Lacy Hunt: The Bang Point


Below is the concluding segment of the thought-provoking interview we conducted with Dr. Lacy Hunt. He offers some intriguing ideas regarding which of the national dominoes might be first to fall, and reminds us that there is more than one way to get out of a sovereign debt-crisis situation. For those who haven't seen it or would like a refresher, Part 1 of the Lacy Hunt interview is available for viewing or reading in our archives.

[Lacy Hunt made a strong a case for investing in government bonds at our recent Recovery Reality Check Summit. Even if you disagree with his investment strategy – which we do – know this: He's made his clients a ton of money in recent years in the bond market. Dr. Hunt outlined his bond investment strategy at the Summit, and you can hear his presentation in its entirety on the Summit Audio Collection.]

Interviewed by Alex Daley of Casey Extraordinary Technology

Alex: So the American economy – the strongest economy in the world – could become as bad as Greece in the next few years?

Lacy: I don't know if it's the next few years, and I don't think it could become as bad as Greece, but it could become something – conditions that we've never experienced before. I mean, we have a lot of advantages. We have a huge resource base, but already this prolonged period of economic underperformance is beginning to adversely affect our demographics. Our family formation rate is coming off, the birth rate is declining. The number of people moving into the United States is dropping off. Part of the reason that our demographics are deteriorating is because people no longer see the economic opportunities.

So yes, we have a lot of latent strengths that should prevent that, but nevertheless if we pursue the wrong governmental policies, that's where we're headed. I'm not saying that that's something that happens in the next year or the next several years, but it is a process – it's a slow process – and we're on a very unsustainable and negative path.

Alex: Would it be fair to say that this could happen over the course of a generation, and that maybe the next generation might be the first in American history to not live as well as the generation that preceded it?

Lacy: Well, I think that's true right now. If you look at the employment levels since the peak in '07 and '08, we've lost approximately six million jobs. We've lost jobs in every age group, except the group that's 55 years of age or older. The reason for that is, is that people who are in that group are not retiring or they're coming back into the labor force, which is stunting the mobility. And so we have a lot of youngsters that are unemployed, are in colleges and universities hoping the situation will improve. So the latent problems are there. They're not very visible at the present time, but they're there.

Alex: Now, wouldn't cutting Social Security benefits actually increase the problem that you just spoke of – putting more seniors back into the workforce and exacerbating the problem with young people being unable to find work?

Lacy: Well, yes. There are going to be serious tradeoffs, but if you can do these tradeoffs – reform Social Security and Medicare, and hold the marginal tax rates or possibly lower them, eliminate the loopholes, cover some of the debt problems by a consumption-based tax – eventually the economy will begin to recover. You'll free up resources for productive investment, but it will not occur quickly, and it will take time.

Alex: The policy in this country of late seems like it has been short-term gain for long-term pain.

Lacy: That's correct.

Alex: "Let's boost the economy a little bit now, maybe get our officials re-elected and back in office for another term, and suffer the pain later." It sounds like what you're advocating is a little bit more short-term pain for a large long-term gain.

Lacy: Yes, and I think that's what the McKenzie data show. They looked at 32 cases of extremely overindebted economies where the over-indebtedness led to a financial crisis. They're all the documented cases since the 1930s, and in 24 cases out of 32 – which would be 75% – it required austerity. "Austerity," as defined by McKenzie, is a sustained rise in the saving rate.

Some people think, "Well, we could use inflation as a way out." In McKenzie's database, the only cases where inflation solved the problem were very small, emerging economies. I don't think that would work in the US for a variety of reasons, one of which is the fact that the debt-to-GDP ratio is so high. Interest expense at the federal level right in 2011 was 10% of revenues. If you make the assumption that the market interest rates hold through 2030 – in other words, 2% on the ten-year note and that they hold to 2030, which is a very unrealistic assumption – the interest expense rises to 20% of federal revenues by the end of this decade, and 35% of revenues by 2030. By the end of this decade, the three largest components of the federal budget will be Social Security, Medicare, and interest. Now let's say that you get an inflationary process going; interest rates will rise proportionally with inflation.

Alex: Of course.

Lacy: Unless you want to make the assumption that investors on average will be willing to lose money from a transaction, which they're not going to do. So if the inflation rate goes up two percentage points, then the bond yield and the interest costs will go up by 2%. That would add another $350 billion a year to the federal budget. Now, would rising inflation boost GDP as much or would it rise more slowly than interest costs?

If you go into an inflationary situation, there will be some that will benefit. But what has happened historically in the United States and in numerous other cases, when inflation takes off, wages do not rise as rapidly.

Alex: So once again our middle class is worse off –

Lacy: And the GDP will not rise proportionally with the interest cost. If you get into an inflationary situation, the interest will become an increasing proportion, not only of the federal government budget, but of the state and local governments. You will have to transfer funds from other operating expenditures into interest expense, which is the least-productive type of spending, so basically in my view, inflation is not the answer for the United States.

Alex: If we try to inflate our way out of this, we're going to end up spending more and more of our money on debt. We're going to end up hurting the middle class. So the way out of this is…what?

Lacy: We're going to have to engage in austerity. We're going to need a program of shared sacrifice at the federal level because the federal government is a critical component. You're going to have to do the four things that I said. You're going to have to reform Social Security and Medicare; you're going to need to eliminate tax loopholes, so that all taxpayers share in the sacrifice; you're going to have to have some modest consumption-based tax; and hopefully we protect the marginal tax rates. If you cannot do that, then there is no path out – and that may be the path we take.

Alex: It sounds like a very reasonable plan to me. I guess we can only hope that our politicians will become reasonable. But I'm not sure that's ever going to happen.

Lacy: That's what concerns me. It's not that we don't know what to do. There are some very sound proposals that have been taken. For example, there was the Simpson-Bowles Commission appointed by President Obama. I didn't really agree with the bulk of the recommendations, but it was a comprehensive plan. And we're going to need a comprehensive plan that hopefully captures some of these elements, but unfortunately the political will wasn't there even to try.

Alex: Wow. So if the United States doesn't have the political will to try, yet we seem to be less worse off than Europe, what does the situation look like in Europe for the next few years? What has to happen there to fix this?

Lacy: Well, they're more chronic, in part because they've made promises that are greater and their demographics are much worse. But I would not take a great deal of solace in the fact that their demographics are worse than ours, because ours are starting to deteriorate. Everybody points out that Japan has terrible demographics. Yes, they do; but their demographics today are not as bad as they were 20 years ago. In other words, when you get into these debt-induced periods of economic deterioration, one of the things that responds are the population parameters.

Alex: Interesting. I always hear of demographics cited as a cause for economic instability, but rarely hear of it as an effect.

Lacy: Yes, it can be.

Alex: That's very interesting. Now, we've talked a lot about the major Western economies and, of course, about Japan, but the elephant in the room these days is that one of the largest economies in the world continues to be China. They have been posting great GDP growth numbers for many years, but now there are talks about whether or not there is a bubble in China, whether or not China's GDP might come in at lower numbers. What does the situation look like in China? Are they as indebted as Western nations?

Lacy: Well, we don't know the private debt totals in China. If you look at the official government debt in China, it's 16%, which looks really good, since we're over a hundred. However, 45% of the enterprises in China are owned by the government, and these enterprises have issued a lot of debt to build things – new railroads, new airports, new port facilities, cities that are vacant, facilities that are operating at virtually no capacity. If you look at their hidden liabilities, their government debt is about 165% of GDP versus our gross government debt of about 100.

Studies have shown that once gross government debt moves above 90%, bad things start to happen... that economic growth begins to slow, and materially so, and you can produce economic instability. In China's case, I think that the risk is quite great, because this big expansion in debt pushed investment spending to 70% of GDP. Consumer spending is only 30. In the United States, consumer spending is 70 and investment is 16. To have an investment spending to consumer spending of 70 to 30 is not sustainable.

Alex: Why is that not sustainable? Isn't building infrastructure –building schools and highways and ports – really something that helps stimulate the economy?

Lacy: It does help. In short term it's very helpful, but then you have to maintain it. And the banks made the loans and the loans are not being repaid and the interest is not being repaid. And so what we're getting closer to is a point in time in which the Chinese government will have to tighten funds from its operating budget and move them to recapitalization of the banks. That's what happened in the mid 1990s.

Alex: Yes, haven't we seen this story before? Wasn't China the cause of the original economic crisis in Asia?

Lacy: That's right. And it all stemmed from the fact that they had to take operating expenditures and shift it to the banks to recapitalize them. It produced the Asian economic crisis, affected Russia, even brought down one of our big hedge funds in 1998, Long-Term Capital Management. China may be more unstable now, and in fact I think the Politburo in China is very badly split. It's not as cohesive. There are tensions. I think that there is what you might call the "old guard" and the "new guard" for lack of another term. The new guard knows that they're going to have to respond to this imbalance, and the old guard thinks that they can continue doing what they've always done. I think the new guard is right, and it looks like there are many inside of China that know that they are on a potentially unstable course.

One final point. The IMF produced a study published earlier this year, and it was given wide circulation. It was on the front page of the Wall Street Journal. It was called China 2030. There is enough dissent inside of China that in this report (in which the Chinese participated), they agreed with the conclusion that China's economy could experience extreme downside volatilities. It's inherently volatile and it could erupt at any time. I think that's a risk.

Alex: So China has just as much if not more potential for a major crash coming as Europe and the US has?

Lacy: I think they do. I think they do. And I also think that the lesson of history may be against them too.

Alex: Now, one of the major economic booms of the last few years, despite all of the problems we've seen in the US and European economies has been natural resources. Gas prices are up, oil prices are up, gold prices, silver prices. China is a major consumer of most industrial metals in the world, the major importer of oil: would a major disruption to the Chinese economy cause problems in the resource markets?

Lacy: I think it would for industrial commodities and for industrial fibers and things like that. I think gold and silver is a different matter, because I think in periods of economic instability gold and silver will hold their value or even appreciate.

Alex: So we've seen a serious correction in gold in the last few months. Does that mean that today you think gold is a good investment?

Lacy: Well, I'm really not in a position to say. I'm in the fixed-income markets. So I'm not a professional here. But I will just say that as a personal matter I make investments in gold and silver coins, and I'm going to continue to do that. I hope that helps you. That's as explicit as I can get.

Alex: I think a number of us hold gold and silver coins. It's sort of the insurance policy against all other money falling apart, isn't it?

Lacy: It is.

Alex: It's good to have something that is not at some level someone else's liability, which all other money in the world is.

Lacy: But I can't give you this as a professional. I'm not a student of – this is not where I make my money. But I think that there is value and I think it should be in someone's portfolio.

Alex: You make your money in the bond markets – what is the outlook these days for the bond markets? Do you see major rise in the interest rates coming, major problems with bonds? Or are we going to continue to see this low-interest-rate policy for a long time?

Lacy: I think we are going to see a low-interest rate policy and I think that we may, over the next couple of years – 2-5 years – go even lower in terms of the long-term rates. The long Treasuries went to 2% for 10 or 15 years in the late 19th century after the buildup of railroad debt in the 1860s and 1870s. On the eve of World War II, 1941, long Treasuries averaged 2.1%. This was a long period, and it was trending lower, 12 years after the panic year of 1929.

The Japanese rates, when their panic year occurred in 1989, the JGBs were at 5.6. They're at 1% today. So interest rates are a measure of economic activity.

Many people don't think of them that way, but they are. If times are good, business conditions are good and robust and there's legitimate demand for money, interest rates will be high. If conditions are not good, interest rates will be low. And I think that one of the side attributes of an overindebted situation and a shift of the borrowing to more and more unproductive uses is that it makes the economy weaker and it produces the effect of lower interest rates.

Alex: But if the American economy is struggling so bad and the American government continues to go into deeper and deeper debt, won't the people who buy our government debt eventually start to demand higher interest rates?

Lacy: There will be that point, that's what we call the bang point. Dr. John Cochran at the University of Chicago is one of our leading macroeconomists. He's former president of the American Finance Association, one of the leading researchers. He says, "Think about an asset, and how do you value an asset?" You look at the income from that asset and you discount it by some appropriate interest rate, and that gives you net present value. Well, what is the net present value of a Treasury bond or Treasury security? Dr. Cochran makes the point that it is the discounted value of future government surpluses, which would be government revenues minus government spending. If you hit the point where the investment markets no longer have confidence in that stream of future revenues, then the discount rate will rise, and monetary policy won't be able to control it. Fiscal policy won't be able to control it.

Alex: So as we've seen in Greece, as we've seen in Italy –

Lacy: Absolutely.

Alex: As we are seeing in Spain today, it may take time for that confidence to be lost.

Lacy: That's correct. That is exactly the point – and that's the path that we're on. In other words, if we do not control the deficit spending, we will hit the Cochran constraint or Reinhart and Rogoff's bang point. And once that happens our monetary and fiscal policies will really not work for us, and we'll lose control of the interest rate.

And it's tricky knowing when that happens. I've looked at modern cases, historical cases, and frankly, when the bang point occurs is not that clear. You can be going along, everything can seemingly be quite healthy, and then suddenly it begins to deteriorate. The deterioration can take place relatively quickly. I think maybe Japan is now slightly turning the corner. I don't think that they're going to be in serious trouble, but as the debt levels are getting above 500% of GDP and interest expenses taking up more than half of their federal budget, we're beginning to start to see a fall in the value of the yen.

Alex: So Japan is now at a point where more than half of all the tax dollars that come in are going to just service their debt?

Lacy: That's correct. At very low interest rates. And if the interest rates were to start rising because of the lack of confidence in the Japanese to repay...

Now they have a very much more regimented financial market situation, but regimented financial market situations ultimately break down. I don't want to mislead you here because economic theory has never dealt with this issue, or determined at what point the bang point or the Cochran constraint occurs. This is something that has not been identified by economic theory.

If you look at some of the examples, you get a wide range of experiences. It depends on a whole host of other considerations. Some of them occurred in wartime situations or semi-wartime situations. It seems to make a difference whether countries are politically cohesive or uncohesive. The general wealth of the country. We don't know exactly when, but one of the things that seems to start happening that's an early warning sign is that the currency begins to depreciate. Right now, we're on a bad path. We're heavily indebted, but the Europeans are more indebted. The Japanese are more indebted. And so the dollar is getting a bid, not because of anything inherently good that we're doing, but because the situation is worse in a lot of other critical areas.

Alex: So the irony is effectively we're the least bankrupt family on the block.

Lacy: [laughs] That's correct, right now.

Alex: Wow. If there is no rule of thumb for when these things happen, it sounds like we're not just playing a game of chicken with this massive debt, but that we are effectively playing a game of chicken wearing a blindfold.

Lacy: That's correct. That's correct. We don't know.

Alex: Yet your plan seems so reasonable. We can only hope that politicians and more Americans listen to what you have to say and we take the –

Lacy: It might be reasonable for you and me to sit here and talk about it, but confronting the political will is an entirely different matter.

Alex: A monumental challenge to say the least. Well, thank you very much.

Lacy: My pleasure. Great interview. Thank you.

May 23, 2012