Bond managers come in many religious stripes, but at the office, all believe that the wages of inflationary sin are portfolio death. Relatedly, most believe that fiscal deficits are the raw material for inflationary sins, because they will lead to excessive debt monetization by the Federal Reserve, and “crowd out” private investment. Therefore, budget surpluses are the path to Calvinistic righteousness, as the Fed is freed to focus exclusively on keeping inflation low, and paydowns of government debt “crowd in” productivity-enhancing, inflation-retarding private investment.

Hard to argue with those articles of faith. Indeed, I’ve been known to preach them myself, even though I openly admit to (principled!) populist tendencies. Nonetheless, we here at PIMCO are spending much of our time these days trying to figure out the downside, not the upside, of the secular fiscal surpluses created by an investment- and productivity-driven New Economy.

Bill Gross has written elegantly in recent Investment Outlooks about the most obvious negative downside of fiscal surpluses for as far as the eye can see: The credit quality of the total stock of debt will decline, as default-free governments are replaced by riskier private sector obligations. The portfolio implication is clear: A new era of spread relationships between private sector debt and what remains of government debt.

This does not mean, however, that private sector debt will always be less attractive than government debt for your portfolios. As with so many things in life, it’s a matter of price. The key issue for active portfolio managers is to recognize that the “normalized” yield pick-up for taking credit risk will be higher in a world of secular budget surpluses than one of secular budget deficits.

At the moment, the markets are in a “price discovery process,” seeking the new “normalized” spread relationships. We here at PIMCO are very much part of that market process. We don’t hate credit risk; we just want to make sure your portfolios are adequately compensated for it!

What Does It Mean For The Fed?
As the Fed maven ’round here, I’ve been doing some serious dome scratching about the implications for monetary policy of a world of secular budget surpluses. The most obvious implication, as many analysts are noting, is that the Fed will ultimately have to own something besides Treasury debt in its normal course of creating growth in the monetary base. In contrast to others, however, I don’t think this is a big deal.

My hunch is there will be both a revival and a change in the role of the discount window, with the Fed not buying private sector debt, but rather providing loans to market makers secured by private sector debt (with a haircut, of course). Thus, I don’t think it will be difficult for the Fed to “stay out of the business of credit allocation.” As demonstrated by its smooth handling of the Y2K turn, the Fed can be quite creative in injecting reserves into the banking system, despite a shortage of Treasury collateral. To me, a shift in the mix of assets that the Fed monetizes is simply a matter of a shift in the techniques of monetary policy.

Far, far more important, in my view, are the implications for policy itself. The key issue is that in a world of secular budget surpluses, the economy will lose the “automatic stabilizer” properties of fiscal deficits. Yes, contrary to popular opinion, budget deficits are not everywhere and at all times bad! Government finances are inherently counter-cyclical, while private sector capital formation is inherently pro-cyclical.

Government debt creation is an “automatic stabilizer,” because it rises when the economy falls into recession, even as private sector capital formation dries up (Fig 1). A rising deficit in a recession is a very good thing, particularly when it happens automatically: (1) It replaces some of the income lost in the private sector, and (2) provides default-free obligations for a weakened banking system to buy as private sector credit demand weakens and defaults rise (Fig 2). 

Rising Fiscal Deficits Serve an
"Automatic Stabilizer" Role in Recessions
Figure 1
Source: Commerce Department

Banks Buying of Treasuries Plays a Healing
Role Coming Out of Recessions

Figure 2
Source: Federal Reserve

In a world of secular budget surpluses, government debt creation in a recession would not start until the recession created a cyclical deficit, even as private sector capital formation plummeted. Thus, the automatic stabilizer function of deficits would kick in only with a lag. No big deal, you say. Congress could act to pro-actively turn the surplus into a deficit, not waiting for the recession to produce one. Theoretically, that is correct.

But Congress is not very good at pre-emptive policy making, tending to respond to evidence of macroeconomic distress (and as former President Bush can testify, sometimes fiscal stimulus is eschewed, even in times of macroeconomic distress!). Thus, in a world of secular fiscal surpluses, the Federal Reserve will need to be more, not less, pre-emptive in easing when a recession looms on the horizon.

What Does It Mean For The Dollar?
The US dollar’s role as global reserve currency is a wonderful thing, because it creates structural global demand for dollar assets – both by foreign private entities and the world’s central banks. This gives the US the privilege (nay, duty!) to run secular current account deficits, so as to fulfill that “natural” demand for dollars. And we certainly fulfill our duty.

The mix of “natural” global demand for dollar assets is, however, skewed toward private foreign demand when the dollar is rising, and toward “official” foreign demand – e.g., central banks – when the dollar is falling. This is, of course, just another way of saying the dollar is pro-cyclical, with foreign private sector players buying it on the way up, and foreign central banks buying it on the way down!

Central banks invest overwhelmingly in governments and near-government obligations. Thus, in a world of secular fiscal surpluses and “crowding in” of riskier private sector obligations, global private sector demand for dollar assets will likely take on an even more distinct pro-cyclical character. Foreign central banks will likely be less eager to play a “stabilizing” role on the downside, given the relative shortage of government obligations. This implies that the US dollar will itself become more pro-cyclical, as momentum-driven foreign private investors rush into and out of it (as if it were a high-beta stock!).

In and of itself, this outcome will not undermine the dollar’s role as the global reserve currency, which has a great deal of inertia to it. At the margin, however, a world of secular fiscal surpluses implies faster secular depreciation in the dollar (remember, global reserve currencies always secularly decline, because the role requires a secular current account deficit!). This outcome will, in turn, make disinflation harder to come by on the downside of the cycle, which could make the Fed hesitant to ease aggressively, even as the loss of the “automatic stabilizer” of a fiscal deficit would argue that Fed should do exactly that.

Why Does It Matter Now?
But how does this relate to the current situation, you ask? When the next recession hits, the Fed will ease however much it must ease. Why does that matter now? It matters, and matters hugely, because if private sector economic agents know the Fed is the only game in town, moral hazard will infect the private sector capital formation process, raising the likelihood of a boom-bust scenario.

Indeed, this is precisely the risk-case scenario that is bedeviling the Fed right now. The same glorious investment-and productivity-driven New Economy that is generating secular fiscal surpluses is also generating a secular increase in equity valuations. In turn, the associated wealth effect is cyclically generating aggregate demand growth in excess of sustainable aggregate supply growth, pulling down the unemployment rate. As Fed Chairman Greenspan declared in Humphrey Hawkins testimony on February 17:

“At some point in the continuous reduction in the number of available workers willing to take jobs, short of the repeal of the law of supply and demand, wage increases must rise above even impressive gains in productivity. This would intensify inflationary pressures or squeeze profit margins, with either outcome capable of bringing our growing prosperity to an end.”

Now truth be told, the notion of a squeezing of profit margins does not bother me nearly so much as it does Mr. Greenspan. Indeed, I believe such an outcome would actually extend the expansion, because: (1) Lower profits would reduce investment demand, which would reduce demand for labor; while (2) lower profit expectations would tend to reduce equity market values, tempering the wealth effect that is driving consumption, which would also reduce demand for labor. Thus, to me, a squeezing of profit margins would not be a problem, but a solution – rooted in Adam Smith’s invisible hand!

But Mr. Greenspan does not agree. And his opinion is the one that matters! He sees the path to better cyclical balance not in a “natural” microeconomic shifting of shares of GDP to labor from capital, but in a policy-supported macroeconomic increase in long-term real private interest rates. Again quoting the man directly from Humphrey Hawkins:

Mr. Greenspan has repeatedly denied, of course, that this statement should be taken to mean that he is “targeting” the equity market. Most recently, at the White House, standing but a few feet from the President, he declared:

“The persuasive evidence that the wealth effect is contributing to the risk of imbalances in our economy, however, does not imply that the most straightforward way to restore balance in financial and product markets is for monetary policy to target asset price levels. Leaving aside the deeper question of whether asset price targeting is an appropriate governmental function, there is little, if any, evidence that monetary policy aimed at achieving that goal would be successful.”

Now I know what Ralph Waldo Emerson must have meant when he said that “a foolish consistency is the hobgoblin of a small mind.” I will not even attempt to reconcile Mr. Greenspan’s Humphrey Hawkins testimony with his White House commentary. It is simply duplicitous for Mr. Greenspan to argue that the Fed should not target asset prices, when he openly admits that he is targeting higher long-term corporate bond yields. Yes, Virginia, corporate bonds are an asset, and corporate bond yields do move inversely with corporate bond prices!

What Is The Bottom Line?
A New Era World of secular fiscal surpluses implies a secular increase in equity market valuation, because it implies a faster secular growth rate for investment and productivity. At the same time, a New Era World of secular fiscal surpluses implies a secular decline in private sector quality, as private sector borrowers who were formerly “crowded out” are now “crowded in.” These outcomes leave the Fed with the dual cyclical risks of an equity bubble and a credit bust – at the same time!

Yet the Fed refuses to aim policy directly at the equity bubble, but instead targets the bubble indirectly by targeting rising private sector real interest rates, which exacerbates the risk of a credit bust. But since equity players know that the Fed will surely ease in the event of a credit bust, stocks refuse to go down, and stay down. In response, the Fed threatens to target even higher private sector interest rates, increasing still further the risk of a credit bust.

To me, this scenario has hard-landing risks written all over it. In the long run, to be sure, this risk is less lethal to bond portfolios than inflation. In fact, I’ve heard some argue – yes, even in the hallowed corridors of PIMCO! — that a good old-fashioned hard landing would be good for bonds in the long run, as it would bring some sanity to underwriting standards. I’m not so sure. By definition, private sector credit creation must be less sane in a world of secular fiscal surpluses: Those borrowers that were previously “crowded out” must now be “crowded in!”

Alan should shrug. But instead, he vows to cyclically weaken credit quality through higher real private sector interest rates, so as to (1) drive up what he calls “equity discount factors,” so as to (2) arrest growth in the wealth effect via a non-targeted correction in stocks, which are, of course, in a non-bubble.

Hubris, it seems, can infect even the most devout Libertarian.

Paul A. McCulley
May 1, 2000

“…BBB corporate bond rates adjusted for inflation expectations have risen by more than one percentage point during the past two years. However, to date, rising business earnings expectations and declining compensation for risk have more than offset the effects of this increase, propelling equity prices and the wealth effect higher. Should this process continue, however, with the assistance of a monetary policy vigilant against emerging macroeconomic imbalances, real long-term rates will at some point be high enough to finally balance demand with supply at the economy’s potential in both the financial and product markets.”


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