Face The Music

A few weeks ago John Mauldin featured an interview of Dr. Lacy Hunt of chief economist at Hoisington Investment Management by Kate Welling in his Outside the Box series.


Via the interview (click here for here for the link or see the PDF below)

• Friedman even said Fisher was the greatest American economist, and I think that is correct. 
• And for Friedman, that was for the Federal Reserve to do more to stimulate the money supply so that the private sector would lend more money. Fisher, on the other hand, is saying something entirely different. He’s saying that the insufficiency of aggregate demand is a symptom of excessive indebtedness and what you have to do to contain a major debt depression event — such as the aftermath of 1873, the aftermath of 1929, the aftermath of 2008 — is you have to prevent it ahead of time. You have to prevent the buildup of debt.
• Kindleberger was very precise in "Manias, Panics, and Crashes," when he said that when you have a small credit problem, or many small problems, some say, you don't want the Federal Reserve to respond. Because if the central bank comes in and bails out a small problem, then that will be a sign to those who want to take more risk that they don't need to be cautious — they can always count on the central bank to come in and bail them out. If they do, Kindleberger said— and this was in '78 — then the future crisis will be even greater. "A free lunch for speculators today means that they're likely to be less prudent in the future. Hence, the next several financial crises could be more severe."
• Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government's ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations and 85% for households.
• It wasn't that we weren't taking on more debt. We were, but the debt that we were taking on was becoming more and more counterproductive. We were getting less bang for the buck. The downturn in the velocity of money after 1997 was actually a signal that we were in a potentially troublesome period. One of the things that Fisher specifically cited was that when you get into this highly over-indebted situation, one of the variables that is controlled by that debt overhang is the velocity of money. The Fed has been able to increase money supply growth but their efforts at simulating GDP — except during some brief intermittent episodes— have been thwarted because the velocity of money is trending down. It's now falling below the 111-year average.
• We don't know, because we don't have a lot of experience, but if Fisher is correct, and if we try to solve our current problems by getting deeper in debt, then what Fisher is saying is the additional indebtedness doesn't make us stronger, doesn't increase our options. It makes us weaker, reduces our options. So risk-taking may not be rewarded going forward. This is where we're hamstrung by our lack of sufficient data to evaluate. But what data we have suggests that if we proceed along the path of over-indebtedness, risk-taking will not be rewarded because the economy is going to perform very poorly.
• If you get an inflationary process going, interest rates will rise proportionately with inflation. So, if inflation goes up 1%, in time, interest rates will go up 1%. But your debt is 350% of GDP. If the inflation rate goes up, you will not get an equivalent rise in GDP, because what we've learned is that in inflationary circumstances, a lot of folks can't keep up. In fact, most of your modest and moderate income households will not keep up.
• The Fed engaged in quantitative easing; they got the inflation rate up temporarily, but the main effect was to reduce real income. So, if you try the inflationary route, you're not going to be able to inflate your way out of debt trouble. This other variable, your interest expense, is going to rise proportionately with inflation, and your GDP won't keep up. Many will lag behind and that will worsen the income or wealth divide. So inflation is really not a potential savior in the current situation. Which then forces you back to the conclusion that the only viable way out is austerity, although no one wants it.
• Consumers need to bring their savings back up into alignment with more normative levels, which suggests a severe headwind to consumer spending this year. Exports, we've already talked about; there's not a good outlook there for what has been our most dynamic sector. Capital spending, I think, is going to be extremely weak this year. We're going to see a net decline, principally because the accelerated depreciation rules, which were in effect, expired on Dec. 31. Up until then, you got 100% depreciation. Since Jan.1, you only get 50%. We've seen this happen many times in the past. Firms look as far as they can into the future and move those expenditures forward in order to take advantage of the accelerated depreciation. So it's reasonable to believe that we're going to see a considerable falloff in capital spending this year. Then you've got the government sector. We've got a $1.3 trillion deficit according to the latest projection from the CBO. In real terms, government purchases of goods and services will decline slightly this year, mainly because of defense cuts. Non-defense, at best, will be flat. How could we have a worse situation than with a $1.3 trillion deficit and a decline in real government purchases of goods and services at the federal level? It's hard to imagine how it could be worse.
• We've got to do it in a comprehensive sense in which we lower the budget deficit initially, and we achieve that by cutting spending, eliminating the loopholes, and then we provide some offset through a reduction in the marginal tax rate. If we move in that direction, then ultimately the economy would begin to work out some of these difficulties. I haven't seen the political will to move forward. But this basic approach is very similar to some of the provisions in Bowles-Simpson, and this is the direction in which we have to go.
• The Delevering Process: Four Archetypes

1. "Belt Tightening". The most common delevering path. Episodes where the rate of debt growth is slower than nominal GDP growth, or the nominal stock of debt declines. Examples are Finland '91-'98, Malaysia '98-'08, U.S.'33-'37, S. Korea '98-'00.
2. "High Inflation". Absence of strong central banks, often in emerging markets. Periods of high inflation mechanically increase nominal GDP growth, thus reducing debt/GDP ratios. Examples are Spain '76-'80, Italy '75- '87, Chile '84- '91.
3. "Massive Default". Often after a currency crisis. Stock of debt decreases due to massive private and public sector defaults. Examples are U.S. '29-'33, Argentina '02- '08, Mexico '82- '92.
4. "Growing out of debt". Often after an oil or war boom. Economies experience rapid (and off-trend) real GDP growth and debt/GDP decreases. Examples are U.S. '38- '43, Nigeria '01- '05, Egypt '75- '79.