In a new piece posted by John Hussman yesterday, he makes some excellent points regarding the essence of debt deflation, and the horrendous degree of agency risk that’s been at work in private sector bailouts to date.
On debt deflation, he argues that nominal restructuring (adjusting the principal value and interest payments due on existing credit obligations) is the only way to mitigate debt deflation and its negative effects (emphasis added):
…from our perspective, the essential difficulty of the market here is not Greece, it is not the Euro, it is not Hungary, and it is really not even the slow pace of job growth in the latest report. The fundamental problem is that we have not, as a global economy, accepted the word “restructuring” into our dialogue. Instead, we have allowed our policy makers to borrow and print extraordinarily large band-aids to temporarily cover an open wound that will not heal until we close the gap. That gap is the difference between the face value of debt securities and the actual cash flows available to service them. The way to close the gap is to restructure the debt. This will require those who made the bad loans to accept the associated losses. By failing to do that, we have failed to address the essential problem faced by the world, which is that we have created more debt than we are able to service.
Hussman’s restructuring is related, in an inverse way, to the direct and indirect fiscal expansion we’ve been advocating. Our proposal is focused on “flows”, while his is focused on the nominal “stock” of outstanding debt, or said another way, ours would seek to support nominal incomes (and thus the cash flows required to service debt) while his would focus on lowering the required cash flows on debt service. Our idea is aimed more at preventing deflation, while Hussman’s proposal could have deflationary effects, at least in the short to intermediate term, while offering a more direct and orderly alternative to the immense backlog of filed and yet-to-be-filed bankruptcies.
One serious impediment to his suggested approach is that financial institutions simply aren’t willing to take those haircuts. They’ve leaned heavily on public sector support since the financial crisis erupted, while stalling on measures like MHA that are intended to put some of those haircuts into effect — even though the federal government has promised to eat part of the resulting losses.
Meanwhile, the few haircuts that are taken are being dictated in a piecemeal fashion by bankruptcy judges. Perhaps this will start to change in the months ahead, i.e., private sector actors (banks) will start doing the right thing; private sector fundamentalists have always said that they would, after all! To be fair, some creditors are reportedly offering balance liquidation plans and things like unsecured debt — but they’re doing so with the help of direct and indirect subsidies from the Fed and the Treasury, and typically without reductions in principal.
Hussman captures this political agency risk and asymmetry well:
…when our policy makers insist on defending reckless lenders with public resources, we have to recognize that this is not free money. When the government issues a paper liability for real value, that real value gets directed to the recipient at the expense of countless other activities. Even seemingly costless interventions can be redistributions of wealth. For example, the strategy of dropping short-term interest rates to nearly zero as a way of increasing the interest spread earned by banks has the direct effect of impoverishing savers, very often elderly people who rely on lower risk investments for capital preservation. With regard to Fannie Mae and Freddie Mac, either the Treasury securities issued in order to cover their losses will crowd out other private investment, or the eventual inflationary effects of printing money to do so will act as an implicit tax on people with fixed incomes…
A dollar spent by the government is always a dollar taken from somebody and diverted from some other activity. The only question is whether the dollar spent is more productive, or satisfies a more desperate human need, than the alternative activity would. If not, the spending is hostile to economic growth and public welfare. There is no free lunch. At best, what people call “stimulus” can only occur if the dollars spent by government are more productive than they would have been if they were allocated privately. I cannot imagine how allocating public funds to the same reckless stewards of capital that made the bad loans in the first place can possibly be a productive use of capital.
While we have some quibbles with Hussman’s assumptions regarding printing money and “crowding out”, we wholeheartedly agree with his assessment of the disturbing political aspects of the public support given to date. Beyond the Treasury’s backstopping of part or all of loans that should never have been made, consider the following: the Fed lowers interest rates to levels that allow member banks to bid for new dollars at a very low nominal cost of ~0.25%; the banks buy Treasury or Treasury backed debt at, say, 3.25%; and the banks earn a risk free (for the time being at least) spread of 300 basis points! Great work if you can get it…
Assuming that the yield curve continues to flatten at low nominal rates as we expect, that subsidy will eventually shrink. But until then, it’s a big fat subsidy for the very entities that led us into this mess. And while it’s being supported by this and other public subsidies, the industry has also been forcefully collecting on delinquent obligations.
Perhaps the most disturbing political aspect is that households and the rest of the private sector don’t have the same kind of lifelines available to them as banks do. To see the effects, one need only compare unemployment or welfare benefits and persistent unemployment to the perfect batting averages and ridiculously juicy profits earned by major investment banks’ trading desks in the first quarter of this year.
For households and individuals to ”survive” (literally for some of them) they need reasonably steady incomes, i.e., cash flows. But when the private sector is retrenching — driven not only by balance sheet carnage and pyschology, but also by powerful factors like negative trends in demographic ratios — then incomes can only be supported via concerted fiscal expansion by the public sector. And yet policymakers around the world are promising to do the exact opposite, with the G20 ministers ging their “exquisite foolishness” an hallelujah chorus over the weekend.
Many skeptics (Hussman included, we expect) react reflexively to that proposition as meaning that government is going to compete more intensively with the private sector for resources like labor and financial capital, while running up a larger deficit. While that can happen under certain conditions, it’s (1) not likely today and (2) not what we’re proposing. First, the slack overhanging the real economy for the foreseeable future precludes rampant inflation — the Cassandras are just flat wrong on that count. And second, the federal government has the capacity to utilize idle resources, including labor, via the direct creation of new money — yes, the dreaded “printing press.” Skeptics should realize that this is already occurring in a decidedly non-inflationary manner. All our proposal would do is transfer the money creation process now underway from the control of the banking sector to the unemployed. It’s certainly a more just and democratic approach than the current one.
Another more democratic approach is Warren Mosler’s payroll tax holiday, which has still received little if any attention from policymakers, even though it too would do far more for households than the status quo. Skeptics will reflexively attempt to discredit such a proposal by referring to Ricardian Equivalence, sub-unity fiscal multipliers and the like. But that’s because, personal values and biases aside, too few of them have bothered to critically examine the assumptions underlying the prevailing dogma.
For the foreseeable future, that dogma will lead in the direction of fiscal austerity and ineffective, zero bound monetary policy. And logically, as we’ve been noting of late, there is simply no reason for gold to be climbing in this environment, much less alongside the USD and US Treasuries. But like other bubbles, there’s still a real probability that it traces an irrational parabola much higher before it finally crashes back to earth. However, unlike more recent bubbles, and even the 1920s, the global financial system is in a decidedly deflationary posture today, which makes us wonder if there’s enough dry powder to push gold substantially higher. As we noted recently, we’re watching the technicals. If gold pushes through its current resistance, we’ll close out long GLL positions and replace them with long out of-the-money put options on GLD.
TOH to Ed Harrison for the Hussman piece. Ed put forth an interesting idea on why electorates seem to be pushing for fiscal austerity, despite the obvious damage it will create (emphasis added):
For the US, it is this understanding – that stimulus has merely been used to maintain a malinvested status quo ante – that is causing people to turn to austerity in disgust…
The Obama Administration has effectively demonstrated that special interests are too entrenched to trust the government to apply effective stimulus. They gifted the financial services industry billions and are still bailing them out via Fannie and Freddie. Afterwards, they went on the Healthcare boondoggle which is rightfully seen as a giveaway to the healthcare insurance companies resulting from secret closed door agreements with the Obama Administration.
They have discredited stimulus as a policy tool. And even deficit spending via tax cuts is now seen as irresponsible because of their efforts. Americans are willing to go with fiscal austerity if only to stop this predatory transfer of wealth.
Interesting take, and there might be something to it. But we doubt that public sector fiscal austerity will do anything to curb moral hazard in the financial sector, especially given the difficulties politicians and regulators are having in limiting systemic financial risk. Instead, we think austerity is likely to cause further economic dislocation and thus cause current problems to intensify. To the extent that this causes the payment system to freeze up again, the public sector will supply yet more support to the banking system, without symmetrical support to the household and other business sectors. Should that happen, the political upheaval could be significant.
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