The Paradox of Deleveraging

(Phoenix) Paul McCulley, one of the keynote speakers at Commonwealth Financial Network’s recent education conference, is a managing director of Pimco. He speaks frequently to industry groups about his outlook on the Federal Reserve and economic policy.

“I don’t know about you, but I’ve aged six years in the past six weeks, at least,” he told Commonwealth advisors, who met in Phoenix in early October. “The level of activity is intense.”

In addition to laying out his overall understanding of the credit crisis, as he describes below, he also made a case for a super-Federal Deposit Insurance Corporation as the “cleanest” method to resolve some of today’s liquidity issues.

“For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income — the fountain from which savings flow,” he explains.

“This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: What holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

“Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution — banks and shadow banks alike — decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

“At the collective level, however, it has given us the paradox of deleveraging: When we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth.

“This process is sometimes called, especially by Fed officials, a negative feedback loop. And it is, though I prefer calling it the paradox of deleveraging, because the very term cries out for both a monetary and fiscal policy response, not just a monetary one. Lower short-term interest rates via Fed easing are, to be sure, useful in mitigating deflating asset prices, particularly if they serve to pull down long-term rates, which are the discount rates for valuing assets with long-dated cash flows.

“But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.