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Doug Duncan: Even US Government Economists Predict Trouble Ahead

Fannie Mae forecasts an economic slowdown by 2019
Monday, April 16, 2018, 11:53 AM

Doug Duncan is not your average beltway economist.

The chief economist for Fannie Mae is surprisingly outspoken about the troublesome outlook for the US economy. He's worried about the rising cost of debt service as outstanding credit continues to mount at the same time interest rates are starting to ratchet higher, too.

He predicts the US will enter recession within a year, concurrent with a topping out of America's real estate market. It wouldn't surprise him to see the stock market falter, too, as central banks around the world begin a coordinated tightening of monetary policy and -- similar to the thoughts recently expressed within our podcast with Axel Merk -- Doug expects Jerome Powell to be much more reluctant to intervene in attempt to support asset prices. Having met personally with Powell, Doug thinks the Fed is now happy to see some of the air come out of the Everything Bubble (just not too much and not too fast) -- a market change from past Fed administrations:

Our forecast definitely sees slowing economic activity, particularly in the second half of '19. Part of it has to do with the length of the expansion. Just because an expansion is long doesn't mean it's going to end; but they all have eventually ended, and this one is getting pretty old. I think if it's not the second longest, it's getting to be the second longest that we've ever had shortly.

The tax bill was viewed differently by different parties, but the capital markets initially took that -- plus the $300 billion agreement to get past the expiration of government funding plus the budget agreement -- they took all those things as inflationary. The tax bill itself has a lot of temporary provisions – some of them don’t expire for up to seven years – but some start expiring as soon as three years out. Like, on occasions, take actions today which they see having benefits up until that time of the expiration of those terms, plus the spending component – the $300 billion – also will likely take place in the next four quarters. That suggests that the second half of '19 we may well see the impulse from those things starting to fade. And that will be happening at the same time as the Fed, if it does what it says its going to do, will be continuing its tightening(...)

So,what keeps me up at night? Well, I don’t like the idea that we have a debt to GDP ratio of 100 percent. I don't think we're Japan because we have a more entrepreneurial economy, not a mercantilist economy, but that doesn't mean that debt doesn’t reduce your flexibility. It definitely reduces your flexibility, so it raises risks from that perspective.

The trade negotiations, obviously, are of a concern. Milton Freeman said a good free trade agreement can be written on one page. NAFTA was two thousand pages. It would be silly to suggest Trump doesn't have a point that there's not something in that two thousand pages that didn't work against American interests. On the other hand, if you're going to throw $150 billion of tariffs at the second largest economy in the world, you should expect a reaction. Those who read the history books and the Smoot Hawley tariffs and the Depression and have some understanding of the relationship between the two of those have to be a bit nervous. The Fed, I'm sure, is looking at that.

And the domestic economy, the thing that probably troubles me more than anything else is the decline in new business formation. It's been underway for thirty years. I've got staff that are working just trying to understand that. There's a couple reasons why I worry about that. I just make a comment about ours being an entrepreneurial economy which means it is 'dynamic' – people don’t care if the average income is higher than theirs if theirs is the median. If they expect that there's an opportunity for them to grow and gain one of those high incomes, then they're OK. But if they lose that hope, that leads us to some different possible political economy outcomes which I don’t view as particularly optimal.

But from a self-interested perspective -- remember that we're in the housing and new business formation space – it used to be the case that a when small business would start, it couldn't afford to pay the same wage rate as a large business did because it didn't have the scale or the output or that kind of thing. But what the worker who got the lower wage job also got was training on how to get to work on time, how to work a full day. They would pick up some skills and some behaviors that worked broadly in the employment market. Over time they would move up, and most of them would eventually get to the middle class and buy a house. That's breaking down.

If that engine of growth for people has been cut off, then we could be facing a permanent underclass which carries a whole different set of connotations for a society which, to me, is pretty troubling.

Click the play button below to listen to Chris' interview with Doug Duncan (45m:19s).

Transcript: 

Chris: Welcome, everybody, to this Peak Prosperity podcast. Hey, we're on the road today. Adam and I are Fort Lauderdale, Florida, and we are at the Real Estate Investors Summit, and we have the great fortune of being able to get and on-the-fly forecast with Doug Duncan, the Chief Economist of Fannie Mae. Gave a great talk today titled Fiscal Policy and the Feds. Some really great insights, particularly having met Jerome Powell, the new Chairman of the Federal Reserve, and some great insights there as well as some predictions about where you think the data is showing us the economy might go over the next year or so. So first, welcome.

Doug Duncan: Thank you. Thanks for inviting me. Glad to be here.

Chris: It was a great talk this morning, really good, very riveting for an economist.

Doug Duncan: Well, you know, our profession deserves all the acrimony that it gets for being understandable. In some cases, it's a strategy, I think, not to be understand, but hopefully, it's useful.

Chris: And we've got Adam Taggart here as well, of course.

Adam: Very glad to be here, and Doug, I just want to echo what Chris said. Really enjoyed your presentation, both this year and last year, actually. When we were here last year we were coming up on stage to present right after you, and we were planning on, when we saw the Chief Economist from Fannie Mae was going to proceed us, that we were going to open our remarks with, hey, the opposite of whatever that guy just said. And we find ourselves coming on the stage and saying the exact opposite, which is we agree with everything this guy just said. So I think our listeners here are actually going to enjoy what they hear from you today.

Doug Duncan: Good.

Chris: So, let's start with the economy and your views there. You said in this talk if you were going to pick, if you had to pick one spot where a recession might come, it would be in the second half of 2019. How is it that your views and data sort of lead you there?

Doug Duncan: Well, if you look at our actual published forecast, you'll see it doesn't actually have a recession in it. But it definitely has slowing economic activity, particularly in the second half of '19. Part of it has to do with the length of the expansion. Just because an expansion is long doesn't mean it's going to end, but they all have eventually ended, and this one is getting pretty old. I think if it's not the second longest, it's getting to be the second longest that we've ever had shortly.

The tax bill was viewed differently by different parties, but the capital markets initially took that, plus the $300 billion agreement to get past the expiration of government funding plus the budget agreement they took all those things as significantly, potentially inflationary. The tax bill itself has a lot of temporary provisions – some of them don’t expire for up to seven years – but some start expiring as soon as, say, three years out. Like, on occasions, take actions today which they see having benefits up until that time of the expiration of those terms, plus the spending component – the $300 billion – also will likely take place in the next four quarters. That suggests that the second half of '19 we may well see the impulse from those things starting to fade. And that will be happening at the same time as the Fed, if it does what it says its going to do will be continuing its tightening.

Chris: Now, I'm wondering, in your many factors that go into looking at that slowing that you see in the models, do you use anything what's termed a credit impulse which is a term that the chief economists at Saxo Bank, they track the credit impulse which for looking at the change in credit creations system, and they're seeing a negative value in that right now. And they say, you just take that, fast forward nine months, any you find that has about a 60 percent correlation with a slowdown in the economy. The other 40 percent will be things you can't predict – fiscal policy, monetary actions, things like that. Do you track credit as part of that?

Doug Duncan: What we do, we're in the credit insurance business at Fannie Mae – basically we're a big insurance company that guarantees investors type of payment principal and interest on securities that they decide to purchase. So, absolutely. I noted with interest that aligns with their story yesterday that consumer credit fell way below what the expectations were. It was expected to be about $15 billion; it only grew about $10 billion. That aligns with some consumer conservatism. The other aspect of that that I would say people have been ignoring is the fact that the Fed is shrinking its portfolio, which is in itself a tightening of credit.

So I'd say those things align with what they're suggesting. I think that maybe this spending component at the Federal level may override some of that in the short run and extend the time period maybe out to that second half of '19. So, whereas that nine-month projector might say the first half of '19, I think that spending at the Federal spending may push it a little further out.

Chris: Now, this Federal spending, of course, a lot of eyes on that right now; it's pretty dramatic. I'm going to use rough numbers, but with about two and a half percent growth in the economy last year, that would have been roughly $400 billion of incremental growth. The government deficit spent about a trillion according to the Public Debt to the Penny website, so if we take out – does the government – how committed is the government to continue to deficit spend at these levels without impacting the economy unfavorably?

Doug Duncan: Well that's why the title of the thing, it was Fiscal Policy and the Fed. The Fed's part of the government, then we have the legislative part of the equation, so they manage fiscal policy, but the Fed is going to respond to that one way an another. Whether imputing their actions directly to the change that they see in fiscal policy or not, they're going to respond one way or another. So the market believes, today, anyway, that there is going to be, as a result of that uncontrolled and continuing government spending in deficit inflation eventually. The Fed has to make a decision. I would say the recent indicators suggest we haven't seen yet actual inflation – we've seen expectations of inflation – but the Fed's also trying to juggle $150 billion of potential tariff's to be put up in international trade, and what does that do to not just to the international trade component of the economy, but what do consumers perceive that it will – because it will definitely raise costs domestically to consumers.

And so they're going to be weighing this. And if they don’t' see significant growth in measurable inflation, I think that Powell is likely to me more patient than, for example, Yellen was. Because the one comment that he's made about the Phillip's curve, which was very much driving Janet Yellen's view was that appears to have flattened. That was not a casual comment because the Fed, as an entity, has lived off the Phillip's curve whether it's been a good predictor or not. It's only been a good predictor five of the last twenty-five years which, if I were characterizing myself as data driven, I might review that a little bit. So what I'm saying is I think Powell may be a little bit more patient as he balances those questions. It's interesting how that organization is changing now with him in leadership.

Chris: When you say more patient, what does that mean?

Doug Duncan: Well, right now the market has an expectation of two additional rates increases this year, and some possibility of a third additional rate increase. I would say if you don't get the third-rate increase, that's some evidence of patience. If the third one is – so we had one – the next one will come in June, almost certainly – if the third one is delayed until December, which is what's in our forecast, we believe that's a demonstration that they're waiting to see actual inflation as opposed to expected inflation.

Chris: This is interesting.

Adam: Well, I just wanted to build on your comments that about Jerome Powell, Doug. You mentioned earlier today that you'd been in some meetings with him and had some observations you took away from how he might differ from Yellen and some of his other predecessors at the Fed. I don’t want to put words in your mouth, but one of the comments you made that really stuck with me was saying that you see him as much less likely than a Bernanke or a Yellen to step in if the market starts correcting as long as the system itself isn't at threat. Is that an accurate?

Doug Duncan: Yeah, that's right. In one of the meetings that I was in, the market closed while the meeting was going on, someone came in and gave him a piece of paper. The market had been down a thousand points that day, and it was unremarked throughout the meeting. It was not – there was no discussion of that event. That might have gotten different attention from someone else, but I think his experience having built the industrial mergers and acquisitions businesses at Carlisle, having spent time at treasury, having spent several years at the Fed now, I think gives him a rounded perspective from the business side of the equation that some of the other Fed Chairs have not had.

Both Bernanke and Yellen were much more on the academic side of the equation – he comes from a much different background. I think it's useful and particularly at this time. So one other thing I would say, as you listen to him, listen to the language and the language that he uses will be much more attuned to the language that the market itself uses or that the general public uses about the market changes around themselves.

Adam: Just one more point, and it's just for listeners here, I just want to point out that what I'm really liking and appreciating about this is we've had Axel Merck on the program previously who's made very similar comments about Jerome Powell and his differences, and they're just very cooperative of what Doug is saying. And I like it when we hear very similar intelligence from people who have their own different exposure to key players in the space. So I definitely take these words as being probably very highly accurate because they're now coming from two sources that we have a lot of respect for.

Chris: So this is fascinating because we had Greenspan, who remains an enigma to me – I'm still not quite clear on how to place him in my mental map of things – and you're right, Bernanke and Yellen, very academic coming from a PhD economist sort of a place, and I'm a PhD myself, so I can now cast dispersions on that. But I understand that the incentives in an academic environment are very much about perception and your reputation and needing to be right and all off that. It's just a shaping thing. Lawyers are shaped differently from professors. And I'm a big believer in how we get shaped by those things. So when you see somebody like Jerome Powell coming in with more of a business side as well as a legal framework, in your mind, what's different in the decision making in that organization now?

Doug Duncan: Well, I think that what you'll see is that Powell will have, as advisors, people that will have a traditional cadence or vernacular of economists around him, but he'll interpret through that. So he himself, he has his particular way of thinking through the movements within markets, and he respects economists, I don’t think there's any doubt about that. In one of the meetings he had some of the economist ask some questions, so he would – but as he listened to them ask the question and get the response, he would then rephrase things in a slightly different way which, to me, reflected his processes that bring some insights from market behaviors.

Chris: Right. And I think there's still four open seats on the FMOC, so the composition is going to change. We don’t know who's going to be brought in. do we have any sense of that yet?

Doug Duncan: Well, there have been a couple names that have been floated – Marvin Goodfriend was one. He had been at the Richmond Fed and was an academic at Carnegie Mellon. My sense was that was – he was never formally nominated, but it's kind of backed off because he had vociferously supported negative interest rates as a policy tool as opposed to the portfolio, and I think there's not much appetite for the negative interest rate approach. So my sense is that possibility has faded. There's some discussion in moving one of the Regional President's from the Cleveland Fed in as the Vice Chair. I don’t know, I haven't listened for any kind of intelligence on whether that's making progress or not. I would say this is likely to be an interesting and differently balanced board than we've seen for some time, perhaps less politically or technically oriented and more business oriented.

Chris: All right, so again, not to put words in your mouth, but I think a comment you made earlier was that you felt Jerome Powell was likely to be less interventionist. Maybe he would be more tolerant of market volatility in the equity space before responding in some way.

Doug Duncan: I believe that. It was called the Greenspan put because of Greenspan's reaction to, I think it was, Black Friday, Black Thursday, whatever it was. I don’t expect to see that unless significant institutions are threatened. If you saw something like B of A was threatened with failure, I think you'd see some intervention, but that's less about shareholders and more about the system.

That's one thing I would say about Bernanke and his administration of the Fed is, to me, the single most successful government program I have ever seen was the short-term money conduit that they threw up, that they had never had a conduit for commercial paper. They created a conduit for commercial paper. It went from zero to $300 billion in 90 days, and it was wound down as rapidly. The purpose of that was corporations like Ford and other major employers were not able to get the markets in which they take short term funding to meet payroll went illiquid. They threw that up; it proved to the market that there was going to be stability; they wound it down; it went back to zero. That to me was an insight that he got from his research into the oppression which turned out to be immensely valuable for that period of time.

Whether the QE story is one that's going to written as well about him as that, I do believe he's going to get a lot of credit for in terms of what happened in terms of the institutions. Powell would do the same thing I believe for the institutional structure, but I think he is not particularly concerned about whether your stock portfolio goes up or down in value.

Chris: And from a perception standpoint, that would be a change because my perception has been that during other key periods under Yellen, we would see Fed officials get trotted out during what I would consider to be very minor moments of market volatility to…

Doug Duncan: Well, you guys believe in markets, right. So one of the ways that you learn about risk return pricing is when prices move. So volatility actually has a purpose in discovery. So if the Fed's policy was to remove volatility, what they're saying is we’re removing price discovery from markets which, to me, inhibits the functioning of markets and leads to the potential, at least, of the misallocation of resources.

Chris: Absolutely. A total agreement on that one. I have a semi-wonkish question for you, and it concerns these interest rate hikes that are happening. And prior to 2008 an interest rate hike meant the Fed didn't have a magic dial. They had to go into the marketplace and remove enough cash until the overnight rare would sort of settle around the target spot. So if they wanted to make rates go down, they would push money out. If they wanted to make rates go up, they'd pull money out.

Since 2008, and in particular recently, I've seen that the Fed hasn't had to withdraw any liquidity from the market; they’ve just taken the interest on excess reserves, the IOER, they just dial that up, and that is their magic dial now. So the question is, are these actually truly rate hikes like we understood them in the past? And if they're not, how do we understand them?

Doug Duncan: They're not like they were in the past. Part of it is because of the change in overall financial regulation that's taken place. They were driven by the breaking of the buck, the money fund, that was really the thing that drove that shift. So what you see now is when they make the short-term rate change, they talk about the range, moving the range, because they can't actually control on the decimal point exactly where that rate is going to end up. So the conduct of monetary policy now has multiple tools in it.

Whether there will be an attempt to change that in this administration or within the leadership of J. Powell, I don't know, except I do know he was the governor that was tasked with trying to find the replacement for LIBOR because Fannie Mae throws off a lot of cash. so we're one of many institutions that they talk to about – and now, that is in the marketplace, went into the market place this past week. So that piece of experience in terms of looking through the instruments in the market that make the market function well may open the potential that they would take a look at some of the other tools that the Fed uses to see whether or not they're as effective as they think.

Chris: All right. Well, speaking of LIBOR, it's been spiking lately. Do you have any explanation for that?

Doug Duncan: I don’t. I'm watching it like others and trying to figure out whether it's a liquidity question or whether there's some sort of speculative activity in it that's driving it. Unfortunately, it's the index for a lot of adjustable credit products, and whether or not they're being properly priced to the consumer because of movements that we can't explain in the markets is an open question and an important one. And it'll be sometime until this new measure can be brought in broadly.

There's a whole bunch of contract changes that have to be made. I know we're looking at that in the mortgage space. What are all the things that have to be adjusted in order to make sure we keep consumer protections in place and understand how the instruments will perform with this as an index and all that kind of thing?

Chris: Sure. I've be watching that and also the LIBOR4 OIS spread which is the dollar basis on top of the LIBOR, for people listening. I'm not sure what that is but I'm squinting at it. Is this a funding crisis that's brewing in Europe or is this related to the tax package which has American companies withdrawing dollars from the Euro system and repatriating them, creating a temporary shortage?

Doug Duncan: Those are things that you've heard discussed, but I haven't seen solid empirical work that suggests to any one or particular combination of those things as the driver. But I'm sure the Fed is on it. They have hundreds of economists. Whether that's good or not, I'm not sure.

Chris: Well, Doug, what keeps you up at night, if anything? Do you see any sort of storm clouds here or things sort of more or less cooking along?

Doug Duncan: Well, I don’t like the idea that we have a debt to GDP ratio of 100 percent. I don't think we're Japan because we have a more entrepreneurial economy, not a mercantilist economy. But that doesn't mean that debt doesn’t reduce your flexibility. It definitely reduces your flexibility, so it raises risks from that perspective, so that's a big picture item. The trade negotiations, obviously, are of a concern. Milton Freeman said a good free trade agreement can be written on one page. NAFTA was two thousand pages. It would be silly to suggest Trump doesn't have a point that there's not something in that two thousand pages that didn't work against American interests.

On the other hand, if you're going to throw a $150 billion if tariffs at the second largest economy in the world, you should expect a reaction. And those who read the history books and the Smoot Hawley tariffs and the Depression and have some understanding of the relationship between the two of those have to be a bit nervous. The Fed, I'm sure, is looking at that. So that's something that I think about. Those are kind of big picture items.

And the domestic economy, the thing that probably troubles me more than anything else is the decline in new business formation. It's been underway for thirty years. I've got staff that are working just trying to understand that. There's a couple reasons why I worry about that. One is, I just make a comment about ours being an entrepreneurial economy which means dynamic – it goes back to our earlier conversation we had about if people expect that – they don’t care if the average income is higher than theirs if theirs is the median. if they expect that there's an opportunity for them to grow and gain one of those high incomes. If they lose that hope, that leads us to some different possible political economy outcomes which I don’t view as particularly optimal.

But from a self-interested perspective, that we're in the housing space, new business formation – it used to be the case that a small business would start, it couldn't afford to pay the same wage rate as a large business did because it didn't have the scale or the output or that kind of thing, but what the worker who got the lower wage also got was training on how to get to work on time, how to work a full day. They would pick up some skills and some behaviors that worked broadly in the employment market. Over time they would move up, and most of them would eventually get to the middle class and buy a house.

If that engine of growth for people has been cut off, then we could be facing a permanent underclass which carries a whole different set of connotations for a society which, to me, is pretty troubling. So that's actually in the domestic economy, pretty close to me number one, if not my number one, concern for us. I don’t know the reasons for that.

Chris: So there's probably a bunch of factors, and I'm sure you have much better numbers than I do, but if I could just sort of use my thumbs and paint broadly here – about a trillion dollars in interest income is missing because of the low interest rate policies of the Fed that would have gone to savers. Let's call it boomers, grandparents, parents of children. That trillion dollars is no longer there to help capitalize new business formation. I'm concerned that there's a whole big giant chunk of money missing that would have been the capital formation for new businesses, and plus, as a couple of small business entrepreneurs ourselves, we'll tell you it's hard to start a business in this country. And increasingly, regulations and…

Adam: Employees are increasingly expensive to…

Doug Duncan: Oh yeah. My wife has her own business. She has twelve employees. She has to file multiple regulatory reports in eight different states because the employees work out of their homes and meet at clients. Pillow talk in our house is cashflow. Have you met payroll, honey? You're hot [PH]. [laughter] We're really risqué. So no question, that's a big challenge. And you could actually see what you're talking about in terms of savings in the demographic data that I showed. This morning I showed that it's the older age groups whose workforce participation has been increasing. They're not increasing because they want to work later – they have to. If you go in our community and you go to the Checker's and you go to the grocery stores, most are over 65, maybe over 70. If you're only getting a half a percent or one percent interest on your savings and your retirement plan had assumed five percent, you got to add a lot of principal to get the same cashflow off of that that you were expecting in retirement. So it is, again, it's one of those side effects of Fed policy that kinds of gets glossed over, but it has real impacts in the local economy.

Chris: Absolutely.

Adam: So I want to get back to Chris's question about what keeps you up at night. There's a question I want to ask you, but I need to ask you another question first. So in your talk today, near the end, you mentioned I think three factors you saw as contributing to higher interest rates going forward. Do you remember what those were?

Doug Duncan: Well, there's the underlying rise in the ten-year treasury. So I was talking about mortgage rates, so the underlying rise in the ten-year treasury, that's the base off of which mortgages are priced because the average life of a mortgage in a typical, cyclical is seven to nine years. So the ten-year treasury is kind of the benchmark. So that's risen about fifty basis points, based on expected, not realized, inflation.

But the second thing is the Fed's purchase of mortgage backed securities to the point it became the worlds' single largest holder of mortgage backed securities, about $1.8 trillion. They’ve programmed to the market what they intend to do about letting that run off, and it had stared to run off. Our view of new production, plus the runoff from the Fed's portfolio that's going to have to picked up by private or other sovereign investors around the globe is that their appetite – the traditional holders of those securities will be sated probably mid-year, or maybe a little bit after the middle of the year, in which case we'll have to find out what's the yield requirement for the incremental investor, and that's almost certainly going to be higher. So that would be a second upward pressure on the headline mortgage rate.

And then the third thing is the Fed's buy – and if you look at primary and secondary spreads in the mortgage market, what you'll see is the Fed's buy and open the door for the FHFA to have the GSEs increase their guaranty fees by about twenty five or twenty eight basis points simply because the Fed's exits – they're not going to reverse that. So that will be a third, upward pressure on mortgage rates going forward. So I would expect all other things being equal, that you will see higher mortgage rates if, for no other reason, then just those technical factors that will show up at the market.

Adam: All right. So here's my follow up question which is, the pieces I put together listening to you earlier today, here's how they play in my mind, and I'd love to hear if you think I'm putting them together correctly, and if I am, what you think. But we're coming off eight years of basically a forty-five degree ramp up in the equity markets year after year, very little correction. We've seen price inflation in a lot of asset markets such that there's a lot of macro thinkers, many from here at this conference, who are saying that we're in an everything bubble. You can parse out how accurate that is or whatnot. But certainly you can't deny that stocks, bonds, real estate, they’ve all been kind of on a one-way elevator trip over the past bunch of years. And in many ways, that's largely due to a lot of the liquidity that's been in question by the world Central Banks, the Fed, ECB, others.

So that's the reality that we've gotten used to over the past six, seven, eight years. Now we seem to be entering a phase, if I'm hearing you correctly, where the Central Banks will start net tightening. So that money spicket is going to start getting turned off, and it sounds like we're already seeing data showing that is beginning to happen with the Fed, and maybe even beginning with the ECB. So let's assume for a moment they actually do what they say they're going to do. To me, that just seems like a colossal reversal of trend of what we've been accustomed to.

We then have rising interest rates as part of that process, and the Fed's going to keep hiking, and it's a matter of how patient Powell may be, but there's still a number of expected rate hikes coming forward. We now have rising mortgage rates, which you mentioned as well. And we have a new Fed Chairman who is not willing to be the market's backstop the way that his processors have been.

So I string all that together and think, oh my gosh, that is a huge reversal trend on like four major fronts that have been propping up world asset markets. So if anyone of those pillars was sort of getting kicked out, I'd have some concerns. But to know that four of those are going to be falling over the next year, several years, that makes me very concerned as an investor that this is not a time to be speculating or being aggressive with investment capital. It's probably very much a time for playing defense. Am I seeing things correctly through your lens, or am I finding danger that I might be seeing at a higher degree than you think is really true?

Doug Duncan: I think we're in the same place that if you think about the Fed's stated objectives in the quantitative easing, it was really about three things. Put a floor on the house prices. That's a particular asset class because you had two thirds of the households in the country that had equity at one point in that asset class. So it was a broad-based way to put a floor under the price of that asset, to remove volatility from the marketplace and to stabilize the financial system. Those are really the three objectives. So the second component of the objective of putting a floor under the asset valuation is the wealth effect, their belief that monetary policy could be used to generate a wealth effect through assets.

Now it's not clear to me, if you look at the consumption patterns, that they didn't inflate the asset valuations, but not receive the consumption expansion. So I'm a pretty skeptical macro economist about the benefits of the so-called wealth effect because I just haven't seen a substantive impact of that. Now, partly, if I was going to argue against my own position, I would say, well, it's because the benefits affected households who are much higher income and wealthier and therefore the consumption, they're a smaller part of the total population, and their propensity to consume is lower than it is for lower income households. That's a legitimate point, I'll grant that.

But no question that the Fed is going to reverse that as they tighten and all Central Banks as a group. I think back to the late 1970s and early 1980s and I wonder if Gerome Powell isn't a little bit in the place that Paul Volker was. And Volker had – who I view as our best ever Central Banker – I was going to say towering but I mean, I had lunch with him a few times, and I asked him one time what was the biggest mistake he ever made? And he said, I had no idea the damage Fannie Mae could do. He's just a tremendous intellect. But he had the benefit of being a peer civil servant. He really didn't have an objective other than to do the right thing for the economy. That was his whole life's objective. And I know for Princeton, I know he heads a group that attempts to build civil servants that are nonpartisan.

But he also had a President who respected the dollar, cared about a sound currency, cared about economic growth, those kinds of things, and backed him. so he could attack inflation, do the things that were difficult to do because he got the political support even through the Fed is a nonpartisan organization, that doesn't mean it's not subject to politics.

If Powell does the right thing in terms of shrinking the Fed's footprint in capital markets, shrinking the portfolio, supporting efforts to reduce the overall debt level within the economy, the Fed can play a part in that, but they're going to have to have some support to do that because some of that's going to be painful. You're going to be reversing some things, like you say, we've had this forty-five-degree upward path of assets. Some of that's not going to be there.

Chris: And so we've heard painful used possibly euphemistically, so let me paint what that might mean in one case. I was shocked to discover that pension funds, and particularly state and municipal funds, had switched from a 60/40 bond to stock to a 60/40 stock to bond allocation over this period of time. And, of course, they were starved for yields as everybody was. You know, we talked about elderly or pensioners being starved, but the pension funds themselves being starved – so if they are not exposed 60/40 equity/bond, and there's a route that comes along in the equites, the pain is going to be felt in places like, I don't know, towns in California, cities, Chicago, places that are going to find already burdensome sort of pensions payments that are going to have to go in possibly catastrophic, like deal breakers. Like we saw a couple of towns or cities, I think Harrisburg, you know, went bankrupt largely due to a lot of mismanagement. The pensions was a pretty heavy stone on a weak back.

Doug Duncan: You asked earlies about what keeps my up at night. That's in that category. I think we're just – we've made commitments, public commitments, that are simply not going to be sustainable. Watching Illinois and watching the Supreme Court say, well, you have to honor these obligations, but as you raise taxes then your taxpayers leave the state, there's a point at which it's simply impossible. It won't happen. And there's two or three states that are fast approaching that. There's a lot of people who have made assumptions about their retirement, and they're at a point where they can't go back to work, or where it's very unrealistic that they would earn a significant income if they went back to work. That's a very troubling sociological issue to me.

Chris: I think it was the governor of Michigan put up a billboard, and as people left Illinois, said, welcoming all these wonderful people who were coming into his state, and he loved it because they were the wealthy, entrepreneurs, people who had businesses, people that the taxes were directed against were exactly the wrong ones – they're not the people you want to…

Adam: They're the last ones you want to lose.

Doug Duncan: That's exactly right, yeah. Lots of business people, successful, folks that live in Florida. Florida benefits from the same issue.

Chris: Yeah, New Jersey discovered that there's only so far you can squeeze hedge funders before they discover…

Doug Duncan: We're in Fort Lauderdale. They call Fort Lauderdale/Miami area the fifth borough, the sixth borough, whatever it is.

Adam: It's so refreshing to hear somebody at such a position of leadership in a government institution speak the way you do and think the way you do. How unique are you? In other words, are you the only one that thinks this way, or are we mistaken? Do many of your peers think this way?

Doug Duncan: It depends on the issue that you're talking about. We were just talking about the pension issue.

Adam: Let's talk about these concerns that keep you up at night.

Doug Duncan: Yeah, I think there – whether people focus on them the way that we do at our company, I don't know. They resonate with other people. I mean, to take a small business or a new business formation issue, there's a related issue which economists have been commenting on which is since the passage of Sarbanes-Oxley, the number of listed companies on our stock exchange has fallen by half.

So if you thought of a business that started up and eventually wanted to be a publicly held company, the incentive to go that route has declined dramatically which has raised the power of the hedge funds and private equity investors which are not necessarily accessible to the public broadly. So these are things that are well known among the economist's circles. A lot of times it depends on who they work for or where the focus of the energy is, but this would not be alien concerns to them at all.

Adam: Okay. Well, that's good to hear. How about in terms of the wheels of government actually turning to address some of these systemic risks? In other words, it sounds like at least a fair enough people are aware of some of these issues and think about it. Are we actually doing enough, in your opinion, from the government to actually try to head off some of these potential crises?

Doug Duncan: You know, the easiest one of the entitlements to fix is Social Security. You could make social security solvent for, I've seen estimates I think from the Social Security trust fund, for seventy-five years if you raise the – over a period of years – which I can't remember the number they cited – it might have been as much as ten years – you raise the eligible retirement age to 70. That's a fairly straight forward solution, but we can't even muster the political will to make that fairly straight forward decision. So I understand why people are pessimistic about our ability to address some of those fundamental issues.

I do think within the economics profession, as in many other parts of the economy, there's much too much focus on personality today. The President is a lightening rod for lots of discussions. But our institutions are working. So those places where he's pushed on things that were offensive but also illegal, the courts have weighed in and stopped him. That's what they're supposed to do, so our institutions are still robust. The legislative piece maybe the least robust of them simply because it's reflecting – remember, it's representative government – so it's reflecting the turmoil that's in the public's own mind, and it's maybe accentuated one way or another by gerrymandering or some technology issues like that. But to me, it's not surprising that's there's turmoil in Washington because there's turmoil out in the country.

I showed you our survey that showed even though this is the second longest, third or second – I can't remember what date it becomes the second – longest expansion we've ever had. Up until the election, the majority of people believed the economy was heading on the wrong direction even though it was a recovery. So there's this underlying dissatisfaction that I think is being reflected in Washington. It won't surprise me if there's more political turmoil there, changing leadership multiple times over the next few years until we establish a direction.

Chris: Yeah, I think somebody else had a slide up that said from a – I think a CBS Market Watch article that said that 60 percent of American's have $500 or less at their disposal. So that's 60 percent now going paycheck to paycheck. And, of course, the Federal Reserve policies have driven an extraordinary amount of wealth toward the people who can get to it first, the people at the front end of the tough, as predicted, right, that's not a surprise. That's how it kind of always works that way.

So given that, until or unless there's some sort of redistribution of the pie, it feels like those pressures you're talking about, I would concur, they're just going to grow. And for some people, I've had people personally say how affects they are by Trump and how this is very upsetting to them. I said, if you don't like Trump, you might really hate who comes next.

Doug Duncan: That's right. I have to look at public service and ask, why would anybody really want to do that? A part of me, I'm from the Midwest, and you're not supposed to have an ego if you're from the Midwest, so I realize ego plays a part for some folks. But we, and especially at the higher levels, we have these expectations of perfection of the people who we elect to represent us, and we're not perfect. It's unrealistic to expect them to be perfect. If you've ever made a significant decision in your life, you’ve made a mistake. If you try and do things, some of it's going to work. Some of it doesn’t work. So the ides that we would elect people who have never made a mistake is, to me, exactly wrong.

What I'd like is some people that accomplished a bunch of things and learned some stuff along the way that can apply that when they get into the leadership position. So it would be really good if we could back off on some of the – and that's both parties. It always comes up to me when somebody has somebody on the Congressional stand and says, where were you on the afternoon of July 13th, 1992? I haven't a clue. Right. Why would I expect anybody to be able to…?

Chris: I had a hard time remember what I was doing last Tuesday.

Doug Duncan: Right. So part of it is just the heed around Washington.

Chris: Well, Doug, thank you so much for your time today, just riveting insights and a great talk today. And great job keeping the ego under wraps.

Doug Duncan: Thanks for the invitation. It's been great being with you.

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7 Comments

richcabot's picture
richcabot
Status: Silver Member (Offline)
Joined: Apr 5 2011
Posts: 169
The economy WAS heading on the wrong direction

Doug said "Up until the election, the majority of people believed the economy was heading on the wrong direction even though it was a recovery."  That's because it was, and is, heading in the wrong direction.  Though the government jobs numbers might be improving, people who work for a living know that things have gotten steadily worse through most of the time since 2008.  The numbers improved because people were working multiple part time jobs just to get by.  All those jobs were counted as gains by the government, not the real quality of life decrease that they represent.  It's only recently that employment has tightened up enough that salaries show any hint of increasing.  Health care costs were and are exploding.  Returns on savings are negative in real terms.  Why would the average American think things are getting better?

Snydeman's picture
Snydeman
Status: Gold Member (Online)
Joined: Feb 6 2013
Posts: 475
The Fed

is part of the government?!

Snydeman's picture
Snydeman
Status: Gold Member (Online)
Joined: Feb 6 2013
Posts: 475
richcabot wrote:   It's only
richcabot wrote:

  It's only recently that employment has tightened up enough that salaries show any hint of increasing.  Health care costs were and are exploding.  Returns on savings are negative in real terms.  Why would the average American think things are getting better?

Agreed, and that’s not counting those who’ve fallen off the unemployment insurance, the underutilized, etc. I’ve still got retail stores and restaurants closing in my solidly middle-class area at an alarming rate. The nearest shopping center now has over half the store fronts shuttered. The pain is worse than the numbers show, which only causes people to lose more faith in the system. When people lose faith in the system, and feel lied to, they change the system. 

 

That is rarely a clean or peaceful process.

richcabot's picture
richcabot
Status: Silver Member (Offline)
Joined: Apr 5 2011
Posts: 169
Multiple jobs

My wife manages catering and special events for a local restaurant group.  Most of the line employees have second jobs, despite the fact that the restaurant pays significantly above Oregon minimum wage and offers subsidized group health insurance.

Their plight is made worse by the housing bubble dramatically increasing local rents.

pat the rat's picture
pat the rat
Status: Silver Member (Offline)
Joined: Nov 1 2011
Posts: 108
Bon Ton

The local Bon store will go belly up soon. The government tells things are getting better ,but all I see little sings that things are getting worse.                                              Witch one is wrong I don't know? 

SagerXX's picture
SagerXX
Status: Diamond Member (Offline)
Joined: Feb 11 2009
Posts: 2231
Snydeman wrote: I’ve still
Snydeman wrote:

I’ve still got retail stores and restaurants closing in my solidly middle-class area at an alarming rate. The nearest shopping center now has over half the store fronts shuttered.

Same here.  My hometown is losing retail stores, incl big-box types (Barnes & Noble, The Sports Authority, K-Mart) at a steady rate.  And yet, new retail space is being built out at a breakneck pace.  It's mind-bending.  Somewhere, in somebody's spreadsheet, all this activity shows up as a "profit" on which somebody's making a tidy bonus.  Or, the universe simply is an absurd place...

VIVA -- Sager

newsbuoy's picture
newsbuoy
Status: Silver Member (Offline)
Joined: Dec 10 2013
Posts: 242
The Center Has Fallen and There's No Going Back

https://brooklynrail.org/2018/04/field-notes/PHIL-NEEL-with-Paul-Mattick

"...The ecological analogy is a good one, then: the decisive conjuncture has already passed. We’ve already failed. But I think that it’s only in these conditions that there are real possibilities. The foreclosure of any easy utopian future forces people to act in qualitatively different ways. And it doesn’t make sense to try and predict whether we’ll face the harshest conditions or the best, because it’s still a bit too far off, and all the elements are just too variable. It’s a game of black swans—you can lay bets, but all your models will fail. What I can say is that things generally don’t fall to one side only. The likelihood of “total war against the working class” is probably about as good as “Bernie Sanders leads the peaceful overthrow of the capitalist system,” if only because of power’s own inherent paradox. Beyond this, speculation is probably best left to science fiction—which isn’t to dismiss it, of course. But just remember that even a “Global Syria” would still include a Global Kurdistan, whatever that might mean."

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