I have always been intrigued by paradoxes. My intrigue was probably birthed in my childhood, when I was, as the son of a fundamentalist Baptist minister, constantly exposed to doctrinal debates between Calvinists and Arminians (not to be confused with Armenians, my dear friend Mohamed El-Erian stresses!). It always befuddled me that the fundamentalist umbrella was large enough for both those who believe in absolute predestination (Calvinists) and those who believe in the possibility of salvation for all (Arminians). Do Man and Woman have free will, or not?

I found this debate paradoxical, because I never could figure out the fundamentalist common ground between those who believed in salvation through God’s inexplicable grace, and those who believed in salvation through Man and Woman’s explicit willingness to accept God’s invitation. To me, the difference between the two propositions was so profound that there could be no common ground. But I observed the ground being plowed, re-plowed, and then plowed again. There was common ground, I could see, even if I couldn’t see it.

It intrigued me then, and it intrigues me now, even though my adult spirituality is of a different nature, framed in personal terms, rather than doctrinal debates. But paradoxically, the older I get, the more respect I have for those who find spiritual succor in the debates of my childhood. Not that I have any personal desire to engage in their debate. I religiously don’t. But if it works for them, it works for them. I’ve become, I suppose, ecumenically secular in my thinking; or maybe that’s secularly ecumenical. Or maybe I’m just growing old.

But I still enjoy a good paradox and a good debate about how to resolve it. My day job fortunately provides more than enough opportunities for such enjoyment. I actually get paid to watch the never-ending dance amongst:

• Economic fundamentals, which are continually evolving, both structurally and cyclically;
• Economic policy, both in reaction to and anticipation of those evolving economic fundamentals; and
• The markets’ discounting of those evolving fundamentals and policies.

This dance is the essence of capitalism, and it is riddled with paradoxes. Understanding and forecasting this dance is the essence of active portfolio management, both top-down and bottom-up. Which is why you, dear clients, pay PIMCO, which pays me. I love my job.

When Stuff Hits The Oscillator, Greenspan Unplugs It

Figure 1

Source: Federal Reserve, Standard & Poors

Indeed, capitalism and active portfolio management are inherently fellow travelers. While the individual investor can certainly index to the markets, capitalist markets themselves could not exist without active portfolio management. The existence of markets requires diversity of opinions — about value, about risk, about time preference – and motives. Or, as Adam Smith wrote in 1776:

Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”

Active portfolio management is the grease on Mr. Smith’s invisible hand. Active investors willing to take risk versus the market make it possible for passive investors to take the risk of the market. I say this without any ill will at all towards either index investors or index investment managers. Indeed, I am personally an index investor in some asset classes, and I’m very happy to pay the low fees charged. As a macro matter, however, active management is the foundation of capitalistic markets, which makes passive management possible.

Self-serving thing for a PIMCO man to say, I grant. But that doesn’t make it any less true. Which brings me to what I really want to talk about this month: the paradox of mark-to-market capitalism. Never heard of it? Perhaps not with that label, but you’ve certainly heard of it, and live it everyday. The paradox is really quite simple.

The Illusion of Liquidity for All
Organized securities markets make financial investments that are fixed for the community liquid for the individual. Such markets thereby beget the illusion of liquidity for all, or the illusion that mark-to-market prices are realizable for all. They patently cannot be, of course, as the very act of marking prices to the market presumes that there is a two-way market. The illusion that all can realize mark-to-market prices does, however, incite a higher collective willingness to take risk than would be the case in a world of un-securitized private claims.

This is good, implying a faster secular growth path for entrepreneurship, innovation, investment and productivity. The elevated risk appetite fostered by the illusion of mark-to-market liquidity for all is, however, also a prescription for cyclical boom and bust in real investment in productive assets. Thus, the paradox:

The very system that best fosters long-term prosperity also is the same system that is most likely to make pursuit of that prosperity a manic-depressive journey.

Keynes wrote eloquently about this boom-bust pathology, beget by the parallel existence of (1) the illusion of liquidity for all in organized securities markets, and (2) the inherent illiquidity of fixed, real investment. Keynes was tempted to recommend a policy solution, yet stopped short, because even his great mind could not resolve the paradox. Specifically, he said:

The spectacle of modern investment markets has sometimes moved me toward the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. But a little consideration of this expedient brings us up against dilemma, and shows us how the liquidity of investment markets often facilitates, though it sometimes impedes, the course of new investment. For the fact that each individual investor flatters himself that his commitment is ‘liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk.

If individual purchases of investment were rendered illiquid, this might seriously impede new investment, so long as alternative ways in which to hold his savings are available to the individual. This is the dilemma. So long as it is open to the individual to employ his wealth in hoarding or lending money, the alternative of purchasing an actual capital asset cannot be rendered sufficiently attractive (especially to the man who does not manage the capital assets and knows very little about them) except by organizing markets wherein these assets can be easily realized for money.”

This cogent reasoning was the basis for Keynes’ conclusion that capitalism is not inherently self-stabilizing. But that did not make Keynes a closet socialist or a flaming liberal, as the Wall Street Journal’s Editorial Page regularly preaches. Rather, Keynes rationally deduced that capitalism is inherently prone to booms and busts. Keynes believed in capitalism, and was a practicing capitalist (speculator!) himself.

Keynes did not intellectually reject Adam Smith’s invisible hand. Rather, Keynes rejected the notion that the invisible hand would ineluctably act in a self-correcting way to foster full employment. He also rejected the notion that monetary policy was adequate to the task of dampening capitalism’s boom-bust pathology, for the simple reason that swings in private sector risk appetites (animal spirits!) can overwhelm policy-induced swings in interest rates.

Thus, Keynes became the intellectual father of activist, counter-cyclical fiscal policy, so as to directly counter pathological deviations in aggregate demand. When Keynes published the General Theory in 1936, of course, the problem was a deficiency of aggregate demand, so he favored government investment funded with borrowed money. Contrary to popular lore, however, Keynes was not a one-armed fiscal activist; later in his life, in the boom after WW II, Keynes actually advocated fiscal tightening to dampen the boom. And he was criticized for such advocacy, which led him to famously declare to his critics that they were “more Keynesian than me.” Love that line! But enough about Keynes for now. His legacy is simple: he celebrated capitalism, while legitimizing governmental stabilization policies. He founded macroeconomics.

Ever since, the business of government has been about nurturing capitalism’s wonderful exuberance, while tempering its pathological extremes. Which brings us to the paradox of capitalism in a democracy:

Capitalism works on the principle of one dollar (monetary unit), one vote, while democracy works on the principle of one person, one vote. Thus, capitalism and democracy are inherently in paradoxical conflict. Capitalism celebrates the power of money, but needs government to temper its boom-bust pathologies. In contrast, democracy celebrates the power of the individual, but needs capitalism to temper its populist, redistributative proclivities.

Thus, the coexistence of capitalism and democracy really is a paradox wrapped in an enigma, to borrow from Churchill. And it is also the worst possible system, except for all others, again borrowing from Churchill. Organized investment markets with active investment managers provide the illusion of liquidity for all, fostering long-term capitalist investment, but also begetting boom-bust pathologies. Government grounded in the legitimacy of democracy has both the duty and the ability to temper capitalism’s pathologies.

From Theory To Practice
For good or for bad, the current economic environment provides a wonderful template for seeing these paradoxes in action. Faith in the power of capitalism has been in secular ascendancy for over twenty years, on a journey to a putative New Economy, with government power in a parallel secular bear market. Indeed, faith in capitalism morphed into a cult in the second half of the 1990s, as evidenced by soaring P/E multiples for stocks, reflecting both expectations of rising secular corporate profitability and expectations of falling cyclical volatility. To me, it was always irrational to expect both of these things simultaneously: by definition, more capitalism should bring more, not less, cyclical volatility. To wit, capitalism is inherently prone to cyclical boom and bust; to conclude otherwise is manifestly a case of irrational exuberance. But what the hey, a good party is a good party, and human nature is very good at presuming away hangovers.

Particularly when the heavy-pouring New Economy bartender was none other than Alan Greenspan, the last bastion of concentrated governmental power in our turbo-charged capitalistic economy. Let there be no mistake: Mr. Greenspan was the ironic enabler for irrational exuberance, correctly identifying the disease, which is endemic to capitalism, but then refusing to diagnose the US economy as suffering from the disease. He simply promised that if evident exuberance did turn out to be irrational exuberance, he would, unlike his Japanese brethren a decade ago, administer a massive dose of monetary ease.

And so it came to pass, as the millennium turned, boom begat bust, as is the wont of capitalism. Nothing intrinsically wrong with that. Booms are the medium of progress in a capitalistic society, and are welcomed. If capitalism had no booms, it really wouldn’t be worth the effort. But since capitalism also has busts, which are not self-correcting, it is necessary for government to underwrite at least some of the downside risk, so as to under gird continuing popular support for capitalism.

Put more bluntly, successful capitalism in a democracy is about privatizing much of the upside of booms and socializing the downside of busts. Yes, I know that sounds terrible, and it is politically incorrect to offer such a view. But that doesn’t make it any less true: capital markets-driven capitalism in a democracy runs on moral hazard. The only issue for debate is choosing the “right” octane of moral hazard to put into the tank.

Living on Hope and the Greenspan Put
Over the last year, Mr. Greenspan has practiced Jerry Garcia’s dictum that too much of everything is not enough: slash short rates until stocks go up. He’d deny that, of course, arguing that his Herculean 475 basis points of easing — a 73% cut from a 6 1/2% Fed funds starting point – was not about stoking stocks, but stoking the economy. He’d concede, perhaps, that he was trying to boost investors’ risk appetites – Keynes’ animal spirits! – as a means to stoking the economy. But he’d demur that he has been underwriting the downside for stocks. To wit, he’d deny that he has been putting a Greenspan Put beneath the equity market.

And his denial would indeed have the ring of “plausible deniability,” a favorite term of the Richard Nixon White House, Greenspan’s original political patron. But as a substantive matter, Greenspan has indeed been socializing the downside risk of the stock market, encouraging risk seekers to privatize the upside potential of stocks. Nothing wrong with this, I stress, at least in my opinion (though perhaps not in the opinion of some of my PIMCO colleagues!).

And who is paying the premium for the Greenspan Put? Holders of cash and near-cash: investors in money market funds, short-term bond funds, bank CDs, et al. Cash has indeed been turned into trash as an investment, with real short-term interest rates at zero. Cash has been returned to its original purpose as a store of wealth, not a generator of wealth. Since cash carries no price risk at all (the one unforgivable sin for a money market fund manager is to “break the buck”), logic implies that cash should not generate a real rate of return, but rather pay an interest rate that preserves cash’s real purchasing power (similar to the case under the Bretton Woods framework, when $35 of cash bought one ounce of gold, which does not pay interest).

The Greenspan Put beneath stocks is, in the end, “funded” by holders of cash. And to me, that is the way it should be.

Capitalism is about individuals taking self-interested investment decisions that, as if by an invisible hand, benefit society. Capitalism is also inherently given to boom and bust, as the illusion of liquidity created by organized securities markets generates waves of irrational exuberance followed by waves of irrational pessimism. The democratic process (Congressional law!) grants the Fed monopoly control over cash creation. Thus, it is entirely legitimate for the Fed to redistribute income between the lenders and borrowers of cash, when Adam Smith’s invisible hand generates capricious outcomes for society as a whole.

A New Ticket to Ride
In my youth, I struggled as to how Calvinists and Arminians could find common ground, ‘cause I couldn’t figure out how the doctrine of predestination fit with the doctrine of free will. Never could figure it out, but learned to accept that there was a fit, ‘cause I could witness them worshipping together. As my hair turns gray, I similarly struggle to figure out how the doctrines of capitalism fit with the doctrines of democracy. Present economic conditions of Post Bubble Disorder provide a wonderful laboratory for study.

The bottom line: the Greenspan Put is in play. And it should be, as the Fed, a legitimate creation of democracy, seeks to re-incite the private sector exuberance for risk that is the necessary fuel of capitalism. The secular ascendancy over the last two decades of the power of capitalism over the power of democracy is cresting. A new secular journey to find a more perfect union between these inherently contradictory powers lies on the horizon.

Can’t wait for PIMCO’s Secular Economic Forum in May; Bill Gross presiding.

Paul A. McCulley
Managing Director
January 28, 2002