Greatest Moral Hazard, Says Paul McCulley, Is Austerity Here And Now (Mauldin)

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 who want to subsidize 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 monetize 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 levering 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 labor 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 theater 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!

Because —

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.

A great weight off your shoulders, I would imagine.

Definitely. I spent a great deal of time on macro issues during my money management career because that was the fountain from which money-making ideas flowed. But one of the things I want to take advantage of in my retirement is that I can spend a little more time analyzing the fountain as opposed to figuring out what size bottles to put the water in.

So tell me, is there a way to address the housing problem within this liquidity trap?

I think there is. It’s been pretty clear cut for a long time that we need to reset the mortgages that are massively under water. This is sometimes known as “principal forgiveness” and the words are usually uttered with a pejorative lisp.

But wouldn’t that be terribly unfair to everyone who has faithfully made their mortgage payments?

Yes, exactly. I can’t argue with the proposition that it would be unfair. But the only way that I can respond is that life is not necessarily always fair.

Indeed, sometimes foolishness is rewarded.

It is — and as long as we hold to the existing pretense that a large chunk of our housing stock is worth the debt on it, we’re going to be stuck in this liquidity trap. So the reason we’re going to be stuck here is this issue of moral hazard. There’s a reluctance to do anything because, you know, restriking mortgage terms would be letting people off the hook. There’s a moral overtone that we can’t deal with, so therefore we will just live with it. Actually, in that camp, you also have those who are genuine liquidationists. But society is not going to stand for the wholesale liquidation of 25 million families in America, so they’re not going to follow the Mellon prescription. In other words, if you’re not going to recast the mortgages to get rid of the negative equity, and you’re not going to force people out of their homes and liquidate them, then the market gets stuck in suspended animation. And that’s where we are. I’d like to think that for mortgages held by Fannie and Freddie, this should be pretty easy to deal with because we, the taxpayers, are already taking the credit risk on all of those mortgages. So to recast those, conceptually, is simply to recast the credit risk that we’ve already assumed. I mean, if I’m the taxpayer and we’ve lent you $100,000 to buy a house that’s now worth $75,000, I’m nonetheless on the hook for the $100,000. Since your house is worth $75,000, this is an existing loss, whether I crystallize it or not. Conceptually, this should not be that big of a deal — but it is a huge deal.

Because the banks, which the taxpayers have already bailed out, have been allowed to extend and pretend —

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