Saturday, November 22, 2008

Breaking the Paradox of Deleveraging

This essay by Paul McCulley, the head of PIMCO's money market desk, is worth reading: "The Paradox of Deleveraging Will be Broken". Below are a few excerpts.

[T]he genius of banking, if you want to call it that, is simple: a bank can take more risk on the asset side of its balance sheet than the liability side can notionally support, because a goodly portion of the liability side, notably deposits, is de facto of perpetual maturity, although it is notionally of finite maturity, as short as one day in the case of demand deposits.

It’s the same alchemy that permits mutual funds to commit to next-day redemption at tonight’s NAV, even though all reasonable people know that a mutual fund – with the possible exception of a money market fund – could not possibly liquidate all assets on the wire tomorrow at tonight’s NAV marks. Systemically, it’s the illusion of liquidity [...]

Yes, liquidity for all at last night’s marks is an illusion. But for banks, unlike mutual funds, it’s not so much an illusion after all, for two simple reasons: banks have access to deposit insurance underwritten by fiscal authorities and to a discount window underwritten by the monetary authority (and one step removed, the fiscal authority). Thus, banks are unique institutions, providing a “public good:”


I could regale you yet again about the power of the analytical thinking of Hyman Minsky, complete with his Forward Journey turning into his Moment, followed by his Reverse Journey. But I don’t need to do that any more: we’ve collectively lived it and are now caught in the debt-deflationary pathologies of “the paradox of deleveraging.” Not everybody in the private sector can delever at the same time without creating a depression. Accordingly, the sovereign must go the other way, levering up the public balance sheet. And Washington has finally started to do so with appropriate vigor and enthusiasm.

It’s not a pretty picture. In fact, it’s repugnant, giving proof to the proposition that breaking the paradox of deleveraging does involve socializing the downside of previously profitable private sector activities. In a recent speech, I called it “creeping socialism” and was interrupted by an irate, older man in the back of the room bellowing, “It ain’t creeping socialism, it’s galloping socialism!” I really didn’t have a soothing come back, noting that many things are what they are only in the eye of the beholder. But his point wasn’t lost on me or anybody else in the room.

Fortunately, the sovereign is currently able to borrow money for thirty years at about 3.7%.


ravinsu said...

Dave, the link given doesn't go to the essay, it shows a JPEG of Paul McCulley.

DaveinHackensack said...

Thanks for the heads up, Ravinsu. It's fixed now.

Sivaram Velauthapillai said...

Paul McCulley captures the essence of what is happening. The government has been leveraging up while others leverage down. The fact that the FedRes balance sheet went up by a trillion within two weeks alludes to this.

However, the thing, though, is that the government may successfully lever up to counter-balance the financial institutions, but I believe it won't be able to counter-balance the leveraging down that will occur as the consumer de-levers. The only hope is that the consumer de-levers slowly and builds up savings over a period of many decades rather than in one or two years.