John Hussman: Structural Problems Remain

by: John Hussman

Excerpt from the Hussman Funds' Weekly Market Comment (1/10/11):

If we are looking for policies to encourage economic activity such as real investment, the best approach is to create an environment that rewards the accumulation and productive allocation of savings. Instead, the Federal reserve is punishing savings by depressing the rates of return available on nearly every class of assets, while simultaneously ensuring that whatever scarce savings do emerge are misallocated to the most speculative pursuits.

Look historically, and you'll find that growth typically does not follow depressed or negative real interest rates, but instead usually follows high ones. High real interest rates are an inducement to save, and therefore encourage the accumulation of savings that can be allocated to productive investment. Undoubtedly, the situation is helped when many productive investment opportunities exist. In that event, real interest rates are also bid up by demand for funds to needed finance these projects.

In the chart below, real interest rates are in blue on the left scale, and real GDP growth over the following year is depicted in red on the right scale. While there were periods of strong GDP growth in the 1960's and 1970's beyond what would have been expected given the level of real interest rates, it is important to recognize that population growth and other factors at that time combined to produce a growth rate in "potential GDP" (which is regularly calculated by the Congressional Budget Office) that was nearly double the rate that can be expected over the coming decade.

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As I've noted in recent weeks, simply to gradually close the present output gap over a 4-year period (which has historically been reasonable), the "mean reversion benchmark" would be for GDP to grow by about 3.8% annually over the coming 4 years, with average employment growth in the range of 200,000 jobs per month. The problem is that while this might be the outcome if underlying structural problems were absent, in reality the U.S. economy continues to be burdened by continuing underlying fiscal challenges and credit difficulties - even if these difficulties are made opaque as a result of 2009 changes to FASB accounting rules.

For now, the surface veneer of economic recovery continues to be relatively intact. That may change at some point, for example, around mid-year when Federal stimulus runs out and state budgets hit what is referred to as "the cliff." But in any event, the distortive policies of recent years will most likely provoke another downturn long before we take up the existing output gap. The process of stable recovery would be dramatically helped by debt restructuring and abandonment of the more egregious efforts to distort the credit markets through Fed intervention, but there appear to be few prospects for more enlightened policy here. We have to invest in the real world, and during the next several years, we will almost certainly live in interesting times.