Lacy Hunt & Brent Johnson: The US Has Entered A New Inflationary Era That Will Prove Bad For Bonds

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This is a job for Indeed Sponsored Jobs. Welcome folks to this discussion held for zero hedge. I'll be your host today, Adam Taggart. I'm the founder of Thoughtful Money. It's a financial media company that does a lot of interviews like this. We are incredibly lucky today folks to be speaking with two giants, I'll say. The first one is Lacey Hunt. Lacey is one of the most accomplished economists still living these days. He is a former senior economist to the Federal Reserve. He now is the executive vice president at Hoysington Investment Management. Just to paint a little bit of a picture of Lacey's background, I'd show you how accomplished his career has been. He earned his doctorate at Temple and for many years served on its board of trustees. He's now an honorary trustee of the institution. He's done a lot of rigorous academic research in his career, published in all sorts of different venues, like the Federal Reserve of Dallas, where he also sat on the committee of financial security, as well as its international committee. Later, his work was published in the Journal of Finance. He has written an incredibly influential book about a 100 variable economic model of the financial markets that he created. And that's been well-reubed by a number of different sources in the financial media, but including institutions like the Wall Street Journal. He has traveled the world working for HSBC, Chase Aconometrics. His main fields of study have been macroeconomics, international markets, and finance. He has, over the span of his career, seen the inflation caused by the Vietnam War, the failed response of both Burns and Miller, running the Fed, although he did also see the success that Volcker finally had in taming the inflation of the '70s and early '80s. He was at the Fed when the country went off the gold standard. He had a front-row view to all of that. And he's seen the failure over time of price controls, every time they've been attempted pretty much, and has, over his career, gotten to know specifically a lot of the greats in the economic world, like Milton Friedman. He's debated Nobel laureates. After that, he became an investment manager. And right now, as I said earlier, he's at Hoysington Investment Management. Really, truly, one of the most accomplished living economists, as I said. Joining us as well with Lacey is the dollar milkshake founder himself, Brent Johnson. Brent is the CEO and CIO, I believe, at the Santiago Capital Fund, where Brent is a money manager and manages hundreds of millions in assets under management. I've gentlemen, I thank both of you for joining us for this discussion today. Lacey, we're gonna be diving deep into your most recent letter, which was kind of a bombshell in the economic ecosystem, because you've kind of been known as somewhat of Dr. Deflation over much of your career, but in your latest letter, you have pivoted, basically, and you give all the reasons why, where you're now more concerned about inflation versus deflation going forward, and we very much look forward to digging into your reasons why. But anyways, Lacey, thank you so much for joining us. Thank you. - All right, we'll be with you all. - Thank you, well, it's such a treat. And Brent, my friend, thank you for joining us as well. - Thanks for having me. I'm really here to listen and learn, and I may have a few questions towards the end, but really just feel privileged that I get to sit here and listen to Lacey for a while. - Yeah, like I said, it's a great privilege. Lacey, you've got an awful lot of fans out there in the world. So folks, what I'll do is I'm gonna walk through with Lacey kind of the main tenets of that recent pivot paper that I talked about. Brent, feel free at any time to chime in, and then after Lacey's sort of flushed out his whole reasoning, then Brent and I will start asking a bunch of clarifying questions. So Lacey, if we can kick it off, it's just at a very high level. Why the pivot? I'll ask you a number of specific questions about it, but at a high level, why are you less concerned about deflation going forward and more concerned about inflation? - I think that we're seeing a major secular shift that we're now moving into a period of capital shortage as well as we're witnessing the end of the three-decade period of globalization, which led to significant disinflation. And that the picture is going to persist for a long while. There will be intermittent episodes when the secular forces will fade, but the big picture is considerably different. We're gonna have higher inflation. We're gonna have greater volatility in inflation. Trend and interest rate is going to be higher. And we're going to have generally poor economic performance in which the standard of living will stagnate and basically a complete reversal of what we saw over the previous three decades from let's say 1990 to 2020. - Okay, well Lacey, let's take all those in order if we can then. So you talk about a capital shortage. So a lot of people see the Federal Reserve balance sheet is still increasing. They see episodes like we saw yesterday where the treasury is stepping in and basically buying more treasury bonds. So I think a novice might say, well, it looks like there's still a lot of liquidity in the system. When you say capital shortage, what do you mean and what is causing that? - Well, the Federal Reserve can not solve the capital shortage situation. They can increase the money supply, but to have physical investment, you need saving out of income. And at the present time, we have very substantial projects, physical projects. We're financing artificial intelligence. We're building an expansion of semiconductor. We need to expand the electrical grid. There's space exploration. We've got a massive federal budget deficit with superior rate. And at the same time, net national saving is near the all time lows since 1929. The national saving encompasses what is being said by the household sector, the corporate sector, the government sector and the foreign sector. Historically, it's been just under 7% of net national income. And now it's very close to zero. And so there is going to be this tremendous demand for capital, which suggests that real interest rates will have to rise. And because the overall inflation is going to be going up at the same time, that means that this will reinforce the rise in nominal interest rates. - Okay, so as you said there, that capital scarcity contributes to higher inflation and higher interest rates or higher bond yields, we'll say. You pair that with globalization or specifically the end of the era of globalization, deglobalization as many call it. So with this new world era where we're no longer structuring our supply chains to be the most efficient and just buying from whichever country can produce it the most cheaply. Instead, now we're in an era where we are reshoring lots of different parts of industry or many countries are reshoring. And that means they're maybe very wide. is reasons for that from a national security standpoint, but that basically means higher prices going forward because you take a country like the U.S. that is reshoring supply chains from China, just the cost of human labor in the U.S. is a lot more expensive in China. So how would you give the scarcity of capital and the effects of de-globalization equal weight here or is one more important than the other? I think globalization, they're both powerful forces, it's not really possible to say which is the more important. But when the iron and bamboo curtains came down, we had an incredible outpouring of labor that was available to the global production process, massive, hundreds of millions of people came into the labor, to miss facilitated the development of great manufacturing hubs and concentrated supply chains. In addition, it led to immense economies of scale because we were able to sell the production over increased volume of markets. And I think the way to look at that is to use the production function, one of the most important concepts in economics, which says that output is determined by technology interacting with the factors of production, labor, natural resources, and capital. And as a result, the supply, the aggregate supply curve was shifting outward very dramatically, unprecedentedly. And so, even though debt was increasing rapidly, and time's money supply growth was rapid, it didn't really matter because there was such an increased availability of supply. And the emphasis during this time period was on cost efficiency. This was the world of Adam Smith's invisible hand and of David Ricardo's comparative advantage. And now the production function is turning adverse. The emphasis is on resiliency, rather than on cost efficiency. We're moving from just in time inventory situation to just in case. We're having to have backup teams of supply. As you mentioned, there we're doing on-shoreing, we're doing print-shoreing. We want to be sure that the output is going to be available to it. And the fragmentation of the world is reducing the economies of scale, which were so evident during the earlier time period. This is not the world of Ricardo's comparative advantage. And that has huge differences. And so both of them are going to be operating at the same time. >> Okay. So some people would say, Lacey, but hey, the age of AI is arriving just in time here. And it's going to save us because it's going to increase the productivity of our domestic businesses here and drive costs down. What would your response to that be? >> Well, that's a possibility and many people are optimistic. But we have to look at this in the stages in which the action is going to occur. And first of all, we have to build this infrastructure. We have to create it. And it's going to require huge physical resources and huge amounts of capital. In addition, we're trying to do all these other things at the same time, besides financing of growing and huge federal budget efforts. We also have to, we're starting to engage in space exploration. And in order to effectuate for the potential productivity benefit of AI, we have to provide them to the energy. This is a huge absorber of energy. And this comes at a time when our electrical grid is not in good shape. And so we have to meet the demands of energy. So the draining effects come first. And then the productivity benefit that they occur will be later in the cycle process. >> Okay, that makes sense. And I've interviewed some folks recently that might even, it would really underscore your if those productivity benefits arrive. There's certainly a healthy amount of skepticism out there. I'm not smart enough to know which way, be able to predict which way it's going to go. But your point is, even if AI does deliver a productivity boom, that's down the road. And in the interim, you get to do a lot of spending in large part, which will be inflationary. >> I think there will never lose sight of the fact that we're undertaking these capital of mine when net national saving is mill as a critical factor. It's not just a physical demand. It's the supply of saving out of income that's necessary. >> All right, fantastic. I want to dig into that with you. So quickly, I'm just curious, what's happening in Europe, expert in the treasury market. One of the things that has appeared to be pushing treasury yields higher is the fact that there is now a lot more options out there for the bond buyer. Because in the AI space, these hyperscalers have been issuing gobs of credit. I don't know how much of this year's 800 billion in cap expending is debt financed. But I know a fairly good amount of it is. So just a lot of supply and demand, there's just a lot more bonds coming to market these days. And so that means the price will go down, that means yields will go up. How big of a factor is that to your kind of scarcity of capital argument? >> They're both significant elements. Of course at the margin, the private capital demands are greater than the government demand, but the government demands are increasing. Until July, virtually everyone, in both officialdom and outside of officialdom, said that the federal budget deficit would be about $1.8 trillion, $1.7 trillion, about 5.8% of GDP. And then suddenly, in the last 10 days, everyone is shifted in thing. The budget deficit is now $2.1 trillion, $6.4% of GDP. And we're going into a time period in which the political situation in Washington is changing. The administration needs a lot more in the way of defense spending to rebuild its stock firewall inventory, and the opposition party wants an expansion of social spending. We'll need one of them who's going to be able to have their way. And in the past, what has happened, they've compromised by doing both. The end result is that the budget deficit gets even worse. And so the both of them are interacting at the present time. The upward shift in private capital demand is greater. But the treasury is not helping. Okay. And everything you just mentioned, the deficits, the growing deficits, the growing deficits, the percent of GDP, this is all happening in, quote unquote, the good times, right? With low unemployment and record stock market prices, how worried do you get should the country enter a recession? I mean, it seems to stand a reason that deficits would really blow out then. Does that just make everything worse? Yes, because then, first of all, the stabilizers would kick in. Your tax revenues would go down. Your support for the labor markets would have to rise. Your food stamps all over the problem. And in addition, there would be the demand for more stimulus. And so really, at this stage of the game, the budget deficit should be one to two percent of GDP, not 6.4. We're in a very, very difficult situation. If you look at the governmental demand, according to the IMF, the United States, all the federal state and local government have a deficit of 7.5 percent for this year. And I think my outlook is for even a greater number next year and in the years to come. And federal debt is already approaching 120 percent of GDP. And it's on its way to 130 percent of GDP. And the problem is that all of the past fiscal policy payers are now catching up with. And that's evident in the interest exchange. Interest expense is a very vital problem of how the world works and what will happen. The noted economic historian, Neil Ferguson, has pointed out that when your interest expense exceeds military spending, great empires go into decline. I think that's a very real possibility. But the more immediate concern is that the interest expense is so great. now that interest interest expense is going to continue rising as the federal debt levels increase. But that will not support the economy. But I suspect that it will lead to an increase in the risk premium on Treasury debt. And of course, to my way of thinking, and it's not been repealed yet, if you think of the American financial markets as an inverted pyramid, it's the Treasury market that's sitting at the neck of that pyramid. And if the risk premium begins to rise on Treasury, then this will filter up the curve. And it will lead to higher borrowing costs in the mortgage market and in the corporate market. And so the Treasury will exert upward pressure going up. And the private market will exert pressure also to the upside because of their intense need for capital. You think you know a browser, but Gemini and Chrome, that's new. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50 page restoration block, or finally break down that long article you've had open for weeks. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsored Jobs. Need a hiring hero? Okay. So, yeah, we're in the good times right now, even though we have all these problems, bad times arrived. They're going to be quite bad for all the reasons that you just mentioned. The end expense means that the fiscal problems are now intractable. The Treasury Secretary yesterday tried to gimmick. He said he's going to buy a two billion more of, he's going to buy a longer day to paper and presumably sell Bill 14 billion over seven weeks in the early November. Well, the budget deficit is 2.1 trillion. Small program, the problem is that it's the wrong medicine. It sends the wrong message. The chairman of the Federal Reserve Board wants the long end of the Treasury market to be left alone so that the private market can signal to the Treasury and to the Federal Reserve and to the rest of the world that we have imbalances. The investors are concerned about inflation. They're concerned about the capital needs and the political course that the country is taking. And so when the Treasury attempts to come in and interfere with these fundamental market forces, all it does is, is distort the signal that the Federal Reserve needs to do the right thing. And so there's a great contradiction. And my suspect is that it's nothing more than temporary meddling. And what the Treasury Secretary will learn is that the Treasury markets are far more powerful than he is. And they're ultimately going to set the course. Okay. I think that makes a lot of sense. I have some sympathy here. And it's not often I say this, but I have some sympathy here for Fed share, Kevin Warsh, because he was put in place by Treasury Secretary Bessons. And I think they agreed on how Kevin was going to run the Fed. Kevin has been very clear so far. I don't want to be meddling that much. The way that the Fed has in the past, because I want the market to provide an adulterated signal, that's very important. And over the past bunch of years, the Fed has basically masked the market signal by intervening frequently. But then all of a sudden, his boss, not as boss anymore, but the guy that put him in a seat, his seemingly just kind of cut his legs out from under him, because he's muddying up the price signal from the market, as you just said. Well, if it does, that works as well. It will survive some additional liquidity to use a short end of the market. But we have to keep in mind that the Federal Reserve began to significantly scale the easing in mid-December. Since mid-December, they purchased nearly 1,500 of Treasury bills. And they've gone into the Fed's portfolio. Right? No, I'm a net basis. The Fed balance sheet has been increasing this year. Very dramatically. And the previous Fed said that this was a technical operation. That there was an insufficiency of reserves. This was a plumbing operation, it was called. But look what happened to the bank balance sheet. The bank deposits and bank loans in particular, they've served very, very dramatically since mid-December. And so now you have enough tech and deposit growth and money supply growth, which in my opinion is moving further into the inflationary direction. Well, when the Treasury attempts to provide liquidity to the front end of the market, even though it won't hold, it moves the country in the wrong direction. What we need here is restraint to deal with the inflationary problem. And Washington has to feel the urgency of correcting that the past fiscal policy is on. The Fed chairman is in a very debacle place. He was handed this stealth easing. Another problem that it's hitting with is that during the period of globalization, factors combined to greatly reduce the velocity of money, which is not discussed nearly enough. And so between the late 1990s and 2020, the velocity of M2, for example, was cut in half, from 2.2 to 1.1. And it's now rebounded to about 1.4. And so what is happening is that the private sector now is unleashing the money balances that were created during the COVID expansion, complicating the job the chairman law has. At the same time that this stealth easing and the Fed's balance sheets in December is also complicating the problem. Now, we have to cut some credit or some slack here, because he's only been in the job a couple of months. But it is important for him to establish credibility. He has said all the right word. He has said that inflation is a choice. He has said that he is the stern anti-inflationist. But the fact of the matter is, he has to deliver on those promises. And if he does not deliver on those promises, then he will lose his credibility. And not only he will be yield served by that, but the country will be yield served. Okay, a couple of questions for you around that. Then we'll get back to that national savings, the low level of net national savings. For Worsh, how come he hasn't ended that QE program? He said, he opposed the second round of QE when he was a member of the board. And he wrote a significant paper. It's very scholarly paper with the Nobel Laureate Michael Spence, who was the dean of the business school at Stanford when he was a student. He was my dean when I was there. That financialization is caused. When the Federal Reserve comes in and gives the signal to the market that they're going to support the stock market, the liquidity in the stock market and the price level of stocks, if within when needed, then what that serves to do is it's a signal to the corporate managers that they should put more investment in financial assets and less investment in real assets. But here's the rub. It's the real assets that raise the standard of living. Not the financial investments. And so what has happened at the same time, that financial financialization in the Fed put were boosting the stock market. It's served to undermine the growth in the standard of living. 1970, 100 years prior to that, but in real per capita terms, we grew to 0.3%. Last 20 years, last 10 years, we've only grown it about 1.1% per ounce. The growth rate has been cut almost in half. You have to stick to the fundamentals. And the paper transactions can have certain benefits over a short period of time. But fundamentally, what you have to have is you have to have a successful operation of the country's production function. And what we're moving away from is a solid production function to a deteriorating production function. Right. Right. Which you said earlier. I guess what I just don't get is if Worsh has a history of thinking that way. And now he's in the captain's chair. Why doesn't he stop the balance you'd increase? I think that that would have been a very sensible program. For example, bank law. are increasing commercial and industrial loans, which is the most powerful impact of the banking loan situation has literally exploded since mid-December. And as I said, we've had the other categories increased very rapidly, including loans to non-depository financial institutions who in turn are lending to borrowers with very low credit. And while that process has short-term benefits, it's an indication that the large assets of the Federal Reserve is supporting an over-leveraging cycle, which could ultimately have highly deleterious effects on the U.S. economy. All right. Well, I am going to get to that national savings. By the way, Brent, I hope you're taking good notes. We're going to pull you in pretty soon. So, Lacey Hunt, free this year, was very concerned about deflation. And an important factor in your calculus back then, if I understood it correctly, was the debt situation, the deficit, the debt and the deflationary impacts that too much debt can have on an economy. Now you're more concerned about inflation. Why are you not as worried about the disinflationary impacts of too much debt, as you were before? Why are you less worried about that now? Well, let me say this, that debt was working in a deleterious way on economic growth. But it didn't matter because the production function shifted outward so dramatically. It was the other factors in the picture. But the increase in debt meant that people had to pay more in the way of interest expense and that shifted away from normal spending growth. And so, the net result was that the tremendous increase in the supply of global output and the interest effect of the debt was to produce disinflation. Now what is happening is that we no longer have the benefits of the aggregate supply curve of the world shifting outward. It's shifting inward. And the debt function will still work, but it will be overwhelmed by the effect of the capital shortage and the deterioration in the global production function. It took me a long time to realize that the interpretation that I made in the earlier period was not correct. I attributed the movement to the debt and it was not the debt. It was the production function. It was the expansion of the production function at that time. So, if I heard you correctly, the disinflationary impacts of debt, they're still here in the system, but the inflationary elements are so large that on a net basis, things are net inflationary in your eyes, which is the shift in your perspective. You just said it better than I did. No, I could never say it better than you, I say. Okay, finally, we get to net national savings. So, I know that one of the things that concerns you about the future of the economy is that it's productive, if I get this right, sort of productive investment comes from saved capital, not from the financial gerrymandering that the Fed or the Treasury might be doing with their gimmicks. But we have an extremely low national savings rate. You tell me, is it negative now or just very low? I think you have the chart. You're in a position to put that chart up. Yes, let me find that chart and hold it up here. Real slightly positive, we have the data going back to 1929. You'll see a couple of periods during the 20s, net national saving went, actually went negative. Then we went negative for a while during the GFC, but historically it's almost 7%, and we're currently less than 1% right now. And so, one of the fundamental propositions of economics is that physical investment must equal saving, not household saving. Household savings is only one component. We have to add in the business, the government sector and the foreign sector, and it's minimal. Now some people will say the Federal Reserve can come in and help to provide, well, the Federal Reserve can increase the money supply, but in the current environment, all that would do is would allow the pass-through of energy and other costs that are occurring, and actually worse on the inflationary picture. All right, Lacey, and I think I have the screen up here. Do you see it that your chart here? I know it pretty well. I don't see it, but I know it so well. Yeah, you've done a great job of talking to it. Okay. Yeah, there it is. Okay, great. Deeply negative in the 20s went negative during the GFC, and here we are in booming times. Stock market or record level, unemployment rate low, and net national saving is zero. And we have all of these capital demands, physical demand for capital. Lacey, if you look at the momentum of his chart, I mean, it's been in a downward trajectory kind of since like the mid-60s. Do you expect that to continue, meaning if we're having this conversation in a couple of years, you know, it might be negative two, negative four? I think one of the basic problems here is if you go back to 1970 before we exited the gold extension. Total government share of economic activity was about 35 to 25% of GDP. And today, it's around 25. I'm sorry, it was 25% in 1970. And today, it's 35. And there are two outstanding sweet and sweet economists, Hendrickson and Burke have pointed out that every one percent increase in the government share of GDP, it lowers the standard of living about one tenth of one percent. And their calculations are actually coming to fruition. So what you do is you engage in fiscal monetary and fiscal policies to try to make the economy do better. And they work for a short period of time like I believe will be the case with yesterday's intervention by the Treasury Secretary. But ultimately, they reduce the long-term growth prospects. And during that time period that we witnessed here in which the government share of economic activity came out of the rate of growth in the standard of living fell, we did not have the huge interest expense. And the federal budget that we have today, which is a whole new factor. You think you know a browser, but Jim and Ryan Chrome, that's new. It can help you with practically anything on the web. Like restoring a vintage motorcycle from a 50-page restoration block or finally break down that long article you've had open for weeks. Jim and I and Chrome is here for it. When you need to build up your team to handle the growing chaos at work, use Indeed Sponsor Jobs. Listeners of this show will get a $75 sponsor job credit at Indeed.com/podcast. That's Indeed.com/podcast. Terms and conditions apply. You need a hiring hero? This is a job for Indeed Sponsor Jobs. Okay. We'll see. I've only got just a couple of quick questions for you left and then we'll unleash Brent here. The Fisher equation, you think is quite important into this story. Can you just briefly explain what the Fisher equation is and why you think it's so relevant? Okay. So the Fisher equation developed in the purchasing power in theory of the bond market by Fisher in 1930 says that the nominal treasury bond yield is equal to the real rate plus expected inflation plus the risk premium. Now, it. Economist and virtually everyone else have just focused on the first two the real rate and expected inflation and they assume that the risk premium was mill So what do we have now? The real rate is gonna rise and The reason it's gonna rise Adam is because of what we just talked about That we have this imbalance between the demands for physical capital and the supply-saving So it's gonna drive the real rate higher inflation is gonna go higher Because we have wheat demographics Labor force is hardly going to grow and remember the Potential rate of economic growth is Increasing productivity plus the increase in the labor force So from since 1949 Productivity was two per atom growth the labor force was about one and a half percent So the potential growth in the economy was three and a half But going into a period where the labor force may be essentially stable immigration has come to all We've had a declining birth rate for a long time As we've known for a long time also The number of retirees is gonna increase significantly the baby boomers are now eligible for social security and Medicare and So the potential growth rate is not going to stay at three and a half It's gonna gravitate down toward two or two and a half and This really creates a significant problem for the Fed because Freakman's optimum quantity of money said the Fed target should be the potential growth rate plus the inflation target So the potential growth rate is coming down the two to two and a half If we have an in two percent inflation target money supply growth should be a four to four and a half and The latest year over year growth rate is is approaching seven and a half percent. It's too fast So we're we're like 60% or so over what Freakman's target would that is correct, and that recommend lead that's going to feed the rise in inflationary expectations And then the Federal Reserve The wash is at least started putting money supply and velocity into the Fed minutes Which is which it end to his testimony to Congress? This is this is a welcome development We're putting it in the minutes are saying that you're looking at it doesn't mean the same thing is if you are Taking account of what those variables are telling us about the economic future And so money supply growth is too rapid and and and right now we've not shown any action to curtail it and Then the last element which has not been a problem But is the is the risk premium and and the thing that that I believe is gonna change the risk premium is the fact that the interest expense is making It almost impossible From a political standpoint to address the deficit which means that the deficit direction is worse and worse Okay, and that means you think the risk premium will change by moving higher, right? There'll be more volatile the the secular trend can be reversed if we hit a recession Or if the Fed contains money supply growth or if we get a supply shock But the fundamental structural forces are Suggesting higher in a more volatile environment All right, and I just want to clarify that statement. So you see the future trajectory for inflation is higher Over time, but you're saying look there will be Cyclical events in there. So, you know, there can be periods where we go into recession say whatever that that in the short term Overwhelmed the long-term trajectory, but then things will mean revert and over time like I said its trajectory is higher And the cyclical episodes are in a response to a distinct monetary slowdown We could have a supply shock of some kind it would help us on the positive side not evident But I think what we'll find in a cyclical episode is that the the rates will decline But not nearly as significantly as they would in a more favorable global environment Okay, all right, Lacey two last questions for you then one is there anything else about your Your new framework that I haven't been smart enough to ask you about yet I don't think so Adam you covered the waterfront You are such a charmer I need to hire you as my publicist, okay, so Last question is is just okay, so Lacey If the viewers here say Lacey sounds wicked smart, I trust what he says is gonna happen Just what it what does that mean just rubber meets the road You know, what are what are some of the implications that come out of this, you know, obviously higher inflation higher prices as one that people should prepare for What else obviously this is not gonna be very favorable for bonds, which is your bellywick? I imagine going forward what other knock on effects that Just the regular investor should practically prepare for should your vision of the future prove true well one of the things that will happen here is that Demographic variables are very sensitive economic growth and As we go lower this won't escape our households They will understand this they understand it now and they're unhappy But the fact of the matter is the policies are sending us in that direction Which means that the birth rate which is which is already in a major downtrend Will become even weaker at the same time that we're aging and There's a reluctance to Bring in waves of new immigration Prepare that it will displace job opportunities for those that are already struggling And so the the demographics As bad as they are today will get worse and I think China's an example of a lesson. I mean the the the Chinese The average age in China is about 41 or 42 But every two years the average age goes up a year They've got a tremendous mismatch between young men and young women The young women are in tremendous demand, but they're reluctant to get married because the economic prospects are bleak and When they get married, they're even reluctant to have children and And so it's undermining them, but we're not in China's shape But that's that's sort of an indication of what the weaker economic growth will do to our demographics and There was a great French philosopher Contemporary of David Ricardo August Compte The former former really the founder of of Fundamental analysis hypothesis testing you believe that we should look at the facts to help us determine what's going on Try to avoid the value judgments, but he also made a very wise statement And he said demographics is destiny And and we don't have that now in our favor, and that was a big element For for my entire lifetime until now And that really changes the the whole mix of the economic variables as we go forward Okay, so we have sort of deteriorating Situation given our demographics here Um, I'm curious You know basically what I hear you saying is is all the people in America that are kind of struggling right now You sort of say like hey hate to say this but prepare for things to get even worse going forward And what's interesting is these policies which you're not very much in agreement with are still being done by administrations and fed chairs and whatever who Who believe in capitalism Right, they're they're they're they're trying to continue the capitalist Experiment um you may not be agreeing with the the policies we're choosing to do so, but that is their intent because of the Increasing will say emiseration of the majority of Americans that you see going forward do you expect Uh a major political shift to occur at some point and specifically I think one can argue we're already beginning to see it with a rise of Socialism um Here in America the rise of socialist candidates um Would you expect a movement like that to continue as people get more and more frustrated with how things are going for them individually going forward? You know um, I think that that's a risk, you know, I've read several times over the years that Panging in economics would help save capitalism and and maybe it gave capitalism boost along the way but over there is an in-game. When the debt and the interest expense undermine the viability of the Kingsian prescription, which is the only prescription that we seem to know. And so we've gone to more the government shares rising, yet the economic performance is deteriorating, and for some people what they think is the solution is even greater government interference. In other words try to remove more resources from the private sector to the government sector. Right. Which I get to imagine you are not in there, but the government sector is not the efficient allocator of resources, not the efficient allocator of capital. That's why I want one of the things is to serving about the recent action taken by Secretary Besen. What we want is we want the private markets to indicate the stresses and strains of the marketplace and not to be distorted. And so the movement toward socialism will actually accelerate the problems that we've been going forward. It will increase further the government share of economic activity, which I think will worsen demographics, not improve demographics. There may be some short term benefit, but it's a serious challenge, and the system is very vulnerable, in my opinion. And the reason is not just something that's happened in the last one or two years, three years or four years. It's a process that's been going on for a long period of time. That's new. Check responses set up require compatibility and availability very 18 plus. Listeners of this show will get a $75 sponsor job credit and indeed.com/podcast. Need a hiring hero? Brent, you have been ridiculously patient. I'm going to unleash you in just a second. I've got one last question here for Lacey. Lacey, I know you're very conscientious about this and saying that none of what you've said so far is personal financial advice. You're talking about these grand trends as you see them. I'm going to tell you what I'm taking away from what you're telling me, and I just would love your reaction to it. Given everything you said, it's hard for me to see, to make a bullish case for bonds in this future that you see coming. Yeah, that's for my baby. Okay, yeah. And then I think that I think that if we are staring at a prolonged inflationary era ahead, then assets that generally perform well in inflationary environments or have intrinsic value that can't be easily inflated away. I'm thinking of things like repression metals and other hard assets. Those are likely to do fairly well. Historically, that has clearly been the case. In my bedroom, we're just leaving it at that. Okay, great. I got what I needed from that. Okay, thank you. All right, Brent, buddy, thank you. I'm sure I've seen you fiercely taking notes the whole time here. So I'm just going to unleash you to ask whatever questions you'd like to ask Lacey here. Sure. So Lacey, first of all, thank you for including me on this and you probably don't remember this. I think it was five or six years ago. I had some questions about all of this and I called you. And you took my call and you were very patient and very understanding with my people attempts to get my hands around this. So I hope you grant me the same grace today that you did back then. Well, it's I've greatly admired your work from afar. And I'm sorry that we haven't met other than over the telephone. And I'm glad to see you face to face, Brent. Yeah, yeah, good, good. Okay, so one of the questions, well, obviously one of the things that has dominated not only this conversation, but much of the last two years. And specifically the last year with regard to long rates is that the the interest cost is now much higher interest rates are much higher on the debt, whether as just an absolute number or percent of GDP, percent of income, all of that stuff. And I can certainly understand the problems associated with that. The question I have is I think sometimes people forget that those payments are going back into the private markets. And so it's not like that money is going down a hole. It's going back into people's accounts. And then that money gets sent to lead to a certain extent into the economy. And so my question to you is, do you believe that higher rates are stimulative up and until we hit the wall? Or am I misunderstanding that? This is the way I would look at it. Of course, there are a lot of interpretations here, but the if you look at our household saving. And you look at it by each desial. I think what the data will show I haven't looked at it in a little while. So my memory could be a little off here, but the net national saving for the lower eight desials is virtually zero. That all the saving is done by the top two desial. And so when you have higher interest expense, it increases the income of the first and second desial. Whereas the increase in interest expense is much more important to the lower eight desials, because they need to borrow money to have a better quality life. They need to have a good mortgage so they can have a high mortgage so they can get a good ice and likewise. And so the rise in interest expense, the burden of it falls on our modest and moderate income households. Whereas the benefit accrues to the theft of our households. And the fact is similar to inflation. Inflation robs everyone. I think that's clear. But it does the greatest damage to the modest and moderate income households. And so when the inflation is higher, interest expense is going to be higher. And the benefits slice the wrong way. Great question, Brent. Great question. Well, and so then I would assume that that, in your opinion, correct me if I'm wrong, is what is probably contributed greatly to the K-shaped economy. And it's why those, the uppercase keeps going higher and the lower part of the cake keeps going lower. No, I think that the quantitative easing feds balance sheet. We've seen it many QE, in my opinion, last eight months. And academic research supports this. If you look at the work of Darrell Duffy at Stanford University, Ricardo Rees on the School of Economics or Mark Gerber, when the fed comes in like they did in December, it brought down the credits breadth, which gave the impression of economic strength, encouraged activity there, stimulated the stock market. And there were a lot of folks that benefited very significantly from that. But the benefits were very, the benefits were quite asymmetric. And so we need policies that are going to lift the overall standard of living. And we can't do that if you, if what we're doing is relying on increasing federal budget deficits and somehow the monetary authorities to do a dance that makes the process look good outwardly while it's declining inwardly. Another great question. So the other thing that we just talked about, and I've seen been seen more of it, or you and Adam talked about it, and I've been seen more of it over the last couple of months, is at least it seems to me a reversal of the fiscal dominance. And what I mean by that is the other part of these higher rates, the demand for cash from the government and the higher interest expense leads to this fiscal dominance and the crowding out, where you know, because more capital is going to have to go to the government's needs, it's going to crowd out the ability for the private market to get it. But it almost feels like that's getting reversed with these hyperscalers. We've talked about how, in some ways, the hyperscalers are crowding out the government and as a result, that's one of the reasons long-term yields are going higher. Do you agree with that? Or do you think that's a good way? I think it's a married to your argument. The way I would say it is they both have huge demands for credit. The private credit demands are increasing much more rapidly right now than the government credit demands. But the fact of the matter is, if we had a normal tactical policy, the federal budget deficit should be falling. We're in a late state's expansion. This is supposed to be the best of all times. And virtually no one in the country is happy with the exception of those that are heavily invested in the stock market. Great, great, additional question there. Okay, so now I want to ask you about the best since move yesterday. I think I think you said it was a gimmick, I tend to agree. But I think, at least from what I've read so far, I think there's perhaps a misperception of why he's doing what he's doing, at least from my side of the business. My guess is that he is doing this as much for the long-term bond holding portfolios that the bank's own as he is for the cost of funds from the government. In other words, I would guess he is more worried about the bank's long-term portfolios decreasing and values as interest rates rise, so then he is in the ability for the treasury auctions to function properly. Do you think I'm off base there? Well, I have a look at the note numbers a little bit, but I think the average treasury portfolio at the commercial banks is under five years, whereas their buying is in the 10 to 20 year area. They're not buying in the intermediate portion of the curve where the banks are invested. But on the banks, they do have a difference between, I think, I don't know the exact technical terms that they use, but there's kind of a short-term and tradable portfolio, and then there's other bonds that they buy, and they have to classify them as long-term in order to not have to mark them to market, as I understand it. They do have that classification, but I think when you waited all out, I would be very surprised if the average maturity is much greater than five years. Okay, banks just don't typically operate there. Even if you look at the Fed's loan portfolio, I mean, the commercial bank loan portfolio and the Fed surveys this on well-not-a-well-known source, I think the average loan at the bank is probably less than five years, too, so I think the bank are intermediate to short-term lenders. We certainly were. I spent almost half of my career in banking, and of course I was in the Fed Reserve, too. The banks are not really much in the way of seven, ten, twenty, thirty-year-type lenders. Okay, so going back to, we talked about, I guess, the inflationary effects of QE, the certain extent or the continuing programs, the extension of the Fed balance sheet, I would argue that part of the reason that that has contributed then to higher inflation is not necessarily because what they are doing, but because what the commercial banks are doing, because they are the ones that actually create the money when they loan it. As you mentioned earlier, the extension of bank balance sheet has been going up because they have been extending credit. So I guess my question to you is, how does, how do wars and bests manage that process? Because they want the banks to continue to lend, they don't want the, they don't want the banks to not lend because then that would restrict liquidity, but how do, how do they balance the, the past keeping the bank lending but not having the higher inflation? Well, what you have to do is you have to make sure that you, you have to basically apply Friedman's optimum quantity of money. That's the thing. It's, it's all, what you said is sound, extremely sound and, and, and Friedman's rule was that you take into a rate of growth, the rate of growth and productivity. That's it to labor force is trending down towards zero, which means that the potential growth rate is, is maybe two, two and a half percent now in this current and demographic environment. And also we've not only got, it's more complex. We have retirees, fewer income works. And in addition, there's your inflation target. So money supply growth needs to be four to four and a half percent. It's too fast. They need to get it down there as rapidly as possible. And I don't really think that, um, Besson's action, Besson's action, it's trivial, I mean, it's 14 treatment. Yeah, I mean, it's so small. Right. It's, it's symbolically a problem because once they started the market may insist that they continue it. In other words, it gets them trapped into providing a put. And what that would mean is that they then are going to continue to distort the functioning of the treasury bond market, which chairman war says he doesn't want fiddled with. And I think that that sounded fine. Well, yeah, I mean, a conflict and I think that it increases the need for war to as soon as possible, once he, once he's established himself a fair to establish his bona fides in terms of the carrying out of monetary policy. Words are not enough. They have to be confirmed by action. And he may have a little bit more time, but I suspect the clock is ticking. It can help you with practically anything on the web, like restoring a vintage motorcycle from a 50 page restoration block or finally break down that long article you've had open for weeks. If you need your job posts, the boost it needs to be seen and helps reach people with the right skills, certifications, and more. That's indeed.com/podcast, terms and conditions apply. Meet a hiring hero, this is a job for indeed sponsor jobs. Yeah, I hate to intervene here. Just giving a time check. We've got about eight minutes left. So wonderful questions, Brent, just letting you know a bit of the time situation and also two. It's fine. And I just want to toss one in case it's not on your list. You are the dollar milkshake, man, Brent. One of the things that we haven't discussed yet in this conversation is what is Lacey expect for the dollar going forward, giving the dynamics that he's laid out for us. If that's of interest to you to find out, I'd love to hear the answer. Great. I suspect that the dollar is going to have increasing problems, but I think the rest of the world is also going to have increasing problems. Physical policy is no longer working in a traditional Keynesian manner, but yet no one knows how to do anything else except apply additional Keynesian techniques. And so in this environment, I think we move back and forth. The near term direction and the dollar might be lower, but I think that ultimately these will, the episodes will follow that will sort of bring the dollar back. There's really no one to lead the global economy to that. That's the bottom lines for some concern. So we talked about the Fed, I'm sorry, the Treasury having to pay more in interest payments and how that money goes into the economy. We talked about how the banks are continuing to lend, and that creates new money into the economy. Well, it's the excessive rate of lending that I'm concerned. Okay. Fair enough. Fair enough. The one thing we have not yet talked about is the massive amount of capital that has come into the United States from abroad over the last 10 years. I don't have the number right in front of me, but I think the net interest, net international investment position in the United States has almost doubled in the last 10 or 12 years. And a lot of that has happened in the last five years, to host to it. It seems to me that also contributes to the K, of the K shaped economy going higher. And I think all things being equal, we would rather be a magnet for capital from around the world. [BLANK_AUDIO] want to tell the world you could no longer participate in the United States. So to a certain extent I think that that contributes to the upper side of the K and I wonder if if you agree or if that's just something that is just a coincidence but not causation. No, I think it's an and it's a beautiful fact and in fact if you look at the tick's data in the last 12, 12 months that the increase in equity investments which would include flows as well as appreciation is almost the treatment hours in just 12 months alone. The Treasury, the investment in Treasury, however, is dwindling down and coming off quite significantly because there's a an opinion that on foreign investors it leased up until now that they don't want anything to do with fixed income and they won't they just want to take advantage of the stock market but it has been a sizable investment there. Yes it has no question about it. Okay, now here's a rather dark question so give me. Would this be easier to solve if we were not a constitutional republic? I don't I don't know any I don't think of the parliamentary forum as doing any better than we are. Frankly well do you think that the non-historian is a history is my allocation but I'm not expert but it looks like the parliamentary government in England and Germany and France not functioning that well either. What if you had more of benevolent dictator? I wouldn't want to go there. I don't think that that's desirable. No no no I don't want to go there anywhere. I'm just I'm that that's where my mind goes unfortunately. Okay so I think we have to make decisions collectively. The problem the problem is that we collectively are apparently increasingly less smart every day that passes. So is it fair to say I think what you were saying to Adam and I'm just asking for clarification not not challenging what you said that you see let's say over the next 10 to 15 to 20 years higher rates higher levels of inflation but along the way there may be periods of disinflation along the way and is that because you see the cost of capital rising the potential supply shocks showing up which then caused these short-term perhaps supply shocks would push prices higher and then those higher prices create the pressure that creates short-term deflation and then the central bank or the treasury announces these new programs that try to re-inflate it. Is that is this back and forth yo-yo part of the reason you see it trending higher over time or is it just the structural issues that we face? Well I think I don't think that the capital shortage is a story for several years and I think that I don't think that we will go back to to the era of globalization. It proved to be too costly during the pandemic it proved to be too costly with the conflict in the Middle East the conflict between the Ukraine and Russia. Supply chains have to depend upon availability and certainty. We can't do just in time inventory and all relying on economic resiliency costs. Moreover when you begin to fragment markets which is what's going on today you do not get economies of scale. We talk about that in economics but it's invisible but it's one of the most important concepts in economics and so until we can reestablish the global era in a more equitable footing and keep in mind if the footing had been more equitable maybe it wouldn't have dissolved but nevertheless it is what it is. Great last question then I'm going to hand it back to Adam. This is kind of a broad one but what does this mean for the rest of the world? In other words can we have all these problems in the United States perhaps recessions perhaps crises however you want to define that and the rest of the world not be affected as a result of it? No because we're still we're still the world's predominant engine of growth and that'll be the case for the time being China cannot do that role. I think we're seeing high-come defruition in China you know ultimately commanding control economy so the seeds of their own demise. We saw this in the case the Soviet Union but China has just great economic problems which stemmed from too much commanding control and that should be a lesson to all of us when many people are advocating a greater commanding control economy. Commanding control economies do not work they break down they become more inefficient you don't have the marketplace allocating capital and resources you have the government and but with the thing about it is what we're seeing now is more industrial policy with industrial policy is just an aspect of commanding control and it doesn't lead to efficient allocation of resources and with that I hope we end it. Well I will continue to maintain you with a nicest guy in finance. I wouldn't know about that I'm just an old boy from Texas. Well gentlemen it pains me to do this I think I myself but I think a lot of the viewers would love for this to go on for another hour and we're just having to deal with the time constraints that sadly were put in place before we started recording here but fantastic conversation. Lacey thanks for being so detailed and generous with your analysis here and it's fascinating and I think very important to the future. Brent great questions my friend I'm sorry we couldn't play in a little bit earlier. Yes absolutely. You did great. Okay last question for both of you for folks that have enjoyed listening to you here and would like to follow you in your work where should they go. Lacey we'll start with you. Well we as a public service we post our letter quarterly on our website which is hoisin.com. Educational either public service and as for educational purposes only. Okay so again folks I want to go there it's hoisin.com. Brent how about you? The best place to go to follow our work is research.stomptiagocapital.com and I'm also pretty active on Twitter I'm not quite as much of a gentleman as Lacey is if you want to if you want to mix it up on there I'm not particularly there every day. All right and I highly recommend Brent as X follow it's it's a great education and yeah when he takes the knives out it's actually fun to watch. Lastly folks if you'd like to get another dose of Brent and Lacey in the same place at the same time they will be presenting at Thoffamoney's fall online conference which is going to be Saturday October 17th. Don't worry if you can't watch live. Everybody who registers is going to get replay videos of the entire event but Lacey kicks it off with a grandiose keynote and so if you want to hear his latest thoughts on this whole framework he's been walking us through here you'll get those at the conference there in mid-October and Brent has very graciously agreed to come back as a faculty member and Brent feel free to react to anything about Lacey's presentation then but obviously with love to hear your latest thoughts on the whole dollar milkshake theory and where you think the dollars headed. General oh and so if you're interested in that folks just go to Thoffamoney.com/conference you can get your ticket now and you can actually get it at the lowest early bird price discount that we're offering so it's good time to get a great deal on that. Gentlemen this has been such a pleasure Lacey thank you so much for agreeing to do this yeah. Thank you. Brent it's always wonderful to be in your aura buddy. Wonderful job to all of you and everybody else I hope you've really enjoyed this presentation and I'm sure the folks at zero heads are kicking up or cooking up some great follow-ons to this with some other great minds. Hope you tune in for that too. Good everybody. Thanks so much for watching. Great. You think you know a browser but Gemini and Chrome that's new. It can help you with practically anything on the web like restoring a vintage motorcycle from a 50-page restoration block or finally break down that long article you've had open for weeks. When you need to build up your team to handle the growing chaos at work use indeed sponsor jobs. It gives your job post the boost it needs to be seen and helps reach people with the right skills certifications and more spend less time searching and more time actually interviewing candidates who check all your boxes. listeners of this show will get a $75 sponsor job credit and indeed.com/podware. Need a hiring hero? 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