The Gold Report: In January, the Federal Reserve's extension of a near-zero rate interest policy to the end of 2014 stunned a good many investors. Unless the Fed changes its mind again, that will mean six years of artificially low rates. You've indicated that interest rates have nothing to do with the Fed and that they're really governed by the velocity of money and the health of the economy. Would you elaborate on that?
Lacy Hunt: To clarify, the Fed can control the short-term rates, but the long-term rates are in the hands of the marketplace. The Fed's influence there is very minuscule. Some may think the Fed has produced the low interest rates today and a long yield market. I don't think its influence has been that important. It is a reflection of the economy's poor performance.
The U.S. didn't have a Federal Reserve and the country was on the gold standard when it experienced a tremendous debt build-up in the 1860s and 1870s. Brought on by building the railroads and the industries that fed into them, the debt build-up badly damaged the economy. Economic activity languished. The panic year, 1873, launched a long, difficult period of economic adjustment. For 15 years in the late 19th century and the early part of the 20th century, long-term Treasuries were around 2%—without any type of central bank intervention.
Fast-forward to the 1920s and another huge build-up of debt. By then, the Federal Reserve existed. Indeed, Fed policies encouraged and facilitated this surge in debt. The debt bubble burst in the panic year of 1929. The Fed did some things—not as well as people wanted—to try to bring interest rates down. Its efforts certainly were not consistent; there was intermittent tightening during the period. But in 1941, when the U.S. entered World War II, the long-term Treasury yield was at 2% and trending lower. In other words, very low rates occurred in the aftermath of a huge period of over-indebtedness. Thus, there are two examples of extreme over-indebtedness, one with and one without central banks. But in both cases, long-term interest rates fell to very low rates and stayed there for a long time.
TGR: One of the core points you make is that the quality of debt determines the velocity of money. If the debt is productive, the velocity increases. At this time, the velocity of money is moving in the other direction. What's wrong with our debt?
LH: The debt problem is complex. U.S. debt is about 360% of the Gross Domestic Product (GDP), public and private—too much relative to GDP. We have about $55 trillion (T) in debt and only $15T of GDP. The debt-to-GDP ratio is more than 100 points higher than in 1997–1998, yet our standard of living is unchanged. A key problem is that the composition of the debt has deteriorated. A greater proportion now supports daily consumption, either directly by consumer borrowing or indirectly via the Fed. Such loans won't generate future income. The debt is unproductive or even counterproductive, and the more it grows, the more it diminishes our ability to service the debt. As long as we proceed along this course, the velocity of money will continue to decline.
It's a very interesting question you raise. Just within the last couple of years, velocity has fallen below the post-1900 mean of 1.68. In the first quarter, velocity fell to 1.58—a very significant deviation from the mean and about the lowest level in 50 years. The decline in velocity confirms that the quality of the debt is deteriorating.
There is another way to observe the deterioration. We need increases in productive lending to generate increases in output per hour, which in turn is necessary to generate increases in income. Prosperity is measured by income, not GDP. GDP only measures spending, and although we've had some GDP expansion, disposable income per capita has basically been close to zero for most of the last two years. The spending only supports daily consumption; it won't generate the productivity needed to raise our standard of living.
TGR: But isn't productivity being driven by the fact that companies are making money through development of high-tech products that consumers are buying? Aren't the free cash flow and the growing sums of cash these companies have on their balance sheets driving the economy?
LH: Individual firms are making good use of loans. As you suggest, there's investment in the high-tech sector, for instance, and substantial resources are going into developing shale and certain types of new oil products. But these investments amount to no more than $200 billion (B)—with a federal budget deficit at $1.3T and rising. So while some creative and productive things are going on, the bulk of our debt is going to counterproductive uses and we aren't going to be able to service this rising debt. We don't know what the outcome of the Affordable Care Act will be, but the Congressional Budget Office (CBO) says it will cost $200B a year. One of the Medicare Trust Fund trustees claims CBO's calculations are low; that it will cost at least $360B and maybe as much as $540B.
TGR: You've also written about a "bang point" that occurs when credit to government and private borrowers is cut off because the marketplace has no confidence the debts will be repaid.
LH: That's what's happening in some European countries today. In the U.S., during the first six months of the fiscal year that started in October 2011, for every dollar the federal government spent, $0.58 came from tax revenues and $0.42 was borrowed. Some of the weaker European countries, in the southern tier, have the reverse situation. They're trying to borrow 65%, 70%, 75% and an even higher percentage of the euros they spend, and the marketplace has no confidence that they can repay their previous loans. They've managed to put together interim financings to patch the system together, but basically the marketplace is no longer willing to lend and some of these governments are very close to the point at which they'll be forced to fall back on their revenue bases alone.
The U.S. has not reached the bang point, but covering 100% of its expenditures from the revenue base—instead of the 58% it is now—would create very destructive conditions. That's the path we'll take if we continue to let the debt rise relative to GDP and without turning it to productive purposes.
TGR: Does Congress have the will to make the necessary changes?
LH: I'd like to think we have the political will to try to tackle the problems, but I'm fearful we do not. Here's the problem. Federal outlays have been running at 25% of GDP for each of the last three years, which is the highest since 1942–1944. Based on existing laws that govern Social Security and Medicare, at that rate federal outlays will account for 40% of GDP in 25 years.
TGR: That's frightening.
LH: Yes, but I personally don't believe it can happen. We'd have to transfer 15% of our resources from working households to retired households, either through tax increases or indirectly through some other means. I cannot see that happening. Unfortunately, there doesn't seem to be any urgency to deal with the problem. Unless that changes, I'm afraid we'll reach the bang point, the markets will take control and we'll have to make the adjustments in some type of crisis situation. It will be much the same as it is now in some of the European countries, which have to make adjustments in the midst of market crisis.
TGR: How long will it take for the U.S. to get to the bang point?
LH: We really don't know. A lot of economic analysis historically has downplayed the role of debt. I've done an exhaustive search of the literature, and never found a model that indicates when you reach the bang point. A host of parameters can play into the situation, but one of the triggering elements concerns the percentage of the revenue base of the governmental entity that must go to interest expense. As the interest expense rises, it absorbs a bigger and bigger portion of the revenue.
TGR: Is there a typical tipping point?
LH: We haven't been able to identify one. There are some indications. Interest expense right now is about 10% of revenues. If you make the heroic assumption that market interest rates hold through 2030—which they won't—the interest expense would be 20% of federal revenues by the end of the decade and 35% by 2030. Right now, the largest components of the federal budget are Social Security, Medicare, defense and interest. By the end of the decade, interest jumps above defense. And that's under the heroic assumption that these market rates hold.
TGR: It also gets to your point of the makeup of the debt.
LH: Totally counterproductive. It doesn't build one bridge or create one innovative idea. It doesn't move you forward. So we're on a path here that historically has not worked. The sum of the problematic areas that occurred historically seemed to be when the interest expense gets above 50%.
TGR: But that means we have a long way to go.
LH: It may occur sooner than we think. If interest rates in the marketplace were to go up 200 basis points, it would add approximately $350B a year to the federal budget deficit. Of course, you'd have to borrow that, and then borrow more and more in succeeding years. So the interest expense is really a potential time bomb. I don't think a rise in long-term rates is at hand, but it's very problematic as we go forward.
TGR: You also write about a negative risk premium—when the total return of the S&P 500 is less than the return on long-term Treasuries and thus equity investors aren't being rewarded for the risks they take. It seems to contradict the concept that we're marching toward this bang point. Will the negative risk premium continue until we reach the bang point?
LH: First of all, let me explain a bit more about the negative risk premium. We know that over very long periods of time investors in stocks have received a premium over investors in long-term Treasuries. If that didn't hold true over the long run, people wouldn't take the risk. But there have been significant exceptions. Following the build-up of debt in the 1860s and 1870s, we had a 20-year span during which the S&P 500 return was lower than long-term Treasury returns. Then, even though World War II interrupted, another period of negative risk premiums lasted from 1928 to 1948. In both instances, 20 years was a long time to wait for risk to be rewarded. Certainly there were quarters, even years, during those spans when the S&P 500 returns were better than the Treasuries, but when you stand back and you look at the entire period, risk was not rewarded.
We've had another massive build-up of debt over the last 20 years, and since 1991 we've been in another negative risk premium cycle. We've past the 20-year point already, and if we continue along the path toward increased indebtedness, we'll extend the negative risk premium interval this time around. I think it will be very difficult for the normal economic conditions to prevail.
A lot of the pioneering work on the role of debt was done by Irving Fisher. He thought the economy operated on a normal business cycle model, one to two bad years, four to five good years. The one to two got a little testy, but it was over and you went on. That's why he was fooled by the Great Depression. He freely admitted he was fooled. He made some outrageous statements about the health of the economy in 1929, but he did his mea culpa, reexamined what he thought and concluded that the normal business cycle doesn't work in highly over-indebted situations. In those situations, the indebtedness controls nearly all other economic variables—including the risk premium. The normal bounds don't work, just as they did not work after the panics of 1873, 1929, and 1989, when risk was not rewarded.
So by trying to solve this over-indebtedness problem by getting further in debt, the standard of living will not rise and, in the final analysis, the stock market will reflect how well our people are doing. And our people are not doing well. Of course, the bang point is a point of calamitous development, but it would mark the climax of a prolonged period of underperformance and financial risk management. It's not at hand. We have the ability to control it, but we have to have the political will to do so. At present, it doesn't appear to be forthcoming.
TGR: You've indicated that the only way for developed nations to get out from under this debt burden is austerity, not inflation or more Quantitative Easing (QE). With the income of average American citizens stagnant, at best, for a decade already, what would spark the political will to force austerity measures on a beleaguered populace?
LH: No one wants austerity. Neither the politicians nor the public want it. The McKinsey Global Institute did an outstanding study of what happens to highly overleveraged countries that get into crisis situations. It found 32 cases that have fully played out, starting with the 1930s. In 16 cases of the 32—or half—austerity was required. Only eight cases were resolved by higher inflation, but they were all very small, emerging economies. A small country with no major role in world markets can get away with debasing its currency, but a major player cannot do that.
TGR: Exactly how does a country's role in world markets come into play when it comes to devaluing currencies?
LH: A major economy that tries to correct debt problems by dropping the value of its currency will bring on immediate retaliation—and a race to the bottom. In today's world, devaluation is not really an option. This isn't new. Starting in the late 1920s, there had been a huge build-up of debt around the world. Some of the heaviest build-up was in resource countries. We were on the gold standard at the time. The Dutch East Indies devalued because it could no longer service its debt and then Australia shortly thereafter. They gained a momentary advantage, but lost it when competitors in Latin America and elsewhere also were forced to devalue.
By 1931, the British devalued. A lot of the countries that had devalued previously devalued more. The U.S. tried to hang on to the gold standard, but between April 1933 and January 1934, the U.S. devalued by 60%. It had been devastated by a loss of export markets, as everyone else had been devaluing. Like the Dutch East Indies and Australia in the late 1920s, the U.S. temporarily regained some benefit, but lost it when France and the gold bloc countries devalued in 1937 and 1938.
Then, when the U.S. entered World War II, a tremendous surge in exports took place. We were able to sell anything American mines, factories and farms could produce. Its citizens were paid for that work, but with mandatory rationing, they couldn't spend the money they were making. They couldn't buy new cars, washing machines and houses.
TGR: The result was forced savings.
LH: People were willing to stand for the austerity because we were in an endeavor they believed was worthwhile. If they needed 10 pounds of sugar and could only get one, they took it. If they needed 20 gallons of gasoline and they could only get five, they stood for it. So they saved their funds. The saving rate went up to 25% for three consecutive years. We paid off the debt. By the end of World War II, the U.S. was a wealthy nation once again, and it fueled the post-war boom.
TGR: But that history doesn't appear likely to repeat itself.
LH: In the current environment, the European countries that are in trouble don't want austerity. France's budget deficit is deteriorating badly, but it's quite possible that it's going to engage in more deficit spending. It's not as bad as in Italy and Spain, but France already has a massive problem.
TGR: What if the European Central Bank (ECB) decided to devalue the euro? Would it just be the first domino to fall?
LH: Yes. It would start another race to the bottom.
TGR: What would happen to investments?
LH: Investment values would decline. It would be chaos.
TGR: We'd only have bonds in the secondary market at that point.
LH: You wouldn't want to be in debt. And you'd want assets you can control and have complete confidence in—assets such as an income-producing property that you're confident of the income stream or if you have an asset that is perfectly acceptable in exchange.
Europe today has not yet really gone to austerity. The ECB policy objective was to try to stimulate a recovery, boost the revenue base and bring their deficits under control. These bridge financings didn't solve the underlying problem. Instead, their economies deteriorated and the deficits worsened.
TGR: So if there is no willingness to save, will the endgame be either that bang point or QE?
LH: I think it will be the bang point, but it's hard to say.
TGR: If they go with the bang point, forced austerity would reverberate through other countries that export to Europe.
LH: There is a pathway out for the U.S., but it requires very intelligent uses of what we know about the multipliers for government expenditures, what we call the tax expenditures or loopholes, the marginal tax rates and general behavior. The U.S. has too much debt now and will have even more. The government expenditure multiplier is very close to zero; it might even be slightly negative. So the U.S. needs to cut down government spending, but is not going to be able to do so unless there's shared sacrifice by taxpayers. The magnitude of the problem is too great.
The U.S. has options on the tax side. It could raise the marginal tax rates or eliminate loopholes. The econometric work indicates that the multiplier on the marginal tax rates is between -2 and -3, meaning that raising the marginal tax rate by $1 would lower GDP by $3 after about three days. In other words, raising the marginal tax rate would be immediately counterproductive.
It appears that the multiplier on the tax loopholes may be only -0.5, a bet that is not nearly as powerful. The evidence for that is what happened in 1986. Bill Bradley, a Democratic Senator from New Jersey, and Ronald Reagan, a Republican president, worked out a revenue-neutral tax bill that brought marginal tax rates down and eliminated the loopholes. Ten years later, the economy progressed very nicely. So the U.S. could cut government spending and get the shared sacrifice on the tax side from the elimination of loopholes. From my standpoint, I would eliminate them all, let the private sector allocate that capital, and hold the marginal tax rates. The preferable thing would be to lower the marginal tax rates and substitute for them some type of small consumption-based tax.
The great philosopher who had a huge impact on Thomas Jefferson and the other founding fathers was Thomas Hobbes. He wrote a book called Leviathan, in which he said that income measures your contribution to society. Spending measures what you take from society. The U.S.' problem is that it has been overspending and has had insufficient income. So it needs to cut government spending. Social Security and Medicare certainly must be reformed. If that cannot be done, I wouldn't even try on the other proposals—just slide on toward the bang point.
But if we could cut government spending, reform Social Security, have sacrifice on the tax side by eliminating the loopholes, reducing the marginal tax rates a little bit and instituting a consumption-based tax, the economy would begin to grow over time. But this requires a lot of political will and leadership, plus some sort of mechanism to explain it and to get the American public on board. Right now, I can't be optimistic. There are some very smart people who have looked at this and basically most of the programs have these elements in them.
TGR: All of the scenarios we've been talking about are multi-years in the future. What should investors be focusing on now? Aside from physical assets that we can control and be confident about, what are the investment opportunities until we get to the bang point?
LH: For the time being, I think Treasuries will continue to perform strongly, but I think we'll see the long Treasury yields go down to 2.5%, possibly even 2% for a while. As I said, we went to 2% on the long Treasuries in the late 19th century and again in 1941. Japan has experienced less than 2% for many years. As long as the U.S. and European debt levels continue rising, we will see the longer Treasury yields continue to work irregularly lower and be very volatile. It's not for the faint of heart.
TGR: Thanks for your insights.
Lacy H. Hunt is executive vice president of Hoisington Investment Management Company (HIMCO), a Texas-based registered investment adviser specializing in the management of fixed-income portfolios for large institutional clients. The firm has more than $4.5 billion under management, with a client base of corporate and public funds, foundations, endowments, Taft-Hartley funds and insurance companies. An internationally known economist, Hunt joined HIMCO in 1996. His background includes roles as chief U.S. economist for the HSBC Group, one of the world's largest banks, executive vice president and chief economist for Fidelity Bank, vice president for monetary economics at Chase Econometrics Associates, Inc. and senior economist for the Federal Reserve Bank of Dallas.
A native of Texas, Hunt earned a Bachelor of Arts degree from the University of the South, a Master of Business Administration from the Wharton School of the University of Pennsylvania, and a doctorate in economics from Temple University. He has authored two books, A Time to Be Rich and Dynamics of Forecasting: Financial Cycles, Theory and Techniques, and numerous articles in leading magazines, periodicals and scholarly journals. He is an honorary life trustee of Temple University and served on the board from 1987–2010.
For more of Hunt's insights in HIMCO's Quarterly Reviews, click on "Economic Overview" at Hoisington Management's website.
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