A conversation with Morgan le Fay, the author’s family pet and early-morning debating partner)

PM: Good morning, Morgan. Thank you for agreeing to chin wag with me about the outlook for the global economy and markets. Third year in a row we’ve done this. ¹ I look forward to it.

But first, let me compliment you on yet another year of aging gracefully: You’re still the Princess!

MLF: Thanks, Mac. Eight of my years is more than 48 of yours, so it is only right that you treat me with ever more respect each year. And you do, so I ain’t complaining. Life is good, living here on the dock of the bay, watching the fruits of capitalism float by.

PM: They are called boats, Morgan. But you are also right that they are the fruits of capitalism, or as Adam Smith put it long ago:

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. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, 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.

The invisible hand created all those boats, Morgan. The hand has been good to Southern California.

MLF: A mighty fine hand it is! Mighty fine. First time you’ve ever quoted this Smith dude to me. Was he a friend of your secular god Mr. Keynes?

PM: No, Princess, Mr. Smith lived over a century before Mr. Keynes. Mr. Smith, and a few of his buddies, taught the world how free markets combined with individual self-interest bring efficiency to the allocation of a nation’s resources. Really cool idea.

Mr. Keynes gave us macroeconomics, founded on the proposition that the invisible hand’s supply of goods does not necessarily create its own demand for goods at full employment, creating a unique imperative for the visible fist of government to underwrite full-employment aggregate demand.

Smith and Keynes aren’t in conflict, Morgan, just two chefs working together to cook up the awesome feast called the American economy. And, as you know all too well, Morgan, it’s macroeconomics that floats my boat.

MLF: Mac, you don’t own a boat. A Waverunner is not a boat! But I get your drift. So, what are we going to talk about today? Are we going to do something fun like solve Mr. Greenspan’s conundrum?

PM: Don’t know if we can solve the thing, Morgan, but it’s a great point of departure for us, just as Mr. Greenspan is about to depart the Fed. To be replaced, I hasten to note, by the dude you’ve fondly called Gentle Ben over the years. Bet that Mr. Bernanke is the only central banker in the world with a rabbit as a charter member of his fan club!

Mr. Greenspan’s conundrum is, in the first instance, about the relationship between the short-term rate that the Fed pegs and the long-term rates that the market determines, otherwise known as the yield curve. Normally, it is positively sloped, to reflect a risk premium – called the term premium – for the inherent uncertainty and volatility of the return of longer-dated bonds relative to cash.

And, history says, if the Fed goes on a rampage in hiking cash rates, longer-term rates will rise, too, just by less. So, while the yield curve will flatten as the Fed tightens, long-term rates will still rise.

In the ongoing – but nearly finished! – Fed tightening cycle, that hasn’t happened: long rates – notably the 10-year rate – have fallen slightly as the Fed has been tightening, totally collapsing the yield curve. Or, alternatively, totally collapsing the term risk premium.

This time has been different, regardless of how dangerous those words usually are to the wallet. And trying to figure out why it is different has become an industry: the conundrum-busting brigade.

MLF: So, what’s the answer, Mac? Why is this time different?

PM: There is no single answer, Morgan, which is why it is such fertile ground for investigation. The key question, it seems to me, is whether the fall in long rates versus short rates is a fall in the term risk premium or a fall in the equilibrium real rate. Put differently, are investors demanding less of a yield premium for holding inherently more risky long-dated paper, or are they implicitly projecting a structurally lower real short-term rate in the future?

MLF: Well, which is it?

PM: Bit of both, me thinks, but I lean heavily toward the thesis of a structurally lower real short-term rate in the future. Back when I was a young man, Morgan, the cliché on Wall Street during Fed tightening cycles was that the Fed couldn’t stop too soon, or else long-term rates would rise on the back of un-scotched inflationary expectations. Now, the cliché is that the Fed can’t stop, or else long-term rates will fall, providing inflationary stimulus to aggregate demand.

What a long, strange reversal! To me, that’s a siren signal that secular victory over inflation has been won.

The name of the game now is not forecasting inflation, as it is well-anchored, but forecasting what real rates the Fed will need to impose to keep inflation well-anchored.

MLF: Intriguing. If that’s the case, doesn’t it imply that the ‘flation that matters now is inflation and deflation in asset prices, rather than goods and services inflation?

PM: Right you are, most clever bunny! If Fed-engineered changes in nominal rates no longer reflect changes in long-term inflationary expectations, but rather changes in real rates, then logic suggests that long-dated income-producing assets – bonds, stocks and real estate – will become inherently more prone to bubble and burst.

Accordingly, it seems to me, asset prices inevitably must take on a higher priority in the Fed’s reaction function than during the War Against Inflation. As long as inflation was too high for the Fed’s secular taste, bubbles and their bursting didn’t carry grave harm. They misallocated resources, to be sure, like all good Austrians properly preach.

But as long as there was somewhere secularly lower the Fed wanted to go with inflation, bursting bubbles and the recessions they brought were opportunistic: they paid welcome disinflationary dividends in goods and services prices.

With the War having been won and the Fed now trying to secure the Peace of Price Stability, recessions are no longer welcome. Indeed, they will become a frightening prospect if beget by bursting bubbles, because bursting bubbles imply debt liquidation.

MLF: Which, as that dude Minsky warned, can become debt deflation. Or a liquidity trap, as your hero Keynes warned.

PM: You are a wonderful student, Princess. Maybe I should start calling you Grasshopper! To my mind, there is no question that asset prices should be elevated in the Fed’s reaction function. But should and will are two different things, I’ve learned by bitter experience. I’m not persuaded that the Fed has reached that level of enlightenment yet, even as its contemporaries on foreign shores have moved decidedly in that direction.

And in all fairness to the Fed, it simply isn’t as easy for the custodian of the global reserve currency to implicitly target asset prices as it is for other central banks. For, you see, the United States is at the center of what is known as the Bretton Woods II (BW II) arrangement, whereby the United States and the Emerging World are in a de facto monetary union.

MLF: Ah, I knew we would get to this BW II thing! It’s been the primary focus of our annual chin wags the last two years. Still alive and well?

PM: Yes, Morgan, but remember, it’s not a stable equilibrium. As we at PIMCO have preached for years, it is a stable disequilibrium. The United States and the Emerging World are not what economists call an "optimal currency zone," or a natural zone for sharing a currency and a common monetary policy. Rather, BW II is a symbiotic relationship that emerged following the Emerging World Crisis of 1997-1998.

Ever since, the Emerging World has operated under the dictum of "never again," meaning that they never again want to be hostage to the mercurial whims of strangers providing dollar-denominated credit. Accordingly, they have pursued development policies that can only be described as mercantilist, in which they make more than they consume, exporting the difference to the developed world, notably the United States, while simultaneously financing those exports with huge increases in dollar reserves (a process called vendor finance ‘round here).

Effectively, this mercantile behavior has represented a positive shock to the supply of both labor and savings available to meet America’s aggregate demand. In turn, it has very logically put downward pressure on both U.S. real wages and
U.S. real long-term interest rates. And downward pressure on real long-term interest rates is the stuff of asset inflation, notably for long-duration assets and in particular, property.

MLF: So, the housing bubble, or whatever you want to call it, ain’t America’s fault, but rather the Emerging World’s fault?

PM: No, Morgan, it isn’t anybody’s fault; it just is. When the Emerging World decided to shift from being a net user to a net provider of savings, those savings had to go somewhere, they had to finance something. Otherwise, the entire world would have fallen into a liquidity trap, triggering a global depression.

Once the Emerging World made that switch, it became America’s global civic duty to run an ever-larger current account deficit, so as to maintain sufficient global aggregate demand to avoid unwelcome deflationary pressures. And, Morgan, we Americans are a very dutiful people!

MLF: Sounds like a very self-serving argument, Mac. Very Orange County of you. You’re telling me that America living beyond its means to the tune of a 6%+ current account deficit ain’t a sin but a virtue?

PM: No, dear Morgan, I’m telling you that it is neither. It just is, an outcome that was and is the dual outcome of the choices that the Emerging World made and the responsibilities of America as the custodian of the world’s reserve currency. If and when there is a sudden outward shift in the global demand for dollar reserves, America is the only country that can meet that demand.

And we do so by running a larger current account deficit. It really is, Princess, a matter of double-entry bookkeeping.

MLF: But how long can this last, Mac? At what point will the Emerging World decide that enough is enough on reserve building? When can those countries prudently declare that they are sufficiently self-insured against a replay of 1997-98? At what point do the peoples of the Emerging World get to more fully enjoy the fruits of their own labor?

PM: Most excellent questions, Morgan, but no clear cut answers. I believe that many Emerging Countries have more reserves than they will ever need. I believe they should relax both fiscal and monetary policies, Keynesian style, to foster more ebullient domestic demand growth. But again, that’s me saying should. I don’t actually think they will, at least in the year ahead.

It is important to remember just how nasty the 1997-98 crisis was for the Emerging World, on the order of the Great Depression for my parents. For people who have experienced such a nefarious episode, debt becomes anathema – rationally or irrationally, for a long, long time.

MLF: Well if that’s the case, does this BW II deal just keep on keeping on for a number of years to come?

PM: Conceptually, yes, but there are numerous risks. The most important, in my judgment, is that the whole arrangement requires under-levered assets that Americans can lever up, effectively borrowing from the rest of the world in order to buy from the rest of the world. The property market has been the star of this show in recent years, fostering a new cat named MEW.

MLF: Do not, repeat do not, bring up cats in this conversation or it is over! Got it? Cats meow, they don’t MEW, blockhead. What is this non-cat thing called MEW?

PM: Sorry, Princess, didn’t mean to set off your fear of felines. MEW is Mortgage Equity Withdrawal, which is Americans taking equity out of their homes by putting more debt on them. Or what I dubbed several years ago, turning the house into an ATM.

Rightly or wrongly, most Americans look at MEW as the closest thing there is to a free lunch: home prices magically go up, generating unrealized capital gains, which can be magically monetized, if not realized, by borrowing against them.

It’s not really free, of course, as homeowners must pay interest on the debt that extracts the equity. They are also exposing themselves to intensified risk of declining home prices, just like people who put increased margin debt on their stock portfolios. But it’s fun while house prices are rapidly appreciating, enabling consumers to increase their spending faster than their paychecks.

Indeed, according to detailed statistical work conducted by none other than Fed Chairman Greenspan himself, MEW in recent years has been running at 6-7% of after-tax disposable personal income, as displayed in the chart alongside.

MLF: Hey, that’s pretty cool, Mac! MEW truly has been a magical mystery tour. But isn’t it inherently unsustainable, kinda like the stimulative effect of budget deficits? Remember, as you preach all the time, it ain’t the level of the deficit that impacts growth in aggregate demand, but rather changes in the deficit.

Only a rising deficit represents fiscal stimulus, while a falling deficit represents fiscal drag, according to Keynesian doctrine. Shouldn’t we look at MEW the same way, Mac?

PM: Most awesome insight, sweet Morgan. You are right: it ain’t the level of MEW but the change in MEW that provides an impulse – positive or negative – to growth in aggregate demand. Which brings us to the key issue for the year ahead: MEW is very likely to decline, as the huge run-up in property prices of recent years hoists itself on its own affordability petard.

MLF: Wow, dude, that’s a mouthful. I don’t know a thing about petards. Whatcha talking about?

PM: Sorry, Morgan. Let me back up here for a little primer on the housing market. Rising home prices are a game that requires a constant influx of new buyers. And in a growing economy with a growing population, that’s a reasonable expectation. After all, people are born short a roof over their head and have got to cover, either renting one or buying one and implicitly renting it from themselves.

Thus, home price valuation is "tied down," as economists say, by the rental value of the home. It’s not a tight tie, I want to stress. The price-to-rent ratio for houses moves around a lot, just like the price-to-earnings ratio does for stocks.

But ultimately, there is a limit to how high the price-to-rent ratio can go, because as the ratio increases, fewer prospective home buyers have sufficient income to support the debt necessary to pay asking prices, particularly when mortgage interest rates rise. That’s called declining affordability, and it will ultimately bring any bubble in house prices to an end, undermining the MEW game.

That’s what we expect in the year ahead. Indeed, I would suggest that the downside for home price appreciation (note, being an optimist, I said downside for home price appreciation, not home prices themselves!) is particularly acute right here in California, where over 80% of new mortgages over the last year have been exotic creatures – interest only, pay option, and negative amortization concoctions.

Fed tightening has finally put the half Nelson on the ability of the mortgage industry to price these creatures at a level that prospective home buyers can afford and the mortgage industry can also make a profit. Thus, I think the consensus is going to be really surprised in the New Year by just how quickly and materially home price appreciation slows, taking MEW with it.

Reinforcing this view is a really cool chart presented at our recent Cyclical Economic Forum by my buddy Scottie Simon. Displayed alongside, it shows that when home price appreciation is running higher than mortgage rates, the market booms, if not bubbles, as momentum players chase the market higher, a text book example of what George Soros calls reflexive demand. But once the momentum breaks – and again, Morgan, declining affordability is the fundamental break – reflexive demand becomes reflexive supply, as former speculative buyers become eager sellers.

Reflexive markets – and property is one if there ever was one – inherently tend to have V-shaped tops, not rolling tops. Thus, both volumes in total home sales, particularly existing home sales, and MEW are set to fall sharply in the year head. Not the stuff of recession, I hasten to add, Morgan, but clearly the stuff of a serious slowdown in consumer spending.

MLF: Won’t that be a problem for foreign members of the BW II arrangement? Didn’t you say that they are as addicted to our spending as we are to their financing of our spending?

PM: Yes, Morgan, I did say that. Which implies that when the American property market comes off the boil, maybe turning tepid, the world will feel the impact, not just American homeowners. Such is the nature of globalization, when the ex-USA world has a shortage of aggregate demand or, put differently, runs a surplus of savings relative to desired domestic investment.

In the fullness of time, I fervently hope – and, indeed, forecast – that the Emerging Market World will morph from mass production to both mass production and mass domestic investment and consumption, providing the Keynesian support to global aggregate demand that is needed to thwart unwelcome global disinflation forces. But regrettably, time is not yet full.

Thus, when American demand slows on the back of MEW drag (yes, like fiscal drag, Morgan!), it will be necessary for the Fed to reverse course and start an easing cycle. Not on the immediate horizon, certainly, but a year from now, that’s what we are going to be talking about.

MLF: Well, if we’re going to be talking about it then, Mac, the markets are going to start discounting it way before then. Like the dollar and the stock market, no?

PM: Yes, Princess, markets do anticipate. Well before the Fed takes its first easing step, logic would suggest that the dollar takes a bit of a beating, while the stock market has a happy time, particularly the large-cap growth stocks, which have languished severely on a relative basis during the Fed’s tightening process.

MLF: And gold? And commodities more generally?

PM: Hard to tell, as weaker global aggregate demand growth says lower, while a lower dollar says higher. Kind of a push would be my guess, but only a guess.

MLF: So, Gentle Ben is going to be blessed with an exciting financial market vista when he moves into his new office?

PM: Yea verily, Morgan. And you and I are going to have lots of fun every morning at 4 am talking about his excellent new adventure. He’s promised continuity with Mr. Greenspan’s policies, but also enlightened evolution, notably in genuine transparency into the Fed’s strategic thinking, rather than simply transparency in tactics, using a thesaurus.

Who knows, Morgan, Mr. Bernanke may ultimately reveal himself to be a principled populist, just like you and me!

MLF: Don’t get carried away, Mac. You are forever projecting yourself. You need to start listening more!

PM: Touché, Morgan. Touché. Let’s wrap this up. You want the last word?

MLF: Don’t mind if I do. Actually, let me close for the both of us, in the spirit of the season, as we did last year:

May God bless you and keep you, May God’s face shine upon you and be gracious to you, May God lift up his countenance upon you, And give you peace.

The Priestly Blessings
Numbers 6:22-27

Paul McCulley
Managing Director
December 15, 2005
mcculley@pimco.com

¹  "Confessions of Optimistic, Principled Populists,"

Fed Focus, December 2004 and "Isle of the Pears,"
Fed Focus, January 2004.