Economist Lacy Hunt On Debt Deflation
Business Spectator's Isabelle Oderberg recently interviewed economist Dr Lacy Hunt of Hoisington Investment Management (link courtesy of Dah Hui Lau). Hunt is quite outspoken on the deflation of the debt bubble. Excerpt:
Isabelle Oderberg: How did we get ourselves into debt deflation?
LH: Well it's been a long time in the making. The debt to GDP ratio took out the highs of the 1930s and 2003. At that point in time total debt was just a little bit more than $3 of debt for every dollar of GDP. Today it is just under $3.60 of debt for every dollar of GDP and we are going to see that ratio move higher, in part because normal GDP in the United States is now falling and the difficulty of repaying this debt is going to be very difficult, because the loans are denominated in dollars and the assets that were borrowed against are dropping in value. The income generating capacity of these assets are also dropping and the US economy is in something called a debt deflation. A very rare situation. It only occurs every 3 to 8 or 9 decades. The last time that we experienced it was the 1930s in the United States. We experienced it in the 1870s and 1880s and Japan experienced a debt deflation post 1988 but it has happened historically. It is very rare and the two main things that identify it are setting a new peak in the debt to GDP ratio and also a lot of borrowing that is improperly financed and where there is little likelihood that the borrower can repay the principal and the interest of the loan.
IO: What scenario are we going to see now?
LH: These debt deflationary periods tend to last. They're very pernicious, they're very persistent and they tend to last a long time. Really, the only thing that brought the United States out of the post 1929 debt deflation was our participation in World War II. The debt deflation that ensued after the panic of 1873 lasted another 20 to 23 years and the Japanese, they had debt deflation which started 1989 and is still running for all practical purposes today. They last for a very long time.
IO: According to your quarterly review and outlook, we're now essentially in a 15-year process. Does that mean that it's going to take 15 to 20 years for this situation to actually stabilise or normalise?
LH: Well, there are other intervening events that could occur. If we would have very significant technological breakthroughs that might shorten the process, but one of the things that suggest it's long running is you can look at what happened to interest rates and stock prices after these prior debt manias. Post-1928 you had a negative risk premium for 20 years. Negative risk premium meaning the total return on treasury bonds exceeded the total return on the S&P 500. Post-1872 you had another 20 year period of a negative risk premium and we've seen a negative risk premium post-1988 in Japan. The low in interest rates after those previous debt bubbles occurred about 14 or 15 years later, for example the low post 1928 occurred in 1941 on the yearly average basis at 1.95 per cent. Once we went into World War II, then there were some very minuscule increases 20 years after 1928 interest rates were up slightly, but not very much from the lows that were reached in 1941 and that was also a characteristic of the Japanese situation and our situation in the US post 1872.
IO: So if we're in any way mirroring the '31 to '33 situation, is the S&P at risk currently of a bear market rally?
LH: Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.
When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.
After the experience of the 1930s the savings rate in the United States rose irregularly into the early 1980s and it's been in a decline since then irregularly to extremely low levels, virtually the same low levels that we reached in the 1930s and if history is a guide and there are not many data points we're now beginning to see an upturn in the saving rates that will last for a very long time.