If you’re British you’ve undoubtedly heard of the Caterham 7 and Brooklands. But for those of you unfamiliar with the car, it’s a British open two-seat sports car manufactured by Caterham Cars since the early 1970s. Previously the car had been known as the Lotus 7 and was originally designed by Colin Chapman, the iconic founder of Lotus Engineering and a fellow alumnus of the University of London.
Save a handful of car buffs, few outside Britain have ever heard of the Caterham 7, or any number of once-famous British auto and motorcycle manufacturers--Morris, Austin, Singer, Rootes, Reliant, Standard-Triumph and Vauxhall all spring to mind. Fewer still are aware that the UK was once the world’s largest car exporter, accounting for more than half of the world’s car exports at one point in the 1950s and employing over 1 million Britons at its pinnacle.
Now the British auto industry is a shadow of its former self. Granted, there are a few small, niche producers like Caterham and Bristol that are still British-owned. But most of the quintessentially British auto brands including Lotus, Land Rover, Jaguar and Bentley are in foreign hands, and models made by the likes of Ford (F), Toyota (TM), Nissan (OTCPK:NSANY) and Volkswagen (OTCPK:VLKAF) now dominate the UK car market.
In the 1960s and ‘70s, the UK car industry was plagued by the actions of aggressive labor unions and the constant threat of industrial action--in 1974 alone there were nearly 3,000 documented industrial disputes in Britain.
Undoubtedly, bad management, poor quality and uninspiring design for mass-produced cars also contributed to the industry’s gradual loss of market share in the 1960s and early ‘70s. Between the late 1960s and late ‘70s alone, the import share of the UK car industry jumped from less than 10% to more than half.
Of course, the British government was concerned about the declining health of one of the country’s largest employers and the loss of national prestige due to the perceived low quality of British automobiles. In the late 1960s, the government engineered the merger of two of the largest manufacturers to create the British Leyland Motor Corporation, a sort of national champion and Europe’s fourth-largest producer.
But by 1975, after seven years of declining profitability and prestige, British Leyland again teetered on the edge of bankruptcy and sank into 6th place in terms of European market share. The government commissioned a report on Leyland’s market position and decided to invest additional public capital, making the UK government the majority shareholder. In other words: Leyland was nationalized.
The government had grand designs for the firm. With access to capital for investment, the firm could revitalize its car designs, cut bloated costs and improve quality--all of which would enable it to better compete with foreign producers and preserve British jobs.
Unfortunately, this story doesn’t have a happy ending. The British government continued to throw good money after bad--even the market-oriented Thatcher government bailed out Leyland on several occasions.
The government poured an amount equal to 11 billion pounds sterling ($18 billion) into the company in the late 1970s. But the UK taxpayer didn’t get much bang for its quid: Leyland eventually evolved into MG Rover, which died a quiet death in 2005.
This cautionary tale should sound familiar. More than three decades after the British nationalized Leyland the US government undertaking the same venture.
Even the rhetoric is eerily reminiscent. The US government plans to remake the US auto industry around advanced “green” automobiles, such as GM’s electric Volt car. The pitch has an intoxicating allure: Save the US auto industry, save the environment and save jobs--all it takes is a bit of public “investment.”
But the US government is suffering from the same fatal conceit as the British government in the 70s: assuming that it can run an automobile company more effectively than the private sector. GM is broken. Throwing more money at a failing company won’t rescue it, nor will the involvement of bureaucrats who have little or no experience in the automobile business.
Unfortunately, the problem extends beyond the car business. It’s no accident that the gradual implosion of the British auto industry that occurred between the 1960s and 1980s coincided with a period of dramatic decline in the domestic economy.
In 1976 the nation that was once the most powerful military and economic empire of the modern era was forced to go hat-in-hand to seek an emergency loan from the International Monetary Fund (IMF). Without that infusion of cash, the mighty pound sterling--long the world’s reserve--was in danger of collapse.
One of the main reasons Britain faced such a frightful state of affairs in the 1970s was the government’s profligate post-war spending. Along with taking over the domestic car business to save jobs, the government also increased its involvement in just about every imaginable sector of the economy. As the graph below demonstrates, Leyland wasn’t the only British firm to be nationalized over this time period. (Click charts to enlarge)
This graph traces the UK government total spending as a percent of the nation’s gross domestic product (GDP) from 1900 onward. The two prominent spikes in spending coincide with the two wars and post-war rebuilding.
From an economic perspective, the 1950 to the late 1970s is far more salient to our current situation. Over this period, government spending increased from less than a third of Britain’s economy to around half its output.
Britain’s era of big government brought several major problems. First, the country simply couldn’t afford its expenditures; by 1980 just the interest on Britain’s public debt consumed more than 5% of GDP.
To finance the deficit, the country imposed punitive tax rates that made the UK an unattractive place to invest. The government’s excessive involvement in the economy also produced a maze of regulations and laws that further impeded economic development. Unemployment was high, economic growth was weak and inflation was out of control.
And all that government spending crowds out private investment. In a free market, capital flows into industries where it can produce the highest returns. In a State-focused economic system such as the one that prevailed in Britain in the 1970s, capital flows from the citizens to the government via taxation and into areas the government deems worthy of spending. Although a market-oriented system isn’t perfect and breakdowns do occur, over the years the market has proven a far more successful allocator of capital than government bureaucrats.
Across the Pond
I’ve had the good fortune to travel widely and see myriad other cultures and countries first-hand. I like many places I’ve visited and return, but I’ve only loved and called two countries home: the US, my native land, and the UK, my home for several years in the 1990s.
It pains me to watch the US follow the disastrous path that the UK followed in the mid-20th century. The graph below tells the tale.
This graph tracks the federal government’s spending as a percent of US GDP going back to the early 20th century and includes projections from the Congressional Budget Office. The data doesn’t include spending at the state level; the fiscal health of several major US states, particularly California, is so weak one can only assume market participants believe the Federal government will ultimately ride to the rescue. Throwing state spending into the mix further darkens the picture.
Note the gradual upturn in the size of the US government’s budget since 2000; current spending as a percentage of GDP has reached its highest point since World War II. The disastrous upward trend in US government spending began under the Bush administration, but the current administration has taken irresponsible spending to a new extreme.
Most of the money the government spends is borrowed; countries like China and Japan are our biggest lenders. To date, the US government has had little trouble financing its massive spending plans; auctions of US government bonds continue to be well received and interest rates are at rock bottom. But much like the consumer who borrows money from a credit card with a “teaser” rate, the US will undoubtedly face a reckoning in the future.
Ultimately, the market is more powerful than any government--though it is possible to temporarily postpone the inevitable. Our foreign creditors are now being asked to fund a dizzying array of new programs including health care reform, a potential second stimulus package and a complex and dubious energy policy.
To make matters worse, for a few months it appeared that the cost of last year’s financial bailout, The Troubled Assets Relief Program (TARP), might be receding as banks began to pay back the monies borrowed. It's now clear that the government views TARP as a honey pot of unspent funds; it's increasingly likely that the US will use TARP cash to fund populist social programs.
Under rather conservative projections from the Congressional Budget Office (CBO), US debt in the hands of the public will rise from 40% of GDP last year to more than 70% in 2019.
Foreign buyers of US bonds eventually will demand higher returns to continue funding a country that's pursuing reckless fiscal policies and has a currency that’s of dubious value. Such a situation spells higher interest rates. Higher rates mixed with excessive government and household debt form a toxic brew. Add in attempts to plug the deficit through confiscatory taxation and you don't have a recipe for long-term economic health and growth.
The US government is certain to follow the well-worn path governments have followed for millennia when faced with mounting debt problems: inflation. The government has and will continue to print money to monetize its debt, a policy that will produce inflation akin to what occurred in the 1970s--if not worse. Short-term rallies aside, the US dollar will continue its secular slide in coming years.
How do we protect ourselves from these inevitable consequences while actually growing our portfolios? I suggest following a few core strategies: play the cycles, invest abroad and in hard assets.
The trends I have described are secular in nature. The British economy was a slow-motion train wreck for much of the 1960s and ‘70s; it likely will take some time for some of the problems I highlighted to become front page news. Heed the advice of another famous Briton, John Maynard Keynes: "The market can stay irrational longer than you can stay solvent."
Even when markets experience a secular decline, cyclical fluctuations around the trend that can lastfor years. We are currently experiencing such a cyclical rebound, and investors would be well advised to invest accordingly.
Second, while the UK experienced a long period of economic decay in the 20th century, other countries performed far better. For example, investors made a great deal of money investing in Japan from 1960 to 1980 while the country grew rapidly. Similarly, the debt situation in the US and many European countries appears to be unsustainable--but that's not the case in emerging markets such as China and India.
Finally, gold and other commodities serve as a hedge against inflation and a declining US dollar. Over the long term, energy should remain a core investment theme as much of the growth in energy demand will continue to come from China, India and other emerging markets. Gold should be another core holding; prices have roughly quadrupled from their lows. And gold prices could triple from current levels as the long-term trends I described play out.
Disclosure: long positions