"The defaults sparked a deleveraging, and the deleveraging destroyed the confidence which was keeping asset prices aloft. "

Felix Salmon discusses the notion of Brad DeLong's missing $17 Trillion:

"But really all finance is a confidence game, and just as Madoff dwarfs Voysey, so do total stock-market losses (in the tens of trillions of dollars) dwarf Madoff's. So long as investors had faith in Voysey, or Madoff, or stocks, everything worked fine. It was only when they tried to take their money out in quantity that things imploded.

Edward Hadas calls this "the noble lie":

The noble lie is the foundation on which all banking is built -- the ability of a bank's depositors and borrowers both to consider the same funds as their own. It's a lie because no bank, no matter how well capitalised, can always let each depositor cash every account...
The fiction of potentially unlimited withdrawal is not limited to bank accounts. Holders of the more advanced financial instruments -- bonds, shares and derivatives -- cannot all sell at once. If more than a few try, the market price drops sharply. If there is a stampede for the exit, the market disappears entirely.

"Stampede for the exit", of course, is also known under its more wonkish name: "global deleveraging". If everybody's selling and nobody wants to buy, what you thought of as wealth -- that number at the bottom of your brokerage statement, whether you have an honest broker or not -- can evaporate with astonishing speed."

I don't think this is a lie. Since it works, it's true. Also, not everyone has rushed to get their money out. But I do agree that it's a loss of confidence. But the loss of confidence was in the power of the government to solve this crisis. Underlying this system was trust, but, ultimately, trust in the government.

This trust in government still exists where it has some determinate meaning, which is why people who have FDIC insured accounts aren't pulling their money out, why increasing the FDIC insurance amount was a good idea, why the Fed paying interest on reserves has led banks to leaving their money there, and why the Flight To Safety landed in US Treasuries. There are other areas as well where the government guarantees are still believed and are effective. In other words, people only trust the banks to the extent that the government is guaranteeing them. This also explains why the Noble Lie isn't a lie: The government has the ability to make everyone whole. The consequences and conditions might be painful and rough, but the government can do this ( One can imagine limits to this statement, but we are very far away from it being operative here, which is why these government guarantees are still taken seriously. )

"Which I think is the answer to Brad DeLong's question of how on earth $20 trillion of wealth has been lost, when total loan defaults are only on the order of $2 trillion. The defaults sparked a deleveraging, and the deleveraging destroyed the confidence which was keeping asset prices aloft."

I agree, but it's a loss in the confidence of government to adequately deal with this crisis. Here we can say that it has become obvious that not everyone will be made whole or even reasonably well compensated. Some people are going to have to take real losses. This loss of faith in the power of government to keep the losses to a minimum is akin to a loss of faith in a creed or mode of life, especially since there was nothing even resembling an alternative. It feels like a loss of faith in a creed after which there are no alternative creeds that can take its place.

"For example: if there's just one person willing to pay $950 for my Google stock, then that's how much it's worth. But if that marginal buyer goes away, and there's a general sentiment that people would rather have cash than Google stock, the price can fall precipitously without much if any news. DeLong tries to model the preference for cash over Google stock as a rise in such things as "liquidity discount" and "risk discount", but that's not how it works in the real world: few people ever bought Google stock because they did the math and decided that the risk-adjusted present value of future dividends was $950. (Especially since Google doesn't pay a dividend.)"

I disagree. There are methods to determine a stock's worth, which, while not without flaws, are very useful. But, in a panic, that worth is worthless.

"Sure, DCF jockeys exist, but they don't tend to be price-setters. Brad DeLong, who's done a lot of original research on the equity risk premium, is basically in that camp: he buys stocks because he has faith in his own analysis. But most of us aren't that clever: we just buy stocks out of some combination of greed and fear (that we won't have enough money to live on, decades hence, if we don't invest our money in ways which make it grow substantially)."

Okay.

"In times of turmoil, we start worrying less about not having enough money in 20 years, and more about not having enough money in 20 weeks. (What if I lose my job? What if my investments fall further?) So we sell our investments."

Sometimes foolishly.

"Can this be modelled as an increase in the liquidity discount? Maybe, but in that case Brad has already answered his own question:

As long as we love our children as ourselves (and most of us do) and as long as we have access to and can credibly pledge collateral for financial transactions (and we can) the magnitude of the liquidity discount should be roughly equal to the technologically and organizationally driven rate of labor productivity growth divided by the intertemporal elasticity of substitution. The technologically and organizationally driven rate of labor productivity growth is a fairly steady 2 percent per year. The intertemporal elasticity of substitution is in the range from 1/2 to 1.

The intertemporal elasticity of substitution might normally be close to 1, but it sure isn't there right now -- not for those of us without tenure, anyway. It came down a lot in the summer of 2007, when the commercial paper market first started seizing up, and it's even lower now. Ask any hedge fund manager dealing with massive redemptions -- it might not be rational to buy with a long time horizon and then suddenly decide to liquidate, but this is not a rational market, and it hasn't been for some time."

This is true.

"There's also a strong feedback loop here. In normal markets, the more that prices fall, the more people want to buy. In financial markets, during a time of crisis, the more that prices fall, the more people want to sell. The intertemporal elasticity of substitution isn't a constant: it's a variable, which falls along with the market. And the people who don't adjust their discount rate fast enough to new realities end up, like Bill Miller, getting crushed."

This is basically the fear and aversion to risk and accompanying flight to safety.

"Especially if you're buying financials and other confidence stocks, you need a lot of other people to be buying them too, otherwise they have a tendency to go to zero. More generally, whenever lenders lose confidence in a company and refuse to refinance its debt, shareholders are likely to find themselves severely diluted at best, and quite possibly wiped out entirely."

Financial Stocks have suffered, like the Bush Administration, from a general feeling that they are being led by incompetent leaders, if not by criminals.

"It's entirely reasonable to draw a distinction between Mr Voysey and Bernie Madoff -- the men with the ignoble lies -- and the more noble lies underlying the stock market. But deleveraging is no respecter of nobility. Which is why all of us are now suffering, not just those who invested with Bernie."

They're both guilty, but one has committed a more heinous crime than the other. However, neither should be let off. Prosecuting some people who have committed crimes is a good way to restore confidence in government.

"The gap between bond and equity yields is becoming a critical issue in financial markets.": Is Anything Not Critical?

Here's an interesting post on the FT by Tony Jackson:

"The gap between bond and equity yields is becoming a critical issue in financial markets.

For half a century, equities have consistently yielded less than bonds. But the reverse is now starkly true in both the US and UK. Something is badly wrong."

Yields: For The Last 50 Years

Bonds: Higher

Stocks: Lower

This has changed? Can we tell yet if it's a positive or negative change?

"The obvious place to look for clues is Japan, which has had a reverse yield gap on and off for years. So do investors think the Japanese disease of deflation and economic contraction is coming to the west?"

Yields: Today

Stocks: Higher

Bonds: Lower

This means:

Economic Downturn

Deflation

In Japan, this meant an economic downturn and deflation. Does it mean that here?

"The short answer is probably yes. But, to clarify the logic, we should first consider the relationship between bond and equity yields more closely."

Yes, and he'll tell us why.

"Until 1959, the norm was for equities to yield more than bonds in both the UK and US. This was a simple expression of what is now called the equity risk premium."

Previous to the last 50 years, we had the following:

Yields: More Than 50 Years Ago

Stocks: Higher

Bonds: Lower

Reason:

Equity Risk Premium

This sounds like it means that stocks involve more risk than bonds. Let's see. Words can be awfully deceptive at times.

"Just as in a horse race, where the odds are better on an outsider than on the favourite, it seemed obvious that risky equities should promise a higher return than safe bonds. But, from 1959 onwards – until today – the formula reversed. Why was that?"

A gambling reference. How interesting. You'll win more if the underdog wins in a horse race. In the horse race between stocks and bonds, stocks were considered the underdog. The underlying theme is that you expect a higher return for more risk.

"Financial theory – which, not coincidentally, had its origins in the 1950s – has an answer to that. As Professor Paul Marsh of the London Business School explains, it allows us to state that the yield gap equals the expected risk premium on equities minus the expected growth in dividends."

You figure out the risk premium for a stock, and then subtract it from the dividend yield of a stock.

"Before the reader’s eyes glaze, let me hastily say this expresses a fairly simple concept. To arrive at the equity yield, investors notionally add a risk premium to the bond yield. But they then adjust for the fact that equity dividends grow in real terms and also tend to rise with inflation, whereas bond dividends do neither."

The yield of a stock dividend =

1) The Bond Yield +
2) Some Extra Money To Compensate For The Fact That Stocks Are Riskier +
3) Since Stock Dividends Can Go Up ( Or go down ) , Whereas Bond Yields Are Often Fixed, You Have To Fiddle With The Figures A Bit. In this scenario, it sounds like stocks can be less risky over time, since they can figure in inflation, for example.

"It follows that inflation and growth are both crucial in determining whether the yield gap is positive or negative. The higher each of them is, the more equity yields will tend to fall below bond yields."

On 3, the higher inflation and growth is, the less risky stocks are as compared to bonds, so the yield of stocks will fall in relation to bonds.

"The Japanese example supports this.
Peter Eadon-Clarke of Macquarie has a chart comparing the Japanese yield gap with nominal GDP growth over the past decade. Broadly speaking, when nominal GDP is negative, the yield gap tends to be too."

3 happened in Japan, only in reverse. As GDP went down, stocks got more risky.

"The GDP figure here may be taken as a rough proxy for dividend growth. And the essential point is that it is nominal, thus including inflation. Generally, for nominal GDP to shrink, both inflation and growth must be negative. Japan is the one country to have displayed that malign combination so far."

In economics, nominal value refers to any price or value expressed in money of the day, as opposed to real value, which adjusts for the effect of inflation.

GDP = Dividends : in this example

"I should add that the historic record is rather less tidy. Prof Marsh has data* showing that both dividend growth and inflation were higher in the second half of the last century than in the first."

What about the first 50 years? Why did it change 50 years ago?

"But I calculate that, in the five years to 1959, US inflation and GDP growth were both higher than in the five years following. So why the crossover should have happened just then remains problematic.'

"Problematic" means "Unexplained". One question is whether investors came to simply value dividends less, or were there changes in the tax laws, etc. ?

"In addition, a crucial part of Prof Marsh’s equation is the equity risk premium. But, as he puts it, the premium is unobservable – that is, it can be measured only in retrospect, not at the time."

Oh dear. That's a serious problem for looking forward.

"All that suggests that, when we come to the present situation, we should proceed with due caution. That said, what do we think is going on now?"

No one knows exactly what's going on, but:
1) I need to post a column, and this is pretty interesting.
2) Since no one knows exactly what's going on, there's room for me to speculate without fear of being clearly refuted. Unless, of course, I use fallacious reasoning, misread graphs, etc.

"In essence, the steep fall in Treasury bond yields across the developed world does indeed suggest strongly that investors fear deflation while the steep rise in equity yields suggests they fear a sustained collapse in dividends. And they are presumably also pricing in a higher risk premium for equities. So all the parts of the equation are heading the same way."

Before, wasn't it a kind of inverse ratio?

"That said, the reality is slightly more complex. Today’s low bond yields represent a tension between opposing forces. On the one hand, investors crave security. On the other, an enormous amount of new bond issuance is likely on both sides of the Atlantic."

The tension sounds like supply and demand.

"And, with another part of their minds, investors do not regard bonds as all that safe. The cost of insuring UK government bonds against default has risen from eight basis points in February to 110 basis points today – still quite a modest level but not reassuring."

It reminds me of the song line, "Trying To Make It Real, Compared To What?".

"In fact, bond yields could prove the vulnerable part of the equation. In the bubble years, risk was ludicrously underpriced. Quite reasonably, we should now expect it to become overpriced by a similar amount."

That's what I basically expect, except that it isn't an exact equation, although "similar" might be fine.

"When that eventually corrects itself, bond yields should rise. Equity yields might also fall – to the extent that investors recover their risk appetite. And indeed, fears of deflation might prove unfounded, as might the prospect of an extreme collapse in dividends.

But not just yet, I think. In the meantime, the old-style pre-1959 yield gap could become part of the landscape."

Let's see: 3 mights, 1 should, 1 to the extent, 1 not just, 1 think, 1 could. Thanks for going out so far on a limb. We'll keep track of all of your hedged bets, to use a gambling phrase.

This isn't the first post I've read about this. It is, however, among the clearer and more interesting. In fairness to Tony Jackson, I've laid off this topic precisely because they have to include a lot of speculation.