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Economic and Market Commentary

State Of Mind


The global economic landscape is a-changing with a global synchronized recovery underway. By definition, that means the sweet nirvana of robust U.S. growth with falling inflation is yesterday’s investment thesis.

U.S. business and residential investment has risen hand-in-hand with foreign savings inflows. This pattern stands in dramatic contrast to the mid-1980s when the U.S. fiscal and current account deficits grew together, which former Fed Chairman Volcker famously labeled the “twin deficits.”

Global economic healing need not be toxic to the health of the U.S. economy. But it might, if the Fed mistakenly pursues a blood-letting policy. Accordingly, prudent investors should be stocking the shelves with lower-fat, lower-salt food. We are doing precisely that here at the PIMCO home.


When I announced at Warburg in April that I was returning to PIMCO, colleagues and friends asked, “Why?” My response, “I’m going home.” Now, anybody who’s heard me speak more than two words knows that I didn’t grow up in southern California. So, they asked, “How can you be going home?”

Home to me is not a geographical place, but a place where a group of people share common values and goals, and at the same time, respect an individual’s right to be different. Home is a place where success is both individual and collective, where brothers fight like hell to quarterback the high school football team, but then cheer like hell for the chosen one to make the family proud on Friday night. Home is also a place where criticism can be offered and received, bluntly and frankly, without enduring rancor or embarrassment. Home is a place where imperfect human beings agree to transform their collective strengths into a force more powerful than their individual weaknesses. In sum, home is not actually a place, but a state of mind.

PIMCO has that state of mind. Last month’s “Fed Focus” was my coming-home rite of passage. Bill Gross’ counsel was simple, though elegant:

“Dare to sound stupid to your old Wall Street economist peers. Keep it simple, keep it concise, and draw common sense conclusions, which are not all that common.”


What We've Done With Foreign Savings
   Figure 1 is a chart showing U.S. non-residential investment, residential investment, and the current account, from 1970 to 1990. All of the metrics are expressed as a percentage of U.S. gross domestic product. Non-residential and residential investment are relatively flat over the period. Non-residential investment as a percentage of GDP rises to 11%, up from around 9.5% in 1992, while that of residential investment rises to about 4.2%, up from 3.5%. The current account metric declines to negative 2.5% in 1999, down from 0% in 1991. The metric is around 0% in 1970, around which it fluctuates until the early 1980s, before dipping to a chart low of about negative 3.5% by 1987.
Figure 1
Source: First Boston

I took Bill’s dare, offering a kind word for populism, which I don’t think any of my old Wall Street peers have ever done. I haven’t heard from many of them, so I must have done something right! As for Bill’s injunction to keep it “simple and concise,” let’s just say I’m working on it. Global monetary policy is anything but simple at the moment, so it’s hard to explain concisely. But I will try harder, starting now.

The Global Economic Landscape Is A-Changing

The 1990s have been a secular journey of a de-synchronized global business cycle, with the U.S. consistently robust, but with Japan, Europe and the Emerging Countries rotating in and out of the cyclical cellar. Economically speaking, this has been unfortunate for the world, but salutary for the U.S. Excess global capacity has operated as a “shock absorber” for cyclical inflationary pressures and global excess savings have operated as a “shock absorber” for capital market strains. The global economic landscape is a-changing, however, with a global synchronized recovery underway . By definition, that means the sweet nirvana of robust U.S. growth with falling inflation is yesterday’s investment thesis.

And it calls for a new Fed state of mind. The Fed, like PIMCO, is a home of individually-smart people trying to synergistically blend their smarts to serve their clients. Unlike PIMCO, however, the Fed is charged with serving its domestic clients first, and its international clients second. In fact, the Fed’s biggest dilemma in recent years has been to find the “sweet spot” between policy that is right for the U.S. and policy that is right for the rest of the world.

As a practical matter, the Fed has been viscerally and strategically biased to tighten in recent years, viewing extraordinary U.S. growth and falling inflation as inherently unsustainable in the long run. To be sure, the FOMC has not been tactically biased-to-tighten all the time; but that’s where its collective “soul” has been. It was both intellectually and emotionally difficult for the Fed to go the other way and ease last year. It did so only when it was unambiguously clear that a globally-driven “seizing up” of the U.S. credit markets, itself at least in part an “externality” of the Fed’s domestic-driven bias to tighten, threatened to undermine U.S. economic performance. It was not a comfortable shift for the FOMC, and it took the shut-up-and-listen leadership of Chairman Greenspan to implement it.

But the FOMC’s collective, domestic-driven urge to tighten didn’t go away, and the Fed has “taken back” two-thirds of last year’s internationally-driven easing. In fact, minutes of last year’s FOMC meetings reveal that Mr. Greenspan promised his anti-ease colleagues last fall that some or all of the easing would be unwound, if and when it was no longer “needed.” I have no doubt that most of Mr. Greenspan’s colleagues would like to “take back” the last one-third of the easing. And here at PIMCO, we believe the FOMC will indeed do so, probably within the next six months.  

And After That?

For investment strategy, the question of whether there will be a “last take back” is not all that important. Let’s assume the Fed does. The key investment strategy issue is what happens after that. Will the U.S. economy slow sufficiently to relieve policymakers’ visceral hunch that too many Americans are employed?

“Hold on,” I hear some of you retorting. Tightening is not needed to throw people out of work. The problem is not that too many Americans have a job, but that too many Americans spend too much and save too little, as evidenced by America’s mushrooming and unsustainable trade deficit. Thus, tightening is required to curb Americans unsustainable spending on foreign goods and services, which by definition must be financed dollar-for-dollar with foreign savings inflows.

Thus, you continue, the case for tightening is not about throwing Americans out of work, or even dealing with the wage-inflation risk of the existing level of U.S. employment. Rather, the case for tightening is about pre-emptively reducing America’s dependence upon foreign savings, before foreign savers abruptly cut us off.

The argument has a moral overtone. But I can’t really complain about that, because my argument for principled populism also has a moral overtone. In the end, matters of political economy always have a moral overtone, and reasonable people can have honest differences of opinion. Such debates should, however, be informed by facts, and I submit that the data simply does not support the proposition that Americans are in the midst of an orgy of consumption funded by foreign savings.


Greenspan Has A Higher-Quality "Problem" Than Volcker Did
   Figure 2 is a line graph showing U.S. net private, public, and foreign savings, from 1970 to 1999. The savings rates are expressed as a percentage of nominal U.S. gross domestic product. In mid-1998, net foreign savings reach almost 4%, up from about 0% in 1993 and are at their highest point since about 1987. Net public savings are at almost 2% in mid-1998, up from a low of more than negative 4% in 1992. Net private savings are at their lowest level on the chart in mid-1998, at more than negative 4%, down from almost positive 4% in 1991.
Figure 2
Source: First Boston

The Facts

As Figure 1 displays, U.S. business and residential investment has risen hand-in-hand with the U.S. current account deficit, which is identical to American’s capital account surplus, or foreign savings inflows. This pattern stands in dramatic contrast to the mid-1980s, as shown in Figure 2, when the U.S. fiscal and current account deficits grew together, which former Fed Chairman Volcker famously labeled the “twin deficits.” Back then, America was using foreign savings to buy $600 toilet seats for military aircraft. Now, America is using a fiscal surplus and foreign savings to buy a larger, more technologically-advanced capital stock, and to build enough houses to drive the home-ownership rate to its highest in American history.

Yes, it might well be the case that high equity P/Es are over-stating the prospective return from some of that business investment. But if the Fed deems that overstatement to be so egregious as to represent a bubble, then it should deal with it directly, by hiking margin requirements for borrowing against stocks (as I argued last month). It is simply not the case, however, that residential property valuation is in bubble territory, as the P/E has fallen despite increased foreign savings inflows.

As shown in Figure 3, valuation for residential U.S. property market has been in secular decline ever since 1979! In contrast to the 1970s environment of rising property valuation on the back of rising inflationary expectations, property valuation has actually become progressively “cheaper” on the basis of “shelter services” (the analytical equivalent of stock earnings), which have been rising more quickly than the value of property itself.

To be sure, some of those homes may have more bathrooms than they need, in both Newport Beach, California and in Newport, Rhode Island. But I know of no macroeconomic text that advocates that the Fed should fine-tune the plumbing in either Newport! A proper macroeconomic test for whether foreign savings inflows have promoted “irrational exuberance” in U.S. property must be based on nationwide data.

Thus, I believe Fed should reject the moralist notion that Americans must pre-emptively start “living within their means,” cutting their so-called dependence on foreign savings. The financing has been used for a combination of technology-driven business investment and increased home ownership. The fiscal deficit of the 1980s “crowded out” both of those things; the current fiscal surplus is “crowding in” those things. I thought that was the objective of fiscal restraint!

But the fact remains, many will counter, that the U.S. private sector is running a huge international financing deficit, as displayed in Figure 2. Absolutely true. As a matter of accounting, not economics, it is a tautology that the fiscal surplus plus the capital account surplus (the current account deficit, with the sign flipped) must equal the private sector’s investment minus its savings. But with all due respect to accountants, accounting is a static exercise. In contrast, both capitalism and macroeconomic policymaking are dynamic exercises.

What Housing Bubble?
   Figure 3 is a line graph that shows the U.S. housing price-to-rent multiple, the average price of an existing home, and the average rent, from 1970 to 1999. The housing price-to-rent multiple is around 20% in 1999, close to its chart-bottom of 19%, and down from a chart-high of about 26% in 1980. The average price of an existing home rises steadily over the graph, reaching around 6.8 around 1999, up from its index of 1.0 in 1970. Average rent also rises over the period, to about 6.0, up from an index level of 1.0 in 1970.
Figure 3
Source: Warburg Dillon Read

Remebering Keynes

 If the United States were to refuse to allow entrepreneurs to invest unless they could “fund” themselves with their personal savings, the world would be in a dire state. As Keynes taught long ago, investment should not be viewed as constrained by the availability of savings, which are a function of income, but by the willingness of animal-spirited economic agents to take risk. Indeed, that was the essence of Keynes’ revolutionary insight: While investment and savings must, as an accounting matter, equal each other after the fact, such an accounting necessity in no way means that investment and savings will equal each other at a desirable level. Indeed, the accounting tautology of investment = savings will/must hold in a depression!

With the world economy presently and manifestly operating at less than full employment, an increase in global investment would be a wonderful thing, and by increasing global income, would generate increased global savings. Simply put, global investment is not a zero-sum game out of a fixed supply of global savings. Both can, and should, go up at the same time!

Changes in prospective relative returns to investment around the world will, to be sure, lead to changes in the relative prices of those investments. And with the ex-U.S. world improving, that means that investments outside the U.S. should/will rise in price relative to those in the U.S. That can happen in a variety of ways, of which the most deleterious would be for non-dollar assets to go down, with dollar assets going down even more, via some combination of a falling dollar and falling dollar asset prices.

The possibility of this outcome is, of course, nectar for the sky-will-fall crowd, which argues that the Fed should vigorously tighten to choke U.S. demand growth, thereby reining in the “unsustainable” current account deficit. I submit that if the Fed follows this advice, the consequence will be a far worse outcome than the current account deficit! By destroying the investment climate in the U.S., vigorous Fed tightening would inevitably produce a hard landing: less investment, lower income growth, less savings, and more inflation. Such an approach, as MIT Professor Krugman has preached, would represent a return to “depression economics.”  

So, What Should The Fed Do?

It should accept that in a globally-healing economic world, the U.S. inflation rate is unsustainably low, and should let it rise somewhat. “The Fed simply can’t do that,” some of you will retort. “The Fed’s mission, as you admit yourself, is America first, and the Fed simply cannot, and will not sacrifice America’s hard-won victory over inflation.”

I agree. But I also believe that victory over inflation must be measured in secular time, not cyclical time. A disciplined, proven central bank need not prove its anti-inflation credibility in real time, just like a disciplined, proven investment manager need not outperform his/her benchmark every minute of every day. Both need a long-term view, and the Fed’s long-term view is, and should be, to maximize U.S. economic activity consistent with price stability.

Price stability is not a precise rate of inflation, held precisely constant all the time. Rather, as Mr. Greenspan has famously declared, price stability is a state of mind: That place where long-term investment decisions are not contaminated by either inflationary or deflationary expectations, where risk premiums associated with the financing of long-term investments will be their lowest and, by implication, where employment will be at its highest. The combination of high equity P/Es relative to residential property P/Es is a powerful proof statement that the U.S. has reached the promised land of price stability with full employment.

It is unfortunate that the U.S. has achieved this goal while the rest of the world has not. But it would be the height of folly for the U.S. to declare that it will pro-actively make the U.S. a less attractive place for investment, as a hedge against the risk that foreign investors might conclude that it is a less attractive place to invest, in the context of an improving global investment environment. The hard-landing cost of the hedge would be worse than the risk, which is not actually a risk, but a desired outcome.  

Trouble In The G-3 Central Bank Home

This is particularly the case in light of the Bank of Japan’s resolute pursuit of deflationary policy and the European Central Bank’s avowed intent to tighten monetary policy at the first signs of growth, which is actually being driven not by inflationary demand, but a deflationary supply side revolution. Indeed, as Mohamed El-Erian, PIMCO’s Head of Emerging Markets, has cogently and publicly warned, a significant risk to the global healing scenario is that the G-3 central banks tighten for parochial reasons (in Japan’s case, blithely accepting a stronger yen) and, in the process, give the world a deflationary shock. 1

The global central bank community was a functioning home last fall, with a clear goal of re-liquefying the globe, which ineluctably involved a falling dollar. It was a proud moment. Now, however, with re-liquefaction inching toward reflation, the central bank community is inching toward a dysfunctional home, with members threatening individually rational courses that are collectively irrational.

I believe the Fed will resist getting sucked into this deflationary game, aiming for a U.S. soft-landing, not a rapid reduction of the U.S. current account deficit, which could only be “achieved” via a hard landing. I must admit, however, that the FOMC’s decision last week to readopt a tightening bias did not bolster my soft-landing faith. After all, the FOMC officially declared, as recently as late August, that inflation risks were “markedly diminished.” Perhaps Mr. Greenspan signed off on the bias, merely to keep peace in the FOMC home, since he plans to “take back” the last of last year’s easing. If so, no problem. But the associated rhetoric did hint that prospective tightening might not be just about taking back easing, but about brute forcing U.S. growth into submission: “…the Federal Open Market Committee will need to be especially alert in the months ahead to the potential for costs to increase significantly in excess of productivity growth in a manner that could contribute to inflationary pressures.”  


Global economic healing need not be toxic to the health of the U.S. economy. But it might, if the Fed mistakenly pursues a blood-letting policy. Accordingly, prudent investors should be stocking the shelves with lower-fat, lower-salt food. As Bill explained in his unique shut-up-and-listen fashion in last month’s Investment Outlook , we are doing precisely that here at the PIMCO home. We are in a quality state of mind.

Paul McCulley
Executive Vice President
October 11, 1999







1 " The World Is Healing, But Still Delicate,” Sunday Business, September 26, 1999.


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, 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 is 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. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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