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It is with both joy and trepidation that I take pencil to paper this month. For, you see, next week is Secular Economic Forum week here at PIMCO. Held every May for the last twenty-two years, the Forum is a sacred PIMCO tradition, involving all PIMCO investment professionals. The Forum is the soul of our investment philosophy: a long-term orientation, above and beyond the business cycle, aimed at identifying the powerful, even if glacially-slow, structural changes that will shape the fate of economies and markets.
The Forum is a delicious mental torture chamber, made so by the sheer force of the business cycle that is always in our face. We force ourselves to leave both the business cycle and our egos at the door, and think out loud together for three days, a process turbo-charged with outstanding guest lecturers. This year's Forum is going to be an exciting one, as we continue our examination of recent years into the ways and means, and the imbalances and bubbles, of the secular journey to Global Capitalism.
Our investment professionals are read up and psyched up, and we've got an outstanding line up of guest lecturers. And when Bill Gross and I talk about the agenda, the twinkle in his eyes tells me he's torqued up for his role as Maestro. As always, Bill will be following up with his Investment Outlook about what we thought and why we thought it; and what we plan to do, and equally important, not do, with all that thinking.
On A Price-to-Service (P/S) Basis Valuation Of A Roof Over Your head Is The Cheapest In A Generation
*Total market value of US homes (P) divided by total "shelter services" (explicit and implicit) costs paid by consumers (S) **The average price of an existing home is approximately 25% higher than the median price (between 1989 and 2001). Here we use this relationship to extrapolate backwards an average price series for existing homes (E) ***Total rent (explicit and implicit) paid by consumers divided by teh US housing stock
Standing Invite, Alan Meanwhile, I find myself contemplating what it would be like to have the other Maestro, Alan Greenspan, as one of our guests next week. Can't happen, of course, though I think I can say, without even checking with Bill, that Mr. Greenspan has a standing invite to address our Secular Economic Forum the first May after he leaves office. As a practical matter, however, Mr. Greenspan will be with us in spirit this year, as he has been in recent years, because Mr. Greenspan has strong secular views about Global Capitalism, above and beyond his day-job duties of fine-tuning the business cycle and saving the world when it needs saving. Indeed, Mr. Greenspan is the patron saint of Global Capitalism, even when, perhaps especially when, he is bailing it out of its own excesses.
Not that Mr. Greenspan would admit to being the maven of bailouts, I hasten to add. In fact, and in contrast to his predecessor Paul Volcker, Mr. Greenspan has little taste for micro economic bailouts - particular sectors or Ayn Rand forbid, particular firms. No, Mr. Greenspan is a fan of macro economic bailouts: slicing short-term interest rates, over which he has monopoly control, whenever the gambling instincts - Keynes' "animal spirits" - that are the grease of Global Capitalism fade.
In contrast to Mr. Volcker, who worried about individual gaming tables going bust, bailing them out when necessary (remember Drysdale and the Hunts?), Mr. Greenspan worries about the casino called capitalism going bust, for lack of interest or lack of patrons, or both. At the end of the day, he sees his job as making sure that there is sufficient action somewhere to keep the lights burning in the betting parlor. He's a libertarian capitalist about which games people want to play, but a socialist capitalist in demanding they collectively keep playing. And he's willing to socialize - bailout! - the downside of all that action, when necessary, with what we call 'round here the Greenspan Put: a willingness to slash short rates, transferring income from the risk-adverse to the risk-seeking, when the risk-seeking run out of will or wallet, or both.1
Re-Visiting Irrational Exuberance That's harsh, I know, but Mr. Greenspan's own words underscore his enabling role in bubble formation - as part of capital formation, of course! - in the late-1990s, notably and particularly in the technology-rich (or is that poor?) NASDAQ. Recall, it was on December 5, 1996 that Mr. Greenspan introduced the words "irrational exuberance" to the financial lexicon, declaring:
"Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threatento impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy."Apologists for Mr. Greenspan's subsequent "failure" to address the bubbling in stocks always note that Mr. Greenspan never declared stocks to be "irrationally exuberant" in the December 5, 1996 speech, but that he merely mused out loud as to how he would know if they were. With the release earlier this year of the transcripts of the September 24, 1996 FOMC meeting, that apologist dog no longer hunts. Some ten weeks before uttering "irrational exuberance," and with the Dow at 5,874 and the NASDAQ at 1,215, Mr. Greenspan declared to his colleagues: "I recognize that there is a stock market bubble problem at this point, and I agree with Governor Lindsey that this is a problem we should keep an eye on. We have very great difficulty in monetary policy when we confront stock market bubbles. That is because, to the extent that we are successful in keeping product price inflation down, history tells us that price-earnings ratios under those conditions go through the roof. What is really needed to keep stock market bubbles from occurring is a lot of product price inflation, which historically has tended to undercut stock markets almost everywhere. There is a clear tradeoff. Now, unless we have the capability of playing in between and managing to know exactly when to push a little here and to pull a little there, it is not obvious to me that there is a simple set of monetary policy solutions that deflate the bubble. We have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it. My concern is that I am not sure what else it will do. But there are other ways that one can contemplate."
"I recognize that there is a stock market bubble problem at this point, and I agree with Governor Lindsey that this is a problem we should keep an eye on. We have very great difficulty in monetary policy when we confront stock market bubbles. That is because, to the extent that we are successful in keeping product price inflation down, history tells us that price-earnings ratios under those conditions go through the roof. What is really needed to keep stock market bubbles from occurring is a lot of product price inflation, which historically has tended to undercut stock markets almost everywhere. There is a clear tradeoff. Now, unless we have the capability of playing in between and managing to know exactly when to push a little here and to pull a little there, it is not obvious to me that there is a simple set of monetary policy solutions that deflate the bubble. We have the possibility of raising major concerns by increasing margin requirements. I guarantee that if you want to get rid of the bubble, whatever it is, that will do it. My concern is that I am not sure what else it will do. But there are other ways that one can contemplate."
The simple facts are: (1) Greenspan had, in fact, already identified a bubble in stocks, and his musings ten weeks later were not a rhetorical question in search of an answer, but an answer veiled in a rhetorical question; and (2) Greenspan did indeed identify a hike in margin requirements - a micro regulatory tool - as guaranteed to work to "get rid of the bubble," but declined to pursue it, for fear that it would work too well. Those are the facts.
Yet, over three years later on Feb 17, 2000, with the Dow at 10,514 and the NASDAQ at 4,549, in open forum before the House Banking Committee, Mr. Greenspan declared:
"The problem that I have had with the issue of moving on margins is not concern of what it would do to the marketplace, it's the evidence which suggests that it has very little impact on the price structure of the market, or anything else. It has one characteristic, however. It basically has its impact, its incidence on smaller investors, because they have no alternative means of financing. Larger investors have all forms of financing, and margin is a small part of their financing. It is true that there probably are some professional investors who are using margin debt for purposes of various different types of hedging or what-have-you. My impression is that it's probably very small and not an issue that one should be concerned about."
Funny how the margin-requirement tool morphed from a "guaranteed" way to get rid of the bubble in September 1996 to a tool of no importance in February 2000, except perhaps to discriminate against small punters. The truth of the matter is that margin debt did, in fact, emerge in 1999 as helium in the NASDAQ bubble, as vividly displayed in Figure 2 below. And it was not just small punters breathing the stuff, but men like Bernie Ebbers, a leading architect of the bubbles in investment and leverage in the telecom sector that bedevil the economy today. Those are the facts.
Anybody Besides Me See Double Bubbles?
Housing Next? "Doesn't matter," I hear some of you retorting. "He didn't hike margin requirements, but he did hike rates in 1999-2000, and deflated the NASDAQ bubble. He did what needed to be done, even if he had to do a little white lying to get it done." At some philosophical level, I agree with that proposition, but at the practical level, I don't. I firmly believe that it makes no sense for the Fed to eschew using the micro regulatory tool when the consequence of doing so is to (1) transfer capitalism's inherent bubble proclivities from sector to sector, while (2) generating unnecessary volatility in the Fed's macro interest rate tool.
Which brings us to the matter of the potential for a bubble in the US residential property market, in lagged response to the Fed's massive easing in the wake of the bursting of the NASDAQ bubble. I weighed in on this subject last summer, applauding the Fed for its on-going aggressive easing, opining that "there is room for the Fed to create a bubble in housing prices, if necessary, to sustain American hedonism."2
Our analysis, displayed once again in Figure 1 on the cover page, shows that the national housing market - but not necessarily your house, dear reader! - is secularly cheap relative to the service (dividend, if you will) that it provides: a roof over your head. And, unlike the case with stocks, you are born short a roof over your head; you gotta either buy or rent a roof, while you can live a quite happy life never, ever owning a stock.
Thus, if capitalism in America depends upon always having a game in the casino that can be levered for capital gains that can be spent, then capitalism in America is just fine: housing is the game and Mr. Greenspan is both the croupier and the credit clerk. Mr. Greenspan would, no doubt, disagree with that phraseology, but he actually agrees with our analysis. Indeed, he actually weighed in two weeks ago to declare that the American residential housing market is not a bubble. Given that he had resolutely refused to publicly indict or exonerate the NASDAQ for bubble tendencies, I must admit I was surprised that he was willing to pre-emptively exonerate residential housing for such proclivities. Here's what he said, on April 17, 2002:
"The ongoing strength in the housing market has raised concerns about the possible emergence of a bubble in home prices. However, the analogy often made to the building and bursting of a stock price bubble is imperfect. First, unlike in the stock market, sales in the real estate market incur substantial transactions costs and, when most homes are sold, the seller must physically move out. Doing so often entails significant financial and emotional costs and is an obvious impediment to stimulating a bubble through speculative trading in homes. Thus, while stock market turnover is more than 100 percent annually, the turnover of home ownership is less than 10 percent annually-scarcely tinder for speculative conflagration. Second, arbitrage opportunities are much more limited in housing markets than in securities markets. A home in Portland, Oregon is not a close substitute for a home in Portland, Maine, and the 'national' housing market is better understood as a collection of small, local housing markets. Even if a bubble were to develop in a local market, it would not necessarily have implications for the nation as a whole.
These factors certainly do not mean that bubbles cannot develop in house markets and that home prices cannot decline. Indeed, home prices fell significantly in several parts of the country in the early 1990s. But because the turnover of homes is so much smaller than that of stocks and because the underlying demand for living space tends to be revised very gradually, the speed and magnitude of price rises and declines often observed in markets for securities are more difficult to create in markets for homes."
By exonerating housing from charges of bubble infractions, Mr. Greenspan revealed the fundamental (Keynesian!) policy bet that he has made: during the rehabilitation of Corporate America from its sins of excess in investment and leverage, the American household will be encouraged to bid up houses, lever up houses, and to spend the capital gains winnings. Which, of course, begs the secular question of how Greenspan, or his successor, will end the housing game: with a micro regulatory tool, or the macro interest rate tool?
Temper Me Up I eagerly anticipate next week's Secular Economic Forum , a chance for me to shut up and learn, since I rarely say anything I don't already know (or don't know, some might say!). Our secular theme of recent years has been spot on, as our British colleagues might say: global capitalism may be a great destination, but the journey there will be marked by booms and busts, as capitalism is inherently given to excesses of both irrational exuberance and irrational doom. Human nature is as human nature does. Along the way, the Fed's job is to temper the excesses, with a tempered amount of macro moral hazard. Next week, we will explore how much the excesses of the late 1990's have been tempered, and at how much cost in terms of increased macro moral hazard.
Gonna have fun at Hotel PIMCO, as we seek to find the passage back to the place we were before.
Paul A. McCulley Managing Director May 2, 2002 email@example.com
1 See "In The Fullness of Time," Fed Focus, January 3, 2000. 2 See "Show A Little Passion, Baby," Fed Focus, June 25, 2001.
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