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Is Deleveraging Bad for the Economy?

Mises Daily: Wednesday, August 20, 2008 by


On Wednesday July 30, the Federal Reserve announced that investment houses could tap the central bank for a quick source of cash through January 30. The program, started on March 17, was originally supposed to last until mid-September. Another program, where investment firms can temporarily swap more risky investments for safe Treasury securities will also continue through January 30, the Fed said. And, it will also let commercial banks, in a separate program, bid on cash loans that last longer — for 84 days, besides the 28-day loans now available.

The extension of various schemes to boost liquidity indicates that US central-banke policy makers are still concerned with the tight liquidity conditions in financial markets, which they believe pose a threat to the economy.

Most economic experts blame the tight liquidity conditions on bank actions to improve their solvency. In fact, it is believed, the collective attempt of banks to improve their solvency actually runs the risk of making them less solvent thereby deepening the liquidity crisis.

Take, for instance, company X, which has equity of $200. The company borrows $800 and buys an asset worth $1000. In this example we can say that company X has a leverage of 5. That is to say the equity of $200 represents 1/5 of the $1000 asset. If the value of the asset falls by 10%, that is, to $900 given the debt of $800, it implies a fall in equity or net worth to $100 — or 1/9 of the $900 asset, raising the leverage from 5 to 9 and making company X less solvent.

Let us now assume that company X has decided to deleverage and to lower its leverage back to 5 (by doing this the company will become more solvent). To achieve this company X sells assets for $400 and reduces its debt to $400. Consequently company X will now have $500 in assets, $100 in equity and $400 in debt: the leverage is now 5 again. But if many companies try to lower their leverage then there is a risk that the value of assets will fall. If, for instance, the value of company X's assets falls by 10% to $450, then, given the value of debt of $400, net worth falls to $50 implying that the leverage goes back to 9.

As a result of the real-estate market crisis and the fall in the value of houses, banks and various financial institutions took the decision to reduce their leverage, i.e., to deleverage. However, by cutting lending — trimming their assets — banks are forcing various borrowers to sell off their assets to prevent insolvency. Consequently this sets in motion asset-price deflation. This in turn lowers borrower collateral and causes banks to reduce their lending further, etc.

It follows that if all financial institutions are doing the same thing (trying to fix their balance sheets), they could drive asset prices down, which for a given debt will shrink their net worth and actually increase their leverage, or make them less solvent. This is the paradox of deleveraging.[1] If this process is not arrested in time it could seriously damage the real economy, so it is held.

So what should be done here? According to popular thinking, the central bank or the government must step in and start buying the assets that banks are trying to get rid of. This, it is held, will stop the asset-price deflation and prevent the nasty dynamics that can ruin the real economy.

Some commentators are of the view that "the paradox of deleveraging," follows the same principle as "the paradox of thrift," which was put forward by John Maynard Keynes.

The "paradox of thrift" states that if everyone acts more carefully with his money and saves more, then this will lower aggregate demand, which in turn will lead to a fall in economic growth. As a result, total savings in the economy will decline.

In this way of thinking, spending by one individual is income for another individual and it follows that if all individuals were to increase their savings — that is, lower their spending — the overall income in the economy will fall. A smaller income will permit less saving. From this it is concluded that if people are hesitant to spend, then the government must step in and lift overall monetary spending to prevent the economy from falling into a recession.

In his writings, Keynes relied on the ideas of Bernard Mandeville to provide credence to the "paradox of thrift." According to Mandeville,

As this prudent economy, which some people call saving, is in private families the most certain method to increase an estate, so some imagine that, whether a country be barren or fruitful, the same method if generally pursued (which they think practicable) will have the same effect upon a whole nation, and that, for example, the English might be much richer than they are, if they would be as frugal as some of their neighbours. This, I think, is an error.[2]

To reinforce his view that saving is bad for economic growth, Keynes also quotes Malthus:

I distinctly maintain that an attempt to accumulate very rapidly, which necessarily implies a considerable diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth… But if it be true that an attempt to accumulate very rapidly will occasion such a division between labour and profits as almost to destroy both the motive and the power of future accumulation and consequently the power of maintaining and employing an increasing population, must it not be acknowledged that such an attempt to accumulate, or that saving too much, may be really prejudicial to a country?[3]

Monetary Expenditure and Real Savings — What is the Connection?

Observe that spending, saving, and income in this way of thinking is in terms of money. We suggest that what matters as far as real economic growth is concerned is not monetary expenditure, as such, but real savings. It is real savings and not money that funds tools and machinery, i.e., capital goods, which in turn permits the expansion in real wealth.

Monetary expenditure as such does nothing as far as formation of real savings is concerned. By means of money a wealth producer exchanges goods that he has produced for the goods of another wealth producer. So in this sense, payment is always with goods. Money just makes it possible to exchange various goods. Note that without the existence of goods there cannot be any exchange.

Contrary to popular thinking, the heart of credit is not money but saved final goods and services. If John the baker produces ten loaves of bread and consumes one loaf, his saving is nine loaves of bread. The baker's saving now permits him to secure other goods and services.

For instance, the baker can now exchange his saved bread for a pair of shoes with a shoemaker. Observe that the baker's saving is his real means of payments — he pays for the shoes with saved bread. Likewise the shoemaker pays for the nine loaves of bread with the shoes that are his real saving.

The baker may also engage in a different transaction with the shoemaker. He could lend him nine loaves of bread in return for ten loaves of bread in one week's time. Note that the loaned bread sustains the shoemaker and allows him to continue making shoes. After one week, hopefully, the shoemaker has produced enough shoes to be able to secure the ten loaves of bread needed to repay the baker the loan of nine loaves of bread plus the interest of one loaf.

The introduction of money in our story doesn't alter what has been said so far. Without the medium of exchange — money — no market economy could take place. By means of money people can channel real savings, which in turn permits the widening of the process of real wealth generation.

Whenever an individual lends some of his money, he transfers the medium of exchange to a borrower. By means of money, the borrower can access the existing pool of final goods and services. By means of money, the borrower can now secure real savings (final goods and services) that will support him while he is engaged in the production of other goods and services. Note however that the final goods must already be in existence for the exchange to take place.

In the same way that real savings sustain the producers of final consumer goods, such as the shoemaker in our example, savings also fund the production of tools and machinery, which in turn permits the expansion of final goods and services. This increase in turn permits a further increase in savings that can now support the buildup of a more sophisticated production structure, which in turn permits a further expansion in the production of final goods and services. In this sense real savings are the key to economic expansion. This is contrary to popular thinking, which argues that savings can be bad for economic growth.

Observe that popular thinking reaches erroneous conclusions because it is only concerned with monetary flows without paying attention to real stuff. Again, for mainstream thinking what matters is monetary spending, since the more people spend, the greater the monetary income is going to be. From this it is concluded that an increase in saving, which is less monetary spending, must be bad news.

But does it make sense to suggest that people save money?

Demand for Money and Savings

People don't save money as popular thinking suggests but rather exercise a demand for money. Once real savings are exchanged for money the recipient of money can exercise his demand for money in a variety of ways. This however will not have any effect on the existent pool of real savings.

An individual can exercise his demand for money either by holding it in his pocket or in his house or by placing it in the custody of a bank in a demand-deposit or even in a safe-deposit box. Whether the individual lends out his money or puts it under the mattress, it does not alter the given pool of real savings.

By putting the money under the mattress, an individual doesn't engage in an act of saving he is just exercising a demand for money. What individuals do with money cannot alter the fact that real savings are already funding a particular activity. (Whether individuals decide to hold onto the money, or lend it out alters their demand for money, but has nothing to do with savings).

Whenever an individual lends some of his money to a borrower this means that he transfers a medium of exchange that the borrower could activate in order to secure real goods and services. By lending money, the individual has lowered his demand for the services of the medium of exchange. Conversely the borrower has increased his demand for the services of the medium of exchange.

Note that the act of lending money doesn't alter the existent pool of real savings. Likewise, if the owner of money decides to buy a financial asset like a bond or a stock he simply transfers the services of the medium of exchange to the seller of financial assets — no present real savings are affected as a result of these transactions.

Also note again that people don't demand money to hold it, as such, but rather to use it in an exchange. Even if prices are going down, it doesn't follow that people will start hoarding money. They will still continue to use it to maintain their life and well-being.

The greater the expansion in the production of goods and services, the greater the demand for the medium of exchange is going to be. Again the increase in the demand means an increase in the demand for the services of the medium of exchange to enable a greater amount of goods and services to be exchanged.

Once it is realized that saving is real stuff and has nothing to do with money as such the so-called paradox of thrift turns out to be a logical impossibility. If we have two bakers and each of them has saved nine loaves of bread, collectively we cannot have less then eighteen loaves of bread saved as the paradox of thrift implies. We can also conclude that, contrary to the "paradox of thrift," the increase in savings is the key for economic prosperity.

Is Deleveraging Really Bad for the Economy?

The existence of banks enhances the use of real savings. By fulfilling the role of middleman, banks make it easier for a lender to find a borrower. When a bank lends money, it in fact provides the borrower with the medium of exchange that can be employed to secure goods and services.

What determines the flow of lending is the flow of real savings. If the baker were to consume his entire production of ten loaves of bread then there will be nothing left for lending.

It is therefore futile to urge banks to lend more if real savings are not there. Likewise it doesn't make much sense to suggest that the Fed can somehow replace nonexistent real savings — in this case nine loaves of bread — by printing more money. (It is also an exercise in futility to raise government spending to fix the problem. After all if a government spends more it means that somebody else will have less resources left.) All that adding more money to the economy will do is to weaken wealth generators and thereby reduce the future supply of real savings and weaken future real economic growth.

The fact that banks are at present trimming their lending is in response to the damage inflicted to the pool of real savings. Note that the key factor behind this damage is the loose monetary policy of the Fed and the subsequent expansion of credit not supported by real savings, i.e., credit "out of thin air." (Between January 2001 and June 2003, the fed funds rate was lowered from 6% to 1%.) A tighter stance between June 2004 and September 2007 (the fed funds rate raised from 1% to 5.25%), the effect of which is presently in force, is undermining various false activities that have emerged on the back of the previous loose monetary stance.

As a result, these activities can now divert less real wealth from wealth producers, i.e., they are now in trouble. Consequently, banks' bad loans or bad assets are starting to increase. After all, banks have supplied these activities with credit "out of thin air." Obviously then it doesn't make much sense to prevent a fall in the value of assets when the previous asset prices represent false activities. The fall in asset prices of these activities puts things in proper perspective.

From this we can only suggest that if the Fed were to succeed in raising the pace of monetary expansion through its loose-interest-rate stance and prevent asset-price deflation it will only make things much worse. What about the situation where the curtailing of credit hurts the "good guys" — the wealth generators? No doubt this can occur, but the reason for it is not banks' unwillingness to lend, as such, but the poor state of the pool of real savings. (The good guys now have to pay higher interest.)

If the pool of real savings is in trouble no tricks such as buying assets by the government or the Fed to prevent asset-price deflation can help real economic growth. On the contrary it will only further falsify the price-signal mechanism and produce more squandering of real savings.

So what then are we to make of the "paradox of deleveraging"?

Is it true that if every bank were to attempt to "fix" its balance sheet, the collective outcome would be disastrous for the real economy? On the contrary, by adjusting their balance sheet to true conditions, banks would lay the foundation for a sustained economic recovery. After all, by trimming their lending, banks by implication also curtail the expansion of credit "out of thin air." As we have seen, it is this type of credit that weakens wealth generators and hence leads to economic impoverishment. Contrary to the proponents of the "paradox of deleveraging" we can only conclude that if every bank were to aim at fixing its balance sheet, in the process curtailing the expansion of credit "out of thin air," this would lay the foundation for a healthy economic recovery.


For most commentators, a major threat to the US economy is the fact that banks are curtailing their expansion of credit in order to improve their net worth and hence solvency. This, it is argued, sets in motion a vicious process that leads to asset-price deflation, which for a given value of liabilities actually weakens banks' net worth and makes them less solvent.

When all banks are trying to "fix" their balance sheets, the outcome could be the exact opposite of what they intended to achieve, so it is held. So what should be done to arrest this vicious process? According to popular thinking, the central bank and the government must step in and start buying assets that banks are trying to get rid of.



Note that this conclusion is in line with the writings of Keynes. Contrary to this way of thinking we have concluded that, by adjusting their balance sheets to the facts of reality, banks actually set up a process that permits sustained economic growth.

On this Ludwig von Mises had the following to say:

The unprecedented success of Keynesianism is due to the fact that it provides an apparent justification for the "deficit spending" policies of contemporary governments. It is the pseudo-philosophy of those who can think of nothing else than to dissipate the capital accumulated by previous generations.

Yet no effusions of authors however brilliant and sophisticated can alter the perennial economic laws. They are and work and take care of themselves. Notwithstanding all the passionate fulminations of the spokesmen of governments, the inevitable consequences of inflationism and expansionism as depicted by the "orthodox" economists are coming to pass. And then, very late indeed, even simple people will discover that Keynes did not teach us how to perform the "miracle ... of turning a stone into bread," but the not at all miraculous procedure of eating the seed corn.[4]


[1] Paul McCulley. The Paradox of Deleveraging in PIMCO Market Commentary. July 2008.

[2] John Maynard Keynes. The General Theory of Employment. London Macmillan &Co., Ltd. 1964 p. 361 ("Notes on Mercantilism," etc.).

[3] Ibid., pp. 362–363.

[4] Ludwig von Mises, "Lord Keynes and Say's Law."