Today, the world economy is in uncharted territory.
Never before has the developed world carried this much debt. Never before have the central banks of those same countries expanded their balance sheets so much. Never before has so much sovereign debt been outright monetized. Never before have major financial institutions been officially designated as “too big to fail” and thereby been granted special license to assume gigantic risks.
Dr. Lacy Hunt, economist and current executive vice president of Hoisington Investment Management Company, expects the macroeconomic situation to get worse from here:
The main problem is that we have too much debt. We have too much of the wrong type of debt. That’s not very well understood.
The great Austrian economist, Bohm-Bawerk, said that Debt is an increase in current spending in lieu of a decline in future spending. Fisher modified that a bit and he said that it ultimately depends on whether the debt is productive or not. If the debt generates an income stream to repay principal interest, then you're OK, you don’t have a down cycle later on. But unfortunately as the debt levels have risen higher, more and more of it has become consumptive in nature or financial speculation; neither of which will generate a sustaining income stream to repay principal and interest. That’s the difficulty: there’s a light side to credit and debt, and there’s a dark side.
Now it’s been emphasized that business loans and consumer loans are going up this year. There have been articles about how credit standards are being lowered to make mortgages and automobile loans. The banks have confidence. And the percentage of subprime automobile loans has returned to the peak of a decade or so ago. The problem is that there’s a dark side. Martha Olney at California Berkeley wrote a book a number of years ago called Buy Now, Pay Later. You take on debt to buy now, but you have to pay later. Many presume that you never have to pay later — but that’s a faulty assumption. That’s the difficulty that we have, and we’re trying to solve an indebtedness problem by taking on more debt.
Not only is that the problem in the United States, but it’s also the problem around the rest of the world. We’re all trapped in this debt sclerosis. U.S. public and private debt is about 346%; it’s been rising now for three quarters, we no longer de-leveraging here. And the Eurozone, in all in the 17 countries there, the debt figures are a hundred percentage points higher; higher still in the UK. And then in Japan, public and private debt is about 650%. What’s significant is that the countries with the higher debt levels are performing the worst, which is very consistent with the academic studies. I mean Europe is in the process of triple dipping. Japan remains mired in difficulty; their economy declined in the first half of the year.
Over-indebtedness is the basic problem. And we don’t really have a way out of it because monetary policy is not really suited to address such a problem.
Click the play button below to listen to Chris' interview with Lacy Hunt (44m:14s):
Chris Martenson: Welcome to this Peak Prosperity podcast. I am your host, Chris Martenson, and today we are going to talk economics; big, tasty, macroeconomics with one of the world's very best economists. Why macroeconomics and why now? Because we are in such uncharted territory—landscape so thoroughly unexplored that we need to study the outlines of the big maps to have any hope of divining where we're headed. Never before has the developed world carried this much debt. Never before have the central banks of those same countries expanded their balance sheets so much. Never before has so much sovereign debt been outright monetized. Never before have major financial institutions been officially designated as "too big to fail" and thereby been granted special license to assume gigantic risks. On our show a few months ago, you heard Stein Jacobsen make the call that German bunds were going to 1%, in stark contrast to most other bank economists; but the bund certainly did go to that level.
Today we have on our show an internationally known economist who's making a similar call about U.S. treasuries; they are going a lot lower. Our special guest today is Dr. Lacy Hunt, executive vice president of Hoisington Investment Management Company; a firm that manages over five billion dollars for pension funds, endowments, insurance companies and others. Nearly all of that money is in long term U.S. bonds. Lacy Hunt is the author of two books. His articles have appeared in Barrons, the Wall Street Journal, New York Times, among other places. Among his previous roles, Lacy was the chief U.S. economist for the HSBC group, executive vice president and chief economist at Fidelity Bank, and as senior economist for the Federal Reserve Bank of Dallas.
Lacy, we first met at a Casey Conference and I have been looking forward to having on this show ever since. Welcome.
Dr. Lacy Hunt: My pleasure to be with you, Chris.
Chris Martenson: Well let's start on the outside of this cake and nibble our way in. By the numbers, how is the U.S. economy doing?
Dr. Lacy Hunt: Very poorly. Both so far this year and in longer term perspective. In the first half of this year, the economy grew at only a 0.9% annual rate. You strip out the inventories, we gained at a 0.6% annual rate. If you express it in per capita terms, GDP was flat first half of the year, which means standard of living stagnated. But from a longer term perspective, from the start of the Republic in 1790 or close to the start, the economy has grown about 3.9% per annum. Since the debt levels moved above 275% of GDP—that's public and private—the economy has grown less that 1.9% per annum. The growth from 2000 forward thru the first half of the year is not as bad as the 1930s but it's not that much better either. So it's been a very difficult standpoint. We've clearly downshifted; it's been long and coming, and I think our people are suffering from it.
Chris Martenson: Well if you were going to diagnose the principal cause of that slow and maybe even slowing GDP growth, what would that be?
Dr. Lacy Hunt: I think the main problem is that we're excessively—we have too much debt, we have too much of the wrong type of debt. Debt's not very well understood. The great Austrian economist, Bohm-Bawerk, defined it. He said that debt's an increase in current spending in lieu of a decline in future spending. Fisher modified that a bit and he said that it ultimately depends on whether the debt is productive or not. If the debt generates an income stream to repay principal and interest then you are ok. You don't have a down cycle later on. But unfortunately as the debt levels have risen higher, more and more of it has become consumptive in nature—finances, speculation. Neither of which will generate a sustaining income stream to repay principal and interest. That's the difficulty yet. There's a lot of ways of saying it.
There's a light side to credit and debt, and there's a dark side. Now it's been emphasized that the business loans and consumer loans are going up this year. There have been articles about how credit standards are being lowered to make mortgages and automobile loans, the banks have confidence, and that the percentage of subprime automobile loans has returned to the peak of a decade or so ago. The problem is that there's a dark side. Barbara Olney at California Berkeley wrote a book a number of years ago called Buy Now. Pay Later. You take the debt on, you buy now, but you have to pay later. Many presume that you never have to pay later, but that's a faulty assumption. That's the difficulty that we have, and we're trying to solve an indebtedness problem by taking on more debt.
Not only is that the problem in the United States, but it's also the problem around the rest of the world. We're all trapped in this debt sclerosis. U.S. public and private debt is about 346%; it's been rising now for three quarters. No longer deleveraging here. In the eurozone, the 17 countries there, the debt figures are a hundred percentage points higher; higher still in the UK. And then in Japan public and private debt is about 650%. And what's significant is that the countries with the higher debt levels are performing the worst, which is very consistent with the academic studies. I mean Europe is in the process of triple dipping, Japan remains mired in difficulty. Their economy declined in the first half of the year. And the United States, although we are doing very poorly by long term historical comparison, we're not doing as poorly as the countries that are more indebted, and that's the basic problem. We don't really have a way out of it because monetary policy is not really suited to address such a problem.
Chris Martenson: Well it sounds like you're almost saying that if you live beyond your means for a while that eventually you have to live below your means, and is this not exactly—that's one of my diagnoses. When I look at total debt to GDP, starting at about 1980 just to round off, you see that figure start to climb. Meaning we were increasing our debt at almost twice the rate of our real GDP growth. Doesn't that, by definition, point to the fact that it's the wrong kind of debt that you were talking about? That is, if we were taking on debt that was really productive debt, that we would have seen not that large of a gap occur between those two figures?
Dr. Lacy Hunt: That's a very well taken point. We're taking on some productive type of debt. We're investing in oil and gas exploration, we have some investment in plant equipment, new technologies; we have some infrastructure expenditures that we're financing with debt. The problem is that the consumptive type debt, the speculative type debt, is three or four times greater than the debt that we know will generate a cash stream to repay principal and interest. The difficulty that we have here is exactly the problem that occurred during the 1920s. We lived far beyond our means; we took on a lot of debt. It was the extreme over-indebtedness which set up the 1930s. It was the extreme over-indebtedness of Japan during the 1970s and 1980s that led to their panic year in 1989. It's extreme over-indebtedness in the U.S. in the first part of this century, and in Europe as well, that set up their difficulties. Once you go through this period of over accumulation of debt or under saving, you can look at it in either terms, then the negative outlook is basically baked in the cake. That's really where we are and we don't have a will to get out of it. We have to rely on tough fiscal policy decisions and strong political leadership, and that's just not an option in the U.S., Japan, Europe or anywhere.
Chris Martenson: It's interesting, I noted as many did, that—the crisis erupts in 2008. I think the principal cause was we had just taken on too much debt. It was time for some of that fiscal leadership. It was time to deleverage and bring the balance sheets back down. It was time to switch away from nonproductive debt and start to heavily weight towards productive debt; but even as we saw private debt fall, public debt just sky rocketed. It seemed to me as if our political leadership said, "We have to keep this debt bubble growing no matter what." How would you characterize that—the many, many trillions of dollars of public debt (I'm talking federal debt) that's been taken on? Would you characterize that—in terms of the productive / unproductive ratio—what kind of a ratio would you give to it?
Dr. Lacy Hunt: I would say that approximately 85% to 90% of it is consumptive type debt, it's not productive, it's not going to generate a cash stream. The demographics are going to force that kind of debt even higher. There's a pretty great economist at the University of California, Berkeley by the name of Barry Eichengreen, who wrote a significant book a few years ago published by Oxford University Press called, Exorbitant Privilege. What Dr. Eichengreen points out is that without changes in Social Security and Medicare, federal outlays—which right now are abound 23% or so of GDP—in 25 years they're going to be 40%. This is going to go for consumptive type debt; it's coming, it's heading our way.
Another problem: interest expense is consumptive type debt; it doesn't generate an income stream. Last year we paid interest, net interest, on about 12.3 trillion dollars; total debt was over 17 trillion, it's higher now. There were some securities that are in government trust accounts at the federal reserves, so we were paying net interest on about 12.3 trillion dollars. In a decade from now, instead of paying interest on 12 trillion we're going to be paying interest on about 24 trillion. Which means that even if market rates of interest are flat for the next decade, the interest expense at the federal level will double. In 2024, if interest rates were to rise 1%, then that would add 240 billion dollars a year to the interest expense. And so the trends are not really good now and they're going to become increasingly unfavorable without fiscal reforms; and the fiscal reforms are not really doable in the current political environment.
Chris Martenson: Now what you're describing though, this idea of rate normalization where we would get back to some normal set of rates, is not really actually—it's not possible, in the sense that if it happens it will be highly destructive. I've heard numbers bandied about that if Japan's rates went to somewhere between 2% and 3%, that 100% of their government income from taxes would then be applied to debt service interest payments alone; meaning that Japan would go into that nuclear feedback state and just meltdown economically if their interest rates normalized. Are you saying that interest rates cannot normalize at this point?
Dr. Lacy Hunt: They cannot, no. Many people forget that interest rates are a barometer of economic activity and inflation. The reason that interest rates are depressed in the United States and globally is because business conditions are poor, there's no inflation, there's some transitory inflation from time to time because of the vagaries of food and fuel, and extraneous governmental policies related to issues such as healthcare. These intermittent inflationary spikes are all drowned out because economic growth is too weak. So the trend globally and domestically is downward in inflation. As long as that's the case, your short term interest rates are going to be hovering close to zero; and your long term rates are going to continue trending downward. That's the situation that we're dealing with. We're not able to lift the economy into a normal trajectory.
We took on a lot of debt in the 1920s. We drew down the saving rate but in the 1940s we had a tremendous surge in the saving rate; the saving rate went up to 25%, it remained high after the post-war period. We paid the debt to GDP ratio down, and we were able to have the great post-war boom. But unfortunately, unlike what happened in the late 1940s and the 1950s, we're trying to take on more debt and take on more of the wrong type of debt. Debt—it's not just a matter of borrowing money and spending it and making the economy better. Some will say, and I think it's terribly misleading—you cannot just borrow money and spend it. There's a short term benefit but there is a long term negative. You have to borrow the money wisely, and if you don't do that then you make economies weaker and weaker. This is a process that is, I think, very well identified historically.
There was a San Francisco Fed study published in late 2012 by three authors, one of which was Alan Taylor at the University of Virginia, who's a Harvard Ph.D. The title of the study is When Credit Strikes Back. They looked at 223 different cycles over 140 years in 14 different advanced economies. The conclusion of their study—and econometrics is quite elegant—is that recessions are greatly influenced by the degree of reliance upon credit in the expansion. We didn't deleverage to any significant degree, we didn't improve the saving rate to any significant degree during this expansion. Now we're drawing the saving rate down, we're taking on more debt. So what we've achieved here is through more credit extension, which means that even though this expansion has not been good—it's been quite poor by any historical standard—we're setting up for a difficult time period.
We cannot rely on more credit, more debt to try to restore the economy. The policy makers here are in a bit of a dilemma. We can't move forward on fiscal policy, the decisions are too tough, too onerous for too many people. No one's willing to have shared sacrifice. So we rely on monetary policy with all of its flaws and its negative consequences. And so the economy, in a very important structural sense, is fundamentally weaker now than we were a decade ago, or two decades ago, or three decades ago.
Chris Martenson: Fundamentally weaker, simply because of, structurally, the flavor of debt, or is there more to it than that?
Dr. Lacy Hunt: The aggregate size of debt and the composition of the debt; the two factors together. And the fact that we have not tried to resolve the indebtedness problem. We have tried to solve the indebtedness by moving further in the direction of increased debt and increased _____ [Inaudible 00:18:28] composition of debt.
Chris Martenson: Well Lacy, that's very interesting. You talk about monetary negative consequences. I would argue that there's a strain of convention "wisdom," and I have air quotes flashing when I say that word "wisdom", that says it really is different this time. Some people say, and I've heard this articulated directly, that we can safely ignore history and assume that these are really uncharted waters and the central banks are going to do whatever it takes to prevent us all from ever experiencing losses again. What's your view on that point of view?
Dr. Lacy Hunt: Well Draghi made that statement, "We'll do whatever it takes," and rallied the stock markets in Europe and the U.S., and there's considerable optimism. But the proof of the pudding is in the eating. Europe is now triple dipping. They got a temporary lift. When you take on more debt and you spend it, that's an increase in current spending up cycle. But then the debts come due. If they don't generate the income stream, then you get the down cycle. So we've seen numerous episodes in Japan where they've had massive rounds of central bank action, and you can produce the short term effect, but then it's swamped by the longer term problems of the over-indebtedness. That's where Europe is; they're more advanced in this process. Their debt sclerosis is at a higher and more advanced stage than the U.S. Japan is higher than Europe, but we're moving along that course, and the outcome is not going to be different.
But let's look at it from a longer term perspective. One of the greatest minds in mankind was the enlightenment thinker, David Hume, who mentored Adam Smith. My professor said that the Enlightenment could not have happened without David Hume. Hume was a complete man; his greatest work of course, A Treatise of Human Nature, in which he talked about a lot of subjects including time and space. Einstein gave him credit for generating the thoughts that led to the theory of relativity. But Hume, the great historian and complete man that he was, in the early 1750s wrote a paper of public finance. He looked at all of the situations of countries that became extremely over-indebted. Now he didn't have the quantitative data that we have, it's been pieced together by the archivists since then. But he was able to look at the outcome, and at the end of the article he wrote, "When a county has mortgaged all of its future revenues, the state by necessity lapses into tranquility, languor and impotence." Languor, of course, is where we derive the term "languishing." There are many notable examples. In 1781 the greatest military power, economic power in the world is France. They've just achieved their great victory at York Town. We would call it "our" victory at York Town, but the fact of the matter is it was French fleet that blocked the British fleet which prevented the evacuation of Cornwallis; it was French funds which paid our soldiers and the French soldiers that were there. The forces were co-commanded by French and the French General Rochambeau and Washington. But within ten years the Bourbons of France are dissolved. The thing that brings them down is all the debt that they took on to finance the French and Indian Wars, then the American Revolution, then lavish living; it's a story that's well-known.
The great Roman Empire is the same story, the Mesopotamian Empire, and many other lesser cases. The path toward extreme over-indebtedness is something that is well documented by history. I would suggest that if you want to get a qualitative feel for this, an extremely well written book is to read The Ascent of Money, which was a best seller book a few years ago by the eminent Harvard economic historian, Niall Ferguson. But it all tells the same story. This is an outcome that we know and that's the path that we're on.
Chris Martenson: So this is a very interesting point. You mentioned earlier that you think that rate normalization is not really in the cards because if it happens, it is going to really wreck things. In the most recent Hoisington Quarterly Review and Outlook, which by the way is a great read for anybody listening, I read it religiously; in there, you noted a relationship between nominal GDP growth. You started out earlier telling us about the 0.9% real growth for the first half of the year, but nominal GDP growth, you had a relationship there between that and bond yields that's really driving some of your outlook around bonds. I found that interesting. What is that relationship?
Dr. Lacy Hunt: The relationship between bond yields and nominal GDP is what economists call the Wicksell effect. Wicksell was a Swedish economist; he was born in 1851, died in 1926, contemporary of _____[Inaudible 00:24:05] also born in 1851. What Wicksell said, and there's a lot of validity in it and it's been confirmed by more contemporary studies, is that the key to monetary policy is to look at the relationship between the market rate of interest and the natural rate of interest. If the market rate of interest is above the natural rate of interest, that will depress economic activity; because you'll have to take resources from the income stream and put it into the financial stream. Otherwise, if you get the market rate of interest below the natural rate of interest, then you can take resources from the financial stream and divert it to the income stream. Now probably the best measure of that for the market rate of interest would be something like the Baa rate. The Baa is the lowest investment grade rate. So you've got all types of credit out there and the natural rate of interest would be nominal GDP growth rate. Well we have this relationship, you can look at the date since 1930, and what you see is when the market rate goes above the natural rate, you get recessions; when it goes below, you get expansions.
The market rate went above the natural rate during the 2007-2008 period and in spite of the Fed's efforts, the market rate—the Baa—rate has stayed above the nominal GDP growth rate. The only way that you can possibly deleverage this system is to create the other situation. My way of thinking is that our central bank policy's inability to activate the Wicksell effect is a symptom of the extreme over-indebtedness in the same way that the low inflation rate subdued economic growth, the growing deterioration in demographic fundamentals in the U.S., Europe and Japan are all occurring. These are symptoms of the over-indebtedness. The root cause of the problem is too much debt, too much of the wrong kind of debt and trying to solve an indebtedness problem by taking on more debt.
By the way, there's another new book on the subject called, House of Debt by Mian and Sufi. Mian is professor of economics at Princeton and Sufi is professor of economics at the Booth School at the University of Chicago. Clever title, House of Debt; it's a play on the term "house of cards." What they do is they pull together all of the historical, theoretical and empirical evidence and they show what happens in these situations. They clearly document the disastrous consequences of trying to use more debt when the problem is already excessive indebtedness. So the evidence is continuing to build and unfortunately that's where we are. We're not willing to try to address the fundamental problem; we try to deal with the symptoms with the wrong solutions.
Chris Martenson: Now are you saying that monetary policy maybe has hit its limits? The failure of the Fed to activate the Wicksell effect is not for lack of trying, I would argue. They've done everything they can to force people to chase yield wherever they can find it. I assume in the Baa rate among all the other crevices they're targeting. Or is there more, do you think, that can and will be tried by the Fed and other central banks if and when another recession strikes? Where are we in this story? Are they about out of bullets or is there more they're going to do here?
Dr. Lacy Hunt: Well I think the evidence is that the quantitative easing failed, both one, two and three. The ten and 30 year yields were higher when the phase down of quantitative three was announced than before quantitative one began. And the academic studies, which are impressive, indicate that the large scale asset purchases actually had a counterproductive effect.
Here's the difficulty, and I think it goes back to over reliance on Keynesian economics. Keynes, before he died in 1946, developed a concept of an underemployment equilibrium in which the U.S. economy would remain mired with excessive unemployment and this was baked into the cake. Unless the government ran large deficits when World War II ended, and that was the only way out. Now remember that Keynes' interpretation of the 1930s was that there was insufficiency of aggregate demand; there was not enough of consumer spending. I think that Keynes was correct in arguing that the Great Depression was due to an insufficiency of demand. But where Keynes failed is that he did not understand that the insufficiency of demand in the 1930s was baked in the cake once we had taken on the excessive debt of the 1920s. What the modern Keynesians do not understand is that the underperformance that we are experiencing today was baked into the cake by the big run-up in debt in the 20 years leading up to the 2008, possibly the 30 years leading up to 2008.
The reason that Keynes' paper on the underemployment equilibrium is so important is that he was wrong about us having an underemployment equilibrium. We had a great post-war boom. The unemployment came down; there was tremendous prosperity. Standards of living were lifted, we provided new housing and a whole host of other benefits to the American middle class. What Keynes did not understand is that the problem of the 1920s had been rectified by the high saving rate and the debt pay down that occurred during World War II and in the aftermath of World War II. The reason that we have not been able to regenerate the immediate post World War II boom is that we have not corrected the balance sheet imbalances; and as long as they persist, we are stuck in this situation.
Chris Martenson: What you're saying is there is a basic cause and effect misdiagnosis going on; that Keynes was right, that there was a reduction in aggregate demand that was important, but it's an important symptom. So the doctor would not—
Dr. Lacy Hunt: It was baked in the cake by what happened in the 1920s, basically.
Chris Martenson: Right, so then the cause is the excessive debt that was already baked in the cake. Are you saying then that the Federal Reserve currently is repeating the same mistakes that were made back then, in diagnosis?
Dr. Lacy Hunt: Yes, because we're trying to solve—this is why the Mian and Sufi book is so important; because we're trying to solve the indebtedness problem by taking on more debt, getting people more leverage. That's not the pathway to stability. It can produce these intermittent bouts of recovery but they quickly fizzle out.
Chris Martenson: And this gets me to the central question that I've really been hoping to get to is, you mentioned the word "stability." Given that this is the path that we're on, we're attempting to remedy a predicament that came about by too much debt by applying more debt, what sorts of systemic risks, if any, concern you at this point in time?
Dr. Lacy Hunt: Well there are two. First of all, as you become more indebted and you have more of the wrong type of debt, the first effect is that you see this long slog downward in a country's growth rate. As growth rates get weaker, there are consequences. Number one, you get a widening income and wealth divide because the pie is growing so slowly. So the government is asked to do more, the central bank is asked to do more to help, but what they do is in fact make the situation worse, which exacerbates the income and wealth divide. They're motivated to act because people are hurting, there's underperformance, but this process of a slow downward grind in the growth rate is only a prelude to the point at which you hit the bang point. Now the bang point does not occur quickly, it's off in the distance; but it's at that point in which you lose the confidence of the markets and you're unable to rollover your existing debt. At that point in time, you have chaotic conditions but the bang point is not what we're facing, in my opinion, certainly not in the United States immediately, but we're facing this slow downward grind in economic growth. Japan is interesting because they're much more advanced than we are and it will be interesting to see when they hit it. In the meantime, because the U.S. is less indebted than the rest of the world, the dollar retains its value. It's not that we're doing anything right, but it's our debt sclerosis is not as advanced. And so the dollar in a comparative sense holds its value, holds its bid.
Chris Martenson: So the bang point—we'll probably see this play out in other markets. Japan obviously with their debt to GDP ratio, plus they're attempting to stimulate aggregate demands through monetary policy in a country with a falling demographic and an aging demographic, which seems like a couple of headwinds that I'm not even—I haven't seen anybody in Japan even remotely address that particular gap. So I agree—
Dr. Lacy Hunt: That's one of the big problems for them, but keep in mind that in 1989 their demographics were not that good, but after 30 years of deteriorating economic conditions the situation, the demographics have gotten worse and worse. And the demographics have been deteriorating in Europe and now the demographics are deteriorating in the U.S. Our demographics are not nearly what they were five to ten years ago.
Chris Martenson: Right.
Dr. Lacy Hunt: The weakening in the demographics are a symptom of the extreme over-indebtedness.
Chris Martenson: So for an average investor then, someone who might be with a typical brokerage where they might have a 60/40 portfolio, 60% stocks, 40% bonds with, let's imagine the bonds are held along a spread of credit ranging from safe to junk, what should they be thinking about at this point in time?
Dr. Lacy Hunt: Well, I'm not in the business of giving advice to individual investors. I'm in institutional fixed income management. I will tell you that we can operate anywhere on the treasury curve that we want. We're given that mandate by our institutional clients, and right now if they want to track one small piece of our business is the Wasatch Hoisington Treasury Bond Fund, which we are a sub advisor. But we manage it like our institutional accounts. If you look at that, which is in the public domain, you'll see that it has a 20 year duration; not maturity, duration. And we're positioned on the long end of the curve because we think that the environment is going to bring inflation rates lower, that economic growth is going to be depressed, and while we acknowledge that interest rates can rise over the short run for any one of too many factors to mention, we don't think that interest rates can stay up. They can rise, but they cannot stay up in this kind of environment. So we're positioned in the long end of the treasury market.
Chris Martenson: Understood. So that means that you are fundamentally of the opinion that structurally we're going to see low growth going forward, and therefore having a duration of 20 years means that you're looking for rates to be moving down, not up, going forward. The quick translation in my book for people who are in equities is that you need to understand the extent to which equities are priced for rapid growth. It feels to me like there's a pretty big gap between what equities are telegraphing and what bonds are currently telegraphing, about as large as I can recall in my lifetime watching markets as carefully as I do now. Would you think that is a fair characterization, that there's a bit of a—
Dr. Lacy Hunt: I think that is a fair characterization. I personally don't think the stock market is a very good barometer of economic activity. I know that the Fed thinks that wealth influences economic activity, consumer spending, but that's not what the studies show. I mean last year we had a tremendous increase in wealth, stock prices and home prices together after inflation were up more than 30%, but consumer spending is just barely moving this year. In fact the latest numbers are quite disappointing. I mean 1987, many people recall the market meltdown of that year, Wall Street crowd said that we would have economic Armageddon in 1988 yet the GDP growth rate was 4%. But a lot of folks assume, and I think incorrectly, that the stock market is the economy. I don't. I think the stock market will only turn down after it becomes apparent that the economic situation is faltering. And so I would not take confidence, I think that right now the economy is much weaker than is generally understood.
To just tell you one sort of approach that we use here, we're very interested in what happens to money supply growth and the velocity of money. We consider them equal partners. Since 1987 velocity has been trending down at about 3% per annum, but in the first half of this year velocity actually decelerated at a 4% annual rate; which is an indication that the composition of debt is moving it the wrong direction. So we have money growth around six and velocity declining at least three, but perhaps at four; which suggests that nominal GDP growth is only in the 2% to 3% range. Well you've got to take that 2% to 3% and split it between inflation and real growth. Which means, and most people have the inflation rate this year somewhere around 1.5%, maybe a little bit higher. Well one and a half nominal growth is two, that only leaves you half a percent real; if nominal growth is three that leaves you with 1.5%. I think that we're going to be lucky to have 1.5% real growth rate this year.
The problem with money velocity is that it too is a symptom of the extreme over-indebtedness, just as is the inability of the Fed to activate the Wicksell effect or to bring up the inflation rate. These are—they're operating the way they do because of the indebtedness problem. I think if you look at the big ticket sectors of the economy, as of right now, August of 2014, the big ticket sectors are flattening out, if not faltering. Ford Motor in releasing the July vehicle sales said that the automobile market is flattening out, and that's with a record percentage of subprime loans. If you look at new home sales, flattening out would be a generous interpretation, they're trending lower. If you look at nondefense capital goods shipments, they have flattened out. They might be trending lower than machine tool orders last month; you may have seen the numbers were negative year over year. Well machine tool orders are just a small component of capital spending but it's hard to envision a situation where capital spending in general can be doing well when the machine tool component is negative.
So what we're left with, basically with your big ticket items flattening out, is you've got to try to move the economy by selling items that fit into the grocery cart or that go across the counter. Well you can keep an economy kind of stable, keep the nose above the water line, but the economy is not going to move forward in this type of environment.
Chris Martenson: Well fascinating, and thank you so much for your time today. I have a final question for you. It relates to the idea of inflation, a lot of people wondering where it is. I know that you made the point that there's just so much industrial capacity across the world that it's hard for inflation to really get going. So here's the question, what would happen if China and Russia go back behind their walls and iron curtains respectively at this point in history?
Dr. Lacy Hunt: Well that would be worrisome and it would change the dynamic because the price level is determined by the intersection of the aggregate demand and aggregate supply curves. The aggregate supply curve is really the cost of production. Now the cost of production is heavily influenced by the scale, the economies of scale. We saw that when the Berlin Wall came down in the late 1980s that there was a tremendous increase in economies of scale which brought the cost of production downward. So if you were to pull Russia and China out of the picture, that would matter. Now if it's just Russia by itself, that's not that consequential. China in my opinion is the lynchpin; but they are so dependent on export sales. As a matter of fact, as a result of the way in which they trended they've become more dependent on export sales to the west. So for the time being I don't think the risk of China pulling out is that great, but it's certainly something that we would have to monitor.
Chris Martenson: Absolutely. Well with that I really want to thank you so much for your time. We've been talking with Lacy Hunt of Hoisington Asset Management. Lacy, obviously extremely well-grounded in history and that comports well with how we view the world. There's nothing new under the sun. We have to understand where we are in terms of where we've been. So, Lacy, thank you for much for your time today.
Dr. Lacy Hunt: Great pleasure to be with you, Chris, and congratulations on your work and best wishes for your continued success.
Chris Martenson: Thanks and likewise for you.
Dr. Lacy Hunt: Okay, all the best.