Deleveraging

Paul McCulley of PIMCO:

PIMCO - Global Central Bank Focus - July 2008 "The Paradox of Deleveraging": [M]acroeconomics is not just the summation of microeconomic outcomes, but rather the interaction of microeconomic outcomes. For me, a simple concept brought this realization: the paradox of thrift... 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... 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... 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....

[M]onetary 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.... [T]hat somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government...

By definition, levering Uncle Sam’s balance sheet to buy or guarantee assets to temper asset deflation will put the taxpayer at risk – but will do so for their own collective good! This was de facto what the Federal Reserve did when it put up $29 billion on nonrecourse terms to buy assets so as to facilitate the merger of Bear Stearns into JPMorgan... this was a fiscal policy operation.... At the end of the day, there are $29 billion more Treasuries on the open market than otherwise would be the case, and the Treasury is, one small step removed, on the hook for any losses the Fed experiences on the $29 billion of non-Treasury assets it now de facto owns....

Which brings us to Mr. Paulson’s request to Congress to give him – and his successor – the power to spend unlimited amounts of taxpayers’ funds to buy the debt or equity of Fannie Mae and Freddie Mac. I confidently predict that he’s not going to get unlimited authority; it will most likely be checked by counting any such deficit-financed injections into Fannie and Freddie against the Treasury’s statutory borrowing limit, which can be lifted only by Congress. But Mr. Paulson is going to get most of what he wants, if only because legislators are too fearful of the consequences if they stiff arm him.... This is the way it should be: bailouts and backstops with taxpayer funds should be legislated by Congress and placed on the Treasury’s, not the Fed’s, balance sheet....

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.... [C]onventional 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.   Fortunately, Congress is finally grappling with this reality, as it moves towards passage of Mr. Paulson’s plan for backstopping Fannie and Freddie with taxpayer funds. It’s not a fun thing to do, particularly following the use of $29 billion of taxpayer funds to facilitate the merger of Bear Stearns into JPMorgan. But it is the right thing to do. And it is further the right thing that Congress is doing it, not the Fed under Section 13(3), except as a possible bridge to Treasury authority.

Comments

[Maynard Handley]

"At the individual level, that made perfect sense. At the collective level... "

Or to put it more simply, the whole Invisible Hand concept is a crock. Or, more specifically, it is a crock to claim that at all times, in all places, it will solve all problems.
Why is it that even your smarter libertarians like Richard Epstein, the ones who will admit that there might, in theory, be such a thing as externalities, even though they'll never actually admit to one in practice, can't seem to get this?
And why is it that econ 101, at the same time that it is going on about the wonders of free trade, and the importance of not setting the minimum wage too high, is not flogging this type of example with the same enthusiasm? The primary reason that the country is populated by a large number of gullible fools who believe everything the GOP feeds them about the importance of removing regulation is because of what is taught in AP Economics and Econ 101. This sort of pattern is enough to make one a Chomskyan.

Now, with respect to the details of this plan. Once again we have a situation where, sure it's for the taxpayers' benefit, but, once again, it turns out that it will be the super-rich who benefit most. Once again, I have to ask: if it's so essential that this sort of bill get passed, why not pass it in tandem with legislation that lays the bill where it is due; for example a surtax on incomes above a certain level, or on financial industries, or a very small financial transactions tax (like the stamp tax of many countries) that won't dissuade transactions of genuine financial merit but will dissuade vast amounts of the meaningless sloshing of money back and forth that we see these days?

[PrahaPartizan]

Or, to put it more succinctly: "Privatize profits; socialize losses!" When do the citizens get compensated for the risks they are forced to bear so the uber-wealthy can send their brats to exclusive schools, dine well and fly on their corp jets?

[bigTom]

I'm not an economist, but in my understanding we gave the financial industry the right to loan money into existence (leveraging money into the economy). Now that that process is running in reverse, isn't the main macroeconomic problem that the money supply is shrinking through the private sector's deleveraging? What I don't understand is why we need to rescue (bailout is too strong a term) said private institutions as part of the cure? If the macroeconomic problem is the ongoing destruction of money, then the cure is to print enough money to keep the overall supply within agreed limits. I don't see that this newly "created" money needs to be fed to the verysame deleveraging institutions. Couldn't we find a more equitable way to do this? And while we are at it, perhaps we can avoid future moral hazards?

[piotr]

"If we all decide to save more..."

There is more to this paradox. Objectively, one can establish the minimum lavel of savings that is prudent for a household. If economy would collapse in the event when most of the people save that minimum, something is wrong. Perhaps a small collapse is in order, or some better solution (like increase in wages, so people consume sufficiently for the demand not to collapse, while also having the desired levels of saving).

If I were in charge of regulating financial markets, I would try to change conditions of savings and borrowing to increase the attractiveness of savings if it drops too much, or of lending, if it drops to much.

Similarly, one can establish a sustainable relation between incomes and prices of real estate, and when we are waaay above this level, something has to give. Having the government as the buyer of last resort propping those prices, lest they collapse, does not strike me as a necessarily good idea.

[GK]

Where is the paragraph on DIGOURGING the ill gotten gains from the thieves and con-men, I mean the senior executives and traders at the banks and brokerage houses that caused this mess.

I know the "Greater Good" will be served when these people are broke and serving time in a read prison. A lesson to the next generation of would be criminals that run To Big to Fail Companies.

[jdm]

This seems like a wise policy. Whenever a bubble, fueled by leverage, starts to collapse and cause all sorts of collateral damage to the wider economy, lets have the Treasury and Fed come in and buy up all the inflated assets. This will prop up the value of the bubble prices and everyone - taxpayer, worker, investor - will be better off. Why didn't someone think of this earlier - it's so simple.

[enobarbus37]

Here's my counter argument. Am I wrong?

What ails us today is the end result of blind subsidy of housing: the mortgage interest deduction, Fannie and Freddie, and then, finally, Alan Greenspan.

How can more of the same, even if the sovereign appears to be bending in the other direction, make sense?

In other words, if the sovereign should borrow money, shouldn't the sovereign spend it on infrastructure, at the very least? Or perhaps new factories.

Brad Setser makes the point that if China had been buying corporate bonds, then we might not be in the fix we're in.

Do we really need government subsidized McMansions?

[enobarbus37]

Here's my counter argument. Am I wrong?

What ails us today is the end result of blind subsidy of housing: the mortgage interest deduction, Fannie and Freddie, and then, finally, Alan Greenspan.

How can more of the same, even if the sovereign appears to be bending in the other direction, make sense?

In other words, if the sovereign should borrow money, shouldn't the sovereign spend it on infrastructure, at the very least? Or perhaps new factories.

Brad Setser makes the point that if China had been buying corporate bonds, then we might not be in the fix we're in.

Do we really need government subsidized McMansions?

[Elizabeth]

There are several issues with the article.

First, perhaps a quibble, but he shows a basic lack of understanding of what micro and macroeconomic are. Macro is the summation of individuals (although the macroeconomists ingore this reality generally). The global impact can be different than the local effect but that is not micro vs macro.

Second, as mentioned previously, Pimco is talking their book but at a level I've never seen attempted before.

Third, going back to the global thing. If the first impact of increased savings is decreased consumption which then leads to a slowdown then the second impact should be an increase in productivity because of all the capital available for investment... there will be pain with getting back to normal savings but I don't know how it can/ should be avoided.

[derrida derider]

The problem for any really large bailout is that the Treasury's balance sheet is already looking pretty sick due to the US government's spending having been put on the credit card in the past eight years. You really don't want to be trying to get the Chinese to accept more IOUs at the moment because they might well refuse, given the clear intention the US has of inflating its foreign debt obligations away. As a foreigner myself, I can tell you it would take very high returns to make me buy US dollar denominated bonds.

It's this that distinguishes this bailout from past ones the US government has done, and that limits the room for manoeuvre.

[Frank Dean]

Ah, the wonderful world of American capitalism.

Homeowners are enduring a collapse in their wealth, because real estate prices have fallen. I have yet to hear any Serious Person suggest the Federal Reserve should make large payments to homeowners to compensate for this loss. This would just reward feckless borrowers.

However, if you are a financial institution enduring a loss in wealth because the value of your debt obligations has fallen, the Federal Reserve stands ready and willing to help you out. Serious Persons blithely endorse this wealth transfer from taxpayers to feckless lenders and lazy bondholders.

Observe that if the Federal Reserve made large payments to homeowners, the leverage problem of both homeowners and the financial institutions would go away.

Except the wrong set of pigs would be feeding at the government trough, so it is unmentionable. The moral hazard problem isn't just speculative: these same pigs had a big feed just two decades ago in the S&L crisis.

Better still, those who don't own homes or mortgages should get an even bigger check from the Fed to reward them for their prudence and foresight. This too will solve the leverage problem, avoids the moral hazard problem, and yet Serious Persons don't mention it. I wonder why?

[kharris]

Frank,

Strictly speaking, homeowners do not have to pass on money received from the Fed to mortgage lenders. The would still have the option of walking away from their homes.

The trick is that the lending system, because it is perched atop the flow of credit between all other participants in the economy, represent the most efficient point for intervention. If there is a credit problem that involves, for instance, savers and manufacturers, giving money just to manufacturers only gets half the job done, and is inequitable, to boot. Intervene via the financial intermediary, and both sides of the credit problem have a chance of being addressed. Still inequitable, though. We might want to ask ourselves is whether, knowing that the lending system is uniquely positioned to attract intervention, we shouldn't have a very different regulatory structure.

[MaryCh]

I have what I hope is an unabsurd meta-economics question: Who among the Econnointed has attempted a grand theory of everything (micro and macro reconciled, or at least made mutually understandable, possibly through game theory?)

I succeeded in faking enough macroeconomic knowledge for Ben Bernanke not to fail me years ago, but freely admit that macroeconomics always trickles through my mind like water through a sieve.

Q: "What if everybody thought that way?"

A (Yossarian): "Then I'd be a damn fool to think any other way!"
- Catch-22