Sunday, September 7, 2008

We are all Keynesians now

I don’t know when it was exactly that Pimco’s Bill Gross took his SAT exam but it must have been a long time ago. And that’s not a judgment on his looks, which brim with So Cal youthfulness. Rather, it’s a judgment based on his latest call for the US Treasury to step in to buy (on behalf of taxpayers) the numerous acronym-of-securities that are being dumped into the market by troubled financial institutions.

Cynics of course could rush to read this as a frantic plea to the government to… “for god’s sake…! Save our as*&*&s,..! We were wrong… Got in too early… failed to see how massive a deleveraging would be needed to correct the excesses of recent years.. (excesses we invariably disparaged, by the way, and take credit for avoiding).. So we used our pile of cash to buy, you know, those “bargains” that emerged from the ashes early on.. the Citigroups of this world, Fannie & Freddie MBS.. and so on.. but prices keep on falling.. it hurts!”

I won’t go there. And that’s because, apart from billions of assets “hurting,” Gross and his Pimco buddies have (high-quality) brains. And they seem to have used them in this case to offer an economic rationale for their call. So let’s see if that one works.

The paradox of deleveraging: The idea of Treasury intervention goes back to an earlier article by Pimco’s “spokesman” par excellence, Paul McCulley. McCulley argues that it is one thing for a single bank to shed assets in order to reduce its leverage to more acceptable levels; but it’s another thing if every bank does so at the same time.

The reason is that collective asset-shedding drives asset prices down, creating losses for all those who own them (including the banks), which in turn reduces banks’ equity. Lower equity means leverage goes back up—which makes the whole deleveraging effort counterproductive. That’s what McCulley calls “the paradox of deleveraging.”

The solution? Bring in the Treasury! Have them buy enough dumped assets to stop their prices from falling… so that all those who need to deleverage can do so in peace (and those with cash can buy some of the dumped stuff without worrying about further price declines).

Makes sense? Well, it makes as much sense as another paradox that McCulley uses as an analogy, Keynes’ paradox of thrift: That’s the thesis that if everyone, collectively, save more, aggregate consumption will fall, and so will incomes. And, since people save less when they earn less, aggregate savings will fall—once again, beating the purpose of saving in the first place. So savings is bad for growth??! Sounds like it, and the way to stop this is to have the government step in and spend more!...

...Right, only that economic thought has advanced since then (a little bit). Indeed, I hear that even big Keynes fans like Nobel-prize winner Paul Samuelson dropped references to the thrift paradox in more recent versions of their economic textbooks (evidently after McCulley and Gross’ time!)

The reason is that the “paradox” ignores a few basic points: First, lower consumption should drive prices down—eventually by enough to spur new consumption. Moreover, the “paradox” confuses “savings” with cash hoarding: When people save, they don’t actually keep their cash in their drawers. They put it in stocks, a new home or other investments or, alternatively, in banks, which go on to lend to the productive sector. That’s good for growth! Finally, when the supply of savings increases, interest rates should fall, spurring higher investment—again, good for growth.

Back to deleveraging: Never mind the paradox of thrift. But what about the paradox of deleveraging? Hmmm… The argument rests on the assumption that current asset prices don't make sense.. that they are falling way below what is justified by fundamentals—say, historic default and recovery rates on mortgages.

But hey, if that’s so obvious, why isn’t the “buy-side” stepping in? Why is Gross warning (/threatening?) that “We, as well as our Sovereign Wealth Fund (SWF) and central bank counterparts, are reluctant to make additional commitments”? If anything, some of the “bargains” they bought in January are even better bargains now! Gross of course can defend himself: Ongoing deleveraging will keep on lowering prices. So why buy now instead of waiting until prices are cheaper?.. and cheaper?.. even cheaper?

A role for the government then? Perhaps. But not the one Gross and McCulley call for. IF prices are "fair" (or way below fair), the problem seems to be one of (failure of) coordination: Pimco doesn’t get in because, alone, it will get hurt. But suppose Paulson organized a luxury weekend retreat for the Pimcos and Blackrocks and Wellingtons of this world… and brought in the Chinese too, and a few SWFs from the Gulf states. I mean, some of these guys are flush with cash. Together, they should be able to garner an impressive demand for all the acronymed "bargains" floating out there—and entice smaller players in the process. Not a penny of taxpayer money—the government is just the coordinator.

Problem is, the “fairness” of current prices remains a trillion-dollar question. Especially as the economy weakens further and unemployment keeps climbing. And even more so since the prices of many of these securities were extremely dubious to begin with—to the point that Gross himself labeled some of them as “garbage” only a few months back.

So that's it, the government is called to buy the garbage... Or could I be reading this wrongly? Maybe it’s just called to buy the “good”, truly undervalued, stuff? (You know, those bargains that that Pimco and others bought early on?) But if one were to stop the spiraling impact of deleveraging on prices one should not discriminate, right?

Internalizing the externality: But could a government intervention be justified by the existence of a market failure, like an externality? You know, when you have some agents (read “undercapitalized banks”) deleveraging and, in the process, cause collateral damage (read “falling asset prices”) on good guys (read “Pimco & co”)? Even here, the government’s role is not obvious. The market-based solution would have the “bad” guys “internalize” the cost of their actions.

Of course, it’s unrealistic to ask Merrill, Citi & co. to compensate investors for the losses they have inflicted on them. But maybe they should start paying a bigger price. There are more than one ways for banks to deleverage—shed assets, which hurts everyone, or raise capital, which hurts them, as new capital is becoming more and more expensive. What? Did I hear Lehmans was having trouble raising money from the Koreans because it didn’t like the price??! It’s about time banks swallow it. Needless to say, that would be good news for Pimco & co, who should be able to participate in the recapitalization process at much more attractive rates.

Ultimately, the excesses of the past few years are turning out to have been too gigantic for even the wildest of imaginations. But asking the government (taxpayer) to assume a liability of still-unknown proportions is clearly wrong—a massive wealth transfer from (greedy) borrowers to (prudent) savers. Yet, this is what we are seeing, with July’s housing bill and the latest government plan to bail out Fannie and Freddie.

We are all Keynesians now.

Glossary: deleveraging, paradox of thrift, externality, Keynesian economics

Bill Gross: Government must buy assets to prevent “tsunami”

Government takes control of Fannie and Freddie


Banastre_Badcat said...

Go, Chevelle, go!! I was wondering if anyone was going to call Gross out for his condescension and "threats." This arrogance has gone on long enough; the video game is over, "the masters of the universe" are exposed as the biggest con since the last Gilded Age (and THAT, at least, provided something of value in return for its cruelty and brutality).

Keep writing, please!!


JFK said...

Spirited, Chevelle - but we should all happy that Paulson FINALLY pulled the trigger (after first having secured the option from a skeptical Congress) on the two worst financial monstrosities of the world! OK, so what if it costs us all as Poole says $300bn for the bailout? F&F have been paying out at least a VERY conservative $25bn a year (a back of the envelope $5tr x 50bp above treasures for agency debt) to bondholders, while staying in the AAA-rated share of the Treasury.... Thumbs UP for him for putting shareholders (especially the preferred!) to the stake, even if the need to formally keep F&F off the gov. balance sheet requires that it be done in a drip-feed! The required de-levering of the F&F fiction is after 2010 not only good economics, its common sense!! PIMCO should indeed be happy, as all agencies should now be trading like regular low-yielding treasuries!!

Anonymous said...

the shocking part of the bailout is that, unlike the shareholders, the bondholders of fannie and freddie did not get a haircut (DEBT haircut)
Which validated their presumption that the premium they were getting paid all these years for holding "riskier" securities was a free lunch. Repeat, free lunch. Seems like economic theory is being re-written here.