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

Exactly. And I understand how the bank bailout — necessary as it was — left a sour taste. But putting families out on the curb doesn’t make sense, so we’re not going to take the Mellon route out of this liquidity trap; we’re not going to have liquidation and more liquidation. But we’re also not using the recasting of mortgages route, either. I’m clearly against the Mellon route, but if you’re also not going to go the recasting route, then you’ve gotten yourself into a cul-de-sac, going around and around and around. Capitalism doesn’t function in a culde-sac. It just doesn’t. Folks don’t have positive animal spirits when going around and around in a cul-de-sac. And especially when they’re going around and around in a cul-de-sac and their political leaders are telling them they are in a roundabout. That makes me feel like I’m being lied to. “Sir, this is not a roundabout. I don’t come out on the other side. This is a cul-de-sac. I go round and round and round.” If our leaders could just see the significant difference between a roundabout and a cul-de-sac, we’d be making major intellectual progress in Washington — one of these days.

First, you’ll have to find an intellect or two on those environs.

Touché. So I’m pessimistic.

Why am I not shocked? But how pessimistic?

Well, I don’t think we’re going to have an Armageddon outcome. I don’t necessarily think we’re even going to have another recession. We’re just going to be stuck in a high-unemployment, low-ambition, discouraged economy for a long period of time — and that doesn’t work well for capitalism, certainly, because that doesn’t imply positive animal spirits. And it doesn’t work well for the welfare, broadly defined, of our country, either. Our children are the first generation to face the reality that they will not be able to achieve as much as their parents did, as a generation. Certainly, I know that my grandparents’ generation wanted more for their children — and their children could realistically expect that they’d do better. And our parents felt the same way. There was a sense that the future was limitless — and that’s not the case anymore, I don’t think. Or, to the extent that it still exists, that sense is very bifurcated in this society. The income distribution, the division between the “haves” and the “have nots” in our economy is as great as at any time in my 54 years.

Greater, I’d venture, and I have a few years on you.

Okay, greater. And I’m not a socialist by any stretch of the imagination. Therefore, I don’t think that the notion of equal incomes is a valid idea at all. But I do believe that our country was founded and has prospered on the notion of equal opportunity.

Hear, hear!

And to say we have equal opportunity right now is to be speaking with forked tongue. That discourages me as a citizen. Let me be plain: My own circumstances are fine; my son’s circumstances are fine. So I’m not talking in the particular. I’m talking as a citizen and it makes me discouraged going forward about the vibrancy of our economy and our society and I think the valuation of assets, including the damn stock market, is going to reflect that. The P/E level of the stock market is tied to a lot of things. But fundamentally it’s tied to — and it’s interesting that I used the word fundamentally there, because many people would think I am making a statement about behavioral economics here. But I do think that behavioral economics has a lot of fundamental truth to it. And I do think the stock market’s multiple is tied to the notion of whether or not we have optimism about the future. If we do have optimism about the future, it can be a self-fulfilling optimism — if we believe we can, we can. That’s what I’m not seeing out there on the horizon anymore. Let’s go back to the equity market, where this is working in reverse. Defeatism is also self-feeding — and fiscal austerity in a liquidity trap, my favorite hobbyhorse these days, is defeatism on broad display, naked. It’s really unfortunate. I’d be ecstatic to be able — a year from now — to look back and say that I underestimated the ability of our political system to transform itself. I would be ecstatic to reach that conclusion.

Join the very large club.

I’m not so sure how large it really is. That is another way of saying that I will be delighted to be proven wrong. You hear that all the time from people on Wall Street who are managing money or making explicit forecasts. They’ll say, “This is my forecast and this is how I’m structuring my portfolio, but I would like to be wrong.” Nonsense! Money managers have fiduciary responsibility and if you think that you’re going to be wrong, then restructure your portfolio right now. Otherwise, you don’t have credibility with me. Not if you’ve got billions of dollars riding on this viewpoint and you say “but I hope I’m going to be wrong”! In contrast, I have credibility in my forecast of enduring grinding pessimism on the part of the American people — because I don’t have billions of somebody else’s money on the line — and I really want that forecast to be wrong. I don’t have a bet, that’s my genuine wish as a citizen. But as an analytical person who has spent more than a little bit of time in this arena, I don’t have an analytical basis for hoping that. I really don’t. This whole sorry notion that we can achieve prosperity via austerity and its accompanying zero appreciation for the paradox of thrift, or the liquidity trap, drives me about as bonkers as it does Paul Krugman. And the fact that we both have beards now is not the reason!

It’s not a hippie-dippy notion, as, say, Rush Limbaugh, might proclaim?

No, it has nothing to do with facial hair, and everything to do with appreciation for basic macroeconomic principles that we learned many, many years ago and that still endure. In my case, it has a lot to do with the fact that I’ve been the mantle carrier for [economic therorist] Hyman Minsky for so long — and Minsky essentially was a disciple of John Maynard Keynes. Krugman, of course, is Keynsian. So we don’t start with the notion that government is inherently bad — and when we’re in a liquidity trap, we pray that governments choose wisely. Austerity is a very good antidote to an overheated inflationary economy. But applying austerity to an economy trapped in a liquidity trap is probably not just an ineffectual idea but actually a toxic idea.

And this is the antithesis of an overheated, inflationary economy, that’s for sure.

The big thing is here is that fiscal austerity can always give you a boost to the economy, if you can offset it with easy monetary policy.

But if you can’t —

Then you’re up the creek and you’re a paddle short. When you look at episodes historically in which austerity has been a path to success, you find that universally, they have involved at least one of two things. One, you can have austerity with monetary policy ease that leads to a positive wealth effect and greater private sector demand in interest-rate-sensitive sectors, particularly housing. And/or — and I stress that because you can have both — you can have austerity that begets a weaker currency and so you can steal somebody else’s demand. Only then does fiscal austerity work. But if you don’t have the conditions in place to have those two countervailing offsets, then you’re doing austerity for the sake of austerity — and you’re starving an anorexic.

You’re saying fiscal austerity won’t work. And the Fed is pushing on a string. But what’s the likelihood of Bernanke coming forward and volunteering to get behind some big fiscal effort? The pols love skewering the Fed.

That’s true. Ben’s in an incredibly difficult situation. I mean, I’ve been looking at his full range of academic and analytical work, and he is truly one smart dude. You can infer very logically that he can do the diagnosis. The issue is that the political climate is such that he can’t do what he would do in the textbook. In fact, if you laid out our current set of conditions in an exam, he would know all the right answers. But he would have to deliver a “B” blue book, because an “A” blue book wouldn’t be politically acceptable. It must be incredibly discouraging and frustrating for him to know that “the only way I can continue to be matriculated in this university called Washington, D.C. is to turn in ‘B’ blue books.” Because Ben Bernanke has never turned in a “B” blue book in his entire lifetime! But he’s being asked by the political system to do exactly that right now. One of the things that I think a lot about — and I think others do, too, because you often hear it said — is that Washington only comes to its senses when it has no other choice. Wasn’t it Winston Churchill’s famous contention that America ultimately can be trusted to make the right decisions — but only after exhausting all other possibilities? Nonetheless, intellectually, I have difficulty with the notion that you need to do something stupid in order to reach enlightenment. It just bothers me, intellectually. There must be a path to enlightenment besides the bitter experience of stupidity —

Perhaps you expect too much of fellow humans—

I hope not. I’d hate to have to see enlightenment as a fruit stupidity. But let’s say that doctrine is correct, for the moment, anyway. If that is the truth, then let’s see 3,000 points taken off of the Dow, in order to enlighten the stupid. Then Washington would respond. Nothing concentrates minds in Washington like 3,000 points in Dow — on the south side. Now, whether that really matters or doesn’t matter is an open question. But it does tend to concentrate minds. We saw that in the first vote on the TARP bill — remember that one? Congress voted it down and then three days later, they passed it. The American public said, “Hell no, don’t pass that bailout,” but it didn’t even take dropping 3,000 Dow points, for them to turnaround and say, “Okay, Harry, vote for it. I can’t take this pain in my 401k anymore.” So actually maybe I do understand the doctrine that enlightenment comes through stupidity — and maybe we need a little bit of that in this country right now, unfortunately.