Paul McCulley, a managing director at bond giant PIMCO, just recently posted his latest Global Central Bank Focus. (You can read it in full here.)
I’ve been reading McCulley’s monthly missives for years, and I almost always enjoy them. McCulley is down to earth and extremely smart. He is also a die-hard Keynesian, which I most certainly am not. (That’s one reason I like his stuff — it’s refreshing to take in a well-articulated viewpoint that runs counter to your own.)
McCulley’s latest, “When Unconventional Becomes Conventional,” is a Keynesian tour de force.
Here is the thrust of his argument as I interpret it:
- In normal times, it is the Fed’s job to “take away the punchbowl” and fight inflationary borrow-and-spend pressures.
- In post-bubble episodes of deflationary danger, however, the Fed’s role changes completely.
- When there is real danger of deflation, the Fed should print and stimulate with abandon.
McCulley puts it like this (emphasis mine):
When, however, the economy suffers from Post Bubble Disorder, characterized by private sector deleveraging and a fat-tail risk of deflation, conventional monetary policy doesn’t cut the mustard. In such a liquidity trap, private sector demand for credit is, axiomatically, very inelastic to low interest rates, as evidenced by contracting private sector debt footings, even when the central bank’s policy rate is pinned against zero.
In such circumstances, the central bank has a profound duty to act unconventionally, ballooning its balance sheet by monetizing assets, either government or private, or both. Put differently, the central bank has a profound duty to meld itself with the fiscal authority, until the fat-tail risk of deflation is cut off (and then killed, in the famous words of General Colin Powell).
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Keep in mind, here, that McCulley is no lightweight. Nor is he a mere pundit like Paul Krugman, who, in spite of his Nobel Prize, is still just an academic and a New York Times columnist. McCulley is a higher up with the 1,000 pound gorilla of the bond world.
Disinflation as bad as Deflation?
This assertion of McCulley’s was particularly eye-opening (emphasis again mine, as with all to follow):
Fast forwarding to today in the United States, it is true that we are not experiencing goods and services deflation, as was the case in Japan in 2003 (and now). Yet inflation in the United States is presently well below the Fed’s implicit target, in the context of a huge unemployment gap, implying that inflation will likely fall further.
And as a practical matter, there is nothing magic about the zero line for inflation. Inflation that is too low implies similar pathologies as actual deflation, just not as severe: Incentivizing private sector deleveraging, even while making it more difficult to achieve, generating negative animal spirits and a chronic shortage of aggregate demand relative to aggregate supply potential. Or, cutting to the chase, exactly what is unfolding in the United States right now.
So, according to McCulley, we do not need outright deflation — an official decline in the price of goods and services — in order to head into the disaster scenario. It is bad enough to experience mere disinflation: The phenomenon where prices are rising, but at a dangerously slow rate.
Already in a Liquidity Trap?
McCulley says something else rather aggressive — he lays his cards on the table and declares that yes, we are in a liquidity trap:
But the housing boom, riding not just easy money but a systemic degradation of underwriting standards (per Minsky5), morphed into a bubble that burst, and the household sector is presently not only unwilling to increase leverage but is deleveraging. That is called a liquidity trap. And, unfortunately, that is where we are in the United States. Thus, I believe the argument for the Fed to explicitly commit to print money to fund increased fiscal expansion is growing by the day.
Print, baby, print! To McCulley’s great annoyance, though, Congress is “wrapped around the austerity axle,” which McCulley says is “bad policy, very bad policy.”
To wit, McCulley thinks that Congress is too focused on belt-tightening, and that the Obama administration “doesn’t have the political capital to change Congress’ collective mind.”
Unless, of course, the following darkly muttered prophecy (secret wish?) comes to pass:
But that could change, if the risk of a return to recession continues to rise, spooking the equity market. A few thousand points of Dow might be what is needed to get the attention of Austerian legislators wanting to get re-elected! Am I forecasting that? Not yet, but the odds are rising, I think.
A few thousands points on the Dow? That sounds like a cross between “Hey idiots!” and a Tony Soprano style threat. (Though of course, by every indication McCulley is an uber-nice guy and would not wish genuine harm on anyone.)
McCulley then rounds out his Keynesian clarion call with a further argument as to why, in a time when the private sector is actively deleveraging, the public sector must step up (and leverage up) if liquidity trap disaster is to be avoided.
McCulley’s final words are a direct challenge — perhaps even a poke in the eye — to austerity advocates and non-Keynesians on the whole:
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This [refusal to print] is not only irony; it is sad. The nation deserves better, especially the 8 ½ million Americans who have lost their jobs. When deflation is the fat tail risk, when the Fed is willing to monetize deficits, there is no excuse for the fiscal authority to resist running bigger deficits to directly finance job creation.
No excuse, none at all.
No Excuse? Really?
So, no excuse for avoiding bigger deficits eh?
Here’s one: How about the will of the people?
Consider the following from a recent WSJ piece, Voters Back Tough Steps to Reduce Deficit:
Frustrated voters, fixing on the $1.5 trillion federal deficit as a symbol of Washington’s paralysis, appear increasingly willing to take drastic steps to address the red ink.
Leonard Anderson, 56 years old, a Richmond, Va., drug-maker engineer and a Republican, said he would be willing to accept a national sales tax to raise revenues. Kimberly Moore, 46, a Richmond Democrat and bank information-technology analyst, said everyone will have to accept budget cuts. And at 67, Paul DesJardins, a Henrico, Va., Republican, said he would accept higher Medicare co-payments and deductibles.
“As Americans, we’re all going to have to cut back and take less,” said Lois Profitt, a 58-year-old small-business owner and political independent from Chesterfield, Va.
With the November midterm elections looming, voters appear ahead of Washington in grappling with the tough choices to come, according to national polling and a focus group commissioned by The Wall Street Journal in the bellwether city of Richmond.
Then, too, there is the perverse logic of the liquidity trap itself:
- By McCulley’s own admission, we are already in a liquidity trap.
- By definition, liquidity trap conditions are such that stimulus does not work!
- Not only that, but stimulus thus far has been seen to benefit all the wrong players.
- It has flowed to the coffers of banks and public companies — NOT small businesses or the public.
And last but not least, there is the logical and basic question to ask: If government job creation efforts have failed miserably thus far, why should we expect yet more of the same to make a difference?
The United States is at an extremely uncomfortable juncture. We have arrived here through a legacy of “extend and pretend” combined with a long, drawn out series of extremely poor choices.
Financing our way out of the jobs hole through more deficit spending is a blatant fantasy, yet it seems the best that sharp observers like McCulley can come up with. Unfortunately, the intractable realities of the liquidity trap (and the grotesque expansion of government balance sheets) suggests the Keynesians have run out of answers.