Recovery Via Shared Sacrifice: Lacy Hunt
Source: Karen Roche of
The Gold Report
If the people and politicians of the U.S. can't muster the
will to reform Social Security and Medicare, the country will
slide on down toward what internationally renowned economist Lacy
Hunt calls the "bang point." What we'd face on the other side
would be bad news indeed. But in this exclusive interview with
The Gold Report
Hunt goes on to list a few steps to turn the tide on economic
growth. The route won't be an easy one but it would address the
debt and begin to improve living standards.
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?
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.
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?
The debt problem is complex. U.S. debt is about 360% of the Gross
Domestic Product (
), public and private-too much relative to GDP. We have about $55
) 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.
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
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 (
)-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
) 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.
You've also written about a "
" that occurs when credit to government and private borrowers is
cut off because the marketplace has no confidence the debts will
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.
Does Congress have the will to make the necessary changes?
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.
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.
How long will it take for the U.S. to get to the bang point?
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.
Is there a typical tipping point?
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.
It also gets to your point of the makeup of the debt.
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%.
But that means we have a long way to go.
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.
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?
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
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
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
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
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
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.
Exactly how does a country's role in world markets come into play
when it comes to devaluing currencies?
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
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.
The result was forced savings.
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.
But that history doesn't appear likely to repeat itself.
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.
What if the European Central Bank (ECB) decided to devalue the
euro? Would it just be the first domino to fall?
Yes. It would start another race to the bottom.
What would happen to investments?
Investment values would decline. It would be chaos.
We'd only have bonds in the secondary market at that point.
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
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.
So if there is no willingness to save, will the endgame be either
that bang point or QE?
I think it will be the bang point, but it's hard to say.
If they go with the bang point, forced austerity would
reverberate through other countries that export to Europe.
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
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
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
The great philosopher who had a huge impact on Thomas
Jefferson and the other founding fathers was Thomas Hobbes. He
wrote a book called
, 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.
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
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.
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
For more of Hunt's insights in HIMCO's Quarterly Reviews,
click on "Economic Overview" at Hoisington Management's
Hunt was a speaker at the May 2-4 Strategic Investment
Conference sponsored by
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