Thursday, August 21, 2008

Credit unwiding: good or bad?

This article has been making the rounds. The author, Paul McCulley, argues that as the banks deleverage their balance sheets they are counter-acting each other. As bad mortgages are sloughed off, the prices of homes generally fall, driving down the asset columns of all banks' balance sheets simultaneously.

He has a point, but this is a symptom of the fraudulent nature of fractional-reserve banking and money multiplication, not an indictment of the sound practice of sloughing bad assets to shore up one's balance sheet. McCulley proposes a band-aid solution that only serves to perpetuate the root problem: shifting the bad assets off of the banks that took them on and forcing taxpayers to foot the bill.

The moral hazard of socializing investment risk should be obvious. Frank Shostak of the Mises Institute gives a detailed response to McCulley's article here.

A key difference between McCulley and Shostak is the mainstream (Keynesian) view of savings versus the Austrian view of savings. In the mainstream view, savings are a reduction in someone else's income (McCulley alludes to this in his discussion of Keynes's paradox of thrift). Savings, then, always result in decreased productivity. On this view, if everyone starts saving money (perhaps because they are fearful or uncertain about the future), this is unhealthy for the economy. In the Austrian view, savings are deferred consumption. When I save money, I am simply exchanging present consumption in favor of future consumption. Shostak explains this view in his article.

What is crucial to understand is that when you consume in the present, you are employing resources to satisfy your present consumption. When you defer consumption (save), you are freeing the resources you would otherwise have employed to satisfy your present consumption. These resources are then free to be employed in other ways, perhaps at a lower price. In an uncertain economy, the first things on which people cut spending are luxury goods. People cancel their premium cable and go to basic cable or broadcast TV. They get fewer manicures and buy less fashionable clothes.

It might be argued that this is the worst possible thing that can happen in an uncertain economy - people are getting laid off and jobs are being destroyed. But this is not the case at all. The demand for money increases which drives down prices (making necessary goods and services more affordable) and human and capital resources are freed from more frivolous sectors (luxury goods) and can be repurposed to production of the more in-demand basic necessities. In an uncertain economy, this is exactly what should happen. When people are uncertain about the future, dancing and making merry is madness.

As people become less uncertain as the economy recovers, the demand for money decreases, savings decrease, spending increases, consumption increases, prices rise, and the sale of luxury goods returns to its normal levels quickly. Without monetary savings, the recovery would be hampered by a lack of liquidity. As Shostak argues in the article, there is no paradox of thrift - or paradox of deleveraging - in the real world, only in the fantasy land of Keynesian economics. Just as thrift is exactly the right medicine for an uncertain economy, so deleveraging is exactly the medicine our credit-saturated economy needs to take. Pushing the consequences of our drunken credit binge out onto the public purse only ensures the next hangover will be even worse.

No comments: