The Fed Has Put Itself Out of Business, Where to Now?
By John Mauldin
New federal initiatives—whether tax cuts, infrastructure, or otherwise—will not provide a boost to the economy if they are funded with increases in debt.
—Lacy Hunt
As a young bond manager during the Great Inflation and Richard Nixon’s wage and price controls, Lacy Hunt saw the bear market in bonds coming in the late 1970s and made a fortune for his clients.
—Bloomberg
I often write about the Fed’s abysmal track record in managing the economy. The main reason they have consistently got it wrong is that they are hampered by their “dual mandate,” which sets “the goals of maximum employment, stable prices, and moderate long-term interest rates.” I know, that is actually three goals, not two, but let’s run with it.
The rationale behind their dual mandate is that by keeping inflation and interest rates steady, they will create a stable economic environment, which will be conducive to employment growth. In theory, the Fed’s mandate works well:
- When the economy is slowing: The Fed lowers interest rates, spurring economic activity. This helps the economy avoid recession.
- When the economy is booming: The Fed hikes interest rates, slowing activity. This stops the economy from overheating.
As there is a time delay between the Fed’s actions and the impact of those actions, they invariably overshoot the mark. Fed actions end up working in a pro-cyclical, instead of a counter-cyclical, manner. The Fed’s failures are directly tied to the problems facing the US economy today.
Strict adherence to their dual mandate has made them blind to certain economic developments. For example, while the Fed was focused on unemployment and inflation during the 1990s and early 2000s, they failed to do anything about the massive buildup of debt. This laid the groundwork for the financial crisis.
Sources: Hosington Investment Management
The Fed’s failure to address over-indebtedness has caused irreversible damage to the economy.
When debt levels rise past a certain threshold, additional debt-financed stimulus becomes ineffective. Worse yet, when an economy becomes extremely indebted, monetary policy stops working altogether.
I often get asked if I am still a deficit hawk. The answer is, “Yes, more than ever,” because current debt levels are rendering monetary and fiscal policy ineffective. And that, my friends, is a game-changer.
With traditional methods of stimulus incapable of spurring growth, what will happen in the next downturn? As this trend develops, it could force a rewiring of the financial system and a deleveraging of the global economy. Given the wide-ranging implications, this is a critical trend for investors to grasp.
When I need insight into the relationship between debt and the economy, there is one person I turn to. And that is my dear friend, Lacy Hunt. You almost certainly know Lacy, but in keeping with the spirit of this series, I’ll give him a brief introduction.
Lacy Hunt is the executive vice president and chief economist at Hoisington Investment Management. Lacy was also the chief US economist for HSBC, and senior economist for the Federal Reserve Bank of Dallas.
I’ve known Lacy for over 25 years, and I can say without hesitation that he has been, and continues to be, one of the most influential people on my thought process. I really do enjoy picking his brain about all things economics. I regularly phone him on a Monday morning when something is puzzling me.
Today, I want to focus on Lacy’s insights into the debt overhang and how it has made the US economy resistant to fiscal and monetary stimulus. As Lacy says, “By allowing the country to become extremely over-indebted, the Fed has put themselves out of business.”
Let’s begin with Lacy’s thoughts on the huge debt burden, and why it is having a dilapidating effect on the economy.
The Definition of Insanity
In a recent interview, Lacy cited a study by the McKinsey Global Institute which analyzed dozens of instances where countries had become over-indebted:
In 2010, McKinsey looked at 24 advanced economies that became extremely over-indebted. [The findings] show that an indebtedness problem cannot be solved by taking on additional debt. McKinsey says that a multi-year sustained rise in the savings rate, what they term austerity, is needed to solve the problem. As we all know, in modern democracies, that option doesn’t seem to exist.A decade on from the financial crisis, instead of deleveraging, our debt burden has increased. I referenced these figures in the first part of this series, here’s a quick reminder:
- Since 2008, total Federal government debt has increased by 113%
- Nonfinancial corporate debt is up 79% over the same period
- Household debt has surpassed its previous all-time peak which was made in Q3 2008
As Lacy often says to me, “starting points are critical, John.”
Research from Carmen Reinhart and Kenneth Rogoff shows that when a country’s government debt-to-GDP ratio stays over 90% for more than five years, its economy loses around one-third of its growth rate. Lacy also points out that “the longer the debt overhang persists, the relationship between economic growth and debt becomes nonlinear.” This is happening to the US today with the economy growing at only half its long-term growth rate.
Sources: Hosington Investment Management
Until the debt burden is reduced, further debt-financed stimulus will not spur growth. It’s that simple.
One only has to look at the insignificant effect that the $800 billion+ American Recovery & Reinvestment Act had on growth in 2009 to see this problem in action.
While nobody in Washington seems to have realized that our debt problem cannot be solved by more debt, it is important for investors to keep this in mind when allocating capital. Future tax cuts and other fiscal measures may generate spurts of growth, but given the debt burden, it will fizzle out shortly thereafter.
Although the amount of debt in itself is acting like a millstone around the economy’s neck, the type of debt being created is worsening the problem, significantly.
Pouring Money Down the Consumption Drain
At my Strategic Investment Conference this past May, Lacy commented on the type of debt being borrowed:
The composition of our debt is becoming increasingly inferior. We have the wrong type of debt. We’re taking on debt that is not going to generate an income stream, and that feeds financial speculation. That may benefit some, but not the society at large.
The debt has become so burdensome because much of it is for consumptive purposes and doesn’t generate an income stream to repay the principal and interest.
For example, look at Federal government spending. In 2017, mandatory spending totaled $2.7 trillion, of which almost half went toward social security. As Lacy puts it: “The [debt being created] is going back into our household sector, not into productive end uses. It’s going to finance daily living needs, the least productive type of debt.”
But the government doesn’t have a monopoly on borrowing debt for unproductive uses, corporations are also quite good at that.
In 2016, total corporate debt increased by $717 billion, yet investment in plant and equipment fell by $21 billion. Where did the money go? The majority of it has gone toward share buybacks and dividend payouts. It has been a similar story over the past decade as buybacks have risen to near record levels.
Sources: Yardeni Research
The Fed is at the heart of why corporations have preferred financial investments over real investments. In Lacy’s words, “When the Fed undertook QE, they gave a signal to the corporate managers: Your financial investments are protected by us, but we can’t do anything for you on the real side.”
While equity prices and shareholders have increased as a result of financial engineering, it has done nothing to increase the growth capabilities of the US economy.
Economists have been perplexed by the absence of growth and inflation over the past decade.
The unproductive nature of the debt being borrowed goes a long way to explaining why. As I discuss next, this trend is ensuring growth is unlikely to return anytime soon.
Velocity Is Freefalling
In a recent interview, Lacy detailed why economic growth has been poor and will continue to be so:
The critical factors that determine GDP are both working lower. [We are] experiencing considerably slower growth [in the] money supply, at the same time the velocity of money is in a major downtrend. In 1997, $1 of new [money] increased GDP by $2.20. [Now] it is $1.43. This reflects the fact that we have too much of the wrong type of debt.You may think the velocity of money is some obscure indicator used only by economists. But as Lacy pointed out, it is one of two determinates of nominal GDP, our most important economic indicator.
Put simply, the velocity of money measures the rate at which money is exchanged from one transaction to another, and how much it is used in a given period of time. Therefore, if money is being used for unproductive purposes and doesn’t generate an income stream, velocity will fall.
I think of velocity as a machine which money has to go through to produce economic activity. If the machine is on a low setting, it doesn’t matter how much money you put in—you won’t get growth. The falling velocity of money, which is at its lowest point since 1949, is another reason why growth has remained subdued in the post-financial crisis world.
Sources: Hosington Investment Management
Velocity can also tell us about the long-term direction of bond yields. As velocity is a main determinate of nominal GDP, and yields track nominal GDP, Lacy believes that the secular low for interest rates are not in hand: “In my view, we will not see the secular low in interest rates until the velocity of money reaches its secular trough, and that is not something that’s going to happen soon.”
This is why I consider Lacy’s insights invaluable. His ability to always see the big picture in spite of short-term market moves is truly exceptional. It’s no coincidence that his mutual fund has beaten its benchmark by a wide margin over the past two decades.
While the debt burden is putting downward pressure on velocity, which is dampening growth, it is also incapacitating monetary policy.
Monetary Policy Has Become Asymmetric
Here is Lacy explaining how debt has rendered monetary policy ineffective at stimulating growth:
The root cause of [monetary policy’s] underperformance is extreme indebtedness. The debt creates a situation where monetary policy capabilities are asymmetric. In other words, a lot of action is needed to provoke even a muted impact on the economy, whereas the slightest monetary tightening goes a long way in depressing economic activity.Again, the reason why inflation and growth have remained anemic despite record-low interest rates and multiple rounds of QE is the over-indebtedness of the US economy.
I don’t wish to get too deep into the weeds here, but to explain this, you have to look to the money multiplier. The money multiplier is the amount of money that banks generate with each dollar of reserves. Due to the over-indebtedness of the economy—or more precisely, the lack of “savings”—the multiplier has plunged from 12.1 in 1985, to 3.6 today.
Sources: Hosington Investment Management
Just as falling velocity has blunted fiscal stimulus, the decline in the money multiplier has made monetary easing less effective in generating growth.
Unfortunately for the Fed, monetary tightening has become more powerful because of the debt.
Lacy mentioned in his latest quarterly review that, “Excessive debt, rather than rendering monetary deceleration impotent, actually strengthens central bank power because interest expense rises quickly. Therefore, what used to be considered modest changes in monetary restraint that resulted in higher interest rates now has a profound and immediate negative impact on the economy.”
This outsized effect can be seen by looking at how the five rate hikes since December 2015 have produced a noticeable slowing in the growth of the money supply and several important areas of bank lending.
Given the strong impact the five 25-basis-point hikes have had on the money supply and bank lending, I am highly doubtful that the Fed can continue on their current tightening path. I am more convinced than ever that the over-indebtedness of the nation is the biggest challenge facing the US economy.
Where Do We Go from Here?
Lacy often quotes David Hume, the great Enlightenment thinker, regarding the debt situation: “When a state has mortgaged all of its future liabilities, the state, by necessity, lapses into tranquility, languor, and impotence.”Will the US and other advanced economies lapse into languor and impotence now that monetary and fiscal policy become incapable of generating growth? Even before we reach the endgame, there are many questions to be answered.
Given the outsized effect that monetary tightening is having on the economy, will the Fed be able to continue on its current tightening program? How are stocks and bonds likely to perform in this environment? And how will the coming wave of retirees, which will significantly increase mandatory spending, affect the measures I discussed in this letter?
There are many twists and turns ahead. As investors, we must prepare for every eventuality.
I know nobody better qualified to provide insight into where we are today, and where we are headed, than my dear friend, Lacy Hunt. That’s why I’ve invited him back to speak at my Strategic Investment Conference, in San Diego, next March.
Lacy has spoken at almost every SIC since inception and each time he has put on a masterclass for attendees around debt, monetary policy, and the economy. I know this year will be no different because he always brings his A-Game.
His expertise is the reason why Lacy is one of the highest ranked speakers, every single year. I’m really excited to see what Lacy has to say at the SIC, and I hope you can be there in person to experience it with me. Learn more about attending the SIC 2018, and about the other speakers who will be there, here.
“Another great conference. I will echo what many others say… that this is the best conference that I attend each year.” —Michael P (past SIC attendee)So, that’s the fourth installment in this series wrapped up. Although we have covered four groundbreaking ideas, I think the best may be yet to come. In part five, you’ll get my insights into Niall Ferguson and his thoughts on why the liberal international order is over.
Before you go...
What are your thoughts about Lacy’s research into debt and the effect it is having on the economy?
I’d love to hear your questions or comments about Lacy’s insights—or anything else on this five-part series. Please post them in the comment section below.
Your wondering how this debt situation gets resolved analyst,
John Mauldin
Chairman
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