I have often commented about the problem of personal savings. We worry about the lack of savings here in the US, but many do not understand that if everyone started to save 5% of there income immediately that it would seriously impact consumer spending, pushing the US into a recession.

Back in college, most of us took microeconomics before we took macroeconomics. In fact, at Grinnell College where I went, microeconomics was a prerequisite for macroeconomics. The reason was simple: microeconomics begins with the concepts of supply and demand, an essential starting point for the study of macroeconomics. But you only know you’ve mastered both when you intuitively grasp that macroeconomics is not just the summation of microeconomic outcomes, but rather the interaction of microeconomic outcomes.

For me, a simple concept brought this realization: the paradox of thrift. For those of you who might not recall, the paradox of thrift posits that if we all individually cut our spending in an attempt to increase individual savings, then our collective savings will paradoxically fall because one person’s spending is another’s income – the fountain from which savings flow.

This principle is part of a whole range of macroeconomic concepts under the label of the paradox of aggregation: what holds for the individual doesn’t necessarily hold for the community of individuals. Understanding this paradox is absolutely vital to understanding macroeconomics and even more so to understanding what is presently unfolding in global financial markets.

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.

But monetary easing is of limited value in breaking the paradox of deleveraging if levered lenders are collectively destroying their collective net worth. What is needed instead is for somebody to lever up and take on the assets being shed by those deleveraging. It really is that simple.

Time to Lever Up Uncle Sam’s Balance Sheet

As Keynes taught us long ago, that somebody is the same somebody that needs to step up spending to break the paradox of thrift: the federal government, which needs to lever up its balance sheet to absorb assets being shed through private sector delevering, so as to avoid pernicious asset deflation. That’s a fiscal policy operation and, fortunately or unfortunately, fiscal policy is not made by a few learned technocrats above the political fray of the democratic process, but is squarely in the hands of the legislative branch, consisting of 535 politicians, with far more lawyers than economists among them.

Yes, I know that Congress passed a properly Keynesian stimulus package earlier this year, the benefit of which we are feeling now, sending over $100 billion in rebates to the citizenry, borrowing the money to do so and levering up the Treasury’s balance sheet with debt in an equal amount. So, yes, I may be too harsh when I challenge the economic literacy of Congress: they do understand that Uncle Sam should borrow and spend, directly or indirectly through tax rebates to citizen spenders, to truncate the paradox of thrift (even if they don’t know what that is).

But levering up Uncle Sam’s balance sheet, to buy assets to break asset deflation resulting from the paradox of deleveraging still seems to be a foreign, if not a sinful proposition. This need not be, and should not be. Yet we hear endlessly that any levering up of Uncle Sam’s balance sheet to buy assets must be done in a way that “protects tax payers.” By definition, levering Uncle Sam’s balance sheet to buy or guarantee assets to temper asset deflation will put the taxpayer at risk – but will do so for their own collective good!

This was defacto what the Federal Reserve did when it put up $29 billion on nonrecourse terms to buy assets so as to facilitate the merger of Bear Stearns (NYSE:BSC) into JPMorgan (NYSE:JPM). As I said at the time, and wrote about two months ago, this was a fiscal policy operation, conducted by the Fed. Logically, it should have been conducted by the Treasury using appropriated spending power from Congress. But alas, that “right” solution was not legally available to the Treasury, whereas the Fed did have the power to act: Section 13(3) of the Federal Reserve Act of 1932 gave the Fed the power to lend to essentially anybody against any collateral, so long as it declares it is necessary to do so because of “unusual and exigent circumstances.”

But make no mistake, it was a fiscal policy action demonstrated by (1) the fact that the Fed sold a similar amount of Treasuries from its portfolio, increasing the supply of Treasuries in the market by the same amount, and (2) the fact that any losses the Fed experiences on that $29 billion will reduce dollar-for-dollar the amount of seigniorage profits that the Fed remits to the Treasury. At the end of the day, there are $29 billion more Treasuries on the open market than otherwise would be the case, and the Treasury is, one small step removed, on the hook for any losses the Fed experiences on the $29 billion of non-Treasury assets it now de facto owns.

Yes, that $29 billion is actually a loan to a Limited Liability Corporation (LLC) set up to hold the Bear assets, with JP Morgan providing a $1 billion subordinated loan (sometimes called the “first loss” tranche) to the LLC. But that is merely a technical detail – the bottom line is that we the taxpayers bought $29 billion of Bear’s assets.

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