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I'm in the camp that believes what we have in store here in the U.S. and much of the mature economies of the world is stagflation. Stagflation is the combination of stagnation, which is a prolonged period of slow economic growth, coupled with inflation. I believe the inflation will be moderate, but painful. Definitions are key to understanding economics. An economy for example, is defined as: The production and consumption of a given area, region or country.

There are two factors that impact total production (of both goods and services) in a given area or region:

1. Total aggregate hours worked over a period of time

and

2. The output per hour worked, also known as productivity.

Here is the case for why our economy is going to continue to grow slowly in the years ahead.

Aggregate hours worked in a given area, region or country can grow simply by having more of a working age population. The working age population in the U.S. is growing at the slowest rate since at least 1970, if not ever! It stood at 239,618,00 people in 2011 and grew only 0.75% from 2010.

Here is a chart showing year-over-year percent change in the working age population in the U.S.:

(click to enlarge)

Other factors affecting aggregate hours worked aside from simply a growing working age population include:

1. Average number of hours worked per year

and

2. The percent of the population that's employed.

The average number of hours worked per year in 2011 was 1758. Here is a chart going back since 1970 of the average annual hours worked per private employed person:

(click to enlarge)

Getting more current data, we can tell that in 2012, average weekly hours worked, which we get monthly from the BLS, grew only 0.1% from 2011.

(click to enlarge)

Now we can look at the percent of the population that is employed (red) side the civilian labor force participation rate (blue) via this chart:

(click to enlarge)

We're at 58.6% of the civilian population to employment ratio as of December 2012. That is the same rate in December of 2011. Where this ratio goes in the years ahead will make a very big difference in how much the economy grows or declines.

The labor force participation rate is forecast to continue to decline into 2020 mainly due to the effects of demographics per the CBO. (Congressional Budget Office)

To summarize the state of aggregate hours worked growth, here is what we have:

1. A working age population that is growing sub 1% per year.

2. Average weekly hours worked growth that only grew 0.1% in 2012 from 2011.

3. An employment to population ratio that is stuck in the mid-to-upper 58% range.

Putting this all together, we are likely to see 1%-2% total aggregate hours worked growth on average. The second and most important factor of creating economic growth is productivity per hour worked.

According to The Conference Board, a terrific global research association, the growth of labor productivity, when measured in GDP per hour worked, rose only 0.2% in 2012, down from rising 0.8% in 2011 in the United States. They forecast labor productivity to grow only 0.6% in 2013. That would be 3 years in a row of sub 1% productivity growth. Why is productivity growing so slowly? One reason is because of a lack of investment in gross capital formation.

I wrote about this a few months ago in an article titled: Paltry Fixed Income Investment Ringing Alarm Bells, where I warned this was going to impact productivity growth.

The Conference Board (pg. 3) says this about the plunge in productivity growth to 0.2% in 2012:

The slowdown in labor productivity growth is due to a combination of slow investment growth, held back by low business confidence in part related to the fiscal crisis, and few efficiency gains account for most of the productivity slowdown in the United States.

[Emphasis mine]

Fixed private investment as a percentage of GDP remains very low and it appears to be trending down again:

(click to enlarge)

Given the continued low levels of fixed private investment in the U.S., we should have low expectations for future gains in productivity. We should also have low expectations for total aggregate hours worked growth given current demographic trends in the workforce. So we are in for a prolonged period of slow economic growth for the reasons described above.

Raising productivity is all about getting the cost to make something lower and make the wages higher. If you are a barber and can cut 10 heads of hair in an 8 hour day and make $10 per haircut, you can make $100 a day in revenue. But if you invest in a new hair cutting tool that will allow you to cut 20 heads of hair in an 8 hour day, you can both cut the cost of the haircut, to steal customers from competitors, and charge just $8 a haircut. Then, you can make $160 a day in revenue. The investment in the hair cutting tool made you more productive and lowered the cost someone has to pay for a haircut. You also made more money.

But what if your hair cutting tool begins to jam every so often or is not sharp anymore? All tools wear and tear and you need to constantly invest in either upkeep or put money aside for replacement. If you don't keep it up or replace it, it might lose its efficiency and you won't be able to cut 20 heads of hair a day but now just 15 heads. Your taxes just went up and your rent just went up. Now you will have to raise prices to cover the added expenses or watch your net wages crash.

What happens if mature and very efficient economies of the West fail to do the proper upkeep of their tools or fail to replace them when needed replacing? I would argue you can expect them to be less efficient. Less efficient means your productivity isn't going to go up. Our low Fixed Capital Investment as a percent of GDP means just that.

This doesn't bode well for prices of goods and services to be able to come down but rather increase more and more in the coming years. Hence, the "flation" side of why I expect "Stagflation" or rising prices that outpace the rise in wages which makes them even more painful.

Over the next 10 years, I believe the best investment gains for the buy and hold investor will be in the East, especially China, where productivity gains are some of the strongest in the world. I believe gold and silver should prove to be a good hedge against the stagflation we'll be seeing in the years ahead.

I don't expect anything to take off any time soon as markets in much of the world are either quite high and or are very overbought. I'm keeping powder dry holding cash and being patient for better entry points to enter Asia and precious metals more meaningfully in the months and years ahead.

Source: Get Ready For Stagflation