The Debt-Deflation Theory of Great Depressions (1933)
Following the Great Global Unified Response to the Global Financial Crisis (GFC), we are coming to the end of the first "huff and puff" stage. Most government interventions and spending initiatives in response to the world Great Recession are now running to their end ... or at least, are being evaluated for their effectiveness. It is clear that spending and stimulus programs in Canada, the UK and the USA (not to mention many other nations) have not yet pump-primed self-sustaining recoveries. What will it take to do so? Unemployment remains high, households continue to deleverage, and more credit assets continue to submerge under still tepid real estate values. And, in the US, government revenues are still tracking 10% below year ago levels ... and this almost two years after the onset of the Great Recession.
As such, as 2010 dawns, we are coming to an important point of confluence in a number of respects. For one, the premise that monetary and fiscal interventions can solve any and all problems anytime without limit will be up for a test. Over $10 trillion in interventions of various types in the US have yet to deliver a confirmed self-replicating economic recovery. Will more stimulative programs be introduced? Or will Western governments decide that budget deficits are already extreme enough ... that exits must be soon attempted? It is an important question as it also relates to a basic context of the Great Recession. Is it a typical recession ... or, one of those rare "balance sheet-driven" downturn? There is a big difference.
To date, statistics definitely betray that the latter type is being experienced in a number of countries ... Spain, the UK, some peripheral European countries, and above all, the US There, both households and corporations are deleveraging. For the first time, since the 1930s, households (whether voluntarily or involuntarily) are reducing outstanding credit ... some 4% lower year-over-year in the case of households. Massive amounts of capital were destroyed. And, demand for money has risen hugely. Why else would short-term rates nearly drop to zero? The key question to resolve, therefore, is this: Just how large and long will this shift in behavior last? Will it run a few years longer? Such changes certainly lasted a long time following previous Great Recessions or Depressions. That was also the case in Japan throughout the 1990s.
The answer will also resolve another great debate ... is an inflationary blow-off inevitable or will deflationary forces continue to weigh down the ship?
Here, famously evident, are two major camps. On the one side is The Keynesian-Krugman Cabal (the KKC, presently fronted by Paul Krugman, Joseph Stiglitz and others). These are the proponents that are inciting the "gold thesis" which is now sure that massive monetary malfeasance and long-term government budget imbalances must eventually transpire in a dollar crash and a gilded moon shot for bullion and other nearprecious commodities. These indeed would be logical outcomes provided that the American household can find a way to again launch a new debt-driven spending spree. The KKC take the position that massive stimulative spending must continue ... i.e. if peacetime budget deficits of 14.5% of GDP don’t do the trick in generating economic recovery faster than stall speed, then even higher deficits must be attempted. Future generations can be left to atone for today’s desperate bail-outs. The KKC is convinced that steep yield curves and heavy government deficit spending will do the trick as always. A legacy of enormously higher government debt levels can be survived, say these fiscal spendthrifts.
On the other side, roughly categorized, are the deflationists. Many in this group have been influenced by classical Austrian School economic thought. They argue that ultimately, after the world has run out of string (bubbles, collateralizable assets, and human gullibility) all asset prices do collapse to underlying productive values as a surfeit of debt and credit are destroyed. Then, once all malinvestment is rightly written-off, the system will quickly reprime, and recovery ensues. We admit that we identify with this latter camp. However, the question remains: Can the KKC engineer at least one more inflationary "last hurrah" before the deflationary "deck clearing" of malinvestments finally occurs? Or, is it more likely that a long-running stagflationary stand-off will take place? Though this is the minimum intended objective of policymakers presently, the jury is still out. And, frankly, in our view, the probabilities are still rather split requiring us now to stick to the safe shore of a relatively balanced asset mix between bonds, stocks and commodity exposures.
But, there is one major structural factor that stands to tip the odds to a further credit contraction ... a longerrunning environment of low interest rates (probably with high real rates) and high and increasing government debt: Demographics. As the graph on the front page shows, advanced OECD nations -- which includes North America -- are experiencing an aging phenomenon in their populations. The older cohorts who are nearing retirement age are waking up to a stark reality. The long predicted "income crisis" has finally happened. Many pensions are underfunded and those relying on selfmanaged savings programs or defined-contribution plans are discovering that expected retirement lifestyles are looking grim. Due to the losses suffered in the Global Financial Crisis (GFC), a not insignificant number are choosing to retire later. Many are resolved not to lose any more of their retirement capital. As a result, a change in spending and savings behavior is underway, not to mention in risk appetites.
In fact, it could be argued that deteriorating retirement demographics already were a major factor at the root of disappointing returns over the past decade. As populations age, (assuming no more than modest productivity growth) there will be less income -- quality and quantity -- than is required at the very time that it is needed most. Simple mathematics proves this apparent paradox. These pressures have lured investors (both private and professional) up the risk curve ... attempting to accumulate retirement assets through capital gains. That is all well, good and sustainable, provided that underlying incomes grow as well. Without supporting income growth, inflated asset values cannot be sustained over the long-term. Indeed, the downside of this imbalance already has played out to an extent.
Now that short-term interest rates are near zero, core inflation still comatose, 10-year real rates are high, and chastened cohorts nearing retirement are in a defensive mode with declining appetites for risk, the rush for sustainable low-risk income may have begun. An aging population cannot comfortably tolerate low interest rates ... certainly not zero. In the past, we have dubbed this condition Zero Intolerance.
The remarkable phenomenon being witnessed is that any sure and safe income is now being pursued. In a sense, households beleaguered with low employment income growth, decimated retirement portfolios and home equity have become conservative. They know that the leveraging game is over ... and, in any case, knew that it never was sustainable. One doesn’t need to be a Wall Street economist to know that. The reason that the recent bubbles did occur is because it could ... and for a time, investors and home-buyers could get away with it. No longer. Except for governments, the "debt gig" is up. Now, households are effectively trying to immunize their losses--what future retirement prospects they have left-- by buying fixed-income, low risk investments.
The Federal Reserve’s Flow of Funds report is documenting just such a shift in investing behavior. Year-todate to the end of the third quarter 2009, the US household sector is shown to have purchased $529 billion of US treasuries, sopping up approximately 45% of ballooning new issuance. That represents 4 times the pace of purchases of 2008. Granted, investment statistics for households in this report have been notoriously imprecise and mysterious in the past. Nevertheless, it is reasonable to observe that a massive swing in investor preferences is occurring. No doubt, it will not be a smooth shift.
A Longer-running Behavior Shift?
Back to the stand-off. The Austrian-influenced analysts are emboldened, having studied the credit-driven contractions of Japan in the 1990s, other such examples in history, read the Austrian School economists, and Irving Fisher’s famous debt deflation treatise (The Debt-Deflation Theory of Great Depressions - 1933). They are convinced that periods involving credit contractions are a different beast. The lighthouses of "statistical tradition" (namely, the "quant" models comprised of econometric coefficients born of the typical post-WWII economic cycle experience) have therefore been moved and are giving off erroneous navigational information at this time. The Austrian-influenced analysts recognize that there can come a point where no amount of government largesse and cheap money can resurrect demand during a period of over-capacity and household balance sheets overladen with the remnant toxins of overconsumption.
Remaining Tolerant of Differing Outcomes
Which group will be right? The KKC or the Austrians? It is yet not completely clear which of these sets of outcomes will unfold next. That said, we have our biases.
For now, we observe a schizophrenic set of factors:
For the hyperinflationary case: Rising gold (certainly so in USD) and commodity prices, high money growth, resuming global currency reserve growth, China continuing to effectively fix its yuan to the dollar, rising sovereign indebtedness, rebounding equity markets ... a re-emerging carry trade ... etc.
For the deflationary case: Low and still declining interest rates for several years more, high and possibly rising real rates, unhelpful demographics, a privatesector debt contraction, rising government interest costs, and, possibly, that renewed government stimulus could negatively impact bond markets.
Which will win out ... and how soon? It’s a timely question that needs to be adequately "probability-weighted." A number of cross-currents continue to challenge with broadly opposite outcomes that may well mean that bonds, stocks and gold (and other perceived inflation hedges) enter a more volatile phase for a time, oscillating within wider trading ranges. For a time, inflationary fears may emerge only to succumb to higher bond yields. Just such a duelling contest seems to have emerged in recent weeks. The gold price has fallen 12% from its high, while the US dollar and long treasury yields surged. As such, rising rates in turn are likely to quell inflationary fears for the time being.
Higher longer-term interest rates (especially so at a time of high real rates) will have their attractions to an income starved cohort looking to lock-in or rescue a retirement lifestyle for the future. Irving Fisher’s comment (see front page) should not be ignored in this regard. While policymakers are resolute in trying to avoid the feared effects of deflation, they may not successfully avoid high real interest rates. "Balance sheet" recessions, according to Fisher, can have "complicated disturbances" with respect to nominal interest rate levels. While we think that bonds are now oversold and remain a necessary diversification at the present time, by no means are we suggesting that fundamentals on the current trajectory are favourable for this asset class for the longer-term. At the same time, we must keep on eye on "real rates."
Reactions to Monitor
Some important inflection points may be approaching. One Significant Event (SE) that we have in our sights is the response of governments once past stimulus spending runs off. Should governments choose to discontinue or slash spending (already happening at the US state and municipal levels) the probability of a further deleveraging and deflationary outcome rises.
Meanwhile, household savings and investing behavior will remain key. Are dreams of new stock market and real estate bubbles only temporarily deferred, or have hard realities tempered previously "sugar-plum" expectations? If the latter, then a longer-running asset shift towards fixed-income investments will remain underway ... though perhaps not as pronounced as in the 1930s to 1950s era following the Great Depression nor in the 1990s in Japan. After a 5-decade shift to equities, private and public pensions, as well as forwardingthinking future retirees, will show a preference for fixed-income securities. If so, current fixed-income allocations are still far below the averages of the past half century.
A recent comment from former central bank head, Mr. Paul Volcker, appears to signal his expectation that further crisis in the banking sector is not to be ruled out if proper reforms are not soon put in place. His prescriptions to date have been mostly ignored. Speaking at a recent conference in England, he said: "I am not alone in this, and in fact I think that I am probably going to win in the end." Just what would swing the consensus of bankers (again high on the hog) and the political process to make the respected Mr. Volcker "right in the end"? We can only speculate. Could it be high "real interest rates" and further write-downs due to the further impacts of asset deflation on their balance sheets?
In conclusion, we expect that investment prospects in 2010 will remain challenging. There are too many scenarios to consider with diametrically-opposed outcomes -- domestic and global, geopolitically, monetarily and economically. As well, consensus views are too unified and correlations across global investment types too high to rest in the expectation that the current status quo will remain untested in 2010. Strategic diversification (cash is still the ultimate non-correlated asset) and a degree of caution remains warranted at the present time.