Dr. Lacy Hunt's Deflation Argument
In his most recent 4Q20 review and 2021 outlook, Dr. Lacy Hunt reiterated his long-term bullish view that the long dated U.S. Treasury rates will eventually gravitate to lower levels as inflation continues to recede. While many people expect interest rates to rise throughout 2021 driven by inflation created by loose fiscal and loose monetary policy, Dr. Lacy Hunt argues that a secular inflation cycle is not at hand, given: (1) the massive void in economic activity and destruction of wealth created by the virus and related shutdowns of businesses in the U.S. and abroad will take years to fill; (2) U.S. fiscal multipliers are generally negative, rendering much government spending counterproductive in terms of stimulating economic growth; and (3) Monetary policy becomes much less impactful since the debt overhang was massive before the pandemic and is now even worse, not just in the United States but in virtually all parts of the world.
To better understand his thought process and complete view on this topic, I watched several interviews he gave in the past few years, these are the key takeaways.
Dr. Lacy Hunt’s Overarching Approach
Economics is very complex. The initial conditions are constantly moving, and the relationships that are at work are heavily influenced by the initial conditions. Investment managers are looking for simple nostrums, they may be willing to pay an expensive price for a black box, but they’re not willing to confront the complexities of these economic relationships, but there are no simple nostrums. And managers feel that they have to follow whatever is the orthodox approach, but one of the things that Lacy Hunt has learned the very, very hard way is that the conventional wisdom, which is anchored by the Fed, Wall Street, the IMF is basically always wrong, and in fact, it never really asks the right questions. He recommends to folks is that they accept, embrace the complexity, and try to understand the complexity. And when you do that, you can identify the various influences on both and you can get some determination of what are the important weights.
Using the Fisher equation as an example: Treasury bond yield = real rate + expected inflation. Two components: (1) The real rate is extremely volatile, and it’s not predictable. However, it is mean-reverting at about 2% in the long term. (2) The price expectations variable, which is complex, but it can be extrapolated. Therefore, the price expectations are going to determine the long movements in the bond yield. It can cause a lot of pain in individual years when the volatile elements cause a short term deviation in the real rate from its mean. But those will be reversed if you can get the inflationary environment right. And to do that, you have to get the macroeconomic picture.
Nominal GDP = P*Q = M*V. Lacy Hunt looks at all of the various indicators but thinks the nominal GDP, which is not estimated, is the most critical. Nominal GDP is determined by money times velocity. Both money and velocity captured a very complex multivariate equation.
Understanding the Monetary Process
A monetary process has to achieve the following things: (1) An increase in the monetary base, which we have; (2) A simultaneous interlocking advance in both assets and liabilities of the banks; and (3) The velocity of money has to be stable, at a minimum. The GDP equals money times velocity (Nominal GDP = P*Q = M*V). When the Federal Reserve buys U.S. Treasuries, the bank’s holdings of overnight deposits at the Fed go up (i.e. the liabilities of the Fed to the depository institutions go up by the same amount), Treasury securities outstanding (one type of government liability) goes down.
QE increases the money supply (M). When this money initially moves through the system, there is an increase in the money supply. However, there is another important linkage here.
But the velocity of money (V) will go down if the marginal revenue product of the debt is declining. With regard to velocity, most people think of velocity in terms of the mechanics of the equation (i.e. how many times money turns over a year, and creating GDP). That’s the technical definition. That’s not an explanation of what causes velocity to move. Velocity is largely driven by the productivity of debt. The Fed can execute this first-round increase, the issue is that the depository institutions have to charge a rate sufficient to cover the risk premium in case borrowers default, and the borrowers in the private sector have to be willing to borrow (i.e. accept the risk premium). If the debt generates an income stream to repay principal and interest, velocity will be stable or it will rise. If the banks do make the loans but they are not productive and do not generate a sufficient income stream, then the marginal revenue product of the debt will decline, and the velocity of money will decline. And the more unproductive the debt becomes, the greater the risk is for a decline in velocity. Fisher’s mea culpa paper in 1933 pointed out that when economies become extremely over-indebted, the central bank cannot control the rate of money growth and they cannot control the velocity of money.
FED operations, in his view at this stage of the game, are disinflationary and they are not supportive of growth, because the productivity of debt and velocity of money is at a historical low.
Overindebtedness
Government debt is a short-sighted solution. With COVID, net national savings is going to be negative for the first time since the 1920s, as: (1) Household savings are going up, as people got burned living too close to paycheck to paycheck; (2) Corporate saving will take a significant hit; and (3) Government dissaving is going to go from ~6% to 12%-17%. There are consequences of negative national savings. As physical investment (not financial investment) must equal saving out of income, and the trends in saving are slow to reverse. As households increase savings and corporates need to repair their balance sheet coming out of COVID (reduced investment), the US government is the only sustaining part to keep it afloat. But the debt is being taken on by the government sector is actually going to create an insufficiency of saving. It is a short-sighted solution, because the larger the budget deficit, the more the federal dissaving, which then cuts into the private saving and then undermine the investment.
The economy had a lot of vulnerabilities and he’s afraid that one of the very serious adverse consequences of the pandemic is that we have now created an even greater debt overhang than ever existed before in the United States or in the global economy.
Overindebtedness causes two problems:
Overindebtedness undermines economic growth. One of the most important lessons of economic theory and economic experience is that an increase in debt is an increase in current spending in exchange for a decline in future spending, unless that debt generates an income stream to repay principal and interest. You do get a transitory boost, but if you don’t generate that income stream, then bad things happen when the debt comes due.
The debt creation causes critical asset prices to rise when their fundamental intrinsic measures are declining. People enjoy over trading because asset prices are going up, but it eventually leads to instability. The timing of that is totally impossible to predict. But when it does, then that has an even more dramatic depressing effect on velocity.
Overall, his basic philosophy is that the velocity will continue its 20 years downward trend. And if we continue to try to solve an indebtedness problem by taking on more debt of a questionable nature, then we’re going to further weaken the capacity of the economy to grow. It is a downward spiral. Economies are extremely overindebted —> the overindebtedness tends to put downward pressure on real growth and inflation —> brings the Treasury yield curve down. The economy is underperforming because of the overindebtedness —> fiscal policymakers respond by taking on more debt —> (1) the imbalance between saving and investment moves farther apart (i.e. insufficient net national saving to fund physical investment); and (2) Flattening yield curve undermines the viability of the financial institutions.
An outstanding McKinsey study was done in 2010. They looked at 24 advanced economies between 1900 and 2008 and they found that in all 24 cases, the overindebtedness had to be solved by what McKenzie defined as austerity. They define that as a substantial increase in net national savings. In other words, if you think about what is indebtedness? Indebtedness is living beyond your means. The way you have to correct it is by living inside your means.
If you look at the data, the $2T stimulus package in 2009, bipartisan increase in federal spending and tax cut in 2018, the economy received a bounce of about one to one and a quarter. Then the debt began to cut into the longer-term economic growth rate.
GPD Growth Outlook
The production function suggests no sustaining power to economic growth. Production function says that GDP growth is determined by technology interacting with land, labor, and capital. We have (1) poor demographics, in which Lacy Hunt noted that demographics have deteriorated is because the real rate of economic growth has declined; and (2) The returns to capital are too weak, at the end of 2019, the marginal revenue product of debt was 40 cents in the US (i.e. we generated about 40 cents of GDP growth for every dollar of new public and private debt), and it was lower everywhere else in the world. When you look at the two factors together, Lacy Hunt doesn’t see a case for more than 1% growth in real per capita terms.
Supply Chain Reconstruction & Inflation
Will forced repatriation of supply chains create inflationary pockets? There are some pockets, but Lacy Hunt doesn’t think that you could look at inflation from a micro pocket to a micro pocket. In other words, inflation is determined by the intersection of the aggregate demand and aggregate supply curve. To the extent that we bring production back to the United States will shift the aggregate supply curve inward (i.e. a higher price level for any level of aggregate demand). But the aggregate demand curve is going to shift down more due to its deleterious effect. The total level of unutilized resources will assure that that’s the case.
Negative Rates
The benefit of the negative rates: (1) If inflation rate< 0 but Treasury rates >0, then the real interest rate begins to rise (i.e. financial tightening); (2) U.S. Treasury rates >0 when other countries have negative rate, you tend to add to the strength of the dollar and the dollar is already fundamentally strong. There are negatives of negative rate, at a bare minimum, there’s no net benefit.