I love a good frank with the works at a ball game, chased with a cold one. But I have little desire to watch the manufacturing of the frank, or the cold one for that matter. Likewise, I love the ideals of democracy, and bask in the glory of its freedoms. But watching a campaign is about as appealing to me as hanging out in a hot dog factory, or a brewery. Some things I just don’t want to know.

Thus, I eagerly await next Tuesday’s election, not just as a celebration of the people’s will, but also as a celebration of the end of the campaign. Not that this campaign doesn’t have substance; it does. You can choose between compassionate conservatism and principled populism. And there is a difference. You can vote for conservatives who apologize for preaching that greed is always good, or you can vote for liberals who apologize for preaching that greed is never good.

In fact, however, it really is a matter of whiter shades of pale. America is already charting a Third Way, the result of Bill Clinton having triangulated both right and left wing zealots. The Third Way is a middle ground between those who believe that markets always know best and those who believe that markets are always capricious. Call it market-driven capitalism with a heart.

That’s what the American people want, and both Bush and Gore know it.

There’s no groundswell of public support for any revolution right now. We’ve been there and done that over the last twenty years. We won the secular cold war against communism. We won the secular hot war against inflation. We won the secular Calvinistic war against budget deficits. We won the secular bonehead war against government regulation. Americans are tired of fighting wars that have already been won, and want simply to enjoy life.

Social Security Ain’t An ERISA Plan

And, of course, prepare for their retirement. I submit the defining issue in the current campaign is not what to do with the budget surplus, even though that’s all anybody seems to want to talk about. Bush wants to give some of it back to the hard-working taxpayers (why is it that politicians find it necessary to always call us “hard working”?). And Gore wants to invest (not spend, invest!) it on behalf of those same hard-working taxpayers, particularly those whose work doesn’t generate sufficient income to fully participate in the American dream.

Stocks’ Mantra: When Stuff Happens, The Fed Eases
Figure 1 is a line graph showing the S&P 500 index versus a four-week moving average of the U.S. fed funds rate, from 1981 to 2001. The S&P 500, scaled on the left-hand vertical axis, rises to a peak of above 1500 in 2000, up from a low of around 150 in 1982. It ends the chart at less than 1400 by early 2001. Over the time span, the fed funds rate, scaled on the right-hand side, moves in an opposite direction, trending down from highs of around 18% in early 1982. It bottoms at around 3% in the early 1990s, ending the chart at around 6%. The chart notes that the Fed historically eases after major events, such as the 1987 crash, and the combination of the savings and loan crisis, Gulf War, and 1900-1991 recession. The Fed also eased as a result of the Mexican peso crisis in the mid-1990s, and the Russian ruble and Long-Term Capital Management collapse in 1998.
Figure 1
Source: Bloomberg

These are important differences, and they do, at the margin, matter for the performance of both the economy and the capital markets in the years ahead. But they’re small potatoes stuff, in my view. The projected surplus in excess of that which is generated by “excess” social security taxes will be returned (not “dissipated,” as Wall Street Neanderthals insist!) to the electorate, one way or the other.

If there is a large spud difference between Bush and Gore it is about what to do with the “excess” social security taxes themselves. Bush wants to let the hard-working (there’s that word again!) taxpayers invest some of it for themselves. Gore wants to use it to pay down the national debt, so as to make room for future debt issuance to pay for the social security benefits promised to today’s hard-working Baby Boomers. From a big picture perspective, however, today’s social security promises will be met, one way or the other. Thus, it is disingenuous of Gore to charge that Bush’s plan to let taxpayers “invest some of their own money” will threaten future social security benefits. It is also disingenuous, however, for Bush to charge that Gore’s plan to “keep the taxpayers money” will generate an inferior total return to society.

The truth of the matter is that social security has always been a pay-as-you-go compact between generations: grandparents receive, and children pay, until such time they receive, and the grandchildren pay. Social security never was designed as a defined-benefit ERISA pension plan, to be fully funded on an actuarial basis. No, social security is a welfare plan, which re-distributes the fruits of the real-time economy between generations. Yes, I know it is not politically correct to call social security a “welfare plan;” it is only economically correct to do so. Today’s taxes and benefits are an outcome of the political process. And tomorrow’s taxes and benefits will also be an outcome of the political process.

Mr. Gore argues for the status quo, on the implicit proposition that the higher is the future unified (total) budget surplus, the greater will be the electorate’s willingness to pay today’s “promised” social security benefits. Mr. Bush argues that a reduction in the unified surplus, if it comes about because citizens are “allowed” to invest a portion of their social security taxes in productivity-enhancing capital formation, will make the citizens more able to pay today’s “promised” future social security benefits.

From an economic perspective, both positions are eminently defensible. They really are; I could write an academic paper either way that would get an “A” at any of the nation’s finest graduate schools (I promise I won’t!). So, on this core difference between Gore and Bush, economists have little unique insight to offer the electorate. It really is a judgment call for the political process. I have a preference, but that is all it is: there is no “right” answer. 

Monetary Policy Is The Straw That Stirs The Drink

From a capital market perspective, that means there is no compelling reason to take a large position solely on the basis of the election. The key differences between Gore and Bush are not about cyclical matters on cyclical time frames; the wisdom of the electorate’s decision will be revealed only in the fullness of secular time. What really matters for investment strategy is not what Bush or Gore are talking about, but about what they, for reasons of political correctness, refuse to talk about: monetary policy.

To be sure, both men say all of the perfunctorily correct words about the importance of Federal Reserve independence. But neither man, nor the Washington political arena at large, is willing to speak candidly about the conduct of monetary policy. Indeed, I would submit that monetary policy has replaced Social Security as the new “third rail” of political discourse: Don’t touch it, or the Wall Street crowd will fry you.

In fact, Bill Clinton broke the code on this new political reality from the get-go, inviting Alan Greenspan to sit next to his wife in front of the world at his first State of the Union address. And he has kept a hands-off policy with respect to the Federal Reserve for eight years, if not in other matters. Say what you want about Clinton, but he knows power when he sees it, and knows how to pre-emptively surrender to it, when that’s a winning political strategy.

Monetary policy arrangements and affairs have not always been an off-limits subject for political debate in America. Quite to the contrary, the seminal economic-driven elections of the 1800s were fought over monetary matters, notably Andrew Jackson’s victory in 1832, and William Jennings Bryan’s loss in 1896. Whether or not money should be hard or soft, favoring either lenders or borrowers was not considered a matter for bureaucrats, but a matter of political power, to be decided at the ballot box.

No more. But ain’t nothing I can do about it. Reality is as reality does, as that famous philosopher Forrest Gump might say. And the reality is that democracy no longer includes debate about monetary policy, even though monetary policy is far more important, and powerful than fiscal policy over cyclical economic horizons. It may still be true that the President proposes and the Congress disposes (which is why Wall Street is so intensely focused on the Congressional elections next Tuesday). But the Fed rules!

Indeed, in the matter of which is more powerful, fiscal or monetary policy, Nobel Prize Winner Paul Samuleson said it all 1985 when, in an interview prior to the publication of the 12th edition of Economics , the bible of Keynesian macroeconomics, he declared:


“In the early editions of the book, fiscal policy was top banana. In later editions that emphasis changed to equality. In this edition we take a stand that monetary policy is most important.”



Cutting to the Chase

If policy anticipation is part of your investment process, and it certainly is here at PIMCO, the key issue before us in what Greenspan is going to do, not what Bush or Gore are going to do. And to me, the key issue for Greenspan is as simple as it is difficult: 

The problem for Greenspan has been that a laissez faire regulatory environment inevitably begets excesses. In and of themselves, such excesses are not a bad thing. A dynamic, capitalist economy expanding the frontier of growth requires risk taking; from a macroeconomic perspective, ‘tis better to have risked and lost, than to have never risked at all. A culture of risk taking becomes a problem, however, when capital market risk takers up their risk tolerances on the presumption that the Fed will truncate the downside with monetary reflation.

Grabbling With Moral Hazard

Technically, this problem is known as moral hazard. The textbook example of this phenomenon is with banks and deposit insurance: Bankers take more risk than they should (act immorally) because they don’t have to worry about the wrath of depositors, who sleep well knowing that if their bank goes bust, the government will make good on the deposits. This set-up is a prima facie case for government to regulate the behavior of bankers, to prevent them from doing what the (capitalist!) logic of the arrangement motivates: Excess risk taking in the knowledge that the upside will accrue to private hands, while the downside will be shared with public hands.

In a de-regulated world of a blurring between banking and capital markets activity, this textbook example of moral hazard has become antiquated. But that doesn’t mean moral hazard has gone away. To the contrary, I believe it has become more pervasive, and taken on a more pernicious character. It is no longer a matter of bank depositors not disciplining their bankers, because deposit insurance takes away their incentive to do so, but a matter of capital market investors, notably equity investors, believing that the Fed will always ease to prevent equity losses from becoming too painful.

Revisiting the Greenspan Put

How do you manage the business cycle in the secular New Economy of a structural shift from fiscal surpluses to increased private sector leverage? More specifically, how do you manage to avoid a boom-bust investment cycle, underwritten by moral hazard? How do you let capitalism purge its excesses, with maximum punishment of the foolhardy, but with minimum punish of the innocents?

There are no easy answers, particularly for a man like Greenspan, who has consistently advocated a laissez faire, libertarian approach to financial regulation. In the early 1980s, before he was Fed chairman, he supported the deregulation of thrifts. In the late 1980s and early 1990s, he supported the IMF’s advocacy of the elimination of capital controls and currency inconvertibility in the emerging market world. And throughout the 1990s, he consistently argued against any regulation of financial institutions’ use of over-the-counter derivatives, and for the repeal of regulatory barriers between banking, securities underwriting and insurance. In and of themselves, these positions were consistent with market-driven capitalism, the mother’s milk of the New Economy.

Here at PIMCO, we call this phenomenon the Greenspan Put, a pervasive belief that Greenspan will ease, “stopping out” equity speculators’ losses at some “reasonable” level below current equity levels. Back in February 1 , when the P/E multiple was about 32 for the S&P 500, I estimated that without the Greenspan Put, the fair level for the P/E would be 18! More specifically, assuming (1) a 4% real earnings growth (consistent with a 4% New Economy potential real GDP growth rate); (2) a 4% real long-term risk-free interest rate (consistent with 30 year TIPs); and (3) a return to the historical equity risk premium of 5.5% (i.e., withdrawal of the Greenspan Put), the fair value for the P/E for the S&P 500 would be 18.

My objective wasn’t to forecast that the market would crash to that level, but merely to point out just how much the Greenspan Put was elevating equity market values, creating the wealth effect that was driving Greenspan ‘round the bend, inciting him to aggressive tightening. I thought a better way to deal with the wealth “problem” was to hike margin requirements, introducing fear of the Fed on the upside. Greenspan didn’t think much of my idea, of course.

He continued tightening, targeting a correction in the equity market, while denying he was doing so. The non-targeted correction arrived right on target in the spring, and again this fall. So, Greenspan looks brilliant. The NASDAQ bubble has been deflated, and the P/E on the S&P 500 now stands at 27.

But the Greenspan Put is still very much alive and well. Indeed, that’s all anybody in the financial markets wants to talk about these days, even if they don’t know it. Put more bluntly, “everybody” knows that you are “supposed” to buy stocks if the Fed is going to ease, so “everybody” is trying to figure out whether now is the time to load up on stocks, in anticipation of Fed easing. More narrowly, what “everybody” wants to know is whether the FOMC is going to ditch its bias to tighten on November 15, a step towards eventual easing. That question, more than who wins the White House on Tuesday, is the paramount issue for stocks (and by implication, Treasury bonds in the opposite direction) in the months/quarters immediately ahead. Is Uncle Alan, once again, going to reward risk-taking predicated on the notion that he is willing to “stop out” the downside?

Look Out For Credit “Event ”

I don’t know. I really don’t. My hunch, and it is only that, is that Greenspan desperately wants to cancel the Greenspan Put. Wouldn’t you? Thus, I sense that either economic conditions and/or financial market conditions will have to become much more dire than at present to get Greenspan to ease. Might he take a half way step by ditching the FOMC’s tightening bias? Yes, that’s more or less a done deal, either at the November 15 FOMC meeting or the one thereafter on December 19; quite independent of the issue of markets, incoming economic data simply do not “support” a continuing bias to tighten.

But easing, actual easing, the nectar of stock speculators, is a much harder call. I suspect the path to easing, as it has throughout Greenspan’s tenure, will be paved with a “credit event,” as vividly displayed in the cover graph. Accordingly, while it is tempting to say the worst is over for the credit risk markets, prudence argues powerfully to resist that temptation. Moral hazard interruptus is a mighty tricky monetary policy maneuver.

In contrast, the choice of a frank and a cold one to celebrate Tuesday’s election will be an easy call! 

Paul McCulley
Executive Vice President
November 3, 2000

1 Me and Morgan le Fay,” Fed Focus, February 8, 2000.


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.