Thursday, January 22, 2009

Is More Debt the Answer?

Many Americans have probably never heard of Pimco, the giant mutual-fund complex based in Newport Beach, California. As one of the largest buyers of Treasury bonds in the world, it functions as the intermediary for millions of people globally between their need to save, and the government's need to borrow. This makes it one of the most important institutions in the economy.

Given that American households have ceased borrowing to pay for frivolous things like bigger houses and $6 lattes, Pimco economist and portfolio manager Paul McCulley thinks the government should now start throwing huge amounts of money around to revive activity. He spoke on CNBC today:

“What you have to have is the sovereign, Uncle Sam himself, lever up to soften the blow of the de-leveraging in the private sector. And, you’re seeing that with respect to the TARP .. The FDIC …. [ and ] the dramatic expansion of the Fed’s balance sheet. Essentially you have a private sector de-leveraging and de-risking, and a public sector going the other direction. And that is absolutely critical to avoid a cascading into depression. Washington is taking the right responses, meeting a de-levering force with a re-leveraging force.”

In many ways, this is classic "Keynsian" economics, the idea that the government should step in to counter swings in the business cycle. (I put Keynsian in quotes because I am not convinced that John Maynard Keynes would ever agree with some of the ideas emerging today in his name.)

While I have vast respect for Paul McCulley as an investor and economist, I have several objections to his argument:

1-Debt needs to be paid back. Americans are beginning a long process of paying back their debts after years of reckless spending and borrowing. We're going to pay this money back no matter what. If we allow the government to simply run off more debt, we'll have to pay it back a second time with either inflation or higher taxes.

2-All spending is not equal. It amazes me how apparently rational economists want the government to wantonly spend money regardless of the purpose. They seem to forget that money represents real resources, real wealth, real human labor, and real human spirit. As the government tries to find ways to spend, it will inevitably squander real resources, causing millions of people to spend billions of man-hours on unproductive activities. This debt-financed economic system has already proven a bad judge of allocating capital -- that's why we have millions of empty houses scattered across exurban America. When the government spends the money directly, it will be even less rational.

3-It won't work. The Congressional Budget Office says that less than $180bln of the $825bln sought by Barack Obama would be spent by the end of 2010. Rock-star bank-analyst Meredith Whitney sees about 10x that amount leaving the economy over the same period as credit-card issuers cope with losses and sell fewer bonds to finance people's balances. Furthermore, state and local governments are only now starting to take it on the chin, and will soon be forced to cut jobs and spending.

Years of covering earnings and economics has taught me that things change very slowly. Industries that have served one set of clients in the private sector for years will not simply just switch to the government. New business takes 2-3 years to really get moving, which means you'd be better off just waiting for the economy to rebound. By announcing big spending plans, you run the risk of delaying private-sector growth because people will wait to see how the government programs go. That means the recovery programs can actually prevent the recovery. (The problem is that, just like the stock market, people react what they know is coming, which I address right below with the mention of "static vs. dynamic.")

McCulley, known for discussing economics with his pet rabbit, argues that the combination of recession and bank failures will cause "debt deflation" a la the 1930s. The basic ideas is that as banks implode, they will cut lending and money will stop moving through the economy. As companies fail and workers lose their jobs, prices and wages will both drop. That makes it harder for everyone to pay their debts, resulting in more failures and more bad banks. (Imagine a store borrowed $1 million to stock up on merchandise for Christmas and expecting to bring in $2 million. Then every other retailer slashes prices and the store only earns say $1.5 million. That missing $500,000 comes right out of salaries, rent, etc.)

I completely agree with him about the danger of deflation, even though in an earlier post, I thought he was too nonplussed by rising prices. (That was before the failure of Lehman, which changed everything to me.)

However, I don't agree with McCulley's solution to the problem. The basic concept of "fighting deflation with inflation" makes sense purely on an academic level, divorced from reality. Like many ideas hatched in the 1930s, McCulley's argument is based on a completely static understanding of social behavior: Just replace private-sector spending with public-sector spending, and the economy will never know the difference... Kind of like changing a lightbulb or a sparkplug.

The truth is obviously different: Social behavior is dynamic. Private sector money tends to be spent by real people with real concerns, so it needs to be legitimately productive. Public sector money is spent by politicians interested in getting re-elected and transfering money to constituents. I believe that much of it will end up in private bank accounts and never be spent in "the real economy." The debt incurred, however, will be very real.

And, once money is spent by the government, interest groups and lobbyists proliferate -- much as sea worms cling to rocks miles beneath the ocean. They subsist on chemicals leaked from geothermal vents in a lifeless environment, much as trees thrive in oasis in the middle of the desert.

Sea Worm From Deep-Ocean Vent

McCulley's underlying argument fails to address the fact that behavior changes when money is spent. If you pay people to be unproductive and allocate energy wastefully, they will. That's how we wound up with a housing bubble in the first place: The government subsidized homeownership and mortgage lending for decades, and encouraged what we now know as sprawl as a way to deal with an economy that was producing too much stuff. (Much of this resulted from the two World Wars, when the U.S. supplied other countries with vast amounts of materiel.)

Government spending is a bit like suicide: It's a permanent solution to a temporary problem. It elevates a crisis to the level of national policy, and condemns the country to live in its wake for generations to come. This is is why we have such an inefficient health-insurance system, for instance; it allowed employers to dodge wage limits during the Second World War. Once it was enshrined in the tax code, an industry grew around it. Don't think the spending McCulley urges will be any different now. Because government is based on coercion rather than voluntary compliance, its programs last forever.

I once saw a show about people suffering tragic face-devouring tumors. I will spare readers the image, but you can follow the link. Needless to say, they make the worm above look like Clark Gable. One thing that struck me was that one patient had the opportunity to be cured after 10-20 years of this horrible ailment -- yet was reluctant because he had grown to identify with the disease. Similar cases can be found in some parts of the U.S., where welfare dependency was passed down from one generation to the next. Once people percieve themselves to be victims of something, and "in need," it becomes incredibly difficult to break free. This kind of "reflate the economy at all cost" thinking is no different. Such initiatives will perpetuate the state of crisis and make it the new normal, preventing any return to the old normal of healthy growth. Japan and Venezuela, which both had severe banking crises in the early 1990s, both exemplify this pattern.

When McCulley appeared on CNBC today, they put up a list of ideas he had for how the government could help the economy:
1-Sidestep banks and move to buying munis and commercial bonds over time
2-Set up aggregator bank to lift bad assets
3-Stimulus package to deal with shortage of demand

I am flattered to think that Paul McCulley may be reading this blog, because I have been harping about point #1 since early October.

One more point about Pimco is that it is staffed with a lot of very intelligent people. (I am also a huge fan of Mohammed El-Erian, whose understated manner is the polar opposite of the colorful McCulley.) I am not sure how much they consider the problems I have addressed in this posting, but they must be aware of them on some level.

The concern is that, as an institution, Pimco has a vested interest in the government borrowing as much money as possible. They run the world's biggest bond funds, and probably have more than half their total $700bln of assets in Treasuries. Because of their prominence and skills, the Fed has already tapped them to run some of its rescue programs.

I would almost say that Pimco is an adjunct of the government, but the truth is they do far too good of a job to ever be compared to the public sector. (My own 401(k) has directly benefitted from their wise management.)

Like all good businesses, Pimco inevitably wishes to see its market grow. The more Treasury issuance, the more money under management and the more fees they earn. I think anyone heeding their advice needs to remember that, like any organization, Pimco is responding to its own set of incentives. It's a bit like the ratings agencies, which had a clear incentive to grow the securitization market. The country paid the price for that. We should think hard about doing the same thing on a much bigger scale by "reflating the economy."

This is especially true because McCulley doesn't say what will come after the stimulus. Now that home prices and mortgage lending are both collapsing, I believe the consumer-based growth model is broken. It's not 1990 or 2000 when we can just count on going back to normal. And without a sense of what comes after "reflation," McCulley's argument is a bridge to nowhere -- except a future in hoc.


This chart show the long-term trends that are now coming unravelled.

Since the end of WWII, American households went on what was probably the most lasting and thorough borrowing spree in financial history. This largely drove the huge rise in non-government debt (see the green and red lines above), aided to a lesser extent by business borrowing. (Business borrowing is also a big problem, which I address in this blog entry.)

Interestingly, government debt is still quite small relative to GDP, meaning it has a lot of room to go up. (The data above includes state and local bonds and loans, but doesn't include most "entitlement" liabilities such as social security or pensions. All the borrowing discussed in this article would be at the federal level only.)

This raises the question of another trend I have noticed from my time covering credit: Problems tend to "work their way up a capital structure" over time. A company's equity is designed to absorb losses before lenders. That means stock prices get hit first, then bonds, then finally loans. Each category is progressively "more senior."

It's interesting that this financial crisis didn't begin with Lehman Brothers, or even Bear Stearns. It began in February 2007 with the bankruptcy of a subprime lender called New Century Financial. It fell first because it was closest to the bad assets. Since then, the problems have worked their way "up the capital structure," claiming bigger and more prominent institutions. (Bank of America, Citi) Even supposedly AAA borrowers like Fannie Mae and Freddie Mac are now essentially bankrupt. This leaves only the sovereign rating of the USA itself with any credit (or credit-ability). But, we're talking about burdening future generations with trillions of dollars in unnecessary debt. The mere fact it's the only thing to leverage doesn't mean we should.

To borrow an analogy understood by most elementary schoolers: Just because Paul McCulley says to jump off a building doesn't make it a good idea.


I'd like to end with one final criticism of the "reflation by government force" argument with a quote from "A Reason to Believe" off Bruce Springsteen's Nebraska album:

"Seen a man standin' over a dead dog, lyin' by the highway in a ditch,
He's lookin down kinda puzzled, pokin' that dog with a stick,
Got his car door flung open, he's standin out on highway 31,
Like if he stood there long enough, that dog'd get up and run ..."

The economic model we all know an love, the consumer, is the dog in the song -- D-E-A-D.. dead. After years of buying ever bigger houses, cars, stainless-steel refrigerators and aspirational handbags, he's lying in a ditch at the edge of the shopping mall parking lot, his guts smeared across the road by an $80,000 Hummer and a $30,000 credit card bill.

Home prices are falling, lending is contracting and an entire generation of Americans is learning about the dark side of debt the hard way. This is not 2000, when people still felt rich from the bull market of the 1990s. Ben Bernanke and Tim Geithner can poke and prod all they want, but this dog is not going to get up and run. They might get it to move by shocking it with a defibrillator, but that proves nothing. It's time to move on.


This is why I am calling for a new paradigm based on undoing some of the excesses of the last few decades. I believe if we're going to throw money around for anything, we should buy up/condemn entire subdivisions and pay unemployed construction workers to dismantle houses. They would leave the roads and sewers (and maybe slab foundations), and allow the land to return to wild. That way in 10-20 years, it could be redeveloped. But by removing the houses now, you will prevent major social problems that could likely result from large numbers of derelect structures.

Secondly, I think we need to promote a new urbanism. Our car-based suburban lifestyle is unsustainable on many levels -- mainly from a financial point of view. We already are going to have a major crisis in commercial real estate, so why not turn the problems into profits? I propose that we encourage investors to convert shopping malls into cities. Convert department stores into offices and industrial space. Once jobs are in place, some people will wish to live there. Allow other parts of the mall to become apartments, grocery stores, bars and gyms. Do stuff to encourage communities to develop, like opening up parts of the space to bands and plays, etc.

It could be a great way to live because you could still have a car left outside, when you need to travel. But, most people would probably find they use it rarely.

These are just primitive ideas, but I think they are of greater long-term utility to the economy than just throwing money at the problem. To me, it's important that any solutions be more than just bandages -- they need to offer the potential for profitable activity in the future. (This is why the 1930s model based on sprawl and the automobile worked -- becuse it was profitable.) If it's not based on long-term profits, it will wind up like welfare in the inner city, or the UK coal industry before Thatcher. I explain the problem with economic altruism in an earlier posting.

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