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Economic and Market Commentary

Sitting On The Dock Of The Cliff​

I'm a "framework" kind of guy. I have an intense - yes, obsessive, some might say - desire for knowing the framework within which I operate. A regime kind of guy, to put a New Yorker Magazine spin on it. I want to know the rules of the game in play, even as I know the rules of the game, or the game itself, might change.

Are we seated in the front row of Carnegie Hall, or the bleacher seats at Wrigley Field? Not that it matters all that much which it is; I'm pretty mellow about these things. I just want to know the framework. Am I supposed to have a glass of funky chardonnay to chase funny-ass brie on dry crackers; or am I allowed to have a hot dog with the works, including onions, chased with a big-ass cup of Old Style?

I can play it either way; I just want to know. Logical men, and women, don't drink expensive chardonnay with a frankfurter! And they don't chug cheap beer with expensive cheese. Would be embarrassing, you see. And I don't like to embarrass myself out of ignorance. What's the framework in play?

In portfolio management, the framework is an investment manager's philosophy and process. Here at PIMCO, our framework starts with our secular assessment, involving many dimensions. Most fundamentally, however, our secular forecasting process is about anticipating structural change in the power relationship between the public sector and the private sector: the never ending struggle between democracy, founded on the principle of one person, one vote; and capitalism, founded on the principle of one dollar, one vote. And that's just for the United States, founded on the principle of democratic capitalism.

Over the years, particularly since the end of the Cold War, our secular forecasting process has evolved and expanded to include efforts to anticipate structural change in the power relationship between countries, some which reject democratic capitalism itself and many which embrace a different strain of democratic capitalism than the United States. This is not easy stuff, making the process seem like a three-dimensional (at least!) chess game at times. But it is necessary work, and never more so than after the Tragedy of September 11, 2001, which profoundly changed both (1) the relationship between the public and private sectors here in the United States, and (2) the relationship of the United States with other sovereign countries.

Thinking people everywhere viscerally knew the world changed the day the Towers crumbled. But only now are the true dimensions of the associated secular, or structural, macroeconomic changes coming into view:

  • America is becoming a less capitalistic place, as the visible hand of government grabs power from the invisible hand of capitalist markets.


Secular Victory Over Inflation Justifies Fed Accommodation Of Fiscal Deficits
The figure is a line graph showing the real U.S. fed funds rate and federal deficit, superimposed with U.S. CPI (Consumer Price Index) inflation, from 1955 to 2003. The line for the CPI inflation is roughly symmetrical over the period, peaking at around 11% in 1980, but showing more normal ranges on either side of the peak, of about 0% to 4% for most years. The real fed funds rate, by contrast, fluctuates between about negative 5% to positive 4% before 1980, but afterwards it mainly floats between 0% and 5%, with a peak of near 8% in the early 1980s. However, the real fed funds rate has trended downward ever since, and goes negative in 2002, falling to lower than negative 1%. The federal deficit over the time period shows it growing over time, meaning on the graph it trends deeper into the negative until the early 1980s, where it bottoms around negative 5%, then starts trending upward to a surplus of more than 2% around 2000, before then ending up at about negative 2% in 2002.

  • America is becoming more unilateralist and less multilateralist in its dealings with other sovereign countries, increasingly telling both foes and friends that they can embrace the American way or hit the highway of isolation.

As an American citizen, I have a personal view on these matters, as discussed two months ago. 1 As an investment manager, however, my personal view does not matter. Rather, what matters is that an America-led overthrow of the Iraq political regime will ineluctably beget secular changes in America's - indeed, the world's - macroeconomic policy regime.

It matters in detail, of course, whether America pursues a multi-lateral or a unilateral road to Baghdad. But most elementally, it does not. American imperialism is, by definition, a retreat away from global capitalism, a retreat from the invisible hand of markets in favor of a more dominant role for the visible fist of governments. It's a framework change!

Who Will Discipline Whom?
While my private soul agonizes over the prospect of America preemptively going to war, I recognize that I only have the professional bona fides to comment on the macroeconomic "externalities" of the matter. And the one that fascinates me most is a looming change in the monetary/fiscal policy mix: who will discipline whom?

In 1981, Tom Sargent (a father of the "rational expectations" school of theoretical economic thought) and Neal Wallace wrote a seminal academic article on this question: Some Unpleasant Monetarist Arithmetic, published in the Minneapolis Fed Quarterly Review. 2 I'll never forget when I first read their theoretically powerful, yet easy to read, essay on the nature of the fiscal/monetary policy framework.

I quickly grasped (as a young man without the baggage of a career of public views!) the essence of Sargent and Wallace's work: the "sustainability" of any monetary/fiscal policy mix comes down to the arithmetic relationships between three variables.

  • The level for short-term real interest rates maintained by the monetary authority.
  • The real growth rate of the economy.
  • The growth path for the real stock of debt incurred by the fiscal authority, as determined by real fiscal deficits as a share of real GDP.

Sargent and Wallace demonstrated - using arithmetic! - that it is not possible for (1) the monetary authority to sustainably peg real short-term interest rates above the real growth rate of the economy if (2) the fiscal authority insists on enduringly running fiscal deficits as a percent of GDP that is higher than the real growth rate of GDP. Such a combination implies exponentially rising growth for real fiscal interest costs as a share of GDP, which is arithmetically unsustainable. Ultimately, such a combination implies a confrontation: either (1) the monetary authority must cut real short-term interest rates (speed up growth in the monetary base) and/or (2) the fiscal authority must cut deficits as a share of GDP.

Recall, the context for Sargent and Wallace's work was 1981, with Paul Volcker running monetary policy as described, and President Reagan running fiscal policy as described. The monetary and fiscal authorities were playing a grand game of chicken: who would discipline whom?

As secular time unfolded over the 1980s and 1990s, Sargent and Wallace's question was answered: the monetary authority sustained its secular course of "opportunistic disinflation" and the fiscal authority blinked.

  • President Reagan "mid-course corrected" with tax hikes in 1984, notably on the corporate sector, in particular by lengthening depreciation schedules.
  • President George Walker Bush recanted his "read my lips" not to hike taxes by doing so in 1990, notably by hiking the highest marginal income tax rate on the rich.
  • President Clinton recanted his campaign call for tax cuts for the middle class, notably by hiking the highest marginal income tax rate on the rich, while also uncapping the income limit on payroll taxes designated for Medicare expenditures.

In all three cases, the putative reward for fiscal tightening was monetary loosening: a more "sustainable" mix between growth in the fiscal authority's real debt service burden and the monetary authority's peg for the real short-term interest rate. Everybody "knew" this was the deal, even though the monetary authority denied that it was trying explicitly to discipline the fiscal authority. The Fed claimed it was simply targeting "sustainable" growth in the real economy in the context of secular disinflation. The monetary authority was not reacting to fiscal deficits per se, the mantra went, but only to how fiscal deficits - and expectations of fiscal deficits - were affecting the economy.

It was always ruse, aided and abetted by the cheering of Wall Street, notably the mythological "bond market vigilantes." We all knew the framework: The Fed was going to resolutely target lower and lower nominal GDP growth, cycle by cycle, until it had secularly squeezed the inflation component of nominal GDP growth to a rate consistent with the holy grail of "price stability." Thus, fiscal actions to stimulate nominal aggregate demand would be met with tighter monetary policy; and fiscal actions to restrain aggregate demand would be met with easier monetary policy. The Fed's goal of secularly lower nominal GDP growth would be a binding constraint: the fiscal policy authority could alter the composition of real GDP growth, maybe even boost it through "supply side" incentive effects. But the fiscal authority would not be allowed to boost nominal GDP growth.

And so it was, and by the end of the 1990s, America had achieved secular "price stability." Fed Chairman Greenspan had become the Maestro: the fiscal authority kissed his backside at every chance, seeking his blessing for whatever they might contemplate; and Wall Street kissed his ring at every chance, in thanks for the riches wrought by soaring P/E multiples on stocks.

America had also, regrettably, inflated triple bubbles in equity valuation, business investment and corporate leverage. Such was the price, an inevitable and unavoidable price for winning the secular war against inflation, Mr. Greenspan argued last summer in Jackson Hole. 3 Nothing it could have done about it, he resolutely maintains.

In contrast, I resolutely believe that bubbles can be identified as they are bubbling, not just in the aftermath of them blowing up. Put differently, I believe that the Fed could have, and should have, tempered the bubbles of the late 1990s, using all available means. But the Fed didn't. I hasten to add that this is not simply a matter of me holding a grudge against Mr. Greenspan, as some will surely suggest (with some degree of validity!). I am quite sure that Mr. Greenspan does not care in the least about what I think.

Rather, what matters is that America (1) achieved secular price stability while (2) blowing up the triple bubbles. This is a nasty combination, with deflationary risk written all over it. Accordingly, the time has come for a new framework for the monetary/fiscal policy mix, on both cyclical and secular horizons.

It is time for a reversal in who disciplines whom: it is time for fiscal policy to lead, and monetary policy to follow, the exact opposite of the last two decades. It's a new mix capable of reflating nominal GDP growth in the face of Post Bubble Disorder 4 in private business: re-leveraging of the fiscal authority's balance sheet, accommodated by the monetary authority, as the private sector de-leverages its balance sheet.

These are not simply matters of personal political preferences. Are policy makers willing to embrace a bold reversal to fiscal policy dominating monetary policy, rather than the other way around? If so, reflationary policies are likely to "get traction." If not, deflationary risk will inch closer to deflationary reality. It really is that simple, with profound implications for global asset allocation, and for portfolio strategy within asset classes.

Is the Fed Willing To Go Unconventional Preemptively?

That's a mouthful of a question, but a key one, I think. Last November, in the testimony before Congress, 5 Fed Chairman Greenspan trumpeted the unused powers of the Fed to address deflationary risk, even if the Fed funds rate were to hit the lower zero limit: the Fed could bring down long term rates by lengthening the duration of its holdings.

A couple weeks later, in a speech before the National Economists Club, 6 Fed Governor Bernanke saw Mr. Greenspan's ante and upped him: the Fed not only has the power to address deflationary risk, hopefully preventing it, but also the power to cure deflation reality, if preventative efforts fail. Mr. Bernanke quite logically argued that the " best way to get out of (deflationary) trouble is not to get into it in the first place." It was, in his own words, a "commonsense injunction."

And he offered three conventional preventative steps. Again in his own words:

  • "First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation all the way down to zero.
  • Second, the Fed should take most seriously - as of course it does - its responsibility to ensure financial stability in the economy.
  • Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and aggressively than usual in cutting rates."

But what if this three-prong preventive program were to fail? In the finest example of policymaker transparency I've witnessed in over twenty years of looking for it, Governor Bernanke candidly asked: " …suppose that, despite all precautions, deflation were to take hold in the US economy and, moreover, that the Fed's policy instrument - the federal funds rate - were to fall to zero. What then?" The answer, he declared, was "the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys."

Echoing Chairman Greenspan, he opined, " I suspect that operating on longer-term Treasuries would provide sufficient leverage for the Fed to achieve its goals in most plausible scenarios." But he didn't stop there, going on to say that if such efforts "proved insufficient to restart spending, the Fed might next consider attempting to influence the yields on privately issued securities." I immediately dubbed this statement as the birth of The Bernanke Put, an explicit reflationary promise beneath private sector debtors' heavy wings!

It was a powerful statement about the power of the Fed's printing press. Wall Street rejoiced, notably those trafficking in corporate bonds. The Fed was not too blind to see the risk of a debt deflation meltdown, and was ready to respond forcefully, if that risk morphed into reality! That declaration by Governor Bernanke was the stuff of headlines, and rightly so. I only wish that the headlines had also included what Mr. Bernanke said about fiscal policy, and particularly the scope of anti-deflation coordination of monetary and fiscal policy.

Here's what he had to say, which I believe is hugely important, as it applies not just to the case of arresting deflationary reality but mitigating deflationary risk. Indeed, I submit that Mr. Bernanke should have made a coordination of monetary/fiscal policy the fourth course on his three-course menu of monetary cooking to prevent deflationary anoxia in nominal aggregate demand!

Here's what Governor Bernanke said:

"Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous 'helicopter drop' of money.

Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets"

Bottom Line

Wow! Every time I read and re-read that passage from Governor Bernanke, I ask: why doesn't Mr. Greenspan - the Maestro, remember? - read it, and surrender some of his hegemony in the Beltway to the fiscal authority? Why do fiscal authorities continue to genuflect to Mr. Greenspan, a man who achieved much for his country by grasping power, but who doesn't know how to let go? Why, why, why?

I don't know. But what I do know is that until the monetary/fiscal policy mix is structurally changed to restore the preeminence of the fiscal authority, monetary policy promises to address deflationary risks, and to reverse deflationary realities, are a frankfurter without onions, smothered with dividend tax-cut brie, chased with a flat chardonnay spritzer, served in a dirty beer cup.

Pardon me if I my risk appetite refuses to belch with satisfaction. It's hard to do so while sitting on the dock of the deflationary cliff.

Where are John Maynard Keynes and Otis Redding when you need them?

Paul A. McCulley
Managing Director
December 27, 2002

1 "Necking In The Mezzanine," Fed Focus, December 2002.

2 http://minneapolisfed.org/research/qrqr531.html

3 http://www.federalreserve.gov./boarddocs/speeches/2002/20020830/default.htm

4 Post Bubble Disorder, Fed Focus, April 2001.

5 http://www.federalreserve.gov./boarddocs/testimony/2002/20021113/default.htm

6 http://www.federalreserve.gov./boarddocs/speeches/2002/20021121/default.htm


Past performance is no guarantee of future results. Investment return will fluctuate and the value of an investor's shares will fluctuate and may be worth more or less than original cost when redeemed. This article contains the current opinions of the author but not necessarily Pacific Investment Management Company LLC, and does not represent a recommendation of any particular security, strategy, or investment product. The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale.

Treasury Bonds guarantee timely repayment of interest and does not eliminate market risk, shares of a funds are not guaranteed. P/E is a ratio of security price to earnings per share. Typically, an undervalued security is characterized by a low P/E ratio, while an overvalued security is characterized by a high P/E ratio..

No part of this publication may be reproduced in any form, or referred to in any other publication, without express
written permission of Pacific Investment Management Company LLC (PIMCO). ©2003, PIMCO

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