From zeevs thread via george cole
Top PIMCO strategist says Fed should aggressively reflate to avoid economic "meltdown."
More troubling, Pimco managing director Paul McCulley argued on the firm's Web site
today that the entire U.S. economy may be on the brink of a "meltdown" due to ongoing
revelations of corporate malfeasance and resulting risk intolerance among banks.
"If we don't see a renewal in risk appetite in the corporate lending market in the next six
to 12 months, then we are on a very greased banana peel toward a Japan-type
syndrome," McCulley said, with typical flair, in a follow-up interview. (Concerns about
Japan-style deflation were commonly heard last year but have recently faded, as the
economy improved and some signs of inflation re-emerged. McCulley certainly isn't
alone in warning of the risk of a deflationary spiral here, but is the most notable market
participant to publicly discuss it, certainly in recent memory.)
Being the conduit for the Fed's role as lender of last resort, banks "serve a unique place
in the financial firmament," he continued. "The banking system has got to step up and
take responsibility, as opposed to contracting banks' lines of credit," as is occurring
now.
The most recent Fed survey of senior loan officers found "further tightening of standards
and terms for loans to both businesses and households."
McCulley recommended the Fed "order the banking system to quit withdrawing from
'liquidity lending,'" using the term "order" quite intentionally. The quid pro quo of the
commercial banks' access to the Fed's discount window is they are "supposed to lend
when the capital markets are caught in a paroxysm of rectitude," he wrote.
Of course, banks prefer to lend when times are flush and retreat in tougher
environments, but "with inflation near the 'tipping point' into deflation, the pro-cyclicality of
bank lending is noxious at the macroeconomic level," McCulley wrote.
Let's set aside for now the debate over whether a Japan-style deflationary scenario is
more a risk than the re-emergence of inflationary or "stagflationary" pressures: McCulley
clearly believes the former risk is greater and his second recommendation is that Fed
Chairman Alan Greenspan should convey "the doctrine of pre-emptive tightening to be
dead and buried." Point being it's easier for the Fed to deal with a re-emergence of
inflation than the onset of deflationary pressures, as Japan's experience demonstrates.
In arguing "the Fed must be willing to use all its powers to save capitalism from itself,"
McCulley incorporated the macroeconomic theories of John Maynard Keynes, the
essence of which he described as: "Attack private sector deflation with public sector
reflation."
Secondly, McCulley cited the work of Hyman Minsky, an economics professor and author
of (among others) Stabilizing an Unstable Economy, who in 1992 wrote about three
types of corporate borrowers, which the professor labeled "hedge, speculative, and
Ponzi finance."
The concern being that many speculative finance units -- which Minsky defined as those
that "need to 'roll over' their liabilities -- issue new debt to meet commitments on
maturing debt," i.e. most of Corporate America -- are "being exposed as Ponzi finance
units in drag," McCulley wrote. "These developments are, as Minsky declared, a
prescription for an 'unstable system' ... in which the purging of capitalist excesses is not
a self-correcting therapeutic process, but a self-feeding contagion: debt deflation."
McCulley doesn't believe we reached that juncture yet, but fretted we're "far closer to the
point than I thought we would get 18 months ago, or even three months ago."
Meanwhile, as I write this, President Bush is talking about the potential for investors to
lose faith in the free enterprise system.
Hard times, indeed.
P.S.
I did ask McCulley about the cynical view that his piece is curiously timed. Pimco has,
with some fanfare, recently taken positions in high-yield corporate bonds and telecom
debt, most notably of AT&T (T:NYSE - news - commentary - research - analysis) and
Sprint (FON:NYSE - news - commentary - research - analysis). Some saw today's
missive as a backhanded request for a bailout.
He replied: "It doesn't surprise me that charge is on the tip of someone's tongue, and
there's no question we are the beneficiaries, along with the economy at large, of
enlightened monetary policy. [But] we're big boys and are not saying 'bail us out.' This is
more of a piece of policy advocacy, which benefits all investors."
For the record, McCulley was critical of the Fed in the late 1990s for not doing more to
help quell the boom -- i.e. raising margin requirements -- but said "now is not the time
[for the Fed] to operate in a temperate fashion."
Finally, McCulley agreed the Treasury bond market would have a visceral reaction if the
Fed were to take additional accommodative measures -- beyond keeping the fed funds
rate at a 40-year low despite a 6.1% first-quarter GDP and widespread consensus the
rebound continues.
But comparing Treasuries to "an insurance policy against Armageddon," he suggested,
"the last thing you want is a screaming rally in Treasuries. You can barely measure
interest rates in Japan and that's not a good thing." |
