It seems the world has gone mad, Paul. And the markets with it.

We’ve been watching it go crazy for a number of weeks. The marketplace has really been discounting a bipolar world, which fortunately is not something we deal with all the time. You normally have a range of uncertainty around some type of mean, but lately the marketplace has been a red/green switch. It’s either “the world as we know it works,” or “the world as we know it doesn’t work."

"Bipolar" or "schizophrenic" are exactly the way to describe this.
Yes. It’s very difficult to have a table-pounding viewpoint about day-to-day events. I have table-pounding views about bigger picture sort of stuff, but day-to-day in this market it’s very difficult to know how far extreme the extreme really is.

It shifts faster than the sands in the Iraqi desert, I guess.
Yes, that’s a fair way of putting it. It’s something that we haven’thad to grapple with in our adult lifetimes. The whole doctrine ofpre-emptive war is brand new. This is a pre-emptive war againsta bad dude and a bad regime. Obviously the short-term outcomeis fraught with uncertainty in terms of whether he does or doesn't use weapons of mass destruction; whether or if he blows up oil wells and stuff. So there’s all of that nano or micro uncertainty.

But the bigger, macro uncertainty is what does the world order look like, post-America declaring and then executing the doctrine of pre-emptive war? Particularly since America has done so in more of a unilateral fashion than it looked like it would, even a few weeks ago.

All of this is brand new territory for policymakers and for the marketplace.

Listening In

Paul McCulley is “that other fellow” at PIMCO. Writes its monthly “Fed Focus” commentary, manages billions of short-term funds, keeps a sharp eye on the economy. Also talks, in the wee hours, to his family's pet rabbit, Morgan le Fay. Then he has the temerity to write
about it. Extremely well. Lately he’s had it with the Fed Head, and has been arguing forcefully that brave new policies—and portfolio management strategies—are necessary to cope with this Brave New World. Makes a lot of sense.
- Kathryn M. Welling
Formerly Senior Editor at Barron’s and now founder and proprietor at welling@weeden, a research service of Weeden & Co. LP.

Fortunately, we don’t have a lot of historical data points to draw upon. Whether or not there will be unintended consequences that come back to haunt us, we simply do not know. This also raises questions about the whole issue of, “Has the path to global capitalism, which seemed to be what everyone was in love with for the last two decades, fundamentally come to an end? Are we in a new world in which the power of America’s fist dominates the power of the invisible hand?” That’s a profound question.

Can’t imagine why you’d say that! But why delve into the broad philosophical issues?
When you’re at secular turning points you’re, by definition, dealing with broad philosophical issues.

That’s precisely what this is, according to the pieces you’ve been writing for PIMCO for a while now.
Yes, exactly. On the domestic front, I’ve focused intensely on the inherently tense relationship between democracy and capitalism in a mixed economy, where democracy runs on the principle of one person, one vote and capitalism runs on the principle of one dollar, one vote. How do you get a happy combination of those two? It was made happy during the 1980s and ’90s—particularly through the ’90s—as capitalism effectively triumphed and you had a bear market, if you will, in the power of the government; a bull market in the invisible hand. But then, the invisible hand overshot into a bubble and blew up. And that happened in the context of having reached secular price stability, which brought out the beast of burden called deflation risk. Which, by definition, requires a reversal in the balance of power—shifting power back in the direction of the government. The thing is, all of that was happening independent of geopolitical issues. Now, of course, we have all of the geopolitical issues on top of the redistribution of power. It brings home the reality that there are a number of things that capitalism really can’t do very well. The top two on that list, I think, are dealing with deflation risk and providing national security. The upshot is that we’ve had a profound one-two punch for a bull market in government.

“A bull market in government” is profoundly not music to Wall Street’s ears, philosophically speaking.
No, it’s not. A bull market in capitalism was good for a tripling of the P/E multiple during the 1980s and ’90s—the tripling of the P/E ratio was what the whole bull market in stocks was about. It certainly wasn’t about real earnings growth, merely a revaluation of earnings. A bull market in capitalism is inherently anti-inflation. As the government retreats and you move towards more of a capitalist structure, you get secular disinflation in celebration of capitalism, which gives you a bull market in bonds. And that, in turn, provides the scope for a bull market in P/E multiples. Which at the end of the 1990s morphed into a bubble in stocks.

And now it has popped. What does this new bull market in government imply for the markets?
Well, if you start with the premise that capitalism is in retreat and that we have started a new bull market in government in which markets don’t necessarily dominate, but sovereign nations enforce their wills, that doesn’t at first wash tell you that P/E multiples on stocks are likely to go up.

Quite the contrary.
But it does tell you that the equity risk premium is too damn skinny. That is the bottom line. That doesn’t mean that the stock market has to go down. What it tells you is that the starting point valuation is a residual of a bull market in capitalism—and is not necessarily what you would ideally sketch out at the beginning point for a bull market in government.

If there’s a bull market in government, it’s inherently going to be more inflationary. In fact, part of the anti-deflation effort is to reflate. A bull market in government that reflates the economy and a bull market in government that is biased towards explicit national security concerns—including the doctrine of pre-emptive war—is an environment in which you are supposed to get paid a meaningful risk premium for owning, if you will, a call option on capitalism.

A call on capitalism?
That’s how I look at stocks. They are call options on capitalism. But the call has gone somewhat out of the money.

Actually, it’s been bouncing in and out of the money like a ball of Silly Putty.
Well, day-to-day—or minute-to-minute.

What do you bond guys at PIMCO know about stocks, anyway?
Bond guys understand corporate finance.

Great comeback!
We know how to read a balance sheet.

You mean an income statement doesn’t tell all?
Exactly. What’s more, when we lend somebody money, we expect to get it back.

How positively quaint. Yet at the moment you seem to be saying—with great equanimity—that you’ll be getting it back in inflated dollars. And that’s just not normal for a bond guy.
Well, a bond guy would rather get paid back in devalued dollars than not be paid back at all. When you are on the cusp of deflation, you basically have two choices: You can allow the borrower to default on you, in which case you effectively get nothing. Or you can reflate the economy and play the old money illusion game. In which case, you will get paid back your nominal dollars. They’ll just be worth less in real terms. There’s simply no question, post the bubble we had—really, a triple bubble, in equity valuation, business investment and corporate leverage—that there will be losses. The issue is, how do you split them between default losses and purchasing power losses as a result of reflation?

Doesn’t your preference there depend on whether a borrower or a lender you be?
Sure. But I think, from the standpoint of capitalism as a going concern, it is a whole lot better for us to think in terms of being paid back in less purchasing power than it would be to be defaulted upon. So it’s not totally inconsistent for a bond guy to say a kind word about inflation.

Analyze This, Mr. Greenspan: Who Makes More Sense To Lever?


Just don’t let any real bond vigilantes hear you talking that way.
As I have written many, many times, deflation is the beast of burden that capitalism can’t bear alone—because capitalism doesn’t own a printing press. But yes, the Austrians certainly would say that we never should have gotten into this situation in the first place.

Doesn’t that conservative economic theology also preach that since we did, we should take a cold reality shower, to clean out the system? In other words, that we should simply let over-leveraged companies and other organizations fail. Let the folks who were dumb enough to lend to them take their licks?
I think that’s appropriate from a micro perspective; from an individual company perspective. But from a macro perspective, it is precisely what Mr. [Andrew] Mellon recommended in 1931.

Yes. Remember his famous liquidate speech? “Liquidate labor, liquidate capital, liquidate, liquidate. Assets will shift to more moral hands and we will live a more moral life.”

“We, the few, the chosen, the exceedingly rich,” he forgot to add.
This brings me to the whole paradox of aggregation: A trip to the Betty Ford Center for Balance Sheet Repair can make sense from a bottom-up perspective. But it’s just not good if you have the entirety of corporate America at the Betty Ford Center for Balance Sheet Repair. And that’s what we have in the economy right now, as we look at it, because you are not being allowed to “party” out there—and I’m assuming you understand “party” in this instance, means to make business investments.

Somebody has to spend to keep the ball rolling.
Everyone wonders why businesses are not investing. Well, for God’s sake, they had a bubble in investment and financed it with a bubble in debt—and they blew up. You’ve got capacity utilization way down here because there is excess capacity out the wazoo; no one’s got any pricing power and return on invested capital sucks canal water. Why would any logical person in this environment go into the boss and say, “Let’s ramp up the capital budget?”

There are practicing economists who insist yours is entirely too dark a vision. Who point to rising industrial production statistics and such—
That’s true. In this game, as you know, there is an element of truth to almost every argument. I don’t believe the economy is going to have a 1930s-style depression. We’re not that collectively stupid as a nation.

See, you are an optimist at heart.
Yes, I am, I think. We are seeing a healing process going on. And we will see some degree of investment unfold. A lot of the excesses were concentrated in particular sectors. The new age economy got excess capital. Some of the old age economy didn’t get enough. You can see that in the energy sector. The new age component of the energy sector got a lot of investment—all of the energy trading schemes. But the basic business of finding natural gas—putting a hole in the ground and getting it out — those sorts of businesses didn’t get enough investment. So to the extent that we can rotate available investment dollars in the economy away from the drunken and to those who are thirsty, that is a very good thing. We will see some investment.

Another delightful thing that I am watching these days is the recovery in commodities prices and the nice things that does for emerging markets. Part of the long secular war against inflation was, effectively, deflation in commodities prices, and that had, obviously, a disproportionately negative effect on emerging markets. So what is going on is a little bit of ex-post settling up, if you will, as commodities prices are lifting from incredibly low levels. But I don’t look at that as an inflationary problem. In part, because we’re still getting deflation in the new age stuff. The bone of contention I have with the consensus and particularly with Mr. Greenspan these days is the thesis that geopolitical risk is the only thing holding this economy back from a glorious, cap-ex-driven recovery.

The “fog of war” isn’t our only problem?
That is just wrong. To think that corporations all of a sudden are going to re-lever their balance sheets to do a pot load of investing is wrong. We focus, along with a lot of other people, on the financing gap.

Which is?
The question is how big a net user of funds is the corporate sector? Obviously, corporations became a huge net user of funds during the 1990s, levering the daylights out of their balance sheets. Meanwhile, Uncle Sam did the opposite—ultimately running a surplus and being a net saver.

All too briefly by many folks’ lights—
But the stimulus has to come from somewhere. And now the corporate sector at large doesn’t merely want to reduce its net borrowings but actually in many cases wants to become a net saver. In the language of corporate finance that is becoming cash flow positive. Again, from a micro perspective, that is good for an individual company. But if everybody wants to become cash flow positive at the same time, you get the corporate version of the paradox of thrift. Remember, one man’s spending is another man’s income. The risk is that we get into a Keynesian-Minsky-type of debt deflation loop if everyone tries to get cash flow positive at the same time. If you have one sector delevering, you need to have some other sector re-levering in order to maintain aggregate demand.

The federal government is obviously your candidate.
Sure, it was effectively in its own Betty Ford Center for most of the 1990s—and now has a de-levered balance sheet. I focus so much these days on fiscal versus monetary policy because the thrust of monetary policy is to get the private sector to lever. Which, as we’ve been saying, the corporate sector doesn’t want to do right now. Therefore, the household sector is doing it on the back of the property market. In other words, monetary policy is “working” by levering up the household sector.

Not the best idea, you imply?
Well, every other week Mr. Greenspan has to come out and say that there is not a bubble in housing. Yet clearly, if you look at debt charts in the household sector, there is some serious levering going on even as the de-levering is unfolding in the corporate sector. It seems to my simple Keynesian mind that instead we ought to re-lever the balance sheet of the sector with the printing press. Call me madcap, but it seems pretty obvious.

Yet one of the big reasons that the government could delever during the 1990s has already evaporated—the huge capital gains tax receipts generated by the stock market bubble.
Absolutely. One of the biggest beneficiaries of the bubble was Uncle Sam himself.

While companies, perversely, didn’t take advantage of the bubble—and the longest economic expansion on record—to raise equity, on balance. Leaving their balance sheets more levered than ever—
Yes. Which is a proof positive that you had a bubble.

Even if the Fed Chairman couldn’t see it.
He is willing to admit it now. I think he has actually uttered the words in the past tense—

But he still insists he couldn’t possibly have recognized it at the time.
Yes. He hasn’t relented on that one iota. He gave his magnus opus at Jackson Hole last August, when he basically said that a bubble was the inevitable consequence of secular success in fighting inflation—because lower inflation lifted valuations. And lower inflation also increased expectations of the longevity of the economic expansion. But the bubble was just an externality, he argued, of that which he had done beautifully well—which was to conduct a winning war against inflation. Essentially, he said, “I couldn’t do a damn thing about it.”

Which is baloney.
Well, you know how I feel about the whole thing. I mean, if you accept the logic of the thesis that a victory over inflation will create irrational exuberance in capital asset prices, which is a reasonable thesis to start with—and if you are a central banker who is charged with stabilization policies, broadly speaking—then it seems to me it’s incumbent upon you to be on the lookout for bubbles as you whip inflation. And, to say, when you look out the window and see signs, “By God, I think
I might see one.”

Well, it was either that or there was a Lawrence Welk convention next door—
“Tiny bubbles!” Anyhow, when you see them, then you have to decide what tool you want to use. Greenspan, back last August at Jackson Hole said, “Even if we had declared it was a bubble, we couldn’t have rationalized hiking interest rates enough to pop it, because doing so would have thrown the economy into a recession.”

A central banker actually pleading impotence!
My rejoinder would have been, “Sir, do you have only one tool?” To which his rejoinder would have been, “Don’t talk to me about the margin tool because I didn’t want to use it and I didn’t think it was going to work.”

Whatever the practical limits of that move would have been, the psychological/public relations impact would have been tremendous.
Yes, exactly. The announcement effect would have been immense because actually hiking margin requirements would have been tantamount to Mr. Greenspan saying, “It’s a bubble.” That would have been absolutely profound, independent of the mechanics of enforcing margin calls on those who were leveraged. The problem was that he knew that.

Was that it?
Yes. In fact, if you go back to 1996, in the transcripts of that September’s FOMC meeting (the famous one that a number of people have written about because Greenspan had a conversation during that meeting with Larry Lindsay about the whole thing), Greenspan said that the one thing that would be guaranteed to work was a hike in margin requirements. Then he went on to say, “but I’m not sure what else it would do.” It’s bizarre that in 1996 he said privately, but categorically, that raising margin requirements would be the one thing “guaranteed” to pop a bubble. Then, just a few years later, he publicly insisted that it was a damp squib. It’s either a live firecracker or it ain’t, sir. As I wrote at the time and testified before Congress in the early part of 2000, he simply did not want to be named the father of a bear market.

Easy Money Makes Room For Debt, Particularly For Uncle Sam


Your regard for the Chairman is touchingly obvious.
Well, to give Greenspan his due, he was the general who presided over the ultimate victory over inflation. As I wrote not too long ago, history will treat him very well for winning that war. His rationale for not seeing the bubble or doing anything about it was, “It wasn’t my job.” If we want to follow that logic, we’ll say, “OK, sir, we won’t blame you for that. You had a marvelous victory over inflation.” But that would be the end of the Greenspan story.

Aren’t you being mighty generous, considering that Paul Volcker was the strategic genius who devised and started the war on inflation that Greenspan carried on?
Absolutely. Volcker actually did the hard stuff. By contrast, Mr. Greenspan’s mandate was to nurture Volcker’s successes. Then he adopted for himself in the second half of the 1990s the roles of chief cheerleader and chief bartender for the new age economy. I mean, he volunteered, talking about how we were experiencing a once or twice in a century synergistic combination of technologies that was going to do all sorts of wonderful things. To me that’s bubble promotion. I really wish that Greenspan hadn’t given me so many grounds on which to be critical of him. But when I look at the evidence, Greenspan’s culpability is pretty clear and so is the fact that hubris is still in a bull market in his office.

You’d like to see him declare victory in Volcker’s war and move on?
Absolutely. Declaring victory in the war against inflation, to me anyway, means that the central bank loses its right to dictate to other policymakers. Now that the war on inflation has been won, there’s no reason for the monetary authority to dominate the fiscal authority. Plus, if we now instead face deflationary risk then I believe strongly that the fiscal authority should dominate the monetary authority. If you face deflationary risk as a result of excess bubble-like leverage in the private sector, then the path out of that mess by definition is re-levering the sovereign’s balance sheet. That’s a fiscal policy function and it is quintessentially part of the democratic process.

Okay, there’s no doubt we finally whipped inflation, Paul. But didn’t that have at least as much to do with the opening of China and the huge disinflationary impulse it created as with anything done here on the policy front? And China doesn’t play by capitalism’s rules. Which may be another reason the hand of government is strengthening—
China is a very interesting part of the story. I mean, when I look at Volcker’s war against inflation, one of his military units, if you will, was capitalism itself, the bringing down of trade barriers, the opening of capital accounts in most of the world, and the spread of capitalism in markets. Because markets are inherently disinflationary relative to fiat-controlled, planned economies. So he was aided by the global shift towards more reliance on the invisible hand of markets and deregulation. That was part of the story through the 1980s and 1990s. Obviously, China decided to become part of that.

The interesting thing about China from my perspective is that they didn’t go nearly as far down the line of being capitalist as a lot of the other emerging markets did. To this day, they don’t have an open capital account and a fully convertible currency. They have a pegged currency, so they did not fully expose themselves to the capricious invisible hand of the marketplace. Yet at the same time, they’ve become a huge player—and a source of deflation. Which ultimately gets back into the political arena, as you’re seeing now, in cries that China needs to up-value its currency to relieve the deflationary pressures from the supply side and also, to act as a positive terms of trade shock to their consumers, who’d have more global purchasing power—making China less a factor of supply and more a factor of demand on the global stage.

Back to these shores, you’re saying we’re at a crossroads?
The theme I keep coming back to is that we’re at a secular inflection point in a post-bubble world with price stability. Not to mention a newly defined doctrine of diplomatic arrangements, if I may put that delicately. But the biggest implication on the investment side—which both Bill Gross and I have written a lot about—is that investors need to have realistic expectations about what stocks and bonds can return in years ahead.

That is saying a mouthful. Expectations are anything but realistic, in general.
Our point is that the returns of the last 20 years reflected a one-off victory in the war against inflation and the power of government—the disinflationary monetary policy and a shrinking of the power of government in the markets. But that era ended in bubbles and now we are in a brand new and different world. Therefore, the returns of the last 20 years, by definition, cannot be replicated. Also by definition, it literally comes down to starting point valuations, even though it is very much wrapped up with the whole issue of the prevailing environment, too.

In what way?
Once you get to below 4% on the 10-year note, and you’ve got the beginning of a bull market in government—explicitly aimed at reflation—you ain’t going to get double-digit returns in bonds.

It sounds pretty strange to have the biggest bond managers out there talking down their own game.
Well, in bonds, if you don’t accept the arithmetic, you should be fired for being blind. Bonds are a matter of arithmetic. And no, we’re not talking down expectations so we can beat them, either; this is simply what the arithmetic is. On the stock side, it’s more contentious, because your arithmetic is wrapped up in a couple of assumptions. Estimating earnings growth is different than looking at a bond and seeing what the coupon is. With a Treasury bond, there’s not a great deal of argument about the coupon. It is stated right there.

Though the real rate depends on inflation.
But you know what the nominal coupon is. You also know, in the bond context, what government explicitly is trying to do—reduce the purchasing power of that nominal coupon. So the policy intent is pretty straightforward. On the equity side, by contrast, there’s no earnings growth number printed on the stock certificate. So there’s a fair amount of room for reasonable people to debate. Just not as much as I see people doing. I mean, the notion that you’re going to have normalized double-digit growth in profits in a world with 5% nominal GDP growth doesn’t work very well for me.

It works only if you live in Lake Wobegon, and all your children are way above average.
But that’s arithmetic that many investors have yet to adopt. They have to recognize that double-digit returns in stocks over the last two decades weren’t really about double-digit growth in profits.

Not a particularly easy lesson for folks raised on the notion of stocks for the long haul, as Peter Bernstein pointed out in this space a couple of issues back—
Exactly. I’m just singing out of Peter’s hymnbook. He’s right. People just don’t want to accept something like 1.5% real growth in profits as realistic. Then there’s the whole issue—which Peter and Rob Arnott have written a great deal about, as has my partner, Bill—of what the equity risk premium should be.

What’s your take?
Well, you can clearly compute what it has been historically—otherwise known as the excess returns thrown off by an asset class. But as Peter rightfully notes, if people had started out expecting those returns, then they wouldn’t have gotten them. Besides, when you compute the equity risk premium in a backward-looking fashion, it doesn’t necessarily tell you anything about what the true equity risk premium is. Investors’ very high expectations of the return on stocks today stand in stark contrast to 1981. So, given the high starting point for P/Es, too, excess returns for stocks axiomatically should be less than they were in the past. In fact, given that we’re living in a world entering a bull market in government with the doctrine of preemptive war, I would suggest that a rational person would conclude that the equity risk premium should be higher, because it’s a more risky world.

Are you predicting a crash from here?
This doesn’t mean that stocks have to go to hell in a hand basket. The most pleasant thing that could happen would be for stocks to meander around where they are for a long, long time.

That’s pleasant?
People have just got to accept mid-single digits as all they can do. There’s no bull trend in stock valuations to be exploited.

On that happy note, thanks, Paul.

Kathryn M. Welling
March 28, 2003

Reprinted with permission from
welling@weeden, a research service of
Weeden & Co. LP


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