The Paradox of Deleveraging: Bill Gross & Paul McCulley Go into More Detail on Housing & Debt Devaluation

Widespread fear about the financial sector brought a dramatic end to the recent stock rally, as investors scrambled to take profits from bank shares and sent the Dow Jones industrials down more than 280 points, its worst loss in a month. Washington Mutual had to reiterate for a second time this week that it was financially sound.  Bill Gross continues on his July Investment Outlook letter of the trillion US dollars needed to get us out of this credit crisis in his August Letter.  Paul McCulley of Pimco sounded off on his Global Central Bank Focus,August, to Investors about what he terms "the paradox of deleveraging."

Paradox of Aggregation - Double Bubbles Bust. Once the double bubbles in housing valuation and housing debt burst a little over a year ago, everybody, and in particular, every levered financial institution – banks and shadow banks alike – decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense.

At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed. Put differently, not all levered lenders can shed assets and the associated debt at the same time without driving down asset prices, which has the paradoxical impact of increasing leverage by driving down lenders’ net worth.

 This process is sometimes called, especially by Fed officials, a negative feedback loop. And it is, though I prefer calling it the paradox of deleveraging, because the very term cries out for both a monetary and fiscal policy response, not just a monetary one. Lower short-term interest rates via Fed easing are, to be sure, useful in mitigating deflating asset prices, particularly if they serve to pull down long-term rates, which are the discount rates for valuing assets with long-dated cash flows.