[Lacy Hunt gave a controversial presentation at our recent Summit, making a case for investing in government bonds. You can hear it, along with presentations from Doug Casey, former Director of the US Office of Management and Budget David Stockman, and 28 other financial experts, on the Summit Audio Collection.]
Interviewed by Alex Daley, Editor, Casey Extraordinary Technology
Alex Daley: Hello, I'm Alex Daley, and welcome to this edition of Conversations with Casey. Today we have with us Lacy Hunt, executive vice president of Hoisington Asset Management, one of the nation's top bond firms.
Lacy Hunt: Alex, great to be with you.
Alex: So, Lacy, what do you see as the major roadblocks to recovery in America?
Lacy: The main problem is that the country is excessively indebted. We have got too much debt – public and private – relative to GDP, and an increasing portion of this debt is unproductive or even counterproductive, which means that we are not going to be able to generate income in the future to service the debt.
It's already affecting us quite dramatically. In the last fifteen years, debt-to-GDP ratio has risen from roughly 250-260% to a hundred points higher, 360 today, and our standard of living is no higher. By "standard of living" I mean the median household income. It's really a tragic situation. We've taken on the debt, it's bought some gains in GDP, but it has not improved the welfare of the majority of our people.
Alex: Hasn't the United States been here before? Haven't we seen periods where we have had excessive government debt, say in the 1800s or the early part of the 20th century, and we've managed to climb out of that quite successfully and come out ahead?
Lacy: Yes, this is really the fourth episode of extreme indebtedness. Now to my way of thinking, I am looking at public and private debt, so when I have a debt-to-GDP ratio, I am talking about $55 trillion of debt. Part of that's in the government, part's in the private sector. This is the fourth episode. They have occurred at very long, irregular intervals. That's one of the difficulties, that the people weren't alive at the time of the prior ones.
The first occurred in the 1820s and the 1830s, when we were building the canals, the turnpikes, steamship lines. Initially, there were some good uses there, but then it was overdone and then credit was used to finance living beyond our means. The panic was 1838. The bubble burst, speculative prices collapsed in real estate, and a whole host of other things. The economy experienced a very difficult time all the way to the American Civil War, but we eventually saved, paid down the debt, and were able to recover.
The next major episode was in the 1860s, which was the building of the railroads. Initially, good purpose, we built what was known as the central route. Then we built northern and southern routes, and a whole host of feeder lines. Real-estate speculation occurred… other types of assets, stock market speculation, lavish consumption, living beyond our means. All of the railroads failed except one, and it was the one that was not financed by the government. Government involvement was very great. In other words, that government created the incentives, but the private sector bet on the incentives, was one of the characteristics.
Alex: So you're saying that in the previous two debt bubbles that we talked about, what we saw was effectively government-manipulated incentives which drove overinvestment in a particular area?
Lacy: That's correct, and overconsumption, and overspeculation. Charles Kindleberger, in his great book Manias, Panics, and Crashes, called it "overtrading." In other words, people do things beyond their fundamentals, and for a time it is very enjoyable. Incomes are rising, prices are rising, people are being employed, but the process can go too far; and then Kindleberger said that you eventually move into what is called "discredit." Discredit is when a certain discerning minority starts pulling their money out. And then discredit leads to revulsion, when the general population realizes that there are a lot of core problems and they try to pull out, and then you have your crash.
The crash years were 1838, then 1873 – then the 1920s. Here again, the incentive for the overspeculation was really the excessive liquidity of the Federal Reserve. The Federal Reserve did a very bad job. Now they were newly established at that time, had just come into existence in 1913. Interestingly, there were some Federal Reserve officials that were aware that the problem was out of control, but they were drowned out, because everybody was having too much of a good time, and so then we had a very difficult time period. And basically, the US economy didn't recover until we entered World War II.
But the austerity of World War II and the inability to spend your paycheck, which was mainly driven by gains in exports to our allies who were in war-torn situations, pushed the saving rate up to 25%. We repaid the debt, and this laid the foundation for the post-World War II boom. So the 1920s was the third episode, and the fourth episode was the last 20 years.
Again, the incentives came from the government sector, mainly the Federal Reserve, but the federal government played its hand through two government-sponsored corporations – Fanny Mae and Freddy Mac – that allowed the bundling and created the façade that the mortgage was secure regardless of how poor the fundamental characteristics of any individual loan were. Of course, that was a false notion, and so we have now had another very difficult time period and we are certainly not getting a normal recovery. The standard of living is continuing to fall, in spite of gains in GDP. We have a much more dramatic monetary and fiscal response, but therein lies the problem. We are not achieving a rise in the saving rate, the austerity that's needed.
Alex: Excuse me. You keep going back to the rise in the savings rate. I thought that, and I think the common wisdom is that World War II helped spawn recovery of the economy because of the increase in government spending. The government was out stimulating the economy, building troop transports and tanks and shipping people across the Atlantic Ocean. Wasn't that the cause of the recovery?
Lacy: There have been very substantial econometric studies by first-rate scholars: no. The thing that drove the expansion was really the exports. Robert Barro at Harvard University calculated the multipliers year by year. The largest increase in government spending ever was 1942, and government spending accounted for the largest share of GDP and the largest share of the gain. But when you look at the movements using very precise statistical measuring devices, the multiplier is only 0.6 in 1942, and it falls to 0.4 in 1943. And if you look at the longer time period, using all of the quarterly data up to recent times, Barro has found that the government expenditure multiplier is 0.01, but it has a negative sign in front of it.
When Barro's findings were established, an outstanding European econometrician by the name of Roberto Perotti, who at the time was on leave at the European Central Bank, was funded to do a study. This allowed him to calculate the government multipliers – not only for the United States, in order to determine whether Barro's findings were correct or not – but for five other countries: the UK, Germany, Australia, Canada, and Japan. And what he learned was that the government-expenditure multiplier in all six cases was very close to zero. Not negative, as Barro found – slightly positive, but clearly there was no benefit from it.
And so, here's the rub: if you are overindebted, and you try to cure the indebtedness problem by taking on more debt, you buy some transitory gains, which then makes the economy weaker in due course.
Alex: That's a lot like a family taking on excess debt. If you have ten thousand dollars in credit-card debt, and you decide to solve that by paying those bills with another five thousand in credit-card debt, you can live pretty well in the short term.
Lacy: In the short term. That is exactly right, said much better than I said.
Alex: The historical corollaries here really strike me amazingly. You keep going back to the savings rate and the increase there, and so really it was about America was exporting to the world to help supply the war effort, to help supply the rebuilding efforts around the world, yet we couldn't spend our own money, which sort of –
Lacy: Because of mandatory rationing.
Alex: Yes, it was almost enforced household austerity...
Lacy: That's correct, and our people understood it; and they were glad to do it. They supported the cause. And so when you got your paycheck from your export-driven gains, what people did is they either bought savings bonds or other types of liquid assets or paid down debt and so by, when World War II ended, a lot of the Keynesian economists thought we would go back into a slump. But they didn't understand that the cause for the problem in 1929 was excessive indebtedness, and we'd paid the debt down, so we had a very substantial recovery.
The problem for us night now is that we are not restoring saving rates. This is exactly what Japan has done in the last – since 1989. Their saving rate was 25%. It is now zero. They are trying to continue to live beyond their means. They are not willing to correct the problem, and so if we try to cure the indebtedness with more debt, we buy a little bit of happiness for a short-term period, and then we add to the problems down the road. Bad things will happen.
Alex: Interesting. I think Japan has a lot of lessons for the American government to take away, but where are we today relative to where we were in those other periods of time? How bad is our debt level, relative to, say, the 1930s or the 1860s?
Lacy: We are much higher. I mean, the past high-water mark – we are more than sixty points higher. And if you use the reference point of 1928, which was when the debt buildup was essentially complete, we are more than 100 percentage points higher. We are very indebted.
We are not as indebted today as Japan is. But take gross government debt – there is an alternative series privately held, but I think the gross is more important now – plus private debt. Then get the projections from the IMF – which will not be entirely correct, but they are impartial (they are trying to do a good job) – which have gross government debt rising sharply this year and next year. If you assume that private debt to GDP is stable, which is an optimistic assumption to say the least, the total debt levels rise in 2012 and further in 2013.
Alex: So we're twice as bad off as we were in terms of leverage in the economy as we were in the great crash that brought on the Great Depression.
Lacy: That's correct.
Alex: And we're still increasing that debt at a very rapid rate.
Lacy: That's correct.
Alex: So something has to give.
Lacy: Which suggests that the potential of another panic year is out there. In other words, yes, the 2008 panic year is behind us, but there may be another panic year ahead of us.
Alex: So we have all this potential built up in the United States economy, yet it seems all the attention today is focused on Europe. Why is that?
Lacy: Well, I think that the situation in Europe is even worse. I mean, we have about $55 trillion in debt and we have $15 trillion of GDP or a debt ratio of about 360. In the 17 countries that are in the euro, they have about $68 trillion of dollar-equivalent debt and only $14 trillion of GDP, so Europe is even more heavily indebted. Germany's in good shape, but most of the others are not. Spain, Portugal, Italy, the debt problems there are escalating much more than people are willing to admit, and even in France. And you have an ironic situation – it looks like after the French election, France is going to try more debt to cure its problem. That really won't work. So Europe is on a very unstable course, in my opinion.
Alex: Now, all the governments are taking on more debt, because they are trying to boost liquidity in their economies. Doesn't increased liquidity increase investments, and doesn't increased investment increase productivity and ultimately help us get out of this situation?
Lacy: Unfortunately, no. When the Fed expands its balance sheet or the European Central Bank expands their balance sheet, they inject liquidity into the system, and over the short run it will boost stock prices, it will boost commodity prices.
If you think of, say, a fundamental demand and supply curve – and one of the short-term influences of demand is liquidity – so if the Fed comes in and pumps liquidity into the system, they'll shift the demand curve outward. But once they inject the liquidity into the system, they have no control over it. And what happened in QE2 and also in the stealth easing since December is that more of the liquidity went into sensitive commodities, particularly gasoline. Well, gasoline is important to cost of living.
When the Fed began quantitative easing 2, in 2010, you had a situation where wages were rising two percent and prices were rising one. So at the end of the month, your modest and moderate income households were a little bit better off. The Fed expanded their balance sheet. Commodity prices shot up, and the inflation rate went up to four, but wages stayed at two. So what happened to real income? Real income declined, and the economy fell back.
When the Fed began the stealth easing, which was an expansion of the balance sheet to aid the European Central Bank, wages were still rising at two and inflation was rising at two. It had come back off, because QE2 had ended. Then we saw speculation in commodities. The inflation rate went up to three but wages stayed at two. So in the first quarter, we had a decline in real per-capita disposable income. We had a small gain in GDP, but the standard of living did not improve.
Alex: So the majority of Americans are becoming worse and worse off, progressively, as a result of these policies. These policies aren't necessarily getting us out of these problems, they are not increasing our productive economy. They are just sort of misaligning investments again. So what is the theory, why do Bernanke and the president continue to go after these? It didn't work in Japan, yet we're doing it here in the US, and they're doing it in Europe. What's the theory behind this, and why do they believe it will still work?
Lacy: Well, I'm afraid the theory is very flawed. I mean, the classical economists were of the view that what creates prosperity is the hard work, creativity, and ingenuity of our people, and there has been a prevalent view in the US and Europe for a long time that you can create prosperity through financial transactions. And I am afraid that that's simply not correct. We have to do it the old-fashioned way, and if we use our borrowing capacity and channel it into more and more unproductive uses, then we are not going to get gains in output per hour, which are essential to rising real wages.
Rising productivity, rising real wages are the key to an increasing standard of living. These types of policies, like the Federal Reserve's quantitative-easing operations, they do benefit some people. The stock market has recovered. There have been increases in wealth for some; but unfortunately, these types of policies have exacerbated what economists call the income or wealth divide. The majority of our people, their main resource is what they earn from their daily labor, and that's not generating a return, so we're skewing the distribution of income between those that are extremely well off and the majority of our people. The basic policies are, in my opinion, very hurtful, and counterproductive.
Alex: So President Obama went out in election mode and said he was all for a transfer of wealth between classes. But it seems that his policies have actually been transferring the wealth from the average individual to the wealthiest Americans.
Lacy: He has.
Alex: That's an ironic conclusion, that he really didn't specify what side.
Lacy: It is an ironic conclusion. He champions the little guy, but the little guy is considerably worse off. His rhetoric, of course, is that he's out to be their protector, but the net result – the decline in real disposable per capita income speaks for itself.
Alex: Now it's easy for us to pick on Obama, because we are feeling the pinch of these problems today. But this is not a uniquely Democrat or Republican, nor an Obama-specific problem.
Lacy: And I don't want to make it sound like that either, because one of the things that concerns me is that the simple solutions proposed by the Democrats and the Republicans are not going to solve the problem. It's going to require a great deal of shared sacrifice, and the Democrats are going to have to be willing to give, and the Republicans are going to have to be willing to give.
And by the way, I aggravate them both when I say what I am about to say: We are going to have to reform Social Security and Medicare.
We made promises that we cannot keep. If we can't do that, then we're not going to be able to get our house in order, because federal outlays without changes there – which are now 25% of GDP – are going to jump to 40% in just 25 years, which would mean we would have to transfer 15% of our GDP from our working households to our retired households. Well, that's not going to happen. Or we are going to have to borrow the money – and we can't borrow the money. So the process is going to come to an end. The debt levels are so high and the magnitude of the problem is so great that there are also going to have to be tax increases.
Now, here we have two options. There is a very harmful type of tax increase, and then there is a considerably less harmful type of tax increase.
On the tax side, we have marginal tax rates, and then we have what are called tax expenditures or "loopholes." Now, when you raise the marginal tax rates, you really hurt the economy. In fact, the studies show that if you raise the marginal tax rates by a dollar, you lower GDP between two and three dollars. You create a downward spiral. But we need shared sacrifice. In other words, we can't do it all on the spending side – the problem is too great. But what we could do is eliminate the loopholes.
My feeling is that the multiplier on the loopholes is only about -0.5, and my main evidence for that is what happened in 1986. We had a revenue-neutral tax bill, result of the ingenuity of a Republican president and a Democratic senator from New Jersey, Bill Bradley. And what they did did not increase the deficit; they lowered the marginal tax rates, and they eliminated loopholes. And 10 years later the economy accelerated substantially. So what my solution would be is to reform Social Security and Medicare. If we can't do that, we might as well just trot along down the road until disaster hits.
So that we can move forward, there has to be shared sacrifice. You try to hold the marginal tax rates where they are and eliminate the loopholes. You know, we have about 3,300-3,400 loopholes and they benefit individual groups. They're powerful in Washington. They protect themselves, but they are not benefitting the overall economy. And we are going to have to do one more thing – and I wish I did not have to say this, but I'm just trying to be realistic when I look at it. We are going to have to have some degree of a consumption-based tax, I would say probably only 4% or 5%, but that is preferable to raising the marginal tax rates.
Thomas Jefferson and the other founders of our republic were very heavily influenced by a man by the name of Thomas Hobbes, a great 17th-century thinker. He wrote a book calledLeviathan, and he made a very valid point. He said that income measures what you contribute to society, and spending measures what you take from society. So your taxes, really – you don't want to tax what people are contributing, you want to tax what they're taking. So we're going to have to make wholesale changes, and it's going to require shared sacrifice on a lot of people's part, and it's going to require a bending of the simple but incorrect assumptions on both the Democrat and the Republican sides.
We're going to have to reform Social Security and Medicare. We're going to have to eliminate loopholes – which would be a shared sacrifice for the taxpayer – hold the marginal tax rates, and have some modest consumption-based tax. Other than that we can't solve the problem. Now, what I've just described is a very tall order, and it may well be that we don't have the political will.
Alex: I think a lot of Americans would agree that it seems neither party is going to step up to the plate and really talk about this…
Lacy: In that case what we do is we move along the road until we hit what Ken Rogoff and Carmen Reinhart called the "bang point." I don't think that that's immediately at hand, but the bang point occurs at the point in time in which governments are no longer able to borrow funds. In other words, the marketplace concludes that the current level of debt cannot be repaid, so they're not going to lend them any more. Bang points are very disruptive, socially disruptive. We're seeing that in Europe. In the first six months in the current fiscal year, our federal government had 58 cents of tax revenues and 42 cents of borrowing. Well, think what would be the consequence if the federal government had to fall back to its revenue base.
Alex: That means a 42% drop in federal spending.
Lacy: That's right.
Alex: Aren't we talking there about massive unemployment, a large number of people losing their jobs, and big federal government cuts in benefits?
Lacy: Absolutely. And what has happened in Greece, what's happening in Spain, Italy? There's social unrest. So the real risk here is that because the magnitude of the problem is so great – and increasing – that we move along toward the bang point.
