24 September 2009

Debt deflation debacle ~ Dr Lacy Hunt, of Hoisington Investment Management

Steve Keen has support here...

Isabelle Oderberg: How did we get ourselves into debt deflation?

LH: Well it's been a long time in the making. The debt to GDP ratio took out the highs of the 1930s and 2003. At that point in time total debt was just a little bit more than $3 of debt for every dollar of GDP. Today it is just under $3.60 of debt for every dollar of GDP and we are going to see that ratio move higher, in part because normal GDP in the United States is now falling and the difficulty of repaying this debt is going to be very difficult, because the loans are denominated in dollars and the assets that were borrowed against are dropping in value. The income generating capacity of these assets are also dropping and the US economy is in something called a debt deflation. A very rare situation. It only occurs every 3 to 8 or 9 decades. The last time that we experienced it was the 1930s in the United States. We experienced it in the 1870s and 1880s and Japan experienced a debt deflation post 1988 but it has happened historically. It is very rare and the two main things that identify it are setting a new peak in the debt to GDP ratio and also a lot of borrowing that is improperly financed and where there is little likelihood that the borrower can repay the principal and the interest of the loan.

IO: What scenario are we going to see now?

LH: These debt deflationary periods tend to last. They're very pernicious, they're very persistent and they tend to last a long time. Really, the only thing that brought the United States out of the post 1929 debt deflation was our participation in World War II. The debt deflation that ensued after the panic of 1873 lasted another 20 to 23 years and the Japanese, they had debt deflation which started 1989 and is still running for all practical purposes today. They last for a very long time.

IO: According to your quarterly review and outlook, we're now essentially in a 15-year process. Does that mean that it's going to take 15 to 20 years for this situation to actually stabilise or normalise?

LH: Well, there are other intervening events that could occur. If we would have very significant technological breakthroughs that might shorten the process, but one of the things that suggest it's long running is you can look at what happened to interest rates and stock prices after these prior debt manias. Post-1928 you had a negative risk premium for 20 years. Negative risk premium meaning the total return on treasury bonds exceeded the total return on the S&P 500. Post-1872 you had another 20 year period of a negative risk premium and we've seen a negative risk premium post-1988 in Japan. The low in interest rates after those previous debt bubbles occurred about 14 or 15 years later, for example the low post 1928 occurred in 1941 on the yearly average basis at 1.95 per cent. Once we went into World War II, then there were some very minuscule increases 20 years after 1928 interest rates were up slightly, but not very much from the lows that were reached in 1941 and that was also a characteristic of the Japanese situation and our situation in the US post 1872.

IO: So if we're in any way mirroring the '31 to '33 situation, is the S&P at risk currently of a bear market rally?

LH: Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.

When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.

After the experience of the 1930s the savings rate in the United States rose irregularly into the early 1980s and it's been in a decline since then irregularly to extremely low levels, virtually the same low levels that we reached in the 1930s and if history is a guide and there are not many data points we're now beginning to see an upturn in the saving rates that will last for a very long time.

IO: You said that this could be a 15 to 20 year process unless there are technological breakthroughs. I was just wondering if you could give me some examples of breakthroughs that might occur and whether you're referring to any form of government intervention that might help ease the situation.

LH: Well, I don't believe that government intervention, particularly of the type that we're taking. is going to be helpful. In fact the government intervention may be hurting the situation.

IO: Are you referring to stimulus packages in their current form...

LH: A stimulus package in its current form? I don't even think the word 'stimulus' should be used. It's a grab bag of various political promises. The most recent academic research that I have seen, published in 2008, indicates that the multiplier on government expenditure is just close to zero. If the government spends an additional dollar it has to fund that dollar either by raising taxes on the private sector or borrowing funds in the capital markets that would have gone to the private sector. Government spending, the government sector in the US, the productivity is at best zero and perhaps slightly negative, so when we enlarge the government sector and shrink the private sector we reduce the growth, potentiality, of the US economy. We shrink the pie and we make things worse off.

The very extensive efforts that government spending by the Roosevelt administration in the 1930s really produced no meaningfully positive results. In April of 1939 as the rest of the world was going to war our unemployment rate was still above 20 per cent. The Japanese ran deficits of 10, 12, 14 per cent of GDP. They've had nothing more than a few interim cyclical recoveries in the past 20 years. We had a very long difficult process after we unwound the extreme amount of debt that was taken, that was built up during the railroad bubble of the 1860s and 1870s. Government spending in this matter in fact may make the situation worse.

Let me just give you another point here. Last year the treasury borrowed about $170 odd billion to mail out rebate cheques and a few other short-term stimulus packages. Conclusive economic research indicates that people did not really spend transitory income to any significant degree. And they did not in this case. In fact, they even spent less of these rebates than they did the Bush rebates of 2001. So we borrowed the money and deprived the private sector of the capital. The recessionary momentum rolled along and now we have another $170 odd billion of debt on our books which we're paying interest for. There is one thing that would help on the government side, but I doubt that politically it can be done. Christine Rohmer, who is the incoming chair of the Council of Economic Advisors, in her academic work has found that every one dollar reduction in the marginal tax rates will raise GDP by $3 after three years. The problem is that that takes time, because in the interim you have to still borrow the money. The treasury does not have the funds in its checking account, but we're not going the route of either reductions in the personal or the corporate tax rate and so we're actually engaging in spending activities that have a zero multiplier and are very unlikely to change the economic dynamic going forward.

IO: So essentially there's nothing that the government can do in this situation to assist?

LH: Well, I think that one of the things that might have helped would have been an alternative approach to the so called TARP [Troubled Asset Relief Program] bail out bill. There are two ways that we could have gone here, but there was no hearings held. It was just decided that that was the only way that we could go and so the treasury borrowed funds, used its borrowing capacity to try to prop up the entities.

The alternative, which the Japanese would have done and the better way to go, is to use the treasury borrowing capacity to protect the depositors and the customers of the banks and the insurance companies and perhaps extend unemployment benefits for their employees that are laid off. Zombie-like institutions intact with wholesale federal dollars, borrowed federal dollars – those institutions are really not able to grow or contribute to the economy. If instead we had protected the savers and the depositors, then institutions would have failed, but the healthy banks and insurance companies would have taken over the business of the institutions that made the mistakes and then we would have a growth trajectory going forward. So it's quite possible that the actions that we've taken and cost hundred of billions dollars, hundreds of billions of dollars have actually not helped the situation and may have had severe unintended negative consequences.

IO: You mentioned that there were no hearings for the TARP and I'm sure if we had a government spokesman on the call he or she would say 'well, we had to act quickly, we couldn't afford to hold a series of hearings and whatever', but I don't quite understand how they managed to get it quite so wrong if they had so many people telling them not to do this – very few people I've spoken to support the TARP.

LH: Well the public is hurting. The politicians feel the pain of the public sector. They want to be seen as responding to the pain and there is an overwhelming feel that they have to do something to help the public so we rushed through the rebate bill last year, the recessionary momentum moved on. It had no effect but that begs the whole issue of whether you should do something and if so if you do something is it the right measure or is it the wrong measure or does it have unintended negative consequences and I believe that we're taking the wrong steps.

Take for example one of the big things in the so called 'stimulus bill' is to increase spending for roads, highways and bridges. Last year we sent about $75 billion on such matters out of an economy of $14.5 trillion. An infinitesimally small component. If we were to double the component, the $75 billion spending it would still be an infinitesimally small component, but we couldn't double it overnight because you need architectural studies, engineering studies, you have to get environmental approval, you have to buy right of way, you have to satisfy community groups and in final analysis, road building is not a labour intensive function, it’s a capital intensive process. The folks that have been laid off in management and insurance and real estate and our young college graduates, they don't want to go and work alongside the road and there's not many of those jobs anywhere.

This is not the 1920s or 30s or even the 50s where there were thousands an thousands of people working alongside the road building the interstate highway system. This is a capital intensive process. It's not going to provide the jobs that are basically needed for the economy so here in this particular case we do get better roads and bridges which we need and which is a good thing in its own right, but it is not a stimulus package. In the case of construction of the green power plants, last year we spent less than $10 billion. If you double that which you couldn't do quickly it's still an infinitesimal part of the economy and it's also a capital intensive type activity and it would not provide jobs that people need.

IO: What specific things do you think the US government should be doing to try to create jobs?

LH: Well, you have to do things that change behaviour and the only thing that I know that changes behaviour is to reduce the marginal tax rates for individuals and also for corporations. Even this would not work quickly because of the deficit financing problem over the near term, but if you have a permanent reduction in the tax rates you raise the after tax rates of return and over time you will get definite multiplier benefits. As I mentioned earlier, the incoming chair of the Council of Economic Advisors has found that ever $1 reduction in the marginal tax rates will increase the GDP of total spending by $3. That's a multiplier of 3 to 1. In the case of government spending, the multiplier is zero. There's no net benefit for going along the expenditure route. So in the haste to do something and to show the public that they care about their plight, the politicians are doing something but in fact they're doing the wrong thing.

IO: Do you think with the shift in the way that unemployment figures are measured in the US, do you think that the situation is worse than it appears with unemployment?

LH: I think that there is a lot of unemployment. There's not just the standard headline unemployment rate, but we have the unemployment rate that takes into consideration people that are looking and can only find part time work, far less than the want, including people that have quit looking over the last year . But going back a number of years back to the Clinton Administration we used to have a U7 unemployment rate that took into account people that had quit looking because they couldn't find work in the last five years. I think if you were to use that old, expanded, non-official definition of unemployment you might find that it's probably as high as 17 or 18 per cent. The U6 rate which is published by the Bureau of Labor Statistics is currently showing about an unemployment rate of about 13.6 per cent, double the official or headline number.

IO: Specifically on lending and borrowing, you said there is a pattern of consumers are starting to move towards saving more and living perhaps within their means. In your note you say lending and borrowing is pretty much suspended. No one's lending, no one's borrowing. Is there anything the government, Geithner or anyone else can do to try and invigorate that situation? Interest rates are about as low as they can go.

LH: The great American economist Irving Fisher who did the pioneering work in debt deflation. Milton Friedman the Nobel Laureate called Irving Fisher the greatest' economist that America ever produced'. One of the Fisher's great competitors during his lifetime was Joseph Schumpeter [an Austrian economist] who taught at Harvard. Fisher was at Yale. Schumpeter said Fisher was the brightest man that he ever met.

Fisher, who did the seminal work in debt deflation, lays out the case that once you have in a period of extreme over indebtedness and a price disturbance began, the price level or the value of the assets falls and the income generating capacity of the assets falls, that it controls all or nearly all other economic variables. That's a contrary view to what Milton Friedman said. Friedman contended that if the Fed had prevented the decline in the money supply during the Great Depression the velocity of money which is outside the Feds control would have stabilised. So would have nominal GDP and the Depression would have [been avoided]. Fisher takes a different view.

Once we've got the extreme over indebtedness, really there's nothing that we can do and one of the problems is that the velocity of money is likely to fall very sharply and although the Fed has managed to increase the money supply, velocity has dropped even more sharply and that's why nominal GDP is falling so at least in the early stages of this difference of opinion between Friedman and Fisher, Fisher appears to be correct.

IO: There's no intervention that the Fed or anyone else could do to stop that process from evolving?

LH: Well I think the Fed is doing all that it can. If you read Ben Bernanke's essays on the Great Depression it's clear that he believes that the Friedman view is correct and he is pulling out all the stops to try to contain these deflationary forces but there is a credible expert in the field that made the point that it was quite possibly at the situation that nothing meaningfully can be done other than time to correct the problem. I know no one wants to hear that but that in fact may be the situation.

IO: In terms of S&P going forward, there could be a series of false starts or bear rallies, but is that how you see the market unfolding? Can you give a little insight into your outlook for the market going forward?

LH: I don't have a short-term view but I think if you look at the 20 years, post-1929 in the US, 1928 in the US, 1988 in Japan and post-1872 in the US, for those 20-year periods, you had a situation where the total return on treasury bonds, which was in the single digits leading into low single digits, exceeded the total return on equities and the total return, not only the income or the dividend, plus or minus whatever the change was in the capital value. And I think that we may be facing a situation similar to that as this process unfolds and although it cannot be said definitively, I think that there is a risk that the diversified portfolio model may not work in debt deflations.

Debt deflations, although they're very rare, if you study them you will see that they turned the world upside down as we know it. And another difficulty with these debt deflations is that no one that's alive today has in their own personal data bank, their personal history of experiences the prior experiences because they didn't live through them. It occurred before they were born. If they were alive during those time periods they were very small children. They may have learnt something either from parents or grandparents or so forth but it is very difficult for people of experience and practicality to understand what is gripping the situation when they have not ever lived it and that's one of the great difficulties for the US today and I suspect for the world as well.

IO: There have been some downgrades to the sovereign debt of some nations and some are predicting there will be more, especially the European countries that have very large current account deficits. Do you think that there will be likely further downgrades to sovereign debt and whether we will start to see defaults?

IO: Well I think that one of the difficulties for the entire world is that it's been very dependent upon sales of goods and sending their production to the US consumer. The main determinants of consumer spending in the US are income and wealth. We have experienced a wealth loss of approximately $11 trillion in the household sector through the end of last year. We don't know the final numbers but it's in that vicinity. The Federal Reserve's econometric model indicates that every $1 wealth loss will lower consumer spending 7.5 cents over three years.

Using that formula, the drain on consumer spending from the wealth loss alone is about 3.4 per cent per annum this year and 3.4 per cent per annum in 2010 and 3.4 per cent in 2011. And that's a larger drag than the average rise in consumer spending of about 2.9 per cent over the past two decades. The wealth loss will have a very material impact. The wealth loss is now being reinforced by an income loss. The income loss is stemming from massive lay offs and increases in unemployment and reductions in employment and those two forces are causing imports into the United States to fall.

As we buy less from the rest of the world it means there's less income and production overseas. One of the benefits is that the US trade deficit, which was 6 per cent of GDP has declined or improved to 3 per cent of GDP and as the further wealth and income effects depress discretionary spending it's quite possible that the US trade deficit may be eliminated in the next three or four years, which means that we'll continue spreading weakness to the rest of the world and it raises the risk of financial difficulties around the globe.


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