Why the US will turn Japanese by 2010

For better or worse, we live in an economy dominated by consumer spending. This fact is a cause of concern for many traditional economists, as they believe that it is largely capital investment on the "supply side" that drives economic growth.

An economy that consumes more than it produces is bound to collapse into insolvency, right? And by this rationale, we're due for a massive economic correction to purge these excesses, right?

It is highly likely that these economists will be correct about an eventual crash, though the reasons they list are effects, not underlying causes. And this inevitable crash will happen a little later than most economists think. Our forecast, at the H.S.Dent Foundation - and we have been largely correct thus far - is for the US economy and markets to boom for the rest of this decade.

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But around 2010, the day of reckoning that economists have long feared is likely to finally come.

First, a little background. We acquired a fair amount of notoriety in the late 1980s by forecasting that the Japanese boom was quickly going to go bust and that the US was on the verge of its own two-decade boom. At the time, every major financial figure, with the sole exception of Sir John Templeton, forecasted that the 1990s would be a miserable time for American investors and that Japan would soon be the pre-eminent world economy.

In our book, 'The Great Boom Ahead' (1993), we forecasted falling interest rates, falling inflation, growth in productivity, and - perhaps most audacious given the economic mood of the day - we even forecasted that the Dow would hit 10,000 and that the US government's unprecedented deficit in 1992 would turn into a surplus between 1998 and 2000 due to a massive increase in revenue.

We will discuss below how we reached our conclusions and what all of this means for us today, in 2006. But first, there are traditionally two ways of explaining how an economy grows.

An old-school classical economist would insist that savings and investment in productive assets is what pushes the economy forward - "Supply creates its own demand," as Say's law says. "To the contrary," a Keynesian might retort, "What happens when there are no buyers for what you have to sell? The key is aggregate demand that spurs production."

In fact, both of these points of view are true to an extent, but neither sees the full picture. Production creates jobs, which provides income and gives the means for consumer spending, so classical economics certainly have merit. Company profits are reinvested, and the virtuous cycle continues. But the other side of the coin, Keynesian economics properly points out, is that consumers must make decisions on how that income is used; will it be spent or saved?

Both of these views attempt to explain the "how" of economic growth, but neither explains the "why". And both are focused disproportionately at the macro level. It is at the micro level - the extreme micro level - where we find the answers.

The single biggest expense to the average family is children, and the older they get the more expensive they become until they finally leave home. The US Government estimates that the cost of raising a child born today from birth through high school to be $211,370. Raising the standard two children would set an American family back nearly half a million dollars, and these figures do not take university education costs into account. It is this highly-predictable spending by families that drives our modern, mass-affluent economy, just as in Britain.

This spending continues even during very difficult times, as the first half of this decade has shown. Since the year 2000, Americans have suffered through one of the worst bear markets in history, a disputed presidential election in 2000, and the worst terrorist attack in American history, two subsequent wars in Afghanistan in Iraq, and a massive oil bubble. Yet despite the chaos, consumer spending has actually risen every quarter though it all. It appears that even calamities of biblical proportions cannot stop the consumer.

Are Americans blind to the world around them? Of course not. At worst, they can be accused of being a little stubborn. Americans will do anything in their power to maintain their standard of living, even if it means taking on more debt than they should. The typical American dad doesn't consider the trade deficit or the price/earnings ratio of the S&P 500 when Junior grows an inch and needs a new pair of jeans. Instead, Dad just buys the jeans and figures out how to pay for it later. As a general rule, people simply do not consider the macro economy when making household decisions. They may fret about it, but at the end of the day they still buy that big, gas-guzzling SUV when Junior and his friends start carpooling to soccer practice.

Enough about Junior. What about the economy and the stock market? Well, as it would turn out, Junior leads us to quite a bit of insight. On average, people progress through a set of very predictable stages; marrying, having children, purchasing homes, and finally retiring in successive chapters of their lives. Understanding that this life cycle exists, and then seeing how it can be forecast, is the key to understanding the economy and the stock markets.

By studying consumer purchasing data compiled by the US Bureau of Labor Statistics, we can forecast demand for hundreds of goods and services, including things as simple as potato chips. From this wealth of data, we know that the average American's spending on potato chips peaks at age 42. This can be expected, given that the average American marries at about age 26, has an average child at about age 28, and 14 years later that child is eating everything in sight at the peak of their calorie cycle. Just as this type of forecasting can be done for individual products and services, it can also be done for aggregate household spending. Total household consumer spending tops out when the breadwinning hits age 48, just as the average kid is leaving home.

The good news is that the largest section of the Baby Boomer generation is quickly approaching their peak spending years, which will shift our economy into another bubble boom. The bad news is that once this mass of Boomers passes that threshold, consumer spending will slow down progressively for over a decade. When it does, our economy and stock markets will suffer.

And unlike recent recessions, where an accommodative Federal Reserve and free-spending US Congress were able to muster enough demand to produce a relatively quick recovery, no amount of government stimulus will compensate for the loss of spending this time. For an idea of what to expect, look east.

Japan's rise from the ashes of World War II was truly meteoric. No country in history could match Japan's growth rates from the 1950s through the 1970s. In just two decades, Japan evolved from a largely agrarian country to an industrial giant that rivalled the US and

Europe. By the 1980s, American companies found themselves struggling to compete with Japanese manufactures in steel, autos, and consumer electronics. Business schools began teaching classes on Japanese management techniques, and American workers looked on in fear as their bosses were replaced with Japanese managers.

The Japanese stock market played its part too. After putting up good returns throughout the 1960s and 1970s, shares shot through the roof in the 1980s, and by the middle of the decade Japanese stocks were in a full-blown bubble. Between 1985 and 1990 the Nikkei tripled, hitting a high just shy of 40,000 in December of 1989.

Today, we see a very different Japan. The present rally notwithstanding, the Nikkei is still down over 60% from the top - more than fifteen years later! Japan has spent the last fifteen years in and out of recession, never able to get any real momentum.

So what caused Japan to fall into this hibernation? The falling desire of Japanese consumers.

Low consumer demand due to the aging of the population meant low profits for Japanese companies, which in turn led to decreased hiring and even lower demand. A vicious cycle developed with no way out. This cycle - lower demand, lower profits, lower production, etc, is exactly what we see in our future.

The Japanese consumer got old. As he slowed his purchases in the early 1990s, the economic bubble burst despite all efforts to keep it inflated.

The Bank of Japan cut interest rates from 6% to zero, essentially giving money away in the hopes that someone would spend it to build a factory, increase production, or to consume. In the standard formula, cutting interest rates spurs consumption and investment. As the reward for saving money gets smaller, the incentive to spend it gets bigger. But an odd thing happened in Japan; interest rates dropped, but savings remained high. Consumer spending stayed flat and then fell. New investment in productive assets stalled - Japanese business already had more than enough capacity.

The United States will start "turning Japanese" around mid- to late 2010. The demographic trends that have powered the economy since the early 1980s will peak at this time and finally reverse as the Baby Boomers begin to save every dollar they can spare for their impending old age. Demographically, we will be in the same place as the Japanese when they began their slow, grinding decline in 1990. And when consumer demand falls, American businesses will have a hard time turning a profit. Stocks will likely enter a long bear market, and investor portfolios will be ravaged.

Our policymakers will follow the example of the Japanese, because it is the only model they can reasonably be expected to follow. And as in Japan, the policies used will ease the pain a little but will certainly not cure the disease. Americans, long scolded by the rest of the world as being spendthrifts, will suddenly start to resemble their Asian counterparts in their saving habits. Consumer spending will fall, and the economy will scratch and claw frantically just to avoid falling into the abyss of deflation, the likes of which haven't been seen on American shores since the 1930s.

The moral of the story? Save and invest as much money as you can in the next five years, and put your money more in growth stocks as opposed to real estate or bonds. Enjoy the grand finale of the greatest boom in history!

But as we get closer to the demographic turning point, you need to get conservative. You'll need to start "acting Japanese".

By Harry S.Dent for The Daily Reckoning. You can read more econommic commentary from many other respected investment writers at www.dailyreckoning.co.uk.

Harry S.Dent Jr. is a noted author who has written several books, including two best sellers. Mr Dent has appeared on 'Good Morning America', CNBC, CNN/Fn, and has been featured in numerous publications including Barron's, Investor's Business Daily, Entrepreneur, Fortune, Success, US News & World Report, and The Wall Street Journal. For more information on his research, please visit the new H.S.Dent Foundation website: https://www.hsdent.com