## 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.