(A conversation with Morgan le Fay, the author’s roommate)

PM:   You’re looking mighty fine, Morgan. Age is treating you well:   5 ½ years, the north end of middle age for bunnies, and you are still as aristocratic to the eyes as the day you came to California in the summer of 1999. And, let me say, congratulations on a great year in calling global macroeconomic policy. The Morgan le Fay Plan, which you so articulately advocated on this page November a year ago, has become the currency of the global policy realm:   brute force reflation, with a declining dollar playing the role of the brute.

MLF:   Thanks, Mac. But I take offense at the notion of being middle aged, even though the years have treated me well. Were it that I could say the same about you. Give you a couple more years, and your hair will be as white as the fur on my back, and not nearly so soft. And thatwaistline tells me that you need to exercise more, drink less beer, or both. But I’m in a charitable mood today, so I’ll cut you some slack, particularly since you’ve been bringing me one of those Harry and David pears every day for the last two weeks. They are awesome, particularly when you peel them and cut them up into candy-size pieces.

PM:   Well, I am glad you are in a charitable mood, as a number of my colleagues sent me questions for you for this year-end chat. Or maybe they are questions for you to ask me. In any event, to start off our chin wag, allow me to quote back to you what you said on October 31, 2002 1  when introducing your Plan:

“The time has come for the Fed and the U.S. Treasury to join forces, with Alan Greenspan cutting short rates and Paul O’Neill explicitly declaring that a strong dollar is not in America ’s interest. It is also time for America to announce to its G-3 partners that a weaker dollar is not a problem to be solved, but an opportunity to be seized by Euroland and Japan to aggressively ease monetary policy, using all available means, including non-sterilized currency intervention to temper the dollar’s fall, and monetization of private sector assets. Yes, my friends, it is time for G-3 Keynesianism, in an all-out preemptive war against deflation.”

Nice call, Morgan:   Mr. Greenspan did indeed cut rates two more times after you wrote that – 50 basis points in November and 25 more in June of this year – and President Bush found it in his best interest to fire Mr. O’Neill and hire a fellow named Mr. Snow, who cleverly re-defined a “strong” dollar as one that is difficult to counterfeit. And a chap named Bernanke, who you fondly call Gentle Ben, explained to both his FOMC colleagues and the world at large that the Fed has a printing press that can kick out dollars like your species kicks out babies, requiring more and more dollars to buy the same amount of stuff. Yes, Morgan you are running with some fine reflationist company!

MLF:   Thanks, dude. But don’t you talk to me about rabbit proliferation; I ain’t fixed, but you still won’t buy me a fix of anything but dandelions. Which I appreciate, I hasten to add, but still think you ought to let some of those wild hares in the neighborhood get into my play yard, rather than watching them hurt their noses trying to get at me through the mesh fence. But what the heck, you’re smarter than I am; or so you say. You rail against Austrian austerity at the office, then you make me practice it at home. If Keynesian is good, why ain’t it good for me?

PM:   Enough of that, Morgan. You know as well as I do Emerson’s dictum that a foolish consistency is the hobgoblin of small minds. Speaking of which, the gold bugs had a thoroughly enjoyable year in 2003. Do you think the yellow metal has still got some room to go?

MLF:   That was rude, dude, even if true. The gold bugs have been fundamentally right, just practically wrong for two decades:   in the end, fiat currency regimes cannot resist the urge to use the printing press to debauch the real value of their debts, both the sovereign and that of their cowboy capitalists friends. What the gold bugs missed in the 1980s and 1990s was a grand experiment to prove this verity wrong. Indeed, the experiment was so grand that central banks ‘round the world – who ought to know better! – started selling off their gold reserves, on the notion that Uncle Sam had become more holy in monetary matters than Bill Bennett.

As Alan Greenspan intoned so boastfully last summer, the data of the last two decades have screamed that it might just be possible for fiat currency regimes to eschew their inherent inflationist proclivities. The gold bugs missed that. But they were not wrong, even though most of them went broke. In the end, fiat currency regimes are inflationist. Soaring gold over the last year has coincided with the Fed’s open acknowledgement that it has fallen off the disinflation wagon, not because it could not help itself, but because it had no choice.

As you wrote yourself in January 2001 2, Mac, deflation is the beast of burden that capitalism can’t bear, borrowing from what that really smart fellow Minsky wrote long ago. In the fullness of time, the Fed figured this out, and time became full, with gold soaring. What’s so hard to understand here? Do you need to have lunch with your partner Brent Harris, who has forgotten more than you will ever know about commodities, to understand the basics here? Or that really clever fellow Bob Greer, who joined PIMCO to further expand your understanding of the international commodity markets.

PM:   Morgan, my friend, you are wired; what’s gotten into you? Are you making bootleg hooch in your hutch with those expensive dandelions from Gelson’s that you insist that I buy? Messrs. Harris and Greer and I talk all the time. And notwithstanding his god-awful selection in ties, PIMCO TIPS guru John Brynjolfsson and I are good personal friends, debating monetary policy regimes ‘til the non-mad cows come home. Cut me a break, Morgan. What’s your point here? Should I have been holding more gold, or more broadly speaking, more “stuff” in my portfolio?  Do you think I have had too much in money market funds, as a hedge against a rainy day?

MLF:   If I didn’t like you so much, Mac, I’d just gag myself with a carrot, like Moon Zappa sang long ago. Yes, you should have owned more gold. Let me quote back your own words to you on this, watch you cry, and then let’s change the subject, okay.

“If the war against inflation was started with the Fed flogging the gold speculators, then the war against deflation risk should logically commence with a Fed embrace of the gold speculators. The simple fact of the matter is that America , and the world, needs a devaluation of paper versus ‘stuff’ – the exact opposite of twenty-odd years ago. And gold is the global symbol for ‘stuff.’ 3

PM:   Morgan,  Ms Moon sang of a spoon, not of a carrot. But I take your point. Indeed, I’ve been singing your point out on the rubber fish circuit for well over a year:   we are at a secular turning point, in which the flight to financial assets of the last two decades is morphing into a flight to tangible assets, as the Fed has won the war against inflation and has commenced a new campaign to win the peace of price stability. And, I hasten to add, I mention you quite frequently in my speeches, Morgan. I don’t pretend that there isn’t a lady behind the scenes that makes me the man that I am. You are that lady, Morgan.

MLF:   You make me blush, Mac, I appreciate that. But you just flatter me. What I really want to know is if you are still a financially-principled populist, like your best friend Mohamed El-Erian. I got an email the other day from a dude named John Loftus, claiming to be your partner and a good friend, and he said there is a rumor that you’re thinking about becoming a Republican. Tell me this is not true!

PM: It is true, dear Morgan, that John is a good friend. It is not true, however, that I’m thinking of becoming a Republican. For god’s sake, you know me better than that! John is just having one of his flights of fantasy, which is not altogether a bad thing; his job includes navel gazing about new ways to make money. That’s what I do, too, Morgan, using macroeconomics. You did know that, right? And by the way, just when did you get an email account?

MLF:   Yep, I most certainly know that’s what you do, given that I have to tolerate you quoting that Keynes fellow all the time. And it’s none of your damn business if I have my own email account now. Back to the point at hand:   What is it that you see in that Keynes man’s writing? Do you have an inferiority complex; are you jealous of him; just what the hell is it?

PM:   No, sweet Morgan, I don’t have an inferiority complex about Keynes. I’m simply inferior. And that’s different from having a complex. The dude was good, Morgan, very good. Now hush up about him. I will not tolerate you getting bent about me having a dead intellectual mentor!

MLF:   Sorry, dude. Didn’t mean to offend. You are right. It’s a free world, and you have the right to be as nutty as you foolishly choose. And I have to admit, I do have a lot of sympathy with that Keynes guy: he believed that capitalism is, in the end, about increasing the capacity to consume. And, I admit – begrudgingly since I don’t want you to think you own me – that I’m pretty happy that you are a capitalist.

Bringing good things to life, or something like that, like those GE folks sing. They’re right, but could you get them to switch to Jefferson Airplane’s “White Rabbit?” Much better tune, and if they want, I’ll be happy to star in their commercials for free; would help to make amends for you blowing out billions of their commercial paper way back when. You and that Gross fellow do have a flair for the dramatic, don’t you?

PM:   No, Morgan, we have a penchant for getting it right, and getting it right sometimes involves calling a dandelion a weed. In any event, GE and PIMCO are getting along just fine these days, since they cleaned up their balance sheet, just like you lick your paws all the time. PIMCO owns over $2 billion of their commercial paper now. Which is about the same amount that foreigners invest every day in America, to fund our current account deficit. Mr. Gross spends a lot more time these days worrying about that than he does GE, which is doing just fine.

MLF:   Well, you guys are paid to worry, so I’m glad he’s worrying. Maybe you should worry more, too, Mac;   you can be pretty cavalier in arguing that central banks ‘round the world will keep on funding American hedonism on agreeable terms, when foreign private investors manifestly don’t like the dollar. Didn’t your close buddy Peter Bernstein just write a rather compelling essa y 4   arguing that resolution of America’s twin deficits could end rather badly?

PM:   Yes he did, Morgan. And I take Peter’s concerns very seriously. There is no question that the symbiotic relationship between Americans’ love of consuming and Asians’ love of saving is a tricky one. But for it to break down badly, I think you’d have to have a geopolitical gerbil fall into the soup. Haven’t had a chance for an extended chin wag with Peter about it, but I think the current mutuality of interest between American consumers and Asian savers can last for a long time, similar to the Bretton Woods arrangements.

Remember, Morgan, America was able to easily stack up dollars in foreign hands for a long time before that De Gaulle fellow, a true Frenchman if there was one, called America’s bluff, demanding that we ship all the gold in Fort Knox to Paris. And then we called his bluff and changed the rules, telling him that the dollar was worth the paper it was printed on, and not an ounce more. It still is, and Asian central banks can buy it up by printing their own fiat money, if that is in their own best interest. It is right now, and I think it will continue to be so for a extended period, which is much longer than a considerable period. In the end, Morgan, money in a fiat currency world ain’t nothing but a state of mind.

MLF:   Deep, Mac, very deep. Money is indeed the glue of contracts between the present and the future, notably contracts involving exchanges of goods and services. Money itself is nothing but what sovereigns say it is, and is worthless unless economic agents are willing to use it as a means of exchange. And since the dollar fits that bill, it is “strong,” as Mr. Snow lectures us. Indeed, the dollar is so strong that China links the Renminbi to the dollar, de facto hiring the Fed to run Chinese monetary policy. And since the other countries in Asia don’t want to see their currencies appreciate against the Renminbi, they shadow the dollar, too, de facto importing monetary policy from the Fed.

De facto: a cool word, Mac, which your son Jonnie, the Latin whiz, taught me. Bretton Woods was a de jure monetary arrangement; the current one between America and Asia is a de facto arrangement. But the results are the same:   Americans get to commit the sin of conspicuous consumption and get by with it!

PM:   Don’t get moralistic on me, Morgan!

MLF:   I’m not; just parroting you, Mac. Let’s change the subject:   didn’t you say that some of your colleagues had questions for me? Let me talk to somebody besides your monotone self, would you?

PM:   Fair enough, Morgan. Here’s an email I got for you from my PIMCO partner and good friend Margaret Isberg; guess she didn’t know you have your own email address now.

Miss Morgan,

In your friend Paul’s last Fed Focus, he identified China as the second locomotive of global growth. Help me understand why an economy that is about the size of California can have such a significant impact. Even if domestic Chinese demand is accelerating rapidly, it does so from such a small base that I don’t understand how it can have much of a marginal impact on global growth. Moreover, a huge portion of Chinese demand (for oil and other commodities, for capital goods, even for infrastructure) is still linked to demand from developed economies, the U.S. in particular. Doesn’t a good portion of that export-related demand represent a shift in production from higher cost producers rather than a self-feeding expansion of the global pie? Please help convince me with some numbers.

Proportionally Skeptical
(aka Margaret Isberg)
PS - I hope Santa brings you lots of carrots!

MLF:   Ah, a tough question indeed, Proportionally Skeptical. And regrettably, I can’t prove Mac’s thesis to you empirically, other than to point to the cover graph in last month’s Fed Focus 5, which shows that domestic demand – both consumption and investment – is driving China’s robust growth, not net exports. But I do understand that you are worried that domestic growth in China is just one step removed from domestic growth here in the U.S. of A.It is something to worry about, but there is something going on in China besides the multiplier effect of America profligacy.

China is in the midst of a secular transition from a command economy to a market economy, from a low starting point of consumption and a huge population. Internally-driven growth in China has massive upside. And since it does, it kicks off something called the accelerator principle, which is a secular concept, very different from the cyclical multiplier principle.

Think of it this way:   California is about 15% of the United States, similar in size to China’s GDP. Now imagine there was an unexpected shock to aggregate demand in California, permanently raising its annual growth to 10% (ain’t gonna happen, of course, given that California is a lousy place to do business, but it’s fun to dream). Such a positive shock to California would arithmetically add 1.5 points to American GDP growth. But far more important, such a shock would kick off a nationwide investment boom via the accelerator principle, which links the desired size of the capital stock to expected normalized aggregate demand.

Such is the case with China:   internal demand growth in China is acting as a similar shock, both within China and the world more broadly, notably in the emerging world. Soaring commodity prices have a cyclical multiplier effect on emerging market countries, but they also provide the basis for a boom in investment to find and supply commodities – the accelerator principle. Mac’s friend Marc Fabe r 6  is an expert on this, dear Margaret; might I suggest you get his book?

PM:   Cut the sass, Morgan. Here’s another question for you, from my good buddy Joe McDevitt, who runs PIMCO’s London office.

Lots of talk here about Uncle Alan not moving rates higher until after the November election. Question: Given his tenure, why should he really care? While I understand he’s a Republican, if there’s a case to move rates up earlier than November to preserve his legacy, won’t that take priority over helping Mr. Bush get reelected?

MLF:   You are right, Joe, that Mr. Greenspan has a huge amount of latitude to do whatever he wants to do; if he wants to hike rates in front of the election, he certainly can. Indeed, as you suggest, doing so might be a legacy builder for Uncle Alan, scotching any notion that he’s a flunky of Bush’s. The real issue here is not politics, but macroeconomics: what problem would hiking rates fix? It certainly can’t be an inflation problem, as the Fed wants inflation to move up from the bottom half to the top half of its implicit 1-2% zone for the core PCE deflator. And by the Fed’s own admission, unemployment ain’t likely to be too low for a long, long time.

The strongest case for early tightening is simply that the 1% Fed funds rate is well below “neutral,” fueling excessive speculation in financial assets:   the longer the Fed waits, the more nasty will be the unwind of that speculation. Mr. Greenspan is unlikely to get into bed with this thesis, however, as he abhors the notion of using monetary policy to tinker with asset prices, unless he has a compelling macroeconomic reason for tinkering anyway.

PM:   One more question, Morgan, and then we’ve got to wind up here. This one is from my pal Mark McCray, PIMCO’s Muni Guru:

Morgan, please discuss the risk I call the “reverse Pascal’s wager – that is, the risk that the devil exists. The devil in this case is inflation, which the world has written off as impossible or at worst a rather puny minion of evil no taller than 2-3 feet. We’ve just had the most massive blast of fiscal and monetary stimulus the world has seen in quite some time. Currencies have readjusted a bit too. Sure there is an industrial revolution in China but there are also strong cyclical constraints on their production cycle, like raw materials input, access to transportation for goods produced and importantly, energy to operate factories. Sure some American service jobs are going to India, but unemployment is at just 5.9%, remarkably low compared to the slack in the system coming out of previous recessions, and down from 6.4% just 6 months ago.

Something smells funny about the “job-sucks” argument if unemployment can drop 1/2% in 6 months before an inventory cycle even begins. Anyway Morgan, the arguments against inflation have been well-prepared, wholly swallowed and digested by the market, the press, policy makers and even Sports Illustrated – look at the players coming from Japan! What about the chance, small as it may be, that Bernanke has it wrong, that his output gap analysis has a flaw, that it isn’t predictive. Aren’t the consequences bloody massive, or is it as simple as a few well-timed hikes and problem solved?

MLF:   Long question, Mark. I got a short answer. Yes, the devil of inflation might exist. Both Mac and Mr. Bernanke might well be wrong. In which case, the answer as to what you should do is simple:   for a small portion of your portfolio, buy TIPS, hedged into the Renminbi.

PM:   You, Morgan, are becoming quite the sophisticate. Harry and David’s pears must be brain food for you. I have most enjoyed chin wagging with you, and thank you for your patience in putting up with me at 4 am. I’ll give you the last word, if you promise to give our friends a forecast for the stock market.

MLF:   My pleasure, Mac. Stocks are simple:   they are rich, but will get richer still, until the Fed can credibly threaten to hike short rates; and then they will go down hard, particularly those small cap little buggers. After that, I don’t know.

As you taught me long ago, smart bunnies don’t forecast ‘round two corners. That’s your job. Mine is simply to enjoy life on the Isle of the Pears, where your friend Mr. Keynes runs the central bank.  

Paul McCulley
Managing Director
December 31, 2003


1 “The Morgan Le Fay Plan”, Fed Focus, November 2002.  
2 “Capitalism’s Beast of Burden,” Fed Focus, January 2001.  
3 “Late For The Sky,” Fed Focus, January 2003.  
4 www.peterlbernsteininc.com
5 “Through Holes In The Floor Of Heaven,” Fed Focus, December 2003. 
6 www.gloomboomdoom.com


This article contains the current opinions of the manager and does not represent a recommendation of any particular security, strategy or investment product. Such opinions are subject to change without notice. This article is distributed for educational purposes and should not be considered investment advice.

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