Transcription
The economy is facing a long, difficult slog. I think that the tax changes will not work quickly nor effectively in the current environment. And another problem here, too, is that too much of the focus is on the short run. Very little of the focus is on the long run. And we've had some pretty great economists that have looked at overindebtedness. You can go back to David Hume, one of the greatest minds of man, Adam Smith in the 18th century, David Ricardo in the early 1800s, and then later on, you get Nikolai Kondratiev, and then in the 20th century, you get Irving Fisher and you get Hyman Minsky, Charles Kindleberger, and now, in the last 25 years, you have research from really outstanding scholars using econometrics and other scientific measuring effects, such as the great Swedish economists Henriksson and Berg, and then extensive work of the Reinharts and Rogoff, and a whole host of others.
And what they show is that overindebtedness depresses economic growth. And part of this is that if you overuse a factor of production, you trigger diminishing returns. Another element is that the interest expense builds up. And one of the things that's happening to us now is that the interest expense is on the path to move above what we're spending for defense. And the great economic historian Niall Ferguson, author of "The Ascent of Money," has shown that great economic powers begin to crumble internally when interest expense exceeds military. If you read Ferguson's paper, "Empires on the Verge of Chaos," he looked at four specific great empires: Mesopotamia, Rome, the Bourbons of France, and the British Empire at the end of World War II. And in each of those cases, the debt undermined the viability and sustainability of the economy. Interest expense became too great. It's a deadweight loss. It doesn't pay salaries, doesn't pay soldiers, doesn't build bridges. And that's where we're headed.
And in our particular case, 30% of the interest is being paid to service our debt, treasury debt held by foreigners. And so the debt has to be dealt with. And as far as I'm concerned, if we get a tax package and spending package next year and we don't alter the deficit curve, then the debt today is almost 125% of GDP. The high water mark of World War II, when we had 30 million folks in the armed services, was under 120%. The Reinhart and Rogoff deleterious impact point is at 90%. We're all above these levels. And one of the things which I think will work against us for a long time is the debt surged during the pandemic. But then when the economy recovered, there was no meaningful reduction. And in the past, we were at least able to cyclically get some significant reduction in the deficits and the debt. And there's really nowhere you can go in the federal budget to alter the trajectory that well. And so our ability to control the debt buildup and prevent it from going to 150% in 25 years or 30 years is diminishing. And that's where the OMB and the CBO are suggesting that we're going to go in, you know, two decades more or less. So we've got a very serious problem here, and it's not going to go away.
We're only able to take it back to 1963. It all the deposit liabilities would be M2 excluding currency and the money market mutual funds. And the reason I exclude currency is currency is a medium of exchange, there's no question about that, so it is money, but its influence is diminishing, and it's going to continue to diminish. And I don't want that secular influence in a variable that I'm trying to use to calibrate cyclical movements. So I, at this stage of the game, eliminate the currency and then the money market mutual funds. I don't include. I follow Friedman in this. The money market mutual funds cannot create deposits for them to buy a commercial paper or a treasury bill or some other short-term instrument. They have to go out and bid for the deposits. And so the deposits come from the existing pool. They may speed up the rate at which deposits turn over, but they cannot create deposits. So I prefer to look at other deposit liabilities.
And so when the real detrended 4-year growth rate is at zero, monetary policy is neither too hot nor too cold. Currently, it is quite negative. I might also share with you here that the lead time between the peak in detrended 4-year real ODL and the start of a recession is more than 3 years. And if you exclude the 2000-2001 recession, which probably wouldn't have been a recession without 9/11, it's, you know, 40 months, which is close to the four years. And so the monetary restraint that the Fed put into the system is still there, and that's one of the elements that is very hidden. It takes time to work its way through, and so monetary policy is too restrictive, either using M2 for the longer time period going back to 1914 or using ODL for the more recent time period since 1963. I think that they should ease. I don't think they should postpone the system. And I say that because we're getting a current significant downshift in federal spending. Taxes will be cut next year. It won't be cut that much, which is mainly going to be making permanent the 2017 cuts so they don't go back up, and maybe tax cuts for tips and a few other items, but it is not going to be a massive tax cut. And moreover, I think it is very unwise to assume that this tax bill will have a quickly beneficial impact.
If you go back and look at the Reagan tax cuts in 1981, they were slow to work. And in fact, they were so slow working that the economy was in bad shape when we had the congressional elections in 1982, and the Republicans suffered very heavy losses in the congressional elections of '82. But this time, I think the tax cuts will work, or the tax changes will work more slowly because in 1981, gross government debt was 30% of GDP or thereabout, and it's now 124%. It's not the same deal. So we're in an irregular. We know fiscal policy is coming down. We have economically depressive effects of the tariffs. We know from prior historical experience as well as the theoretical model, the microeconomic model which I explained to you. Yes, prices go up, but quantity demanded and total revenue go down. They're not separate acts.
I think the Federal Reserve needs to take the longer-term view, but because they are data-dependent and the inflation rate, while it's coming down, is still above their target. And so they're going to be on hold at a time when they shouldn't be on hold. But that's what they're doing. And I think that the dual mandate of the Federal Reserve has served them very poorly. There should only be one mandate, and that's the inflation rate, and inflation rate over time, not month-to-month or quarter-to-quarter or even year-to-year. You have to look at it from a long-term perspective, and the Federal Reserve is misfocused. One of the key things that they think that monetary policy works is through something called forward guidance. My view is that the forward guidance has resulted in a shift of investable funds from the real economy to the financial economy. They've given too much weight to the stock market, equity markets. So whenever the equity markets begin to waffle, they come in and support it. And they've created this impression that financial investments and equities are higher returning, more liquid, and safer assets than investment in plant and equipment. And so it has caused a reallocation from the hard assets that raise the standard of living into financial assets, which serves us very poorly.
And if you look at what the debt's been a factor here, debt's been going up, which is adversarial to growth through diminishing returns. Forward guidance has encouraged investment in financial rather than real assets. And between the two, in the last 20 years, our real per capita growth rate has dropped to 1.2% to 2% from 2.3%. It's a 40% decline. Part of the blame is fiscal policy, but the Federal Reserve has contributed to this negative impact. There's no question in my mind. And yet, they go ahead talking about all these short-run movements and relying on data series that are revised and very little of value in the long run. And that's the policy outcome that we get. But I'm afraid monetary policy is very misplaced in terms of the way it's conducting itself.
There are two key factors that determine the bond yield. The first is the Fisher equation, which says that the risk-free long rate is equal to the real rate plus the expected inflation. Right now, if you look at the year-over-year increase in the consumer price index, it's up about 2.4%. Historically, excluding a few extreme situations that don't apply in a normal cyclical sense, the spread is about 150 basis points. So that would put you at 3.9%. We're around 4 and 3/4 to 4.80. Another way that you could look at it, the CPI has problems in computing the shelter expense, which is 36%. It appears to be very flawed. We now have, you know, really well-honed estimates of what's actually happening to shelter as a result of the advancement of computers and the surveying and so forth. And there's a major inconsistency between what those surveys are saying and what the Bureau of Labor Statistics is computing. So if you exclude the shelter component, we're running about 1.4%. And historically, the bond yield would be about 200 basis points above that, which would be 3 1/2. So if I'm right that the inflation rate is going to hold at this level and go down, eventually the bond yield will move into alignment with where the inflation rate is. Right now, the process of adjustment is always slow.
The other element that matters quite a bit over the short term is the direction of the federal funds rate. The federal funds rate is going to need to decline cyclically, in my opinion, in order for the economy to recover next year. And so I think those two forces together will be enough to pull the bond yield downward. Tariffs are ultimately deflationary. That is also quite true when the money supply in real terms declines. And I think we're going to very shortly see that the money supply was just one of a numerous broad group of economic variables that were impacted by the tariffs. Tariffs affected imports. They affected inventories. They affected vehicle sales, buying of cell phones, a lot of different types of raw materials and so forth. But it also had an impact on bank loans and bank deposits. Deposits are money supply. And so the little blip that we saw here that was related to advanced buying ahead of the tariffs has, I think, given a false indication of where the money supply currently is.