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Monday, November 9, 2009

The "Paradox of Deleveraging"

CNN Money with the details of Friday's continued decline in consumer credit outstanding:

Consumer credit fell in September for the eighth straight month, the longest streak of declines since the Federal Reserve started keeping records in 1943.

Total consumer borrowing fell a seasonally adjusted $14.8 billion, or 7.2%, to $2.456 trillion in September, according to the Federal Reserve.

Ed over at Credit Writedowns asks whether this decline in consumer credit shows actual deleveraging.
My baseline for deleveraging is Debt to Nominal GDP – when debt to GDP goes down, that shows deleveraging. For example, for the latest data released in September for Q2 2009, Private sector total debt to GDP (incl. financial services) in the U.S. was 292.2% of GDP. Because of the huge drop in nominal GDP, this was actually up from 283.0% when the recession began in Q4 2007. For households, the number was 96.8% in Q2 2009, up slightly from 95.9% at the end of Q4 2007. What this shows is that deleveraging has yet to begin in earnest as debt levels have remained relatively high even while GDP had collapsed.
Ed makes an important observation that debt to GDP levels are not improving, but I don't agree with his definition of deleveraging. Lets call our disagreement a 'chicken or the egg' problem:
  • Did deleveraging NOT occur because GDP declined more than the level of debt outstanding?
  • Or... Did deleveraging occur, which caused GDP to decline more than the debt outstanding?
There are many examples of this paradox in economics (I detailed Paul Krugman's Paradox of Thrift back in the summer... i.e. the more people save, the less overall savings is in the short run as the whole savings pie shrinks). As it relates to deleveraging, lets go back to Paul McCulley:
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.
Deleveraging has the ability to drive down GDP as well as asset prices. Our economy is heavily dependent on consumption, which in itself is dependent on debt financing, which in itself is dependent on asset prices that serve as collateral for the financing (or in the case of banks, improve their capital requirement ratios so they can put more capital to work). This is the reason why the Fed has intervened in an attempt to re-inflate asset prices with a wide assortment of initiatives.

Will it work? If the goal was to reinflate these assets back to 'fair value' following the deleveraging of 2008 than these new prices may be sustainable. The issue (in my opinion) is that the goal seems to be to reinflate asset prices (i.e. homes, financial assets, etc...) to pre-crisis "bubble" valuation levels. So far we've seen subsidized financing, tax incentives, private/public partnerships (i.e. TALF and PPIP), purchases by the Fed, etc... to make this happen. I am of the opinion that whenever these initiatives roll off, prices will once again (absent inflation), fall.

Is this bad? For GDP in the short run... absolutely. But in the long run we need debt levels as a percent of GDP to rebalance. There are only two ways to do this... decrease the numerator (i.e. delever) or increase the denominator (through growth or inflation). Thus, absent atrong growth and/or perfectly timed and scaled inflation, we need to accept the inevitable pain before we pump up prices to even more unsustainable levels.