T he United States Senate is known as the world’s greatest debating society. I submit this reputation is greatly exaggerated, particularly now, with 55% of the Senate of the same party as a president who believes he has a mandate to pursue fundamentalist imperialism.

The Senate will prove itself great only if it re-learns that America is a constitutional republic with three separate but equal branches of government, not a parliamentary system, with the legislature subservient to its party leader. And the Senate will prove itself a great debating society only if it re-learns to debate, agreeing to agree when to disagree, getting on with the nation’s business, rather than agreeing to debate for the sake of debating, SIG-alerting the nation’s business.

Yes, I worry about America’s democracy, in which party politics seems to demand division where there isn’t division among the citizenry, and where Gotcha is the coin of the political realm.

Playing to Win, Which Sometimes Is All About Not Losing
Fortunately, I don’t have to worry about such matters when it comes to PIMCO’s Investment Committee. First, we are a parliamentary body, with Chairman Bill Gross the unquestioned leader. And he is the unquestioned leader precisely because he demands questioning. We leave our political affiliations at the door and have a singular objective: making the right decisions for our clients’ portfolios. That sometimes demands swallowing one’s pride, agreeing to implement collective decisions that go against one’s personal biases, for the simple reason the history of our process proves that we are collectively smarter than we are individually.

Fortunately, I don’t have to worry about such matters when it comes to PIMCO’s Investment Committee. First, we are a parliamentary body, with Chairman Bill Gross the unquestioned leader. And he is the unquestioned leader precisely because he demands questioning. We leave our political affiliations at the door and have a singular objective: making the right decisions for our clients’ portfolios. That sometimes demands swallowing one’s pride, agreeing to implement collective decisions that go against one’s personal biases, for the simple reason the history of our process proves that we are collectively smarter than we are individually.

This does not mean, I hasten to add, that members of PIMCO’s Investment Committee are short of ego. Quite to the contrary, I’ve never met a group of investment professionals with greater individually-justified intellectual mojo. But when it comes to clients’ money, we leave our egos at the door, as getting it right is far more important than having the right to say, "I told you so." We are, in fact, a great debating society, striving to win. Which, in the fixed income management business, is primarily about not losing.

No, you didn’t miss-read that last sentence. At its core, fixed income portfolio management is about not losing. Unlike my dear friend Bill Miller of Legg Mason equity management fame, Bill Gross and PIMCO’s Investment Committee cannot score "ten-baggers." As I tease Bill Miller, his job is easy: pay the tracking-error ante of concentrated value-laden aces in the hole, waiting for the market to recognize and properly value those aces. He teases (or is that retorts?) back that unrecognized aces ain’t all that easy to recognize and that even when you do, the hard part just begins: emotionally accepting that you will probably lose a lot of money before you make a lot of money. And he always gets the last laugh with me when he calmly notes that while my job is buying senior bonds with both a coupon and maturity date printed on them, his job is buying junior bonds with un-printed coupons and infinite maturity.

He’s right, of course. Stocks are indeed subordinated claims, which are worth nothing unless and until legal obligations to pay interest and principal to debt holders are honored. And in that sense, equity investors do have a harder analytical job than bond investors. But it is also true that equity managers can dream of "ten-baggers", while fixed income managers can only pray to get their money back. Which helps explain, perhaps, why Bill Miller and I are good friends: we don’t compete with each other, but rather appreciate that we play different games. By definition, equity managers play to win, while bond managers play to not lose.

You Can Have an Interest Rate Policy or a Currency Policy: But Not Both!
It is also the case that fixed income managers and foreign exchange managers play different games, even though they, like equity and fixed income managers, traffic on common macroeconomic terrain. Most important, in a world of fiat currencies, we both look to central banks for direction. It is an undisputed fact that central banks can peg either the short-term interest rate for borrowing/ lending their currency or peg the exchange value of their currency against others. But they cannot do both at the same time! Put more technically, once a central bank, with monopoly power over the creation of its currency, pegs either its short-term interest rate or the foreign exchange value of its currency, the non-pegged variable becomes market determined.

It is also the case that fixed income managers and foreign exchange managers play different games, even though they, like equity and fixed income managers, traffic on common macroeconomic terrain. Most important, in a world of fiat currencies, we both look to central banks for direction. It is an undisputed fact that central banks can peg either the short-term interest rate for borrowing/ lending their currency or peg the exchange value of their currency against others. But they cannot do both at the same time! Put more technically, once a central bank, with monopoly power over the creation of its currency, pegs either its short-term interest rate or the foreign exchange value of its currency, the non-pegged variable becomes market determined.

Thus, strictly speaking, it is impossible for a country to have both an interest rate policy and a currency policy, even though an interest rate policy influences currency outcomes and a currency policy influences interest rate outcomes. And the dominant channel of influence is the inflation rate.

• If an interest rate peg is too high, it will tend to beget a market-driven deflationary appreciation for the currency, forcing the central bank to consider lowering the interest rate peg. And if the interest rate peg is too low, it will tend to beget an inflationary depreciation for the currency, forcing the central bank to consider raising the interest rate peg.
  
  
• If a currency peg is too high, it will tend to beget a market-driven deflationary bull flattening/inversion in the yield curve, forcing the central bank to consider lowering the currency peg and cutting short-term interest rates. And if the currency peg is too low, it will tend to beget a market-driven bear steepening in the yield curve, forcing the central bank to consider lifting the currency peg and hiking short-term interest rates.

If an interest rate peg is too high, it will tend to beget a market-driven deflationary appreciation for the currency, forcing the central bank to consider lowering the interest rate peg. And if the interest rate peg is too low, it will tend to beget an inflationary depreciation for the currency, forcing the central bank to consider raising the interest rate peg.If a currency peg is too high, it will tend to beget a market-driven deflationary bull flattening/inversion in the yield curve, forcing the central bank to consider lowering the currency peg and cutting short-term interest rates. And if the currency peg is too low, it will tend to beget a market-driven bear steepening in the yield curve, forcing the central bank to consider lifting the currency peg and hiking short-term interest rates.

Yes, as some of you are no doubt thinking, the interest rate/currency nexus is, in the first instance, a 2-by-2 matrix, with four possible combinations between high and low interest rates and high and low currency values. I only wish it was so simple, which it ain’t.

A global system of fiat central banking demands that any individual central bank consider the choices of all other central banks when deciding whether its own interest rate peg or currency peg is too high or too low. Well, not actually "all" other central banks, but rather ones that matter in the aggregate picture of global money creation, which determines the global outcome for inflation (the exchange value of a global basket of fiat currencies for a global basket of goods and services).

Commodity Standard or Fiat Standard?
This is where it gets interesting, turning the game of global monetary policy into a game of leadership, followship, or coordination; or all three at the same time! Indeed, the Bretton Woods arrangements in place from the end of World War II until 1971 involved all three: America led by pegging the dollar to gold at $35 per ounce the rest of the world followed by pegging their currencies to the dollar; and the game was coordinated by capital controls and official lending, which thwarted market-driven forces when they threatened to overturn the game. Which they ultimately did, of course, when America refused to honor other central banks’ demands to exchange their intervention-driven accumulation of dollars into gold.

This is where it gets interesting, turning the game of global monetary policy into a game of leadership, followship, or coordination; or all three at the same time! Indeed, the Bretton Woods arrangements in place from the end of World War II until 1971 involved all three: America led by pegging the dollar to gold at $35 per ounce the rest of the world followed by pegging their currencies to the dollar; and the game was coordinated by capital controls and official lending, which thwarted market-driven forces when they threatened to overturn the game. Which they ultimately did, of course, when America refused to honor other central banks’ demands to exchange their intervention-driven accumulation of dollars into gold.

Ever since, the global monetary policy exercise has been an uncoordinated game, punctured by periodic bouts of failed coordination. More technically, the game has been one dominated by American self-interest, unconstrained by dollar convertibility into anything except more dollars. And, to America’s credit, the game has not necessarily been badly played, as articulated this summer by none other that Alan Greenspan himself, in response to questioning from Congressman Ron Paul:

Where You Stand Depends Upon Where You Sit
In this fiat global monetary policy game, the world has depended upon (1) the good judgment of Alan Greenspan coinciding with (2) global economic conditions coinciding with the self-interest of the United States. To wit, the world has been hostage to what is good for America being good for the world, not unlike the notion long ago that what was good for business was good for America. And, truth be told, what has been good for America has, in fact, been overwhelmingly good for the developed world since the end of the Bretton Woods system. As Greenspan intoned, the Fed deserves excellent marks for getting a grip after the 1970’s global inflationary hangover from the bust-up of Bretton Woods, and winning the Great Disinflationary War of the 1980s and 1990s.

In this fiat global monetary policy game, the world has depended upon (1) the good judgment of Alan Greenspan coinciding with (2) global economic conditions coinciding with the self-interest of the United States. To wit, the world has been hostage to what is good for America being good for the world, not unlike the notion long ago that what was good for business was good for America. And, truth be told, what has been good for America has, in fact, been overwhelmingly good for the world since the end of the Bretton Woods system. As Greenspan intoned, the Fed deserves excellent marks for getting a grip after the 1970’s global inflationary hangover from the bust-up of Bretton Woods, and winning the Great Disinflationary War of the 1980s and 1990s.

Countries should not, equal truth be told, be so charitable in grading the Greenspan Fed. While the Fed has done a fine job of stabilizing inflation at a low level for a basket of goods and services in America and other developed countries, the cost of that "victory" has been a boom and bust pattern for globally-traded goods and in particular, globally-traded commodities, as vividly displayed in the chart on the cover.

For good or for bad, developing countries have a comparative advantage versus developed countries in commodities, both literal commodities and goods (and, increasingly, services) that embody commodity-like labor (known as sweat-of-the-brow labor, where I grew up in the Shenandoah Valley of Virginia). Accordingly, when a highly-developed country like America is driving the global monetary game, developing countries are the whipping boys, punished unwarrantedly when non-traded services in developed countries are inflating undesirably, and rewarded unwarrantedly when growth in non-traded services in developed countries is faltering undesirably.

Yes, I’m a principled populist and I have a real problem with the reality that "price stability" in the developed world implies soaring inflation followed by plummeting inflation in the developing world. America may have a comparable advantage in the creation of re-runs of Baywatch, but I have both economic and moral problems with America manipulating its terms of trade between inches of re-runs of Baywatch and ounces of what emerging market countries have a comparative advantage in producing. America preaches free trade, but until the day in which there is free trade in developed countries’ passports (like with New York City taxi medallions!), globalization will be a comparative advantage game tilted to the advantage of the haves relative to the have-nots.

I hasten to stress - with fist on pulpit! - that such bastardized globalization is not absolutely bad for developing countries. Quite to the contrary, even trickle-down globalization is absolutely good for the poor, as globalization is the means by which the technological innovations of the rich are diffused to the poor. For good or for bad, the best way to get rich is to go to school on the rich man’s know how. The long-run consequence is an increasing standard of living for both the rich man and the poor man. But the real-time journey is fraught with the potential for destabilizing currency and asset price adjustments, both up and down (as well as bouts of protectionist whiplash).

A De Facto Monetary Union
The best way to define the monetary arrangement between the United States and China over the last decade is a de facto Bretton Woods arrangement, in which China has pegged the Renminbi at 8.3 to the dollar, while America has pegged its currency to the good judgment of Alan Greenspan.

The best way to define the monetary arrangement between the United States and China over the last decade is a Bretton Woods arrangement, in which China has pegged the Renminbi at 8.3 to the dollar, while America has pegged its currency to the good judgment of Alan Greenspan.

Nobody, at least nobody that I know who wears properly-fitted macroeconomic trousers, would argue that the United States and China represent an "optimal currency zone," per Nobel Prize winner Mundell’s framework. Yet for the last decade, the United States and China have operated as a de facto monetary union. Therefore, we must conclude (at least!) two things:

• It has been in the mutual best interests of the United States and China to operate as a dollar block, even though such an arrangement defies sustainable macroeconomic logic; and
  
  
• This arrangement is destined to ultimately unwind, as global capital flows eventually expose, exploit and explode the arrangements’ internal contradictions of logic.

It has been in the mutual best interests of the United States and China to operate as a dollar block, even though such an arrangement defies sustainable macroeconomic logic; andThis arrangement is destined to ultimately unwind, as global capital flows eventually expose, exploit and explode the arrangements’ internal contradictions of logic.

But as both Bills have taught me, it is no easy task to handicap the timing of the demise of the unsustainable. Or, as Lord Keynes said long ago:

This is particularly the case when speculating on the demise of fixed exchange rate regimes - de facto monetary unions - because central bankers are not constrained by the same profit-maximizing exigencies of market mavens. Men (and women!) with presses that print money, and who get their ink for free, are different than the rest of us. Most importantly, central bankers can always stop appreciation of their currencies. That’s not to say they should, but a central bank does have that ability: it can keep printing its currency until it stops going up. In contrast, central bankers cannot always stop depreciation of their currencies; a central bank can only buy its currency to the limit of its reserves of other currencies and/or its ability to borrow other currencies.

China has, of course, proven the inherent power of a central bank to prevent appreciation of its currency, creating Renminbi and selling them for dollars so as to preserve the 8.3 Renminbi peg, notwithstanding U.S. Treasury Secretary Snow’s incessant requests for China to let the Renminbi appreciate against the dollar. But as macroeconomic logic dictates, there is a cost to China’s currency policy: the inability to run an independent Chinese interest rate policy. Alan Greenspan runs China’s interest rate policy. And as macroeconomic logic again dictates, America’s interest rate policy is not necessarily conducive to China’s long-term best interest, given that China and America are not an "optimal currency zone."

Most notably, made-in-America interest rate policy is fostering asset speculation in China, in fixed investment and perhaps even more critically, property markets. Such speculation is ineluctably setting China on a boom-bust course, as bubbles are as bubbles do, in the words of that famous economist Forrest Gump.

Accordingly, it is becoming less and less appropriate for China to choose a peg for its currency rather than to peg its interest rates. In contrast, there is no reason whatsoever for America to be upset about China’s currency peg to the dollar, notwithstanding Mr. Snow’s constant carping. The peg allows America to sustain a higher investment course and a higher trajectory for its living standard than would be the case were China to let its currency appreciate. To be sure, the China peg implies a faster growth path than otherwise would be the case for America’s international "indebtedness"; but rising debt is not, per se, an evil. This is particularly the case when a country’s international debt is denominated in its own currency, which can be printed up at will for free.

Okay, not for free in the long turn, as a falling dollar implies higher United States inflation than otherwise would be the case. But higher inflation is not an evil, either. It is, of course, if you are a lender; but if you are a borrower, higher inflation is actually your friend. Accordingly, since America is a net international borrower, in its own currency, there is little to fear from a lower dollar.

Unless, of course, the Fed were to get wrapped ‘round the axle of orthodoxy and partially surrender its autonomous interest rate policy on the altar of defending the dollar. In that scenario, which is highly unlikely, in my opinion, America would be inviting an asset deflation-driven recession upon itself. And if America were to do such a stupid thing, the rest of the world would suffer, too, including most importantly, perhaps, China.

Thus, in the famous words of Richard Nixon’s Secretary of Treasury, shortly after the break-up of the Bretton Woods arrangements, "the U.S. dollar is America’s currency, but a falling U.S. dollar is the rest of the world’s problem!" But more bluntly, the right time for America to debauch its currency, as all right-thinking countries who issue debt in their own currency should want to do, is when a falling dollar inflicts more growth pain on countries with appreciating currencies than it does inflationary pain on the United States.

Bottom Line
Now is such a time. Indeed, it’s been debauch-in-the-dollar time for a long time. In that connection, I would change only a few words of a sermon I wrote on the subject two years ago on these pages ^1:

Now is such a time. Indeed, it’s been debauch-in-the-dollar time for a long time. In that connection, I would change only a few words of a sermon I wrote on the subject two years ago on these pages

What would I change? I’d call for Mr. Greenspan to announce a pause in the Fed’s current tightening course, rather than cutting rates. And I’d urge Mr. Snow, who replaced Mr. O’Neill, to quit embarrassing himself and the President by uttering the words "strong dollar". It is patently clear that America doesn’t have - can’t have! - a currency policy, strong or weak, if it wants to retain sovereignty with respect to its interest rate policy.

But other than that, things are much as they were two years ago: the burden of adjustment for global imbalances - assuming they must be rebalanced, of course! - lies with countries experiencing deflationary appreciation of their currencies, not with America, for whom a depreciating dollar is not a problem but a debtor’s blessing.

Paul McCulley
Managing Director
November 21, 2004

1 See "The Morgan le Fay Plan," Fed Focus, October 31, 2002.

In December…
"Next month, I will be having my second annual conversation on the outlook for the year ahead with the redoubtable economist, Morgan le Fay, my co-author of the January 2004 Fed Focus , " Isle of the Pears". If you have questions for either one of us, please shoot me an email."