Dr. Lacy Hunt: “QE Has Slowed Economic Activity”

Readers of any duration will be familiar with Dr. Lacy Hunt—renowned economist, a favorite at our Casey Research Summits, and past contributor to these pages. I'm happy to have him back today with original analysis about what to expect for the US economy in 2014, including his take on inflation, interest rates, debt, and much more.

Two things always strike me whenever I read Dr. Hunt's work. One, his analysis is fiercely independent. I guarantee you won't agree with everything you're about to read. His take on interest rates in particular is sure to stir up some controversy.

Two, Dr. Hunt's scholarly approach is refreshing. He draws on his unmatched knowledge of economic history to back up every statement with studies, data, and historical examples. Given the sheer number of facts he always seems to have on his side, it's usually hard to argue with his conclusions, even if you don't agree with them.

I'll leave you to explore Dr. Hunt's analysis for yourself, and to ponder its implications for your own portfolio.

Lacy Hunt on the 2014 Economy

Lacy H. Hunt, Ph.D., Economist

In his book The Theory of Interest, Irving Fisher, whom Nobel Laureate Milton Friedman called "America's greatest economist," created the Fisher equation. It states that the nominal yield of a bond is equal to its real yield plus expected inflation. This equation serves as the pillar of all of macroeconomics and as the foundational tenet of the bond market. It has been reconfirmed many times by scholarly examination and by the sheer force of historical experience. If we examine periods of both low and high inflation, we'll see how each variable in the Fisher equation affects the outcome.

From 1871 to 1948, a period of relatively low inflation, the US Treasury bond yield averaged 2.9%, with the inflation rate 1.0% and the real yield 1.9%. From 1948 to 1989, a period of higher inflation, inflation jumped to 4.3% on average. The Treasury bond yield increased to 6.0%, but the real yield remained close to historical norms at 1.7%.

More recently, the inflation rate has declined, but the real rate has remained close to historical averages. My point is that while average inflation and bond yields were volatile, the average real yield was far more stable. Over longer stretches, the real yield was never far from its post-1871 average of 2.2%. Thus, over long periods of time, bond yields fluctuated in response to rising and falling inflation. However, the real bond yield steadily reverted to its mean.

Inflation

While a host of factors caused inflation to vary in the aforementioned periods, two significant ones are easily identifiable. First, the 70-year span between 1871 and 1948 (excluding the World War years) was an extended global market era. A new paradigm of uninterrupted transcontinental railroad travel plus the completion of the Suez Canal ushered in this era of rapidly expanding global trade. By 1871, 10% of US railroad traffic carried globally traded goods. This era produced increasing returns to scale and minimized price pressures.

Second, the 1871-1948 period encompassed two episodes of high indebtedness: the 1870s, and then the 1920s until the mid- to late 1940s. Both severely destabilized economic activity and produced minimal inflation, which in turn led to depressed bond yields that eventually reached slightly less than 2%.

Those episodes roughly correspond with the two 20-year periods of that era when the total return on long-term Treasury bonds exceeded the total return on the S&P 500: one from the 1870s to the 1890s and another from 1928 to 1948. On top of that, the traditional demographic vibrancy in the United States ended during the 1930s as both the birth rate and total increase in population slowed dramatically.

The period from 1948 to 1989 differs markedly. By 1948, a global market did not exist, and the excessive indebtedness of the 1920-1930s had been eliminated. In the late 1940s, the Iron and Bamboo Curtains imposed by Russia and China removed roughly 50% of the world's population from global trade, reducing economies of scale. During the war years, from 1933 to 1948, the US ratio of public and private debt to GDP dropped from 295% to 139%, as the personal saving rate jumped from below zero to 28%. With normal and sustainable debt levels the US entered the post-war boom, a period of rapidly rising prosperity that produced greater returns on the S&P 500 than on long-term Treasury bonds. Additionally, the abysmal demographics of the 1930s gave way to the post-war baby boom as households became more optimistic about their economic prospects.

Today, conditions resemble the 1871-1948 period. Global trade is once again less inhibited, and public and private debt is high and rising. The saving rate is greatly depressed. Demographics have soured. The birth rate in 2013 fell to its lowest level on record, and the rate of population increase was the slowest since the Depression-era year of 1937. Thus, fundamental conditions are now conducive to an inflation rate averaging 1% or less. Based on the Fisher equation, long-term bond yields should be comfortable trading at 3% or lower.

Many factors influence the global inflation rate, but the current bout of low inflation and insufficient demand are both symptoms of extreme over-indebtedness. Price weakness is evident in numerous different measures. Over the last twelve months ending November, the durable and nondurable goods components of the US personal consumption deflator fell by 2.0% and 0.6%, respectively. Prices of imported goods fell 1.5% over the same period; excluding oil, the decline was nearly as large. Facing weak domestic demand, foreign producers cut prices on goods headed toward the US market, and this forced domestic producers to match those lower prices.

A lack of pricing power is likely to continue in 2014, for three main reasons. First, the global economy continues to incur more indebtedness. Both public and private debt in the major economies of the world continue to rise further above the levels that depress economic activity. Second, monetary conditions moved in the wrong direction last year, partly as a result of misguided policy efforts at quantitative manipulation of reserves. Third, although the sequester of government expenditures will be less in 2014 than in 2013, fiscal policy in the broadest sense is not supportive of economic growth.

Indebtedness

Academic research shows that a public and private debt-to-GDP ratio above the range of 260-275% depresses economic growth. In 2000, the US debt level exceeded this range. Since then, the bond yield has averaged 4.6%, with inflation at 2.1% and the real yield 2.5%.

By comparing growth and debt figures prior to 2000 with those afterward, we can assess the magnitude of the problem and likelihood of its persistence. From 1871 to 1999, private and public debt averaged less than 165% of GDP (well below the 260-275% critical level), and the trend growth in real GDP was 3.8%. From 2000 through 2013, GDP growth has faltered to just 1.9%. Based on the latest 2013 figures, total private and public debt amounted to $58.2 trillion, or 344% of GDP.

If the debt-to-GDP ratio were currently the same as the average from 1871 to 1999, total debt would be only $30.5 trillion, or almost half of the existing level. The debt-to-GDP ratio declined since peaking in 2009, but not enough to reenter the normal range. Moreover, the ratio resumed its upward trajectory in 2013. Thus, the US appears to be following the Japanese example of trying to cure a debt problem by accumulating more debt.

Scholarly research conducted in the US and Europe over the past three years indicates that the amount of government debt relative to GDP has reached levels that historically have produced a deleterious effect on economic growth. This effect has historically lasted two decades or longer. As termed by European researchers, the current levels have reached the "non-linear zone." This means that the negative effects on growth are likely to intensify as this debt ratio moves higher.

Ignoring this research is ill advised, especially since the debt levels are still advancing. Although the US budget deficit was smaller last year, the more critical debt ratio continued to rise.

According to the Organization for Economic Cooperation and Development (OECD), general US government gross financial liabilities as a percent of GDP reached 104.1% in 2013, the highest level since the early 1950s. (Gross, rather than net, government debt is the appropriate measure; netting out the government debt held in other government accounts is not appropriate since the social insurance trusts have far greater liabilities than they have government securities to fund those future commitments.) By the end of 2015, the OECD projects this figure to jump to 106.5%. And according to the Congressional Budget Office, over the next 25 years, government debt to GDP will move dramatically higher.

Since European fiscal policies mirror those in the US, it is not surprising that European growth prospects remain dismal. According to the OECD, general government gross financial liabilities in Europe reached 106.4% of GDP in 2013, up from 95.6% in 2011, an even faster rise than in the United States.

New research shows that the world average of total public debt, expressed as a percent of global GDP, is approximating its highest level since 1826 (IMF Working Paper WP/13/266, "Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten," December 2013, by Carmen M. Reinhart and Kenneth S. Rogoff). Private debt to GDP in the Eurozone and the UK (and interestingly, in Japan) are all higher than in the US and even further above the levels that research has identified as being detrimental to growth.

Monetary Conditions

Monetary policy continues to be a negative for growth. Three academic papers presented at the Jackson Hole conference last August determined that the present approach of quantitative easing by the Federal Reserve has actually slowed economic activity. Four considerations show that monetary policy is working against economic growth.

First, monetary policy works primarily through price effects. The level of real interest rates determines the price of credit. In 2013, long-term Treasury bond yields rose 100 basis points, or 1.0%. The inflation rate, measured by the year-over-year change in the Fed's targeted core personal consumption expenditure deflator, dropped 50 basis points. This pushed the real yield on the 30-year bond to nearly 3% at the close of 2013. Thus, real yields currently carry a significant premium to the long-term average.

The effects of this rising price of credit are visible in the high-frequency housing data. Recently, pending and existing home sales fell below year-ago levels. Mortgage applications for home purchases in December were at their lowest level in more than a decade.

Second, the money multiplier that reflects the conversion of bank reserves into deposits (money) by the banking system fell to a new 100-year low of less than 3 in late December 2013. This indicates that the Fed's large-scale asset purchases (LSAP) are not currently producing real, tangible economic effects and are not likely to in the future.

Since 1913, $1 of high-powered money has, on average, resulted in an increase of $8.20 of M2. The current multiplier constitutes an unprecedented historical gap. To accelerate economic growth from a monetary perspective, an increase in the multiplier would be necessary. The best indicator of whether this acceleration process is working would be the expansion of bank credit, which includes bank investments and bank loans. Unfortunately, for the past 12 months the expansion of total bank credit is only 2.0% higher than one year ago, and bank loans have expanded by only 1.9%.

Third, in spite of the Fed's LSAP, which was larger in 2013 than 2012, M2 expanded at a considerably slower pace of 5.3% in the 12 months ending December 2013, down from 8.2% a year ago. The reduced money growth is an indication that LSAP is becoming more counterproductive.

Fourth, the velocity of money (V) continues to reject the argument that monetary policies are gaining traction. Velocity, or the speed at which money turns over, links M2 to the level of nominal economic activity. With the money supply expanding at 5.3% in the latest year, it would be reasonable to expect the same growth rate in nominal GDP if V were stable. Unfortunately, since 1997 velocity has been falling—and in the last 12 months it has dropped by 3.0% to 1.57, the lowest level in six decades.

While a myriad of factors influence velocity, the rate of change of financial innovation and lending for productive purposes affect its direction. If debt generates an income stream that repays principal and interest and creates other activities, it will tend to expand economic activity and cause V to rise. Student, auto, and other loans for consumption (which represent the bulk of the increase in consumer credit in 2013) do not meet that criterion—those forms of debt are merely an acceleration of future consumption and tend to inhibit the borrower's ability to increase consumption down the road. Further, new regulations on our financial industries are discouraging financial innovation, and this could bring further downward pressure on velocity.

In 2014, if velocity erodes at a generously low (and unlikely) 2% pace and money supply continues to grow at its current rate, nominal GDP will expand at about a 3% growth rate. If 2013 growth rates in velocity and money persist in 2014, then nominal growth would be even less.

Fiscal Issues

Based on scholarly research, only half of the negative economic impact emanating from the $275 billion 2013 tax increase has been registered so far. Due to the recognition and implementation lags, the remaining drag on growth from the tax increase will occur this year and again in 2015. Carrying a negative multiplier of 2 to 3, this impact far outweighs the sequester (which is expected to be slightly less in 2014 than in 2013) since the multiplier for government expenditures is zero, if not slightly negative.

An important fiscal policy event for 2014 is the Affordable Care Act (ACA). Health care is the largest US industry, comprising 17.2% of the economy in 2012. That's more than twice as large as residential construction, oil and gas exploration, and the automotive sectors combined.

The scope and scale of ACA may divert energy and activity away from more productive endeavors. The ACA's employer mandate was waived in 2013, as were similar obligations of labor unions and others, but these waivers expire this year. Firms may have to cut full-time employees to part-time, reduce total employment, or cut benefits since they lack pricing power to cover these costs.

As such, this will place the burden of adjustment on consumers. On January 1, health insurance premiums that target small businesses and individuals were raised. These groups create jobs and are vital for growth, so although the amount of the increase is small, this is not a positive development for the economy. While the ACA is an unprecedented event for which no historical point of comparison exists, history does confirm that substantial increases in government regulation are not a springboard for innovation, the lifeblood of economic activity.

The slow nominal growth rate anticipated for 2014 should continue to put downward pressure on the inflation rate as insufficient demand continues to foster highly competitive markets. With slower inflation, lower long-term interest rates are a probable outcome.

Dr. Lacy H. Hunt is executive vice president of Hoisington Investment Management Company ($4.5 billion under management) and author of two books, and articles in Barron's, the Wall Street Journal, the New York Times, the Journal of Finance, the Financial Analysts Journal, Business Economic, and the Journal of Portfolio Management.

Previously, he was Chief US Economist for the HSBC Group and Senior Economist for the Federal Reserve Bank of Dallas.

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