The End of an Era
Feb 17, 2009
Below is an excerpt from
a commentary originally posted at www.speculative-investor.com
on 12th February, 2009.
Sometimes things really are different. For example, in his book "Against the Gods -- the Remarkable Story of Risk" Peter Bernstein explains that prior to 1959 the US stock market's average dividend yield was almost always greater than the yield on long-dated US Government bonds. Furthermore, a drop in the average dividend yield to below the bond yield had traditionally been a reliable indication that stocks were very over-valued and that a substantial stock market correction lay in the not-too-distant future. As a result, many prudent investors would automatically reduce their exposure to the stock market whenever dividend yields dropped below bond yields. However, in 1959 the US stock market's average dividend yield fell below the Treasury bond yield and stayed there. Those prudent investors who exited the stock market in 1959 and began to wait for the S&P500's dividend yield to move back above the bond yield -- something it had always done in the past -- prior to re-building their equity portfolios, are still waiting.
The conventional wisdom in 1959 was that stocks should, and invariably did, yield more than bonds because they were riskier, but this age-old relationship was turned on its head by inflation. As an asset class stocks will be riskier than bonds -- and generally yield more than bonds -- in a world where the currency maintains its purchasing power over the long-term. However, in a world where the currency is almost guaranteed to lose its purchasing power at the rate of more than 3% per year there will be a strong tendency for equity yields to be lower than bond yields. The reason is that as prices rise throughout the economy the nominal earnings, and hence the nominal dividend payments, of most companies will also rise. A typical bond, on the other hand, will continue to provide the same nominal income regardless of how much the currency devalues.
1959 was the year when a critical mass of people came to realise that a knock-on effect of the changing nature of money would be unrestrained growth in the money supply, making bonds inherently riskier than stocks over the long haul. Such 'sea changes' naturally happen very rarely, but they do happen.
2008 could have marked another such change -- one that could prove to be far more dramatic and to have far wider implications than 1959's crossover in bond and stock yields. We are referring to the potential for 2008 to go down in history as the year when the secular expansion of private-sector credit came to an end.
For decade after decade after decade, the total amount of private-sector debt increased with only brief interruptions. This multi-generational upward trend was supported by central banks, especially by central bank policies that attempted to cut-short every pullback in the economy-wide level of indebtedness and keep commercial banks in operation regardless of how over-extended their balance sheets became. The trend eventually/inevitably culminated in a multi-year credit binge, which, in turn, led to the current situation in which the total amount of private-sector debt is potentially so high relative to real economic output that no amount of monetary manipulation will bring about the resumption of the former trend.
The above paragraph is consistent with the writings of prominent deflation forecasters, but where we have always differed from the deflationists is in our belief that faced with a 'tapped out' private sector the government would become the sole engine of credit creation and monetary inflation. In particular, we have always thought that a reduction in the amount of money borrowed into existence by the private sector would prove to be a fairly minor obstacle to the long-term inflation trend because when 'push came to shove' the government would make full use of its unlimited borrowing power. The amount by which a private entity is willing or able to go into debt is limited by its ability to repay the debt, but there is no limit to the amount of debt a government can take-on provided that the debt is denominated in a currency that can be created out of nothing by its central bank. Witness how rapidly the US government has been able to expand its indebtedness over the past few months and the complete lack of concern about how the debt will ever be repaid.
In a nutshell, there is no limit to the amount of bonds that the US government can issue to the Fed in exchange for newly-created dollars, or that any other government can issue to its central bank in exchange for newly-created currency. The only question is: what will the new money be spent on? The answer to this question gets to the heart of the biggest problem facing the economy today.
During the final years of an inflation-fueled economic boom there will always be a great deal of mal-investment and generally wasteful spending within the private sector, which, in essence, is why we need a system that's not subject to booms and busts. But private sector credit creation is not inherently bad. In fact, as long as it is real savings -- as opposed to currency units created 'out of thin air' -- that are being loaned/borrowed, credit expansion contributes to economic growth. Government credit creation, on the other hand, is inherently bad, because almost all government spending is wasteful. And this is truer than ever when the spending is being done in order to "stimulate" the economy, because in such cases the goal is to spend as much as possible as quickly as possible. Therefore, the shift from the private sector being the dominant credit creator to the government being the dominant credit creator has major adverse implications for economic growth.
The shift from private-sector-powered credit expansion to government-powered credit expansion also has major adverse implications for freedom and peace. This is because individual rights are invariably diminished when the government becomes more involved in economic activity and because war is one of the most efficient ways for a government to spend money (efficient in that war provides the excuse and the means to spend a lot of money quickly).
If we are correct that a secular change has occurred in the realm of credit creation then it makes no sense to compare the current situation to the recessions that occurred during the 1970s, the 1980s, the 1990s, or even 2001-2002. Also, it opens up the possibility that the Dow/Gold ratio will not stop falling after it reaches one.
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