Paul McCulley explains the paradox of deleveraging for you

It’s Bill Gross’s rambling pleas for action from Washington that get most of the attention. But I think PIMCO strategist and portfolio manager Paul McCulley is actually much better than his boss at laying out the case for government intervention. This is from his July commentary, which I just stumbled across:

[T]he 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. …

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.

So what is to be done? McCulley continues:

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.

Apple CEO Cook Gives Up $75M in Stock Dividends

NEW YORK — Apple CEO Tim Cook is giving up $75 million in dividends on restricted stock that the company is awarding to all of its employees.

In a filing with the Securities and Exchange Commission on Thursday, Apple Inc. said that Cook requested that his restricted stock units not receive dividends. The dividends that Apple workers are getting amount to $2.65 per quarter for each restricted stock unit held. The shares are not normally eligible to receive dividends, so Apple’s decision is a perk for its employees.

Curmudgeon

You know, I might be more tempted to buy into this this if it weren’t for the fact that their multi-million dollar paychecks weren’t so intimately tied to a government bailout. That especially goes for Bill Gross, whom the financial press seems to have adopted as a reasonable spokesperson on the economy in general.
Justin Fox

Yeah, I guess an asset manager would see asset deflation as especially “pernicious.”

That said, I still kind of buy the argument.
Bryan from Houston

The real reason to buy into this idea of leveraging up is that if the government does not perform that action. Nobody else will. You become stuck in a hopeless cycle where deleveraging feeds upon itself.

And if e learned nothing from Japan, it is, that while painful, fixing overheated inflation is preferable to trying to stem deflation.

In that vein, the housing bill is simply a day late and a dollar short. This begs the question:

Why is the housing bill set to only become effective on 1 October? With Barney Frank pleading with lenders to hold out until then, I predict that by then the worst of the housing debacle will be over. Most foreclosures will have occurred and life as we know it will be on the upswing.
JordanT

Most foreclosures will have occurred and life as we know it will be on the upswing.

I’m sorry, but the foreclosures are just getting started in California. We have a near majority of the neg am loans, and 80% of the people are only making the minimum payments. These are just now starting to reset, which has driven foreclosure rates back up. The problem isn’t the interest rate, it’s that the mortgagee now has to pay full interest + principal on a loan that’s higher than when they started.
Bryan from Houston

Jordan,

Even though Cali has a near majority of neg am loans, my comments refer to the timing of when this bill becomes effective 1 October!!

And even then, it will not magically overnight begin to cure the ills that afflict the market.

I’ll stand by the statement as I understand from various economists (Volker and Gross, if I recall) surmise that we are nearing the half-way mark in the number of foreclosures. As they do get there, the bill Congress just passed will still be waiting or just going into effect.
futuresmkt

We accept the gist of Mr. McCulley’s argument. The difficulty is that the US govt/Federal Reserve is not able to substantially lever (add debt to an equity/asset base) beyond what they are currently doing – to purchase/refinance sovereign securities – without a major revison to our economic structure. Fundamentally, we believe the West (US/Europe/Japan) is at an inflection point with regard to real economic growth for the foreseable future. Demographics factors have increasingly pressed upon our domestic productive capacity, across the spectrum, until we have reached the point of no return. Unfortunately the gross terminology of, “economic growth”, “the economy”, shroud what are really economic improvements globally (principally in the developing world). Our consumption society worked when we had a productive citizenry who could fund their consumption with earnings. That time has, generally, passed. The political/societal pertubations, from the election of a non-traditional President to the Tea Party, all augur general recognition of the environment, if not to a satisfactory end. What is the solution? I have none except to say, the average age of the “West” is about 40 and, the average age of the rest of the world is about 20. Let some sage explain the global economic implications.
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[...] of cases you get a payment stream, you dont depress aggregate demand and dont induce Koo/mcculley paradox of deleveraging – asset firesales driving down prices further. The numb headed UK financial services [...]
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[...] what some recent economic writing (based on Fisher analysis of the Great Depression) has called the paradox of deleveraging. It is irrational to sell so markets don’t clear. The banks are aware of this revived [...]