In this interview of economist, Lacy Hunt by Kate Wellin, the current world economic status is reviewed with particular attention to the U.S. The primary focus is current government debt levels and what those mean to future prosperity. The interview also goes into economic theory and comparison of the U.S. situation with Europe which is actually buying Uncle Sam some time. But, time is running out and if the latest budget proposal from President Obama does not scare the bejeezers out of you,
then you are made of sterner stuff than me.
A little background on Dr. Lacy Hunt is first so you can decide if your time is well spent on the rest of the interview.
Road Back To Prosperity Is Through Shared Sacrifice, Says Lacy HuntLast time Dr. Lacy Hunt, the chief economist at Austin, TX-basedHoisington Investment Managementwas interviewed in these pages, in July, 2009, the rebound in stocks from their crisis lows was only months old yet he remained firmly in the bull camp on bonds. As it turns out, Lacy, and the entire portfolio management team at Hoisington, led since the firm's founding by Van R. Hoisington, couldn't have been proven more right: Rates, which "couldn't go lower" have continued to sink. Much to the benefit of Hoisington's institutional clients and investors in the Wasatch-Hoisington U.S. Treasury Fund, which the firm sub-advises. When I gave Lacy a call earlier this week, he always a gentleman and a scholar patiently explained not only why he's still bullish on long Treasuries, but why there's simply no easy exit from the debt morass in which the whole economy, public and private, is trapped. Listen in.
The historical information is important in understanding why Lacy is taking a somewhat contrarian view on long-term Treasuries. Almost all forecasters say that rates must turn up very shortly. So, stick with this line so you can open your mind to a different economic model and understanding of past recessions, depressions and what is needed now.
I have to say the first one stopped me showing debt as a percentage of U.S. GDP all the way back to 1870? What data goes back that far?
Dr. Robert Gordonat Northwestern Universityhas been very helpful to me, recreating a lot of data. The National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis (BEA) only start in '29. But NBER (the National Bureau of Economic Research) funded two studies, one by Christina Romer and the other by Robert Gordon, to estimate the nation's GDP back to 1870. So we have those data sets. They're not identical, obviously, but what most economists do, including me, is use an average of the Romer and the Gordon estimates, which seems to work out pretty well.
Still, I suspect most folks looking at a line on a chart interpret it as "historical fact" instead of as an estimate based on spotty data on the workings of a very different economic environment.This is a really important point because so many of us have been influenced by the medias complete buy-in to Friedman and Keynesian theory which basically says that if you have an economic downturn just keep pumping up government debt. It seems the problem is that the selective use of datasets is what caused Friedman to reach wrong conclusions.
Well, what the profession is saying is that economic propositions need to be tested and verified over as complete a sample as possible. Admittedly, some of these earlier periods, you didn't have a central bank; you didn't have an income tax; you had various political regimes; sometimes you were on the gold standard, sometimes you were off. The point is, most people feel that these institutional differences shouldn't obscure the verifiable observation of basic economic relationships. So you want to test this over as much time as you possibly can and I think that's a reasonable proposition. Anyway, that's my approach, and that's increasingly the approach in the profession.
I was just noting that what we actually know about the economy in days gone by is lot squishier than terms like "data sets" or lines on charts seem to imply. But clearly, observations over short times can be misleading.
Absolutely. Take the subject of debt. If you confine your analysis to post-war period, you only have one major debt-dominated cycle and that's the one we're currently in ó and have been in for a number of years. But if you go back far enough, you have three more. You have the 1820s and 1830s. You have 1860s and 1870s and then you have 1920s and their aftermath. Sometimes it's essential to take your analysis back as far as you possibly can.
The inerview continues into some fascinating discussion about economic theory as understood by Fisher, Friedman and Minsky and interpretated by Bernanke. All good stuff for the economic student and anyone who wants to understand where the US is going wrong now. This sums up the outcome of that discussion.Sure. Doesn't your second chart, on the velocity of money [below], show how none other than Milton Friedman was misled into thinking that it was a constant because he only looked at post-war data?That's correct and, in fact, I was misled along with him because I was also doing analysis based on the post-war data. Friedman's period of estimation was basically from the 1950s to the 1980s. Well, if you look at the velocity of money in that time period, it's not a constant, but it's very stable around 1.675. So if you tracked money supply growth then, you were going to be able to get to GDP growth very well. Not on an individual quarterly basis, but even the individual quarterly variations were not that great. Until velocity broke out of that range after we deregulated the banking system. Now, velocity is breaking below the long-term average and it's behaving exactly like Irving Fisher said, not like Friedman said, absolutely.
What a perfect example of the difference your frame of reference can make.Yes, Friedman even said Fisher was the greatest American economist, and I think that is correct. Fisher had a broader understanding of the economy in a very, very critical way and in a way that I don't think either Friedman or John Maynard Keynes understood it, and even a lot of contemporary economists, such as Ben Bernanke. Keynes and Friedman both felt that The Great Depression was due to an insufficiency of aggregate demand and so the way you contained a Great Depression was by your response to the insufficiency of aggregate demand. For Keynes, that was by having the federal government borrow more money and spend it when the private sector wouldn't. And for Friedman, that was for the Federal Reserve to do more to stimulate the money supply so that the private sector would lend more money. Fisher, on the other hand, is saying something entirely different. He's saying that the insufficiency of aggregate demand is a symptom of excessive indebtedness and what you have to do to contain a major debt depression event ó such as the aftermath of 1873, the aftermath of 1929, the aftermath of 2008 ó is you have to prevent it ahead of time. You have to prevent the buildup of debt.And that your goose is cooked if you don't you cut off the credit bubble before it overwhelms the economy?Yes, and Bernanke is thinking that the solution is in the response to the insufficiency of aggregate demand. That was Friedman's thought. That was Keynes' thought and most of the economics profession has traditionally thought the same way. They were looking at it through the wrong lens. Fisher advocated 100% money because he wanted the lending and depository functions of the banks separated so we couldn't have another event like the 1920s.You're saying that Fisher argued against fractional reserve banking?Yes, and so did the people that more or less followed in Fisher's footsteps, principally Charles Kindleberger and Hyman Minsky. Minsky felt that the way you prevented a major debt deflation cycle was to keep the banks small.
Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government's ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations and 85% for households.People and economists love the U.S. economic situation created during and after WWII. That time is used over and over as the example that huge debt loads are good. This is the economic explanation of why that is not so and what is going on right now.
And yet Greenspan's rejection of the danger of an excessive buildup of debt in his book put him in a different mindset, not just in evaluating the events of the 1930s, but when it came to understanding what was going on in the early part of this century, up to 2006 and '07. Because he thought he could respond to a debt problem and contain it. But that was not at all what Fisher taught. Fisher said you have to prevent a debt deflation ahead of time. That's a very powerful, critical, difference. What Fisher is saying is that once you get into this extremely over-indebted situation, and the prices of assets begin to fall, these two "big bad actors," those are the terms he used, control all or nearly all other economic variables. Then, if you attempt to respond to the problem by leveraging further, it's counterproductive. That's the term Fisher used in one of his letters to FDR expressing concerns about deficit spending.There now seems to be a consensus developing about the level of government debt where it is counter-productive to the economy. That is the piece that has been missing in economic models for a long time. The U.S. is right at or just barely over it. This is what concerns me about the latest Obama budget and the general lackadaisical attitude about both political parties to solving the deficit problem.
A Cal Berkeley Ph.D., a very serious economist, Checcetti said, "Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare." In other words, when banks engage in their traditional business and consumer lending, it improves. There's no question about that. But when they lend imprudently in excess, the result can be a disaster for individuals, households, firms. And "Over-borrowing leads to bankruptcy and financial ruin for a country. Too much debt impairs the government's ability to deliver essential services to its citizens."
I noticed that Cecchetti even specified how much debt becomes cancerous.More data on why the U.S. is at a critical tipping point.
That's right. I like his use of that medical term. And the level of government debt he specifies is consistent with what Carmen Reinhart and Rogoff wrote in their paper for the NBER called "Growth in a Time of Debt."They found that after you get above 90% of debt to GDP that you lose 1% off the median growth rate, and even more off the average growth rate. So it's clear that debt plays a major role in the economy. Most of the time, it is a benign factor, but you get these irregular intervals in which debt builds up excessively. And, once it has built up excessively, it's a controlling influence for a long time. Plus, you cannot solve that over-indebtedness problem by getting deeper in debt. That's the problem.
We spent $3.6 trillion last year at the federal level. We borrowed around 35% of that and we had tax revenues to cover around 65%. Some of the European governments are trying to borrow more than that ratio, and it's being denied to them. Reinhart and Rogoff call that the "bang point." When that happens, your spending levels then have to fall back to your tax revenues. That's where we're headed unless we correct the problem. It's obviously going to get greater, because we have built-in guaranteed increases in our obligations under Social Security and Medicare.
In the last three years, federal outlays have averaged 25% of GDP, which is the highest three-year period since 1943 - '45, when we were in a multi-continent war. What Dr. Eichengreen is saying is that federal outlays are going to go to 40% of GDP within 25 years, without major structural reforms.
The discussion moved into comparing the situation in the U.S. and the rest of the world, particularly Europe and Japan where age demographics and other infrastructure issues show where the U.S. is going to be in a few years if the course is not corrected right now. These issues in Europe are going to run up the value of the dollar and this along with impacts on demand are probably going to cause another U.S. recession.
While there's nothing salutary about the U.S. situation, we're not in as an extreme position as are some of the other major areas of the world, Europe, Japan, the U.K.Can the trend in bonds continue? Will the Treasury rates keep going down? Where is the inflection point and when do we arrive there? The discussion prepares you for those questions.
You're implying that the dollar is like the best house in a lousy neighborhood?
Yes, if you think of foreign currency movements being determined like a beauty contest, if you've got 10 ugly contestants, the least ugly wins. This tends to support the value of the dollar for no meritorious reason; it's simply comparative valuation.
True, and not terribly good news for U.S. companies trying to compete on a global basis.
No, especially not because this recovery such as it is since the middle part of '09, has been heavily influenced by exports.
The percentage of GDP growth attributable of late to exports is really eye-popping.
It is. While exports have been growing at 10% per annum, consumer spending has been growing at only 2% per annum.
That's positively un-American!
Export growth has been just under 50% of the cumulative gain in GDP. It really has been the driving force. But now, income is trending down overseas. And, in international trade flows, income is four or five times more powerful than price effects. So the spreading recessions in Europe and Japan and elsewhere are going to knock down the demand for our exports and the fact that the dollar is rising serves to worsen that trend.
Like Keynes, Fisher was a big investor and, of course, he was wiped out by the events of the late 1920s, early 1930s. But he later made that statement that the extreme over-indebtedness controls all or nearly all other economic variables. It appears to control the risk premium, too, as that table [above] I sent you shows. We've now had three 20-year periods: 1874 to 1894, 1928 to 1948, and the last 20 years, in which the risk premium stayed negative. I didn't have the final official numbers to include last year's Q4, but it doesn't change the picture, I'm pretty sure.
So you're saying investors get risk-averse in severe downturns?What needs to be done? Political leaders do not want to prepare the public for what needs to happen. Why? They learned from Jimmy Carter that honesty is not what the American public wants. They want a Reagan who can tell them what they want to hear.
My point is that we know that, over the long run, you have to have a positive risk premium, stocks have to outperform bonds, because investors must be rewarded for holding riskier assets. But after the extreme buildup of debt in the 1860s and the early 1870s, risk-taking was not rewarded. After the extreme buildup of debt in the 1920s, for 20 years risk-taking was not rewarded. And for the last 20 years, it hasn't been rewarded either. So my table may be instructive. We don't know, because we don't have a lot of experience, but if Fisher is correct, and if we try to solve our current problems by getting deeper in debt, then what Fisher is saying is the additional indebtedness doesn't make us stronger, doesn't increase our options. It makes us weaker, reduces our options. So risk-taking may not be rewarded going forward. This is where we're hamstrung by our lack of sufficient data to evaluate. But what data we have suggests that if we proceed along the path of over-indebtedness, risk-taking will not be rewarded because the economy is going to perform very poorly.
Certainly not if you listen to what we've heard so far in terms of campaign rhetoric.Will China save the day? Not very likely according to Dr. Hunt.
Part of the problem is that these are serious matters and to solve them, it's going to require a lot of sacrifice by a lot of people. That's why I really like that Eichengreen quote. The thing is, no one wants to have austerity. We all enjoy the good life. We don't want to have to raise taxes; that's unpleasant. We're going to have to change the benefits tables for Social Security and Medicare. We're going to have to cut discretionary spending ó even though it has already been cut substantially. Right now, the four main components of the federal budget are Social Security, Medicare, Defense and interest payments on the debt. By the end of this decade, if market rates are unchanged.
Suppose one of Europe's Hail Mary passes actually miraculously works, and the Chinese decide to lend them a ton of dough?Where does this leave us now and what is the forecast then?
I'm not an expert on China. But I did spend some time there earlier in my career, and I don't think the situation is that stable. I sent you a quote from the book, "Red Capitalism" by Carl Walter and Fraser Howie. Carl Walter is a pretty serious observer, Stanford Ph.D., has lived in Beijing for about 20 years, speaks Mandarin. His basic point is that the government has forced the banks, which they control, to make loans to the provincial governments for all of these expansion projects. There's now a great deal of excess capacity and the projects are not generating sufficient cash flow to service the high levels of debt that the banks have extended. We're reaching the point at which the banks will have to be recapitalized. We had an episode of that in the late '90s when the Chinese banks needed to be recapitalized and the government had to shift expenditures into bank recapitalization. That caused the Asian economic crisis. Now there's some evidence to suggest that China will have to recapitalize the banks again and when it does that, it will produce economic weakness in China that will reverberate around the world. So the Chinese may be more of a problem than a solution.
I suppose all this means you expect a recession this year?It has seemed the long-term Treasury rate could not go lower and could not be sustained at these levels. Maybe there is a real case that taking a longer term view that rates are not that low. It is just our perception from a limited time frame.
Well, consumer spending will slow this year very dramatically from a very weak base. We had a decline in real disposable income in 2011. GDP rose, but GDP measures spending, not prosperity. In 2011, as is often the case, when inflation rises, households initially try to maintain their standard of living.
Turning back to interest rates. Why do you suppose real rates have gravitated to 2% for so long?For the average investor it seems prudent to hold some long-term Treasuries in spite of the fact we have all been hearing to avoid them. The contrarian wins again!
I suspect, and I don't know this, but I suspect it's because that may be the very long-term average increase in productivity or real income. I've tried to verify that, but it's only a guess. Excellent question. It may be that the factors of production in the long run earn about the same, but I don't know. We do know that productivity is in that range, over a very long period. Whether they exactly equilibrate or not, I don't know. But they seem to be pretty similar over the long haul. They're certainly not similar over the short run. I don't want to give anyone that impression.
So what will it take to make you shorten maturities?
That's a very great question. We need to see a fundamentally different policy response. There are things that could be done in the realm of fiscal policy to change the outcome, if we were to use our knowledge correctly. Now, before I describe what we could do, let me say that it's hard to visualize how this could happen right now, but maybe that could change going forward. So what do we know? Well, No. 1, we know that the government expenditure multiplier is, at best, zero and maybe slightly negative. By that I mean if we increase deficit spending, although you can get a transitory boost in GDP for a few quarters, at the end of 12 quarters, there's no gain in GDP. But you do shrink the private sector, increase the government sector, and you take on a higher level of debt, which makes the economy still weaker. So the deficit spending, if we continue that, that will continue to weaken the economy. If we could reduce the deficit spending although it would reduce economic growth over the short run ó over the long run it would revive the private sector.
Have you adjusted your portfolio positions at all for this year?
Not yet, we still have a very long duration portfolio. If the situation changes, we hope to be able to be flexible enough to react to it and we're prepared to react. But we don't think that situation is immediately at hand, though nothing can be taken for granted.
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What are you doing in your portfolio? It seemed to me that with everyone piling into bonds over the last few years that we had reached the point where it would turn. With stocks in a rally the last year many people thought we had reached that point. If the situation in Europe does worsen as it seems there is no other possible result, then long-term Treasuries could be golden.