Excessive Debt and Its Impact on Structural Growth

| February 15, 2012

During the last several years, we have spent a great deal of time discussing excessive debt and its impact on economic growth. We believe that the foundation for the next structural growth cycle cannot be created until the debt issue is addressed in a meaningful way. In a recent interview with Kate Welling of Weeden & Co., economist Lacy Hunt of Hoisington Management discussed the problem in great detail, dissecting the opposing view of conventional thinkers such as Federal Reserve Chairman Ben Bernanke. A brief excerpt from the interview is reprinted below, but we would highly recommend that you read the transcript in its entirety at the Weeden & Co. web site. The interview is long and relatively technical, but it provides excellent “big picture” perspective and insight.

Happy New Year, Lacy. And thanks for sending all those charts to background me for our conversation. I have to say the first one stopped me — showing debt as a percentage of U.S. GDP all the way back to 1870? What data goes back that far?

Dr. Robert Gordon at Northwestern University has been very helpful to me, recreating a lot of data. The National Income and Product Accounts (NIPA) from the Bureau of Economic Analysis (BEA) only start in ’29. But NBER (the National Bureau of Economic Research) funded two studies, one by Christina Romer and the other by Robert Gordon, to estimate the nation’s GDP back to 1870. So we have those data sets. They’re not identical, obviously, but what most economists do, including me, is use an average of the Romer and the Gordon estimates, which seems to work out pretty well.

Still, I suspect most folks looking at a line on a chart interpret it as “historical fact” instead of as an estimate based on spotty data on the workings of a very different economic environment.

Well, what the profession is saying is that economic propositions need to be tested and verified over as complete a sample as possible. Admittedly, some of these earlier periods, you didn’t have a central bank; you didn’t have an income tax; you had various political regimes; sometimes you were on the gold standard, sometimes you were off. The point is, most people feel that these institutional differences shouldn’t obscure the verifiable observation of basic economic relationships. So you want to test this over as much time as you possibly can and I think that’s a reasonable proposition. Anyway, that’s my approach, and that’s increasingly the approach in the profession.

I was just noting that what we actually know about the economy in days gone by is lot squishier than terms like “data sets” or lines on charts seem to imply. But clearly, observations over short times can be misleading.

Absolutely. Take the subject of debt. If you confine your analysis to post-war period, you only have one major debt-dominated cycle and that’s the one we’re currently in — and have been in for a number of years. But if you go back far enough, you have three more. You have the 1820s and 1830s. You have 1860s and 1870s and then you have 1920s and their aftermath. Sometimes it’s essential to take your analysis back as far as you possibly can.

Sure. Doesn’t your second chart, on the velocity of money [below], show how none other than Milton Friedman was misled into thinking that it was a constant because he only looked at post-war data?

That’s correct and, in fact, I was misled along with him because I was also doing analysis based on the post-war data. Friedman’s period of estimation was basically from the 1950s to the 1980s. Well, if you look at the velocity of money in that time period, it’s not a constant, but it’s very stable around 1.675. So if you tracked money supply growth then, you were going to be able to get to GDP growth very well. Not on an individual quarterly basis, but even the individual quarterly variations were not that great. Until velocity broke out of that range after we deregulated the banking system. Now, velocity is breaking below the long-term average and it’s behaving exactly like Irving Fisher said, not like Friedman said, absolutely.

What a perfect example of the difference your frame of reference can make.

Yes, Friedman even said Fisher was the greatest American economist, and I think that is correct. Fisher had a broader understanding of the economy in a very, very critical way and in a way that I don’t think either Friedman or John Maynard Keynes understood it, and even a lot of contemporary economists, such as Ben Bernanke. Keynes and Friedman both felt that The Great Depression was due to an insufficiency of aggregate demand and so the way you contained a Great Depression was by your response to the insufficiency of aggregate demand. For Keynes, that was by having the federal government borrow more money and spend it when the private sector wouldn’t. And for Friedman, that was for the Federal Reserve to do more to stimulate the money supply so that the private sector would lend more money. Fisher, on the other hand, 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 depression 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. If you follow  these great economists and the interesting infographic information they give you can really see where our nation got into trouble.

And that your goose is cooked if you don’t you cut off the credit bubble before it overwhelms the economy?

Yes, and Bernanke is thinking that the solution is in the response to the insufficiency of aggregate demand. That was Friedman’s thought. That was Keynes’ thought and most of the economics profession has traditionally thought the same way. They were looking at it through the wrong lens. Fisher advocated 100% money because he wanted the lending and depository functions of the banks separated so we couldn’t have another event like the 1920s.

You’re saying that Fisher argued against fractional reserve banking?

Yes, and so did the people that more or less followed in Fisher’s footsteps, principally Charles Kindleberger and Hyman Minsky. Minsky felt that the way you prevented a major debt deflation cycle was to keep the banks small.

Prevent them from ever becoming too big to fail in the first place?

Right. Don’t let them merge. You don’t want them to get big. I actually gave a paper with Minsky once, in 1981, in which he advocated that position. Kindleberger was very precise in “Manias, Panics, and Crashes,” when he said that when you have a small credit problem, or many small problems, some say, you don’t want the Federal Reserve to respond. Because if the central bank comes in and bails out a small problem, then that will be a sign to those who want to take more risk that they don’t need to be cautious — they can always count on the central bank to come in and bail them out. If they do, Kindleberger said— and this was in ’78 — then the future crisis will be even greater. “A free lunch for speculators today means that they’re likely to be less prudent in the future. Hence, the next several financial crises could be more severe.”

Too bad nobody paid attention.

So we came along and we bailed out Long-Term Capital Management in the late 1990s.

Not to mention the banks that got in trouble in Latin America in the early ’80s, the entire S&L sector in the early ’90s.

Absolutely. You could even include the bailout of Chrysler in 1980, because that was a signal to the automobile companies and to their unions: “Do what you want. If you get in trouble, the U.S. taxpayer’s behind you.” But the Chrysler bailout and the LTCM bailout were very small. I mean, LTCM was a $3 billion problem. That’s a quaint number today. Yet the Fed came in with all its big guns blazing. They used monetary policy to ease the pain. A debt buildup was already underway, but the Fed greatly facilitated it and encouraged it. So, it seems Fisher and Kindleberger and Minsky were right. The only prudent way you can deal with these huge debt problems is to prevent them from building up in the first place. The response after the fact matters some, but it’s not the route you should go.

That’s great, in theory. Except that it is the route we went. Once again, we didn’t prevent the excessive buildup of debt, so now we have to deal with pressing deflationary forces.

That’s why Fisher wanted to segregate the lending and deposit-taking functions of the banks.

Does that sound a mite like Paul Volcker, daring to suggest banning the banks’ speculative proprietary trading activities — and getting nothing but grief from the industry for his efforts?

Well, that’s right. Fisher couldn’t get it done, either. And warned that we would do it again. I had a brief acquaintance with Kindleberger; I didn’t know him well, but I knew him and he was helpful to me. He taught Ken Rogoff. And, in fact, “This Time, It’s Different” is really a quantification and verification of a lot of the qualitative themes that Kindleberger expressed. My sense was that Kindleberger thought that once the economy got into over-trading, there was no one who was going to stand in its way.


That was the old-timey term that Kindleberger used. He said there are three phrases of behavior as you move toward manias, panics, and crashes. The first phase is over-trading, where you start buying assets at prices far beyond their fundamentals. People enjoy this phase, because initially it boosts income and raises wealth and so forth. So it becomes very irrational. Then you get to what he called the discredit phase, where the smart people start pulling their funds out. Then you get what he called revulsion. The classical economists used those terms: Over-trading, discredit, revulsion. As I said, I got the impression from Kindleberger that once you get into that over-trading phase, there’s no one who is going to stand in the way of it.

Why stand in front of a freight train?

Especially when it doesn’t seem to be in anyone’s interest to stand there. Regulators, banks, companies, investors, everybody’s having a good time; profits are being made, employment is strong.

So we’ve just seen.

No one dealt with the credit excesses in the subprime market, until the crisis hit. And no one dealt with the excessive speculation in the financing of the railroads in the middle of the 19th Century, or in the financing of the canals and turnpikes and steamship lines in the 1820s and 1830s. Nor did anyone step in to try to stop the foolishness that was going on in the 1920s.

Kindleberger took it all the way back to the tulip mania, and I’d venture that wasn’t the first time in human history when an auction market got out of hand.

That is correct. Absolutely. You push things beyond their fundamental value. But this isn’t the conventional economic view of debt and it’s important. I sent you some quotes contrasting conventional wisdom with this newer understanding.

I noticed you picked something Bernanke wrote to illustrate conventional wisdom—

I chose that Bernanke quote [below] because Bernanke addressed the Fisher – Kindleberger theme in the early part of this century — and that’s when we really needed Bernanke to say something and to do something. But as you can see, Bernanke rejected Fisher and Kindleberger in his book, “Essays on The Great Depression.” And notice that he doesn’t reject Fisher because he says Fisher’s data is flawed. He doesn’t reject Fisher because Fisher’s argument is flawed or Kindleberger, either. He rejects them because an excessive buildup of debt implies irrational behavior.

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) and Charles Kindleberger (1978) have in several places argued for the inherent instability of the financial system, but in doing so have had to depart from the assumption of rational economic behavior. Footnote: I do not deny the possible importance of irrationality in economic life: however, it seems that the best research strategy is to push the rationality postulate as far as it will go.”

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

Vs. New View

“The U.S. economic recovery has been weak. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. The evidence is more consistent with the view that problems related to household balance sheets and house prices are the primary culprits of the weak economic recovery. King (1994) provides a detailed discussion of how differences in the marginal propensity to consume between borrowing and lending households can generate an aggregate downturn in an economy with high household leverage. This idea goes back to at least Irving Fisher’s debt deflation hypothesis (1933).”

-Federal Reserve Bank of San Francisco Economic Letter January 2011. Atif Mian University of California Berkeley, Haas School of Business and Amir Sufi, University of Chicago Booth School of Business.

“Debt is a two-edged sword. Used wisely and in moderation, it clearly improves welfare. But, when it is used imprudently and in excess, the result can be a disaster. For individual households and firms, overborrowing leads to bankruptcy and financial ruin. For a country, too much debt impairs the government’s ability to deliver essential services to its citizens. Debt turns cancerous when it reaches 80-100% of GDP for governments, 90% for corporations 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.

Well, hello!

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

To mention that what can seem rational on an individual level can be irrational when an entire economy does it.

We see it all the time, every day of every week. And yet Greenspan’s rejection of the danger of an excessive buildup of debt in his book put him in a different mindset, not just in evaluating the events of the 1930s, but when it came to understanding what was going on in the early part of this century, up to 2006 and ’07. Because he thought he could respond to a debt problem and contain it. But that was not at all what Fisher taught. Fisher said you have to prevent a debt deflation ahead of time. That’s a very powerful, critical, difference. What Fisher is saying is that once you get into this extremely over-indebted situation, and the prices of assets begin to fall, these two “big bad actors,” those are the terms he used, control all or nearly all other economic variables. Then, if you attempt to respond to the problem by leveraging further, it’s counterproductive.

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Category: Commentary, Market Update

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