Tuesday, 2 November 2010

Liquidity, Solvency, Switching Equilibria -- and Paul Krugman

Paul Krugman believes that we are in a liquidity trap (interest rates can’t go any lower), and that the only way to break out of it is via increased government spending. Here’s a column expressing his views (apologies for the long excerpt but I want to make sure I don’t quote him out of context):
One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all ... one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets ... In the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened that has forced the Sams to stop borrowing, and indeed to pay down their debt. For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem.

What can be done? One answer is inflation ... But what if inflation can’t or won’t be delivered?

Well, suppose a third character can come in: Government Gus. Suppose that he can borrow for a while, using the borrowed money to buy useful things like rail tunnels under the Hudson. The true social cost of these things will be very low, because he’ll be putting resources that would otherwise be unemployed to work. And he’ll also make it easier for the Sams to pay down their debt; if he keeps it up long enough, he can bring them to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment.

Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen.

Prof. Krugman is correct as far as he goes. Increased (deficit-financed) government spending can indeed boost incomes, employment and consumption, and thus help the private sector clean up its balance sheet. Then when the private sector has recovered, government can unwind its fiscal expansion and return to running a primary surplus, thus paying down the (temporary) debt it has accumulated.

So all is hunky-dory? Not quite. We have skipped over a very crucial assumption in Prof. Krugman’s argument: the assumption that Government Gus is a ‘player with low debt’, and can thus borrow money at low interest rates, both now and in the future, for as long as it takes until the private sector has recovered and primary surpluses can be reinstated.

Is this assumption valid? Well, it certainly appears valid at the moment. After all, 30-year bond yields (the rate at which the Treasury finances its debt) are close to multi-year lows. Surely if the market were truly concerned about the size of government debt it would charge a higher interest rate on government bonds?

Not quite. Appearances can be deceptive. In this particular case, there are two errors that contribute to the mistake: a confusion between liquidity and solvency, and a misunderstanding of how markets work. Let’s take a deeper look at both of these.

Consider, first, the aforementioned two measures of fiscal position: solvency and liquidity.

Solvency is a ‘stock’: if your total assets are larger than your total liabilities, then you’re solvent.

Liquidity is a ‘flow’: if your monthly income is greater than your monthly expenditure, then you’re liquid.

Put another way, solvency is the level of your “assets minus debts” while liquidity is the derivative (the rate of change) thereof.

Now, you might think that solvency is somehow more important than liquidity, when determining the future of an enterprise. But this is not necessarily the case. You can be insolvent but stay in business for a long time, as long as you have the cash with which to pay your monthly bills. Conversely, you can be perfectly solvent but go out of business, if you don’t have cash in hand when the bill-collector comes calling.

This is a key point. Bankruptcy is always and everywhere a liquidity event. Nobody ever goes bankrupt because their consolidated balance sheet shows greater liabilities than assets. No, they go bankrupt because they can’t make a payment in the here and now.

Does that mean solvency is unimportant? Again, not quite. Because solvency and liquidity are not independent; they feed into each other. Specifically, it’s usually the perception of solvency (or insolvency) that drives the availability (or absence) of liquidity.

If you appear long-term solvent, you can often borrow money to tide you over any short-term liquidity problems. What’s more, the interest you pay on the borrowed money will be low, reflecting your perceived status as a ‘safe’ borrower, and thus enhancing your solvency. High credit quality is thus a self-fulfilling prophecy. (Once again, it’s our old friend positive feedback!)

And the converse is also true. If you appear insolvent, it’s hard to borrow money except at punitive rates; the high cost of servicing your debt further degrades your solvency, and before you know it you are in a ‘liquidity death spiral’ and out of business.

How does this apply to Government Gus? Well, there’s no question that Gus has ready access to liquidity; that is the message of the capital markets (30-year bond yields at 4%). But Gus is most definitely insolvent:
The fiscal gap is the value today (the present value) of the difference between projected spending (including servicing official debt) and projected revenue in all future years ... Based on the Congressional Budget Office’s data, I calculate a fiscal gap of $202 trillion, which is more than 15 times the official debt. This gargantuan discrepancy between our “official” debt and our actual net indebtedness isn’t surprising. It reflects what economists call the labelling problem. Congress has been very careful over the years to label most of its liabilities “unofficial” to keep them off the books and far in the future.

(The quote is from BU’s Prof. Lawrence Kotlikoff, who specializes in inter-generational accounting.)

Prof. Krugman elides the distinction; he claims that because Gus is liquid right now, he will have no problem borrowing money for as long as it takes to help the economy recover; and long-term solvency simply does not matter.

But it does. And to understand why, you have to understand how markets work.

See, traders don’t really care about long-term solvency per se (or long-term anything, for that matter). Traders only care about short-term price action, because that’s what they get paid for. Annual bonuses depend on annual profits.

And short-term price action is a mess of positive and negative feedback, self-fulfilling prophecies, tipping points and overshooting.

Right now, 30-year bond yields are low because we’re in a feedback loop, wherein banks borrow money from the Fed at 0% and deposit it in Treasury bonds at 4%. The low level of interest rates convinces everyone that government insolvency and inflation are nothing to worry about. And that in turn justifies further buying of bonds.

Thus we are in what appears to be a stable equilibrium. But we could easily flip over into another less healthy equilibrium. If, for whatever reason, the market loses some of its confidence in the government’s ability to roll over its debt, then positive feedback will begin to operate in the opposite direction1. Rates will go higher, debt service payments will go higher, and the liquidity/solvency situation will get worse, causing rates to go higher still. We saw an example of precisely this dynamic in Greece earlier this year.

Another way to look at it is this. There is no ‘right’ and ‘wrong’ when it comes to trading; no ‘fundamental value’ or ‘fair price’; there is only ‘profitable’ and ‘unprofitable’. And the sole determinant of whether a particular trade is profitable or not, is the behavior of other traders. (Keynes’ famous analogy of the beauty contest). If the market as a whole believes that Government Gus is liquid, then the optimal strategy for any given trader is to lend money to Gus and take home the carry; if the market as a whole believes that Government Gus is broke, then the optimal strategy is to squeeze him. And the belief system of the market as a whole can turn on a dime.

This is what Prof. Krugman does not seem to understand: the rapidity with which markets can go from one equilibrium to another, once a tipping point is reached, thanks to feedback effects. And the worse the initial solvency position of the government, the more likely it is that the tipping point will be reached. This is the link between solvency and liquidity; it has nothing to do with fundamentals, and everything to do with trader behaviour in a feedback market.

So we’re in a race against time. Will deficit spending resuscitate the private sector before the debt service tipping point is reached? That, indeed, is the question, and it is one that Prof. Krugman does not even ask, let alone answer.

(Personally I’m pessimistic on both fronts. I doubt that government spending will suffice to repair private sector balance sheets or confidence any time soon; Japan is Exhibit Number One for how an economy can remain in the doldrums for years despite massive government spending2. And I think the tipping point may come sooner rather than later, simply because there seems to be an utter lack of political will to do anything at all about the deficit situation. I hope I am proven wrong.)

Footnotes

# 1You don’t need a complete loss of confidence; all you need is a change on the margin, and positive feedback takes care of the rest.

# 2I believe Prof. Krugman’s response to the ‘Japan critique’ is to say that Japan’s own implementation of QE was not aggressive enough. There are two problems with this response. First, of course, it is a classic unfalsifiable argument. Second, and more important, I believe that one should defend or attack QE as it is, not QE as it ‘should be’. Perhaps in an ideal world we would get a sufficiently large QE to in fact solve the economy’s problems just like Prof. Krugman hopes. But in the real world the amount of QE that is politically tenable is likely to fall well short of this ideal amount. And there is no reason to expect that the effectiveness of QE scales monotonically with size; it is entirely possible that ‘no QE’ will be better for the economy than ‘half-hearted QE’, albeit worse than ‘ideal QE’.

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