May 4, 2010
Imagine the economy as a pie, with a 79% slice representing private sector spending and the other 21% being the government’s share. If you increase the government’s slice of the pie, according to Ricardo, the size of the pie doesn’t increase in the long run. The private sector segment, which is more productive than the government, simply gets smaller.
Economics professors have taught Keynes and ignored Ricardo, Hunt said, “but statistics have confirmed that Ricardo was right and Keynes was wrong.”
Studies have shown that the multiplier for government spending – such as the recent $787 billion fiscal stimulus – is less than one. Hosington’s most recent quarterly report cites research showing that in the post-Korean War period the spending multiplier was zero. During World War II and the Korean War, the spending multiplier was 0.6, meaning that a $1 rise in government spending would lift the economy as a whole by 60 cents while reducing private spending by 40 cents.
Major tax increases are coming, Hunt said, including the expiration of the Bush tax cuts and new taxes imposed by the recently passed health care legislation. He estimated that those hikes will total $2 trillion over the next decade. A study by Robert Barro of Harvard showed the tax multiplier is -1.1 and another study by Christina Romer said it is -3.0. Romer is now a presidential advisor. Using the Barro and Romer multipliers, we should expect a contractionary force of between $2.2 and $6 trillion on economic growth over the next ten years.
“The policy mix of substantial increases in spending and increases in taxes means you are going to contract aggregate demand,” Hunt said. “It does not create growth; it sends you in the opposite direction.”
Japan’s history, unsurprisingly, validates Hunt’s thesis. Its debt-to-GDP ratio has grown from 50% in 1989 to almost 200% today. The general perception was that its fiscal policies should have been stimulative, yet Japan remains in serious trouble, he said. Nominal GDP is where it was 16 years ago and employment has not risen in nine years.
Asset class forecasts and the value of the dollar
Hunt’s firm manages $4.5 billion in bonds, and he expects yields to go lower over the next several years, consistent with his forecast for deceleration in M2 growth, low economic growth and low inflation. He is bullish on long-term bonds, and in the first quarter his fund had a longer duration that exceeded the Barclay AGG index’s.
In an email exchange, I asked Hunt whether he could envision a scenario in which real interest rates (i.e., TIPS rates) rise, potentially above nominal rates, which would imply that inflation expectations remained low or negative. Such a scenario could arise, for example, from an oversupply of Treasury securities relative to demand or from an increased perceived sovereign debt risk.
Hunt said he doubts that would happen, citing the fact that the real rate has historically been strongly mean-reverting to 2% over the long term, even though it is volatile over the short term. Over the past 30 years, the real rate has been well above the mean, he said. “This would not have surprised Fisher because inflation expectations adjust very slowly to actual inflation,” he said. “Thus the nominal rates have not yet adjusted to the drop in inflation of the past three decades.”
Over the long term, the value of a country’s currency depends on its current account deficit. At its worst, our deficit was 7.5% of GDP, and it is now 2.5% of GDP, better than it has been since 1997. Hunt forecasts a strong dollar, since he believes the ineffectiveness of both monetary and fiscal policy will cause imports to decline and move the current account deficit to zero. He cautioned that the value of the dollar over the short-term depends on factors that are “too complex to understand.”
“Markets covey no meaningful information over the short run and economic conditions prevail over the long run,” he said.
As for equities, his view is dim, given the low dividend yield, high P/E ratios, and his deflationary forecast. “In the current environment, you are not being paid for taking risk,” he said.
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