The Investment Scientist

Why was the Great Depression so bad? Are we likely to experience something like that in our lifetimes?

This month and next, I plan to write a series of articles about financial crisis. The ideas for this series will come from my Oxford University economics class. The class was taught by Professor Oren Sussman, a prominent scholar on the subject of financial crises. My aim is to explain concurrent economic policies, as well as to answer important questions like those posted above.

Irving Fisher (1867 – 1947) was an American economist who had a very simple theory about the great depression, and who inspired many post-Keynesian economists in later years. He observed that the prices of all things tumbled during the great depression, 43% to be exact, and that had a devastating impact on firms. See a stylized example of a surviving firm below.

Irving Fisher’s debt-deflation theory of the great depression

The firm had $100 in assets on its balance sheet. On the liability side, it had $50 in debt so its capital or owners’ equity was $50. Once the gross price level P fell by 43%, the firm’s assets were reduced to 57, its debt remained at $50, thus its capital or the owners’ equity dwindled to only $7. That’s a devastating 86% loss. The simple example isn’t just an unrealistic example. During the Great Depression, the S&P 500 actually did fall by 87%!

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For the final article of this macroeconomics series, I want to write about something that is much more relevant to your financial wellbeing, whether you are a wage earner or business owner. That is, what would happen if the dollar loses its status as the predominant reserve currency?

The Quantity Theory of Money states:

M/P = kY where

M is the total money supply, P is the gross price level, and kY can be interpreted as the demand for money.

If the dollar loses its “gold” status, central banks around the world will need much fewer dollars and the demand kY for the dollar will drop. To balance this out, either the gross price level P will increase, or the total money supply M will have to be reduced. To put it in layman’s terms, we will get hyper inflation and hyper interest rates, the latter to reduce the money supply.

Let’s look at a historical precedence. See the chart below

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“Why are so many countries lending to the US for negative real interest?” Professor Sussman opened the floor for debate at our Oxford macroeconomics class. In totality, foreign countries own $6.2T of US debt. The chart below shows the countries that lend to the US.

In the previous three articles, I wrote about The Gold Standard, The Fiat Money andThe National Saving Shortage respectively. I hope I explained that the trade deficit is recycling of foreign savings for US private investments. And as long as we are paying negative real interest on our national debt, It’s not a problem, but a win to be able to keep borrowing. What I did not explain is why foreign countries would lend to us at negative real interest, and this is exactly what the professor asked in class and what I hope to explain with this article.

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