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Economic and Market Commentary

The Morgan le Fay Plan

Mohamed El-Erian, PIMCO's Emerging Market's Maestro, is a close professional colleague. He's also an even closer personal friend. He and I talk a lot, about a lot of things, both professional and personal. We do not, however, talk about anything between 4 am and 5 am. For, you see, Mohamed and I have very different perspectives about the early morning hours. He believes that if a man is silly enough to work Wall Street hours on the West Coast, he should be either asleep at 4 am, or up and on his way to work. In contrast, I believe that it is perfectly rational for a man to get up at 4 am to simply sit in the solitude of the last hours before dawn, gathering his wits and contemplating life, if not his navel.

Thus, on most work days, if you want to reach Mohamed between 4 am and 5 am, you should either email or call him at his trading desk. If you want to reach me, you can certainly email me, as I'm wired in my home study. But please, don't call me, as you'll unnecessarily wake up my family and probably not get a hold of me either, as I'm only in my study intermittently (when emailing with Mohamed or my right hand man on PIMCO's Money Market Desk, Saumil Parikh). Most of the time between 4 am and 5 am, sometimes a touch longer, I'm hanging out in the small yard just outside my study, sometimes reading and sometimes not. Most of the time, I'm simply enjoying the soothing quiet of the darkness with Morgan le Fay, my family's pet Netherlands Dwarf rabbit. Morgan likes the early hours too, as is the genetic wont of rabbits, and is a happy companion, particularly if I spoil her with dandelion greens, her favorite.

Unlike Jimmy Stewart's rabbit pal, Harvey, Morgan does not engage in conversation, even when I quote long passages of Keynes to her. She just munches on her greens and wiggles her ears, as if in agreement with whatever I'm muttering about. I like that; and I'll wager it's a much better greeting than Mohamed gets from many of the sell-side brokers that are contemporaneously jangling his phone! In any event, my one-way conversation with Morgan in the early hours inevitably comes 'round to the macroeconomic question that has been befuddling me for years: Is the world safe for G-1 Keynesianism?

American Producers of Durable Goods Have Negative Pricing Power

Figure 2 is a line graph showing the trade-weighted U.S. dollar index of major currencies versus the global durable goods price deflator, from 1982 to late 2000. Overall, both metrics are in long-term downward trends. The trade weighted dollar index, expressed on the right-hand vertical axis, is around 100 in 2000, down from about a peak of 140 around 1985.  But in recent years, the index trends upward, to a seven-year high of almost 110 before declining slightly, still up from around 80 in 1995. The other metric—the year-over-year change in the durable goods price deflator, is expressed on the left-hand vertical axis. It falls to about negative 3% by late 2000, down from its chart high of around 5.6% in 1982.

Figure 1
Source: Federal Reserve, Bureau of Economic Analysis

In the Fullness of Time, When Is Time Full?
I actually coined that question in November 1998, six months before coming home to PIMCO. I was on a two-week sojourn through Asia with senior macro colleagues at UBS Warburg, right after the Committee To Save the World, composed of Alan Greenspan, Bob Rubin and Larry Summers had acted to, well, save the world: a Fed-orchestrated bailout for LTCM and U.S. interest rate cuts in a fully-employed American economy. Such an approach risked higher domestic inflation, but was warranted, the Committee decided, so as to bolster flagging global aggregate demand in the wake of imploding emerging market economics and systemic risk aversion and contagion in "risk assets."

Being a congenital optimistic from south of the Mason Dixon Line, and also a Keynesian, I dubbed the Committee's preemptive war against global deflation to be G-1 Keynesianism, and declared that it was good. My old colleagues, most of British extraction, agreed that it was Keynesianism alright, and agreed that the Committee's actions were good for the moment. But they argued that "in the fullness of time" (which became the nickname for the tour after it was over!), G-1 Keynesianism would simply exacerbate already evident global imbalances: too much consumption in the United States, excessive speculation and investment in the United States, too little saving in the United States, and too large a current account deficit in the United States. All of these excesses would simply be made worse by G-1 Keynesianism, I was told, and there would be a day of reckoning, when the rest of the world would "force" the United States to start "living within its means," presumably by fleeing the dollar.

I certainly agreed with their forecast that putative U.S. imbalances would get even larger: if they didn't, the Committee to Save the World would have failed! G-1 Keynesianism was all about America playing global spender, investor and borrower of last resort, which definitionally meant a larger, much larger U.S. current account deficit, and its mirror image, a larger, much larger U.S. capital account surplus: America would play the Keynesian drinker and the rest of world would play mercantile bartenders. Not the best way to run a global economy, I agreed with my colleagues from the other side of the pond, but better than a world of no drinkers and only tea-totaling barkeeps. G-3 Keynesianism was what the world really needed, but better G-1 Keynesianism than G-0 Keynesianism, I preached. My old colleagues reluctantly agreed, but would not stop carping about the unsustainability of it all, and how it would all come back to bite America in the bum. In the fullness of time, of course.

Still Waiting
That was four years ago, and G-1 Keynesianism has been the coin of the global macroeconomic realm ever since. America's putative imbalances have gotten bigger and bigger, just as forecast. But there has been no day of reckoning, in which the world has boycotted the dollar, forcing America to start living within its means. Quite to the contrary, the biggest fear in global macroeconomic circles is that America will choose - not be forced! - to start living within its means, notably the America consumer, the last bastion of American hedonism. Time has passed, but time has not become full for G-1 Keynesianism, because the alternative remains G-0 Keynesianism, rather than the much preferred G-3 Keynesianism. While the world may not be safe in the long run for the imbalances wrought by G-1 Keynesian, the long run ain't here yet. Put differently, the rest of the world has not "forced" America to start living within its means via a crash for the dollar. And for that, we should be grateful, even if not surprised.

At the same time, G-1 Keynesianism is much less potent than it was four years ago, because it (helped to) beget bubbles in corporate investment and leverage in America, which subsequently blew up. Thus, the power of G-1 Keynesianism has increasingly become hostage to its "ability" to produce a bubble in U.S. property prices, which the American consumer can monetize through ever-higher leverage. Accordingly, I believe that the time has come for America to orchestrate a regime change in global monetary affairs.

Rather than the rest of the world "forcing" America via a lower dollar to start living within its means, the time has come for the United States to "force" the other two G-3 members via a higher Euro and Yen to start living up to their means. Put differently, rather than a falling dollar forcing tighter Fed policy, the worrywarts' forecast (hopes?) for years, the time has come for a rising Euro and Yen to force easier European Central Bank and Bank of Japan policy. Put differently still, for those who like their macroeconomics kept simple, the time has come for America to stick a lower dollar into the deflationary ears of the European and Japanese monetary authorities, until they scream reflationary Keynesian aggregate demand uncle.

But, you retort, America has a "strong dollar" policy, articulated first by Committee to Save The World co-founder Robert Rubin, reaffirmed by fellow Committee member Larry Summers, and reaffirmed still again by current Treasury Secretary O'Neill. Didn't Mr. O'Neill say that he'd rent out Yankee Stadium to announce any change in that "strong dollar" policy, if in the fullness of time, he were ever to make such a change? Yes, Mr. O'Neill did in fact say that. Thus, before America could stuff a lower dollar into the deflationary ears of European and Japanese monetary authorities, it would indeed be necessary for Mr. O'Neill to change his rhetoric. But since rhetoric has been the sum and substance of American currency "policy" for many years, that shouldn't be a problem. After all, Mr. O'Neill has shown that he does know how to chew his shoe off, when his foot has inadvertently planted it in the wrong place. His prudent flip-flop on the matter of the prudence of a lending package for Brazil was a case in point.

On the matter of the America's "strong dollar" policy, my hunch is that Mr. O'Neill really would like to rent out Yankee Stadium and ditch Mr. Rubin's words. After all, no less an authority than Committee to Save the World co-founder Alan Greenspan repeatedly says that Mr. O'Neill, and only Mr. O'Neill, speaks for the President on America's currency policy. Yet Mr. O'Neill is constrained from speaking by the words of his predecessors: a most uncomfortable straightjacket on the tongue of a man that likes to talk! He could set himself free by simply declaring himself free. His time has become full.

Bretton Woods Nostalgia
Morgan le Fay and I frequently meditate nostalgic about Bretton Woods, because it was a system in which it was easy for America to "force" its trading partners to follow the Fed's lead. Recall, Bretton Woods was a very simple arrangement: (1) the dollar was pegged to gold at $35 an ounce, (2) non-dollar currencies were fixed against the dollar, and (3) America ostensibly stood ready to exchange gold for dollars accumulated by non-U.S. central banks. Thus, if America wanted to pursue Keynesian aggregate demand stimulation (and it did!), America could "force" other central banks to follow.

How so? A boost in aggregate demand in the United States would (1) increase America's trade/current account deficit, which would (2) tend to put downward pressure on the dollar vs other countries, which would (3) compel them to pursue easier monetary policy, including buying dollars, so to (4) prevent gold from rising above $35 an ounce and/or their currencies from appreciating against their fixed ratios vs the dollar. Theoretically, of course, non-U.S. central banks could stop the "game" by demanding that the United States deliver gold at $35 ounce for the dollars they were accumulating, compelling the United States to curtail aggregate demand, and thus reduce its trade/current account deficit - the source of "excess" dollar supply that was putting downward pressure on the dollar.

As a practical matter, however, America had no intention of sending all the gold in Fort Knox anywhere, as France's Charles De Gaulle found out when he suggested that America do so in exchange for the "excess" - inflationary! - dollar reserves that the Bank of France was accumulating to keep the French Franc from appreciating. In August 1971, President Richard Nixon simply "closed the gold window," effectively blowing up the Bretton Woods arrangements: the dollar was as good as America said it was, and not an ounce of gold more.

Which, of course, ushered in the accelerating inflation of the 1970s. So, why would I wax nostalgic for such a system? Simple: it was a mighty fine system for avoiding deflation. As a thought exercise, consider what would have happened under the Bretton Woods arrangements if America had pursued deflationary policies, put downward pressure on the dollar price of gold, making it "want" to trade south of $35 an ounce. Didn't happen, of course, but just the opposite. But if it had, America would have been "compelled" to reflate, so as to keep gold from deflating. The beauty of the Bretton Woods system was that it linked global monetary policy to something tangible, which served as a proxy for globally-traded goods prices.

Don't get me wrong here. The "something" of Bretton Woods was gold, and I've never, ever been a gold bug. The beauty of Bretton Woods was not gold per se, but a nominal anchor for globally-traded goods prices. Indeed, Bretton Woods could have been founded on a basket of globally-traded goods, rather than gold. The founders of the system - led by Keynes himself! - actually considered that possibility, but wisely rejected it, given the historical role/acceptance of gold as a monetary anchor. The risk of the system was that America would print too many dollars, not too few, relative to its stock of gold. And, of course, this risk was realized, which forced all central banks to print too much money relative to the global stock/supply of gold, begging accelerating global inflation. But at least the system had the redeeming characteristic of being anti-deflationary, because of the lead role of (Keynesian!) American monetary policy.

Such is not the case today. To be sure, American monetary policy is Keynesian, in that the Fed is explicitly seeking to boost aggregate demand in the United States. But Fed policy is not anchored by a nominal price target for globally-traded goods, which are deflating even in the context of positive aggregate inflation for the United States. Even more troubling, G-1 Keynesianism tends to put upward, not downward pressure on the dollar, as global investors rationally seek to park their savings in a country that is pro-growth in a deflationary world. Thus, the Paradox of G-1 Keynesianism is revealed: America cannot stop deflation in globally-traded goods prices by itself (see graph on cover).

Bottom Line
The time has come for the Fed and the U.S. Treasury to join forces, with Alan Greenspan cutting short rates and Paul O'Neill explicitly declaring that a strong dollar is not in America's interest. It is also time for America to announce to its G-3 partners that a weaker dollar is not a problem to be solved, but an opportunity to be seized by Euroland and Japan to aggressively ease monetary policy, using all available means, including non-sterilized currency intervention to temper the dollar's fall, and monetization of private sector assets. Yes, my friends, it is time for G-3 Keynesianism, in an all-out preemptive war against deflation.

Next Wednesday's FOMC meeting provides an excellent opportunity for the Fed to start the campaign. Here's what I'd like to hear the FOMC say:

"Incoming evidence, from both high-frequency data on Main Street and price action in capitalism-driven private sector asset prices on Wall Street, suggest that the risks to renewed economic growth are deteriorating, while the risks to price stability are unfortunately skewed in the direction of deflation in global-trading good prices. Accordingly, the Federal Open Market Committee, cognizant of its responsibility to promote stability in both the domestic and global economic theaters, voted today to cut the Federal Funds rate by 50 basis points, to 11/4 percent, while encouraging the U.S. Treasury Department to incorporate this action into its setting of American currency policy, and asking other G-3 members to take complementary actions to stimulate recovery in globally-traded goods prices. A revival in global profitability in the traded goods sector, as evidenced by an end to deflationary pricing exigencies, should be the collective, and united objective of G-3 monetary authorities."

The FOMC's not going to say that, of course. The FOMC is, however, likely to cut the Fed funds rate by 50 basis points to 11/4%. And I'm willing to bet that the European Central Bank follows in a matter of weeks, if not days.

Call it the Morgan le Fay Plan on the installment plan.

Paul A. McCulley
Managing Director
October 31, 2002


Past performance is no guarantee of future results. This article contains the current opinions of the author but not necessarily Pacific Investment Management Company LLC. This article is distributed for educational purposes only and does not represent a recommendation of any particiular security, strategy, or investment product. The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed reliable, but not guaranteed. No part of this publication may be reporduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC (PIMCO). Copyright 2002 PIMCO FF019-103002

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