Face The Music
Road Back To Prosperity Is Through Shared Sacrifice, Not Government Stimulus; Case Against Fractional Reserve Lending
John Mauldin posted an extraordinary interview by Kate Welling of Dr. Lacy Hunt, the chief economist of Hoisington Investment Management.
Dr. Lacy Hunt correctly identifies fractional reserve lending as the culprit behind the massive rise in debt. Hunt also explains why government spending cannot help, why Europe is in worse shape than the US, why a US recession is coming, and why Ben Bernanke is an exceptionally poor student of the great depression.
The entire PDF is a lengthy 29 pages, but well worth a read in entirety.
Here are some pertinent snips from "Face the Music".
Face The Music
Road Back To Prosperity Is Through Shared Sacrifice, Says Lacy Hunt.
Kate: Happy New Year, Lacy. And thanks for sending all those charts to background me for our conversation. I have to say the first one stopped me -- showing debt as a percentage of U.S.
Lacy: If you confine your analysis to post-war period, you only have one major debt-dominated cycle and that's the one we're currently in -- and have been in for a number of years. But if you go back far enough, you have three more. You have the 1820s and 1830s. You have 1860s and 1870s and then you have 1920s and their aftermath. Sometimes it's essential to take your analysis back as far as you possibly can.
Kate: Doesn't your second chart, on the velocity of money [below], show how none other than Milton Friedman was misled into thinking that it was a constant because he only looked at post-war data?
Lacy: That's correct and, in fact, I was misled along with him because I was also doing analysis based on the post-war data. Friedman's period of estimation was basically from the 1950s to the 1980s. Well, if you look at the velocity of money in that time period, it's not a constant, but it's very stable around 1.675. So if you tracked money supply growth then, you were going to be able to get to GDP growth very well. Not on an individual quarterly basis, but even the individual quarterly variations were not that great. Until velocity broke out of that range after we deregulated the banking system. Now, velocity is breaking below the long-term average and it's behaving exactly like Irving Fisher said, not like Friedman said, absolutely.
Kate: What a perfect example of the difference your frame of reference can make.
Lacy: Keynes and Friedman both felt that The Great Depression was due to an insufficiency of aggregate demand and so the way you contained a Great Depression was by your response to the insufficiency of aggregate demand. For Keynes, that was by having the federal government borrow more money and spend it when the private sector wouldn't. 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.
Kate: And that your goose is cooked if you don't you cut off the credit bubble before it overwhelms the economy?
Lacy: Yes, and Bernanke is thinking that the solution is in the response to the insufficiency of aggregate demand. That was Friedman's thought. That was Keynes' thought and most of the economics profession has traditionally thought the same way. They were looking at it through the wrong lens. Fisher advocated 100% money because he wanted the lending and depository functions of the banks separated so we couldn't have another event like the 1920s.
Kate: You're saying that Fisher argued against fractional reserve banking?
Lacy: Yes, and so did the people that more or less followed in Fisher's footsteps, principally Charles Kindleberger and Hyman Minsky. Minsky felt that the way you prevented a major debt deflation cycle was to keep the banks small.
Kate: Prevent them from ever becoming too big to fail in the first place?
Lacy: Right. Don't let them merge. You don't want them to get big. I actually gave a paper with Minsky once, in 1981, in which he advocated that position. 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."
Kate: Once again, we didn't prevent the excessive buildup of debt, so now we have to deal with pressing deflationary forces.
Lacy: That's why Fisher wanted to segregate the lending and deposit-taking functions of the banks.
Kate: Does that sound a mite like Paul Volcker, daring to suggest banning the banks' speculative proprietary trading activities -- and getting nothing but grief from the industry for his efforts?
Lacy: Well, that's right. Fisher couldn't get it done, either. And warned that we would do it again. I had a brief acquaintance with Kindleberger; I didn't know him well, but I knew him and he was helpful to me. He taught Ken Rogoff. And, in fact, "This Time, It's Different" is really a quantification and verification of a lot of the qualitative themes that Kindleberger expressed. My sense was that Kindleberger thought that once the economy got into over-trading, there was no one who was going to stand in its way.
Lacy: That was the old-timey term that Kindleberger used. He said there are three phrases of behavior as you move toward manias, panics, and crashes. The first phase is over-trading, where you start buying assets at prices far beyond their fundamentals. People enjoy this phase, because initially it boosts income and raises wealth and so forth. So it becomes very irrational. Then you get to what he called the discredit phase, where the smart people start pulling their funds out. Then you get what he called revulsion. The classical economists used those terms: Over-trading, discredit, revulsion. As I said, I got the impression from Kindleberger that once you get into that over-trading phase, there's no one who is going to stand in the way of it.
Kate: Why stand in front of a freight train?
Lacy: Especially when it doesn't seem to be in anyone's interest to stand there. Regulators, banks, companies, investors, everybody's having a good time; profits are being made, employment is strong.
Kate: So we've just seen.
Lacy: No one dealt with the credit excesses in the subprime market, until the crisis hit. And no one dealt with the excessive speculation in the financing of the railroads in the middle of the 19th Century, or in the financing of the canals and turnpikes and steamship lines in the 1820s and 1830s. Nor did anyone step in to try to stop the foolishness that was going on in the 1920s.
Kate: I noticed you picked something Bernanke wrote to illustrate conventional wisdom
Lacy: Bernanke rejected Fisher and Kindleberger in his book, "Essays on The Great Depression." And notice that he doesn't reject Fisher because he says Fisher's data is flawed. He doesn't reject Fisher because Fisher's argument is flawed or Kindleberger, either. He rejects them because an excessive buildup of debt implies irrational behavior.
Kate: Well, hello!
Lacy: That's the world I live in. You, too, probably.
Kate: To mention that what can seem rational on an individual level can be irrational when an entire economy does it.
Lacy: We see it all the time, every day of every week. And yet Greenspan's rejection of the danger of an excessive buildup of debt in his book put him in a different mindset, not just in evaluating the events of the 1930s, but when it came to understanding what was going on in the early part of this century, up to 2006 and '07. Because he thought he could respond to a debt problem and contain it. But that was not at all what Fisher taught. Fisher said you have to prevent a debt deflation ahead of time. That's a very powerful, critical, difference. What Fisher is saying is that once you get into this extremely over-indebted situation, and the prices of assets begin to fall, these two "big bad actors," those are the terms he used, control all or nearly all other economic variables. Then, if you attempt to respond to the problem by leveraging further, it's counterproductive. That's the term Fisher used in one of his letters to FDR expressing concerns about deficit spending.
Kate: Debt becomes cancerous.
Lacy: That's right. Carmen Reinhart and Rogoff wrote in their paper for the NBER called "Growth in a Time of Debt." They found that after you get above 90% of debt to GDP that you lose 1% off the median growth rate, and even more off the average growth rate. So it's clear that debt plays a major role in the economy. Most of the time, it is a benign factor, but you get these irregular intervals in which debt builds up excessively. And, once it has built up excessively, it's a controlling influence for a long time. Plus, you cannot solve that over-indebtedness problem by getting deeper in debt. That's the problem.
Kate: True, but you can postpone it a while.
Lacy: The point is that it doesn't really matter whether you're using the Federal Reserve's monetary tools to get the private sector to leverage up or whether you're engaged in deficit spending at the federal level to try to address the insufficiency of demand. Both tacks take you in the wrong direction. Now, what we're beginning to understand -- at least with regard to governments, because we have known this is true for the private sector for a long time -- is that there comes a point in time at which additional debt is no longer available. That's where a lot of countries in Europe are. And that is probably where we're going in a number of years. We're not there now, but that's where we're headed. We spent $3.6 trillion last year at the federal level. We borrowed around 35% of that and we had tax revenues to cover around 65%. Some of the European governments are trying to borrow more than that ratio, and it's being denied to them. Reinhart and Rogoff call that the "bang point." When that happens, your spending levels then have to fall back to your tax revenues. That's where we're headed unless we correct the problem. It's obviously going to get greater, because we have built-in guaranteed increases in our obligations under Social Security and Medicare. That's why I also sent you a passage from Exorbitant Privilege, by Barry Eichengreen. He's a Yale Ph.D., taught at Harvard many years, Cal Berkeley. In the last three years, federal outlays have averaged 25% of GDP, which is the highest three-year period since 1943 - '45, when we were in a multi-continent war. What Dr. Eichengreen is saying is that federal outlays are going to go to 40% of GDP within 25 years, without major structural reforms.
Kate: Just based on the programs in place and demographics?
Lacy: Yes. To him, that means that the current laws cannot remain unchanged and I agree with him. I don't think you can transfer an additional 15 percentage points of GDP to the government. There's no practical way that we can do it. But the political process doesn't seem to want to respond in advance, so it's very difficult to see how this is going to work out in any salutary way.
Kate: Let's put some numbers on this. The first chart you sent me [first chart] shows total public and private debt in the U.S. approaching 400% of GDP.
Lacy: Yes, that's the conventional approach, using publicly held federal debt as the measure of government debt. But that, in my opinion, is really not appropriate. The more appropriate measure is really gross federal debt. [chart immediately above].
Kate: And the difference is that the gross figure includes debt held in intragovernment accounts?
Lacy: That's correct. But what Dr. Eichengreen is saying, and I agree, is that even that gross debt number is not really sufficient because we've also got $59 trillion, at present cost, of unfunded liabilities in Social Security and Medicare. We have about $52 trillion of current debt, public and private, the way I measure it. We have about $15 trillion in annual GDP. So if you substitute the gross government debt for the privately held debt and if you use the IMF's projections for the increase in gross government debt going forward and you assume private debt-to-GDP stays flat, well, we're going to new peak debt levels in the next several years.
Kate: And we're not the only nation in this fix.
Lacy: The situation in Europe is worse. I put together some charts that are interesting; took a lot of effort, anyway. If you look at U.K. debt, public and private [1st chart below] it's 100 percentage points higher than in the U.S. The Japanese debt [2nd chart below] is approaching 150 percentage points higher. The Eurozone, just the countries in the Euro currency zone, have got about $62 trillion in current debt equivalence (3rd chart below). They only have $14 trillion of GDP equivalent. So they've got about $10 trillion dollars more of debt than we do and $1 trillion less of GDP. I have another little piece of information on that score that's interesting: Their unfunded liabilities also appear to be greater than ours. A study published in 2009, but really based on data from 2006, called "Pension Obligations of Government Employer Pension Schemes and Social Security Pension Schemes Established in EU countries," by Freiburg University, which was commissioned by the European Central Bank, showed that the unfunded pension liabilities of the EU member countries studied amounted to about five times their GDP. And the report only covered unfunded liabilities in 19 of the 27 EU member countries -- 11 members of the Euro currency zone and 8 non-currency zone countries. Now, Europe had a big recession, too, in 2008, which opened the gap further. So their unfunded liabilities are about five times their GDP, whereas in the U.S., they are about four times. The debt problems in Europe are at an advanced stage relative to where they are here. Also, their demographics are much worse than ours. [See article for charts]
Kate: That's sure what's going on in Europe.
Lacy: The Europeans have two problems. No. 1, they've been financing themselves short. They have an enormous rollover problem and a lot of the folks who have lent to them don't want to extend those loans. In addition, the folks that don't want to extend their loans are being asked to make even bigger loans and so, the borrowers are not really responsive. Do you know John H. Cochrane? He is at the University of Chicago, a very serious economist. Cochrane's argument is that at the point in time that the markets lose confidence that there is a future stream of revenues to pay off the debt, to service the debt, then the discount rate will move up sharply. It doesn't matter what monetary or fiscal policies are, the discount rate explodes. That's what's really happening in Europe. Perhaps, because Europe is in a graver situation, indebtedness-wise than we are, it's buying us some time. But we don't seem to be willing or able to, we don't seem to have the political will to deal with our problem.
Kate: Certainly not if you listen to what we've heard so far in terms of campaign rhetoric.
Lacy: Part of the problem is that these are serious matters and to solve them, it's going to require a lot of sacrifice by a lot of people. That's why I really like that Eichengreen quote. The thing is, no one wants to have austerity. We all enjoy the good life. We don't want to have to raise taxes; that's unpleasant. We're going to have to change the benefits tables for Social Security and Medicare. We're going to have to cut discretionary spending -- even though it has already been cut substantially. Right now, the four main components of the federal budget are Social Security, Medicare, Defense and interest payments on the debt. By the end of this decade, if market rates are unchanged --
Kate: Quite an assumption.
Lacy: Yes, but at these rates, by the end of the decade, the three top components of the budget will be Social Security, Medicare, and interest; that's according to the Congressional Budget Office projections. If you hold market interest stable through 2030, by then interest payments will absorb 35% of the budget. If the market interest rates go up by two percentage points, that adds about $300 billion a year to our deficit. By the way, that's why you hear it said often that one of the solutions is to inflate our way out.
Kate: That's supposedly the easy alternative, at least politically.
Lacy: But I don't think you can do that because your debt is 350% of GDP. 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.
Kate: Not good, considering that "the 99%" are already restive, with reason.
Lacy: That's correct. We saw this in a microcosm in 2011. 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.
Kate: I suppose all this means you expect a recession this year?
Lacy: Well, consumer spending will slow this year very dramatically from a very weak base. We had a decline in real disposable income in 2011. GDP rose, but GDP measures spending, not prosperity. In 2011, as is often the case, when inflation rises, households initially try to maintain their standard of living. So in the face of rising inflation and trailing wages, which was the story in 2011, families resorted to increased credit card usage or to drawing down their saving. But in addition to a decline in real disposable income in 2011, we also saw a net decline in net worth [lower chart below]. And a year-over-year decline in net worth has been associated with the start of all the recessions since 1969.
Debt Stimulates Until The Collapse
Lacy Hunt makes a stunningly good case why adding on more Keynesian stimulus is doomed to failure. Should Bernanke actually succeed at creating inflation, interest on the national debt would crucify us all.
Please note the references to 100% backed money. Recently, there has been a number of seriously misguided articles on how the gold standard failed to prevent depressions prior to 1929. Such articles fail to point out that fractional reserve lending which allows extending more credit and making more loans than there is money is the culprit. The solution is 100% gold-baked money and the end of fractional reserve lending.
Fisher and Hunt have this correct, as do the Austrian economists.
Unfortunately, in their inflation predictions, most of the Austrian economists only consider money supply and not the collapse in credit and the value of that credit on the books of banks. This led to galling bragging by Keynesian economists who are likewise clueless about what is really happening and why.
Simply put, what cannot be paid back won't, debt will collapse back to a more sustainable level, and benefit promises that people expect will be reneged on, just as is happening in Europe today.
This process is the debt deflation cycle I have talked about at length for years.