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.


  1. Jake,

    There is no paradox of savings. That should be obvious to everybody. Only eCONomists claim a paradox exists because their junk theories and accounting systems which are based on asset inflation demand such lies.

    The paradox (or lie) rests on the deceptive notion that aggregate bank credit is sacred and must be preserved at all costs. That deflation must be prevented.

    By increasing supply above demand, prices fall and bogus credit (faux wealth) is destroyed. However, the real wealth (excess houses or whatever) remains and at lower prices to boot.

    Only inflation repositories/gatherers (financial companies) as well as non-competitive producers fear deflation. Two decades of pyramiding debt has created ruin for tens of millions and unimaginable instability.

    "Friedman and Schwartz estimated that prices in general fell from 1869 to 1879 by 3.8 percent per annum. Unfortunately, most historians and economists are conditioned to believe that steadily and sharply falling prices must result in depression: hence their amazement at the obvious prosperity and economic growth during this era." -- Murray Rothbard

  2. so in the extreme, you think it is impossible? picture this... consumption falls by 50% overnight (i.e. people only buy necessities).

    you think this wouldn't affect broader businesses that make non-necessities? i think they'd lay off workers and/or close shop.

    does this reduce the housing stock? no... but all goods aren't durable. non-durables (and durables in the longer run) wear out and break. with no business creating new product to offset the declines, overall real wealth... declines.

    in addition, do you think this reduces demand and the size of the economy? i sure do.

  3. "we need to accept the inevitable pain (before we pump up prices to even more unsustainable levels)."

    Never! America is still the greatest, isn't it? Accept economic pain? The American psyche wont stand for it and the American system wont now allow it. It's too late for pain that would be too painful. Shoot for the easy way out and hope to hell something turns up in the meanwhile.

  4. Jake,

    so in the extreme, you think it is impossible?

    I could address the reasons why the paradox of savings argument is a ruse but there is no need. The manner in which Krugman, McCulley and others frame the argument is specious.

    We have a problem of too much debt and too little savings. Literally trillions of our debt is non-economic and un-payable. Is that from saving too much? Or is it from CONsuming too much and allowing banks to issue trillions in bad debt? Did these problems arise because people suddenly started saving? Even excess savers like Japan get in trouble when they take on too much debt.

    Krugman thinks money grows on trees and that wealth comes from the Government (if only we followed his ideas). McCulley is sitting on hundreds of billions in dubious credit assets that would plummet in value but for the heroic efforts of the Fed and the Government.

    The paradox of savings crowd all have an adgenda. Primarily, they want private assets/investments to be guaranteed by the Government. They want faux asset values and ponzi wealth preserved by the taxpayer.

    We have 19 million vacant homes and yet homes are unaffordable. We produce a surplus of food with less than 2% of our work force yet 1 in 9 is on food stamps. The people that build the houses and grow the food can't afford the products. There's your paradox. And it doesn't stem from excess savings, it stems from too much bad debt.

  5. we're in complete agreement on the too much debt front, but i'm trying to communicate that shedding some of that debt (by an increase in savings) will be a painful, but needed process.

    but, as stevie b said, it will be doubtful that we will work it off without kicking and screaming, thus the likelihood that we'll just make matters worse (and the economy will appear better) in the short run.

  6. Jake,

    but i'm trying to communicate that shedding some of that debt (by an increase in savings) will be a painful, but needed process.

    I don't even agree with that. Minsky labeled three types of credits/debts.

    1. Self liquidating (borrowings that generate income to pay principal and interest payments.

    2. Speculative (borrowings that generate income to meet only the interest payments).

    3. Ponzi (borrowings that don't even generate enough income to meet interest payments).

    Shedding ponzi debt, of which we have trillions, will be a net positive for the economy. The pain has been felt by the majority for years and more pain will come from the Fed's immoral attempts to lay the cost of the ponzi debt on the productive class.

    Bernanke (the Fed) is preserving trillions in ponzi credit to save venal bankers, imprudent investors and imprudent borrowers. All at the expense of the prudent.

    Also, Bernanke and the Fed are covering up their own incompetence. They failed to regulate and allowed bonus seeking bankers to poison our credit system.

    We should have admitted to the problem, nationalized the banks, written off and restructured debts and put this sordid mess behind us.

  7. mab states: "We should have admitted to the problem, nationalized the banks, written off and restructured debts and put this sordid mess behind us."

    completely agree, BUT not sure how this isn't painful. less painful than doing nothing and trying to inflate our way out of it? possibly, but painful none-the-less when we see our supposed savings stored at banks or in "high-quality" debt wiped out.