown caused by lockdowns.

This monetary policy of austerity is similar to the shock therapy imposed to Greece by the European Central Bank (ECB) during the 2009 crisis when their debt to GDP ratio grew too large. As with Greece, this shock therapy might lead to social unrest in an already polarized society.

The FED and the new president of the US might not have the disposition to go through such a crisis to “clean the house”, especially after the riots caused by the death of George Floyd in 2020 and the recent storming of the Capitol by Trump supporters. Social unrest may embolden extremist parties to take action and unscrupulous politicians to exploit them. In my opinion this is an unlikely scenario as there’s just too much to lose.

Scenario 2: Inflation

The premise of this scenario is similar to scenario 1, the FED’s money printing ends up affecting the CPI. What changes is that in this case the FED decides to not intervene to avoid the outcome described in scenario 1. The FED will instead continue business as usual printing money to fund deficits. As the average price of goods increases, the government will need to increase its expenses to keep up (salaries, products and services get more expensive), which means borrowing even more money from the FED. This spiral could drive inflation out of control with a fast depreciation of the US dollar.

Central banks around the world would see this loss of purchasing power of the US dollar and might start getting rid of US treasury bonds, flooding the market with this instrument, further decreasing their value. In this scenario the role of the US dollar as a reserve currency might come to an end and with it, the ability of the US to keep buying goods abroad without having to rebalance their trading sheet. Ultimately this might hand over the control of the world economy to China.

Some variation of this scenario is moderately likely to happen but I’m still not totally convinced. Dethroning the US dollar as a reserve currency has huge geopolitical implications in a moment when the US and China are embroiled in an economic war.

Scenario 3: Reinvention

Maybe all is not lost and the entrepreneurial spirit of the US might triumph once again with another technological breakthrough like the Internet in the 70’s and the World Wide Web in the 90’s that led to the creation of titans like Amazon, Google, Facebook and Uber. In this day and age we have incredible entrepreneurs like Elon Musk that has created revolutionary companies that are highly sought after by investors world wide.

As a society we also seem to be at the cusp of technological milestones as revolutionary as the Internet: fusion energy, quantum computers, high capacity batteries, private space exploration, etc. The question is if this time around the US will be at the forefront of these technological innovations or if other countries will take the lead instead.

My gut feeling tells me that it’s unlikely that new technologies will help grow the real economy to keep up with the money printing. China is presenting itself as a fierce competitor in those fields as well. Back in the 90’s when the Web and the Internet became mainstream, the Soviet Union had just recently crumbled under its own weight. Japan was the real victim of that struggle but let’s not forget how different in size and population Japan and China are. Also, it’s important to remember that Japan was defeated by the US during WWII and that American troops are still deployed there. One can only wonder how much autonomy does Japan really had to make bold decisions that could have undermined US competitiveness.

Scenario 4: Japan

Initially this article only had 3 scenarios but there is a country that defies my logic of how the economy works: Japan. Japan is the only country to have a debt to GDP ratio of more than 200% while at the same time exhibits not only no inflation but deflation. I’m not going to try to explain how this is even possible, it’s beyond my understanding of macro economics.

According to The Economist, Japan’s monetary policy has given birth to “zombie” corporations: companies that can only exist if the government keeps injecting them with money. The newspaper claims that up to 15% of all corporations in Japan can be classified as zombies. Zombie companies have lost their capacity to be efficient or innovate as they behave more like public companies that are supported by taxpayers. This seems to align with Japan’s loss of competitiveness since the 90’s. After all, when was the last time you used a product “Made in Japan”? I haven’t, for a long time.

This scenario can’t be discarded for the US as well as Japan might have paved the way for an extreme monetary policy that other advanced economies might try to emulate. It’s also unclear if this policy could work for the US in particular given the role of its currency as a global reserve asset.

Conclusion

In my opinion, scenarios 1 and 2 are the most likely to happen. Which one will materialize will depend on how much inflation increases, how independent the FED really is and Joe Biden’s plan for economic recovery.