Wondering why economic growth can’t seem to take off or why inflation continues to fall? According to Dr. Lacy Hunt, Executive Vice President of Hoisington Investment Management, it all comes down to debt, which helps to explain most of the world’s economic problems today. Lacy describes the six characteristics of over-indebted economies, the most toxic type of debt to economic growth and financial stability, his view of the endgame, and why he still sees "signficant value" in long-dated US Treasury bonds.
What are the six characteristics of over-indebted economies?
"The first is that transitory spurts in economic growth, inflation, wage rates, and bond yields cannot be sustained because debt is too much a constraint on economic activity. Debt is an increase in current spending in exchange for a decline in future spending unless the debt generates an income stream to repay principal and interest. Unfortunately we have too much unproductive and counterproductive debt that does not do that.
A second characteristic is that the over-indebtedness produces inherently weak aggregate demand and because of that economies are subject to downturns without cyclical pressures. Now that's not what a lot of people have experience with. We're familiar with downturns that occur when interest rates and inflation are rising and pent up demand is being exhausted, but over-indebted economies can turn down without those cyclical pressures…
A third characteristic is that productivity deteriorates but this is not inflationary—it's just another symptom of the fact that debt is controlling the overall environment.
A fourth characteristic is that monetary policy is ineffectual if not negative. Interest rates fall to very low levels close to zero and this takes out of the gain the price effect in monetary policy. The price effect is very important in economics. And that price is the short-term interest rates in monetary conditions. In debt constrained economies, central banks can expand their balance sheets but they don't really have good control over the money supply…
A fifth characteristic of over-indebted economies is inflation falls dramatically and increases the risk of deflation. And deflation is a different animal because it transfers income and wealth from the borrower back to the lender—it's a hard concept to understand.
And, sixth, in a low inflationary environment you get extremely depressed Treasury bond yields because the Treasury bond yield is basically determined by the Fischer equation, which says the nominal bond yield is equal to the real rate plus the expected inflation...the driving variable over time and as it goes down so does the bond yield. Those are the six characteristics."
What are the three types of bad debt we see at work in the economy today?
"The first is what we call unproductive debt; and that's where the debt finances current consumption. For example, if a household borrows to buy a new car. Well, you take on auto debt, spending goes up but the automobile doesn't generate an income stream and so that results in a decline in future spending. Same is true for housing or when the government sector takes on debt to finance current consumption on behalf of the household sector—that is also unproductive debt.
Now there are two types of counterproductive debt, one of which is readily understandable. That's where you make a loan to someone, you don't get back your principal and interest but you have to take them into default or bankruptcy and there's associated costs with that and your money is tied up for much longer time period than the borrower anticipated.
The worst of type of counterproductive debt, and the one that's least understood, was explained by the late MIT economist Charles Kindleberger. Kindleberger…explained that in asset markets like stocks or real estate or so forth there's a fundamental demand and supply curve but when there's excess debt creation, you can shift the demand curve outward and cause the market price of stocks or other assets to move above the fundamental price, which Kindleberger referred to as over-trading and is the direct result of excessive debt creation.
Then the next phase is discredit where some start pulling their credit back because they can see that the market prices are not related to the underlying fundamentals and then the final phase is revulsion where everybody tries to get out at the same time. That destabilizes the economy…"
What do you see as the most likely outcome for the US and other overly-indebted economies? What's the endgame look like in your view?
"Well, it could be just like in Japan where you labor on, the standard of living declines, economic performance declines and eventually it begins to exacerbate the demographics; the standard of living continues to languish—it's been unchanged for 20 years. We're in the sixth year of the economic expansion and the standard of living is 4% lower than where it was in 2009 when the recession ended."
What do you think is the greatest risk to the stability of the financial markets currently?
"The greatest risk right now is the one described by Kindleberger, which I mentioned earlier that when you get excess debt creation it tends to inflate the market price of assets like real estate and equities relative to the fundamental price—what Kindleberger called overtrading and then that leads to discredit where some people start pulling their debt offerings back and then the final phase which is revulsion, which we saw in 2008, 2000, 1929, 1873, 1838…
We are clearly in an overtrading phase; it doesn't mean that it comes to an end quickly. In fact, Kindleberger was quite clear in making the point that this period of overtrading fueled by excess debt creation can go on but at some point in time it destabilizes the system."
Many believe that the bull market in bonds is close to an end and that bond yields have hit their all-time lows. What is your view?
"I don't think that we are anywhere near the secular low in long-term rates. I think that's way out in front of us. Right now for example you can get 3% on the 30-year bond; the inflation rate is nil, which means you get a 3% real yield. In the last 145 years or since 1870 the real yield has averaged about 2%, which means right now that your real yield is 50% better than what the average investor got in about a century and a half. I think there's great value in the long end of the treasury market. Doesn't mean that you'll achieve that value immediately but from an investment standpoint there's significant value…in the long end of the Treasury market."