Dear readers,
This week we move away from our macro-economic analysis and focus on a worrisome development in the banking sector that was brought to our attention via a Bloomberg story posted this Friday.
Despite the enormous fiscal cost to the tax payer around the world, the past twelve months have been a treasure for global macro players like us who try to detect imbalances and exploit these opportunities or at least protect our investments against these excesses. We were privileged to sit on the first row to see the Great Credit Crisis unfold and it gave us a massive amount of inspiration to write about it. This even ended up in an invitation from Moorad Choudhry to contribute a chapter on the Origin of a Crisis for the 3rd edition of one of his many books he has published so far. More info on this you will find on http://www.palgrave.com/Products/title.aspx?PID=335493
This throws us immediately into our subject of this week. One can easily sum up more than 10 reasons that can be held responsible for causing this crisis. Each of them has a different weighting. For example despite what populists may argue the bonus culture is not top on the list but is rather a Tier 3 or 4 factor in all this. The combination of leverage and the fact that financial firms chose not to transfer credit risk could be appointed as one of the root causes of the financial crisis.
We are now in the midst of a process that governments and regulators are trying to fix the system and make the rules more robust to prevent this from happening again. Certainly one should hope that we would not return to the old sins that brought us into trouble in the first place. Unfortunately when we read the Bloomberg headline we were shocked that some market players return to their old bad habits. It is as if the party has just started again and everybody is singing Lionel Richie's song " We are dancing on the ceiling."
At this moment banks are gearing up their lending to buyers of high-yield corporate loans and mortgages and this at a pace which is even faster then before the outbreak of the Great Credit Crisis in July 2007. To quote Bob Franz, co-head of syndicated loans at CSFB “I am surprised by how quickly the market has become receptive to leverage again.”
According to data from the Fed one can see that among the 18 prime dealers who bid for US Treasuries there is a total of $ 27.6 billion of securities held as collateral for financings lasting more than one day as of August 12. This is up 75% since the beginning of May!!!
The increase proves money is being used for riskier home loans, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by
Fannie Mae, Freddie Mac and/ or Ginnie Mae.
Furthermore the increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. Fortunately lenders are asking more collateral for the loans.
We have no issues with the technique of using a bit of leverage especially when a fair amount of collateral is behind it. Risk needs to be taken. This is crucial to our financial capitalistic system. It may sound harsh but a market economy needs to some degree bankruptcies as it is a healthy sign of risk taking. A financial system so stable that no bankruptcy would take place would be an indication that risk taking is (too) low and this will negatively affect entrepreneurship.
The only issue we have is that there is a justified political pressure on banks to start lending again, but this would be the last form one would expect to return. To the degree leverage coming back represents a normalization of the markets but the idea it should be part of any permanent residential or commercial mortgage securities portfolio strategy is not clever. It is like a heart patient who just recovered from a heart transplant and is immediately trying to run a marathon again.
The risk now is that this new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to rating agency Moody’s. Then there still is the ticking time bomb of commercial real estate.
The end game of this is very colourful described by Julian Mann, a $ 5 billion fund manager in California, “If you leverage up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable.” We don’t have to remind you what happened from July 2007 onwards…
Stepping back from the experience of the current crisis, and looking forward, it is clear that the issue of financial stability should remain a central focus. The experience of the past few decades in both emerging markets and advanced economies shows the pervasiveness of financial crises. These crises, signals of financial instability and the failure of the proper working of the financial system, have important economic and financial consequences, and usually lead to severe economic contractions that may either be short-lived or persist over time. If the real effects persist, the long-run potential and actual growth rate of an economy may be significantly lowered, negatively affecting long term welfare. (1)
(1) Viral Acharya and Matthew Richardson “Restoring Financial Stability. How to Repair a Failed System.” NYU Stern, 2009
Friday 28 August 2009
Wednesday 12 August 2009
Deflationary spirals
Dear readers,
We keep on digging in the deflation (D) versus inflation (I) theme as this will keep on dominating the debate for the foreseeable future. In our hunt for an I-D outcome in our last letter, we took a strong bias towards deflation. This week in our I-D series we share a few thoughts from Dr. De Grauwe, who was once on the short list to be nominated on the board of the ECB.
In our Tamiflate (July 2009) and Central Banker’s Paradox (Feb 2009) articles we already highlighted the task of a central bank and the Fed more in specific to inject extra inflation into the system in order to avoid a Dark Decade scenario like Japan. However we also explained at the time that expanding its balance sheet by asset purchases is not enough to influence the price level. Other parameters that might be out of reach of a central bank need also be influenced, i.e. the money multiplier must rise and/or the velocity of money must rise and/or the aggregate supply must show an upward sloping curve.
Remember this is captured in the simple equation GDP = M2 * V (see also Text book economics and keeping President Hoover in mind – April 2009) with M2 a measure for money supply and V representing the velocity of money.
We all know by know that none of these conditions are fulfilled. Personal income is still dropping, consumer spending is contracting due to the deleveraging process and the world will suffer for a very long time from overcapacity. Despite the fact that the new US jobs report last Friday accrued the camp of those who believe in a V-shaped recovery, we should warn for a false perception. The recovery we are seeing is first of all the result of government intervention and stock adjustments. And of that government intervention we can also argue that the only one that is having a significant impact is the one coming out of China. The US stimulus packages hardly make a difference. Once again this empirically proves the very low multiplicator effect of state aid to economic growth. In one of our earlier articles we also pointed out that for every USD spend by the government this would add maximum .3% to economic growth as far as the US is concerned. Furthermore the assumption that the US would lead the world back to growth would mean that the US consumer would return to his old habit of stretching his credit card like wet clay. We all know we are still in the midst of a deleveraging process, so this is not going to happen.
Bear also in mind, and this brings us immediately back to our topic of this week, deleveraging causes deflationary pressures.
Coming back to our equation we will show you why a central bank has limited impact on the money supply. Let’s argue that M2 = MB * m with MB the monetary base and m the money multiplier.
The money multiplier interacts with changes in time, Treasury deposit ratios and the currency. As a rule of thumb when Treasury deposit ratios or excess reserve ratios rise, the money multiplier drops. With the Fed now expanding its balance sheet like there is no tomorrow the excess reserves rise sharply, and as a consequence the money multiplier drops.
The excess reserves simply rose due to the fact that the Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. We still see that a lot of banks park their liquidity at their corresponding central banks. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). This is the reason that this money does not get recycled into the system. If it is parked at the Fed, ECB, BoE or BoJ it will not be used for investments or new loans issuance.
This is why commercial trade and industrial production fell of a cliff. Now productivity has been rebounding recently and on Tuesday it surprised on the upside, but there is a logical explanation for this. Labour costs have dropped at such a rapid pace as well. This explains why companies have been beating earnings estimates. Before the recession of 2001 productivity typically fell in recessions because companies waited too long to respond to the
downturn. Now, however, the pace of layoffs and the drop in hiring has been so quick and severe that productivity is up 1.8% y/y and unit labor costs are down 0.6%. Labor is the biggest cost by far for most businesses so if demand stabilizes while costs are falling, earnings improve. And the pressure on inflation eases too.
Four deflationary spirals
At this moment there are four deflationary spirals at work, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. However it becomes a dangerous cocktail when they are mixed together.
Keynesian savings paradox.
When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.
When the desire to save more is the result of a collective lack of confidence ( our favorite animal spirits theme from Shiller) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.
Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.
Fisher’s debt deflation:
When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.
When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.
Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will not work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.
Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.
When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.
There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.
This is not contradictory to what we have stated above. There we made the assumption that labour costs would drop in case of a stabilizing demand. In case of a deflationary environment demand will not stabilize but drop further as well and ultimately will effect the profitability of firms.
Bank credit deflation:
When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.
When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.
There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.
This reduction by bank loans got once again confirmed last month. According to the Wall Street Journal 13 out of 15 US banks cut back on their loan book in the second quarter. And the trend is continuing. Total bank credit contracted $41 billion (a 20% plunge at an annual rate!) for the week ending July 15. This was the fourth weekly decline in bank credit, totaling $94 billion. During the July 15th week, residential loans contracted $23 billion and have been down now for five of the past six weeks. Credit card outstandings fell $1.5 billion during the week (also a 20% annualized slide). Commercial & industrial loans dropped $1.7 billion — down over $50 billion in just the past three months or a 13% annual rate, which is unprecedented. It is worth highlighting that credit is the tint that makes the mare run — there is zero chance that the green shoots will amount to anything with bank credit in contraction mode as of mid-July, ironically the same month that so many pundits are pegging as the end of the recession.
Now coming back to the deflationary spirals that we described above, they all have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion ( once again we refer to animal spirits of Akerlof and Shiller(2009)). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. As a consequence there is a failure to coordinate individual actions to avoid a bad outcome.
Cyclical movements in optimism and pessimism (animal spirits) have always existed. The question is though why exactly now they lead to such a breakdown of coordination? Paul De Grauwe makes a thorough analysis on this that we share in full text with you:
“The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.
In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.
When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox.” (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).
The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.
The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.
The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
The irrelevance of modern macroeconomics
Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).
Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.
Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.
The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.
The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.
There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.
The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.
The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.
A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.
Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.
The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the euro zone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.
Figure 1
Source: European Commission
The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.
To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g. Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.
References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press,
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279
We keep on digging in the deflation (D) versus inflation (I) theme as this will keep on dominating the debate for the foreseeable future. In our hunt for an I-D outcome in our last letter, we took a strong bias towards deflation. This week in our I-D series we share a few thoughts from Dr. De Grauwe, who was once on the short list to be nominated on the board of the ECB.
In our Tamiflate (July 2009) and Central Banker’s Paradox (Feb 2009) articles we already highlighted the task of a central bank and the Fed more in specific to inject extra inflation into the system in order to avoid a Dark Decade scenario like Japan. However we also explained at the time that expanding its balance sheet by asset purchases is not enough to influence the price level. Other parameters that might be out of reach of a central bank need also be influenced, i.e. the money multiplier must rise and/or the velocity of money must rise and/or the aggregate supply must show an upward sloping curve.
Remember this is captured in the simple equation GDP = M2 * V (see also Text book economics and keeping President Hoover in mind – April 2009) with M2 a measure for money supply and V representing the velocity of money.
We all know by know that none of these conditions are fulfilled. Personal income is still dropping, consumer spending is contracting due to the deleveraging process and the world will suffer for a very long time from overcapacity. Despite the fact that the new US jobs report last Friday accrued the camp of those who believe in a V-shaped recovery, we should warn for a false perception. The recovery we are seeing is first of all the result of government intervention and stock adjustments. And of that government intervention we can also argue that the only one that is having a significant impact is the one coming out of China. The US stimulus packages hardly make a difference. Once again this empirically proves the very low multiplicator effect of state aid to economic growth. In one of our earlier articles we also pointed out that for every USD spend by the government this would add maximum .3% to economic growth as far as the US is concerned. Furthermore the assumption that the US would lead the world back to growth would mean that the US consumer would return to his old habit of stretching his credit card like wet clay. We all know we are still in the midst of a deleveraging process, so this is not going to happen.
Bear also in mind, and this brings us immediately back to our topic of this week, deleveraging causes deflationary pressures.
Coming back to our equation we will show you why a central bank has limited impact on the money supply. Let’s argue that M2 = MB * m with MB the monetary base and m the money multiplier.
The money multiplier interacts with changes in time, Treasury deposit ratios and the currency. As a rule of thumb when Treasury deposit ratios or excess reserve ratios rise, the money multiplier drops. With the Fed now expanding its balance sheet like there is no tomorrow the excess reserves rise sharply, and as a consequence the money multiplier drops.
The excess reserves simply rose due to the fact that the Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. We still see that a lot of banks park their liquidity at their corresponding central banks. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). This is the reason that this money does not get recycled into the system. If it is parked at the Fed, ECB, BoE or BoJ it will not be used for investments or new loans issuance.
This is why commercial trade and industrial production fell of a cliff. Now productivity has been rebounding recently and on Tuesday it surprised on the upside, but there is a logical explanation for this. Labour costs have dropped at such a rapid pace as well. This explains why companies have been beating earnings estimates. Before the recession of 2001 productivity typically fell in recessions because companies waited too long to respond to the
downturn. Now, however, the pace of layoffs and the drop in hiring has been so quick and severe that productivity is up 1.8% y/y and unit labor costs are down 0.6%. Labor is the biggest cost by far for most businesses so if demand stabilizes while costs are falling, earnings improve. And the pressure on inflation eases too.
Four deflationary spirals
At this moment there are four deflationary spirals at work, i.e. the Keynesian savings paradox, Fisher’s debt deflation, the cost cutting deflation, and the bank credit deflation. Each of these deflationary spirals can be dealt with when they occur in isolation. However it becomes a dangerous cocktail when they are mixed together.
Keynesian savings paradox.
When one individual desires to save more, and he is alone to do so, his decision to save more (consume less) will not affect aggregate output. He will succeed to save more, and once he has achieved his desired level of savings he stops trying to save more.
When the desire to save more is the result of a collective lack of confidence ( our favorite animal spirits theme from Shiller) the individual tries to build up savings when all the others do the same. As a result, output and income decline and the individual fails in his attempt to increase savings. He will try again, thereby intensifying the decline in output, and failing again to build-up savings. There is thus a coordination failure: if the individuals could be convinced that their attempts to build up savings will not work when they all try to do it at the same time, they would stop trying, thereby stopping the downward spiral.
Somebody must organize the collective action. An individual agent will not do this because the cost of collective action exceeds his private gain.
Fisher’s debt deflation:
When one individual tries to reduce his debt, and he is alone to do so, this attempt will generally succeed. The reason is that his sales of assets to reduce his debt will not be felt by the others, and therefore will not affect the solvency of others. The individual will succeed in reducing his debt.
When the desire to reduce debt is driven by a collective movement of distrust, the simultaneous action of individuals to reduce their debt is self-defeating (Fisher(1933)). They all sell assets at the same time, thereby reducing the value of these assets. This leads to a deterioration of the solvency of everybody else, thereby forcing everybody to increase their attempts at reducing their debt by selling assets.
Here also there is a coordination failure. If individuals could be convinced that their attempts to reduce their debt will not work when they all try to do this at the same time, they would stop trying and the deflationary cycle would also stop. An individual, however, will have no incentive to organize such a collective action.
Cost cutting deflation
When one individual firm reduces its costs by reducing wages and firing workers in order to improve its profits, and this firm is alone to do so, it will generally succeed in improving its profits. The reason is that the cost cutting by an individual firm does not affect the other firms. The latter will not react by reducing their wages and firing their workers.
When cost cutting is inspired by a collective movement of fear about future profitability the simultaneous cost cutting will not restore profitability. The reason is that the workers who earn lower wages and the unemployed workers who have less (or no) disposable income will reduce their consumption and thus the output of all firms. This reduces profits of all firms. They will then continue to cut costs leading to further reductions of output and profits.
There is again a coordination failure. If firms could be convinced that the collective cost cutting will not improve profits they would stop cutting their costs. But individual firms have no incentives to do this.
This is not contradictory to what we have stated above. There we made the assumption that labour costs would drop in case of a stabilizing demand. In case of a deflationary environment demand will not stabilize but drop further as well and ultimately will effect the profitability of firms.
Bank credit deflation:
When one individual bank wants to reduce the riskiness of its loan portfolio it will cut back on loans and accumulate liquid assets. When the bank is alone to do so (and provided it is not too big), it will succeed in reducing the riskiness of its loan portfolio. The reason is that the strategy of the bank will not be felt by the other banks, which will not react. Once the bank has succeeded in reducing the riskiness of its loan portfolio it will stop calling back loans.
When banks are gripped by pessimism and extreme risk aversion the simultaneous reduction of bank loans by all banks will not reduce the risk of the banks’ loan portfolio. There are two reasons for this. First, banks lend to each other. As a result when banks reduce their lending they reduce the funding of other banks. The latter will be induced to reduce their lending, and thus the funding of other banks. Second, when one bank cuts back its loans, firms get into trouble. Some of these firms buy goods and services from other firms. As a result, these other firms also get into trouble and fail to repay their debt to other banks. The latter will see that their loan portfolio has become riskier. They will in turn reduce credit thereby increasing the riskiness of the loan portfolio of other banks.
There is again a coordination failure. If banks could be convinced that the simultaneous loan cutting does not reduce the risk of their loan portfolio they would stop cutting back on their loans and the negative spiral would stop. They have no individual incentives, however, to engage in collective action.
This reduction by bank loans got once again confirmed last month. According to the Wall Street Journal 13 out of 15 US banks cut back on their loan book in the second quarter. And the trend is continuing. Total bank credit contracted $41 billion (a 20% plunge at an annual rate!) for the week ending July 15. This was the fourth weekly decline in bank credit, totaling $94 billion. During the July 15th week, residential loans contracted $23 billion and have been down now for five of the past six weeks. Credit card outstandings fell $1.5 billion during the week (also a 20% annualized slide). Commercial & industrial loans dropped $1.7 billion — down over $50 billion in just the past three months or a 13% annual rate, which is unprecedented. It is worth highlighting that credit is the tint that makes the mare run — there is zero chance that the green shoots will amount to anything with bank credit in contraction mode as of mid-July, ironically the same month that so many pundits are pegging as the end of the recession.
Now coming back to the deflationary spirals that we described above, they all have the same structure. The actions by economic agents create a negative externality that makes these actions self-defeating. This spiral is triggered by a collective movement of fear, distrust or risk aversion ( once again we refer to animal spirits of Akerlof and Shiller(2009)). Individuals (savers, firms, banks) are unable to internalize these externalities because collective action is costly. As a consequence there is a failure to coordinate individual actions to avoid a bad outcome.
Cyclical movements in optimism and pessimism (animal spirits) have always existed. The question is though why exactly now they lead to such a breakdown of coordination? Paul De Grauwe makes a thorough analysis on this that we share in full text with you:
“The four deflationary spirals we identified, although similar in structure, are different in one particular dimension. The savings paradox and the cost deflation can be called “flow deflations”. They arise because consumers and firms want to change a flow (savings and profits). The other two involve the adjustment of stocks (the debt levels and the levels of credit). We call them “stock deflations”. Problems arise when the flow and stock deflations interact with each other.
In “normal” recessions such as the ones we have experienced in the postwar period prior to the present crisis, only the flow deflations were in operation. There had not been a preceding period of excessive debt accumulation and unsustainable levels of bank loans. As a result, households, firms and banks were not trying to adjust their balance sheets. The pessimism of households and firms was related to expected shortfalls in income and profits, and led to increased savings and cost cutting. In such an environment in which the stock levels were perceived to be right, there were sufficient automatic equilibrating mechanisms that prevented these two flow deflations from leading to an unstoppable downward spiral. The most important equilibrating mechanism occurred through the banking system.
When banks function normally they have a stabilizing force on the business cycle. The reason is that in a recession the central bank typically reduces the interest rate making it easier for banks to lend. In normal circumstances, when banks are not in the process of cleaning up their balance sheets, they will be willing to transmit this interest rate decline into a reduction of the loan rate. As a result, banks will engage in automatic “distress lending” to firms and households. Households will be less tempted to increase their savings. In addition, private investment by firms will be stimulated, i.e. firms will be willing to dissave, thereby mitigating the deflationary potential provoked by the savings paradox.” (In De Grauwe(2009) I show this in the context of a simple IS-LM analysis).
The interest rate decline will also mitigate the cost cutting dynamics. This is so because it improves the profit outlook for firms, giving them lower incentives to go on cutting costs. Thus when the banking system functions normally, there are self-equilibrating mechanisms that prevent the flow deflations from degenerating into uncontrollable downward spirals.
The problem the world economy faces today is that flow and stock deflations interact and reinforce each other. The period prior to the crisis was one of excessive buildups of private debt and banks’ assets. The result of these excessive buildups of private debt and balance sheets is that the stock deflation processes described in the previous section operate with full force. As a result, the equilibrating mechanism that exists in normal recessions does not function. The lower interest rates engineered by central banks are not transmitted by the banking sector into lower loan rates for consumers and firms. In addition, we now are confronted by the interaction of the flow and stock deflations. This interaction amplifies these deflationary processes. This interaction, which is especially strong in the US, can be described as follows. Because of excessive debt accumulation of the past, households desire to reduce their debt levels. Thus they all attempt to save more. As argued earlier, these attempts are self-defeating. As a result, households fail to save more, and thus fail to reduce their debt. This leads them to increase their attempts to save more. The fact that the banks do not pass on the lower deposit rates into lower loan rates makes things worse. There are no incentives for firms to increase their investments (no dissaving). Nothing stops the deflationary spiral.
The interaction goes further. The deteriorating conditions in the “real economy” feed back on the banking system. Banks’ loan portfolios deteriorate further as a result of increasing default rates. Banks reduce their lending even further, etc. In De Grauwe(2009) it is shown that a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
The irrelevance of modern macroeconomics
Modern macroeconomics as embodied in Dynamic Stochastic General Equilibrium models (DSGE) is based on the paradigm of the utility maximizing individual agent who understands the full complexity of the world. Since all individuals understand the same “Truth”, modern macroeconomics has taken the view that it suffices to model one “representative individual” to fully represent reality. Thus as a consumer the agent continuously maximizes an intertemporal utility function and is capable of computing the implications of exogenous shocks on his optimal consumption plan, taking full account of what these shocks will do to the plans of the producers. Similarly, producers compute the implications of these shocks on their present and future production plans taking into account how consumers react to these shocks. Thus in such a model coordination failures cannot arise. The representative agent fully internalizes the external effects of all his actions. When shocks occur there can be only one equilibrium to which the system will converge, and agents perfectly understand this (Woodford(2009)).
Deflationary spirals as we have described them in the previous sections cannot occur in the world of the DSGE-models. The latter is a world of stable equilibria. It will not come as a surprise that DSGE-models have not produced useful insight allowing us to understand the nature of the present economic crisis. Yet vast amounts of intellectual energies are still being spent on the further refining of DSGE-models.
Collective action to stop the deflationary spirals
The common characteristic of the different deflationary spirals is a coordination failure. The market fails to coordinate private actions towards an attractive collective outcome. This market failure can in principle be solved by collective action. Such a collective action can only be organized by the government. Let us analyze what this collective action must be to deal with the different forms of deflation.
The key to economic recovery is the stabilization of the banking sector. As argued earlier, a banking sector that is in the grips of credit deflation and deleveraging can destabilize the economy and can push the economy into a true deflationary spiral.
There is no secret about how the bank credit deflation can be stopped. Here are the principles (see Hall and Woodward(2009) for a more detailed analysis). First, bad loans should be separated from good loans, putting the former in separate entities (“bad banks”) to be managed by specialized management teams whose responsibility it is to dispose of these assets. Losses on these bad assets are inevitable, and so is the inevitability that the taxpayer will be asked to foot the bill.
The good loans remain on the balance sheet of the “good bank”. The hope is that this good bank, freed as it is from the toxic assets, will feel liberated and will be willing to take more risk so that the credit flow can start again. One can doubt, however, that a privately run good bank will have sufficient incentives to start lending again. The reason is that extreme risk aversion and a desire to “save the skin” of the shareholders will restrain the managers of the good bank in extending loans. If that is what the managers of the good bank do, the bank credit deflation process described earlier will not stop. This leads to the issue of whether it is not desirable to (temporarily) nationalize the good bank. Such nationalization would take away the paralyzing fear that new bank loans put the bank’s capital (and its shareholders) at risk.
There is a second reason why the government may want to temporarily nationalize the good bank. The bad bank – good bank solution carries the risk of socializing the losses while privatizing the profits. Indeed, the losses of the bad bank will necessarily be borne by the taxpayers. If the good bank remains in private ownership the expected future profits will be handed out to the shareholders. But these profits will be realized only because the toxic assets have been separated and the losses on these assets have been borne by taxpayers. It is therefore more reasonable to make sure that these future profits are given back to the taxpayers.
The resolution of the bank crisis along the lines discussed in the previous paragraphs is a necessary condition for the recovery. It will also make the use of other macroeconomic policies easier and more effective. These other macroeconomic policies must be geared towards resolving the other deflationary processes. Let us discuss these consecutively.
The Keynesian savings paradox
The collective action failure implicit in the Keynesian savings paradox calls for the government to do the opposite of what private agents do, i.e. to dissave. Dissaving by the government is a necessary condition for making it possible for private consumers to succeed in their attempts to save more.
A well-functioning banking sector reduces the need for dissaving by the government. When the banking sector works well, the consumers’ attempts to save more leads to a lower interest rate and induces firms to invest more (they dissave). As a result, the required dissaving by the government is reduced correspondingly.
Fisher’s debt deflation
Government action is required to solve the coordination failure implicit in the debt deflation process. This can be done by taking over private debt and substituting it with government debt. In doing so, the government makes it possible for the private sector to reduce its debt level. The private sector will then stop attempting (unsuccessfully) to reduce its debt level. The debt deflation process can stop.
The issue that arises here is whether the substitution of private by government debt will not lead to unsustainable government debt levels. There are two aspects to this issue. Let us first look at the debt levels of the public and private sectors in the euro zone. These are shown in figure 1. The most remarkable feature of this figure is how low the government debt is relative to private debt. In addition, the government debt is the only one that has declined (as a percent of GDP) during the last 10 years. This contrasts with the debt of households and especially the debt of financial institutions that has increased significantly and that stood at 250% of GDP in 2008. This is three times higher than the debt of the government which stood at approximately 70%. We conclude that more than the public debt, the private sector’s debt has become unsustainable. The process of substitution of private debt by public debt can go on for quite some time before it reaches the levels of unsustainability of the private debt.
Figure 1
Source: European Commission
The second dimension to the sustainability issue of government debt arises from the question of what will happen in the absence of a government takeover of the private debt. The answer is that in that case the debt deflation process is not likely to stop soon. As a result, output and income are likely to go down further. This will negatively affect tax revenues and will increase future budget deficits, forcing governments to increase their debt. Refusing to stop the debt deflation dynamics by issuing government debt today will not prevent the government debt from increasing in the future. The same problem of sustainability of the government debt will reappear.
To conclude it is useful to formulate a methodological note. The effectiveness of fiscal policies has been very much analyzed by economists. It appears from the empirical evidence that fiscal policy is limited in its effect to boost the economy. This evidence, however, is typically obtained from equilibrium models estimated during “normal” business cycle movements (see e.g. Wieland(2009), Cogan, et al. (2009)). In the context of the flow and stock deflations that are disequilibrium phenomena and that at the core of the present economic downturn, fiscal policy becomes an instrument to stabilize an economy that otherwise can become unstable. This feature is absent from modern macroeconomic models that are intrinsically stable. The evidence obtained from these models may not be very relevant to gauge the effectiveness of fiscal policies in the present context.
References
Akerlof, G., and Shiller, R., (2009), Animal Spirits: How Human Psychology Drives the Economy and Why It Matters for Global Capitalism, Princeton University Press,
Cogan, J, Tobias, C, Taylor, J, and Wieland, V., (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March 2009.
De Grauwe, P. (2009), Keynes’ Savings Paradox, Fisher’s Debt Deflation and the Banking Crisis, http://www.econ.kuleuven.be/ew/academic/intecon/Degrauwe/PDG-papers/Work_in_progress_Presentations/Flow-Stock%20Deflations.pdf
Fisher, I, (1933), The Debt-Deflation Theory of Great Depressions, Econometrica, 1, October, pp. 337-57.
Hall, R., and Woodward, S., (2009), The right way to create a good bank and a bad bank, www.voxeu.org/index.php
Minsky, H., (1986), Stabilizing an Unstable Economy, McGraw Hill, 395pp.
Wieland, V., (2009), The fiscal stimulus debate: “Bone-headed” and “Neanderthal”? http://www.voxeu.org/index.php?q=node/3373
Woodford, Michael (2009), “Convergence in Macroeconomics: Elements of the New Synthesis”, American Economic Journal: Macroeconomics, Vol. 1, No. 1, 267-279
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