"Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
- John Maynard Keynes, The General Theory

Over the last week, I've been asked approximately 289 times whether the Fed is going to cut rates at Tuesday's FOMC meeting. My answer, approximately the same number of times, has been "I don't know, but I think not." And in response to that response, I have been called a wimp approximately 114 times, a two-armed economist approximately 75 times, a jackass twice, and things unprintable approximately 98 times. People just don't seem to like equivocation in the matter of handicapping Fed rate cuts: will they or won't they, that is the question. And the answer, questioners implicitly or explicitly declare, should be a simple yea or nay.



The figure is a line graph that superimposes non-financial U.S. corporate debt outstanding against non-financial corporate profits, from 1991 to 2002. The two move almost inversely to one another on the graph. Since the early part of the decade, debt outstanding, scaled on the right-hand vertical axis, falls a level of 5% year-over-year change, down from its most recent peak of about 12% in 2000. By contrast, corporate profits, scaled on the left, rise steeply to about a 20% year-over-year change, up from negative 20% in 2001. The two lines come to almost touch by late 2001.
Figure 1
Sources: Commerce Department, Federal Reserve

Not complaining really, as I've been doing this for twenty years, and know the drill. And, I have to admit, it is flattering to have others think I might actually know something that I don't know. It is frustrating, however, to be repeatedly asked the wrong question. The right question, about which I do know something is: are Fed funds cuts, by themselves, sufficient to break the ongoing debt-deflation meltdown in the corporate sector? My unambiguous answer: No.

Some Definitions First
Before "building out" my argument, as PIMCO's Account Managers are fond of saying, let me first define the dynamics of a "debt-deflation meltdown." It is not about a fall in the CPI or the PPI, even though those popular price indexes might fall. A debt-deflation meltdown is about a self-feeding fall in the market value of assets relative to the par value of debt assumed to acquire them, which provokes lenders to withdraw wholesale the presumption that debtors are going concerns, demanding that their maturing debts be paid, rather than "rolled-over." To wit, debt deflation is about lenders demanding that borrowers liquidate themselves.

In a falling market for assets, however, that's damned difficult for individual borrowers, and impossible for the community of borrowers. But the very fact that it is impossible for the community to liquidate all its debts by selling all its assets (you gotta have somebody to sell to!) reinforces the incentive for individual lenders to demand that individual borrowers liquidate themselves as quickly as possible, so as to monetize their assets before prices deflate even more.

This individually rational, but collectively irrational behavior is , of course, the stuff of bank runs - nasty self-feeding things, as George Bailey found out. In the language of finance, the "run" dynamic is called systemic risk, and leads us, as a civilized capitalistic society, to have structural prophylactic arrangements: deposit insurance for bank deposits, and a Fed discount window for banks to "re-discount" (not sell!) their loan and security portfolios for hard cold cash. Indeed, the banking system itself is a prophylactic against debt deflation in the capital markets, a place where solid companies unable to "roll over" their maturing commercial paper and debentures turn for loans to "take out" maturing paper.

In fact, contingent commitments by the banking system to lend to companies are an integral part of most companies' ability to actually place debt paper in the capital (non-bank) markets. Capital market buyers of company debt demand that issuers have a bank "back-up line" for rolling over maturing debt, as an insurance policy against forced liquidation in the event that the capital markets are caught in a bout of infectious risk aversion.

Most elementally, the capital markets and the bank lending market are complements, not substitutes. They need each other: banks need capital markets to determine, in real time, non-bank intermediaries' appetite for risk, and at what price, and capital markets need banks to act as a conduit for the Fed's lender-of-last-resort function . And when the capital markets are caught in a paroxysm of remorse after an inflationary bubble in asset prices, the "circuit breaker" to prevent a debt-deflation meltdown must be a banking system willing to serve as a contingent lender of last resort.

And if the banking system cannot, or will not, play that role, as was the case in the Great Depression, then a debt-deflation meltdown will beget a more generalized deflation in goods and services prices - to wit, the PPI and the CPI - as economic activity grinds to a halt. Thus, when thinking about deflationary risk, as all right-thinking risk takers should be doing at the moment, it is hugely important to think in terms of unaborted deflation in asset prices. By undermining asset-based leverage structures, such deflation is the proximate cause of the rising risk of goods and service price deflation. Accordingly, policy authorities cannot wait for deflation in goods and services prices to become proactive in fighting deflation. The time to act is when asset price deflation is calling into systemic question the "money goodness" of private sector debt arrangements.

The Austrians Are Wrong
It is not in the nature of bankers to want to act counter-cyclically, of course, as bankers put on their trousers just like risk takers in the capital markets, acting in pro-cyclical fashion, as is the wont of the human nature. Nothing is so exhilarating to the appetite for risk as making money, and nothing is so debilitating to the appetite for risk as losing money. Human nature is as human nature does, as Alan Greenspan regularly incants, most recently in his observation about greed: what the late 1990s was about, he philosophized, was not an increase in the human greed drive, but the efficiency of avenues for exercising that drive (in a different context, Bill Clinton ran with the same argument!).

Indeed, capitalism is a marvelous economic system founded on the basic human urge to get rich: Adam Smith's invisible hand in action, carrying out Joseph Schumpeter's process of creative destruction! Nothing wrong with that, but something very right: technology-driven innovation and increases in standards of living. Capitalism's problem, and it most certainly has one, is that it is inherently given to boom-bust pathologies, because it is founded on the same human urge that begets gambling. Except, in the case of capitalism, "we the people" do collectively win, whereas in the case of casino gambling, only the casino owners win on net. Capitalism is way cool, fer sure fer sure.

But like, not totally. The dominant political question of civilized society is whether to try to temper capitalism's boom-bust pathologies. For me, to answer the question: yes, civilized societies, particularly those founded on democracy, not only have the right, but the duty to harness capitalism, even while celebrating it. 1

Members of the Austrian school of economics vehemently disagree, arguing that capitalism's boom-bust pathologies, even if they exist, are magnified, not tempered, by the visible hand of government. In particular, Austrians hold central banking in high contempt, arguing that fiat credit creation (printing-press money!) is the dominant source of capitalism's boom-bust proclivities.

And contrary to the presumption of the legions of Austrians who write me every month (to accuse me of macroeconomic immorality!), I actually have some sympathy with the notion that central bank policy can be a source of boom-bust pathology itself. But I call that bad central bank policy, not an indictment of the legitimacy of central banking.

Good central bank policy involves tempering the pro-cyclicality of capitalists' human urges by acting counter-cyclicality: watering down the punch before the partiers start swinging from the chandeliers, and offering Alka Seltzer before the hung-over partiers start gagging themselves with spoons. Thus, I agree with current-day Austrians that the origin of the current risk of a debt-deflation meltdown was not just irrationally exuberant capitalists, but the enabling hand of the New Age Economy's chief bartender, Alan Greenspan. He could have tempered irrational exuberance, and should have tempered irrational exuberance. And he didn't.

Where I disagree with modern-day Austrians is in their righteous advocacy that the time has finally come for Greenspan to repent his sins and make drunken capitalists drink ipecac, rather than serving them yet more monetary policy accommodation. The Austrians are bedfellows with Treasury Secretary Mellon, who said to President Hoover in 1931 that the time had come to:


"Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness of the system. High costs of living and high living will come down. People will work harder, live a more normal life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

Mellon's advice, and modern-day Austrians' amen chorusing is a perfect prescription for a debt-deflation meltdown. And, my friends, two wrongs do not make a right. Yes, it may have been wrong for Greenspan to have enabled the bubble, but it would be even more wrong for him to embrace debt-deflation in repentance.

Greenspan Ain't No Austrian
(Or Libertarian) On The Downside

Greenspan has no intention of listening to the whining and pining of Austrians for a purge. He is self-admittedly a macroeconomic hermaphrodite when it comes to bubbles: hands off when they are inflating, and hands on when they are deflating. As noted, I don't share this philosophy with Greenspan, and said so unambiguously and forcefully while the bubble was bubbling, in the very first edition of Fed Focus in September 1999, 2 and in testimony before Congress in March 2000. 3

I didn't, however, pound the table for Greenspan to hike the Fed funds rate to abort the equity market bubble (and its associated bubbles in business investment and corporate leverage), as many critics of Greenspan did at the time, and continue to argue today. Rather, I advocated that the Fed hike margin requirements for the (initial) purchase of stocks on debt.

And my rationale was simple: the equity bubble was a New Economy affair, in which stocks were valued as lottery tickets, while Old Economy stocks - and the Old Economy itself - were not bubbling, but actually languishing in the deflationary wake of the 1997-98 collapse in emerging market countries. Thus, I believed then, and believe now, that hikes in the Fed funds rate were the wrong tool to arrest irrational exuberance in New Economy stocks, carrying unnecessary "collateral damage" for the Old Economy. Or, as I testified before Congress:


"I know of no economic model that postulates a high interest elasticity of demand for lotteries! Virtually every economic model incorporates, however, a high interest elasticity of demand for the goods and services of the Old Economy."


Thus, using the interest rate tool exclusively to thwart wealth creation in New Economy stocks carries grave risks for the Old Economy. It makes no sense to try to get the attention of gluttons by starving anorexics. It's bad macroeconomic policy, and it is also morally wrong."

Mr. Greenspan didn't agree, of course, and pedantically (as in, "won't you please shut up") rejected calls for a hike in margin requirements. But at least I can take some solace that I was in good company in making the call: Yale Professor Robert Shiller testified along side me, literally days before his Irrational Exuberance hit the book stores; he kindly gave me an "author's copy" from his briefcase.

Bob has gone on to great fame, of course, and rightly so: it was a great book, not because he called the equity market top (he didn't; he'd been bearish since 1996!), but because he articulated, and documented, a "behavioral" approach to understanding bubbles. John Maynard Keynes' "animal sprits" matter, and matter hugely. On the upside then, of course, and on the downside now.

Fed Rate Cuts Work When/Where Uncle Sam Works
Which brings us back to the matter of whether the Fed should or will cut the Fed funds rate again at Tuesday's FOMC meeting. True to his word during the bubble, Mr. Greenspan became very hands-on once it blew up (after maintaining he had nothing to do with blowing it up, of course!): he slashed the Fed funds rate from 6 1/2% to the current 1 3/4% within a year.

Bravo for him, and the U.S. economy. Easy monetary policy is indeed "working" where it is manifestly supposed to work: the residential real estate market, a (the last remaining?) pillar of the Old Economy. Property prices are rising, and credit is both abundant and cheap for buying property. Animal spirits are indeed alive and well in that sector, and Mr. Greenspan rightfully takes both credit for and pride in the outcome.

Too much, I think, though that is not really meant as a criticism. Housing finance in America is actually a quasi-governmental function, not a "pure" capitalist function. Fed easing works very well to promote housing, because housing leverage in America is funded by financial intermediaries that fund themselves on the good name of Uncle Sam -- otherwise known as "we the people."

I'm talking about Aunt Fannie Mae and Uncle Freddie Mac, of course, who've done a marvelous job of implementing their federally-chartered mandate to provide a steady supply of funding to the housing sector: the agencies get the privilege of "implicit" backing from Uncle Sam, which affords them access to capital market credit at tight spreads to LIBOR (negative out to five years!), with the quid pro quo responsibility of channeling those funds into property loans. They take their responsibility very seriously and execute it faithfully, and well.

It's a sweet deal for them, a sweet deal for American households, and a sweet deal for capital market investors. It's a too-big-to-fail arrangement, which "we the people" demand from our government. We also pay for the arrangement, of course, in that "we the people" are on the hook as taxpayers, if the agencies ever get into trouble, just like we are on the hook for deposit insurance. It's a deal with ourselves, the outcome of the democratic process.

Yes, it is fraught with moral hazard, but then, government-supported financial intermediation is always fraught with moral hazard: the free rider problem, in which the upside of risk-taking accrues to the individual, but (most) of the downside accrues to the community of individuals. The existence of moral hazard is not, however, a sufficient case for rejecting implicit or explicit government backing for financial enterprise. "We the people" retain the right to enter into risk-sharing arrangements, despite the rantings of "pure" capitalists about the evils of moral hazard. We have done so with both deposit insurance and housing finance in this country, and I submit that an overwhelming majority of Americans ("we the people" again!) applaud the results.

Bottom Line
Further cuts in the Fed funds rate would/will certainly stimulate housing, as housing financing runs through a too-big-to-fail conduit. Further cuts in the Fed funds rate would not/will not, however, materially abort the risk of a debt-deflation meltdown in a corporate sector suffering from Post Bubble Disorder. 4 Cutting that risk would/will require that the Fed roto rooter the conduit through which its lender-of-last- resort function is supposed to flow: bank liquidity lending, and most importantly, banks' commitment to liquidity lending.

But how can the Fed get banks to re-engage in underwriting corporate default risk when they don't want to, you ask? The answer, it seems to me, is quite straightforward: just tell them to do it! But will they listen, you ask? Yes, they would, I submit, particularly if Mr. Greenspan were to declare that he is also instructing his bank examiners to act counter-cyclically , not pro-cyclically, in evaluating capital and credit-reserve policies. As an additional incentive for banks to unclog their lending pipes, Mr. Greenspan should publicly call for Congressional investigators to call off their find-a-crook dogs.

The time for bank regulators to get tough is when times are good, not when times are bad. They didn't, of course, during the bubble years, but that is not a rational justification for getting tough now. If counter-cyclical is good for Fed funds policy, then counter-cyclical is good for bank regulatory policy, too. Interestingly, famed economist Henry Kaufman applied this logic just this week 5 in calling for a cut in margin requirements for stocks, after having been a fellow traveler with me and Bob Shiller in advocating a hike in margin requirements during the bubble years.

Henry surprised me on this score, even though his logic was perfectly reasonable: regulatory policy should be counter- cyclical and since margin requirements are a regulatory tool, a cut certainly wouldn't hurt to break infectious risk aversion (though unlike the case of a hike, it would be less likely to "work," for proverbial "you can lead a horse to water, but…" reasons). What Henry should have advocated, if I may be so presumptuous, is a counter-cyclical easing in the implementation of bank regulatory policies.

Renewed bank appetite for corporate liquidity lending, outright and on a contingent basis, is the necessary condition for truncating debt-deflation risk, not cuts in the Fed funds rate. Not that I'm necessarily against further cuts in the Fed funds rate. (I've often been accused of never meeting a Fed funds cut that I didn't like, and there is some truth to that.) My point is that if all the Fed does is cut the Fed funds rate, the risk of a debt-deflation melt down will remain the dominant risk in the macroeconomic outlook. Restarting the rate-cutting engine, alone , would be the start of a journey to zero Fed funds - not in real terms, but nominal terms. Hello, Sir Greenspan-san!

Indeed, since Fed funds cuts "work" through the government-supported housing finance sector, the dominant risk of a Fed funds-only policy of "accommodation" is an unrelenting deflationary bust in the corporate assets and an accelerating inflationary boom in residential property prices. The Austrians are right that fighting busted bubbles with new bubbles is a lousy way to run a railroad. They are wrong, however, in arguing that busted bubbles should be allowed to bust in Mellonesque fashion.

The right approach is to directly contain the deflationary fallout of the busted bubble, without inflating one somewhere else. And the conventional Fed tool of changes in the Fed funds rate ain't the right tool, even when applied counter-cyclically. It's time for the Fed to act unconventionally, and break the conventional pro-cyclical pattern of bank lending and bank regulatory policy. Further cuts in the Fed funds rate would be easy, but not wise. In contrast, opening up the banking system conduit for the Fed's lender-of-last-resort function will not be easy, but wise.

Yes, I remain a Principled Populist, who believes in the power of "we the people" to protect ourselves from our capitalist selves.

Paul A. McCulley
Managing Director
August 9, 2002

1 See "Rotor Tilling Behind Bill's Tractor," Fed Focus, June, 2002.

2 See "Principled Populism," Fed Focus, September, 1999.

3 See "A Call for Fed Action: Hike Margin Requirements!," Fed Focus, April, 2000.

4 See "Post Bubble Disorder," Fed Focus, April, 2001.

5 "A Double Dip Wouldn't Be a Summer Treat," The Wall Street Journal, August 7, 2002.









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