Porter dispels Wall Street rumors that Buffett will come to the rescue of General Electric (GE) and tells you about the time he sat next to former CEO Jack Welch at a New York City Broadway play. Nobody knew what kind of financial engineering Jack was up to in the 1990s, possibly even Welch himself. Did the GE slogan “Imagination at Work” apply to their accounting, too?
International economist Dr. Lacy Hunt from Hoisington Investment Management joins Porter and Buck to reveal whether record debt will break economies around the world, slow them down, or leave everything largely unaffected. Porter asks Lacy if a debt jubilee will come to pass. Despite history, you’ll be surprised to hear Dr. Hunt’s answer. Lacy reminds Porter that out of all the major economies in the world, the US is still “the best of the worst.”
Listeners ask about the ethics of investing in companies like Facebook and what will happen to Berkshire Hathaway when it’s two famous principles finally leave. Porter tells you why he’s actually glad social media companies watch him, and how he would run Berkshire post-Buffett and Munger.
Economist and Executive Vice President, Hoisington Investment Management
Male: Broadcasting from Baltimore, Maryland and New York City, you're listening to the Stansberry Investor Hour. Tune in each Thursday on iTunes for the latest episode of the Stansberry Investor Hour. Sign up for the free show archive at InvestorHour.com. Here are the hosts of your show, Buck Sexton and Porter Stansberry.
Buck Sexton: Hey everybody. Welcome back to another episode of the Stansberry Investor Hour. I'm nationally syndicated radio host, former CIA analyst, and semi-professional bacon chef Buck Sexton. With me here today, the founder of Stansberry research, Mr. Porter Stansberry. Hello good sir.
Porter Stansberry: Buck, and that reminds me. We slaughtered two of our Berkshires and I have some home-grown bacon that I would be happy to share with you.
Buck Sexton: That sounds amazing and I would like to thank Doc Eifrig from the last podcast for sending me his wine. This podcast, you're sending me bacon. Hey, Country Club Guy, what do you got for me? You got some good gin or something? Come on.
Country Club Guy: Actually, I do. I have a lot of gin.
Porter Stansberry: He's got a new boat gin.
Country Club Guy: Mm-hmm. The back of the bottle is flat so you can lay it on the table and not worry about it falling over. That's what I did last weekend.
Porter Stansberry: Genius.
Buck Sexton: Jamison may be named for whiskey but I know he's a gin drinker. I can tell when I see one. So anyway, let's get into all the latest here. Today in the show, we welcome from the great state of Texas, Dr. Lacy Hunt. Dr. Hunt is an internationally-known economist and Vice President of Hoisington Investment Management company, an Austin-based firm managing nearly $6 billion for pension funds, endowments, and insurance companies. Lacy is the author of two books and his articles appear in Barren's, the Wall Street Journal, the Journal of Finance, and the Journal of Portfolio Management.
In our last episode, you heard Porter refer to Dr. Hunt's work discussing the effective concurrent, consumer, and corporate debt loads on inflation and economic growth so we're happy to have him here with us to talk with us about his current view of the markets and economic environment. And with that, Mr. Porter, GE.
Porter Stansberry: Yeah, let's talk about GE. The big rumor on the street is that Buffett's going to buy GE and I want to take this on because I think it's really funny and it's the way that –
Buck Sexton: Because he may have heard the Buck bought some GE, like a few dozen shares of it.
Porter Stansberry: [Laughs] Yes. Well, that was much earlier this year or … yes.
Buck Sexton: That's true.
Porter Stansberry: Earlier this year or earlier last year?
Buck Sexton: Yeah. Earlier this year. Earlier this year. Yeah.
Porter Stansberry: Oh, boy.
Buck Sexton: I sold it.
Porter Stansberry: Yes. Well, you should have read one of the dozens of essays I've written about GE over the past 20 years warning folks that it was in a debt-driven death spiral but you didn't, Buck, and you learned a lesson.
Buck Sexton: I did. I did. You burn your hand on the stove, once, it's not your fault.
Porter Stansberry: So two things about this. First of all, let me just back up for one second and tell everybody, the guest we have on the podcast today, Dr. Lacy Hunt is someone who is incredibly important and whose ideas have been completely ignored by the major mainstream macroeconomic community, but his ideas have become more and more influential in the financial community.
So this is not the kind of economist who writes textbooks. This is the kind of economist who guides lots of billions of dollars of investing and he has been very successful [laughs]. So one of the things you very rarely see is a rich economist because as Buck points out, economists have an awfully hard time predicting the future, but not this economist. So this economist manages $6 billion or $8 billion personally and advises hundreds of billions of dollars, maybe trillions of dollars globally.
So I would urge everybody to listen carefully to this interview and I'll give you a warning. I expect the conversation to be a little more technical than I would wish. I'm going to try to keep it in terms that everybody can understand but you're dealing with a guy who spent his entire career studying data and macroeconomic models. So it's not going to be as plain English as we would like. I hope that you will listen carefully and try to get something from it.
Now, about GE, I've written about GE for so long and we had a great discussion on the podcast about GE recently. I forget what episode it was but I'm sure someone can put a link into it. The problem with GE was really simple and also magnificent because GE took every single accounting angle, every single game you could play with debt and share count. They took it to the absolute largest extreme.
So let me give you an example. One of the things that happens when you have an economy like ours that's based on paper money and where interest rates are set by the central bank and manipulated heavily to the benefit of asset holders, you have a big gap in the yield curve. And GE exploited that gap more so than any other business in the world. So Buck, what is the largest scale, highest interest rate lending environment that exists in our economy? Where do people borrow the most money at the highest possible interest rate?
Buck Sexton: Payday loans.
Porter Stansberry: Oh, you got me. GE did not do payday loans. But there's not a lot of volume there. I want to talk about large volume. $1 trillion in outstanding loans.
Buck Sexton: Corporate debt?
Porter Stansberry: No. Credit cards.
Buck Sexton: Oh, okay. Close enough.
Porter Stansberry: All right. So you're talking about annual interest rates on GE's book of credit-card debt of around 20 percent. And nobody knew that GE was in the credit-card business because they would have fronts. So they would buy the credit-card receivables from Target, from other retailers. I happen to know Target because it was a big particular credit-card deal I remember.
Okay. So they had credit-card debt, high yield credit-card debt they would buy. They would also buy a lot of subprime auto loans and eventually, of course, they got into subprime mortgages as well and again, they went to extremes. They're not just doing subprime lending in America. They're doing it in Poland [laughs]. They're issuing mortgages to Polish borrowers on Polish property but they're using the Swiss frank as the currency. What could possibly go wrong, Buck? Any ideas?
So you just saw them take every financial gain they could to an extreme. Meanwhile, on the funding side, where do they get the capital? Well, again, they went to the extreme. They funded billions and billions and billions of these investments using 30-, 60-, and 90-day loans that they had to constantly roll over. And this all was how they monetized their triple-A rating. People thought that GE was in the business of building light bulbs and dishwashers and plane engines. They weren't.
Those things existed to earn a triple-A credit rating and all of the money they were making was coming from the exploitation of that triple-A credit rating. And it was clear to anyone who bothered to look at the business that all the money they were making came from finance. So that worked great from the early 1990s all the way until about 2007 as that credit bubble built and built and built and then burst. So by the year 2000, GE was the largest publically traded stock in the world, and had the largest market capitalization.
But almost all of its profits were coming from financial gimmicks, not because they really had great businesses. And this enormous increase in debt made a hero out of Jack Welsh but all he did was borrow more and more and more money. And it worked great as long as that financial bubble was building and the moment it crested and turned over, GE was cooked. So here's an interesting question for you. If you looked at the ten largest sovereign buyers in the world, so entire countries that have the power to tax, GE was number 10 –
GE. Right? A publically traded private business. Made no sense. And so they are still suffering the hangover from this gross success and I would argue, as I did in 2010 and 2011 and 2012 and as I warned about it starting as early as 2002, that there is no way this company is actually solvent. It may be liquid still because they can still borrow money to pay their bills but it is not solvent.
If you were to liquidate the entire company, what you would owe would be worth more than what you owned. And of course, their accounting did not reflect that as I showed for many years, and still doesn't. But the truth of the matter is, they've sold all of the stuff they can sell and what they're stuck with is the problems. The idea that Buffett's going to come into that morass is crazy.
GE can't earn enough money right now to pay its bills. It's going to have to do another equity financing. It's going to have to dilute its current shareholders. There is no way Buffett is going to buy this stock. No way. 0 percent chance. Buck, that's the company you bought. Smart decision.
Buck Sexton: And sold, I will have you know. Now I just can't think of the show, what is it, 30 Rock the same way because they have a character based on Jack Welsh and he's supposed to be this finance genius guy but apparently not.
Porter Stansberry: It's interesting about Jack Welsh. I really don't know at the end of the day if he really even understood what was happening because he wasn't the guy who was running GE capital. There was another guy and I can't remember his name right now. Country Club Guy I'm sure can pick it up for us. But if you guys remember from the early 2000s, the guy who ran GE capital was involved in a divorce and at the time, it was the most expensive divorce in history.
So when a guy working for you is paying $300 million to divorce his wife and you're an executive at a publicly traded private business, what the hell is going on? How did an employee make that much money? It's just nuts. And the answer is because GE Capital was delivering all of GE's earnings and they were playing all kinds of games, which are now under SCC investigation.
But here's what they would do, Buck. They would say to somebody, "Hey. We really want you to buy some of our airplane engines," and the guy would say, "Well, your airplane engines are really expensive and Rolls Royce is over here in Europe and I was thinking I was going to buy their engines." And GE would go, "No, no, no. Don't do that. We'll give you all the money that you need to buy those engines." "Well, what do you mean?" "Yeah. Well, we have this thing, GE Capital, and so we go and borrow money in a 60-day paper market. We pay like a point and a half and we'll just give you all that money that you need and we'll keep borrowing to make sure that the loan doesn't get called so you'll be fine."
"Well, are you going to give me all the money?" "Yeah. I'll give you all the money." "Well, then I'm going to buy your aircraft engines." "Okay. Great." Now, those aircraft engines get sold and get booked as a profit to GE but where did the money really come from? GE Capital. Okay, now how is that loan structured?
Well, that's where it gets tricky. It's not structured as a loan. It's structured as a long-term service agreement. "We're going to provide service on those engines for 20 years and that's our price to do that. It's just a loan to buy the engines." All that stuff has been papered over and lied about and I know about it because people at GE reached out to me when I was talking about how much leverage they had, they said, "You don't know the half of it. You have to look into these service contracts."
And do you know the regulator that finally caught the real corruption at GE was a Kansas insurance regulator? Now, let me just point out to you that I don't think the sharpest minds in finance are working as a regulator at the Kansas insurance department. No offense to folks from Kansas. I'm just saying that that's not where all of the world's hedge funds find their sharp minds. So my point to you is if it took a regulator from Kansas' insurance department to finally blow the whistle on GE, imagine how many people in New York were in on this in some way or another.
Either their banks were lending GE money or they were financing these agreements or they were getting commissions on these sales. GE was the largest company in America and its accounting is complete bullshit. Complete. How much did Jack Welsh know? I really don't – I have no idea. I don't know. The only time I ever had a conversation with Jack Welsh was at a play or a musical, rather, in Manhattan many years ago. Almost 20 years ago now.
Do you guys remember The Producers? It was the hot show in New York for a season and –
Buck Sexton: Matthew Broderick was in it. Yeah.
Porter Stansberry: Matthew Broderick. Yes. And the heavyset gay singer and dancer. Nathan …
Buck Sexton: Lane?
Porter Stansberry: Nathan Lane. Yeah. It was a great show. Anyways, that was right around when I started my own business and I had some cash in my pocket for the first time ever in my life and so I took my wife for a fancy holiday weekend in New York and we saw the show and I got us good seats. Anyways, Jack Welsh was sitting next to us and so at intermission, we all got up to use the facilities and I ended up in line directly behind him. And I don't know if you guys have ever seen him but he's about 4 feet tall. [Laughs] I'm not kidding.
And I'm not small. So I just felt like I was towering over this guy and we're crunched into this line in a bathroom and it's a little awkward when you're going to the bathroom and you're smashing sardines and everyone's trying to be polite but it's too crowded and you keep bumping into the guy. And I finally, I'm basically knocking him over because someone was pushing me from behind and I just looked at him and I said, "Jack. This must be one hell of a show if you're in line to pee," and he said, "You got that right."
[Laughs] That's the only reaction I ever had with Jack Welsh. But just the idea that Buffett's going to step into this situation and buy it when it's under FCC investigation and he knows it's accounting is a bunch of a bunk, there's just no chance.
Buck Sexton: You know he was tight with Obama, right? I remember that. There were a few CEOs. I think Berk who was the head of Comcast. He was very tight with Obama and wasn't Jack tight with Obama too?
Porter Stansberry: Yeah. We used to refer to GE as the for-profit wing of the Democratic Party.
Buck Sexton: Right. I just would wonder if you were to look back at it now with more of the truth out there and more of a recognition of what really happened, how much favoritism in terms of policy was doled out?
Porter Stansberry: Oh, sure. Like I said, when the Kansas insurance department is the guy who catches the $15 billion fraud at GE, which is only one of GE's problems [laughs] – that's an enormous fraud. Think about this for a second. Right? Enron was the largest bankruptcy of the time. That was $60 billion. That's a whole company going bankrupt. We're talking about $15 billion in losses and fraud from one insurance product at GE, which at one point, had $600 billion in financial investments. The scope of what went on at GE, we are nowhere near knowing.
We may never know and how many investigations, how many inquiries, how many problems got squashed because Imelt and Obama said, "Let's not bring that up now. We're in the middle of a financial crisis. We need to sweep that under the rug." I don't know but I'm sure there was a lot. And who knows? Maybe a subscriber or a podcast listener, maybe someone's out there. Because as you know, Buck –
Buck Sexton: You remember when –
Porter Stansberry: There's no way to hold this conspiracy in forever. Eventually, it unravels. It comes apart. Everyone starts pointing fingers. The truth comes out.
Buck Sexton: GE has the 57,000-page tax return back in 2011, right in the middle of the Obama administration, if you recall. 57,000-page tax return, zero taxes on $14 billion in profits. That's pretty amazing.
Porter Stansberry: That's pretty amazing. They also had, if you recall [laughs] it wasn't enough for Imelt to fly around the world all the time on a gigantic Boeing corporate jet. Right? He had to have another one behind him.
Buck Sexton: That's like Saudi royal family stuff right there. That's big time.
Porter Stansberry: Well, there's an extra plane that follows me wherever I go just in case there's a problem and I can't be delayed.
Buck Sexton: Is it an F16 just in case things get spicy up there?
Porter Stansberry: I don't know. I don't think so. I think it was just some kind of another corporate jet. I don't know if it was another Boeing or another Gulfstream. But just think about the imperial attitude of these people. Do you think that anyone was thinking about the shareholders at that company? Anyone? Did you find the name of the GE capital guy?
Country Club Guy: George Wendt?
Porter Stansberry: George Wendt. Yeah. Yeah.
Country Club Guy: Well, do you find it ironic what Jack is doing now? He's Jack Welsh, Management Institute, MBA program. You know what the slogans are? Become a great leader and help your company win. He's teaching others. I'll sign up tomorrow.
Buck Sexton: I also think that GE, probably, Porter, was able to get away with a lot more of the stuff you're talking about for a long time because it's GE. People think of it like –
Porter Stansberry: Good things come to life.
Buck Sexton: They're a bunch of guys –
Porter Stansberry: What I liked was that my buddy Jim Grant, fantastic newsletter writer, he pointed out that for many years, GE's corporate slogan was, "Imagination at work," and he was like, "Well, at least in the accounting department."
So here's another thing I want to point out to you guys. This is a little controversial and I think there's a lot of people out there who would argue that this is not the right way to think about things. But it's always occurred to me that if a guy can't be honest with his wife or if a guy's personal life is sort of always in shambles, that he may not be the person you want running your company. I understand – I'm going to argue that there's no real difference between public ethics and private ethics.
And Jack Welsh, just the stories of him interviewing that woman and cheating on his wife and all that drama right when he was putting out that book From the Gut, all that stuff –
Country Club Guy: Well, it's OK because he ended up marrying her.
Porter Stansberry: I don't know if it's OK or not. It just occurs to me that a lot of times, people that have a hard time managing their private lives also have a hard time managing fiduciary obligations. That's my only point. And listen, you're never inside someone else's marriage. You can't know what's really going on. But when you've had four of them [laughs] let's just say the odds are the problem wasn't with the woman. Just a thought.
Buck Sexton: This week on the Stansberry Investor Hour we are joined by Dr. Lacy Hunt. Dr. Hunt is an internationally known economist and executive vice president of the Hoisington Investment Management Company, an Austin-based firm managing nearly $6 billion for pension funds, endowments, and insurance companies. Lacy is the author of two books and his articles appear in Barron's, the Wall Street Journal, the Journal of Finance, and the Journal of Portfolio Management, just to name a few. He also spent time as chief U.S. economist for the HSBC group, one of the world's largest banks and is an honorary life trustee of Temple University.
A native Texan, Dr. Hunt has served as senior economist for the Federal Reserve Bank of Dallas. Please welcome to the Stansberry Investor Hour, Dr. Lacy Hunt.
Porter Stansberry: Dr. Hunt, Porter Stansberry here. Thank you so much for joining us. I want to introduce you to our audience by telling a story that's weak in details about your general investment philosophy, so please forgive the quick summary. I know I'm skipping over lots of nuances. But folks, the reason why Dr. Hunt grabbed my attention is he has had a long-term bet and a huge investment in the very long end of the sovereign credit yield curve.
So for decades, he and his investment firm have been very well known for owning the longest-term U.S. debt that you can buy and they have ridden that investment all the way from when yields were very high. Dr. Hunt will have to fill in the details about this but over 10% annually to where they are now and I – again, Dr. Hunt will have to forgive me for not knowing the exact details – but where these yields and long-term debts got down to around 2%.
So those are enormous gains. He's done very well for investors and he's done so in probably the most contrarian way I can imagine by developing an economic theory that says that as economies become over-leveraged and over-indebted, that additional stimulus, that his additional government debts do not actually provide further economic growth. They retard it. And that has allowed him to confidently stay at the far end of the yield curve where any outbreak of a large inflation would be devastating to his investments. Dr. Hunt, can you please, in the most easy and least technical way possible, tell our audience about how you became convinced that long-term interest rates and long-term inflation was going to decline and how you've been right and why you stuck with it for so long even till today?
Lacy Hunt: Well, I've been trained. I was trained in classical, neo-classical economics and long ago, I was introduced to the Ricardian equivalence theorem. David Ricardo was one of the great minds in economics. Probably did more to establish economics as a profession than even Adam Smith. But Ricardo was asked back in the 1820s whether it would have been better to finance the British wars with Napoleon by raising taxes or borrowing, issuing debt to cover it. And Ricardo thought the matter through and he concluded that they were the equivalent.
Either way, you either tax the funds from the private sector or you borrow the funds from the private sector. Now, Ricardo was candid enough to say that he didn't know and there was no way that we could empirically test whether Ricardo's proposition was right. The economics profession follows Ricardo all the way to 1936 when J.M. Keynes reverses Ricardo and he advocates that there is a significant multiplier, that if we engage in deficit financing to both tax cuts or expenditures, that we will have this multiplier where $1 of deficits will boost GDP $4 or $5.
Keynes was not candid to say that he didn't really know and he could not answer the question, because at the time, we didn't have the statistical techniques and a computer capacity that we do today. But as a result of ability to create long-running statistical theories, analyze them very quickly, and test them using sophisticated methods, in my opinion, the academic research is unequivocally clear that Ricardo is right and Keynes is wrong, that there is basically no benefit engaged in deficit spending or financing of other government activities with tax cuts.
And in fact, I myself have published information that shows that if you are late per capita changes in GDP to per capita changes in federal debt, that basically what you have is essentially a flat line. Actually, the line is slightly negative. In other words, we lose something by engaging in the process, but essentially Ricardo is right. And so the other side to this question is that not only is there no benefit other than for perhaps, a very fleeting period of time, a buildup of debt has to meet very stringent tests. Debt is an increase in current spending in exchange for the client and future spending.
Now, the debt can be successful and be profitable to those that engage in it, to the economy as a whole, but it has to generate an income stream to repay principal and interest. And if debt does not do that, as you move to higher and higher levels of debt, you will produce weaker and weaker economic growth and that's another consequence that we have – the academic studies show that when debt rises, when government debt rises above 90% of GDP for more than five years, that the economies lose about one third of their trend rate of growth.
Well, we moved about 90% a long time ago. We're currently at 107% before the end of the next decade because of the debt finance tax cuts and this mammoth budget that was just this mammoth bipartisan budget that was just enacted, our government that is going to be approximately 120% substantially higher than it is today. The academic research indicates that when you're at these high levels, economies lose about one third of their trend rate of growth. From 1790 through 1990 when we moved into these high-debt zones, the per capita GDP growth was about 2.1%.
We should have moved down to a trend rate of growth of 1.4. However, we've dropped even more than that. The trend rate of growth now is only about 1.1%, but there was an outstanding academic study led by Dr. Phillip Rother, who's head of the fiscal affairs department of the European Central Bank, that when government debt moves into these high zones above 80 to 90% of GDP, that the effect becomes non-linear, that you lose growth at an even faster pace.
So debt is very detrimental. There's little, if any gain, over the near term, and the buildup of debt cuts into economic performance. Now, in just the past several months, I thought of another way and a simpler way of expressing the problem, and that is to use the law of diminishing returns, which you start with an economy's production function and production is a function of the factors of production or inputs that would be labor capital natural resources.
And what the law of diminishing returns says is that if you increase one of the factors, let's say debt capital, substantially, in the beginning there will be increasing returns to scale or output will rise very rapidly. But as you continue to make disproportionate use of debt capital, the returns will start diminishing. Then they will flatten out and then they will go negative. And I believe that this is the more comprehensive way to now look at the problem, and what it suggests is that we're on the path to economic decline. It will occur gradually and there may be some cyclical interruptions, but the trend is not a healthy one at all.
Porter Stansberry: Dr. Hunt, I've got to ask you the obvious question. Because when I first heard you explain this thesis and show this data, I was really off struck and shocked by it and it makes so much sense [laughs] and the data is so convincing that immediately, I begin to wonder why haven't more people thought of this before? And for me, the big breakthrough came after the enormous monetary stimulus of 2009 when I saw that the Fed was buying up huge amounts of Treasury notes and bills and bonds, I, like so many other people thought, "Oh, my lord. This is going to be very inflationary."
And I expected to see negative returns in the bond markets and as you know, that's not what happened. The long bond has rallied considerably since wherever the highs were and yields maybe in 2012 or so. And then you saw yields go to new all-time lows since, and I imagine that you were still along those instruments and have done very well with your investments. But the question I have for you is: What is the difference between the kind of financing that we have engaged in in America and the kind of financing that they have engaged in in Zimbabwe or in Venezuela?
Why has the increasing amount of government debts and the monetization of those debts through the central bank not resulted in a loss of confidence in the currency and in runaway inflation?
Lacy Hunt: Well, that's an excellent question. There is an outstanding model, which is used in all of the leading macroeconomic textbooks of money supply determination, bank credit determination. It was developed by the late economists Karl Brunner and Allan Meltzer. And what they were able to show is that the money stock M2 is equal to the monetary base, which the Fed controls, times the money multiplier. Now, the Fed does not control the money multiplier.
The money multiplier is dependent upon an algebraic set of known determinants: the excess reserve ratio, the currency ratio, the time deposit ratio, and the Treasury deposit ratio. And what happened, the Fed expanded the balance sheet by four times but the money multiplier, which is an equal partner with the monetary base in the money and credit determination process, fell from roughly nine to three and money supply growth did not accelerate.
We saw this same pattern in the Great Depression. The Fed can inject the excess reserves into the system but the banks have to have the capital and you have to have the unleveraged balance sheets in this household and business sector to be able to absorb more debt. And so the base quadrupled but money supply growth basically remained around the trend rate of growth from 1900, which is around just slightly below 7%. There were few times when they were able to get it up a little bit but then it fell below trend and so money supply growth did not accelerate.
But money supply itself does not determine GDP. You have to take into account what – the speed at which money turns over, the velocity of money. Keeping in mind that the money multiplier and the velocity of money are different concepts. And so money supply growth was basically attrend in this expansion but the velocity of money fell to basically the lowest level since the 1940s and velocity is not a very well understood concept and there are many, many factors that influence it. But the overriding one is the productivity of the debt.
In other words, if the loan is made to someone and the loan generates the income stream to repay principal and interest, then the velocity of money will be stable or will rise. But the decline, the massive decline and the velocity of money was another consequence of the fact that we were extremely over indebted. And so the – when you become extremely over indebted, not only do the debt policies not work other than for a very brief period of time and then they create this longer term drag but highly leverage economies, monetary policy become asymmetric.
When the Fed tightens, as they are now, in fact, the extreme leverage facilitates the damage that the Fed can do to the economy and I think we're going to see that as this year plays out. But when the Fed is trying – the Fed's tools are extremely ineffective, extremely ineffective in the current situation. And that will remain the case, unless, of course, we revoke the Federal Reserve Act of 1937. The Federal Reserve does not have the ability to print money. They do not have the techniques to print money. They do not have the mechanisms to print money.
They can increase the monetary base at will but that's not tantamount to increasing the money supply. Their skills, however, are still intact. And in fact, their skills are intensified whenever they are engaging in a tightening process. And the reason their skills are intensified is that when an economy is heavily [...], a small increase in interest rates results in a substantial increase in interest expense.
So the indebtedness has many consequences and as time goes by, the extreme over indebtedness results in some longer term problems. The growth rate comes down. Family formation, population growth, the birth rate are all very sensitive to economic growth. So we see historically in Japan and other cases that the growth rate comes down in the face of too much debt. Then, you get a baby bust, a household formation bust, a population growth and that serves to reinforce the weakness.
Another consequence, another symptom of the extreme over indebtedness is that the productivity falls. And that's happened. If you go back to 1950 when the quarterly data start, the productivity has grown by about 2.1% per annum. The latest five years is the lowest five years of productivity growth since 1952 when the data originates. And then the weakness in productivity then undermines the standard of living, which is a real disposable per capita income. And if you look at the 10- year rate of growth there, it's now under 1%. It's historically been 2.1% per capita terms.
So the standard of living erodes and then that reinforces the negative demographics and the economy goes into a long-term funk. And so this expansion, it was a long-running one but it was the least satisfactory to people, to their hopes, their aspirations. And the debt was the center part of the problem.
Porter Stansberry: Dr. Hunt, I want to get to one other big idea big topic besides the negative money multiplier and the likelihood of weaker economic growth going forward. And that is, I want to explore two topics that are related. I want to know what role you think paper money as opposed to a gold back system has played, if any, and the widening of the wealth gap in America and I want to know your thoughts on the likelihood or risks of a debt jubilee in America. And I think those two ideas are fundamentally related.
So the first question is, do you think our central banking system, our monetary system that has been in place at various degrees since 1913 but in a full paper way since the '71, I believe. Do you think that has contributed to the collapse and correlation between productivity and wages in our economy and in the resulting wealth gap?
Lacy Hunt: Well, the most critical step – and this is an excellent question, Porter – was really 1971 when Richard Nixon was undertaking the new economic program to close the gold standard. And I will tell you in all candidness, as I was two years out of my PhD program, I supported that. I thought it was a great thing. I believe in free markets and I wanted the currency markets to fluctuate like everything else.
Unfortunately, when we were taking off the gold reserve standard, it put the fluctuations in the dollar on the back pages of the newspapers. And so it then freed Congress and the monetary authorities to really make bad decisions. Because up until that time when bad decisions were made, the dollar fell and the policymakers took note of it. And so one of the unintended consequences of closing the gold window was that it resulted in increasingly poor monetary and fiscal policy decisions, something that I didn't anticipate. Neither did Professor Friedman.
In other words, the one rudder, the one barometer of sound or unsound policies was gone and so I think that the floating exchange rate standard did not work well for us, did not work well for us at all. And what was the second question again, Porter?
Porter Stansberry: Well, I wonder about that, specific about a feature of the failure of the system in my mind has been the strange and amazing collapse between correlations – between the tight correlation between the productivity and wages. So you've had now, a 40-year period where wages in real terms haven't increased at all. Flatlined for four decades.
But productivity has – maybe not at the former pace, as you pointed out – but productivity has continued to grow. It's been a very, very strange gap in the way that our economy used to work. To give you an example, I would make the point that what resulted in the end of slavery around the world was not really morality but economics. But as productivity increased, people couldn't afford to have slaves anymore [laughs] because slaves were the least productive of the workers and the other workers were too valuable, so we had to free them so that they could be productive.
And so this increasing human productivity has played a huge role in human history, development, economic growth, wealth. It's the source of all these things and our wages no longer transmit that growth equally or fairly among all wage earners. And I see that – that break in that correlation – in the early 1970s, and I don't believe it's a coincidence.
Lacy Hunt: Well, here – you make a sound case. There is clearly a link between the ability of firms to pay higher wages and the rate of growth in productivity. And I have estimated a lot of those functions myself, and I was trained in econometric model building and built large-scale models for more than a decade. My career, my doctoral dissertation was a large-scale econometric model. The key factor is the rate of change in productivity.
It's not whether it's going up or down but it's the speed at which it's going up or down. And if we have some time, I'll sit down with you and show you some of this work. And as we've come down from rates of gain that were well above 2.1% in the '50s and '60s to where we are today running .9%, that tends over time to limit the real wage gains. It's not the only factor. There's a lot of moving parts. Lot of moving parts.
But in more recent years, there is the impact of the aggregate supply and aggregate demand model. Now, aggregate supply curves like all supply curves are upward sloping. Firms are going to provide more goods and services the higher the price, the aggregate demand curve is downward sloping. Aggregate demand equals GDP but GDP also equals money times velocity.
And so algebraically in the final analysis, that aggregate demand curve is whether it shifts outward and produces higher inflation including higher wages or whether it shifts inward, ultimately is going to be determined by what happens to the rate of growth in the money supply and velocity. It's just the same thing.
And in fact, if you were to look at one of the leading texts in macroeconomics by former chairman, Ben Bernanke and Professor Abel at Wharton, when they draw the downward sloping demand curve, they algebraically show that in the final analysis, it's equal to money times velocity.
Porter Stansberry: Well, I have to admit, Dr. Hunt, [laughs] you're way above my head.
Lacy Hunt: But it's a point that everyone needs to understand, and so what's happening is that money supply is not above trend. It's not well below trend because of the tightening process but the velocity of money is declining – which means that over time, the aggregate demand curve is shifting inward and all prices will rise at a slower rate including wages. In other words, the weakness in wages is another symptom of the extreme over-indebtedness.
Porter Stansberry: I have a simpler way of understanding it. I'm sure that if you drew a bunch of algebra around what I'm saying and curves, we'd end up at the same idea. But it seems to me that when – in our economy, when things happen like companies taking on huge amounts of additional leverage to buy their own shares, that the benefits of those decisions in the real world accrue to asset owners. And that asset inflation is enabled by the paper standard because credit can grow way in excess of savings because of that.
But those same benefits, even if they're temporary, do not accrue to the average wage earner. And I'm sure, like I said, if you were to map all that out economically or econometrically, we'd end up at the same place. But the real point to me –
Lacy Hunt: I think we're on the same wavelength. I absolutely do.
Porter Stansberry: Thank you. But the real crux of this issue is the second point of my question – which I wanted to give you time to respond to – and that is that I know there is a growing sense in our country that the social construct in America is not fair, that people see some folks, the digerati, if you will, and the financial leaders of our country and the CEOs just enjoying unprecedented prosperity and wealth. Hell, they've got cars that can drive themselves and solar panels on their roof.
But the average worker, the 60% of America, if you will –because I don't believe in the 1%, 99%. That's nonsense. But the 60% of America has seen its standard of living decline for 40 years. And the question I have for you is these policies, whether you think fundamentally, they're triggered by central bank policy– or whether they're triggered by just over-indebtedness regardless of who's responsible. Those have real political and social consequences, and the question I have for you is in your studies about over leveraged economies, what role, if any, does a debt jubilee play?
And that idea, I'm sure you're familiar with it is that maybe you can reset the economy just by allowing certain borrowers for their debts to be completely forgiven. And do you think that is something that could ever happen in America?
Lacy Hunt: I do not. Unequivocally, I do not because you would collapse the baking system because the baking system, the insurance financial institutions all own, have issues the debt and it would not be – it would be a chaotic situation. Now if you go back and look at, say, you look at the Mesopotamian and Roman empires and some other smaller dictators. These economies basically were very great, very flourishing world empires at the time, but they collapsed under debt. Now, as they were building the debt up, there were instances in those cases where there were debt jubilees and some cases, we didn't have banks in those days but we had moneylenders.
We had moneylenders and what the emperors did, or the dictators or the kings or what have you did in some cases is they were building up the debt. They would kill the moneylenders or the equivalent or force them to do these changes. But as time went by, no one would lend to them in the future. And let me just give you a more recent example.
We've had earlier periods of extreme over-indebtedness in the United States. We had a massive buildup in debt in 1820s and 1830s. The panic year was 1838. Martin Van Buren was president. He had no idea what hit him. We had another massive buildup of debt in the 1860s and 1870s. It started with building the transcontinental railroads and then the industries that fed them. Was over speculation, over consumption much as we see today, just exactly the situation you described. There was extreme inequality.
The panic year was 1873. Grant is president. He has no more of an idea of what hit him than Van Buren did in 1838. And a lot of the debt was actually underwritten by state and local governments to participate in the railroad boom and so forth. And just has had the canal building and the building of the original steamship lines and railroad in the 1820s and 1830s. And a lot of state and local governments failed. Federal government did not fail but state and local governments failed.
And as a consequence, several things happened. Number one, the state and local governments had to rewrite their constitutions and agree to operate with a balanced budget. But even with that, credit was denied to them for many years. Creditors' memories are very, very long and eventually, we forgot that experience. But in my view, given the complexities and the wealth laws and the undermining of the financial intermediaries and even the corporate sector which were all job providers, that that's simply not a viable solution.
Porter Stansberry: Well, I don't know if it is viable or not and I certainly hope that it doesn't occur. But I think you're going to see more and more political demands for it.
Lacy Hunt: I think you will because the social fabric is fraying. No question that it's fraying.
Porter Stansberry: And you have –
Lacy Hunt: And we're seeing a major divergence between the standard of living in the top quintile and the upper portion of the second quintile compared to all the rest. And that's not only evident in what they're earning but also in what they're saving. The saving rate currently is just slightly above 3% since 1900. It's averaged around 8.5%, which is bad enough in its own right, but the evidence indicates that all of the saving, all of the 3.3, 3.4% of saving is in the top quintile. No net saving in the lower four.
Porter Stansberry: So then all of this, Dr. Hunt, leads me to my ultimate question and I know this is something you must think about quite a bit. We have this economy that is unsustainable and that has a nugget of multiplier. Therefore, as the trendline extends, it's heading to crisis. And at what point do you therefore abandon your long -held investment and the sovereign long bonds?
Lacy Hunt: Well, it's conceivable. This process of debt decline is very, very long and the … remember that the element that would destabilize it would be a protracted weakness in the dollar. But the dollar is a funny animal and the way the dollar is viewed. And although our situation with regard to debt is much worse than it's been historically, we are not even close to being the most over-indebted country in the world. Our public and private debt in the non-financial sector is about 250%. But China has surged above us. It's at 300%.
Porter Stansberry: Yeah. The debt growth in China in the last decade has just been maybe unprecedented in history. Have you ever seen anything like it?
Lacy Hunt: No, and by the way, if I'm correct, the law of diminishing returns applies to the buildup of debt and the increasingly weaker and weaker returns to GDP. Then it does not matter that the Chinese owe the debt largely to themselves or that they have the command and control economy. The results are going to be weaker. And then debt in Europe is higher than it is in China and the debt in Japan is the highest of all.
And this terrible choice, when investors look around the world, these fundamentally longer-term trends, there is not a compelling case to be made for selling the dollar. Now, it would become compelling if the U.S. economy became more highly leveraged than the others and the dollar could then go into a tailspin. And that could lead to what has been referred to as the bang point and that would be inflationary.
I would just give you one little quote from a pretty smart fellow. His name was David Hume. My professor said that the enlightenment could not have happened without David Hume. Hume was mentor to Adam Smith. Smith, who was a smart fellow, said that Hume had the greatest intellect of anyone that he met. And Hume knew Benjamin Franklin. He knew Voltaire. He knew all the other figures of the enlightenment.
It was Hume that Albert Einstein gave credit for the inspiration to the theory of relativity. Hume was not just a political scientist economist, but Hume knew everything there was to know in the world. His father had insisted that he be this type of person. And in 1752, Hume wrote two papers, which you can easily obtain. One called Of Money. The other called Of Public Finance and Of Money, he gave us the equation of exchange. He didn't write the equation of exchange down, which says that GDP equals money times velocity, but he clearly understood the concept.
Fisher wrote the equation down in 1909. But he also wrote a companion piece to Of Public Finance, and he looked at all of these great examples of extreme over-indebtedness, particularly at Mesopotamia and Rome, as well, as a number of lesser-known cases that none of us remember exactly. And toward the end of Public Finance, Hume left us with a summary conclusion and this is what he said. It's a very precise statement:
"When a state has mortgaged all of its future revenues," that's, to me, a pretty clear statement, indication of a sharp mind, "When a state has leverage all of its future revenues, the state, by necessity lapses into tranquility, languor, and impotence," which is consistent with, of course, the evidence that we're receiving today using much more modern techniques. It's one of decline. And at the very end of the process, you can have a bang point in rising inflation but in the current international settlement, in the current international situation, the dollar is a least – the U.S. economy has a least worrisome debt situation than China, Europe, and Japan.
Porter Stansberry: So we're relatively less broke than everybody else.
Lacy Hunt: That's correct. There are smaller countries that are better off but they're not in the position to absorb the flows.
Porter Stansberry: I'm going to go ahead and say that Dr. Hunt is by far the most intelligent guest we've had on the podcast to date and you've –
Lacy Hunt: You're too kind [laughs]. You're too kind.
Porter Stansberry: You've given us much to think about. Maybe in the future, someone will say … what's the current version of the enlightenment? The technological revolution would not have been possible without the thinking of Dr. Lacy Hunt. Sincerely, thanks very much for your time today.
Lacy Hunt: I don't know when I've been asked better questions and more thoughtful questions.
Porter Stansberry: I'm flattered and I'm looking very much forward to having you at our conference and being able to introduce you to our audience and person. So thanks again for joining us.
Lacy Hunt: I'm looking forward to it as well.
Porter Stansberry: All right. Thanks again, Dr. Lacy.
Buck Sexton: Thanks everybody for writing to us this week in the mailbag, filling up our inbox with useful feedback. People like Mike L, John W, Steven W, Blain B, CJ, and Dennis H, keep the comments and questions coming, please. We love to hear from you. [email protected] and we've even got some other ideas to get some other ways of hearing from all of you. We should set up a Stansberry Facebook account, by the way, Porter. We should get that going.
So Larry from Maryland is coming into the mix here. He writes, "Porter, you have been a student of Buffett for some time and produced some insightful analysis. What is your prediction for Berkshire when Buffett and Monger leave? Will they break it up? Pay out a large dividend? Thoughts would be appreciated."
Porter Stansberry: When they leave, they're going out in a box, I'm pretty sure. Monger's 94. Buffett's 87. I don't know what their life expectancy is but they've probably each got a 10 percent chance of dying at any year. That's the normal mortality for those kinds of ages. By the way, I don't wish them death. I think they're both very nice people. I just think that they have made some very important mistakes on how they've allocated capital.
And I think the solution's very simple. I don't know what will happen because I don't have any insight to the board members at Berkshire and I know that Buffett would prefer the company not be broken up. But I think you can make a very compelling case. It would be much better for shareholders if Berkshire were split into two businesses. One is an industrial conglomerate essentially at an unleveraged General Electric.
So they own railroads. They own car manufacturing. They own … what do they own? They make all kinds of stuff. I don't want to get into the details. They own industrial businesses and that probably is worth something like $150 billion, something like that. Well, they've got the big energy company too. So that's a very highly capital intensive, very secure business that you could load responsibly, not like GE did. You could load responsibly with long-duration fixed-rate debt. So you could leverage that business 75% to equity so then you would have very good business.
Because yes, it has maybe a 5% return on investment capital and it has maybe a 10% or 12% return on equity because of the leverage so it's a nice, very stable business that's growing alongside GDP and pays a big dividend. So it's the kind of business you'd want to own if you were retired and you needed safe income. Fine. On the other hand, their Ferrari is their insurance companies and their best-in-class consumer brands businesses. And those businesses are typically owned as equities, not directly, although See's Candies is under – there's exceptions.
But basically, you're talking about your American Express, your Coke, your Apple Stock, all that stuff, and your insurance companies. And that company, you can't leverage at all because it has to have all that insurance float ready in case of a catastrophic insurance claim. And so that business would be very difference. That business will be very volatile and it would revolve around insurance underwriting and investment returns. But that business is the one to own.
That business is the one that can really double your capital every five years if they're managing it well. And they did for years and years and years. I know someone can do that again for them. But that company can't deliver growth to investors as long as it's shoehorned alongside that big, giant anchor of those industrial businesses.
Buck Sexton: Next up, we've got James, which fun fact, is actually my first name as well. "Hello Porter and Buck, I can't remember which guest it was that mentioned Boeing but it was Porter himself that brought up Facebook in a recent episode, in particular, that its correction provides a good opportunity to buy more shares of a capital-efficient company."
"Here's the rub. I get the impression that Porter is somewhat libertarian. Many libertarians condemn war and the military-industrial complex. As they do, Big Brother style's surveillance. Boeing and Facebook are prime examples of what libertarians seem to be against. So how does Porter approach this subject? Is investing a politically and morally neutral sphere of your life? I'm not passing judgment. I just want to hear your thoughts. Keep up the great work. James."
Porter Stansberry: That's a great question, James. I will tell you that I don't perceive Facebook as doing anything immoral whatsoever. Facebook certainly doesn't make any weapons and it doesn't force anyone to agree to its terms of service. So if you choose to allow yourself to be monitored, then that's not surveillance. That's just participating in a marketing company. And I actually appreciate Facebook tracking me and watching what I'm clicking on and understanding what my friends like and knowing what demographic I'm in because they can serve me ads that I'm going to find more attractive and more useful.
And I don't object to any of that advertising on Facebook. I never have. It seems totally innocuous to me. People believe that Facebook is going to manipulate my political views. That's just nonsense, I don't buy into that at all. I've had the same political views since I was 24 years old and I can't imagine them ever changing. Maybe they will but it won't be Facebook that does it. It'll be a book that I read or a person that I meet or a place that I go.
In regards to Boeing, I think you make a much better point and I don't have any defensive investing in Boeing. I personally probably would never own Boeing because I would have a lot of moral qualms about owning a business that designs weapons that are used for aggression. And I can imagine the folks who are military folks in America going crazy [laughs]. If, and this is a big if, if we lived in a different kind of country where we armed our citizens and we defended ourselves and we didn't attack other countries and we weren't militarily aggressive, I think you'd be much more comfortable to own Boeing.
And then so then there's a third thing, which is that nobody pays me for my morality or my ethics. They pay me for my financial research. So as a professional, I leave all that stuff aside and I tell people what stocks I think are going to go up the most. It's that simple and then I leave the ethics and the morality up to the reader. Just kind of like I would about gin. I like alcohol. I drink gin. Not everyday, but when I drink, I'll have a gin.
But I don't smoke marijuana. I can't defend it. It's just what broke down to me. It's what made sense to me. I liked this drug and I didn't like that drug and I'm not pretending that they're any different or that one's better than the other. It's just my choice. But if I was writing a spirits guide, I wouldn't worry about the ethics of whether you smoke pot or you drink gin. I'm just providing a guide and that's what I do in publishing. I provide a guide to finance. How you use that, whether you do so ethically or morally and how you set up those rules for yourself, that's just none of my concern.
Buck Sexton: All right. Last one for this week. Brian writes in, "Buck, Porter, and Bill Shaw, Bill was featured on your podcast sharing what he witnesses in subprime auto-loan markets in Baltimore. What caught my attention was that most, if not all vehicles being pounded due to loan defaults were junk cars with over 100,000 mileage. Maybe the used cars with relatively much lower mileage are being bought by legitimately qualified consumers and that the banks or the lenders already factor this into their strategy. Your input will be appreciated, especially at this time when the stocks like car, C-A-R, HTZ, F are climbing up fast.
Porter Stansberry: You lost me on the stock symbols. You mean Ford? F? And CAR is Hertz or Avis? Avis.
Male: Hertz is HTZ.
Porter Stansberry: And Hertz is HTZ. Yeah. Okay. So it's a very, very interesting observation and I would tell you that the reason why most of the cars that are repossessed have over 100,000 miles or are old or both is because that entire business is just a giant fraud. It's not a real business. Those are not real buyers and those are not real cars and this is a whole game of what people called predatorial lending.
Now, I don't believe in predatory lending. So I know I'm now talking out of both sides of my mouth. What I'm saying is that this business has no functional economic redeeming value. It's not helping the lender. It's not really helping the borrower. It's kind of like the payday loan business. Right? It only exists because people are desperate. They're not making any kind of sensible financial decision.
They need a car this month, period. They don't expect to keep it. Same thing with the rent-to-own furniture places. It's a kind of business that we don't really understand because we've never been that financially desperate. Do I think people should have the freedom to engage in these transactions? Yes, I certainly do. You should be responsible for yourself and if you want to borrow money at 600% interest rates, knock yourself out. If you are dumb enough to lend to people on those terms, you're going to spend the rest of your life chasing them. And that's what these people do.
It is a business and it's part of a free society but I think it's abhorrent for both people. I think it's a waste of time so I don't invest in these kind of companies because they never last. As I like to say, guys, "shit doesn't scale." Can you make a lot of money with a payday lending operation or a subprime auto operation? Yeah, if you're a local business and you really keep your costs down, yeah, you can. You can make a lot of money doing it.
Can you scale that to a national chain? Can you become the Starbucks of payday lending? No. It doesn't scale. You end up just having all kinds of problems because you're dealing with the worst kinds of people, both your employees and your customers. So my advice to you is the same advice that Ayn Rand gave on the Donahue show many years ago. Phil Donahue, famous talk show guy, Buck, way before your time, asked Ayn Rand – she was explaining her philosophy of freedom and objectivism and Phil said, "Well, what about the poor?"
And Ayn said, "Don't be one of them. The poor have always been with us. They will always be with us but you don't have to be one of them." And that's the advice I have to tell you about subprime borrowing and subprime lending.
Buck Sexton: Well, that's going to be it for the mailbag this week, everybody. Keep your feedback coming. Write to us. [email protected] We use your question, we will send you some goodies courtesy of Stansberry research. Love us or hate us. Just don't ignore us. Thank you for listening. Mr. Porter, thank you, sir.
Porter Stansberry: Mr. Buck, it was always a pleasure and guys, thanks for listening to Lacy Hunt. We probably won't have many economists on [laughs] but I hope that you'll think deeply about what he's saying in general about the way that debt is forcing our economy into a death spiral and take heed of that advice and think about it and use it in your investing. That is all.
Buck Sexton: And with that cheery note, we will see you all next time.
Male: Thank you for listening to the Stansberry Investor Hour. To access today's notes and receive notice of upcoming episodes, go to investorhour.com and enter your email. Have a question for Porter and Buck? Send them an email at [email protected] If we use your question on air, we'll send you one of our studio mugs. This broadcast is provided for entertainment purposes only and should not be considered personalized investment advice. Trading stocks and all other financial instruments involves risk. You should not make any investment decision based solely on what you hear. Stansberry Investor Hour is produced by Stansberry Research and is copyrighted by the Stansberry Radio Network.
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