Did we grow our way out of WWII debt?

 

We are facing a major debt crisis in the US, yet the alarm bells don’t seem to matter. The argument is that we run the economy hot, and stronger growth will get the debt issue under control, or at least allow us to see a decline in the debt-to-GDP ratio. 

The argument for growing our way out of the debt crisis rests on the view that we have seen high debt before and solved it through growth. The WWII debt was huge, but the debt-to-GDP ratio declined during the post-WWII expansion. The COVID debt expansion was like a world war, yet we can solve the problem through strong post-COVID expansion. 

In an interesting paper, “Did the United States Really Grwo out of Its World War II Debt”, we find that this argument may be wrong. Debt/GDP would have declined much less if not for the policies of the pre-Accord peg (financial repression) and the distortion of real rates from surprise inflation. 

The debt/GDP ratio fell from 106 to 23 percent in actual history, but if not for the rate distortions, it would have declined only to 74 percent.

This is an interesting application of counterfactual analysis, yet it is a sobering thought that solving the debt/GDP problem will have to come through surprise inflation and financial repression.

From theory to reality - the ineffectiveness of socialism

 

Chantrill's four laws on the ineffectiveness of socialism. 

1. Socialism cannot work because of prices for multiple goods (Mises)
2. Administrative government cannot work because of the Knowledge Problem (Hayek)
3. Regulation does not work because of “regulatory capture” (Stigler).
4. Government programs cannot work because you can never reform them (Chantrill).

There is the positive economics of what we would like the economy and the normative of what it actually is. Reality often gets in the way of theory.  All things are flawed, and systems are broken. Economies are often inefficient due to structural issues rooted in human behavior. Our job in finance and economics is to determine how to navigate an inefficient system to move capital and resources to the places where they will have the greatest impact.

Earnings sustainability and equity returns

Nothing lasts forever. Many believe that trends are sustainable over the long term, but that is not the case, so today’s trend or growth rate may not tell us what will happen tomorrow. Too often, analysis compares two variables with the same timeframe when it is important to look to the future. In the case of long-term earnings growth, strong earnings today are not linked with strong forward performance. The chart above shows long-term earnings growth and compares it with forward earnings. There is a strong negative relationship. We should see forward earnings versus forward returns, and current earnings growth versus current returns, to close the loop on different combinations.

The end result is the same. Stock returns are tied to forward expectations, not what has happened currently or in the past.

Kahneman's solution to system1 thinking

 

Daniel Kahnemena came up with the idea that people either use system 1 or system 2 decision-making. In system 1, the brain makes impulsive decisions with little analytical thought, leading to behavioral mistakes. In the case of system 2 thinking, the brain slows down and uses analytics and logic to mkae decisions. There is nothing wrong with system 1 thinking when appropriate, and using system 2 for all thinking may be exhausting. Nevertheless, to combat the problems of system 1 thinking, Kahmean uses the SODAS problem-solving framework.

The SODAS acronym stands for situation, options, disadvantages, advantages, and solution. To bypass the automatic System 1 mind, the decision-maker should first define the exact problem faced, then review or brainstorm possible options to handle the situation. Third, the decision-maker should list the disadvantages and then the advantages for each available option. Finally, the decision-maker should select the best solution after the review. The SODAS method. It’s not the first, nor the last, method for making better decisions. It is simple and direct, and anyone can try it. 

Follow those small cap stocks; not the overvalued mega-caps

 

With all of the talk about the AI revolution and the Mag 7 over the last year, many investors have missed a really strong investment story - the rise of small-cap stocks. 

There has been a strong move in 2026, but more importantly, there is strong outperformance versus the megacaps. The market is signaling it wants to rotate out overvalued large caps and start putting money to work in smaller caps. Whether the story is about extreme overvaluation or opportunities in smaller, riskier names, the result is an opportunity that we have not seen for some time. There has been the view that the small-cap premium is dead, but there seems to be new life in these names that requires a second look.

Gun violence - the solution is following the research

Finished reading Unforgiving Places: The Unexpected Origins of America's Gun Violence by Jes Ludwig of the University of Chicago and I am once again awed by the power of good economic research. I may have had some biases before starting the book, but I had an open mind to learn about one of the worst problems in America. 

Ludwig also presents his case and evidence without any political bias. He wants to get to the heart of the issue, and, as with many economic problems, the obvious is not always right. Most of our views on many topics are, at best, only partially correct and do not serve as the only answer. Ludwig presents all sides of the argument about why there is gun violence and what possible solutions there are, but the main driver is behavioral economics. Gun violence is not about rationality but often irrational or, as Kahneman says, system 1 reactionary thinking. You put guns in the hands of people that have different reactions to situations not based on rational but on react, fight or flight thinking, and there will be a problem with tragic results. He makes a strong argument that many current models cannot explain why two neighborhoods that are adjacent and have similar demographics can have very different gun violence statistics. The only explanation is behavioral and social interaction between individuals. The poverty argument cannot explain gun violence - there are too many contradictory facts, and the idea of "bad people" does not explain the majority of violence, nor can using jails be the solution. 

For something inherently political, this book is well-written, thoughtful, and shows the power of good research that is able to separate common opinions from real facts. 

The end of forward guidance - Good, let's use rules

 

Recent comments from Fed Chairman Warsh suggest that he is not in favor of the current forms of forward guidance. No dot plots, or perhaps not in the current form. The Fed has proven to be a poor forecaster, so the guidance may not be helping the market. It does not make sense for Fed governors and presidents to give speeches on their views of the economy when most are wrong. Let’s not have the market hanging on guidance that may be wrong. 

I have always been in favor of having a more rules-based approach that provided clarity on the general direction of policy. Can there be deviations from the rules? Yes, but there have to be good reasons that are infrequent. Of course, many governors and presidents like to give speeches, so there has to be a change in the messages to the market.

Gold overtakes Treasuries as central bank reserves

 

From work done by the ECB, gold has now overtaken US Treasuries as the largest reserve asset for central banks. This is driven by the strong price appreciation of gold over the last year, even with the recent declines. US Treasuries have seen yields rise, reducing the value of the asset. This is not surprising, given the strong buying by central banks, especially over the last four years, amid rising inflation. Still, it suggests that central banks have less confidence in government debt as a safe asset.

Safety is relative, and from the perspective of central banks, it makes sense to hold an asset that is likely to preserve its value during periods of higher inflation. Is the inflation-gold link strong? Not really, but it does seem to be a better inflation hedge than bonds when an inflation shock is expected. Gold can earn some yield if it is leased, but generally there is no yield, whereas bonds may earn a positive real yield.  

Central banks are telling us they lack confidence in their ability to control inflation globally.

Forming better decisions through known, unclear, and presumed framework

 

This book, Thinking in Time: The Uses of History for Decision Makers is now 40 years old, yet it provides some good, simple insights on how to make better decisions. You may not be interested in the political stories provided, but they provide context on how best to use the Neustadt and May framework.

The method is defined as the K-U-P/L-D, or the known, unclear, and presumed, which is then used to compare with likeness and differences. 

Determine what is known, define what is unclear, and then assess what is presumed by the decision maker. The decision-maker should then look for likenesses and differences in history, which can be used to define what is now of concern and what will be new objectives. 

The authors suggest the Gldberg rule: don't ask "what is the problem?" Rather, ask, "What is the story?" by using a timeline from now to the start of the story.

Be a journalist and ask when, what, where, who, how, and why. 

While this is not a quantitative process, it can be useful for framing discussions. 

The current inflation divergence - trimmed mean versus core PCE

The preferred inflation measure for the Fed is core PCE. The idea behind using a core measure is that it filters out extremes that may be driven by supply shocks. Fed Chairman Warsh has a different preferred measure: the trimmed mean, which includes food and energy but removes extreme values, both high and low, from the inflation index. If food and energy are on the high end, those prices will be trimmed, but that need not be the case. 

History shows that the trimmed mean is smoother and will lag the core PCE, but now we are seeing something different: the core PCE is rising while the trimmed mean is falling. Which one you place more stock in will drive your decision on Fed action and the direction of rates.

There will be politics over whether Warsh will be able to get others on board with the trimmed-mean measure, and that will determine any Fed action. 

Warsh politics starts inside the Fed

 

The most important political issue for Fed Chairman Warsh is not working with Congress or keeping President Trump happy, but working on the politics within the Fed. While not like the Volcker period, the current problem is the uptick in no (dissents) to yes votes during the last year of the Powell era. While dissent does not make the Fed ineffective, it creates more market uncertainty. A high dissent ratio indicates disagreement over policy direction, which will spill over into market thinking. Is consensus necessary? No, but it is helpful, especially if there is a change in policy direction.