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The Paradox of Deleveraging

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(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.

“As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation.

“That’s a fiscal policy operation and, fortunately or unfortunately, fiscal policy is not made by a few learned technocrats above the political fray of the democratic process, but is squarely in the hands of the legislative branch, consisting of 535 politicians, with far more lawyers than economists among them,” McCulley shares.

“But make no mistake: Asset price deflation can be every bit as nefarious as goods and services deflation. Indeed, asset price deflation in the context of deleveraging is, in my view, much more nefarious than modest goods and services price deflation, since asset price deflation undermines the capital base of levered financial intermediaries, begetting yet more deleveraging and further asset price deflation … [I]t is very clear that [Ben] Bernanke sees the role of the central bank as different in deflationary times than inflationary times.

“In fact, I believe the Fed faces a more daunting challenge now than the Bank of Japan did back then [in 1998], in that the Fed has to balance the risks of both goods and services inflation and asset price deflation, whereas the Bank of Japan did not have to do so. Put differently, Japan faced both the paradox of thrift and the paradox of deleveraging, screaming for the Bank of Japan to subordinate itself for some time to the fiscal authority. This is not the case now in the United States, which is experiencing only the paradox of deleveraging, not the paradox of thrift, though the latter malady is certainly a fat tail risk if the former malady is not ameliorated, notably in house prices.

“Conventional wisdom holds that when an economy faces a paradox of private thrift, it is appropriate for the sovereign to go the other way, borrowing money to spend directly or to cut taxes, taking up the aggregate demand slack. Indeed, that is precisely what Congress did earlier this year, sending out $100-plus billion of rebate checks, funded with increased issuance of Treasury debt. Good ole fashioned Keynesian stuff!

“Concurrently, conventional wisdom is struggling mightily with the notion that when the financial system is suffering from a paradox of deleveraging, the sovereign should lever up to buy or backstop deflating assets. But analytically, there is no difference: both the paradox of thrift and the paradox of deleveraging can be broken only by the sovereign going the other way,” he concludes.

Janet Levaux, MBA/MA, is the managing editor of Research; reach her at [email protected].


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