listeningin january 20, 2012 face the...

Last time Dr. Lacy Hunt, the chief economist atAustin, TX-based Hoisington InvestmentManagement was interviewed in these pages, inJuly, 2009, the rebound in stocks from their crisislows was only months old — yet he remained firm-ly in the bull camp – on bonds. As it turns out,Lacy, and the entire portfolio management teamat Hoisington, led since the firm’s founding by VanR. Hoisington, couldn’t have been proven moreright: Rates, which “couldn’t go lower” have con-tinued to sink. Much to the benefit of Hoisington’sinstitutional clients and investors in the Wasatch-Hoisington U.S. Treasury Fund, which the firm sub-advises. When I gave Lacy a call earlier thisweek, he — always a gentleman and a scholar —patiently explained not only why he’s still bullishon long Treasuries, but why there’s simply no easyexit from the debt morass in which the whole econ-omy, public and private, is trapped. Listen in. KMW

Happy New Year,Lacy. And thanks forsending all thosecharts to backgroundme for our conversa-tion. I have to saythe first one stoppedme — showing debtas a percentage ofU.S. GDP all the wayback to 1870? Whatdata goes back thatfar?Dr. Robert Gordon atNorthwestern Universityhas been very helpful tome, recreating a lot of

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data. The National Income and Product Accounts(NIPA) from the Bureau of Economic Analysis(BEA) only start in ’29. But NBER (the NationalBureau of Economic Research) funded two stud-ies, one by Christina Romer and the other byRobert Gordon, to estimate the nation’s GDPback to 1870. So we have those data sets. They’renot identical, obviously, but what most econo-mists do, including me, is use an average of theRomer and the Gordon estimates, which seems towork out pretty well.

Still, I suspect most folks looking at a lineon a chart interpret it as “historical fact”instead of as anestimate based onspotty data on theworkings of a verydifferent economicenvironment. Well, what the profes-sion is saying is thateconomic propositionsneed to be tested andverified over as com-plete a sample as possi-ble. Admittedly, someof these earlier peri-ods, you didn’t have acentral bank; you did-n’t have an income tax;you had various politi-cal regimes; some-times you were on thegold standard, some-times you were off.The point is, most peo-ple feel that theseinstitutional differ-ences shouldn’tobscure the verifiableobservation of basiceconomic relation-ships. So you want to test this over as muchtime as you possibly can and I think that’s a rea-sonable proposition. Anyway, that’s myapproach, and that’s increasingly the approachin the profession.

I was just noting that what we actuallyknow about the economy in days gone byis lot squishier than terms like “datasets” or lines on charts seem to imply.But clearly, observations over short timescan be misleading. Absolutely. Take the subject of debt. If you con-

fine your analysis to post-war period, you onlyhave one major debt-dominated cycle and that’sthe one we’re currently in — and have been infor a number of years. But if you go back farenough, you have three more. You have the1820s and 1830s. You have 1860s and 1870sand then you have 1920s and their aftermath.Sometimes it’s essential to take your analysisback as far as you possibly can.

Sure. Doesn’t your second chart, on thevelocity of money [page 4], show hownone other than Milton Friedman was misledinto thinking that it was a constant

because he onlylooked at post-wardata?That’s correct and, infact, I was misledalong with himbecause I was alsodoing analysis basedon the post-war data.Friedman’s period ofestimation was basical-ly from the 1950s tothe 1980s. Well, if youlook at the velocity ofmoney in that timeperiod, it’s not a con-stant, but it’s very sta-ble around 1.675. So ifyou tracked moneysupply growth then,you were going to beable to get to GDPgrowth very well. Noton an individual quar-terly basis, but eventhe individual quarter-ly variations were notthat great. Until veloc-ity broke out of that

range after we deregulated the banking system.Now, velocity is breaking below the long-termaverage and it’s behaving exactly like IrvingFisher said, not like Friedman said, absolutely.

What a perfect example of the differenceyour frame of reference can make. Yes, Friedman even said Fisher was the greatestAmerican economist, and I think that is cor-rect. Fisher had a broader understanding of theeconomy in a very, very critical way and in away that I don’t think either Friedman or JohnMaynard Keynes understood it, and even a lot of


“Fisher ... is saying

something entirely different.

He’s saying that

the insufficiency of aggregate

demand is a symptom

of excessive indebtedness

and what you have to do

to contain a major debt event —

such as the aftermath of

1873, the aftermath of 1929,

the aftermath of 2008 —

is you have to prevent it

ahead of time. You have to

prevent the buildup of debt.”

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contemporary economists, such as BenBernanke. Keynes and Friedman both felt thatThe Great Depression was due to an insuffi-ciency of aggregate demand and so the way youcontained a Great Depression was by yourresponse to the insufficiency of aggregatedemand. For Keynes, that was by having thefederal government borrow more money andspend it when the private sector wouldn’t. Andfor Friedman, that was for the Federal Reserveto do more to stimulate the money supply sothat the private sector would lend more money.Fisher, on the other hand, is saying somethingentirely different. He’s saying that the insuffi-ciency of aggregate demand is a symptom ofexcessive indebtedness and what you have to doto contain a major debt depression event — suchas the aftermath of 1873, the aftermath of1929, the aftermath of 2008 — is you have toprevent it ahead of time. You have to preventthe buildup of debt.

And that your goose is cooked if you don’tyou cut off the credit bubble before itoverwhelms the economy?Yes, and Bernanke is thinking that the solutionis in the response to the insufficiency of aggre-gate demand. That was Friedman’s thought.That was Keynes’ thought and most of the eco-nomics profession has traditionally thought thesame way. They were looking at it through thewrong lens. Fisher advocated 100% moneybecause he wanted the lending and depositoryfunctions of the banks separated so we couldn’thave another event like the 1920s.

You’re saying that Fisher argued againstfractional reserve banking?Yes, and so did the people that more or less fol-lowed in Fisher’s footsteps, principally CharlesKindleberger and Hyman Minsky. Minsky felt thatthe way you prevented a major debt deflationcycle was to keep the banks small.

Prevent them from ever becoming too bigto fail in the first place?Right. Don’t let them merge. You don’t wantthem to get big. I actually gave a paper withMinsky once, in 1981, in which he advocatedthat position. Kindleberger was very precise in“Manias, Panics, and Crashes,” when he saidthat when you have a small credit problem, ormany small problems, some say, you don’t wantthe Federal Reserve to respond. Because if thecentral bank comes in and bails out a smallproblem, then that will be a sign to those who

want to take more risk that they don’t need tobe cautious — they can always count on the cen-tral bank to come in and bail them out. If theydo, Kindleberger said — and this was in ’78 —then the future crisis will be even greater. “Afree lunch for speculators today means thatthey’re likely to be less prudent in the future.Hence, the next several financial crises couldbe more severe.”

Too bad nobody paid attention.So we came along and we bailed out Long-TermCapital Management in the late 1990s.

Not to mention the banks that got in trou-ble in Latin America in the early ’80s, theentire S&L sector in the early ’90s —Absolutely. You could even include the bailoutof Chrysler in 1980, because that was a signalto the automobile companies and to theirunions: “Do what you want. If you get in trou-ble, the U.S. taxpayer’s behind you.” But theChrysler bailout and the LTCM bailout werevery small. I mean, LTCM was a $3 billionproblem. That’s a quaint number today. Yet theFed came in with all its big guns blazing. Theyused monetary policy to ease the pain. A debtbuildup was already underway, but the Fedgreatly facilitated it and encouraged it. So, itseems Fisher and Kindleberger and Minskywere right. The only prudent way you can dealwith these huge debt problems is to preventthem from building up in the first place. Theresponse after the fact matters some, but it’snot the route you should go.

That’s great, in theory. Except that it isthe route we went. Once again, we didn’tprevent the excessive buildup of debt, so


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now we have to deal with pressing defla-tionary forces. That’s why Fisher wanted to segregate the lend-ing and deposit-taking functions of the banks.

Does that sound a mite like Paul Volcker,daring to suggest banning the banks’

speculative propri-etary trading activi-ties — and gettingnothing but grieffrom the industryfor his efforts? Well, that’s right.Fisher couldn’t get itdone, either. Andwarned that we woulddo it again. I had a briefacquaintance withKindleberger; I didn’tknow him well, but Iknew him and he washelpful to me. Hetaught Ken Rogoff. And,in fact, “This Time, It’sDifferent” is really aquantification and veri-fication of a lot of thequalitative themes thatKindlebergerexpressed. My sensewas that Kindlebergerthought that once theeconomy got into over-trading, there was noone who was going tostand in its way.

Over-trading?That was the old-timey term that Kindlebergerused. He said there are three phrases of behav-ior as you move toward manias, panics, andcrashes. The first phase is over-trading, whereyou start buying assets at prices far beyondtheir fundamentals. People enjoy this phase,because initially it boosts income and raiseswealth and so forth. So it becomes very irra-tional. Then you get to what he called the dis-credit phase, where the smart people startpulling their funds out. Then you get what hecalled revulsion. The classical economists usedthose terms: Over-trading, discredit, revulsion.As I said, I got the impression fromKindleberger that once you get into that over-trading phase, there’s no one who is going tostand in the way of it.

Why stand in front of a freight train?Especially when it doesn’t seem to be in any-one’s interest to stand there. Regulators,banks, companies, investors, everybody’s hav-ing a good time; profits are being made,employment is strong.

So we’ve just seen.No one dealt with the credit excesses in the sub-prime market, until the crisis hit. And no onedealt with the excessive speculation in thefinancing of the railroads in the middle of the19th Century, or in the financing of the canalsand turnpikes and steamship lines in the 1820sand 1830s. Nor did anyone step in to try to stopthe foolishness that was going on in the 1920s.

Kindleberger took it all the way back tothe tulip mania, and I’d venture that was-n’t the first time in human history whenan auction market got out of hand. That is correct. Absolutely. You push thingsbeyond their fundamental value. But this isn’tthe conventional economic view of debt and it’simportant. I sent you some quotes contrastingconventional wisdom with this newer under-standing.

I noticed you picked something Bernankewrote to illustrate conventional wisdom —I chose that Bernanke quote [box page 9]because Bernanke addressed the Fisher -Kindleberger theme in the early part of thiscentury — and that’s when we really neededBernanke to say something and to do some-thing. But as you can see, Bernanke rejectedFisher and Kindleberger in his book, “Essays


Policy Responses:Letting It Burn Out & Others

The moral hazard problem is that policymeasures undertaken to provide stability tothe system may encourage speculation bythose who seek exceptionally high returns

and who have become somewhat convincedthat there is a strong likelihood that

government measures will be adopted toprevent the economy from imploding — and

so their losses on the downside will be limited. A ‘free lunch’ for the speculators

today means that they are likely to be lessprudent in the future. Hence the next several financial crises could be moresevere. The moral hazard problem is a

strong argument for nonintervention as afinancial crisis develops, to reduce the likelihood and severity of crises in thefuture. Will the policymakers be able to

devise approaches that penalize individualspeculators while minimizing the adverse

impacts of their imprudent behavior on theother 99% of the country?

Charles P. Kindleberger (1978). Manias, Panics,And Crashes: A History of Financial Crises,pages 204-205.

on The Great Depression.” And notice that hedoesn’t reject Fisher because he says Fisher’sdata is flawed. He doesn’t reject Fisher becauseFisher’s argument is flawed or Kindleberger,either. He rejects them because an excessivebuildup of debt implies irrational behavior.

Well, hello!That’s the world I live in. You, too, probably.

To mention that what can seem rationalon an individual level can be irrationalwhen an entire economy does it. We see it all the time, every day of every week.And yet Greenspan’s rejection of the danger ofan excessive buildup of debt in his book puthim in a different mindset, not just in evaluat-ing the events of the 1930s, but when it came tounderstanding what was going on in the earlypart of this century, up to 2006 and ’07.Because he thought he could respond to a debtproblem and contain it. But that was not at allwhat Fisher taught. Fisher said you have to pre-vent a debt deflation ahead of time. That’s avery powerful, critical, difference. What Fisheris saying is that once you get into this extremelyover-indebted situation, and the prices of assetsbegin to fall, these two “big bad actors,” thoseare the terms he used, control all or nearly allother economic variables. Then, if you attemptto respond to the problem by leveraging fur-ther, it’s counterproductive. That’s the termFisher used in one of his letters to FDR express-ing concerns about deficit spending. One of the newer quotes I sent [page 9] is fromStephen Cecchetti, a former director of researchfor the New York Fed. A Cal Berkeley Ph.D., avery serious economist. It’s from a paper hegave at Jackson Hole shortly after Bernankespoke about holding a special two-day meetingof the Fed. Here’s what Checcetti said, “Debt isa two-edged sword. Used wisely and in modera-tion, it clearly improves welfare.” In otherwords, when banks engage in their traditionalbusiness and consumer lending, it improves.There’s no question about that. But when theylend imprudently in excess, the result can be adisaster for individuals, households, firms. And“Over-borrowing leads to bankruptcy andfinancial ruin for a country. Too much debtimpairs the government’s ability to deliveressential services to its citizens.”

I noticed that Cecchetti even specifiedhow much debt becomes cancerous. That’s right. I like his use of that medical term.

And the level of government debt he specifies isconsistent with what Carmen Reinhart andRogoff wrote in their paper for the NBER called“Growth in a Time of Debt.” They found thatafter you get above 90% of debt to GDP that youlose 1% off the median growth rate, and evenmore off the average growth rate. So it’s clearthat debt plays a major role in the economy.Most of the time, it is a benign factor, but youget these irregular intervals in which debtbuilds up excessively. And, once it has built upexcessively, it’s a controlling influence for along time. Plus, you cannot solve that over-indebtedness problem by getting deeper indebt. That’s the problem.

True, but you can postpone it a while —The point is that it doesn’t really matterwhether you’re using the Federal Reserve’s


monetary tools to get the private sector toleverage up or whether you’re engaged indeficit spending at the federal level to try toaddress the insufficiency of demand. Both tackstake you in the wrong direction. Now, whatwe’re beginning to understand — at least withregard to governments, because we have knownthis is true for the private sector for a longtime — is that there comes a point in time atwhich additional debt is no longer available.That’s where a lot of countries in Europe are.And that is probably where we’re going in anumber of years. We’re not there now, butthat’s where we’re headed. We spent $3.6 tril-lion last year at the federal level. We borrowedaround 35% of that and we had tax revenues tocover around 65%. Some of the European gov-ernments are trying to borrow more than thatratio, and it’s being denied to them. Reinhartand Rogoff call that the “bang point.” Whenthat happens, your spending levels then have tofall back to your tax revenues. That’s wherewe’re headed unless we correct the problem.It’s obviously going to get greater, because wehave built-in guaranteed increases in our oblig-ations under Social Security and Medicare.That’s why I also sent you a passage [box, page11] from “Exorbitant Privilege,” by BarryEichengreen. He’s a Yale Ph.D., taught atHarvard many years, Cal Berkeley. In the lastthree years, federal outlays have averaged 25%of GDP, which is the highest three-year periodsince 1943 - ’45, when we were in a multi-conti-nent war. What Dr. Eichengreen is saying isthat federal outlays are going to go to 40% ofGDP within 25 years, without major structuralreforms.

Just based on the programs in place anddemographics?Yes. To him, that means that the current lawscannot remain unchanged and I agree withhim. I don’t think you can transfer an additional15 percentage points of GDP to the govern-ment. There’s no practical way that we can doit. But the political process doesn’t seem towant to respond in advance, so it’s very difficultto see how this is going to work out in any salu-tary way.

Let’s put some numbers on this. The firstchart you sent me [page 1] shows totalpublic and private debt in the U.S.approaching 400% of GDP. Yes, that’s the conventional approach, using pub-licly held federal debt as the measure of govern-


ment debt. But that, in my opinion, is really notappropriate. The more appropriate measure isreally gross federal debt. [chart page 5].

And the difference is that the gross figureincludes debt held in intra-governmentaccounts?That’s correct. But what Dr. Eichengreen is say-ing, and I agree, is that even that gross debtnumber is not really sufficient because we’vealso got $59 trillion, at present cost, of unfund-ed liabilities in Social Security and Medicare.We have about $52 trillion of current debt,public and private, the way I measure it. Wehave about $15 trillion in annual GDP. So if yousubstitute the gross government debt for theprivately held debt and if you use the IMF’s pro-jections for the increase in gross governmentdebt going forward and you assume privatedebt-to-GDP stays flat, well, we’re going to newpeak debt levels in the next several years.

And we’re not the only nation in this fix. The situation in Europe is worse. I put togethersome charts that are interesting; took a lot ofeffort, anyway. If you look at U.K. debt, publicand private [chart, page 6] it’s 100 percentagepoints higher than in the U.S. The Japanesedebt [chart, page 6] is approaching 150 per-centage points higher. The Eurozone, just thecountries in the Euro currency zone, have gotabout $62 trillion in current debt equivalence(chart, page 6). They only have $14 trillion ofGDP equivalent. So they’ve got about $10 tril-lion dollars more of debt than we do and $1 tril-lion less of GDP. I have another little piece ofinformation on that score that’s interesting:Their unfunded liabilities also appear to begreater than ours. A study published in 2009,but really based on data from 2006, called“Pension Obligations of Government EmployerPension Schemes and Social Security PensionSchemes Established in EU countries,” byFreiburg University, which was commissionedby the European Central Bank, showed that theunfunded pension liabilities of the EU membercountries studied amounted to about five timestheir GDP. And the report only covered unfund-ed liabilities in 19 of the 27 EU member coun-tries — 11 members of the Euro currency zoneand 8 non-currency zone countries. Now,Europe had a big recession, too, in 2008, whichopened the gap further. So their unfunded lia-bilities are about five times their GDP, whereasin the U.S., they are about four times. The debtproblems in Europe are at an advanced stage

relative to where theyare here. Also, theirdemographics aremuch worse than ours.So we’ve got this situa-tion, if you accept whatFisher said about debtcontrolling all othereconomic variables in adebt deflation, thenthe levels of indebted-ness in the U.S. andEurope are also playinga heavy hand in the for-eign exchange markets.

How so?While there’s nothingsalutary about the U.S.situation, we’re not inas an extreme positionas are some of theother major areas ofthe world, Europe,Japan, the U.K.

You’re implying thatthe dollar is like thebest house in alousy neighborhood?Yes, if you think of for-eign currency move-ments being deter-mined like a beautycontest, if you’ve got10 ugly contestants,the least ugly wins.This tends to supportthe value of the dollarfor no meritorious rea-son; it’s simply com-parative valuation.

True, and not terribly good news for U.S.companies trying to compete on a globalbasis.No, especially not because this recovery — suchas it is — since the middle part of ’09, has beenheavily influenced by exports.

The percentage of GDP growth attribut-able of late to exports is really eye-pop-ping.It is. While exports have been growing at 10%per annum, consumer spending has been grow-ing at only 2% per annum.


China’s Potential Debt Woes

China's model has produced supergrowth, lustrous office towers,

massive and grand new airports andother visible signs of wealth and success.

But, beneath this glamorous veneer, the growth model is

flawed and fragile. Substantial andunknowable risks

are accumulating in the Chinese bankingsystem. “The fact that it

is well-insulated from outside markets does not mean that China's

finances are crisis-proof. The system can be disrupted by purely

internal factors, as it clearly has been in the past.“

Red Capitalism: The Fragile FinancialFoundation of China's Extraordinary Riseby Carl E. Walter and Fraser J.T. Howie(John Wiley, 2011), page 207.

Utilizing micro- and macroeconomics as well as

psychology, biology (contagion), and politics a model is developed to identify booms that bust. This

framework applies to recent as well asdistant boom/busts. "Although China

appears to be in the midst of an unsus-tainable boom, the timing of a bust isextraordinarily difficult to predict."

Boombustology by Vikram Mansharamani(John Wiley and Sons, 2011), page 237.


That’s positively un-American!Export growth has been just under 50% of thecumulative gain in GDP. It really has been thedriving force. But now, income is trending downoverseas. And, in international trade flows,income is four or five times more powerful thanprice effects. So the spreading recessions inEurope and Japan and elsewhere are going to

knock down the demandfor our exports — andthe fact that the dollar isrising serves to worsenthat trend.

Wonderful. I can’thelp but note,though, that it’spretty ironic thatwe’re talking aboutIrving Fisher’s repu-tation as an econo-mist being rehabili-tated now, when hedestroyed it himselfby being so wrongabout Crash in 1929. True, but that in itselfis instructive. He didmake some outrageousstatements that weretotally incorrect and itgreatly damaged hisstature. No one wasreally willing to listento him, although hiswork was there and sowere a series of letters

that he wrote to FDR. But he was our best andhe was just so wrong that people could neverlook at him the same way after the Crash. Itprobably was frustrating for him. But, Fisheractually was a very modern guy, in some ways.Richard Thaler, the co-founder of behavioralfinance, wrote an interesting paper a decade orso ago called “Irving Fisher: Modern BehavioralEconomist.”

I’ll have to dig it out. [link]It’s an interesting paper. In economics, thereare two conditions: Equilibrium and transition.The economics profession mainly teaches equi-librium economics; the general presumption isthat we’re at equilibrium most of the time.Transition, we know it occurs, but transition isconsidered the short, uninteresting phase.Equilibrium is the long, interesting phase.That’s the way it’s taught. But in actuality, whatwe’re learning is what Fisher understood longago: The transition is long and equilibrium isshort. We move toward equilibrium, but usuallywe achieve equilibrium only on the way toanother transitional phase of disequilibrium.The economics profession has used the analogyof an airplane. When it’s on the tarmac, it’s inequilibrium. Then, as it takes off and climbs toan altitude of 40,000 feet, it’s in transition, rel-atively uninteresting. Then you’re at equilibri-um again at 40,000 feet, until you return to thetarmac. So conventionally, you’re at equilibri-um most of the time, either at 40,000 feet or onthe tarmac. But for Fisher, the equilibriumphases were short and the transition phaseswere long. I think that’s where the professionis headed, certainly the way I’m thinking aboutit.

In other words, economic equilibrium isnot a very stable state?No, we hit equilibrium on the way to anotherdisequilibrium. If you’re looking, for example,at my velocity of money chart [page 4], you cansee that one period, from the early ’50s to theearly ’80s when it hovered around 1.67. But inmost of the other instances shown, we’re eithermoving above it or we’re moving below it. Wecross it, but we don’t spend much time there. Ithink the reason we had that post-war period ofstable velocity is that there was not a really sub-stantial buildup of debt and we had a heavilyregulated banking system. Once we deregulatedthe banking system and allowed the massivebuildup of debt, the velocity of money startedtaking off. But then it turned down in ’97, just

The Delevering Process:Four Archetypes

1. “Belt Tightening”. The most common deleveringpath. Episodes where the rate of debt growth isslower than nominal GDP growth, or the nominalstock of debt declines. Examples are Finland ’91-

’98, Malaysia ’98-’08, U.S.’33-’37, S. Korea ’98-’00.2. “High Inflation”. Absence of strong central

banks, often in emerging markets. Periods of highinflation mechanically increase nominal GDP

growth, thus reducing debt/GDP ratios. Examplesare Spain ’76-’80, Italy ’75- ’87, Chile ’84- ’91.

3. “Massive Default”. Often after a currency crisis.Stock of debt decreases due to massive private and

public sector defaults. Examples are U.S. ’29-’33,Argentina ’02- ’08, Mexico ’82- ’92.

4. “Growing out of debt”. Often after an oil or warboom. Economies experience rapid (and off-trend)

real GDP growth and debt/GDP decreases. Examplesare U.S. ’38- ’43, Nigeria ’01- ’05, Egypt ’75- ’79.

McKinsey Global Institute. Debt and deleverag-ing: The global credit bubble and its eco-nomic consequences, page 39. December 2010.

as it had turned down in the early 1920s.

Why? We certainly kept borrowing —It wasn’t that we weren’t taking on more debt. We were, but the debt thatwe were taking on was becoming more and more counterproductive. Wewere getting less bang for the buck. The downturn in the velocity ofmoney after 1997 was actually a signal that we were in a potentially trou-blesome period. One of the things that Fisher specifically cited was thatwhen you get into this highly over-indebted situation, one of the variablesthat is controlled by that debt overhang is the velocity of money. The Fedhas been able to increase money supply growth but their efforts at simulat-ing GDP — except during some brief intermittent episodes — have beenthwarted because the velocity of money is trending down. It’s now fallingbelow the 111-year average.

And when you look at velocity on your chart going back to 1900,it sure looks like the time it spent in equilibrium was the outlier,not the norm. It does, and Fisher understood that.

What little reading I’ve done about Fisher says he was unusuallytalented and energetic, despite some weaknesses typical in theperiod, like being a fan of eugenics.Very true. Paul Samuelson, who disagreed with a lot of what Fisher had tosay, said that Fisher’s doctoral dissertation was the greatest one ever writ-ten — and it was on transition and equilibrium. Fisher gave us the formulasfor all the price indices we’re currently using. People forget that. JamesTobin said he was our leading expert in index numbers. He invented thedistributed lag. Joseph Schumpeter said that Fisher had the keenest intel-lectual mind of anyone he ever met. Schumpeter was no slouch, in his ownright. Fisher even invented the Rolodex. But he didn’t see The GreatDepression coming. By the way, neither did Keynes.

True enough, and he lost a bundle. So what did Fisher miss?Why Fisher missed the Depression call is instructive. It was because atthat point he assumed that the U.S. economy was dominated by cyclicalforces. As we went through this business cycle, we’d have a brief period ofbad times followed by an extended period of good times. Yes, the period ofbad times could be a little unsettling, but it didn’t last too long and thenwe would have another extended period of good times. But what Fisherlater wrote was that once an economy becomes extremely over-indebted,this normal business cycle model that everybody believes to be what con-trols the situation really becomes inoperative in the traditional sense. Thebusiness cycle attempts to work, but it can’t, against the strong secularforces of excessive indebtedness. Like Keynes, Fisher was a big investorand, of course, he was wiped out by the events of the late 1920s, early1930s. But he later made that statement that the extreme over-indebted-ness controls all or nearly all other economic variables. It appears to con-trol the risk premium, too, as that table [page 5] I sent you shows. We’venow had three 20-year periods: 1874 to 1894, 1928 to 1948, and the last20 years, in which the risk premium stayed negative. I didn’t have thefinal official numbers to include last year’s Q4, but it doesn’t change thepicture, I’m pretty sure.

So you’re saying investors get risk-averse in severe downturns? My point is that we know that, over the long run, you have to have a posi-


Debt and Economic Activity Conventional View

Beginning with Irving Fisher (1933) and A. G. Hart(1938), there is literature on the macroeconomic

role of inside debt. Hyman Minsky (1977) andCharles Kindleberger (1978) have in several placesargued for the inherent instability of the financial

system, but in doing so have had to depart from theassumption of rational economic behavior.

Footnote: I do not deny the possible importance ofirrationality in economic life: however, it seems

that the best research strategy is to push the ratio-nality postulate as far as it will go.

Ben S. Bernanke (2000). Essays on the GreatDepression, pages 42-43.

Vs. New ViewThe U.S. economic recovery has been weak. A

microeconomic analysis of U.S. counties shows thatthis weakness is closely related to elevated levelsof household debt accumulated during the housing

boom. The evidence is more consistent with theview that problems related to household balance

sheets and house prices are the primary culprits ofthe weak economic recovery. King (1994) provides adetailed discussion of how differences in the mar-ginal propensity to consume between borrowing

and lending households can generate an aggregatedownturn in an economy with high household lever-age. This idea goes back to at least Irving Fisher’s

debt deflation hypothesis (1933).

Federal Reserve Bank of San Francisco EconomicLetter January 2011. Atif Mian University ofCalifornia Berkeley, Haas School of Business andAmir Sufi, University of Chicago Booth School ofBusiness.

Debt is a two-edged sword. Used wisely and in mod-eration, it clearly improves welfare. But, when it isused imprudently and in excess, the result can be adisaster. For individual households and firms, over-borrowing leads to bankruptcy and financial ruin.For a country, too much debt impairs the govern-ment's ability to deliver essential services to its

citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corpora-

tions and 85% for households.

The Real Effects for Debt by Stephen G. Cecchetti,M. S. Mohanty and Fabrizio Zampolli. September,2011. Bank for International Settlements, page 1.

tive risk premium, stocks have to outperformbonds, because investors must be rewarded forholding riskier assets. But after the extremebuildup of debt in the 1860s and the early1870s, risk-taking was not rewarded. After theextreme buildup of debt in the 1920s, for 20years risk-taking was not rewarded. And for thelast 20 years, it hasn’t been rewarded either. Somy table may be instructive. We don’t know,because we don’t have a lot of experience, but ifFisher is correct, and if we try to solve our cur-rent problems by getting deeper in debt, thenwhat Fisher is saying is the additional indebted-ness doesn’t make us stronger, doesn’t increaseour options. It makes us weaker, reduces ouroptions. So risk-taking may not be rewardedgoing forward. This is where we’re hamstrungby our lack of sufficient data to evaluate. Butwhat data we have suggests that if we proceedalong the path of over-indebtedness, risk-tak-ing will not be rewarded because the economyis going to perform very poorly.

Is there perhaps a glimmer of hope in thefact that the earlier instances you citelasted roughly 20 years, and this one isalready 20 years old? Well, they all came after major buildups ofdebt. The panic years were 1873, 1929 and2008, but if you go back and look at my firstchart [page 1], in the first instance, we had thismassive buildup of debt that was complete by1873. The panic year was 1875. The debt-to-GDP ratio peaked in 1875 because the denomi-nator, GDP, collapsed. Then in the secondinstance, the debt buildup was complete by ’29.The debt-to-GDP ratio peaked after the fact in1933, because GDP declined. And the same was

true in 2009. The debt-to-GDP ratio peaks ayear or so after the panic, because you’ve gotthe denominator in this ratio. But what’s inter-esting is that after the 1875 peak, you don’t goabove it until 1916. You don’t go above the1933 peak until 2003. So once you get theseperiods of extreme over-indebtedness, it takes avery long time to resolve them.

And it’s usually not a lot of fun. No. That’s why I sent you those quotes from agreat study by the McKinsey Global InstituteStudy [page 8], listing what they call the FourArchetypes of the Delevering Process. What itboils down to is that austerity is required inabout 75% of the cases. Either you do it yourselfor it’s imposed upon you. They do address thepossibility of “growing out of debt” and theycite the case of the U.S. in World War II and acouple of other instances. But to my way ofthinking, the U.S. during WWII was also anausterity case. If you look at my chart of thepersonal savings rate back to 1929 [page 8],you can start to see that what really brought usout of the Great Depression were our exports.Our allies’ countries were being disrupted byactual fighting and they had manpower short-ages. So we were selling them everything thatwe could produce — but meanwhile, our peoplecould not spend the income we were receiving.

Right, there was rationing and tremendousausterity on the home front. So the onlything that people could do with the moneythey were making was buy war bonds.That’s correct. And that’s what they did — lookat the personal saving rate. We’re not gettingthat same response here. The saving rate wentup for a while, but it’s now back to 3.5%. We’reessentially back where we were when the reces-sion started.

It’s more than a little perverse to pull foranother world war to pull us out of thismess. Wasn’t the debt deflation in the19th Century simply cured by the passageof time? In the earlier case, the excessive indebtednessjust burned itself out. That was the title ofKindleberger’s chapter on policy responses:“Letting It Burn Out and Other Devices.” Isent you an excerpt from that, too. [page 4] Youmight do better to just let it burn out.Everybody rejects that as being too harsh;“How could you possible advocate that?” But itmight be better.


Sure, like a forest fire. But that argumentisn’t very strong in today’s highly inter-connected economy. We’re not facing anyisolated conflagration. Well, you hear that argument, but I’m not surethat I buy it. I think the world was very inter-connected in the 1920s and I really see a lot ofparallels. We don’t have good data outside theUnited States, but we do know that a lot of thecommodities-producing countries took on a lotof debt to finance commodities productionback then.

So vendor financing wasn’t invented dur-ing the internet bubble.Not at all. And the problems in the late ’20sstarted, I believe, in the commodities produc-ing countries. The first country to devalue inthe late ’20s was the Dutch East Indies, a hugecommodities producer. Then it was Australia.Both had expanded very substantially withdebt. Then there were a number of other deval-uations and, finally, in ’31, the British deval-ued. In the meantime, we stayed on the goldstandard and so everybody that was devaluingagainst the U.S. dollar. Their incomes weredeclining, which undermined our exports andthen the price considerations went against usso we started losing our exports. Then, betweenApril of ’33 and January of ’34, we had about a60% devaluation. That helped us, compensato-rily, to regain some of the markets that we hadlost, and everybody stood still for that, becausewe were still sort of operating under the rules ofthe gold standard game. But then, in ’37 and’38, the gold bloc countries finally devalued;we lost some of the gains we had made and theeconomy fell back. So there was a great deal ofinternational interconnectedness in that peri-od. But what this also shows is that the marketsdeal with the serious problems first and thenthey move on to the next most serious and soon. So this whole process could be much longerand more persistent than many people believe.Particularly because, if we continue to try tosolve the over-indebtedness problem by takingon more debt, that ultimately creates moreproblems than it solves.

That’s sure what’s going on in Europe. The Europeans have two problems. No. 1,they’ve been financing themselves short. Theyhave an enormous rollover problem and a lot ofthe folks who have lent to them don’t want toextend those loans. In addition, the folks that

don’t want to extendtheir loans are beingasked to make evenbigger loans and so, theborrowers are not real-ly responsive. Do youknow John H. Cochrane?

Haven’t had thepleasure —John Cochrane is at theUniversity of Chicago,a very serious econo-mist.

He has the AQRCapital Chair, if I’mnot mistaken —Yes. He was presidentof the AmericanFinance Association, avery serious academi-cian. What he haspointed out is that thereal value of govern-ment debt must equalthe discounted value ofthe stream of futuresurpluses. If you thinkabout that, any assethas to be equal to thediscounted value of itsfuture revenue stream.So, what you’ve got inthe present value for-mula is the discountedstream of future flowsand then your discount rate. Well, Cochrane’sargument is that at the point in time that themarkets lose confidence that there is a futurestream of revenues to pay off the debt, to ser-vice the debt, then the discount rate will moveup sharply. It doesn’t matter what monetary orfiscal policies are, the discount rate explodes.That’s what’s really happening in Europe. Theinvestor cannot see a viable revenue stream toservice the existing debt levels. I don’t thinkthat we’re at that point here yet, but we couldbe. I hope we have some time. Perhaps, becauseEurope is in a graver situation, indebtedness-wise than we are, it’s buying us some time. Butwe don’t seem to be willing or able to, we don’tseem to have the political will to deal with ourproblem.

Certainly not if you listen to what we’ve


Federal Outlays Heading Toward 40% Of GDP?

Dr. Barry Eichengreen of the University of Californiaat Berkeley estimates that after 2015 federal out-lays as a percent of GDP are headed to 40% overthe next quarter century without major structuralreforms in Social Security and Medicare. For Dr.

Eichengreen this means that the current law cannotremain unchanged in spite of the lack of political

will to deal with the issue.“The United States will suffer the kind of crisis thatEurope experienced in 2010, but magnified. These

events will not happen tomorrow. But Europe'sexperience reminds us that we probably have lesstime than commonly supposed to take the steps

needed to avert them. Doing so will require a com-bination of tax increases and expenditure cuts.” Hegoes on to point out that, “At 19% of GDP, federal

revenues are far below those raised by central gov-ernments in other advanced economies with spend-

ing on items other than health care, SocialSecurity,defense and interest on the debt having

shrunk from 14% of GDP in the 1970s to 10% today,there is essentially no non-defense discretionary

spending left to cut. One can imagine finding smallsavings within that 10%, but not cutting it by half

or more in order to close the fiscal gap.”

Barry Eichengreen, Exorbitant Privilege: The Riseand Fall of the Dollar and the Future of theInternational Monetary System, Oxford UniversityPress, 2011

heard so far in terms of campaignrhetoric.Part of the problem is that these are seriousmatters and to solve them, it’s going to requirea lot of sacrifice by a lot of people. That’s why Ireally like that Eichengreen quote. The thingis, no one wants to have austerity. We all enjoythe good life. We don’t want to have to raisetaxes; that’s unpleasant. We’re going to have tochange the benefits tables for Social Securityand Medicare. We’re going to have to cut dis-cretionary spending — even though it hasalready been cut substantially. Right now, thefour main components of the federal budget areSocial Security, Medicare, Defense and interestpayments on the debt. By the end of thisdecade, if market rates are unchanged —

Quite an assumption.

Yes, but at these rates, by the end of the decade,the three top components of the budget will beSocial Security, Medicare, and interest; that’saccording to the Congressional Budget Officeprojections. If you hold market interest stablethrough 2030, by then interest payments willabsorb 35% of the budget. If the market inter-est rates go up by two percentage points, thatadds about $300 billion a year to our deficit. Bythe way, that’s why you hear it said often thatone of the solutions is to inflate our way out.

That’s supposedly the easy alternative, atleast politically.But I don’t think you can do that because yourdebt is 350% of GDP. If you get an inflationaryprocess going, interest rates will rise propor-tionately with inflation. So, if inflation goes up1%, in time, interest rates will go up 1%. Butyour debt is 350% of GDP. If the inflation rategoes up, you will not get an equivalent rise inGDP, because what we’ve learned is that ininflationary circumstances, a lot of folks can’tkeep up. In fact, most of your modest and mod-erate income households will not keep up.

Not good, considering that “the 99%” arealready restive with reason. That’s correct. We saw this in a microcosm in2011. The Fed engaged in quantitative easing;they got the inflation rate up temporarily, butthe main effect was to reduce real income. So, ifyou try the inflationary route, you’re not goingto be able to inflate your way out of debt trou-ble. This other variable, your interest expense,is going to rise proportionately with inflation,and your GDP won’t keep up. Many will lagbehind and that will worsen the income orwealth divide. So inflation is really not a poten-tial savior in the current situation. Which thenforces you back to the conclusion that the onlyviable way out is austerity, although no onewants it.

Suppose one of Europe’s Hail Mary passesactually miraculously works, and theChinese decide to lend them a ton of dough?I’m not an expert on China. But I did spendsome time there earlier in my career, and Idon’t think the situation is that stable. I sentyou a quote from the book, “Red Capitalism” byCarl Walter and Fraser Howie [page 7]. CarlWalter is a pretty serious observer, StanfordPh.D., has lived in Beijing for about 20 years,speaks Mandarin. His basic point is that thegovernment has forced the banks, which they



control, to make loans to the provincial govern-ments for all of these expansion projects.There’s now a great deal of excess capacity andthe projects are not generating sufficient cashflow to service the high levels of debt that thebanks have extended. We’re reaching the pointat which the banks will have to be recapitalized.We had an episode of that in the late ’90s whenthe Chinese banks needed to be recapitalizedand the government had to shift expendituresinto bank recapitalization. That caused theAsian economic crisis. Now there’s some evi-dence to suggest that China will have to recapital-ize the banks again and when it does that, it willproduce economic weakness in China that willreverberate around the world. So the Chinesemay be more of a problem than a solution.

I suppose all this means you expect arecession this year? Well, consumer spending will slow this yearvery dramatically from a very weak base. Wehad a decline in real disposable income in 2011.GDP rose, but GDP measures spending, notprosperity. In 2011, as is often the case, wheninflation rises, households initially try to main-tain their standard of living. So in the face of ris-ing inflation and trailing wages, which was thestory in 2011, families resorted to increased cred-it card usage or to drawing down their saving. Butin addition to a decline in real disposable incomein 2011, we also saw a net decline in net worth[lower chart, page 13]. And a year-over-yeardecline in net worth has been associated with thestart of all the recessions since 1969.

It’s certainly not a good thing, in terms ofconsumers’ ability to spend —Exactly. Consumers need to bring their savingsback up into alignment with more normativelevels, which suggests a severe headwind to con-sumer spending this year. Exports, we’vealready talked about; there’s not a good outlookthere for what has been our most dynamic sec-tor. Capital spending, I think, is going to beextremely weak this year. We’re going to see anet decline, principally because the accelerateddepreciation rules, which were in effect,expired on Dec. 31. Up until then, you got 100%depreciation. Since Jan.1, you only get 50%.We’ve seen this happen many times in the past.Firms look as far as they can into the future andmove those expenditures forward in order totake advantage of the accelerated depreciation.So it’s reasonable to believe that we’re going tosee a considerable falloff in capital spendingthis year. Then you’ve got the government sec-

tor. We’ve got a $1.3 trillion deficit accordingto the latest projection from the CBO. In realterms, government purchases of goods and ser-vices will decline slightly this year, mainlybecause of defense cuts. Non-defense, at best,will be flat. How could we have a worse situa-tion than with a $1.3 trillion deficit and adecline in real government purchases of goodsand services at the federal level? It’s hard toimagine how it could be worse.

Well, toss this in: State and local spendingisn’t going to fill that gap. No, you probably saw the statement from NewYork Gov. Andrew Cuomo that the situation hasdeteriorated in New York. About half of thestate governments either have deficits that theymust address for the remaining six months of

the current fiscal year, or they’ll have deficits inthe new fiscal year. Now, that’s an outwardimprovement. But the state budgets do notinclude the unfunded liabilities of their pensionplans. Last year was another in which theirinvestment returns did not match their actuari-al assumptions, so those pension plans are inworse shape now than they were a year ago.How is that problem going to be rectified?Either you have to cut the benefits, or you haveto get additional funds from the state and localgovernments. The only way that can beachieved is by cutting other programs or raisingtaxes. So the state and local governments willremain a drag. Guess what? We are looking at arecession in 2012.

And that means what, for the markets?Let’s look at the last chart in the package I sentyou, the long-term Treasury rate going back to1871 [page 14]. We had 10 or more years in thelate 19th Century and early 20th Century whenlong Treasuries got to 2% or less; those were inthe aftermath of the huge buildup of debt in the1860s and 1870s. In 1941, as you can see on thechart, long Treasuries were at 2% again, thenPearl Harbor came along. Another way of look-ing at this is that, since 1871, long Treasurieshave averaged about 4.3%. The inflation ratehas been about 2.1%, 2.2%; so you had a realreturn of about 2%. Notice, too, that in theperiod from the rise of the Iron Curtain to itsfall, interest rates averaged about 6% and theinflation rate was 4%, so you had a real rate of2%. In the earlier global market period from1870, the interest rate was around 2.9% and theinflation rate was 0.9%. So your real rate gravi-tates towards 2%. If we go towards zero infla-

tion over the next several years, that’s saying tous at Hoisington Management that the longTreasury will eventually get to 2%.

All the way down to 2%?Rates have done that in Japan for a lot of thelast 15 years. Getting there will not occur in astraight line. It will be in a very frustrating pat-tern. We’ll see a lot of volatility and there willbe some episodes where it will look like thetrend toward lower rates will be interrupted. Itmay well be interrupted for intermittent peri-ods of time. To put this in another way, if youasked me to write down all of the reasons whyinterest rates could rise, I couldn’t list them all.There are a lot of reasons why interest ratescould rise over the short run. In this generallypoor economic environment, there will be sometime periods when the data will get a little bitbetter. There may be massive portfolio sellingfrom time to time. There may be expectationsthat problems in Europe or elsewhere are beingsolved. There are a whole host of seasonal andother factors that can intervene. But as long asthe United States is confronted with these vari-ous structural factors, interest rates can rise —but they really can’t stay up for very long. Theyultimately have to go back down. We’re in agradual process toward lower rates. Five or 10years down the road, we will end up thinkingabout is this as a period of low interest rates.And its volatility won’t seem too important afterthe fact. But I can assure you it will be impor-tant during the interim.

Especially if you have to worry about littlethings like portfolio returns —Absolutely, because as you go lower in yield,each basis point has a larger and larger priceeffect.

The math is pretty plain, although itescapes a lot of people.It is. Of course, this is our bread and butter. Didyou see the returns in our fund last year?

How could I miss them? You did blindinglywell, not just against your peers, but theuniverse. Up well over 30%. The mutual fund that we sub-advise, theWasatch-Hoisington Treasury Bond Fund, actuallyis up over 41%. The institutionally managedaccount was up slightly in excess of 40%. It wasa volatile process, a nerve-wracking process,getting there and I don’t anticipate going for-ward it will be any easier.


What are you doing?We’ve basically been long, but we’ve gradually,over the last several years, increased the per-centage of our portfolio in zero coupons.They’ve performed very handsomely. They’vehad volatility, but they’ve done very well and ifrates go lower, it’s clear that the best perfor-mance will come from the zero coupon bonds,because they don’t entail the reinvestment risk.

That couldn’t have been more of a con-trary position a year ago. And it still is.Yes. “Rates are going higher. They can’t go anylower; they’re at all-time lows.” Or so they say.

Well, that depends on how far back yourchart goes, as you’ve demonstrated.That’s exactly right. All you have to do is lookback to 1941. But it specifically boils down tothe following situation. The critical thing for usis that the economy’s extreme indebtedness is adeterrent to growth. It’s not a positive forgrowth. What the classical economists said istrue: What creates prosperity is the hard work,creativity and ingenuity of individuals and busi-nesses. Your prosperity does not come fromgovernmental financial transactions.

Nor, from highly leveraged purely financialtransactions, no matter how many tran-spire per second in the private sector. Absolutely. I agree with that. I don’t knowwhether you ever read David Hume’s essay writ-ten in 1752, “A Public Credit.”

I believe I did, but a very long time ago.Hume is among the 10 greatest intellects ofmankind. His treatise on human nature, ofcourse, is what he’s remembered for the most;Adam Smith said that Hume was the greatestintellect that he ever met, and Smith knew allthe great figures of the Enlightenment. At anyrate, the point Hume makes in “A PublicCredit” is that when a government has mort-gaged all of its future revenues, the state lapsesinto tranquility, languor, and impotence. Andhe discussed various historical situations.Hume died in 1776, not long after readingSmith’s “Wealth of Nations”, which was alsopublished in 1776. What we are seeing today isthat Hume was correct — and some of the inter-vening smaller thinkers were not. I’ll tell youanother little thing. Immanuel Kant said that itwas Hume that opened his eyes to the reality ofthe world.

Turning back to interest rates. Why do you

suppose real rates have gravitated to 2%for so long? I suspect, and I don’t know this, but I suspectit’s because that may be the very long-termaverage increase in productivity or real income.I’ve tried to verify that, but it’s only a guess.Excellent question. It may be that the factors ofproduction in the long run earn about thesame, but I don’t know. We do know that pro-ductivity is in that range, over a very long peri-od. Whether they exactly equilibrate or not, Idon’t know. But they seem to be pretty similarover the long haul. They’re certainly not similarover the short run. I don’t want to give anyonethat impression.

Maybe the short-term volatility is tellingus something about the capriciousness ofhuman nature —Absolutely. Maybe it’s a sign that there are verysignificant emotional elements in our decisionmaking process. We try to be rational and to makeconsiderate judgments, but in the final analysismay have limited time. We may have to makedecisions based upon rules of thumb or general-izations. Decisions are overly hasty, emotional.

Your charts also show that ideas abouthow low rates can go depend on perspec-tive. What period you are looking at. Yes. If you came into the market in 1991, theserates are extremely low. If you came in in 1971,they’re even lower. If you look at the sweep ofhistory in both the United States and aroundthe world, these rates are low, but not at all-timelows. That’s an important consideration. It’sequally important to understand the conditionsthat produce the low rates as well as the condi-


tions that produce the high rates. For the timebeing, the trend in rates is still downward. Weare approaching the point at which longTreasury portfolio maturities will have to bechanged, but we’re not there yet.

So what will it take to make you shortenmaturities?That’s a very great question. We need to see afundamentally different policy response. Thereare things that could be done in the realm of fis-cal policy to change the outcome, if we were touse our knowledge correctly. Now, before Idescribe what we could do, let me say that it’shard to visualize how this could happen rightnow, but maybe that could change going for-ward. So what do we know? Well, No. 1, weknow that the government expenditure multi-plier is, at best, zero and maybe slightly nega-tive. By that I mean if we increase deficit spend-ing, although you can get a transitory boost inGDP for a few quarters, at the end of 12 quar-ters, there’s no gain in GDP. But you do shrinkthe private sector, increase the governmentsector, and you take on a higher level of debt,which makes the economy still weaker. So thedeficit spending, if we continue that, that willcontinue to weaken the economy. If we couldreduce the deficit spending — although it wouldreduce economic growth over the short run —over the long run it would revive the privatesector. The tax expenditure multipliers, howev-er, are quite large. They’re between -2 and -3.By that I mean, if you raise the marginal taxrate by a dollar, you will lower GDP by $2 to $3after about three years. If you cut the marginaltax rate by a dollar, you will raise GDP by $2 to$3 at the end of three years. But there is also athird component of the federal budget — the so-called tax expenditures, or what are more com-monly called the loopholes.

Or the root of most the evil in the taxcode —Well, in the ’86 legislation, as Martin Feldsteinat Harvard pointed out, we had a revenue neu-tral bill in which we lowered the marginal taxrates and eliminated the loopholes. We broughtthe tax expenditures down from 10% of GDP to6%, which is where they are today. But yet, theeconomy responded more to the reduction intax rates than to the elimination of loopholes.Now, I don’t know of any studies that confirmthis, but it suggests that the multiplier on taxexpenditures is considerably less than the mul-tiplier on tax rates.

Which stands to reason, since they benefitonly specific minorities. It probably is because in some cases these loop-holes especially in the corporate code, can go toa very few. But let’s take the biggest tax loop-hole on the household side, which is the mort-gage interest deduction. We’ve done a lot tostimulate housing in the United States — andwhat we’ve gotten is overproduction and clearlya negative multiplier. To move forward, it’sclear that we need a program of mutual sacri-fice. There are going to have to be tax changesand expenditure changes. It seems to me, thebetter thing to do is to start scaling back asrapidly as possible the future promises thathave been made under Social Security andMedicare. To have shared sacrifice, we shouldeliminate the loopholes. I, personally, am infavor of elimination of all the loopholes in boththe personal and corporate tax codes. But Idon’t know how that could be achieved — thereare so many beneficiaries and the whole systemis designed to support those loopholes.

Not to mention all the tax attorneys you’dbe throwing out of work.True, but to keep the economy growing, weneed some reduction in the marginal tax rates.And it could be done, while lowering thedeficit, because of the higher multiplier on taxrate changes, in a way where the cuts in spend-ing and the elimination of loopholes are greaterin terms of dollar volume than the reduction inthe marginal tax rates. So we could deal withthe debt situation. We don’t have the optionthat John Kennedy had in the early 1960s orRonald Reagan had in the early 1980s, where wehad sluggish growth and just responded by cut-ting the tax rates, so the economy improvedover time. We don’t have that option becausewe’re so heavily indebted. We’ve got to do it in acomprehensive sense in which we lower thebudget deficit initially, and we achieve that bycutting spending, eliminating the loopholes,and then we provide some offset through areduction in the marginal tax rate. If we movein that direction, then ultimately the economywould begin to work out some of these difficul-ties. I haven’t seen the political will to move for-ward. But this basic approach is very similar tosome of the provisions in Bowles-Simpson, andthis is the direction in which we have to go.

And we probably need political campaignfinance reform first, so good luck! Everyone is a special interest. But we don’twant the tax codes to incentivize investments


Weeden & Co. LP’s

Research Disclosures

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that are not consistent with the most productiveuse of capital. What we really want is tax codesthat are neutral in terms of the allocation of thecountry’s goods and resources. That would pro-duce a better net result, but there are many whobenefit from the existing structure and they’regoing to fight the changes as hard as they possi-bly can. This is not a case where we lack the tech-nical knowledge to deal with our problems.There’s a lack of political will or political cohe-siveness to deal with the problem.

What about the private sector? You men-tioned earlier that Minsky wanted to keepbanks small. We’ve only let them growlarger. We’ve made no real progress indelevering the private sector since the cri-sis—No, and we’ve got to deleverage. I don’t think itreally matters whether we deleverage in the pri-vate sector or the government sector. The factis, we’re going to have to deleverage in both inorder to clear the way for prosperity. After all,isn’t that in the final analysis what we want toachieve? But we’re not doing that. The realmedian household income right now is where itwas in the late 1990s. We’ve had no improve-ment in the standard of living, even though thedebt-to-GDP ratio has risen about 100 percent-age points. The problem is not solely in the gov-ernment sector. It’s not solely in the privatesector. It is the aggregate problem, the aggre-gate over-indebtedness, which is the key.

Have you adjusted your portfolio positionsat all for this year?Not yet, we still have a very long duration port-folio. If the situation changes, we hope to beable to be flexible enough to react to it andwe’re prepared to react. But we don’t think thatsituation is immediately at hand, though noth-ing can be taken for granted. In economicanalysis, there are two things that are impor-tant. First and foremost, you have to have someunderstanding of how the world works and thenyou have to evaluate the incoming data in termsof the way in which the world works.Responding to the individual indicators, atHoisington Management, we don’t think that

works. The indicators have to be interpreted inlight of a more fundamental structure. What’svery difficult about bond management is thatthe short-term trading is really dominated bythese whole hosts of psychological and behav-ioral characteristics, which are very difficult tosort out. But the bond market, in our opinion,does move toward equilibrium, though theprocess is slow and torturous. To know whenyou’re moving toward equilibrium and in whichdirection the equilibrium exists, requires thisbroader understanding of the fundamental eco-nomic relationships. That’s what we try to do.

You’re saying you try to stay focused onthe big picture? Not react to each blip inthe data? Yes, and the thing about it is, it’s counter-intu-itive. You might assume that we’d have greaterknowledge about the short run and less knowl-edge about the long run. But in our approach,the only knowledge that we think we have per-tains to these longer term fundamental consid-erations, not to the short-term trading. So we’relooking at the world through an entirely differ-ent prism.

So short term moves are just noise?Yes, and trying to sort out the short-term noiseis an impossible task. Our approach atHoisington Management is that you cannotreact to these short-term swings. If you do that,you’ll generally be buying at the wrong time andselling at the wrong time.

Words to the wise. Thanks, Lacy.

W@W Interviewee Research Disclosure: Dr. Lacy Hunt joined Hoisington Investment Management Company as chief economist in 1996. This interview is not in any sense a solicitation or offerof the purchase or sale of securities. This interview was initiated by Welling@Weeden and contains the current opinions of the interviewee but not necessarily those of Hoisington InvestmentManagement. Such opinions are subject to change without notice. This interview and all information and opinions discussed herein is being distributed for informational purposes only andshould not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sourcesbelieved to be reliable, but is not guaranteed. In addition, forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted asinvestment advice, or as an offer or solicitation for the purchase or sale of any financial instrument. No part of this interview may be reproduced in any form, or referred to in any other pub-lication, without express written permission of Welling@Weeden. Past performance is no guarantee of future results.


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