Bill Gross, the founder of PIMCO and manager of the world’s largest bond fund, has just released his most recent Economic Outlook. In it, he takes a tack regarding the fix to the present turmoil in the markets with which I disagree. However, I would like to draw your attention to his analysis as his voice carries weight in the market place.
The current financial and economic crisis is difficult to appreciate, not only for the drop in elevation, but because of the swiftness of the declines. It’s been a Wile E. Coyote 12 months – straight down like a dead weight. A year ago, global equity prices were nearly twice today’s levels and recession was only a whisper on the lips of the gloomiest of economists. Today, descriptions drawing parallels to the Great Depression make it obvious that a major shift in economic growth and its historic financial model, as well as policy prescriptions for its revival, are underway. Most of the world’s connected economies and its citizens are in shock, conscious but not fully aware of the seismic shifts that will unfold in future years.
PIMCO’s thesis for several years has held that the levered global economy long ago morphed from a banking-dominated regime to one that hid behind securitized lending and structures resembling a “shadow banking” system. SIVs, hedge funds, CDOs and increasingly levered mortgage and investment banks fueled asset appreciation in all investment markets, which in turn propelled real economic growth and employment to unsustainable levels. But, with U.S. housing prices as its trigger, the delevering process did a Wile E. Coyote and headed over the cliff in mid-year 2007, dragging down almost all asset prices except government bonds. The real economy followed shortly thereafter, not just in the U.S., but globally, proving that linkages work on the “down” as well as the upside. To PIMCO, the remedy for this deflationary delevering and mini-depression is simple and almost axiomatic: stop the decline in asset prices. If that can be done, the real economy will level out as well. When home prices stop going down, newly created households will be more willing to take a chance on ownership as opposed to renting. If stock prices consolidate, recently burned investors will be more willing to invest, as opposed to stuffing their 401(k) mattresses with Treasury bills. Business investment, jobs, and profits should follow quickly behind.
My disagreement with Gross comes mainly from my view that asset prices should not be propped up artificially, but rather should find a floor as quickly as possible. In my view, stopping the decline in prices — a decline which I see as inevitable due to excessive leverage and debt — is only going to drag things out. Dragging things out reduces confidence, creating an environment of fear and uncertainty in which spending stops, bank runs start, and the nanny state intervenes. Gross takes a view that I see akin to the Japanese solution, but in an environment which is more dangerous because of the leverage debt and synchrony in the downturn across economies globally.
To be fair, Gross does admit that the solution would not be easy once deflation has taken hold as it did in Japan. However, I would argue that deflationary forces are very close to taking hold here now if they have not done so already.
Gross closes his piece with his advice to policy makers in Washington:
PIMCO’s advice to policymakers is as follows: you can’t bail out everyone, yet economic recovery is not possible unless certain critical asset sectors are not only reliquefied, but rejuvenated in price. The prior Administration’s focus on the banks has been critical but unidimensional. The shadow banking system with its leverage and financial innovation, powered a near 25-year global economic expansion, but it is the delevering of those hidden quasi-banks that is now threatening its petrification. Policymakers should not focus entirely on one-off bailouts of large real estate developers, municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather, they should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even investment grade corporate bonds is a necessary step towards eventual economic revival. Capitalism at its philosophical and practical center depends on credit, and while new loans can be and are being advanced via the banking system, it’s a much more difficult task to force shadow banks to lend. That lending depends on securitization which in turn depends on stable and eventually higher asset prices than currently exist. The original focus of the TARP was on asset prices, but the prior Administration quickly lost its way or perhaps its nerve.
Despite my disagreement with Gross, please do read the full article linked below. His comments regarding deleveraging in the shadow financial system are very much a concern because this deleveraging of the shadow banking system is the major source of credit contraction right now. Banks themselves may, in fact, be lending more. The ballooning of the M2 money supply aggregate suggests this is indeed the case. Gross’ desire to end one-off solutions and look to a more all-encompassing approach is also right on the money. Moreover, he is an investor who has often proven correct.
Source
Beep! Beep!: PIMCO investment Outlook, February 2009 – Bill Gross, PIMCO