Summary:
Paul McCully (M.D. of Pimco) defends Paulson's request to Congress for unlimited spending power on the grounds that the financial system is victim of the paradox of deleveraging: every levered financial institution is in the process of delevering their balance sheets, a wise thing to do on an individual level. Collectively, however, it is creating deflation in the assets from which leverage is being removed: not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices. Solution similar as when the economy faces a paradox of thrift: in order to break the negative feedback loop, the Fed should borrow and spend. I.e. both a monetary and fiscal policy response are needed, not just a monetary one. But: levering Uncle Sam’s balance sheet to buy or guarantee assets to temper asset deflation does put the taxpayer at risk. Not popular, but ultimately in the taxpayer's best interest. (Published: 30/07/08)
Notes:
- 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
- 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
- year ago: burst of double bubbles in housing valuation and housing debt
- every levered financial institution decided individually that it was time to delever their balance sheets
- at the individual level, that made perfect sense
- at the collective level, 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
- has the paradoxical impact of increasing leverage by driving down lenders’ net worth
- negative feedback loop!
- need 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
- that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government
- needs to lever up its balance sheet to absorb assets being shed through private sector delevering
- so as to avoid pernicious asset deflation
- i.e. should borrow and spend
- that’s a fiscal policy operation
- 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
- levering up Uncle Sam’s balance sheet, to buy assets to break asset deflation resulting from the paradox of deleveraging
- still seems to be a foreign, if not a sinful proposition
- hear endlessly that any levering up of Uncle Sam’s balance sheet to buy assets must be done in a way that “protects tax payers.”
- 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!
- Fed and Bear Stearns
- put up $29 billion on nonrecourse terms to buy assets so as to facilitate the merger of Bear Stearns into JPMorgan
- was a fiscal policy operation, conducted by the Fed
- demonstrated by
- (1) the fact that the Fed sold a similar amount of Treasuries from its portfolio, increasing the supply of Treasuries in the market by the same amount
- (2) the fact that any losses the Fed experiences on that $29 billion will reduce dollar-for-dollar the amount of seigniorage profits that the Fed remits to the Treasury.
- $29 billion is actually a loan to a Limited Liability Corporation (LLC) set up to hold the Bear assets
- but the bottom line is that we the taxpayers bought $29 billion of Bear’s assets
- logically, it should have been conducted by the Treasury using appropriated spending power from Congress
- but: that “right” solution was not legally available to the Treasury, whereas the Fed did have the power to act
- Fed has power to lend to essentially anybody against any collateral, so long as it declares it is necessary to do so because of “unusual and exigent circumstances.”
- Paulson’s request to Congress to give him the power to spend unlimited amounts of taxpayers’ funds to buy the debt or equity of Fannie Mae and Freddie Mac
- 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
- But: between now and then, the Federal Reserve stands ready to lend to Fannie and Freddie
- unlike the case with the $29 billion spent for Bear’s assets, any Fed lending to Fannie and Freddie is explicitly being billed as a “bridge” to Treasury lending or investing in the agencies
- 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
- Treasury should also buy out the Fed’s $29 billion loan to the LLC holding Bear’s assets, putting it on the Treasury’s balance sheet, where it belongs
- currently, in the United States, asset price deflation is the menace at hand, not goods and services price deflation (cfr. Japan)
- asset price deflation can be every bit as nefarious as goods and services deflation
- Bernanke sees the role of the central bank as different in deflationary times than inflationary times:
- inflation
- often associated with excessive monetization of government debt
- virtue of an independent central bank is its ability to say “no” to the government
- deflation
- excessive money creation is unlikely to be the problem
- more cooperative stance on the part of the central bank may be called for
- not inconsistent with the independence of the central bank
- any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty
- 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
- US currently only experiencing 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: 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
- is precisely what Congress did earlier this year, sending out $100+ billion of rebate checks, funded with increased issuance of Treasury debt.
- Good ole fashioned Keynesian stuff!
- but: 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
- 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
- not a fun thing to do, but it is the right thing to do
