McCulley believes the sudden obsession with “austerity” will kill the country.
When the private sector is deleveraging (reducing debt) as it is now, McCulley says, the last thing the government should do is cut spending. Because government spending is the only thing that can keep the economy afloat.
For proof of this, McCulley says, all you need to do is look at the Great Depression. It wasn’t until the government enacted a positively massive spending and stimulus plan known as World War 2, the Marshall Plan, and the GI Bill that the country’s productive engines finally started humming again.
Cutting government spending now, McCulley argues, is “ludicrous.” It’s like putting an anorexic patient on a diet. It will prolong the agony and send us crashing back into a recession (and worse).
After analysing the situation, our conclusions are the same as McCulley’s (See: Here’s What’s Wrong With The Economy (…And How To Fix It)). Economist Richard Koo has also laid out compelling evidence to support this view.
Here’s an excerpt from the interview, which was published by John Mauldin in his “Outside The Box” email newsletter (which you can sign up for here).
KATE WELLING: I want to hear all about [what you do now that you have retired from PIMCO]. But first, let’s talk about what’s happening in this crazy economy. You started saying we’re in a liquidity trap some time ago. Where are we in that process?
PAUL MCCULLEY: I like how you ask the question as, “where are we in this liquidity trap” because that allows me to fine tune the diagnosis. Most of the marketplace, and the policy makers even more so, are still debating the diagnosis: Are we, or are we not, in a liquidity trap? To me, it’s absolutely critical that this diagnosis is made correctly. Because if you conclude that you’re in a liquidity trap — and I do unambiguously embrace that conclusion — it has profound implications for the right set of policies. It also has profound implications for how markets will discount the policies. What this means is that policy is not a matter of a large menu, encompassing, “Well, we might know we’re in a liquidity trap and we also might not be in one, therefore we’ll do –
A little of this and a little of that—
Right. There are clear-cut things that you do if you’re in a liquidity trap. A liquidity trap is simply defined as when the private sector is in a deleveraging mode, or a de-risking mode, or an increasing savings mode — all of which you can also call deleveraging phenomena — because of enduring negative animal spirits caused by legacy issues associated with bubbles. In that scenario, the animal spirits of the private sector are not going to be revived by a reduction in interest rates because there is no demand. It’s not the price of credit driving the deleveraging. It’s “I took on too much debt during the bubble. I have negative equity in my home. I don’t care what the price of credit is, I already have too much outstanding. I am paying down credit!” That can be entirely rational for an individual household. It can be rational for an individual firm. It can be rational for an individual country. However, in the aggregate, it begets the paradox of thrift. What is rational at the microlevel is irrational for the community, or at the macro level, and I’m amazed that this is not assumed as a given description of what we’ve got going on right now. The paradox of thrift and the liquidity trap are fellow travellers that are functionally intertwined.
Could it be that people are confused because of all the attention paid to the liquidity the Fed has pumped into the system via quantitative easing — even though most of that only flowed into the most speculative and unproductive pockets in Wall Street?
That could very well be the case. But that diversion of attention is unfortunate because it clouds people’s vision of the larger picture, which is pretty straightforward. It’s really textbook sort of stuff. My friend, [Nobel Laureate, Princeton Economics professor and New York Times columnist] Paul Krugman, has been writing a great deal about it recently. If the private sector is deleveraging and de-risking and you’re caught in the paradox of thrift, the public sector is supposed to go in the exact opposite direction. The exact opposite direction.
You mean that cutting federal spending in a liquidity trap, like we’re in, is absolutely counterproductive?
Yes, it’s ludicrous and I don’t use that word too often. There’s a large range of opinions about most issues, and rightfully so. But if you are in a liquidity trap and you are advocating frontloaded austerity—
The Tea Party is really talking about killing the economy —
Again, it’s absolutely ludicrous. And if we need an example, we can just look across the pond and see what’s going on in Euroland. Putting somebody who is suffering from anorexia on a diet doesn’t make a lot of sense to me. But essentially that’s what the austerity folks are preaching and that’s what we’ve been grappling with here in the United States.
Of course, the proponents of austerity are worried that this country’s debt load is already too much for future generations to handle.
“We have to go on a diet for our long-term well-being. The only question is how severe of a diet?” — That is the question being asked. As opposed to what we should be discussing, which is, “Gosh, we’re talking about someone who is underweight here! Why do we need to be on a diet? Maybe we should have more food!” Incredibly, to suggest such a thing is to be considered a heretic these days. Paul actually gets more wound up about it than I do. I enjoy reading him now with the luxury of doing it whenever I get around to it during the day. I just smile. Though on any given day, I have to admit to a bit of envy, from the standpoint of thinking Paul’s piece was really good, but that if I were still in the arena, I could have upped his ante. But his is a really good ante, in just calling out the silliness. That’s what worries me the most about the domestic economic scene — and the global economic scene, too — this presumption that seems to be in currency that government is the problem. Therefore, if we can simply reduce the government, the problem will go away. That is not the case at all, when the problem is actually the combination of a liquidity trap and the paradox of thrift. If you take the government out of the picture, you exacerbate the pre-existing conditions. Yet that seems to be where the body politic conceptually has gone.
Are you implying that the Tea Party has been sold a bill of goods?
Yes, they have. I mean, the historical parallel that a lot of us point to would be 1931, when Andrew Mellon said, essentially, liquidate, liquidate, liquidate and assets will be transferred to moral hands, and we’ll live a more moral life.
Until we starve to death.
Right — but we will live a moral life.
Mellon was quite the Austrian—
Absolutely, that was in 1931. Then in 1937, when it looked like the economy might have been having “a decent” economic recovery, we decided to slap it in the face with monetary and fiscal policy tightening.
And it only took World War II to lift us out of that extension of the Depression.
Yes. What I mean is that the war in effect forced the application of the government’s balance sheet to a deficiency of aggregate demand — and it worked. Some might call that Keynesianism, and I would. But you could describe it more simply by saying that the government’s balance sheet — including the central bank’s balance sheet (because the Fed was subordinate to the fiscal authority during WWII) — was used to stimulate aggregate demand. And it absolutely worked, although I don’t think anyone would applaud going to war to accomplish that. However, it is interesting that after World War II the biggest concern in economic policy circles was that we would fall back into a depression because we were taking away all of the government demand, for the war machine. But what we found out was that this didn’t necessarily have to be the case. Partly, the postwar recovery came about because of the infrastructure and the technologies, etc., that had been developed during the war. But another important ingredient after the war was the GI Bill.
The GI Bill and the Marshall Plan basically saved the West.
And they both used the government’s balance sheet, I’ll point out. My dad went to college on the GI Bill. He was one of the youngest WWII veterans — he’s 85 now but he went into the service in ’44.
Same as mine.
So he went to college on the GI Bill, bought his first house on the GI Bill — and he didn’t consider either one of those to be welfare.
No doubt, he thought he earned it.
Yes, and the payoff to society of the Marshall Plan and the GI Bill were absolutely monstrous. The private sector simply can’t internalize the rate of return on that sort of thing. So this presumption that somehow government investment is bad and private sector investment is good—
Hold on, you’re using the term “investment” and that’s not politically correct. You’re supposed to call it, “spending, waste and fraud.”
OK, so my dad’s education and the house that I grew up in were, what were those words? “Waste and fraud”?
Yes, according to the conservative meme, it was “wanton government spending” allowing your family to live above your means. The argument that a family has to live within a budget and therefore so does the government, is so specious—
Absolutely. The irony of all this is that I now hear my dad ranting and raving about “big government” at 85 years old — and it was big government that paid for his education and put him into his first home. The real notion that people have is that government is bad — unless it’s helping me!
That’s clearly endemic and epidemic. My dad did the same, until he passed away.
There obviously are a lot of inconsistencies that we have to deal with in a democratic society. But what really puzzles me is how the concept of public investment is being perceived as an oxymoron. That’s just wrong. The notion that if we just would quit subsidizing idleness, that the unemployed would go to work, is another thing that is just ludicrous. I don’t know a lot of people who want to be subsidized in idleness. Nor do I know a lot of people who want to subsidise it. But there are just no jobs out there. There aren’t jobs because we had a bubble in housing. We went from 2 million housing starts to half a million housing starts. The notion that you could monetise equity in your home with a second mortgage is an oxymoron. Nonetheless, we had a housing sector bubble and everything that goes with it. Actually, if housing starts were our only problem, that wouldn’t be a big deal. But the house became the magic genie that made up for the fact that we’ve had stagnant real wages in our country for a long time — and then the genie died.
The housing ATM is definitely busted!
It ain’t there anymore. And now, if you happen to have a factory job making boat trailers, you’ve got a problem. Because the guy who had been buying a boat trailer was able to buy it — and the boat that went on it — only because he took a second on his “appreciating” home. He could have never afforded a boat otherwise. Now most likely the guy at the trailer factory has lost his job because people can’t buy boats in that fashion. That’s reality. And we’re not going to restimulate the housing market so that people can take out seconds to buy boats.
Not when the problem is too much debt.
That’s true. It wouldn’t make a lot of sense. We need to deleverage the private sector and we can do that without a depression if we are not afraid of leveraging the government sector. And from my perspective, there’s no reason to be afraid because we have a huge output gap and the risk that public investment will overheat our economy is a risk that I’m more than happy to underwrite. Overheating of our economy and too few workers for available jobs would be very high-quality problems. So I’m not worried about overheating from an inflation perspective at all.
What? Despite all the money that’s been created? All the debt we’re piling on future generations?
Monetary claptrap! Money is as money does, as the famous economist Forrest Gump once sort of said. And it ain’t doing nothing. So I don’t worry about inflation and I don’t worry about interest rates. In fact, the lower the interest rates go, the more I worry — because the easiest way to have super-low interest rates is to have a depression. Interest rates are low, but they’re low in many respects for unhealthy reasons. There’s absolutely no private-sector demand for credit and so there is no crowding out. I mean, that’s the old textbook notion — you aren’t supposed to want to add government debt because that supposedly would crowd private sector investment out of the market. But, excuse me, exactly what are we crowding out right now? Where is the evidence that the marketplace for credit is tight and that government borrowing is displacing private sector borrowing? There’s zero evidence for it. Yet this “crowding out” dogma keeps being invoked when people claim that we can’t have government deficits because they’re going to crowd out private sector investment. God, I wish it were so, because that would mean that private sector investment was doing fine, just fine. And that we were going to overheat the labour market. As I said, that would be a very high-quality problem.
What about the argument that our foreign creditors are going to stop lending to us?
That’s the notion that if we run deficits, the rest of the world will refuse to fund us. But we have a shortage of global aggregate demand and nobody wants their currency to go up. Therefore, the idea that we are going to suffer a buyer’s strike for dollar-dominated debt is preposterous.
China’s sure making noises about wanting a new international reserve currency.
Right, with their mercantilist economic model! If you’re building a mercantilist economic model, by definition, you are piggy backing on somebody else’s demand. Why would you even contemplate having freedom in your currency until you have sufficient homegrown demand to eat the fruits of your own production? You wouldn’t. Therefore, I don’t worry about that one, either. Essentially, the path that we’re on right now is one of intellectual paralysis, born of inertia of dogma. Risk assets, including the equity market, have kind of figured it out. I don’t want to get into details necessarily about day-by-day market moves because I don’t do that anymore. But during that event at the end of July — that whole debt ceiling theatre of the absurd — I was hearing that if we could just reduce uncertainty over the debt ceiling, we would have spontaneous combustion of animal spirits and all would be well with our economy. Excuse me! I didn’t see any spontaneous combustion of animal spirits, when the deal was struck.
What I heard were Wall Street’s “capitalists” whining for more QE the next day.
You saw the same thing that I did. It was what I dubbed a few years ago, a “reverse Ricardian notion.” Ricardo doesn’t work in reverse. Bill Gross [PIMCO founder and co-CIO] recently wrote about this in one of his monthlies: Just how many families sit around and say, “We have to cut back on our spending today because the out-years’ government budget deficits are going up and our future taxes are going up?” That would be the reverse Ricardian notion in action. Likewise, if Ricardian equivalence operated on the household level, we’d hear people saying, “Well, they’re cutting out-year government spending. That means our future tax liability is going to be lower, so we can spend more money today. Let’s go out to Ponderosa for dinner.” I just don’t see that conversation happening, either. I would say average Americans don’t know who Ricardo was.
I would bet you’re right. And reducing prospective government deficits years in the future is not going to get them back in Walmart (WMT), buying the large economy sizes, either.
I don’t think the average American spends a whole lot of time navel-gazing about the budget deficit in 2028. I just don’t.
No, but they get worried when they see noxious and nasty gridlock in DC, supposedly over deficits.
Sure, to the extent that they had already-existing negative animal spirits, because they’ve got negative equity in their homes, the sorry spectacle in Washington probably exacerbated that. It certainly did not relieve their existing negative animal spirits. It turned, “Honey, we can’t afford a vacation this year,” into, “We can’t afford a vacation for the rest of our lifetime!” We can exacerbate a bad situation with the notion that cutting future government debt is going to magically turn around the thinking of someone who has negative equity in his home. That is beyond comprehension to me.
I actually spend a lot of time thinking about these things these days with the benefit of not having fiduciary responsibility for a large, large pile of somebody else’s money. As a money manager, I was paid to have informed opinions about how the dealers should be dealing the cards. But I had to manage the money based upon the cards that I was playing with. I had to play the cards adroitly, even if I thought it was a silly game that the dealer was dealing. Whereas now, since the only cards that I’m working with are my own personal cards, I can actually feel — and do feel — liberated to say that the dealer is calling a lousy game!
I don’t think it’s a game that is productive. What’s more, he’s selling the game with hokum — and risk assets, including the equity market, are going to break the code. I can say that now without someone accusing me of talking my book, quite frankly, and that is liberating. It is wonderful to have the fiduciary responsibility for significant amounts of other people’s money, but it is a very sobering experience of responsibility. It really, really is. Those who are good at it take that as a sacred responsibility and act accordingly. That’s why our business is such a tough business from the standpoint of your physical health, mental health, etc. So not having that immediate fiduciary responsibility is liberating.
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