Lacy Hunt: US Debt Becoming Increasingly Counterproductive

Lacy Hunt: US Debt Becoming Increasingly Counterproductive

If the Trump administration successfully repeals Dodd-Frank regulations, what impact will that have on the US banking system? Will the too-big-to-fail problem improve or worsen?

Repeal of Dodd-Frank will not have an immediate impact on the US banking system. Debt from the four domestic, non-financial sectors relative to GDP surged to an all-time record high of 251.9% of GDP in the third quarter. This is in contrast to the destabilizing 246.8% reached in the final quarter of 2009.

This debt has become increasingly counterproductive. In the latest four quarters, this aggregate of debt (composed of the US government, state/local, household, and corporate sectors) surged by $2.6 trillion—or $5 for each $1 of GDP generated. From 1952 to 1999, $1.70 of debt generated $1 of GDP, and from 2000 to 2015, the figure was $3.30.

This suggests that productive lending opportunities are becoming increasingly limited. The financing of such debt poses significant longer-term risks to economic growth, especially when banks are generally undercapitalized. Also, a repeal of Dodd-Frank does not change the high number of extremely large financial institutions.

Hyman Minsky's recommendation to prevent the consequences of extreme over-indebtedness is worth remembering. Minsky advised constantly breaking up financial institutions in order to prevent the excessive and unwise extension of credit within a few financial institutions from impaling the system.

If US corporations are given a window to repatriate foreign-held profits to the US under favorable termsand they do itwhat benefits, if any, do you see accruing to the economy?

The benefits may be considerably less than generally believed, and they carry at least some possible adverse consequences for the US economy. The tax repatriation should incentivize corporations to shift about $2.6 trillion in foreign liquid assets into liquid assets domiciled in the United States. While a bulk of these funds are dollar denominated, 10% to 30% of these funds could be denominated in foreign currencies.

Additionally, the bulk of these assets are held by already cash-rich, high-tech, pharmaceutical and energy companies. The concentrated ownership of these liquid assets suggests that they will not be placed in physical investments, but shifted into domestic-domiciled financial assets like share buybacks, mergers, dividends, or debt repayment after the US corporations pay the US Treasury an estimated $260 billion in taxes.

Putting the funds into financial engineering will improve earnings per share and further raise equity valuations for individual firms. However, such transactions will not grow the economy. The reason that these overseas funds were liquid in the first place is that management could not find viable real investment opportunities. Since the fundamentals have not changed, the shift into liquid assets domiciled in the US is unlikely to lead to more domestic physical investment.

Capacity utilization was only 75.3% in October 2016—well down from the peak of 78.4% reached in November 2014. In addition, corporate profits in the latest available quarter were unchanged from the fourth quarter 2011. Also, those assets denominated in foreign currency will need to be converted to US dollars. This will place additional upward pressure on the dollar, which recently surged to a 14-year high as measured by the Wall Street Journal Index, thereby reinforcing the loss of market share for US firms in domestic and foreign markets.

The sharp rise in the dollar and the surge in bond yields since the election will place additional downward pressure on the velocity of money, which was already declining sharply due to the increasing counter-productiveness of total public and private US debt. In the third quarter, money velocity fell to the lowest level since the early 1950s. A hike in the federal funds rate in December would reinforce this effect. Since the benefit from the personal and corporate tax cut is in the distant future, the repatriated funds are likely to remain in the financial sector for a considerable time.

With the prospect of lower capital gains tax rates in 2017, is the current market rally being sustained by investors delaying taking profits until the new year?

Households and businesses will endeavor to shift as much of their income as possible—regardless of the source—from 2016 into 2017. A substantial amount of 2013 income was pulled into the fourth quarter of 2012 in anticipation of the 2013 tax increase. That process will now work in reverse.

In a rare Hoisington Update, you stress that the factors which influence economic growthsomething you accurately term initial conditions—have become increasingly negative of late. Is there anything in the Trump agenda, assuming that it is enacted, that would positively affect the initial conditions?

On Election Day, the new administration was facing the following negative initial conditions: exhaustion of pent-up demand, adverse demographics, extreme over-indebtedness (domestically and globally), weak and fragile global economic growth, and built-in further increases in federal debt.

The degree to which mandatory federal outlays will rise over the next decade and a half is massive and will boost gross government debt steadily higher to new levels relative to GDP. The entitlement spending will surge due to the aging of the US population. Consequently, the government expenditure multiplier, which is already negative, will become even more negative.

In addition, as government debt increases relative to GDP, this will boost the non-interest costs of US debt—including mal-investment, less saving, weaker productivity, and worse demographics. Boosting Japanese government debt from 67.1% of GDP in 1966 to 210.2% in the third quarter of this year coincided with a sharp decline in nominal GDP.

The best opportunity to improve domestic economic conditions is to cut the marginal household and corporate income tax rates, while concentrating the tax cut entirely for middle income households. Due to the extremely high level of federal debt, these tax cuts need to be balanced to the fullest extent possible with reductions in negative-multiplier federal expenditures. If current spending cannot be reduced, then future commitments to the entitlement programs need to be reduced, so that—at a minimum—the longer-term federal debt trajectory does not worsen.

Since Election Day, two further adverse initial conditions have emerged. Interest rates have risen sharply, and the dollar has risen. Within two years, the increase in interest expense for the US could rise by $200 billion per year… this is not good for an economy that has risen only $500 billion in the past year.

For the fiscal initiatives to work, monetary conditions must be supportive, not adversarial. Due to much higher debt levels, the tax cuts will not work nearly as effectively as they did for Presidents Kennedy, Reagan, and Bush. Moreover, the Reagan tax reduction was substantially larger than the one currently being proposed. The negative consequences of a rise in both interest rates and the dollar since Election Day may be equal to or even greater than the potential future benefit of the fiscal actions under discussion.

In your extensive body of research, you talk about the relationship between US recessions/expansions and the financial cycle, specifically cyclical turning points. With the current US expansion a bit “extended” by just about any measure, are the monetary and credit markets signaling a recessionary turning point ahead?

In late-stage expansions, such as we have at present, exhausted, pent-up demand renders an economy susceptible to the downturn. It does not, however, pinpoint when such a downturn could occur. Pent-up demand appears to be exhausted in the following four sectors: motor vehicles, single-family homes, apartments, and capital spending. Signs of the exhausted pent-up demand include falling apartment rents and car prices, as well as a noticeable decline in new home sales from the peak reached in the second quarter.