For the first time since another Democrat occupied the White House, investors from Beijing to Zurich are challenging a president’s attempts to revive the economy with record deficit spending. Fifteen years after forcing Bill Clinton to abandon his own stimulus plans, the so-called bond vigilantes are punishing Barack Obama for quadrupling the budget shortfall to $1.85 trillion. By driving up yields on U.S. debt, they are also threatening to derail Federal Reserve Chairman Ben S. Bernanke’s efforts to cut borrowing costs for businesses and consumers.

The 1.4-percentage-point rise in 10-year Treasury yields this year pushed interest rates on 30-year fixed mortgages to above 5 percent for the first time since before Bernanke announced on March 18 that the central bank would start printing money to buy financial assets.

“The bond-market vigilantes are up in arms over the outlook for the federal deficit,” said Edward Yardeni, who coined the term in 1984 to describe investors who protest monetary or fiscal policies they consider inflationary by selling bonds. “Ten trillion dollars over the next 10 years is just an indication that Washington is really out of control and that there is no fiscal discipline whatsoever.”

The bond vigilantes are being led by international investors, who own about 51 percent of the $6.36 trillion in marketable Treasuries outstanding, up from 35 percent in 2000, according to data compiled by the Treasury.

There is a lot of talk about the possibility of heading towards a ” New Great Depression” but we do NOT think so.

The good news is that we think  that we aren’t headed for the Great Depression, but the bad news is that we are in for the Great Recession, where household sector, the nonfinancial business sector and the financial sector will suffer a lot.

The contraction in asset values and debt will ultimately be pushed even further than they would normally have to go. So it is going to take years.

Here is a very basic fact about this period. Balance-sheet contraction makes it impossible for the private sector to generate the profits it needs to function, whereas balance-sheet expansion generates booming profits. Therefore, it isn’t a matter of getting rid of the bad assets from the bank, and then the economy is ready to go. This process involves not just cleaning up the banking sector, but also shrinking assets and liabilities.

We think that the earliest recovery would be in 2010. But we are not sure we are going to get a recovery then, based on the economic-stimulus plan that has been passed so far, although it is moving in the right direction. The enormity of what it is trying to overcome may be too great. It is very likely we will see additional moves by the government later this year, so there will be something added, mainly because of higher unemployment.

One of the problems for any government trying to deal with this situation is the expectation that, like past recessions, it is a problem that should get cleaned up and we should go back to some level of prosperity

Among the possible outcomes of this shock are: massive and prolonged fiscal deficits in countries with large external deficits, as they try to sustain demand; a prolonged world recession; a brutal adjustment of the global balance of payments; a collapse of the dollar; soaring inflation; and a resort to protectionism. The transformation will surely go deepest in the financial sector itself.

The proposition that sophisticated modern finance was able to transfer risk to those best able to manage it has failed. The paradigm is, instead, that risk has been transferred to those least able to understand it. 

Remember what happened in the Great Depression of the 1930s. Unemployment rose to one-quarter of the labour force in important countries, including the US. This transformed capitalism and the role of government for half a century, even in the liberal democracies. It led to the collapse of liberal trade, fortified the credibility of socialism and communism and shifted many policymakers towards import substitution as a development strategy.

The Depression led also to xenophobia and authoritarianism. Frightened people become tribal: dividing lines open within and between societies. In 1930, the Nazis won 18 per cent of the German vote; in 1932, at the height of the Depression, their share had risen to 37 per cent.

The impact of the crisis will be particularly hard on emerging countries: the number of people in extreme poverty will rise, the size of the new middle class will fall and governments of some indebted emerging countries will surely default. Confidence in local and global elites, in the market and even in the possibility of material progress will weaken, with potentially devastating social and political consequences. Helping emerging economies through a crisis for which most have no responsibility whatsoever is a necessity.

IMF latest analysis : http://www.imf.org/external/np/g20/pdf/031909a.pdf