John Mauldin's Outside the Box : US Economy

The Clash of Generations

John Mauldin — Tue, 15 May 2012 17:19:00 GMT

There are plenty of books about the entitlement disaster in our future, but few come with the backing of an academic press. The Clash of Generations is an exception. Written by economist Larry Kotlikoff, one of the creators of generational accounting, and my good friend of long standing, Scott Burns, Clash shows what current policies have already done to young people, tells stories about how both parties have allowed it to happen, and offers actual policy solutions– for banking, taxes, healthcare, and Social Security.

But it's way more than a "policy book." It also tells us what we can do to protect ourselves if the politicians fail.

Nobel Laureate George Akerlof writes that the book "is so well written that Scott Burns and Laurence Kotlikoff should be considered the Stieg Larssons of economics." For today's Outside the Box, I asked Scott to give us some excerpts from the book, with an emphasis on policy matters rather than personal investing. This is a book you will want to read, and I hope our policy makers read it as well, to get a clue about the impending crisis, should they fail to take action. Will you like all of their solutions? I can guarantee you won't, as they will gore a lot of sacred oxen; but then any real set of solutions will. We have gone far past the point where there were easy solutions.

You can get the book at http://www.amazon.com/clash. And while you're at it, you should get a copy of my new book, The Little Book of Bull's Eye Investing. It is getting a lot of great reviews, and I am pleased with the response so far.

I am in Stamford, Connecticut tonight, where I will speak tomorrow morning at a private conference for Pitney-Bowes. They have brought in a rather solid line-up of speakers, trying to get a peek into the future so they set an effective business strategy. I am looking forward to listening and learning as much as I can.

Right now I am off to dinner with the other speakers, so it should be a fun evening with lots of interesting conversation, which I really enjoy. Wednesday and Thursday I am in NYC, with a lot of media appearances and interviews and a few meetings and speeches worked in here and there. It will be a very busy schedule, especially since I am trying to keep up with my reading and work on my own next book. Have a great week!

Your wondering how we solve the entitlement crisis analyst,

John Mauldin, Editor
Outside the Box

The Clash of Generations

By Laurence Kotlikoff and Scott Burns

Prologue: The Last Straw

The day was coming—for years, decades, really.

Warnings had been sounded, loud, clear, and often.

Most heard, few listened. The problem was distant, its size unclear.

"No worries. We'll fix it. The next election, the next party, the next leader."

There was time.

There wasn't.

The contract was simple: 100,000 barrels of oil, delivered to this country, at this port, on this day. Payment in Chinese yuan.

The seller was big and always insisted on dollars.

Not that day.

Thanks to U.S. pressure, the yuan was floating free. You could buy and sell it anywhere.

The yuan was strong and rising. The dollar was weak and falling.

No wonder: America's economy was awful; over 30 million, mostly young, looking for work; and Uncle Sam was broke. But Sam's ace in the hole was the dollar—the world's reserve currency. If Sam needed money, he'd print it, and everyone would take it.

No longer.

"Our shareholders come first. The dollar's too risky. Let's settle in yuan."

And so the contract said yuan.

The medium of exchange was the message, and the message was broadcast, posted, e-mailed, tweeted, Facebook'd, and texted around the globe, in seconds.

"They switched. We should too."

Denominating contracts in anything but dollars became routine.

If only. If only that company had waited or kept it quiet. If only that company was smaller or foreign.

But there it was. A major U.S. oil company had publicly called it quits on the greenback.

America's economic death was quick and painful.

In short order, the dollar plunged. Interest rates soared. Bond and stock markets vaporized. Towns, cities, states, and businesses—large and small—started declaring bankruptcy.

And massive layoffs began. The young got the first pink slips.

The Fed rode to the rescue.

"Not to worry. We'll print more dollars, buy bonds, and lower rates."

"Worked before."

"You need a loan. Step right up. We've got money."

This time was not different.

This time, ancient economic law prevailed: more money begets higher prices.

With prices rising, the dollar became a hot potato. No wonder. The longer you held it, the less it would buy.

And faster money pushed prices even higher.

Next came the bank runs.

Deposit insurance didn't matter. Everyone wanted to get and spend their money before it became worthless.

Uncle Sam printed trillions of dollars to honor insurance and other guarantees to depositors, money market funds, bondholders—you name it.

Inflation reached double digits.

Per month, per week, per day, per hour.

The economy was unraveling.

And then the next generation took to the streets.

From Chapter 2: Catastrophic Success

Centenarians, Left, Right, and Center

As one example of the lurking danger of the-really-long-retirement problem, consider America's fastest-growing population. We're not talking illegal immigrants. We're talking centenarians—those aged one hundred and over. Today there are 79,000 members of the old old-old. By 2050 (when today's newborns are middle aged), this figure will reach 601,000. That's enough centenarians to fill up Washington, D.C. We can imagine movies being remade to suit an older demography, such as Butch Cassidy and the Sunda nce Centenarian. Coming soon.

Next, contemplate a much scarier vision: the annual health care costs, circa 2050, of these projected 601,000 residents of the new Century City.

Later in Chapter 2

Your Money or Your Life

We could solve the financial problem Social Security and Medicare represent simply by reducing life expectancy, but there is a remarkable lack of public enthusiasm for the idea. No politician has suggested a new program with special tickets to shorter lives. Unlike the 1973 science-fiction movie Soylent Green, there are no arrangements for a few glorious final moments before being turned into food for the young. And when palliative care was part of the 2010 health care reform bill, it was quickly labeled "death squads" and removed from the bill.

We like being alive, thank you, and aim to stay that way for as long as possible.

What we have never faced up to, however, is that we literally have a your-money-or-your-life decision. The operative word here is or—but we want both. We won't give up our growing years of life, but we don't want to pay for them. Politicians of both parties know this and act accordingly. They promise more public benefits because that's what we want. Then they hide the bill in the diaper of a newborn. This would be a minor issue if the advances in life expectancy were not so great and supporting the elderly at the style to which they've become accustomed so expensive.

Further in Chapter 2

Modern Aging and the Arrival of the Lupies

Science-fiction writer Richard Matheson offered a brand-new perspective on our terminal state. His 1956 novella, "I Am Legend," introduced us to the "living un-dead," otherwise known as "lupies," and death in life hasn't been the same since. As many sad newspaper stories tell it, the real death in life can be found in the Alzheimer's unit of any nursing home. This is simply too painful to bear, so our culture offers us the darkly comic movies that tell us about what might be called the Modern Zombie.

The first of those movies was the classic 1968 B flick directed by George Romero, Night of the Living Dead. Scott's favorite line from it is, "We may not enjoy living together, but dying isn't going to solve anything either."

So even as the baby boomers were coming of age and learning about birth control pills, some other part of the public imagination was worrying about what was going to happen when this crowd got to be really old. Imagination answered: it will be hell. The truly living young will be outnumbered, isolated, and besieged by the living undead. The actual situation of our young will be physically far less frightening and contain less visual drama, but in reality, young people will be defending themselves from the ever increasing demands of the elderly.

From Chapter 3: Living beyond Our Children's Means

Doing Ponzi Proud

The $30,000 combined Social Security, Medicare, and Medicaid payment that is being handed, on average, to each of today's elderly equals almost two-thirds of per capita GDP. By the time the boomers are fully retired, the figure could exceed 100 percent of per capita GDP. Whoever said America isn't a welfare state? It is a welfare state, but the welfare is for the elderly, not the poor. While our two parties argue over the haves and have-nots, we are blind to what the nows are doing to the laters.

And later in the chapter

Uncle Sam's Fiscal Gap

When you add up all our unofficial future bills and net out all the future taxes that will be available to pay them, the difference, that is, the fiscal gap, is staggering. Since a dollar in the future is not the same as a dollar today, we have to make sure this adding up makes less of (discounts the value of) dollars paid or received down the road. Once you do so, using the government's preferred 3 percent real (inflation-adjusted) discount rate, you learn that the value in the present (the present value) of all the future bills, less all the future taxes, is $201 trillion. The icing on this enormous debt cake is the $10 trillion of official U.S. debt in the hands of the public. Add that with a deft hand, and you've got a fiscal gap of $211 trillion! Public discussion is all about the icing. It's never about the whole cake.

Further in Chapter 3

Voodoo Economics

Maybe we've missed something, but we've yet to hear any politician advocate raising all taxes by 64 percent for, well, forever. Nor have we heard any politicians advocate a 40 percent immediate and permanent cut in federal outlays.

On the contrary, Republicans want to cut taxes and Democrats want to increase spending. Both groups are engaged in what President George H. W. Bush called voodoo economics. Republican supply siders are sure that every federal tax would produce more revenue if only it were cut. We think setting all tax rates to zero and forcing Republicans to announce each day's tax collections would change their tune, but maybe not.

Democrat demand siders are equally subject to magical thinking. They believe that raising federal spending, even if it entails paying people to dig ditches and fill them back up, will stimulate the economy so much it will pay for itself through extra taxes. We think providing all Americans a year's free vacation and forcing Democrats to provide daily revenue reports would alter their thinking, but who knows.

In the dream world of our political parties, their favorite action always "pays for itself." Republicans buy votes by reducing taxes and claiming they pay for themselves. Democrats buy votes by spending money and calling it an "investment." Setting just one set of these loonies loose on the economy would be damaging enough, but in recent years we've opened the asylum. We've watched them combine forces to both raise spending and cut tax rates. The bill goes to the kids who, conveniently, are never in the room.

Also from Chapter 3

Is the United States in the Worst Fiscal Shape?

Based on official debt figures, the United States appears to be in relatively good fiscal shape compared to other developed countries. Its 69 percent debt-to-GDP ratio is, for example, roughly half of the comparable ratio for Greece. But on a fiscal gap basis, the United States appears to be in either worse or much worse fiscal shape than its co-members in the the Organization for Economic Cooperation and Development (OECD), the club for developed economies.

The U.S. fiscal gap now stands at fourteen times U.S. GDP. For Greece, this figure is roughly twelve times GDP. Compare the two numbers and you see the naked emperor: on a fiscal gap basis, the United States is in worse fiscal shape than Greece even though its ratio of official debt to GDP is roughly half that of Greece.

And ending Chapter 3

Darkness at the End of the Tunnel

If you're not thoroughly bummed out at this point, we haven't done our job. You've learned that our country is in much far worse fiscal shape than any politician has let on and that our official debt bears no intrinsic relationship to our nation's true indebtedness. But don't stop reading. The story gets worse. Our reckless, generationally immoral fiscal policy has done terrible damage to the underlying economy. Yet few economists, let alone politicians, have connected the dots.

From Chapter 4: Economic Fallout

America's scariest economic chart is a snapshot of postwar American economic decline. Figure 4.1 shows that our country is now saving nothing and investing next to nothing. This isn't anything new. Hop onto either the saving curve or the investment curve in 1950 and you'll take a ride downhill, with some uphill stretches, over the next sixty years.

Countries that don't save don't have the wherewithal to invest, so it's not surprising that our nation's net domestic investment rate has followed our national saving rate down the tubes. But there is one way for a spendthrift country to experience investment: let other countries invest in our stead. That's what the green bars show—the U.S. current account deficit (measured as a share of national income). They measure the difference between our rate of saving and our rate of investment. When our national saving is less than our domestic investment, as has been the case for decades, our current account is negative (a deficit). This means foreigners are investing more in the United States than we Americans are investing abroad.

Later in Chapter 4

Like AARP's most ardent supporters, we're old. Some of our best friends are old. One of us, Larry, has a ninety-two-year-old mother whom he loves dearly and who is getting younger by the year, thanks to Medicare's assistance and her own spirit and exercise routine. And yes, the poverty rate among the elderly in 1960 was 35 percent. By 1995, it was down to 10 percent. That's a fabulous achievement, and we give Social Security, Medicare, and Medicaid full credit for achieving this success.

But the achievement was not a free lunch. At the same time poverty rates were dramatically lowered for the elderly, they were little changed for the young. Today over one in five children live in poverty. Among minorities, the child poverty rate is about one-third and 35 percent live in "food insecure households." Back in 1960, one in four children lived in poverty. So we've made some progress, again thanks in large part to Social Security, Medicaid, and Medicare (which covers disabled children), yet we're sitting here today with 13 million impoverished children. Another 16 million children live in households with very low levels of income, albeit that exceed the poverty threshold. To be clear, we consider the current distribution of wealth, income, and consumption to be outrageous. When some children go hungry while others are whisked to summer camp on the family private jet, you know the maldistribution of income has gone too far. Yet how to reduce inequality is open to debate.

But our main point here is that most of the massive postwar redistribution from the young to the old has not been from rich young people to poor old people. It has mostly been from middle-class young people, who pay high employment taxes, to middle-class old people who receive them. And that redistribution has left the young with a fiscal sword of Damocles suspended over their heads. Furthermore, that redistribution has cut our national saving rate from 15 percent to 0 percent. It has cut our domestic investment rate from 15 percent to 4 percent, and it has contributed to the lack of real wage growth, which marks the death knell of the American dream. Reducing poverty among the elderly (or any other group) is a wonderful goal, one that we should pursue. But we seriously doubt that anyone, of any political or chronological persuasion, would want to do it at the cost of literally wrecking the country.

From Chapter 5: Beatings without Bruises

A Rare and Modern Wedding

To say the wedding was long awaited is an understatement. Beyond the area where the bride and groom would exchange vows, a gentle creek is backed by a dramatic escarpment. The location is Driftwood, Texas, about twenty miles outside Austin. Behind the bucolic scene, a rustic building is ready with a waiting band, servers, food, and champagne. The slightly balding groom walks carefully with his arms held slightly ahead of his body. He is cradling his six-month-old daughter. He is in his early forties, an executive with a rapidly growing Internet-based firm. The bride follows with her father. The bride, dark haired, lovely, and in her mid-thirties, is a court judge.

The ceremony is short, sweet, and serious. The groom promises to cherish his bride forever, but hopes she will forgive his occasional lapse from vegetarian meals. If there is a leitmotif here, it is intentionality and consciousness. These two know exactly what they are doing. They have waited a long time. They are sure. And they are telling the world they are sure.

In an odd way, this wedding opens a window on how we have changed over the past half-century and how much different our world looks to the young than it did a few decades ago. For starters, weddings are getting to be rare events. And this couple, unlike the many who don't dare these days, can marry with confidence. Both have good jobs, both have good educations, and they own a home. They are ready. No one can say they were impulsive.

They are fortunate. And their child is particularly fortunate, or so it would seem. Unlike more and more children, this child will grow up with a decent living standard, excellent education, and, most important, two parents to help her reach adulthood. But there's the rub. Once she's released into the world of grownups, things are likely to be very difficult as they are for so many young adults today.

From Chapter 8: Unsafe at Any Speed

The financial meltdown that's surely coming and will do more lasting damage to our kids won't be triggered, like the last one was, by the production and sale of trillions of dollars in fraudulent securities. It will be a run on the Treasury and the Fed triggered by the global realization that Uncle Sam is in far worse fiscal shape than ever imagined.

The moment of reckoning can come at any time, and when the markets finally realize that our fiscal problem is enormous and cannot indefinitely be papered over by the Fed's money creation, things will change abruptly. We'll have a tremendous financial collapse that hits the bond and the stock markets, and not on a short-term basis. That will accelerate the fiscal collapse, which will reinforce the financial collapse—in short, a vicious cycle. By design, our financial institutions have built no firewalls separating themselves from one another. Instead, there are only fire paths, waiting to ignite.

The hour is extremely late. We can no longer afford doing too little too late, putting off tough decisions for tomorrow, and enduring political gridlock. To fix America, we need to start from the ground up. Only radical, fundamental reforms of the financial system, the tax system, the health care system, and Social Security will solve our problems and get our country turned around. But it can be turned around.

From Chapter 12: Becoming Our Own Solution

In an ideal world, one inhabited by wise and compassionate human beings blessed with flexibility and foresight, our postcard solutions might become a reality. We'd have a broad consensus on our social contract. Government would be the primary instrument for having that contract work. The problems we face would be solved.

But that isn't our world.

Since 1935 the budget of the U.S. government has been in surplus (and you've seen how unreal that is) a total of eight years. Other than 1999 and 2000, you have to go back a half-century, to 1960, to find another year of surplus. And the 1960 surplus was trivially small—a mere $3.9 billion in today's dollars. Over the long sweep of seventy-five years, the evidence is clear: balanced budgets are un-American. We do deficits.

Unfortunately, as discussed above, official deficits—changes in the stock of federal debt—represent less than the tip of the iceberg when it comes to the growth in our overall liabilities. While federal debt owned by the public is now approaching an entire year of U.S. output, our nation's true debt—the fiscal gap, which includes all of Uncle Sam's unofficial spending commitments, net of all the taxes he'll likely to collect to cover these commitments—is a gargantuan 14 times GDP.

We're broke beyond broke. But like General Motors before its bankruptcy, we're lumbering on because of our enormous size and borrowing capacity. And given our long history of dumping both formal and informal debts in the laps of youngsters, while legislating greater and greater benefits for oldsters, don't hold your breath awaiting a rational solution. The most likely scenario is the simultaneous and colossal fiscal, financial, and economic meltdown portrayed in the prologue.

This returns to the question you have, no doubt, been asking since page 1: How can we protect ourselves?

We're all asking this question, and the answers are getting more and more unusual. A visit to a bookstore is instructive. While Barnes and Noble saw the vampire romance trend early and created an entire section devoted to "teen paranormal romance" novels, it has yet to create an "American Armageddon" section. But the books are there, mixed in with the ever-growing shelf of survivalist tomes. So if you think the future will require having emergency food and water supplies that you defend with your newly purchased AK-47 or assault rifle, there are a lot of instruction manuals you can buy.

Our personal salvation advice is far less extreme. There are lots of straightforward small steps you and your family members can take that will leave you in a safer position for facing what's coming. So there's no need to join freedom fighters in Montana, transcendent new age groupies in California, or defiant religious cult members in Texas.

Let's start with a mental reboot—an understanding that we can change our personal fate far more readily and quickly than government policy.

Trust Yourself, Not Short-Lived Institutions

Most of us have years of conditioning telling us that we are small and temporary while the institutions around us are big and permanent. Nothing could be further from the truth. The notion of small and temporary versus big and permanent persists in spite of some obvious realities. It is a good bet, for instance, that regardless of your age or marital status, you've had your name longer than your current bank has had its name. One banker Scott knows likes to tell people about having worked at the same desk, in the same office, for thirty years while the bank he works for has been taken over, digested, and renamed four times.

With Americans now living an expected eighty years, few things or institutions have our duration. In the material world, we're outlasting our computers, our cars, our home appliances, our household goods, even some of our homes, and certainly the tenure of whatever political party is in office.

Only one of the original twelve companies in the Dow Jones Industrial Average still has the same name: General Electric. The other eleven companies have been sold, renamed, liquidated, or otherwise become something else since 1885. According to Jeremy Siegel's classic Stocks for the Long Run, 987 new names were added to the Standard & Poor's 500 Index (an index of large-capitalization stocks that accounts for about 74 percent of all stock market value in the United States) between its creation in 1957 and 2006. In its single greatest year of change, 1976, a whopping sixty new stocks were added to the list and sixty were displaced. However you slice it, most of us will be around longer than a typical large American enterprise whose average life expectancy is less than fifty years, about the life span of the average American more than a century ago.

As individuals we are a lot stronger and more durable than we think, and we are likely to become more so. In futurist Alvin Toffler's prescient 1970 book Future Shock, his driving theme was accelerating change in technology, information, knowledge, products, and businesses. In addition to the idea of the information economy, much the same was predicted in Fritz Mazlop's classic 1972 book, The Production and Distribution of Knowledge. Both authors were incredibly prescient about a growing truth—things don't last.

In the last chaotic decade alone we've seen the decline of the newspaper industry, a revolution in the distribution of music that has now spread to movies and books, a need to dramatically shrink the U.S. Post Office because people aren't using traditional mail, and the familiar list of big corporate failures. We're not talking about the constant change in small retail stores or restaurants. We're talking about the institutions that define our world. And the fact that they are relatively short-lived makes their long-term promises inherently untrustworthy.

Think about it. Thirty years from now, today's politicians and all their lofty promises will be gone. Many of today's banks and insurance companies will be gone. Many of today's investment advisors will be gone. Many of today's employers will be gone. Many of today's pension funds will be gone. Many of our tax breaks and benefits will be gone. Much of our good climate may be gone. Our two-party political system may be gone, and the list goes on.

They'll be gone, but we'll, for the most part, still be here. It's an uncomfortable mind reset, but the truly durable institutions in society are people—that is, us. We generally outlive the supposedly eternal institutions that we rely upon so heavily. As a we have no option but to make careful long-term plans for ourselves. That's a big responsibility and most of us aren't prepared for it because we are beset by thinking traps, unrecognized cognitive failures.

From Chapter 14: The Coming Generational Storm

There are about 70 million Americans between eighteen and thirty-five years old. Imagine they all march on Washington. Imagine they let their elders know they aren't happy with their treatment. Imagine they join together in a party—the Generational Equity Party—and start voting for candidates who represent the interest of today's and tomorrow's young generations. Imagine how that would change the conversation.

And imagine those older than sixty seeing their faces and hearing their voices and saying Yes, they're right. These are our children and grandchildren. We need to protect them. They are on earth, if not in heaven, our only true future.

Face the Music

John Mauldin — Tue, 14 Feb 2012 05:30:00 GMT

No one does it like Kate Welling – we're talking financial-world interviews here, "interrogatory journalism," as Kate would put it – and her interview of Dr. Lacy Hunt, which you're about to read, is in my opinion one of the best she's ever done, and the best I've seen with Lacy.

Kate's interviews, which she publishes in welling@weeden, normally get seen only by the institutional investors and other market pros who are her clients; but she has kindly allowed me to share this one, in which Lacy tackles the same fundamental challenge I've been writing about these past few years: How do we deal with the economic crisis we've brought upon ourselves through the buildup of too much debt? How do we get out of the hole we've been digging, when the tried-but-not-so-true Keynesian (and Bernankean) methods just get us in deeper? How do we work through the end game of the Debt Supercycle, when there are seemingly no good or easy choices left, and find our way forward into an era of renewed growth and hope?

Lacy doesn't give us The Answer, but what he does give us that is really helpful is a deep historical understanding of economic forces and the key players who have tried to manage them, guys like Irving Fisher, who completely missed the call of the Great Depression, but learned a thing or two from it. Bottom line: "... 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."

My answer to everything tonight, as my brain, which is still in Cape Town, tries to catch up with my body in Dallas: round up a hot date and take in a Mavs game!

Your giving microeconomic forces their due analyst,

John Mauldin, Editor
Outside the Box

listeningin

Face The Music

Road Back To Prosperty Is Through Shared Sacrifice, Says Lacy Hunt

Last time Dr. Lacy Hunt, the chief economist at Austin, TX-basedHoisington Investment Managementwas interviewed in these pages, in July, 2009, the rebound in stocks from their crisis lows was only months old — yet he remained firmly in the bull camp— on bonds. As it turns out, Lacy, and the entire portfolio management team at Hoisington, led since the firm's founding by Van R. Hoisington, couldn't have been proven more right: Rates, which "couldn't go lower" have continued to sink. Much to the benefit of Hoisington's institutional clients and investors in the Wasatch-Hoisington U.S. Treasury Fund, which the firm sub-advises. When I gave Lacy a call earlier this week, he — always a gentleman and a scholar— patiently explained not only why he's still bullish on long Treasuries, but why there's simply no easy exit from the debt morass in which the whole economy, public and private, is trapped. Listen in.

KMW

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. GDP all the way back to 1870? What data goes back that far?

Dr. Robert Gordonat Northwestern Universityhas been very helpful to me, recreating a lot of data. The National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis (BEA) only start in '29. But NBER (the National Bureau of Economic Research) funded two studies, one by Christina Romer and the other by Robert Gordon, to estimate the nation's GDP back to 1870. So we have those data sets. They're not identical, obviously, but what most economists do, including me, is use an average of the Romer and the Gordon estimates, which seems to work out pretty well.

Still, I suspect most folks looking at a line on a chart interpret it as "historical fact" instead of as an estimate based on spotty data on the workings of a very different economic environment.

Well, what the profession is saying is that economic propositions need to be tested and verified over as complete a sample as possible. Admittedly, some of these earlier periods, you didn't have a central bank; you didn't have an income tax; you had various political regimes; sometimes you were on the gold standard, sometimes you were off. The point is, most people feel that these institutional differences shouldn't obscure the verifiable observation of basic economic relationships. So you want to test this over as much time as you possibly can and I think that's a reasonable proposition. Anyway, that's my approach, and that's increasingly the approach in the profession.

I was just noting that what we actually know about the economy in days gone by is lot squishier than terms like "data sets" or lines on charts seem to imply. But clearly, observations over short times can be misleading.

Absolutely. Take the subject of debt. 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.

Sure. 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?

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.

What a perfect example of the difference your frame of reference can make.

Yes, Friedman even said Fisher was the greatest American economist, and I think that is correct. Fisher had a broader understanding of the economy in a very, very critical way and in a way that I don't think either Friedman or John Maynard Keynesunderstood it, and even a lot of contemporary economists, such as Ben Bernanke. 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.

And that your goose is cooked if you don't you cut off the credit bubble before it overwhelms the economy?

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.

You're saying that Fisher argued againstfractional reserve banking?

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.

Prevent them from ever becoming too big to fail in the first place?

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."

Too bad nobody paid attention.

So we came along and we bailed out Long-Term Capital Management in the late 1990s.

Not to mention the banks that got in trouble in Latin America in the early '80s, the entire S&L sector in the early '90s —

Absolutely. You could even include the bailout of Chrysler in 1980, because that was a signal to the automobile companies and to their unions: "Do what you want. If you get in trouble, the U.S. taxpayer's behind you." But the Chrysler bailout and the LTCM bailout were very small. I mean, LTCM was a $3 billion problem. That's a quaint number today. Yet the Fed came in with all its big guns blazing. They used monetary policy to ease the pain. A debt buildup was already underway, but the Fed greatly facilitated it and encouraged it. So, it seems Fisher and Kindleberger and Minsky were right. The only prudent way you can deal with these huge debt problems is to prevent them from building up in the first place. The response after the fact matters some, but it's not the route you should go.

That's great, in theory. Except that it isthe route we went. Once again, we didn't prevent the excessive buildup of debt, so now we have to deal with pressing deflationary forces.

That's why Fisher wanted to segregate the lending and deposit-taking functions of the banks.

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?

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.

Over-trading?

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.

Why stand in front of a freight train?

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.

So we've just seen.

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.

Kindleberger took it all the way back to the tulip mania, and I'd venture that wasn't the first time in human history when an auction market got out of hand.

That is correct. Absolutely. You push things beyond their fundamental value. But this isn't the conventional economic view of debt and it's important. I sent you some quotes contrasting conventional wisdom with this newer understanding.

I noticed you picked something Bernanke wrote to illustrate conventional wisdom—

I chose that Bernanke quote [box below] because Bernanke addressed the Fisher - Kindleberger theme in the early part of this century — and that's when we really needed Bernanke to say something and to do something. But as you can see, 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.

Debt and Economic Activity — Conventional View

Beginning with Irving Fisher (1933) and A. G. Hart (1938), there is literature on the macroeconomic role of inside debt. Hyman Minsky (1977) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior. Footnote: I do not deny the possible importance of irrationality in economic life: however, it seems that the best research strategy is to push the rationality postulate as far as it will go.

Ben S. Bernanke (2000). Essays on the Great Depression, pages 42-43.

Vs. New View

The U.S. economic recovery has been weak. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery. King (1994) provides a detailed discussion of how differences in the marginal propensity to consume between borrowing and lending households can generate an aggregate downturn in an economy with high household leverage. This idea goes back to at least Irving Fisher's debt deflation hypothesis (1933).

Federal Reserve Bank of San Francisco Economic Letter January 2011. Atif Mian University of California Berkeley, Haas School of Business and Amir Sufi, University of Chicago Booth School of Business.

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.

The Real Effects for Debt by Stephen G. Cecchetti, M. S. Mohanty and Fabrizio Zampolli. September, 2011. Bank for International Settlements, page 1.

Well, hello!

That's the world I live in. You, too, probably.

To mention that what can seem rational on an individual level can be irrational when an entire economy does it.

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.

One of the newer quotes I sent [above] is from Stephen Cecchetti, a former director of research for the New York Fed. A Cal Berkeley Ph.D., a very serious economist. It's from a paper he gave at Jackson Hole shortly after Bernanke spoke about holding a special two-day meeting of the Fed. Here's what Checcetti said, "Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare." In other words, when banks engage in their traditional business and consumer lending, it improves. There's no question about that. But when they lend imprudently in excess, the result can be a disaster for individuals, households, firms. And "Over-borrowing leads to bankruptcy and financial ruin for a country. Too much debt impairs the government's ability to deliver essential services to its citizens."

I noticed that Cecchetti even specified how much debt becomes cancerous.

That's right. I like his use of that medical term. And the level of government debt he specifies is consistent with what 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.

True, but you can postpone it a while—

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 [box below] 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.

Just based on the programs in place and demographics?

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.

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.

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].

And the difference is that the gross figure includes debt held in intra-government accounts?

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.

And we're not the only nation in this fix.

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 [1^st chart below] it's 100 percentage points higher than in the U.S. The Japanese debt [2^nd 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 (3^rd 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. So we've got this situation, if you accept what Fisher said about debt controlling all other economic variables in a debt deflation, then the levels of indebtedness in the U.S. and Europe are also playing a heavy hand in the foreign exchange markets.

How so?

While there's nothing salutary about the U.S. situation, we're not in as an extreme position as are some of the other major areas of the world, Europe, Japan, the U.K.

You're implying that the dollar is like the best house in a lousy neighborhood?

Yes, if you think of foreign currency movements being determined like a beauty contest, if you've got 10 ugly contestants, the least ugly wins. This tends to support the value of the dollar for no meritorious reason; it's simply comparative valuation.

True, and not terribly good news for U.S. companies trying to compete on a global basis.

No, especially not because this recovery —such as it is — since the middle part of '09, has been heavily influenced by exports.

The percentage of GDP growth attributable of late to exports is really eye-popping.

It is. While exports have been growing at 10% per annum, consumer spending has been growing at only 2% per annum.

That's positively un-American!

Export growth has been just under 50% of the cumulative gain in GDP. It really has been the driving force. But now, income is trending down overseas. And, in international trade flows, income is four or five times more powerful than price effects. So the spreading recessions in Europe and Japan and elsewhere are going to knock down the demand for our exports— and the fact that the dollar is rising serves to worsen that trend.

Wonderful. I can't help but note, though, that it's pretty ironic that we're talking about Irving Fisher's reputation as an economist being rehabilitated now, when he destroyed it himself by being so wrong about Crash in 1929.

True, but that in itself is instructive. He did make some outrageous statements that were totally incorrect and it greatly damaged his stature. No one was really willing to listen to him, although his work was there and so were a series of letters that he wrote to FDR. But he was our best and he was just so wrong that people could never look at him the same way after the Crash. It probably was frustrating for him. But, Fisher actually was a very modern guy, in some ways. Richard Thaler, the co-founder of behavioral finance, wrote an interesting paper a decade or so ago called "Irving Fisher: Modern Behavioral Economist."

I'll have to dig it out.

It's an interesting paper. In economics, there are two conditions: Equilibrium and transition. The economics profession mainly teaches equilibrium economics; the general presumption is that we're at equilibrium most of the time. Transition, we know it occurs, but transition is considered the short, uninteresting phase. Equilibrium is the long, interesting phase. That's the way it's taught. But in actuality, what we're learning is what Fisher understood long ago: The transition is long and equilibrium is short. We move toward equilibrium, but usually we achieve equilibrium only on the way to another transitional phase of disequilibrium. The economics profession has used the analogy of an airplane. When it's on the tarmac, it's in equilibrium. Then, as it takes off and climbs to an altitude of 40,000 feet, it's in transition, relatively uninteresting. Then you're at equilibrium again at 40,000 feet, until you return to the tarmac. So conventionally, you're at equilibrium most of the time, either at 40,000 feet or on the tarmac. But for Fisher, the equilibrium phases were short and the transition phases were long. I think that's where the profession is headed, certainly the way I'm thinking about it.

In other words, economic equilibrium is not a very stable state?

No, we hit equilibrium on the way to another disequilibrium. If you're looking, for example, at my velocity of money chart [above], you can see that one period, from the early '50s to the early '80s when it hovered around 1.67. But in most of the other instances shown, we're either moving above it or we're moving below it. We cross it, but we don't spend much time there. I think the reason we had that post-war period of stable velocity is that there was not a really substantial buildup of debt and we had a heavily regulated banking system. Once we deregulated the banking system and allowed the massive buildup of debt, the velocity of money started taking off. But then it turned down in '97, just as it had turned down in the early 1920s.

Why? We certainly kept borrowing —

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.

And when you look at velocity on your chart going back to 1900, it sure looks like the time it spent in equilibrium was the outlier, not the norm.

It does, and Fisher understood that.

What little reading I've done about Fisher says he was unusually talented and energetic, despite some weaknesses typical in the period, like being a fan of eugenics.

Very true. Paul Samuelson, who disagreed with a lot of what Fisher had to say, said that Fisher's doctoral dissertation was the greatest one ever written— and it was on transition and equilibrium. Fisher gave us the formulas for all the price indices we're currently using. People forget that. James Tobin said he was our leading expert in index numbers. He invented the distributed lag. Joseph Schumpeter said that Fisher had the keenest intellectual mind of anyone he ever met. Schumpeter was no slouch, in his own right. Fisher even invented the Rolodex. But he didn't see The Great Depression coming. By the way, neither did Keynes.

True enough, and he lost a bundle. So what did Fisher miss?

Why Fisher missed the Depression call is instructive. It was because at that point he assumed that the U.S. economy was dominated by cyclical forces. As we went through this business cycle, we'd have a brief period of bad times followed by an extended period of good times. Yes, the period of bad times could be a little unsettling, but it didn't last too long and then we would have another extended period of good times. But what Fisher later wrote was that once an economy becomes extremely over-indebted, this normal business cycle model that everybody believes to be what controls the situation really becomes inoperative in the traditional sense. The business cycle attempts to work, but it can't, against the strong secular forces of excessive indebtedness. Like Keynes, Fisher was a big investor and, of course, he was wiped out by the events of the late 1920s, early 1930s. But he later made that statement that the extreme over-indebtedness controls all or nearly all other economic variables. It appears to control the risk premium, too, as that table [above] I sent you shows. We've now had three 20-year periods: 1874 to 1894, 1928 to 1948, and the last 20 years, in which the risk premium stayed negative. I didn't have the final official numbers to include last year's Q4, but it doesn't change the picture, I'm pretty sure.

So you're saying investors get risk-averse in severe downturns?

My point is that we know that, over the long run, you have to have a positive risk premium, stocks have to outperform bonds, because investors must be rewarded for holding riskier assets. But after the extreme buildup of debt in the 1860s and the early 1870s, risk-taking was not rewarded. After the extreme buildup of debt in the 1920s, for 20 years risk-taking was not rewarded. And for the last 20 years, it hasn't been rewarded either. So my table may be instructive. 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.

Is there perhaps a glimmer of hope in the fact that the earlier instances you cite lasted roughly 20 years, and this one is already 20 years old?

Well, they all came after major buildups of debt. The panic years were 1873, 1929 and 2008, but if you go back and look at my first chart, in the first instance, we had this massive buildup of debt that was complete by 1873. The panic year was 1875. The debt-to-GDP ratio peaked in 1875 because the denominator, GDP, collapsed. Then in the second instance, the debt buildup was complete by '29. The debt-to-GDP ratio peaked after the fact in 1933, because GDP declined. And the same was true in 2009. The debt-to-GDP ratio peaks a year or so after the panic, because you've got the denominator in this ratio. But what's interesting is that after the 1875 peak, you don't go above it until 1916. You don't go above the 1933 peak until 2003. So once you get these periods of extreme over-indebtedness, it takes a very long time to resolve them.

And it's usually not a lot of fun.

No. That's why I sent you those quotes from a great study by the McKinsey Global Institute Study [box below], listing what they call the Four Archetypes of the Delevering Process. What it boils down to is that austerity is required in about 75% of the cases. Either you do it yourself or it's imposed upon you. They do address the possibility of "growing out of debt" and they cite the case of the U.S. in World War II and a couple of other instances. But to my way of thinking, the U.S. during WWII was also an austerity case. If you look at my chart of the personal savings rate back to 1929 [above], you can start to see that what really brought us out of the Great Depression were our exports. Our allies' countries were being disrupted by actual fighting and they had manpower shortages. So we were selling them everything that we could produce — but meanwhile, our people could not spend the income we were receiving.

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.

McKinsey Global Institute. Debt and deleveraging: The global credit bubble and its economic consequences, page 39. December 2010.

Right, there was rationing and tremendous austerity on the home front. So the only thing that people could do with the money they were making was buy war bonds.

That's correct. And that's what they did —look at the personal saving rate. We're not getting that same response here. The saving rate went up for a while, but it's now back to 3.5%. We're essentially back where we were when the recession started.

It's more than a little perverse to pull for another world war to pull us out of this mess. Wasn't the debt deflation in the 19th Century simply cured by the passage of time?

In the earlier case, the excessive indebtedness just burned itself out. That was the title of Kindleberger's chapter on policy responses: "Letting It Burn Out and Other Devices." I sent you an excerpt from that, too. [box below] You might do better to just let it burn out. Everybody rejects that as being too harsh; "How could you possible advocate that?" But it it might be better.

Policy Responses:

Letting It Burn Out & Others

The moral hazard problem is that policy measures undertaken to provide stability to the system may encourage speculation by those who seek exceptionally high returns and who have become somewhat convinced that there is a strong likelihood that government measures will be adopted to prevent the economy from imploding — and so their losses on the downside will be limited. A ‘free lunch' for the speculators today means that they are likely to be less prudent in the future. Hence the next several financial crises could be more severe. The moral hazard problem is a strong argument for nonintervention as a financial crisis develops, to reduce the likelihood and severity of crises in the future. Will the policymakers be able to devise approaches that penalize individual speculators while minimizing the adverse impacts of their imprudent behavior on the other 99% of the country?

Charles P. Kindleberger (1978). Manias, Panics, And Crashes: A History of Financial Crises, pages 204-205.

Sure, like a forest fire. But that argument isn't very strong in today's highly interconnected economy. We're not facing any isolated conflagration.

Well, you hear that argument, but I'm not sure that I buy it. I think the world was very interconnected in the 1920s and I really see a lot of parallels. We don't have good data outside the United States, but we do know that a lot of the commodities-producing countries took on a lot of debt to finance commodities production back then.

So vendor financing wasn't invented during the internet bubble.

Not at all. And the problems in the late '20s started, I believe, in the commodities producing countries. The first country to devalue in the late '20s was the Dutch East Indies, a huge commodities producer. Then it was Australia. Both had expanded very substantially with debt. Then there were a number of other devaluations and, finally, in '31, the British devalued. In the meantime, we stayed on the gold standard and so everybody that was devaluing against the U.S. dollar. Their incomes were declining, which undermined our exports and then the price considerations went against us so we started losing our exports. Then, between April of '33 and January of '34, we had about a 60% devaluation. That helped us, compensatorily, to regain some of the markets that we had lost, and everybody stood still for that, because we were still sort of operating under the rules of the gold standard game. But then, in '37 and '38, the gold bloc countries finally devalued; we lost some of the gains we had made and the economy fell back. So there was a great deal of international interconnectedness in that period. But what this also shows is that the markets deal with the serious problems first and then they move on to the next most serious and so on. So this whole process could be much longer and more persistent than many people believe. Particularly because, if we continue to try to solve the over-indebtedness problem by taking on more debt, that ultimately creates more problems than it solves.

That's sure what's going on in Europe.

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?

Haven't had the pleasure —

John Cochrane is at the University of Chicago, a very serious economist.

He has the AQR Capital Chair, if I'm not mistaken —

Yes. He was president of the American Finance Association, a very serious academician. What he has pointed out is that the real value of government debt must equal the discounted value of the stream of future surpluses. If you think about that, anyasset has to be equal to the discounted value of its future revenue stream. So, what you've got in the present value formula is the discounted stream of future flows and then your discount rate. Well, 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. The investor cannot see a viable revenue stream to service the existing debt levels. I don't think that we're at that point here yet, but we could be. I hope we have some time. 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.

Certainly not if you listen to what we've heard so far in terms of campaign rhetoric.

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 —

Quite an assumption.

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.

That's supposedly the easy alternative, at least politically.

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.

Not good, considering that "the 99%" are already restive with reason.

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.

Suppose one of Europe's Hail Mary passes actually miraculously works, and the Chinese decide to lend them a ton of dough?

I'm not an expert on China. But I did spend some time there earlier in my career, and I don't think the situation is that stable. I sent you a quote from the book, "Red Capitalism" by Carl Walter andFraser Howie. Carl Walter is a pretty serious observer, Stanford Ph.D., has lived in Beijing for about 20 years, speaks Mandarin. His basic point is that the government has forced the banks, which they control, to make loans to the provincial governments for all of these expansion projects. There's now a great deal of excess capacity and the projects are not generating sufficient cash flow to service the high levels of debt that the banks have extended. We're reaching the point at which the banks will have to be recapitalized. We had an episode of that in the late '90s when the Chinese banks needed to be recapitalized and the government had to shift expenditures into bank recapitalization. That caused the Asian economic crisis. Now there's some evidence to suggest that China will have to recapitalize the banks again and when it does that, it will produce economic weakness in China that will reverberate around the world. So the Chinese may be more of a problem than a solution.

China's Potential Debt Woes

China's model has produced super growth, lustrous office towers, massive and grand new airports and other visible signs of wealth and success. But, beneath this glamorous veneer, the growth model is flawed and fragile. Substantial and unknowable risks are accumulating in the Chinese banking system. "The fact that it is well-insulated from outside markets does not mean that China's finances are crisis-proof. The system can be disrupted by purely internal factors, as it clearly has been in the past."

Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise by Carl E. Walter and Fraser J.T. Howie (John Wiley, 2011), page 207.

Utilizing micro- and macroeconomics as well as psychology, biology (contagion), and politics a model is developed to identify booms that bust. This framework applies to recent as well as distant boom/busts. "Although China appears to be in the midst of an unsustainable boom, the timing of a bust is extraordinarily difficult to predict."

Boombustologyby Vikram Mansharamani (John Wiley and Sons, 2011), page 237.

I suppose all this means you expect a recession this year?

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.

It's certainly not a good thing, in terms of consumers' ability to spend —

Exactly. 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.

Well, toss this in: State and local spending isn't going to fill that gap.

No, you probably saw the statement from New York Gov. Andrew Cuomo that the situation has deteriorated in New York. About half of the state governments either have deficits that they must address for the remaining six months of the current fiscal year, or they'll have deficits in the new fiscal year. Now, that's an outward improvement. But the state budgets do not include the unfunded liabilities of their pension plans. Last year was another in which their investment returns did not match their actuarial assumptions, so those pension plans are in worse shape now than they were a year ago. How is that problem going to be rectified? Either you have to cut the benefits, or you have to get additional funds from the state and local governments. The only way that can be achieved is by cutting other programs or raising taxes. So the state and local governments will remain a drag. Guess what? We are looking at a recession in 2012.

And that means what, for the markets?

Let's look at the last chart in the package I sent you, the long-term Treasury rate going back to 1871 [above]. We had 10 or more years in the late 19th Century and early 20th Century when long Treasuries got to 2% or less; those were in the aftermath of the huge buildup of debt in the 1860s and 1870s. In 1941, as you can see on the chart, long Treasuries were at 2% again, then Pearl Harbor came along. Another way of looking at this is that, since 1871, long Treasuries have averaged about 4.3%. The inflation rate has been about 2.1%, 2.2%; so you had a real return of about 2%. Notice, too, that in the period from the rise of the Iron Curtain to its fall, interest rates averaged about 6% and the inflation rate was 4%, so you had a real rate of 2%. In the earlier global market period from 1870, the interest rate was around 2.9% and the inflation rate was 0.9%. So your real rate gravitates towards 2%. If we go towards zero inflation over the next several years, that's saying to us at Hoisington Management that the long Treasury will eventually get to 2%.

All the way down to 2%?

Rates have done that in Japan for a lot of the last 15 years. Getting there will not occur in a straight line. It will be in a very frustrating pattern. We'll see a lot of volatility and there will be some episodes where it will look like the trend toward lower rates will be interrupted. It may well be interrupted for intermittent periods of time. To put this in another way, if you asked me to write down all of the reasons why interest rates could rise, I couldn't list them all. There are a lot of reasons why interest rates could rise over the short run. In this generally poor economic environment, there will be some time periods when the data will get a little bit better. There may be massive portfolio selling from time to time. There may be expectations that problems in Europe or elsewhere are being solved. There are a whole host of seasonal and other factors that can intervene. But as long as the United States is confronted with these various structural factors, interest rates can rise— but they really can't stay up for very long. They ultimately have to go back down. We're in a gradual process toward lower rates. Five or 10 years down the road, we will end up thinking about is this as a period of low interest rates. And its volatility won't seem too important after the fact. But I can assure you it will be important during the interim.

Especially if you have to worry about little things like portfolio returns —

Absolutely, because as you go lower in yield, each basis point has a larger and larger price effect.

The math is pretty plain, although it escapes a lot of people.

It is. Of course, this is our bread and butter. Did you see the returns in our fund last year?

How could I miss them? You did blindingly well, not just against your peers, but the universe. Up well over 30%.

The mutual fund that we sub-advise, the Wasatch-Hoisington Treasury Bond Fund, actually is up over 41%. The institutionally managed account was up slightly in excess of 40%. It was a volatile process, a nerve-wracking process, getting there and I don't anticipate going forward it will be any easier.

What are you doing?

We've basically been long, but we've gradually, over the last several years, increased the percentage of our portfolio in zero coupons. They've performed veryhandsomely. They've had volatility, but they've done very well and if rates go lower, it's clear that the best performance will come from the zero coupon bonds, because they don't entail the reinvestment risk.

That couldn't have been more of a contrary position a year ago. And it still is.

Yes. "Rates are going higher. They can't go any lower; they're at all-time lows." Or so they say.

Well, that depends on how far back your chart goes, as you've demonstrated.

That's exactly right. All you have to do is look back to 1941. But it specifically boils down to the following situation. The critical thing for us is that the economy's extreme indebtedness is a deterrent to growth. It's not a positive for growth. What the classical economists said is true: What creates prosperity is the hard work, creativity and ingenuity of individuals and businesses. Your prosperity does not come from governmental financial transactions.

Nor, from highly leveraged purely financial transactions, no matter how many transpire per second in the private sector.

Absolutely. I agree with that. I don't know whether you ever read David Hume's essay written in 1752, "A Public Credit."

I believe I did, but a very long time ago.

Hume is among the 10 greatest intellects of mankind. His treatise on human nature, of course, is what he's remembered for the most; Adam Smith said that Hume was the greatest intellect that he ever met, and Smith knew all the great figures of the Enlightenment. At any rate, the point Hume makes in "A Public Credit" is that when a government has mortgaged all of its future revenues, the state lapses into tranquility, languor, and impotence. And he discussed various historical situations. Hume died in 1776, not long after reading Smith's "Wealth of Nations", which was also published in 1776. What we are seeing today is that Hume was correct —and some of the intervening smaller thinkers were not. I'll tell you another little thing. Immanuel Kantsaid that it was Hume that opened his eyes to the reality of the world.

Turning back to interest rates. Why do you suppose real rates have gravitated to 2% for so long?

I suspect, and I don't know this, but I suspect it's because that may be the very long-term average increase in productivity or real income. I've tried to verify that, but it's only a guess. Excellent question. It may be that the factors of production in the long run earn about the same, but I don't know. We do know that productivity is in that range, over a very long period. Whether they exactly equilibrate or not, I don't know. But they seem to be pretty similar over the long haul. They're certainly not similar over the short run. I don't want to give anyone that impression.

Maybe the short-term volatility is telling us something about the capriciousness of human nature —

Absolutely. Maybe it's a sign that there are very significant emotional elements in our decision making process. We try to be rational and to make considerate judgments, but in the final analysis may have limited time. We may have to make decisions based upon rules of thumb or generalizations. Decisions are overly hasty, emotional.

Your charts also show that ideas about how low rates can go depend on perspective. What period you are looking at.

Yes. If you came into the market in 1991, these rates are extremely low. If you came in in 1971, they're even lower. If you look at the sweep of history in both the United States and around the world, these rates are low, but not at all-time lows. That's an important consideration. It's equally important to understand the conditions that produce the low rates as well as the conditions that produce the high rates. For the time being, the trend in rates is still downward. We are approaching the point at which long Treasury portfolio maturities will have to be changed, but we're not there yet.

So what will it take to make you shorten maturities?

That's a very great question. We need to see a fundamentally different policy response. There are things that could be done in the realm of fiscal policy to change the outcome, if we were to use our knowledge correctly. Now, before I describe what we could do, let me say that it's hard to visualize how this could happen right now, but maybe that could change going forward. So what do we know? Well, No. 1, we know that the government expenditure multiplier is, at best, zero and maybe slightly negative. By that I mean if we increase deficit spending, although you can get a transitory boost in GDP for a few quarters, at the end of 12 quarters, there's no gain in GDP. But you do shrink the private sector, increase the government sector, and you take on a higher level of debt, which makes the economy still weaker. So the deficit spending, if we continue that, that will continue to weaken the economy. If we could reduce the deficit spending —although it would reduce economic growth over the short run — over the long run it would revive the private sector. The tax expenditure multipliers, however, are quite large. They're between -2 and -3. By that I mean, if you raise the marginal tax rate by a dollar, you will lower GDP by $2 to $3 after about three years. If you cut the marginal tax rate by a dollar, you will raise GDP by $2 to $3 at the end of three years. But there is also a third component of the federal budget — the so-called tax expenditures, or what are more commonly called the loopholes.

Or the root of most the evil in the tax code —

Well, in the '86 legislation, as Martin Feldstein at Harvard pointed out, we had a revenue neutral bill in which we lowered the marginal tax rates and eliminated the loopholes. We brought the tax expenditures down from 10% of GDP to 6%, which is where they are today. But yet, the economy responded more to the reduction in tax rates than to the elimination of loopholes. Now, I don't know of any studies that confirm this, but it suggests that the multiplier on tax expenditures is considerably less than the multiplier on tax rates.

Which stands to reason, since they benefit only specific minorities.

It probably is because in some cases these loopholes especially in the corporate code, can go to a very few. But let's take the biggest tax loophole on the household side, which is the mortgage interest deduction. We've done a lot to stimulate housing in the United States— and what we've gotten is overproduction and clearly a negative multiplier. To move forward, it's clear that we need a program of mutual sacrifice. There are going to have to be tax changes and expenditure changes. It seems to me, the better thing to do is to start scaling back as rapidly as possible the future promises that have been made under Social Security and Medicare. To have shared sacrifice, we should eliminate the loopholes. I, personally, am in favor of elimination of all the loopholes in both the personal and corporate tax codes. But I don't know how that could be achieved— there are so many beneficiaries and the whole system is designed to support those loopholes.

Not to mention all the tax attorneys you'd be throwing out of work.

True, but to keep the economy growing, we need some reduction in the marginal tax rates. And it could be done, while lowering the deficit, because of the higher multiplier on tax rate changes, in a way where the cuts in spending and the elimination of loopholes are greater in terms of dollar volume than the reduction in the marginal tax rates. So we could deal with the debt situation. We don't have the option that John Kennedyhad in the early 1960s or Ronald Reaganhad in the early 1980s, where we had sluggish growth and just responded by cutting the tax rates, so the economy improved over time. We don't have that option because we're so heavily indebted. 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.

And we probably need political campaign finance reform first, so good luck!

Everyone is a special interest. But we don't want the tax codes to incentivize investments that are not consistent with the most productive use of capital. What we really want is tax codes that are neutral in terms of the allocation of the country's goods and resources. That would produce a better net result, but there are many who benefit from the existing structure and they're going to fight the changes as hard as they possibly can. This is not a case where we lack the technical knowledge to deal with our problems. There's a lack of political will or political cohesiveness to deal with the problem.

What about the private sector? You mentioned earlier that Minsky wanted to keep banks small. We've only let them grow larger. We've made no real progress in delevering the private sector since the crisis—

No, and we've got to deleverage. I don't think it really matters whether we deleverage in the private sector or the government sector. The fact is, we're going to have to deleverage in both in order to clear the way for prosperity. After all, isn't that in the final analysis what we want to achieve? But we're not doing that. The real median household income right now is where it was in the late 1990s. We've had no improvement in the standard of living, even though the debt-to-GDP ratio has risen about 100 percentage points. The problem is not solely in the government sector. It's not solely in the private sector. It is the aggregate problem, the aggregate over-indebtedness, which is the key.

Have you adjusted your portfolio positions at all for this year?

Not yet, we still have a very long duration portfolio. If the situation changes, we hope to be able to be flexible enough to react to it and we're prepared to react. But we don't think that situation is immediately at hand, though nothing can be taken for granted. In economic analysis, there are two things that are important. First and foremost, you have to have some understanding of how the world works and then you have to evaluate the incoming data in terms of the way in which the world works. Responding to the individual indicators, at Hoisington Management, we don't think that works. The indicators have to be interpreted in light of a more fundamental structure. What's very difficult about bond management is that the short-term trading is really dominated by these whole hosts of psychological and behavioral characteristics, which are very difficult to sort out. But the bond market, in our opinion, does move toward equilibrium, though the process is slow and torturous. To know when you're moving toward equilibrium and in which direction the equilibrium exists, requires this broader understanding of the fundamental economic relationships. That's what we try to do.

You're saying you try to stay focused on the big picture? Not react to each blip in the data?

Yes, and the thing about it is, it's counter-intuitive. You might assume that we'd have greater knowledge about the short run and less knowledge about the long run. But in our approach, the only knowledge that we think we have pertains to these longer term fundamental considerations, not to the short-term trading. So we're looking at the world through an entirely different prism.

So short-term moves are just noise?

Yes, and trying to sort out the short-term noise is an impossible task. Our approach at Hoisington Management is that you cannot react to these short-term swings. If you do that, you'll generally be buying at the wrong time and selling at the wrong time.

Words to the wise. Thanks, Lacy.

Charts courtesy Hoisington Investment Management Co.

W@W Interviewee Research Disclosure: Dr. Lacy Hunt joined Hoisington Investment Management Company as chief economist in 1996. This interview is not in any sense a solicitation or offer of the purchase or sale of securities. This interview was initiated by Welling@Weeden and contains the current opinions of the interviewee but not necessarily those of Hoisington Investment Management. Such opinions are subject to change without notice. This interview and all information and opinions discussed herein is being distributed for informational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed. In addition, forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, or as an offer or solicitation for the purchase or sale of any financial instrument. No part of this interview may be reproduced in any form, or referred to in any other publication, without express written permission of Welling@Weeden . Past performance is no guarantee of future results.