At the recent Casey Summit in Carlsbad, CA, I had the great pleasure to interview Dr. Lacy Hunt, internationally-known economist, executive vice president of Hoisington Investment Management Company (HIMCO), senior economist for the Federal Reserve Bank of Dallas (yes, that Federal Reserve…), and well-known financial author and speaker.
(HIMCO is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies.)
With great thanks to the team at Casey Research, and with extra-special thanks to their outstanding videographer, Erik Nelson, I sat down with Dr. Hunt and asked him all kinds of questions from an individual investor’s perspective — a rare opportunity as his research is normally reserved for their institutional clients only!
Dr. Hunt is a very, very smart man, and has been one of the few to make the call that interest rates would remain low over the past several years, when many others predicted they simply had to rise. His firm has an outstanding track record, and he is a great historian to boot.
I asked him for his thoughts on the global macroeconomic environment, whether he thinks the U.S. government will default on its debt, how to navigate the current markets as an individual investor, what on earth the “velocity of money” is, and more…his answers were insightful and fascinating, and I hope you enjoy watching (or reading the transcript) as much as I enjoyed our interview!
Please let me know what you think in the comments, and have a fantastic weekend!
And of course, for those of you with limited time or who prefer reading to watching, here is the transcript…
Hello! Thank you for being here today.
Nice to be with you.
You are one of the smartest people I think I have ever met, and you also do a great job of explaining these really complex economic terms in a way that we individual retail investors understand, and I hope you’ll help me do that a little bit today.
Well, thank you, I’ll do my best.
So you just gave a great talk on the debt, and I just wrote an article a week ago on the enormity of the debt. I think people understand it, but I also think that when you’re out walking around and going on about your normal day, you don’t think about how big of a problem it really is.
But I’ve found in my research (with thanks to Tony Robbins and Iowa Hawk), that 1 million seconds ago was 12 days ago, and 1 billion seconds ago was 32 years ago, and 1 trillion seconds ago was 32,000 years ago…back to when man wasn’t even man. It’s really big, and that’s only 1 trillion, and we just reached 16 trillion.
I was wondering if you could tell me a little bit about why this debt is so bad, and why this quantitative easing is not really helping this problem?
Well those are great questions.
The important concept is to relate debt to our GDP. And right now our federal debt is around $16 trillion, and our GDP is less than $16 trillion. So our gross debt-to-GDP ratio is above 102.
And there is a great deal of economic research done in the United States, in Europe, in Sweden, that shows that when the gross government debt rises above 70% to 80% to 90% of GDP that economic activity begins to slow. In other words, bad things happen, there are deleterious effects.
And the basic problem with the debt is that it is not going to be able to generate an income stream to repay the debt.
Debt can be very useful. Debt by itself is not a bad thing. The traditional lending that banks and that small financial institutions do to their customers, who they know, and when the customer has the capability to go out and expand his business and repay the debt, that’s a good thing.
But when debt is taken on and it goes to finance current consumption, then there is not going to be a future income stream.
And so the government, the overall economy, will have to devote more and more resources to just paying the interest.
And this is where the rubber is now starting to hit the road.
Because of the huge build-up in debt that’s taking place, the interest expense on the federal debt will double between 2011 and 2020, and that’s under the assumption that interest rates do not change.
If interest rates were to rise 1% in 2020, that would add $200 billion to the federal budget deficit.
By 2020, the three largest components of the federal budget will be Social Security, Medicare, and interest.
Interest will jump above Defense.
And none of those items will generate an income stream to repay the debt.
So we are on a debt treadmill that is going to produce weaker and weaker economic activity.
The standard of living right now is already the lowest since 1997, but we’re not going to be able to reverse out of this treadmill by doing more of what we’ve done, and that is taking on more debt to GDP.
Is there anything that we could do to help us get out of this treadmill? Is there any solution?
There are solutions. There are solutions. And there are some very fine economists who have worked on this who have basically come to similar conclusions.
The problem is the lack of political capacity—it’s going to involve very, very tough choices.
If, for example, we could rein in government spending, and we could stabilize the marginal tax rates, and raise revenues by eliminating loopholes or instituting a consumption-based tax, we could have a system of shared sacrifice between the tax receivers and the taxpayers, but the problem is the political structure likes the current system, and the current system has created a situation where our federal outlays are basically 25% of GDP, and federal revenues are 16%, and those who do not want the tax rates to go up are able to protect the tax situation, and those who do not want the expenditure rate to go down are able to protect that, and so we are left with a perpetual 9% deficit.
Which means over time the total debt is going to continue to rise, and the interest-paying portion of the federal budget will continue to rise, which means the economy just sort of grinds down and down and down.
So if, then, those solutions are not implemented, because it sounds unfortunately more than likely that they won’t be, what will happen to our economy? I believe you had a statistic that said something to the effect of low interest rates for the next 23 years?
There was one study, it was produced by Carmen Reinhart, Vincent Reinhardt, and Ken Rogoff, writing for the National Bureau of Economic Research, published in April of this year, called “Debt Overhangs, Past and Present”, and what they found (and they found 26 of these episodes, where government debt was at least 90% of GDP for more than 5 years) was:
1. There were severe negative consequences for economic growth—that you lose more than 1% of GDP growth vs. trend.
And as a result of the detrimental impact on economic growth,
2. Interest rates remained very depressed.
The increase in debt by itself, if it were the only factor, would tend to drive the rates up, but the high debt debilitates the economy and trumps the effect of the higher interest, until you reach what may be called “the bang point”, when government institutions have so much debt, that they are denied access to the credit markets and can no longer borrow.
We’ve seen this repeatedly happen in Europe and in other cases historically over the last several hundred years, and that forces the government to spend only what it has in revenues.
So far in the current fiscal year, which started in October, for every dollar that the federal government spent, it had about $0.58 in revenues, and it had to borrow $0.42.
If that borrowing stream were denied, then we could only spend $0.58, and that would create a real crunch.
In European countries where that’s happened it’s created a lot of social chaos.
So what is actually happening in Europe, I’m afraid, is a warning sign to us. We must get our house in order. We cannot assume that we are the great United States of America and that these trends, these empirical findings, the laws of economics, do not apply to us.
Right, because they definitely do.
Yes. You said something interesting about GDP, and how that is not really a measure of prosperity, but more of spending. Could you explain that a little?
Yes. GDP is total spending. It’s total spending of the consumers, the businesses, the government, and the foreign sector.
It’s a relatively easy trick to increase spending by getting people to borrow money, and some people equate this to an increase in aggregate demand, and aggregate demand is supposed to lead to an increase in jobs, and so forth.
If the debt levels were very low, which was true in earlier times, there might be some validity to that. But when the debt levels are very high, there is no validity to that.
The critical issue is not whether you borrow money and spend it—the critical issue is the quality of the debt.
If you borrow money to finance current consumption, or if you borrow money to make interest payments, that doesn’t generate an income steam.
You can also have a situation where you have counterproductive debt.
The most clear cut example was the lowering of credit standards to make mortgage loans, starting in the late 1990’s.
Initially, there were some positive benefits from that, but when the less-than-creditworthy mortgage borrowers defaulted, then you set up a negative income stream.
The key here is the productivity of the debt.
To put things in perspective, from 1997 to today, the debt-to-GDP ratio, public and private debt, is 100 points higher. Roughly 260 vs. 350.
But our standard of living, which is what most people care about—we call it the median household income in real terms, adjusted for inflation, is no higher than it was 15 years ago.
Yes, you mentioned something called the misery index. Could you explain a little more about that?
Yes. The misery index was developed in the 1960’s, and it was an outgrowth of the notion that greater government involvement in the economy would produce a better social outcome.
The feeling of the 1960 election was that the policies of President Eisenhower were too much hands off—too laissez-faire. He didn’t intervene to moderate the recessions.
He could have done things, by increasing the deficit, or trying to stimulate the economy through more aggressive monetary policy.
So the notion was, when government became more involved, the social outcome would be improved, and we needed an objective arbiter, that people could look at and say, “Oh yeah, well look, it was 10% and now it’s 5%; we’re clearly better off!”
And so that’s really the sum of the unemployment rate and the inflation rate.
Well as it turns out, the lowest misery index by decade was the 1950’s, and we’ve never gotten back there.
The average misery index from 1950 to the present is around 8.5%.
So, greater government involvement actually produced a worse social outcome.
Wow. That’s just terrible.
It is, it really is. And right now, in the last 12 quarters, it’s been about 11.5%.
When the misery index was developed, the economists thought that the labor force participation rate would be relatively stable. Unfortunately, now, because job opportunities are so few, people have quit looking for work.
And the labor force participation rate in August was the lowest since 1981.
And in actuality, if the labor force participation rate had stabilized over the last 3 years, the misery index in the last 12 quarters would not be 11.5%, but it would be close to 13.5%.
Wow, so even worse.
It would be even worse, yes.
So from an investor standpoint, is there anything we can learn from this, is there anything we can do? If interest rates are possibly going to be low for the next 23 years, what does that mean to an investor?
Well, they are going to be low as long as we have this current policy mix.
And so the reversal of the situation is going to have to occur at the government level, and the government is going to have to set the example both with monetary and fiscal policy.
So far there is no indication that that’s happening.
Federal Reserve policies have been more harmful than helpful, because they encourage people to get into debt, the debt is not productive—it exacerbates the problem.
So what happens is you grind the growth rate down. The growth then trumps other effects…the debt rises, and the debt by itself would tend to push the interest rates higher, but the growth weakness is more powerful element in the picture so the interest rates remain low as a symbol of the deteriorating economic conditions.
It’s not a good thing—it’s actually a bad thing.
Right. And that’s very difficult for people on fixed incomes, and seniors, and for people trying to find any sort of yield in this type of environment.
Right. It’s another feedback loop. We have a lot of negative feedback loops.
We’ve taken on more debt; yet, the standard of living has not risen for 15 years. The percentage of people below the poverty line is the highest in 5 decades.
Another symptom of the high indebtedness is that the birth rate is falling. The birth rate this year is going to be the lowest in 25 years. Well this is because our youngsters do not have economic opportunity—they’re not able to afford to have children. Children are expensive.
Another social consequence is we are approaching the situation where we have something that might be referred to as a 50/50 economy. We have 50% working hard, paying taxes, although the portion of those paying income taxes is only 41% now, which is a record low, and we have 50% that are on some type of welfare, either food stamps, or Medicaid, or other subsidies, and the trends are not good.
The contributing component is grinding down, and the non-contributing component is going up. And that’s all a reflection of the failure of the policies that have produced this over-indebtedness.
So do you think then that since these interest rates are probably going to be low for the foreseeable future, what does that mean then for bond investors?
Well, bond investors are what I am. I am in the bond business. And we think over the next several years, in a very volatile pattern, the long treasuries will grind down toward 2%.
So there are some capital gains there. But buying long bonds, and we’re talking 30 year here, it’s a very difficult thing for individuals to do, because the trading there is very volatile.
You can see price movements over a very short period of time of +/- 5%. So it’s very difficult to buy in, and the volatility chases people in and out.
But that’s been the case over the last decade, and for those who have been patient and willing to sift through the opportunities, the returns have been good.
If we were to have had this interview five years ago, and I would have been advocating (and I was, the record is clear on this, and we were invested for declining rates), the prevailing market was around 5%. And most people thought that was a record low; that it couldn’t possibly go any lower—it was very unattractive.
But as we look back, over the past 5 years, who wouldn’t want to have that 5% return today?
So it’s quite possible, as unreasonable as this may seem, and as counter-intuitive as it may seem, the 2.80% yield that we have today may be as attractive as the 5% was 5 years ago.
And that is something to think about.
It is. And the tragedy is that that is a difficult asset for individuals to invest in. Individuals have to be very careful in how they go out there because there is a lot of price volatility.
How would the individual investor go out and do that? Is there anything you can do to manage your risk and the volatility?
Well, if you’re going to be an investor in long treasuries, you have to do it very gently—you have to average in over a considerable period of time, unless, of course, certain events give a spike in rates and you’re convinced that the spike is not related to the underlying fundamental problems.
But you have to continue to make that assessment.
Our attitude on interest rates is this, and this has been the view at Hoisington Management for a long time:
There are more reasons than I could tell you why interest rates could rise over the short term—over the next week, the next month, possibly even the next year.
I couldn’t write down all the factors that might cause them to go up. But our view is that they cannot stay up. They can go up, but they cannot stay up.
So that when they’re higher than they present opportunities to acquire positions, but you have to do so in a disciplined manner, and you have to be prepared to live with the volatility.
If you are not able to deal with the volatility then stay away. Just accept the low returns that the banks pay.
Wise words, very wise words—thank you.
I have one last question for you, and it’s a slightly different topic, but you often talk and I hear it in the economy all of the time, about the velocity of money. Could you explain in layman’s terms what is the velocity of money and why is that important?
Well it’s very important. The velocity of money is the speed at which money turns over in creating GDP or total spending.
It was a concept that was developed in 1909 by the great American economist Irving Fisher, who was a professor at Yale University. He wrote a book called The Purchasing Power of Money and he gave us a formula, that is a truism, which says that GDP or total spending, in current dollars, is equal to the stock of money times the velocity of money.
Now money is basically balances that we can spend, like currency and checking deposits, but money alone does not determine GDP.
It’s money * velocity.
Now, you calculate velocity by dividing money into GDP, so in that sense it’s a residual.
But even though it’s a residual by calculation, it’s a very important indicator, and we know something about what causes it to move.
By the way, there are a lot of other economic indicators that are calculated by residual. We can’t measure productivity directly, but we know productivity is an important concept, but to get productivity, we have to divide hours worked into GDP. We can’t go out and measure how effectively everybody is working.
The savings rate is another calculated number. We know what people earn and what they spend—we subtract the two and we get savings.
So there are a lot of numbers that are residual, but that does not mean that they do not have economic consequence and that they are not determined in a rather regular way.
Now what determines whether velocity rises or falls is really the productivity to which the money is used.
If funds are borrowed and they go to current consumption, that is what we call non-productive debt. If they go to finance activities that are going to lead to default, or bankruptcy, or liquidation, then that produces a negative income stream.
Since 1900, on average, velocity has turned over 1.69 times per annum.
So if money supply growth were, let’s say 5%, then on average, GDP would have been 9.
(5 * 1.69)
In 1997, velocity peaked at around 2.12. It has now dropped to 1.57, which is the lowest in 5 decades.
To my way of thinking, it is a confirmation that the productivity of our debt is either non-productive or counterproductive. And that’s confirmed by these other measures; mainly, the fact that the standard of living has not risen—the fact that the employment-to-population ratio, which is the best of all of the employment measures, is at a multi-decade low.
In other words, what you do is you try to find confirmation, not on the basis of one single indicator, but on multiple indicators, and what they’re saying is that we’re kind of on a downward spiral, and we’re not going to reverse it until we reverse the policies. Good luck is not going to do it.
And if we don’t reverse the policies, do you think there is any chance that the United States would default on our debt?
I don’t think that’s imminent—I don’t think it would happen in the next 5 or 6 years…what you’re really asking is when the bang point would occur.
The concept of the bang point, as an economic term, was only developed in 2009.
There were economists who knew it by other names prior to that, but so far, we do not have any systematic economic research that indicates the variables that trigger the bang point.
Before it was always assumed that governments could always borrow whatever they needed, and now we know that that’s not the case. We should have known it for a long time.
I’ll tell you one little story—in the 1820’s, 1830’s, and then again in the 1860’s, and early 1870’s, state and local governments took on a lot of debt.
In part to help finance canals, steamship lines, turnpikes, and railroads.
They took on too much debt and the activities were redundant, they didn’t generate an income stream—we had a panic here in 1838, another one in 1873…one of the consequences of all of these state and local government defaults was that they were forced to adopt balanced budget amendments.
Now they really had no choice, because they had burned their lenders. No one was going to lend to them anyway. And so the state and local governments who still have that in their constitutions reflect those earlier time periods.
So one of the consequences that may come out of this, if we reach the bang point, or if the Europeans reach the bang point, is that they will be forced to put it into their constitutions that they constitutionally balance the budget.
Which would be a good thing!
It would be a good thing, but it will only come after the crisis, not before.
Thank you so much—I really appreciate your time.
My pleasure—glad to be with you.
I could have talked with Lacy for hours — what a knowledgeable man!
I will be back soon, perhaps tomorrow!, with our Kung Fu Finance survey results! Thank you all so very much who took the time to take the quiz/survey — I truly appreciate it and am voraciously reading the results (I was overwhelmed by the responses — thank you!).
Have a fantastic weekend, and thank you for being an awesome Kung Fu Finance subscriber!
To your financial success,
— Kung Fu Girl
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