Going down the road again
By Daniel M. Ryan
As the extent of the now-collapsed subprime bubble continues to be revealed, there have been an increasing number of comparisons to the pre-Great-Depression 1920s. One of them, from Reuters, is linked to in this blog post. According to such comparisons, the subprime bubble will lead to a huge credit crunch in which the money supply will be seriously deleveraged due to a restriction of credit supply. Since supply will be cut down while demand will (presumably) be unaffected, this squeeze will result in a jump-up of interest rates.
Since monetary deleveraging implies a fall in the money supply unless the Fed expands reserves to compensate, this squeeze would result in seriously high real interest rates. The resultant general price decrease will make the real burden of debt even more onerous, as nominal rates cannot go negative. If they did, then people would have a clear incentive to borrow, sit on the cash, and get paid for doing so. No rational private-sector agency would lend on that basis, as they could reap any reward by hanging on to the cash. Any government agency that lent that way would be engaged in frank subsidy.
The fact that a real return can be earned simply by holding onto cash is the nub of "pushing on a string" meeting the "liquidity trap." It's the standard Keynesian explanation for the Great Depression. Those most prone to believe it are financial professionals. A more down-to-earth person would joke it away in this manner: "Oh, right. So if it pays me to hold cash, why don't I hold on to my food budget so as to scoop the price decrease. How long would it take me – six months of starvation to be rational?"
(A more relevant critique would be that consumers use the possibility of future price decreases as one of many factors when deciding on the timing of any purchase. Otherwise, no-one would have bought a new computer: future price decreases are the accepted norm in that industry.)
This point being noted, a Keynesian can come up with two objections. The simple Keynesian can reply that the liquidity trap will not lead to an economic standstill, but it will lead to a decline in consumption spending (and GDP) because of that aforementioned "paid for waiting" effect. It will still have a retardive influence once price declines become general.
A more sophisticated Keynesian would reply that, in a liquidity trap, a drop in consumption isn't the major worry. A decline in investment is. Consumers may keep on consuming, though at a reduced rate, but investment will plummet because investors (unlike consumers) don't have to invest at all. It's reasonable to assume that investors only invest money they don't have to touch, so the counter-argument relevant for consumers doesn't hold for investors. If such a Keynesian is well-read, he or she may note that a collapse in the "investment function" is precisely what Keynes himself was worried about under depression conditions, for the above reason. (He or she would be right. Keynes had originally intended government spending in a depression be redirected to take up the slack left by a dearth of private investment.)
This argument, too, has its critiques, mostly focusing around the rigidities that are assumed by the Keynesian model – as well as the underlying assumption that there is some pre-depression "normalcy" that a depression-ridden economy has to return to. Believe it or not, there are industries that prosper under depression, and those industries would receive investment on the usual basis. As a kind of counter-example, here are two trivia facts about Great Depression winners, neither of them miserly by any reasonable standard: Charles Atlas, who "made it big" in the 1930s, and the gold sector. Looking at historical Canadian claim maps in Ontario will show a lot of ground stakes in 1930 and 1931. A look at a gold-stock index for the period 1930 to 1933 would be even more so.
That being said, though, the above paragraph makes a technical economic point. It shouldn't obscure the fact that the 1930s was a rough decade, economically speaking. The overall statistics, as well as anecdotal information pointing in the other direction, clearly show it.
Speculations though, including my own just above, do leap the gate somewhat as they beg the question: is the ‘00s decade a reprise of the 1920s?
I have to admit being jaded on this one. In 1988 or 1989, I bought in hardcover a book by PBS commentator "Adam Smith" entitled The Roaring ‘80s. Those my age or a little older may remember their economic perceptions being anchored by a best-selling book called The Great Depression of 1990. Books like these are a coming of age for the college-confined naïf: I remember myself being convinced that the "nasty ‘90s" were "coming" as of post-crash 1987.
The Scottish have a maxim that's of use when assessing exciting predictions of this sort: "Fool me once, shame on you; fool me twice, shame on me." The 1990s, instead of being the huge depression decade that many were expecting, instead turned into another decade of prosperity for North Americans as well as for many Europeans. The only nation for which the 1990s could be seen as "economically nasty" were the Japanese. If the Nikkei 225 is an adequate proxy for the Japanese economy, the fact that the Nikkei is at the same level now as it was in 1985 is telling evidence of the troubles that the Japanese economy has had to slog through. It's also a telling counter-example for advocates of a government-stimulus package to save the economy. Japan tried the Keynesian remedy last decade, which may have helped keep things ticking over but did not turn the slump around. The recently-collapsed yen "carry trade," where foreigners borrowed yen at the miniscule rates that Japan offered and put somewhere else, may have had more of a beneficial effect than the stimulus programs by the Japanese government. Even if the Japanese economy didn't receive the funds for investment, such demand for Japanese credit (denominated in Japanese yen) still limited any further monetary deleveraging caused by the general credit collapse at the end of the ‘80s. Even if the yen were simply sold forward, someone still had to buy them. Entering into a new credit transaction doesn't decrease the money supply.
As long as monetary deleveraging does not kick in, as prompted by a general desire to pay back debt without incurring more, there won't be a reply of the Great Depression. As I noted earlier, this would imply a monumental – and well-telegraphed – reversal of financial mores in North America. It won't happen by stealth. Unless it does, a reasonable assumption to make would be that any China-driven collapse would be a repeat of the ‘80s, not the ‘20s. China would fall into the same economic rut that Japan has had to endure since the 1990 real-estate collapse.
What if it does occur, though? What investment class is likely to be decimated as a result?
Certainly not the stock market. There's been no bubble there. As I write this, the Dow Jones average is almost exactly equal to its high set in 2000. If any historical parallel is indicated, it would be the 1970s, not the 1920s, for the DJIA. There hasn't been any overall "go-go" market in American, or Canadian, equities so far during this decade. The TSX composite is barely above its 2000 high.
Finding an asset class that's most vulnerable to a severe bear market requires a certain descent into stodginess, into investment orthodoxy. The vulnerable asset class is one that's had a huge run-up over the past several years; it also has attracted newly-mainstreamed, and plausible, theories explaining why this investment has reached a "permanently high plateau." The credibility of this (by standards of normality) incredibly bullish bias can be tested by using the "25%/year gain" question. 25% is known to be unsustainably high by normal investment standards, so it serves as a useful benchmark to flush out hidden mania in an asset class, or an investment which has a huge amount of trading volume – one comparable to an asset class in its entirety. If you predict a 25% gain for that investment over the next couple of years, and the only scoffing you receive is for being too pessimistic, then you've zeroed in on a bubble in the making.
The investment that best fits the above test is none other than oil.
You can try it yourself by passing around a 25%-test prediction. From the recently-reached price of $US95/bbl, a fitting forecast would be "$US150/bbl by early February 2010." Passing around this prediction, while asking if it's off the mark, will flesh out the extent of the bubble mentality surrounding that commodity.
Gold has also gone through a multi-year bull market of go-go proportions, although more quietly than has oil. Commodities in general are in a hot phase too, as indicated by repeated record highs made by the CRB index. Gauging a potential collapse next decade by the go-go status enjoyed in the current decade reveals that the asset class most vulnerable to a 90%-or-so decline in a future depression (if any) is commodities – which makes sense, given that a deflation would be expected to hammer down the price of real goods.
(P.S.: Even if there is no "new 1930s" in the offing, using the 25% test flushes out an asset class, or major investment, which is coming due for a spill anyway. The extent of the decline would, of course, be far less than a near-wipeout if we face no more than the usual time of troubles in our business-cycle-ridden economy.)