Monday, September 27, 2010

The deleveraging fallacy

Paul Krugman speaks for the bears when he argues that "when everyone tries to pay down debt at the same time, the result is a depressed economy and falling inflation, which cause the ratio of debt to income to rise if anything." I think his logic is flawed, just as the logic is flawed behind the assumption that an increase in outstanding debt leads to an increase in total demand.

The fallacy here is that borrowing increases demand, while deleveraging reduces demand. It's simply not true, except in the case that the lender happens to be a bank that is using its reserves to increase the money supply. Even then, an increase in the money supply cannot result in a real increase in demand, otherwise we could print our way to prosperity. Dumping money into the economy only increases prices.

If A borrows $100 from B and spends the money, there has been no increase in demand because B now has less money to spend. Similarly, if A repays his $100 loan to B, then A has less money to spend and B has more. When the private sector creates credit, it is not creating new money or new demand, it is only shifting money from one pocket to another. Now it's true that increased credit may result in a more efficient economy (though not necessarily), and that may result in a net increase in demand, but on the margin when one person lends to another, demand is shifted from one person to another, but no additional demand is created.

As supply-side theory tells us, new demand is created by new supply. Global demand cannot increase at all unless global production rises. Otherwise we could all get rich just by spending more, or as the late Jude Wanniski was fond of saying, "we could spend our way to prosperity." It just can't happen.

So deleveraging needn't result in a weak or depressed economy.

Mark Perry has a nice post today that is effectively a corollary to the above, recalling Milton Friedman's point that deficit spending is also powerless to stimulate an economy.


Benjamin said...

If central bankers target an inflation rate, some say fiscal stimulus then counteracted by monetary policy.

I prefer a monetarily bullish policy and balanced federal budgets. I think that is what Friedman would call for today.

When he visited Japan in the 1990s, he advised them to engage in QE until they generated inflation. They did not listen. They are still wallowing in deflation, come what may on commodities markets.

Frozen in the North said...

CBP: You cannot begin your argument with a domestic analysis and end it with a global analysis. apple and oranges.

My guess is American deleveraging will occur when banks have to MtM. Once they have to recognize their losses they will actively seek to clean up their balance sheet.

W.E. Heasley said...

Mr. Grannis:

You are exactly correct.

Mr. Krugman, hmmmmm, lets say he would be well served to pick up a copy of Thomas Sowell’s book Economic Facts and Fallacies. Alternatively, we could all purchase a “Krugman Truth Squad T-shirt” and go on our merry way (link follows):

marmico said...
This comment has been removed by a blog administrator.
Bill said...

marmico: Since you are such a genius and have clearly solved out all of the problems of the world, why do you waste your time on this website? Please enlighten, oh great one.

CFP, EA said...


First off, thanks again for all of your work. I really don't think people understand the effort involved. As a former reporter turned financial adviser who gets tired just writing my once-a-quarter article for my newsletter to my clients, I'm amazed as the number and quality of your blogs.

Now, on to business.

This is something that, to be frank, I've never quite understood. In a sense, I agree with you. The question in my mind comes from the banks. If I make a $10,000 loan to you to buy a car, then demand remains the same.

At that point, deleveraging doesn't matter, perfectly in line with your thesis.

But when you bring banks into the mix, things change. I deposit my $10,000, and they can use it as reserves, which allows them to make $70,000 worth of loan assuming a 7-to-1 loan-to-reserve ratio, or, yikes!, $100,000 worth of loans if they decide that a 10-to-1 ratio works better.

Now, let's assume that banks decide that a 6-to-1 ratio is more "prudent" and that they're simply willing to accept the lower profit in exchange for more stability. Their loan amount drops from $100,000 to $60,000 on my $10,000 deposit. That obviously decrease demand.

It's the banks and their reserve ratios that have always confused me with your side of the deleveraging argument.

However, I'll admit that I'm a bit of a babe in the woods when it comes to this. I'm a simple CFP and EA with a BS in econ (heck, I got a B in calc II . . . calc II!), so I don't claim to be an expert. But I'd love to hear your side of the bank argument.

Why don't banks and their ratios mess up your thesis.

Thanks again,

Scott Grannis said...

CFP: Your question is a good one, since I think that trips up a lot of people. First, let me say that if banks always loaned out to the max degree as allowed by their reserves, then we would have a monumental inflation problem on our hands already. But in fact there is $1 trillion of reserves sitting at the Fed, unused by the banks.

Second, if there were monster money creation going on, then I submit we should see some evidence of increased MZM, M1 or M2. But no, all these aggregates are growing at a modest pace, in line with nominal growth in the economy.

Third, bank actions to expand and contract the money supply needn't have any impact on the size of the economy. Pure money creation only fuels inflation. In the absence of uncontrolled bank lending (of which there is no evidence to date), then the economy will grow only to the extent that the economy produces. I must earn money first before I can lend it to someone. When successful, the net result of the Fed's actions is to provide enough reserves to the banking system, at the right price, so that money will end up expanding at a rate that accommodates nominal growth in output.

They don't always get it right, but the inflation record to date says they haven't made any big mistakes since the 1970s.

Charles said...

Krugman must not mean deleveraging. Perhaps he means rebuilding net worth. This would of course restore leverage to levels seen before the collapse in asset values. In any case, it's hard to see how deleveraging - absent an increase in savings - would have any effect at all except to shrink the financial sector. I could pay off my mortgage today - deleveraging - except for the fact that this is my strategy for protecting against inflation and minimizing taxes.

Scott Grannis said...

Charles: even rebuilding net worth does not subtract from demand or shrink the economy. I can only save if I give the money I've earned to someone else who promises to spend it in some productive fashion. Money saved is simply recycled to others who spend it. Savings are always spent. Always.

Well, there is an exception I suppose, and that would be when people (mostly foreigners I think) save by literally stuffing $100 bills under their mattress. But that can only account for a small fraction of total savings.

HFT said...

poor Krugman --

he never misses a chance to allow his politics to get in the way of economics

Public Library said...

"Pure money creation only fuels inflation."

Isn't this what we saw in 2000 (DOTCOM), 2003 - 2008 (REAL ESTATE/OIL), and now 2010 (COMMODITIES).

Maybe your broad + average definition of inflation is what skews your vantage point on inflation and fractional reserve banking.

Seems like we are swapping one calamity for another when the root of the problem is the mismanagement of the money supply via fractional reserve banking.

Scott Grannis said...

Public: don't get me wrong--I would be the last person to defend the Fed's record of managing monetary policy. I think they have made grievous errors along the way, and much of the boom/bust that has occurred in the economy can be traced back directly to Fed policy errors. I have had quite a few posts on this subject over the past few years. I was also quick to point out the potential dangers behind the Fed's QE program that began in late 2008. I am still worried that they are going to make a mistake.

Public Library said...

I guess with all of your bullish commodity posts, I am wondering when you will realize the current Fed monetary policy 'mistake' is already in the 5, 6, or maybe 7th inning of the process.

Signs are everywhere central governments are racing to the bottom of the currency barrel. Japan, China, Brazil, and the US are in full currency manipulation boom.

Scott Grannis said...

I've consistently said that rising commodity prices are a sign of accommodative monetary policy, and investors should take that as evidence that deflation is not a concern. Rising inflation is more likely than deflation.

Public Library said...

Yes you have repeatedly expressed your view on accommodative policy and I agree with it.

However, I am much more concerned this policy is not only accommodative, but inevitably destructive to the US and World economy.

Scott Grannis said...

Instead of "inevitably" destructive I think it is more correct to say "potentially." To date the Fed's accommodative policy stance has been effective and helpful, because it has offset the huge increase in money demand that we saw during and in the wake of the recession. Money demand remains very strong (witness ongoing deleveraging, strong currency growth). The problems will arise if/when money demand declines and the Fed fails to offset this with a tightening of policy conditions.

John said...

Pub and Scott,

Very interesting and informative conversation. I enjoyed reading it. Thank you.

On your Fed topic, Randall Forsyth of Barrons has an article today on possible fed 'qualitative' easing in which they target treasury bond rates. The link to the article is on Tuesday morning edition.