Friday, January 16, 2009

Hoisington Quarterly Review and Outlook -- THE GREAT EXPERIMENT

The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed. Our current Fed Chairman, Ben Bernanke, is an expert on the Great Depression, and he has, in fact, adopted Friedman’s strategy to greatly expand the money supply. Whether this prescription for economic stability will work in a period of over indebtedness, such as now exists in the U.S., is most uncertain. Indeed, this could be called the “great experiment” since this economic theory has yet to be thoroughly tested in the real world.

While the historical record indicates that the ultimate low in Treasury yields lies years away, the path to the ultimate low will be anything but smooth or linear as significant volatility continues. As the experience from U.S. and Japanese history indicates, many “false dawns” will occur, with investors assuming that the long-delayed cyclical recovery in economic activity is at hand. During these pleasant but relatively short interludes, stock prices will probably rise dramatically and bond yields will increase. If history is a guide, however, these episodes will further drain wealth and will be thwarted by the persistent forces of the debt deflation. With yields in the long Treasury market very low in nominal terms, the real return will be greater if deflation sets in. Moreover, in Japan from 1988 to the present, as well as in the U.S. from 1872 to 1892 and 1928 to 1948, the total return on Treasury bonds exceeded the total return on stocks. Such a condition cannot happen for the long run, but it did happen in these three instances spanning two decades. As a hedge against a recurrence of a prolonged debt deflation, some investors may want to consider even larger positions in high quality, long term Treasury securities.

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