John Maynard Keyne’s treatise, the General Theory of Employment, Interest and Money that was supposedly a solution for depression and deflation was not published until 1936, i.e., after the Great Depression. Between 1941~1979, the Keynesian economic philosophy was in its ascendancy, but the US economy had already pulled out of depression by then. From 1979~1979, criticism from Milton Friedman and what became known as the monetarist economic philosophy replaced Keynesian thought, but the US Federal Reserve officially abandoned monetarism as a monetary policy in 1984.
As a result of the worst financial crisis and economic recession in 80 years, everyone has suddenly become a Keynesian again. President-elect Barak Obama’s economic team is perceived to have a strong Keynesian bent, including Lawrence Summers, Timothy Geithner and Cristina Romer.
Americans (of which I include myself) would still like to believe that they can avoid a major debt deflation/depression like the 10-year malaise that Japan experienced in the 1990s, but the jury is still very much out on this conclusion, even with the inauguration of Mr. Obama.
As observed by Milton Friedman, money stock during the Great Depression (1929~1933) decreased a massive 31%, while the velocity of money (defined as GDP divided by the money supply) fell 21%. The result was a 50% decline in GDP. Famous economists like Irving Fisher, Charles Kindleberger, Hyman Minsky, Joseph Schumpeter and Nikolai Kondrachieff have observed that “all or nearly all” other economic variables (such as during 1929~1933, 1837 and 1873) are effectively controlled by excessive debt and price declines during debt deflations. Once debt deflation begins, fiscal and monetary policy become impotent to stimulate the economy because the velocity of money is declining.
The US Fed has essentially pulled out all the stops in dramatically inflating its balance sheet and making every effort (including quantitative easing) to expand the money supply and ensure liquidity. The Obama administration is promising record ($800 billion-plus) fiscal stimulus. But government investment and spending was but 17.8% ($2.1 trillion) of the US economy in Q3 2008. Between Q4 2006 and Q3 2008, household assets (real estate and stock assets) depreciated by some $5.6 billion, and the losses are expected to have exceeded $10 trillion by Q4 2008.
New York University’s Noriel Roubini now says that losses in the financial system could exceed $3 trillion, and has been steadily upping his forecasts of the potential losses since boldly predicting that losses would reach $1 trillion at a time when the government and other economists thought the losses would be 1/4th that. Goldman Sachs is now estimating that total losses and write-offs in the financial sector will reach $2.1 trillion, while major banks, insurers and GSE (government sponsored enterprises like Freddie Mac and Fannie Mae) had realized just over $1 trillion at the end of December 2008. However, as we have seen over the past week, the losses continue on a global basis, necessitating further bail-outs in the US, the UK, Ireland, France and other OECD nations.
This after the Fed and US treasury had committed over $8 trillion to backstop the US financial system. As an indication of the balance sheet deleveraging that still needs to be done, Merrill Lynch has estimated that the major European banks would need to shrink their balance sheets by 5.5 trillion Euros to bring them back in line with pre- credit bubble (2002~2003) levels, whereas only some 800 billion Euros of deleveraging has occurred so far. In addition, the $3 trillion number of losses quoted by Mr. Roubini compares to US bank capital of only $1.4 trillion when the crisis began—i.e., the bulk of the US banking system is effectively bankrupt.
All of this Keynesian fiscal largesse comes at a time when total debt (government, financial sector, non-financial sector and individual) in the US has already reached some 360% of GDP. This is already a mind-boggling number, and is poised to become even more mind-boggling.
Yet the historical pattern of debt deflations indicates that the ultimate low in US treasury yields lies years away. That said, the path to the ultimate low will not be a straight line. As the experience from Japan indicates, there could be many “false dawns” that draw investors back into the stock market. If history is any guide, however, these “bear traps” will only result in more losses and further wealth destruction as the persistent forces of a debt deflation. In Japan from 1988 to present, in the US from 1872 to 1892 and between 1928 and 1948, the total return on bonds exceeded the total return on stocks. Thus the currently popular notion that Treasuries should be shorted could prove to be a painful exercise. Another approach to the same question is to look at the reverse yield gap in equities versus bonds. Japan has had a reverse yield gap on equities versus bonds on and off for the past four years, while the US and the UK are also now experiencing reverse yield gaps.
The yield gap can be expressed as the expected risk on equities minus expected growth on dividends, with inflation and growth being crucial factors. A steep fall in bond yields indicates growing fears of deflation as well as a flight to safety. Conversely, a steep rise in equity yields indicates growing fear of a collapse in dividends. In Japan’s experience, the yield gap has tracked GDP growth relatively well over the past decade. When nominal GDP is negative, the yield gap is also usually negative, as GDP growth is a proxy for dividend (profit) growth. Following the Great Depression, investor perceptions of equity risk dramatically changed, resulting in a reverse yield gap that persisted until around 1959. In other words, investors came to demand a yield premium over bond yields to purchase equities because of the perceived risk.
Japan investor tokyo takes 