Monday, June 27, 2011

What "Deleveraging" Means

The point, if there is a point, to Keynesian stimulus is to carry the economy over a temporary slump where asset values have been reduced to panic lows. But what about a situation where asset values are permanently reduced, as in the current housing slump?

Chances are that there is no way that house prices will recover to their 2006 highs any time soon. That means that people with underwater mortgages are screwed. They must either continue to pay their mortgages down and eat the loss, or they must take the loss now and walk away from their underwater mortgages.

That, you may say, is their problem. But it is our problem too. So long as the housing market is depressed and there are millions of underwater mortgages, so long will the economy sputter along. It's easy to see why.

When borrowers are above water, then everything is fine. The borrower is making payments and anyway, if the borrower were to get into trouble, the borrower could sell the asset and still repay the loan. When the borrower is underwater, then creditors know they are in danger of losses. They cannot trust the current borrowers because the borrowers are likely renege on their loans. That makes creditors more conservative; they must create a reserve against losses to protect their own financial position and are thus less able and less likely to loan money.

Creditors in this position are "deleveraging." They are reducing the amount of credit they are extending. Debtors too are doing the same thing. They are reducing their indebtedness to reduce the risk of default.

In the US, according to Michael Pento, the temporary stimulus of 2008 to 2010 is spent. "Government intervention can only temporarily circumvent the deleveraging process that is necessary for viable growth."

In other words, sooner or later, all Americans must adjust their financial assets to the new reality after the crash. They must reduce their debt or increase their equity so that their balance sheets show a healthy positive net worth.

Of course, one of the purposes of the government printing money is to lower the value of the dollar and the underwater mortgages so that the nominal dollar value of houses will increase. The problem with that is that, so far, the inflationary money creation has increased commodity prices like oil, gold, silver, copper, and grains and left house prices underwater. Meanwhile the strict regulatory regime of the Dodd-Frank financial reform has made banks less inclined to make risky loans.

We are seeing, to coin a phrase, the euthanasia of Keynesian economics. It is easy to sneer, as Keynes did, at the "rentier" class, the holders of government bonds, and call for their "euthanasia." Maybe back in the 1920s there were just a few of them and it served them right. But today the rentier is the ordinary middle-class saver, the government employee with a stake in a pension fund. Is that what the ruling class wants? To euthanize the ordinary middle-class striver and saver?

The current sluggish recovery is a shocking indictment of everything we have been taught to believe about the ability of government to manage the economy. In fact, the government should observe the Hippocratic oath, do "do no harm," because that is all that it can really achieve, long term. But that kind of policy wouldn't help politicians buy votes.

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