You've probably heard of Salomon Brothers' Henry Kaufman and First Boston's Albert Wojnilower, the Dr. Doom and Dr. Gloom of economic forecasting. During the late 1970s, their warnings about high inflation could send the markets into a tailspin. But the economy has now passed them by. We are in the Age of Disinflation, and the economist who predicted it first -- and perhaps understands it best -- is an iconoclastic free-lancer named A. Gary Shilling.
Call him Dr. Loom, for the recession that he always sees looming in the future -- including 1987. Dangerously high levels of debt, high real-interest rates, and a whopping trade deficit all combine to provide the basis for a painful and prolonged downturn, he says. A drop in consumer spending will start it off. And a couple of major bank failures could turn it into an old-fashioned depression.
Even if you don't agree with Shilling's prognosis, you have to admire the skepticism and common sense he brings to economic forecasting -- all of it in refreshingly plain English. His role as the bear among the bulls is a familiar one for him: back in 1973, when he was the 36-year-old chief economist at the investment firm of White, Weld & Co., he alone predicted the 1973 recession after seeing an ominous buildup in inventories. A decade later, his book, is Inflation Ending? Are You Ready?, was a bit early for economic-forecasting purposes, perhaps, but well timed for him to take his own advice and make a small fortune in the bond market.
Shilling and his staff provide economic advice to about 100 corporate clients from their offices in New York City. He was interviewed by senior writers Bruce Posner and Paul B. Brown.
INC.: Why should anybody who knows his own business, his own industry, bother with forecasts from big-shot economists who all tend to say the same things and, as often as not, are wrong?
SHILLING: There's no doubt there is a love-hate kind of relationship between businesspeople and forecasters. With the economy now so volatile, the larger economic forces press in on many more business decisions than they used to, which makes the forecasts more important. Yet the volatility has another result: because of it, much of the forecasting has become pretty lousy.
INC.: That's a pretty serious indictment of your profession.
SHILLING: You have to look at it in a historical context. Forecasting really came into its own during the '50s and '60s, a time of almost uninterrupted growth in the U.S. economy. In those days, it was easy to forecast -- all you had to do was take the recent past and put a ruler on it. People were navigating by looking in the rearview mirror -- and it worked, because the road was straight. But the result was that there was a vast overselling of forecasters' abilities, so that when the economy returned to what were probably more normal circumstances -- when the road got crooked all of a sudden in the '70s -- looking in the rearview mirror didn't work any longer. And business people began feeling as if they had been bagged.
I blame that on the economists mostly, because it was their responsibility to give some perspective on what they were doing. They had forgotten the first rule of economics, which is that there is no free lunch.
INC.: Free lunch?
SHILLING: If you can make a forecast with absolute certainty, then nobody is going to pay you for it because everybody else can do it, too. It becomes a free lunch, which is worth what you pay for it. The only forecasts that are really worth anything are those that have some risk to them -- the ones that give you some insight on when the consensus is wrong, that tell you where the glitches are, the deviations, the turns in the road. What an economist gets paid to do is to spot the significant, but as yet undiscounted, deviations from the trend.
INC.: So your criticism is that economists, just like journalists, travel in herds?
SHILLING: The fact is that economists are just like other people: they'd rather go wrong in the good company of their colleagues than be out on a limb, where they risk being a laughingstock. Obviously, you're going to make mistakes if you diverge from the consensus. But to me, no guts means no glory.
INC.: That argument has a certain emotional appeal. But it doesn't exactly square with the common understanding of what forecasters do. Don't you simply plug lots of hard, objective data into your computer models and wait for the magic numbers to come out the other end? What does that have to do with guts or glory?
SHILLING: Perhaps I can explain it this way. Years ago, I used to go to a forecasting conference at the University of Michigan. A guy named Daniel Suits was running that model then. He used to get up every year and say, "Here is our forecast of a year ago. But since then, we found that our model was really off in the auto area, so we went back, and we reworked our auto equations, then plugged in the numbers again, and -- what do you know? -- it comes out right on the money. Isn't that wonderful? Now here's our projection for next year."
What Dan Suits didn't say is that next year it isn't going to be autos that are going to go haywire -- it will be housing or capital spending or whatever. And so forecasters spend so much time correcting the model for last year that they don't spend the time asking themselves what is to be really important next year -- figuing out what are the one or two factors that are going to deviate from the trend, from past experience. That is the only question that is really worth asking. Otherwise, computer modeling is just a glorified trend-forecasting technique -- it's very complicated, and it's very sophisticated, but it's not very good at predicting the turning points.
INC.: So there is a fair amount of guesswork, as you see it, in any forecast that looks beyond trends.
SHILLING: I guess I'd call it common sense, not guesswork. It involves reading the press, talking to businesspeople, gauging the reaction of consumers, figuring out what is going to happen in Washington. To do it right, you get into psychology, sociology, finance, politics, and economics and try to put all those things together. I am not saying that, theoretically, it's impossible to write a computer model that will do all of that. But the point is that nobody has come even close, particularly the economists using the big econometric models now, which are still based on sample period that dates laregly to the '50s and '60s -- which are irrelevant.
INC.: So when we read somewhere that Gary Shilling predicts gross national product growth of 3% next year . . .
SHILLING: Actually, we are saying 1% to 2% . . .
INC.: But is there nothing that backs it up in terms of a computer model?
SHILLING: You always back it up. But I have to say that, to a great degree, we sort of know where we are going to end up before we put the pieces together. In fact, we might have come out with a negative number for GNP growth in 1987, but we didn't know how negative it would be. So we looked at the consensus opinion of 3% growth, and we said it would not be 3%, but 1%, to indicate that we think the consensus is too high.
INC.: So that's an arbitrary number, the 1% to 2%.
SHILLING: It almost is.
INC.: With that disclaimer then, what do you see for 1987?
SHILLING: Before I answer that specifically, I think we should take a look at the significant deviations that are going on in the economy right now, because they pretty much indicate the direction.
Perhaps most important, for the first time since the '30s, we're in a world of excess supply of almost everything. During World War II, there was no problem of excess supply, certainly. And after the war, supplies were short: Europe and Japan were rebuilding, which absorbed a tremendous amount of goods, while at the same time the United States was catching up for the lack of spending during the Great Depression and the war years. By the '60s, all that catching up was over, but lo and behold, inflation took over. And inflation created its own demand, as everybody was buying ahead and recycled petrodollars were being lent out by banks with gay abandon to underdeveloped countries.
That inflation-generated demand carried us to the early '80s, but then inflation began to disappear very quickly. And suddenly everything was turned on its head: there were really very few sources of demand left in the world. The underdeveloped countries turned overnight from big importers to big exporters, because they had to export everything they could to earn the foreign exchange to service their debts. In 1970 these newly industrialized countries -- Taiwan, South Korea, Hong Kong, Singapore, Mexico, Brazil -- accounted for only 4% of the world's exports.Now they account for 10%. Meanwhile, Europe, which everybody had been looking to as the next locomotive of the world's economy, has turned out to be the little engine that couldn't. We've seen there not only the inability to generate growth, but very high unemployment -- 11% on average in the Common Market -- which gives those countries a lot of incentive to increase their exports and reduce their imports.
INC.: So, except for in the United States, there is too much supply, too little demand.
SHILLING: Precisely. And that was something new. We've gone from a world of perceived shortages and inflation in the '70s to a world of surpluses and disinflation in the '80s. And that is a fundamental change. There is practically nobody in business today who knows how to deal with that, except a few guys left over from the '30s.
INC.: The Keynesians would look to government to stimulate demand by increasing government spending -- government demand. The monetarists would opt to stimulate demand by increasing the money supply.
SHILLING: Aah, but look at what has happened.
On the spending side, we are in a situation in which not one of the major economic powers -- the United States, France, West Germany, Great Britain, Japan -- is willing to use its budget to stimulate demand. In fact, the leaders of all these countries read the voters as wanting to curb government activity and deficits. Nobody in the world is advocating fiscal stimulus as a way of increasing demand, either at home or around the world.
In terms of money supply, the Federal Reserve has its own problem, which gets a little esoteric, but it's important. It has to do with velocity -- the ratio between the amount of money that is out in the economy and the amount of economic activity it generates, which is essentially the GNP. And in every major country except France, that ratio is declining for the first time in the postwar period. What that says, in effect, is that people and businesses have more money in their checking accounts and their money-market accounts in relation to the purchases they make.
There are a number of reasons for that, but the most obvious is that, in a period of deflation, money is worth holding. Another is that with the prices for tangible assets collapsing -- oil, commercial buildings, farmland, and so on -- people want more liquidity. For the Fed and the central banks of other countries, this presents a dilemma: in order to stimulate demand, they have to pump in a lot more money to get the kind of demand stimulus they desire. We estimate now that if the Federal Reserve were simply neutral in its policy -- that is, not trying to increase or decrease demand -- then the discount rate would have to be reduced to 3% from the 5 1/2% it is now. And to stimulate the economy, the Fed would have to lower it even further.
So what I'm saying is that government is not likely to be able or willing to provide much help in stimulating the economy.
INC.: Yet the economy seems to be muddling along . . .
SHILLING: And if we're lucky, it might continue to muddle along as it has, with the GNP rising 1% to 2% a year -- but only if the consumer is willing to keep it going. In the last eight quarters, consumers accounted for 90% of the growth in real GNP.
INC.: Yet consumers are, by mahy accounts, extended as far as they can go.
SHILLING: Precisely. Consumers are doing it with a tremendous increase in their debt. But why? Why do people put themselves out on a limb like that? And the reason, we think, is that consumers are struggling simply to maintain their life-styles against a decrease in their purchasing power. Remember, real family incomes have been declining since 1973. First, it was inflation. More recently, it is the result of companies forcing down wages as they try to close the gap between our labor costs and the rest of the world. But Americans don't really want to accept the reality of lower incomes: we think our birthright includes living better than our parents and retiring rich. And so we've adjusted to this new reality in a variety of ways. The first thing we did was to delay having children and send the women off to work. That worked for a while, but only a while. Now we're bridging the gap by borrowing, figuring that somewhat it will all go away.
INC.: But where does it end?
SHILLING: That's the problem: nobody is willing to blow the whistle. The Fed isn't going to blow the whistle -- if anything, it's getting more and more concerned about recession, so I don't see it tightening up appreciably anytime soon. The banks could blow the whistle, but why should they? If they can continue to borrow from the Fed at, say, 6% and lend it out on a credit card at 18%, they can cover a lot of delinquencies with that spread and still make money. So lenders aren't going to blow the whistle. That leaves it up to the consumers, and you really don't know when they're going to call it quits and decide that enough is enough. Our best guess is that it will come sometime at the beginning of next year, and it will trigger a recession.
INC.: What would be the first sign of it, something we all could spot?
SHILLING: What I would look at is auto sales, because a car is a big-ticket, postponable item -- you don't have to buy one this year -- and because it is heavily financed; about three-quarters of the cars on the road are financed. If consumers start to get scared about the future and about their level of borrowing, this is where they are going to show it.
INC.: How severe a recession can be expect?
SHILLING: It could be anything from a very mild one to something that could get us into a '30s situation.
INC.: That's a pretty wide range from a no-guts-no-glory forecaster.
SHILLING: The problem in predicting the severity is that once the recession starts, there are three factors that could be very significant in deepening it. But they are factors that nobody can predict.
One is consumer savings. If consumers start to pull back on their borrowing, that will trigger a downturn. And once the economy softens, they are likely to get even more cautious and increase their savings rate -- say from 4% now to a normal range of 6% to 7%. That could take 2% to 2 1/2% out of the GNP by itself, which is a big recession right there. And if people really get scared, it could go a lot higher.
The second thing that is likely to deepen the recession is protectionism. Because of this world of surpluses that we have, there are already tremendous pressures to raise barriers and tariffs in order to protect domestic wages and prices. A recession will only aggravate that, and Congress, looking for a scapegoat, will probably go along. Right away, two things would happen: U.S. imports, which have been the only source of economic growth to the rest of the world, would decline; and U.S. exports would decline, because other countries would retaliate with their own protectionist measures. And the result would be a slowdown in everybody's economic activity, and the recession would deepen here and broaden to the rest of the world.
Finally, there's a tremendous amount of debt out there -- personal, corporate, governmental. The U.S. economy -- the world economy -- is highly leveraged, and a recession is likely to aggravate that financial weakness, especially in sectors that feel the effect of collapsing prices for tangibles. That's the oil patch. That's savings and loans that plunged into shaky real estate investments. That's much of the agricultural sector. That's Mexico, Brazil, and Argentina and their U.S. banks. So far, the Fed has been able to handle a few of these problems as they've come up -- Mexico, Continental Illinois. But when you get into a recession, the problems will be coming so fast and furiously that the Fed is not going to be able to handle them all.
INC.: What economic change do you think is likely to start that kind of snowball rolling?
SHILLING: If I had to pick a candidate, I would say Texas real estate. The banks down there have protected themsleves much better from declining oil prices than they have from declining real estate prices -- the only thing holding that up right now, really, is faith. Even today, newly constructed, well-located buildings in Houston are selling for half of what it cost to build them. If that really starts to open up, then I think the Texas banks are finished.
INC.: OK, you're running a business somewhere outside of Texas, and you hear Shilling predict that, at best, the economy will be essentially flat the next year and, at worse, we'll be in a depression. So what do you do, Doctor?
SHILLING: The first thing is to implement ruthless and permanent cost-control systems. And in that, I think small companies have an advantage, because both management and employees in a small company have a much clearer understanding of their vulnerability.
Second, I think people have to orient themselves toward volume expansion. In a world of surpluses, in the middle of a recession, you can't really raise prices. So the only way to grow is to sell more, even if it means cutting your margins a bit. And there again, I think a small company is much better positioned than a large one.
The third thing is to stay clear of borrowing at high real-interest rates, which is what we have now: a wide spread between the prevailing interest rate and the inflation rate. Holding down borrowing is more than simply a question of cleaning up the accounts receivable. It's a matter of being very skeptical about buying a new piece of equipment or building a new plant. Remember that in a world of surpluses, the price for the machinery or the plant is likely to go down, not up. So why buy now? In fact, why buy at all? Why not lease and let somebody else take the risk?
It's also important to keep your borrowing short term. Rates are likely to drop even further. Somebody who locks himself into 10% borrowing for 10 years is really assuming, whether he realizes it or not, that he's going to be able to raise his prices even more than that sometime soon. That's doubtful. And without price increases, those interest payments are going to take a big chunk out of the bottom line.
INC.: What do you see for interest rates in the next year?
SHILLING: I think before it's over you could see rates cut in half. Right now, we have these high real-interest rates because neither the Fed nor the bond market is convinced that inflation is over. Sooner or later -- certainly one we're fully into a recession -- they'll finally become convinced, and we could well go back to 2% to 3% real interest rates. If you figure inflation at about 2%, that means that long -- 20- to 30-year -- Treasuries will be at about 4% or 5%.
INC.: You suggest keeping borrowing short term. Does that mean you also recommend that business planning be kept short term?
SHILLING: Certainly, it will be important to keep your commitments short term. Don't buy something until you need it. And shorten supply times. Go to your suppliers as much as possible and shove the purchase material inventories back on them. Or use truck rather than rail to shorten the amount of inventories in transit. You could try the same with your customers, too. The principle is the same in either direction: use your muscle to try to get the other buy to hold your inventory.
INC.: In other words, keep an eye on the financials.
SHILLING: Exactly. The paramount emphasis has to be on financial strength. Build up your balance sheet: retain earnings, reduce debt, trim inventories, don't take that expense-account trip to Rio this winter -- whatever it requires. We're heading into an era in which both domestic and international competition is going to be intense, and if you don't have the financial strength -- particularly a small company -- then I think your odds of survival are very, very poor.
INC.: Are there some categories of businesses where survival is more in question than others?
SHILLING: In general, I'd say it would be those that are vulnerable to foreign competition, which is only likely to intensify.
INC.: And what does that mean for the company owner?
SHILLING: The best advice I can give is to pull into a niche in which you are not going to be in the way of competition, or get into a product with high service content so that somebody can't duplicate it and produce a zillion of them in Hong Kong, forcing you out of the business. If you're going to be in a commodity -- something anybody can produce -- then absolutely make sure you are the low-cost producer.
INC.: And if you can't be the low-cost producer?
SHILLING: Then get out of that commodity.
INC.: I suspect a lot of business owners read a sweeping statement like that and say to themselves, "Hey, this guy doesn't know my particular product, my market, my business. Why should I change my whole strategy on the basis of some generalization about the world economy?"
SHILLING: It's true. They probably operate in a local economy in terms of immediate suppliers and customers. But I think that one of the things we've all learned recently is that there are very few businesses that are isolated from international competition any longer, from the effects of rising or falling commodity prices, from rising or falling interest rates. And in those respects, everyone operates in a national or even international economy. If your bank has some bad loans in Mexico, you're going to feel the effects of that one way or another. If you're in the Midwest, the strength of your sales are, in some way, going to be affected by grain production in Argentina. The industries that are now considered noncyclical have shrunk considerably from what they used to be. And the aggregate forces -- the forces of the national economy -- have been so strong, and so volatile, that those who've ignored them have been the losers.
INC.: Yours are some of the gloomier forecasts. How do you find business owners react to them?
SHILLING: Many companies, small companies especially, are headed by people who are basically supersalespeople, and by nature they are eternal optimists. That's why they are good at sales. They hate to hear negative news. They want their companies to grow. And sometimes that desire spills over onto their judgment.
INC.: Then how should chief executive officers -- given their ingrained prejudices about economists and their ingrained optimism -- how should they react, realistically, to a gloomy forecast from an economist like you?
SHILLING: A forecast is really all envelope of possibilities. It isn't one number. It isn't one word: recession or depression or expansion. What a forecast -- a credible forecast -- really is, is a set of possibilities with probabilities assigned to them. And that means you obviously have to accept the possibility of extremes with a lot of gray areas in between.
I think the best forecast is the one that alerts the listener to the extremes and emphasizes them in a way that can help businesspeople prepare for them. Because the best strategy is one that not only takes advantage of the best that can happen, but also protects the organization from the worst. You know, even if there is a low probability of things really coming unraveled, I would rather have people mentally and financially prepared for that -- not that they are going to distort their businesses and run them solely on the basis of some theoretical forthcoming depression, but at least so they will be ready. I would rather have people prepared for that kind of thing and have it not occur than to have them so totally unprepared that they get caught with their pants down.