Theory of a Bondman

There has been a lot of talk about rising debt levels in the U.S., rising interest rates and inflation. What if the result is actually deflation? I recently read an article in the CFA Institute Conference proceedings quarterly March 2010 publication titled “The Debt Deflation/Inflation Debate” by Van R. Hoisington. He argues that price levels will drop due to deflation and he makes some interesting points to support his argument. He points to Irving Fisher and his theory of debt deflation in 1933, in which deflation follows deep recessions. Here is a summary of the key points and considerations in your investment choices over the next few years.
The main premise of the argument is that debt levels will be a drag on growth for years to come. The spring 2010 RBC Global Economic Outlook reports there is a correlation between growth and debt levels once you get over 90% debt-to-GDP. The debt-to-GDP is over 90% in the U.S. and is forecast to grow to over 120% by 2014. A current live example of this is Japan, which has a debt-to-GDP level that grew from 50 to over 170% from 1989-2008. The result is interest rates fell from 5.7% in 1989 to 1.1% in 2008; the Nikkei was down 77.2% over that period and both employment and GDP are where they were 20 and 16 years ago respectively. In the U.S. interest rates are artificially low and personal consumption is down due to a drop in net worth, no income growth and unemployment has risen.
Despite the entire stimulus added to the U.S., the economy continues to struggle. Furthermore once this stimulus has been used up there is no room for further stimulus if we have more financial troubles on the horizon. In the short run when the government spends, an immediate positive impact occurs. The only problem is the government has no money of its own to spend, so the money has to be borrowed or taxed from the private sector. Van Hoisington points out that to the extent that this occurs, the private sector becomes smaller, which means that the second-order effects on GDP of an increase in government spending are at best zero and more likely negative. Therefore, government spending produces nothing but higher levels of debt.
He argues that there needs to be three requirements for inflation to occur. The first is an upward sloping supply curve. Inflation will not occur until excess supply is used up. Excess supply is created during a period where government stimulus has occurred and there is downward pressure on prices. There is an excess supply of manpower and productive capacity, which means a flat to downward sloping supply curve. The second requirement for inflation is a stable or rising velocity of money. Velocity of money increases due to innovation or leverage. Although there is no evidence that innovation has dropped, leverage certainly has. As a result, even though the Fed increased the money supply recently, the velocity of money has fallen 12.2%. Since GDP = M X V, this will have a negative effect on GDP. The third requirement is a stable or rising money multiplier. Historically, the money multiplier has been close to 10 which means for every dollar that goes into the banking system 10 new are created through loans etc.. In 2008, the money multiplier declined to less than 5. He points out that even though the Fed’s open market operation injected $1 trillion the money supply has not grown so the multiplier has effectively dropped to 0.
In terms of your investment choices this would bode well for bonds. The average long-term treasury rate from 1870 through the second quarter of 2009 is 4.3% and the average CPI (inflation rate) is 2.1%. If inflation goes to 0 then the bond yield should fall to 2%. A reasonable expectation of investors is that as a countries debt level goes up so does their risk and investors will demand higher yields for higher risk and the price of bonds should fall. A consideration not mentioned in this argument is that most of the debt held in Japan is held domestically versus a lot of the debt held in the U.S. is by foreigners. This may explain partly why yields have remained low for an extended period of time. Theory may or may not play out this time.