Paul McCulley explains the paradox of deleveraging for you

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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.

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