Wednesday, August 25, 2010

Stopping Deflation with Government Stimulus

Credit NY Fed
This post was inspired by a comment over at The Big Picture. Barry Ritholtz posted some interesting chart pr0n from the NY Fed's report on Household Debt & Credit and a commentator by the name of "HelicopterBen" brought up Richard Koo, whom I've written about before, and whose book I reviewed.

I feel like a broken record, but I'll say it again: Koo's GIGANTIC assumption is that the government will spend the money in projects with a NPV greater than zero. I quote myself below:
I'm just not comfortable leaving that decision up to the guys that decided to try to reflate the bubble by pulling-forward demand, subsidizing toy arrows and foreign liquor and build useless airports. Just sayin.
As I said in my response in TBP (I comment there as "X on the MTA"), trying to return to the good times by maintaining the money supply inflated is like trying to--ignore the negative connotation of disease for a second--infect a patient by inducing the symptoms. Or, if you prefer, curing the symptoms instead of the disease, either analogy works for me. I'm not going to rant about malinvestment, because I've already done so--although Pettis said it better  and then what Steve Waldman said it best. instead, I'm going to make a quick point about the money supply.

One of the Fed's goals is to maintain relative price stability. When Paul Volcker was first appointed Chairman of the FRB, he changed how things work and decided to try to control inflation by targeting the size of the money supply. Little '84 hiccups aside, it is in my opinion he did a good job navigating this new, uncharted territory. At the time this "monetarist" thing was fairly new, but it makes sense to control inflation by controlling the growth of the money supply. This works well because the Fed can act in the markets via the FOMC, and they can release accommodate expansion when it's needed and tighten when things are heating up too fast.

Koo--correctly, in my opinion--argues that during a large-scale deleveraging, when rates are already pushing zero, monetary policy becomes impotent. He argues that no matter how much money a central bank puts out, it won't create inflation if businesses and households are all focused on paying down debt. I think he is totally correct. Where I disagree with him is where he argues that the government should become the borrower of last resort to keep the money supply from shrinking. Yeah, the government can soak-up funds when there's an excess, but can we trust them to release them when the private sector needs them? More so, can the government allocate capital in anything but a wasteful manner? Which brings me to my main point: why do we need to keep the money supply inflated, and businesses and households leveraged? I am not saying we should allow a violent deflationary crisis to take place, or the government shouldn't stimulate when it makes sense, I'm just saying there is nothing wrong with having excess reserves when there's nothing to invest them in. Americans are simply not going to halt spending because of small price declines are expected. I'll put money on that.

Borrowing is contracting and there is excess reserves because people want to save and pay-down debts. Some may need to save the money for future expenses, others may want to pay down the underwater component of a mortgage so they can refinance at a lower rate or sell and move. CC debtors may need to lower their debt-service so they can start spend that money elsewhere. Some may want to lower DTI ratios so they can borrow in the future. Slack in the system is a good thing, just like cash in an investment account. There is nothing wrong with not being fully leveraged or fully invested. Businesses and households are preparing and keeping their powder dry so that once a suitable investment comes, they can act on it. That is healthy and rational.

Businesses and households may be paying down debt because they have ugly balance-sheets as a result of the decline in asset values. Fixing balance sheets is not a bad thing, it leads to strong businesses that can grow once their internal problems are fixed. Trying to keep businesses and households in their current, insolvent and over-leveraged state to prevent a few bankruptcies is like locking up junkies and keeping them high so that they don't have to go through withdrawals: ultimately counterproductive.

I would favor going through a painful deflationary cycle and dealing with the bankruptcies of weak businesses and households, but if the Koo sympathizers really want to transfer debt from businesses and households to the government aka "the borrower of last resort", maybe we could do it by having the government borrow large amounts at record-low rates and sending checks to tax-payers instead of poorly investing it. Tax payers could then use that money to pay-down debts, get out of homes they can't afford, or consume and invest if they are so inclined. If nothing else, it would speed-up the process of getting consumers back to a healthy place where they can start spending again so businesses have an incentive to start investing again. Of course we'd have to deal with higher taxes to serve that debt, but something tells me Uncle Sam has a better rate than Joe the Plumber's Capital One card.

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