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Large Budget Deficits, High Levels ofGovernment Debt - A Force for

Lower Interest Ratesby Lacy H. Hunt, Ph.D., Chief EconomistHoisington Investment Management Co.

Presented to:Grant's Conference

New York, NYOctober 4, 2016

page 1

Source: Federal Reserve Board, Bureau of Economic Analysis. Office Management and Budget. Through Q2 2016.

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 '00 '03 '06 '09 '12 '1520%

30%

40%

50%

60%

70%

80%

90%

100%

110%

20%

30%

40%

50%

60%

70%

80%

90%

100%

110%

Gross Federal Debt as a % of GDP (Excluding Off Balance Sheet Liabilities)

quarterly

Avg. = 55.2%

Q2 2016:Debt = 19.3 tril.GDP = 18.4 tril.Debt/GDP ratio 104.9%

Net present value of unfunded liabilities = $60 trillion in excess of Social Security and other trust funds.

1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 201220%

30%

40%

50%

60%

70%

80%

20%

30%

40%

50%

60%

70%

80%

Federal Outlays as a % of Total OutlaysDiscretionary and Mandatory

fiscal year

Mandatory

Discretionary

page 2

1. The government expenditure multiplier is already negative.

2. The composition of the spending suggests the multiplier is likely to trend even more negative.

3. The federal debt-to-GDP ratio moved above the deleterious 90% level in 2010 and has stayed above it for more than five years, a time span in which research shows the constriction of economic growth to be particularly severe. It will continue to move substantially further above the 90% threshold as debt suppresses the growth rate.

4. Debt is likely to restrain economic growth in an increasingly nonlinear fashion.

5. The first four problems produce a negative spiral from federal finance to the economy through the allocation of saving, productive investment, productivity growth and eventually to demographics.

6. The policy makers force themselves into a downward spiral when they rely on more debt in order to address poor economic performance. More of the same does not produce better results, only more of the same but worse, a situation we term a policy trap.

Six Considerations Indicate Federal Finance Will Produce Slower Growth

page 3

1. Alesina, Alberto, Carlo Favero and Francesco Giavazzi. “The Output Effect of Fiscal Consolidation Plans”, NBER working paper 18336 (2015). Forthcoming in the peer reviewed Journal of International Economics.

2. Barro, Robert J. “The Ricardian Approach to Budget Deficits, The Journal of Economic Perspectives”, Vol. 3 (Spring, 1989). “Macroeconomics A Modern Approach, Thomson/Southwestern” (2008).

3. Blanchard, Olivier, and Roberto Perotti. “An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output”. Quarterly Journal of Economics (2002).

4. Dupor, William, and Rodrigo Guerrero. “Does Government Spending Create Jobs, Even During Recessions”. The Regional Economist (2016).

5. Ilzetzki, Ethan, Enrique G. Mendoza and Carlos A. Vegh Gramont. “How Big (Small?) are Fiscal Multipliers?“, IMF working paper (March 2011).

6. Owyang, Michael T., Valerie A. Ramey and Sarah Zubairy. “Are Government Spending Multipliers Greater during Periods of Slack? Evidence from Twentieth-Century Historical Data”. American Economic Review, Volume 103, No. 3 (May 2013). “Government Spending Multipliers in Good Times and in Bad: Evidence from U.S. Historical Data”. (June 9, 2016).

7. Perotti, Roberto. “Estimating the Effects of Fiscal Policy in OECD Countries”, IGIER working paper 276 (December 2004).

Bibliography of Government Expenditure Multiplier Studies

page 4

59 63 67 71 75 79 83 87 91 95 99 '03 '07 '11 '1560

80

100

120

140

160

180

200Thousands

60

80

100

120

140

160

180

200Thousands

Japan Births annual

Source: Ministry of Health, Labour & Welfare, Haver Analytics. Through December 2015.

1989 = 103,9002015 = 83,804-19.3% decline

U.S. Birth Rate Births/1000 Population, annual

1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 200912

14

16

18

20

22

24

26

28

30

32

12

14

16

18

20

22

24

26

28

30

32

Sources: National Center for Health Statistics, Haver Analytics. Through 2014.

1990 = 16.72014 = 12.5

1981 1986 1991 1996 2001 2006 2011 2016

0%

2%

4%

6%

-2%

-4%

-6%

0%

2%

4%

6%

-2%

-4%

-6%

Japan: Productivity: Output per Employed Personannual % change

Sources: Cabinet Office, Ministry of Health, Labour & Welfare, Haver Analytics. Through 2015.

1981-1991 = 3.2%2005-2015 = .50%

1989 = 3.3%2015 = .20%

1980 1985 1990 1995 2000 2005 2010 20155%

10%

15%

20%

25%

30%

35%

5%

10%

15%

20%

25%

30%

35%

Japan: Household Gross Saving Rateannual

Sources: Cabinet Office, Haver Analytics. Through 2014.

1989 = 26.6%2014 = 5.6%

page 5

19982000

20022004

20062008

20102012

20142016

40%

50%

60%

70%

80%

90%

100%

110%

120%

2.0%

3.0%

4.0%

5.0%

6.0%

Sources: Federal Reserve, O.E.C.D, Haver Analytics. Through Q1 2016.

United States: Debt as % of GDP and 30 year Government Bond Yield

annual

Debt to GDP:left scale

yield:right scale

19982000

20022004

20062008

20102012

20142016

100%110%120%130%140%150%160%170%180%190%200%210%220%230%240%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Sources: Ministry of Finance Japan, O.E.C.D, Haver Analytics. Through Q1 2016

Japan: Debt as % of GDP and 30 year Government Bond Yield

annual

Debt to GDP:left scale

yield:right scale

19982000

20022004

20062008

20102012

20142016

50%

60%

70%

80%

90%

100%

110%

120%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Sources: Bank of England, O.E.C.D, Haver Analytics. Through Q1 2016.

United Kingdom: Debt as % of GDP and 10 year Government Bond Yield

annual

Debt to GDP:left scale yield:

right scale

19982000

20022004

20062008

20102012

20142016

70%

75%

80%

85%

90%

95%

100%

105%

110%

115%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Sources: European Central Bank, O.E.C.D, Haver Analytics. Through Q1 2016.

Euro Area: Debt as % of GDP and 10 year Government Bond Yield

annual

Debt to GDP:left scale

yield:right scale

page 6

Correlation Coefficients

(A) (B)

1. U.S. -0.95

2. Euro Area -0.85

3. Japan -0.80

4. United Kingdom -0.94

Correlation Coefficients Between Gross Government Debt to GDP and Long Term

Government Bond Yields in Four Major Economic Areas 1998-2016

annual

Source: HIMCO.

page 7

Source: Federal Reserve Board, Bureau of Economic Analysis. Through Q1 2016.

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 '00 '03 '06 '09 '12 '15100%

125%

150%

175%

200%

225%

250%

275%

100%

125%

150%

175%

200%

225%

250%

275%

Total Nonfinancial Debt as a % of GDP(Excluding Off Balance Sheet Liabilities)

year ending levels

Avg. 167.5%

Q4 2009 = 245.5%

Q1 2016 = 249.9%Change in Debt per $ of GDP:

1952-1999 $1.72000-2015 $3.3Q1 2015-Q1 2016 $4.4Q2 2015-Q2 2016(est.) $5.5

Q1 2015 - Q1 2016Debt: +$2.19 tril.GDP: +$.5 tril.Q2 2015 - Q2 2016(est.)

Debt: +$2.4 tril.GDP: +$.44 tril.

page 8

Source: Federal Reserve Board, Bureau of Economic Analysis. Through Q1 2016.

52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 '00 '03 '06 '09 '12 '1520%

30%

40%

50%

60%

70%

80%

20%

30%

40%

50%

60%

70%

80%

Business Debt as a % of GDP (Excluding Off Balance Sheet Liabilities)

quarterly

Avg. = 51.7

Q4 2007= 68.7%

Q1 2016= 71.3%

Q4 2014 = 67.7%

Q4 2008 = 73.42%

Q1 2015 - Q1 2016Debt: +$833 bil.Investment: -$64 bil.

page 9

Bibliography of Debt Studies Post 2009

1. Arcand, Jean-Louis, Enrico Berkes and Ugo Panizza. "Too Much Finance?" IMF Working Paper, Number 12/161 (June 2012).

2. Buttiglione, Luigi, Philip Lane, Lucrezia Reichlin and Vincent Reinhart. "Deleveraging? What Deleveraging.” Geneva Reports on the World Economy 16, International Center for Monetary and Banking Studies (September 2014).

3. Cecchetti, Stephen G., M S Mohanty and Fabrizio Zampolli. “The real effects of debt.” BIS Working Paper, number 352 (September 2011).

4. Checherita, Cristina and Philipp Rother. “The Impact of High and Growing Government Debt on Economic Growth, An Empirical Investigation for The Euro Area.” European Central Bank Working Paper, Number 1237 (August 2010). 5. Dobbs, Richard, et al. “Debt and (Not Much) Deleveraging.” McKinsey Global Institute (February 2015).

6. Jorda, Oscar, Moritz Schularick and Alan M. Taylor. "When Credit Bites Back: Leverage, Business Cycles, and Crises." NBER Working Paper, Number 17621 (November 2011).

7. Kumar, Manmohan S. and Jaejoon Woo. "Public Debt and Growth." IMF Working Paper, Number 10/174 (July 2010).

8. Mian, Atif and Amir Sufi. "Consumers and the Economy, Part II: Household Debt and the Weak U.S. Recovery.” Federal Reserve Bank of San Francisco Economic Letter (January 2011).

page 10

Bibliography of Debt Studies Post 2009 (cont.)

9. Mian, Atif and Amir Sufi. House of Debt. University of Chicago Press, 2014.

10. Mian, Atif and Amir Sufi. "Household Leverage and the Recession of 2007-2009.” IMF Economic Review Volume 58 (August 2010): Pages 74-117. 11. Pattillo, Catherine, Helene Poirson and Luca Antonio Ricci. "External Debt and Growth." Review of Economics and Institutions Volume 2, Number 3, Article 2 (Fall 2011).

12. Reinhart, Carmen M., Vincent R. Reinhart and Kenneth S. Rogoff. "Public Debt Overhangs: Advanced-Economy Episodes since 1800." Journal of Economic Perspectives Volume 26, Number 3 (Summer 2012): Pages 69-86.

13. Roxburgh, Charles, et al. "Debt and Deleveraging: The global credit bubble and its economic consequences.” McKinsey Global Institute (January 2010). 14. Roxburgh, Charles, et al. “Debt and Deleveraging: Uneven progress on the path to growth.” McKinsey Global Institute (January 2012). 15. Taylor, Alan M. “The Great Leveraging.” NBER Working Paper, Number 18290 (August 2012).

page 11

1. Growth is abnormally weak. Transitory spurts in economic growth, inflation and high-grade bond yields cannot be sustained because debt constrains economic activity.

2. Due to debt repayment obligations, economies are subject to structural downturns without the cyclical excesses of rising interest rates and inflation.

3. Deterioration in productivity is not inflationary but just another symptom of the debt overhang.

4. Traditional monetary and fiscal policy actions are asymmetric. They can restrain but not stimulate growth. Fiscal policy options exist provided they do not increase aggregate indebtedness.

5. Inflation falls dramatically, increasing the risk of deflation.

6. Treasury bond yields fall to extremely low levels and remain depressed for an extended period since the Fisher equation (1867-1947) states that the long risk-free yield is equal to the real yield plus expected inflation.

7. When multiple major economies are simultaneously over-indebted, the world lacks an engine of growth.

8. Indebtedness problems cannot be solved with more debt and if that is the course, the first seven symptoms will not only persist, they will worsen. Historically, debt overhangs in major economies have only been cured by a significant multi-year rise in saving of which different ways can achieve this result.

9. During periods of prolonged over-indebtedness, demographics may deteriorate reinforcing the negative influences of the first eight characteristics.

Characteristics of Extremely Over-Indebted Economies

page 12

Nominal GDP, Yyear over year % change, quarterly

48 55 62 69 76 83 90 97 '04 '11

0%

5%

10%

15%

20%

25%

-5%

-10%

0%

5%

10%

15%

20%

25%

-5%

-10%

Source: Bureau of Economic Analysis. Through Q2 2016.

Q4 to Q4 % change 2013 2014 2015

Q2 2016 y-o-y % change

(A) (B) (C) (D) (F)

1. Nominal GDP 4.3% 4.1% 3.0% 2.4%

2. Real GDP 2.7% 2.5% 1.9% 1.2%

Y = P(price level)*Q(Real GDP)Y = M*V

page 13

Real Per Capita GDP Growth, Selected Periods average annual growth

1790-1999 2000-20160.0%

0.5%

1.0%

1.5%

2.0%

2.5%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

Sources: Bureau of Economic Analysis, Congressional Budget Office, Office of Management and Budget, N.S. Balke & R.J. Gordon, C.D. Romer, Measuring Worth. Through Q2 2016.

1.9%

1.0%

page 14

Real Per Capita GDP Growth, Current Expansion vs. Prior Expansions

average annual growth

1790-2008 2009-20160.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

Sources: Bureau of Economic Analysis, Congressional Budget Office, Office of Management and Budget, N.S. Balke & R.J. Gordon, C.D. Romer, Measuring Worth. Through Q2 2016.

2.7%

1.3%

Q2 16 y-o-y = .46%

page 15

Sources: Census Bureau. Bureau of Labor Statistics. Through Q2 2016. Real Median HH Income through 2014.53 56 59 62 65 68 71 74 77 80 83 86 89 92 95 98 '01 '04 '07 '10 '13 '16

0%

1%

2%

3%

4%

5%

-1%

0%

1%

2%

3%

4%

5%

-1%

Nonfarm Business Sector: Productivity6 year % change a.r., quarterly

Avg.

page 16

M2 Money Stockannual % change

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

0%

5%

10%

15%

20%

25%

30%

-5%

-10%

-15%

-20%

0%

5%

10%

15%

20%

25%

30%

-5%

-10%

-15%

-20%

Sources: Federal Reserve Board. Bureau of Labor Statistics;Monetary Statistics of the United States. Through August 2016. Last plot is 12 months ending August

2016 vs. same period a year ago.

Avg. = 6.6%

page 17

Velocity of Money 1900-2016Equation of Exchange: GDP(Y) = M*V

annual

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 20101.00

1.25

1.50

1.75

2.00

2.25

1.00

1.25

1.50

1.75

2.00

2.25

Sources: Federal Reserve Board; Bureau of Economic Analysis;Bureau of the Census; The Amercian Business Cycle, Gordon, Balke and Romer. Through Q2 2016.

Q2 2016; V = GDP/M, GDP = 18.4 tril, M2 = 12.7 tril, V = 1.46

avg. 1900to present = 1.74

1918 = 2.0

1946 = 1.2

1997 = 2.2

1.45

GDP = MB*m*V

V = Y/M

Lowest since 1950

avg. 1953 to 1983 = 1.75

page 18

Composite M2 Growth for China, U.S., Japan and Europe

annual % change

1999 2004 2009 20144%

6%

8%

10%

12%

4%

6%

8%

10%

12%

Sources: Bureau of Economic Analysis, European Central Bank, Bank of Japan, China National Bureau of Statistics, Haver Analytics. Through Q4 2015.

Avg. = 7.6%

page 19

M2 Velocity annual

1998 2001 2004 2007 2010 2013 20160.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

Sources: Bureau of Economic Analysis, Federal Reserve, European Central Bank, Bank of Japan, China National Bureau of Statistics, People's Bank of China, Haver Analytics. Through Q4 2015.

China

Japan

Euro

U.S.

page 20

Long-Term Government Bond Yields Starting with Historic Panic Years: Japan 1989, U.S. 1873 and 1929

annual average

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 261%

2%

3%

4%

5%

6%

7%

1%

2%

3%

4%

5%

6%

7%

Sources: Federal Reserve Board, Homer & Sylla. Bank of Japan. (U.S. 2016 through July)

U.S. 1929U.S. 1873

Japan 1989

U.S. panic year 1873 = year 1U.S. panic year 1929 = year 1Japan panic year 1989 = year 1

U.S. 2008