Will the Horses Drink?

Policymakers’ strategy to fight the recession and credit crunch has been to make vastly more funds available through fiscal stimulus, low rates, and quantitative easing. Ironically, to get the country back on track requires encouraging the exact behavior that got us here in the first place. It is not possible to delever all at once because of what PIMCO’s Paul McCulley calls the “Paradox of Deleveraging”—deleveraging causes asset prices to fall thus increasing debt to equity. It is hard to imagine how recovery can occur if the consumer delevers as this would mean a fall in consumption—70% of GDP. The government has made massive amounts of funds available, the question is how will people behave. Just taking a horse to the watering hole doesn’t necessarily mean it will drink.

The question is one that goes back to an intellectual dispute between economists Milton Friedman and Irving Fisher about the Great Depression. Friedman argued the Fed could have prevented the Great Depression by increasing the money supply. Fisher argued once a credit bubble has burst, deflationary pressures will be so strong consumer behavior changes no matter if credit conditions change. Easy money or “candy floss money” increased asset prices in the “forward Minsky journey” until the Minsky Moment, when assets and debt deflate. Easy money has to be repaid with precious hard money. The question is whether the government can reinflate or whether consumer behavior has changed to the point where this is impossible.

This question largely depends on asset prices. Personal savings to personal income was around 10% in the 60s, 70s, and 80s, though ever since the rapid increase in asset prices during the 90s it has fallen to almost 0%. This article illustrates this trend. As asset prices fall, personal savings as % of personal income should increase, especially since incomes will fall as well. We've already seen an increase in the savings rate.

Remember the macroeconomic equation MV=PQ. The money supply (M) is increasing but the velocity of money (V) is decreasing. If the velocity of money doesn’t pick up, it will have a negative effect on production (Q) and price (P). If consumers and businesses don't retrench to far, the velocity of money will pick up and Milton Friedman will have been correct. (If it increases close to 2007 levels it will mean massive inflation.)

There are also non-behavioral impediments to the velocity of money. For example, massive downgrading from ratings agencies or perceived counterparty risk. Another example is Obama’s new restrictions on credit card rates. One reason for these high rates is because companies need to charge these rates to cover their huge default rate. These new rules will mean credit card companies offer less loans since they can’t charge a return high enough to compensate for the risks. We already saw revolving consumer credit fall at a 9.7% annualized rate in February. Politically motivated policies like this one (or Barney Frank calling for TARP repayments) can push the velocity of money even lower, feeding the deflationary spiral.