Gary Shilling on Interest Rates, Deleveraging, and Corporate Profits

Economic growth in the U.S. will probably remain weak for another four years and interest rates are likely to fall even further, Gary Shilling recently told Financial Sense Newshour. The number one reason, he says, is “the overpowering reality of deleveraging…which is still dominating the economy and the world.”

“I think that's what most forecasters including the Fed miss...they just don't understand the power of delevering and until that is over we're going to have slow growth and we're probably not going to have much in the way of Federal Reserve tightening either,” he said.

Here are a few excerpts from his interview that recently aired to our subscribers (click here for audio):

Most people assumed that interest rates would rise after the Fed stopped buying Treasuries; instead, they fell. What did most analysts miss?

“I think what they really missed is the overpowering reality of deleveraging. It is going on; it is a matter of working down excess debt that was built up during the solid days and, as normal, after a major financial crisis it takes years, usually a decade, to work off all that debt. You see it in the financial sector; you see it in the US household sector; you see it elsewhere. And that deleveraging is so powerful that it swamped all the monetary and fiscal stimuli we've had and the result is basically very slow growth—about 2% real GDP growth—a little more than half what you'd expect in a recovery…particularly after a severe recession.”

Why haven't low interest rates been able to spur more spending in the economy?

“The really credit worthy borrowers, a lot of them have plenty of money, they don't really want to spend. They have no need to borrow and of course a lot of the lenders, the banks particularly, have been so chastised and are under so much regulatory pressure that they're scared to lend except to the people who don't need to borrow.”

“The real wealth effect—the rise in equities—that was certainly very much felt by the higher income people because they own stocks, but those folks don't generally change their spending patterns that much as their assets go up and down so you never really got the spending effect. Now of course what most people own, if they have any assets, is not stocks but a house. House prices have revived but not nearly to the extent of stock prices. And so, as a result, we really haven't had that real wealth effect that the Fed was hoping for.”

Is that one reason we haven't seen much inflation (outside of the stock market) with the Fed's creation of all this money?

“What's been missing is the multiplier effect. We have what's called a fractional reserve system. The banks don't have to hold 100% of those reserves behind their loans. They only have to hold a tiny fraction. It's a matter of fact, normally when the Federal Reserve creates a dollar of reserves…that one dollar in reserves turns into of M2 money. That's basically cash in circulation and checking accounts. Well, this time those reserves have not got lent. Again, the banks are reluctant to lend, the credit worthy borrowers don't really need to borrow or want to borrow so it wasn't 70 to 1—it was 1.3 to 1. In other words, they got very very little effect and that's what's happened since August 2008 when they started all this massive pumping of money into the banks by the Fed. So you've gotten very little carry-on effects. Now you did have the first effect because some people did use the proceeds, they sold Treasuries in effect to the Fed and turned around and bought stocks—pushed up stocks. But again those were higher income people by and large. But they didn't get nearly the bang for the buck that the Fed normally has and again it's all part of this retrenchment, this pulling back, this restructuring, this delevering, which is still dominating the economy and the world and I think that's what most forecasters including the Fed miss...they just don't understand the power of delevering and until that is over we're going to have this slow growth and we're probably not going to have much in the way of Federal Reserve tightening either.”

Many well-known analysts have been pointing out that corporate profits are at all-time highs and that this trend can’t continue for much longer. What are your thoughts on this?

“Well, I think there are limitations. We looked at the increase in profit margins, which leaped from a very very low level during the Great Recession to now record highs, and our analysis shows that 81% of that was due to cost cutting, 19% was due to refinancing lower interest rates; so it was a combination of the two. But I think interest rates are still going lower and the bulk of the decline is over in terms of refinancing opportunities and cost cutting... I think it's really getting tougher and tougher to go this's pretty hard to have a sustainable profits picture and, again, if the route to increasing profits is through cutting costs and those costs are labor, then you see the effects: you don't have the incomes out there for the people to buy the goods and services they are producing.”

“Henry Ford famously paid his workers a day. That was unprecedented at the time and he basically reasoned that he should pay them enough that they could afford to buy the Model T’s they were producing…that's no longer the case...”

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