The Policy of Doom

We’ve finally found the long-awaited (due to a browser refresh issue?) Hoisington Investment Management Quarterly Review and Outlook, Second Quarter 2012. As usual, Dr. Lacy Hunt has produced a 4-page newsletter based on solid economic theory but written in a manner that a layman may understand. This one is centered on Interest Rates and Over-indebtedness. He is basing his discussion on three recent papers, especially research [that] includes the first systematic evidence of the association between high public debt and real interest rates. As he states:

both low long [bond] rates and the stagnant economic growth [the current US ‘recovery’] are symptoms of the excessive indebtedness [current sovereign debt levels] and/or low quality debt usage [government spending].

Although he relates the studies to the interest rate on the long bond, an important issue for investors, especially pension funds, there are more important broader implications for Western economies in general.

Key points from the three studies Hunt cites are:

  • One study by Reinhart, Reinhart and Rogoff (NBER, 2010) identified that debt overhangs are associated with a 1.2% lower GDP growth rate than during the low debt periods. The new finding is that the duration averaged 23 years. This means that the US and many other western nations can look forward to 23 years of low growth on the average due to their high public debt levels.
  • Other impacts beyond reduced GDP growth are a wider output gap (the difference between what the economy produces and what it could produce if the debt effects did not exist), slower inflation, and lower long-term interest rates.
  • In the second study Hunt looked at, the authors found that an increase in governmentsize by ten percentage points is associated with a 0.5%to 1% lower annual growth rate.
  • The third study not only confirms the finding by Reinhart and Rogoff (2010) that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth, but that as the government debt rises to higher levels, the adverse growth consequences accelerate.
  • It is often said that economic conditions would have been much worse if the government had not run massive budget deficits and the Fed had not implemented extraordinary policies.This whole premise is wrong. In all likelihood the governmental measures made conditions worse, and the poor results reflect the counterproductive nature of fiscal and monetary policies.


Certain critical observations are generated from this research:

  1. Beyond a debt/GDP ratio of 90-100%, economic growth is negatively impacted.
  2. The period of diminished growth is found, based on experience, to lasts 23 years on the average. [In support of this, John Hussman writes in July 23, 2012 – Extraordinary Strains: What interest rates are telling you; what the Federal Reserve is telling you; what the equilibrium created by lenders and borrowers is telling you – is that time is economically worthless and that economic malaise will extend for years.]
  3. As the ratio increases, the rate of decrease in growth accelerates in a positive feedback loop.
  4. Deficit financed Keynesian stimulus at high debt levels is precisely the wrong policy to follow, accelerating the economic collapse.
  5. We’re all screwed.


In When Money Dies, Adam Fergusson chronicles the actions and policy decisions of the German government and the Reichsbank, that in part led to and exacerbated the Wiemar hyperinflation. We also understand now that the policies of the US government and the Federal Reserve led to and exacerbated the Great Depression. In other words, officials thought they were doing the right thing when in fact it appears they were doing the wrong thing.

Coming into recent times, we assume that officials in the US government and Fed (and their European counterparts) have implemented policies to try and create economic stability and growth. Further, with the current crisis that emerged in 2007, we assume these officials continued to analyze the situation and craft policies that by their understanding would alleviate it. The counter assumption would be that officials acted knowingly in ways that damaged the economy. Granted that self interest and ignorance may have been part of the solutions attempted, but this is always the case.

Based on this we make the following hypothesis:

  1. Government (and central bank) officials will always create policy optimal on their understanding of a situation;
  2. there will be sufficient agreement or support to implement the policy;
  3. such policies cumulatively will lead to a crisis;
  4. and since the the crisis is the result of the best understanding of officials, they will not see it coming, they will not understand it when it comes, and they will have no alternative policy framework with which to fix it.

In short, this time is different but the result will be the same – or welcome to the next Great Depression.

Addendum: Unintended Consequences of Well-Intended Policies

Subsequent to the above essay, Lacy Hunt submitted another short essay on the topic to Zero Hedge: Lacy Hunt On The Unintended Consequences Of Well-Intended Policies. He discusses the failure of activist monetary and fiscal policy of the 1960s and 1970s supported by the same three papers.

He briefly discusses the idea of the “bang point, or the condition where a government engages in deficit spending for such a prolonged period of time that a massive buildup of debt leads to denial of additional credit to the government because of fear that the existing debt will not be repaid.

The current brand of Keynesianism as the current activist policy, intended to ameliorate economic conditions has failed and in fact is exacerbating them. Also view this presentation:

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