The End Game Ep. 6 – Lacy Hunt

The End Game Ep. 6 – Lacy Hunt

August 9, 2020

Bill and Grant welcome a man who is the absolute epitome of the phrase ‘a scholar and a gentleman’, Lacy Hunt, to The End Game.

The three discuss arguably one of the greatest trades of the century: Lacy and his partner, Van Hoisington’s 40-year bet on deflation.

Lacy talks about staying the course, the methodology they used to simplify their framework and what it might take for them to change tack after all this time.

The perfect counterpoint to Russell Napier’s appearance in Episode 5 of The End Game, Lacy uses his encyclopedic knowledge of econometric analysis, financial history and regulatory frameworks to explain why he remains resolute in the face a rising number of calls for the return of inflation.

The Grant Williams Podcast
The Grant Williams Podcast
The End Game Ep. 6 - Lacy Hunt
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In the sixth episode of The End Game, Bill and Grant are joined by the inestimable Dr. Lacy Hunt of Hoisington Asset Management.

Lacy has been arguably the most consistent (and erudite) ‘bond bull’ for the last four decades and has maintained his steadfastly resolute position despite many periods where his and Van Hoisington’s thesis was under serious challenge.

In this fascinating conversation, Lacy outlines his simple but highly effective framework, explains why he still believes this train is worth staying aboard and highlights the things he would need to see happen to convince him that inflation was about to return and negate what has been a four decade-long winning trade.

 

Grant Williams:

Before we get going, here’s the bit where I remind you that nothing we discuss during The End Game should be considered as investment advice. This conversation is for informational, and hopefully entertainment purposes only. So, while we hope you find it both informative and entertaining, please do your own research or speak to a financial adviser before putting a dime of your money into these crazy markets. And now, on with the show.

Grant Williams:

Welcome everybody to another edition of The End Game. Our search continues for the answers, Bill. Joining me, as always, Bill Fleckenstein. Mate, how are you?

Bill Fleckenstein:

I’m doing just fine, thank you, and given that our prior podcast was with Russell Napier, who has a rather radical viewpoint now compared to where other folks have been regarding inflation, it’s just wonderful to be able to talk to Lacy Hunt, who’s been so right on the other side of things. It’s going to be great to have these two podcasts sandwiched next to each other.

Grant Williams:

Yeah, exactly right. So, our guest this week, as Bill just said, is Lacy Hunt, who has been extraordinarily right, extraordinarily strident about his views for, to my mind, a couple of decades now. He’s the one guy… Three decades, four decades, who knows?

Bill Fleckenstein:

Four and a half. A long, long time.

Grant Williams:

It’s a while.

Bill Fleckenstein:

It’s an amazing batting average.

Grant Williams:

And no matter what arguments have been put up against him and his partner, Van Hoisington, these guys have stayed solid. They’ve stayed firm, they’ve stayed resolute, and they’ve stuck to their guns. And dear God, they’ve been right this whole time. So I think what Bill and I want to try and find out from Lacy is, are they still there? Are they still on that bandwagon? Do they see any signs that might shake them off it? And if so, what might they be? And so, as Bill said, what better bookend to our last podcast with Russell Napier than to talk to Lacy Hunt. So, why don’t we do that?

Bill Fleckenstein:

Let’s let it roll, let’s do it.

Grant Williams:

Lacy.

Dr. Lacy Hunt:

Hello.

Grant Williams:

How are you?

Dr. Lacy Hunt:

Very well, thank you, how are you, Grant?

Grant Williams:

I’m very well, and let me introduce you to Bill Fleckenstein. You haven’t met before, I’m surprised to hear.

Bill Fleckenstein:

Nice to meet you, Lacy. I was lucky enough to have beers with Van, and Jim Grant, and couple of other guys one time. I was speaking at a Shad Rowe conference and that was a real treat. Obviously, you guys are on the same page. But I’ve been running money about as long as you guys have, so I remember your firm back in the ‘80s and ‘90s when Van first started making his calls. Pretty impressive.

Dr. Lacy Hunt:

I’ve been in the business 52 years.

Grant Williams:

Wow, 52.

Dr. Lacy Hunt:

I went into the Federal Reserve with my brand new PhD when I was 26 in 1969, and Arthur Burns was chairman of the Fed. I was at the Dallas Fed, Phil Coldwell was president. And when I left the Dallas Fed to go to Chase Econometrics to work on long-scale models with Mike Evans. Chase Econometrics was a subsidiary of Chase Manhattan, which was run by David Rockefeller, who I did a number of projects for during my tenure there, so I’ve been around.

Bill Fleckenstein:

You have been around.

Grant Williams:

And you know, the amazing thing actually is, and this is something that Bill and I really wanted to pick your brains about, and that is of those 52 years, a big part of that time you guys, you and Van have had this bet on, essentially, which is a rodeo ride that so many people have been shaken off along the way. And you guys have… Well, Bill and I were chatting privately before this, what we think is arguably one of the greatest trades of the century, that you guys have managed to put on. And so, I know Bill had a couple of questions that he wanted to ask you about that, so rather than trying to paraphrase, I’m going to let him ask them himself.

Bill Fleckenstein:

Okay, let’s-

Dr. Lacy Hunt:

I want to tell y’all something you may not… Van was, in the ‘70s, Van was at Texas Commerce. I was at Fidelity in Philadelphia, which was the largest bank in Philadelphia, and I was running the commingle fixed income fund and trust department and he was doing the same at Texas Commerce. And both of us, independently of each other, went into cash equivalence and set out the bear market of the ‘70s. In fact, there have been quite a few articles about the fact that I called the bear market of the ‘70s and the bull market since then. Not an easy thing to do.

Grant Williams:

No.

Dr. Lacy Hunt:

Many people don’t realize that there was about a 40-month bear market, mini, mini bear market, in the late ‘80s and we sidestepped that as well.

Grant Williams:

So, in other words, what you’re saying is so that was a really tricky wicket to step around. Being in the cash with a really nasty bear market, and then getting the sideways down stuff in the late ‘80s. And then from ‘90 til now, it hasn’t been smooth sailing. But one of the things I’m fascinated to try to understand from a money management standpoint is, over that basically 30 years of being dead-right about this, forgetting the sidestepping you did before, were there very many times along the way where you guys had to scratch your heads and say, “Gee, could this be changing? Are we still going to get it right?” Did you get shaken much at all, or was it pretty easy to just stay with it? I’m just fascinated to know what it’s like behind the scenes to do something so well, so right, for so long.

Dr. Lacy Hunt:

Well, the discipline was always the same, the approach was always the same. And what Van and I have said to our clients repeatedly is that we’re going to take a multi-year horizon here, at least three years or longer, and that we’re going to stay focused on the trends and inflation. Now, we’re treasury investors only, duration managers. Not many people do that, and we had an advantage that the uninformed don’t understand. There is no standard measure of value for the stock market. There are many competing measures, but there is none that prevails. In the bond market, there is a standard and it’s known as the Fisher equation.

Dr. Lacy Hunt:

And the Fisher equation was developed in his famous book in 1930, “The Theory of Interest”, and it says that the risk-free long rate is equal to the real rate plus expected inflation. And so, if you’re able to capture the trends in real economic growth over time, and the inflationary environment, you’re going to be on the right side. And over that time period, the real growth rate was coming down and the inflation rate was coming down.

Dr. Lacy Hunt:

Now, since 1990, there were 10 years that we didn’t look too smart, but we had tried to prepare our clients for that. And we said to them repeatedly that if you want us to manage from quarter to quarter or year to year, then don’t hire us. If the volatility bothers you, don’t hire us. Do yourself and do us a favor because what Van and I both strongly believe, contrary to the prevailing view, is that the short-term is not predictable. There are too many extraneous factors, unimportant factors. In addition, the market looks at all these indicators but does not know how to weight them, and that’s extremely critical. Also, the market does not understand that economic numbers do not come out in a vacuum, and that one of the most important points for evaluating the market are initial conditions. Economies don’t start at the same place every year, and so you have to be able to discern the initial conditions, and you have to understand the weights.

Dr. Lacy Hunt:

And Van and I both had training in Econometrics. Together we fit many thousands of functions, consumption, investment, inflation functions, interest rate functions. And so, we have an understanding of what’s important, what’s not, but we never lose sight of the initial conditions, and we had the standard of the Fisher equation. We stayed with it, we still stay with it. And that’s how we did what we did. And we took 10 pretty bad years, but they didn’t matter. They didn’t matter at all, really.

Bill Fleckenstein:

Lacy, was that 10 collectively, or you didn’t have 10 bad-

Dr. Lacy Hunt:

For a whole time period.

Bill Fleckenstein:

Right, you didn’t have 10 bad ones back to back, I can’t-

Dr. Lacy Hunt:

Never had more than one bad year.

Bill Fleckenstein:

Right, okay. That’s what I kind of assumed but I wasn’t sure.

Dr. Lacy Hunt:

Never more than one bad year.

Bill Fleckenstein:

I got it. Was any one of them, given your thought process that you’ve shared a tiny bit with there, was there any one of those periods trickier than the other, where you had to actually wring your hands a little bit? Or did it not rise to that level?

Dr. Lacy Hunt:

Well, we always wring our hands, and we always do our due diligence. And we relied upon our own understanding, and I think that we’ve stayed abreast of the peer-reviewed research. We realize that economics is a social science, it’s not a physical science but there is very important research that continues at scholastic institutions and at other research facilities, and we’ve tried to stay abreast of it. And I would have to say that probably the most important understanding that we had is that we are very familiar with the economic theory. But we also have done a great deal of hypothesis testing to sort out valuable economic theory from economic theory that does not matter. And I would say that there were a couple of things that were provided important guidance to us.

Dr. Lacy Hunt:

Number one, we have felt that, contrary to the conventional wisdom, debt accelerations do not lead to higher interest rates. They may lead to higher interest rates for some transitory period of time, but debt accelerations are nothing more than an increase in current spending in an exchange for decline in future spending unless that debt is productive in the sense that it generates an income stream to repay principal and interest. And so, we had felt, and you can see this in our writings, that we had rejected the notion of Keynesian multiplier on government activity. When I left graduate school in 1969, there were a couple of propositions that I strongly believed in. They were both key to understanding monetary policy, and both of them together said that monetary and fiscal policy are powerful.

Dr. Lacy Hunt:

The first proposition is that there is a powerful government expenditure multiplier. When I first started to study economics, the expenditure multiplier was between four and five. Today, even the extreme Keynesians will not argue that it’s much more than one. But I would say by the late 1990s, certainly by the early 2000s, we felt that the government expenditure multiplier was slightly negative. In other words, if you engaged in a dollar of deficit spending, the government spending goes up by a dollar but total private spending declines by more than a dollar. And that there was nothing to be gained from it, other than this transitory boost that occurs for a very limited period of time. By the way, the boost from the deficit-financed activity, the transitory boost is getting shorter and shorter, and the multiplier keeps getting more and more negative.

Dr. Lacy Hunt:

The second proposition that I had believed in when I left Temple University, and this served me in great stead in the 1970s, was that the velocity of money was stable. So, in the 1970s, money supply growth was 10 and nominal GDP was 10 because that was the time period in which Friedman was operating and the empirical evidence that was available, Friedman said the velocity of money was stable. However, in the early 1980s it broke out of that stable range and we were able to pick that up and we have felt that in highly-indebted economies, the velocity of money declines. And I will tell you that if you read Fisher’s great article in 1934, his mea culpa, the article that he wrote to explain why he missed the Great Depression so egregiously, one of the things that he said is that he had assumed that the velocity of money was stable but in highly-indebted economies, the velocity of money falls.

Dr. Lacy Hunt:

And so, what happens when you become extremely over-indebted, monetary policy’s capabilities become asymmetric. If the Fed wishes to tighten conditions, the monetary policy still works. But in this circumstance such as we have today, where the economy is extremely over-indebted, the debt is highly unproductive, and we can have objective verification of that, the velocity of money falls. And so, since 1997, velocity peaked at $2.20 and today it’s around 1.30 and a fraction. Hadn’t declined every quarter, certainly, and hadn’t declined every year but it’s in a major secular downturn. And one of the things that we were quick to pick up on is that the other economies of the world… Major economies, Japan, Europe, China, are more over-indebted than we are. The productivity of their debt is weaker, and the velocity of money is not only declining there, but is even below what it is in the United States. For example, money in Europe is not even turning over one time a year, it’s down to 0.9 times. And the velocity of money in Japan and China are both around a half a time per year.

Dr. Lacy Hunt:

And so, we’ve operated on those two propositions. And so, we actually put forth a theorem that received quite a bit of recognition in which we said, the theorem was this. That government debt accelerations ultimately lead to lower, not higher, interest rates. We film people that the empirical evidence, not only for the United States but for the other major economies of the world. And all you have to do is chart it. Chart government debt to GDP on the right axis, or the left axis, and then put the government bond deal on the other, and you’ll see that it’s an inverse correlation.

Dr. Lacy Hunt:

And we have a lot of evidence, serious evidence, that when government debt to GDP gets to about 50% of GDP, there is a deleterious impact on economic activity, and that when the government debt ratio rises above 65% it becomes very serious and increasingly so. Now, what I’ve just described to you is a nonlinear relationship, and that’s important. Economics is not accounting, let me make that clear. And more need not be more.

Dr. Lacy Hunt:

And so, what we were able to figure out, using the production function, the production function says that the real GDP, economic output, is determined by technology interacting with the factors of production, land, labor and capital. If you overuse one of those factors of production, let us say debt capital, initially the GDP will rise. But if you continue to overuse that factor of production, real GDP flattens out and then it turns down. It’s called diminishing returns, it’s nonlinear.

Dr. Lacy Hunt:

Now the accounting mind will say if you borrow and spend $2 trillion and that doesn’t work, then try 4 trillion. If 4 trillion doesn’t work, then try 8 trillion. But they do not understand that the relationship is nonlinear. And by the way, we all have production functions, including the Chinese. The fact that they’re a command and control economy, that doesn’t matter. You overused a factor of production, you’re going to get weaker economic growth. And so, what is happening? The economic growth rate is coming down very substantially. Take in the United States, from the founding of the republic in 1790 to the period at which we reached these high over-indebtedness levels in the late 1990s, the real per capita GDP growth was 2% per annum. And since then, we’re only growing 1% per annum.

Dr. Lacy Hunt:

And so, as investors see that happening, the growth rates coming down, they’re willing to accept a lower real rate. That’s part of the Fisher equation. The real rate plus inflationary expectations. So the real rate’s coming down, and there’s evidence that investors are now even willing to accept an even lower real rate because the economic potentiality is deteriorating. Not just in the United States, but everywhere you look the real rate of growth is deteriorating. In addition, the inflation rate is coming down. So this is a very powerful influence once you understand that in a general equilibrium model, the Fisher equation prevails. It’s one of the pillars of macroeconomics.

Grant Williams:

Lacy, it’s interesting that you’ve boiled down an incredibly long and successful career to something very simple to understand. And obviously there’s a temptation these days to overcomplicate things with the sheer amount of data that we can dig out or we are presented with. When you pin your flag to that mastered Fisher equation and simplify, and kind of take away all the clutter, does that make it easier for you? Because you have this phenomenal knowledge of history. And so I wonder whether that knowledge of history, does that help or hinder in terms of trying to understand what’s going on now and how the previous parallels might come into play when you’re trying to boil it down to something as simple as let’s build this around the Fisher equation?

Dr. Lacy Hunt:

The economic history is essential. I was trained in econometric model building, and I first of all built reduced-form models and they were published in peer review journals. The Journal of Finance, the Financial Analyst’s Journal. And then I built the first large-scale econometric model of the financial market for Chase Econometrics. That was my first book, “Dynamics of Forecasting Financial Cycles”. And one of the biggest mistakes that I made in the earlier models was that I estimated the parameters over too short of a time period.

Dr. Lacy Hunt:

Take all of my early work, all of the early work of Friedman, most of the other economists of my generation and the generation before me, were basically estimating parameters from early 1950s forward. So by the 1970s you have 20 years of data, and then by the end of the 80s you have [inaudible 00:21:22]. And where those models went wrong is that that data sample was too limited. And so, it became apparent that we need to look at all of the data. And so, in part thanks to Friedman, part thanks to funded research at The National Bureau of Economic Research, we have the monetary data and the outline of the national income and profit accounts from the 1870s.

Dr. Lacy Hunt:

So, one of the things which we did was to test our hypothesis from 1870 forward. And the view was, my view was that if a proposition is valid, then it should hold up regardless of whether you have an income tax or you don’t, whether you have a central bank or whether you don’t, whether you’re on the gold standard or whether you’re not on the gold standard. Or whether you’re on a fixed exchange rate standard or a floating rate standard. In other words, that none on these initial conditions should matter in a model that is truly accepting by the data.

Dr. Lacy Hunt:

And so, it was important to make sure that our propositions held over the entire sample period, and so I would say it became very important. And so, one of the things that we did, with the help of David [Hoisington 00:22:54], who’s worked very closely with me, we engaged in a lot of archival research and we pieced together the historical record. And I think that I’m just really not interested in 20, 30, 40, 50 year time spans. And people that draw propositions from them, they may be lucky but they will not be consistently right. Economic propositions have to stand the entire sample period.

Dr. Lacy Hunt:

And so I would say that one of the things that I benefited from very significantly, being trained when I was trained, is that I was taught the econometrics but I was able to study under some professors that still taught economic history, and the history of economic theory. And so we looked at European and US economic history. That was not my major, my appeals are macroeconomic, international economics and finance in econometrics, but I tool those courses and I had the benefit of that qualitative analysis, and because it’s very important to understand, in my view. Economics is tough, and reading press releases from governmental agencies or hearing the interpretations in the financial press, people may think that makes you an economist. Not in my view. It’s a very serious business.

Dr. Lacy Hunt:

And one of the things that a couple of my professors told me when I left Temple University with my new doctorate is they said that they had done the best for me that they could do, but they reminded me that economics is a science and that hypothesis testing and technological advance will occur. And you have to stay abreast of that. I’ll just give you one little example. When Adam Smith wrote “The Wealth of Nations”, it was a tremendous book. He made one major flaw, and that flaw was that price was determined by labor content. Adam Smith’s labor theory of value. Karl Marx’s whole system is based on labor theory of value. Well, we know that’s wrong. It was not until 1870, Smith writes in 1776, it’s almost a hundred years later before William Stanley Jevons conceptualizes the demand curve. And then it takes another 20 years after that for Alfred Marshall to say price is determined by the intersection of demand and supply.

Dr. Lacy Hunt:

And so, economics is… We become smarter, the tools available to us, the availability of data. People have recreated historical data in a more complete framework. And so, our understanding is not standing still. And to assume… One of the things that I get really leery of is when someone starts lecturing me on what they learned in Econ 45 years ago because there are certain things, particularly in microeconomics, that hold but macroeconomics allow the propositions that are taught in schools are simply not valid and haven’t been valid for a long time.

Grant Williams:

So Lacy, there’s plenty of people who spend a lot of time trying to figure out analogs going back in history to where we are now, to try and understand what’s happening and how it might play out. And obviously the most commonly cited one for where we are right now is the Great Depression. That’s the one that people seem to continually go back to, whether it’s the roaring ‘20s and then the bust or it’s the pandemic damage to the economy. Whatever it is, there seems to be something in that period of time which gives people something to hang their hat on. Is that the most sensible period to look at? Or if not, which periods are you guys looking at as a potential clue to what may happen from here?

Dr. Lacy Hunt:

Well, I think in the United States, this year we’re going to hit a new peak in total public and private debt to GDP which will eclipse the peak that we reached in ‘08 and ‘09. The peak in ‘08 and ‘09 was the third secular peak since 1870. One occurred in the early 1870s, then 1929, 1930, and 2008, 2009 and now. In each of those cases, we were all extremely over-indebted. The surge in the debt to GDP ratio reflected both the numerator and the denominator of the equation. The debt went up, the GDP went down. In each of the three earlier cases, the result was disinflation. The inflation rate came down, unequivocally. In some of the instances, the fallen inflation was enough to cross the zero bal. In other words, we not only got a fall in the inflation rate but it took us into negative territory, no exceptions. Extreme over-indebtedness leads to a weak economic activity.

Dr. Lacy Hunt:

Now, thanks to Fisher’s great article in 1934, Fisher had not only discussed what happened in the 1930s, but the 1870s and then an earlier case in 1838. Now, the one in 1838, we don’t really have hard data but it was very, very similar. There had been massive over-speculation in the building of the canals. We started with the Erie Canal, but then we built more than 100 other canals. And then we built the early steamship lines. We financed it all with debt. There was over-living, there was over-consumption. The panic hit in 1838, Van Buren is president. He has no idea what hit him.

Dr. Lacy Hunt:

In the 1860s, after the Civil War, we started building the Transcontinental Railroad. This was done on debt. Then we built the feeder lines. We first of all built the central route, Transcontinental Railroad, then we built the northern, the southern routes, feeder routes. The industries that fed the railroads, there was over-consumption, over-investment. Grant is president, he is no better equipped to deal with what happens to him in 1873 than Van Buren was equipped to deal with in 1838. And then we have 1929, the economy was even more indebted than in those two previous cases but the consequences were the same. We had disinflation and in some cases the disinflation was severe enough to lead to deflation.

Dr. Lacy Hunt:

Now, after 2008, 2009, contrary to the 1870s and the ‘20s and ‘30s, we were not able to deleverage the debt and get it back to normal. We managed to bring it down somewhat. And here, the pandemic has hit and we have now established, within 12 years, a new peak going all the way back to 1870. And that’s not a good sign, it’s a very bad sign, in my opinion.

Bill Fleckenstein:

Lacy, I have a friend of mine who runs a bond fund and he’s a big fan of yours and your letters, and he has exactly the similar viewpoint that you do, except he has now potentially concerned about his thesis, which is very similar to yours although probably not backed up by as much data as you have, that the introduction of government guaranteed loans to the banks, like the PPP here and the one in England and Germany and also in Spain, might be something to kick the Ms into gear, and that concerns him. But he weighs that against the unproductive nature of these debts. Can you comment on those two kinds of opposing forces, please?

Dr. Lacy Hunt:

Okay. Okay, so we had a situation back in March and April in which the private credit markets sort of panicked, right? The Federal Reserve came in and they did things that are really not directly authorized by the Federal Reserve Act. They justified by the exigent circumstances rule. Personally, I’m not comfortable with what they did in terms of the law, but no one else seems to object so we’ll let that pass. But when the Federal Reserve comes in and engages in all of this lending, they’re able to stabilize the markets. And thus, therefore, firms that would not have been able to have stayed in business are able to stay in business.

Dr. Lacy Hunt:

And so, people hail that as an accomplishment. But we’ve seen maybe two dozen of these instances in Japan, and we’ve probably seen close to a dozen instances in Europe where firms really were not worthy of credit but through heroic efforts, that’s a term that Charles Kindleberger used, great MIT economist of an earlier generation, the Fed comes in and stabilizes the markets. And that does work over the short run. However, it blunts two of the most important relationships of the free market economy. One of them is it blunts Schumpeter’s creative destruction. For economies to grow and to thrive, there has to be failure. Resources have to be allocated to the up and coming ones that have the new ideas, the new concepts, and have the ability to grow rapidly.

Dr. Lacy Hunt:

It also blunts moral hazard. I mean, the Japanese have now not only extended the operations to credit, but to the stock market. But really, the stock market in Japan hasn’t done well. And more importantly, the economy has not done better. So the Fed comes in with all of these powerful lending tools and it stabilizes the markets, and everyone says hooray, but the job of the economist is to understand the initial effects, the seen and the unseen. And a lot of people don’t want to be concerned with the unintended consequence. But we know, from Japanese, the European, and the Chinese experience that when you undertake these actions you thwart creative destruction and moral hazard. And so, you’re basically removing two of the most important mechanisms that allow the free market system to outperform the rest.

Dr. Lacy Hunt:

Now, initially of course, there is going to be an increase in the money supply. And the money supply, year over year, has shot up to 25%. And that’s the fastest money supply growth, probably, in history. Certainly the highest since World War II. However, the equation of exchange doesn’t say GDP equals money. It says GDP equals money times velocity. Now, money is very complex variable, and one has to take into account all of the factors that influence money. But velocity is also a very complex factor, and there are a lot of things going on here.

Dr. Lacy Hunt:

Now when the Federal Reserve comes in to the system and they lend… When they buy government securities, the net result is, generally speaking, is that the average maturity of the federal debt goes down and the banks are forced to take overnight deposits to Fed. All it does is change the maturity of the consolidated debt of the Fed and the Treasury. And this short-term stabilizing effect is very pronounced. There’s a first round increase in the money supply. The banks have tons of reserves, and many people assume that because they have tons of reserves, they will lend it out but that’s not what determines bank lending. The bank lending process is very complex. The banks, to be able to put reserves to work, they have to have the capital base to take the risk that the loans will not be repaid. Also, the banks have to price the loans to make a profit, and that includes not only their interest cost and their various overhead costs, but it includes the risk premium. And moreover, the borrower has to be able to pay all those costs plus the risk premium.

Dr. Lacy Hunt:

And so, when we had quantitative one, two and three, the Fed expanded the balance sheet, money supply went up, people said the Fed was printing money, and there was certainly a large first round increase, might not as large as today. And folks went out and assumed that that would lead to hyper-inflation, the dollar would decline, commodities would rise. But what happened? The velocity of money fell. There was a transitory boost in economic activity, but it didn’t last that long.

Dr. Lacy Hunt:

Well, in my view this is really no different. The sum, the first round increase in money supply, is greater but I think it will be more than compensated for by decline in the velocity of money. There is one caveat. We’ve just seen where the Fed has done things that were not authorized under the Federal Reserve Act. Now, it says in there explicitly the Fed cannot buy government securities, buy corporate and agency securities, or lend them. Or lend to those entities. But they did it. They do have the exigent circumstances rule, but exigent circumstances, to me, doesn’t imply that you can buy whatever assets you want.

Dr. Lacy Hunt:

Now, there is a growing risk that the whole nature of the Federal Reserve Act will be changed and that it will not be the same act that we have operating. When the Federal Reserve Act had to be rewritten after we left the gold standard in 1934, and that job mainly fell to Senator Carter Glass of Virginia, who was a pretty smart fellow, and he went to the two leading monetary economists of the time, Irving Fisher at Yale University and Charles Whittlesey at the University of Pennsylvania. By the way, Whittlesey gave me my macroeconomic oral when I was getting my MBA at Penn. And what Glass told them is that we want to give the Fed great lending power but we do not want them to be able to use their liabilities for spending. In other words, the central banks’ liabilities are not legal tender.

Dr. Lacy Hunt:

Now, to be money you have to meet three criteria. It has to be a medium of exchange, a store of value, and a unit of account. When the Fed buys government securities, once it clears, the electronic deposit stays on the books of the Fed. The banks are holding an overnight liability, those do not circulate. They can lead to a first round increase in the money supply. And as we’ve seen currently, it’s a substantial increase in the money supply. However, it is not legal tender. But there are folks who would like to make the Fed’s liabilities legal tender. In other words, have the Fed directly pay the bills, make them a medium of exchange.

Dr. Lacy Hunt:

I don’t know what will happen there, but there is that risk. And if that happens, either by rewriting the Federal Reserve Act or by saying they need to do it for exigent circumstances, then the whole picture would change. And in very short order you would again get very rapid inflation. Gresham’s law would take effect. Bad money would chase out the good. For money to have value, money must have value. If it does not have value, then you get very rapid inflation and we’ve seen this happen in Shanghai, China in the 1930s. We saw it in Germany after World War I. We’ve seen two great documented cases, one in Hungary, another in Yugoslavia at the end of World War II. Numerous cases.

Dr. Lacy Hunt:

Before we had banking systems, we had three great empires that become extremely over-indebted. Mesopotamian, Roman and Bourbon, and they basically could not obtain additional loans from money lenders or what rudimentary banking did exist. And so, what did they do? They issued a worthless metallic coin. Having the Fed’s liability as legal tender would be the same equivalent. That would change the whole system.

Bill Fleckenstein:

Yeah, that’s a great way to put it.

Dr. Lacy Hunt:

And we have seen that outcome, we have seen that outcome. Now, if we stay under the current system of monetary rules of the Federal Reserve Act, then we have a standard to go by from a very outstanding research project that was done by McKinsey Global Institute in 2010. And you can go on the McKinsey website and you can read it, and they looked at 24 advanced economies for the time, from 1900 through 2008, that became extremely over-indebted, and they followed the build-up in debt. And the solution, and what they found, was in all 24 cases the over-indebtedness had to be solved by what they called austerity. That’s their term, McKinsey’s term, not mine. And they defined austerity as a multiple-year significant rise in the saving rate. In other words, if you think of indebtedness as living beyond one’s means, then you have to live inside your means.

Dr. Lacy Hunt:

And what we have today, there’s no political will to go to austerity. And so, currently we’re trying to basically take on more debt to solve an indebtedness problem. There’s an inherent fallacy in that concept. It’s not working in China, it’s not working in Japan, it’s not working anywhere, nor has it ever worked. So ultimately, there is some risk at some point in time that you, what I like to call say, cross the rubicon and instead of confining the central bank to lending operations, you allow them to begin spending, or they either usurp the power.

Grant Williams:

Let me ask you, because this brings up something that came up in our previous conversation with Russell Napier. And we got to talking about inflation, and Russell’s point was that the change in the mechanism here by which the government is now essentially going to the commercial banks, getting them to lend, and guaranteeing them loans, and thereby making those loans contingent liabilities on the government balance sheet, that it changes the dynamic here. That a lot of those loans are expected to go bad, many of them won’t be paid off. So you’ve had this huge credit pulse go into the market that’s going to sit there, and Russell thinks that that could be final moment.

Grant Williams:

And Russell, like you, has been on the disinflationary/deflation train for over a decade now, but he’s seen something that has made him change his mind and start to think that this particular action, taking power away from the central banks and putting it in the hands of the government, may actually be the straw that breaks the camel’s back. Do you think there’s credibility to that? Or what would it take for you, perhaps, to start thinking, “Okay, maybe we are going to see the end of this deflationary trend, and we are going to move towards a more inflationary pulse.”

Dr. Lacy Hunt:

I consider the steps taken so far to be of relatively small amount relative to the economy, and not a continuing framework. But if you moved to the point where you use the Federal Reserves liabilities for spending, either to absorb losses for others or to purchase goods or services, the ultimate outcome would be inflation. I don’t think we’re on that path yet, but we might be. I think that the current steps are relatively unimportant, but they could lay the foundation, ultimately, but not immediately, no.

Bill Fleckenstein:

Lacy, I’m curious… I want to go back to Japan for a second if I might. Obviously, they started their monetization scheme over there when their debt to GDP was probably the highest of the G7 countries and now they’ve managed to absorb half of the… I’m not telling you anything you don’t know, half the JGBs and bunch of the ETFs. What’s going to be the end game in Japan? I assume that the BOJ is never, ever going to reduce its balance sheet. What’s the end game once you go down that process? Do you have a thought about that?

Dr. Lacy Hunt:

I have, and some pretty smart people have thought about it as well. I think one of the greatest minds of mankind was David Hume. David Hume was a mentor to Adam Smith. Smith knew all the figures of the enlightenment. He knew Ben Franklin, who was a genius, as we all know. And he knew Voltaire, and he knew Watt. He knew them all, and he said that Hume had the greatest intellect. By the way, Hume read Adam Smith’s “Wealth of Nations” shortly before he died, he was in poor health, and he sent Smith a short letter and he spotted Smith’s flaw of the labor theory of value. It’s a short letter, we don’t know whether he ever met with Smith after the letter was written because of his death, and he congratulated him because London was in a very celebratory mood. Smith is saying the visible hand is going to make everybody better off, free enterprise works. London was the center of free enterprise, so London was celebrating it. But he said if you were at my fireside, I would say to you with regard to your labor theory of value, what about the demand for or utility of a good? And tons of people read this letter. But yet, we don’t have the demand curve until 1870.

Dr. Lacy Hunt:

Another thing, Hume discussed time and space and it was that discussion that, according to Albert Einstein, led to the theory of relativity. My professor said that the enlightenment could not have occurred without David Hume. Anyway, Hume wrote this tremendous piece on public credit in 1772, and he said in there if you do not control public credit, it will control you. And his final conclusion is that when a state has mortgaged all of its future revenues, the state lapses into tranquility, languor and empathy. And now we have a lot of examples.

Dr. Lacy Hunt:

And so, you become weaker and weaker and weaker, and whether you manage to hold it together with high levels of indebtedness, or whether you try to use some sort of worthless instrument to pay debt off, the system really doesn’t work well under it. And what we have here, and really the thrust of where the modern monetary theory is going… People are talking about the technicals of MMT. The real flaw is that what creates economic prosperity, well-being, advancement is hard work, ingenuity, saving, reinvesting. The solution is not with the government. But you see, what we are looking for is some sort of easy governmental solution, which is not the way we achieved our prosperity. That’s the fundamental flaw in MMT.

Dr. Lacy Hunt:

And so, government policy has failed, and so we’re going back to the government asking for more of the same types of policy. But we’re getting off into areas where the results could be even more catastrophic. In disinflation, or even low inflation, it’s not a good system, but if we start making the Fed’s liabilities legal tender everyone’s going to be totally miserable in very short order. People will not want to hold financial assets, they’ll only want to hold commodities that they can consume or trade for consumable commodities. You require double coincidental wants, productivity collapses, the whole system begins to malfunction. And there are people that are willing to take that risk in order to get beyond the debt problem.

Dr. Lacy Hunt:

And so, we are moving into a time where the situation could become more volatile. But that is not today, we are not there now. We may be on the path, but we’re not there.

Bill Fleckenstein:

If I could ask sort of a black and white question, back to Japan for a second. I understand what you just said, but let’s suppose for a moment that the BOJ goes to the Ministry of Finance and says, “Look, we’re just going to exchange these bonds for a 200-year perp,” or some worthless asset but it’s an asset. But now they’ve basically expunged the debt, for all intents and purposes. The next day after they did that, how would JGBs trade? Do you have an opinion?

Dr. Lacy Hunt:

No, I don’t.

Bill Fleckenstein:

What would be the impact on… Okay.

Dr. Lacy Hunt:

The only way that it would really matter is if they were to default on the debt, and they can’t default because, even though they’re the main owner, the banking system and the corporate sector and individuals hold a lot of JGBs. So, you could eliminate the debt held by the BOJ, since the BOJ is a subsidiary of the government, but you cannot eliminate the debt in the hands of the private sector. You would bankrupt it. And the fact of the matter is the debt is still effectively there, which means that you cannot bypass the law of diminishing returns. Because what you’re thinking is that we somehow put it aside and then we go about borrowing more money to facilitate… Well, if you overuse a factor of production, the growth rate will just get weaker and weaker. There’s no financial solution. Everybody’s looking for a cutesy-tootsie fix and it’s not there.

Grant Williams:

So this debt jubilee idea is, it doesn’t [crosstalk 00:51:28].

Dr. Lacy Hunt:

By the way, I’ve heard people say to me, “I’ve been told that you’re a bright fellow. Well if you’re so bright, why can’t you tell me what the fix is.” There is no fix.

Bill Fleckenstein:

Yeah, I love it. They say, “Well, if you were in charge of the Federal Reserve now, how would you solve things?” I said, “You mean painlessly? Because that’s what you really want to know.”

Grant Williams:

Yeah.

Dr. Lacy Hunt:

By the way, I don’t get into these policy disputes. I’m in the investment management business, and so I don’t make policy recommendations.

Grant Williams:

But let’s see. So, is there anything that would make you change your mind? Because maybe it’s if we start to see the US Treasury curve turn negative. How would that change your approach to this?

Dr. Lacy Hunt:

Okay, so let’s go back to the Fisher equation. Fisher equation says the long treasury equals the real rate plus inflation. So let’s say we stay on this path under the current system. The growth rate’s going to grind down, and by the way, if you look at the inflation adjusted securities, they’re negative. Real yields are negative, which is basically a way of investors saying that they’re expecting the growth rate to deteriorate, and maybe even be negative for a prolonged period of time. So the real rate’s going to come down, inflation rate’s going to fall. So the Fisher equation does not have a zero bound, so the thrust of the Fisher equation is going to want to try to push the Treasury rates through zero. Now the Federal Reserve has said they do not want negative rates, which to me is the same thing as saying is that we’re hoping and praying we don’t go into deflation.

Dr. Lacy Hunt:

Now, if the Fed holds the overnight rate, and the inflation rate goes negative, at that point in time the real treasury rates will start rising. You see? Because we’d be stuck there, we’ll be hunkered down close to, so if we still go to 2% negative, the real treasury rate will start rising. Now, remember that the Fisher equation has a counterpart for the corporate yields and the private yields, and that is the private yields are equal to the real yield plus inflationary expectation, plus the risk premium. All right, if we go into deflation the risk premium is going up, that’s what’s happened in Japan. That’s what happened during the Great Depression. So at the point in time you go into negative inflation rate, the real treasury rates rise and the private borrowing rates will rise even more because in a deflationary environment, pricing power will evaporate and the risk premium will rise. Well, if you’re working with a general equilibrium model, you’re not going to achieve your equilibrium. You’ll remain in a perpetual downward spiral. So ultimately, they may need to allow the zero bound to be cracked.

Grant Williams:

If that happens, and obviously we can talk for all we want about what they may or may not allow, but what we’ve seen in other sovereigns… I’m thinking particularly places like Germany, is a rush for safe assets, tight yields negative normally at the market side of things. Does that present a potential problem for the Federal Reserve that the market may take… And we’re very close, if you look at where yield are now, we’re very close to that paradigm being crossed. If that decision to go negative is taken out of their hands, how does that affect things?

Dr. Lacy Hunt:

Well, to my way of thinking, the interest rate differentials are not the most important factor with regard to the dollar, but they are a factor. So the rest of the world is taking their rates negative, and they’re going even more negative this year, on average, from where we started. Which means that, as time goes by, the interest rate differential will work against the US, which means that the dollar will be incrementally stronger. Now I know a lot of people are worried because the dollar has been weak over the last six or seven weeks, and there are people predicting dollar armageddon, but I don’t buy those views.

Dr. Lacy Hunt:

First of all, the rest of the world is more over-indebted than we are, and they are doing worse economically than we are doing. I mean, look at the GDP numbers for Europe versus the United States. We had a 32% decline, Europe was down 48% annualized. Europe weathered this much worse than we did, and they’re far more indebted, and they’re indebtedness numbers are going to look terrible because they have borrowed a great deal and their GDP has dropped even faster than we did. And their demographics are worse. So, the economic fundamentals in the United States, looking at the production function, the marginal revenue product of the debt and the productivity, the United States has the capability of growing at a slightly better rate than Europe and Japan, which means that the dollar will hold value. And if they go negative in their short rates, then this will reinforce the strength of the dollar, which will tend to shift economic output away from the United States.

Dr. Lacy Hunt:

I think the discussion in here is misplaced right now. The dollar is not doing that badly, and if you look at the Fed’s trade-weighted measure, in spite of all of this talk about the dollar collapsing, we’re still up on the year. We’re higher now than we were at the start of the year, and we’re outperforming. In other words, this is a psychological episode, in my opinion.

Bill Fleckenstein:

Yeah, I think it’s a-

Dr. Lacy Hunt:

It’s not supported by the fundamentals.

Bill Fleckenstein:

I think it’s also a function of positioning. I think a lot of people got themselves hyped up on a dollar shortage thesis because of debt in the world, and that hasn’t quite played out, and it’s just created some noise, and now everyone’s taken a modest drop in the dollar as the end of the world, it seems to me.

Dr. Lacy Hunt:

We’ve had several of these episodes. You’re exactly right, I couldn’t agree more. And for example, when the Fed started on QE1 and Bernanke said the Fed was effectively printing money, there was a huge surge in the foreign currencies, huge surge in the commodities. Economic activity got a little lift, but the reserves the banks were not utilized, the velocity of money fell, the economy’s growth rate fell back. And so those projections at the time of QE1, QE2 and QE3 about an inflationary outcome with a weak dollar. Well, where are those brave folks? A lot of them have returned to the same forecast.

Dr. Lacy Hunt:

And as I said earlier, we’re still operating under the same system. Maybe the system’s going to change, but we still have the same fundamental relationships as we previously had. I don’t know why everybody wants to have hyper-inflation because we’re going to make our people miserable. We’re going to make them totally miserable, and hyper-inflations are socially disruptive. They are not helpful.

Grant Williams:

No, I think a nice modest 3, 4% would do most people just fine at this point. Lacy, so look-

Dr. Lacy Hunt:

You make the Fed’s liabilities legal tender, we’ll go 3 or 4 or 5 or 10 quickly.

Bill Fleckenstein:

Yeah.

Grant Williams:

Well look, just in wrapping up, just is there anything… As you look out at this landscape, say from the perspective of someone that has had this trade on for such a long time, and has had it tested at multiple junctures during that couple of decades, is there anything you see looking out ahead that has you, if not concerned that this may be coming to an end, but certainly something that you think, “I need to keep an eye on that because if a change is going to come, a secular change in the inflationary environment, here’s a place where I think it might start?”

Dr. Lacy Hunt:

Well, my focus is the production function. And so, the production function is technology interacting with land, labor and capital. We know they are overusing debt capital, so that’s a major negative via the law of diminishing returns. It’s going to undermine economic [inaudible 01:00:41]. And moreover, it’s coming at a time when our demographics are deteriorating. Now, last year our population growth was about 0.4% per annum. It was only half that in Europe, 0.2% per annum. It was unchanged in China, and negative 0.2 in Japan. There’s a Brookings study that indicates that we will have roughly 300- to 500,000 fewer births next year, the United States. As a result of the pandemic and it’s economic consequences. But it’s likely that that’s going to be a worldwide phenomenon. We don’t have a study on the rest of the world.

Dr. Lacy Hunt:

So the demographic element was very poor. US population growth last year was the slowest since 1918, which is rather ironic because that was the Spanish flu. And world population last year was the slowest since 1952, and the advanced economies outside the United States were at multi-decade lows. So we’re going to to get a drag from both the overuse of debt capital and the deteriorating demographics. What could change the pattern?

Dr. Lacy Hunt:

Well, we could presumably have a windfall of new natural resource discoveries. I don’t know what that would be, but the natural resource base really hasn’t changed significantly in quite some time, so it probably will not be a factor unless we start harvesting minerals from outer space or something. And I wouldn’t discount that in due course, but I don’t think that’s an immediate. So, that leaves the one element of technology. Bill Gates believes that technology will save us, and Bill Gates is a smart fellow, and we have to recognize that he holds that view, and others hold that view. And I would not eliminate technology as a factor because I, myself, have taken advantage of technological change with regard to staying abreast of economic theory.

Dr. Lacy Hunt:

But I think the basic pattern here that we’re following in technology was well laid out by Robert A. Gordon in his outstanding book “The Rise and Fall of American Economic Growth”. It’s just a tremendous book, it’s on the American production function. And Gordon’s point is that during our heyday of growth, from 1870 to 1970, what we had were revolutionary inventions that enhanced the demand for natural resources and labor. Combustion engine, think of what the combustion engine requires. Assembly lines, complex supply systems. Then it requires enhancing the road infrastructure and bridges. So the combustion engine meant that we enhanced the demand for other elements in the production function.

Dr. Lacy Hunt:

Think of transmission of electricity, another one of the critical five. Building the electric grid and what that took. We knew about electricity since Franklin, but Edison told us how we could transmit it. But we didn’t complete building the electric grid until World War II. That required a lot of things. And so did modern sanitation, and communication, and pharmaceuticals and chemicals.

Dr. Lacy Hunt:

So technology, I think, could bail us out but it’s going to have to be of a revolutionary nature, not of an evolutionary nature. What we’re seeing today is changing lives in many, many ways but it’s not enhancing the demand for natural resources and labor. But that’s what we have to be abreast of, and I’ll personally tell you that that’s something that most economists are not that well equipped to deal with.

Grant Williams:

So, I’m guessing by that that you don’t see TikTok or Twitter as that revolutionary [crosstalk 01:04:55].

Dr. Lacy Hunt:

I’m alert to technology but I don’t see the revolutionary type of technology that lifts the whole production function up with it.

Grant Williams:

Fantastic. Lacy, it’s been an incredibly dense hour, as it always is whenever I get the chance to speak to you, and I thank you for that. The beauty of these podcasts that Bill and I have been doing is that the people listening to them are listening to them three or four times because they’ve all been extraordinarily complex, with an awful lot of information and some really interesting and provocative viewpoints that the people hadn’t considered before them. And although your work is well-regarded and well-established and well-read by many people, I think there aren’t enough opportunities to hear you talk about this stuff. So, my thanks to you for-

Dr. Lacy Hunt:

I appreciate you allowing me to have a window on the world.

Grant Williams:

No, it’s always a great pleasure. And sincerely, thank you so much for taking this time to share those thoughts with us.

Dr. Lacy Hunt:

Bill, nice to… Thank you both for your great questions.

Bill Fleckenstein:

Well, thank you. More importantly, thank you for your great and in-depth answers. I could listen to the replay of this and I probably took four pages of notes while you were talking. So thank you.

Dr. Lacy Hunt:

Okay.

Grant Williams:

Lacy, thanks so much. I hope we see each other in person again soon.

Dr. Lacy Hunt:

All right. It won’t be this year.

Grant Williams:

No, it looks that way.

Bill Fleckenstein:

Take care.

Dr. Lacy Hunt:

Do you know anybody that has any trips scheduled this year or next year?

Grant Williams:

You know, I don’t. I really don’t. I know every-

Dr. Lacy Hunt:

I ask everybody I talk to, no one does.

Bill Fleckenstein:

No.

Grant Williams:

I don’t either. I know someone that had someone in December, but they put a line through it this week.

Dr. Lacy Hunt:

All the best to both of you.

Grant Williams:

All right, take care Lacy, thanks so much.

Bill Fleckenstein:

Thank you, thank you.

Dr. Lacy Hunt:

All right.

Grant Williams:

And that, we thought, was that. The interview ended, we finished the recording. And then, within a couple of hours, I guess, an article dropped on Bloomberg which essentially pointed to the exact solution that Lacy said would give him cause for concern. So I went back to Lacy and asked him for some thoughts on this article, which was basically a proposal for the Fed sending money directly to households. And I’m going to read his reply because I want to make sure that you get it in his words. And then Bill and I are going to talk about it for a second because I think it’s important. Here’s what Lacy wrote.

Grant Williams:

“This proposal is not going to pass this year.” I can’t do the southern drawl, just in case you’re expecting me to-

Bill Fleckenstein:

Wait wait, no. That’s not fair, I want the-

Grant Williams:

This proposal is not going to pass this year.

Bill Fleckenstein:

There you go.

Grant Williams:

I can’t do it how Lacy does.

Grant Williams:

“Nor will the recommendation pass quickly in 2021. To move the proposal along, Powell and the Fed establishment would need to endorse the proposal. This is not a Fed proposal. I don’t think that Powell would do this, but the new president gets to appoint his own chair in February, 2022. Hearings have not even been held, so hearings would have to occur first but that will only happen if the Fed is willing to lead the process. All of the various other Fed proposals, some equally extreme, would get thrown into the hopper. This will slow the process down. Then the arguing would have to go on, then the bill would need to be drafted. It would probably go through revisions, and then it would need to pass both House and Senate, and the president would have to sign it. I doubt this legislation could only pass before the end of next year at the earliest, if Powell and the Fed are onboard.

Grant Williams:

“If Powell is unwilling to lead such a legal revision, then the process of changing the law could not change until after the new Fed chair has settled into the job. Notice that this proposal would likely end currency and force a digital currency. The government would be able to track everyone’s financial record. It will be a great intrusion on private freedom. At the end of the day, this proposal would put the Fed in the money printing business. It would constitute a major break within our system. Money would have no value as soon as the money illusion passed and Gresham’s law would prevail. It’s part of the view that financial transactions create income and wealth, not hard work, creativity, and saving out of income. In other words, it would be the triumph of the free lunch school of economics. The US will at that point have achieved banana republic status. To go along this path would lead to hyper-inflation and widespread miserable condition of the American household. Lacy.”

Grant Williams:

So, it’s funny. It was the last thing we talked about on the podcast, pretty much, and it happened so quickly. What are your thoughts on that, Bill?

Bill Fleckenstein:

Well, I saw that the morning after we’d finished recording the interview, and I was stunned because that was the very thing that he said, you could tell was his number one concern. I think that he makes an excellent point on how long it might take to actually implement that. Thus, perhaps it’s not something we should necessarily worry about. But the caveat I would make, because his reply was so well thought out, the only caveat I would have is that if we get some economic data, or financial market problems that start to snowball, we all know that they will change course quickly. So it may not take quite as long as his logic would suggest, though I’m not really prepared to argue with him. I just know that these things can happen fast in a sloppy fashion.

Bill Fleckenstein:

I think the more important point is how serious he takes that possibility, and how bad it would be for all of us. So it’s not something any of us would like to see, but it would certainly be a continuation of a lot of the wrong-headed policies we’ve seen for a long time, and it would finally be the end game, period. That’s it, it’s game over for bonds, stocks, our currency. I mean, not over but real destruction, for sure.

Grant Williams:

Sure, sure. I looked at the timeline, too, which again, Lacy laid out in a beautifully detailed paragraph, and thought the same thing. That’s a long way to get through, but unusual and exigent circumstances. We saw how quickly they got the top through when they needed it through, and we saw how quickly that the Fed got into the direct lending business, and how quickly they circumvented the junk bond rules. These things tend not to take long. I mean, I understand that this comes down to the Federal Reserve Act, I presume is what they would need, the bill would need to get through, but one would imagine at that point that it would be very difficult for any politician to hold this thing up. That’s what worries me, particularly when the Fed put the frighteners on us, as we know they’ll do. They’ll talk about the collapse of the system and the end of America as we know it, and when what they’re trying to get through, to Lacy’s point, is arguably the end of America.

Bill Fleckenstein:

Right, right. Well it’s perversely… When I see the New York Fed talk about diversity and income inequality, when they’re the engines of it. Some of the perverse irony is obviously lost on these people, but it’s obviously potentially very serious. And given the fact that we’re not doing a really good job of being able to get the economy back on track, whether you think we should lock down more or lock down less, the fact of the matter is we’ve allowed the politicians to make all the decisions. They’re the least capable, and now they’re micromanaging every aspect of every business in America. And then you’ve got the possibility for lawsuits and what that’s going to do to business.

Bill Fleckenstein:

So, all I’m trying to suggest is the chance for the economy to be really poor for quite a while is there, and that would be a precondition, I think, to have us get sent down this path, and that’s I think it’s worthwhile to remember that. Those two things together.

Grant Williams:

Yeah. No, absolutely. The other part of it that’s really interesting, obviously, is he’s right. This would force a digital currency. And it makes you wonder, obviously the Federal Reserve is, and refuses to allow any currencies to compete with the dollar. So one wonders what would happen to things like Bitcoin and Ethereum, other digital currencies at the point where the Fed have imposed, or the US government imposed its own digital currency.

Bill Fleckenstein:

I don’t really see it… I mean, maybe I’m missing it, but I don’t really see it as necessarily a digital currency. I see it as a digitally delivered currency, which is different. Our money in the bank is basically digital now, and this would just be a faster way to move it around but we wouldn’t go to the store, necessarily, and pay in fedcoin as opposed to green paper.

Grant Williams:

No, but you’d pay on your credit card. It would just get… It would be basically cashless, it would be a cashless society.

Bill Fleckenstein:

It would move in that direction, for sure. But anyway, we don’t need to get into the gory details of that.

Grant Williams:

No, that’s one for another day.

Bill Fleckenstein:

That’s so far down the road, hopefully.

Grant Williams:

We’ll get into that another day. But yeah, it was definitely worth adding this little bit to the podcast. The timing of that was, I guess, unfortunate it didn’t come out 24 hours earlier, but it was very good of Lacy to take the time to send us his very thoughtful reply.

Bill Fleckenstein:

I agree. His very, very well-worded and thoughtful reply, yes.

Grant Williams:

It’s amazing. Every time I listen to Lacy, I never have a camera in front of me because we’re doing this on Zoom. People are only going to hear the audio, we’re seeing it on Zoom. And so, I actually had the chance to look at my face, and I concentrate so hard when I’m listening to him because it’s such an extraordinary repository of knowledge. And when you talk to Lacy, he’s the guy that makes me realize how complicated economics is. Because everybody spends their life trying to simplify it, and Lacy will tell you what it is rather than what you want to hear, and it’s unbelievable.

Bill Fleckenstein:

He kind of put… People like him, that have studied what they study, make economics sound like a legit science, whereas most of what we all hear that is considered economics is just pablum. It’s the weight of the crowd believing the same thing that already happened, and extrapolation. And when you look at the depth of the knowledge and understanding that he brings to the table, it’s a totally different picture than most. I mean, obviously there are other economists in the world that are good at what they do, but there’s a certain rigor there that I find missing in a lot of things.

Bill Fleckenstein:

I think it was interesting that several times, he mentioned the potential for the Fed to have its charter changed, or said differently, turn liabilities into money. And he mentioned it enough times that it sounds to me like that’s one worry that’s out there on his radar, for sure. And it seems to me that Russell [Napier 01:15:48]’s observation that if these governments start getting into subsidization and do the loan guarantees, that’s sort of a back door way of turning those liabilities into money. But we’ll have to see how far this goes. So far it’s a bunch of one-off programs and whether it gathers steam, or whether they just go in and rewrite the Federal Reserve Act. And the lobbying I’ve heard amongst the liberals is to get the Fed to try to work on diversity. Well, if they start doing stuff like that, then his worst fears, and I guess all of ours collectively, will be realized.

Grant Williams:

And the ECB are taking on climate change now as part of their mandate, so-

Bill Fleckenstein:

Right, forgot about that.

Grant Williams:

But yeah, but this is it. This is what’s so fascinating. Because the solutions that are required at this point, no matter you talk to James, you talk to Russell, you talk to Mike Greene, you talk to Lacy. The solutions are getting more complex and more dramatic almost by the day, right? The things they’re going to have to do to try and solve this problem now. And rewriting the Federal Reserve Act is a big one. I think that’ll be an easy one for them to do, frankly.

Bill Fleckenstein:

I think they’ll do that in five minutes. The next time the market gets busted up badly, I think that could easily happen. I think what the search is for, and he pointed out in not so many words, is what everyone wants is a painless solution. [crosstalk 01:17:12] Yes, we’re strung out on heroin and yes, we tried alcohol, and some Percocet, but now we’re even more messed up than before so can you make it all go away without any pain? We’ve been kicking the can so long on so many different… that the simple, or not too painful, solutions don’t exist.

Grant Williams:

It’s a great point because we all know there is a very straightforward solution to all this. But that’s the part where people stop thinking there because we all know that it requires immense amounts of pain.

Bill Fleckenstein:

You mean we should let the markets clear?

Grant Williams:

Yeah, well God forbid that should ever happen again, right? No, that’d be the one thing they’re trying to stop. Yes, it’s fascinating, right? To talk to Russell and Lacy back to back, two guys with an extraordinary weight of intellect.

Bill Fleckenstein:

It would be fun, in a while down the road, if it looks like the landscape is changing in some way, to see if we could cajole the two of them to come on together. Now that would be something to listen to, particularly if the landscape starts to change, you know?

Grant Williams:

Exactly right. I’d give us a fighting chance of being able to convince them to do that. I think that’ll be interesting. Well mate, we’ve reached the end of another episode. We’re racking them up now, and each one is more though-provoking than the last. I’m loving this series.

Bill Fleckenstein:

Yeah, me too. This has been extremely educational for me.

Grant Williams:

All right, well listen, thanks to you for sticking with us and listening to this series. I’ll make my usual plea. If you wouldn’t mind taking a couple of minutes to rate and review us on iTunes, it would really help us. Between now and the next episode, if you don’t follow us already on Twitter, you can do that. You’ll find me @ttmygh.

Bill Fleckenstein:

And I’m @fleckcap.

Grant Williams:

Yes he is, and he will be there tomorrow at the same name as well. Thanks for listening, and we’ll see you next time.

Grant Williams:

Nothing we discussed during The End Game should be considered as investment advice. This conversation is for informational and, hopefully, entertainment purposes only. So, while we hope you find it both informative and entertaining, please do your own research or speak to a financial adviser before putting a dime of your money into these crazy markets.

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