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Economic and Market Commentary

Necking In The Mezzanine

President Bush has staked his legacy-to-be on forcing a regime change in Iraq. I have a viewpoint on whether this is a good or bad idea, but I will keep it to myself. As a man who has traveled extensively in the Middle East over the last decade (but never to Iraq!), some fifteen sojourns, I realize that the more I know, the less I know about how the constellation of regimes in that part of the world should be aligned. And cogitative impotence is a good reason to avoid contributing to cogitative dissonance.

Not so here in the Homeland. I know more than a few things about the constellation of economic policy regimes in Washington, and feel no compunction whatsoever to keep my mouth shut. In fact, the fiduciary duty that PIMCO's clients entrust to us demands that we anticipate regime change in America's economic order, and preemptively position portfolios accordingly to bring profits to clients' bottom lines. That's what they pay us to do. And it is also part and parcel of PIMCO's Secular Economic Forum process: leaving the business cycle at the door and anticipating structural changes in the institutional linkages of the economy, policy and markets.

The figure is a line graph that shows the spreads of S&P 500 yield and BBB corporate bonds to the 10-year U.S. Treasury bond, from 1990 to late 2002. Spreads of BBB corporates over Treasuries, scaled on the left-hand vertical axis, trend upward to peak at around 340 basis points late in 2002, up from a chart-low of around 75 in mid 1997. The spreads drop steeply after their 2002 peak, to finish the chart 270, but still well above their average of 151 over the period, shown by a solid horizontal black line. Spreads of equities over Treasuries, scaled on the right, are around negative 40 basis points in late 2002, up steeply from a recent low of around negative 320 in early 2002. The two metrics, when superimposed, show the line for the spreads for the S&P yields to Treasuries is above that for BBB corporate bonds spreads since 1999. 

Or, as I like to put it sometimes (perhaps too often!), our secular forecasting process is about anticipating changes in the "marriage" of democracy , founded on the principle of one person, one vote, and capitalism , founded on the principle of one dollar, one vote. We live in a mixed economy, with both collective property rights and private property rights, institutionalized and legitimized by the democratic process, grounded in the rule of law.

It's a messy system, as democracy inherently celebrates our collective property rights, instilling a lust for power in the public sector, while capitalism inherently celebrates our private property rights, instilling a lust for power in the private sector. Thus, at its core, secular forecasting is about anticipating changes in the power relationship between "we the people" as a top-down body and "we the people" as a bottom-up collection of profit-maximizing bodies.

Many factors influence this relationship, of course, with two of the most powerful being time operating on a country's demographic characteristics and changing geopolitical arrangements with other sovereign nations. PIMCO's investment professionals spend a lot of time and energy in our Secular Economic Forum exploring these exigencies; they move glacially, but powerfully, requiring constant vigilance in analysis.

Both forces are currently at "tipping points," as the jargon goes, as (1) financial and health security in the retirement years and (2) physical security of the Homeland have risen to the top of the democratic agenda. Making a killing in the stock market, the defining agenda of America and Americans in the 1980s and 1990s, no longer defines us.

Not that we individually and collectively no longer want to make a buck. We most certainly do. An ethos of entrepreneurial capitalism remains very much alive in America, and for that we should be both individually and collectively grateful. At the same time, there is no question that our mixed economy is undergoing a structural remixing.

Or, as I wrote 1 after our Secular Economic Forum in May:

"America's twenty-year journey toward more unfettered capitalism, fueled by a shifting of power over resources from the public sector to the private sector, is over."

As the millennium turned, America's-and indeed, the world's-twenty-year party in celebration of unfettered capitalism ended in triple bubbles in equity valuation, business investment and corporate leverage. And the bursting of those interrelated and self-feeding bubbles unleashed and revealed the risk of capitalism's unbearable beast of burden: a debt-deflation melt-down, defined as a self-feeding fall in the market value of assets relative to the par value of debt that had been assumed in acquiring them.

Preempting the risk of such an outcome-or arresting it in the event that the risk becomes a reality-is by definition a job for the public sector: we the people using our collective power over resources to protect ourselves from the summed bottom-up consequences of our individually irrationally-exuberant behavior. Or, as I wrote in June:

"The years ahead will involve a remixing of America's mixed economy-indeed the global mixed economy-toward greater public sector power over resources."

Think Seriously, My Friends
The most powerful (economic!) resource that we the people collectively own is the printing press: the ability of our central bank to buy anything, paying for it with money created out of thin air. So powerful is this resource, of course, that we the people put constraints on its use to protect ourselves from our inflationary selves: we have an operationally independent central bank, which is granted a legal monopoly over money creation. No one else is allowed to touch the money printing press, most importantly, the fiscal authority, a potential road to hyperinflationary ruin.

The Federal Reserve is the embodiment of both our power as we the people and also our restraint on the use of that power. That's why the chairman of the Fed is called the "second most powerful man in America," if not the world. The President is first, of course, because he is legitimized by the democratic electoral process, while serving as Commander In Chief of our military resources: he holds the keys on behalf of we the people to the nation's nuclear arsenal. But make no mistake, the chairman of the Fed is indeed the second most powerful job in our nation: he holds the keys on behalf of we the people to the press that prints money.

Most of the time, the Fed's job is to "just say no," in the famous words of Nancy Reagan. Indeed, that's why the Fed is operationally independent within the government, with control over its own budget: the Fed can say no to cranking the printing press, even when the political pressure to do so is overwhelming, and not worry about paying the light bills.

Fed Chairman Greenspan is a master at just saying no to fiscal authorities wanting more energetic money creation; and his predecessor Paul Volcker was, I would argue, even better. The policy regime of the last two decades has unambiguously been one of monetary policy dominating fiscal policy . Easy money was simply not possible, both Greenspan and Volcker preached, without fiscal discipline. Well perhaps it was possible, they allowed, but not without an inflationary consequence, which they vowed to never allow.

Thus, it came to pass, President George W. Bush's father President George H. W. Bush found it "necessary" to recant his "read my lips, no new taxes" mantra, upon which he was elected, before Mr. Greenspan would get serious about cranking up the printing press in 1991; Bush senior lost his job as a consequence, of course. And then, it came to pass, President Bill Clinton, Mr. Bush's successor, found it "necessary" to ditch his campaign mantra of "tax cuts for the middle class" in favor of tax hikes for the wealthy, as a quid pro quo for Mr. Greenspan keeping the printing press running freely in 1993. Two-for-two for the monetary authority over the fiscal authority.

Mr. Greenspan probably would not fully agree with my memory on these matters; he would likely retort that sturdier fiscal discipline was necessary in both those cases so as to bring down long-term interest rates, which the Fed does not control. And yes, that was indeed Mr. Greenspan's argument. His predecessor Mr. Volcker used the same argument, even more powerfully, during the early years of the Reagan Presidency: the Fed only controls short-term interest rates, he thundered, and in the absence of fiscal discipline, long-term interest rates would likely go up in the context of a short-term rate cut. A lack of fiscal discipline in the context of easy money would only exacerbate inflationary expectations, he preached. Yes, Mr. Volcker and Mr. Greenspan made the so called Treasury market (no-default-risk here!) vigilantes, who loved fiscal discipline and falling inflation, to be the gods of capitalism, and the Fed's chosen policy beacon.

It never ceases to amaze me that the dudes got away with this, but they did: men with the keys to the money printing press arguing variously that they couldn't find their keys; or that the keys didn't fit; or that the press didn't print in the right colors; or that a bunch of bond punters who didn't own a press were more powerful than the press itself. Technically, it was always a lie, in pursuit of a loftier goal of bringing down inflation. The Fed has always had the technical (though not, necessarily, the precise legal) power to "monetize" anything in unlimited quantity, if it were willing to court accelerating inflation and/or asset price bubbles.

But in deference to the notion that little white lies are sometimes justified in pursuit of greater goals, I don't want to be too harsh on Mr. Volcker and Mr. Greenspan. After all, I've occasionally fibbed to my 13-year old about the whereabouts of my wallet, when he's complained about a mismatch between the number of dollars of his allowance and the number of days in the week. Gotta teach some fiscal discipline here! A little constructive ambiguity can be useful as a teaching device, most parents have learned: it's not really lying.

But sometimes, ambiguity is not constructive. I do want my Jonnie to know that my wallet can be found, and will be opened, if he really needs it. God forbid that he would decline to spend every cent of his allowance on a cab home from a party, so as to avoid riding with an older teenager who was drinking, out of fear that I wouldn't reimburse the fare in full.

Constructive Ambiguity Isn't Always Constructive
Such is the case right now with monetary policy. God forbid that capitalists get themselves caught in a debt-deflation spiral, out of self-feeding fear that the man with the keys to the printing press can't find them, or that the press might be on the fritz. This has been the message of Fed Focus for two years now, as I've pounded the table for the Fed to unapologetically, unambiguously, pursue a reflationist money-printing course, while shutting the hell up about the need for fiscal discipline. A debt-deflation (Minsky) moment, threatening to morph into a debt-deflation (Minsky) meltdown, is all about a deficiency of nominal aggregate demand. The Fed's printing press is the right tool to reinvigorate nominal aggregate demand, including "accommodating" large and growing fiscal deficits .

To me, the matter has been as clear as reimbursing Jonnie for that theoretical cab fare: no second-guessing, just do it! Perhaps at 200 cents on the dollar, as a statement of trust . Thus, I admit to being strident at times in my criticism of the Fed's, and Greenspan's, feigned limits on the power of the printing press. I also admit to outright pedantry in my bombast of Greenspan's sermonizing about the need for fiscal discipline: a debt-deflation meltdown is all about an over-levered private sector attempting to de-lever, which screams for a purposeful relevering of the public sector's balance sheet, especially after a decade of de-levering it.

To witness Greenspan argue otherwise, or to say as he did a couple weeks ago that he's "still thinking about it," is offensive, given that he endorsed President Bush's secular tax cut one week after Bush junior took office (in atonement for screwing his old man?) 2, on the notion that the country was on a course of paying off the national debt too quickly. There is a limit to how much happy horse stuff I can take.

But what the hey: I'm in a charitable mood today and I actually have something positive to say about the Fed, including Mr. Greenspan, and especially new Fed Governor Ben Bernanke. Since last month's Fed Focus , the (1) Fed has cut the Fed funds rate 50 basis points, as we both urged and forecast 3; (2) Mr. Greenspan finally admitted that the Fed has the power to directly bring down/peg long-term interest rates; and (3) Mr. Bernanke delivered a powerful, candid speech on the awesome power of the Fed's printing press. Doesn't get much better than that for a principled populist 4, who also believes in the wonder of capitalism!

Global equity markets and even more important, global corporate bond markets have been rejoicing, too, as well as they should. For, you, see, the combined effect of those three Fed events was a screaming billboard announcement that the Fed has finally, and decisively, declared victory in its two-decade war against accelerating inflation, and has started a new secular war against deflation risks. A regime change, my friends, a regime change!

How Sweet It Is
The FOMC's "surprise" 50 basis point rate cut on November 6 spoke for its anti-deflation self, though the press release was silent as to the matter of the FOMC's explicit concern about debt-deflation risks. Mr. Greenspan's testimony to Congress one week later, on November 13, was not. He declared:

"Although economic growth was relatively well maintained over the past year, several forces have continued to weigh on the economy: the lengthy adjustment of capital spending, the fallout from the revelations of corporate malfeasance, the further decline in equity values, and heightened geopolitical risks. Over the last few months, these forces have taken their toll on activity, and evidence has accumulated that the economy has hit a soft patch. Households have become more cautious in their purchases, while business spending has yet to show any substantial vigor. In financial markets, risk spreads on both investment-grade and non-investment-grade securities have widened. It was in this context that the Federal Open Market Committee further reduced our target federal funds rate last week."

The key sentence in that verbiage was the penultimate one: "In financial markets, risk spreads on both investment-grade and non-investment-grade securities have widened." Finally, finally, market participants sighed everywhere, he gets it : the corporate bond market, not the corporate equity market, is the straw that stirs the drink in the debt-deflation risk scenario! Widening risk premiums on private sector debt are both a symptom and a cause of debt-deflation risks. Mr. Greenspan, by linking the FOMC's "surprisingly-large" rate cut to such a development, effectively announced a covenant with risk takers: buy private sector debt, and the Fed will use the printing press, if necessary, to make sure that you won't lose (diversified!) money in the sector. Simple and profound as that.

In questioning after his formal testimony before Congress, Mr. Greenspan upped the anti-deflation ante, dismissing the notion that the Fed would become impotent, perchance the Fed funds rate hit zero. Specifically, he said:

"There is an implication in the notion (of fighting deflation risks) that we are restricted solely to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term assets and invested in long-term Treasuries. We do have capability, if required to do so, to go well beyond activities related to short-term rates."

After a career of arguing that the Fed couldn't really do anything to control long-term rates, Mr. Greenspan said the Fed could, and if necessary would, peg them low/lower to prevent a debt-deflation spiral. It was mighty civil of Mr. Greenspan to acknowledge the technically obvious, after the last two years championing-and sharing the credit for-homeowners extracting equity from their houses by levering up into larger, lower fixed rate (long-term!) mortgages. It was wonderful to hear Mr. Greenspan explicitly declare that the Fed knows where the monetary policy Viagra is stored.

Gentle Ben
The really interesting event, however, was Governor Bernanke's speech on November 22, which was a tour de force regarding the Fed's ability-and presumed willingness- to print money with abandon, if necessary, to abort or reverse a debt-deflationary spiral. We actually know Ben well here at PIMCO, as he was a featured speaker at our May 2000 Secular Economic Forum. We invited him because he had given the keynote address at the Fed's August 1999 Jackson Hole conference, where he had argued strongly for the Fed to (1) adopt an explicit "flexible" inflation-targeting regime, which would (2) render unnecessary any need for monetary policy to "target" asset bubbles.

I personally disagreed with both propositions, which is why I wanted to have Ben speak with us: as a wise man once said, you only learn something from those who disagree with you. He essentially reiterated the "path-breaking" analysis he presented at Jackson Hole: if the Fed were to (1) adopt a "flexible" inflation target, then (2) "ordinary" monetary policy actions working through (3) a Taylor Rule reaction function 5 would "automatically" (4) lean against the winds of both inflating and deflating asset bubbles, (5) obviating any need for monetary policy to address them directly.

It was not a path-breaking argument, even though it made Ben famous, and now a Fed governor; I tip my hat to him. The Taylor Rule incorporates an output gap term (actual GDP relative to potential GDP), which is really nothing more than an unemployment gap (actual employment versus the "natural" unemployment rate, commonly known as the NAIRU, or the non-accelerating inflation rate of unemployment). Put more simply, the Taylor Rule is founded on the Phillips Curve notion that there is a cyclical trade-off between inflation and unemployment: if inflation is too high, the Fed should tighten to induce employers to throw some people out of work; if inflation is too low, the Fed should do just the opposite.

Nothing extraordinary about that proposition: it's only what the Fed has been doing forever! The Taylor Rule could just as easily be called the "activated" Phillips Curve Rule, even though it made Mr. Taylor famous, too, paving the path to his current job as Under Secretary of the Treasury. Taylor's (marginal) contribution was simply to say that even if the output gap was zero (the actual unemployment rate was at NAIRU), the Fed should hold the real Fed funds rate above "neutral," if the actual inflation rate was above the "target" inflation rate. Indeed, the clever part of Taylor's Rule, if there was one, was that Taylor said precisely how much the Fed should "err" on the side of restraint: the Fed should, he proclaimed, maintain the real Fed funds rate 2 basis points above the "neutral" rate for each 1 basis point that the actual inflation rate was over the "target" inflation rate (holding all else constant, of course!).

Fed Governor Bernanke simply took the Taylor Rule to its logical conclusion, arguing that if an asset bubble were forming, putting upward pressure on aggregate demand versus aggregate supply, closing the output gap (driving down unemployment relative to the NAIRU), the Fed would be justified in tightening, independent of the asset bubble per se . Likewise, if a bursting asset bubble were unfolding, putting downward pressure on aggregate demand versus aggregate supply, opening the output gap (pushing unemployment up toward or through the NAIRU), the Fed would be justified in easing, independent of the bursting asset bubble per se .

Thus, Ben argued, the Fed should "prudently" stay away from ever "targeting" asset markets; the Fed should just do what it should do accordingly to the Taylor Rule, which would implicitly incorporate the impact of any asset bubbles via their impact on aggregate demand , the output gap (unemployment gap versus NAIRU), and thus, inflation (versus a "flexible" inflation target, of course).

A quite logical argument, I had concluded when he made it at Jackson Hole (I wasn't there, of course; I just read it!), and again when he presented it at PIMCO, as long as two hugely important assumptions held :

  • The Phillips Curve is stable, implying a stable trade-off between the output gap and the cyclical course of inflation; and

  • The impact of bubbles and bursting bubbles is symmetrical on aggregate demand.

With those two key assumptions, and in the absence of shocks, Mr. Bernanke's "flexible" inflation target proposal was "robust"-no need to worry about asset price bubbles per se, or God forbid, aim monetary policy directly at them. My quarrel with Ben was that I didn't have confidence in the two key (unspoken!) assumptions of his proposed "regime."

Most importantly, I didn't have confidence in the notion that asset bubbles and their bursting have symmetrical (linear) impacts on aggregate demand. And my concern was aggravated by an environment of low inflation, nearing the (implicit) target of "price stability." At such low inflation, there was limited room for error, or more technically, limited distance from the risk of a (Minsky-style! 6) debt-deflationary spiral, I feared, in the event of either a bursting bubble or an exogenous shock to aggregate demand.

Bluntly put, I thought 7 that Bernanke's Rule (of non-engagement of bubbles by the monetary authority) in tandem with Taylor's Rule of holding the real Fed funds rate above "neutral" if inflation was above "price stability" was a powerful one-two prescription for precisely what has unfolded in the American economy over the last two years: a bursting equity market and business investment bubble that would nail aggregate demand not just via a retrenchment in investment, but via a systemic (Minsky!) urge/necessity to delever balance sheets suffering from a bubble of excess debt.

There would come a time, I've argued repeatedly and not always pleasantly in this space, when the Fed would have to quit pretending that all it really could do was peg the Fed funds rate, and admit that it indeed had the power of the printing press itself to save capitalism from its boom/bust, deflationary self. To wit, there would come a time when the Fed would have to quit feigning impotence, and announce that it did indeed have the necessary powers to prevent/abort a Minsky Meltdown, including "unconventional" means, most importantly, the power to put a price floor under private sector credit obligations.

I've urged 8 the Fed to do that implicitly by "ordering" the banking system to quit withdrawing from contingent lines of credit for private business, either directly or indirectly, via the credit default swap market. The Fed responded with one hand clapping. Until last week , when Mr. Bernanke saw my ante and upped me; big time! Rather than focus on the "micro" details of aborting a debt-deflationary spiral, as I've done, he openly declared that there was a "macro" way: monetizing, directly and indirectly, private sector debt!

And, indeed, Mr. Bernanke's very declaration of the Fed's power to do so, and willingness to do so, if necessary, actually makes the potential need to do so fall precipitously . The famous (or infamous) Greenspan Put 9, heretofore "applied" to common stocks and household real estate, has now been supplemented by the Bernanke Put for private sector debt . And the more that private sector risk takers believe in the Bernanke Put, the less likely it is that it will ever "go into the money," requiring the Fed to actually monetize anything.

Bravo, Ben! As Keynes intoned long ago, smart men change their minds when they get new information, and I applaud you for changing your mind about the efficacy of "targeting" asset prices, if necessary to prevent/abort a debt deflationary spiral . (Truth be told, I'm quite sure that Governor Bernanke has always believed this, notwithstanding his strident advocacy of the view that the Fed should eschew "targeting" asset prices). Here's what he said, first at the most general level:

"…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

And after echoing Mr. Greenspan's declaration that the Fed has the power to reduce/peg long-term government rates, Gentle Ben issued the Bernanke Put:

"If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities."

Governor Bernanke stressed that the Fed should never, ever allow the economy to get into a debt-deflationary spiral requiring such "unconventional" uses of the Fed's powers to reverse it. Preempting deflation was a far preferred course to reversing it, he evangelically preached. Amen, and amen, I shout. But it was hugely important that Mr. Bernanke put the facts squarely on the table: If America "accidentally" goes into the Japanese deflationary soup, it will not stay in the Japanese deflationary soup, as the Fed policy makers are not too blind to find the printing press. And use it!

Bottom Line
I am not qualified to opine on the course of regime change in Iraq. I am, however, qualified to opine on regime change in Federal Reserve policy, and I'm ecstatic to report, my friends, that we just witnessed one ! The Fed's secular war against inflation, which Paul Volcker inaugurated on October 6, 1979, is over . Alan Greenspan declared victory on November 13, and Ben Bernanke laid out the terms of the armistice on November 21. In the years ahead, democracy and capitalism will be necking in the mezzanine where the Fed keeps the printing press.

Inflation in America can go no lower without morphing into deflation, a hellish place where capitalism would be consumed by its own debt-deflationary fire, as in Japan. The Fed is not too blind to see, and will do whatever it takes, using the full scope of its printing press powers, to reflate the American economy back from the deflationary cusp.

My principled populist soul rejoices. And but for the matter of the course of genuine uncertainty about looming regime change in Iraq, my cravenly capitalist instincts would be to advocate a wholesale swap of U.S. Treasuries into U.S. corporate bonds: The Fed has put its reflationary PUT beneath corporations' wings!

But I don't know, and can't know, the course of President Bush's plans for Iraq. Thus, let me conclude more circumspectly, with the closing three sentences of my June Fed Focus, written after PIMCO's Secular Economic Forum 2002:

"Secular shifts by definition occur in the context of cyclical exigencies, shaping the prices for secularly-oriented portfolio shifts. That said, sometimes it is important to buy and sell at the right prices, and sometimes it is important to buy and sell. So, dear reader, if you are still lifting your glass in celebration of the ascendancy of capitalism in our mixed economy, don't just stand there: do something!"

Paul A. McCulley
Managing Director
November 29, 2002

1 "Rotor Tilling Behind Bill's Tractor," Fed Focus, June 2002.
2 "Through Holes In The Floor Of Heaven," Fed Focus, February 2001.
3 "The Morgan Le Fay Plan," Fed Focus, November 2002.
4 "Principled Populism," Fed Focus, September 1999.
5 "NAIRU's Valentine," Fed Focus, June 2000.
6 "Capitalism's Beast of Burden," Fed Focus, January 2001.
7 "If Only Alan Would Shrug," Fed Focus, May 2000.
8 "Time To Rotor Rooter The Lender-of-Last-Resort Function," Fed Focus, August 2002.
9 "Me and Morgan le Fay," Fed Focus, February 2000.








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